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11.8 Hedge effectiveness criterion
Publication date: 14 Oct 2019
us IFRS & US GAAP guide
Both US GAAP and IFRS permit application of hedge accounting to only certain eligible hedging instruments and hedged items and require formal designation and documentation of a hedging relationship at the beginning of the relationship and an assessment of effectiveness. However, the detailed requirements for hedge effectiveness vary between the two frameworks. Unlike US GAAP, there is no high effectiveness criterion to qualify for hedge accounting under IFRS. Instead, IFRS 9 requires an economic relationship between the hedged item and the hedging instrument, which is a less restrictive test.
US GAAP
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IFRS
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Hedging relationships are required to be highly effective in achieving offsetting changes in fair value or cash flows attributable to the hedged risk.
The term “highly effective” has been interpreted in practice to mean that the change in fair value/cash flows of the designated component of the hedging instrument is within 80 to 125% of the change in fair value/cash flows of the designated proportion of the hedged item attributable to the risk being hedged.
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A hedging relationship needs to meet the following effectiveness requirements:
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11.8.1 Nature and timing of effectiveness assessments
Both US GAAP and IFRS require initial and ongoing assessments of effectiveness. However, the nature and timing of these effectiveness assessments vary between the two frameworks.
US GAAP
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IFRS
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In certain cases, an initial quantitative assessment is required. In addition, periodic effectiveness assessments need to be performed on both a prospective basis (to reconfirm forward-looking expectations) and a retrospective basis (to determine whether the hedge was highly effective).
Effectiveness assessments are required at hedge inception and periodically thereafter, with an assessment required whenever financial statements or earnings are reported, and at least every three months. The initial assessment may be completed by the end of the quarter. Additionally, simplified approaches exist for nonpublic nonfinancial institutions.
When assessing effectiveness of hedges of forecasted transactions, entities can ignore timing differences between the hedged transactions and the maturity date of the hedging instrument within 31 days or a fiscal month (when that is the only difference between the derivative and the hedged forecasted transactions).
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A retrospective effectiveness assessment is not required. However, an entity must make an ongoing assessment of whether the hedge continues to meet the three hedge effectiveness criteria described in SD 11.8.
There is no requirement to perform effectiveness assessments every three months. The ongoing effectiveness assessment needs to be performed at each reporting date (which may only be semi-annually or annually) or upon a significant change in circumstances. It is only a forward-looking test.
The requirement to maintain the hedge ratio (#3 in SD 11.8) ensures alignment with the economic hedging strategy. The hedge ratio must be rebalanced to maintain the hedge ratio that the entity actually uses to achieve its economic hedging strategy. Entities should not need to rebalance very often if they have a good risk management strategy in place and the economic relationship is stable.
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11.8.2 Recognition of ineffectiveness
IFRS requires measurement and recognition of ineffectiveness in a hedging relationship even though the hedge meets the effectiveness criteria. US GAAP no longer has a concept of ineffectiveness that is separately measured and disclosed, although there may still be an income statement impact for certain hedges. Both IFRS and US GAAP permit an entity to exclude certain components from the assessment of effectiveness and separately account for them, which may improve hedge effectiveness, as discussed in SD 11.8.3.
US GAAP
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IFRS
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For cash flow and net investment hedges, hedge ineffectiveness is not separately measured and recognized in income each reporting period. If the hedge is highly effective, all changes in the fair value of the derivative hedging instrument will be recorded in other comprehensive income (OCI) (in cumulative translation adjustment (CTA) for net investment hedges), unless different recognition is prescribed/elected for any excluded components. Any difference between the gain or loss on the hedged item and the derivative (except for the excluded component) is recognized when the hedged item affects earnings, at which time the amount deferred in AOCI from the hedging instrument is released to earnings.
On the other hand, for fair value hedges, because the change in fair value of the hedged item attributable to the hedged risk and the derivative hedging instrument are both recorded in current earnings, if the hedge is not perfectly effective, there will be an income statement impact. While not identified as ineffectiveness, a reporting entity is required to disclose the change in fair value of the hedged item attributable to the hedged risk and the change in fair value of the derivative.
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For cash flow hedges, the effective portion of the change in the fair value of the hedging instrument is recognized in OCI. The amount recognized in OCI should be the lower of (1) the cumulative gain or loss on the hedging instrument from the inception of the hedge, and (2) the cumulative change in the fair value (present value) of the expected cash flows on the hedged item from the inception of the hedge. The remaining ineffective portion of the change in the fair value of the hedging instrument (if any) is recognized in profit or loss.
For hedges of a net investment in a foreign operation, the effective portion of the change in the fair value of the hedging instrument is recognized in OCI and the ineffective portion of the hedging relationship is recognized in profit or loss.
For fair value hedges, both the effective and ineffective portions of the hedge relationship are recorded in profit or loss.
IFRS 7 requires disclosure of ineffectiveness.
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11.8.3 Amounts excluded from effectiveness assessment
Both US GAAP and IFRS permit an entity to exclude certain components of the change in the fair value of a hedging instrument from the assessment of effectiveness. However, the standards diverge in certain respects on what is permitted to be excluded.
US GAAP
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IFRS
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An entity may elect to exclude certain components of the change in value of the derivative from the assessment of effectiveness for fair value and cash flow hedges:
For derivatives designated as net investment hedges, an entity is only permitted to use either (1) the spot method in which the entire difference between the spot price and the forward or futures price is excluded or (2) the full fair value method. Further, an entity is not permitted to exclude only part of the spot-forward difference when using the spot method.
US GAAP prohibits the exclusion of any other components of the hedging instrument.
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IFRS 9 only permits three components to be excluded from the effectiveness assessment:
IFRS 9 does not prescribe a specific methodology for calculating the value of the excluded components. However, a discounted calculation (such as discounted spot or discounted intrinsic value) is generally required since IFRS requires an entity to consider the time value of money when measuring hedge effectiveness.
Additionally, entities can elect to exclude only the foreign currency basis spread component of the spot-forward difference for forward contracts, which is not permitted under US GAAP.
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11.8.3.1 Accounting for amounts excluded from effectiveness assessment
US GAAP and IFRS diverge regarding how to account for a component excluded from the assessment of effectiveness.
US GAAP
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IFRS
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For cash flow, fair value, and net investment hedges, an entity may choose between two methods to account for an excluded component:
Amortization approach
The initial value of the excluded component is recognized in earnings using a systematic and rational method over the life of the hedging instrument, with any difference between the change in fair value of the excluded component and the amount in earnings recognized in OCI (CTA for net investment hedges).
Mark-to-market approach
The changes in fair value of the excluded component are recognized in current earnings.
Unlike IFRS, US GAAP does not have a specific concept of aligned time value (i.e., time value that only relates to the hedged item) or aligned forward element.
When using the spot method, discounting of the spot rate is not required (and in the case of a net investment hedge, discounting is not permitted).
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IFRS 9 has specific guidance by type of derivative.
Options
For cash flow, fair value, and net investment hedges, if an entity elects to designate only the intrinsic value of the option as the hedging instrument, it must account for the changes in the “aligned time value” (i.e., when the critical terms of the option and hedged item are aligned) in OCI and hold those changes in a hedging reserve in equity.
Recognition of the aligned time value in profit or loss will depend on whether the hedge is transaction-related (and recorded in profit or loss at the same time as the hedged item) or time period-related (and recorded in profit or loss using a systematic and rational basis over the period of the hedge).
Forwards points and currency basis spread
An entity may recognize changes in value due to changes in forward points or foreign currency basis spread in profit or loss immediately or defer them using the recognition guidance for options.
Aligned portion
Recognition of the excluded component applies to the aligned portion, i.e., the portion for which the critical terms such as notional, price, term and underlying of the derivative and the hedged item are aligned. This is called the “aligned time value” or “aligned forward element.”
IFRS 9 specifies a particular calculation methodology that can be complex to apply when the actual time value or forward element is lower than the aligned time value or forward element at inception of the hedge.
When the change in spot rate is the designated hedged risk, entities still need to consider the time value of money and, when appropriate, measure the hedged item using the discounted spot rate. However, for a net investment hedge, we believe that an entity can choose not to impute a time period into the hedging relationship and designate the hedged risk without discounting.
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