Qualifying criteria for hedge accounting

Three criteria for hedge accounting

A hedging relationship qualifies for hedge accounting only if all of the following criteria are met:

Eligible instruments only

The hedging relationship consists only of eligible hedging instruments and eligible hedged items.

Formal designation and documentation

At the inception of the hedging relationship there is formal designation and documentation of the hedging relationship and the entity’s risk management objective and strategy for undertaking the hedge. That documentation shall include identification of the hedging instrument, the hedged item, the nature of the risk being hedged and how the entity will assess whether the hedging relationship meets the hedge effectiveness requirements (including its analysis of the sources of hedge ineffectiveness and how it determines the hedge ratio)

Hedge effectiveness

The hedging relationship meets all of the following hedge effectiveness requirements:

  1. there is an economic relationship between the hedged item and the hedging instrument
  2. the effect of credit risk does not dominate the value changes that result from that economic relationship; and
  3. the hedge ratio of the hedging relationship is the same as that resulting from the quantity of the hedged item that the entity actually hedges and the quantity of the hedging instrument that the entity actually uses to hedge that quantity of hedged item. However, that designation shall not reflect an imbalance between the weightings of the hedged item and the hedging instrument that would create hedge ineffectiveness (irrespective of whether recognised or not) that could result in an accounting outcome that would be inconsistent with the purpose of hedge accounting.

Hedge effectiveness

When the fair value of the hedged item increases, then the fair value of the hedging instrument decreases in the case of an economic hedging relationship. But, sometimes, the incremental change in the fair value of the hedged item may not exactly off set the fair value changes in the hedging instrument, resulting in some ineffectiveness.

Hedge effectiveness is the extent to which changes in the fair value or the cash flows of the hedging instrument offset changes in the fair value or the cash flows of the hedged item. When the hedged item is a risk component, the relevant change in fair value or cash flows of an item is the one that is attributable to the hedged risk. Hedge ineffectiveness is the extent to which the changes in the fair value or the cash flows of the hedging instrument are greater or less than those on the hedged item.

Whenever there is ineffectiveness, the entity should analyse the source of hedge ineffectiveness that are expected to affect the hedging relationship during its term. This analysis forms the basis while analysing the entity’s assessment of meeting the hedge effectiveness requirements.

Economic relationship between hedged item and hedging instrument

The requirement that an economic relationship exists means that the hedging instrument and the hedged item have values that generally move in the opposite direction because of the same risk, which is the hedged risk. Hence, there must be an expectation that the value of the hedging instrument and the value of the hedged item will systematically change in response to movements in either the same underlying or underlyings that are economically related in such a way that they respond in a similar way to the risk that is being hedged (for example, Brent and WTI crude oil)

Sometimes when the underlyings are not the same but are economically related, the incremental changes in the fair values of the hedged item and the hedging instrument may move in the same direction instead of the anticipated opposite direction. This happens due to the price differential between two related underlyings changes while underlyings themselves do not move significantly. In this case, the economic relationship between the hedged item and the hedging instrument may still be consistent if the incremental changes in the fair values are expected to eventually move in the opposite direction. The ultimate test is whether an economic relationship exists that satisfies the requirements of the risk management objective of the entity. But, mere existence of a statistical co-relation between the two variables does not by itself mean that there is an economic relationship between the hedged item and the hedging instrument.

Effect of credit risk

The hedge effectiveness is determined only with respect to the economic relationship between the hedged item and the hedging instrument. However, the effect of credit risk may sometimes vitiate the fair value changes of either or both the hedging instruments and the hedged items. Where the counter party for both these instruments is the same, then the credit risk involved in the economic hedging relationship is nullified completely.

The effect of credit risk means that the incremental fair value changes of the two items may be erratic. This may be due to change in the credit risk of the hedged item or the hedging instrument or both and the change is of such magnitude that it vitiates the existing economic relationship between the two instruments. The main reason for the requirement that the effect of the credit risk does not dominate the fair value changes that result from the economic relationship is to prevent the excessive hedge ineffectiveness on account of the existence of credit risk in one or both instruments.

Hedge ratio

Hedge ratio refers to the number of units that are used is hedging instrument for the purpose of hedging the hedged item. Usually, the ratio is 1:1 for most of the financial instruments. For example, if the entity wants to hedge a fixed rate debt instrument of say Rs 10 crore, then if the hedging instrument happens to be an interest rate swap, then the notional amount of the interest rate swap would also be Rs 10 crore. This means that the hedge ratio is 1:1.

In accordance with the hedge effectiveness requirements, the hedge ratio of the hedging relationship must be the same as that resulting from the quantity of the hedged item that the entity actually hedges and the quantity of the hedging instrument that the entity actually uses to hedge that quantity of hedged item.

If an entity hedges 85% of the exposure on a hedged item, then the entity should use the same hedge ratio of 85% while designating a hedging relationship using the same hedge ratio. For example, if an entity hedges only 60% of the fixed rate debt exposure as per its risk management strategy, then while designating the hedging relationship the entity should designate only 60% of the value of debt security as the hedging instrument. The entity is not allowed to increase or decrease the hedge ratio that is in accordance with the actual hedge that the entity undertakes as per its risk management strategy.

The designation of the hedging relationship using the same hedge ratio that the entity actually uses in its risk management strategy should not create an imbalance between ratings of the hedged item and the hedging instrument that is used by the entity for hedging purposes.

Frequency of assessing the hedge effectiveness requirements

An entity shall assess at the inception of the hedging relationship, and on an ongoing basis, whether a hedging relationship meets the hedge effectiveness requirements. At a minimum, an entity shall perform the ongoing assessment at each reporting date or upon a significant change in the circumstances affecting the hedge effectiveness requirements, whichever comes first. The assessment relates to expectations about hedge effectiveness and is therefore only forward looking.

Methods for assessing the hedge effectiveness requirements

The accounting standard does not specify a method for assessing whether a hedging relationship meets the hedge effectiveness requirements. An entity shall use a method that captures the relevant characteristics of the hedging relationship including the sources of hedge ineffectiveness. Depending on those factors, the method can be a qualitative or a quantitative assessment.

Matching critical terms

When the critical terms (such as the nominal amount, maturity and underlying) of the hedging instrument and the hedged item match or are closely aligned, it might be possible for an entity to conclude on the basis of a qualitative assessment of those critical terms that the hedging instrument and the hedged item have values that will generally move in the opposite direction because of the same risk and hence that an economic relationship exists between the hedged item and the hedging instrument.

Out of money/In the money

The fact that a derivative is in or out of the money when it is designated as a hedging instrument does not in itself mean that a qualitative assessment is inappropriate. It depends on the circumstances whether hedge ineffectiveness arising from that fact could have a magnitude that a qualitative assessment would not adequately capture.

Critical terms not closely aligned

If the critical terms of the hedging instrument and the hedged item are not closely aligned, there is an increased level of uncertainty about the extent of offset. Consequently, the hedge effectiveness during the term of the hedging relationship is more difficult to predict. In such a situation it might only be possible for an entity to conclude on the basis of a quantitative assessment that an economic relationship exists between the hedged item and the hedging instrument. In some situations a quantitative assessment might also be needed to assess whether the hedge ratio used for designating the hedging relationship meets the hedge effectiveness requirements. An entity can use the same or different methods for those two different purposes.

Changing the method

If there are changes in circumstances that affect hedge effectiveness, an entity may have to change the method for assessing whether a hedging relationship meets the hedge effectiveness requirements in order to ensure that the relevant characteristics of the hedging relationship, including the sources of hedge ineffectiveness, are still captured.

Hedge effectiveness requirements

Rebalancing is permitted for the purpose of maintaining the hedge ratio to comply with the hedge effectiveness requirements. Changes to designate quantities of a hedged item or hedging instrument for a different purpose do not constitute rebalancing.
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