At the interface of Treasury and Accounting:

Over the past business year, we observed many treasury departments using derivative financial instruments for risk management purposes for the first time. At year-end, these new hedges presented the accounting department with the challenge as to how to recognize them in the balance sheet for the first time. We share insights from our findings in this article. 

As a result of rising interest rates, it was particularly common to enter into interest rate hedging instruments such as interest rate swaps and/or interest rate options in the form of interest rate caps and interest rate floors for the first time as a means of managing interest rate risks economically. When there are one or more floating-rate loans in a rising market interest rate environment, it may make absolute economic sense to fix the interest rate for the company via an interest rate swap or to limit the risk with a cap. Also, currency hedging instruments in the form of forward exchange contracts and forex options have been increasingly entered into for the first time. Businesses can use these instruments to help reduce their exposure to exchange rate fluctuations in purchases and sales, thereby increasing planning certainty. 

When derivative financial instruments are entered into for the first time in a company, however, it is important to consider not only the economic perspective but also the accounting perspective. It is possible to account for derivative financial instruments as freestanding instruments or to designate them for hedge accounting in accordance with the requirements of IFRS 9. With freestanding derivatives, changes in fair value are recognized in full in the income statement over the derivative's life cycle. By contrast, a designation in hedge accounting means that the changes in the value of the hedging instruments are either recognized in other comprehensive income (cash flow hedge accounting/net investment hedges) or the hedged item and the hedging instrument are subject to the same accounting policy and therefore offset in the income statement (fair value hedge accounting). However, the use of hedge accounting requires that the formal requirements of IFRS 9.6.4.1 are met, that hedging instruments and hedged items can be measured appropriately in accordance with IFRS 13, and that their correct recognition in the balance sheet is ensured, for example, by means of test cases. In addition, extensive disclosures must be generated in the Notes within the meaning of IFRS 7.21 et seq. 

Below, you will find practical examples taken from the implementation of hedge accounting, which illustrate the challenges that arise from the conflicting demands of economic hedging and material accounting errors:

1. Valuation of derivative financial instruments
   If derivative financial instruments are to be correctly recognized in the balance sheet, a corresponding valuation infrastructure is required, which traditionally lies within the responsibility of the treasury department. It is essential to be able to value derivative financial instruments in the company, regardless of whether hedge accounting is applied or not. Even simple instruments such as forward exchange transactions require a proper determination of fair value, based on current market data at the valuation date and a correspondingly appropriate methodology (ideally a treasury management system with corresponding valuation functionality). Using simplified approaches such as translating the far leg of a forward exchange contract using the spot rate without factoring in discounting is not sufficient and can lead to significant valuation differences, particularly in an environment of increased interest rates. In addition, IFRS 13 requires a determination of the credit default risk for the derivatives portfolio, which often requires market data that is not readily available with CDS spreads. Determining the credit default risk is also relevant for hedge accounting purposes and is therefore a necessary data input for the accounting department. Where the hedging instrument is subject to credit default risk as defined by hedge accounting, no credit default risk is to be allocated to the hedged item as part of the determination of effectiveness. For this to be reflected appropriately by the accounting department, it must be possible to determine the credit default risk at the level of the individual hedging relationship. Another relevant factor for hedge accounting under IFRS 9 is that valuations of forex hedging instruments can differentiate between spot and forward components.¹ The reason for this is that individual components of the forward component (for example, the foreign currency basis) are generally not included in the hedged item and must therefore be recognized either as ineffectiveness or, if so designated, separately in OCI II (cost of hedging reserve), while the effective portion of the spot component is recognized in OCI I (cash flow hedge reserve) not affecting profit or loss. Consequently, the treasury department must provide the relevant information to ensure adequate processing in the accounting department. 
2. Interest rate hedges including follow-up financing
   For economic reasons, it may make sense for the treasury department to use interest rate hedges to hedge the current financing and anticipatory underlying transactions. A good example is the hedging of an already firmly contracted financing including follow-up financing (forecast debt issuance), which is exposed to an interest rate risk owing to a variable interest rate. If it is intended to account for this hedging relationship in hedge accounting, it needs to be taken into account that the fixed contracted term of the financing has a shorter term than the hedging instrument. For the portion of the forecast debt issuance, proof must be provided that the occurrence at the designation date and over the term is considered highly probable (see IFRS 9.6.3.3 in conjunction with IFRS 9.B6.5.27(b)).² Should the treasury department not (or no longer) be able to provide this proof at the beginning or during the hedging relationship, the accounting department must immediately discontinue its hedge accounting and adjust its accounting system accordingly.
3. Diverging closing dates between hedged item and hedging instrument (interest)
   Upon entering into the derivative and the financing, the treasury department must ensure that the relevant valuation parameters, such as the interest payment dates, the reference interest rate or the interest calculation method, are the same for both and that there is no overhedging in order to implement hedge accounting in the most standard way possible. At the same time, an interest rate swap can be concluded together with the underlying loan. In practice, however, an interest rate swap is frequently concluded at a later date to hedge an existing variable-rate loan. In such cases, the most effective hedging relationship requires that the parameters such as interest payment dates, term, nominal, etc. are consistent between the underlying and hedging transactions. If the value-determining parameters do not match, it is not possible to use the so-called critical terms match method to prospectively measure effectiveness. In that case, quantitative evidence of the economic hedging relationship is required prior to applying hedge accounting.³ One example of such quantitative evidence is the hypothetical derivative method, which, similar to the content described under 1), requires a corresponding valuation infrastructure. Using this method, effectiveness can be measured by comparing changes in the value of the hedging instrument with changes in the value of the hedged item which is represented by the hypothetical derivative. Often, a mirror of the hedging instrument is used for the hypothetical derivative in practice. It should be noted that the hypothetical derivative may only contain characteristics of the hedged item in the form of the hedged risk. This means that it generally does not contain any credit default risk and may not have a market value at the time of designation. In case that the parameters of the hypothetical derivative deviate, it is necessary to calibrate to EUR 0 at the designation date, in which the fixed leg is adjusted accordingly. Any ineffectiveness arising from the existing deviating calibrated leg must be measured on an ongoing basis during the hedging relationship and recognized accordingly in profit or loss by the accounting department. 

The successful application of hedge accounting requires close cooperation between a company's treasury department and its accounting department.

While Treasury ensures that the economic risk of the hedged item and hedging instrument are consistent and provides the derivative measurement, Accounting ensures that the hedging instruments and hedged items are correctly recognized in the balance sheet. For the purpose of ensuring that IFRS 9's extensive requirements for the application of hedge accounting, as well as IFRS 7's more extensive requirements for the reporting of hedging relationships, are met, it is essential that the departments treat the possible introduction of hedge accounting as a joint project. Because only through close cooperation between the treasury and the accounting departments and a clear division of responsibilities can it be ensured that the requirements for the application of hedge accounting are met and that correct accounting is applied. Ideally, the departments should coordinate their activities before derivatives are entered into to ensure that the hedging strategies can be appropriately reflected in the balance sheet. The Finance and Treasury Management team will gladly assist you in taking the necessary steps to implement hedge accounting in your organization.

Source: KPMG Corporate Treasury News, Edition 133, June 2023
Authors:
Ralph Schilling, CFA, Partner, Head of Finance and Treasury Management, Treasury Accounting & Commodity Trading, KPMG AG
Marie Czentarra, Managerin, Finance and Treasury Management, Treasury Accounting & Commodity Trading, KPMG AG

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¹ IFRS 9.6.5.15(c)
² The phrase "highly probable" is not explicitly defined in IFRS. The literature states that there must be a probability of occurrence of at least 90% for the transaction to be considered highly probable (cf. KPMG Insights into IFRS (2022/2023), para. 7.9.430.20).
³ KPMG Insights into IFRS (2022/2023), para. 7.9.830.100