Hedge accounting models
|Fair value hedge
|Cash flow hedge
|Net investment hedge
Top 10 differences between IFRS 9 and ASC Topic 815
Hedge accounting, which is optional, appeals to companies involved in hedging activities. It matches gains and losses on hedging instruments with the hedged items that would otherwise be mismatched because of measurement or recognition differences – with derivatives requiring measurement at fair value through earnings absent a hedge accounting designation. Not all economic hedging relationships are eligible and the qualifying criteria are complex and subject to strict documentation. With the introduction of IFRS 91 in 2018, the eligibility of hedge accounting has significantly expanded and here we summarize how hedge accounting works and key differences between IFRS 9 and ASC 815.
The objective of hedge accounting under IFRS Standards is to represent, in the financial statements, the effect of risk management activities that use financial instruments to manage the exposures arising from certain risks that could affect profit or loss (P&L) or other comprehensive income (OCI).
The appropriate hedge accounting model employed depends on whether the hedged exposure is a fair value exposure, a cash flow exposure, or a foreign currency exposure on a net investment in a foreign operation.
|Fair value hedge
|Cash flow hedge
|Net investment hedge
Hedge accounting is subject to meeting the following strict qualifying criteria.
|Qualifying hedged items
The hedged item is an item (in its entirety or a component of an item) that is exposed to the specific risk(s) that a company has chosen to hedge based on its risk management activities. To qualify for hedge accounting, the hedged item needs to be reliably measurable.
A hedged item can be:
|Qualifying hedging instruments
Only contracts with a party external to the reporting entity can be designated as hedging instruments.
The following contracts with a party external to the reporting entity may qualify:
Many of the hedge accounting requirements are the same under IFRS Standards and US GAAP, such as the three hedge accounting models, documentation and qualifying criteria; however, since the introduction of IFRS 9 in 2018 and the FASB’s release of ASU 2017-123, the differences in hedge accounting have expanded as the two Boards have differing views.
The 10 differences described below represent some of the most significant differences that could pose a challenge to dual reporters, companies that are changing their reporting between IFRS Standards and US GAAP, and companies that are converting an acquiree’s accounting policies from IFRS Standards to US GAAP (or vice versa).
1. Hedge effectiveness requirement
‘Hedge effectiveness' is the extent to which changes in the fair value or cash flows of the hedging instrument offset changes in the fair value or cash flows of the hedged item for the hedged risk.
When testing effectiveness, IFRS 9 has moved away from bright lines and focuses on an objective-based test that requires an economic relationship of critical terms between the hedged item and the hedging instrument. If the critical terms of the hedging instrument and the hedged item – e.g. the nominal amount, maturity and underlying – match or are closely aligned, then it may be possible to use a qualitative methodology to determine whether an economic relationship exists between the hedged item and the hedging instrument. In other cases, a quantitative assessment may be more appropriate. Additionally, IFRS 9 requires that (1) the effect of credit risk does not dominate the value changes that result from that economic relationship and (2) the hedge ratio matches the quantity of the hedged item and hedging instrument that the company hedges. Unlike IFRS 9, to qualify for hedge accounting under US GAAP, the hedging relationship must be highly effective – generally accepted to mean a range from 80% to 125% – which is more restrictive than IFRS 9. The assessment relates to expectations about hedge effectiveness; therefore, the test is only forward-looking or prospective.
Further, IFRS 9 provides the concept of ‘rebalancing’ the hedge ratio, which does not require a company to dedesignate the hedging relationship if it subsequently fails to meet the hedge effectiveness requirement but the company's risk management objective for that designated hedging relationship remains the same. Unlike IFRS 9, US GAAP has no concept of mandatory ‘rebalancing’. If a company subsequently modifies the critical terms of a hedging relationship, the company may be required under US GAAP to dedesignate the original hedging relationship and in that case may designate a new hedging relationship that incorporates the revised terms.
2. Measurement of ineffectiveness
For qualified cash flow hedges, under IFRS 9 the effective portion of changes in the hedging instrument’s fair value is recognized in OCI and reclassified into profit and loss when the associated hedged item affects earnings. Ineffectiveness is recognized in profit and loss only when the cumulative change in fair value of the hedging instrument is greater than the cumulative change in the fair/present value of the expected future cash flows on the hedged item attributable to the hedged risk. A similar ‘lower of’ test is also used for net investment hedges. While measuring ineffectiveness under IFRS Standards, a company is required to consider the time value of money; therefore, the value of the hedged item is determined on a present value basis.
Under US GAAP, a company is not required to separately measure hedge ineffectiveness. Instead, the entire change in the fair value of the hedging instrument included in the assessment of hedge effectiveness is recorded in OCI (or the currency translation adjustment section of OCI in the case of a net investment hedge).
3. Hedge effectiveness assessment methodology
IFRS 9 requires only prospective assessment of hedge effectiveness on an ongoing basis, at inception of the hedging relationship and at a minimum when a company prepares annual or interim financial statements. Unlike IFRS 9, US GAAP requires a prospective and a retrospective assessment whenever financial statements are issued or earnings are reported, and at least every three months.
4. Voluntary dedesignation
IFRS 9 does not permit voluntary dedesignation of a hedge accounting relationship that remains consistent with its risk management objectives. Dedesignation is required when the hedging relationship ceases to meet the qualifying criteria, such as through a change in the initially determined risk management objective. Unlike IFRS 9, US GAAP permits voluntarily dedesignation of a hedging relationship at any time after inception of the hedging relationship.
5. Risk component hedging
IFRS 9 and US GAAP both permit hedging risk components related to nonfinancial items in cash flow hedges. US GAAP limits the nonfinancial component hedging by requiring the hedged component to be contractually specified. However, IFRS 9 is more flexible: the ability to hedge noncontractually specified components that are ‘separately identifiable’ and ‘reliably measurable’ typically increases the extent to which nonfinancial risk components can be separately hedged, and consequently the effectiveness of these hedges.
6. Hedging foreign currency risk in a business combination
IFRS 9 permits hedging foreign currency risk in a business combination under the fair value and cash flow hedging models if certain requirements are met. This allows, for example, a company to hedge its functional currency equivalent cash flows in a cross-border business combination. Unlike IFRS 9, a firm commitment to enter into a business combination or an anticipated business combination does not qualify as a hedged item under US GAAP.
7. Shortcut method
The shortcut method is an exception under US GAAP that permits a company to assume that certain narrowly defined types of interest rate hedging relationships – where the critical terms of the hedging instrument and the hedged asset or liability are the same – are perfectly effective. Additionally, no quantitative hedge effectiveness assessment is required if this method is applied. IFRS 9 does not contain a similar shortcut method allowing for the assumption of perfect effectiveness; however, IFRS 9 does not prescribe the methods that should be used in measuring effectiveness prospectively (i.e. qualitative or quantitative methods).
8. Combination of derivative and nonderivative instruments
In some cases, a company may desire to hedge an aggregate exposure that results from combining a risk exposure in a nonderivative instrument and a separate exposure in a derivative instrument. For example, a company may wish to eliminate exposure to variability in cash flows from changes in interest rates on a debt instrument using an interest rate swap as well as eliminate foreign currency exposure. IFRS 9 allows an aggregate exposure comprising a nonderivative and a derivative instrument to be designated as the hedged item; therefore, hedge accounting need not be applied to each instrument separately. In the provided example, the aggregate exposure comprising the combination of the debt instrument plus the interest rate swap would be eligible to be designated as the hedged item.
Unlike IFRS 9, US GAAP does not allow an aggregated exposure to be designated as a hedged item because the items making up the aggregated exposure do not share the same risk exposure for which they are being hedged. Additionally, derivatives are not allowed to be designated as hedged items under US GAAP.
9. Hedging foreign currency risk of lower-level subsidiaries
In applying IFRS Standards, IFRS 104 permits a direct consolidation viewpoint where a company may directly consolidate a lower-level subsidiary even if there are one or more intermediate subsidiaries. This allows the parent to apply a net investment hedge, in accordance with IFRS 9, on a lower-tier subsidiary even if the intermediary subsidiary has a different functional currency. Unlike IFRS Standards, US GAAP does not permit net investment hedging of the lower-tier subsidiary if there is an intermediary subsidiary with a different functional currency.
10. Reference rate reform
Both IFRS 9 and US GAAP5 provide guidance to help support the transition from benchmark interest rates that are being discontinued by providing relief to specific hedge accounting requirements. Differences in the respective exceptions are nuanced, but at a high level each is intended to provide relief to requirements that would otherwise cause hedging relationships to be modified or otherwise affected.
For example, when a modification of a financial asset or financial liability is required due to a change in the benchmark interest rate, IFRS 9 provides a practical expedient that allows a company to update the effective interest rate to reflect the change in the benchmark interest rate. US GAAP allows a company to assume perfect effectiveness when a mismatch arises between the hedged item and the hedging instrument if certain conditions are met related to reference rate reform, while IFRS 9 does not have the same allowable exception. A careful evaluation is needed when determining the implications between reporting in accordance with IFRS 9 versus US GAAP.
Given the significant differences between hedge accounting under IFRS 9 and ASC 815, the following companies need to be particularly aware of these differences and the related accounting implications: dual reporters, companies that are changing their reporting between IFRS Standards and US GAAP, and companies that are converting an acquiree’s accounting policies from IFRS Standards to US GAAP (or vice versa).