IFRS 9 explained – Hedge effectiveness thresholds

IFRS 9 explained – Hedge effectiveness thresholds

In this month’s look at IFRS 9 Financial Instruments we examine the change to one of the conditions around hedge accounting - the removal of effectiveness testing thresholds.

Current rules

In order to apply hedge accounting under IAS 39 Financial Instruments: Recognition and Measurement businesses must meet a number of conditions. One of the more onerous conditions relates to the requirement to meet hedge effectiveness thresholds. Under IAS 39, hedge effectiveness must be between 80% and 125%, and this test must be met both retrospectively and prospectively. One of the key changes under IFRS 9 is the removal of these hedge effectiveness thresholds. 

How will this change on adoption of IFRS 9?

The removal of the hedge effectiveness thresholds mean that hedging relationships that failed to meet this condition previously may now be eligible for hedge accounting under IFRS 9. For example, an entity that has a hedging relationship that is only 75% effective may now be able to apply hedge accounting under IFRS 9 whereas under IAS 39 this was not possible. 

Some common examples of where this could arise would be where the critical terms of the hedging instrument and hedged item did not match, or where the hedging instrument had a fair value at the point of designation.

What’s the catch?

IFRS 9 still contains a number of hedge effectiveness requirements which must be met in order for a hedging relationship to qualify for hedge accounting. These requirements must be met both at inception of the hedge relationship and prospectively. 

One of the effectiveness requirements relates to the hedge ratio, ie the relationship between the quantity of the hedging instrument and quantity of hedged item. IFRS 9 requires that this should be consistent with the actual hedge ratio used for risk management purposes internally, and how an entity determines this ratio must be included in the formal hedge documentation created at the inception of the hedging relationship. The hedge ratio must be maintained for the life of the hedge, and changes to the quantities of the hedging instrument and/or hedged item are to be effected in order to achieve this as long as the risk management objective for the hedging relationship has not changed. This is known as rebalancing and does not result in a discontinuation of the hedging relationship. A decision to hedge more or less constitutes a change in risk management objective.

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