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Derivatives and hedging

Derivatives

IFRS and US GAAP specify requirements for the recognition and measurement of derivatives.

Definition

IFRS A derivative is a financial instrument:

• whose value changes in response to a specified variable or underlying rate (for example, interest rate);

• that requires no or little net investment; and

• that is settled at a future date.

US GAAP Sets out similar requirements, except that the terms of the derivative contract should require or permit net settlement. There are therefore some derivatives, such as option and forward agreements to buy unlisted equity investments, that fall within the IFRS definition, not the US GAAP definition, because of the absence of net settlement.

Initial measurement

All derivatives are recognised on the balance sheet as either financial assets or liabilities under IFRS and US GAAP. They are initially measured at fair value on the acquisition date.

Subsequent measurement

IFRS and US GAAP require subsequent measurement of all derivatives at their fair values with changes recognised in the income statement, except for derivatives used in cash flow or net investment hedges. However, under IFRS, a derivative that is linked to and should be settled by delivery of an unquoted equity instrument whose fair value cannot be reliably measured is carried at cost less impairment until settlement.

Embedded derivatives

IFRS and US GAAP require separation of derivatives embedded in hybrid contracts when the economic characteristics and risks of the embedded derivatives are not closely related to the economic characteristics and risks of the host contract, a separate instrument with the same terms as the embedded derivative would meet the definition of a derivative, and the hybrid instrument is not measured at fair value through profit or loss. IFRS and US GAAP provide an option to value certain hybrid instruments to fair value instead of bifurcating the embedded derivative.

There are some detailed differences between IFRS and US GAAP for certain types of embedded derivatives on what is meant by ‘closely related’. Under IFRS, reassessment of whether an embedded derivative needs to be separated is permitted only when there is a change in the terms of the contract that significantly modifies the cash flows that would otherwise be required under the contract. Under US GAAP, if a hybrid instrument contains an embedded derivative that is not clearly and closely related to the host contract at inception, but is not required to be bifurcated, the embedded derivative is continuously reassessed for bifurcation.

Hedge accounting

Detailed guidance is set out in the respective standards under IFRS and US GAAP dealing with hedge accounting.

Derivatives and hedging

Criteria for hedge accounting

Hedge accounting is permitted under IFRS and US GAAP provided that an entity meets stringent qualifying criteria in relation to documentation and hedge effectiveness. Both frameworks require documentation of the entity’s risk management objectives and how the effectiveness of the hedge will be assessed. Hedge

instruments should be highly effective in offsetting the exposure of the hedged item to changes in the fair value or cash flows, and the effectiveness of the hedge is measured reliably on a continuing basis under both frameworks.

A hedge qualifies for hedge accounting under IFRS and US GAAP if changes in fair values or cash flows of the hedged item are expected to be highly effective in offsetting changes in the fair value or cash flows of the hedging instrument (‘prospective’ test) and ‘actual’ results are within a range of 80% to 125% (‘retrospective’ test). US GAAP, unlike IFRS, also allows, assuming stringent conditions are met, a ‘short-cut’ method that assumes perfect effectiveness for certain hedging relationships involving interest-rate swaps.

Hedged items

IFRS and US GAAP contain additional requirements for the designation of specific financial assets and liabilities as hedged items. These are outlined in the table below. Additional detailed application differences may arise.

Hedging instruments

Only a derivative instrument can qualify as a hedging instrument in most cases. IFRS, however, permits a non- derivative (such as a foreign currency borrowing) to be used as a hedging instrument for foreign currency risk. US GAAP provides that a non-derivative can hedge currency risk only for a net investment in a foreign entity or a fair value hedge of an unrecognised firm commitment.

Under IFRS, only instruments that involve a party external to the reporting entity can be designated as hedging instruments. Under US GAAP, certain internal derivatives (ie, derivatives entered into with another group entity such as a treasury centre) can qualify as a hedging instrument for cash flow hedges of foreign currency risk if specific conditions are met.

Under IFRS, a written option cannot be designated as a hedging instrument unless it is combined with a purchase option and a net premium is paid. Under US GAAP, a written option can be designated as a hedging

IFRS US GAAP

Held-to-maturity investments cannot be designated as a hedged item with respect to interest-rate risk or prepayment risk.

Similar to IFRS.

If the hedged item is a financial asset or liability, it may be a hedged item with respect to the risks associated with only a portion of its cash flows or fair value provided that effectiveness can be measured.

The designated risk is the risk of changes in: the overall fair value or cash flow; market interest rates; foreign currency exchange rates; or the creditworthiness of the ‘obligor’. Portions of risk cannot be designated as the hedged risk. If the hedged item is a non-financial asset or liability, it may

be designated as a hedged item only for foreign currency risk, or in its entirety for all risks because of the difficulty of isolating other risks.

Similar to IFRS.

If similar assets or similar liabilities are aggregated and hedged as a group, the change in fair value attributable to the hedged risk for individual items should be

proportionate to the change in fair value for the group.

Similar to IFRS.

A firm commitment to acquire a business cannot be a hedged item, except for foreign exchange risk, because the other risks that are hedged cannot be specifically identified and measured.

The hedged item cannot be related to: a business combination; the acquisition or disposition of subsidiaries; a minority interest in one or more consolidated subsidiaries; or investments accounted for using the equity method.

The foreign exchange risk in a firm commitment to acquire a business cannot be a hedged item.

Derivatives and hedging