Dear Client,

Re: Application of IFRS 9 to cash flow hedge accounting

Thank you for your message and query. Based on the facts provided by you, please see below the scope of services we are providing and also our full response in the form of an analysis of the IFRS requirements involved.

Our understanding of the query

You are currently applying cash flow hedge accounting for an economic hedging relationship which consists of:

• hedged item being 95% of the nominal value of a floating rate USD-denominated loan with interest formula of USD LIBOR plus the bank’s margin,
• hedging instrument being an Interest Rate Swap (“IRS”) transaction, where the client pays a contracted fixed rate to the counterparty and receives the USD LIBOR,
• hedged risk being the risk of variability of cash flows due to changes in the reference market rate (USD LIBOR).

According to information received from you, the effectiveness of the hedge has been measured on reporting dates and the effective portion of changes in fair value of the IRS has been presented in OCI, while the ineffective portion of changes in fair value of the IRS have been presented in profit or loss.

You are considering the re-financing of the hedged item and also, as we understand, a simultaneous novation of the IRS agreement with the counterparty, in order to adjust for changes in terms of the debt. You would like to know how such a change to the economic hedging relationship will impact the cash flow hedge, in particular if cash flow hedge accounting should be discontinued and if any amounts previously recognised in OCI due to application of hedge accounting should be recycled to profit or loss, in accordance with requirements of IFRS 9.

Scope of services

We analysed the information provided by you in the request in the light of the requirements of IFRS 9 Financial Instruments, and formulated our answer as presented below. You should be aware that our answer is based on our best knowledge, currently available interpretations of IFRS 9 and on information provided by you. Should information provided by you, or currently available interpretations of IFRS 9 change, the conclusions of our analysis could be different. Any conclusions presented in this document refer only to the situation presented by you in the query.

Our work did not include:

• analysis of your hedge accounting documentation, hedging strategy and hedge objectives,
• assessment of the approach to effectiveness testing nor did we verify if the hedge is effective,
• verification of your approach to recognition of any amounts due to application of hedge accounting,
• assessment on whether the hedge accounting in question should be subject to application of IAS 39 or IFRS 9.

Our response to your enquiry

In accordance with IFRS 9 B6.5.22, hedge accounting should be discontinued prospectively from the date on which the qualifying criteria are no longer met. Therefore, the decision regarding the appropriate accounting treatment of the considered change in the economic hedging relationship, should be based on assessment of how this change impacts the qualifying criteria of hedge accounting. The considered change includes changes that will be made with respect to both the hedged item, which will be re-financed, and to the hedging instrument, which will be novated. Below we analyse the impact of both changes on the hedging relationship.

The impact of re-financing of the hedged item

As we understand, your intention is to re-finance the issued debt in order to obtain more favourable terms of financing, such as longer tenure, lower margin etc. Typically, such changes imply changes to contractual cash flows generated by such debt, and we propose that you assess how the re-financing will impact the accounting treatment of the loan, by applying the requirements set out in IFRS 9 3.3 (Derecognition of financial liabilities). Application of the derecognition criteria may potentially lead to a conclusion that the loan should be derecognised. From the perspective of hedge accounting criteria, such a situation could mean that the original hedged item be terminated and substituted by a new one, with different terms. The implication of the substitution of the hedged item on the hedge accounting qualifying criteria will depend on how you documented the strategy and objective of the hedge in the formal hedge documentation.

If in the documentation the hedged item was precisely defined as a particular USD-denominated loan, which can be separated from other financing agreements, the substitution will mean that the hedged position was terminated on the date of its re-financing and derecognition. Consequently, the entire hedging relationship should be terminated starting from that date.

However, if your documentation defined the hedged item with a more general term, for example as “a group of financial liabilities exposing the entity to variability of cash flows due to changes of USD LIBOR” or similar, then potentially you could conclude that the re-financed debt is in line with the hedging strategy and objective. In such a case the substitution would not result in an automatic derecognition of the hedging relationship. It should be mentioned however, that the re-financed debt should expose you to similar risks as the original loan, in order to ensure that the hedge accounting qualifying criteria are still being met.

The impact of the novation of the hedging instrument

As we understand, the refinancing of the hedged loan will be followed by a renegotiation of the hedging IRS to ensure that its critical terms properly match the terms of the re-financed loan. As we understand, the economic substance of such a change in the terms of the IRS contract will result in the termination of the existing contract and opening a new one with new amended terms. Then, the entire hedging relationship should be terminated and hedge accounting discontinued. This is because in accordance with IFRS 9 6.5.6 termination of the hedging instrument is presented as an instance leading to discontinuation of hedge accounting with respect to the hedging relationship in its entirety, unless the termination is caused by novation of the contract in a derivative required by laws or regulations due to a clearing obligation.

The above analysis indicates that the hedging relationship should be discontinued in its entirety if any of the following take place:

1. the re-financing of the hedged loan is treated as termination of the hedged item in accordance with how the hedged item was defined in the formal hedge documentation,
2. the hedging IRS agreement is terminated due to its novation.

However, if your hedging strategy, hedge objective and hedge documentation allow for substitution of the hedged item as described above, and the hedging IRS agreement is not terminated, then, subject to meeting all qualifying criteria as set out by IFRS 9 6.4, the re-financing of the loan would not result in termination of the hedging relationship.

Accounting treatment of discontinuation of hedge accounting

IFRS 9 requires that hedge accounting is discontinued prospectively, which means that the entity does not retrospectively adjust accounts for periods, when the qualifying criteria were met.

From the date on which the hedge is discontinued, all changes in fair value of the hedging instruments should be recognised in the profit or loss. The approach to treatment of the cumulative changes in fair value of the hedging instrument, previously recognised in OCI, can be determined per analogy to IFRS 9 6.5.12. If the reason for discontinuation of hedge accounting is termination of the hedged item, then the amounts previously recognised on OCI shall be immediately reclassified from the cash flow hedge reserve to profit or loss as a reclassification adjustment. Please note that after termination of the hedge, you can designate the re-financed loan and the IRS contract to a new hedging relationship after the original hedge has been terminated.

Should the change in the hedged item be treated as continuation of cash flow hedge accounting (for example because the hedge strategy and objective as documented in formal hedge documentation, and the hedging IRS is not modified), then the hedge is not discontinued and the amounts previously recognised in OCI are not reclassified to profit or loss immediately. It is important to note, however, that substitution of the hedged item may impact the effectiveness of the hedging relationship and in consequence lead to increases in the amounts of ineffective portion of change in fair value of the hedging derivative being recognised in the profit or loss in future periods.

We hope that the above is useful to you. Please let us know in case you have any additional questions or you need any clarifications.

Kind regards,

Your Helpline Team