5.2.1 Functional Currency and Presentation Currency

An entity's assets, liabilities and results are measured in a functional currency. IAS 21 defines the functional currency of an entity as “the currency of the primary economic environment in which the entity operates”. Within a group, the functional currency of each entity must be determined individually based on its particular circumstances. IAS 21 ensures that the selection of the functional currency is a matter of fact rather than management choice. IAS 21 includes some primary indicators that must be given a priority in determining an entity's functional currency, and also some secondary indicators. The primary indicators are:

• The currency that mainly influences sales prices for its goods and services, and of the country whose competitive forces and regulations mainly determine the sale prices of its goods and services.
• The currency that mainly influences labour, material and other costs of providing goods or services.

If these primary indicators do not provide an obvious answer, then the entity would need to turn to the secondary indicators, as follows:

• The currency in which funds from financing activities (i.e., from issuing debt and equity instruments) are generated.
• The currency in which receipts from operating activities are usually retained.

IAS 21 also describes some other factors to consider in determining whether the functional currency of a foreign operation is the same as that of the parent company. For example, this would apply where a foreign subsidiary is used to market goods from the parent company and its cash is all remitted back to the parent.

In reality, most functional currencies used by each subsidiary throughout a group are generally the subsidiary's local currency (i.e., the currency of the country of its location). However, the group sometimes has a functional currency that differs from its local currency. This is often the case for oil companies and high-tech companies. For example, STMicroelectronics, despite being a Franco-Italian semiconductor company and incurring most of its labour costs in EUR, used the USD as its functional currency as “the reference currency for the semiconductor industry is the U.S. dollar, and product prices are mainly denominated in U.S. dollars”.

The presentation currency is defined as the currency in which the financial statements are presented. Unlike the functional currency, the presentation currency can be any currency of choice. Presenting the financial statements in a currency other than the functional currency does not change the way in which the underlying items are measured. It merely expresses the underlying amounts, which are measured in the functional currency in a different currency.

Except where the functional currency is the currency of a hyperinflationary economy, an entity that translates financial statements from its functional currency into a presentation currency other than its functional currency uses the same method as for translating financial statements of a foreign operation.

5.2.2 Relevant Dates in an FX Transaction

Three different dates are relevant in a foreign currency transaction: the

• The transaction date – the date on which the transaction is initially recorded on the books.
• The settlement date – the date on which the payment or receipt is made.
• The financial reporting dates between the transaction date and the settlement date.

5.3.1 Monetary versus Non-monetary Items

In order to determine the appropriate translation exchange rate to use, IAS 21 groups assets and liabilities that are not part of the financial statements of a group's foreign operations into monetary accounts and non-monetary items. Monetary items are items that are settled in a fixed or determinable number of units of currency. All other assets and liabilities are non-monetary. Equity and income statement accounts are neither monetary nor non-monetary items. Examples of monetary and non-monetary items are:

5.3.2 Translation Rates

Under IAS 21, the exchange rate to be used to translate the different FX denominated items is determined as follows:

1. Foreign currency transactions are translated at the exchange rate prevailing on the date of the transactions.
2. Monetary assets and liabilities are translated at the exchange rate prevailing at the reporting date. This FX rate is usually referred to as the “closing rate”.
3. Non-monetary assets and liabilities that are not valued at fair value are translated at the exchange rate prevailing on the date of the transaction. In other words, there are no further retranslations.
4. Non-monetary items that are valued at fair value are translated at the exchange rate prevailing on the date when the latest fair value was determined.
5. Assets and liabilities of all the group foreign entities are translated at the closing rate.
6. Profit or loss statements of all the group foreign entities are translated at the average exchange rate for the period. Whilst it is also possible to use the exchange rate prevailing on each transaction date, in practice few entities adopt this alternative.

5.4.1 Summary of Most Commonly Used FX Derivatives

The following table summarises the most frequently used FX hedging derivatives, and the implications of their use from an IFRS perspective:

5.5.1 Background

Suppose that on 1 October 20X4, ABC Corporation, an exporter whose functional currency was the EUR, was expecting to sell finished goods to a US client and the export to be denominated in USD. The sale was expected to occur on 31 March 20X5, and its related receivable was expected to be settled on 30 June 20X5. Sale proceeds were expected to amount to USD 100 million, to be received in USD.

The sale exposed the entity to a depreciating USD relative to the EUR until the future USD 100 million proceeds were exchanged into EUR. The following table summarises the effects on the resulting cash flow caused by fluctuations in the EUR–USD exchange rate:

To hedge its exposure to the EUR–USD rate, on 1 October 20X4 ABC entered into an FX forward contract with the following terms:

The FX forward locked in the amount of EUR to be received in exchange for the USD 100 million sale, as shown in Figure 5.3.

5.5.2 Setting the Hedging Relationship Term

From an accounting perspective, the company was exposed to the EUR–USD exchange rate for three consecutive periods (see Figure 5.4):

• An initial period from the moment when the sale became highly expected to the moment when the goods were delivered. During this period, no FX remeasurement was required from an accounting perspective. At the end of this period, the sale was recognised in the entity's profit and loss statement and its related USD receivable was recorded in the entity's statement of financial position. Both the sale and the receivable were translated into EUR at the EUR–USD spot rate prevailing on the day the sale was recognised.
• A second period that elapsed when the customer paid the receivable. During this period, the receivable was remeasured at each reporting date and changes in its fair value due to the EUR–USD exchange rate movements were recognised in profit or loss. At the end of this period, the USD payment was received and, as a result, the receivable was settled. Prior to its derecognition, the receivable was revalued using the EUR–USD rate prevailing on that date. The received USD cash was recognised in the entity's statement of financial position using the EUR–USD exchange rate used in the receivable's last revaluation.
• A final period that elapsed when the entity exchanged the USD cash into EUR cash. During this period, the USD cash was remeasured at each reporting date and changes in its fair value due to EUR–USD exchange rate movements were recognised in profit or loss. In our case, this third period did not exist as the exchange into EUR cash took place through the derivative at the same time as the receipt of the USD cash.

ABC designated the forward contract as the hedging instrument in a foreign currency cash flow hedge and the highly expected sale as the hedged item. When forwards are used, IFRS 9 permits an entity to choose whether or not to include the FX forward points (i.e., the forward element) in the hedging relationship. From a hedge accounting perspective, three alternatives are available:

• To designate the FX forward in its entirety as the hedging instrument. In other words, to include the forward element of the FX forward in the hedging relationship.
• To designate just the spot element of the FX forward as the hedging instrument (i.e., to exclude the forward element from the hedging relationship) and to temporarily recognise the change in the forward element in OCI to the extent that it relates to the hedged item.
• To designate just the spot element as the hedging instrument (i.e., to exclude the forward element from the hedging relationship) and to recognise the change in the forward element in profit or loss.

One important decision that ABC had to make was the term of the hedging relationship. ABC considered the following two approaches:

• To establish the term of the hedging relationship from 1 October 20X4 (i.e., when the forward was traded) to 30 June 20X5 (i.e., when the USD payment was received). Under this approach the hedged items were the forecast sale and its ensuing receivable. On 31 March 20X5, once the sales transaction was recognised, ABC decided either to maintain the hedging relationship or to discontinue it by changing the hedge objective. This section will cover the accounting mechanics under this alternative.
• To establish the term of the hedging relationship from 1 October 20X4 (i.e., when the forward was traded) to 31 March 20X5 (i.e., when the sale was recognised). Under this approach the hedged item was the forecast sale. Section 5.6 will cover the accounting mechanics under this alternative.

In the case covered in this section both the maturities of the hypothetical derivative and the hedging instrument coincided (30 June 20X5), enhancing hedge effectiveness. However, unless a discontinuation is provoked, it implied an extra operational burden as in the period from 31 March 20X5 to 30 June 20X5 an additional calculation/recognition of effective and ineffective parts and the subsequent reclassification of the effective part into profit or loss would be required.

An alternative to avoid such administrative complexity was to provoke on 31 March 20X5 the discontinuation of the hedging relationship by changing the hedge's risk management objective on that date, an approach that may be questioned by auditors. In this section I will cover this approach as well.

Figure 5.5 shows that the hedging relationship ended on 30 June 20X5, when the FX forward ended. As a result, the maturity of the hypothetical derivative and that of the hedging instrument (i.e., the forward) coincided.

5.5.3 Hedging Relationship Documentation

ABC designated the forward contract as the hedging instrument in a cash flow hedge. At the inception of the hedging relationship, ABC documented the hedging relationship as follows:

5.5.4 Hedge Effectiveness Assessment – Hypothetical Derivative

Hedge effectiveness will be assessed by comparing changes in the fair value of the hedging instrument to changes in the fair value of a hypothetical derivative. The terms of the hypothetical derivative – a EUR–USD forward contract for maturity 30 June 20X5 with nil fair value at the start of the hedging relationship – reflected the terms of the hedged item. The terms of the hypothetical derivative were as follows:

(*) The forward rate of the hypothetical derivative (1.2520) was different from that of the hedging instrument (1.2500) due to the absence of CVA in the hypothetical derivative (the counterparty to the hypothetical derivative is assumed to be credit risk-free).

Changes in the fair value of the hedging instrument will be recognised as follows:

• The effective part of the gain or loss on the hedging instrument will be recognised in the cash flow hedge reserve of OCI. The accumulated amount in equity will be reclassified to profit or loss in the same period during which the hedged expected future cash flow affects profit or loss, adjusting the sales amount and thereafter the revaluation of the receivable.
• The ineffective part of the gain or loss on the hedging instrument will be recognised immediately in profit or loss.

Hedge effectiveness will be assessed prospectively at hedging relationship inception, on an ongoing basis at each reporting date and upon occurrence of a significant change in the circumstances affecting the hedge effectiveness requirements.

Hedge effectiveness assessment will be performed on a forward-forward basis. In other words, the forward element of both the hedging instrument and the expected cash flow will be included in the assessment.

The hedging relationship will qualify for hedge accounting only if all the following criteria are met:

1. The hedging relationship consists only of eligible hedge items and hedging instruments. The hedge item is eligible as it is a highly expected forecast transaction that exposes the entity's profit or loss to fair value risk and is reliably measurable. The hedging instrument is eligible as it is a derivative and it does not result in a net written option.
2. At hedge inception there is a formal designation and documentation of the hedging relationship and the entity's risk management objective and strategy for undertaking the hedge.
3. The hedging relationship is considered effective.

The hedging relationship will be considered effective if all the following requirements are met:

1. There is an economic relationship between the hedged item and the hedging instrument.
2. The effect of credit risk does not dominate the value changes that result from that economic relationship.
3. The hedge ratio of the hedging relationship is the same as that resulting from the quantity of hedged item that the entity actually hedges and the quantity of the hedging instrument that the entity actually uses to hedge that quantity of hedged item. The hedge ratio should not be intentionally weighted to create ineffectiveness.

Whether there is an economic relationship between the hedged item and the hedging instrument will be assessed on a qualitative basis. The assessment will be complemented by a quantitative assessment using the scenario analysis method for one scenario in which the EUR–USD FX rate at the end of the hedging relationship (30 June 20X5) will be calculated by shifting the EUR–USD spot rate prevailing on the assessment date by +10%, and the change in fair value of both the hypothetical derivative and the hedging instrument compared.

5.5.5 Hedge Effectiveness Assessment Performed at Hedge Inception

The hedging relationship was considered effective as all the following requirements were met:

1. There was an economic relationship between the hedged item and the hedging instrument. Based on the qualitative assessment performed, supported by a quantitative analysis, ABC concluded that the change in fair value of the hedged item was expected to be substantially offset by the change in fair value of the hedging instrument, corroborating that both elements had values that would generally move in opposite directions.
2. The effect of credit risk did not dominate the value changes resulting from that economic relationship as the credit ratings of both the entity and XYZ Bank were considered sufficiently strong.
3. The 1:1 hedge ratio of the hedging relationship was the same as that resulting from the quantity of hedged item that the entity actually hedged and the quantity of the hedging instrument that the entity actually used to hedge that quantity of hedged item. The hedge ratio was not intentionally weighted to create ineffectiveness.

Due to the fact that the main terms of the hedging instrument and those of the expected cash flow closely matched and the low credit risk exposure to the counterparty of the forward contract, it was concluded that the hedging instrument and the hedged item had values that would generally move in opposite directions. This conclusion was supported by a quantitative assessment, which consisted of one scenario analysis performed as follows. A EUR–USD spot rate at the end of the hedging relationship (1.3585) was simulated by shifting the EUR–USD spot rate prevailing on the assessment date (1.2350) by +10%. As shown in the table below, the change in fair value of the hedged item was expected to largely be offset by the change in fair value of the hedging instrument, corroborating that both elements had values that would generally move in opposite directions.

Notes:

(1) Assumed spot rate on hedging relationship end date (30 June 20X5)

(2) 73,611,000 = 100,000,000/1.3585

(3) 6,389,000 = 80,000,000 – 73,611,000

(4) 6,389,000 = 6,389,000 × 1.00

(5) 102% = 6,389,000/6,261,000

The hedge ratio was established at 1:1, resulting from the USD 100 million of the hedged item that the entity actually hedged and the USD 100 million of the hedging instrument that the entity actually used to hedge that quantity of hedged item.

Another hedge assessment was performed on 31 December 20X4 (reporting date). That assessment was very similar to the one performed at inception and has been omitted to avoid unnecessary repetition. Similarly, the hedge ratio was assumed to be 1:1 on that assessment date.

5.5.6 Fair Valuation of Hedged Item and Hypothetical Derivative at the Relevant Dates

The spot and forward exchange rates prevailing at the relevant dates were as follows:

(*) Credit risk-free forward rate

The fair value calculation of the hedging instrument at each relevant date was as follows:

Notes:

(1) 76,923,000 = 100,000,000/1.3000

(2) 3,077,000 = 80,000,000 – 76,923,000

(3) 3,047,000 = 3,077,000 × 0.9901

(4) 3,046,000 =3,047,000+ <1,000>

(5) 1,204,000 = 3,046,000 – 1,842,000

(6) This figure includes a CVA as well as the bid/offer. The figure is relatively large due a substantial additional profit applied by XYZ Bank. ABC decided not to initially recognise any up-front loss on the trade

The fair value calculation of the hypothetical derivative at each relevant date was as follows:

The calculation of the effective and ineffective parts of the change in fair value of the hedging instrument was performed as follows:

Notes:

(1) Lower of 3,046,000 and 2,920,000

(2) Nil + 1,719,000, the sum of all prior effective amounts

(3) 2,920,000 – 1,719,000

(4) Change in the fair value of the hedging instrument since the last fair valuation

(5) Lower of 1,201,000 (available amount) and 1,204,000 (period change in fair value of hedging nstrument)

(6) 1,204,000 (period change in fair value of hedging instrument) – 1,201,000 (effective part)

5.5.7 Accounting Entries – Hedge Objective Unchanged: No Discontinuation

The required journal entries were as follows.

1. To record the forward contract trade on 1 October 20X4

   No entries in the financial statements were required as the fair value of the forward contract was zero.

2. To record the closing of the accounting period on 31 December 20X4

   The change in fair value of the forward since the last valuation was a EUR 1,842,000 gain, of which EUR 1,719,000 was effective and recorded in OCI, and EUR 123,000 was ineffective and recorded in profit or loss.

3. Accounting entries on 31 March 20X5

   The sale agreement was recorded at the EUR–USD spot rate prevailing on 31 March 20X5 (1.2950). Therefore, the sales EUR amount was EUR 77,220,000 (=100 million/1.2950). Because the sold machinery was not yet paid, a receivable was recognised. Suppose that the machinery was valued at EUR 68 million in ABC's statement of financial position, and that ABC recognised the delivery of the machinery.

4. The change in the fair value of the FX forward since the last valuation was a gain of EUR 1,204,000. The effective part was EUR 1,201,000 and recognised in OCI, while the ineffective part was EUR 3,000 and recorded in profit or loss.
5. The recognition of the sales transaction in profit or loss caused the release to profit or loss of the deferred hedge results accumulated in OCI.
6. To record the settlement of the receivable and the forward on 30 June 20X5

   The receivable was revalued at the spot rate prevailing on this date, showing a loss of EUR 1,463,000 (=100 million/1.3200 – 100 million/1.2950).

7. The change in the fair value of the forward contract since the last valuation was a gain of EUR 1,196,000. The effective part was EUR 1,194,000 and recognised in OCI, while the ineffective part was EUR 2,000 and recorded in profit or loss.
8. The revaluation of the receivable in profit or loss caused the release to profit or loss of the deferred hedge results accumulated in OCI.
9. The receipt of the USD 100 million cash payment from the customer was valued at the spot rate on 30 June 20X5 (1.32), or EUR 75,758,000 (=100 million/1.32).
10. The forward was settled: the USD 100 million cash was exchanged for EUR 80 million under the physical settlement provision of the forward.

The following table gives a summary of the accounting entries, excluding the entries related to the cost of goods sold. The table shows that the forward contract locked in a EUR 80 million overall income.

5.5.8 Accounting Entries – Hedge Risk Management Objective Changed: Discontinuation

In our previous approach, on 30 June 20X5 an additional calculation/recognition of effective and ineffective parts and the subsequent reclassification of the effective part into profit or loss was required. An alternative to avoid such administrative complexity was to discontinue the hedging relationship on 31 March 20X5 by changing the hedge's risk management objective on that date. Whilst under IFRS 9 voluntary discontinuation of a hedging relationship is not permitted, discontinuation is required when a hedging relationship does not meet its risk management objective. By changing the risk management objective an entity may provoke a mandatory discontinuation of the hedging relationship. In my view, this solution may be challenged by auditors, especially when a pattern of changing risk management objectives has been implemented solely to overcome the restrictions of IFRS 9. However, as happened with IAS 39 (the previous hedge accounting standard), over time the auditing community comes to accept practices that at the beginning of the implementation of a standard may seem questionable. I will cover this approach next.

The accounting entries up to, and including, 31 March 20X5 were identical to those of the previous example, so are omitted here.

On 31 March 20X5, following the recognition of the receivable, ABC updated the hedge documentation as follows: “The risk management of the EUR–USD foreign exchange risk stemming from the accounts receivable will no longer be managed under this hedging relationship, but instead in conjunction with the EUR–USD foreign exchange risk stemming from the FX forward as there is a natural offset in profit or loss of both risks. As a result of this change in the risk management objective, the hedging relationship is discontinued from 31 March 20X5”.

The accounting entries made on 30 June 20X5 were as follows. The receivable was revalued at the spot rate prevailing on this date, showing a loss of EUR 1,463,000 (=100 million/1.3200 – 100 million/1.2950).

The change in the fair value of the forward contract since the last valuation was a gain of EUR 1,196,000, recognised in profit or loss, as the forward was undesignated.

The receipt of the USD 100 million cash payment from the customer was valued at the spot rate on 30 June 20X5, EUR 75,758,000 (=100 million/1.32).

The forward was settled: the USD 100 million cash was exchanged for EUR 80 million under the physical settlement provision of the forward.

The following table gives a summary of the accounting entries, excluding the entries related to the cost of goods sold:

Note: Total figures may not match the sum of their corresponding components due to rounding.

5.6.1 Setting the Hedging Relationship Term

As mentioned above, the hedging relationship would end on 31 March 20X5, when the sales transaction was recognised, before the FX forward matured (see Figure 5.6).

• Until 31 March 20X5, the effective part of the changes in fair value of the forward would be recorded in OCI.
• On 31 March 20X5, the hedged cash flow (i.e., the sale) would be recognised in ABC's profit or loss and, simultaneously, the amount previously recorded in equity would be reclassified to profit or loss. Also on 31 March 20X5 a receivable denominated in USD would be recognised in ABC's statement of financial position. The hedging relationship would end on that date.
• During the period from 31 March 20X5 until 30 June 20X5, the derivative would be undesignated. There would be an almost fully offset between FX gains and losses on the revaluation of the USD accounts receivable and revaluation gains and losses on the forward contract.

5.6.2 Hedging Relationship Documentation

ABC designated the forward contract as the hedging instrument in a cash flow hedge of its USD-denominated highly expected sale. At the inception of the hedging relationship, ABC documented the hedging relationship as follows:

5.6.3 Hedge Effectiveness Assessment

Hedge effectiveness will be assessed by comparing changes in the fair value of the hedging instrument to changes in the fair value of a hypothetical derivative. The terms of the hypothetical derivative – a EUR–USD forward contract for maturity 31 March 20X5 with nil fair value at the start of the hedging relationship – reflected the terms of the hedged item. The terms of the hypothetical derivative were as follows:

(*) The forward rate of the hypothetical derivative (1.2460) was different from that of the hedging instrument (1.2500) due to their different maturity dates (31 March 20X5 and 30 June 20X5) and the absence of CVA in the hypothetical derivative (the counterparty to the hypothetical derivative is assumed to be credit risk-free).

Changes in the fair value of the hedging instrument will be recognised as follows:

• The effective part of the gain or loss on the hedging instrument will be recognised in the cash flow hedge reserve of OCI. The accumulated amount in equity will be reclassified to profit or loss in the same period during which the hedged expected future cash flow affects profit or loss, adjusting the sales amount.
• The ineffective part of the gain or loss on the hedging instrument will be recognised immediately in profit or loss.

Hedge effectiveness will be assessed prospectively at hedging relationship inception, on an ongoing basis at each reporting date and upon occurrence of a significant change in the circumstances affecting the hedge effectiveness requirements.

Hedge effectiveness assessment will be performed on a forward-forward basis. In other words, the forward element of both the hedging instrument and the expected cash flow will be included in the assessment.

The hedging relationship will qualify for hedge accounting only if all the following criteria are met:

1. The hedging relationship consists only of eligible hedge items and hedging instruments. The hedge item is eligible as it is a highly expected forecast transaction that exposes the entity's profit or loss statement to fair value risk, is reliably measurable and affects profit or loss. The hedging instrument is eligible as it is a derivative and does not result in a net written option.
2. At hedge inception there is a formal designation and documentation of the hedging relationship and the entity's risk management objective and strategy for undertaking the hedge.
3. The hedging relationship is considered effective.

The hedging relationship will be considered effective if all the following requirements are met:

1. There is an economic relationship between the hedged item and the hedging instrument.
2. The effect of credit risk does not dominate the value changes that result from that economic relationship.
3. The hedge ratio of the hedging relationship is the same as that resulting from the quantity of hedged item that the entity actually hedges and the quantity of the hedging instrument that the entity actually uses to hedge that quantity of hedged item. The hedge ratio should not be intentionally weighted to create ineffectiveness.

Whether there is an economic relationship between the hedged item and the hedging instrument will be assessed on a qualitative basis. The assessment will be complemented by a quantitative assessment using the scenario analysis method for one scenario in which the EUR–USD FX rate at the end of the hedging relationship (31 March 20X5) will be calculated by shifting the EUR–USD spot rate prevailing on the assessment date by +10%, and the change in fair value of both the hypothetical derivative and the hedging instrument compared.

5.6.4 Hedge Effectiveness Assessment Performed at Hedge Inception

The hedging relationship was considered effective as all the following requirements were met:

1. There was an economic relationship between the hedged item and the hedging instrument. Based on the qualitative assessment performed supported by a quantitative analysis, ABC concluded that the change in fair value of the hedged item was expected to be substantially offset by the change in fair value of the hedging instrument, corroborating that both elements had values that would generally move in opposite directions.
2. The effect of credit risk did not dominate the value changes resulting from that economic relationship as the credit ratings of both the entity and XYZ Bank were considered sufficiently strong.
3. The 1:1 hedge ratio of the hedging relationship was the same as that resulting from the quantity of hedged item that the entity actually hedged and the quantity of the hedging instrument that the entity actually used to hedge that quantity of hedged item. The hedge ratio was not intentionally weighted to create ineffectiveness.

Due to the fact that the terms of the hedging instrument and those of the expected cash flow closely matched and the low credit risk exposure to the counterparty of the forward contract, it was concluded that the hedging instrument and the hedged item had values that would generally move in opposite directions. This conclusion was supported by a quantitative assessment, which consisted of one scenario analysis performed as follows. A EUR–USD spot rate at the end of the hedging relationship (1.3585) was simulated by shifting the EUR–USD spot rate prevailing on the assessment date (1.2350) by +10%. The fair value of the hedging instrument was calculated, assuming that the forward rate for 30 June 20X5 was 1.3625 and the discount factor from 31 March 20X5 to 30 June 20X5 was 0.99. As shown in the table below, the change in fair value of the hedged item was expected to largely be offset by the change in fair value of the hedging instrument, corroborating that both elements had values that would generally move in opposite directions.

Notes:

(1) Forward rate to 30 June 20X5

(2) Assumed spot rate on hedging relationship end date

(3) 73,394,000 = 100,000,000/1.3625

(4) 6,606,000 = 80,000,000 – 73,394,000

(5) 6,540,000 = 6,606,000 × 0.99

(6) 98% = 6,538,000/6,646,000

The hedge ratio was established at 1:1, resulting from the USD 100 million of hedged item that the entity actually hedged and the USD 100 million of the hedging instrument that the entity actually used to hedge that quantity of hedged item.

Another hedge assessment was performed on 31 December 20X4 (reporting date). That assessment was very similar to the one performed at inception and has been omitted to avoid unnecessary repetition. Additionally, the hedge ratio was assumed to be 1:1 on that assessment date.

5.6.5 Fair Valuation of Hedged Item and Hypothetical Derivative at the Relevant Dates

The spot and forward exchange rates prevailing at the relevant dates were as follows:

(*) Credit risk-free forward rate

The fair value calculation of the hedging instrument at each relevant date was covered in Section 5.5.6, resulting in the following amounts:

The fair value calculation of the hypothetical derivative at each relevant date was as follows:

The calculation of the effective and ineffective parts of the change in fair value of the hedging instrument was calculated as follows:

Notes:

(1) 3,037,000 = lower of 3,046,000 and 3,037,000

(2) 1,842,000 = Nil + 1,842,000, the sum of all prior effective amounts

(3) 1,195,000 = 3,037,000 – 1,842,000

(4) Change in the fair value of the hedging instrument since the last fair valuation

(5) Lower of 1,195,000 (available amount) and 1,204,000 (period change in fair value of hedging instrument)

(6) 1,204,000 (period change in fair value of hedging instrument) – 1,195,000 (effective part)

5.6.6 Accounting Entries When the Forward Element is Included in the Hedging Relationship

The required journal entries were as follows.

1. To record the forward contract trade on 1 October 20X4

   No entries in the financial statements were required as the fair value of the forward contract was zero.

2. To record the closing of the accounting period on 31 December 20X4

   The change in fair value of the forward since the last valuation was a gain of EUR 1,842,000. As the hedge was fully effective, all that change in fair value was recorded in OCI and none in profit or loss.

3. To record the sale agreement and the end of the hedging relationship on 31 March 20X5

   The sale agreement was recorded at the EUR–USD spot rate prevailing on 31 March 20X5 (1.2950). Therefore, the sales EUR amount was EUR 77,220,000 (=100 million/1.2950). Because the sold machinery was not yet paid, a receivable was recognised. Suppose that the machinery was valued at EUR 68 million in ABC's statement of financial position, and that ABC recognised the delivery of the machinery.

4. The change in the fair value of the FX forward since the last valuation was a gain of EUR 1,204,000. The effective part was EUR 1,195,000, recognised in OCI. The ineffective part was EUR 9,000, recognised in profit or loss.
5. The recognition of the sales transaction in profit or loss caused the release to profit or loss of the deferred hedge results accumulated in OCI.
6. To record the settlement of the receivable and the forward on 30 June 20X5

   The receivable was revalued at the spot rate prevailing on this date, showing a loss of EUR 1,463,000 (=100 million/1.3200 – 100 million/1.2950).

7. The change in the fair value of the forward contract since the last valuation was a gain of EUR 1,196,000. The gain was recognised in profit or loss as the derivative was no longer part of a hedging relationship (i.e., it was undesignated).
8. The receipt of the USD 100 million cash payment from the customer was valued at the spot rate on 30 June 20X5, EUR 75,758,000 (=100 million/1.32).
9. The forward was settled: the USD 100 million cash was exchanged for EUR 80 million under the physical settlement provision of the forward.

With the hedge, ABC locked in EUR 80 million proceeds from the USD sale. Including the EUR 68 million cost of goods sold, the hedge locked in EUR 12 million earnings before tax (EBT). The majority of the change in fair value of the forward contract during the hedging relationship (i.e., until 31 March 20X5) adjusted the sales amount. From that date, the entirety of change in fair value of the forward contract was recognised as “other financial income/expenses”. The inclusion of the forward points in the hedging relationship caused the expected deterioration, during such relationship, of the exchange rate implied by the forward points to end up adjusting sales (i.e., within earnings before interest, taxes, depreciation and amortisation (EBITDA)), and not in the “other financial income/expenses” line. The effects of the hedge in ABC's profit or loss are shown in Figure 5.7. Without the hedge, the EBT and the proceeds from the sale would have been EUR 4,242,000 lower.

The following table gives a summary of the accounting entries, excluding the entries related to the cost of goods sold. The table shows that the forward contract locked in a EUR 80 million overall income.

Note: Total figures may not match the sum of their corresponding components due to rounding.

5.6.7 Accounting Election When the Forward Element is Excluded from the Hedging Relationship

When an entity elects to exclude the forward element (i.e., the forward points) from a hedging relationship (i.e., only the spot element is part of such relationship), IFRS 9 allows entities to elect between:

• Recognising the changes in the forward element in profit or loss.
• Recognising the changes in the forward element temporarily in OCI to the extent that these changes relate to the hedged item. The amount accumulated in OCI is later reclassified to profit or loss – adjusting the sales figure – when the sale is recognised. In our example, it would mean that a substantial part of the forward points would adjust the sales figure.

It is likely that ABC would have selected the first alternative. Firstly, the forward element implied a loss because the forward rate (1.2500) was unfavourable relative to the spot rate (1.2350). As a result, under the first alternative the sales figure was likely to look better than under the second alternative. Secondly, the first alternative was much simpler than the second alternative from an operational perspective. However, the forward in its entirety (including both the spot and forward elements) could be thought of as “insurance” bought to guarantee that the proceeds from the sale were EUR 80 million, and probably the second alternative provided a more complete picture of the entity's activities by incorporating in the sales line the “insurance” related to such sale.

5.6.8 Accounting When the Forward Element is Excluded from the Hedging Relationship and Recognised in Profit or Loss

Suppose that in the previous hedge ABC decided to exclude the forward element from the hedging relationship and to recognise the change in the fair value of the forward element in profit or loss. Excluding the forward element from the hedging relationship implied that hedge effectiveness would assessed taking into only changes in fair value due to changes in the spot exchange rate (what is termed “spot-to-spot” assessment).

Forward Contract Fair Valuation

The fair value of the forward component was calculated as the difference between the total fair value of the forward contract and the fair value of its spot component:

The changes in fair value of the spot and forward elements of the forward contract were calculated as follows (the total fair values of the forward contract were calculated in Section 5.6.5):

	1-Oct-20X4	31-Dec-20X4	31-Mar-20X5	30-Jun-20X5
Total fair value (FV)	0	1,842,000 (1)	3,046,000	4,242,000
Period FV change	—	1,842,000	1,204,000	1,196,000
Spot element fair valuations:
Nominal in USD	100,000,000	100,000,000	100,000,000
Initial spot rate	/1.2350	/1.2350	/1.2350
Initial EUR amount	80,972,000	80,972,000	80,972,000
Nominal in USD	100,000,000	100,000,000	100,000,000
Spot rate	/1.2350	/1,2700	/1,2950
Value in EUR	80,972,000	78,740,000	77,220,000
Difference	-0-	2,232,000	3,752,000
Discount factor	× 0.9804	× 0.9839	× 0.9901
Fair value (spot element)	-0-	2,196,000	3,715,000
Period FV change (spot element)	—	2,196,000	1,519,000
Cumulative FV change (spot element)	—	2,196,000	3,715,000
Forward element fair valuations:
Fair value (forward element)	-0-	<354,000> (2)	<669,000>
Period FV change (forward element)	—	<354,000>	<315,000>
Cumulative FV change (forward element)	—	<354,000>	<669,000>

Notes:

(1) A split between the spot and forward components was not needed on 30-Jun-20X5, as the forward was undesignated from 31-Mar-20X5

(2) From table in Section 5.6.5

(3) 1,842,000 (total fair value) – 2,196,000 (fair value of spot element)

The changes in the fair value of the spot and forward elements of the hypothetical derivative were calculated as follows (the total fair values of the hypothetical derivative were calculated in Section 5.6.5):

	1-Oct-20X4	31-Dec-20X4	31-Mar-20X5
Total fair value (FV)	-0-	1,928,000 (1)	3,037,000
Cumulative FV change	—	1,928,000	3,037,000
Spot element fair valuations:
Nominal in USD	100,000,000	100,000,000	100,000,000
Initial spot rate	/1.2350	/1.2350	/1.2350
Initial nominal EUR	80,972,000	80,972,000	80,972,000
Nominal in USD	100,000,000	100,000,000	100,000,000
Spot rate	/1.2350	/1,2700	/1,2950
Value in EUR	80,972,000	78,740,000	77,220,000
Difference	-0-	2,232,000	3,752,000
Discount factor	× 0.9842	× 0.9895	× 1.0000
Fair value (spot element)	-0-	2,209,000	3,752,000
Cumulative FV change (spot element)	—	2,209,000	3,752,000
Forward element fair valuations:
Fair value (forward element)	-0-	<281,000> (2)	<715,000>
Cumulative FV change (forward element)	—	<281,000>	<715,000>

Notes:

(1) From table in Section 5.6.5

(2) 1,928,000 (total fair value) – 2,209,000 (fair value of spot element)

The effective and ineffective parts of the change in fair value of the hedging instrument (i.e., the spot component of the forward contract) were calculated as follows:

	31-Dec-20X4	31-Mar-20X5
Cumulative change in fair value of hedging instrument (spot element)	2,196,000	3,715,000
Cumulative change in fair value of hypothetical derivative (spot element)	2,209,000	3,752,000
Lower amount	2,196,000	3,715,000 (1)
Previous cumulative effective amount	Nil	2,196,000 (2)
Available amount	2,196,000	1,519,000 (3)
Period change in fair value of hedging instrument (spot element)	2,196,000	1,519,000 (4)
Effective part	2,196,000	1,519,000 (5)
Ineffective part	Nil	Nil (6)

Notes:

(1) Lower of 3,715,000 and 3,752,000

(2) Nil + 2,196,000, the sum of all prior effective amounts

(3) 3,715,000 – 2,196,000

(4) Change in the fair value of the hedging instrument (i.e., spot element) since the last fair valuation

(5) Lower of 1,519,000 (available amount) and 1,519,000 (period change in fair value of hedging instrument – i.e., spot element)

(6) 1,519,000 (period change in fair value of hedging instrument – i.e., spot element) – 1,519,000 (effective part)

Accounting Entries – Forward Element Changes through Profit or Loss

The accounting entries shown next assume that ABC elected to recognise the changes in the forward element in profit or loss. The required journal entries were as follows.

1. To record the forward contract trade on 1 October 20X4

   No entries in the financial statements were required as the fair value of the forward contract was zero.

2. To record the closing of the accounting period on 31 December 20X4

   The change in fair value of the spot element since the last valuation was a EUR 2,196,000 gain. That entire amount was considered effective and recorded in OCI, and as a result there was no ineffective amount. The change in fair value of the forward element resulted in a EUR 354,000 loss, recognised in profit or loss as it was excluded from the hedging relationship.

3. To record the sale agreement and the end of the hedging relationship on 31 March 20X5

   The sale agreement was recorded at the EUR–USD spot rate prevailing on the date the sales are recognised (1.2950). Therefore, the sales EUR amount was EUR 77,220,000 (=100 million/1.2950). Because the sold machinery was not yet paid, a receivable was recognised. Suppose that the machinery was valued at EUR 68 million in ABC's statement of financial position, and that ABC recognised the delivery of the machinery.

   The change in fair value of the spot element since the last valuation was a EUR 1,519,000 gain. That entire amount was considered effective and recorded in OCI, and as a result there was no ineffective amount.

   The change in fair value of the forward element resulted in a EUR 315,000 loss, recognised in profit or loss as it was excluded from the hedging relationship.

4. The recognition of the sales transaction in profit or loss caused the release to profit or loss of the deferred hedge results accumulated in OCI.
5. To record the settlement of the receivable and the forward on 30 June 20X5

   The receivable was revalued at the spot rate prevailing on this date, showing a EUR 1,463,000 (=100 million/1.3200 – 100 million/1.2950) loss.

6. The change in the fair value of the forward contract since the last valuation was a EUR 1,196,000 gain. Since the forward contract was no longer part of a hedging relationship, the gain was recognised in profit or loss.
7. The receipt of the USD 100 million cash payment from the customer was valued at the spot rate on 30 June 20X5, EUR 75,758,000 (=100 million/1.32).
8. The forward was settled: the USD 100 million cash was exchanged for EUR 80 million under the physical settlement provision of the forward contract.

The following table gives a summary of the accounting entries, excluding the entries related to the cost of goods sold. The table shows that the forward contract locked in a EUR 80 million overall income.

	Cash	Forward contract	Accounts receivable	Cash flow hedge reserve	Profit or loss
1-Oct-20X4
Forward trade	0	0
31 Dec-20X4
Forward revaluation		1,842,000		2,196,000	<354,000>
31-Mar-20X5
Forward revaluation		1,204,000		1,519,000	<315,000>
Reserve reclassification				<3,715,000>	3,715,000
Sale recognition			77,220,000		77,220,000
30-Jun-20X5
Forward revaluation		1,196,000			1,196,000
Forward settlement	80,000,000	<4,242,000>
	<75,758,000>
Receivable revaluation			<1,463,000>		<1,463,000>
Receivable settlement	75,758,000		<75,758,000>
TOTAL	80,000,000	-0-	-0-	-0-	80,000,000

(1) Note: Total figures may not match the sum of their corresponding components due to rounding.

With the hedge ABC locked in EUR 80 million proceeds from the USD sale. Including the EUR 68 million cost of goods sold, the hedge locked in EUR 12 million in EBT. While all the change in fair value of the spot element (a EUR 3,715,000 gain) during the hedging relationship (i.e., until 31 March 20X5) adjusted the sales amount, the change in fair value of the forward element (a EUR 669,000 loss) was recognised in “financial expenses” of profit or loss and not within EBITDA, as shown in Figure 5.8. From that date, the entirety of the change in fair value of the forward contract was recognised as “other financial income/expenses”. Without the hedge, the EBT and the proceeds from the sale would have been EUR 4,242,000 lower.

5.6.9 Accounting When the Forward Element is Excluded from the Hedging Relationship and Aligned Portion Temporarily Recognised in OCI

The accounting entries shown next assume that ABC elected to recognise the changes in the forward element temporarily in OCI to the extent that they related to the hedged item.

The forward element of the forward contract entered into by ABC was called the actual forward element. That element was compared to the forward element of a theoretical forward that would have had critical terms that perfectly matched the hedged item – the aligned forward element.

The actual forward element valuations (see Section 5.6.8) at each relevant date were as follows:

In our case, the aligned forward element corresponded to the forward element of the hypothetical derivative. Based on the hypothetical derivative's fair value and spot elements calculations in Section 5.6.8, the aligned forward element valuations at each relevant date were as follows:

Notes:

(1) 1,928,000 – 2,209,000

(2) <715,000> – <281,000> (previous fair value of the aligned forward element)

At hedge inception, both the actual and the aligned forward elements were nil. Whilst IFRS 9 provides guidance when actual and aligned forward elements differ, it does not address a situation in which both forward elements coincide. ABC decided to apply the guidance set for when the actual forward element exceeds the aligned forward element: the amount to be recognised in OCI would be determined only on the basis of the aligned forward element. Any remainder would be recognised in profit or loss. Additionally, because in our case the hedged item was a transaction-related item, the amount accumulated in OCI was reclassified to profit or loss, adjusting the sales figure.

The split of the change in the actual forward element between the amounts recognised in OCI and in profit or loss was calculated as follows:

Notes:

(1) Equals the period change in aligned forward element

(2) <315,000> – <434,000>

The required journal entries were as follows.

1. To record the forward contract trade on 1 October 20X4

   No entries in the financial statements were required as the fair value of the forward contract was zero.

2. To record the closing of the accounting period on 31 December 20X4

   The period change in the total fair value of the forward contract was a EUR 1,842,000 gain. The change in fair value of the spot element since the last valuation was a EUR 2,196,000 gain. That entire amount was considered effective and recorded in OCI, and as a result there was no ineffective amount. The change in fair value of the forward element resulted in a EUR 281,000 loss recognised in OCI and another EUR 73,000 loss recognised in profit or loss.

3. To record the sale agreement and the end of the hedging relationship on 31 March 20X5

   The sale agreement was recorded at the EUR–USD spot rate prevailing on the date the sales are recognised (1.2950). Therefore, the sales EUR amount was EUR 77,220,000 (=100 million/1.2950). Because the sold machinery was not yet paid, a receivable was recognised. Suppose that the machinery was valued at EUR 68 million in ABC's statement of financial position, and that ABC recognised the delivery of the machinery.

   The period change in the total fair value of the forward contract was a EUR 1,204,000 gain.

   The change in fair value of the spot element since the last valuation was a EUR 1,519,000 gain. That entire amount was considered effective and recorded in OCI, and as a result there was no ineffective amount.

   The change in fair value of the forward element resulted in a EUR 315,000 loss, split between a EUR 434,000 loss recognised in OCI and a EUR 119,000 gain recognised in profit or loss.

4. The recognition of the sales transaction in profit or loss caused the release to profit or loss of the EUR 3,715,000 deferred cash flow hedge results accumulated in OCI.
5. The recognition of the sales transaction in profit or loss caused the release to profit or loss of the EUR <715,000> forward element results accumulated in OCI.
6. To record the settlement of the receivable and the forward on 30 June 20X5

   The receivable was revalued at the spot rate prevailing on this date, showing a loss of EUR 1,463,000 (=100 million/1.3200 – 100 million/1.2950).

7. The change in the fair value of the forward contract since the last valuation was a gain of EUR 1,196,000. Since the forward contract was no longer part of a hedging relationship, the gain was recognised in profit or loss.
8. The receipt of the USD 100 million cash payment from the customer was valued at the spot rate on 30 June 20X5, EUR 75,758,000 (=100 million/1.32).
9. The forward was settled: the USD 100 million cash was exchanged for EUR 80 million under the physical settlement provision of the forward.

The following table gives a summary of the accounting entries, excluding the entries related to the cost of goods sold. The table shows that the forward contract locked in EUR 80 million in overall income.

Note: Total figures may not match the sum of their corresponding components due to rounding.

This alternative increased the amount of the change in fair value of the forward temporarily recognised in OCI (see Figure 5.9), which helped reduce volatility in profit or loss. However, it was substantially more complex from an operational standpoint as the entity was required to keep track of the aligned time values. For such a short transaction, probably it was better just to recognise all the changes in the forward element in profit or loss.

5.6.10 Final Remarks: Inclusion versus Exclusion of the Forward Element

The forward element (i.e., the forward points) of an FX forward represents the expected depreciation of one currency relative to the other currency during a specific period. Forward points result from the interest rate differential between both currencies. Under IFRS 9, the measurement of the hedge effectiveness between the forecasted transaction and the FX forward may be based on either the spot element (i.e., excluding the forward element from the hedging relationship) or the forward contract in its entirety (i.e., including both the spot and the forward element in the hedging relationship). No method is best as both approaches have potential benefits and drawbacks. Whilst under both alternatives the EBT is the same, the effect on EBITDA is dependent on the chosen alternative.

I analyse next the impact of the three previous approaches on EBITDA. In our case, the forward points implied a depreciation of the USD relative to the EUR, a loss that necessarily arose during the life of the forward contract.

Note: Total figures may not match the sum of their corresponding components due to rounding.

5.7.1 Hedging Relationship Documentation

At inception of the hedging relationship, ABC documented the hedging relationship as follows:

5.7.2 Hedge Effectiveness Assessment

Hedge effectiveness will be assessed by comparing changes in the fair value of the hedging instrument to changes in the fair value of a hypothetical derivative. Intrinsic values will be measured, comparing the spot exchange rate and the strike price. Effectiveness will be assessed only during those periods in which there is a change in intrinsic value.

The terms of the hypothetical derivative – a EUR–USD tunnel for maturity 30 June 20X5 with nil fair value at the start of the hedging relationship – reflected the terms of the hedged item. The terms of the hypothetical derivative were as follows:

(*) The USD call strike rate of the hypothetical derivative (1.2150) was different from that of the hedging instrument (1.2120) due to the absence of CVA in the hypothetical derivative (the counterparty to the hypothetical derivative is assumed to be credit risk-free).

Changes in the fair value of the hedging instrument (i.e., the tunnel's intrinsic value) will be recognised as follows:

• The effective part of the gain or loss on the hedging instrument will be recognised in the cash flow hedge reserve of OCI. The accumulated amount in equity will be reclassified to profit or loss in the same period during which the hedged expected future cash flow affects profit or loss. When the sale is recognised in profit or loss, the amount reclassified from OCI will adjust the sales amount. When the resulting receivable is remeasured though profit or loss, the amount reclassified from OCI will be recognised in the “other financial income/expenses” account of profit or loss.
• The ineffective part of the gain or loss on the hedging instrument will be recognised in profit or loss.

The change in time value of the tunnel (i.e., the “actual time value”) will be excluded from the hedging relationship. Due to the absence of actual time value at the beginning and end of the hedging relationship, the changes in actual time value will be recognised temporarily in the time value reserve of OCI. No reclassification from OCI to profit or loss will be carried out during the term of the hedging relationship as the carrying value of the time value reserve in OCI is expected to be nil at the end of the hedging relationship.

Hedge effectiveness will be assessed prospectively at the hedging relationship inception, on an ongoing basis at each reporting date and upon occurrence of a significant change in the circumstances affecting the hedge effectiveness requirements.

The hedging relationship will qualify for hedge accounting only if all the following criteria are met:

1. The hedging relationship consists only of eligible hedge items and hedging instruments. The hedge item is eligible as it is a highly expected forecast transaction that exposes the entity to fair value risk, affects profit or loss and is reliably measurable. The hedging instrument is eligible as it is a derivative combination in which the written option represents an offset to the purchased option and does not result in a net written option.
2. At hedge inception there is a formal designation and documentation of the hedging relationship and the entity's risk management objective and strategy for undertaking the hedge.
3. The hedging relationship is considered effective.

The hedging relationship will be considered effective if the following three requirements are met:

1. There is an economic relationship between the hedged item and the hedging instrument.
2. The effect of credit risk does not dominate the value changes that result from that economic relationship.
3. The hedge ratio of the hedging relationship is the same as that resulting from the quantity of hedged item that the entity actually hedges and the quantity of the hedging instrument that the entity actually uses to hedge that quantity of hedged item. The hedge ratio should not be intentionally weighted to create ineffectiveness.

Whether there is an economic relationship between the hedged item and the hedging instrument will be assessed on a qualitative basis. The assessment will be complemented by a quantitative assessment using the scenario analysis method for two scenarios in which the EUR–USD FX rate at the end of the hedging relationship (30 June 20X5) will be simulated by shifting the EUR–USD spot rate prevailing on the assessment date by +10% and by –10%, and the change in fair value (i.e., the change in intrinsic values) of both the hypothetical derivative and the hedging instrument compared.

5.7.3 Hedge Effectiveness Assessment Performed at Hedge Inception

Hedge effectiveness was assessed on 1 October 20X4, at the start of the hedging relationship. The entity concluded that the hedging relationship was considered effective as the following three requirements were met:

1. There was an economic relationship between the hedged item and the hedging instrument. Based on the qualitative assessment performed, supported by a quantitative analysis, ABC concluded that the change in fair value of the hedged item was expected to be substantially offset by the change in fair value of the hedging instrument, corroborating that both elements had values that would generally move in opposite directions.
2. The effect of credit risk did not dominate the value changes resulting from that economic relationship as the credit ratings of both the entity and XYZ Bank were considered sufficiently strong.
3. The hedge ratio of the hedging relationship was the same as that resulting from the quantity of hedged item that the entity actually hedged and the quantity of the hedging instrument that the entity actually used to hedge that quantity of hedged item. The hedge ratio was not intentionally weighted to create ineffectiveness.

5.7.4 Fair Valuation of Hedged Item and Hypothetical Derivative at the Relevant Dates

The actual spot exchange rates and discount factors prevailing at the relevant dates were as follows:

The fair value of the tunnel was calculated using the Black–Scholes model and incorporating CVA/DVA. The intrinsic value was calculated using the spot rates. The time value of the tunnel was calculated as follows:

The following table details the calculation of the changes in the tunnel intrinsic and time values. The time value of the instrument entered into is also referred to as the actual time value. It is worth noting that although the tunnel had no time value at the beginning and end of its life, its time value change showed a remarkable volatility.

Notes:

(1) Calculated using the Black–Scholes model and incorporating CVA/DVA

(2) Calculated using the Black–Scholes model and incorporating CVA/DVA

(3) 1,761,000 = (1) + (2) = 1,761,000 + Nil

(4) 77,519,000 = 100,000,000/1.2900

(5) 75,758,000 = 100,000,000/1.3200

(6) 1,761,000 = max(77,519,000 – 75,758,000; 0)

(7) 1,761,000 = 1,761,000 × 1.0000+ Nil =(6) × Discount factor – CVA

(8) 82,508,000 = 100,000,000/1.2120

(9) 75,758,000 = 100,000,000/1.3200

(10) Nil = – max(75,758,000 – 82,508,000; 0)

(11) Nil = Nil × 1.0000 + Nil = (10) × Discount factor – CVA

(12) 1,761,000 = 1,761,000 + Nil = (7) + (11)

(13) 266,000 = 1,761,000 – 1,495,000

(14) 1,480,000 = 1,761,000 – 281,000

(15) <1,214,000> = Nil – 1,214,000

The following table shows the change in fair value of the hypothetical derivative. Remember that a hypothetical derivative has no time value, so only the change in its intrinsic value was needed to determine the hedge's effective and ineffective parts.

5.7.5 Calculation of Effective and Ineffective Amounts

The effective and ineffective amounts of the change in fair value of the hedging instrument (i.e., the change in intrinsic value of the tunnel) were calculated, comparing such change with the change in fair value of the hypothetical derivative (remember that the hypothetical derivative had only intrinsic value) since hedge inception and taking into account the previously recorded effective amounts, as follows:

Notes:

(1) 281,000 = Lower of 281,000 and 296,000

(2) 1,761,000 = Lower of 1,761,000 and 1,761,000

(3) 281,000 = The sum of all prior effective amounts = Nil + 281,000

(4) 1,480,000 = 1,761,000 – 281,000 = (2) – (3)

(5) Change in the fair value of the hedging instrument (i.e., the tunnel's intrinsic value change) since the last fair valuation

(6) Lower of 1,480,000 (available amount) and 1,480,000 (period change in fair value of hedging instrument) = Lower of (4) and (5)

(7) Nil = 1,480,000 (period change in fair value of hedging instrument) – 1,480,000 (effective part)

Under IFRS 9 the cumulative change in fair value of the time value component of an option from the date of designation of the hedging instrument is temporarily accumulated in OCI to the extent that it relates to the hedged item.

In our case, due to the absence of actual time value at the beginning (1 October 20X4) and the end (30 June 20X5) of the hedging relationship, changes in actual time value were recognised temporarily in the time value reserve of OCI, as shown in the table below. No reclassification to profit or loss was carried out during the term of the hedging relationship as the carrying value of the time value reserve in OCI was expected to be nil at the end of the hedging relationship.

Of note is that the carrying value of the time value reserve when the sale was recognised in profit or loss (i.e., on 31 March 20X5) was not nil (i.e., EUR 1,214,000) as the tunnel was still alive. ABC decided that no reclassification to profit or loss was needed at that moment due to the reserve's expected convergence to nil at the end of the hedging relationship, a decision consistent with the fact that the entity paid no overall up-front premium for the protection.

An interesting situation may arise when a change in circumstances causes the hedging relationship to end prior to the maturity of the tunnel. Imagine for example that, after the tunnel was traded, the negotiations were accelerated and, as a result, the sale and the receivable were expected to occur sooner than initially anticipated. In this scenario, the hedging relationship would be shortened, causing the tunnel to last beyond the end of the hedging relationship. As a result, it is likely that the time value of the tunnel at the end of the hedging relationship would not be nil. Whilst IFRS 9 requires the changes in actual time value to be recorded in OCI to the extent that they relate to the hedged item, it does not provide guidance on how to proceed in such a particular situation. Furthermore, at the time of writing, the auditing community has not opined on how to treat such situations. In the meantime, it would be reasonable to maintain the original policy of recognising in OCI any changes in the actual time value and to reclassify to profit or loss any amount remaining in OCI at the end of the hedging relationship.

5.7.6 Accounting Entries

The required journal entries were as follows.

1. To record the tunnel trade on 1 October 20X4

   No on-balance-sheet entries in the financial statements were required as the fair value of the tunnel was zero.

2. To record the closing of the accounting period on 31 December 20X4

   The change in fair value of the tunnel since the last valuation was a gain of EUR 1,090,000. This gain was solely due to the tunnel's change in time value, which was recognised in OCI:

3. To record the sale agreement on 31 March 20X5

   The sale agreement was recorded at the spot rate prevailing on that date (1.2950). Therefore, the EUR equivalent of the sale amount was EUR 77,220,000 (=100 million/1.2950). Because the machinery sold was not yet paid, a receivable was recognised. Suppose that the machinery was valued at EUR 68 million in ABC's statement of financial position.

4. The change in the fair value of the tunnel since the last valuation was a gain of EUR 405,000. Of this amount, a gain of EUR 281,000 was due to a change in the tunnel's intrinsic value, fully considered effective and recorded in equity (i.e., no ineffectiveness was present). The remainder, a gain of EUR 124,000, was due to a change in the tunnel's time value and taken to the time value reserve in OCI.
5. The recognition of the sales transaction in profit or loss caused the release to profit or loss of the amounts accumulated in the cash flow hedge reserve of OCI (EUR 281,000).
6. To record the settlement of the accounts receivable on 30 June 20X5

   The receivable was revalued at the spot rate prevailing on this date, showing a loss of EUR 1,463,000 (=100 million/1.3200 – 100 million/1.2950).

7. The change in the fair value of the tunnel since the last valuation was a gain of EUR 266,000. Of this amount, a gain of EUR 1,480,000 was due to a change in the tunnel's intrinsic value, fully considered effective and recorded in equity (i.e., no ineffectiveness was present). The remainder, a loss of EUR 1,214,000, was due to a change in the tunnel's time value, taken to the time value reserve in OCI.
8. Because the hedged item (the receivable) impacted profit or loss, the amounts accumulated in the cash flow hedge reserve were reclassified to profit or loss.
9. ABC received USD 100 million from the client. Simultaneously, the tunnel expired and ABC exercised the USD put, exchanging the USD 100 million for EUR 77,519,000.

The following table gives a summary of the accounting entries, excluding the entries related to the cost of goods sold.

Note: Total figures may not match the sum of their corresponding components due to rounding.

5.7.7 Accounting Entries – Discontinuation by Changing Risk Management Objective

In our previous approach, on 30 June 20X5 an additional calculation/recognition of effective and ineffective parts and the subsequent reclassification of the effective part into profit or loss were required, besides an additional calculation of the changes in actual time value. An alternative to avoid such administrative complexity was to discontinue the hedging relationship on 31 March 20X5 by changing the hedge's risk management objective on that date. Whilst under IFRS 9 voluntary discontinuation of a hedging relationship is not permitted, discontinuation is required when a hedging relationship does not meet its risk management objective. By changing the risk management objective an entity may provoke a mandatory discontinuation of the hedging relationship. In my view, this solution may be challenged by auditors, especially when a pattern of changing risk management objectives has been implemented solely to overcome the restrictions of IFRS 9. However, as happened with IAS 39 (the previous hedge accounting standard), over time the auditing community comes to accept practices that at the beginning of the implementation of a standard may seem questionable. I will cover this approach next.

On 31 March 20X5, following the recognition of the receivable, suppose that ABC updated the hedge documentation as follows: “The risk management of the EUR–USD foreign exchange risk stemming from the accounts receivable will no longer be managed under this hedging relationship, but instead in conjunction with the EUR–USD foreign exchange risk stemming from the FX tunnel as there is a natural offset in profit or loss of both risks when the tunnel is in-the-money. As a result of this change in the risk management objective, the hedging relationship is discontinued from 31 March 20X5.”

The accounting entries up to, and including, 31 March 20X5 were identical to those of the previous example, and have therefore been omitted to avoid unnecessary repetition.

5.7.8 Final Remarks

The obligation to account for the time value of an option based on the aligned time value notably reduced the volatility in profit or loss, but operational complexity was significantly increased. In my view, IFRS 9 should allow entities to choose, when an option time value is excluded from the hedging relationship, between this approach and an alternative involving recognising all changes in an option time value in profit or loss. This choice is available in the case of forward elements of forward contracts and of basis elements of cross-currency swaps. Other approaches available to ABC would not work appropriately:

• To set 31 March 20X5 as the end of the hedging relationship. Under this approach, on 30 June 20X5 the change in fair value of the tunnel would be recognised in profit or loss, sparing ABC from performing the complex calculations of effective/ineffective parts and actual time values. However, due to the different maturities of the tunnel (30 June 20X5) and the hypothetical derivative (31 March 20X5), substantial volatility in profit or loss may be created due to potentially differing behaviours of the actual and aligned time values during the life of the hedging relationship.
• To designate the tunnel in its entirety as the hedging instrument. This would have reduced the operational complexity as it avoids calculating the time value component of the tunnel. However, substantial volatility may arise in profit or loss as the hypothetical derivative does not have time value. Additionally, there could be periods in which, due to time value changes in the tunnel, the change in fair value of the tunnel and that of the hypothetical derivative have opposite signs, potentially endangering the conclusion that there is an economic relationship between the hedged item and the hedging instrument.