Designation of primary financial instruments

When establishing (balance sheet) hedging relationships, derivative financial instruments are usually used as hedging instruments to mitigate (financial) risks. However, in addition to the designation of derivative financial instruments as hedging instruments, the regulations on hedge accounting in accordance with IFRS 9 also permit the designation of non-derivative financial instruments as hedging instruments. At the moment, the designation of non-derivative financial instruments is rarely used in practice, so the following article discusses the possibilities and applications of designating primary financial instruments as hedging instruments under IFRS 9 in more detail.  

In general, the IFRS (International Financial Reporting Standards) do not define non-derivative or primary financial instruments in any specific way. This means that primary financial instruments are all financial instruments that do not fully meet the characteristics of a derivative financial instrument in accordance with IFRS 9, Appendix A. Among these are, for example, cash and cash equivalents, equity instruments of other companies as well as contractual agreements to receive (asset) or pay (liability) cash or other financial assets or to exchange them on favorable or unfavorable terms. This means that primary financial instruments can be structured as either financial assets or financial liabilities, depending on their characteristics (see IAS 32.11).

To be eligible to apply the hedge accounting rules, the (general) application requirements in accordance with IFRS 9.6.4.1 must be met cumulatively. Each hedging relationship must be formally documented and designated, and evidence of a high level of effectiveness must be provided at inception and on an ongoing basis. For the designation of hedging instruments, it is also a requirement that hedging instruments must always be entered into with a party external to the entity (see IFRS 9.6.2.3). 

The following instruments can be designated as hedging instruments with regard to the designation of primary financial instruments¹: 

• In total or as a percentage of the instrument: primary financial instruments that are classified in the measurement category at fair value through profit or loss in accordance with IFRS 9. 
  • The exception to this are financial liabilities that are voluntarily measured at fair value under the fair value option and whose changes in value due to default risk are recognized in OCI in accordance with IFRS 9.5.7.7 (see 9.6.2.2).
• Currency risk component of the instrument: primary financial instruments regardless of the measurement category to hedge the foreign currency risk.
  In this case, the hedging instrument does not necessarily have to be a financial instrument in the scope of IFRS 9, but (primary) financial instruments in accordance with IAS 32 that are outside the scope of IFRS 9 can also be designated (see KPMG Insights, 19th ed., para. 7.9.590.20) This means that primary financial instruments such as lease liabilities or, under certain conditions, refund liabilities can also be designated as hedging instruments.
  • This excludes financial investments in equity instruments whose changes in value are (voluntarily) recognized in other comprehensive income (cf. IFRS 9.5.7.5). 

For foreign currency risk hedges, it should be noted that the foreign currency component of a non-derivative financial instrument must be determined in accordance with IAS 21 (see IFRS 9.B6.2.3). As a result, the gain or loss on the hedging instrument results from the remeasurement of the foreign currency component of the carrying amount in accordance with IAS 21 (and is not subject to discounting) and a certain degree of hedge ineffectiveness may be unavoidable (see IFRS 9.B6.5.4).  

There are no specific restrictions with regard to the type of hedging relationship depending on the risk to be hedged due to the designation of primary hedging instruments. As such, primary financial instruments can serve as hedging instruments in fair value hedge accounting as well as in cash flow hedge accounting or in hedges of a foreign net investment. Similarly, there are no restrictions that a primary financial instrument may only be included in one hedging relationship. This means that a primary financial instrument may not only be designated as a hedging instrument in one hedging relationship (for example, against foreign currency risk), but may also be the hedged item in another hedging relationship (for example, for interest rate risk).  

In the following, corresponding examples are given in which non-derivative financial instruments can be used as hedging instruments:

A)
One example of a non-currency-related hedge is the hedging of an expected highly probable procurement of commodities through the acquisition of shares in a corresponding commodity fund with comparable exposure. The hedging relationship can be recognized in accordance with the provisions of cash flow hedge accounting. Based on their characteristics, the shares in the commodity fund are to be measured at fair value through profit or loss and can therefore be designated in total (or according to the number of shares acquired, which corresponds to the nominal volume to be hedged) as non-derivative hedging instruments to hedge the commodity price risk (see KPMG Insights, 19th Ed., para. 7.9.590.70-90). There may be possible ineffectiveness depending on the match of the risk exposure and other design features between the hedged item and the hedging instrument. 

B)
When hedging foreign currency risk, for example, the spot rate risk of expected highly probable sales in 18 months in the amount of USD 5 million (functional currency is EUR) can be hedged using a fixed-interest financial liability with a nominal volume of USD 5 million and a term of 5 years. Here too, the hedging relationship is recognized in accordance with the provisions of cash flow hedge accounting. It is also important to note that the respective revaluation of sales revenue must be carried out on a discounted basis when measuring effectiveness, whereas this does not apply to the hedging instrument (i.e. the foreign currency component based on IAS 21) and this may result in corresponding ineffectiveness.

C)
An additional example of hedging foreign currency risk using non-derivative financial instruments is the hedging of a foreign investment using a foreign currency bond. In this case, the hedged risk is the translation-related foreign currency risk of the net assets of the foreign subsidiary and the hedging relationship is shown as hedges of a foreign net investment. To the extent that the critical value parameters of the hedged item and the hedging instrument are identical, no ineffectiveness is to be expected. This is because the designated hedged item (compared to the examples in A) and B)) is already a recognized item and therefore both the hedged item and the hedging instrument are subject to the spot rate change from the subsequent measurement as at the reporting date in accordance with IAS 21. 

Overall, it can be said that the designation of primary financial instruments as hedging instruments in hedge accounting also provides numerous use cases and should be taken into account when evaluating possible hedging strategies in light of the more extensive options under IFRS 9. The designation of non-derivative financial instruments as hedging instruments can prove to be particularly advantageous in this context if there is no access to derivatives markets due to country-specific regulations, if hedging is only possible using exchange-traded derivatives and corresponding margin obligations or if no (unsecured) OTC derivatives are to be concluded due to the default risk. 

The Finance and Treasury Management team would be pleased to assist you should you be interested in evaluating the possibilities of of designating primary financial instruments as hedging instruments.

Source: KPMG Corporate Treasury News, Edition 139, December 2023
Authors:
Ralph Schilling, CFA, Partner, Head of Finance and Treasury Management, Treasury Accounting & Commodity Trading, KPMG AG 
Björn Beckmann, Senior Manager, Finance and Treasury Management, Treasury Accounting & Commodity Trading, KPMG AG 

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¹ By contrast, under IAS 39 only the use of non-derivative financial instruments for hedging foreign currency risks was permitted (see IAS 39.72).