The IFRS Interpretations Committee (Committee) discussed the following matter and tentatively decided not to add a standard-setting project to the work plan. The Committee will reconsider this tentative decision, including the reasons for not adding a standard-setting project, at a future meeting. The Committee invites comments on the tentative agenda decision. All comments will be on the public record and posted on our website unless a respondent requests confidentiality and we grant that request. We do not normally grant such requests unless they are supported by good reason, for example, commercial confidence.
Tentative Agenda Decision
The Committee received a request about applying the hedge accounting requirements in IFRS 9 when the risk management objective is to ‘fix’ the cash flows in real terms.
The request asked whether a hedge of the variability in cash flows arising from changes in the real interest rate, rather than the nominal interest rate, could be accounted for as a cash flow hedge. More specifically, the request describes a fact pattern in which an entity with a floating rate instrument referenced to an interest rate benchmark, such as LIBOR, enters into an inflation swap (which swaps the variable interest cash flows of the floating rate instrument for variable cash flows based on an inflation index). The request asked whether the entity can designate the swap in a cash flow hedging relationship to hedge changes in the variable interest payments for changes in the real interest rate.
Hedge accounting requirements in IFRS 9
Paragraph 6.1.1 of IFRS 9 states that the objective of hedge accounting is to represent, in the financial statements, the effect of an entity’s risk management activities that use financial instruments to manage exposures arising from particular risks that could affect profit or loss (or other comprehensive income).
One type of hedging relationship described in paragraph 6.5.2 of IFRS 9 is a cash flow hedge in which an entity hedges the exposure to variability in cash flows that is attributable to a particular risk associated with all, or a component of, a recognised asset or liability and could affect profit or loss.
Paragraph 6.3.7 of IFRS 9 specifies that an entity may designate an item in its entirety, or a component of an item, as a hedged item. A risk component may be designated as the hedged item if, based on an assessment within the context of the particular market structure, that risk component is separately identifiable and reliably measurable.
With respect to inflation risk, paragraph B6.3.13 of IFRS 9 states ‘there is a rebuttable presumption that unless inflation risk is contractually specified, it is not separately identifiable and reliably measurable and hence cannot be designated as a risk component of a financial instrument’.
Paragraph B6.3.14 of IFRS 9 states that an entity cannot simply impute the terms and conditions of an inflation hedging instrument by projecting its term and conditions onto nominal interest rate debt. This is because, when developing IFRS 9, the Board specifically considered inflation risk and put in place restrictions to address its concern that entities might impute the terms and conditions of a hedging instrument onto the hedged item ‘without proper application of the criteria for designating risk components’ as a hedged item (paragraph BC6.193 of IFRS 9). To appropriately account for hedge (in)effectiveness, paragraph B6.5.5 of IFRS 9 requires an entity to measure the (present) value of the hedged item independently of the measurement of the value of the hedging instrument.
Given the request asked whether the real interest rate component could be designated as a risk component, the Committee’s analysis focussed on whether a non-contractually specified real interest rate risk component is separately identifiable and reliably measurable in the proposed cash flow hedging relationship described in the request.
Can a non-contractually specified real interest rate risk component be designated as the hedged item in a cash flow hedging relationship?
To apply cash flow hedge accounting in the fact pattern described in the request, the Committee considered that it would be necessary to determine:
- whether the floating rate instrument has exposure to variability in cash flows that are attributable to the real interest rate risk component as required by paragraph 6.5.2(b) of IFRS 9; and
- whether that risk component is separately identifiable and reliably measurable as required by paragraph 6.3.7 of IFRS 9.
The Committee noted that a nominal interest rate comprises a real interest rate, an inflation component (for example, breakeven inflation and inflation premium), and other components (for example a liquidity premium). Unlike a currency, inflation varies based on the underlying methodology used to determine actual inflation (and can vary within a currency area). This means, even within a jurisdiction, there can be multiple rates of inflation depending on the inflation index to which the financial instrument is referenced—for example, a retail price index, consumer price index or another inflation index.
The Committee observed that, to meet the requirements in IFRS 9 for a cash flow hedge designation, the variability of individual cash flow streams attributed to the designated risk component needs to be separately identifiable in currency or nominal terms. The Committee considered that the interest rate for variable rate financial instruments is defined in nominal terms for a given currency. Each currency unit of cash flow of a financial asset or financial liability (that is, each principal and interest cash flow) is equally exposed to inflation risk. Measurement and forecasts of actual inflation are based on statistical methodologies and therefore entail a time lag. The real interest rate, and therefore the effect of inflation, is not a risk component that explicitly or implicitly influences the determination of a nominal benchmark interest rate. There is therefore no identifiable variability in the benchmark rate-based nominal cash flows (for example, LIBOR cash flows) on a floating rate financial instrument that is attributable to the real interest rate risk component as required by paragraph 6.5.2(b) of IFRS 9.
In addition, the Committee considered that, in the proposed cash flow hedging relationship, the real interest rate would be an implied residual risk component (after combining the variable inflation-linked cash flows and the floating benchmark rate-based cash flows). The Committee therefore concluded that changes in cash flows on a floating rate instrument arising from the real interest rate risk component cannot be identified independently of changes in cash flows arising from other risk components. Consequently, the real interest rate risk component does not meet the requirements in paragraph 6.3.7 of IFRS 9 to be designated as a risk component. It therefore is not an eligible hedged item as required by paragraph 6.4.1 of IFRS 9.
The Committee concluded that the requirements in IFRS 9 provide an adequate basis for an entity to determine whether a hedge of the variability in cash flows arising from changes in the real interest rate, rather than the nominal interest rate, could be accounted for as a cash flow hedge. Consequently, the Committee [decided] not to add a standard-setting project to the work plan.
The deadline for commenting on the tentative agenda decision is 15 February 2021. The Committee will consider all comments received in writing by that date; agenda papers analysing comments received will include analysis only of comments received by that date.
