Off-market hedge accounting under IFRS 9

Most companies assume that if an interest rate swap acts to remove all interest rate risk from their hedged borrowing, and they are applying cash flow hedge accounting, then they will have no ineffectiveness in their hedge relationship. Take the simple example below:

The only complexity here is that this example company’s swap is ‘off-market’, meaning that the swap rate is not equivalent to a market rate at designation date. In this example, the swap has a fixed rate of 2%, but the market swap rate for the hedged period at designation date is 5%. This means that the swap has a non-zero fair value (in this case, the swap would be a significant asset to the client as it is fixing the rate on the loan below current market levels).

There are several reasons why a company might end up with an off-market swap, most commonly:

• The company initially chose not to apply hedge accounting and then subsequently decides to designate the swap for cash flow hedge accounting some months (or years) after trade date.
• The swap was acquired by the company in a business combination.
• The swap was restructured after trade date, requiring the swap to be redesignated for hedge accounting.
• The company has exchanged another asset or liability for a swap that is off-market at initial trade date. Examples of this could include making an upfront payment to reduce the fixed rate on the swap or embedding the fair value of an existing swap into a new swap as part of a restructuring exercise.

IFRS requires treating this discrepancy as a source of ineffectiveness, and companies need to model the differences in fair value movement between their actual hedging instrument and a hypothetically perfect hedge to capture this ineffectiveness. The modelling of ineffectiveness from off-market swaps can be complex and difficult for companies to manage unless they have access to sophisticated valuation tools. A further challenge arises, however, from the need to ensure that the cash flow hedge reserve is cleared to zero by the end of the hedge relationship. One way of picturing this problem is to think of the cash flow hedge reserve as a bucket that is empty at the start of the hedge relationship and needs to finish empty. Consider this illustration of how this works in an at-market hedge relationship:

When a swap has a non-zero fair value at designation date, that fair value is embedded into the future settlements. This means that post the designation date and swap settlements will not equal the fair value movements. The bucket will not be emptied unless the reclass from the cash flow hedge reserve into P&L is adjusted to avoid ‘double-counting’ the designation date fair value of the swap. Chatham’s in-depth Off-Market Hedge Accounting white paper details the various approaches for calculating the required adjustments. Whilst there is some diversity in practice in exactly how adjustments to swap reclasses are calculated and allocated to different accounting periods, it is imperative that appropriate adjustments are made to swap reclasses. Failure to make the adjustments result in a potentially significant balance being incorrectly stored in the cash flow hedge reserve resulting in misstated earnings.