The last episode of the IFRS 9 trilogy
The IASB (International Accounting Standards Board) released its long awaited Exposure Draft (ED) on Hedge Accounting in December 2010, being the last stage of the IFRS 9 trilogy reform program to replace IAS 39. The Board is still deliberating specific hedge accounting elements like macro and portfolio hedging, which will be addressed in a later installment.
The predecessor of IFRS 9, IAS 39, and especially the hedge accounting part has been widely regarded as complex, rules based and not always presenting correctly the underlying economic reality in accounting. Restrictions of IAS 39 prevent some economic hedging strategies from qualifying for hedge accounting treatment. The aim for the redesign of the hedge accounting standard has been to address this criticism. The proposal’s aim is to integrate and link hedge accounting more closely with the risk management objectives and policies of a company and also to provide more useful information to the users of financial statements by enhancing the disclosures requirements. Although substantial changes have been proposed, this ED does not imply a complete revamp of hedge accounting, though it will result in a more dynamic and principles-based accounting standard.
What will change?
The following key elements have been proposed in IASB’s Exposure Draft on hedge accounting:
What financial instruments qualify for designation as hedging instruments?
Non-derivative financial instruments, not only those used to hedge FX risk, are allowed under certain circumstances to be designated as a hedge instrument under hedge accounting. Other than for hedges of FX risk, these non-derivative hedge instruments need to be designated in their entirety.
What items qualify for designation as hedged items?
It will be possible to designate a combination of an exposure and a derivative as a hedged item in a hedge relationship, which may particularly be helpful for commodity hedging. Another important improvement is that the ED proposes to allow the designation of a certain risk component of a hedged item provided that the hedged risk can be identified and measured separately. This accommodates corporates that want to hedge a particular risk element out of a hedged item. A well known example of this is when airliners want to hedge the crude oil component for their jet fuel price risk. Under IAS 39 this was only allowed for the FX risk component.
Hedging net positions is a common strategy for corporate treasuries. Under IFRS 9, a net position would now be an eligible hedged item if certain conditions are met. However the condition that the underlying cash flows should affect the P&L in the same period is likely to prevent most companies from taking advantage of designating these net positions.
“It will provide more flexibility, be less bureaucratic and will better support the economic concept of risk management.”
How an entity should account for a hedging relationship
IASB will remove the arbitrary 80-125% rule with regards to effectiveness testing. Currently, an effectiveness ratio of 79% is considered to be ineffective and below the boundary of 80% at which hedge accounting can be applied. Instead, the proposed hedge effectiveness requirements will be purely prospective and will be driven by the risk management strategy and objective of the entity to enhance the link between hedge accounting and an entity’s risk management activities. This means that a hedging relationship may not contain a deliberate mismatch which would result in a biased outcome creating ineffectiveness. The proposed effectiveness requirements are that the hedge designation must be unbiased and is expected to achieve effectiveness other than accidental offsetting. The ED does not yet provide particular guidance on which method to use. However, both qualitative as well as quantitative methods can be used depending on the characteristics of the hedge.
Furthermore, the ED also proposes that a company can rebalance a hedge relationship to continue to meet the objective for hedge effectiveness assessment provided that the risk management objective remains the same for that hedge relationship. This will avoid an entity having to de-designate a hedge relationship when it fails the prospective hedge effectiveness test and designate a new hedge relation for the adjusted hedged item and hedge instrument, as is the case under IAS 39. Also, voluntary discontinuation of a hedge relationship will no longer be permitted. This means that discontinuation of hedge accounting once the hedge item has been recognized on the balance sheet will not be possible in future.
The option to apply the so called ‘basis adjustment’ under IAS 39 will now become a mandatory one. IASB also proposes to bring the accounting treatment of fair value hedges more in line with cash flow hedges. This will mean that for fair value hedges the effective fair value changes for both the hedge item and the hedge instrument will be booked into OCI1. Furthermore IFRS 9 will also better support and facilitate the usage of options under hedge accounting. The way IAS 39 currently deals with the time value component is that it does not allow deferral; consequently resulting in P&L volatility.
Hedge accounting presentation and disclosures
Additional disclosure requirements are proposed. In particular, the proposal on an entity’s risk management strategy and the impact of the hedging activities on the amount, timing and uncertainty of its future cash flows may enhance the transparency regarding the entity’s hedging activities. IFRS 72 mainly focused on risks of specific financial instruments rather than a company’s broader financial risk management process. However there is also concern that these disclosure requirements go too far since it may require sensitive commercial information to be disclosed.
Link between hedge accounting and risk management practice
Although the current hedge accounting ED is not yet the final standard and a lot may change in the meantime, it at least shows the direction IASB is taking with regards to hedge accounting. Although some elements may not be supportive for certain hedge accounting strategies, many corporates will welcome the changes that have been proposed in the ED. It will provide more flexibility, be less bureaucratic and will better support the economic concept of risk management. Furthermore, it will also result in more sound economic hedges that could qualify for hedge accounting treatment. However, further clarification and guidance on some elements will be required from the IASB in order to be able to make an assessment of the practicalities involved.
Furthermore the central theme of this hedge accounting ED is the emphasis on the link between hedge accounting and risk management objectives. It will therefore become even more important for corporates to clearly define their risk management strategy including clear risk limits and boundaries. Also consideration should be given to operational aspects. Hedge accounting procedures and systems will require changes to execute hedge accounting under IFRS 9. It seems that there will be an increased number of situations in the hedge accounting process that will require subjective human assessment; this may result in practical issues and also potentially limit the degree of automation.
What may be worrying are the conceptual differences between US GAAP3 and IFRS regarding the proposed changes of their respective standards for hedge accounting. IASB seems to have gone much further than FASB in its reform. One may wonder if it will ever come to a true single standard, although different bodies have stressed the necessity for convergence.