Published: March 01, 2012
The International Accounting Standard Board (the Board) completed deliberation in September 2011 to make significant changes to proposals in the Exposure Draft Hedge Accounting (ED) issued in December 2010, being the proposals for the third part of IFRS 9, the project to replace IAS 39.
The main objective of the ED is to simplify hedge accounting to provide a better linkage between an entity’s risk management strategy, the rationale for hedging and the impact of hedging on the financial statements. The proposals represent a fundamental shift from the way entities have applied hedge accounting in the past.
The IASB’s efforts are welcomed by market participants to reduce complexity of hedge accounting that can be applied for both financial services and corporate entities. However, although market participants are supportive of the overall intent and direction of the proposals, they are interested in clarifying the wording of the ED to make the ED more operational.
Using a more principles based approach, financial reporting would reflect more accurately how an entity manages its risk and the extent to which hedging practices mitigate those risks as a result of these proposals.
The most significant benefits are likely to be realized by non-financial corporate entities. For example, hedge accounting will now be permitted for risk components of non-financial items such as certain commodities, provided that certain criteria have been met. Layer components and combinations of derivatives and non-derivatives will also be eligible. Hedges are designated with qualifying hedging instruments and hedged items, including both financial instruments measured at fair value and through other comprehensive income. Written options and internal derivatives will continue to be prohibited.
Under the ED, hedge effectiveness testing will be simpler as it will only be required on a prospective basis. Previously, it was necessary to perform retrospective and prospective tests. There will be no more arbitrary 80 to 125% retrospective effectiveness to qualify for hedge accounting. Qualitative testing will be possible where appropriate and there will be no arbitrary bright lines in the new model. Ineffectiveness is measured and recognized in profit or loss which does not change from current practice.
Rebalancing would be required if the hedge ratio used for risk management purposes changes, or if accounting rebalancing is required to prevent the existing risk management hedge ration resulting in an imbalance that would deliberately create hedge ineffectiveness. Rebalancing, a common risk management technique, will not necessarily result in de-designation and re-designation. As a consequence, current challenges of ineffectiveness due to non-zero fair value derivatives on re-designation can be avoided. Proportional de-designation or partial continuation is now possible in some circumstances. However, when a risk management objective does not change, voluntary de-designation is not permitted.
Items in gross positions must be individually eligible for hedged accounting and be managed on that basis for risk management. Layer components are now permitted for forecast as well as existing transactions subject to some criteria. Group of net positions are permitted subject to certain criteria.
Option premiums which generally represent the time value and forward points in a forward contract can be deferred in other comprehensive income.
‘Own use’ commodity contracts can be fair valued in certain circumstances if managed on a fair value basis rather than applying hedge accounting.
There is no change proposed for the mechanics of fair value hedges, cash flow hedges and hedges of net investments.
There would be additional disclosures, including an entity’s risk management strategy and how it is applied to management risks, how hedging activities may affect the amount, timing and uncertainty of future cash flows, and the overall effect that hedge accounting has had on the entity’s financial statements.
For banks and other financial institutions, macro hedge accounting will be deliberated as a separate proposal.[[[PAGE]]]
The understanding of the key improvements of the ED is particularly relevant for accountants, treasurers and all who are involved in hedging activities in both financial services and corporate entities.
Although the new hedge accounting proposals are more closely aligned with entities’ risk management activities, the ED appears to present some new challenges.
The first challenge is that hedge accounting may no longer be possible for risk management objectives that simply do not qualify for hedge accounting. This contrasts with IAS 39 which allows hedge accounting for any eligible hedging instrument and hedged item that are matched with a relationship that complies with the 80 to 125% effectiveness test. This applies even in cases when the relationship does not align with an entity’s actual risk management strategy.
The second challenge is that, in relation to hedging risk components, there are several practical issues in identifying the valid risk components and measuring them reliably as required by the ED, especially when the components are not contractually specified. The IASB clarified that the market structure is key in determining whether an eligible risk component exists. The final standard will include additional guidance and illustrative examples. For example, the final standard will include a rebuttable presumption that non-contractually specified inflation risk will usually not be an eligible hedged item. Examples of two scenarios will be provided, one in which an inflation risk component may be eligible for hedge accounting and another where it may not.
The third challenge created by the ED is the replacement of the prospective and retrospective 80 to 125% test with the requirement for the hedging relationship to meet the effectiveness criteria:
Although the IASB provide the additional guidance above, from a practical perspective, entities currently with numerous hedge relationships can simply rely on automated processes to determine whether a mathematical calculation is within a boundary of 80 to 125% without significant intervention. Under the ED, significant estimates and judgment are now required to ensure whether each hedge relationship is meeting the above effectiveness criteria and also whether a hedge relationship is required to be re-balanced. Automated software solution may be helpful in identifiying trends and developments but human intervention will be required to apply judgment and determine the point in time when rebalancing needs to take place.
The ED provides more opportunities to better align hedge accounting and economic hedging activities. Entities in both financial services and corporate sectors may want to review their current economic hedging activity to identify new opportunities. They may also want to revisit their risk management objectives and strategies and clarify them as necessary to apply hedge accounting under the new model. Finally, entities could facilitate a smoother transition by determining what hedge relationships will need to be designated in the future and by developing the related hedge documentation by the mandatory adoption date of 1 January 2015.
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