IFRS 9: A Practical View of Hedging

by Dipak Khot, Thought Leadership, Global Markets Corporate Services, EMEA and Michael Anthony, Global Head, Thought Leadership, Global Markets Corporate Services, HSBC

Fulfilling hedge accounting requirements under IAS 39 has been a major headache for treasurers since it took effect in 2005, often requiring complex hedge designation, documentation and new processes to assess hedge effectiveness and measure ineffectiveness.

In many cases, HSBC has observed that treasurers found that accounting considerations have become more important in defining risk management policy than the risks themselves, creating an inevitable tension. Whilst IFRS 9 hedge accounting still involves complexity and detailed requirements, the alignment to risk management activities could offer a variety of advantages for treasurers. 

This article highlights the potential benefits of adopting IFRS 9 hedge accounting, specifically for corporates. As with any such internal accounting replacement programmes, in order to achieve the full benefits there is likely to be cost involved due to operational changes that will be required. It might also expose corporates to a potential for increased accounting risk due to complexity. 

IFRS 9 in summary

There are three parts to IFRS 9:

• Classification and measurement 
• Impairment; and 
• Hedge accounting. 

 In the first instance, having classified how assets and liabilities are managed, IFRS 9 introduces a principles-based model that then uses cash flow-based characteristics to further determine the classification of assets, replacing the more rule-based requirements under IAS 39 that can sometimes be difficult to apply. Second, the new standard better recognises credit risk inherent in financial instruments by introducing a requirement to recognise expected credit losses on a more timely basis, addressing weaknesses of the incurred loss model in IAS 39 that were exposed during the global financial crisis. Finally, hedge accounting requirements now enable treasurers to focus more on hedging financial risks with perhaps more of their activities actually qualifying for hedge accounting.

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Potential benefits of IFRS 9 hedge accounting

These elements could represent a change for corporate treasurers in the way that they address risk and determine appropriate hedging policies, easing the hedge accounting burden and enabling them to pursue a hedging strategy that better reflects their economic risks:

• Commodity hedging - Under IAS 39, treasurers cannot designate non-financial items in hedge relationships on a risk component basis (with the exception of FX risk), so it can be difficult for treasurers to qualify for hedge accounting in respect of hedges of commodity price risk due to high amounts of hedge ineffectiveness arising from the other risks included in the hedge designation. IFRS 9 simplifies hedge accounting for commodities by allowing the risk component of a non-financial item (e.g., the nickel component of stainless steel) to be hedged, so long as that component is separately identifiable and reliably measurable. This avoids the problem inherent with IAS 39, namely that the company must either choose to designate all risks associated with the stainless steel price in an IAS 39 hedge relationship (if it qualifies) and measure the resulting in-effectiveness, economically hedge the nickel component using the nickel swap and accept full P&L volatility from the swap, or opt to leave the exposure unhedged, thereby remaining exposed to commodity price risk.
• Hedges of net positions - IFRS 9 permits corporates to designate a single derivative to hedge the FX risk of a specifically identifiable, gross amount of forecast sales and gross amount of purchases in a cash flow hedge, but the accounting result is not then grossed up to affect both the sales and cost of sales lines. Instead, the hedging result is shown as a single line item on the P&L, which although not perfect, represents a huge improvement on IAS 39, wherein the hedging adjustment is taken to either income or expense depending on whether a gross amount of sale or purchase has been designated.
• Inclusion of derivatives in designated hedged exposures - IAS 39 prohibits the designation of a combination of an exposure that could qualify as a hedged item and a derivative i.e., aggregated exposures, even though there may be economic reasons for hedging such risks. For example, a EUR functional borrower issues a USD denominated fixed rate bond and uses a cross-currency interest rate swap to convert the bond into a floating EUR borrowing. At a later date, the borrower overlays this arrangement with a short-term EUR swap to convert it into a fixed rate borrowing. Under IAS 39, only the first hedge qualifies for hedge accounting and the derivative designated in the second relationship would be considered to be a trading derivative. Conversely, IFRS 9 permits the first derivative entered to be designated in a fair value hedge relationship and the second derivative entered at a later stage to be designated in a cash flow hedge relationship.
• Reduced P&L volatility from time value of options, forward points and currency basis –Currently, IAS 39 allows an option to be designated in a hedge relationship excluding the fair value changes associated with its time value, with the intrinsic value achieving hedge accounting treatment and the fair value changes associated with the time value taken to the P&L leading to volatility. Under IFRS 9, the excluded time value (to the extent it relates to the hedged item) is amortised to P&L on a systematic and rational basis (as a cost of hedging) over the duration of the hedge avoiding P&L volatility. Further, any subsequent fair value changes in time values are recorded in equity. The amortisation profile would be in line with when the hedged item impacts the P&L, which would generally be straight line for time-based hedges and deferred until maturity for transaction related hedged items. IAS 39 permits hedging instruments to be designated excluding forward components and under IFRS 9 they can be recorded the same way as the time value of options. Additionally, IFRS 9 now allows currency basis to be excluded from designated derivatives and recorded in the same way as the time value of options. 
• Qualification based on economic relationships – To qualify for hedge accounting, IFRS 9 requires an economic relationship between the hedging instrument and the hedged item that endures over the life of the hedge relationship which may lead to more economically hedged exposures qualifying for hedge accounting in contrast to IAS 39 which required hedge relationships to be highly effective within a range of 80-125%. For instance, a risk on the price of oil based on one index could be hedged using a derivative based on another price index, as long as there is a supportable economic relationship between the two. Evidence of the economic relationship is required to go beyond statistical correlation because the offset cannot be coincidental.
  
  

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• Hedge re-balancing – on a similar theme, if a previously strong correlation between two linked variables (e.g., WTI/ Brent) starts to weaken, suggesting a structural change in the relationship, under IFRS 9, the treasurer is required to maintain the hedge consistently with what is done for risk management purposes by rebalancing the hedge ratio i.e., increasing or reducing the size of the hedged item, or the hedge itself. This is a positive change from the current arrangement where treasurers need to de-designate an old hedge and designate a new one with a new hedge ratio. This approach is often unwelcome because the old derivative will have a non-zero fair value at the inception date of the new hedge, which can cause hedge ineffectiveness.
• Hedge effectiveness: Unlike IAS 39 where treasurers need to perform quantitative prospective testing at inception and subsequently on both a prospective and retrospective basis, IFRS 9 requires only an ongoing prospective assessment which can be qualitative provided that the method captures the relevant characteristics of the hedge relationships including the sources of ineffectiveness. It is expected that only complex hedges will attract quantitative effectiveness testing. Actual hedge ineffectiveness will still need to be measured and recorded for accounting purposes The method of assessing hedge effectiveness assessment can be changed after inception of the hedge due to subsequent changes without triggering the need to discontinue the hedge. Hedge documentation can also be updated after inception to reflect the change in hedge effectiveness without triggering the need to discontinue the hedge. .
• Fair value options for credit risk hedges – As the prices of bonds and credit default swaps (CDS) do not move in a way that results in an observable credit risk, it has proved difficult to designate the credit risk component of the bond. Under IFRS 9, treasurers will be able to account for the item at fair value through profit and loss (in its entirety) when the credit risk is hedged with a CDS. This is different from the general fair value option because it does not have to be chosen at the inception date of the hedged item. It can also be de-designated if the relationship to the CDS ceases.  

For more information, please email [email protected] or visit gbm.hsbc.com/dealing-room-of-tomorrow