IFRS 9 Hedging – Was it Worth the Wait? (part two)

by Clarette du Plooy, Director, Corporate Treasury Solutions, Kees-Jan de Vries, Director, Capital Markets and Accounting Advisory Services and Aliénor Fromont, Assistant Manager, Capital Markets and Accounting Advisory Services, PwC

The IASB issued the hedging chapter of IFRS 9, ‘Financial instruments’, in November 2013. This was generally considered good news for treasury. Hedge accounting has not only become easier but also more aligned with risk management in the business. To summarise some of the changes and the key points covered in our previous article:

• More instruments may qualify as hedging instruments. Besides derivatives and financial instruments for currency risk, non-derivative instruments that are carried at fair value through profit or loss may also be designated as hedging instruments in future.
• More items may qualify as hedged items. The most important new items are risk components of non-financial items (e.g., LME component of a purchase of an item containing aluminum), aggregated exposures, (e.g., an investment in a portfolio of shares, with shares in different industries), net positions and combinations of derivatives and non-derivatives (e.g., a fixed-rate loan combined with an interest rate swap) that all now qualify as hedged items.
• Hedge documentation is still required in order to qualify for hedge accounting.
• Hedge effectiveness criteria have been simplified but still exist. For the criteria to be met, an entity has to show that an economic relationship exists between the hedged item and the hedging instrument and that credit risk does not dominate the relationship. In addition, a hedge ratio has to be defined, which may change throughout the life of the relationship according to market developments.

In this article, we will be discussing in more detail hedging with options and forwards, the journal entries relating to hedge accounting under IFRS 9, alternatives to hedge accounting and transition and disclosure requirements.

Hedging with options and forward contracts

IAS 39 allows applying hedge accounting for purchased options. However, under IAS 39, the change in time value of the option always had to be directly recorded in profit or loss. Under IFRS 9 this is different. Changes in the time value of an option can now be deferred in Other Comprehensive Income (OCI) in equity if the option is an effective hedging instrument in a hedge accounting relationship. The option premium (time value) paid upon purchase of the option can be recorded in the income statement at the same time that the underlying hedged item affects profit or loss. This may reduce volatility in the income statement for entities that use hedging strategies involving options.

For cash flow hedges, the amount that is deferred in OCI will then be recognised in the income statement in line with the underlying hedged item. This can be over the life of the option if the hedged item is ‘time related’. As an example, consider the case where a three-year interest rate cap is purchased to hedge interest rate risk. For this type of hedge relationship, it makes sense to amortise the premium paid over the three-year period of the cap.

If the option hedges a transaction that will take place at a specific moment in time, this is called a ‘transaction related’ hedge. In this case, the amount of time value will be deferred until the hedged transaction affects profit or loss. As an example, consider the use of a currency option hedging a future purchase in foreign currency. And assume the underlying hedged item is a non-financial item, such as an item that is part of costs of goods sold, or an item of property, plant and equipment. IFRS 9 requires the total deferred amount in OCI with respect to the hedging instrument to be reclassified to the initial cost of the item being hedged. This can be inventory valuation, or the initial cost price of the property, plant and equipment item. Through the inventory item hitting the income statement as costs of goods sold, or the item of plant, property and equipment being depreciated, the hedging results end up in the income statement. The same distinction on the treatment of time value for transaction- and time-related hedge relationships also applies to hedging FX risk with currency forward contracts.

With respect to the amounts of time value for options and currency forward contracts that may be deferred in OCI, IFRS 9 introduces some notable differences compared to IAS 39. As under IAS 39, it is possible under IFRS 9 to use an option or a currency forward contract in a hedge relationship and only designate the change in spot rate as the risk being hedged. Doing a ‘spot designation’ for hedging currency risk makes proving hedge effectiveness easy. As explained in our previous article, it is allowed under IFRS 9 to prove hedge effectiveness by demonstrating that the critical terms of the hedging instrument and the hedged item match. If only the spot element of the forward contract is designated as a hedging instrument, this means comparing the nominal amount of the hedged item to that of the hedging instrument.

When it comes down to determining the journal entries for an effective hedge relationship, IFRS 9 is different from IAS 39. For options, whether spot or forward designation has been chosen, the amount of changes in fair value due to changes in time value that is allowed to be deferred in OCI has to be determined using the ‘aligned time value’ approach. This aligned time value should match the terms of the hedged item. Therefore, when the terms of the hedged item and the hedging instrument (the option) do not match, this may lead to a part of the change in time value being booked in profit or loss. Also when applying spot designation, the time value that exists at the inception of the hedging relationship is amortised on a systematic and rational basis over the period to which the time value relates (time-period related or transaction related).

Companies hedging with currency forward contracts and choosing for a spot designation have two possibilities for determining the journal entries. The first one is based on using an aligned forward element approach that is comparable to the aligned time value model when hedging with options. The second alternative is using the current IAS 39 spot designation approach, where only the change in spot value of the currency forward is deferred in OCI and all other changes in fair value are booked in profit or loss directly. An interesting addition in IFRS 9 is the fact that this approach may also be applied to the currency basis spread present in currency forward contracts.

Companies therefore have to keep in mind the potential administrative burden of deferring in other comprehensive income the change in fair value of the forward element if the critical terms of the hedge item and the hedge instrument are not ‘aligned’.

What do you have to do now?

• Companies may want to consider whether under IFRS 9 the use of options as a hedging instrument is more desirable now that the accounting impact in profit or loss will be less volatile.
• Companies need to consider in which way to set up the accounting models when hedging with forward contracts. 

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Journal entries relating to hedge accounting

For hedge relationships not involving options and currency forwards, not much has changed. IFRS 9 still requires journal entries for effective cash flow hedge relationships that are based on a ‘cumulative dollar offset’ type of test. In such a test, the change in fair value of the hedging instrument is compared to the change in fair value of the hedged item. The lower of the two (in absolute terms) can then be deferred in OCI. For fair value hedges, the carrying amount of the hedged item can only be adjusted for the risk being hedged as present in that hedged item.

IFRS 9 provides some clear examples of where accounting ineffectiveness may occur in hedge relationships that would be in line with an entity’s risk management policy and to which hedge accounting can thus be applied. Examples given are hedging a debt in foreign currency (either fixed or variable rate debt). If in the cross-currency swap being used as hedging instrument a currency basis spread is present, this cannot be taken into account in measuring the change in fair value of the hedged debt. As such, the change in fair value of the cross-currency swap due to changes in the currency basis spread will end up directly in the income statement.

Similarly, the effect of CVA and DVA may end up in the income statement directly, as it cannot be taken into account in the item being hedged if it is not present in such item.

The difference with IAS 39 is therefore that currency basis spread and CVA/DVA will not risk hedge relationships to be no longer effective (end up outside of the 80-125% range under IAS 39). But in terms of income statement volatility, the same (or even more) accounting ineffectiveness will occur under IFRS 9 as under IAS 39.

With respect to hedging net positions allowed under IFRS 9, it should be noted that the hedging gains or losses should be presented in a separate line in the income statement and cannot be presented on the lines affected by the hedged items. This means that if an entity is hedging the net FX exposure between revenue and costs of goods sold, a separate line has to be presented in the income statement with the hedging gains or losses. Revenue and costs of goods sold will remain to be booked at the spot rates at which they occur. 

What do you have to do now?

• Companies should understand the possible impact on profit or loss of being able to assign more effective hedge relationships while still being required to book accounting ineffectiveness.
• Companies should consider the impact on income statement presentation of applying hedge accounting to hedging net positions.

Alternatives to hedge accounting

Another interesting aspect of IFRS 9 is the ‘fair value option for financial liabilities’ that is included in the recognition and measurement phase of IFRS 9 (refer to the paragraph below on transition rules for a description of the different phases of IFRS 9). In short, this fair value option makes it easier for an entity to measure its own liabilities at fair value through profit or loss. Such an option also exists under IAS 39, but it can only be applied in certain confined cases. This is due to the fact that, by using this option, the counterintuitive effect occurs that a decline in the entity’s creditworthiness will lead to booking a gain due to the reduced fair value of the entity’s debt.

Under IFRS 9, this option can be more easily applied, but changes in the fair value of the liability that are caused by changes in the entity’s own credit risk have to be booked directly in OCI. Recording the entity’s own liabilities at fair value through profit or loss may pose an alternative to applying hedge accounting in certain circumstances. However, the possible volatility in equity from changes in own credit risk should be taken into account.

Disclosures requirements

Users of financial statements often claimed that the hedge accounting disclosures in the financial statements are not helpful and do not provide enough transparency on companies’ hedging activities. The IASB took this into consideration in the new standard and amended the disclosure requirements in IFRS 7 to provide more useful information to the users of financial statements.

The disclosure required remains lengthy and will mean an increase compared to current disclosure requirements. While it is not possible to comment on all of the disclosure, the following points are worth highlighting:

• The new standard requires certain disclosure to be made in risk categories that the entity decides to hedge. However, the standard does not prescribe which categories to use and leaves that to management’s judgment. The objective of the categories is to help the user of the financial statements to understand how information in the primary statements links to information that is not included in there but in other parts of the notes – e.g., risk management strategy.
• Entities will have to disclose how they measure effectiveness. This includes information on how the economic hedge relationship is determined, how the hedge ratio is determined (and monitored) and from which sources ineffectiveness may be occurring. In addition, where ineffectiveness occurs, entities will have to explain this, including the source where the ineffectiveness is coming from.
• In addition, entities need to explain how they determine which components to hedge and what impact these components have on the full fair value of the item being hedged.
• These requirements seem to include a lot of sensitive information. But actually, the exposure draft included at first a far more controversial requirement to disclose future exposures that are being hedged. After a lot of comments on that proposed disclosure, the IASB agreed that such future exposures being hedged contain a lot of ‘sensitive’ forward-looking information. So the IASB amended the requirement to disclose how financial instruments will affect future cash flows and not the actual exposures.
• Lastly, it is worth mentioning that the new tabular requirements on hedged items and hedging instruments should provide more transparency to users, as it aims to bring all hedge accounting effects together in a limited number of tables.

It is important to note that the above mentioned disclosures in IFRS 7 will be applicable, even if the entity continues to apply IAS 39 (refer to the paragraph on transition rules on the next page).[[[PAGE]]]

What do you have to do now?

• Start early to gather and prepare all the necessary information.
• Think of the disclosure from a user’s perspective. This should not only be a compliance exercise but also an opportunity to illustrate to users where risk comes from, how it is uniquely managed and lastly how it is reflected in the accounting.

Transition rules

For entities outside the EU, IFRS 9 is immediately available for (early) application. Entities within the EU still need to wait for endorsement by the EU and it is currently unclear when this will happen. This is due to the fact that the IASB has split IFRS 9 in three separate phases. These phases are: 1) Classification and measurement, 2) Impairment and 3) Hedge accounting. Phase 1 has been issued by the IASB, but is currently again being changed. Phase 2 is still being drafted by the IASB. And phase 3 is out, but does not contain the sensitive ‘macro fair value hedge accounting model’ that is particularly important to financial service entities. The EU is likely to consider endorsement only after at least all three phases of IFRS 9 are finalised. This is also the reason why the IASB has recently removed the mandatory effective date for IFRS 9.

The current transition rules are flexible. Entities basically have a choice between any of the four options below when it comes to the adoption of IFRS 9, ‘Financial instruments’.

For entities that are considering option 4, even more choices have to be made. As stated, IFRS 9 does not currently deal with macro fair value hedging. The IASB is working on this, but it is unlikely to issue the final macro hedging chapter in 2014. While this is not particularly relevant for Corporate Treasuries, some entities may prefer to wait for either the exposure draft or the final standard on macro fair value hedging before they decide on whether they want to adopt the IFRS 9 hedging part or not. However, the standard allows for an annual choice of:

1. Applying IFRS 9 hedging chapter as is
2. Applying IFRS 9 hedging chapter and macro hedging under IAS 39
3. Applying hedging rules under IAS 39 (similar to option 3 above).

Of course, these different options are currently only relevant for entities outside of the EU, as the rest will have to await EU endorsement first. As the IASB is still working on two phases of IFRS 9, this could in future result to a change in the transition requirements.

What do you have to do now?

• Determine how important macro hedging is for the business and whether you should wait for more detail on that.
• Determine, in collaboration with your accounting team, which IFRS 9 adoption option is the most beneficial for your company.
• Determine the most appropriate time for adopting.

Conclusion

The final IFRS 9 hedge accounting rules are in many ways an improvement to current IAS 39. It will often be easier to prove that hedge accounting relationships are effective. However, the detailed guidance in IFRS 9 on how accounting (in)effectiveness has to be recorded may prove difficult to implement in practice and may still result in significant income statement volatility. The requirements with respect to disclosures appear to be more challenging than current IFRS 7 as well.

Transition rules for IFRS 9 are complex, and there are many different scenarios that may be applied. But for the moment we need to wait until the EU has endorsed the final IFRS 9 standards that have not yet all been published. The IASB has removed the mandatory application date. We will keep you informed once there will be more clarity on this.