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.