by François Masquelier, Head of Corporate Finance and Treasury, RTL Group, and Honorary Chairman, ATEL

This article describes the main key proposals made by the IASB in London for financial instruments hedge accounting. Is this third and last act of IAS 39 revamping a revolution or a simple reform of existing principles? Hedge accounting has always been a controversial topic. Are these new proposed measures acceptable for corporate treasurers? Sometimes, adjustments could be better than a complete reform of basic rules. The convergence with US GAAP should remain a critical issue for IASB in coming months.

Third and final part of IFRS 9

The corporate treasurers in Europe were impatiently waiting for the third part of IFRS 9 (www.iasb.org). Eventually, this lengthy tripartite  process of IFRS 9 was as long as an elephant’s  gestation. The IASB based in London has recently issued a third Exposure Draft (ED – released on 9 December 2010 for comments by 9  March 2011) on proposals to replace the hedge accounting requirements previously defined in the famous and controversial IAS 39 Financial Instruments Recognition & Measurement.  Unquestionably no single treasurer could dare to pretend that IAS 39 is/was not highly complex and inaccurate on different items. It has long been an area of difficulties for both preparers (companies applying IFRS/IAS standards) and users (investors using these financial reports under IAS/IFRS). After G20 in London, IASB wanted more than ever to improve the information available for investors. This  explains why it decided to revisit IAS 39 in depth. However, after this third part of the IFRS 9 Exposure Draft trilogy, it is doubtful whether the initial goal of completely revamping IAS 39 has been achieved. We could consider that IASB has proposed an interim consensual solution with amendments on existing rules, more than a comprehensive reform of financial instruments (hedge) accounting model.

In short, hedge accounting rules concern the reporting of derivative instruments used by a company to hedge its exposures to financial risks which could potentially affect its business. The general treatment of such derivative products is to measure it at fair value with changes being reported to gains and losses in the income statement,unless the hedge accounting exception applies. This exception is needed to faithfully represent the activity of a company  which intends to protect and hedge a defined exposure. IASB has always considered the cost basis for derivatives would be inappropriate for measuring their (current) value.

Struggle to understand IAS 39 reporting

The criticisms of IAS 39 are related to its too prescriptive approach of what can and cannot qualify for hedge accounting.

For users,hedging and hedge accounting activities have always been an area of business in which they often struggle to understand what is going on and how to interpret a company’s financial risk strategy. These rules have frustrated many preparers too, as the requirements have not been linked with common risk management practices. Hedge accounting has often been impossible or very costly, even when hedging was economically rational as risk management strategy.It has not been helped by the restrictions by which IAS 39 arguably limited the practical ability of companies to report their risk management activities faithfully.These exceptions and restrictions explain why some companies have refused to apply hedge accounting, while providing users with supplementary non-IFRS disclosures (unaudited) to explain their hedging approaches and strategies. It results in confusion and a lack of the comparability which is essential for investors, both accounting boards and even G20 members. 

Some complainers also claimed that the use of different methods of hedge accounting created additional confusion. It is true and fair to say that accounting rules often created artificial restrictions which may negatively affect the way a business was managed. The criticisms of IAS 39 are also related to its too prescriptive approach of what can and cannot qualify for hedge accounting, the distinction between cash flow hedge and fair value hedge and eventually the disclosures to users which are insufficient for understanding the risk management strategy of the company.The major idea of the IASB was to adopt a principle-based approach for aligning hedge accounting measures more closely to financial and non-financial risk exposures. IFRS 9 also proposes an enhanced presentation and new disclosure requirements for improving transparency (that at least is what IASB firmly believes).   [[[PAGE]]]

Key measures proposed by IASB in third ED

• Enhancement of disclosures: IASB proposes a comprehensive set of new disclosures supposed to better explain risks being hedged and how hedge accounting affects financial statements (rather than information on the hedging instrument itself which is covered by IFRS 7).
• Removing of the artificial qualification criteria for effectiveness: we now have the ‘high effectiveness’ (a priori and a posteriori) approach and the 80%-125% corridor which will be changed.The artificial bright line will be removed. The hedges should be determined in an unbiased manner in order to minimise ineffectiveness and in accordance with risk management policy. The ineffectiveness will continue to be reported in P&L.The effectiveness testing would then be quantitative as well as qualitative. Any ineffectiveness that arises will continue to be booked into P&L.
• Changes to treatment of option premiums in order to prevent artificial volatility created by change in time value. The idea is to treat time value differently because it is irrelevant given the fact options generally run until maturity and make time value changes lost.
• Aggregated exposures of non-derivatives and derivatives instruments: until now, a derivative cannot be part of the hedged item, causing problems for many risk management approaches and strategies (e.g., hedging of commodities into USD fixed amount, then hedged against the functional currency of the company. The fixed amount of USD cannot be designated as the hedged item).
• The hedging of groups of items would be easier and more flexible, although it does not cover macro hedging (which will be in another ED to be released in 2011). However these hedged net positions consist of forecasted transactions, which all have to relate to the same period (certainly too restrictive for corporates). 
• Presentation of all hedges in OCI (Other Comprehensive Items – equity account) and not only the cash flow hedges. 
• A hedge of risk components of non-financial items was restricted in IAS 39 as hedging part of the hedged item was not authorised. This was a real problem for non-financial companies where the available hedging instrument does not always match the hedged item (e.g., hedging of jet fuel risk for airline companies with crude oil component). It is permitted providing the risk component can be separately identified.

What should corporate treasurers do?

The corporate treasurers and their national or international associations should answer and comment on the ED. All in, this third ED is not so bad. Eventually, IASB has understood that we need to maintain the hedge accounting exception, with some amendments to simplify it. Some users will certainly complain and ask for minimal changes.Others (including users) might think the simplification process is not satisfactory. EACT, like the other main national treasury associations, will prepare comment letters to underline the issues identified. For example, treasurers complain about the extended disclosures which could in some cases give competitive advantages to peers (however we all need now to report under IFRS, and are therefore on an equal footing). We could also refuse to accept that the basis adjustment becomes compulsory for cash flow hedge accounting (maintaining of optionality would be better). The netting with forecasted transactions related to the same period seems to be difficult and insufficient in practice. We should also welcome the option treatment more in line with US GAAP, while maintaining some slight divergences. At the end of the day, treasurers would be inspired in confirming to IASB all the positive elements addressed in the ED.In my opinion,it is a much better ED compared with some previous proposals made by IASB the last couple of years.

Next steps

The corporate treasurers and their national or international associations should answer and comment on the ED.

The final standard, after amendments and comments received from users and preparers will be published in the course of the second quarter of 2011 (i.e.,mid-May 2011).We then expect the EU to endorse it, as finalised by the IASB. Once endorsed, it will be mandatory for accounting periods commencing on and after the first of January 2013; but corporates will be able to adopt this new standard early.Of course the third ED, once agreed and adopted, will form part of IFRS 9 and will include the other changes on classification and measurement of financial assets and financial liabilities (IFRS 9 part 1) and impairment of financial assets (IFRS 9 part 2).Then the financial instruments accounting standards trilogy will become IFRS 9 (which will replace IAS 39).

We hope that IASB will then eventually finalise the hedge accounting part of IFRS 9 with the recommended amendments and get it endorsed by the European Commission.Of course, many treasurers are not convinced that all these changes and additional disclosures will effectively improve information delivered to users and investors.Even if we have major doubts about users’ general understanding of corporate risk management strategies under IFRS 9, it will not stop IASB trying to improve information, as requested by G20 after the financial crisis. More does not necessarily mean better in financial accounting. But who could contest the need for more transparency?