Aligning hedge accounting with risk management
the international accounting standards board (iasb) recently issued a new hedge accounting model that aims to more closely align hedge accounting with the risk management activities of an entity.John McCarroll and Goind Ram Khatri ask whether the new rules are likely to make the life of corporate treasurers much easier.
First published in Accountancy Ireland: April 2014.
The current hedge accounting rules, under IAS 39, have been criticised for being too complex.Treasurers, in particular, argue that they are being forced to apply a rules-based hedge accounting model which does not mirror how they actually manage the risks and therefore deviates their thought process from ‘how do I minimise the risk?’ to ‘how do I achieve hedge accounting?’.This, to some treasurers, has impacted the operational efficiency of their risk management process.The IASB responded to the concerns of the reporting entities and their treasurers and started a project to overhaul the existing hedge accounting model on a priority basis. Due to the complexity of the issues it has taken eight years to finalise the project.
The new hedge accounting model issued in November 2013, as part of IFRS 9, represents a significant milestone as it completes another phase of the IASB’s project to replace IAS 39.The new general hedge accounting model will allow reporting entities to reflect risk management activities in the financial statements more closely as it provides a more a flexible approach to apply hedge accounting.
The new standard is effective for annual periods beginning on or after 1 January 2018, subject to EU endorsement. The entities that apply IFRS 9 will have an accounting policy choice to apply the hedge accounting model in IAS 39 or IFRS 9. The IASB will revisit this accounting policy choice when it finalises its work on the macro hedging project.
Similarities between IFRS 9 and IAS 39 hedge accounting models
Although the IFRS 9 model differs significantly from IAS 39 there are still some similarities in the models, which include:
- Hedge accounting is not mandatory; it is optional in both standards;
- Much of IAS 39 terminology has been retained in IFRS 9 including terms such as hedging instruments, hedged items, cash flow hedges, fair value hedges and hedge ineffectiveness;
- The accounting entries for cash flow hedges, fair value hedges and net investment hedges are the same under both standards;
- The general prohibition on hedge accounting with written options is retained in both models.
What has chaaged in the new hedge accounting model under ifrs 9?
Compared to IAS 39,the new model,under IFRS 9, more closely aligns hedge accounting with risk management activities undertaken by the reporting entities when hedging their financial and non-financial risk exposures.The new model will enable more entities, particularly non-financial institutions, to apply hedge accounting to reflect their actual risk management activities.This, combined with enhanced disclosures, will assist users of financial statements in understanding entities’ risk management activities.
Key changes introduced by the new model
Eligibility of hedging instruments
Except for certain written options, IAS 39 allows reporting entities to designate derivative instruments (or portions thereof) as hedging instruments and also, in the case of hedging foreign currency risk only,allows designation of non-derivative financial instruments as hedging instruments. Under IFRS 9, any financial instrument measured at fair value through profit and loss, irrespective of whether it is a derivative or not, can be designated as a hedging instrument.The exception with regards to written options still applies in IFRS 9.
For non-financial assets and non-financial liabilities, IAS 39 prohibits the designation of risk components (other than foreigncurrency risk). In contrast, the IFRS 9 permits entities to designate risk components of non-financial assets and liabilities as hedged items as long as certain criteria are met (e.g. the risk component is separately identifiable and can be reliably measured). This change provides much greater flexibility to hedge key risks and will be a welcome relief for many treasurers.
IFRS 9 expands the list of eligible hedged items by allowing entities to designate as a hedged item an aggregated exposure (i.e.the combination of an eligible hedged item and a derivative instrument) as well as certain group and net exposures (e.g. a net interest rate exposure), which were generally not eligible as hedged items under IAS 39.
Hedge effectiveness assessment
The qualifying criteria of the IFRS 9 hedge accounting model differ significantly from those in IAS 39 with no 80–125 percentage bright line threshold for effectiveness testing. IFRS 9 instead employs a more principlesbased approach.The following conditions must be met for a hedging relationship to be considered effective and qualify for hedge accounting under IFRS 9:
- There is an economic relationship between the hedged item and the hedging instrument;
- The effect of credit risk should not dominate the value changes that result from that economic relationship; and
- The hedge ratio should reflect the actual quantity of hedging instruments used to hedge the actual quantity of a hedged item (provided it does not deliberately attempt to achieve an inappropriate accounting outcome).
The IFRS 9 hedge accounting model requires entities to perform a hedge effectiveness assessment only prospectively, thereby removing the burden of performing retrospective hedge effectiveness assessments as currently required by IAS 39.
Cashflow hedge accounting and basis adjustments
Under IAS 39, if an entity’s hedge of a forecast transaction results in the recognition of a non-financial asset or liability,the entity can choose to either reclassify the effective portion of the cash flow hedge recorded in hedging reserve to profit or loss when the hedged item affects earnings or to include the amount recorded in the hedging reserve in the initial cost or carrying amount of the non-financial item. Under IFRS 9, there is no longer a choice and an entity must remove the amount from the hedging reserve and include it in the initial cost or carrying amount of the non-financial item.
Discontinuing hedge accounting
Under IAS 39, a hedge relationship is discontinued when it meets certain facts and circumstances including when an entity revokes the hedge designation.Under IFRS 9,the same facts and circumstances generally will still trigger discontinuation of a hedging relationship; however, an entity cannot voluntarily revoke or otherwise dedesignate a hedging relationship. IAS 39 and are treated as regular purchase and sale contracts.
To mitigate the need for hedge accounting, the alternative requirements, under IFRS 9, result in an extension of the fair value option to contracts that meet the ‘own use’ scope exception if doing so eliminates or significantly reduces an accounting mismatch.
Equity investments designated at fair value through other comprehensive income
In November 2009 when the IASB issued the first chapter of IFRS 9, it introduced a new classification of financial assets - equity instruments designated at fair value through other comprehensive income (OCI). Under this classification all fair value changes are permanently recognised directly in OCI.
Under the new model,the IASB decided that because all fair value changes are permanently recognised in OCI for these equity investments, any hedge effectiveness should position, statement of comprehensive income and statement of changes in equity.
The new standard provides an opportunity to many treasurers to revisit their hedging strategies to avail of hedge accounting under the new rules.However,at the same time the application of new rules requires careful consideration and due care is needed on first time application.First time implementation of the new rules is a challenging task for both corporate treasurers as well as directors requiring significant investment of time, appropriate planning and training and streamlining of information generating channels or systems.The most significant aspect of the changes relates to the hedging of non-financial risk and is expected to be of particular interest to non-financial institutions.
The new rules fundamentally changeaccounting for hedges. However, the likely benefits of these rules within the European Union generally and Ireland specifically depend on EU endorsement.
Modifying a hedging relationship
Under IAS 39, changes to a hedging relationship generally require an entity to discontinue hedge accounting and start a new hedging relationship that captures the desired results. However, for risk management purposes hedging relationships are sometimes adjusted in reaction to changes in circumstances. Under IFRS 9, such rebalancing would not trigger a discontinuation of an entire hedging relationship. The entity must adjust the hedge ratio so that it meets the hedging criteria prospectively.
Hedging own use contracts to buy or sell a non-financial item
‘Own use’ contracts to buy or sell a nonfinancial items are not subject to derivative accounting as they are outside the scope of also be recognised in OCI. As a result, for such hedges both the effective and ineffective fair value changes are recognised in OCI with no recognition in the profit and loss.
The flexibility afforded by the IFRS 9 hedge accounting model is tempered by the IASB’s amendments to the related hedge accounting requirements in IFRS 7.
The new disclosure requirements are built around three objectives that shall provide information about:
- An entity’s risk management strategy and how it is applied to manage risk.
- How the entity’s hedging activities may affect the amount, timing and uncertainty of its future cash flows.
- The effect that hedge accounting has had on the entity’s statement of financial benefits of these rules within the European Union generally and Ireland specifically depend on EU endorsement. So far the EU is delaying its debate on the first phase of moving over from the existing financial instruments accounting standard. It is too early to conclude when and to what extent the EU will adopt or react to these new standards.