This article was first published in the September 2011 Ireland edition of Accounting and Business magazine.
In March 2008, the IASB issued the discussion paper Reducing Complexity in Reporting Financial Instruments. This was the beginning of the current plethora of new guidance on accounting for financial instruments. In December 2010, the board released an exposure draft (ED) Hedge Accounting with proposals to substantially simplify hedge accounting under International Financial Reporting Standards (IFRS).
The ED is only on general hedge accounting and excludes macro hedge accounting. The ED on macro will be published in Q4 2011 or early 2012. The comment period for the ED ended to 9 March 2011 but re-deliberations are ongoing. The final standard is expected to be issued in Q3 2011.
What are the main difficulties under IAS 39?
A recurring theme that surfaces is the lack of an overall principle in the hedge accounting requirements of IAS 39. Hedge accounting is an exception to the normal recognition and measurement principles, and IAS 39 permits the exception by way of rules, restrictions and bright-line tests. The lack of a principle, coupled with rules (that are sometimes conflicting) is the main source of the complexity of the hedge accounting requirements under IAS 39.
Hedge accounting is optional under IFRS. Many entities economically hedge (i.e., manage) their risks, but find that they are unable to fully reflect this fact in their financial statements because of the rule-based nature of the existing hedge accounting requirements.
Because of this, there is often a mismatch between the application of hedge accounting and the entity’s risk management objectives. For corporate entities, one main concern has been the inability to hedge specific components of non-financial items. For example, an airline may wish to hedge its exposure to the movements in the price of jet fuel by entering into forward crude oil contracts.
Although crude oil is a key component of the refined product (i.e., jet fuel), it is not considered a valid hedged item under IAS 39. This is because, under the existing rules for hedging non-financial items, an entity can only hedge either the foreign currency risk or the entire non-financial item (the purchase price of jet fuel, in this case). Even if an entity uses derivatives to manage its exposure to price risk in such cases, the current rules do not permit such economic hedging practices to be reflected in financial reporting.
Other criticisms include the onerous requirements to perform quantitative effectiveness tests, insufficient guidance on how to quantify hedge effectiveness and bright-line tests that give rise to arbitrary results and severe consequences.
- Hedging by risk components will be permitted for both financial and non-financial items, if separately identifiable and measurable;
- Eligible hedged items can now include combinations of derivatives and non-derivatives; portions or proportions of nominal amounts; and one-sided risks (e.g., a hedge against price movements in only one direction);
- A layer component will be permitted as a hedged item for fair value hedges;
- Hedge accounting will be permitted for equity investments at fair value through other comprehensive income (FVTOCI) and any ineffectiveness will be presented in other comprehensive income (OCI);
- Hedging instruments can include non-derivatives provided these instruments are not at amortised cost;
- Changes in accounting treatment for time value of options (including zero-cost collars);
- Forward points at inception of hedge relationship to be recognised in profit or loss over time on a rational basis;
- The bright line test of 80-125% for hedge effectiveness testing will be eliminated;
- The assessment of hedge effectiveness will be prospective and driven by the risk management strategy — with a requirement that no imbalance between the weightings of the hedged item and hedging instrument would create ineffectiveness that is inconsistent with the risk management objective;
- Rebalancing of the hedge ratio will be required when necessary to maintain the risk management objective. Accordingly, it is no longer necessary to restart the hedge relationship;
- Discontinuation of the hedge relationship will be mandatory if the hedging relationship no longer qualifies (including if risk management objective changes). Voluntary de-designation will not be permitted;
- Cashflow hedges of net positions would only be available for hedges of foreign currency risk and the pattern of how the offsetting cashflows in a net position will affect the income statement must be set out at initial designation; and,
- There are significant new disclosure requirements.
Carried forward from IAS 39
- Hedges of net investments;
- The mechanics of fair value and cashflow hedge accounting;
- The requirement to formally designate and document hedge relationships;
- The requirement to record in profit or loss any hedge ineffectiveness that actually arises; and,
- The restrictions that prohibit the use of internal derivatives (e.g., contracts between entities forming part of the same reporting entity) and intra-group monetary items (transacted between two group entities with different functional currencies) as hedging instruments.
According to the ED, the objective of hedge accounting is to represent, in the financial statements, the effect of an entity’s risk management activities, which use financial instruments to manage exposures arising from particular risks that could affect profit or loss.
Risk components may be designated as hedged items if they are separately identifiable and reliably measurable. Risk components could be part of a financial or non-financial item and may or may not be contractually specified. Entities could, therefore, choose to apply hedge accounting to particular risks of a non-financial item, as opposed to the current need to designate the entire item.
Portions (or ‘layers’) of the entire item would also be eligible in certain situations, e.g., 50,000 cubic meters of natural gas stored in location xyz or the first 100 barrels of oil purchased in June 2011. An entity can hedge a layer component within the hedged item for the amounts that are not prepayable or can hedge a prepayable layer if prepayment effect is included in measurement of the hedged item.
- Hedging instruments
The use of options as hedging instruments has been problematic under IAS 39. The ED proposes to resolve the issue by making a distinction between two types of hedged items: transaction related (e.g., the forecast purchase of a commodity) and time-period related (e.g., hedging price changes affecting commodity inventory). The cumulative change in the fair value of the option’s time value of money initially accumulated in OCI is removed and included in the carrying cost of the hedged item in the former case. In the latter, it is recycled to profit or loss. The ED proposes to allow cash instruments classified at fair value through profit or loss to be considered as hedging instruments for any risk previously restricted by IAS 39.
- Hedge effectiveness assessment
The bright-line test of 80-125% for hedge-effectiveness testing required under IAS 39 is eliminated, and there will be no target level for achieving hedge accounting. No specific method of quantitative assessment is prescribed by the ED. Hedge effectiveness assessment will be prospective and can be qualitative or quantitative dependent on the relevant characteristics of the hedging relationship and the potential source of ineffectiveness. If there are changes in circumstances that affect hedge effectiveness, an entity may have to change the method for assessing whether a hedge relationship meets the hedge effectiveness requirements. Any ineffectiveness arising from the hedge relationship will be recognised in profit or loss using the dollar offset method i.e. the difference in the fair value of the hedging instrument and hedged item attributable to hedged risk.
The ED proposes significant changes to IFRS 7 Financial Instruments: Disclosures to provide a better link between the 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 cashflows and the effect that hedge accounting has had on the entity’s financial statements.
The new hedge accounting requirements will be applicable prospectively, with no restatement of comparative figures (or requirement to give the disclosures for the comparative period). Almost all of the previous hedge accounting relationships under IAS 39 would still qualify under the proposed model and thus be regarded as continuing hedges.
It is proposed that application of the standard will be mandatory for annual periods beginning on or after 1 January 2015, with earlier application permitted.
As with other phases of the financial instruments project, the new hedge accounting model can only be adopted together with all other IFRS 9 requirements that were finalised earlier. However, early adoption of previously finalised IFRS 9 requirements (such as classification and measurement) will not necessitate early adoption of the final hedge accounting requirements.
The ED is likely to have a significant impact on those entities that already apply hedge accounting, as well others that use economic hedging practices that do not qualify for financial reporting. The most significant benefit may be for non-financial services entities, because hedge accounting will be permitted for components of non-financial items.
Financial institutions also stand to gain from the new proposals, because hedge effectiveness testing will be simpler and only required on a prospective basis, qualitative testing will be possible where appropriate and there will be no arbitrary bright lines.
Fergus Condon is director, Financial Accounting Advisory Service (FAAS), Ernst & Young