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This article was first published in the November/December International edition of Accounting and Business magazine.
IAS 39, Financial Instruments: Recognition and Measurement, sets out the requirements for recognising and measuring financial assets, and financial liabilities. Many users of financial statements felt that the requirements in IAS 39 were difficult to understand, apply and interpret. Thus, the International Accounting Standards Board (IASB) is developing a new standard for the financial reporting of financial instruments that is principle-based and less complex. The three main phases of the IASB’s project to replace IAS 39 are:
A Phase 1: Classification and measurement of financial assets and financial liabilities. In November 2009, the IASB issued the chapters of IFRS 9, Financial Instruments, relating to the classification and measurement of financial assets followed by the requirements related to the classification and measurement of financial liabilities in October 2010.
B Phase 2: Impairment methodology. The IASB is redeliberating the proposals issued in an exposure draft and the supplement to that draft to address the comments received from respondents.
C Phase 3: Hedge accounting. On 7 September 2012, the IASB issued a draft of the general hedge accounting requirements that will be added to IFRS 9.
In addition to the three phases above, in June 2010 the IASB decided to retain the existing requirements in IAS 39 for the derecognition of financial assets and financial liabilities but to finalise improved disclosure requirements, which were issued in October 2010 as an amendment to IFRS 7, Disclosures.
The current rules on hedge accounting in IAS 39 have frustrated many preparers, as the requirements are not really linked to common risk management practices. The detailed rules have at times made achieving hedge accounting impossible or very costly, even when the hedge was an economically rational risk management strategy. The IASB wishes to provide better links between an entity’s risk management activities, the rationale for hedging and the impact of hedging on the financial statements.
The requirements also establish a more principle-based approach to hedge accounting and address inconsistencies and weaknesses in the hedge accounting model in IAS 39. However, the IASB has made some significant changes to certain aspects of the proposals contained in the draft that was issued in December 2010. The proposals do not fundamentally change the current types of hedging relationships, or the current requirement to measure and recognise ineffectiveness; however, the proposals mean that more hedging strategies used for risk management would qualify for hedge accounting.
The draft relaxes the requirements for hedge effectiveness assessment and consequently the eligibility for hedge accounting. Under IAS 39, a hedge must be expected to be highly effective both at inception and on an ongoing basis. Subsequently, the entity must demonstrate that the hedge has been highly effective. ‘Highly effective’ is defined as a quantitative test of 80% to 125% under IAS 39. Under the draft, more judgment is needed to assess the effectiveness of the hedging relationship. A hedging relationship would need to be effective at inception and on an ongoing basis, and would be subject to a qualitative or quantitative, forward-looking effectiveness assessment.
The following requirements need to be met:
- an economic relationship must exist between the hedging instrument and the hedged item
- the effect of credit risk must not dominate the value changes that result from that economic relationship
- a hedge ratio must reflect the relationship between the quantities of the hedged item and hedging instrument used by the entity for its risk management purposes
- an entity cannot intentionally weight the hedging instrument or hedged item to achieve an accounting outcome inconsistent with the purpose of hedge accounting.
The first requirement means that the hedging instrument and the hedged item must be expected to move in opposite directions because of a change in the hedged risk such that there is causality and not just correlation between the items. Perfect correlation between the hedged item and the hedging instrument is not required and is not sufficient, as there must be an economic relationship. For example, there are different prices quoted for oil. These include the prices of West Texas Intermediate (WTI) crude oil and Brent crude. The former reflects the price at Cushing, Oklahoma, and nexus for the delivery of American and Canadian crudes and the latter reflects the price of North Sea oil. Therefore, it would be possible to hedge a Brent crude exposure with a WTI derivative.
The second requirement means that the impact of changes in credit risk should not be of a magnitude such that it dominates the value changes, even if there is an economic relationship between the hedged item and hedging derivative, and the third requirement indicates that the actual hedge ratio used for accounting should be the same as that used for risk management purposes, unless the ratio is inconsistent with the purpose of hedge accounting. The IASB appears to be specifically concerned with deliberate under-hedging, which either minimises the recognition of ineffectiveness in cashflow hedges or creates additional fair value adjustments to the hedged item in fair value hedges.
The draft includes a number of changes to the definition of a hedged item. Risk components of non-financial items can be designated as a hedged item provided the risk component is separately identifiable and reliably measurable. The draft retains the principle for financial and non-financial risk components to be separately identifiable and reliably measurable and this must be assessed within the context of the particular ‘market structure’.
However, ‘market structure’ is not defined. It does not follow that, if there is a derivative instrument on aluminium and aluminium components are used in manufacturing cars, that aluminium is an eligible risk component in a hedge of car component purchases. There is probably a need to see how aluminium car components are priced in the market and how this relates to the price of aluminium.
The draft now includes a rebuttable presumption that non-contractually specified inflation risk will not usually be an eligible component of a financial instrument. Two scenarios are set out in the draft, one of which indicates that an inflation risk component is eligible for hedge accounting and another in which it is not.
Entities can hedge non-financial items for a price risk, for example, a commodity price risk that is only a component of the overall price risk of the item. This is currently prohibited under IAS 39.
The draft also makes the hedging of certain groups of items more flexible. A group of items, including a group of items that constitute a net position, may be a hedged item under the proposals if:
- it consists of items that are eligible hedged items
- the items in the group are managed together on a group basis for risk management purposes.
The draft makes the hedging of groups of items more flexible, although it does not cover macro hedging which will be the subject of a separate document. Entities commonly group similar risk exposures and hedge only the net position, which could be the net of forecast purchases and sales of foreign currency. Under IAS 39, a net position cannot be designated as the hedged item. The draft permits such hedging strategies if the entity hedges on a net basis for risk management purposes. However, if the hedged net position consists of forecasted transactions in a cashflow hedge, hedge accounting on a net basis is only available for foreign currency hedges.
An entity is not allowed to voluntarily terminate a hedging relationship that continues to meet its risk management objective and all other qualifying criteria. However, the draft has retained the requirement for rebalancing to be undertaken if the risk management objective remains the same, but the hedge effectiveness requirements are no longer met.
Normally, accounting rebalancing will only be undertaken when adjustments are made to the actual quantities used for risk management purposes unless deliberate and inappropriate action is undertaken to achieve an accounting result that is inconsistent with the purpose of hedge accounting.
The proposals on discontinuation have not changed but further guidance is given on how to distinguish between an entity’s risk management strategy and its risk management objective. Risk management strategy is established at the highest level and could include some flexibility to react to changes in circumstances without requiring a new strategy. The risk management objective is applied at the particular hedge relationship level.
The draft retains the current IAS 39 requirements for fair value hedge accounting. However, the fair value option in IFRS 9 is extended to contracts that can be settled net in cash and meet the exception whereby applying fair value accounting eliminates or significantly reduces an accounting mismatch.
Additionally, the draft would permit certain credit exposures to be designated at fair value through profit or loss if a credit derivative that is measured at fair value through profit or loss is used to manage the credit risk of all, or a part of, the exposure on a fair value basis.
Some industries, such as banking and insurance, may see the proposals as of less importance than the IASB’s forthcoming macro-hedging paper, but sectors with substantial commodity-related risk such as airlines and manufacturers will welcome the opportunities provided. The new proposals are likely to benefit non-financial services entities which can hedge clearly defined individual risk items. However, the guidance remains complex in some areas and to comply companies may need to apply a greater degree of judgment. A principle-based approach requires additional disclosures to users of how a company is managing risk.
Graham Holt is an examiner for ACCA, and associate dean and head of the accounting, finance and economics department at Manchester Metropolitan University Business School