This article was first published in the April 2011 edition of Accounting and Business magazine.
The IASB has recently released an exposure draft (ED) Hedge Accounting, with proposals to make substantial changes to hedge accounting under International Financial Reporting Standards (IFRS). The ED is the third phase of the IASB's project to replace IAS 39, Financial Instruments: Recognition and Measurement.
A difficulty with IAS 39 is the lack of a recognisable set of principles in the hedge accounting requirements. Hedge accounting is not compulsory under IAS 39 and the lack of a principle, together with conflicting rules, is the main issue relating to the hedge accounting requirements under IAS 39.
The current accounting rules raise recurring difficulties for preparers of financial statements, which prevent them from appropriately reflecting in their financial statements the economic effects of hedging transactions.
Some financial instruments used for risk management purposes are currently creating volatility in profit or loss, whereas they do constitute an effective economic hedge of a specific risk exposure.
Non-GAAP measures or detailed disclosures on the impact on profit or loss of some economic hedges not eligible for hedge accounting are the only alternatives found by some entities to reflect their actual hedging results.
The current IAS 39 hedge accounting rules do not allow the economic offset of significant hedging activities to be reflected in the financial statements for both financial and non-financial entities.
In this respect, IAS 39 hedging rules create confusion and misunderstanding for users of financial statements. Entities manage their risks, but find that they are unable to fully reflect this in their financial statements.
Additionally information relating to an entity's risk management strategy and practices may not be clearly reflected in the financial statements because of a mismatch between the application of hedge accounting and the entity's risk management objectives.
The IAS 39 rules often prevent entities hedging specific components of non-financial items. An example is where a logistics company wishes to hedge its exposure to movements in the price of diesel fuel by entering into a forward contract for crude oil. Although oil is a key component of diesel, it is not considered an acceptable hedged item because, under the existing rules, an entity can hedge only the foreign currency risk or the price of diesel itself.
Designating groups of hedged items is difficult under the current rules because several criteria need to be satisfied. For example, items may only be grouped together if they have similar risk characteristics and share the risk exposure being hedged, which means that many hedged items cannot be designated as a group even if they have an apparent economic link. Hedge accounting cannot, therefore, be used for the hedge of the equities that comprise an index (such as those making up the FTSE 100) using an index future.
IAS 39 has been criticised for its onerous requirements to perform effectiveness tests because of insufficient guidance on how to quantify hedge effectiveness. Hedge accounting cannot be dispensed with as the IASB has retained a mixed measurement approach. Both amortised cost and fair value are used in IFRS 9, and it is advantageous to entities to use hedge accounting to address measurement mismatches – for example, where an investment property is valued at fair value but the related debt is valued using amortised cost. The fair value option does not eliminate the complexities, but it simplifies the accounting related to fair value hedges of financial instruments.
Hedge accounting is also needed for hedges of forecast cashflows that are not yet recognised in the financial statements. Many believe that the distinction in IAS 39 between cashflow hedges and fair value hedges adds complexity and is confusing.
The ED proposes requirements designed to enable companies to better reflect their risk management activities in their financial statements, and, in turn, help investors to understand the effect of those activities on future cashflows. The proposed model is principles-based, and is designed to align hedge accounting more closely with risk management activities undertaken by companies when hedging their financial and non-financial risk exposures.
The proposed model combines a management view that aims to use information produced internally for risk management and an accounting view that seeks to address the risk management issue of the timing of recognition of gains and losses.
The ED proposes relaxing the requirements for hedge effectiveness and, consequently, the eligibility for hedge accounting. Under IAS 39, the hedge must both be expected to be highly effective, and demonstrated to have been highly effective, with 'highly effective'; defined by means of a quantitative test of between 80% and 125% effectiveness.
The ED requires the hedge to be designated so as to be neutral and unbiased, and in a way that minimises expected ineffectiveness. This may be demonstrated qualitatively or quantitatively, depending on the complexity of the hedge. A simple hedge may require a qualitative test, whereas a complex hedge may require a quantitative analysis.
Hedge ineffectiveness must still be measured and reported in the profit or loss. Effectiveness testing is conducted by reference to the entity's risk management objective, relies on a judgmental test and is only conducted prospectively, reducing the accounting burden for hedge relationships.
The proposals remove restrictions that prevent some economically rational hedging strategies from qualifying for hedge accounting. The ED proposes that risk components can be designated for non-financial hedged items, provided the risk component is separately identifiable and measurable – for example, operating lease rentals linked to inflation.
More instruments and 'economic' hedges will qualify for hedge accounting so long as the appropriate criteria are met. Entities that hedge non-financial items for a commodity price risk that is only a component of the overall price risk of the item may find that it is likely to result in more items qualifying for hedge accounting.