IFRS 9 hedge accounting reforms: a closer reflection of risk management?
Senior Manager,UK IFRS Centre of Excellence, Deloitte
- 1 Introduction
- 2 Applying hedge accounting
- 3 Why introduce an alternative to the IAS 39 hedge accounting model?
- 4 Risk management ‘strategy’ and ‘objective’
- 5 Hedge effectiveness assessment
- 6 Hedge effectiveness measurement
- 7 Accounting for time value of options (and other “costs of hedging”)
- 8 Hedging risk components
- 9 Summary of other changes
- 9.1 Hedged items that include derivatives (or “synthetic positions”)
- 9.2 Groups of hedged items and net position
- 9.3 Hedging equity investments designated as at fair value through other comprehensive income
- 9.4 Eligibility of hedging instruments
- 9.5 Cash flow hedge accounting and basis adjustments
- 9.6 Modifying a hedging relationship (“rebalancing”)
- 9.7 Extending the fair value option – hedging “own use” contracts to buy or sell a non-financial item
- 9.8 Extending the fair value option – hedging credit risk
- 9.9 Disclosures
- 10 Effective date and transition
- 11 Impact on other reporting frameworks
- 12 Closing thoughts – a closer reflection of risk management?
- 13 Notes
Despite the intention of companies to reduce risk by using financial instruments such as derivatives, when it comes to the accounting, such activities can create accounting volatility. This is because, for accounting purposes, the underlying exposure is not necessarily recognised and measured on the same basis as the financial instrument used to hedge it. For example, a foreign currency derivative used to hedge a forecast transaction will be recognised and measured at fair value through profit or loss (FVTPL) from inception, whereas the forecast transaction will remain unrecognised until it happens. Hence, although over the long term, the financial statements present the cumulative effect of hedging which may stabilise the entity’s net assets, an accounting mismatch, and consequently volatility can arise in reporting periods.
Hedge accounting under IAS 39 Financial Instruments: Recognition and Measurement is an exception to the normal recognition and measurement requirements in IFRSs that helps to address this accounting mismatch. Through the application of hedge accounting, an entity can effectively match, in profit or loss, gains and losses on the financial instruments used to hedge (“hedging instruments”) with losses and gains on the exposures hedged (“hedged items”). However, the restrictive hedge accounting rules of IAS 39 have led to some companies not applying hedge accounting or in some cases changing their risk management approach to become eligible.
For the new general hedge accounting model in IFRS 9 Financial Instruments (the standard that replaces IAS 39), the International Accounting Standards Board (IASB) has taken a different approach. The IFRS 9 model focuses more on reflecting the risk management activities in the financial statements and gives greater opportunities to apply hedge accounting. In this article we provide an overview of the key differences between the IAS 39 and IFRS 9 hedge accounting models considering the reflection of, and potential impact on, risk management activities.
Applying hedge accounting
The mechanics through which hedge accounting achieves matching of gains or losses on the hedging instrument with the hedged item under IAS 39 varies depending on the nature of the hedge:
- Generally, hedges of exposures to variability in cash flows are dealt with by deferring in other comprehensive income (OCI), changes in value of the hedging instrument, with amounts later removed or reclassified and ultimately recognised in profit or loss at the same time as the hedged item. This is referred to as cash flow hedge accounting.
- Generally, hedges of existing hedged items without variable cash flows are matched with the hedging instrument by also re-measuring the hedged item through profit or loss. This is referred to as fair value hedge accounting.
- A third and final category of hedge accounting is net investment hedging, which applies to hedges of foreign currency risk on net investments in foreign operations and is accounted for in a similar way to cash flow hedge accounting.
Hedge accounting is voluntary and can only be applied prospectively from the point that a hedging instrument and hedged item are formally designated in a hedging relationship and the other qualifying criteria are met, including an assessment of the expected effectiveness of the hedge (see below). If for any reason a hedging relationship does not meet all of the necessary conditions, hedge accounting cannot be applied.
Given all of the requirements for hedge accounting and the fact that it is voluntary, some entities may choose not to apply hedge accounting and accept the accounting volatility that arises, or they may consider alternatives to hedge accounting that can achieve a similar outcome. These alternatives include designating the underlying exposure at FVTPL to reduce the accounting mismatch arising from measuring financial instruments used to hedge at FVTPL.
Why introduce an alternative to the IAS 39 hedge accounting model?
The hedge accounting requirements in IAS 39 have been criticised by some for having too many rules that are not connected with the entity’s risk management activities. Not only have the restrictive rules in IAS 39 made it difficult for entities to apply hedge accounting, but they have also made it difficult for entities to explain the results of applying hedge accounting in the context of the entity’s business and its risk management activities. This disconnect is because IAS 39 only approaches hedge accounting as an exception to the normal recognition and measurement requirements in IFRSs, rather than also as a means of portraying how an entity manages risk. This is what the IASB has sought to address with the hedge accounting requirements in IFRS 9.
The IASB has decided that hedge accounting should also be a means for entities to communicate their risk management activities. In other words, the job of hedge accounting is to convey the purpose and effect of the hedging instruments (generally derivatives) and how they are used to manage risk. However, hedge accounting continues to be voluntary and remains an exception from the normal accounting requirements.
In this article we focus on how the IFRS 9 hedge accounting requirements seek to reflect and may ultimately change risk management behaviour in four key areas:
- The importance of risk management ‘strategy’ and ‘objective’;
- The assessment and measurement of hedge ineffectiveness;
- The accounting for the time value of options (and other “costs of hedging”); and
- Hedging risk components.
The final sections provide a brief overview of the other major differences between the IAS 39 and IFRS 9 model and the effective date and transitional requirements.
Despite the new emphasis on reflecting risk management activities, the IAS 39 and IFRS 9 hedge accounting models are similar in some respects. In addition to the application of hedge accounting remaining a choice, the terminology in the IAS 39 hedge accounting model is retained in the IFRS 9 model. The mechanics of fair value, cash flow and net investment hedges are also broadly similar.
It is also important to note that entities that apply IFRS 9 will have an accounting policy choice under the standard as to whether to continue to apply the hedge accounting model in IAS 39 on transition to IFRS 9. The IASB decided to provide this policy choice because of concerns regarding macro cash flow hedges applied primarily by financial institutions, but the choice is available to all entities. The IASB will revisit this accounting policy choice when it finalises work on the macro hedging project1.
Risk management ‘strategy’ and ‘objective’
There are no accounting rules governing an entity’s risk management strategy and objective for a hedge except that, to achieve hedge accounting, an entity must have documented its strategy and objective. The hedge relationships an entity wishes to apply hedge accounting for must be consistent with these stated policies. Therefore, the policies and objectives should, as a minimum, include a list of the risks that the entity is exposed to and how the entity intends to manage those risks.
This is consistent with IAS 39; however, unlike IAS 39 the risk management objective is an important factor in determining whether a hedging relationship under IFRS 9 can or should be discontinued. Under IAS 39, hedging relationships are discontinued when the:
- hedging instrument expires or is sold, terminated or exercised;
- hedged forecast transaction, for cash flow hedges, is no longer highly probable;
- hedge no longer meets the criteria for hedge accounting; or
- entity amends or revokes the designation.
The first three of these criteria for discontinuing hedge accounting were carried over to the hedge accounting requirements under IFRS 9. However, the IASB did not deem it appropriate for entities to voluntarily discontinue hedge accounting when the risk management objective has not changed for the hedging relationship. Hence the IASB eliminated the ability for entities to voluntarily revoke their hedge accounting designations under the IFRS 9 hedge accounting model. This means that when an entity chooses to apply hedge accounting, it cannot be discontinued until the risk management objective for the hedging relationship has changed or the hedge expires or is no longer eligible if an entity chooses to apply the IFRS 9 hedge accounting model. It is, therefore, important to understand the distinction between risk management strategy and objective.
For the purposes of IFRS 9, an entity’s risk management strategy is distinguished from its risk management objectives. The risk management strategy is established at the highest level at which an entity determines how it manages its risk and typically identifies the risks to which the entity is exposed and sets out how the entity responds to them. This is normally set out in a general document that is cascaded down through an entity through policies containing more specific guidelines. In contrast, the risk management objective for a hedging relationship applies at the level of a particular hedging relationship. It relates to how the particular hedging instrument that has been designated is used to hedge the particular exposure that has been designated as the hedged item. Hence, execution of a risk management strategy can involve many different hedging relationships whose risk management objectives relate to executing that overall risk management strategy.
In practice, the narrowly defined hedge objectives allow a great deal of flexibility in relation to how an entity manages risk under its risk management strategy. For example, if an entity has a strategy of maintaining a mix between variable and fixed rate funding within a certain range (e.g. 20 to 40%), it may discontinue a previously designated hedge for a number of reasons. For example, it may discontinue or partially discontinue a hedge of variable rate debt with an interest rate swap if it issues new fixed rate debt that impacts its overall mix between fixed and variable rate funding such that the original risk management objective is no longer valid. It may also discontinue or partially discontinue the hedge relationship because it has changed its view on where within the 20 to 40% range it wishes to position itself. Depending on the circumstances the entity might retain the swap and either use it to hedge another exposure or enter in to an offsetting swap.
The adoption of the IFRS 9 hedge accounting model may be a good time for an entity to review its risk management policies and procedures. A documented risk management strategy that does not correspond to the day-to-day risk management activities may create problems with designation and de-designation of hedge relationships (for example where the stated policy is to hedge a set proportion of an exposure, but in reality the exposure is hedged within a range). In addition, the differences between the IFRS 9 and IAS 39 hedge accounting models may mean that entities may wish to look again at how they manage their risk. For example hedging with options may have been unattractive under IAS 39 because of the resulting profit or loss volatility (see below); the changes under IFRS 9 may eliminate that volatility and so make hedging with options more attractive.
Hedge effectiveness assessment
Hedge effectiveness is the extent to which changes in the fair value or cash flows of the hedging instrument offset changes in the fair value or cash flows of the hedged item.
To qualify for hedge accounting under IAS 39 there must be an expectation that the hedge will be highly effective (i.e. the prospective test) and that expectation must be realised for each hedged period (i.e. the retrospective test). Therefore, under IAS 39 it is not known whether hedge accounting will apply for each period until the end of that period. IAS 39 defines a hedge as highly effective if the offset is in the range of 80-125%. This results in an entity being required to perform numerical effectiveness tests to demonstrate offset within this range if it wishes to qualify for hedged accounting. These requirements are seen to be onerous, not in line with risk management practices and vulnerable to technical failures (rather than a breakdown in the economics of the hedge). In addition, it is difficult to explain an entity’s risk management strategy when hedge accounting is not allowed because of an “accounting-based threshold” of 80-125%. This approach also fails to show the true performance of the hedge when offset falls outside the 80-125% range.
To address these issues the IASB developed principles-based qualifying criteria for the IFRS 9 model, avoiding specific offset thresholds that could be inconsistent with risk management approaches. Under IFRS 9 a hedge relationship must comply with the following to qualify for hedge accounting:
- There should be an economic relationship between the hedging instrument and the hedged item.
- The effect of credit risk should not dominate the value changes that result from that economic relationship.
- The hedge ratio should reflect the actual quantity of hedging instrument used to hedge the actual quantity of hedged item (i.e. consistent with the ratio used for risk management purposes), provided this does not deliberately attempt to achieve an inappropriate accounting outcome.
The new effectiveness criteria require judgment to determine whether an economic relationship exists between the hedged item and the hedging instrument. Depending on how complex the hedging relationship is, that judgment may need to be supported by a qualitative or a quantitative assessment of the hedging relationship.
For example, the critical terms (timing, amounts, rates, etc) of the hedging instrument and the hedged item may match and in such instances a qualitative analysis will be sufficient to conclude that an economic relationship exists. However, consider an entity that hedges an item using an instrument that introduces significant basis risk. To demonstrate an economic relationship a numerical assessment may be required. It is expected in such cases that the assessment may already be performed as part of the risk management process to assess the suitability of the hedging instrument. In some cases a numerical assessment may also be required to support the hedge ratio used for the hedging relationship.
The IFRS 9 hedge accounting model only requires a hedge effectiveness assessment to be performed prospectively, that is to assess whether the hedging relationship is expected to be effective going forward. This removes the burden of the retrospective hedge effectiveness assessment as currently required in IAS 39, which in turn eliminates the uncertainty of whether hedge accounting will fail in future periods. It should be noted, however, that hedge ineffectiveness must still be measured and recognised at the end of each reporting period (see below).
The relaxation of the hedge effectiveness requirements makes it easier to qualify for hedge accounting, and also results in accounting that is more reflective of an entity’s risk management activities. This may, therefore, increase the pressure from the users of financial statements to apply hedge accounting. However, the application of hedge accounting is not without its cost. Hedge accounting may still require more information than would be used for risk management purposes alone (e.g. to measure the effectiveness of the hedge, or to componentise the fair value of an instrument when it is only partially designated in a hedge). Therefore, applying hedge accounting for the first time may either require investment in a more sophisticated treasury management system, or more time to manually obtain or process the required information.
Hedge effectiveness measurement
The recognition and measurement of hedge ineffectiveness follows from the mechanics of hedge accounting. When applying hedge accounting it is necessary to measure both the hedging instrument and the hedged item in order to determine the required accounting entries. If there is a difference between the value changes of the hedged item and hedging instrument, hedge ineffectiveness will arise. Hedge ineffectiveness is the extent to which the changes in the fair value or the cash flows of the hedging instrument are greater or less than those on the hedged item. In a fair value hedge any ineffectiveness is always recognised. However, in a cash flow hedge no hedge ineffectiveness is recognised in profit or loss if the cumulative gain or loss on the hedging instrument from inception of the hedge is less than the cumulative change in fair value of the expected future cash flows on the hedged item from inception of the hedge. In some cases it will be straightforward to measure the change in value of the hedged item. For example, where an entity hedges the foreign currency spot component of a net investment in a foreign operation in a net investment hedge, the hedged item can be measured by comparing the functional currency value of the hedged amount of net assets translated at the opening and closing foreign exchange rates for the hedged period. In other cases an entity may need to use a proxy, such as a “hypothetical derivative”. This is necessary when, as in cash flow hedges, the fair value of the hedged item cannot be measured directly.
The hypothetical derivative method for measuring hedge effectiveness uses a derivative with terms that match the critical terms of the hedged item as a proxy to measure changes in value of the hedged item. Use of the hypothetical derivative method is common under IAS 39 and will continue to be so under IFRS 9. IFRS 9 contains additional guidance on the use of this method which explains that the hypothetical derivative cannot include features that only exist in the hedging instrument but not in the hedged item. The guidance is illustrated with the example of foreign currency debt, and it is stated that the “hypothetical derivative cannot simply impute a charge for exchanging different currencies even though actual derivatives under which currencies are exchanged might include such a charge (for example cross-currency interest rate swaps)” – i.e. the foreign currency basis spread of a cross-currency instrument can give rise to ineffectiveness.
Under IAS 39, it is common practice not to recognise hedge ineffectiveness due to foreign currency basis spreads where the hypothetical derivative method is used. To address this, the IASB decided to allow an extension of the treatment applied to time value of options (see below) to foreign currency basis spreads. This means that entities will be able to limit the profit or loss volatility arising from foreign currency basis spreads, in fair value as well as cash flow hedges under IFRS 9. However, this will make the accounting for hedges with cross-currency hedging instruments more complex, as:
- the value of the hypothetical derivative will not be calculated on the same basis as the actual hedging instrument; and
- in order to exclude the foreign currency basis spread element of a cross-currency instrument from a hedge relationship, the value of this element will need to be calculated separately.
Accounting for time value of options (and other “costs of hedging”)
Under IAS 39, entities that hedge account with options generally recognise the fair value change in the time value component of the option in profit or loss. This can lead to volatility in earnings. However, risk management generally views the time value of an option (usually equal to the premium paid at inception) as a cost of hedging. In other words, a cost incurred to protect the entity against unfavourable changes in price.
Consequently, under the IFRS 9 model the IASB decided that the undesignated time value of an option contract should be accounted for in profit or loss on a cost basis rather than on a fair value basis. This accounting treatment results in less profit or loss volatility. The accounting of the time value can be viewed as a two-step process (which in some ways is similar to the mechanics of cash flow hedge accounting).
The first step is to defer in OCI, over the term of the hedge, the fair value change of the time value component of the option contract (to the extent that it relates to the hedged item).
The second step is to remove amounts from equity to recognise in profit or loss. However, the basis of this reclassification depends on the categorisation of the hedged item, which will be either:
- a “transaction related” hedged item (e.g. a hedge of a forecast transaction); or
- a “period related” hedged item (e.g. a hedge of an existing item, such as inventory, over a period of time).
For “transaction related” hedged items the cumulative change in fair value deferred in OCI is recognised in profit or loss at the same time as the hedged item. If the hedged item first gives rise to the recognition of a non-financial asset or a non-financial liability the amount in equity is removed and recorded as part of the initial carrying amount of the hedged item. This amount is recognised in profit or loss at the same time as the hedged item affects profit or loss in accordance with the normal accounting for the hedged item.
For “period related” hedged items the reclassification of amounts deferred in equity is different. Instead of matching the option cost with a specific transaction, the amount of the original time value of the option that relates to the hedged item is amortised from equity to profit or loss on a rational basis (possibly straight line) over the term of the hedging relationship.
In some cases, companies may have wanted to hedge options from a risk management perspective, but may have elected either not to use option contracts because of the accounting consequences under IAS 39, or may have used options but decided not to apply hedge accounting as it did not fully reflect the economics of the transaction. The treatment set out above may, therefore, result in more entities hedging with options, or applying hedge accounting to their current economic hedges. When considered together with the more relaxed effectiveness assessment, the revised rules for the accounting for options may also result in an increase in the use of structured options. This is because it could be argued that there is an economic relationship between a structured option and a hedged item in circumstances when it would not be possible to demonstrate that offset would fall within the 80-125% range required by IAS 39.
Following consultation on its initial proposals, which outlined the treatment above for option contracts, the IASB agreed to allow similar treatment for the forward element of a forward and foreign currency basis element of a cross-currency financial instrument when these elements are excluded from the hedge designation. The treatment for the forward or foreign currency basis elements is optional so it is not required to apply the treatment set out above. Where the alternative treatment is not applied, the excluded element is recognised at FVTPL.
Hedging risk components
Under IAS 39, a non-financial item may be designated as a hedged item in its entirety (i.e. all risks), for foreign exchange (FX) risks or for all risks except FX risk. As a result, if an entity economically hedges a non-financial item for a risk component other than FX risk, it is not permitted to designate a hedge for that component in isolation. For example, an entity could not hedge only the inflation component of an operating lease where the contractual rental payments were linked to inflation. Generally in such cases an entity either does not apply hedge accounting or designates the entire item, or a proportion of it. Not applying hedge accounting or designating the entire item when this is not the intention of the economic hedge gives rise to profit or loss volatility that does not reflect the risk management objective of the hedge.
To address this issue, the IASB introduced a principle in IFRS 9 that permits risk components of non-financial items to be eligible hedged items if they are separately identifiable and reliably measurable. In practice, the ability to meet these criteria will depend on the specific facts and circumstances. Generally it would be easier to demonstrate that a risk component is “separately identifiable and reliably measurable” if it is a price variable referenced in a contract (i.e. a contractually specified risk component) than if the component is not contractually specified but implied. For non-contractually specified risk components it will be necessary to provide sufficient analysis about the market structure of the item from which the risk component is identified in order to demonstrate that the hedged component is eligible.
In cases where an entity hedges a physical item, such as finished electrical goods, looking to the physical components of that item, such as copper components, may be a starting point to identify risk components that could be hedged. However, the presence of physical components in an item would not necessarily mean that such components are eligible for hedge accounting because that physical component may not be a separately identifiable and reliably measurable component of the fair value or cash flows of the item. For example, changes in the copper price may not result in an identifiable change in the price of finished electrical goods because, given the market structure, there are many influencers on the price of the finished goods such that the copper component of the overall price is not separately identifiable and reliably measurable. That said, there will be some cases where the presence of a physical component does have an identifiable and reliably measurable impact on the price of an overall item. One such example provided in IFRS 9 is a hedge of the crude oil component of jet fuel. In these cases, the role of risk management will be key, as careful judgment and clear understanding of the workings of the market, how prices are determined and the basis for entering into the hedge from a risk management perspective will all be relevant to establish the existence of a risk component.
Allowing the designation of risk components makes the results of hedge accounting more reflective of risk management practices, by allowing only changes in value of the hedged item due to the risk economically hedged to be reflected in the financial statements. As the results of hedge accounting will be more meaningful more entities may choose to apply it.
Summary of other changes
Hedged items that include derivatives (or “synthetic positions”)
The IFRS 9 hedge accounting requirements permit an aggregated exposure that includes a derivative to be an eligible hedged item. This is different to IAS 39 as that standard generally prohibits a derivative from being designated as a hedged item. This has proved challenging in practice for some entities that manage risk exposures that include derivatives.
Consider the following example: an entity has a forecast purchase requirement of a commodity denominated in a foreign currency (FC). That entity may manage the commodity price risk (in FC) two years in advance by transacting a net settled forward contract that fixes the price at FC100 per unit. A year later, it may wish to hedge the foreign currency risk that arises on the combination of the forecast purchase and the commodity derivative (i.e. the aggregate or synthetic foreign currency exposure of its purchase of commodities at FC100 per unit). The hedge accounting model under IFRS 9 permits the aggregated exposure to be designated in a hedge accounting relationship.
Groups of hedged items and net position
In order to efficiently hedge risk exposures, risk management strategies often analyse risks on an aggregated portfolio basis. This approach allows an entity to take advantage of naturally offsetting risk positions rather than, for example, hedging individual exposures with offsetting derivatives. IAS 39 restricts the application of hedge accounting for groups of items and net positions such that in some cases hedge accounting cannot be achieved, resulting in an accounting outcome that doesn’t match the risk management view. Under IFRS 9, groups of items (e.g. a group of assets) and a net position (e.g. the net of assets and liabilities, or net of forecast sales and purchases) can be hedged collectively as a group, provided the group consists of individually eligible hedged items and those items are managed together for risk management purposes. However, cash flow hedges of net positions are permitted only for foreign exchange risk.
Hedging equity investments designated as at fair value through other comprehensive income
When IFRS 9 was issued in November 2009, it introduced the ‘fair value through other comprehensive income’ (FVTOCI) category for certain equity investments. Under this classification, all fair value changes are permanently recognised directly in OCI except for dividends received on the investment. Hedge accounting is permitted for such investments because many entities would manage the market risks of equity investments irrespective of the accounting classification. Because all fair value changes are permanently recognised in OCI for these equity investments, the IASB decided that hedge ineffectiveness should also be recognised in OCI rather than profit or loss.
Eligibility of hedging instruments
The only difference to the IAS 39 model in which hedging instruments are eligible for hedge accounting is the inclusion of non-derivative financial instruments measured at FVTPL under IFRS 9.
Under IAS 39, hedging instruments are limited to those that meet the definition of a derivative, with a single exception that non-derivative financial instruments (e.g. a foreign currency loan) can be used to hedge foreign currency risk. Under the new alternative model in IFRS 9, the IASB decided not to focus the eligibility criteria on whether an instrument is a derivative or a non-derivative, but rather on whether it is measured at FVTPL.
In practice there have been limited examples of non-derivatives measured at FVTPL used for economic hedging purposes. However, such a scenario could arise, for example, when an entity uses an investment in a fund where the fund invests in commodity linked instruments and uses that investment as a hedge of price risk of a forecast purchase of a commodity.
Cash flow hedge accounting and basis adjustments
There is only one aspect of cash flow hedge accounting that is different from IAS 39. This difference relates to what is commonly referred to as “basis adjustment”. When hedging a forecast transaction that results in the recognition of a non-financial item, basis adjustment refers to the removal of the amount that has been accumulated in the cash flow hedge reserve and recording it as part of the recognised non-financial item. Under IAS 39, applying basis adjustment for such a hedge is a choice (the alternative is to retain the deferred gain or loss in reserves and reclassify to profit or loss when the hedged item affects profit or loss). This also applies in cases where a forecast transaction in a cash flow hedge becomes a firm commitment for which fair value hedge accounting is subsequently applied.
The IFRS 9 hedge accounting model has eliminated the choice for basis adjustment that exists under IAS 39. Instead, an entity shall be required to apply a basis adjustment when a forecast transaction in a cash flow hedge results in the recognition of a non-financial item if it chooses to apply the IFRS 9 hedge accounting requirements.
Modifying a hedging relationship (“rebalancing”)
Under IAS 39, changes to a hedging relationship would generally require the entity to discontinue hedge accounting and restart with a new hedging relationship that captures the desired changes. However, for risk management purposes hedge relationships are sometimes adjusted in reaction to changes in circumstances. Consequently, the IASB allows under the IFRS 9 hedge accounting model certain changes to the hedge relationship after inception as part of a continuing hedging relationship without forcing discontinuation for the entire hedging relationship.
Rebalancing of a hedging relationship is required by IFRS 9 when a hedging relationship ceases to meet the hedge effectiveness requirement relating to the hedge ratio, but the risk management objective for that designated hedging relationship remains the same.
Extending the fair value option – hedging “own use” contracts to buy or sell a non-financial item
Certain contracts to buy or sell a non-financial item that qualify for “own use” are not subject to derivative accounting as they are outside the scope of IAS 39 and are treated as regular sales or purchase contracts. A typical example includes a purchase of a commodity by an entity that uses it to produce goods for sale.
Some entities, e.g. commodity processors, hedge the economic risk exposure of their purchase and sale contracts of non-financial items along with commodity inventories with derivatives measured at fair value. As some of the purchase and sale contracts may not be recognised in the statement of financial position this can lead to accounting mismatches. Because of the large number of transactions that these entities enter into and the constant changes in the net exposure, hedge accounting under IAS 39 is an onerous and sometimes impractical way of accounting for these transactions.
To mitigate the need for hedge accounting, IFRS 9 extends the fair value option to contracts that meet the “own use” scope exception if doing so eliminates or significantly reduces an accounting mismatch.
Extending the fair value option – hedging credit risk
The IFRS 9 hedge accounting model permits an entity to elect FVTPL accounting for credit exposures (such as loans, bonds and loan commitments) when they are hedged with a credit derivative (e.g. credit default swap) and certain conditions are met.
The IASB also changed the related disclosure requirements in IFRS 7 Financial Instruments: Disclosures, which introduces extensive disclosures where hedge accounting is applied. These disclosure requirements will be applicable when an entity applies IFRS 9, irrespective of an entity’s accounting policy choice to continue to apply the hedge accounting model under IAS 39 or IFRS 9.
The IFRS 9 hedge accounting requirements focus on providing users of financial statements with information about that entity’s risk management activities. In other words, they provide information about the purpose and effect of the hedging instruments (generally derivatives) and how they are used to manage risk.
The new disclosure requirements are built around three objectives that 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; and
- the effect that hedge accounting has had on the entity’s statement of financial position, statement of comprehensive income and statement of changes in equity.
Effective date and transition
IFRS 9 is mandatory for annual periods starting on or after 1 January 2018. The standard is available for early adoption. However, IFRS 9 will need to be endorsed by the EU before it can be applied by entities reporting under EU endorsed IFRSs. IFRS 9 also includes other aspects of financial instruments accounting which would need to be considered in deciding whether to early adopt the standard.
The IFRS 9 hedge accounting model, if adopted, applies prospectively with limited exceptions. Retrospective application of the accounting for the time value of options would, however, be required for all hedging relationships in which only the intrinsic value of an option is designated under IAS 39. Retrospective application would be permitted for hedging relationships in which the hedging instrument designated under IAS 39 is the spot element of a forward contract or where the foreign currency basis spread is separated and excluded from the designation of a financial instrument as the hedging instrument.
Impact on other reporting frameworks
The changes to hedge accounting under IFRS may also impact local GAAPs. For example in the UK some entities2 applying UK GAAP are able to choose to apply the recognition and measurement requirements of IFRS 9. Such entities are not required to wait for EU endorsement of IFRS 9 and hence may have the opportunity to adopt the IFRS 9 hedge accounting model under UK GAAP sooner than under IFRS.
Closing thoughts – a closer reflection of risk management?
The IFRS 9 hedge accounting model certainly gives entities more opportunities to reflect their risk management activities in their financial statements. Many of the changes should make hedge accounting easier to apply, allow the application of hedge accounting in more circumstance or enable better reflection of the economics of a hedge. However, in some cases this makes collection of data for, or mechanics of, hedge accounting more complex, which may in turn require additional time or resources from both treasury and finance departments. The treasurer will play a key role in evaluating the relative costs and benefits of the new model.
1 The IASB's project on macro hedge accounting is ongoing and deals with hedge accounting for dynamic open portfolios. The IASB issued a discussion paper in April 2014 entitled “Accounting for Dynamic Risk Management: a Portfolio Revaluation Approach to Macro Hedging”.
2 Those choosing to apply FRS 102 The Financial Reporting Standard applicable in the UK and Republic of Ireland.