Hedging clarifications

Finance directors and their colleagues are set for welcome relief on the more obscure elements of hedge accounting. While the move by the International Accounting Standards Board is not a radical revisiting of the much despised IAS39 Financial Instruments: Recognition and measurement, the proposals should both clarify and extend what risks can be designated as a hedged risk.

The proposals should also help improve the relationship between auditors and their clients. According to one technical expert, some audit firms have gained a reputation “for being very sticky on what they allow to be a valid hedge”.

User demands for additional guidance on what IAS39 permits to be designated as a hedge is forcing this change, although the IASB has positioned the amendments as an attempt to reach the position where they intended to be all along.

Key amendments

The amendments contained in exposure draft (ED) to IAS39 Exposures Qualifying for Hedge Accounting sets out two main points. First, that the risks that qualify for designation as hedged risks when an entity hedges its exposure to a financial instrument. Second, when a company may designate a portion of the cash flows of a financial instrument as a hedged item.

In the ED the IASB says: “Subject to certain restrictions, a financial instrument may be designated as a hedged item for interest rate risk, foreign exchange (FX) risk, credit risk, prepayment risk or the risks associated with the contractually specified cash flows of a recognised financial instrument.” Students of the US GAAP/FASB reconciliation programme will know that this new list differs slightly from US GAAP where only interest rate, FX and credit risk can be hedged.

What this means is that, under the new rules, a company would be permitted to designate, as a hedged item, changes in the fair value of a fixed-rate sterling financial asset attributable to changes in sterling Libor or the Bank of England base rate. This recognises the risk that the fair value or future cash flows of the financial instrument will fluctuate because of changes in interest rates.

Yann Umbricht, a partner in the treasury group at PricewaterhouseCoopers, was cautious in his assessment of the IASB’s help. “The proposals are expected to have little effect in practice because few companies are hedging risks or portions that are not on the lists set in the exposure draft. However, for hedging one-sided risks of forecast transactions with options, there is one area where a significant change in practice is proposed,” he says.

Separating risk

While these proposals are brief, it is clear that companies will be able to use hedge accounting more often. The changes will allow FDs to separate a portion of the overall risks. FDs can pull out interest rate risk, FX risk and credit risk, and they can separate a portion of the cash flows, for example, the first three years’ worth of cash flows on a loan.

Martin O’Donovan, assistant director, policy and technical, at the Association of Corporate Treasurers, says: “Listing the details of what risks and which portions of cash flows can be separated out is helpful, but it illustrates the problems of heading down the rules route. You end up needing more details. I wonder whether it would have been possible to find a general principle and leave a certain amount to common sense.”

The issue has been knocking about for the best part of a year. All this came about because the International Financial Reporting Interpretations Committee (IFRIC) received requests for guidance on what IAS39 permits to be designated as a hedged item.

Rather than dealing with these requests individually, the IFRIC attempted to develop a principle that could be used as guidance on what IAS39 permits to be designated as a hedged item. It was unable to develop such a principle so it threw the problem to the board.

The IASB has made it clear that it is not yet open season to comment on IAS39 in its entirety. While those involved in sorting out companies’ hedge positions may welcome the clarification, the IASB is refusing to be rushed into changing the bigger picture on accounting for financial instruments. The IASB says it is undertaking research that will ultimately lead to the replacement of IAS39, but the work is at an early stage. You could hedge your bets on when that finally appears.

The guidance can be found at www.iasb.org