COMPLETION of the IASB’s hedge accounting phase of its financial instruments project represents a key milestone in its long-standing commitment to replace IAS 39 Financial Instruments: Recognition and Measurement with a more principles-based and simplified standard. The new hedge accounting model, added to IFRS 9 Financial Instruments, provides greater opportunity for reporters to apply hedge accounting in the financial statements and it also reduces volatility arising from the application of hedge accounting.
The IASB’s objective for the new hedge accounting model has been to remove the arbitrary restrictions in IAS 39 and allow companies to reflect risk management activities more closely in the financial statements. In line with IAS 39, the hedge accounting requirements remain optional, but given the direction of changes it is likely that more hedge accounting will be applied under the new rules.
The new model includes a number of changes in many different areas of hedge accounting, although three key areas of change are particularly noteworthy for corporates. Firstly, hedge accounting is more achievable by increasing the eligibility of the types of risks for which hedge accounting can be applied.
Under the new model more risk components, or “portions”, of non-financial items qualify for hedge accounting. For example, the crude oil component of a jet fuel purchase could be hedged under the new model where it is separately identifiable and reliably measurable, which is not permitted under IAS 39. Derivatives may also be included as part of the hedged item with the combination hedged by a further derivative under the new model.
This change will accommodate common risk management activities where more than one risk in an item is hedged at different stages. For example, where a commodity purchase in a foreign currency is first hedged for the commodity price risk and then later hedged for foreign currency risk, there can be two separate hedge relationships for each risk under the new model, which can reduce profit or loss volatility compared to IAS 39.
Secondly, the new model reduces the burden of proving that a hedging instrument is a good hedge of a particular risk by removing the 80% to 125% offset requirement found in IAS 39. The new IFRS 9 requirement involves demonstrating that an “economic relationship” exists between the hedged item and hedging instrument which may be done qualitatively or quantitatively, depending on how closely matched the hedge is.
Also, IFRS 9 only requires an assessment at the beginning of a hedge period to determine whether hedge accounting will be applied for the period. This is different from IAS 39 which also requires a test at the end of the period. IFRS 9 therefore reduces the uncertainty regarding whether hedge accounting will be applied and better reflects the actual effectiveness of the hedge. For example, if the hedge is only 60% effective, this is what gets reported.
Finally, hedge accounting with option contracts will yield less profit or loss volatility compared to IAS 39 due to revised mechanics for the accounting of the time value of an option (usually equal to the premium paid for the option) when the intrinsic value is designated in the hedge. Under IAS 39, the time value of an option contract is recognised in profit or loss on a fair value basis.
Under IFRS 9, this volatility is recognised in other comprehensive income with subsequent removal from equity and recognition in profit or loss on a less volatile basis. For example, for a hedge of foreign currency risk on the sale of goods using an option contract with matched terms, the change in time value would be deferred in equity through other comprehensive income and reclassified to profit or loss when the sale impacts profit or loss, effectively including the option premium as part of the sale.
Some of the hedge accounting changes introduced by IFRS 9 will be welcomed by corporates – however, IFRS 9 does not yet have an effective date and early adoption in Europe is only permitted after EU endorsement. The effective date will be added once the standard is complete with a new impairment model and proposed classification and measurement amendments, expected later this year, after which the endorsement process is expected to begin.
Kush Patel is a director at Deloitte UK, IFRS Centre of Excellence
Increased eligibility of hedged items:
• Risk components of non-financial items may be designated, provided they are separately identifiable and reliably measurable
• Derivatives may be included as part of the hedged item
• Groups and net positions may be designated hedged items
• Financial instruments allowed at fair value through profit or loss may be designated as hedging instruments
• New way to account for the change in time value of an option when the intrinsic value is designated
• Requirement for an economic relationship between the hedged item and hedging instrument, with no quantitative threshold
• Increased disclosures about an entity’s risk management strategy, cashflows from hedging activities and the impact of hedge accounting on the financial statements