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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

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

The guidance can be found at

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