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Hedge accounting closer to risk

THE INTERNATIONAL ACCOUNTING STANDARDS (IASB) has released a final draft of its proposals on general hedge accounting. The draft provides an opportunity for companies to consider the impact before it is finalised at the end of this year and to provide comments.

There are many aspects of the draft that companies will welcome. The idea that hedge accounting should follow risk management is the foundation for the model. Although the requirements seem complex, much of this is aimed at making sure companies do not stretch the boundaries of risk management too far. If hedge accounting is applied, it must be based on solid economic relationships reflected in documented risk management strategies and processes.

The fundamentals in IAS 39 (the accounting standard for financial instruments) are unchanged. To qualify for hedge accounting, hedge relationships must be documented and tested for effectiveness. Ineffectiveness is recognised in profit or loss. The mechanics of the three hedge accounting models – fair value, cash flow and net investment hedging – are the same.

One of the main changes is that the bright-line effectiveness test disappears, along with the risk of losing hedge accounting if that test fails. In complex hedges – for example, when derivatives are added in layers or existing derivatives are put into new relationships – hedge accounting could be much easier to achieve.

A forward-looking effectiveness test is required. However, it will only need to confirm that the economic relationship remains valid, that the hedge ratio reflects the best economic fit, and that credit risk is unlikely to dominate the relationship. For simple hedges in which the terms of the hedged item and hedging instrument are similar, the assessment will be straight-forward. In more complex hedges with known sources of ineffectiveness and/or hedge ratios other than one-to-one, a statistical analysis may be needed.

Hedges using options – derivative financial instruments – may become more attractive for corporates. Fluctuations in the time value of the option will not create volatility in profits as they do now. The premium paid for an option, like an insurance premium, will usually be amortised over the period of protection. This could lead to wider use of option hedges.

A similar opportunity exists to amortise the forward points in a forward contract. Hedges of net positions in foreign currencies will also be permitted in some circumstances. Companies may want to reconsider their foreign exchange hedging methods to take advantage of these concessions.

Significant benefits

Corporates using commodity contracts could see significant benefits. Unlike under IAS 39, hedge accounting can be applied to a component such as the crude oil part of a forecast purchase of jet fuel or the standard market price component of a contract to buy cocoa beans. This opens up opportunities to consider different strategies which could largely avoid volatility in reported profits.

Financial institutions will, to some extent, benefit from these changes. However, banks will be most interested in the outcome of the separate project on macro-hedging which will follow later.

In short, the new approach can bring real advantages. Companies will need to review their risk management and hedge accounting strategies to realise those benefits. Those that have chosen not to apply hedge accounting may revisit that decision. The increased level of judgement and relaxation of effectiveness requirements are, however, accompanied by extensive disclosure requirements and these may require systems changes.

The IASB expects that the new standard, IFRS 9, including classification and measurement, impairment and hedge accounting, will be effective in 2015. Adoption for EU companies, however, will only be possible after EU endorsement, which may take some time. ?

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