IASB issues review draft on hedge accounting

12 September 2012

The IASB has issued a review draft (RD) that details the new hedge accounting requirements.

The IAS 39 requirements on hedge accounting have frustrated many preparers as they have not been well linked with common risk management practices. The detailed rules have at times made achieving hedge accounting impossible or very costly, even when the hedge has been an economically rational risk management strategy. Users have also found the current distinction between achieving hedge accounting or not as meaningless; they have often struggled to fully understand an entity’s risk management activities based on its application of the hedge accounting rules.

The IASB has addressed several of these concerns in this third phase of its replacement of IAS 39 with IFRS 9.

Key provisions

Hedge effectiveness tests and eligibility for hedge accounting

The RD relaxes the requirements for hedge effectiveness assessment and consequently the eligibility for hedge accounting. Under IAS 39 today, the hedge must both be expected to be highly effective (a prospective test) and demonstrated to have actually been highly effective (a retrospective test), with ‘highly effective’ defined as a ‘bright line’ quantitative test of 80-125%. The RD replaces this with a requirement for there to be an economic relationship between the hedged item and hedging instrument, and for the hedged ratio of the hedging relationship to be the same as the quantity of the hedged item and hedging instrument that the entity actually uses for its risk management purposes. An entity is still required to prepare contemporaneous documentation to support hedge accounting. In addition, hedge ineffectiveness must still be measured and reported in the profit or loss.

Hedged items

A number of changes have been made to the rules for determining what can be designated as a hedged item. The changes primarily remove restrictions that today prevent some economically rational hedging strategies from qualifying for hedge accounting. For example, the RD states that risk components can be designated for non-financial hedged items provided the risk component is separately identifiable and reliably measurable. This is good news for entities that hedge non-financial items for a commodity price risk that is only a component of the overall price risk of the item as it is likely to result in more hedges of such items qualifying for hedge accounting. In addition, the RD makes the hedging of groups of items more flexible, although it does not cover macro hedging (this will be the subject of a separate due process document in the future). Treasurers commonly group similar risk exposures and hedge only the net position (for example, the net of forecast purchases and sales in a foreign currency). Under IAS 39 today, such a net position cannot be designated as the hedged item. The RD permits this if it is consistent with an entity’s risk management strategy. However, if the hedged net positions consist of forecasted transactions, hedge accounting on a net basis is now (in a change from the ED) only available for foreign currency hedges. In its re-deliberation regarding the hedged item, the board also decided to allow hedge accounting for equity instruments at fair value through other comprehensive income, even though there will be no impact on profit or loss from these investments under IFRS 9.

Hedging instruments

The RD relaxes the rules on using purchased options and non-derivative financial instruments as hedging instruments. For example, under the current hedging rules, the time value of purchased options is recognised on a fair value basis in profit or loss, which can create significant volatility. In contrast, the RD views a purchased option as similar to an insurance contract, such that the initial time value (that is, the premium generally paid) will be recognised in profit or loss – either over the period of the hedge if the hedge is time related, or when the hedged transaction affects profit or loss if the hedge is transaction related. Any changes in the option’s fair value associated with time value will be recognised in ‘other comprehensive income’. The same accounting requirement may also be applied for the interest component of a forward contract. This should result in less volatility in profit or loss for these types of hedges.

Presentation and disclosure

The accounting mechanics and presentation requirements in IAS 39 remain largely unchanged in the RD. However, the RD requires all disclosures on the effects of hedge accounting to be disclosed in one comprehensive note in the financial statements.

How will this affect Corporate Treasurers?

All entities that engage in risk management activities, regardless of whether they use hedge accounting today, will potentially be affected by the changes. As many of the changes remove restrictions, it may be beneficial for entities to revisit their risk management strategies that currently do not achieve hedge accounting to see if they will now be permitted. The new requirements are effective for accounting periods beginning on or after 1 January 2015, with earlier application permitted only if the earlier completed phases of IFRS 9 are also adopted at the same time.

The board is not actively soliciting comments on the RD but published the review draft to provide an extended ‘fatal flaw review’ period, largely to ensure it is operational. The final standard is expected late 2012. Given the potential impact on accounting and operations, management should assess the implications of new requirements on existing hedging strategies and consider commenting on the RD where it has concerns about how to apply it in practice.


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Australian companies have already started considering how the new hedge accounting standards will affect them. Under the new proposal, the IASB aims for accounting practices to mirror the ways companies manage their risks. The revisions mean that firms can use reserve accounts to record losses or gains, rather than putting it into their P&L account. In the past, many organisations shied away from hedging their currency exposures because of the impact on their financial statements.

Although the shift in accounting standards means adjustments must be made, the overall changes will enable corporates to manage their exposure more effectively. Firms that access foreign debt markets directly typically hedge with options or use cross-currency interest rate swaps on foreign borrowings. Those that are partially floating and partially fixed will have more flexibility under the new rules.

If the hedging relationship fails to meet the objective of hedge effectiveness, it can be rebalanced prior to expiry provided that the risk management objective hasn’t changed. The time/value of an option will be treated more favourably and will not necessarily hit their P&L.

In addition, previously hedging the net of several exposures was very difficult because each individual exposure had to be hedged separately. Now corporates can bundle a particular group of items which could be hedged.

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