Hedge accounting – hedging risk components
24 January 2014
Nobody would argue against the assertion that the new hedge accounting requirements in IFRS 9 are more principles-based than the existing IAS 39 guidance. This is a welcome improvement and is more consistent with IFRS’s overall principles-based approach. However, do not be misled; application of the new guidance will not be straightforward.
In certain situations, significant management judgement will be required, for example, when hedging risk components of non-financial items. Under IFRS 9 this type of hedge is now allowed when the risk component is separately identifiable and reliably measurable. But what will this mean in practice?
Hedging a risk component that is explicitly specified in a contract should be relatively straightforward. On the other hand, when not contractually specified there is likely to be an additional layer of complexity. One area where the new standard is likely to see significant take up is with hedges of commodity price risk exposures. The fact that a commodity is traded in an active market helps to demonstrate that it is separately identifiable and that its value changes are reliably measurable but the required judgments don’t stop there.
IFRS 9 also requires an entity to assess risk components within the context of the particular market. IFRS 9 does not provide a definition of market structure and other than a few examples there is little accompanying guidance on how to make this assessment.
Continuing with the commodity hedge example, should the assessment be made based on the commodity’s market? For example, if an American company producing oil refined products wants to hedge its exposure to crude oil prices, then should it use the American WTI benchmark (the crude oil the entity uses to manufacture its products) or could it use crude oil benchmarks corresponding to other geographic locations (e.g. European benchmark Brent)?
And to go one step further, should the entity consider the market of the entity applying hedge accounting or only the market for the hedged commodity)? For example, a manufacturer of woollen jumpers might want to hedge its exposure to wool prices. Would the market structure differ between a manufacturer of generic woollen jumpers, as compared to a manufacturer of a well-known, high end brand of woollen jumpers, or for manufacturers in different geographic locations?
The new guidance is an improvement, but will it still be praised once entities begin to assess the practical implications of applying the guidance? Lots of complex judgments will require some carefully thought through disclosure.