Hedge accounting under

IFRS all set for change

Introduction
Reducing complexity has become a familiar term to those who follow the International
Accounting Standard Boards (the IASB or the Board) project on fnancial instruments.
Keeping with the theme, the Board has just released Exposure Draft Hedge
Accounting (ED) with proposals to substantially simplify hedge accounting under IFRS.
The ED is the third phase of the IASBs ongoing project to replace IAS 39. However,
proposals relating to macro (portfolio) hedge accounting are not included in the ED, but
will be released later in 2011.
In this supplement, we take a look at the main complexities of hedge accounting under
IAS 39 and how the IASB proposes to simplify the requirements in the new standard
IFRS 9 Financial Instruments.
The proposed changes at a glance
Hedging by risk components will be permitted for both fnancial and non-fnancial
items, if separately identifable and measurable
Eligible hedged items include combinations of derivatives and non-derivatives,
portions or proportions of nominal amounts and one-sided risks
Hedging instruments can include non-derivatives
The bright line test of 80-125% for hedge effectiveness testing will be eliminated
The assessment of hedge effectiveness will be prospective and driven by the risk
management strategy with a requirement that no systematic under- or over
hedge-hedging is expected
Rebalancing of the hedge ratio will be required when necessary to maintain the
risk management objective
Discontinuation of the hedge relationship will be mandatory if the hedging
relationship no longer qualifes (including if risk management objective changes).
Conversely, voluntary de-designation will not be permitted if the risk management
objective continues to be met
For fair value hedges, the hedged item will not be adjusted and the cumulative
gains or losses attributable to hedged risk will be recorded in a separate balance
sheet line. The fair value changes of both hedging instruments and hedged items
will be taken to Other Comprehensive Income (OCI) and any ineffectiveness will be
immediately taken to proft or loss
It will not be possible to apply hedge accounting to equity instruments recorded at
fair value through OCI
There are new rules for hedges of groups of eligible hedged items
There are signifcant new disclosure requirements
ey.com/IFRS
Issue 91 / December 2010
Supplement to IFRS Outlook
2
Hedge accounting under IFRS all set for change
What are the main diffculties under IAS 39?
A recurring theme that surfaces is the lack of an overall principle in the hedge accounting requirements under IAS 39. Hedge
accounting is an exception to the normal recognition and measurement principles, and IAS 39 permits the exception by way of
rules, restrictions and bright-line tests. The lack of a principle, coupled with rules (that are sometimes conficting) is the main
source of the complexity of the hedge accounting requirements under IAS 39.
Hedge accounting is optional under IFRS. Therefore, at one end of the spectrum, entities are not required to apply it if they do
not wish to. At the other end, many entities economically hedge (i.e., manage) their risks, but fnd that they are unable to fully
refect this fact in their fnancial statements because of the rule-based nature of the existing hedge accounting requirements.
In addition, analysts and other users fnd information relating to an entitys risk management strategy and practices to be
valuable, but this information may not be clearly refected in the fnancial statements because of a mismatch between the
application of hedge accounting and the entitys risk management objectives.
For corporate entities, one main concern has been the inability to hedge specifc components of non-fnancial items. For
example, an airline may wish to hedge its exposure to the movements in the price of jet fuel by entering into forward crude oil
contracts. Although crude oil is a key component of the refned product (i.e., jet fuel), it is not considered a valid hedged item
under IAS 39. This is because, under the existing rules for hedging non-fnancial items, an entity can only hedge either the
foreign currency risk or the entire non-fnancial item (the purchase price of jet fuel, in this case). There are many cases where
entities seek to hedge the purchase or sale of raw material components such as copper, gold, rubber, sugar and cocoa using
commodity derivatives. In each case, a price is readily available for the raw material, and it is often specifed in the contract as a
component of the overall price. Even if an entity uses derivatives to manage its exposure to price risk in such cases, the current
rules do not permit such economic hedging practices to be refected in fnancial reporting.
Designating groups of hedged items is a challenge under the current rules because many criteria need to be satisfed. Items
may be grouped together only if they are similar, have similar risk characteristics, share the risk exposure being hedged and the
change in fair value (for the hedged risk) for each individual item in the group is approximately proportional to that of the group
as a whole. As a result, many hedged items cannot be designated in a hedge relationship as a group, despite the apparent
economic link. The most widely quoted example is that one cannot achieve hedge accounting for the hedge of the equities that
comprise an index (such as those making up the FTSE 100) using the index future. Again, there is a discrepancy between
fnancial reporting and an entitys risk management.
Other criticisms include the onerous requirements to perform quantitative effectiveness tests, insuffcient guidance on how to
quantify hedge effectiveness and bright-line tests that give rise to arbitrary results and severe consequences.
Can hedge accounting be completely dispensed with? No, for two reasons. First, the Board has chosen to retain a mixed
measurement model (i.e., both amortised cost and fair value) for IFRS 9 and, generally, both preparers and users fnd it helpful
to use hedge accounting to address measurement mismatches. For example, a mismatch could arise when the hedged item
(such as a fxed rate loan) is carried at amortised cost, whereas the hedging instrument (such as an interest rate swap) is
measured at fair value. Second, hedge accounting will continue to be needed for hedges of forecast cash fows that are not yet
recorded in the fnancial statements.
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Hedge accounting under IFRS all set for change
Highlights of the ED
The ED states that the objective of hedge
accounting is to represent, in the fnancial
statements, the effect of an entitys risk
management activities which use fnancial
instruments to manage exposures arising
from particular risks that could affect
proft or loss.
Hedged items
Risk components may be designated as
hedged items if they are separately
identifable and reliably measurable. Risk
components could be part of a fnancial or
non-fnancial item and may or may not be
contractually specifed. Entities could,
therefore, choose to apply hedge
accounting to particular risks of a non-
fnancial item, as opposed to the current
need to designate the entire item.
The two examples of risk components in
non-fnancial items provided in the
application guidance to the ED are:
Hedging the gas oil component of a
long-term natural gas supply contract
that is priced according to a formula
that references various commodities
and factors including the price of gas oil
Hedging the crude oil component of
forecast jet fuel purchases, on the basis
that crude oil is a building block of jet
fuel
Eligible hedged items will include
derivatives, combinations of derivatives
and non-derivatives, portions or
proportions of nominal amounts and
one-sided risks (e.g., a hedge against
price movements in only one direction).
What is carried forward from
IAS 39?
Hedges of net investments
The mechanics of cash-fow hedge
accounting
The requirement to formally
designate and document hedge
relationships
The requirement to record in proft
or loss any hedge ineffectiveness
that actually arises
The restriction that prohibits the
designation of risk components
whose cash fows would exceed
those of the hedged item as a
whole
The restrictions that prohibit the
use of internal derivatives (e.g.,
contracts between entities forming
part of the same reporting entity)
and intra-group monetary items
(transacted between two group
entities with different functional
currencies) as hedging instruments
On discontinuation of cash fow
hedges, the amounts recorded in
OCI are carried forward to the
extent that the hedged item is still
expected to occur and recycled to
proft or loss when the hedged item
affects proft or loss
Groups and net positions
The ED sets out proposals for accounting
for hedges of closed portfolios which do
not change over the period of the hedge.
To be eligible for hedge accounting, an
entity must demonstrate that it manages
the items on a group basis for risk
management purposes. Other qualifcation
criteria applicable to individual hedged
items must also be satisfed (for example,
eligibility of the hedged items and hedging
instruments; hedge effectiveness
requirements; and documentation; etc).
Groups of items may contain either
fnancial or non-fnancial items, existing
(frm commitments) or anticipated
(forecast) transactions, and may be hedged
by way of either a fair value hedge or a
cash fow hedge. Helpfully, the change in
fair value of individual hedged items need
not be proportional to that of the overall
group (unlike in IAS 39), but all items must
be subject to the same hedged risk.
A combination of two or more gross
groups could give rise to a net position.
Consistent with IAS 39, the ED permits net
positions to be hedged, only as long as the
gross amounts are designated as hedged
items (so it will not be suffcient to
designate just the net amount). Some
restrictions will be placed in respect of
eligible groups, for example, net cash fows
would only be eligible for hedge accounting
if the offsetting cash fows affect proft or
loss in the same reporting periods
(including interim periods).
Portions (or layers) of the entire item
would also be eligible in certain situations.
The examples of layers provided in the
application guidance include:
50,000 cubic metres of the natural gas
stored in location XYZ
Or
The frst 100 barrels of the oil
purchases in June 201X
However, a layer of a contract that includes
a prepayment option is not eligible to be
designated as a hedged item if the
prepayment options fair value is affected
by changes in the hedged risk (although
the application guidance suggests that this
restriction is only applicable for fair value
hedges).
Open portfolios
The proposals for closed portfolios should
be seen as a step towards developing a
more sophisticated portfolio hedge
accounting model, to deal with open
portfolios in which the hedged items
change continuously over time, along with
adjustments to the instruments used to
hedge the risks to rebalance the hedge
relationship.
4
Hedge accounting under IFRS all set for change
Banks and fnancial institutions typically
manage their interest rate risk exposures
on a net basis at a portfolio (or macro)
level, giving rise to fundamental
differences between the requirements in
the existing standard and actual hedging
practices. Portfolio hedging is a
contentious topic and has been debated at
length and over many years by the IASB
and the banking industry. Although some
of the banks concerns were dealt with in
previous revisions to IAS 39, many were
not dealt with fully.
For example, there are signifcant
restrictions in the way in which fair values
of fnancial liabilities with a demand
feature are measured that prevent banks
from applying fair value hedge accounting
to the majority of their current accounts.
Although the goal for hedge accounting is
a better and stronger link with risk
management, in this particular case, the
differences between risk management and
hedge accounting are signifcant. For risk
management purposes, on-demand
deposits are typically risk-managed based
on their expected withdrawal behavior,
which is typically later than the contractual
maturity. Under IAS 39, such deposits can
never have a fair value less than the claim
amount, making them ineligible for fair
value hedge accounting.
The Board has just commenced its
discussions on a macro hedge accounting
model for open portfolios. Consequently,
no new rules are proposed in the ED for
macro hedging. Instead, a separate
exposure draft is expected later in 2011.
Hedging instruments
Time value of options
The use of options as hedging instruments
has been problematic under IAS 39. For
hedges involving fnancial options, both
IAS 39 and the ED give entities the choice
to: (a) designate the option as a hedging
instrument in its entirety; or (b) separate
the time value of the option and designate
as the hedging instrument only (the
change in) its intrinsic value. It is usual to
apply choice (b), in which case, the time
value of the option has to be recorded at
fair value through proft or loss.
Consequently, there can be signifcant
volatility in the recorded proft or loss.
The ED proposes to resolve this issue by
accounting for the time value of options by
making a distinction between two types of
hedged items:
Transaction related (e.g., the forecast
purchase of a commodity)
Time period related (e.g., hedging price
changes affecting commodity inventory)
For both transaction-related and time-
period-related hedged items, the
cumulative change in fair value of the
options time value would initially be
accumulated in Other Comprehensive
Income (OCI). In the former case, the
amount is removed from OCI and included
in the initial cost or other carrying amount
of the hedged item. In the latter case, the
amount is recycled from OCI to proft or
loss, in order to amortise the original time
value of the option over the term of the
hedging relationship.
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Hedge accounting under IFRS all set for change
Other changes
IAS 39 restricts the eligibility of cash (i.e.,
non-derivative) fnancial instruments as
hedging instruments to hedges of foreign
currency risk. The ED proposes to allow
cash instruments classifed at fair value
through proft or loss to be considered as
hedging instruments for any risk.
The ED proposes that derivatives that are
embedded in hybrid contracts, but not
separately accounted for, cannot be
designated as hedging instruments.
Hedge effectiveness assessment
The objective of the hedge effectiveness
assessment is to ensure that the hedging
relationship will produce an unbiased result
(i.e., there is no expectation that changes
in the value of the hedging instrument will
systematically either exceed or be less
than the change in value of the hedged
item) and minimise expected hedge
ineffectiveness. Therefore, a hedging
relationship cannot refect a deliberate
mismatch between the weightings of the
hedged item and the hedging instrument
(the hedge ratio) that would create hedge
ineffectiveness. It is also necessary to
demonstrate that any expected offsetting
between changes in the fair value or cash
fows of the hedging instrument and the
hedged items is not accidental. This is
done by analysing the economic
relationship between the hedged item and
hedging instrument. However, this does
not mean that a hedging relationship has
to be expected to be perfectly effective in
order to qualify for hedge accounting.
The assessment will be prospective and
needs to be performed at inception on an
ongoing basis (note: IAS 39 requires both
prospective and retrospective
assessments). The type of assessment
quantitative or qualitative will depend on
the relevant characteristics of the hedging
relationship and the potential sources of
ineffectiveness. The bright-line test of
80-125% for hedge-effectiveness testing
currently required by IAS 39 will be
eliminated, and there will be no target level
for achieving hedge accounting. For
quantitative assessment, the ED does not
prescribe any specifc method for the
effectiveness assessment (percentage
based or statistical methods can be used).
If there are changes in circumstances that
affect hedge effectiveness (an example
might include a shift in the basis risk
between the hedge and hedged item), an
entity may have to change the method for
assessing whether a hedging relationship
meets the hedge effectiveness
requirements (e.g., by moving to a
quantitative approach). If this occurs, the
entity also needs to ensure that the
relevant characteristics of the hedging
relationship including the sources of hedge
ineffectiveness are still captured.
According to the ED, the main source of
information to perform the hedge
effectiveness test will be the risk
management information used for
decision-making purposes.
Hedge ineffectiveness measurement
All ineffectiveness arising from the hedge
relationship will be recognised in proft or
loss. It will be calculated using the dollar
offset method i.e., the difference between
the change in the fair value of the hedging
instrument and the change in the fair value
of the hedged item attributable to the
hedged risk. The effect of time value of
money must be considered when
determining the changes in fair value.
Discontinuation of a hedging relationship
Discontinuation of hedge accounting will
be mandatory (on a prospective basis) if
the risk management objective changes.
Conversely, voluntary de-designation will
not be permitted when the risk
management objective remains the same.
In some situations, there may be no
change in the risk management strategy,
but some of the variables affecting the
hedging relationship may change such that
the qualifying criteria (particularly the
effectiveness assessment test) are no
longer met. In such situations, the hedge
relationship must be rebalanced to refect
the new hedge ratio. This is treated as a
continuation of the hedge relationship.
The own use exception
The accounting for commodity contracts
under current IFRS can result in an
accounting mismatch because it may not
be aligned with how some entities manage
risk within the context of their business
models. Many commodity buyers and
sellers manage their overall commodity
risk position on a fair value basis even
though they buy or sell for their own use
These contracts are excluded from IAS 39
and, therefore, may not be recorded on a
fair value basis. The Board considered
feedback from these entities and agreed
that hedge accounting is not an effcient
solution in such cases because entities
manage a net position of derivatives,
executory contracts and physical long
positions in a dynamic fashion.
The ED proposes that derivative
accounting may be applied to contracts
that would otherwise meet the own use
scope exception, if that is in accordance
with the entitys fair value-based risk
management strategy, in order to avoid a
mismatch or complex hedge accounting.
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Hedge accounting under IFRS all set for change
Fair value hedge mechanics
The ED proposes to change the mechanics
of how fair value hedges are presented in
the fnancial statements:
The cumulative gain or loss on the
hedged item attributable to the hedged
risk will be presented as a separate line
item in the balance sheet next to the
line item that includes the hedged asset
or liability, while the carrying amount of
the hedged item will remain unadjusted.
The fair value change of both the
hedging instrument and the hedged
item will be recognised in other
comprehensive income (OCI) and any
difference (ineffectiveness) will be
transferred to proft or loss immediately.
Routing the fair value changes through OCI
has no net effect since the net impact in
OCI for any period would be zero. However,
the Board expects that users will beneft if
all the effects of hedge accounting are
presented in one place in a primary
statement.
Disclosures
The ED proposes signifcant changes to
IFRS 7 Financial instruments: Disclosures
to provide a better link between the
entitys risk management strategy and how
it is applied to manage the risk, how the
entitys hedging activities may affect the
amount, timing and uncertainty of its
future cash fows, and the effect that
hedge accounting has had on the entitys
fnancial statements. The effects of hedge
accounting on the primary statements will
have to be disclosed in some detail using a
tabular format (by type of risk and type of
hedge). All of the disclosures required by
the ED are to be presented in a single note
or a separate section of the fnancial
statements.
Transition and effective date
The new hedge accounting requirements
will be applicable prospectively, with no
restatement of comparative fgures (or
requirement to give the disclosures for the
comparative period). For entities that
already apply IFRS, it is expected that
almost all of the previous hedge
accounting relationships under IAS 39
would still qualify under the proposed
model. They would be regarded as
continuing hedges and, hence, would not
involve a discontinuation and restart.
However, although not many such
situations are envisaged, previous hedge-
accounting relationships that do not
qualify under the proposed model would
need to be discontinued. There are no
changes proposed to the transition
requirements in IFRS 1 First-time Adoption
of IFRS.
It is proposed that application of the
standard will be mandatory for annual
periods beginning on or after 1 January
2013, with earlier application permitted.
Nevertheless, the ED states that the
feedback from an ongoing consultation on
effective dates for new standards will be
considered in fnalising the mandatory
effective date of the new standard.
As with other phases of the fnancial
instruments project, the new hedge
accounting model can only be adopted
together with all other IFRS 9
requirements that were fnalised earlier.
However, early adoption of previously
fnalised IFRS 9 requirements (such as
classifcation and measurement) will not
necessitate early adoption of the fnal
hedge accounting requirements.
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Hedge accounting under IFRS all set for change
Business impact
Overall, we consider that a principles-
based approach to hedge accounting is
conceptually preferable and consistent
with the IASBs objective to simplify and
reduce complexity under the new standard.
While fnancial reporting will be more
aligned to risk management, the proposals
also place a greater onus on entities to
manage their hedge relationships in line
with their risk management approach.
The ED is likely to have a signifcant impact
on those entities that already apply hedge
accounting, as well others that use
economic hedging practices, but are
currently unable to refect this in their
fnancial statements. The most signifcant
beneft may be for non-fnancial services
entities, because hedge accounting will be
permitted for components of non-fnancial
items. Banks and fnancial institutions also
stand to gain from the new proposals,
because hedge effectiveness testing will be
much simpler and will only be required on
a prospective basis, qualitative testing will
be possible where appropriate and there
will be no arbitrary bright lines.
However, one of the main hedging issues
for banks is macro (portfolio) hedging for
which no changes are yet proposed in the
current ED. Although the proposals reduce
the complexity of hedge accounting, the
transition to the new standard will require
a full assessment of all hedging
relationships whether for economic or
hedge accounting purposes, to determine
how to apply the changes.
It is important that all entities assess the
impact of the proposals and provide
feedback to the IASB within the comment
period. We will bring you an in-depth
analysis of the implications of the ED in
January 2011.
The 90-day comment period ends on
9 March 2011
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