1 Unit
CPD technical article
Graham Holt examines the implications for preparers of financial statements resulting from the International Accounting Standards Board’s hedge accounting proposals
This article was first published in the April 2011 edition of Accounting and Busines magazine.
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The IASB has recently released an exposure draft (ED) Hedge Accounting, with proposals to make substantial changes to hedge accounting under International Financial Reporting Standards (IFRS). The ED is the third phase of the IASB's project to replace IAS 39, Financial Instruments: Recognition and Measurement.
A difficulty with IAS 39 is the lack of a recognisable set of principles in the hedge accounting requirements. Hedge accounting is not compulsory under IAS 39 and the lack of a principle, together with conflicting rules, is the main issue relating to the hedge accounting requirements under IAS 39.
The current accounting rules raise recurring difficulties for preparers of financial statements, which prevent them from appropriately reflecting in their financial statements the economic effects of hedging transactions.
Some financial instruments used for risk management purposes are currently creating volatility in profit or loss, whereas they do constitute an effective economic hedge of a specific risk exposure.
Non-GAAP measures or detailed disclosures on the impact on profit or loss of some economic hedges not eligible for hedge accounting are the only alternatives found by some entities to reflect their actual hedging results.
The current IAS 39 hedge accounting rules do not allow the economic offset of significant hedging activities to be reflected in the financial statements for both financial and non-financial entities.
Confusion reigns
In this respect, IAS 39 hedging rules create confusion and misunderstanding for users of financial statements. Entities manage their risks, but find that they are unable to fully reflect this in their financial statements.
Additionally information relating to an entity's risk management strategy and practices may not be clearly reflected in the financial statements because of a mismatch between the application of hedge accounting and the entity's risk management objectives.
The IAS 39 rules often prevent entities hedging specific components of non-financial items. An example is where a logistics company wishes to hedge its exposure to movements in the price of diesel fuel by entering into a forward contract for crude oil. Although oil is a key component of diesel, it is not considered an acceptable hedged item because, under the existing rules, an entity can hedge only the foreign currency risk or the price of diesel itself.
Designating groups of hedged items is difficult under the current rules because several criteria need to be satisfied. For example, items may only be grouped together if they have similar risk characteristics and share the risk exposure being hedged, which means that many hedged items cannot be designated as a group even if they have an apparent economic link. Hedge accounting cannot, therefore, be used for the hedge of the equities that comprise an index (such as those making up the FTSE 100) using an index future.
IAS 39 has been criticised for its onerous requirements to perform effectiveness tests because of insufficient guidance on how to quantify hedge effectiveness. Hedge accounting cannot be dispensed with as the IASB has retained a mixed measurement approach.
Both amortised cost and fair value are used in IFRS 9, and it is advantageous to entities to use hedge accounting to address measurement mismatches – for example, where an investment property is valued at fair value but the related debt is valued using amortised cost. The fair value option does not eliminate the complexities, but it simplifies the accounting related to fair value hedges of financial instruments.
Hedge accounting is also needed for hedges of forecast cashflows that are not yet recognised in the financial statements. Many believe that the distinction in IAS 39 between cashflow hedges and fair value hedges adds complexity and is confusing.
Risk management
The ED proposes requirements designed to enable companies to better reflect their risk management activities in their financial statements, and, in turn, help investors to understand the effect of those activities on future cashflows. The proposed model is principles-based, and is designed to align hedge accounting more closely with risk management activities undertaken by companies when hedging their financial and non-financial risk exposures.
The proposed model combines a management view that aims to use information produced internally for risk management and an accounting view that seeks to address the risk management issue of the timing of recognition of gains and losses.
The ED proposes relaxing the requirements for hedge effectiveness and, consequently, the eligibility for hedge accounting. Under IAS 39, the hedge must both be expected to be highly effective, and demonstrated to have been highly effective, with 'highly effective'; defined by means of a quantitative test of between 80% and 125% effectiveness.
The ED requires the hedge to be designated so as to be neutral and unbiased, and in a way that minimises expected ineffectiveness. This may be demonstrated qualitatively or quantitatively, depending on the complexity of the hedge. A simple hedge may require a qualitative test, whereas a complex hedge may require a quantitative analysis.
Hedge ineffectiveness must still be measured and reported in the profit or loss. Effectiveness testing is conducted by reference to the entity's risk management objective, relies on a judgmental test and is only conducted prospectively, reducing the accounting burden for hedge relationships.
The proposals remove restrictions that prevent some economically rational hedging strategies from qualifying for hedge accounting. The ED proposes that risk components can be designated for non-financial hedged items, provided the risk component is separately identifiable and measurable – for example, operating lease rentals linked to inflation.
More instruments and 'economic' hedges will qualify for hedge accounting so long as the appropriate criteria are met. Entities that hedge non-financial items for a commodity price risk that is only a component of the overall price risk of the item may find that it is likely to result in more items qualifying for hedge accounting.
In addition, the ED makes the hedging of groups of items more flexible, although it does not cover macro hedging. Entities often group similar risk exposures and hedge only the net position. An example would be the netting off of forecast purchases and sales of foreign currency. Under IAS 39, the net position cannot be designated as the hedged item. This will be permitted under the ED if it is consistent with an entity's risk management strategy.
However, if the hedged net positions consist of forecasted transactions, all hedged transactions have to relate to the same period. The ED would permit changes in hedge relationships without undermining the original hedge relationship or hedge accounting.
Under the current hedging rules, the time value of purchased options is recognised on a mark-to-market basis in profit or loss, which can create significant volatility. The ED proposes specific accounting requirements for the time value of an option when an entity separates the intrinsic value and time value of an option contract and designates as the hedging instrument only the change in the intrinsic value.
Any changes in the option's fair value associated with time value will be recognised in 'other comprehensive income' (OCI). This should result in less volatility in profit or loss for these types of hedges and may make options more attractive as hedging instruments.
The ED changes the presentation of fair value hedge accounting. The hedged item is not adjusted for changes in the fair value attributable to the hedged risk. The fair value changes will be presented as a separate line item in the statement of financial position. The fair value changes of the hedging instrument will be presented in OCI on a gross basis. Any ineffectiveness is reported in profit or loss.
Hedge and risk
Concerns have been raised over the linkage between hedge accounting and risk management regarding how this will work in practice. The ED includes certain rules that could preclude hedge accounting that reflects actual risk management activity.
The ED has been written on the assumption that risk management activities are undertaken at a micro level and that risk management policies can forecast every eventuality. While financial institutions may make transactional decisions at a micro level, risk management is usually applied at a higher, macro or portfolio level.
It is common for daily changes to the profile of hedging transactions to occur as the underlying hedged portfolio changes, without any amendment to risk management strategy. There are also some concerns that the separate transfer of hedging ineffectiveness from OCI to profit or loss will present some operational challenges.
It is thought that entities may have valid risk management activities in place that might not be represented under the proposed hedge accounting model, either because the economic hedging relationship does not meet the qualifying criteria for the application of hedge accounting or because the strategy is neither strictly a fair value hedge nor a cashflow hedge.
The proposals introduce new concepts and definitions that may not be well understood and which could create uncertainty around the operation of the model. Given the importance of macro hedging, many also believe that the IASB should not finalise a standard on the general hedge accounting model before developing a model for macro hedging.
The IASB needs to consider the various phases of the IAS 39 replacement as a whole before finalising the resulting standards, because the piecemeal approach being adopted could result in inconsistencies and difficulty of operation.
Graham Holt is an examiner for ACCA and executive head of the accounting and finance division at Manchester Metropolitan University Business School
1 Unit