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IFRS 9 Hedging – Was it Worth the Wait? (part two)
by Clarette du Plooy, Director, Corporate Treasury Solutions, Kees-Jan de Vries, Director, Capital Markets and Accounting Advisory Services and Aliénor Fromont, Assistant Manager, Capital Markets and Accounting Advisory Services, PwC
The IASB issued the hedging chapter of IFRS 9, ‘Financial instruments’, in November 2013. This was generally considered good news for treasury. Hedge accounting has not only become easier but also more aligned with risk management in the business. To summarise some of the changes and the key points covered in our previous article:
- More instruments may qualify as hedging instruments. Besides derivatives and financial instruments for currency risk, non-derivative instruments that are carried at fair value through profit or loss may also be designated as hedging instruments in future.
- More items may qualify as hedged items. The most important new items are risk components of non-financial items (e.g., LME component of a purchase of an item containing aluminum), aggregated exposures, (e.g., an investment in a portfolio of shares, with shares in different industries), net positions and combinations of derivatives and non-derivatives (e.g., a fixed-rate loan combined with an interest rate swap) that all now qualify as hedged items.
- Hedge documentation is still required in order to qualify for hedge accounting.
- Hedge effectiveness criteria have been simplified but still exist. For the criteria to be met, an entity has to show that an economic relationship exists between the hedged item and the hedging instrument and that credit risk does not dominate the relationship. In addition, a hedge ratio has to be defined, which may change throughout the life of the relationship according to market developments.
In this article, we will be discussing in more detail hedging with options and forwards, the journal entries relating to hedge accounting under IFRS 9, alternatives to hedge accounting and transition and disclosure requirements.
Hedging with options and forward contracts
IAS 39 allows applying hedge accounting for purchased options. However, under IAS 39, the change in time value of the option always had to be directly recorded in profit or loss. Under IFRS 9 this is different. Changes in the time value of an option can now be deferred in Other Comprehensive Income (OCI) in equity if the option is an effective hedging instrument in a hedge accounting relationship. The option premium (time value) paid upon purchase of the option can be recorded in the income statement at the same time that the underlying hedged item affects profit or loss. This may reduce volatility in the income statement for entities that use hedging strategies involving options.
For cash flow hedges, the amount that is deferred in OCI will then be recognised in the income statement in line with the underlying hedged item. This can be over the life of the option if the hedged item is ‘time related’. As an example, consider the case where a three-year interest rate cap is purchased to hedge interest rate risk. For this type of hedge relationship, it makes sense to amortise the premium paid over the three-year period of the cap.
If the option hedges a transaction that will take place at a specific moment in time, this is called a ‘transaction related’ hedge. In this case, the amount of time value will be deferred until the hedged transaction affects profit or loss. As an example, consider the use of a currency option hedging a future purchase in foreign currency. And assume the underlying hedged item is a non-financial item, such as an item that is part of costs of goods sold, or an item of property, plant and equipment. IFRS 9 requires the total deferred amount in OCI with respect to the hedging instrument to be reclassified to the initial cost of the item being hedged. This can be inventory valuation, or the initial cost price of the property, plant and equipment item. Through the inventory item hitting the income statement as costs of goods sold, or the item of plant, property and equipment being depreciated, the hedging results end up in the income statement. The same distinction on the treatment of time value for transaction- and time-related hedge relationships also applies to hedging FX risk with currency forward contracts.
With respect to the amounts of time value for options and currency forward contracts that may be deferred in OCI, IFRS 9 introduces some notable differences compared to IAS 39. As under IAS 39, it is possible under IFRS 9 to use an option or a currency forward contract in a hedge relationship and only designate the change in spot rate as the risk being hedged. Doing a ‘spot designation’ for hedging currency risk makes proving hedge effectiveness easy. As explained in our previous article, it is allowed under IFRS 9 to prove hedge effectiveness by demonstrating that the critical terms of the hedging instrument and the hedged item match. If only the spot element of the forward contract is designated as a hedging instrument, this means comparing the nominal amount of the hedged item to that of the hedging instrument.
When it comes down to determining the journal entries for an effective hedge relationship, IFRS 9 is different from IAS 39. For options, whether spot or forward designation has been chosen, the amount of changes in fair value due to changes in time value that is allowed to be deferred in OCI has to be determined using the ‘aligned time value’ approach. This aligned time value should match the terms of the hedged item. Therefore, when the terms of the hedged item and the hedging instrument (the option) do not match, this may lead to a part of the change in time value being booked in profit or loss. Also when applying spot designation, the time value that exists at the inception of the hedging relationship is amortised on a systematic and rational basis over the period to which the time value relates (time-period related or transaction related).
Companies hedging with currency forward contracts and choosing for a spot designation have two possibilities for determining the journal entries. The first one is based on using an aligned forward element approach that is comparable to the aligned time value model when hedging with options. The second alternative is using the current IAS 39 spot designation approach, where only the change in spot value of the currency forward is deferred in OCI and all other changes in fair value are booked in profit or loss directly. An interesting addition in IFRS 9 is the fact that this approach may also be applied to the currency basis spread present in currency forward contracts.
Companies therefore have to keep in mind the potential administrative burden of deferring in other comprehensive income the change in fair value of the forward element if the critical terms of the hedge item and the hedge instrument are not ‘aligned’.
What do you have to do now?
- Companies may want to consider whether under IFRS 9 the use of options as a hedging instrument is more desirable now that the accounting impact in profit or loss will be less volatile.
- Companies need to consider in which way to set up the accounting models when hedging with forward contracts.