Post-Trade Hedge Accounting
by Yin Toa Lee, Partner and Leader of Financial Accounting Advisory Services, Ernst & Young, Financial Services, Far East Area
Re-designation of non-zero fair value derivatives is one of the most problematic areas in post-trade hedge accounting under IFRS in Asia, given the relatively more manual post-trade hedging processes and procedures involved. Many corporations in Asia often made the incorrect assumption of perfect effectiveness in many different scenarios. For example, a typical scenario includes rolling over into new hedging relationships derivatives that have originated in the past which have fair values other than zero. This is often the case when the recent volatilities in the Asian markets requires hedging strategies to be more dynamically rebalanced given the relatively lesser liquidity and wider spreads than other markets.
IAS 39 does not prohibit such re-designation as long as the new hedge relationship is considered to be ‘highly effective’. Many Asian corporations are making such an inappropriate assumption without quantifying the impact of the ‘off-market’ nature of the ‘old’ derivatives on the new hedging relationship. Such ‘off-market’ nature is economically the embedded financing within the derivative representing the amount that would have to be paid if the entity were to settle the derivative at the date of re-designation. This embedded financing would create a source of ineffectiveness that must be evaluated especially as interest rates increase.
This article provides practitioner insights into pitfalls of re-designation and practical recommendations to minimise such effectiveness.Commonplace scenariosIn Asia, using off-market derivatives in hedging relationships is more common than many corporations realise; three examples include:
1. Renegotiation of terms with derivative counterparty
Given the current low interest rate environment, market participants could lock themselves into an interest rate swap pre-financial crisis paying a high fixed leg and receiving a low variable leg. Such an ‘under-water’ interest rate swap, which is a liability, is renegotiated with the counterparty to include less onerous terms on the pay fixed leg, which has created the overall negative fair value, while extending the time to maturity. The hedger therefore avoids cashing out the ‘under-water’ derivative at a realised loss because it agrees to enter into a new derivative at the identical ‘under-water’ fair value. These common strategies are known in the market as ‘blends and extends’. Effectively, the counterparty has financed the payoff of the original interest rate swap by restructuring the financing into the terms of the new swap, while simultaneously reflecting the shape of the current interest rate curve over the new time horizon. In Asia, without properly assessing the financing element, companies often would re-designate the swap in a new cash flow hedge, as they have eligible forecasted transactions during the new and extended time frame of the swap.
2. Temporary interruption of hedging strategy
A company using a derivative in a highly effective hedge decides to de-designate the hedge and default to regular derivative accounting on a prospective basis due to the administrative burden using a manual process. Later, perhaps because of a change in treasury department management to utilise hedging software, the company decides to attempt hedge accounting again with the same derivative. In this case, the derivative does not have a fair value of zero at the inception of the proposed new hedge relationship. In this region, very often the derivative’s off-market nature has not been fully considered when trying to resume hedge accounting.
3. Attempt to restate hedge accounting following a documentation deficiency
A company believes it has qualified for hedge accounting, but, a few months later, its auditor identifies deficiencies in the company’s hedge documentation in that not all of the requirements in IAS 39 are met. The company corrects the deficiencies, and revises its financial statements to reflect the failure to achieve hedge accounting for the period from the inception of the hedge to the date the documentation was corrected. However, now the company notes that the derivative’s fair value has moved significantly off-market relative to a new derivative that would begin on the date the documentation is corrected. In correcting the documentation and re-establishing the hedge, Asian companies frequently have been fully able to support an expectation of ‘highly effective’ for the ‘new’ hedge relationship using the now off-market derivative, even if the initial hedge that failed due to inadequate documentation was perfectly effective.