Exposure Draft Hedge Accounting: Challenges or Opportunities?
by Yin Toa Lee, Partner and Financial Services Leader, Ernst & Young, Financial Accounting Advisory Services, Asia Pacific
The International Accounting Standard Board (the Board) completed deliberation in September 2011 to make significant changes to proposals in the Exposure Draft Hedge Accounting (ED) issued in December 2010, being the proposals for the third part of IFRS 9, the project to replace IAS 39.
The main objective of the ED is to simplify hedge accounting to provide a better linkage between an entity’s risk management strategy, the rationale for hedging and the impact of hedging on the financial statements. The proposals represent a fundamental shift from the way entities have applied hedge accounting in the past.
The IASB’s efforts are welcomed by market participants to reduce complexity of hedge accounting that can be applied for both financial services and corporate entities. However, although market participants are supportive of the overall intent and direction of the proposals, they are interested in clarifying the wording of the ED to make the ED more operational.
Proposed hedge accounting model
Using a more principles based approach, financial reporting would reflect more accurately how an entity manages its risk and the extent to which hedging practices mitigate those risks as a result of these proposals.
The most significant benefits are likely to be realized by non-financial corporate entities. For example, hedge accounting will now be permitted for risk components of non-financial items such as certain commodities, provided that certain criteria have been met. Layer components and combinations of derivatives and non-derivatives will also be eligible. Hedges are designated with qualifying hedging instruments and hedged items, including both financial instruments measured at fair value and through other comprehensive income. Written options and internal derivatives will continue to be prohibited.
Under the ED, hedge effectiveness testing will be simpler as it will only be required on a prospective basis. Previously, it was necessary to perform retrospective and prospective tests. There will be no more arbitrary 80 to 125% retrospective effectiveness to qualify for hedge accounting. Qualitative testing will be possible where appropriate and there will be no arbitrary bright lines in the new model. Ineffectiveness is measured and recognized in profit or loss which does not change from current practice.
Rebalancing would be required if the hedge ratio used for risk management purposes changes, or if accounting rebalancing is required to prevent the existing risk management hedge ration resulting in an imbalance that would deliberately create hedge ineffectiveness. Rebalancing, a common risk management technique, will not necessarily result in de-designation and re-designation. As a consequence, current challenges of ineffectiveness due to non-zero fair value derivatives on re-designation can be avoided. Proportional de-designation or partial continuation is now possible in some circumstances. However, when a risk management objective does not change, voluntary de-designation is not permitted.
Items in gross positions must be individually eligible for hedged accounting and be managed on that basis for risk management. Layer components are now permitted for forecast as well as existing transactions subject to some criteria. Group of net positions are permitted subject to certain criteria.
Option premiums which generally represent the time value and forward points in a forward contract can be deferred in other comprehensive income.
‘Own use’ commodity contracts can be fair valued in certain circumstances if managed on a fair value basis rather than applying hedge accounting.
There is no change proposed for the mechanics of fair value hedges, cash flow hedges and hedges of net investments.
There would be additional disclosures, including an entity’s risk management strategy and how it is applied to management risks, how hedging activities may affect the amount, timing and uncertainty of future cash flows, and the overall effect that hedge accounting has had on the entity’s financial statements.
For banks and other financial institutions, macro hedge accounting will be deliberated as a separate proposal.