Get Ahead in the Hedge Accounting Game
by Olga Cileckova, Director in the Corporate Treasury team, PwC
Hedge accounting rules are (finally) changing – the time to act is now! The long-awaited new financial instruments standard – IFRS 9 - was issued in the last week of July. The hedge accounting section of IFRS 9 is designed to respond to the criticism and frustration of most treasurers who feel that accounting often drives the economics.
In short, these changes are good news for corporates and my clients keep asking if they can start applying them straight away. Unfortunately, the standard will not be effective until 2018 and an early adoption is not available for EU-based companies as the EU has not endorsed the standard yet. Currently no date is scheduled for this endorsement and early adoption remains open to non-EU companies only.
Treasurers should act now to take a full advantage of the upcoming good news – hopefully before 2018.
Despite this rather long waiting time, treasurers should act now to take a full advantage of the upcoming good news – hopefully before 2018. The new accounting rules might require revision of risk management policies, instruments used for hedging and the underlying data and their granularity and / or structure. Such system and process changes do not happen overnight. It’s time to take action now to maximise the available benefits.
The treasury teams must be closely involved in the analysis and interpretation of the new rules and their impact on the treasury operations. It should be not assumed this is ‘just’ an accounting change and that the finance team will handle it. A full understanding of the risk management policies combined with in-depth knowledge of the financial instruments is necessary to achieve the optimal outcome.
What are the key changes?
The new hedge accounting rules will be both easier to apply and more aligned with risk management. The accounting will hopefully no longer drive the economics and I am looking forward to no longer having to explain to companies why they are getting volatile profits from hedges that, from a risk management perspective, are sound.
Under the new rules, as long as the risk being hedged is aligned with the documented risk management policy and an economic relationship can be demonstrated between the hedging instrument and the hedged exposure, then hedge accounting is permitted. Although the infamous 80% - 125% range for hedge effectiveness is removed, hedge ineffectiveness will still need to be measured and recorded in the income statement. Now is the time for treasurers to review and re-assess their risk management policies to ensure the data needed for effective economic hedges and for achieving hedge accounting can be collected and analysed.
Despite all these positive changes, hedge accounting will remain a privilege rather than a default accounting option
Treasurers should also re-assess the instruments used for hedging, as it will be easier and / or more attractive to apply hedge accounting to certain types of derivatives. In particular, effective hedge accounting should be possible for commodity derivatives as long as the commodity risk being hedged is clearly identifiable and separately measurable – for example, hedging the aluminium price risk in an aluminium purchase contract where the purchase price is clearly linked to the LME index. Also, hedging with net purchased options is expected to be used more widely in practice. The new accounting rules will allow the time-value of the option to be treated in a way similar to an insurance premium, thus reducing income statement volatility when hedging with net purchased options.
Despite all these positive changes, hedge accounting will remain a privilege rather than a default accounting option, and certain hedge accounting criteria will have to be met in order to qualify. In particular, formal hedge documentation must exist at inception of the hedge. Also, hedge ineffectiveness will have to be measured (albeit the frequently criticised 80% - 125% range is gone) and recorded in the income statement.
- Review your risk management policies to ensure they are the best fit for your business and allow for new hedging strategies and instruments. In particular, are changes to commodity executory contracts needed to define the commodity exposure in a separately identifiable and measurable way (as required by the new hedging rules)?
- Consider the terms of longer-term instruments as these will need to be accounted for under the new rules.
- Consider the impact of the revised hedging strategy on tax, distributable reserves and key financial ratios.
- Assess the impact on systems, processes and people. The new hedge accounting rules allow for more dynamic hedging strategies which better reflect the economics of the risk being hedged. However, this comes at the price of strong and robust treasury management systems and processes.
- Communicate the revised hedging strategy to the board and secure required funding to implement it.
- Consider changes to other accounting frameworks, for example local hedge accounting rules applied in the stand-alone accounts, to ensure the transition work is done in the most efficient way and consistent decisions are reached across the board. Relevant for many will be the hedge accounting rules under UK accounting rules which are fundamentally changing from 1 January 2015.
- Leverage on the knowledge of early adopters, mainly companies with commodity exposures in Australia and South Africa.
- Consult with a treasury accounting expert to ensure you properly address all angles in this complex jigsaw.