On 7 September, the International Accounting Standards Board (IASB) released a new draft of proposed new standard International Financial Reporting Standards (IFRS) 9. This is phase III of their financial instrument project and it covers hedge accounting, which is currently governed under International Accounting Standards (IAS) 39. We are now more than two thirds of the way into a 90-day comment period and a final standard is expected out in January, with the new standard to be effective from 1 January 2015. That might seem like a while away, but the IASB is allowing early adoption, as long as the company adopts the entire standard (just hedge accounting is not an option).
While there has been great concern in the market (part one report) about how the standard appears to treat cash flow hedges of foreign exchange (FX), there is a chance that specific language will be changed before the final rule is issued next month. It is therefore important for corporate treasurers to become familiar with the IFRS 9 standard as a whole, in order to make an educated decision about whether early adoption makes sense.
What has Changed?
It’s important to understand that this proposed standard represents a 180 degree turn from the IASB’s existing approach – this is no minor fiddling. The very starting point is different; under US and existing IFRS standards, hedge accounting was an exception made as a departure from existing standards. According to a recent Citibank report the new rule designates hedge accounting as the “preferable alternative for providing a presentation of the results of economic hedging in the financial statements compared to a no hedge accounting alternative”.
The end result is greater flexibility, with a focus on economic results. The main drawback is that with flexibility comes a great degree of ambiguity. That may well lead to divergent auditor applications and ongoing struggles with what’s permissible and what’s not.
The important changes are as follows:
- Documentation: Everything in the rule ties back to the hedging strategy statement, i.e., is the hedge consistent with the strategy. So if the strategy states that the company hedges its floating rate exposures, and on a specific debt issue the company decides it’s best to leave it floating, it would fall foul of hedge accounting. The same could happen if the strategy states that the company will hedge a certain share of its FX exposures, and its forecast changes.
The focus on broader strategy will lead to an overhaul of hedge documentation, with a focus on providing enough flexibility in the broad strategy statement so that specific hedges won’t fall out of line.
“Risk management strategy is established at the highest level at which an entity manages risk and may include some flexibility to react to changes in circumstances without requiring a new strategy,” comments the firm of Ernst & Young (E&Y). “The risk management objective, however, applies at the particular hedge relationship level and is a means of executing the risk management strategy.”
- Commodities: The best news in the guidance relates to commodity hedges. This will have a direct impact on many Canadian and European companies. Under the proposed rule companies can designate an item in its entirety, or a component of that item, as the hedged item for non financial and financial hedges, provided that the hedged risk is identifiable and can be reliably measured. In addition, a component can be either a contractual or a non-contractual item. Some of the examples show how this is relevant. For example, in one case a company has a supply contract for natural gas that includes a pricing formula that references the price of oil. It can then hedge the oil price component.
- Portfolio approach: Companies will also be allowed to hedge risk on a portfolio basis, or groups of items that constitute a net exposure, with some reasonable restrictions. According to Citi: “For the purposes of determining whether hedge effectiveness requirements are met, when an entity hedges a net position, the change in fair value of the hedging instrument is considered along with the changes in the values of the items that constitute the net position.” The examples cover FX long and short position hedges, but there are also examples of multi-currency positions when correlation is taken into effect.
- Options accounting: This is another major change, and a positive one. At the moment, changes to the time value of an option are recorded in earnings in each period. Under the proposed guidance the changes attributable to time value will be recorded in other comprehensive income (OCI). There is a distinction in how and when to then reclassify the accumulated gain or loss. It is a little convoluted as it sets up two categories: ‘transactions’ and ‘time-period’ items. It’s unclear whether the rules will prevent companies from designating the entire value of the option in the hedging relationship.
- Assessing effectiveness: This, too, represents a major departure. The so-called 80/125 rule is out. Instead, according to a KPMG commentary, “whether or not hedge accounting would be permitted would be based partially on a qualitative, forward-looking hedge effectiveness assessment”. This assessment would include three basic components:
• The existence of an economic relationship between the hedged item and the hedge instrument.
• That the effect of credit risk does not dominate changes in value in that relationship.
• The hedge ratio designated is the one that’s actually used for risk management; i.e., the result has to be consistent with the broader objective (see first point).
- Voluntary de-designation: If the hedge continues to meet its objective, companies will not be able to voluntarily terminate it. “This prohibition would affect the use of certain dynamic hedging strategies,” according to KPMG.
As usual, experts say, the ‘best stuff’ about the guidance is in the back of the book, buried in the basis for conclusions. The standard is downloadable from the IASB website for anyone who wants the complete text. It’s long, and some say it could have made the same points in less than half the number of words, although that’s not really surprising.
The news for US generally accepted accounting principles (GAAP) reporters is not as good, in two main respects.
- Roadblocks: First, the infamous convergence effort between the IASB and the Financial Accounting Standards Board (FASB) is hitting major road blocks and hedge accounting is one of them. The FASB issued its own proposals in May 2010, but that exposure draft was scrapped. The industry asked whether using the IASB approach instead was an alternative, but the FASB has not responded.
One area on which the two organisations are known to disagree is on whether to allow early adoption of the new standard. The IASB is allowing it, the FASB opposes it. “The FASB proposals differ significantly from the IASB’s and are intended to resolve specific, major practice issues,” according to KPMG. While the US standard-setter had requested comments about the IASB’s approach it has yet to decide how the international direction may affect its own.
- Ambiguity: Second, the Securities & Exchange Commission (SEC) has been pretty much silent on whether GAAP filers can opt for IFRS standards and, if so, when. The US agency has completed its deliberations without issuing any recommendations. “There are some issues there in terms of whether it’s happening at all,” one accounting expert said. “We don’t think it’s going to happen.” The unfortunate consequence is that “the gap is just getting wider between US and non-US companies,” in particular when it comes to hedge accounting.