36 fINANcIAL REpoRtINgAccouNtANcy IRELANDApRIL 2014 VoL.46 No.2

aLigninghedge aCCOUnting

With Risk management

the international accounting standards board (iasb) recently issued a new hedge accounting model that aims to more closely alignhedge accounting with the risk management activities of an entity.John McCarroll and Goind Ram Khatri ask whether the new

rules are likely to make the life of corporate treasurers much easier.

he current hedge accounting rules,under IAS 39, have been criticisedfor being too complex.Treasurers,in particular, argue that they arebeing forced to apply a rules-based

hedge accounting model which does notmirror how they actually manage the risksand therefore deviates their thought processfrom ‘how do I minimise the risk?’ to ‘howdo I achieve hedge accounting?’.This, tosome treasurers, has impacted theoperational efficiency of their riskmanagement process.The IASB respondedto the concerns of the reporting entities andtheir treasurers and started a project tooverhaul the existing hedge accountingmodel on a priority basis. Due to thecomplexity of the issues it has taken eightyears to finalise the project.

The new hedge accounting model issuedin November 2013, as part of IFRS 9,represents a significant milestone as itcompletes another phase of the IASB’sproject to replace IAS 39.The new generalhedge accounting model will allowreporting entities to reflect risk managementactivities in the financial statements moreclosely as it provides a more a flexibleapproach to apply hedge accounting.

The new standard is effective for annualperiods beginning on or after 1 January2018, subject to EU endorsement. Theentities that apply IFRS 9 will have anaccounting policy choice to apply the hedgeaccounting model in IAS 39 or IFRS 9.The IASB will revisit this accounting policychoice when it finalises its work on themacro hedging project.

T “thE NEw hEDgEAccouNtINg moDELIssuED IN NoVEmbER

2013,As pARt of IfRs 9,REpREsENts AsIgNIfIcANt

mILEstoNE As ItcompLEtEs ANothERphAsE of thE IAsb’spRojEct to REpLAcE

IAs 39”

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similArities Between ifrs 9And iAs 39 hedgeAccounting modelsAlthough the IFRS 9 model differssignificantly from IAS 39 there are still somesimilarities in the models, which include:

➤ Hedge accounting is not mandatory; itis optional in both standards;

➤ Much of IAS 39 terminology has beenretained in IFRS 9 including terms suchas hedging instruments, hedged items,cash flow hedges, fair value hedges andhedge ineffectiveness;

➤ The accounting entries for cash flowhedges, fair value hedges and netinvestment hedges are the same underboth standards;

➤ The general prohibition on hedgeaccounting with written options isretained in both models.

whAt hAs chAnged inthenew hedgeAccountingmodel under ifrs 9?Compared to IAS 39,the new model,underIFRS 9, more closely aligns hedgeaccounting with risk management activitiesundertaken by the reporting entities whenhedging their financial and non-financialrisk exposures.The new model will enablemore entities, particularly non-financialinstitutions, to apply hedge accounting toreflect their actual risk managementactivities.This, combined with enhanceddisclosures, will assist users of financialstatements in understanding entities’ riskmanagement activities.

Key chAnges introducedBythe new modeleligibility of hedging instrumentsExcept for certain written options, IAS 39allows reporting entities to designatederivative instruments (or portions thereof)as hedging instruments and also, in the caseof hedging foreign currency risk only,allowsdesignation of non-derivative financialinstruments as hedging instruments.UnderIFRS 9, any financial instrument measuredat fair value through profit and loss,irrespective of whether it is a derivative ornot, can be designated as a hedginginstrument.The exception with regards towritten options still applies in IFRS 9.

hedged itemsFor non-financial assets and non-financialliabilities, IAS 39 prohibits the designationof risk components (other than foreign-currency risk). In contrast, the IFRS 9permits entities to designate risk com-ponents of non-financial assets and liabilitiesas hedged items as long as certain criteria aremet (e.g. the risk component is separatelyidentifiable and can be reliably measured).This change provides much greaterflexibility to hedge key risks and will be awelcome relief for many treasurers.

IFRS 9 expands the list of eligible hedgeditems by allowing entities to designate as ahedged item an aggregated exposure (i.e.thecombination of an eligible hedged item anda derivative instrument) as well as certaingroup and net exposures (e.g. a net interestrate exposure), which were generally noteligible as hedged items under IAS 39.

hedge effectiveness assessmentThe qualifying criteria of the IFRS 9 hedgeaccounting model differ significantly fromthose in IAS 39 with no 80–125 percentagebright line threshold for effectiveness testing.IFRS 9 instead employs a more principles-based approach.The following conditionsmust be met for a hedging relationship to beconsidered effective and qualify for hedgeaccounting under IFRS 9:

➤ There is an economic relationshipbetween the hedged item and thehedging instrument;

➤ The effect of credit risk should notdominate the value changes that resultfrom that economic relationship; and

➤ The hedge ratio should reflect the actualquantity of hedging instruments used tohedge the actual quantity of a hedgeditem (provided it does not deliberatelyattempt to achieve an inappropriateaccounting outcome).

The IFRS 9 hedge accounting modelrequires entities to perform a hedgeeffectiveness assessment only prospectively,thereby removing the burden of performingretrospective hedge effectiveness assessmentsas currently required by IAS 39.

cashflow hedge accounting andbasis adjustmentsUnder IAS 39, if an entity’s hedge of aforecast transaction results in the recognition

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38 fINANcIAL REpoRtINgAccouNtANcy IRELANDApRIL 2014 VoL.46 No.2

of a non-financial asset or liability,the entitycan choose to either reclassify the effectiveportion of the cash flow hedge recorded inhedging reserve to profit or loss when thehedged item affects earnings or to includethe amount recorded in the hedging reservein the initial cost or carrying amount of thenon-financial item. Under IFRS 9, there isno longer a choice and an entity mustremove the amount from the hedgingreserve and include it in the initial cost orcarrying amount of the non-financial item.

discontinuing hedge accountingUnder IAS 39, a hedge relationship isdiscontinued when it meets certain facts andcircumstances including when an entityrevokes the hedge designation.Under IFRS9,the same facts and circumstances generallywill still trigger discontinuation of a hedgingrelationship; however, an entity cannotvoluntarily revoke or otherwise de-designate a hedging relationship.

modifying a hedging relationshipUnder IAS 39, changes to a hedgingrelationship generally require an entity todiscontinue hedge accounting and start anew hedging relationship that captures thedesired results. However, for risk manage-ment purposes hedging relationships aresometimes adjusted in reaction to changesin circumstances. Under IFRS 9, suchrebalancing would not trigger a dis-continuation of an entire hedgingrelationship. The entity must adjust thehedge ratio so that it meets the hedgingcriteria prospectively.

hedging own use contracts to buyor sell a non-financial item‘Own use’ contracts to buy or sell a non-financial items are not subject to derivativeaccounting as they are outside the scope of

IAS 39 and are treated as regular purchaseand sale contracts.

To mitigate the need for hedgeaccounting, the alternative requirements,under IFRS 9, result in an extension of thefair value option to contracts that meet the‘own use’ scope exception if doing soeliminates or significantly reduces anaccounting mismatch.

equity investments designated atfair value through othercomprehensive incomeIn November 2009 when the IASB issuedthe first chapter of IFRS 9, it introduced anew classification of financial assets - equityinstruments designated at fair value throughother comprehensive income (OCI). Underthis classification all fair value changes arepermanently recognised directly in OCI.

Under the new model,the IASB decidedthat because all fair value changes are perm-anently recognised in OCI for these equityinvestments, any hedge effectiveness should

also be recognised in OCI.As a result, forsuch hedges both the effective and ineffect-ive fair value changes are recognised in OCIwith no recognition in the profit and loss.

Additional disclosuresThe flexibility afforded by the IFRS 9 hedgeaccounting model is tempered by the IASB’samendments to the related hedgeaccounting requirements in IFRS 7.

The new disclosure requirements arebuilt around three objectives that shallprovide information about:➤ An entity’s risk management strategy

and how it is applied to manage risk.➤ How the entity’s hedging activities may

affect the amount, timing anduncertainty of its future cash flows.

➤ The effect that hedge accounting hashad on the entity’s statement of financial

position, statement of comprehensiveincome and statement of changes inequity.

conclusionThe new standard provides an opportunityto many treasurers to revisit their hedgingstrategies to avail of hedge accounting underthe new rules.However,at the same time theapplication of new rules requires carefulconsideration and due care is needed on firsttime application.First time implementationof the new rules is a challenging task forboth corporate treasurers as well as directorsrequiring significant investment of time,appropriate planning and training andstreamlining of information generatingchannels or systems.The most significantaspect of the changes relates to the hedgingof non-financial risk and is expected to beof particular interest to non-financialinstitutions.

The new rules fundamentally changeaccounting for hedges. However, the likely

benefits of these rules within the EuropeanUnion generally and Ireland specificallydepend on EU endorsement.So far the EUis delaying its debate on the first phase ofmoving over from the existing financialinstruments accounting standard. It is tooearly to conclude when and to what extentthe EU will adopt or react to these newstandards.

John McCarroll, FCA, is a partner with DeloitteJohn McCarroll, FCA, is a partner with Deloitteand Goind Ram Khatri, FCCA,ACA, is asenior manager in the same firm. John and Goindare specialised in financial instruments accountingand valuation.

“thE NEw RuLEs fuNDAmENtALLy chANgE AccouNtINg foR hEDgEs.howEVER,thE LIkELy bENEfIts of thEsE RuLEs wIthIN thE EuRopEAN uNIoN

gENERALLy AND IRELAND spEcIfIcALLy DEpEND oN Eu ENDoRsEmENt.”

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