All businesses are exposed to market risk of some form. A common response is to hedge against those risks but in accounting terms this can create undesirable P&L volatility. Hedge accounting may be an effective remedy to this problem, but it can be a demanding process. Treasury Today calls upon a number of experts to shed some light on this dark art.
As deep and mysterious topics go, one of the clear leaders of the pack in financial circles is hedge accounting. It can strike fear into the heart of even the most seasoned finance professional. But, notwithstanding its complexities, it can be an effective means of mitigating the risk of potentially damaging volatility in profit and loss (P&L) accounts caused by the mark-to-market fluctuation of a hedging instrument and allowing a better reflection of economic performance to be provided. It is a voluntary accounting process (it has been described as a privilege, not a right) but for those that use it – typically listed companies whose accounts are exposed to public scrutiny – it must be applied with precision.
So what is it? A business may hedge financial or non-financial assets or liabilities by using a financial instrument in order to manage its exposure to a risk it may have around interest rate, FX, equity, credit or commodity price, for example. Accounting requirements often insist that assets/liabilities (frequently recorded at amortised cost or as a forecast item not yet recognised on the balance sheet) and the instrument used to hedge (which is accounted for as a trading instrument at its market valuation – in other words ‘fair value’ recognised in the P&L account) are accounted for differently. But where differences in measurement arise, such as between the fair value measurement of the hedge and the amortised cost for the assets/liabilities, a mismatch in the valuation or timing of income statement recognition is created, giving the appearance of corporate earnings volatility, which does not provide useful information to investors and shareholders.
Enter hedge accounting, which can be used as a means of reflecting the relationship between an asset/liability and the associated hedging instrument (for example by re-measuring the asset/liability for the hedged risk and recognising that value change in P&L to provide an offsetting effect with the measurement in P&L of the hedging instrument).
As long as the hedge is fully effective (more on this later) most mismatches in the P&L should be evened out by the relationship between the two and thus the business can better depict its performance through its financial statements.
Hedge accounting has a strict set of rules and requirements. These are typically laid out in the standardised accounting guidelines of each jurisdiction known as ‘generally accepted accounting principles’ (GAAP). In Singapore, for example, it is the Accounting Standards Committee (ASC) that is in charge of standard setting. In the US, hedge accounting under GAAP is tackled by the country’s Financial Accounting Standards Board FAS 133 rule-set (now known as ASC 815).
When hedging structures are complex, there may be judgements to make where the local accounting standards “do not necessarily address all the possible scenarios”, according to Yann Umbricht, Partner and Treasury UK Leader at PwC. He adds that for listed companies accounting at group level, alongside appropriate local GAAP reporting requirements for individual entities, international accounting standards must normally be applied. In this respect, the IFRS Foundation was established to develop and promote a single set of globally accepted accounting principles (known as International Financial Reporting Standards or IFRS). It works through its independent standard-setting body, the International Accounting Standards Board (IASB), and has global influence. Members of the IASB are responsible for the development and publication of IFRS, which is applied in over 100 countries, including two-thirds of the G20.
Hedge accounting requirements are contained in IAS 39 Financial Instruments: Recognition and Measurement, much of which had its genesis in similar requirements in US GAAP.
Pierre Wernert, Senior Consultant at Zanders Treasury and Finance Solutions, offers the following information on the conditions that must be met prior to hedge accounting under IAS 39:
At the start of the hedge, the hedged item and the hedging instrument has to be identified and designated.
At the start of the hedge, the hedge relationship must be formally documented.
At the start of the hedge, the hedge relationship must be highly effective.
The effectiveness of the hedge relationship must be tested periodically.
Ineffectiveness is allowed, provided that the hedge relationship achieves an effectiveness ratio (the level of offset between the two) of between 80% and 125%.
Adopting IFRS 9
Following a consultation period, the section of IAS 39 relevant to hedge accounting has been updated. According to Umbricht, the new requirements, published under IFRS 9, are intended to reflect business and investor concerns that hedge accounting is “too complicated” and that it unnecessarily excludes some “very well-defined and acceptable hedging strategies”.
IFRS 9 will eventually replace IAS 39. Currently, from an IFRS perspective, the new standard is available for application but in some jurisdictions, such as in Europe, IFRS 9 has not yet been endorsed for inclusion in European law. US GAAP must be used by US companies, of course, but IFRS standards including IFRS 9 can now be used in that jurisdiction by foreign businesses that need to file group reporting by US regulations (such as an entity that has listed debt in the US).
The switch to IFRS 9 for users of hedge accounting was due to become mandatory on 1st January 2015 but amendments made to IFRS 9 in November 2013 removed the mandatory effective date (although, as before, businesses in jurisdictions that use IFRS may still choose to apply IFRS 9).
The hedge accounting requirements in IFRS 9 are intended to be less administratively burdensome than IAS 39 by being more closely aligned with risk management. As part of the discussion that led the IASB to make these changes, it was clear that investors in business wanted to be able to understand the risks faced by a particular entity, what its management is doing to manage those risks and how effective those risk management strategies are, says IASB Board Member, Sue Lloyd. It is thus the IASB’s intention “to more closely align hedge accounting with risk management” and to make the presentation of information more accessible to non-accountants. It is, she comments, “a new generation of hedge accounting”.
IFRS 9 retains requirements for documentation of risk and hedging processes. It requires enhanced disclosure around exactly what those risk management activities are when applying hedge accounting. From an auditing viewpoint there are specific requirements to state what will be treated as a hedge accounting relationship and how each will be executed. “Hedge accounting is still complex,” states Umbricht. The changes will not make it easy, “but it will become easier”.
The role of technology
Blaik Wilson, chairman of treasury technology vendor Reval’s Hedge Accounting Technical Taskforce believes the inherent complexity of hedge accounting, under any ruleset, lends itself to technological intervention. “Companies can enable rules-based processes and workflows which will only allow a hedge relationship to be created, and hedge accounting be conducted, if the appropriate documentation is in play,” he explains. Such solutions – either outsourced or controlled by organisations themselves – can take account of local variations not just of the rules but also in how documentation must be presented; the latter giving rise to the use of templates. “If you haven’t got a robust workflow attached to your processes, elements will be missed,” he warns.
Inappropriate or missing documentation is the number one reason for a hedge ceasing to be eligible for hedge accounting treatment. “One of the reasons it gets picked up frequently is that it is quite an easy audit point to discover, and you’ve either done it correctly or you haven’t,” he notes. “Companies have to be vigilant in their processes to ensure they document every single one of their hedges correctly.”
Despite claims of reduced administrative burden, for example by using more economic concepts to determine whether a relationship is eligible for hedge accounting, IFRS 9 will almost certainly introduce extra work for preparers of financial statements when it comes to disclosure, admits Lloyd. But by providing information that has been designed to help users of financial statements understand the effects of hedging on future cash flows, she argues that it gives a business “the opportunity to better explain its story”.
There are other benefits. For example, companies can now hedge risk components in non-financial items. “IFRS 9 gives companies the ability to use risk components, slicing and dicing the hedged item for risks in non-financial items in the same way as for financial items, as long as the component is reliably measurable and separately identifiable,” explains Ian Farrar, partner in PwC’s Global Accounting Consultancy Services group and leader of PwC’s corporate treasury practice in Hong Kong and China. This, he adds, will be “really useful” for companies dealing with commodities. “If you buy something that has high copper content, with IAS 39 you would have to hedge the whole item; now with IFRS 9 you can just choose to hedge the copper content.” The same componentised approach to hedging applies to airlines and jet fuel, for example. The change effectively means more entities will be able to apply hedge accounting to reflect their risk management activities.
Aggregated exposures – those that have a derivative and non-derivative together – can also now be hedge accounted. The treatment of net positions is changing too. IAS 39 does not allow aggregation of items that have off-setting risk. With IFRS 9 it is now possible, for example, to designate a hedge of both sales and purchases on a gross basis with a net derivative. The downside explains Farrar, is that it is not permissible to recognise those gains and losses within revenues and cost of sales, for example; they have to be reflected in a separate line in the income statement. “In terms of presentation this is not perfect, but certainly it is a big step forward from where we are today.”
There is however a “slight narrowing” of what is possible in terms of using undiscounted spot, notes Umbricht. He points out that application of IAS 39 has been “fairly flexible” when using the spot element of a forward contract to hedge a foreign currency risk that will occur in the future, where the time value of money could be ignored. If a company with a future dollar exposure took a dollar contract, the spot element was fully offset. But, he comments, the IASB has been “very clear” in its requirement to take into account the value of money, and discount back to present value both the hedged item and the hedging instrument. “It’s all fine if the timing is very similar or the interest rate environment of the country where you operate is low,” he notes. “But where you have uncertainty around the timing of the hedged item, and a higher interest-rate environment, this may create more ineffectiveness than we have been used to in the past.”
One of the most difficult issues to deal with over the years has been hedge effectiveness testing. To be able to use hedge accounting under IAS 39, although IASB does not specify a method of calculating effectiveness, it does stipulate an effectiveness range – a so-called ‘bright line’ within which fair value must fall both prospectively and retrospectively – of between 80% and 125%. With IFRS 9 it is the duty of the business to satisfy auditors that on a prospective basis all intended hedges will be effective. But instead of using arbitrary accounting metrics, it can use information produced internally for risk management purposes. Lloyd believes that this less-prescriptive, more economic model should reduce the costs of implementation compared with those for IAS 39. However, it places the onus on the entity to establish prospectively that there is a sound economic relationship between each asset/liability and its hedge that will provide offset of risk. Failure to continue to do so would result in hedge accounting ceasing for that particular hedge relationship so any volatility experienced for that hedge would then hit the P&L.
What changing to IFRS 9 means
For those using IAS 39 or any similar GAAP model, the initial move to IFRS 9 hedge accounting may be seen as yet another issue to overcome. “Some people think hedge accounting is too hard. But put it into perspective; every entity will look at the amount of hedging it does and decide whether it is worth the effort or not,” says Lloyd.
Where US GAAP and IAS 39 hedge accounting had many similarities, IFRS 9 is quite different, notes Wilson, adding that this may create “quite a headache” for global companies who must incorporate disparate GAAP requirements across their various jurisdictions. Lloyd however notes that even where there are differences, hedge accounting is “ultimately a choice”. For Umbricht, the switch from IAS 39 to IFRS 9 signals no major operational undertaking. However, he reserves concern for the UK and Republic of Ireland where changes in local GAAP for statutory accounts will increasingly resemble IFRS rules. Companies in the UK and Ireland will need to move quickly to adapt to the new financial reporting framework, which will impose changes to the format of the financial statements and the disclosures required, becoming effective on 1st January 2015.
Lloyd argues that the shift to IFRS 9 represents more opportunity to engage in “finely-tuned” hedge accounting. US GAAP constituents were even encouraged to (and actively did) take part in the consultation period and she believes there may be convergence in time. Until then, businesses may even be “pleasantly surprised” to find that things that weren’t possible before “could now be possible”.
Many of the changes will enable companies to address some of the areas where IAS 39 was causing a “misalignment of accounting with common risk management strategies”, says Farrar. It offers “friendlier accounting” for commodity risk managers, and being able to have derivatives as hedged items will also give companies more flexibility in how they designate hedge relationships. It will also enable them to “avoid some of the problems they have been having with derivatives with non-zero fair values” when going into hedge relationships.
The concluding observations from Wilson on the complexities of hedge accounting and the way in which the rules are changing are impressively forthright. “Businesses changed the way they were hedging economically to make it easier to do the accounting, and that’s not a great situation,” he states. “I don’t think the standard-setters wanted firms to do that; they want businesses to manage their risk the best way they feel they need to, and for the accounting to reflect that. With IAS 39, we’ve often got the tail wagging the dog, with the accounting driving the economic hedging.” Notwithstanding his reservations on the divergence between the likes of US GAAP and IFRS 9, he feels the new international standard for hedge accounting will address most issues by re-aligning accounting with risk management and, on the whole, “gets it right”.