Recently the IASB issued its long-awaited exposure draft (ED) on its proposed changes to hedge accounting. This ED is the third and final phase to replace IAS 39, with the proposed changes aimed at simplifying the requirements to hedge account financial instruments.

It is anticipated that IFRS 9 will be required to be adopted prospectively on or after 1 January 2013 with early adoption permitted. To early adopt the new hedge accounting model, the first two stages of IFRS 9 (Classification and measurement and Impairment methodology) previously finalised must also be adopted together.

After a significant outreach programme, the proposed changes put more emphasis on the financial reporting being aligned to a company’s risk management objectives. These changes will have a significant impact on companies that already hedge account as well as companies that have elected not to hedge account, as the criteria under the current rules were considered too onerous given their economic hedging program.

What companies should begin thinking about prior to IFRS 9 being adopted?

First, companies should undertake a review of their current risk management and hedge accounting policies to highlight how the proposed changes will impact these policies given the new IFRS 9 requirement. The proposed rules can operate on three core levels:

1)      Current hedge accounting practice – It is expected that existing hedge relationships will continue to qualify under IFRS 9 but the criteria to achieve hedge accounting would be significantly different compared to IAS 39 particularly with regards to effectiveness testing. How will this impact your hedge accounting processes? What would be the impact to the financial statements?

2)      Scenarios not currently hedge accounted – Potentially, hedge accounting can be applied to scenarios under IFRS 9 that were not available (or easy) under IAS 39. Are there such scenarios in your current hedging programme? What would be the potential benefit to the bottom line in applying hedge accounting?

3)      Hedging strategy – Given that IFRS 9 links accounting outcomes to economic outcomes, what changes (if any) would you apply to your hedging strategy? For instance, many avoided using instruments with optionality components, given the implied P&L volatility under IAS 39. In most circumstances, this P&L volatility would be avoided under IFRS 9 – would you consider expanding the use of option-based products given this change to accounting? For commodity hedgers, ineffectiveness due to basis risk can be significantly reduced – would you hedge more commodity exposures as a result?

The IASB will allow early adoption of all phases of IFRS 9 prospectively, so such an impact analysis will be vital in assessing your company’s strategy regarding early take up of this new guidance. Also, check in with your system providers to understand their plans for accommodating the new rules to meet your timelines.

London, Sweden, Finland, all in five days.    My travels last week took me to all of those cities in order to share best practices regarding interest rate risk management.  Accompanying me on my “roadshow” were several different expert speakers from leading financial institutions and Big 4 accounting firms.    We held multiple events in Sweden and Finland, and what stood out to me the most from all of those meetings was the commonly shared concept of including non-performance (i.e. credit) risk in valuing derivatives.

I felt an acute sense of déjà vu as many of the discussions that are going on in the Scandinavian countries are similar to the ones that I was hearing in the United States two to three years ago with the advent of FAS 157 (now ASC 820).   While the discussions in the Scandinavian countries still seem to be in the relatively early stages, they seem to be focusing on all the things that have come to the forefront with regards to the global financial crisis.   Everything from zero threshold CSA’s,  discounting using OIS, and all related impacts on hedge accounting.  

IFRS doesn’t currently have a devoted accounting standard to the measurement of fair value like FAS 157 under US GAAP. However, the application guidance of IAS 39 does require entities to use the same valuation techniques employed by market participants, and this could include adjustments for credit. Many of the audit firms and leading corporates seem to be taking the lead from US GAAP and incorporating non-performance risk in the valuation of derivatives. The IASB has an exposure draft on Fair Value Measurement which is almost identical to FAS 157 – with the new standard due in 2011, it appears that a clear, consistent, and comprehensive model for valuing OTC derivatives would seem to be a welcomed sight for auditors’ sore eyes.

Since the financial crisis, many organisations have experienced significant P&L volatility on their cross currency interest rate swaps through movements in currency basis. This is in spite of the hedges being perfectly matched to the underlying exposure and the application of best case hedge accounting techniques. Recently, a new technique for applying hedge accounting to these instruments has emerged which has significantly reduced the ineffectiveness flowing through to the bottom line. 

As companies seek out cheap funding in the US, we are also seeing more cross currency swaps being dealt to lock in the currency and at times interest rate risk. In instances where an organisation looks to swap to floating rates locally, the accounting has been problematic because the principal and benchmark elements must be represented in a Fair Value hedge, not a Cash Flow hedge. In a Fair Value hedge relationship, the hedging instrument (cross currency swap) must be valued with currency basis applied whereas the hedged item (US denominated debt) does not – any movement in currency basis therefore causes P&L volatility.

In the days before the GFC, currency basis represented a small element of a valuation with little volatility. Post crisis, we have seen significant swings in currency basis by over 50 basis points or more at times which can cause havoc to a treasurer’s P&L on what is ‘suppose’ to be a perfect hedge. This has caused frustration for many corporations who know that economically they are hedged yet their financial statements do not reflect it.

Some auditors and advisors are now working with their clients to create a new way of designating hedge relationships that better reflect the economic hedging reality. In this manner of designation, all of the movements in currency basis are effectively maintained within Other Comprehensive Income. The only impact to P&L may be a small amount of ineffectiveness arising on the first coupon of the swap’s floating leg – a much better result for corporate.

Why the change of heart? Clearly the recent volatility has made this a higher priority for treasurers and CFO’s and they have encouraged their stakeholders to consider alternative approaches here. However, I think there is also an emerging pragmatic trend in hedge accounting under IFRS. More and more, auditors are looking to align the accounting results with the economic hedging situation and each company’s risk management policy. We see this now at the highest levels, where the IASB’s tentative decisions around IFRS 9 include aligning hedge accounting outcomes consistent with your risk management policy.

This is all good news for those who have suffered the whims of currency basis through their profit and loss. On a bigger scale, it is also very encouraging development for other aspects around hedge accounting, particularly when we get our first look at Phase 3 of IFRS 9 – for many, it can’t come soon enough.