IFRS9 was billed as being heaven-sent to corporates who undertake to hedge market risks, presenting not only new opportunities to hedge many more exposures but also to make current hedging mechanics that bit easier. And if IAS39 had never existed, heaven IFRS9 would certainly be.
Unfortunately, IAS39 did exist and has done so since 1998. Having become familiar with IAS39, IFRS9 Hedge Accounting adoption may turn out to be hell for some corporates. Systems, auditors, hedge documentation and treasury policies have evolved to ensure compliance with IAS39. Those just about getting comfortable with IAS39, including myself, who do not expect to take advantage of the new hedging opportunities presented by IFRS9, at least in the short term, may find that applying the new hedge accounting rules only offers downsides.
The significant changes requiring employee time centres around hedge effectiveness requirements. Removing the 80-125% bright line required by IAS39 to prove effectiveness and replacing with a requirement for an economic relationship to exist between the hedged item and the hedging instrument, opens a raft of measurement options but also introduces some ambiguity.
Simply, there are 4 main methods to prove an economic relationship exists, in order of increasing complexity and levels of quantitative assessments:
1) Critical terms
2) Scenario analysis
3) Regression
4) Monte Carlo
The choice of method will depend on the extent of the mismatch between the terms of the hedging instrument and the hedging item. If the dates, notionals and underlying risk are aligned then critical terms, with perhaps one scenario, is good enough to prove that an economic relationship exists. If there are mis-matches in the terms and/or a complex hedging instrument is being used (for example knock-in knock-out options or forwards) then regression analysis or a Monte Carlo simulation is required.
Prospective effectiveness assessments are undertaken at inception, at each reporting date and if there are any significant changes in the hedge relationship. Retrospective testing is no longer required.
Hypothetical derivatives usage has caused a bit of confusion. They are a popular effectiveness measurement method for cash flow hedges and net investment hedges but are NOT an assessment method; their use is as a mathematical expedient for calculating the fair value of the hedged item. IAS39 was silent on their use and it seems to have become commonplace to base the hypothetical on the hedging instrument instead of the hedging item as was originally intended. Doing this will always ensure effectiveness is 100%, so what is the point some may ask.
Because IAS39 had not addressed the usage of hypotheticals, treasury systems have allowed this practice and auditors have accepted it. IFRS9 puts a stop to this by stating explicitly that the hypothetical should be based on the hedged item, which means it must exclude anything that is not contained in the hedging item, which can be forward points, credit risk and cross currency basis spreads. These may have been included in the hypothetical derivative as part of the IAS39 hedging relationship, as well as the hedging instrument resulting in 100% effectiveness. Under IFRS9, these must be excluded which could lead to increased ineffectiveness.
IFRS9 gives choices regarding the treatment of cross currency basis spreads and forward points:
1) To include these in the hedging relationship, as naturally in the hedging instrument but not the hedged item and accept the ineffectiveness that could arise.
2) To exclude them from the hedging relationship and record the changes in the fair value of the hedges item attributable to basis spreads and forward points in profit and loss
3) To exclude them from the hedging relationship and record in Ordinary Comprehensive Income (equity), amortising to profit or loss over the life of the hedge relationship.
The first and second options were available in IAS39, but the third option is new in IFRS9 due to the recognition by the IASB that the new requirements could cause volatility in the Income Statement and offered an alternative.
This is only a small snapshot of IFRS9 Hedge Accounting; there is a lot more to it. There is plenty of information out there, but it will take time to get through it all, digest and understand the requirements before being able to make informed decisions on your approach to adoption.
To comply with the new standards, after you have read and understood the standard and other guidance, there are a few things to consider, including:
- Will you need system changes and updates, and if so how long with this take? The modular nature of today’s TMS means some vendors are asking corporates pay for an IFRS9 module.
- Documentation updates: hedge documentation and treasury policies may need updating for IFRS9 requirements. If these are produced by the system, then you may need the vendor to help with this or to install an IFRS9 module. Remember that hedge documentation needs to be in place by the date of initial application.
- Decisions will need to be made with regards to the testing and assessment methodologies required to comply with IFRS9. You may need to run several different methods to discern which produces the best or/and desired outcome.
For those struggling for time and resource to comply with the new requirements, are happy to stick with vanilla hedging tools and cannot see an advantage in applying IFRS9 hedge accounting at present, may consider continuing with IAS39. This is allowable by IFRS9 until the macro hedging project run by the IASB is completed, which could be many years away. Given IFRS16, ring fencing rules, MifiD ii and other regulations, I am sure treasury departments have got enough on their plates to keep them busy. Delaying IFRS 9 Hedge Accounting could give some much-needed breathing space.
If you have already adopted IFRS9 Hedge accounting, which many may have done given the effective date is for periods starting on or after 1 January 2018, then remember what Winston Churchill said: If you are going through hell, keep on walking…
About the author
Joe Scattergood ACA FCT is a corporate treasurer and chartered accountant with over 11 years broad finance experience.
Simon Lynch is the owner of Treasury Talent
Treasury Talent is a specialist treasury talent provider solely focussed on the treasury market with offices in Sydney covering Australia, Singapore covering Asia, and San Francisco covering California and the USA. To make contact simon@treasurytalent.net