IFRS 9 hedge accounting should be viewed as a potential financial opportunity for corporate treasuries, rather than a compliance constraint. What are the risk management benefits of using this new accounting standard?
- For hedge accounting, corporate treasuries can continue to apply the requirements of IAS 39 or use the new standard, IFRS 9.
- IFRS 9 opens up possibilities to apply hedge accounting in a wider variety of situations, which are consistent with common risk management practices.
- Companies are seeing IFRS 9 hedge accounting as a multi-faceted change project, rather than an adaptation of existing processes.
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IFRS 9 — the new accounting standard for financial instruments — became mandatory from 1 January 2018 in IFRS jurisdictions around the world.
Since then, it has become a reality for many organizations, particularly those in countries where IFRS standards govern in full.
Meanwhile for hedge accounting specifically, firms have had a choice between two accounting policies: continue applying the requirements of IAS 39, the previous standard, or apply the new requirements of IFRS 9, the new standard.
Therefore, as IFRS 9 was becoming mandatory around the globe, its most important aspect for corporate treasury remained optional.
However, companies still applying the IAS 39 requirements should consider a full move to IFRS 9 as a potential financial opportunity — before it becomes a compliance constraint.
IFRS 9: The scope for corporate treasury
The implementation of IFRS 9 has been a major event for all organizations participating in financial markets, but corporate treasuries were differently impacted across its three main pillars.
- Classification and measurement of financial instruments
All financial instruments are initially measured at fair value plus or minus transaction costs. IFRS 9 allows debt instruments to be subsequently measured at amortized cost, if the following two conditions are met:
- The Business Model Test: The objective of the entity is to collect contractual cash flows through to maturity, rather than to re-sell the instrument for profit.
- The Cash Flow Test: The instrument must be ‘solely payments of principal and interest’.
Regarding derivatives, all those within the scope of IFRS 9 must be measured at fair value, generalizing an already existing requirement in many jurisdictions.
Value changes are accounted for in profit or loss, unless hedge accounting is applied (see below).
Thus, under IFRS 9, more than ever, corporate treasurers are expected to rely on market data and analytics for fair, accurate, and independent valuation of derivatives.
- Impairment of financial assets (for expected credit losses)
The general principle is that expected credit losses on financial assets must be recognized earlier than under the previous standard, and always in profit and loss.
While the business model of corporates does not generally involve investing in financial assets on a large scale, those affected should certainly factor the implementation of the new expected credit loss model into their IFRS 9 plans.
- Hedge accounting
Even though the IFRS 9 hedge accounting requirements remained optional, that area of the regulation proved by far the most impactful for our corporate treasury customers, in a mostly positive way.
Pierre Vidal, Head of Trading Desktop, Foreign Exchange, estimates that over 80 percent of non-financial companies hedge at least one type of financial risk arising from their operations.
Thus risk management is the primary driver for those entities to transact in financial derivatives on a regular basis.
Many choose to apply hedge accounting to those financial instruments held strictly for hedging purposes, as that allows unexpected variability in reported profit and loss to be reduced.
It should be noted that hedge accounting does not remove the need for measuring hedging derivatives at fair market value — it simply allows reporting changes in market value in a special reserve account (Other Comprehensive Income) in a way that does not impact profit and loss.
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Benefits of IFRS 9 hedge accounting
The overall driver for companies to apply hedge accounting is to protect their profit and loss reports from financial markets volatility.
That entails both applying hedge accounting in the widest possible range of situations, and also eliminating any remaining volatility where hedge accounting is applied.
IFRS 9 brings improvements on both accounts, but more fundamentally, its key benefits are simplification and alignment with risk management principles.
The stated objective is to “align the accounting treatment with risk management activities”.
That is a sharp contrast and improvement to IAS 39, which was often criticized for biasing risk management strategies because of accounting constraints.
Retrospective hedge effectiveness test
Under IAS 39, hedge effectiveness had to be proven using a retrospective test (statistical calculation), which was onerous to implement, and prevented some fundamentally effective hedges from qualifying.
Under IFRS 9, the “80-125 percent rule” is no longer required.
Hedge effectiveness is still a requirement in order to apply hedge accounting, but is established based on a prospective and qualitative assessment ensuring:
- There is an economic relationship between the hedged item and the hedging instrument.
- The effect of credit risk does not dominate the value changes that result from that economic relationship.
- The hedge ratio of the hedging relationship is the same as that used in the economic hedge.
Those conditions are generally passed a priori by the most-used hedging derivatives, such as forwards, vanilla options and simple strategies.
Time value of the hedging option
An entity may separate the intrinsic value and the time value of an option, and only designate the intrinsic value as the hedging instrument to obtain hedge effectiveness.
In such case under IAS 39, the entity had to account for changes in fair value of the time value element through profit or loss. That resulted in undesirable volatility in reported results, since an option’s time value can move up or down substantially before expiry.
IFRS 9 now treats the time value of the hedging option as cost of hedging, either once-off at the settlement of the hedged transaction, or amortized linearly.
The example below illustrates the reported P&L impact of hedging a foreign currency cash flow using a zero-cost collar with data and calculations from Eikon.
The chart compares the marginal impact of the same considered risk on monthly reported P&L, but under different scenarios:
- No hedging
- Hedging with the collar, but no hedge accounting
- Hedging, with hedge accounting under IAS 39
- Hedging, with hedge accounting under IFRS 9
While the three hedging scenarios meet the primary purpose of hedging (limiting the final loss), we can see that only IFRS 9 allows complete elimination of volatility in intermediary reports.
IFRS 9 also allows the forward points in a forward contract, and the cross-currency basis element of a derivative, to be similarly accounted as cost of hedging, when those elements are excluded from the hedge accounting designation.
Those new possibilities in IFRS 9 are clear advantages for corporates, and in particular bring a new incentive to use options as hedging instruments.
Extended possibilities of application
IFRS 9 opens possibilities to apply hedge accounting in a wider variety of situations, which are consistent with common risk management practices:
- IFRS 9 allows designating a risk component of a non-financial item as the hedged item (e.g. a commodity benchmark price used to index the price of a procurement contract).
- IFRS 9 broadens possibilities to apply hedge accounting to a group of items as a whole.
Moving to IFRS 9 hedge accounting
Companies who saw benefits in IFRS 9 hedge accounting seem to have approached it as a multi-faceted change project, rather than a “tick in the box” adaptation of existing processes for the sake of compliance.
In line with the guiding principle of the new standard, moving to IFRS 9 hedge accounting should be the occasion to put re-defined risk management objectives and strategies first, and to streamline and update processes and tools supporting them.
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