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ANALYSIS: Hedge Accounting Under IFRS 9 Friend or Foe?

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It may be time to start investigating the opportunities that IFRS 9 could offer, writes Rodgers Mavhiki

Whenever IFRS 9 Financial Instruments is mentioned, impairment is the first word that comes to mind. People generally view IFRS 9 as daunting, but every cloud has a silver lining.

In particular the IFRS 9 principles relating to hedge accounting appear to offer banks more business opportunities and seek to align hedge accounting more closely with risk management. Consequently, more hedge strategies that currently used to achieve an economic hedge may now qualify for hedge accounting.

NON-FINANCIAL ITEMS

IFRS 9 allows for separately identifiable and reliably measured risk components of non-financial items to be designated as hedged items. At present, under IAS 39, non-financial items can only be designated as hedged items for foreign currency or, in its entirety, for all risk. Hedging a non-financial item in its entirety usually fails effectiveness testing, and therefore many non-financial items are currently not being hedged for all risk.

Because IFRS 9 allows components of non-financial items to be designated as hedged items, many economic hedges may now qualify for hedge accounting. Economic hedges are driven by the entity’s risk management strategies. Since hedge accounting provides an opportunity to reduce income statement volatility that would otherwise arise if these hedged items (components of a non-financial item) and hedging instruments were accounted for separately without regard to the entity’s risk management strategies, many entities may now look to hedge components of their non-financial items.

As many companies seek to hedge components of non-financial items, the volume of commodity derivatives traded is likely to increase significantly. Some of these derivatives may be over the counter, while some may be exchange-traded. Either way, there appears to be a new business opportunity for banks, whether they buy the derivatives for their clients or are the counterparty in the transaction (over the counter).

Banks may also give high-level guidance on hedge accounting to its clients as a value proposition. This is likely to have a ripple effect: as clients become savvier in hedge accounting, they are likely to buy more derivatives (hedging instruments) to manage their risk exposures.

CONTRACTS TO BUY OR SELL NON-FINANCIAL ITEMS FOR OWN USE

Contracts to buy or sell non-financial items that are entered into and continue to be held for the purpose of the receipt or delivery of non-financial items in accordance with the entity’s expected purchase, sale or usage (own-use contracts) are currently scoped out of IAS 39. These contracts are currently treated as executory and are therefore accounted for only when the buy or sell transaction takes place. If an entity enters into a derivative for the purpose of economically hedging the changes in fair value of the executory contract, there will be an accounting mismatch.

IFRS 9 allows entities to designate own-use contracts at fair value through profit and loss if designating it as such eliminates or significantly reduces an accounting mismatch. As the derivative is measured at fair value through profit or loss, the entity does not need to apply hedge accounting to achieve accounting offset.

Many entities are likely to transact much more in these own-use contracts and commodity derivatives as they will be able to achieve an accounting offset without applying the still-burdensome hedge accounting. Again, banks may stand to benefit by trading in commodity derivatives with these entities.

REBALANCING

Currently, under IAS 39, if a hedging relationship fails, hedge accounting must be discontinued. IFRS 9 allows an entity to rebalance the relationship if the risk management objective is still the same. Rebalancing can be effected in one of two ways:

•          An entity can increase the weighting of the hedged item either by increasing the volume of the hedged item or by decreasing the volume of the hedging instrument, or

•          It can increase the weighting of the hedging instrument either by increasing the volume of the hedging instrument or by decreasing the volume of the hedged item.

Rebalancing gives rise to potential new transactions after an entity has designated the hedging instrument (normally derivatives) for the same hedging relationship. This implies additional business for traders of the hedging instruments.

EQUITY INVESTMENTS

Hedge ineffectiveness resulting from the hedging of equity investments is currently recognised in profit or loss. Under IFRS 9 hedge ineffectiveness for equity instruments designated as at fair value through other comprehensive income (OCI) can be recognised in OCI. Since this eliminates profit-or-loss volatility from hedge ineffectiveness, more entities are likely to hedge their equity investments designated as at fair value through OCI.

SUMMARY

As a result of this new standard, more entities may apply hedge accounting to a broader range of strategies. This will mean more volumes of transactions especially in hedging instruments, and therefore banks will potentially benefit, particularly those that are in a position to advise their clients on hedging opportunities.

The chapter on hedge accounting (excluding macro-hedging) was published by the IASB on 19 November 2013.

Furthermore, although the mandatory effective date for IFRS 9, in its entirety, is 1 January 2018, the hedge accounting chapter is available for early adoption.

However, this chapter cannot be adopted in isolation and entities will need to consider the impact of previously issued chapters of IFRS 9 relating to classification and measurement and own credit.

Given that the chapter relating to macro-hedging is still in its infancy and that it is unlikely to be completed before the final IFRS 9 standard is issued, the IASB has made a concession for entities to adopt the IFRS 9, excluding the hedging chapter, and thus continue to apply the hedging rules of IAS 39.

However, this concession is not permitted if entities choose to adopt early.

Since 2008 IFRS 9 has no doubt been one of the most anticipated and intensely debated topics in accounting circles. And, as the scapegoat for the economic crisis, the principles of impairment have garnered the lion’s share of the attention. Now that the reality of IFRS 9 draws closer, perhaps it is time that we start turning our gaze to the opportunities that IFRS 9 could offer. ❐

Author: Rodgers Mavhiki CA(SA) is from IFRS Advisory & Specialised Projects at Nedbank