Hedge Accounting under IFRS

John McDonnell, IFRS Services Partner, PricewaterhouseCoopers, looks at hedge accounting under IFRS and its possible impacts on a company’s processes.

This article first appeared in the April 2004 edition of Accountancy Ireland

Hedge accounting will create a number of significant issues in Irish companies converting to the international standards for the first time in 2005.

Why should this standard be a cause for significant concern for Irish companies? IFRS requires that effectively all derivatives be held on the balance sheet at fair value, with the changes in the fair value being recognised through the profit and loss account. Where companies are using derivatives to hedge exposures accounted for on an accruals basis they face the prospect of having to take changes in the fair value to the profit and loss account without being able to recognise the associated changes in the underlying hedged item or exposure unless some very complex and restrictive rules for hedge accounting are followed. For companies with substantial portfolios of hedging derivatives this will expose their reported profits to significant volatility if IFRS hedge accounting conditions cannot be met.

IFRS requires that hedges meet certain criteria in order to qualify for hedge accounting. These include requirements for formal designation and documentation of the hedging relationships as well as rules on hedge effectiveness. Let us examine each in turn.

Designation of hedging relationships

What can be designated as a hedging instrument? All derivatives that involve an external party may be designated as hedging instruments except for some written options. An external non-derivative financial asset or liability may not be designated as a hedging instrument except as a hedge of foreign currency risk.

What items or transactions can be hedged? The fundamental principle is that the hedged item creates an exposure to risk that could affect the income statement. The hedged item can be a single asset, liability, firm commitment or forecast transaction; a group of assets, liabilities, firm commitments or forecast transactions with similar risk characteristics; a non-financial asset or liability (such as stocks of goods) for either foreign currency risk or the risk of changes in the fair value of the entire item; a held-to-maturity investment for either foreign currency risk or credit risk; a portion of the risk or cash flows of any financial asset or liability; or a net investment in a foreign operation.

Categories of hedges

The two types of hedging relationships are fair value hedges and cash flow hedges.

1. A fair value hedge is a hedge of the exposure to changes in the fair value of a recognised asset or liability that is attributable to a particular risk and could affect reported profit or loss. In a fair value hedge, the gain or loss from re-measuring the hedging instrument at fair value is recognised immediately in the profit and loss account. At the same time, the carrying amount of the hedged item is adjusted for the gain or loss attributable to the hedged risk and the change is also recognised immediately in the profit and loss account to offset the value change on the derivative.

2. A cash flow hedge is a hedge of the exposure to variability in cash flows that (i) is attributable to a particular risk associated with a recognised asset or liability or a highly probable forecast transaction and (ii) could affect the reported profit or loss. The portion of the gain or loss on the hedging instrument that is determined to be an effective hedge is recognised directly in equity. The gain or loss deferred in equity is recycled to the profit and loss account when the hedged cash flow affects income.

Documentation

IFRS requires key information about the hedging relationships to be formally documented prior to hedge accounting treatment being applied. Failure to establish this documentation will mean hedge accounting cannot be adopted regardless of how effective the hedge actually is in offsetting risk.

IFRS sets out the areas that hedge documentation should cover, but does not go as far as giving specific pro-forma examples. IFRS hedge documentation requirements are set out below. It is important to note that a high level of detail will be needed in describing how effectiveness will be measured. A good test of the level of documentation is whether it would be sufficient to enable a third party to re-perform the effectiveness testing.

• Risk management objective and strategy
• Identification of the hedging instrument
• The related hedged item or transaction
• The nature of the risk being hedged
• How the entity will assess the hedging instrument’s effectiveness

Hedge effectiveness testing

In addition to the documentation of the hedging relationship, IFRS requires companies to prove that their hedging instruments are indeed ‘effective’ in mitigating the hedged risk or variability in cash flows in the underlying item. IFRS discusses the need for two separate effectiveness tests.

Firstly, prospective effectiveness testing has to be performed at inception of the hedge and at each subsequent reporting date during the life of the hedge. This testing consists of demonstrating that the company expects changes in the fair value or cash flows of the hedged item to be almost fully offset (i.e. nearly 100%) by the changes in the fair value or cash flows of the hedging instrument.

Secondly, retrospective effectiveness testing is performed at each reporting date throughout the life of the hedge in accordance with a methodology set out in the hedge documentation. The objective is to show that the hedging relationship has been highly effective by showing that actual results of the hedge are within the range of 80-125%.

All hedge ineffectiveness is systematically and immediately reported in the profit and loss account.

IFRS does not address what constitutes an acceptable method of hedge effectiveness. In practice there are a number of general factors to consider when looking at hedge effectiveness, including which one of a range of methods to use, from the intuitively straightforward, to the mathematically sophisticated. It is critical to consider carefully the method of effectiveness testing adopted, since the careful design of an effectiveness test can mean the difference between a hedging relationship passing and failing the test.

Systems and resources

The above issues highlight that IFRS hedge accounting requirement will have a major impact for companies in the areas of both systems and resources. Where a company undertakes a significant volume of hedging transactions then the manpower required to establish and maintain documentation, identify and monitor the hedged and hedging items and conduct effectiveness testing can be considerable. Existing transactional level systems are unlikely to be configured to allow the designation and documentation of hedges and to perform the associated hedge effectiveness testing.

Some companies will need to choose or build dedicated systems that maintain the underlying data and automatically conduct effectiveness testing. Such systems by their nature are complex and cannot be designed and built easily or cheaply given the cost of employing suitable IT resources. A challenge for companies will be to weigh the costs of meeting the requirements for hedge accounting against the consequences of the potential earnings volatility arising by not implementing hedge accounting. Hedging strategies may have to be simplified greatly, purely on the grounds of the systems costs needed to maintain them.

A time of change

IFRS will radically change the ability of Irish companies to achieve hedge accounting, resulting in increased earnings volatility. Many are likely to feel this effect to be sufficiently severe or misleading of the ‘true’ (or economic) performance that it justifies incurring the additional costs needed to achieve hedge accounting treatment. Management of companies should consider the matter of hedge accounting thoroughly and as soon as possible so that they are making an informed decision and putting in place the most appropriate response.

With the potential difficulties inherent in achieving hedge accounting, putting in the process that will be compliance may involve substantial effort and resources and involve a timescale denominated in months rather than days. Given the timetable for the introduction of IFRS, companies need to be deciding on their strategy and taking action now.