IASB issues final standard which aligns hedge accounting with risk management.
The IASB released new guidance on hedge accounting1 under IFRS that more closely aligns it with an entity’s risk management strategies. The new guidance establishes a more principle-based approach to hedge accounting and addresses inconsistencies and limitations in the current IFRS hedge accounting model.
Hedge effectiveness tests and eligibility for hedge accounting
The new guidance relaxes the current requirement for the hedging relationship to be highly effective in order to qualify for hedge accounting. It replaces today’s 80% to 125% bright line test with a requirement for an economic relationship between the hedged item and hedging instrument, and for the designated accounting ‘hedged ratio’ to be based on the quantity of the hedged item and hedging instrument the entity actually uses for risk management purposes. An entity is still required to prepare contemporaneous documentation to support hedge accounting; however, some of the information will differ. Hedge ineffectiveness is still measured and reported in profit or loss (P&L).
The new guidance removes restrictions that prevented some economically rational hedging strategies from qualifying for hedge accounting. For example:
The new guidance relaxes the rules on using purchased options, forwards, and non-derivative financial instruments as hedging instruments. Under today’s guidance, the time value of purchased options is recognized on a fair value basis in P&L, which can create significant volatility. The new guidance views a purchased option as similar to an insurance contract, such that the initial time value (the premium) will be recognized in P&L – either over the period of the hedge, if the hedge is time-related, or when the hedged transaction affects P&L, if the hedge is transaction-related. Any changes in the option’s fair value associated with time value will be recognized in other comprehensive income.
Similar accounting may also be applied to the forward element of a forward contract and currency basis spreads arising from foreign currency interest-rate derivatives. This should result in less volatility in P&L for these types of hedges.
In addition, non-derivative financial items may be used as hedging instruments for risks other than foreign currency risk, as long as they are measured at fair value through P&L.
Accounting, presentation and disclosure
The accounting mechanics and presentation requirements for hedge accounting will remain largely unchanged. However, entities will now be required to reclassify the gains and losses accumulated in equity on a cash flow hedge to the carrying amount of a non-financial hedged item when it is initially recognized. This is currently permitted, but entities are also able to choose to leave them in equity.
The amendments to IFRS 9 have removed the previous mandatory effective date of January 1, 2015, but the standard is available for immediate application. The standard provides an accounting policy choice for an entity to continue to apply hedge accounting (and hedge accounting only) under IAS 39 instead of IFRS 9 until the IASB completes its separate macro hedging project.
Entities can elect to apply IFRS 9 for (1) the “own credit risk” requirements for financial liabilities, which recognizes in OCI the change in fair value attributable to own credit risk for liabilities designated under the fair value option, (2) classification and measurement (C&M) requirements for financial assets, (3) C&M requirements for financial assets and financial liabilities, or (4) the full current version of IFRS 9 (that is, C&M requirements for financial assets and financial liabilities and hedge accounting).
These transitional provisions are likely to change upon completion of all phases of IFRS 9.
The European Union has not yet endorsed any aspects of IFRS 9, and therefore the new guidance may not be adopted by entities subject to regulation by the European Union.
We expect the FASB to begin discussions of hedge accounting under U.S. GAAP in the near future. PwC will issue a Dataline that compares the current U.S. GAAP hedging requirements to the new IASB guidance in the coming weeks.
PwC clients who have questions about this In brief should contact their engagement partner. Engagement teams who have questions should contact the Financial Instruments team in the National Professional Services Group (1-973-236-7803).
1This is the third phase of the IASB’s replacement of IAS 39, Financial Instruments: Recognition and Measurement (“IAS 39”). It is an amendment to IFRS 9, Financial Instruments (“IFRS 9”), IFRS 7, Financial Instruments: Disclosures, and IAS 39 that incorporates new guidance on hedge accounting.