Introduction Reducing complexity has become a familiar term to those who follow the International Accounting Standard Boards (the IASB or the Board) project on fnancial instruments. Keeping with the theme, the Board has just released Exposure Draft Hedge Accounting (ED) with proposals to substantially simplify hedge accounting under IFRS. The ED is the third phase of the IASBs ongoing project to replace IAS 39. However, proposals relating to macro (portfolio) hedge accounting are not included in the ED, but will be released later in 2011. In this supplement, we take a look at the main complexities of hedge accounting under IAS 39 and how the IASB proposes to simplify the requirements in the new standard IFRS 9 Financial Instruments. The proposed changes at a glance Hedging by risk components will be permitted for both fnancial and non-fnancial items, if separately identifable and measurable Eligible hedged items include combinations of derivatives and non-derivatives, portions or proportions of nominal amounts and one-sided risks Hedging instruments can include non-derivatives The bright line test of 80-125% for hedge effectiveness testing will be eliminated The assessment of hedge effectiveness will be prospective and driven by the risk management strategy with a requirement that no systematic under- or over hedge-hedging is expected Rebalancing of the hedge ratio will be required when necessary to maintain the risk management objective Discontinuation of the hedge relationship will be mandatory if the hedging relationship no longer qualifes (including if risk management objective changes). Conversely, voluntary de-designation will not be permitted if the risk management objective continues to be met For fair value hedges, the hedged item will not be adjusted and the cumulative gains or losses attributable to hedged risk will be recorded in a separate balance sheet line. The fair value changes of both hedging instruments and hedged items will be taken to Other Comprehensive Income (OCI) and any ineffectiveness will be immediately taken to proft or loss It will not be possible to apply hedge accounting to equity instruments recorded at fair value through OCI There are new rules for hedges of groups of eligible hedged items There are signifcant new disclosure requirements ey.com/IFRS Issue 91 / December 2010 Supplement to IFRS Outlook 2 Hedge accounting under IFRS all set for change What are the main diffculties under IAS 39? A recurring theme that surfaces is the lack of an overall principle in the hedge accounting requirements under IAS 39. Hedge accounting is an exception to the normal recognition and measurement principles, and IAS 39 permits the exception by way of rules, restrictions and bright-line tests. The lack of a principle, coupled with rules (that are sometimes conficting) is the main source of the complexity of the hedge accounting requirements under IAS 39. Hedge accounting is optional under IFRS. Therefore, at one end of the spectrum, entities are not required to apply it if they do not wish to. At the other end, many entities economically hedge (i.e., manage) their risks, but fnd that they are unable to fully refect this fact in their fnancial statements because of the rule-based nature of the existing hedge accounting requirements. In addition, analysts and other users fnd information relating to an entitys risk management strategy and practices to be valuable, but this information may not be clearly refected in the fnancial statements because of a mismatch between the application of hedge accounting and the entitys risk management objectives. For corporate entities, one main concern has been the inability to hedge specifc components of non-fnancial items. For example, an airline may wish to hedge its exposure to the movements in the price of jet fuel by entering into forward crude oil contracts. Although crude oil is a key component of the refned product (i.e., jet fuel), it is not considered a valid hedged item under IAS 39. This is because, under the existing rules for hedging non-fnancial items, an entity can only hedge either the foreign currency risk or the entire non-fnancial item (the purchase price of jet fuel, in this case). There are many cases where entities seek to hedge the purchase or sale of raw material components such as copper, gold, rubber, sugar and cocoa using commodity derivatives. In each case, a price is readily available for the raw material, and it is often specifed in the contract as a component of the overall price. Even if an entity uses derivatives to manage its exposure to price risk in such cases, the current rules do not permit such economic hedging practices to be refected in fnancial reporting. Designating groups of hedged items is a challenge under the current rules because many criteria need to be satisfed. Items may be grouped together only if they are similar, have similar risk characteristics, share the risk exposure being hedged and the change in fair value (for the hedged risk) for each individual item in the group is approximately proportional to that of the group as a whole. As a result, many hedged items cannot be designated in a hedge relationship as a group, despite the apparent economic link. The most widely quoted example is that one cannot achieve hedge accounting for the hedge of the equities that comprise an index (such as those making up the FTSE 100) using the index future. Again, there is a discrepancy between fnancial reporting and an entitys risk management. Other criticisms include the onerous requirements to perform quantitative effectiveness tests, insuffcient guidance on how to quantify hedge effectiveness and bright-line tests that give rise to arbitrary results and severe consequences. Can hedge accounting be completely dispensed with? No, for two reasons. First, the Board has chosen to retain a mixed measurement model (i.e., both amortised cost and fair value) for IFRS 9 and, generally, both preparers and users fnd it helpful to use hedge accounting to address measurement mismatches. For example, a mismatch could arise when the hedged item (such as a fxed rate loan) is carried at amortised cost, whereas the hedging instrument (such as an interest rate swap) is measured at fair value. Second, hedge accounting will continue to be needed for hedges of forecast cash fows that are not yet recorded in the fnancial statements. 3 Hedge accounting under IFRS all set for change Highlights of the ED The ED states that the objective of hedge accounting is to represent, in the fnancial statements, the effect of an entitys risk management activities which use fnancial instruments to manage exposures arising from particular risks that could affect proft or loss. Hedged items Risk components may be designated as hedged items if they are separately identifable and reliably measurable. Risk components could be part of a fnancial or non-fnancial item and may or may not be contractually specifed. Entities could, therefore, choose to apply hedge accounting to particular risks of a non- fnancial item, as opposed to the current need to designate the entire item. The two examples of risk components in non-fnancial items provided in the application guidance to the ED are: Hedging the gas oil component of a long-term natural gas supply contract that is priced according to a formula that references various commodities and factors including the price of gas oil Hedging the crude oil component of forecast jet fuel purchases, on the basis that crude oil is a building block of jet fuel Eligible hedged items will include derivatives, combinations of derivatives and non-derivatives, portions or proportions of nominal amounts and one-sided risks (e.g., a hedge against price movements in only one direction). What is carried forward from IAS 39? Hedges of net investments The mechanics of cash-fow hedge accounting The requirement to formally designate and document hedge relationships The requirement to record in proft or loss any hedge ineffectiveness that actually arises The restriction that prohibits the designation of risk components whose cash fows would exceed those of the hedged item as a whole The restrictions that prohibit the use of internal derivatives (e.g., contracts between entities forming part of the same reporting entity) and intra-group monetary items (transacted between two group entities with different functional currencies) as hedging instruments On discontinuation of cash fow hedges, the amounts recorded in OCI are carried forward to the extent that the hedged item is still expected to occur and recycled to proft or loss when the hedged item affects proft or loss Groups and net positions The ED sets out proposals for accounting for hedges of closed portfolios which do not change over the period of the hedge. To be eligible for hedge accounting, an entity must demonstrate that it manages the items on a group basis for risk management purposes. Other qualifcation criteria applicable to individual hedged items must also be satisfed (for example, eligibility of the hedged items and hedging instruments; hedge effectiveness requirements; and documentation; etc). Groups of items may contain either fnancial or non-fnancial items, existing (frm commitments) or anticipated (forecast) transactions, and may be hedged by way of either a fair value hedge or a cash fow hedge. Helpfully, the change in fair value of individual hedged items need not be proportional to that of the overall group (unlike in IAS 39), but all items must be subject to the same hedged risk. A combination of two or more gross groups could give rise to a net position. Consistent with IAS 39, the ED permits net positions to be hedged, only as long as the gross amounts are designated as hedged items (so it will not be suffcient to designate just the net amount). Some restrictions will be placed in respect of eligible groups, for example, net cash fows would only be eligible for hedge accounting if the offsetting cash fows affect proft or loss in the same reporting periods (including interim periods). Portions (or layers) of the entire item would also be eligible in certain situations. The examples of layers provided in the application guidance include: 50,000 cubic metres of the natural gas stored in location XYZ Or The frst 100 barrels of the oil purchases in June 201X However, a layer of a contract that includes a prepayment option is not eligible to be designated as a hedged item if the prepayment options fair value is affected by changes in the hedged risk (although the application guidance suggests that this restriction is only applicable for fair value hedges). Open portfolios The proposals for closed portfolios should be seen as a step towards developing a more sophisticated portfolio hedge accounting model, to deal with open portfolios in which the hedged items change continuously over time, along with adjustments to the instruments used to hedge the risks to rebalance the hedge relationship. 4 Hedge accounting under IFRS all set for change Banks and fnancial institutions typically manage their interest rate risk exposures on a net basis at a portfolio (or macro) level, giving rise to fundamental differences between the requirements in the existing standard and actual hedging practices. Portfolio hedging is a contentious topic and has been debated at length and over many years by the IASB and the banking industry. Although some of the banks concerns were dealt with in previous revisions to IAS 39, many were not dealt with fully. For example, there are signifcant restrictions in the way in which fair values of fnancial liabilities with a demand feature are measured that prevent banks from applying fair value hedge accounting to the majority of their current accounts. Although the goal for hedge accounting is a better and stronger link with risk management, in this particular case, the differences between risk management and hedge accounting are signifcant. For risk management purposes, on-demand deposits are typically risk-managed based on their expected withdrawal behavior, which is typically later than the contractual maturity. Under IAS 39, such deposits can never have a fair value less than the claim amount, making them ineligible for fair value hedge accounting. The Board has just commenced its discussions on a macro hedge accounting model for open portfolios. Consequently, no new rules are proposed in the ED for macro hedging. Instead, a separate exposure draft is expected later in 2011. Hedging instruments Time value of options The use of options as hedging instruments has been problematic under IAS 39. For hedges involving fnancial options, both IAS 39 and the ED give entities the choice to: (a) designate the option as a hedging instrument in its entirety; or (b) separate the time value of the option and designate as the hedging instrument only (the change in) its intrinsic value. It is usual to apply choice (b), in which case, the time value of the option has to be recorded at fair value through proft or loss. Consequently, there can be signifcant volatility in the recorded proft or loss. The ED proposes to resolve this issue by accounting for the time value of options by making a distinction between two types of hedged items: Transaction related (e.g., the forecast purchase of a commodity) Time period related (e.g., hedging price changes affecting commodity inventory) For both transaction-related and time- period-related hedged items, the cumulative change in fair value of the options time value would initially be accumulated in Other Comprehensive Income (OCI). In the former case, the amount is removed from OCI and included in the initial cost or other carrying amount of the hedged item. In the latter case, the amount is recycled from OCI to proft or loss, in order to amortise the original time value of the option over the term of the hedging relationship. 5 Hedge accounting under IFRS all set for change Other changes IAS 39 restricts the eligibility of cash (i.e., non-derivative) fnancial instruments as hedging instruments to hedges of foreign currency risk. The ED proposes to allow cash instruments classifed at fair value through proft or loss to be considered as hedging instruments for any risk. The ED proposes that derivatives that are embedded in hybrid contracts, but not separately accounted for, cannot be designated as hedging instruments. Hedge effectiveness assessment The objective of the hedge effectiveness assessment is to ensure that the hedging relationship will produce an unbiased result (i.e., there is no expectation that changes in the value of the hedging instrument will systematically either exceed or be less than the change in value of the hedged item) and minimise expected hedge ineffectiveness. Therefore, a hedging relationship cannot refect a deliberate mismatch between the weightings of the hedged item and the hedging instrument (the hedge ratio) that would create hedge ineffectiveness. It is also necessary to demonstrate that any expected offsetting between changes in the fair value or cash fows of the hedging instrument and the hedged items is not accidental. This is done by analysing the economic relationship between the hedged item and hedging instrument. However, this does not mean that a hedging relationship has to be expected to be perfectly effective in order to qualify for hedge accounting. The assessment will be prospective and needs to be performed at inception on an ongoing basis (note: IAS 39 requires both prospective and retrospective assessments). The type of assessment quantitative or qualitative will depend on the relevant characteristics of the hedging relationship and the potential sources of ineffectiveness. The bright-line test of 80-125% for hedge-effectiveness testing currently required by IAS 39 will be eliminated, and there will be no target level for achieving hedge accounting. For quantitative assessment, the ED does not prescribe any specifc method for the effectiveness assessment (percentage based or statistical methods can be used). If there are changes in circumstances that affect hedge effectiveness (an example might include a shift in the basis risk between the hedge and hedged item), an entity may have to change the method for assessing whether a hedging relationship meets the hedge effectiveness requirements (e.g., by moving to a quantitative approach). If this occurs, the entity also needs to ensure that the relevant characteristics of the hedging relationship including the sources of hedge ineffectiveness are still captured. According to the ED, the main source of information to perform the hedge effectiveness test will be the risk management information used for decision-making purposes. Hedge ineffectiveness measurement All ineffectiveness arising from the hedge relationship will be recognised in proft or loss. It will be calculated using the dollar offset method i.e., the difference between the change in the fair value of the hedging instrument and the change in the fair value of the hedged item attributable to the hedged risk. The effect of time value of money must be considered when determining the changes in fair value. Discontinuation of a hedging relationship Discontinuation of hedge accounting will be mandatory (on a prospective basis) if the risk management objective changes. Conversely, voluntary de-designation will not be permitted when the risk management objective remains the same. In some situations, there may be no change in the risk management strategy, but some of the variables affecting the hedging relationship may change such that the qualifying criteria (particularly the effectiveness assessment test) are no longer met. In such situations, the hedge relationship must be rebalanced to refect the new hedge ratio. This is treated as a continuation of the hedge relationship. The own use exception The accounting for commodity contracts under current IFRS can result in an accounting mismatch because it may not be aligned with how some entities manage risk within the context of their business models. Many commodity buyers and sellers manage their overall commodity risk position on a fair value basis even though they buy or sell for their own use These contracts are excluded from IAS 39 and, therefore, may not be recorded on a fair value basis. The Board considered feedback from these entities and agreed that hedge accounting is not an effcient solution in such cases because entities manage a net position of derivatives, executory contracts and physical long positions in a dynamic fashion. The ED proposes that derivative accounting may be applied to contracts that would otherwise meet the own use scope exception, if that is in accordance with the entitys fair value-based risk management strategy, in order to avoid a mismatch or complex hedge accounting. 6 Hedge accounting under IFRS all set for change Fair value hedge mechanics The ED proposes to change the mechanics of how fair value hedges are presented in the fnancial statements: The cumulative gain or loss on the hedged item attributable to the hedged risk will be presented as a separate line item in the balance sheet next to the line item that includes the hedged asset or liability, while the carrying amount of the hedged item will remain unadjusted. The fair value change of both the hedging instrument and the hedged item will be recognised in other comprehensive income (OCI) and any difference (ineffectiveness) will be transferred to proft or loss immediately. Routing the fair value changes through OCI has no net effect since the net impact in OCI for any period would be zero. However, the Board expects that users will beneft if all the effects of hedge accounting are presented in one place in a primary statement. Disclosures The ED proposes signifcant changes to IFRS 7 Financial instruments: Disclosures to provide a better link between the entitys risk management strategy and how it is applied to manage the risk, how the entitys hedging activities may affect the amount, timing and uncertainty of its future cash fows, and the effect that hedge accounting has had on the entitys fnancial statements. The effects of hedge accounting on the primary statements will have to be disclosed in some detail using a tabular format (by type of risk and type of hedge). All of the disclosures required by the ED are to be presented in a single note or a separate section of the fnancial statements. Transition and effective date The new hedge accounting requirements will be applicable prospectively, with no restatement of comparative fgures (or requirement to give the disclosures for the comparative period). For entities that already apply IFRS, it is expected that almost all of the previous hedge accounting relationships under IAS 39 would still qualify under the proposed model. They would be regarded as continuing hedges and, hence, would not involve a discontinuation and restart. However, although not many such situations are envisaged, previous hedge- accounting relationships that do not qualify under the proposed model would need to be discontinued. There are no changes proposed to the transition requirements in IFRS 1 First-time Adoption of IFRS. It is proposed that application of the standard will be mandatory for annual periods beginning on or after 1 January 2013, with earlier application permitted. Nevertheless, the ED states that the feedback from an ongoing consultation on effective dates for new standards will be considered in fnalising the mandatory effective date of the new standard. As with other phases of the fnancial instruments project, the new hedge accounting model can only be adopted together with all other IFRS 9 requirements that were fnalised earlier. However, early adoption of previously fnalised IFRS 9 requirements (such as classifcation and measurement) will not necessitate early adoption of the fnal hedge accounting requirements. 7 Hedge accounting under IFRS all set for change Business impact Overall, we consider that a principles- based approach to hedge accounting is conceptually preferable and consistent with the IASBs objective to simplify and reduce complexity under the new standard. While fnancial reporting will be more aligned to risk management, the proposals also place a greater onus on entities to manage their hedge relationships in line with their risk management approach. The ED is likely to have a signifcant impact on those entities that already apply hedge accounting, as well others that use economic hedging practices, but are currently unable to refect this in their fnancial statements. The most signifcant beneft may be for non-fnancial services entities, because hedge accounting will be permitted for components of non-fnancial items. Banks and fnancial institutions also stand to gain from the new proposals, because hedge effectiveness testing will be much simpler and will only be required on a prospective basis, qualitative testing will be possible where appropriate and there will be no arbitrary bright lines. However, one of the main hedging issues for banks is macro (portfolio) hedging for which no changes are yet proposed in the current ED. Although the proposals reduce the complexity of hedge accounting, the transition to the new standard will require a full assessment of all hedging relationships whether for economic or hedge accounting purposes, to determine how to apply the changes. It is important that all entities assess the impact of the proposals and provide feedback to the IASB within the comment period. We will bring you an in-depth analysis of the implications of the ED in January 2011. The 90-day comment period ends on 9 March 2011 In line with Ernst & Youngs commitment to minimise its impact on the environment, this document has been printed on paper with a high recycled content. This publication contains information in summary form and is therefore intended for general guidance only. It is not intended to be a substitute for detailed research or the exercise of professional judgment. 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