Hedge Accounting

Hedge accounting under IFRS all set for change

IntroductionReducing complexity has become a familiar term to those who follow the International Accounting Standard Boards (the IASB or the Board) project on financial 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 financial and non-financial items, if separately identifiable 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 qualifies (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 profit 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 significant new disclosure requirements

ey.com/IFRS

Issue 91 / December 2010

Supplement to IFRS Outlook

2Hedge accounting under IFRS all set for change

WhatarethemaindifficultiesunderIAS39?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 conflicting) 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 find that they are unable to fully reflect this fact in their financial statements because of the rule-based nature of the existing hedge accounting requirements. In addition, analysts and other users find information relating to an entitys risk management strategy and practices to be valuable, but this information may not be clearly reflected in the financial 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 inabilitytohedgespecificcomponents of non-financial 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 refined 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-financial items, an entity can only hedge either the foreign currency risk or the entire non-financial 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 specified 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 reflected in financial reporting.

Designating groups of hedged items is a challenge under the current rules because many criteria need to be satisfied. 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 financial reporting and an entitys risk management.

Other criticisms include the onerous requirements to perform quantitative effectiveness tests, insufficient guidance on how to quantify hedge effectiveness and bright-line tests that give rise to arbitrary results and severe consequences.

Canhedgeaccountingbecompletelydispensedwith? 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 find it helpful to use hedge accounting to address measurement mismatches. For example, a mismatch could arise when the hedged item (such as a fixed 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 flows that are not yet recorded in the financial statements.


Highlights of the EDThe ED states that the objective of hedge accounting is to represent, in the financial statements, the effect of an entitys risk management activities which use financial instruments to manage exposures arising from particular risks that could affect profit or loss.

Hedged itemsRisk components may be designated as hedged items if they are separately identifiable and reliably measurable. Risk components could be part of a financial or non-financial item and may or may not be contractually specified. Entities could, therefore, choose to apply hedge accounting to particular risks of a non-financial item, as opposed to the current need to designate the entire item.

The two examples of risk components in non-financial 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 IAS39? Hedges of net investments

The mechanics of cash-flow hedge accounting

The requirement to formally designate and document hedge relationships

The requirement to record in profit or loss any hedge ineffectiveness that actually arises

The restriction that prohibits the designation of risk components whose cash flows 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 flow hedges, the amounts recorded in OCI are carried forward to the extent that the hedged item is still expected to occur and recycled to profit or loss when the hedged item affects profit 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 qualification criteria applicable to individual hedged items must also be satisfied (for example, eligibility of the hedged items and hedging instruments; hedge effectiveness requirements; and documentation; etc). Groups of items may contain either financial or non-financial items, existing (firm commitments) or anticipated

(forecast) transactions, and may be hedged by way of either a fair value hedge or a cash flow 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 sufficient to designate just the net amount). Some restrictions will be placed in respect of eligible groups, for example, net cash flows would only be eligible for hedge accounting if the offsetting cash flows affect profit 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 first 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.


Banks and financial 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 significant restrictions in the way in which fair values of financial 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 significant. 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 financial 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 profit or loss. Consequently, there can be significant volatility in the recorded profit 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 profit or loss, in order to amortise the original time value of the option over the term of the hedging relationship.


Other changes

IAS 39 restricts the eligibility of cash (i.e., non-derivative) financial instruments as hedging instruments to hedges of foreign currency risk. The ED proposes to allow cash instruments classified at fair value through profit 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 assessmentThe 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 reflect 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 flows 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 specific 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 measurementAll ineffectiveness arising from the hedge relationship will be recognised in profit 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 relationshipDiscontinuation 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 reflect the new hedge ratio. This is treated as a continuation of the hedge relationship.

The own use exceptionThe 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 efficient 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.


Fair value hedge mechanics The ED proposes to change the mechanics of how fair value hedges are presented in the financial 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 profit 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 benefit if all the effects of hedge accounting are presented in one place in a primary statement.

DisclosuresThe ED proposes significant 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 flows, and the effect that hedge accounting has had on the entitys financial 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 financial statements.

Transition and effective dateThe new hedge accounting requirements will be applicable prospectively, with no restatement of comparative figures (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 finalising the mandatory effective date of the new standard.

As with other phases of the financial instruments project, the new hedge accounting model can only be adopted together with all other IFRS 9 requirements that were finalised earlier. However, early adoption of previously finalised IFRS 9 requirements (such as classification and measurement) will not necessitate early adoption of the final hedge accounting requirements.


Business impactOverall, 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 financial 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 significant impact on those entities that already apply hedge accounting, as well others that use economic hedging practices, but are currently unable to reflect this in their financial statements. The most significant benefit may be for non-financial services entities, because hedge accounting will be permitted for components of non-financial items. Banks and financial 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

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Hedge Accounting

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