Publication: Bank Asset / Liability Management
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On July 24, 2014, the IASB issued IFRS 9 which addresses accounting for financial instruments. The standard has a mandatory effective date for annual periods beginning on or after January 1, 2018 with earlier implementation dates permitted. IFRS 9 represents a significant overhaul to hedge accounting, compared to IAS 39, and better aligns the accounting treatment with an organization’s risk management activities.
While many organizations have been working diligently to implement IFRS 9 in advance of its mandatory effective date, there is still some confusion on how IFRS 9 differs from IAS 39. The table on page 2 summarizes some of the changes that are relevant to hedge accounting that bank asset/liability managers can expect when switching from IAS 39 to IFRS 9.
Despite the significant overhaul with IFRS 9, some concepts found in IAS 39 have been preserved; these include the following:
The three types of hedges remain the same - cash flow hedge, fair value hedge, and a hedge of a net investment in a foreign operation.
Hedge effectiveness is still measured and all inefficiencies are recognized in profit and loss.
Hedge documentation is still required to be maintained.
Due to its complexity, time requirement and resource requirement, successful IFRS 9 implementation is expected to be challenging for those that hedge and want the favorable
accounting treatment available from IFRS 9. Given this, many organizations started early with implementation programs and many also chose to early adopt IFRS 9. Those that have
delayed implementation of IFRS 9 can learn from those that chose to early adopt. The benefits that appear to be most appreciated by those that chose early adoption are reduced P&L volatility, more risk management options and a general competitive advantage. Below is more detail on the benefits the early adopters are realizing.
Reduced Profit & Loss Volatility
Many hedges that did not qualify for hedge accounting treatment under IAS 39 may now qualify under IFRS 9. Under IFRS 9, organizations may be able to designate the component of a non-financial item in a hedge. Doing this, P&L volatility can be reduced as the changes in fair value
of the derivative likely can be posted to equity. To do this, it is necessary that the component of the non-financial item be separately identified and reliably measured.
Additional Risk Management Options
Under IAS 39 many organizations did not hedge with instruments that included optionality. One of the primary reasons for this was the fact that the time value of the option had to be posted in P&L, thus introducing unwanted volatility to earnings. IFRS 9 allows cost of hedging to be treated as a separate component of equity. Costs of hedging includes the time value of options, as well as currency basis and forward points, introducing more creative hedging strategies as viable risk management tools. Among early adopters of IRFS 9, there has been an increase in the use of options for hedging purposes.
Many early adopters of IFRS 9 have moved away from hedging risk on a silo basis to applying dynamic risk management approaches. By being able to assess correlations among exposures in multiple asset classes through detailed analytics, organizations are able to better understand their respective drivers of risk. This helps those responsible for risk management to avoid over-hedging, to decrease their cost of hedging and to limit their counter-party risk.
While many organizations have been working diligently to implement IFRS 9 in advance of its mandatory effective date, there is still some confusion on how IFRS 9 differs from IAS 39.
When an entity has decided to take advantage of the favorable accounting treatment available from applying hedge accounting under IFRS 9, one item of particular importance is for the hedger to create hedge documentation that considers current and future hedging strategies and maximizes the likelihood that the hedge will not fall out of effectiveness at some point in the future. While IFRS
9 does not specifically define hedge documentation, what should be written into the document each time a new hedge is established are the following:
The risk management objective and why the hedge was established.
Details on the hedging instrument.
Details on the hedged item.
Explanation of what risk is being protected against.
The type of hedge that is being established (cash flow, fair value or net investment in a foreign operation).
How hedge effectiveness will be assessed (quantitative versus qualitative testing, and details on the testing methodology).
One of the biggest mistakes that organizations make is to apply hedge accounting without sufficient or well thought out documentation. If the documentation is insufficient from the beginning, this usually will be discovered by the company’s external auditor, and they will not allow for the
favorable accounting treatment available under IFRS 9, in the company’s financial statements.
Another common mistake is creating hedge documentation that is overly specific, or too general, both of which can cause an entity to have to de-designate a hedge, and no longer realize the benefit of hedge accounting. Considering how the hedging program may evolve over time should be
considered and drafted into the hedge document to provide adequate flexibility and minimize the risk of de-designation.
Another common mistake is to create the hedge documentation subsequent to the hedging program’s start. While the IFRS 9 accounting guidance does not define a fixed period of time when the documentation should be established, it is best practice to prepare the hedge document at
the inception of when the hedge is put in place. For those that are running a dynamic hedging program, the hedge documentation can be satisfied by creating a master hedge document that broadly covers the entire dynamic hedging program, and to create separate addendums when each new hedge is established. This can cut down on the cost and time that goes into hedge documentation.
The other decision that must be considered is whether to have the hedge accounting prepared internally or outsourced. The hedge accounting tasks can be broken into two distinct categories - pre-hedge implementation and post-hedge implementation. A company can decide to handle all of these tasks internally, handle some internally and outsource the rest, or to outsource all activities.
The scope of this article does not discuss the benefits of outsourcing these tasks versus maintaining these tasks internally, but rather to highlight the need to decide who will do what. It is not uncommon for a company to work with an outside consultant to establish the hedge accounting
program and prepare the hedge documentation, and for the company to handle the quarterly testing and reporting.
However, some companies may find the quarterly testing and reporting to be burdensome and a poor use of resources, and instead outsource to a company that has systems to efficiently accomplish this work. The point being that every company will have unique needs. These needs must be understood prior to implementing a hedge accounting program, and decisions need to be made to assign responsibilities.
In summary, IFRS 9 creates a unique opportunity for organizations that have avoided hedging because they could not get the favorable accounting treatment, or did economic hedging and accepted the introduction of volatility to their earnings. Through the enhancements provided by IFRS 9, many more organizations will now be able to realize the benefits that come from favorable accounting treatment that is achieved when properly applying hedge accounting.
Heidi Lindahl - marketing manager