Hedge Accounting: IAS 39 vs. IFRS 9

Business world as of today presents a huge amount of various risks to almost every company or entrepreneur. I’m sure that also your company faces at least some of these risks: foreign currency risk, price risk, inflation risk, credit risk – just name it.

Many businesses decided to do something about these risks and started to manage their exposures. How?

They undertake various risk management strategies. In most cases, companies acquire certain derivatives or other instruments to protect themselves.

What is a hedging?

A hedging is making an investment or acquiring some derivative or non-derivative instruments in order to offset potential losses (or gains) that may be incurred on some items as a result of particular risk.

Example of a hedge

As an example, imagine your company that normally operates is USD. Recently, your company has decided to spread its business to Europe and made a contract to sell some goods to European customer for let’s say 20 million EUR with delivery in 9 months.

However, your company is afraid that due to movements in foreign currency rates it will get significantly less USD after 9 months and therefore, it enters into offsetting foreign currency forward contract with bank to sell 20 mil. EUR for some fixed rate after 9 months.

What’s the hedge here?

Hedged risk is a foreign currency risk.

Hedged item is a highly probable forecast transaction (sale).

Hedging instrument is a foreign currency forward contract to sell EUR for a fixed rate at a fixed date.

What is a hedge accounting?

A hedge accounting means designating one or more hedging instruments so that their change in fair value offsets the change in fair value or the change in cash flows of a hedged item.

Let’s explain it on our example: how would you account for a change in fair value of the above foreign currency forward?

Without hedge accounting, any gain or loss resulting from the change in fair value of foreign currency forward would be recognized directly to profit or loss.

With hedge accounting, this hedge would be accounted for as a cash flow hedge. It means that you would recognize full or a part of gain or loss from foreign currency forward directly to equity (other comprehensive income).

As you can see, the impact of the same foreign currency forward contract on profit or loss statement with hedge accounting can be significantly lower than without it.

Why hedge accounting?

First of all, hedge accounting is NOT mandatory. It is optional, so you can select not to follow it and recognize all gains or losses from your hedging instruments to profit or loss.

However, when you apply hedge accounting, you show to the readers of your financial statements:

• That your company faces certain risks.
• That you perform certain risk management strategies in order to mitigate those risks.
• How effective these strategies are.

In fact, with hedge accounting, your profit and loss statement is less volatile, because you basically match these gains and losses with gains / losses on your hedged item.

Why do hedge accounting rules change?

Hedge accounting rules in IAS 39 are just too complex and strict. Many companies that actively pursued hedging strategies could not apply hedge accounting in line with IAS 39 because the rules did not allow it.

Therefore, investors often required preparation of non-audited “pro-forma” information. Thus a company’s accountants might have ended with a task to prepare 2 sets of financial statements:

1. Audited financial statements where no hedge accounting was applied due to not meeting the rules in IAS 39.
2. Non-audited, pro-forma financial statements with applied hedge accounting to reflect true risk management situation.

As a result, new hedging rules in IFRS 9 were issued on 19 November 2013.

What do IAS 39 and IFRS 9 have in common?

There are several major points that remained almost the same:

1. 1. Optional
      A hedge accounting is an option, not an obligation – both in line with IAS 39 and IFRS 9.
   2. Terminology
      Both standards use the same most important terms: hedged item, hedging instrument, fair value hedge, cash flow hedge, hedge effectiveness, etc.
   3. Hedge documentation
      Both IAS 39 and IFRS 9 require hedge documentation in order to qualify for a hedge accounting.
   4. Categories of hedges
      Both IAS 39 and IFRS 9 arrange the hedge accounting for the same categories: fair value hedge, cash flow hedge and net investment hedge. The mechanics of the hedge accounting is basically the same.

1. Hedge ineffectiveness
   Both IAS 39 and IFRS 9 require accounting for any hedge ineffectiveness in profit or loss. There is an exception related to hedge of equity investment designated at fair value through other comprehensive income in line with IFRS 9: all hedge ineffectiveness is recognized to other comprehensive income.
2. No written options
   You cannot use written options as a hedging instrument in line with both IAS 39 and IFRS 9.

Differences in hedge accounting between IAS 39 and IFRS 9

The basics of hedge accounting have not changed. In my opinion the major change lies in widening the range of situations to which you can apply hedge accounting.

In other words, under new IFRS 9 rules, you can apply hedge accounting to more situations as before because the rules are more practical, principle based and less strict.

Let’s go through the most important changes:

1. What can be used as a hedging instrumentUnder older rules in IAS 39, companies did not have much choices of hedging instruments. Either they took some derivatives, or alternatively they could take also non-derivative financial asset or liability in a hedge of a foreign currency risk. Not much.IFRS 9 allows you to use broader range of hedging instruments, so now you can use any non-derivative financial asset or liability measured at fair value through profit or loss.

   Example: Let’s say you have large inventories of crude oil and you would like to hedge their fair value. Therefore you make an investment into some fund with portfolio of commodity – linked instruments.

   In line with IAS 39, you cannot apply hedge accounting, because in a fair value hedge, you can use only some derivative as your hedging instrument.

   In line with IFRS 9, you can apply hedge accounting, because IFRS 9 allows designating also non-derivative financial instrument measured at fair value through profit or loss. I assume your investment into the fund would meet this condition.

2. What can be your hedged itemWith regard to non-financial items IAS 39 allows hedging only a non-financial item in its entirety and not just some risk component of it.IFRS 9 allows hedging a risk component of a non-financial item if that component is separately identifiable and measurable.

   Example: an airline might face significant price risk involved in jet fuel. The prices of jet fuel might change due to several reasons: rising inflation, changing crude oil price and many other factors. Therefore, an airline might decide to hedge only a benchmark crude oil price risk component included in the price of jet fuel. Such a hedging might be performed by acquiring commodity forward contracts to buy crude oil.

   

   In line with IAS 39, an airline would not have been able to account for this commodity forward contract as for a hedge. The reason is that an airline’s hedged item is just one risk component of a non-financial asset (jet fuel) and IAS 39 allows hedging non-financial items only in their entirety.

   In line with IFRS 9, an airline can apply hedge accounting because IFRS 9 allows designating separate risk component of non-financial item as a hedged item.

3. Testing hedge effectiveness
   Testing the hedge effectiveness significantly simplified and came closer to the risk management needs.IFRS 9 enables an entity to use information produced internally for risk management purposes and stopped forcing to perform complex analysis required only for accounting purposes.IAS 39 requires testing hedge effectiveness both prospectively and retrospectively. A hedge is highly effective only if the offset is in the range of 80-125 percent. It means that if a company applies IAS 39, its accountants must perform numerical test of effectiveness – often these tests were performed solely in order to meet IAS 39 and for no other reason.IFRS 9 outlines more principle-based criteria with no specific numerical thresholds. Namely, a hedge qualifies for hedge accounting if:
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   • There is an economic relationship between the hedging instrument and the hedge item.
     This relationship requires some judgment supported by a qualitative or a quantitative assessment of the economic relationship.
   • The effect of credit risk does not dominate the value changes that result from that economic relationship.
   • The hedge ration is designated based on actual quantities of hedged item and the hedging instrument.
4. RebalancingRebalancing a hedge means modifying the hedge by adjusting a hedge ration for risk management purposes. It’s usually performed when the quantities of a hedge instrument or a hedged item change.In a similar situation, IAS 39 required terminating the current hedge relationship and starting the new one. In practical terms, you would have to start all over again: prepare a hedge documentation, assess its effectiveness etc.IFRS 9 makes it easier, because it allows certain changes to the hedge relationship without necessity to terminate it and to start the new one.
5. Discontinuing hedge accountingIAS 39 allowed companies to discontinue hedge accounting (except for other circumstances) voluntarily, when the company wants to.On the other hand, IFRS 9 does not allow terminating a hedge relationship voluntarily, so once you decide to apply hedge accounting under IFRS 9, you cannot discontinue it unless the risk management objective changed, the hedge expired or is no longer eligible.
6. Other differencesThere is a number of other differences between hedge accounting under IAS 39 and IFRS 9. Just to name a few of them:
   • Possibility to apply hedge accounting to exposures that give rise to two risk positions that are managed by separate derivatives over different periods – new in IFRS 9.
   • Less profit or loss volatility when using options and / or forwards.
   • Option to account for “own use” contracts to buy or sell a non-financial item at fair value through profit or loss if it eliminates accounting mismatch– new in IFRS 9.
   • More alternatives for hedges of credit risk using credit derivatives

Please watch the following video about the hedging under IAS 39 and IFRS 9 here:

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