“Simplifying hedge accounting” by Josephine Adrienne A. Abarca (March 21, 2011)

SUITS THE C-SUITE By Josephine Adrienne A. Abarca
Business World (03/21/2011)

In today’s increasingly complex world of financial uncertainty, risk mitigation has become a key corporate strategy. Increased volatility in interest rates, foreign exchange rates and commodity prices have encouraged — some might even say pushed — more companies to go into derivative transactions. Derivatives have become a very important risk management tool.

Simply put, a derivative is a financial contract whose value depends on the value of one or more underlying assets or indices (e.g., an interest rate, foreign exchange rate, or commodity price). Common derivative contracts are forwards, swaps, futures and options. A company uses a derivative contract to manage its exposure to changes in the value of the underlying asset or index.

Unfortunately, most companies that enter into derivative transactions find themselves unable to reflect their hedged positions on their financial statements. This is because of the stringent hedge accounting rules of International Accounting Standard (IAS) 39, Financial Instruments: Recognition and Measurement.

IAS 39 hedge accounting requirements

Hedge accounting is a special accounting treatment that enables a company to capture in its financial statements the offsetting effect of the derivative and the hedged risk (i.e., matching the timing of profit or loss recognition on the derivative and the risk being hedged). Under IAS 39, hedge accounting is a privilege that is available only to companies that meet specific conditions.

The reality, however, is that most companies find the conditions imposed by IAS 39 too stringent, complex and, perhaps, even arbitrary.

IAS 39 restricts what items can be hedged and what hedging instruments can be used. It also imposes a threshold on the degree of offsetting (referred to in the standard as “hedge effectiveness”) between the hedged item and the hedging instrument. Specific and formal designation of the hedging relationship and regular hedge effectiveness assessment are also part of the hedge accounting requirements.

Failure to comply with any one of the conditions would prevent a company from qualifying for hedge accounting treatment. This poses a concern since non-hedge treatment would result in volatility in earnings — i.e., the derivative will be recognized at fair value on the balance sheet, with fair value changes recognized in profit or loss, while the hedged item may simply be carried at cost (or even off-books if the hedged item is still a forecasted transaction). This is somewhat ironic, as such volatility implies greater exposure to the risks against which the company was precisely trying to hedge itself.

Proposed changes to hedge accounting

The International Accounting Standards Board (IASB) saw the need to do a fundamental review of its hedge accounting rules. As part of its project to revise the rules on accounting for financial instruments, the IASB also began revising its hedge accounting rules. The guiding objective was to reduce the complexity of hedge accounting.

In December 2010, the IASB released the Exposure Draft-Hedge Accounting with proposals to substantially simplify hedge accounting rules. Although the IASB has not addressed the very important issue of macro hedging in the exposure draft, the hedge accounting model it proposes must be welcome news for companies, as it replaces the existing rule-based, complex and inflexible hedge accounting requirements with a simpler, principle-based approach.

Moreover, there will be better alignment between hedge accounting and a company’s economic hedging activities. With the proposed changes, a company should be better able to reflect on its financial statements how it manages its risks, and the extent to which its hedging transactions mitigate those risks.

The key improvements of the proposed hedge accounting model can be summarized as follows:

• no more arbitrary 80%-125% retrospective effectiveness testing to qualify for hedge accounting;

• Risk components of both financial and non-financial items can be hedged items — a significant change, particularly for hedging commodity risks;

• Eligible hedge items are now expanded to include combinations of derivatives and non-derivatives, as well as portions or layer components of individual financial and non-financial items;

• ability to use qualitative effectiveness testing in some circumstances;

• Rebalancing (which is a common risk management technique) will not necessarily result in de-designation and re-designation; the consequential ineffectiveness that arises due to nonzero fair value derivatives on re-designation can therefore be avoided;

• Proportional de-designation/partial discontinuation is now possible in some instances;

• There are significant relaxations of the rules relating to hedges of groups of gross or net positions as well as layer components of gross groups;

• Option premiums (time value of options) can be deferred in equity and are either included in the cost of the hedged item or amortized to profit or loss; and

• ‘Own use’ commodity contracts can be fair-valued in certain circumstances if managed on a fair value basis rather than applying hedge accounting.

The comment period for the exposure draft ended last March 9 and the IASB is expected to release a final draft by middle of this year. The much-anticipated proposals on macro hedging may also come out within 2011. The expected effective date for the IASB’s new hedge accounting rules would be in 2013.

It should be highlighted, though, that even with the proposed changes above, not all economic hedges are expected to qualify for hedge accounting. This is because the proposed model still prescribes rules, albeit much less stringent than IAS 39, on what can be a hedging instrument, what may be a hedged item, and what sorts of relationships can qualify for hedge accounting. Still, the proposed changes are significant enough, and companies can look forward to a relatively simpler hedge accounting model in the future. Companies should start looking at the proposed model now to better identify how current and anticipated hedging activities can complement their requirements.

(Josephine Adrienne A. Abarca is a Partner of SGV & Co.)

This article was originally published in the BusinessWorld newspaper. It is for general information only and is not a substitute for professional advice where the facts and circumstances warrant. The views and opinion expressed above are those of the author and do not necessarily represent the views of SGV & Co.