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TMI | Issue 222 33

T he IASB issued the hedging chapter of IFRS 9,‘Financial instruments’, in November 2013. This wasgenerally considered good news for treasury. Hedge

accounting has not only become easier but also more alignedwith risk management in the business. To summarise some ofthe changes and the key points covered in our article lastmonth (TMI issue 221):

� More instruments may qualify as hedging instruments. Besidesderivatives and financial instruments for currency risk, non-derivative instruments that are carried at fair value through profitor loss may also be designated as hedging instruments in future.

� More items may qualify as hedged items. The most importantnew items are risk components of non-financial items (e.g., LMEcomponent of a purchase of an item containing aluminum),aggregated exposures, (e.g., an investment in a portfolio ofshares, with shares in different industries), net positions andcombinations of derivatives and non-derivatives (e.g., a fixed-rate loan combined with an interest rate swap) that all nowqualify as hedged items.

IFRS 9 Hedging – Was it Worth the Wait?by Clarette du Plooy, Director, Corporate Treasury Solutions, Kees-Jan de Vries,Director, Capital Markets and Accounting Advisory Services and Aliénor Fromont,Assistant Manager, Capital Markets and Accounting Advisory Services, PwC

� Hedge documentation is still required in order to qualify for hedgeaccounting.

� Hedge effectiveness criteria have been simplified but still exist. Forthe criteria to be met, an entity has to show that an economicrelationship exists between the hedged item and the hedginginstrument and that credit risk does not dominate the relationship.In addition, a hedge ratio has to be defined, which may changethroughout the life of the relationship according to marketdevelopments.

In this article, we will be discussing in more detail hedging withoptions and forwards, the journal entries relating to hedgeaccounting under IFRS 9, alternatives to hedge accounting andtransition and disclosure requirements.

Hedging with options and forward contracts

IAS 39 allows applying hedge accounting for purchased options.However, under IAS 39, the change in time value of the optionalways had to be directly recorded in profit or loss. Under IFRS 9 this

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34 TMI | Issue 222

is different. Changes in the time value of anoption can now be deferred in OtherComprehensive Income (OCI) in equity if theoption is an effective hedging instrument ina hedge accounting relationship. The optionpremium (time value) paid upon purchase ofthe option can be recorded in the incomestatement at the same time that theunderlying hedged item affects profit orloss. This may reduce volatility in the incomestatement for entities that use hedgingstrategies involving options. For cash flow hedges, the amount that is

deferred in OCI will then be recognised inthe income statement in line with theunderlying hedged item. This can be overthe life of the option if the hedged item is‘time related’. As an example, consider thecase where a three-year interest rate cap ispurchased to hedge interest rate risk. Forthis type of hedge relationship, it makessense to amortise the premium paid overthe three-year period of the cap. If the option hedges a transaction that

will take place at a specific moment in time,this is called a ‘transaction related’ hedge. Inthis case, the amount of time value will bedeferred until the hedged transactionaffects profit or loss. As an example,consider the use of a currency optionhedging a future purchase in foreigncurrency. And assume the underlyinghedged item is a non-financial item, such asan item that is part of costs of goods sold,or an item of property, plant andequipment. IFRS 9 requires the totaldeferred amount in OCI with respect to thehedging instrument to be reclassified to theinitial cost of the item being hedged. Thiscan be inventory valuation, or the initialcost price of the property, plant andequipment item. Through the inventoryitem hitting the income statement as costsof goods sold, or the item of plant, propertyand equipment being depreciated, thehedging results end up in the incomestatement. The same distinction on thetreatment of time value for transaction-and time-related hedge relationships alsoapplies to hedging FX risk with currencyforward contracts.With respect to the amounts of time

value for options and currency forwardcontracts that may be deferred in OCI, IFRS9 introduces some notable differencescompared to IAS 39. As under IAS 39, it ispossible under IFRS 9 to use an option or acurrency forward contract in a hedgerelationship and only designate the change

in spot rate as the risk being hedged. Doinga ‘spot designation’ for hedging currencyrisk makes proving hedge effectivenesseasy. As explained in our previous article, itis allowed under IFRS 9 to prove hedgeeffectiveness by demonstrating that thecritical terms of the hedging instrumentand the hedged item match. If only thespot element of the forward contract isdesignated as a hedging instrument, thismeans comparing the nominal amount ofthe hedged item to that of the hedginginstrument. When it comes down to determining the

journal entries for an effective hedgerelationship, IFRS 9 is different from IAS39. For options, whether spot or forwarddesignation has been chosen, the amountof changes in fair value due to changes intime value that is allowed to be deferred inOCI has to be determined using the‘aligned time value’ approach. This alignedtime value should match the terms of thehedged item. Therefore, when the terms ofthe hedged item and the hedginginstrument (the option) do not match, thismay lead to a part of the change in timevalue being booked in profit or loss. Alsowhen applying spot designation, the timevalue that exists at the inception of thehedging relationship is amortised on asystematic and rational basis over theperiod to which the time value relates(time-period related or transactionrelated).Companies hedging with currency

forward contracts and choosing for a spotdesignation have two possibilities fordetermining the journal entries. The firstone is based on using an aligned forwardelement approach that is comparable to thealigned time value model when hedgingwith options. The second alternative is usingthe current IAS 39 spot designationapproach, where only the change in spotvalue of the currency forward is deferred inOCI and all other changes in fair value arebooked in profit or loss directly. Aninteresting addition in IFRS 9 is the fact thatthis approach may also be applied to thecurrency basis spread present in currencyforward contracts. Companies therefore have to keep in

mind the potential administrative burden ofdeferring in other comprehensive incomethe change in fair value of the forwardelement if the critical terms of the hedgeitem and the hedge instrument are not‘aligned’.

Journal entries relating tohedge accounting

For hedge relationships not involvingoptions and currency forwards, not muchhas changed. IFRS 9 still requires journalentries for effective cash flow hedgerelationships that are based on a‘cumulative dollar offset’ type of test. Insuch a test, the change in fair value of thehedging instrument is compared to thechange in fair value of the hedged item.The lower of the two (in absolute terms)can then be deferred in OCI. For fair valuehedges, the carrying amount of the hedgeditem can only be adjusted for the risk beinghedged as present in that hedged item. IFRS 9 provides some clear examples of

where accounting ineffectiveness mayoccur in hedge relationships that would bein line with an entity’s risk managementpolicy and to which hedge accounting canthus be applied. Examples given arehedging a debt in foreign currency (eitherfixed or variable rate debt). If in the cross-currency swap being used as hedginginstrument a currency basis spread ispresent, this cannot be taken into accountin measuring the change in fair value ofthe hedged debt. As such, the change infair value of the cross-currency swap dueto changes in the currency basis spread willend up directly in the income statement.Similarly, the effect of CVA and DVA may

end up in the income statement directly, asit cannot be taken into account in the itembeing hedged if it is not present in suchitem.The difference with IAS 39 is therefore

that currency basis spread and CVA/DVAwill not risk hedge relationships to be nolonger effective (end up outside of the 80-125% range under IAS 39). But in terms of

What do you have to donow?� Companies may want to considerwhether under IFRS 9 the use ofoptions as a hedging instrument ismore desirable now that theaccounting impact in profit orloss will be less volatile.

� Companies need to consider inwhich way to set up theaccounting models when hedgingwith forward contracts.

It is allowed

under IFRS 9

to prove

hedge

effectiveness

by

demonstrating

that the

critical terms

of the hedging

instrument

and the

hedged item

match.

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Entities will

have to

disclose how

they measure

effectiveness.

income statement volatility, the same (oreven more) accounting ineffectiveness willoccur under IFRS 9 as under IAS 39.With respect to hedging net positions

allowed under IFRS 9, it should be notedthat the hedging gains or losses should bepresented in a separate line in the incomestatement and cannot be presented on thelines affected by the hedged items. Thismeans that if an entity is hedging the netFX exposure between revenue and costs ofgoods sold, a separate line has to bepresented in the income statement with thehedging gains or losses. Revenue and costsof goods sold will remain to be booked atthe spot rates at which they occur.

Alternatives to hedgeaccounting

Another interesting aspect of IFRS 9 is the‘fair value option for financial liabilities’that is included in the recognition andmeasurement phase of IFRS 9 (refer to theparagraph below on transition rules for adescription of the different phases of IFRS9). In short, this fair value option makes iteasier for an entity to measure its ownliabilities at fair value through profit orloss. Such an option also exists under IAS39, but it can only be applied in certainconfined cases. This is due to the fact that,by using this option, the counterintuitiveeffect occurs that a decline in the entity’screditworthiness will lead to booking again due to the reduced fair value of theentity’s debt.Under IFRS 9, this option can be more

easily applied, but changes in the fairvalue of the liability that are caused bychanges in the entity’s own credit riskhave to be booked directly in OCI.

What do you have to donow?� Companies should understand thepossible impact on profit or lossof being able to assign moreeffective hedge relationshipswhile still being required to bookaccounting ineffectiveness.

� Companies should consider theimpact on income statementpresentation of applying hedgeaccounting to hedging netpositions.

Recording the entity’s own liabilities atfair value through profit or loss may posean alternative to applying hedgeaccounting in certain circumstances.However, the possible volatility in equityfrom changes in own credit risk should betaken into account.

Disclosures requirements

Users of financial statements oftenclaimed that the hedge accountingdisclosures in the financial statements arenot helpful and do not provide enoughtransparency on companies’ hedgingactivities. The IASB took this intoconsideration in the new standard andamended the disclosure requirements inIFRS 7 to provide more useful informationto the users of financial statements. The disclosure required remains lengthy

and will mean an increase compared tocurrent disclosure requirements. While it isnot possible to comment on all of thedisclosure, the following points are worthhighlighting:

� The new standard requires certaindisclosure to be made in risk categoriesthat the entity decides to hedge.However, the standard does notprescribe which categories to use andleaves that to management’s judgment.The objective of the categories is to helpthe user of the financial statements tounderstand how information in theprimary statements links to informationthat is not included in there but in otherparts of the notes – e.g., risk

management strategy.� Entities will have to disclose how theymeasure effectiveness. This includesinformation on how the economichedge relationship is determined, howthe hedge ratio is determined (andmonitored) and from which sourcesineffectiveness may be occurring. Inaddition, where ineffectiveness occurs,entities will have to explain this,including the source where theineffectiveness is coming from.

� In addition, entities need to explain howthey determine which components tohedge and what impact thesecomponents have on the full fair valueof the item being hedged.

� These requirements seem to include a lotof sensitive information. But actually, theexposure draft included at first a far morecontroversial requirement to disclosefuture exposures that are being hedged.

Figure 1 – Options for adopting IFRS 9

Option 1

Option 2

Option 3

Option 4

Apply only the new ’own credit risk’ model for financialliabilities at fair value through profit or loss

Apply only the classification and measurement rules forfinancial assets

Apply only classification and measurement for both financialassets and financial liabilities

Apply classification and measurement for financial assets andfinancial liabilities and also apply the new hedge accountingrequirements

Clarette du PlooyDirector, CorporateTreasury Solutions,PwC

Clarette du Plooy is aDirector based inSwitzerland. She has beenadvising clients acrossvarious countries andindustries on a broadspectrum of treasury matters including hedgingstrategies, policies, processes and accounting for morethan nine years.

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After a lot of comments on that proposeddisclosure, the IASB agreed that suchfuture exposures being hedged contain alot of ‘sensitive’ forward-lookinginformation. So the IASB amended therequirement to disclose how financialinstruments will affect future cash flowsand not the actual exposures.

� Lastly, it is worth mentioning that thenew tabular requirements on hedgeditems and hedging instruments shouldprovide more transparency to users, as itaims to bring all hedge accountingeffects together in a limited number oftables.

It is important to note that the abovementioned disclosures in IFRS 7 will beapplicable, even if the entity continues toapply IAS 39 (refer to the paragraph ontransition rules below).

Transition rules

For entities outside the EU, IFRS 9 isimmediately available for (early)application. Entities within the EU still needto wait for endorsement by the EU and it iscurrently unclear when this will happen.This is due to the fact that the IASB hassplit IFRS 9 in three separate phases. Thesephases are: 1) Classification andmeasurement, 2) Impairment and 3) Hedgeaccounting. Phase 1 has been issued by theIASB, but is currently again being changed.Phase 2 is still being drafted by the IASB.And phase 3 is out, but does not containthe sensitive ‘macro fair value hedgeaccounting model’ that is particularlyimportant to financial service entities. TheEU is likely to consider endorsement onlyafter at least all three phases of IFRS 9 arefinalised. This is also the reason why theIASB has recently removed the mandatoryeffective date for IFRS 9. The current transition rules are flexible.

Entities basically have a choice betweenany of the four options below when itcomes to the adoption of IFRS 9, ‘Financialinstruments’. For entities that are considering option

4, even more choices have to be made. Asstated, IFRS 9 does not currently deal withmacro fair value hedging. The IASB isworking on this, but it is unlikely to issuethe final macro hedging chapter in 2014.While this is not particularly relevant forCorporate Treasuries, some entities mayprefer to wait for either the exposure draft

What do you have to donow?� Start early to gather and prepareall the necessary information.

� Think of the disclosure from auser’s perspective. This should notonly be a compliance exercise butalso an opportunity to illustrateto users where risk comes from,how it is uniquely managed andlastly how it is reflected in theaccounting.

or the final standard on macro fair valuehedging before they decide on whetherthey want to adopt the IFRS 9 hedgingpart or not. However, the standard allowsfor an annual choice of:

1. Applying IFRS 9 hedging chapter as is2. Applying IFRS 9 hedging chapter andmacro hedging under IAS 39

3. Applying hedging rules under IAS 39(similar to option 3 above).

Of course, these different options arecurrently only relevant for entities outsideof the EU, as the rest will have to await EUendorsement first. As the IASB is stillworking on two phases of IFRS 9, this couldin future result to a change in the transitionrequirements.

Conclusion

The final IFRS 9 hedge accounting rules arein many ways an improvement to currentIAS 39. It will often be easier to prove thathedge accounting relationships areeffective. However, the detailed guidance inIFRS 9 on how accounting (in)effectivenesshas to be recorded may prove difficult toimplement in practice and may still result insignificant income statement volatility. Therequirements with respect to disclosuresappear to be more challenging than currentIFRS 7 as well. Transition rules for IFRS 9 are complex,

and there are many different scenarios thatmay be applied. But for the moment weneed to wait until the EU has endorsed thefinal IFRS 9 standards that have not yet allbeen published. The IASB has removed themandatory application date. We will keepyou informed once there will be more clarityon this. �

What do you have to donow?� Determine how important macrohedging is for the business andwhether you should wait for moredetail on that.

� Determine, in collaboration withyour accounting team, which IFRS9 adoption option is the mostbeneficial for your company.

� Determine the most appropriatetime for adopting.

Aliénor FromontAssistant Manager,Capital Markets andAccounting AdvisoryServices, PwC

Aliénor Fromont is a memberof the Corporate Treasurypractice in Amsterdam. Shehas almost six years ofexperience in auditing andadvising corporates on financial instruments and treasuryinternal controls.

Kees-Jan de VriesDirector, CapitalMarkets andAccounting AdvisoryServices, PwC

Kees-Jan de Vries is aDirector in the CorporateTreasury practice inAmsterdam. He has 13 yearsof experience in the field ofaccounting, valuation, auditing and internal controls forfinancial instruments in the corporate and utilitiesindustries. He also regularly teaches on these topics atclients, PwC and university.

For more guidance on IFRS 9 for corporate treasurers, pleasesee ‘Treasury research and insights’ atwww.pwc.com/gx/en/audit-services/corporate-treasury-solutions, ‘Hedge accounting – what will IFRS 9 mean foryou?’ or PwC’s YouTube channel for the same.

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