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On 1 January 2018 IFRS9 replaced IAS39 in Europe and other jurisdictions around the world. Now, treasurers and financial controllers can sleep better knowing that their hedging activities are better aligned to the economics of their transactions, and that avoiding P&L volatility will not require as much effort as under the now defunct IAS39…or can they?
Accounting practitioners and financial statements readers have been complaining for a long time that IAS39 hedge accounting principles were too complex to implement and to understand. The IASB has listened to industry concerns and, after several postponements, IFRS9 is now a reality.
Overall, IFRS9 does an excellent job in reducing the complexities of complying with hedge accounting and reducing hedging associated P&L volatility:
1 - Hedge designation documentation is simpler, with a stronger emphasis on risk management strategies and objectives
2 - Quantitative effectiveness assessments ( based on regression or dollar offset) almost totally disappear, as long as the terms of the hedge and the exposure match, which is the case for a high proportion of hedging strategies
3 - The 80-125% ‘brightline’ disappears so that when there is a basis risk between hedge and underlying (i.e. commodity hedging) or mismatches in terms between the derivative and the exposure, it will be possible to apply hedge accounting
4 - Particularly with options and cross currency swaps, the consideration of their time value and basis spread as ‘costs of hedging’ will remove significantly P&L volatility
Nevertheless, some new complexities arise:
1 - Unless an entity has relatively sophisticated valuation models, it may become very difficult to quantify the costs of hedging
2 - Hedging aggregated exposures may produce fair value adjustments and OCI movements at the same time that are difficult to understand and account for
3 - Net hedging, particularly of FX, is very complex from an accounting perspective, as the impact of a hedge will have to be split in two different P&L lines (i.e. sales and purchases in foreign currency) at potentially two different times
4 - Hedging risk components, mostly for commodity hedging, is a welcome addition, but very detailed analysis of the exposures and their components will be needed in order to articulate the economic relationship between a hedge and its hedged risk. As a consequence, two competing companies in the same sector, may produce different analysis and apply hedge accounting in different ways, leading to difficulty in comparing the impact on their KPIs of their respective risk management strategies.
Large companies, where IFRS9 can produce meaningful reductions in P&L volatility, have spent considerable time and resources over the last 12-18 months analysing the impacts and how to be ready to transition from IAS39 to IFRS9.
These are companies that are heavily exposed to commodities (as they could reduce the ineffectiveness of hedges by designating risk components) or with extensive issuance programmes in foreign currency (where they could avoid ineffectiveness by considering the basis spread as a cost of hedging). For the rest, where the hedges are mostly simple interest rate swaps and/or FX forwards, IFRS9 is a very welcome tool to help reduce the burden of applying hedge accounting.
JCRA is helping many clients face the implementation challenges of IFRS9 and benefit from a simpler hedge accounting framework. Please contact us if you need any support in making the most out of the new standard.
Have you got a question about how you hedge your financial risks, or structure and arrange your debt?
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