The recently released accounting standard, IFRS 9 (2013) – General hedge accounting could offer some welcome relief to corporate South Africa. The standard, released in November 2013 as part of a multi-phased project to replace IAS 39 Financial Instruments: Recognition and Measurement, focusses on aligning the accounting treatment for economic hedges to an organisation's risk management objectives. A welcome change for many corporates, who have previously criticised the existing more rules based hedge accounting model.
Surprisingly, the level of application of hedge accounting in South Africa has been low to date. Incongruent with a country with large exposures to foreign exchange markets and a historically commodity based economy. This is not attributed to a resistance to economic hedging in the financial markets, but rather the complexities in the existing IAS 39 hedge accounting model.
One of the functions of hedge accounting is to offer relief with respect to the accounting recognition and measurement mismatches between the hedged item and hedging instrument. These accounting mismatches arise because the underlying exposures, or hedged items, are either, for accounting purposes, not immediately recognised or, at minimum, only recognised on a conventional accrual basis. The hedging derivatives are, however, required to be regularly fair-valued through profit or loss and therefore immediately reflect the full impact of market movements. These timing differences will eliminate over the lifetime of the hedge, however, for financial reporting purposes, a mismatch will be recorded. If hedge accounting is not applied or achieved, this has resulted in many organisations not actually reflecting the result of the economic hedges transacted in their financial results as well as reflecting increased volatility in their financial reporting.
With this background, the revised standard should be particularly welcomed by organisations with large foreign exchange and commodity price exposures. Airlines, transport companies or other entities which have large commodity input costs could be the largest beneficiaries through now being able to apply hedge accounting to risk components of non-financial items. This is as a result of the standard's broadened application of possible hedge accounting strategies and the more principles based approach aligned to the entity's risk management practices. This is good news for local markets currently under the pressure of pronounced exchange rate and commodity price volatility.
Some of the key changes inherent in the new hedge accounting standard
Additional exposures which may be designated as hedged items, making hedge accounting more feasible, including:
- Risk components of non-financial items, if separately identifiable and reliably measurable;
- Non-contractually specified inflation, in certain instances;
- Certain net positions and layer components; and
- Aggregated exposures, being a combination of non-derivative and derivative exposure.
Furthermore, new requirements to achieve hedge accounting focus on the economic relationship between the hedged item and hedging instrument, the effect of credit risk and the hedge ratio. The 80-125% bright line for assessing hedge effectiveness has been removed. Judgement is however needed in assessing prospective hedge effectiveness, with no retrospective testing required.
In addition, the new standard also allows for certain alternatives to hedge accounting which will also mitigate accounting mismatches, including:
- Certain 'own use' contracts to buy or sell non-financial items, e.g. commodities, may be measured at fair value if they are economically hedged with derivatives. This is a simpler alternative to hedge accounting and eliminates the accounting mismatch.
- Certain credit exposures (e.g. loan portfolios and commitments) may be measured at fair value through profit or loss if credit derivatives are used to manage all, or part of the exposure. This alternative eliminates the challenges of separating fair value changes attributable to credit risk for hedge accounting.
It should however be noted that while the new proposals offer much relief, a more principles-based statement brings with it more judgement. Furthermore, changes to existing processes and systems will be required both in implementing the new hedge accounting requirements and in formulating the additional disclosures required.
From a transitional perspective, the new standard removes the 1 January 2015 mandatory effective date of IFRS 9. The new mandatory effective date will only be determined once the classification and measurement and impairment phases of IFRS 9 are finalised. Early application of the general hedge accounting model is however permitted so long as all existing IFRS 9 requirements are applied at the same time or have already been applied. Entities will however need to evaluate the benefits of applying the new hedge accounting model against the potential costs of early implementation and the acceleration of other accounting changes and the potential for two transitions as classification and measurement requirements are further refined.
For a more detailed discussion and insights on the new standard, please refer to KPMG's publication, "First Impressions: IFRS 9 (2013) – Hedge accounting and transition".
The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.