In November 2013, the IASB issued the long-awaited IFRS 9,‘Financial instruments’, which replaces hedge accountingunder IAS 39. The new standard responds to a number of

needs:

� to improve the previous accounting standards for financialinstruments, particularly given the increased use andsophistication of hedge accounting; and

� to address a number of accounting issues that emerged as aresult of the financial crisis in 2008, especially with respect tothe IAS 39 impairment model.

Treasurers and accountants have often complained that thehedge accounting requirements under IAS 39 were onerous,complicated and not really useful to the readers of financialstatements. For example, IAS 39 comprises around 300 pages ofthe total 2,800 pages of IFRS, so 10%. Much of these 300 pagescover detailed hedge accounting guidance and rules. In practice,

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

26 TMI | Issue 221

accounting has become a key driver in how treasurers managerisk, instead of reflecting how management decides to managefinancial risks. This is especially true where companies arehedging commodity risks.The good news for treasurers is that hedging under IFRS 9 will

be both easier and more aligned with risk management. The badnews is that documentation is still required in order to qualifyfor hedge accounting. And although effectiveness testing as weknow it today will no longer be required, there is a newrequirement to maintain a hedge ratio and rebalance whereneeded. Accounting ineffectiveness will also continue to affectincome statements.Over two articles, we will dive into more detail and show the

key changes to hedging under IAS 39, explain new conceptsintroduced by IFRS 9 and, most importantly, look at what thatmeans for you. In next month’s edition, we will also addresstransition and early adoption, especially interesting for readersoutside the EU.

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Qualifying criteria

As indicated by Figure 1, therequirements for hedge accountingremain relatively unchanged, but themeaning of effectiveness testing will bedifferent.

Qualifying hedginginstruments…

Under IFRS 9, more instruments mayqualify as hedging instruments. Besidesderivatives and financial instruments forcurrency risk, non-derivative instrumentsthat are carried at fair value through profitor loss (FVTPL) may also be designated ashedging instruments. This, combined withthe fact that IFRS 9 allows for many moreinstruments to be carried at FVTPL, meansthat more (and easier) hedge accountingcan be achieved. In practice, this will nothave a lot of benefit for the corporatetreasurer. But it could mean, for example,that it is possible to hedge a loan given forinterest rate risk with a loan that is carriedat FVTPL, or that it is easier to set upcertain commodity risk hedge relations. Similarly to IAS 39, embedded

derivatives have to be considered infinancial liabilities or non-financialcontracts; if these are deemed not to beclosely related to the host contract, theyare accounted for separately. Derivativesthat are separately accounted for can stillbe designated as hedging instruments.Under IFRS 9 the concept of embeddedderivatives for contracts that are financialassets has been removed. This means thatcertain non-derivative financialinstruments (for example, a loan givenwith a structured interest index) will haveto be carried in their total at FVTPL. Suchcontracts can now be designated ashedging instruments as well.

What do you have to donow?� Review your treasury policies toensure they allow new hedgingstrategies and instruments

� Review the hedging strategies toensure they are best fit for thecompany and the risk beingmanaged.

…and hedged items

IFRS 9 brings a dramatic change from IAS39 with respect to which positions andrisk can be designated as items beinghedged. And change will be for thebetter. A number of exposures that werenot allowed to be designated as hedgeditems under IAS 39 now can be. The mostimportant are risk components of non-financial items, aggregated exposures,net positions and combinations ofderivatives and non-derivatives.

Risk components of non-financial items

IAS 39 is infamous for ‘discriminating’between financial and non-financial risks.Think about trying to hedge thealuminum component in a purchasecontract for soda cans. Although thealuminum part in the cans is well knownand can easily be measured separately,IAS 39 only allows the total change inmarket price of soda cans to bedesignated as a hedged item. This meansthat hedging the future purchase of sodacans with LME aluminium futures willnever create a 100% effective hedgerelation. This is due to the fact thatmarket prices of soda cans will beinfluenced by more than just aluminiumprice changes. Ink and production costsare also components of the price. And ofcourse these are not present in thealuminium futures. This distinction is removed under IFRS

9. This means that non-financial items

qualify as hedged items when they areseparately identifiable and reliablymeasurable. We will discuss what is‘separately identifiable and reliablymeasurable’ under the hedgeeffectiveness testing paragraph in thisarticle. For entities that hedgecommodities, this will lead to an increasein qualifying relationships and also anincrease in the effectiveness of theserelationships.

Aggregated exposures

Aggregated exposuresAssume a company invested in a portfolioof shares that in relative weight andcomposition exactly matched theAmsterdam main stock index AEX. If thecompany then bought AEX options toprotect the value of these shares, itwould not be able to apply hedgeaccounting under IAS 39. This is becausethe underlying shares would not meet

What do you have to donow?� Assess which non-financial itemsyou potentially want to hedge

� Review contracts to ensure riskcomponents are separatelyidentifiable and measurable

� Determine appropriate hedgingstrategies to address the risks

Under IFRS 9

the concept

of embedded

derivatives

for contracts

that are

financial

assets has

been

removed.

Figure 1 – Qualifying criteriaQualifying for hedge accounting

Qualifying criteria

1. Only eligible hedging instruments and hedged

items 2. Formal designation and

documentation

3.Meets the hedge effectiveness requirements

3.1 Economic relationship between hedged item and hedging instrument gives rise to offset

3.2 Effect of credit risk does not dominate the value changes

3.3 Hedge ratio results from the quantity of hedged item hedged and hedging item used to hedge

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The formal

prospective

hedge

documentation

requirements

of IAS 39 have

not changed

under IFRS 9.

the ‘similar items’ test. In other words,the shares would not all move in thesame direction if the AEX index moved.Under IFRS 9, there no longer needs to bea ‘similar items’ relationship. Rather, thehedge strategy should be in line with thecompany’s documented risk managementpolicy, and it should be able to prove thehedge is effective in offsetting the risk.

Net positionsCompanies often hedge currencyexposure for the net balance of purchasesand sales in a foreign currency. Under IAS39, you cannot designate the net balanceof these as the item being hedged. Inpractice, this does not really lead to anymajor issues, as under IAS 39 it wouldstill be possible to assign the net amountas either a hedge of the purchases or thesales in foreign currency. However,conceptually it seems strange that thenet risk in this case cannot be hedged, asthat is exactly in line with the company’srisk management policy. Under IFRS 9 itis possible to designate the net amountas a hedged item. The drawback of applying the IFRS 9

model is that the impact from thehedging instrument should be booked ina separate income statement linebetween revenue and cost of sales.However, in practice this removes someof the counterintuitive principles of IAS39 for many corporate treasurers.

Combination of derivative and non-derivativeIt is a common risk management strategyto combine a derivative with a non-derivative in an ‘economic hedgerelationship’, but in the past, it was notpossible to achieve hedge accounting forthis. Under the new rules, aggregatedexposures or hedged items that includederivatives qualify as hedged items. Inpractice, this happens when a company ishedging the forecast issue of a bond witha forward starting interest rate swap. Itmay be that at the moment of issuing thebond, it is decided that the bond will notbe issued in the originally foreseen (andhedged) currency, but in anothercurrency. Under IFRS 9, the companywould then be able to conclude a cross-currency interest rate swap and assignthe combination of the bond and theoriginal interest rate swap as a hedgeditem in a new hedge relationship with thenew cross-currency interest rate swap.

Formal designation anddocumentation

The formal prospective hedgedocumentation requirements of IAS 39have not changed under IFRS 9. In fact,documentation plays a more importantrole under IFRS 9. This is because, toprove effectiveness, a company shouldbe able to prove that the designatedhedge relationship is in line with thecompanies’ document risk managementpolicy. As this will be the main criterionfor assessing whether a hedge relation iseffective, this documentation should beprecise.Where a company is hedging a risk-

component of non-financial items, it isvery important to document howmanagement will measure the riskcomponent that is being hedged.Without this documentation, it would beimpossible to prove after the fact howthe hedge was set up.

The hedge relation shouldmeet the hedgeeffectiveness criteria

Economic relationship between hedgeditem and hedging instrument gives riseto offset. IAS 39 requires hedgeeffectiveness testing to be done in aquantitative manner, taking into accountthe full (change in) fair value of thehedging instrument. The (change in) fairvalue of the hedging instrument is thencompared to the (change in) fair value ofthe hedged item. The ratio of these twoshould fall between 80% and 125%. If ahedge relationship under IAS 39 isoutside of this range, no hedgeaccounting can be applied at all. IFRS 9 recognises that such bandwidth

is arbitrary. In practice, it is of coursepossible that a company may be willingto enter into a hedge that may falloutside of this range, as there may be nobetter alternatives. The 80-125% range istherefore removed. So IFRS 9 bringsgreater alignment between how acompany manages risk and theaccounting for that. As already stated,the main principle is that if a hedgerelation is in line with the entity’sdocumented risk management policy,and the risk being hedged can bemeasured reliably, hedge accounting canbe applied.

Under IFRS 9, companies will have to

demonstrate that the hedgingrelationship does not achieve accidentaloffsetting and that there is a realeconomic relationship between thehedged item and the hedginginstrument. The mere existence of astatistical correlation between twovariables cannot support, by itself, theeconomic relationship. As an example,there may be a (weak) statisticalcorrelation between LME aluminiumfutures prices and euribor interest.However, it would clearly not be possibleto hedge interest rate risk on a loan withLME aluminium futures. On the otherhand, there may be a strong statisticalcorrelation between Brent prices and gasprices in an energy market. Thatcorrelation may sometimes be outside ofthe 80% -125% range of IAS 39, but itmay still be the company’s documentedhedge strategy to hedge gas purchaseswith Brent derivatives if there are no gasderivatives available. IFRS 9 mentions ina detailed example the way many airlinecompanies hedge jet fuel usingcombinations of crude oil, gas oil and jetfuel swaps depending on the applicabletime horizon and whether or not theseswaps are liquid. By reference to crackspread swaps, it can then be argued thatjet fuel is based on gas oil prices andthat gas oil prices are dependent oncrude oil prices. It is therefore possible todefine an effective hedge relationship ifmanagement documents and proves acorrelation between the aforementionedprice components of jet fuel.To recap, the underlying risk should be

the same or economically related andtherefore have a similar but oppositeresponse to the hedged risk.

The effect of credit risk does notdominate the value changesIFRS 9 requires that the change in fairvalue of the hedging instrument withoutconsidering the change in credit qualitycannot be too small to compensate thechanges in fair value of the hedged item.In that case, the changes in credit riskdominate the fair value changes, andhedge accounting cannot be applied. Forexample, if a company enters into a long-term interest rate swap and after twoyears, the credit rate of the counterpartyrating significantly decreases, and it maynot be possible to continue the hedgeaccounting relation, as the counterpartycredit risk will dominate the fair value

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changes of the swap.IFRS 9 explains that this should not lead

to unwanted accounting outcomes. Ifthere is little change in the fair value ofthe hedging derivative and the underlying,even a small credit risk-related change inthe value of the hedging instrument orthe hedged item might affect the valuemore than the underlying. This does notcreate dominance of credit risk in thevalue changes. After the introduction of IFRS 13, hedge

accounting sometimes becamechallenging under IAS 39. Some hedgerelationships were terminated, as they nolonger passed the 80%-125% rangerequirement due to the inclusion ofCVA/DVA in the hedging instrument andnot in the hedge item. So thesimplification of effectiveness testingunder IFRS 9 will be helpful. However, theaccounting ineffectiveness in terms ofjournal entries is not likely to changesignificantly.

The hedge ratio of the hedgerelationship needs to be maintained IFRS 9 effectiveness requirementsintroduce the concepts of hedge ratio andrebalancing. The idea is that there willalways be an optimal ratio of the amountof hedging instrument versus the amountof risk being hedged. And if this ratiochanges, the entity should change itshedging position or should book hedgeineffectiveness. Rebalancing thus refers tothe adjustment(s) made to the designatedquantities of the hedged item or thehedging instrument in an already existinghedging relationship. This concept hassome parallels with the IAS 39 ‘deltaneutral hedging’ concept when usingoptions, but now it is a requirement.As an illustration, consider an entity

hedging 100 tonnes of coffee purchaseswith standard coffee futures contracts.These contracts have a contract size of37,500 pounds (lbs). The entity now canuse either five or six contracts (equivalentto 85.0 and 102.1 tonnes respectively) tohedge the purchased volume of 100tonnes. In this case, the entity designatesthe hedging relationship using the hedgeratio that results from the number ofcoffee futures contracts that it actuallyuses (the five or six, depending on thecompany’s documented hedging policy).The hedge ineffectiveness resulting fromthe mismatch in the weightings of thehedged item and the hedging instrumentis not created in order to achieve anaccounting outcome that is inconsistentwith the purpose of hedge accounting.Assume that, at inception, the companydecides to hedge the risk with fivestandard future contracts, which wouldlead to a hedge ratio of 0.85. It may bethat six months later, the companyconsiders that the best way to hedge therisk is to use six standard future contractsinstead of five. In this case, the entityadjusts the hedge ratio to 1.2. Themodification of the hedge ratio is called‘rebalancing’. Under IFRS 9, rebalancing does not

lead to the existing hedge relationshipbeing terminated. However, an analysisof the sources of ineffectiveness that areexpected to affect the hedgingrelationship during its remaining termshould be performed. The hedgedocumentation should be updatedaccordingly. In addition, the hedgeineffectiveness should be recognised in

profit or loss up to the date ofrebalancing. The concept of rebalancingdoes not exist under US GAAP. Under IFRS 9, it is no longer possible

to voluntarily de-designate a hedgerelationship that still meets the riskmanagement objective. Due to theconcept of rebalancing, the removal ofthe 80%-125% range, and thepossibility of including derivatives aspart of the hedged item under IFRS 9,this may not be a problem. However, thisis a considerable change from IAS 39.Under IFRS 9, it is no longer possible tostop hedge accounting; a hedgerelationship can only be stopped if therisk management objective changes orthe hedge relationship ceases to meetthe qualifying criteria.

Conclusion

The IASB has tried to solve a number ofpractical problems under IAS 39. IFRS 9 isclearly an improvement on IAS 39.However, there remain a number of formaldocumentation requirements and therequirement to prove ineffectiveness(although the infamous 80%-125% rangeis removed). IFRS 9 certainly is animprovement for companies hedgingcommodity risks. For corporate treasurersin companies where only FX and interestrate is hedged, there may not be so manychanges. It probably makes sense to reflecton the extent of hedge effectivenesstesting currently taking place, and thendecide on whether some of those can bestopped when IFRS 9 is applied.In the next article, we will be

discussing in more detail the journalentries relating to hedge accountingunder IFRS 9, hedging with options andforwards and transition and disclosurerequirements. �

What do you have to donow?� Determine the optimal hedgingratios for existing hedgingstrategies

� Consider whether your tools areappropriate to measure the hedgeratio during the existence of thehedge relationship.

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.

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.

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