By Joseph Neu
With all the focus on the impact Dodd-Frank rules will have on their hedging, treasurers should not lose sight of the implications of the IASB’s proposed changes to hedge accounting under IFRS 9 (expected to be finalized in Q3). One area of concern is the IASB’s attempt to link hedge accounting more closely with a firm’s overall risk management strategy, as well as its risk management objectives with a given hedge.
A recent IASB staff paper “(No) voluntary discontinuation—clarification” sheds light on how the IASB views the linkage between hedge relationship and risk management strategy and objective. It also illuminates where its application comes to a head.
- De-designation flash point. One of the more problematic features of proposed hedge accounting guidance is a hedger’s loss of flexibility to adjust or de-designate and re-designate hedges in hedge relationships in line with changes in their exposures. Recall under the FASB’s proposed guidance, there is no de-designation so a hedge must be terminated and a new hedge put on.
Under the proposed IFRS 9 guidance, hedgers are handcuffed by the criteria documented to qualify a hedge relationship for hedge accounting, which are to include the risk management objective and strategy.
The constraints are two sided: 1) hedge accounting is disallowed if the criteria are no longer being met; however, 2) the hedge must continue, if the criteria continue to be met. Accordingly, no discontinuance or de-designation is allowed if the hedge continues to perform in line with risk management strategy or objective. Or, if either is changed, the hedge put in place under the old objective/strategy must cease.
The IFRS guidance even takes this a step further by suggesting that a hedge should be automatically rebalanced in line with the objective in order to maintain a qualifying hedge relationship.
Comment letters on this guidance asked for a clearer definition of risk strategy and objective for accounting purposes. They also wanted to better understand how a change in approach to fulfilling a strategy or objective, say in response to changing exposure, might affect their hedge accounting eligibility. In response, the IASB staff noted as follows in their recent paper:
“The risk management strategy is the highest level at which an entity determines how it manages its risk…[it will] typically identify the risks to which the entity is exposed and sets out how the entity responds to them.” The staff went on to note: “This is normally a general document that is cascaded down through an entity through policies containing more specific guidelines.”
“The risk management objective for a hedging relationship applies at the level of that hedging relationship. It relates to how the particular hedging instrument designated is used to hedge the particular exposure designated as the hedged item.”
To help demonstrate the linkage, the staff used the example of a strategy to maintain a fixed-to-floating ratio on debt funding between 20 and 40 percent. To hedge interest- rate risk, the firm in the example swapped 30 percent of its variable debt to fixed. If, subsequently, it issues new fixed-rate debt, bringing the fixed rate ratio above 40 percent it would need to discontinue enough of the swaps on the variable debt to bring the ratio back into range (as they no longer qualify on the objective or relationship level) in order to maintain hedge accounting with its other swaps.
- Practical challenges. Such an approach raises practical challenges, as Matthew Daniel and his colleagues at Citi’s Corporate Solutions Group noted in a June client report. It is one thing to document a risk management objective in the context of a given hedge relationship, it is another to consider the impact on each prior hedge relationship as risk management strategy is executed and reacts to new exposures.
In response, not only would risk management polices need to be evaluated and audited alongside accounting policies to determine if hedges are or remain eligible, but chances are policies will be rewritten with more of an eye to hedge accounting eligibility—and they would become less meaningful from a risk management perspective.
Or, as we see it, more firms could decide to forgo this new practical complexity and give up seeking hedge accounting.