Non-financial companies domiciled in countries outside the European Union (EU) that use the International Accounting Standards Board’s (IASB) recently approved hedge-accounting guidelines will have a competitive advantage in terms of hedging risks more accurately and reducing profit and loss volatility.
The IASB issued its IFRS 9 Financial Instruments amendment Nov. 19 that permits companies domiciled outside the EU, including Australia, Hong Kong, Taiwan and Canada, to adopt the new guidelines at their convenience. But those in EU member states, however, must continue with existing IAS 39 guidelines, noted Blaik Wilson, chairman of the hedge-accounting technical taskforce at Reval, a software-as-a-service provider of integrated treasury and risk-management solutions.
Mr. Wilson said those companies’ use of IFRS 9 is predicated on the IASB delivering a standard for impairment, the second phase of its three-stage financial instruments project, “and then the EU reviewing the entire standard for ratification.”
In a note to clients, Ernst & Young wrote that non-financial entities will have an incentive to apply the amended IFRS 9 before its ongoing deliberations on new guidelines to account for impairment. That’s because upon impairment’s completion, the accounting standard setter intends to create a consolidated version of the hedge-accounting guidelines that will reduce their ability to choose different parts of the IFRS 9 guidelines available early on.
“Applying [new IFRS 9 guidelines before they are] superseded by a consolidated version would enable hedge accounting to be applied whilst deferring the application of the requirements for impairment until the mandatory effective date,” the note said. It added that it’s uncertain how other ongoing projects impacting financial companies will interact with IFRS 9, thereby inhibiting their use of the hedge accounting guidelines.
The new guidelines provide a significant advantage over IASB 39 guidelines as well as the Financial Accounting Standards Board’s existing and proposed hedge accounting rules, because they enable a company to hedge the component of underlying price risk as long as it can be separately identified and measured. So, noted Reval, as an example, commodity hedgers reporting under IFRS 9 will be able to hedge components of nonfinancial items, such as the rubber in rubber tires.
As such, the new standard will enable companies to reduce P&L volatility on common hedging scenarios more than under the current IASB an FASB standards.
“Under current US GAAP and IAS 39 under IFRS, when measuring commodity risk you must incorporate the entire price exposure – this means including quality differences, freight, locational pricing [differences], et cetera,” Mr. Wilson said.
He added that companies using the new IFRS 9 guidelines will have a competitive advantage given that investors place a premium on companies that can smooth out profit and loss volatility on their financial statements.
Other advantages under the new IFRS 9, Reval said, include the ability to mitigate P&L volatility associated with option time value, or the value of the chance to exercise an option over time. Wilson said companies use option-based derivatives for a variety of reasons, such as the ability to participate in favorable interest-rate movements rather than locking in a single rate. But the fair-value calculation of an option portfolio must incorporate time value, which can move in both positive and negative directions, Mr. Wilson said, adding that under IAS 39, those movements must be recorded in P&L and so cause volatility.
“Under IFRS 9 and US GAAP, those movements can typically be deferred to “other comprehensive income and, as such, the P&L volatility is avoided,” Mr. Wilson said. Another advantage to the new guidelines is the elimination of the “80 percent-125 percent bright line rule,” where to receive hedge-accounting treatment a hedge must offset the underlying risk exposure by at least 80 percent but not more than 125 percent.
“Many hedges can go from effective to ineffective in the course of a single month if they are close to those boundaries—this makes hedge accounting very unpredictable and leads organizations to go to extreme measures and complicated methodologies to minimize the chance of failing the test,” Mr. Wilson said.
The IASB is currently re-deliberating the classification and measurement phases of its financial instruments project, for which hedge accounting is the third phase. A completed version of the entire project is expected in the first half of 2014, according to Ernst & Young.
The IASB and FASB’s goal to converge their accounting standards has become less definitive over the last year and their guidelines are now expected to achieve some convergence but remain distinct. The FASB is now considering comments it received on its hedge accounting proposal and the IASB’s exposure draft that it issued as a discussion paper, both earlier this year.
“The FASB will then decide on the best way to proceed with [its] deliberations on hedge accounting,” Ernst & Young said.
Mr. Wilson said there’s been talk recently about FASB looking at hedge-accounting guidance issued under IFRS 9 and adopting it under US GAAP.
“However, I think because these standard tend to operate in conjunction with other standards, it is very difficult to cherry pick certain aspects in isolation,” Mr. Wilson said.