Good news for multinationals: the International Accounting Standards Board has revised a component of a proposed international financial reporting standard so that now hedging currency (FX) risk won’t prompt income-statement volatility. It comes with a trade-off, however: the accounting gets more complex.
The standard, the IFRS 9 Financial Instruments exposure draft, which was issued last September, would have required changes in currency basis—the charge above the risk-free rate in the foreign country to compensate the counterparty for country risk—to flow through profit and loss (P&L). That can create significant and unpredictable volatility in the income statement for multinational corporations seeking hedge-accounting treatment, as the recent financial crisis highlighted.
Such unanticipated volatility typically isn’t considered by companies in their risk management objectives and strategies, said Blaik Wilson, head of Reval’s hedge accounting technical taskforce, and it could reduce the effectiveness their currency hedging.
The IASB’s change essentially allows companies to defer the impact of currency basis in reserves as a “cost of hedging,” when under the previous language it would flow into P&L, Mr. Wilson said. He added that basis risk “is part of the cost of hedging, much like premiums for options or insurance, and it’s not useful to see bottom-line performance get moved around by an inherent part of hedging currency risk.”
While welcomed, the IASB’s solution increases the complexity to achieve hedge accounting because it practically splits the hedge into forward rates quoted in the market and theoretical forward rates that contain no currency basis. “So for a basic currency hedge, a company will have to monitor different elements and apply a different logic to each,” Mr. Wilson said.
Many companies already have the information for fair value hedges, in order to record any currency-basis ineffectiveness in comprehensive income, and under the revised proposal they’ll have to do the calculations for cash flow hedges as well, said Anthony Clifford, a partner in Ernst & Young’s London office.
“They’ll have to calculate the actual fair value of the derivative and its hypothetical value, and so operationally it will definitely mean more work,” Mr. Clifford said.
Overall, IFRS 9 is anticipated to be a major boon to companies, especially those with significant exposure to commodities, since it will allow them to apply hedge accounting to components of non-financial items, as long as those components can be separately identified and measured. By applying hedge accounting to offsetting exposures, their changing mark-to-market values no longer have to be reported in P&L.
However, not only is the IFRS accounting language more complicated, but it is very different than generally accepted accounting principles (GAAP) in the US requiring some multinationals to apply both standards. Consequently, companies may have to make significant technology investments to apply the more complicated IFRS 9 alongside GAAP, if they don’t have a software-as-a-service solution, and they may have to rethink their hedging strategies.
The board deemed last week’s changes minor enough to avoid re-exposing the new language for comment, suggesting the recent change will likely appear in the final standard, expected to be finalized later this month or in March. IFRS 9 allows for early adoption, Wilson said, and companies should consider that option.
“For those companies that will see benefits, they should consider adopting IFRS9 as soon as possible because it will allow them to remove a lot of volatility from the P&L,” Mr. Wilson said, adding that mandatory adoption begins for financial periods after Jan. 1, 2015, and early adoption can commence once the standard is issued.