IFRS 91 introduces an approach that aligns hedge accounting more closely with risk management, which many corporates view as a positive step forward. In the United States, the FASB recently issued ASU 2017-122, which provides new opportunities to use hedge accounting – some of which are similar to IFRS 9. While hedge accounting finally appears more accessible under both GAAPs, the requirements are not fully converged, creating new challenges for dual reporters.
When the IASB and FASB began discussing hedge accounting, both were seeking to ease current rules, often considered by preparers to be rigid and burdensome. In addition, both Boards aimed to align hedge accounting more closely with risk management and to provide useful information about the purpose and effect of hedging instruments. Both delivered on that promise, but in different ways.
The IASB took a comprehensive approach in revising its hedge accounting guidance. Effective for most companies in 2018, IFRS 9 brings many welcomed changes.
For example, it provides new flexibility compared to the current model3 by:
However, IFRS 9 also brings certain new requirements and prohibitions, such as the:
In contrast, the FASB has introduced targeted improvements to address specific practice issues. Although some of the changes made by IFRS 9 and ASU 2017-12 are similar, hedge accounting under IFRS and US GAAP will not be completely converged going forward.
We have highlighted below some of the changes introduced by IFRS 9 and how they compare to the ASU; these differences require consideration as you rethink your hedge accounting and hedging strategies. Contact your KPMG team to further understand how these differences could apply to your circumstances.
IFRS 9 creates a new fair value option for certain credit exposures. This may allow companies a better accounting treatment for their credit risk management activities without having to apply hedge accounting. Companies can designate a credit exposure (or a proportion of it) as measured at fair value through profit or loss (FVTPL) if a credit derivative is used to manage that credit exposure.
IFRS 9 also creates a fair value option for contracts that meet the own-use scope exception if certain conditions are met. This addresses the accounting mismatch that occurs when a derivative is used as an economic hedge of a commodity contract that is not accounted for as a derivative.
The ASU does not include these fair value options.
Generally under IFRS 9, a nonderivative asset or a nonderivative liability (except in certain situations) that is measured entirely at FVTPL may be a hedging instrument for any risk, not just foreign currency risk. However, for hedges of risks other than foreign currency risk, the nonderivative instrument must be designated in its entirety or proportionately.
The ASU does not permit this expanded opportunity to use nonderivative instruments for hedge accounting.
IFRS 9 allows a company to exclude from hedge relationships certain components of various hedging instruments. Changes in fair value of those excluded components are recorded in either profit or loss (P&L) or other comprehensive income (OCI).
|Hedging instrument||Excluded component||Change in fair value of the excluded component recorded in:|
P&L or OCI - as elected
Foreign currency basis spread
P&L or OCI - as elected
Amounts recorded in accumulated OCI will eventually be reclassified to P&L. Timing may vary depending on whether the hedged item is transaction- or time period-based, which may create some new complexity.
The ASU continues to allow a company to exclude time value and forward element components from hedge accounting, and also permits excluding foreign currency basis spreads. In addition, the ASU allows a company to elect to recognize the fair value changes of the excluded components in P&L (like current US GAAP), or to amortize the initial value of the excluded component in P&L over the term of the hedge.
IFRS 9 expands the number of qualifying hedging strategies by allowing additional exposures to qualify as hedged items.
Example 1, Risk components. A specified risk component of a financial or nonfinancial item may be a hedged item if it is separately identifiable and reliably measurable. For example, it may be possible for the crude oil component of jet fuel to be an eligible hedged item.
Example 2, Net positions. A net position of a portfolio of financial instruments may be a hedged item if:
Example 3, Layer components. A layer component may be a hedged item (e.g. the last $20 million principal payment of a $100 million debt instrument) if the effect of the prepayment option is included in the effectiveness assessment.
Example 4, Aggregated exposures. The combination of a derivative and a nonderivative exposure that is managed together for risk management purposes may be designated as the hedged item in a hedge relationship.
The ASU allows risk components of nonfinancial items to be designated as a hedged item if they are contractually specified. Unlike the ASU, IFRS does not require the component to be contractually specified; instead, it requires that the risk component be separately identifiable and reliably measurable.
The ASU also allows a ‘last of layer’ approach for fair value hedges. However, this approach differs from the layer component approach in IFRS 9. In addition, the ASU does not allow hedge accounting for net positions or aggregate exposures.
IFRS 9 replaces the bright-line 80–125 percent effectiveness test with a forward-looking assessment that can be performed qualitatively if certain conditions are met. It generally requires that:
an economic relationship must exist between the hedging instrument and the hedged item;
the effect of credit risk does not dominate the value changes that result from that economic relationship; and
the hedge ratio designated is the one actually used for risk management.
The ASU retains the ‘highly effective’ threshold to qualify for hedge accounting; however, it eases the current subsequent quantitative effectiveness assessment requirements, and the application of the shortcut method and the critical terms match method. As a consequence, differences between US GAAP and IFRS may arise in practice in these areas.
Other requirements and prohibitions of IFRS 9
Companies may be required to rebalance a hedge relationship that is not behaving as expected by adjusting the quantity of the hedged item or hedging instrument. This allows hedge accounting to continue without needing to stop and restart a hedge relationship.
Companies are prohibited from voluntarily terminating a hedge relationship that continues to meet its risk management objective and other qualifying criteria – which could affect the use of certain dynamic hedging strategies.
However, if the risk management objective for a hedge relationship has changed, the hedge relationship would be discontinued. Companies could designate a new hedge relationship involving the hedging instrument or hedged item from the discontinued hedge relationship.
US GAAP will continue to allow voluntary termination of a hedge relationship after adoption of the ASU.
There will be some other noteworthy differences between IFRS and US GAAP once ASU 2017-12 becomes effective. In particular, the ASU eliminates the separate measure and reporting of ineffectiveness. The change in the hedging instrument’s fair value will be reported as follows.
For fair value hedges, in the same income statement line item that captures the change in the hedged item’s fair value attributable to the hedged risk.
For cash flow hedges, entirely in OCI (no splitting between OCI and earnings). When the amounts from OCI are reclassified to P&L, they will be reported in the same income statement line item where the hedged item’s gains/losses are presented.
While IFRS 9 solves many concerns for corporates, some financial institutions and insurers are expecting more. The IASB continues to work on an alternative macro-hedging model. This model attempts to reflect how financial institutions manage the dynamic net interest margin resulting from typical banking book assets and liabilities. The IASB staff is scheduled to present the Board with the objectives and outline of this proposed model for a potential Discussion Paper targeted for the second half of 2018.
1 IFRS 9, Financial Instruments; effective for annual periods beginning on or after January 1, 2018
2 ASU 2017-12, Targeted Improvements to Hedge Accounting; effective for public business entities for fiscal years beginning after December 15, 2018, and one year later for all other entities
3 IAS 39, Financial Instruments: Recognition and Measurement
4 Contracts to buy or sell nonfinancial items that can be net settled that were entered into and continue to be held for the purpose of the receipt or delivery of a nonfinancial item in accordance with the company's expected purchase, sale or usage requirements