In late 2010, international accounting standards setters unveiled one of the most significant accounting rule changes in recent years, by promising to align risk management with accounting and facilitate the use of more derivatives for hedging purposes. The move was greeted warmly by the corporates and the derivatives industry in Asia, where some parties believe accounting rules have contained the ability of corporations to hedge their risks.
The International Accounting Standards Board (IASB) published its new hedge accounting exposure draft on December 9, 2010. The standard is due to come into force on January 1, 2013, reforming International Accounting Standard 39 (IAS 39) to a new standard called International Financial Reporting Standard 9 (IFRS 9). The IAS 39 hedge accounting rule is often described as unwieldy and is accused of failing to provide companies with sufficient income statement protection when they choose to use derivatives for hedging.
Hedge accounting is a way for corporates and financial institutions that buy and sell derivatives to mitigate risk exposures to account for these financial instruments appropriately on their financial statements. Use of derivatives can lead to large profits and losses at any point in time, depending on market conditions, if these positions are accounted for on a mark-to-market (MTM) basis. These swings make can make for misleading readings of profit and loss statements.
Detractors of the IAS 39 rules say the hedge accounting approach is too rigid and restrictive, and is a test that even large corporations find difficult to meet. Consequently, many corporates have decided not to use it and show their derivatives hedges at MTM through their profit and loss accounts. They then have to explain why there are often volatile swings in these positions to investors – not always an easy task, especially in some parts of Asia.
Adopting hedge accounting better reflects these derivatives positions without impacting P&L, and avoids volatility in financial statements. “The major gripe with the current standard is that it is very rules-based, arbitrary and can often lead to spurious results,” says Nik Tandy, head of Gaap solutions at HSBC in Hong Kong. “At present you have an arbitrary set of rules on one side, how clients behave on the other, and occasionally they come together.”
The new rules adopt a principles-based approach that aims to align risk management with accounting and simplify many of the rigid rules. Generally they have been well-received in Asia where companies are often growing at a rapid pace and are keen to show investors and analysts they are using best practice in managing their risks.
“If you have a greater need for financing from capital markets then financials become more important because you need to prove how your business is performing,” says Tandy. “Huge movements in the P&L from derivatives look unusual, even if you are in control of them, unless there is a very strong business reason for using those derivatives.”
One of the most contentious aspects of the current standard is the ‘80-125 rule’, which requires a hedge to be highly effective within a range of 80-125% to offset the gain or loss from the hedged exposure. There is acknowledgment on the part of the accounting profession that the determination of the 80-125 rule was largely a qualitative judgment rather than the result of quantitative study. “Someone thought a 20% mismatch was about right. Really it’s an arbitrary figure,” says a source close to the IASB.
The new standard requires the hedging relationship to ‘minimise hedge ineffectiveness’ and produce an ‘unbiased result’. This raises the question of whether an entity must choose the hedging instrument that provides the best possible offset to the hedged item, which may be the most expensive choice offered by a bank. However, as an entity is guided under IFRS 9 by its risk management policy to determine this, a well-worded policy would take transaction costs into account before deciding on a particular hedge.
In a comment letter from the Hong Kong Association of Banks to the IASB, concerns were raised about the wording of the new standard: “While we are supportive of eliminating the current highly effective threshold, we have serious concerns regarding requirements to minimise hedge ineffectiveness… We believe the criteria are highly conceptual and likely to result in a significant diversity in practice. The ‘minimise’ criteria could be interpreted to be an even higher threshold to achieving hedge accounting eligibility.”
Commodity hedges to soar?
However, airlines and other heavy users of commodity inputs may well benefit from the new rules. Air carriers, for example, look set to be able to use crude oil to hedge their jet fuel exposures without having to incur wild swings on their profit and loss accounts. The use of crude contracts was previously deemed insufficiently effective to fall under hedge accounting. Jet fuel is a derivate of crude oil, yet price moves between the two products are not perfectly correlated.
“If you are hedging the price fluctuation of jet fuel you can now have a crude oil derivative as the hedging instrument as long as it is highly correlated,” says Yin Toa Lee, partner in financial accounting advisory services at Ernst & Young in Hong Kong. “In the past hedge accounting was seen as a privilege so they made it restrictive for hedging relationships that were not of the same commodity class, even if they were more economically correlated.”
Tina Koutsoukis, treasurer of operations at Australian airline Qantas in Sydney, agrees that the new component hedging rules will now expand the use of derivatives available for hedging in the airline industry.
“We should be able to use Brent crude derivatives to hedge the Brent component of jet fuel oil,” she says. “IAS 39 forced us to correlate movements in all our derivatives, such as crude derivatives and gas oil, against movements in the jet fuel price, which was not always correlated and resulted in P&L volatility coming through.”
Arguably the most significant change between the two standards will be the enhanced suite of options tools available to corporates, due to the change in the treatment of the time value of options under IFRS 9. Currently options only receive hedge accounting treatment for their intrinsic value – the difference between strike and spot price – whereas changes in time value go into the P&L. That was the allowance in the standard to pass the 80-125 test.
The flipside is that time value can be volatile and create big swings in earnings as companies would take the options’ premiums as a loss on their financial statements in the first year, which could amount to several millions of US dollars. These swings in financial accounts are not necessarily representative of what’s actually taking place in real profits and losses, and have had a negative impact on the use of options for hedging purposes, according to a number of market participants. “To have highly volatile earnings from the time value or the premium that they paid doesn’t make sense so you saw a big drop in the use of options,” says Tandy.
Currently, for example, an Australian company may be buying an item of capital equipment from the US in 12 months time for $100 million. The machinery will be used over seven years for a specific project. The company can either hedge this US dollar exposure with an at-the-money-forward at 1.04, or purchase an option for 3% notional.
Figure 1 shows the accounting impact over the next eight years under both current IAS 39 and proposed IFRS 9, as well as using an FX forward. Under IAS 39, the option strategy will lead to a large P&L loss as the time value of the option must be expensed in year one. Under IFRS 9, this loss in time value can be spread over years two to eight, so making options a more attractive strategy. Additionally, it can be seen that using an FX forward compared with an option could produce a large loss if the Australian dollar appreciates to 1.20 and only a slightly bigger profit if the Australian dollar depreciates to 0.90.
“In the past, the option time value was recorded in P&L, creating a lot of volatility, so you bought an insurance against a catastrophe. But you would need to account for the time value of that option in your income statement even though the transaction hadn’t occurred yet,” says Val Pilch, a director in the risk advisory and analytics group at Citi in Singapore. “This deterred corporate entities from using options, which are a good risk management solution. With the change in treatment of time value in options and an options premium being viewed like insurance, corporates will be able to consider hedging with options in the new framework.”
Koutsoukis at Qantas welcomes this change, but says the Australian airline currently discloses two sets of accounts to address P&L volatility and has not decided yet whether to abandon this approach. “We have P&L volatility, but we disclose an underlying P&L, which reflects the gains and losses on hedging contracts in line with the underlying exposures, and separately disclose statutory accounting entries which reflect the volatility in the hedge accounting numbers,” she says. “This helps people understand why we use the derivatives and aligns how we use them and how we see them being used, separately from the volatility.”
Tandy adds that, from his conversations with clients, the use of options for large capital expenditure projects may come back on to the table. This means that people will still have to take effectiveness into account, but will also consider more options structures. He also believes it may be possible to hedge more risks on the balance sheet further down the line now that components can be hedged.
“For example, a manufacturing company has a big energy bill. Rather than deal with that by changing pricing, it may start to quantify how exposed it is to certain energy prices and look for a proxy hedge for that,” he says. “They know it’s a big part of their input costs but there’s not necessarily a direct derivative to hedge the risk. Down the line if there’s something they can use that’s highly correlated then they could use that.”
Rebalancing not restarting
A further area of interest to corporates is the ability to rebalance a hedge rather than starting again. This is particularly significant for the Asia Pacific region, where companies frequently rely on the offshore markets for funding. “Given globalisation of capital markets, there are lots of opportunities for companies to borrow funds in a different currency to their functional currency, swap it back into their currency and make a cost saving in doing so,” Tandy says.
For example, if a company issues a floating rate note it can initially hedge it into a fixed rate using a swap. But if market conditions change and the company wants to swap the fixed rate note back to a floating one using another swap, this is determined as a derivative on a derivative so hedge accounting would have to be discontinued and restarted for the note to re-qualify for hedge accounting. Under IFRS 9, a derivative on a derivative qualifies for hedge accounting as part of a rebalancing of hedges.
Tandy explains this is also useful for interest rate liability management, where an Australian company might raise US dollar funding and swap it back to floating rate in Australian dollars. It would then face a challenge if it wanted to fix the interest rate risk in Australian dollars as this doesn’t qualify under IAS 39. Under the new rules, the corporate would be allowed to ‘designate’ an Australian interest rate swap on the synthetic Australian dollar position it has created on day one, which matches how it runs its business.
But not all companies plan to take the same approach. “The new rules are more commercial but... we won’t be rushing to be hedge effective,” says Victor Chin, treasurer at Goodwood, a real estate investment trust (Reit) based in Sydney. “If you don’t hedge account and regardless of whether you are deeply in- or out-of-the-money with a derivative, you have to take the profit/loss into the income statement as an unrealised gain or loss. The ‘analyst community’ will strip this ‘noise’ out and refer back a company’s FFO [funds from operations].”
A source at another large Reit in Sydney explains that as it has to explain valuation figures on the balance sheet to shareholders and investors, it does the same with regards to explaining hedging instruments going through fair value on the P&L.
According to a comment letter by Insurance Australia Group to the IASB, mandatory rebalancing, as proposed, is still not in line with risk management policy: “We [IAG] believe that the requirement to rebalance an existing hedging relationship as proposed under the [exposure draft] is an improvement to the guidance in IAS 39, which requires hedge accounting to be discontinued,” stated the letter. “We believe that rebalancing should be optional and not a requirement. Requiring rebalancing would be counter to the objective that hedge accounting should be aligned with an entity’s risk management practices.”
Emerging market risks
Lee, at Ernst & Young, says the new, more flexible rules do raise some concerns related to emerging markets companies, as their risk management governance can be fairly basic and execution is often not as advanced as developed world peers. There is also a smaller range of derivatives products to support the hedging strategy.
“As this standard is more in line with risk management and there’s no effectiveness testing, some [emerging market] companies might mistakenly think they can do what they want without checks and balances,” he says, adding that companies must guard against using hedges for speculation and making profits from good fortune rather than a well thought-out strategy.
Ana Cortez, a partner in KPMG’s professional practice in Hong Kong, also sees some Asian corporates struggling to cope with the new rules. “In emerging markets they have less hedge accounting experience and basic derivatives markets so they may they need more guidance,” she says. “Without the rules they will find it hard to adapt to the principle-based approach.”
A further risk is that the new standard will cause confusion about the link between risk management policy and strategy in accounting. “It’s up to the company to write its own risk management policy and execute it. This is a vague area in the standard which gives flexibility to people,” Pilch says. “Companies may get the measurement of risk wrong. The 80-125 rule was an arbitrary number, but it was not subjective like the new standard, so there’s a danger that a company estimates risk inaccurately. They may need to measure risk with modern risk management tools like VAR, which have been used at banks for a while.”
But not all corporates are dazzled by accounting rules. “If we can’t use hedge accounting we just use fair value.” says Chris Leong, group treasury manager at Fraser and Neave, a Singapore based corporate. “We don’t let accounting rules dictate the commercial substance of a transaction. From a recording perspective we prefer to use hedge accounting as it takes away the distortion. But if you remove the arbitrary 12-month recording periods, the risk is hedged through the entire period of the exposure so you are merely trying to bucket it into the correct period.”
Fraser & Neave has a broad range of business interests including beverages, publishing and property. It typically hedges 50-75% of risk using interest rate derivatives and FX derivatives.
Lee believes the implementation of IFRS 9 will be delayed. “January 1, 2013 is the effective date, but given the EU won’t approve that standard until macro-hedging comes out; the earliest it will be endorsed is 2012,” he says. “And, typically, with large accounting changes it will take at least three years with changes to systems, people and documentation so we believe it could be delayed by up to two years.”
Once the new rules do come into force, many parties believe the use of derivatives – particularly options – as hedging instruments is only likely to expand in Asia Pacific. “In Asia we have seen a move away from not worrying about hedge accounting to more focus on hedge accounting, which is probably to do with globalisation of world markets and comparisons with companies here and elsewhere,” says Tandy at HSBC. “The growing importance of Asia and companies in Asia means that they want to be leading best practice. A few derivatives scandals, which has nothing to do with accounting rules has also led to a more cautious approach about how people use derivatives and the accounting result.”
IFRS 9 compared to IAS 39
The G20 summit in April 2009 called on accounting standard setters such as the International Accounting Standards Board (IASB) and the US Financial Accounting Standards Board (FASB) to achieve a single-set of high-quality global accounting standards, and to complete the convergence project by June 2011.
As part of its efforts, the IASB has proposed a new standard called IFRS 9 that will govern hedge accounting, replacing IAS 39. But FASB in the US is broadly sticking to its current rules, including FAS 133 which obliges companies to recognise every derivative as an asset or a liability, measured at fair market value, and accounted for in P&L reports.
IFRS 9 consists of three phases: classification and measurement of financial instruments, amortised costs and impairments, and hedge accounting. Hedge accounting itself consists of a separate phase that deals with portfolio or macro-hedging. Principles on macro-hedging are due to be released in the third quarter of this year.
On hedge accounting, IFRS 9’s key differences with IAS 39 are a move to a principles-based approach from a rules-based approach, a different treatment of the time value of options, rebalancing of hedges, and hedging components of commodity exposures.
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