Risk Management and IFRS 9 – One year on
IFRS 9 was tagged as the accounting standard that would remove complexity around the accounting for risk management strategies.
One year on from the mandatory adoption date we review how some of the key headlines of the new standard have been received and how it has impacted the risk management activities of corporates.
The unprecedented volatility in financial markets that has been witnessed in recent times has brought increased scrutiny from investors on how companies are managing risks and shareholder wealth. Those that have decided not to hedge certain market risks in recent years have been impacted by this volatility as a) the market negotiated its way through both the highs and lows of Brexit and b) for some companies, the increase in oil prices from $40 per barrel to $65-$70 per barrel.
Figure 1: GBP-EUR spot exchange rate
Those entities that have actively sought to manage these volatilities have performed stronger over the same period by fixing prices by using derivatives.
Figure 2: Brent Crude Spot Price
Where an entity has navigated this difficult time through effective risk management, the good work can often be eroded by not obtaining the right accounting result for the instruments used as part of these strategies.
IFRS 9 was intended to address this through aligning an entities risk management strategy and objectives with the accounting for this strategy by making the application of hedge accounting for financial instruments used in economic hedging activities more achievable. One year on we take a deeper look at how the introduction of IFRS 9 has made some hedge accounting strategies better or in some cases worse when it comes to the accounting.
although the 80-125% rule has been abandoned under IFRS 9, the need for the calculations to assess this still exists
Hedging Risk Management Components and IFRS 9 (Commodities, Interest Rates and Inflation)
The new rules introduced under IFRS 9 were aimed at ensuring entities could, if they chose to, manage their risk exposure in the most efficient manner available. The intention of allowing corporates to identify the individual risk components within both financial and non-financial host contracts was to ensure that if there was a derivative that could be acquired to match the dominant variable component within these contracts then the accounting should follow this matched relationship and strategy.
As a result, entities across infrastructure, utilities, retail and various other corporate sectors have undertaken widescale reviews of their existing commodity and interest rate risk management strategies in order to identify the dominant components they are exposed to variability in.
For companies exposed to commodity risks IFRS 9 has resulted in easier application of the hedge accounting requirements with many entities now able to achieve critical terms matching with their hedge strategies as a result of aligning the terms of instruments traded with the exact terms of the contract they are exposed to. This has been the achieved through in-depth analysis of contracts to identify the exact variable pricing and ensuring that the traded instruments align in order to remove the possibility of ineffectiveness in the strategy and ultimately the accounting at the outset.
Inflation – Hedge accounting solutions for inflation linked derivatives as a component of nominal interest rates exist and have been implemented. However, this has become an area where the rules around a component being separately identifiable and measurable have meant that this can only be achieved in certain circumstances.
Companies that have not yet done so should be undertaking a comprehensive review of existing customer and supplier arrangements to ensure that there is no margin erosion as a result of unidentified components that could have been hedged and subsequently hedge accounted for.
80-125% Testing (Operational Application of Hedge Accounting)
This was the headline act of the IFRS 9 hedge accounting module for many corporates. Immediately this was seen as a way of making hedge accounting operationally easier and would result in less cost associated with systems, controls and auditor overruns ensuring that the 80-125% testing requirement of IAS 39 was met.
In practice, one year on and as a result of conversations with auditors companies are beginning to realise the measurement of ineffectiveness in economic relationships is still required and although the 80-125% rule has been abandoned under IFRS 9, the need for the calculations to assess this still exists in order to be able to accurately measure the ongoing journals required to apply hedge accounting.
Those hedge accounting relationships that contain mis-matches between the instrument traded and the item it is intended to hedge will always require quantitative assessment in order to measure the extent of the offset between item and instrument and allow a company to accurately reflect this in their accounts.
While the economic relationship assessment can often be a qualitative exercise in line with what was outlined in the designation documentation for the hedge accounting relationship, this only determines whether an entity can apply the concepts of hedge accounting under IFRS 9.
The dollar offset method that many companies used to assess the 80-125% test in the past now acts as a measure of how much hedge accounting a company qualifies to apply under IFRS 9.
Ultimately what companies have found is that auditors would like to see both the assessment of an economic relationship on a prospective basis and the measurement of ineffectiveness on a retrospective basis for a company to meet the requirements to continue to apply hedge accounting to their economic risk management activities under IFRS 9.
Companies should consider their current risk management activities and hedge accounting being applied to determine whether they may need to keep hold of the systems and processes they had under IAS 39 and re-purpose them to meet the requirements of IFRS 9.
Costs of Hedging (Options and FX Risk Management)
In response to concerns over accounting for time value on option contracts and for currency basis within fair value hedge relationships both resulting in profit and loss volatility under IAS 39, the IASB introduced a new accounting treatment for these unavoidable costs associated with carrying out a hedge strategy.
The new rules allow for the deferral in a separate cost of hedging reserve within equity for these costs of hedging, therefore benefitting those entities that use options to hedge and have fair value hedges impacted by cross currency basis.
However, by addressing the accounting for currency basis as a specific item within the standard, this has resulted in less complex hedging strategies being impacted by the requirement to deal with currency basis as a cost of a hedge relationship.
For example, many corporates exposed to FX risk have in the past employed simple strategies of using FX forward or swap contracts to manage this risk. In hedge accounting for these the assessment of an economic relationship (or hedge effectiveness under IAS 39) was often a qualitative exercise without the need for any complexity in the valuation.
As a result of the costs of hedging rules being applied to currency basis and with currency basis being priced into FX forward and swap contracts, corporates are now having to perform a complex valuation exercise in order to identify the value attributable to currency basis where they continue with their existing strategy of designating forward rate risk as the hedged risk.
In many cases this turns out to be an immaterial amount for the purposes of the financial statements but is still required to be calculated adding a layer of complexity to what was a less than complex hedging strategy that did not exist under IAS 39.
This has been a key focus area for auditors in the first year of IFRS 9 application as many companies that have used instruments such as cross currency swaps get to grips with explaining currency basis to investors within the accounts and why the balance of this within their overall derivative MTM has moved materially over the last number of years.
Companies that have considered using options as part of their hedging strategies in the past and avoided due to the complexity in the accounting should dust off these plans and review whether they are now fit for purpose in combination with the easier application of hedge accounting.
Those companies using instruments such as cross currency swaps should ensure that at the outset of any hedging strategy, they fully understand the components of the pricing and how these may impact the accounts over time. This aspect of IFRS 9 has the potential to be operationally complex in the future if not set up correctly at the beginning.
Key considerations for Corporates and how Centrus can help with your risk management strategy:
• Review current risk management policies to determine if they are fit for purpose;
• Cost vs. Benefit analysis around hedging of identified risks;
• Review current hedge accounting processes for IFRS 9 impacts and quantify;
• Ensure required data is available to perform relevant assessments required on an ongoing basis; and
• Benchmarking risk management practices against peers.
Corporates should ensure that they are undertaking a review of their current risk management landscape and ensure they are doing enough to protect their company values through these times of uncertainty.
While companies are still navigating their way through the finer points of the IFRS 9 implementation process arising as part of the first year-end under the new standard, the final impacts on hedging activities and whether the adoption of IFRS 9 has revolutionised the way Corporates manage risk remains to be seen.