IASB: Reforming hedge accounting by Stephen Cooper
24 January 2011
As a part of IASB/IFRS Foundation's efforts to encourage its staff to express their individual views, Stephen Cooper,a Board member of the IASB, published update on hedge accounting matters.
The IASB, recently issued an exposure draft (ED) on proposals to replace the hedge accounting requirements in IAS 39 Financial Instruments: Recognition and Measurement. Hedge accounting is a complex and controversial topic in financial reporting and has long been an area of difficulty both for companies seeking to inform investors about what they are doing and for standard‑setters in trying to regulate it appropriately.
Essentially, hedge accounting concerns the reporting of derivative instruments that companies hold to hedge various exposures to risk that affect their business. The general accounting treatment of a derivative instrument is that it should be measured at fair value with changes being reported as gains and losses in the income statement. This was the approach in IAS 39 and has been carried forward to IFRS 9 Financial Instruments. While some commentators have suggested a cost basis for derivatives, most consider that cost measurement would be completely inappropriate, because the cost is often zero and changes in value can be significant.
The main problem, though, is that most derivatives are held in order to hedge more than one risk. If such an exposure arises from an asset and liability that are recognised in the balance sheet, and it is measured at fair value with changes in value reported in the income statement, then there is no problem if that exposure is hedged against fair value changes. Gains and losses on both the hedged exposure and the hedging instrument are reported together and the hedging activity is correctly reported. This simple state of affairs might arise where, for example, an entity uses a forward contract to hedge an investment in an equity instrument, because both instruments are reported at fair value through profit and loss. However, matters are not so simple for many other hedges, which present a greater accounting challenge.
Gains and losses on a hedged risk exposure may not be reported in profit or loss for two main reasons. Firstly, the asset or liability may be measured at cost or amortised cost and secondly, there may be no asset or liability at all, because the risk exposure relates to, for example, a transaction that has not yet actually happened. In these circumstances some modification to the accounting for the derivative or to the hedged item is necessary to faithfully represent the activity. This is where hedge accounting is needed.
Hedging and hedge accounting has been an area of business activity and financial reporting where investors often struggle to understand what is going on. This has not been helped by the restrictions in IAS 39 which, arguably, limit the practical ability of companies to faithfully report their risk management activity. Some companies, because of these restrictions, choose not to apply hedge accounting at all. Instead, they provide supplementary non-GAAP disclosures reflecting their own version of hedge accounting. Others use IAS 39 hedge accounting for some risks, but present similar supplementary non-GAAP information. The resulting lack of comparability, together with the use of sometimes confusing unaudited supplementary disclosures, creates problems for investors. Hedge accounting that is applied in accordance with IAS 39 can be confusing, because of the different methods available (cash flow and fair value hedges) and the lack of clear disclosure requirements. In addition, many companies feel that the accounting creates artificial restrictions on how they may hedge, which has negatively affected the way in which the business was managed. It is for all these reasons that the IASB has proposed significant changes to the hedge accounting model.
The main proposal in the hedge accounting exposure draft is to adopt a principle-based approach that will align hedge accounting more closely with risk management activities undertaken by companies when hedging their financial and non-financial risk exposures. The proposals also include enhanced presentation and new disclosure requirements. Investors should find the application of the new hedge accounting model more logical, and they should also find that its effects are more transparent and easier to understand.
Press release
© IASB - International Accounting Standards Board
