January 1, 2018, is set to be a big day in accounting circles. As the new year dawns, IFRS 9 becomes the new accounting standard for financial instruments, replacing the current IAS 39 regulations. With the new standards come substantial changes to the way that derivative instruments and hedging strategies are accounted for, along with potential benefits for a broad range of businesses – provided they are able to take advantage of the opportunity.
IAS 39 has been the standard for hedge accounting for a number of years. The objective of hedge accounting is to represent, in the company’s financial statements, the effect of using complex financial instruments to manage exposures and the impact they have on profit or loss. It describes a means of giving fair value to options, swaps, futures and more exotic instruments that are dependent on the changing value of an underlying instrument.
One of the key advantages of hedge accounting is that it helps to smooth earnings over time. For firms dealing with FX and interest rate swaps, or who are heavily exposed to physical and financial commodity markets, hedge accounting reduces the impact of volatility on their market capitalization and Price and Earnings statements.
Understandably, this has been popular with stakeholders and market analysts alike, since they prefer smoothed out earning statements to unexpected shocks. The problem has been that hedge accounting – certainly under the IAS 39 regime – is far from straightforward and requires a vast amount of data. The probability of making a mistake is relatively high, which results in withdrawn and re-stated earnings. In other words, an unexpected shock: exactly the opposite of what was trying to be achieved.
For this reason, a limited number of firms have adopted favorable Hedge Accounting treatment under IAS 39 and awareness of its implications has very rarely left the treasury department. So when the accountants welcome in the New Year with its replacement, they are unlikely to be joined by colleagues in the risk management department – or indeed anywhere else.
However, they will miss a significant opportunity. The new accounting standard has much wider repercussions than many at first assume. First of all, IFRS9 is being introduced to make the hedge accounting process easier, and to enable firms to align their hedge accounting more closely with their overall risk management strategy. In effect, it represents a move away from a purely quantitative methodology into something more qualitative.
In practice, this means that instead of running extensive and complicated mathematical risk assessments in order to qualify for hedge accounting treatment, firms merely have to demonstrate that a specific derivative instrument fulfills the hedging purpose as set out in their enterprise risk strategy. In other words, companies can use information from their risk policies to justify their accounting.
By making the relationship between hedge accounting and enterprise risk more explicit, and at the same time removing the need for rigorous analysis of validated historical data to justify the positions that have been stated, the new standard should create a simpler process overall. The net result is likely to be that more companies will be able to adopt hedge accounting strategies – and more will be able to explain their risk management strategy to investors as a key part of their communications strategy.
The second point about IFRS 9 is that is significantly more lenient when it comes to what can and cannot be treated under hedge accounting rules. It means that companies can hedge a component of their risk – for example, just the commodity - rather than all fair-value movements, which can be posted to equity.
The impact of this change could be wide reaching. While some financial institutions and major commodity traders found that application of the old IAS 39 standard was beneficial overall, they were a fairly exclusive club. But now it is possible to envision scenarios in which a manufacturing firm would individually hedge one or more of the contractually agreed components that go into their final product. In so doing, they reduce the risks associated with exposure to volatile global markets and international supply chains.
IFRS 9 therefore could be the catalyst that draws accountancy and risk management together. It should certainly make hedge accounting more accessible to a wider range of firms. And it may add a new weapon to the risk manager’s arsenal. But there are some caveats.
Hedge accounting is not a spreadsheet process. Swapping market risk for the operational risk of non-specialist tools does not represent much of a step forward. Hedging strategies may backfire without the proper tools to accurately gather, assess, analyze and integrate risk.
The amount and variety of data required is likely to increase. Under the new standard, firms are required to incorporate credit risk considerations into the valuation of their financial assets and liabilities under an expected credit loss model. This adds complexity to general accounting requirements, because firms need more data to calculate those potential losses, they need to know what the probabilities are of default; they need recovery rates and to make a decision on types of data to support the expected loss calculation.
Nor can firms opt for complete abandonment of the quantitative approach. To date, hedge accounting has required firms to obtain concise and reliable information, which, in turn, supports an enterprise-wide view of a company’s real and potential risk exposures. Shifting to a qualitative-only approach can obscure this view, and may weaken hedge accounting practices – even when internal risk management guidelines are met.
A commitment to hedge accounting is therefore still not something to be undertaken lightly. The policies and procedures for aligning risk management activities and treasury need to be supported by centralized and integrated systems designed for the task. Disparate systems are the easiest way to lose control of the data needed to inform company strategies and to build up of information silos that restrict the effectiveness of those strategies.
Integration is also essential to prevent data quality and integrity from being compromised whenever hedge accounting figures created in one system flow to another. Such an integrated solution gives firms a holistic view of their risk. An integrated system also enables firms to directly calculate valuations from the underlying transactions and asset values – without having to stage data across from other sources – and recalculate values in response to changing data.
With data flowing seamlessly from front to back, accountants, risk managers, and even auditors can see precise valuations at any given point down to a very granular level.
The advent of IFRS 9 is a timely one. Hedge accounting looks more appealing in the light of increased uncertainty in international geopolitics, climate and demographics. It opens up the possibility of compliant hedge accounting to more firms – and it allows more of our businesses to protect themselves, their shareholders and their customers from the consequences of that global uncertainty. The only question for those businesses is this: is taking advantage of IFRS 9 on your list of new years’ resolutions?
By Roman Scheller is Principal Consultant, Strategic Client Services, Openlink.