The International Accounting Standards Board has introduced a new hedge accounting model as a major step forward in the financial instruments project on which it has been collaborating with the Financial Accounting Standards Board.

The amendments to IFRS entail a substantial overhaul of hedge accounting to enable entities to better reflect their risk management activities in the financial statements. Some of the changes would address the so-called “own credit” issue that were already included in IFRS 9 “Financial Instruments” to  be  applied in isolation without the need to change any other accounting for financial instruments. In addition, the changes would remove the Jan. 1, 2015 mandatory effective date of IFRS 9, to provide sufficient time for preparers of financial statements to make the transition to the new requirements.

The new hedge accounting model introduced by the IASB on Tuesday, along with corresponding disclosures about risk management activity for those applying hedge accounting, came in response to concerns raised by preparers of financial statements about the difficulty of appropriately reflecting their risk management activities in the financial statements. The changes also address concerns raised by users of the financial statements about the difficulty of understanding hedge accounting. 

“This package includes several, long-awaited reforms to financial instruments accounting,” said IASB chairman Hans Hoogervorst in a statement. “First, we have introduced a new hedge accounting model. This is a significant change in accounting that enables companies to better reflect their risk management activities. This change has received strong support from corporates around the world. Second, we have provided a mechanism to enable entities to benefit from the fix to the ‘own credit’ issue before making more comprehensive changes to their financial instruments accounting. Third, we have responded to concerns that the mandatory effective date for IFRS 9 provided insufficient time for companies to adequately prepare.”

Hoogervorst spoke about the new hedging standards Monday during Financial Executives International’s Current Financial Reporting Issues Conference in New York, saying preparers are “wildly enthusiastic” about them (see IASB Adjusts to Changing Relationship with FASB).

“Why is that the case? They think it makes it easier for them to really show their activities to minimize their economic risk,” Hoogervorst said Monday. “It takes out the mathematical bright lines in current hedge accounting and retraces them with more qualitative criteria. It’s more principle-based and will therefore be easier to retain hedge accounting, although this is not a free choice. We do require proper documentation of the hedge strategies. But I think it will be a huge improvement. Preparers around the world are waiting for us to finish this.”

FASB chairman Russell Golden seemed to be in favor of the IASB’s work, noting that FASB had placed its priorities elsewhere in its work on the financial instruments project. “We made a judgment call a few years ago that said we need to think about classification, measurement and impairment first for a couple of reasons,” he said. “We felt that was where the priority for improvement was, and we thought we needed to understand what was going to be the measurement philosophy of the instrument that you might be hedging before we dealt with hedge accounting. I think that today’s hedge accounting in the U.S. is overly proscriptive. I think it prevents companies from actually entering into hedge accounting as something that they think is mitigating their risk, and I think it needs to be improved in the U.S. As we go forward, we will look at what the IASB has finalized to see if it can and should work in the United States, and we will start with that model.”

The new model represents a substantial overhaul of hedge accounting that will enable entities to better reflect their risk management activities in their financial statements. The most significant improvements apply to those that hedge non-financial risk, and so these improvements are expected to be of particular interest to non-financial institutions. As a result of these changes, users of the financial statements will be provided with better information about risk management and about the effect of hedge accounting on the financial statements.

As part of the amendments, the changes introduced by the IASB also enable entities to change the accounting for liabilities that they have elected to measure at fair value, before applying any of the other requirements in IFRS 9. This change in accounting would mean that gains caused by a worsening in an entity’s own credit risk on such liabilities are no longer recognised in profit or loss. The amendments will facilitate earlier application of this long-awaited improvement to financial reporting.

Professional Judgment

The Institute of Chartered Accountants in England and Wales saw benefits in the new hedging standard as a way to simplify hedge accounting.

“Hedge accounting is arguably one of the most complex areas of accounting,” said Dr. Nigel Sleigh-Johnson, head of the ICAEW’s Financial Reporting Faculty, in a statement. “The current hedge accounting standard is rules-based, is difficult for companies to use and does not reflect risk management activities well, so it was ripe for replacement. With the new standard, hedge accounting —which is a way for companies to reduce volatility in their reported results stemming from, for example, foreign currency exposure, and is widely used by both financial and non-financial companies—should become more accessible, allowing companies to better align their accounting with their risk management strategies.”

The new standard will require more disclosures because it is more principles-based than the standard it replaces, the ICAEW noted. That brings with it some challenges in itself, and highlights the difficulties involved in reducing the length of IFRS financial statements.

“More judgment means an increased need for disclosures,” said Sleigh-Johnson. “That may be a challenge for some. What is critical is that the longer disclosures don’t result in key information becoming obscured.”

The hedge accounting standard is part of IFRS 9, which will replace IAS 39, the accounting standard that received so much attention in the wake of the global financial crisis. IFRS 9 is not yet complete however, as there are still deliberations on impairment going on.

“Replacing IAS 39 has proved a much slower and tougher task for the standard setters than originally thought,” said Sleigh-Johnson. “That has been a source of huge frustration. They are not there yet, but the hedge accounting standard is an important strand of what has become a rather tangled and complex web of much-needed financial reporting reforms.”

Because the impairment phase of the IFRS 9 project has not yet been completed, the IASB decided that a mandatory date of Jan. 1, 2015 would not allow sufficient time for entities to prepare to apply the new standard. As a result, the IASB has decided that a new date should be decided upon when the entire IFRS 9 project is closer to completion. 

The amendments made to IFRS 9 in November 2013 remove the mandatory effective date from IFRS 9.  However, entities may still choose to apply IFRS 9 immediately.

A high-level summary of the amendments can be downloaded here.