Out of all the changes put forth in IFRS 9 with regard to Hedge Accounting, one that will likely be well received will be the ability to hedge the risk components of non-financial items. This is big news to many companies out there, in particular the foods industry and airlines. Under IAS 39 and current FASB rules, they are not allowed to isolate the risk associated with a component of the risk being hedged. For instance a company that produces baked goods must hedge the overall cost of flour and cannot simply isolate the cost of the wheat component to qualify for hedge accounting. Likewise, an airline cannot hedge crude oil as a component of it forecasted jet fuel requirement.
The current standard requires that the entity compare the entire change in value of the hedged item with the change in the value of the hedging contract to prove effectiveness. Due to changes in other variable costs, such as milling costs in the case of flour, or refining margin, in the case of jet fuel, derivative contracts may not always correlate well.
Certainly, the economic aspects are intact regardless of whether or not the hedge actually qualifies for hedge accounting under the accounting standards. The consequences would be undesirable income volatility, since the gains or losses of unqualified derivatives must be taken into income immediately and would not match up with the actual timing of the risk being hedged.
An important precept in IFRS 9 regarding component risk is that there is no need for a component to be contractually specified in order to be eligible for hedge accounting. This should not be interpreted as an anything goes clause. IFRS 9 guidance states that the component risk, when not contractually specified, must be “separately identifiable and reliably measurable”. This will certainly be easier for some markets than others. When the component risk isn’t clearly spelled out in a contractual specification, it may be require a bit of effort in determining the influence of individual components to price of the end product.
As was the case under IAS-39, proper documentation is essential to qualify for hedge accounting. From a hedge documentation perspective, you will need to clearly identify your risk if you are electing to hedge a component. You will need to also state your method of assessing hedge effectiveness as well as your anticipated level of effectiveness. Since IFRS 9 now allows the rebalancing of hedges, it will be necessary to fully document any hedging relationship changes on an ongoing basis.
For many companies, where the economics and value of hedging have always been apparent, adopting IFRS 9 may now allow them to finally achieve the accounting benefits.
Now if only we can get to the long awaited convergence of IFRS and US GAAP, wouldn't that be nice?
For more information about hedging the risk components of non-financial items, see Ernst & Young’s Hedge accounting under IFRS 9 Guide (pages 8-10).