A Fatal Flaw in the IFRS 9 Proposal?

When the IASB issued its final proposal for hedge accounting under IFRS 9: Financial Instruments, to treasurers and others, on 7 September the initial reaction was mostly positive. There were, admittedly, grumbles that the new standard fell way short of its promise to provide clarify and greater simplicity. Nonetheless the draft did contain a true overhaul of the thinking about hedge accounting with some very beneficial changes, especially for companies that hedge commodities.

Initial optimism however quickly gave way to grave concerns, as experts read through the application guidance, generating a series of very concerned comment letters to the IASB in the hope of changing specific language that could dramatically affect how companies account for cash flow hedges of currency risk. The board is set to issue its final language in early January 2013, while the market holds its breath to see whether it will listen to the comment letters and make the necessary adjustments. The standard is issued in nearly final language and only what the IASB would consider a ‘fatal flaw’ would trigger any revisions. Whether the IASB would agree this is a fatal flaw is debatable. But on one thing there’s no disagreement – left unchanged the language will generate substantial volatility in income statements even for basic foreign exchange (FX) hedges.

Currency Basis

Concerns centre on a specific paragraph in Appendix B of IFRS 9 (paragraph B6.5.5). What’s at stake is the description of how to calculate the effectiveness of hedges using the hypothetical derivative method. And what the current language suggests would lead to great volatility in the income statement as a result of the potential for significant ineffectiveness, between the derivative value and the value of the hypothetical derivative. This would affect primarily cross-currency swaps and FX forwards. In essence, the guidance suggests that companies cannot use market prices for measuring the value of the hypothetical derivative in order to assess the effectiveness of the hedge. Instead they would have to rely on finance theory using the divergence in interest rates between currencies: a difference that, of late, has had little to do with the value of currency derivatives. At stake are hedges as common as FX forward and cross-currency swaps.

“The specific issue is the requirement for the hypothetical derivative to exclude features in the value of the hedged item that only exist in the hedging instrument,” explained a comment letter of 15 November from treasury and risk management vendor, Reval. “Further, the specific example states that a hypothetical derivative cannot impute a charge for exchanging different currencies even though this is how they are exchanged in the market place.”

Instead, it appears, hedgers would have to calculate the theoretical value of the derivative based on the interest rate differential, a factor that often has nothing to do with how derivatives are priced in the market place. “If currency basis must be excluded from the measurement of the hedged item, it implies that significant income statement volatility can arise on such hedging strategies [as FX forwards and currency swaps],” comments Reval.

The International Swaps and Derivatives Association’s (ISDA) draft comment letter points out the same flaw. “In making this statement, the new standard would appear to fundamentally change the way that cash flow hedges of foreign currency are accounted for,” it says. It cautioned that this change had not been contemplated during the IASB deliberations and would have severe consequences for hedgers. Nor is it in line with the standard’s own stated objective: to align accounting with the stated objective of companies’ risk management strategies. Clearly, market risk, not theoretical FX risk, is what companies seek to hedge.

ISDA and Reval point out several other fatal flaws with the current methodology:

1. It’s technically wrong: While it’s not entirely clear, it appears that the standard would require companies to compute effectiveness based on market theory rather than practice. Whereas paragraphs B6.3.8 and 9 state that effectiveness must be assessed based on “separately identifiable and reliably measurable” items, and “should be assessed “within the contact of the particular market structure.
2. Not meaningful information: By using market pricing to construct the hypothetical derivatives, hedgers can ensure that gains/losses on the hedge will coincide with gains/losses on the derivative. However, the theoretical route would deprive financials from the reflection of what hedges really do in the market place and what they’re worth.
3. Not aligned with risk management:  As ISDA notes: “none of what is proposed is consistent with the way that FX risks are actually managed.”
4.  Complexity and operational difficulty: The proposed language would add another layer of complexity to the process, according to Reval’s letter. Companies would have to implement new systems and processes to extract the hypothetical forward curve from observable market rates.  

Next Steps

As mentioned above, the final language on IFRS 9 is due out next month. In a recent conversation among leaders of the big accounting firms, bank experts and IASB staff, the staff member who worked on the project indicated the board is unlikely to change its wording, according to one party on the call. But experts are not sure. Several say that it’s unlikely that the staff intended these consequences and the final language would eliminate the contentious paragraph. “I really don’t know how it will turn out,” said one hedge accounting expert, however, at a major bank. 

Implementation is not mandatory for two years, and even if the language survives there’s a chance the board will make some accommodation in practice as companies begin to implement.

This is likely to stop anyone who considered early implementation, in order to take advantage of some of the more favourable aspects of the new rules, especially accounting for components of commodity risk and time value of options – both radical departures from predecessor IAS 39.

Added to which there is the practical issue of wider adoption. “You can’t adopt it if it’s not endorsed by the European Union,” said Jacqui Drew, senior solution consultant at Reval. Drew said that the EU does not plan to begin the endorsement process until the entire standard is complete, and that means waiting for the next phase of IFRS 9 (impairment). Clients in Asia could go first but initial positive reaction has since been tinged with concern over the currency basis. “For many as soon as they quantified the impact of currency basis, it outweighed all the other benefits,” Drew said.

There are three actions that companies can take in the interim period:

1. Write comment letters to the IASB expressing their concern about how this would impact their ability to hedge. Comments from practitioners often carry more weight, since they include real life consequences.
2. Stay in close touch with auditors about emerging interpretation.
3. And stay tuned, ahead of the IASB issuing its final language next month.