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As an aside, sticking with the example that the hedging instrument reports a gain of $19m if we were to assume that the cost of the asset had only risen by $9.5m then the cash flow hedge would be 200% effective (19/9.5 = 200%) and therefore outside of the 80–125% effectiveness rule. The hedging relationship is not highly effective and therefore hedge accounting is not permitted. The whole $19m gain on the hedging instrument must therefore be recognised in the statement of profit or loss.
However, assuming as we did in the first place, that the hedge was effective at the reporting date and we then jump forward a few months into the middle of year 2 and further assume that the asset is indeed bought for $120m and is a financial asset, then the previously recognised gain of $19m on the hedging instrument sitting in reserves is recycled from equity and recognised in the statement of profit or loss. Recycling has meant that this gain of $19m has appeared within the statement of comprehensive income in two consecutive years, firstly in other comprehensive income and secondly in the statement of profit or loss. Many argue that recycling is double counting and therefore inappropriate. This is one of the few remaining situations of recycling being permitted by reporting standards. For example IAS 16,Property, Plant and Equipment clearly prohibits the recycling of previously recognised gains on the disposal of revalued property. The other comprehensive statement must clearly distinguish between those gains and losses which may or may not be recycled to the statement of profit or loss in future periods.
If the asset is a non-financial asset – for example, inventory that is sold in the accounting period – then the previously recognised gain of $19m on the hedging instrument can be recycled from its reserve in equity and recognised in the statement of profit or loss. However, if the asset is property, plant and equipment, then the reserve would be recycled over the useful life of the property, plant and equipment.
IAS 39 takes a rules-based approach to hedge accounting and these rules are often complex and sometimes contradictory. An example of this is the quantitative effectiveness rule of 80%–125%. These are arbitrary numbers. It has also been argued that requirements to perform quantitative effectiveness tests are onerous and that there is insufficient guidance on how to actually quantify hedge effectiveness.
Under the new proposals the assessment of hedge effectiveness will only be required on a prospective basis and the 80%–125% test for hedge effectiveness testing will be dropped. The hedge effectiveness will assessed by a review of the risk management strategy – with a requirement that no systematic under or over hedging is expected. Under the proposals a hedging relationship must comply with the following to qualify for hedge accounting:
? there should be an economic relationship between the hedging instrument and the hedged item
? the effect of credit risk should not dominate the value changes that result from that economic relationship, and
? the hedge ratio should reflect the actual quantity of hedging instrument used to hedge the actual quantity of hedge item.
In other words this is a more principles-based approach.
IAS 39 requires a different accounting treatment depending on whether the hedge is classified as a fair value hedge or a cash flow hedge. With a fair value hedge the gain or loss on the hedging instrument is recognised in the statement of profit or loss whilst with the cash flow hedge the gain or loss on the hedging instrument is initially recognised in the other comprehensive income with the potential for it being recycled to the statement of profit or loss at a later date. Accordingly similar items are being treated in an inconsistent manner, which is not ideal. Further it can be difficult to distinguish between a fair value hedge and a cash flow hedge.
IAS 39 allows hedge accounting to be optional. Therefore, even if a company does actually hedge and complies with the current rules they do not need to apply hedge accounting. The rules-based approach to hedge accounting also results in some companies who do hedge not being able to apply hedge accounting because they fall foul of the rules. An example of this is the inability to apply hedge accounting for specific components of non-financial items. For example an airline wishing to protect itself from changes in aircraft fuel prices can in reality do so by entering into forward crude oil contracts. This is because crude oil is a major component of aircraft fuel and the price of aircraft fuel will be closely correlated to crude oil prices. However, this is not considered a valid hedge under IAS 39 as the company can only account for a hedge of either the foreign currency risk, or the entire non-financial item (the purchase price of the aircraft fuel).
Under the new proposals hedging by risk components will be permitted for both financial and non-financial items, if separately identifiable and measurable. In addition, hedging instruments can include non-derivatives and there are significant new disclosure requirements.
IAS 39’s restrictive rules have resulted in some companies not applying hedge accounting or changing their risk management approach to become eligible to apply hedge accounting. The proposed revision of the restrictions should cause changes in the risk management approach and more application of hedge accounting.
Tom Clendon FCCA, Kaplan Financial
Last updated: 20 Apr 2015