New international accounting rules due to come into force in 2015 will resolve complexities on corporates seeking to hedge currency risk exposures that were prevalent in old accounting standards, but only partially.
The International Accounting Standards Board’s (IASB) IFRS 9 amendment to hedge accounting is a win for corporates as cross-currency basis spreads will now be considered a cost of hedging similar to option premiums.
The IASB’s alternative solution applies a fix to the way the IFRS 9 amendment, issued last September, treated the element of currency basis in forward foreign exchange (FX) pricing, which would have left companies exposed to substantial profit and loss (P&L) volatility.
“In theory, if you want to hedge FX exposures, you will see movements in currency basis spreads. It’s unavoidable,” said Blaik Wilson, Asia Pacific solutions consulting manager at Reval to Asiamoney PLUS in a telephone interview on February 8. “The accounting outcome is such that movements in currency basis won’t reside in the P&L, it will reside in reserves for other comprehensive income.”
Accumulated other comprehensive income differs from net income – which has already been realised. It is often attributable to gains and losses yet to be realised from a variety of sources including unrealised pension costs, gains and losses on securities and derivatives, foreign currency hedges and net foreign investments.
Prior to this change, B6.5.5 sought to remove features that are normally used in calculating hypothetical derivatives, notable the inclusion of currency basis – the cost of exchanging different currencies – into the equation.
If currency basis must be excluded from the measurement of the hedge item, it will have substantial negative implications on a corporate’s income statement for cash flow hedges of currency risk and would have created misalignment between their risk management strategies and accounting.
“Many people got concerned about this issue because it seemed to be a step backwards relative to where we are today which isn’t in keeping with the objective of IFRS 9 in many people’s eyes. This resulted in a lobbying effort led by various industry groups which prompted corporations and banks to respond to this issue," said Colin McKee, London-based director for corporate advisory at the Royal Bank of Scotland (RBS) to Asiamoney PLUS in a telephone interview on February 14.
As a result of the recent amendments made by the IASB, market participants believe could boost corporate adoption of derivatives in their day-to-day operations.
Cash flow hedges will now become an effective tool because of the new treatment of cross-currency basis spreads, which will not result in a mismatch between the fair value of the actual and hypothetical derivative.
“If we do get to a point of consistency between cash flow and fair value hedge accounting, whereby the cross-currency basis spread is treated as an allowable cost of hedging under each of the models, I would like to think it would lead to people making the right economic decision with respect to what they want to hedge,” said McKee. "The accounting treatment should not be driving that decision and the latest proposal on this issue is another good reason not to avoid using derivatives.”
All of these changes, however, come at a price. The downside is that the solution itself will create a layer of complexity when accounting for FX hedges.
“To get the accounting outcome that everybody thought was the right thing to do, they have sacrificed simplicity,” said Reval’s Wilson. “The currency basis which mirrors the one for option time value is a complex process to manage.”
According to Reval, the decision made at the end of January means that most companies will elect to designate only the spot risk of their currency hedging. This will minimise P&L volatility in most cases but it increase complexity as both hedge and excluded components must be monitored separately.
“Corporates would have to invest in the complexity because the returns on investment on moved earnings far outweigh the cost and hassle of implementing a robust hedge accounting,” added Wilson. “’Too hard or too much work’ isn’t really a good justification of not wanting to apply it and that people need to be thinking about how they are going to adapt [to this complexity].”