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The Bruce Column — Changing the thinking on hedging

  • Robert Bruce Image

26 Nov 2010

When people talk about how IFRS has become so complex that laymen, (including Sir David Tweedie's oft-quoted but mythical Aunt Agatha), have no chance of understanding them people are most often referring to the issue of financial instruments.

And in that world hedge accounting, for all its innocuous and rural title, bulks large. The official IASB summary of where they are in the development of their thinking on hedge accounting may give simplify hedge accounting as its primary mission under the heading of "broad direction" but anyone who has sat in on a group of people discussing the topic know that, for all the erudition of those involved, they might as well be talking in Mandarin Chinese or some long-lost language recently rediscovered during an archaeological dig.

Small wonder the hopes for the forthcoming hedge accounting exposure draft are so high. Stripping out the confusions which have gathered, barnacle-like, on the structure can only help. The exposure draft is due to be published imminently and its two main objectives are, the IASB hopes, within reach. At a recent roundtable for members of the UK Hundred Group of Finance Directors and the IASB, facilitated by Deloitte, the IASB associate director on the project, Sue Lloyd, made it clear that the twin goals of simplification and allowing a clearer representation of an organisation's risk management were achievable.

For one thing aligning the accounting much more closely with the risk management policies of an organisation and what it is doing on the hedging front will make it much clearer to the outside world what the business objective of entering into the hedging transaction was in the first place. Companies use derivatives for many reasons. Banks may use them either to mitigate risk or to speculate. Other companies use them mostly to hedge risks. And up until now the mass of rules-based hedge accounting requirements have simply prevented sound economic hedges from being presented fairly. Rules and bright lines, as in many areas of financial reporting, simply distort the true position.

So moving to a principle-based system, however difficult, will help. And getting rid of the 80/125 rule will undoubtedly help. Until now the rule has been that a hedge must be 80% to 125% effective. But, as the IASB agrees, those percentages are completely random. And there were two tests, prospective and retrospective testing. What the exposure draft will say is that organisations have got to align the hedging instrument and the hedged item so there is no bias to being over-hedged or under-hedged. And then report the offset based on the effectiveness.

That alone gets rid of lots of issues and not just the bright lines. It should reduce compliance costs. It will create a better alignment with risk management. And it will allow more hedges to become eligible. It will have far-reaching effects.

And the frequent criticism that it was not possible, as it were, to compare apples and pears when hedging a risk will also be overcome. Now, as long as each component is separately identifiable and reliably measurable, all will be well. This already applied for financial hedges but this amounts to the biggest change for non-financial hedges.

The overall result should broadly cheer corporates, which have always argued that they have not been listened to enough in this field, and leave banks watching all this with interest but knowing that it is the macro-hedging debate in the future that they are eagerly awaiting. And people should like the overall reduction in compliance.

Now all everyone has to do is deal with the exposure draft. It will be published in a few days time. There are only ninety days of exposure and the final standard is expected to be issued before the end of June, just before Sir David Tweedie steps down as Chairman. The ninety days of exposure period will be tight. If simplicity and an alignment of the financials with risk management are to be achieved there is a lot of work for people to do.

Robert Bruce
November 2010

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