IMPLICATIONS OF IFRS 9 HEDGING PRACTICES: ADDRESSING THE FINE LINE BETWEEN FINANCE AND RISK
The IASB’s discussion paper on accounting for macro hedging published in April 2014 discusses how to tackle open portfolios within an IFRS 9 context. The paper raises several important points and marks a significant step towards shaping the IFRS 9 standard as a whole. One of the most interesting points to note is the recurring topic of whether IFRS requirements are more pertinent to the risk or to the finance department within a firm. For example, the portfolio revaluation approach discussed within this discussion paper use ALM practices as a base, and the input for the hedge accounting principles is based on dynamic risk management principles. This, with several other factors in the paper, points towards firms adopting a more integrated finance and risk approach, the implications of which will be discussed in this comment piece.
The core aim of the IASB’s discussion paper was to adjust and improve the way hedging standards are currently disclosed within financial reporting (IAS 39). Prior to this discussion paper, IFRS 9 held a mixed measurement principle following the amended phase 1 of the standard which did not represent the risk department’s use of hedging strategies within financial reporting. If these standards were not addressed and adjusted in this way, they would give rise to P&L volatility – which most CFOs are adverse to. By outlining the principle in this way, the IASB should take away the conflict of interest between the CFO (who is generally volatility adverse) and the CRO (who relies on hedging for risk management practices) and better align the risk and finance functions. But this move towards risk and finance alignment raises the issue of who is responsible for these different practices.
A first observation here is that in theory, because a CRO is responsible for managing risk, they should also be responsible for hedging strategies as a consequence. The question then however, is will a finance department then have all the necessary tools and details to put this ‘complexity’ within an accounting standard? This issue is highlighted again within IFRS 9 itself, where risk management policies will influence the effectiveness of certain hedge relationships. For example, if – from an accounting perspective at least – the rebalancing of an existing hedge relationship results in a perfect hedge, but does not conform to risk management policies, it could mean that the hedge is labeled as ineffective and is thus discontinued. What is clear here though is that it does not mean there is a trade-off between accounting and risk hedging optimizations but that there is a common influence as to how this should be tackled.
The second observation is that in addition to the IFRS 9 expected loss exposure draft, the disclosures requirement following the portfolio revaluation approach and the current IFRS 9 standard gives insight into how and why risk management departments actually hedge. From an investor’s perspective, it could be argued that this insight would lead to more transparency in how the CRO is managing its risks. However on the other side of that coin, from a CRO’s point of view, it can be viewed that due to the internal and sensitive nature of hedging – and in that respect the expected loss proposals – is disclosed, there is a danger that competitive advantage could be lost.
A third observation would be the fact that the portfolio revaluation approach within the discussion paper would lead to additional disclosures. Besides the affect described in the previous paragraph another important question is the additional pressure it would bring to fulfilling all these disclosures. As mentioned in previous comment pieces, the pressure is already quite high given the existing number of disclosures expected from firms.
Another observation as a consequence of the closer alignment of finance and risk functions is the impact that has on firms’ operational systems, as previously mentioned, in the case of hedging it is clear that co-operation will be needed from a system perspective in translating risk information into clear and accurate financial reporting.
Internal reporting requirements surrounding the internal structure of entities and the management reporting around source of ineffectiveness will also be challenged, as the revaluation approach on a portfolio as a whole will become more complex as it builds detailed internal reporting to determine the different sources included in a firm’s P&L explained report. Similarly, the management reporting process will also be impacted as firms will need to follow the portfolio revaluation approach with the necessary attention. Having a complete view on where all the P&L items are coming from has become one of the major topics. Financial institutions clearly now have to have a closer control on profit versus loss versus risk.
While it is difficult to answer the question of who exactly will take care of hedge accounting requirements, what is clear is that firms are faced with a cross-department challenge which highlights the need to have a more integrated finance and risk view.