Practical guide on general hedge accounting Dec 2013

Practical guide 6. Alternatives to hedge accounting 6.1. Extended use of fair value option for ‘own use’ contracts IFRS 9 applies to all items within the scope of IAS 39. As part of the publication of IFRS 9, the remaining version of IAS 39 has been amended to extend the option to irrevocably designate and measure certain items at fair value through P&L (‘fair value’ option). Entities are allowed to apply the fair value option where doing so eliminates or significantly reduces an accounting mismatch. Under IFRS 9 entities are now able to apply the fair value option to contracts to buy or sell non-financial items which qualify for the ‘own use’ exception. These are contracts that can be net settled but that were entered into for the purpose of the receipt or delivery of a non-financial item in accordance with the entity’s expected purchase, sale or usage requirements. PwC insight: This is good news for non-financial entities, for example, entities in the utilities industry. Utilities often have a large number of contracts requiring physical delivery of the energy (that is, the contracts are not for trading purposes), generally these contracts are ‘own use’ contracts under IAS 39. These entities commonly hedge with energy derivatives. By electing to designate the physical sales contracts at fair value through P&L they would likely significantly reduce the measurement inconsistency between the sales contracts and the energy derivatives and thus achieve offsetting effects without the need to apply hedge accounting (and therefore comply with the hedge accounting criteria). 6.2. Option to designate a credit exposure at fair value through P&L IFRS 9 states that the credit risk of a debt instrument is a risk component that does not meet the eligibility criteria to be designated as a hedged item. The spread between the risk free rate and the market interest rate incorporates credit risk, liquidity risk, funding risk and any other unidentified risk components and margin elements. Therefore, the Board believes that credit risk cannot be isolated, and so does not meet the separately identifiable criteria in IFRS 9. Credit derivatives (such as credit default swaps) that are used to hedge credit risk are accounted for at fair value through P&L, while credit exposures are usually measured at amortised cost or are unrecognised (for example, loan commitments). Where there is credit deterioration, this results in recognising gains on the credit derivative while the impairment on the hedged item is measured on a different basis, which results in P&L volatility that does not reflect the credit protection obtained. IFRS 9 now provides the option to designate the financial instrument (all or a proportion of it) at fair value through P&L. This option is available only where:  The name of the credit exposure (for example, the borrower or the holder of a loan commitment) matches the reference entity of the credit derivative (‘name matching’); and  The seniority of the financial instrument matches that of the instruments that can be delivered in accordance with the credit derivative. This fair value option is different from the one described for ‘own use’ contracts, since this can be elected at initial recognition, subsequently or even while the hedged credit exposure is unrecognised (for example, in the case of a loan commitment). In addition, it is not irrevocable but, once this option is elected, specified criteria must be met to discontinue its use. General hedge accounting PwC  22

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