Financial Reporting Exposure Draft (FRED) 51 provides a new hedge accounting model for FRS 102, which might make it more attractive for groups previously put off from applying FRS 102 by the limited number of allowable hedges in FRS 102 and differences from IFRS. However, in order to benefit from hedge accounting at transition to FRS 102, entities need to act now! Hedges must be designated and documented by 1 January 2014 for a December 2015 year-end entities.
Why were the FRS 102 hedging accounting rules changed?
The accounting for financial instruments and hedging is one of the most significant changes between current and new UK GAAP. Under new UK GAAP – be it FRS 101 or FRS 102 – derivatives will be brought on balance sheet at fair value, with changes recorded through the income statement. Under current UK GAAP, derivatives are typically held off balance sheet, with changes reported in the income statement only as they arise. This major change will likely gross-up the balance sheet, impact net earnings and increase volatility in the income statement. The income statement volatility can be reduced if hedge accounting is applied.
The original version of FRS 102 allowed hedge accounting for limited and relatively straightforward hedges. As a result, hedge accounting could not be achieved in many cases when the hedge provided good economic hedge and was in line with the entity’s risk management strategies – for example, hedging with options.
The FRC decided to address these limitations and revised section 12 of FRS 102 to make it align with the evolving IFRS hedge accounting rules – that is, the hedge accounting chapter of IFRS 9. The IFRS 9 hedge accounting rules are generally less prescriptive and better reflect the economic substance than current hedge accounting under IAS 39. This could mean that entities might prefer to adopt FRS 102 in their stand-alone accounts as opposed to FRS 101 or full IFRS. In theory, this could also mean that entities will be able to apply more flexible hedging rules in their stand-alone accounts as opposed to the group’s consolidated accounts (which currently have to follow IAS 39). Two sets of hedge documentation might be required in this case. This discrepancy might survive for a while, as IFRS 9 is not expected to be effective until 2016 at the earliest.
What are the key principles?
The objective of FRED 51 is to allow entities to apply hedge accounting when this reflects their economic and risk management strategies, without onerous conditions. It also uses concepts and language that are, as far as possible, consistent with IFRs 9.
While much has changed, the underlying mechanics of the different types of hedges are unchanged. In addition, entities must still designate and document hedging relationships at inception and comply with the other formal hedge accounting criteria. Even though the FRED 51 changes will not have been finalised by 1 January 2014, companies should still document their hedges based on the exposure draft by the transition date.
The amendments do not cover macro-hedging because the macro-hedging part of IFRS 9 has not yet been finalised. So it is expected that entities – particularly financial institutions and building societies, which hedge risk on a portfolio basis – will continue to take an accounting policy choice within FRS 102 to apply the hedging provision of IAS 39.
What should entities do now?
As with all new accounting standards, there are number of areas to be finalised and clarified. In particular, the final hedging changes to FRED 51 are not expected before Q2 2014. Still, entities need to act now, putting in place a project plan and creating working assumptions that can be firmed up over time.
Actions to take now!
• Understand your financial instruments and hedging scenarios and choose the appropriate option under new UK GAAP – do you want to apply EU IFRS (and be consistent in between the subsidiaries and the consolidated accounts), FRS 101 (IFRS with limited disclosures), the ‘full’ FRS 102 (slightly simplified IFRS with hedging rules aligned with IFRS 9) or FRS 102 with IAS 39?
• Assess the impact of the different UK GAAP options on tax, distributable reserves and key financial ratios.
• Assess the impact on systems, processes and people – remember how complex and time-consuming the IFRS adoption by listed groups was in 2005? The UK GAAP conversion is expected to be even more challenging, as it will affect every active company in the UK group, and the UK GAAP numbers drive the tax numbers.
• Act now and put hedge documentation in place if you wish to apply hedge accounting at transition to FRS 102 – 2014 comparatives are required, meaning 1 January 2014 is the transition date for December year-end companies.
• Ask an accounting expert to ensure you properly consider all angles in this complex jigsaw.
Olga Cileckova is a director in PwC's Corporate Treasury Team