World events over the last 18 months have resulted in some significant currency movements – and many European companies have suffered as a result. Deutsche Telekom, for example, reported that net profit was down 18% last year when the company’s stake in BT lost value “mainly as a result of a fall in BT’s share price and in the pound sterling following the Brexit referendum.” Meanwhile, EasyJet reported pre-tax losses of £212m in the first half of this year, largely due to the weaker pound.
These developments have underlined the importance of managing risk effectively: a suitable hedging strategy can mitigate the impact of movements in FX, commodities and interest rates. In practice, many companies decide against hedging, not least because of the complexities involved in hedge accounting. However, all of this is changing with the arrival of IFRS 9 – and companies which have previously held back should consider whether it’s time to hedge.
The objective of hedging is to achieve predictability over the company’s cash flows by gaining certainty about the impact of FX, interest rate and commodity movements. Failing to hedge can leave companies at a competitive disadvantage if their competitors have effective hedging programmes in place. But despite the many reasons for hedging, many treasurers decide not to do so.
Additional reading: The CFO’s Toolkit: Minimize Risk and Ensure Compliance
There are a number of reasons why companies might decide against hedging. One is expense: the cost of using derivatives can be considerable, as can the cost of the people and technology needed to support a hedging programme. Treasury teams may also lack the in-house expertise needed to make hedging decisions with confidence. Aside from these factors, the difficulties involved in achieving hedge accounting and the costs involved in complying with the relevant rules can be a major consideration for companies when deciding whether or not to hedge.
Enter IFRS 9
The good news is that upcoming accounting rule changes make it easier for companies to hedge effectively. IFRS 9 Financial Instruments was issued in 2014, and the mandatory adoption date for the new accounting standard is 1st January 2018. IFRS 9 replaces IAS 39, which has been widely criticised as overly complex.
The new standard is expected to bring considerable benefits:
- Compared to IAS 39, IFRS 9 makes hedge effectiveness testing simpler. Under the previous rules, hedge accounting could only be applied if the results of the hedge fell within an effectiveness range of 80-125%. This is no longer the case under IFRS 9, which focuses on the economic relationship between the hedging instrument and the item being hedged.
- Companies will be able to manage commodities exposures more effectively, enabling them to avoid profit and loss volatility.
- The new standard also brings benefits for FX and interest rate options, as some of the hurdles associated with IAS 39 have been removed.
As a result, IFRS 9 enables treasurers to hedge more effectively with less back office complexity, as well as enabling a company’s risk management objectives to be better aligned with the accounting treatment of a hedge.
Risk management solutions
The arrival of IFRS 9 means that hedging may be more attractive for treasurers who haven’t hedged until now – or who have hedged only to a limited degree. A hedging programme can have a considerable impact on the financial health of a company. But first of all, it’s important to have the right tools in place.
The good news is that modern treasury management and risk management solutions make hedge accounting more accessible than in the past. As well as analysing the effectiveness of hedges under IFRS 9, today’s sophisticated solutions can support the full workflow, including hedge definition, effectiveness testing and generating accounting entries. Technology can help in different ways:
- Valuation. With scheduled reporting and in-built market data, risk management solutions can help companies calculate the change in value for a derivative over the current period.
- Documentation and reporting. Technology helps companies document their hedging relationships, for example by including templates and enabling relevant documents to be attached in support of the hedge.
- Effectiveness testing. Technology can simplify the processes involved in performing effectiveness testing.
- Create accounting entries. Systems also use accounting engines to create journal entries from valuations and effectiveness testing. This includes splitting which portion of a company’s unrealised gains and losses are effective and which are ineffective.
In summary, recent turbulence has underlined the need for companies to hedge their exposures. For companies which have avoided hedging in the past, it’s never too late to start. IFRS 9 provides a compelling opportunity to revisit the benefits of hedging, while today’s cloud-based systems means that hedge accounting technology is more affordable than it used to be.
Simply put, using the right technology can make the difference between wanting to hedge – and actually doing it.