Hedge accounting – latest trends, issues, and ION capabilities

International accounting standards evolve continually due to changes in market conditions, feedback from corporations and their auditors, or post-implementation review  of the regulation updates.

In this article, we present some of the latest news and thoughts from international standard setters – notably International Accounting Standards Board (IASB) and Financial Accounting Standards Board (FASB) – and the implications for the corporate treasury. The content covers post-implementation review of IFRS9, portfolio layer hedge accounting, and current thoughts about the future dynamic risk management (DRM) model for hedge accounting.

Our goal is to share these developments in a compact yet comprehensible manner.

IFRS9 post-implementation review

The post-implementation review (PIR) summarizes experiences from the application of a particular standard. It may result in further clarifications or extensions in applying that standard. In July 2024, IASB completed a PIR of application of impairment (IFRS9) and related credit risk disclosures.

The main goal of IFRS9 has been achieved. The standard allows for timely recognition of expected credit losses (ECL) and provides investors and creditors with relevant information.

The review also determined that the methodology and approach to ECL, and related disclosures, vary between the entities. These are the variations identified:

• Intragroup financial instruments – Some entities report ECL on such transactions, while others do not. Recognition of ECL on internal loans and receivables, or issuances traded between internal group companies may require enhanced statistical models for the intragroup activity.

• Loan commitments – The standard defines loan commitments as “firm commitments to provide credit under pre-specified terms”. Differences arise in the ECL determination for such instruments, either as a forecast purchase of a convertible bond (where the settlement is in a different instrument than the one originally purchased) or corporate overdrafts.

• Financial guarantees – This is about treatment of premiums received over time rather than upfront. Some entities recognize future premiums not yet due, while others do not.

• Purchase or origination of credit-impaired instruments – The question is how to deal with decreased credit risk since the initial recognition in such assets. Some entities adjust the carrying amount, while others recognize that as negative ECL.

• Disclosures for the significant increase of credit risk (SICR) – The determination of SICR differs among entities. Further differences are in the details that entities disclose – some provide sensitivity analysis, while others provide additional “post-model-adjustments” (for example, management overlays on top of statistical models such as risk and uncertainties due to the COVID-19 pandemic).

IASB decided that while there are differences in applying IFRS9 in the identified areas, this does not require a standard-setting action within IFRS9. However, a new project for credit risk disclosures (IFRS7) will be initiated in the second half of 2024 [1].

Portfolio layer hedge accounting

The portfolio layer method (PLM) in hedge accounting is specified in the FASB’s Accounting Standard Update (ASU 2022-01) [2]. It represents an extension of the last-of-layer fair value hedging accounting for a closed portfolio of debt instruments. Designation of transactions along several slices (layers) is allowed in such a portfolio. While applicable within the US GAAP / ASC815 standards, the corresponding software tools are useful in the general context of macro-hedging.

PLM’s starting point is a closed portfolio of interest-rate assets. The portfolio can contain amortizing or bullet instruments, instruments with or without prepayments, fixed or floating. It is split into the layers according to the amortizing and prepayment schedules, including consideration of the default probabilities. The total notional within each layer represents the minimum amount outstanding that is expected at the end of the layer’s time bucket.

As an example, consider assets totaling 100 million at inception and amortizing as shown in the following figure. 60 million is expected to be outstanding (not yet amortized) at the end of the 5-year period, 25 million is the expected amount left in 10 years. These are two layers with two different maturities and designated nominals.

Layers are designated as individual hedge relations. Technically, each layer is a hedged item and can be represented by a hypothetical transaction. A hypothetical transaction maps proportionally – using a “systematic and rational method” – onto the real underlying transactions within the layer. Each layer is hedged with an external derivative. The standard allows for fair value hedge accounting entries to be generated and posted on the aggregated level per layer.

The notional of hedged items within a layer can decrease below the expected amount left, for example, below 25 million in less than 10 years. This can be due, for example, to faster-than-expected prepayments. Then a partial de-designation has to be executed. Unlike the hedge accounting postings that may be on the aggregated level per layer, the resulting basis adjustment has to be attributed onto the individual transactions, and amortized according to the terms of these transactions.

Dynamic risk management model

An exposure draft for the new hedge accounting standard under IFRS – the DRM model – will be released in 2025. Recently, IASB shared some initial thoughts [3].

The intended main building blocks augment current hedge accounting concepts. The entity will designate the current net open risk position (CNOP). The entity will use a target profile (TP) and risk mitigation intention (RMI) to determine the qualification of hedges, as shown in the next figure[3].

CNOP is associated with its risk terms, for example, with PV01 of the portfolio. Risk managers decide on hedging with externally traded derivatives. The PV01 of CNOP combined with the PV01 of hedging derivatives shall fit into the risk limits interval; the latter is defined in the accounting policy as a TP – a range of risk limits that are acceptable for ongoing hedge assessment and qualification purposes. Finally, benchmark hedging derivatives (hypotheticals) are constructed so that they match the PV01 of traded derivatives at inception. The PV01 of benchmark derivatives then evolves in time and represents the RMI.

TP and RMI are set by period and may differ period by period. Period-end measurements compare the RMI (PV01 of benchmark derivatives) to the designated external derivatives. This comparison determines the aligned (with RMI) and misaligned portions of those external derivatives. The fair value of these designated externally traded derivatives is then split: the aligned part is posted to the “DRM adjustment” account and the misaligned part is recognized in the P&L.

The DRM model is still under development. Various particularities may still change before the exposure draft release date (2025) and expected effective date (2028). However, the intention of bringing hedge accounting methods closer to the risk management practices seems set. DRM will allow for an open portfolio of transactions to be designated, and the entities will apply risk figures to assess the qualification of hedges.

ION Treasury’s commitment

At ION, we closely follow developments in accounting standards. We update our software to provide tools and features that allow our customers to achieve compliance with the accounting standard updates.

ION’s corporate treasury management systems (TMS) support IFRS9 accounting and hedge accounting. The ASC815 PLM is also available. We are monitoring developments of the DRM model to understand its applicability across industry segments.

ION’s HATT team – comprising hedge accounting specialists across ION’s TMS products – is available for any specific and detailed questions, proof of concept exercises, or other engagements related to the new regulatory developments. To speak to the HATT team, talk to your ION account manager about arranging a meeting.