The International Accounting Standards Board (IASB) is developing a new standard for hedge accounting to more closely reflect power and utility companies' risk management activities, Dennis Deutmeyer reports.
Under current International Financial Reporting Standards, economic hedging by power and utility companies does not always qualify for hedge accounting — and even when it does, accounts can appear more volatile than actual business practice.
The current hedge accounting model in IAS 39, Financial Instruments: Recognition and Measurement, is complex, includes some arbitrary limits, requires a lot of documentation, and often results in a mismatch between recognition of the hedged item and the derivative, which flows through profit and loss.
The new standard should address these issues. Its approach to hedging is more principles-based and aims to produce a better matching of the accounting for the hedged item and the derivative, more accurately reflecting economic activities.
Significant changes that may impact power and utility companies
Hedge effectiveness assessment
To qualify for hedge accounting under IAS 39, companies must document the effectiveness of the hedge derivative in offsetting related risk exposures. This sometimes requires a time-consuming retrospective and prospective quantitative assessment, with the hedge effectiveness required to stay within a bright-line threshold of 80% to 125%.
In the new standard, the effectiveness assessment will be more principles-based and performed only prospectively. A hedge will be considered effective if all of the following criteria are met:
- Causality and correlation. As a result of an economic relationship, the hedging instrument and the hedged item are expected to move in opposite directions because of a change in the hedged risk.
- Quantities. The weightings of the hedged item and the hedging instrument (i.e., the hedge ratio) are designated based on the quantities of the hedged item and hedging instrument that the entity actually uses to meet the risk management objective, unless doing so would deliberately create ineffectiveness.
- Credit risk. The impact of changes in credit risk (of a counterparty) is not so large that it dominates the changes in fair value of the hedged item or the hedging instrument.
Depending on the complexity of the hedging instrument used and the hedging relationship, the above assessment will usually be qualitative. Although the new rules should allow more hedges to qualify as effective, power and utility companies will still need to measure and record any actual ineffectiveness in profit or loss.
Electricity prices are sometimes based on the cost structure of a power plant in addition to the cost of the inputs used to generate the electricity (e.g., coal). A company that has agreed to buy this electricity at a future date may also enter into a hedge transaction to reduce its exposure to coal price fluctuations (i.e., hedge a component of the total electricity price only).
Under current rules, hedge accounting is not allowed for such risk components of non-financial items. The new model will allow the coal derivative to qualify as a hedge of the coal risk component of the electricity price, provided that component is separately identifiable and reliably measurable. This should result in less ineffectiveness being recorded in profit or loss.
Current accounting rules preclude derivatives from being part of a hedged item, which excludes many common risk strategies from being covered by hedge accounting. The new standard will allow "an aggregated exposure that is a combination of an exposure and a derivative [to] be designated as a hedged item."
A company whose functional currency is the Euro has coal purchase contracts denominated in US dollars (USD). To hedge against fluctuations in the USD market price of coal, it enters into USD coal swaps to fix the coal price for the following year.
Three months later, it enters into a hedge against the foreign exchange exposure on the fixed USD coal price (i.e., the combination of the actual variable USD coal price and the USD coal swap). Under the previous model (IAS 39), the first transaction would qualify for hedge accounting, but the second would not. Under the new approach, both transactions qualify.
Most power and utility companies enter into forward contracts to buy or sell gas and electricity as part of normal operations. These own-use arrangements are treated as executory contracts and are not recorded in their financial statements until they actually buy or sell the gas or electricity.
Power and utility companies also enter into derivative transactions to mitigate fair-value exposure to fluctuations in commodity price. Changes in the fair value of the derivatives are reflected in profit or loss each reporting period without the offsetting changes from the fair value of the related own-use contracts. This results in an accounting mismatch in earnings.
The new standard will allow companies to report own-use contracts at fair value through profit or loss where this will significantly reduce or eliminate an accounting mismatch. This change will minimize the volatility in earnings for companies using this option.
The final standard is expected to be issued in the second half of 2012, and we expect entities will need to adopt on 1 January 2015.
For more information on the impact of the new hedging standard, please contact us, or read our additional publications at www.ey.com/ifrs.
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