Accounting for hedging activities

No. 2014-03 January 30, 2014 What s inside: Overview... 1 Background... 1 Key provisions... 3 Qualifying for hedge accounting... 3 Eligible hedged items... 9 Hedging instruments... 17 Presentation... 21 Alternatives to hedge accounting... 22 Disclosures... 24 What s next... 24 Effective date and transition... 24 Accounting for hedging activities IASB new general hedge accounting requirements Overview In November 2013, the IASB published the new general hedge accounting requirements added to IFRS 9 as a result of the third phase of its project to revise its financial instruments accounting model. The new requirements result in the IASB s model being more principles-based than the previous IASB and current US GAAP models. The requirements reflect the IASB s goal to simplify hedge accounting, align it more closely with the risk management activities undertaken by companies, and provide decision-useful information about an entity s risk management strategies. Hedges of net positions involving open portfolios of financial instruments and forecasted transactions (portfolios where the population can change over time, sometimes known as macro hedges ) are not addressed by the new IASB general hedge accounting requirements. Those transactions are the subject of separate IASB deliberations and will be addressed in the future. In the meantime, companies using IFRS 9 for hedge accounting may continue to apply the IAS 39 requirements for fair value hedges of interest rate risk of a portfolio of financial assets or financial liabilities or apply IAS 39 in its entirety until the new macro hedge guidance is issued. The IASB s principal objective in this phase of its financial instruments project was to improve IAS 39, not to achieve convergence with the FASB. The new IASB hedge accounting model differs significantly from current US GAAP and the proposal issued by the FASB in May 2010. We believe the FASB will re-activate its hedge accounting project soon, perhaps before it completes its financial instruments projects on impairment and classification and measurement. Background.1 The rules on hedge accounting in IAS 39, Financial Instruments: Recognition and Measurement, have frustrated many preparers, as the requirements have not been well linked with common risk management practices. The detailed rules have at times made achieving hedge accounting impossible or very costly, even when the hedge was an economically rational risk management strategy. The IASB has addressed many of these concerns in this third phase of its efforts to replace IAS 39 with IFRS 9..2 The new IASB hedge accounting model introduces the following fundamental changes: National Professional Services Group CFOdirect Network www.cfodirect.pwc.com Dataline 1

Replacement of the highly effective (80% to 125%) threshold as the qualifying criteria for hedge accounting with a requirement focusing on: (1) the need for an economic relationship between the hedged item and hedging instrument (2) a requirement for credit risk not to dominate the value changes resulting from that economic relationship, and (3) a hedge ratio that reflects the relationship between the quantities of the hedged item and hedging instrument actually used for risk management purposes. Rebalancing of the hedge is generally required if the risk management hedge ratio changes (e.g., due to changes in the economic relationship between the hedged item and the hedging instrument). However, a rebalancing will not be treated as a dedesignation and re-designation of the hedge relationship. Prohibition of voluntary de-designation of the hedging relationship, unless the risk management objective for such relationship changes. Ability to designate specifically identifiable and reliably measurable risk components of non-financial items as hedged items. More flexibility in hedging groups of dissimilar items (including net exposures). Accounting for the initial time value as a cost of buying the protection when hedging with options in both fair value and cash flow hedges. Similar accounting will be permitted for the forward points when the spot method is elected and for the currency basis spread associated with a hedge of foreign currency risk. If the credit risk of a financial instrument is managed with a credit derivative, the financial instrument can be designated as at fair value through profit or loss on initial recognition or subsequently. Introduction of incremental disclosure requirements to provide users with useful information on the entity s risk management strategy..3 The FASB s May 2010 exposure draft included, but was not limited to, the following major changes: Relaxation of the rules pertaining to the assessment of hedge effectiveness by reducing the effectiveness threshold from highly effective to reasonably effective. Elimination of the short-cut method and critical terms match method as techniques to assess effectiveness. Recognition of hedge ineffectiveness resulting from under-hedges of cash flows. Elimination of the ability to voluntarily de-designate hedging relationships. For a detailed discussion of the significant changes proposed by the FASB in May 2010, refer to Dataline 2011-06 dated February 1, 2011. National Professional Services Group CFOdirect Network www.cfodirect.pwc.com Dataline 2

Key provisions Qualifying for hedge accounting Qualifying for hedge accounting at inception.4 This is an area where IFRS 9 significantly relaxes the previous rules to allow more hedging relationships to qualify for hedge accounting. IAS 39 and current US GAAP require that the hedge must be expected to be highly effective (a prospective test) at inception and on an ongoing basis. Additionally, the relationship must be demonstrated to have actually been highly effective (a retrospective test) at each subsequent reporting date. Highly effective is defined as a bright line quantitative test of 80% to 125%..5 Under IFRS 9, a hedge qualifies for hedge accounting if the following criteria are met: The hedging relationship consists only of eligible hedging instruments and hedged items. Similar to under IAS 39, there should be a formal designation and documentation at inception of the hedging relationship and the entity s risk management objective and strategy for undertaking the hedge. The documentation requirements are not very different from the requirements in IAS 39; therefore, there is not much relief from the current administration necessary to achieve hedge accounting. However, as no retrospective effectiveness test is required, this test does not need to be documented. There is an economic relationship between the hedged item and the hedging instrument (i.e., they have values that generally move in the opposite direction because of the hedged risk). Hence, there must be an expectation that the value of the hedging instrument and the value of the hedged item will systematically change in response to changes in a common, or very similar, underlying such that they are economically related. An ongoing analysis of the possible behavior of the hedging relationship during its term is required, in order to ascertain whether it can be expected to meet the risk management objective. The mere existence of a statistical correlation between two variables does not, by itself, support a valid conclusion that an economic relationship exists. PwC observation: While the requirement for an economic relationship is new, it would be unlikely that an entity would use an instrument that did not provide a valid economic relationship for risk management purposes. Accordingly, this is unlikely to be a problematic requirement. The effect of credit risk does not dominate the value changes that result from that economic relationship. An example of credit risk dominating a hedging relationship is when an entity hedges an exposure to commodity price risk using an uncollateralized derivative. If the counterparty to that derivative experiences a severe deterioration in its credit standing, the effect of the changes in the counterparty s credit standing might outweigh the effect of changes in the commodity price on the fair value of the hedging instrument whereas changes in the value of the hedged item depend largely on the commodity price changes. National Professional Services Group CFOdirect Network www.cfodirect.pwc.com Dataline 3

PwC observation: IFRS 9 does not provide a definition of what dominate means. However, it is clear that the effect of credit risk should be considered on both the hedging instrument and the hedged item. For example, an entity hedging the interest rate or foreign currency risk of a financial asset (such as a bond), will need to look at the credit risk of the bond. If the bond s issuer has a high credit risk, then the bond might not qualify for hedge accounting. During the financial crisis there were many situations where entities that purchased claims to troubled financial institution s assets and the amount that would ultimately be realized was very uncertain and so may not have qualified for hedge accounting. On the other hand, if derivative instruments are covered by collateral agreements and Credit Support Annexes to a much greater degree, it is much less likely that credit risk will dominate. The hedge ratio of the hedging relationship is the one resulting from the quantity of hedged item that the entity actually hedges and the quantity of the hedging instrument that the entity actually uses to hedge that quantity of hedged item under its risk management strategy. PwC observation: The elimination of the 80-125% hedge effectiveness bright line removes a significant obstacle to hedge accounting for many risk management strategies. Under IAS 39, a hedge that was 81% effective would achieve hedge accounting with 19% ineffectiveness being recorded (subject to the lower of test for cash flow and net investment hedges). Whereas a hedge that was 79% effective would not achieve hedge accounting and the full fair value changes of the derivative would be recorded in profit or loss (i.e., the accounts would show 100% ineffectiveness). From a risk management perspective, the difference between 79 and 81% effectiveness is minimal, yet the accounting rules did not reflect this. Hence we expect that many will welcome this change. The following table provides a summary of the key changes introduced by IFRS 9 and a comparison with US GAAP and IAS 39 in this area: Hedge effectiveness US GAAP IAS 39 IFRS 9 Highly effective (generally 80%- 125%) Similar to US GAAP Hedge designation based on the economic hedge and actual risk management strategy No imbalance that could create ineffectiveness in order to achieve an accounting outcome inconsistent with the purpose of hedge accounting Credit risk does not dominate the National Professional Services Group CFOdirect Network www.cfodirect.pwc.com Dataline 4

value changes that result from the economic relationship Hedge ratio and rebalancing.6 A retrospective effectiveness testing is not required under IFRS 9. However, companies must make an ongoing assessment of whether the hedge continues to meet the hedge effectiveness criteria described in paragraph 5..7 IFRS 9 requires ensuring that the hedge ratio is appropriate. Put another way, companies should verify that the hedge ratio is aligned with that required by their economic hedging strategy (risk management strategy). Deliberate imbalances must be avoided. A mismatch of weightings between the hedged item and the hedging instrument should not be used to achieve an accounting outcome that is inconsistent with the purpose of hedge accounting. This doesn t imply that the hedge relationship must be perfect, but the weightings of the hedging instruments and hedged item actually used cannot be selected in order to introduce ineffectiveness..8 In relation to the hedge ratio, IFRS 9 introduces a requirement for rebalancing. This is consistent with the requirement of avoiding an imbalance in weightings at inception of the hedge, but also at each reporting date and upon significant changes in the circumstances. Not every change in the extent of offset between the changes in the fair value of the hedging instrument and the hedged item s fair value or cash flows constitutes a change in the relationship between the hedging instrument and the hedged item. The sources of hedge ineffectiveness that are expected to affect the hedging relationship are evaluated to see whether the hedge ineffectiveness represents: Fluctuations around the hedge ratio that remains valid (i.e., continues to appropriately reflect the relationship between the hedging instrument and the hedged item); or An indication that the hedge ratio no longer appropriately reflects the relationship between the hedging instrument and the hedged item..9 Fluctuation around a constant hedge ratio (and hence the related hedge ineffectiveness) cannot be reduced by adjusting the hedge ratio in response to each particular outcome. Hence, in such circumstances, the change in the extent of offset is a matter of measuring and recognizing hedge ineffectiveness, but does not require rebalancing..10 However, if changes in the extent of offset indicate that the fluctuation is around a hedge ratio that is different from the hedge ratio currently used for that hedging relationship, or that there is a trend leading away from that hedge ratio, hedge ineffectiveness can be reduced by adjusting the hedge ratio. In such circumstances, an entity must evaluate whether the hedging relationship reflects an imbalance between the weightings of the hedged item and the hedging instrument that would create hedge ineffectiveness (irrespective of whether recognized or not) in order to achieve an accounting outcome that is inconsistent with the purpose of hedge accounting. On rebalancing, any ineffectiveness of the hedging relationship is determined and recognized immediately in profit or loss before adjusting the hedge relationship. National Professional Services Group CFOdirect Network www.cfodirect.pwc.com Dataline 5

Example: Rebalancing of a hedge Rebalancing not required An entity with a EUR functional currency has a forecast purchase in HKD in 6 months time amounting to HKD 7.8 million. In order to hedge its future exposure, the entity wants to purchase foreign currency (i.e., enter into foreign currency forward contracts) to effectively fix the purchase price in EUR. HKD is pegged to the USD (which means that the exchange rate is maintained within a band or at an exchange rate set by the Hong Kong Monetary Authority). The entity could enter into a forward contract to buy HKD and pay EUR. However, entering into a forward contract to buy HKD and pay EUR is more expensive than entering into an agreement to buy USD and pay EUR (as there is a smaller market and less liquidity in HKD compared with USD). The entity decides instead to enter into a USD:EUR forward. As long as the HKD is pegged to the USD, using a USD derivative as a hedging instrument will work just as well for the entity as a HKD derivative. The peg ratio is HKD 7.8: USD 1. However, even though it s pegged it is not completely fixed (the HKD is allowed to trade within the narrow range of HKD 7.75 to 7.85). Since the range is very small this entity is willing to accept this risk, so it enters into a forward contract for USD$1 million (HKD 7.8m). Rebalancing is not required where ineffectiveness arises merely because of fluctuations in exchange rates within the narrow trading range originally expected at inception. Accordingly the hedge ratio remains valid. Rebalancing required Consider the facts as per the previous example, however, now assume that the exchange rate HKD:USD is re-pegged to, say, HKD 7.2: USD 1. If the derivative continues to be for USD$1 million, the hedge ratio will no longer reflect the economic relationship between the hedging instrument and hedged item and thus will result in mandatory rebalancing. Rebalancing should reflect its risk management strategy which could either be reducing the hedged item to HKD 7.2m of the forecast purchase of HKD 7.8m, or increasing its hedging instrument by buying another derivative to cover the remaining HKD0.6m of the hedged item..11 Rebalancing is a continuation of the hedging relationship. That is, the hedge is not reset by de-designation and re-designation, and hence does not require setting up a new hypothetical derivative or amortization (in the case of a fair value interest rate hedge) of an effective portion of fair value changes to profit or loss. IFRS 9 permits rebalancing by increasing or decreasing the volume of the hedged item or hedging instrument in the relationship..12 When rebalancing a hedging relationship, an entity must update its analysis of the sources of hedge ineffectiveness that are expected to affect the hedging relationship during its (remaining) term. The documentation of the hedging relationship must be updated accordingly. The following table provides a summary of the key changes introduced by IFRS 9 and a comparison with US GAAP and IAS 39 in this area: National Professional Services Group CFOdirect Network www.cfodirect.pwc.com Dataline 6

Rebalancing US GAAP IAS 39 IFRS 9 The concept of rebalancing does not exist. But if it does occur, it is a de-designation and re-designation event. Similar to US GAAP Rebalancing is generally required if the risk management ratio changes Rebalancing is a continuation of the hedging relationship without the need to reset the hypothetical derivative (cash flow hedges) or start amortization (fair value hedges) Nature of effectiveness tests.13 IFRS 9 has retained the periodic effectiveness assessment criterion (at least, at each reporting date or when circumstances change). However, the effectiveness test is only a forward-looking test (i.e., no retrospective test is required)..14 IFRS 9 allows an entity to demonstrate effectiveness qualitatively or quantitatively, depending on the characteristics of the hedge relationship. For example, in a simple hedge where all the critical terms match, a qualitative test might be sufficient. On the other hand, in highly complex hedging strategies, some type of quantitative analysis may need to be performed..15 In measuring ineffectiveness, entities should take into consideration the impact of time value of money on the hedged item PwC observation: The IASB staff believes that this is not a change in guidance and hence should not have any practical implications. However, this may affect hedges involving forward contracts. Currently, in practice, many entities separate the forward points from the forward contract and designate only the spot element as the hedged risk. The spot element is not discounted; hence the impact of timing is ignored, which is a critical factor in rolling strategies and partial term hedges. More entities will now have to keep track of the timing of the hedged transaction and measure any ineffectiveness arising from a difference in expected timing between the hedged transaction and the derivative. National Professional Services Group CFOdirect Network www.cfodirect.pwc.com Dataline 7

The following table provides a summary of the key changes introduced by IFRS 9 and a comparison with US GAAP and IAS 39 in this area: Effectiveness test US GAAP IAS 39 IFRS 9 Nature of test Time value of money Prospective test at inception Prospective and retrospective each reporting period or at least every three months Short cut method can be applied in certain circumstances In practice, entities designate only the spot element of a forward contract as the hedged risk. Spot is used on an undiscounted basis. This is done so that timing differences between the hedged item and the hedging instruments does not have an impact on the effectiveness Prospective test at inception Prospective and retrospective when circumstances change or at least each reporting period Retrospective test is quantitative Similar to US GAAP Prospective test only required at each reporting period or when circumstances change if sooner Test can be qualitative or quantitative depending on complexity of hedge relationship Entities should take into consideration the impact of time value of money on the hedged item. If only this spot element of a forward contract is considered in assuming effectiveness, then the spot method must be applied on a discounted basis. Voluntary de-designation.16 IAS 39 and US GAAP allow the voluntary de-designation of a hedging relationship. Under IFRS 9 an entity cannot de-designate and thereby discontinue a hedging relationship that: Still meets the risk management objective on the basis of which it qualified for hedge accounting (i.e., the entity still pursues that risk management objective); and Continues to meet all other qualifying criteria (after taking into account any rebalancing of the hedging relationship, if applicable)..17 The distinction between the notions of risk management strategy and risk management objective is important to determine when the discontinuation of a hedging relationship is required or not allowed. The risk management strategy is the highest level at which an entity determines how it manages risk. The risk management strategy identifies the risks to which the entity is exposed and sets out how the entity responds to them. Conversely, risk management objective refers to the objective that applies to a particular hedging relationship. In other words, it relates to how the particular designated hedging instrument is used to hedge the particular exposure designated as the hedged item. National Professional Services Group CFOdirect Network www.cfodirect.pwc.com Dataline 8

.18 A risk management strategy often will involve many different hedging relationships whose risk management objectives relate to executing that risk management strategy. Hence, the risk management objective for a particular hedging relationship can change even though the entity s risk management strategy remains unchanged. If the objective changes the hedge relationship must be discontinued. Voluntary dedesignation US GAAP IAS 39 IFRS 9 Permitted Similar to US GAAP Prohibited if risk management objective is the same Eligible hedged items.19 IFRS 9 provides greater flexibility in the designation of exposures as hedged risks. The changes primarily remove restrictions that today prevent some economically rational hedging strategies from qualifying for hedge accounting. The standard allows designating risk components of non-financial items and groups of dissimilar items (including net exposures) as hedged items. The following table provides a summary of the key changes introduced by IFRS 9 and a comparison with US GAAP and IAS 39: Hedged item US GAAP IAS 39 IFRS 9 Components of non-financial items Derivatives Groups of similar items Groups of dissimilar items (net positions) Prohibited except for FX risk Derivatives cannot be designated as hedged items Permitted only if fair value change for each of individual item is proportional to the overall change in the group's fair value Not permitted, except when hedging with internal derivatives in limited circumstances Prohibited except for FX risk Similar to US GAAP Similar to US GAAP Not permitted Permitted if the risk component is separately identifiable and reliably measurable Permits hedging aggregated exposures which include derivatives Designation permitted without regard to the fair value changes of the individual items if certain conditions are met. Permitted for fair value hedges and for FX risk cash flow hedges Net nil positions Not permitted Similar to US Permitted if National Professional Services Group CFOdirect Network www.cfodirect.pwc.com Dataline 9

Layers, including bottom layers and layers of groups of items Equity instruments at fair value through OCI Layers are permitted for cash flow hedges. Hedges of bottom layers or "last of" are not allowed Not permitted GAAP Similar to US GAAP Similar to US GAAP certain criteria are met Permits hedges of layers, including bottom layers for fair value and cash flow hedges Permitted Hedging risk components of non-financial items.20 IAS 39 and US GAAP allow hedges of components for financial items only. However, IFRS 9 permits entities to hedge risk components for non-financial items, provided such components are separately identifiable and reliably measurable. This is an area of significant interest for risk management functions in non-financial service organizations..21 In assessing whether a risk component of a non-financial item is eligible for designation as a hedged risk, an entity should take into consideration factors, such as: Particular market structure to which the risk relates and where the hedging activity takes place, Whether the risk component is a contractually specified component (where the contract entails a formula-based pricing structure (or example, commodity A plus a margin), Example: Contractually specified risk component Entity A has a long-term supply contract for natural gas that is priced using a contractually specified formula that references certain commodities (e.g., gas oil, fuel oil, etc.) and other factors such as transportation charges. Entity A can hedge the specified gas oil component in the natural gas supply contract using a gas oil forward contract. Whether the risk component is implicit in the fair value or cash flows of the item (non-contractually specified risk components, for example where the contract includes only a single price instead of a pricing formula) Example: Implicit risk component An entity purchases a product (such as aluminum beverage cans) in which a metal, such as aluminum, is used in the production processes. Contracts to purchase aluminum cans are commonly priced by market participants based on a building block approach, as follows: The first building block is the LME price for a standard grade of aluminum ingot. National Professional Services Group CFOdirect Network www.cfodirect.pwc.com Dataline 10

The next building block is the grade premium or discount to reflect the grade/ quality of aluminum and/or the location differential used as compared to the standard LME grade/location. Additional costs will be paid for conversion from ingot into cans and delivery costs. A profit margin for the seller. The entity may want to use an aluminum LME futures or forwards to hedge its price exposure to the aluminum component of the product s cost. The nature of the commodity (i.e., aluminum is market traded) and its significance to the overall product (i.e., it is the principal component cost of the beverage can) will likely enable the entity to conclude it is separately identifiable and reliably measurable. PwC observation: The ability to hedge risks components will be welcomed by many corporations who may not have been able to achieve hedge accounting in this area in the past. Neither US GAAP nor IAS 39 allows just the LME component of the price to be the hedged item in a hedge relationship. All of the pricing elements must be designated as being hedged by the derivative instrument. This causes ineffectiveness that is recorded within the profit and loss and in extreme cases, caused sensible risk management strategies to fail to qualify for hedge accounting. IFRS 9 now allows entities to designate a risk component of a non-financial item as the hedged risk as long as it is separately identifiable and reliably measurable. It will be easy to demonstrate that the risk component is separately identifiable and reliably measurable when it is contractually specified. However, this may prove more challenging outside the contractually specified area. IFRS 9 requires an entity to assess if risk components are separately identifiable and reliably measurable within the context of the particular market structure to which the risk or risks relate and in which the hedging activity takes place. However, IFRS 9 does not specify the criteria to be used in the analysis of the market structure, nor guidance on what defines the market to be analyzed. It will therefore be an area subject to judgment. Derivatives as hedged items.22 Currently, derivatives are not permitted to be designated as hedged items under US GAAP or IAS 39. IFRS 9 permits the designation of aggregate exposures resulting from a combination of a derivative and another exposure. This is generally the case when entities seek to manage risk on a layering basis. Example: Including a derivative as part of the hedged item Entity A, which has USD as its functional currency, takes out a 10-year floating rate loan in EUR (a foreign currency). It wants to eliminate its exposure to variability in cash flows from changes in interest rates, so it enters into a floating-to-fixed interest rate swap in EUR. To reduce volatility in the P&L, it designates the swap in a cash flow hedge. In a later period, it wants to also eliminate the FX exposure, so it takes out a USD: EUR fixed-fixed cross currency interest rate swap to eliminate its exposure. However, IAS 39 would not allow the issuer to designate the combined loan and EUR interest rate swap as the hedged item, as a derivative generally cannot be a hedged item. Under IAS 39, the entity would instead have needed to combine the original swap and the new cross-currency interest rate swap as the hedging instrument, which would necessitate the de-designation of the original interest rate National Professional Services Group CFOdirect Network www.cfodirect.pwc.com Dataline 11

hedge. This was not consistent with their risk management strategy of simply overlaying one derivative to eliminate the net foreign currency risk. However, under IFRS 9, the aggregated exposure (combination of the debt instrument plus the interest rate swap) is eligible to be designated as the hedged item. Groups of items.23 US GAAP and IAS 39 allow hedges of groups of items only if all items within the group are subject to similar risks, and changes in the fair value of each individual item is proportionate to overall change in fair value of the group. IFRS 9 includes significant changes in this area to provide better alignment with risk management strategies..24 IFRS 9 allows hedges of: (1) groups of similar items without a requirement that the fair value change for each individual item be proportional to the overall group (for example hedging a portfolio of S&P 500 shares with a S&P 500 future) as well as (2) groups of offsetting exposures (for example, exposures resulting from forecast sale and purchase transactions)..25 IFRS 9 stipulates additional qualifying criteria for such hedges, however. These include: The group should consist of items that are eligible as hedged items on an individual basis, The items in the group are managed together for risk management purposes, and In the case of a cash flow hedge of net exposures, it is a hedge of the foreign currency risk and the hedge designation specifies the reporting period in which the forecast transactions are expected to affect profit or loss as well as their nature and volume. Example: Hedge of a net exposure Assuming an entity with a EUR functional currency is forecasting purchases of inventory and sales of USD150 and 100 respectively in six months. The entity will be allowed to designate a USD50 forward purchase as a hedge of the USD150 purchases and the USD100 sales. PwC observation: The ability to hedge net exposures is in line with common risk management practices and would remove the need to identify specific gross cash flows (e.g., a specific amount of purchases which matches the net open position) which is currently required under IAS 39..26 For net exposure hedges, IFRS 9 specifies that the impact of the hedge should be reflected as a separate line within the income statement. For example, if an entity is hedging sales and cost of sales, the impact of the hedge would be shown as a separate line after the sales and cost of sales lines. National Professional Services Group CFOdirect Network www.cfodirect.pwc.com Dataline 12

Example: Profit or loss presentation of a hedge of a net exposure Assume an entity with a EUR functional currency has sales of USD100 and expenses of USD80 (both forecasted in 3 months) and wants to hedge against the fluctuations in exchange rates. It hedges USD20 with a forward contract at a rate of 1.33 accordingly locking its margin at EUR15. The spot rate on settlement is 1.25 which gives a loss on the forward of EUR1. The following table depicts how the IFRS 9 presentation would compare with how a similar hedge is reflected under IAS 39. Hedged item IAS 39 accounting (Reflect the hedge impact only on the gross identified position) IFRS 9 accounting (Reflect hedge impact as a separate line) Sales 79 80 Expenses 64 64 Hedge result - (1) Operating profit 15 15 The presentation under US GAAP would be similar to that under IAS 39 in a hedge of a percentage of gross revenue. However, if internal derivatives are used, then a gross presentation would be allowed and the hedge impact would be reflected in each of the sales and expenses lines. PwC observation: Showing the hedge impact separately does not necessarily reflect the full risk management strategy for the items which are hedged on a net basis. Risk managers typically view all items within the net position as hedged, and hence may like to present those items at the hedged rate. Hedges of net nil positions.27 An entity is permitted to designate as a hedged item a group that is a nil net position (i.e., the hedged items among themselves fully offset the risk that is managed on a group basis), in a hedging relationship that does not include a hedging instrument, provided that: The hedge is part of a rolling net risk hedging strategy, whereby the entity routinely hedges new positions of the same type as time moves on (e.g., when transactions move into the time horizon for which the entity hedges); The hedged net position changes in size over the life of the rolling net risk hedging strategy and the entity uses eligible hedging instruments to hedge the net risk (i.e., when the net position is not nil); Hedge accounting is normally applied to such net positions when the net position is not nil and it is hedged with eligible hedging instruments; and National Professional Services Group CFOdirect Network www.cfodirect.pwc.com Dataline 13

Not applying hedge accounting to the nil net position would give rise to inconsistent accounting outcomes, because the accounting would not recognize the offsetting risk positions that would otherwise be recognized in a hedge of a net position. Hedges of layers.28 IAS 39 and US GAAP allow cash flow hedges of a proportion (percentage) or a portion ( layer ) of a specific item or groups of items. However, in the case of a fair value hedge this is restricted to proportion of specific items (including groups). If a layer approach is used, the layer should be identified in the relationship with sufficient specificity so that when the transaction occurs it is clear that transaction is or is not the hedged transaction..29 Under IFRS 9, an entity will now also have the ability with certain restrictions to enter into a fair value hedge for either a percentage or a portion of the specific item or groups of items, such as, hedges of bottom layer of a fixed rate debt. However, if an item includes a prepayment option, a layer of such item is not eligible to be designated as a hedged item in a fair value hedge if the option s fair value is affected by changes in the hedged risk, unless the designated layer includes the effect of the prepayment option when determining the change in fair value of the hedged item. Other differences.30 In addition, there are numerous other differences between US GAAP and IAS 39 that have not been affected by IFRS 9. Some of the key differences are discussed below: Hedged item US GAAP IAS 39 and IFRS 9 Components of financial items Partial term hedging (fair value hedges) Hedging more than one risk with a single derivative Permitted for benchmark interest rate, credit risk and foreign exchange risk. "Benchmark" was restricted to U.S. government borrowing rates and LIBOR. In June 2013, The Emerging Issues Task Force reached a final consensus to include the Fed Funds rate (OIS) as a benchmark. Permitted but likely to be ineffective Not permitted, except for basis swaps Permitted. Definition of benchmark is not restricted Permitted Permitted Hedging risk components of financial items.31 IFRS permits any components of risks of financial instruments to be eligible hedged items, provided the types of risk are separately identifiable and reliably measurable. In contrast, US GAAP specifies that the designated risk must be the changes in one of the following: (1) overall fair value or cash flows, (2) benchmark interest rates (explicitly limited to specified benchmark interest rates (interest rate on treasury obligations of the U.S. Federal Government or LIBOR in the US or the Fed Funds rate (OIS) and comparable rates for non-us instruments), (3) foreign currency exchange rates, or (4) credit risk. Additionally, practice has developed in the U.S. such that measurement of National Professional Services Group CFOdirect Network www.cfodirect.pwc.com Dataline 14

benchmark interest rate is very restrictive. The IFRS model is therefore already more flexible in this area than US GAAP..32 The calculation of ineffectiveness also differs in this area between IFRS and US GAAP. For example, when hedging a fixed rate debt for changes in benchmark interest rate, US GAAP requires that the fair value of the hedged item must be determined using the "contractual interest rate." This may result in significant ineffectiveness recorded in income. IFRS, on the other hand, allows using the swap rate for calculating the fair value of the hedged risk. This difference is illustrated in the following example. Example: Measuring ineffectiveness in an interest rate fair value hedge Assuming an entity issues a fixed-rate debt instrument at 7 percent. The swap rate on a receive fix-pay LIBOR swap is 5 percent at issuance date. The entity designates the swap as a hedging instrument in a fair value hedge of changes in LIBOR in the fixedrate debt. Under IFRS, the designated hedged risk is the swap rate of 5 percent; therefore, effectiveness is assessed, and ineffectiveness is measured with reference to the 5 percent portion of the total 7 percent fixed rate. Under US GAAP, the cash flows used to calculate ineffectiveness must be based on the contractual cash flows of the entire hedged item (unless the shortcut method is used). Therefore, while the designated risk is a benchmark interest rate, effectiveness is assessed and ineffectiveness is measured with reference to the contractual 7 percent fixed rate; as such, ineffectiveness will arise which may be significant. Partial term hedging.33 IFRS is more permissive than US GAAP with respect to a partial term fair value hedging relationships. It permits designating a derivative as hedging only a portion of the time period to maturity of a hedged item, if effectiveness can be measured reliably and the other hedge accounting criteria are met. Example: Partial term hedging Entity A acquires a 10 percent, fixed-rate government bond with a remaining term to maturity of 10 years. Entity A classifies the bond as available for sale. To hedge itself against fair value exposure on the bond associated with interest rate payments until year five, entity A acquires a five-year, pay-fixed/receive-floating swap. The swap may be designated as hedging: the fair value exposure of the interest rate payments for five years, and the change in value of the principal payment due at maturity to the extent affected by changes in the yield curve relating to the five years of the swap. In other words, IFRS allows imputing a five-year bond from the actual 10-year bond. US GAAP does not permit defining the hedged risk as described above. Hedging multiple risks with a single hedging instrument.34 IFRS allows a single hedging instrument to be designated as a hedge for more than one type of risk, provided that: National Professional Services Group CFOdirect Network www.cfodirect.pwc.com Dataline 15

The hedged risks can be identified clearly, The effectiveness of the hedge can be demonstrated, and It is possible to ensure that there is specific designation of the hedging instrument and different risk positions. Accordingly, under IFRS a single derivative may be separated into two components by inserting (hypothetical) equal and offsetting legs, provided that they are denominated in the entity s own functional currency. US GAAP, however, does not permit creation of hypothetical components in a hedging instrument, and hence does not allow such a hedging strategy (except in a cash flow hedge using a basis swap). The following example illustrates a situation in which hedge accounting would be permitted under IFRS but not under US GAAP. Example: Hedging multiple risks with a single hedging instrument Entity A s functional currency is EUR, and it wishes to hedge the following two items with one swap as the hedging instrument: Hedged items: (1) 10-year, 5 percent, fixed-rate USD borrowing and (2) 10-year, six-month LIBOR + 80 bp loan receivable denominated in Swiss francs (CHF). Hedging instrument: 10-year cross-currency interest rate swap (CCIRS) under which entity A will receive fixed interest in USD and pay variable interest in CHF at six months LIBOR (the rate representing a six-month interbank deposit in CHF). Under IFRS, a single swap may be separated by imputing hypothetical equal and offsetting legs. These legs may be either fixed or floating, provided either alternative qualifies for hedge accounting. In addition, IFRS does not necessarily require the two hedge relationships to be of the same type; as such, an entity could have two different hedge relationships (i.e., a cash flow and a fair value hedge). National Professional Services Group CFOdirect Network www.cfodirect.pwc.com Dataline 16

In this example, the original CCIRS may be separated in either of two ways: Hedging instrument Hedged item Hedge type ALTERNATIVE A: INSERT EUR FLOATING LEGS IN THE SWAP Receive fixed USD/pay floating EUR Receive floating EUR/pay floating CHF Currency and interest rate risk on USD debt Currency risk of CHF loan receivable Fair value hedge of interest rate and currency risk Cash flow hedge of currency risk ALTERNATIVE B: INSERT EUR FIXED LEGS IN THE SWAP Receive fixed USD/pay fixed EUR Receive fixed EUR/pay floating CHF Currency risk on USD debt Currency and interest rate risk of CHF receivable Cash flow hedge of currency risk Cash flow hedge of interest and foreign currency risk Hedging instruments.35 IFRS 9 allows cash instruments, which are classified at fair value through profit or loss, to be eligible for hedging different types of risks. Under IAS 39, cash instruments are restricted to the hedges of foreign exchange exposures only. In addition, IFRS 9 also includes significant changes to the accounting for the time value of options and hedges with forward contracts. The following table provides a summary of the key changes introduced by IFRS 9 and a comparison with US GAAP and IAS 39: Instrument US GAAP IAS 39 IFRS 9 Cash instruments Permitted only for hedging foreign exchange risk in limited circumstances Permitted for hedging foreign exchange risk Instruments classified at fair value through profit or loss are permitted to be used as hedging instruments for all types of risks Debt instruments classified at amortized cost can be hedging instruments for foreign exchange risk only Embedded derivatives Permitted under US GAAP if embedded derivative is separated Similar to US GAAP Not permitted for embedded derivatives in hybrid financial assets under IFRS 9 (since they are no National Professional Services Group CFOdirect Network www.cfodirect.pwc.com Dataline 17

longer separated) Embedded derivatives separated from hybrid financial liabilities can still be designated as hedging instruments Embedded derivatives separated from non-financial hosts would also remain eligible hedging Options US GAAP permits time value for certain qualifying cash flow hedge relationships to be deferred in OCI, and subsequently released into profit or loss The time value component of an option is marked to market through profit or loss resulting in income statement volatility Any time value paid is treated similar to an insurance premium for both fair value and cash flow hedges Accounting for the premium depends on whether the hedged item is transaction or time related Subsequent changes in time value are deferred in OCI and subsequently released in profit or loss depending on whether the hedged item is time related or transaction related. This accounting treatment applies only to the extent that the time value relates to the hedged item (aligned time value) Cash flow hedges with forward contracts Either the forward rate or Similar to US GAAP In addition to the spot rate National Professional Services Group CFOdirect Network www.cfodirect.pwc.com Dataline 18

Internal derivatives spot rate may be designated; if the spot rate is used, changes in fair value due to forward points are recorded in profit or loss Permitted for foreign exchange risk only in limited circumstances and forward rate methods, the initial forward points may be treated similar to the time value of options and recorded in profit and loss depending on whether the hedged item is time related or transaction related Not permitted Not permitted Accounting for time value of options.36 Under US GAAP for certain qualifying cash flow hedge relationships, the time value component of a purchased option can be deferred in OCI and subsequently released to profit or loss when the hedged item affects net income..37 IAS 39 only allows the intrinsic value of the option to be designated as the hedging instrument while the time value is marked to market through profit or loss. IFRS 9 introduces significant changes to the guidance related to accounting for the time value of options. It analogizes the time value to an insurance premium. Hence, the time value is recorded as an asset on day 1 and then released to profit or loss based on the type of item the option hedges. For example, an entity assesses whether the hedge is transaction related (e.g., the hedge of a forecast purchase of inventory in foreign currency) or whether it is time-period related (e.g., a hedge of the fair value of commodity inventory for the next six months using a commodity forward contract). Any changes in the fair value of the option attributable to the time value is recorded in OCI (along with changes in intrinsic value) and then reclassified to profit or loss as discussed above. The IFRS 9 treatment also applies to fair value hedges..38 If the critical terms of the hedging option and the hedged item do not match, IFRS 9 provides that the accounting treatment for the time value previously described applies only to the extent that the time value relates to the hedged item. This is referred to as the aligned time value. The aligned time value can be determined based on the valuation of an option with critical terms that perfectly match the hedged item. Changes in the time value of the option in excess of the aligned time value are recorded in profit or loss. PwC observation: Overall this is a welcomed change for many IFRS preparers, and may result in an increased usage of purchased options in hedge accounting because the income statement volatility of the time value can now be avoided. National Professional Services Group CFOdirect Network www.cfodirect.pwc.com Dataline 19

Hedging with forward contracts and cross currency swaps.39 Under US GAAP, IAS 39 and IFRS 9, an entity has a choice regarding whether to designate a hedge of foreign currency risk using either the forward rate or the spot rate. If the forward rate is used, the entity is hedging with the full fair value of the derivative. If only the spot rate is hedged, changes in fair value related to the forward points are recognized in profit or loss..40 Under IFRS 9 the entity can continue to account for these hedges as described in the previous paragraph. However, IFRS 9 also allows a third alternative. Under this approach, the initial forward points may be treated similar to the time value of options with subsequent changes deferred in other comprehensive income. The initial forward points are subsequently recorded in profit and loss depending on whether the hedged item is time related or transaction related..41 It should be noted that while the accounting for the time value of options under IFRS 9 described earlier is mandatory, recognizing changes in fair value of the forward points in a manner similar to time value of an option is optional. The entity could instead choose to recognize all changes in forward points in profit or loss..42 IFRS 9 makes it explicit that items not included in the hedged exposure cannot be assumed to exist in testing effectiveness. This applies regardless of whether a fair value hedge or a cash flow hedge is used, and whether the hypothetical derivative approach is adopted. An explicit prohibition on the inclusion of currency basis risk in the hypothetical derivative represents a significant change to current practice. However, during its redeliberations, the IASB decided to broaden the concept of cost of hedging (applicable to the time value of options and forward points in forward contracts) to also incorporate the currency basis spread. This will help to reduce income statement volatility mainly in cash flow hedges of foreign currency risk. Internal derivatives.43 Under IAS 39 and IFRS 9, only instruments that involve a party external to the reporting entity can be designated as hedging instruments. As internal derivative contracts are eliminated in consolidation, they do not qualify under IFRS for hedge accounting in the group's consolidated financial statements. The restrictions under IFRS compel entities to either: Enter into separate third-party hedging instruments for the gross amount of foreign currency exposures in a single currency rather than on a net basis (as a typical treasury center would do to hedge group exposure), or Enter into hedging instruments with third parties to on a net basis and designate such contracts as a hedge of a portion of one of the gross exposures. The "gross" approach may not be desirable given the cost of entering into multiple external derivative contracts..44 Similar to IFRS, US GAAP generally only permits those instruments that involve an unrelated external party to be eligible as hedging instruments. However, US GAAP permits internal derivatives in cash flow hedges of foreign currency risk if certain conditions are met. These include: All the criteria for hedge accounting are met by the entity with the hedged exposure, and The treasury center must either: National Professional Services Group CFOdirect Network www.cfodirect.pwc.com Dataline 20