Transition to IFRS 9
are you prepared to take advantage of opportunities?
In 2014 the International Accounting Standards Board (IASB) published the final version of the new standard IFRS 9 Financial Instruments.
This new standard will replace IAS 39 Financial Instruments: Recognition and Measurement. This final version of IFRS 9 is still pending EU endorsement for European companies, which is expected to take place in the second half of 2016 and becomes effective for accounting periods starting on or after the 1st of January 2018.
IFRS 9 consists of three pillars:
- Classification and measurement;
- Hedge accounting.
For financial institutions there will be significant impacts on the rationalization of the different classification and measurement categories for financial assets and liabilities, calculations for credit risk impairment provisions and hedge accounting. For most corporates though, it will mainly affect hedge accounting, although corporates should also carefully assess the impact of the new impairment rules on classification and measurement.
Hedge accounting models
IFRS 9 addresses some of the criticism that many corporate treasurers had with the hedge accounting rules under IAS 39. In general IFRS 9 is more principles based and will better align the accounting effects for derivatives with underlying economics of risk management activities. Although the basic hedge accounting models do not change under IFRS 9, there are significant changes in the standard, such as:
- Increased eligibility of hedged items. For example risk components of non-financial items (such as crude oil, grains or base metals) can be designated as hedged if the risk component is separately identifiable and measurable by means, for instance, of contractually specified pricing formulas. This will open up hedge accounting treatment for a far broader range of commodity hedges. Also a group of hedged items and net positions (for FX risk) can be an eligible hedged item;
- Increased eligibility of hedging instruments. FX forward elements, time value of an option and cross-currency basis spread can be excluded from the hedge relation and deferred in OCI . This will also better support and facilitate the usage of options under hedge accounting;
- Hedge effectiveness testing will become simpler. The old and arbitrary ‘80%-125%’ hedge offset ratio thresholds have been eliminated. Under the new standard a hedging relationship must meet the following three criteria:
1. An economic relationship exists between the hedged item and the hedging instrument;
2. The effect of credit risk does not dominate the fair value changes;
3. The hedge ratio of the hedging relationship is the same as that resulting from the quantity of hedged item that the entity actually hedges and the quantity of the instrument that the entity actually uses to hedge that item;
IFRS 9 introduces the concept of rebalancing which is an adjustment in the designated quantities of the hedging instrument and or hedge item of a hedge relationship so that it meets the qualifying criteria again for a failed hedge relationship;
Hedge effectiveness testing is only permitted prospectively (as opposed to also retrospectively under IAS 39). The hedge effectiveness test under IFRS 9 can also be qualitative (as opposed to IAS 39 which was solely quantitative);
Dynamic hedge documentation under IFRS 9. The hedge documentation is to be updated in case of rebalancing or where the analysis of the sources of ineffectiveness is updated (as opposed to more static hedge documentation under IAS 39).
Overall, IFRS 9 is considered to be an improvement compared to IAS 39 in terms of hedge accounting. IFRS 9 offers clear opportunities, with the increased flexibility on qualifying hedged items and hedging instruments. Sound economic hedges that could not qualify for hedge accounting treatment before may now qualify under IFRS 9. Companies will also be better able to reflect economic risk management objectives in hedge accounting and financial results. Even more so than under IAS 39, it will be important for companies to clearly define their risk management strategy and objectives. The introduction of the IFRS 9 standard can be an excellent opportunity for companies to revisit their financial risk management strategy and objectives.
If IFRS 9 is adopted early it must be adopted in its entirety, so all elements in the standard are applied at the same time. The new rules will also require systems and processes to be updated, possibly with specific training for employees. Furthermore, all hedge documentation needs to reviewed and updated.
We believe it pays off to be ‘ahead of the game’ and to start taking stock of the impact and opportunities of IFRS 9.