New rules that will transform the accounting of financial instruments will go live next year. Are you prepared?
As of 1st January 2018 corporates will need to comply with the new IFRS 9 standards that will have a significant impact on how financial instruments are accounted for. These changes may directly impact the P&L and corporate balance sheet.
The role of the treasurer in preparing for the incoming changes may be larger than expected, as credit risk on commercial counterparties will now be more in line with the current view on financial counterparty risk.
Credit risk management
According to Pieter Sermeus, Senior Treasury and Risk Consultant at Zanders, while credit risks can be a significant threat to business continuity, provisions for credit losses have shown to often be ‘too little too late’.
“IFRS 9 imposes a much more proactive credit risk methodology, moving from an incurred loss to an expected loss approach with a three-stage model, where the provision is equal to the expected loss over the next 12 months or over the lifetime of the instrument depending on its credit quality,” he says.
Correctly calculating the expected loss is based on an accurate estimation of current and future probability of default (PD), exposure at default (EAD), loss-given default (LGD) and discount factors.
“This will increase the importance of risk models and the need for a robust governance framework,” adds Sermeus. “In the end, provisions under IFRS 9 will make reserves more timely and sufficient which will have a positive impact on P&L volatility.”
Principles-based hedged accounting
Although the basic hedge accounting models under IFRS 9 do not change from those under IAS 39, Sermeus explains that IFRS 9 is more principle-based, with better alignment of the accounting impact to the underlying risk management activities and an increased qualification of hedging instruments and hedged items.
“Hedge effectiveness criteria are now more principle-based – abandoning the mandatory 80%-125% effectiveness range – and look for instance at the economic relationship between the hedged item and hedging instrument,” he says.
The result is that economic risk management objectives will be reflected better in hedge accounting under IFRS 9. It will also offer more flexibility on qualifying hedged items and hedging instruments, especially when there is an underlying economic relationship which may not have qualified for hedge accounting under IAS 39.
Upcoming tax regulations like BEPS and Anti-Tax Avoidance Directive by the European Commission are aimed at reducing artificial profit shifting and require arms-length pricing for intercompany loans. If the loan is not made ‘at arm’s length’, it will have to be split in a below-market (or above-market) element and a residual loan element under IFRS 9.
“The below-market element will typically be recorded as an investment in the parent’s financial statements while being recorded as equity in the subsidiary’s financial statements,” explains Sermeus. “Under IFRS 9, this difference in accounting treatment can seriously impact the willingness of a corporate to issue intercompany loans which are not at arm’s length.”
IFRS 9 clearly brings fundamental changes to financial instruments accounting and certainly has its challenges, however for Sermeus it also offers clear benefits.
“For corporates that are already familiar with IAS 39, the new standards of IFRS 9 introduce some useful changes to better align corporate objectives with accounting impact and financial results,” says Sermeus. “The role of the corporate treasurer under IFRS 9 may be larger than expected due to the alignment of credit risk on commercial counterparties with current financial credit risk practices.”
According to Sermeus the early adopters that he has been working with have expressed that the experience of migrating to IFRS 9 has been generally positive. And with the mandatory deadline right around the corner it is something that all treasurers must begin to consider.