Pieter Sermeus, Senior Treasury and Risk Consultant, Zanders:
With the mandatory implementation deadline of 1st January 2018 less than six months from now, the impact of IFRS 9 should not be underestimated. The standard significantly changes the accounting of financial instruments which can directly impact the P&L and balance sheet. The role of the treasurer 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.
Proactive credit risk management through forward looking provisions
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.
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. In the end, provisions under IFRS 9 will make reserves more timely and sufficient which will have a positive impact on P&L volatility.
A more principles-based hedge accounting
Although the basic hedge accounting models under IFRS 9 do not change from those under IAS 39, 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.
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.
Market based intercompany financing
Upcoming tax regulations (such as the Base Erosion Profit Shifting project by the OECD or the 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. 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 opportunities
IFRS 9 brings fundamental changes to financial instruments accounting and has its challenges, but 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. 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. While early adopters have experienced the migration to IFRS 9 as generally positive, the main appraisal for both IFRS 9 as the corporates implementing it will be in the months ahead, with the mandatory deadline right around the corner.
For accounting periods beginning on or after 1st January 2018, IFRS 9 will be replacing IAS 39 as the accounting standard for financial instruments. However there is more to the standard than hedge accounting; it impacts how financial instruments are classified and measured, how impairments are calculated and what disclosures need to be given.
Robert Waddington, Director Corporate Treasury and Commodity Group, PwC:
For corporates, the new standard has been well received, with promises that some of the frustrations of hedging under IAS 39 have been addressed. However, what are these benefits and are corporates ready for the change?
Alignment of accounting and risk management
The great news is that IFRS 9 provides an opportunity for alignment between accounting and your risk management. This was an annoyance of many when applying IAS 39 where what made sense from an economic point of view was not reflected in the accounting. This resulted in either P&L volatility from derivatives not being hedge accounted for or even worse, transactions that made economic sense not being entered into.
With more hedging instruments now achieving hedge accounting, I see this as an opportunity for treasurers to reassess how they manage risk.
Reduction in P&L volatility
As noted above, instruments that did not achieve hedge accounting previously might do so under IFRS 9, thus reducing P&L volatility. In addition most corporates have either used or thought about using options as a way to manage risk. Under IAS 39 the time value of an option was typically excluded from the hedging relationship and recorded in the P&L; causing more unwanted P&L volatility. Under IFRS 9, the movement in the time value of the option during its life can be deferred in reserves therefore, away from the P&L.
Hedge effectiveness has got easier
Under IAS 39, in order for a hedging relationships to be effective, the movement in the fair value of the hedging instrument divided by the fair value movement in the hedged item had to be between 80%-125%. Therefore, if the ratio was 80% then hedge accounting could be applied, however if the ratio was just 1% less at 79%, the hedge was deemed ineffective resulting in P&L volatility.
Under IFRS 9 there is now no 80%-125% threshold. However, the standard does still require you to assess effectiveness however in a different way and any ineffectiveness does still need to be calculated and recorded.
Are corporates ready for the change? At our recent IFRS 9 event, 53% of people had either:
- Not yet started looking at IFRS 9.
- Only read the standard.
- Are just about to set up a project team.
With the clock ticking it is vital that corporates focus on it now.
As IFRS 9 looms closer, many treasury teams are looking to embrace a number of advantages that will simplify hedge accounting compliance.
Bob Stark, VP Strategy, Kyriba:
Under IAS 39, one of the main issues was that the pursuit of hedge accounting treatment sometimes conflicted with the reason treasury teams were hedging in the first place. Achieving a perfect ‘accounting hedge’ was not necessarily in sync with the ideal ‘economic hedge’. Thus, a key objective of IFRS 9 was to better align the accounting treatment of a hedge with the treasury team’s risk strategy.
One of the most obvious differences between IAS 39 and IFRS 9 is the lack of prospective effectiveness testing and the removal of the 80/125 rule for retrospective testing. It was felt that these particular elements of effectiveness testing could be susceptible to outside factors that falsely suggested the hedge was ineffective. Unfortunately, this could affect whether hedge accounting could continue or could even be pursued in the first place. Under IFRS 9, ineffectiveness amounts will continue to be booked to income accounts but a low effectiveness testing result will not require de-designation of the hedge.
While most corporates utilise forward contracts for hedging, some may reconsider the use of options, as the time value of options receives better treatment under IFRS 9. Under IAS 39, the time value of an option was excluded from effectiveness tests and journalised directly to P&L. This created volatility in the income statement, which is ironically what treasurers were looking to avoid in their initial pursuit of hedge accounting treatment. As a result, many avoided using options in their hedging programmes.
Fortunately, IFRS allows deferral of the option’s time value to the balance sheet for a temporary period. Like the effective portions of the option’s intrinsic value, the time value will ultimately be reclassified back to income accounts. But it is this initial deferral which solves a big concern for those that had previously used options to hedge prior to hedge accounting being first introduced.
Enterprises that hedge commodity risk also have much to gain under IFRS 9. One of the biggest critiques of IAS 39 was that the entire underlying commodity transaction had to be hedged. IFRS 9 takes a different approach, where individual risk components can be isolated for hedge accounting. This will mostly help organisations that have multiple risks within business contracts – and it will encourage them to hedge more because they will no longer be punished for having multiple risks within their business contracts.
With any regulatory update, there are bound to be some negatives. For most, perhaps the biggest surprise within IFRS 9 may be that hedges cannot be de-designated unless the risk management objective itself changes. Under prior legislation, treasury teams could stop their pursuit of hedge accounting and end the hedge if results didn’t go their way or they wanted to try something better. That flexibility no longer exists, which puts more importance upon the setting of risk management objectives when designating the hedge in the first place.
Overall, IFRS 9 seems to have achieved its objective to solve the most popular concerns of treasury teams. The hope is that with IFRS 9 more organisations will be compelled to hedge more of their FX, interest rate and commodity risks, thus better protecting financial assets and business value of their organisations.
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