IFRS 9 Financial Instruments was published on July 24, 2014 and is effective for financial years commencing on or after January 1, 2018 and contains new rules on "hedge accounting" for industrial businesses. This can mean major implications for industrial and trading companies that hedge against financial risks using derivatives.
Material changes are found in regard to the hedged underlying transactions. It will now also be permitted to designate only individual risk components for non-financial items, for instance the metal content in metal products. Besides the metal content, companies often pay a premium for processing crude metal, which over time is also subject to fluctuations, but cannot be hedged against using suitable derivatives. Therefore, hedging must be restricted to hedging the metal component; however, according to IAS 39, this component may not be separated from the risk item and designated separately as an underlying transaction. This is a condition that, due to a lack of parallel development of the values between the underlying transaction and derivative, often leads to the failure of hedge relationships, even though there is no economic justification for this. The new rules provide better options for applying hedge accounting to commodity price risks.
Furthermore, IFRS 9 will allow aggregated exposures to be designated as an underlying transaction of a hedging relationship. For instance, if an EUR company issues a fixed-interest 10-year USD bond, one possible risk strategy could be to, on a rolling basis, finance with fixed interest for the next 2 years, but then with a variable rate for the remaining term. The company would initially enter into a cross currency swap, which turns the fixed-interest USD bond into a variable EUR bond over the duration of the term. Now, on a rolling basis, an interest rate swap is entered into every two years, which for the next two years swaps the interest from variable to fixed. Under IFRS 9, the bond along with the cross currency swap can be designated as an underlying transaction, which is currently not permitted under existing rules.
IFRS 9 also explicitly allows for the designation of net positions as part of hedging foreign exchange risks. This is especially important if a company makes and receives payments in a foreign currency. Under IAS 39, it is still necessary to designate the hedged net position to a gross share of the underlying transactions aggregated in the net position.
In terms of measuring effectiveness, IFRS 9 abolishes the effectiveness range of 80-125%, which was considered to be arbitrary. In the future, assessment of hedge effectiveness must be applied prospectively in order to designate a hedging relationship. Based on an analysis of existing risk management strategies, there now appears to be an opportunity for simplified implementation of hedge accounting.
Further key changes include how postings to accounts are to be carried out and results disclosed. As part of hedging non-financial underlying transactions, IFRS 9 abolishes the option of reclassifying OCI (other comprehensive income) to the income statement either when the underlying transaction is actually recognized through profit or loss (e.g. upon material consumption) or already when added as an adjustment to acquisition costs. IFRS 9 now allows only the latter. Furthermore, recognition of the fair value will change within the scope of hedging with options. Whereas, under IAS 39 and with a view to effectiveness, changes in fair value must be regularly recognized in the income statement, IFRS 9 interprets the fair value as a part of the hedging costs and thus changes must, as is the case with the intrinsic value, first be recorded under OCI, as well. This means that for transaction-based hedging (e.g. cash flow risk due to hedging against price fluctuations in connection with expected purchases of raw materials) the fair value recognized under OCI is reclassified at the end of the hedging horizon as a part of the initial cost. In the case of period-specific hedges (e.g. fair value risk from hedging inventories against price risks), the value is written down over the course of the hedging relationship.
Besides the new rules enacted by IFRS 9 and outlined herein, which are generally considered to be an improvement in terms of their application to hedge accounting, aligning the balance sheet presentation with risk management's activities now means that an entity is no longer permitted to voluntarily dedesignate hedging relationships. Dedesignation will be possible in the future only if the objective of risk management has changed as well.
In summary, it can be concluded that the new hedge accounting rules will have far-reaching consequences in many cases. These rules not only impact the balance sheet, but also require adjustments to internal risk management policies and processes. Therefore, companies should consider the implications of IFRS 9 and how to deal with them in the future early on.
Author: Christian Freiberger, Senior Manager, email@example.com
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