FINANCIAL REPORTING AND IR

After nearly a decade of debate and discussion, the effective date for the International Accounting Standards Board’s (IASB) new financial instruments standard (IFRS 9) is less than one year away. IFRS 9 is one of three new accounting standards effective in the next two years that represent wholesale changes to the way companies account for significant transactions. While the new revenue standard (IFRS 15) and the new leases standard (IFRS 16) have been stealing the spotlight recently, the impacts and opportunities provided by IFRS 9 are no less important for some companies.

The new financial instruments standard brings significant changes to how companies classify and measure financial assets, record impairment and apply hedge accounting in their financial statements.

Certain industries, mainly banks and other financial institutions, have been focusing on this standard for quite a while. The new expected credit loss model for recognition and measurement of impairment will have a massive impact on the provision for credit losses on their loan portfolios. A bank’s provision for bad debts will likely be larger and could be more volatile under IFRS 9.

While implementation projects at the banks are well underway, other companies should be putting plans in place to identify the impacts and take advantage of the opportunities this new standard provides. The most significant area of opportunity is the new hedge accounting model, which enables a broader range of economic hedging strategies to achieve hedge accounting. By achieving hedge accounting, companies are able to eliminate or reduce volatility in the statement of profit and loss created by the changes in fair value of a financial instrument. Eliminating this volatility has led some companies, particularly those with significant commodity exposure, to adopt IFRS 9 early.

Better alignment with risk management strategies

To understand the potential opportunities presented under the IFRS 9 hedging model, it is important to acknowledge the pitfalls of the current financial instruments standard (IAS 39). The current hedge accounting model under IAS 39 has been described as complex, not reflective of risk management activities used by many treasury departments, excessively rules-based and resulting in arbitrary outcomes.

To better align the hedge accounting model and risk management strategies commonly used by companies, the IASB moved to a more principles-based model and has done away with the bright-line effectiveness test under IAS 39.

The new standard aligns hedge accounting more closely with risk management activities in two ways.

First, the new standard expands the types of risk management activities that can qualify for hedge accounting. This is a significant step towards addressing criticism that some companies are unable to fully reflect their actual risk management activities in their financial statements.

Second, the new standard requires that a company’s hedge accounting be more closely aligned with its actual risk management objectives. The new standard goes beyond the requirement of IAS 39 to formally document “the entity’s risk management objective and strategy for undertaking the hedge” to qualify for hedge accounting. A company’s application of hedge accounting will now have to be consistent with the new objective of hedge accounting – i.e. to reflect the effect of a company’s risk management activities in the financial statements.

New opportunities to apply hedge accounting

With a move toward a more principles-based model, IFRS 9 opens up new areas for companies to apply hedge accounting where the previous model did not.

By far the most anticipated change is the ability to apply hedge accounting to risk components of non-financial items. Many companies use derivatives based on non-financial items as key risk management activities. However, IAS 39 does not permit hedge accounting for a risk component of a non-financial item (other than foreign currency risk), forcing volatility to be recorded in the statement of profit and loss. Airlines, mining companies, manufacturers and others that have to manage significant commodity price exposures have the most to gain from being able to apply hedge accounting to risk management strategies that involve derivatives on:

• agriculture – grains and oilseeds, livestock, dairy, forest, softs (e.g. cocoa, coffee, cotton, sugar)
• energy – crude oil, natural gas, ethanol, refined products (e.g. heating oil, gasoline, diesel)
• freight – forward freight agreements, container swaps
• metals – precious, base, ferrous

Where some companies may have previously avoided entering into certain derivatives for managing the risk of these non-financial items because of the accounting mismatch created by IAS 39, these companies may wish to reconsider the potential costs and benefits of hedging these non-financial risks under IFRS 9.

In addition, IFRS 9 allows certain net positions to be designated as the hedged item, whereas IAS 39 does not allow net position hedging even if a company’s risk management strategy is to combine all exposures centrally and transfer the risk to external parties on a net basis.

Finally, IFRS 9 provides the ability to hedge an aggregated exposure (a combination of a derivative and a non-derivative exposure), which may or may not be designated in another hedging relationship. By allowing net and aggregated position hedging, the new standard provides additional flexibility to treasury departments. 

With these exposures now potentially eligible for hedge accounting, a company may be able to reflect in its financial statements an outcome more consistent with how management assesses and mitigates risks for key inputs into its core business. To complement a more principles-based approach, additional disclosures will now also be required to explain to users how a company is managing its risks.

Less volatility means a clearer message

For companies that have been unable to reflect their risk management strategies in their financial statements, considerable effort may have been expended explaining to investors the accounting mismatch running through the statement of profit and loss. With these expanded hedge accounting opportunities potentially eliminating this mismatch, IR professionals may be able to focus more on the message of the company’s underlying performance and less on arbitrary accounting outcomes. The new standard is welcome news for most preparers and users of financial statements.

Andy Brown, CPA, CA is a Senior Manager, and Rob Brouwer, FCPA, CPA is Canadian Managing Partner, Clients and Markets, for KPMG LLP in Canada.