IFRS: issues for the treasurer
Senior Manager,UK IFRS Centre of Excellence, Deloitte
- 1 Introduction
- 2 IFRS and the IASB – some background
- 3 The European breakthrough and growing use
- 4 Credit issues
- 5 Distributable reserves
- 6 IFRS of specific relevance to treasurers
- 6.1 IFRS 2 share-based payments
- 6.2 IFRS 3 business combinations
- 6.3 IFRS 7 financial instruments: disclosure
- 6.4 IFRS 10 consolidated financial statements
- 6.5 IFRS 13 fair value measurement
- 6.6 IAS 7 cash flow statements
- 6.7 IAS 17 leases
- 6.8 IAS 19 employee benefits
- 6.9 IAS 21 the effects of changes in foreign exchange rates
- 6.10 IAS 32 financial instruments: presentation
- 6.11 IAS 39 financial instruments: recognition and measurement
- 6.12 IFRS 9 financial instruments
- 7 The present and the future
Given the growing importance of treasurers within the financial affairs of corporate entities it should come as no surprise that treasury professionals are increasingly impacted by changes in the world of financial reporting. The one predominant driver of change in this area over the past decade has come in the form of International Financial Reporting Standards, as developed by the International Accounting Standards Board (IASB).
IFRS and the IASB – some background
The IFRS Foundation is an independent, not-for profit private sector organisation working in the public interest. One of its principal aims is to develop a single set of high-quality, understandable, enforceable and globally accepted IFRS through its standard-setting body, the IASB. In this regard the IASB is continuing the mission of its predecessor body, the IASC, which first seized upon the goal of developing international accounting standards.
The IASB, currently comprising 14 full-time members, is based in London, operating under the chairmanship of Hans Hoogervorst. The IFRS Interpretations Committee (formerly known as IFRIC) is the IASB’s interpretations body. The term “International Financial Reporting Standards” (IFRS) comprises International Accounting Standards (IAS), issued by the IASB’s predecessor body, the IASC, SIC Interpretations issued by the Standing Interpretations Committee, International Financial Reporting Standards issued by the IASB, and Interpretations originated by the IFRS Interpretations Committee.
In addition to the main text which lays out the objectives, definitions, principles and rules, IFRS contain “basis for conclusions” and application and implementation guidance. These can be very helpful in obtaining an understanding of the IASB’s thought process underpinning certain aspects of standards, as well as providing some illustrative examples.
The European breakthrough and growing use
A crucial step in increasing the importance of IFRS came in the form of a European Union decision. EU law (IAS Regulation EC 1606/2002) requires the consolidated accounts of all companies governed by the law of a member state with securities listed on a regulated exchange within a member state to be produced under IFRS for accounting periods starting on or after 1 January 2005. This meant that many corporate treasurers will have been in some way involved in the time-consuming and complicated transition from previously applied local GAAP (Generally Accepted Accounting Standards) in Europe. The EU is not alone in its adoption of IFRS. Currently over 120 countries in the world either require or permit use of IFRS for all or some companies, with the number still increasing.
As part of the IFRS Foundation’s initiative to assess the progress towards global adoption of IFRS 140 jurisdiction profiles (including all G20 jurisdictions) have been published on the IFRS website. The eventual aim is to provide profiles for every jurisdiction that has either adopted or is on a programme to adopt IFRS in order to provide a central source of information on global adoption of IFRS.
The most significant jurisdiction yet to permit the adoption of IFRS for domestic issuers is the US. The US standard setter, the Financial Accounting Standards Board (FASB), has been co-operating with the IASB on a US GAAP-IFRS convergence programme since the signing of a memorandum of understanding in February 2006. As a result of this process, in December 2007 the SEC made the decision to eliminate the reconciliation requirement for foreign companies that file using IFRS, as promulgated by the IASB. Previously, foreign registrant companies had to reconcile their non-US financial statements to US GAAP for filing with the SEC.
The objective of common global accounting language is to bring significant benefits to companies, investors and other participants in world capital markets by enhancing the efficiency of such markets and increasing the transparency and comparability of financial information. This should lower the cost of capital for companies and encourage greater international investment. To this end close attention has been paid to whether the SEC will bring IFRS into their national accounting language for domestic issuers and in doing make IFRS truly global. Progress has been slow and the SEC has not yet committed to such an approach.
One area of interest to corporate treasurers that has been heavily impacted by the adoption of IFRS is that of covenants within loan documents. These often refer to accounting measures such as “cash flow” and concepts such as “net debt” and “the group”. Care must be taken to ensure that any loan document is clear with respect to the applicable GAAP and that any covenants which were not onerous under local GAAP have not become so under IFRS. In the event that “frozen local GAAP” is applied, care must be taken since it will be difficult to maintain two accounting systems over time.
Another credit issue with which treasurers need to be familiar is the view of financial statements prepared under IFRS taken by the credit rating agencies. The main issues often cited are the expected increase in earnings volatility caused by the need to fair-value derivatives under IAS 39 and the impact of bringing pension fund liabilities on balance sheet. Generally, agencies have stated that provided there has been no change in the underlying economic position, then their credit view will not change, but that it may do so in the event that the new accounting rules reveal information which the agencies had previously been unaware of.
Treasurers must be conversant with those factors impacting on the company’s ability to make distributions to its shareholders. While some countries have a solvency-based approach to permitted distributions, others, like the UK, look at the level of realised profits. A company may have substantial cash balances but, if it does not have sufficient realised profits out of which it can make a distribution, its ability to return cash to shareholders in the form of dividends may be hampered. Three points are worth making in such cases. First, dividends are paid by a company, and not a group, and so it is the distributable reserves of the individual companies within the group and in particular the parent company (the listed entity) which are relevant. Second, the rules as to whether gains and losses are realised are not straightforward and require a good understanding in order to ensure they are properly applied to a company’s individual circumstances.
Third, company law is an important consideration in determining the legality of a distribution and thus legal advice may need to be sought. With respect to UK companies, extensive guidance is available from the Institute of Chartered Accountants of England and Wales (ICAEW) on the realisation of profits and losses. This comes in the form of a technical release: TECH 02/10 “Guidance on the determination of realised profits and losses in the context of distributions under the Companies Act 2006” and is of particular relevance in terms of IFRS.
IFRS of specific relevance to treasurers
This standard requires an entity to recognise share-based payment transactions in its financial statements on a fair value measurement basis. The standard covers the accounting for all transactions in which an entity receives or acquires goods or services either as consideration for its equity instruments (equity-settled transactions) or by incurring liabilities for amounts based on the price of the entity’s shares or other equity instruments of the entity (cash-settled transactions).
For equity-settled share-based payment transactions, the goods or services received (recognised as either assets or expenses), and the corresponding credit to equity, are measured at the fair value of the goods or services received, unless that cannot be estimated reliably. In such cases it should be measured by reference to the fair value of the equity instruments granted and, given treasurers’ specialist knowledge in this area, they may become involved in supporting such valuations.
IFRS 3 business combinations
Certain accounting assessments that may affect treasury arise on the date of a business combination where an acquirer obtains control of another business. Two assessments are of note. Firstly, in order to achieve hedge accounting in the consolidated group immediately following the business combination the consolidated group will need to put in place hedge accounting documentation, including hedge effectiveness testing. This may differ from the hedge documentation that the acquired business had put in place, if at all. As the date of designation in the consolidated financial statements is likely to differ from the date of designation in the financial statements of the acquired business this can lead to difficulties in achieving hedge accounting for cash flow hedges because the fair value of certain derivatives may be considered off-market at the date of acquisition. Secondly, the consolidated financial statements will need to assess the existence and potential separation of embedded derivatives on the date of the business combination.
IFRS 7 financial instruments: disclosure
IFRS 7 requires entities to provide disclosure in their financial statements that enable users to evaluate the significance of financial instruments for the entity’s financial position and performance, the nature of risks arising from financial instruments to which the entity is exposed, and how the entity manages those risks. In particular, with respect to the significance of financial instruments for an entity’s financial position and performance, the requirements include those pertaining to balance sheet disclosures, income statement and equity disclosures, in addition to disclosures about hedge accounting, and the fair value of each class of financial asset or financial liability. As regards the nature and extent of risks arising from financial instruments, the disclosure requirements include qualitative and quantitative disclosures about exposures to each class of risk separately for credit risk, liquidity risk and market risk (including sensitivity analyses). The standard is explicit in stating that the qualitative disclosures it requires are to describe management’s objectives, policies and processes for managing risks arising from financial instruments. The quantitative disclosures on the other hand are to provide information about the extent to which the entity is exposed to risk, based on information provided internally to the entity’s key management personnel.
With respect to sensitivity analysis the standard requires that for each market risk to which the entity is exposed (e.g. interest rate risk, foreign exchange risk, equity price risk on investments) the entity discloses what would be the effect on profit or loss and on equity for a reasonable change in the relevant risk variable. The analysis will be based on each risk in isolation, so does not need to reflect interdependencies, say between foreign currency and interest rates. Companies will need to take a view on what additional narrative explanations they provide to explain and clarify the true risks. As the effect on profit or loss and equity is a hypothetical one based on a hypothetical change in a risk variable the exercise is of a different nature to that of calculating real fair values at a reporting date. The scoping of IFRS 7 needs to be considered carefully to ensure that a full and complete set of financial instruments is being considered in the analysis.
The definition of liquidity risk applies only to financial liabilities that are settled by delivering cash or another financial asset. For non-derivative financial liabilities and those derivative financial liabilities for which contractual maturities are essential to an understanding of the timing of cash flows, the standard requires a maturity analysis showing the undiscounted cash flows comprising the liability on the basis of remaining contractual maturities. Other derivative financial liabilities (i.e. those for which contractual maturity is not essential to an understanding of the timing of cash flows) must still be included in a maturity analysis of some description (albeit that this need not be a contractual maturity analysis on the basis of undiscounted cash flows). The aim of a liquidity maturity analysis is to provide a user of the accounts with a table that will show all the undiscounted cash flows that are to be paid out (based on conditions at the balance sheet date) with respect to many financial liabilities in scope of the standard.
IFRS 7 also requires disclosures of credit risk, which include some that may have a surprisingly wide application throughout the entity. Entities are required to disclose the amount that best represents the entity’s maximum exposure to credit risk for each class of financial instrument, taking account of collateral held and credit enhancements. The standard also requires information about credit quality of financial assets including an analysis of the age of financial assets that are past due as at the reporting date but not impaired. It is worth noting that the relevant financial assets include instruments far beyond the treasurer’s day-to-day activity and include, most notably for corporate entities, trade receivables.
Where financial assets are transferred (eg in a debt factoring arrangement where receivables are sold) IFRS 7 requires specific disclosures to enable users to better evaluate a company’s risk exposure associated with assets transferred. Treasurers may be required to provide the information for these disclosures, as in many cases they will relate to funding transactions where the transferred financial asset has been transferred as collateral or where it has been sold to raise finance but some involvement with the asset remains.
Following the move to increasing use of central clearing counterparties, IFRS 7 was amended in 2011 to require further disclosures about financial assets and financial liabilities that are offset in the statement of financial position or are subject to enforceable master netting arrangements (eg derivatives instruments transacted under an ISDA agreement). The purpose of the new disclosure requirements are to enable users of financial statements to evaluate the effect or potential effect of netting arrangements on the entity’s financial position (not limited solely to central clearing counterparties). The disclosures also allow better comparison of the financial position of entities that report under IFRS and those that apply US GAAP where the requirements for offset are different. For companies applying the new financial instrument standard, IFRS 9, a number of additional disclosure requirements apply in respect of hedge accounting and impairment. These disclosures are extensive and will require a significant amount of new information and data to be collected and presented to comply with the requirements. For those companies transitioning to the new standard, this will require careful planning.
IFRS 10 consolidated financial statements
These standards are relevant to treasurers since they determine how the results and position of subsidiaries, associates and joint ventures are reported in the consolidated financial statements. This has implications in several key areas, such as the extent to which the balances of subsidiaries, associates or joint arrangements contribute to the group’s reported net debt and cash flows. When treasurers are involved in M&A activities it is important that they are conversant with the manner in which a potential target company will be reported in the event that a bid is successful.
IFRS 13 fair value measurement
Fair values are commonly required in accounting for initial recognition of assets and liabilities and also for on-going measurement. IFRS 13 includes detailed guidance on how to determine fair value, whether for financial instruments or non-financial items.
Treasurers may be called upon to provide such valuations for the finance team, hence it is important for them to understand what is required by the accounting standards as this can differ in some cases from valuations used for risk management purposes (eg valuations provided by bank may not be compliant with the accounting requirements). One significant effect of IFRS 13 arises in respect of fair valuing a financial liability. This is because the definition of fair value for a financial liability changed in 2013 when IFRS 13 first applied. The IAS 39 definition was based on the settlement value and this changes to the transfer value in IFRS 13. Under IAS 39 some excluded the effects of changes in own credit risk in the fair value of a financial liability on the basis that any change in value arising from this would not be realisable on settlement with the counterparty. IFRS 13’s definition based on transfer value requires the fair value of the liability to be determined based on what would be payable to a market participant to take on that liability. Furthermore it states that the liability’s fair value should be equal, in absolute terms, to the value of same item held as an asset, thereby requiring the credit risk of the obligor to be included in the fair value of the liability.
IFRS 13 also contains fair value disclosure requirements describing valuation techniques and inputs used to determine fair values. In particular, it requires all assets and liabilities measured at fair value to be categorised into one of three levels of a fair value hierarchy based on the observability and significance of inputs used in making the measurements. Corporate treasurers are likely to be closely involved in categorising instruments into level 1 (quoted prices, unadjusted in active markets for identical instrument), level 2 (inputs other than quoted prices included in level 1 that are observable) or level 3 (inputs for the instrument that are not based on observable market data). In addition, for entities with assets or liabilities falling into level 3, a reconciliation of movements between the opening and closing balance sheet position is necessary.
IAS 7 cash flow statements
The cash flow statement is one of the primary statements within the financial statements and, given that cash management is an integral part of the treasurer’s role, it is one with which treasurers need to be familiar. It reports changes in cash and cash equivalents according to the following three activities; operating, investing and financing. While all three are important, the treasurer is likely to be involved in the review, and even the preparation of the information relating to the last two of these.
IAS 17 leases
Whether or not a lease is classified as a finance or operating lease is important since it determines the accounting treatment and whether or not the leased asset is recorded on the balance sheet in accordance with IAS 17. A finance lease transfers to the lessee substantially all the risks and rewards of ownership and the accounting reflects the substance of this by requiring the leased asset, and associated liability, to be recorded on the balance sheet, with the liability often being considered by analysts as part of net debt.
All leases other than finance leases are operating leases for which the rental payments are expensed on a straight-line basis over the lease term (unless another systematic basis is more representative of the time pattern of the lessee’s benefit). Despite the fact that operating leases are not recorded on the balance sheet, a company’s total future commitment under operating lease agreements is required to be disclosed in the financial statements and may be considered by analysts and credit rating agencies when assessing the company’s debt. It is therefore necessary for a treasurer to understand the figures disclosed in respect of operating lease commitments.
The IASB issued an exposure draft on leasing in August 2010 where it proposed recognising all leases, including operating leases, as right to use assets and liabilities on the balance sheet. In May 2013 they issued a second exposure draft responding to issues highlighted through the consultation process. The comment closed in September 2013, redeliberations are currently ongoing and a revised standard is due before the end of 2015.
IAS 19 employee benefits
IAS 19 shall be applied by an employer in accounting for all employee benefits, except those to which IFRS 2 applies. Employee benefits are all forms of consideration paid for services of employees and, of these, of most relevance to treasurers are pensions. Contributions payable to a defined contribution plan are recognised as an expense as the employee provides services.
Defined benefit plans may be unfunded, or wholly or partly funded. A company is required to recognise a liability equal to the net of the present value of the defined benefit obligations, deferred actuarial gains and losses and deferred past service cost, and the fair value of any plan assets at the balance sheet date. The amendment to IAS 19 issued in 2011 removed the present “corridor” method of deferred recognition of actuarial gains and losses for pension plans as well as revised requirements regarding presentation and disclosure in this area.
IAS 21 the effects of changes in foreign exchange rates
This standard is relevant for any company or group which enters into transactions in foreign currencies or has foreign operations. It prescribes how to include these in the financial statements of an entity and how to translate them into a presentation currency. IAS 21 requires an entity to determine its functional currency, defined as the “currency of the primary economic environment in which the entity operates”. A number of factors to be considered in making this assessment are provided and the determination must reflect the underlying transactions, events and conditions of the entity. Once determined, the functional currency should not be changed unless these factors change. The guidance is mostly relevant to operating companies. However, one of the factors to be considered is whether the activities of the foreign operation are carried out as an extension of the reporting entity, rather than with a significant degree of autonomy. This has implications for existing and proposed new holding and financing companies for which the functional currency may be deemed to be that of the parent company. An entity may present its financial statements in any currency. For a group containing entities with different functional currencies, the results and financial position of each are expressed in the group’s presentation currency in order for consolidated financial statements to be prepared. Assets and liabilities are translated at the closing rate and amounts in the income statement are translated at rates applicable on the dates of the transactions (in practice, an average rate for the period is often used), with all resulting exchange differences recognised in group equity.
Treasurers working within groups with foreign subsidiaries need to be aware of how IAS 21 requires foreign exchange movements on certain intragroup balances to be treated. If an entity (which in this context means any subsidiary of the group) has a monetary item that is receivable or payable to a foreign operation for which settlement is neither planned nor likely to occur in the foreseeable future, it is in substance a part of the entity’s net investment in that foreign operation. Such balances need not follow the direct ownership chain, but may be between sister companies within a group and may include long-term receivables or loans, but not trade balances. Any exchange differences arising on the revaluation of such balances are recognised in the income statement in the separate financial statements of the reporting entity or foreign operation (or both, if the item is denominated in neither the functional currency of the entity nor the functional currency of the foreign operation). However, on consolidation, such exchange differences shall be recognised initially in group equity, and reclassified to the income statement on disposal of the foreign operation.
In order to assess whether the above is relevant, it is necessary to determine whether an entity meets the definition of a foreign operation (“a subsidiary, associate, joint venture or branch of a reporting entity, the activities of which are based or conducted in a country or currency other than those of the reporting entity”). With respect to foreign operations, an entity need not be located in a foreign location in order to be classified as such, provided its activities are conducted in a currency other than that of the reporting entity.
Whether settlement of the receivable or payable with the foreign operation is planned or likely to occur in the foreseeable future is important in determining whether the foreign currency risk on the receivable or payable is recognised in consolidated equity. This may cause difficulties for groups which operate centralised treasury operations and which require subsidiaries to deposit surplus cash with, or borrow from, the centre. Such funding balances may not qualify for retranslating via equity due to the foreign operation’s cash requirements fluctuating as a result of the working capital cycle of the business. In such a case (which is a common funding strategy for many groups) it may be necessary for exchange differences to be recognised in the group income statement.
IAS 32 financial instruments: presentation
This standard applies to the presentation of financial instruments, from the perspective of the issuer, as either financial liabilities or equity instruments, the classification of related interest and dividends, and the circumstances in which financial assets and financial liabilities should be offset (i.e. netted on the balance sheet). Its definitions of a financial instrument, financial asset, financial liability and equity instrument are referred to in IAS 39 and IFRS 9.
Given that treasurers may be involved in finance raising activities through the issue of financial instruments (such as preference shares, convertible debt) they would benefit from a familiarity with the principles in IAS 32 regarding classification of instruments as either financial liabilities or equity of the issuer. In the case of many preference shares the appropriate classification will be that of a financial liability since the definition of financial liability within the standard includes any contractual obligation to deliver cash or another financial asset to another entity. With respect to debt that is convertible into shares of the issuer (or shares of the subsidiary in the case of consolidated financial statements) IAS 32 has strict guidance as to how these instruments should be accounted for. Subject to meeting certain criteria the instrument may be presented partly as a liability (being the present value of interest and principal) and party as equity (being the conversion option into equity shares). In other cases the instrument maybe presented wholly as a liability with fair value gains/losses recognised in profit loss with respect to the conversion feature. Caution is needed in this area as the accounting standards are complex.
With respect to offsetting a financial asset and financial liability on the balance sheet, this is limited, in accordance with IAS 32, to circumstances where an entity has a currently enforceable legal right to set off the recognised amounts and intends either to settle on a net basis, or to realise the asset and settle the liability simultaneously. An entity may have a conditional right to set off recognised amounts, such as in many master netting agreements where set off is conditional on default of one of the counterparties to the financial instruments. However, if the right of set off is enforceable only on the occurrence of some future uncertain event then the conditions for offset are not met, resulting in assets and liabilities being presented gross on the balance sheet. IAS 32 also requires shares held in treasury to be deducted from equity with no gain or loss recognised on the purchase, sale, issue or cancellation of an entity’s own equity instruments.
IAS 39 financial instruments: recognition and measurement
- Introduction – Arguably the most complicated and controversial standard, IAS 39 establishes the principles for recognising and measuring financial assets and financial liabilities and as such will be of key interest to treasurers. IFRS 9 Financial Instruments has been developed by the IASB to replace IAS 39 (see below). However, IAS 39 will continue to be the standard applied by entities reporting under IFRS as endorsed by the EU at least until IFRS 9 is endorsed.
IAS 39 defines several categories of financial instrument (defined in IAS 32 as “any contract giving rise to a financial asset of one entity and a financial liability or equity instrument of another entity”) and, while all are initially measured at fair value, subsequent measurement depends on the category to which the instrument belongs:
- “Financial asset or liability at fair value through profit or loss” (including derivatives, unless designated as part of certain effective hedging relationships) – carried at fair value, with movements recognised in profit and loss.
- “Held to maturity investments” and “loans and receivables” – both of which are carried at amortised cost using the effective interest method.
- “Available for sale financial assets” – carried at fair value with any gains or losses recognised in equity (with the exception of interest, impairment and foreign exchange movements on monetary assets, which are reported in profit or loss, and dividend income on equity investments).
- Other financial liabilities – measured at amortised cost using the effective interest rate method.
Each category has specific eligibility criteria.
- Hedging – The requirement for derivatives to be recognised on balance sheet and carried at fair value is significant, in particular when the derivative is hedging an item which is either off-balance sheet (such as a forecast foreign currency transaction), or is accounted for at amortised cost (such as a borrowing). In such cases, in order to address the potential profit and loss volatility, IAS 39 permits hedge accounting provided certain conditions are met. These include the need to designate formally and document the hedge relationship and to demonstrate that the hedge is highly effective, from both a prospective and retrospective perspective. A hedge is considered to be highly effective if its results are within a range of 80% to 125%, i.e. the change in fair value of the hedging instrument and hedged item are between 80 and 125% of each other.
Three types of hedging relationship are permitted:
- 1. Fair value hedge – To hedge the exposure to changes in fair value of a recognised asset or liability, or an unrecognised firm commitment. For example, an interest rate swap may be entered into in order to convert the fixed coupon on a bond to variable rate interest. Ordinarily, the swap would be fair valued and the bond carried at amortised cost. However, provided the hedge can be shown to be effective and is appropriately documented, the bond can be revalued in respect of the hedged risk (e.g. market interest rate, excluding any credit spread) with any movements in value taken to profit or loss where they will, in the case of high effectiveness, largely offset with the revaluations of the swap (depending on the degree of effectiveness).
- 2. Cash flow hedge – To hedge exposure to variability of a future cash flow. For example, a company with a euro functional currency may purchase US dollars forward in order to hedge the planned purchase of an item of plant in US dollars. In the absence of hedge accounting, revaluation of the foreign currency forward would give rise to volatility in the income statement, which would be unmatched since the hedged item is off-balance sheet. Provided the criteria for hedge effectiveness are met and the hedge is documented in an appropriate manner, a cash flow hedging relationship may be designated and the effective portion of any gain or loss on the revaluation of the foreign currency forward will be recognised in other comprehensive income (with the ineffective portion recognised in profit or loss) and recycled to the profit and loss when the hedged transaction impacts earnings. Note that a hedge of the foreign currency risk of a firm commitment may be treated as either a fair value or a cash flow hedge.
- 3. Hedge of a net investment in a foreign operation – Accounted for similarly to cash flow hedges and generally applies in the consolidated financial statements only. For example, a sterling presentation currency group with a sterling functional currency parent may have a euro borrowing in a sterling entity which is an economic hedge of the net asset foreign currency exposure from the parent’s investment in euro-denominated operating companies. In the absence of hedge accounting the euro borrowing would give rise to an accounting foreign currency exposure for the group (arising from consolidating the sterling income statement of the parent into the group financial statements). However, by designating the euro borrowing as a hedge of the equivalent value of the group’s euro net assets, any foreign currency movements on the borrowing (to the extent effective) will be recognised in group equity, where it will offset the foreign currency movements on the revaluation of the hedged item (the equivalent value of euro net assets). Treasurers should note that IFRIC 16 Hedges of a Net Investment in a Foreign Operation clarifies that a parent entity may designate as a hedged risk only the foreign exchange differences arising from a difference between its own functional currency and that of its foreign operation (not the difference between the group’s presentation currency and the functional currency of the foreign operation). IFRIC 16 also clarifies that the hedging instrument may be held by any entity or entities within the group. The interpretation also concludes that while IAS 39 must be applied to determine the amount that needs to be reclassified to profit or loss from the foreign currency translation reserve in respect of the hedging instrument, IAS 21 must be applied in respect of the hedged item.
- Hedged item – A hedged item can be a recognised asset or liability, an unrecognised firm commitment, a highly probable forecast transaction or a net investment in a foreign operation. For the first three of these, only those involving a party external to the entity can be designated as hedged items. However, as an exception, the foreign currency risk of an intragroup monetary item may qualify as the hedged item in the consolidated financial statements if it results in an exposure to foreign exchange rate gains and losses that are not fully eliminated on consolidation. Also, the foreign currency risk of a highly probable forecast intragroup transaction may qualify as a hedged item in consolidated financial statements provided that the transaction is denominated in a currency other than the functional currency of the entity entering into that transaction and the foreign currency risk will affect consolidated profit or loss. Treasurers may also wish to note that when applying hedge accounting to a one side risk (eg for price increases above or below a set price) time value may not be regarded as part of the hedged risk. Hence if a purchased option is used as a hedging instrument, changes in time value of the option can give rise to volatility in profit or loss. It is also worth noting that IAS 39 is explicit that inflation cannot be designated as a hedged risk of a financial instrument unless it is contractually specified.
- Hedging instrument – With the exception of some written options, IAS 39 does not restrict the circumstances in which a derivative may be designated as a hedging instrument (provided the conditions for hedge effectiveness and documentation are met). However, a non-derivative financial asset or liability, for example a foreign currency denominated borrowing, may be designated as a hedging instrument only for a hedge of foreign currency risk. Furthermore, only instruments that involve a party external to the reporting entity can be designated as hedging instruments. This has important implications when subsidiaries are obliged to hedge their exposures with another group company.
With a couple of exceptions (the time value of an option, and forward element of a forward contract may be excluded from the hedge and accounted for at fair value through the profit or loss), a hedging instrument must be designated in a hedging relationship in its entirety. However, it is permitted to designate a proportion (such as 50% of its notional value) of the hedging instrument. Also, a hedging relationship may not be designated for only a portion of the time period during which a hedging instrument remains outstanding (e.g. the first four years of cash flows of a ten year swap cannot be designated in a hedge with the remaining six years of cash flows left undesignated). Finally, two or more derivatives, or proportions of them (or in the case of a hedge of currency risk two or more non-derivatives or proportions of them, or a combination of derivatives and non-derivatives or proportions of them) may be jointly designated as the hedging instrument providing none of them is a written option or a net written option.
- Embedded derivatives – IAS 39 defines an embedded derivative as a component of a hybrid (combined) instrument that also includes a non-derivative host contract, with the effect that some of the cash flows of the combined instrument vary in a way similar to a standalone derivative. For example, a euro functional currency entity may have a purchase or sale contract for a non-financial item (e.g. inventory) where the future euro payments under the contract are determined by applying a EUR/USD exchange rate (revised on a periodic basis, for example annually) to an underlying USD price list, with this feature on a standalone basis meeting the definition of a derivative. If this is the case then an embedded derivative exists. However, the existence of an embedded derivative may not always be as obvious as this. For example, a euro functional currency entity may have a purchase or sale contract for a non-financial item (e.g. inventory) where the fixed payments under the contract are denominated in USD, with this foreign currency feature meeting the definition of a derivative. As discussed below, despite the existence of an embedded derivative in both of these examples, it is not necessarily the case that the embedded derivatives must then be separated from their host contracts and accounted for as derivatives under IAS 39.
If the entire hybrid contract is not measured at fair value through profit and loss, the standard requires an analysis of whether the economic characteristics and risks of the embedded derivative are closely related to the economic characteristics and risks of the host contract. In the case where the embedded derivative is not closely related, and the entire hybrid contract is not fair valued through profit and loss, the embedded derivative will need to be separately measured at fair value through profit and loss. The application guidance is helpful in determining if embedded derivatives are closely related, with IAS 39.AG33(d) of particular relevance and assistance with respect to embedded foreign currency derivatives. These are considered as closely related to the host contract provided the feature is not leveraged, does not contain an option feature, and requires payments denominated in one of the following currencies:
- the functional currency of any substantial party to the contract;
- the currency in which the price of the related good or service that is acquired or delivered is routinely denominated in commercial transactions around the world (such as US dollar for crude oil transactions); or
- a currency that is commonly used to purchase or sell non-financial items in the economic environment in which the transaction takes place (e.g. a relatively stable and liquid currency that is commonly used in local business transactions or external trade).
IFRS 9 financial instruments
- Introduction: The IASB has completed IFRS 9, the replacement for IAS 39, in phases. The IASB first issued IFRS 9 in 2009 with a new classification and measurement model for financial assets followed by requirements for financial liabilities and derecognition added in 2010. Subsequently, IFRS 9 was amended in 2013 with the addition of new general hedge accounting requirements. The final version of IFRS 9 published in July 2014 amends the classification and measurement of financial assets and introduces a new expected loss impairment model. The latest version of IFRS 9 will supersede all previous versions of the standard. However, there is an option to elect to apply the earlier versions of IFRS 9 for a limited period as long as the date of initial application is before 1 February 2015.
IFRS 9 has a mandatory effective date for annual periods beginning on or after 1 January 2018, with earlier application permitted. IFRS 9 will need to be endorsed by the EU, though, before it can be applied by entities reporting under EU endorsed IFRS.
- Classification and measurement: IFRS 9 applies a dual test, based on contractual cash flow characteristics and the entity’s business model, to determine the classification of financial assets. Where a financial asset’s contractual cash flows are solely a return of principal and interest on the principal outstanding it is measured at (i) amortised cost if it is held within a business whose objective is to hold financial assets to collect the contractual cash flows, or (ii) fair value through other comprehensive income (FVTOCI) if it is held within a business whose objective is to hold financial assets to collect the contractual cash flows and to sell the financial assets, or (iii) fair value if the business models in (i) or (ii) do not apply. Where a financial asset’s contractual cash flow is not solely a return of principal and interest on the principal outstanding it is always measured at FVTPL. Separation of embedded derivatives in financial assets is not permitted.
For debt instrument assets that meet the criteria for amortised cost and FVTOCI classification they must be measured that way unless an entity elects to measure them at FVTPL, which only applies if doing so significantly reduces or eliminates an accounting mismatch. For equity investments, the FVTOCI classification is an election. The requirements for reclassifying gains or losses recognised in other comprehensive income are different for debt instruments and equity investments.
Accounting for financial liabilities under IFRS 9 remains largely unchanged from IAS 39 with the exception that for financial liabilities designated at FVTPL fair value movements in credit risk are not presented in profit and loss but presented in other comprehensive income. IFRS 9 permits the early adoption of the requirements relating to own credit risk for financial liabilities without the requirements of the rest of the standard.
- Impairment: IFRS 9 introduces a new impairment model based on expected losses, rather than incurred losses as applied in IAS 39. Under the IFRS 9 model, provisions for impairment are expected to be larger and to be recognised sooner than under the IAS 39 model. IFRS 9 requires losses to be measured through a loan loss allowance for either 12-month expected losses or lifetime expected losses. The latter applies for most assets only if credit risk has increased significantly since initial recognition of the financial instrument. However, the recognition of lifetime expected losses is required from initial recognition for purchase credit impaired assets and some trade receivables and can be elected for other trade and lease receivables.
IFRS 9 requires the same measurement basis for impairment for all items in the scope of the impairment requirements. This differs from IAS 39 where impairment is calculated differently for amortised cost assets and those available-for-sale assets measured at FVTOCI. Further, IFRS 9 applies the same measurement approach to certain loan commitments and financial guarantee contracts where previously these were measured differently in accordance with IAS 37 Provisions, Contingent Liabilities and Contingent Assets.
- Hedge accounting: The objective of the IASB in developing this part of IFRS 9 has been to more closely align the hedge accounting requirements with risk management activities, which should result in more useful information for users of financial statements. The mechanics of hedge accounting and terminology used are broadly the same as under IAS 39. However, the requirements of IFRS 9 are less rules based than IAS 39 and many of the restrictions in IAS 39 have been removed. For example, the 80-125% offset requirement for hedge effectiveness testing is removed and there is no requirement to perform a retrospective hedge effectiveness test. Instead a prospective test assessing the economic relationship is required and thereafter actual hedge ineffectiveness is measured and reported.
IFRS 9 permits a wider range of items to be designated as hedged items – for example, risk components of non-financial items are eligible for hedge accounting provided they are “separately identifiable and reliably measurable”. Hedged items can also include derivatives which can be useful when the risk management objective is to hedge two different risks in the same item at different points in time thereby looking to designate the synthetic position created by the first hedge (i.e. including a derivative) to be designated in a subsequent hedging relationship.
The most significant change relating to hedging instruments under IFRS 9 is the way forward and option contracts are accounted for when designated as a hedging instrument. As under IAS 39 time value of an option contract or interest element of a forward can be excluded from the designation a hedging relationship. However, unlike IAS 39, IFRS 9 will require/allow some or all of the change in time value or forward element to be deferred in other comprehensive income and recognised in profit or loss on a more stable basis. IFRS 9 also allows this treatment to be applied to the foreign currency basis spread of a derivative financial instrument. If the foreign currency basis spread is not excluded from a derivative financial instrument it will result in ineffectiveness in all types of hedges. This is in contrast to established practice under IAS 39 where foreign currency basis spread has not generally given rise to ineffectiveness in cash flow hedge relationships.
The IASB has decided to develop new requirements for macro hedging (hedging an open portfolio) outside the IFRS 9 project. The specific requirements for macro fair value hedges will remain in IAS 39 and entities can apply these in combination with the rest of IFRS 9. However, IFRS 9 also allows preparers a choice between continuing to apply the general hedge accounting requirements of IAS 39 and those of IFRS 9. This choice is expected to remain available until the completion of the macro hedging project.
The present and the future
The growing use of IFRS across the world has led to the need for treasurers to be aware of the issues associated with these standards. While much of the focus in this respect is on the suite of standards dealing with financial instruments (IAS 32, IAS 39, IFRS 7 and IFRS 9), there are a number of other standards that treasurers may come into contact with and are thus relevant to their work. These range from standards dealing with employee benefits and share based payments to the standard dealing with cash flow statements. The involvement of treasurers in IFRS issues will vary from playing a central role in providing or verifying valuations necessary for measuring certain financial instruments and share based payment transactions in the financial statements, through providing information necessary to meet disclosure requirements to giving consideration to how treasury transactions and hedging strategies will be accounted for.
Treasurers will also need to keep abreast of the changes to the IFRS landscape, whether that is new standards or interpretations of existing ones. The need to apply IFRS 9 by 2018 is by far the biggest challenge for corporate treasurers. Treasurers are likely to be involved in the implementation of IFRS 9, particularly hedge accounting, measuring expected losses on holdings of debt securities and loans, as well as assisting in meeting the new financial instrument disclosures.
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For a brief guide to IFRS see ‘IFRS in your pocket’: http://www.iasplus.com/en/tag-types/ifrs-in-your-pocket/ifrs-in-your-pocket