To Hedge Or Not To Hedge Under IFRS 9
Effective in Australia and New Zealand, IFRS 9 Financial Instruments has become the mandatory accounting standard for financial instruments.
However, the hedge accounting component of IFRS 9 continues to remain optional. Furthermore, entities who conduct hedge accounting may continue reporting under IAS 39. Given this choice, why would entities make the effort to transition?
The motivation lies in hedge accounting’s restructure from a set of arbitrary rules to a principles-based standard. IFRS 9 introduces a number of choices to the application of hedge accounting, and its overall objective is to improve the value of financial statements in decision-making by capturing the impact of an entity’s risk management strategies on its financial operations.
Under IFRS 9 entities have access to the following benefits:
- Removal of the 80-125% effectiveness test
The 80-125% quantitative effectiveness test has been replaced with a principles-based test. To qualify for hedge accounting under IFRS 9, entities must demonstrate that an economic relationship exists between the hedged item and the hedging instrument.
- More risks and hedging instruments qualify
Following the removal of the 80-125% effectiveness test, more hedged risks and hedging instruments will qualify for hedge accounting, including aggregated exposures, layers of monetary or physical transactions, net positions, and equity instruments at fair value through other comprehensive income. Where separately identifiable and reliably measured, risk components of non-financial items can also now be designated as hedged items.
- Reduced volatility in the income statement
IFRS 9 introduces recognition for the time value of money in hedging instruments. Because of the time value of certain hedging instruments is recognised in other comprehensive income, only the amortised portion will show in the income statement. The impact of the amortization on profit or loss will be consistent from year to year, resulting in reduced volatility in the financial statements.
The costs involved in applying IFRS 9 include:
- Increased administrative costs
Entities must perform ongoing analysis to ensure that the hedge relationships continue to meet the entity’s risk management objectives and that an economic relationship continues to exist between the hedging instrument and hedged item. This, along with the requirement to discount hedge instruments for the time value of money, will likely increase the administrative cost of the hedge accounting regime.
- Removal of voluntary discontinuation of hedge accounting
Although an entity could voluntarily discontinue hedge accounting under IAS 39, this concession no longer exists under IFRS 9.
Mandatory application of IFRS 7
Regardless of which standard the entity adopts for hedge accounting purposes, the application of IFRS 7 Financial Instruments: Disclosures is now mandatory from periods beginning 1 January 2019. These disclosure requirements are aligned with IFRS 9, and entities will need to follow the process outlined in IFRS 9 in order to prepare the required disclosures.
In summary, whilst there may be an increased administrative cost associated with IFRS 9, this is offset by the fact that entities must follow the mandatory disclosure requirements of IFRS 7. The adoption of IFRS 9 presents a stronger opportunity for reporting entities to communicate their risk management strategy through their financial statements, and this can only result in improved information for users.
Please do not hesitate to contact your local PKF representative to discuss any queries or further clarifications that you may have.
* The above content applies to Australian entities reporting under the equivalent Australian standards AASB 9 and AASB 7, which came into effect for financial periods beginning on or after 1 January 2018. New Zealand equivalents become effective for financial periods beginning on or after 1 January 2019.