IFRS 9 – Financial Instruments
Why is accounting for financial instruments considered one of the most important and challenging topics in IFRS?
The increasing use of financial instruments by companies and business entities, along with the complexity of these instruments, makes accounting for financial instruments one of the most important, complex and challenging topics in IFRS Accounting Standards. Financial instruments are used, among other things, to achieve objectives such as hedging risks or exposures of various kinds, raising funding sources, or making strategic or speculative investments. Such use may expose reporting entities to a wide range of risks arising, among other things, from factors such as fluctuations in foreign exchange rates, changes in interest rates, changes in the prices of underlying assets, or changes in the credit quality of counterparties.
Why did traditional financial accounting provide limited solutions for financial instruments?
In general terms, traditional financial accounting was built (mostly) around classical manufacturing companies, which transform factors of production such as raw materials and labor into finished goods intended for sale. The main challenge of accounting for such traditional entities concerned issues relating to the historical cost basis, including proper application of the accrual basis, proper matching of costs with revenue and proper application of revenue recognition principles. However, these traditional accounting rules provided little or no solution for the treatment of financial instruments.
What is the core accounting challenge in determining the accounting treatment of financial instruments?
The challenge in determining the accounting treatment of financial instruments is to ensure that the financial statements of entities that use such instruments adequately reflect the full range of financial risks relevant to the reporting entity.
How did the evolution of financial instruments and the 2007 financial crisis influence IFRS reforms?
In recent decades, the field of financial instruments has been characterised by dynamic evolution. This evolution was reflected both in how the field was presented in reporting entities’ financial statements and in the dramatic changes made to IFRS Accounting Standards dealing with financial instruments.
Until the “subprime crisis” in 2007, the use of structured finance, credit derivatives, and various asset-backed securities increased significantly. The financial crisis led, among other things, to the collapse of major financial institutions, such as Lehman Brothers, and the need for massive government bailouts of major financial institutions, such as the American insurer AIG, which received an infusion of about USD180 billion. Following the crisis, significant changes occurred in the regulatory environment of financial institutions. These regulatory changes included improvements in capital adequacy and strengthened supervision of credit rating agencies. In this context, banks increasingly used financial instruments such as contingent convertible or conditionally written-down bonds (commonly known in practice as “CoCo bonds”), intended to reduce governments’ bailout costs of failing financial institutions.
What criticism arose after the crisis and how did IFRS 9 respond?
In the aftermath of the financial crisis, criticism arose that the existing accounting rules at the time did not adequately and promptly reflect the developments in financial markets. These rules allowed financial institutions to defer recognition of losses related to financial instruments, including in situations where market liquidity declined. The IASB, together with its U.S. counterpart, the FASB, initially attempted to address this criticism with the hope of cooperation and convergence, or at least a certain common denominator, which later dissipated. Thus, the solutions provided by each of the leading global standard-setters to the issue of delayed recognition of losses were not necessarily identical. Other issues that highlighted the need for deep reform of IFRS Accounting Standards for financial instruments included the complexity and subjectivity inherent in IAS 39, Financial Instruments: Recognition and Measurement, which was the main standard dealing with financial instruments at that time.
IFRS 9 Financial Instruments was first issued in 2009 with the full version completed only in 2014. IFRS 9 superseded IAS 39 except for certain limited aspects of hedge accounting. IFRS 9 was designed to address the major criticisms raised during and after the financial crisis, particularly around impairment of financial assets. In this context, sweeping changes were made to classification principles, hedge accounting and other aspects compared to IAS 39. At the same time, disclosure requirements relating to financial instruments were updated and expanded. However, the dramatic changes in financial instruments accounting did not (at this stage) extend to IAS 32, Financial Instruments: Presentation.
How is the IFRS accounting treatment of financial instruments spread across standards?
As of the time of writing, and following the completion of the reforms mentioned above, the accounting treatment of financial instruments under IFRS is spread across several standards:
- IAS 32 – Financial Instruments: Presentation
This was the first in a series of standards on financial instruments. It mainly addresses issues relating to the definition of financial instruments, distinguishing between financial assets and financial liabilities on the one hand, and equity instruments on the other, and the implications of this distinction for matters such as issuance costs, interest payments or dividend payments on equity instruments issued. In addition, IAS 32 addresses offsetting financial assets and financial liabilities, as well as certain types of options and futures contracts where the underlying item is the entity’s own equity instruments. - IFRS 9 – Financial Instruments
This is the main standard dealing with financial instruments. It primarily addresses classification, recognition and measurement of financial assets and financial liabilities and complements IAS 32’s treatment of equity instruments. Among other things, it covers issues such as timing of recognition and derecognition of financial assets and financial liabilities, classification of financial assets and financial liabilities among different measurement categories (including amortised cost and fair value), presentation of results in profit or loss or other comprehensive income, impairment of financial assets and hedge accounting. - IFRS 7 – Financial Instruments: Disclosures
This is a standard specifying disclosure requirements for financial instruments. - IAS 39 – Financial Instruments: Recognition and Measurement
With the introduction of IFRS 9, IAS 39 was superseded, except for the (supposedly temporary) option provided under IFRS 9 to continue applying the hedge accounting rules of IAS 39.
Beyond these standards, note that a fair value measurement is relevant to a significant portion of financial instruments. Therefore, much of the guidance on fair value measurement, as well as related disclosure requirements contained in IFRS 13 Fair Value Measurement, is also relevant to financial instruments.
What definitions, recognition and scope points are highlighted in IFRS 9?
Definitions, recognition and classification requirements of IFRS 9
IFRS 9 addresses, among other things, the measurement of financial assets and financial liabilities. The standard fully adopts the definitions of financial assets and financial liabilities in IAS 32. In general, whether a particular item meets the definition of a financial asset or a financial liability is highly significant, since financial assets and financial liabilities are typically recognised and measured under IFRS 9 from the date the reporting entity first becomes party to the contract. For example, a purchase contract that is not classified as a financial instrument (e.g., a binding contract to purchase fixed assets in the future) is accounted for as an off-balance sheet item. By contrast, a contract that meets the definition of a financial instrument (e.g., a forward contract to purchase foreign currency) is recognised under IFRS 9 as a financial asset or financial liability and subsequently measured at fair value until settlement.
Another important definition in IFRS 9 concerns derivatives. This term can refer to financial or non-financial instruments. Its importance lies, among other things, in the fact that derivative financial assets and liabilities are generally measured at fair value through profit or loss. Other implications of this definition include hedge accounting, separation of embedded derivatives and more.
As for the scope of the standard, although many items could potentially meet the definition of financial instruments, IFRS 9 (like IAS 32) excludes from its scope certain items dealt with in other IFRS Accounting Standards, such as insurance contracts or contracts to buy or sell non-financial items. Conversely, the standard requires certain items to be accounted for (or in some cases that may be designated) as if they were financial assets and financial liabilities.
How does IFRS 9 classify financial instruments and what bases does it use?
One of the key differences between the scope of IFRS 9 and that of IAS 32 relates to the reporting entity’s own equity instruments: while these fall within the scope of IAS 32, they are excluded from IFRS 9, which deals solely with financial assets and financial liabilities.
Classification under IFRS 9
Classification means categorising the instrument in financial statements. In general, IFRS 9 contains two main measurement bases for financial instruments: amortised cost and fair value. In addition, there are various forms of presentation regarding how gains or losses are recognised in profit or loss or in other comprehensive income.
One of the most far-reaching changes introduced by IFRS 9 relates to the classification of financial assets. In classifying financial assets, IFRS 9 considers both the characteristics of the financial asset’s contractual cash flows and the business model for managing these assets. This reflects the growing trend in IFRS to incorporate entities’ specific business models into their financial reporting.
As for financial liabilities, in most cases financial liabilities are classified in the amortised cost category.
What are the key measurement principles for financial instruments under IFRS 9?
Measurement of Financial Instruments
On initial recognition of a financial asset or financial liability, IFRS 9 requires, among other things, to classify them within the relevant measurement categories. Once classification has been made, the financial asset or financial liability are measured at the date of initial recognition based on their measurement category. Subsequently, their carrying amount and the amounts recognised in the statement of comprehensive income are updated in accordance with their measurement category and the nature of the financial instrument.
In general, the principal measurement bases under the Standard are fair value and amortised cost (effective interest method). The guiding principles for fair value measurement are included in IFRS 13 Fair Value Measurement, and they have not changed when IFRS 9 was issued. Among other things, IFRS 13 includes specific provisions relating to the fair value measurement of financial instruments.
At initial recognition of financial assets and financial liabilities, the guiding principle is that financial assets and financial liabilities are measured at fair value, with relevant transaction costs added to the carrying amount in certain cases. When the fair value differs from the transaction price, the Standard imposes certain restrictions on the ability to depart from the transaction price at the date of initial recognition.
As a rule, investments in shares and other equity instruments are measured at fair value at each reporting date. Thus, IFRS 9 prohibits the measurement of equity investments at historical cost. However, IFRS 9 permits to designate equity instruments as at fair value through other comprehensive income, with no recycling of gains or losses to profit or loss upon derecognition of the instrument.
Regarding the measurement of financial liabilities, changes in the fair value of financial liabilities designated as at fair value through profit or loss, attributable to changes in the reporting entity’s own credit risk, are presented in other comprehensive income rather than in profit or loss. Without this requirement, a deterioration in the reporting entity’s credit standing would have led to the recognition of gains due to the decrease in the fair value of those financial liabilities and vice versa, a situation the Standard sought to avoid.
It is important to note that, with respect to financial assets measured at fair value through other comprehensive income, the impairment model of IFRS 9 also applies.
What is the impairment model under IFRS 9 and why was it designed?
Impairment of Financial Assets
IFRS 9 sets out the accounting for impairment of financial assets that are debt instruments, measured at amortised cost or at fair value through other comprehensive income.
The accounting for impairment of financial assets that are debt instruments constitutes a dominant component of their measurement at amortised cost or at fair value through other comprehensive income. The effective interest rate on investments in debt instruments classified in those categories is calculated based on the contractual cash flows of the asset and, therefore, in practice reflects the assumption that the reporting entity will not incur any credit losses from holding the financial asset, except where the financial asset was purchased or originated credit-impaired.
Beyond the calculation of the effective interest rate, the amortised cost method is based on the contractual cash flows of the instrument in subsequent periods as well. Therefore, absent an additional adjustment for impairment, it does not reflect changes in expected credit losses since the initial recognition of the financial asset.
It should be noted that ignoring expected credit losses when calculating the effective interest rate generally results in an increase in the effective interest rate compared to the expected economic yield inherent in the investment.
Why is an additional impairment component needed – an illustration?
For illustration, assume a reporting entity purchases for $87,982 a portfolio composed of several similar zero-coupon loans, with an aggregate principal of $100,000. The portfolio is classified as measured at amortised cost. The loans are not credit-impaired at initial recognition and are due to be settled in two years from the purchase date. Further assume that, at the purchase date, based on historical experience and forward-looking information, it is expected that approximately 3% of the loans will not be repaid due to borrower default (assuming, for simplicity, that the loss given default is 100%). In other words, the expected cash flows from the portfolio are $97,000 (= 97% * 100,000), expected to be received in two years.
In this situation, the economic annual yield inherent in the investment is 5% = (97,000 / 87,982) ^ 0.5 – 1. Moreover, under the assumption that the actual credit losses will indeed match the forecast, the investor’s yield on the portfolio will accordingly be 5% per year. However, the calculation of the effective interest rate under the Standard, which is based on the contractual cash flows and ignores the expected credit losses, will result in 6.61% = (100,000 / 87,982) ^ 0.5 – 1. The difference in the effective interest rate will not affect the measurement of the asset at initial recognition, but after one year, the gap in the asset’s balance (and correspondingly in the recognised interest income) arising from the difference between using the Standard’s effective interest rate (6.61%) and the expected economic yield (5%) will amount to $1,417, and after two years will accumulate to $3,000. At this point, if the actual results match the forecast and in the absence of a credit loss provision, a loss would be recognised under the Standard’s effective interest rate approach (6.61%)—due to the difference between $100,000 and the actual $97,000 collected, whereas no loss would have been recognised under the economic yield approach (5%).
Thus, the simplified example above demonstrates the need for an additional component to compensate for the fact that the effective interest rate is calculated ignoring expected credit losses. Furthermore, clearly, if expectations regarding credit losses change, an additional adjustment may be required.
How did the IAS 39 incurred loss model work and what was the “Cliff Effect”?
Under IAS 39 which preceded IFRS 9 and dealt with impairment of financial instruments, the issue described above was addressed applying the incurred loss model. Under this model, designed to prevent earnings management through subjective timing of expense recognition, the recognition of impairment for credit losses was in most cases delayed until objective evidence of impairment existed. As in the above example, this model resulted in higher interest revenue than would have been recognised under the economic yield approach. However, at certain points in time, when objective evidence of impairment arose, substantial losses were recognised. This effect, whereby credit losses were recognised in profit or loss upon the occurrence of a trigger event, was sometimes referred to in practice as the “Cliff Effect.”
What real-world example illustrates the Cliff Effect?
A prominent example of this effect is described in the study Impairment of Greek Government Bonds under IAS 39 and IFRS 9: A Case Study, published by the European Parliament in October 2015. This research analysed the accounting treatment in the financial statements of major banks holding Greek government bonds at the peak of Greece’s sovereign debt crisis in 2010–2011. Thus, during 2010, Greek bonds (with a maturity of about nine years) traded at values reflecting only 60–80% of their par value and were rated “speculative” by leading international credit rating agencies. That same year, Greece also received a support package of about €45 billion from the IMF and EU member states. Despite the above, no impairment losses were recognised on these investments, classified as measured at fair value through other comprehensive income or amortised cost, by the banks holding them in that year. Only in the first half of 2011, when debt restructuring discussions involving a “haircut” for bondholders had already begun, and with quoted prices at about 50% of par, did most banks recognise impairment losses on their investments.
What approach does IFRS 9 use to reduce the Cliff Effect and incorporate forward-looking information?
One of the main objectives set in designing the new impairment model in IFRS 9 was to reduce the Cliff Effect and to incorporate more forward-looking information into the timing and measurement of credit losses. This generally results in higher overall provisions for impairment compared to the model under IAS 39. Nevertheless, even under IFRS 9, measurement of credit losses is not to be based on assumptions or outcomes that are artificially conservative, which would undermine the principle of faithful representation.
The original proposal for IFRS 9 briefly provided that the economic yield (rather than the contractual yield) approach would be used for all financial assets subject to the impairment provisions in IFRS 9. Under this approach, all expected credit losses over the life of the instrument would have been reflected in the calculation of the effective interest rate and in subsequent periods, similar to the treatment of purchased or originated credit-impaired financial assets. However, ultimately, except for the treatment of purchased or originated credit-impaired financial assets, IFRS 9 requires applying a different approach, in which measuring impairment losses is a distinct (or supplementary) process, while the recognition of income under the effective interest method generally ignores credit losses. Only once the instrument becomes credit-impaired (or is initially recognised as credit-impaired) is interest revenue recognised on a net basis to reflect the economic substance of the instrument’s yield.
It is important to note that the Standard requires impairment losses to be recognised only in respect of credit losses. Accordingly, declines in the fair value of a financial asset arising from other reasons, e.g., a fall in bond prices due to increased inflation expectations or a general rise in risk-free interest rates, will not necessarily lead to recognition of an impairment loss, even if they result in a decline in fair value that appears permanent and is not expected to reverse.
How are 12-month and lifetime expected credit losses determined under IFRS 9?
For financial assets measured at amortised cost or fair value through other comprehensive income, and not initially recognised as credit-impaired, the measurement of credit losses under IFRS 9 depends on whether there has been a significant increase in the credit risk of the asset since initial recognition. If no such increase has been identified, the credit losses are generally measured based on 12-month expected credit losses. If a significant increase in credit risk has been identified, credit losses are measured based on lifetime expected credit losses. Thus, apart from a few specified cases, the Standard requires monitoring the credit risk of the financial asset to determine whether a significant increase has occurred (or whether such increase has reversed).
One reason for this approach was the practical difficulties in calculating lifetime expected credit losses for all types of relevant instruments, especially for open portfolios that include newly-added financial assets over time. In addition, calculating 12-month expected credit losses involves data and techniques already available to some entities applying IFRS for regulatory purposes, unlike lifetime expected credit losses. Above all, the impairment allowance under this approach recognised by reporting entities will in most cases be significantly lower than under an approach in which lifetime expected credit losses are recognised for all financial assets subject to impairment. Thus, IFRS 9 requires measuring lifetime expected credit losses only for those financial assets initially recognised as credit-impaired or whose credit risk has increased significantly since initial recognition. However, the model under IFRS 9 is also characterised by a certain conservatism, relating to double counting of credit losses around the time of initial recognition of a financial asset.
What are the derecognition provisions in IFRS 9 and why are they complex?
Derecognition of Financial Instruments
IFRS 9 includes detailed provisions regarding the derecognition of financial assets and financial liabilities. These provisions deal both with the timing of derecognition and with the measurement and presentation of its consequences.
In this context, the term “derecognition” refers, in practice, to the full or partial removal from the reporting entity’s statement of financial position of a financial asset or financial liability previously recognised. The simplest case in which derecognition of a financial asset or financial liability is required in ordinary circumstances occurs when the asset or liability has reached the end of its contractual life, e.g., it has been repaid, expired, or settled, such as in the case of a written or purchased option, as applicable. From this point in time, the reporting entity is no longer contractually obligated to settle the financial liability, or it no longer holds the contractual right underlying the financial asset.
The question of the proper timing for derecognition of assets or liabilities from the statement of financial position is not unique to financial instruments, and it may also be relevant to other types of assets and liabilities. Accordingly, some IFRS Accounting Standards include provisions on derecognition. However, the derecognition principles relating to financial instruments are the most detailed and complex among all derecognition principles within IFRS. This complexity can be explained by the fact that, during the life of financial instruments, many events may occur that raise the question of whether derecognition of the asset or liability is required. The following are some notable examples of such events:
- Changes in the contractual terms of financial assets or financial liabilities, such as rescheduling of payments, changes in the stated interest rate, changes in financial covenants, debt “haircuts”, currency changes, changes in indexation or in the interest-setting mechanism, addition of conversion rights, forced conversions and similar modifications.
- Sales of financial assets to third parties, such as factoring of receivables, or transfers of assets to a special purpose entity (SPC) for securitisation. Sometimes such transactions are carried out while retaining some degree of exposure to the risks of the transferred assets.
- Repurchase agreements (repos), or transactions in which options related to the assets sold are granted or performance guarantees are provided.
When such events occur, the question of whether to derecognise the financial asset or financial liability can be highly significant. The following are some examples of the accounting implications of derecognition:
- If the event leading to derecognition involves a change in the contractual terms of the financial instrument, derecognition may result in recognition of new financial instruments, possibly with a different classification from the original instruments. For example, a derecognised financial asset may have originally been classified in the amortised cost category, while the newly recognised asset may be classified in the fair value through profit or loss category. In addition, initial recognition of new financial instruments typically requires measurement at fair value, recalculation of the effective interest rate, and so forth.
- Derecognition may result in recognition of gains or losses, including reclassification to profit or loss of amounts previously recognised in other comprehensive income, such as for debt investments classified as measured at fair value through other comprehensive income.
- When new financial liabilities are recognised after derecognition, it is required to reassess whether they contain embedded derivatives not closely related to the host debt contract.
- If a transfer of a financial asset qualifies for derecognition, the asset is removed from the statement of financial position, and the proceeds are not presented as a loan. Conversely, if the financial asset is not derecognised, the proceeds may be accounted for in a manner similar to a loan. Thus, derecognition could impact the leverage in the statement of financial position.
How do the derecognition rules address “off-balance sheet” exposure?
The derecognition provisions in IFRS 9 relating to financial assets are also intended to address the problem of “off-balance sheet” financial assets. This refers to situations in which the reporting entity remains substantially exposed to certain financial assets, yet this exposure is not adequately reflected in its statement of financial position. Consider the following example: a company holds a financial asset, such as equity shares of another entity. The company sells this asset to a third party while simultaneously entering into a forward contract to repurchase the financial asset from the third party at a fixed price on a specified future date. In this case, the company clearly remains almost fully exposed to the risks of the financial asset even after the sale. In particular, the company continues to bear all the risks and rewards related to fluctuations in the fair value of the asset, since the repurchase price is fixed. In other words, from an economic perspective the “sale” transaction is in effect a loan transaction, in which the financial asset serves as collateral. In such a situation, derecognition of the asset would render it “off-balance sheet” for the company. In this simplified example, applying the Standard’s derecognition principles would not generally result in derecognition of the financial asset, but rather treating the sale and repurchase transactions together, as a single loan transaction. However, the complexity of the derecognition principles for financial assets also arises from the fact that they are designed to address many less clear-cut intermediate cases. For example, when the repurchase transaction does not expose the reporting entity to all the risks and rewards of the financial asset, but only to part of them. This may occur, for instance, by granting only partial guarantees or by issuing an out-of-the-money put option to the buyer at the inception of the sale transaction.
It is important to note that the derecognition principles for financial assets and those for financial liabilities are not symmetrical. The main criterion for derecognition of financial liabilities is whether there has been a formal legal release from the original contractual obligation to settle the liability. In contrast, for transfers of financial assets, other key features are considered, including the extent to which risks and rewards of the transferred asset have been passed on, and the transfer of control over the asset.
IFRS 7 Financial Instruments: Disclosures include detailed disclosure requirements relating to transfers of financial assets. These requirements are intended to complement the derecognition provisions of IFRS 9 in terms of disclosure.
In general, since IFRS 9 does not apply to the reporting entity’s own equity instruments, its derecognition principles also do not address financial instruments that are the entity’s own equity. It appears that changes in the terms of the reporting entity’s own equity instruments, not as part of a share-based payment transaction, do not themselves result in recognition of gains or losses. Thus, if after the modification the instruments still meet the definition of equity, the effect will at most be reflected as equity distributions. An example would be converting ordinary shares into preference shares or vice versa. Similarly, if the modification of an equity instrument results in recognition of a financial asset or financial liability, it will be treated as initial recognition of such an asset or liability, with a corresponding entry to equity rather than recognition of any gain or loss.
What is hedge accounting under IFRS 9 and what problem does it seek to solve?
Hedge Accounting
The business activities of different corporations may expose them to various financial risks, including, among others, exposures to changes in foreign-currency exchange rates, price indices, interest rates and equity or commodity prices. Sometimes there is a desire to reduce these exposures by using various derivative instruments, such as options, forwards, futures, and interest rate swaps (IRS), among others.
For example, a UK industrial company (whose functional currency is the pound) that imports its raw materials from the U.S. and is exposed to changes in the pound/USD exchange rate may enter into a hedging transaction to buy a call option to purchase U.S. dollars at a future date for a fixed pound amount, in order to reduce the existing exposure.
Often, as in the example above, hedging is carried out through derivative financial instruments. However, non-derivative financial instruments are also sometimes used to reduce such exposures. For instance, a UK company may raise a loan denominated in Canadian dollars to reduce the exposure to pound/CAD exchange-rate movements arising from an investment in an income-producing asset in Canada.
The term “hedge” describes a strategy to protect against exposures faced by reporting entities. The growing use of financial instruments to hedge exposures to financial risks led to the need for developing and applying hedge accounting principles. It is important to distinguish between an “economic hedge” and “hedge accounting”, with the premise that not every economic hedge qualifies for hedge accounting, as detailed below.
What is the gap between an economic exposure and an accounting exposure?
To understand the need for special hedge accounting principles, it is first important to recognise the gap between an economic exposure and an accounting exposure, as follows:
- Economic exposure — as the name implies, economic exposure arises from changing economic factors to which the reporting entity is exposed. Common types include exposure to movements in exchange rates, commodity prices, equity prices, interest rates, inflation and many other variables. Whether a given economic exposure constitutes a risk for an entity depends largely on the reference point, e.g., in which currency the entity prefers to measure its economic results, as well as on the entity’s risk appetite, e.g., does it seek some speculative exposure or prefer to focus on its core business. Economic risks may arise when changes in the factors noted above can cause unplanned volatility in cash inflows or outflows, or in asset values. Exposure to economic risks can create challenges in planning and pricing, and the need for larger reserves or buffers when preparing budgets or contracting with suppliers and customers to absorb negative, unforeseen cash flows. Economic exposures may also manifest as a risk of changes in the fair value of certain items that erode the entity’s economic equity, e.g., a change in a market variable that increases the fair value of the entity’s liabilities without a corresponding increase in the fair value of its assets. Managing economic exposures can be performed in various ways, including entering into derivatives, borrowing or depositing in various currencies or indexations, as well as entering into long-term purchase or supply contracts and embedding pricing mechanisms in long-term contracts with customers and suppliers.
- accounting exposure – in contrast to an economic exposure, an accounting exposure arises when the accounting recognition, measurement, or presentation of a given risk factor exhibits a mismatch. Often, an accounting exposure emerges precisely when (and only because) an economic exposure has been addressed by the reporting entity. Such a mismatch can stem from measurement bases, where the hedged item is not measured in the same way as the hedging instrument, for example, a derivative used for the economic hedge. Consider a company that receives a fixed-rate bank loan measured at amortised cost. The company wants to hedge its economic exposure to changes in the loan’s fair value due to market interest-rate movements, to stabilise its economic equity, so it enters into an interest rate swap receiving fixed and paying floating interest rate. Without hedge accounting, the swap (a derivative) would be measured at fair value through profit or loss, while the loan remains at amortised cost. Consequently, profit or loss would reflect only the fair-value movements of the hedging instrument, even though there is little (or no) net exposure at the position level. The mismatch also affects the statement of financial position, where the carrying amounts of the loan and the derivative will not amount to the fair value of the loan.
What is a timing mismatch example that hedge accounting addresses?
Another prominent accounting exposure is a timing mismatch, when the hedged item has not yet been recognised in the financial statements while the derivative used for hedging has already been recognised and measured at fair value through profit or loss. For example, an entity enters into derivatives to hedge future changes in raw-material prices for goods it has not yet purchased. The derivatives are recognised, but the raw materials have not yet been purchased or consumed (the underlying may be firm commitments or even forecast transactions), so there is no accounting impact yet from the hedged item. Likewise, a UK company with a U.S.-dollar functional currency, that wants to hedge pound payroll expenses for production staff in the UK may enter a pound/USD forward. Without special hedge accounting, the company would recognise fair-value changes on the forward at each reporting period even though the related payroll expenses have not yet been recognised.
What is the stated objective of hedge accounting?
The stated objective of hedge accounting is to reflect in the financial statements the effect of the reporting entity’s risk-management activities when it uses financial instruments to manage exposures arising from risks that could affect profit or loss (or, for equity investments designated as at FVOCI, other comprehensive income). This includes illustrating the link between hedging instruments for which hedge accounting is applied and the hedged items, to help users understand the purpose of holding them and their effect on the reporting entity.
What is the core alignment challenge in hedge accounting?
In general, the challenge at the core of hedge accounting is to create alignment between the accounting recognition of the hedged item (e.g., the timing of recognising payroll expenses in the example above) and the recognition of gains or losses from fair-value changes of the hedging instrument (timing issue), as well as aligning the classification of the hedging instrument’s gains or losses with the line item where the hedged item’s effects are recognised (classification issue). Importantly, hedge accounting leads to the same profit-or-loss classification for the effect of the hedge as for the risk being hedged. In the example above, if hedge accounting is applied, the hedge results would be presented within the payroll expense line, so that payroll expense reflects its hedged cost.
Why are hedge accounting principles considered exceptions under IFRS 9?
Practically, hedge accounting principles are exceptions to the usual recognition and measurement requirements of IFRS 9 and sometimes other IFRS Accounting Standards. These exceptions may involve recognising items that would not otherwise be recognised at that time (e.g., firm commitments), measuring items on a basis different from their normal measurement, and reclassifying gains or losses on hedging instruments (such as derivatives) into specific line items to align them with the hedged item.
Is hedge accounting optional and what eligibility conditions exist?
Notwithstanding the above rationale, and to prevent misuse of hedge accounting to mask speculative outcomes, IFRS 9 impose eligibility conditions for applying hedge accounting. From a conceptual standpoint, hedge accounting is optional. Thus, even if an entity meets (or could meet) all eligibility criteria, it may always choose not to apply hedge accounting. Moreover, an entity may choose to apply hedge accounting only for certain transactions or positions, on a case-by-case basis.
How does IFRS 9 align hedge accounting with risk management, and what option exists to keep IAS 39?
IFRS 9 aims to better align hedge accounting with risk-management activities, compared with its predecessor, IAS 39. Accordingly, IFRS 9 increases flexibility in eligibility and application, broadening practical use, by changing or removing some of the requirements and prohibitions set out by IAS 39. Given the complexity and operational challenge of hedge accounting, IFRS 9 unusually allows entities to continue applying the IAS 39 hedge accounting model. In any case, hedge accounting remains one of the most complex and demanding areas in modern IFRS.
What alternatives exist when hedge accounting is not applied?
In certain cases where an entity does not wish, or is unable, to apply hedge accounting, other approaches may help mitigate the accounting mismatch described above. A notable alternative is using the fair value option, i.e., designating financial instruments and, in some cases, other contracts that would not normally be financial instruments, as at fair value through profit or loss. In addition, as an alternative to hedge accounting, IFRS 9 permits designating credit risk exposures as at fair value through profit or loss.
What types of hedging relationships does IFRS 9 recognise?
IFRS 9 recognises three types of hedging relationships:
- Fair value hedge
- Cash flow hedge, and
- Hedge of a net investment in a foreign operation.
What is worth noting about judgment and documentation in hedge accounting?
It is worth noting that, beyond being optional, the application of hedge accounting can involve considerable judgment and flexibility in defining the hedging instrument, the hedged item, and the hedging relationship. In certain circumstances, the documentation and designation for accounting purposes need not be identical to the entity’s risk-management view, though they must be consistent with it.