Sandra Thompson in the Accounting Consulting Services team in the UK and Jessica Taurae in the ACS Central Team look at the impact of the proposals to change hedge accounting.
The rules on hedge accounting in IAS 39 have frustrated many preparers, as the requirements have not been well linked with common risk management practices. The detailed rules have at times made achieving hedge accounting impossible or very costly, even when the hedge has been an economically rational risk management strategy. Users have also found the current distinction between achieving hedge accounting or not, meaningless; they have often struggled to fully understand an entity’s risk management activities based on its application of the hedge accounting rules. The IASB is addressing several of these concerns in this third phase of its efforts to replace IAS 39 with IFRS 9.
Hedge effectiveness tests and eligibility for hedge accounting
The exposure draft (ED) proposes relaxing the requirements for hedge effectiveness assessment and, consequently, the eligibility for hedge accounting. Under IAS 39 today, the hedge must both be expected to be highly effective (a prospective test) and be demonstrated to have actually been highly effective (a retrospective test) with “highly effective” defined as a “bright line” quantitative test of 80% - 125%. The ED replaces this with a requirement for the hedge to be designated to be neutral and unbiased, and in a way that minimizes expected ineffectiveness. This could be demonstrated qualitatively or quantitatively, depending on the characteristics of the hedge. For example, a qualitative test might be sufficient in a simple hedge where all the critical terms match. Some type of quantitative analysis – such as that required under current rules – would need to be performed in highly complex hedging strategies. The 80% - 125% bright line rule would be removed; however, hedge ineffectiveness must still be measured and reported in profit or loss.
A number of changes are proposed to the rules for determining what can be designated as a hedged item. The proposed changes primarily remove restrictions that, today, prevent some economically rational hedging strategies from qualifying for hedge accounting. For example, the ED proposes that risk components can be designated for non-financial hedged items, provided that the risk component is separately identifiable and measurable. This is good news for entities that hedge non-financial items for a commodity price risk that is only a component of the overall price risk of the item, as it is likely to result in more hedges of such items qualifying for hedge accounting.
The ED would also make the hedging of groups of items more flexible; although, it does not cover macro hedging – this will be the subject of a separate ED in 2011. Treasury management teams commonly group similar risk exposures and hedge only the net position (for example, the net of forecast purchases and sales in a foreign currency). Such a net position cannot be designated as the hedged item under IAS 39 today. The ED proposes that this be permitted if it is consistent with an entity’s risk management strategy. However, if the hedged net positions consist of forecasted transactions, all hedged transactions have to relate to the same period.
The ED relaxes the rules on using purchased options and non-derivative financial instruments as hedging instruments. For example, under the current hedging rules, the time value of purchased options is recognized on a mark-to-market basis in net income, which can create significant volatility in profit or loss. In contrast, the ED views a purchased option as similar to an insurance contract, such that the initial time value (that is, the premium generally paid) will be recognized in profit or loss – either over the period of the hedge if the hedge is time related, or when the hedged transaction affects profit or loss if the hedge is transaction related. Any changes in the option’s fair value associated with time value will only be recognized in other comprehensive income (OCI). This should result in less volatility in profit or loss for these types of hedges.
Presentation and disclosure
The ED changes the presentation of fair value hedge accounting. The hedged item will no longer be adjusted for changes in fair value attributable to the hedged risk. Instead, those fair value changes will be presented as a separate line item in the balance sheet. The changes of the fair value of the hedging instruments will be presented in OCI on a gross basis. Any ineffectiveness is then reported in profit or loss. All hedge accounting results are then reflected in the same statement (OCI). The new presentation disclosure requirements are designed to give the user of the financial statements better information about how the entity’s risk management activities relate to its use of hedge accounting and hedge effectiveness.
All entities that engage in risk management activities may be affected by the changes regardless of whether or not they use hedge accounting today. It may be beneficial for entities to revisit their risk management strategies that currently do not achieve hedge accounting to see if they will now be permitted. The impact of the new eligibility criteria – unbiased hedging relationships – may make it necessary to evaluate existing hedge accounting strategies that work today and consider whether they will continue to be eligible.
The new requirements are proposed to be effective for accounting periods beginning on or after January 1, 2013, with earlier application permitted. However, the IASB has recently issued a discussion paper on effective dates and transition, the results of which may impact the IASB’s decision on the ultimate timing of IFRS 9 application.
The comment letter period ends on March 9, 2011; a final standard is expected mid-2011. Management should assess the implications of the proposals on existing hedging strategies and consider commenting on the ED to ensure its views are considered.
The IASB and FASB are seeking views on the effective dates of the major projects due for completion next year in order to reduce the implementation burden for preparers. The IASB will consider the needs of jurisdictions already using IFRS and those planning to do so. The projects covered by the request for views include the second and third phases of financial instruments, revenue from contracts with customers, insurance contracts and leases.
The IASB might amend effective dates of other projects, depending on responses received to its consultation – for example, the “consolidation” and “joint arrangements” projects and the first phase of IFRS 9, Financial Instruments. It will also consider the impact of effective dates proposed in other projects, such as financial statement presentation and financial instruments with the characteristics of equity.
The IASB is asking financial statement users, preparers and auditors to provide feedback about the expected time and effort involved in properly adapting to the proposed standards; and the implementation timetable and sequence of adoption that facilitates cost-effective management of changes.
The IASB’s questions in the request for views focus on four main issues:
All current and future IFRS reporters are likely to be affected by the decisions reached following this consultation. The comment letter deadline is January 31, 2011. We encourage preparers to respond to the request.
The IASB has issued a non-mandatory practice statement to help entities present a narrative report, often referred to as “management commentary.” This is the information that management might choose to provide to users of their financial statements to explain the entity’s financial position, financial performance and cash flows. It explains management’s objectives and its strategies for achieving those objectives.
The focus of management commentary will be specific to each entity. The IASB’s practice statement provides a broad framework of principles, qualitative characteristics and elements that might be used to provide users of the financial report with decision-useful information.
Entities that are not currently required to provide management commentary and now elect to do so will be able to apply the new practice statement. Entities that currently provide management commentary in accordance with local legislation or listing requirements are unlikely to be affected.
Entities that elect to apply the non-mandatory practice statement should review any existing management commentary to identify and include some or all of the features required by the practice statement.
The IASB has amended IAS 12, Income Taxes, to introduce an exception to the existing principle for the measurement of deferred tax assets or liabilities arising on investment property measured at fair value. The current principle in IAS 12 requires the measurement of deferred tax assets or liabilities to reflect the tax consequences that would follow from the way that management expects to recover or settle the carrying amounts of the entity’s assets or liabilities. However, the IASB believes that entities holding investment properties that are measured at fair value sometimes find it difficult or subjective to estimate how much of the carrying amount will be recovered through rental income (that is, through use) and how much will be recovered through sale.
The IASB has, therefore, added another exception to the principles in IAS 12, the rebuttable presumption that investment property measured at fair value is recovered entirely by sale. This presumption is rebutted if the investment property is depreciable (for example, buildings and land held under a lease) and is held within a business model whose objective is to consume substantially all of the economic benefits embodied in the investment property over time, rather than through sale before the end of its economic life. The presumption cannot be rebutted for freehold land that is an investment property, because land can only be recovered through sale.
The amendments also incorporate SIC 21, Income Taxes – Recovery of Revalued Non-Depreciable Assets, into IAS 12; although, investment property measured at fair value is excluded.
The amendments are effective for annual periods beginning on or after January 1, 2012. Management can elect to early adopt the amendment for financial years ended December 31, 2010. Entities should apply the amendment retrospectively in accordance with IAS 8, Accounting Policies, Changes in Accounting Estimates and Errors.
All entities holding investment properties measured at fair value in territories where the capital gains tax rate is different from the income tax rate (for example, Singapore, New Zealand, Hong Kong and South Africa) will be significantly affected. The amendment is likely to reduce significantly the deferred tax assets and liabilities recognized by these entities. It will also mean that, in many cases, there is no tax impact of changes in the fair value of investment properties. It might be necessary for management to reconsider recoverability of an entity’s deferred tax assets because of the changes in the recognition of deferred tax liabilities on investment properties.
The IASB has issued two amendments to IFRS 1, First-time Adoption of International Financial Reporting Standards.
The first amendment creates an additional exemption when an entity resumes presenting financial statements in accordance with IFRS after being subject to severe hyperinflation. The exemption allows an entity to elect to measure assets and liabilities held before the functional currency normalization date at fair value; and to use that fair value as the deemed cost of those assets and liabilities in the opening IFRS statement of financial position.
An entity might be unable to prepare financial statements in accordance with IFRS for a period of time because it could not comply with IAS 29, Financial Reporting in Hyperinflationary Economies, due to severe hyperinflation. The exemption applies where the entity is able to begin reporting in accordance with IFRS.
The amendment is effective from annual periods beginning on or after July 1, 2011. Earlier application is permitted. For more information, see our Straight away guidance: IASB amends IFRS 1.
The amendment is expected to have a limited impact, because the exemption is only available to entities whose functional currency was subject to severe hyperinflation. The Zimbabwean economy has been identified as an economy that was subject to severe hyperinflation until quarter one of 2009; the amendment is unlikely to apply in other territories.
The amendment would not change or allow any IFRS 1 exemptions for a reporting entity that has an interest in an entity subject to severe hyperinflation, except to the extent that the reporting entity is also a first-time adopter.
The second amendment eliminates eliminate references to fixed dates for one exception and one exemption, both dealing with financial assets and financial liabilities.
The first change requires first-time adopters to apply the derecognition requirements of IFRS prospectively from the date of transition, rather than from January 1, 2004.
Removal of fixed dates
The IASB has also amended IFRS 1 to eliminate references to fixed dates for one exception and one exemption, both dealing with financial assets and financial liabilities.
The first change requires first-time adopters to apply the derecognition requirements of IFRS prospectively from the date of transition, rather than from January 1, 2004.
The second amendment change relates to financial assets or financial liabilities at fair value on initial recognition where the fair value is established through valuation techniques in the absence of an active market. The amendment allows the guidance in IAS 39 AG76 and IAS 39 AG76A to be applied prospectively from the date of transition to IFRS, rather than from October 25, 2002 or January 1, 2004. This means that a first-time adopter does not need to determine the fair value financial assets and financial liabilities for periods prior to the date of transition. IFRS 9 has also been amended to reflect these changes.
The amendment is effective from annual periods beginning on or after July 1, 2011. Earlier application is permitted. For more information see our Straight away guidance: IASB amends IFRS 1.
Entities that had derecognized financial assets or financial liabilities before the date of transition to IFRS will need to apply the derecognition guidance from the date of transition, as it is a mandatory exception. The second change will only be relevant for entities that elect to use the exemption for fair value established by valuation techniques.
This is the first article in a series about issues affecting countries that are moving to IFRS. Ian Farrar and Niranjan Raman in PwC India look at some IFRS 1 application issues arising locally, challenges around revenue recognition, and determining the useful life of fixed assets.
IFRS 1, first-time adoption (Ind AS 41 in India), provides an optional exemption from the requirement to present comparative information in the year of adoption. In the first financial statements prepared using CIAS, management may voluntarily present the comparative information under CIAS; although, this is not mandatory.
An entity that opts not to present the comparative information under Ind AS 41 should present a reconciliation of equity at the balance sheet date between IFRS and previous GAAP (as if previous GAAP had continued), in addition to the more usual reconciliation of equity at the date of transition. This exemption provides welcome relief to preparers in India. It will, however, impair users’ ability to understand the entity’s year-on-year performance.
The National Advisory Committee on Accounting Standards has approved a carve-out for IFRIC 15, Agreements for the Construction of Real Estate. There has also been a carve-in to bring such transactions directly into the scope of the CIAS equivalent to IAS 11, Construction Contracts, in order to prevent this interpretation being required by way of the hierarchy in IAS 8, Accounting Policies, Changes in Accounting Estimates and Errors. Revenue will, therefore, be recognized on a percentage-of-completion method for all transactions involving the construction and sale of real estate.
IAS 18, Revenue, incorporates guidance to assist in its application to various aspects of revenue recognition, such as determining whether an entity is acting as a principal or as an agent, accounting for transfers of assets from customers and the requirements for customer loyalty programs. Indian GAAP does not contain similar guidance. Accounting practices have, therefore, developed over time in certain industries that differ from the manner in which the same underlying principles are applied under IFRS.
Specific areas where the timing or measurement of revenue recognition will need to be reconsidered as part of the convergence with IFRS include:
The minimum rates of depreciation to be charged by a company have been defined in the Companies Act based on certain asset categories. The accounting literature in Indian GAAP has historically required preparers to estimate useful life of assets subject to these minimum rates. The review of residual value and useful lives at each balance sheet date is not specifically required under Indian GAAP; although, it is allowed. Evidence suggests that most preparers default to these minimum rates.
It is proposed that similar guidance will be provided in the Companies Act, with a list of indicative estimated useful lives instead of the minimum rates of depreciation as at present. For example, the indicative useful life suggested for factory buildings is 30 years; for computers and data processing units, it is six years; for automobiles, it is five years; and for furniture, it is ten years, etc.
The inclusion of indicative useful lives could be considered as being at odds with the requirement for management to use judgment to determine and annually review useful lives of property, plant and equipment. However, it is hoped that rigorous application of IAS 16’s principles will prevent these indicative rates again becoming the de facto useful lives.
Indian companies are certainly feeling the pain of convergence, as IFRS presents a sea change from existing GAAP. Will they be able to reap the promised rewards of greater access to cheaper capital, despite the multiple carve-outs and exceptions? Only time will tell.
Barry Johnson and Lisa Dang of PwC’s Accounting Consulting Services in the UK assess the practical implications of implementing the next wave of new standards. It is likely to require all hands on deck.
The IASB is expected to publish a significant number of new IFRS and amendments over the next year or so. The level of complexity and the operational challenges will vary from standard to standard but may be severe. Management’s ability to cope with this wave of change will vary, depending on the entity’s circumstances and, in some cases, the industry in which it operates. The IASB has acknowledged the strain this is likely to put on management and systems. The IASB’s request for views has been published on how to schedule the effective dates of the new standards (deadline for comments: January 31, 2011).
The table (which can be found in the PDF) considers these challenges and some of the industries that are likely to be affected. This summary is based on information available as of December 2010. The new standards and amendments are still in development, so the projects and their timetable for completion are subject to change. One thing is likely, many of the below are unlikely to appear when expected.