IBOR Reform - Proposed amendments to the financial instruments standards, IAS 39 and IFRS 9, on affected hedging relationships
IFRS
IBOR Reform – Proposed amendments to the financial instruments standards, IAS 39 and IFRS 9, on affected hedging relationships
Mon 05 Aug 2019
The ongoing reform of short-term interest rate benchmarks, and the growing uncertainties affecting future cash flows, have persuaded the International Accounting Standards Board (“IASB”) to put forward proposed amendments to the hedge accounting requirements in IAS 39 Financial Instruments: Recognition and Measurement (“IAS 39”) and IFRS 9 Financial Instruments (“IFRS 9”) by issuing the Exposure Draft Interest rate Benchmark Reform. So, what is the background and rationale for issuing the exposure draft and the impact of the reform on the hedge accounting requirements.
Background to the exposure draft Following the 2008 liquidity crisis and the market manipulation of short-term InterBank Offered Rates (“IBOR”), such as LIBOR or EURIBOR, the Financial Stability Board (“FSB”) issued a report in 2014 questioning the reliability of these rates. Drawing from the lessons of these events, the report recommended improving the governance of existing reference rates (including IBOR, but also very short-term rates like EONIA) and introducing alternative risk-free interest rates (RFR).
In response to these recommendations, a large-scale reform was launched, but there has been no consistent implementation in the various national and transnational jurisdictions affected. While some jurisdictions have moved towards the effective replacement of the existing interest rate benchmarks, others have left the door open to the coexistence of old and new reference rates, or have even simply maintained the old rates. These disparities are also reflected in the divergence between timetables for introducing the reforms from one jurisdiction to another and one rate to the next.
The reform therefore introduces uncertainties regarding the
timing and the amount of future contractual cash flows based on these reference
rates. In some cases, the replacement of existing rates by alternative rates
could require amendments to affected contracts, which of course would be very
onerous, particularly if the amendments needed agreement and sign-off with the
counterparties, and time-consuming; the effective dates of these changes could
in practice be spread over many months or even years.
Because
of the uncertainties, the IASB launched a review in 2018 to consider the potential
accounting impacts of the reform. Due of its scale, the project has two phases:
Phase
I – addressing accounting issues identified in the period before the effective replacement
of an existing interest rate benchmark (pre-replacement issues); and
Phase II – addressing accounting issues raised by the
effective replacement of the interest rate benchmark (replacement issues).
The
exposure draft, which was published in May 2019, forms part of phase I and
proposes amendments to the hedge accounting requirements of IAS 39 and
IFRS 9. The amendments are being proposed, therefore, because of the
uncertainties and implications arising from the reform that are likely to cause
some hedging relationships to be discontinued, such as:
the
disappearance (or the no longer “highly probable” nature) of a benchmark
interest rate risk component or of the hedged cash flows;
the
amendment of hedged contracts that might lead to their derecognition; and/or
an ineffective relationship, generated by the reform,
between the hedging instrument and the hedged item.
Proposed amendments to the hedging requirements The main aim of the proposed amendments is to relax the IAS 39 and IFRS 9 eligibility conditions for an interest rate hedging relationship, in order to avoid a situation in which a hedging relationship is discontinued or becomes ineligible solely due to the uncertainties caused by the reform of benchmark rates for future contractual cash flows. The proposed reliefs relate, firstly, to the criteria for the prospective assessments. For
cash flow hedges, IAS 39 and IFRS 9 both require that if a hedged
item is a future transaction, it must be “highly probable” if the hedging
relationship is to be eligible. If this future transaction corresponds to cash
flows based on the existing interest rate benchmarks, its “highly probable”
nature may be called into question by the potential replacement of the existing
reference rate by an alternative. The IASB proposes to deal with this risk by
taking no account of the effects of the ongoing interest rate reform when
assessing whether such a future transaction is “highly probable”.
The
IASB also proposes to overlook the impact of the reform on the prospective
effectiveness assessments carried out for fair value and cash flow hedges,
namely:
the
prospective effectiveness assessment under IAS 39 (i.e. the changes in
future values of the hedging instrument and the hedged item should offset each
other such that the hedge is expected to be “highly effective” throughout its
life); and
the
demonstration of an economic relationship between the hedged item and the
hedging instrument under IFRS 9 (i.e. the value of the hedging instrument
and the value of the hedged item will generally move in opposite directions
because of the same risk, which is the hedged risk).
Another
expedient is being proposed for the special case of a hedge of an interest rate
risk component affected by the reform that is not contractually specified. This
arrangement relates, for example, to situations where an entity establishes a
fair value hedging relationship in which the hedged risk corresponds to the
changes in value of a fixed-rate instrument (e.g. a fixed rate liability at 4%)
in light of a benchmark interest rate (e.g. EURIBOR 3M). IAS 39 and
IFRS 9 allow the hedging of a designated risk component of an item rather
than the item in its entirety, provided that this risk component is separately
identifiable and reliably measurable from inception and throughout the life of
the hedging relationship. The exposure draft therefore proposes that an entity
should apply the requirement (that the benchmark interest rate risk component
hedged is separately identifiable) only at the inception of the hedging
relationship, rather than continuously.
It is important to note, however, that the intention of the proposed amendments is solely to prevent the discontinuation of hedging relationships affected by the benchmark rate reform due to a failure to meet the prospective eligibility criteria, and not to eliminate the recognition of any ineffectiveness caused by the reform: the exposure draft is clear that any ineffectiveness caused by the rate reform would continue to be recognised in profit or loss.
Impact on the required disclosures – Disclosures are required to be provided to identify the hedging relationships that are affected by the proposed amendments. The IASB proposes that the quantitative disclosures for hedge accounting, as required by IFRS 7 Financial Instruments: Disclosures (“IFRS 7”), should be presented, separating the relationships affected by the amendments from other hedging relationships. The disclosures which would therefore be required are as follows:
Hedging
instrument
– Carrying amount of the instrument – Fair value change of the instrument used as a basis for recognition of hedge relationship ineffectiveness – Nominal value of instrument
Hedged item
Fair value hedges: – Carrying amount of the hedged item. – Balance of the reserve for fair value hedge adjustments on the hedged item recognised in the statement of financial position. Cash flow hedge or hedge of a net investment in a foreign operation: – Balances in the cash flow hedge reserve / foreign currency translation reserve for continuing hedges. – Balances in the cash flow hedge reserve and the foreign currency translation reserve from any hedging relationships for which hedge accounting is no longer applied. All hedges: – Change in the fair value of the hedged item used as the basis for recognising hedge ineffectiveness.
Mandatory application
The
IASB propose that this amendment must be applied retrospectively as of
1 January 2020, with early application possible (subject to EU
endorsement[†]).
The
amendment would apply for a limited period, ending either:
when
there is no longer any uncertainty with respect to the timing and the amount of
the interest rate benchmark-based cash flows; or
when
the hedging relationship is discontinued, or when the entire amount accumulated
in the cash flow hedge reserve accounted for in other comprehensive income (“OCI”)
with respect to that hedging relationship is reclassified to profit or loss.
The
exposure draft closed for comments on 17 June 2019. The letters
received have been published on the IASB’s website and can be viewed
here.
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