Effects on the Financial Reporting of Financial Instruments under IFRS
The reform of the IBOR interest rates essentially means that the method for determining IBOR interest rates has changed. Up to now, IBOR interest rates had been determined on the basis of the interest rates charged by 11 to 18 big banks, i.e. the rates which the latter would charge London’s interbank market for unsecured credits (reported on a daily basis). At the moment, it seems that the interest rates succeeding the old IBOR interest rates won’t be standardized. Rather, the respective central banks will decide individually on how they are going to determine the method. However, these future approaches are all likely to have a closer link to actual transactions. The hope is that linking IBOR interest rates closer to actual transactions will make it harder to manipulate them.
The IBOR reform will have a noticeable effect on the Treasury, the Finance and the Accounting functions of virtually every company. There will be obvious effects on the fair value valuation of financial instruments and the interest rate framework connected to this in treasury management systems. Apart from the valuation of financial instruments, the IBOR reform will also affect the basic contracts in Treasury (i.e. debt financing, inter-company financing, cash pools, etc.). Finally, companies have to clarify whether and how financial reporting according to IFRS will be affected by the IBOR reform. An early and comprehensive analysis of the effects in Treasury is therefore essential in order to prevent unwanted surprises and to make available sufficient resources for any necessary adjustments. Below, we expand on the effects on the financial reporting.
The effects on the financial reporting of financial instruments according to IFRS can be manifold. In order to cope with the uncertainties in connection with the IBOR reform, the IASB has introduced the project “IBOR Reform and Its Effects on Financial Reporting”. The initial phase of this project, which included some adopted changes in IFRS 9, IAS 39 and IFRS 7, is now complete. It regulates hedge accounting; the second phase, on the other hand, mainly addresses the classification and the valuation of financial instruments.
With the IBOR reform, institutions would have run the risk that numerous hedging relationships could no longer be continued under the existing regulations. Possible reasons for this are the fact that the criterion of a high likelihood of secured interest cash flows is not fulfilled because of changes made to the reference interest rates, insufficient proof of effectiveness or the non-identification of designed risk components. In order to avoid having to end hedging relationships because of the changes made to the reference interest rates, the IASB amended IFRS 9 and IAS 39 in an initial project phase; these amendments should make it possible to keep the existing hedging relationships during a transitional period.
For instance, the IBOR reform should have no effect on the high probability of occurrence criterion. Companies may thus assume that the interest rate on which hedged cash flows are based will not change. Therefore, when estimating the likelihood of occurrence of hedged cash flows, the same cash flows should be used as a basis as they would have been used without any uncertainty stemming from the IBOR reform.
Likewise, when evaluating the financial relationship between the underlying and the hedging instrument according to IFRS 9, one should assume that the reference interest rate on which the hedging relationship is based won’t change because of the reform. If hedge accounting is being used in accordance with IAS 39, the effectiveness range of 80% - 125% no longer applies to the retrospective measurement of effectiveness if the exceedance or the shortfall of the effectiveness limits is caused by changing reference interest rates. Instances of ending hedging relationships because of prospective ineffectiveness (IFRS 9) or retrospective ineffectiveness (IAS 39) resulting from insecurities in connection with the interest rate reform can thus be avoided.
An evaluation of whether a risk component is to be identified separately is now only necessary at the start of a hedging relationship. An additional evaluation of whether a risk component is to be identified separately at a later time is no longer necessary and is indeed unlawful. Accordingly, ending existing hedge relationships because new evaluations have separately identified designated risk components is neither necessary nor allowed.
These changes become applicable for reporting periods starting on 01.01.2020, subject to EU endorsement. The rules are no longer applicable if the insecurities concerning the date or size of the cash flows based on reference interest rates no longer exist or if the hedging relationships have ended. To sum it up, the effects of the IBOR reform on the financial reporting of hedging relationships are limited because of the amendments made to IFRS 9 and IAS 39. Because of amendments made to IFRS 7, significant reference interest rates that have an effect on hedging relationships and that are affected by the IBOR reform must be disclosed. In addition, the extent of the exposures which are affected by IBOR as well as the nominal volumes of the affected hedging transactions have to be specified. Finally, it must be disclosed how the transition to the new reference interest rates was implemented, specifying significant assumptions and evaluations.
These reporting requirements in the notes necessitate the identification of the affected hedging relationships and the analysis of effects of the IBOR reform on the (secured) interest rate exposures of companies. An analysis of the affected hedging relationships should be at the heart of the impact analysis of the IBOR reform performed by Treasury.
Source: KPMG Corporate Treasury News, Edition 96, November 2019
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