AASB 9 - Simplifying hedge accounting

1 The new financial instruments standard, aasb 9, reduces the constraintsassociated with hedge accounting , allows more types of hedging relationships andhelps reduce income statement volatility. Not surprisingly, a number of corporatesare early adopting aasb 9 to take advantage of these benefits. There are, however,a number of other new requirements that early adopters need to consider. Thispublication looks at the benefits of early adopting aasb 9 for hedging and providessome insights into these other benefits of early adopting hedge accounting under aasb 9 Although the core principals and purpose of hedge accounting have not changed, aasb 9 simplifies hedgeaccounting and aligns it with the overall risk management strategies of companies.

2 The chart below summarisesthe aspects of hedge accounting that have been simplified under the new standard and the key benefits forcorporates: aasb 9 - Simplifying hedge accountingLess restrictive criteria to qualify for hedgeaccounting. The requirement to demonstrate aneconomic relationship between the hedged itemand hedged instrument replaces the quantitative80-125% hedge effectiveness thresholdRetrospective effectiveness tests are no longerrequiredThe hedge relationship can be rebalanced whencircumstances change but the risk managementobjective remains the sameSimplificationThe exposures that can be subject to hedgeaccounting have been broadened.

3 These include: aggregated exposures components of non financial items, and groups of items such as net positions and layersof transactionsWhen hedging with options or cross currencyswaps, fair value changes due to time value inoptions and currency basis in cross currency swapscan be deferred in will permit more hedging relationships to bedesignated and should see more hedge relationshipscontinue that may have failed under the existinghedge effectiveness thresholdAlthough corporates still need to measureineffectiveness, the onerous burden of formallydemonstrating highly effective hedges is removedShould see more hedge relationships continue thatmay have failed under the existing 80-125%effectiveness thresholdBenefit of simplificationShould reduce profit and loss volatility in a number ofareas, including: Aggregated exposures for example, a debt and aswap can now be included as a hedged item.

4 Thiscould benefit companies that raise fixed rateoverseas funding and swap the foreign currencycash flows back to fixed AUD using a combinationof cross currency and AUD interest rate swaps Components of non financial items for example,the aluminium in a can could be separately hedgedusing aluminium futures as opposed to the cost ofthe entire can itself. Net positions for example, purchases and salesin a single currency could be hedged based ontheir net exposure. Hedging such a position ismore difficult under the existing reduce income statement volatility by deferringtime value of options and currency basis in crosscurrency swaps in equity and amortising them toP&L on a systematic and rational basisInsights on Practical Application for CorporatesImpairment of financial assetsThe new requirements in aasb 9 introduces a forward looking expected loss model that replaces the existingincurred loss model.

5 A credit loss provision will be required on initial recognition of financial assets subject tothese requirements. This means that a credit event is no longer required before a credit loss provision isrecognised. This provision will usually be based on expected credit losses arising from default events over a 12month period following initial recognition. However, over time, when there has been a significant increase in thecredit risk of the financial asset, the provision needs to be updated using expected credit loss data arising fromdefault events over its lifetime, and not just for 12 months.

6 For corporates, however, there are a number ofoperational simplifications available when applying these impairment requirements. We consider these and measurement of financial assets and financial liabilitiesAASB 9 has a more simplified approach for classifying and measuring financial assets. All equity investments aremeasured at fair value through profit and loss (FVTPL) unless the exception detailed below is taken up. Debtinvestments are subject to two assessments based on the asset s contractual cash flow characteristics and the way it ismanaged by the entity.

7 Depending on the outcome of these assessments, debt investments can be measured at eitheramortised cost, fair value through other comprehensive income (FVOCI) or FVTPL. There has been no substantialchanges to the measurement of financial liabilities. The diagram below outlines some of the benefits and challenges tocorporates when applying the classification and measurement requirements. There are options on how to measure theexpected credit loss provision for tradereceivables and certain other financialassets, including those with low credit aim of this simplification is to reducethe burden of assessing when a significantincrease in credit risk has occurred for theseassets For trade receivables, the guidance allowsthe use of a provision matrix ( based onageing) to measure the provision.

8 The use ofsuch a tool provides some relief fromtracking deterioration in credit risk onreceivables individually In practice, for corporates with a rollingportfolio of receivables, the provision maynot move significantly after its approach Determining the provision for financialassets that are outside the scope of theoperational simplifications ( in debt securities with highcredit risk) For these assets, corporates must considerforward looking information, includingmacroeconomic factors, to determineprovisions. Collecting and manipulatingsuch information may requireconsiderable cost and effort Corporates will also need to periodicallyassess if there has been a significantincrease in credit risk for these assets Considering the amount of provision anddetermining what is significant willrequire judgement and consideration ofmaterialityChallenges Investments in equities not held for tradingcan be measured at FVOCI, minimising P&Lvolatility.

9 Embedded derivatives in financial assets areno longer required to be separated, removingan onerous burden under the existingguidance Investments in listed debt investments maybe accounted for at amortised cost instead offair value, which may be easier to measure Movements in fair value due to an entity sown credit risk for financial liabilities electedto be measured at FVTPL is taken throughequity, minimising P&L Investments in unquoted equities can nowonly be measured at cost in very limitedcircumstances which is expected to be rare. Changing the measurement category for adebt investment is subject to a high hurdle Investments currently accounted for asAvailable- for -sale may no longer meet thecriteria for FVOCI classification and result inFVTPL classification Determining the contractual cash flowcharacteristics and the way the entitymanages financial assets may requiresignificant judgementChallengesCorporates adopting aasb 9 for hedge accounting must also apply its impairment of financial assetsrequirements and classification and measurement requirements.

10 We consider these 2015 PricewaterhouseCoopers. All rights refers to the Australian member firm, and may sometimes refer to the PwC network. Each member firm is a separate legal see for further content is for general information purposes only, and should not be used as a substitute for consultation with professional is limited by the Accountant s Scheme under the Professional standards Australia helps organisations and individuals create the value they re looking for. We re a member of the PwC network of firms in158 countries with close to 169,000 people.