IFRS 9 Financial Instruments

Transcription

1 IFRS 9 Financial Instruments What do corporates need to know about IFRS 9? November 2017 For your next step 1

2 Executive summary International Financial Reporting Standard 9 ( IFRS 9 ) is the new accounting standard for financial instruments. It will become mandatory for IFRS reporters in the EU (including the UK) for reporting periods starting on or after 1 January The introduction of IFRS 9 represents the most significant change to financial instrument accounting since the advent of IFRS in Europe over ten years ago. While much of the public commentary on IFRS 9 has focused on its impact on financial institutions, the new accounting standard will also affect corporates. Those with significant hedging activities, long-dated assets, or significant non-cash investments will be particularly impacted. In this article, we focus on ten key questions, and areas of change that we believe will be relevant for corporates from providing an overview of IFRS 9 to focusing on a number of the specific areas of change and complexity in the hedge accounting rules. We also discuss the option to defer application of the Hedge Accounting section of IFRS 9, and the actions companies that choose to adopt the new rules now may want to consider. Note that IFRS 9 is not directly relevant for the vast majority of companies which report in accordance with FRS 102 in UK GAAP, unless they have adopted an accounting policy of applying IAS 39 or IFRS 9 to their financial instruments. 2

3 1. What is IFRS 9? IFRS 9 Financial Instruments is the new financial instrument accounting standard that will replace the existing rules of IAS 39 in their entirety. It represents the culmination of a long-running project to improve and simplify the accounting and reporting of financial instruments, and is one of the most significant accounting changes since the initial implementation of IFRS in the UK and the rest of the European Union ( EU ) in The development of IFRS 9 was split into three main components, or phases, each of which are explained in overview in the table below. Each addresses a specific area of financial instrument accounting. Phase Scope IFRS 9 approach relative to IAS Classification & Measurement Determines how financial assets & liabilities are accounted for; in particular, whether they are held at amortised cost or fair value Embedded derivative rules Recognition & de-recognition of financial assets and liabilities New model for classifying financial assets Embedded derivative concept eliminated for financial assets Financial liability accounting largely unchanged De-recognition rules of IAS 39 retained, although new guidance included for modifications of debt instruments 2. Impairment Determines the timing and quantum of impairment loss recognition on financial assets Existing incurred loss model of IAS 39 replaced with a forward-looking, expected loss model Losses will be recognised earlier in the cycle; greater volatility of loss provisions in the income statement 3. Hedge Accounting Determines the timing of recognition of gains/ losses from hedging activities Presentation of hedging gains/losses (income statement geography ) IFRS 9 introduces a substantially reformed hedge accounting model adopting a simpler, principlesbased approach Designed to align the accounting outcome with the economics of the hedging strategy, which should result in less income statement volatility Source: IFRS 9, Lloyds Bank analysis, November 2017 Application of IFRS 9 is mandatory for IFRS reporters in the EU (including the UK) for reporting periods beginning on or after 1 January This means that calendar year-end reporters have only a limited amount of time to finalise their assessment of the impact of the new rules and to prepare for change, in order to be ready for the initial application date. However, it is important to note that companies do not have to adopt the Hedge Accounting section of IFRS 9 immediately: IFRS includes an option for companies to continue applying the Hedge Accounting rules of IAS 39. This option will remain in place until the International Accounting Standards Board s (IASB) separate macro-hedging project is finalised, which may be several years away. Once finalised, adoption of the new Hedge Accounting rules will become mandatory. 3 back to Executive summary

4 2. Which sections of IFRS 9 are expected to have the most significant impact on corporates? While much of the public commentary on IFRS 9 has focused on its impact on financial institutions in particular, the impact of the new impairment model on banks the new accounting standard will also affect corporates. Those with significant hedging activities, long-dated financial assets such as contract receivables, or significant non-cash financial investments will be particularly affected. The majority of the impact on corporates is expected to come from changes to the Hedge Accounting rules, which are covered in detail later in this article. However, the Classification & Measurement and Impairment sections of IFRS 9 are also important. Classification & Measurement accounting for financial liabilities, including bank debt and issued bonds, is expected to remain largely unchanged under IFRS 9, with the vast majority of financial liabilities continuing to be accounted for on an amortised costs basis. On the other side of the balance sheet, many corporates financial assets have relatively straightforward terms for example, trade receivables and short dated cash-like investments, the accounting for which should also be largely unaffected by IFRS 9. Potential areas of impact that companies should consider include the following: Receivable purchase / factoring arrangements companies that monetise portions of their receivables book may be required to fair value receivables that are not expected to be held to the ultimate collection date due to the new business model test of IFRS 9. Non-cash financial investments money market deposits and certain repo investments that companies may use as part of their liquidity portfolios should be reviewed to determine whether they can continue to be accounted for on an amortised costs basis. Liability management transactions IFRS 9 changes the application of exchange accounting which may result in the immediate recognition of a gain or loss in Profit and Loss ( P&L ) on liability management transactions, and may require a retrospective adjustment for historic transactions completed prior to the adoption date. Impairment IFRS 9 introduces a more complex, expected loss model for impairment, requiring an impairment amount to be calculated for all financial assets and recognised immediately in P&L. For trade receivables that do not include a significant financial component, IFRS 9 includes a number of operational simplifications relative to the general impairment model, and allows for the use of a provision matrix. This is likely to be similar to the existing provisioning approach used by many corporates under IAS 39. However, companies will need to consider how to incorporate forward-looking information into their calculation of potential loss rates. 4

5 3. What changes have been made to the existing Hedge Accounting rules, and how might they impact typical companies? The existing Hedge Accounting provisions of IAS 39 have been widely criticised over the years by both preparers and users of financial statements. The approach is generally viewed as heavily rules-based, to the extent that hedge accounting can be difficult to achieve for commonly used risk management strategies. As a result, many companies have either chosen to change their risk management practices since the advent of IFRS, or to suffer volatility in their P&L as a result of continuing with economic hedging strategies that do not meet the strict hedge accounting criteria of IAS 39. The IASB recognised these issues in their explanatory notes which accompany IFRS 9: The hedge accounting requirements in IAS 39 were complex and rule-based. They involved trying to fit transactions that were originated for risk management purposes into an accounting framework that was largely divorced from the purpose of the transactions. Some users of financial statements regarded hedge accounting as being incomprehensible and often removed its effects from their various analyses. Users frequently argued that they had to request additional information (often on a non-gaap basis) to be able to perform their analyses because the way in which the hedging activities were accounted for and the disclosures that were provided were often considered not to portray risk management in a useful way. (IFRS 9 Basis of Conclusions, paragraphs BCE ) IFRS 9 seeks to resolve these issues by introducing a simpler, principles-based hedge accounting model, designed to enable companies to achieve an accounting outcome that reflects the economics of their risk management activities. While a substantial portion of the mechanics of hedge accounting remains largely unchanged under IFRS 9, the criteria which need to be met in order to apply it are changing significantly. Hedge accounting should not only be easier to achieve, but should also be available for a wider range of risk management strategies and activities. A summary of the changes and similarities between the IFRS 9 and IAS 39 models is presented in the table below. Overview of the Hedge Accounting changes of IFRS 9 Benefits No change Potential drawbacks The 80% - 125% hedge effectiveness corridor is eliminated Risk components of non-financial items can be hedged, e.g. commodity risks The scope for applying hedge accounting to inflation swaps is expanded Hedges of aggregated positions including derivatives are permitted solving a number of known problem areas P&L volatility from costs of hedging, e.g. time value of options and crosscurrency basis spreads, should be reduced Hedge effectiveness assessments are prospective only and may be qualitative for less complex strategies Hedge accounting remains a choice Hedge accounting models remain unchanged - Cash flow hedge - Fair value hedge - Net investment hedge Limited changes to the range of eligible hedging instruments Hedge documentation still required at inception Hedge ineffectiveness must still be measured and recognised in the P&L IFRS 9 removes the ability to assess effectiveness of hedges of FX spot risk using undiscounted spot valuations approach frequently used by companies hedging FX transaction risks Hypothetical derivatives can no longer include risks which are not present in the hedged item The concept of re-balancing hedge relationships is required Voluntary termination of hedge accounting is prohibited if the risk management objective remains unchanged A number of known problem areas will remain, e.g. hedging FX risk of foreign earnings, hedging equity instruments Source: IFRS 9, Lloyds Bank analysis, November back to Executive summary

6 On the whole, these changes are expected to be of particular benefit to corporates: Many more commonly used risk management strategies should now be eligible for hedge accounting The model should allow for greater flexibility of hedging strategies while still being able to achieve hedge accounting Income statement volatility arising on certain existing hedging strategies should be reduced Existing hedges which are eligible and have been designated for hedge accounting under IAS 39 should remain viable under IFRS 9 4. Hedge accounting should be easier to apply for hedges of commodity risks Under the existing rules of IAS 39, hedge accounting can be difficult to achieve in relation to commodity exposures. This is largely due to the fact that IAS 39 does not permit hedging of specific risk components of non-financial items (with the exception of FX risk). For example, a company with a known diesel purchase requirement over the next two to three years may wish to hedge its exposure using a diesel swap. Even though the swap is designed to be a valid economic hedge of the wholesale diesel price risk, the company would not be able to define the hedged risk specifically as such. Instead, the swap would have to be designated as a hedge of the all-in purchase price as illustrated below. Due to this restriction, the hedged item is sensitive not only to changes in the wholesale diesel price, but also to changes in other components of the purchase price e.g. fuel duty, supplier margin, etc. As a result, it may not be possible to apply hedge accounting, either because hedge effectiveness cannot be reliably measured due to the un-hedgeable risks included within the hedged item, or because the company cannot show that it expects hedge effectiveness to fall within the required 80% - 125% limits of IAS 39. This issue has often resulted in companies making accounting-driven decisions not to hedge commodity exposures due to the risk of incurring P&L volatility. The change of IFRS 9 to allow specific risk components of non-financial items to be designated for hedge accounting should largely alleviate this problem; it will allow hedge accounting to be applied to many more hedges of commodity exposures and could significantly reduce P&L volatility on existing hedge relationships. In order to be eligible for separate designation, the risk component must be separately identifiable and reliably measurable. This is the case if the risk component is either: Contractually specified in the underlying purchase agreement e.g. a fuel purchase agreement may include a pricing formula which uses a specific wholesale fuel price reference; or Implicit in the pricing structure of the exposure e.g. for fuel purchases made without a supply agreement (e.g. petrol pump purchases), the wholesale fuel price may be an implicit component of the total purchase price. Where the risk of income statement volatility was previously considered a limiting factor to hedging commodity risks, companies should review their material commodity exposures and determine how the new hedge accounting rules may benefit them. Hedging wholesale diesel price risk in forecast purchases Forecast purchases Hedging instrument Hedged risk Hedge ineffectiveness Not hedgeable Margin Fuel duty IAS 39 IFRS 9 IAS 39 IAS 39: hedge ineffectiveness often significant enough to preclude hedge accounting IFRS 9: ability to designate risk component should largely resolve the issue Hedgeable Wholesale diesel price Diesel swap Total purchase price Economic hedge Total price variability Risk component Non-hedged variability Source: Lloyds Bank analysis, November

7 5. The ability to hedge aggregated exposures will provide flexibility and enable hedge accounting for commonly used risk management strategies One of the main criticisms of the Hedge Accounting rules of IAS 39 has been their inflexibility compared to common risk management practices. The current rules do not readily allow for changes to be made to existing hedges without terminating the hedge relationship, for example, or for additional hedges to be added to an already hedged position. IFRS 9 seeks to address this misalignment between the Hedge Accounting rules and risk management practices by permitting aggregated exposures, a combination of an underlying position which is eligible for hedge accounting and a derivative, to be designated as hedged items for accounting purposes. This change should allow for much greater flexibility of hedging strategies, such as allowing risk management positions to be amended, while maintaining the ability to achieve hedge accounting. The aggregated exposure changes will be relevant for a number of hedging strategies. However, one area that is likely to be of particular interest to larger corporates is pre-hedging interest rate risk in foreign currency debt issuances. For example, a GBP functional currency company may be able to achieve a lower cost of funding by issuing debt denominated in EUR and swapping it back to GBP via a crosscurrency swap. Under IAS 39, the company would not be able to apply hedge accounting to a pre-hedge of its GBP interest rate risk exposure arising from the synthetic GBP debt issuance. This is because the interest rate risk arises from a combination of EUR debt plus a derivative, i.e. the cross-currency swap. As the ability to hedge aggregated exposures extends to forecast transactions, such a strategy could be eligible for hedge accounting under IFRS 9. The new rules state that an eligible hedged item includes a forecast transaction of an aggregated exposure (i.e. uncommitted but anticipated future transaction that would give rise to an exposure and a derivative) if that aggregated exposure is highly probable and, once it has occurred is eligible as a hedged item. (IFRS 9 paragraph 6.3.4) This change should mean that issuers are able to apply hedge accounting to pre-hedging strategies without necessarily knowing the currency in which they will issue debt, thus allowing them to take advantage of the most cost-effective market at the time of issuance. Other common risk management strategies to which the changes will apply include separately hedging commodity and foreign exchange risks, such as those arising in forecast fuel purchases that are priced in US Dollars. It should also be noted that while the ability to hedge aggregated exposure is expected to be beneficial and of practical use to many companies, the likely degree of complexity in applying the new rules should not be overlooked. Aggregated exposures eligible as hedged items Hedge relationship 1 Aggregated exposure Non-derivative exposure (e.g. fixed rate foreign currency debt) Hedge 1 (e.g. cross-currency swap to floating functional currency) Hedge 2 e.g. 1 year later, interest rate swap to fix a portion of the swapped debt in functional currency Hedge relationship 2 Source: Lloyds Bank analysis, November back to Executive summary

8 6. The concept of costs of hedging is introduced by IFRS 9, which could reduce accounting volatility on a number of common hedging instruments IAS 39 does not permit portions of derivatives to be designated for hedge accounting; derivatives generally have to be designated for hedge accounting in their entirety. The limited exceptions to this rule are that IAS 39 permits the time value component of an option, and the forward points component of a forward contract to be excluded from hedge designations, designating only the intrinsic value or spot component for hedge accounting respectively. IFRS 9 retains these existing exceptions and adds a third the ability to exclude the cross-currency basis spread component of a financial instrument from the hedge designation. While this change alone would have been of limited practical impact, IFRS 9 allows these components to be treated as costs of hedging (IFRS 9 Basis of Conclusions paragraph BC6.287). Instead of having to recognise changes in the value of these components directly in the income statement, as is the case under IAS 39, companies will be able to defer them in a separate component of Other Comprehensive Income (OCI), and release their initial value to P&L on a systematic and rational basis (IFRS 9 paragraph ). This systematic release to P&L is required for option time value and is a choice for forward points and cross-currency basis spreads. The timing of recognition of costs of hedging in P&L will depend on the nature of the underlying hedged item. For example: A purchased interest rate cap hedging interest expense on floating rate debt over the next three years would be considered as time period related, such that the premium or time value component of the cap should be recognised in P&L as an expense over the three years which are hedged. A purchased FX option used to hedge a forecast foreign currency cost is likely to be considered as transaction related with the time value component of the option being recognised in P&L in the future when the underlying transaction impacts P&L. In either case, P&L volatility should be reduced compared to the existing treatment of IAS 39. The inclusion of cross-currency basis spreads as a cost of hedging is expected to have both positive and negative impacts on common strategies for swapping foreign currency debt, as outlined in the table below. For both cash flow and fair value hedges, companies should be able to use the cost of hedging provisions from IFRS 9 to minimise P&L volatility. Hedge type IAS 39 IFRS 9 Swapping into fixed functional currency Cash flow hedge Generally little or no P&L volatility Hedged item modelled via hypothetical derivative Changes in basis spreads generally impact hypothetical derivative and actual swap equally, resulting in little to no hedge ineffectiveness IFRS 9 is explicit in that the cross-currency basis spread cannot be imputed into the hypothetical derivative (IFRS 9 paragraph B6.5.5) To minimise P&L volatility (i.e. to maintain the IAS 39 position), companies could consider: - Excluding the basis spread component from the hedge designation - Amortising it to P&L as a cost of hedging Swapping into floating functional currency Fair value hedge Generally gives rise to a degree of P&L volatility As the hedged item is not modelled via the hypothetical derivative approach, basis spread movements can result in P&L volatility IFRS 9 offers an improvement over IAS 39 for fair value hedges involving cross-currency swaps P&L volatility may be reduced vs. IAS 39 by excluding the basis spread component from the hedge designation and amortising it to P&L over the term of the hedge Source: Lloyds Bank analysis, November

9 7. Hedge accounting for transactional FX exposures may become more complex under IFRS 9 Many companies hedge foreign currency risks associated with future cash flows, for example cash flows arising from forecast foreign currency sales or purchases in future periods ( FX cash flows ). Under the rules of IAS 39, companies hedging such future cash flows are able to choose whether they define the hedged risk as the spot FX rate or the forward FX rate. Often, the timing of such future foreign currency cash flows may be subject to a degree of uncertainty; purchase orders may be delayed, for example. In such situations, companies frequently elect to designate the spot FX rate as the hedged risk rather than the forward FX rate. They calculate the spot value of the hedging instrument and hedged item, ignoring the time value of money i.e. on an undiscounted basis. This approach provides a means of simplifying the hedge effectiveness assessments and measurements required by IAS 39. It allows companies to disregard the impact of changes in timing of the hedged cash flows on hedge effectiveness within a reasonably short period, as changes in the spot FX value of the hedging instrument should offset changes in the spot FX value of the hedged future cash flows, irrespective of any reasonable difference between their settlement dates. In one of the few potentially negative changes in the new hedge accounting model of IFRS 9, companies will now be required to take the time value of money into account when measuring hedge effectiveness. This means that continuing the current practice of designating foreign currency exposures for hedge accounting on an undiscounted spot FX basis is not likely to be possible. This change is likely to have operational impacts for companies with significant transactional FX hedging programmes to the extent those hedges are currently designated against the spot FX rate. Conversely, companies that designate the hedged risk as the forward FX rate should consider whether they are required to exclude the cross-currency basis spread element of the forward FX rate when modelling the hedged item for hedge effectiveness purposes. Companies will have to determine an appropriate methodology for measuring hedge effectiveness under the new rules or, at the very least, perform an exercise to determine whether or not the impact of discounting or of cross-currency basis spreads is material. When measuring hedge ineffectiveness, an entity shall consider the time value of money. Consequently, the entity determines the value of the hedged item on a present value basis and therefore the change in the value of the hedged item also includes the effect of the time value of money. (IFRS 9 paragraph B6.5.4) 9 back to Executive summary

10 8. Companies can defer adoption of the hedge accounting section of IFRS 9 until a later date Many companies may be unaware that adoption of the Hedge Accounting section of IFRS 9 is not actually mandatory from 2018 onwards even though application of the remainder of IFRS 9 is required. An exemption from immediate application of the Hedge Accounting section has been provided (IFRS 9 paragraph ) as the IASB has not yet finalised its separate project on macro-hedging a project which is of much more relevance to banks than typical corporates. Under the exemption, the new hedge accounting provisions of IFRS 9 are only expected to become mandatory once the macro hedging project is completed, which could be several years away. It should therefore be possible for companies to defer the application of the new hedge accounting rules for each reporting date between 2018 and the completion of the macro-hedging project. Why might companies want to defer adoption of the new hedge accounting rules? While many of the changes introduced by the new hedge accounting model can be viewed as positive and should address the weaknesses of the IAS 39 model, below are a number of reasons why some companies may not yet want to adopt the new rules. Resources IFRS 9 is not the only significant accounting change to be implemented in the near-term brings mandatory adoption of IFRS 15, dealing with revenue recognition, and in 2019, we have mandatory adoption of IFRS 16, covering lease accounting. This may give rise to significant implementation projects, with resource pressures placed on the Finance and Treasury teams of many companies. Range of risk management strategies companies with simpler hedging requirements, such as those which raise funding and hedge interest rate risk in a single currency only, may not perceive any material benefits in applying the new hedge accounting rules. However, a decision to defer could mean that a company misses out on the opportunities to apply hedge accounting to a broader range of risk management strategies. They may also miss out on potentially reducing income statement volatility on existing hedging strategies, as well as some of the administrative burdens associated with the effectiveness testing requirements of IAS 39. Consideration should also be given to whether a company s peer group is likely to adopt IFRS 9 in full, and to how any decision to defer the new hedge accounting rules is communicated to stakeholders. 9. Transition to the new hedge accounting rules is generally prospective, but restatement of the prior year s figures may be required for certain hedges Entities that adopt the new Hedge Accounting rules of IFRS 9 will need to apply them prospectively from the date of initial application for example, 1 January 2018 for calendar year-end companies meaning that the comparative year s balance sheet and income statement do not need to be restated for changes due to the new hedge accounting rules (subject to a number of exceptions explained below). Hedge relationships that exist on the date of initial application, i.e. transactions to which companies have applied hedge accounting under the existing rules of IAS 39, and which also meet the new Hedge Accounting criteria of IFRS 9, will be treated as continuing hedge relationships. This approach to transition is important as it ensures that hedge effectiveness, and hence P&L volatility, should not be adversely impacted by having to redesignate existing hedge relationships. There are, however, a number of exceptions for hedge relationships to which the new costs of hedging provisions of IFRS 9 are applied. These include companies which have elected to separate: the time value component of options; the forward point component of FX (or other) forwards; or which want to take advantage of the new ability to treat cross-currency basis spreads as a cost of hedging. In the above cases, retrospective application of the new rules may apply i.e. the comparative year s balance sheet and results may have to be restated for such hedge relationships where the impact is considered to be material. Options if a company previously designated only the intrinsic value component of an option for hedge accounting, retrospective application of the new rules is required in relation to the treatment of the option s time value. This could impact a number of balance sheet and income statement line items. Restatement is required for option based hedge relationships which were in place on or after the beginning of the earliest comparative period, e.g. 1 January 2017 for calendar year-end companies. Forward contracts and cross-currency swaps a similar approach can be adopted for the forward point component of forward contracts where only the spot component was designated for hedge accounting, and also for cross-currency basis spreads where companies elect to treat this component as a cost of hedging under IFRS 9. However, retrospective application of the rules in these instances, and hence restatement of the comparative period s figures is a choice rather than a mandatory requirement. 10

11 Companies which are likely to be impacted should review the transition rules to determine what elections they may want to make in respect of the new costs of hedging provisions, and what data they may be required to collect. 10. What actions can companies consider ahead of adoption of the new hedge accounting rules? For those companies intending to adopt the new Hedge Accounting rules of IFRS 9, action is necessary. At a minimum, the impact of the new requirements on existing hedge relationships should be considered, including by companies which do not immediately intend to take advantage of the new hedge accounting strategies allowed by IFRS 9. Hedge documentation for all existing hedge relationships, new hedge documentation will be required on the date of initial application of IFRS 9. Areas of change which companies should consider include: - Defining the risk management objective IFRS 9 places greater importance on the risk management objective of a hedge relationship, as it will determine whether or not a company can terminate hedge accounting in the future. Companies should consider how best to define the risk management objective of each hedge in order to allow for discontinuation in the future should circumstances change. - Hedge effectiveness requirements IFRS 9 changes the hedge effectiveness criteria, requiring not only an economic relationship (IFRS 9 paragraph 6.4.1) to exist between the hedging instrument, but also consideration of credit risk, and for relationships to be designated in a way that produces an unbiased result. Each of these requirements will need to be addressed in the new IFRS 9 hedge documentation. Sources of hedge ineffectiveness also need to be specifically identified. - Method of assessments of hedge effectiveness companies should consider whether a qualitative approach to assessing hedge effectiveness can be used for each category of hedge relationship in order to reduce administrative costs. Again, the new methodology should be included in the IFRS hedge documentation. For hedge relationships impacted by the new costs of hedging concept, i.e. involving options, forwards and cross-currency basis swaps, companies should consider whether they want to separately account for the cost of hedging component in order to minimise income statement volatility going forward. If so, they should establish what information is required to enable this, and whether existing systems can provide it. Existing hedges could be reviewed to determine whether IFRS 9 allows for a more favourable hedge designation. For instance, re-designating commodity hedges against a specific commodity risk component should increase hedge effectiveness and reduce income statement volatility. Companies should also establish what information is required to support hedge accounting for non-contractually specified risk components. Companies with existing hedges which are currently ineligible for hedge accounting under IAS 39 should consider whether the new rules may allow them to apply hedge accounting going forward. 11 back to Executive summary

12 IAS 39 treatment Categorisation relative to IFRS 9 changes IFRS 9 treatment and key actions Examples Designated as hedges Trades for which no significant change to the hedge designation is required Continuing hedge relationship Prepare IFRS 9 hedge documentation Determine new effectiveness assessment methodology Interest rate swaps designated as either fair value or cash flow hedges Trades impacted by: (i) costs of hedging rules - FX forwards, cross-currency swaps, options (ii)requirement to incorporate discounting when hedging FX spot risk Continuing hedge relationship Prepare IFRS 9 hedge documentation Decide on optimal treatment of costs of hedging Determine new effectiveness assessment methodology Are systems able to separate costs of hedging? Determine any impact on comparative year figures and what data is required Cross-currency swaps elect to treat basis spread as a cost of hedging to minimise P&L volatility and determine how to implement this Options collect information required for restatement of time value FX forwards decide if a spot FX (discounted) or forward FX rate designation is more appropriate Not designated Trades for which IFRS 9 may allow for a more effective hedge designation Trades for which IFRS 9 may enable hedge accounting to be applied New hedge relationship Prepare IFRS 9 hedge documentation Determine new effectiveness assessment methodology For non-contractual risk component hedging, consider what supporting information is needed Where basis risk exists, consider optimal hedge ratio Commodity hedges re-designate against risk component to minimise P&L volatility Inflation/commodity hedges where hedge accounting was not previously possible Trades where hedge accounting is not possible/required Not designated Natural offsets, e.g. offsetting interest rate swaps, natural FX hedges, where hedge accounting adds no benefit Source: Lloyds Bank analysis, November

13 Conclusions All companies reporting under IFRS will be impacted by the changes of IFRS 9. Many companies may be well advanced in their preparations for its implementation, however, others may still have further analysis to perform and decisions to make ahead of adoption. It is expected that the most significant area of impact for many corporate users of derivatives will arise from the Hedge Accounting section of IFRS 9 where the majority of the changes are beneficial, and have been designed to address known problem areas in the existing model. However, a number of areas of complexity exist. Companies impacted by the changes will actively have to make decisions and prepare for implementation in advance of their initial date of adoption which could be as early as 1 January While Lloyds Bank does not provide accounting advice, we would be delighted to work with our clients and their advisors or auditors to determine how the accounting changes of IFRS 9 may impact their existing and future hedging strategies. List of abbreviations used IFRS 9 IFRS 9 Financial Instruments IAS 39 IAS 39 Financial Instruments: Recognition and Measurement IFRS International Financial Reporting Standards IASB International Accounting Standards Board P&L Profit and Loss, i.e. the Income Statement OCI Other Comprehensive Income FX foreign exchange / foreign currency Repo a sale and repurchase agreement CONTRIBUTORS Stanislav Varkalov Director, Capital and Risk Advisory, Lloyds Bank Commercial Banking Colin McKee Director, Capital and Risk Advisory, Lloyds Bank Commercial Banking 13

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