IMPACT OF IFRS Johann Kruger CA (SA), CFA and Gerry Daly IFRS and - - PowerPoint PPT Presentation

WHOLESALE BANKING & MARKETS Johann Kruger CA (SA), CFA and Gerry Daly IFRS and Financial Risk Management Consultants

IMPACT OF IFRS

IFRS accounting for financial instruments:

• Loan
• FX forward
• Interest rate swap
• Cash
• Liquid resources: investment in bonds

AGENDA

Determine which of the following scenarios is a cash flow, fair value or net investment hedge and explain why… Corporate A issues a fixed rate bond and then uses an interest rate swap to convert that to floating rate debt. This is a cash flow hedge True False Depends Corporate B (£ functional ccy) issues a fixed rate $ bond and uses an interest rate swap to convert that to fixed rate £ debt. This is a fair value hedge True False Depends Bank A receives floating deposits from customers and protects against rises in interest rates using interest rate caps. This is a cash flow hedge True False Depends

Questions:

Determine which of the following scenarios is a cash flow, fair value or net investment hedge and explain why… Corporate C hedges its floating rate facility by using interest rate swaps to convert floating rate debt to fixed rate debt. This is a cash flow hedge True False Depends Corporate D sells an interest rate Floor to generate income. It has floating rate debt which it wishes to hedge. This is a cash flow hedge True False Depends Corporate E issues inflation linked debt and uses an interest rate swap to convert to fixed rate debt. This is a cash flow hedge True False Depends

Questions:

CASE STUDY: MEET ENGINE LTD

Winning commercial contracts and managing financial risks

High value-add UK engineering company

Engine Ltd

• UK held company
• Pays dividends in £
• £ and US$ denominated costs
• £, US$ and EUR denominated sales
• 30% gross margin
• 15% net profit margin
• Holds only minimally necessary cash

6

Engine wins a large contract

• In May 2011 Engine ltd signed a contract

for sale of engine components to big UK name (a defense contractor)

• Contract involves sourcing a significant

amount of high-tech components from the US

• Competitors are in US, Brazil and

Singapore

• Where should Engine Ltd base the

production for the contract?

• Hedge FX on USD purchases?
• How should Engine Ltd fund the project?

FUNDING THE PROJECT, INTEREST RATE RISK

Borrowings, cash, short term investments and hedging the interest rates

Funding the project

• Engine arranges a bank borrowing of £10m, with a bullet repayment in 4 years
• Expects interest rates to rise soon – enters into an interest rate swap (‘IRS’)
• Draws on the loan but does not need the cash for 6 months – invests in high

quality corporate bonds

• Later sells the bonds and spends cash on incremental CAPEX for the project

Financial Instruments Measurement Categories – IAS 39

Fair value through PL Available for sale Loans and receivables Held to maturity FINANCIAL ASSETS Fair value through PL Other liabilities FINANCIAL LIABILITIES PL Not revalued Not revalued Equity Fair value revaluation:

• How would the borrowing be classified?
• And the cash?

How would a loan (or a deposit) be recorded at inception?

£1,000 Year 4 £60 And Interest Interest (coupon) £60 £60 £60

• £1,000

Year 1 Year 2 Year 3 Receive now Loan @ inception Discounting at 6% Total future cash flows:£1,240

Time

Principal At fair value…

How would the investment in bonds be classified?

Fair value through PL Available for sale Loans and receivables Held to maturity FINANCIAL ASSETS Fair value through PL Other liabilities FINANCIAL LIABILITIES

Corporate Bond Investment : Change in Fair Value due to Change in Market Interest Rates

Principal Future Interest (coupon) £60 £60 £1,000

• £901

Year 1 Year 2 Year 3 Year 4 £60 Total future cash flows: £1,180 Value now

Time

Already happened @ end of year 1 Was £1,000 Now £901,

FV loss: £99

Discounting at 10%

And Interest

Available for Sale: ongoing

£99

Fair value Revaluation loss

£60

Interest

Profit or loss Equity

Available for Sale: on sale of the investment

£99

Fair value Revaluation loss

Profit or loss Equity

Funding the project – interest rate risk

• Borrowed £10m, bullet 4 years
• Expects interest rates to rise– enters into an interest rate swap

Revenue uncorrelated to interest vs. floating interest on debt Interest rate exposure

Balance sheet Profit & Loss account

• 10m

Floating rate debt

+ Fixed revenue

(uncorrelated with i%)

+ £10m Operating assets

• Floating

interest

Cash Flow & Accounting Volatility

Interest rate hedge – before IFRS (UK GAAP)

Balance sheet

Profit & Loss account

• £10m

Floating debt

• Fixed i% (swap)

+ Fixed revenue

(uncorrelated with i%)

+ £10m Operating assets

• Fixed i%

+ floating i% SWAP (FV) + floating interest (swap)

• floating interest (debt)

= Smoother

cash flows and accounting profits

UK GAAP: swap is off BS, coupon accruals in P&L acct

Assume swap fair value is £1.5m liability Assuming hedge accounting not applied Cash flow position is hedged However P&L for the year will be volatile due to swap fair value movement

Interest rate swap cash flow hedge - IFRS

Balance sheet Profit & Loss account

• £10m

Floating rate debt

+ Fixed revenue (uncorrelated with i%)

+ £10m Housing assets

£1.5m fair value

• Pay Fixed

+ floating SWAP Dr £1.5m change in FV

• Pay Fixed

+ floating SWAP

=

Smoother Cash flows

• Floating

interest

Acct Volatility – Float interest and swap FV

CFH accounting allows to “park” fair value of the swap in equity And then release a portion to P&L to reflect the hedged rate

Cash flow hedge accounting

Profit & Loss account Balance sheet

• £10m

Floating rate debt

+ Fixed revenue (uncorrelated with i%)

+ £10m Operating assets

£1.5m fair value

• Pay Fixed

+ floating SWAP

• Fixed

interest

Dr £1.5m change in FV

• Pay Fixed

+ floating SWAP

Assets Liabilities Equity Release to P&L

• Floating

interest

• Fixed interest

Charge (per the swap)

Hedge effectiveness test for IRS – an example

Key Phases Of A Swap Underwrite And Syndication

Transparent: “Market Hedge” & relationship banks for syndication agreed Confidential: Market hedge transacted based on agreed margin Relationship: Banks supply credit / intermediation level Competitive: Smart Hedge reviews pricing levels & selects counterparties Counterparties informed and intermediation effected AT EXECUTION SYNDICATION PHASE PRE EXECUTION 1 2 3 4 5

1. Defining the hedge structure 2. Testing it against IAS 39 criteria 3. Exploring the impact of not applying hedge accounting 4. Design desired solution 5. Producing hedge documentation 6. Prospective hedge effectiveness testing 7. Retrospective hedge effectiveness testing 8. Accounting journal entries

The hedging/hedge accounting process

FORMAL DESIGNATION Reliable measurement

• f

effectiveness

The hedge is expected to be and is highly effective

formal hedge documentation + risk management policy

Requires hedge effectiveness between 80‐125%: 125% 100% 80% No hedge accounting (P&L) Ineffectiveness to P&L CF: No Ineffectiveness FV: Ineffectiveness to P&L No hedge accounting (P&L) Hedge Effectiveness IAS 39.96 Cash flow hedge lesser of the cumulative change

IAS 39 requires hedge effectiveness between 80-125%:

Regression parameters R-squared >.8 Slope 0.8 to 1.25

Hedge Type How is P&L fair value volatility neutralised Timing of income statement recognition of deferred derivative gains/losses

Cash Flow Hedge Remove volatility from Income statement – post it to equity When underlying cash flow occurs Net Invest. Hedge Remove volatility from Income statement – post it to equity Upon disposal of underlying net investment Fair Value Hedge Show fair value of underlying item in balance sheet and post changes to income statement to offset those of the derivative N/A Note: CFH and NIH still impact ratios involving equity and the reserves available for dividend payments

Objective is to remove volatility from the income statement IAS 39 – Overview of the CFH and other models

HEDGING THE FX RISKS OF THE PROJECT

Protecting the downside FX value of future cash flows

Hedging FX

Engine decides to use FX options to hedge FX risk of USD purchases

• Matching maturity and amount and currency
• Designated as cash flow hedges
• Intrinsic value basis

Delivery of components to Energy Ltd is delayed, the USD cash flows occur 2 months late

• Energy would need to amend the hypothtical derivatives, keep hedge relationship,

little impact on effectiveness Options rolled into forwards Forwards settled net

Hedge designation: FX options Future US$ cash flow

• 10 US$

Option to buy +10 US$ buy £ Time Value Intrinsic Value May 2011 May 2011 Jan 2012 Jan 2012

Hedge Effectiveness Report for an FX Option

FX Option – Hedge Accounting Journals

Conclusion

So what have we covered today? Accounting for financial instruments:

• Loans / borrowings
• Cash
• Investments in a corporate bonds
• FX options
• Interest rate swaps
• Main hedge accounting models
• IFRS hedge documentation
• Hedge effectiveness examples
• Questions?