Insights & Other News

IFRS 18 is the newest IFRS Accounting Standard.  IFRS 18 sets out the overall requirements for presentation and disclosures in the financial statements. It will affect all companies and all investors.

IFRS 18 responds to investors’ demand for better information about companies’ financial performance.  It will improve how information is communicated in financial statements and give investors a better basis for analysing and comparing companies’ performance. 

IFRS 18 will introduce three key sets of new requirements: 

i)                The first set of requirements will create structure in the Statement of Profit or Loss by requiring companies to present two new defined subtotals.  This will provide a consistent and comprehensive starting point for investors’ analysis and help investors compare financial performance between companies.  

ii)              Companies will be required to disclose information about some non-GAAP measures in a single note to the financial statements.  These are referred to as management-defined performance measures in IFRS 18.  The disclosure of these measures will enable companies to complement information provided using the new structure for the Statement of Profit or Loss with company-specific information about performance.

iii)             The third set of requirements enhances guidance on grouping of information (i.e. aggregation and disaggregation) in the financial statements.  This will help ensure investors receive material information, making financial statements more useful.  

Together these three sets of requirements will provide better information for better decisions by increasing comparability and transparency of information in the financial statements. 

The effective date for IFRS 18 will be 1 January 2027.  There is an option to apply IFRS 18 earlier.  

For more information on the new IFRS 18 – see the IASB website https://www.ifrs.org/news-and-events/news/2024/04/new-ifrs-accounting-standard-will-aid-investor-analysis-of-companies-financial-performance/

For assistance in implementing the new IFRS 18 – contact us

Entities are exposed to diverse risks.  Sometimes entities may choose to manage risks by using financial instruments such as derivatives.  

Despite the intention to reduce risk by using financial instruments for hedging purposes, when it comes to the accounting, such activities can actually create accounting volatility. This is because the underlying exposure is not necessarily recognised and measured on the same basis as the financial instrument used for hedging purposes.  

For example:  A foreign currency derivative may be used to hedge a forecast transaction.  The derivative will be recognised and measured at fair value through profit or loss from inception.  However, the forecast transaction will remain unrecognised until it has occurred and is eligible for recognition.  Although over the long term, the financial statements will present the cumulative effects of hedging, accounting mismatches can arise in the intervening reporting periods.

Hedge accounting helps to address this difference in measurement and recognition.  The objective of hedge accounting is to represent in the financial statements the effect of an entity’s risk management activities.

Through the application of hedge accounting, an entity can match, in profit or loss (or other comprehensive income), gains and losses on the financial instruments used to hedge (‘hedging instruments’) with losses and gains on the exposures hedged (‘hedged items’) to the extent the hedge is effective.

We have extensive experience in supporting our clients apply hedge accounting.  Some common pitfalls we have identified over time include:

1)     Pre-requisites for the application of hedge accounting
Hedge accounting is voluntary on a hedge by hedge basis and can only be applied prospectively from the point that a hedging instrument and hedged item are formally designated in a hedging relationship and the other qualifying criteria are met, including an assessment of the expected effectiveness of the hedge (IFRS 9: 6.4.1).

It is imperative to correctly identify and designate a hedge relationship for hedge accounting purposes by setting up comprehensive hedge accounting documentation.  In so doing, it is also important to ensure that a hedge effectiveness testing approach is selected that is most appropriate for the nature of the proposed hedge designation and expected sources of hedge ineffectiveness.

2)     Dealing with sources of hedge ineffectiveness
Hedge ineffectiveness can arise from many sources.  The presence of known sources of hedge ineffectiveness can affect the method used to assess hedge effectiveness and can also affect the selection of an appropriate hedge ratio to comply with the hedge effectiveness requirements.  Some of the common sources of ineffectiveness include:

o   Timing mismatches
The term of the hedging instrument does not match the term of the underlying exposure being hedged.

o   ‘Late’ designation of a derivative in a cash flow hedge
If a non-optional derivative (e.g. swap contract), has a fair value other than zero at inception of the hedge, future changes in its fair value are affected by that starting value. 

o   Credit risk
Credit risk inherent in derivative contracts to hedge a specified exposure will give risk to hedge ineffectiveness.

o   Basis risk
Basis differences result from using a hedging instrument that is based on a specific risk that is similar, but not identical to the risk being hedged in the hedged item.  For example – basis differences in 3 month JIBAR vs. 1 month JIBAR.

To ensure the successful application of hedge accounting throughout the entire term of the hedge relationship, it is imperative to identify, assess and address the expected sources of ineffectiveness up front, as part of the hedge designation process.

Correctly applying cash flow hedge accounting in the financial statements

In applying cash flow hedge accounting, it is imperative to carefully consider how the cash flow hedge reserve will be treated over the term of the hedge relationship (specifically quantifying the deferral to and release from the reserve).  This will ensure that the application of hedge accounting produces the best possible results in the financial statements, considering the sources of hedge ineffectiveness (reducing volatility as much as possible).   

We have extensive experience in assisting our clients assess the eligibility and successfully apply hedge accounting - contact us  

A common structure employed to structure BEE deals in South Africa involves an entity assisting a BEE investor finance the acquisition of shares in the entity.  This can be simplistically explained as follows:

·       The BEE investor acquires an equity stake in Entity A.

·       To finance the acquisition of the equity stake, the BEE investor issues preference shares.

·       The preference shares are purchased by Entity A.  In other words, Entity A assists the BEE investor acquire the stake in its equity shares.

·       The preference shares are settled from the dividends paid on the equity shares held by the BEE investor.  

IFRS 2 requires that the fair value of a BEE transaction be calculated using a suitable valuation model. The valuation approach applied for this type of BEE transaction structure is an option pricing approach, as economically the payoff of the rights given to the beneficiaries of the BEE transaction mimics that of a call option, with the value of the outstanding debt at the maturity date of the transaction as the strike price of the option.

A Monte Carlo simulation procedure is used.  A Monte Carlo simulation can be defined as a procedure for randomly sampling changes in market variables in order to value a derivative.  This model is sufficiently sophisticated to cater for the path-dependency inherent in the option payoff.  In this instance, the “market variable” is the entity’s share price (Entity A in the illustration above). The path-dependency of the option results from the relationship between the entity’s share price and the strike price of the option, by virtue of the impact on the strike price of dividends paid by the entity during the term of the BEE transaction, which are in turn impact the share price evolution over time. 

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As the transition away from certain familiar Interbank Offered Rates in foreign jurisdictions reaches finalisation, reforms to South Africa’s reference interest rate are accelerating rapidly. The Johannesburg Interbank Average Rate (JIBAR) will be replaced by the new South African Overnight Index Average (ZARONIA).

One of the key consequences brought about by the transition from existing benchmark rates to alternative reference rates are the impacts on reported financial results and accounting.  From an International Financial Reporting Standards (“IFRS”) accounting point of view, well-documented reliefs were published and have stood up well in assisting with a smooth transition, and for the large part, avoiding accounting disruption and volatility. These reliefs are discussed in this article.

The International Accounting Standards Board (“IASB”) identified two groups of accounting issues related to the reference rate reform that could impact financial reporting:

·       Pre-replacement issues – these are issues affecting the accounting in the period before the terms of the financial instruments are modified.

·       Replacement issues – these are issues that might affect the accounting when an existing interest rate benchmark is either reformed or replaced.

We have provided a summary of the key amendments to the accounting standards arising from the reference rate reform.  

Pre-replacement issues

These amendments only affect entities that apply hedge accounting (under IFRS 9 or IAS 39 ) to hedging relationships directly affected by the reference rate reform.  

These amendments provide temporary relief from applying specific hedge accounting requirements to affected hedging relationships. The reliefs have the effect that the reference rate reform should not generally cause hedge accounting to terminate during this pre-replacement phase. However, any hedge ineffectiveness should continue to be recorded in the income statement.

The amendments additionally introduce further disclosure requirements to be considered by the preparers of financial statements.  

Replacement issues

The amendments here address issues that might affect accounting application during the reform of an interest rate benchmark.

The amendments are pervasive and will affect many entities. Some of the key amendments are briefly summarised below. 

·       Changes in the basis for determining the contractual cash flows as a result of reference rate

The amendments provide specific guidance on how to treat financial assets and financial liabilities where the basis for determining the contractual cash flows change as a result of the reference rate reform.  As a practical expedient, the change in the basis for determining the contractual cash flows is applied prospectively by revising the effective interest rate.

·       Hedge accounting
The amendments introduced by the IASB allow a series of exemptions from the strict hedge accounting rules.  

·       Other standards

Minor amendments were also introduced to other accounting standards as a result of the reference rate reform, including IFRS 16 (the standard dealing with the accounting of leases) and IFRS 4 (the standard dealing with the accounting for insurance contracts).  

It is important to note that the potential accounting impacts arising from the reference rate reform may be extended across various standards (and not just to those standards identified above and to which specific amendments were introduced by the IASB).

The amendments introduce additional disclosure requirements to be considered by the preparers of financial statements.  

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