• Discussed at September 2009 IASB Meeting
• Discussed at Special 6 October 2009 IASB Meeting
• Discussed at Special 16 October 2009 IASB Meeting
• Discussed at December 2009 IASB Meeting
• Discussed at January 2010 IASB Meeting
• Discussed at 2 February 2010 Special Joint IASB-FASB Meeting
• Discussed at February 2010 Joint IASB-FASB Meeting
• Discussed at Special 3 March 2010 IASB Meeting
• Discussed at April 2010 IASB Meeting
• Discussed at May 2010 IASB Meeting
• Discussed at July 2010 IASB Meeting
• Discussed at Special 3 August 2010 IASB Meeting
• Discussed at Special 24 August 2010 IASB Meeting
• Discussed at September 2010 IASB Meeting (jump to notes below)
• October 2010: Overview of tentative decisions on hedge accounting project
• Discussed at Special 5 October 2010 IASB Meeting (jump to notes below)
• Discussed at October 2010 IASB Meeting (jump to notes below)
• Discussed at Special 27 October 2010 IASB Meeting (jump to notes below)
• Discussed at November 2010 IASB Meeting (jump to notes below)
• 9 December 2010: Exposure Draft on Hedge Accounting
• Discussed at December 2010 IASB Meeting (jump to notes below)
• Discussed at March 2011 IASB Meeting (jump to notes below)
• Discussed at April 2011 IASB Meeting (jump to notes below)
• Discussed at Special 27 April 2011 IASB Meeting (jump to notes below)
• Discussed at Special 12 May 2011 IASB Meeting (jump to notes below)
• Discussed at Special 31 May - 2 June 2011 IASB Meeting (jump to notes below)
• Discussed at July 2011 IASB Meeting (jump to notes below)
• Discussed at Special 28 July 2011 IASB Meeting (jump to notes below)
• Discussed at September 2011 IASB Meeting (jump to notes below)
• Discussed at November 2011 IASB Meeting (jump to notes below)
• Discussed at December 2011 IASB Meeting (jump to notes below)
• Discussed at January 2012 IASB Meeting (jump to notes below)

Timetable

• Click for IASB Project Timetable

The Board considered possible approaches to hedge accounting during this session. FASB Board members and staff joined the debate via video link.

The staff presented a wide range of possibilities for the future of hedge accounting ranging from its complete elimination to retaining and amending the current conditions and criteria. The staff recommended replacing fair value hedge accounting by permitting recognition outside profit or loss of gains and losses on financial instruments designated as hedge instruments (an approach similar to cash flow hedge accounting). The staff further proposed some simplification of current cash flow hedge accounting model. A majority of the Board agreed with this basic approach. Several Board members focussed on the need for further simplification of the hedge accounting requirements and development of a single set of hedge accounting rules.

Nonetheless, some Board members were concerned with some detailed issues as well as interaction of the project with the Classification and Measurement phase of the financial instruments project.

One Board member was concerned with the proposed approach as he believed that it would create more questions and issues than it would solve. He was particularly concerned with evaluating the effectiveness of hedge accounting.

Several Board members were concerned by the lack of convergence with FASB. The FASB clarified that it had not yet considered (either publicly or privately) the hedge accounting standards. The FASB and several IASB Board members seemed to be particularly concerned with the application of fair value hedge accounting to financial instruments measured at amortised cost due to the application of business model. For them the intuitive argument would be to prohibit the usage of fair value hedge accounting for such instruments. The staff replied that that interaction must be fully analysed and would be addressed by both Boards at a later stage.

The Board generally agreed that initially general requirements for hedge accounting had to be developed and agreed (in the form of an ED) and, based on the adopted approach and public consultation, application for portfolio hedging should be developed.

The Board agreed that portfolio hedge accounting was a very complicated area that would need to be assessed at a later stage and would require significant time to be completed.

The Board continued with discussion on hedge accounting for net investments in a foreign operation. Most of the Board agreed that this issue should not be addressed at this stage as the issue did not relate as much to hedge accounting as to IAS 21 requirements. Nonetheless, some Board members stressed the need for a single hedge accounting model. The Board agreed that it would address this issue at a later stage, when basic model of hedge accounting was agreed.

One Board member suggested that definition of hedging instrument should be based on cash flow characteristics. The staff will investigate how to fit this suggestion into the model.

Discussion at the Special IASB Meeting 6 October 2009

Application of cash flow hedge accounting mechanics to fair value hedges

The Board considered the application of the Board's September 2009 decision to replace fair value hedge accounting with a mechanism that permitted recognition outside profit or loss of gains and losses on financial instruments designated as hedging instruments – that is, applying the mechanics of cash flow hedge accounting also to fair value hedges. The major implication would be the application of the so-called 'lower-of test' to fair value hedges. The 'lower-of test', currently applied to cash flow hedges only, ensures that only ineffectiveness due to excess cash flows on the hedging instrument (that is, the derivative) is recognised in profit or loss.

The Board members disagreed with the extension of the 'lower-of test' to fair value hedges. The Board was concerned that it was inconsistent with the nature of fair value hedging, could lead to changes in eligibility of portions, could have unintended consequences in the area of deliberately under-hedging, and in effect would lead to a situation that there would be no ineffectiveness in fair value hedges as such. A FASB member clarified that in the FASB approach to hedge accounting (given the recent discussions over the issue) the 'lower of test' would not be applied to fair value hedges.

After a short debate the Board decided by a bare majority (8 votes) to retain the 'lower-of test' for cash flow hedges only. A third of the Board members abstained in this vote.

Discussion at the Special IASB Meeting 16 October 2009

Eligibility of financial instruments managed on a contractual cash flow basis in a fair value hedge

The Board discussed whether in principle any items measured at amortised cost still qualified as hedged items for fair value hedge accounting.

The Board agreed that hedge accounting for fair value hedges for instruments that are managed on a contractual cash flow basis did not contradict this classification condition, and said there are situations where such hedge accounting was appropriate. One Board member noted that financial institutions used fair value hedges to lock in their margin and thus to stabilise the yield. In his opinion that would not contradict the classification condition.

On the other hand, several Board members remained unconvinced, as they feared that hedge accounting for fair value hedges in such situations might lead to structuring opportunities and would represent create a synthetic yield as opposed to contractual yield that was the basis of the classification condition.

Discussion at the December 2009 IASB Meeting

Summary of outreach activities [Educational Session]

The Boards considered the feedback received on the hedge accounting from the recent outreach activities undertaken by both Boards. The overriding consensus from constituents was that the Boards should consider a principle-based approach for hedge accounting that would lead to simplification of the hedge accounting requirements.

Many constituents asked for simplification of the rules relating to designation of hedge accounting items, testing of effectiveness, and eligibility of hedge accounting as well as clearer alignment of risk management practices to the hedge accounting guidance. On the other hand, some of the FASB constituents from the user community preferred eliminating cash flow hedging instead of using its mechanics for current fair value hedging (solution preferred by the IASB and its constituents).

The Boards discussed the high level principles of hedge accounting and its alignment with risk management practices. Some Board members felt that such approach might lead to increase earnings management and thus would not support it. Others would prefer if that approach was complemented by comprehensive disclosures that would show the primary statements without the effects of hedge accounting.

This was an educational session, no decisions were made.

The Boards also provided a brief update from the recent strategic meeting on the updated plan for the financial instruments project. The Boards agreed to deliberate hedge accounting as well as classification and measurement of financial liabilities jointly in January and February 2010. For this purpose the Boards will meet twice a month in January and February 2010. Following deliberation phase, the FASB will expose its comprehensive model for comments. At the same time, the IASB will expose the remaining parts of its model. Both Boards plan to provide a joint description of differences between the models and align questions asked to constituents.

Discussion at the January 2010 Joint IASB-FASB Meeting

Timetable for Hedge Accounting Discussions

The Boards discussed which issues related to hedge accounting should be addressed as part of the Financial Instruments project. The Boards noted that according to the project plan, both Boards pledged to publish a comprehensive ED on Financial Instruments in March 2010. Nonetheless, based on the discussions with the project team, any comprehensive review of hedge accounting would not be finished before end of May 2010 at the earliest.

The Boards therefore discussed possibilities of delaying the hedge accounting part of the project or addressing only a narrow set of issues related to hedge accounting.

Most of the Board members were concerned that the Board promised a comprehensive review of hedge accounting and anything less than a full comprehensive review would be criticised as unsatisfactory by constituents.

Moreover, some Board members believed that this time provided a unique opportunity for review of hedge accounting that might not be repeated for many years.

Consequently, the Boards decided to tackle the hedge accounting in its entirety, but to divide the hedge accounting part of the Financial Instrument project into two phases.

The Boards agreed to include in the FASB comprehensive ED to be published in March (as well as corresponding IASB ED) the parts of the hedge accounting that directly relate to the classification and measurement of financial assets and liabilities (that would most probably include the overall model for the fair value and cash flow hedging, effectiveness consideration as well as bifurcation by risk). On the other hand, issues related to non-financial items as well as portfolio hedging would be addressed in the second phase of the project. The IASB tentatively discussed that the second phase should be completed by June 2011.

The Boards would discuss at the next meeting the precise timetable of deliberations. The staff noted that special sessions would be necessary for completing the proposed timetable.

Discussion at the January 2010 IASB Meeting

The objective of hedge accounting

The Board discussed the objective of hedge accounting. Some Board members expressed their concerns that this issue was being discussed at a separate meeting and not at the joint meeting. In their view, this approach would not lead to perception of joint project. The staff responded that the FASB was not prepared to discuss this issue at the joint meeting earlier this week, and the staff believed that a kind of educational session was required to start the discussion given the ambitious project plan. The FASB would have held a separate educational session. Finally, the objective of hedge accounting would be deliberated jointly at one of the following joint meetings.

The Board decided that this would be an educational session. As a consequence, no decisions were taken.

The Board considered two possible objectives of hedge accounting:

• to provide a link between entity's risk management and its financial reporting, or
• to mitigate the recognition and measurement anomalies between the accounting for hedged items and to manage the timing of the recognition of gains or losses on derivative hedging instruments used to mitigate cash flow risk.

In general, the Board members expressed divergent opinions on this subject. They perceived the first objective as being too broad and thought that it needed to be scaled down, whereas on the other hand, the second objective seemed to be too narrow. Even though the Board members agreed that the objective of hedge accounting should be defined at a high level and should be further limited by additional principles, many members of the Board believed that the first objective was defined too broadly.

Some Board members believed that the first (broad) objective did not capture sufficiently the difference between hedging activities (economic hedging) and hedge accounting. Moreover, they believed that the objective should focus on financial risks, as risk management might address a variety of risks that could not be captured in the financial statements.

Other Board members believed that objective of hedge accounting should tie more closely with risk mitigation. They expressed their view that currently proposed first objective was more appropriate for comprehensive risk disclosures project rather than for hedge accounting.

In further discussion on application/illustration of this objective, the Board tentatively agreed that a possibility to designate risk components should be retained if the risk component was separately identifiable and measurable for the purposes of determining the hedge ineffectiveness. The Board nonetheless asked the staff to consider how operational would these criteria be.

The majority of the Board also expressed a preliminary view that consistent principles should be applied for eligibility of risk components for financial and non-financial items.

The Board will continue its discussion at the following Board meeting.

Discussion at the 2 February 2010 Special IASB-FASB Joint Meeting

The Boards considered the objective of hedge accounting. The Board members expressed a variety of preferences. Some Board members supported the objective proposed by the staff as a compromise between the two views discussed at the January meeting; others were concerned that the objective was very ambiguous as it represented the combination of the two. Consequently, the Boards agreed not to develop an objective of the hedge accounting for the time being and to re-discuss the question when the initial decisions on more detailed level were made.

The Boards continued their discussion with the designation of risk components ('bifurcation by risk'). The IASB in principle agreed that bifurcation-by-risk should be permitted on the basis of proper identification and measurement of risk components. Some IASB members were concerned whether a principle based on identification and measurement of risk components could be operational, but they supported it from a conceptual point of view as a basis for exploring the approach.

The FASB members engaged in a long discussion that reflected the FASB members' opinions on the FASB ED: Accounting for Hedging Activities. Some FASB members argued against permitting bifurcation-by-risk. They believed that their model of financial instruments accounting based on fair value would accommodate some of the hedge accounting issues. Other FASB members disagreed. Finally both Boards agreed in principle to explore the bifurcation-by-risk accounting considering both models of accounting for financial instruments (IFRS 9 and the FASB proposals respectively).

The Boards also initially agreed that they would first consider the financial items related bifurcation-by-risk before proceeding to explore the application to non-financial items. From the discussion it seemed that the issue of basis risk was more important for the IASB than for the FASB.

Discussion at the February 2010 Joint IASB-FASB Meeting

Hedged items: Approach for determining what risk components are eligible for designation

The Boards discussed, primarily in the IASB context, possible conditions for bifurcation-by-risk. The discussion was a follow-up to the 2 February 2010 Discussion in which some IASB members expressed their concerns that the broad approach to risk components designation might lead to what would be a free choice in componentisation of item and could lead to situation that designation of a component would automatically result in accounting relationship being 100% effective.

The staff paper provided an analysis of the current requirements of IAS 39 with the emphasis on the criteria for eligibility of risk components to be designated as hedged items being separately identifiable and reliably measurable.

Based on application of the IAS 39 criteria to a set of risk components may or may not be explicitly specified in the contract, the staff concluded that IAS 39 criteria do not lead to a free choice of how to split an item into components and do not automatically lead to 100% effectiveness of hedging relationship. Nonetheless, the staff concluded that current requirements of IAS 39 are problematic as they are rule-based and internally inconsistent.

Following this discussion the Board agreed to explore a new criterion for the purpose of determining eligible hedged components. The staff will present such analysis at a future Board meeting.

In the following discussion about possible criteria, one Board member expressed his concerns whether, in case of non-contractually specified risk components, would the risk component be separately identifiable within the entire hedged items. He argued that application of IAS 39 in some of these cases do not result from the fact that the risk component was separately identifiable, but rather from the fact that IAS 39 allows it to be a hedged item. He expressed his concerns about interdependence of risk components in many of the cases.

Another IASB member reinforced this view, by expressing his doubt whether this proposed approach would be operational. He also expressed his view that hedge accounting as such is an exception to the classification and measurement principles of financial instruments. Therefore, in his view, it would be difficult to formulate a broad principle underpinning hedge accounting, and some rules would be necessary.

The staff responded that it was not their intention to formulate the principle behind hedge accounting but rather a principle-based approach for designation of risk components that, in their view, should be possible.

Another Board member supported the broad direction the staff had taken. He asked the staff whether, based on the preliminary analysis, the new criteria for designation of risk components would be broader or narrower in comparison with current requirements of IAS 39. The staff responded that the answer would depend on the usefulness of the information provided to the users of financial statements.

One FASB member noted that the criteria need to be fleshed out before it was possible to determine how operational would the guidance be.

The staff noted that more attention should be focused on the reliably measurable criterion, rather than separately identifiable criterion.

One IASB member stated an example of an AA rated fixed rate instrument. He noted that in the past the benchmark interest rate decreased by 50 basis points whereas the AA rate increased by 100 basis points. He asked the staff to apply any criteria to the example and assess whether the benchmark interest rate was eligible for risk component designation.

The discussion continued by focusing on the FASB approach to bifurcation-by-risk for financial instruments within the remits of the overall FASB model for financial instruments.

The FASB staff recommended the application of the current bifurcation-by-risk model in the ASC Topic 815 if the FASB retains the tentative classification and measurement model for financial instruments. Further, the staff recommended that if the FASB increases the amortized cost category to allow more financial instruments to be measured at amortized cost, the FASB should utilize bifurcation-by-risk guidance similar to that proposed in FASB ED Accounting for Hedging Activities, issued in June 2008, to determine if the relationship qualified for hedge accounting.

The FASB agreed with this staff recommendation. The FASB also agreed that the reasonable effective threshold for hedge effectiveness (also proposed in June 2008 FASB ED) should be carried forward into the new guidance, thereby allowing more hedging relationship to qualify for hedge accounting. The FASB members noted that given the FASB tentative model, the current US GAAP model is the least onerous. However, they noted that any drift to amortized cost category beyond own debt would mean that a more fundamental change was required. The Boards discussed both models and concluded that it is very difficult to further specify the hedge accounting models until the classification and measurement guidance is finalised (the cut between the fair value and amortised cost). The differences between both models are based mainly on the fact that the FASB and IASB classification and measurement models are different, thus leading to different requirements for hedge accounting.

The FASB briefly discussed any need for fair value hedge accounting in the context of financial instruments held for the contractual cash flows. The Board members noted that it is more a synthetic accounting rather than a hedge accounting, that is, its purpose is in many cases to lock-in a cash flow in case of mismatch of fixed-rate financial assets financed by variable-rate financial liabilities (such as in the context of a financial institution).

The Boards summarised that the FASB hedge accounting model would portray all the risk in the financial statements whereas the IASB model consistently with the amortised cost notion would not portray all the risks in the financial statements. One IASB member noted that a paradoxical implication of the FASB model in the IASB context would be that financial instruments measured at amortised cost subject to hedge accounting rules would also portray effects of non-hedged risks in the profit and loss (fair value) whereas reporting entities not applying hedge accounting rules would not.

The FASB disagreed as they believed that their model provided a consistent measurement attribute and any inefficiency in the profit or loss portray the actual financial risks and their management by the reporting entity.

The IASB members noted that the IASB had previously decided to apply the cash flow hedge mechanics also to fair value hedges that would provide a consistent measurement attribute. Finally, both Boards noted that the different position on hedge accounting is reflection of the differences of the classification and measurement models. Nonetheless, both Boards expressed their willingness to explore a set of criteria for designation of risk components and discuss them at one of the following Board meetings.

Discussion at the Special 3 March 2010 IASB Meeting

Eligible hedged items: derivatives as hedged items

The Board discussed whether derivatives should be eligible as hedged items. The staff argued that many entities are economically required to enter into transactions that result in commodity price risk, interest rate risk, and foreign exchange risk, and they manage these risks independently of each other.

Most Board members agreed with the idea that hedge accounting should reflect the management of the risk of the underlying (including a derivative) as modified by another derivative, if that is an entity's strategy used for managing different risks. Nonetheless, many Board members were concerned that the proposed wording was too general and could allow general designation of derivatives as hedged items. Those Board members noted that although such designation would have no net effect on profit or loss, because all derivatives should be measured at fair value through profit or loss, it might decrease clarity and increase opportunity for structuring.

The staff responded that even now there are some exceptions to the general prohibition of designating derivatives as hedged items (a purchased option is eligible to be designated as a hedged item if it hedged by a written option). Moreover, some special types of derivatives might not qualify for measurement at fair value through profit or loss – for example, some embedded derivatives that are not separated from the host contract that is measured at amortised cost or contracts that are measured at fair value in their entirety as they did not fulfil the own-use exemptions.

Some Board members suggested that the wording should be tightened to reflect the concerns expressed above. Finally, the Board agreed with the general principles presented but agreed to define the eligibility more narrowly and to provide more examples.

Eligible hedged items: components of nominal amounts

The Board briefly discussed and agreed with the designation of components of nominal amounts as hedged items. Those requirements would reflect the current IAS 39 requirements.

Some Board members were concerned with clarity and suggested:

• clarification of the terms 'portion' and 'proportion', and
• inclusion of examples of nominal amounts in terms of monetary and physical metrics.

Some Board members discussed a broader issue related to proportions and their eligibility in connection with timing of the forecast transactions. The staff clarified that those issues would be addressed at a later stage as part of the effectiveness criterion debate.

Eligible hedged items: one-sided risk components

The Board agreed to carry forward the IAS 39 requirements that permit the designation of one-sided risk components as hedged items.

One Board member asked the staff whether they considered changing the prohibition to use written options as hedging instruments. The staff replied that this discussion should not imply any such change and should be limited to eligible hedged items. Moreover, they noted that they would discuss option strategies at a future meeting.

Discussion at the April 2010 IASB Meeting

Overview of items

The staff presented the Bard an overview of issues to be addressed as part of the hedge accounting project. No decisions were made.

The Board agreed to pursue the general hedge accounting approach and subsequently to consider the issues related to portfolio hedges. The staff also clarified that some issues related to both general approach and portfolio approach need to be addressed early in the deliberations (for example, groups of items and net positions).

Some Board members expressed some concerns with the tentative decision of the Board to apply cash flow hedge mechanics to fair value hedges. The staff noted that this issue will need to be re-deliberated to consider concerns expressed by several constituents in the outreach about possible unintended consequences of such decision.

The staff also clarified that based on the outreach, constituents prefer a comprehensive overview of the hedge accounting rather than a 'quick fix'. On the other hand, the FASB will publish its ED on Financial Instruments including proposed hedge accounting guidance in May.

The Board will continue in deliberations of hedge accounting at its May meeting.

Discussion at the May 2010 IASB Meeting

Eligible hedge items: Groups and net positions

The Board considered eligibility criteria for groups of hedged items that constitute a gross position and groups of hedged items that constitute a net position in the context of a general hedging model. These positions constitute common risk management strategies and are a building block of a portfolio hedging model.

The staff suggested limiting the discussion only to firm commitments as forecasted transactions would be discussed at a later stage. Some Board members clarified that the groups of items relate to a closed portfolio of instruments in contrast to a full portfolio hedging model that would be discussed after the general model is finalised.

Some Board members also questioned whether some of these issues are not influenced also by the application of the mechanics of a cash flow hedge to a fair value hedge.

The aim of the discussion was to consider whether and how to relax the restrictions on the types of groups of items that qualify for hedge accounting under IAS 39.

Eligible hedge items: Groups of hedged items

The Board debated whether any specific eligibility criteria are necessary for groups that are gross positions of hedged items of the same nature, with different risk characteristics, that impact profit or loss in the same period. Most Board members tentatively agreed that in these narrow circumstances no specific eligibility criteria are necessary.

Some Board members expressed their view that such positions should be eligible only if the groups are constantly re-measured. They believed that ultimately such decisions would lead to structuring and would lead to failure of effectiveness testing. The staff clarified that effectiveness would be considered at a later stage of the project. In addition, it noted that there are issues in the practice that even this narrow set could influence (e.g. seed corn hedge dependent on the benchmark corn price component and seed corn yield component).

Another Board member was concerned with the notion of same reporting period. He pointed out to the interactions with guidance in IAS 34 and questioned whether eligibility should depend on the fact whether the company prepares interim accounts. The staff would further analyse the issue.

Eligible hedge items: Net positions

The Board considered eligibility and presentation of some types of net positions for hedge accounting. The staff suggested that the designated hedged items would not be adjusted but instead the offsetting gain/loss resulting from the hedging instrument would be presented in a separate line of the statement of comprehensive income.

For most Board members the scenario (based on two form commitments - purchase of material and sale of goods in a foreign currency leading to a net risk position) was predominantly a presentation issue. Some Board members suggested that the staff considered presentation in its entirety as the suggested approach would lead to a separate line when hedging a net position but not when these transactions were hedged separately. These Board members questioned whether such presentation would increase transparency in dealing with derivatives.

In addition, one Board member expressed his concerns that the Board continues to require separate lines in a primary statement that could lead to a situation that the primary statements would become too cluttered by separate disclosure to be useful. He questioned whether note disclosure would not address the transparency issue.

Finally, despite seeing merits in the suggested approach, the Board agreed that the staff should consider presentation issue for hedge instruments in its entirety.

The Board then extended its discussion on multiple reporting periods. The Board considered the mechanics of the accounting for hedged items and hedging instruments. Some Board members questioned the mechanics of the proposed model that would lead to revaluation of both hedging instrument and hedged items related to the hedged risk directly in the other comprehensive income (that is, would differ from the current cash flow hedging mechanics). Such mechanics would include direct reclassification from profit or loss to the other comprehensive income. Several Board members questioned such reclassification as well as the fact whether the Board agreed such mechanics. The Board did not conclude this issue and would continue its discussion on Thursday.

Eligible hedge items: Net positions

[continuation of above discussion]

The Board continued the discussion from Wednesday on net positions consisting of a closed group of existing, non financial hedged items, with different risk characteristics that affect profit or loss in different reporting periods (for instance, a group of partially offsetting FX firm commitments that settle over five periods, with a forward FX contract used to hedge the net risk).

Several Board members were unhappy with the proposed model and challenged the staff that the proposed model (which would require changes of both the hedging instrument as well as the remeasurement of the fixed commitments to be recognised in the OCI) is inconsistent with basic features of the model as discussed by the Board. These Board members believed that the new hedging model should be limited to the pure cash-flow hedge mechanics (that is, only remeasurement of the derivative hedging instrument). Those Board members would prefer to recognise the results from recognising remeasurement of the unrecognised firm commitments as assets and liabilities that have an effect on the profit or loss (rather than the proposed accounting in OCI with a corresponding 'double entry' in the profit or loss). Those Board members also asked the staff to further clarify the criteria when the hedged items (with respect to the hedged risk) would be remeasured in the OCI and when not.

On the other hand, a majority of the Board members wanted the staff to pursue the proposed hedging model and develop it further. They encouraged the staff to explore the model so that the Board may be able to make decision whether the developed model is improvement over the current requirements. Consequently the staff would come back with further features of the model at a future meeting.

Eligible hedge items: contractually specified risk components

The Board considered the eligibility of contractually specified components of an item for hedge accounting (both financial and non-financial items). Most Board members agreed that that a contractually specified risk component should be eligible for designation as the hedged item in a hedging relationship for hedge accounting purposes, irrespective of whether it is the component of a financial or a non-financial item and thus that the current restrictions in IAS 39 should be softened (currently IAS 39 restricts eligible risk components to separately identifiable and reliably measureable risk components of financial items and foreign currency risk for non-financial items).

Some Board members expressed their reservations to the proposal. They argued that the current restrictions in IAS 39 were introduced as a way to ensure that the items are not marked away from the market.

Finally, the Board agreed to pursue these criteria. Some Board members indicated that some of the eligibility criteria need to be tightened to make the model operational. The staff would provide additional analysis at a following Board meeting.

Discussion at the July 2010 IASB Meeting

Presentation

During the September 2009 meeting, the Board had tentatively decided to replace fair value hedge accounting with a model similar to cash flow hedging with gains and losses on the effective portion of the hedging instrument recognised in other comprehensive income and any hedge ineffectiveness recognised in profit and loss.

During constituent outreach, the staff received concern regarding the artificial volatility created within equity as a result of this decision. Those entities expressing this concern included banks and certain non-financial entities who enter into foreign exchange contracts to hedge the risk associated with long term firm commitments, such as aerospace manufacturers and shipbuilders. These entities are concerned over the potential implications from adding the effective portion of hedging relationships into equity, including the possibility of having an overall negative balance within equity as well as the impact on leverage ratios.

The staff proposed three alternatives to address the concerns raised including:

1. retaining the original decision of recognition in other comprehensive income,
2. adding a separate balance sheet line item "valuation allowance" for recognition of the effective portion of the hedging relationship (rather than remeasuring the hedged item itself), or
3. retaining the approach within IAS 39 of remeasuring the hedged item.

The staff recommended alternative 2 by creating a separate line item within the statement of financial position to reflect the effective portion of the hedge relationship.

The Board discussed the three alternatives focusing primarily on alternatives 1 and 2. One Board member expressed reservation on whether the separate line item would meet the definition of an asset or a liability while others felt that rather than needing to meet the definition of an asset or liability, it was strictly a valuation allowance for a recognised asset or liability or a recognised firm commitment in a hedge relationship.

A majority of the Board ultimately agreed with the staff recommendation to create a separate line item within assets or liabilities to recognise the effective portion of the hedge relationship.

The Board then discussed an alternate proposal brought by one staff member which recommended a linked presentation approach for fair value hedges of firm commitments. Discussion ensued over the difference between a linked presentation approach and offsetting (primarily that offsetting presents two items as a single item within the financial statements where linked presentation "links" two separate items (typically one asset and one liability) that have a natural connection and are beneficial to present together rather than in separate sections of the statement of financial position. While the suggested alternative was only to allow linked presentation for fair value hedges of firm commitments (as the hedged item is not recognised within the statement of financial position), many Board members discussed extending the approach to all fair value hedges. The Board tentatively agreed not to permit a linked presentation alternative at this point but to continue outreach on this issue.

Effectiveness Assessment

One of the issues constituents have recommended addressing during the project to reconsider hedge accounting is the effectiveness assessment to initially qualify and continually retain the eligibility for hedge accounting. Many belief the current effectiveness requirements are overly rules driven (the arbitrary 80 to 125 percent brightline), the testing requirements are too onerous (requirement to continually perform both prospective and retrospective effectiveness tests), the cliff effect of failing the effectiveness criteria is too severe (effectiveness outside the 80 to 125 band in any one period results in the loss of hedge accounting), and potentially most important - there is little to no correlation between the hedge accounting qualification requirements and the underlying risk management strategy.

The staff considered whether an approach of establishing a minimum level of effectiveness to allow certain hedges in or an approach of establishing guidelines such that hedges with accidental offsetting were kept out was preferable. The staff also considered the use of qualitative thresholds, quantitative thresholds, or some combination of the two as the effectiveness assessment criteria. The staff proposed four alternatives to the Board for effectiveness assessments:

1. a quantitative threshold
2. a qualitative threshold,
3. rely solely on an entity's risk management policy, or
4. a combination of qualitative thresholds with minimum requirements tied to risk management or supplementary tests.

The Board agreed with the staff recommendation for alternative 4 to incorporate a model for effectiveness assessment using both qualitative thresholds and risk management policies. Using this approach the staff further proposed an approach that would bifurcate hedging relationships into non-complex and complex hedging relationships.

Non-complex hedging relationships would be those where the critical terms are either matched or closely aligned such that the hedge is expected to be highly effective throughout its life. Because these hedges are expected to be highly effective, they would be qualitatively assessed for effectiveness prospectively at inception and on an ongoing basis unless events occur that would result in the hedge no longer being considered effective in which a quantitative assessment would be performed.

Complex hedging relationships would not have matching terms thereby increasing the uncertainty regarding the level of offset between the hedging instrument and the hedged item. Because of the level of uncertainty regarding their effectiveness, these hedging relationships would be quantitatively assessed prospectively at inception and on an ongoing basis.

The Board had mixed views on the staff proposal with some members supporting the proposal. However, other Board members expressed concerns ranging from operationalising the proposal for complex hedging relationships, the lack of convergence with the FASB's proposals and concerns that the criteria set for qualifying for effectiveness did not seem sufficiently stringent enough. One Board member proposed a model where effectiveness should be assumed to be very highly correlated and as part of the hedge designation, the entity would document those risks that would contribute to ineffectiveness of the hedge relationship from its risk management policy. Other Board members seem to support the underlying concept of this proposal and the Board asked the staff to further develop this approach.

Effectiveness – Method of Assessment

The Board continued its discussion on hedge effectiveness assessment from the previous day. This session focused on what method of assessment reporting entities should utilize in performing their effectiveness analysis and whether the IASB should prescribe or exclude any measurement techniques. The staff expressed concern with the use of percentage-based methods, particularly in respect of more complex hedging relationships as they felt the information provided was limited and did not provide economic meaning. However, the Board agreed that they should not proscribe any effectiveness methodology and would allow the percentage-based methods for effectiveness assessment.

Hedging Eligibility – Net Positions

IAS 39 currently prohibits the hedging of a net position requiring reporting entities looking to hedge a net exposure to either enter two offsetting derivative instruments or to hedge a portion of one side of the gross exposure. The Board had previously agreed to develop a model to permit hedge accounting for net positions. In the May 2010 meeting, the Board tentatively decided that gains or losses arising from hedging of net positions should be presented in a separate line item within profit or loss (because the hedging instrument is mitigating the risk of two separate financial statement line items, the question was which line should reflect the hedging instrument offset).

During this meeting, the staff expanded the previously discussed example of a net hedge of FX risk of two firm commitments to a net hedge of FX risk of two highly probable forecast transactions which impact profit and loss during separate reporting periods. The staff proposed that hedge accounting for a net position of forecast transactions should be permitted. Some members of the Board expressed reservations with applying hedge accounting to a net position of a forecast transaction, primarily around the linkage between the two items. The example of hedging FX risk on future sales and cost of sales used in the staff example was converted to hedging FX risk on future sales and advertising expenses and whether those two items would be correlated enough to be considered a net position. Some Board members felt that if the correlation was sufficiently documented within the initial designation documentation that would help support why the risk management policy links the two transactions as a net position. One Board member felt that the model needed enhanced discipline around what could be considered a hedge of a net position which received support from other Board members.

The Board also discussed how to identify the hedged item when hedging groups of items. This is one of the building blocks to begin future discussions around portfolio hedging. The staff recommended that the net position can be identified as multiple gross hedge items which may offset within and across reporting periods. The Board felt that the same issues discussed in the discussion of the net hedge of a forecast transaction were relevant in this discussion as well.

While no official decisions were made, the Board expressed agreement for the general direction the staff was heading but cautioned to incorporate the suggestions and concerns expressed throughout the meeting.

Discussion at the Special 3 August 2010 IASB Meeting

Discussion on Hedge Effectiveness

In July 2010, the Board tentatively agreed not to proscribe a required methodology in performing a hedge effectiveness assessment for determining whether a hedging relationship initially and continues to qualify for hedge accounting. Additionally, the Board had agreed rather than requiring a bifurcated approach to hedge effectiveness (qualitative for non-complex hedging relationships where the critical terms matched and quantitative for complex hedging relationships) the model should consider whether the initial hedging relationship was designed to be highly effective and any ineffectiveness should be considered and documented as part of the risk management policy.

In consideration of these Board decisions, the staff had concerns that the existing brightlines within IAS 39 (the 80% to 125% effectiveness threshold) would continue in practice in part because of the use of the term "highly effective" in the effectiveness assessment. Additionally, the staff had concerns over the use of percentage based effectiveness assessment techniques (e.g., dollar offset) and whether they may provide results that give the appearance of a highly effective hedging relationship when in fact a statistical effectiveness assessment may identify the relationship as not being highly effective.

The staff did not ask for any Board decisions during this session, but rather wanted to address these concerns in determining how to further develop the Board's previous decisions.

One Board member disagreed with the staff's premise that the use of a statistical effectiveness assessment technique in isolation would properly identify a hedging relationship as being highly effective and felt that one may need to consider both percentage based and statistical based techniques in determining effectiveness.

The Board revisited the decision reached at their previous meeting that the hedge relationship should seek a one-to-one offset with an upfront understanding of why one-to-one would not be achieved as part of the risk management decision making (i.e., from basis differential). Given the concern over the carryover of the term "highly effective" the Board shifted to utilizing the term "neutral" for describing the initial hedge relationship (i.e., that one is not overhedged or underhedged) with an understanding of the sources of ineffectiveness.

The staff summarised the Board discussion and direction provided as an entity has multiple tools available to them for assessing hedge effectiveness including qualitative considerations (including the level of matching between the various terms of the hedging instrument and the hedged item), quantitative consideration, percentage based assessment techniques, and statistical based assessment techniques. Companies will need to consider based on their specific circumstances what techniques will be utilised to assess that the hedging relationship is "neutral" at inception and that future sources of ineffectiveness are identified as part of the initial hedging documentation.

Identifying Portions of a Hedged Items

The staff introduced the topic of whether it would be appropriate to identify part of an existing item that is designated as a hedged item in a hedge relationship as a portion of the entire item. The discussion focused on differentiating between a proportion (e.g. 80% of an entire $100 million firm commitment) and a portion (e.g., a component other than a proportionate part of the entire item). The importance of being able to identify a portion as a hedged item primarily relates to assessing and measuring the level of effectiveness in the hedging relationship.

The staff provided the Board with two examples illustrating the concepts, the first a firm commitment purchase in a foreign currency when there exists uncertainty as to the counterparty's ability to deliver under the commitment and the second a fixed rate loan with options to prepay at fair value.

In the first example, an entity decides to hedge the foreign currency risk for 70% of the firm commitment purchase of PP&E because of its risk management policy and uncertainty on the counterparty's ability to deliver in full under the contract. The counterparty delivers 9 of the 10 ordered items (a 90% fulfilment) and the remainder of the contract was cancelled. If the entity had hedged a 70% proportion of the purchase in the hedge relationship, the hedge would have encountered 10% ineffectiveness (because 10% of the contract was cancelled) resulting in 10% of deferred gains and losses recognised in OCI reclassified to profit in loss for a cash flow hedge and 10% of the commitment recognised in the balance sheet being derecognised and charged to profit and loss for a fair value hedge. However, if the entity had hedged a 70% portion of the purchase in the hedge relationship, ineffectiveness would not arise so long as 70% or the order had been fulfilled (e.g., the first 7 purchases were the hedged item). The differences between the two approaches result in significant differences in profit and loss recognition as a result of the measured ineffectiveness.

In the second example, an entity issues £100 million of five year debt at a 7% fixed interest rate and an issuer option to prepay any of the outstanding principal and unpaid interest at fair value. The entity's risk management policy limits fixed rate debt exposure to 50% of total issued debt. Also, the entity believes it may prepay up to £30 million prior to maturity. The entity enters into a swap of 5% fixed for 3-month UK Libor floating on £50 million of notional. If the entity had designated a 50% proportion of the debt as the hedged item and prepaid £30 million, then the £30 million and any fair value hedge adjustment related to the debt would be derecognised and the redemption amount paid would be recognised in profit or loss. In order to maintain an effective hedging relationship, the entity would have to designate £15 million of previously unhedged debt using an off-market swap (which also results in an impact to profit and loss). However, if a £50 million portion of the debt were the hedged item, the above mentioned issues would not arise as the hedge relationship would continue for the initially designated £50 million of debt.

One Board member expressed concern about the application to instruments with prepayment features, but the staff confirmed that the question at hand related to prepayment features whose fair value was not impacted by the hedged risk and the Board would be brought the issue related to other prepayment features at a later date.

Another Board member expressed that this will add emphasis on the robustness of the initial hedge designation documentation to clearly specify which portion is part of the hedge relationship.

The Board tentatively agreed with the staff's recommendation to permit part of an existing item to be identified and designated as a portion (or layer) of the entire item in cases where:

• The portion is identified and documented at inception of the hedge,
• The designation is in line with the entity's risk management strategy, and
• The fair value of any prepayment/termination clause is not affected by the hedged risk.

Discussion at the Special 24 August 2010 IASB Meeting

Effectiveness Assessment

The Board continued its previous discussions from the 3 August and July meetings on the development of a hedge effectiveness assessment method to qualify for hedge accounting. During those previous meetings the Board had developed a concept of seeking a hedge relationship that should have the intention of being highly effective at inception while understanding and documenting any potential sources of ineffectiveness as part of the designation process. The Board asked the staff to further build a model around this concept.

The model the staff developed and proposed at this meeting included the following:

• The objective of the effectiveness assessment is to ensure the hedging relationship has an unbiased result (e.g., no intentional over or under hedging) and to minimise ineffectiveness.
• Hedging relationships should also be expected to achieve other than accidental offsetting (a second screening criterion in addition to the unbiased hedge requirement above).
• Effectiveness assessment is a forward looking concept performed at inception of the hedging relationship and ongoing throughout the life of the relationship.
• The type of effectiveness assessment (whether quantitative or qualitative) will largely depend on the entities� risk management system, the specific characteristics of the hedging relationship and the potential sources of ineffectiveness. No method will be prescribed.
• Changes in the method of assessing effectiveness are required when unexpected sources of ineffectiveness occur in the hedging relationship or if the relationship is rebalanced and is no longer capable of capturing the sources of ineffectiveness, the entity would be required to change the method for assessing effectiveness.

The incorporation of the neutral or unbiased result concept acknowledges that many hedging activities cannot eliminate all sources of ineffectiveness (either because the perfect hedging instrument is not available or is cost prohibitive to obtain); however, the hedging relationship should not be established in such a way as to include a deliberate mismatch in the weightings of the hedged item and of the hedging instrument.

One Board member expressed concern over the use of the term neutral hedge and preferred utilising the unbiased hedge terminology. Another Board member expressed concern over the example used in the Agenda paper discussing the additional effectiveness criteria regarding accidental offsetting. He used an example of hedging the price of whiskey by entering into a hedging instrument over the price of steel as an example where any level of offset would clearly be accidental in nature.

The Board tentatively agreed with the staff�s proposed model for hedge effectiveness assessment.

Hedging a Portion of a Group of Items

The Board continued its previous discussions from the 3 August meeting regarding designating a portion of an item (rather than a proportion) in a hedging relationship. The Board�s previous tentative decision to permit hedging of a portion of an item focused specifically on an individual item. Today�s discussion expanded the previous discussion to include a portion of multiple items, such as a specific portion (e.g., �700K) of multiple firm commitments to purchase multiple items of property, plant and equipment in the same foreign currency or a top layer portion (e.g., �50M) of two issued bonds.

Consistent with the previous discussion on single items, items with fixed term prepayment features (in which the hedged item would have a change in fair value from changes in interest rates) were excluded from the scope of the discussion and will be discussed separately at a later date.

The Board tentatively agreed to require, when hedge accounting is elected, part of a group of existing items to be identified and designated as a portion of the entire group of items when:

• the portion is identified and documented at inception of the hedge,
• the designation is in line with the entity�s risk management strategy,
• the entity can demonstrate that:
• the hedged items are existing items that can be clearly identifiable,
• each item in the group are exposed to the same hedged risk,
• it is possible to appropriately track the portion and entirety of items to measure hedge ineffectiveness and when to release amounts recognised in the balance sheet once the hedged item impacts profit and loss, and
• the hedged portion is clearly identifiable and reliably measurable, and
• the fair value of any prepayment or termination features is not impacted by the hedged risk.

Eligibility to Hedge Instruments Measured at FVOCI

As a result of the issuance of IFRS 9 and the ability to elect to measure certain equity investments at fair value with gains and losses recognised permanently in other comprehensive income (OCI), the question has been raised on whether (and how) an entity would be permitted to apply hedge accounting to such an investment. The current definition of both fair value and cash flow hedges refer to affecting profit and loss. Because the requirements of IFRS 9 do not permit recycling of gains and losses held within OCI when an investment is disposed of, there will naturally be a disconnect in the application of the hedge accounting principles (i.e., both with ineffectiveness during the life of the investment and with effectiveness at realisation of the investment - since the hedged item does not impact profit and loss the deferred amounts in the balance sheet would be realised in profit and loss upon settlement with no offset from the derecognition of the hedged item).

To address the issue of whether to permit hedge accounting for equity investments measured at fair value through OCI would require consideration of a separate hedge accounting model for these items. Additionally, the IFRS 9 provision to measure an equity investment at fair value through OCI is an election. As a result, the staff recommended the Board prohibit the application of hedge accounting to equity investments designated at fair value through OCI.

The Board agreed with the staff proposal. However, two Board members disagreed with the staff proposal to not permit hedge accounting for these items while another Board member expressed concern with the proposal but because of the elective nature of the designation ultimately did not vote against the proposal. One of the Board members who voted against the staff proposal felt that it was a valid hedging strategy to protect capital and therefore it should not be excluded simply because it did not fit within the existing hedge accounting model. Additionally, because of the pending standard which plans to create a single statement of comprehensive income where profit and loss and other comprehensive income would be shown together, they felt that no distinction should be made.

Discussion at the September 2010 IASB Meeting

Group Hedge Accounting

The staff presented the Board with a summary of the individual tentative decisions on group hedging activities made over the previous four months. The summary also highlighted some of the Board member concerns with the proposed model and a staff response to those concerns.

The staff presented three alternatives on how to finalise the discussions around group hedge accounting before proceeding with discussion on portfolio hedging.

• Alternative 1 would carryover all of the existing restrictive criteria that apply to groups of hedged items within IAS 39.
• Alternative 2 would carryover some of the existing restrictive criteria that apply to groups of hedged items within IAS 39
• Alternative 3 would not carryover any of the existing restrictive criteria that apply to groups of hedged items within IAS 39 and instead incorporate the criteria and principles previously made by the Board

One Board member expressed concern around the decisions the Board has made to date stating that each decision was made in isolation however when considering in the entirety, he did not feel the Board has been provided enough information to make a decision. The Board member was particularly concerned with the use of cash instruments hedging other cash instruments as well as the application to forecasted transactions as no ineffectiveness would be recognised should the forecasted transaction never occur.

Another Board member expressed concern that the project has been advertised as a simplification project; however, there seems to continuously be more and more rules added to the model. Other Board members echoed this concern. The staff responded that the project was not designed solely as a simplification project but rather to more closely align the hedge accounting model with a company's risk management process. However, in doing so, this may result in additional complexity in which the Board will have to consider and weigh those implications.

The Board ultimately agreed to proceed with an approach based on Alternative 2 which would limit application of group hedging potentially excluding such items as forecasted transactions.

Portfolio Hedging

The staff provided the Board with a preliminary summary of potential issues involved with portfolio hedging of interest rate risk. The staff will be bringing papers to the Board related to portfolio hedging during future meetings.

Hedge Ineffectiveness Measurement

During the 24 August 2010 Board meeting, the Board agreed on a model for hedge effectiveness assessment. During this meeting, the staff presented to the Board an objective, principle and guidance related to the measurement of hedge ineffectiveness.

The objective developed by the staff for measurement of hedge ineffectiveness is "the quantification of the portion of the change in fair value of the hedging instrument that has not been offset by the change in the fair value of the hedged item attributable to the hedged risk (and vice versa for fair value hedges) in a reporting period."

The principle developed by the staff is that of a "dollar-offset" approach (calculation of hedge ineffectiveness using the ratio between the change in the fair value of hedging instrument and the change in the fair value of the hedge item) should be followed to measure ineffectiveness which would be recognised at the earlier of 1) the end of the reporting period or 2) an occurrence of a rebalancing of the hedging relationship.

The guidance on measuring ineffectiveness developed by the staff would include that entities should calculate hedge ineffectiveness using dollar-offset using the actual performance of the hedged item and hedging instrument and that recognition of ineffectiveness will differ based on if the hedge were a fair value or cash flow hedging relationship because of the "lower of" test for cash flow hedges.

The Board agreed with the objective, principle and guidance developed by the staff.

The staff then raised the question of whether the time value of money should be considered as part of the measurement of hedge ineffectiveness. This question had been raised to the IFRIC in March 2007; however, they decided not to add the issue to their agenda on the basis that a reason for ineffectiveness relates to the timing of the interest payment or receipts of the swap and the hedged item. To do so, entities would need to consider the effect of the time value of money. The staff recommended that the standard specifically address that the time value of money be considered when calculating an ineffectiveness measurement. The Board agreed with the staff recommendation.

The staff also raised the topic of utilising a hypothetical derivative as part of the measurement of ineffectiveness to the Board. The current hypothetical derivative approach under IAS 39 is intended to be an input to an effectiveness test rather than the effectiveness test itself however there is a lack of clarity in the current standard. The staff asked the Board whether the hypothetical derivative method should be allowed, not as a method on its own, but as one way to determine the change in the value of the hedged item attributable to the hedged risk which may then be used as an input for another measurement method. Some Board members stressed that the hypothetical derivative method should be treated only as an input for another measurement method and asked the staff to emphasise this point in the forthcoming exposure draft.

The staff also raised a question regarding a component of the FASB's proposed Accounting Standards Update (ASU) on financial instruments which permits an accommodation separate from the hypothetical derivative concept for groups of items that would settle within a specific time period. The Board agreed to permit the use of a hypothetical derivate as an input into the ineffectiveness measurement method and to not permit a similar specific exception as currently proposed in the FASB ASU.

Scope of Disclosure

The staff raised the topic of disclosures related to hedge accounting by providing an overview of the staff's planned approach. The staff's planned approach is to expand the current IFRS 7 disclosures to include the exposure to a specific risk when an entity applies hedge accounting and to limit the disclosures to those exposed risks the entity tracks as part of its risk management process.

One Board member asked for clarification on the criteria for those risks tracked by a risk management process. The staff clarified that the disclosure would include both the exposure and any hedging of that exposure.

Another Board member expressed concern that there may be risks for which an entity is exposed but yet does not actively track and would like disclosure of that information. Other Board members felt that exceeded the scope of disclosures related to hedging activities and should be considered as part of management commentary instead.

The Board agreed with the staff planned approach for development of hedge accounting disclosures.

Hedge Accounting Presentation

The final hedge accounting discussion of the day focused on two specific presentation issues.

The first topic discussed was the accounting policy choice currently within IAS 39 related to cash flow hedges of forecast transactions that result in the recognition of non-financial items. Currently an entity may either 1) adjust the initial carrying amount of the hedged item for the gain or loss on the hedging instrument, or 2) leave the gain or loss on the hedging instrument within other comprehensive income (OCI) until the hedged item impacts profit and loss when it is then recycled from OCI to profit and loss. The current accounting policy choice results in various comparability issues including that a basis adjustment approach is not available for financial assets, U.S. GAAP precludes basis adjustments, and the two elections result in differing carrying amounts for the recognised non-financial asset and while not resulting in differing amounts recognised within profit and loss, differing amounts are recognised within OCI.

However, from an operational perspective, applying the basis adjustment requires less effort to track the timing of impact to profit and loss in comparison to the recycling approach from OCI to profit and loss. When the basis of the non-financial item is adjusted, it is automatically recognised in profit and loss at the time of consumption, either through a depreciation charge, as a component of cost of sales, etc. As such, the IASB outreach performed has requested that either the accounting policy choice remain or if one alternative were to be eliminated that the basis adjustment be retained.

The staff presented the Board with four alternatives on how to address the issue:

• Alternative 1 – Continue to permit the accounting policy choice in IAS 39
• Alternative 2 – Require entities to leave hedging gains and losses in OCI
• Alternative 3 – Require basis adjustments upon recognition of the non-financial item
• Alternative 4 – Require basis adjustments from accumulated other comprehensive income (AOCI) or equity directly, without impacting the performance statement upon transfer.

The staff recommended alternative 4 in part because of their belief that it (along with alternative 3) is the most operational and helps to reduce complexity as well as reduces comparability issues by removing an accounting policy choice. Additionally, both alternative 3 and 4 would not result in different presentation for recognised items resulting from foreign currency hedged firm commitments regardless of whether cash flow or fair value hedge accounting were elected (the second of the two presentation issues, discussed further below). Alternative 4 also does not result in the cliff effect to OCI that results from alternative 3 when the basis adjustment is transferred out.

One of the Board members expressed concern over the staff's proposal. He noted what appeared to be an inconsistency in the proposals as for fair value hedges the Board has removed the basis adjustment approach with a separate line item valuation allowance. However, for cash flow hedges of forecasted transactions, the Board is going to require basis adjusting the recognised asset. They asked the staff if a fair value hedge of inventory would result in a basis differential or a separate line item valuation which the staff confirmed would require a separate line item valuation allowance. The staff asserted that the difference in the scenarios is that for cash flow hedges of forecasted transactions the asset was yet to be recognised and the gain or loss on the hedging instrument was adjusting the initial cost of the asset which would not be re-measured again like a financial asset may be. The Board member also expressed concern that this decision would create additional divergence with U.S. GAAP which was echoed by another Board member.

Another Board member mentioned that analysts feel that the basis adjustment provides the most decision useful information. Another Board member expressed his support for alternative 3 as he felt there was a fundamental principle that the cash flow hedge should be recognised through OCI. Ultimately, a majority of the Board agreed with the staff recommendation to require basis adjustments from AOCI or equity directly without impacting OCI.

The second presentation topic the Board discussed related to hedging foreign currency risk of a firm commitment. IAS 39 currently allows for the hedge to be designated as either a cash flow hedge or a fair value hedge because it impacts both the cash flows and fair value of the hedged item. Because of the Boards previous decisions regarding fair value hedge accounting, the presentation of the hedge of a foreign currency risk of a firm commitment would vary based on the type of hedge designation elected, which is made on a hedge-by-hedge basis.

The staff presented the Board with three alternatives on addressing the issue:

• Alternative 1 – Continue to permit a choice of electing cash flow or fair value hedge designation on a hedge-by-hedge basis
• Alternative 2 – Require cash flow hedge accounting only
• Alternative 3 – Require fair value hedge accounting only

The staff recommended alternative 1 to retain the choice of designating the relationship as either a fair value hedge or a cash flow hedge. The Board agreed with the staff recommendation.

October 2010: Overview of tentative decisions on hedge accounting project

To assist those following the hedge accounting phase of the project to replace IAS 39 the IASB has posted an overview of the tentative decisions to date on its hedge accounting project page. This includes references to the relevant meetings and observer notes to enable interested parties to read further background information. Click for the summary of tentative decisions to date (PDF 234k, link to IASB website).

Discussion at the Special 5 October 2010 IASB Meeting

The IASB discussed three topics related to the eligibility of certain items as hedging instruments within a hedge accounting relationship.

Eligibility of embedded derivatives as hedging instruments

IFRS 9 removed the bifurcation of embedded derivatives concept for financial assets as contained within IAS 39 as hybrid financial assets under IFRS 9 would typically be measured in their entirety at fair value through profit and loss. However, because the derivative included within the financial host contract is no longer bifurcated, it is no longer eligible as a hedging instrument.

The staff considered three possible alternatives to address hedge accounting when the hedging instruments is embedded within a financial asset:

1. Making bifurcation of embedded derivatives a choice to permit hedge accounting;
2. Allowing designation of risk components of a hybrid financial asset as a hedging instrument; or
3. Not permitting a hybrid financial asset to be a hedging instrument.

The staff recommended not permitting hybrid financial assets as eligible hedging instruments to avoid increasing the complexity that would arise from permitting a designation of risk components or creating exceptions to IFRS 9 by permitting bifurcation of embedded derivatives for hedging relationships. Additionally, the other two alternatives would result in increasing the scope of the hedge accounting project inevitably resulting in additional delays.

The Board agreed not to permit a hybrid financial asset as a hedging instrument. Many Board members expressed concern with reopening the decisions made in IFRS 9 or deviating from those decisions by permitting a bifurcation of embedded derivatives to permit hedge accounting.

Eligibility of cash instruments as hedging instruments

The Board also discussed whether a cash instrument (e.g., non-derivative financial instrument) should be permitted as an eligible hedging instrument within a hedge accounting relationship. IAS 39 currently permits non-derivative financial instruments to be designated as hedging instruments only for hedges of foreign exchange risk.

The staff considered three possible alternatives:

1. Retaining the restriction in IAS 39 that limits the eligibility of cash instruments as hedging instruments to hedges of foreign exchange risk
2. Removing the restriction in IAS 39 only for those cash instruments that are accounted for at fair value through profit and loss; and
3. Removing the restriction in IAS 39 for all cash instruments.

The staff recommended allowing cash instruments measured at fair through profit and loss as eligible hedging instruments. The staff supported this approach because they felt that it would reduce complexity by providing a consistent rationale for the eligibility of hedging instruments and by facilitating an alignment of financial reporting and risk management.

The Board was in agreement against Alternative 3 to not permit all cash instruments as eligible hedging instruments. However, in determining whether to permit all cash instruments accounted for at fair value through profit and loss as eligible hedging instruments (Alternative 2), several Board members expressed concern over the staff's recommendation. The views of those with concerns primarily focused on trying to identify what practice issue the staff's recommendation was attempting to address or cure and why the use of the fair value option would not be an acceptable alternative. The Board was split and therefore asked the staff to expand their analysis and provide additional information at a future meeting to enable the Board to decide between Alternatives 1 and 2 above.

Eligibility of internal derivatives as hedging instruments

The Board discussed whether an internal derivative (e.g. a derivative between a subsidiary and a central corporate treasury function) should be permitted as an eligible hedging instrument in a hedge accounting relationship. IAS 39 does not currently allow for internal derivatives to be designated as a hedging instrument in a hedge accounting relationship. However, U.S. GAAP currently permits the use of internal derivatives to apply hedge accounting related to foreign exchange risk.

During outreach activities performed by the staff, both large financial institutions, large corporate entities, and auditors have mentioned that in many instances entities are required to enter into internal derivatives with a central treasury function and the central treasure function will then enter into an external derivate which may not match the internal derivative. As a result of these internal derivatives not being eligible for hedge accounting, these entities feel the application of hedge accounting is difficult to understand and lacks consistency with the risk management practice. Many central treasury groups encounter difficulties in applying hedge accounting because of the various exposures managed on a net basis and the frequent adjustments of hedge positions.

The staff recommended that internal derivatives not be eligible as hedging instruments as they do not represent an instrument which transfers risk to an external party and contradicts the underlying consolidation principles as those instruments would be eliminated upon consolidation. The Board agreed with the staff recommendation to not permit internal derivatives as eligible hedging instruments.

Discussion at the October 2010 IASB Meeting

The IASB discussed three topics related to the ongoing hedge accounting project.

Scope - Own Use Exception

IAS 39 currently requires that contracts to buy or sell a non-financial item that can be settled net, but are entered into for the purposes of receipt or delivery of the non-financial item as part of the entity's expected purchase, sale or usage requirements would be outside the scope of IAS 39. As a result, those contracts are not considered derivatives and would not be marked to market at each reporting period.

During outreach performed by the staff, commodity processors and servicing providers have expressed concern about the requirement within IAS 39 related to the "own use" exception. The business model for these entities includes acquiring a commodity, refining that commodity and then distributing the commodity, oftentimes into a fairly liquid market (e.g. sugar or canola oil) or are priced based on a commodity benchmark plus a processing margin. To mitigate risks in commodity price fluctuation during the refinement process (as their business model is strictly earning the margin related to the refinement process) these entities often enter into derivatives to fix their sales price of the refined product.

These entities manage their business on a fair value basis and oftentimes also on a net basis, however the inability to recognise the original acquisition contract as a derivative because of the own use exception results in an accounting mismatch. Applying fair value hedge accounting is a possible alternative, but is difficult because of the volume of contracts in place and the fact that many positions offset each other. Entities that do apply net hedging are required to frequently designate, dedesignate and redesignate the hedge relationship because of the frequent movements of the overall net position.

The Board considered three possible alternatives to address the own use exception issue:

• Retain the current "own use" exception requirement within IAS 39,
• Allow for election of the "own use" exception (approach similar to current practice under US GAAP), or
• Require entities that manage their business on a fair value basis to account for contracts that meet the "own use" exception as a derivative.

One Board member asked the staff whether under alternative three, similar to IFRS 9, an entity could have more than one business model for managing their business as the agenda paper referred to "an entire business" being managed on a fair value basis. The staff confirmed that similar to IFRS 9, entities could have more than one business model.

That Board member also asked whether the act of net settling a few contracts would prohibit those entities not managing their business on a fair value basis to continue to receive the own use exemption. The staff responded that the guidance related to the net settlement definition of a derivative was not being reconsidered as part of the hedging project and the requirements under IAS 39 would be retained within IFRS 9.

The Board tentatively agreed to retain the own use exception within IAS 39 but to require those entities who manage their business on a fair value basis to account for contracts to acquire non-financial items and permit net settlement as derivatives.

Risk Components – Hedging Items with a Negative Spread to LIBOR

IAS 39 currently requires that if a portion of the cash flows for a financial asset or liability are designated as a hedged item, the designated portion must be less than the total cash flows of the asset or liability. However, an entity may designate as a hedged item an asset or liability with an effective interest below LIBOR to be hedged for a component risk of changes in LIBOR. The difference between LIBOR and the negative LIBOR spread on the hedged item will be a source of hedge ineffectiveness, but so long as the effectiveness remains within the 80-125% effectiveness bandwidth, hedge accounting is retained. Entities may also choose a hedge relationship of other than one to one to improve the hedge effectiveness.

The staff raised the issue of whether a LIBOR-component of an interest bearing financial asset or liability exists if the effective interest rate of the instrument is lower than LIBOR and whether the LIBOR-component should be eligible for designation as a hedged item. The staff provided an analysis of an entity with a sub-LIBOR instrument who enters into a LIBOR for fixed swap. As LIBOR rates dropped below 1% a negative margin on the instrument occurs because of the floor of the fixed pay-leg.

The Board considered whether to retain the current guidance within IAS 39 described above or whether to allow for the designation of risk components on a benchmark risk basis that assumes cash flows exceeding the total actual cash flows of the hedged item. The Board tentatively agreed to retain the current guidance within IAS 39.

Disclosures

The Board continued its discussion from the September 2010 Board meeting on disclosures related to hedge accounting activities.

For the impact of hedge accounting on the balance sheet, the staff is developing a disclosure approach requiring a tabular format presentation of information by type of hedge and by risk category. For both fair value and cash flow hedges, an entity would disclose the notional amount and the carrying amounts of the hedging instrument (separating assets and liabilities). For cash flow hedges, an entity would also disclose the balance within accumulated other comprehensive income from revaluation of the hedging instrument that relates to the hedged item and the balance of any discontinued hedged items. For fair value hedges, an entity would also disclose the carrying amount of the accumulated gain or loss on the hedged item (the valuation allowance recognised on the balance sheet).

For the impact of hedge accounting on profit and loss, OCI and the cash flow hedge reserve, similar to the balance sheet disclosures above, the staff is developing a disclosure approach requiring a tabular format presentation of information by type of hedge and by risk category. For both cash flow and fair value hedges, an entity would disclose the changes in the value of the hedging instrument, the ineffectiveness recognised in profit or loss, and the line item in profit or loss in which hedge ineffectiveness is included. For cash flow hedges, an entity would also disclose the effective hedging gain or loss recognised in a separate line item in the income statement for hedges of net positions, the amount transferred out of accumulated OCI to profit or loss, the line item affected in profit or loss because of the transfer and a reconciliation of the cash flow hedge reserve.

In addition to the impacts of hedge accounting recognised in the financial statements, the staff is also developing disclosures on information not captured within the financial statements. These disclosures include information on the risk management strategy, quantitative information of risk exposures and how the risk is hedged including the monetary amount or quantity (barrels, tonnes, etc.) exposure for that risk, the amount or quantity of the risk exposure being hedged, and how hedging has changed the exposure.

The staff has favoured not requiring any specific level of aggregation for disclosure purposes rather stating that management judgment would be required in determining the appropriate level.

One Board member encouraged the staff to develop a disclosure framework that follows a logical manner rather than simply starting with the accounting information. Another Board member questioned how certain of the disclosures could be aggregated to any meaningful level given the requirement to disclose specific quantities. But the Board overall supported the direction the staff was proceeding with in developing the disclosure requirements.

Use of Credit Derivatives

Financial institutions often use credit derivatives to manage the credit risk of their lending activities (both outstanding loans and loan commitment facilities). Lending activities typically include various optionality features including prepayment options, liquidity options (undrawn facilities), and extension options. The credit derivatives used to manage credit risk are credit default swaps (CDS) (derivatives marked-to-market under IAS 39) which creates an accounting mismatch and results in financial reporting that doesn’t faithfully represent the underlying economics. Loans are typically measured at amortised cost under IAS 39 (and IFRS 9) and loan commitments typically fall within the scope of IAS 37 rather than IAS 39.

Fair value hedge accounting is difficult to achieve for these relationships because of the inherent difficulty in isolating and measuring the credit risk component. Similarly, the fair value option is not a suitable alternative for a variety of reasons. For loans, the decision to purchase credit protection through CDS is typically made after origination of the loan so the decision to designate the loan as at fair value through profit and loss would have to be made prior to the decision to protect the credit exposure with credit derivatives. Also, entities often do not fully protect their credit exposure but instead leverage the CDS protection for a portion of their credit exposure. However, designating the entire loan at fair value and a CDS with a notional amount less than the loan exposure would still result in an accounting mismatch. For loan commitments, they typically fall outside the scope of IAS 39 and therefore are ineligible to designate as at fair value through profit and loss.

The staff presented three alternatives to the Board for consideration of how to permit fair value accounting for the loan or loan commitment. The first alternative was to permit fair value designation only at initial recognition, permit designation of a component of a nominal amount and permit discontinuance of fair value accounting. The second alternative is similar to alternative one except that the fair value designation could be made at any time, but if made subsequent to initial recognition, then the difference between the carrying amount and fair value at the date of designation would be recognised in profit and loss. The third alternative is similar to alternative two, except rather than recognising the difference between the carrying amount and the fair value immediately through profit and loss, it would be deferred and amortised.

The Board had significant reservations with the staff proposals. One Board member acknowledged the problem under current practice and said that the Board needed to do something to address the accounting mismatch. However, he framed the staff proposals as a new hedge accounting model. He said his preference would be to somehow allow for fair value hedge accounting under the model being developed by the Board (where the hedged item would not be remeasured but instead would have a separate valuation allowance) because when recording the loan at fair value investors lose information about the amortised cost and interest margin on the loan.

Another Board member expressed his concerns with the proposals stating the Board will get pressure to provide similar allowances for the fair value option for other instruments such as permitting designation after initial recognition and discontinuing designation. He suggested that an approach under U.S. GAAP’s hedge accounting model could be a basis for a solution. ASC 815-20-25 (formerly DIG G20) addresses the assessment and measurement of the effectiveness of a purchased option used in a cash flow hedge. The Board member analogised the premium payments on a CDS to an annuity payment to acquire a purchased option.

The Board tentatively decided not to permit exceptions to the fair value designation for loans and loan commitments being managed for credit risk with credit derivatives. However, the Board did agree to further explore other potential alternatives as solutions.

Discontinuation of Hedge Accounting

The Board next discussed if and when a hedging relationship could or should be discontinued.

The staff proposed criteria for discontinuing a hedging relationship as follows:

• Mandatory discontinuation occurs when the hedging relationship ceases to meet the qualifying criteria for hedge accounting (entities would be able to start a new hedging relationship with the items previously included in the discontinued hedge)
• Adjustments to the hedging relationship would require discontinuation when there was a change in the risk management objective of the hedge relationship.
• Adjustments to the hedging relationship are permitted for a continuing hedge relationship when the qualifying criteria (other than risk management objective) have either failed or anticipate failing.
• Elective dedesignation would not be permitted when the qualifying criteria are still met.
• The designation documentation supporting the hedge relationship must be updated to address any changes in the hedge relationship.

The Board discussed whether hedge accounting would be elective or mandatory as that decision could be relevant to whether elective dedesignation were permitted. The staff responded that the Board had not made any decisions on whether hedge accounting would be mandatory or elective but conceded that with the model under development it would be difficult to require mandatory use of hedge accounting.

Several Board members expressed support for the criteria proposed by the staff for discontinuation. One Board member summarised it as “bringing rigor, discipline and transparency” to hedge accounting.

Other Board members expressed concerns with the staff proposals, particularly with respect to the criteria of not being able to dedesignate the hedge accounting relationship. One Board member mentioned that he just participated in the FASB financial instruments roundtable and their exposure draft had a similar proposal which very few supported.

There was a question on the documentation criteria as the staff has not raised the components of the hedge documentation requirements with the Board. The staff responded that it had not brought the issue to the Board yet, but the hedge documentation would likely include such items as the hedging instrument, the hedged item, the risk being hedged, whether the hedge was on a risk components basis, the period of the hedge relationship and anticipated sources of ineffectiveness in the hedge relationship.

The Board tentatively agreed with the staff proposal on the discontinuance criteria.

Rebalancing and Reassessment of the Hedge Ratio

Under the hedge accounting model being developed by the Board, the effectiveness assessment requires entities to rebalance their hedge relationships such that they do not result in unexpected hedge ineffectiveness. To accommodate the need for entities to rebalance their hedge relationships in order to continue to meet the qualifying criteria, the Board tentatively agreed to permit voluntary rebalancing for continuation of hedging relationships which would not be dependent on the type of unexpected hedge ineffectiveness but rather that the risk management objective continues to apply.

The Board was also provided with the following examples of the application of rebalancing and its interaction with discontinuation of hedging relationships:

• Changes in the behaviour of the benchmark: increase in the premium between benchmark and hedged commodity with no change in the hedged item
• Changes in the behaviour of the benchmark: reduction in the premium between benchmark and hedged commodity with no change in the hedged item
• Changes in the quantity of the hedged item (increase) with no changes in the basis
• Changes in the quantity of the hedged item (reduction) with no changes in the basis

Based on the examples provided, the Board tentatively decided that assuming the risk management objective had not changed, then adjusting the hedge ratio would not impact the measurement of changes in the fair value of the hedged item, rebalancing may require partial discontinuation if the changes are above the expected levels of ineffectiveness, and if the quantity of highly probable forecast transactions is overestimated then partial discontinuation would be appropriate assuming there is no history of routinely overestimating such transactions.

Eligibility of Hedged Items — Groups and Net Positions

Based on requests made by the Board at the September 2010 Board meeting, the staff developed illustrative examples of net position hedges. Based on the additional information provided, the Board reconsidered the three alternatives of how to establish criteria for applying hedge accounting for net positions originally discussed during the September 2010 Board meeting.

The first alternative is to carry over from IAS 39 all of the existing restrictive criteria that apply to groups of hedged items. The second alternative is to include some of the restrictive criteria, such as that a net position cannot be an eligible hedged item in a cash flow hedge. The third alternative would not carry over any of the existing restrictive criteria from IAS 39, but rather include concepts such as demonstrating that it manages the items on a group basis for risk management purposes and identifying and designating gross amounts as part of the hedge relationship.

The Board was primarily split between Alternatives 2 and 3. However, one Board member was not comfortable with either Alternative 2 or 3 and therefore preferred Alternative 1. The Board tentatively agreed to proceed with Alternative 2 (with 8 votes) but also plans to explain Alternative 3 within the exposure draft.

The Board also discussed the topic of whether a net nil position (inbound and outbound firm commitments of the same amounts) should be eligible for hedge accounting. The staff acknowledged that this would likely be a rare scenario in practice, but did recommend permitting the hedging of a net nil position as it would be inconsistent to not allow hedge accounting because an entity manages foreign exchange risk on a net basis. The Board tentatively agreed to permit hedge accounting for a net nil position.

Discussion at the Special 27 October 2010 IASB Meeting

The IASB discussed the final planned topics of phase one of the hedge accounting project.

Use of intragroup nonderivative financial instruments as hedging instruments

At the 5 October 2010 Board meeting, the Board tentatively decided not to permit derivatives between parties within a consolidated group to be eligible hedging instruments. Today, the Board discussed another issue involving whether internal financial instruments could be eligible hedging instruments.

The staff presented an example of a parent with a highly probable transaction to acquire another entity with consideration payable in 12 months in a currency other than the acquirer's functional currency. Either because of an inability of locating the appropriate currency forward for the needed currency or because of concerns over the credit risk involved with the counterparty to the forward, an entity may enter into an intercompany loan with a foreign subsidiary that has the same functional currency as the forecasted acquisition. In this scenario, an accounting mismatch is created because of the translation of the loan into the parent's functional currency through profit and loss (under IAS 21) while the forecast transaction has yet to occur. So even though the parent has economically hedged their foreign exchange risk exposure to the transaction, the accounting does not follow suit.

The Board considered whether an exception should be permitted for FX risk associated with a business combination, whether a comprehensive review of IAS 21's interaction with hedge accounting should be performed, or whether to carryover the guidance currently within IAS 39. The Board had little interest in addressing the issue and tentatively decided to carryover the guidance within IAS 39 that internal non-derivative financial instruments would not be eligible hedged items.

Eligible hedged items – non-contractually specified risk components

At the May 2010 Board meeting, the Board tentatively decided to permit designation of risk components for non-financial items as eligible hedged items when the risk component is contractually specified (financial items are already permitted for risk component designation under IAS 39). Today, the Board discussed whether to further permit risk component designation of non-contractually specified items as eligible hedged items for both financial and non-financial items (a source of significant problems under today's hedge accounting model).

The staff analysis originally prepared for the May 2010 Board meeting noted that differentiating the designation of risk components between financial and non-financial hedged items had no rational basis. Additionally, the hedge effectiveness model developed under this project may result in distortion of the hedge ratio should designation of risk components not be allowed.

The staff initially recommended aligning the risk components for both financial and non-financial items so long as "the risk component is reliably measurable — for which identifiability of the risk component is a precondition." The Board was generally supportive of permitting risk component designation for non-financial items; however, there was concern over the staff's proposed language as it implied a change for financial items as to what is currently within IAS 39. The staff clarified that the intention was not to substantively change the requirements but rather to provide the requirement in its logical order. However, because of certain Board member concerns on how the change in language would be interpreted, the staff said it would retain the current language within IAS 39 related to "separately identifiable" and "reliably measurable". The Board tentatively agreed to permit designation of risk components for both financial and non-financial items when the risk components are separately identifiable and reliably measurable.

Time value of options

Another common practice issue under the current hedge accounting model relates to consideration of the time value of money for option-type derivatives. IAS 39 currently requires an entity to choose between designating as the hedging instrument either the option-type derivative in its entirety or separating the time value of the option and designating only the intrinsic value of the option. However, in reality, this results in the requirement to separate the time value component of the option; otherwise the amount of ineffectiveness recognised in the hedging relationship associated with the time value of the option would likely fall outside of the 80-125 effectiveness threshold. When the time value component of the option is separated, it is treated as held-for-trading and measured at fair value through profit or loss.

This issue is particularly concerning as the accounting requirements are currently driving risk management decision making as risk managers opt for the use of non-option derivatives over option-type derivatives because of the accounting implications rather than the economic implications.

The staff developed an approach for considering the time value component of an option as an insurance premium. Under the "insurance premium view", for transaction related hedged items (e.g., forecast purchase of a commodity) the cumulative change in the fair value of the option attributable to time value would be recognised in OCI and then recycled (capitalised for a non-financial asset or into profit or loss for hedged sales). Likewise, for time period related hedged items (e.g., hedging existing commodity inventory over a time period) the cumulative change in the fair value of the option attributable to time value would be recognised in OCI and amortised to profit or loss as insurance premium paid on a rational basis. To avoid accounting issues associated ith option terms not matching the hedged items, if the actual time value is less than the time value of an option that perfectly matches the hedged item, then the amount recognised in accumulated AOCI would be determined as the lower of the fair value change of the actual time value and the time value of the "perfect" option. Those amounts in OCI would also be subject to an impairment test.

The Board had mixed views on the proposal developed by the staff. Some Board members felt the proposal helped to maintain consistency with the overall hedging model being developed. Other Board members expressed "reluctant support" for the proposal, acknowledging the problem within IAS 39 but not whole heartedly behind the proposal as the best alternative and questioned whether this was a better answer than the current guidance in IAS 39. Two Board members did not support the proposal, one because he felt it added additional complexity and the other because he disapproved of the capitalisation of the option value for transaction related hedged items (the capitalisation issue was also raised by some of those Board members in the "reluctant support" category.

The Board tentatively agreed to the "insurance premium view" of accounting for the time value associated with options but will include in the exposure draft a specific question regarding the capitalisation issue.

Cash Instruments as Eligible Hedging Instruments

At the 5 October, 2010 Board meeting, the Board was presented with three alternatives of whether to permit cash instruments (e.g., financial instruments) as eligible hedging instruments in a hedge accounting relationship. Those alternatives included retaining the current guidance within IAS 39 which limits the use of cash instruments to hedges of foreign exchange risk, permitting only those financial instruments measured at fair value through profit or loss as eligible hedging instruments, or permitting all financial instruments as eligible hedging instruments.

Today, the Board resumed their consideration on this topic. The Board tentatively decided to permit financial instruments measured at fair value through profit and loss as eligible hedging instruments, in part because their measurement attribute is similar to that of a derivative. One Board member disagreed as he felt the staff had not made a sufficient case as to what practice issue the expansion of the scope of use of cash instruments as hedging instruments was attempting to address. He felt the question should be asked in the exposure draft and then any decisions could be made at that point. However, the Chairman noted that such an approach could require re-exposure.

Transition

Because of the inherent complexity of applying a new hedge accounting model, the Board tentatively agreed to only require prospective application of the proposed amendments, but that the amendments would apply to all hedging relationships and not just those designated subsequent to initial application. However, for those fair value hedge accounting relationships existing under IAS 39 and continuing under the new model, separate presentation of the hedged item valuation allowance would be required for the entire life of the hedge.

Hedge accounting relationships under IAS 39 that qualify under the new model would be considered continuing hedges (i.e., no discontinuation and restart). However, hedge accounting relationships under IAS 39 that do not qualify under the proposed model would be subject to the guidance regarding discontinuation of hedge accounting.

The proposed amendments will include adoption guidance similar to that of IFRS 9 with the proposed effective date of annual periods beginning on or after 1 January 2013 with earlier application permitted. Entities would only be able to early adopt these provisions if they also adopt all other IFRS 9 requirements that were finalised earlier.

Drafting of Exposure Draft

As today marked the end of planned deliberations on phase one of the hedge accounting project, the Board agreed to permit the staff to begin drafting of the forthcoming exposure draft. The staff noted that they would continue developing the portfolio hedging phase of the project but because of the time requirements they were working under, those proposals would form part of a separate exposure draft at a future date.

The Board also agreed on a 90 day comment period on the exposure draft and the plan is to issue the exposure draft sometime before year end. Certain Board members expressed concern with not providing a 120 day comment period, in particular because of the holidays and that calendar year end companies will be preparing their financial statements during this period. However, the Chairman affirmed that to meet the 30 June 2010 deadline, a 90 day comment period must be used in order to provide the staff with time for redeliberations during the second quarter of 2011.

The staff also asked the Board if anyone intended to dissent (or provide an alternative view). One Board member mentioned his intention to dissent citing disagreement with several Board decisions, including using cash instruments as eligible hedging instruments and permitting net hedging with the use of either a small or no derivative as the hedging instrument. He also feels that the proposals do not achieve a reduction in complexity (any reduction in complexity is offset by additional complexities elsewhere in the proposals) and will result in financial reporting that is more difficult to understand.

Discussion at the November 2010 IASB Meeting

Continuing from its preliminary discussions from the September 2010 meeting, the IASB discussed portfolio hedge accounting (also referred to as macro hedge accounting) at today's meeting. It provided the Board with an overview to their approach in developing a fair value hedge accounting model for a portfolio of prepayable fixed rate assets/liabilities.

The staff first provided a brief overview of common bank strategies for economically hedging interest rate risk. The staff then provided a summary of the current hedge accounting alternatives available under IAS 39 and discussed whether the alternatives effectively portray the economic objective of a bank that hedges interest rate risk on prepayable fixed rate assets/liabilities on a portfolio basis. The staff discussed the requirement to use a proportional approach to identify the hedged item under the current accounting model before outlining a basis to consider the use of an alternative bottom layer approach when identifying the hedged item.

For purposes of its deliberations, the staff encouraged the Board to consider the following points:

• When hedging interest rate risk, a key objective of a bank is to stabilise net interest margin over a given period
• A bank would typically under-hedge its interest rate exposure
• A bank hedging interest rate risk will consider both fixed rate and floating rate assets and liabilities together and not focus only on one type of instrument (e.g., fixed or floating) on one side of the balance sheet (e.g., asset or liability), and
• Matching interest cash flows on both sides of the balance sheet not only reduces cash flow variability but also reduces fair value variability due to changes in interest rates. However, the risk management objective is not to fully offset the fair value change of pre-payable items due to changes in interest rates. It is to stabilise net interest margin.

The staff noted that while many banks apply a fair value hedge accounting model, the model's objective is not fully consistent with a bank's risk management policy. Accordingly, the staff outlined two alternative approaches to address the inconsistency:

• Develop an entirely new hedge accounting model with different objectives to the current cash flow or fair value hedge alternatives that is consistent with the risk management objective (i.e., what is currently in IAS 39), or
• Make certain changes to the objective and workings of the current model under IAS 39 to make it more operational and consistent with the risk management objective.

The staff stated their preference for the second alternative. Accordingly, the staff presented the Board with three proposed changes to the current portfolio fair value hedge accounting for interest rate risk model:

• Proposal #1: Permit the hedge designation to include both benchmark interest rate risk and full prepayment risk (i.e. not just the interest rate risk part of the prepayment risk)
• Proposal #2: Allow an entity to partial term hedge some of the cash flows of a portfolio of prepayable items. As a consequence this allows an entity to only hedge the prepayment risk associated with the hedge cash flows and not all cash flows
• Proposal #3: Allow an entity to view its portfolio of prepayable items as a single unit that behaves in a more predictable manner. With this view an entity can characterise the prepayable nature of the bottom layer cash flows differently to the top layer. In other words, the cash flows in the bottom layer are viewed to be far less exposed to prepayment risk than the cash flows in the top layer.

After providing a summary of their reasoning for each of the proposed changes, the staff asked the Board if it supported its suggested overall approach to address this issue, as well as its proposals to change the current model to consider a bottom layer approach for defining the hedged item.

The Board's discussion focused on the differences between the use of a proportional approach and a bottom layer approach, with some Board members noting that a proportional approach is more effective when looking at an individual transaction, and not a portfolio.

One Board member expressed concern with the use of a bottom layer approach, noting that a part of a bank's business model is prepayment risk which is in turn interdependent with interest rate risk. The Board member questioned whether it was possible to separate prepayment risk and interest rate risk, and expressed concern that a bottom layer approach might not provide a full depiction of an entity's risk.

Multiple Board members expressed the need for the Board to obtain an understanding of the views of financial statement users, including what types of disclosures would provide relevant and useful information about an entity's risk management and hedging strategies. Another Board member suggested that the Board ask financial statement users about the level of importance that is placed on understanding the changes in fair value of an entity's instruments being hedged in such a portfolio.

By a vote of 10 – 5, the Board tentatively supported the staff's suggested overall approach to address the issue, as well as the proposed changes to the hedge accounting objective to further consider the use of a bottom layer approach in defining the hedged item.

December 2010: IASB publishes exposure draft on hedge accounting

on 9 December 2010, the International Accounting Standards Board (IASB) published for public comment an exposure draft on the accounting for hedging activities. The exposure draft proposes requirements designed to enable companies to better reflect their risk management activities in their financial statements, and, in turn, help investors to understand the effect of those activities on future cash flows.

The proposed model is principle-based, and is designed to more closely align hedge accounting with risk management activities undertaken by companies when hedging their financial and non-financial risk exposures.

Summary of the ED proposals A new hedge accounting model which combines a management view that aims to use information produced internally for risk management purposes and an accounting view that seeks to address risk management issue of the timing of recognition of gains and losses Look only at whether a risk component can be identified and measured, as opposed to determining what can be hedged by type of item (financial or non-financial) Base qualification for hedge accounting on how entities design hedges for risk management purposes and permit hedging relationships to be adjusted without necessarily stopping and potentially restarting hedge accounting Treat the time value premium of a purchased option as a cost of hedging, which will be presented in other comprehensive income (OCI) Extending the use of hedge accounting to net positions (to improve the link to risk management) A comprehensive set of new disclosures that focus on the risks being hedged, how those risks are being managed and the effect of hedging those risks upon the primary financial statements

The exposure draft forms part of the IASB’s overall project to replace IAS 39 Financial Instruments: Recognition and Measurement, and when its proposals are confirmed they will be incorporated into IFRS 9 Financial Instruments. The exposure draft does not include consideration of portfolio macro hedge accounting which the IASB will continue to discuss.

The exposure draft ED/2010/13 Hedge Accounting is open for comment until 9 March 2011. The IASB intends to finalise and issue the proposals during the first half of 2011.

Click for:

• IASB press release (PDF 40k)
• Access to the Exposure Draft (link to IASB's website)
• IASB Snapshot: Hedge Accounting (PDF 106k)

Discussion at the December 2010 IASB Meeting

Education session

The IASB and FASB held an educational session for the IASB staff to present the proposals in ED 2010/13 Hedge Accounting to the FASB.

FASB questions on the hedge accounting proposals were primarily clarifying in nature, focusing on such topics as:

• basis adjustments related to time value of options
• recognition of hedge ineffectiveness when the hedge relationship is rebalanced
• the "other than accidental" offsetting requirements in the effectiveness criteria
• presentation of the hedged item risk adjustment
• application of hedge accounting to groups of items
• application of the disclosure proposals.

The FASB then asked the dissenting IASB member for a summary of his concerns with the proposals. The IASB member gave a brief overview of his concerns primarily focusing on potential abuses including the ability of entities to circumvent the requirements within IFRS 9 and also the ability to "park" amounts within other comprehensive income through designating a hedge relationship. He also cited that the hedge accounting model within IAS 39 has been flipped so that derivatives are now eligible hedged items and cash instruments are no eligible hedging instruments.

The acting Chair of the FASB mentioned what she viewed as a contradiction the IASB's proposals on hedge accounting and the decisions made on the joint offsetting project. In her view, the hedge accounting proposals permit an exception to adjust the recognition of items in profit or loss to more accurately reflect an entity's risk management activities. However, in the offsetting project, an entity is not permitted a similar exception to adjust the balance sheet presentation to reflect their management of credit risk (i.e., through the use of a master netting agreement for derivative settlement in bankruptcy).

Discussion at the March 2011 IASB Meeting

Comment letter summary

The comment period on the hedge accounting exposure draft closed on 9 March 2011. During the comment period, the IASB members and staff conducted extensive outreach activities across the globe with various constituents. During this meeting, the staff provided the Board with an update on the outreach activities and a summary of the comment letters received as of 9 March 2011. This was an educational session only and no decisions were made.

The outreach activities were held on six continents with 145 separate meetings involving over 2,500 participants. Those participants included preparers (including treasurers and risk managers), auditors, regulators, users and national standard setters.

Objective

Almost all constituents support the proposed objective of hedge accounting to better align the hedge accounting requirements and an entity's risk management activities. However, many feel the objective should not be limited to items impacting profit or loss but also extend to those items impacting other comprehensive income. Additionally, some commented that the term 'risk management' is not defined which could result to divergence in practice or, as some viewed it, as another test to achieve hedge accounting. Some comment letter respondents did not support the proposed objective as they believe the only purpose for hedge accounting is to eliminate an accounting anomaly.

Eligible Hedging Instruments

Almost all respondents support the eligibility of non-derivative financial assets and financial liabilities measured at fair value through profit or loss as hedging instruments. The outreach activities identified that in certain jurisdictions (specifically parts of Asia) the use of derivatives is restricted by regulators; the expansion of permitting non-derivatives as hedging instruments is particularly supported by these constituents.

Eligible Hedged Items

Most of the participants/respondents are supportive of the exposure draft's proposals related to aggregated exposures (permitting an eligible hedged item and derivative to be combined and designated as a hedged item). However, many asked for additional clarification and guidance including information on (1) how the hedge accounting mechanics should be applied for complex hedges, (2) how hedge effectiveness should be assessed, and (3) how hedge ineffectiveness should be measured.

Almost all participants/respondents strongly support the proposal to extend the ability to designate risk components for non-financial items as well as financial items. However, many requested additional guidance for non-contractually specified risk components as there were concerns over the potential for divergence in practice. Additionally, many participants had concerns over the restriction of entities not being able to designate an inflation component in a financial item. Similar concerns were raised by financial institutions about the Boards not addressing the hedging of credit risk.

Most participants/respondents support the exposure draft's proposals to allow designation of a layer component for fair value hedges. Most participants (particularly financial institutions) would like the proposal to also extend to prepayable items where the prepayment option's fair value is affected by changes in the hedged risk. Many would also like to see the prepayment option issue addressed as part of the deliberations on macro hedging. Many comment letter respondents requested the Board clarify whether the designation of a top-layer approach for an open population of items would be permitted (IAS 39 specifically mentions the population cannot be identified while the exposure draft was silent).

Many participants/respondents raised concerns with the exposure draft's prohibition of cash flow components being larger than the cash flows of the entire item ('the sub-libor issue'). Constituents noted that this issue did not apply only to financial institutions with the the sub-libor issue but also to non-financial institutions where negative spreads (or discounts) occur in contracts due to differences in quality between the hedged item and the benchmark.

Hedge Effectiveness

Almost all participants/respondents are supportive of the removal of the 80-125% effectiveness threshold and the retrospective effectiveness test requirement and replacing with a more principles-based approach. Some of the participants/respondents requested more stringent guidance for qualifying for hedge accounting including some who suggested the use of the FASB's proposal of a 'reasonably effective' threshold. However, other respondents expressed concern that the proposed approach implies a higher threshold than the existing 80-125% requirement (interpreting the 'unbiased' term to assume 100% effectiveness). Some others had concern over the requirement to minimise ineffectiveness also implies that a 'perfect' derivative must be utilised rather than the most economical derivative which meets management's risk management objective.

Rebalancing/Discontinuing the Hedging Relationship

Participants/respondents had mixed views on the requirement to rebalance the hedging relationship when the hedging relationship fails to meet the objective but the risk management objective is unchanged. Most support a rebalancing notion and believe it may address current practice issues under IAS 39. However, many requested additional guidance on those events that would be considered to require rebalancing and those events that would not. Some also believe that mandatory rebalancing could also be onerous on computer systems.

Many participants/respondents had concerns or requested additional clarification on the exposure draft's proposal that did not permit voluntary discontinuance of hedge accounting. Many felt that voluntary discontinuance is important for dynamic hedging strategies and questioned what level of risk management strategy should be considered in determining if discontinuance was appropriate - the hedging relationship level or some higher level (e.g., portfolio basis). Some also felt that as applying hedge accounting is options, discontinuing hedge accounting should also be optional.

Presentation and Disclosure

There are also mixed views by participants/respondents over the exposure draft's proposals for presentation of fair value hedges (where the hedged item is adjusted in a separate line item in the statement of financial position and effectiveness recognised in other comprehensive income while ineffectiveness recognised in profit or loss). While some welcome the proposals, others have concerns over the statement of financial position becoming 'cluttered' with the additional of separate valuation line items and questioned whether the valuation line item met the definition of an asset or liability. Many respondents also have concerns with expanding the use of other comprehensive income prior to the Board addressing the overall purpose of other comprehensive income. Also mentioned as a concern were operational complexities over tracking additional amounts in other comprehensive income. Most respondents agreed with the proposal not to allow linked presentation although constituents in Korea were particularly supportive allowing linked presentation.

Most participants/respondents agreed with the objective of the proposed disclosure requirements but have concerns with some of the proposed disclosures. Those concerns primarily focused on the requirement to disclose forward looking information and commercially sensitive information (such as locking into specific hedged rates in future periods). Participants/respondents mentioned that the requirement to disclose such information may impact the decision of whether to apply hedge accounting.

Time Value of Options

Most participants/respondents are supportive of the proposals regarding accounting for the time value of options. Some commented that the proposals would add complexity and preferred a single approach for all options or proposed alternative models.

Groups of Items

Respondents were generally supportive of the proposals regarding hedging groups of items, but many view this topic as part of the macro hedging discussions and therefore reserved comment until those proposals are finalised.

Contracts for non-financial items that can be settled in cash as a derivative

Most participants/respondents generally supported the proposal but some requested additional clarification such as whether the proposal would affect contracts which cannot be settled net in cash. Also, some requested the proposal to be extended to risk management strategies which are not managed to be close to zero. Some respondents had concerns over the requirement aspect of the proposal and preferred an option approach instead, similar to that in US GAAP.

Effective Date and Transition

Most participants/respondents agreed with the prospective application requirements. However, certain jurisdictions (Australia and New Zealand) requested retrospective application be permitted for the provision on time value of options as applying on a prospective basis would not capture the previous changes in fair value in other comprehensive income. Some respondents also requested early application of only the hedge accounting provisions (without early adopting other aspects of IFRS 9) for non-financial items.

Discussion at the April 2011 IASB Meeting

Eligibility of Equity Investments at Fair Value through Other Comprehensive Income as Hedged Items

The hedge accounting exposure draft prohibited designating financial instruments carried at fair value through other comprehensive income (FVTOCI) as eligible hedged items because the risk exposure being managed did not impact profit or loss as the gains and losses recognised in OCI are never recycled to profit or loss. Several comment letter respondents raised this issue requesting the board to also permit these items as eligible hedged items. They asserted that while these equity investments may not impact profit or loss, they are often times hedged in a similar manner to other financial investments at fair value through profit and loss. In particular, they noted hedging these investments for foreign exchange risk and the hedging of equity price risk.

The Board considered whether to retain the prohibition in the exposure draft or to allow designation of equity investments as eligible hedged items, and if so, how to deal with the ineffectiveness that results from the hedging relationship.

The Board was quite divided on the issue. Certain Board members were vehemently opposed to allowing hedge accounting for these investments as they believed it could encourage further use of this designation category under IFRS 9. The Board’s intention with creating this category was only for strategic investments, but because of difficulty in defining the term strategic appropriately left it available to items not held for trading.

Some of these Board members suggested that IFRS 9 be reopened in order to properly narrow the scope of the FVTOCI designation. Others felt that the FVTOCI category was an exception and now they were being asked to create another exception to resolve issues around the initial exception. One IASB member mentioned he would be open to consideration of allowing investments at FVTOCI as hedged items if the dividends on those investments were also recognised in OCI rather than in profit or loss. The IASB Chair mentioned he would be open to permitting a one-time election at initial recognition of the hedge accounting provisions to move items previously designated at FVTOCI to fair value through profit or loss in order to achieve hedge accounting.

However, other Board members empathised with the concerns raised by constituents and felt the accounting should portray the risk management activities. Ultimately, the Board tentatively decided in a narrow vote (8-7) to permit equity investments designated at FVTOCI as eligible hedged items. The Board also agreed that any ineffectiveness resulting from the hedging relationship to be recognised in OCI.

Based on the vote of the Board, one IASB member requested that IFRS 9 be reconsidered in an attempt to narrow the definition of investments eligible for designation at FVTOCI.

Once the decision to permit investments designated at FVTOCI as eligible hedged items was made, the Board then had to consider whether to limit the scope expansion just to this item or whether to expand the scope of hedge accountings to all risk exposure that impact profit or loss or other comprehensive income. The other primary component of OCI where entities will utilise economic hedging relates to defined benefit obligations. The Board had hesitations over expanding the scope of hedge accounting to all items impacting comprehensive income and tentatively decided to limit eligible hedged items to only those equity investments designated at FVTOCI.

Sub-LIBOR Issue

The hedge accounting exposure draft carried forward the existing hedge accounting guidance from IAS 39 related to designation of portions of items that are larger than the cash flows of the hedged item (commonly referred to as the ‘sub-LIBOR issue’). While the issue is not limited only to hedging of interest rate risk, this is where the issue primarily arises; specifically because certain instruments are priced sub-LIBOR and therefore have cash flows less than the benchmark interest rate.

During the comment letter process and Board’s outreach activities, the staff recognised there was some level of confusion around the guidance included in the exposure draft. Some respondents requested that the Board differentiate between sub-LIBOR instruments with a floor at zero per cent and instruments without a floor as the original agenda paper prepared by the staff noted the issue only arises when the interest-bearing instrument has a floor. Additionally, respondents requested the Board reconsider the restriction with respect to 1) hedging a net exposure where the aim is to lock in a fixed interest margin, 2) hedging a non-financial item priced below the benchmark, and 3) hedging of core deposits and macro hedge accounting.

For the discussions today, the staff asked the Board to focus solely on the issue of using a hedging instrument based on a benchmark risk to hedge an item with total cash flows less than those associated with that benchmark, and the purpose is to hedge a fixed margin between an interest-bearing financial asset and an interest-bearing financial liability.

The staff proposed retaining the restriction from the exposure draft for portions of items larger than the cash flows of the hedged item when an interest rate floor is in place. Their belief that doing so avoids counterintuitive results such as paying interest on an asset and deferral of hedge ineffectiveness while illustrating that a ‘fixed’ margin does in fact become variable when LIBOR drops below a critical range (i.e., the range of the negative spread to LIBOR).

The discussion began with one Board member asking a question that since the guidance from IAS 39 was carried in to the exposure draft, whether it was possible to get hedge accounting today for these issues. The staff responded that hedge accounting was possible, but because of the 80-125% effectiveness threshold, entities may have experienced issues with failing hedge accounting, particularly in today’s current low interest rate environment. One Board member suggested that taking a second look at the wording in the exposure draft may help to resolve a lot of the questions around the issue. The Board tentatively decided to retain the restriction in the exposure draft when an interest rate floor is in place but to consider ways to further clarify the guidance.

Cash Instruments as Eligible Hedging Instruments

The hedge accounting exposure draft proposed that financial instruments carried at fair value through profit or loss be eligible hedging instruments. Comment letter respondents raised certain issues related to this part of the proposals.

Eligibility of Cash Instruments Not Measured at Fair Value through Profit or Loss

Some of the respondents requested that cash instruments not designated at fair value through profit or loss (i.e., amortised cost) also be eligible hedging instruments as they asserted conceptually there was no basis for differentiation.

The Board had little interest in expanding the proposal beyond its original scope and tentatively decided to limit cash instruments as eligible hedging instrument to those cash instruments measured at fair value through profit or loss.

However, the discussion turned to a broader discussion of the proposals around eligibility of cash instruments. One of the Board members raised the concern over the possibility of creation of ‘synthetic’ available-for-sale classification where one equity instrument is used to hedge the purchase of another equity instrument in a cash flow hedge. He believed that the use of cash instruments should be limited only to fair value hedges because of this reason. The IASB Chair requested the staff develop an example for future consideration by the Board.

Eligibility of Cash Instruments Designated under the Fair Value Option

Some of the respondents thought the Board was not restrictive enough in their proposals related to the eligibility of cash instruments as hedging instruments. In particular, it was noted that assets carried at fair value through profit or loss from election of the ‘fair value option’ would have been done so to eliminate an accounting mismatch. Therefore, application of hedge accounting would undermine the rational for initial election of the fair value option. Additionally, it was noted that for liabilities designated under the fair value option, the credit component is recognised in profit or loss while other changes in fair value are recognised in OCI.

In considering these comments, the staff felt that a blanket prohibition of items designated under the fair value option may be overly restrictive. This is because items may have been initially designated to reduce an accounting mismatch, however because of the irrevocable nature of the fair value option the accounting mismatch may no longer exist and the entity may now wish to designate the item as a hedging instrument in a hedge relationship. However, the staff recognised the need to clarify the issue around financial liabilities designated under the fair value option and their mixed recognition approach (between profit or loss and OCI).

The Board tentatively agreed not to restrict financial instruments designated under the fair value option as eligible hedging instruments but to clarify that financial liabilities designated under the fair value option where part of the change in fair value is recognised in OCI should not be eligible.

Macro Hedge Accounting

The Board held an education session on the forthcoming macro hedge accounting project. No decisions were made during this session.

Based on the research performed to date, the initial observations communicated to the Board included that the risk profile of a portfolio is different from the risk profile of the various individual items. This is due in part to the ‘law of large numbers’, from a statistical standpoint, the greater the number of items will reduce the actual deviation between actual and expected cash flows. Another key observation was that various approaches may be utilised in managing the risk associated with the portfolio. In the example of managing a portfolio of prepayable interest rate assets, potential risk management alternatives include using interest rate options, hedging the portfolio on the basis of tranches (layers based on probability of prepayment), and using dynamic strategies with open portfolios (considering future events and interdependencies between scenarios). One other observation is that hedging strategies for portfolios may focus on cash flows, fair value, income or some combination of some or all of those. Therefore, the existing cash flow and fair value hedge accounting models may not perfectly fit a macro hedge accounting model.

One of the IASB members noted the example used in the agenda paper focused on a bank’s portfolio of interest rate assets. He mentioned that during outreach on hedge accounting, several energy companies had enquired on the macro hedge accounting project and wanted to understand what the scope of the project would include. The staff clarified that the same challenges banks may face in applying hedge accounting to their portfolios, energy, utility and other companies may face in dealing with portfolios of commodities. As such, this project is not intended to address any specific industry or risk but a broad coverage of the use of portfolios to manage risk.

Another IASB member asked a question on the comment made about portfolios may manage risks somewhere between managing fair values and managing cash flows, specifically would the current hedge accounting models not work for portfolios. The staff responded that it may work, but there may need to be adjustments in order to fit portfolio hedging strategies.

Another IASB member encouraged the staff to hold education sessions with financial and non-financial risk managers to provide the Board with insights on the techniques utilised by companies for portfolio level hedging strategies.

Discussion at the Special 27 April 2011 IASB Meeting

As part of its continued deliberations surrounding the Exposure Draft Hedge Accounting (ED), the IASB (individually, the “Board”) deliberated on the following topics:

The Board made a number of tentative decisions in the conduct of these deliberations, as summarised below:

Accounting for the time value of options for 'zero-cost' collars

• the accounting for zero-cost collars and the time value of options would be aligned.

Accounting for nominal components

• fair value changes of the hedging instrument and the hedged item would be taken immediately to profit or loss as is currently required by IAS 39, rather than OCI which was proposed in the ED, with elevated disclosure in the notes to the financial statements that provide the extent of risk management activities and offsetting achieved by hedges;
• the gain or loss on the hedged item attributable to the hedged risk should be reflected as an adjustment to the carrying amount of the hedged item as is currently required by IAS 39, rather than as a separate line item in the statement of financial position which was proposed in the ED, with disclosure of the fair value hedge adjustment in the notes to the financial statements; and
• linked presentation would not be allowed for the purposes of hedge accounting.

Accounting for fair value hedges

• fair value changes of the hedging instrument and the hedged item would be taken immediately to profit or loss as is currently required by IAS 39, rather than OCI which was proposed in the ED, with elevated disclosure in the notes to the financial statements that provide the extent of risk management activities and offetting achieved by hedges;
• the gain or loss on the hedged item attributable to the hedged risk should be reflected as an adjustment to the carrying amount of the hedged item as is currently required by IAS 39, rather than as a separate line item in the statement of financial position which was proposed in the ED, with disclosure of the fair value hedge adjustment in the notes to the financial statements; and
• linked presentation would not be allowed for the purposes of hedge accounting.

Accounting for time value of options — 'zero-cost' collars

As part of the ED, the Board proposed that the time value of options, representative of a premium for protection against risk ('insurance premium' view), would be treated as a cost of hedging, whereby the time value paid in a hedging instrument is deferred in other comprehensive income (OCI) with any subsequent changes in the fair value of the time value accumulated in OCI and reclassified or released to profit or loss depending on the type of the hedged item.

In this meeting, the Board discussed zero-cost collars, which for purposes of this discussion, are representative of a combination of put and call options for the sale (or purchase) of a commodity and have a combined net nil cost (time value) at inception. Given the Board's earlier proposals in the ED, the treatment for time value of options would not apply to zero-cost collars because these collars have no (net) time value at inception. Therefore, the staff sought clarity from the Board as to whether the final requirements for the accounting for time value of options should also apply to zero-cost collars, given that zero-cost collars do provide for fluctuating time value components over the life of the hedging relationship, even absent a time value component at inception. We also acknowledge that the Board has not yet redeliberated on the ED proposal on the time value of options, as this topic is reserved for a future meeting. Instead, the purpose of today's deliberation related strictly on whether the accounting for zero-cost collars and other time value options should be aligned.

The staff highlighted comment letter and outreach feedback in which many respondents viewed that the proposed accounting for purchased options should also apply to all zero-cost collars; highlighting the susceptibility of transaction structuring if alignment is not applied.

Several Board members considered that from a risk management perspective, the change in time value of the combined purchased and written options is exactly the same as for other options used for hedging purposes, with a zero-cost collar generally used to reduce the cost of hedging. Therefore, time value would be viewed as temporary volatility consistent with an upfront premium / cost.

One IASB member expressed concern regarding presentation of zero-cost collars within OCI, as he feared that OCI would be a dumping ground for other option activity. More specifically, he noted that the distinction of zero-cost collars and forward point contracts was not readily distinguishable, and from that perspective, he expressed concern with the implications of aligning zero-cost collars and time value options given that the ED currently proposed to account for the latter within OCI (although the accounting will be redeliberated at a future meeting).

The Board tentatively decided that the treatment for zero-cost collars should be aligned with that of the treatment for time value of options, although the final requirements for the accounting of the time value of options will be deliberated at a future meeting.

Nominal components — layers

Following from outreach questions posed in the ED regarding the designation of a layer of the nominal amount of an item as a hedged item, the Board considered whether to retain the proposals in the ED or change the eligibility of a layer-based designation of hedged items in some circumstances when the hedged item includes a prepayment option. In particular, the ED proposed that (a) a layer component of the nominal amount of an item would be eligible for designation as a hedged item and (b) a layer component of a contract that includes a prepayment option would not be eligible as a hedged item in a fair value hedge if the option's fair value is affected by changes in the hedged risk. These proposals would change how an entity could designate the hedged item for scenarios other than forecast transactions, for which a layer-based designation is already permitted under IAS 39.

The staff presented comment letter and outreach activity feedback, in which most respondents agreed with the proposal that a layer component of the nominal amount of an item should be eligible for designation as a hedged item, while mixed feedback was present regarding the proposal that a layer component of a contract that includes a prepayment option would not be eligible as a hedged item in a fair value hedge, with dissenting respondents highlighting that the proposal is inconsistent with common risk management strategies and the value of a prepayment option of a bottom layer is irrelevant.

In determining whether to retain the proposals in the ED or change the eligibility of a layer-based designation of hedged items in some circumstances, the Board considered the following:

Eligibility of layer designation

Given overwhelming support from respondents, and as considered in the Basis for Conclusions section of the ED, the Board confirmed the proposals in the ED of allowing layer-based designation of a hedged item (when the item does not include a prepayment option whose fair value is affected by changes in the hedged risk). The Board noted the necessary inclusion of a top layer designation example in a final standard based on constituent outreach requesting clarity as to whether top layers would be allowed to be designated as the hedged item and whether their eligibility would depend on whether the layer relates to an open or a closed population of items. As the ED did not specifically include a top layer designation, and since this is a change from IAS 39, the staff will add a top layer designation to the examples in any final standard issuance.

Relevant reference point of the prepayment option

Responding to feedback received from outreach which noted that the ED was not sufficiently clear as to the designation application for partially prepayable items, the staff recommended that for partially prepayable items, a layer-based designation of the hedge item should be allowed for those amounts that are not prepayable at the time of designation. This recommendation is based on agreement with respondents that the prepayment option is only relevant if it relates to the designated layer instead of the entire item or contract, while also considering that eligibility of layer-based designation would be consistent with the Board's rationale for the proposals regarding the effect of prepayment options for layer-based designations.

The Board tentatively agreed with the recommendation of the staff, but one IASB member cited that the assessment should consider interdependence of the relationship as opposed to describing the transaction as partially prepayable (e.g., basis risk versus separability risk).

Designation including the effect of a prepayment option

Based on outreach feedback, the staff then asked the Board to consider an environment in which prepayable items are not prepayable at par, but instead, include a mechanism to compensate the lender for early repayment (e.g., 'make whole' provision) or another prepayment option. The ED cited that if these result in aggregate in an exercise price of the prepayment option at fair value (e.g., repayment at the concurrent fair value on the repayment date), layer-based designation of the hedged item was allowable. However, if the compensation mechanism does not exactly result in an exercise price of the prepayment option at fair value, partial compensation of a layer-based designation is not allowable.

In such an environment, the staff agreed with respondents that a designation of a layer as the hedged item should be allowed if it includes the effect of a related prepayment option when determining the change in fair value of the hedged item. It was noted that this designation would not conflict with the Board's rationale in proposal and would allow entities to align accounting with their risk management while also capturing the effect of prepayment penalties.

Two Board members disagreed with this proposal in highlighting the staff's proposal would not apply a proportionate basis as historically applied under IAS 39, and thus, would not appropriately capture the basis risk independent of the separability risk (e.g., the macro hedge accounting concern which was expressed as part of the 12-15 April 2011 Board meeting).

The Board tentatively decided that a designation of a layer as the hedged item should be allowed if it includes the effect of a related prepayment option when determining the change in fair value of the hedged item, but requested future deliberation which considers feedback expressed in the two dissenting votes outlined above.

Differentiation between written and purchased prepayment options

Following respondent feedback that for the eligibility of layer-based designation of hedged items, written and purchased prepayment options should be differentiated, the staff disagreed with respondents and noted (a) the hedged risk affects the fair value of a prepayment option irrespective of whether the particular option holder actually exercises it at that time or intends to actually exercise it in the future and (b) this would conflict with the Board's rationale in proposal.

Following this feedback, the Board tentatively decided to not differentiate written and purchased prepayment options for the purpose of the eligibility of layer-based designation of hedged items, as consistent with the ED.

Accounting for fair value hedges

Following from outreach questions posed in the ED regarding the presentation of fair value hedges, the Board deliberated on the presentation of fair value hedges, including the ED's proposals of (a) presenting gain or loss on the hedging instrument and hedged item in OCI, with the ineffective portion of the gain or loss transferred to profit or loss, (b) presenting the gain or loss on the hedged item attributable to the hedged risk as a separate line item in the statement of financial position and (c) the disallowance of linked presentation.

Recognising gain or loss on the hedging instrument and hedged item in OCI

Feedback from respondents highlighted that most users supported the Board's proposals for purposes of providing clarity and transparency to the financial statements, and summarising, in one location, the effects of risk management activities (for both cash flow and fair value hedges). Further, such a presentation was believed to provide useful information about the extent of offsetting achieved (e.g., the extent of effectiveness). A minority of respondents, however, highlighted that the use of OCI should be limited until the Board completes its project on what OCI is expected to represent, and thus, did not support the use of presentation within OCI.

Several Board members agreed that the information on the extent of offset, and other risk management considerations, would be useful to users of the financial statements, and thus, agreed that presentation should be clearly provided either on the face of the financial statements or within the notes. A majority of the Board highlighted, however, that inclusion of the effects of risk management activities on the face of the financial statements would be unduly burdensome and limit the usefulness given the addition of a significant number of line items to the financial statements. Similarly, Board members expressed concern with presentation of activity within OCI given the lack of clarity on the definition of OCI.

Following on this discussion, several Board members cited a preference for the approach applied in IAS 39 in which gains and losses on the hedging instrument and the hedged item are presented in profit or loss (for fair value hedges) and OCI (for cash flow hedges), with elevated comprehensive disclosure to provide the effects of risk management activities as well as the extent of the offsetting achieved by hedges. Specific disclosure requirements will be considered in a future meeting. The Board tentatively concurred with this approach. Several Board members expressed a desire to perform specific outreach on this tentative decision given that it differs from the ED proposal which was supported by the majority of outreach respondents.

Separate line item in the statement of financial position

The ED proposed that the gain or loss on the hedged item attributable to the hedged risk should be presented as a separate line item in the statement of financial position in an effort to eliminate the mixed measurement for the hedged item (e.g., an amount that is amortised cost with a partial fair value adjustment).

The staff presented outreach feedback received, in which the majority of respondents and participants supported the elimination of the mixed measurement presentation of the hedged item on the face of the statement of financial position. Most users supported the separate line item presentation and viewed it as useful information, because the effect of the fair value hedges would be transparent on the face of the statement of financial position. These same respondents expressed concern, however, over the additional line items on the face of the financial statements leading to a cluttered presentation, and thus, preferred disclosure in the notes.

The Board was accepting of feedback received from outreach activity and highlighted consistent concern regarding cluttered presentation in the statement of financial position.

As such, the Board tentatively decided to apply the same presentation requirements set forth in IAS 39 (gain or loss on the hedged item attributable to the hedged risk should be reflected as an adjustment to the carying amount of the hedged item), in which the hedge adjustment would be disclosed in the notes to the financial statements.

Linked presentation

The ED proposed not to allow the use of linked presentation for the purposes of hedge accounting, noting that while linked presentation could provide useful information about a particular relationship between an asset and a liability, it does not differentiate between the types of risk that are covered by that relationship and those that are not.

Most respondents agreed with the Board's proposal not to allow linked presentation given that it is thought to impair comparability across entities' financial statements. However, those supporting linked presentation argued that without it, entities that use hedge accounting might be perceived as riskier than those that do not, as separate presentation may not reflect the 'real' economic effects of hedges of foreign currency risk of firm commitments. The Board tentatively decided to retain its original proposal not to allow linked presentation based on the inability to differentiate between the types of risks covered by a relationship, but noted that an industry roundtable is expected on the topic at a later date.

Discussion at the Special 12 May 2011 IASB Meeting

Hedge Effectiveness Assessment

Feedback provided during the Board’s outreach activities and comments received from the hedge accounting exposure draft identified that constituents were very supportive of the removal of the 80-125% brightline threshold and the required quantitative retrospective hedge effectiveness test. Additionally, most supported the introduction of a qualitative hedge effectiveness assessment to qualify for hedge accounting. However, constituents had some concerns with the exposure drafts’ objective based hedge effectiveness assessment proposals.

The staff’s analysis attributed some of that concern to the introduction of new terms and concepts that constituents were not previously familiar with. However, the staff also acknowledged that some of the proposals were being misinterpreted or had unintended consequences. For example, some constituents felt that the proposed requirement that a hedging relationship produce an ‘unbiased result’ that ‘minimises expected ineffectiveness’ would require entities to find the ‘perfect’ derivative rather than a derivative that is most economical and which meets the risk management objective (i.e., effectively replacing the 80-125% effectiveness threshold with a 100% hedge effectiveness requirement). Some respondents also noted that the effectiveness test requirement that ‘no expectation that changes in the value of the hedging instrument will systematically either exceed or be less than the change in value of the hedged item’ could be problematic for ‘late hedges’ when the hedging relationship is entered into at a point after inception of the derivative hedging instrument such that it has an inherent fair value other than nil.

To address the concerns over misunderstanding, lack of clarity and potential unintended consequences, the staff recommended supplementing the term ‘other than accidental offsetting’ by clarifying that a hedging relationship would have to meet the following two criteria: (1) that there is an economic relationship between the hedged item and the hedging instrument, and (2) the effect of credit risk does not dominate the value changes that result from the economic relationship (i.e., the effect of the changes in the underlying). The staff also recommended replacing the guidance in the exposure draft on ‘unbiased hedge’, ‘minimising hedge ineffectiveness’, and ‘the entity has no expectation that changes in the value of the hedging instrument will systematically either exceed or be less than the changes in value of the hedged item such that they would produce a biased result’. Instead, the guidance would be replaced by adding criteria that an entity’s designation of the hedging relationship shall be based on (1) the quantity of hedged item that it actually hedges, and (2) the quantity of the hedging instrument that it actually uses to hedge that quantity of hedged item. Additionally, guidance would be included that an entity shall not designate a hedging relationship such that it reflects a deliberate mismatch between the weightings of the hedged item and the hedging instrument that would create hedge ineffectiveness in order to achieve an inappropriate accounting outcome.

The Board began its discussion by clarifying that this discussion on hedge effectiveness was solely in the context of getting into hedge accounting and not in the context of measuring hedge ineffectiveness. The Board was generally supportive of the staff’s recommendations although there were several comments made on drafting suggestions. Some Board members preferred the usage of ‘anchor’ or ‘umbrella’ terms (such as ‘other than accidental offsetting’ and ‘unbiased result’) feeling that principles based standards require usage of such terms and that overly describing the concepts will only result in additional requests for clarification. However, other Board members felt that adding additional clarity was necessary to ensure the effectiveness criteria were applied as intended by the Board.

The Board had a discussion on whether the revised criteria as recommended by the staff represented a loosening or tightening of 1) the current requirement under IAS 39 and 2) the proposals in the exposure draft. Some Board members felt that the revised criteria represented a tightening of the criteria over both the 80-125% threshold and the exposure draft proposals. Other Board members had concerns over expressing the revised criteria as tightening the requirements in IAS 39 because they felt the current requirements were overly punitive. The staff suggested that the revised criteria could not fairly be compared to the current IAS 39 requirements as ‘looser’ or ‘tighter’ because of the arbitrary results that sometimes occur with the 80-125% threshold. However, the staff acknowledged that the revised criteria should help to tighten the requirements over those in the exposure draft and help to address the concerns of those who interpreted the proposals as allowing inappropriate hedging relationships to qualify for hedge accounting.

Ultimately, the Board supported the staff recommendation subject to wording modification the Board will provide to the staff on the revised hedge effectiveness criteria.

Discussion at the 31 May - 2 June 2011 IASB Meeting

WEDNESDAY, 1 JUNE 2011

Macro hedge accounting – education session

The IASB held an education session on the macro hedge accounting project.

The Board hosted presentations from Toronto Dominion Bank Group (TD Bank) and the European Banking Federation, including representatives from the French Banking Association, Rabobank, BNP Paribas, Intensa Sanpoalo, Commerzbank and HSBC. Both presentations focused on approaches financial institutions utilise to manage risks across the organisation for dynamic portfolios of financial assets and financial liabilities. No decisions were made as part of the education session.

THURSDAY, 2 JUNE 2011

Rebalancing the hedging relationship

The hedge accounting exposure draft introduced the concept of rebalancing a hedging relationship (i.e., reducing or increasing the quantities of the hedging instrument or the hedged item in order to maintain an appropriate hedge ratio). The exposure draft proposed requiring rebalancing the hedging relationship if the risk management objective has not changed but the hedging relationship would otherwise fail the effectiveness assessment. The exposure draft also permitted rebalancing when an entity anticipates that the current hedge ratio may cease to meet the effectiveness assessment in the future. The rebalancing concept was introduced to address issues under IAS 39 where dedesignation and redesignation of a new hedge is required in order to adjust the hedging relationship as well as to facilitate the proposed hedge effectiveness requirements.

Constituents generally supported the introduction of rebalancing the hedging relationship in order to address the issues under IAS 39 regarding dedesignation and redesignation. However, the requirement for mandatory rebalancing raised questions among constituents who requested additional guidance. In particular, they requested guidance on: 1) what level of risk management should be considered for purposes of rebalancing (risk management strategy vs. risk management objective) and 2) the relationship between rebalancing and changes to hedged volumes or amounts. Some constituents also felt the requirement to rebalance should instead be voluntary, noting the exposure draft implies a continual optimisation of 'the perfect hedge ratio', but that in practice risk management may choose not to rebalance a hedging relationship either because doing so would not be cost effective or because the hedging relationship is still within managements acceptable tolerance limits.

During the 12 May 2011 meeting, the Board tentatively decided to change the hedge effectiveness assessment. Those changes (subject to drafting changes) include that the designation of a hedging relationship would be based on the quantity of hedged item that it actually hedges and the quantity of the hedging instrument that it actually uses to hedge that quantity of hedged item provide that it does not reflect an imbalance that would create hedge ineffectiveness in order to achieve an accounting outcome that is inconsistent with the purpose of hedge accounting.

The staff believes it is therefore necessary to align the rebalancing requirements with the tentative decisions on hedge effectiveness assessment. The staff recommended that after the inception of a hedging relationship, rebalancing would occur when an entity adjusts the quantities of the hedging instrument or the hedged item in response to changes in circumstances that affect the hedge ratio of that hedging relationship. However, the hedging relationship for hedge accounting purposes would have to use a different hedge ratio than for risk management purposes if:

• the adjustments for risk management purposes would result in a hedge ratio that would reflect an imbalance that would create hedge ineffectiveness in order to achieve an accounting outcome that is inconsistent with the purpose of hedge accounting or
• for risk management purposes an entity would retain a hedge ratio that in new circumstances would reflect an imbalance that would create hedge ineffectiveness in order to achieve an accounting outcome that is inconsistent with the purpose of hedge accounting (i.e., an entity must not create an imbalance by omitting to adjust the hedge ratio).

By doing so, the staff believes the concept of proactive rebalancing is no longer necessary.

One of the IASB members suggested removing the language of 'in order to achieve an accounting outcome' as he felt that it would be impossible for the Board to make that determination.

Another IASB member mentioned that he had recently heard someone mention that because of rebalancing that an entity would never recognise ineffectiveness. He inquired of the staff why that perception may exist. The staff said it was hard to speculate, but that the exposure draft specifically states that an entity would recognise any ineffectiveness that exists prior to rebalancing the hedging relationship so that perception was incorrect.

The Board tentatively agreed with the staff recommendation to align the rebalancing guidance with the new hedge effectiveness assessment approach.

Discontinuing the hedging relationship

The hedge accounting exposure draft proposes that an entity would discontinue the hedging relationship when the qualifying criteria are no longer met (i.e., the hedging relationship no longer meets the risk management objective and strategy) but does not permit voluntary discontinuance when the risk management objective and strategy is unchanged.

Constituents had mixed views regarding the proposals for discontinuing the hedging relationship. Those supporting the proposal felt it would reinforce the link between risk management and accounting and would improve financial reporting by eliminating a structuring opportunity. Some of those constituents did request additional guidance around the meaning of 'risk management' and at what level risk management should be considered (i.e., the entity wide approach to hedging or a transaction level hedging relationship). However, others felt that entering into hedge accounting was optional and therefore discontinuing hedge accounting should also be optional. In particular, some constituents noted the issues around using voluntary dedesignation as a surrogate approach for portfolio hedging (e.g., banks managing their loan books for interest rate risk when the characteristics of the loan portfolio are constantly changing).

From the constituent feedback received, the staff identified two issues for the Board's consideration 1) whether voluntary discontinuation should be allowed and 2) if clarification is needed regarding the link between the proposed discontinuation requirements and the risk management objective and strategy.

Most of the Board members stated their support for the proposals in the exposure draft as they felt permitting voluntary designation when the initial risk management objective and strategy have not changed would be inconsistent with the overall rational of the project of the accounting better reflecting the risk management activities. They also felt that not permitting voluntary dedesignation works as an anti-abuse clause. One Board member went so far as to express his view that the proposals contained inconsistent logic in that application of hedge accounting was optional while discontinuance was not voluntary; he felt the Board should consider making application of hedge accounting mandatory to be consistent with the approach for discontinuance.

Another Board member raised the topic of the interaction with IAS 8 and accounting policy choices and questioned if an entity made an election to no longer apply hedge accounting entity wide as an accounting policy election if that would be a permitted dedesignation. Both the staff and another Board member felt that hedge accounting is qualified on a transaction by transaction basis and therefore would not be an overall accounting policy election.

One Board member did not support the restriction to not permit voluntary dedesignation. He felt doing so added complexity that people were having difficulty understanding. Additionally, he felt that it was easy enough to circumvent the restriction to not allow for dedesignation by either terminating the hedging instrument or entering into an offsetting position and felt that creating such a restriction did not benefit the hedge accounting model. The incoming deputy Chair also expressed his concern with not permitting voluntary dedesignation.

Ultimately, the Board tentatively decided to retain the prohibition in the exposure draft that voluntary discontinuation of hedge accounting would not be permitted if the risk management strategy and objective remained unchanged. However, additional guidance will be included for instances where hedge accounting is a 'surrogate' for portfolio hedging (e.g., banks managing their loan books for interest rate risk when the characteristics of the loan portfolio are constantly changing) and for hedging relationships that at a specific stage automatically convert to a natural hedge (e.g., hedging foreign currency risk for forecast sales or purchases denominated in a foreign currency). The final standards will also include enhanced guidance on risk management strategy and risk management objective (i.e., risk management strategy is the entity wide approach for managing risk where as risk management objective is the transactional level application of the hedging relationship).

Options as hedging instruments

The Board began discussions on the proposals in the exposure draft related to the accounting for time value of options used as hedging instruments in a hedging relationship. The exposure draft introduced an 'insurance premium' view for the time value of options (i.e., the time value is the cost of hedging). The time value component would be recognised in other comprehensive income and then either expensed for time period related hedges or basis adjusted (or left in OCI) for transaction related hedges.

Two Board members expressed reservations with retaining the proposals in the exposure draft. One noted that he felt the proposals added unneeded complexity and would prefer to see the time value component frozen at inception rather than having the volatility impacting earnings as currently happens under IAS 39. The other Board member felt that the 'cost of insurance' should be recognised in earnings during the coverage period rather than waiting to basis adjust the hedged item for transaction related hedges. However, the Board tentatively decided to retain the proposals in the exposure draft related to the accounting for time value of options.

Constituents had requested additional clarity on the application of the proposals for the accounting for the time value of options, particularly related to differentiating between transaction related and time period related hedged items. The Board tentatively decided to provide additional guidance on the accounting for time value of options including guidance that the amortisation period does not necessarily have to correspond to the period of the hedging relationship but rather to the period over which the hedge adjustment for intrinsic value can affect profit or loss.

Some constituents had suggested the Board establish a principal to assist in better understanding the difference between transaction and time period related hedged items. However, the Board tentatively decided not to create a principal as the suggested principal would not address all items such as hedges of firm commitments.

Some constituents had also suggested that the application of the proposed accounting treatment for time value of options be an accounting policy choice because of the operational complexity associated with the proposals. However, the Board tentatively decided not to introduce an accounting policy choice for the accounting for the time value component of options used as hedging instruments.

Net written options

The hedge accounting exposure draft proposes that a derivative instrument that combines a written option and a purchased option (e.g., an interest rate collar) does not qualify as a hedging instrument if it is a net written option. Similarly, two or more instruments may be designated as the hedging instrument only if none of them is a written option or a net written option.

Constituents have requested the proposals related to net written options be amended so that stand-alone written options combined with other designated hedging instruments that do not result in a net written option be eligible as hedging instruments. This request focuses on the fact that entities will often enter into two separate option contracts that mirror a collar contract rather than a single collar contract because 1) stand alone option contracts are more widely available and therefore more economical as well as reducing credit risk associated with the contract.

One of the Board members was opposed to expanding the use of written options as hedging instruments feeling it would add additional complexity to the hedge accounting requirements. However, other Board members supported the use of multiple contracts that include a component as a written option so long as the net contract was not a net written option and the terms of the options were aligned. The Board tentatively agreed to permit a combination of a written and a purchased option, regardless of whether the instrument arises from a single or multiple contracts, as an eligible hedging instrument unless the combination results in a net written option.
 

Discussion at July 2011 IASB Meeting

WEDNESDAY, 20 JULY 2011 (IASB only)

Forward Points

The hedge accounting exposure draft proposed a change in the accounting for the time value of options but did not propose any changes in the accounting for forward contracts (i.e., an entity may designate either the forward contract in its entirety or the change in the spot element of the forward contract as an eligible hedging instrument. Feedback to the exposure draft requested the board extend the proposals related to time value of options to also include forward points.

The IASB staff noted that the time value of options and forward points do share similar characteristics, in particular that the time value changes over time with the fair value reaching zero at the end of the contract.

Currently under IAS 39, entities who elect to designate the forward contract in its entirety (the 'forward rate method') for transaction related items results in an accounting similar to the proposals in the exposure draft for time value of options (e.g., the initial time value is deferred in OCI and recognised based on the general requirements of the hedged item (i.e., 'basis adjusted'). However, for time period related hedged items, no similar allowance is provided and entities must either use the forward rate method or designate only the spot element (with fair value changes in the forward points recognised as a trading gain or loss). The staff found during outreach this was particularly a relevant issue for financial institutions in Asia who routinely use funding swap transactions. In their view, forward points represent the interest differential between the two currencies at inception and are economically considered an adjustment to the investment yield.

The IASB staff recommended the Board permit the recognition of forward points that exist at inception of a hedging relationship in profit or loss over time on a rational basis and accumulate subsequent fair value changes in accumulated other comprehensive income. One Board member expressed concerns with the proposal stating his view that he looked at forward points as different from time value of options as forward points could be a cost of hedging but could also be an income source. As a result, he considered forward points a basis risk that should be recognised in hedge ineffectiveness. However, other IASB members generally supported the staff recommendation although a couple expressed a preference for making a requirement rather than permitting forward points to be accounted for similar to the approach for time value of options. The Board tentatively agreed to permit the recognition of forward points that exist at inception of a hedging relationship in profit or loss over time on a rational basis and accumulate subsequent fair value changes in accumulated other comprehensive income.

Aggregated Exposures

The hedge accounting exposure draft proposed that if an entity combines an exposure with a derivative in order to create a different aggregated exposure managed as one exposure for a particular risk then that aggregated exposure may be designated as a hedged item.

During outreach activities for the exposure draft, constituents were very supportive of the proposals regarding aggregated exposures as it helps to align hedge accounting with an entity's risk management and removes the current arbitrary restrictions that exist in IAS 39. Only limited constituents disagreed with the proposals; however, several constituents requested the board 1) provide examples to illustrate the accounting mechanics related to aggregated exposures, 2) provide clarification that accounting for aggregated exposures is not a method of 'synthetic accounting' and 3) to clarify whether hedge accounting must be achieved for the combined exposure and derivative as a precondition for the aggregated exposure being an eligible hedged item in another hedging relationship.

Additional topics related to aggregated exposures where constituents asked for further clarity included:

• whether forecast transactions that will constitute aggregated exposures when executed can be designated as an aggregated exposure
• whether derivatives must be designated in their entirety or whether selected cash flows could be designated
• whether a derivative for a shorter period than the non-derivative exposure can still be combined and designated as an aggregated exposure,
• whether derivatives that are basis swaps can be used when hedging aggregated exposures
• how hedge accounting for the aggregated exposures as the hedged item would be impacted if hedge accounting for the combined exposure and derivative were discontinued.

Based on the constituent feedback, the IASB staff recommended that the Board confirm the proposal in the exposure draft subject to providing additional clarifying guidance, include illustrative examples in the final standard, clarify that derivatives that are part of an aggregated exposure are always recognised a separate assets or liabilities and measured at fair value and to provide in the basis for conclusions of the final standard that an aggregate exposure is part of hedge accounting and not a form of 'synthetic accounting', not to impose specific restrictions which would require hedge accounting for the original exposure and derivative that form the aggregated exposure, and to clarify that the notion of an aggregated exposure includes a highly probably forecast transaction of an aggregated exposure if that aggregated exposure once executed is eligible as a hedged item and how to apply the general requirements in the context of designating a derivative as part of an aggregated exposure.

One of the IASB members inquired of the staff on one of the clarification topics in the agenda paper of whether derivatives that are basis swaps can be used when hedging aggregated exposures. The agenda paper highlighted that because the basis swap only changes the type of variability that they do not qualify in either a cash flow or fair value hedge relationship. The Board member mentioned that he would support permitting basis swaps in hedging relationships. Another Board member stated their support for the inclusion of the illustrative examples as he felt that examples provide better clarity than complex and detailed guidance.

However, one Board member stated that he disagreed with permitting aggregated exposures as eligible hedged items in the exposure draft and still had concerns. In fact, he felt as the staff proposals were expanding the ability to hedge aggregated exposures. He would prefer that the Board add more discipline around the initial relationship as he had concerns that entities could override the classification and measurement requirements. Another Board member agreed with this concern.

The Board tentatively agreed to the following:

• reconfirm the proposal in the exposure draft allowing designation of an aggregated exposure as an eligible hedged item
• include illustrative examples in the final standard
• to clarify:
  • in the final standard that derivatives that form part of an aggregated exposure are always recognised as separate assets or liabilities and measured at fair value
  • in the basis for conclusions that the Board noted that accounting for aggregated exposures is part of hedge accounting and different from 'synthetic accounting'
• not impose any specific restrictions regarding the non-derivative original exposure and the derivative that form the aggregated exposure to be an eligible hedged item
• to provide additional clarification to the final standard by:
  • expanding the description of an aggregated exposure to include a highly probable forecast transaction of an aggregated exposure if that aggregated exposure once executed is eligible as a hedged item, and
  • adding application guidance:
    • that the way in which a derivative is designated as a hedged item as part of an aggregated exposure must be consistent with any designation of that derivative as the hedging instrument at the level of the aggregated exposure, and
    • that otherwise a derivative must be designated in its entirety or as a percentage of its nominal amount.
       

FRIDAY, 22 JULY 2011 (IASB only)

Groups and Net Positions

The IASB discussed the proposals in the hedge accounting exposure draft related to hedging groups and net positions. The exposure draft permitted the hedging of groups of items, but for cash flow hedges the exposure draft restricted hedging offsetting cashflows (net positions) when those cash flows affect profit or loss in different periods. This restriction was put in place to address various Board concerns.

The comment letter responses and outreach activities were very supportive of the proposals. However, the feedback received highlighted certain areas where constituents requested additional clarity or flexibility, those issues include:

• uncertainty as to whether the proposals on groups and net positions would be extended to portfolio/macro hedge accounting,
• a request for reconsidering the restriction on the application of hedge accounting to cash flow hedges of a net position with items that affect profit or loss in different periods,
• a request for considering the annual reporting period as the basis for the restriction instead of any reporting period (ie including interim reporting periods), and
• requests for additional guidance on the treatment of the amounts deferred in OCI if, in a cash flow hedge of a net position, the offsetting cash flows initially expected to occur in the same period subsequently change and are now expected to occur in different periods.

To address the request regarding removing the restriction on cash flow hedges impacting profit or loss across reporting periods, the staff presented the Board with five possible alternatives:

• Alternative 1 — Remove the restriction but only for forecast transactions designated in a net position where the forecast transactions are of the same nature and this is specified at the inception of the hedge,
• Alternative 2 — Remove the restriction for forecast transactions designated in a net position only where the reporting period in which the transactions are expected to affect profit or loss (the recognition pattern) and the nature of the transactions is specified at the inception of the hedge,
• Alternative 3 — Remove the restriction for forecast transactions designated in a net position only where the reporting period in which the transaction is expected to affect profit or loss (the recognition pattern), the nature and the volume of each forecasted transaction are specified at the inception of the hedge,
• Alternative 4 — Eliminate the restriction completely, and
• Alternative 5 — Retain the proposals in the exposure draft.

The Board primarily considered Alternative 3 and Alternative 5 based on the staff recommendations. The Board was fairly split on the topic with certain Board members concerned over removing the restriction for cash flow hedges of forecast transactions because of the complexity and the potential for earnings management. Other Board members expressed support for removing the restriction as they pointed out that hedge accounting could be applied by entering in to two separate hedging relationships with derivatives for the gross amounts which seemed overly burdensome and costly when a single derivative for the net position would accomplish the same result. One of the IASB members questioned if there were any risks outside of foreign currency risk where cash flow hedging of forecasted transactions would be used (for example, interest rate risk). The staff noted that the issues that have been raised by constituents have primarily been foreign currency related. The Board member said that limiting the removal of the restriction to only foreign currency transactions would alleviate some of this concerns.

Ultimately, the Board tentatively agreed (9 votes to 6 votes) to extend the eligibility for designation as a hedged item to net positions involving forecast transactions that affect profit or loss in different period when hedging foreign exchange risk.

[Note: The IASB Update clarified the Board’s tentative decision during this session that cash flow hedges of net positions would only be available for hedges of foreign currency risk. The Board also tentatively decided to remove the restriction that the offsetting cash flows in a net position must affect the income statement in the same reporting period. Instead, the eligibility criteria would be extended to require that the items within the net position must be specified in such a way that the pattern of how they will affect the income statement is set out as part of the initial hedge designation.]

The Board also discussed financial statement presentation for hedging of groups and net positions. The exposure draft proposed that gains and losses on the hedging instrument would be presented in a separate financial statement line item when the hedging relationship involves a net position hedge that affects different line items in profit or loss (eg sales and cost of sales). Most comment letter respondents and outreach participants supported the exposure draft proposals; however, some respondents disagreed with the proposals. Those who disagreed felt that, among other reasons, such a net presentation would not adjust the financial statement line items affected by the hedged item and therefore create volatility within those income statement line items. However, the staff also note that presenting the gains or losses on the hedging instrument in as separate line item avoids considering transactions that do not exist (forecast transactions) and presenting artificial gains or losses to achieve a gross presentation.

The Board tentatively agreed that for a hedge of a group of items with offsetting hedged risk positions that affect different line items in the income statement (net position hedges) to present the reclassification of gains or losses on hedging instruments in a separate line item in the income statement without adjusting the line items affected by the forecast transactions.

Discussion at Special 28 July 2011 IASB Meeting

Designation of Risk Components

The hedge accounting exposure draft proposes to expand the ability to designate risk components for separately identifiable and reliably measurable risk components of both financial and non-financial hedged items. In the staff’s view, this proposal aligns the hedge accounting model for financial and non-financial items, more closely aligns hedge accounting with risk management activities and provides information that is more useful for financial statement users.

Constituent views on the proposals were very supportive and they highlighted that this proposal is one of the key aspects of the new hedge accounting model. Many constituents requested additional guidance or clarification, primarily focused on non-contractually specified risk components of non-financial items; however others opposed providing additional guidance for fears that it would result in rule based application. Many constituents also requested the final standard not specifically preclude designating risk components for inflation risk, credit risk, prepayment risk and situations where the component cash flows exceed those of the whole (the ‘sub-LIBOR’ issue although many comments on this topic focused on commodity hedging).

Based on the constituent feedback received, the IASB staff recommended the Board retain the notion or risk components as eligible hedged items using a single set of criteria for both financial and non-financial items based on the component being separately identifiable and reliably measureable. The staff believes that an analysis of the ‘market structure’ is crucial for determining eligible risk components as the market structure determines the parameters for determining eligible risk components and ensures that the risk component cannot simply be imputed from the related hedging instrument. The staff also recommended providing guidance on how to apply the criteria using examples of the analysis required to conclude the risk component is eligible for designation.

A few of the IASB members expressed some concerns with the staff recommendation but from different perspectives. One IASB member asked how restrictive the notion of market structure would be applied; he acknowledged the need for discipline around the designation of risk components but wanted to ensure the model was not so restrictive that it could not be applied in practice. However, another IASB member had serious reservations with the proposal stating he does not believe the model is operational; he felt that if the Board was provided with specific examples they would likely each reach different conclusions. This Board member also said he doesn’t know what ‘market structure’ refers to and that this will undoubtedly lean to huge operational difficulties. He also stated his preference for use of contractually specified risk components instead. Another IASB member expressed concern with the inclusion of examples as he felt they would lead to rules based application.

Other IASB members were more supportive of the staff proposals as they felt that it represents how companies are managing their risks. One IASB member noted that the concept of reliably measurable has worked in practice for financial items. One IASB member stated his view that the current guidance around designation of risk components does not lead to quality financial reporting and therefore retaining the status quo should not be an option. Another IASB member countered that the issue around current practice is the 80-125% effectiveness requirement and therefore designation of the entire item leads to ineffectiveness that could fail hedge accounting qualification. He suggested that the new effectiveness assessment approach in the hedge accounting model may resolve these issues. However, the staff suggested that the 80-125% would not resolve the issue associated with risk components for non-financial items.

Ultimately, the Board tentatively decided [in a 9-1 vote] to retain the notion of risk components as eligible hedged items using a criteria approach in determining eligible risk components based on the hedged item being separately identifiable and reliably measurable for both financial and non-financial items. The Board also tentatively decided [in an 8-2 vote] to prove guidance on how to apply the criteria using examples based on commodity price risk related to coffee purchases, price risk related to jet fuel purchases, and the fair value interest rate risk of a fixed rate bond while also retaining the example of contractually specified risk components in a natural gas contract. The Board also tentatively decided to expand the ‘sub-LIBOR’ example to also include a commodity hedge to illustrate the issues applicable to a market for a non-financial item.

The Board also discussed the issue of inflation risk and the exposure draft’s specific restriction prohibiting designation of inflation risk as an eligible hedged item. The staff provided the Board with the following four alternatives on how to address the issue of inflation risk as a risk component:

• Alternative 1 – Retain the restriction in the exposure draft.
• Alternative 2 – Eliminate the restriction in the exposure draft.
• Alternative 3 – Eliminate the restriction in the exposure draft but add a ‘caution’ or ‘rebuttable presumption’ regarding non-contractually specified risk components of financial items.
• Alternative 4 – Change the outright prohibition in the exposure draft by including an example of a situation in which an inflation risk component is eligible for designation as a risk component and an example of a situation in which inflation risk is not an eligible risk component.

One of the IASB members asked what the caution or rebuttable presumption would look like. The staff responded that both concepts could be incorporated with the rebuttable presumption included in the standard and then including discussion of the caution in the basis for conclusion.

Many of the Board members mentioned their support for Alternative 3 and that Alternative 4 alone would not seem sufficient. One Board member asked if Alternative 4 could be layered on top of Alternative 3 in which the staff said that was a possibility. Ultimately, the Board tentatively decided [in a 7-3 vote] to eliminate the restriction in the exposure draft prohibiting designation of inflation risk as an eligible hedged item. The Board also tentatively decided [in a 9-1 vote] to add a ‘rebuttable presumption’ in the standard and discuss a ‘caution’ in the basis for conclusion regarding non-contractually specified risk components of financial items. The Board also tentatively decided [in a 6-4 vote] to include an example of a situation in which an inflation risk component is eligible for designation as a risk component and an example of a situation in which inflation risk is not an eligible risk component.

Use of Credit Derivatives

During the initial deliberations of the hedge accounting exposure draft, the Board considered methods to address the accounting mismatch which occurs when entities use credit derivatives (eg CDSs) to manage their risk exposures from lending or investment transactions (debt securities, loans and loan commitments). In these scenarios, the debt security or loan is typically measured at amortised cost under IAS 39 (or AFS with gains and losses on fair value remeasurement recognised in OCI) with the loan commitment measured under IAS 37 while the CDS is measured at FVTPL. However, hedge accounting is not readily available because of the difficulty in isolating and measuring the credit risk component. The Board felt the potential alternatives of providing a fair value option were overly complex and therefore did not propose any changes to hedging of credit risk using credit derivatives.

Many constituents commented that the Board should consider how to accommodate hedges of credit risk using credit derivatives as they felt that current IFRS distorts the financial performance reporting for financial institutions. Those institutions who use credit derivatives to hedge credit risk experience increased profit or loss volatility as compared to those institutions who do not hedge their exposure.

The staff again presented the Board with three fair value options as potential alternatives for addressing the accounting mismatch for use of credit derivatives to hedge credit risk.

The Board began its discussions with one member stating the Board needed to clarify whether hedging credit risk is specifically prohibited or whether it is operationally difficult as there is confusion among constituents. Another IASB member stated he did not want to create an exception for hedging credit risk and preferred to stick to the principles in the risk components approach of separately identifiable and reliably measurable. One Board member felt that it was important that something be done to address the accounting mismatch but had some concern about whether creating another fair value option was the right approach. He questioned why designating the entire instrument rather than designating the credit risk component would not be possible. The staff responded that because the instrument includes multiple risks (eg interest rate risk) that it may not meet the effectiveness criteria of other than accidental offsetting and a quantitative assessment of correlation could likely be required in making that determination.

Another Board mentioned that he initially supported the staff proposal (a fair value option at initial recognition or subsequently with any changes in fair value from initial recognition deferred in OCI) but started having reservations over such an approach when thinking of the potential for abuse given the current sovereign debt scenarios where entities could bury losses on investments in OCI rather than recognising impairments. He suggested that this topic should be addressed in contemplation of the impairment project rather than made only in the context of hedge accounting because of the related issues. He also mentioned that another possibility could be expanding the scope of the financial guarantee contract definition.

Overall, the Board supported addressing the issue but decided to defer the issue until the September Board meeting so the staff could further develop other alternatives including the interaction with impairment accounting and exploring scope expansion of the financial guarantee contract.

Disclosure Requirements

The Board began its redeliberations of the proposed disclosure requirement included in the exposure draft. The Board began by tentatively deciding to reconfirm the proposals in the exposure draft that the hedge accounting disclosures be presented in a single note or section of the financial statements but information presented elsewhere (eg management commentary or risk reports) need not be duplicated and instead could be incorporated by cross reference. The Board also tentatively decided to carryforward the requirement in paragraph 23(b) of IFRS 7 requiring a description of any forecast transactions that have been designated as hedged items in prior periods but which are no longer expected to occur.

Scope

The Board next discussed the scope of the disclosure requirements and whether to reconfirm the proposals in the exposure draft to disclose information for only those risks that an entity manages as part of its risk management strategy and where hedge accounting is applied.

One of the IASB members questioned why the scope was being limited to only those risks where hedge accounting is actually applied. In her view, this left a hole by not requiring disclosures when an entity economically hedges a risk position without applying hedge accounting. The staff mentioned that IFRS 7 requires disclosures around the risks associated with financial instruments and therefore disclosures are required when derivatives are held for economic hedges. However, in the Board member’s view the IFRS 7 disclosures provided too much flexibility in what was required to be disclosed. Another IASB member agreed saying the current IFRS 7 disclosures require information about risks associated with the hedging instrument rather than the risks the derivative are used to manage. The staff responded that such disclosures are beyond the scope of the hedge accounting project and may be better suited for a post-implementation review of IFRS 7. Other IASB members agreed with the staff that disclosures around risks being hedged but for which hedge accounting is not applied are outside the scope of the project. The Board agreed [in a 9-1 vote] to reconfirm the scope of the hedge accounting disclosures in the exposure draft to disclose information for only those risks that an entity manages as part of its risk management strategy and where hedge accounting is applied.

Risk Management Strategy

The hedge accounting exposure draft proposed that an entity would disclose information on its risk management strategy for each category of risk to enable users to evaluate (1) how each risk arises, (2) how the entity manages each risk (including hedging the whole or a risk component), and (3) the extent of the exposures that the entity manages.

Nearly all comment letter respondents agreed with the proposal to disclose information about an entity’s risk management strategy for each type of risk citing improved transparency and more useful information. However, some commented about a lack of clarity regarding how detailed of description of the risk management strategy should be and at what level of risk management strategy should the disclosure be applied.

The staff recommended retaining the proposals in the exposure draft of disclosing information on an entity’s risk management strategy and adding additional guidance on the types of information to be provided such as (1) whether the entity hedges an item in its entirety for all risks or hedges a risk component of an item and how each risk arises, (2) the hedging instruments that are used to offset the risk exposure, (3) how the entity determines the economic relationship between the hedged item and the hedging instrument for the purposes of testing hedge effectiveness, and (4) how the entity establishes the hedge ratio and what the sources of ineffectiveness are. Additionally, when risk components have been designated as hedged items, an entity could provide information about (1) how the entity determined the component and (2) how the component relates to the item in its entirety.

One of the IASB members questioned why the staff recommendation included the term ‘could’ rather than ‘should’ and wondered if this implied optionality in the disclosures. The staff responded they were concerned with creating boilerplate language by requiring specific information and preferred instead to include an objective with examples of information that would meet the objective. Another Board member mentioned that other recently issued standards have included disclosure requirements that say ‘at a minimum an entity should disclose...’ and wondered if this approach could be applied here; the staff seemed agreeable to such an approach. Two other IASB members stated their view that additional transparency is the cost of doing hedge accounting and supporting the staff recommendations.

Ultimately, the Board tentatively decided [in a 9-1 vote] to retain the exposure draft proposal that the standard would require an entity to disclose information on its risk management strategy for each category of risk that enables users to evaluate (1) how each risk arises, (2) how the entity manages each risk (including hedging the whole or a risk component), and (3) the extent of the exposures that the entity manages. The standard would also include application guidance on the types of information to be provided to meet the disclosures objective such as (1) whether the entity hedges an item in its entirety for all risks or hedges a risk component of an item and how each risk arises, (2) the hedging instruments that are used to offset the risk exposure, (3) how the entity determines the economic relationship between the hedged item and the hedging instrument for the purposes of testing hedge effectiveness, and (4) how the entity establishes the hedge ratio and what the sources of ineffectiveness are. Additionally, when risk components have been designated as hedged items, an entity could provide information about (1) how the entity determined the component and (2) how the component relates to the item in its entirety.

Effects of Hedge Accounting on the Financial Statements

During the Board’s redeliberations on presentation of fair value hedge accounting, the Board tentatively decided against the proposals in the exposure draft and retain the presentation requirements in IAS 39.

The hedge accounting exposure draft proposed proposes requiring the effects of hedge accounting on the statement of profit or loss and OCI and the statement of financial position to be disclosed in a tabular format separated by risk category and type of hedge. Additionally, in the reconciliation of accumulated other comprehensive income under IAS 1, the amounts related to hedge accounting should be easily identifiable.

Most comment letter respondents agreed with the objective of the disclosures, but some were concerned that the proposed requirements were overly prescriptive. Some also questioned why tabular presentation should be required suggesting the focus should be on the risk management strategy rather than a specific period view. One financial statement user also criticised the tabular disclosure for not appropriately linking the hedging instrument with the hedged item.

The Board tentatively decided [in a 10-0 vote] not to prescribe a specific level of aggregation or disaggregation for the hedge accounting disclosures but entities should be consistent with the level of aggregation used for the IFRS 7 and IFRS 13 disclosures. The tabular disclosures requirement in the exposure draft was also reconfirmed but the Board tentatively decided to add additional columns to provide information on (1) the location of the line item that includes the designated hedged item and hedging instrument in the statement of financial position and (2) changes in fair value of the hedged item and the hedging instrument used to calculate the hedge ineffectiveness. The Board also tentatively decided [in a 7-3 vote] to not introduce a disclosure requirement specifically for distinguishing between financial instruments that have been designated as hedging instruments and those that have not.

Amount, Timing and Uncertainty of Future Cash Flows

The hedge accounting exposure draft proposes disclosure of (1) quantitative information on the risk exposure the entity manages and the extent to which the entity hedges the exposure and (2) a breakdown of that information for each accounting period that the hedging relationship covers the risk exposure. Additionally, an entity should disclose information about the sources of hedge ineffectiveness of hedging relationships for each particular risk category.

Many constituents had concerns with the proposed disclosures on the amount, timing and uncertainty of future cash flows, particularly because it would require disclosure of forecast information. Preparers had concerns with providing such information while auditors had concerns with such information being subject to audit. Many also felt that disclosing forecast information and the hedged rate or price results in disclosing commercially sensitive information. An additional issue identified by the staff was the application of the proposed disclosure to ‘dynamic’ hedging relationships as information of amount, timing and uncertainty of future cash flows would not provide useful information because of the frequent discontinuation and restart of hedge accounting as the portfolio shifts.

As constituents had little concern over the proposal on disclosing sources of ineffectiveness, the Board tentatively decided to reconfirm the proposals in the exposure draft related to entities providing a description of the expected and unexpected sources of hedge ineffectiveness.

With respect to the concerns over commercial sensitivity and use of dynamic hedging strategies, the staff recommended providing a scope out that entities could opt out of the disclosure requirement when providing such information would result in disclosing commercially sensitive information or they use hedge accounting as a surrogate for dynamic hedging. To opt out, an entity would have to disclose:

• for commercially sensitive information, information by risk category about hedging instruments to provide information about the principal, stated, face or other amount (eg notional) and a profile of the timing of the hedging instrument
• for dynamic hedging strategies, information by risk category to provide information on why hedge accounting is used as a surrogate for dynamic hedging and what the ultimate risk management strategy is and how it meets the objective using hedge accounting and designating the particular hedging relationships.

The IASB vice-Chairman expressed sympathy for the requirement to disclose commercially sensitive information but questioned in an opt-out was the right solution. He envisioned potential issues between preparers and auditors on making the commercially sensitive assessment. Another IASB member agreed, stating the view that the Board should not be requiring disclosure of forecasts around commercially sensitive information. One IASB member mentioned that disclosing the fact that information is commercially sensitive could itself be something that is commercially sensitive. He questioned whether entities would be forced into providing the disclosure rather than electing the opt-out. Another IASB member mentioned that was why he could support an opt-out because of the market pressure that would be placed on entities to provide the disclosure. One IASB member suggested that forecast information be removed from the scope of the disclosure entirely rather than providing an opt-out. However, he felt that information on hedged rates and prices were not commercially sensitive and therefore didn’t see the need to remove that portion of the disclosure. Other Board members generally agreed with this approach. As a result, the Board tentatively decided [in a 10-0 vote] to require disclosure of information that would allow users to understand (1) the notional amount of the hedging instrument, a profile of its timing, and if applicable, the average price or rate of the hedging instrument.

For the use of hedge accounting as a surrogate for dynamic hedging, one IASB member questioned if the Board did not finalise anything on the macro hedging project whether the staff’s recommended disclosure here would be the only thing done for macro hedging disclosures. The staff responded that the Board will still have an opportunity to visit macro hedging disclosures separately if the Board was so inclined. One of the Board members stated that all hedging activities are dynamic and questioned when the threshold for opting out of the disclosure would be met. Another IASB member mentioned experience from outreach activities that a certain entity mentioned updating hedging positions intraday and questioned whether the proposed disclosure would provide any relevant information. But another Board member mentioned that other disclosures are often required as of the balance sheet date even though the balance or exposure may change subsequent to the balance sheet date. The Board tentatively decided [in a 7-3 vote] that a separate disclosure requirement would be necessary for dynamic hedging strategies but requested the staff to further explore what information should be provided in those scenarios as they felt the staff recommendation was insufficient.

Linked Presentation for Fair Value Hedges

During the April 2011 Board meeting, the Board had tentatively decided not to permit linked presentation for fair value hedges but requested the staff perform additional outreach. That additional outreach confirmed that the support for linked presentation was primarily driven by regulatory requirements in a specific jurisdiction where entities are forced into a mandatory restructuring if there debt ratio exceeds a certain level. While the staff were empathetic to the issue, they view it as a regulatory issue rather than an accounting standard setting issue.

Based on the additional outreach performed, the Board reconfirmed their previous tentative decision to not permit linked presentation for fair value hedges.

Own Use Contracts

The hedge accounting exposure draft proposes to apply derivative accounting for contracts to buy or sell a non-financial item that can be settled net in cash that were entered into and continue to be held for the purpose of the receipt or delivery of a non-financial item in accordance with the entity’s expected purchase, sale or usage requirements (eg ‘own-use’) if it is in accordance with the entity’s fair value-based risk management strategy and the entity manages the net risk position to nil or close to nil.

Constituents generally supported the Board’s efforts to resolve the accounting mismatch than can occur when a commodity contract outside the scope of IAS 39 is hedged with a derivative. However, some constituents had significant concerns with the proposals in the exposure draft as they noted it could actually create an accounting mismatch applying to apply derivative accounting to ‘own use’ contracts where there are other items managed on a fair value based risk management strategy and other items not measured at fair value.

The staff presented the Board with four possible alternatives to address the accounting mismatch associated with ‘own-use’ contracts. Alternative 1 would retain the proposal in the exposure draft. Alternative 2 would extend the fair value option in IFRS 9 for financial assets to contracts that meet the ‘own-use’ scope exception. Alternative 3 would provide an elective ‘own-use’ scope exception (similar to the irrevocable election for normal purchase, normal sale contracts in US GAAP). Alternative 4 would retain the current IAS 39 requirements and then reconsider the issue when the Board addresses the scope of IFRS 9. The staff recommended the Board proceed with Alternative 2.

One of the IASB members suggested retaining the proposals in the exposure draft and questioned how wide spread the issue raised by constituents about creating a mismatch would really be. The staff responded that the issue is somewhat limited but is a significant issue for those impacted. Two Board members mentioned convergence and questioned why the staff would not recommend Alternative 3 in order to eliminate one of the existing differences between IFRS and US GAAP. The staff responded that as Alternative 3 was a choice it could have broader implications around IAS 39. One of those Board members reaffirmed the preference for Alternative 2 as be viewed Alternative 3 as an exception to an exception that was overly complicated. Another IASB member also expressed concern over the potential for confusion. However, the staff responded that those entities impacted by this issue would sufficiently understand and could apply the exception. Ultimately, the Board tentatively agreed [in a 7-3 vote] to extend the IFRS 9 fair value option to contracts that meet the ‘own-use’ scope exception if doing so eliminates or significantly reduces an accounting mismatch.

Discussion at September 2011 IASB Meeting

TUESDAY, 20 SEPTEMBER 2011

Disclosures: Dynamic hedging strategies

During the July 2011 IASB meeting, the Board made several tentative decisions regarding disclosure requirement for hedge accounting. However, the staff had raised a concern with the application of those disclosure requirements to dynamic hedging strategies as forward looking information about the terms and conditions of the hedging instrument do not provide useful information given the constant discontinuation and re-setting of hedging relationships. At that meeting, the Board asked the staff to consider alternative disclosure requirements for these relationships.

The staff recommended that for dynamic hedging strategies it is more important for users to understand why entities use dynamic hedging strategies and therefore requiring additional information about how an entity uses hedge accounting to reflect their risk management strategy would be more beneficial. Such information could include information about what the ultimate risk management strategy is, a description of how it meets that objective by using hedge accounting and designating the particular hedging relationships, and an indication of how frequently the hedging relationships are discontinued and restarted.

During the July Board meeting, the Board had expressed concern over how to appropriately define dynamic hedging strategies. The staff suggested rather than defining the term dynamic hedging strategies they could simply refer to the example the Board has tentatively decided to include on risk management objectives versus risk management strategies using dynamic hedging strategies as the basis of the example. The Board had also expressed concern with entities not providing information on volumes of hedged items or hedging instruments. The staff noted that the tabular disclosures will provide information on volumes. However, to address the Board's concern, the staff recommended requiring entities to disclose if the volumes as of the reporting date were not representative of normal volumes during the period (similar to the disclosure requirements in IFRS 7 on sensitivity analyses for market risks).

One Board member mentioned he liked the way the staff had defined dynamic hedging strategies in the agenda paper and suggested that be incorporated into the disclosure guidance. Another Board member stated they were not sure whether to support the staff recommendation as they were uncertain how broadly the exemption would apply. The staff retorted that it was not a matter of how many entities could apply the exemption but rather an issue of the information produced by those entities for dynamic hedging strategies not being relevant. Another Board member asked the staff if they envisioned entities providing boiler plate language in response to the proposed disclosure requirements. The staff responded that was always a risk and concern but felt that entities would need to provide sufficiently detailed information to analysts and investors that would prevent boilerplate language.

The Board tentatively decided to exempt dynamic hedging relationships from the requirement to disclose the terms and conditions of the hedging instrument. Instead, the Board tentatively decided that those entities shall expand the description of their risk management strategy by providing 1) information about the ultimate risk management strategy, 2) a description of how it meets that objective by using hedge accounting and designating the particular hedging relationships, and 3) an indication of how frequently the hedging relationships are discontinued and restarted as part of the dynamic process. Additionally, entities would disclose if the volumes of hedging relationships were not representative of normal volumes throughout the year.

Hedging using credit derivatives

During the July 2011 meeting, the Board discussed the accounting mismatch that ensues when entities use credit derivatives to hedge credit risk of financial assets. The Board had previously considered a fair value option during the development of the hedge accounting exposure draft but rejected creating another measurement exception. However, comment letter respondents raised the inability to achieve hedge accounting and the resulting accounting mismatch as a significant concern for financial institutions.

During that meeting, the Board discussed three alternatives to hedge accounting: an elective fair value option, financial guarantee accounting and time value of option accounting. The Board asked the staff to further consider an approach similar to financial guarantee accounting as well as consider the interaction of all these alternatives with the impairment project. The staff presented the Boards with two new approaches, the insurance approach and the deemed credit adjustment approach.

Under the insurance approach, for a credit default swap (CDS) used to manage credit exposure: 1) any premium paid at inception would be amortised over the life of the CDS, 2) the quarterly premium would be expensed as paid, 3) the fair value of the CDS would be disclosed in the notes, and 4) in the assessment of impairment, any cash flow received from a credit event is treated similar to collateral or a guarantee of a financial asset. The staff suggested that upon initially applying the insurance approach, an entity would amortise any difference between fair value and the carrying amount under the insurance approach over the remaining life of the CDS (either on a straight line basis or on an 'aligned' CDS value basis). If an entity were to no longer apply the insurance approach but continue to hold the CDS, the staff suggested an entity would either recognise the difference between fair value and the in profit or loss immediately (with one variation also changing the measurement attribute of the loan or loan commitment to fair value) or amortising the different to profit or loss.

Under the deemed credit adjustment approach, a fair value of a CDS that matches the maturity of the hedged credit exposure is computed (an 'aligned' CDS value). Changes in the fair value of the aligned CDS are accounted for as an adjustment to the carrying amount of the credit exposure and recognised in profit or loss (similar to fair value hedge accounting).

The difficulties associated with the insurance approach focus primarily on when the insurance approach is discontinued before maturity of the credit exposure while the CDS is retained and the resulting potential for earnings management when reverting back to fair value accounting. Additionally, the interaction with impairment accounting can become complex if the maturity of the CDS does not cover the life of the credit exposure as estimating expected credit losses for periods far into the future is inherently more difficult. The difficulties with the aligned CDS approach involves complexity in constructing and if using a credit spread curve would be even more complex. Additionally, the interaction with impairment accounting is significantly more difficult than under the insurance approach as the deemed credit adjustment and the impairment allowance are 'competing mechanisms'.

The staff presented the Board with three alternatives forward (each alternative having multiple possible variations): 1) elective fair value through profit or loss accounting for loan and loan commitments, 2) the insurance approach, and 3) the deemed credit adjustment approach.

One Board member mentioned that he did not believe that a special exception should be made for CDS, rather the Board should stick to the principles of hedge accounting as other exceptions may be requested in the future. Another Board member asked the staff if the fair value option was the approach supported by constituents. The staff responded that in discussions with constituents, those constituents have recognised there is no simple solution. But they feel that all three alternatives are better options than the existing accounting mismatch that results when economically hedging loan and loan commitments with credit derivatives.

In considering the various alternatives presented by the staff, the Board tentatively decided to permit an elective fair value through profit or loss accounting for loan and loan commitments after initial recognition of the financial asset. The Board also tentatively decided on 'Alternative 2' of the FVTPL accounting variations. Under this alternative, the 'measurement change adjustment' (MCA) is recognised immediately in profit or loss, therefore on discontinuation of FVTPL accounting the fair value of loans becomes the new deemed cost and there is no MCA. The Board also tentatively decided to require disclosures when electing this FVTPL approach including 1) a reconciliation of the nominal amount and the fair value of the credit derivatives that have been used to manage the credit exposure of a financial instrument that qualified and was elected for fair value through profit or loss accounting, 2) the gain or loss recognised in profit or loss as a result of electing FVTPL accounting for a credit exposure, and 3) for discontinuation of elective FVTPL for credit exposures the fair value that becomes new deemed cost or amortisable amount (for loan commitments) and the related nominal or principal amount.

Effective date and transition

The Board discussed effective date and transition requirements related to the hedge accounting standard. The hedge accounting exposure draft proposed prospective application, which most constituents supported. However, some constituents asked that hedging relationships that qualified under IAS 39 be grandfathered under the new hedge accounting model until they are discontinued or otherwise rebalanced.

The Board tentatively decided that the effective date would be aligned to the mandatory effective date of IFRS 9. The Board also tentatively decided to not permit retrospective application of the new hedge accounting requirements 1) if it would involve retrospective designation 2) for designation of risk components, 3) for aggregated exposures, and 4) for groups and net positions. However, the Board tentatively decided that retrospective application would be required for the time value of options whose intrinsic value had previously been designated as a hedging instrument and for the alternative treatment of forward elements on an all-or-nothing basis for qualifying hedging relationships.

To address concerns over the time lag between starting the use of the new hedge accounting model and stopping use of the IAS 39 hedge accounting model and the potential for changes in market values, the Board tentatively decided to include clarifying guidance that entities can consider for transition purposes 'the same logical second' when transitioning between hedge accounting models. Finally, the Board tentatively decided to grant a transition provision where entities will be required to consider for purposes of rebalancing, the ratio used under IAS 39 as the starting point for rebalancing as of the transition date by 1) recognising all the ineffectiveness in retained earnings at the transition date, 2) rebalancing the hedging relationship and accounting for as a continuing hedge, and 3) recognising any gain or loss arising from the rebalancing of these hedging relationships in profit or loss.

Next Steps

This discussion completed the Board’s deliberations with respect to the general hedge accounting model. The staff plans to compile a staff draft of the hedge accounting guidance that will be posted to the IASB website. The IASB will not solicit constituent comments but will provide a date in which the standard would not be finalised prior to, such that constituents may provide the Board any feedback prior to that date. This will also allow the FASB to consider the final decisions made by the IASB on hedge accounting so the FASB can decide how to proceed with their own hedge accounting project.

THURSDAY, 22 SEPTEMBER 2011

Financial Instruments: Macro Hedge Accounting

The staff presented the Board with three agenda papers related to the macro hedge accounting project. The first paper provided an example of a common interest rate risk management strategy used by financial institutions. The staff clarified that while the example was focused on a particular industry (financial services) and a particular risk (interest rate) that this was being used as a starting point for discussions and should not be interpreted as simply a solution for one industry or one type of risk.

The second paper highlighted conceptual differences between the risk management approach described in the example and the current hedge accounting requirements, namely 1) the focus on the stabilisation of net interest margin and 2) the focus on the portfolio as unit of account.

The third paper discussed potential alternatives for an accounting solution to address the conceptual differences between risk management and current hedge accounting requirements. The four alternatives presented by the staff are as follows:

• Alternative 1 – Accept a risk management approach including risk management policies;
• Alternative 2 – Accept a risk management approach but restrict entity specific risk management policies;
• Alternative 3 – Deny a risk management approach but provide accounting policy choices instead to bridge the gap; or
• Alternative 4 – Definitely deny a risk management approach.

The IASB Chair began discussions by asking the staff if the financial statements of those entities looking for a macro hedge accounting model are currently distorted. The staff responded that it would depend on the perspective taken. Many of these firms have methods to designate and de-designate multiple micro hedging strategies as a proxy for macro hedging since macro hedge accounting is not an available solution. However, these strategies are cumbersome and don't accurately portray the risk management process so many of these entities will provide 'non-GAAP' measures to provide investors information as if macro hedge accounting were permitted.

One IASB member asked the inverse of the IASB Chair's question, that being if applying macro hedge accounting could cause distortion of financial statements. He acknowledged the challenge of reflecting the risk management activities but felt that appropriate safeguards have been put in place for a purpose. He noted that to truly understand if macro hedging minimises risk one would have to assess that at the enterprise level.

The IASB Chair asked the staff why entities could not just apply the fair value option to eliminate the accounting mismatch that exists. The staff noted in the example in the paper of hedging interest rate risk to lock in net interest margin, electing the fair value option would expose the entity to other changes in fair value such as credit risk. Additionally, the staff noted that IFRS 9 had introduced the business model criteria so that entities whose business model is to hold financial assets to collect contractual cash flows would measure those assets at amortised cost. So sending a message to those entities to simply elect fair value option to address the macro hedge accounting issue would be a contradictory message.

Another Board member acknowledged the issue caused by the inability to apply hedge accounting on a macro basis and mentioned his knowledge of the banking industry struggling with this for some time. But he noted that during the outreach activities on the general hedge accounting model he was made aware of how many other entities (utilities, commodities, etc.) were also impacted with this limitation. However, he also agreed with the other Board member who warned about needing appropriate safeguards, saying the Board needed to fully understand the ramifications and be comfortable that a macro hedge accounting approach would provide better and more transparent financial reporting.

Another IASB member raised the question of whether a macro hedge accounting model could be auditable and also highlighted the issues companies may have in establishing appropriate internal controls over financial reporting.

One Board member mentioned that it may be helpful to see what companies are currently doing now with respect to 'non-GAAP' measures and how they are determining the hedge accounting impacts at a macro level. The IASB staff said they could provide the Board with information but given that they are 'non-GAAP' the level of consistency between entities may fluctuate.

The IASB Chair concluded this session by asking the staff to further explore Alternative 1 (accepting a risk management approach including risk management policies) and Alternative 2 (accepting a risk management approach but restricting entity specific risk management policies). He suggested that the Board needs to get a better understanding of the issues and that a future education session to review 'non-GAAP' measures currently being used in practice would be beneficial.

Discussion at the November 2011 IASB Meeting

The staff presented the Board with two agenda papers on the topic of macro-hedging. The first paper discussed alternatives for developing a business oriented macro-hedging model, continuing with the scenario of hedging interest rate risk as discussed in previous Board discussions. The second paper discussed use of non-GAAP information in the financial reporting of hedging activities.

The staff asked the Board to consider both the areas of the financial statements primarily affected by interest rate risk management and what should be the effect of risk management activities on those financial statement areas.

The staff introduced two possibilities for accounting for hedging instruments under a macro hedging model. The first alternative was titled the 'accrual accounting concept' under which the hedging instrument is accounted for on an accrual basis (either on an amortised cost or full deferral of all fair value changes) consistent with the hedged risk. The second alternative was titled the 'valuation concept' under which the hedged risk position would be valued to offset the measurement of the hedging instrument. The staff noted that one of the limitations of the accrual accounting concept is that when the hedging instrument does not perfectly offset the hedged risk the resulting mismatch would not be visible while under the valuation concept would reflect the imperfect offset to be reflected as valuation elements providing increased transparency. Other reasons the staff presented for supporting the valuation concept included 1) that financial institutions commonly identify interest rate risk on the basis of fixed rate financial instruments using present value based methods and 2) it is in line with long standing treatment under IFRSs that derivatives are accounted for at FVTPL.

Based on the staff view that the valuation concept was preferential to the accrual accounting concept, the staff went on to detail two possible approaches for the valuation concept. The first approach is a 'separate valuation concept' that changes the measurement for elements of the risk position and allows accounting mismatches to be overcome that otherwise arise due to the fair value measurement of the hedging instruments. The second approach is a 'coverage concept' where the risk position is valued to determine the portion of the fair value change of the hedging instruments that are covered by an offsetting effect and therefore not recognised in profit or loss. In considering the valuation of the risk position, the staff identified the following eleven steps that would be need to be considered:

1. Full fair value measurement
2. Fair value attributable to interest rate risk
3. Net interest margin as risk management objective
4. Portfolio as unit of account
5. Open portfolios to be included
6. Applying repricing risk for periods rather than days
7. Multi-dimensional risk objectives
8. Valuation of floating rate instruments
9. Counterparty risk of hedging instruments
10. Internal derivatives
11. Risk limits

The Board expressed their general preference for further development of a valuation concept and the changing of hedged risk position over an accrual accounting concept and changing the measurement of the hedging instrument. One Board member felt that if macro hedging were going to be permitted then the full fair value of the instrument being hedged should be presented on the balance sheet. Another Board member expressed concern with a variety of issues in the staff analysis including the fact that the entire premise of the macro hedging was anchored to risk management yet risk management was not defined. He also thought it was fundamental the unit of account be addressed in the model. Another Board member requested the staff present the Board with numerical examples at a future board meeting as it would help to illustrate the topics being discussed. Another Board member requested the staff to better understand financial statement users' expectations with regard to macro hedging as that would also be an important consideration. Another Board member questioned, if the Board were able to agree on a macro hedge accounting model, whether it would be required or optional.

The Board made no decisions during this session, the staff will continue its work in developing a macro hedge accounting model under the valuation approach.

Discussion at the December 2011 IASB Meeting

The IASB discussed a shortened comment period for the exposure draft Transition Guidance (Proposed Amendments to IFRS 10). The Board tentatively agreed that a comment period of 90 days was considered acceptable and in compliance with the Due Process Handbook for the IASB, because the exposure draft is relatively short, the matter is urgent, the amendments to the guidance are limited to the transitional provisions in the standard and are essentially clarifications of the Board’s intention when IFRS 10 was issued and there is likely to be broad consensus on the topic. These proposed amendments should alleviate concerns that some have that the transitional requirements are more burdensome than had been intended. The shortened comment period would allow for:

1. the proposed amendments' effective date to be aligned with that of IFRS 10 (1 January 2013);
2. the proposed amendments to be provided as early as possible, in order to benefit preparers as they plan for transitioning to IFRS 10; and
3. to provide sufficient time for the endorsement process in jurisdictions that have one.

Discussion at the January 2012 IASB Meeting

The Board continued its discussions on development of a macro hedge accounting model. At the November 2011 Board meeting, the staff introduced eleven steps that will be considered for alternatives in the valuation of the risk position in a macro hedge accounting model. The January discussion focused on the following steps:

• Step 4: Portfolio as unit of account
• Step 5: Open portfolios to be included
• Step 6: Applying repricing risk for periods rather than days.

The staff presented the Board with agenda papers using the example of hedging interest rate risk. These papers focused on risk management approaches based on expected behaviour of a portfolio using 1) portfolios as units of account for hedge accounting purposes and 2) bottom layer approaches. One of the papers walked through these approaches using a closed portfolio as an example with the second paper overlaying application to an open portfolio and the additional considerations introduced with a constantly shifting portfolio. The staff did not ask the Board to make any decisions during this meeting.

The papers laid out three potential alternatives and the implications for each. The first alternative is the portfolio fair value hedge of interest rate risk under IAS 39. The second alternative is a portfolio valuation approach attributable to the hedged risk on the basis of the net position with a constant hedged proportion. This approach would allow designation of the portfolio as the unit of account and therefor the ongoing valuation of the portfolio for purposes of hedge accounting. The third alternative is a bottom layer approach to reflect the net risk position (e.g., a layer of a gross position that represents the net risk).

The staff analysis for the alternative of applying existing IAS 39 highlighted the problems and limitations that currently exist. Over hedging the net risk position (from a risk management perspective) is not visible to the extent the hedging instruments are covered by the gross position designated for hedge accounting purposes. Similarly, under hedging the net risk position is also not visible. Prepayment risk of the net position is only partly visible in that a release of the hedge adjustment is dependent on the hedge proportion and the designated hedged items out of the net risk position. The ineffectiveness of the hedging relationship is also only partly visible based on the hedged proportion and the designated hedged items out of the net risk position. Perhaps most importantly, application of the IAS 39 approach is operationally complex requiring tracking of the hedge adjustment based on changes in hedged proportions, frequent re-designations and 'late hedges'.

The staff analysis for the portfolio valuation approach highlighted that this approach provides visibility in to both over and under hedging the net risk position as the entire hedged portfolio (both assets and liabilities) would be remeasured and therefore increases or decreases in the net position would give rise to ineffectiveness. Additionally, it provides visibility of prepayment risk as each prepayment triggers a release of the related hedge adjustment. This approach also provides visibility to the hedge ineffectiveness. The staff also highlighted that the portfolio valuation approach does not require tracking of hedge adjustments due to a uniform hedged proportion for all items (rather than a proportion) and immediate consideration of changes to the portfolio resulting in no late hedges. They noted that the complexity will depend on the level of synergies with the valuation approaches applied by risk management.

The staff analysis for the bottom layer approach highlighted that it does not provide visibility in to over or under hedging. It also does not provide visibility of prepayment risk if the risk does not lead to a decrease or breach of the designated layer. Visibility of hedge ineffectiveness would be dependent on the flexibility regarding the definition of layers. The staff noted this approach would be the most simple approach so long as the layer does not change, but changes to the designated layer leads to similar tracking issues as hedge accounting but at a portfolio level.

Most of the Board members expressed general support for the portfolio valuation approach based on the staff analysis as it provides the most transparency. One Board member felt the papers did not adequately address the interdependence between interest rate risk and behavioural factors (such as prepayments). Another Board member highlighted the importance of appropriate disclosure for these hedging relationships. One Board member asked the staff if the portfolio valuation approach was consistent with how risk managers currently managing risk citing concerns the accounting approach could instead drive risk management. The staff responded that this approach is the most common approach used by risk managers; however one Board member questioned this noting that some financial institutions focus on the matching of cash flows and are not fair valuing demand deposits and suggested the staff conduct outreach to ensure this approach was operational before proceeding too far down this path.

The Board made no tentative decisions during this session. The staff noted the Board's initial preference towards a portfolio valuation approach and will continue to proceed through the remaining five steps using that approach as a basis for further development.