Discussion at the September 2009 IASB Meeting
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:
- retaining the original decision of recognition in other comprehensive income,
- 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
- 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:
- a quantitative threshold
- a qualitative threshold,
- rely solely on an entity's risk management policy, or
- 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.
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