Financial instruments — Hedge accounting
The Board discussed the following topics:
- Effectiveness assessment
- Hedging a portion of a group of items
- Eligibility to hedge instruments measured at FVOCI.
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.
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.
As a result of the issuance of IFRS 9 Financial Instruments 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.