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

• Accounting for the time value of options for 'zero-cost' collars
• Designation of nominal components
• Accounting for fair value hedges

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.

Designation of 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.

The Boards discussed extensively a set of recommendations aimed at dealing with the subset of insurance contracts that the Exposure Draft (ED) defined as "short term insurance contracts" on the basis that they had a coverage period (i.e. the period during which an insurer stands ready to pay claims) of one year or less and did not contain features that made the cash flows vary significantly.

The ED required that all the short term insurance contracts are accounted for using a modified approach prior to any claims being incurred. Beyond the coverage period the claim liability arising from the short term insurance contracts would be accounted for using the main building blocks model.

Eligibility requirements

The Staff noted that a number of comment letters were particularly critical of the ED because the proposed criterion based on coverage appeared to introduce a bright line and it was not principle-based.

To address this approach the Staff recommended that an insurer would be eligible to use the modified approach based on a new set of criteria which required that (a) the contract does not include a significant financing element and (b) the contract does not contain embedded options or other derivatives that significantly affect the variability of the cash flows, after unbundling any embedded derivatives. The latter criterion is substantially the same as in the ED and the first one being the innovation proposed by Staff.

The new criterion (a) was further explained when two additional criteria are met: (i) the time between the receipt of premium and the provision of coverage is insignificant, and (ii) the amount of premium charged is not substantially different if the policyholder paid at the beginning of the coverage period. Using a recent decision from the Revenue Recognition project, the Staff also recommended including a statement whereby a contract is not considered to have a significant financing element if the coverage period is one year or less. This was the original first criterion from the ED which now is used to underpin the attempt of a broader principle based criterion.

The joint discussion did not appear to generate a tentative decision on the recommendation other than a statement that the Boards intend to have a modified approach based on the unearned premium. Instead it appeared to have highlighted a number of differences that the Boards will have to deal with as they finalise this issue.

FASB noted their preference to treat the modified approach as a separate model from the building block approach rather than a proxy to achieve the same measurement objective of a current measurement of the contractual fulfilment. This departs from the position in the ED and may seem to have little practical impact on the discussion on the pre claim measurement of the short term contracts.

Most IASB members were uncomfortable with the significant financing criterion because it seemed to open the modified approach to a wider subset of contracts that they had anticipated. The IASB position remains on the concept that there is a single measurement model with a simplified approach that delivers substantially the same information when certain criteria are in place. The identification of these criteria should be the focus of the Staff work going forward.

Discounting of the pre-claims obligation

The debate continued on another area where a number of comment letters offered recommendations to the ED proposals to apply an accretion interest expense on the unearned premium release to income.

The Staff recommendation suggested leaving the unearned premium liability undiscounted if the eligibility criteria are met.

The debate noted that the absence of a clear consensus on the detailed eligibility criteria had made the discussion on this point more difficult to progress at this meeting.

Some of the IASB members noted that the new standard will apply to markets where high inflation exists and thus the allowance of an undiscounted approach over a twelve month periods would need to be assessed carefully. They also noted that the reassessment of the significant financing criterion in light of this comment could offer the way forward on this issue.

Treatment of acquisition costs

The ED required the acquisition costs incurred for the contract to be treated as a component of the contractual cash flows. The same principle was retained for the modified approach and the Staff recommended this option to be taken to the final standard. However the recent decision in the Revenue Recognition standard to account for an asset when incremental costs are incurred for a contract with a customer that can generate sufficient revenue to recover them was taken into account and an alternative proposal tabled for discussion.

The IASB members were in favour (9 out of the 10 board members in attendance) of retaining the ED principle in line with the building blocks approach and to use a single definition of contract acquisition costs as recently approved (based on costs that directly relate to the contract acquisition activity — on a portfolio basis).

The FASB members instead challenged the proposals of the Staff and noted that there was an opportunity for the new insurance standard to be aligned with the Revenue Recognition project. The presentation of the acquisition costs as an asset would enhance the comparability with the other industries where the new requirement from the Revenue Recognition project would apply.

The chairs of the two Boards asked the Staff to bring also this issue back in the near future to seek a convergent outcome.

Premium allocation patterns and onerous contract test

The Staff reconfirmed the ED proposal for the release to income of the unearned premium liability and both Boards agreed with the recommendation. The final standard will require the liability to be released to income based on the passage of time over the coverage period subject to a test that another basis that utilises the expected timing of incurred benefits and claims is not significantly different.

The final session on this topic aimed at setting out the criteria for the testing that a portfolio of unexpired short term insurance contracts has become onerous.

The fundamental issue of the role of the risk adjustment liability returned to the fore with the Staff recommending a test based on the first two building blocks (expected cash flows and discount rate) and a number of IASB members highlighting that this would depart from the concept of the modified approach being a simplification of the main model. They argued that if the concept of the proxy prevails the liability test should be done against a full building block calculation not one that is curtailed of the component that captures the uncertainty which often is the cause of the onerous contract situation.

An additional reservation came from the fact that the unearned premium liability is undiscounted and the onerous test uses a discounted amount.

Eventually the Boards found some common ground on the agreement that the onerous contract test (to be defined) will be undertaken when the insurer judges that there are certain indicators that may suggest the insurance liability for the unexpired short term contracts is not sufficient. These indicators were presented as qualitative factors and included deteriorations in the loss ratio or the increase in the severity and/or frequency of the insured events.

Pending further work on the definition of the portfolio the Staff had not recommended the level at which the onerous contract should be performed and they will cover this issue in one of the future meetings.

Finally the decision as to whether to change the ED from requiring the use of the modified approach to one that allows it as an accounting policy choice was deferred to a future date when the other issues left unresolved at the end of this meeting would have been addressed satisfactorily.

This concluded the 27 April IASB meeting.