Financial instruments – Hedge accounting
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.
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 (e.g. management commentary or risk reports) need not be duplicated and instead could be incorporated by cross reference. The Board also tentatively decided to carry-forward 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.
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.