Financial instruments — Hedge accounting
The IASB discussed the following topics:
- Group hedge accounting
- Portfolio hedging
- Hedge ineffectiveness measurement
- Scope of disclosure
- Hedge accounting presentation.
The staff presented the Board with a summary of the individual tentative decisions on group hedging activities made over the previous four months. The summary also highlighted some of the Board member concerns with the proposed model and a staff response to those concerns.
The staff presented three alternatives on how to finalise the discussions around group hedge accounting before proceeding with discussion on portfolio hedging.
- Alternative 1 would carryover all of the existing restrictive criteria that apply to groups of hedged items within IAS 39.
- Alternative 2 would carryover some of the existing restrictive criteria that apply to groups of hedged items within IAS 39
- Alternative 3 would not carryover any of the existing restrictive criteria that apply to groups of hedged items within IAS 39 and instead incorporate the criteria and principles previously made by the Board
One Board member expressed concern around the decisions the Board has made to date stating that each decision was made in isolation however when considering in the entirety, he did not feel the Board has been provided enough information to make a decision. The Board member was particularly concerned with the use of cash instruments hedging other cash instruments as well as the application to forecasted transactions as no ineffectiveness would be recognised should the forecasted transaction never occur.
Another Board member expressed concern that the project has been advertised as a simplification project; however, there seems to continuously be more and more rules added to the model. Other Board members echoed this concern. The staff responded that the project was not designed solely as a simplification project but rather to more closely align the hedge accounting model with a company's risk management process. However, in doing so, this may result in additional complexity in which the Board will have to consider and weigh those implications.
The Board ultimately agreed to proceed with an approach based on Alternative 2 which would limit application of group hedging potentially excluding such items as forecasted transactions.
The staff provided the Board with a preliminary summary of potential issues involved with portfolio hedging of interest rate risk. The staff will be bringing papers to the Board related to portfolio hedging during future meetings.
During the 24 August 2010 Board meeting, the Board agreed on a model for hedge effectiveness assessment. During this meeting, the staff presented to the Board an objective, principle and guidance related to the measurement of hedge ineffectiveness.
The objective developed by the staff for measurement of hedge ineffectiveness is "the quantification of the portion of the change in fair value of the hedging instrument that has not been offset by the change in the fair value of the hedged item attributable to the hedged risk (and vice versa for fair value hedges) in a reporting period."
The principle developed by the staff is that of a "dollar-offset" approach (calculation of hedge ineffectiveness using the ratio between the change in the fair value of hedging instrument and the change in the fair value of the hedge item) should be followed to measure ineffectiveness which would be recognised at the earlier of 1) the end of the reporting period or 2) an occurrence of a rebalancing of the hedging relationship.
The guidance on measuring ineffectiveness developed by the staff would include that entities should calculate hedge ineffectiveness using dollar-offset using the actual performance of the hedged item and hedging instrument and that recognition of ineffectiveness will differ based on if the hedge were a fair value or cash flow hedging relationship because of the "lower of" test for cash flow hedges.
The Board agreed with the objective, principle and guidance developed by the staff.
The staff then raised the question of whether the time value of money should be considered as part of the measurement of hedge ineffectiveness. This question had been raised to the IFRIC in March 2007; however, they decided not to add the issue to their agenda on the basis that a reason for ineffectiveness relates to the timing of the interest payment or receipts of the swap and the hedged item. To do so, entities would need to consider the effect of the time value of money. The staff recommended that the standard specifically address that the time value of money be considered when calculating an ineffectiveness measurement. The Board agreed with the staff recommendation.
The staff also raised the topic of utilising a hypothetical derivative as part of the measurement of ineffectiveness to the Board. The current hypothetical derivative approach under IAS 39 is intended to be an input to an effectiveness test rather than the effectiveness test itself however there is a lack of clarity in the current standard. The staff asked the Board whether the hypothetical derivative method should be allowed, not as a method on its own, but as one way to determine the change in the value of the hedged item attributable to the hedged risk which may then be used as an input for another measurement method. Some Board members stressed that the hypothetical derivative method should be treated only as an input for another measurement method and asked the staff to emphasise this point in the forthcoming exposure draft.
The staff also raised a question regarding a component of the FASB's proposed Accounting Standards Update (ASU) on financial instruments which permits an accommodation separate from the hypothetical derivative concept for groups of items that would settle within a specific time period. The Board agreed to permit the use of a hypothetical derivate as an input into the ineffectiveness measurement method and to not permit a similar specific exception as currently proposed in the FASB ASU.
The staff raised the topic of disclosures related to hedge accounting by providing an overview of the staff's planned approach. The staff's planned approach is to expand the current IFRS 7 disclosures to include the exposure to a specific risk when an entity applies hedge accounting and to limit the disclosures to those exposed risks the entity tracks as part of its risk management process.
One Board member asked for clarification on the criteria for those risks tracked by a risk management process. The staff clarified that the disclosure would include both the exposure and any hedging of that exposure.
Another Board member expressed concern that there may be risks for which an entity is exposed but yet does not actively track and would like disclosure of that information. Other Board members felt that exceeded the scope of disclosures related to hedging activities and should be considered as part of management commentary instead.
The Board agreed with the staff planned approach for development of hedge accounting disclosures.
The final hedge accounting discussion of the day focused on two specific presentation issues.
The first topic discussed was the accounting policy choice currently within IAS 39 related to cash flow hedges of forecast transactions that result in the recognition of non-financial items. Currently an entity may either 1) adjust the initial carrying amount of the hedged item for the gain or loss on the hedging instrument, or 2) leave the gain or loss on the hedging instrument within other comprehensive income (OCI) until the hedged item impacts profit and loss when it is then recycled from OCI to profit and loss. The current accounting policy choice results in various comparability issues including that a basis adjustment approach is not available for financial assets, U.S. GAAP precludes basis adjustments, and the two elections result in differing carrying amounts for the recognised non-financial asset and while not resulting in differing amounts recognised within profit and loss, differing amounts are recognised within OCI.
However, from an operational perspective, applying the basis adjustment requires less effort to track the timing of impact to profit and loss in comparison to the recycling approach from OCI to profit and loss. When the basis of the non-financial item is adjusted, it is automatically recognised in profit and loss at the time of consumption, either through a depreciation charge, as a component of cost of sales, etc. As such, the IASB outreach performed has requested that either the accounting policy choice remain or if one alternative were to be eliminated that the basis adjustment be retained.
The staff presented the Board with four alternatives on how to address the issue:
- Alternative 1 - Continue to permit the accounting policy choice in IAS 39
- Alternative 2 - Require entities to leave hedging gains and losses in OCI
- Alternative 3 - Require basis adjustments upon recognition of the non-financial item
- Alternative 4 - Require basis adjustments from accumulated other comprehensive income (AOCI) or equity directly, without impacting the performance statement upon transfer.
The staff recommended alternative 4 in part because of their belief that it (along with alternative 3) is the most operational and helps to reduce complexity as well as reduces comparability issues by removing an accounting policy choice. Additionally, both alternative 3 and 4 would not result in different presentation for recognised items resulting from foreign currency hedged firm commitments regardless of whether cash flow or fair value hedge accounting were elected (the second of the two presentation issues, discussed further below). Alternative 4 also does not result in the cliff effect to OCI that results from alternative 3 when the basis adjustment is transferred out.
One of the Board members expressed concern over the staff's proposal. He noted what appeared to be an inconsistency in the proposals as for fair value hedges the Board has removed the basis adjustment approach with a separate line item valuation allowance. However, for cash flow hedges of forecasted transactions, the Board is going to require basis adjusting the recognised asset. They asked the staff if a fair value hedge of inventory would result in a basis differential or a separate line item valuation which the staff confirmed would require a separate line item valuation allowance. The staff asserted that the difference in the scenarios is that for cash flow hedges of forecasted transactions the asset was yet to be recognised and the gain or loss on the hedging instrument was adjusting the initial cost of the asset which would not be re-measured again like a financial asset may be. The Board member also expressed concern that this decision would create additional divergence with U.S. GAAP which was echoed by another Board member.
Another Board member mentioned that analysts feel that the basis adjustment provides the most decision useful information. Another Board member expressed his support for alternative 3 as he felt there was a fundamental principle that the cash flow hedge should be recognised through OCI. Ultimately, a majority of the Board agreed with the staff recommendation to require basis adjustments from AOCI or equity directly without impacting OCI.
The second presentation topic the Board discussed related to hedging foreign currency risk of a firm commitment. IAS 39 currently allows for the hedge to be designated as either a cash flow hedge or a fair value hedge because it impacts both the cash flows and fair value of the hedged item. Because of the Boards previous decisions regarding fair value hedge accounting, the presentation of the hedge of a foreign currency risk of a firm commitment would vary based on the type of hedge designation elected, which is made on a hedge-by-hedge basis.
The staff presented the Board with three alternatives on addressing the issue:
- Alternative 1 - Continue to permit a choice of electing cash flow or fair value hedge designation on a hedge-by-hedge basis
- Alternative 2 - Require cash flow hedge accounting only
- Alternative 3 - Require fair value hedge accounting only
The staff recommended alternative 1 to retain the choice of designating the relationship as either a fair value hedge or a cash flow hedge. The Board agreed with the staff recommendation.