Financial instruments – Hedge accounting
Rebalancing the hedging relationship
The hedge accounting exposure draft introduced the concept of rebalancing a hedging relationship (i.e., reducing or increasing the quantities of the hedging instrument or the hedged item in order to maintain an appropriate hedge ratio). The exposure draft proposed requiring rebalancing the hedging relationship if the risk management objective has not changed but the hedging relationship would otherwise fail the effectiveness assessment. The exposure draft also permitted rebalancing when an entity anticipates that the current hedge ratio may cease to meet the effectiveness assessment in the future. The rebalancing concept was introduced to address issues under IAS 39 Financial Instruments: Recognition and Measurement where dedesignation and redesignation of a new hedge is required in order to adjust the hedging relationship as well as to facilitate the proposed hedge effectiveness requirements.
Constituents generally supported the introduction of rebalancing the hedging relationship in order to address the issues under IAS 39 regarding dedesignation and redesignation. However, the requirement for mandatory rebalancing raised questions among constituents who requested additional guidance. In particular, they requested guidance on: 1) what level of risk management should be considered for purposes of rebalancing (risk management strategy vs. risk management objective) and 2) the relationship between rebalancing and changes to hedged volumes or amounts. Some constituents also felt the requirement to rebalance should instead be voluntary, noting the exposure draft implies a continual optimisation of 'the perfect hedge ratio', but that in practice risk management may choose not to rebalance a hedging relationship either because doing so would not be cost effective or because the hedging relationship is still within managements acceptable tolerance limits.
During the 12 May 2011 meeting, the Board tentatively decided to change the hedge effectiveness assessment. Those changes (subject to drafting changes) include that the designation of a hedging relationship would be based on the quantity of hedged item that it actually hedges and the quantity of the hedging instrument that it actually uses to hedge that quantity of hedged item provide that it does not reflect an imbalance that would create hedge ineffectiveness in order to achieve an accounting outcome that is inconsistent with the purpose of hedge accounting.
The staff believes it is therefore necessary to align the rebalancing requirements with the tentative decisions on hedge effectiveness assessment. The staff recommended that after the inception of a hedging relationship, rebalancing would occur when an entity adjusts the quantities of the hedging instrument or the hedged item in response to changes in circumstances that affect the hedge ratio of that hedging relationship. However, the hedging relationship for hedge accounting purposes would have to use a different hedge ratio than for risk management purposes if:
- the adjustments for risk management purposes would result in a hedge ratio that would reflect an imbalance that would create hedge ineffectiveness in order to achieve an accounting outcome that is inconsistent with the purpose of hedge accounting or
- for risk management purposes an entity would retain a hedge ratio that in new circumstances would reflect an imbalance that would create hedge ineffectiveness in order to achieve an accounting outcome that is inconsistent with the purpose of hedge accounting (i.e., an entity must not create an imbalance by omitting to adjust the hedge ratio).
By doing so, the staff believes the concept of proactive rebalancing is no longer necessary.
One of the IASB members suggested removing the language of 'in order to achieve an accounting outcome' as he felt that it would be impossible for the Board to make that determination.
Another IASB member mentioned that he had recently heard someone mention that because of rebalancing that an entity would never recognise ineffectiveness. He inquired of the staff why that perception may exist. The staff said it was hard to speculate, but that the exposure draft specifically states that an entity would recognise any ineffectiveness that exists prior to rebalancing the hedging relationship so that perception was incorrect.
The Board tentatively agreed with the staff recommendation to align the rebalancing guidance with the new hedge effectiveness assessment approach.
Discontinuing the hedging relationship
The hedge accounting exposure draft proposes that an entity would discontinue the hedging relationship when the qualifying criteria are no longer met (i.e., the hedging relationship no longer meets the risk management objective and strategy) but does not permit voluntary discontinuance when the risk management objective and strategy is unchanged.
Constituents had mixed views regarding the proposals for discontinuing the hedging relationship. Those supporting the proposal felt it would reinforce the link between risk management and accounting and would improve financial reporting by eliminating a structuring opportunity. Some of those constituents did request additional guidance around the meaning of 'risk management' and at what level risk management should be considered (i.e., the entity wide approach to hedging or a transaction level hedging relationship). However, others felt that entering into hedge accounting was optional and therefore discontinuing hedge accounting should also be optional. In particular, some constituents noted the issues around using voluntary dedesignation as a surrogate approach for portfolio hedging (e.g., banks managing their loan books for interest rate risk when the characteristics of the loan portfolio are constantly changing).
From the constituent feedback received, the staff identified two issues for the Board's consideration 1) whether voluntary discontinuation should be allowed and 2) if clarification is needed regarding the link between the proposed discontinuation requirements and the risk management objective and strategy.
Most of the Board members stated their support for the proposals in the exposure draft as they felt permitting voluntary designation when the initial risk management objective and strategy have not changed would be inconsistent with the overall rational of the project of the accounting better reflecting the risk management activities. They also felt that not permitting voluntary dedesignation works as an anti-abuse clause. One Board member went so far as to express his view that the proposals contained inconsistent logic in that application of hedge accounting was optional while discontinuance was not voluntary; he felt the Board should consider making application of hedge accounting mandatory to be consistent with the approach for discontinuance.
Another Board member raised the topic of the interaction with IAS 8 Accounting Policies, Changes in Accounting Estimates and Errors and accounting policy choices and questioned if an entity made an election to no longer apply hedge accounting entity wide as an accounting policy election if that would be a permitted dedesignation. Both the staff and another Board member felt that hedge accounting is qualified on a transaction by transaction basis and therefore would not be an overall accounting policy election.
One Board member did not support the restriction to not permit voluntary dedesignation. He felt doing so added complexity that people were having difficulty understanding. Additionally, he felt that it was easy enough to circumvent the restriction to not allow for dedesignation by either terminating the hedging instrument or entering into an offsetting position and felt that creating such a restriction did not benefit the hedge accounting model. The incoming deputy Chair also expressed his concern with not permitting voluntary dedesignation.
Ultimately, the Board tentatively decided to retain the prohibition in the exposure draft that voluntary discontinuation of hedge accounting would not be permitted if the risk management strategy and objective remained unchanged. However, additional guidance will be included for instances where hedge accounting is a 'surrogate' for portfolio hedging (e.g., banks managing their loan books for interest rate risk when the characteristics of the loan portfolio are constantly changing) and for hedging relationships that at a specific stage automatically convert to a natural hedge (e.g., hedging foreign currency risk for forecast sales or purchases denominated in a foreign currency). The final standards will also include enhanced guidance on risk management strategy and risk management objective (i.e., risk management strategy is the entity wide approach for managing risk where as risk management objective is the transactional level application of the hedging relationship).
Options as hedging instruments
The Board began discussions on the proposals in the exposure draft related to the accounting for time value of options used as hedging instruments in a hedging relationship. The exposure draft introduced an 'insurance premium' view for the time value of options (i.e., the time value is the cost of hedging). The time value component would be recognised in other comprehensive income and then either expensed for time period related hedges or basis adjusted (or left in OCI) for transaction related hedges.
Two Board members expressed reservations with retaining the proposals in the exposure draft. One noted that he felt the proposals added unneeded complexity and would prefer to see the time value component frozen at inception rather than having the volatility impacting earnings as currently happens under IAS 39. The other Board member felt that the 'cost of insurance' should be recognised in earnings during the coverage period rather than waiting to basis adjust the hedged item for transaction related hedges. However, the Board tentatively decided to retain the proposals in the exposure draft related to the accounting for time value of options.
Constituents had requested additional clarity on the application of the proposals for the accounting for the time value of options, particularly related to differentiating between transaction related and time period related hedged items. The Board tentatively decided to provide additional guidance on the accounting for time value of options including guidance that the amortisation period does not necessarily have to correspond to the period of the hedging relationship but rather to the period over which the hedge adjustment for intrinsic value can affect profit or loss.
Some constituents had suggested the Board establish a principal to assist in better understanding the difference between transaction and time period related hedged items. However, the Board tentatively decided not to create a principal as the suggested principal would not address all items such as hedges of firm commitments.
Some constituents had also suggested that the application of the proposed accounting treatment for time value of options be an accounting policy choice because of the operational complexity associated with the proposals. However, the Board tentatively decided not to introduce an accounting policy choice for the accounting for the time value component of options used as hedging instruments.
Net written options
The hedge accounting exposure draft proposes that a derivative instrument that combines a written option and a purchased option (e.g., an interest rate collar) does not qualify as a hedging instrument if it is a net written option. Similarly, two or more instruments may be designated as the hedging instrument only if none of them is a written option or a net written option.
Constituents have requested the proposals related to net written options be amended so that stand-alone written options combined with other designated hedging instruments that do not result in a net written option be eligible as hedging instruments. This request focuses on the fact that entities will often enter into two separate option contracts that mirror a collar contract rather than a single collar contract because 1) stand alone option contracts are more widely available and therefore more economical as well as reducing credit risk associated with the contract.
One of the Board members was opposed to expanding the use of written options as hedging instruments feeling it would add additional complexity to the hedge accounting requirements. However, other Board members supported the use of multiple contracts that include a component as a written option so long as the net contract was not a net written option and the terms of the options were aligned. The Board tentatively agreed to permit a combination of a written and a purchased option, regardless of whether the instrument arises from a single or multiple contracts, as an eligible hedging instrument unless the combination results in a net written option.