Financial instruments – Hedge accounting
The hedge accounting exposure draft proposed a change in the accounting for the time value of options but did not propose any changes in the accounting for forward contracts (i.e., an entity may designate either the forward contract in its entirety or the change in the spot element of the forward contract as an eligible hedging instrument. Feedback to the exposure draft requested the board extend the proposals related to time value of options to also include forward points.
The IASB staff noted that the time value of options and forward points do share similar characteristics, in particular that the time value changes over time with the fair value reaching zero at the end of the contract.
Currently under IAS 39, entities who elect to designate the forward contract in its entirety (the 'forward rate method') for transaction related items results in an accounting similar to the proposals in the exposure draft for time value of options (e.g., the initial time value is deferred in OCI and recognised based on the general requirements of the hedged item (i.e., 'basis adjusted'). However, for time period related hedged items, no similar allowance is provided and entities must either use the forward rate method or designate only the spot element (with fair value changes in the forward points recognised as a trading gain or loss). The staff found during outreach this was particularly a relevant issue for financial institutions in Asia who routinely use funding swap transactions. In their view, forward points represent the interest differential between the two currencies at inception and are economically considered an adjustment to the investment yield.
The IASB staff recommended the Board permit the recognition of forward points that exist at inception of a hedging relationship in profit or loss over time on a rational basis and accumulate subsequent fair value changes in accumulated other comprehensive income. One Board member expressed concerns with the proposal stating his view that he looked at forward points as different from time value of options as forward points could be a cost of hedging but could also be an income source. As a result, he considered forward points a basis risk that should be recognised in hedge ineffectiveness. However, other IASB members generally supported the staff recommendation although a couple expressed a preference for making a requirement rather than permitting forward points to be accounted for similar to the approach for time value of options. The Board tentatively agreed to permit the recognition of forward points that exist at inception of a hedging relationship in profit or loss over time on a rational basis and accumulate subsequent fair value changes in accumulated other comprehensive income.
The hedge accounting exposure draft proposed that if an entity combines an exposure with a derivative in order to create a different aggregated exposure managed as one exposure for a particular risk then that aggregated exposure may be designated as a hedged item.
During outreach activities for the exposure draft, constituents were very supportive of the proposals regarding aggregated exposures as it helps to align hedge accounting with an entity's risk management and removes the current arbitrary restrictions that exist in IAS 39. Only limited constituents disagreed with the proposals; however, several constituents requested the board 1) provide examples to illustrate the accounting mechanics related to aggregated exposures, 2) provide clarification that accounting for aggregated exposures is not a method of 'synthetic accounting' and 3) to clarify whether hedge accounting must be achieved for the combined exposure and derivative as a precondition for the aggregated exposure being an eligible hedged item in another hedging relationship.
Additional topics related to aggregated exposures where constituents asked for further clarity included:
- whether forecast transactions that will constitute aggregated exposures when executed can be designated as an aggregated exposure
- whether derivatives must be designated in their entirety or whether selected cash flows could be designated
- whether a derivative for a shorter period than the non-derivative exposure can still be combined and designated as an aggregated exposure,
- whether derivatives that are basis swaps can be used when hedging aggregated exposures
- how hedge accounting for the aggregated exposures as the hedged item would be impacted if hedge accounting for the combined exposure and derivative were discontinued.
Based on the constituent feedback, the IASB staff recommended that the Board confirm the proposal in the exposure draft subject to providing additional clarifying guidance, include illustrative examples in the final standard, clarify that derivatives that are part of an aggregated exposure are always recognised a separate assets or liabilities and measured at fair value and to provide in the basis for conclusions of the final standard that an aggregate exposure is part of hedge accounting and not a form of 'synthetic accounting', not to impose specific restrictions which would require hedge accounting for the original exposure and derivative that form the aggregated exposure, and to clarify that the notion of an aggregated exposure includes a highly probably forecast transaction of an aggregated exposure if that aggregated exposure once executed is eligible as a hedged item and how to apply the general requirements in the context of designating a derivative as part of an aggregated exposure.
One of the IASB members inquired of the staff on one of the clarification topics in the agenda paper of whether derivatives that are basis swaps can be used when hedging aggregated exposures. The agenda paper highlighted that because the basis swap only changes the type of variability that they do not qualify in either a cash flow or fair value hedge relationship. The Board member mentioned that he would support permitting basis swaps in hedging relationships. Another Board member stated their support for the inclusion of the illustrative examples as he felt that examples provide better clarity than complex and detailed guidance.
However, one Board member stated that he disagreed with permitting aggregated exposures as eligible hedged items in the exposure draft and still had concerns. In fact, he felt as the staff proposals were expanding the ability to hedge aggregated exposures. He would prefer that the Board add more discipline around the initial relationship as he had concerns that entities could override the classification and measurement requirements. Another Board member agreed with this concern.
The Board tentatively agreed to the following:
- reconfirm the proposal in the exposure draft allowing designation of an aggregated exposure as an eligible hedged item
- include illustrative examples in the final standard
- to clarify:
- in the final standard that derivatives that form part of an aggregated exposure are always recognised as separate assets or liabilities and measured at fair value
- in the basis for conclusions that the Board noted that accounting for aggregated exposures is part of hedge accounting and different from 'synthetic accounting'
- not impose any specific restrictions regarding the non-derivative original exposure and the derivative that form the aggregated exposure to be an eligible hedged item
- to provide additional clarification to the final standard by:
- expanding the description of an aggregated exposure to include a highly probable forecast transaction of an aggregated exposure if that aggregated exposure once executed is eligible as a hedged item, and
- adding application guidance:
- that the way in which a derivative is designated as a hedged item as part of an aggregated exposure must be consistent with any designation of that derivative as the hedging instrument at the level of the aggregated exposure, and
- that otherwise a derivative must be designated in its entirety or as a percentage of its nominal amount.