Financial instruments — Hedge accounting (IASB only)
In September 2012 the IASB posted a draft of the forthcoming hedge accounting requirements (the “draft requirements”) on their website. This session focused on the feedback received on those proposals. The following topics where discussed:
- Use of ‘hypothetical derivatives’ and accounting for the effect of foreign exchange (FX) basis spreads.
- Transition for new accounting treatment for ‘own use’ contracts.
- The scope of the new hedge accounting model and ‘macro cash flow hedge’ accounting.
Papers relating to compliance with due process and consideration of re-exposure and permission to draft were prepared by the staff in advance of the meeting but were not discussed.
Measurement of the hedged item — ‘hypothetical derivatives’
One of the issues raised most frequently by respondents was the application guidance on measuring hedge effectiveness with a ‘hypothetical derivative'. In particular, concerns focused on the effect of this guidance when hedging foreign currency risk using cross-currency swaps. The staff grouped the concerns in three main areas:
- Due process aspects
- Conceptual considerations
- Implications for hedge accounting practice
The staff explained why they believed due process concerns about the issue were not justified, but highlighted that bringing the issue back to the Board now means that the feedback on the issue will be taken into account in the Board’s redeliberations.
The staff then summarised the conceptual and practical issues, stating that there should be no conceptual difference between cash flow and fair value hedges in relation to this issue, as they both require the independent valuation of the hedged item. Current practice is to treat currency basis as a cause of ineffectiveness for fair value hedges but not for cash flow hedges and the staff expressed their concern about the resulting “accounting arbitrage”. The staff also explained the difficulties both conceptually and in practice of determining the “perfect derivative” that an alternative model for cash flow hedges would require.
The staff presented the Board with three alternatives; to finalise the draft hedging requirements as they are; to allow the use of the hypothetical derivative to be continued in a way that grandfathers existing practice; or expand the notion of ‘costs of hedging’ to accommodate FX basis spreads.
The final option is based on the idea that the FX basis spread is an unavoidable cost of hedging, similar for to the premium of an option or forward element of a forward contract. The draft requirements allow the time value or forward element of the hedging instrument to be excluded from the designation and the relevant part of it to be recognised initially in equity and recycled later. This is allowed as an exception and other unavoidable costs of hedging cannot be treated in this way.
Most Board members commented to the effect that they did not consider the grandfathering of current practice to be acceptable and generally agreed that FX basis spread could be considered to be an unavoidable cost of hedging. A number of Board members expressed concern in relation to expanding the current exception for time value of options and interest element of forward contracts to a general principal that could be applied to all such costs, fearing that this could lead to basis risk or other inefficiencies in the hedging process being deferred in equity rather than being recognised as ineffectiveness. One Board member also highlighted that an introduction of a new principal at this stage could result in a need for re-exposure.
When put to the vote, the Board tentatively supported the staff recommendation expand the notion of ‘costs of hedging’ to accommodate FX basis spreads, but as an additional specified exception rather than replacing the current exceptions with a general principle.
Designation of ‘own use’ contracts as FVTPL — transition requirements
The draft requirements allow the designation of ‘own use’ contracts at fair value through profit or loss (FVTPL) on initial recognition. One issue raised by respondents was that only allowing the designation of new contracts prospectively would result in the new treatment being phased in over a potentially long period. This in turn would result in confusing comparative numbers and may discourage the application of an accounting treatment that could generally provide more useful information.
The staff explained that the transition provisions of the draft requirements had been intended to prevent ‘cherry picking’ and that it still would not be appropriate to allow the designation of existing contracts on transition on a contract by contract basis. However, they also felt that designating on an ‘all-or-none’ basis across an entity or group would be problematic if a variety of ‘own use’ contracts were used across the business for different purposes. The staff therefore recommended amending the transition requirements to include an “all-or-none” election for ‘own use’ contracts to designate all similar contracts existing on transition at FVTPL (with the corresponding consequential amendment to IFRS 1 First-time Adoption of International Financial Reporting Standards).
The Board tentatively supported the staff recommendation.
Scope and interaction with macro hedging activities
The staff explained that the feedback received indicated that there had been confusion amongst respondents in relation to the extent of the scope exemption in the draft requirements for the macro hedging activities and as to how macro cash flow hedging could be accommodated with in the general hedging model.
The first point of clarification by the staff was that the scope exemption in the draft requirements allowing entities to continue to apply the requirements of IAS 39 Financial Instruments: Recognition and Measurement (and the European Union (EU) carve out where applicable) only applies to macro fair value hedging. It was explained that this is because the macro hedging project relates only to the development of a fair value macro hedging model. The staff further highlighted that under IAS 39 macro cash flow hedging is an extension of the general hedging requirements of the standard.
The staff had identified a number of areas where respondents felt clarification or amendment of the draft requirements was needed in order for macro cash flow hedging to remain operational.
Most Board members expressed support for the clarifications suggested by the staff. In particular that;
- the basis of conclusions be amended to clarify that ‘proxy hedging’ that is directionally consistent with actual risk management is consistent with the draft requirements (Recommendation 2);
- minor amendment to the draft requirements to state that discontinuation applies to the extent to which the risk management objective changes (risk management objective at the relationship level as distinct from risk management strategy at a high level, to clarify that the model does not require an all-or-nothing approach whereby discontinuation of one hedge could result in the discontinuation of other hedges where the risk management objective and strategy have not changed; Recommendation 3); and
- an explicit statement in the basis of conclusions that not carrying forward any hedge accounting Implementation Guidance (IG) is without prejudice (Recommendation 4).
However, one Board member highlighted the need to clearly articulate what was meant by phrases such as ‘directionally consistent’ and ‘without prejudice’
Much of the debate focused on the treatment currently applied under IAS 39 as well as on the question of the EU carve out and its applicability to macro cash flow hedges in the context of the draft letter from the European Financial Reporting Advisory Group (EFRAG). As part of this debate the possibility of grandfathering of such treatment by including the IAS 39 IGs relating to macro cash flow hedging was raised. It was stressed that including the IGs would not change the requirements of the standard, as they were intended to illustrate the requirements of the standard rather than amend them (and should not currently be considered to be a departure from the IAS 39 general model). The Board expressed general support for the staff recommendation not to grandfather the IAS 39 treatment by including the IGs in the revised proposals (Recommendation 1). However the final staff recommendation (Recommendation 5) not to make any changes to drafting of the scope exemption for macro hedging and the extent to which IAS 39 applies was more controversial
The chairman stressed that the draft requirements were popular and that further delay was not acceptable. He expressed frustration at receiving the feedback from EFRAG and other respondents at this late stage, but it was acknowledged that expectations of respondents had not been met. He felt that focused research was needed to understand what is the current practice under the carve out, and why this could be considered to result in better accounting. However, it was felt that a satisfactory solution could not be guaranteed.
The Board tentatively supported the staff Recommendations 1-4 as set out about. Recommendation 5 was not voted on and it was agreed to discuss the issue further over the next month or two.