Hedge accounting

Date recorded:


During the September 2009 meeting, the Board had tentatively decided to replace fair value hedge accounting with a model similar to cash flow hedging with gains and losses on the effective portion of the hedging instrument recognised in other comprehensive income and any hedge ineffectiveness recognised in profit and loss.

During constituent outreach, the staff received concern regarding the artificial volatility created within equity as a result of this decision. Those entities expressing this concern included banks and certain non-financial entities who enter into foreign exchange contracts to hedge the risk associated with long term firm commitments, such as aerospace manufacturers and shipbuilders. These entities are concerned over the potential implications from adding the effective portion of hedging relationships into equity, including the possibility of having an overall negative balance within equity as well as the impact on leverage ratios.

The staff proposed three alternatives to address the concerns raised including:

  1. retaining the original decision of recognition in other comprehensive income,
  2. adding a separate balance sheet line item "valuation allowance" for recognition of the effective portion of the hedging relationship (rather than remeasuring the hedged item itself), or
  3. retaining the approach within IAS 39 of remeasuring the hedged item.

The staff recommended alternative 2 by creating a separate line item within the statement of financial position to reflect the effective portion of the hedge relationship.

The Board discussed the three alternatives focusing primarily on alternatives 1 and 2. One Board member expressed reservation on whether the separate line item would meet the definition of an asset or a liability while others felt that rather than needing to meet the definition of an asset or liability, it was strictly a valuation allowance for a recognised asset or liability or a recognised firm commitment in a hedge relationship.

A majority of the Board ultimately agreed with the staff recommendation to create a separate line item within assets or liabilities to recognise the effective portion of the hedge relationship.

The Board then discussed an alternate proposal brought by one staff member which recommended a linked presentation approach for fair value hedges of firm commitments. Discussion ensued over the difference between a linked presentation approach and offsetting (primarily that offsetting presents two items as a single item within the financial statements where linked presentation "links" two separate items (typically one asset and one liability) that have a natural connection and are beneficial to present together rather than in separate sections of the statement of financial position. While the suggested alternative was only to allow linked presentation for fair value hedges of firm commitments (as the hedged item is not recognised within the statement of financial position), many Board members discussed extending the approach to all fair value hedges. The Board tentatively agreed not to permit a linked presentation alternative at this point but to continue outreach on this issue.


Effectiveness assessment

One of the issues constituents have recommended addressing during the project to reconsider hedge accounting is the effectiveness assessment to initially qualify and continually retain the eligibility for hedge accounting. Many belief the current effectiveness requirements are overly rules driven (the arbitrary 80 to 125 percent brightline), the testing requirements are too onerous (requirement to continually perform both prospective and retrospective effectiveness tests), the cliff effect of failing the effectiveness criteria is too severe (effectiveness outside the 80 to 125 band in any one period results in the loss of hedge accounting), and potentially most important - there is little to no correlation between the hedge accounting qualification requirements and the underlying risk management strategy.

The staff considered whether an approach of establishing a minimum level of effectiveness to allow certain hedges in or an approach of establishing guidelines such that hedges with accidental offsetting were kept out was preferable. The staff also considered the use of qualitative thresholds, quantitative thresholds, or some combination of the two as the effectiveness assessment criteria. The staff proposed four alternatives to the Board for effectiveness assessments:

  1. a quantitative threshold
  2. a qualitative threshold,
  3. rely solely on an entity's risk management policy, or
  4. a combination of qualitative thresholds with minimum requirements tied to risk management or supplementary tests.

The Board agreed with the staff recommendation for alternative 4 to incorporate a model for effectiveness assessment using both qualitative thresholds and risk management policies. Using this approach the staff further proposed an approach that would bifurcate hedging relationships into non-complex and complex hedging relationships.

Non-complex hedging relationships would be those where the critical terms are either matched or closely aligned such that the hedge is expected to be highly effective throughout its life. Because these hedges are expected to be highly effective, they would be qualitatively assessed for effectiveness prospectively at inception and on an ongoing basis unless events occur that would result in the hedge no longer being considered effective in which a quantitative assessment would be performed.

Complex hedging relationships would not have matching terms thereby increasing the uncertainty regarding the level of offset between the hedging instrument and the hedged item. Because of the level of uncertainty regarding their effectiveness, these hedging relationships would be quantitatively assessed prospectively at inception and on an ongoing basis.

The Board had mixed views on the staff proposal with some members supporting the proposal. However, other Board members expressed concerns ranging from operationalising the proposal for complex hedging relationships, the lack of convergence with the FASB's proposals and concerns that the criteria set for qualifying for effectiveness did not seem sufficiently stringent enough. One Board member proposed a model where effectiveness should be assumed to be very highly correlated and as part of the hedge designation, the entity would document those risks that would contribute to ineffectiveness of the hedge relationship from its risk management policy. Other Board members seem to support the underlying concept of this proposal and the Board asked the staff to further develop this approach.

This discussion was continued on the next day.

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