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Financial instruments – Hedge accounting

Date recorded:

The IASB discussed three topics related to the ongoing hedge accounting project:

Scope - Own use exception

IAS 39 Financial Instruments: Recognition and Measurement currently requires that contracts to buy or sell a non-financial item that can be settled net, but are entered into for the purposes of receipt or delivery of the non-financial item as part of the entity's expected purchase, sale or usage requirements would be outside the scope of IAS 39. As a result, those contracts are not considered derivatives and would not be marked to market at each reporting period.

During outreach performed by the staff, commodity processors and servicing providers have expressed concern about the requirement within IAS 39 related to the "own use" exception. The business model for these entities includes acquiring a commodity, refining that commodity and then distributing the commodity, oftentimes into a fairly liquid market (e.g. sugar or canola oil) or are priced based on a commodity benchmark plus a processing margin. To mitigate risks in commodity price fluctuation during the refinement process (as their business model is strictly earning the margin related to the refinement process) these entities often enter into derivatives to fix their sales price of the refined product.

These entities manage their business on a fair value basis and oftentimes also on a net basis, however the inability to recognise the original acquisition contract as a derivative because of the own use exception results in an accounting mismatch. Applying fair value hedge accounting is a possible alternative, but is difficult because of the volume of contracts in place and the fact that many positions offset each other. Entities that do apply net hedging are required to frequently designate, dedesignate and redesignate the hedge relationship because of the frequent movements of the overall net position.

The Board considered three possible alternatives to address the own use exception issue:

  • Retain the current "own use" exception requirement within IAS 39,
  • Allow for election of the "own use" exception (approach similar to current practice under US GAAP), or
  • Require entities that manage their business on a fair value basis to account for contracts that meet the "own use" exception as a derivative.

One Board member asked the staff whether under alternative three, similar to IFRS 9, an entity could have more than one business model for managing their business as the agenda paper referred to "an entire business" being managed on a fair value basis. The staff confirmed that similar to IFRS 9, entities could have more than one business model.

That Board member also asked whether the act of net settling a few contracts would prohibit those entities not managing their business on a fair value basis to continue to receive the own use exemption. The staff responded that the guidance related to the net settlement definition of a derivative was not being reconsidered as part of the hedging project and the requirements under IAS 39 would be retained within IFRS 9.

The Board tentatively agreed to retain the own use exception within IAS 39 but to require those entities who manage their business on a fair value basis to account for contracts to acquire non-financial items and permit net settlement as derivatives.

Risk components - Hedging items with a negative spread to LIBOR

IAS 39 currently requires that if a portion of the cash flows for a financial asset or liability are designated as a hedged item, the designated portion must be less than the total cash flows of the asset or liability. However, an entity may designate as a hedged item an asset or liability with an effective interest below LIBOR to be hedged for a component risk of changes in LIBOR. The difference between LIBOR and the negative LIBOR spread on the hedged item will be a source of hedge ineffectiveness, but so long as the effectiveness remains within the 80-125% effectiveness bandwidth, hedge accounting is retained. Entities may also choose a hedge relationship of other than one to one to improve the hedge effectiveness.

The staff raised the issue of whether a LIBOR-component of an interest bearing financial asset or liability exists if the effective interest rate of the instrument is lower than LIBOR and whether the LIBOR-component should be eligible for designation as a hedged item. The staff provided an analysis of an entity with a sub-LIBOR instrument who enters into a LIBOR for fixed swap. As LIBOR rates dropped below 1% a negative margin on the instrument occurs because of the floor of the fixed pay-leg.

The Board considered whether to retain the current guidance within IAS 39 described above or whether to allow for the designation of risk components on a benchmark risk basis that assumes cash flows exceeding the total actual cash flows of the hedged item. The Board tentatively agreed to retain the current guidance within IAS 39.

Disclosures

The Board continued its discussion from the September 2010 Board meeting on disclosures related to hedge accounting activities.

For the impact of hedge accounting on the balance sheet, the staff is developing a disclosure approach requiring a tabular format presentation of information by type of hedge and by risk category. For both fair value and cash flow hedges, an entity would disclose the notional amount and the carrying amounts of the hedging instrument (separating assets and liabilities). For cash flow hedges, an entity would also disclose the balance within accumulated other comprehensive income from revaluation of the hedging instrument that relates to the hedged item and the balance of any discontinued hedged items. For fair value hedges, an entity would also disclose the carrying amount of the accumulated gain or loss on the hedged item (the valuation allowance recognised on the balance sheet).

For the impact of hedge accounting on profit and loss, OCI and the cash flow hedge reserve, similar to the balance sheet disclosures above, the staff is developing a disclosure approach requiring a tabular format presentation of information by type of hedge and by risk category. For both cash flow and fair value hedges, an entity would disclose the changes in the value of the hedging instrument, the ineffectiveness recognised in profit or loss, and the line item in profit or loss in which hedge ineffectiveness is included. For cash flow hedges, an entity would also disclose the effective hedging gain or loss recognised in a separate line item in the income statement for hedges of net positions, the amount transferred out of accumulated OCI to profit or loss, the line item affected in profit or loss because of the transfer and a reconciliation of the cash flow hedge reserve.

In addition to the impacts of hedge accounting recognised in the financial statements, the staff is also developing disclosures on information not captured within the financial statements. These disclosures include information on the risk management strategy, quantitative information of risk exposures and how the risk is hedged including the monetary amount or quantity (barrels, tonnes, etc.) exposure for that risk, the amount or quantity of the risk exposure being hedged, and how hedging has changed the exposure.

The staff has favoured not requiring any specific level of aggregation for disclosure purposes rather stating that management judgement would be required in determining the appropriate level.

One Board member encouraged the staff to develop a disclosure framework that follows a logical manner rather than simply starting with the accounting information. Another Board member questioned how certain of the disclosures could be aggregated to any meaningful level given the requirement to disclose specific quantities. But the Board overall supported the direction the staff was proceeding with in developing the disclosure requirements.

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