Financial instruments — Hedge accounting

Date recorded:

The IASB discussed:

Use of credit derivatives

Financial institutions often use credit derivatives to manage the credit risk of their lending activities (both outstanding loans and loan commitment facilities). Lending activities typically include various optionality features including prepayment options, liquidity options (undrawn facilities), and extension options. The credit derivatives used to manage credit risk are credit default swaps (CDS) (derivatives marked-to-market under IAS 39) which creates an accounting mismatch and results in financial reporting that doesn't faithfully represent the underlying economics. Loans are typically measured at amortised cost under IAS 39 (and IFRS 9) and loan commitments typically fall within the scope of IAS 37 rather than IAS 39.

Fair value hedge accounting is difficult to achieve for these relationships because of the inherent difficulty in isolating and measuring the credit risk component. Similarly, the fair value option is not a suitable alternative for a variety of reasons. For loans, the decision to purchase credit protection through CDS is typically made after origination of the loan so the decision to designate the loan as at fair value through profit and loss would have to be made prior to the decision to protect the credit exposure with credit derivatives. Also, entities often do not fully protect their credit exposure but instead leverage the CDS protection for a portion of their credit exposure. However, designating the entire loan at fair value and a CDS with a notional amount less than the loan exposure would still result in an accounting mismatch. For loan commitments, they typically fall outside the scope of IAS 39 and therefore are ineligible to designate as at fair value through profit and loss.

The staff presented three alternatives to the Board for consideration of how to permit fair value accounting for the loan or loan commitment. The first alternative was to permit fair value designation only at initial recognition, permit designation of a component of a nominal amount and permit discontinuance of fair value accounting. The second alternative is similar to alternative one except that the fair value designation could be made at any time, but if made subsequent to initial recognition, then the difference between the carrying amount and fair value at the date of designation would be recognised in profit and loss. The third alternative is similar to alternative two, except rather than recognising the difference between the carrying amount and the fair value immediately through profit and loss, it would be deferred and amortised.

The Board had significant reservations with the staff proposals. One Board member acknowledged the problem under current practice and said that the Board needed to do something to address the accounting mismatch. However, he framed the staff proposals as a new hedge accounting model. He said his preference would be to somehow allow for fair value hedge accounting under the model being developed by the Board (where the hedged item would not be remeasured but instead would have a separate valuation allowance) because when recording the loan at fair value investors lose information about the amortised cost and interest margin on the loan.

Another Board member expressed his concerns with the proposals stating the Board will get pressure to provide similar allowances for the fair value option for other instruments such as permitting designation after initial recognition and discontinuing designation. He suggested that an approach under U.S. GAAP's hedge accounting model could be a basis for a solution. ASC 815-20-25 (formerly DIG G20) addresses the assessment and measurement of the effectiveness of a purchased option used in a cash flow hedge. The Board member analogised the premium payments on a CDS to an annuity payment to acquire a purchased option.

The Board tentatively decided not to permit exceptions to the fair value designation for loans and loan commitments being managed for credit risk with credit derivatives. However, the Board did agree to further explore other potential alternatives as solutions.

Discontinuation of hedge accounting

The Board next discussed if and when a hedging relationship could or should be discontinued.

The staff proposed criteria for discontinuing a hedging relationship as follows:

  • Mandatory discontinuation occurs when the hedging relationship ceases to meet the qualifying criteria for hedge accounting (entities would be able to start a new hedging relationship with the items previously included in the discontinued hedge)
  • Adjustments to the hedging relationship would require discontinuation when there was a change in the risk management objective of the hedge relationship.
  • Adjustments to the hedging relationship are permitted for a continuing hedge relationship when the qualifying criteria (other than risk management objective) have either failed or anticipate failing.
  • Elective dedesignation would not be permitted when the qualifying criteria are still met.
  • The designation documentation supporting the hedge relationship must be updated to address any changes in the hedge relationship.

The Board discussed whether hedge accounting would be elective or mandatory as that decision could be relevant to whether elective dedesignation were permitted. The staff responded that the Board had not made any decisions on whether hedge accounting would be mandatory or elective but conceded that with the model under development it would be difficult to require mandatory use of hedge accounting.

Several Board members expressed support for the criteria proposed by the staff for discontinuation. One Board member summarised it as bringing rigor, discipline and transparency to hedge accounting.

Other Board members expressed concerns with the staff proposals, particularly with respect to the criteria of not being able to dedesignate the hedge accounting relationship. One Board member mentioned that he just participated in the FASB financial instruments roundtable and their exposure draft had a similar proposal which very few supported.

There was a question on the documentation criteria as the staff has not raised the components of the hedge documentation requirements with the Board. The staff responded that it had not brought the issue to the Board yet, but the hedge documentation would likely include such items as the hedging instrument, the hedged item, the risk being hedged, whether the hedge was on a risk components basis, the period of the hedge relationship and anticipated sources of ineffectiveness in the hedge relationship.

The Board tentatively agreed with the staff proposal on the discontinuance criteria.

Rebalancing and reassessment of the hedge ratio

Under the hedge accounting model being developed by the Board, the effectiveness assessment requires entities to rebalance their hedge relationships such that they do not result in unexpected hedge ineffectiveness. To accommodate the need for entities to rebalance their hedge relationships in order to continue to meet the qualifying criteria, the Board tentatively agreed to permit voluntary rebalancing for continuation of hedging relationships which would not be dependent on the type of unexpected hedge ineffectiveness but rather that the risk management objective continues to apply.

The Board was also provided with the following examples of the application of rebalancing and its interaction with discontinuation of hedging relationships:

  • Changes in the behaviour of the benchmark: increase in the premium between benchmark and hedged commodity with no change in the hedged item
  • Changes in the behaviour of the benchmark: reduction in the premium between benchmark and hedged commodity with no change in the hedged item
  • Changes in the quantity of the hedged item (increase) with no changes in the basis
  • Changes in the quantity of the hedged item (reduction) with no changes in the basis

Based on the examples provided, the Board tentatively decided that assuming the risk management objective had not changed, then adjusting the hedge ratio would not impact the measurement of changes in the fair value of the hedged item, rebalancing may require partial discontinuation if the changes are above the expected levels of ineffectiveness, and if the quantity of highly probable forecast transactions is overestimated then partial discontinuation would be appropriate assuming there is no history of routinely overestimating such transactions.

Eligibility of hedged items — Groups and net positions

Based on requests made by the Board at the September 2010 Board meeting, the staff developed illustrative examples of net position hedges. Based on the additional information provided, the Board reconsidered the three alternatives of how to establish criteria for applying hedge accounting for net positions originally discussed during the September 2010 Board meeting.

The first alternative is to carry over from IAS 39 all of the existing restrictive criteria that apply to groups of hedged items. The second alternative is to include some of the restrictive criteria, such as that a net position cannot be an eligible hedged item in a cash flow hedge. The third alternative would not carry over any of the existing restrictive criteria from IAS 39, but rather include concepts such as demonstrating that it manages the items on a group basis for risk management purposes and identifying and designating gross amounts as part of the hedge relationship.

The Board was primarily split between Alternatives 2 and 3. However, one Board member was not comfortable with either Alternative 2 or 3 and therefore preferred Alternative 1. The Board tentatively agreed to proceed with Alternative 2 (with 8 votes) but also plans to explain Alternative 3 within the exposure draft.

The Board also discussed the topic of whether a net nil position (inbound and outbound firm commitments of the same amounts) should be eligible for hedge accounting. The staff acknowledged that this would likely be a rare scenario in practice, but did recommend permitting the hedging of a net nil position as it would be inconsistent to not allow hedge accounting because an entity manages foreign exchange risk on a net basis. The Board tentatively agreed to permit hedge accounting for a net nil position.

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