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Financial instruments – Hedge accounting

Date recorded:

As part of its continued deliberations surrounding the Exposure Draft Hedge Accounting (ED), the IASB (individually, the Board) deliberated on the following topics:


Summary

The Board made a number of tentative decisions in the conduct of these deliberations, as summarised below:

Accounting for the time value of options for 'zero-cost' collars

  • the accounting for zero-cost collars and the time value of options would be aligned.

Designation of nominal components

  • A layer-based designation of a hedged item is allowable (when the item does not include a prepayment option whose fair value is affected by changes in the hedged risk);
  • for partially prepayable items, a layer-based designation of the hedge item should be allowed for those amounts that are not prepayable at the time of designation;
  • a designation of a layer as the hedged item should be allowed if it includes the effect of a related prepayment option when determining the change in fair value of the hedged item; and
  • for the purpose of the eligibility of layer-based designation of hedged items there would be no differentiation between written and purchased prepayment options.

Accounting for fair value hedges

  • fair value changes of the hedging instrument and the hedged item would be taken immediately to profit or loss as is currently required by IAS 39, rather than OCI which was proposed in the ED, with elevated disclosure in the notes to the financial statements that provide the extent of risk management activities and offetting achieved by hedges;
  • the gain or loss on the hedged item attributable to the hedged risk should be reflected as an adjustment to the carrying amount of the hedged item as is currently required by IAS 39, rather than as a separate line item in the statement of financial position which was proposed in the ED, with disclosure of the fair value hedge adjustment in the notes to the financial statements; and
  • linked presentation would not be allowed for the purposes of hedge accounting.

Accounting for time value of options — 'zero-cost' collars

As part of the ED, the Board proposed that the time value of options, representative of a premium for protection against risk ('insurance premium' view), would be treated as a cost of hedging, whereby the time value paid in a hedging instrument is deferred in other comprehensive income (OCI) with any subsequent changes in the fair value of the time value accumulated in OCI and reclassified or released to profit or loss depending on the type of the hedged item.

In this meeting, the Board discussed zero-cost collars, which for purposes of this discussion, are representative of a combination of put and call options for the sale (or purchase) of a commodity and have a combined net nil cost (time value) at inception. Given the Board's earlier proposals in the ED, the treatment for time value of options would not apply to zero-cost collars because these collars have no (net) time value at inception. Therefore, the staff sought clarity from the Board as to whether the final requirements for the accounting for time value of options should also apply to zero-cost collars, given that zero-cost collars do provide for fluctuating time value components over the life of the hedging relationship, even absent a time value component at inception. We also acknowledge that the Board has not yet redeliberated on the ED proposal on the time value of options, as this topic is reserved for a future meeting. Instead, the purpose of today's deliberation related strictly on whether the accounting for zero-cost collars and other time value options should be aligned.

The staff highlighted comment letter and outreach feedback in which many respondents viewed that the proposed accounting for purchased options should also apply to all zero-cost collars; highlighting the susceptibility of transaction structuring if alignment is not applied.

Several Board members considered that from a risk management perspective, the change in time value of the combined purchased and written options is exactly the same as for other options used for hedging purposes, with a zero-cost collar generally used to reduce the cost of hedging. Therefore, time value would be viewed as temporary volatility consistent with an upfront premium / cost.

One IASB member expressed concern regarding presentation of zero-cost collars within OCI, as he feared that OCI would be a dumping ground for other option activity. More specifically, he noted that the distinction of zero-cost collars and forward point contracts was not readily distinguishable, and from that perspective, he expressed concern with the implications of aligning zero-cost collars and time value options given that the ED currently proposed to account for the latter within OCI (although the accounting will be redeliberated at a future meeting).

The Board tentatively decided that the treatment for zero-cost collars should be aligned with that of the treatment for time value of options, although the final requirements for the accounting of the time value of options will be deliberated at a future meeting.

Designation of nominal components — layers

Following from outreach questions posed in the ED regarding the designation of a layer of the nominal amount of an item as a hedged item, the Board considered whether to retain the proposals in the ED or change the eligibility of a layer-based designation of hedged items in some circumstances when the hedged item includes a prepayment option. In particular, the ED proposed that (a) a layer component of the nominal amount of an item would be eligible for designation as a hedged item and (b) a layer component of a contract that includes a prepayment option would not be eligible as a hedged item in a fair value hedge if the option's fair value is affected by changes in the hedged risk. These proposals would change how an entity could designate the hedged item for scenarios other than forecast transactions, for which a layer-based designation is already permitted under IAS 39.

The staff presented comment letter and outreach activity feedback, in which most respondents agreed with the proposal that a layer component of the nominal amount of an item should be eligible for designation as a hedged item, while mixed feedback was present regarding the proposal that a layer component of a contract that includes a prepayment option would not be eligible as a hedged item in a fair value hedge, with dissenting respondents highlighting that the proposal is inconsistent with common risk management strategies and the value of a prepayment option of a bottom layer is irrelevant.

In determining whether to retain the proposals in the ED or change the eligibility of a layer-based designation of hedged items in some circumstances, the Board considered the following:

Eligibility of layer designation

Given overwhelming support from respondents, and as considered in the Basis for Conclusions section of the ED, the Board confirmed the proposals in the ED of allowing layer-based designation of a hedged item (when the item does not include a prepayment option whose fair value is affected by changes in the hedged risk). The Board noted the necessary inclusion of a top layer designation example in a final standard based on constituent outreach requesting clarity as to whether top layers would be allowed to be designated as the hedged item and whether their eligibility would depend on whether the layer relates to an open or a closed population of items. As the ED did not specifically include a top layer designation, and since this is a change from IAS 39, the staff will add a top layer designation to the examples in any final standard issuance.

Relevant reference point of the prepayment option

Responding to feedback received from outreach which noted that the ED was not sufficiently clear as to the designation application for partially prepayable items, the staff recommended that for partially prepayable items, a layer-based designation of the hedge item should be allowed for those amounts that are not prepayable at the time of designation. This recommendation is based on agreement with respondents that the prepayment option is only relevant if it relates to the designated layer instead of the entire item or contract, while also considering that eligibility of layer-based designation would be consistent with the Board's rationale for the proposals regarding the effect of prepayment options for layer-based designations.

The Board tentatively agreed with the recommendation of the staff, but one IASB member cited that the assessment should consider interdependence of the relationship as opposed to describing the transaction as partially prepayable (e.g., basis risk versus separability risk).

Designation including the effect of a prepayment option

Based on outreach feedback, the staff then asked the Board to consider an environment in which prepayable items are not prepayable at par, but instead, include a mechanism to compensate the lender for early repayment (e.g., 'make whole' provision) or another prepayment option. The ED cited that if these result in aggregate in an exercise price of the prepayment option at fair value (e.g., repayment at the concurrent fair value on the repayment date), layer-based designation of the hedged item was allowable. However, if the compensation mechanism does not exactly result in an exercise price of the prepayment option at fair value, partial compensation of a layer-based designation is not allowable.

In such an environment, the staff agreed with respondents that a designation of a layer as the hedged item should be allowed if it includes the effect of a related prepayment option when determining the change in fair value of the hedged item. It was noted that this designation would not conflict with the Board's rationale in proposal and would allow entities to align accounting with their risk management while also capturing the effect of prepayment penalties.

Two Board members disagreed with this proposal in highlighting the staff's proposal would not apply a proportionate basis as historically applied under IAS 39, and thus, would not appropriately capture the basis risk independent of the separability risk (e.g., the macro hedge accounting concern which was expressed as part of the 12-15 April 2011 Board meeting).

The Board tentatively decided that a designation of a layer as the hedged item should be allowed if it includes the effect of a related prepayment option when determining the change in fair value of the hedged item, but requested future deliberation which considers feedback expressed in the two dissenting votes outlined above.

Differentiation between written and purchased prepayment options

Following respondent feedback that for the eligibility of layer-based designation of hedged items, written and purchased prepayment options should be differentiated, the staff disagreed with respondents and noted (a) the hedged risk affects the fair value of a prepayment option irrespective of whether the particular option holder actually exercises it at that time or intends to actually exercise it in the future and (b) this would conflict with the Board's rationale in proposal.

Following this feedback, the Board tentatively decided to not differentiate written and purchased prepayment options for the purpose of the eligibility of layer-based designation of hedged items, as consistent with the ED.

Accounting for fair value hedges

Following from outreach questions posed in the ED regarding the presentation of fair value hedges, the Board deliberated on the presentation of fair value hedges, including the ED's proposals of (a) presenting gain or loss on the hedging instrument and hedged item in OCI, with the ineffective portion of the gain or loss transferred to profit or loss, (b) presenting the gain or loss on the hedged item attributable to the hedged risk as a separate line item in the statement of financial position and (c) the disallowance of linked presentation.

Recognising gain or loss on the hedging instrument and hedged item in OCI

Feedback from respondents highlighted that most users supported the Board's proposals for purposes of providing clarity and transparency to the financial statements, and summarising, in one location, the effects of risk management activities (for both cash flow and fair value hedges). Further, such a presentation was believed to provide useful information about the extent of offsetting achieved (e.g., the extent of effectiveness). A minority of respondents, however, highlighted that the use of OCI should be limited until the Board completes its project on what OCI is expected to represent, and thus, did not support the use of presentation within OCI.

Several Board members agreed that the information on the extent of offset, and other risk management considerations, would be useful to users of the financial statements, and thus, agreed that presentation should be clearly provided either on the face of the financial statements or within the notes. A majority of the Board highlighted, however, that inclusion of the effects of risk management activities on the face of the financial statements would be unduly burdensome and limit the usefulness given the addition of a significant number of line items to the financial statements. Similarly, Board members expressed concern with presentation of activity within OCI given the lack of clarity on the definition of OCI.

Following on this discussion, several Board members cited a preference for the approach applied in IAS 39 in which gains and losses on the hedging instrument and the hedged item are presented in profit or loss (for fair value hedges) and OCI (for cash flow hedges), with elevated comprehensive disclosure to provide the effects of risk management activities as well as the extent of the offsetting achieved by hedges. Specific disclosure requirements will be considered in a future meeting. The Board tentatively concurred with this approach. Several Board members expressed a desire to perform specific outreach on this tentative decision given that it differs from the ED proposal which was supported by the majority of outreach respondents.

Separate line item in the statement of financial position

The ED proposed that the gain or loss on the hedged item attributable to the hedged risk should be presented as a separate line item in the statement of financial position in an effort to eliminate the mixed measurement for the hedged item (e.g., an amount that is amortised cost with a partial fair value adjustment).

The staff presented outreach feedback received, in which the majority of respondents and participants supported the elimination of the mixed measurement presentation of the hedged item on the face of the statement of financial position. Most users supported the separate line item presentation and viewed it as useful information, because the effect of the fair value hedges would be transparent on the face of the statement of financial position. These same respondents expressed concern, however, over the additional line items on the face of the financial statements leading to a cluttered presentation, and thus, preferred disclosure in the notes.

The Board was accepting of feedback received from outreach activity and highlighted consistent concern regarding cluttered presentation in the statement of financial position.

As such, the Board tentatively decided to apply the same presentation requirements set forth in IAS 39 (gain or loss on the hedged item attributable to the hedged risk should be reflected as an adjustment to the carying amount of the hedged item), in which the hedge adjustment would be disclosed in the notes to the financial statements.

Linked presentation

The ED proposed not to allow the use of linked presentation for the purposes of hedge accounting, noting that while linked presentation could provide useful information about a particular relationship between an asset and a liability, it does not differentiate between the types of risk that are covered by that relationship and those that are not.

Most respondents agreed with the Board's proposal not to allow linked presentation given that it is thought to impair comparability across entities' financial statements. However, those supporting linked presentation argued that without it, entities that use hedge accounting might be perceived as riskier than those that do not, as separate presentation may not reflect the 'real' economic effects of hedges of foreign currency risk of firm commitments. The Board tentatively decided to retain its original proposal not to allow linked presentation based on the inability to differentiate between the types of risks covered by a relationship, but noted that an industry roundtable is expected on the topic at a later date.

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