Replacement of IAS 39: Hedge Accounting

Date recorded:

IASB-FASB Joint Meeting


Hedged items: Approach for determining what risk components are eligible for designation

The Boards discussed, primarily in the IASB context, possible conditions for bifurcation-by-risk. The discussion was a follow-up to the 2 February 2010 discussion in which some IASB members expressed their concerns that the broad approach to risk components designation might lead to what would be a free choice in componentisation of item and could lead to situation that designation of a component would automatically result in accounting relationship being 100% effective.

The staff paper provided an analysis of the current requirements of IAS 39 with the emphasis on the criteria for eligibility of risk components to be designated as hedged items being separately identifiable and reliably measurable.

Based on application of the IAS 39 criteria to a set of risk components may or may not be explicitly specified in the contract, the staff concluded that IAS 39 criteria do not lead to a free choice of how to split an item into components and do not automatically lead to 100% effectiveness of hedging relationship. Nonetheless, the staff concluded that current requirements of IAS 39 are problematic as they are rule-based and internally inconsistent.

Following this discussion the Board agreed to explore a new criterion for the purpose of determining eligible hedged components. The staff will present such analysis at a future Board meeting.

In the following discussion about possible criteria, one Board member expressed his concerns whether, in case of non-contractually specified risk components, would the risk component be separately identifiable within the entire hedged items. He argued that application of IAS 39 in some of these cases do not result from the fact that the risk component was separately identifiable, but rather from the fact that IAS 39 allows it to be a hedged item. He expressed his concerns about interdependence of risk components in many of the cases.

Another IASB member reinforced this view, by expressing his doubt whether this proposed approach would be operational. He also expressed his view that hedge accounting as such is an exception to the classification and measurement principles of financial instruments. Therefore, in his view, it would be difficult to formulate a broad principle underpinning hedge accounting, and some rules would be necessary.

The staff responded that it was not their intention to formulate the principle behind hedge accounting but rather a principle-based approach for designation of risk components that, in their view, should be possible.

Another Board member supported the broad direction the staff had taken. He asked the staff whether, based on the preliminary analysis, the new criteria for designation of risk components would be broader or narrower in comparison with current requirements of IAS 39. The staff responded that the answer would depend on the usefulness of the information provided to the users of financial statements.

One FASB member noted that the criteria need to be fleshed out before it was possible to determine how operational would the guidance be.

The staff noted that more attention should be focused on the reliably measurable criterion, rather than separately identifiable criterion.

One IASB member stated an example of an AA rated fixed rate instrument. He noted that in the past the benchmark interest rate decreased by 50 basis points whereas the AA rate increased by 100 basis points. He asked the staff to apply any criteria to the example and assess whether the benchmark interest rate was eligible for risk component designation.

The discussion continued by focusing on the FASB approach to bifurcation-by-risk for financial instruments within the remits of the overall FASB model for financial instruments.

The FASB staff recommended the application of the current bifurcation-by-risk model in the ASC Topic 815 if the FASB retains the tentative classification and measurement model for financial instruments. Further, the staff recommended that if the FASB increases the amortized cost category to allow more financial instruments to be measured at amortized cost, the FASB should utilize bifurcation-by-risk guidance similar to that proposed in FASB ED Accounting for Hedging Activities, issued in June 2008, to determine if the relationship qualified for hedge accounting.

The FASB agreed with this staff recommendation. The FASB also agreed that the reasonable effective threshold for hedge effectiveness (also proposed in June 2008 FASB ED) should be carried forward into the new guidance, thereby allowing more hedging relationship to qualify for hedge accounting. The FASB members noted that given the FASB tentative model, the current US GAAP model is the least onerous. However, they noted that any drift to amortized cost category beyond own debt would mean that a more fundamental change was required. The Boards discussed both models and concluded that it is very difficult to further specify the hedge accounting models until the classification and measurement guidance is finalised (the cut between the fair value and amortised cost). The differences between both models are based mainly on the fact that the FASB and IASB classification and measurement models are different, thus leading to different requirements for hedge accounting.

The FASB briefly discussed any need for fair value hedge accounting in the context of financial instruments held for the contractual cash flows. The Board members noted that it is more a synthetic accounting rather than a hedge accounting, that is, its purpose is in many cases to lock-in a cash flow in case of mismatch of fixed-rate financial assets financed by variable-rate financial liabilities (such as in the context of a financial institution).

The Boards summarised that the FASB hedge accounting model would portray all the risk in the financial statements whereas the IASB model consistently with the amortised cost notion would not portray all the risks in the financial statements. One IASB member noted that a paradoxical implication of the FASB model in the IASB context would be that financial instruments measured at amortised cost subject to hedge accounting rules would also portray effects of non-hedged risks in the profit and loss (fair value) whereas reporting entities not applying hedge accounting rules would not.

The FASB disagreed as they believed that their model provided a consistent measurement attribute and any inefficiency in the profit or loss portray the actual financial risks and their management by the reporting entity.

The IASB members noted that the IASB had previously decided to apply the cash flow hedge mechanics also to fair value hedges that would provide a consistent measurement attribute. Finally, both Boards noted that the different position on hedge accounting is reflection of the differences of the classification and measurement models. Nonetheless, both Boards expressed their willingness to explore a set of criteria for designation of risk components and discuss them at one of the following Board meetings.

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