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Financial instruments — Hedge accounting

Date recorded:

The IASB discussed three topics related to the eligibility of certain items as hedging instruments within a hedge accounting relationship:

Eligibility of embedded derivatives as hedging instruments

IFRS 9 removed the bifurcation of embedded derivatives concept for financial assets as contained within IAS 39 as hybrid financial assets under IFRS 9 would typically be measured in their entirety at fair value through profit and loss. However, because the derivative included within the financial host contract is no longer bifurcated, it is no longer eligible as a hedging instrument.

The staff considered three possible alternatives to address hedge accounting when the hedging instruments is embedded within a financial asset:

  1. Making bifurcation of embedded derivatives a choice to permit hedge accounting
  2. Allowing designation of risk components of a hybrid financial asset as a hedging instrument
  3. Not permitting a hybrid financial asset to be a hedging instrument.

The staff recommended not permitting hybrid financial assets as eligible hedging instruments to avoid increasing the complexity that would arise from permitting a designation of risk components or creating exceptions to IFRS 9 by permitting bifurcation of embedded derivatives for hedging relationships. Additionally, the other two alternatives would result in increasing the scope of the hedge accounting project inevitably resulting in additional delays.

The Board agreed not to permit a hybrid financial asset as a hedging instrument. Many Board members expressed concern with reopening the decisions made in IFRS 9 or deviating from those decisions by permitting a bifurcation of embedded derivatives to permit hedge accounting.

Eligibility of cash instruments as hedging instruments

The Board also discussed whether a cash instrument (e.g., non-derivative financial instrument) should be permitted as an eligible hedging instrument within a hedge accounting relationship. IAS 39 currently permits non-derivative financial instruments to be designated as hedging instruments only for hedges of foreign exchange risk.

The staff considered three possible alternatives:

    1. Retaining the restriction in IAS 39 that limits the eligibility of cash instruments as hedging instruments to hedges of foreign exchange risk
    2. Removing the restriction in IAS 39 only for those cash instruments that are accounted for at fair value through profit and loss; and
    3. Removing the restriction in IAS 39 for all cash instruments.

      The staff recommended allowing cash instruments measured at fair through profit and loss as eligible hedging instruments. The staff supported this approach because they felt that it would reduce complexity by providing a consistent rationale for the eligibility of hedging instruments and by facilitating an alignment of financial reporting and risk management.

      The Board was in agreement against Alternative 3 to not permit all cash instruments as eligible hedging instruments. However, in determining whether to permit all cash instruments accounted for at fair value through profit and loss as eligible hedging instruments (Alternative 2), several Board members expressed concern over the staff's recommendation. The views of those with concerns primarily focused on trying to identify what practice issue the staff's recommendation was attempting to address or cure and why the use of the fair value option would not be an acceptable alternative. The Board was split and therefore asked the staff to expand their analysis and provide additional information at a future meeting to enable the Board to decide between Alternatives 1 and 2 above.

      Eligibility of internal derivatives as hedging instruments

      The Board discussed whether an internal derivative (e.g. a derivative between a subsidiary and a central corporate treasury function) should be permitted as an eligible hedging instrument in a hedge accounting relationship. IAS 39 does not currently allow for internal derivatives to be designated as a hedging instrument in a hedge accounting relationship. However, U.S. GAAP currently permits the use of internal derivatives to apply hedge accounting related to foreign exchange risk.

      During outreach activities performed by the staff, both large financial institutions, large corporate entities, and auditors have mentioned that in many instances entities are required to enter into internal derivatives with a central treasury function and the central treasure function will then enter into an external derivate which may not match the internal derivative. As a result of these internal derivatives not being eligible for hedge accounting, these entities feel the application of hedge accounting is difficult to understand and lacks consistency with the risk management practice. Many central treasury groups encounter difficulties in applying hedge accounting because of the various exposures managed on a net basis and the frequent adjustments of hedge positions.

      The staff recommended that internal derivatives not be eligible as hedging instruments as they do not represent an instrument which transfers risk to an external party and contradicts the underlying consolidation principles as those instruments would be eliminated upon consolidation. The Board agreed with the staff recommendation to not permit internal derivatives as eligible hedging instruments.

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