Financial instruments — Hedge accounting

Date recorded:

The IASB discussed the final planned topics of phase one of the hedge accounting project.

Use of intragroup nonderivative financial instruments as hedging instruments

At the 5 October 2010 Board meeting, the Board tentatively decided not to permit derivatives between parties within a consolidated group to be eligible hedging instruments. Today, the Board discussed another issue involving whether internal financial instruments could be eligible hedging instruments.

The staff presented an example of a parent with a highly probable transaction to acquire another entity with consideration payable in 12 months in a currency other than the acquirer's functional currency. Either because of an inability of locating the appropriate currency forward for the needed currency or because of concerns over the credit risk involved with the counterparty to the forward, an entity may enter into an intercompany loan with a foreign subsidiary that has the same functional currency as the forecasted acquisition. In this scenario, an accounting mismatch is created because of the translation of the loan into the parent's functional currency through profit and loss (under IAS 21) while the forecast transaction has yet to occur. So even though the parent has economically hedged their foreign exchange risk exposure to the transaction, the accounting does not follow suit.

The Board considered whether an exception should be permitted for FX risk associated with a business combination, whether a comprehensive review of IAS 21's interaction with hedge accounting should be performed, or whether to carryover the guidance currently within IAS 39. The Board had little interest in addressing the issue and tentatively decided to carryover the guidance within IAS 39 that internal non-derivative financial instruments would not be eligible hedged items.

Eligible hedged items - non-contractually specified risk components

At the May 2010 Board meeting, the Board tentatively decided to permit designation of risk components for non-financial items as eligible hedged items when the risk component is contractually specified (financial items are already permitted for risk component designation under IAS 39). Today, the Board discussed whether to further permit risk component designation of non-contractually specified items as eligible hedged items for both financial and non-financial items (a source of significant problems under today's hedge accounting model).

The staff analysis originally prepared for the May 2010 Board meeting noted that differentiating the designation of risk components between financial and non-financial hedged items had no rational basis. Additionally, the hedge effectiveness model developed under this project may result in distortion of the hedge ratio should designation of risk components not be allowed.

The staff initially recommended aligning the risk components for both financial and non-financial items so long as "the risk component is reliably measurable — for which identifiability of the risk component is a precondition." The Board was generally supportive of permitting risk component designation for non-financial items; however, there was concern over the staff's proposed language as it implied a change for financial items as to what is currently within IAS 39. The staff clarified that the intention was not to substantively change the requirements but rather to provide the requirement in its logical order. However, because of certain Board member concerns on how the change in language would be interpreted, the staff said it would retain the current language within IAS 39 related to "separately identifiable" and "reliably measurable". The Board tentatively agreed to permit designation of risk components for both financial and non-financial items when the risk components are separately identifiable and reliably measurable.

Time value of options

Another common practice issue under the current hedge accounting model relates to consideration of the time value of money for option-type derivatives. IAS 39 currently requires an entity to choose between designating as the hedging instrument either the option-type derivative in its entirety or separating the time value of the option and designating only the intrinsic value of the option. However, in reality, this results in the requirement to separate the time value component of the option; otherwise the amount of ineffectiveness recognised in the hedging relationship associated with the time value of the option would likely fall outside of the 80-125 effectiveness threshold. When the time value component of the option is separated, it is treated as held-for-trading and measured at fair value through profit or loss.

This issue is particularly concerning as the accounting requirements are currently driving risk management decision making as risk managers opt for the use of non-option derivatives over option-type derivatives because of the accounting implications rather than the economic implications.

The staff developed an approach for considering the time value component of an option as an insurance premium. Under the "insurance premium view", for transaction related hedged items (e.g., forecast purchase of a commodity) the cumulative change in the fair value of the option attributable to time value would be recognised in OCI and then recycled (capitalised for a non-financial asset or into profit or loss for hedged sales). Likewise, for time period related hedged items (e.g., hedging existing commodity inventory over a time period) the cumulative change in the fair value of the option attributable to time value would be recognised in OCI and amortised to profit or loss as insurance premium paid on a rational basis. To avoid accounting issues associated ith option terms not matching the hedged items, if the actual time value is less than the time value of an option that perfectly matches the hedged item, then the amount recognised in accumulated AOCI would be determined as the lower of the fair value change of the actual time value and the time value of the "perfect" option. Those amounts in OCI would also be subject to an impairment test.

The Board had mixed views on the proposal developed by the staff. Some Board members felt the proposal helped to maintain consistency with the overall hedging model being developed. Other Board members expressed "reluctant support" for the proposal, acknowledging the problem within IAS 39 but not whole heartedly behind the proposal as the best alternative and questioned whether this was a better answer than the current guidance in IAS 39. Two Board members did not support the proposal, one because he felt it added additional complexity and the other because he disapproved of the capitalisation of the option value for transaction related hedged items (the capitalisation issue was also raised by some of those Board members in the "reluctant support" category.

The Board tentatively agreed to the "insurance premium view" of accounting for the time value associated with options but will include in the exposure draft a specific question regarding the capitalisation issue.

Cash instruments as eligible hedging instruments

At the 5 October, 2010 Board meeting, the Board was presented with three alternatives of whether to permit cash instruments (e.g., financial instruments) as eligible hedging instruments in a hedge accounting relationship. Those alternatives included retaining the current guidance within IAS 39 which limits the use of cash instruments to hedges of foreign exchange risk, permitting only those financial instruments measured at fair value through profit or loss as eligible hedging instruments, or permitting all financial instruments as eligible hedging instruments.

Today, the Board resumed their consideration on this topic. The Board tentatively decided to permit financial instruments measured at fair value through profit and loss as eligible hedging instruments, in part because their measurement attribute is similar to that of a derivative. One Board member disagreed as he felt the staff had not made a sufficient case as to what practice issue the expansion of the scope of use of cash instruments as hedging instruments was attempting to address. He felt the question should be asked in the exposure draft and then any decisions could be made at that point. However, the Chairman noted that such an approach could require re-exposure.


Because of the inherent complexity of applying a new hedge accounting model, the Board tentatively agreed to only require prospective application of the proposed amendments, but that the amendments would apply to all hedging relationships and not just those designated subsequent to initial application. However, for those fair value hedge accounting relationships existing under IAS 39 and continuing under the new model, separate presentation of the hedged item valuation allowance would be required for the entire life of the hedge.

Hedge accounting relationships under IAS 39 that qualify under the new model would be considered continuing hedges (i.e., no discontinuation and restart). However, hedge accounting relationships under IAS 39 that do not qualify under the proposed model would be subject to the guidance regarding discontinuation of hedge accounting.

The proposed amendments will include adoption guidance similar to that of IFRS 9 with the proposed effective date of annual periods beginning on or after 1 January 2013 with earlier application permitted. Entities would only be able to early adopt these provisions if they also adopt all other IFRS 9 requirements that were finalised earlier.

Drafting of the Exposure Draft

As today marked the end of planned deliberations on phase one of the hedge accounting project, the Board agreed to permit the staff to begin drafting of the forthcoming exposure draft. The staff noted that they would continue developing the portfolio hedging phase of the project but because of the time requirements they were working under, those proposals would form part of a separate exposure draft at a future date.

The Board also agreed on a 90 day comment period on the exposure draft and the plan is to issue the exposure draft sometime before year end. Certain Board members expressed concern with not providing a 120 day comment period, in particular because of the holidays and that calendar year end companies will be preparing their financial statements during this period. However, the Chairman affirmed that to meet the 30 June 2010 deadline, a 90 day comment period must be used in order to provide the staff with time for redeliberations during the second quarter of 2011.

The staff also asked the Board if anyone intended to dissent (or provide an alternative view). One Board member mentioned his intention to dissent citing disagreement with several Board decisions, including using cash instruments as eligible hedging instruments and permitting net hedging with the use of either a small or no derivative as the hedging instrument. He also feels that the proposals do not achieve a reduction in complexity (any reduction in complexity is offset by additional complexities elsewhere in the proposals) and will result in financial reporting that is more difficult to understand.

This concluded the special 27 October Board meeting.

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