Financial instruments – Hedge accounting

Date recorded:

Disclosures: Dynamic hedging strategies

During the July 2011 IASB meeting, the Board made several tentative decisions regarding disclosure requirement for hedge accounting. However, the staff had raised a concern with the application of those disclosure requirements to dynamic hedging strategies as forward looking information about the terms and conditions of the hedging instrument do not provide useful information given the constant discontinuation and re-setting of hedging relationships. At that meeting, the Board asked the staff to consider alternative disclosure requirements for these relationships.

The staff recommended that for dynamic hedging strategies it is more important for users to understand why entities use dynamic hedging strategies and therefore requiring additional information about how an entity uses hedge accounting to reflect their risk management strategy would be more beneficial. Such information could include information about what the ultimate risk management strategy is, a description of how it meets that objective by using hedge accounting and designating the particular hedging relationships, and an indication of how frequently the hedging relationships are discontinued and restarted.

During the July Board meeting, the Board had expressed concern over how to appropriately define dynamic hedging strategies. The staff suggested rather than defining the term dynamic hedging strategies they could simply refer to the example the Board has tentatively decided to include on risk management objectives versus risk management strategies using dynamic hedging strategies as the basis of the example. The Board had also expressed concern with entities not providing information on volumes of hedged items or hedging instruments. The staff noted that the tabular disclosures will provide information on volumes. However, to address the Board's concern, the staff recommended requiring entities to disclose if the volumes as of the reporting date were not representative of normal volumes during the period (similar to the disclosure requirements in IFRS 7 on sensitivity analyses for market risks).

One Board member mentioned he liked the way the staff had defined dynamic hedging strategies in the agenda paper and suggested that be incorporated into the disclosure guidance. Another Board member stated they were not sure whether to support the staff recommendation as they were uncertain how broadly the exemption would apply. The staff retorted that it was not a matter of how many entities could apply the exemption but rather an issue of the information produced by those entities for dynamic hedging strategies not being relevant. Another Board member asked the staff if they envisioned entities providing boiler plate language in response to the proposed disclosure requirements. The staff responded that was always a risk and concern but felt that entities would need to provide sufficiently detailed information to analysts and investors that would prevent boilerplate language.

The Board tentatively decided to exempt dynamic hedging relationships from the requirement to disclose the terms and conditions of the hedging instrument. Instead, the Board tentatively decided that those entities shall expand the description of their risk management strategy by providing 1) information about the ultimate risk management strategy, 2) a description of how it meets that objective by using hedge accounting and designating the particular hedging relationships, and 3) an indication of how frequently the hedging relationships are discontinued and restarted as part of the dynamic process. Additionally, entities would disclose if the volumes of hedging relationships were not representative of normal volumes throughout the year.

Hedging using credit derivatives

During the July 2011 meeting, the Board discussed the accounting mismatch that ensues when entities use credit derivatives to hedge credit risk of financial assets. The Board had previously considered a fair value option during the development of the hedge accounting exposure draft but rejected creating another measurement exception. However, comment letter respondents raised the inability to achieve hedge accounting and the resulting accounting mismatch as a significant concern for financial institutions.

During that meeting, the Board discussed three alternatives to hedge accounting: an elective fair value option, financial guarantee accounting and time value of option accounting. The Board asked the staff to further consider an approach similar to financial guarantee accounting as well as consider the interaction of all these alternatives with the impairment project. The staff presented the Boards with two new approaches, the insurance approach and the deemed credit adjustment approach.

Under the insurance approach, for a credit default swap (CDS) used to manage credit exposure: 1) any premium paid at inception would be amortised over the life of the CDS, 2) the quarterly premium would be expensed as paid, 3) the fair value of the CDS would be disclosed in the notes, and 4) in the assessment of impairment, any cash flow received from a credit event is treated similar to collateral or a guarantee of a financial asset. The staff suggested that upon initially applying the insurance approach, an entity would amortise any difference between fair value and the carrying amount under the insurance approach over the remaining life of the CDS (either on a straight line basis or on an 'aligned' CDS value basis). If an entity were to no longer apply the insurance approach but continue to hold the CDS, the staff suggested an entity would either recognise the difference between fair value and the in profit or loss immediately (with one variation also changing the measurement attribute of the loan or loan commitment to fair value) or amortising the different to profit or loss.

Under the deemed credit adjustment approach, a fair value of a CDS that matches the maturity of the hedged credit exposure is computed (an 'aligned' CDS value). Changes in the fair value of the aligned CDS are accounted for as an adjustment to the carrying amount of the credit exposure and recognised in profit or loss (similar to fair value hedge accounting).

The difficulties associated with the insurance approach focus primarily on when the insurance approach is discontinued before maturity of the credit exposure while the CDS is retained and the resulting potential for earnings management when reverting back to fair value accounting. Additionally, the interaction with impairment accounting can become complex if the maturity of the CDS does not cover the life of the credit exposure as estimating expected credit losses for periods far into the future is inherently more difficult. The difficulties with the aligned CDS approach involves complexity in constructing and if using a credit spread curve would be even more complex. Additionally, the interaction with impairment accounting is significantly more difficult than under the insurance approach as the deemed credit adjustment and the impairment allowance are 'competing mechanisms'.

The staff presented the Board with three alternatives forward (each alternative having multiple possible variations): 1) elective fair value through profit or loss accounting for loan and loan commitments, 2) the insurance approach, and 3) the deemed credit adjustment approach.

One Board member mentioned that he did not believe that a special exception should be made for CDS, rather the Board should stick to the principles of hedge accounting as other exceptions may be requested in the future. Another Board member asked the staff if the fair value option was the approach supported by constituents. The staff responded that in discussions with constituents, those constituents have recognised there is no simple solution. But they feel that all three alternatives are better options than the existing accounting mismatch that results when economically hedging loan and loan commitments with credit derivatives.

In considering the various alternatives presented by the staff, the Board tentatively decided to permit an elective fair value through profit or loss accounting for loan and loan commitments after initial recognition of the financial asset. The Board also tentatively decided on 'Alternative 2' of the FVTPL accounting variations. Under this alternative, the 'measurement change adjustment' (MCA) is recognised immediately in profit or loss, therefore on discontinuation of FVTPL accounting the fair value of loans becomes the new deemed cost and there is no MCA. The Board also tentatively decided to require disclosures when electing this FVTPL approach including 1) a reconciliation of the nominal amount and the fair value of the credit derivatives that have been used to manage the credit exposure of a financial instrument that qualified and was elected for fair value through profit or loss accounting, 2) the gain or loss recognised in profit or loss as a result of electing FVTPL accounting for a credit exposure, and 3) for discontinuation of elective FVTPL for credit exposures the fair value that becomes new deemed cost or amortisable amount (for loan commitments) and the related nominal or principal amount.

Effective date and transition

The Board discussed effective date and transition requirements related to the hedge accounting standard. The hedge accounting exposure draft proposed prospective application, which most constituents supported. However, some constituents asked that hedging relationships that qualified under IAS 39 be grandfathered under the new hedge accounting model until they are discontinued or otherwise rebalanced.

The Board tentatively decided that the effective date would be aligned to the mandatory effective date of IFRS 9. The Board also tentatively decided to not permit retrospective application of the new hedge accounting requirements 1) if it would involve retrospective designation 2) for designation of risk components, 3) for aggregated exposures, and 4) for groups and net positions. However, the Board tentatively decided that retrospective application would be required for the time value of options whose intrinsic value had previously been designated as a hedging instrument and for the alternative treatment of forward elements on an all-or-nothing basis for qualifying hedging relationships.

To address concerns over the time lag between starting the use of the new hedge accounting model and stopping use of the IAS 39 hedge accounting model and the potential for changes in market values, the Board tentatively decided to include clarifying guidance that entities can consider for transition purposes 'the same logical second' when transitioning between hedge accounting models. Finally, the Board tentatively decided to grant a transition provision where entities will be required to consider for purposes of rebalancing, the ratio used under IAS 39 as the starting point for rebalancing as of the transition date by 1) recognising all the ineffectiveness in retained earnings at the transition date, 2) rebalancing the hedging relationship and accounting for as a continuing hedge, and 3) recognising any gain or loss arising from the rebalancing of these hedging relationships in profit or loss.

Next steps

This discussion completed the Board's deliberations with respect to the general hedge accounting model. The staff plans to compile a staff draft of the hedge accounting guidance that will be posted to the IASB website. The IASB will not solicit constituent comments but will provide a date in which the standard would not be finalised prior to, such that constituents may provide the Board any feedback prior to that date. This will also allow the FASB to consider the final decisions made by the IASB on hedge accounting so the FASB can decide how to proceed with their own hedge accounting project.


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