Mechanics of the DRM Model—Feedback and staff analysis (Agenda Paper 4A)

In April 2014, the IASB published Discussion Paper DP/2014/1 Accounting for Dynamic Risk Management: a Portfolio Revaluation Approach to Macro Hedging. The comment period for the DP ended on 17 October 2014. In this meeting the IASB continued the discussions on the core model for DRM.

When developing the core model, the IASB tentatively decided that when derivatives align the asset profile with the target profile, the changes in fair value of such derivatives are recognised in other comprehensive income (OCI). At its April 2021 meeting, the IASB discussed feedback from outreach on the DRM core model. Volatility in equity arising from the recognition of fair value changes in OCI was one of the three main challenges identified as key to the viability and operability of the DRM model.

As part of the staff’s research and analysis of feedback from outreach, they considered the hedge accounting mechanics applied for cash flow and fair value hedge accounting in IAS 39 and IFRS 9. The analysis and summary of the feedback about using these mechanics for DRM are set out in this paper. This paper also analyses the unique nature of hedging the repricing risk due to change in interest rates and discusses why alternative accounting mechanics might be justified for the DRM model. The accounting mechanics specify which amounts, and where they are recognised in the financial statements.

In Agenda Paper 4B, the staff explored two potential alternatives for the mechanics the IASB could consider for the DRM model. Both approaches aim to better reflect the risk management activities in the financial statements and address the concerns raised during outreach. At this meeting, the staff sought the IASB’s view on the direction of the future work, without asking the IASB to make any decisions. Based on the IASB’s feedback provided at this meeting, the staff will develop proposals and bring back further analyses at a future meeting.

Based on the analysis in the paper, the staff was of the view that neither cash flow nor fair value hedge accounting mechanics in isolation provide the optimal mechanics to use in the DRM model. Exploring potential alternative accounting mechanics may lead to a better reflection of the economic features of the DRM model.

Mechanics of the DRM model—Alternative Approaches (Agenda Paper 4B)

This paper continued the staff analysis from Agenda Paper 4A and discussed potential alternative mechanics the IASB could consider for the DRM model. The paper only provided the initial analysis on two potential alternative approaches to the DRM mechanics. The staff will ask the IASB at a future meeting whether changes to the DRM mechanics are necessary and if so, which alternative mechanics should be applied.

The paper therefore only considered potential alternative approached about the mechanics of the DRM model. In other words, how to account for the DRM model in the financial statements (i.e. which amounts and where they are recognised in financial statements). The underlying principles and elements of the model would remain unchanged.

The analysis in Agenda Paper 4A highlighted that there are challenges with both cash flow and fair value hedge mechanics, in the context of the DRM model, and neither mechanics on their own provide the optimal way to calculate the amounts recognised in the financial statements.

Accordingly, if the IASB were to decide to reconsider the current mechanics of the DRM model, the staff sought to identify alternative mechanics that would be a ‘hybrid’ of cash flow and fair value hedge mechanics. In this paper, the staff described two potential approaches which retain the core principles and elements of the DRM model and ensure the DRM model would continue to be a valuation model and require that the value of the hedged item is measured independently of the value of the hedging instrument.

Approach A

Approach A is a symmetrical approach, which is similar to the fair value hedge mechanics, but with some changes to reflect to the characteristics of DRM. Applying this approach, the DRM model would be accounted for as follows:

• The designated derivatives would continue to be recognised at fair value in the statement of financial position, with gains or losses recognised in statement of profit or loss
• The risk mitigation intention would be recognised at fair value as a separate line item in the statement of financial position, with gains or losses recognised in statement of profit or loss

Approach B

Approach B is based on mechanics that are a combination of cash flow and fair value hedging mechanics. Applying this approach, the DRM model would be accounted for as follows:

• The designated derivatives would be recognised in the statement of financial position at fair value
• The DRM adjustment would be recognised in the statement of financial position, determined as the lower of:
  • The cumulative gains or losses on the designated derivatives from inception of the hedge
  • The cumulative change in fair value (present value) of the risk mitigation intention from inception of the hedge (measured by using the benchmark derivative as a proxy)
• The DRM adjustment therefore represents the portion of the gain or loss on the designated derivatives that offsets the gain or loss on the risk mitigation intention (the aligned portion). Any remaining gain or loss on the designated derivates, including any changes to the DRM adjustment calculated as above would be recognised in the statement of profit or loss

The staff asked IASB members whether they have any comments or questions about the potential alternative approaches and next steps discussed in this paper. In particular they asked whether there is any significant advantage or disadvantage that is not considered in the staff’s analysis of Approach A or Approach B and whether there are any points or potential implications that IASB members would like staff to research further.

IASB discussion

Agenda papers 4A and 4B were discussed together.

The majority of IASB members seemed to prefer Approach B over Approach A. While Approach A effectively reduces the variability of cash flows, Approach B combines the cash flow hedging and fair value hedging mechanics to reflect DRM. Therefore, Approach B, accompanied by meaningful disclosures about risk mitigation, would be preferable as this approach is more easily understandable for preparers.

Some IASB members seemed to suggest that disclosures alone could solve the problem. However, the Chairman said that explanations would not be able to override the mixed measurement model, which lies at the root of the issues the project is trying to address. This was echoed by the Vice Chair who said that the current tools are not enough to reflect risk management in a meaningful way and therefore the IASB has to develop recognition and measurement requirements to address this.

One IASB member suggested to offer preparers an option between Approach A and Approach B with transparent disclosures. However, this did not find any support among the rest of the IASB members. One IASB member added that sending the staff back to work on alternatives would cost another year or two, while a solution is urgently needed by practice. He suggested to focus on Approaches A and B with the IASB deciding at a later point which one was preferable.

One IASB member said that deferred gains and losses may be conceptually flawed. The Chairman echoed this concern. While fair value hedging is not possible for forecast transactions under IFRS 9, these transactions are included in the DRM model. In other words, the DRM model would cover some items that do not meet the asset or liability definition in the Conceptual Framework. The IASB needs to be aware of this. Financial reporting and risk management are fundamentally different concepts and the struggle lies with aligning these. One of the concepts will have to be compromised for this project, and it may well be financial reporting. IFRS 9 works very well for hedge accounting but is confined by the boundaries of the Conceptual Framework. DRM will extend beyond this boundary and the IASB will have to give a very good explanation to its stakeholders for this departure. The Chairman thinks that this could be achieved. One IASB member agreed but said that the IASB needs to tread very carefully in this case as it may set a dangerous precedent. In his view, the Conceptual Framework must remain an uncompromised tool for the IASB to reject lobbying for any approaches that are outside its boundary.

The Chairman suggested that the DRM model could be made mandatory, instead of being optional. In his view, if an entity publicly states how it manages risk, this should also be depicted in the financial statements. The Vice Chair said that in that case the requirements must be very palatable as otherwise, it will be likely that banks will reject the model.

The Chairman summarised that the IASB supports moving forward with the two approaches, which will now be further explored by the staff.