At this session the Board discussed:
- hedges of credit risk using credit derivatives;
- the distinction between mandatory discontinuation and voluntary dedesignation; and
- net position hedges.
Hedges of credit risk using credit derivatives
The IASB discussed how financial institutions manage credit exposures arising from their lending activities and the resulting accounting implications, as well as possible alternative approaches.
During the outreach activities, the Board learnt that many users of financial statements believe that IAS 39 Financial Instruments: Recognition and Measurement does not reflect the economic outcome of the credit risk management activities of financial institutions.
Accounting mismatches exist today when IFRSs are applied. The fair value changes of the credit derivative that is economically hedging the credit exposure are presented in profit or loss every period but are not offset by the fair value changes of the loans or loan commitments. The Board noted that when applying IAS 39 it is operationally difficult to isolate and directly measure the credit risk component of a financial item in a way that meets the hedge accounting requirements. The Board also noted that the fair value option under IFRS 9 Financial Instruments is not available for most loan commitments that are within the scope of IAS 37 Provisions, Contingent Liabilities and Contingent Assets.
The Board tentatively decided not to allow elective fair value accounting for part of the nominal amount of loans and loan commitments because of its complexity. The Board tentatively decided to explore other possible ways to avoid the accounting mismatch (eg to account for the premium on the credit derivatives in way that it is allocated over time by using other comprehensive income or accounting similar to insurance contracts).
Discontinuation of hedging relationships
The Board discussed the discontinuation of hedge accounting. The Board considered a series of staff papers outlining the following issues:
- discontinuation of a hedging relationship;
- rebalancing and reassessment of the hedge ratio; and
- interaction between rebalancing and discontinuation (illustrative examples).
Discontinuation of a hedging relationship
The Board noted that discontinuation of hedge accounting occurs when the hedging relationship ceases to meet the qualifying criteria and therefore hedge accounting should be discontinued prospectively from the moment that such qualifying criteria are no longer met. It was additionally noted that entities may choose to re-establish the hedging relationship if that reflects the risk management strategy. This has been referred to as discontinuation and restart.
The Board also noted that allowing entities to dedesignate hedging relationships when all the qualifying criteria (including the risk management objective) are still met is inconsistent with the objective of hedge accounting. Hence, the Board tentatively decided that dedesignation should not be permitted in those circumstances.
As a result, the Board tentatively decided that:
- Mandatory discontinuation occurs when the hedging relationship ceases to meet the qualifying criteria. However, entities can start a new hedging relationship that uses the items that were previously part of the discontinued hedging relationship.
- Adjustments to the hedging relationship would only require a discontinuation and restart if there is a change in the risk management objective of the hedging relationship.
- Adjusting a continuing hedging relationship should only be allowed when the risk management objective remains the same but other qualifying criteria have failed or are about to fail (for example the effectiveness testing). Specific facts and circumstances should be considered when distinguishing mandatory discontinuation from dedesignation and redesignation.
- Dedesignation when all the qualifying criteria (including the risk management objective) are still met would not be permitted, because no qualifying criteria have failed and the hedge accounting still reflects risk management.
- Documentation supporting the hedging relationship must be updated to reflect changes to the hedging relationship irrespective of the type of scenario.
Rebalancing and reassessment of the hedge ratio
The Board considered a paper on the role of rebalancing and how it relates to the issue of discontinuation of hedge accounting.
The Board noted that rebalancing occurs when some of the variables affecting the hedging relationship change so that the qualifying criteria (particularly the effectiveness assessment test) are no longer met. The Board tentatively decided that rebalancing is the continuation of an existing hedge in specific circumstances, and does not depend upon the type of unexpected sources of ineffectiveness, but rather upon whether the risk management objective of the hedge still applies. The Board noted that this tentative decision reflects the risk-management link in the hedge accounting approach being developed.
Interaction between rebalancing and discontinuation
The Board considered examples of the application of rebalancing and its interaction with discontinuation.
On the basis of the examples presented, the Board tentatively decided that provided that the risk management strategy remains the same:
- The measurement of the changes in fair value of the hedged item would be unaffected by the adjustment to the hedge ratio.
- Changes to the hedge ratio may require partial discontinuation if those changes are above the expected levels of ineffectiveness.
- If entities fail to predict their volume of highly probable forecast transactions accurately with the result that the expected volume is lower than the originally forecast volume, partial discontinuation is appropriate provided that the entity does not have a history of such downward adjustments of its forecasts.
Eligibility of net positions as hedged items
This Board session was the final discussion on the eligibility of net positions for hedge accounting (in the context of the general hedge accounting model). The staff presented the Board with various examples of net position hedges to help them to decide if any restrictions should be required. The Board tentatively decided that net positions should be eligible hedged items for all fair value hedges and some cash flow hedges.
For cash flow net position hedges, the Board tentatively decided that there should be restrictions to prevent recognition of value changes of anticipated transactions in profit or loss or in other comprehensive income. The effect of this restriction is that a net position of hedged items, in a cash flow hedge, would not be eligible for hedge accounting, if the offsetting cash flows would affect profit or loss in different periods.
The Board also considered whether hedge accounting should be permitted for a nil net position of hedged items that arises in an entity that manages and hedges risk on a net basis.
The Board tentatively decided that a nil net position of hedged items should be eligible for hedge accounting provided that the entity manages risks on a net basis. The Board noted that nil net positions arising in practice at such entities would happen very infrequently, if ever. It was proposed that clear application guidance would be required to explain the restricted circumstances in which this would apply.