Rebalancing and Discontinuation
|IAS 39||91/97/98/100/101||AG113||IE21/IE28 IG F5.2|
Throughout this project we have undertaken extensive outreach with investors, preparers and auditors. In particular, we have tried to understand how they view the requirements for discontinuation of hedge accounting. The feedback received gave a clear indication that the model in IAS 39 Financial Instruments: Recognition and Measurement does not accommodate changes to the hedging relationship that were not envisaged at the inception of the hedge. This forced entities to revoke the designation and hence discontinue the original hedging relationship and (re-)start a new hedging relationship in order to continue hedge accounting.
Click here for a summary of the user feedback.
What is the problem?
In accordance with IAS 39, an entity must discontinue hedge accounting when the hedging relationship ceases to meet the qualifying criteria (including when the hedging instrument no longer exists or has been sold). However, in accordance with IAS 39, an entity may also voluntarily discontinue hedge accounting by simply revoking the designation of the hedging relationship (ie irrespective of the reason).
In practice, entities often revoke the designation of a hedging relationship and redesignate it as a new hedging relationship in order to apply a different method of assessing hedge ineffectiveness than the method that was originally documented (expecting that the new method offers a better chance of passing the hedge effectiveness assessment). Other examples include entities revoking the designation of a hedging relationship because they want to adjust the hedge ratio following a change in the relationship between the hedged item and the hedging instrument (typically in response to a change in the basis risk).
In accordance with IAS 39 all these types of changes to the hedging relationship are treated as a discontinuation of the original hedging relationship and a (re-)start of a new hedging relationship, which creates a disconnection with risk management. The reason is that IAS 39 does not allow adjustments to a hedging relationship after its initial designation that were not envisaged (documented) at the inception of the hedge to be treated as adjustments of an existing hedging relationship that continues.
What are the proposals?
The Board is proposing revised criteria for when a hedge accounting has to be discontinued. The Board discussed in what circumstances discontinuation of hedge accounting is appropriate. The requirements for how to account for a discontinued hedging relationship (ie how to unwind the accounting effects of the hedge accounting relationship) have remained unchanged.
- The proposals consider the role of risk management and the types of changes in circumstances that would require discontinuation of hedge accounting.
The Board is proposing the following model for discontinuation of hedge accounting:
- Mandatory discontinuation of hedge accounting applies when the hedging relationship ceases to meet the qualifying criteria. However, entities can start a new hedging relationship using the items that were previously part of a discontinued hedging relationship.
- The risk management objective of the hedging relationship is part of the qualifying criteria. Hence, if the risk management objective of a hedging relationship changes, hedge accounting for that hedging relationship must be discontinued.
- When the risk management objective of the hedging relationship remains the same but the hedge ratio has to be adjusted in order to continue to meet the objective of the hedge effectiveness assessment that adjustment of the hedge ratio is accounted for as a change to the continuing hedging relationship (see rebalancing below).
- A revocation of the designation of a hedging relationship that still qualifies for hedge accounting (including that it meets the original risk management objective of that hedging relationship) is not to be permitted.
- Documentation supporting the hedging relationship must be updated to reflect changes to a continuing hedging relationship.
The main changes compared to IAS 39 are:
- By providing a means of adjusting an existing hedging relationship that continues, the need for discontinuing and restarting hedging relationships because of changes in the basis risk (which affects the hedge ratio) will be reduced. That also avoids practice issues that arise under the current model (such as the recognition of artificial ineffectiveness from designating derivatives that are in- or out-of-the-money when a hedging relationship is restarted, often referred to as a �late hedge�).
- Eliminating the opportunity to dedesignate a hedging relationship for no particular reason makes hedge accounting information more useful and better ensures it reflects risk management.
The table below provides an overview of the proposed changes and how they correspond to the current model in IAS 39.
| Still valid||Changed (becomes N/A)|
|Dedesignation not allowed||Adjustment of continuing hedging relationship (rebalance)||Mandatory discontinuation|
|Other qualifying criteria||Fulfilled||Failed (regarding the hedge ratio)||Fulfilled|
|Change to existing requirements in IAS 39|
|Consistent with IAS 39|
What is the problem?
IAS 39 does not allow adjustments that were not envisaged (documented) at the inception of the hedging relationship to be treated as adjustments to a continuing hedging relationship. Instead, IAS 39 treats adjustments to a hedging relationship that were not envisaged at inception of the hedging relationship as a discontinuation of the original hedging relationship and the start of a new one. Hence, the hedge accounting model of IAS 39 does not include the notion of changes to a hedging relationship as a continuation of that relationship.
The proposals on rebalancing differentiate between two scenarios:
- Circumstances in which the hedging relationship no longer meets the qualifying criteria (including the risk management objective) even after taking into account the effect of any rebalancing of the hedge ratio. In these circumstances hedge accounting must be discontinued.
- The hedging relationship still meets the original risk management objective but needs to be adjusted to in response to changes in one or more variables affecting the hedging relationship (commonly termed 'sources of hedge ineffectiveness'). This scenario is a continuation of an existing hedging relationship for which the hedge ratio is adjusted (rebalanced) without resulting in the discontinuation of the hedging relationship.
The diagram below illustrates the rebalancing provisions that are proposed in the ED. The diagram distinguishes mandatory rebalancing from proactive rebalancing.
Mandatory rebalancing applies if the hedging relationship fails the effectiveness assessment requirement but would otherwise meet the qualifying criteria. If rebalancing the hedge ratio can ensure that the effectiveness assessment requirements are met again, the entity must rebalance and that hedging relationship continues.
Voluntary (proactive) rebalancing is an adjustment of the hedging relationship when an entity expects that the relationship will fail the effectiveness assessment requirements. For example, this may be if the hedge ineffectiveness might still be considered fluctuation around a trend that is consistent with the existing hedge ratio but could also signal that there is a new trend emerging that would suggest that the hedge ratio that meets the objective of the hedge effectiveness assessment would have to be changed. In this circumstance, the entity can choose to (proactively) rebalance the hedge ratio.
During the Board�s deliberations the staff have discussed several examples illustrating the main features of rebalancing. Refer to agenda paper 17C.
Questions and answers
Click here for other questions and answers on effectiveness assessment and other topics.
As part of our due process, discussions of technical issues take place during public IASB meetings. For these meetings, the staff prepare technical papers on the specific technical topics. The Board then uses these papers as a basis for their proposals.
The papers that have been prepared for the Board to discuss discontinuation of hedge accounting and rebalancing are listed below. Click on the paper reference number to access the specific paper. Click on the related month to access the summary of decisions taken at that month�s IASB meeting.
How to get involved
The exposure draft specifically asks for your views on this (and other) topics. Questions 7 and 8 of the invitation to comment in the exposure draft ask:
(a) Do you agree that if the hedging relationship fails to meet the objective of the hedge effectiveness assessment an entity should be required to rebalance the hedging relationship, provided that the risk management objective for a hedging relationship remains the same? Why or why not? If not, what changes do you recommend and why?
(b) Do you agree that if an entity expects that a designated hedging relationship might fail to meet the objective of the hedge effectiveness assessment in the future, it may also proactively rebalance the hedge relationship? Why or why not? If not, what changes do you recommend and why?
(a) Do you agree that an entity should discontinue hedge accounting prospectively only when the hedging relationship (or part of a hedging relationship) ceases to meet the qualifying criteria (after taking into account any rebalancing of the hedging relationship, if applicable)? Why or why not? If not, what changes do you recommend and why?
(b) Do you agree that an entity should not be permitted to discontinue hedge accounting for a hedging relationship that still meets the risk management objective and strategy on the basis of which it qualified for hedge accounting and that continues to meet all other qualifying criteria? Why or why not? If not, what changes do you recommend and why?
You may choose to answer all the questions or only some of them and you are welcome to comment on any other matter that you think we should consider in finalising the proposals. Comment letters will be posted on our website.
We will carefully consider all feedback and will discuss responses to the proposals in public meetings. We plan to issue the new standard in mid-2011.