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Wednesday 24 May 2017

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IFRS 9: Financial Instruments

Exposure draft and Comment letters [Dec 2010]


 Risk components

(paragraphs 18(a), B13-B18, BC52-BC62)


One of the most important aspects of designating a hedging relationship is how the hedged item is determined. Generally, this can be an item in its entirety (such as an asset, a liability, a firm commitment or a forecast transaction) or a component of such an item. The most important components are risk components, which are also most challenging to determine.

When a risk component is designated as the hedged item, only changes in the cash flows or fair value of an item that are attributable to a specific risk or risks are part of the hedging relationship.

What is the problem?

Risk management often manages exposures by type of risk for different items rather than by type of item for different (or all) risks. In contrast, hedge accounting uses the entire item as the default unit of account and then sets out rules that govern what risk components of that entire item can be used. Hence, what is the normal approach for risk management purposes is the exception in the current hedge accounting requirements. This has resulted in a disconnect between many risk management strategies and the current hedge accounting requirements.

For the purpose of determining what risk components are eligible for designation in a hedging relationship, IAS 39 distinguishes between financial and non-financial items. For financial items, a risk component can be designated if it is separately identifiable and reliably measurable. However, for non-financial items these criteria do not apply and the only risk component that can be designated is foreign currency risk.

Many entities have not been able to achieve hedge accounting for common risk components that they hedge, or only in a way that is onerous and creates artificial hedge ineffectiveness. This artificial hedge ineffectiveness results from comparing the fair value changes of the hedging instrument with changes in the value of the entire hedged item, including changes that the entity did not hedge (eg logistics costs associated with a purchase of a commodity that was only hedged for its benchmark commodity price risk).

Investors find it difficult to understand why many common hedging strategies fail to achieve hedge accounting or are confused by the artificial hedge ineffectiveness.

What are the proposals?

The exposure draft proposes to align financial and non-financial items regarding which risk components are eligible for designation as hedged items. Hence, the same criteria-based approach would be used, ie a risk component can be designated as the hedged item if it is separately identifiable and reliably measureable. This assessment considers the particular market structure to which the risk relates and in which the hedging activity takes place.

An example

An entity buys electric motors from a supplier. The supply contract for the electric motors is a variable price contract with a pricing formula that includes an indexation to the copper price and variable logistics costs. The indexation to copper reflects that electric motors include a significant amount of copper. The variable logistics costs depend upon the price for diesel and upon an inflation index. Under the proposals in the exposure draft, the entity can use copper derivatives to hedge the copper dependent payments under the pricing formula. In contrast, IAS 39 requires entities to also compare the change in the fair value of the copper derivative with the entire price change of the supply contract, ie including the variable logistics costs.

Staff papers

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 risk components 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 (or joint meeting with the US Financial Accounting Standards Board (FASB)).


TopicPaper refMonth discussed
Whether risk components should be allowed for designation as hedged itemsAgenda paper 4C2 February 2010
Bifurcation-by-risk approachesAgenda paper 9BFebruary 2010
Approach for determining what risk components are eligible for designationAgenda paper 9CFebruary 2010
One-sided risk componentsAgenda paper 1C3 March 2010
Contractually specified risk componentsAgenda paper 9DMay 2010
Risk components that are not contractually specifiedAgenda paper 327 October 2010

How to get involved

The exposure draft specifically asks for your views on this (and other) topics. Question 4 of the invitation to comment in the exposure draft asks:

Do you agree that an entity should be allowed to designate as a hedged item in a hedging relationship changes in the cash flows or fair value of an item attributable to a specific risk or risks (ie a risk component), provided that the risk component is separately identifiable and reliably measurable? Why or why not? If not, what changes do you recommend and why?

You may choose to answer all the questions in the invitation to comment 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.