Board Meeting Handout Accounting for Financial Instruments: Hedge Accounting March 10, 2010

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Dominic Merritt
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1 Board Meeting Handout Accounting for Financial Instruments: Hedge Accounting March 10, 2010 PURPOSE OF THE MEETING 1. The purpose of this meeting is to discuss the hedge accounting model to be included in the guidance in the proposed FASB Accounting Standards Update that will be issued under this project. BACKGROUND 2. To address the issues identified related to hedge accounting, the Board issued an Exposure Draft, Accounting for Hedging Activities, on June 6, The comment period for the Exposure Draft ended on August 15, 2008 and an analysis of comments received was presented to the Board at the October 2008 joint meeting. Due to the comprehensive nature of the Accounting for Financial Instruments project, the Board decided to consider hedge accounting issues as part of this project. 3. Based on the tentative classification and measurement model for financial instruments decided on in this project, at the February 17, 2010 joint meeting, the Board decided to continue to permit bifurcation-by-risk for financial items. The Board tentatively decided to retain the current bifurcation-by-risk approach in the guidance on derivatives and hedging in Topic 815 of the FASB Accounting Standards Codfication TM. For fair value hedges, that approach requires the gain or loss on a derivative instrument designated and qualifying as a fair value hedging instrument, as well as the offsetting loss or gain on the hedged item attributable to the hedged risk to be recognized in net income. For cash flow hedges, that approach requires the effective portion of the gain or loss on a derivative instrument designated and qualifying as a cash flow hedging instrument to be recognized in other comprehensive income and reclassified into net income as and when the hedged The staff prepares Board meeting handouts to facilitate the audience's understanding of the issues to be addressed at the Board meeting. This material is presented for discussion purposes only; it is not intended to reflect the views of the FASB or its staff. Official positions of the FASB are determined only after extensive due process and deliberations.

2 forecasted transaction affects net income. The remaining gain or loss on the derivative instrument (the ineffective portion), if any, would be recognized in net income. HEDGE ACCOUNTING MODEL 4. The staff recommends that the hedge accounting model in the proposed Update to be issued under this project should carry forward the changes to hedge accounting proposed in the Exposure Draft with the exception of the proposed changes to bifurcation-by-risk. The guidance in the proposed Update to be issued under this project would incorporate the Board s decision on February 17, 2010 to retain bifurcation-by-risk. 5. Key features of the possible hedge accounting model to be included in the guidance in the proposed Update are as follows: (a) The hedge accounting model would be applicable to all entities within the scope of the guidance in the proposed Update. (b) The types of items and transactions eligible for hedge accounting in Topic 815 would continue to apply. (c) (d) (e) (f) Entities would be required to perform a qualitative (rather than quantitative) test at inception to demonstrate that an economic relationship exists between the hedging instrument and the hedged item or forecasted transaction. However, in certain situations a quantitative test may be necessary at inception. As part of the hedge effectiveness assessment, entities would be required to demonstrate that changes in fair value of the hedging instrument would be reasonably effective in offsetting the changes in the hedged item s fair value or the variability in the hedged cash flows for the risk or risks hedged by the entity in that hedging relationship. After inception of the hedging relationship, an entity would need to qualitatively (or quantitatively, if necessary) reassess effectiveness only if circumstances suggest that the hedging relationship may no longer be reasonably effective. The shortcut method and critical terms match method would be eliminated. An entity would no longer have the ability to assume a hedging relationship is 2

3 reasonably effective and recognize no ineffectiveness in net income during the term of the hedge. (g) (h) An entity would not be permitted to discontinue hedge accounting by simply removing the designation of a hedging relationship. Hedge accounting can be discontinued only if the criteria for hedge accounting are no longer met or the hedging instrument expires, is sold, terminated, or exercised. Entities would be able to designate particular risks as the risks being hedged in a hedging relationship. Only the effects of the risks hedged would be reflected net income. The types of risks eligible as hedged risks in the guidance in Topic 815 would continue to apply. 6. The staff notes that the most significant concerns raised by respondents to the Exposure Draft related to bifurcation-by-risk and hedge effectiveness. In the staff s view, the hedge accounting model described above addresses those concerns. The Board s decision to retain bifurcation-by-risk at the February 17, 2010 joint meeting addresses preparer and auditor concerns related to aligning hedge accounting with an entity s risk management strategies. The tentative classification and measurement model decided by the Board in this project addresses user concerns. That is, since all financial instruments would be required to be measured at fair value (except for a narrow amortized cost option) under the tentative model, all risks, hedged or unhedged, would be reflected in the financial statements. Further, the Board s tentative decision to require one single statement of comprehensive income would allow all risks to be reflected in one statement. Question 1 Does the Board believe the possible hedge accounting model described above should be included in the proposed Update to be issued under this project? If not, which aspects of hedge accounting would the Board like the staff to further analyze and provide alternatives for at a future meeting? 3

4 ENTITIES THAT QUALIFY FOR THE DELAYED EFFECTIVE DATE 7. At its February 24, 2010 Board meeting, the Board decided that certain aspects of the classification and measurement guidance in the proposed Update to be issued under this project would have a delayed effective date for nonpublic entities with less than $1 billion in consolidated total assets. The Board decided that those exempted entities would be required to apply all classification and measurement guidance in the proposed Update four years after its original effective date. 8. The Board decided that entities that qualify for the delayed effective date would measure the following financial instruments at amortized cost in their financial statements for the four-year period between the original effective date and the delayed effective date: (a) (b) Loans that would qualify for certain changes in fair value to be recognized in other comprehensive income under the classification and measurement guidance to be included in the proposed Update Core deposit liabilities. 9. The decision made by the Board on February 17, 2010 to retain bifurcation-by-risk was based on the tentative classification and measurement model for financial instruments decided on by the Board that includes a narrow amortized cost option. The decision made on February 24, 2010 related to a delayed effective date for certain entities would increase the amortized cost category for certain entities for a four-year period between the original effective date and the delayed effective date of the guidance in the proposed Update to be issued under this project. Question 2 Does the Board believe that a different bifurcation-by-risk approach is warranted for financial instruments measured at amortized cost by certain entities during the fouryear period delayed effective date? 4

5 Board Meeting Handout Financial Statement Presentation March 10, 2010 Board Memo 78 Phase A decisions, IAS 1, and IAS 7 Paragraph numbers have been retained from the Board memo for consistency. Issue 1: Phase A and other decisions 2. In August 2002, the FASB decided that the effects of extraordinary, unusual, and infrequently occurring events and transactions should not be presented as a functional category in the statement of comprehensive income as currently required under FASB Accounting Standards Codification Subtopic Income Statement Extraordinary and Unusual Items (originally issued as APB Opinion No. 30). 3. Phase A of this project addressed what constitutes a complete set of financial statements and requirements to present comparative information. Both the IASB and the FASB (the boards) completed their initial deliberations in December The IASB exposed its Phase A decisions in March 2006 and published a final standard in September The FASB decided to expose its Phase A decisions at the same time as its Phase B decisions. 4. The Phase A topics and the extraordinary item topic are included in the staff draft as follows: Complete set of financial statements A complete set of financial statements comprises: (a) a statement of financial position as at the end of the period; (b) a statement of comprehensive income for the period; (c) a statement of changes in equity for the period; (d) a statement of cash flows for the period; (e) notes, comprising a summary of significant accounting policies and other explanatory information; and (f) a statement of financial position as at the beginning of the earliest comparative period when a reporting entity The staff prepares Board meeting handouts to facilitate the audience's understanding of the issues to be addressed at the Board meeting. This material is presented for discussion purposes only; it is not intended to reflect the views of the FASB or its staff. Official positions of the FASB are determined only after extensive due process and deliberations.

6 applies an accounting policy retrospectively or makes a retrospective restatement of items in its financial statements, or when it reclassifies items in its financial statements. A reporting entity may use titles for the statements other than those used in this [draft] Standard A reporting entity shall present with equal prominence all of the financial statements in a complete set of financial statements. Comparative information Except when IFRSs permit or require otherwise, a reporting entity shall disclose comparative information in respect of the previous period for all amounts reported in the current period s financial statements. A reporting entity shall include comparative information for narrative and descriptive information when it is relevant to an understanding of the current period s financial statements A reporting entity disclosing comparative information shall present, as a minimum, two statements of financial position, two of each of the other statements, and related notes. When a reporting entity applies an accounting policy retrospectively or makes a retrospective restatement of items in its financial statements or when it reclassifies items in its financial statements, it shall present, as a minimum, three statements of financial position, two of each of the other statements, and related notes. A reporting entity presents statements of financial position as at: (a) the end of the current period, (b) the end of the previous period (which is the same as the beginning of the current period), and (c) the beginning of the earliest comparative period. Extraordinary items A reporting entity shall not present any items of income or expense as extraordinary items, in the statement of comprehensive income or in the notes. Difference between the staff draft and prior FASB tentative decisions 5. In Phase A, both boards tentatively decided to require a statement of financial position as at the beginning of the period to be presented as part of a complete set of financial statements. That is, a comparative complete set of financial statements would include three statements of financial position. However, the IASB changed its view on that issue based on comments received on the exposure draft that preceded IAS 1 (2007). IAS 1 (2007) only requires an as at the beginning of the period statement of financial position to be presented when an entity applies an accounting policy retrospectively or makes a Page 2 of 5

7 retrospective restatement, or when an entity reclassifies items in the financial statements (see paragraphs 3.2.1(f) and above). Staff recommendation 6. The staff recommend that the Board change its tentative decision to be consistent with the change the IASB made in finalizing IAS 1 in The staff recommend that the Board reaffirm its other prior decisions consistent with the excerpts from the staff draft that follow paragraph 4 above. Question on Issue 1 1. Does the Board agree with the staff recommendation to modify the requirement to present a statement of financial position at the beginning of the period so that a third statement of financial position is only required when an entity retrospectively applies a change in accounting principle, restates previously issued financial statements to reflect the correction of an error, or reclassifies items in the financial statements? 2. Does the Board agree to reaffirm its other Phase A decisions and the decision related to extraordinary items as drafted in paragraphs 3.2.1, 3.2.2, , , and of the staff draft (repeated above)? Issue 2: IAS 1 paragraphs to be included in FASB Exposure Draft 20. The staff recommend that the following paragraphs from IAS 1 be included in the FASB Exposure Draft: (a) Accrual basis of accounting (paragraphs 27 and 28) (b) Frequency of reporting (paragraphs 36 and 37, except the first sentence in paragraph 36) (c) Comparative information (paragraphs 40-44) (d) Materiality (paragraphs 29-31) (e) Consistency of presentation (paragraphs 45 and 46) (f) Information about share capital (paragraphs 79 and 80). Questions on Issue 2 3. Does the Board agree with the staff recommendation to include the IAS 1 paragraphs related to the topics listed above in the FASB Exposure Draft? Page 3 of 5

8 Issue 3: Paragraphs from IAS 1 and IAS 7 not to be included in the FASB Exposure Draft 25. The staff recommend that the following paragraphs from IAS 1 and IAS 7, Statement of Cash Flows not be included in the FASB Exposure Draft: (a) Fair presentation (IAS 1, paragraphs 15-24) (b) Going concern (IAS 1, paragraphs 25-26) (c) Presentation of information about puttable financial instruments (IAS 1, paragraphs 80A) (d) (e) Investments in subsidiaries, associates and joint ventures (related to the statement of cash flows) (IAS 7, paragraphs 37-38) Disclosure of information about changes in ownership interests in subsidiaries and other businesses (IAS 7, paragraph 40). Question on Issue 3 4. Does the Board agree with the staff recommendation not to include the IAS 1 and IAS 7 paragraphs related to the topics listed above in the FASB Exposure Draft? Issue 4: Notes to financial statements Disclosure of measurement basis and of sources of estimation uncertainty 26. IAS 1 requires an entity to disclose in the summary of significant accounting policies the measurement basis or bases used in preparing the financial statements. 27. The staff draft also includes the paragraphs from IAS 1 that require an entity to disclose information about the sources of estimation uncertainty. 28. Prior to issuing the Discussion Paper, the boards had the following preliminary views: (a) (b) An entity should disclose, in its summary of significant accounting policies, information about the measurement basis (or bases) of the assets and liabilities presented in the statement of financial position. If the current measure of an asset or liability contains significant uncertainty that is not required to be disclosed under existing guidance, an entity should include a description of this uncertainty and an explanation of how the recognized amount was determined in the notes to financial statements. Page 4 of 5

9 30. In June 2008 the boards agreed with the staff recommendation that: (a) (b) The boards address disclosure of information about measurement bases in the Exposure Draft stage. The issue of measurement uncertainty not be included in the scope of this project. (This is consistent with the boards intent that Phase B focus on the face of the financial statements.) 31. Consistent with those prior decisions, the staff recommend that the paragraphs on disclosure of measurement basis be included in the FASB Exposure Draft but that the paragraphs on disclosure of estimation uncertainty not be included. Other note disclosure requirements 32. Because the main focus of the FSP project is the face of the financial statements and not the notes, the staff recommend not including in the FASB Exposure Draft the following paragraphs from Chapter 9 of the staff draft that were taken from the paragraphs in IAS 1 related to the notes to financial statements: (a) Structure of the financial statements (paragraphs ) (b) Capital disclosures (paragraphs ) (c) Puttable financial instruments (paragraph 136A) (d) Dividends and background information (paragraphs 137 and 138). Summary of staff recommendations 33. In summary, the staff recommend that the FASB Exposure Draft: (a) Include the paragraphs from IAS 1 that address disclosure of the measurement basis or bases used in preparing the financial statements in the summary of significant accounting policies, but (b) Not include any other paragraphs from IAS 1 on notes to financial statements. Questions on Issue 4 5. Does the Board agree to include the paragraphs concerning measurement basis in the FASB Exposure Draft? 6. Does the Board agree with the staff recommendation to exclude the items listed in paragraph 32 from the FASB Exposure Draft? Page 5 of 5

Comparison of the FASB s and the IASB s Proposed Models for Financial Instruments (as of May 2010)

Comparison of the FASB s and the IASB s Proposed Models for Financial Instruments (as of May 2010) The following table provides a side-by-side comparison of the FASB s and the IASB s proposed models for