Issues & Trends Defining Issues September 2012, No. 12-44 IASB Issues Hedge Accounting Model The IASB today issued a review draft (RD) of its hedge accounting model to provide a principles-based standard that aligns hedge accounting under International Financial Reporting Standards (IFRS) more closely with risk management. 1 The IASB intends for the RD to address significant criticisms that current hedge accounting guidance is complex, inconsistent, and has other significant weaknesses. 2 The FASB also has proposed changes to its hedge accounting model, and at this point, it is unclear how the concepts in the IASB s RD would affect the FASB s conclusions on hedge accounting. 3 The FASB s proposals differ significantly from the IASB s and are intended to resolve specific, major practice issues. Although the FASB requested comments on the IASB s hedge accounting model and discussed them last year, the FASB has not yet redeliberated its own hedge accounting proposals and, when it does, it is unclear how the FASB will include the IASB in the redeliberations. 4 Contents Hedge Effectiveness Assessment 2 Rebalancing Hedging Relationships 2 Prohibition on Voluntary Termination of Hedging Relationships 2 Additional Exposures Could Be Hedged Items 2 Nonderivative Financial Instruments as Hedging Instruments 4 Purchased Options and Forward Contracts as Hedging Instruments 4 Fair Value Option for Certain Own-use Contracts 4 Fair Value Option for Managing Credit Risk Using Credit Derivatives 4 Additional Disclosures 4 Effective Date and Transition 5 Comparison of IASB s and FASB s Proposed Models 6 The RD s proposals are generally consistent with the IASB s proposed guidance that was issued in December 2010 and would not change the three types of hedging relationships (i.e., fair value hedges, cash flow hedges, and hedges of net investments in foreign operations). 5 The RD also would not change the current requirement to recognize hedge ineffectiveness. However, the RD likely would expand the ability to use hedge accounting under IFRS. An entity would be required to use significant judgment to implement the RD s proposals and likely would need to make changes to its information systems and business processes. The RD addresses hedging relationships in which the hedged item is a single item or a closed portfolio (i.e., a portfolio where items cannot be added or removed without creating a new portfolio). However, an entity often uses derivatives and financial instruments to manage risks associated with portfolios from which items are added or removed over time without creating a new portfolio (i.e., an open portfolio). Because open portfolios may complicate hedge accounting, the IASB decided to address hedging of open portfolios (also called macro hedging) separately and plans to issue a discussion paper before the end of the year. This edition of Defining Issues highlights the significant changes proposed in the IASB s RD and includes a comparison of the IASB s and FASB s proposed hedge accounting models. 1 Draft of forthcoming IFRS on general hedge accounting, available at www.ifrs.org. 2 IAS 39, Financial Instruments: Recognition and Measurement. 3 FASB Proposed Accounting Standards Update, Accounting for Financial Instruments and Revisions to the Accounting for Derivative Instruments and Hedging Activities, May 26, 2010, available at www.fasb.org. 4 FASB Discussion Paper, Invitation to Comment, Selected Issues about Hedge Accounting, February 9, 2011, available at www.fasb.org. 5 IASB ED/2010/13 Hedge Accounting, December 9, 2010, available at www.ifrs.org.
Hedge Effectiveness Assessment Whether or not hedge accounting would be permitted under the IASB s RD would be based partially on a qualitative, forward-looking hedge effectiveness assessment rather than arbitrary bright lines. The proposed assessment would require that: An economic relationship must exist between the hedging instrument and hedged item. The effect of credit risk does not dominate the value changes that result from that economic relationship. The hedge ratio designated is the one actually used for risk management. However, the hedging instrument or hedged item cannot be intentionally weighted to achieve an accounting outcome inconsistent with the purpose of hedge accounting. Rebalancing Hedging Relationships An entity could be required to rebalance a hedging relationship that is not behaving in the expected manner by adjusting the quantity of the hedged item or hedging instrument. This would allow hedge accounting to continue without the need to stop and restart a hedging relationship. Prohibition on Voluntary Termination of Hedging Relationships An entity would be prohibited from voluntarily terminating a hedging relationship that continues to meet its risk management objective and all other qualifying criteria. This prohibition would affect the use of certain dynamic hedging strategies. However, the IASB s RD specifies that if the risk management objective for a hedging relationship has changed, the hedging relationship should be discontinued. The entity would be permitted to designate a new hedging relationship involving the hedging instrument or hedged item from the discontinued hedging relationship. Additional Exposures Could Be Hedged Items There are additional exposures that could qualify as hedged items, which would expand the breadth of hedging strategies that qualify for hedge accounting under IFRS. Risk Component. A contractually or noncontractually specified risk component of a financial or nonfinancial item could be a hedged item if it is: Separately identifiable; and Reliably measurable. An entity would assess whether a noncontractually specified risk component is separately identifiable in the context of the relevant market structure. A risk component could be reliably measurable if, for example, sufficient observable forward transactions exist. Thus, many risk components for nonfinancial items (e.g., the crude oil component of jet fuel) could potentially be eligible in addition to foreign currency risk. The IASB s RD contains a rebuttable presumption that unless inflation risk is contractually specified, it is not separately identifiable and reliably measurable. Defining Issues / September 2012 / No. 12-44 2
Net Position. A group of items, including a net position (e.g., the net position of a portfolio of financial assets and a portfolio of financial liabilities) could be a hedged item if the individual items comprising the group are eligible hedged items and are managed together for risk management purposes. For a cash flow hedge, a group of items with offsetting cash flows that affect profit or loss (P&L) in different periods (e.g., the cash flows from forecasted purchases and sales) could be a hedged item if: The hedged risk is foreign currency risk; and The period in which the forecasted transactions are expected to affect P&L and their nature and volume are specified. Layer Component. A layer component could be a hedged item in a fair value hedge (e.g., the last $20 million principal payment of a $100 million debt instrument). This component of a prepayable instrument would be eligible only if the effect of the prepayment option is included in the hedge effectiveness assessment. A layer component must meet certain conditions to be a hedged item in a fair value hedge. Aggregated Exposure. An aggregated exposure is a combination of a derivative and a nonderivative exposure that is managed together for risk management purposes. The components of an aggregated exposure could be designated in a hedging relationship and the aggregated exposure could be a hedged item in another hedging relationship. The hedging relationships could start at different times without stopping and restarting the initial relationship. For example, assume a U. S. dollar-functional entity issues a 20-year, fixed-rate debt denominated in euros and hedges the change in fair value of the debt due to foreign currency and interest rate risks by entering into a cross-currency interest rate swap. The entity documents this as a fair value hedge and designates the debt as the hedged item and the cross-currency interest rate swap as the hedging instrument. One year later it decides to hedge the variability of cash flows due to the interest rate risk associated with this aggregated exposure using a 5-year U.S. dollar-denominated interest rate swap. The entity views its euro-denominated fixed-rate debt and the cross-currency interest rate swap collectively as a U.S. dollar-denominated variable-rate aggregated exposure. The IASB s RD would allow the entity to document this second-level hedge as a cash flow hedge in which it would designate the next 5 years of interest payments from the 20-year aggregated exposure as the hedged item and the 5-year interest rate swap as the hedging instrument. An aggregated exposure by itself would not need to be a hedging relationship to be the hedged item in a hedging relationship. Equity Investments at Fair Value Through Other Comprehensive Income (FVTOCI). The foreign exchange risk or equity price risk of an equity investment accounted for at FVTOCI could be a hedged item with changes in the fair value of the derivative and hedged item, as well as any hedge ineffectiveness, recognized in other comprehensive income (OCI). Restriction on Hedging Sub-LIBOR Components. The current restrictions in IFRS on hedging sub-libor components would continue to apply. For example, a LIBOR component of a variable-rate liability paying LIBOR minus 100 basis points would not be allowed as a hedged item. However, an entity would be permitted to designate the change in the cash flows of the entire liability that is attributable to changes in LIBOR as the hedged item. Defining Issues / September 2012 / No. 12-44 3
Nonderivative Financial Instruments as Hedging Instruments Generally, a nonderivative financial asset or liability measured at fair value through profit or loss (FVTPL) could be a hedging instrument for any risk, not just foreign currency risk. A financial liability designated under the fair value option (FVO) and for which the changes in fair value due to credit risk are recognized in OCI would not be eligible, nor would an equity investment at FVTOCI be eligible to hedge foreign currency risk. A financial instrument accounted for at FVTPL as a result of electing the FVO to avoid an accounting mismatch also would not be eligible as a hedging instrument if the designation would recreate the mismatch. Purchased Options and Forward Contracts as Hedging Instruments An entity would be permitted to designate only the intrinsic value of a purchased option (including a zero-cost collar) or the spot element of a forward contract as the hedging instrument as allowed under IAS 39. However, the change in the undesignated time value of a purchased option would not be immediately recognized in P&L. Rather, it would be deferred in OCI and amortized over the period during which the option s intrinsic value could affect P&L or deferred until the hedged transaction affects P&L. Similar treatment would apply to the forward element of a forward contract. The result could be less P&L volatility but more OCI volatility. The designation would apply to fair value or cash flow hedges. Fair Value Option for Certain Own-use Contracts A contract that can be settled net in cash and meets the own-use (normal purchase and normal sale) scope exception would be eligible for the FVO if applying fair value accounting would eliminate or significantly reduce an accounting mismatch. This would address the current accounting mismatch that occurs when an entity is required to account for a commodity contract as an executory contract and uses a derivative instrument as an economic hedge. Fair Value Option for Managing Credit Risk Using Credit Derivatives To accommodate managing credit risk and as a substitute for hedge accounting, the IASB has proposed a new fair value option for certain credit exposures. Under the new fair value option, if an entity uses a credit derivative to manage the credit risk of a credit exposure on a fair value basis, then it may designate that credit exposure, or a proportion of it, as measured at fair value through profit or loss. A credit exposure may be a financial instrument (e.g., a loan or loan commitment) that is managed for credit risk. The designation can be made only if the name and seniority of the financial instrument and the instrument that would be delivered in accordance with the credit derivative match. Additional Disclosures For all risk exposures to which it applies hedge accounting, the IASB s RD would require an entity to disclose: Its risk management strategy and how it is applied to manage risks; Its hedging activities and how they could affect its future cash flows; and Defining Issues / September 2012 / No. 12-44 4
The effect that hedge accounting has had on its primary financial statements. For a strategy involving frequent resets of hedging relationships, an entity would be required to describe the strategy and its objectives and to disclose the expected frequency of the discontinuation and restart of hedging relationships. Effective Date and Transition The IASB s hedge accounting proposals would be effective for annual periods beginning on or after January 1, 2015. Early adoption would be permitted only if all existing IFRS 9 requirements are adopted at the same time or have already been adopted. 6 Transition generally would be prospective. However, retrospective application would be required for the time value of purchased options and permitted for the forward element of forward contracts if certain conditions are met. The IASB has not requested comments. However, the RD will remain on its Web site until early December 2012 to allow time for constituents to do a fatal flaw review and let IASB staff members conduct outreach activities. 6 IFRS 9, Financial Instruments. Defining Issues / September 2012 / No. 12-44 5
Comparison of IASB s and FASB s Proposed Models The following chart summarizes and compares the IASB s hedge accounting model described in the RD and the FASB s hedge accounting model included in the FASB s financial instruments exposure draft. IASB s Proposed Model FASB s Proposed Model Approach Comprehensive review led to fundamental change. Review addressed specific issues. The proposed model would retain most of the current provisions of hedge accounting and would make only several key changes. Scope Does not address macro hedges and carries forward the guidance in IAS 39 for fair value hedges of the interest rate exposure of a portfolio of financial assets or financial liabilities. (The IASB is currently discussing macro hedging as a separate project.) Includes all hedging relationships. Nonderivative Financial Instruments Designated as Hedging Instruments for Foreign Currency Risk Would be permitted under all hedging models. Would be permitted for a hedge of a net investment in a foreign operation and a fair value hedge of a firm commitment. Nonderivative Financial Instruments Measured at FVTPL Designated as Hedging Instruments for Risks Other Than Foreign Currency Would be permitted, unless the nonderivative is an equity instrument for which an entity has elected to present changes in fair value in OCI or a liability that has been designated under the FVO for which the amount of changes in fair value attributable to changes in credit risk is presented in OCI. Defining Issues / September 2012 / No. 12-44 6
IASB s Proposed Model FASB s Proposed Model Allowable Hedged Risk Components for Financial Instruments Risk component would need to be separately identifiable and reliably measureable. It could be either contractually or noncontractually specified, and could combine the risk components. Benchmark interest rate risk, foreign currency risk, and credit risk, as well as a combination of these risks, would be allowed. There would be a rebuttable presumption that unless inflation risk is contractually specified, it would not be an allowable hedged risk component. Certain credit exposures would be permitted to be designated under the FVO as a substitute for hedge accounting. Allowable Hedged Risk Components for Nonfinancial Items Would be the same as financial instruments. The entire risk of the item would have to be hedged; foreign currency risk also could be hedged. Fair Value Hedge of a Layer Component met. Effectiveness Assessment Requirement Assessment would be based on the existence of an economic relationship, lack of credit risk dominance, and proper hedge ratio. A hedging relationship would need to be assessed as reasonably effective. Frequency of Effectiveness Assessment Effectiveness assessment would be required, at a minimum, each reporting period or upon a significant change in the circumstances affecting the hedge effectiveness requirements, whichever comes first. Reassessment would be required only if circumstances suggest that the hedging relationship may no longer be reasonably effective. Defining Issues / September 2012 / No. 12-44 7
IASB s Proposed Model FASB s Proposed Model Assumption of Perfect Effectiveness Cash Flow Hedge Accounting The effective portion of the gain or loss on the hedging instrument would be recorded in accumulated other comprehensive income (AOCI); the effective portion would be the lower of the cumulative change in fair value of the hedging instrument and the cumulative change in fair value of the hedged item. The effective portion of the gain or loss on the hedging instrument would be recorded in AOCI; the ineffective portion would be the difference between the cumulative change in fair value of the hedging instrument and the cumulative change in fair value of the hedged item. Forecasted Transaction That Was the Hedged Item in a Cash Flow Hedge That Subsequently Results in Recognizing a Nonfinancial Item Upon recognition of the nonfinancial item, the amount of the gain or loss that was accumulated in AOCI as part of the cash flow hedge accounting would be removed from AOCI and added to the original carrying amount of the nonfinancial item. The same accounting would apply upon the recognition of the forecasted transaction for a nonfinancial item becoming a firm commitment for which fair value hedge accounting would be applied. The amount of the gain or loss that was accumulated in AOCI as part of the cash flow hedge accounting would remain in AOCI and would be reclassified to earnings when the nonfinancial item affects earnings. Mandatory Rebalancing An entity would be required to rebalance when the hedging relationship fails the effectiveness assessment, but the entity s risk management objective remains the same. Rebalancing would be treated as a continuation of hedging relationship. Rebalancing would never be mandatory. Rebalancing would be treated as a new hedging relationship. Defining Issues / September 2012 / No. 12-44 8
IASB s Proposed Model FASB s Proposed Model Voluntarily Discontinuing Hedge Accounting Would be prohibited; however, an entity could effectively terminate a hedging derivative by meeting certain criteria. Change in Risk Management Objective Triggers Discontinuing Hedge Accounting Yes. No. Accounting for the Time Value of a Purchased Option When the Intrinsic Value of the Option Is Designated as a Hedging Instrument Changes in fair value of the time value would be recognized in OCI based on the time value of a purchased option with critical terms that align with the hedged item. Amounts in equity would be reclassified to P&L or recognized as basis adjustments depending upon whether the hedged item is transaction related or period related. This would apply to cash flow and fair value hedges. The time value would be treated as a freestanding derivative; however, if total changes in the option s cash flows are designated as the hedging instrument, then the changes in fair value of the time value would be recognized in OCI. These amounts would be reclassified from AOCI to earnings during the term of the hedge relationship. This would apply only to certain cash flow hedges. Accounting for the Forward Element of a Forward Contract When the Spot Element of the Forward Contract Is Designated as a Hedging Instrument Changes in fair value of the forward element would be recognized in OCI based on the forward element of a forward contract with critical terms that align with the hedged item. Amounts in equity would be reclassified to P&L. This would apply to cash flow and fair value hedges. The forward element would be treated as a freestanding derivative; however, if total changes in the forward contract s cash flows are designated as the hedging instrument, then the changes in fair value of the forward element would be recognized in OCI. These amounts would be reclassified from AOCI to earnings during the term of the hedging relationship. This would apply only to certain cash flow foreign currency hedges. Defining Issues / September 2012 / No. 12-44 9
IASB s Proposed Model FASB s Proposed Model Hedging Gross Positions met. The criteria would not include the criterion that the change in the fair value attributed to the hedged risk for each individual item in the group must be approximately proportional to the overall change in the fair value of the group for the hedged risk. The individual items within the group must have similar risk characteristics and the change in the fair value attributable to the hedged risk for each individual item in the group must be approximately proportional to the overall change in the fair value of the group for the hedged risk. Hedging Net Positions met. Hedging Nil Net Positions without a Hedging Derivative Instrument met. FVO of Own-use (Normal Purchase and Normal Sale) Contracts met. However, use of the normal purchase and normal sale exclusion is elective. Aggregated Exposure as the Hedged Item met. Contact us: This is a publication of KPMG s Department of Professional Practice 212-909-5600 Contributing authors: Enrique M. Tejerina Michael A. Gaiso Earlier editions are available at: http://www.kpmginstitutes.com/financial-reporting-network The descriptive and summary statements in this newsletter are not intended to be a substitute for the potential requirements of the proposed standard or any other potential or applicable requirements of the accounting literature or SEC regulations. Companies applying U.S. GAAP, IFRS, or filing with the SEC should apply the texts of the relevant laws, regulations, and accounting requirements, consider their particular circumstances, and consult their accounting and legal advisors. Defining Issues is a registered trademark of KPMG LLP. 2001-2012 KPMG LLP, a Delaware limited liability partnership and the U.S. member firm of the KPMG network of independent member firms affiliated with KPMG International Cooperative ( KPMG International ), a Swiss entity. All rights reserved. KPMG and the KPMG logo are registered trademarks of KPMG International Cooperative ( KPMG International ), a Swiss entity.