Finalised hedge accounting requirements
Banking on Tax, Issue 10
The hedge accounting requirements in IAS 39 have been criticised by some for having too many rules which are not connected with the entity’s risk-management activities. Not only have the complex rules in IAS 39 made it difficult for entities to apply hedge accounting, but IAS 39 has also made it difficult for entities to explain the results of applying hedge accounting in the context of the entity’s business and its risk-management activities.
The IASB undertook a project to address these concerns and released the general hedge accounting exposure draft ED/2010/13 Hedge Accounting in the fourth quarter of 2010, followed by a ‘review draft’ of the hedge accounting section of IFRS 9 Financial Instruments, published on 7 September 2012, and dealing with general hedge accounting. The finalised requirements are expected to be issued in the second half of 2013 and, based on the ‘review draft’, would represent a significant change to the current hedge accounting approach under IAS 39.
The macro hedging rules are still being considered and these rules will be critical for banks which generally perform interest rate hedging at a portfolio level. The IASB will consider feedback on the general hedge accounting exposure draft; however, the focus so far has been on understanding different risk-management approaches and initially discussing macro hedging for interest rate risk before extending it to other risks.
At the May 2012 IASB meeting, it was tentatively agreed that accounting for macro hedging would be decoupled from IFRS 9. Accounting for macro hedging is now expected to be issued as a separate standard. The IASB continues to deliberate issues surrounding macro hedge accounting and expects to issue a Discussion Paper in the second half of 2013. The draft general hedge accounting standard permits application of IAS 39 instead of the new hedge accounting model for fair value hedge accounting for portfolio hedges of interest rate risk until the macro hedge accounting project is finalised and becomes effective.
Summary of major changes to hedge accounting
- Expansion of the instruments that qualify as eligible hedging instruments
- Reduced profit or loss volatility when accounting for the undesignated time value of an option contract and forward points in a forward contract.
- A risk component is eligible as a hedged item as long as it is separately identifiable and reliably measurable, irrespective of whether it resides in a financial or non-financial item and irrespective of whether it is contractually specified or not
- A hedged item designated in a hedging relationship may include a derivative combined with an eligible non-derivative (sometimes referred to as a ‘synthetic exposure’)
- Groups and net positions can be designated as hedged items
- Equity investments classified as fair value through other comprehensive income under IFRS 9 are eligible hedged items.
Qualifying criteria for hedge accounting
- The 80-125 per cent offset requirement is replaced by principles-based hedge effectiveness assessment criteria
- Hedge effectiveness assessment criteria are applied prospectively only.
Accounting for qualifying hedges
- Basis adjustment is required when cash flow hedging forecast transactions that result in the recognition of a non-financial item
- A hedging relationship may be amended (‘rebalanced’) in certain circumstances without causing a discontinuation and redesignation of the hedge (e.g. to change the amount of a hedged item or hedging instrument)
- Once designated, a hedging relationship shall be discontinued only if it is no longer eligible or there is a change in the risk-management objective.
Hedging credit risk
- Expansion of fair value option accounting to accommodate credit risk hedging.
- More disclosure requirements that require the hedging strategy to be explained for each type of hedge and for each category of risk, supplemented with quantitative disclosures of the effect of hedge accounting on the financial statements.
- Prospective application with limited exceptions (e.g. time value of options and forward points amortisation).
Summary of retained features of hedge accounting
- Applying hedge accounting remains a choice
- Terminology from IAS 39 is retained in many cases (e.g. hedged items, hedging instruments, fair value hedges, cash flow hedges, hedge ineffectiveness, etc.)
- Fair value, cash flow and net investment hedge accounting alternatives are retained
- With the exception of hedge ineffectiveness related to hedges of equity investments designated as at fair value through other comprehensive income, all hedge ineffectiveness is recognised in profit or loss
- The “lower of” test continues to apply for the equity component of cash flow hedges
- General restriction on hedge accounting with written options is retained.
The IASB intends to publish a final standard during the second half of 2013. When finalised, the standard was expected to be mandatorily applicable from 1 January 2015. However, during the July IASB meeting, the board proposed a further delay in the mandatory application date for IFRS 9. The standard will still be available for early adoption.
Taxation of financial arrangements (TOFA)
The changes to hedge accounting may have implications for banks that have elected to use the hedging method under the TOFA provisions in Division 230 of the Income Tax Assessment Act 1997. As set out in Issue 6 of Banking on Tax, the hedging method requirements in the TOFA provisions and the Explanatory Memorandum are linked to the current accounting standards and guidance. Changes to the TOFA hedging method may be required to ensure that it continues to operate as intended following the changes to the accounting standards outlined above.
Submissions on the discussion paper, “Improving the operation of the tax hedging provisions”, closed more than 12 months ago on 25 April 2012. The Government has not yet issued a response. The amendments to the hedging method in Tax and Superannuation Laws Amendment (2013 Measures No 2) Act 2013 did not address the issues raised in the discussion paper. So, it is unclear whether or not Treasury is currently considering changes to the hedging method TOFA provisions as a result of the changes to hedge accounting. Until there is some clarity on possible changes to the TOFA hedging provisions, banks will need to consider the tax impacts of the accounting changes and monitor developments to understand any differences between accounting and tax, and to contribute to the question of whether the bank should adopt the accounting standard early.