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Summary of Exposure draft on Hedge Accounting IAS 39 issued by IASB on 9-Dec-2010

Please find below the summary of the Exposure Draft on hedge accounting under IAS 39 issued by IASB on 9th December 2010.

We are all aware that IFRS is principle based while US GAAP is rule based. However, the hedge accounting portions of IAS 39 do contain certain rule based criteria for testing hedge effectiveness. The proposals in the ED seeks to move away from this by making this principle based.

The main objective of ‘hedge accounting’ under the current standards is to mitigate the recognition and measurement anomalies between the accounting for hedged items and to manage the timing of the recognition of gains or losses on derivative hedging instruments used to mitigate cash flow risk. As per the ED the objective is to represent in the financial statements the effect of managing exposures arising from particular risks that affect profit or loss.

So long ‘hedge accounting’ is considered to be a privilege and the entity is supposed to earn such privilege by fulfilling several rigourous conditions. Considering the fact that the new proposal are aimed at the entities to show the effect of managing risks in the financial statements, it will not be surprising if this is made mandatory soon.

Parameter Existing IAS 39 Standard Proposed IFRS 9 Standard
Objective To mitigate the recognition and measurement anomalies between the accounting for hedged items and to manage the timing of the recognition of gains or losses on derivative hedging instruments used to mitigate cash flow risk To represent in the financial statements the effect of managing exposures arising from particular risks that affect profit or loss
Hedging instruments A non-derivative financial asset/liability measured at fair value through profit or loss is not eligible for designation as a hedging instrument A non-derivative financial asset/liability measured at fair value through profit or loss may be eligible for designation as a hedging instrument
Hedged items An aggregated exposure that is a combination of an exposure and a derivative cannot be designated as a hedged item An aggregated exposure that is a combination of an exposure and a derivative may be designated as a hedged item
Non-financial items Risk component separately identifiable and reliably measureable may be designated as  the hedged item in a hedging relationship but only for financial items  Risk component separately identifiable and reliably measureable may be designated as the hedged item in a hedging relationship for non-financial items also 
Hedge effectiveness testing Rule-based: The offset is within the range of 80-125 % a hedge is effective and only then it qualifies for hedge accounting Principle-based: The hedging relationship should meet the objective of the hedge effectiveness assessment as laid down in the risk management policy of the entity
Retrospective testing On an ongoing basis an entity should assess the effeictiveness of the hedge by retrospective testing The assessment relates to expectations about hedge infectiveness and offsetting and therefore is only forward looking.  
No retrospective testing 
Rebalancing of a hedging relationship There is no such thing as rebalancing. When a hedge effectiveness assessment objective fails an entity can modify the hedge ratio to meet the objective of hedge effectiveness assessment, so long as the risk management objective remains unaltered
Modifying the hedge ratio is not permitted 
Discontinuing hedge accounting If the effectiveness testing fails either prospectively or retrospectively hedge should be discontinued Hedge accounting shall be discontinued prospectively only when the hedging relationship ceases to meet the qualifying criteria affecting the risk management activities 
Fair value hedges The effective and ineffective portions are taken to the profit and loss The gain or loss on the hedging instrument and the hedged item should be recognized in other comprehensive income. The ineffective portion should be transferred to profit and loss
Time value of options The entire fair value of an option including the time value is treated as held for trading and is accounted for at fair value through profit or loss When designated, entity should follow specific accounting requirements for accounting the time value of an option
Net position hedging  IAS 39 does not allow net positions to be hedged  Extend the use of hedge accounting to net positions, improving the link to risk management 
Credit derivatives as hedging instrument  Under the current standards entities using credit derivatives do not achieve hedge accounting as it is operationally difficult if not impossible  Three alternative approaches of accounting proposed where credit risk is hedged by credit derivatives with separate qualification and discontinuation criteria 
Hedges resulting in non-financial asset/ liability  Option to either basis-adjust or to route the hedge gain/loss directly in profit or loss from other comprehensive income  Proposal withdraws the choice and the hedge gain/loss should be subject to basis-adjustment 
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