The International Accounting Standards Board (IASB) is inviting comment on its discussion paper on macro hedging, which explores an approach to better reflect entities’ dynamic risk management activities in financial statements
Many financial institutions and other entities manage risks, such as interest rate risk, dynamically on a portfolio basis rather than on an individual contract basis. Dynamic risk management is a continuous process because the risks that such entities face evolve over time, as does their approach to managing those risks. However, the existing accounting requirements of IAS 39, Financial Instruments, are generally considered to be difficult to apply when accounting for such transactions.
As part of its comprehensive response to the global financial crisis, the IASB is replacing IAS 39 with an entirely new financial instruments accounting standard, known as IFRS 9, Financial Instruments.
Although this project is in the final stages of completion, the IASB has decided to treat it as a separate project to the macro hedging component of these reforms in order to elicit views from a broader range of constituents.
The latest discussion paper, Accounting for Dynamic Risk Management: a Portfolio Revaluation Approach to Macro Hedging, represents the first stage in this project, by seeking public comment on a possible approach to accounting for an entity’s dynamic risk management activities, the portfolio revaluation approach (PRA). Under the PRA:
• Exposures that are risk-managed dynamically would be revalued for changes in the managed risk through profit or loss.
• Fair value changes arising from risk management instruments that are used to manage this risk (derivatives) would also be recognised in profit or loss.
• The success of an entity’s dynamic risk management is captured by the net effect of the above measurements in profit or loss.
• Fair valuation of the risk exposures that are dynamically managed is not required.
The PRA also addresses the needs of users by providing a more comprehensive set of disclosures concerning an entity’s dynamic risk management activities.
Commenting on the paper, IASB chairman, Hans Hoogervorst, Chairman of the IASB said that current requirements make it difficult to faithfully represent dynamic risk management in entities’ financial statements and can increase operational complexity.
‘This discussion paper sets out preliminary views on an accounting approach that better reflects the economics of dynamic risk management as compared to the current accounting requirements. Users of financial statements will also benefit from presentation that shows how dynamic risk management has affected an entity’s profit or loss,’ said Hoogervorst.
Andrew Spooner, financial instruments lead partner at Deloitte said that the paper purposely asks more questions than the IASB has answers for.
‘It is the start of what will be a long journey to solve the ongoing debate as to how to best account for banks’ macro hedging of interest rates. To date, the accounting standards have tried to accommodate macro hedging activities, but not to everyone’s satisfaction.
‘This is a fearsomely complex area of accounting. But, that is no reason why efforts should not be made to reset the debate and ask the broad and important questions as to how macro risk management can be fairly presented in financial statements.
‘When IFRS 9 was developed, the IASB took strides to make the accounting better reflect risk management activity. This discussion paper goes further and asks how this can be done for more complex and dynamic hedging strategies used by banks, where the volume of hedging transactions and exposures is far greater and the hedging is done at a far more aggregate level.
If some of the ideas discussed in the paper were finalised it would fundamentally change banks’ accounting for lending and deposits,’ said Spooner.
The discussion paper is available for comment until 17 October 2014.
In addition to seeking input in the form of comment letters, the IASB will undertake an outreach programme designed to obtain feedback on the areas covered in the discussion paper.
On 29 April 2014 the IASB will hold two live webcasts on the Discussion Paper taking place at 10am and 2pm (both London time).
Further information is available on the project page.