Derivative Accounting Convergence: The path from Where We Are (US GAAP) to Where We Are Headed (IFRS)

Derivative Accounting Convergence: The path from Where We Are to Where We Are Headed Presented by: Helen Kane, President www.hedgetrackers.com February 17, 2011

International Financial Reporting Standard
IAS were issued 1973 - 2001 by the International Accounting Standards Committee (IASC).
In 2001, the new IASB took over from the IASC the responsibility for setting International Accounting Standards and adopted existing IAS
Subsequent standards IASB issued are called IFRS
110 countries have either adopted or in the process of adopting IFRS

Background
August 2008, the SEC proposed that IFRS replace U.S. GAAP with a complete phase-in by 2014
2009 Obama administration put plan under review
February 2010, the SEC Commissioner Walter approved a new IFRS timeline
June 2011: scheduled completion date for IASB/FASB convergence projects
Later 2011: SEC will vote on IFRS mandate
Implementation probable 2015 or 2016 if adopted

Current Events
Project exists to replace IAS 39 with IFRS 9 by 6/2011
Phase 1-- Classification and Measurement of Financial Assets
Phase 2-- Amortized Cost and Impairment, expected issuance 12/10
Phase 3-- 12/10 Issued Hedge Accounting Exposure Draft , 6/11
To be applied prospectively for annual periods beginning on or after 1/1/13 with early application permitted (for all of IFRS 9)

Current Events
The IASB published an exposure draft of proposed amendments on 12/9/2010
Comments due by 3/9/2011
The FASB published an invitation to comment on IASB’s exposure draft 2/9/11
Comments due by 4/25/2011
FASB to participate in IASB discussion of comments in Q2/11

Exposure Draft Objectives
IFRS:
To represent in the financial statements the effect of an entity’s risk management activities that use financial instruments to manage exposures that could affect profit or loss
Establish objective-based approach
FASB:
Simplify hedge accounting to improve compliance
Make financial reporting of hedge activities useful and transparent

IAS 39 Background
Treatment for all Financial Instruments
Principles for recognizing/measuring financial assets, financial liabilities and some contracts to buy or sell non-financial items.
Derivative accounting is subset
Cash Flow
Fair Value
Net Investment Hedging
Virtual and Embedded Derivatives remain an issue
Disclosure separately handled under IFRS 7

Comparison Flow
ASC 815
ASC 815
Current Guidance
ASC- ED ASC-Proposed Update Exposure Draft May 26, 2010 IAS 39 IAS 39 Current Guidance IASB-ED IASB Exposure Draft Exposure Draft December 9, 2010

Derivative Defined
ASC 815
Financial instrument or contract with
Underlying(s),
Notional or payment provisions
Little or no initial net investment
Net settle-able
ASC- ED No significant change
IAS 39
Financial instrument whose value changes in response to changes in underlying variables
Little or no initial net investment
Settled at a future date
IASB-ED No significant change

Virtual Derivatives
ASC 815
Documentation required to scope out normal purchase/normal sale contracts from Derivative Accounting requirements
Climatic/geological contracts scoped out
ASC- ED No significant change IAS 39 No documentation requirements surrounding “Own Use” contracts (assumption of normal purchase/normal sale) Election of either insurance or derivative accounting required IASB-ED “ Own Use” contracts may elect treatment as derivatives

Embedded FX Derivatives
ASC 815
3 rd Currency contracts = derivatives
if not local or functional currency of either counterparty,
if not denominated in 3 rd currency around the world,
ASC- ED
No longer bifurcate derivatives embedded in financial instruments
If not clearly and closely related, fair value the hybrid contract in earnings
IAS 39
Similar to ASC with additional caveat
If not the currency used in such contracts in the economic environment in which it takes place

Hedging AFS Securities
ASC 815
Gain or loss on AFS Security recorded in OCI without special hedge accounting. Cash flow or fair value accounting aligns currency related earnings effect of hedge and security
ASC- ED No significant change IAS 39 Currency gain or loss on AFS Security recorded in P&L, therefore special hedge accounting not required to align currency earnings effect of hedge with security IASB-ED No significant change

Fair Value
ASC 815
Amount that would be received to sell an asset or paid to transfer a liability in orderly transaction
Mid-market pricing as practical expedient
ASC- ED No significant change IAS 39 Amount an asset could be exchanged or a liability settled between knowledgeable willing parties No “own credit” effect Bid/Ask pricing unless offsetting Elect and disclose use of trade-date or settlement-date accounting IASB-ED Own credit effects recorded in OCI

Qualifying Hedging Instrument
ASC 815
Non derivative financial instruments are not permitted to be a hedging instrument (except as FX hedges of Net Investment or Fair Value)
IAS 39
Derivative instruments with 3rd parties
All changes in derivative except time value in options & forward points in forwards must be designated
Designate proportion of notional
Must include credit
IASB-ED Nonderivative financial assets and liabilities measured at fair value in P&L eligible as hedging instrument (not net written options) Interco balances can only be designated for FX risk May designate layers

Qualifying Hedged Risks
ASC 815
Benchmark interest rates
Foreign Exchange
Credit
Overall
ASC- ED IAS 39 Separately identifiable and reliably measured financial risk Foreign Exchange Credit Overall
IASB-ED
May designate all changes or “something other than the entire fair value change or cash flow variability of an item, i.e. a component .
Provided component is separately identifiable and reliably measured

Qualifying Hedged Items
ASC 815
FX risk on firm or anticipated acquisition of business not a qualifying hedged item
IAS 39
FX risk on firmly committed acquisition of business qualifies for special hedge accounting
Gain/loss reclassed to income with impairment or disposal of entity

Qualifying Interco Hedged Items
ASC 815
FX risk of a highly probable forecast intragroup transaction may qualify in a cash flow hedge provided currency risk will affect consolidate profit or loss
ASC- ED Royalty payments , interest payments or management charges between members of the same group cannot qualify as hedged item IAS 39 Intragroup transaction may qualify in a cash flow hedge provided currency risk will affect consolidate profit or loss Usually royalty payments, interest payments or management charges cannot qualify IASB-ED No significant change

Qualifying Hedged Items
ASC 815
Groups of similar items can be hedged together
Back to back hedging allows centralized treasury to hedge netted exposures from different entities
Layers of cash flows can be hedged, % of Fair Value and Entities
ASC- ED No significant change IAS 39 Portfolio of interest rate items permitted. All other groups must be similar No centralized netting permitted IASB-ED Items in group must individually qualify for hedge accounting treatment May represent offsetting positions , can net to zero Offsetting positions are grossed up , gain/loss apportioned to P&L

Hedge Effectiveness Testing
ASC 815
Whenever financial statements are prepared but at least quarterly
ASC- ED
No significant change
IAS 39
Whenever financial statements are prepared (could just be annually)

ASC 815
Prospective and retrospective testing required at inception and each reporting date
“ Highly Effective” Expectation
Short-Cut, Matched Terms, critical term comparison, dollar-offset analysis, regression
ASC- ED
Reasonably Effective
Qualitative Evaluation
No Short-Cut or Matched Terms
Inception test with limited additional testing
IAS 39
Prospective and retrospective testing required at inception and each reporting date
“ Highly Effective” Expectation
No assumption of perfect offset
Critical term comparison, dollar-offset analysis, regression
IASB-ED No more retrospective testing Expectation of other than accidental offset and meets “objective” of strategy No “bright lines”

Credit in Hedge Effectiveness Testing
ASC 815
Credit risk from derivative is applied to hedged item as well
ASC- ED
IAS 39 Derivative credit adjusted for counterparty, underlying not IASB-ED No significant changes

ASC 815
No prohibition against deliberate mismatch of hedge item and derivative to create over or under hedging
ASC- ED
IAS 39 No prohibition against deliberate mismatch of hedge item and derivative to create over or under hedging IASB-ED Ensure that hedge relationship does not produce and unbiased result: reduce ineffectiveness

Hedge Effectiveness Measurement
ASC 815
Change in variable cash flow for zero fair value designations
Hypothetical derivative
Change in fair value method
ASC- ED
IAS 39 Present value guiding concept Hypothetical derivative Change in fair value method IASB-ED No significant change

Hedge Accounting
ASC 815
Special Hedge Accounting for
Cash Flow
Fair Value
Net Investment: direct subsidiary
IAS 39
Special Hedge Accounting for
Cash Flow
Fair Value
Net Investment: direct or indirect subsidiary

Hedge Accounting for Options
ASC 815
For hedges of intrinsic value record option time value changes in P&L as they occur
For hedges of total changes under G20 concepts effective time value is reclassified to P&L with hedged item
ASC- ED Option premium expense to be amortized to income in “rational way ” IAS 39 Special Hedge Accounting for Intrinsic Value of Options only: time value changes recorded in P&L as they occur
IASB-ED
Underlying defines if premium
amortizes over life when hedging or
Premium impacts earnings together with hedged item

Hedge Accounting
ASC 815
Cash Flow ineffectiveness limited to over performance of derivative
Changes in Fair Value of hedged item recognized in underlying asset/liability in BS and P&L
ASC- ED Both over and under- performance of cash flow hedges in income IAS 39 Cash Flow ineffectiveness limited to over performance of derivatives Changes in Fair Value item recognized in underlying asset/liability in BS and P&L IASB-ED No change to cash flow ineffectiveness calculation: addressed by no bias requirement Changes in Fair Value item in BS (separate) and OCI, not P&L

Hedge Accounting for Cash Flow Exposures
ASC 815
Effective gains/losses remain in OCI until hedged item recognized in income
ASC- ED No significant change IAS 39 Effective gains/losses may remain in OCI until hedged item recognized in income or may adjust the basis of hedged items recorded in balance sheet IASB-ED Must adjust the basis of hedged items recorded in balance sheet

Hedge Accounting for Cash Flow Exposures
ASC 815
Gains/losses on anticipated transactions possible but not probable of occurring stay in OCI until probable not to occur
2 additional months for hedged item to occur
ASC- ED No significant change IAS 39 Gains/losses on anticipated transactions stay in OCI until no longer expected to occur No specified 2-month extension of hedge period IASB-ED No significant change

Hedge Accounting for Net Investment
ASC 815
Gains/losses on Net Investments remain in OCI/CTA until substantial liquidation of subsidiary
ASC- ED No significant change IAS 39 Gains/losses on Net Investments in OCI/CTA reclassified upon disposal or partial disposal of foreign operation IASB-ED No significant change

Termination of Hedge Relationship
ASC 815
Qualifying criteria for designation no longer met
Hedging instrument expires, sold, terminated or exercised
Company dedesignates relationship
ASC- ED No voluntary dedesignation Compensating contract relationship must be documented
IAS 39
Qualifying criteria for designation no longer met
Hedging instrument expires, sold, terminated or exercised
Company dedesignates relationship
IASB-ED No voluntary dedesignation Change in hedge objective can terminate relationship

Dedesignation/Redesignation Events
ASC 815
Changes in any of the critical terms of the instrument or hedged item would require dedesignation
ASC- ED Adjustments to derivative notional only requires amendment of inception documentation, not dedesignation
IAS 39
Changes in any of the critical terms of the instrument or hedged item would require dedesignation
IASB-ED Proactive “rebalancing of hedge relationship” requires update to documentation The replacement or rollover of a hedge instrument is not an expiration (dedesignation) if contemplated in documentation

Corporate Status

Status on adoption for US companies Source: PricewaterhouseCoopers

Resources

ASC Update Reference Paragraphs
ASC- Proposed Update Derivative & Hedging Guidance buried throughout the standard:
Questions from FASB on hedging
Questions 56-58 and 61-64
Proposed guidance: 110-128
Implementation guide: IG172-180
Background/conclusions: BC216-235
http:// www.fasb.org/cs/ContentServer?c = Document_C&pagename =FASB%2FDocument_C%2FDocumentPage&cid=1176156904144

IASB Exposure Draft
FASB Invitation to Comment:
Background
Questions (from FASB) for Respondents
High Level Comparison
Copy of entire IASB Exposure Draft
http:// www.fasb.org/cs/ContentServer?site = FASB&c = Document_C&pagename =FASB%2FDocument_C%2FDocumentPage&cid=1176158233827
IASB Exposure draft direct:
Guidance, Basis for Conclusions, Illustrations
http://www.ifrs.org/Current+Projects/IASB+Projects/Financial+Instruments+A+Replacement+of+IAS+39+Financial+Instruments+Recognitio/Phase+III+-+Hedge+accounting/edcl/ed.htm

Additional resources
IASB ( www.iasb.org )
FASB ( www.fasb.org )
AICPA IFRS resources site ( www.ifrs.com )
Securities and Exchange Commission ( www.sec.gov )
SEC Roadmap to IFRS ( www.sec.gov/spotlight/ifrsroadmap.htm )
Deloitte ( http:// www.iasplus.com )
PricewaterhouseCoopers
( http://www.pwc.com/gx/en/ifrs-reporting/index.jhtml )
EY ( http:// www.ey.com /IFRS )
KPMG ( http://www.kpmginstitutes.com/ifrs-institute/index.aspx )

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Derivative Accounting Convergence: The path from Where We Are (US GAAP) to Where We Are Headed (IFRS)

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Derivative Accounting Convergence: The path from Where We Are (US GAAP) to Where We Are Headed (IFRS) Presentation Transcript