Comment letter on Round-table discussions

Comment letter on Round-table discussions

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NJO=açêëÉí=oáëÉ= qÉä=HQQ=EMF=OM=TSVQ=USQM= =içåÇçå= c~ñ=HQQ=EMF=OM=TPNN=PPNN= =b`Qv=Ubk= au=PUMRM=_ä~ÅâÑêá~êë= =råáíÉÇ=háåÖÇçã= = ==== Sir David Tweedie Chairman Your ref International Accounting Standards Board 30 Cannon Street Our ref th London EC4M 6XH Contact Terry Harding 020 7694 8640 17 March 2003 IAS 32/39 Round Tables Many thanks for the opportunity to attend the Round Tables last week. We appreciate the time and effort that the Board and the Staff spent in preparing for the Round Tables and in listening to respondents’ views. Having observed a number of the sessions, I thought it might be helpful to set out a number of suggested amendments in the area of hedge accounting that we did not have time to explore fully at our session last week and that were not covered in our comment letter. We believe these may go some way to striking a balance that eases the implementation difficulties for banks and corporates without compromising the principles in the Standards. Prospective effectiveness assessment The requirement in IAS 39.146, that changes in the fair value or cash flows on the hedged item and the hedging instrument should be expected to ‘almost fully offset’, is regarded by many as unduly restrictive. We note the concerns of both banks and corporates that accounting rules should not drive their economic hedging strategies, and the assertion by banks that their risk management systems should be capable ...

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Sir David Tweedie
Chairman
International Accounting Standards Board
30 Cannon Street
London
EC4M 6XH
17 March 2003
Your ref
Our ref th
Contact Terry Harding
020 7694 8640
IAS 32/39 Round Tables
Many thanks for the opportunity to attend the Round Tables last week.
We appreciate the time
and effort that the Board and the Staff spent in preparing for the Round Tables and in listening to
respondents’ views.
Having observed a number of the sessions, I thought it might be helpful to
set out a number of suggested amendments in the area of hedge accounting that we did not have
time to explore fully at our session last week and that were not covered in our comment letter.
We believe these may go some way to striking a balance that eases the implementation
difficulties for banks and corporates without compromising the principles in the Standards.
Prospective effectiveness assessment
The requirement in IAS 39.146, that changes in the fair value or cash flows on the hedged item
and the hedging instrument should be expected to ‘almost fully offset’, is regarded by many as
unduly restrictive.
We note the concerns of both banks and corporates that accounting rules
should not drive their economic hedging strategies, and the assertion by banks that their risk
management systems should be capable of ensuring that ineffectiveness will never exceed
narrow limits.
We understand that the requirement is more restrictive than US GAAP, and we
are not convinced of the rationale for setting a higher hurdle for expected effectiveness than is
required for actual effectiveness.
One suggestion would be to amend paragraph 146 to require
both prospective and retrospective hedge effectiveness to fall within the 80-125% range. The
impact of actual ineffectiveness would, following the Board’s principle, continue to be
recognised in income. Both corporates and banks may find such an amendment helpful in that it
would allow them to align existing effectiveness procedures with those required to qualify for
hedge accounting under IAS 39.
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IAS 32/39 Round Tables
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Copyright © 2003 KPMG International, a Swiss nonoperating association.
All rights reserved.
Internal derivatives as hedging instruments
IGC 134-1-b currently permits hedge accounting for foreign exchange risk to be applied at the
subsidiary level, and also on consolidation, without the need for redesignating hedging
relationships for group reporting purposes.
The basis for that conclusion is, essentially, that the
accounting would be the same, whether or not the hedge is redesignated because, in effect, gross
positions within the group offset (hedge) each other on consolidation.
To address the concerns of corporates and financial institutions that sound risk management
should, where appropriate, drive hedge accounting requirements, the Board may wish to consider
an alternative approach.
That is to allow hedge accounting claimed at a subsidiary or divisional
level, using an internal derivative as the hedging instrument, to continue to qualify for hedge
accounting at the group level where it can be demonstrated that the hedged risk has been fully
transferred outside the group through one or more external transactions.
Effectiveness would be
tested at the subsidiary level and ineffectiveness would be recognised in income at that level. An
additional requirement would be that all internal and external derivatives are measured at fair
value using the same sources of fair value data.
Under this approach, a group risk management policy that prevents each subsidiary from
hedging externally, but instead requires the passing of risk to a treasury centre, the netting of
those risks and the external offset of the net risk, is seen as part of a sensible risk/cost
management approach that should not affect the accounting result.
The transfer of risk
externally ‘validates’ the internal hedging relationship, even on consolidation.
We note that both
the approach in IGC 134-1-b and the alternative above are practical accommodations to avoid
the need to duplicate documentation and effectiveness testing requirements.
Conceptually, the
hedge should be redesignated at the group level, even if the result is the same, because the
internal hedging instrument does not exist in the group financial statements. Our suggested
alternative is equally pragmatic but perhaps more consistent with the way that corporates view
and manage the risk, and less reliant on the accounting outcome being the same.
Since this approach does not rely on the idea that a non-derivative qualifies as a hedging
instrument only for foreign exchange risk, the Board might also consider whether it could
usefully be applied in interest rate risk management by financial institutions.
We understand that
the approach in respect of interest rate risk would diverge from US GAAP. However, it would
seem that allowing banks to designate interest rate hedges at the banking book level, then net the
risk centrally before passing it externally, may be part of a solution that would address some of
the concerns expressed. Whether that risk transfer might be achieved through a ring-fenced and
tightly controlled ‘trading desk’ would need to be considered separately.
Hedging components or ingredients of a non-financial asset
IAS 39.129 and 130 require a non-financial item to be designated as a hedged item either in its
entirety (for all risks) or for foreign exchange risk only.
The reason is that changes in the price
of a component or an ingredient of a non-financial asset or liability generally cannot be
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Copyright © 2003 KPMG International, a Swiss nonoperating association.
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measured reliably.
In practice we have seen several cases where it seems prices of components
or ingredients could be measured reliably. For example a standard price for coffee, measurable
from a futures price, could be a component of a contract to purchase coffee in a specified
location.
In the oil industry, we understand that the ‘components’ of an oil price can be
separately and reliably measured.
One suggestion would be to restate paragraphs 129 and 130 in
the form of a principle, that components or ingredients of a non-financial asset or liability should
qualify as a hedged item only when the value of the component can be reliably measured,
possibly by reference to an active market. Again, we note that such an amendment would
diverge from US GAAP.
Matching the critical terms of a hedged item and hedging instrument
Having observed and taken part in the discussions on ‘critical terms’ and ‘portions’ last week,
we continue to believe that both accommodations may be useful. We do not understand why
(accepting that ‘portions’ is a wider accommodation than ‘critical terms’) allowing ‘portions’
means that a ‘critical terms’ exemption should not also be allowed. Although we agree that
matching of critical terms may be difficult and perhaps costly to achieve, it does seem that some
companies would be prepared to incur that cost if it would largely eliminate the requirement to
test for effectiveness.
It therefore seems unduly restrictive to prohibit it. We note that IAS
39.151 seems already to allow an assumption of no ineffectiveness when critical terms are
matched, although IGC 147-1 takes a different view. As a minimum, the apparent inconsistency
should be clarified.
Designating a hedging relationship for part of the life of a derivative
IAS 39.145 prohibits a derivative from being designated as a hedging instrument for part of its
life.
The reason for this is unclear. The requirement can create difficulties in practice, for
example where a derivative matures at the end of the month in which a stream of cash flows is
expected, or where a hedged cash flow takes place earlier than originally expected. We agree
that the timing mis-match will give rise to ineffectiveness, but, once again, the prohibition seems
unduly restrictive.
We hope you find these additional comments helpful, and would ask that you circulate them to
other Board members.
I would be happy to discuss them further if that would be helpful, or
indeed to help in any way I can as the project progresses.
Terry Harding
Partner, KPMG LLP
IAS Advisory Services