14 January 2008 Sir David Tweedie Chairman International Accounting Standards Board 30 Cannon Street London EC4M 6XH United Kingdom Exposure Draft of Proposed Amendments to IAS 39 Financial Instruments: Recognition and Measurement – Exposures Qualifying for Hedge Accounting Dear Sir David We are pleased for the opportunity to comment on the Exposure Draft of Proposed Amendments to IAS 39 Financial Instruments: Recognition and Measurement – Exposures Qualifying for Hedge Accounting (herein referred to as ‘the ED’). The FTA represents a significant number of corporate and non-corporate finance and treasury professionals in Australia and this submission has been developed by, and in consultation with, our members. We recognise and agree with the Board’s objective to clarify and improve IAS 39 Financial Instruments: Recognition and Measurement. However, in some respects the proposed amendments to IAS 39 Financial Instruments: Recognition and Measurement do not adequately clarify what risks are eligible for hedge accounting and what portion can be designated as a hedged item and may in-fact introduce further uncertainties. We do not agree that clarification is required in respect of what portion should be designated as a hedge and likewise we think the Board’s approach to the accounting treatment of time value on options, whilst perhaps a technically correct application of the original standard, has significant undesirable influences on the hedge practices of our members. We consider this element of the standard needs improvement to enable the Board to achieve their original objective of a mixed model approach. In previous meetings with Board members, we have been advised that the Board will make improvements to this complex standard. In this context, there currently exists a significant opportunity for the Board to remove the unintended bias that IAS 39 has against legitimate and economically rational option hedge strategies. It is also an opportunity for the Board to remove one of the major differences between FAS 133 and IAS 39. In relation to the proposed amendment, we confine our comments to the treatment of the time value in cash flow hedge relationships. However, the FTA remains of the view that further significant review of the overall standard is required to ensure that in all significant respects, the requirements of the standard with respect to hedge accounting produces financial information which aligns with economic reality and therefore leads to information in financial statements which is useful to their users. Our comments on the detailed questions set out in the Exposure Draft are set out in the Appendix to this letter. If you have any questions or require elaboration on the comments, please contact Frank Micallef, of the Victorian Technical Committee of the FTA, on telephone +61 3 9665 7479 or at firstname.lastname@example.org. Yours sincerely Judy Hartcher Chief Executive Officer Appendix Question 1 – Specifying the qualifying risks Do you agree with the proposal to restrict the risks that qualify for designation as hedged risks? If not, why? Are there any other risks that should be included in the list and why? The FTA does not agree with the proposal to restrict qualifying risks in hedge accounting for other than all risks when hedging financial instruments. Our members have not experienced divergent practice in this area. We understand that this issue may have as its source a merchant bank trying to hedge a portion of a fixed coupon with a CPI swap which we understand was appropriately rejected by the big accounting firms. Further, the amendments add complexity to an already complex standard and are not considered an improvement. Question 2 – Specifying when an entity can designate a portion of the cash flows of a financial instrument as a hedged item Do you agree with the proposal to specify when an entity can designate a portion of the cash flows of a financial instrument as a hedged item? If you do not agree, why? The FTA disagrees in principle with this proposal as we do not believe it improves this standard. Firstly, the use of the word ‘portion’ in the first sentence of paragraph 80Z might lead to unintended consequences with regard to hedging one-sided risk for non-financial items (which are outside the scope of this amendment). Paragraph 80Z(c) in combination with this introductory sentence might imply that one-sided risks are always considered portions. IAS 39.82 restricts non-financial items to be designated for foreign currency risks or all risks in their entirety. This paragraph also states the reason for this limitation is ‘the difficulty of isolating and measuring the appropriate portion of cash flows [emphasis added] or fair value changes attributable to specific risks other then foreign currency risks’. Paragraph 80Z, as currently drafted, could be interpreted as effectively prohibiting designating one-sided risks arising from non-financial items, which we do not believe was the Board’s intention. Secondly, the interaction of paragraph 80Z(d) and the existence of (non-separable) put or call options within debt instruments is confusing. Paragraph 80Z(d) states that “an entity may designate as a hedged item one or more of the following portions of the cash flows of a financial instrument: any contractually specified cash flows that are independent from the other cash flows of that instrument (for example, the first four interest rate payments on a floating rate financial liability). [emphasis added]” It could be argued that interest and principal cash flows occurring after the first exercise date of such an option are not independent. Although put or call options could have an impact on the eligibility of designation (for example, whether cash flows are highly probable to occur) and impact hedge effectiveness, it would be surprising if it is the Board’s intention to prohibit a designation when put or call options exist. Therefore, the amendment should be removed as it creates confusion where, based on our member’s experience, none currently exists. Thirdly, the FTA strongly disagrees with the clarification on hedging with options as set out in paragraphs AG99E and BC15 of the ED. Rather, we recommend that the Board take this opportunity to change the standard to permit the deferral of the time value of options consistent with DIG G20. This would be a significant practical improvement in the standard and would align the accounting to the economic reality. In addition, it would have the advantage of eliminating one of the major differences between FAS 133 and IAS 39. This change would have no negative impact of the integrity of any other aspect of the standard and indeed would make the resulting information in financial statements more useful to users, as it would result in accounting that accorded with economic reality. The actual wording the proposed AG 99E of the standard is very difficult to understand as it seeks to address a multiple of issues, other than the time value treatment of options. We would suggest instead a single change to the standard stating: When hedging a forecast transaction in a cash flow hedge for one sided risk with an option or a collar, it is permissible to include the time value of the hedge in the hedge reserve based on a hypothetical hedge for the designated hedge strategy. Finally, paragraph AG99E as currently drafted could be read as inappropriately prohibiting partial term hedging in this case because to achieve an effective partial term fair hedge of a 10 year bond with a 5 year swap it is necessary to impute a notional cash flow in the hedged item at the end of the 5 year period, even though the principal is not settled in year 5. The proposed AG 99E states that you cannot specify in the hedged item a cash flow that does not exist. The same can be said of certain cross currency hedges; for example where the company may hedge 10 year foreign currency (FC) debt with a 10 year Cross Currency Interest Rate Swap (CCIRS) (receive fixed FC pay floating local currency) in combination with a 5 year IRS, whereby there is a cash flow hedge for the first five years and a fair value hedge for the last five years. This hedge strategy requires the insertion of nominal cash flows in the hedged item at the end of the cash flow hedge and the start of the fair value hedge to be effective. Question 3 – Effect of the proposed amendments on existing practice Would the proposed amendments result in a significant change to existing practice? If so, what would those changes be? As discussed above, the FTA considers that the accounting treatment of expensing of the time value fair value changes in respect of vanilla options has had a significant negative impact on the hedging strategies of corporations. The accounting required for vanilla option hedging has resulted in information that does not reflect the economic reality of using vanilla options in legitimate hedging strategies. This is a major frustration of CFO’s, finance directors and boards and significantly detracts from the credibility of these accounting standards as a result. There has been a significant reduction in hedging with options due to the significant profit volatility an option strategy creates compared to hedging with forward contracts that achieve perfect hedge accounting. This has created a bias in the corporate world against the use of options despite the fact that options effectively lock in the down side risk of cash flow movements while allowing participation in favourable movements. When hedging a forecast transaction, the time value element of the hedge can and should be considered a legitimate cost in purchasing or selling the underlying hedged item. Accounting standards should cater for boards that seek to maintain the upside for shareholders after considering the cost of such a strategy. This is, in many cases, more prudent than forward-based hedging strategies and the accounting standards should reflect this economic reality rather than requiring an accounting treatment which will confuse users of financial reports and decrease the utility of financial statements for making economic decisions. Whilst we accept that derivatives should be on the balance sheet at fair value and there should be appropriate documentation to qualify for hedge accounting, the current treatment of vanilla option hedge strategies produces volatility that biases corporates against their use and, more importantly, produces less useful information for decision making by users of financial statements. Rather than attempt to clarify an accounting approach that we consider inappropriate, the FTA requests the Board reflect on the approach under DIG G20. FASB effectively modified FAS 133 via G20 because it made good sense. G20 is consistent with all the principles of IAS 39 and can be implemented as a major interim improvement until the accounting standard moves to the next stage of a full fair value model. The irony of the current situation is that the current bias in the present mixed attribute model promotes the use of forwards and yet in a full fair value model, options would be less volatile than forwards. IAS 39 was meant to be a compromise between fair value accounting, whilst at the same time producing a historical cost profit and loss result that is relevant and reliable to readers of the financial statements. The current approach to vanilla options creates significant profit and loss volatility despite the fact that they are a perfect hedge. This is not consistent with the mixed attribute model that the Board sought to achieve. Question 4 – Transition Is the requirement to apply the proposed changes retrospectively appropriate? If not, what do you propose and why? The FTA agrees with this approach from a conceptual point of view. However, we recognise that full retrospective treatment for those entities that previously deferred time value of options in the cash flow hedge reserve would result in full restatement of that amounts to retained earnings. There would be no ability to restate to the position had they designated intrinsic value only, ie deferring only intrinsic value in the cash flow hedge reserve, because the very nature of hedge accounting is that is can only be applied prospectively and clearly hedge documentation was not in place that supported that alternative designation. Those entities would, therefore, only be able to defer intrinsic value on purchased options prospectively if new hedge documentation was put in place and all cumulative time value would have to be restated to retained earnings. As IFRIC recognised that there was diversity in practice with respect to designation of time value, we request that the Board consider an alterative transition requirement that will enhance comparability by allowing entities that had designated both time and intrinsic value to restate their cash flow hedge reserve to include intrinsic value only. This transition approach is similar to concessions that Board made when it amended IAS 39 for Cash flow hedge accounting of forecast intragroup transactions. The transition arrangements could be as follows: (1) Full retrospective application of the ED for all hedging relationships that designated both intrinsic and time value as they do not qualify for hedge accounting and hence, restate the opening retained earnings for the earliest prior period presented for amounts retained in the cash flow hedge reserve. (2) Retrospective application only for the time value element where both intrinsic and time value were designated (assuming all other elements of this ED and hedge accounting criteria are met). The opening retained earnings for the earliest prior period presented will be restated only for changes in the fair value of the hedging instrument resulting from changes in the time value and amounts previously included in the cash flow hedge with respect to the intrinsic value are retained.