14 January 2008 Sir David Tweedie Chairman International

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14 January 2008 Sir David Tweedie Chairman International Powered By Docstoc
					14 January 2008

Sir David Tweedie
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
Yours sincerely

Judy Hartcher                                              Chief Executive Officer

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
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

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
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.

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