Tuesday, April 29, 2014

IASB Member Outlines New Approach to Accounting for Derivatives Risk

It is imperative that financial reporting provide more clarity around risk management activities, said IASB Member Steve Cooper, adding that managing risks, such as interest rate risks, on a continuous and dynamic basis is one of the key elements of financial risk management. In recent remarks, he referenced the just published IASB Discussion Paper on Accounting for Dynamic Risk Management, which explores the accounting aspects of dynamic risk management and discusses preliminary views on a new accounting approach for derivatives hedging that may improve financial reporting in this area. The particular focus of the white paper is the management of interest rate risk by banks; however, it also applies to other dynamic risk management activities in other industries, for example, commodity price risk.

Developing a new approach does not mean that current accounting practices are necessarily failing investors, he pointed out. IFRS already includes a general hedge accounting model, which provides for the fair value and cash flow hedge accounting with which most investors will be familiar. The model has recently been improved through the new financial instruments Standard IFRS 9. However, even the general hedge accounting approach has limitations in which risk management practices are more complex and the risks being hedged are more dynamic

For example, IFRS currently does not require fair value measurement for many of the assets and liabilities that create risk exposures that may be hedged by derivatives. For example, banks’ loans and deposits are generally measured at amortized cost. The accounting focuses on the net interest income generated over the life of the instruments rather than changes in value.

However, the fair value measurement of derivatives and the cost cost-based measurement of bank loans and deposits do not sit well together when the objective of holding those derivatives is to manage the interest rate risks of that business activity. This is when hedge accounting becomes necessary to provide investors with clear, transparent information about the related activity.

The general hedge accounting model of IFRS 9 can be applied to dynamic risk management and, in many cases, is adequate to enable the economics of the activity to be faithfully reflected in financial statements. However, applying the general hedge accounting model to risks managed dynamically can present challenges and complexity for preparers, he noted, and can result in financial statements that are difficult for investors to understand. There are also certain dynamic risk management activities that are difficult to reflect properly in financial statements and that may consequently result in volatility that is not reflective of the underlying situation. It is for these reasons that the IASB is considering an alternative accounting approach.           

Portfolio Revaluation Approach. The paper suggests a new method of accounting for dynamic risk management called the Portfolio Revaluation Approach (PRA). The aim of the PRA is to provide an alternative to the present general hedge accounting model that will be easier for preparers to apply and that will better represent and be more consistent with risk management activities, resulting in better information for investors

The PRA involves identifying a portfolio of exposures that is subject to dynamic risk management, and remeasuring these for the risk being managed. For a bank this could be a portfolio of loans and deposits. This is not a full fair value approach, as only one component of changes in value would be recognized in the revaluation adjustment. For example, for dynamic interest rate risk management only changes in value of the loan or deposit due to the hedged benchmark interest rate risk component would be included in the revaluation.

Other components of the change in fair value including credit risk, expected credit losses and other components of the credit spread such as liquidity are not included in the adjustment This revaluation adjustment is the reported in profit or loss together with the full fair value changes of the derivatives that the bank is using to manage that risk.

There are two key advantages of this approach over the general hedge accounting model. One is that the PRA can be more easily applied to open portfolios. The second is that the PRA would enable entities to better reflect their dynamic risk management practices in their financial statements. In general, the PRA is designed to result in a recognition and measurement approach that better reflects the economics of risk management, to provide for a presentation that shows how dynamic risk management has impacted net interest income for the current period and to separate this impact from the ineffectiveness of risk management and the financial effect of risks that are unhedged.