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ESMA Praises Joined up Approach to Valuations and Risk Management in IAS 39 Hedge Accounting Changes

The European Securities and Markets Authority (ESMA) has sent a letter to the head of the International Accounting Standards Board (IASB) regarding its views and concerns about incoming hedge accounting changes that are included in the recent exposure draft on IAS 39. ESMA indicates in the letter that the proposals will allow for a more joined up approach between the valuation and risk management functions by allowing accounting to “better reflect risk management practices”, but asks for further guidance to be provided around several new items, including the concept of “reliably measurable” for risk items.

The feedback is the result of the work of ESMA’s Standing Committee on Corporate Reporting, which has been charged with reviewing the changing requirements about how hedging is to be included in firms’ financial statements under International Financial Reporting Standards (IFRS). It notes of the inclusion of hedging: “This will enhance the relevance and comparability of the financial statements for users and should mean less of a need for the information therein to be supplemented by, for example, non­GAAP disclosures or management commentary, neither of which are likely to be subject to the same level of objectivity (in preparation) and comparability (in use) as disclosures in IFRS financial statements themselves.”

On the face of it the changes seem to suggest that the requirements will remove some of the requirements for supplementary data to be included alongside valuations. However, as the letter continues, it becomes evident that ESMA is keen for much more data to be provided about risk management practices and decision making in order to determine its impact on the accounting and valuations process.

Although it praises the review of the current hedge accounting practices, which it describes as “excessively complex, arbitrary and rules-based”, ESMA sounds a note of caution about the potential misinterpretation of certain items. The concept of “reliably measurable” risk components is one such item that the regulator recommends should be further elaborated upon by the IASB. It suggests that the fair value measurement guidance under IAS 39 could be a starting point for this work.

ESMA also indicates that the hedge effectiveness requirements are “not articulated clearly enough” and that this could result in inconsistency of application of the requirements by industry participants. On this note, it also states: “ESMA agrees with the concept of rebalancing but believes that the distinction between rebalancing and discontinuation could be ‘blurred’ by management and thus result in a free choice between the two. To prevent this, there should be a requirement for hedge accounting to follow pre­defined and comprehensively documented risk management strategies, and – importantly ­ disclosure of the rationale for, and timing of, any changes to risk management strategies that impact the entity’s approach hedge accounting.”

This certainly reinforces the more joined up approach that the regulator is seeking from the industry with regards to accounting and risk management practices. To this end, ESMA also wants the accounting requirements to go one step further than currently proposed and compel disclosures about hedging activities and their impact on risk management practices.

ESMA says: “Such disclosures are important, because without them it may difficult for users (and enforcers of IFRS) to understand the relationship between risk management and hedging. It may also allow scope for management to undertake inappropriate changes to hedge accounting on the premise that such changes have arisen from changes in risk management activities.”

It suggests that certain additional disclosures should be required, including: comprehensive information about a firm’s risk strategy; supporting data around the judgement of what constitutes reliably measurable risk items; details about risk management tolerance levels; justification of changes in hedging practices; and qualitative data on decision making around changes to these practices. It also suggests another item to be included: “For fair value hedges, a detail of the single net amount of the fair value hedge permitting to identify and understand the hedged items and their associated gains and losses.”

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