In brief: IASB provides relief for novation of derivatives (No. 2013-34)

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In brief 06/28/2013 by Assurance services
In brief: IASB provides relief for novation of derivatives (No. 2013-34)

At a glance

The IASB has published narrow-scope amendments to IAS 39, Financial instruments: Recognition and measurement. Similar provisions will be incorporated into the forthcoming chapter on hedge accounting in IFRS 9, Financial instruments. The amendments provide relief from parts of the hedge accounting requirements when a derivative is novated to a central counterparty (CCP), such as a central clearing organization, provided certain conditions are met.

What's new?

The IASB has published narrow-scope amendments to IAS 39, Financial instruments: Recognition and measurement. Similar provisions will be incorporated into the forthcoming chapter on hedge accounting in IFRS 9, Financial instruments. The amendments provide relief from parts of the hedge accounting requirements when a derivative is novated to a central counterparty (CCP), such as a central clearing organization, provided certain conditions are met.

What are the key provisions?

Widespread legislative changes have been introduced globally to improve the transparency and regulatory oversight of over-the-counter (OTC) derivatives by requiring them to be transacted with a CCP. As a result, entities are novating existing OTC derivative contracts (that is, replacing one party of the derivative contract with a new party; in this case, the CCP), some of which have been designated in hedging relationships.

IFRS requires an entity to stop hedge accounting when such a novation occurs, because the original derivative no longer exists. Although the new derivative can be designated in a new hedging relationship, it will have a non-zero fair value and therefore may result in additional hedge ineffectiveness that increases the risk that the hedging relationship will fail to meet the threshold for being highly effective.

As a result of the amendments, continuation of hedge accounting is permitted if both:

  • as a consequence of laws or regulations, the parties to the hedging instrument agree to have one or more clearing counterparties replace their original counterparty. For this purpose, a clearing counterparty is a CCP or an entity, for example, a clearing member of a clearing organization, that is acting as counterparty in order to effect clearing by a CCP. When the parties replace their original counterparties with different counterparties, each of the parties must clear the derivative with the same CCP, and
  • the changes to the terms arising from the novation are consistent with the terms that would have existed if the novated derivative were originally cleared with the CCP. For example, there can be changes in terms such as collateral, rights to offset receivables and payables, and charges levied, but there can be no changes to maturity dates, payment dates, contractual cash flows, or the basis of their calculation, unless they are a consequence of transacting with a CCP.

Any changes to the derivative’s fair value that arise from the novation must be reflected in its measurement and therefore, in the measurement of hedge effectiveness.

The amendments are broader than those proposed in the exposure draft (ED), which referred to novations ‘as a consequence of’ laws or regulations rather than those ‘required by’ laws or regulations. The amendments also expand the scope described in the ED to allow the use of clearing brokers.

Is convergence achieved?

In the United States, the SEC staff provided similar relief. In a letter to the International Swaps and Derivative Association (ISDA) dated May 2012, the SEC staff agreed that it would not object to the continuation of an existing hedging relationship where there is a novation of a derivative contract under specific circumstances. However, those specific circumstances differ somewhat from those proposed by the IASB and therefore, could lead to application differences. For further details on the SEC staff views, refer to Dataline 2012-16, Implications to hedge accounting of changes to derivative counterparties or hedging relationships.

Who's affected?

The amendments apply to all entities applying hedge accounting that are subject to novation of OTC derivatives as a consequence of laws or regulations.

What's effective date?

The amendments are effective for annual periods beginning on or after January 1, 2014. The amendments must be applied retrospectively in accordance with IAS 8, Accounting Policies, Changes in Accounting Estimates and Errors. Early application is permitted.

Questions?

PwC clients who have questions about this In brief should contact their engagement partner. Engagement teams that have questions should contact the Financial Instruments team in the National Professional Services Group (1-973-236-7803).

Authored by: 

John Althoff
Partner
Phone: 1-973-236-7021
Email: john.althoff@us.pwc.com

José Arostegui
Director
Phone: 1-973-236-5646
Email: jose.arostegui.llama@us.pwc.com

Steve Halterman
Director
Phone: 1-973-236-4179
Email: steven.g.halterman@us.pwc.com