In brief: IASB issues exposure draft on novation of derivatives (No. 2013-12)

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In brief 03/06/2013 by Assurance services
In brief: IASB issues exposure draft on novation of derivatives (No. 2013-12)

At a glance

The IASB has issued an exposure draft proposing a limited scope amendment to IAS 39, Financial instruments: Recognition and measurement, and to the forthcoming chapter on hedge accounting in IFRS 9, Financial instruments. The exposure draft proposes some relief from the hedge accounting requirements when a derivative is novated to a central counterparty (CCP), such as a central clearing organization, under certain circumstances.

What’s new?

The IASB has issued an exposure draft proposing a limited scope amendment to IAS 39, Financial instruments: Recognition and measurement, and to the forthcoming chapter on hedge accounting in IFRS 9, Financial instruments. The exposure draft proposes some relief from the hedge accounting requirements when a derivative is novated to a central counterparty (CCP), such as a central clearing organization, under certain circumstances.

What are the key provisions?

Regulations have been introduced (based on the G20 commitments arising out of the financial crisis) that will require “over the counter” (OTC) derivatives to be transacted with a CCP to improve transparency, consistency, and regulatory oversight of OTC derivatives. This will result in the novation (that is, replacing one party of the derivative contract with a new party, in this case the CCP) of existing OTC derivative contracts.

Existing guidance requires an entity to stop hedge accounting when such a novation occurs because the original derivative no longer exists. The derivative with the CCP can be designated in a new hedging relationship. However, this may result in more hedge ineffectiveness, particularly for cash flow hedges, and increases the risk that the hedging relationship will fail to meet the threshold for being highly effective because the new derivative has a non-zero fair value.

The exposure draft proposes to allow the continuation of hedge accounting when a hedging derivative is novated to a CCP and all of the following conditions are met:

  • The novation is required by laws or regulations.
  • The novation results in a CCP becoming the new counterparty to each of the parties of the novated derivative.
  • The changes to the terms arising from the novation are consistent with the terms that would have existed if the novated derivative had originally been entered into with the CCP. For example, there can be changes in terms such as collateral, rights to offset receivables and payables, and charges levied by the CCP, but there can be no changes to maturity dates, payment dates, contractual cash flows, or the basis of their calculation.

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.

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 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 limited scope amendments will be beneficial to entities applying hedge accounting that are subject to mandatory novation of OTC derivatives.

What’s the effective date?

Although the exposure draft does not specify an effective date, the IASB hopes to complete the amendments as soon as possible because the new regulations to mandate CCP clearing of OTC derivatives will become effective shortly.

What’s next?

The comment period ends on April 2, 2013. Entities should consider responding to the proposals so that their views can be considered by the IASB in its finalization of the amendment.

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:

Marie Kling
Partner
Phone: 1-973-236-4460
Email: marie.kling@us.pwc.com

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

In Brief is designed to provide a timely, high-level overview of significant financial reporting developments. It is issued by the National Professional Services Group of PwC. This publication is for general information purposes only, and should not be used as a substitute for consultation with professional advisors. To access additional content on financial reporting issues, register for CFOdirect Network (www.cfodirect.pwc.com), PwC’s online resource for financial executives.