Editorial note: Inserted by Amendments to IAS 39, March 2004 with effect for annual periods beginning on or after 1 January 2005. An entity shall apply the amendments to an earlier period when it applies IAS 39 (as revised in 2003) and IAS 32 (as revised in 2003) to that period.
BC136B. Additionally, comments made in response to the Exposure Draft Fair Value Hedge Accounting for a Portfolio Hedge of Interest Rate Risk demonstrated that it was unclear how the prospective effectiveness test was to be applied. The Board noted that the objective of the test was to ensure there was firm evidence to support an expectation of high effectiveness. Therefore, the Board decided to amend the Standard to clarify that an expectation of high effectiveness may be demonstrated in various ways, including a comparison of past changes in the fair value or cash flows of the hedged item that are attributable to the hedged risk with past changes in the fair value or cash flows of the hedging instrument, or by demonstrating a high statistical correlation between the fair value of cash flows of the hedged item and those of the hedging instrument. The Board noted that the entity may choose a hedge ratio of other than one to one in order to improve the effectiveness of the hedge as described in paragraph AG100.
Editorial note: Inserted by Amendments to IAS 39, March 2004 with effect for annual periods beginning on or after 1 January 2005. An entity shall apply the amendments to an earlier period when it applies IAS 39 (as revised in 2003) and IAS 32 (as revised in 2003) to that period.
Hedges of Portions of Non-Financial Assets and Non-Financial Liabilities for Risk Other Than Foreign Currency Risk
(paragraph 82)

Editorial note: Amendments to IAS 39, March 2004 inserts "initially" before "decided to retain" in the last sentence with effect for annual periods beginning on or after 1 January 2005. An entity shall apply the amendments to an earlier period when it applies IAS 39 (as revised in 2003) and IAS 32 (as revised in 2003) to that period.
BC136A. However, when subsequently finalising the requirements for portfolio hedges of interest rate risk, the Board received representations from constituents that some hedges would fail the "almost fully offset" test in IAS 39, including some hedges that would qualify for the short-cut method in US GAAP and thus be assumed to be 100 per cent effective. The Board was persuaded that the concern described in the previous paragraph that an entity might deliberately underhedge would be met by an explicit statement that an entity could not deliberately hedge less than 100 per cent of the exposure on an item and designate the hedge as a hedge of 100 per cent of the exposure. Therefore, the Board decided to amend IAS 39:
(a) to remove the words "almost fully offset" from the prospective effectiveness test, and replace them by a requirement that the hedge is expected to be "highly effective". (This amendment is consistent with the wording in US GAAP.)
(b) to include a statement in the Application Guidance in IAS 39 that if an entity hedges less than 100 per cent of the exposure on an item, such as 85 per cent, it shall designate the hedged item as being 85 per cent of the exposure and shall measure ineffectiveness on the basis of the change in the whole of that designated 85 per cent exposure.

BC135A. IAS 39 permits a hedged item to be designated as a portion of the cash flows or fair value of a financial asset or financial liability. In finalising the Exposure Draft Fair Value Hedge Accounting for a Portfolio Hedge of Interest Rate Risk, the Board received comments that demonstrated that the meaning of a 'portion' was unclear in this context. Accordingly, the Board decided to amend IAS 39 to provide further guidance on what may be designated as a hedged portion, including confirmation that it is not possible to designate a portion that is greater than the total cash flows of the asset or liability.
Editorial note: Inserted by Amendments to IAS 39, March 2004 with effect for annual periods beginning on or after 1 January 2005. An entity shall apply the amendments to an earlier period when it applies IAS 39 (as revised in 2003) and IAS 32 (as revised in 2003) to that period.
Expected Effectiveness
(paragraphs AG105-AG113)
BC136. Qualification for hedge accounting is based on expectations of future effectiveness (prospective) and evaluation of actual effectiveness (retrospective). In the original IAS 39, the prospective test was expressed as "almost fully offset", whereas the retrospective test was "within a range of 80-125 per cent". The Board considered whether to amend IAS 39 to permit the prospective effectiveness to be within the range of 80-125 per cent rather than "almost fully offset". The Board noted that an undesirable consequence of such an amendment could be that entities would deliberately underhedge a hedged item in a cash flow hedge so as to reduce recognised ineffectiveness. Therefore, the Board initially decided to retain the guidance in the original IAS 39.

BC131. The Exposure Draft proposed few changes to the hedge accounting guidance in the original IAS 39. The comments on the Exposure Draft raised several issues in the area of hedge accounting suggesting that the Board should consider these issues in the revised IAS 39. The Board's decisions with regard to these issues are presented in the following paragraphs.
Consideration of the Shortcut Method in SFAS 133
BC132. SFAS 133 Accounting for Derivative Instruments and Hedging Activitiesissued by the FASB allows an entity to assume no ineffectiveness in a hedge of interest rate risk using an interest rate swap as the hedging instrument, provided specified criteria are met (the 'shortcut method').
BC133. The original IAS 39 and the Exposure Draft precluded the use of the shortcut method. Many comments received on the Exposure Draft argued that IAS 39 should permit use of the shortcut method. The Board considered the issue in developing the Exposure Draft, and discussed it in the roundtable discussions that were held in the process of finalising IAS 39.
BC134. The Board noted that, if the shortcut method were permitted, an exception would have to be made to the principle in IAS 39 that ineffectiveness in a hedging relationship is measured and recognised in profit or loss. The Board agreed that no exception to this principle should be made, and therefore concluded that IAS 39 should not permit the shortcut method.
BC135. Additionally, IAS 39 permits the hedging of portions of financial assets and financial liabilities in cases when US GAAP does not. The Board noted that under IAS 39 an entity may hedge a portion of a financial instrument (eg interest rate risk or credit risk), and that if the critical terms of the hedging instrument and the hedged item are the same, the entity would, in many cases, recognise no ineffectiveness.
Hedges of Portions of Financial Assets and Financial Liabilities
(paragraphs 81, 81A, AG99A and AG99B)

BC130. The Board could not find an acceptable way to distinguish reversals of impairment losses from other increases in fair value. Therefore, it decided that precluding reversals of impairment on available-for-sale equity instruments was the only appropriate solution. In its deliberations, the Board considered:
(a) limiting reversals to those cases in which specific facts that caused the original impairment reverse. However, the Board questioned the operationality of applying this approach (ie how to decide whether the same event that caused the impairment caused the reversal).
(b) recognising all changes in fair value below cost as impairments and reversals of impairment through profit or loss, ie all changes in fair value below cost would be recognised in profit or loss, and all changes above cost would be recognised in equity. Although this approach achieves consistency with IAS 16 and IAS 38, and eliminates any subjectivity involved in determining what constitutes impairment or reversal of impairment, the Board noted that it would significantly change the notion of 'available for sale' in practice. The Board believed that introducing such a change to the available-for-sale category was not appropriate at this time.
Hedging

BC127. For available-for-sale debt instruments, the Board decided that impairment should be reversed through profit or loss when fair value increases and the increase can be objectively related to an event occurring after the loss was recognised.
BC128. The Board noted that (a) other Standards require the reversal of impairment losses if circumstances change (eg IAS 2 Inventories, IAS 16 Property, Plant and Equipment and IAS 38 Intangible Assets); (b) the decision provides consistency with the requirement to reverse impairment losses on loans and receivables, and on assets classified as held to maturity; and (c) reversals of impairment in debt instruments (ie determining an increase in fair value attributable to an improvement in credit standing) are more objectively determinable than those in equity instruments.
Reversals of impairment on available-for-sale equity instruments
(paragraph 69)
BC129. For available-for-sale equity instruments, the Board concluded that if impairment is recognised, and the fair value subsequently increases, the increase in value should be recognised in equity (and not as a reversal of the impairment loss through profit or loss).

BC125. In the Exposure Draft, the Board proposed that impairment losses on debt and equity instruments classified as available for sale should not be reversed through profit or loss if conditions changed after the recognition of the impairment loss. The Board arrived at this decision because of the difficulties in determining objectively when impairment losses on debt and equity instruments classified as available for sale have been recovered and hence of distinguishing a reversal of an impairment (recognised in profit or loss) from other increases in value (recognised in equity). Accordingly, the Board proposed that any increase in the fair value of an available-for-sale financial asset would be recognised directly in equity even though the entity had previously recognised an impairment loss on that asset. The Board noted that this was consistent with the recognition of changes in the fair value of available-for-sale financial assets directly in equity (see paragraph 55(b)).
BC126. The Board considered the comments received on its proposal to preclude reversals of impairment on available-for-sale financial assets. It concluded that available-for-sale debt instruments and available-for-sale equity instruments should be treated differently.
Reversals of impairment on available-for-sale debt instruments
(paragraph 70)

BC123. The Board decided that for the purpose of assessing impairment on a portfolio basis, the method employed for grouping assets should, as a minimum, ensure that individual assets are allocated to groups of assets that share similar credit risk characteristics. It also decided to clarify that when assets that are assessed individually and found not to be impaired are grouped with assets with similar credit risk characteristics that are assessed only on a collective basis, the loss probabilities and other loss statistics differ between the two types of asset with the result that a different amount of impairment may be required.
Estimates of future cash flows in groups
(paragraphs AG89-AG92)
BC124. The Board decided that to promote consistency in the estimation of impairment on groups of financial assets that are collectively evaluated for impairment, guidance should be provided about the process for estimating future cash flows in such groups. It identified the following elements as critical to an adequate process:
(a) Historical loss experience should provide the basis for estimating future cash flows in a group of financial assets that are collectively assessed for impairment.
(b) Entities that have no loss experience of their own or insufficient experience should use peer group experience for comparable groups of financial assets.
(c) Historical loss experience should be adjusted, on the basis of observable data, to reflect the effects of current conditions that did not affect the period on which the historical loss experience is based and to remove the effects of conditions in the historical period that do not exist currently.
(d) Changes in estimates of future cash flows should be directionally consistent with changes in underlying observable data.
(e) Estimation methods should be adjusted to reduce differences between estimates of future cash flows and actual cash flows.
Impairment of investments in available-for-sale financial assets
(paragraphs 67-70)

BC120. Another view is that there should be no need to complement an individual assessment of impairment for an asset that is specifically identified as impaired by an additional portfolio assessment, because objective evidence of impairment exists on an individual basis and expectations of losses can be incorporated in the measurement of impairment for the individual assets. Double-counting of losses in terms of estimated future cash flows should not be permitted. Moreover, recognition of impairment losses for groups of assets should not be a substitute for the recognition of impairment losses on individual assets.
BC121. The Board decided that assets that are individually assessed for impairment and identified as impaired should be excluded from a portfolio assessment of impairment. Excluding assets that are individually identified as impaired from a portfolio assessment of impairment is consistent with the view that collective evaluation of impairment is an interim step pending the identification of impairment losses on individual assets. A collective evaluation identifies losses that have been incurred on a group basis as of the balance sheet date, but cannot yet be identified with individual assets. As soon as information is available to identify losses on individually impaired assets, those assets are removed from the group that is collectively assessed for impairment.
Grouping of assets that are collectively evaluated for impairment
(paragraphs 64 and AG87)
BC122. The Board considered how assets that are collectively assessed for impairment should be grouped for the purpose of assessing impairment on a portfolio basis. In practice, different methods are conceivable for grouping assets for the purposes of assessing impairment and computing historical and expected loss rates. For example, assets may be grouped on the basis of one or more of the following characteristics:
(a) estimated default probabilities or credit risk grades;
(b) type (for example, mortgage loans or credit card loans);
(c) geographical location;
(d) collateral type;
(e) counterparty type (for example, consumer, commercial or sovereign);
(f) past-due status; and
(g) maturity.
More sophisticated credit risk models or methodologies for estimating expected future cash flows may combine several factors, for example, a credit risk evaluation or grading process that considers asset type, industry, geographical location, collateral type, past-due status, and other relevant characteristics of the assets being evaluated and associated loss data.

BC116. The Board was persuaded by the arguments in favour of a portfolio assessment for individually assessed assets that are found not to be impaired and decided to confirm that a loan or other financial asset measured at amortised cost that is individually assessed for impairment and found not to be impaired should be included in a group of similar financial assets that are assessed for impairment on a portfolio basis. This is to reflect that, in the light of the law of large numbers, impairment may be evident in a group of assets, but not yet meet the threshold for recognition when any individual asset in that group is assessed. The Board also confirmed that it is important to provide guidance about how to assess impairment on a portfolio basis to introduce discipline into a portfolio assessment. Such guidance promotes consistency in practice and comparability of information across entities. It should also mitigate concerns that collective assessments of impairment should not be used to conceal changes in asset values or as a cushion for potential future losses.
BC117. Some respondents expressed concerns about some of the detailed guidance proposed in the Exposure Draft, such as the guidance about adjusting the discount rate for expected losses. Many entities indicated that they do not have the data and systems necessary to implement the proposed approach. The Board decided to eliminate some of the detailed application guidance (eg whether to make an adjustment of the discount rate for originally expected losses and an illustration of the application of the guidance).
Assets that are assessed individually and found to be impaired
(paragraph 64)
BC118. In making a portfolio assessment of impairment, one issue that arises is whether the collective assessment should include assets that have been individually evaluated and identified as impaired.
BC119. One view is that methods used to estimate impairment losses on a portfolio basis are equally valid whether or not an asset has been specifically identified as impaired. Those who support this view note that the law of large numbers applies equally whether or not an asset has been individually identified as impaired and that a portfolio assessment may enable a more accurate prediction to be made of estimated future cash flows.