Thanks to a reversal of a prior tentative decision redefining the meaning of "almost full offset" in the context of prospective effectiveness tests, the IASB has created a problematic ripple across global hedge accounting.

A seeming "nit" sort of difference between IAS 39 and FAS 133 was the way the IASB was interpretating the perennial question of modern hedge accounting: What level of effectiveness do you need to have an "effective" hedge? In the FAS 133 world, the discussion was largely around the interpretation of what's within 20 percent: 80%-120% or 80-125%. This was considered effective enough, or "highly effective," if you will. With the deliberations around IAS 39, the IASB took this a step further calling for a different and higher standard for prospective effectiveness tests versus those done in hindsight (retrospective). This created a much higher hurdle for hedges to qualify for hedge accounting. The language chosen (per paragraph 146) was "almost fully offset," which most interpret to mean very close to 100%, e.g., 95-105%.

Good news came earlier this year, in July, when the IASB tentatively decided, in the name of convergence with FAS 133, to amend the language in paragraph 146 to bring it into line with FAS 133's "highly effective" idea. However, during the IASB meeting in Toronto in late October, a number of board members dug in their heels and flipped the tentative decision to reinstate the fully effective language. "This is not good news for hedgers," notes Matt Daniel with Abn Amro's risk advisory practice in New York, "especially commodity hedgers under IAS 39."

The implications of this reversal are indeed significant as illustrated by ISDA in its November 20 comment letter to the IASB addressing the decision made in Toronto.

More than a "nit" difference

"This decision represents a significant diversion from US GAAP, and will introduce substantial profit and loss volatility in financial statements," the ISDA comment letter notes, pointing to the two largest implications. The reason for the latter, is that the higher effectiveness hurdle may preclude many hedging strategies from getting hedge accounting. "It is our experience that many common hedging strategies which have been proven as highly effective in reducing risk, both from an economic perspective, and under US GAAP, will fail the prospective test as proposed, and will therefore be required to be treated as speculative trading positions under IFRS," says ISDA. ISDA believes that this will only serve "to mislead the market and misrepresent the business of our members."

In an appendix to its comment letter, ISDA elaborates further highlighting several practical reasons to maintain a consistent effectiveness threshhold for both propective and restrospective tests, not to mention for both international and US GAAP.

An effectiveness paradox. With two different thresholds, according to ISDA, the IASB would be creating a paradoxical situation where a hedge continues to be effective at all the crucial junctures of its life on a retrospective basis, but falls out of hedge accounting when, looking forward at any one juncture, the hedge fails on a prospective basis.

Operational burdens. Citing Implementation Issue E-7 under FAS 133, which indidcates that prospective effectiveness testing "can be based upon regression or other statistical analysis of past changes in fair values or cash flows as well as on other relevant information," ISDA notes that many US GAAP filers, as a practical matter, use a single regression test as the basis for both their prospective and retrospective effectiveness tests. Filers falling under IAS 39 would have to maintain different tests in certain circumstances and overcome the resulting operational and systems burdens.

Problems for interest rate hedging. A further disadvantage for IAS filers will also result from the higher effectiveness bar. Deprived of the equivalent of FAS 133's short-cut method of assumed effectiveness, swap hedges are even more likely to be ineffective on a prospective basis, stripping them of the ability to get hedge accounting.

ISDA uses the example of a company issuing fixed debt, noting that the coupon rate will include a market perception of the credit rating of the company as well as the market interest rate for the fixed term of the debt. If the company hedges its interest rate exposure with a market rate swap, there will be a difference between the rate on the debt and that of the swap. Per paragraph 128 of IAS 39, the "benchmark interest rate component" can be designated as a hedge. This is consistent with paragraph 21(f)(2) of FAS 133's allowance for a hedge of exposure to "changes in the designated benchmark interest rate".

However, depending on how the credit-spread enters into the effectiveness testing calcuation, the swap hedge may be held ineffective. And ironically, the ineffectiveness is due to the credit risk portion which is not being hedged. ISDA bases its concern, according to the letter, on member experience with accounting firms advising clients that all of the hedged item’s contractual cash flows must be included in the effectiveness test per FAS 133--i.e., they may not exclude "the portion of the interest coupon in excess of the benchmark interest rate"). Though, as ISDA acknowledges, creative partial hedge designations may create enough effectiveness to get hedge accounting, but this in an unwarranted complication being imposed on swaps used by hedgers.There is also the ineffectiveness generated in discounting the fixed and floating legs of a swap hedge. According to ISDA, the resulting ineffectiveness is typically not enough to throw a hedge out of 80-125%, but may well with 95-105%.

Meanwhile, the US GAAP hedger assumes 100% effectivness under the short-cut method.

Commodity hedging. While ISDA probably is most concerned with the implications for swap hedgers, it does note, to Mr. Daniel's point above, the even worse implications for commodity hedgers, Commodity hedgers often must turn to available hedge contracts derived from commodities other than the underlying they're looking to hedge--e.g., airlines hedging jet fuel pricing with gas oil derivatives. Basis risk requires a more liberal effectiveness test criteria to apply if many commodity hedges are to get hedge accounting.

And hedging via treasury centers. The ISDA letter also speaks out for its dealer member's multinational corporates clients who have difficulty hedging internal contract exposures via treasury centers under IAS 39. So long as internal trades are not eligible for hedge accounting, treasury centers must identify external derivatives that match assets or liabilities and designate these as hedges. Splitting the difference between the net exposure on the internal contracts and that on the designated assets/liabilites generates ineffectiveness. The tighter effectiveness requirement would make this approach much less feasible.

Not a level playing field

The underlying theme throughout the ISDA letter is also the most important consideration: the IASB reversal on its prospective  test guidance runs against international accounting convergence.

From ISDA's perspective, this some of its members, operating under IAS 39 guidelines, will be at a disadvantage.

For those being asked to adopt IAS 39, this is not a welcome prospect.

For those who are operating under FAS 133, you can only hope that the IASB's decision does not lead to the FASB  eventually considering tweaking hedge accounting under US GAAP in a similar direction. 

This is yet another reason why it is important for everyone to encourage standard setters to seek shared principles and convergence for global accounting--and ideally adopt accounting standards that everyone can live with in the process.