Special Report: Hedge Accounting

Special Report: Hedge Accounting

This special report on IAS39 is the first in a series of monthly themed reports on GTNews. Each month, we will bring together the best articles and material on a key treasury topic - so you don't have to search the Internet for them.

In this first report, published in association with Reval, we explore how hedge accounting regulations are changing best practice in risk management. IAS 39 is all but finalised and FAS 133 has been in place for three years, but hedging strategies and compliance issues continue to evolve. Are you keeping up?

In association
with

It is easy to lose sight of the wider perspective when looking at the minutia of hedge effectiveness testing under FAS133 / IAS39. But long before Sarbanes met Oxley, shareholder protection concerns called accounting regulators to action. The introduction of hedge accounting regulations by the FASB (U.S. Financial Accounting Standards Board) and later the IASB (International Accounting Standards Board) was initially a reaction to the off-balance use of derivatives in the late 1980s. The message from the regulators to corporate treasurers was clear: if you are using derivatives to hedge exposures arising naturally from your firm's business activities, fine; but if you are using them for trading purposes, act like a bank and mark them to market. This way, everyone - including the board and the shareholders - knows what you are doing.

So, how did we get from this laudable starting point to a regulation so controversial as to end up heading to the European courts? And how should treasurers prepare for the introduction of IAS39 into European and other jurisdictions in 2005? How are corporates' hedging techniques changing? Can the lessons of FAS133 be a guide to handling IAS 39? This overview article - supported by the articles and resources to which it links - aims to answer these and related questions.

IAS39 - A Brief History

Although there are many similarities between the two standards, IAS39 is not just an international version of the U.S.'s FAS133. First, IAS 39 is part of a new international accounting framework which replaces national standards, while FAS133 was an amendment to US GAAP. The introduction of International Financial Reporting Standards (IFRS), of which IAS39 is just one part, is therefore a bigger 'sea of change' than FAS 133 was for US GAAP followers. John Morley, Senior Manager, Financial Services at BearingPoint, says the work involved in preparing for IFRS should not be underestimated. "The necessity of maintaining reporting practices while still implementing change is causing businesses to work with fragmented (and continually fragmenting) processes and systems," he asserts, "The mandate to successfully upgrade that infrastructure is in itself a substantial challenge." Making the Most Out Of IFRS - John Morley, BearingPoint

The IASB was established in 2001 to "develop a single set of high quality, understandable, and enforceable global accounting standards and work with national standard setters to achieve worldwide convergence." International Accounting Standards - Past, Present and Future - Greg Fletcher, AFP This vision is scheduled to take a great leap forward next year when IFRS will be mandatory for EU-listed, Australian and certain Russian companies. According to Claude Lopater of PricewaterhouseCoopers, the emphasis of the framework is on value and transparency. "In the past, the basis of comparability was historical cost," he observes, "Now, comparability depends not just on what was paid for assets, but more on assumptions management makes about the future. The fair value of assets is thought to give a better indication of an asset's current and future value." Strategy and Value in IFRS Financial Statements - Claude Lopater, PwC

There is also a difference of approach between the two standards: IAS is principle-based while FAS133 is a rules-based regulation. "This should mean there is more flexibility to obtain hedge accounting and to demonstrate compliance with IAS39 than FAS133," according to Jiro Okochi, CEO of risk management technology vendor Reval. "However, sometimes it's easier to follow rules than principles. A lot of European companies are looking at how US companies complied with FAS133 and are just taking that workflow and layering it onto IAS39. But simply following these rules does not necessarily lead to a compliant hedge strategy under IAS principles."

Fair Value - Strict Guidelines

At its most basic, IAS 39 is an accounting standard that sets guidelines for the reporting of financial assets and liabilities at fair value. As such, it has far-reaching implications in the treasury and beyond. IAS39 - Classification and Measurement - Brendan van der Hoek, PwC But the attention of corporate treasurers has been focused most closely on the implications for their hedging strategies. Under IAS39, hedges must be marked to market and their value added to the P&L, unless they can be shown to fall into one of the three types of hedging relationship that qualify for hedge accounting treatment under the terms of the standard. IAS-39 - A Challenge Today, Not Tomorrow - Part Two - Ben Keeping, Deloitte and Touche. Firms that cannot guarantee hedge accounting may have to decide between abandoning certain hedging strategies and risking P&L volatility.

IAS 39's guidelines on hedge accounting - generally considered to be stricter than FAS133 - have been subject to considerable revision. In December 2003, the IASB issued revisions to its June 2002 Exposure Draft and a further amendment, on macro-hedging of fixed interest rate hedging, is expected in 2004. History of Amendments to IAS 39 - PwC More changes may result from the need to converge more closely with US GAAP. In particular, the inclusion of the FAS133 'short-cut' method, and revision of the allowed range for prospective effectiveness testing and inter-company foreign currency derivatives, are pencilled in for further review. With the EU yet to give final approval to the current version of IAS39, the IASB has plenty of work ahead, according to PwC's Olivier Cattor, "As it is a delicate if not impossible exercise to soften the rules of IAS 39 to please European banks and insurance companies, while achieving convergence with US GAAP." Convergence between IAS 39 and US GAAP - Olivier Cattoor, PwC

Separated by a Common Standard

Just as the US and the UK are separated by a common language, the US and countries adopting IFRS are separated by a seemingly common approach to hedge accounting that, on closer inspection, hides many nuances. For example, the FAS 133 short cut method for interest rate swaps allows U.S. firms to forego effectiveness testing if the swap matches the underlying debt perfectly in all respects, including any call provisions. Square Pegs in Round Holes - Jeff Wallace, Greenwich Treasury Associates So far, the IASB has stood firm against this rule. Other guidelines on prospective hedge effectiveness testing and the treatment of the inefficient portion of hedges also differ on either side of the Atlantic (see section below) But while Europeans are currently denied the short-cut rule, some auditors appear to be willing to allow the hypothetical derivative methodology. Under FAS 133 (G7, G20) if an actual hedge against an exposure can be proved to be as effective as a hypothetical 'perfect' hedge (by measuring changes in value), the hedge should be considered an effective hedge and therefore FAS 133 compliant. As in all matters IAS39, auditors should always be consulted for their view.

The Temptation to Forsake Derivatives

Many treasurers preparing for 2005 have looked to learn from the U.S.. In general, the reaction of U.S. firms to FAS133 can be broken down into three main categories: early adopters, who acted quickly to minimise disruption to their hedging strategies; fence-sitters, who waited to see what everyone else was doing before acting; and the non-believers who either stopped hedging or carried on regardless. Some U.S. firms, especially those with limited treasury resources, decided to abandon hedges that required complex justifications to qualify for hedge accounting. In particular, many treasuries have opted out of using interest rate swaps that did not fit easily into the short cut methodology for FAS 133. As Charles Palmer, Managing Director of treasury systems vendor Richmond Software, points out, this reaction is contrary to the original ethos of the regulations. "Some corporates are just saying 'Let it all go to the P&L and the poor shareholders can sort out what it all means. For some the burden is so horrendous that they are ducking out altogether. On one level, hedge accounting is designed to protect the shareholder, but in some cases it will increase the burden on the shareholder."
Richard Bowden, Head of Sales EMEA at SuperDerivatives, an options pricing solutions vendor, agrees that firms that use IAS39 as an excuse not to hedge are letting their shareholders down and believes that effective foreign exchange risk management is being put in jeopardy by concerns over earnings volatility. "Earnings volatility may be a very small price to pay if it means assets are managed properly. Would shareholders prefer not to have earnings volatility, but see money thrown away because an asset is mismanaged?," asks Bowden. At a time when the financial press is regularly reporting the negative impact of adverse currency moves on profits, Bowden calls for foreign exchange to be treated as an asset class in its own right. "If a company reported to its shareholders that its borrowing costs had doubled because it had not swapped from fixed debt to floating or vice versa, we could expect a serious enquiry," he says. "But a multi-million pound loss because the dollar weakened, even when that move had been predicted by almost every analyst and commentator in the market, barely raises a whisper." IAS 39 - An Unjustly Maligned Regulation? - Richard Bowden, SuperDerivatives.

Moreover, a recent study by Bank of America's Risk Management Advisory team suggests that concerns about earnings volatility may be overplayed. The study focuses on how the part of the cash flow hedge deemed ineffective under IAS39, i.e. the change in time value, may change in size across reporting periods. Analysis under a variety of scenarios shows potential for increased volatility under IAS39. But when the underlying exposure was also taken into consideration, "the combined increase in volatility, when measured relative to the budget rate, is negligible." Hedging Forecast Exposures Under IAS39 - Joakim Lidbark, Bank of America

Getting Back on Track

Three years on, the early adopters in the U.S. who resorted to spreadsheets to get things up and running as soon as possible have now gone through the auditing and reporting process several times (as well as Sarbanes-Oxley compliance). They are exploring alternative risk management strategies and new initiatives to create more automation in FAS 133 reporting with the aim of improving operational efficiency and controls. Others have been content to work within the new boundaries. "For many the approach has been, 'Well, I was FAS 133 compliant last year, so I'm not going to revisit'," notes Okochi "That's a common mistake as there are always ways to improve your process to comply with existing hedge strategies and alternative hedge strategies may also be compliant - it's just takes time working with your auditors or bank to identify them."

While there was a public outcry that FASB did not put enough consideration to practical hedging issues, Cash Flow hedges have benefits over Fair Value Hedges, should one be able to obtain that designation. Although treated slightly differently under IAS39, derivatives designated as cash flow hedges by FAS133 allow the lesser of the change in value of the hedge to be booked into OCI or Other Comprehensive Income. "OCI allows the hedger to minimise some of the earnings volatility that will occur with an ineffective hedge, as the change in value of the derivative remains in this 'silo' until the underlying forecasted exposure is actually realised," according to Reval's Okochi. For fair value hedges, (e.g. a swap of fixed rate debt to floating) the ineffective components pass to earnings at every period, whereas for Cash Flow Hedges only the over hedged ineffective component goes to earnings at each period. OCI is typically ignored because it is a component of Accumulative Other Comprehensive Income and so not reflected in the income statement and not used to compute earnings per share. "However, there is life and value beyond EPS,' says Okochi, "Where the book value of the company will have serious implications for companies who are in the midst of assessing their own value or that of a potential merger or acquisition of another company with derivatives in OCI." Cash Flow Hedging's Impact On Book Valuation - Jiro Okochi, Reval

Europe's Treasurers: United in Uncertainty?

Despite the distinctions between the two hedge accounting standards, there is every chance that Europe's learning curve will not be as steep as that experienced in the U.S.. Already, some U.S. firms are returning to use of options, even exotics, providing proof that there is life after IAS39. But the extent of IAS39's impact depends inevitably on the sophistication of the existing hedging strategy. Richmond's Palmer draws a distinction between UK and continental European treasuries. "UK treasurers are traditionally more conservative, matching hedge to exposure on a one-to-one basis, so the main impact of IAS 39 is on the documentation rather than the strategy. European treasuries are more adventurous and much more likely to pursue a portfolio hedging strategy, but many of these have been put on hold due to the uncertainty surrounding IAS 39."

Palmer identifies three sources of uncertainty: regular revisions to the standard by the IASB, the threat of legal action in the EU courts by French banks, and the inconsistent advice provided by auditors. "The audit firms are the main guardians of interpretation, but they are not expressing strong or consistent opinion on IAS39," he comments. Widely varying levels of scrutiny has been the experience of treasurers attempting to secure hedge accounting both IAS39 and FAS133. For example, relative materiality may be taken into consideration when assessing compliance. Incorrect compliance on one transaction that would result in a $100,000 adjustment may not be material for a $20bn company with thousand of derivatives, but may indeed be material for a small company with a handful of trades.

One outcome of treasurers being offered differing opinions, sometimes from within the same audit firm, is a wide variation in the standards of sophistication and detail required for documentation purposes. "The bottom line is: have you done the preliminary work necessary, have you satisfied preliminary requirements to qualify for hedge accounting?" observes Ira Kawaller, an independent treasury and risk management consultant. While one auditor might say, 'This hasn't been done with sufficient specificity', another might say. 'Well this may not be perfect, but the intent is obvious, so we are going to qualify it.' "Unfortunately, it is often the case that the guys that have the hardest time passing are the ones that have the most sophisticated and knowledgeable auditors," notes Kawaller, "The guys that have really dotted the i's and crossed the t's are dealing with auditors that have a much higher set of standards."

Hedge Effectiveness Testing - A Barrier to Options

Whether striving for FAS133 or IAS39 compliance, ensuring that hedges fall within the 'highly effective' range (80-125%) that qualifies them for hedge accounting has proved a major headache for treasurers. Made To Measure - Jeffrey Wallace, Greenwich Treasury Advisors Hedges must be proved effective in advance and retrospectively, with the IASB insisting on "almost perfect offset" being proved at the outset. Failure means the net change in the value of the derivative is immediately and fully recorded in current earnings, with different treatments for the effective portions of cash flow and fair value hedges. IAS-39 - A Challenge Today, Not Tomorrow - Part Two - Ben Keeping, Deloitte and Touche

The risk of a hedge falling out of the acceptable 'highly effective' range is ongoing. Take, for example, the U.S firm that is using the dollar offset ratio method. One day, someone notices that, under typical market conditions, a $10m exposure moves $10 but the derivative moves $20. Suddenly their dollar offset ratio is no longer within the effectiveness range. Some auditors will regard such changes as not material, but others will consider it a breach.

More commonly, at least at the start of the compliance effort, treasurers are focused to qualify existing hedges - by any means necessary. "Most companies are doing trades that can be proved to be effective via simple assessment methodologies," says Reval's Okochi, "But as soon as there are trades that don't fit, that's when more 'creative' assessment methodologies are tried." In response, banks are offering volatility reduction methodologies using Monte Carlo simulations as an alternative way to show assessment for FX hedging. To Okochi, this smacks of overkill. "If you are going to that level of sophistication to prove the hedge's effectiveness, there's probably a simpler way to show effectiveness or a better hedge out there for the risk you are hedging."

A Constraint to Best Practice

Okochi also argues that the 80-125% effectiveness straightjacket under FAS133 is unnecessary, as treasurers will always try to minimise ineffectiveness anyway. Instead of being knocked out completely at 79% or 126%, the total ineffectiveness should just be reported. "Outside the 80-125% bandwidth, you're going to have to do full mark-to-market," says Okochi, "That's putting too much emphasis on assessment, rather than accepting your lumps through effectiveness measurement."

The results of a GTNews snapshot poll conducted in the last quarter of 2003 indicated that treasurers believe that hedge accounting regulations have a tendency to constrict. When asked whether IAS39/FAS133 compliance inhibited best practice in FX management, 69 per cent of Western European and 67 per cent of Asia Pacific respondents agreed. Interestingly, North American respondents - many of whom were already operating under FAS 133 - indicated less concern; only 59 per cent believed that hedge accounting compliance inhibited best practice in FX management. Hedging Compliance - Necessary Evil or Just Plain Evil?

With both IAS39 and FAS133 demanding prospective as well as retrospective demonstration of hedge effectiveness, firms must declare in advance the methodologies they intend to use, constricting the treasurer's room for manoeuvre in the future. For example, a treasurer that anticipates issuing a 10-year note might - having set up the hedge - decide instead to issue a five-year note and roll it over due to changes in the yield curve, FAS133 does allow for this, but the hedge will only qualify for hedge accounting if it is appropriately documented in advance. "Often best practice will require you to tweak a hedge, but in doing so it then makes more sense to look at the effectiveness differently to how you originally planned," explains Kawaller. "It is very hard to state your procedures with sufficient specificity to qualify and yet give you flexibility to make the adjustments that might later be necessary."

"The standard really forces people to think twice before using anything other than plain vanilla instrument, even options are considered too much trouble" argues Kawaller. "Think of the firm that has a 10-year interest rate; because it covers 40 quarters, the firm finds it has to process forty distinct instruments in terms of the OCI reclassification - that's a real pain in the neck." Ultimately, it's a question of resources. "They guy who can spend $500,000 on a system might not have that much of a problem, but they guy with perhaps a dozen swaps is going to struggle without making an infrastructure investment," he observes.

For Richmond's Palmer, the problem is in the shift in the regulator's role in the market. "Instead of recording the way business is done, the regulations are now changing the way business is done. It can prevent treasurers from undertaking perfectly reasonable strategies perfectly reasonable strategies that they would otherwise have undertaken."

The View From the Treading Desk

According to the derivatives and risk management experts at major banks, accounting considerations are clearly evident in purchasers' minds. According to Lutfey Siddiqi, Global Head of FX Structuring at Barclays Capital, the combination of IAS 39 and current 'out-of-sample' levels in many currency pairs has generated a large amount of "soul-searching" on the economic rationale underpinning alternative risk management strategies. But for the time being, economic factors take precedence over accounting considerations, rather than the other way round. "The first step is to understand where IAS39 stands in terms of what is a hedge-able item and what is not. Then to determine what strategy or derivative contract should be assigned as the hedge instrument. Finally, you must decide to what extent is the proposed hedge instrument expected to be 'effective'," says Siddiqi, who notes that many corporates are already factoring accounting implications into their purchasing decisions. "Corporates are keen to gain clarity ahead of entering into any derivative transaction. This is especially important because on several issues IAS does not provide absolute answers and much depends on the bilateral agreement between corporate and auditor," he explains.

Joakim Lidbark, Senior Risk Management Advisor at Bank of America, points out that a knee-jerk switch from exotic to vanilla instruments is not necessarily the best policy. "There are plenty of companies still using exotics despite the fact that this may lead to some hedge ineffectiveness. We have to remember though that under IAS 39, even a vanilla call will have some ineffectiveness as the change in time value of the option is deemed ineffective and as such will go to earnings." And more sophisticated buyers are beginning to realise that IAS39 is compatible with a sophisticated hedging strategy after all, according to Lidbark. "Interestingly, we have in recent months seen examples of early-adopters of IAS 39 who initially changed their preferred hedging tools to more vanilla type products and who now have a renewed interest in using more exotic structures again. As the treasury and auditors grow more comfortable with IAS 39 we may see this trend continue." IAS 39 - A Mountain to Climb? - Joakim Lidbark, Bank of America

Although the introduction of FAS133 in the U.S. quickly curtailed use of derivatives amongst corporates, Barclays' Siddiqi is adamant that Europe should not follow the same learning curve as the U.S.. "I see no reason for a reduction in the use of economically-sound derivative contracts purely because of reporting concerns. Used correctly, derivatives can be fantastic tools for risk reduction - especially in the current market environment where a degree of flexibility is desirable, options can provide the right mix of protection and participation." To this end, banks including Barclays are providing quantitative analysis to give corporate clients (and their auditors) comfort around the likely accounting treatment of specific derivative contracts. Siddiqi also points out that U.S. corporates are now emerging from their shells. "The thinking was, 'I don't have to mark an unhedged position to market but I might have to mark my derivative hedge to market. So I am better off not hedging at all,'" explains Siddiqi, "More than three years on, these corporates have realised that such a strategy may have led them to economically unsound risk management decisions." But now blind aversion to all things derivatives has been replaced by pragmatism. "Many corporates attempt to obtain hedge accounting in the first instance. If that is not possible, they will try to quantify and contain the market-to-market impact of these hedges in the absence of hedge accounting," observes Siddiqi, "If the magnitude of this impact is something they can live with, they will enter into the transaction regardless of FAS133 implications. So, economic objectives often override interim accounting considerations."

10 Months and Counting ...

So are treasurers ready for IAS39? In Europe at least, many firms are still in the early stages of effectiveness testing of their hedging strategies, according to Charles Palmer of Richmond. "We have been amazed by the lack of reaction to IAS39 by some corporates until very recently. One or two companies have been involved since day one and are now ahead of the curve. Others only sat up and took notice in the last quarter of last year, realising they had to make a decision about supplying comparatives that are IAS-compliant." But some larger firms have already invested time in reviewing internal processes, policies and systems in order to ensure that comparative data is available. Palmer cites one firm that currently accounts for instruments on the usual 'coupon basis' has had to run a parallel accounting system to incorporate the requirement of the IASB's December 17 release for hedges to be reported on an effective interest rate basis.

But will all the effort be worthwhile? The jury is out. Ira Kawaller gives hedge accounting regulations a cautious thumbs-up for forcing senior management to pay attention to risk management, but he feels that developing statistical analysis to demonstrate compliance with hedge accounting standards has the capacity to misdirect resources. In particular, he feels IAS39 is a lost opportunity to eliminate the need to proved hedge effectiveness prospectively. "Why do you have to go through this preliminary testing when effectiveness is completely transparent after the fact? To my mind, the attention to the question of whether or not the hedge is effective is a misdirected concern," he asserts, "The bigger question is: what's the degree of the exposure that's being addressed by hedging? The whole hedge accounting effectiveness issue means we are much too closely focused on a narrow a piece of the puzzle."

IAS39 / FAS133 Resources on the Internet