ASB comments on ACT response to IAS39 ?informal? consultation

ASB comments on ACT response to IAS39 ‘informal’ consultation

In November 2001, the Association submitted a report to the ASB on proposed amendments to IAS 39 with a view to the arguments put forward by the Association being considered by the ASB during formal submissions to the IASB. The ACT analysis was based on the experience and expertise of both the ACT IAS39 Working Group and respondents from the treasury departments of leading companies presently reporting under IAS, UK and US GAAP.

The ASB has now come back with comments on how the IASB may react to the views put forward by the ACT and the aspects of IAS39 where progress in line with the thinking of treasury professionals is most likely to be made. A brief summary of the ACT’s key points, together with highlights of the related ASB commentary in bold, is provided below:

Proposals to MAINTAIN existing approach of IAS39

Held-to-maturity financial assets, loans and receivables (originated by the enterprise and not held for trading) and other liabilities (apart from derivative liabilities) to be valued at amortised cost
Cross-currency swaps to be eligible for hedge accounting even where neither leg is denominated in an entity’s reporting currency (where adequately supported by hedge designation and hedge effectiveness testing)
The ability of a central group treasury unit to hedge net foreign exchange risks across several entities to be retained (i.e. where the risk hedged and the designated hedging instrument may be booked in different group legal entities without the need for subsequent booking "back-to-back" transactions with individual subsidiary companies)

ASB comment : It is the ASB’s understanding that the IASB intends to maintain the existing approach in these areas.

Deferral of fair value adjustments on cash flow hedges of forecast transactions and subsequent initial adjustment by the deferred amount of any asset or liability recognised on completion of the forecasted transaction (referred to as ‘basis adjustment’) to be retained. [In contrast to the FAS133 approach which requires the deferred amount to remain in, and be amortised from, equity.]

ASB comment : The ASB briefing supported the view of the ACT. However, at the November 2001 IASB meeting, it was tentatively decided that "basis adjustment" would be discontinued. The next opportunity to raise this issue will be at the exposure draft stage.

Availability of cash flow hedge accounting for "highly probable" forecast revenue cash flows to remain. [However, it is proposed that the current guidance suggesting that cash flows may only be regarded as "highly probable" if anticipated within a short term (under two year) planning horizon be amended to allow the time horizon to be linked to a company’s formal planning and budgeting cycle which may incorporate, for example, a 3 year or 5 year corporate plan]

ASB comment : The ASB is not aware that time horizons have been specifically discussed in relation to this issue. This point may be worth pursuing if it would have a significant positive impact though there may be some cynicism as to whether longer term projections can be "highly probable". As the text refers to "normally those expected in the short term", there may be value in seeking clarification of what exceptions to this rule are foreseen.

Availability of hedge accounting for non-derivatives used to hedge future foreign currency revenue streams, subject to hedge effectiveness testing to remain e.g. use of a foreign currency borrowing to hedge future foreign currency revenues. [As opposed to the FAS133 approach which restricts the designation of hedges against future foreign exchange revenue streams to either a net investment or a firm commitment hedge.]
The broad definition of a "hedged risk" to be such that each sub-component of each type of risk can be hedged, provided that its impact is measurable. [FAS133 restricts the definition of hedged risk to the entire risk of change in fair value or entire currency risk, with the exception of permitting the hedging of interest rate risk based on specified benchmark rates.]

ASB comment : It is the ASB’s understanding that the IASB intends to maintain the existing approach in these areas.

Proposals to AMEND IAS39

The effectiveness test range of 80-125% in retrospective hedge effectiveness testing should be extended to also apply to prospective effectiveness tests. [IAS39 currently requires an approximate 100% effectiveness in prospective hedge effectiveness testing.]

ASB comment : This issue has been the subject of some debate and it would appear at this stage that there is little broad support for the ACT approach on this issue.

The anomaly between the IAS and FAS definition of a "derivative" (relating to the prerequisite of "net settlement" ) should be eliminated to avoid added complexity for dual listed companies

ASB comment : The ASB sees some merit in the IASB revisiting this issue. The IASB may be reluctant to converge with the US standard in this case due either to its assessment that the IAS definition is more appropriate or to problems which have been experienced in the US in applying the "net settlement" criterion. Also in practice , the difference may be, to an extent, illusory as the exclusion in IAS39 for gross settled contracts that qualify as ‘normal sales and purchases’ has similar effect to the extensive US guidance on the net settlement definition and is arguably simpler to implement.

To avoid the burden of costly and time-consuming analysis, embedded derivatives in foreign currency denominated contracts should be excluded from the scope of IAS39 (except where the foreign currency provisions are leveraged) and normal hedge effectiveness testing applied to any instrument subsequently used to hedge the foreign currency cash-flows. Even where the derivative is more naturally separable from the contract, an option should exist whereby a company may choose not to separate an embedded derivative but merely mark the whole contract to market
The above treatment for embedded derivatives in foreign currency denominated contracts should be extended to all embedded derivatives

ASB comment : There may be merit in this suggested approach as the bifurcation of embedded derivatives is one of the areas with which preparers of financial statements encounter the most difficulties. However, to date the approach has been instead to make changes intended to ease the burden of separating out these derivatives.

The treatment for changes in the time value of options set out in FAS DIG G-20 should be adopted by IAS39. [FAS DIG G-20 takes the approach that, where the change in the fair value of an option is perfectly effective in offsetting the changes in the future cashflows hedged, movements in the fair value of the option should be taken to Other Comprehensive Income (OCI), thereby deferring recognition of such movements on the income statement until the transaction which is hedged affects earnings. This eliminates income statement volatility resulting from the erosion of the time value of options.]

ASB comment : It is our understanding that the DIG approach was not the preferred treatment as it was considered that it represented a departure from the IAS39 view on hedge accounting to defer changes in time value which would never be offset by future cashflows on the hedged item.

Hedge accounting for derivative instruments containing net written options should be permissible if the use of written options is consistent with the enterprise’s risk management policies. [IAS39 currently precludes hedge accounting for derivative instruments which contain net written options because the standard maintains that a written option cannot be a hedge unless designated to fully or partially offset a purchased option.]

ASB comment : Based on circumstances presented by the ACT to date, the ASB does not see a need for a revision in this area.

The current difference in treatment between a) the issue of a bond to investors with an embedded interest rate derivative e.g. a cap or floor and b) the issue of a plain vanilla bond with a derivative contract being separately transacted with an intermediary (typically the arranging bank) should be eliminated. Derivatives contracted in connection with a financing transaction and concurrently with it should be treated as for a similar embedded derivative, that is, that they should not require separation or "bifurcation" and should be eligible for hedge accounting on that basis. This would be particularly appropriate in the case of a floor which, as a written option, would not currently under IAS39 be eligible for hedge accounting if transacted separately from the bond issuance

ASB comment : The ASB also considers this an issue with IAS39 which merits addressing. It is alluded to in Mary Keegan’s letter of 14 November 2001 to Sir David Tweedie (para 3.5). The IASB staff, however, take the view that this treatment represents "synthetic accounting" which is an approach generally opposed by standard setters.

Our thanks go to Mr Paul Ebling of the ASB for his assistance in the preparation of this summary.

This "informal" phase of the debate has now concluded but the ACT is planning to become actively involved in the public consultation phase on the new exposure draft of IAS39 which is expected in early April 2002. Membership of the existing ACT Working Group on IAS39 has re-opened for any member or non-member who would like to participate in the next phase of work on amendments to IAS39. Please contact technical@treasurers.co.uk.