Features : Brought to Book

New accounting rules covering derivatives and hedging transactions will have profound implications for corporations. They may affect the viability of some common transactions.


Rob de Gidlow, treasury consultant for JPMorgan

Treasury Services

Even before accounting scandals such as Enron unfolded, financial standards boards in the United States and Europe were considering measures to improve the transparency of corporate accounts. They were particularly concerned that the use of derivatives in hedging and risk management was making companies financial statements harder to understand.The US was first to bring out a new regulation, FAS 133, which in early 2001 imposed new accounting rules on derivatives and hedging transactions for US-domiciled companies.

At the same time the London-based International Accounting Standards Board (IASB) was formulating an equivalent set of rules, IAS 39, scheduled for implementation in January 2005. Both have potentially far-reaching implications, requiring companies to disclose, on the corporate balance sheet, losses or gains made from derivatives. The aim is to increase transparency by discouraging companies from using hiddenderivatives that might misrepresent the financial position of a company.The basic premise of IAS 39 and FAS 133 is that derivatives should be valued at market or fair value.

While the need for such standards is undisputed, the details of the regulations have become the subject of considerable debate. In its submission to the IASB, the International Group of Treasury Associations (IGTA) says IAS 39 has the potential to bring clarity to a difficult area and thereby potentially improve transparency. But some key concerns remain about the impact of hedge accounting on earnings volatility, the administrative burden of implementing the standards,and whether they could actually prove counterproductive, encouraging companies to work around the standards by implementing off balance sheet structures.

Central to these concerns is the fact that the two standards have some key differences.IAS 39 diverges from the US equivalent in ways which will cause real harm to corporates and additional earnings volatility from even the most prudent hedging, Richard Raeburn, chief executive of the Association of Corporate Treasurers in the UK,says. In addition to recording any gains or losses from derivatives contracts, companies must be able to prove the hedges effectiveness.The two standards diverge on the rigor with which effectiveness testing is enforced. Raeburn alleges IAS 39s effectiveness tests are more onerousand divergent from the sensibleUS approach. Under IAS 39, before initiating a hedge, treasurers must select an effectiveness test. Once a method is selected, it must be documented and applied to all hedges. The association has called on the IAS to align itself with the US standard. Failure to do so, it stated, would make hedge accounting virtually impossible to achieve for many risk classes.

Even under the US standard, hedge effectiveness is still a difficult concept for most companies to implement, says Ira Kawaller of Brooklyn, NY-based consultants Kawaller & Co. and author of Management Guide for Preparing for Hedge Accounting.Kawaller says some US companies still do not use hedge accounting. In some cases, trying to qualify for hedge accounting may be harder than most people think, he explains.The most frustrating aspect is that these rules can dramatically change the capability of companies to operate with the flexibility they would otherwise have.While FAS 133 and IAS 39 may force treasury professionals to more carefully scrutinize their hedging strategies,Kawaller believes the better emphasis would be on how much risk is hedged, rather than how well existing hedges work.

There is also a concern that some treasury professionals may change their existing hedging strategy to their commercial detriment.What is a viable and business-oriented hedging strategy may be corrupted by the need to comply with these standards, asserts Rob de Gidlow, treasury consultant for JPMorgan Treasury Services. In the short term he anticipates that companies will dispense with more complex hedging strategies until they have a better understanding of what the regulations require them to do.

Transactions Must Be Documented

In order to comply with both standards, companies also need to ensure there is a clear link between the instrument and the underlying exposure being managed, which means that every transaction must be documented and monitored.The way that large companies have operated in the past is that subsidiaries have typically submitted their hedging requests via phone, fax, email or spreadsheets, explains Olle Malmgren, regional sales manager for Swedish-based treasury solutions provider Trema.In order to streamline the process, higher levels of straight-through processing (STP) are needed.

Historically, subsidiaries of larger companies have hedged FX exposures internally. Central treasury then combines the internal deals into a net position that is hedged externally. IAS 39, however, does not recognize the net of the internal deals as a hedged item.Corporates are now confronted with an additional problem, Malmgren explains.Due to IAS rules, corporates are no longer able to simply hedge the net amount. In the case of a corporate receiving 100 internal hedge requests a day,almost all those hedges would need to be traded externally, making the use of manual processes no longer sufficient.

IGTA has lobbied the IASB to follow FAS 133s lead by allowing treasury center hedging for foreign currency risk. It has also called for extension of the short-cut method to hedging for interest rate swaps, which is permitted under FAS 133. Using this method, two transactions simply need to match the same set of terms, which substantially reduces the administrative overheads associated with effectiveness testing.The complexity of applying the IAS rules as they stand imposes a burden, which for some companies will outweigh any financial reporting benefit and may cause some companies to cease hedging interest rate and foreign exchange risk, IGTA states.

Questions also remain over the issue of embedded derivatives within commercial contracts, which IAS 39 states should be recognized as financial instruments and disclosed. This is an administrative nightmare for treasuries, says JPMorgans de Gidlow, pointing out that although IAS 39 takes effect in January 2005, it could take companies at least 12 months to fully comply with the standard.

Hedge accounting is also likely to fundamentally impact a companys profit-and-loss statementand ultimately shareholder confidence. For the first time, any losses made on derivatives must be documented and accounted for, which treasury professionals maintain could introduce unnecessary income volatility.Companies also need to think about how they will present their accounts, says Martin ODonovan, technical officer of the Association of Corporate Treasurers.If there is volatility, they will have to explain and justify it.

In trying to make hedge accounting less complex and more transparent, IAS 39 and FAS 133 may, in fact, have made the game less clear for everyone concerned.The problem is that the issues can be so idiosyncratic and the treatment is so esoteric that auditing departments dont have the expertise to implement this without bringing in specialist expertise, says Kawaller.

By Anita Hawser