The International Accounting Standards Board (IASB) has just (December 9) published for public comment an exposure draft (ED) on accounting for hedging activities. The draft proposes requirements that will enable companies to reflect their risk management activities better in their financial statements, and, in turn, help investors to understand the effect of those activities on future cash flows. The proposed model is principle-based, and will more closely align hedge accounting with risk management activities undertaken by companies when hedging their financial and non-financial risk exposures. The proposals also include enhanced presentation and new disclosure requirements.
IAS 39 (Financial Instruments: Recognition and Measurement) was adopted in the EU in 2004, and, in the US, FAS 133 (Accounting for Derivative Instruments and Hedging Activities) was first issued in 1998 and amended many times. Both are, at best, inadequate and, at worst, incomprehensible. As Sir David Tweedie, chairman of the IASB, who inherited IAS 39 from the IASB’s predecessor, is fond of saying: “If you understand it, you haven’t read it properly.”
The projected replacement for IAS 39 is the IASB’s own IFRS 9 (Financial Instruments) and it has dominated 2010 in its own right and is the grounds for substantive debate with the US Financial Accounting Standards Board (FASB) on how to achieve international comparability in accounting standards. It has also provided a test for the IASB of how to accelerate standard-setting with consultation and feedback which went well beyond that of its formal due process.
To achieve this, the IASB adopted a step-by-step approach, splitting the old IAS 39 into three phases: classification and measurement, impairment of financial assets and hedge accounting.
The first part was relatively straightforward: simplifying the measurement criteria and changing how to measure “own credit” (how to account for liabilities booked at fair value in the income statement). The second phase presented (and continues to present) the greater difficulties of futurology. Losses are easy to account for when they are lost (“incurred” in the jargon) but future losses and when to account for them are very different. Defining the foreseeable future (no less than 12 months) and revising it in the light of experience (something expected didn’t happen) in a model is the task under consideration by an Expert Advisory Panel. This week’s joint meeting examined the possible models but it’s difficult to avoid agreeing with the FASB’s laconic observation: “the longer you look out, the harder it is.” Even so, the IASB is hoping to complete this phase by June next year.
Finally, there remains hedge accounting: in principle, in detail and in reality. At the moment, IAS 39 is heavily based on rules (bad in itself) which are inflexible and difficult to apply (worse) and inconsistent with how companies (especially non-financial companies) actually manage their business. Risk management is much more important than plain hedging but hedging provides the building blocks for it. Do you value the house on the basis of its architecture or the number of bricks?
The IASB has now published an exposure draft (on 9 December) which it hopes will enable companies to reflect in their financial statements what they really do in managing risk and thus help investors to understand how that will impact on future cash flows.
Commenting on the proposals, Sir David Tweedie, Chairman of the IASB, said: “These proposals sweep away the existing rule-based, complex and inflexible hedge accounting requirements and replace them with a simple, principle-based approach. The result, if adopted, will be a much simpler model that better reflects risk management practices whilst providing more useful information to investors.”
As an overall objective, the ED proposes a model for hedge accounting that aims to align accounting with risk management activities. The proposed model combines a management view that aims to use information produced internally for risk management purposes and an accounting view that seeks to address the risk management issue of the timing of recognition of gains and losses. This will provide investors with more useful information and will allow entities to use risk management information as a basis for hedge accounting.
There is also new treatment proposed for hedging net positions. Currently, IAS 39 does not allow net positions to be hedged. However, companies often hedge net positions; for example, they may hedge a net foreign exchange position of 20 that is made up of an asset of 100 and a liability of 80.
This creates an inconsistency between hedge accounting and risk management activity. The ED proposes extending the use of hedge accounting to net positions and, thereby, improving the link to risk management.
There are also changes to the treatment of options. Hedge accounting in IAS 39 treats part of the value of a purchased option (the part that reflects time value) as if it was a derivative held for trading purposes. This creates volatility in P&L. However, when hedging, risk managers view the time value premium paid as a cost of hedging rather than a speculative trading position. The ED proposes that the time value premium should be treated as a cost of hedging, which will be presented in OCI. Therefore, this will decrease inappropriate volatility in P&L and be more consistent with risk management practices.
IAS 39 also sets a high hurdle before hedge accounting is available. It also sets a high hurdle for hedge accounting to continue. These hurdles result from a strict quantitative test, and the accounting consequences of failing this test are drastic. This is widely criticised as being arbitrary and for causing hedge accounting not to be available or to stop when a hedge is a good one economically. The ED proposes to base qualification for hedge accounting on how entities design hedges for risk management purposes. It also proposes that hedging relationships can be adjusted without necessarily stopping and potentially restarting hedge accounting. This enables hedge accounting to better reflect risk management activity, which often requires adjustments to hedges to accommodate changes in market conditions.
This means that the new rules will end the current distinction in treatment between fair-value hedges, which limit exposure to changes in the value of an asset or liability, and cash flow hedges, which limit exposure to variability in cash flows such as future interest payments on a variable rate debt. They will also, unlike the existing rules, allow hedge accounting to be used for net positions, where a company has offset assets and liabilities and only hedges the difference.
It will also end a distinction in the old rules that allows a company to hedge components of a financial item, such as the LIBOR risk component of a bond, but not components of a non-financial item, such as the oil price variability component of jet fuel prices.
However, much remains to be done. The IASB and FASB have been consulting and discussing on matters of principle which govern International Financial Reporting Standards (IFRSs) and US Generally Accepted Accounting Practices (US GAAP) and also getting into the nitty gritty of individual standards. All this individual and joint work in the framework of the bodies’ Memorandum of Understanding has been conducted against the background of political pronouncements from the G-20 and other international bodies such as the Financial Stability Board and the Basel Committee.
The two accounting boards published a progress report on their work towards convergence in November but there are conflicts at every level. Does it make sense to go into details when the principles themselves are under revision and discussion? And does political pressure (“Something must be done, this is something, therefore this must be done”) mean that urgency takes the place of practicality? There remains also the deep philosophical difference between the US approach, which likes rules, and the IASB’s more pragmatic way of proceeding, which prefers principles. In either case, there must be a balancing of quantitative and qualitative reporting and also a good degree of linguistic flexibility.
So IFRS 9 remains a work in progress. But it is a practical illustration of how to do things while the philosophical work goes on. Back in September, even as the detail was under discussion, the IASB and FASB announced that they had finished the first phase of their joint project to develop an “improved conceptual framework”. For IASB, that meant revisions to its existing framework while FASB issued a new “Concept Statement 8” to replace its “Concept Statements 1 and 2”. Another framework from the IASB was on the presentation of the narrative to accompany the numbers while the IFRS Foundation, the oversight body of the IASB, has also invited public comment on its mission to move beyond international standards to global standards.
So concepts or detail? The last word goes to Tweedie: “On balance, I believe that the development of IFRS 9 has shown how 21st century standard-setting should be done, and the legacy of the project will be a high quality, principle-based standard that provides increased, useful information for investors and other users of financial statements.”
PS There will be an interactive webcast on 13 December on IFRS 9 and you can make comments until 9 March 2011. Go to ifrs.org