The new FRS 102 rules on derivatives accounting are far from intuitive. Careful consideration is required for compliance says expert.
If you never really considered the accounting implications of hedging instruments before entering into derivatives, new rules are about to change your attitude. In fact, for businesses using derivatives and facing the new UK GAAP FRS 102 accounting rules, a significantly bigger challenge is about to be confronted than for the implementation of its accounting cousins, IAS 39 and the upcoming IFRS 9.
As part of the new UK GAAP, applicable in the UK and Ireland for reporting periods after 1st January 2015, many organisations impacted by the change are of a size that means compliance with certain aspects of FRS 102 – the most common accounting standard choice – can be “a major headache”, says Paco Carballo, Director, Hedge Accounting, JC Rathbone Associates.
As the new standard is based on IFRS, the ICAEW (the accounting body in the UK) says there are a number of key differences between existing UK GAAP and FRS 102. It notes that topics where the accounting treatment under FRS 102 is substantially different include investment properties, business combinations, deferred tax, defined benefit pension schemes and financial instruments.
The most pressing questions arising from FRS 102 are, firstly, by how much will earnings be impacted, and, secondly, can this impact be reduced by applying hedge accounting?
One of the main outcomes of the new standard is the change in accounting for derivatives compared to the now defunct version of UK GAAP. “For decades, derivatives were kept off the balance sheet, and organisations entering into OTC products such as interest rate swaps or FX forwards, were recording the impact in their books when settlements occurred, or when they reached maturity,” explains Carballo.
This, he explains, was a “very intuitive way of accounting”. Indeed, the interaction with the hedged item was usually reflected as the combined impact of the derivative and the underlying hedged exposure. Under the new standards, accounting for these derivatives, categorised as ‘non-basic financial instruments’, has, he notes “changed radically” and requires “more than intuition to navigate”.
Fair value reflection
Derivatives now have to be presented on the balance sheet at their fair value, and the credit risk to both counterparties in the transaction needs to be reflected in the calculation. This, says Carballo, usually requires a valuation, provided by the counterparty bank, or external advisors, deploying relatively complex derivative valuation models.
“Additionally, changes in the derivatives’ fair value now have to be recorded in the income statement, which will produce an unexpected volatility that makes it impossible to accurately forecast earnings, and could have unintended consequences on covenants and distributable reserves,” he comments.
Under FRS 102 the derivative is accounted for independently from the hedged transaction, which can be an unrecognised cash flow – for instance, a highly probable forecast transaction, sale, or purchase in foreign currency, or future variable interest rate payments – explains Carballo. “This means the impact of the derivative on the income statement may not occur at the same time as the underlying hedged transaction, nor in fact be represented in the same line item (that is, it not being part of EBITDA or interest expense).
Organisations can reduce or eliminate income statement volatility arising from derivatives by applying hedge accounting. But they can only do so providing they can meet certain requirements, and then actively elect to do so. These requirements are:
To document the existence of a hedging relationship between derivative and hedged transactions.
To demonstrate an economic relationship (that derivative and hedged transactions are expected to move in opposite ways), usually by the coincidence of the critical terms of both transactions or by undertaking a quantitative analysis of their correlation and;
To specify and quantify causes of ineffectiveness – possible mismatches between the derivative and the hedged transaction – by modelling the hedged transaction, usually using a ‘hypothetical derivative’ (the best possible hedge, being a proxy for the hedged risk and transaction).
Hedge accounting implications
“Under the old UK GAAP, many treasurers have grown accustomed to not considering the accounting implications of hedging instruments,” notes Carballo. “Now they, and other key stakeholders, are increasingly concerned with a number of new accounting considerations that must be taken before entering into derivatives.”
Some of the key questions and issues arising include whether or not to designate the derivatives as accounting hedges, and the decision of which instrument to enter into, whether it can be designated or not, and evaluating the subsequent accounting impact. “It is also important to understand and quantify sources of income statement volatility and any ineffectiveness,” says Carballo. He lists further points in need of attention as:
Analysing the termination of existing derivatives; whether the impact in the income statement happens at the time of the termination or in the future.
Restructuring of derivatives – where an existing derivative’s fair value (‘mark-to-market’) is embedded into a new hedge, usually for a larger notional or maturity, producing:
A potential hedge accounting de-designation event, with the immediate or deferred release of the amount accumulated into other comprehensive income (OCI) for cash flow hedges.
A source of ineffectiveness if the new off-market hedge is designated as an accounting hedging instrument.
Understanding the presence of embedded derivatives that can cause ineffectiveness such as embedded floors in variable rate loans, particularly zero percent floors.
Reporting under FRS 102, with regards to derivative hedges, is a challenge that requires substantial knowledge and expertise. It is likely that many outstanding derivatives were entered into well before the transition to the new standard and fair values are very large, particularly given the volatility in financial markets since the 2008 financial crisis. In light of the complexity of the analysis to be undertaken, organisations should be preparing for the task at hand.
“The days of intuitive accounting are done and the paradigm has shifted,” comments Carballo. “By mobilising and upskilling both internal resources such as treasury and accounting teams, and marshalling third-party experts and external advisors, organisations can ensure they’re well equipped to traverse this new world.”