Treasury Today Country Profiles in association with Citi
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February 2005

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Accounting versus economics

International Financial Reporting Standards, and in particular IAS 39, have been criticised because they may lead to some companies and banks changing their habits, such as their hedging strategies.

In some circles, phrases such as “the accounting tail wagging the economic dog” have been used. They suggest that if a change in accounting treatment forces a company to adopt a different hedging strategy, then the standard is weak.

The problem is it assumes those companies were previously following good practice. One impact of IFRS is that companies have to disclose far more of their derivative and other offbalance- sheet transactions. It will also force companies to be much more diligent when setting their hedging strategies.

The concept of bringing derivatives onto the balance sheet is a good one. The problem is that it is hard to value these instruments, particularly those bought ‘over-the-counter’. Marking these instruments to market will increase the volatility of many companies’ balance sheets. This is not an insurmountable problem. As participants in the market get used to international standards, volatility will be anticipated and better understood.

The real issue is whether previous hedging strategies were appropriate. In particular, IAS 39 requires companies to document and test their hedges to qualify for hedge accounting. If companies find it difficult to do so, this may be because they do not fully understand the nature of the hedging instrument.

IAS 39 places a greater onus on a company to understand and explain its hedging strategy. If this is not possible, then the hedging strategy should not be used. If the change in accounting rules results in the proper use of derivatives, the rules have achieved their objective.