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Monday, 15th April 2024
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The Treasury Accounting Bombshells Back  
As of March this year financial reporting standards for derivatives have become more rigorous, say Cormac Murphy and Lisa Hayes
Changes in global financial markets have meant that the financial activities of businesses have been transformed in recent years. Increased volatility in foreign exchange, interest rates and other market prices has greatly increased market, credit and liquidity risks. This has resulted in a growth in the extent, complexity and use of derivative financial instruments. Accounting standards have found difficulty in keeping pace with these changes.

Greater consistency has now been called for in the way entities in different industries disclose and account for derivative products. It is believed that most approaches to date failed to strike a balance between complete and accurate disclosure of derivatives and hedge-accounting needs. Many derivatives are carried off balance sheet regardless of whether they are part of a hedging strategy and users of the financial statements are frequently confused and potentially misled.

The Accounting Standards Board (ASB) in the UK and Ireland recently published FRS 13, ‚€ėDerivatives and other financial instruments: Disclosures‚€ô. FRS 13 is effective for periods ending on or after 23 March 1999 although earlier adoption is encouraged. An even more challenging development in the form of FAS 133, ‚€ėAccounting for Derivative Instruments and Hedging Activities‚€ô, has been issued by the Financial Accounting Standards Board (FASB) in the US. This statement is effective for periods ending after 15 June 1999 although again, earlier adoption is encouraged. These statements require for companies in their respective jurisdictions a radical increase in the level of qualitative and quantitative disclosure required in the financial statements in relation to the whole area of treasury management. Both boards expect the statements will give top management, directors, investors, creditors and regulators a clearer picture of the uses and effects of derivatives. Each statement is considered separately below. In addition, because of its relatively low profile todate ‚€‘ detailed suggested templates are setout for those companies which will need to comply with FRS13.

To avoid even greater confusion ‚€‘ the International Accounting Standard number 32, which is very similar to FAS 133, is not addressed. To describe this paper as anything other than an introduction would be misleading. These standards are complex and professional advice is required in deciding how to implement the requirements for your organisation. FRS 13 has a remarkably low profile at present while FAS 133 is recognised as a huge challenge in the US. The key difference between the two is that the US standard addresses the thorny issue of accounting for derivatives while the UK / Irish standard does not. Whether the US accounting model ‚€‘ with all of its controversy ‚€‘ is adopted in these islands is a real issue for the future.

In simple terms, the US standard deals with the problematic area of hedge accounting both by offering new definitions and guidelines and, more fundamentally, by requiring that all derivatives be included in balance sheets at their fair value. This has the obvious effect of highlighting the levels of gains and losses embedded in derivative positions ‚€‘ even if the underling positions being hedged are not recorded at fair value. You can see why this is causing so much controversy.

FRS 13

Scope

FRS 13 applies to all entities, other than insurance companies, that have one or more of their capital instruments listed or publicly traded on a stock exchange or market and to all banks and similar institutions. Whether the standard will be extended to private companies in the near future is a real question as the ASB is always reluctant to distinguish between the approaches taken by different legal structures. Also unusually, the standard is divided into three distinct parts, each of which applies to a different type of company or group as follows:

1. Reporting entities other than financial institutions and financial groups (which includes building societies and credit unions)
2. Banks and similar institutions and banking and similar groups
3. Other financial institutions and financial institution groups

The different disclosure requirements reflect the differences in the relative significance of the main risks that arise from the use of derivatives and other financial instruments by financial institutions and other corporates.

Main Features

FRS 13 requires both narrative and numerical disclosures. The narrative disclosures are intended to describe the role that financial instruments have in creating or changing the treasury risks that the entity faces, including its objectives and policies in using financial instruments to manage these risks. The numerical disclosures are designed to show how these objectives and policies were actually implemented in the period and assist in the evaluation of significant or potentially significant treasury exposures.

Definition of Financial Instrument

FRS 13 defines a financial instrument as any contract that gives rise to both a financial asset of one entity and a financial liability or equity instrument of another entity. For the purposes of the disclosure requirements, however, the FRS explicitly excludes certain financial instruments from its scope (such as the reporting entity‚€ôs own equity shares) and permits an entity to elect not to include its short-term debtors and creditors in the disclosures. Very generous, you might say.

Narrative Disclosures

The narrative disclosures required by FRS 13 include an explanation of the objectives and policies agreed by the directors, for holding or issuing financial instruments and similar contracts, and the strategies for achieving these objectives. Where appropriate, the reporting entity should also disclose any significant changes from the previous accounting period and any future change already agreed by the directors at the date on which the accounts are approved. These disclosures are to be related back to the commercial disclosures, with an explanation, where applicable, of the extent to which the period end numerical disclosures are materially unrepresentative of the entity‚€ôs position during the period or its stated objectives.

The narrative disclosures are mandatory and therefore subject to audit. Nevertheless, FRS 13 accepts that they may be provided in a statement, such as the operating and financial review, provided that they are incorporated in the financial statements by means of a cross-reference to their exact location.

Numerical Disclosures

Reporting entities within the scope of the FRS are required to provide detailed numerical disclosures on the following:

· interest rate risk;
· currency risk;
· liquidity risk (except for banks as this is covered by existing requirements);
· summarised fair values of the financial instruments held;
· financial instruments used for trading (including, for banks and some other financial institutions, information on the market price risk of their trading book);
· financial instruments used for hedging and
· certain commodity contracts

The numerical disclosures are intended to be highly summarised and consequently the FRS encourages and, in some cases, prescribes offsetting and aggregation to be used. Nevertheless, it also encourages the disclosure of additional information where it is not otherwise possible to trace the components back to their respective balance sheet captions.

Commodity Contracts

Commodity contracts do not fall within FRS 13‚€ôs definition of financial instruments.
Nevertheless, the FRS requires cash-settled commodity contracts to be treated as if they were financial assets and liabilities for the purposes of the narrative disclosures and certain specified numerical disclosures.

Next steps with FRS 13

We continue to be greatly surprised at the lack of awareness among accountants ‚€‘ whatever about among treasurers, of this standard. The disclosures required are incredibly extensive, as demonstrated by the attached template. Affected organisations need to get familiar with the detail and give serious consideration before their next year end to how their disclosures might look in comparison to their peers.



FAS 133

This statement is the US equivalent of FRS 13 in the area of disclosures. However, FRS 13 does not address the issue of how to account for financial instruments. The US standard confronts and prescribes. It may well also predict the future for accounting practice in these islands.

Scope

Statement 133 applies to all entities operating under US Generally Accepted Accounting Practices.

Main Features

Under the statement, every derivative is recorded in the balance sheet as either an asset or liability measured at its fair value. The accounting for changes in the fair value (that is, gains and losses) depends on whether it is designated and qualifies as part of a hedging relationship and, if so, on the reason for holding it. The statement requires that changes in the derivative‚€ôs fair value be recognised in current earnings unless specific hedge accounting criteria are met.

Statement 133 also requires that a company must formally document, designate and assess the effectiveness of transactions that receive hedge accounting.

Definition of Derivative

FAS 133 defines a derivative as a financial instrument or other contract with all three of the following characteristics:

1. It has one or more underlyings and one or more notional amounts or payment provisions or both. Those terms determine the amount of the settlement and in some cases whether or not settlement is required
2. It requires no initial net investment or an initial net investment that is smaller than would be required for other types of contracts that would be expected to have similar response to changes in market factors.
3. Its terms require or permit net settlement, it can readily be settled net by a means outside the contract, or it provides for delivery of an asset that puts the recipient in a position not substantially different from the net settlement.

In other words, a very broad definition has been drafted in an attempt to defeat attempts at creative accounting.

Disclosures

Statement 133 brings numerous new and different requirements. The main difference from previous US GAAP rules is that all derivatives are recorded in the balance sheet at a fair value. This is hugely controversial but considered the only solution to the subjectivities inherent in the previous hedge accounting model (which is what substantially continues to be applied in Ireland and the UK). The hedge accounting issue will continue to be problematic so long as any financial assets and liabilities are recorded at other than their fair values.

The following items are among the new disclosures required:
- objectives, strategies, risk management policies for holding or issuing financial instruments
- description and purpose of hedging and non-hedging financial instruments
- concentration of credit risk based on the gross value of related financial instruments
- net gain/loss recognised in earnings from derivatives (and qualifying non-derivatives) and where the amount is reported in the income statement

Definition of, monitoring of, and accounting for hedges

The statement requires that changes in derivatives‚€ô fair value be recognised currently in earnings unless specific hedge accounting criteria are met.

Though statement 133 does not extend hedge accounting to all transactions that are economic hedges, by establishing uniform hedge accounting criteria for all derivatives, it eliminates previous inconsistencies while:

- Accommodating many existing hedge accounting practices;
- Broadening the scope of hedge accounting for foreign-currency-denominated, forecasted transactions; and
- Giving new - albeit narrow - latitude to hedge accounting for net written options that hedge embedded purchased options.

Statement 133 requires that a company must formally document, designate, and assess the effectiveness of transactions that receive hedge accounting. The mechanics of hedge accounting are more complex than current practice ‚€‘ special accounting for qualifying hedges allows a derivative‚€ôs gains and losses to offset related results on the hedged item as follows:

- In a fair value hedge, a derivative is marked to its fair value currently through earnings with an offsetting, partial mark-to-fair-value of the hedged item (for the risk being hedged) currently through earnings.
- In a cashflow hedge, a derivative is first marked to its fair value through other comprehensive income (equity); the gain or loss on the derivative is removed from equity and recognised in earnings in the same period as the loss or gain on the hedged cash flow.
- In a hedge of a net investment in a foreign operation, the changes in fair value of the derivative (or the translation gain or loss on a qualifying nonderivative instrument) are reported the same as the cumulative transaction adjustment.

By requiring greater use of fair-value accounting, statement 133 increases volatility in earnings and other comprehensive income. Volatility is also increased by the statement‚€ôs requirement that hedge ineffectiveness of any magnitude be recognised currently in earnings.

In transition, statement 133 requires that (a) all existing freestanding derivatives and many existing embedded derivatives be recorded in the balance sheet at fair value and (b) all hedging relationships be evaluated and designated anew, resulting in cumulative-effect-type transition adjustments to earnings and other comprehensive income. Upon initial application, the statement allows a company to reclassify investments in held-to-maturity and available-for-sale securities without calling into question management‚€ôs stated intent for other securities.

Despite measurement of derivatives at fair value under statement 133, accounting for other transactions will continue to mix current and historical prices. Recognising that, the Board decided that statement 133 should preserve and unify criteria for special hedge accounting.

Written with the knowledge that financial innovation will continue apace and with the goal of accommodating certain current hedging practices, statement 133 splits the universe of conceivable hedges into two broad categories ‚€‘ those that address changes in the fair value of a hedged item and those that address the variability in a hedged item‚€ôs future cash flows. The only qualifying hedge that falls outside these two categories is a hedge of a net investment in a foreign entity, for which statement 133 preserves accounting like that in statement 52, Foreign Currency Translation.

Companies will need to survey existing hedging strategies and determine whether those strategies qualify for special hedge accounting under statement 133‚€ôs new model. Hedge accounting continues to be elective ‚€‘ management may choose whether or not to designate a transaction as a hedge. And, as with pre-statement 133 principles:

- Not all activities that management consider hedging ‚€‘ in an economic sense ‚€‘ will qualify for special hedge accounting
- The failure of certain market-risk exposures and derivatives to qualify for hedge accounting won‚€ôt necessarily preclude earnings offset.

For example, statement 133 prohibits hedge accounting for hedges of fair-value changes that already go to earnings (for example, spot rate changes in foreign-currency-denominated receivables and payables). The rationale is that the required mark-to-fair-value of a derivative so employed already will affect earnings in the same period as the transaction gain or loss on the hedged receivables or payables. However, here and elsewhere, there will be some rough edges due to spot rate and forward rate differences.

In some ways, statement 133 broadens the scope of transactions and instruments that may qualify for hedge accounting. Specifically, it allows hedge accounting for:

- Forecasted foreign-currency transactions using forward contracts. (Earlier standards limited hedge accounting strategies for such transactions to purchased options with little if any intrinsic value)
- The foreign-currency-exchange-rate risk of forecasted intercompany transactions using forward contracts.
- Net written options (that is, any net premium is received rather than paid) to the hedge embedded purchased options.

The statement also allows hedge accounting for cash flow hedging with a rollover strategy (that is, using a consecutive series of shorter-term contracts to hedge a transaction forecasted to occur over a long term) and hedging of mortgage and other servicing rights. Though a mortgage banker‚€ôs interest-rate-lock commitment would not qualify for fair-value-hedge accounting, forward sale commitments to investors may qualify as cash flow hedges of the forecasted loan sales.

Statement 133 allows the use of complex options (corridors, knockouts, range strategies, and so on) as hedging instruments as long as they are not written options and meet all other hedge criteria.

Under statement 133, hedge accounting continues to be a ‚€úprivilege‚€Ě not a right ‚€‘ specified qualifying conditions must be met and an item must meet specific criteria to be designated as being hedged. Further, hedge accounting is prohibited for a variety of transactions and positions, even if other hedge criteria can be met. Under statement 133, none of the following transactions (or related forecasted transactions) qualify:

- Assets, liabilities, or acquisitions thereof that will be remeasured with fair value changes reported currently in earnings
- Minority interests (including preferred stock) in consolidated subsidiaries
- Equity investments in consolidated subsidiaries
- Equity-method investments
- Anticipated business combinations, including anticipated acquisitions or disposals of subsidiaries, minority interests, or equity-method investees
- Unrecorded intangibles (for example, core deposit intangibles) not involving a firm commitment
- A company‚€ôs own equity instruments
- Interest-rate risk of held-to-maturity debt securities
- Price risk of major ingredients of nonfinancial assets or liabilities (eg. effects of crude oil prices on the fair value of the oil content of gasoline or effects of copper prices on cashflows to purchase the copper content of bronze)
- Groups of assets or liabilities that are dissimilar or do not share the same risk (‚€úmacro‚€Ě hedges)
- Future net income of a subsidiary
- Transactions with stockholders as stockholders, such as projected purchases of treasury stock or payments of dividends
- Intercompany transactions (except for foreign-currency-denominated forecasted intercompany transactions) between companies included in consolidated financial statements, including forecasted dividends from a subsidiary
- The price of stock expected to be issued pursuant to a stock option plan for which recognised compensation expense is not based on changes in stock prices after the date of grant.

In each circumstance, a company will need to designate a hedging relationship at its inception and formally document the company‚€ôs risk management objective and strategy for the hedge, including the:

- Hedged item
- Hedging instrument
- Risk being hedged

To qualify for hedge accounting under statement 133, a derivative has to be highly effective in achieving offsetting changes in fair value or offsetting cashflows for the risk being hedged. Statement 133 is more explicit than previous GAAP about the need to anticipate, measure, and account for hedge ineffectiveness. Under previous GAAP, hedges were either effective or ineffective ‚€‘ partial hedge ineffectiveness was not recognised. Under statement 133, even if a hedge is highly effective, all ineffectiveness ‚€‘ even when small ‚€‘ is recognised currently in earnings.

A company must document how effectiveness will be assessed and:

- Define a method that provides a ‚€úreasonable basis‚€Ě for assessment (for example, spot rate changes or intrinsic value changes), explicitly defining whether time value (for example, the time value of an option used in a cash flow hedge or forward points on a forward contract used in a fair value hedge) of the derivatives will be included in or excluded from the assessment method;
- Expect the hedge to be ‚€úhighly effective‚€Ě in achieving offsetting changes in fair value or variability in cash flows;
- Assess hedge effectiveness whenever financial statements or earnings are reported and at least quarterly;
- Measure ineffectiveness of the hedge and report it currently in earnings.

If excluded from the test of effectiveness, changes in the time value of certain derivatives will simply be allowed to erode as the hedging instrument is marked to fair value, through earnings, at each balance sheet date. It will no longer be appropriate to amortise the time value of a hedging instrument over the hedging instrument‚€ôs life on a basis other than changes in its fair value.

For certain interest-rate-swap transactions, statement 133 explicitly allows companies to apply a ‚€úshort cut‚€Ě method to determine and account for hedge effectiveness. Under the method, if certain key terms of the swap and hedged item match, the company may assume perfect effectiveness and follow hedge accounting, without having to reassess effectiveness prospectively.

Where to start with FAS 133?

Statement 133 will forever dispel the myth that accounting for derivatives affects only financial markets companies. By changing hedge accounting, as well as provisions for commodity contracts and embedded derivatives, statement 133 will affect many commercial companies. Effective planning will involve accounting and other functional areas, such as treasury and technology. The following are fundamental questions every relevant company should ask itself now to kick off planning for statement 133 implementation.

Which instruments and contracts (or features embedded in those instruments and contracts) meet the definition of derivative?
Companies should inventory the types of financial instruments and commodity contracts held or used as a starting point for determining statement 133‚€ôs effects.

What hedging relationships exist?
Companies will need to rethink hedging relationships. Those that received special hedge accounting in the past may no longer qualify under statement 133. Some that previously did not receive special hedge accounting (such as many anticipated foreign currency transactions) may now qualify. And those that continue to qualify will be accounted for differently.


Are information processes and systems ready?
Beyond keeping tabs on fair values of derivatives, hedged items, and related gains and losses, companies will have to track premiums and discounts on items hedged in fair value hedges, amounts deferred in other comprehensive income for cash flow hedges, and hedge ineffectiveness for all hedges. In short, statement 133‚€ôs complexity means systems efforts could be extensive.

When to adopt?
Companies whose derivatives and hedging activities primarily involve foreign currency transactions (including intercompany transactions) may find early adoption appealing given statement 133‚€ôs level playing field for hedged foreign currency transactions.

Derivatives are useful if not essential risk management tools, and some believe that the inadequacy of past financial reporting may have discouraged their use by contributing to an atmosphere of uncertainty. Both FRS 13 and FASB 133 cast a wide net, sweeping in a broad population of companies and transactions. They increase the visibility, comparability, and understandability of the risks associated with derivatives and will undoubtedly bring greater focus to the risk management aspect of the treasurer‚€ôs job. The benefits of improving financial information comes at a cost as many entities will incur one-off costs to ensure the required information is available. However the benefits of more credible and more understandable information will be ongoing.

FRS 13 is effective for March 1999 year ends and FAS 133 is effective from 15 June 1999. Disclosure of corresponding amounts is encouraged but not required in the first accounting period in which these statements come into effect. Therefore we encourage companies to begin assessing the effects of these statements. A number of companies are already unwinding certain hedging transactions to present a ‚€ėfairer‚€ô view of their year end position. Waiting until after the year end to which the applicable standard applies is to vastly underestimate the disclosures required.

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