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IAS 39 – the story so far Back  
IAS 39, the accounting standard which deals with financial instruments such as derivatives was introduced in January of this year. Ten months on, Ciaran Kane looks at the impact of the standard on corporate treasurers’ use of derivatives since its introduction, and finds that, overall, there has been a tendency by companies adopting IAS 39 to use more vanilla products such as forwards and purchased options.
International Financial Reporting Standards in general, and IAS 39 in particular, have been mandatory for EU listed companies since 1st January 2005. It is the first time that most European companies will have to account for derivatives transactions on their balance sheet, and a big step from local accounting standards, which in most countries required only a footnote disclosure of derivatives. This article looks at the impact of the standard since its introduction and asks if any lessons can be learned from the implementation of similar accounting regulations under U.S. GAAP in the form of FAS 133 which took effect in July 2000.
Ciaran Kane

What is sometimes forgotten is that IAS 39 provides firms with essentially three alternatives in reporting derivative transactions used for hedging:

(1) Firms can elect to cease hedging and avoid the subject. This will have an impact on their earnings as well as potential competitive implications for the firm vis-?-vis firms in its industry which elect to hedge their economic exposures.

(2) Firms can continue hedging and elect not to use hedge accounting. This option will allow the firm to avoid costs associated with the documentation and compliance process. However, the mark-to-market impact of derivative transactions will flow through the profit and loss statement, leading to swings in the reported earnings of the firm and potentially to negative implications on the market value of the firm. Also, firms still need to generate objective mark-to-market valuations from independent sources.

(3) Firms can continue hedging and utilise hedge accounting where possible. To gain favourable hedge accounting treatment requires following the documentation and effectiveness testing process which can be automated to various degrees. This option will minimise earnings volatility from derivatives as the effective portion of hedge strategies will either flow through a part of shareholder’s equity and released through earnings on a scheduled release (in the case of a cash flow hedge) or be offset in earnings by the change in value of the underlying (in the case of a fair value hedge).

For the purposes of this discussion, we will assume that the first two alternatives above remain unpalatable to the prudent treasurer or finance director. Overall we have seen a tendency by companies adopting IAS 39 to use more vanilla products such as forwards and purchased options. Companies will, at least initially, have a natural bias to use derivatives for which they can more easily get hedge accounting. This does not necessarily mean that the hedging volume done by the typical company has decreased. Rather it is the instrument they use to hedge that may have changed. Interestingly we have, in recent months, seen examples of early-adopters of IAS 39 who initially changed their preferred hedging tools to more vanilla type products, and who now have a renewed interest in using more exotic structures again. As the treasury and auditors grow more comfortable with IAS 39 we may see this trend continue.

The answer to the question also seems to have to do with geographies. Irish and UK companies, for example, seem to be more inclined to the view that IAS 39 will mean that there is a more limited choice of hedging instruments available to them. It appears to us that companies in countries such as Belgium and France on the other hand seem, on a relative basis, to be more interested in exploring ways in which they can continue to use the same type of (exotic) hedging instruments as they currently do. Obviously this statement does not hold true for all companies in these three countries, but may be indicative of a general mindset in different regions.

As mentioned above there may be a tendency by some companies to move away from highly exotic hedging strategies to more vanilla products. There are however plenty of companies still using exotics despite the fact that this may lead to some earnings volatility. We have to remember though that under IAS 39, even a vanilla call option will show some earnings volatility as the change in time value of the option is deemed ineffective and as such will go to earnings. A recent independent corporate survey indicated that more than half of responding companies say that they can tolerate some degree of ineffectiveness if the hedge accomplishes their economic goals. Though this survey predominately includes answers provided by US companies it could still be indicative of the mindset of (mostly European) companies affected by IAS 39.

Furthermore, using exotic hedging strategies does not automatically mean that you need to mark-to-market the entire hedge to earnings. In many cases it is possible to separately transact the components of the strategy where one of these components is eligible for hedge accounting while the ‘residual’ part is fully marked-to-market via P/L. It is also possible to consider certain option-combining strategies that include a sold option as ‘net-purchased options’, enabling the company to qualify the entire structure for hedge accounting in the same way as a purchased vanilla option. This would mean that only the change in time value would need to be passed through the P/L as opposed to the entire change in fair value. Modelling of specific hedging strategies can show what type of P/L impact is likely to result and how different the resulting P/L impact may be compared to alternative hedging instruments with which the corporate is currently comfortable.

So what has been the experience of the U.S. based treasurer who has been dealing with FAS 133 since mid 2000? Issues have arisen across a number of areas including documentation, the requirement to regularly test for hedge effectiveness, inter-company transactions, portfolio hedging and embedded derivatives. Has it changed how U.S. companies hedge their exposures? The answer is yes as most enterprises seem unable to take their eyes off short-term reported earnings. The evidence for this assertion is that, albeit following a bout of derivative juggling to restructure old hedges to better comply with the new standard, financial institutions reported a reduction in ongoing hedging by enterprises. Several companies greatly reduced, or even ceased, hedging activity for exposures of less than one-year duration. There is strong evidence to suggest that most U.S. companies have found ways of living with the standard and the economic rationale for entering into transactions now takes precedence over the accounting rationale.

Which leads nicely onto a point that is on the minds of many Irish treasurers that we encounter in the course of business – to what extent should the treasurer rely on the auditor’s advice? In general it seems only reasonable that treasurers seek advice from a variety of sources. This is however especially important when dealing with IAS 39, as this particular standard is relatively new to everyone - treasurer, auditor, bank or consultant alike.

In certain aspects IAS 39 is still open to interpretation and it is not uncommon for these interpretations to vary between different parties. In certain instances this has even led to some of our clients receiving conflicting advice on the same issue by audit firms. As this advice/interpretation is likely to have far reaching consequences for the way in which the company manages its exposures, it could certainly be seen as prudent to get more than one opinion.

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