Convergence Between IAS39 and US GAAP: Still Some Room for Relaxation
In the Financial Times of February 2nd, The SEC was warning the European Commission
against watering down IAS 39. The controversial accounting standard on financial
instruments and derivatives is at the core of an intense debate involving regulatory
authorities, CEO’s and CFO’s, academics, and even heads of state
such as Mr Chirac. IAS 39 could become yet another point of dispute between
Europe and the US as the SEC may go into reverse gear on its project to accept
IAS accounts for companies listed in the US, should those companies not comply
with IAS 39. As a reminder, IAS 39 is based in essence on US GAAP.
In the wake of Enron, criticism of the essentially rules-based US accounting
standards was widespread, and the more synthetic principles-based IAS approach
won credit both internationally and in the US. In this context, the IASB and
the US FASB have publicly endorsed the concept of convergence towards a single
set of high quality, global accounting standards, and this is viewed as a high
priority item on the IASB’s agenda. In respect of financial instruments
and hedging however, this will be a very delicate exercise. Indeed the IASB
is likely to find it difficult if not impossible to soften the rules of IAS
39 to please European banks and insurance companies, whilst achieving convergence
with US GAAP.
Looking more in detail at the key differences between US GAAP and IAS 39 in
respect of hedging, it is striking to see that there are a number of areas where
IAS 39 is actually more stringent than US GAAP, which shows that there is still
some room for relaxing IAS 39 while aligning with US GAAP. Examples include
the shortcut method (allowed under FAS 133, but not under IAS 39), the seemingly
narrower range for prospective effectiveness testing under IAS, and the use
of hedge accounting for intercompany foreign currency derivatives, allowed under
FAS 138 in specific circumstances, but not under IAS 39.
Under FAS 133, the shortcut method means, in summary, that
if the critical terms of an interest rate swap are the same as those of the
hedged loan and there are no other unusual features to the structure, the company
does not need to test effectiveness and benefits from a significantly simplified
accounting treatment. The IASB has chosen not to allow this simple exception
under IAS 39 on the basis that it is just more rules and that it’s use
is limited in scope; the absence of a shortcut method under IAS 39 creates implementation
difficulties for banks and corporates using very simple, static hedges. Indeed
demonstrating effectiveness for “perfect” plain vanilla hedges,
particularly of the Fair Value type, often requires the use sophisticated statistical
methods, which would not be required for such structures under US GAAP.
The IASB, in spite of ongoing pressure from a number of major companies and
treasury associations, has also chosen not to allow hedge accounting based on
internal foreign currency derivatives laid off externally through
a treasury centre, a practice used by many corporates across the world. Instead,
to qualify for hedge accounting at consolidated level, companies must document
hedge relationships based on third party derivatives, which will force many
treasurers to rethink the role of their company’s internal banks as consolidation
and netting centres for group foreign currency exposures. FAS 133 on the other
hand, has been amended by FAS 138 to allow hedge accounting for internal deals
which are netted through a treasury centre, provided certain stringent conditions
are met within the treasury centre.
Both FAS 133 and IAS 39 require companies to demonstrate why they expect hedge
relations to be effective in the future. This is commonly known as the prospective
effectiveness test. Generally accepted practice under FAS 133 has set
the required effectiveness range at 80% to 125% prospectively. Despite intense
lobbying, the IASB has maintained a stricter approach, with a required expectation
of “almost full offset” prospectively. The IASB has not translated
this wording into any specific quantitative range, but it seems the Board (and
previously the IGC) views this as meaning “close to 100%”. Such
a narrow range would disqualify many common hedging strategies, especially those
relating to commodity risks and certain types of hedges of interest rate risk.
It would also appear that another GAAP difference has been created in the latest
version of the IAS standard in respect of intercompany foreign currency exposures.
IAS 39, unlike US GAAP, does not explicitly allow hedge accounting for hedges
of foreign currency exposure resulting from forecasted intercompany transactions.
Indeed the IGC interpretation, which allowed such hedge accounting in certain
circumstances under IAS, has been removed, suggesting a clear intention to disallow
this type of hedging. If this remains the position, it is likely to be hugely
problematic for many multinational companies where foreign currency exposure
is centralised at Group level through intercompany invoicing in the local currency
of foreign subsidiaries.
However, the IASB has also been more flexible in some areas,
especially in recent months, as a result notably of intense lobbying by financial
institutions in the area of interest rate hedging. During the summer, the IASB
published a significant draft amendment to IAS 39 entitled “Fair Value
hedge accounting for a portfolio of interest rate risk”, but more commonly
referred to as macro-hedging of interest rate risk. The amendment
aims to provide financial institutions with an accounting solution which better
recognises their approach to interest rate risk management. This is notably
relevant in relation to the Assets and Liabilities Management strategies of
banks.
In addition, the IASB has allowed companies to classify any financial asset
or liability as “held for trading”, giving them the possibility
of choosing to mark-to-market any such instruments through P&L. This is
sometimes known as the “New Trading Book” and adds
an additional element of flexibility to the IFRS hedge accounting toolbox. The
“New Trading Book”, like the draft amendment on macro hedging has
no equivalent in US GAAP, making both of these areas where the IASB has given
companies more room for manoeuvre than the FASB.
Of arguably more relevance to corporates, the IASB has also allowed the possibility
(it is a choice) to use the “basis adjustment”
approach for Cash Flow hedges which result in the recognition
of non-financial assets or liabilities. Under this approach deferred gains and
losses on hedging derivatives are removed from equity to adjust the carrying
amount of the asset or liability on recognition. Companies can therefore choose
between amortising out of equity into P&L in symmetry with the hedged item
(as is required under FAS 133) or adjusting the carrying value of the hedged
item on recognition. This flexibility will be particular useful for companies
hedging foreign currency risk on forecasted transactions which result in the
recognition of say raw material stocks or fixed assets.
As a final example of greater flexibility in the latest version of IAS 39,
and in order to ease the burden of implementation, the IASB has also decided
to provide the option to either use the cash flow hedge or
the fair value hedge model for hedges of foreign currency risk in firm
commitments. US GAAP also allows this choice.
Ultimately, the decision of the European Commission to endorse or reject IAS
32 and 39 will be very much a political decision. Most specialists agree that
IAS 39 is far from perfect and many feel that its rules could be further relaxed
to facilitate implementation (the examples above on treasury centre hedging,
prospective testing and forecasted intercompany exposures have particular merit
in this respect). However, it would clearly be disastrous for the European Commission
not to endorse IAS 32 and 39 as this decision would leave a gaping hole in what
should be a comprehensive set of accounting standards for Europe. The standard
setters themselves recognise IAS 39’s imperfections, but the time required
to come up with an alternative is too short. In spite of all this any objective
assessment of the pros and cons of endorsement must finally fall in favour of
Europe adopting IAS 39, since the lack of standards on financial instruments
would be overly detrimental to European capital markets. Companies implementing
the new standards will need to make the best of what flexibility the IASB has
already allowed them, and continue to defend the case for further change.