GovernanceRegulationIAS 39 – A Mountain to Climb?

IAS 39 - A Mountain to Climb?

Q. Should the introduction of IAS 39 be welcomed by the treasurer?

A. The introduction of IAS 39 means that companies can no longer keep derivatives
off the balance sheet. Instead these instruments are treated as assets or liabilities
and as such must be marked-to-market on an ongoing basis. Fear of additional
volatility through the company’s P/L account may lead company boards and
CFOs to issue guidelines to treasury along the lines of “please ensure
that all hedges get full hedge accounting” and “it is paramount
to minimise the P/L volatility impact from hedging”. This is likely to
restrict the scope of hedging tools the treasurer has at his/her disposal.

Furthermore, the extra administrative tasks brought on by the new legislation
combined with the education needed to operate new treasury systems, are very
likely to mean that the often stretched treasury unit will need to stretch even
more. Though most treasurers understand and agree with the reasons (e.g. increased
transparency) behind the new legislation, it does not necessarily mean that
they are welcoming the change with open arms.

Q. How are firms changing their hedging strategies?

A. 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 geographics. UK companies,
for example, seem to think to a larger extent 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.

Q. Are many firms abandoning sophisticated strategies or are they adapting? If the latter, how?

A. 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 hedge ineffectiveness. We have to remember though that under IAS 39,
even a vanilla call will have some ineffectiveness as the change in time value
of the option is deemed ineffective and as such will go to earnings. Results
from Bank of America’s 2004 corporate survey indicate 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 IAS39.

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 break up the strategy into several building blocks where one of
these building blocks is eligible for hedge accounting while the ‘residual’
part is fully marked-to-market. 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.

Q. How important is technology to IAS 39 compliance?

A. A well integrated treasury system will be of critical importance to companies’
accounting under IAS 39. The new legislation asks that each hedge is matched
with an underlying asset or liability. At inception of the hedge, documentation
must be generated to support this relationship. Furthermore tests need to be
carried out throughout the life of the hedge to monitor the effectiveness of
the hedge. This in turn will have a direct bearing on the required accounting
entries. Complying with all these requirements can be a mammoth task, especially
when considering that many companies have hundreds, if not thousands, of hedges
on their books at any point in time. However, as many companies tend to use
the same type of hedging contract over and over again, most of the tasks required
are of a repetitive nature. Hence there may be a lot to gain from investing
in technology that simplify/automate parts of this process.

Q. To what extent should the treasurer rely on the auditor’s advice?

A. 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 their auditors. 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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