If some press reports are to be believed the advent of IFRS, and more specifically IAS 32 and 39, is seen by some to be the reporting equivalent of preparations for Y2K – expensive and a bit of a damp squib. Like preparing computer systems for the millennium, will companies spend a great deal of time and money on a new reporting system only to experience very little change?
It is clear that the time for whingeing about IAS 39 has passed and energies are now devoted to:
- Assessing company hedging policies especially with respect to FX and commodity hedging.
- Preparing strategies to ensure that the accounting treatment follows the economic rationale of the transaction.
- Ensuring robust documentation processes to avoid accounting treatment “shocks”.
- Ensuring that any anomalies between accounting and economics are adequately explained to stakeholders.
- Lobbying for change.
A recent Association of Corporate Treasurers conference, sponsored by Commerzbank, discussed the repercussions of IAS 39. The conference covered the implementation of IAS 39 by using corporate case studies and presenting the issues faced by users of accounts represented by a rating agency and equity research house.
Impact on Ratings
At the conference, Standard & Poor’s addressed the key areas where IAS 39 could impact ratings (see Standard & Poor’s paper “Transition Without Tears” 6 Dec 2004). It identified that reported numbers may change in the following areas: non-amortisation of goodwill, financial instruments (debt vs equity treatment), stock-based compensation, revaluation of property and assets and deferred tax. S&P identified the issues as:
- Regulatory capital and other actions
- Legal solvency, ability to pay dividends
- Taxation
- Financial covenants
- Capital market reactions
- Implementation and compliance risks
Already I have seen a ‘real world’ effect of this with the repayment of some convertible bonds due to the reported higher interest costs.
As always, the core requirement in any accounting standard change is a detailed reconciliation from old to new; IFRS is no different. Analysts (both equity and credit) will attempt to adjust their models for the effects of the fair value changes with some actually reversing existing adjustments (for example, many analysts already capitalise operating leases and add them to debt figures).
The Banker’s Perspective
From the banker’s point of view, more disclosure and transparency is always welcome. It is very comforting for the banks to see treasurers and financial controllers shining a torch into their operating business units to search for financial exposures, derivatives and contractual embedded options even though it is a huge amount of work for them. The Financial Times recently ran a headline screaming “IFRS could cause breach of covenants” and the article covered detailed work done by the ACT to alert companies to the possible need to adjust their bank covenants to reflect potential volatility induced by IFRS. Almost all borrowers have given themselves breathing space by including a “frozen GAAP” clause in their loan documents, which permits restating IFRS accounts into current UK GAAP. This procedure will be onerous for most companies so it is advisable to engage with their banks as soon as the major effects of IFRS are known, in order to set covenants appropriately. Having sat in credit committees discussing even technical covenant breaches, I cannot stress enough the need to manage this well before any breach has occurred.
At the conference, Cazenove noted that less than half of the companies that have given IFRS presentations, plan to adopt IAS 39 in 2004/5, so comparative figures will make useful analysis difficult. Whilst some companies have changed their hedging policies to ensure hedge treatment, compliance, many have not. There is a spectrum of opinion with many companies attempting to achieve hedge accounting on the bigger “plc” transactions, while using fair valuing for the smaller exposures. IAS 39 requires complex administration to demonstrate hedge effectiveness and limited treasury resources in some companies will restrict them to this treatment. European companies that already report under the standard do not appear to favour the “fair value everything” option and, from anecdotal reports, this approach seems likely to be mirrored in the UK.
Impact on Companies
BP Finance described how the accounting standards will deal with the company’s three main financial hedging areas: interest rate risk management, FX hedging for procurement and FX hedging for group exposures. It described how to deal with the main risks: matching the critical terms on swapped bonds and disaggregating FX forwards into spot and forward legs so that hedge accounting is achieved for the volatile part (the spot rate) and fair valuing for the forward adjustment. Key issues to be tackled for them include the overlay of new swaps on to old ones (derivatives-on-derivatives) and lack of hedge accounting on the time value of options.
UK company Rexam also detailed the issues that IAS 39 threw up and categorised them as: inter-company FX transactions, commodity hedges, cross-currency swaps and bonds and embedded derivatives in contracts. IAS 39 makes inter-company netting difficult with hedges needing to be recorded gross in order to achieve satisfactory accounting. This is clearly a big issue for many treasurers and Philips described a neat solution – transacting the net amount with the bank, then asking the bank to book this as the two gross transactions. For example, sell €20 to the bank but receive two confirmations of ‘sell €100’ and ‘buy €80′ – it will be fascinating to see if banks’ back offices can cope with this strategy! However, revised rules are expected to deal with this issue. Commodity risk is more complex and Rexam described separating the contracts into the underlying commodity purchase price (hedgeable) and any processing costs. It will be tougher to achieve this approach for soft commodities. The issue of derivative-on-derivative treatment might lead treasurers to issue debt in the currency required rather than issuing in the most favourable and swapping into another using a cross-currency swap.
To date, the capital markets’ reactions to IAS 39 information has been limited to permanent changes to sales or cost of goods sold, i.e. those impacting structurally higher or lower margins. A good example is financial companies where fees are taken up-front but which will now be spread over the life of the contract. This effect may also affect companies who take up-front fees for services which are common in the outsourcing sectors. “Below the line” IAS 39 adjustments are likely to lead to more detailed assessments of corporate hedging policies and at Commerzbank, we have seen a number of companies unwinding swaps with embedded options in them this year.
Conclusion
In summary, the general opinion from the conference was that the markets have yet to react to the new information that will be disclosed under IAS 39. Analysts will attempt to adjust their models for the effects of the fair value changes, with some actually reversing existing adjustments. Changes in reported numbers perceived as a “permanent step-change” in reported earnings may lead to valuation adjustments. There is some evidence to show that some companies are modifying their financial behaviour in order to influence the presentation of results. Like the Y2K issue where companies achieved a better understanding of their information technology infrastructure leading to higher quality systems (albeit at a high cost and with much hassle), the transition to IAS 39 should ultimately lead companies to a better understanding of their financial risks and policies.