Lessons from FAS 133: IAS 39 and Fair Value
Accounting standards have not historically been objects of great controversy. Until, that is, IAS 39 came along. This admittedly complex standard has attracted wider attention – and more violent disagreement – than any other International Financial Reporting Standard (IFRS).
IAS 39 (financial instruments, recognition and measurement) is generally understood to be primarily an attempt to move beyond the traditional accrual, or cost-based, system of accounting. How, for instance, could an accrual system successfully communicate the rights and obligations created by derivatives such as currency swaps or interest rate options which, while often having zero origination cost, nonetheless contain huge potential liabilities if the market moves against the derivative position? In these cases, the mark-to-market valuation system is a significantly improved approach, hence IAS 39’s demand that all financial assets be reported at fair value.
The standard also responds to several situations in which liabilities incurred through derivatives have led to the insolvency of otherwise sound entities, such as metals trader Metallgesellschaft, as well as investors taking positions in companies without being aware of the attendant liabilities. A recent high-profile example of this was when a 15 per cent stake in China Aviation Oil Company was sold a month before it came to light that the company had built up a naked short position equivalent to 50 million barrels of jet fuel during 2003. This was closed out at record highs, incurring losses of $550m for the company thereby causing its insolvency. Preventing this kind of misrepresentation is not only central to the International Accounting Standards Board’s (IASB’s) financial reporting mandate, but also consistent with global corporate governance initiatives.
In line with these aims, IAS 39 not only requires companies to report their derivative portfolios at fair value, but also to fully document and explain the hedging strategies that lie behind these portfolios in a disciplined, methodical manner. Such requirements are consistent with tight corporate governance procedures and – if applied consistently – would significantly increase management’s understanding and ability to actively monitor the use of derivative instruments for hedging. As such, IAS 39 is not ‘anti-hedging’ – it simply seeks to appropriately report the risks associated with holding portfolios of highly volatile derivatives.
Furthermore, the standard acknowledges that this volatility is often absorbed within hedge relationships. In these cases, it allows hedge accounting, a type of offset accounting, to take place via a number of different means. Hedge accounting allows changes in the fair value of derivatives to be matched to changes in the fair value of the underlying exposures they hedge – meaning there is limited net effect on the income statement. The standard’s level of complexity comes from the IASB codifying situations in which hedge accounting is permitted, or explicitly not permitted.
The new standard has, however, elicited a wide range of responses from the private sector. A core concern for some is that failing to achieve hedge accounting for all derivatives will result in volatility entering the income statement – damaging perception among investors when the underlying financial health of the company remains unchanged. Yet others have stated that they trust stakeholders to remain focused on the core business profile and see through accounting volatility.
However, while IAS 39 allows for volatility to be removed via hedge accounting, this is more suited to some derivatives than others. The main distinction is whether the instrument allows participation in favourable market movements, while protecting a specified worst-case scenario.
Generally, forward based instruments protect a worst-case scenario, but do not allow participation in favourable market movements. Their pay-off profile is generally the inverse of the underlying item, with respect to the hedged risk, i.e. symmetrical. These instruments tend to be ‘IAS 39 friendly’, due to the way in which hedge effectiveness is measured and the mechanics of hedge accounting. Examples would be interest rate swaps, forward rate agreements and commodity futures (although the latter are not included in the following figures).
Generally, option based instruments protect a worst-case scenario, but allow some measure of participation in favourable market movements. Their pay-off profiles are often the inverse of the underlying item with respect to the hedged risk for only certain market movements, e.g. those market movements against which the option holder is protected. This asymmetry may be caused by the existence of what is called time value in an option-based structure, as well as the existence of trigger elements within the pay-off profile. Time value can be described as the value of an option being related to the possibility of further market movements, which may be favourable to the option holder. Under IAS 39, the value of underlying hedged positions is not considered to have any time value. These instruments therefore tend to be ‘IAS 39-unfriendly’ as the existence of an absolute protected (or hedged) level of the hedged variable does not guarantee IAS 39 effectiveness. Examples would be most foreign exchange (FX) and interest rate options.
This is supported by patterns of derivatives use following the implementation of FAS 133 (accounting for derivative instruments and hedging activities), the US equivalent of the derivatives and hedging rules in IAS 39. FAS 133 also demands that financial instruments are reported at fair value. In 2001, the standard became mandatory for all companies, including unlisted companies and foreign listings in the US, reporting under US Generally Accepted Accounting Principles (GAAP), most of which have their year-end on 31 December. At the time, the prevailing view was similar to the one currently being expressed over IAS 39 – that corporates would avoid more complex hedging instruments until the market, including investors and auditors, became more comfortable with the impact of fair value accounting.
There also remained several grey areas, as is the case with the current version of IAS 39, providing further motivation to use simple, ‘FAS 133-friendly’ hedging instruments until market standards were established. So significant was the changeover that the US Financial Accounting Standards Board (FASB) postponed the effective date by a year to allow companies to implement the standard. Yet – and encouragingly for companies now making the transition to IAS 39 – this apprehension appears to have been short lived, as figures 1 and 2 reveal1.
The charts demonstrate that ‘FAS 133-unfriendly’ instruments did indeed decline in volume following the standard’s implementation – almost certainly due in part to companies shying away from the new accounting requirements. By contrast, those instruments that can broadly be considered ‘FAS 133-friendly’ registered a continued increased in use during the period of implementation – suggesting a continually increasing overall demand for derivatives during the period.
Yet there is a deeper and more positive message contained in these figures. The fact that volumes of ‘FAS 133-unfriendly’ instruments rebounded very strongly soon after implementation in 2001 seems to indicate that concerns were soon allayed as new practices entered the mainstream and the wider corporate market became comfortable with hedging under FAS 133.
Equally striking is the overall increase in the use of all derivatives from 2001 to 2004. A number of explanations could account for this, including fund managers’ growing interest in FX as an alternative to equity or fixed income assets. Other reasons could include the growing importance of hedge funds, which tend to be more active in the currency markets, and the then outlook on global interest rates, especially US$.
Yet whatever the reasons for this growth, the introduction of FAS 133 in the US and the original version of IAS 39, which was adopted by some groups of companies in 2000/2001, appeared to have had a limited impact on market behaviour after the initial apprehension settled. Hopefully, when figures are released for derivatives volumes during the IAS 39 implementation period in Europe a similar or better response will be revealed. In addition, those European groups that also report under US accounting standards will have gathered direct experience of fair value accounting under FAS 133, further softening the overall impact of IAS 39 on the hedging strategies being employed by European corporates.