International accounting standards watchdogs have proposed new rules for the treatment of derivatives following the global financial crisis of 2008. Multinational corporations (MNCs) – once warmed up to the new idea of adopting the rules – will be more open to using these instruments in their day-to-day operations, believes HSBC.
In the wake of the 2008 financial crisis where financial derivatives contributed to the crisis, the International Accounting Standards Board (IASB) overhauled its rules on financial instruments. One change was to replace the International Accounting Standard 39 (IAS 39) with the IFRS 9.
The IAS 39 was widely considered to be one of the most unfriendly International Financial Reporting Standards (IFRSs) due to its complexities and internal inconsistencies. In contrast, the IFRS 9 promises to align risk management with accounting and facilitate the use of more derivatives for hedging purposes when it comes into force in 2015.
“IAS 39 was far too restrictive on what companies can or cannot do and has caused accounting problems. Macro hedge accounting is more a banking issue and they decided to strip it out of the general accounting as it is very technical and not relevant to everyone,” said Nik Tandy, head of GAAP (general accepted accounting principles) solutions for global markets at HSBC at a conference held by Reval, the treasury software provider, on July 25. “A lot of those issues have been dealt with quite well in the [new IFRS 9] proposals.”
‘Hedge accounting’ is a way for corporates and banks that buy and sell derivatives to mitigate risk exposures to account for these financial instruments appropriately on their financial statements.
HSBC’s Tandy highlights that under the previous IAS 39 accounting rules, the use of derivatives can lead to large profits and losses at any point in time, depending on market conditions, if these positions are accounted for on a mark-to-market (MTM) basis.
These swings make can make for misleading readings on profit and loss statements.
“You get this perverse outcome where quite often when you apply hedge accounting to that option, you create more volatility compared to when you leave your exposure unhedged in your profit and loss (P&L) statement,” declared Tandy.
Detractors of the IAS 39 rules say the hedge accounting approach is too rigid and restrictive, and is a test that even large corporations find difficult to meet, notes HSBC. As a result, corporates tend to avoid using options over the longer period of more than six months because their exposure to volatility lasts longer.
Time value vs. intrinsic value
Currently options only receive hedge accounting treatment for their intrinsic value – the difference between strike and spot price – whereas changes in the time value of the deposit go into the P&L. Time value can be volatile and create big swings in earnings as companies would take the options’ premiums as a loss on their financial statements in the first year, which could amount to several millions of US dollars.
These swings in financial accounts are not necessarily representative of what’s actually taking place in real profits and losses, and have had a negative impact on the use of options for hedging purposes.
“Because you have to expense this time value, what you find is that in the hedging period before your project occurs, you will always have an expense, whereas if you use a foreign exchange (FX) forward, all the gain and loss in your hedging instruments gets held up until the next period,” declared Tandy. “This is a particular issue for those companies with big tickets in hedging their capital expenditure (capex) using forwards as they quite like to use an option because they [can enjoy some upside].”
Adopting hedge accounting that better reflects these derivatives’ positions without impacting P&L, and avoids volatility in financial statements is taken into consideration under the new IFRS 9 ruling, where the accounting of derivatives are treated more like insurance products as “you are insuring your risks”, notes HSBC.
Also, under the IAS 39, the only thing corporates can hedge is the value of the final product in its entirety, as oppose to the raw materials that is used to manufacture that specific good. This has now changed under the IFRS 9.
“As long as you can identify that there’s something that belongs to a component part of a bigger item, you will be able to hedge that without having to worry about the difference between the component part of the overall cost,” said Tandy. “You can hedge the rubber part of the tire, or aluminum component of a tin can, for example.”
HSBC also believes it may be possible to hedge more risks on the balance sheet further down the line now that components can be hedged.
Rebalancing not restarting
A further area of interest to companies is the ability to rebalance a hedge rather than restarting.
For example, if a company issues a floating rate note, it can initially hedge it into a fixed rate using a swap if interest rates are forecasted to go up. But if market conditions change and the company wants to swap the fixed rate note back into a floating one using a swap – also known as derivative on derivative – hedge accounting will be discontinued under the IAS 39 and will have to be restarted from when the note was issued on day one.
“As IAS39 is written now, you must take your existing swap on day one and new swap that you are doing today, put those two in combination and apply them as a hedge of the loan that you have from day one,” said Tandy. “Theoretically that is do-able, it will work but in practice you but there’s going to be complexities with the starting value of your swaps which isn’t going to be zero.”
This has led to the behaviour where companies engage in a hedge and are afraid to swap out of it when conditions turn favourable as they would like to avoid messing up of their hedge accounting.
However, under the new IFRS 9, a derivative on derivative qualifies for hedge accounting. The corporate would be allowed to hedge that synthetic risk of their underlying position it has created since day one using a swap, which matches how it runs its business.
“This really should align the hedge accounting with how corporates behave and it follows on to hedging different components of risk at different times,” said Tandy. “It’s a great step forward and gets rid of one of the many frustrations that we see. If companies want to do something but can’t because of the accounting difficulties and thus leaving things in place and missing out on real economic value.”
On hedge accounting, IFRS 9’s differences with IAS 39 are a move from a rules-based approach to a principles-based approach, declares HSBC, a different treatment of the time value of options, rebalancing of hedges, and hedging components of exposures.
Because of this, Australian companies have been particularly proactive in adopting and preparing for the new rules ahead of time.
“Those companies with big capex are really looking into adopting the IFRS 9 as soon as they can so that they can start hedging these big exposures with options again,” said Tandy. “They are quite happy to pay some premium upfront for the potential upside that they can gain over a 10- or 15-year project. But what they are not willing to do is take that expense today and take it through the P&L account [at a loss] before the project even begins.”
“Even though this won’t come to a standard until 2015, rather than waiting, companies should get ready and start looking at what they can or can’t do under their existing policies. So that when the time comes, they can take advantage of these changes,” he added.