The International Accounting Standards Board made several concessions at its Board meetings in late July and continues to listen to intellectual and practical arguments on IAS 39 from the European banks. This article is the first half of a summary of the July update published by the IASB. It remains the IASB's intention to issue a final standard by the end of the first quarter. A further exposure draft on macro hedging was issued last week.
Transition & Effective Date Of IAS 32 & 39
The Board tentatively agreed that, for first time adopters, the effective date of the standards will be January 1 2005, although early adoption is allowed.
The Board agreed transitional rules that provide the following concessions for first time adopters:
1. The derecognition rules in IAS 39 will only apply to assets
or liabilities derecognized on or after January 1 (previously
International Financial Reporting Standard 1 set
the effective date as January 1 2001)
2. They will not be required to restate comparative figures for
IAS 39. Therefore hedges will only need to be designated by
December 31 2004, which gives an extra year to make
system changes.
As the standard will not be issued until March it will be difficult for companies to adopt it early and will lead to the accounts of many companies for 2005 being prepared under IFRS, with comparative figures for 2004 under IFRS except for IAS 39.
There will also be a requirement to produce three reconciliations as follows:
1. The closing balance sheet at December 31 under local
GAAP and the opening balance sheet at January 1, under
IFRS excluding IAS 39
2. The closing balance sheet at December 31 2004 under local
GAAP and the opening balance sheet at January 1 2005
under IFRS
3. The closing balance sheet at December 31, under IFRS
excluding IAS 39 and the opening balance sheet at
January 1 2005 under IFRS including IAS 39.
These entities must apply the transitional provisions set out in IAS 39 but are permitted to take advantage of the transitional derecognition rule.
Hedge Accounting
Prospective Hedge Effectiveness
The Board tentatively agreed to amend the wording of IAS 39 in line with the terminology expressed in U.S. GAAP. IAS 39 requires that a hedge should meet two ongoing tests of effectiveness: one that is prospective and a second that is retrospective. The retrospective test requires that the hedge was, in the period highly effective, with the example given that the effectiveness should be in the range of 80-125%. However, the current prospective test is that movements in the value of the hedge and the hedged item should almost fully offset, which is more demanding than the highly effective 80-125% test applied retrospectively. Not only is this an extremely stringent requirement that many hedges would fail to meet, but it is also inconsistent with the practice followed in the U.S.
Although the Board has not gone so far as to say that the prospective test can be measured against the 80-125% range, this will almost certainly be the test that companies will seek to apply.
Fair Value Hedge Accounting For A Portfolio
Hedge Of Interest Rate Risk
Hedge Designation
The Board tentatively concluded that it would re-expose the whole instrument approach, but describe the host instrument approach in their basis of conclusions and provide an invitation to comment on its conclusions.
In brief, this means that for macro hedges the hedged item should be designated as a percentage of the assets or liabilities in each time period.
The practical result of this is that there will be ineffectiveness whenever there is prepayment risk on assets included in a macro hedge and complicated processes will need to be established to calculate and record this ineffectiveness.
How To Measure Ineffectiveness
It was tentatively concluded that the most appropriate method of assessing hedge ineffectiveness would be to apply the initial hedge ratio to each time period.
When using the whole instrument approach, hedge ineffectiveness will arise wherever there is prepayment risk on assets included in a macro hedge. An example of applying the initial hedge ratio is in the box opposite.
Treatment Of Core Deposits
Derivatives are often held as hedges of a bank's call and time deposits (often referred to as core deposits). The Board debated whether core deposits should be included in a fair value hedge by scheduling the repayment on a) the dates the bank expects the portfolio to repay, or b) the earliest dates on which the customers can demand repayment.
It tentatively concluded that core deposits should be included in the fair value hedge scheduling at their earliest repayment dates. The basis for its conclusion is that the fair value of a liability that is repayable on demand does not change with movements in interest rates and so cannot be subject to a fair value hedge.
This conclusion will be of particular concern to some banks even with the macro hedging approach described. If the structure of the bank's balance sheet means that it would like to define the hedged item to be the core deposits then it will not be permitted to. This could leave it with derivatives that cannot be attached to an eligible hedge accounting relationship despite being established as an economic hedge.
Hedging Interest Rate Risk On Held To Maturity Investments
Currently IAS 39 does not permit financial assets classified as held to maturity to be hedged items with respect to interest rate risk. The logic of this for a fixed rate instruments is that it does not expose the investor to changes in fair value if held to maturity. However, the market had expressed concerns that in certain currencies they are unable to purchase a fixed rate bond but only a variable rate instrument and thus needed to hedge their exposure to changes in the cashflows of the instrument.
The Board agreed to continue with the current approach. This ensures a consistent treatment of fair value and cash flow hedges but the Board provided no clear reasons for reaching its answer.
This week's Learning Curve was written by Charlotte Jones, partner at Ernst & Youngin London. She is technical advisor to the International Swaps and Derivatives Association's accounting committee.
