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Hedge Accounting Paperwork Might Not Be Worth The Bother

Conference speakers and delegates were undecided whether the huge administrative burden that companies would have to undertake to achieve favorable accounting rules for derivatives would be worth the manpower. So-called hedge accounting means that derivatives trades have been deemed hedges and can be accounted for in a way that minimizes earnings volatility.

The rules on hedge accounting will not be finalized until March, but there is unlikely to be a shortcut provision similar to that in the U.S. version FAS 133, according to Melissa Allen, an accounting specialist in the global risk solutions group atBNP Paribas and chair of the International Swaps and Derivatives Association's European accounting committee in London. This means fewer corporates are likely to use hedge accounting.

Jason Clark, head of risk control (Swindon) for RWE Trading, said it has decided to use hedge accounting, but only for the simplest derivatives. The default will be to take the earnings volatility, but when it enters a derivative which clearly qualifies it will go through the process. BAA's treasury manager, Wan Lung Chow, said it will only use plain-vanilla swaps and will link them with bond issues to qualify for hedge accounting.

There are several rules that make hedge accounting difficult to achieve. For example, in most cases net positions can't be hedged, internal trades do not qualify and it has to be designated as a 'highly effective' hedge at the start of the transaction.

The lack of sophistication of some equity analysts, however, may force companies to build the necessary systems and dedicate the resource needed to using hedge accounting. Davis said, "Many analysts focus on simplistic ratios and sophisticated rationale about why the numbers have moved might go over their heads." If this is the case, some companies will not want to risk their balance sheet being misunderstood and will opt to use hedge accounting.

If corporates do opt out of hedge accounting and take the volatility on their balance sheet they must spend a lot of time explaining this to analysts and rating agencies, according to Sue Harding, European chief accountant at Standard & Poor's in London.

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