Hedge accounting: hedging their bets

Cocoa beans: common component in hedging transactions

They’re long overdue, but the International Accounting Standards Board (IASB)
is finally preparing to release its hedge accounting proposals with, it hopes,
just enough spare time to claim victory at the site of its greatest defeat.

The 2005 decision by European leaders to cut out nine paragraphs from
accounting standard IAS 39 has been a lasting frustration for the IASB, but if
new hedging rules (see box below) are accepted in Europe the economic bloc will
finally be on board using full international accounting standards.

Present hedge rules have been criticised for failing to reflect corporate
risk strategies and, at worst, distorting companies’ business models. New rules
promise to allow companies more freedom to describe their hedge relationships.

But it’s in the troubled banking sector where the proposals will likely sink
or swim. Current rules force banks to undertake effectiveness tests to qualify
for hedge accounting.

Banks are likely to embrace rules which cause minimal change to their
internal accounting setups and enable them to tell their shareholders how they
manage risk. The IASB has signaled it would do this, but achieving it will prove

On the continent

Resistance to today’s rules says as much about European culture as it does
about accounting. The political drive, under the Thatcher government, towards
home ownership, created a generation of aspirational homeowners, which shaped UK
banking practices.

Across the channel, European banks were, in contrast, demanding high
collateral for loans often with shorter payback periods. What this meant was
that hedge accounting policies which worked for UK banks, were not necessarily
in line with continental European practices.

The IASB, acutely aware of European concerns, are sure to address banking
concerns in its exposure draft. Allowing banks to better represent their risk
strategies in their financial accounts is likely to attract enough support to
bring the banks on-board, however achieving on a consistent basis, is a delicate
technical task which will take all the considerable brain power of the IASB.

“What I think got missed in the early part of the debate is that there was a
difference in the way banks operate in different countries,” said Pauline
Wallace, head of public policy and regulatory affairs at PwC.

There’s also a great appetite for new rules outside the banking sector. Plans
to scrap the so-called “bright-line” rule – which forces companies to prove that
the effectiveness of the hedging relationship between two transactions will be
more than 80% but less than 125% effective – is likely to be popular. Under the
rule, if a hedge falls outside the 80%-125% bright line, the hedging
relationship breaks and each transaction is treated separately.

The rule has discouraged companies with many preferring to explain their
strategy to investors. In 2006, engine manufacturer Rolls Royce signaled its
disdain for the rules when it publicly refused to alter “its hedging activities
in order to achieve a particular accounting presentation”.

New hedging rules will particularly affect the UK which has one of the
world’s largest foreign exchange markets. Daily turnover in foreign exchange
markets was $1.9bn (£1.1bn) during April according to the Department of

“There is a very good reason why the UK has been at the forefront of foreign
exchange derivatives,” Wallace said. She believes new rules should better
reflect risk management procedures, especially when it comes to non-financial

Up in the air

The rules will be closely watched by the airline industry which needs to
hedge volatile jet fuel. Under the new rules, they can more effectively hedge
the crude oil component of its fuel cost.

Even within the IASB there seems to be wide acknowledgement that current
hedge accounting has failed. Of the three financial instrument projects released
in the wake of the crisis, hedge accounting has created the biggest stir.

“The project has elicited the highest number of requests from constituents
for meetings with the staff and Board members – that is, meetings not solicited
by us,” an IASB briefing paper stated. “Many users noted that today’s hedge
accounting requirements are overly complex… This complexity has encouraged
analysts to ‘strip out’ the effects of hedges, whether hedge accounting was
achieved or not, and/or to simply rely on information provided by management.”

The proposals need releasing quickly. Hedge accounting is by far the most
complex proposal to be released since the crisis and a new standard needs to be
in place by June 2011, in time for the US accounting convergence deadline.

Originally earmarked for the March, the proposals have dragged on, but
success will do more than satisfy banks and governments, it may cancel the carve
out and finally address an issue left unresolved since Europe first accepted
accounting standards in 2005.


Complex rules

Hedge accounting is complicated territory. It allows companies to link
two separate transactions in their accounts to show how they have planned for
risk. Com­panies must demonstrate how risks associated with one transaction
balances risks associated with another. Under current rules they can only use
hedge accounting treatment if the hedge is 80-125% effective.

Related reading

Fiona Westwood of Smith and Williamson.