IFRS update spring 2006 - hedge your bets

In association with PwC

The warnings about the difficulties involved in applying the international
accounting
standards
32 and 39 on financial instruments were many and dire. So as companies start
publishing their first full accounts under international financial reporting
standards, were IAS 32 and 39 as stressful as feared?

Link:
Access IFRS – PwC’s IFRS
resource centre

‘I’m tempted to say “no” because everybody’s expectations were built up so
high,’ responds Ken Wild, technical partner at Deloitte. ‘But it was fairly bad.

They [IAS 32 and 39] are complex and they are mixed measurement rules, so
they produce some anomalous results.’ Some clients have looked at the accounting
answers for financial instruments produced under IAS 39, the recognition and
measurement standard, and found it hard to believe the results were correct.

This isn’t just due to the newness of the accounting rules, Wild believes,
but also because they don’t always follow the economic rationale underpinning
transactions.

Looking back on the IAS 32 and 39 compliance process, Yann Umbricht, a
director of PricewaterhouseCoopers’ corporate treasury department, sees two
distinct phases. ‘The first was very treasury related, and was around whether
hedging structures were complying with the standard [IAS 39],’ he says.

‘When they were, it then involved looking at what was required to be put in
place to comply, for example, with the documentation and effectiveness testing.
The second stage is around the accounting processes for these transactions.

‘At both stages there have been significant issues. It hasn’t been easy for
anyone, primarily because of the lack of underlying systems and a moving target.
There has been a lot of manual inputting and many discussions over the
interpretation of the standard. It has been a fairly complicated process.’

One of the challenges has been to decide where hedge accounting can be
applied under the International Accounting Standards Board’s approach. This
requires a considerable paper trail and testing.

‘Most companies will have tried to get hedge accounting, at least for some of
the most volatile structures,’ Umbricht says. ‘Very few have decided to get it
for everything at any cost. Very few have decided not to hedge account at all.’

The downside of not hedge accounting is potentially increased volatility in
profit and loss. Financial instruments need to be shown at fair value in the
balance sheet, with subsequent changes in those fair values recorded in the
income statement.

Companies unable to meet the conditions for hedge accounting under IAS 39,
but which have decided their hedging strategies remain economically sound, have
had to explain the impact of their decisions, and the related accounting,
carefully. Rolls-Royce is one such company (see below).

One bit of relief for companies applying IFRS for the first time came in the
exemption for first-time adopters from the need to restate their prior-year
figures in line with IAS 32 and 39. Many companies have taken advantage of this.

The exemption was introduced in recognition of the complexity of the
financial instruments standards and the fact that the requirements were slow to
be finalised, creating a moving target. ‘Even when they were monitoring the
moving target, it introduced uncertainty into things,’ says Deloitte’s Wild.

‘So when there was the chance not to restate some parts, that seemed to be
the sensible option.’ Gaining an extra year could also provide the time needed
to set up the right systems in order to qualify for hedge accounting.

While it might be assumed that most of the pain associated with complying
with IAS 32 and 39 will soon be over, that isn’t necessarily the case. Adopting
the standards for the first time was always going to be hard, but there is still
plenty of work to be done in relation to future reporting. Umbricht points out
that this year’s process has been largely spreadsheet-based, with considerable
manual inputting.

‘Companies are now thinking about what systems are available to them on the
market, and what they want their systems to do,’ he says. ‘They are now trying
to automate the process.’

Implementing and bedding in such systems will take some further effort.
‘Companies are still investing in and developing their people and their
knowledge, because IAS 39 is such a complicated standard,’ he adds.

‘It’s important that the company has more than one person who understands the
requirements.’ This is beneficial, not only in terms of improving controls over
the reporting process, but also for reducing reliance on third-party experts.

Second, the chances are that IAS 32 and 39 will take some time to settle down
in terms of the frequency of restatements required. Umbricht refers to US GAAP
experience. The similar US standard (SFAS 133) has been in place for seven or
eight years.

‘Companies are still restating their accounts because of the complexity,’ he
says. ‘Going forward, it’s possible that companies will have to restate some of
the numbers because of IAS 39.’

That could have an impact on the share price in future if the restatements
required are significant. However, so far companies’ share prices do not appear
to have been affected by announcements on financial instruments. ‘My feeling is
that analysts exclude anything to do with IAS 39 at the moment and look at the
underlying operating profit of the company,’ Umbricht says.

Peter Elwin, head of accounting and valuation at Cazenove, confirms that
analysts and investors welcome the impact of IAS 39 being stripped out. ‘It’s
helpful that companies are breaking out these fair value movements,’ he says.
‘This is what people are encouraging companies to do.’

Rolls-Royce

IAS 39 has come under attack partly because its rules can be seen as too
rigid. Hedging activity performed by a company for what it believes to be valid
economic reasons will not necessarily qualify for hedge accounting under IAS 39,
even though it did previously under UK GAAP. This is the case for Rolls-Royce,
in terms of its foreign exchange and commodity derivative hedge book.

When announcing its preliminary 2005 results this February, the famous engine
maker noted that: ‘The Group has determined that its existing hedging strategy
is in the best interests of the business and its shareholders. It is not,
therefore, altering is hedging activities in order to achieve a particular
accounting presentation under IFRS. In applying IAS 32 and IAS 39, the Group has
chosen not to seek to hedge account its future foreign exchange and commodity
transactions.’

Rolls-Royce first explained its position last year, when publishing
information on the impact of the adoption of IFRS. It noted that: ‘The strict
methodology to achieve hedge accounting under IAS 39 will limit its application
for use by the Group unless there are significant changes to the way in which
the Group operates its economic hedging policies.’ Management decided that it
was not willing to make these changes.

As a result of not hedge accounting for its forecast foreign exchange
transactions, Rolls-Royce now has to recognise in its income statement the
movements on the fair value of derivative contracts held for the purpose of
hedging these transactions. As the company explained, the size of the movement
in fair values is largely dependent on movements in spot exchange rates.

Like many companies, Rolls-Royce has reported an underlying profit figure in
its accounts, with the impact of IAS 39 stripped out.

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