Consulting » Insight – Jumping hedges to order

Insight - Jumping hedges to order

FDs who don't think that they are affected by the new international accounting standard on derivatives are in for a rude awakening.

Finance directors in the UK who are already uncomfortable with the volatility that FRS17 on pension accounting brings to their balance sheets are going to be less than thrilled by IAS39. This standard represents the International Accounting Standards Committee’s attempt to throw a noose around the complicated world of financial instruments.

Like FRS17, which has the potential to make nebulous market movements transfer into the balance sheet as eye-catching liabilities, IAS39 is another fine way of adding volatility to the balance sheet.

IAS39 came into force (where IASC standards apply) for accounting periods beginning on or after 1 January 2001 and takes a severe view on hedging.

Hedged deals that do not meet its stringent specifications will generate liabilities that have to be taken into the accounts.

Of course, IASs are not mandatory in the UK. And FDs may draw comfort from the fact that there is no sign yet of the ASB rushing to emulate the IASC. However, they should not be complacent, because there are two factors that are likely to bring IAS39 into play for UK corporates in the not too distant future. As Pauline Wallace, a partner in the financial markets division of Arthur Andersen, and a member of the IASC working party on the interpretation of IAS39, explains, the first is that there is a European Commission commitment to deploy IASs across all member states by 2005. A draft directive to this effect is due out shortly.

The second is that, as Sir David Tweedie, the new head of the IASC Board (and, of course, the former head of the Accounting Standards Board) made clear in his acceptance speech recently, the IASC intends to set globally applicable standards. “The mission of the newly-created IASB is simple.

In partnership with national standard setters, we will aim to increase the transparency of financial reporting by achieving a single, global method of accounting for transactions – whether in Stuttgart, Sydney, Seattle or Singapore,” he said. (No significance should be read into the omission of Solihull from this list.)

If that seems clear enough, the same cannot be said for the detail work in IAS39. The standard recognises that derivatives, like elephants, are tricky beasts to define but basically, you knows one when you see one. As IAS39 puts it, derivative deals may be complex, but they always have certain fundamental characteristics, “There is an underlying variable, no or little initial net investment, and a future settlement component”. Find these, and IAS39 comes into play.

So, is a currency swap that requires an exchange of different currencies of equal fair values at inception a derivative?

“Yes,” says the Q&A in the standard. “The definition of a derivative instrument includes such currency swaps. The initial exchange of currencies of equal fair values does not result in an initial net investment in the contract. Instead, it is an exchange of one form of cash for another form of cash of equal value. Also, the contract has underlying variables (the foreign exchange rates) and it will be settled at a future date.” Ergo, it is a derivative.

This is tricky stuff. But as Pauline Wallace observes, someone had to start thinking about a standard for accounting for financial instruments at some stage. Just because financial instruments come in a variety of guises does not mean that companies should be allowed to disguise what are often significant risks from the readers of their accounts.

But what is the significance of this for UK companies? Wallace issues a blunt warning: “This is actually frightening as and when it comes in for UK companies. The fact of the matter is that most UK companies do not have hedging strategies that would meet IAS39,” she says.

The US now has a standard on derivatives, FRS113, which became effective on 1 July 2000, she points out, and it is hurting US companies. “There is no doubt that UK finance directors will have to revisit their hedging strategies if and when the UK moves in this direction. The up side is that users of accounts will be able to see, even more clearly than they can now, if companies choose to “take a punt” in areas where they have little proven competency …” she concludes.

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