Getting ready for IAS

Key provisions of IAS 39
The key provision of the standard is to recognise all financial instruments on the balance sheet at fair value. For most companies, this will be the first time that financial instruments are recognised on the face of the financial report, as they were previously disclosed in the notes. Unless they qualify as hedges, changes in the fair value of derivatives will be recognised in profit and loss. If the company’s hedges qualify for hedge accounting under the specific criteria stipulated in the standard, then the impact of the hedges on the company’s profit and loss account will be the same as is currently the case under historical cost accounting. Accordingly, users of the financial statements will now be left in no doubt as to the risks borne by a company from its use of financial instruments. This change should make the financial statements more relevant and reliable.

The new accounting rules for fair-value derivatives together with increased disclosure will allow and encourage greater investor scrutiny, leaving companies with no choice but to ensure their use of derivatives is closely monitored,and strictly in accordance with the company’s risk management strategy.

Effective implementation date
The Financial Reporting Council formally announced in July 2002 that International Financial Reporting Standards would be adopted in Australia for financial periods beginning on or after January 1, 2005. This declaration provided Australian companies with the certainty (and the deadline) to begin preparing their operations for the implementation of IAS 39, among other standards.

Early preparation is crucial, not only because of the complexities involved, but also due to the requirement to present comparative information in the financial report. Most Australian companies have financial year-ends at June 30. Therefore, they will effectively need to be IAS 39-compliant from July 1, 2004 so that prior-year information can be presented in the financial report. Companies should be ready to apply the standard from the companies’ transition date. For December year-end companies, this is less than six months away.

One of the most significant changes for companies making the transition to IAS 39 is hedge accounting. The criteria that must be satisfied in order to apply hedge accounting under IAS 39 are far more stringent than those under existing Australian standards. Many financial instruments that are currently classified as hedges under Australian accounting standards will not qualify as hedges under IAS 39.

Hence companies will be required to make the difficult decision of continuing with what may be sound economic hedges and be affected by the profit volatility of making such hedges, or rearranging their hedges to qualify for hedge accounting under IAS 39. Based on impact studies carried out to date, most boards arerequiring that profit volatility be minimised.

Two types of hedges: cashflow and fair value
Under IAS 39, there are two types of hedges: cashflow and fair value. A cashflow hedge is where a company hedges the risks of changes in future cashflows. A fair-value hedge is where a company hedges against changes in fair value of a recognised asset or liability.

The key hedge accounting requirements of IAS 39 are:

• Formal detailed documentation of the hedge at inception.
• An expectation that the hedge will be highly effective.
• The forecast underlying transaction must be highly probable (for a cashflow hedge).
• The effectiveness of the hedge must be assessed and measured at inception and on an ongoing basis to ensure it remains highly effective throughout the reporting period.

The hedge documentation must specifically designate the item being hedged and the financial instrument used as a hedge. Without detailed documentation the hedge accounting requirements will not be met, and the derivatives will need to be marked-to-market through the profit and loss. Meeting these requirements may require significant changes to systems and processes. Having the ability to track individual hedge contracts, particularly for entities with a large number of hedges in place, will be critical.

Hedge effectiveness must be measured
The effectiveness of the hedge must be formally assessed on an ongoing basis. While current Australian standards require hedges to be effective in order for hedge accounting to be applied, they do not provide any information on what this actually means. This lack of specific guidance has led to significantly different interpretations, and potentially misinter- pretations, as effectiveness is judged in the eye of the beholder. IAS 39 fills this gap by providing specific criteria (the 80–125% rule) to apply when assessing effectiveness over the life of the hedge arrangement. IAS 39 requires that the cashflow or fair-value changes in the hedge relationship must “almost fully” offset at inception of the hedge relationship, which is a tougher standard to meet at inception than the 80-125% rule.

Under IAS 39, effectiveness is assessed in one of two ways:

• For a cashflow hedge, it is the ability to achieve offsetting cashflows for the risk being hedged, such that the final cashflows are effectively fixed.
• For a fair value hedge, it is the ability to achieve offsetting changes in fair value for the risk being hedged, such that there is no impact on the company from fair-value changes.

Beware of increased volatility
Where a derivative does not meet these criteria, any changes in market value of the derivative will be recognised immediately in profit or loss. This may introduce a considerable degree of volatility into a company’s reported results, as the recorded value of instruments changes in response to market dynamics.

This increased balance-sheet and earnings volatility may cause a company to breach conditions of its loan covenants. In a cashflow hedge, where the market value of a derivative is negative, the mark-to-market amount is recorded as a liability and a decrease in shareholders’ equity. By reducing shareholders’ equity, a company could find itself with a higher gearing ratio than would have been the case prior to adopting IAS 39.

To use another example, consider a company whose financiers have put in place restrictive covenants with respect to the proportion of profits it may pay out as dividends. Where the company pays out a constant dividend, a decrease in earnings due to unrealised losses recorded on derivatives may increase the dividend payout ratio, causing the company to breach such a covenant. These effects should be discussed with a company’s bankers prior to transition to IAS 39. This will ensure that loan documentation takes the impact of the standard into account when specifying restrictive covenants, and avoids breaches that can be costly both in monetary terms and, potentially even more importantly, in terms of loss of credibility in the market.

These effects will need to be clearly communicated to shareholders, lendersand financial analysts to prevent any ‘shocks’ occurring upon transition.

US multinationals are familiar with IAS 39
Some Australian companies will have been through this process before, when the Financial Accounting Standards (FAS) 133, Accounting for Derivative Instruments and Hedging Activities, was introduced in the US in 1999. This standard is substantially the same as IAS 39, and affected Australian companies who either had issued securities in the US or were subsidiaries of US companies. The adoption of IAS 39, in most cases, should have no more than a superficial impact on these companies. This will not be true in all cases, as IAS 39has some significant differences from FAS 133, including:

• The ability to elect any financial assets or liabilities to be fair valued (with value changes taken to the profit and loss account).
• The ability under IAS 39 to include deferred gains or losses on qualifying cashflow hedges in the cost of the non-financial asset being hedged.
• The recent concession to permit interest rate portfolio hedging (see below).

Banks given special hedge allowance
One part of IAS 39 that has been causing concern, particularly among financial institutions, is the disallowance of hedging items on a portfolio basis. Lobbying by European financial institutions has resulted in the International Accounting Standards Board (IASB) reconsidering its position with respect to net hedges of a portfolio for interest rate risk. At the June 2003 meeting of the IASB, it was agreed to accept an approach to enable fair-value hedge accounting for a portfolio hedge of interest rate risk. This is a significant concession to financial institutions that hedge assets and liabilities according to the interest rate gaps within their asset and liability portfolios. Details of this approach are documented in the IASB summary of the June 2003 meeting – see www.iasplus.com

Massive retraining programme for treasury personnel
While the impact of IAS 39 will be most visible on the large multinationals, the effect on small to medium-size enterprises will also be significant. When one considers the array of instruments that are commonly used by companies today, such as foreign exchange contracts and interest rate swaps, it can be seen that the effect of the standard will be widely felt.

In particular, the lack of expertise among treasury personnel/accountants to value simple derivatives (such as forward exchange contracts) will mean that treasury personnel/accountants will need significant training in this important area. In addition, it is expected that there will be significant demand for treasury systems capable of recording the accounting entries necessary under IAS 39.

Major Australian companies now have IAS projects teams in place, and most have completed a business impact study of IAS. For many companies, IAS 39 is the most difficult component of IAS to implement. Accordingly, most project teamshave a special IAS 39 component focused on treasury issues.

Summary
While the standard is still subject to further change, the major components of the standard are finalised. For all companies, the transition date is fast approaching and failure to appropriately prepare may well mean missedopportunities or unpleasant surprises.

John Kidd is a partner and Jim Godsil is a senior analyst at Deloitte Touche Tohmatsu in Melbourne (jkidd@deloitte.com.au, jgodsil@deloitte.com.au)