CARVING SOMETHING OUT OF THE IAS 39 CONUNDRUM
It is strange that no sooner has IAS 39 been endorsed by the European Union (EU), that there have been calls to take it back to the drawing board. The EU’s formal adoption of a carved-out version of IAS 39 last month was accompanied by the announcement that, within the next year, the carve-outs will be eliminated. Indeed, the EU, now wants the IASB to devise a ‘watered-down’ version of the current Fair Value Option and revise provisions on hedge accounting, with the view to introducing them before the end of 2005.
This news followed a major assault on the sheer principles of IAS 39 by Sir Andrew Large, Deputy Governor of the Bank of England, who called for a complete examination of its basics, followed by a reengineering of the standard to create a less complex, prescriptive one. But in the light of the twists and turns in the fortunes of IAS 39, what should corporates and their treasurers, who now face legal requirements to comply with a carved-out version of IAS 39 in yearend accounts as of January 2005, be doing?
Regardless of future amendments, now is the time to ensure that you are fully prepared to adopt IAS 39 and that any possible negative implications of the new accounting standard are minimised.
In a recent survey of 100 buy and sell-side investment analysts, 53% said they expected the introduction of IFRS to have a major impact on the valuation of companies’ shares. Moreover, while more than 50% anticipated market turmoil as a result of the change in reporting requirements, 35% said they would mark down the shares of a company that showed unexplained volatility in earnings.
An alarming 46% of the analysts surveyed doubted their ability to distinguish between reporting changes resulting from underlying business performance – and those resulting from accounting changes. Indeed, 40% rated their knowledge of IFRS as poor.
With this in mind, corporates must remain aware that, while IFRS will not change the underlying performance of their businesses or cashflows – the markets just might not see it that way.
Every effort must be taken to brief market analysts and other observers of the implications that IAS 39 compliance will have on your financial results. At the same time, you must prepare your stakeholders for any unanticipated volatility in earnings. One way to soften the impact may be the inclusion of statements within your consolidated accounts, explaining to investors that, as use of certain derivatives does not qualify for hedge accounting, they are being being recorded at fair value – a route already favoured by major companies such as Nestlé and Siemens (see Keeping an eye on interest rates, page 12).
This issue of The Treasurer places a special focus on the forthcoming implementation of the new accounting standards, with an update on IAS 39 as it currently stands (see On your marks for IAS 39, page 27), and a checklist of all the things your company will need to consider in the transition to IFRS (see Is the UK ready for IFRS? page 30). Next year is clearly going to be a busy one for all of us.
LIZ SALECKA
Editor
Niall speaks out for treasurers
Reuters Chairman addresses ACT Annual Dinner and encourages corporate treasurers to raise their profile.
These are a selection of bonds announced recently. The details, updated to the middle of last month, were supplied by Thomson Financial Securities Data and other sources.
The PMI for Services indicator is a useful guide to measuring potential interest rate moves that could be made by a central bank. The US Fed would prefer inflation to rise in order to remove risk of deflation in the event of a new recession. There is enough slack in the US economy to indicate growth of 5% without inflation. Despite low European rates, corporate treasurers should expect euro short-term interest rates to stay below the curve. The slowdown in the UK housing market is likely to push the PMI for Services Index below 55.
In this transitional time for risk management, there have been several accounting distractions that may have detracted from the business and economic reasons for hedging. By providing a transparent trading section in their accounts and explanation of their hedging rationale, companies can keep their shareholders advised of the impact of the new accounting standards. This will help reduce share price volatility. Moody’s has also made observations about IFRS, stating mitigating factors to the expected increase in reported P&L volatility. It said: “Moody’s is looking through the reported financial statements in order to focus on the underlying financial reality and economic substance.”
The agency will also continue to place a strong emphasis on cashflow-based measures and metrics. Companies should consider hedging their interest rate exposures over a longer maturity as 30-year rates are at a historic and absolute low and offer an inverse cost of carry if swapping from LIBOR. Demand for long-term investments by pension funds, seeking to match the maturities of their liabilities to their assets, could explain the low rates of 30-year sterling swaps. Interest rates would have to fall considerably to have a negative effect on mark-to-market values. And if rates do fall, companies should be hedged with shorter-dated or floating positions. Most businesses have longer core debt requirements than their existing debt facilities. Long-dated IR hedging can spread the duration of IR risk hedging and reduce rehedging risks. Long-dated hedging should be a sensible proportion of overall hedging so that any expected volatility is on a scale that is within acceptable parameters of overall profit and loss.
Money market funds (MMFs) are an attractive solution for treasurers looking for a safe haven for their organisations’ cash. The interest rate environment in 2004 has led to greater performance differentials, with a widening gap between the highest and lowest returns on offer. It is important for investors to use fund providers that will offer consistent performance over time and a low volatility of returns. This year the money markets have seen a number of developments, especially in the commercial paper market and the asset-backed market. The rise in interest rates has not had any impact on risk premiums or the liquidity of MMFs, with premiums still close to historic lows as evidenced by low spread levels in the high-yield, corporate and asset-backed markets. By mid-2004, the total assets under management in AAA-rated MMFs totalled US$200bn, an increase of nearly US$100bn in just three years. The IMMFA is promoting the use of MMFs as a cash management solution and is fleshing out its guidelines on asset types used in AAA-rated MMFs.
Despite UK and US efforts to legislate against and regulate tax avoidance schemes, international schemes that use at least two tax systems can resist unilateral elimination. TAIFs involve the financing or refinancing of, for example, a UK group’s foreign operations, and rely on one or more double tax treaties. Classic examples of TAIFs include dual-resident ‘double dips’, cross-border ‘repos’ and ‘hybrid debt’. Amendments to the US/UK Treaty; changes in domestic law and greater co-operation between the UK and the US have led to the closure of ‘hybrid’ TAIFs, ‘reverse hybrid’ TAIFs, some ‘double dips’, some ‘repos’ and some third country ‘pref stock’ ‘double dips’ during the last 15 years.
The US is developing regulations to further limit ‘repos’ and ‘double dips’. The UK, US and Joint International Tax Shelter Information Centre (JITSIC) are now examining deferred subscription agreements, which were created to replace ‘reverse hybrids.’ The UK and US now have systems in place to eliminate abusive TAIFs quickly and effectively. In March 2004, the UK announced legislation requiring all scheme promoters to register a scheme with the Inland Revenue when first offering it to a company. Not all TAIFs are abusive, and it is unlikely they will all be closed down. Those that survive will grow out of a rational commercial position and will not be treaty-dependent.
Increased bank liquidity and an increase in the number of banks servicing the mid-market means greater competition for a limited pool of assets. The five major UK banks lent just £5.5bn in the worst year of the current economic slowdown, compared with £7bn of provisions during the worst year of the 1990s recession. Mid-market companies with leveraged balance sheets or inconsistent histories should look to the high-yield bond market to provide liquidity. Securitisation has become an increasingly popular financing tool – for example, in the football club sector.
Change of ownership is often the main driver for a new treasury set-up. The sale of a public sector business, sale or flotation of a non-core business division and break-up and flotation of individual businesses are situations which call for the establishment of a new treasury function. Experienced treasury professionals will be required in the interim to handle the changeover in what can be a high-pressured, fast-changing period. Involvement in the set up of a new treasury may appeal to some treasurers as it can provide some very good experience over a short period of time. The interim treasurer can expect to be responsible for the smooth running of the treasury during the deal period and for some time after. Key issues a new treasury set-up will face include the ongoing provision of cash management services and overdrafts, provision of currency and interest rate hedging lines, and building new relationships with funding banks. Short-term solutions include ensuring a step-bystep process for banking arrangements and the immediate establishment of a framework for good treasury management.
UK-listed corporates will soon have to report under IFRS. Many are still making the necessary changes to their systems and financial reporting processes before the start date of 1 January 2005. The EU’s recent decision to adopt a carved-out version of IAS 39 has made the transition to IFRS more difficult for many companies. It is also unclear whether the DTI will allow UK companies to use their own concept of a ‘true and fair override’ and apply full IAS 39 and the Fair Value Option.
UK companies with listings in the US are also in the dark over how they will deal with dual reporting requirements. UK corporates adopting IAS 39 must impress on stakeholders that business risks and financial risks are managed appropriately. Traditional risk management strategies do not fit in with the hedge qualification criteria laid down in IAS 39. This could lead to greater balance sheet volatility than when accounts were prepared under UK GAAP. Companies need to adopt a strategic framework for managing risk and use the appropriate tools to aid their internal decision-making process.
Forward exchange contracts provide a means of hedging straightforward risks that are certain in nature such as settlement risks linked to payables and receivables. Options, which give the buyer the right – not the obligation – to exchange one currency against the other at a certain rate in the future offer a greater diversity of risk-reward profiles for companies looking to offset complex risks. The option products available range from barrier options to average rate options, double average options and basket options – all of which can play a key role in a corporate’s hedging strategy. Accounting standards, however, only allow limited hedge accounting treatment for options.
Options are a complement to orwards when hedging cashflow volatility. If uncertainty regarding future cashflows is high, a greater proportion of the risk should be hedged using options. Options are also ideal for hedging contingent exposures such as mergers and acquisitions. Debt can provide the best means of offsetting net investment risk, although low premium options are also appropriate. Companies are becoming increasingly concerned about year-on-year FX-induced volatility in their earnings. Double average forwards or options are suitable for hedging earnings translation risk.
Nokia’s treasury operations are managed by a single global virtual treasury operation staffed by global distribution teams in Espoo, Geneva, New York and Singapore. All four centres are fully integrated by a multi-entity treasury management system which provides them with total visibility of the group’s FX exposures and cash positions worldwide at any point in time. One of Nokia’s greatest ‘risk’ exposures is to adverse currency fluctuations against the euro – its reporting currency. In 2003, its ten largest markets accounted for 61% of total sales. More than half of these countries were non-euro countries.
The most significant sales-driven exposures for the year ended 31 December 2003 were in the US dollar, the UK pound and the Australian dollar. The group has costs in both sterling and the US$. Nokia’s FX exposures are consolidated globally, aggregated and then netted off, eliminating the need for any external FX dealing by the group’s operating companies. The exposures are farmed out to one of the treasury centres for hedging. Nokia was an ‘early adopter’ of IAS in 1987 and has also complied more recently with IAS 39 (2001). The group claims hedge accounting for certain forward exchange contracts and options and, for these, changes in fair value are deferred in shareholders equity – to the extent that the hedge is effective.
The introduction of electronic trading platforms has led to radical changes in the FX market over the last decade. Electronic trading platforms now process a significant number of global transactions. A recent survey indicated that the use of eFX trading platforms has risen significantly since 2002, with almost half of $1bn-plus corporates saying that they now trade online. STP has slipped in importance when selecting an online provider. This was ranked as first in 2002 but only appeared fourth in a recent survey.
Disclosure draft overloaded
The ACT calls for the IASB standard on disclosures to be postponed – it says many of the requirements would be better in an Operating and Finance Review.
Keeping to ISDA’s schedule
There are many important issues that will require negotiation before accepting the terms of the schedule to an ISDA 1992 master agreement. Gary Walker and Guy Usher reiterate the point that swap documentation is far from being a standard form that can be automatically accepted.
Deborah Thomas offers some insight into the questions asked in interviews and examines some of the best techniques candidates can use to answer them.
