ACT Response sent via e-mail
Paul Ebling
The Accounting Standards Board
Holborn Hall
100 Gray's Inn Road
London WC1X 8AL
30 November 2001
Dear Paul
Re: The Association of Corporate Treasurers proposal to the Accounting Standards Board of suggested amendments to IAS39 - Financial Instruments: Recognition and Measurement
The Association of Corporate Treasurers ('ACT') would like to thank the Accounting Standards Board ('ASB') for suggesting that the ACT work with treasurers of UK and International companies to draft a proposal of suggested amendments to IAS39. The aim of our response is to propose changes which we believe will assist the implementation of IAS39 for UK companies within the context of the European Union's new financial reporting strategy under which all listed companies in Europe will follow International Accounting Standards by 2005. Some respondents felt that there had not been sufficient consultation with industry in respect of the proposed EU directive and would strongly support such consultations. The views expressed in this response relate both to the impact of implementation of IAS39 on UK companies and the relative impact of implementation for companies also reporting under FAS133.
In order to respond to the ASB, the ACT technical function established a working group comprising four members of its Technical Committee, two members of the Association together with support from PricewaterhouseCoopers to prepare a draft proposal. The draft proposal was sent to over 3000 member and non-member institutions reporting under UK GAAP, IAS, Australian GAAP and/or SFAS. We received responses from over 50 institutions, however only 35 of these responses commented on the draft proposal ('the respondents'). The working group and the respondents are detailed in Appendix 1. There were three main reasons cited for non response to the draft proposal: (a) Institutions not currently reporting under IAS or FAS were given insufficient time to review IAS39 (b) Institutions would not respond to proposals as they strongly disagree with the principles of IAS39 and, in most cases, FAS 133 and the increased use of fair value other than via disclosure in notes to financial statements (c) Institutions felt that it was not possible for one Standard to meet requirements for corporates and financial institutions.
The comments made in respect of our proposed amendments to IAS39 reflect the views expressed in the responses received by the ACT from the 35 respondents. As consensus was not reached on a number of points, the comments should be taken to represent the majority of the respondents' views. Our proposal covers the recognition and measurement of financial assets and liabilities, but we have considered derecognition and commodities to be out of scope. Our proposed amendments are detailed in Appendix 2. We attach as Appendix 3 input we have received from Nestle relating to commodities. The working group endorses these views although we would like to state that these have not been discussed with the wider group of respondents as this was out of scope.
The majority of respondents have considered both IAS39 and FAS133 and support the overarching principles of the Standard, that: - all derivatives should be recognised on the balance sheet - hedge accounting is permitted albeit within strict boundaries - strong effectiveness tests to be applied for hedge accounting - documentation of hedging strategies and designation of hedges It was agreed that the above accounting principles do support many of the treasury policies, procedures and controls that companies already have in place. However most of the respondents felt that FAS133 goes significantly beyond what is required to encourage and promote sound treasury risk management practices. Although the scope of our proposal was to suggest amendments that will facilitate the implementation of IAS39, rather than to propose major changes to the principles of the Standard, it is important to stress that many institutions believe that a mixed model of accounting will always be overcomplicated; and cost accounting, with fair value disclosure and adequate reporting of a company's risk management policies should be sufficient for shareholders.
We would strongly encourage the ASB to reinforce the views of UK and International corporate treasurers in their discussions with the IASB and would suggest further consultation with Industry based on our findings.
Our response is focussed on the following core areas, which we are highlighting as those areas considered being most relevant to corporate treasurers:
1. Measurement of Financial Assets and Financial Liabilities [Paragraphs 66, 68, 69, 73, 93]
2. Hedging through cross currency swaps not referenced to the reporting currency [Q131-3]
3. Treasury centre netting [Paragraph 133, Q134-2 ]
4. Basis adjustment [Paragraph 160, Q160-1]
5. Hedge accounting [Paragraph 142c, Q137-4 ]
6. Hedging with a non-derivative financial asset or liability [Paragraph 122, Q122-3]; Hedge accounting: hedging of future foreign currency revenue streams [Paragraph 137, Q137-4]
7. Definition of hedged risk [Paragraphs 128, 129, Q128-3]
8. Hedge effectiveness [Paragraph 146, Q146-3]
9. Definition of a derivative [Paragraph 8 (c), Q10-2, 10-3, 10-8]
10. Embedded derivatives - foreign currency provisions [Paragraph 25, Q25-9]
11. Options - treatment of time value of bought / written options [Paragraph 144]
12. Options - combination of written and purchased options [Paragraph 124, Q124-1; 144, Q144-1] and Hedge accounting: use of written options in combined hedging instruments
13. Embedded derivatives: capital instruments [Paragraphs 23 to 25]
We hope that you find our comments useful and constructive and thank you for having given use the opportunity to comment on this subject. If you wish to discuss further any of the issues raised in our response please contact our technical team on 0207 213 0738 or at technical@treasurers.co.uk1.
Yours sincerely
Jon Boyle Chairman of Technical Committee
Working Group members Jon Boyle Fidelity International Philip Gillett ICI plc Terry Harding PricewaterhouseCoopers David Harrison Arthur Andersen Valerio Pace Lehman Brothers Stephen Pugh Economist Group Helen Wilkinson The Association of Corporate Treasurers
Respondents
D.Adams Express Dairies plc
C.Archer-Lock American Institute for Foreign Study
D.Booth Carlsberg-Tetley
H.Brady PricewaterhouseCoopers
M.Buttrick F. Chan Coca-Cola HBC S.A.
D.Colley Granada plc
H.Cooper Whatman plc
M.Cooper Lattice Group plc
R.Dougall Goldfields Limited
M.Finn Express Dairies plc
J.Giles Optus Adminstration Pty Ltd
R.Graham-Adriani FKI plc
N.Green Nestle UK Limited
B.Hall Arriva
N.Jeffreys World Health Organisation
J.Laurie Scottish and Newcastle plc
S.Leadill BBC plc
P.Leavy FTI Finance
S.Lines Southern Cross Cable Network
A.Longden British Telecommunications+D9 plc
A.Marsh Pilkington plc
B.Marshall Premier Farnell plc
P.Matza RWE AG
D.Michell-Innes Sussex Commodities Limited
A.Murphy British Airways plc
J.Nhovo Cresta Marakanelo (Pty) Ltd
K.Pollocks Basell Australia Pty Ltd
K.Rainbow CSR Limited
M. Sanderson Reuters Limited
H.Seerden EIB S.Seetaram Petrotrin
C.St. Quintin Hunting plc
J.Vowles Kuwait Petroleum International
D.Witter Deutsche Bank
In addition to the above, we received input from David Michell, Technical Manager on behalf of The Finance and Treasury Association (FTA). The FTA is a non-profit association representing 1300 financial risk professionals in Australia and the Asian region.
1. Measurement of financial assets and financial liabilities [Paragraphs 66, 68, 69, 73, 93]
We support the approach that requires measurement of held to maturity financial assets, loans and receivables originated by the enterprise and not held for trading, and other liabilities apart from derivative liabilities to be valued at amortised cost. We believe that this approach will reflect the fair value volatility in the P&L where appropriate, allowing shareholders to distinguish between those financial instruments which increase risk and those, which decrease risk. This treatment will allow treasurers to continue to manage cash flow risk, which should lead to lower P&L volatility. We strongly support maintaining the IAS39 approach
2. Hedging through cross currency swaps not referenced to the reporting currency [Q131-3]
FAS133 requires that any cross currency swap must be booked through the reporting currency in order to qualify for hedge accounting. This builds in unnecessary complexity and cost and therefore, we endorse the IAS approach which allows the swap to be booked through different currencies, supported by designation and hedge effectiveness testing. The following example is taken from Q131-3: Company A's measurement currency is the Japanese yen. Company A has a five-year floating rate US dollar liability and a ten-year fixed rate pound sterling-denominated note receivable. The principal amounts of the asset and liability when converted into the Japanese yen are the same. Company A enters into a single foreign currency forward contract to hedge its foreign currency exposure on both instruments under which it receives US dollars and pays pounds sterling at the end of five years. If Company A designates the forward exchange contract as a hedging instrument in a cash flow hedge against the foreign currency exposure on the principal repayments of both instruments; it can qualify for hedge accounting provided that certain criteria are fulfilled. We strongly support maintaining the IAS39 approach
3. Treasury centre netting [Paragraph 133, Q134-2]
The approach taken in IAS39, in respect of foreign exchange risk, is that a treasury centre can collect information on the risk exposures from each subsidiary, group the transactions, as they will appear on the group balance sheet and hedge each of those assets and liabilities externally, on behalf of the entity with the risk. In other words, the entity with the risk need not be a party to the hedging instrument. The cost and administration involved for many companies implementing FAS133 which has forced the recording of back-to-back internal hedging transactions between the treasury centre and subsidiaries, so that each subsidiary is party to the hedging transaction is extremely onerous. We strongly support maintaining the IAS39 approach
4. Basis adjustment [Paragraph 160, Q160-1]
IAS39 requires the fair value adjustment relating to cash flow hedges of forecast transactions to be deferred in equity until the future transaction occurs. When the forecast transaction results in the recognition of an asset or liability, then the deferred amount is incorporated into the initial measurement of the asset or liability (the 'basis adjustment'). The FAS approach is burdensome requiring the deferred gains and losses to remain in equity and be amortised from there. We strongly support maintaining the IAS39 approach
5. Hedge accounting [Paragraph 142c, Q137-4 ]
The Standard states that for cash flow hedges, a forecasted transaction that is the subject of the hedge must be highly probable, and Q137-4 suggests that forecast revenue cash flows would only be highly probable in the short-term. Some companies may want to hedge future cash flows for some of their exposures extending beyond a 2 year time horizon, supported for example by a 3 or 5 year business plan, therefore, we would suggest that restrictions on time horizon are not placed on the 'highly probable' criteria, but linked to a company's formal budgeting and planning processes. In practise the effectiveness test may well restrict the ability to achieve hedge accounting. We strongly support maintaining the IAS39 approach, but would suggest that there are no restrictions on the time horizon relating to the highly probable criteria but rather to the company's internal planning processes on a rolling basis.
6. Hedging with a non-derivative financial asset or liability [Paragraph 122, Q122-3]; Hedge accounting: hedging of future foreign currency revenue streams [Paragraph 137, Q137-4]
We strongly support the current proposal that does allow a non-derivative, such as a foreign currency borrowing to be designated as a hedge of future foreign currency revenues. We do not believe that this should be restricted, as it is under FAS133 to either a net investment hedge or a firm commitment hedge in a foreign currency (fair value hedge). Although in practice the effectiveness test may well restrict the ability to achieve hedge accounting, this is an appropriate hedging technique used by many companies, and therefore we support the existing Standard. We strongly support maintaining the IAS39 approach
7. Definition of hedged risk [Paragraph 128, 129, Q128-3]
The Standard does not specify what can qualify as a hedged risk, so any sub-component of each type of risk could be hedged a long as the impact can be reliably measured. FAS restricts what can qualify as a hedged risk to the entire risk of change in fair value, or the entire currency risk, although it does allow the hedge of interest rate risk based on specified benchmark rates. We strongly support the pragmatic approach taken in IAS and would not encourage the adoption of more restrictive requirements as detailed in FAS133 as this will overcomplicate implementation and require numerous definitions of benchmarks etc. We strongly support maintaining the IAS39 approach
8. Hedge effectiveness [Paragraph 146, Q146-3]
We support the approach that hedge accounting is permitted only if the hedge is both expected to be highly effective and is actually highly effective in practice. The Standard states that the expectation must be that changes in value or expected cash flows "almost fully offset" and in practice they must offset within the 80 - 125% range. The Standard under Q146-3 states that the 80 - 125% range should only be used for retrospective testing, and that prospective testing should approximate 100% effectiveness. We propose that the Standard be amended allowing a bit more flexibility such that the 80 - 125% range applies both retrospectively and prospectively. In practice it would be expected that the prospective effectiveness should be higher than the retrospective effectiveness required. We strongly support maintaining the IAS39 approach, but suggest an amendment such that the 80 - 125% range applies consistently, both retrospectively and prospectively.
9. Definition of a derivative [Paragraph 8 (c), Q10-2, 10-3, 10-8]
Under both IAS and FAS, a derivative is defined by its characteristics. Under IAS39 a derivative does not have to be settled net whereas FAS133 (6) requires that a derivative be effectively settled on a net basis and list the following conditions: - The terms must require or permit net settlement - The contract can readily be settled net by entering in an offsetting contract with a third party, or - The contract provides for delivery of an asset that puts the recipient in a position not substantially different from net settlement. FAS133 (9) states that there are 3 ways to achieve net settlement: - Neither party is required to deliver the asset - There is a market mechanism that facilitates net settlement - The asset is readily convertible into cash We believe that it would be convenient to conform part c of the IAS definition to the FAS definition and this would simplify implementation for companies with dual listings We would suggest aligning the IAS definition to FAS to avoid unnecessary complexity
10. Embedded derivatives - foreign currency provisions [Paragraph 25, Q25-9]
Companies operating in hyperinflationary economies will have a large proportion of their commercial contracts denominated either in (1) hard currency, or (2) local currency, indexed to a devaluation factor to protect customers or suppliers from currency devaluation risk. Equally, for companies operating in non hyperinflationary economies a large proportion of their sales and/or supplier contracts may be denominated either in (1) the functional currency of customer / supplier, or (2) the currency in which the price of the related good or service is customarily transacted in the relevant economy. However, the burden and cost of splitting out embedded derivatives can be very time consuming and costly. Our proposed approach would be to exclude embedded derivatives unless the foreign currency provisions are leveraged. Then if companies wish to hedge the foreign currency cash flows associated with an embedded derivative contract, the normal hedge effectiveness test will apply. Even if embedded derivative can be separated, the entity should have a choice not to separate it and just mark to market the whole contract. We would suggest that embedded derivatives do not require separation except where they increase the risk to the company or its shareholders. We also propose that this exclusion should apply to all embedded derivatives, and not just embedded foreign currency clauses.
11. Options - treatment of time value of bought / written options [Paragraph 144]
We are proposing the alternative approach taken in FAS DIG G-20. If the entity concludes that the change in the purchased option's future cash flows (the change in the purchased option's fair value) will be perfectly effective in offsetting the changes in the expected future cash flows on the hedged transaction (that is, for prices above the specified level), the entity would simply record all changes in the option's fair value in OCI. Thus, in that situation, the entity would not recognise any part of the option's gain or loss in earnings prior to the date that the hedged transaction affects earnings. In effect this means that under FAS 133, with appropriate hedge designation and documentation there is no volatility in the income statement as a result of movements in time value.
12. Options - combination of written and purchased options [Paragraph 124, Q124-1; 144, Q144-1] and Hedge accounting: use of written options in combined hedging instruments
The Standard states that any derivative instrument that includes a written option cannot be designated as a hedging instrument if it is a net written option because written options are precluded as hedging instruments unless designated to offset fully or partially a purchased option. However, a greater degree of flexibility is appropriate for companies, for example, who may already have a bought option, and at a later date may want to write an option partially or fully against the bought option. We propose that hedge accounting for written options should be permitted if this is consistent with an enterprise's approved risk management policies. We do not believe the Standard should place limits on an enterprise's treasury policy, objectives and controls but we support the requirements in the standard to disclose information about the policies and procedures adopted. Those disclosures should include policies on the use of written options.
13. Embedded derivatives: capital instruments [Paragraphs 23 to 25]
If a bond is issued simultaneously with an embedded interest rate derivative such as a cap or floor, directly to investors, then under IAS 39.25(a) and (b), the embedded derivative is generally not required to be separated However, if the bond is issued directly to investors and the option is separately executed with an intermediary (typically the bank arranging the transaction), then the option would need to be separated and marked to market even if the bond and derivative are transacted at the same time Q23-6 and 23-7. This causes an inconsistency in the accounting and also inefficiency in the market, as investors and issuers do not necessarily want precisely the same terms. It seems inappropriate to require a different accounting result depending on whether two contracts are entered into separately (but concurrently), or one is embedded in the other to form a single contract. We propose that interest rate derivatives which are transacted at the same time as the related non-derivative transaction and clearly in contemplation of each other as part of a single financing transaction would be eligible for hedge accounting in all situations where the equivalent embedded derivative would not have required bifurcation. This issue may be particularly significant where the embedded derivative(s) is a written option such as a floor. In that case the separate net written option component would not currently qualify for hedge accounting under IAS39 but under this proposal would be eligible for hedge accounting.