The Accounting Standards Board
Holborn Hall
100 Gray’s Inn Road
London
WC1X 8AL
14 October 2002
Dear Paul
We appreciate this opportunity to comment on FRED 30 and on the IASB’s exposure draft of proposed amendments to IAS 32 and IAS 39. This letter represents the views of the ACT Derivatives Accounting Working Group (“DAWG”) (Appendix 1) and has been agreed by the ACT Technical Committee. Whilst it follows consultation with and endorsement by many of our members, we cannot be certain that it would be representative of all views within the membership of the ACT.
The differences between FRED 23 / 30 and IAS 32 / 39 are not, in our view, sufficiently major to justify changing UK GAAP ahead of the implementation of IAS 32 / 39.
The number of sets of accounting records which many UK based international companies need to keep is already large and would otherwise have to increase – for example in many cases from four sets to five (i.e. current UK GAAP, proposed amended UK GAAP, IAS GAAP, US GAAP, and the internal management accounts which most companies use to manage many day to day business decisions). Demands on management and the accounting functions, to meet the information requirements of different stakeholders, are already high. Pressure to increase controls to ensure the accuracy of accounts and accounting records, for each set of stakeholders, using established procedures, is, rightly at unprecedented levels, following in particular events at Enron and WorldCom. The proposed changes would, in our view, increase the risk both of materially incorrect mis-statements being made, and, by increasing complexity, increase the risk of financial statements being misunderstood. We believe that there is insufficient justification to ask analysts, shareholders and other accounting stakeholders to understand two consecutive restatements of accounts and comparative figures in successive years, and fear that such frequent restatement of accounts may undermine confidence in the reliability of financial statements. We believe, instead, that it is important to limit the frequency of restatements by co-ordinating changes wherever practically possible.
We share the ASB’s concerns about implementing the proposed ‘continuing involvement’ approach to derecognition of financial assets. We believe the ‘risks and rewards’ approach that has been used in the UK is conceptually strong, has proved simple to apply and is sufficiently robust in achieving what most would regard as the appropriate result, particularly in the current environment. The risks and rewards model features strongly in the existing IAS 39, and, despite its complexity, we do not believe it is appropriate to abandon the IAS 39 model in favour of an approach that has not been properly tested.
In particular, we are concerned that the combination of ‘continuing involvement’ and ‘pass-through’ proposals would result in significant amounts of assets and liabilities (beneficial interests) being removed from the balance sheets of traditional securitisation vehicles. We do not believe this is an appropriate conclusion without a detailed analysis of when, and to what extent, such beneficial interests transfer portions of underlying assets and when they should be considered to be borrowings secured against those assets. Generally, we believe it would be inappropriate for such interests to be removed from the balance sheet when a majority of the risks and rewards in the related assets remain with the sponsor/transferor of assets. In other words, we support the ‘risks and rewards’ approach in SIC-12 and do not believe it should be possible to override them with the proposed derecognition model.
It is often impossible to know the exact date on which an asset (such as ownership of shares in an overseas subsidiary) will be realised, but can be prudent to put a hedge in place to protect against risks (such as currency fluctuations) and to renew such a hedge until the asset is ultimately realised. In such circumstances, we believe that it is important that the accounting standards that are being developed make it practically possible for companies to put hedges in place whereby eventual recognition of gains and losses on the asset will co-incide with eventual recognition of offsetting gains and losses on the hedge (in respect of the risks being covered by the hedge – e.g. exposure to foreign currency fluctuations).
We do not share the ASB’s conceptual concerns about recycling; indeed there seems no more conceptual logic in deferring gains and losses ‘amongst’ assets and liabilities as the ASB proposes. On balance we believe the accounting is more transparent if cash flow hedging gains and losses are deferred in a reserve within equity.
We therefore agree with the IASB that gains and losses on a qualifying hedge, and if the hedge is renewed or replaced by another qualifying hedge that the realised gains or losses arising on both the realised hedge and the replacement hedge, should be recognised outside the profit and loss account (i.e. in equity) and subsequently transferred to the profit and loss account when the asset is sold or to the extent that the asset is impaired.
We understand that recycling under IAS is under review as part of its project on reporting financial performance. The existence of this significant unresolved issue is, in itself, good reason not to implement IAS 39 in the UK until the position under IAS has been properly resolved.
This would clarify the position of paragraph 134 of IAS 39 and the associated IGC interpretation. The reasoning behind this is given in appendix 2 to the submission from the EACT (the grouping of euro-zone treasury associations).
Also, as explained in point 2 of our 30 November 2001 letter, we support the approach taken in IAS 39 that a treasury centre can collect information on the risk exposures from each subsidiary, group the transactions, as they will appear on the group’s balance sheet, and hedge each of those assets and liabilities on a gross or net basis externally. 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 of implementing FAS 133 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 have a number of technical recommendations, which would ease the implementation of IAS 39 without impairing the quality of financial statements. In our view these would allow increased or easier use of hedge accounting where transactions are, in substance fully hedged, but where the current rule based IASB proposals might prevent use of hedge accounting or make it administratively burdensome.
Where the critical terms of the hedging instrument and the underlying asset or cash flow are the same, for example for an interest rate swap or a cross currency swap in interest and principal on a bond issue, then we believe hedge accounting should be possible without the need for detailed effectiveness testing. If material, the components of the transaction should be disclosed in the notes. We believe that it is important to look primarily at the substance of transactions, instead of their form, that the “short cut” method will result, more often, in matching accounting treatment for transactions which are in substance the same, and will often be operationally easier for companies to use. We would propose extending the short-cut method to cover any hedging relationship where the critical terms of the hedged item and the hedging instrument are the same.
Allowing this choice avoids a significant implementation issue for companies who would otherwise have to re-designate hedges from cash flow to fair value as the hedged item moves from a forecast cash flow to a firm commitment. This would also bring greater consistency with US GAAP. This point is made in greater detail in Appendix 1 of the submission from the EACT).
Where a company seeks to hedge the net exposure of a group of transactions,be they relating to foreign exchange, interest rates or other identifiable risks, we believe that the company should be able to designate the net exposure as a hedged item provided the formal documentation specifically indicates the link between the hedging instrument(s) and hedged items, and providing hedge effectiveness can be reliably measured. The existing discipline around hedge accounting relationships in the guidance would ensure that only those hedges that are expected to be almost fully offsetting could qualify for hedge accounting. An outright ban on hedging of net positions contravenes popular risk management methodologies. The suggested workarounds in the existing guidance encourage an artificial hedge relationship which in no way reflects the true intent of the originally structured hedge. This is particularly true where foreign currency sales must be proportionally designated to achieve the hedging of profit after tax from foreign subsidiaries.
Where the introduction of accounting under IAS 39 leads to recognition of unrealised gains or losses in the profit and loss account of UK companies, those changes, unless they represent changes in the unrealised value of equities, are likely to become taxable. We therefore think it is important that accounting standards do not place unduly restrictive conditions for qualifying for hedge accounting. Many of the changes we have recommended elsewhere in this letter are therefore aimed at ensuring that it is possible to achieve hedge accounting for hedges that are effective in an economic sense. We wish to avoid circumstances where unrealised gains become taxable without offset for realised or unrealised losses on hedges.
We continue to support the overarching principles of IAS 39, and to believe that:
We believe that the points we made in our response, dated 30 November 2001, including those in section A numbered 1 to 7, and in section B numbered 8 to 13, remain valid.
We hope that you will find our comments useful and constructive and thank you again for having given us the opportunity to comment on this subject. If you wish to discuss any of the issues raised in our response please contact me (telephone number 01737 837911 or email jon.boyle @ uk.fidelity.com) or Richard Raeburn (telephone number 0207 213 0734 or email rraeburn @ treasurers.co.uk). We will send a copy of this letter to the IASB.
Yours sincerely
Jon Boyle
Chairman of the Technical Committee
APPENDIX 1
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Jon Boyle Jim Coleman Sebastian Di Paola Philip Gillett Terry Harding David Harrison Joe Peka Lee Perkin Michelle Price Stephen Pugh Richard Raeburn Nathan Reeve Hugh Shields Peter Skeggs Alain Stangroome John Francis Stewart Wilson Woo |
Fidelity Investments International Nationwide PwC Belgium ICI KPMG Ernst & Young LLP BUPA PwC Deloitte Economist ACT Deloitte KPMG Law Debenture HSBC UBS Zurich EY Singapore |
Note: Working group members provided their views as individuals. These do not necessarily represent the views of their employer institutions (apart from the ACT).