September 2009 Newsletter

If you had the occasion to (or will soon have to) negotiate ISDA agreements with your bank counterparties, you may face unwelcome surprises. As banks continue to recover from the financial industry meltdown, they are taking various steps to cap their interest rate risk (for more about this, see last quarter’s newsletter article) as well as their credit risk exposure. So far, the evidence is anecdotal and thus it’s not clear how many banks or customers are involved. However, it’s useful for everyone to be aware of some of these new requirements and their potential impact on hedge accounting under FAS 133, reported earnings, and disclosures

One new way banks have been trying to mitigate their credit risk is by attempting to insert new language into ISDA agreements; referred to as an elective early termination clause, the language gives either party the option to cancel or “call” the derivative at some specified interval, e.g., at 3 or 6 or 12 months, and at similar intervals thereafter. This sort of bilateral option is often called a Bermuda option. (Another way banks have tried to manage their credit risk is by adding minimum liquidity clauses into the ISDA, e.g., $2 million in cash and cash equivalents.)

Calling a Spade a Spade

Be it a Bermuda option or a liquidity “floor,” both approaches are pretty much the equivalent of a margin call on the exchanges or a collateral requirement, resulting in similarly unpredictable cash consequences. There’s irony here. On the one hand, banks have been lobbying hard to exempt corporate end users from the exchange or clearing house requirements in the Administration’s proposed derivative legislation. Under the proposal, much of the OTC market will be driven into exchanges or clearing houses, to mitigate non performance risk and enhance price transparency. On the other hand, banks are clearly attempting to reshape the way they do business with corporate clients to reduce their credit exposure, but in this case, no promise of heightened price transparency.

The way most Bermuda options are structured present some immediate issues for companies – from hedge program to disclosures.

While there was some initial confusion of whether, e.g., a 12-mos forward with a 6-mos Bermuda option would qualify as a hedge of a 12 month exposure at inception, there seem to be no are no issue at inception. However, when either party calls the derivative at the stated interval, the derivative will settle at market and any gains or losses will be booked into OCI where they will stay until the maturity debt of the underlying transaction. At the same time, the company would presumably enter into a new derivative, at market, to hedge the reminder of its exposure.

Bermuda options must also be seen through the lens of FAS 161, which requires companies to disclose any event that would trigger a call on cash. The early termination clause certainly fits the mold. So, if companies accept their banks’ ISDA language, they will have to update their disclosures under 161 to reflect the potential for early termination, detailing both the terms and the dollar amounts at risk to a “collateral call”.

Be Proactive

When banks attempt to alter the ISDA language, companies can and do fight back. “We just had our legal discussion with the bank,” reported one treasury executive. An important component of the discussion was the fact that the company would prefer not to transact its longer-term cash flow hedges with this specific institution. Some companies have already pushed back “I know of at least one other corporate that successfully convinced its bank to drop the language,” said the treasury professional.

She advised treasury to do its homework and ensure any ISDA-related edits are reviewed and discussed before the documents begin to be tossed back and forth between respective legal departments. The idea is to give the bankers a chance at understanding how the new language would affect their customer’s business as well as their own.

The Bottom Line

But perhaps the most important lesson to be learnt is that banks’ heightened credit concerns are clearly changing the market dynamics and way counterparties do business, well before the implementation of new derivative regulations. In both the case of the legislation and the retooled ISDAs, derivative trading will require a form of collateral or margin. But while the legislation promises to shine a bright light leading to price transparency, the ISDAs come with no such guarantee.

Understanding the differences between IAS 39 and FAS 133

It’s easy to dismiss the future mandatory conversion from US GAAP into IFRS rules as none-mission critical, because the go-live date for conversion is 2014 for large accelerated filers and 2015 for everyone else. But the effect of conversion will be felt much sooner, and US companies should keep an eye on IFRS developments as changes in IFRS rules will ultimately affect them as well.

Certainly, right now, 2014 seems far away, and there are so many much more pressing issues on treasurers and accountants’ desks; however, the path to convergence does not begin in 2014. It actually starts a lot sooner. The SEC will require companies to file their first IFRS financial statements in an annual report containing three years of audited financial statements. In other words, large companies must begin to produce audited IFRS statements alongside their US GAAP statements in 2011-2012. And that’s not that far away at all.

The expected transition to IFRS requirements thus puts pressure on treasury and accounting executives to become familiar with a slew of new standards. However, for the sake of this article, we are focusing on IAS 39, the standard that covers derivative and hedge accounting, as well as other areas, which in the US are handled by separate standards, such as FAS 115 (financial instruments), FAS 157 (fair value). The possibly good news is that despite its breadth, IAS 39 is under 200 long, compared to its US equivalents. FAS 133 alone is nearly 1,000 pages long.

Side by Side

Here are a few examples of how IFRS rules and US GAAP diverge, when it comes to derivatives and hedge accounting:

1. Definition of a derivative
Right off the bat, the two standards diverge when it comes to the definition of a derivative. FAS 133 requires that a derivative will have an underlying with one or more notional amounts or a payment provisions to count as a derivative; in addition, 133 says the derivative must require or permit a net settlement, be readily settled by means outside the contract or be settled for a value similar to what it would cost to net settle it.

In contrast, IAS 39 does not require a notional amount and does not require net settlement as a “prerequisite.” While it does say that for a financial instrument to be counted as a derivative it needs to be settled in cash or another financial instrument, the definition of net settlement is much broader. For example, the contract may say “settlement at a future date” and thus be a derivative.

2. What’s hedgeable? Another fundamental distinction between the US and international accounting rules is in the way each defines hedgeable risk. Under FASB rules, hedgers can only designate one of four types of hedgheable risk: benchmark interest rate, credit, foreign exchange or a change in the overall fair value or cash flow. In contrast, the IFRS version is broader for hedges of financial instruments, allowing a company to hedge more specific risk, e.g., hedge only the risk associated with a prime rate-based loan and as such more easily achieve a high degree of effectiveness. Unfortunately, neither IAS 39 nor FAS 133 allow hedgers to selectively hedge non-financial exposures, which remain subject to “overall” change requirements.

3. Partial-term hedging. Under FAS 133, companies may elect to partially hedge a fair value exposure; however, in most cases (hedging the first 5 yrs of a 10 yrs debt), the hedge will very fail to be highly effective and thus, de facto, excluded. In other words, companies can partially hedge, they just won’t get hedge accounting treatment. Meanwhile, IAS 39 says its OK to designate only a portion of the period for which the hedged item is outstanding, which means it’s a lot more likely that the hedge will be highly effective.

4. Time value of an option. Under US GAAP, companies hedging with options have a better chance at being highly effective than companies filing under IFRS. That’s because DIG issue G20 allows hedgers to exclude the time value of he option from effectiveness testing. Under IAS 39, time value must be included when calculating effectiveness. Because the time value is only present in the hedge – not the hedge item – hedgers are less likely to be highly effective and would have to record ineffectiveness.

5. Shortcuts. Initially, the two standards diverged on the issue of whether there are any situations that would permit companies to assume zero ineffectiveness. For example, FAS 133 offered the shortcut method for interest rate swaps and the critical terms match (CTM) for commodity and currency hedges. IAS 39 did not offer similar methods. Overtime, however, FAS 133 morphed into a philosophy closer to IAS 39. Because of perceived abuses and SEC actions, CTM and shortcut have for all intents and purposes been abandoned, replaced with the long haul method, which requires regression nalysis and more granular details.

6. Using a non derivative to hedge: US GAAP limits designation a non-derivative, e.g., foreign currency debt, to fair value and net investment hedging , whereas IAS 39 permits there use in a cash-flow hedging relationship

7. OCI re-classes: Under US rules, when a hedge of a non-financial asset or liability is discontinued (e.g., a hedge of inventory) all balances that had accumulated in OCI must be reclassified into earnings in the same period. Under IAS 39, companies can choose one of two approaches:

8. The changes in variable cash flow method. In this case, US GAAP is more liberal. FAS 133 allows this method for measuring ineffectiveness as long as the swap is at or close to zero. IFRS rules do not allow it under any circumstance. Hypothetical derivative and change in fair value methods described in G7 are acceptable for measuring effectiveness.

• They can take all the balances out of OCI and recognize them in earnings for the period (similar to FAS 133); alternatively
• They can include those amounts in the initial cost basis or other carrying amount of the acquired asset or liability. In other words amounts may be reclassified from OCI to inventory, deferred revenue, fixed assets, etc,

Conclusion

While the SEC has announced its path to IFRS, a couple of recent issues may change the relationship between FAS 133 and IAS 39 in the least, or derail the project altogether.

• The first obstacle is political pressure from EU finance ministers who are frustrated with the asset impairment and fair value measurement criteria in IAS 39. Their point of view was shared with Congress in the US, where, too, there’s been pressure on the SEC and FASB to review fair value measurement guidance under FAS 157. In both cases, politicians were and are concerned that tough fair value measures will force banks and other companies to write down further large losses.
• The next potential obstacle is the FASB shift to a codification method for all accounting literature (see Bulletproof, June 2009). The complete overhaul of the way US GAAP is catalogued and created is forcing audit firms and their clients to overhaul their accounting guides and actual references to specific financial accounting standards in their financial statement. The enormous effort is perplexing given that the IASB has not announced a similar cataloging method, which make conversion more difficult. [I think the FASB thinks this will make integration easier?I don’t think ifrs has eitfs, fins, etc, they just have ias/ifrs
• But that’s not all. FAS IAS 39 was originally created as a temporary measure but has since grown organically and often inconsistently. In early May (in part for political reasons) the IASB announced that it will take a fresh look at three areas in IAS 39 with an eye toward changing them. The IASB plans to completely replace IAS 39 in three phases:
  1. Quantification and measurement (ED was issued in July)
  2. Impairment of financial assets;
  3. Hedge accounting (to be handled after the first two efforts are concluded)

If the IASB manages to stick to its timetable, the new standardswill be ready just in time for US companies to begin to keep IFRS-compliant copies of their financial statements.

The Hedge Accounting View

In our June issue, we covered some of the motivations and implications of the FASB’s Codification™ project. Effective July 1, codification must be implemented for 10-Qs and 10-Ks starting with any statement issued after the effective date. For many companies, this means Q3 of 2009. Here are some pointers to make the adoption easier, at least when it comes to derivatives accounting.

While the Codification™ recast all of US GAAP into this new reference system, there are a finite number of topics and sections that apply to corporate hedgers, specifically topics 806-860 are of interest to financial risk managers. For example, 815 covers derivative and hedging and most FAS 133 elements; 820 focuses on fair value measurement and disclosures per FAS 157, and 830 addresses foreign currency accounting. [For a more granular and very helpful breakdown, we note that Matthew Daniel of Citi wrote a very informative piece in Citi's CSG Monthly issue 53, July 2009. If you are a Citi client you may be able to get a copy of the publication; it contains a lot of practical advice on how to implement Codification within the hedge accounting world.]

Some of the key topics to read are contained within 815. There is codification of the precise documentation requirements for special hedge accounting detailed in 815-20-25 together with eligibility of hedged items and hedge instruments. Brand new is a section called “Implementation Guidance and Illustrations” offering relatively detailed examples (don’t expect too much). Fair value and cash flow hedges are addressed independently in 815-25 and 30, respectively. Net investment hedging can be found in 815-35. The codification also contain useful examples and direct links to related guidance.

Effective September 2009, you and/or your auditors need to replace references to existing guidance with the correct number under Codification™. Helpfully, there’s a cross referencing functionality, which makes the search for sections, topics and specific paragraph less burdensome.