Peeling away financial reporting issues one layer at a time

Hedge Accounting: Convergence Crunch Time

If you want to appreciate the political circus masquerading as “due process” in accounting standards setting, I recommend that you read two recent documents. The first one is the CFA Institute’s stinging 39-page comment letter* on the IASB’s hedge accounting exposure draft:

We do not find investors calling for a standard which allows broader and more liberal application of hedge accounting and which permits its use to alter the IASB’s classification and measurement of financial instruments. Rather, our research indicates that users find hedge accounting and disclosures to be confusing, difficult to understand and low in quality. We would be interested to hear how the IASB’s outreach to users allows them to conclude that this proposal will benefit users.” [Emphasis supplied.]*

And second, this equally-detailed publication from Ernst & Young, which hit the internet at about the same time:

“Among the proposals issued by the … [Boards] … to amend financial instruments accounting, the hedge accounting sections were the most favorably received. Both Boards heard support from constituents for attempting to make hedge accounting easier to accomplish with changes that constituents found substantial and helpful.

That much is all you need to get the sense that preparers, as represented by EY’s clients, are clearly talking past investors, as represented by the CFA Institute. If you need more evidence, search for the word “users” or “investors” in EY’s 26-page document. You’ll find “users” once, but not in any relevant context to the point I am making. What you will find is a lot of support for the IASB from EY, buttressed by this kind of client cheerleading: “hedgers like”, “valuable to many industries”, “entities typically want to match”, “many banks and financial institutions have long wanted”, “entities … would benefit”, etc.

Ask yourself whose views should carry more weight at the IASB (or FASB): the prestigious CFA Institute, which represents more than 100,000 investment professionals worldwide, and whose stated purpose is to advocate for investor protections; or EY – and its clients? Next, ask yourself whose views are actually weighted more by the IASB (or FASB)?

Case closed.

Whither Hedge Accounting – and Convergence?

The FASB has also issued its own discussion paper, Selected Issues about Hedge Accounting, but they are substantially different. While the FASB has proposed incremental liberalizations of their existing approach to hedge accounting, the IASB took a clean sheet of paper – and has drawn a picture of what accounting standards would look like if the U.S. would kindly step aside.

I want to be clear at the outset that if I had my way, there would be no such thing as hedge accounting, and I believe many investors share my preferences. If the probability is 1/x that reasoning life forms reside on another planet, the probability of their adopting more complex hedge accounting standards than ours is 1/x2. Hedge accounting is already ridiculous enough; and with that introduction, I present but a taste of the Institute’s many concerns with the IASB’s further plumbing of the depths:

  • Absence of investor primacy – The Institute believes that most investors would prefer broader application of fair value and increased rigor around the permissibility of hedge accounting, not the opposite which is being proposed. The IASB has done nothing to demonstrate how their proposal would benefit investors. If investor primacy no longer exists at the IASB, then it should say so. Moreover, increased use of fair value accounting, which the CFA Institute has consistently recommended, would reduce any “need” for hedging accounting, yet the IASB is proposing to expand hedge accounting, a dubious and anomalous concept. (My strong sense is that, consistent with my own views, the Institute would eschew hedge accounting altogether if it could get the Boards to agree.)

     

  • Lack of conceptual basis – The foundation of the ED is a new concept of risk management strategy that is only vaguely specified, and has no foundation in either economics or the conceptual framework definitions of assets and liabilities. Moreover, the ED has been so broadly written and so removed from any conceptual framework that there seems to be no way it can be adequately policed for abuses. Investors would benefit more from the disclosures of the risks that are not hedged, than the (inadequate and vaguely-specified) disclosures of risks that are purportedly being managed.

     

  • More ways to management earnings – Especially because of the failure of the financial statement presentation project, the notion of accounting treatments being driven by management intent has become discredited, so now we are being sold other amorphous concepts like “risk management strategy” which really means ‘more choices for management.’ Global accounting standards are being promoted under the premise that enhanced comparability will be the result. But, no one can seriously argue that the IASB’s ED will move comparability anywhere but on a serious jag in the wrong direction.

     

  • Hedge effectiveness threshold lowered – Like the FASB, the IASB is eliminating the requirement to assess hedge effectiveness quantitatively. But, the IASB’s new criteria is much more amorphous: to minimize ineffectiveness, and to be “unbiased and other than accidental offsetting” – whatever that means. Relatedly, retrospective assessment of ineffectiveness would no longer be required.

     

  • Increased use of “other comprehensive income” – OCI has yet to be defined for any other purpose, yet this “principles-based” hedge accounting proposal would run all hedging gains and losses through OCI.

     

  • Held to maturity positions can be hedged – Although these will be re-named when IFRS 9 becomes effective, measurement based on amortized costs only makes sense if management is indifferent to changes in the fair value of their investments. Permitting hedge accounting of these investments means exactly the opposite – that management is not indifferent to price changes, which was what had been asserted to allow amortized cost accounting. What a farce!

     

  • Derivatives can hedge other derivatives – Don’t like the bet you made on a commodities future contract anymore – and don’t want to recognize a loss when you sell it? Under the proposal, you can construct a hedged item out of your anticipated purchase of the commodity and your under-water forward contract (which had been designated as a hedge in order to put the gains and losses in OCI). All you would have to do is to find an offsetting derivative that better suits your new view of price movements, and now the gains and losses on both derivatives can be thrown into OCI.

     

  • The ability to hedge a portion of an item – This is where the games start to get really interesting.  There is no restriction that requires that the identified hedge portion be unrelated to the unhedged portion.  So, management could identify a portion (such as the copper component of insulated wire) and describe the hedged portion as a perfect offset of the derivative. Even though the “risk management strategy” may be questionable, who is going to question it? And, there need never be any ineffectiveness to report in net income.

 

  • The new concept of “net nil positions” – Which in effect says that when assets and liabilities (which may include derivatives) net to zero, both sides are hedged items – and voila all restrictions on what qualifies as a hedging instrument are swept away, because the asset and liability positions qualify as hedged items.   The fair value option and its restrictions (elected only at inception, irrevocable, gains and losses through net income) are circumvented.  Even better (or worse, depending on your point of view), it could be that all aspects of IFRS 9 classifications can be “managed” with the right financial engineering.

     

  • Cash instruments to be used as hedging instruments — Currently under US GAAP, cash instruments (such as debt instruments) may be used to hedge the net investment in a foreign subsidiary whose functional currency is the local currency (an utterly stupid concept to begin with) or a firm commitment denominated in foreign currency. Under the proposal, cash instruments that are measured at fair value through net income could be designated in various kinds of hedging relationships. That means, of course, that the gains and losses on those cash instruments would flow through OCI instead of net income.

The Institute has many other gripes, and a lot of it has to do with process; i.e., timeframe, risks, etc. But, I think I have given you enough to convey the impression that the most prestigious association of investment professionals in the world is trying to tell you that the IASB’s ED is a HORRIBLE HORRIBLE document. Yet, politics being what they are, there will doubtless be a lot of pressure put upon the FASB to come as close as they can to the IASB’s madness as it re-deliberates its own more modest discussion paper.

Who Are These Guys Anyway?

In understanding where the notions in the IASB’s ED come from, it is important to remember that circumstances essentially forced the IASC (IASB’s predecessor) to swallow US-style hedging accounting with one big bite. Basically, the IASB was thrust from relative obscurity into international prominence when, in 1995, the International Organization of Securities Commissions (IOSCO) tasked the IASC with establishing a set of high-quality accounting standards, within five years, covering all of the core topics IOSCO specified.

Of these core topics, financial instruments proved to be the gnarliest; plus everyone knew that the final arbiter of high quality was to be the US, where FAS 133 was published in 1998. By then, time was running out on the IASC, and an international consensus on hedge accounting was nowhere at hand. In desperation, the IASC essentially made a carbon copy of U.S. financial instruments accounting and dubbed it IAS 39.

I can’t say for sure why the IASB has so sharply tacked away from the FASB on hedge accounting at the eleventh hour of the current convergence project. But, it is clear that the Europeans hated IAS 39 from its inception of the IOSCO “core standards” project 12 years ago. With the hedge accounting ED, either the EU is trying to tell the US to take a hike, or they realize that the promise of a “stable platform” for accounting standards would effectively wed them to US-style hedge accounting rules forevermore — unless they make a bold move within the convergence timeframe.

In bringing the EY document to my attention, Bob Jensen wrote:

“There’s an old saying when cable companies are bringing fiber to households: ‘The last mile costs more than all the other miles.'”

To which I will add a sports adage: Crunch time is when you learn the most about your teammates.

Hedge accounting is crunch time for the SEC.

Speaking of IFRS

You may have noticed the advertisement on my website for the Core Concerns Conference in Chicago this June, sponsored by CFO.com. I will be attending all three days of the conference, and I would welcome the chance to meet and share ideas with any Accounting Onion readers in attendance.

You might also be interested in two other things about that conference. First, if you click on the ad on my website to register, you will receive a $300 discount off the standard registration fee.

Second, and apropos to this post, the conference will feature a panel discussion entitled “One Global Accounting Standard — IFRS in America.” The panelists are:

  • Paul Cherry, Chairman, Standards Advisory Council, IASB; Former Chairman, Canadian Accounting Standards Board
  • Brian Fiedler, VP Finance, Canadian Tire
  • Christian Leuz, University of Chicago’s Booth School of Business
  • William Hildebrand, Financial Accounting Standards Board (FASB) Practice Fellow
  • Jack Klingler, Director of Accounting Research and IFRS Implementation, Alcoa, Inc.

You can count on me to use the opportunity to ask questions, and I hope to see you there!

__________

* This document was provided to me via email from a member of the CFA Institute. Since neither the IASB nor the Institute has posted it on the internet as of the time of this writing, I am taking the liberty of posting it to my own website. I just wanted you to know that this is where the link will take you.

2 Comments

  1. Reply Steve May 4, 2011

    Tom,
    Consiering the quality of the IASB Board members, I am not surprised that they will vote for such document.
    Of the 15 IASB Board members, I don’t know how many actually know much about hedge accounting. What a shame! If you doubt my observation, you can check it out by listenign to their Board meetings.
    In regards to the ED, I don’t understand why it starts by saying that hedge accounting is an exception to the general accounting model, then tries to broaded its application.
    I also don’t understand why it states that its objective is to reflect risk managment, then limits hedging accounting of credit risk, inflation, etc.
    Also, if IASB is so keen on the concept of reflecting risk managment, then why not try to account for all the risk that entity manages? Why is hedge accounting optional?
    Steve

  2. Reply Independent Accountant May 5, 2011

    Tom:
    I would end hedge accounting. That SFAS 133, as interpreted, is 1,060 pages, shows it has no conceptual basis.

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