A Treasurers’ Dilemma

– How to manage economic and accounting impacts of hedging and funding activities

by Jonathan Chesebrough, Head of Risk & Accounting Advisory at RBS Global Banking and Markets and Colin McKee, Risk & Accounting Advisory, RBS Global Banking and Markets

Since the implementation of IFRS, many treasurers have had to increase their focus, and indeed have had their decisions increasingly driven by the accounting for certain transactions. In some cases this has been beneficial, as the accounting has provided increased economic transparency. On the other hand, we have seen a few cases where treasurers have opted for what they felt are less desirable economic alternatives, as they felt the accounting for the more economically sensible options was so misleading that it was not a sensible choice.

At RBS, we have recognised the challenges that many of our customers have faced with certain aspects of IFRS in general, and specifically IAS 39. As such we have a team of dedicated accounting advisory personnel, who can provide a range of assistance, from understanding how the accounting works for a certain transaction to assistance with structuring certain transactions to achieve the desired accounting result. This article provides an overview of some of the more common ways we have assisted treasurers with the impact of IFRS, including:

• Compliance with derivative and hedge accounting requirements

• Restructuring of existing trades

• Balancing the economic vs. accounting debate

• Structured funding

• Managing covenant and rating agency metrics

Compliance with derivative and hedge accounting requirements

One of the key considerations for companies in developing an appropriate hedging strategy has been whether or not the chosen approach will comply with the requirements of IAS 39 and so be eligible for hedge accounting.

We have also been involved with structured funding, ensuring that companies can obtain potentially advantageous funding costs by embedding derivatives in the funding.

At RBS, we have been assisting clients to design suitable hedging strategies in order to meet the requirements of the standard and so achieve the desired accounting result.

The first hurdle which many companies face is how the hedging instrument will ‘fit into’ the hedge accounting models of IAS 39. In many cases, for example, vanilla foreign exchange or interest rate products, this can be relatively straightforward, however some instruments, such as cross currency swaps between two foreign currencies, can require a greater degree of thought.

Preparing adequate hedge documentation and performing hedge effectiveness assessments are issues which many companies struggle with initially, due to a potential lack of familiarity with the pitfalls of IAS 39. In order to address this problem, we have developed a suite of hedge documents which can be tailored according to the client’s specific scenario. We have also developed a web-based tool, the RBS IAS 39 Toolkit, which allows companies to perform hedge effectiveness assessments for a variety of trades. This has been particularly valuable to many of our customers as it assists them in performing what is often seen as the most technical and computationally intensive aspect of achieving hedge accounting.

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Restructuring of existing trades

One of the key themes for many corporates over the past six months has been how best to restructure their existing hedge portfolios in order either to mitigate further mark to market movements or to take advantage of opportunities which the current market volatility has presented.

For example, companies who have hedged foreign exchange exposures may be sitting on significant mark to market gains on the hedging instrument which they wish to monetise. If a portion of the gain is extracted in the form of cash, the existing hedge relationship must be terminated and a new hedge relationship designated. We have assisted a number of clients in modelling how the release of the deferred gain on the original hedge and ineffectiveness on the new hedge relationship may come through to profit and loss, so that they can weigh up the initial cash benefit against any expected future profit and loss volatility.

Another popular hedging strategy over the past year has been the addition of a basis swap (for example, paying 6-month Libor and receiving 1-month Libor) to an existing interest swap hedging underlying floating rate debt, while simultaneously changing the reset period on the underlying funding to 1-month Libor. This has significantly reduced the all-in funding cost for corporates by monetising the value of the option the company has to adjust the tenor of the roll period in the underlying funding. We have found that auditors may not permit the addition of the basis swap to the existing hedge relationship, so that it must either be carried at mark to market through profit and loss, or a new hedge relationship designated. We have successfully assisted a number of clients, and indeed their auditors, in understanding and modelling the potential hedge effectiveness issues around this trade.

Balancing the economic v. accounting debate

Another theme which has received considerable focus recently is the balance between the economic decision to hedge and the accounting result achieved. Even though a particular strategy may give the desired economic result, it may not achieve hedge accounting under IAS 39.

This can be a particular issue for trades which do not qualify in their entirety as eligible hedging instruments, such as trades involving written options (for example, extendible FX forward contracts). One hedge accounting approach that has been accepted is to split such trades into a portion which is eligible for hedge accounting, and a portion which will be carried at mark to market through profit and loss. Whilst an element of volatility will remain, many corporates have been willing to accept this in order to achieve the desired economic result.

Another example of the potential disconnect between economics and accounting arises with the forecast issue of foreign currency debt. From an economic point of view, the company will very probably consider locking in the interest cost of the debt in its own functional currency terms by entering a forward starting hedge. However, such a strategy does not fit into the hedge accounting models of IAS 39, therefore does not achieve hedge accounting. This could potentially lead companies to make incorrect economic decisions, i.e. they could choose not to hedge, underlining the importance of ensuring that a valid economic hedge can be accounted for as such. This has become an increasing issue recently as a greater number of companies seek to access a wider source of funding.

In such cases, we have assisted corporates in analysing the potential income statement volatility versus the economic cash cost in order to enable them to make informed decisions about the strategy.

Structured funding

We have also been involved with structured funding, ensuring that companies can obtain potentially advantageous funding costs by embedding derivatives in the funding, while avoiding the separation and resultant mark-to-market accounting of these embedded derivatives. This topic has been very popular of late, as many companies have been keen to sell options in order to potentially benefit from the current high implied volatility.

One type of structured funding that has been used more frequently in recent months, is the ‘Puttable Callable Reset Bond’, which guarantees the issuer an advantageous funding rate for an initial period, but has an uncertain maturity (i.e., the issuer may find the need to obtain new funding if rates rise).

Managing covenant and rating agency metrics

Another key point, especially over the past six months, has been helping customers understand how their covenant or credit rating agency metrics (for example, Net Debt/EBITDA or FFO/Adjusted Net Debt) can be impacted by different financial risks, and risks to these metrics can be mitigated.

This has been a key area of concern due to the recent high volatility in the FX markets, especially in areas of weaker currencies, for example for UK corporates with large overseas operations.

While the types of hedges can be different, it typically involves the synthetic conversion of debt from one currency to another via a derivative overlay. A big accounting angle to this issue is which hedge accounting model to use (e.g., cash flow, fair value, or net investment hedging), as well as how to ensure the impact of any hedges are included in the key metrics themselves.