by Jiro Okochi, Chief Executive Officer, Reval
How the world has changed since our first Hedge Accounting Guide of 2008. According to many pundits and bank lobbyists, fair value accounting rules under FAS 157 stood near the epicentre of the financial maelstrom. Who knew accountants were the real masters of the universe dancing around the many bonfires of the vanities.
With or without the necessary clarifications of how to fair value under FAS 157 or the pending FAS 157- like amendments to IFRS 7, adjusting fair values for credit is nothing new. Both FAS 133 and IAS 39 clearly reference the need to adjust derivative fair valuations to account for the impact of the credit worthiness of the counterparty. Issued by the FASB in 2006, FAS 157 probably would have been one of those “check-the-box” standards, but thanks to the financial crisis and 200-300 bps over LIBOR AA bank spreads, credit-adjusted fair valuations is the hot topic among our clients and a material concern for their auditors.
Who knew accountants were the real masters of the universe dancing around the many bonfires of the vanities.
As all of us at Reval remain passionate about derivatives, accounting and technology, we were fast to respond, releasing a FAS 157 module before the inception date of the standard in the fall of 2007. Working with leading corporations, banks and the Big 4, we continued to enhance the module, as the best practice interpretations of the standard and real life implementations began to unfold, leading to an award-winning FAS 157 module.
Simultaneously, we enhanced our IFRS capabilities to include credit adjustments for our clients looking to prepare for the inevitable requirements internationally. Our outsourcing service, Reval CenterTM, was also able to provide credit-adjusted fair values for private companies without any publicly available credit data or Credit Default Swap information.
As ever-changing accounting and regulatory requirements continue to be a challenge for treasury departments around the world, you will find this to be a major theme in this year’s Guide, as well as the impact that unprecedented volatility—especially with respect to commodities—has had on the role of treasury.
Spotlight on the Treasurer
From 2007 to 2008, companies saw commodities prices more than double, only to then free fall in a matter of months. This triggered a wake-up call at the C-Level around the world for a need to understand and hedge commodities risk. Treasury departments were called into action to apply their years of experience with handling FX and interest rate risks, as well as their understanding of hedge accounting to commodities risk, which is typically handled by procurement.
Leading treasurers were learning about the difference between bushels and bips and crack spreads and credit spreads. The financial crisis had already put a spotlight on the importance of treasury, and now Tim Geithner far surpassed Tom Cruise in popularity on Google search. Geithner now in fact scores a 100 on a scale of 0-100 for Google searches, while over the same period Tom Cruise only reached 21. The ranking is probably justified as Geithner’s current challenges would make for a good "Mission Impossible Part IV" story line.
For every challenge created an opportunity is born. This environment has given treasury the opportunity to become even more strategic by aligning with procurement and getting more involved with the actual business. [[[PAGE]]]
Act 2: Cloudy with a Chance of Volatility
Volatility crossed all asset classes and markets, especially with the rapid and unexpected surge in the US dollar. Despite the Federal Reserve’s printing presses, the strong dollar caused much pain to corporations with USD costs, companies with “unhedged” forecasted sales or anyone trying their luck in the carry trade. There were record losses reported by mostly non-US companies who were marking-to-market their derivatives and not trying to, or willing to, achieve hedge accounting under IAS 39. From Brazil to Mexico to China to India, billions of losses were reported. The losses have been so extensive that, at the time of writing, it has been reported that about 500 Korean companies are on the brink of bankruptcy due to FX losses stemming from betting against the greenback.
The importance of prudent risk management practices and controls, coupled with a healthy dose of hedge accounting can eliminate the risk of a restatement or surprise misbehaviour of a hedge.
Interestingly, many of the countries that reported these large derivative losses had not fully adopted their version of IAS 39. We are seeing them revisit hedge accounting and better controls and processes. Sadly, India decided to push back AS 11 for two years, which required mark-to-market disclosures on the impact of FX to the fair values of assets and liabilities as too many Indian companies were reporting losses. The political pressure, during an election year, to push back the standard which would have resulted in significant mark-to-market losses was too great.
For countries already following IAS 39, we have seen a migration back by many to avoid marking-to-market and to go for hedge accounting qualification, as the P&L volatility due to the mark-to-market of their derivatives has been too volatile and distracting. In the good old days, any noise from derivative-related P&L volatility had little long-term impact as company stock would go up the next day. Along with conventions in Las Vegas, gone are those days, and now any hint of poor risk management or surprises in earnings can result in a clobbering of the stock. By the time the pitchforks reach the castle gates, it’s usually too late to control the angry mob!
The Epilogue . . . Or Maybe the Sequel
The importance of prudent risk management practices and controls, coupled with a healthy dose of hedge accounting, can eliminate the risk of a restatement or surprise misbehaviour of a hedge. Despite the headaches of documentation and effectiveness testing for FAS 133 or IAS 39, it’s worth the effort to reduce P&L volatility and put into place a decent process that prospectively tests the effectiveness of a hedge.
We are very pleased with how well received our first edition of the Guide has been and are excited to provide you with our second edition. Once again you will find a diverse array of articles on compelling topics and companies, written by insightful thought leaders in our industry. On behalf of everyone at Reval, I would like to extend a special thanks to all of the contributors who were somehow able to find the time during their increasingly busy days to write for this important second edition.