From US GAAP to IFRS – Treasurers Beware

by Sebastian di Paola, Partner and Michiel Mannaerts, Senior Manager, PricewaterhouseCoopers SA, Switzerland

Introduction

As most readers will be aware, the accounting rules for financial instruments under IFRS originated from their US GAAP equivalent, FAS 133. This first version of IAS 39 nonetheless contained a number of significant differences compared to FAS 133, creating difficulties for foreign private issuers (FPI) which reported under both IFRS and US GAAP. Some of these differences have been eliminated over time; however, new differences have gradually been created through changes to both standards, and through evolving interpretation.

Some context from the US: a year after the November 2007 SEC vote to accept IFRS financial statements submitted by FPI’s without a US GAAP reconciliation, the SEC published a “Roadmap for the Potential Use of Financial Statements Prepared in Accordance with IFRS by US Issuers”. This Roadmap sets forth several milestones that, if achieved, could lead to the required use of IFRS by US issuers in 2014. As part of the roadmap, the SEC is proposing amendments to rules & regulations which, if adopted, would allow a limited number of US issuers to file IFRS financial statements for fiscal years ending on or after 15 December 2009.

Treasurers need to pay attention to the impact of any potential accounting standards conversion on their treasury activities, as longer dated hedges, being put in place now, may be affected.

This development clearly has significant implications for US treasurers. Alongside this process, a number of companies in Europe currently using US GAAP are also considering converting to IFRS. Treasurers need to pay close attention to the impact of any potential accounting standards conversion on their treasury activities, as longer-dated hedges, being put in place now, may be affected. Companies should not assume that accounting for financial instruments under IFRS is the same as US GAAP, as significant differences exist. It is also simplistic to summarise IFRS as more principles-based and hence more lenient than US GAAP, or vice versa. In some areas IFRS offers more flexibility and hence new opportunities, whereas in other areas IFRS is comparatively more complex.

This article highlights some of the key differences with respect to hedge accounting of which treasurers need to be aware. In particular, we focus on the areas of treasury centre netting, risk designation, effectiveness testing, hedging with options and net investment hedging. Further significant differences exist with respect to classification and measurement of financial assets and liabilities, impairment of financial assets, derecognition, derivatives and embedded derivatives, but these are outside the scope of this article.

Treasury Centre Netting

Treasury Centre Netting has long been a major area of debate under both the US and international frameworks. Initially neither IFRS nor US GAAP allowed hedge accounting for hedges on a net basis through a treasury centre. However, following intense pressure from the many corporates with centralised treasuries, FAS 133 was amended by FAS 138 in June 2000 to permit hedge accounting, provided that the treasury centre met specific criteria. IFRS on the other hand, having been initially somewhat vague on this point, was clarified in 2005 to explicitly exclude hedge accounting for net hedges through a treasury centre. These changes have created a situation where IFRS is more restrictive than US GAAP. Corporates reporting under IFRS and various treasury associations have been lobbying the IASB to address this issue for many years, with little success. For companies converting from US GAAP, this would result in a very significant change.

More specifically, FAS 133 allows the designation of intercompany FX derivatives entered into with another member of the group (the treasury centre) as hedging instruments in the consolidated books if that other member has entered into an offsetting contract with an unrelated third party. The FAS 138 amendment allows hedge accounting for intercompany FX derivatives under specific conditions:

• Netted internal derivatives must involve the same currency and mature within the same 31 day period

• Third party derivatives must mature within the same 31 day period and must be entered into within 3 days of designation of the internal derivative as a hedging instrument

• Third party gain/loss must closely approximate the aggregate or net loss/gain on the internal contracts

• The company cannot alter the 3rd party derivative unless this is initiated by the subsidiary.

Essentially, this involves the treasury centre fully laying off the exposure externally and not holding the position. Whilst these rules are somewhat restrictive, they remain workable for most centralised treasuries, although companies reporting under US GAAP have had to make some change to their FX hedging procedures.

Although under IAS 39, netting is not allowed and use of internal or inter-company derivatives as hedging instruments is prohibited, IAS 39 points out the “loophole” which can be used to avoid these constraints, which is to designate an appropriate portion of the gross exposure. For example sales of EUR 100 and purchases of EUR 80 would result, for hedge accounting purposes, in a hedge of sales of EUR 20. Companies can hedge the gross exposures externally, although this significantly increases the transaction volume and costs. Net hedging with allocation to a portion of the gross exposure results in residual volatility in results, as the offsetting cash flows (EUR 80 purchases and sales) may have a different timing in terms of P&L recognition and will have different P&L geography. Therefore, individual sales and cost of sales lines are not properly immunised from the effects of foreign currency moves in spite of being hedged economically. [[[PAGE]]]

Risk designation: portions and multiple risks

Most readers will be aware of the availability under US GAAP of the so-called “short-cut method” for hedges with interest rate swaps which is not allowed under IFRS. In compensation for this, the IASB has allowed designation of portions and multiple risks, neither of which is possible under US GAAP. In this case IFRS creates opportunities which are interesting to treasurers and which do not exist in US GAAP.

Combining a derivative and a non-derivative as hedging instrument:

Under IFRS, for foreign currency risk, two or more non-derivatives or proportions of them, or a combination of derivatives and non-derivatives or proportions of them, can be jointly designated as a hedging instrument. US GAAP prohibits considering a separate derivative and non-derivative as a single hedging instrument.

Hedging more than one risk

IFRS permits designating a single hedging instrument as a hedge of more than one risk in two or more hedged items. This is achieved in practice by, for example, separating a single swap into two hedging instruments if certain conditions are met. US GAAP does not permit this. The IFRS treatment can be particularly useful for companies making use of cross-currency interest rate swaps.

Hedging portions of risk

Unlike US GAAP, IFRS allows a portion of a specific risk to qualify as a hedged risk (as long as effectiveness can be reliably measured). The designated hedged risks may be those risks that are associated with all or a portion of cash flows or fair value of a hedge item. In practice, this could mean excluding the portion of a fixed rate bond’s cash flows which relate to the credit spread in a fair value hedge of interest rate risk. Such a designation, if properly used, will reduce the amount of ineffectiveness that needs to be recorded in the income statement under IFRS and may even protect the hedge from failing the normal effectiveness test.

Time portions of hedged item

IFRS permits designating a derivative as a hedge for a portion of the life of a hedged financial instrument. For example a company might designate a 5 year interest rate swap as a fair value hedge of the first 5 years’ cash flows on a fixed rate bond. Under US GAAP, an entity may designate a proportion of a hedged item (e.g. a percentage of a bond) similar to IFRS. However, US GAAP does not permit a hedge of a portion of part of the life of a hedged item.

Effectiveness testing

Neither IAS 39 nor FAS 133 specify a single method for assessing hedge effectiveness prospectively or retrospectively. The method an entity adopts depends on its risk management strategy and should be included in the documentation prepared at the inception of the hedge. The methods most commonly used under both frameworks include:

• critical (or matched) terms comparison

• the dollar offset method (including the use of a “hypothetical derivative” for cash flow hedges)

• regression analysis

• risk reduction methods (such as volatility or variance reduction)

However, differences exist in the detail of how these methods are practically applied, highlighted below.

Short-cut method: Under FAS 133, the “short-cut method” may be applied to fair value or cash flow hedges of interest rate risk using an interest rate swap. Under this method, an entity may assume no ineffectiveness (and is therefore not required to perform an effectiveness test) if a number of very strict criteria are met. In practice, however, these criteria have proved complex to apply, and the very strict approach by the SEC has resulted in a number of high profile restatements by US corporations.

The very strict approach by the SEC has resulted in a number of high profile restatements by US corporations.

IAS 39 does not provide such a “short-cut”, but, as described earlier, permits portions of risk to be designated as the hedged risk, such as selected contractual cash flows or a portion of the fair value of the hedged item, which can improve the effectiveness of a hedging relationship. In practice, a careful designation of a hedge relationship, using portions of risk under IFRS, may result in nearly zero ineffectiveness (except for changes in credit risk or liquidity of the hedging instrument). Nevertheless, entities will need to test effectiveness and measure the amount of any ineffectiveness under IFRS. This could be particularly problematic when compared to US GAAP in the case of fair value hedges. The well-documented problem of “small changes” in value causing ineffectiveness is particularly acute for fair value hedges, owing to the residual “noise” from the variable leg of the swap. Under US GAAP this problem has frequently been avoided by the use of the short-cut method.

Matched terms method under DIG G9: Under FAS 133 interpretation DIG G9, subsequent assessments of hedge effectiveness can be performed by verifying and documenting whether the critical terms (amount, currency, timing, etc) of the hedging instrument and the forecasted transaction have changed during the period under review (including increasing risk of counterparty default). If there are no such changes in the critical terms or adverse changes to the counterparty’s creditworthiness, the entity may conclude that there is no ineffectiveness.

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IFRS does not specifically discuss the methodology set out in DIG G9. However, if the entity can prove for hedges in which the principal terms of the hedging instrument and the hedged item are the same, that the relationship will always be 100% effective based on an appropriately designed test, then the same qualitative test referred to in DIG G9 (i.e. reconfirming that the terms still perfectly match) is sufficient. While IAS 39 requires an entity to test effectiveness, the test does not need to be quantitative in all cases, although as a minimum, the company needs to demonstrate that the derivative counterparty’s credit risk is insignificant, particularly in the current market circumstances.

Variable cash flows method under DIG G7: FAS 133 interpretation DIG G7 discusses three methods for testing hedge effectiveness of a cash flow hedge that involves an interest rate swap, when the requirements of the short-cut method are not satisfied. One of these methods is the variable cash flow method, which US GAAP specifically allows. Under IFRS however, the “variable cash flows method” is permitted only for the purposes of conducting a prospective hedge effectiveness test, but not the retrospective test. This is due to the explicit IFRS requirement that hedge effectiveness testing should be based on the entire fair value of the derivative, which the variable cash flows method does not achieve, since it excludes the fixed leg of the swap. This should not be a major issue for most companies since a “variable cash flows” approach can be replaced with a test based on hypothetical derivatives.

Credit risk and the hypothetical derivative method: An important difference between the two standards, which is of particular relevance in the current climate, relates to the impact of credit risk on hedge effectiveness when the hypothetical derivative method is employed. Indeed US GAAP allows the credit risk inherent in the actual derivative to be mirrored in the hypothetical derivative, meaning changes in the creditworthiness of the derivative counterparty will not lead to ineffectiveness. Under IFRS there is no basis for imputing credit risk in the hypothetical derivative, meaning ineffectiveness will in principle arise due to derivative counterparty credit risk.

Frequency of effectiveness testing: US GAAP requires hedge effectiveness tests to be performed at least quarterly, whereas IFRS requires these to be performed with the same frequency as the entity’s external IFRS reporting. In practice, most companies reporting under IFRS undertake effectiveness testing at least once per quarter, and some do so on a monthly basis.

Hedging with options

As is well documented, the main issue around hedging with options relates to the exclusion of time value from the hedge relationship. Initially both IFRS and US GAAP were criticised for their anti-option bias owing to the P&L volatility created by marking option time value to market through income. US interpretation DIG G20 addressed this, allowing inclusion of time value in a properly designed cash flow hedge. IFRS has now been amended to explicitly disallow this approach (please see TMI Guide to Hedge Accounting 2008 at www.treasury-management.com for more information). The issue has been particularly acute for industries making extensive use of options in long-dated cash flow hedging strategies, such as for jet fuel hedging by airlines.

Another key difference relating to hedging with options relates to offsetting options. Under IFRS, in order for a written option and a purchased option to be combined and viewed as one contract, the contracts must be entered into contemporaneously with the same counterparty. US GAAP does not include this constraint. In practice, this means that under IFRS a collar or risk-reversal strategy must be structured with a single bank to qualify for hedge accounting, whereas under US GAAP, the options can be bought and sold from different banks, resulting in greater flexibility and potentially finer pricing.

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Net investment hedging– IFRIC 16

An interpretation issued by IFRIC, the IASB’s interpretations committee in July 2008 significantly widens the scope of net investment hedging allowed under IFRS as compared to US GAAP. IFRIC 16 explicitly states that a hedging instrument can be held by any entity in a group, even if hedging a currency other than the functional currency of the entity with the net investment exposure. For example, an external USD 300m loan in subsidiary A can be used to hedge the USD net investment of subsidiary B in subsidiary C in the parent’s group accounts. Arguably, this goes beyond what a treasurer would normally consider an appropriate economic hedge and indeed is not allowed under US GAAP, which requires the hedging entity to have the same functional currency as the entity carrying the exposure.

This rather liberal treatment in IFRS could arguably be used to achieve hedge accounting for transactions which are not truly part of any coherent hedging strategy.

Conclusion

The publication of the Roadmap by the SEC suggests that in the long term, differences between US GAAP and IFRS will cease to be of significant importance. In the short to medium term however, treasurers of companies converting from US GAAP to IFRS need a clear understanding of the accounting differences. The evolution of the IASB’s Discussion Paper on “Reducing Complexity in Reporting Financial Instruments”, published in March 2008, will be particularly relevant and it will be interesting to see how this project impacts on the IASB/FASB convergence agenda. Last but not least, the US regulators will have their own interpretations of IFRS and we expect these to have a significant impact.