Published: September 02, 2011
On the face of it, it seems odd that a practice utilised by so few companies other than financial institutions, and usually for something as mundane as risk management, should enjoy the attention that is accorded to hedging. However, a little thought quickly reveals some insight - hedging is a complex and difficult business, ill understood by markets and badly served by current accounting practices. It doesn’t help that hedging usually involves the use of derivative financial instruments, long regarded as the dark science of finance.
In this article, I intend talking a little about what we are doing about current accounting practices.
At the heart of any financial reporting relationship is the professional scepticism that exists between investors and managers of companies. Hedging activities contain all of the ingredients for exaggerating the discord in a relationship premised on scepticism. Hedging seeks to address well-understood basic risks in individual industries through the introduction of elaborate, complex, and often misunderstood financial instruments. These instruments usually behave in a predictable way, but occasionally go off the charts in an entirely unpredictable way. Essentially, what is a laudable business aim, the reduction of inherent risks, can seem to an outsider to effectively introduce new and unpredictable risks to the way a known and understood business operates. This perception has been exacerbated by the recent global crisis. During the course of the crisis, the complexity, some would say over-complexity, of derivative instruments, and lack of consistency and transparency in their reporting was exposed.
A minor change in the value of a derivative will often lead to a major change in its balance sheet value.
The essence of a good risk management strategy is that when it is working, it is invisible, and therefore to an outside observer, of no consequence. However, when it fails, it becomes instantly and dramatically observable and the consequences are, almost inevitably, negative. But just as important, when seeking to understand risk management strategies, is the balance sheet presence of derivative instruments. They have, by their very nature, a small balance sheet footprint. Derivatives, like icebergs, hide most of their bulk out of sight below the surface. Whereas a minor change in the value driver of an on-balance sheet item will lead to a similarly minor change in its balance sheet value, a minor change in the value of a derivative will often lead to a major change in its balance sheet value. Since balance sheets are a point in time measurement, it is often difficult to represent the potential balance sheet and income statement impact of a derivative instrument that for the most part remains below the surface.
It is in this dark and murky place that the IASB is endeavouring to amend hedge accounting rules. Currently part of the financial instrument accounting standard, IAS 39, these accounting rules were primarily intended to address accounting mismatches.
Accounting standards as they are currently written, define two distinct approaches to the valuation of assets and liabilities on the balance sheet. The historical cost approach is by far the most easily understood and traditionally more easily accepted method of accounting. Under the historical cost convention, a balance sheet item is valued at its original cost, less any reduction attributable to usage. The value is cash flow based, and is reliable. Arguably, cost presents the best indicator of value where an entity intends retaining the asset or liability. Fair value on the other hand, is a methodology for accounting that is somewhat newer and was introduced primarily for use with financial instruments. As the name implies, it reflects the current fair value of items on the balance sheet at any point in time. Fair value always presents the user of financial statements with a current view of the balance sheet, but arguably can be misleading when there is not a liquid market to price an instrument, and/or where the entity has no intent, ability or need to dispose of an asset or liability.
Since the two valuation methods often produce substantially different answers, and since it is often appropriate that they are both used within the same set of financial statements, their use can give rise to a financial statement mismatch. A mismatch arises when an asset and a corresponding liability are measured on different basis, giving rise to different values for essentially the same event. Existing accounting under IAS 39, and prospective accounting under IFRS 9 permit changes in measurement methodology where it will reduce mismatches.
These matching exceptions however prove impossible under certain circumstances. Those circumstances include in particular hedging activities.
Hedging is a business activity undertaken when an enterprise seeks to reduce an inherent economic risk, by acquiring a financial instrument with risk characteristics opposite to those it seeks to hedge. The hedged item is usually an integral part of an entities business, and is often a financial instrument or obligation. The hedging instrument may also be an inherent part of an entities business (a natural hedge), but is more often a financial instrument and usually a derivative instrument. Derivative instruments are popular as hedges because they require little capital outlay and can be tailored to the specific risk the entity is trying to hedge.
In current and prospective financial instrument accounting practice, derivatives must be accounted for at fair value. Hedged items, because of their nature as core to the business, are often accounted for at historic cost. This gives rise to mismatches. [[[PAGE]]]
Mismatches are an accounting problem, arising because of the dual approach to measuring assets and liabilities. Hedging is the most substantive manifestation of this problem. Current hedge accounting is an accounting methodology introduced with the objective of resolving this accounting problem. In principle, hedge accounting works by allowing the measurement characteristics of instruments subject to hedge relationships to be changed in such a way that matching is achieved.
The hedged item is usually an integral part of an entities business, and is often a financial instrument or obligation.
The current hedge accounting framework seeks to regulate the reporting of hedging through a deliberately accounting-based framework. While this approach has a number of merits, its chief weakness is the artificial nature of the accounting parameters that define and limit its application. These various parameters do not in themselves attempt or assert to recognise the reason for hedging, the rationale behind selecting certain hedging instruments, or the economic impact of those hedges, resulting in an onerous and sometimes artificial accounting process.
The consequence of this is that many entities which apply hedging have chosen not to apply hedge accounting, and that those entities who do apply hedge accounting find the process expensive to maintain, and not always reflective of underlying activities.
In December last year, the IASB introduced a revised proposal for dealing with hedge accounting. The proposal was released to the public as an exposure draft. An exposure draft is intended to give an airing to a proposal by the IASB, and allow constituents the opportunity to review and understand our thinking. We received numerous comment letters on the proposal and are in the process of working through the issues raised within them. As a consequence of these letters, and our re-deliberations, we may make some changes to the proposal released in December.
This proposal begins with a radical rethink of the objective of hedge accounting. It accepts at the outset that the activity of hedging is a normal tool of corporate risk management, and as such is a definable business activity. This changes the entire focus of hedge accounting - rather than imposing rules to limit its use, the new proposal focuses on ensuring that the economics of hedging are consistently accounted for. This in turn means that rather then attempt to burden hedge accounting with a number of artificial barriers to entry, we instead focus on ensuring that hedge accounting reflects the risk management activities within an organisation.
So what does this all mean in practice? At the outset, the principle of hedging is driven by a risk management objective. Risk management objectives take account of issues such as what is being hedged, what is the most appropriate hedge to use, and how should the success of any hedging strategy be measured. A corporate risk management function would also naturally assess its hedging relationships so as to ensure that they continue to provide it with a valid and reasonable risk-mitigating outcome.
Of course, for many entities, hedging is a very vanilla enterprise. The relationships at the heart of the risk mitigation strategy are easy to understand, easy to maintain and easy to communicate. In these entities, the accounting burden should be light, because of the simplicity of the underlying relationships. However, as complexity increases, the ability of an entity to find cost-effective hedges which exactly match the risk been hedged becomes increasingly difficult. In these circumstances, greater focus needs to be placed on the entities technical understanding of the instruments they using for hedging.
For the purposes of this proposal, a qualifying hedged item is an item that the risk management function of the organisation believes should and can be hedged. A hedging instrument, similarly, is an instrument that the risk management function, using its best endeavours, and applying a cost benefit analysis, has decided will appropriately hedge the underlying risk. Hedge effectiveness should be determined by the risk management function, taking account of its objective. Hedge ineffectiveness is reported in the income statement, and if and when ineffectiveness becomes intolerable to risk management, it can discontinue the relationship.
No accounting standard can be considered complete, until full consideration is given to the potential for abuse.
An accounting model that is premised on reporting the outcomes of a risk management process leaves it to the reporting entity to determine the robustness of its process internally, in the context of its own structure and complexity. The controls that ensure that such a process is effectively managed shift from accounting discipline to market discipline. This latter requires consistent and transparent reporting which allows investors to better understand the risk management imperative behind a particular risk mitigation strategy pursued by an entity, the extent of those risk management activities, the success or otherwise of those activities and finally the impact of those activities on the balance sheet and income statement of the reporting entity. From a management perspective, it is possible to see how a defined management strategy has given rise to consequences, which the entity can more easily discuss and/or defend with investors. [[[PAGE]]]
No accounting standard can be considered complete, until full consideration is given to the potential for abuse. Hedge accounting is particularly susceptible to this concern, because it alters the measurement and classification principles applied to financial instruments. In doing this, hedge accounting in effect circumvents the restrictions placed on the original classification and measurement concepts within accounting standards. The hedge accounting proposal put in place certain accounting safeguards to restrict the potential for abuse. Comment letters we received in response to the proposal suggested that certain of these accounting restrictions have unintended consequences. In our re-deliberations, we are relooking at the restrictions to reduce the unintended consequences, while still retaining the inherent robustness of the standard.
An accounting approach which seeks to faithfully represent an underlying business activity, without trying to change it, and which provides sufficient disclosure for investors to challenge that activity, while ensuring that the reporting is consistent with the economic outcome of management strategies is an ideal outcome (perhaps even fantasy). This is the objective of any standard setting process. The process of re-deliberations with which we are currently busy should be finished within the next couple of months, and we are aiming towards a final standard by the end of the year.
Now if only we could make the world love derivatives again!
The views expressed in this article are those of the writer, not necessarily those of the IASB or the IFRS Foundation.
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