Managing Financial Risk during Market Turbulence

An Interview with Wayne Read, Partner, Financial Risk Management, KPMG

What risk management and hedge accounting issues do you see CFOs and treasurers facing in the current climate?

In Australia, as in many other parts of the world, one of the most challenging issues for CFOs and treasurers is coming to terms with the implications of ineffectiveness in hedge relationships, when IAS 39’s fair value measurement rules are contributing to income statement volatility.

Many long term commodity, foreign exchange and interest rate hedges were designated for accounting purposes when financial market conditions were benign. Invariably, hedge designation practices were designed with administrative convenience in mind due to system constraints. These hedges are now being impacted, with the effects of market illiquidity, basis and counterparty credit risks compromising hedge effectiveness, sometimes with dire consequences.

The recent market turmoil has provided a salient reminder to CFOs of the importance of understanding the economics of hedging relationships, the fair value measurement process and designing effectiveness tests that accommodate a variety of adverse market conditions.

In assisting companies to document their hedge relationships, we focus on the “what if” scenarios, including the impact of market changes on the valuation of the instrument, basis risks and cash flow modelling assumptions. IAS 39 is a prescriptive standard, but it does provide mechanisms to accommodate less than perfect hedge

relationships. The key is to appreciate that credit, basis, liquidity and other sources of ineffectiveness are magnified in a fair value measurement world. With the benefit of hindsight, many CFOs would prefer to have documented their hedge relationships differently than deal with income statement volatility or re-designate ineffective hedges into new hedge relationships.

How do you see treasurers going about addressing these challenges?

The focus on risk management objectives in structuring transactions and hedging strategies is now being complemented by greater awareness of the accounting requirements of IAS 39 generally, and an understanding of the fair value measurement process in particular.

Accounting for derivatives is no longer an afterthought. This applies equally to structuring commercial arrangements where pricing features have derivative-like features. Finance is now an integral part of the transaction approval process.

We are also seeing continued investment in building treasury management capability, in terms of both quantitative and valuation skill sets, but more importantly in terms of the upgrading of systems to support quantitative risk management and derivative accounting functions.

How well prepared are directors to assess the accounting implications of their company’s risk management strategy?

Directors are acutely aware of the accounting complexity associated with derivative and related hedging activities, particularly in the current environment. Strong finance experience often features prominently in deciding the composition of the Board, particularly where derivatives are used extensively to manage balance sheet, earnings and cash flow exposures.

Other responses made by directors in order to manage accounting complexity include appointing an accounting advisor to support the CFO function and facilitate regular sessions with directors on derivative-related risk and accounting matters.

These responses complement initiatives by management to improve transparency in reporting the impact of treasury activities and highlighting contentious accounting issues at an early stage.

How are treasurers ensuring that their risk management and hedge accounting processes stand up to scrutiny?

When IAS 39 was first adopted in many countries, we expected treasury departments to take the opportunity to invest in their system capability as an important element of their implementation strategy. In many cases this investment did not occur, with many companies relying on manual or spreadsheet-based solutions.

Today, this investment is occurring. Streamlining cumbersome hedge accounting processes; reducing operational risk and building internal capability to more effectively analyse transaction pricing and effectiveness, hedging structures are important factors underpinning the business case. [[[PAGE]]]

Bearing in mind the difficulties that companies have had in adopting hedge accounting and ensuring continued hedge effectiveness, what have accounting standards such as IAS 39 and FAS 133 really added?

IAS 39 (and FAS 133 in the United States) is not considered a ‘good news’ topic in many executive forums. Most attention focuses on its prescription, a transaction-orientation that largely ignores common portfolio management practices in corporate risk management and potential for income statement volatility.

However, IAS 39 simply accounts for the risk management decisions. It prompts CFOs and treasurers to better understand the fair value measurement process and challenges conventional wisdom on hedge effectiveness. Ultimately, standards like IAS 39 are contributing to building risk management capability within the corporate risk management function. There is an expectation that the IASB’s current improvement project for the standard will contribute to reducing the administrative cost associated with this investment.

While the clarity of IAS 39 has evolved over time, what outstanding issues do you see?

Amongst Australian corporates, there is often a preference for option-based hedging strategies to manage down-side risks leaving shareholders exposed to positive cash flow variability. The way in which IAS 39 currently deals with options has an impact on those companies in reporting the impact of these strategies in the income statement. For all practical purposes, IAS 39 does not permit an option premium to be deferred and matched with the underlying hedged cash flow.

The simplification of the standard, which is currently underway, should be an opportunity to review the rules relating to options. This initiative would be welcomed by most directors and CFOs managing foreign exchange, commodity and energy related exposures in Australia, and align accounting impacts with the economics of risk management activity.

It would also simplify presentation of financial reporting on risk management activities to key stakeholders in the capital markets.

The market turmoil in recent months has emphasised to all stakeholders the need for transparency of business risks and how these are managed. How do current accounting standards contribute to this?

Treasurers and CFOs are under increasing pressure from external stakeholders to report the financial risks of the business in a meaningful way and explain how these are being managed.

The standard on disclosure of financial instruments, IFRS 7, does not necessarily achieve this aim as it focuses on the risks of specific financial instruments rather than a company’s broader financial risk management process. Reconciling these perspectives is challenging.

In the current environment, Boards are particularly focused on capital and liquidity management disclosures. The result is more comprehensive disclosure, which is a positive development.

As we have discussed, the last 12 months have already seen significant changes in the way that treasurers and CFOs approach hedge accounting and risk management. What do you think the next 12 months could bring?

Corporate risk management is evolving in the current environment, both in terms of priorities and approaches. Frameworks focusing on day-to-day risk management are being complemented by approaches that provide an alternate view of risk i.e. "managing for event risk."

Some industries exposed to these risks already operate integrated frameworks and are quite adept at accessing capital markets to create a cushion to avoid liquidity events irrespective of their causes.

In the mainstream, these frameworks are still a work in progress with cash flow at risk, integrity and reliability of forecasting systems and stress liquidity analysis starting to dominate the CFO’s agenda.

Another focal area is working capital management, particularly as the provision of credit for most companies has been tightened. Accelerating cash locked-up in the balance sheet is driving many internal projects; the challenge for CFOs is how to make the benefits sustainable. This involves changing business practices and calibrating cash flow forecasting and performance measurement systems to provide the right signals.

We see that treasurers will need to balance day-to-day cash management with the ability to deal with “what if” scenarios. This does not necessarily entail adopting a quantitative cash flow-at-risk model, but it does require thought about how to structure the company’s liquidity profile to achieve medium-term corporate objectives, despite short-term shocks. This is likely to be one of the most salient lessons learnt from the current economic environment which, if done correctly, will put companies in a good position for the future.