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Counting Down the Days to Accounting Standard
October 1, 2004
If history is any indication, the Jan. 1, 2005 deadline for the transition to International Accounting Standard (IAS) 39 will arrive far too soon for many.
The new standard contains some controversial provisions that will require the risk management strategies to be evaluated, documentation procedures to be developed and methodologies for measuring hedge effectiveness to be designed.
If European firms take the year or more that U.S. firms needed to prepare for FAS 133 in January 2001, then they have a lot of catching up to do. And estimates on compliance costs range from several million to tens of millions of dollars, depending on the state of existing risk management and documentation practices.
IAS 39 is part of the new International Financial Reporting Standards (IFRS), which will affect some 7,000 firms listed on European Union exchanges, including U.S. financial institutions.
The general goal of the IFRS is to harmonize disparate reporting standards and promote transparency. IAS 39 targets derivative transactions, which firms have typically omitted from their balance sheets--unless included for trading purposes--on the grounds that "hedging" does not affect the bottom line.
The new rules on derivatives accounting are similar to the U.S. Financial Accounting Standard Board's standard FAS 133, which provides that companies preparing U.S. GAAP-based financial statements--absent certain stringent criteria--must mark their derivative holdings to market and record the resulting gains and losses on a P&L statement.
"As a rule of thumb, U.S.-headquartered financial institutions are better prepared then their European counterparts, since they have had sufficient time to digest FAS 133," notes Jeremy Jensen, the London-based director of the IFRS conversion group at PricewaterhouseCoopers.
In both FAS 133 and IAS 39, for example, the gain or loss from a hedge transaction can be deferred only if there is formal documentation of the underlying instrument and the derivatives contract. Firms must also show that the hedge is "highly effective" in mitigating risk.
The two standards differ in one key way, however: FAS 133 allows for "short-cut effectiveness testing"; IAS 39 does not. Under FAS 133, a hedge transaction is deemed "effective" if it can be shown beforehand that the terms of the hedge and the underlying transaction will offset one another perfectly. IAS 39 requires a post-transaction evaluation of actual results in all cases.
For this reason, IAS 39 compliance will involve areas of the firm that may not be used to dealing with accounting issues. "The trading desk must link derivative transactions to initial transactions; risk managers must track exposures and test for effectiveness; and the back office will have to produce documentation," said Martin Boyd, director at SunGard Treasury Systems--a subsidiary of SunGard Data Systems--which introduced an IAS 39 compliant software package two years ago.
Indeed, record keeping was the hardest part of FAS 133 compliance for many U.S. regional and national firms. In a large global bank, data may be dispersed among offices in different corners of the world.
Because IAS 39 does not favor macro-hedging--a risk management process typically used by many banks--many hedges that make good sense from a risk management perspective will have to be treated as trading items, according to Hee Lee, a partner at the accounting firm of Ernst & Young in New York. In other words, whereas banks normally seek to reduce risk rather than eliminate it entirely, IAS 39 now takes the position that only hedges that eliminate risk can be recognized. The shift in perspective will introduce a significant degree of volatility into profit and loss statements.