Corporate treasurers have faced many a regulatory challenge before, and IFRS 13 is no exception. Deploying a compliant fair value methodology under this new standard has been causing many treasurers significant angst over the last few months. They are not helped by the plethora of mixed messages, confusing guidance and inconsistent treatment from various experts in the market. Reval, which already has been working under the US equivalent standard ASC 820 (FAS 157), is able to provide some practical insights gained through our experience in the US.
The calculation of fair value defined under IFRS 13 typically results in organisations needing to implement new fair value methodologies. The guidance itself is reasonably straight forward, as IFRS 13.9 defines fair value as: “The price that would be received to sell an asset or paid to transfer a liability in an orderly transaction between market participants at the measurement date.”
So, fair value must be calculated at an exit price, and the standard later confirms that that price must include the non-performance (credit) risk. As most ‘market participants’ in the derivatives space are banks, the initial interpretation of this requirement was that corporations should fair value their portfolio the same way banks price their trades. However, there are a number of issues with trying to mirror how banks price transactions, particularly in respect to the pricing of non-performance risk:
In general, corporations have very little visibility into their banks’ internal processes and margin levels. The Potential Exposure models tend to be proprietary and not replicable outside of the bank. It is also safe to assume that no two banks price the same transaction identically, given all of the variables in play. To this end, it would not be practicable for corporates to replicate each bank’s pricing methodology.
So on to Plan B: Although not replicating the bank’s pricing, corporates could adopt the same Potential Exposure methodology to recreate the general credit pricing approach in the market. The big challenge here is complexity. These models tend to be built and maintained by the bank’s team of quantitative experts who analyse the CVA outcomes, tinkering with credit inputs and market rate volatilities to approximate the most accurate assessment of credit risk.
The typical corporate finance or treasury function doesn’t have the internal expertise or technology to build such a model. Even if they were to purchase a vendor solution, many organisations would struggle to interpret the results and manage the ongoing assumptions required to make these models work. Auditors themselves have begun to recognise the increased operational risk such a complex model would bring in the hands of smaller treasury teams.
Furthermore, the majority of corporations need CVA and DVA adjustments per transaction, as hedge accounting is a per-deal–mechanism. Typically, Potential Exposure methods are portfolio-based measures that don’t translate well in transaction-level breakdowns.
That leaves us with Plan C: Corporates could move to a selection of simpler, easier-to-manage CVA and DVA calculation methodologies such as simplified duration and discount spread approaches. While these methods are not as sophisticated as the bank methodologies, they make up for that in being transparent, easier to understand and applicable to individual deals as well as portfolios. Reval’s discount spread approach has been tested across hundreds of clients for the last six years and will deliver robust credit adjustments for organisations seeking compliance with IFRS 13.
Caught between a bank and a hard place? Getting close enough to the bank, while maintaining a method that is easy to understand and deploy seems to be the best way out of this latest regulatory squeeze for corporate treasurers.
Reval recently asked corporations that apply IFRS across the globe their opinion on the latest IFRS 9 Review Draft. In particular, Reval wanted to know how they felt about the controversial treatment of hypothetical derivatives embodied in Paragraph B6.5.5. This paragraph currently outlines how hypothetical derivatives, and by implication the exposures themselves, cannot include elements that only exist in the hedging instrument, not the hedged item. Practically, the most obvious impact of such guidance is in forward foreign exchange rates which include a currency basis component, particularly for longer duration periods beyond one year.
The survey found that nearly 40% of respondents were not even aware of this specific guidance as it was never exposed during the consultation process the IASB conducted in compiling IFRS 9. In fact, it only came to light when the Review Draft was issued in September 2012, and even then, it was buried deep in the Application Guidance, not in the main body of the standard. It is not surprising, then, that so many of our respondents were taken aback when learning of how this would impact their financial results.
The most obvious impact of this guidance would be to an organization’s currency hedging programme. We wanted to get a sense of how significant this issue would be, so we asked respondents to quantify the impact of Paragraph B6.5.5. The results were stunning – over a third saw this impacting between 75 and 100 percent of their current hedging programme, and more than half of respondents saw an impact of 50 percent or more of their hedging programme. This implies that the change will have far reaching consequences for organisations, even if many of them were not yet aware that such guidance even exists.
When questioned further on what should happen prior to the final standard being issued, over 90% wanted the guidance either removed or amended. I think these results are indicative of what happens when you issue new guidance that has a significant impact to most organisations’ hedging programmes, with seemingly no due diligence on testing the issue with your constituency. We have already heard cases of organisations delaying their adoption timeline of IFRS 9as a result of this paragraph.
Fortunately, the IASB meeting on Friday 14th December mentioned the feedback the IASB received around this issue – in fact, it was IASB Chairman Hans Hoogervorst who indicated that he had reviewed the comment letters personally. The IASB Staff suggested that they will present three alternatives for the treatment of hypothetical derivatives in the IASB’s next meeting in late January. This is clearly a great result; the IASB has heard the concern of the 90 percent! However, it does mean that we will not see a standard issued by the beginning of 2013 as the IASB indicated back in September. They do expect to outline the plan for issuing the standard in their January meeting, so hopefully the delay will not be too long. I think most of us would take a delay of a couple of months if it means fixing this fatal flaw to a more palatable outcome.
In September this year, the International Accounting Standards Board (IASB) finally issued the Review Draft for Hedge Accounting, phase three of the replacement project for IAS 39 (under the banner of IFRS 9). Although this is not the final draft of the standard, the IASB do not expect any changes between now and the final standard to be issued in December 2012, bar any ‘fatal flaws’ identified over the next ninety days. The standard becomes mandatory in 2015 and early adoption is permitted.
The general feedback from the International Financial Reporting Standards (IFRS) community is that this standard represents a significant improvement on the existing, rules-based approach of IAS 39 – and it should. It was constructed after an unprecedented outreach programme across the IFRS constituency. The only issue is, a significant chunk of the global financial reporting community may never get to apply it.
Why? First, it seems that the IASB and the Financial Accounting Standards Board (FASB) simply cannot work together on the hedge accounting issues. IFRS 9 represents a significant departure from anything the FASB have in their current rules or with their proposed exposure draft that came out a couple of years ago. The FASB did expose the IFRS 9 Hedge Accounting Exposure Draft to their constituency for feedback, but they have made no commitments to incorporate these rules into their own FAS 133 / ASC 815 replacement project. It seems they can work together on impairment and classification and measurement, but hedge accounting is just in the “too hard” basket.
The IASB has not helped in this area with some of the guidance they have come up with. Take their treatment of hedge accounting for options for example. Most IFRS reporters under IAS 39 have looked on with envy at their US counterparts, for which the US GAAP treatment of options has resulted in significantly less P&L volatility than experienced under IAS 39, in most instances. Having heard these complaints of anti-option bias within IAS 39, you would think the easiest route for the IASB would be to adopt the US approach for option treatment and, in particular, the popular DIG 20 interpretation. This would address most of the concerns from their outreach programme and achieve convergence on this particular issue.
Alas it wasn’t to be. The IASB, in their wisdom, identified yet another alternative for option treatment, very different from IAS 39 and US GAAP. The new methodology embodied in the IFRS 9 Review Draft admittedly achieves the accounting outcomes most people felt were appropriate, yet it places another hurdle in the way of the FASB on their own path to convergence. It means existing processes and systems that work under IAS 39 and FAS 133 must be replaced with something new. To me, this is a classic example of principle overcoming pragmatism, which ultimately puts the convergence dream at risk.
And it’s not just the US we have to worry about. The EU has put off endorsing each element of IFRS 9 until the entire standard is available to assess, and this means that they must wait until the new impairment rules are finalized. Now, they may love the hedge accounting piece, but if the EU does not feel comfortable ratifying the new impairment guidance, the whole standard will not be passed for adoption within the EU. As such, EU countries will continue to work under their current version of IAS 39.
Where would this leave us? Well by 2015, we could be in a situation where three large chunks of the financial reporting community are working under different GAAP for their hedge accounting – specifically, the US, Europe and the rest of the IFRS community (including large parts of Asia Pacific and Canada). The compliance burden on global multinationals could be particularly significant in such an environment , let alone the lost comparability.
Hardly the dream of convergence set out in the Memorandum of Understanding jointly issued by the IASB and FASB and revised in 2008.