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Old 08-23-2009, 08:20 PM   #1 (permalink)
Fegu's Avatar
 
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Join Date: Jun 2009
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Post Hedge Accounting

International Accounting Standard 39 (IAS 39) is the part of the International Financial Reporting Standards (IFRS) which relates to financial instruments, derivative transactions, and hedging activities. These standards have been adopted by publicly listed entities in most parts of the world since 2005, including the EU and the UK. In the USA, FAS 133 and its related literature governs the accounting for derivatives and hedging activities.

While many of the principles of FAS 133 and IAS 39 are similar with respect to hedge accounting, material differences exist between the two standards.

According to IAS 39, all derivatives are to be reported at ‘fair value’ (i.e. current Mark-To-Market) on the Balance Sheet as assets or liabilities, separate from the items they are hedging. In certain cases, however, derivatives can qualify for ‘Hedge Accounting’ which corrects the Income Statement timing mismatch that would otherwise arise from carrying derivatives at fair value. This is achieved by changing the timing of recognition of gains and losses on either the hedged item or the hedging instrument.

Changes in fair value of derivatives not qualifying as ‘hedges’ have to be recorded in the Income Statement in each reporting period in which changes occur, which can lead to significant volatility in the Income Statement.

Two key points regarding IAS 39 / FAS 133 are worth emphasizing:

1. The accounting rules do not prohibit the trading of any kind of product or instrument.
2. The change in MTM of all derivatives is always reported.

Volatility in the Income Statement vs. Volatility in the Balance Sheet

When valuing companies, equity analysts generally focus on earnings more closely than changes in asset values. For this reason companies will seek to minimise volatility in earnings (reported in the Income Statement) over reducing Balance Sheet volatility.

Some Definitions

Fair value
Fair value is defined in IAS 39 as “the amount for which an asset could be exchanged, or a liability settled, between knowledgeable, willing parties in an arm’s length transaction.”

Income Statement
Income - Expenses = Net Profit (covers a defined reporting period)

Balance Sheet
Assets - Liabilities = Net Equity (snapshot at a single point in time)

What is the purpose of these accounting requirements?

The aim of the IAS 39 and FAS 133 accounting requirements is to increase the transparency of financial reporting and to make it more difficult to disguise ‘speculative trading’ as hedging.

The Difference Between IAS 39 and FAS 133

One of the main differences between IAS 39 and FAS 133 is that under IAS 39 only the intrinsic value of an option designated as a hedge qualifies for hedge accounting. Changes in the time value must always be recorded on the Income Statement. This requirement was introduced to IAS 39 in the July 2008 amendment and is effective for reporting periods beginning on or after 1 July 2009. Under FAS 133 both the intrinsic value AND the time value of an option may be designated for Hedge Accounting.

The criteria for hedges to qualify for hedge accounting treatment are:

1. The item to be hedged and the hedge itself must be fully documented.
2. The hedge must be 80-125% effective.
3. Effectiveness must be assessed periodically, retrospectively and prospectively.
4. For cash flow hedges the forecasted transaction must be highly probable. ‘Highly probable’ is not specifically defined in IAS 39, however it can be interpreted to mean ‘significantly more likely than not’.
5. It must be possible to reliably measure the effectiveness and fair value (i.e. the MTM) of the hedge.
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