By Joseph Neu
As noted in our Latest Intelligence posting on December 27, the IASB is pushing hedge accounting in a new direction with the release of its Exposure Draft (ED) on the overhaul of IAS 39. Digging further into the commentary of Matthew Daniel and Hector Lugo of Citi’s Corporate Solutions Group FX team, it seems that the language in the ED reflects an on-going effort by the IASB staff to proscribe approaches to risk management via new guidance on hedge accounting.
Not exactly flourish
With this in mind, hedging may not be actually allowed to flourish under the new IASB approach as was suggested in our online post. Again, reading the “Basis for Conclusions” that accompanies the ED, the IASB tries to argue that it split the difference between 1) allowing hedging, or risk management context to drive financial reporting and 2) mitigating the recognition and measurement anomalies, and timing differences, between accounting for hedges (often derivatives) and the items being hedged.
Relatively speaking, leaving room for risk management, rather than seeking to eliminate hedge accounting anomalies on the path to a full fair value approach, is a positive. And in large part, as Messrs. Daniel and Lugo have noted, this is due to the considerable outreach efforts the IASB staff made to understand constituent concerns and the practical difficulties of applying hedge accounting. This outreach apparently made them true believers in hedging.
Indeed, Messrs. Daniel and Lugo have noted that “in a real sense, the IASB Staff consider it their mission to transform risk management and allow it to evolve to a higher level.”
Unfortunately, the IASB accounting standard setters, like most rule-makers, tend to want you to adhere to their preferred way of doing things in order to be permitted to do them. As the Citi advisors noted in an earlier report: “In many ways, the proposed rewriting of IAS 39 looks like nothing more than a series of explicit rules as the IASB Staff searched for ways to steer the application of the guidance in a direction that they felt appropriate.”
One example cited by Messrs. Daniel and Lugo is the apparent fixation with hedging being an effort to lock-in a position above or below a certain price, i.e., hedging a “one-sided risk.” Accordingly, the flexibility offered by a lower threshold for hedge effectiveness (found both under the IASB‘s and the FASB’s new proposal) is marred by the need to compare the performance of even an exotic option against the plain-vanilla hypothetical. This would limit more esoteric hedging strategies from the benefits of hedge accounting.
Forgetting First Principles
In the end, the IASB’s fascination with their own efforts to shake things up, in the Citi commentators’ view, has put the IASB on a path tantamount to a rules-based approach and led them to abandon their principles-based ideals.
Guiding hedgers to better risk management via accounting rules should not be the IASB’s mandate and it would be a step backwards that is unlikely to end well (see FAS 133, as an example).
Messrs. Daniel and Lugo also point out that the breadth of the IASB’s reach will further complicate how accountants apply the new hedge accounting requirements consistent with hedging practices in their own jurisdictions. These sorts of unintended consequences bring the Citi commentators in line with the dissenting view of IASB board member John T. Smith.
Per the “Basis for Conclusion” accompanying the ED, Mr. Smith does not support the substantial reliance on risk management “because risk management is not defined, it has no boundaries and is not applied uniformly.” This is why hedge accounting was better left as an exception to the rule. Attempting to promote risk management through accounting, furthermore, undermines efforts to simplify financial reporting and leads to provisions such as many in the ED that “are not operational, lack rigour and would produce unintended consequences.”
Thus, the IASB Staff will be tempted to rule further in response to auditor questions, operational challenges and to fix unintended consequences. And this temptation will only grow as IFRS accounting is adopted in more and more diverse places around the world.