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Thursday, January 27, 2011

The tail wagging the horse-how hedge accounting impacts business decisions.

Hedge accounting under IAS-39(the financial instruments omnibus standard under IFRS) mainly aimed at curbing chances for earnings management, and so had tight 'bright line' rules. Like all rules enforced without discretion, this rule also affected genuine transactions. When the clamour from industry became too loud to be ignored, IASB(the standard setter under IFRS) had to consider revising the whole gamut of rules. The example given by IASB here is quite eye opening.

Consider an entity that hedges foreign currency risk on a net basis. It has a foreign currency sale of FC100 and purchase of FC(80). It would usually  hedge the net exposure FC20, but under IAS-39, you need to designate a specific instrument. Now, the entity has 3 options

  1. Artificially split the sale contract of FC 100 into FC80 and FC20(hedging FC-20). This can be accounted but does not represent the 'substance' of hedging the net transaction
  2. Even (1) is not possible when maturity mismatches occur
  3. Enter into two equivalent forwards whose net value is 20
The CFO of any entity would like to avoid the added earnings volatility from option (1)/(2) and so would go for the economically wasteful option of entering into two partially offsetting gross forward contracts(business decision) to match the amount and timing of the hedged items (eg one forward for FC(100) and one forward for FC80). This would allow an entity to apply hedge accounting on a gross basis and present both transactions as hedged.

The options accounting under IAS-39 discussed in an earlier post also prompts using other non-efficient instruments to achieve the desired result.

Impact This may make banks happy but the corporates spend more. Secondly, and maybe more importantly, the capital markets are boosted by 'false'\'economically unnecessary' transactions. Making markets efficient by such means are avoidable.

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