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Extremely difficult to achieve perfect hedge effectiveness
May, 28th 2008

Thanks to the hullabaloo surrounding derivatives and accounting rules, the phrase successful hedging is fast becoming an oxymoron. Losses, even if notional, on account of hedges seem to suggest that it creates more damage than good. Is it really so difficult? An expert and author stands up in defence. No, having a hedge is not at all difficult. In fact most companies hedge their risk, i.e. they take actions to mitigate or offset the risk that arise from their activities. It is often extremely difficult to achieve perfect hedge effectiveness from an accounting perspective, says Ms Pooja Gupta, author of Financial Instruments Standards: A Guide on IAS 32, IAS 39 and IFRS 7 (, published recently. A Senior Financial Consultant, Country Finance - Projects, Standard Chartered Bank, Mumbai, she however cautions that many problems may arise when applying a technical theory to practical situations.

Excerpts from the email interaction in which Ms Gupta shares with Business Line her views on disclosures, embedded-derivatives, derecognition and lots more.

How important are disclosures in the derivatives issue? Do you believe that Indian accounting standards currently required for disclosures are best for companies, investors or both?

The disclosure requirements are focused on providing information that enhances a users understanding of the impact of financial instruments on a companys performance, its financial position and cash flows. The importance of disclosure requirements in the financial statements can be known from the fact there is a complete accounting standard IFRS 7 Financial Instruments: Disclosures dealing with just the disclosure requirements. Disclosures help the users of financial statements make more informed judgment about risk and return. IFRS 7 applies to both financial and non-financial companies.

The extent of disclosure required depends upon the extent of entitys use of financial instruments, and its exposure to risk. It is divided into two distinct sections. The first covers disclosures about numbers in the balance sheet and the income statement. The second deals with risk disclosures

The Institute of Chartered Accountants of India (ICAI) on May 16, 2008 issued AS 32 Financial Instruments: Disclosures which would be applicable to all (financial and non-financial) companies. This standard is modeled on IFRS 7 and there are no differences in both the standards. With AS 32 becoming mandatory (earlier application is encouraged!) in 2011 there would be improved disclosures of more meaningful and consistent information about risk exposures, valuations, off-balance sheet entities and related policies which in turn would augment market confidence and help people read financial statements to assess risk.

There is a lot of talk surrounding hedge accounting nowadays. By the very name of it, it has to be effective to be accounted as a hedge. Then, there are three hedge accounting models. Is having a hedge so difficult?

No, having a hedge is not at all difficult. In fact most companies hedge their risk, i.e. they take actions to mitigate or offset the risk that arise from their activities. It is often extremely difficult to achieve perfect hedge effectiveness from an accounting perspective. Many problems may arise when applying a technical theory to practical situations.

Hedge accounting enables gains and losses on the hedging instrument which are generally derivatives to be recognised in the same performance statement, and in the same period, as offsetting losses and gains on the hedged item i.e. the matching concept. This avoids much of volatility that would arise if the derivative gains and losses were recognised in the income statement, as required by normal accounting principles. In order to apply hedge accounting, strict criteria, including the existence of formal documentation and the achievement of effectiveness tests, must be met at inception and throughout the term of the hedge relationship. These criteria are onerous and have system implications for all entities. Hedge accounting is optional, and management should consider the costs and benefits when deciding whether to use it.

Hedge accounting can be applied to three types of hedging models; namely, fair value hedge (fixed rate debt converted to floating rate with an interest rate swap), cash flow hedge (floating rate loan converted to fixed rate with an interest rate swap) and hedge of a net investment in a foreign operation (entity having foreign operations can hedge the currency risk associated with the translation of the net assets of these foreign operations into the groups presentation currency).

IAS 39 is so crucial to accountants. Yet, the standard itself has left out accounting for financial liabilities. Why? We have seen companies hedge even liabilities (or, ensuing interest costs). Why is the standard so averse to debt?

Of all the pronouncements IAS 39 is the most talked about and controversial. It introduces the recognition and measurement of financial instruments and also covers hedge accounting. IAS 39 does not address accounting for equity instruments issued by the reporting enterprise but it certainly does deal with classification and accounting for financial liabilities (debt). IAS 32, Financial Instruments: Presentation deals with the critical issue of classification of an instrument as a liability or equity.

Concerns are raised about the complexities of the existing debt/equity model. In January 2008 the European Financial Reporting Advisory Group (EFRAG) published a discussion paper Distinguishing between Liabilities and Equity . Subsequently in February 2008 the IASB published a discussion paper Financial Instruments With Characteristics Of Equity and has put the liabilities and equity project on its active agenda. The recent amendment to IAS 32 dealing with puttable instruments shows that the standard setters are not averse to debt.

There is a lot of interest about the embedded derivatives. What are these and why are they so important?

Embedded derivatives are those instruments that are contractually attachable to what IAS 39 terms as host contract. A common example would be a convertible bond that has a host debt contract and an equity conversion option embedded within it. IAS 39 ensured that the requirement for mark-to-market of derivatives is not avoided by embedding a derivative into a financial instrument that is accounted for differently, either amortised at cost or revalued through equity.

The principle in respect of embedded derivatives is that the fact that a derivative is not a legally separate individual contract instrument should not prevent it from being accounted for in the same way as other stand-alone derivatives under the standard. The result of this is that in many circumstances, embedded derivatives must be separated from their host contract and accounted for in the same way as stand-alone derivative instrument.

Embedded derivatives do not only appear in financial instruments, they are also common in other contracts that might be outside the scope of IAS 39. The fact that host contract is outside the scope of the standard does not prevent the embedded derivative from being assessed under the requirements of IAS 39.

We have seen in the recent budget exercise, a term such as off-balance sheet item crop up many times. Corporates too can resort to de-recognition, we are told. How is this done? More importantly, why is this done? Are there any deterrents to stop mis-use?

Derecognition is the term used for the removal of asset or liability from the balance sheet. It is true that many corporates as well as banks resort to derecognition. They take part in the schemes that provide financing by selling portfolios of trade receivables, loans, etc. One of the objectives of such scheme is to provide finance that is off-balance sheet, i.e. the assets sold are removed from the balance sheet and funding provided is not recognised on the balance sheet. Examples are debt factoring, securitisation structures, etc.

IAS 39 lays down very stringent and detailed rules in this area focused on whether control of the contractual rights that comprise an asset has been transferred from the seller to buyer. It takes substance over form approach in determining control. The standard also covers rules for derecognition of financial liabilities including treatment of restructured loans.

In the Indian GAAP, however, there is no guidance available which addresses the accounting for special purpose entities (SIC 12: Consolidation Special Purpose Entities). The Indian AS 21: Consolidated Financial Statements while defining control lays a lot of emphasis on majority stake or majority representation at the board which is different from control as defined in IAS 27: Consolidated and Separate Financial Statements. Many derecognition structures use special purpose entities (SPEs), e.g. trusts, etc that have been set up only for acquisition of transferred assets. The companies in India, in the absence of IAS 27 and SIC 12 are not bound to follow the consolidation principles of SPE.

You have mentioned in your book that during the early nineties, accounting standards were not in sync with practices in the derivatives space. How has the situation changed today? Are they in sync today?

The book speaks of the long journey of the standard setters to develop the requirements of financial instruments. During the nineties the accounting standards did not keep pace with the market derivative activities. When the IASC Board, the predecessor of International Accounting Standards Board (IASB), voted to approve IAS 39 in December 1998, it noted that - at about the same time - the US had adopted new standards on derecognition, derivatives, and hedging, and that other countries did not have comprehensive standards on accounting for financial instruments. Consequently, the IASC Board recognised that there was little experience in applying principles similar to those in IAS 39 in most countries.

The situation has indeed changed from the nineties when derivatives were not recognised on the balance sheet, and the disclosure about the extent of derivatives use and risk management policies were minimal or none.

Prior to the issuance of Financial Instruments Standards, there was no comprehensive guidance addressing derivatives. IAS 39 introduced new requirements of marking derivatives to market, derecognition of financial instruments and hedge accounting. IFRS 7 and IAS 32 introduced the disclosure and presentation requirements. The adoption of IAS 39 is a monumental shift with a lot of financial instruments being treated as on balance sheet which were not there before. Financial Instruments Standards have survived the test of time.

Should authorities behind standards set them in such a way that it is often misinterpreted? What functions do implicit standards serve?

At this point I quite disagree that the standard-setters set standards in a way that is often misinterpreted. The standards may be complex but they are not loosely written. Recently the large firms published a White Paper Principle Based Accounting Standards discussed at the Global Public Policy Symposium in New York. It was acknowledged in the paper that neither a purely rules-based nor a purely principles-based system ever existed, or will ever exist. Each accounting standard will exist somewhere along the spectrum between rules and principles. The goal must be to seek the sweet spot on that spectrum.

As someone who has had loads of experience working with standards day in and day out, what has been your experience with standards?

As a professional working on IFRS, which are perceived to be more principles-based standards than the US GAAP, my experience has been that there is a greater reliance on sound professional judgment where clarification cannot constantly be sought from the standard-setter.

IFRS places more emphasis on the exercise of judgment providing reasonable assurance that the financial statements are fairly stated keeping in mind the users interest. The problem is some preparers, auditors, users, etc of financial statements want the comfort of a detailed rule book. For these, living with judgments will require something of a change in mindset.

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