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ISDA Workshop – The practical implications of the new accounting rules

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  1. ISDA International Swaps and Derivatives Association, Inc. ISDA Workshop – The practical implications of the new accounting rules 24 January 2005

  2. “Standard’s rules may obscure the true picture” (FT,Jan) “Companies “face hedging errors” (FT, Dec) “IFRS für alle? - Viele Mittelständler zögern noch” (Handesblat, Jan) “Rule changes put Vodafone in the black” (Evening Standard, Jan 05) “IAS, L’adeguamento colpisce ali oneri”(Sole 24 Ore Jan) “Les nouvelles normes comptables, frien potential aux introductions en Borse” (Les Echos, Jan)

  3. IFRS and their significance • What are IFRS and where do they come from? • Importance in the short term • (i) EU adoption • (ii) Rest of the world • (iii) Local GAAP convergence • Long term significance • (i) FASB/IASB Convergence project • (ii) SEC/US Senate • (iii) Impact on local GAAP (influence on FASB)

  4. IFRS – Key standards for financial instruments accounting IAS 39: - Recognition and measurement of financial assets and liabilities; - Treatment of certain other non-financial items eg, commodity contracts; - Derecognition of financial assets and liabilities IAS 32: - Presentation of financial instruments from the perspective of the issuer; - Provides detailed rules covering netting; - Requires disclosures to enable a user to understand significance of financial instruments to an entity’s financial position SIC 12: -Consolidation of Special Purpose Entities IFRS 4: - Insurance contracts IAS 37: - Provisions, contingent liabilities and contingent assets ED-7: - Financial Instruments: Disclosures

  5. The measurement categories • IAS 39 includes an option to designate ANY financial instrument at fair value at inception

  6. Hedge accounting • Since all derivatives need to be recorded at fair value, but items they “hedge” may not • Extremely complex • Based on US GAAP but not the same

  7. Fair Value Measurement • Defined as: “The amount for which an asset could be exchanged, or a liability settled, between knowledgeable, willing parties in an arms length transaction” • It is not the amount that an entity would receive or pay in a forced transaction or distressed sale • Active v non-active markets • Includes assessment of credit

  8. Consolidation and Derecognition • Significant differences from the previous IAS 39 and US GAAP • Risks and rewards are given more weight than control

  9. Presentation • IAS 32 rules are different from US GAAP • Debt v equity • Derivatives on own equity • Offset rules

  10. IFRS: Analysis and Impact

  11. The measurement categories

  12. The measurement categories • Increased volatility of earnings and equity • As with US GAAP, banned from using HTM if sell or reclassify, but with two year limit • IAS 39 includes an option to designate ANY financial instrument to be held at fair value through profit or loss at inception • But resistance from banking regulators. European Union has forbidden such designation for liabilities • IASB has issued ED and now new proposals to restrict the option, to try to placate regulators and the EU • Rules on embedded derivatives similar to US GAAP, with no “grandfathering”

  13. Hedge accounting – similar to US GAAP • Originally based on FAS 133 • Similar need to designate, demonstrate effectiveness and document • Similar restrictions on what can be treated as a hedge and what can be hedged • Similar concepts of fair value hedge and cash flow hedge • Leading to p/l volatility where hedge fails to qualify for hedge accounting or ineffectiveness, and equity volatility for cash flow hedges

  14. Hedge accounting – differences from US GAAP • No “short cut” method. Need instead to demonstrate effective and record ineffectiveness • But allowed to hedge a “component”, eg LIBOR risk on debt without necessarily any ineffectiveness • Items can be hedged for part of their term under IAS 39 • Wider use of non-derivative assets and liabilities as FX hedges • Macro hedging models – both cash flow and fair value – but not possible to include demand deposits in fair value macro hedge. Opposition led to EU “carve out” of constraints on fair value macro hedging. Discussions continue • Intragroup FX hedges – still under debate

  15. Fair Value Measurement • Active markets –where “quoted prices are readily and regularly available” and “represent actual and regularly occurring market transactions” • Must use quoted price • Allows for valuation on a portfolio basis • Other reserves necessary to adjust to fair value are acceptable (with the exception of block discounts) • Markets with quoted rates are considered active, even though rates are an input to a model

  16. Fair Value Measurement (cont) • Non-active market – models that are commonly used by the market are considered appropriate for valuing financial instruments • “Day one profit” can be recognised only if all inputs to a model are observable in the market – similar to US EITF 02/03, but choice of transition date • Fully retroactive • 25 October 2002 • 1 January 2004 • IASB has so far not given significant guidance on when day one profit can subsequently be recognised

  17. Consolidation and Derecognition Consolidation Principles (SIC 12) • An enterprise should consolidate enterprises it controls • Control of SPEs is determined by considering • Who benefits • Who has the control to obtain the majority of the benefits • Who has the majority of the risks and rewards • This is not the same as FIN 46 • There is no concept of a “Q” Derecognition Principles (IAS 39) • Applied to transferor’s consolidated group, including SPEs if consolidated • Mixed model, based on both risks and rewards and control.

  18. Consolidation and Derecognition Consolidate subsidiaries (including SPEs) No Yes Has entity transferred its right to receive cash flows? No Has entity assumed obligation No Don Don ’ ’ t derecognise t derecognise to pass through cash flows? Yes Yes Derecognise Derecognise Has entity transferred substantially all risks/rewards? No Yes Don Don ’ ’ t derecognise t derecognise Has entity retained substantially all risks/rewards? No No Has entity retained control of the assets? Derecognise Derecognise Yes Continue to recognise the assets to Continue to recognise the assets to IAS 39 AG36 extent of continuing involvement

  19. Consolidation and Derecognition • There are no “grandfathering” rules for SIC 12 • Many securitisations, including most securitisations of short term assets will not achieve “off balance sheet” presentation • Otherwise, derecognition rules do not need to be applied to transactions pre 1 January 2004

  20. Presentation – Debt v Equity • Many instruments that are equity in legal form are treated as liabilities under IAS 32– eg most preference shares, and many fund units • Some instruments have both a liability and equity component – eg convertible bonds. The fair value of the liability is initially recorded in the liability section of the balance sheet and the “plug” in equity • Complex rules for derivatives on own shares

  21. Presentation –Netting • Financial assets and liabilities may only be offset in the balance sheet when there is both: - a legal, enforceable right of set-off; and- an intention to exercise the right or settle simultaneously • An ISDA master agreement will not meet these criteria if the set-off rights are contingent upon default or other circumstances expected to arise outside of the normal course of business • This treatment is not consistent with US GAAP, where master netting agreements such as an ISDA are explicitly allowed for netting purposes, even if the netting would only be done upon a contingent event