A V Rajwade: Accounting for problems

The new methods of standardised international accounting have some issues to be cleared

The lengthy and laborious efforts of the International Accounting Standards Board (IASB) to harmonise accounting standards across the globe have at last seen fruition.

Companies reporting accounts in conformity with the International Financial Accounting Standards (IFRS) accounts from Beijing to Buenos Aires will be comparable to each other, permitting the investor to readily compare, say, Posco's accounts with Mittal Steel.

The European Union has made IFRS mandatory for all listed companies effective January 1, 2005. (To be sure, the EU authorities have made an exception in the case of IAS 39 about derivatives""more on this later in the article.)

A hundred countries have already agreed to adopt IFRS and the US GAAP would also be harmonised with IFRS, hopefully by 2007. India too will have to follow suit sooner or later.

In a way, IFRS is a corollary to the globalisation of capital.

While generally the move has been welcomed, in the short run, the new standards are expected to lead to several issues and questions. Some of the more important ones:

IFRS removes the automatic amortisation of goodwill in companies' books. However, the actual outstanding amount would be subject to annual "impairment reviews".

The result will be that there would be uncertainty about the year-to-year goodwill charge on the profit and loss account, leading to greater volatility of reported profits.

IFRS also requires the amortisation of the fair value of employee stock options, over the vesting period. US GAAP is also making a similar change despite protestations from IT and media companies that the change will affect their ability to attract talent by offering stock options.

The difference between the market value of corporate pension fund assets and the present value of the estimated pension liabilities, would need to be carried to the balance sheet (a similar practice is already there in the UK and US but has now been incorporated in IFRS).

There are also worries that the new standards may lead to breach of covenants entered into by companies as part of their credit packages.

There are questions about tax implications of IAS 39 rules about fair value accounting of derivatives, particularly for special purpose vehicles (SPVs).

In fact, it is the question of accounting for derivatives and its impact on reported profitability that has proved to be the most controversial part of IFRS.

Lobbying, particularly by banks and other financial intermediaries, against the acceptance of IAS 39 in the present form, was so strong that the European Commission was forced to allow member countries to adopt IAS 39 minus the controversial rules.

IAS 39 is a close parallel to FAS 133, which has been adopted for use in the United States since 2002""and seems to be a concession to the US to persuade it to conform to IFRS.

In the process, many Europeans feel that the pendulum has swung too far towards rule-based, as distinct from principles-based, accounting standards.

But the major point at issue is the hedge accounting rules for derivatives. Before looking at the issue involved, it is as well to distinguish between fair value and cash flow hedges, a distinction which both FAS 133 and IAS 39 make.

As the two terms signify, derivatives used as fair value hedges are used as a protection against adverse price fluctuation of an asset. For instance, the holder of a bond may be worried about rising interest rates and its impact on its market value, and may hedge the risk in the futures market.

There are not too many problems on accounting treatments of such fair value hedges, other than the issue of hedge effectiveness criteria.

IFR standards have prescribed stringent rules on the subject (in our own case, the RBI has prescribed hedge effectiveness standards for futures transactions undertaken by banks to hedge their bond holdings).

In the case of fair value hedges, whether the holder marks to market both the hedge and the underlying, or neither, as permitted, leaves the bottom line substantially unaffected.

Such is not however the case in respect of cash flow hedges and their treatment as required by IAS 39. Cash flow hedges are intended to protect the cash flows of an entity from changes in market prices.

A simple illustration may help clarify the issue. Consider that a financial intermediary has borrowed 5-year funds at LIBOR-based interest rates, and used the money to fund a fixed-rate loan.

Clearly, the intermediary is running an interest rate risk as the cost of funds will fluctuate with market interest rates, while the income from the loan remains unchanged.

To hedge the risk, the intermediary enters into an interest rate swap: receive LIBOR, pay fixed. With this swap, he has eliminated the interest rate risk and can expect steady cash flows from the transaction (barring of course credit risk issues).

Consider, however, what would happen if he is required to mark the interest rate swap to market and provide the difference in his books. If interest rates fall, the derivative contract will have a negative value and the difference will have to be provided.

On the other hand, the intermediary is unable to revalue the loan in his books (because it is not a traded instrument): such revaluation, if possible and permitted, would have offset the effect of mark to market of the swap.

The problem becomes much bigger if you consider the case of a financial intermediary like a commercial bank, having a large number of deposits and loans and gaps in the interest rate book.

In the normal course, it may like to use the interest rate swap market to hedge the gaps, fully or partially. Moreover, the portfolio of deposits and loans would keep changing continuously and cannot be static through the life of the swap.

In these circumstances, if the rule requires the swap to be marked to market, but there is no way to do so in respect of the portfolio of assets and liabilities, this can lead to a great deal of volatility in the year-to-year reported profit of the bank.

No wonder the banking system in Europe lobbied hard to get IAS 39 changed. In March last year, the IASB went some way towards modifying IAS 39 to address the concerns expressed by the banks.

It has also promised to continue further discussion on the subject to arrive at a mutually satisfactory solution. Not satisfied with the changes made, banks lobbied the European Commission hard for not accepting IAS 39 even in the amended form.

The result has been the adoption by the European Union of IAS 39 in a truncated form. To be sure, major banks like HSBC and Barclays have announced that IAS 39 would not make a significant difference to their accounts.

The worries of bankers are not just theoretical as the cases of the two giant housing finance companies in the US, and their problems with FAS 133, illustrate (see World Money, May 17, 2004).

Indeed, given the rigidity of the rules, concerns are being expressed whether the accounting treatment of hedges, and not their economic justification, would govern corporate decisions! That would indeed be a case of the proverbial tail wagging the dog!

avrco@vsnl.com