ISDA Workshop The practical implications of the new accounting rules

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

• 24 January 2005

2

• Standards 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, Ladeguamento colpisce ali oneri (Sole 24
Ore Jan)
Les nouvelles normes comptables, frien
potential aux introductions en Borse (Les Echos,
Jan)
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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)

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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 entitys 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
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The measurement categories

• IAS 39 includes an option to designate ANY
  financial instrument at fair value at inception

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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

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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

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Consolidation and Derecognition

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

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Presentation

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

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IFRS Analysis and Impact
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The measurement categories
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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

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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

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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

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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

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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

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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 transferors consolidated group,
  including SPEs if consolidated
• Mixed model, based on both risks and rewards and
  control.

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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

t derecognise
Don

t derecognise
to pass through cash flows?
Yes
Yes
Derecognise
Derecognise
Has entity transferred substantially all
risks/rewards?
No
Yes
Don

t derecognise
Don

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
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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

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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

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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