From US GAAP to IFRS – Treasurers Beware
by Sebastian di Paola, Partner and Michiel Mannaerts, Senior Manager, PricewaterhouseCoopers SA, Switzerland
As most readers will be aware, the accounting rules for financial instruments under IFRS originated from their US GAAP equivalent, FAS 133. This first version of IAS 39 nonetheless contained a number of significant differences compared to FAS 133, creating difficulties for foreign private issuers (FPI) which reported under both IFRS and US GAAP. Some of these differences have been eliminated over time; however, new differences have gradually been created through changes to both standards, and through evolving interpretation.
Some context from the US: a year after the November 2007 SEC vote to accept IFRS financial statements submitted by FPI’s without a US GAAP reconciliation, the SEC published a “Roadmap for the Potential Use of Financial Statements Prepared in Accordance with IFRS by US Issuers”. This Roadmap sets forth several milestones that, if achieved, could lead to the required use of IFRS by US issuers in 2014. As part of the roadmap, the SEC is proposing amendments to rules & regulations which, if adopted, would allow a limited number of US issuers to file IFRS financial statements for fiscal years ending on or after 15 December 2009.
Treasurers need to pay attention to the impact of any potential accounting standards conversion on their treasury activities, as longer dated hedges, being put in place now, may be affected.
This development clearly has significant implications for US treasurers. Alongside this process, a number of companies in Europe currently using US GAAP are also considering converting to IFRS. Treasurers need to pay close attention to the impact of any potential accounting standards conversion on their treasury activities, as longer-dated hedges, being put in place now, may be affected. Companies should not assume that accounting for financial instruments under IFRS is the same as US GAAP, as significant differences exist. It is also simplistic to summarise IFRS as more principles-based and hence more lenient than US GAAP, or vice versa. In some areas IFRS offers more flexibility and hence new opportunities, whereas in other areas IFRS is comparatively more complex.
This article highlights some of the key differences with respect to hedge accounting of which treasurers need to be aware. In particular, we focus on the areas of treasury centre netting, risk designation, effectiveness testing, hedging with options and net investment hedging. Further significant differences exist with respect to classification and measurement of financial assets and liabilities, impairment of financial assets, derecognition, derivatives and embedded derivatives, but these are outside the scope of this article.
Treasury Centre Netting
Treasury Centre Netting has long been a major area of debate under both the US and international frameworks. Initially neither IFRS nor US GAAP allowed hedge accounting for hedges on a net basis through a treasury centre. However, following intense pressure from the many corporates with centralised treasuries, FAS 133 was amended by FAS 138 in June 2000 to permit hedge accounting, provided that the treasury centre met specific criteria. IFRS on the other hand, having been initially somewhat vague on this point, was clarified in 2005 to explicitly exclude hedge accounting for net hedges through a treasury centre. These changes have created a situation where IFRS is more restrictive than US GAAP. Corporates reporting under IFRS and various treasury associations have been lobbying the IASB to address this issue for many years, with little success. For companies converting from US GAAP, this would result in a very significant change.
More specifically, FAS 133 allows the designation of intercompany FX derivatives entered into with another member of the group (the treasury centre) as hedging instruments in the consolidated books if that other member has entered into an offsetting contract with an unrelated third party. The FAS 138 amendment allows hedge accounting for intercompany FX derivatives under specific conditions:
- Netted internal derivatives must involve the same currency and mature within the same 31 day period
- Third party derivatives must mature within the same 31 day period and must be entered into within 3 days of designation of the internal derivative as a hedging instrument
- Third party gain/loss must closely approximate the aggregate or net loss/gain on the internal contracts
- The company cannot alter the 3rd party derivative unless this is initiated by the subsidiary.
Essentially, this involves the treasury centre fully laying off the exposure externally and not holding the position. Whilst these rules are somewhat restrictive, they remain workable for most centralised treasuries, although companies reporting under US GAAP have had to make some change to their FX hedging procedures.
Although under IAS 39, netting is not allowed and use of internal or inter-company derivatives as hedging instruments is prohibited, IAS 39 points out the “loophole” which can be used to avoid these constraints, which is to designate an appropriate portion of the gross exposure. For example sales of EUR 100 and purchases of EUR 80 would result, for hedge accounting purposes, in a hedge of sales of EUR 20. Companies can hedge the gross exposures externally, although this significantly increases the transaction volume and costs. Net hedging with allocation to a portion of the gross exposure results in residual volatility in results, as the offsetting cash flows (EUR 80 purchases and sales) may have a different timing in terms of P&L recognition and will have different P&L geography. Therefore, individual sales and cost of sales lines are not properly immunised from the effects of foreign currency moves in spite of being hedged economically.