IAS 3239 What has EACT done so far

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IAS 32-39What has EACT done so far ?

• F. Masquelier
• EACT Meeting
• Milano, May 24th , 2003

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Aims of EACT on IAS 39

• To inform our members
• To lobby IASB in order to propose ACTs comments
  issues
• To comment E.D. of June 2003
• To participate to Roundtables on ED
• To further promote E.A.C.T. within the financial
  community

IAS 32-39 remains a very hot topic for corporate
treasurers
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Reminder on IAS 39

• IAS 39 issued in 1999
• Application 1st January 2001
• E.D. issued in June 2002
• Comments welcomed before Octobre 2002
• Roundtable in March 2003
• E.D. final / second E.D. (?)

The Banks are lobbying to ease E.D. and to
postpone IAS (39) enforcement
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The Roundtables of March

• E.A.C.T. represented by F. Masquelier
• 155 comment letters received
• 108 invitees to Roundtables Session in Brussels
  London
• Expectations elephant giving birth to a mouse
  ?
• Banks positions ?? corporate treasurers position

Banks made more fuzz than treasurers about it !
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Press release of E.A.C.T.
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Summary of Meeting with I.A.S.B.(John Smith,
Board Member)London - April 23, 2003

• F. Masquelier

Presentation made with PwC
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Goal of the Meeting with IASB

• To meet John Smith, Board Member of IASB, in
  charge of IAS 32-39 Exposure Draft (ED)
• To make further lobbying with some corporates
  in order to re-insist on major issues for
  corporate treasurers.
• To have more time (than at Roundtable Sessions)
  to focus on (FX) hedging issues and to detail
  corporate concerns.
• To anticipate final draft (knowing that a second
  (ED) is planned in the coming months following
  strong lobbying from banks and bank federations)

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Achievements of E.A.C.T.

• We have explained in detailed (cf. next slides -
  Treasurers major issues).
• J. Smith has understood better treasurers
  concerns although we could not really say whether
  those will be taken into account in final
  version.
• We will prepare few examples on Treasury Netting
  Centre (with PwC) in order to better address
  specific situations.
• We now have created a direct contact to one of
  the most influent Board Members for IAS 32-39.

It will be very tough to ease I.A.S.B. position !
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List of attendees to lobbying meeting

• Sebastian di Paola Pauline Wallace
  PricewaterhouseCoopers
• Jon Boyle ACT
• Timo Thamuotila Nokia
• François Masquelier E.A.C.T.
• David Blackwood I.C.I
• John Smith and two assistants I.A.S.B.

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Contents

• Treasury Centres Netting
• Use of Treasury Centres for centralised FX
  hedging
• IAS 39 paragraphs 133 and 134/126B
• Alternatives now available to companies using
  Treasury Centre hedging
• IGC QA 134-1-b
• Situation under US GAAP (FAS 133 as amended by
  FAS 138)
• Summary and proposed alternative solution
• Prospective testing (almost full offset)
• Adjustments in cash flow hedges
• Hedging of FX denominated firm commitments
• Interest rate hedging by corporates

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Centralised FX Hedging most common approach
adopted by multinationals

• Benefits of this approach
• Saving spread by benefiting from natural hedges
• Operational and internal control efficiency
• Single face to the market

Companies designation of hedge relationships
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IAS 39 paragraphs 133 and 134 (ED - 126B)

• 133. Because hedge effectiveness must be assessed
  by comparing the change in value or cash flow of
  a hedging instrument (or group of similar hedging
  instruments) and a hedged item (or group of
  similar hedged items), comparing a hedging
  instrument to an overall net position rather than
  to a specific hedged item (for example, the net
  of all fixed rate assets and fixed rate
  liabilities with similar maturities), does not
  qualify for hedge accounting. However,
  approximately the same effect on net profit or
  loss of hedge accounting for this kind of hedging
  relationship can be achieved by designating part
  of the underlying items as the hedged position.
  For example, if a bank has 100 of assets and 90
  of liabilities with risks and terms of a similar
  nature and wishes to hedge the net 10 exposure,
  it can designate 10 of those assets as the hedged
  item. This designation could be used if such
  assets and liabilities are fixed rate
  instruments, in which case it is a fair value
  hedge, or if they are both variable rate
  instruments, in which case it is a cash flow
  hedge. Similarly, if an enterprise has a firm
  commitment to make a purchase in a foreign
  currency of 100 and a firm commitment to make a
  sale in the foreign currency of 90, it can hedge
  the net amount of 10 by acquiring a derivative
  and designating it as a hedging instrument
  associated with 10 of the firm purchase
  commitment of 100.
•  
• 134/126B. For hedge accounting purposes, only
  derivatives that involve a party external to the
  enterprise can be designated as hedging
  instruments. Although individual companies
  within a consolidated group or divisions within a
  company may enter into hedging transactions with
  other companies within the group or divisions
  within the company, any gains and losses on such
  transactions are eliminated on consolidation.
  Therefore, such intra-group or intra-company
  hedging transactions do not qualify for hedge
  accounting treatment in consolidation.

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Treasury Centre - Hedging on a Net Basis
Exchange Rate 1 FC / 1 EUR
Treasury Center EUR Functional Currency Net
Exposure is 55 million Forecasted FC Receivable
Sell 55 million FC
Derivatives Dealer
Buy 55 million EUR
Hedge
Hedge
Hedge
Points 1. All foreign subsidiaries could apply
hedge accounting in their stand-alone financial
statements 2. TC cannot apply hedge accounting
in its stand-alone financial statements 3.
Consolidated entity could not apply hedge
accounting under this structure due to paragraph
134 4. Alternatives A. Can correct by having
the TC treat FC exposures gross and entering into
separate contracts with the derivative dealer B.
TC can enter into one contract with the dealer
for 55 million and allocate that contract down to
part of subsidiary As exposure
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Alternative A Gross external hedges
Exchange Rate 1 FC / 1EUR
Treasury Center
Derivatives Dealer
Contract 2
Sell 75 million EUR
Buy 75 million FC
Buy FC 30 million
Sell FC 75 million
Buy EUR 75 million
Sell EUR 100 million
Buy FC 100 million
Sell EUR 30 million
Foreign Subsidiary A Exposure 100
million Forecasted FC Receivable
Foreign Subsidiary B Exposure 75
million Forecasted FC Payable
Foreign Subsidiary C Exposure 30
million Forecasted FC Receivable
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Alternative B Allocating external hedge to an
exposure
The 3rd party FX fwd is designated as a hedge of
60 of the USD forecast exposure in Sub C, which
results in the deferral of gains and losses on
the FX fwd in equity in consolidated financial
statements
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Analysis of Alternatives

• Alternatives A
• Pro Reflects economic reality (as compared to
  B)
• Cons
• Dramatically increases the spread paid to
  external counterparts
• Significantly increases operational risk
• Alternatives B
• Pro Avoids spreads in A
• Cons
• Does not reflect economic reality (increase in
  operational risk due to additional layer of IAS
  39 hedges)
• Assumes other exposures are natural hedges of
  each other (not necessarily true eg due to
  differing PL timing)

-
-
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OFFSET OF NET FOREIGN CURRENCY EXPOSURES
IAS 39 Paragraphs 133 and 134 (126B in the
Exposure Draft)

• IAS 39 does not allow designation of a third
  party derivative as the hedge of a net exposure gt
  netting is not allowed long and short foreign
  currency exposures have to be hedged separately
  ( 133)
• IAS 39 does not authorise the use of internal or
  intercompany derivatives as hedging instruments
  (134 - ED 126B)
• "For hedge accounting purposes, only derivatives
  that involve a party external to the enterprise
  can be designated as hedging instruments.
  Although individual companies within a
  consolidated group or divisions within a company
  may enter into hedging transactions with other
  companies within the group or divisions within
  the company, any gains and losses on such
  transactions are eliminated on consolidation.
  Therefore, such intra-group or intra-company
  hedging transactions do not qualify for hedge
  accounting treatment in consolidation."

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IGC QA 134-1-b Full Text

• Offsetting internal derivative contracts used to
  manage foreign currency risk
• If a central treasury function enters into
  internal derivative contracts with subsidiaries
  and various divisions within the consolidated
  group to manage foreign currency risk on a
  centralised basis, can those contracts be used as
  a basis for hedge accounting in the consolidated
  financial statements if, before laying off the
  risk, the internal contracts are first netted
  against each other and only the net exposure is
  offset by entering into a derivative contract
  with an external party?
• It depends. As discussed in Question 134-1-a,
  the accounting effect of two or more internal
  derivatives that are used to manage interest rate
  risk at the subsidiary or division level and that
  are offset at the treasury level is that the
  hedged non-derivative exposures at those levels
  would be used to offset each other in
  consolidation. There is no income statement
  impact if the internal derivatives are used in
  the same type of hedge relationship (that is,
  fair value or cash flow hedges) because the gains
  and losses reported in net profit or loss or in
  equity will offset in consolidation. There may
  be an income statement impact if some of the
  offsetting internal derivatives are used in cash
  flow hedges, while others are used in fair value
  hedges.
• Provided that the internal derivatives represent
  the transfer of foreign currency risk on
  underlying non-derivative financial assets or
  liabilities, hedge accounting can be applied
  because IAS 39.122 permits a non-derivative
  financial asset or liability to be designated as
  a hedging instrument for hedge accounting
  purposes for a hedge of a foreign currency risk.
  Accordingly, in this case the internal derivative
  contracts can be used as a basis for hedge
  accounting in the consolidated financial
  statements even if they are offset against each
  other.
• However, any cumulative net gain or loss on an
  internal derivative that has been included in the
  initial carrying amount of an asset or liability
  under IAS 39.160 (basis adjustment) would have to
  be reversed on consolidation if it cannot be
  demonstrated that the offsetting internal
  derivative represented the transfer of a foreign
  currency risk on a financial asset or liability,
  because an unrecognised firm commitment or
  forecasted transaction does not qualify as a
  hedging instrument."

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Potential issues with IGC 134-1-b

• Is IGC QA 134-1-b a robust interpretation ?
• Sound objective behind 134-1-b (ie allowing
  treasury centre netting with intercompany
  contracts), but result may be in conflict with
  paragraph 134/126B itself (which specifically
  excludes this treatment).
• Future of remaining IGC interpretations not taken
  up in amendment draft is uncertain. In any case
  such interpretation are very low in the hierarchy
  Is the interpretation robust?
• Reasoning behind 134-1-b is complex and may lead
  to confusion as to when it can actually be
  applied.
• Nonetheless the interpretation is right in
  principle Treasury Centre FX netting should be
  allowed for hedge accounting under IAS.

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Where does US GAAP stand on this issue?

• Treasury Centre Netting (TCN) is now allowed
  under US GAAP for forecasted FX risk
• Original text of FAS 133 allowed intercompany
  (I/C) derivatives as hedges only if offset
  externally.
• Netting of exposures prior to external lay-off
  not originally allowed under FAS 133.
• In response to extreme market pressure from
  corporates using treasury centres, this issue was
  included in an amendment to FAS 133, resulting in
  FAS 138.
• Hedging with I/C contracts on a net basis through
  a treasury centre is now allowed under US GAAP,
  for FX hedges.
• Detailed rules govern the TCN (paragraph 40B of
  FAS 133 as amended).

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Summary and proposed alternative solution

• Treasury Centre FX hedging under IAS arguments
  for a change
• Currently not allowed in the standard in spite of
  widespread use by multinationals for valid
  economic reasons
• IGC 134-1-b incorporates the right principles.
  These principles should be made explicitly part
  of the standard.
• Alternatives (such as gross lay-off with a single
  bank coupled with netting agreements to reduce
  spread) are not economically justified and
  increase operational cost and risk
• Convergence US GAAP allows treasury centre
  netting for FX subject to specific rules
• Implementation of IAS 39 would become possible
  for companies with Treasury Centres, without
  requiring payment of unnecessary additional
  spread cost (elimination of this spread is a
  major part of the raison dêtre for Treasury
  Centres) and without increased operational risk.
• Would improve attitudes towards IAS 39 from many
  in the Treasury profession.
• Proposed solution
• Following the intention behind IGC 134-1-b, allow
  a new exception to paragraph 134, allowing
  hedging on a net basis for companies fully
  laying-off FX exposures through a Treasury
  Centre.
• Exception should be based on same underlying
  principle as applied under US GAAP (ie full
  offset of the exposure), but in the spirit of
  IAS, without resorting to the same detailed
  rules.

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Comments on Treasury Netting Centres for FX

• IASB understood corporate treasurers issue on
  netting
• J. Smith confirmed interpretation I.G.C. 134 I.b.
  that suggests Netting of FX hedging for I/C is
  possible
• Therefore, he does not see reason for including
  that interpretation into E.D. He thought that
  netting was only possible for some type hedges
  (cash flow hedges or fair value hedges, but not
  between one with the other type)
• Examples proved that it is not that easy
• (ie. Without Basis Adjustments depending of the
  type of fixed asset and its related amortisation,
  deferred releases from O.CI./E.H.R could create
  discrepances)
• PwC will prepare additional examples for J. Smith
  in order to analyse best potential solution88
• J. Smith also addressed the fact that FAS 138,
  although clearer, is more restricted than current
  I.G.C. intrepretation
• IASB is principles-oriented (rather than
  rule-oriented) it does not want to create
  internal result.
• .

It remains e very difficult issue chances to see
it in E.D. are rather low. Lots of corporates
will still depend on IGC 134.7.b. and will stay
Border-line in term of Fx netting
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2. Prospective testing range under IAS 39

• IAS 39.146
• Highly effective almost fully offset (IGC
  close to 100) prospectively and 80-125 -offset
  retrospectively
• No bright-line test for prospective
  effectiveness, but would certainly be at least
  95-105
• FAS 133.20b and 28b
• Highly effective (80-125) both prospectively and
  retrospectively
• GAAP difference between IAS and US GAAP
• If properly applied, means many FAS 133 hedges
  would fail at inception under IAS 39
• Many commodity hedges would be automatically
  invalidated if say historic correlation is over
  90 but below 95(eg jet fuel and gasoil)

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3. Basis Adjustments

• Corporate Treasurers think that operationally
  management of O.C.I. / E.H.R. releases are very
  complicate especially of underlying is Fixed
  Asset wity long or gradual / depressive
  amortisation schedule.
• i.e. Film Rights for RTL Group
• We proposed to offer a choice to preparers
• J. Smith said that it does not go towards
  convergences with FAS 133

We do believe Basis Adjustments will be removed
in final E.D.
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4. Hedges of FX demonstrated firm commitments

• It seems very logical in order to duplicate FAS
  133 to give the choice to preparers to use Cash
  Flow Hedge (CFH) or Fair Value Hedge (FVH) models
  for hedging their un-recognised firm
  commitments.
• It appeared to be a slight mistake in E.D. which
  should be amended in final draft.

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5. IR Hedging in corporates the concept of
ineffectiveness

• Corporates generally use Interest Rate Swaps
  (IRS) to manage the interest rate profile of
  their debt
• IAS 39 allows hedge accounting for broadly 2
  strategies with IRS
• Swap liabilities from fixed to floating ie FV
  hedge (eg 10yr fix to 3mth LIBOR)
• Swap liabilities from floating to fixed ie CF
  hedge (eg 6mth LIBOR to 3yr fix)
• NB there is no such thing as a functional
  interest rate (vs functional currency) so a
  corporate can never eliminate interest rate risk.
• Basic FV and CF hedges are the two extremes, but
  strategies in between are common practice (eg
  transform a 5 yr duration to a 2 yr duration with
  stacked IRSs).
• Treasurers argue the objective was to achieve a 2
  yr duration. The strategy is therefore perfectly
  effective in achieving that objective, so why
  record ineffectiveness
• Viewed in another way, CF hedges are treated more
  favourably than FV hedges
• CF hedge effectiveness test basically ignores
  the fixed leg of the IRS
• FV hedge we cannot ignore the floating leg of
  the IRS gt ineffectiveness.
• What is ineffectiveness and why should there be
  ineffectiveness in a FV hedge if the desired
  profile has been precisely achieved?

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Conclusions Next step

• It is really difficult to convince IASB of the
  relevance proposed amendments from Treasurers,
  although they make sense in practice.
• At least, J. Smith will review all these points
  in detail (especially part n1 on FX netting)
• EACT (together with other Associations) has
  created a direct contract to the Board of IAS ()
• Nobody knows when final version will be released.
  Nevertheless, lobbying from banks is so strong
  that a second ED and a further delay in releasing
  amendment could occur.
• EACT will keep following that ED on IAS 32-39

() EACT will be represented at Misys Conference
on IAS 39 in Septembre 2003. Panel Session with
IASB Board Members