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The Bruce Column — Towards a better understanding of risk

07 Sep 2012

The IASB has released the draft of its hedge accounting proposals and it contains much to cheer for those in favour of transparency and a greater understanding of risk. Robert Bruce, our resident columnist, explains.

Hedge accounting is there to show the effect of the financial instruments which a company uses to manage its exposure to market risks. Investors need to understand this. They need to know what risk management efforts have been employed and how they may affect future cash flows.

And until now this has not been easy. But the publication of the IASB’s draft on the subject brings us closer. We are moving towards a process of thinking in terms of the business model. The existing rules-based IAS 39 doesn’t work for all situations. Under those rules there are many cases where companies cannot meet the hedge accounting requirements laid down in the standard and so cannot effectively represent the risk management benefits which they are achieving. What treasurers, for example, are doing to manage risks can be very different from what the accounting is showing. It doesn’t mean the treasurers are not taking measures to deal with the risks that the company faces. They may well be, but the accounts don’t necessarily show what they have done.

The draft changes all of this. It builds on the proposals published by the IASB in 2010. Many of the obstacles to achieving hedge accounting when derivatives are used to hedge market risks are removed. The 80-125% effectiveness test requirements are gone. Hedging with options produces less volatile profit or loss accounting than under the current requirements. And risk components of non-financial items can be hedged.

All of this helps, and in particular it helps the non-financial corporates who currently struggle with the results produced by IAS 39.

As it is intended as a fatal flaw review rather than an exposure draft, the new draft brings us one step closer to a final standard and it could come into force for accounting years beginning on or after 1 January 2015. The one snag may be endorsement in Europe. Hedge accounting is but one part of the jigsaw of reforming IAS 39. And the EU had previously stated that it wants to see the whole package endorsed at the same time. So this could delay the hedge accounting reforms for companies within Europe. But the pressure will come because companies that want to use the new system as soon as possible will feel disadvantaged by companies outside Europe which would be able to use the new rules as soon as they are finalised.

In a nutshell the proposals are a good move. They provide greater transparency. Accounts should show what is being done to manage risks and under the proposals they should do just that.

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