Hedging and hedge accountingare, perhaps unfortunately, twovery different things. The need of

accounting standard setters to ensurethat rules are sufficiently specific to avoidearnings manipulation are almost invari-ably at odds with the need for dynamicand flexible corporate financial risk man-agement. This conflict stems largely fromthe fact that hedging is, by its very nature,highly judgmental and that the boundarybetween hedging and position taking isnotoriously difficult, sometimes impossi-ble, to define in practice. Accountants,and in particular the standard setters, donot like this sort of grey area, since itopens the door for fiddling the bottomline. Treasurers and risk professionals onthe other hand are at pains to point outthat placing excessive restrictions onhedging activities is not in the best inter-ests of shareholders as it limits the abilityto react to market circumstances byadapting the corporate risk profile.

With FAS 133, the standard settershave taken a hard line which largelyavoids this debate, by focusing on themicro-level relationship between a hedg-ing instrument and a hedged item andignoring the question of whether enter-prise-wide risk reduction (required in cer-tain earlier standards) is actuallyachieved.

With the new rules on derivatives andhedging the US’s Financial AccountingStandards Board (FASB) has donesomething which goes beyond what wewould normally expect of an accountingstandard setter. FAS 133 does more thanjust define how the debits and creditsshould be recorded, since it implicitlygoes a long way in describing the waythe internal policies and processes ofcompanies using derivatives for hedgingought to look. This is really more likeregulation than accounting and is almostcertainly a reaction by the FASB to aperceived failure by the market toproperly control derivatives activities.

Accounting as a driver for derivatives internal controlThe increasing use of derivatives by cor-porates over the last 20 years has reflect-ed the increasing sophistication of thenon-financial community in the area ofrisk management and the drive toenhance shareholder value by better har-nessing market risk. Unfortunately, thelack of clear and enforced policies on theuse of derivatives has, particularly in the1990s, led to a series of well publicisedcontrol failures which in terms of theirnumber (rather than size) are no doubtonly the tip of the iceberg. Inevitably thishas led to calls for stricter regulation ofderivatives activities within both banksand corporates and for harmonisedaccounting standards.

The debate on whether the new rules

on derivatives accounting are ultimatelythe best answer to the lack of trans-parency and comparability which previ-ously existed will no doubt rage on.However, those directly affected by thestandard have had to put aside their ini-tial feelings and get on with the job ofimplementing the policy and processchanges required to comply effectivelywith the standards.

Cost benefit analysisThe initial gut reaction of many of thetreasurers affected has been to suggestthat the simplest and most economicallyjustified approach was to ignore theaccounting impact and continue withthe hedging policies they had applied inthe past, since these were presumablythe most appropriate for protectingcorporate value. If this meant that manyderivatives hedges would simply bemarked-to-market through earnings foraccounting purposes, then so be it.However, a better understanding of theimpact on reported earnings of such anapproach has led most treasurers,usually following discussions with theCFO, to conclude that hedgeaccounting was required, at least forsome hedging strategies, and that somedegree of change to existing policiesand processes would be needed.

SPOTLIGHTFAS 133

The Treasurer – November 2000 3 5

Hedging and internalcontrol post-FAS 133FAS 133 has changed the way treasuries manage financial risks. Sebastian diPaola and Olivier Cattoor of PwC examine the new rules and their implications.

Cost benefit analysis is the firstmajor step in any

implementation ofFAS 133 and should

not be shortcircuited

Sebastian di Paola Olivier Cattoor

SPOTLIGHTFAS 133

3 6 The Treasurer – November 2000

Indeed shareholder value studies andanalysis of stock market behaviour haveshown that investors and hence shareprices are highly sensitive to earningsvolatility.

The process of determining wherehedge accounting is required essentiallyboils down to a cost benefit analysis.Companies must weigh up, per strategy,the cost of implementing the changesrequired for hedge accounting versus thebenefit in terms of reduced earningsvolatility.

This analysis is the first major step inany implementation of FAS 133 andshould not be short circuited, since itforms the basis for the board or CFO todetermine the company’s FAS 133implementation approach.

Those who avoided this first step anddid not obtain formal sign-off on theconclusions have often found them-selves back at square one when, furtherdown the implementation process, itbecame clear that sub-optimal deci-sions had been made up-front.

Hitting a moving targetThe process of reviewing strategies andprocedures to ensure compliance withFAS 133’s strict documentation andmonitoring requirements has beenhampered for many by the fact that therules are, in a number of respects, amoving target. Ongoing interpretationof FAS 133 by the DerivativesImplementation Group (DIG), as well asthe amendment which was released inJune (FAS 138), has made it difficult forimplementers and for system vendors todefine exactly what it was they were try-ing to implement. Many have had torevisit their initial conclusions and revisepost-FAS 133 policies to take account ofthe latest from the DIG. Companiesimplementing IAS 39 face a similarchallenge from the ongoing work of theInterpretations Guidance Committee(the IGC), which has now issued itsfourth batch of interpretative Q&As.

The area of foreign exchange hedg-ing via centralised treasury centres hascaused particular problems, especially

as regards FAS 133’s initial prohibitionon netting of exposures for hedgeaccounting. This prohibition has nowbeen relaxed in respect of hedges offorecast exposures (cashflow hedges),though not without considerable addi-tional restrictions on how the centralisednetting is to be conducted.

Other impacts of FAS 133: embed-ded derivatives and commoditiesIn addition to the usual derivativesknown to treasury, the standard alsocaptures so-called ‘embedded deriva-tives’: these are sub-components ofother instruments or contracts which,though their host is not a derivative,themselves satisfy the definition (anequity option embedded in a convertiblebond is the classic example). Embeddedderivatives may be found throughoutthe organisation, not just in the treasuryfunction, and as such companiesimplementing the standard arerequired to perform a search forunusual pricing or settlement clauses in

Linking derivatives to exposuresGetting hedge accounting for hedges of forecast commercial foreigncurrency flows is particularly onerous, due to the daunting systemsand process challenge of identifying and linking foreign currencycommercial exposures (which arise from a multitude of ongoingtransactions entered into throughout the group) with the hedges takenout by treasury. While the exposures themselves are highly decen-tralised, the hedging of those exposures on the market is generallyperformed centrally by group treasury, which nets the affiliates’ for-eign currency exposures to reduce the hedging cost. In such struc-tures, the exposure item and hedging instrument generally exist in dif-ferent and unconnected systems. FAS 133 requires that these trans-actions should be linked in some way to ensure proper documenta-tion, to test effectiveness and to properly recycle OCI balances.

Detailed specification of hedged foreign currency exposureFAS 133 requires that specification of the hedged exposure should besufficiently detailed to enable objective determination of the occur-rence of the forecasted exposure. In other words, the company needsto be able to determine precisely when the hedged forecasted trans-action actually occurs, and is recorded on the balance sheet as apayable or receivable. At this point the hedge becomes a hedge of abalance sheet item (which is revalued at the spot rate under FAS 52)rather than a forecast. The accounting for the hedging derivative isalso modified at this point, with gains and losses being recorded inP&L rather than OCI.

The gains and losses on the hedging derivative, which had beendeferred in OCI during the forecast period, must be released at thesame time as the hedged transaction affects P&L in the consolidatedfinancial statements. In practice, this requirement implies that releaseof the balance of deferred gains and losses takes place, for example:

● immediately in the case of a sale which directly impacts earnings;

● in the case of a sale to an intermediary sales branch (ie an inter-company sale), at the time the sales branch makes a sale outsidethe group (DIG issue H13);

● in line with the depreciation charge when hedging the purchase ofa fixed asset; and

● in the case of a hedge of inventory purchases in foreign currency,when cost of goods sold is recognised, ie at the time of the ultimatesale of inventory or related finished goods.

In both the second and last case, OCI release could take placesome considerable time after the hedged inventory purchase or inter-company sale transaction is recorded on the balance sheet. Given thevirtually insurmountable practical difficulty of linking individual inven-tory components to deferred gains and losses, companies must makeassumptions about stock turnover periods to support the timing ofrecognition of deferred gains and losses in P&L. These assumptionsshould be supported with factual evidence to pass the test of an exter-nal audit and the resulting financial statements must, of course, bematerially correct.

Enhancing foreign currency forecasting capabilityNumerous implementers have identified improved forecasting as oneof their key needs under FAS 133, but are also able to point to this asan area where treasury can benefit significantly from the improvedprocess. Indeed, treasury has long sought to obtain better forecastinformation from affiliates, and many argue that FAS 133 is the per-fect tool to enforce this.

Forecast transactions need to be at least ‘probable’ of occurringto be allowed as hedged items, and companies need to confirm atleast on a quarterly basis that these forecasts are still expected tooccur. This implies a need to revisit or flex forecasts on a regularbasis. The probability issue can, however, be dealt with by usingsliding hedge ratios (such as hedging only 50% of the forecast

Hedges of forecast FX via a centralised treasury

continued on page 38....

normal commercial contracts andassess whether these constitute embed-ded derivatives which might requireseparate accounting (at Fair Value ofcourse). This has proved a particularchallenge for those active in the utilities,energy and other commodities sectorsand can be an extensive exercise.Unlike hedge accounting there are nodecisions to be made here (other thanperhaps choosing to avoid certainderivative-type clauses in the future),since the accounting treatment for FAS133-embedded derivatives, which aregenerally not hedges, is fixed.

An additional challenge for thosebuying and selling commodities is thefact that forward purchases and salesmay meet the definition of a derivativeand hence need to be recorded at theirfair value, creating potentially signifi-cant volatility in the bottom line. On thispoint, many will wish to benefit from the‘normal purchases and sales’ exceptionwhich has been expanded by FAS 138.This exception enables companies toavoid having to mark-to-market OTCforward purchases of commoditieswhich will result in actual delivery anduse in the business.

Significant impact on hedgingpoliciesIt is clear from existing experience thatFAS 133 will often drive changes in trea-sury policy. Many have already adjusted

their hedging strategies or decided nolonger to hedge some exposures. MostFX hedgers have redefined the roles andresponsibilities of group treasury andaffiliates in view of the complex process-es required when hedging forecasts. Inaddition, various common hedginginstruments, such as foreign currencyoptions and collars, have suffered at thehands of FAS 133’s effectiveness test asa result of the volatility of time value.

In spite of all this change and of theanti-FAS 133 sentiment which is doubt-less out there, many companies whichhave already implemented now seesome positive side to FAS 133. Theyview the standard as an opportunity toget treasury out of its ivory tower and

closer to the underlying business, and toencourage affiliates to produce infor-mation which is more relevant to trea-sury, particularly in the form ofimproved forecasts.

Still, on the plus side, the implementa-tion of FAS 133 has created an opportu-nity for companies to revisit theirapproach to managing financial risksand to ensure that exposures are proper-ly captured and policies aligned to corpo-rate objectives. The standard also nowprovides a common language for thetreasury and accounting functions tocome together on the complex issue ofcontrolling derivatives. Ultimately, thethrust of the standard from a process per-spective is likely to drive some degree ofimprovement in the control environmentas companies rationalise their hedgingpolicies and implement better automatedand transparent processes, with improvedintegration from front office to account-ing. Nonetheless treasurers will continuefor years to come to regret the loss of flex-ibility in risk management decisions andto suffer from some of the more extremeaspects of the new rules. ■

Sebastian di Paola and Olivier Cattoorare respectively Director and SeniorConsultant in the Treasury Solutions Groupat PricewaterhouseCoopers, Brussels.

sebastian.di.paola@be.pwcglobal.com olivier.cattoor@be.pwcglobal.com

SPOTLIGHTFAS 133

3 8 The Treasurer – November 2000

beyond six months); in this case the first 50% of transactions areusually probable even if the full 100% were not. Over-hedging issanctioned by all or part of the hedging derivative being re-quali-fied as trading, resulting in P&L volatility. Hedges may be de-desig-nated during their life cycle, but cherry-picking aimed at earningsmanipulation is clearly not permitted.

Centralised versus decentralised processing approachThe fact that the treasury management system (TMS) is generally onlyavailable at the level of treasury drives most companies towards acentralised approach to compliance. In this model, treasury acts asa service centre, documenting, testing and managing hedgerelationships on behalf of affiliates and generating the FAS 133hedge accounting entries to be used in the consolidated financialstatements. In order for hedging relationships to be maintainedcentrally in this manner, foreign currency exposures, in the form ofdetailed FX forecasts, must be imported or centrally input into theTMS. This could be achieved by uploading spreadsheets or, withmore companies using browser-based TMS technology, via theintranet. This model means that, as a minimum, affiliates mustprovide treasury with decent and regular forecasts. For those usingERP systems such as SAP, the solution to some of the processingissues, such as gathering forecast data and identifying the timing ofthe actual transactions may lie in the enterprise-wide system’s abilityto pull all this data together seamlessly.

The danger of centralising the process in this manner, lies in the riskof disconnection between the hedging instrument and the true lifecycle of related commercial flows. Some companies have thereforechosen to opt for a decentralised model for managing FAS 133 hedg-ing relationships by establishing appropriate functionality, such asTMS, at affiliate levels.

Use of the TMS as main platform for FAS 133 complianceAutomation of the FAS 133 process is a key to success. Most compa-nies choose to use the TMS as the centralised platform for FAS 133compliance and many have changed systems to implement a TMSwith relevant FAS 133 functionality and strong instrument pricingcapability (to support fair value measurement of relevant derivatives).

Other solutions to the FX hedging conundrumIn light of the practical difficulty of managing hedge relationshipswhere the hedging instrument and hedged items exist in different enti-ties and systems, some have chosen to adapt their foreign exchangeprofiles, by locating all exposures in a single entity, which is also thehedging entity. Factoring and reinvoicing solutions can both achievethis objective, allowing the treasury centre to bear all FX risk andremoving affiliates from the foreign currency equation altogether. Amore extreme answer to the problem, but one which has been adopt-ed by a few companies with lower levels of exposure has been to sim-ply decide not to hedge at all. ■

....continued from page 36

In spiteof all this change

and of the anti-FAS133 sentiment

which is doubtlessout there, many

companies whichhave already

implemented nowsee some positiveside to FAS 133