As companies dealing in cash management come under greater scrutiny from the new IAS 39 accounting standard, the fundamental issue for them will be fair valuation of their assets, and whether to put them on balance sheet, writes Jules Stewart.

Starting next year, corporates will be faced with International Accounting Standards (IAS) – a new set of rules that will confront companies with a radical new way of conducting their business. There is a gradually increasing realisation on the part of corporates that there is more to the accounts than the headline profit figure.

More companies, as well as banks, are having to consider tactical IT solutions to meet the challenges of IAS, including wider use of spreadsheets, putting huge strain on existing systems and raising concerns about the ability of auditors to be comfortable with the accuracy of data produced in this way.

While all European listed companies have to comply with IAS in their 2005 consolidated accounts, US listed institutions face the additional task of having to certify their systems under Section 404 of the Sarbanes-Oxley regulations; getting that wrong carries criminal sanctions. For companies dealing in cash management, the biggest changes will be around IAS 39, the standard for financial instruments. The fundamental issue concerns the use of fair value, and the linkage and the extent to which the hedging of the various elements of the business is going to need to change as a result.

New system

IAS will have a significant impact on groups that, in the past, tried to get assets off balance sheets by entering into arrangements in which assets are sold, possibly leased back or sold on to a special-purpose vehicle that securitises these assets. All of these situations will need to be looked at very carefully, and some say that many of them will not work under the new rules, hence some assets may need to stay or come back on balance sheet.

This applies to corporates more than banks. Many of the predominantly core areas of cash management will not see a huge amount of change. Smaller players are not likely to be squeezed out of trading financial instruments, although this will make them much more reliant on their advisers, who might be providers of various forms of outsourcing of cash management functions.

This includes instruments like repo trades or various kinds of factoring trades, particularly if they include special-purpose entities where the accounting becomes much more specifically required by the standard. A company might sell its debt to a debt-factoring organisation, while the credit risk would be retained by the seller. Under IAS 39, the company would be required to show that debt on its balance sheet.

Hedging hedged in

There are changes to the way that people might have to account for some of these instruments. The areas most affected will be the more complex operations, such as hedging and securitisation.

If a corporate requests a bank to act as its custodian or provide some sort of FX overlay, IAS will not have a major effect on accounting. However, any organisation that parks its excess liquidity in financial instruments such as bonds will need to have a facility to value them fairly in future and recognise those gains and losses, either in the profit and loss account, if they are held for trading, or through a separate component of equity, if they are held for resale.

“Hedging is probably the single largest area of impact,” says Tony Clifford, a partner at Ernst & Young. “There is still some debate in the EU on whether they will endorse IAS 39 and if this will be done in time. Until now, the UK and most jurisdictions haven’t had any particular rules on hedge accounting. One of the most fundamental impacts of IAS 39 is the set of quite detailed rules on when you can use hedge accounting. On the one hand, there are some types of hedging relationships for which you’ll never be able to get hedge accounting. Furthermore, even if you do, there is quite a burden of documentation and a need for proving the effectiveness of hedges before you can use hedge accounting. This applies whether cash management is done in-house or outsourced.”

Tougher measurement

The criteria for measuring the effectiveness of the hedging relationship between a hedged item and a hedging instrument will also be far tougher than formerly.

In the past, banks and corporate treasuries have been able to use a macro-hedging model, assessing the total exposure, usually through a central treasury, and laying off only the net unhedged amount into the market through the use of derivatives, and other instruments. Under IAS 39, this type of macro-hedging is not allowed.

Smaller players will need assistance from larger organisations to help them do the accounting. So many more things have to be at fair value, and many of the smaller organisations will not be in a position to come up with the values themselves. Mr Clifford believes that banks and other institutions will be faced with a lot of requests from their clients about how much things are worth in order to use the figures in their accounts.

“The actual process of cash management and hedging management does not necessarily have to provoke any outsourcing,” he says. “But if hedge accounting is only feasible for certain hedges within certain very prescribed rules, and an organisation wants to make sure its hedging is effective for accounting and it doesn’t believe it has the expertise to do that, we may see more of them saying that if they outsource some of this process, at least they can make sure what they do works from an accounting point of view.”

Tightening up

IAS 39, with its emphasis on hedging and the effectiveness of hedging, will make companies tighten up a number of systems. There is likely to be tighter treasury management that will have some cash effects associated with it. Ken Wild, global head of IAS at Deloitte, says that the less desirable end of this is that, while accounting should not change people’s behaviour, it is assumed that analysts and investors want to see particular things in accounts. “There’s always a tendency to make the accounts look the same, even when the language has changed,” he says.

“Many years ago, companies moved from cash accounting to accruals accounting. Cash is key, and companies fail because they run out of cash, so understanding it is terribly important. But you get another dimension when you go to accruals accounting. What we’re seeing with IAS is a move beyond accruals accounting to fair value accounting and this will also provide another dimension.

“Fair value accounting should extend people’s understanding, management and insight. IAS will bring a new dimension in the way people look at things, which may have a knock-on effect on management, including cash management,” says Mr Wild.

Deep impact

In effect, any company that uses derivatives in its liquidity strategy is likely to be heavily impacted by IAS 39. “Anyone who is trying to protect against cash flow or fair value uncertainty – perhaps, for example, in relation to purchases and sales in foreign currencies, interest flows on debt instruments and other sources of funding, or perhaps with regard to extensive CAPEX programmes or investment assets used in short and medium-term liquidity policies – is going to have to deal with all the issues associated with hedge accounting,” says Lee Perkin, head of accounting advisory at ABN AMRO.

He says that such issues include, but are not limited to, mark-to-market, documentation, effectiveness testing, tracking, processes, systems and probably high-level policy decisions.

“Under UK GAAP, the guidance for accounting for derivatives and hedging was minimal,” he says. “Companies are now faced with a detailed, very much rules-based standard, and it’s a significant and demanding hurdle.”

The leap is not limited to the UK. Throughout Europe, many “local” standards have historically been silent or unprescriptive when it came to dealing with derivatives and hedging. Accounting for derivatives and hedging has been, until now, an untouched area. It was only in 2000 that FAS 133, the US standard that deals exclusively with derivatives and hedging, came into being.

The search for a solution

Mr Perkin says that most FTSE 100 companies are fully aware of some of the implications surrounding IAS 39, but he does not believe that they have all arrived at the full solutions that they need. “A lot of corporates are still investigating solutions to bridge the gap between old GAAP and IAS 39, others have decided on solutions that, in the short term, are likely to result in makeshift solutions, heavily reliant on manual processes, spreadsheets and support from their relationship banks,” he says.

“They have not been helped by the fact that treasury management system vendors have been very slow in their development. Even today, I don’t believe there exists a fully comprehensive treasury management system that can deal with all aspects of IAS 39 and hedge accounting.”

Another key issue that arises with hedging under IAS 39, which is in fact not new to liquidity management, is cash-flow forecasting. Under IAS 39, if a company wants to hedge a forecast transaction, it has to be highly probable. And that brings in the question of the definition of “probable”. The large accounting firms have settled on something around a 90% probability mark on the premise that “highly probable” is much tighter than “more likely than not”.

But Mr Perkin argues that many companies have mediocre cash flow forecasting processes. He says that some corporates that have adopted hedging strategies under IAS 39 and FAS 133 have had to reduce their hedge horizons on the basis that their forecasting processes and systems did not produce enough evidence to support the concept of high probability.

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