The IAS 39 poses real risk for treasury departments in the first two quarters of next year. Dan Barnes examines the potential impact of the new accounting standard and the late change that is contributing to compliance problems.
The compliance efforts of many banks have been thrown into turmoil by the decision of the European Accounting Regulatory Committee (ARC) to delete a few lines of text from IAS 39. The deletion removes the option for banks to fair value liabilities. Removing the option to fair value debt, such as structured notes, a matter of months before the implementation deadline means that a sudden rush of activity is adding to compliance stress. In the UK, the Financial Services Authority (FSA) has even offered an additional 30 days for companies to prepare their Q1 results, in recognition of concerns about uncertain standards.
Further issues arising from IAS 39 implementation include a shift in the products that are traded and volatility in reported earnings for many. There is a risk that the market place may also misinterpret data that is released, leading to a misunderstanding of the true economic situation of some companies. Banks must redress their compensation for traders as profit recognition is delayed, filtering through over a matter of years.
Unpopular standard
Unsurprisingly, IAS 39 is not popular and, although the standards are the best available right now, that does not mean they work particularly well says Ken Wild, global head of International Accounting Standards at Deloitte. “Looking at the vast amount of controversy that it has generated, it is not a good standard.
“Everybody knows that it is a compromise standard. Everybody knows that to get the compromise when IAS 39 was written, it was not [founded on] a good, deep principle. It is mixing different measurement bases to try to compromise between where the standard setters would really like to be – which is much more fair value – and some of the problems that it will cause – some of the concerns of preparers and users.
“There are all sorts of things wrong with it but it’s the best we have got,” he adds.
Lee Perkin, accounting solutions, financial markets advisory at ABN AMRO, agrees that the EU alteration to IAS 39 is causing problems. “First and foremost, it is a bit late. Many of us in the banking sector have to put together transition projects only on the basis of what we had in front of us, in terms of a standard. So in instances where we have not been able to get hedge accounting, we might have chosen to fair value our own financial liabilities for natural offset. Or we have designed hedging strategies that ring-fence demand deposits.”
This preparation has now been put in jeopardy, he says. “Now, suddenly, the EU would like to endorse something that could potentially change some of the decisions that we have been making,” he says.
Drawback for debt
The knock-on effects are that non-vanilla products will not have day one profit recognition. Issued debt with an embedded derivative will now require the issuer to rate the liability at amortised cost while fair valuing the derivative.
David Todd, banking partner at KPMG, explains the change: “Normally if a bank issues debt such as structured notes into the market then the notes would be accruals accounted, with separate accounting for any embedded derivatives. Prior to the EU amendment of IAS 39 banks would have had the ability under certain circumstances to opt to fair value the notes – this was anticipated to be very helpful for investment banks in achieving accounting that they felt reflected the economics of their structured note businesses.”
Bumpy ride
The historical precedents for this style of accounting do not suggest it will be an easy ride. “This is caused by the rules around the separation of embedded derivatives, which are similar to ones that the US banks have also struggled with in recent years. Many IAS banks were hoping to avoid this accounting through making use of the fair value option. Now, at least in the short term, that has been taken away by the EU,” says Mr Todd.
Such a small change has seriously altered the principle of the rules, says Deloitte’s Mr Wild. “It seems like an easy compromise: let’s carve out this small number of sentences. In practice, the differences that it will introduce are exactly what the whole system was designed to avoid.”
Impact on products
The US standards led to changes in the products used by treasuries and similar effects are now expected in Europe. The standard slows the recognition of profit with some of the more complex products and this may sway banks and corporates toward dealing in more vanilla products.
Mr Todd acknowledges that, in the long term, this should not be an issue. “In a steady state, the slower recognition of profit on exotic products would not necessarily lead to the business earning less year on year. For example, consider an exotic derivative book where the average life of the book is five years. The profit recognised on the new trades in any one year may well be less, but there should also be profits feeding through from other trades executed in the previous four years.”
Short-term blip
However, ABN’s Mr Perkin expects to see a “blip” in the short term, until treasuries are more comfortable with the rules. “If you use the US as an example, everyone backed away [from complex products]. What happens then is that the banks like ourselves need to re-educate our customers on the products and on the accounting as well,” he says.
“People are going to want a couple of years of stable reporting before they start dipping into things that might be more aggressive,” says Mr Perkin. And, while experience in the US could have led to some EU companies having expertise in this area, it seems unlikely because it was possible for them to just ignore hedge accounting and still comply with the US regulation SFAS 133.
The two years predicted will be needed to build up confidence and refine the project bit by bit. “As time progresses, people will look to back up their conversion efforts with more robust systems and processes. A lot of banks will adopt on the basis of existing systems and slight modification, makeshift solutions. As money starts being spent and they start to get the hang of it, things will get better,” predicts Mr Perkin.
Recognising revenue
Mr Wild says that, internally, this change will require more thought in the long term, as traders payments are addressed. “Revenue recognition is key. Gone are the days when if you trade to lend a client Ł10m you get Ł1m in fees – that fee will now be spread out over 10 years. Suddenly, a guy who was being rewarded on his profit performance used to have a profit of Ł1m for that trade, and now has got a profit of Ł100,000.
“It is something that everyone conforming to IAS 39 needs to factor into their conversion plans. You need to rework your incentives, you need to rework your performance measures and your performance contracts,” Mr Wild says.
So, from the end of this month some changes can be expected and, for the unprepared, some problems. Mr Perkin says: “What we will expect is, between Q1 and Q2, [companies are] going to have high volatility in reported earnings, because any derivatives they were hoping to offset will now be standing in the profit and loss account on their own. So we can expect high volatility and high levels of volatility on the balance sheet as well, leading to a bit of unpredictability with regards to Q1 and Q2 releases.
“Hopefully, by Q2, a lot of them will have got it under control with regards to hedge strategies and we should be seeing a softening of this volatility. That’s the worst-case scenario. Most banks will have progressed significantly and they should be okay,” Mr Perkin says.
The control of information released to market will be important. To ensure that results that do not reflect the underlying economics will be properly interpreted, other information releases will be a vital resource. Mr Perkin is confident that banks, the majority at least, will be fully prepared to cope with that. “I do not think that it is too difficult to isolate it. I think many of us, particularly in the banking sector, are very clever about how we release our financial information.
“And if you do have volatility driven from purely an accounting change, then it is very easy to ring-fence it – in press releases for example. You are only restricted in how you report your financial statements, you are not restricted in what you disclose to the market in the form of press releases, as long as these releases and that information reconcile back to the core documents,” he adds.
Confusion warning
Mr Wild is more cautious on this front, due to the speed with which the market can react to information releases. Although he offers the caveat of not wanting to simplify the role of the analyst, he warns there could still be confusion ahead. “With the way the markets operate, analysts and the markets react very, very quickly when a piece of information comes out. So when companies put out their preliminary reports – notwithstanding the fact that they may put in a stack of words saying ‘don’t be fooled by that bit of volatility, it’s just created by the European Central Bank government commission forcing us away from proper accounting’ – the analysts always start by looking at the bottom line figures,” he says.
This is a necessity, he claims, although historically there have been situations in which this has led to an impact on share price. “If you have to react quickly [the bottom line] is the only place to look,” says Mr Wild. He adds that there have been instances in the past, where although a situation was unchanged economically, the presentation of information differed to market expectations causing some upheaval, as in the case of Argyll Foods in the UK (see box).
Too late to change?
Although providing additional information can have influence on the market, the speed at which it responds to that information can limit the beneficial effect of the data released after original results. “If the data hits an analyst’s screen and you’re going to start saying buy/sell, and it looks different [to what you had expected], no amount of explanation that you will be able to read 10 minutes, a quarter of an hour or a day later, stops that initial reaction,” says Mr Wild.
“While I think banks will compensate for the removal of the fair value option, the problem will be the instantaneous reaction to the volatility that it creates.” Bottom line figures: the case of Argyll Foods The impact on share prices that changes in the appearance of reported earnings, when no economic changes have occurred, can be found in the case of Argyll Foods. Following the purchase of another company in 1981, Argyll Foods put the two companies under one brand. The acquisition had been widely publicised and it informed the market that it was going to be carrying out rebranding. It also had made public that it was to spend Ł90m on the process. Ken Wild of Deloitte takes up the story. “Everything was known. This was back in the days of extraordinary items. The market assumed [the cost of rebranding] would be put through as an extraordinary item and therefore miss the earnings per share. In the event, when Argyll announced its results, it said that because it may do further acquisitions it might have other such costs. So it didn’t put it in as an extraordinary item; it put in an exception and of course that hit earnings per share. Its share price fell about 25p and the whole of the retail sector was marked down. “When you stand back from that, it’s ink on paper: the market knew every single bit of the economics. Nothing was different by printing a number two inches further up the page. There was a reaction. The market expected to see one earnings per share figure, saw a different earnings per share figure and reacted,” says Mr Wild.
