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IASB Derivatives Rules Force New Hedging Strategies (March 1, 2005)

Location: London
Author: Ellen J. Silverman
Date: Tuesday, March 1, 2005

The International Accounting Standards Board (IASB) says its main objective is to ensure companies report what they do in a clear and transparent way. This is forcing companies to change the way they manage risk.

International accounting rules require companies to give investors more information about the derivatives they use either by showing them at market value in accounts or explaining how they hedge risk. The extra disclosures and potential earnings volatility are leading some companies to revamp their hedging tactics.

It is not yet clear whether the changes make sense, but the IASB and others are optimistic. Stephen Cooper, managing director of the global valuation group at UBS , said in a recent report that standards setters appeared to have written rules on hedge accounting to flush out speculators. Under previously lax regimes, companies trading derivatives for profit had been able to pass them off as hedges and keep the instruments out of their accounts. "The problem," wrote Mr. Cooper, "is that in order to avoid abuse, the criteria for the use of hedge accounting are very strict, such that some transactions, which are economic hedges, will not qualify for hedge accounting."

That leaves companies the choice of recognizing derivatives in earnings or revamping their hedging tactics. Allister Wilson, senior partner at Ernst & Young, says, "If companies manage risk in the most appropriate way and the rules don't let them get hedge accounting, the worst thing that can happen is that they manage risk in a less prudent way to obviate volatility."

Tom Jones, vice-chairman of the IASB, agrees up to a point. "If I were an investor and a company was changing a policy to achieve an accounting result I wouldn't be very impressed," he says. But he adds that some companies could probably hedge more effectively and suggests the tougher rules impose a discipline that is prompting much needed reform. "People say accounting shouldn't change behavior. I don't agree with that. In some cases it should if the behavior isn't appropriate," he explained further.

A few companies corroborate that view. Re-examining its tactics last year, Astra- Zeneca found its interest rate derivatives did not effectively hedge a longer-dated bond issue and switched instruments to get a better match. Many companies, says John Walker, director at JC Rathbone, a risk management advisory group, are deciding to ditch complex derivatives for simpler products that are easier to understand and easier to value.

Despite the novelty of some of the derivatives they target, one close observer notes that the IASB rules are reinforcing an old financial maxim: "You manage what you measure." As European companies report a raft of new figures for the first time, the management decisions behind them are taking on a whole new importance.

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