Living with volatility

Three months after the new International Financial Reporting Standards came into effect, European companies are waiting to see how the rules will be received by investors and analysts. Duncan Wood reports

On page 35 of food manufacturer Nestlé’s latest annual report, there’s one of those dry, bloodless sentences that is the corporate accountant’s stock-in-trade. On this occasion, though, it was probably written with gritted teeth and a smarting sense of injustice.

The sentence sits at the bottom of a table showing Nestlé Group’s derivatives liabilities, and states that “some derivatives, while complying with the group’s financial risk management policies of managing the risks of the volatility of the financial markets, do not qualify for applying hedge accounting and are therefore classified as trading”.

Philippe Gaberell, Nestlé’s head of guidelines in the group accounting and reporting department at the company HQ in Vevey, Switzerland, says that many of the derivatives that are reported as trading positions in the 2004 accounts were actually bought for risk management purposes. But there’s not a lot that he – or any other European derivatives user – can do about it. New accounting rules, known as International Financial Reporting Standards (IFRS), came into effect for all EU companies on 1 January and state that all derivatives failing strict hedge effectiveness criteria must be classified as if they are held for trading.

This may sound like a dry, technical debate, but it still packs a punch – as Nestlé has already discovered.

Although Switzerland is not part of the EU, many large Swiss companies are listed on EU stock exchanges and want their accounts to be comparable with their European competitors. As such, Nestlé and other Swiss multinationals such as Novartis and Roche adopted the new rules years ago. The rules have changed considerably since Nestlé switched to the earliest version of IFRS in 1989, but the company still has a head start on most European companies. And Gaberell knows from bitter experience what can happen when derivatives bought for hedging purposes are reported as though they were held for trading: investors start fretting.

“We have received calls from analysts confused to see an industrial company trading derivatives so actively,” says Gaberell. Nestlé’s 2004 accounts show the company with more than Sfr5 billion ($4.2 billion) notional in derivatives liabilities that are held for trading and just under Sfr3 billion notional in derivatives assets that fall into the same bracket.

An analyst from one US research firm was particularly persistent when quizzing Nestlé about its 2002 accounts, says Gaberell. “He asked several questions and was concerned about Nestlé taking too much risk by trading derivatives.”

There was communication back-and-forth, with Nestlé explaining the accounting restrictions it faced, and the analyst pressing the company about its use of derivatives.

In the end, says Gaberell, the analyst’s report acknowledged that the accounting environment created some difficulties for Nestlé, but maintained that it faced substantial market risk, which the analyst tried to quantify for investors.

“The problem is, we are not buying derivatives short of underlying positions, but either we can’t demonstrate the hedging relationship, or the tests required by the standard are too cumbersome” says Gaberell. “The risk is mitigated, but that is not what the market sees.”

From the start of this year, whenever one of the EU’s 7,000 or so listed companies puts on a hedge, it could be exposed to the same kind of questions as those that bombarded Nestlé. And the potential problems don’t end with the classification of hedges as trading positions. All derivatives now have to be carried at fair value, meaning end-users have to obtain market values for all their positions at the end of each reporting period – and any changes in the value of their derivatives have to be reported as a profit or a loss.

None of this has come out of the blue, of course. The portion of IFRS that deals with recognising and measuring derivatives – known as IAS 39 – has a tortured history, with end-users complaining from the start that carrying derivatives at fair value could mislead investors by making their core businesses appear to produce volatile and unreliable earnings.

End-users’ protestations have not cut much ice with accountants. The IFRS standards were drawn up by the International Accounting Standards Board (IASB) which fought tooth and nail to have market value enshrined as the standard by which derivatives are reported, arguing that any other approach would leave investors in the dark. A similar struggle between accounting standard setters and derivatives end-users ensued in the US when the Financial Accounting Standards Board proposed its own fair-value standard for the measurement of derivatives – FAS 133. US companies are now in their fifth year of reporting under FAS 133.

“With FAS 133, people were forecasting that the world would end. Of course, that didn’t happen,” says a source close to the IASB. “Anecdotal evidence seems to suggest the same will happen in the EU – the fuss will die away and people will just get on with it.”

In practical terms, ‘getting on’ with IFRS means companies have to work out how their financial statements will be affected by the new standard, then decide whether they can live with the impact, says Chris Jones, a partner at PricewaterhouseCoopers (PwC) in London and head of the firm’s corporate treasury practice in the UK.

“The first thing most companies do is try to work out how much volatility their underlying transactions could create in profit and loss. When they can quantify the volatility, they then have to decide how much they can bear.”

There is a safe harbour, known as “hedge accounting”, but qualifying for this treatment isn’t simple. Companies have to be able to demonstrate that the hedge will be highly effective which, according to the IFRS definition, means that the value of the derivative and the value of the hedged item must remain within an 80–125% range of each other.

Companies have responded to the new rules in various ways. The source close to the IASB says some companies have taken a fresh look at their positions and, where they don’t fall into the 80–125% bracket, have simply stopped putting hedges on: “IFRS has forced them to ask ‘why were we doing this stuff in the first place?’”

Georgette Bailey, a managing director in the strategic solutions group at Deutsche Bank in London, argues that a drop in hedging activity is a natural reaction to the initial uncertainty accompanying the arrival of IFRS. But she adds that most companies will realise that the “profit and loss neutral” strategies they are currently gravitating towards may not serve their economic interests best in the long run. Given a year or so to settle down, she believes the business or economic arguments will prevail over the accounting argument.

Some companies – such as Rolls-Royce in the UK – have already come to the conclusion that if their hedging strategy made sense before the first of January this year, it still makes sense today, whether they can get hedge accounting or not. Rolls-Royce has long-term exposures to the sterling/dollar exchange rate, partly stemming from its engine servicing business, says Peter Barnes-Wallis, the company’s London-based head of financial communications. That poses two problems. First, it’s difficult to demonstrate the effectiveness of long-dated derivatives. Second, there’s unlikely to be a specific underlying item to hedge. The result is that hedge accounting is all but impossible to achieve.

“We’re not a transaction hedger: we don’t usually know that we’ll need to hedge a specific contract in a specific month,” he says. “We’re really hedging a portfolio of exposures, and as a result of that, hedge accounting is not available to us.”

Nevertheless, Rolls-Royce is sticking to its existing hedging policy. That may seem like common-sense, but it’s also brave: the implications for the company’s reported earnings are huge. Barnes-Wallis says if the company had been reporting under IFRS in 2003, its profits would have been £746 million higher. Rolls-Royce’s actual reported profits in 2003 were £285 million. “We’re aware that there will be additional volatility hitting profit and loss, so it’s up to us to communicate our results clearly so that investors can see the true performance of the business. But we think they’ll support what we’re doing. Our hedging strategy is very effective and investors have seen its value over the years.”

Another company that recently decided to take IFRS-related volatility on the chin is Vivendi Universal (VU) in France. Philippe Parmenon, the Paris-based head of equity corporate derivatives sales at Société Générale, says the bank helped VU devise a strategy for a 20% stake it held in Veolia Environnement last December.

While VU wanted to dispose of a large chunk of the stake, it also believed Veolia’s share price was set to appreciate, and wanted to retain some upside exposure. It did so by selling 10%, keeping a direct stake of 5% and buying a call option on a further 5%. VU will not be able to get hedge accounting for the option, says Parmenon, but that did not dissuade it from entering into the transaction.

“There was a strong anticipation that the Veolia share price would recover and they wanted to participate in that, so they had to accept a potential impact on profit and loss,” he says. “My bet is that we’ll see this kind of thing happening more often. The economic purpose of transactions will dominate the accounting considerations, and companies will accept some impact on profit and loss.”

Germany’s BASF has also refused to alter its hedging strategy as a result of IFRS, says Matthias Dohrn, a member of the financial reporting and controlling group at the company’s Ludwigshafen headquarters: “At BASF, business drives accounting, not vice-versa.” That doesn’t mean the company is happy about the changed accounting treatment though. “IAS 39 does not allow us to classify transactions between group companies as underlying a hedge. If we want to obtain hedge accounting on these currency risks, we must declare an external transaction as the hedged item. This requires time-consuming documentation and audit effort, so the existing micro hedges for group companies’ transactions are not treated as fair value or cashflow hedges by BASF.” The result: fair-value changes in those hedges will go through to profit and loss.

But will decisions such as those taken at Rolls-Royce, VU and BASF prove to be the exception or the rule? Opinions differ. Accounting standard-setters believe hedges ruled ineffective under IFRS are just that – ineffective – and they see limited reasons for companies to proceed with ineligible hedges. One source from the standard-setting world notes that although US companies complained bitterly about FAS 133 at first, “later – and very quietly – many companies reported that they were happy to have discontinued some strategies and for the discipline that hedge accounting requires”.

In the US, FAS 133 has resulted in a “simplification of the hedging instruments being used”, says PwC’s Jones. But one banker argues that the introduction of IFRS in the EU need not produce the same results as FAS 133 in the US. The source says that the EU’s investing culture is less focused on quarterly results, so “EU companies may have a greater tolerance of profit and loss volatility than their US counterparts”.

IFRS will test exactly how far that tolerance will go.