Map of CongoIn our circles, when we talk about the Dodd-Frank Act, we tend to gravitate our conversations to Title VII – Wall Street Transparency & Accountability.  It is, of course, the most hotly disputed, high profile part of the legislation.   So, it’s easy to forget some of the other sections of DFA that may concern corporations.  One such section is 1502.

Section 1502 – Conflict Minerals

This section requires a disclosure that on the surface seems fairly well intended.  Since Congress has determined that “the exploitation and trade of conflict minerals originating in the Democratic Republic of the Congo and adjoining countries is helping to finance conflict characterized by extreme levels of violence in the eastern Democratic Republic of the Congo, particularly sexual- and gender-based violence, and contributing to an emergency humanitarian situation”, corporations will be required to disclose their sources of “Conflict Minerals”.  Conflict Minerals include columbite-tantalite (coltan, niobium, and tantalum), cassiterite (tin), gold and wolframite (tungsten) and their derivatives. The State Department can add new minerals when they determine it is necessary.

Who will be impacted?

The impact will be broad, and will encompass all publicly traded companies that source the listed minerals. If you think about it, that covers quite a cross-section of industries: automotive, communications, electronics – you name it. By the SEC’s own estimates, at least 6,000 companies will be impacted. They will be required to disclose in their 10-K, 20-F and 40-F filings the use of “Conflict Minerals” in their products. Even if the source of the material cannot be established, that will also require disclosure. Lacking a de minimis provision in the law, any sourced quantity will necessitate disclosure.  The law also calls for due diligence, although that has not been entirely defined. In all likelihood the model of due diligence proposed by Organization for Economic Co-operation and Development (OECD), would serve as a template.

Court of Public Opinion

There are problems with distilling the complex problems of the Democratic Republic of the Congo to a sourcing disclosure and expecting it to be the solution.  There are legitimate tribal mining operations that are likely to suffer as a result of this requirement.  Regions of the DRC are not in conflict, but they are already witnessing the impact of the proposed rulemaking. According to a recent New York Times article, many mining operations in Eastern Congo have been damped or halted completely. And so the SEC struggles – delaying its final rulemaking yet again. With no established SEC guidelines, I would anticipate more mining operations to close. The concern among manufacturers is also heightened, and it is not just a cost of compliance issue. The fear is that the public’s perception will drive investment or product purchase decisions based solely on a DRC tag or a lack of traceability.  Keep in mind, the legislation does not make it illegal to source Conflict Minerals, it just requires the disclosure of that information. I’m all for doing the right thing here, but I’m just not entirely convinced that this is the right thing. Not for the people of the DRC or the corporate world.

Michel ZadoroznyjIf you get the feeling that we’ve been here before, you’re right. I’m talking about the convergence efforts of the two accounting standards organizations – FASB and IASB.  After all, they have been at it for nearly ten years, so the probability of my addressing it at one time or another are quite high. Well, at the end of January the two boards renewed their efforts to find common ground in the development of standards and disclosure requirements. “The boards have been urged to converge their standards on financial instruments. Today’s decision to work together on key differences—which represent the most significant remaining differences between the decisions reached to date—is responsive to stakeholders in the US and abroad”, said FASB Chairman Leslie Seidman.  A commitment with a rhyme – what could go wrong?

As an optimist, I want to believe that it can happen, and there certainly are signs that indicate that it just might come to fruition. Of course, if you’re a pessimist, you are just as likely to find many signs to indicate that it won’t happen.  If the renewed talks aren’t enough evidence for you, then you may want to consider a staff paper that the SEC issued back in May, 2011, titled “Work Plan for the Consideration of Incorporating International Financial Reporting Standards into the Financial Reporting System for U.S. Issuers”. That paper explores the incorporation of IFRS, and is essentially an approach combining elements of convergence and endorsement, thus coining the now popular phrase, “Condorsement”.   With an endorsement approach, jurisdictions would simply incorporate an individual IFRS standard into their standards, while a convergence approach keeps local standard and attempts converge them with IFRS. The condorsment approach suggests a phased one, where the scheduled convergence projects continue to move forward while seeking areas where endorsements of individual IFRS make sense.

The concept of allowing corporations to adopt IFRS reporting is not that new. It was first pitched in 2008 by then SEC Chairman Christopher Cox, and there now seems to be some serious momentum behind the proposal. Even though the SEC recently delayed its decision on the topic, IASB  Chairman Hans Hoogervorst remains confident that SEC will ultimately decide to go with IFRS. In a recent speech given at an Ernst & Young IFRS seminar in Moscow, Hoogervorst stated, “The US already has developed a sophisticated set of financial reporting standards over many decades. Transitional concerns have to be carefully considered. That is why I have supported the general approach for the endorsement of IFRSs described by the SEC staff’s work plan. It is also important to note that the US is committed to supporting global accounting standards. It is SEC policy, it is US Government policy and it is the policy of the G20, in which the US is a key player. “

Most of the G20 member countries currently require the use of IFRS. Also, more than a hundred countries globally currently allow or require IFRS reporting.  Detractors call IFRS Euro-centric. I find that interesting, since much of the seeding for the standards in IFRS were a result of groundwork laid out by FASB. In a global economy, it is essential that we end up with a uniform approach. So let’s keep it moving along – make it international and rational.  I love rhymes.

Michael ZadoroznyjOut of all the changes put forth in IFRS 9 with regard to Hedge Accounting, one that will likely be well received will be the ability to hedge the risk components of non-financial items.  This is big news to many companies out there, in particular the foods industry and airlines.  Under IAS 39 and current FASB rules, they are not allowed to isolate the risk associated with a component of the risk being hedged.  For instance a company that produces baked goods must hedge the overall cost of flour and cannot simply isolate the cost of the wheat component to qualify for hedge accounting. Likewise, an airline cannot hedge crude oil as a component of it forecasted jet fuel requirement.

The current standard requires that the entity compare the entire change in value of the hedged item with the change in the value of the hedging contract to prove effectiveness.  Due to changes in other variable costs, such as milling costs in the case of flour, or refining margin, in the case of jet fuel, derivative contracts may not always correlate well.

Certainly, the economic aspects are intact regardless of whether or not the hedge actually qualifies for hedge accounting under the accounting standards. The consequences would be undesirable income volatility, since the gains or losses of unqualified derivatives must be taken into income immediately and would not match up with the actual timing of the risk being hedged.

An important precept in IFRS 9 regarding component risk is that there is no need for a component to be contractually specified in order to be eligible for hedge accounting.  This should not be interpreted as an anything goes clause.  IFRS 9 guidance states that the component risk, when not contractually specified, must be “separately identifiable and reliably measurable”.  This will certainly be easier for some markets than others.  When the component risk isn’t clearly spelled out in a contractual specification, it may be require a bit of effort in determining the influence of individual components to price of the end product.

As was the case under IAS-39, proper documentation is essential to qualify for hedge accounting.  From a hedge documentation perspective, you will need to clearly identify your risk if you are electing to hedge a component.  You will need to also state your method of assessing hedge effectiveness as well as your anticipated level of effectiveness.  Since IFRS 9 now allows the rebalancing of hedges, it will be necessary to fully document any hedging relationship changes on an ongoing basis.

For many companies, where the economics and value of hedging have always been apparent, adopting IFRS 9 may now allow them to finally achieve the accounting benefits.

Now if only we can get to the long awaited convergence of IFRS and US GAAP, wouldn’t that be nice?

For more information about hedging the risk components of non-financial items, see Ernst & Young’s Hedge accounting under IFRS 9 Guide (pages 8-10).

 

Posted in: General   |   Tagged 

Michel ZadoroznyjWhether you work in the front, middle or back office of a company that trades derivatives, life will be changing for you in a big way. Well, that may be a bit dramatic, but really, your current work-flow will certainly be changing. To what degree largely depends on how your company gets branded – swap dealer, major swap participant or end user.

Trading

Regardless of your company’s Dodd-Frank branding, its approach to derivative trading will most certainly be impacted. Your business processes may need to be adapted to keep records throughout a swap’s existence and for five years following final termination or expiration of the swap. In addition all swap data must be readily accessible throughout the life of a swap and for two years following its final termination. Daily trading records for swaps must be identifiable by counter party. The CFTC has the authority to request ad-hoc reporting from an entity. Your systems will need to support such requests.

If your company happens to fall into the category of swap dealer or major swap participant, you will likely be faced with additional trading room challenges. Your entire transaction history is to be tracked – from the moment of initiation onward.  All of the correspondence related to transaction activity – phone, email, text messaging – is subject to examination at the CFTC’s request. Swap dealers and major swap participants also must maintain a “complete audit trail for conducting comprehensive and accurate trade reconstructions.”[1]

The real-time reporting requirement will no doubt spawn the need to capture information that would not typically be captured in smaller trading operations. Don’t count on the on a status of end-user to exempt you from these requirements. Even if you qualify for end-user exception, depending on your counter party, you’ll need to assert who in fact will ultimately be responsible for reporting the transaction to a swap data repository (SDR).

Risk and Credit

Since the CFTC introduces two tests of substantial position as a daily requirement, you can bet that your risk and credit department will be busy. The first test of substantial position is based on an entity’s current uncollateralized exposure, and the CFTC’s proposed rule sets the threshold at a daily average of $1bn for credit, equity, or commodity swaps, and $3bn for interest rate swaps. The second test is based on an entity’s (PFE) potential future exposure, and is set at a daily average of $2bn for credit, equity, or commodity swaps, and $6bn for interest rate swaps. Moving beyond the thresholds dictated by these tests can push your company into being categorized as an MSP within a particular swap category.  It is important to note that the substantial position tests exclude those trades that are used for hedging or mitigating commercial risk.

In addition, your risk and credit groups will need to prepare a substantial counterparty exposure test.  This test raises the thresholds for current uncollateralized exposure and potential future exposure to $5bn and $8bn, respectively, without any exclusion for positions held for hedging or mitigating commercial risk.

Since the requirement is that all swaps that can be cleared must be cleared, unless exempted, margining becomes a concern. The credit group will need to carefully assess and project margin requirements.  Liquidity management, as important as it has been in the past, will now take on a role in the spotlight.

Hedging

Your hedge accounting group will need to maintain accurate records to substantiate your company’s hedging program.  This will be important if you wish to establish an end user exception for these transactions.  Business processes must assure that the proper documentation and tracking of hedging activity is in place from intent to inception.

Coordination

 

In a Dodd-Frank world, a successful implementation of compliance depends on an escalated level of communication and coordination between the various groups and systems within an organization.  You must consider it an enterprise deployment – trading, legal, risk, credit, finance, and IT – all must be part of the process and the solution.  Only by evaluating the implications of Dodd-Frank across all these areas will you be able to develop solid compliance plans.

Although, the rules are still in the making, it’s never too early to start planning and assessing your potential problem areas.


 

[1] Commodities Exchange Act – Section 4s(g)(4)

Posted in: Regulation and Standards   |   Tagged  Dodd-Frank, Regulation

Birthday Cake

So, here we are, one year later, and still trying to get our collective heads around the complexity introduced by the Dodd-Frank Act.  So, how’s progress? Well, let’s take a quick look at the numbers.  As of July 27th, the CFTC had finalized 11 out of the 47 rules required, only 23% of the way there.  The SEC is fairing at about the same rate of finalization.  Now it is important to note that we’re primarily talking about Title VII of the DFA; other sections of the law haven’t had a stellar rule adoption rate either. This raises the question, “Shouldn’t more of the key moving parts be in place by now?”

What Is Taking So Long, Anyway?

We’ve recently seen a level of Washington partisanship push us near to default status on our debt, so it should come as no surprise that legislation like the Dodd-Frank Act would inspire a predominantly divisive environment.  There are many bills that were recently introduced in Congress that hope to redact sections of DFA, not to mention the budget cuts that are planned for the regulatory bodies.  More with less seems to be the Congressional mantra.

To add to the legislative distress, President Obama is having a difficult time getting a new director to head up the Consumer Financial Protection Bureau. In mid July, he nominated former Ohio Attorney General Richard Cordray to the post. This nomination came when it was clear that Elizabeth Warren, the bureau’s acting director, was not going to get Senate approval to a permanent post.  Senate Republicans are not likely to back Mr. Cordray’s nomination either.  In fact, they don’t even want a director at all. They would rather have the bureau headed by a bipartisan five-member board.  Without a director, the CFPB cannot enact any rules.

If you caught the Daily Show on Comedy Central last week, there was a segment spoofing the Schoolhouse Rock cartoon “I’m Just a Bill”, where John Oliver portrays a very battered Dodd-Frank Bill.  Yeah, it’s funny, but sadly, it does illustrate some of the real problems that DFA faces, and quite possibly why we are witnessing such a slow rollout.

Hurry Up and Wait

With the CFTC and SEC both acknowledging the need to extend some deadlines along with their power to do so, it is apparent that we won’t see significant OTC regulation until the year end. We will also see much of the implementation moving in through calendar year 2012.  CFTC Chairman Gary Gensler has stated on more than one occasion that it is important to get this right. Overall, I believe, that the CFTC has made reasonable attempts to acquire industry guidance and input throughout the rulemaking process.  Perhaps this is a major contributing factor for some of the delays. I do, however, question the order in which the rules were proposed. I would have thought that the regulators would have tackled the bulk of the definitions first, but that’s just my view.

So, Happy First Birthday, DFA!

(What do you get a one-year old that needs everything?)

 

Michel ZadoroznyjLast month I wrote about three pieces of legislation, one House bill and two Senate bills, crafted to repeal the Dodd-Frank Act (DFA). I went into an analysis of why the passage of these bills really weren’t that likely. Well, this time around it seems that House Republicans are trying a different tactic – delay.  Bill HR 1573, sponsored by House Agriculture Committee Chairman Frank Lucas, R-OK, co-sponsored by House Financial Services Chairman Spencer Bachus, R-AL, targets to delay much of DFA’s Title VII, the highly contested derivatives section, until late 2012.

The truth of the matter is that this bill has just as much probability of passing into law as the bills calling for repeal – that probability being zero – due to many of the same reasons cited in my previous article.  The broader reality is that Dodd-Frank has become a partisan issue, with the GOP defending HR 1573 as a necessary sanity check to prevent the implementation of hastily thought out rules, while the Democrats cite a delay bill as a Republican ploy to wait for a more favorable repeal environment, namely a Republican held Senate or Obama’s defeat in 2012.

The CFTC hasn’t been silent on this topic either. Chairman Gary Gensler stated that CFTC already possesses the authority to extend dates if necessary, so a law is not required.  The CFTC already said it won’t get all the rules engaged by July 16, 2011, of course referring back to its lack of funding as the reason. In a surprising move last month, the agency extended the comment periods on all of their proposed rules, including previously closed comment periods.  Essentially, all rule comment periods that were closed as of May 4, 2011 were extended to June 3, 2011. The CFTC also sought public comment on the order in which the agency should finalize the rules.

Trusting the CFTC’s stance that they already possess the power to extend and delay components of Title VII, why would anyone feel it necessary to draft delay legislation?  The most compelling Republican argument from HR 1573 supporters has been that the proposed bill is not just about delaying the engagement of the regulator’s rules, but also about delaying some of DFA’s automatic or self-executing rules. These rules are embedded in the DFA and don’t depend on any regulatory body rulemaking, and there are plenty of them. These rules repeal sections of the Commodity Exchange Act and the Commodity Futures Modernization Act of 2000, which creates a kind of legal limbo for certain OTC contracts, and introduces a slew of documentation and registration requirements, expecting all entities to be in compliance within the sixty days after June 16th. All this in an environment where the infrastructure hasn’t fully developed past what many view as a straw man phase.

The CFTC is well aware of the potential issues surrounding these triggered rules, and CFTC Commissioner, Scott O’Malia stated in a Reuter’s interview this week, that they are “working on a document and a proposal right now that creates certain safe harbors for self executing rules, to delay them until the new rules are in place.”

Make sure you are all buckled in tight, because this is going to be one helluva ride.

Michel ZandorocnyjHouse of Representatives Bill, H.R. 87, introduced by Rep. Michele Bachmann, R-Minn. back in January, called for the full repeal of the Dodd-Frank Act (DFA).  As one would expect a repeal to be worded, the bill’s text simply states, “The Dodd-Frank Wall Street Reform and Consumer Protection Act (Public Law 111–203) is repealed and the provisions of law amended by such Act are revived or restored as if such Act had not been enacted.”

Oddly, even with Republican leadership in the House, the bill seemed to lack any serious momentum. There are, however, two nearly identical Senate bills, S. 712 and S. 746, introduced by Sen. Jim DeMint [R-SC] and Sen. Richard Shelby [R-AL], respectively, that have really started to gain support.  In fact both bills have the backing of the entire Republican Senate. But will it be enough?  Right now – not likely. Remember that in the Senate, the Republicans are still the Minority party – just ask Senate Minority Leader Mitch McConnell, whose title serves as a daily reminder.

Without winning over any Senate Democrats, neither bill will likely see the light of day. But, let’s just say they do indeed pick up some votes from the Democrats, and the bill passes – they still need to get it through the House.  This is fun! Ok, now let’s pretend that by some stroke of luck the bill squeaks past the House and now sits on the President’s desk. Come on – you know it’s veto time! There is absolutely no way that President Obama will let this go, and if you remember your civics lessons (Do they still teach that?), both Houses would need to pass it with a two-thirds majority to make it stick. Now, with that, we are stretching the boundaries of reality.

What’s likely is Congress will not increase the CFTC’s and SEC’s budgets. In the current economic climate, that really shouldn’t be a surprise. In fact, Congress intends to slash the agencies’ budgets (see my March 23rd article). This will effectively hamper rule making and regulatory oversight as CFTC Chairman Gary Gensler has pointed out while relentlessly pleading for more funding.

As I see it, the killing off of DFA is not going to happen. As the DFA deadlines draw near, we may see some amendments to the legislation. I believe that Congress will be receptive to revise disputed sections of the Act, but to a wholesale repeal – no way.

So, for now, don’t go dumping any plans relating to compliance. Remember, a bill is just a bill, but right now, Dodd-Frank is law.

Gary GenslerAs the Dodd-Frank deadlines rapidly approach, most of us wonder where the CFTC is regarding the rulemaking process. Are they done?  Do we know what’s to be expected?  Well, the short answer is – no, not exactly – at least not yet.

Although, the CFTC has pulled off what many would consider a herculean effort, promulgating proposed rules in 28 of the 31 areas that require their consideration under Dodd-Frank, they’re not quite close to doing an end zone dance.  

They have quite a stack of proposed rules on the table, and are now faced with the arduous task of getting them finalized.  And it’s all going to happen before July 15th, 2011 the designated drop dead date – right? Not necessarily. A good indication that the CFTC may not have all the pieces together by the target date came from CFTC Chairman Gary Gensler himself at an address given before the Futures Industry Association on March 16, when he cited that Congress gave the CFTC flexibility as to setting of the implementation or effective dates of the rules. He also indicated that the CFTC would likely undertake a phased approach to implementation, possibly based on asset class, market or market participant.

The hopes are to finalize many of the high profile rules this spring, such as the process for mandatory clearing, entity definitions, registration requirements, large trader reporting and the enigmatic end-user exception.

End-User Exception

 There’s perhaps no rule that has had more discussion, rumor and concern than the end-user exception. That certainly qualifies it as high-profile.

The end-user exception does provide the ability to opt-out of clearing swap transactions if one of the counterparties to the swap:

1.      is not a financial entity
2.      is using swaps to hedge or mitigate commercial risk;
                     and…
3.      notifies the Commission how it generally meets its financial obligations regarding those swaps.

As the end-user proposed rule stands, there is little offered in the way of loosened reporting requirements. In fact, the proposed regulation would require non-financial entities to notify the Commission each time the end-user clearing exception is elected by delivering specified information to a registered SDR (Swap Data Repository) or, if no registered SDR is available, to the Commission itself.  That means each time a transaction is used for hedging purposes it must pass along several more pieces of information along with the usual bits that would normally be required of cleared transactions.  The proposed regulation also appears to require board approval on a transaction-by-transaction basis for swaps opted out of the clearing requirement.  This does not seem at all practical for most organizations and really requires some further clarification.

However, the real elephant in the room for the CFTC, regarding the exception, has been margin. Until recently, they have been circumspect when asked if margin requirement rules would apply to end-users. In remarks before the House Agriculture Committee on February 10th, CFTC Chairman Gensler stated that “Proposed rules on margin requirements should focus only on transactions between financial entities rather than those transactions that involve non-financial end users.” 

This is good news for bona-fide hedgers, who consider a clearing exemption without a margin exemption entirely inadequate.

Where’s The Money?

The CFTC is concerned about its ability to provide oversight to swaps market given the current state of its budget which is at $169 million.  With the possibility of the Congressional Republicans’ plan to cut their funding by $56.8 million, Chairman Gensler questions the ability of the CFTC to fulfill their responsibilities dictated by Dodd-Frank. This is clearly at odds with President Obama’s proposed 2012 budget of $308 million for the agency. The President’s’ budget increase would be funded by fees charged to the entities that the agency regulates.

On March 17th, Chairman Gensler took the CFTC’s case before a U.S. House Appropriations subcommittee, where he pleaded for a budget increase saying that “without oversight of the swaps market, billions of taxpayer dollars may be at risk.”

Michel ZadorznyjIASB and FASB Convergence

The International Accounting Standards Board and its U.S. counterpart the Financial Accounting Standards Board have been talking about compatible standards for years.  As companies increasingly become global entities, disparate accounting standards complicate things for both corporations and investors. As it currently stands, a U.S. subsidiary of a foreign corporation is essentially running two sets of financial disclosures, one according to U.S. GAAP (Generally Accepted Accounting Principles) and one according to IFRS (International Financial Reporting Standards). The benefits of applying a single standard should be obvious in terms of cost and clarity. Both boards recognize this, and since 2002 they’ve been engaged in a dialog to bring the two standards together.

Less talk more action

Let’s fast forward a bit to 2004. The FASB and the IASB issue a Memorandum of Understanding (MoU), and it is apparent that the two organizations are taking this commitment seriously.  The MoU not only reiterates the need for a single standard, but also cites specific convergence topics as well as expected timeframes. The hope is that it will all come together by the end of 2011. In fact the G-20 (Group of Twenty nations) has recently turned the heat up for a 2011 project completion. The G-20 hopes that a single standard will revitalize global economies. (We could sure use a little boost here.)

Ok, so this is no cakewalk, and there has been bickering along the way, particularly with respect to the issues related to the recent economic crisis. That alone sparked a highly charged dialog on how to cope with toxic assets. At times it seemed almost as if the process was destined to stall. When the IASB issued an exposure draft in December of 2010 on hedge accounting, the document posed a very different approach to hedge accounting than that offered by FASB’s May 2010 exposure draft. So just when it looked like we would achieve confluence, a whole new batch of differences was introduced.  I presume that many hoped that the IASB would offer proposals more in line with those of the FASB. I can also presume that many were ecstatic that the proposals were not.

Some of the Key Differences

 

IASB

FASB

Both financial and non-financial instruments may be used as hedging instruments, with the exception of certain written options. Non-derivative financial instruments may not be used for hedging purposes unless they are used for foreign exchange or net investment risk.
In hedges where an option’s intrinsic value is the designated hedging instrument, the initial time value may be amortized over the time period related to the hedge. In hedges where an option’s intrinsic value is the designated hedging instrument, the initial time value is immediately recognized in earnings.
Component risks are allowed to be hedged. The hedging of component risks is not allowed.
Aggregated exposures (a combination of an exposure and a derivative) may be designated as a hedged item. Not allowed.
To qualify for hedge accounting, a hedging relationship is required to both (a) meet the objective of the hedge effectiveness assessment (that is, to ensure that the hedging relationship will produce an unbiased result and minimize expected hedge ineffectiveness) and (b) be expected to achieve other-than-accidental offsetting.

To qualify for hedge accounting, current U.S. GAAP requires that the hedging relationship be expected to be highly effective in achieving offsetting of the changes in fair values or cash flows.

Under proposed U.S. GAAP, the “highly effective” requirement would be changed to “reasonably effective.”

After inception of a hedge, an entity must reassess hedge effectiveness on a prospective basis in an ongoing manner. A retrospective assessment is not required for qualification purposes. The proposed guidance does not specify whether an entity would perform a qualitative or quantitative analysis when determining whether a hedging relationship meets the hedge effectiveness requirements.

Proposed U.S. GAAP would require that, after inception, an entity assess hedge effectiveness after inception of a hedge on a prospective basis and retrospective basis only if changes in circumstances suggest that the hedging relationship may no longer be reasonably effective

An entity may adjust an existing hedging relationship (referred to as “rebalancing”) and account for the revised hedging relationship as a continuation of the existing hedge rather than as a discontinuation when any of the following occur:

a. A hedged item changes.

b. A hedging instrument changes.

c. The expectation of hedge effectiveness changes.

d. Any combination of the above.

The part of the hedging relationship that remains after the rebalancing would be reported as a continuing hedge, with the part that is no longer hedged after rebalancing reported as a discontinued hedge.

Under proposed U.S. GAAP, an entity may modify the hedging instrument by adding a derivative to an existing hedging relationship that would not offset fully the existing hedging derivative and would not reduce the effectiveness of the hedging relationship. That modification would not result in the termination of the hedging relationship.

For fair value hedges, the gain or loss on the hedging instrument and hedged item (excluding the ineffective portion) would be recognized in other comprehensive income.

For fair value hedges, the gain or loss on the hedging instrument and hedged item (for changes in the hedged risk) are presented in profit or loss.

For fair value hedges, fair value changes attributable to the hedged risk would be presented as a separate line item in the statement of financial position. That separate line item should be presented next to the line item that includes the hedged asset or liability.

For fair value hedges, the carrying amount of the hedged item is adjusted for the change in its fair value attributable to the hedged risk.

Finding Middle Ground

While it’s too early to break into a chorus of “What a Wonderful World”, progress is being made. This month, the FASB issued a discussion paper on hedge accounting that actually included the IASB’s exposure draft.  This could be an indication that the FASB may be leaning towards IASB’s proposals. At least that’s the way it looks. Both organizations are keen to simplify the hedge accounting rules, so I view the FASB’s issuance of this document as a positive step towards a single standard.

 

As things stand today, multi-national corporations need to constantly look to multiple sources for guidance on every accounting and disclosure issue. This is an important issue. Adhering to a mixed set of standards for global entities benefits no one – neither corporations nor investors.

The comment deadline for the IASB’s exposure draft for hedge accounting is March 9, 2011, while the comment period for FASB’s discussion paper ends April 25, 2011.

 

Michel ZadoroznyjAlthough in its early stages, European Financial Reform is rapidly developing. There are challenges unique to the European Union in terms of jurisdictional complexity that make Dodd-Frank look like a stroll in the park.  Providing regulatory oversight without stepping on nationalist toes will be some trick indeed.

In spite of the obvious obstacles, the EU is moving forward.  In December the European Parliament moved legislation that created the European Systemic Risk Board. The ESRB is part of the European System of Financial Supervision (ESFS), the purpose of which is to ensure the supervision of the Union’s financial system. The ESRB closely resembles the Financial Stability Oversight Council, which was created by the Dodd-Frank Act. It will be responsible for the macro-prudential oversight of the financial system within the EU in order to assist in the prevention or mitigation of systemic risks to financial stability in the EU.

This month, the European Parliament established three new European Supervisory Authorities: the European Banking Authority, the European Securities and Markets Authority, and the European Insurance and Occupational Pensions Authority.  These are the guys that will be setting the technical standards for financial institutions.  They will work very closely with the ESRB in laying the groundwork for the new regulatory policies.  One key stipulation that the ESAs must abide by is that they must ensure that no decision impinges on the fiscal responsibilities of EU member states.  I can see situations arising where a national interest and a rule issued by an ESA may be at odds.  One wonders what the reconciliation process will be like.

In order for these newly established entities to be effective the EU will need to come up with joint data standards.  Data standards across national supervisory bodies have long been considered a kind of Achilles’ heel for the EU.  With 27 member states, it will be interesting to see how the data standards develop – I can’t get my family to agree on lunch.

What About Derivatives?

Regarding the regulation of derivatives we see the European Commission proposing rules similar to those seen in Title VII of Dodd-Frank.  Through the MiFID (Markets in Financial Instruments Directive) revision proposals we see the central themes of greater transparency, central clearing and reduced operational risk clearly taking shape.

Trade Repositories

European entities will be subject to mandatory reporting of OTC derivative trades to central data centers.  Very much like its US counterpart, the Swap Data Repository, the trade repository will collect position information by derivative class and publicly disseminate the information.  It will be the responsibility of the European Securities and Markets Authority to govern these repositories.

Central Clearing

Very much like in Dodd-Frank, over-the-counter derivatives that can be cleared must be cleared through central counterparties.  Eligible transactions will include those that are standardized or that possess a high level of liquidity.

Operational Risk

 

The European Commission’s proposal strongly promotes the use of electronic means for the timely confirmation of the terms of OTC derivatives contracts as a means of reducing operational risk. Entities should develop and maintain an organizational structure, internal controls and a reporting system suitable for the identification, assessment, control and monitoring of operational risks in market-related activities.

When?

Prompted by the 2009 G-20 agreement that stated – “all standard OTC derivative contracts should be traded on exchanges or electronic trading platforms, where appropriate, and cleared through central counterparties by end-2012 at the latest”, the European Commission has made it clear that it intends to stick to that time frame.

We will be watching these developments very closely.

 

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