Fair value accounting: an open and shut case

For the first time this year many financial institutions will have included derivatives at their fair value on balance sheets and, in many cases, this will have been a major headache.

Although fair value accounting became mandatory for the UK’s larger banks and building societies in 2005, when 29 European countries introduced International Financial Reporting Standards (IFRS), it has only become a requirement for smaller firms recently and must now be evident in their accounts.

Fluctuation in interest rates from one period to another causes fair value to change materially and, as a result, there is potential for large volatility in reported earnings and profits.

The accounting standard IAS 39 was amended in March 2004 to specifically allow a portfolio approach to hedge account for a fair value portfolio of derivatives used to hedge interest rate risk.

In order to conform to the relevant guidelines, and despite their complexities, many banks do adopt this portfolio hedge accounting approach where constant amortisation adjustments for de and re designation are often required.

These adjustments are often made on large spreadsheets, introducing the risk of human error; these adjustments can cause the value on the balance sheet to become distorted from the true economic fair value; and the accounts can also distort what is actually happening between the hedge and the hedged item.

It is, however, perfectly feasible to adopt open portfolio hedge accounting, allowing a firm to take an open portfolio of interest rate swaps and apply the concept of dynamic hedging without the need for constant adjustments..

With this in mind, the ideal software will properly calculate the value of the designated hedged item while following the very specific rules laid out in provisions AG126 and AG 127 of IAS 39. It will include the individual loans and have the ability to calculate their fair value based on expected cash flows. If it can’t, then we go back to the headache of de designating every month and amortising the fair value out.

Surely adopting a cleaner approach to hedge accounting, that doesn’t require all of these adjustments, is essential, where the hedged item amount reported always reflects the economic value of that hedged item without the distortion?


Related reading

Dominic Mac