Challenges of the Fair Value Approach (Part 2)

August 23, 2004 by admin

Needless to say, the poor economic situation in 2001 and 2002 – and especially capital losses in the stock markets – had a tremendous impact on the valuation of financial assets according to International Accounting Standards (IAS). Independent of the valuation approach and the treatment of valuation results of the particular holding category, any permanent depreciation is to be documented in the profit and loss statement. According to IAS 39, a company must regularly examine its financial assets with regard to permanent depreciation. If this is the case, income statement-related valuation based on fair value must be applied. This guarantees higher transparency of the success of the company.

Impairment

Financial assets valuated for amortized costs, as well as the previously mentioned financial assets available for sale, are relevant when examining for impairment. This pertains to loans, government bonds, company bonds, or stock. These assets all have one thing in common: they are not valuated according to income statement-related valuation of fair value. In light of the impairment principle, when permanent depreciation is the case, IAS 39 ensures that market losses for every financial instrument are documented in the profit and loss statement.
In this context, every treasury solution is challenged not only to provide normal valuation routines, but also to provide an unscheduled valuation with an income statement-related fair value assessment varying from the rules that are normally applied. Normal valuation routines are carried out on balance sheet key dates for all existing financial instruments, such as valuating amortized costs for all loans and receivables. On the other hand, unscheduled valuation is necessary if a certain financial instrument detected permanent depreciation at a certain point in time – such as if its market value had dropped under a certain percentage of acquisition costs. This can be determined with SAP Treasury and Risk Management evaluation functions. In particular, to make company profits more transparent when financial assets are available for sale, previous valuation results recognized in equity are automatically transferred in the profit and loss statement.

components of book value

components of book value

This functionality for creating impairments has been featured in SAP Treasury and Risk Management’s parallel position management application since SAP CFM 2.0 and is now included in the standard mySAP ERP offering. Furthermore, within mySAP ERP write-offs due to permanent depreciations can be reported separately from other valuation results. This provides users with a constant overview as to how the book value of assets is determined. Book value is determined by relevant acquisition costs, amortizations, and by valuations on scheduled balance sheet key dates, as well as by unscheduled impairments.
Compared to the poor economic situation in 2001 and 2002, in recent months SAP clients have repeatedly asked whether impairments can be reversed. This would seem to indicate that the lean stock market years are now over. At any rate, SAP Treasury and Risk Management supports reversals of impairments.

Hedging instruments used by cash flow hedges

One important and controversial area of IAS 39 is hedge accounting. In hedge accounting, a hedging relationship between an underlying transaction and a hedging instrument is created. IAS 39 names several kinds of hedging relationships, including cash flow hedges. The underlying transaction of a cash flow hedge is a cash flow in the future that carries a certain risk, such as from exchange rates or interest rate fluctuations. For instance, the underlying transaction would be for a European company to target a certain revenue for the U.S. market, which would be subject to exchange rate fluctuation between the euro and U.S. dollar. Hedging instruments are usually derivatives, such as forward exchange transaction or options.
The substantial documentation requirements of IAS 39 include, among other things, being able to prove the effectiveness of a hedging relationship. A hedging relationship is considered effective when the change in the value of an underlying transaction is almost totally offset by a corresponding change in the value of the hedging instrument. For instance, if the underlying transaction assumes a revenue target of U.S. $1,000,000, this amounts to about EURO 800,000 at the current rate of exchange. Should the exchange rate to the dollar drop to Euro 0.75 on the balance sheet key date, the underlying transaction would have lost Euro 50,000. However, if the revenue goal is hedged by a forward exchange transaction, then the hedging relationship is considered to be effective if the value of the forward exchange transaction climbs to about Euro 50,000 on the same date.
According to IAS 39, the derivative must be valuated according to the fair value and the profit documented as income statement related. However, if the derivative is viewed as a hedging instrument in a cash flow hedge, the part of the valuation result considered to be effective for the hedging relationship can be documented in equity as not affecting net income. Particularly when options are used as hedging instruments, splitting the fair value changes can even go a step further when the change in the time value is disregarded when effectiveness is checked. Only at the termination of a hedging relationship valuation results documented as not affecting income have to be rebooked in the profit and loss statement. Thus, hedge accounting gives a company the opportunity to avoid swings in profit and loss calculation in various reporting periods. This is important to display (as transparently as possible) business processes in the balance sheet across several reporting periods – such as with revenue targets for several business periods and their currency hedging. Without hedge accounting for cash flow hedges, the valuation result for the derivative of the current period would show up in the profit and loss statement calculation every subsequent period.
Hedge accounting places high demands on treasury software. For one thing, the entire hedge accounting process must be displayed, including documentation of the hedging relationships, the effectiveness testing, the resulting postings, and any possible changes during the validity period of the hedging relationship. Furthermore, hedge accounting guidelines in IAS 39 are comparatively new for some companies and are also subject to change.

Is the extra security worth the effort?

Hedge accounting in IAS 39 requires extensive documentation, and the necessary processes require a lot of effort, which sometimes creates a controversy concerning security. However, if hedge accounting is not used as a security mechanism, IAS 39 can result in large swings in profit and loss calculations, as the cash flow hedges example shows. In reality, companies tend to decide against hedging risks in their operational business for balancing reasons, although it could very well make sense from a corporate point of view. SAP Treasury and Risk Management features various tools to deal with IAS 39 hedging issues – especially for currency risks. These include managing hedging relationships, featuring various methods to check effectiveness, and correctly documenting valuation results.
IAS 39 examples, such as financial assets available for sale, impairment, and hedge accounting, make it clear that the fair value approach includes various aspects that go well beyond income statement-related valuation of the fair value approach. An accounting solution that adopts the fair value approach must address these issues, which is the case with SAP Treasury and Risk Management.
Part 1

Stefan Schmid

Tags: ,

2 comments

  1. Hello, not sure if it’s my computer or your site, but your right sidebar is covering some of the text in the middle of the page if that makes any sense? I’ve reloaded the page a few times, and the same thing keeps happening. I stop by from time to time and havn’t noticed this before.

  2. Thanks for the ideas you have provided here. Yet another thing I would like to state is that pc memory demands generally rise along with other innovations in the engineering. For instance, any time new generations of cpus are introduced to the market, there is certainly usually a matching increase in the dimensions preferences of both the computer system memory in addition to hard drive space. This is because the application operated through these cpus will inevitably rise in power to leverage the new know-how.

Leave a Reply