One of the proposed changes from IAS 39 in the new standard IFRS 9 is the removal of the ability to make ‘basis adjustments’ to non-financial hedged items. This could be a major issue for many importers who hedge their currency risk. The whole process of capturing gross margin in the ERP/Stock Management system may need to change or importers may risk losing margin on sales.
The current IAS 39 allows for effective fair value stored in Equity to be released against the carrying value of the non-financial hedged item – this is called a “basis adjustment”. In essence, this allows offshore inventory and fixed asset purchases to be recorded on the balance sheet at the effective rate that a company hedged at. This is important for many importers, since sales margins are imposed on the local currency value of inventory.
The US equivalent standard ASC 815 (FAS 133) does not allow such treatment – all fair values stored in Other Comprehensive Income (OCI) must be taken to P&L at the same time as the hedged item affects earnings. This inconsistency between standards may be eliminated in the new versions of IAS 39 – IFRS 9, which due out later this year as the IASB looks to converge to the US standard and simplify application. How can such a little rule make such a difference?
Consider an example where a Euro reporting “Company A” imports goods from China denominated in US dollars. Company A locks in the currency risk with forward exchange contracts; however, by the time the goods were receipted into inventory, the Euro had strengthened significantly. Using the basis adjustment approach, the inventory will be receipted into the system at the effective hedged rate – this means the inventory’s value reflects the actual amount of Euros paid for it. All users of that information, from distribution agents, cost accountants and sales managers can confidently price and value goods safe in the knowledge on what the goods or raw materials cost the company.
Contrast that situation to a world where such basis adjustments are not allowed. IFRS will require that the inventory is receipted in at the market spot rate of that time. The finance team will attempt to recycle fair value on the forward exchange contract out of OCI based on average stock turnover (say) but this recycling effect usually operates at the macro level and unlikely to be recorded within the inventory system itself. All of the users of that inventory system will now see goods valued at cheaper Euros than it actually cost Company A. This could lead to a mis-pricing of goods and deals sold at low gross margins or even at a loss!
The IASB and FASB’s goals around convergence and simplification are good and beneficial for all – however the IASB should not throw out the good rules with the bad ones. The process of basis adjustment reflects the underlying business practice embedded in many importers’ systems and processes – simplifying the standard should not be done at the expense of good accounting practice.