A long-expected transition from U.S. Generally Accepted Accounting Principles (GAAP) to International Financial Reporting Standards (IFRS) is looming, with the potential to wreak havoc on the processes that precede and underlie a company's financial reporting. Finance, accounting, legal, tax, IT and other departments must coalesce behind a unified approach before effective systems changes can be made -- not the least of which is a reliable and compliant valuation process.

GAAP is based on rules, IFRS on principles that are more open to interpretation. Transitioning to IFRS thus implies a higher level of disclosure to ensure compliance. Disclosures must stand up to more intense scrutiny under different interpretations rather than against definitive rules.

IFRS 7 contains a number of requirements intent on increasing the transparency, usability and reliability of financial instrument valuations. In addition, IFRS 9 is progressing towards a proposed effective date of January 2013 to replace IAS 39. Under IFRS 9, a whole new model for hedge accounting is expected. Convergence of GAAP with IFRS will need to include a reckoning of fair value and hedge accounting approaches.

Short Versus Long Term

The Securities and Exchange Commission this year may ratify a 2014 time frame for mandatory transition. But in the short run, intended convergence of GAAP and IFRS will be encoded directly into U.S. principles. Ultimately, changes to both GAAP and IFRS will result in parallel convergence activities, meaning the U.S. transition to IFRS should not be regarded as solely a one-way movement.

The scope of long-term, full convergence will be much broader, encompassing accounting practices from revenue recognition to leasing to the reporting of financial instruments and derivatives. In addition to the regulatory aspects of convergence, the SEC has recently considered the practical issues of financial statement users' understanding of IFRS, independence within the standard-setting body and the readiness of human resources. It is wise to add corporate system and process readiness to this list.

Because U.S. laws make direct reference to GAAP, it is a conceivable option to use a "converged" U.S. GAAP rather than "converged" IFRS rules to meet the demand for uniform global standards. While the implementation mechanism is important - and could turn out to be GAAP instead of IFRS - this article discusses the implications embodied in updated IFRS information, on the premise that convergence work streams are incorporated within all recent changes. The discussion is around IFRS 7 and IFRS 9 because both are relevant to corporate treasury readiness for convergence.

IFRS 7 Financial Instruments: Disclosures discusses categories of financial instruments, assets measured at fair values, collateral, hedge accounting, credit risk, liquidity risk, market risk, and sensitivity analysis. It is very broad in scope and takes on the daunting task of describing required disclosures for all the above.

The implications of short- and long-term preparation for IFRS are that each corporate treasury must decide on its most effective areas of contribution without creating a reliance on extraordinary effort. If resources are required to put system, people and process changes in place, these must be planned with an eye towards convergence while not over-committing in case of changes to the ordained path or predicted timeline.

Hedge Accounting

Regarding IFRS 9 preparations, proposed changes include the intent to replace, in phases, IAS 39 Financial Instruments: Recognition and Measurement with IFRS 9: Financial Instruments. IAS 39 is the international standard that is comparable to FAS 133 in the U.S.

While not the main thrust of any phase, the first (Classification and Measurement) and third (Hedge Accounting) phases leading toward a final IFRS 9 include attention to the transparent valuation of financial instruments and/or derivatives. (Phase 2, Impairment of Financial Assets, planned for completion in mid-2011, focuses on an expected loss model for determining asset impairments.)

Phase 3, pointing toward a new hedge accounting model to make it easier for non-financial companies to make disclosures closely matching their risk management practices, deserves special mention. Companies have gained much experience with hedging since IAS 39, which has come to be viewed as overly complex and detached from actual risk management practice. IFRS 9 is intended to reduce these difficulties, enabling more usability and a closer representation of what treasuries are doing.

As sections are added to IFRS 9, they replace parts of IAS 39. So that creates a moving target for comments contributed by treasuries and accounting departments to the exposure draft. In addition, finalized disclosure requirements will be included in IFRS 7.

The December 2010 exposure draft on hedge accounting proposes that companies use internally generated risk management information as the basis for hedge accounting. This ties the ability to elect and maintain hedge accounting benefits directly to operational risk management systems. Choices of risk and valuation solutions will directly impact the effectiveness and expediency of decisions like designation and de-designation of hedging instruments in closed portfolios.

The new principles-based approach to hedge accounting will be more flexible to allow for economic hedge adjustments, while not disqualifying them from hedge accounting.

The Compliance Curve

Some European and Canadian companies elected to produce early drafts of their financial statements under IFRS. This was done partly as a test run and partly to demonstrate that they were becoming more transparent, adhering to a global definition rather than being compelled by compliance requirements.

The idea of draft preparedness also serves to identify lurking dependencies such as required technological changes by forcing the production of an end goal -- the IFRS statements themselves.

While approaching the relevant areas for corporate compliance, taking the perspective of directly complying with IFRS 7 and IFRS 9 (regardless of the official timeline to be determined) serves two purposes: It looks at specific requirements for compliance which, if adhered to, will most likely meet U.S. GAAP changes intended to mirror IFRS 7. And it facilitates a draft test run for IFRS 7 statement preparation. This exercise will identify any hidden process or technology requirements and, if successful, will serve as a voluntary indication of a company's pursuit of transparency.

A primary provision is for a business to transparently report its usage of financial instruments. Complying means discussing the relationship of financial instruments with a corporation's financial strategy, regarding why those instruments are held and the risks they expose the business to. Companies are obliged to report how they manage the exposed risks. Further, some disclosures require illustration of the behavior of financial instruments under different economic conditions - in other words, scenarios where risks manifest.

In parallel with quantitative disclosures, qualitative descriptions are required. Treasury's day-to-day exposure to the operation of financial instruments, as related cash flows execute and interact with the corporate cash portfolio, gives the treasury staff a uniquely informed perspective. This enhances the importance of clear and regular communication between treasury and the chief financial officer function, because IFRS is not merely about calculations, but also the interpretation of their impact on corporate financial strategy. The CFO must clearly articulate the strategy, and treasury must support that with actual and scenario interpretations of financial instrument behavior. All metrics provided by treasury serve this common goal because IFRS 7 is intended to disclose the internal reasoning behind financial holdings to external stakeholders.

Risk Management Support

Companies with debt instruments already value them for trading and reporting reasons. In some cases, formal sensitivities to such factors as interest rate changes are calculated for portfolio management and trading purposes, but this is not universal. To many, the implementation of sensitivity reports will be a new step towards more informed risk management.

The general requirement in IFRS 7 is to disclose instrument sensitivities to interest rates, currency exchange rates and other observable price risk. The sensitivities of these market risks can be disclosed by evaluating the impact of "reasonably possible" rate or price changes on the valuations of the affected instruments. Also usable are methodologies such as value at risk, but parameter inputs must be explained. There is no specific, recommended methodology for sensitivity measures in IFRS 7, and the methods chosen will likely vary with the types of instruments measured. The emphasis is on using the methods relevant for internal management purposes.

FAS 157 specifically refers to a valuation hierarchy distinguishing valuations from direct market quotes (Level I), derived from market observable inputs (Level II) and using unobservable inputs (Level III). IFRS 7 similarly distinguishes observable quotes from those using valuation techniques, but it goes further to require description of valuation changes specifically resulting from assumptions not supported by market evidence.

It is this descriptive requirement that emphasizes a need for treasury to demand transparency from its valuation solution - the market data inputs must be above reproach and readily describable. Also, the "potential effect of using reasonably possible assumptions" in models must be described, most likely by quantification. A valuation process or system must therefore provide scenario capabilities or quantify the effect of parameter changes in a report.

Fair Values, Centralized

On the income statement, more fine-grained category disclosures are required for gains and losses from fair value changes, meaning larger groupings of securities must be disaggregated into smaller categories, thereby requiring valuations closer to the instrument level. Specific disclosures are to be determined by corporate accounting policies, but they will likely translate into more fine-grained reporting of valuations by treasury. Because the chosen groupings of securities for reporting categories will now change, aggregated valuation reports will now be redefined. This can require a revamping or increased volume of reports provided by treasury.

All of this makes centralized processing of valuations and related reporting more attractive and of higher relevance in the IFRS world, with all position data and valuation outputs stored in one system where reports can be run on demand for consistency of method and continuity of transparency.

IFRS 7 requires quantitative disclosures of concentration risk, where multiple financial instruments or their magnitudes of exposure have common characteristics, such as to individual industries, geographies, markets, or counterparties.

Since explanation of risk management is a recurring theme in IFRS 7, it is worthwhile exploring possible solutions for concentration-risk calculations such as for counterparty risks.

Conclusion

The transition from a rules-based to a principles-based accounting philosophy will mean tighter scrutiny of interpretations for complex disclosures, such as for derivatives valuations, valuation changes and the disaggregation of their component risk premiums or discounts (particularly with credit, market and liquidity risk). IFRS 9 will draw this type of scrutiny for hedge accounting, while at the same time simplifying and replacing provisions of IAS 39.

The IFRS 7 and IFRS 9 rules that touch on valuations aim to identify, describe and explain the risk management applied to financial instruments and the exposures to bring on. Qualitative inclusions demand that risk management approaches be articulated with management's viewpoint. IFRS 9 will bring accounting disclosures closer to risk management practices, meaning information used internally for risk management will now contribute more directly to accounting disclosures.

For treasurers who may not provide IFRS 7 disclosures directly, this means systematizing the provision of financial information that underlies disclosures. The prime example is valuation of financial instruments and derivatives, including valuations for hedging instruments. These quantitative outputs, if questioned, need to be explained. Therefore, it is a source of comfort to know that a valuation solution uses widely accepted valuation methods and market data and that both can be easily examined in more depth.

Bob Park is president and CEO of Canada-based derivatives analytics and valuations systems company FINCAD. His e-mail address is b.park@fincad.com.