Revised standards on financial instruments

ACCA's head of financial reporting, Richard Martin, reports

The IASB finally published the improved versions of its existing standards, including the revised versions of its now notorious standards (IAS 32 and IAS 39) on financial instruments. This is a milestone on the road to adopting International Financial Reporting Standards (IFRS) by 2005 for the many businesses in the European Union, Australia and elsewhere. The major part of the rules to be used in the conversion and restatement process are now finalised.

One can say a few things right away about these two standards:

• every company has financial instruments of one sort or another - not just derivative contracts, but investments, borrowings, cash, debtors, creditors are all included
• certain sectors (e.g. finance and insurance) are likely to be affected more than most
• IAS 32 and 39 are long (over 500 pages in all), complex and still hard to understand
• many countries have no equivalent standards and so changes are inevitable for most companies
• implementation may involve not only new accounting, but also new data to be gathered for disclosures, new valuation methods and even new systems to enable this, and
• there are choices in classification of assets and in the amount of hedge accounting indulged in.

IAS 32 deals with presentation and disclosure. It establishes the dividing line between what should be presented as a liability (debt) and what as equity. Preference shares (especially those which are redeemable) may need to be shown as a liability even though, legally, they are share capital. Convertible debt needs to be divided into liability and equity elements.

The disclosures required are extensive and cover not only the detail of financial assets and liabilities, but also perhaps less familiar requirements to explain the company's approach to managing financial risks and the extent of exposures to interest rate changes and to credit risks.

When applying IAS 39 (recognition and measurement) companies will have to sort their financial assets into four categories. This is critical as the accounting for each will be different.

• Held for trading - all derivatives must be included here, plus any others so designated by management. All must be stated at fair value, with increases or falls taken as a profit or loss.
• Loans and receivables - these should be stated at amortised cost.
• Held to maturity investments - as for loans and receivables, except that there are penalties if they are ever reclassified or sold before maturity.
• Available for sale - which is everything else, including most investment portfolios for instance. These must be shown at fair value but changes go direct to equity until the asset is sold.

Liabilities are essentially to be shown at amortised cost. There is, however, a general option to treat any asset or liability as if they were held for trading.

Two thoughts arise from these classifications and valuations. Firstly, many items will continue to be valued as they commonly are at present - those at amortised cost and mark-to-market for trading items. Secondly, there are some (derivatives and investments, for example) where fair values need to be estimated for the first time. Companies may need new information and systems to do this. The resulting fair values could create volatility, especially in balance sheet values.

One way companies have tried to manage volatility and financial risks is by hedge accounting. Hedge accounting is allowed by IAS 39 as long as certain tests are passed. The hedges have to be designated and documented from the outset and their continued effectiveness has to be proved. These conditions are easier said than done, and new systems to record and track the hedged items may be needed. But hedge accounting is an entirely voluntary activity.

Another problem area with financial instruments is deciding when you have got rid of them - derecognition. The revision to IAS 39 includes a series of tests based first on the degree of risks and rewards retained and then on the extent of control continued to be exercised.

IAS 32 and 39 are among the most important of IASB's standards and, unsurprisingly, the most controversial. The EU pointedly did not endorse them when the other existing standards were passed last summer. Whether the improved versions now published will get the nod remains to be seen. European companies need, however, to work on the assumption that they will be endorsed. The alternative risks unravelling the whole 2005 project.

Richard Martin is head of financial reporting at ACCA.