Alessandro Miolo, Arthur Andersen,
The International Accounting Standards Committee (IASC) has issued IAS 39: Financial Instruments: Recognition and Measurement as part of a core set of accounting standards that may be endorsed by the International Organisation of Securities Commissions (IOSCO) for cross-border capital raising and listing purposes.
The need for a new standard on financial instruments was mainly due to the current wide range of alternative measurements which led to incomparability and a number of unrecognised financial assets and liabilities, particularly derivatives.
The objective of the new standard is to establish principles for recognising, measuring, and disclosing additional information about financial instruments for companies which establish the financial statements in accordance with International Accounting Standards.
This Standard significantly increases the use of fair value accounting for financial instruments, consistent with the long-term objective of the IASC of full fair value accounting for all financial assets and liabilities.
Under the International Accounting Standard 39 (IAS 39), all financial assets and financial liabilities have to be recognised on the balance sheet. including all derivatives. Furthermore, the standard requires that the embedded derivative of a hybrid instrument be separated from the host contract, provided certain criteria are met. If it has to be separated, such as a call or put option on debt that is issued at a significant discount, the embedded derivative will have to be fair valued and accounted for individually.
This new accounting standard establishes uniform hedge accounting criteria for all derivatives. Hedge accounting recognises symmetrically the offsetting effects on net income of changes in fair value of the hedging instrument and the hedged item in order to reduce volatility in the income statement. IAS 39 requires that an enterprise must formally designate a hedging instrument to a related item or to a group of similar items being hedged, and to assess and document the effectiveness of transactions that receive hedge accounting.
By increasing the use of fair values in accounting for financial instruments and implementing provisions for certain embedded derivatives, as well as consistent accounting standards for the use of hedge accounting, IAS 39 will affect many companies. Compliance will have major, widespread impacts on users of financial instruments.
Major potential impacts of IAS 39 include volatility in the income statement and in equity, require significant changes in financial risk management strategies and to business processes and systems, as well as modified and additional information to stakeholders. Therefore, companies preparing their financial statements under IAS will have to consider the impact on the functional areas involved in managing, processing, controlling and accounting for financial instruments.
Volatility in Equity and the Income Statement
According to IAS 39, at inception all financial instruments are measured at their cost value. The subsequent remeasurement depends on the initial classification of the financial instrument. Financial assets and liabilities held for trading - including all derivatives - are re-measured to fair value with unrealised gains or losses to be included in the income statement.
Financial assets classified as 'available-for-sale' are also re-measured to fair value, but the company has the option to include unrealised gains or losses in equity. Other categorises of financial assets are those classified as 'Assets held-to-maturity' which are re-measured at amortised cost and 'Originated loans and receivables' which are subsequently measured at cost (without fixed maturity) or amortised cost (with fixed maturity). Financial liabilities - except those held for trading and derivatives are re-measured at amortised cost (see Figure 1 below).
Figure 1: Measurement of Financial Instruments According to IAS 39
Hedge accounting may be adopted in order to decrease the volatility of the income statement. The standard distinguishes between fair value hedges, cash flow hedges and the hedges of a net investment in a foreign entity.
Whereas the fair value hedge is utilised to hedge the variability of changes in fair value of a recognised asset or liability, a cash flow hedge is used to hedge the exposure to the variability in cash flows associated with a recognised asset or liability, a firm commitment or a forecasted transaction. A hedge on a net investment in foreign entity is applied to hedge the company's share in the net assets of that entity which is not a subsidiary, an associate, or a joint venture.
Significant Changes in Financial Risk Management Strategies
To properly anticipate and manage volatility in equity and the income statement, companies will need to look at current hedging strategies and accounting policies. Financial risk management objectives and strategies have to be re-assessed in order to achieve overall objectives.
Procedures to designate hedging instruments to hedged items and to measure the hedge effectiveness have to be put in place. Since all derivatives have to be fair valued, sources of fair value information have to be identified. Documentation of hedge relations, the measurement of the hedge effectiveness and the valuations of financial instruments has to be ensured.
Changes to Business Processes and a Need for Systems Solutions Upgrade
By applying hedge accounting, IAS 39 prescribes a forward-looking approach to measure expected hedge effectiveness at inception and a backward-looking approach to measure realised hedge effectiveness throughout the life of the hedge. The method an enterprise adopts for assessing hedge effectiveness will depend on its risk management strategy and can vary between different types of hedges, and therefore, has to be carefully selected.
Beyond keeping tabs on fair values, companies will have to track premiums and discounts on items hedged in fair value hedges and amounts deferred in equity for cash flow hedges. Information to meet disclosure requirements has to be compiled and automated journal entries have to be evaluated to determine the magnitude of potential system adoptions and enhancements.
Information to Stakeholders
The new standard requires additional disclosures in the financial statements relating to accounting policies, hedging and financial instruments. The methods and assumptions in estimating fair values, information on the risk management objectives and policies, a description of designated hedges and significant items of gains and losses on financial instruments are only a few of the additional disclosure requirements as set out by IAS 39.
For accounting purposes the chart of accounts and internal reporting packages have to be revised, standard accounting journal entries have to be determined and accounting transition adjustment entries have to be carefully assessed. Management reports should enclose the likely impact on the income statement and equity of the mark-to-fair-value, since this can be of considerable interest. Not least, it is advisable that a clear communication strategy to rating agencies, investors, analysts and other external parties is developed.
With the increased use of fair value accounting for financial instruments, the treatment of embedded derivatives and the hedge accounting principles the IASC created a challenging new accounting principle. Since IAS 39 affects not only accounting, but also other functional areas, the implementation should be planned thoroughly.
A successful implementation requires a multi-disciplinary effort which demands treasury, operations, risk management and accounting expertise. IAS 39 will be effective for financial statements for financial years beginning on or after January 1, 2001. With this date fast approaching, companies are encouraged to begin assessing the effects of IAS 39 already now.
|Originally published in Swiss Derivatives Review
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