By Richard C. Jones and Elizabeth K. Venuti
FEBRUARY 2005 – The International Accounting Standards Board (IASB) has found the task of establishing standards on accounting for financial instruments, including derivatives, as challenging as FASB has. The international guidance on accounting for financial instruments is contained mainly in two standards: International Accounting Standard (IAS) 32, Financial Instruments: Disclosure and Presentation, and IAS 39, Financial Instruments: Recognition and Measurement.
In December 2003, the IASB issued amendments to both standards. The revised IAS 32 and IAS 39 are effective for financial years beginning on or after January 1, 2005, with early adoption permitted.
In the process of completing the most recent series of amendments, the IASB conducted an extensive due process, which began in 2001 and included the following:
- Conducting numerous board deliberations prior to the June 2002 exposure drafts;
- Discussing the exposure drafts with constituent groups in nine roundtable meetings;
- Receiving and evaluating over 270 comment letters; and
- Discussing the topic regularly at board meetings and with its many advisory committees and various national standards-setters around the globe, including FASB.
Despite its considerable efforts, the IASB admits that the current guidance is a stopgap that fails to address important fundamental issues that must be addressed in a major future project. But the IASB might decide to reconsider parts or all of the financial instrument’s guidance for other, more practical reasons.
Despite having recently stated that in 2005 it would endorse some or all of the IASB standards as the primary financial accounting and reporting rules for its member states, the European Commission proposed excluding certain provisions of IAS 39 when the international standards are adopted. The commission’s proposal resulted from concerns expressed by major international financial institutions about certain provisions of the amended IAS 39. The IASB continues to deliberate on those controversial topics.
IAS 32 and IAS 39 provide guidance on accounting and reporting on financial instruments. Where other available guidance was deemed sufficient, the IASB excluded certain financial instruments from the documents’ scope. The excluded topics include the following:
- Assets and liabilities under an employee benefit plan;
- Contracts for contingent consideration in a business combination;
- Certain insurance contracts;
- Most loan commitments; and
- Interests in subsidiaries, associates, and joint ventures, except where specific guidance requires application of IAS 39.
Overview of IAS 32
Initially issued in 1995 and amended several times since then, IAS 32 defines the key financial instrument terms and provides the basic financial reporting disclosures and some financial statement presentation requirements for financial instruments, including derivatives. In the United States, similar guidance is addressed in several separate statements, interpretations, and Emerging Issues Task Force items. The following are the major U.S. standards that address financial instruments accounting and reporting:
- SFAS 107, Disclosures About Fair Value of Financial Instruments.
- SFAS 133, Accounting for Derivative Financial Instruments and Hedging Activities.
- SFAS 140, Accounting for Transfers and Servicing of Financial Assets and Extinguishments of Liabilities.
- SFAS 150, Accounting for Certain Financial Instruments with Characteristics of Both Debt and Equity.
IAS 32 defines a financial instrument as any contract that gives rise to both a financial asset of one enterprise and a financial liability or equity instrument of another enterprise. A financial asset is either: 1) cash; 2) an equity instrument of another enterprise; 3) a contractual right to receive cash or another financial asset from another enterprise; or 4) a contractual right to exchange financial instruments with another enterprise under conditions that are potentially favorable.
A financial liability involves a contractual obligation to either deliver cash or another financial asset, or to issue another financial instrument, under terms that are potentially unfavorable to the issuer. An equity instrument is any contract that evidences a residual interest in the assets of an enterprise after deducting all of its liabilities. Similar to the U.S. guidance, IAS 32 requires reporting mandatorily redeemable preferred stock as a liability because of the obligation to redeem the security using cash.
In the case of compound financial instruments, which are instruments with both debt and equity features (i.e., bonds convertible into cash or equity instruments), IAS 32 requires separating the component parts into its debt and equity portions. Interest, dividends, and transaction gains and losses associated with the instrument should be accounted for and reported consistent with the classification of the component from which those amounts were derived. For example, payments related to a component classified as an equity instrument would be reported similarly to a dividend, but payments on a component classified as a debt instrument would be accounted for and reported as interest expense.
Last, a derivative is defined as a financial instrument that changes in value in response to a change of a specified underlying financial or nonfinancial item or variable; requires little or no initial investment; and is settled at a future date.
Financial assets and financial liabilities may be reported net in the balance sheet when a current legal right of set-off is present and the company intends either to settle the instruments on a net basis or to realize the asset and settle the liability simultaneously. When the legal right of set-off is retained but the company does not intend to exercise that right, it should not net the financial assets and financial liabilities in the balance sheet.
IAS 32 requires numerous disclosures about financial instruments, including the associated risks and policies for managing those risks; the accounting policies applied to the instruments; the business purposes the instruments serve; and the extent of the company’s use of financial instruments.
Overview of IAS 39
Issued in 1999, IAS 39 was the culmination of a long process aimed at defining and establishing recognition and measurement guidance for financial instruments. When the International Accounting Standards Committee (IASC, the predecessor of the IASB) deliberated IAS 39, FASB was the only major accounting standards setter with formal guidance on the recognition and measurement of financial instruments. Thus, the IASC based much of its deliberations and final guidance on U.S. standards.
Because it addresses recognition and measurement of all financial assets and financial liabilities, IAS 39 is a complex document. Among the issues it addresses are the recognition and derecognition of financial assets and financial liabilities, the accounting for derivative transactions and hedges, and the impairment of financial assets. In the U.S., FASB addressed many of these issues with separate standards, including the following:
- SFAS 114, Accounting by Creditors for Impairment of a Loan.
- SFAS 115, Accounting for Certain Investment in Debt and Equity Securities.
- SFAS 133, Accounting for Derivative Instruments and Hedging Activities and various amendments.
- SFAS 140, Accounting for Transfers and Servicing of Financial Assets and Extinguishments of Liabilities, a replacement of SFAS 125.
Recognition and Derecognition of Financial Assets and Liabilities
In general, IAS 39 requires recognition and measurement of all financial assets and liabilities, including derivatives. Equity instruments are specifically excluded from its scope. Initial measurement should be based on the cost of the financial asset or liability. Subsequent measurement of financial assets depends on their classification:
- Financial assets classified as trading assets, including all derivative instruments that are not classified as hedges, should be measured at fair value, with changes to fair value reported on the income statement.
- Financial assets classified as available for sale should be measured at fair value, with changes to fair value reported as a component of equity. When such assets are disposed of, the accumulated gains or losses that were reported in equity would be reported on the income statement.
- Financial assets classified as held-to-maturity investments should be measured on an amortized cost basis, like originated loans and receivables.
The recent amendment to IAS 39 permits any financial asset or financial liability to be designated as a trading instrument, which requires fair value reporting. Such designation must occur when the instrument is initially reported. One advantage associated with such designation is that a company can achieve the objective of hedge accounting without having to meet the hedge-accounting criteria. A major disadvantage is that the designation is permanent. Therefore, if the hedge relationship is discontinued, the company must continue to report the hedged instrument at its fair value, with increases and decreases in fair value reported in income. This differs from the hedge accounting rules, which, in certain instances, permit amortization of the adjusted value of the hedged instrument into income over the instrument’s remaining life when a fair-value hedge relationship is discontinued. In response to comments received from certain regulators and financial industry observers, in April 2004 the IASB issued a proposal to limit the application of the fair-value option to five specific situations. The IASB currently is reviewing and considering the comments it has received on the proposal.
For a company to derecognize a financial asset, IAS 39 requires the following considerations:
- An assessment as to whether the transaction meets the criteria for removal of all or only a portion of a financial asset or group of similar assets.
- A determination that the asset was in fact transferred. A transfer occurs either when the contractual rights to receive the associated cash flows are transferred, or when the contractual rights to receive the cash flows from the asset have been retained but a contractual obligation to pass those cash flows on to another entity has been assumed in an arrangement that meets criteria specified in IAS 39.
- If the asset has been transferred, a determination of whether substantially all of the risks and rewards of ownership were transferred. If substantially all of the risks and rewards of ownership were retained, derecognition is not permitted.
- Last, where some, but not substantially all, of the risks and rewards of ownership were retained, an assessment of whether control of the asset has been relinquished. Derecognition is permitted to the extent that such control has been relinquished.
A financial liability can be removed from the balance sheet only if the debtor has been discharged from the obligation by the creditor through repayment, legal release from the debt contract, or cancellation or expiration of the obligation.
Hedge Accounting Guidance
Similar to U.S. guidance, IAS 39 permits designation of a derivative financial instrument as an offset of net profit or loss associated with changes in the fair value or cash flows of a hedged item. IAS 39 provides for the following categories of hedging transactions: cash flow hedges; fair value hedges; a portfolio hedge of interest-rate risk; and hedges of a net investment in a subsidiary.
Cash flow hedges are derivatives that are used to reduce the exposure associated with the variability posed by the cash flows of a recognized asset or liability or a highly probable purchase or sale transaction. The gain or loss of the cash flow hedge is reported as a portion of equity until the cash flow transaction is complete, at which time the accumulated gain or loss either adjusts the carrying amount of the acquired asset or liability or is reported in the net income in the same period as the completed transaction, as applicable.
Fair value hedges are derivatives that are used to reduce the exposure to reported gains or losses associated with changes in the fair value of a reported asset or liability, a firm commitment to buy or sell an asset at a fixed price, or an identified portion of an asset or liability or firm commitment. Changes in the fair value of the hedge are recognized in income along with changes in the fair value of the hedged asset or liability.
Under specific circumstances, a company can apply hedge accounting for the interest-rate risk associated with an identified portfolio of assets and liabilities. This hedging issue, called macro-hedging, was added to IAS 39 in a separate amendment issued after December 2003.
IAS 39 also requires an organization to account for derivative instruments that are used to hedge its net investment in a foreign affiliate as a cash flow hedge.
Impairment of Financial Instruments
Impairment, or the decline in the value of a financial asset, is recognized when there is objective evidence of impairment, as a result of a past event, to an asset reported at amortized cost. For debt instruments, IAS 39 states that objective evidence of impairment might include indicators of financial difficulty or delinquency on the part of the debtor, concessions made by a lender, or a high probability of bankruptcy or financial reorganization of the debtor. Examples of objective indicators for equity instruments include significant adverse changes in the technological, market, economic, or legal environment in which the company operates, or significant or prolonged decline in the fair value of the investment.
In determining the amount of impairment loss to recognize, a company should consider only losses that have already been incurred, and not potential future losses. Impairment losses are reported in net income, even for financial assets designated as available for sale. For debt instruments, IAS 39 provides criteria for reporting, in income, increases in the fair value of the instrument for which an impairment loss has been recognized. For equity instruments, however, such increases must be reported in equity.
Convergence with U.S. GAAP
While these amendments have brought U.S. GAAP and the IASB accounting rules closer, differences remain. For example, IASB rules now permit macro-hedging, while U.S. GAAP does not. Additionally, IAS 39 addresses the classification and reporting for all types of financial assets that might be classified as available for sale, held to maturity, or trading assets. In the United States, SFAS 115, which specifies similar classification and reporting guidance, applies only to certain investment securities.
These are two of the many differences between the U.S and international rules. In all likelihood, FASB and the IASB will address such differences in their ongoing short-term convergence project.
Richard C. Jones, PhD, CPA, is an associate professor, and Elizabeth K. Venuti, PhD, CPA, is an assistant professor, both in the department of accounting, taxation, and legal studies in business at the Zarb School of Business, Hofstra University, Hempstead, N.Y. Venuti is also a member of the NYSSCPA’s International Accounting and Auditing Committee.