Organizations around the world are continuously recording data and reporting financial information to the used for many purposes by the respective users. A tremendous amount of financial transactions continuously stir in the organizations, some transactions occur each second or minute whereas some transactions are very unique and take place occasionally as a result of a specific event. That is why to bring things in conformity and consistency, it is important that organizations establish standards and procedures for recording their data.
In doing so present results will be in a position to be compared with historical data and with entities in similar industry. Listed companies have to particularly follow standard formats and disclose their financial information in such a way that it is easily understood by the users of the financial statements. This is because consistency flows through not just one organization but the entire industry making outcomes easier to contrast. These objectives are being addressed by standard setting boards such as IAASB by setting International Accounting Standards (IAS) and International Financial Reporting standards (IFRS).
Both IFRS and IAS are equal in terms of their value and standing. (Tatum Malcum) All transactions need to be recorded as suggested above. One of the aspects that are a part of recording is financial instruments; created by a legal document and having different monetary values. They can be classified as cash or derivative instruments. Cash type of financial instruments is widely used and can be most easily understood. Currency in itself is a cash instrument or a bank cheque is a good example which can be used to transfer money from one bank account to another.
However derivative instruments include those tools such as futures; an instrument saying that the seller will sell the asset or buyer will buy it at a future date. Price of such transactions is determined at the time of entering into a future contract. There are other instruments as well such as options and swaps whereas sometimes stocks, bonds and currency forwards are also termed as financial instruments. (Tatum Malcum) Due to the wide range of financial instruments being used, IAS 39 was introduced by International Accounting Standards Committee (IASC) in 2001 to regulate the process of recognition and measurement of such transactions.
The organizations dealing with them were facing problems with respect to treatment as different approaches were being applied by entities. This led to inconsistency of disclosing and recording of appropriate amounts within the industry as they were no standard process for recording the financial instruments. This directed the results of entities within the same industry to be incomparable with one another. Many of transactions involving financial instruments remained unrecognized as no proper recognition and measurement processes were known to the accountants.
Hence CFO and CEO were in a position to distort the actual results and lead shareholders astray. (Miolo Alessandro, Andersen Arthur) In response to that IAS 39 introduced a concept of fair value accounting. The standard increased the importance of the fair value accounting for the financial instruments and therefore required entities to record assets and liabilities on the face of the balance sheet and discloses the nature of derivatives in the financial statements.
In case of hybrids, the structure had to be broken down into two components (Miolo Alessandro, Andersen Arthur). This is because hybrid instruments have a mixture of characteristics of both debt and equity thereby market price of the hybrid instrument is sensitive to both the interest rates and quoted price for the stock (Riskglossory. com). The two components of the hybrid contract are real contracts however derivative is separated from the contract to be measured at fair value. (Miolo Alessandro, Andersen Arthur)
IAS 39 also introduced hedge accounting for all derivatives in order to minimize the volatile affects on the income statement. Further segregation in the standard came into place as the “intention” of hedging was used to establish which accounting rules will be applied. As a result a fair value hedge, net investment hedge in foreign currency and cash flow hedge accounting rules was launched. In fair value hedging the risks are connected to the fluctuation of fair value of an underlying asset or liability.
Whereas cash flow hedges are those in which the exposure is connected to the future cash flows of assets or liabilities recognized or any future commitment or forecasted cash flow of the organization. Moreover, the net investment hedge in foreign currency is hedging the risks of an entity’s net asset which is not an associate, joint venture or a subsidiary. (Miolo Alessandro, Andersen Arthur) Implication of this IAS affected all the users of financial statements and also the people who were trying to comply with the standard.
The development of this standard and its implementation had significant impact on the strategies in dealing with financial risks. As the financial instruments have volatile affects on the equity portfolio and income statements these affects were then being countered by engaging in hedging strategies and transparent accounting policies. (Miolo Alessandro, Andersen Arthur) IAS 39 also provides organizations with the recognition criteria on how to record hedging instruments when entering into a transaction.
After that at each period end gain and loss is recognized on an ongoing basis. So it has a forward looking stance at initiation but a backward bearing when re-assessment of investment’s effectiveness is carried out. The organizations needed to asses which process of reassessment would be right for their investment portfolio. A proper system was therefore required to record and reassess not only cash flows and fair values but also take into account the premiums and discounts involved.
Moreover, IAS required the disclosure of all the investments and subsequent gains or loss arising due to it. (Miolo Alessandro, Andersen Arthur) The first revision of the IAS 39 took place in 2004 which incorporated Macro hedging, involving interest rates risks hedge. This amendment was made due to the increase use of these instruments and such investments were not addressed by IAS 39. Macro hedge is an investment technique to reduce or minimize the risks associated with the whole portfolio of investments (Peter Williams).
This investments technique was widely spread because of the ease of information available about the interest rate and currency fluctuations between different countries. The macro managers earned by hedging the risks in different market by buying long and short in different markets of the globe. That increasing trend required the correct measurement and recognition of such investment which could only be linked with financial instruments dealt in IAS 39. (Hubpages, Inc. ) Further amendment took place on the issue of initial recognition of financial asset or liabilities and the subsequent charging of gain or loss.
Initially all of such instruments were allowed to be measured on fair value if measured reliably. In 2005 the option to value instruments at fair value had been restricted to only those investments which had significantly reduced due to accounting mismatch along with those financial instruments whose fair values were regularly managed evaluated for its correctness. In addition IAS 39 stated before October 2008 that once an instrument is classified on the basis of fair value i. e through profit and loss category, it cannot be reclassified.
Amendment in 2008 allowed some of the instruments to be reclassified from fair value and available for sale category under certain conditions and a disclosure is required in case of such a reclassification. Moreover it was stated that all the derivatives need to be reassessed in case of any reclassification; an issue that was developed due to the global credit crunch, significantly affecting the financial market. (Delloitte Touche Tohmatsu) With all the problems and issues dealing with financial instruments IASB and FASB started working together on IFRS 9 to replace IAS 39.
Its purpose is to reduce difficulty in accounting for financial instruments and hedging activities. This development took place in phases. Phase one tends to improve and simplify the measurement and classification of the financial instruments. Though this phase has been completed but the exposure draft has been under plan to be issued and the implementation is to be completed in the current year. (International Accounting standard board) This new standard has raising concerns in the world in corporate sectors on how this will be implemented and how it will affect their operations.
Many are happy for the change to take place as the IAS 39 is thought to be a difficult standard to implement. The replacement is a result of the world’s economic crises after which all the investors and the regulators of financial institutions were demanding for an accounting system which showed the types of assets and liabilities held at a given time, the risks that they are exposed to and gain and losses expect to be realized. (IFRS 9 – Deconstructing IAS 39) In 2008 when Lehman Brothers share price collapsed, the investors in turn rushed to purchase the share prices in anticipation of prices bouncing back.
However they couldn’t see the situation of the bank’s exposure in financial instruments related to subprime loans as less information was disclosed for their understanding. Hence it was later suggested that accounting needs to be clearer which became evident upon the fall of many banks. IFRS 9 strived to cater and answer all these major issues in hand while giving organizations an option to adopt this standard before it becomes mandatory in 2013. Only the first phase of the standard is completed and all the stakeholders are waiting to implement it upon finalization of IFRS 9 completion. IFRS 9 – Deconstructing IAS 39) IFRS 9 looks to tackle all the current problems and questions probed by various investors but it cannot give a guarantee to prevent any crises in future. It is important that accountants, regulator and the investors remain vigilant because no matter how much IFRS 9 helps to simplify the accounting of financial reporting, when this economy starts its recovery phase no one can stop the development of new financial instruments eluding the situation like before.
European Union refused to adopt IFRS 9 last year posing some questions relating to fair value of investments coverage. On the other hand Japan signed it for an early adoption in March 2010 which is a significant step toward promoting transparency in policies and implementation (IFRS 9 – Deconstructing IAS 39). Hence it can be clearly seen that IASB and FASB have been working for the betterment of the society by incorporating the external changes in the market which can be reflected upon the replacement of IAS 39 with IFRS 9.