The regulators are tasked with keeping the financial ship afloat. IAS 39 is a good example of carefully written rules commensurate with the risks being assumed today by all sorts of companies, and most particularly by financial institutions.
At root, it is a strong accounting standard related to truly hedging portfolio risk, and this is the reason why it is resented by some institutions.
Well-managed companies do appreciate that they need a strong accounting stan- dard rather than a weak one, because the latter can lead them into trouble.
Therefore, to a rather significant degree, underlying the arguments advanced against IAS 39 lies the fact that banks have different degrees of:
● Appreciation of their exposure, and
● Sophistication in their risk management solutions.
IAS 39 is not the only component part of IFRS to represent a well-crafted set of accounting rules fitting our epoch. Another example of a higher level of steward- ship connected to accounting standards is provided by IAS 32 (see Chapter 4).
IAS 32 states that ifan instrument includes both debt and equity characteristics, thenthese must be separated in accounting into:
● Debt, and
● Equity.
As an example, convertible bonds must be separated into debt and equity parts.
If the convertible bond is redeemable, then it is debt. If it is perpetual, it is equity.
Underlying this accounting rule is the bifurcation associated with financial instruments depending on intent. The pattern can be seen in Figure 5.1.
A similar approach to careful distinction between items that look alike but are not the same prevails under AIS 39. Derivatives such as options, futures, for- wards, interest rate swaps and currency swaps are products meeting the defini- tion of a financial instrument. However, FRS rules specify that a purchased call option, or other similar contract acquired by an entity that gives it the right to re- acquirea fixed number of its own equity, is not a financial asset of the entity.
Reacquisition along the lines described in the preceding paragraph may take place in exchange for delivering a fixed amount of cash, or another financial asset. The reason for the aforementioned distinction lies in the fact that any con- sideration paid for such a contract is deducted from equity.
Because today’s financial instruments are complex, if a light approach is taken in handling them, these will lead to confusion. To provide the proper basis, IFRS rules state that derivative financial instruments create rightsand obligationsthat have the effect of transferring between counterparties one or more of the financial risks.
● These risks are inherent in an underlying primary financial instrument, and
● For that reason they qualify as risk elements in financial instruments, in IFRS reporting.
FINANCIAL INSTRUMENT
HELD TO MATURITY
ORIGINATING
RECEIVABLES FOR TRADING
ACCRUALS AT COST MARK TO MARKET
Figure 5.1 Different accounting rules address the way in which a financial instrument is handled
This is consistent with the fact that IAS 39 defines a derivative as a financial instrument whose value changes in response to the change in the underlying, but more so because of leverage. Leveraging comes from the fact:
● A derivatives transaction requires either no initial investment, or a small investment, and
● The derivatives contract is typically settled at a future date.
Sophisticated approaches to accounting are necessary because, in principle, all derivative contracts with a counterparty may be designated as hedging instru- ments (except for some written options). By contrast, an external non-derivative financial asset, or liability, may not be designated as a hedging instrument except as a hedge of foreign currency risk.
In the general case, specific cash flows inherent in a derivative cannot be desig- nated in a hedge relationship while, according to IAS 39, other cash flows are excluded. But intrinsic valueand time valueof an option contract may be sepa- rated, with only the intrinsic value being designated as a hedge.
In their normal course of business, companies do different types of hedges to protect themselves from market moves – at least theoretically so. Hence the need for hedge accounting, which is examined in section 3. Some of these hedges are for interest rate risk management. An example is fair value hedges through inter- est rate swap agreements to:
● Control exposure to interest rate movements, and
● Achieve a mix of floating and fixed-rate debt, while trying to minimize liq- uidity risk.
Interest rate swaps designated as fair value hedges effectively convert fixed-rate debt to floating rate, by receiving fixed rate amounts in exchange for floating rate interest payments over the life of the agreement. This is done without an exchange of the underlying principal amount. That sort of hedge may be address- ing the firm’s current risk but the reader should appreciate that the hedge itself involves risk, and this could affect profit and loss. IAS 39 specifies that:
● The gain or loss from the change in fair value of the hedging instrument is recognized immediately in profit or loss, and
● The carrying amount of the hedged item is adjusted for the corresponding gain or loss with respect to hedged risk, which is also recognized immedi- ately in net P&L.
Alternatively, the company may enter into cash flow hedges through interest rate swap agreements. These aim to reduce the impact of interest rate movements on future interest expense, by converting a portion of its floating-rate debt to a fixed- rate. But there is risk behind a cash flow hedge:
● Attributable to a particular exposure associated with a recognized asset or liability, and
● Likely to affect profit and loss at some future period specified by the contract.
With IAS 39, the portion of the gain or loss on the hedging instrument that is determined to be an effective hedge is recognized directly in equity and recycled to the income statement when the hedged cash transaction affects profit or loss.
But if the hedged cash flow(s) result(s) in recognition of a non-financial asset or liability, the entity can choose to adjust the basis of the asset or liability for the amount deferred in equity.
A company may also have foreign exchange hedges. These can be part of its cur- rency exchange risk management programme, on reducing transaction exposure in connection to consolidated cash flow. A transaction exposure may result from payments made to, and received from, overseas companies and, as such, it could be material to the consolidated financial position.
Alternatively, there may be a hedge of a net investment in foreign operation or some other commitment in foreign currency, to be accounted for as a fair value hedge or cash flow hedge. IAS 39 provides clear rules for fair value hedge accounting for portfolio hedges (macro-hedging).
Practically all of the examples we have seen in this section on legitimate hedg- ing activities, and their instruments, may involve considerable risk, even if such positions are taken for exposure management reasons. Therefore, the marking to market fair value option specified by IAS 39 must be applied to any derivative financial instrument. If my understanding is correct,
● Central bankers and regulators want to strengthen this definition, making this information transparent for market discipline reasons.
● By contrast, commercial bankers do not want the new rule, even if it is to their interest to know their exposure, in order to be in charge of it.
A very useful feature of IAS 39 is that it provides a procedural hierarchy on how to determine fair value. Marking to model is a possibility, but as Warren Buffett states, sometimes marking to model becomes synonymous to marking to myth. A sound rule is that when one cannot see a price in the active market, one must be
very reasonable – indeed, quite conservative in fair value estimates. This is most important with IAS 39 because:
● It specifies that all derivatives must be marked to market, and
● It provides accounting rules for hedging all the way to treatment of core deposits (demand deposit accounts, DDAs).
Another major improvement of IAS over past and parochial accounting stan- dards is that the latter have been principally concerned with registering histori- cal numbers – not real economic and financial decisions which affect the company’s future. For a long time, the emphasis on past cost has been an accepted accounting practice, but in a market characterized by globalization, deregulation, innovation, and rapid technological development reliance on past numbers can be self-destructive.