IFRS - IAS39 focus

The switch to international financial reporting standards is one of the most significant events in accounting history. Given the immense pressures the complex process places on companies, you would hope that the matter would be dealt with smoothly and professionally by those responsible for laying this burden at their doorstep.

Link: More on IAS39 and private companies

Unfortunately this didn’t turn out to be the case. As a result companies and users of their accounts are now paying the price, and will do so for some time to come.

Most of the problems centre around one issue, IAS39. The standard that sets out how to recognise and measure financial instruments – such as derivatives and hedge funds – has been the subject of intense political machinations. Sparks flew during the last two years between the three main parties involved, the International Accounting Standards Board, the European Commission and the European Central Bank.

The end result has been two different versions of the standard, a full version from the IASB and an EC-endorsed ‘carved-out’ version.

Concerns from banks in Europe, mainly French, over the volatility that the standard was likely to cause in their accounts forced the ECB to lean heavily on the then-internal market commissioner Frits Bolkestein to act. Famously, French president Jacques Chirac even waded into the debate, warning IAS39 would have ‘nefarious consequences for financial stability’.

This led to pressure from the EC on the IASB to make changes to the standard. Two parts of the standard were under scrutiny – hedge accounting and the fair value option. The IASB however, wasn’t for budging, and Europe decided that the only way of pressing ahead was to remove the most controversial parts until the situation was resolved.

This has created a precarious situation. IAS39 is probably the most complex and resource consuming standard for large companies to apply. It is also the standard that analysts, shareholders and other market watchers will struggle hardest to comprehend. Now that there are two different versions of it floating about, confusion could abound and comparing company accounts becomes increasingly troublesome.

It is still early days, with most companies yet to reveal their critical first interim figures. However, there are promising signs that the political infighting may not prove too harmful in the long run.

‘We have not heard of any major financial institutions going down the route of applying the carved-out version,’ says Jeremy Foster IFRS partner for banking and capital markets at PricewaterhouseCoopers. ‘Because of all the noise around IAS39, potentially the only country that will use it will be France.’

It has been a long, hard slog for the businesses involved, and there are still problems to overcome. Fortunately, many market watchers are aware of the difficulties that have surrounded the standard and this may give companies a bit of breathing space.

‘We are expecting a long bedding-in period for IAS39,’ says Sue Harding, managing director of Standard & Poor’s credit market services. ‘Companies will be checking if derivatives were properly priced. There will be a lot of looking back and some level of restatement.’

Communication with the market is still vital in ensuring that share prices don’t go awry, as others in the City are still unsure of the impact of IAS39 and how to react to the changes it brings.

‘IAS39 increases disclosures but the rules are complex and the outputs are not always easy to understand,’ says Peter Elwin, head of accounting and valuation at Cazenove. ‘This can cause confusion and analysts will always sell first and work out the answers later. A number of companies are not adopting IAS32 and IAS39 for 2004, so the 2005 numbers could come as a shock.’

A recent warning by the Financial Services Authority over the timeliness of disclosing IFRS information will pile further pressure on companies to make sure they portray financial instruments as accurately as possible first time around. Despite it being the European banks kicking up a fuss over how the standard will affect them, the standard will hit a much broader range of companies.

‘It was mainly financial services businesses that were expected to experience impacts from IAS39, but business in other sectors such as manufacturing have also been affected,’ says Mark Vaessen, chief executive of KPMG’s international financial reporting practice. ‘Restatements are a possibility. This is not a small changeover and there will be glitches.’

And while it is currently just listed entities that are affected, the chances are that by 2007 all bar the smallest UK companies will be required to use IAS39, with the Accounting Standards Board proposing to extend the rules on financial instruments to private businesses.

‘This is going to have a big impact on everybody,’ says PwC’s Foster. ‘For a small or medium-sized corporation, this change will be significant, although how significant will depend on the number of hedges they use.’

But while the European companies get on with the task of applying the standard, the goalposts continue to shift. Foster says that issues surrounding the fair value option may be resolved soon, as the ECB is satisfied with recent revisions made by the IASB. This would reduce the differences between the two standards, but it is far from the end of the story.

The IASB is still tinkering around the edges of IAS39, and still no-one is sure how long it will take to reach a conclusion on the hedging rules.

A working group has been established by the board to explore hedge accounting issues and problems, but there is no guarantee that it will bring any short-term resolutions.

Until this sore point is removed, markets will simply have to endure two similar, but fundamentally different standards. Company executives will hope they are not the ones to pay for this situation with their share prices.

Euro and full IAS39 – key differences
There are two key differences between euro IAS39 and the IASB’s full IAS39.

In the euro version the fair-value option for financial liabilities is removed, and certain aspects of portfolio fair-value hedge accounting of interest rate risk have been relaxed.

The carve-out is intended to be a temporary measure to ensure that EU listed companies have a standard that deals with recognition and measurement of financial instruments. The EU regulation (EC 2086/2004) specifically states that companies using euro IAS39 will be regarded as equivalent to first-time adopters of full IFRS. Therefore companies would still qualify to use the exemptions and exceptions in the Euro-adopted version of IFRS1.

The result of this is that European listed groups must use euro IAS39 and the financial statement accounting policy note will need to state clearly that euro-IFRS has been adopted.

It is possible to comply with full IAS39 and euro IAS39 if the fair value option for financial liabilities is not used and the more restricted hedge accounting rules under full IAS39 are implemented.

Link: More on IAS39 and private companies