Cash & Liquidity Management

IAS 39

Published: Oct 2013

When International Financial Reporting Standard 9 (IFRS 9) eventually becomes mandatory in 2015, treasurers will no longer have to apply International Accounting Standard 39 (IAS 39). But what was IAS 39 and why was it introduced in the first place? In this article, Treasury Today summarises one of the most complex accounting standards and explains why, following the recent financial crisis, calls mounted for a new standard to be introduced in its place.

Most companies use derivatives to mitigate or offset various financial risks such as interest, currency and commodity price risk. The objective of hedge accounting is to reflect the results of a company’s hedging activities, particularly in instances where those hedges involve the use of derivatives. This allows companies to avoid the standard accounting treatment for derivatives, thereby escaping the temporary undesired volatility in profit and loss (P&L) caused by valuation and timing differences. However, at the present time, any corporate who wishes to apply hedge accounting treatment to its derivatives trades must meet the complex requirements set out in International Accounting Standard 39 (IAS 39). But what exactly does IAS 39 involve?

Setting standards

International standardisation of financial instrument reporting began in 1988, under the supervision of the International Accounting Standards Committee (IASC). During the 1990s, the committee attempted to devise a fundamentally new approach to developing a standard. But unable to secure a consensus on measurement issues, the initial standard released in 1995 was limited solely to aspects of presentation and disclosure. This problem persisted and in 1998, as the target date for IAS 39 was fast approaching and with next to nothing on the table, the Board decided to base the new standard almost entirely on US General Accepted Accounting Principle (GAAP). The committee only ever intended this to be an interim solution, however, and as a result IAS 39 went through a number of evolutionary adjustments over the subsequent decade as the International Accounting Standards Board (IASB), the IASC’s successor, attempted to develop a workable and truly international standard.

The final standard

The final standard, adopted in January 2005, sets out the way in which financial instruments should be recognised and measured on a company’s balance sheet. Below is a brief summary of the main principles embedded in the standard.

Under IAS 39, financial instruments are defined as “any contract that gives rise to a financial asset of one entity and a financial liability or equity instrument of another entity”.

One significant change was the introduction of embedded derivatives. Some contracts that do not appear to be financial instruments may have derivatives embedded in them – for example, leases which include an option to buy and debt instruments that give the option to prepay). The IAS 39 standard stipulates that any embedded derivative should be separated from its host contracts and accounted for as a distinct instrument. This treatment is the case when the economic risk and characteristics of the embedded derivative are not closely related to those of the host contract.

The IAS 39 standard covered three main areas:

  1. Recognition and derecognition.

    The standard stipulates that all financial assets and financial liabilities, derivatives included, must be recognised on the balance sheet. Only when an entity is released from its primary obligation relating to that liability can it remove, or ‘derecognise’, the assets from its balance sheet.

  2. Measurement.

    There are categories into which financial assets must be classified: fair value through profit or loss; held to maturity; loans and receivables; and available for sale. Financial liabilities, meanwhile, can be categorised as either fair value through profit or loss, or amortised cost.

  3. Derivatives and hedge accounting.

    Under IAS 39, fair value must be used for the measurement of all derivatives, with gains and losses in the income statement. Derivatives, however, are often used to hedge recognised assets or liabilities. These may be recorded at amortised cost or at fair value with gains and losses recognised in equity or forecast transactions, causing a mismatch in the timing of income statement recognition. By changing the timing recognition in the income statement, hedge accounting corrects this mismatch.

The standard allowed for companies to adopt hedge accounting as long as the hedge is formally designated and documented and meets hedge effectiveness tests both prospectively and retrospectively.

The three types of hedge accounting permitted under IAS 39 were:

  1. Fair value hedge.

    This is designed to manage the risk that there is a change in the value of an item (whether an asset or a liability) that is measured to a fair value and will have an effect on the income statement.

  2. Cash flow hedge.

    This is designed to manage the risk that there will be volatility in the value of future cash flows that will have an effect on the income statement.

  3. Hedge of a net investment in a foreign operation as defined in IAS 21.

Under the latest revision to IAS 39, fair value hedge accounting can also be used for a portfolio hedge of interest rate risk. This is often known as macro hedging.

Finally, IAS 39 determines the circumstances in which hedge accounting must be discontinued. These include when a hedge ceases to be effective, the hedged instrument expires or is sold or exercised, and if the company stops designating the relationship as a hedge.

Impact upon corporates

International accounting standards, such as IAS 39, were initially developed with the objective of creating greater transparency and consistency in the way in which companies report financial instruments by unifying the various rules relating to this process.

But in retrospect IAS 39 clearly had the opposite effect. The standard was extremely complex and, in some places, contradictory – particularly the section which related to hedge accounting. As a consequence, many companies struggled to apply the standard correctly when reporting their derivatives trades.

One of these companies was Volkswagen International Finance (VWIF) who, like many others, had struggled to implement the standard in time for the January 2005 adoption deadline, which the International Financial Reporting Standard (IFRS) board had suddenly announced less than a year before.

In an article in Treasury Today back in 2008, Volkswagen explained that the challenge was complicated further when the company consulted the accounting profession for guidance and discovered that what the audit firms classified as “compliant hedge accounting solutions” varied considerably. In the end the company decided to work with its treasury management system (TMS) provider, IT2 (now part of Wall Street Systems) to develop a tailored solution, which entailed sending the exposures to VWIF from the central SAP system. The company’s TMS solution then derived the results and reported on hedge effectiveness both retrospectively and prospectively as stipulated in the standard. The solution went live the first week of December 2005 and 14 VW companies decided to use the hedge accounting reporting service.

IFRS 9: a fresh start?

Following the 2008 financial crisis, IAS 39 came under heavy scrutiny. Experts claimed that IAS 39’s strict rules on fair value had contributed to the proliferation of toxic derivatives assets that nearly caused the collapse of the global financial system. In 2009, leaders of the G20 group of nations declared that financial reporting needed to improve and called upon the standard setters to reduce the complexity of the hedge accounting standard and make it less open to interpretation.

In response, the IASB announced that the introduction of a new set of accounting standards, IFRS 9, would be fast-tracked. A draft of requirements for hedge accounting, the third step in a tripartite group of proposals, were finally published in September 2012. Corporates wishing to use hedge accounting will have until 1st January 2015 to comply with new requirements.

Although IFRS 9 might prove to be less problematic than its predecessor, don’t think there won’t be more rules and room for further interpretations.

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