Financial markets have developed extremely in volume and complexity in the last 20 years. International investments are booming, due to the general relaxation of capital controls and the increasing demand of international diversification by investors.
Driven by these developments the use and variety of financial instruments has grown enormously. Risk management strategies that are crucial to business success can no longer be executed without the use of derivative instruments.
Accounting standards have not kept pace with the dynamic development of financial markets and instruments. Concerns about proper accounting regulations for financial instruments, especially derivatives, have been sharpened by the publicity surrounding large derivative-instrument losses at several companies. Incidences like the breakdown of the Barings Bank and huge losses by the German Metallgesellschaft have captured the public‘s attention. One of the standard setters’ greatest challenges is to develop principles applicable to the full range of financial instruments and implement structures that will adapt to new products that will continue to develop.
Considering these aspects, the focus of this paper is to illustrate how financial instruments are accounted for under the regulations of the International Accounting Standard (IAS) 39. It refers to the latest version, “Revised IAS 39”, which was issued in December 2003 and has to be applied for the annual reporting period beginning on or after January 1. 2005. First, the general regulations of this standard are demonstrated followed by special hedge accounting regulations. An overall conclusion that points out critical issues of IAS 39 is provided at the end of the paper.
IAS 39 is highly complex and one of the most criticized International Financial Reporting
Standards (IFRS). In many cases, the adoption of IAS 39 will lead to significant changes compared to former accounting regulations applied. Therefore the paper is designed to provide a broad understanding of the standard and to facilitate its implementation.
Table of Contents
1. Scope
2. Financial Instruments - General Definitions and Regulations
2.1. Overview
2.2. Financial Assets
2.3. Financial Liabilities
2.4. Five Categories of Financial Instruments
2.4.1. Financial Assets and Liabilities at Fair Value through Profit or Loss
2.4.2. Held-to-Maturity Investment Assets
2.4.3. Loans and Receivables
2.4.4. Available-for-Sale Financial Assets
2.5. Offsetting of Financial Assets and Liabilities
2.6. Equity Instruments
2.7. Differentiation between Equity and Liabilities
2.7.1. Compound Equity and Liability Instruments
2.8. Derivatives
2.8.1. Overview
2.8.2. Derivatives under IAS 39
2.8.3. Embedded Derivatives
3. Initial Recognition and Measurement
3.1. Initial Recognition
3.1.1. Trade Date versus Settlement Date
3.2. Initial Measurement
3.2.1. Fair Value
3.2.2. Transaction costs
4. Subsequent Measurement
4.1. Fair Value versus Amortized Cost
4.2. Financial assets at Fair Value
4.3. Financial Assets excluded from Fair Valuation
4.3.1. Amortized Cost and Effective Interest Method
4.4. Impairment
4.4.1. Impairment of Financial Assets Carried at Amortized Cost or Cost
4.4.2. Impairment of Available-for-Sale Asset
4.5. Financial Liabilities
5. Derecognition
5.1. Derecognition of Financial Assets
5.1.1. Gains and Losses on Derecognition Date
5.1.2. Recording based on Continuing Involvement
5.2. Derecognition of Financial Liabilities
6. Hedge Accounting
6.1. Overview
6.2. Requirements and Definitions
6.2.1. Hedged Item
6.2.2. Hedging Instruments
6.2.3. Formal Designation and Documentation
6.2.4. Hedge Effectiveness
6.3. Types of Hedges
6.3.1. Fair Value Hedge
6.3.2. Cash Flow Hedge
6.3.3. Net Investment in a Foreign Entity
6.4. Discontinuing Hedge Accounting
6.5. Portfolio Hedging
6.5.1. Current Regulations under Revised IAS 39
6.5.2. Portfolio-Hedge under ED 2003
7. Summary & Conclusion
Research Objectives and Key Topics
The primary objective of this thesis is to illustrate the accounting treatment of financial instruments under the International Accounting Standard (IAS) 39, specifically focusing on the "Revised IAS 39" version issued in December 2003. The study aims to provide a comprehensive understanding of the standard's requirements to facilitate its successful implementation for the annual reporting periods starting from January 1, 2005.
- General definitions and classification of financial instruments under IAS 39.
- Initial and subsequent measurement methodologies, including fair value and amortized cost.
- Complex regulations surrounding derecognition of assets and liabilities.
- Detailed examination of hedge accounting, including definitions, effectiveness testing, and specific hedging types.
- Discussion on the implications of IAS 39 for financial institutions and corporate risk management strategies.
Excerpt from the Book
2.8. Derivatives
Derivatives are instruments whose fair values derive from the value of an underlying asset. In the context of finance- and risk management activities, derivatives are mainly used for protection against changes in commodity prices, interest rates and exchange rates. Derivative can reduce an entity’s risk exposure tremendously and are indispensable in modern risk management strategies.
However, derivatives are not only used for managing risk, but also for speculation activities. The bankruptcies of Orange County, the Barings Bank and the near failure of Long-Term Capital Management all involved speculative trades in financial derivatives. The crucial aspect about derivatives is that they offer a great amount of leverage; the possibility to realize a disproportionate gain or loss compared to a relative small initial investment.
Thus, the recognition of derivatives on the balance sheet has been a major demand of the public to the standard setters. One of the main challenges is to display derivatives in financial statements in a way that misinterpretations can be avoided and a fair view of the economic situation is presented.
Historically, derivatives have been treated as off-balance sheet items in many national accounting principles. This is due to the fact that an asset in most national GAAP is not recognized until a transaction occurs. In contrast, derivatives are pending transactions since neither party has performed at inception. In addition, many derivative contracts have an initial value of zero and therefore, do not meet the recognition requirements of most national accounting principles. Conservatism, which is incorporated in almost all national regulations to a variable degree, leads to another problem since anticipated gains cannot be realized but anticipated losses have to be recorded. Therefore, even if a derivative would meet the recognition criteria it would lead to a constant recognition of the negative changes in its value, positive changes, however, would not be considered.
Summary of Chapters
1. Scope: This chapter defines the applicability of IAS 39, noting that it applies to all entities regardless of size or industry, with specific exemptions for instruments covered by other standards.
2. Financial Instruments - General Definitions and Regulations: This section establishes the fundamental definitions of financial assets, liabilities, and the five distinct categories into which financial instruments must be classified for accounting purposes.
3. Initial Recognition and Measurement: This chapter details the criteria for when a financial instrument is recognized on the balance sheet and the principles for its initial valuation, including the treatment of transaction costs.
4. Subsequent Measurement: This section outlines the "mixed model" approach for valuing financial instruments over time, comparing fair value versus amortized cost methods and detailing impairment testing procedures.
5. Derecognition: This chapter explains the complex criteria for removing financial assets or liabilities from the balance sheet, utilizing both the Risk-and-Reward and Control approaches.
6. Hedge Accounting: This extensive chapter defines the restrictive rules for hedge accounting, covering the requirements for hedged items, hedging instruments, effectiveness testing, and the three types of hedging relationships.
7. Summary & Conclusion: This final chapter synthesizes the impact of IAS 39, highlighting the increased volatility expected in financial statements and the operational challenges entities face in adapting to these strict standards.
Keywords
IAS 39, Financial Instruments, Fair Value Accounting, Amortized Cost, Hedge Accounting, Derivatives, Derecognition, Impairment, Risk Management, Hedging Effectiveness, Embedded Derivatives, Financial Assets, Financial Liabilities, International Financial Reporting Standards, Income Volatility
Frequently Asked Questions
What is the primary focus of this thesis?
The thesis focuses on explaining how financial instruments are accounted for under the "Revised IAS 39" regulations, which became effective in 2005.
Which categories of financial instruments are discussed?
The standard categorizes instruments into five groups: fair value through profit or loss, held-to-maturity assets, loans and receivables, available-for-sale assets, and non-trading liabilities.
What is the main objective of hedge accounting in IAS 39?
The goal is to bridge the gap between different measurement methods (cost vs. fair value) to match the timing of gains and losses, thereby reducing income statement volatility.
Which scientific method is employed in this research?
The thesis utilizes an analytical approach, reviewing existing accounting standards, comparing them to previous regulations, and illustrating practical application through provided examples and case studies.
What does the main body cover?
The main body covers the identification, classification, measurement, derecognition of financial instruments, and the highly detailed requirements for hedge accounting.
Which keywords best characterize this work?
Key terms include IAS 39, hedge accounting, fair value, derivatives, risk management, and derecognition.
What is the "tainting rule" mentioned in the text?
The tainting rule prohibits an entity from classifying financial assets as held-to-maturity for two financial years following the sale or transfer of an insignificant amount of such assets before maturity.
How does IAS 39 treat embedded derivatives?
Under specific conditions, embedded derivatives must be separated from their host contracts and accounted for individually as if they were stand-alone derivatives.
Why is portfolio hedging a controversial topic in IAS 39?
The standard historically prohibited macro-hedging (portfolio-hedging), forcing banks to designate individual items for hedging, which contradicted their existing risk management practices of hedging on a net, portfolio basis.
- Quote paper
- Kathinka Kurz (Author), 2004, IAS 39 - Accounting for Financial Instruments, Munich, GRIN Verlag, https://www.grin.com/document/30146
