The IASB has recently issued its revised standards on financial instruments - although further amendments to incorporate macro-hedging for interest rate risk are expected to be issued in March 2004. These standards set out detailed requirements relating to financial instruments - a widely defined category of assets and liabilities, and including certain commodity and other contracts that can be settled net. Some of the areas covered are not dealt with by existing UK requirements and the IASB standards are more prescriptive than is generally the case with UK standards.

This article summarises some of the key differences between the IASB standards and current UK standards.

IAS 39 Financial Instruments: Recognition and Measurement

Measurement and hedging

Under existing UK requirements, financial instruments are generally carried at amortised cost - less impairment provisions in the case of financial assets - although some entities mark-to-market trading books with changes in value recognised in the profit and loss account. IAS 39 requires specific measurement bases to be applied to different categories of financial instrument, which would require a number of significant changes to existing UK practice.

Under IAS 39, all derivatives, and nonderivative financial instruments held for trading purposes, must be measured at fair value with changes in value recognised in the profit and loss account. This also applies to certain derivative-like features - including some prepayment options or settlement options - that are incorporated into a non-derivative contract, which must be separated from the main contract and accounted for as a derivative. IAS 39

allows any other financial asset or liability, when initially recognised, to be designated as being at ‘fair value through profit or loss’. This ‘fair value option’ may simplify the accounting in certain circumstances. Detailed rules for the method of determining fair value are set out, including requirements for the use of valuation models for instruments that are not traded on a market.

Other financial assets that are loans or other receivables and are not traded on a market are measured on an amortised cost basis. Accrual of interest must be calculated on the effective yield basis which spreads the interest, together with any initial fees or costs, over the life of the asset at a constant yield. Financial liabilities are also measured at amortised cost, unless the option to designate them as at ‘fair value through profit or loss’ is chosen.

Securities and other financial assets that the entity has the intention and ability to hold to maturity and which meet certain other criteria may be classified as ‘held to maturity’ and measured on the amortised cost basis; however, disposal of any such held-tomaturity assets before maturity will restrict use of this accounting for the future. Other financial assets not falling within one of the above categories are treated as ‘available for sale’ and measured at fair value. Changes in their fair value are recognised directly as part of equity and only included in the profit and loss account when they are realised.

All assets, other than those held for trading or measured at fair value under the ‘fair value through profit or loss’ option must be tested for impairment in accordance with the detailed methods set out in the IAS.

All derivatives must be measured at fair value, whether used for hedging or trading purposes - unlike current UK practice, where hedging derivatives such as interest rate swaps are often accounted for on an amortised cost basis to match the accounting treatment of the hedged item. IAS 39 permits special hedge accounting, allowing recognition of gains or losses on the hedged item in some circumstances but imposes strict requirements for hedge designation and effectiveness testing of the hedge relationship - whereas existing UK standards do not address hedge accounting other than hedges of net investments in foreign operations.

Derecognition

IAS 39 also addresses the circumstances in which an entity should cease to recognise (derecognise) financial assets and financial liabilities. This material has important consequences for the accounting treatment of financing arrangements that involve the transfer of rights to future cash flows, such as securitisations, debt factoring, subparticipations and repos. The existing UK requirements on this subject are in FRS 5.

At either extreme - in other words, when the reporting entity has retained substantially all the risks and rewards inherent in the transferred rights to cashflows or when it has transferred substantially all those risks and rewards - IAS 39 and FRS 5 require broadly the same accounting treatment (continued recognition of the asset in the first case, derecognition in the second). However, between the extremes the accounting may differ because, unlike FRS 5 - which focuses on exposure to risks and rewards - IAS 39 analyses such transactions by reference to control.

IAS 32 Financial Instruments: Disclosure and Presentation

Although IAS 32 deals largely with matters also covered by existing UK standards, there are a number of important differences.

(a) Under FRS 4 ‘Capital Instruments’, instruments issued are classified as either part of shareholders’ funds or as liabilities. Preference shares, for example, are reported within shareholders’ funds. Under IAS 32 instruments are either ‘equity’ or ‘liabilities’, and many preference shares will be classified as liabilities. This also has consequences for the profit and loss account, because dividends paid on preference shares classified under IAS 32 as liabilities will be interest payments, not dividends.

(b) IAS 32’s requirements on the circumstances in which a debtor or other financial asset should be shown in the balance sheet netted off (offset) against a financial liability are different from the offset requirements in FRS 5 ‘Reporting the Substance of Transactions’. For example, under FRS 5 the existence of a master netting agreement is often sufficient in itself to enable debtor and creditor balances to be offset; under IAS 32 there needs also to be an intention to offset.

(c) There are many detailed differences between the financial instrument disclosure requirements in IAS 32 and those in FRS 13 ‘Derivatives and other Financial Instruments: Disclosures’. For example, IAS 32 requires credit risk disclosures, and requires banks to disclose fair value information about their banking books, whilst FRS 13 does not. Furthermore, the scope of IAS 32 is wider than FRS 13 - IAS 32 applies to all entities; FRS 13 does not apply to unlisted entities or to insurance companies.