A managed transition that applies equally to unlisted entities

At the beginning of June, the EU adopted a Regulation that requires, from January 2005, all listed European companies to prepare their consolidated financial statements using 'adopted international accounting standards’. The expectation is that these adopted international accounting standards will be the standards (IFRSs) produced by the International Accounting Standards Board (IASB).

Over the last couple of years, the ASB has been talking with preparers, users and other interested parties on how best to respond to the Regulation. The message has been clear: the ASB should help listed companies manage the transition to IFRSs, whilst at the same time ensuring that the standards that unlisted companies apply are broadly those also being applied by listed entities. The ASB has taken this message on board and is proposing, prior to 2005, to replace a number of existing UK standards with new standards based on IFRSs. These will apply, in the main, to both listed and unlisted entities.

As part of this process, the ASB issued in May six exposure drafts—FREDs 24 to 29—that together propose the replacement in 2003 of six existing UK standards with nine new standards based on IFRSs. Responses to FREDs 24 to 29 are requested by 16 September 2002.

On 20 June, the ASB issued a seventh exposure draft—FRED 30 ‘Financial Instruments: Disclosure and Presentation & Recognition and Measurement’—that proposes the implementation in the UK in 2004 of two further UK standards based on IFRSs—IAS 32 ‘Financial Instruments: Disclosure and Presentation’ and IAS 39 ‘Financial Instruments: Recognition and Measurement’. Responses to FRED 30 are requested by 14 October 2002.

How the proposals would affect UK accounting

IAS 32 was first issued in 1995 and does not appear to have been the cause of much concern since. IAS 39, on the other hand, has proved to be both controversial and difficult to implement. In July 2001 the IASB announced that it would carry out an IAS 39 amendments project to try to simplify implementation of the standard. Consequential amendments would need to be made to IAS 32. In June 2002, the IASB issued the result of its amendments project in the form of exposure drafts of revised versions of the two standards. The amendments being proposed— recognition and derecognition apart— are relatively minor when viewed from IASB’s perspective. However, viewed from a UK perspective, the two standards involve some big changes to existing UK practice.

For example, consider IAS 32:

• Preference shares—The implementation in the UK of IAS 32 will result in most preference shares being classified as liabilities and most preference share dividends being treated as interest expense. Currently no preference shares are treated in the UK as liabilities and no preference share dividends are treated as interest.

• Split accounting—IAS 32 also requires the debt and equity elements of convertible debt and similar instruments to be dealt with and presented separately in the accounts. FRS 4 requires convertible debt to be classified wholly as a liability.

• Derivatives on own equity—The proposed revised IAS 32 contains material on the classification of derivatives based on an entity’s own equity shares. The material covers similar ground to UITF Abstract 33 on Obligations in Capital Instruments but has wider application.

• Fair value measurement—All derivatives and all financial instruments held for trading are required by IAS 39 to be measured at fair value, with changes in those fair values recognised immediately in the profit and loss account. For many non-financial institutions, this will mean using fair value numbers in their balance sheets and earnings numbers for the first time. IAS 39 also requires ‘available-for-sale’ financial assets to be fair valued with all changes in those fair values recognised immediately in the statement of total recognised gains and losses.

• Hedge accounting—In UK accounting standards at present, there is virtually no reference to hedge accounting. Last month the ASB issued FRED 23 ‘Financial instruments: Hedge accounting’, which proposes that hedges should be eligible for hedge accounting only if they are pre-designated and have proved to be effective, a principle derived from IAS 39. IAS 39 (as included in FRED 30) contains a number of further restrictions on the use of hedge accounting which are not incorporated in FRED 23. Furthermore, although restrictions proposed in FRED 23 should not, the ASB believes, cause most well-run companies much difficulty, the additional restrictions in IAS 39 seem likely to mean that hedging strategies that companies are convinced are legitimate will not attract hedge accounting treatment. Some companies will be able to continue to use hedge accounting if they restructure their hedging strategies; some may not.

• Recognition and derecognition—The IASB is proposing to replace the existing material in IAS 39 on the recognition and derecognition of financial instruments with material based on a new approach to the subject. This new basis of accounting (known as the continuing involvement approach) involves a different philosophy from that underlying the UK’s FRS 5 ‘Reporting the Substance of Transactions’.

As well as setting out, and inviting comment on, the IASB’s revised standards, FRED 30 also proposes how they might be implemented in the UK prior to 2005. It proposes in particular that UK standards based on IASs 32 and 39 should be implemented for all types of entities with effect from 1 January 2004, except that:

• amendments would be made to IAS 39’s requirements to eliminate the requirement to recycle certain gains and losses. (Recycling is the practice that involves first recognising gains and losses in the statement of total recognised gains and losses and then, at a later date, recognising them again in the profit and loss account.)

• the disclosure requirements in the new standard would apply only to listed entities and unlisted banks. This proposal broadly mirrors the limited scope of the existing disclosures standard (FRS 13 ‘Derivatives and other Financial Instruments: Disclosures’).

• the requirements based on IAS 39’s measurement and hedge accounting requirements would be mandatory from that date only for entities— listed or unlisted—that chose to adopt fair value accounting. Entities wishing to adopt this aspect of IAS 39 prior to 2005—perhaps because they were having to prepare similar information for their US filings— would be able to do so, and those that wanted to wait would also be able to do so.

• IAS 39’s requirements on recognition and derecognition would not be implemented in the UK at the present time.

The proposals in FRED 30 are subject to two very important caveats: that the existing legal barriers to implementing in the UK the proposed revised IASs 32 and 39 are eliminated by 1 January 2004; and that the ASB is satisfied by then that there will not be further changes to IASs 32 or 39 prior to 2005. In this context it is worth noting that there are parts of IAS 32— for example, the equity/liability issue— that the ASB has been encouraging the IASB to take another look at.

Unlike the proposed standards in FREDs 24 to 29, which seem unlikely to have a significant effect on existing UK accounting practice, IASs 32 and 39 will have a major impact on many entities’ financial statements. FRED 30 is therefore a very important exposure draft. Not only does it represent the first opportunity that the UK has had to comment on IASs 32 and 39 but it also gives commentators the chance to tell the ASB whether it should extend its phasing in of IFRSs to include IASs 32 and 39. It is vitally important that UK commentators study the IASB’s proposals carefully, think through the ASB’s implementation proposals, and then let the ASB (and IASB) know their views.