Introduction

The ASB has two projects on financial instruments: a short-term project that is bringing the existing UK accounting treatment of financial instruments into line with international accounting standards and a longer-term project that is monitoring IASB/FASB work on developing comprehensive and definitive solutions to the accounting issues raised by financial instruments. This page of the ASB's website presents the current accounting treatment for financial instruments for entities reporting under UK GAAP. A summary of the long-term project is provided further down the page.

Summary of current position

FRS 25

In December 2004 the ASB issued FRS 25 ‘Financial Instruments: Disclosure and Presentation’ implementing the disclosure and presentation requirements of IAS 32 'Financial Instruments: Disclosure and Presentation'. The presentation requirements of FRS 25 applied to all entities in the UK for accounting periods beginning on or after 1 January 2005.

The disclosure requirements of FRS 25 applied to entities within the scope of FRS 26 ‘Financial Instruments: Recognition and Measurement’ for periods beginning on or after 1 January 2005. During 2005 the ASB issued FRS 29 ‘Financial Instruments: Disclosures’ which had the effect of withdrawing the disclosure requirements of FRS 25. FRS 29 is applicable to entities within the scope of FRS 26 for accounting periods beginning on or after 1 January 2007.

During August 2008 the ASB issued an amendment to FRS 25 to change the classification from liabilities to equity of certain puttable financial instruments and for certain financial instruments that impose on the entity an obligation to deliver to another party a pro rata share of the net assets of the entity only on liquidation. These changes, upon implementation, would ensure that FRS 25 remains converged with IAS 32, which was amended by the IASB in February 2008.

The amendment is effective for accounting periods beginning on or after 1 January 2010. Early adoption is only permitted for accounting periods beginning on or after 1 January 2009.

FRS 26

In December 2004 the ASB issued FRS 26 ‘Financial Instruments: Measurement’, implementing the measurement requirements of IAS 39 'Financial Instruments: Recognition and Measurement'. The measurement requirements of FRS 26 applied to all listed entities following UK GAAP for accounting periods beginning on or after 1 January 2005 and to unlisted entities whose financial statements are prepared in accordance with the fair value accounting rules set out in the Companies Act from 1 January 2006.

In April 2005 the ASB issued an exposure draft proposing the extension of the scope of FRS 26 to all entities other than those applying the Financial Reporting Standard for Smaller Entities (FRSSE). The exposure draft proposed that this should apply to accounting periods commencing on or after 1 January 2007 (with no restatement of comparatives required). However, the ASB having considered respondents’ views on this proposal decided to defer its decision until it has reached a conclusion on its project considering the convergence of UK standards with International Financial Reporting Standards (IFRS).. The exposure draft also proposed the implementation of the recognition and derecognition parts of IAS 39 into FRS 26 and was issued as standard in April 2006. The amendments are effective for accounting periods commencing on or after 1 January 2007.

In October 2005 the ASB issued an amendment to FRS 26 which had the effect of implementing in full into FRS 26 the following amendments to IAS 39, by the IASB:

1. transition and initial recognition of financial assets and financial liabilities;
2. cashflow hedge accounting of forecast intragroup transactions;
3. the fair value option; and
4. financial guarantee contracts and credit insurance.

FRS 29

In December 2005 the ASB issued FRS 29 ‘Financial Instruments: Disclosures' implementing the requirements of IFRS 7, which replaces the disclosure requirements in IAS 32.

The disclosures in FRS 29 incorporate many of FRS 25's requirements as well as:

• additional qualitative and quantitative disclosures on the risks arising from financial instruments; and
• new disclosures about entities’ management of their capital resource.

This standard is mandatory for entities applying FRS 26 and is effective for accounting periods beginning on or after 1 January 2007. However, earlier adoption of the revised requirements is be permitted.

Background and long-term project

The last twenty years or so have seen a rapid growth in the use of financial instruments. They have also seen increased complexity in the instruments being used and the transactions involved. As a consequence, financial instruments often have a major impact on an entity’s financial performance and financial position and can be important in assessing an entity’s financial adaptability and cash generation ability. Unfortunately, another consequence is that accounting practice has struggled to report the significance and effect of financial instruments in a comprehensive, timely and relevant manner.

• Financial instruments can rapidly transform the risk profile of an entity. Yet, until recently such changes to the entity’s risk profile would not have been apparent to users of financial statements. Indeed, the extent of the entity’s exposure to future gains and losses would often not be reported on in its financial statements.
• Until the issue of FRS 26 most entities measured the majority or all of their financial instruments at cost-based amounts. However, cost is not an appropriate measurement basis for financial instruments. The value of some financial instruments can change significantly over short periods of time, resulting in an instrument acquired at little or no cost quickly becoming a substantial asset or liability and giving rise to a large gain or loss. Yet, under the historical cost based system of reporting, increases in the value of financial instruments are typically recognised not when they occur but when they are realised in the form of cash flows. Therefore:
  
  
  1. substantial assets can be obscured from view and there are often delays in reporting gains. Such delays mean that reported financial performance will not fully reflect the economic events of that period and will, instead, reflect some of the events that have occurred that period and some of the events that have occurred in prior periods; and
     
  2. as losses (and liabilities) tend, unlike gains (and assets), to be recognised immediately, there is an asymmetry of accounting treatment. This asymmetry makes financial statements more difficult to understand and is another reason why special accounting techniques such as hedge accounting are used.
     
• Many entities use financial instruments to ‘hedge’ risk exposures, ie they acquire or create a financial instrument—the hedge—whose value or cash flows are expected, wholly or partly, to move inversely with changes in value or cash flows of an exposure or position being hedged. Under existing accounting, unrealised losses tend to be recognised in the profit and loss account before unrealised gains, which would mean that gains (or losses) on the hedge would, under ‘normal’ accounting, not be recognised in the profit and loss account in the same period as the offsetting losses (or gains) on the hedged position. In order to address this apparent anomaly, ‘special’ accounting techniques known as ‘hedge accounting’ are used to defer recognition of the losses until the offsetting gains are recognised. There is, however, little consistency about the way in which hedge accounting is applied, with different entities adopting different criteria to determine when to apply it and then applying different types of hedge accounting. There are also concerns about the validity of the techniques themselves, and about the additional complexities they create.

In 1997 the predecessor body to the International Accounting Standards Board (IASB), the International Accounting Standards Committee (IASC) recognised that, although there was a need for a comprehensive, definitive standard on financial instruments, that would take a long time to develop and improvements to existing accounting were needed urgently. The IASC therefore developed an interim standard, IAS 39, to address these issues. The standard was first issued in 1998 and the amendments were finalised in March 2004.

As noted above, the ASB has implemented IAS 39 as FRS 26, although the scope of this standard does not at present include all UK entities.

In the longer term, the ASB continues to believe that a comprehensive, principle-based definitive standard on financial instruments ought to be a priority for standard-setters throughout the world. It therefore supports the IASB’s decision to establish a Working Group to help it take a fresh look at IAS 39, examining and questioning the fundamentals of the standard. The Working Group first met at the end of September 2004. The ASB will take a close interest in the discussions in the Working Groups and the development of the IASB’s project.

Proposed Amendments

In November 2008 the ASB issued Financial Reporting Exposure Draft (FRED) ‘Improvements to Financial Instrument Disclosures’ which proposes amendments to FRS 29 consistent with those the IASB is proposing for IFRS 7 ‘Financial Instruments: Disclosures’. The proposed amendments seek to improve the information, available to users of financial reports, about fair value measurements and the liquidity risk of financial instruments. Specifically, the ASB is proposing to:

• Introduce a fair value hierarchy for inputs into fair value measurements
• Require additional information about financial instruments carried at fair value in the balance sheet
• Require fair value disclosures for instruments carried in the balance sheet on a basis other than fair value
• Change the liquidity risk maturity analysis for derivative financial liabilities to expected values (based on how the entity manages liquidity risk)
• Require credit risk disclosures for loans and receivables

The FRED closes for comment on 30 January 2009.

Contact: Project Directors: Simon Peerless, Peter Godsall and Seema Jamil O'Neill