INTRODUCTION

The general purpose of IFRS is to provide a single set of high quality, global accounting standards that require transparent and comparable information in general purpose financial statements (Deloitte, 2012).

This particular paper is based upon the analysis of IAS 39 Financial Instruments: Measurement and Recognition and the effect of its implementation on the preparation of financial statements. Key features of IAS 39 will be discussed in the following part of the document along with applicable example of an implementation of this standard in published financial statements.

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The third part of the paper is dedicated to the assessment of underlying rationale of IAS 39 and the background to its development.

Criticism of fair value accounting in general and particularly the underlying reasons for some commentators to treat IAS 39 as a deficient standard will be covered in the fourth part of the document; and concluding remarks will be provided in the final part of the paper.

KEY FEATURES OF IAS 39 FINANCIAL INSTRUMENTS: RECOGNITION AND MEASUREMENT

IAS 39 itself is by far the most difficult standard the International Accounting Standards Board (IASB) has produced (HMRC, 2012).

The primary objective of IAS 39 Financial Instruments: Recognition and Measurement is to establish principles for recognizing and measuring financial assets and financial liabilities (Melville, 2009:182). In other words, IAS 39 deals with recognition and de-recognition of financial instruments, measurement of financial instruments and hedge accounting.

In the case of IAS 39 the principle of recognition prescribes when financial assets and / or financial liabilities should be presented in the statement of financial position (SOFP) of an entity, whereas the principle of measurement deals with the criteria as to how financial assets and / or liabilities and hence determines the amount at which these items should appear in the financial statements (SOFP). However, the main feature of IAS 39 is that it is based upon the fair value accounting.

In order to assess key features of IAS 39 Financial Instruments the terms ‘financial instruments’, ‘financial assets’, ‘financial liabilities’ and ‘fair value’ accounting have to be defined.

2.1 Key Features of IAS 39

2.1.1 Definitions

Financial Instrument if defined by ACCA (2010:227) as ‘any contract that give rise to both financial asset of one entity and a financial liability or equity instrument in another equity’.

Financial Asset is commonly referred to as any asset that is either cash, another entity’s equity instrument or a contractual agreement that gives rise to one of the above. Financial assets include trade receivables, options and shares if held as an investment.

Financial Liability is commonly referred to as ‘a contractual obligation to deliver cash or another financial asset to another entity or to exchange financial instruments with another entity under the conditions that are potentially unfavourable’ (ACCA, 2010:227). Financial liabilities include trade payables, debenture loan payables and redeemable preference (non-equity) shares.

2.1.2 Recognition

IAS 39 requires financial instruments to be recognised and therefore to appear in the statement of financial position of an entity when it becomes a party to contractual provisions of an instrument.

2.1.3 Measurement

Under IAS 39 an entity should initially recognise financial instruments at their fair value plus the applicable transaction costs that are directly attributable to an issue of financial liability or an acquisition of financial asset.

Fair value is defined by IASB (2012) as ‘the amount for which an asset could be exchanged, or a liability settled between knowledgeable, willing parties in an arm’s length transaction.’

For the purpose of the subsequent measurement of financial instruments or the measurement after the initial recognition, financial instruments have been classified into the following four categories under IAS 39:

financial assets at fair value through profit or loss;

held-to-maturity investments;

loans and receivables; and

available-for-sale financial assets.

2.2 Practical Example of IAS 39 Implementation

Extracts from the published set of accounts of LVMH Group along with applicable annual report of the group have been taken into consideration in order to illustrate an effect of IAS 39 Financial Instruments: Recognition and Measurement on preparation of financial statements.

Table 2.1: Presentation of Financial Instruments in the Balance Sheet

Breakdown and Fair Value of Financial Assets and Liabilities According to the Measurement Categories Defined by IAS 39

*Retrieved from 2010 Annual Report of LVMH Group published on the official website of a group.

Financial statements of LVMH Group are prepared in full compliance with the requirements of IFRS as published by IASB. As it can be seen from the above table and from the tables shown in Appendices A and B, financial assets and liabilities of the group appear in the statement of financial position of an entity at their fair value (and as indicated above book value of financial instruments is equal to their fair value, this has been specifically outlined in LVMH Group 2010 annual report to show its full compliance with the requirements of IFRS and with IAS 39 in particular). In the annual report of the group it is also specifically outlined that fair value is considered as third party acting freely would be willing to pay for an asset or liability in question (LVMH Group 2010 Annual Report). In addition, it is stated that fair value is based upon commonly used valuation models and on available market data, however it is also mentioned that it may be confirmed in the case of complex instruments by reference to values quoted by independent financial institutions.

The most notable effect of IAS 39 on the preparation of financial statements is that the changes in fair values associated with subsequent measurement are recognised in the net financial income or expense as it can be seen in the Appendix B, which appears to be the most significant ground for the criticisms imposed on the standard. This will be discussed later on in the document.

UNDERLYING RATIONALE OF IAS 39

3.1 Rationale of the Standard

In order to assess the rationale of IAS 39 Financial Instruments: Recognition and Measurement the idea behind the fair value accounting has to be understood.

When historical cost accounting (HCA) is implemented financial instruments are recognised at their historic value, which even though is measured reliably (transaction cost etc) it is still based upon past events and therefore falls to reflect current economic reality and prevailing market conditions. Fair value accounting is primarily aimed at assigning current values to both assets and liabilities. Therefore it addresses the issues associated with historical cost accounting (where information presented in the financial statements might appear misleading simply because it is out of date). Therefore, as opposed to historical cost accounting fair value accounting provides comparability in values of financial instruments acquired at different time periods.

In addition, financial disclosures that use fair value provide investors with insight into prevailing market values, further helping to ensure the usefulness of financial reports (The Bond Market Association & Derivatives Association, 2002).

ECB (2004) provided arguments supporting the view that the primary advantage brought about by IAS 39 is the improved scope for market discipline and corrective action. To be precise, ECB (2004) argued that discipline exercised by informed and uninsured investors is an essential complement of supervisory control.

Hence, the rationale of IAS 39 is to ensure information presented in the financial statements allow for current economic environment and prevailing market conditions by requiring the values of financial instruments to reflect it.

3.2 Historical Development of the Standard

IAS 39 had been originally issued in 1998, and was a subject to revision in 2000 and an effective implementation date of 1 January 2001 (for the financial periods commencing on or after 1 January 2001).

Extensive guidance for the implementation of IAS 39 was published by IASB in 2000. According to HMRC (2012), an exposure draft of amendments to both IAS 32 and IAS 39 was published by IASB as a part of its “improvements project” in 2002; afterwards revised standards have been issued in December 2003 along with both application and implementation guidance.

Hedging aspect (fair value hedge accounting for a portfolio hedge of interest rate risk) of IAS 39 had been revised in March 2004 and applicable amendments appeared in the standard in 2005.

CRITICISMS OF IAS 39

An introduction of a new standard or an amendment of an existing one inevitable reduces the management’s flexibility in profits manipulation. To be precise, Way (2012) provides evidence that sometimes management may deliberately arrange certain asset sales to use gains or losses from the sales to increase or decrease net income as reported at its desired time.

BIS (2000) argues that IAS 39 significantly increases the use of fair values in accounting for financial instruments, compared to both the existing international accounting standards and most countries’ national standards. As a result, once fair value accounting is implemented gains and losses resulting from the change in the price of an asset are reflected in the financial statements of the period in which they occur and to which they relate.

The effect of IAS 39 appeared not to be limited solely to the representation of figures in the statement of financial position; it significantly affected the hedging strategies of banks and other financial institutions. In addition, the use of IAS 39 brought a wide range of practical issues especially in the absence of an active / liquid market for specific types of financial instruments. Moreover, according to PWC (2009-2012), critics contend that reporting fair value during illiquid markets needlessly creates earnings volatility and destroys bank capital and have even called for its temporary suspension.

The main opponents against the introduction of IAS 39 were European banks, whose assets were primarily financial. This opposition was supported at high levels, as in 2003 president of France, Jacques Chirac express his concern that the adoption of IFRS and especially IAS 39 would not be in the best interests of Europe. The case of IAS 39 could therefore be considered as an example of political lobbying at the highest governmental level.

As a result of this opposition, two versions of the standard had been published, IAS 39 and IAS 39 “Carve-Out” for the adoption in Europe. This amendment to the original version of IAS 39 undermined the adoption of global standards by the EU (Armstrong, 2008). Nonetheless, in 2005 one of the two existing carve-outs has been eliminated, which in its turn increased the likelihood of IFRS adoption in Europe.

To sum up it should be stated that fair value accounting and IAS 39 in particular had been heavily criticised and even treated by some critics as deficient for a number of reasons: first of all, for its complexity, secondly for the substantial degree of subjectivity in the valuation process, for its effect on the reported profits and the dependence upon the prevailing market conditions, especially in the light of the recent economic downturn. Gary Kabureck, the chief accountant and corporate vice president at Xerox Corp, argued that it would l take more than a change in rules to make companies comfortable with the move to fair value accounting, it will take a change in “mindset”.

CONCLUSION

To conclude it should be stated that several aspects of fair value accounting covered in IAS 39 have been discussed in this document.

First of all, key features have been identified and it was outlined that IAS 39 appears to be the most complex standard ever published by IASB, nonetheless addressing the issues associated with historical cost accounting.

Secondly, the underlying rationale of the standard has been covered highlighting the need and therefore the background to its development. It was specifically outlined that due to its complex nature IAS 39 underwent several significant revisions and had faced political lobbying at the highest levels due to its controversial effect on the preparation and presentation of financial statements. This lobbying resulted in two versions of the standard and undermined the adoption of global financial reporting standards in Europe.

Finally, it was explained why the IAS 39 had been heavily criticised and even being referred to as “deficient”. Upon the primary reasons the standard complexity and the high degree of subjectivity have been identified.

However, to sum up it should also be mentioned that it may be argued that increased volatility in accounting magnitudes is not necessarily a problem if investors correctly interpret the information disclosed (ECB, 2004).

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