June 18, 1998

The International Accounting Standards Committee (IASC) has published, for public comment, proposed standards on recognition and measurement of financial instruments. The proposal is part of a series of projects that IASC has undertaken in the area of financial instruments. An earlier project led to final standards for disclosure and presentation that took effect in 1996.

The new accounting proposals are set out in Exposure Draft E62, Financial Instruments: Recognition and Measurement. E62 would take effect for financial years beginning on or after 1 January 2001.

"E62 represents a major milestone in what has proved to be the most challenging project in IASC's history,"" said Sir Bryan Carsberg, Secretary-General of the IASC. "Because of wide ranging concerns, we were never able to finalise two prior Exposure Drafts, E40 and E48, issued in 1991 and 1994 respectively. And a March 1997 Discussion Paper that proposed measuring all financial assets and liabilities at fair value, with fair value adjustments reported in income, met with a number of concerns. Our constituents expressed particular discomfort about the usefulness and reliability of comprehensive fair value measurements, especially for an enterprise's own debt. They also raised issues about the understandability of the resulting effects on income. A number of industry-specific concerns were also expressed, such as how a bank might measure the fair value of its 'core deposits'. We concluded that further and comprehensive study of those matters was essential."

That kind of study might take several years, and delaying a recognition and measurement proposal for financial instruments simply is not an option for IASC. "There is an urgent need for the standard," said Paul Pacter, the IASC's project manager on E62. "In many of our 101 member countries, the variety of current reporting practices creates a risk that investors who rely on accounting reports labelled as complying with IASC standards may not be adequately forewarned of damaging investment losses or may not understand how corporate profits can be altered by selective securities sales. On top of that, there is urgency about IASC completing its 'core standards' to allow the International Organization of Securities Commissions to consider its endorsement of our work as soon as possible. I believe that E62 represents a big step forward in accounting for financial instruments while still allowing us to explore the concerns that were expressed about a full fair value model."

The Standards proposed in E62 would be required only for publicly-traded companies. Other companies would be encouraged to follow them as well.

IASC is proposing that all financial assets and financial liabilities must be recognised on the balance sheet, including all derivatives. They would initially be measured at cost, which is the fair value of whatever was paid or received to acquire the financial asset or liability.

At present, many companies do not recognise some types of derivatives at acquisition because they have a zero cost, and they continue to keep them out of their accounting reports even if their value changes to a significant positive or negative amount. Additionally, many companies measure financial assets at amortised cost even though there are reliable quoted market prices, those prices differ widely from amortised cost, and the assets are readily available for sale.

Under E62, subsequent to initial recognition, all financial assets would be remeasured to fair value, except for the following, which would be carried at amortised cost:

• fixed maturity investments, such as debt, loans, receivables, and mandatorily redeemable preferred shares, that enterprise intends and is able to hold to maturity; and
• financial assets whose fair value cannot be reliably measured.

On the other hand, after acquisition under E62 most financial liabilities will be measured at original recorded amount less principal repayments and amortisations. Only derivatives and trading liabilities are remeasured to fair value.

For those financial assets and liabilities that are remeasured to fair value, an enterprise would have a single, company-wide option either to:

• recognise the entire adjustment in net profit or loss for the period, or
• recognise in net profit or loss for the period only the portion of the adjustment relating to securities held for short-term trading, with the non-trading portion reported in equity until the financial asset is sold, at which time the realised gain or loss is reported in net profit or loss.

E62 proposes conditions for determining when control over a financial asset or liability has been transferred to another party. If part of a financial asset or liability is sold or extinguished, the carrying amount is split based on relative fair values. If fair values are not determinable, a cost recovery approach to profit recognition is taken.

Hedging, for accounting purposes, means designating a derivative or other financial instrument as an offset, in whole or in part, to the change in fair value or cash flows of a hedged item. A hedged item can be an asset, liability, firm commitment, or forecasted future transaction that is exposed to risk of change in value or changes in future cash flows. Hedge accounting recognises the offsetting effects on net profit or loss symmetrically.

Hedge accounting would be permitted under E62 in certain circumstances, provided that the hedging relationship is clearly defined, measurable, and actually effective. E62 provides guidance on when a hedge is effective.

To encourage commentators, IASC has put the complete text of E62 on its Internet web site for people to access electronically for the first time. The web site address is http://www.iasc.org.uk Printed copies of E62 are also available from IASC's Publications Department, 7th Floor, 166 Fleet Street, London EC4A 2DY, United Kingdom, Tel: +44 (171) 427-5927, Fax: +44 (0171) 353-0562 at a price of £15 each (US $25).

IASC has requested that comments be sent by E-mail to: CommentLetters@iasc.org.uk so as to be received by 30 September 1998 (though it will endeavour to consider late comments up to 25 October). The Board's goal is to approve a final Standard by the end of 1998.

That Standard will not complete IASC's work in the area of financial instruments. Work continues through IASC's participation, with representatives of 12 national standard-setters, in a task force that is developing a proposal that will deal more comprehensively with fair value adjustments for all financial assets and financial liabilities and with reporting those adjustments in income.

Additional Information for Editors Regarding Hedge Accounting

For a hedge of changes in the fair value of an existing asset or liability, any gain or loss on the hedging instrument and on the hedged item are included in net profit or loss for the period. The carrying amount of the hedged item is adjusted even if that asset or liability is otherwise carried at cost.

For a cash flow hedge of an existing asset or liability or a forecasted transaction, the gain or loss on the hedging instrument is reported directly in equity until the hedged transaction affects net profit or loss. A key question for hedges of anticipated asset acquisitions is whether the amount reported in equity becomes part of the measure of the original acquisition cost of the asset when the forecasted transaction occurs. E62 invites comment on two alternatives but does not express preference for either:

• leave the amount in equity and amortise it over the same periods as the acquired asset or liability affects profit or loss, or
• transfer the amount as part of cost of the acquired asset or liability. This is sometimes called "basis adjustment."

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