and Reporting for Financial Instruments: International Developments
Richard C. Jones and Elizabeth K. Venuti
2005 - The International Accounting Standards Board (IASB)
has found the task of establishing standards on accounting
for financial instruments, including derivatives, as challenging
as FASB has. The international guidance on accounting for
financial instruments is contained mainly in two standards:
International Accounting Standard (IAS) 32, Financial
Instruments: Disclosure and Presentation, and IAS 39,
Financial Instruments: Recognition and Measurement.
December 2003, the IASB issued amendments to both standards.
The revised IAS 32 and IAS 39 are effective for financial
years beginning on or after January 1, 2005, with early
the process of completing the most recent series of amendments,
the IASB conducted an extensive due process, which began
in 2001 and included the following:
Conducting numerous board deliberations prior to the June
2002 exposure drafts;
Discussing the exposure drafts with constituent groups
in nine roundtable meetings;
Receiving and evaluating over 270 comment letters; and
Discussing the topic regularly at board meetings and with
its many advisory committees and various national standards-setters
around the globe, including FASB.
its considerable efforts, the IASB admits that the current
guidance is a stopgap that fails to address important fundamental
issues that must be addressed in a major future project.
But the IASB might decide to reconsider parts or all of
the financial instrument’s guidance for other, more
having recently stated that in 2005 it would endorse some
or all of the IASB standards as the primary financial accounting
and reporting rules for its member states, the European
Commission proposed excluding certain provisions of IAS
39 when the international standards are adopted. The commission’s
proposal resulted from concerns expressed by major international
financial institutions about certain provisions of the amended
IAS 39. The IASB continues to deliberate on those controversial
32 and IAS 39 provide guidance on accounting and reporting
on financial instruments. Where other available guidance
was deemed sufficient, the IASB excluded certain financial
instruments from the documents’ scope. The excluded
topics include the following:
Assets and liabilities under an employee benefit plan;
Contracts for contingent consideration in a business combination;
Certain insurance contracts;
Most loan commitments; and
Interests in subsidiaries, associates, and joint ventures,
except where specific guidance requires application of
of IAS 32
issued in 1995 and amended several times since then, IAS
32 defines the key financial instrument terms and provides
the basic financial reporting disclosures and some financial
statement presentation requirements for financial instruments,
including derivatives. In the United States, similar guidance
is addressed in several separate statements, interpretations,
and Emerging Issues Task Force items. The following are
the major U.S. standards that address financial instruments
accounting and reporting:
SFAS 107, Disclosures About Fair Value of Financial
133, Accounting for Derivative Financial Instruments
and Hedging Activities.
SFAS 140, Accounting for Transfers and Servicing of
Financial Assets and Extinguishments of Liabilities.
SFAS 150, Accounting for Certain Financial Instruments
with Characteristics of Both Debt and Equity.
32 defines a financial instrument as any contract that gives
rise to both a financial asset of one enterprise and a financial
liability or equity instrument of another enterprise. A
financial asset is either: 1) cash; 2) an equity instrument
of another enterprise; 3) a contractual right to receive
cash or another financial asset from another enterprise;
or 4) a contractual right to exchange financial instruments
with another enterprise under conditions that are potentially
liability involves a contractual obligation to either deliver
cash or another financial asset, or to issue another financial
instrument, under terms that are potentially unfavorable
to the issuer. An equity instrument is any contract that
evidences a residual interest in the assets of an enterprise
after deducting all of its liabilities. Similar to the U.S.
guidance, IAS 32 requires reporting mandatorily redeemable
preferred stock as a liability because of the obligation
to redeem the security using cash.
the case of compound financial instruments, which are instruments
with both debt and equity features (i.e., bonds convertible
into cash or equity instruments), IAS 32 requires separating
the component parts into its debt and equity portions. Interest,
dividends, and transaction gains and losses associated with
the instrument should be accounted for and reported consistent
with the classification of the component from which those
amounts were derived. For example, payments related to a
component classified as an equity instrument would be reported
similarly to a dividend, but payments on a component classified
as a debt instrument would be accounted for and reported
as interest expense.
a derivative is defined as a financial instrument that changes
in value in response to a change of a specified underlying
financial or nonfinancial item or variable; requires little
or no initial investment; and is settled at a future date.
assets and financial liabilities may be reported net in
the balance sheet when a current legal right of set-off
is present and the company intends either to settle the
instruments on a net basis or to realize the asset and settle
the liability simultaneously. When the legal right of set-off
is retained but the company does not intend to exercise
that right, it should not net the financial assets and financial
liabilities in the balance sheet.
32 requires numerous disclosures about financial instruments,
including the associated risks and policies for managing
those risks; the accounting policies applied to the instruments;
the business purposes the instruments serve; and the extent
of the company’s use of financial instruments.
of IAS 39
in 1999, IAS 39 was the culmination of a long process aimed
at defining and establishing recognition and measurement
guidance for financial instruments. When the International
Accounting Standards Committee (IASC, the predecessor of
the IASB) deliberated IAS 39, FASB was the only major accounting
standards setter with formal guidance on the recognition
and measurement of financial instruments. Thus, the IASC
based much of its deliberations and final guidance on U.S.
it addresses recognition and measurement of all financial
assets and financial liabilities, IAS 39 is a complex document.
Among the issues it addresses are the recognition and derecognition
of financial assets and financial liabilities, the accounting
for derivative transactions and hedges, and the impairment
of financial assets. In the U.S., FASB addressed many of
these issues with separate standards, including the following:
SFAS 114, Accounting by Creditors for Impairment of
SFAS 115, Accounting for Certain Investment in Debt
and Equity Securities.
SFAS 133, Accounting for Derivative Instruments and
Hedging Activities and various amendments.
SFAS 140, Accounting for Transfers and Servicing of
Financial Assets and Extinguishments of Liabilities, a
replacement of SFAS 125.
and Derecognition of Financial Assets and Liabilities
general, IAS 39 requires recognition and measurement of
all financial assets and liabilities, including derivatives.
Equity instruments are specifically excluded from its scope.
Initial measurement should be based on the cost of the financial
asset or liability. Subsequent measurement of financial
assets depends on their classification:
Financial assets classified as trading assets, including
all derivative instruments that are not classified as
hedges, should be measured at fair value, with changes
to fair value reported on the income statement.
Financial assets classified as available for sale should
be measured at fair value, with changes to fair value
reported as a component of equity. When such assets are
disposed of, the accumulated gains or losses that were
reported in equity would be reported on the income statement.
assets classified as held-to-maturity investments should
be measured on an amortized cost basis, like originated
loans and receivables.
recent amendment to IAS 39 permits any financial asset or
financial liability to be designated as a trading instrument,
which requires fair value reporting. Such designation must
occur when the instrument is initially reported. One advantage
associated with such designation is that a company can achieve
the objective of hedge accounting without having to meet
the hedge-accounting criteria. A major disadvantage is that
the designation is permanent. Therefore, if the hedge relationship
is discontinued, the company must continue to report the
hedged instrument at its fair value, with increases and
decreases in fair value reported in income. This differs
from the hedge accounting rules, which, in certain instances,
permit amortization of the adjusted value of the hedged
instrument into income over the instrument’s remaining
life when a fair-value hedge relationship is discontinued.
In response to comments received from certain regulators
and financial industry observers, in April 2004 the IASB
issued a proposal to limit the application of the fair-value
option to five specific situations. The IASB currently is
reviewing and considering the comments it has received on
a company to derecognize a financial asset, IAS 39 requires
the following considerations:
An assessment as to whether the transaction meets the
criteria for removal of all or only a portion of a financial
asset or group of similar assets.
A determination that the asset was in fact transferred.
A transfer occurs either when the contractual rights to
receive the associated cash flows are transferred, or
when the contractual rights to receive the cash flows
from the asset have been retained but a contractual obligation
to pass those cash flows on to another entity has been
assumed in an arrangement that meets criteria specified
in IAS 39.
the asset has been transferred, a determination of whether
substantially all of the risks and rewards of ownership
were transferred. If substantially all of the risks and
rewards of ownership were retained, derecognition is not
Last, where some, but not substantially all, of the risks
and rewards of ownership were retained, an assessment
of whether control of the asset has been relinquished.
Derecognition is permitted to the extent that such control
has been relinquished.
liability can be removed from the balance sheet only if
the debtor has been discharged from the obligation by the
creditor through repayment, legal release from the debt
contract, or cancellation or expiration of the obligation.
to U.S. guidance, IAS 39 permits designation of a derivative
financial instrument as an offset of net profit or loss
associated with changes in the fair value or cash flows
of a hedged item. IAS 39 provides for the following categories
of hedging transactions: cash flow hedges; fair value hedges;
a portfolio hedge of interest-rate risk; and hedges of a
net investment in a subsidiary.
flow hedges are derivatives that are used to reduce the
exposure associated with the variability posed by the cash
flows of a recognized asset or liability or a highly probable
purchase or sale transaction. The gain or loss of the cash
flow hedge is reported as a portion of equity until the
cash flow transaction is complete, at which time the accumulated
gain or loss either adjusts the carrying amount of the acquired
asset or liability or is reported in the net income in the
same period as the completed transaction, as applicable.
value hedges are derivatives that are used to reduce the
exposure to reported gains or losses associated with changes
in the fair value of a reported asset or liability, a firm
commitment to buy or sell an asset at a fixed price, or
an identified portion of an asset or liability or firm commitment.
Changes in the fair value of the hedge are recognized in
income along with changes in the fair value of the hedged
asset or liability.
specific circumstances, a company can apply hedge accounting
for the interest-rate risk associated with an identified
portfolio of assets and liabilities. This hedging issue,
called macro-hedging, was added to IAS 39 in a separate
amendment issued after December 2003.
39 also requires an organization to account for derivative
instruments that are used to hedge its net investment in
a foreign affiliate as a cash flow hedge.
of Financial Instruments
or the decline in the value of a financial asset, is recognized
when there is objective evidence of impairment, as a result
of a past event, to an asset reported at amortized cost.
For debt instruments, IAS 39 states that objective evidence
of impairment might include indicators of financial difficulty
or delinquency on the part of the debtor, concessions made
by a lender, or a high probability of bankruptcy or financial
reorganization of the debtor. Examples of objective indicators
for equity instruments include significant adverse changes
in the technological, market, economic, or legal environment
in which the company operates, or significant or prolonged
decline in the fair value of the investment.
determining the amount of impairment loss to recognize,
a company should consider only losses that have already
been incurred, and not potential future losses. Impairment
losses are reported in net income, even for financial assets
designated as available for sale. For debt instruments,
IAS 39 provides criteria for reporting, in income, increases
in the fair value of the instrument for which an impairment
loss has been recognized. For equity instruments, however,
such increases must be reported in equity.
with U.S. GAAP
these amendments have brought U.S. GAAP and the IASB accounting
rules closer, differences remain. For example, IASB rules
now permit macro-hedging, while U.S. GAAP does not. Additionally,
IAS 39 addresses the classification and reporting for all
types of financial assets that might be classified as available
for sale, held to maturity, or trading assets. In the United
States, SFAS 115, which specifies similar classification
and reporting guidance, applies only to certain investment
are two of the many differences between the U.S and international
rules. In all likelihood, FASB and the IASB will address
such differences in their ongoing short-term convergence
C. Jones, PhD, CPA, is an associate professor, and
Elizabeth K. Venuti, PhD, CPA, is an assistant
professor, both in the department of accounting, taxation,
and legal studies in business at the Zarb School of Business,
Hofstra University, Hempstead, N.Y. Venuti is also a member
of the NYSSCPA’s International Accounting and Auditing