IAS 39: is this now the final version?

The IASB has finalised the 'platform' of standards for the transition in 2005 by companies in the European Union, Australia and elsewhere. The final element of that platform was an amendment to IAS 39 called Fair Value Hedge Accounting for a Portfolio of Interest Rate Risk. To describe such a subject as obscure would to most of us be a case of classic understatement. To find that the IASB takes 63 pages of closely typed text to deal with it might bemuse us. This apparently obscure and elaborate document, however, might hold the key to keeping the EU's 2005 project on the rails.

IAS 39 on the recognition and measurement of financial instruments requires investments and other financial assets (those held for trading, for example) to be stated at fair (or market) value. Derivative contracts (which often have a negligible cost) must all be shown at fair value. As markets move, as interest rates go up or down or currencies fluctuate, the fair values of some of these items can change significantly, creating volatility in the earnings and in the balance sheets of companies. Banks are dealers in financial instruments more than any others and so their accounts might be most affected by this volatility.

To mitigate volatility two sorts of hedge accounting are allowed: fair value and cash flow. Fair value hedges are the best sort to have. Both the hedged asset, or liability, and the hedging derivative are stated at fair value and the offsetting gains and losses go to profit in the period. Cash flow hedging is less good as balance sheet volatility is not avoided. Here the derivative's fair value (positive or negative) is taken direct to equity and released in following periods to match with the cash flows from the hedged item. Interest rate hedges can potentially be treated either as cash flow or fair value hedges.

Unrestricted hedge accounting could be a powerful tool in manipulating and disguising the true results of a company. So IAS 39 requires that, to qualify, all the hedges must be:

• designated from the start - identified assets or liabilities and the derivative contracts
• documented fully, and
• proved to remain effective.

This is easier said than done. For banks especially, the sheer volume of financial instruments they have over a period make these requirements difficult to achieve. The banks wanted therefore to be able to group their assets or liabilities into portfolios for designation as fair value hedges and not have to use individual items or have to treat them as cash flow hedges.

The banks have now achieved this by way of this amendment, as a result of lobbying the IASB a year ago and also through political channels in Europe. President Chirac surprised the accountancy profession by writing to the Commission on this subject last summer. EU endorsement of IAS 39 has been withheld as a result and it is still not clear that it will be granted even after the amendment. The banks are still unhappy about other aspects. They would like to be able to include deposits repayable on demand (for example, current accounts) in these portfolios. IASB is unwilling to grant this as it could mean including these liabilities at less than their face value. Negotiations are continuing and further amendments to IAS 39 are possible as a result of these, or out of a review by some of Europe's leading financial regulators (set in train earlier this year by the IASB and EU Commission).

What will be the outcome? The banks may be satisfied by the current amendment and any further tinkerings to which the IASB agrees. Endorsement of IAS 39 by the EU might then be expected sometime later this year, just in time for 2005. If not, EU companies will face a choice next year. Either they can ignore IAS 39 and explain to their investors what standards they have complied with (which may also put their auditors on the spot). The SEC has already signalled that for any US listed companies this may not be acceptable. Alternatively, they can choose to apply IAS 39 anyway on a voluntary basis. HSBC has already indicated among European banks that it will do so and that is an important precedent for investor pressure to build on.

Richard Martin is head of financial reporting at ACCA.