Applying the standards

By Ian P.N. Hague

It’s not too soon to prepare for adopting the new accounting standards for financial instruments

New accounting standards that comprehensively address accounting for financial instruments are expected to be issued at the end of 2004. The standards are not straightforward and in many cases will require significant advance planning to apply, so companies should start to consider how to apply these new standards as soon as possible. How might a company go about applying the standards? Whether a company is small or large, uses complex or straightforward financial instruments, a number of steps should assist in determining the key issues the company needs to take into account and the extent to which the new standards will affect it.

Identify all financial instruments
The first step in applying the standards is to identify all the finan-cial instruments the company has. Therefore, a company needs to understand the basic definitions of a financial instrument, financial asset, financial liability and derivative instrument to ensure that all items affected by the standards are identified. Financial instruments include cash, trade receivables and payables, loans and notes receivable and payable, investments in equities and debt instruments (including investments in common shares and bank term deposits), as well as derivative contracts such as forward contracts, swaps and options. Even though a firm may not actively enter into derivative contracts, its accounting is likely to be somewhat affected by the standards. The standards also apply to some contracts to buy or sell non-financial items.

1. Equity instruments that do not have a quoted market price in an active market are measured at cost even if the instruments are classified as financial assets available for sale.

Even companies with no direct involvement with derivatives might have a derivative embedded in another type of instrument. Examples include investments in convertible debt; loans where the interest payments, or possibly the final principal amount, are linked to changes in the price of a commodity; equity or currency other than that in which the debt or loan is denominated; and terms and conditions in purchase orders or sales contracts linking the price to changes in variables such as foreign currency rates or commodity prices. An embedded derivative is a feature in a conventional contract that changes key elements of the contract in response to changes in a specified rate, price, index or other underlying variable. Since the general requirement for derivatives is to measure them at fair value, a company may need to separate derivatives embedded in any in-strument accounted for other than at fair value (if they meet certain conditions). companies also need to take account of the requirements for embedded derivatives as they negotiate new loans, leases, insurance and other contracts.

A company must also understand which financial instruments are excluded from the scope. A number of financial instruments, whose accounting is addressed in other standards, are excluded from the new financial instruments standards. These include such items as interests in subsidiaries and joint ventures, employee benefit plan rights and obligations and insurance contracts.

Identifying all financial instruments will almost certainly involve consulting with individuals outside the accounting department to ensure all instruments come to the attention of those responsible for the accounting. A company will, therefore, need to understand the types of in- struments it is searching for and explain in straightforward terms to those who might not be familiar with accounting terminology, what those instruments are — particularly for more complex instruments such as derivatives and embedded derivatives.

Classify all financial instruments
Classification of financial instruments is a vital step in the accounting process, as this classification will determine how the financial instrument is measured and when gains and losses are recognized in net income. In many cases, the initial classification cannot be changed after the financial instrument is first recognized.

All financial instruments are classified as being in one of the following categories:

• Financial assets and financial liabilities held for trading — all derivatives are in this category, as are any instruments the company is actively trading. In addition, a company may choose to designate fi-nancial instruments when first recognized to be included within this category when doing so may assist with having a financial instrument accounted for on the same basis as other financial statement items it is managing.
• Held-to-maturity investments — this category is for fixed maturity financial as-sets with fixed or determinable payments that the company has the positive intention and ability to hold to maturity. A company uses this category only if it is virtually certain it will hold the financial asset to its maturity. If there are significant sales of assets within this category before maturity it is necessary to reclassify all financial assets in this category to the available-for-sale category, unless the reason for the sales is outside the company’s control. Therefore, care needs to be taken in allocating financial instruments to this category.
• Loans and receivables — trade receivables, as well as longer term loans receivable and most loans made by a financial institution would generally be included in this category. Alternatively, loans and receivables may be designated as held for trading or available for sale.
• Available-for-sale financial assets —in-cludes all financial assets that are not classified as held for trading, held-to-maturity investments or loans and receivables. It will generally include investments in equity in-struments, since these may only be classified as held for trading or available for sale, but might also include debt instruments that an entity does not wish to classify as held to maturity.

Record financial instrument on balance sheet
All financial assets and liabilities are recognized on the balance sheet. They are initially measured at their fair value when the company becomes a party to the contract creating the item. Usually this will be the cash paid or received. However, if the in-strument confers an apparent benefit on one of the parties (usually by incorporating off-market rates, as in the case of an interest-free loan), fair value must be de-termined with the resultant premium or discount recognized in a manner consistent with the substance of the transaction.

Measure financial instrument in subsequent periods
Subsequent measurement depends on the manner in which the financial instrument was classified in step 2. Therefore, that classification decision has an important effect on the subsequent accounting for the financial instrument.

• All financial assets and financial liabilities classified as held for trading, including all derivatives and all available-for-sale financial assets, are measured at fair value.
• Held-to-maturity investments, loans and receivables and financial liabilities other than those classified as held for trading are measured at amortized cost. This will probably be little different from the manner in which such instruments are accounted for today.
• Investments in equity instruments that do not have a quoted market price in an active market are measured at cost.

For many financial instruments, calculation of fair value will require locating a reliable current price or rate. When a current price in an active market is not available, future cash flows are discounted using appropriate discount rates for the term of each cash flow. For more complex derivatives and other financial instruments it may be necessary to use valuation models. Some are relatively straightforward, such as certain option pricing models. However, others may require de-velopment of more complex instrument-specific models. Development of a consistent approach is necessary for all.

Amortized cost is required to be determined using the effective interest method.

Recognize gains and losses
Like the measurement requirements, the method of recognizing gains and losses in net income depends on the classification of the financial instrument.

• Instruments classified as held for trading, including all derivatives — all gains and losses are included in net income in the period in which they arise.
• Held-to-maturity investments, loans and receivables, and other financial liabilities — amortization of premiums or discounts using the effective interest method, and losses due to impairment, are included in current period net income, as are most foreign exchange gains and losses in accordance with Handbook Section 1650. Other gains and losses are recognized only on removal of the instrument from the balance sheet.
• Available-for-sale financial assets — gains and losses, other than impairment losses, are included in other comprehensive income until the asset is removed from the balance sheet. Any premium or discount recognized on acquisition of a fixed income investment is amortized to net income as interest income or expense using the effective interest method. Losses due to impairment are included directly in net income.
• Gains and losses on financial instruments classified as financial liabilities are recognized in net income, whereas those classified as equity are recognized in equity.

Provide disclosures
Once a company has determined how to account for its financial instruments, it needs to consider how to provide information about instruments in the financial statements in a manner that will enable a user to understand their use. These include information about the financial in-struments themselves and the manner in which a company uses financial instruments in financial risk management. In some cases, the firm will need to develop systems to gather necessary information to provide the required disclosures.

Hedge accounting will be the subject of a similar article in December’s issue.