Doubts expressed over revaluation proposals

Billed as one of the Accounting Standards Board’s most radical and far-reaching set of proposals yet, the ASB’s Derivatives and Financial Instruments discussion paper has ignited debate in the profession.

The full implications of the document, issued last July, had barely registered when sparks began to fly. The Scots ICA branded it ‘too much too quick’, while the English ICA believed that many users of accounts were unaware of its far-reaching consequences.

The most immediate impact of the proposals is on disclosure of financial instruments. The ASB intends to move to a Financial Reporting Standard on disclosure as soon as possible.

The implementation of the more ground-breaking areas of the proposals, covering measurement of financial instruments and hedge accounting, have been scheduled for the longer term, but there is no doubt that the ASB believes historical cost accounts are unsuitable for financial instruments, and a second standard is likely to follow within two years.

The ASB wants to move quickly to adopt the first stage of the discussion paper, requiring disclosure of financial instruments. The proposals include a statement giving the ‘big picture’ in the operating and financial review and the explanation of policies on financial instruments. Numerical disclosures are proposed in the notes to the accounts.

The Scots ICA has criticised the extent of the numerical disclosure as excessive and the proposed speed of implementation of disclosures as too fast.

Others seem prepared to go along with the pace and the detail of the ASB’s disclosure proposals. Richard Martin, senior technical officer of ACCA, said the disclosure period will be important for ironing out problems.

He said there will be ‘considerable practical valuation problems’ at the disclosure stage, which will provide essential learning experience for companies.

Though many UK companies already provide extensive disclosure to comply with international accounting standards, some companies, like British Aerospace (which is generally in favour of disclosure), are worried about making such detailed information about foreign cover available to competitors.

Valuation proposals

While the disclosure requirements are ruffling some feathers, the ASB’s proposal that all financial instruments be revalued on the balance sheet has greater implications. The proposals on the table, primarily aimed at listed companies, not only revalue derivatives and debt instruments, but also their own borrowings.

The ASB believes companies should revalue their own long-term, fixed-rate loans. Take the situation of companies who took out long-term borrowing in the early 1990s, when base rates were around 15%. Revaluation of that debt at much lower current base rates would give rise to a loss not previously recognised in an accounting sense. Under the ASB proposals, such losses or gains would be taken to the statement of total realised gains and loss (STRGL).

The impact of accounting for long-term debt in the balance sheet in this way has caused particular concern. Ian Wright, technical partner at Price Waterhouse, said that where a loan in the books is hedged against a derivative, the revaluation of both sides would net off in the STRGL, but that revaluation gains and losses of an unhedged fixed-interest loan would not net off in the STRGL and there would be performance implications.

British Aerospace’s group treasurer David Brent believed this could have the effect of discouraging companies from taking out fixed-rate and longer-term borrowings.

Ian Wright said that, since most companies are locked in to fixed-rate, long-term debt until maturity (unless they have early payment arrangements), the relevance of revaluing them at market rates is questionable.

Tony Wedgwood, accounting technical partner at KPMG, said the ASB had backed itself into the valuation of long-term loans. If you value the hedge on a fixed-rate debt you have to revalue the borrowings as well, or there will be an imbalance and an artificial gain or loss, he said.

Wright added that the ASB’s solution to revalue all financial instruments had a ‘symmetry and eloquence’ to it, but the fact is that the majority of European companies have long-term debt without swap arrangements.

Ron Paterson, technical partner at Ernst & Young, said a distinction should be made between long-term debt and other financial instruments in the balance sheet.

Hedge accounting

Hedge accounting, which allows companies to defer reporting derivatives, has also caused debate. The ASB has proposed three alternative treatments for hedge accounting. The first is to ban it. The other two alternatives allow it to some degree.

Richard Martin, senior technical officer at ACCA, said that leaving the decision entirely up to management as to when to use hedge accounting was drawing the definitions too wide. Where companies have taken out hedges against anticipated foreign currency sales, the company ought to use hedge accounting where the sales are ‘commercially committed’, he believed.

British Aerospace operates in the US dollar-dominated market of commercial aircraft sales. Group treasurer Brent said it was not clear how the term ‘commercially committed’ is defined.

Companies like British Aerospace, which sell foreign currency forward against anticipated sales received in foreign currency, could face big swings in the profit-and-loss account or the STRGL as foreign exchange fluctuates.

E&Y’s Ron Paterson added: ‘The ASB is misleading itself about the amount of abuse that is going on in hedge accounting.’

The ASB seems to have an urgency about its proposals on financial instruments.

It is aware of the need to keep up with the rest of the national standard-setting bodies, which are already making strides in this area. But an important reason to keep the momentum going on this issue is to educate accountants and treasurers in the field.

ASB technical director Allan Cook said part of the aim was to improve people’s understanding of accounting for financial instruments. ‘The information in the accounts will create a picture that nails management down, so people can check that they are sticking to what they say they do in policy terms.’