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Executive Summary

1. The Association of Chartered Certified Accountants (ACCA) is pleased to have this opportunity to comment on the Exposure Draft (E62) of a proposed International Accounting Standard on the recognition and measurement of financial instruments from the International Accounting Standards Committee (IASC). This is an important and wide-ranging subject.

2. E62 contains alternative accounting treatments which will allow enterprises substantial flexibility in preparing accounts. It is also one-sided in applying fair values to financial assets, while leaving liabilities at cost. It should not therefore remain the definitive standard for financial instruments, and ACCA supports the efforts to work on a more comprehensive standard. ACCA recognises, however, the urgency of producing an interim standard, and is generally supportive of E62 on that basis.

3. Financial instruments are defined very broadly in E62. The impetus for this standard comes from the need for a fair value model for derivatives, money market instruments and quoted investments. The wide definitions it employs, however, catch a number of other items, for example trade debtors. We consider that they are best treated as held-to-maturity and excluded as such. The conditions for held-to-maturity status need to be adjusted in a number of respects to accommodate them.

An interim measure

1. We generally support the provisions of this proposed standard. We have noted, however, that the Exposure Draft (ED) leaves open various important areas. For example, most liabilities are excluded from the scope, and E62 would allow alternative treatments for movements in fair values. It seems inherently one-sided to have a standard which would bring in fair values for assets, while ignoring the liabilities. We find alternative accounting treatments inherently unsatisfactory and contradictory in a document which is attempting to set standard practice.

2. In this regard we have noted in the introduction IASC's comments on the Joint Working Group with some national standard setters, and its aim to produce a comprehensive standard in due course. We endorse this intention, and indeed were supportive in the main of the more comprehensive proposals set out in the Discussion Paper of April 1997, which was the forerunner of E62.

3. We have also noted the comments about the urgency of the need for an interim standard, while the more comprehensive standard is being prepared, and appreciate the circumstances in which E62 has been developed and issued. It is only on the basis that E62 is an interim measure and due to be superseded in due course, that we can support its main provisions and issuance at this time.

   Definition of financial instruments

4. While we appreciate that the definitions of financial assets and financial liabilities are the same as those used in IAS 32, we consider them to be very widely drawn. The definitions of financial assets and liabilities include all investments, debtors, cash, creditors, borrowings and preference shares. The only items in effect excluded would be tangible and intangible fixed assets, stock, provisions (perhaps), accruals and equity.

5. In addition to the items currently on the balance sheets, the definitions would draw into the scope of the standard, items currently off-balance sheet. Some of these like derivatives with a zero cost are rightly included, but others like non-cancellable commitments, unfulfilled sales orders and the like have, probably inadvertently and incorrectly, been drawn in as well. The position of executory contracts needs to be reconsidered.

6. This ED is proposing radically different accounting treatments for financial assets, and for a more limited range of financial liabilities, from those commonly used at present. The impetus for this project came from the need to ensure that the accounting for derivatives and other money market instruments was appropriate to the changing commercial conditions. We are uneasy with the wide definition of financial instruments which would apply those radically different accounting treatments to a whole host of other assets (e.g. trade debtors, or amounts recoverable under long term contracts) for which the existing accounting model is perceived to be working entirely satisfactorily. We think that this wide definition of financial instruments should either be amended to focus on the items which need the new accounting model, or the standard should ensure that these items should be excluded from the fair value provisions in the same way that liabilities are, for example.

7. It has been said that the fair value of trade debtors will in most cases equate to their cost less suitable provisions for uncollectable amounts. Any adjustment for such assets on restatement to fair values, is said to be restricted to cases where the payment periods are longer than a few months. We disagree with this contention as it ignores
   • the definition of fair value as market value,
   • the existence of markets in receivables (factoring and the like) and
   • the fact that the time value of money would be only one factor influencing the market price.
   A third party will demand a premium to take on the credit risk and to cover their lesser knowledge of, and perhaps influence over, the debtors involved. There is likely to be a significant difference between the market value of portfolios of trade debtors and their cost less bad debt provisions.

8. Another source of difference lies in the greater value of the asset to the original company, because of the importance of the management of the receivable to the ongoing commercial relationship with the customer. This points to the right treatment, in our view, being to treat trade debtors as held-to-maturity items and not therefore fair valued at all under this ED.

9. If that were to be the treatment adopted, commercial companies would, we believe, be able to demonstrate that they have the positive intent and ability to hold their trade debtors to maturity. We are concerned, however, that

• trade receivables are not included among the examples in paragraph 16,
• the term "investment" might not include a trade receivable, and
• trade debts might not meet the strict fixed maturity conditions in all cases.

• references to fixed maturities should be removed,
• the items involved should be described as "held-to-maturity assets",
• paragraph 16's examples should be amended and
• the "stands ready to sell" exclusion should be modified (see our answer to Question 11 below)

ACCA's responses to the specific questions in E62

Q1. Should the Board: (a) retain the proposed scope of applicability only to publicly traded enterprises; (b) expand the scope to include non-public enterprises; or (c) further restrict the scope, for example, to financial instruments issued in connection with cross-border securities sales?

ACCA has generally opposed differential measurement and recognition on the grounds of size. Given the interim nature, however, of the proposed standard and the particular circumstances driving its publication, we think that a limitation to listed companies is justifiable for the time being. We would propose, however, an extension to other public interest entities and not just those with publicly traded securities. Examples might include privately-owned banks and insurance companies or some public sector bodies. They would be significant holders of financial instruments and in whose accounts a wider range of people might have a legitimate interest.

The comprehensive project should reconsider the scope of applicability, and we would expect the integrated and harmonised standard developed would apply to all entities.

Q2. Should the effective date of this Standard be: (a) applicable to insurance enterprises as well as to other enterprises; or (b) deferred for insurance enterprises pending completion of the insurance project?

We can see no overwhelming case for delaying the application to insurers. We agree that insurance contracts should be excluded from the scope of E62, and their accounting will be a key focus of the insurance project. We can see no compelling reason, however, why the investment portfolios and other financial assets of insurers should not be shown at fair value. The same problems of held-to-maturity items, matching risk exposures and hedging might affect insurers as much as other entities.

Q3. Should the Board: (a) retain the applicability of this Exposure Draft to strategic equity investments if the equity method is not appropriate; or (b) require the amortised cost method for such equity investments even if fair value can be reliably measured and, if so, how should "strategic investment" be defined?

We think that there are cases where the right answer is for certain investments, which are not equity accounted, nonetheless to be stated at amortised cost. Examples include defensive holdings in joint venturers, suppliers or customers, and share stakes that are required in order to be a member of an exchange or trade body. As to how such strategic investments should be defined, E62 itself has gone most of the way to defining them as "investment in equity securities … with the intent of establishing or maintaining a long-term operating relationship". The key attribute is that the rationale for the investment is to be found in an operating relationship, quite separate from the normal return for investors of dividends or capital growth.

Q4. Should non-derivatives: (a) be allowed to be hedging instruments if the criteria for hedge accounting otherwise are met, as proposed; or (b) not be allowed as hedging instruments?

E62's principle is to permit hedge accounting where the hedging is designated and effective. If non-derivatives can meet those criteria then it seems difficult not to allow them. One of the forms of hedge accounting specifically permitted under current IASs is that of foreign currency borrowings (i.e. a non-derivative) hedging a net investment in a foreign enterprise under IAS21. It would seem difficult to justify allowing hedge accounting in one case but not the other. We support option (a).

Q5. Do you concur: (a) that at least some embedded derivatives should be recognised and measured separately; or (b) embedded derivatives should never be recognised and measured separately?

In principle it seems right for contracts to be broken down into their component parts where necessary for the substance of these transactions to be accounted for fairly. Therefore some embedded derivatives should be valued separately from the host contract.

The list in paragraph 20 is a list of embedded derivatives that should not be separated. It might be helpful to give some examples of ones that should be valued separately. A number of the terms (e.g. interest-only strip) do not seem to be in common use, and yet are employed here without definition. Some of these more remote circumstances could perhaps be dealt with as part of an SIC Interpretation, and not clutter up the main standard

Q6. Do you believe that: (a) the derecognition criteria are appropriate; or (b) paragraphs 25 - 29 require substantive modification and, if so, how?

We consider the criteria appropriate and the guidance in this respect adequate.

Q7. Transaction costs should be included in the initial measurement of investments which will be carried at amortised cost, but should be excluded from the initial measurement of financial instruments that will be re-measured to fair value. Do you: (a) concur with this distinction; (b) believe that transaction costs should be excluded from the initial measurement of all financial assets; or (c) believe that transaction costs should be included in the initial measurement of all financial assets?

Transaction costs will not always be a material amount in comparison with the rest of the cost. It is established practice for the historical cost of investments to include the transaction costs of the purchase. We do not find the arguments for changing this persuasive. We would not, therefore, favour option (b) above. For items at fair value, though the distinction seems less important, we prefer option (a). This seems more consistent with the way fair value will be calculated subsequently (see Question 8 below), and because transaction costs might otherwise be part of a write-off direct to equity in some cases.

Q8. Do you: (a) concur that transaction costs should not be deducted in determining fair value; or (b) believe that transaction costs should be deducted in determining fair value?

We accept that the deduction of the expected transaction costs of sale from the fair value, would leave the balance sheet value as close as possible to the realisable value. However on balance we concur with option (a) because this matches the transaction costs with the timing of the sale. Option (b) would tend to charge the costs of both purchase and sale in the year of acquisition.

The phrasing, however, in paragraph 46 of the ED, "fair values excluding transaction costs..", does not seem as clear as the way the intention is expressed in Question 8, "transaction costs should not be deducted in determining fair value". We think that the text of paragraph 46 should be reworded.

Q9. Do you believe that: (a) the guidance in paragraphs 46(b) and 63 - 66 on reliable measurement is appropriate, clear and sufficient; or (b) the guidance should be modified, and if so, how?

On the whole we think that the guidance is appropriate, clear and sufficient. We think, however, that paragraph 63 should make it clear that all the data inputs should come from active markets.

Q10. Do you favour: (a) the approach in this Exposure Draft that, sometimes, fair value may not be reliably measurable; or (b) the alternative that cost or amortised cost may be the best indicator of fair value?

We favour option (a). This seems a relatively unimportant matter, as it concerns solely the justification for using cost where fair value cannot be reliably measured. Cost would seem to be only an indicator of fair value at the time of acquisition. Thereafter it would not necessarily be so.

Q11. Paragraph 51(b) says that an enterprise does not have the positive intent to hold an investment to maturity if it stands ready to sell the asset in response to liquidity needs. Do you believe that: (a) paragraph 51(b) is appropriate as drafted; or (b) paragraph 51(b) should be modified and, if so, how?

This condition seems unreasonably strict as drafted. We consider that some qualification along the lines of "in normal market conditions" should be added.

We have also noted above, among the principal comments, our concerns about other changes which should be made to the definition of held-to-maturity items.

Q12. Do you believe that: (a) the sale of more than an insignificant amount of any held-to-maturity investment should call into question the enterprise's intent to hold its entire portfolio to maturity; or (b) the grouping permitted by paragraph 52 is appropriate?

We think that the grouping permitted by paragraph 52, on the whole, is appropriate. It would seem wrong that, if the held-to-maturity intent is broken in one area, that all such assets in all areas must be reclassified to a fair value basis. It could be argued, indeed, that under E62 the groupings into which assets should be divided are too broad, and not the reverse. Mortgage loans, for instance, must be dealt with as a whole, and no geographical segments within that heading would be allowed.

Q13. If an enterprise changes its measurement of a financial asset from fair value to amortised cost, paragraph 58 requires that any prior gain or loss relating to that asset that was reported directly to equity should be amortised over the remaining period to maturity. Do you: (a) concur with amortisation approach in paragraph 58; or (b) believe that paragraph 58 should be changed to require that the amount in equity be immediately reported in net profit or loss when reclassification takes place?

We concur with the amortisation approach in paragraph 58.

Q14. Do you: (a) concur that a single method, amortised cost, should be the only requirement for financial liabilities other than derivatives and trading liabilities; or (b) believe that the Standard should permit, though not require, other financial liabilities to be reported at fair value?

We have noted above under our principal comments, that it seems inconsistent to have fair values for financial assets, but not for liabilities. We endorse the development of a more comprehensive standard that might tackle this inconsistency amongst others. We have also noted our opinion that alternative treatments in accounting standards are inherently unsatisfactory. We support the ED as drafted in this regard, but only on the basis that this would be an interim standard.

Q15. Do you: (a) concur with allowing alternatives for the treatment in profit for the period of an adjustment to fair value of a non-trading financial asset (pending further study); (b) disagree with allowing alternatives and, instead, would require that the fair value adjustment always be included in net profit or loss; or (c) disagree with allowing alternatives and, instead, would require that the fair value adjustment for non-trading financial assets and liabilities always be recognised directly in equity until sold, collected or otherwise disposed of or extinguished.

We have noted above our general view on the inherently unsatisfactory nature of alternatives in accounting standards, and our support for the standard only on the basis that it is an interim one. The treatment of the fair value adjustments is an important matter which the Joint Working Group should address. We are content to accept the ED as drafted, on an interim basis.

Q16. Do you: (a) concur with the use of the original effective interest rate in the case of an impairment test of a held-to-maturity investment; or (b) favour discounting at the current market rate of interest?

We support option (a). The ED's position seems consistent with the view that held-to-maturity items, because they will not be disposed of, will be unaffected by changes in interest rates during their life. In the language of the impairment standard, the write-down will not be to net realisable value, because its recoverable amount will always be its value in use.

Q17. Do you: (a) favour including a principle that addresses uncollectability of a portfolio of financial assets in general; or (b) disagree with including such a principle?

We do not see any reason for there to be a principle, beyond the impairment provisions already included.

Q18. Paragraph 76 requires an impairment test for a financial asset that is not carried at fair value because its fair value cannot be reliably measured. The impairment test can be made using a current market rate of interest to estimated cash flows. Do you (a) concur with paragraph 76; (b) believe that it should be revised and, if so, how; or (c) believe that it should be deleted as inoperable?

There does seem a logical inconsistency in paragraph 76 requiring assets, where a reliable measure of fair value is not possible, being written down to their net present values, even to the extent of specifying the discount rate to be used. If all these factors are known why is the asset not shown at fair value? The possibility of impairment of the cost cannot simply be ignored however, even though the test cannot perhaps be carried out in the way that E62 is suggesting.

We recommend that paragraph 76 is retained with its reference to impairment. It should be revised, however, and the detail of how impairment might be assessed should be left more flexible.

Q19. Do you: (a) concur that a hedge of an unrecognised firm commitment to buy an asset is a cash flow hedge; or (b) favour treating it as a fair value hedge?

It seems difficult to see how such a hedge could be anything but a cash flow hedge, given the definition in paragraph 85(b).

Q20. The Board asks commentators to indicate, of the alternative treatments for hedges of forecasted transactions, whether and why they: (a) prefer Version A; (b) prefer Version B; or (c) prefer some alternative.

We prefer Version A as this appears to be more straightforward and because the credit balance under version B would not appear to fit particularly well with the definition of a liability in the IASC's Framework.

Q21. Matters not covered by a specific question

We do have some further comments not covered by the specific questions above. These are included among our principal comments above.

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