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Dear Sir David Tweedie
I am writing on behalf of the Msc Accounting course student in Leeds Metropolitan University. With this letter we are going to give our recommendations about the IAS 39 (Financial Instrument Recognition and Measurement). The many ways of measuring financial instrument and the associated rules are the main concern of this letter, because that various measurement of financial instrument is becoming more complexity these day. (International Accounting Standard Board,2008,[p.10])
The potential for opacity has therefore increased, so it is essential that accounting standards are clear and capture the economic substance (Bank Of England,2004,[P4]). Removing inconsistencies in the accounting for financial instruments between IFRS and US GAAP is another objective about this letter, Because by removing inconsistencies in accounting and financial instruments would enable comparison to be made more easily between entities applying IFRS or those using US GAAP. Here are the examples of variety measurement methods required or allowed today for financial instruments, some of the measurements described below are IFRS requirement only, some are US GAAP requirement only, in addition some of the measurement described below are applicable for investment that are outside of the scope of IAS 38 or US standards for financial instruments.
1. Equity method
2. Consolidation - recognition of individual assets and liabilities of the issuer of the equity instruments
3. Proportionate consolidation
4. Fair value with gains and losses in earning
5. Fair value with gains and losses in other comprehensive income until realized
6. Fair value with gains and losses in other comprehensive income until realized except required impairment losses that are reported in earnings immediately
7. Fair value with part of the gains and losses in earning and part of the gains or losses in other comprehensive income (cash flow hedge accounting)
8. cost less required impairment losses that are reported in earnings
Those are the some of the measurement methods.
My recommendations for the complexity problem are:
1. To use single measurement method for all types of financial instrument within the scope of standard for financial instruments as long term solution.
2. Provide ideal standard that present relevant information and more easily understandable information for users of financial statements, because if it doesn't it will reduce the relevant information available or make it more difficult to understand.
3. Ideally the standard should be changed to be more simple for prepares, auditors and users.
Fair value seems to be the only measure that is appropriate for all types of financial instrument because:
1. Having a single measurement method for all types of financial assets would significantly simplify the existing standards by avoiding 'boundary' issues (eg how fixed is fixed and what variability is needed to require fair value). A single statement would also eliminate any confusion about the measurement method for each different type of financial assets.
2. In addition, fair value is a better measure for use in assessing the effect on cash flow prospect of credit risk for financial assets because:
1. It provides information about anticipated future losses, not just losses that have been incurred
2. It provides information about improvements in credit risk since acquisition
3. Compare with cost based measures, The fair value of financial asset better reflects the price of the asset that would be received at the measurement date. Such information is generally useful. There are often events and circumstances beyond management's control that create a need to sell. Therefore even if management has no plans to sell an asset, it is useful for users of financial statements to know the potential effects of such events and transactions (although they are not considered highly probable by management).
(International Accounting Standard Board,2008,[p.44])
4. The best reasons to use fair value for financial liabilities are:
A single measurement method for all financial liabilities would also reduce complexity and enhance understandability
1. Enhance comparability because entities with comparable credit ratings and obligations will report liabilities at comparable amounts even if the borrowing occurred at different times in different interest rate environments. The reverse is also true-entities with different credit ratings and obligations will report different liabilities.
2. Fair value would result in an entity reporting the same measure for two equally secure payment obligations with identical cash flow requirement (amount and timing). Currently different amounts are likely to be reported if two obligations were incurred at different times (because market interest rates or the entity's credit spread change between the two)
3. Fair value better reflects the cash flows that would be paid if liabilities were transferred at the re measurement date.
(International Accounting Standard Board,2008,[p.50])
4. Full fair value accounting for all financial instrument provide information that is more reliable to the users of financial statements because for liquid instruments traded on an active market, fair value can be reliably determined. It is equal to the quotation price. For instruments not quoted on an active market, but managed on a fair value basis, sophisticated evaluation and modeling techniques have been employed to estimate fair value. (International Banking Federation,2008,[p.14])
How ever the financial markets around the world began experiencing significant illiquidity and volatility and its creating conditions that made fair value method more controversial, the value of today innovative and complex financial instruments is subject to market illiquidity and volatility. Many people agree that fair value is not perfect method (Price Waterhouse Coopers,2008.[p1])
Earnings volatility sometimes happened when markets become illiquid and market prices are not available (Price Waterhouse Coopers,2008.[p3]), When the methods described above for determining fair value are applied, the effect on earnings may be as unpredictable as the market. It may fluctuate as a result of market realities revealed in fair value assessments.
In response to recent economic condition, it has been suggested that fair value accounting be suspended or changed for certain financial instruments, or that businesses should apply their own method, which may show a less volatile long-term scenario(Price Waterhouse Coopers,2008.[p3]. The current market, it is contended, is an anomaly. However, these concerns must be balanced against investors' desires to know the current values of these assets. If fair value were suspended or replaced with some method based on historical cost, investors would be left to their own devices to determine the current value of these instruments-which would be less reliable and could delay any market recovery.(Price Waterhouse Coopers,2008.[p3])
Although it has generated controversies, Fair value continues to represent the best available methodology for determining and reporting the value of financial instruments.
Markets naturally respond to financial information that fair value provides. The impacts
of such measurements whether positive or negative, it because the result of market forces, not accounting methodologies. When market conditions result in volatility in values and earnings, investors benefit when companies transparently report on these circumstances and their impact on financial reporting.(Price Waterhouse Coopers,2008.[p3]
I hope my explanation and argument above being your consideration to revise or make improvement in IAS 39.
In responding of Susetyo Putranto letter, we as user or company do not agree with him because we are dealing with uncertainty of future cash flows, uncertainty of global economic situation and several risks. Which as management we have to mitigate or reduce those kind of risks such as foreign currency exchange rate risk, Liquidity risk, Credit risk, Interest rate risk, commodity risk and other price risk. But in some area of his argument we agree about the complexity of measurement in relation with financial instrument method. We need flexible method or measurement to measure or classified financial instrument which represent our purpose as management which responsible to financial reporting users or our stakeholder. Based on our experience and knowledge we suggest there are two measurements, the first is amortized cost and the second is fair value method, because with two measurements we can chose which method is the best according to current economic situation and management needs. The most important thing is how we classified which instrument using amortized cost and which instrument using fair value method. We recommend process of determining measurement as below:
Process for determining Measurement
(International Accounting Standard Board,2009,[p.3])
We believe that amortized cost provides decision useful information about the amounts, timing and uncertainty of future cash flows:
- Do the financial have basic loan features?
- Is the instrument managed on a contractual yield basis?
Instruments are managed on contractual yield basis if the business model is to pay and receive the contractual cash flows that are generated when held or issued.
Basic loan features are contractual terms that give rise to cash flows that are payments of principal and interest on the principal outstanding.
The impact if using only fair value or single measurement to financial report
We use Rolls Royce Plc financial report from 2007 to 2008 as an example. Where available market values have been used to determine fair values, one crucial problem for the accountant is if where market values are not readily available. The accountant has to decide another method to measure the value of that instrument. In Rolls Royce Plc financial report, one of the financial instrument accounts called Financial RRSPs (Principally in respect of derivatives, borrowings and financial RRSPs). The fair values have been estimated by discounting expected future cash flows using prevailing interest rate curves. Because in that time the market value for Financial RRSPs did not available.
2008 2007 Book value Fair value Book value Fair value Borrowings - Current (23.00) (23.00) (34.00) (34.00) - Non current (1,325.00) (1,291.00) (1,030.00) (1,058.00) Financials RRSPs (455.00) (487.00) (315.00) (340.00) (Source: Rolls Royce Plc annual report 2008)
As we can see from the illustration above, we can see the difference if we use book value or fair value method. The financial RRSPs will increase 7.03% if using book value in 2008 and increase7.9% in 2007 (In their balance sheet Rolls Royce Plc use Book value method to record Financial RRSPs account). Those changes will automatically change the total current liabilities and also the current ratio.
Current Liabilities 2008 2007 Book value 8,573.00 4,754.00 Fair value 8,605.00 4,779.00 CURRENT RATIO 2008 2007 Book Value 1.10 1.53 Fair Value 1.09 1.52 (Source: Rolls Royce Plc annual report 2008)
In this case the changed in numbers is not significant, but the main problem is. If the IASB approved Susetyo Putranto letter and agree to change the standard into one measurement which fair value is the only one method for measuring financial instrument, and one day the situation like Rolls Royce Plc happened. What the accountant should do.
The other crucial impact if we only using one measurement are, when the global economic condition in downward or in crisis. The fair value measurement will give significant impact for the income statement especially the net profit caused by unrealized loss account.
Account 2008 2007 Revenue 9,082 7,435 Cost of sales -7,311 -6,003 Gross Profit 1,771 1,432 Other operating income 79 50 Commercial and administrative costs-666 -653 Research and development cost -403 -381 Share of profit of joint ventures 74 66 operating profit 855 514 Profit/loss on sale or termination of business 7 -2 Profit before financing 862 512 Financing income 432 718 Financing costs -3,186 -497 Net Financing -2,754 221 Loss.profit before taxation -1,892 733 Taxation 547 -133 Loss/profit for the year -1,345 600 (Source: Rolls Royce Plc annual report 2008)
Account 2007 2008 Financing income (718.00) (432.00) Financing cost (497.00) (3,186.00) Net Financing (221.00) (2,754.00) (Source: Rolls Royce Plc annual report 2008)
The table shows that the financing cost (from derivative transaction) is significantly increased approximately 1146% compare to 2007. During 2008 the groups uses various financial instruments to manage its exposure to movements in foreign exchange rate, Interest rate financial instrument and commodity financial instrument, because during 2008 the global economic condition was in downward position. If we see carefully the Rolls Royce Plc income statement, The gross profit is does not changed significantly but the bottom line is drop significantly, as we know Rolls Royce main business is not financial institution but their financial instrument caused the significant loss and it will influence their investor or decision maker.
(Source: Rolls Royce Plc annual report 2008)
As we see from the illustration above 75% from total 100% cost were dominated by Financing cost where the cost come from unrealized loss in relation with company financial instrument account. If the company such as Rolls Royce which have various financial instrument in their financial reporting, and crisis happen it will hit their financial performance. In summarized from the explanation and our research above we do not agree with the proposal and we suggest to the IASB is made some improvement according with the classification and measurement of financial instrument which:
1 Easy to understand
2 Adaptable with current economic condition
3 Use 2 method, Fair value and amortized cost
4 Method that would Increase transparency of financial statement
What I have learned after doing this assignment is my knowledge about how to measure financial instruments both technical skill and theory skill is enhance significantly. This study helps me to look in different view or perspective in make argument and opinion. Based on this study I have to look from regulator argument and entities or user argument before deciding which is the best or suitable for all. Since studied this assignment I found positive relation between International Accounting Standard Board as regulator and Entities, they have one objective that is maximizing stakeholder wealth. Risk become an important thing after I have done this study, risk is something that we have to consider before deciding something. Dealing with accounting knowledge, this study teach me, if I have problem dealing with accounting problems that will happen on me in the future, I have to look back or refer the problem to the qualitative characteristic of financial statement principle: understandability, relevance, materiality, reliability, faithful representation, substance over form, neutrality, prudence, completeness and comparability. Those qualitative characteristic of financial statement must be considered before make some decision. The limitation to finish this assignment is I used secondary data such as discussion paper, company report and internet web site, it would be much better if i had primary data for this study.
International Banking Federation,2008,"Accounting for financial instrument", International banking federation, London
International Accounting Standard Board,2008,"Discussion paper reducing complexity in financial instruments", International Accounting Standard Board, London
International Accounting Standard Board,2009,"Exposure draft financial instrument :measurement and classification", International Accounting Standard Board, London
Rolls Royce Plc,2008"Annual report", Rolls Royce Plc,London