Dec. 30–Although Thailand has not implemented International Accounting Standard 39 (IAS 39), the recent Thai Accounting Standards are based on and are similar to IAS. It is therefore highlyplausible that the main accounting principles within IAS 39 are likely to be applied in the future. As experienced by many countries, implementing such standards requires serious advancedpreparation. It’s therefore imperative that financial institutions begin now to understand and prepare for IAS 39.
The key provisions in IAS 39 can substantially change the profitability of products, services and even businesses as a whole, forcing organisations to re-engineer their entire trading, investment and value-creation strategies. This is particularly important for businesses with derivative transactions.
Fair valuation One of the critical issues of IAS 39 is how to keep pace with movements in fair value across a diverse range of contracts and how to incorporate such changes into reporting systems and overall business planning.
Under IAS 39, all derivatives will need to be fairly valued. Currently, derivatives don’t have to be reported on balance sheets, which means a financial institution’s true financial position isn’t reflected. This can lead to potential hidden losses or profits in an institution’s operating results. In most cases, IAS 39 also calls for, movements in such valuations to be recorded in income statements unless the derivatives are designated and effective as cash flow hedges.
In addition, certain types of valuation adjustments currently applied for reasons of prudence are no longer permissible. For example, some institutions will underestimate the value of derivatives in order to smooth their earnings. While this will improve transparency for the users of financial statements, it will also increase the potential for income volatility.
IAS 39 also introduces numerous significant system requirements for all financial institutions, regardless of their levels of sophistication. This could be a real challenge for institutions lacking the trade functions used for “marking to market” on a real-time basis.
Implementing IAS 39 will require careful planning, a systematic approach to project management and the full participation of business units outside a company’s finance and accounting functions.
Further complications arise from the requirement to split out and separate fair value “embedded derivatives,” derivative contracts with economic characteristics and risks that are not closely related to the “host contract” (i.e. main contract). Although such splitting will result in a more accurate financial position and operating results, it may also create fluctuations in earnings.
Hedging/Income Volatility Hedge accounting under IAS 39 is complex and the resulting restrictions on its use will increase volatility in reported earnings.
Achieving hedge accounting may become more difficult or costly, because IAS 39 currently only permits micro-hedging — designating one hedge item to one hedging instrument — rather than net balance sheet hedging. Financial institutions will need to consider the cost/benefit equation in developing systems to achieve such hedge accounting. This will be an extensive exercise and potentially involve a complete overhaul of existing group balance sheet management and macro-hedging approaches.
However, for companies that are unable to undertake micro-hedging, “IAS 39 Implementation Guidance Questions and Answers” illustrates a method whereby entities designate as the hedged item a single asset or liability with the same characteristics as the whole portfolio. Alternatively, a proposed amendment deals with fair value hedge accounting for a portfolio hedge of interest rate risk.
To demonstrate that hedging is actually being achieved, IAS 39 requires key information about hedging relationships to be formally documented prior to the application of the hedge accounting treatment. This will be a burdensome exercise for financial institutions holding significant numbers of hedging instruments with respect, for example, to loan portfolios. Failure to establish documentation will mean hedge accounting cannot be adopted regardless of how effective the hedge actually is in offsetting risk.
IAS 39 also requires rigorous hedge effectiveness testing to be conducted. Financial institutions will need to prove numerically, on both a prospective and retrospective basis, that their hedging instruments are indeed effective in mitigating the risks being hedged.
The Road Ahead To prepare for the inevitable, financial institutions must start addressing implementation issues now. Businesses need to consider the likely impact on their profitability and operations. They must identify any potentially damaging earnings’ surprises, product weaknesses and difficulties in meeting the new fair value and hedging requirements.
By assessing systems, personnel and other resource requirements necessary for implementation now, institutions will only be helping themselves in the future.
Boonlert Kamolchanokkul is a director of Assurance at PricewaterhouseCoopers Thailand. He can be reached at boonlert.kamolchanokkul@th.pwc.com
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(c) 2003, Bangkok Post, Thailand. Distributed by Knight Ridder/Tribune Business News.
