European Union: Implications of the European Commission’s Partial Endorsement of IAS 39

European Union issuers that are subject to the IAS Regulation will have to produce consolidated financial information from 2005 in accordance with International Financial Reporting Standards endorsed for this purpose by the European Commission. This Note considers the implications of the recent decision to endorse IAS 39 only in part.

IAS 39 is a Standard issued by the predecessor of the International Accounting Standards Board ("IASB"). It is concerned with the treatment of "financial instruments" in accounts.

The Standard was originally published as long ago as 1998 (which explains why it is an International Accounting Standard, or IAS, rather than an International Financial Reporting Standard or IFRS, which is the more up to date terminology).

A revised version of IAS 39 was published in December 2003, and a further amendment on "Recognition and Measurement of Fair Value Hedge Accounting for a Portfolio Hedge of Interest Rate Risks" was issued at the end of March 2004. The revised Standard, including the amendment, takes effect from I Jan 2005.

In April 2004, the IASB issued an Exposure Draft of proposed amendments to IAS 39, relating to the use of the "fair value option" (discussed below) which would have the effect of limiting the use of that option by:

• limiting the types of financial assets and liabilities to which the option may be applied, and
• requiring that the option may be applied only to financial assets and liabilities whose fair value is verifiable.

The proposed amendments would go some way to meeting objections to IAS 39 raised within the European Union as discussed below, and would align IFRS more closely with US GAAP, under which FAS 133 does not include a fair value option.

In 2000, the Council of Ministers of the European Union decided to require all publicly traded EU companies to prepare their consolidated financial statements in accordance with one set of international accounting standards (i.e. IAS/IFRS) from 2005. This decision is reflected in Regulation (EC) No 1606/2002 on the application of international accounting standards (the "IAS Regulation"). Importantly, the IAS Regulation provides that international accounting standards shall only be adopted for the purposes of that Regulation if endorsed by the European Commission acting through the EU Accounting Regulatory Committee ("ARC"). The Commission has endorsed all of IAS/IFRS except for IAS 32 (disclosure requirements for financial instruments) and IAS 39.

On 1 October 2004, the ARC voted by a qualified majority to approve IAS 39 minus the fair value option as it applies to financial liabilities, and without requiring the application of certain provisions relating to hedge accounting (relevant in particular to hedge accounting of core deposits of banks). A Commission Regulation giving effect to this decision will be issued in the next few weeks. The Commission hopes that, following on from the Exposure Draft mentioned above, the IASB will revise the fair value option provisions of the Standard by the end of 2004, but it does not appear that any such revisions will take effect from as soon as I January 2005.

In other words, IAS 39 has been endorsed only partially for use in the consolidated accounts of EU incorporated and listed companies. The same partially endorsed version of IAS 39 will apply (unless and until IAS 39 is amended in a manner acceptable to the Commission, and fully endorsed):

• where an EU member state requires or permits companies to produce their individual accounts under IAS/IFRS (as will be permitted in the UK): and
• where an issuer has to produce financial information in accordance with IAS/IFRS under the Prospectus Directive and the Transparency Directive i.e. in order to have securities admitted to trading on an EU regulated market.

To summarise the version of IAS 39 that takes effect from 1 January 2005:

The meaning of financial instruments for the purposes of IAS 39 is extremely wide, covering contracts giving rise to both:

• a "financial asset" (which includes the right to receive cash or a financial asset, rights to exchange instruments on favourable terms and equity instruments) and
• a "financial liability" or an equity instrument. A financial liability includes an obligation to deliver cash or a financial asset, or an obligation to exchange instruments on unfavourable terms. Preference shares will be classified as "financial liabilities" rather than as equity instruments.

A contract for the sale or purchase of a non-financial asset is included if it gives either party the right to settle in cash or another financial instrument, or is readily convertible to cash.

In the case of embedded derivatives, IAS 39 generally requires the derivative element to be separated from the "host contract". Similarly, compound financial instruments such as convertibles have to be split into a separate debt component and an equity instrument component (or if the issuer has a cash settlement option on conversion and/or in the case of exchangeables, an option component which, like the debt component, is classified as a financial liability).

Certain instruments are specifically covered by other Standards and therefore outside IAS 39, including loan commitments (IAS 37) and insurance contracts (IFRS 4).

Financial assets and liabilities should be recognised initially, upon acquisition, at "fair value", i.e. market prices. Broadly, they must continue to be measured at current fair value unless they can be categorised as "held to maturity", in which case they need not be marked to market but are amortised over their life. There are strict requirements for instruments to fall within the "held to maturity" category and derivatives, for example, would not be eligible to do so.

Apart from instruments "held to maturity", the other two classifications are "available for sale" and "held for trading" In summary, unrealised fair value gains and losses on instruments that are "available for sale" but still retained in the business are not booked to the profit and loss account, but only through the equity account. Where an asset is "held for trading", which applies to nearly all derivatives contracts, any unrealised gain or loss at fair value will flow through the profit and loss account. This can lead to considerable volatility in P&L.

There is a particular risk of increased volatility in P&L if gains and losses on some items (e.g. derivatives) go to P&L, but gains and losses on other items hedged by those derivatives do not, because treated differently under IAS 39.

There are basically two ways of addressing this concern:

If certain criteria are met, gains or losses on hedging instruments that would otherwise be booked to P&L go to the equity account (instead of to P&L) and then are transferred to P&L at the same time as the hedged item is recognised in the P&L.

However, there are significant restrictions on the ability to apply hedge accounting. For example, a non-derivative financial asset or liability cannot be regarded as a hedge for another item, except as hedging foreign currency risk. Also intra-group transactions are not eligible for hedge accounting treatment in the consolidated accounts (only hedges with a third party outside the group are eligible).

Most significantly, hedging of risks on a portfolio basis, rather than an item-by-item basis, is not recognised (apart from macro hedging of interest rate risks, as set out in the April 2004 amendment to IAS 39).

A subject of huge controversy, which has led to the European Commission not fully endorsing IAS 39 in respect of hedge accounting, is that since banks manage risks in respect of core deposits on a portfolio basis, they cannot achieve hedge accounting treatment for those core deposits and for the instruments used for risk management purposes.

In view of the constraints on cash flow hedge accounting, another approach to minimising P&L volatility is for all mark to market gains and losses on all financial instruments to go through the P&L even if they would not otherwise be treated in this way under IAS 39. Thus, where hedging is effective, the gains and losses on the hedging instrument and on the hedged item would both be recognised at the same time.

Some regulators, including the European Central Bank, have argued that the fair value option might be misused by applying it to financial instruments whose value is not verifiable, and that it might result in profits and losses being recognised as a result of changes in the entity’s own creditworthiness. This has led to the Exposure Draft that proposes changes to the scope of the fair value option, and to the European Commission endorsing IAS 39 without allowing the use of the fair value option in respect of financial liabilities in the meantime.

As noted above, EU companies with securities admitted to trading on a regulated market in the EU will have to produce their consolidated financial reports for 2005 under IAS/IFRS as endorsed by the Commission. In many cases, such companies are intending to use IAS/IFRS for their individual accounts (and in the individual accounts of their various EU subsidiaries). What does the Commission’s decision on partial endorsement of IAS 39 mean for them?

Hedge accounting – while the hedge accounting requirements in IAS 39 have been somewhat relaxed by the European Commission, the ARC has stated that member states do have the option to require companies subject to the IAS Regulation to comply in full with the hedge accounting rules. This is the approach that the Accounting Standards Board ("ASB") in the United Kingdom wants to adopt, although its power to do so is somewhat uncertain.

Fair value option – EU companies that were intending to use the fair value option more widely than now permitted under the partially endorsed IAS 39 may face considerable difficulties. The problems are particularly acute for those European companies that have chosen to adopt IAS 32 and 39 early. The ASB is expected to publish guidance for UK companies on this aspect shortly.

Other implications of partial endorsement – there is considerable uncertainty as to whether a company that produces accounts under the partially-endorsed version of IAS/IFRS is eligible for treatment as a "first time adopter" for the purposes of the reliefs in IFRS 1 (and IAS 1 and IAS 8). This status is intended only to apply to someone who adopts IFRS in full, although the draft Commission Regulation purports to modify IFRS 1 as well so that it is construed as referring to IAS/IFRS as endorsed by the Commission.

Also, the SEC has proposed that non-U.S. issuers can get an exemption from having to show two years comparative financial data as long as they have implemented full IAS/IFRS. It seems that issuers who follow the IAS Regulation version of IAS/IFRS will not be eligible for the exemption, unless the current proposal is amended.

Linklaters is monitoring the developments closely as they may impact on EU corporates and banks, and on non-EU entities that have securities listed in the EU.

This article is intended merely to highlight issues and not to be comprehensive, nor to provide legal advice. Should you have any questions on issues reported here or on other areas of law, please contact one of your regular contacts at Linklaters.