It was clear back in November 1995 when the Accounting Standards Board (ASB) published its Statement of Principles that, as the historical cost convention came under scrutiny, some fierce debating lay ahead. The more recent Derivatives and Other Financial Instruments has further added to the controversy, coming out in favour of current value accounting.
Since the ASB’s last attempt to give a lead on a number of fundamental issues, the need for standardisation has become more urgent. With financial instruments, including derivatives, increasing in both sophistication and use, and the impetus to harmonise international accounting standards becoming greater, it is imperative the UK is not left behind.
Although there are differing views among corporate treasurers on some aspects, agreement is apparent on at least two points: the present way in which financial instruments are accounted for is unsatisfactory; and, more importantly, the disclosure in financial statements is inadequate.
The Association of Corporate Treasurers (ACT) believes the most important aspect of disclosure is the discussion of treasury policies in the operating and financial review (OFR), where an insight should be provided into a company’s sensitivity to market changes and the potential impact on future profitability and risk exposure levels. How prescriptive that disclosure ought to be is a trickier issue; it is more important to say what the reporting is supposed to achieve than to give precise chapter and verse about what is to be disclosed. The ACT hopes to make clear what it regards as best practice in due course, and the ASB plans an exposure draft and a standard on disclosure by the end of 1997.
The most contentious issue for everyone is measurement. How should financial instruments be accounted for: at historical cost or market value? This gets to the heart of the debate and raises all kinds of spectres. Are the ASB’s proposals the thin end of the wedge and is the current cost accounting debate about to start again? How can balance sheets mix historical cost and market values with any credibility? What is achieved by reporting an unrealised profit or loss on long-term debt which a company has every intention of holding to maturity? Of course, there are problems with some of the ASB’s proposed changes but the same could be said of the status quo. The fact is that the present regime leaves key transactions or exposures unaccounted for and unreported. Better disclosure alone will not remedy all the deficiencies. Moreover, some elements of disclosure would make use of market values. Thus, the central question about the future use of current values cannot be fudged.
The ACT is primarily concerned to see better accounting for, and disclosure of, financial instruments, and is less interested in the wider debate about historical cost versus current value. But, as we have seen, the two issues are linked. The purists who argue for either a historic cost or a current value balance sheet have a point, provided their objection is not simply masking a rooted animosity towards current value in any shape or form. The ASB’s sensible stance is to make haste slowly. It is well known that balance sheets already contain a mix of different values at different dates.
The ACT is agreed that, if market values for financial instruments are to be used, they should be used universally or not at all. Otherwise, matching between, say, a derivative and the underlying instrument being hedged will not be achieved. Some are concerned that gains or losses, particularly those arising from the use of market values which may never be realised, may cause actions to be taken which are detrimental to the business. However, the OFR and the education of account users should reduce the problem.
There is an analogy to be drawn here with the use of secret reserves by banks, ended many years ago. To justify their use, one was asked to believe the investor and customer were sophisticated enough to understand the need for secrecy but not intelligent enough to grasp the fact that profits were bound to fluctuate, either because of the economic cycle or the periodic lending sprees of the banks’ managers. An attitude some feel was patronising to both investor and customer. The same might be said to be true if current values for financial instruments are not reported for fear they will not be understood. What has changed in the meantime is that the financial and other markets now enable companies to hedge their exposures and the results of those opportunities, whether taken advantage of or not, should be reported.
Where the gains and losses should be reported in the accounts is discussed at length by the ASB. The ACT believes, if current values are to be used, the statement of total recognised gains and losses (STRGL) should be used only as a “holding tank”, all gains and losses should eventually be reported in the mainstream profit and loss account. For example, gains and losses on hedges where the underlying gain or loss has not yet been reported and gains and losses likely to reverse would all be reported in the STRGL.
This avoids the danger of the STRGL becoming a halfway house between profit and loss and reserve accounting.
The ASB faced problems over hedge accounting. The most difficult issue being a sale or purchase in foreign currency where there is no contract as yet, but history or circumstance strongly suggests it will take place.
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The treasurer wants to hedge but does not want to have to book a gain or loss on the derivative at an accounting date before the transaction is completed. It only seems commercially sensible to allow any gains or losses to be carried in the STRGL until the transaction takes place or is shown to have no likelihood in doing so. But there must be some ground rules about when a firm is “commercially committed”.
The ASB’s proposals, particularly on measurement and accounting, will continue to exercise the minds of treasurers and accountants over the coming months. The broader context is the continuing debate on corporate governance of which financial reporting is only one part. It is easy to make the case for better accounting and disclosure for financial instruments but this has to be seen in the context of business risk as a whole and how this should be dealt with in annual reports – this will be the next challenge.
Jeremy Wagener is director-general of The Association of Corporate Treasurers.
The Association’s latest booklet, A Treasury Policy Blueprint can be obtained by contacting Claire Alexander on 0171 936-2354.