The Nature and Impact of Taiwan's New Accounting Standards for Financial Derivatives
Taiwan’s new Statement of Financial Accounting Standards (SFAS) no. 34 - "Accounting for Financial Instruments" - was issued on Christmas day, 2003. The impact of SFAS 34 on domestic enterprises may well be described as unprecedented because, with a few exceptions, any corporation that holds or issues financial products will fall under the new rules.
More importantly, SFAS 34 makes numerous changes in the current accounting treatment of financial instruments. For example, the lower of cost or market (LCM) valuation method and fair value hedge accounting will no longer apply. For financial insurers whose business is centered around manipulating financial instruments, the impact will be especially pronounced.
Financial accounting standards issued in the past several years have tended to move Taiwan towards alignment with International Accounting Standards (IAS), and SFAS 34 - modeled after IAS 39 - is no exception. There are several places, however, that have yet to be revised or supplemented. For instance, no explanatory examples have been incorporated in Statement 34. Because the contents of the statement are intricate and complicated, it is difficult tell what the main points of many rules are from looking at the text alone, thus undermining their practical application. To remedy this deficiency, the statement needs to be supplemented with explanatory examples.
Other than certain "exceptions" in SFAS 33 and a few inapplicable cases, SFAS 34 is to contain all available accounting treatment for integrated financial products. And given the large-scale changes in current practices being made to align with international standards, many other of Taiwan’s standards will require complimentary revisions. Take "short-term investment" accounting entries and the related LCM method: After SFAS 34 takes effect, these will all belong to the history books. It is estimated that many standards above SFAS number 10 - about one-third of the total - will have to be amended under the impact of SFAS 34, and this does not include official letters of interpretation associated with those standards. The coming amendment (or repeal) project looks vast indeed.
Although there still two years to prepare before SFAS 34 takes effect, the number of rules to be added or changed is so large, and the repercussions for financial statement amounts are potentially so great, enterprises should lose no time in devising strategies for responding to SFAS 34 and applying it to their own circumstances. In the following, I provide a list of matters for organizations to consider as they make their preparations.
| 1. | The application of SFAS 34 will change current practices. Consequently, attention must be given to the following related changes in accounting treatment: (1) Entries under “cumulative effect of changes in accounting principles” will include non-hedging derivatives and financial assets measured by the fair value method. The concern is that incorporating perhaps many years of cumulative effects in the first year that SFAS 34 is applied to balance sheets will have a heavy impact on that year’s profit/loss numbers; (2) Entries under “owners’ equity – equity adjustments” will include, for example, amortized cost measurements and deferred gains/losses on cash flow hedging; (3) If differences result when hedging positions are revalued, this will not necessitate making retroactive adjustments. |
| 2. | Major changes have been made in the way financial assets are classified and their subsequent valuation methods. In terms of classification, SFAS 34 has precise rules for the definitions and special characteristics of different financial assets, so when a transaction takes place, enterprises must give careful consideration to the transaction’s purpose, intention and capability before they can make a correct classification. |
| 3. | A growing number of embedded derivatives have been issued in Taiwan in recent years, including convertible bonds, convertible bond asset swaps, equity-linked notes and principle guaranteed notes. SFAS 34 sets conditions for whether or not embedded derivatives should be handled separately from main contracts. Where the conditions are met and they must be separated, the complexity of the accounting treatment will increase, and preparations should thus be made in advance. |
| 4. | As described above, SFAS 34 has relatively explicit conditions on the applicability of hedge accounting, and places many limits on its use. As a result, if an organization plans to use hedge accounting treatment, using gains/losses on hedging transactions to offset its financial results, it must thoroughly understand all such conditions and limits. These concern, for instance, hedging documentation, measurements of the effectiveness of hedges, and continuous valuation. |
| 5. | The first year that corporations apply SFAS 34, whether it is the above-mentioned inordinate impact of the new treatment on current-period profits/losses, or changes in how financial assets are classified, they all have the potential to produce major movements in the values appearing in that year’s financial statements, which will, in turn, affect various financial ratios. For this reason, enterprises must act first, carefully weighing the changes in the different financial ratios to see if there are undesirable shocks in store for the firm’s finances and operations. Then it can work out solutions for reducing or avoiding those potential negative influences. |
| 6. | Going beyond SFAS 27, SFAS 34 adds many new disclosure requirements for financial products. This applies to fair value-related information and other information about financial products and hedging instruments. The burden on those principally engaged in financial instrument transactions will be great. Therefore, enterprises must act soon to devise and establish, or revamp, their disclosure requirement information systems, with an aim towards raising the information transparency of their financial statements. |
To conclude: Taiwan has long lacked an exhaustive set of accounting treatment standards for financial instruments, at least one that those involved in financial instrument transactions could use. The absence of clear-cut rules has been a frequent source of frustration to people in the industry doing the actual accounting work. The issuing of SFAS 34 can be said to have won widespread support, but nowhere was it more enthusiastically received than in the financial industry itself, where almost everyone looks forward to its early implementation. SFAS 34 is intricate and complicated, however, so even given two years’ preparation time, practitioners must still respond with caution and start laying the groundwork without delay.
James Huang is a partner at PricewaterhouseCoopers: Direct your email to: James.Huang@tw.pwc.com