FRS 139: A minefield for the unprepared?

Considered to be a key milestone in the accounting world, it seeks to fully address the accounting issues of financial instruments, which more often than not remain a mystery to many, accounting professionals included.

In my view, this standard brings to the accounting framework new concepts that even qualified accountants may not be trained for, in particular fair value accounting. This is a concept that many from the old school find difficult, or perhaps unwilling to grasp.

The concepts surrounding the accounting for financial instruments can be mind boggling, be it for those who prepare or users of financial statements, and particularly for the financial services industry. FRS 139 has been, and still is, the subject of numerous debates the world over, in particular on the measurement of instruments at fair value, loan impairment and hedge accounting.

For Malaysia, the ball was set to roll on FRS 139 from Jan 1, 2006. But on Feb 23, the Malaysian Accounting Standards Board (MASB) announced that FRS 139 would only be effective for annual periods beginning on or after Oct 1, 2006. Good news, as companies now have more time to get prepared for FRS 139.

Given the deferment of the effective date, many companies have taken this opportunity to reassess the implications of FRS 139 on their financial statements. However, our observations show that many people continue to have misconceptions, and I would like to share with you some of the "myths" about FRS 139.

Myth 1 - It relates only to financial derivatives
Not true. The definition of financial instruments covers a wider scope than derivatives alone. Even trade debtors, investment in shares, and debt come within the ambit of FRS 139. Many companies in Malaysia will be affected, although the impact will vary depending on the complexity of their business activities.

Myth 2 - It does not affect our business
Few people realise that sale and purchase contracts may be "deemed" to be harbouring embedded derivatives, which under FRS 139, may now be required to be separately identified and valued. What this means is that there may be serious implications when one designs the clauses in sales contracts to cater to specific customer needs.

Entity B, a Malaysian entity, sells gloves to customers in Europe. B agrees on a supply contract with an Italian customer to sell one million pairs of gloves. The Malaysian entity prefers to have an exposure to the yen rather than the ringgit so the payment is specified in yen. In this case, the contract is not denominated in the currency of the primary economic environment in which either party operates, nor is it in the currency in which the price of the related goods or services that are acquired or delivered is routinely denominated in international commerce, such as crude oil.

B's management should therefore treat the contract as a contract to sell gloves in ringgit and a forward currency contract to sell ringgit for yen. A derivative, that is, the forward currency contract, is embedded in the sales contract.

Myth 3 - Only the 'bean counters' should be worried about it
Rest assured that dealers in the treasury front office and financial engineers will fall off their chairs today if they were told that the "hedges" they had entered into previously will create volatility to the company's income statement, or that the securitisation structure will no longer meet the requirements of the new standards.

Then, there are the tainting rules that require a more careful trading strategy - this affects front office treasury. FRS 139 documentation requirements may run into many pages for each hedge - this affects the risk management unit, and will demand extensive documentation management systems, which in turn affects the information technology division. To cope with the sheer volume, derivative fair values may potentially need to be updated daily to prove hedge effectiveness on an ongoing basis. Income volatility resulting from fair valuation of derivatives will attract enquiries from analysts - investor relations personnel need to be aware of and respond to this.

The message is very clear - successful implementation of FRS 139 will require the combined efforts from within the whole organisation and not just the finance function.

Myth 4 - It is relevant only to the financial services industry
Impairment rules will not only affect loans on the banks' balance sheets, but also the likes of trade debtors and inter-company loans in corporates. As users of financial instruments offered by banks, corporates will need to prove the effectiveness of hedge accounting or obtain fair valuation. And this is more than likely to create challenges for many finance functions in a corporate environment due to the lack of appropriate infrastructure.

Key challenges in implementation

The challenges of FRS 139 implementation cannot be over-emphasised. Some areas of implementation are clearly a major undertaking, placing huge demands on availability of data, documentation and disclosure. However, I believe that the real challenge to FRS 139 implementation is this: It is not merely a technical accounting exercise, but rather to embed the change and ensure that everyone in the organisation learns a new language, a new way of working.

The whole basis of reporting to the market is now different. For many companies, this implies fundamental changes that can ripple right across many business operations, from investor relations to everyday processes, changes that can affect the viability of some products and even the reported profitability of the business itself.

Coming below are some of the "non-technical" challenges companies will face in their quest for a successful implementation.

Educating the non-finance personnel
Imagine having to identify all the financial derivatives that may be hidden among the numerous contracts a business enters into. There is a need now to educate non-finance personnel to help identify such embedded derivatives. And herein lies the challenge - to train non-finance personnel to understand the concept of FRS 139 and help identify those derivatives.

Identifying all embedded derivatives is an extremely onerous process in itself, even before trying to value them. In this respect, a successful communication and education strategy for the non-finance personnel will ensure a smoother process.

Reassessment of treasury strategies
The hedge requirements of FRS 139 are onerous. For example, the underlying premise of hedging under FRS 139 is that cash flows on the hedging instrument and the hedged item should be matched exactly in timing, quantum and currency, if a hedge relationship is to be effective from an accounting perspective. In addition, the introduction of measurement rules for derivative instruments has compelled companies to re-evaluate their treasury and risk- management strategies.

Managing market expectations
Fair valuation - a key concept of FRS 139 - has been designed to address the inadequacy of the existing accounting framework to accurately reflect the economics of many sophisticated financial instruments we see in the marketplace. The merit of fair value accounting is that it forces companies to come clean, as such transparency means that companies are less able to undertake unprofitable businesses and hide losses. However, such transparency also implies a potential increase in income volatility. The new level of transparency and income volatility is likely to bring a new dimension to the job of an investor relations manager such as addressing questions from analysts/fund managers that one would not have expected in pre-FRS 139 days.

Companies need to manage market expectations on an ongoing basis, and those responsible for financial reporting should anticipate being put under scrutiny. Companies must have sustainable FRS reporting embedded in their organisations, with the finance function taking leadership in both internal and external reporting.

To sum up, I would like to drive home two main points:

1. Implementation difficulty depends on complexity of business
Based on our experience, FRS 139 is a standard that can be a minefield for the unprepared. It is not only a complex standard but also a standard many people have misconceptions about. Then again, there has to be a balanced view. The extent of difficulty behind FRS 139 is dependent on the complexity of the business of an organisation. After all, at the end of the day, financial reporting standards are meant to reflect the organisation's business strategies.

2. If FRS 139 is so complex, is it worth it?
Time and time again, I am asked whether it is worthwhile to go through the "pain" of FRS 139. I, for one, believe that the merits of FRS 139 outweigh the cost of compliance. In fact, some companies are even keen to take on FRS 139 early. The fact that a company needs to reflect the economic effects of its financial instrument transactions will "force" those responsible to be fully aware of the economic/financial risks that the company is about to undertake. This will help them to make an informed decision as they approve financial instrument transactions, moving forward.

All eyes will be on our financial services industry and large corporates to rise to the challenges of FRS 139. The first set of FRS 139 financial statements is due to hit the market on Feb 28, 2008, being the first-quarter results for public listed companies with a Sept 30, 2007 year-end. This means that there is less than a year for preparation. But, if early adoption is effected, FRS 139 financial statements could well surface as early as May 2006. So, be prepared!

This article was first published in The Edge, 3 April 2006