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a) i) In recent years growth and complexity of financial instruments has been quite significant. Companies use a range of instruments to transform and manage their financial risk. However, accounting standards have not developed at the same rate as the growth in the instruments. The main concern for standard setters is that many derivatives may not be recognized in statement of financial position. The main reason for this is the use of the historical cost concept in financial statements together with the fact that many derivatives have a nil cost. However, derivatives may be substantial assets and liabilities and may expose the entity to significant risk. Additionally many companies measure financial assets at amortized cost even though there are reliable quoted market prices that differ from amortized cost and the assets are readily sale able.
Until IAS 39 Financial instruments: recognition and measurement unrealized gains and losses arising from changes in the value of many financial instruments were often ignored. Unrealized losses were recognized if the instrument was valued on the basis of lower of cost or market value but ignored if the instrument was classed as a hedge. The danger is that such unrealized losses may be overlooked. Additionally companies could choose when they recognized profits on instruments in order that they could smooth profits. This applied both to derivatives and non-derivatives.
The use of hedge accounting caused significant problems.
The practical problem with hedge accounting is translating business decisions into an accounting transaction that satisfies the hedging criteria. Hedge accounting relies on management intent and the result of this is that identical instruments can be accounted for differently depending upon the intentions of management in relation to them. Hedge accounting is often used for hedges of un constructed future transactions and in these circumstances can be used to justify deferring almost any gain or loss on the derivative.
Circumstances can change quickly in the financial markets and the resultant effect on a company’s derivatives can quickly transform the risk profile of a company. The accounting framework did not adequately make this movement in the position and risk apparent to users of financial statements.
ii) Disclosure of the risk of an entity in relation to financial instruments is an important element of accounting for financial instruments and the IASC developed IAS 32 to deal with this issue. However, disclosure requirements alone are not sufficient to deal with the problem. Recognition and measurement issues need to be dealt with. Many derivatives are kept out of the statement of financial position with unrealized gains and losses being ignored. Hedge accounting problems cannot be dealt with purely by requiring narrative disclosures of the hedging instrument or any amount of the deferred or unrecognized gain or loss. It is important that agreement is achieved over the possible measurement bases which can be used. The use of current values for financial instruments requires agreement as it is critical measurement issue. For example, could current values be used for derivatives but not for non-derivatives? There are issues of impairment of financial instruments and the recognition of such instruments which need to be dealt with in standard. Most issues in accounting are dealt with by standards focusing on measurement, recognition and disclosure issues. A financial instrument is no exception in this regard and it is such an important issue that disclosure alone could never effectively deal with the issues satisfactorily. The IASC issued IAS 39 Financial instruments: recognition and measurement to deal with these issues.
b) Under IAS 39, all financial assets and liabilities are recognized in the statement of financial position and this includes derivatives. They are originally measured at cost which is the fair value of whatever was paid or received to acquire the financial asset or liability. Subsequently, all financial assets are measured to fair value with exception of certain specified items.
Of the financial assets specified in the question, two items will be measured at fair value (sh.6000m and sh.3460m respectively) and one amortized cost. The equity securities and other financial assets held for trading and the derivative assets will be valued at fair value whereas the fixed maturity investments to be held to maturity are one of the categories of items to be carried at amortized cost.
Most financial liabilities are measured at original recorded amount less principal repayments and amortizations. Only derivatives and liabilities held for trading are re-measured to fair value. Thus the redeemable preference shares will remain at the carrying amount (sh.3400).
Both the derivatives and the non-derivatives assets held for trading are categorized as financial assets at fair value through profit or loss. This means that in both cases the gain arising during the period should be recognized in the income statement.
marto answered the question on February 14, 2019 at 06:20
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Date posted: February 13, 2019. Answers (1)
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Date posted: February 13, 2019. Answers (1)
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Date posted: February 13, 2019. Answers (1)