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What is IAS 39?

What is IAS 39?

This report describes the nature of IAS 39, written for banking operations managers and IT strategy folk. The reader does not have to be a qualified banker nor an accountant but it does assume some familiarity with some basic accounting principles, the nature of some banking concepts such as derivatives, and the basis of a bank’s balance sheet. Any professional accountants are asked to be charitable to the huge simplifications that are made in order to get the thrust of a complex set of ideas across to a non specialist audience. It is divided into the following sections

  • Introduction to Accounting in Banks
  • The Accounting Profession’s objectives for IAS 39
  • Key features of the new approach

Introduction to Accounting in Banks

Accountants deal with two important ideas

  • Recognizing the existence of an asset or liability
  • Valuing the asset or liability

In traditional banking, loans are recognized as assets and deposits are recognized as liabilities and both are typically valued according to the “historic cost” approach. Thus if the bank issues a 20 year loan for £100M at 10% fixed rate, it is an asset valued at £100M.

The value of this loan hardly ever changes unless all or some of the loan has to be written off because the borrower is (or will be) unable to repay. This write off is taken into the profit and loss account.

Also traditional banks buy and sell bonds and commercial paper, which are effectively loans that have been broken into small units and are bought and sold. These instruments are valued by their sale/purchase price and are generally different to the historic cost of the original loan because the buyers and sellers will use discounted cash flow and risk assessment techniques to put a value on them. Hence in the example above, if the lending bank securitises the £100M loan into 1M £100 bonds the sale price of each bond is very unlikely to be £100, rather it could be close to £0 per bond if it is felt that the original borrower is about to go bust. On the other hand the sale price might be £105 per bond if the 10% interest rate is higher than prevailing interest rates and the risk of default by the original borrower is low. The differences in sale and purchase prices of traded assets and liabilities are taken into the profit and loss account.

Thus we see that banking groups have generally used the same “historic cost” accounting technique to value assets and liabilities, whether in the banking book or in the trading book.

  • The historic value of the original sum of the loan or deposit for loans and deposits kept “in house”
  • The historic value of sale and purchase for traded loans and deposits

Banks have been innovating and now have entered into many many contracts involving derivatives such as Futures, Swaps, Options and so on. These new products or financial instruments are the object of the new International Accounting Standard IAS 39 as they present a number of challenges to current accounting practices. It might be felt that this is only relevant to investment banks and trading companies but these derivatives turn up in all sorts of places in a typical bank group; for example

  • Fixed and capped rate elements of mortgages can be thought of as having a derivative embedded in the variable rate loan.
  • Deposit accounts offering the higher of a fixed interest rate or stock market growth.
  • Internal hedges for the fixed rate personal loan book.
  • Securitised pooled assets such as mortgages and credit card debt.

The Accounting Profession’s Objectives for IAS 39

The principle problem that accountants want to address is that currently many financial instruments do not appear on the balance sheet at all. They believe that they should appear and that their absence can severely distort the true financial position of a company (the presence of large numbers of high value contracts of this nature was a major contributor to the bankruptcy of Barings Bank and of Enron).

The International Accounting Standards Board (IASB), whose web site is www.ifrs.org, has been working for many years to try and achieve international agreement on how to value these instruments under the heading of IAS 39. This has resulted in various draft standards being circulated and then amendments and clarifications being added. There is still quite a lot of hostility towards some aspects of this standard from a number of bank groups across the world, including the UK, but in principle the standard is on course to become effective from 2005.

Key Features of IAS 39

The standard and related documentation (e.g. responses from the banks) can be found at the IASB web site.

The challenges associated with incorporating complex financial instruments are substantive. Firstly from a theoretical perspective;

1. Recognition

Should an instrument be an asset or a liability? This is not always straightforward. For example a contract to buy something in the future at a fixed price could mean the bank ends up being owed money or owing money depending on how the market price changes over time.

2. Valuation

Many instruments have a contract price that is far smaller than their financial impact (e.g. an option price can be very much smaller than the gain or loss on the instrument at the time the option is exercised).

IAS 39, by the authors’ own admission, is the most complex accounting standard ever introduced. The gist of the standard is

  1. All financial instruments should appear on the balance sheet
  2. Many, if not most, should be valued by reference to their current market price; i.e. not historic cost accounting

One key feature of this change is that the Bank’s balance sheet is likely to become more volatile, fluctuating much more with market prices, in a way it did not with historic cost accounting.

  • Unnecessary confusion, not in the interests of long term investors like share holders – say the banks
  • Just reflecting reality, absolutely in the interests of shareholders to know the volatility of balance sheets – say the accountants

From a Business Operations and IT strategy point of view the key changes are likely to be

  • New Financial Reporting processes and systems
  • Significant Changes to the Financial Reporting Systems requiring much more detailed information than previously. Much more overlap between the financial reporting systems and the risk management systems, particularly the market risk management systems.

More on these changes can be found in MI Systems Architecture Implications of Basel II and IAS 39.

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