Hedge accounting can be applied to three types of hedging models; namely, fair value hedge (fixed rate debt converted to floating rate with an interest rate swap), cash flow hedge (floating rate loan converted to fixed rate with an interest rate swap) and hedge of a net investment in a foreign operation (entity having foreign operations can hedge the currency risk associated with the translation of the net assets of these foreign operations into the group’s presentation currency).

IAS 39 is so crucial to accountants. Yet, the standard itself has left out accounting for financial liabilities. Why? We have seen companies hedge even liabilities (or, ensuing interest costs). Why is the standard so averse to debt?

Of all the pronouncements IAS 39 is the most talked about and controversial. It introduces the recognition and measurement of financial instruments and also covers hedge accounting. IAS 39 does not address accounting for equity instruments issued by the reporting enterprise but it certainly does deal with classification and accounting for financial liabilities (debt). IAS 32 Financial Instruments: Presentation deals with the critical issue of classification of an instrument as a liability or equity.

Concerns are raised about the complexities of the existing debt/equity model. In January 2008 the European Financial Reporting Advisory Group (EFRAG) published a discussion paper Distinguishing between Liabilities and Equity. Subsequently in February 2008 the IASB published a discussion paper Financial Instruments with Characteristics of Equity and has put the liabilities and equity project on its active agenda. The recent amendment to IAS 32 dealing with puttable instruments shows that the standard setters are not averse to debt.

There is a lot of interest about the ‘embedded derivatives.’ What are these and why are they so important?

Embedded derivatives are those instruments that are contractually attachable to what IAS 39 terms as host contract. A common example would be a convertible bond that has a host debt contract and an equity conversion option embedded within it. IAS 39 ensured that the requirement for mark-to-market of derivatives is not avoided by embedding a derivative into a financial instrument that is accounted for differently, either amortised at cost or re-valued through equity.

The principle in respect of embedded derivatives is that the fact that a derivative is not a legally separate individual contract instrument should not prevent it from being accounted for in the same way as other standalone derivatives under the standard. The result of this is that in many circumstances, embedded derivatives must be separated from their host contract and accounted for in the same way as standalone derivative instrument.

Embedded derivatives do not only appear in financial instruments, they are also common in other contracts that might be outside the scope of IAS 39. The fact that host contract is outside the scope of the standard does not prevent the embedded derivative from being assessed under the requirements of IAS 39.

We have seen in the recent Budget exercise, a term such as off-balance-sheet item crop up many times. Corporates too can resort to de-recognition, we are told. How is this done? More importantly, why is this done? Are there any deterrents to stop misuse?

De-recognition is the term used for the removal of asset or liability from the balance sheet. It is true that many corporates as well as banks resort to de-recognition. They take part in the schemes that provide financing by selling portfolios of trade receivables, loans, etc. One of the objectives of such scheme is to provide finance that is “off-balance-sheet”, that is, the assets sold are removed from the balance sheet and funding provided is not recognised on the balance sheet. Examples are debt factoring, securitisation structures, etc.

IAS 39 lays down very stringent and detailed rules in this area focused on whether control of the contractual rights that comprise an asset has been transferred from the seller to buyer. It takes substance over form approach in determining control. The standard also covers rules for de-recognition of financial liabilities, including treatment of restructured loans.

In the Indian GAAP, however, there is no guidance available which addresses the accounting for special purpose entities (SIC 12 Consolidation – Special Purpose Entities). The Indian AS 21 Consolidated Financial Statements while defining control lays a lot of emphasis on ‘majority stake’ or ‘majority representation at the board’ which is different from ‘control’ as defined in IAS 27 Consolidated and Separate Financial Statements.

Many de-recognition structures use special purpose entities (SPEs), for example, trusts, etc., that have been set up only for acquisition of transferred assets. The companies in India, in the absence of IAS 27 and SIC 12 are not bound to follow the consolidation principles of SPE.

You have mentioned in your book that during the early 1990s, accounting standards were not in sync with practices in the derivatives’ space. How has the situation changed today? Are they in sync today?

The book speaks of the long journey of the standard-setters to develop the requirements of financial instruments. During the 1990s the accounting standards did not keep pace with the market derivative activities. When the IASC Board, the predecessor of International Accounting Standards Board (IASB), voted to approve IAS 39 in December 1998, it noted that — at about the same time — the US had adopted new standards on de-recognition, derivatives, and hedging, and that other countries did not have comprehensive standards on accounting for financial instruments. Consequently, the IASC Board recognised that there was little experience in applying principles similar to those in IAS 39 in most countries.

The situation has indeed changed from the 1990s when derivatives were not recognised on the balance sheet, and the disclosure about the extent of derivatives use and risk management policies were minimal or none.

Prior to the issuance of Financial Instruments Standards, there was no comprehensive guidance addressing derivatives. IAS 39 introduced new requirements of marking derivatives to market, de-recognition of financial instruments and hedge accounting. IFRS 7 and IAS 32 introduced the disclosure and presentation requirements. The adoption of IAS 39 is a monumental shift with a lot of financial instruments being treated as on balance sheet which were not there before. Financial Instruments Standards have survived the test of time.

Should authorities behind standards set them in such a way that it is often misinterpreted? What functions do implicit standards serve?

At this point I quite disagree that the standard-setters set standards in a way that is often misinterpreted. The standards may be complex but they are not loosely written. Recently, the large firms published a White Paper Principle Based Accounting Standards discussed at the Global Public Policy Symposium in New York. It was acknowledged in the paper that neither a purely rules-based nor a purely principles-based system ever existed, or will ever exist. Each accounting standard will exist somewhere along the spectrum between rules and principles. The goal must be to seek the sweet spot on that spectrum.

As someone who has had loads of experience working with standards day in and day out, what has been your experience with standards?

As a professional working on IFRS, which are perceived to be more principles-based standards than the US GAAP, my experience has been that there is a greater reliance on sound professional judgment where clarification cannot constantly be sought from the standard-setter.

IFRS places more emphasis on the exercise of judgment providing reasonable assurance that the financial statements are fairly stated keeping in mind the user’s interest. The problem is some preparers, auditors, users, etc., of financial statements want the comfort of a detailed rule book. For these, living with judgments will require something of a change in mindset.