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SAS 33 - Implications and Implementation BY Tommy Seah CFE, Texas, USA
What Do Banks Have to Consider? The Council of The Institute of Certified Public Accountants of Singapore has issued SAS 33 (2001): Financial Instruments: Recognition and Measurement as part of a core set of accounting standards that is effective for financial statements covering periods beginning on or after 1 July 2001.
The need for a new standard on financial instruments was mainly due to the current wide range of alternative measurements which led to incomparability and a number of unrecognised financial assets and liabilities, particularly derivatives.
The objective of the new standard is to establish principles for recognising, measuring, and disclosing additional information about financial instruments for companies which establish the financial statements in accordance with International Accounting Standards.
This Standard significantly increases the use of fair value accounting for financial instruments, consistent with the long-term objective of the IASC of full fair value accounting for all financial assets and liabilities.
A new category of asset and liability Under the SAS 33 and the International Accounting Standard 39 (IAS 39), all financial assets and financial liabilities have to be recognised on the balance sheet, including all derivatives. Furthermore, the standard requires that the embedded derivative of a hybrid instrument be separated from the host contract, provided certain criteria are met. If it has to be separated, such as a call or put option on debt that is issued at a significant discount, the embedded derivative will have to be fair valued and accounted for individually.
This new accounting standard establishes uniform hedge accounting criteria for all derivatives. Hedge accounting recognises symmetrically the offsetting effects on net income of changes in fair value of the hedging instrument and the hedged item in order to reduce volatility in the income statement. Both SAS 33 and IAS 39 require that an enterprise must formally designate a hedging instrument to a related item or to a group of similar items being hedged, and to assess and document the effectiveness of transactions that receive hedge accounting.
By increasing the use of fair values in accounting for financial instruments and implementing provisions for certain embedded derivatives, as well as consistent accounting standards for the use of hedge accounting, SAS 33 will affect banks and companies in Singapore. Compliance will have major, widespread impacts on users of financial instruments.
Major potential impacts of SAS 33 include volatility in the income statement and in equity, require significant changes in financial risk management strategies and to business processes and systems, as well as modified and additional information to stakeholders. Therefore, banks and companies preparing their financial statements under SAS 33 will have to consider the impact on the functional areas involved in managing, processing, controlling and accounting for financial instruments.
Volatility in Equity and the Profit and Loss Statement According to SAS 33, at inception all financial instruments are measured at their cost value. The subsequent re-measurement depends on the initial classification of the financial instrument. Financial assets and liabilities held for trading - including all derivatives - are re-measured to fair value with unrealised gain or losses to be included in the income statement.
Financial assets classified as 'available-for-sale' are also re-measured to fair value, but the bank or company has the option to include unrealised gains or losses in equity. Other categories of financial assets are those classified as 'Assets held-to-maturity' which are re-measure at cost (without fixed maturity) or amortised cost (with fixed maturity). Financial liabilities - except those held for trading and derivatives - are re-measured at amortised cost.
Hedge accounting may be adopted in order to decrease the volatility of the income statement. The SAS 33 standard distinguishes between fair value hedges, cash flow hedges and the hedges of a net investment in a foreign entity.
Whereas the fair value hedge is utilised to hedge the variability of changes in fair value of a recognised asset or liability, a cash flow hedge is used to hedge the exposure to the variability in cash flows associated with a net investment in foreign entity is applied to hedge the company's share in the net assets of that entity is applied to hedge the company's share in the net assets of that entity which is not a subsidiary, an associate, or a joint venture.
Significant Changes in Financial Risk Management Strategies To properly anticipate and manage volatility in equity and the income statement, banks and companies will need to look at current hedging strategies and accounting policies. Financial risk management objectives and strategies have to be re-assessed in order to achieve overall objectives.
Procedures to designate hedging instruments to hedged items and to measure the hedge effectiveness have to be put in place. Since all derivatives have to be fair valued, sources of fair value information have to be identified. Documentation of hedge relations, the measurement of the hedge effectiveness and the valuations of financial instruments have to be ensured.
Changes to Business Processes and a Need for Systems Solutions Upgrade By applying hedge accounting, SAS 33 prescribes a forward-looking approach to measure expected hedge effectiveness at inception and a backward-looking approach to measure realised hedge effectiveness throughout the life of the hedge. The method an enterprise adopts for assessing hedge effectiveness will depend on its risk management strategy and can vary between different types of hedges, and therefore, has to be carefully selected.
Beyond keeping tabs on fair values, companies will have to track premiums and discounts on items hedged in fair value hedges and amounts deferred in equity for cash flow hedges. Information to meet disclosures requirements has to be complied and automated journal entries have to be evaluated to determine the magnitude of potential system adoptions and enhancements.
Information to Stakeholders The new standard requires additional disclosures in the financial statements relating to accounting policies, hedging and financial instruments. The methods and assumptions in estimating fair values, information on the risk management objectives and policies, a description of designated hedges and significant items of gains and losses on financial instruments are only a few of the additional disclosure requirements as set out by SAS 33.
For accounting purposes the chart of accounts and internal reporting packages have to be revised, standard accounting journal entries have to be determined and accounting transition adjustment entries have to carefully assessed. Management reports should enclose the likely impact on the income statement and equity of the mark-to-fair-value, since this can be of considerable interest. Not least, it is advisable that a clear communication strategy to rating agencies, investors, analysts and other external parties is developed.
Conclusion With the increased use of fair value accounting for financial instruments, the treatment of embedded derivatives and the hedge accounting principles the IASC and ICPAS created a challenging new accounting principle. Since SAS 33 effects not only accounting, but also other functional areas, the implementation should be planned thoroughly.
A successful implementation requires a multi-disciplinary effort which demands treasury, operations, risk management and accounting expertise. SAS 33 was to be effective for financial statements for financial years beginning on or after July 1, 2001. This has now being deferred to 2004. With this date fast approaching, banks and companies are encouraged to begin assessing the effects of SAS 33 already now.
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