10 July 2001

Mr Keith Alfredson
Chairman
Australian Accounting Standards Board
530 Collins Street (Level 3)
MELBOURNE VIC 3000

Dear Keith

Invitation to Comment
Accounting for Financial Instruments and Similar Items

The Group of 100 (G100) is pleased to provide comments on the Invitation to Comment which has been prepared by the Financial Instruments Joint Working Group of Standards Setters (JWG). You will be aware that the G100 is a strong supporter of the process of international harmonization particularly where the process can be used to achieve convergence of work programs, priorities and responses to issues.

The G100 strongly opposes the recommendations of the JWG particularly as they relate to:

• the recognition and measurement of financial instruments at fair values;
• the recognition of changes in fair values in the statement of profit and loss; and
• the implications of the proposals for hedge accounting and the risk management practices of companies.

We believe that the potential impact of the recommendations is that, if adopted, there would be a real possibility that companies may seek to manage the accounting exposures arising from adoption of the JWG approach and not the underlying economic exposures of their businesses. This, in turn, would be inimical to the creation of shareholder value.

The G100 believes that while some of the JWG proposals have conceptual appeal they should not be proceeded with in Australia at this stage because:

• they are, in general, not capable of being implemented in a manner that will result in reliable and comparable financial information, particularly in respect of financial instruments for which quotations on an active and liquid market are not available; and
• it is highly unlikely that the IASB and other national major standard-setters that already have accounting standards dealing with the recognition and measurement of financial instruments would accelerate projects to implement the proposals. This is particularly so given the current experience of the IASB in respect of IAS 39 "Financial Instruments : Recognition and Measurement" and the FASB in SFAS 133 "Accounting for Derivative Instruments and Hedging Activities."

The G100 strongly supports efforts by the Board to develop comprehensive accounting standards relating to the recognition, measurement and disclosure of financial instruments but believes this should occur in the context of the harmonization and convergence policies of the Board. Accordingly, the G100 strongly believes that Australia should not proceed with proposals based on the JWG recommendations without the participation of other standard-setters. In the absence of Accounting Standards on recognition and measurement of financial instruments in Australia the G100 believes that, notwithstanding our concerns, identified below, the AASB should give priority to developing an Australian Standard based on harmonising with the requirements of IAS 39 which has recently been endorsed by the IASB rather than further developing the JWG proposals. The G100 concerns about IAS 39 include requirements in respect of accounting for hedge transactions including portfolio hedging, the approach adopted in the selection of discount rates and the need for further detailed implementation and interpretive guidance.

Our responses to the principal issues of the JWG are set out below. Rather than respond to each question separately this submission deals with the three major issues that we consider to be fundamental to the JWG recommendations. Because of the specialised nature of the activities of companies engaged in the banking and finance industries and the implications of the proposals for their businesses this submission does not directly address their concerns in any depth. However, we understand that a number of our members engaged in these industries are making submissions which deal specifically with the impact of the JWG recommendations on their activities.

In preparing this response the G100 commissioned one of the Big 5 firms to research the impact of the proposals on the reported profit of a number of companies not engaged in the banking and finance industries. The results of that research are reflected in this response.

1. Fair Value Measurement of Financial Assets and Liabilities (Paras 69-73 Section 4)
The availability of high quality, reliable financial information that presents a comprehensive view of the financial condition, position and performance of a company is essential for the efficient operation of capital markets. However, reliability of the representations in financial statements is a primary characteristic for the usefulness of this information. We do not believe that comprehensive fair value measurement for financial instruments would, at this time, deliver this outcome.

The G100 acknowledges that fair value measurement may portray a better and more accurate reflection of the company's financial position, financial condition and financial performance in those specific cases where fair values are determined in a deep and liquid market. However, we believe that there are presently significant difficulties relating to obtaining reliable and comparable information that arise from the proposed comprehensive requirement for fair value measurement of financial instruments. In our view the nature of these difficulties has a significant impact on the usefulness of the resulting information.

Active markets do not exist for many financial instruments and the information available and methods of calculating fair values, in the absence of observed market prices in deep and liquid markets, require significant further development. The extended use of estimated fair values in financial statements will present a number of issues including:

• the potential for significant error and/or bias in the financial statements where non-quoted financial instruments comprise a significant part of a company's assets and liabilities. This would be a particular issue for banks and financial institutions. For example, the estimation of fair values provides scope for the manipulation of reported amounts, particularly in respect of managing the quantum and volatility of reported earnings through minor changes in assumptions and valuation procedures;
  
• performance of the audit process and the ability for management's assumptions to be challenged particularly in the absence of comparable market information.

As a result of these concerns about the reliability of measurement of the market value of many financial instruments we believe that improvements to financial reporting will be better facilitated by requiring appropriate disclosures regarding fair values, cash flows and exposures to financial risk. Such disclosures are more likely to provide users with useful information for making judgments and assessments of the company than recognition of market value based information in the financial statements. The adoption of a disclosure approach also provides the user with the choice of how much reliance to place on the fair value information.

Further benefits of a disclosure approach in this area is that it provides:

• both users and preparers with the opportunity to improve their methods and incorporate new techniques in their respective processes through experimentation;
• an environment in which the practical problems of estimating fair values can be addressed; and
• a basis for an orderly transition towards the eventual use of comprehensive fair value measurement.

When significant changes in current practices are being considered an analysis and measured response to all the issues and implementation problems is essential if disruptions to financial reporting are to be minimised. The G100 believes that the comprehensive use of fair values for financial instruments has the potential to significantly disrupt financial reporting through diminishing the reliability of information, impairing comparability and eroding the credibility of accounting processes.

2. Recognition of Changes in Fair Value in Statement of Profit and Loss (Para 136 Section 6)
The G100 does not support the JWG recommendation that changes in fair values be recognised immediately in the statement of profit and loss as part of operating earnings. We believe that to do so would introduce unnecessary volatility to the measurement of reported earnings because recognised revenues and expenses would reflect short-term fluctuations in market values and movements in estimates.

The G100 believes that the distinction between realised and unrealised components of changes in values is an important consideration for users, and for management evaluation of performance, in particular where changes in fair values are recognised immediately in operating earnings of the period. In this regard, the G100 has expressed conditional support for recognising fair values in the statement of financial position provided that unrealised movements in fair values are recognised separately in equity as part of other comprehensive income and, subsequently, recognised in operating earnings as realisation occurs.

Research Results
The G100 commissioned research on the impact of the JWG recommendations on the reported earnings of 26 companies not engaged in the banking and finance industries. While this research focussed on a single reporting period it demonstrates the potential volatile effect of the JWG proposals on reported earnings and, as a consequence, on the reported amount of equity. For example, significant adverse changes in equity may result in a company being regarded as technically insolvent. The results do not show the potential variability from period to period and the fact that the impact is not likely to be consistent, either in direction or magnitude, for an entity from reporting period to reporting period. As a result of this research the G100 could not support recognising movements in the fair value of financial instruments within operating profit, in respect of this current proposed fair value model.

This research revealed the following:

• Of the 26 companies examined, as set out in Table 1, nine companies would have reported reduced earnings or increased losses during the year, with 16 companies being impacted favourably and one not being affected;
• Of the nine companies facing an unfavourable impact, five were resources companies and the potential impact as tabulated below was significant (there were no resource companies where the impact was favourable).

Table 1 - Percentage decrease in profits/increase in losses

• For those companies where the impact of the JWG standard is expected to be favourable (see Table 2), the principal cause of the impact is the difference between carrying amount and fair value of assets and liabilities, on- and off-balance sheet. The on-balance sheet items were predominantly listed investments and borrowings, whereas off-balance sheet amounts were essentially related to derivatives.

Table 2 - Percentage Increase in Profits

*includes no change

• A review of the data in Tables 1 and 2 indicates that the relative magnitude of the adverse effects on reported results is more severe for companies that are adversely affected than the relative magnitude of the favourable effects for those companies where the effect was identified as being favourable. This is likely to reflect the fact that in many cases the item being hedged, for example, mineral reserves is not recognised in the financial statements and would tend to indicate that while the effects were significant in the reference period the volatility and the direction of the effects would vary from period to period.

Had the JWG proposals been adopted at the beginning of the relevant financial year, 12 companies would have recognised an adjustment to increase opening retained earnings or no adjustment (two only), and 14 would have recognised an adjusting decrease. The calculation of the potential adjustment is incomplete as the cumulative amounts transferred to foreign currency translation reserve in respect of monetary items forming part of the net investment and hedges of those items were not separately disclosed.

Interestingly, in terms of the amount of the initial impact and the relativity of that amount to the absolute amount of opening retained profits or losses, the major impacts related to non-resources companies.

Table 3: Adjustment to opening retained earnings/accumulated losses

*includes 2 no change

In conducting the analysis, the following was observed:

(i) not all companies separately identified the components of the movement in the foreign currency translation reserve so it was not always possible to identify exchange differences on monetary items forming part of the net investment, and on any associated hedges, that were transferred to that reserve. There is no requirement to do so. Under the revisions to AASB 1018, the amounts transferred will be part of the statement of financial performance, but a financial instruments standard based on the draft JWG standard would cause those differences to be included in the net profit or loss component of that statement;

(ii) a number of companies carried fixed interest debt but did not disclose any difference between the carrying amount and fair value of the debt. A standard based on the draft JWG standard may have a significant impact upon the results of those investees to which the companies applied the equity method of accounting. There was insufficient information available to measure the impact on the equity accounted share of profits or losses recognised by the companies as investors.

The G100 strongly believes that standard-setters should not continue to develop proposals on market value accounting until issues relating to performance reporting are resolved. It is essential that standard-setters address performance reporting as a high priority issue and not seek to introduce market values incrementally.

3. Implications for Hedging Programs (Para 153 Section 7)
The G100 strongly opposes the recommendations as they apply to accounting for hedge transactions. The recommendations are unbalanced since they deal only with the hedging instrument and not the hedged item. While the recommended approach is unlikely to result in companies not entering hedge transactions the removal of hedge accounting, as it is presently practised, has the potential to negatively impact on the way in which companies undertake their risk management activities. There is a real possibility that companies may seek to manage the fair value accounting exposures arising from adoption of the JWG approach and not the underlying economic exposures of their businesses.

The effect of the way hedges are portrayed in the financial statements will lead to increased volatility of reported earnings which will not necessarily reflect the underlying activity of the business because:

• the JWG approach is selective and unbalanced since derivative financial instruments are recognised at their fair values and changes in fair values are immediately reflected in operating earnings even though the hedged item is recognised in the financial statements on a cost basis; and
• the approach does not deal adequately with those situations where unrecognised items are hedged, such as, anticipated sales and purchase transactions. For example, where an airline enters hedge transactions to protect its operations from fluctuations in the price of fuel the effect of changes in the value of the hedge instrument are recognised in the operating earnings of the current period notwithstanding the fact that the purchase transaction and the use of the purchased fuel in the provision of services will not occur until a subsequent period.
• Additionally, in the resources sector, hedging may be undertaken in order to ensure the viability of a project by "locking-in" anticipated proceeds. The purpose of hedging in this context is to protect the business from foreign currency fluctuations and to remove or minimise the uncertainty arising from fluctuations in commodity prices. Management undertakes these programs to reflect the fact that changes in the value of the physical reserves are offset by changes in the value of the hedging instrument; and
• under the proposals the effects of hedging a foreign entity or operation are in accordance with AASB 1018 "Statement of Financial Performance" required to be recognised in the operating result of a period while the translation differences are recognised as part of an equity reserve. This results in an unbalanced reflection of the economic effect of the transactions in the financial reports and distorts the operating result.

The impact of recognising hedge transactions in the manner proposed by the JWG would result in significant variations in the reported earnings of entities which undertake risk management activities and would not reflect the motivations of management and the purpose of the hedging strategy or the overall impact of hedging on an entity. Management uses hedging to achieve a specified level of exposure to the risk of the effects of adverse movements in key drivers of the business performance. Implementation of the recommendations would mean that the reporting outcomes which reflect a "snapshot" of only part of the entity's activities is not consistent with the objectives of the hedging program and the economic effect of the transactions on the entity and is likely to result in misleading representations in the financial statements.

Adoption of the proposals would mean that a partial model was being used. The mixture of valuation bases and recognition rules causes a distortion of reported earnings and the representations in financial statements. It is unlikely that the outcome of these processes will provide information that is reliable, comparable and relevant to users.

Banks and Other Financial Institutions
A number of our members are engaged in the finance sector. As the core of their activities and operations and the vast majority of their assets and liabilities are financial instruments, adoption of the JWG proposals would have a significant effect on the representations made in their financial reports on their financial position and periodic financial performance. This would be particularly so for those entities which are deposit taking institutions and for whom core deposits are a significant feature of their operations.

The effect of using fair values with immediate recognition of changes in values in the statement of financial performance has the potential to be both volatile and material, such that the earnings from operations are likely to be swamped by unrealised changes in value of financial assets and liabilities, particularly in periods when there are significant movements in interest rates. A 1% shift in interest rates could affect the reported profit of a major Australian bank by up to $1 billion.

The implications of the proposals are so significant for retail financial institutions that management is likely to seek to manage accounting risk relating to the effects of using fair values rather than the underlying economic risks, such as the interest rate risk, associated with their businesses. This will be done by either hedging the fair value accounting risk or reducing longer term fixed rate financing. This would change the economic outcomes, potentially with significant implications for long-term shareholder value and the nature of the business that banks would be prepared to write. Additionally there are likely to be significant implications for the ways in which the capital adequacy of financial institutions is measured and evaluated and on their dividend paying capacity and distribution policy.

Conclusion
For the reasons set out above the G100 does not support the principal recommendations of the JWG. The G100 believes that the AASB should give priority to developing an Australian Standard on recognition and measurement of financial instruments that harmonises with IAS 39 rather than seek to progress the JWG proposals in the short-term. We note that the IASB has recently endorsed IAS 39 and other extant IAS Standards. In particular, further guidance is needed in the areas of portfolio hedging and the selection of discount rates. We believe that further progressing and adoption of the JWG proposals, which are significantly in advance of the ability to measure reliably the market value of financial instruments, would, in their present form and in the absence of a comprehensive fair value model, decrease the quality of financial reporting in Australia.

Please do not hesitate to contact me (02 9378 3569) if you are seeking further information on this submission about the effects of the JWG proposals on businesses.

Yours sincerely

Tom Pockett
National President

c.c. Sir David Tweedie
Chairman IASB

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