Argument Against The Case An Accounting Standard

To Regulate The Way In Which Complex Financial Instruments Are Reported In The Financial Statements Of Quoted Companies. Essay, Research Paper

INTRODUCTION :

In this essay, I would like to start with a brief explanation about the accounting regulation and standards set for various treatments consists of gaps where the rules are vague or even incomplete. Then, I would like to give a brief introduction about the development of standards set for capital instrument, such as TR677 (ICAEW), FRED 3 and FRS 4.

Next, I will go into details examining the problems found in these proposals and standard, especially FRS 4. Coming to this stage, I will divide the problems into two parts. Firstly, I will point out the inconsistency found in FRS 4 in relation to FRS 5. Secondly, I will try to deal with the practical point of view, pointing out that the FRS 4 consist of practical problems in accounting treatments for shares and debt.

Finally, I will conclude that the current standard for complex capital instruments is not sufficient to solve the problems found in its accounting treatments. Hence, a more effective standard must be put forward to regulate the accounting treatment for capital instruments as it is becoming increasingly more complex.

ESSAY:

In many countries, accounting regulation is based on a system of detailed rules prescribed in standards and the law. However, rule-based systems can rarely be water-tight. There may be gaps in the rules, and places where the rules are vague or even incomplete. Of equal, if not greater significance is the fact that regulatees may develop schemes which fulfil the letter of the rules, but undermine their spirit. Regulators may find themselves constantly lagging behind the avoidance activities of the regulatees (McBarnet, 1988). In such circumstances, effective regulation breaks down.

For the past ten years, the financial instruments issued by companies have become more and more complex. This has been particularly so since October 1987 which has been a period where equity issues have been difficult and companies have not wanted to increase their capital gearing. Finance has still been required for acquisitions which have continued apace and, as the doors to off balance sheet finance seem to be slowly closing, there has been a need for something more sophisticated. This has help to promote the development of a number of instruments that can be described as hybrids, i.e. partly equity and partly debt.

This period has coincided with developments in accounting to reinforce the concepts of substance over form. The problem with complex instruments is that in a two-dimension balance sheet which includes only debt and equity, it is very difficult to see what the substance is. Apart from this, resort to sophisticated capital instruments as a way to present their overall financial position in a more favourable light; and designed the instruments in such a way to allow companies to secure access of funds which could be classified as equity rather than debt.

At that time, authoritative pronouncements have been limited to a technical release by the ICAEW in 1987 (TR 677). That was effectively a consultative document which was a useful start to a debate, but like any such first short, was the subject of various responses, some supportive and some critical. Unfortunately, after the responses, the debate was not officially taken further, leaving the TR 677 as a relatively useless document.

In December 1992, ASB published FRED 3 which was based on the main proposals set out in the earlier discussion paper. There was a subsequent consultation on one additional matter: the appropriate treatment when debt is renegotiated. Companies in financial difficulties sometimes reach an agreement with lenders which allows them to reduce or defer their future payments of principal or interest under the debt. In these circumstances, the ASB proposed that the renegotiated debt should be stated at its fair values with a corresponding gain being recognised in the profit and loss account. However, commentators criticised this proposal on the grounds, that it was imprudent; in particular they noted that the amount of the reported gain would be inflated because the discount rate used in valuing the debt would reflect the collapse of the company’s own credit rating, which seemed preversed. As a result of these comments, the matter was not dealt with in the eventual standards, i.e. FRS 4, which was issued in December 1993.

Apart from this, one topic addressed by many commentators was the assessment of the maturity of debt: that is, how it should be determined whether debt is short-term or long-term. Here the discussion paper proposed a very strict rule: the assessment was to be made by reference to the contractual maturity of the debt, and no consideration was to be given to facilities which would permit it to be re-financed. However, respondents pointed to situations in which such a rule would seem to give anomalous results. And so FRED 3 proposed that where facilities are held which permit the borrower, in effect, to extend a loan, the maturity of the loan should be assessed by reference to the longest such refinancing permitted. But this does not extend to cases where the loan may be replaced by another. Issuers of commercial paper frequently have back-up facilities to ensure that if further comm