In 2002, the Hong Kong Institute of Certified Public Accountants announced that a series of improvements would be carried out in the accounting standards in Hong Kong. Hong Kong Accounting Standards 32 and 39, which will come into effect for the financial period beginning on or after January 1, 2005, are related to the presentation and measurement of financial instruments. HKAS 32 and 39 will result in changes to the presentation and the recognition of financial statements and make them significantly different from the current presentation and measurement of financial instruments. It is worth mentioning the major changes in thinking that were behind the HKAS 32 and 39 revisions, as an understanding of these will change how you view the statements.

In the following paragraphs are listed the major differences between HKAS 32 and 39 and the way in which financial instruments are presented currently.

Separation of liability and equity elements

Certain financial instruments may contain both a liability element and an equity element. Using a convertible bond as an example, we can easily illustrate how this works.

A convertible bond is a kind of loan raised by a company through the selling of bonds to investors. A bond holder has the option to convert his bond into the company's shares within a defined period of time.

When an instrument is originally in the form of a liability but can be changed into the form of equity, that instrument is said to contain both the liability and equity element.

As there is a conversion option attached to the convertible bond, the interest rates of the convertible bond, in general, are lower than in other borrowings of the company.

The difference in the interest rates represents the equity element attached to a convertible bond. The bond holders assume that they can have a share in the company in the future and are willing to forgo certain interest income.

The interest charged at the coupon rate in the company's income statement may not be fairly reflected in its profit and loss statment for the year. Thus there were calls for the new HKAS 32 and 39 to separate the liability element and equity element so as to fairly reflect the market rate of borrowings in a company's financial statements. Under the rules laid out in HKAS 32 and 39, the equity element of the convertible bond has to be quantified (for example, by means of discounted cash flows, compared with the market interest rate for a similar credit-standing bond) and the carrying amount of the convertible bond is to be divided into a liability portion and an equity portion.

The equity portion will be included as shareholders' equity while the remaining amount will be shown as liability.

In addition, future interest charges will be calculated based on the market rate. In this way, no borrowings will be distorted by the inclusion of an equity element of the financial instrument used. As a result, the cost of a company's borrowings will be more accurately reflected in its financial statements.

Valuation of financial assets and the classification of held-to-maturity assets

Under the revised standards, all financial assets, including cash deposits, bonds, receivables, forward contracts and the like are classified into four major categories - assets with fair value through income statement, assets available for sale, loans and receivables and assets held to maturity. The recognition of these assets will be different under the revised standards.

In general, the first two categories will be measured at fair value, whereas the other two will be measured at cost (less any amortization if applicable). HKAS 32 and 39 aim to ensure that all of a company's financial assets are measured at the fair value (that is, close to their market value).

In addition, a very interesting rule, the "Tainting" rule, was introduced.

The "Tainting" rule will affect a company with held-to-maturity financial assets. (A held-to-maturity financial asset is defined as an asset that has fixed or determinable payments and a fixed maturity date, which the enterprise intends and has the ability to hold to maturity - for example, an investment in bonds).

The "Tainting" rule states that an enterprise should not classify any financial assets as being held to maturity if the enterprise has sold, transferred or exercised put option on more than an "insignificant amount" ("insignificant amount" was not defined under the previous standard) of the held-to-maturity investments, before maturity during the current year or two preceding years.

It means that an enterprise cannot show held-to-maturity investments in its financial statements, if it has sold or transferred these before their maturity date in the previous two years. These assets may be reflected in its financial statements as assets available for sale and measured at fair value instead of costs less amortization.

Separation of financial instruments and non-financial instruments

Under the revised standards, all financial derivatives are always, wherever possible, to be stated at fair value (the published quotation price in an active market) and separately accounted for on a company's balance sheet.

Certain financial derivatives are a combination of a financial instrument and a non-financial instrument or are non-derivative host contracts in nature. Examples of these are: investments in convertible bonds, contingent rentals and contracts that are denominated in currencies other than the functional currency of the reporting entities).

In this instance, the financial instrument and non-financial instrument components under the embedded derivative need to be separated when calculating the value of the financial instrument.

The major purpose is to eliminate the problem of non-financial instruments being treated as financial instruments and presented as such.

To illustrate this point, let's look at the following example:

A Hong Kong company enters into a contract to buy machinery from an Australian company for US$100,000, and that is due for delivery in six months. However, neither party to the contract uses US dollars, the currency in which such assets are normally traded, as their functional currency.

In this case, the deal can be considered as consisting of two separate contracts, a host contract (purchase commitment) and a forward contract for the sale of US dollars, which will mature in six months.

Under HKAS 32 and 39, these two contracts should be accounted for separately, since it has been deemed not necessary to combine the two transactions into one.

To conclude, changes in the accounting standards are aimed at enhancing the users' understanding of financial statements and the significance of financial instruments in relation to a particular entity's financial position, performance and cash flows as well as establishing principles for recognizing and measuring financial assets, financial liabilities and contracts to buy and sell non-financial items.

In the past, accounting practices have been more focused on the legal form of financial transactions rather than their substance. The new accounting standards, HKAS 32 and 39, are an attempt to redress this situation.

* Roy Tsang is senior audit manager of Deloitte Touche Tohmatsu

(HK Edition 11/22/2004 page13)