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Extra info for Accounting for Financial Instruments
This mixed model approach, however, is a compromise solution and one that leads to a great deal of confusion. The problem is even more compounded when the standard setters try to deal with the complex area of derivatives and financial instruments. Indeed, the compromise model may explain why the International Financial Reporting Standards committee took so long to come up with a suitable accounting standard not only for financial instruments, but also for insurance. 4 FAIR VALUE OR COST The box below illustrates how the accounting standards, particularly IAS 39, treat various assets on the balance sheet and through the Profit & Loss account.
Com era, when internet companies, attempting to raise capital, inflated their profits (and profit forecasts), both the American accounting standard setters and their IAS equivalents introduced rules which prevent entities from recognising revenue until there is no doubt that the profit is earned. In America, the SEC devised a document called SAB 101 to remind accountants not to recognise profits based on estimated sales revenue. Instead, the entity has to wait until the service is performed or goods supplied.
The ‘mixed model’ approach therefore creates undesirable volatility – known as artificial volatility. 2 reveals how derivatives – used to hedge an interest rate exposure – create an artificial volatility problem. In essence, the standards require certain items to be shown at market value (or fair value), while they may be financed by liabilities which the entity must show at cost. A bank issues a fixed mortgage to a customer. As with all fixed rate financial instruments the market value fluctuates according to changes in interest rates.