UAE banks are negotiating with the Central Bank and external auditors for the adoption of amendments to international accounting standards that allow the reclassification of financial instruments in their statements under "rare circumstances".
The International Accounting Standards Board (IASB) approved amendments to the IAS 39 Financial Instruments Recognition and Measurement last October. These amendments allow the reclassification of financial assets under rare circumstances.
The IASB considered the global financial crisis and its impact on international markets as a rare circumstance and accordingly allowed all entities applying International Financial Reporting Standards (IFRS) to use the reclassification amendments in statements starting from July 1, 2008.
The Generally Accepted Accounting Principles (Gaap) of the United States already permits the reclassification of financial instruments under rare circumstances.
Banks in the UAE are demanding to use these new rules and amendments to global accounting methods to reclassify their financial assets by shifting financial instruments from their trading portfolio, which should be measured at fair value with changes through the income statement, to 'held to maturity', which will be measured at amortised cost and subject to testing for impairment.
This reclassification will help banks to shift the recording of losses from their income statements to the shareholders' statement.
"The changes permit an entity to reclassify non-derivative financial assets out of the 'fair value through profit or loss' statement and shift it to 'available-for-sale' categories. However, this permission can be used in limited circumstances and such reclassifications will trigger additional disclosure requirements," said Wadah Al Taha, a senior market analyst.
He explained that investors always focus on balance sheets and income statements while ignoring the cash flow statement and shareholders statement of the listed companies. "Investors should look at all statements and assess them carefully because such amendments will allow different entities to shift losses from the income statement to the shareholders' statement," Al Taha said.
However, accounting analysts stressed that the use of such facilities in accounting methods cannot be considered as window dressing of banks' financial statements.
"Due to the global financial crisis, all entities around the world using IFRS or Gaap methods are allowed to reclassify their financial assets to avoid the evaluation of these assets under the current market prices. We have rare circumstances at the moment and banks around the world are using these facilities. Therefore, local banks can also use such reclassification facilities," said a senior accounting analyst, who asked not to be named.
Meanwhile, Al Taha said the IASB has introduced strict measures in the implementation of the reclassification process, including the disclosure of the amount that would be classified as well as the date of reclassification.
"All banks should also take the approval of the Central Bank whenever they are changing their accounting or asset recognition methods because such reclassification will affect their financial statements and, accordingly, investors in the country. Central banks have the right to protect sovereign interests of the population and any interference in this regards is acceptable," he said.
However, other analysts considered the practice as window dressing because listed companies are trying to avoid disclosure of losses in their trading investments in the income statements and shift them to the shareholders' equity statements.
But Al Taha said these losses would be recorded in the shareholders' equity in an exceptional section and it would be disclosed that these financial assets were reclassified.
"Shareholders' equity statement should include outstanding capital, reserves and retained earnings. With the use of such reclassification, their statement will include another section for the reclassified financial assets."
Bankers said they are using the reclassification process not only to avoid reporting high losses, but also to protect investors' rights.
"Banks possess stock and real estate funds for trading, but with the global financial crisis these funds have not moved for a long time, because most banks have refrained from selling their holdings at the very low prices prevailing currently," explained a banker who asked not to be named.
"The evaluation of these financial assets at the current prices will lead to reporting high losses in the income statements and will harm investors. Because these investments are not moving, their actual status turned from trading to 'held for maturity' and can be reclassified in the shareholders' equity statement," he added.
He saw this practice enabling banks to keep these investments for the long term until the markets appreciate again, and then the banks would be able to sell these investments to avoid recording real loses in their financial statements.
"We have a special section in our financial statements for the recovery of bad loans and bad investments. This section will allow us to recover these loses when we are able to sell these financial assets at the real value."
However, this reclassification will create pressure on the capital adequacy ratios of banks because recording such losses in the shareholders' equity statement will affect the asset quality. But, bankers foresee a limited impact because the capital adequacy ratios of the UAE banks are already high, reaching 13.3 per cent by June 2008, while the Central Bank asks for a minimum of 10 per cent and Basel II (Revised International Capital Framework) rules stipulate a minimum of eight per cent.
A TEST OF TRANSPARENCY
Some analysts criticised the reclassification practice, saying that banks cannot hide losses forever and would have to disclose them in the future.
"The sentiment is very negative at the current stage and the expected losses have already been deducted from market prices a long time ago. The markets will accept the disclosure of such losses because of the negative impact of the global financial crisis. It is the right time for banks and other listed companies to get rid of their bad investments," said a banker.
Despite several instances of senior officials in the country stressing the need for more transparency, the financial statements for the results for 2008 will be a test for this new trend. There is a wide agreement that lack of transparency in disclosure was tolerated in the past while the markets were booming, but this lack of transparency during the downturn created high pressures in the markets and worked against the whole Gulf Co-operation Council region.
However, the disclosure of financial results for 2008 has become a critical issue because there is still lack of transparency, while listed entities refrain from explaining the situation or the measures they are taking to handle the impact of the global financial crisis.
And due to the lack of accurate information and data about the financial positions of various listed entities, rumours have dominated sentiment. During such a financial crisis as the present one, investors imagine the worst-case scenarios, according to a majority of analysts.
Rumours are increasing among investors regarding window dressing of financial statements for 2008, while according to international accounting standards there are specific rules for handling "rare circumstances" in global markets – and local entities are using just the same rules as international companies in different areas of the world.
This raises concerns regarding two main issues: transparency of local companies and awareness of investors.
If companies intend to apply the rare circumstances rules in their financial statements, they should clarify the situation for the public because this will increase confidence in the management of these companies, said Mohamed Al Beheiri, Trading Manager at Amanah Financial Services.
Another issue is the role of companies in increasing investor awareness about fair and accurate analyses of financial statements to enable them understand the implications of the new accounting rules. This will allow them to take the right investment decision accordingly, instead of exaggerating the situation and overreacting to any rumours or negative news.
Amendments to IAS 39 Financial Instruments
- A financial asset may be reclassified out of the fair value through profit or loss category only in rare circumstances.
- If an entity reclassifies a financial asset out of the fair value through profit or loss category, the financial asset shall be reclassified at its fair value on the date of reclassification. Any gain or loss already recognised in profit or loss shall not be reversed. The fair value of the financial asset on the date of reclassification becomes its new cost or amortised cost, as applicable.
- A financial asset that would have met the definition of loans and receivables may be reclassified out of the fair value through profit or loss category if the entity has the intention and ability to hold the financial asset for the foreseeable future or until maturity.
- A financial asset classified as available for sale that would have met the definition of loans and receivables may be reclassified out of the available-for-sale category to the loans and receivables category if the entity has the intention and ability to hold the
financial asset for the foreseeable future or until maturity.