It has been more than seven months since Malaysia adopted the new accounting standard known as Financial Reporting Standard (FRS) 139. It is supposed to be “fair value” accounting.

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FRS 139 addresses the laxity of the good old days when the effects of derivatives were only reflected in accounting when they were realised; derivatives were then treated as “off balance sheet” items. With FRS 139, investors are forced to take notice as it affects the bottom line of public limited companies (PLCs).

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The rub is that if no one understands how to use FRS 139, this is equivalent to financial activities being “off balance sheet” anyway. So, those who developed the standard should have shown how it should be practised. Anyone who says that they have been to a three-day course on FRS 139 and now get it are in complete denial. The standard is highly complicated and not easily grasped.

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That said, grasp it we must. FRS 139 was adopted chiefly because, among other things, it clarifies the status of a company’s basket of derivatives or hedging contracts. An example of the standard in action will help us understand better how exactly it benefits investors.

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Recently, we reviewed a PLC which adopted the new standard from Jan 1, 2009, exactly a year before its mandatory effective date of Jan 1, 2010. Now why would the PLC jump the gun to adopt this standard?

Interestingly, the company went into PN17 – a status when a company is in extreme financial distress and required to submit a proposal to the approving authority to restructure and revive the company in order to maintain the listing status – just three months after adopting FRS 139. When we analysed the accounts of the company to understand why it became technically insolvent, we realised that the answer lay in the commodity that its derivative or hedging contract was exposed to – oil.

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Oil price was extremely volatile in 2007 and was a real headache for most transportation companies. Oil-hungry industries hedged against such volatility by building an adjustment for inflation into their sales contract fees. But equally oil-hungry airlines everywhere couldn’t do so because they were under great pressure to keep fare prices down.

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So, in the case of this PLC, when oil was about US$103 a barrel, it took on hedge contracts. If it had also adopted FRS 139 by then, it would have to comply with this standard by reflecting the fair value of its hedge contracts in its balance sheet.

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On the day the PLC adopted FRS 139, oil was around US$40 a barrel. The PLC reflected this loss of about US$63 a barrel against the reserves on its balance sheet.

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On every subsequent quarterly financial reporting date, the PLC’s profit and loss (P&L) statement will reflect the volatility of oil prices due to its hedging contracts. So by June 2009 when oil prices were about US$60 a barrel, this was now a positive entry in the P&L statement.

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Anyone reading the quarterly results would reasonably assume that the PLC was now making money on its hedging contracts, that is, from the difference between US$60 and US$40 a barrel. But the PLC was actually still losing money. One has to look at the difference between US$103 and US$60 a barrel, because it closed the hedging contracts when oil was US$103 a barrel.

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It is also important to note that if a company adopts FRS 139 early, it does not have to comply with FRS 7, which governs disclosures of financial instruments in the notes to financial statements that help users evaluate:

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1) how significant are a company’s financial instruments on its financial position and market performance

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2) the nature and extent of risks from such instruments to which the company is exposed within the relevant quarter and how the company manages those risks. (These disclosures incorporate many of the requirements previously in FRS 132), and

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3) the description of management objectives, policies, and processes for managing those risks and the extent to which the entity is exposed to risk, based on information provided internally to the entity’s key management personnel.

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As the PLC chose not to adopt FRS 7 before the mandatory effective date, anyone outside the company who wants a clearer picture of its financial fitness will have to wait for its future disclosures. This again raises eyebrows:

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●  Why did it adopt FRS 139 so early with such a bullish outlook on oil?

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●  Was this based on consultation with their auditors?

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Remember in the June 2009 announcement, the PLC explained (after adopting the new standard) that it had negative shareholders’ equity as at March 2009; it was technically insolvent.

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For now, we question why the company’s board of directors allowed it to take on such large long-term hedge contracts, and also why it jumped the gun on adopting FRS 139, triggering the PN17 criteria.