Setting global standards

Accounting standard boards have been under fire for the complexity and lack of consistency of their rules for financial instruments. With political pressure being heaped upon accountants, the International Accounting Standards Board has revealed its intentions to replace IAS 39. Christopher Whittall reports


International Accounting Standard (IAS) 39 has attracted more than its fair share of criticism since it was adopted in 2005. Covering the recognition and measurement of financial instruments, the standard has been lambasted by corporate treasurers and banks for contributing to greater balance-sheet volatility due to its requirement that a wide variety of assets be measured at fair value.

Since the onset of the financial crisis, and particularly since the collapse of Lehman Brothers last September, political voices have been added to the calls for accounting standards reform, with claims that fair-value accounting exacerbated the severity of the financial crisis. The result has been a flurry of activity from both the International Accounting Standards Board (IASB) and the US Financial Accounting Standards Board (FASB). But with political pressure being cranked up further following the Group of 20 meeting in London on April 2, the IASB confirmed on April 24 it will replace IAS 39 with a new proposal, to be published within six months.

The IASB said it would work jointly with the FASB to establish a globally accepted replacement of the requirements on accounting for financial instruments - hopefully ironing out many of the inconsistencies between the two bodies and reducing complexity of the standards. The proposals should be ready for public comment by the end of September.

"The problem is that while the two standards are similar, they are not the same. And the best way to address that is to have a comprehensive and urgent review, and develop proposals for a replacement standard within six months. That is what the IASB has committed to do jointly with the FASB," says a source close to the IASB.

A number of modifications have already been made over the past year. The IASB amended IAS 39 and International Financial Reporting Standard (IFRS) 7: Financial Instruments Disclosure on October 13 to allow reclassification of some financial assets, bringing the rules in line with US Generally Accepted Accounting Principles (Gaap). Both the IASB and the FASB also released guidance on how to apply fair value in distressed markets in October, which clarified that firms are not obliged to use market prices in distressed conditions (Risk January 2009, pages 83-851). The FASB followed up on April 9 this year with FAS 157-4 (Determining fair value when the volume and level of activity for the asset or liability have significantly decreased and identifying transactions that are not orderly) (see box).

Both the IASB and the FASB had announced on March 24 they would work jointly towards common standards, with the overall goal of seeking convergence between IFRS and US Gaap, noting a common standard would emerge in "a matter of months, not years". However, the G-20 meeting in April drummed home that politicians expected action quickly. The group called for standard setters to "reduce the complexity of accounting standards for financial instruments" and to address issues arising from the financial crisis. They also called for the two bodies to "make significant progress towards a single set of high-quality global accounting standards" by the end of the year.

In coming up with a common set of standards, the IASB and FASB will focus on several key issues: fair-value measurement, classification, impairment and loan-loss provisioning. In its April 24 release, the IASB noted the guidance on fair-value measurement released by the FASB on April 9 is broadly in line with its expert advisory panel report, Measuring and disclosing the fair value of financial instruments in markets that are no longer active, published on October 31. However, the standard setter said it will use guidance from the FASB's document and will largely use the same language in its exposure draft on fair-value measurements, due for publication in May.

The issue of classification could be more controversial. Currently, financial assets fall into one of four categories under IAS 39: loans and receivables, held-to-maturity, held-for-trading and available-for-sale. Loans and receivables and held-to-maturity assets are measured at amortised cost, minus reductions for impairment, while trading assets are measured at fair value, with changes in value reported in net profit and loss. Available-for-sale assets, meanwhile, are also measured at fair value, with firms given the one-time choice to recognise fair-value changes in net profit and loss or directly in equity until the financial asset is sold (at which time, the realised gain or loss is reported in the net profit and loss). If no market prices are observable for available-for-sale items, they are measured at cost subject to impairment recognition.

US Gaap uses a similar classification scheme, although there are some inconsistencies. For instance, the definition of loans and receivables is narrower under US rules, as it does not allow securities to be placed in this bucket. Under proposals currently being debated, this classification system will be simplified. "The objective is to reduce complexity, and one way of doing that is to reduce the number of measurement classifications. If you have the same financial instrument being treated in different ways by different financial institutions, it makes it very difficult for investors to compare like for like," says the source close to the IASB.

Market participants agree and welcome the plan to simplify classification and bring the two standards into line. "I think there's a lot of appetite on both sides of the Atlantic to try to find solutions, as there are some differences in the accounting treatment that are fairly fundamental at the moment. There is a need to make sure there is a single classification methodology, as classification is the driver for everything that follows," says Pauline Wallace, London-based head of the global financial instruments team at PricewaterhouseCoopers (PwC).

Some participants have expressed a preference for everything to be measured at fair value, simultaneously simplifying the rules and eliminating other areas of contention, such as impairment. "Our belief is full fair value is the best solution to address the overall complexity in the standard," says Vincent Papa, London-based senior policy adviser at the Chartered Financial Analyst (CFA) Institute.

With fair value coming under fire for aggravating the crisis, however, the IASB has distanced itself from such proposals. "Politically, that would never fly because there has been a lot of concern over the use of fair value, particularly when markets become illiquid," says the source.

Instead, the standard setter is believed to be contemplating cutting two categories and maintaining a single bucket for fair value and one for assets measured at amortised cost. "I think there is an appreciation you need fair value through profit and loss and you need some kind of amortised cost category. The categories most likely to get culled are held-to-maturity and available-for-sale assets," says Andrew Spooner, financial instruments partner at Deloitte in London. "We've got used to posting things through equity for available-for-sale assets then recycling them through net income. The IASB needs to decide whether it is going to continue with that, because it has attracted a fair amount of criticism."

If available-for-sale was removed, those assets measured at fair value and recognised directly in equity would either have to be measured at fair value and recognised in net profit or loss or measured at amortised cost. Whichever way the standard setters go, there will be criticisms, say accountants.

"Trying to simplify the number of categories, while pleasing all the people, is going to be the Holy Grail. Almost certainly, they're going to end up upsetting somebody. My own preference would be three categories: fair value through profit and loss for instruments you expect to trade; amortised cost for quite straightforward debt instruments you intend to hold to maturity; and available-for-sale for the rest. But users would still argue they'd rather only have two categories," says Tony Clifford, London-based financial services partner at Ernst & Young (E&Y).

The CFA's Papa is generally supportive of the proposals to simplify classification, but warns the measures must be clear and consistent. "Moving from four categories to two would be an improvement. However, our biggest concern is banks might be given more leeway for classification based on managerial judgement. We believe the new standard should reduce accounting based on managerial intent to minimise subjectivity and the potential to distort recognition of gains and losses," he says.

The process for determining which bucket assets fall into could also be changed. Some suggest the key criterion should be what a firm intends to do with an asset, rather than what the asset is. At the moment, held-for-trading assets are measured at fair value based on the fact the firm intends to trade them, while loans originated by the firm are classified as loans and receivables because of what they are.

"I think we have a bit of both at the moment and that does complicate matters. I suspect one of the biggest questions the IASB will look at is whether we account for things based on what we intend to do with them or based on what the things are," predicts Spooner.

PwC's Wallace also believes this to be a key area, expressing her preference for measuring instruments based on intent. "I'm very interested in the IASB exploring the concept of how entities actually do business. For assets you intend to sell, fair value through profit and loss seems like the right answer. For others you intend to hold for the longer term, it seems more relevant to look at the underlying cashflows," she notes.

Another major area of contention is impairment. There are currently some significant differences between IFRS and US Gaap on this point - even more so after changes announced by the FASB on April 9 (see box). Under IFRS, a firm has to recognise an impairment only if it has objective evidence to support an expectation of a default on contractual cashflows. Under US Gaap, an entity is required to recognise an impairment if it is possible it will not collect all contracted cashflows.

The US rules include 'other-than-temporary impairment' of debt securities classified as available-for-sale or held-to-maturity - a concept that does not exist under IFRS. In fact, impairment under IFRS can be reduced or eliminated if the value of the asset subsequently rises, while other-than-temporary impairment under US Gaap is permanent.

"Under IFRS, if you have a recovery you can reverse it in your financial statement. You can't in US Gaap - the impairment is permanent, and we think that is illogical," says Donna Fisher, director of tax and accounting at the American Bankers Association in Washington, DC.

It is not just the differences between the two standards that participants hope will be ironed out - it's the complexity too. If a company has to recognise impairment on an available-for-sale asset carried at fair value and reported directly in equity, IFRS requires any loss reported in equity be charged against profit and loss. However, some participants believe that if an institution has the ability and intent to hold an asset for a long time, it should only have to mark down credit losses and not those due to other market factors, such as liquidity or interest rate moves. A proposed amendment to the recognition of other-than-temporary impairment by the FASB on April 9 achieves this by requiring the credit component of an other-than-temporary impairment to be recognised in earnings and the remaining portion in other comprehensive income.

Many auditors see the logic in such an approach. "If you are holding an asset for the longer term, the income statement impact of an impairment should be restricted to the income statement impact of the cashflows you won't recover, rather than all the fair-value movements that have gone through that asset over the years," says Wallace.

Nevertheless, this particular issue could be made redundant if the standard setters opt to do away with the available-for-sale category altogether. "If you get rid of the available-for-sale category, assets will either be held at fair value through profit and loss - where impairments aren't applicable - or in an amortised cost category where only credit losses are carried through net income," observes Deloitte's Spooner.

Finally, the two accounting standards boards are likely to consider the issue of loan-loss provisioning. Firms currently have to use the incurred loss model, which requires them to build up reserves when something happens that will prevent them getting paid in full on a loan - an approach that has been widely criticised as being pro-cyclical. An alternative is the expected loss model, in which provisions would be made when an entity expects a loss to occur (see pages 32-34).

"Technically, I think the expected loss model would be more desirable, but you would have to weigh technical purity with commercial practicability. However, an expected loss model doesn't actually help in terms of pro-cyclicality, because if you calculate your expected loss, you are likely to be increasing your estimates just as you go into recession and reducing your estimates just as you come out," says E&Y's Clifford.


The source close to the IASB was unwilling to indicate what direction the standard setters would go with impairment, merely stressing the importance of co-ordinated action. "We're focusing our attention on getting to one impairment model used across IAS 39, and hopefully shared between the two standards, US Gaap and IFRS," he says.

This insistence upon alignment between US Gaap and IFRS is sure to please market participants - and many view it as vital to the success of the project. "Consistency between IFRS and US Gaap is absolutely crucial in all this and we would hate anything to be different. It was supposed to be a joint project - any changes that aren't consistent would be very unfortunate," says Clifford.

The two standards boards have an intimidating task ahead of them. There are also separate reviews under way by the IASB on fair-value measurement and the de-recognition of financial instruments. Hedge accounting is also in need of an overhaul, although this is likely to take a back seat for the moment. But it will be the publication of the exposure draft of the new proposals in September that should mark a real watershed for financial accounting.

"From a historical perspective, this is the furthest down the road we've ever been. There is demand for this to be looked at and there is the goodwill from both standard setters to do that. The output will determine what financial instrument accounting will be for many years, and it is hoped this project will finally put the subject to bed," notes Spooner.


The US Financial Accounting Standards Board (FASB) published three final staff position papers on April 9, designed to provide additional guidance on determining fair value in distressed markets and making changes to the rules regarding other-than-temporary impairments.

Financial Accounting Standard (FAS) 157-4 covers fair-value measurement in distressed markets, and follows feedback that a previous paper, published in October, did not provide sufficient guidance on how to determine whether a market that has historically been active is no longer liquid.

The paper reaffirms that fair value is the price that would be received when selling an asset in an orderly market and not a forced liquidation or distressed sale, and emphasises the need to use judgement to establish whether a market has become inactive and in determining fair values in distressed conditions.

The April 9 paper ditches a previous proposal made on March 16 that would have allowed firms to presume all transactions are distressed unless proven otherwise. This led to an outcry from investors that banks would be given too much scope to adjust balance sheets.

"The pendulum swung too far over, and I think investors and even some practitioners indicated to the FASB it may have overshot a bit. In the revised rules, the FASB gave practitioners and auditors more substantive guidance in determining when individual transactions are distressed and therefore can be ignored or adjusted," explains Wallace Enman, senior accounting specialist at Moody's Investors Services in New York.

Meanwhile, FAS 107-1 and Accounting Principles Board Opinion 28-1 made changes to force companies to include disclosures about the fair value of financial instruments in interim reports, as opposed to just once a year.

The third staff position paper covered the recognition and presentation of other-than-temporary impairments. FAS 115-2 and FAS 124-2 amend earlier guidance to provide greater clarity about the credit and non-credit components of impaired debt securities that are not expected to be sold. Firms have to recognise the credit component of an other-than-temporary impairment of a debt security in earnings, and the other remaining portion in other comprehensive income. Companies will be required to present the total other-than-temporary impairment in the statement of earnings with an offset for the amount recognised in other comprehensive income.

These changes are seen as a real boon for banks and have been welcomed by industry participants. "We think the changes to other-than-temporary impairment represent a real improvement to financial reporting," says Donna Fisher, Washington, DC-based director of tax and accounting at the American Bankers Association.

Investors are less happy with the outcome. "The amendment on impairment makes it a lot more difficult for a reader of financial statements to grasp the true financial condition of a company," says Richard Clayton, director of research at CtW Investment Group, a Washington, DC-based independent shareholder activist group.

The changes were accompanied by stringent disclosure for institutions when implementing the changes. Moody's Enman believes these disclosures should prevent an erosion of investor confidence in financial statements, as it will still be possible to reconstruct the financial position of institutions under the previous rules.

The amendments will be applicable for financial reporting periods ending after June 15, 2009, with early adoption allowed for periods ending after March 15.

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