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Accounting alert 2008/14 - Financial reporting developments from the credit crunch

The collapse of certain banks and other significant market players in recent weeks dominated business headlines as the fallout from the credit crunch gathers increasing momentum. Sir David Tweedie, chairman of the International Accounting Standards Board (IASB) recently noted in a press release that 

"Accounting is not the cause of the credit crisis, but it is important that market participants should have confidence in the information presented within financial statements. It is for this reason that the IASB has been monitoring the performance of IFRSs and has moved swiftly to deal with issues highlighted by the credit crisis…"

On 9 October 2008, the Trustees of the International Accounting Standards Committee Foundation (IASCF) endorsed a quick track approach for the IASB to eliminate differences between IFRS and US GAAP regarding the classification of financial instruments. The Trustees' endorsement suspends certain IASB due process requirements effectively accelerating the decision process - resulting in the issue of amendments to IAS 39 Financial Instruments: Recognition and Measurement earlier this week to allow entities to reclassify certain financial assets currently measured at fair value . Interpretation of the amendments may be varied, as the pronouncement has been issued fairly rapidly.

In this Accounting alert, we focus on the following developments:

The Action Alert from the Australian Accounting Standards Board's (AASB's) board meeting on 10 October proposes a rapid response by the AASB to ensure Australian constituents will be able to maintain compliance with IFRSs (see Accounting alert 2008/13). Accordingly, we may reasonably expect the AASB to approve similar amendments to AASB 139 Financial Instruments: Recognition and Measurement and AASB 7 Financial Instruments: Disclosures out of session without undue delay. However, until such time as the AASB issues consistent amendments to AASB 139 and AASB 7, the option to reclassify qualifying financial assets is not available to Australian entities.

[UPDATE] On 22 October 2008, the AASB publicly released AASB 2008-10 Amendments to Australian Accounting Standards - Reclassification of Financial Assets, with equivalent application date clauses to the IASB amendments. Accordingly, Australian entities are now able to apply the amendments.

Ability to reclassify certain financial assets

An IAS Plus newsletter on the amendments to IAS 39 and IFRS 7 has also been published. This newsletter can be accessed from our IAS Plus website (PDF 96 kb).
Financial assets qualifying for reclassification

The amendments to IAS 39 revise the reclassification requirements of IAS 39 to enable the following financial assets to be reclassified from their original category, provided certain conditions are met:

  • Financial assets classified as fair value through profit and loss (FVTPL) that are no longer held for the purpose of selling or repurchasing it in the near term
  • Available for sale (AFS) financial assets that meet the definition of loans and receivables had they not been designated as AFS on initial recognition.

The amendments do not change existing requirements in respect of reclassifications of other IAS 39 financial assets, including:

  • Financial assets designated into the FVTPL category (e.g. financial assets of some managed investment schemes and financial assets backing life insurance or general insurance liabilities)
  • Other 'held for trading' financial assets classified as FVTPL, including derivative financial assets not held in a designated and effective hedging relationship
  • AFS financial assets that do not meet the definition of loans and receivables (e.g. listed shares).

Circumstances in which these financial assets may be reclassified

The amendments to IAS 39 allow entities to reclassify, subsequent to initial recognition, a financial asset classified as available-for-sale as 'loans and receivables' if:

  • The financial asset would have met the definition of loans and receivables had it not been designated as available for sale. That is, the asset is:
    • A non-derivative financial asset with fixed or determinable payments
    • Not quoted in an active market
    • Not a financial asset for which the holder may not recover substantially all of its initial investment, other than because of credit deterioration
  • The entity has the intention and ability to hold the financial asset for the foreseeable future or until maturity.
It should be noted that the amendment does not refer to instances of reclassifying AFS debt instruments to HTM as the standard, prior to the amendment, already permitted such designations in accordance with IAS 39.54. These reclassifications are not within the scope of this amendment, including the additional disclosures required by IFRS 7.12A referred to below.

Similarly, the amendments allow entities to reclassify a financial asset classified as FVTPL that is no longer held for the purpose of selling or repurchasing it in the near term if:

  • The financial asset would have met the definition of loans and receivables had the entity not been required to classify it as held for trading at initial recognition (as the entity intended to sell the asset immediately or in the near term). That is, the asset is:
    • A non-derivative financial asset with fixed or determinable payments
    • Not quoted in an active market
    • Not a financial asset for which the holder may not recover substantially all of its initial investment, other than because of credit deterioration; and
  • The entity has the intention and ability to hold the financial asset for the foreseeable future or until maturity.
Held to maturity is not an available alternative category as a financial asset that meets the definition of loans and receivables is precluded from being classified as held to maturity.

Lastly, the amendments allow entities to reclassify all other financial assets (i.e. other than a financial asset that would have otherwise met the definition of loans and receivables) classified as FVTPL that are no longer held for the purpose of selling or repurchasing it in the near term, into the applicable of 'held to maturity' or 'available for sale', in rare circumstances. A rare circumstance is not defined within the pronouncement, and the basis of conclusions accompanying the amendments notes that "The Board was also informed that, in practice under US GAAP, reclassification out of the trading category of SFAS 115 [permitted in rare circumstances] is extremely rare". However, the press release accompanying the amendments includes the following quote from Sir David Tweedie: "In addressing the rare circumstances of the current credit crisis …"

Accounting on and after reclassification

The financial asset is reclassified at its fair value on the date of reclassification. That fair value becomes its new amortised cost (or cost, as applicable).

Gains and losses previously recognised in profit and loss are not reversed on reclassification of financial assets initially classified as FVTPL. On reclassification of available for sale financial assets, gains and losses previously recognised in equity shall be recognised in accordance with IAS 39 paragraph 54, which requires:

  • For a financial asset with a fixed maturity, the gain or loss to be amortised to profit or loss over the remaining life of the investment using the effective interest method. Any difference between the new amortised cost and maturity amount is amortised over the remaining life of the financial asset using the effective interest method, similar to the amortisation of a premium and a discount
  • For a financial asset that does not have a fixed maturity, the gain or loss to remain in equity until the financial asset is sold or otherwise disposed of; at which time the gain or loss is recognised in profit or loss.

If the financial asset is impaired post reclassification, any (remaining) gain or loss that has been recognised directly in equity is recognised in profit or loss, in accordance with IAS 39 paragraph 67.

For financial assets measured at amortised cost after reclassification under these amendments, if an entity subsequently increases its estimates of future cash receipts as a result of increased recoverability of those receipts, the effect of that increase is recognised as an adjustment to the effective interest rate from the date of the change in estimate rather than as an adjustment to the carrying amount of the asset at the date of the change in estimate.

Effective date of the amendments

To ensure that the reclassification option delivers a real benefit to entities, the amendments apply from 1 July 2008, i.e. earlier than the date of its issue, 13 October 2008. In its press release announcing the issue of the amendments, the IASB clarified that "Today's action enables companies reporting according to IFRSs to use the reclassification amendments, if they so wish, from 1 July 2008" (emphasis added); that is, entities may reclassify qualifying financial assets at a date from 1 July 2008. However, the pronouncement is clear that any reclassifications of financial assets made under these amendments shall not be applied retrospectively to reporting periods ended before 1 July 2008.

Any reclassification of a financial asset made in periods beginning on or after 1 November 2008 take effect only from the date when the reclassification is made.

[UPDATE] The IASB has issued guidance clarifying the effective date of the fast-tracked IAS 39 amendments permitting reclassifications of certain financial assets. This clarification would apply equally to the amendment to AASB 139.

The key dates are as follows:

  • Reclassifications may not be applied retrospectively before 1 July 2008
  • The decision to reclassify a financial asset on or after 1 July 2008, but on or before 31 October 2008, must be completed before 1 November 2008
  • All reclassification made on or after 1 November 2008 shall be effective from the date of reclassification, irrespective of when the accounting period started.

Therefore, those entities wishing to take advantage of the amendment to retrospectively reclassify financial assets must do so before 1 November 2008 as any reclassifications made on or after this date can only take effect from the date of the reclassification. More information can be found in the IASB Update from the October meeting (PDF 96kb).

Evaluating whether a qualifying financial asset should be reclassified

When evaluating whether to take advantage of the amendments, entities should have regard to various matters, including:

  • The potential longer-term implications, if fair values are expected to increase in the future, of classifying financial assets out of the FVTPL category. The amendments do not permit any financial asset that has been reclassified out of the FVTPL category to be reclassified back into the category in the future. Accordingly, should the financial asset be carried at amortised cost after reclassification, future increases in fair value will not be reflected in the balance sheet immediately. Companies should consider the impact of capping the value of such financial assets on future capital adequacy commitments or ratio analysis
  • Whether other players in the industry will be reclassifying similar financial assets held
  • Whether there is an embedded derivative that will be required to be recognised separately at its fair value on reclassification of the financial asset. Such embedded derivatives are likely to include prepayment options in loans and any linkage of returns to commodity or equity price indexes
  • Whether systems are able to track and correctly measure assets of a similar nature which are classified differently
  • Implications for any compensation or other scheme that is based on fair value Management fees to an investment manager may be based on a percentage change in the gross or net asset value of the investments managed, which are measured historically at fair value - how will affected stakeholders react to the reclassification? Will arrangements need to be redrafted?
  • Implications for any template disclosures that have already been prepared in respect of an approaching year end or a year end that has passed but has not yet been reported on. Larger entities will in general have bedded down their IFRS 7 and other disclosures and amending the classification may result in a certain amount of rework to the current disclosures - the amendments to IAS 39 include consequential amendments to IFRS 7, including a new requirement to disclose information about financial assets reclassified out of the FVTPL category
  • Whether reclassification will result in any real benefit to the entity, especially for those financial assets that will be classified going forwards as available for sale. Exchange differences and interest income on monetary available for sale instruments will continue to be recognised in the income statement, and if the instrument is expected to further decline in value, on determination that impairment exists, all amounts recognised in equity will be reversed out of equity and into profit and loss.
More information

Exposure draft of proposed amendments to IFRS 7

An IAS Plus newsletter on the proposed amendments to IFRS 7 has also been published. This newsletter can be accessed from our IAS Plus website (PDF 202 kb).

Following discussions at its special board meeting on 2 October 2008, the IASB has now issued exposure draft Improving Disclosures about Financial Instruments  (Proposed amendments to IFRS 7) for public comment. In the accompanying press release, Sir David Tweedie, Chairman of the IASB, said: "The credit crisis has heightened concerns about liquidity risk and pointed to the need for entities to explain more clearly to the outside world how they determine the fair value of financial instruments, especially those that are particularly complex...".

 [UPDATE] The AASB issued an equivalent exposure draft, ED 169  Improving Disclosures about Financial Instruments: Proposed Amendments to AASB 7 (PDF 478kb), on 24 October 2008.

The exposure draft includes proposals to amend the existing liquidity and fair value disclosure requirements in IFRS 7 in the following manner:

Maturity profile of financial liabilities

The ED proposes to clarify that liquidity disclosures are only required for financial liabilities that result in the outflow of cash or another financial asset, and that in respect of such financial liabilities, an entity shall disclose:

  • A maturity analysis for derivative financial liabilities that is based on how the entity manages the liquidity risk associated with such instruments
  • A maturity analysis for non-derivative financial liabilities that shows the remaining contractual maturities for all items, and
  • If the entity manages liquidity on the basis of expected maturities, it shall also disclose the remaining expected maturities for those non-derivative financial liabilities.

The proposals would also require an entity to explain how the estimates in the maturity analyses are determined, and provide additional information where estimated cash (or other financial asset) outflows included in the analyses could either occur significantly earlier or be for significantly different amounts from those indicated.

The exposure draft emphasises that an entity must explain the relationship between qualitative and quantitative disclosures about liquidity risk to ensure that users of financial statements are able to evaluate the nature and extent of the liquidity risk of the entity.

Additional disclosures about fair value

IFRS 7 requires disclosure of the fair value of each class of financial asset and financial liability, whether or not the instruments are measured at fair value. The proposals significantly enhance disclosures in respect of the fair value of financial instruments. The proposals are based on the following three-level fair value hierarchy (similar to that applicable under US GAAP):

  • Quoted prices in active markets for the same instrument (i.e. without modification or repackaging) (Level 1)
  • Quoted prices in active markets for similar assets or liabilities or other valuation techniques for which all significant inputs are based on observable market data (Level 2)
  • Valuation techniques for which any significant input is not based on observable market data (Level 3).

The proposals would require entities to provide information including:

  • The level of the fair value hierarchy in which fair value measurements fall
  • For fair value measurements using valuation techniques for which any significant input is not based on observable market data, a reconciliation from the beginning balances to the ending balances
  • The movements of instruments between different levels of the fair value hierarchy, and the reasons for those movements.

The IASB exposure draft is open for comment until 15 December 2008. It has a proposed effective date of annual periods beginning on or after 1 July 2009.

As a matter of good corporate governance, companies may want to give consideration to now including some of these proposed disclosures in addition to those presently required by AASB 7.

More information

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