Financial Instruments - An Accounting Solution

Published October 2012

The recent publication of the draft hedge accounting guidance that will form part of IFRS 9 'Financial Instruments' represents another major milestone in the eventual replacement of IAS 39, a standard which has grown in its infamy over the years.

Users of financial statements and other interested parties have for many years consistently told the International Accounting Standards Board (IASB) that the requirements in IAS 39 'Financial Instruments: Recognition and Measurement' are unduly difficult to understand and interpret and give rise to major difficulties with their application in practice.

The Lead-Up to IFRS 9
As far back as 2005 the International Accounting Standards Board (IASB) and the U.S. Financial Accounting Standards Board (FASB) began working towards a long term objective to improve and simplify financial reporting for financial instruments. The financial crisis which commenced in 2007/2008 magnified the need for a new approach to address shortcomings identified in reporting by banks and other financial institutions. The non-financial corporate sector also experienced many difficulties with practical application of IAS 39.

Significant work commenced in responding to issues highlighted by the financial crisis. With G20 and other international bodies, such as the Financial Stability Board, pressing for action to be taken to strengthen accounting standards, the IASB announced an accelerated timetable for replacing IAS 39. Under their Memorandum of Agreement, the IASB and the FASB set out to have this completed by June 2011 with publication of a new Financial Reporting Standard, IFRS 9 within the IASB framework. Complexity of the many issues involved and disparity of views in various areas between the IASB and the FASB has meant that completion by the target date was not achieved and it remains a work in progress. The original mandatory implementation date has been deferred from 2013 to 2015.

Seldom if ever has there been an accounting topic which has generated such widespread interest at a broader level, much of it attributable to the fundamental importance of banks and other similar entities to overall economic well-being. Political influences have been rampant in many respects, and great care has been needed to try and protect the objectivity of accounting solutions being developed.

The European Union has indicated that it will not endorse the new standard until all phases of the project have been completed and a complete draft standard is available for review and endorsement. It seems at least possible that the EU will put forward a later implementation date than 2015, and the desirability of international comparability will have to be balanced with affording companies adequate time for making the transition. On a similar note, current indications are that the new financial reporting standards on consolidation and joint arrangements which the IASB has put forward for mandatory implementation in 2013 will not be endorsed for use by European companies until 2014.

IFRS 9 - Under development
The IASB is undertaking the IFRS 9 Project in three phases, each of which has seen significant development in the past three years or so, but further work is required in each phase. The clock is now running fast and if a mandatory implementation date of 1 January 2015 is to be achieved, all phases will have to be completed with a final standard published by around mid - 2013 to meet the IASB's principles on the timing of publication and implementation of standards.

The three phases and their current status are:

Phase 1 - Classification and measurement of financial assets and financial liabilities.

In November 2009 the IASB issued the chapters of IFRS 9 relating to financial assets and in October 2010 added to IFRS 9 the requirements related to financial liabilities. In November 2011 the IASB decided to commence consideration of limited modifications to the classification and measurement requirements, much of it emerging from disparity of approach in certain areas between the IASB and the FASB and also in order to consider the interaction between accounting for insurance contract liabilities and financial assets. A revised exposure draft is expected to be published in the fourth quarter of 2012.

Areas under consideration for change include:

• The scope of fair value through other comprehensive income for debt instruments
• The application of the fair value option
• Bifurcation of non-closely related embedded derivatives from financial assets
• Consideration of the effective date for a reclassification to take place
• Accounting for all possible reclassification scenarios between the three measurement categories
• The transition arrangements
• Presentation and disclosure requirements and integration with disclosures proposed in the impairment phase of the IFRS 9 project

Phase 2 - Impairment Methodology

In November 2009 the IASB published an exposure draft, Financial Instruments: Amortised Cost and Impairment, and in January 2011 published a supplement to the exposure draft. The IASB is re-deliberating the proposals in the exposure draft and the supplement to address comments received and suggestions from an expert advisory panel and other outreach activities. A revised exposure draft is on the IASB agenda within the next few months.

The 'incurred loss' model required by IAS 39 assumes that all loans will be repaid until evidence to the contrary (known as a 'loss' or 'trigger' event) is identified. Only at that point is the impaired loan written down to a lower value. This project is considering various forms of an 'expected loss' approach, whereby expected losses are recognised through the life of a loan or other financial asset measured at amortised cost, not just after a loss event has been identified. The 'expected loss' approach would lead to earlier recognition of impairment issues.

The completion of this phase of the project is again largely tied in to resolving disparities between the IASB and the FASB in certain areas, including:

• Application to loan commitments and financial guarantee contracts
• Movements in classification within the 'three-bucket' approach
• Treatment of purchased credit-impaired financial assets
• Determination and presentation of interest income
• Application to assets reclassified from FVTPL
• Achieving disclosure objectives with regard to such matters as expected loss calculations, transfer criteria, collateral, allowance roll-forward, risk disaggregation
• Transition arrangements

Phase 3 - Hedge Accounting

On 7 September 2012 the IASB added to IFRS 9 draft requirements related to general hedge accounting. The IASB did not address specific accounting for open portfolios or macro hedging; proposals are currently being discussed, with the objective of issuing a discussion paper. The IAS 39 treatment continues to apply, and it seems unlikely that macro hedging will be finalised in IFRS 9 in time for 2015 implementation.

The objective of hedge accounting is to represent, in the financial statements, the effect of an entity's risk management activities that use financial instruments to manage exposures arising from particular risks that could affect profit or loss or other comprehensive income. Much of what is in IAS 39 on hedge accounting is retained and applying hedge accounting remains a choice.

What does change is that IFRS 9 hedge accounting requirements align hedge accounting more closely with risk management, establishing a more principles based approach to hedge accounting and addressing many inconsistencies and weaknesses in the IAS 39 model. These changes should, in particular, help the non-financial corporates who currently struggle with the results produced by IAS 39.

The approach now being put in place makes changes which should prove very helpful in practice and be more consistent with the economic substance of what an entity is aiming to achieve when it engages in hedging. These changes include, inter alia:

• Increased eligibility of hedged items and hedging instruments
• New qualification and effectiveness requirements
• New concept of rebalancing hedging relationships
• New rules for discontinuing hedging relationships

A welcome change should be the removal of the 'bright line'of the 80-125% effectiveness test, with it being replaced by the principle of 'economic relationship' giving more latitude for the use of hedge accounting.

Moving to a more principles-based approach does inevitably lead to increased disclosures about an entity's risk management activities, with the purpose and effect of the hedging instruments used (generally derivatives) being more clearly explained.

Much done, a lot left to do! It will undoubtedly take all available time and resources to meet target dates and ultimately complete IFRS 9 in time for implementation on 1 January 2015. The wait will be worthwhile if it results in a final standard more in touch with the underlying economic realities and moves us away from the complicated maze of IAS 39.

First published in Finance Dublin Online.