Accounting Changes in a Financial World
Change - has there ever been a time of such great momentum in seeking to improve and stabilise the financial reporting platform? This is not just for the 'big players' that are required to or have elected to adopt IFRS but right across the full spectrum of reporters. Substantial change is in the pipeline.
Even at the 'small' level EU activity is geared towards changing the reporting framework for small and micro entities, which in number are by far the largest proportion of the population of European companies.
The substantial 'middle-ground' is also about to experience significant change.
The International Scene
The International Accounting Standards Board (IASB) is driving change forward, much of it in response to reporting issues highlighted by the economic and financial crisis. Already we have seen new standards published on consolidated accounts, joint ventures and fair value measurement, all of which are required to be implemented in 2013. In the pipeline are standards on revenue recognition, leasing, insurance and financial instruments.
It is perhaps the financial instruments area where most difficulties are being experienced in developing the optimum overall model, and reaching agreement with the other main standard setter, the US Financial Accounting Standards Board. So much so that the IASB has already deferred mandatory implementation of the complete IFRS 9 from 2013 to 2015. Better to devote time and resources to developing optimum quality and practical solutions in such areas as impairment and hedging than to rush through what might ultimately prove to be an inadequate standard.
As with all IFRS standards, EU endorsement is required before IFRS 9 on financial instruments can be adopted by European companies. We have already seen political influences at play at EU level both at the time when IFRS was initially adopted for listed companies, with macro-hedging excluded, which remains to the present day and later at the peak of the financial crisis regarding classification of assets. A positive outcome of those influences was perhaps the decision at EU level not to adopt IFRS 9 on a piecemeal basis but rather to wait until all the components of a complete standard are in place. The deferral of implementation to 2015 should enable this to be achieved but there remains much to do in reaching consensus and ultimately an effective solution.
The ASB Proposals
Recently, the Accounting Standards Board (ASB) published its revised proposals for the 'Future of Financial Reporting in the UK and Republic of Ireland'. FRSSE (Financial Reporting Standard for Small Entities) continues for those small entities that wish to avail of it, perhaps more Irish companies will elect to do so. Listed entities will continue under regulation to adopt IFRS in preparing their consolidated accounts. For all other entities, the ASB is proposing adoption of a new standard, FRS 102 'The Financial Reporting Standard Applicable in the UK and the Republic of Ireland'. An attractive proposition as the current mish-mash of standards, extending to over 2,500 pages, would be reduced to a single standard of some 250 pages.
Based on the International Financial Reporting Standard for Small and Medium-sized Entities (IFRS for SMEs), there is much difference between the two. Perhaps the most notable areas of difference are the retention of the Companies Acts accounts formats and retention of a number of accounting treatment options, fundamental elements of current GAAP. A common-sense approach has also been applied to accounting for tax, with current GAAP plus some additional requirements being the proposed way forward.
Financial Instruments - Accounting Change
For many entities, the single biggest area of accounting change proposed by the ASB is in relation to financial instruments. The majority of entities, unless required by law or regulation to do so, do not adopt FRS 26 Financial Instruments: Recognition and Measurement and its associated standards or the fair value accounting rules. The requirements of FRS 102 address this and help to fill a gap in current accounting and a growing inconsistency between the way in which entities account and the economic realities of how they operate and transact business, with hedging and derivatives being a key ingredient. Even at a basic level, FRS 102 may well lead to some changes for many companies.
Section 11 'Basic Financial Instruments' and Section 12 'Other Financial Instruments Issues' are the parts of FRS 102 in which the ASB outlines the requirements. Both are effectively the same as the corresponding paragraphs in IFRS for SMEs, with some additional disclosures.
At the basic level...
For the majority of financial instruments commonly held by most companies, Section 11 is key as it deals with a range of commonly held assets and liabilities including cash, deposits, accounts receivable and payable and others. A major change to current accounting, with some exceptions where fair value measurement is required, is to require an amortised cost model for all basic financial instruments. This will not require any adjustment for the majority of assets and liabilities which are current short-term.
However, a common example of where it may change the accounting is in relation to loans, and debt instruments of a longer term, with a fixed principal repayment and a fixed rate of return or a variable rate linked to an observable rate (e.g. LIBOR). Such a loan will be recognised at amortised cost using the effective interest method, whereby the payable is recognised initially at the present value of the cash payable to the bank (interest payments and repayments of principal). Any subsequent changes to estimates of payments shall be accounted for by applying the loan's original effective interest rate to the re-estimated future cash flows. The effective interest rate is the rate that exactly discounts estimated future cash payments or receipts to the carrying amount, taking account of all contractual terms. The interest expense on the loan shall equal the carrying amount of the loan at the beginning of the period multiplied by the effective interest rate.
At a more complex level...
Section 12 of FRS 102 applies to other, more complex financial instruments and transactions. On initial recognition, such assets and liabilities are measured at fair value, normally the transaction price. At the end of each subsequent period fair value is also applied, except for unquoted equity instruments where fair value cannot be measured reliably, which are measured at cost less impairment. The fair value measurement process is similar to that of EU-adopted IFRS with the three-level hierarchial approach being adopted.
Much of what is included in Section 12 deals with hedge accounting, an example of which is foreign exchange forward contracts which are commonly used by many entities. Changes that FRS 102 will bring about are recognition of the underlying asset at the current exchange rate, rather than the contract rate as currently applies, with the fair value of the hedge being recognised. Subject to strict criteria being applied, hedge accounting may be used whereby the gain or loss on the hedging instrument and on the hedged item would be recognised in the profit and loss account. For many entities, this will be a new accounting discipline requiring commitment to training and support.
With the aforementioned IFRS 9 currently work in progress, the ASB intends to issue a supplementary exposure draft for financial instruments when the remaining IFRS 9 phases on impairment and hedging are completed. This will align the recognition and measure requirements in Sections 11 and 12 of FRS 101 with IFRS 9.
The question of which classes of entity would be within the scope of being 'publically accountable' was very much a contentious issue in the initial draft proposals published by the ASB in October 2010.
This was of particular significance to financial institutions.
Many of them will therefore welcome the revised ASB proposals which do not extend mandatory application of EU-adopted IFRS beyond the consolidated accounts of entities listed on regulated markets, as currently required.
However, the ASB recognises that financial institutions, those seeking to generate wealth from financial instruments, need to include additional disclosures in their financial statements of information to enable users evaluate the significance of financial instruments to their financial position and performance.
Accordingly, FRS 101 requires additional disclosures in relation to:
- Disaggregation of financial position line items by class of financial instrument
- Reconciliation of changes in impairment allowance accounts for each class of financial asset
- Analysis of financial instruments in accordance with fair value hierarchy
- Information to enable users to evaluate the nature and extent of credit, liquidity and market risks arising from financial instruments
These requirements are closely aligned with IFRS 7 Financial Instruments: Disclosures.
Reduced Disclosure Framework
Many companies in Ireland are part of a group, subsidiaries of both overseas multinationals and indigenous Irish companies. For such companies, the reduced disclosure framework (RDF) put forward in the ASB proposals for their company-only financial statements for 'qualifying entities' (both subsidiaries and parent company) should ease the disclosure burden. This is particularly so for groups applying EU adopted IFRS, or equivalent, where individual companies can use the same recognition and measurement process, but are exempt from a range of what may be very unwieldy disclosures, on the basis that they have already been attended to adequately in the group consolidated financial statements. Such 'qualifying entities' will be preparing financial statements in accordance with the Companies Acts, required to comply with prescribed formats and disclosures which may lead to some anomalous situations on adoption.
Financial institutions may if they are group companies avail of RDF, but are not entitled to avail of exemption from IFRS 7 Financial Instruments: Disclosure and IFRS 13 Fair Value Measurement.
RDF is also available to group entities adopting FRS 101, on a separate basis.
Irrespective of what financial framework entities adopt, the degree of change in the pipeline is very substantial. Time and resources will be needed to ensure adequate understanding and to develop the capabilities to deal with change.
First published in Finance Dublin Online.