Financial Instruments – Some Current Issues and Developments

Financial Reporting Brief: February 2022

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Never far away from the top of the agenda of financial reporting considerations is how an entity manages its finances, the instruments or mechanisms used, and how the presentation of these in the financial statements may influence the understanding that users have of an entity’s financial well-being and liquidity.

This has perhaps never been more so than in the last couple of years when Covid-19 called for a whole new focus by entities on their continuing and evolving operating capability in the shifting sands of the global pandemic. While restrictions may be lifted in this part of the world, the pandemic is not over. Elsewhere, mainly in less economically developed areas, its ravaging impact continues with more than 3 billion people still unvaccinated.

The general belief is that until the whole world has eradicated the pandemic or at least brought it under control, it will continue to be of major concern for global economic and social well-being. The International Monetary Fund (IMF), and many other global organisations, have expressed their concern that Covid-19 has given rise to economic devastation that may take many years to recover from. Ireland is in a better place going forward with the lifting of restrictions and forecasts of significant economic growth but there are deep concerns about cost inflation.

Entities, particularly those in certain industries, have been sheltered from the worst impact of the pandemic by support schemes from government and its various bodies, and also by banks and other financial institutions not pursuing debt settlement with the same rigour as in otherwise ‘normal’ times. This may change going forward and some that are teetering on the brink of financial collapse may not survive.

In the second quarter of 2020, particularly, it was no surprise that European Authorities, the International Organisation of Securities Co-ordinators (IOSCO) and the standard setters, including the International Accounting Standards Board (IASB) gave priority attention to reiterating the accounting principles regarding financial instruments and providing guidance to entities on the accounting for and disclosure of the overall financial framework.

Accounting for expected credit losses (ECL) is very much to the fore. Covid-19 has had a major impact on the quality of accounts receivable and loans. Pre-Covid-19, what had been low risk accounts that were collectible or being properly serviced have in many cases become doubtful because of collapses in income, doubts about going concern, or deferral of repayment because of government action to protect business.

There have been a number of reports published in recent months which comment on how banks have dealt with the high standards of reporting required, particularly since the pandemic began. These include reports by the European Banking Institute (EBI) and the European Banking Authority (EBA).

Other areas also became more prominent for consideration including, for example, (1) the rapidly increasing momentum towards sustainability, including climate change, and the escalating demand for robust reporting, and (2) supplier financing arrangements.

The IASB has begun its post-implementation review of IFRS 9, with a focus on classification and measurement. Its review of ECL and hedging relationships has been deferred until a later stage.

IFRS 9 – Post-Implementation Review (PIR)

The IASB PIR questions the effectiveness of IFRS 9 in providing useful information to users of financial statements regarding whether:

assessment based on an entity’s business model adequately shows how an entity manages its financial assets to generate cash flows;
a business model assessment can be applied consistently, i.e. whether the distinction between the different business models in IFRS 9 is clear, including dealing with any possible unexpected effects and how significant they are;
the benefits of the business model assessment outweigh costs and are of value to preparers of financial statements, users of financial statements, auditors and regulators;
conditions in IFRS 9 for a change in business model have been met by reclassifications, or otherwise, and whether these are appropriately dealt with;
the information about investments in equity instruments is useful considering the different treatments available under IFRS 9.

Our IFRS in Focus publication IASB seeks views on the post-implementation review of the IFRS 9 classification and measurement requirements provides a useful summary of the IASB project.

Covid-19: Quality of Disclosure

The European Banking Authority (EBA) has published a report summarising the findings of its monitoring activities on the implementation of IFRS 9 by European institutions, particularly during the pandemic, with a focus on the evaluation of the quality and adequacy of ECL models. The report observes that EU institutions have made significant efforts to implement and adapt their systems to the IFRS 9 requirements.

Concerns are expressed in the report, with some of its main findings being:

There is divergence in some accounting practices due to the inherent flexibility embedded in IFRS 9, with Covid-19 adding to associated complexities;
The pandemic pushed IFRS 9 models outside their boundaries, thereby increasing the use of manual adjustments, or overlays, with divergent results in the final ECL amount;
Some practices observed merit greater scrutiny from supervisors, in particular to ensure a timely assessment of a significant increase in credit risk.

The EBA report questions whether the disclosure by banks of Covid-19 impacts on other risk categories is sufficient to enable stakeholders to obtain a comprehensive view of most banks' risk positions, and expresses some dissatisfaction.

The report also expresses some dissatisfaction regarding disclosure in the areas of (1) impairment testing for both intangibles and tangibles, and (2) the effects on the fair value measurement and recoverability of deferred tax assets.

The European Banking Institute (EBI) has also published a similar report, primarily on the reporting of credit risk. It expressed the overall view that while much of the reporting has been appropriate, there is room for improvement in such areas as manual overlays and certain aspects of accounting policy disclosure.

While banks and other lending businesses continue to face the biggest challenges with regard to ECL (including the effects of climate change on credit risk in the longer term), the effect can also be significant for corporates. Regulators (for example, the European Securities and Markets Authority in its 2021 Common Enforcement Priorities) have highlighted a number of considerations of significance to financial institutions, but they may also be relevant to corporate entities with material exposure to variations in ECL. These include management overlays, significant changes in credit risk, changes in loss allowances and forward-looking information.

Our publication ‘Closing Out 2021’ includes a summary in relation to this topic, as well as many others that are current and relevant.

Green Bonds and IFRS 9

The global volume of ‘Green Bonds’ in 2020 was in the region of USD700 billion, and in the first half of 2021 a little over USD500 billion was issued, with more than 50% relating to European issuers. Sharp increases are anticipated in the coming years in such debt instruments, which have contractual features that link the cash flow with the ESG profile of the business.

Currently, practice is developing and constituents are addressing the ‘SPPI test’ (solely payment of principal and interest) for these instruments in different ways. The issue relates to the ESG features that introduce a cash flow variability in the financial instruments when they are held in a ‘held to collect’ or a ‘held to collect or sell’ business model. In addition, the variability introduced by the ESG feature may create issues with the application of the effective interest rate and subsequent measurement.

It is very important that accounting policy disclosure adequately explains the treatment adopted by the entity.

The ESG features may also create challenges for issuers. They will need to assess whether the ESG feature shall be considered an embedded derivative and whether ‘split accounting’ should be adopted.

Given the rapid growth of such financial instruments, particularly in the European market, there is a growing call for the issue to be addressed by the IASB on an urgent basis, separately from the PIR.

Supplier Finance Arrangements

Supplier finance arrangements are not new but they have become increasingly popular in recent years, taking on many different variations. Careful consideration is required to determine whether the financial liability should be presented as a trade payable or whether it should be presented as part of borrowings, with concerns expressed that information needs of users are not being properly met.

Concerns expressed include:

The manner in which they are presented on balance sheet may have a significant impact on the presentation of an entity’s financial position, particularly its leverage and gearing ratios;
It may not be clear from cash flow statements as to the key sources of cash generated;
Inadequate disclosure of borrowings and their related cash flows may undermine assessment of an entity’s financial position and liquidity.
Existing borrowing arrangements may restrict the purchaser’s ability to borrow from alternative sources or take on incremental borrowings without the approval of a purchaser’s principal lenders.

In an Exposure Draft published by the IASB in November, changes proposed by the IASB to IAS 7 and IFRS 7 provide that:

supplier finance arrangements are described in a manner that would consistently capture all arrangements that provide financing of amounts an entity owes its suppliers;
a disclosure objective is added to IAS 7 that would require an entity to provide information about its supplier finance arrangements that enables users of financial statements to assess the effects of those arrangements on an entity’s liabilities and cash flows;
Additional disclosure requirements to include:
- The terms and conditions of each supplier finance arrangement;
- the range of payment due dates;
- At the beginning and end of each accounting period, the carrying amount of financial liabilities that are part of the arrangements and amounts of individual arrangements where payments have already been received;
Aggregation would only be permitted for financial arrangements where terms and conditions are consistent;
In IFRS 7, it is proposed to add supplier finance arrangements as an example within liquidity disclosure requirements.

Our IFRS in Focus publication IASB proposes amendments to IAS 7 and IFRS 7 to address supplier finance arrangements provides a summary.

Conclusion

Challenges are always plentiful in dealing with the judgements and other complexities of accounting for financial instruments, with the related disclosure issues.

We draw attention to some of the more significant current issues and developments and provide some useful references to supporting guidance.

It is merely a snapshot, and it is incumbent on all involved to find time to maintain awareness and the ability to respond.

www.iasplus.com will help with the awareness process, and offers helpful guidance.