The paper from the IASB on the changes to IAS 39 are both more and less interesting than they first appeared. There are a lot of possible changes in there, but at the moment (and as you would expect) they are heavily hedged with questions and possibilities.
First – a word about the process from here. This part of the draft covers only the classification and measurement of financial instruments – so nothing on impairment or hedging, but perhaps there are some hints on the way they are headed. Comments on the draft are due by September 14 and they seem to be hoping to have a finalised new IFRS on this area only by the end of the year. Ambitious, perhaps, but given the relatively focussed nature of the questions in here, possible.
The other sections of IAS 39 will then be progressively deleted as
the relevant sections of it are replaced by the new IFRS. The Board
expects to have all this finished, with a shiny brand new IFRS that
completely replaces IAS 39 to be mandatorily adopted by January 2012,
with early adoption permitted. Given work has been progressing for years
on this having a further 2 and a half years to bed down the transition
is probably enough.
The changes are mainly on the asset side, as the liability side essentially always only had the two categories, so I will concentrate there. Liability side changes are largely consequential – with one open question.
As stated earlier, the big change in the standard will be the elimination of two of the categories of financial instruments, leaving just two – or that is what appears at first sight. In reality there will be three, with the previous classification of fair value through equity being retained. They are:
- Fair value through the income statement (FV from here on)
- Fair value through other comprehensive income (OCI); and
- Amortised cost (AC),
with the election to be made at recognition, no reclassifications permitted and no tainting provisions. The only instruments that will be allowed to use the AC method with be those with “basic debt features” and everything else – including all equity (whether held for trading or not) will be held at fair value – either FV or OCI.
While at first sight this looks like a big change, in reality it is not. The only category that has really been lost is the “held to maturity” which, with its tainting provisions, was rarely used as it was just too dangerous.
This issue (one of the most painful in the old standard) has also been greatly simplified in this draft – with no bifurcation requirements if the host contract is also a financial instrument. This means that contracts with embeddeds will not need any special treatment as you can treat the whole thing as one.
It wold be difficult to imagine many contracts with “basic debt features” having big embedded derivatives, so in practice this means that they will all be FV, unless you decide to go the OCI route.
It looks like the requirement to bifurcate will remain for non-financial host contracts – although this is uncertain at the moment – but this is as it should be.
A big change is the treatment of non-quoted equity, with the requirement to treat this at fair value. In the old standard, provided you could effectively prove that getting a fair value was difficult, you were allowed to hold these investments at cost – with impairments recognised if needed.
This concession is gone from this draft – but they ask the question as to whether it should be. If it stands, this means that you will need to determine a fair value for all equity you hold other than in associates or subsidiaries as they are under another standard. Presumably you would elect to hold these as OCI investments, but this is still going to be a pain for many. Expect a lot of submissions on this question.
Of course, this is going to result in some changes in the way that financial instruments currently held (or purchased before implementation) will need to be held afterwards. Those equity investments currently held at cost will need to be fair valued and an election made as to whether to use OCI or FV. I would expect OCI to be where the overwhelming majority will go. The changes will need to be applied retrospectively, so you will need to change retained earnings and current year income as a result.
The Next Steps
This draft gives a good picture of where the changes are heading – making the standard much, much simpler but putting a few noses out of joint at the same time. I will be fascinated to see how they tackle cash flow hedging as a result of this. Making it simpler would be great (and this is one area that I like the FAS 133 method) but I do not see how they can get it too much simpler without making it as lax as the old standards had it.
The impairment provisions have not (so far) been touched either. Given that the bulk of assets will now be measured at fair value this is probably less of an issue, but many of the comments I have heard on the impairment process over the last few years are barely printable, so I would expect some changes here. As the economy recovers over the next couple of years this is also likely to diminish as an issue, but it would be good to get this right before the next downturn. Upturns are normally the best time to be doing this sort of thing so that everyone is happy with the requirements long before they seriously have to apply them.
The big question on the liability side has always been the one on credit risk – that is whether, when you have a liability out there, whether you get to write down its value to “fair value” based on the possibility that you may default. For example – let’s say you are a big chld care firm in Australia. You issue large quantities of bonds in the US that are rated, say, BBB+ when written. You decide to hold the liability at fair value through P&L.
If you are going through a rough patch due to, say, building too many centres, can you write down the value of the liability based on the fact that your bonds are now trading at a 50% discount? Obviously the problem here is the going concern principle – a default on your liabilities (the only way to realise any such reduction in your liabilities) will then mean that the going concern basis of your accounts will probably be lost. The discussion paper (at IN 12 through 14) points to a discussion paper released in June on this topic.
The exposure draft looks at three possibilities (the three in the discussion paper) and asks for submissions – but they state they prefer the third mooted method, which looks fairly complex. If you are interested in this area, a look at the discussion paper would be almost mandatory. You have until September 1 to comment.
Watch this space.
19 July, 2009 at 10:31
“The impairment provisions have not (so far) been touched either. Given that the bulk of assets will now be measured at fair value this is probably less of an issue”
–> why do you expect that there will be more assets measured at fair value with this possible new approach? Before, FVTPL and AFS was measured at fair value. HTM and L&R was measured at amortised cost. Concerning the big European banks, the HTM category is almost non existing at this moment. So, there will still be the former L&R category (still almost 50% on balance sheets of a lot of financial institutions) measured at amortised cost, no?
19 July, 2009 at 10:46
As far as I can see the loans and receivables category has been narrowed to only those instruments with “basic loan features”, a narrower definition than before (but you are right, it will cover many, if not most, assets of your typical bank). The abolition of the exemption for private equity holdings will also move all of that category wholesale into the fair value category.
You are right, though – for many if not most banks saying “the bulk” is overstated.
There will be an increase, though.
19 July, 2009 at 21:50
Ok, I agree with that.
Already looking forward to the changes to the impairment rules and your comments on it. Furthermore, also curious what will be the outcome of the procyclicality debate : expected loss model impairments, higher capital as such (in Europe there are already offical proposals for this), other non distributable economic cycle reserves, etc.
20 July, 2009 at 03:15
If we can get a simple set of impairment rules I will be happy – but surprised.
As for the procyclicality debates – FWIW my opinion is that the numbers should be left to be what they are. Trying to manipulate published numbers (either Basel II pillar 3 or statutory accounts) to fit with arbitrary ideas what the numbers should be (rather than what they are) is always a mistake. Reducing transparency in published numbers just leads to distrust, and distrust is not something any bank needs.
Japan and Lloyd’s tried having number that were either massaged or heavily delayed and it help neither one. The EU should not make the same mistake.
As for higher capital – I am at best ambivalent. Having bags of capital around increases costs for everyone and does not address (in fact actually hurts) many liquidity considerations.
An extra 20% in capital (an increase from the 10% RWA that is fairly typical to 12%) would not have helped many of the banks that had trouble. An improvement in management would have.
28 August, 2009 at 20:37
I’m certainly interested to see if many changes are proposed for impairments against Amort Cost exposures.
The whole issue over the smoothing of provisions looks like a minefield to me. In my mind, that is what capital is for.
However, I also agree that capital was largely not the issue, it is (was) liquidity and capital has nothing to do with that.
The other issue, for me, was the over valuation of vague financial instruments that inflated the value/profit of business with no basis in yield/risk terms but based on a overhyped market valuation (for a while). Fix that long term, for all applicable exposures and I’ll be happier.
29 August, 2009 at 08:13
http://bit.ly/11FcEE : There is a new but short publication of the BCBS concerning IAS 39 : http://bit.ly/JE0Jn
29 August, 2009 at 19:53
Did you write this post Andrew? I didnt know you were an accountant. Anyway its quite an impressive summary.
30 August, 2009 at 16:09
I did write it. To work in this area you need a strong understanding of the accounting standards.