Accounting for financial instruments – will the future be fair?

Having waited eagerly for the IASB to take its next steps towards improving its standards on accounting for financial instruments, we now have the second discussion paper in a matter of only a few weeks. At the end of February, we saw a discussion paper on the subject of financial liabilities with characteristics of equity (the so-called ‘debt/equity’ issue). Three weeks later, the IASB has issued a discussion paper on the broader topic of ‘reducing complexity in reporting financial instruments’. The ultimate aim of this project is to develop a replacement for IAS 39.

Over the years, IAS 39 has been subject to a fair amount of criticism. It is the only in-force standard that has not been fully endorsed for use within the European Union. We have, however, learned to live with IAS 39 despite the IASB’s chairman, Sir David Tweedie, recently referring to it as “a by-word for being well-nigh incomprehensible”. Nevertheless, any project that seeks to reduce the complexity in reporting financial instruments has to be a good thing.

There have been many conferences over the past few years where a quote, often attributed to Sir David Tweedie, is used to stimulate debate. That is, “IAS 39 could be replaced by a very simple standard that is only two sentences long. First, measure all financial instruments at fair value. Second, re-read the first sentence!”

The discussion paper maintains the view that fair value seems to be the only measure that is appropriate for all types of financial instruments, and that a full fair value model would be much simpler to apply than the current mixed model. This would be a big step, so several interim solutions are proposed, without losing sight of the long term aim. For example, should the number of measurement categories for financial assets be reduced? Can the hedge accounting rules be simplified? Would the standard be easier to apply if all financial instruments were measured at fair value unless they meet certain exception criteria?

However, it is the suggestion that we should move towards measuring all financial instruments at fair value that is likely to get the most attention. To explain its view, the IASB contrasts instruments with highly variable cash flows, such as derivatives, with instruments with fixed or only slightly variable cash flows, such as debt. It argues that fair value is the only relevant measure for instruments with highly variable cash flows. For instruments with fixed or only slightly variable cash flows, accreted cost may be a feasible alternative to fair value. Even so, the discussion paper puts several arguments in favour of the view that fair value measurement for all types of financial instruments would be preferable, namely:

• A single measurement basis for all financial instruments would eliminate any confusion about the measurement of different financial assets.
• There would be no need to consider when and how to quantify impairment losses.
• Fair value better reflects the price of a financial asset that would be received if an entity needed to sell an asset at the balance sheet date. Even if management has no plans to sell the asset, the information is useful.
• For financial assets, it provides information about anticipated future losses, not just losses that have been incurred.
• For financial assets, it provides information about improvements in credit risk since origination or acquisition.
• For financial liabilities, entities with comparable credit ratings and obligations will report liabilities at comparable amounts.
• For financial liabilities, fair value would result in an entity reporting the same measure for two equally secure payment obligations with identical cash flow.
• Fair value better reflects the cash flows that would be paid if liabilities were transferred at the measurement date.

At the same time, the discussion paper acknowledges the concerns that many have expressed about fair value measurement. What is the relevance of reporting fair value changes and the resulting volatility of earnings? Why should unrealised gains and losses be included in earnings? Can fair value always be measured reliably? It also recognises that there are issues to be resolved before fair value measurement for financial instruments can become a universal requirement, namely:

• Presentation: how should the effects of changes in fair values be presented in earnings?
• Disclosure: what information about financial instruments should be disclosed?
• Measurement: what is the definition of fair value and how should it be measured?
• Scope: what is the appropriate definition of a financial instrument and which financial instruments, if any, should be outside the scope of a standard?

These are not small obstacles to overcome, so we may be embarking on a long journey. But if you want to influence the debate you need to get involved now. I would be very interested in your views, either here or by email.