PwC IFRS blog

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.

IFRS 2009 – less to implement than 2005 but critical issues to influence

In July 2006, the IASB gave an undertaking that it would not make any major new standards effective before 2009. This move acknowledged that the many companies that had adopted IFRS in 2005 would benefit from a period of stability. On one hand, this has enabled the financial reporting community to enjoy a period of relative calm, but on the other hand, there has been fear that 2009 would be another year of upheaval with a large number of new standards needing to be implemented all together. Indeed, many who visit this blog do so because they have an interest in “IFRS 2009” or a similar topic.

We are now well into 2008 so it is likely that the only new or amended standards that will apply in 2009 are those that we already know about – and it is not as many as were originally on the agenda. The provisions amendment to IAS 37, for example, has been delayed, while the joint ventures standard, which is expected to prohibit proportional consolidation, is not expected before the final quarter of this year.

The only entirely new standard due for implementation in 2009 is IFRS 8, Operating Segments, which will require management to consider their approach for disclosure of their operating segments. The other key requirements for 2009 are amendments to the following:

• IAS 1, Presentation of Financial Statements’
• IAS 23, Borrowing Costs
• IAS 32, ‘Financial instruments: Presentation’
• IFRS 2, ‘Share-based Payment

The much talked about revision to IFRS 3, Business Combinations, will not apply to most companies until their 2010 year ends (it actually applies to accounting periods beginning on or after 1 July 2009).

Changes on the horizon

But this is not the full story. There may be little new double-entry bookkeeping to do in the next year or so, but changes are on the horizon that will go to the very heart of financial reporting.

Last week, the IASB issued a discussion paper on the subject of financial liabilities with characteristics of equity. Many people refer to this as the debt/equity question. This is a wide-ranging project that will affect most companies and could fundamentally change the way in which debt and equity are dealt with in the financial statements. But this is only the first instalment of what could be a fascinating series of publications by the IASB this year. Other discussion papers and exposure drafts that the IASB says it will publish this year include:

• Post-retirement benefits, including pensions
• Revenue
• Financial statement presentation
• Income tax, including deferred tax
• Financial instruments – a replacement for IAS 39

These are very important topics that have the potential to really change the way you account for your business and possibly the way investors value your business.  You may not be moved to comment on all issues and papers, but you will probably want to consider which topics throw up critical issues for you and contribute your views to the debate before the standards are set in stone.

Time to examine priorities

A few weeks ago, in a previous posting, I asked whether the projects on the IASB’s current agenda are so important that progress needs to be made urgently, or is insufficient attention being paid to agreeing the underlying principles in the Framework?

There is another angle. Many of the projects on which the IASB is currently focusing its attention (including the first four in the list above) are described as ‘convergence projects’. In other words, they were originally driven by the ambition to converge IFRS and US GAAP. Is this still the best goal for the IASB? One of the objectives that the IASB and the FASB signed up to in their Memorandum of Understanding in 2006 was to remove the requirement for a US-GAAP reconciliation in the financial statements of foreign private issuers. Now that the reconciliation requirement has been lifted, it might be the right time to reappraise these goals and ask what the IASB’s priorities should be in building and sustaining robust global standards.

I would be very interested in your views, either by email or by commenting here.