Blowing away the accounting haze

The global financial crisis highlighted the shortcomings of accounting standards and how banks that engaged in lending accounted for credit losses. It also raised questions about whether the recognition of credit losses ought to be more forward-looking. Much criticism has been thrown at the incurred loss model for presenting an initial, over-optimistic assessment of no credit losses, only to be followed by large adjustments once a trigger event occurs. Additionally, fair value of certain equity investments also came under scrutiny. These issues were very real for many GCC banks and investment houses.

Proposed accounting changes will have a significant impact on Gulf institutions. The International Accounting Standards (IAS) board's proposals to amend the important IAS 39 will impact the way impairment losses are recognised on financial assets as well as how equity investments are booked.

Currently, IAS 39 recognises impairment of financial assets using an incurred loss model approach. An incurred loss model assumes that all loans will be repaid until evidence to the contrary is identified. Only at that point is the impaired loan written down to a lower value.

The new proposals, which will impact both net interest revenue and credit impairment, incorporate an expected loss model whereby expected losses are recognised throughout the life of a loan or other financial asset, not just after a loss event has been identified. Accordingly, they will be recognised much earlier. The expected loss model avoids the mismatch under the current model – front-loading of interest revenue while the impairment loss is recognised only after a loss event occurs. Under the new approach, an allowance for expected losses is gradually built over the life of a financial asset by deducting a margin for future credit losses from gross interest revenue, even if no losses have yet been incurred.

Importantly, the proposals will change the way debt instruments are measured. A debt instrument that meets two conditions – business model test and cash flow characteristics – can be measured at amortised cost. For the business test, the objective of the entity's business model must be to hold the financial asset to collect the contractual cash flows [rather than to sell the instrument prior to its contractual maturity to realise its fair value changes]. For cash flow, the contractual terms of the financial asset give rise on specified dates to cash flows that are solely payments of principal and interest on the principal outstanding. All other debt instruments must be measured at fair value through profit or loss (FVTPL). Even if an instrument meets the two amortised cost tests, IFRS 9 contains an option to measure such instruments at FVTPL, with some restrictions. The category into which the asset is classified determines whether it is measured on an ongoing basis at amortised cost or fair value. The available-for-sale and held-to-maturity categories, the value booked which can be subjective, currently in IAS 39 are not included in IFRS 9.

IAS 39 requires the classification of financial assets into one of four classes, each having its own eligibility criteria and different measurement requirements. The eligibility criteria are a combination of the nature of the instrument, its manner of use and management choice. IAS 39 has 'tainting rules' that force an entity to reclassify to fair value through profit or loss all financial assets classified as held to maturity if more than an insignificant amount of the financial assets in this class are sold before their maturity date.

All equity investments are to be measured at fair value in the balance sheet, with value changes recognised in profit or loss. There is no 'cost exception' for unquoted equities. However, if the equity investment is not held for trading, an entity can make an irrevocable election at initial recognition to measure it at fair value through other comprehensive income (FVTOCI) with only dividend income recognised in profit or loss. Despite the fair value requirement for all equity investments, IFRS 9 contains guidance on when cost may be the best estimate of fair value and also when it might not be representative of fair value.

For debt instruments, reclassification is required between FVTPL and amortised cost, or vice versa, if the entity's business model objective for its financial assets changes so its previous model assessment would no longer apply. This is one area of potential subjectivity and weakness in the proposed changes. A presentation option is available in IFRS 9 for investments in equity investments that are strategic investments. If they meet the criteria, an entity may elect, at initial recognition, to record all fair value changes for such equity instruments in other comprehensive income.

IAS 39 has an exception to the measurement rules for unquoted equity instruments for which fair value cannot be measured reliably. Such financial assets are measured at cost. In IFRS 9, all equity investments must be measured at fair value. To alleviate concerns about the ability to measure some such investments at fair value, the International Accounting Board will provide application guidance to help entities identify the circumstances in which the cost of equity instruments might be representative of fair value.

Some still argue that the approach should be that all financial instruments are measured at fair value. However, the proposed mixed attribute approach is practical. One possible alternative is where fair value measurement is the "default" and amortised cost is used only when fair value is unreliable or impractical.

The impact for banks and other investment entities will differ. For some, the proposals will lead to more financial assets being measured at fair value than is currently required. For others, fewer instruments will be measured at fair value.

Whether an entity will have more or fewer financial assets measured at fair value as a result of applying IFRS 9 will depend on the nature of their business and the nature of the instruments they hold. The more risky financial assets an entity holds the more likely it is that those financial assets will be measured at fair value.

The new rules, expected to be finalised in 2010 and to take effect in 2013, will present major challenges for financial institutions in the region.


- The author is a US-based commentator on business issues

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