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Responding to the International Accounting Standards Board’s (IASB) exposure draft reviewing IAS39, Ernst & Young says that it believes “it is the complexity and riskiness of financial instruments themselves, not the way they are accounted for,” that was one of the underlying causes of the financial crisis.
Ernst & Young thinks that through its proposals, the firm has found a way to bring together the many views and differing stakeholder concerns and set a potential scene for the convergence of standards in the future.
Recognising the IASB’s move to review the standard as a “challenging project to reduce complexity in reporting financial instruments”, Ernst & Young also supports recent calls by the G20 to improve the regulation of complex financial instruments.
“The IASB and the Financial Accounting Standards Board (FASB) are moving at a very different pace and have come up with dissimilar proposals for financial instruments, partly due to conflicting demands of various stakeholders including the European Commission, analysts, banks and other financial statement preparers,” says Ernst & Young in its response letter.
Joint effort required
Ernst & Young says that it would be able to support much of the IASB’s proposals. But it strongly believes that any changes to accounting for financial instruments need to be made with the joint efforts of the two boards, so that there is no further pressure on both the IASB and FASB by constituents calling for a “level playing field” or for accounting arbitrage on this significant topic. The firm also acknowledges that there are there are some concerns that the IASB’s proposals do not adequately address the demands of certain stakeholders.
Ruth Picker, Global Leader of IFRS at Ernst & Young, said: “Our proposed approach is two-pronged. One aspect of the approach is to facilitate convergence, while the other aspect is to balance the various stakeholder requests of the IASB. Overall, we believe our suggested way forward achieves both of these objectives simultaneously.”
The way forward
Ernst & Young’s proposals for IAS39 steer a path for convergence between the IASB and the FASB and attempt to balance the demands of various stakeholders. However, the recommendations also contain elements that could be adjusted should convergence not be achievable. Ruth Picker concluded: “We acknowledge that the need to balance conflicting stakeholder needs means that our proposal has more complexity than the IASB’s proposals, but the proposal is considerably simpler than the current standard and we believe it is operational. The proposal demonstrates that there is common ground and that the Boards should be able to work in a coordinated manner to arrive at a mutually acceptable result.” Ernst & Young’s headline proposals are outlined below.
On fundamental principles
- Financial instruments would be measured at fair value through other comprehensive income (OCI), fair value through profit or loss or amortised cost.
- All assets and liabilities held for trading and all derivatives (other than those used for cash flow hedge accounting) should be measured at fair value through profit or loss.
On debt instruments
Debt instruments, including loans and receivables, should be measured at amortised cost if they meet the following criteria:
- contain only “basic loan features”;
- are “primarily held for collection of principal and interest” (similar to the terminology used in the FASB model, which we believe is clearer than the “managed on a contractual yield basis” proposed by the IASB); and
- they would meet the IAS 39 definition of ‘loans and receivables’, including that are not quoted in an active market.
Debt instruments that are not held for trading, but are quoted in an active market and meet the criteria mentioned in 3a and 3b above, would be measured at fair value through OCI. (As mentioned above, we propose this approach for the purpose of IFRS-US GAAP convergence in that debt securities with a readily determinable fair value would be measured at fair value through OCI, consistent with the FASB’s preliminary approach). Impairment for these instruments would be calculated on the same basis as for amortised cost assets ie, only credit losses would be recognised in profit and loss (similar to the approach taken by the FASB in April 2009). Any realised gains and losses on derecognition of such instruments would be recycled from OCI to profit or loss.
However, despite its best efforts, should the IASB conclude that convergence is no longer achievable, we could support measuring such instruments at amortised cost, in accordance with the IASB’s current proposals.
All other debt instruments, including those that have non-basic loan features or complex embedded derivatives (and hence do not meet the measurement criteria for amortised cost or fair value through OCI), would be measured at fair value through profit or loss.
On securitised debt
For investments in the notes issued by securitisation structures, the IASB’s proposals only allow the most senior tranche to be measured at amortised cost and require others to be measured at fair value through profit or loss. While reducing complexity, we have concerns regarding such an unduly form-driven approach, but recommend an alternative approach, such as requiring a “look through” to the underlying assets of the structure. While such an approach would be operationally more complex, it would potentially allow more tranches to be recorded at amortised cost (than proposed by the IASB) and also reduce the opportunities for structuring.
On equity instruments
The IASB's approach requires all other equity instruments to be measured at fair value – through profit or loss or OCI, by choice, on an instrument by instrument basis. We are generally supportive of this approach as it would eliminate the much debated issue of whether a decline in fair value of available for sale equity securities ‘is significant or prolonged’ under IAS39 or ‘other than temporary’ under US GAAP. However, because of concerns about dividend income being taken through OCI under the IASB’s model, we would support an alternative approach which essentially retains the existing available-for-sale category for investments in equity securities, but with more clearly defined and operational impairment rules that also allow for reversals of impairment.
Financial liabilities
We agree with the IASB’s proposals to record financial liabilities at amortised cost (if they have only basic loan features and are held for payment of principal and interest) or fair value through profit or loss. However, as mentioned in our response to the Discussion Paper Credit risk in liability measurement, we recommend a minor modification for financial liabilities at fair value but not held for trading, by requiring changes in fair value related to own credit risk to be recorded through OCI, with recycling from OCI to profit or loss upon any early extinguishment of the liability, if applicable.
Reclassifications
The IASB’s proposals do not allow a reclassification of financial instruments from one category to another subsequent to initial recognition. On balance, we generally support the IASB’s approach to not permit reclassifications in most circumstances. However, we believe that there is merit in requiring reclassifications (on a portfolio basis rather than instrument by instrument) under very limited circumstances such as a significant change in an entity’s business model. We recommend that adequate disclosures be made if any reclassifications are made subsequent to initial recognition.
Transitional rules
The transitional rules requiring retrospective application of the new classification and measurement standard seem particularly onerous. While we agree that financial statements need to be restated retrospectively so as to remain comparable, we believe that it would be more practical and simpler for entities to adopt the new classification and measurement standard if there is some transition relief.
We recommend there should be an option to apply the new classification criteria as an adjustment to the opening retained earnings as at the beginning of the year of initial application, for those entities adopting the new standard in a financial year beginning before 31 December 2010, and the beginning of the immediate comparative year for those entities adopting the new standard in 2011. This would permit the immediate comparative year to be restated based on revised hedging designations and impairment assessed without the benefit of hindsight. This would be similar to the transition relief provided for application of IAS 39 when entities converted to IFRS in 2005.
Insurance companies
We believe it will be difficult for insurers to make choices under the new standard for financial assets without knowing what the final measurement requirements for the related insurance liabilities will be. However, we note that IFRS 4 permits financial assets to be reclassified at fair value through profit or loss whenever an insurer changes its accounting policies for insurance liabilities. We are concerned that insurers may have to perform two major financial asset reclassification exercises
within a short period of time, as the proposals of this ED are likely to be mandatory by 2012 whereas the revised IFRS 4 may not be available until 2014.
We recommend that, to alleviate concerns for insurers, the Board should provide transition guidance or relief (similar to the possible scope exclusion being considered in the revenue recognition project) such that entities can continue to apply their existing accounting principles and are not required to make several changes within a short span of time. When the Board completes its project on insurance contracts, we believe it would be appropriate to require insurance companies to conform their financial instrument accounting policies not scoped into the insurance contract standard to the revised standards on financial instruments.
About Ernst & Young
Ernst & Young is a global leader in assurance, tax, transaction and advisory services. Worldwide, our 135,000 people are united by our shared values and an unwavering commitment to quality. We make a difference by helping our people, our clients and our wider communities achieve their potential.
www.ey.com/Luxembourg
Ernst & Young thinks that through its proposals, the firm has found a way to bring together the many views and differing stakeholder concerns and set a potential scene for the convergence of standards in the future.
Recognising the IASB’s move to review the standard as a “challenging project to reduce complexity in reporting financial instruments”, Ernst & Young also supports recent calls by the G20 to improve the regulation of complex financial instruments.
“The IASB and the Financial Accounting Standards Board (FASB) are moving at a very different pace and have come up with dissimilar proposals for financial instruments, partly due to conflicting demands of various stakeholders including the European Commission, analysts, banks and other financial statement preparers,” says Ernst & Young in its response letter.
Joint effort required
Ernst & Young says that it would be able to support much of the IASB’s proposals. But it strongly believes that any changes to accounting for financial instruments need to be made with the joint efforts of the two boards, so that there is no further pressure on both the IASB and FASB by constituents calling for a “level playing field” or for accounting arbitrage on this significant topic. The firm also acknowledges that there are there are some concerns that the IASB’s proposals do not adequately address the demands of certain stakeholders.
Ruth Picker, Global Leader of IFRS at Ernst & Young, said: “Our proposed approach is two-pronged. One aspect of the approach is to facilitate convergence, while the other aspect is to balance the various stakeholder requests of the IASB. Overall, we believe our suggested way forward achieves both of these objectives simultaneously.”
The way forward
Ernst & Young’s proposals for IAS39 steer a path for convergence between the IASB and the FASB and attempt to balance the demands of various stakeholders. However, the recommendations also contain elements that could be adjusted should convergence not be achievable. Ruth Picker concluded: “We acknowledge that the need to balance conflicting stakeholder needs means that our proposal has more complexity than the IASB’s proposals, but the proposal is considerably simpler than the current standard and we believe it is operational. The proposal demonstrates that there is common ground and that the Boards should be able to work in a coordinated manner to arrive at a mutually acceptable result.” Ernst & Young’s headline proposals are outlined below.
On fundamental principles
- Financial instruments would be measured at fair value through other comprehensive income (OCI), fair value through profit or loss or amortised cost.
- All assets and liabilities held for trading and all derivatives (other than those used for cash flow hedge accounting) should be measured at fair value through profit or loss.
On debt instruments
Debt instruments, including loans and receivables, should be measured at amortised cost if they meet the following criteria:
- contain only “basic loan features”;
- are “primarily held for collection of principal and interest” (similar to the terminology used in the FASB model, which we believe is clearer than the “managed on a contractual yield basis” proposed by the IASB); and
- they would meet the IAS 39 definition of ‘loans and receivables’, including that are not quoted in an active market.
Debt instruments that are not held for trading, but are quoted in an active market and meet the criteria mentioned in 3a and 3b above, would be measured at fair value through OCI. (As mentioned above, we propose this approach for the purpose of IFRS-US GAAP convergence in that debt securities with a readily determinable fair value would be measured at fair value through OCI, consistent with the FASB’s preliminary approach). Impairment for these instruments would be calculated on the same basis as for amortised cost assets ie, only credit losses would be recognised in profit and loss (similar to the approach taken by the FASB in April 2009). Any realised gains and losses on derecognition of such instruments would be recycled from OCI to profit or loss.
However, despite its best efforts, should the IASB conclude that convergence is no longer achievable, we could support measuring such instruments at amortised cost, in accordance with the IASB’s current proposals.
All other debt instruments, including those that have non-basic loan features or complex embedded derivatives (and hence do not meet the measurement criteria for amortised cost or fair value through OCI), would be measured at fair value through profit or loss.
On securitised debt
For investments in the notes issued by securitisation structures, the IASB’s proposals only allow the most senior tranche to be measured at amortised cost and require others to be measured at fair value through profit or loss. While reducing complexity, we have concerns regarding such an unduly form-driven approach, but recommend an alternative approach, such as requiring a “look through” to the underlying assets of the structure. While such an approach would be operationally more complex, it would potentially allow more tranches to be recorded at amortised cost (than proposed by the IASB) and also reduce the opportunities for structuring.
On equity instruments
The IASB's approach requires all other equity instruments to be measured at fair value – through profit or loss or OCI, by choice, on an instrument by instrument basis. We are generally supportive of this approach as it would eliminate the much debated issue of whether a decline in fair value of available for sale equity securities ‘is significant or prolonged’ under IAS39 or ‘other than temporary’ under US GAAP. However, because of concerns about dividend income being taken through OCI under the IASB’s model, we would support an alternative approach which essentially retains the existing available-for-sale category for investments in equity securities, but with more clearly defined and operational impairment rules that also allow for reversals of impairment.
Financial liabilities
We agree with the IASB’s proposals to record financial liabilities at amortised cost (if they have only basic loan features and are held for payment of principal and interest) or fair value through profit or loss. However, as mentioned in our response to the Discussion Paper Credit risk in liability measurement, we recommend a minor modification for financial liabilities at fair value but not held for trading, by requiring changes in fair value related to own credit risk to be recorded through OCI, with recycling from OCI to profit or loss upon any early extinguishment of the liability, if applicable.
Reclassifications
The IASB’s proposals do not allow a reclassification of financial instruments from one category to another subsequent to initial recognition. On balance, we generally support the IASB’s approach to not permit reclassifications in most circumstances. However, we believe that there is merit in requiring reclassifications (on a portfolio basis rather than instrument by instrument) under very limited circumstances such as a significant change in an entity’s business model. We recommend that adequate disclosures be made if any reclassifications are made subsequent to initial recognition.
Transitional rules
The transitional rules requiring retrospective application of the new classification and measurement standard seem particularly onerous. While we agree that financial statements need to be restated retrospectively so as to remain comparable, we believe that it would be more practical and simpler for entities to adopt the new classification and measurement standard if there is some transition relief.
We recommend there should be an option to apply the new classification criteria as an adjustment to the opening retained earnings as at the beginning of the year of initial application, for those entities adopting the new standard in a financial year beginning before 31 December 2010, and the beginning of the immediate comparative year for those entities adopting the new standard in 2011. This would permit the immediate comparative year to be restated based on revised hedging designations and impairment assessed without the benefit of hindsight. This would be similar to the transition relief provided for application of IAS 39 when entities converted to IFRS in 2005.
Insurance companies
We believe it will be difficult for insurers to make choices under the new standard for financial assets without knowing what the final measurement requirements for the related insurance liabilities will be. However, we note that IFRS 4 permits financial assets to be reclassified at fair value through profit or loss whenever an insurer changes its accounting policies for insurance liabilities. We are concerned that insurers may have to perform two major financial asset reclassification exercises
within a short period of time, as the proposals of this ED are likely to be mandatory by 2012 whereas the revised IFRS 4 may not be available until 2014.
We recommend that, to alleviate concerns for insurers, the Board should provide transition guidance or relief (similar to the possible scope exclusion being considered in the revenue recognition project) such that entities can continue to apply their existing accounting principles and are not required to make several changes within a short span of time. When the Board completes its project on insurance contracts, we believe it would be appropriate to require insurance companies to conform their financial instrument accounting policies not scoped into the insurance contract standard to the revised standards on financial instruments.
About Ernst & Young
Ernst & Young is a global leader in assurance, tax, transaction and advisory services. Worldwide, our 135,000 people are united by our shared values and an unwavering commitment to quality. We make a difference by helping our people, our clients and our wider communities achieve their potential.
www.ey.com/Luxembourg
