IAS 39 - Replacement a solution??

No one standard has been more responsible for drawing the whole issue of accounting standards into global focus and political debate than IAS 39 on the recognition and measurement of financial instruments. When transition to IFRS was taking place for European listed companies in 2005, IAS 39 was the one standard which was not adopted in full with the concept of 'carve-out' of certain requirements emerging at the time to appease the demands of certain European interest groups. In 2008 we had the first major episode of fast-tracking standard amendments and rapid fire endorsement by the EU - again it was IAS 39 with this time the issue being reclassification of financial assets.

Once again IAS 39 has been the focus of much attention during 2009 and is likely to continue to be within both accounting and financial reporting circles and also within broad economic and political circles. The issue on this occasion is the replacement of IAS 39, with the financial crisis heightening the demand for improved transparency and consistency in accounting for financial instruments.

Factors for Change

The economic crisis experienced over the past couple of years, combined with extreme difficulties in financial markets, has increased the focus of investors, regulators and other interested parties on the quality and clarity of financial reporting, with severe fluctuations experienced in reported performance and financial position and the dangers of what many see as pro-cyclical reporting becoming more and more evident.

Many observers have expressed views identifying three key reporting issues from the crisis, being:

• First, financial stability depends upon market confidence, and investor confidence, in turn, depends upon the transparency of financial statements
• Second, financial reporting and accounting standard setting must remain focused on the needs of investors
• Third, financial reporting must remain relevant and informative to investors, and should not impose unnecessary or costly burdens that do not add to investor understanding

Adopting these principles, the desirability of convergence on key accounting standards, particularly those relating to financial instruments and other areas relevant to the financial crisis, is seen to be fundamental.

These comments reflect on the views expressed by and actions influenced by many global organisations with such bodies as the G20 group of Ministers wielding significant influence over developments.

G20 Calls for Action

After its April 2009 summit meeting, the G20 group issued a communique requesting standard-setters to take immediate action in a number of areas, including those specifically relevant to IAS 39:

• To redouble efforts to achieve a single set of high quality, global accounting standards and complete the standards convergence project which is currently in progress by June 2011
• To take action to reduce the complexity of accounting standards for financial instruments by the end of 2009
• To take action to strengthen accounting recognition of loan loss provisions by incorporating a broader range of credit information by the end of 2009

The IASB and the U.S. FASB have recently issued a joint statement reaffirming their commitment to improve IFRS and U.S. GAAP and to bring about their convergence. In the interests of timely and continued progress, the two boards have committed to monthly joint meetings and to enhance accountability and transparency by providing quarterly updates on their progress on convergence projects.

IAS 39 Replacement Project

The IASB has taken on board a project to replace IAS 39 with a standard which has the objectives of simplifying the classification and measurement requirements for financial instruments, and to improve the decision-usefulness of financial statements for users.

The project is being carried out in three phases:

• Phase 1 - classification and measurement
• Phase 2 - impairment methodology
• Phase 3 - hedge accounting

The above 3-phased project is in addition to the work currently being carried out by the IASB on derecognition, with an exposure draft published on this subject matter earlier in 2009.

The status of each phase is as follows:

Phase 1

In November the IASB published the first section of IFRS 9: Financial Instruments - on the classification and measurement of financial assets. The Board is committed to completing equivalent work on financial liabilities expeditiously and will include requirements for financial liabilities in IFRS 9 in due course. Classification and measurement are being addressed first because they form the basis of the accounting standard and much of the concerns raised during the financial crisis arose from classification and measurement requirements.

The IASB has set a date for adoption of the standard of 1 January 2013, with earlier application permitted from 2009 onwards. However, the initial understanding that endorsement would be fast-tracked at EU level has been over-ruled with the endorsement process to take place in the normal manner which is likely to extend well into 2010 and may well be deferred until all phases of the project are complete and an overall view can be taken of the new standard. Therefore, European listed companies are not permitted to adopt the standard early for 2009.

In a letter from the European Commission (EC) to the IASB following publication of IFRS 9, the EC expressed some concerns that it would seem that the standard as published may not have struck the right balance between 'fair value accounting' and 'amortised cost accounting', and may lead to more instruments being classified at fair value through profit or loss compared to the existing IAS 39, thus potentially exacerbating income volatility.

Phase 2

In November the IASB published an exposure draft on impairment of financial instruments which proposes to modify the way impairment losses are recognised on financial assets measured at amortised cost from an 'incurred loss model' to an 'expected loss model'. The standard is expected to be published in 2010 with application in 2013.

Phase 3

An exposure draft on hedge accounting is expected to issue in the first quarter of 2010.

IFRS 9 - What Changes?

The new standard divides all financial assets currently in the scope of IAS 39 into two categories -amortised cost and fair value - and generally speaking between debt instruments and equity instruments. This compares with what many would see as the much more complex approach to asset classification under the current IAS 39.

The new approach to debt instruments is essentially premised on the entity's business model, i.e. what its intent is in relation to the instrument - hold or sell, and its cash flow characteristics regarding the contractual terms of the instrument. Debt instruments that are held by an entity to collect the contractual cash flows with the contractual terms specifying dates for payment of principal and interest are normally measured at amortised cost. All other debt instruments must be measured at fair value through profit or loss (FVTPL) and, subject to certain restrictions, this option is available for all debt instruments to be accounted for on that basis. There may also be reclassification if the entity's business model changes regarding its intent in relation to the investment.

All equity investments are to be measured at fair value, with movements in fair value recognised in profit or loss unless at initial recognition an irrevocable election is made that the investments are not held for trading and therefore movements in fair value will be brought through other comprehensive income. In certain circumstances, cost may be the best estimate of fair value.

The embedded derivative concept of IAS 39 is not included in IFRS 9. Consequently, embedded derivatives that under IAS 39 would have been separately accounted for at FVTPL because they were not closely related to the financial host asset will no longer be separated. Instead, the contractual cash flows of the financial asset are assessed in their entirety, and the asset as a whole is measured at FVTPL.

Convergence - Being Achieved?

A major determining factor in this is what approach is being taken by the FASB, and is it consistent with the IASB approach? The expectation is that the FASB will issue one exposure draft in the first half of 2010 that incorporates a single comprehensive model for accounting for financial instruments with the FASB moving towards an approach that is based on fair value measurement for all financial instruments.

With regard to impairment, the FASB has preliminarily decided to focus on a credit impairment approach that would require, at the end of each period, an impairment loss measured as the present value of management's current estimate of cash flows that are not expected to be collected.

There are some fundamental differences between the IASB approach and the FASB approach which will need to be fully considered if the objective of convergence is to be achieved.

Few people, if any, will have regrets regarding the replacement of IAS 39, a standard which the world has struggled to cope with for many years. Because of its complexity, many believe it has certain responsibility for creating a sense of distrust of the manner in which financial instruments are accounted for and reported. This has clearly been exacerbated during the financial crisis when there has been so much uncertainty and major fluctuations in reported performance by entities.

The new standard, however, must represent a firm improvement both in terms of quality of information and transparency of reporting. Differences in approach between the main standard-setters must be ironed out to provide an agreed-upon global platform for the reporting of financial instruments. Any fears or concerns at EU level regarding the appropriateness of the standard must also be fully dealt with. The integrity and credibility of financial reporting going forward would be greatly assisted by a reliable and understandable standard on financial instruments.

Brendan Sheridan, Director of Financial Reporting Services, Deloitte