Accounting and Financial Reporting Developments for Canadian Banks

Over the past year or two, accounting standard setters have learned the hard way that you cannot please everyone. Not only are there the investors and debt holders who are the primary users of financial statements, but there are a variety of other stakeholders, users and interested parties, whose needs and views must be considered.

It is the multiplicity of interested parties and the complexity of the information to be conveyed that makes the job of the standard setter so onerous today. While appropriate independence remains a crucial attribute of any robust standard setting regime, responsiveness to changing needs and changing circumstances is arguably as important.

Replacement of IAS 39 Financial Instruments: Recognition and Measurement

The IASB made a concerted effort to demonstrate such responsiveness by revising its standard on financial instruments in time for 2009 annual reporting, releasing IFRS 9 in November 2009 (although the standard is not mandatory until 2013). By doing so, the IASB also kept its promise to the G201 to have a less complex standard on financial instruments in place.

IFRS 9 in its current form represents the first of three phases in a plan to replace IAS 39 in its entirety by the end of 2010. As the IASB completes each phase, and its separate project on derecognition, it will delete the parts of IAS 39 and replace them with new chapters in IFRS 9.

Some of the reduction in complexity embodied in IFRS 9 involves eliminating certain measurement classifications and options, such as the need to separately account for derivatives embedded in financial instruments, and having to make impairment assessments for equity investments.

To the consternation of many, however, there is much room in the accounting for financial instruments for reducing complexity without achieving simplicity. Unnecessary complexity is indeed to be shunned, but as long as there are complex transactions and complex financial instruments, there will be complex accounting requirements to properly reflect that reality.

Reduced complexity in one respect can also lead to increased complexity in another respect. IFRS 9 simplifies measurement classifications and options by generally requiring all financial assets within the scope of the standard to be measured at fair value with all changes in that fair value measured in net income.

There are only two exceptions:

• Basic loans, receivables and other similar assets which the entity is holding to collect the contractualcash flows in accordance with its business model. You can account for these at amortized cost.
• Changes in the fair value of equity investments not held for trading purposes. You can elect to recognize these changes in other comprehensive income (OCI). If you do, they stay there forever – there’s no recycling to net income, even if you sell the investment. Dividends from post-acquisition earnings, however, always go to the income statement.

Determining fair value is itself a complex task; indeed, even defining fair value has proven to be an arduous and intricate endeavor that both the IASB and FASB are still working on together. The extent of the fair value measurement requirements and the need to recognize most changes in fair value in net income have also proved controversial because of ongoing concern about the effect of fair value reporting on overall financial stability. Fair value accounting, some think, recognizes gains and losses too quickly, causing inappropriate volatility. Perhaps not surprisingly, then, the European Union decided not to accelerate endorsement of IFRS 9, effectively precluding EU companies from adopting it for 2009 reporting. Standard setting, it appears, is not without irony.

A renewed commitment

November also saw the IASB and the US FASB reaffirm their commitment to improve and harmonize standards in major areas by the middle of 2011. Whatever newly-converged financial instrument standard emerges from this process will likely overtake IFRS 9 before many adopt it, especially insofar as the FASB is contemplating a different model that measures all financial assets at fair value with changes recognized in net income, except for those fair value changes related to loans and receivables, which would go through OCI.

Amortized cost and impairment

In December, the IASB released an Exposure Draft which revealed that even though IFRS 9 retains an amortized cost model for basic loans and receivables, the amortized cost model is itself likely to change significantly. Why? Because concern grew during the financial crisis that the existing model systematically overstates interest income and delays recognition of impairment losses until too late in the credit cycle. So although fair value is thought by some to recognize changes too quickly, amortized cost as it now exists is thought by some to be too slow at recognizing such changes. More standard setting irony?

The new proposal entails the following:

• Generally, recognize interest at the risk-free interest rate prevailing when you made the loan, not its contractual rate. This means that reported interest revenue will be less than the interest the lender is contractually entitled to. The difference will be credited to an allowance account or its equivalent. Some have expressed the view that this is uncomfortably like a cushion against future losses.
• Re-measure a loan, and recognize a gain or loss in income whenever there is a change in the loan’s credit risk, either up or down. This treatment would be required even if the change doesn’t trigger a likely default – very much like fair value. However, the amount of gain or loss would be different.

Measuring liabilities

Any comprehensive new standard on financial instruments will have to deal with accounting for liabilities, and the place of fair value in that accounting. Measuring liabilities at fair value results in a gain being reported when an entity’s own credit risk increases. Many users of financial statements consider such a result to be counter intuitive and unhelpful. Users of financial statements generally look to the current measurement of liabilities to obtain information about the present value of future cash flows, assuming performance according to the terms of the liability. Changes in the price of credit risk do not affect the timing or amount of cash flows required to perform according to the terms of the liability, and so incorporating such a change into a current measurement would not provide the most decision useful information to those users who want information about future cash flows assuming performance according to the terms of the liability. But some users do appear to value the credit information contained in a fair value measurement. The standard setters are therefore reaching out to users to try and better understand what information is the most useful and appropriate for their needs.

Derecognition

With so much complexity involved in accounting for financial instruments, thoughts might naturally turn to what must be done to remove them from the balance sheet. But here we run into both complexity and uncertainty once again. The derecognition rules for financial assets in IFRS are undeniably perceived to be complex to understand and difficult to apply in practice, and even internally inconsistent (fewer transactions qualify for derecognition under these rules than under current Canadian GAAP). With that undesirable complexity in mind, the IASB published an Exposure Draft on Derecognition in March of 2009.The Exposure Draft contained not only a proposed approach, but also an “alternative” approach favoured by a minority of board members. After considering the feedback received through the comment letter process and a series of roundtables, the Board decided to pursue the alternative approach contained in the Exposure Draft. Under this alternative approach, derecognition would be much easier to achieve than under the current model. Financial assets would be derecognized when the entity ceases to have present access, for its own benefit, to all of the cash flows or other economic benefits of the asset.

Many questions remain—such as what to do with sale and repurchase (repo) arrangements, and whether to address the differences in offsetting rules between IFRS and US GAAP. Derecognition principles are also inextricably intertwined with the principles of consolidation, which the IASB also continues to work on. The FASB will also join the IASB’s deliberations so that both Boards can learn from the experience of implementing the FASB’s recent amendments to its derecognition rules, which have the effect of making derecognition harder to achieve than under previous US GAAP. The IASB hopes to issue a final amendment of the derecognition guidance in IAS 39 in the second half of 2010.

Many interested parties

It is not only preparers and the primary users of financial statements that are watching the derecognition debate and other accounting developments with concern: financial institution regulators also have a keen interest, insofar as the capital and other requirements they impose are based on or affected by accounting numbers. With the potential for previously derecognized financial assets appearing back on balance sheets with the transition to IFRS under the current derecognition model, and then assets securitized in the future disappearing again with the advent of revised derecognition principles, OSFI—like the institutions it regulates—is faced with a challenging task as it manages the transition to IFRS.

Many other potential changes to IFRS are still just over the horizon. For example, the IASB still tentatively expects to issue an exposure draft on Hedging (at least of financial instruments) sometime in the first quarter of this year, and is still reaching out to interested parties. Hedge accounting will be discussed at the Boards’ joint meeting in February.

With so much change, and so many interested parties, it is a certainty that not everyone will be pleased. But without change, there would almost certainly be even more dissatisfaction. Hold on tight.

The following article was taken from Canadian Banks 2010: Perspectives on the Canadian Banking Industry.

¹ The G-20 (more formally, the Group of Twenty Finance Ministers and Central Bank Governors) is a group of finance ministers and central bank governors from 20 economies: 19 of the world’s 25 largest national economies, plus the European Union.