TORONTO, Sept. 29 /CNW/ - Unless accounting standard setters and regulators steer a path for convergence between the International Accounting Standards Board (IASB) and the Financial Accounting Standards Board (FASB) on complex financial instruments standards, Canada's financial institutions will be caught in the middle of a very delicate situation, Ernst & Young says.
Convergence is particularly important since the credit crisis has shown us that both US and international standards should offer a level playing field for global business. Applying different accounting methods to international financial institutions can cause confusion and competitive disadvantage, while at the same time challenging the integrity of standard setting processes.
"As it stands, the IASB and the FASB deal with financial instruments differently," says Andre de Haan, Partner at Ernst & Young. "This situation will result in a continued lack of uniformity as countries pick and choose approaches they feel are best for them. That defeats the very concept of International Financial Reporting Standards (IFRS)."
He says this is particularly relevant for Canada's financial institutions, which (along with all public companies here) will have to follow IFRS commencing in 2011. "We'll be dealing with financial instruments in a very different way than the US - our neighbour and most important trade partner. That leaves Canadian organizations in an awkward and complicated spot."
In commenting on the IASB's proposals for International Accounting Standard (IAS) 39, Financial Instruments: Recognition and Measurement, Ernst & Young set out a blueprint, which it believes paves the way forward for the development of a single set of accounting standards for financial instruments. The plan makes proposals on fundamental principles, debt instruments, secured debt, equity instruments, financial liabilities and more. Ernst & Young believes there is common ground, and that the IASB and the FASB should work in a co-ordinated manner to arrive at a mutually acceptable result.
"The inherent complexity and riskiness of financial instruments - not the way they are accounted for - is one of the underlying causes of the financial crisis," explains de Haan. "Our proposals address the many views of differing stakeholders, and offer a way forward for standards convergence."
Among the key suggestions, Ernst & Young proposes the following:
On fundamental principles:
- Financial instruments would be measured at fair value through other
comprehensive income (OCI), fair value through profit or loss or
- 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
amortized 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)
- Meet the IAS 39 definition of loans and receivables, including the
absence of quotations from an active market
Debt instruments that are not held for trading, but are quoted in an active market and meet the criteria mentioned would be measured at fair value through OCI. (As mentioned above, we propose this approach for the purpose of IFRS-US generally acceptable accounting principles (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 amortized cost assets. That is, only credit losses would be recognized in profit and loss (similar to the approach taken by the FASB in April 2009). Any realized gains and losses on derecognition of such instruments would be recycled from OCI to profit or loss.
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 amortized cost or fair value through OCI), would be measured at fair value through profit or loss.
On securitized debt
For investments in the notes issued by securitization structures, the IASB's proposals allow only the most senior tranche to be measured at amortized cost and require others to be measured at fair value through profit or loss. While reducing complexity, we have concerns about such an unduly form-driven approach. We 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 (than proposed by the IASB) to be recorded at amortized cost and also reduce the opportunities for structuring.
On equity instruments
The IASB's approach requires all other equity instruments be measured at fair value - through profit, 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 IAS 39 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 - one that retains the existing available-for-sale category for investments in equity securities, but with more clearly defined and operational impairment rules, which also allow for reversals of impairment.
We agree with the IASB's proposals to record financial liabilities at amortized cost (if they have only basic loan features and are held for payment of principal and interest) or at fair value through profit or loss. However, we recommend a minor modification for financial liabilities at fair value but not held for trading, requiring changes in fair value related to credit risk to be recorded through OCI, with recycling from OCI to profit or loss upon any early extinguishment of the liability, if applicable.
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.
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 that there should be an option to apply the new classification criteria as an adjustment to the opening retained earnings. This option should start 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 at 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.
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, Insurance Contracts, 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 exposure draft are likely to be mandatory by 2012, whereas the revised IFRS 4 may not be available until 2014.
To alleviate concerns for insurers, we recommend that the IASB should provide transition guidance or relief, so entities can continue to apply their existing accounting principles and are not required to make several changes within a short period. When the IASB 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
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SOURCE EY (Ernst & Young)
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