The International Accounting Standards Board has amended its financial instruments standards to prevent companies with financial problems from trying to claim a profit based on an inflated value of the debts they owe.

Sir David Tweedie

The new requirements on accounting for financial liabilities will be added to the IFRS 9 “Financial Instruments” standards as part of an ongoing project to replace the old IAS 39 “Financial Instruments: Recognition and Measurement” standards.

The new requirements address the problem of volatility in profit or loss arising from a company choosing to measure its own debt at fair value. This is often referred to as the “own credit” problem.

In response to feedback received during its consultation process, the IASB decided to maintain the existing amortized cost measurement for most liabilities, limiting change to those required to address the “own credit” problem. With the new requirements, an entity choosing to measure a liability at fair value will present the portion of the change in its fair value due to changes in the entity’s own credit risk in the other comprehensive income section of the income statement, rather than within the P&L.

“The new additions to IFRS 9 address the counter-intuitive way a company in severe financial trouble can book a large profit based on its theoretical ability to buy back its own debt at a reduced cost,” said IASB Chairman Sir David Tweedie in a statement.
IFRS 9 applies to financial statements for annual periods beginning on or after Jan. 1, 2013. Entities are permitted to apply the new requirements in earlier periods, but if they do, they must also apply the requirements in IFRS 9 that relate to financial assets.

The second and third phases of IFRS 9 are concerned with accounting for the impairment of financial assets and hedge accounting. The IASB is aiming to complete those phases by June 30, 2011, by adding the impairment and hedge accounting requirements to IFRS 9 and, therefore, replacing IAS 39 in its entirety.

A feedback statement, outlining how the IASB responded to views received in its consultation process, is available by clicking here. A podcast introduction to the new additions to IFRS 9 is available via iTunes, or by clicking here.

“We agreed to replace IAS 39 completely,” said Tom Jones, director of Pace University’s Center for the Study of International Accounting Standards, and a former vice chairman of the International Accounting Standards Board, in an interview with WebCPA. “Nobody liked 39. It was inherited from the old IASC and it was a copy of a number of U.S. standards. But it was changed as well. So we not only incorporated a bunch of U.S. standards into one, we also made changes for the old IASC, and it’s a horrible standard. None of us are proud of it, but we felt that since there was nothing else, we had to adopt it when we adopted all the other standards. The noise got louder with all the economic problems, and in a way it was a good excuse for us. So we replaced 9 in three pieces. The most immediate problem was that we all recognized that there were questions about fair value. I’m not sure those questions were very valid at the end of the day, but we rehashed the whole thing. Basically we adopted what we think is a commonsense view that in financial instruments, anything which is volatile like equities, or unpredictable like derivatives, those must all be fair valued. The basic banking business, which is done by probably 6,000 banks in the U.S., is you take deposits, you lend money, you hold the loan. You don’t package it or sell it. You add the interest. At the end of the day, the principal is repaid, and you take write-offs if the quality of the credit declines. We think that is a pretty good model, the standard banking business.”

Jones expects to see the IASB and the U.S. Financial Accounting Standards Board will eventually resolve their differences over the standards for financial instruments and how loans should be accounted, whether at fair value or amortized cost.

“We have two ways to value: fair value for anything volatile and cost for anything which is predictable,” he said. “The FASB went another way completely, and now we’re stuck with this proposal with everything at fair value including the bank loan book. My prediction is that they will revisit that and come back to something like where we are, in which case it will probably be identical and we’ll bring it together.”