[IMGCAP(1)]IAS 39, Financial Instruments: Recognition and Measurement, is arguably the most complex of International Financial Reporting Standards.
The standard deals principally with accounting for all types of financial instruments such as debt securities, loans and the infamous structured products like collateralized debt obligations that have been mentioned so prominently in the recent financial crisis.
In April 2009, the International Accounting Standards Board undertook a three-stage overhaul of International Accounting Standard 39 to be completed within the ambitious timeframe of one year. In November 2009, following the consultative due process that closed in September 2009, the IASB issued the first phase of IAS 39s replacement, IFRS 9, Financial Instruments: Classification and Measurement, for voluntary adoption by IFRS filers. Mandatory adoption will be required starting in 2013.
The IFRS 9 classification and measurement debate was dominated primarily by the issue of whether to apply fair value or amortized cost measurement to specific financial instruments. The IFRS 9 amendments were guided by a raft of technical considerations, including the establishment of criteria to determine whether to apply fair value or amortized cost measurement to specific financial instruments.
The criteria for applying amortized cost treatment include a) that the business model applied by the entity holding the financial instrument manages the instrument on a contractual yield basis, and b) the underlying contractual cash flows of the financial instrument possess stable characteristics.
In other words, the criteria apply to an instrument held to maturity by the firm such that it can realize full par value. Financial instruments not eligible for amortized cost are measured at fair value, with gains and losses recorded in net income. An exception is allowed, however, for equity instruments that can be accounted for at fair value through other comprehensive income. The scope of these changes is limited to financial assets.
Many stakeholders, including investors, held the view that a revised IAS 39 was necessary. One of the primary instigators of the expedited IAS 39 amendment was the European Commission. Yet on Nov. 11, 2009, the EC announced its decision to defer its endorsement of the newly issued IFRS 9. This has resulted in the ironic situation of the EC now believing IAS 39 reform is no longer so urgent. It is amazing what a six-month rally in equity markets can do for confidence.
However, the delayed endorsement could also be construed as a tacit admission that the push for hasty reforms in such a complex area of accounting should be avoided. Perhaps it is an illustration of the perils of accounting policy formulation based on economic cycles or short-term objectives. Financial reporting information, above all else, is primarily meant to faithfully represent the economic performance over multiple periods and should never be seen as a tool of short-term regulatory interventions.
The EC deferral also hints at flaws in the current EC and IASB relationship. These issues have begun to have a detrimental impact on investors, who benefit from a consistent and predictable global standard-setting process. Of further concern is that different member states appear to articulate their discomfort with IFRS 9 based on idiosyncratic, country-specific reasons. We hope this recent deferral decision does not further contribute to multiple member states seemingly picking and choosing which standards or issues to block.
The entire premise of an effective IFRS framework depends on consistent member-state adoption and implementation. Perhaps their opposition in this case is simply coincidental, but there is growing concern that it is an unrealistic and insuperable task to design any standard that will satisfy the current idiosyncrasies of every IFRS-compliant and prospective member state. Hence, the IASB must seriously begin to deal with this reality, knowing that the long-term attractiveness of its IFRS product hinges on its underlying quality rather than on the futile objective of seeking consensus from multiple states on highly technical decisions.
Some Improvement, but More could be Done
The jury is out as to whether the intended reform objectives were achieved, specifically whether the proposals improved decision-usefulness and reduced the complexity of financial instrument accounting information. The CFA Institute recently conducted a global membership survey. The results show that 47 percent of the 641 survey respondents thought the IFRS 9 model improved decision-usefulness, while 22 percent thought it did not and 31 percent were neutral. The survey also showed that 37 percent of the respondents thought the model reduced complexity, while 28 percent thought it did not and 35 percent were neutral.
While, on balance, there was some perceived improvement, the survey feedback hints that more work is required to achieve the espoused reform objectives, as the majority of respondents did not perceive a measurable improvement. In my opinion, these survey findings reflect the difficulties in measuring the effectiveness of a standard that is based upon so many alternatives or exceptions to the model, revealing that it remains a complex standard.
There are also potential unintended consequences from the proposed amortized cost alternative. Primacy has been accorded to the business model test to determine whether instruments are managed on a contractual yield basis so as to apply amortized cost. This overlooks the extent to which active/total return management across all financial instruments actually occurs within financial institutions and the likelihood of a flawed premise of instruments being managed on a contractual yield basis.
Furthermore, there is the risk that the designated business model definition may end up being shaped by accounting requirements, rather than accounting simply reflecting the underlying business performance. It could also result in differing accounting treatment for similar instruments and lower reporting comparability. For example, a reporting entity claiming to hold a particular financial instrument for liquidity management purposes based on its business model, and another entity using the same instrument for asset-liability matching, will have differing reported results.
Another key message emerging from the survey is that there may be room for more to be done on financial instrument accounting, despite some incremental improvements having been achieved through IFRS 9. When asked which measurement approach could best improve financial instrument accounting, 34 percent of CFA Institute survey respondents selected the mixed measurement attribute, while 60 percent selected some variant of full fair value for financial instruments (i.e., 40 percent selected full fair value, with amortized cost in the notes, and 20 percent selected both full fair value and amortized cost in financial statements with separate presentation).
This finding reveals the skepticism by investors towards the mixed-attribute model as a permanent feature of financial instrument accounting. The CFA Institute has consistently and strongly advocated for a shift away from the use of mixed-measurement attributes towards fair value for all financial instruments, as a means of improving information quality and reducing the complexity of financial instrument accounting. This view is predicated on the belief that the debate about fair value is in part a reflection of concerns that some may have about the impact of fair value on net income. Hence, the IASB should also focus on improved financial statement presentation.
A Rethink Needed
A particularly unfortunate consequence of recent political pressures and threats to the independence of standard setting bodies has been the tainting of the goal of convergence as a means of improving financial reporting. This has even led to a situation of the IASB and FASB potentially proposing divergent solutions for financial instrument accounting and working under different timelines.
Even while pursuing multiple goals, improvement of financial reporting should be the overriding consideration. The CFA Institute survey showed that 79 percent of our members believed improvement of decision-usefulness of financial instrument accounting to be at least or more important a goal than reducing complexity and convergence. On a similar basis, 59 percent viewed reducing complexity and 41 percent viewed convergence as primary goals.
The survey also showed that 59 percent prefer that both the IASB and FASB work in a synchronized fashion and offer a single accounting solution. Hence, it is important to reiterate that there is still a great opportunity at hand to achieve a single set of global, high-quality standards. However, it is necessary for both the IASB and FASB to work in a more coordinated fashion, free from political pressures, based on realistic timelines and anchored towards the primary objective of improving financial reporting quality.
Vincent Papa, CFA, is director of financial reporting policy at the CFA Institutes Centre for Financial Market Integrity.