Adam Deller looks at the concerns over IFRS 9, the new kid on the equity investment classification block that has put an end to the recycling of gains and losses in the P&L
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This article was first published in the June 2018 international edition of Accounting and Business magazine.
Moving house is a stressful experience. There is a new neighbourhood to adapt to, and inevitable challenges with the new home. In all the upheaval, people often look back and wonder if life would have been easier left as it was.
It’s the same with financial reporting. A project to move a standard forward can rumble on for years, and then when changes arrive, they involve inevitable growing pains and a longing for an easier life, for the rules that we all knew, even if we didn’t love them. IFRS 9, Financial Instruments, is one of those standards that is likely to cause its adopters pain and heartache for some years to come.
Issued in July 2014, IFRS 9 came into effect on 1 January 2018, replacing IAS 39, Financial Instruments: Recognition and Measurement. Any standard involving financial instruments inevitably leads to a wide and varied discussion, and the current area of concern for numerous stakeholders revolves around the classification of equity investments.
The European Commission has asked the European Financial Reporting Advisory Group (EFRAG) to research the topic further, and it has produced a discussion paper. Sue Lloyd, vice-chair of the International Accounting Standards Board (IASB), has recently released a response to this issue on behalf of the IASB. This article will look at the concerns and the IASB’s response.
In the old neighbourhood, under IAS 39, there were two distinct classifications for equity investments. If the investment was held for short-term trading, it would be classified as fair value through profit or loss (FVPL), with gains or losses going through the statement of profit and loss (P&L). Alternatively, if the intention was not to hold the item for short-term trading, it would be classified as available for sale (AFS), with the gains or losses listed under other comprehensive income (OCI) on the entity’s income statement and held in an equity reserve.
In the new neighbourhood, there are some similarities. In many ways, these two categories remain, albeit AFS assets are now classified as fair value through other comprehensive income (FVOCI). The classification criteria have changed, however. Now, FVPL is the default, and companies must irrevocably designate an item as FVOCI if the investment is intended to be long term.
Those stakeholders that have taken a look at their new equity investment surroundings have two main concerns. First, they believe the default FVPL position may not reflect the business model of long-term investors. The second concern is to do with the rules surrounding the ‘recycling’ of any FVOCI gains or losses.
Previously when an AFS asset was sold, the gain or loss would be taken out of OCI and recognised in profit and loss. Under the new IFRS 9 rules, this is not the case with FVOCI instruments. Some feel this makes FVOCI unlikely to be an appealing alternative to AFS, as this inability to transfer the accounting to P&L in the event of the sale of an AFS asset may mean the investor’s performance is not properly reflected.
In the face of these concerns, some have suggested that long-term investors may be less likely to hold equity investments on a long-term basis, and that the IFRS 9 requirements should be changed accordingly.
The architect’s response
As the creator of this brave new financial instruments world, the IASB believes the new IFRS 9 classification rules are correct for the following reasons.
- Reporting value changes in the P&L gives better information about value creation over time. The IASB believes that, as the goal of any long-term investor is value appreciation, the default position of treating equity investments as FVPL must be the correct one. As the P&L is recognised as the primary statement of performance, its annual recording of gains and losses is a better reflection of the economic reality than recording one large ‘recycled’ gain after an asset has been held for many years in OCI.
The IASB also points out that some investors hold shares in a company for strategic reasons, such as access to particular supplies or strengthening relationships, rather than simply gains in value. That is why the alternative to hold items as FVOCI remains. The IASB says the FVOCI category is not designed for investments held for value appreciation or dividend payments.
- Recycling can provide a confusing presentation of performance. Consistent with its belief that the FVOCI designation should cover only strategic investments, the IASB says that any gains or losses arising from such investments are not part of an investor’s performance. It adds that recycling shows an incomplete picture of performance, as only impairments and any assets that are sold would be recorded in the P&L. A big concern over the practice of recycling is that investors could choose to sell ‘good’ assets to record profits in the P&L while keeping hold of loss-making investments to mask any poor performance. The IASB believes this displays a lack of prudence, and points to academic research that proves companies have previously used the recycling rules on AFS investments as a way of managing earnings and smoothing profits. The IASB believes this research shows that the recognition of gains or losses in the P&L as they arise is necessary to prevent this tactic of earnings management.
- Reintroducing a recycling rule would make it necessary to add an impairment test. Under the AFS rules in IAS 39, an asset would be classed as impaired if it underwent ‘significant and prolonged decline’. This led to a wide variety of applications, often resulting in impairment being recognised too late and inadequately. The IASB has designed the FVOCI category in IFRS 9 without recycling so that no gains or losses are recorded in the P&L, meaning no impairment rules are required. Similarly, no impairment rules are required for FVPL assets, as the gains or losses are automatically recorded in P&L.
- Relatively few companies hold significant AFS equity investments. The IASB’s research concluded that only a relatively small group of companies, primarily in insurance and utilities, hold significant holdings of equity investments.
Asked by the European Commission to conduct research on these matters. EFRAG has released a discussion paper, inviting further comments. One of the things arising from the paper is the suggestion that if IFRS 9 were to allow recycling, then an impairment model would also be appropriate from a conceptual standpoint.
The EFRAG findings seem to support the IASB’s belief that the number of companies holding large amounts of AFS is relatively small.
One of the main findings of the initial EFRAG research is that the majority of the respondents do not expect to modify their holding period for equities following the introduction of IFRS 9 at the start of this year. It is also worth noting that those who do intend to modify their holding period are doing so because they believe that gains or losses from these investments are part of their performance, and they see the new IFRS 9 rules as a mismatch.
The new community?
There is still work to be done in establishing the new financial reporting environment. EFRAG will collate the responses from the discussion paper and deliver technical advice to the European Commission.
The IASB continues to believe that the principles of IFRS 9 are correct, although it does not claim that they are perfect. It believes the post-implementation review of IFRS 9, which is expected to begin two years after the standard has been applied, is the correct place to address any concerns. If this review finds that IFRS 9 has indeed had a detrimental effect on equity investment, then this will be taken seriously and reviewed at that stage.
It is unlikely that any consensus will be reached any time soon, and this is part of the inevitable fallout from the release of such a large, complex standard. These discussions are all part of the process, and should continue to contribute towards the pursuit of more robust and effective standards.
One thing, though, is for sure: IFRS 9 is here to stay. There may be a period of settling into the new neighbourhood, but it is likely that we will have to adapt to our new surroundings – at least for the next few years.
Adam Deller is a financial reporting specialist and lecturer
CPD technical article
"Some companies used the recycling rules on AFS investments as a way of managing earnings and smoothing profits"