Financial instruments: classification and measurement

Comments from ACCA to the International Accounting Standards Board, September 2009.

General points

ACCA is pleased to have this opportunity to comment on the above exposure draft (ED) which was considered by ACCA's Financial Reporting Committee.

While we have some reservations about the proposals which we have set out in our answers below, we generally support the direction of the classification and measurement system in the exposure draft and consider that it will provide some much needed simplification in this area.

ACCA has supported the development of a single set of global accounting standards and in particular the joint development of new standards between the International Accounting Standards Board (IASB) and the Financial Accounting Standards Board (FASB) to help achieve that. We therefore regret the lack of co-ordination on this the most critical project for a new accounting standard. Currently the two boards seem to be moving at different speeds and towards different positions. FASB appear to be proposing a full fair value model for financial instruments except for an option for own debt to be at amortised cost. IASB are proposing a much wider category of items at amortised cost. There are options in both proposals for changes in fair value to go through other comprehensive income (OCI) rather than profits, but the models are very different in their effect. These are highly significant differences which cannot be skated over. It seems possible that IASB will have issued the first part of their new standard on financial instruments before FASB has consulted in the US on any proposals. This outturn of events continues the problem of demands for a 'level playing field' which have prompted some adverse developments in financial reporting over the last year. 

We note the reduced due process to which these proposals have been subjected including a restricted comment period and the lack of any discussion paper of the principles before proceeding to the ED. Clearly there are significant risks that not all of the problems will be highlighted before the final standard is issued. However, we are well aware of the importance and urgency of the issue and the pressure from governments for the review of the accounting standards for financial instruments to be brought forward, and we accept therefore the reduction in due process proposed.

It seems questionable whether the ED's phased approach is going to be very helpful for either preparers or users. Many preparers are going to want to see the whole package before making their various choices and set their new policies. There are significant risks that there will be problems with having parts of a new standard to co-ordinate and work with parts of the old standard. For users there is going to be a lack of comparability from the early adoption of the first phase by some but not others. We recognise, however, as noted above, the reasons why the phased approach has been adopted and accept it, but with the observation that IASB may need to adjust some of this first phase when the complete standard has been assembled. 

While we acknowledge the importance, highlighted by the crisis, of the financial reporting by banks, we would stress that the proposals should be directed equally to the financial reporting by the much larger numbers of industrial and commercial companies. Currently this has not been fully achieved in the ED.

ACCA'S answers to questions posed by IASB

Q1. Amortised cost as a suitable basis for designated instruments

Yes. We support a mixed model where financial instruments are stated on a cost basis (cost, subject to amortisation and impairment where appropriate). This is most appropriate for initial and subsequent measurement of loans and receivables. It should also be the default measurement basis for all financial liabilities (other than derivatives). Cost is the best accounting basis where the financial assets are intended to be held generally over their contractual life under the company's business model. Cost is also the basis for liabilities that best reflects the entity's actual cost of borrowing. It also addresses most directly the accountability of the company to its owners for their stewardship of the business. We therefore broadly agree with the ED's proposals for amortised cost for financial instruments with basic loan features which are also managed on a contractual yield basis. 

However we are concerned that under these proposals too many items might be at fair value. We note concerns below in answer to Q2, Q3, Q8 and 9.

Q2. Guidance on 'basic loan features' and 'managed on a contractual yield basis'

This guidance seems largely written for banks and not for commercial or industrial companies - for example the references to loan features and to yield are clearly not the way that most other companies think about the majority of their financial assets. 

The meaning is not clear of the third sentence in paragraph B1 “ … terms that change the timing or amount of payments … are not basic loan features unless they protect the creditor or debtor” and the related guidance in B3(c). 

We are not sure how B13(b) should be interpreted in the context of business combinations or how this will fit with impairments on an expected loss basis. Any portfolio of existing loans that was acquired it seems would have to be accounted for differently from originated loans and that would not seem to produce comparability.   

Q3. Other ways to determine what should be at amortised cost

We are concerned that the boundary of the amortised cost category will be too restricted. We have noted some items in Q2 above. Apart from derivatives with negative values, we think other financial liabilities should be at amortised cost as a default position. Under Q5 we accept that where there might be an accounting mismatch then there might be a fair value option. Under these proposals some borrowings with an embedded derivative which is not a basic loan feature, would have to be at fair value - this might apply to some sorts of convertible loans or preference shares.

We also note under Q8 and Q9 that where fair values for financial assets are not reliable then amortised cost should be used.

Q4(a). Embedded derivatives 

We agree that requiring separation of embedded derivatives is a complex feature of the existing IAS39. Therefore the proposed treatment is a simplification, though we note that bifurcation will still be required for contracts that are not financial instruments. Our concern is that for financial instruments where there are embedded derivatives, the whole contract would be at fair value and that this might push too many liabilities especially into the fair value category. The ED might be altered so that the asset or liability could be retained in amortised cost when the derivative is closely linked to the host contract along the lines of the existing paragraph 11 of IAS39.

We would prefer that the business model of the entity would be the major determinant of what should be at cost in this cases, together with the likely variability of the cash flows.

Q4(b). Tranche categories

The implication of B7 and B8 would seem to be that only the most senior tranche in “some types of transactions” could have basic loan features. That seems to be a rather sweeping simplification especially if there are a number of tranches. If this principle were to be applied by analogy outside these securitisation transactions then any debt where some other creditor might have preference might be excluded from the amortised cost category which would seem not the right answer to us. Any form of subordination is providing some sort of credit protection to other creditors.

Q5. Option to use fair value

We accept this option, even though optional treatments in accounting standards are inherently undesirable. This option in the ED for items that would otherwise be at cost to be stated at fair value, would probably not be used frequently. To qualify, items would have to be managed on a contractual yield basis, but be required to be stated at fair value to avoid an accounting mismatch. 

As noted above in Q3, we would prefer that amortised cost was the default measurement basis for liabilities, except for derivatives, with also then this fair value option to deal with accounting mismatches.

Q6. Option to use fair value, further cases

We agree that the current further instances where the fair value option exists in IAS39 would not be needed under the proposals, nor do we see a need for the fair value option in further instances.

Q7. Reclassifications

We accept that there is a balance to be struck here between trying to recognise changed circumstances and avoiding the manipulation of the accounts to achieve a desired result. For example, instruments with basic loan features may have been held for trading and therefore recognised at fair value, then in changed economic conditions they can no longer be traded and are therefore to be held and managed on a contractual yield basis. In principle it seems right that they might need to be reclassified in these circumstances. On the other hand we acknowledge the clarity and avoidance of possible abuse if the classification is once and for all. 

On balance, we think the proper application of the principles of the distinction should be left to the judgement of the preparers and reclassification (in both directions) in the appropriate circumstances should be required. Clear disclosure of the impact of, and the reason for, any reclassification should also be mandated.

Q8 and Q9. Equity instruments with no reliable fair value

We agree that fair value is the most useful measurement basis for equity investments. If, however, reliable fair values cannot realistically be obtained for these instruments then there is no useful information to be gained by users by providing them with arbitrary and subjective values which are unverifiable, not based on what is likely to happen to the instrument and which may turn out to bear little relation to actual realisation values.

This is the current position in IAS39 and we see no reason for that to change simply because the classification system has been changed. It does not make the fair values any more reliable.

Q10. OCI option for some equity investments

In response to the discussion paper earlier this year, we supported the single statement of performance proposed. However, we regretted that the principle of what should be in profit and what in OCI was not properly addressed by that paper. There is therefore no overall framework of principles to guide this standard in this regard. 

While we do not think that diligent users really regard what goes through profit in a fundamentally different way to other gains and losses, we are concerned by the greater visibility and emphasis placed on the profit and loss account as compared to the OCI.  

We further note that this is an area of significant divergence between the IASB's proposals and those of the FASB.

Pending the resolution of these issues and the presentation of a single performance statement, in our view the existing available-for-sale model should continue for the fair value changes in equities with

  • fair value changes up and down in OCI
  • impairments charged to P&L if needed
  • dividends in P&L
  • gain/loss on disposal in P&L

The existing impairment model should be improved by

requiring impairment (except where any impairment has been reversed after the end of the period) measured by fair value

  • removing the 'prolonged or significant' test
  • allowing the reversal of impairments through P&L

Q11. Should the OCI option be an open, but once-and-for-all choice

It would be better if there was some basis for the OCI option rather than leaving it entirely open. We believe that it should be possible to limit the OCI option to strategic investments and think that the phrase 'not held with the primary objective of realising a profit from increases in the value of the instrument and dividends' might be sufficient. 

Having restricted the use of the option we would not make it a once-and-for-all choice, but allow reclassification where the facts have changed.

Q12. Early adoption
We agree that early adoption should be allowed and the disclosures required are appropriate. These are, however, appropriate disclosures to be made by all companies when they adopt the new standard and not just those adopting early.

Q13. Transitional provisions
We have raised among our general comments above concerns over the practical problems raised by the phased approach that has been adopted to replacing IAS39.

We support the retrospective application of the standard, though including the limitations on that set out for impairment and effective interest rates, equities previously on a cost basis and for interim periods (in paragraphs 30, 31 and 33 of the ED). 

We would observe, however, that for the first time application of IAS39 by a number of countries in 2005 a prospective application with no restatements of comparatives was allowed. This replacement standard is being developed on an exceptional fast track basis to allow it to be available for December 2009 year ends. Given the short time between the publication of this standard and the end of 2009 the restatements required by the retrospective application are likely to be very difficult to achieve. Without prospective application for early adopters the interest groups pressing for the rapid changes to IAS39 are unlikely to be satisfied. 

Q14. Alternative model
We would not support this model. This would restrict the amortised cost category even further than in the ED and as noted above we are concerned that this already too narrowly defined. 

Q15. Further variants
As with Q14 in relation to the first variant, we would simply note that the whole treatment of items in the OCI or P&L, and also how fair value changes should be presented in financial statements should have been addressed in the presentation of financial statements project, but was not. 

We would not support the second variant as this would require all financial instruments to be at fair value. We support a mixed model of cost and fair value. 

The alternative proposals in both Q14 and Q15 are inadequately explored or explained in the ED. Given this we are also surprised that the Board did not ask for comments on the alternative proposals of

  • FASB
  • Mr Leisenring
  • and his further suggestion in AV17