Joint Proposals Push Toward IFRS/GAAP Convergence in Issues Affecting Banks

FASB and the IASB announced moves toward convergence of IFRS and GAAP through joint proposals on offsetting transactions and impairment of financial assets.

The two main changes are 1) an exposure draft released last week on a common approach to offsetting financial assets and financial liabilities. This would end a major difference between IFRS and U.S. GAAP. 2) A supplementary document with a new impairment model for financial assets like loans managed in an open portfolio. The proposal would replace the incurred loss model with a more forward-looking expected loss model--a response to complaints in the financial crisis.

The issue with offsetting is that companies can, in some instances, report IFRS balance sheet figures that are 100 percent greater than their U.S. GAAP numbers. This is confusing to the global capital markets and the proposals would eliminate the difference.

U.S. GAAP would only net in more limited circumstances, with note disclosure of other netting arrangements in footnotes.

Offsetting/netting is required when company presents in net amounts on their balance sheet. As it stands now, financial assets and financial liabilities may show up on a balance sheet as one net amount, or as two gross amounts, depending on whether the balance sheet is in IFRS or U.S. GAAP.

The above netting arrangements cause the largest difference between balance sheets using IFRS and U.S. GAAP. Derivative assets and related liabilities are the most common area where this occurs. Balance sheets of financial institutions generally have the largest derivative positions.

The new proposed rules apply only when the right of setoff is enforceable at all times, including in default and bankruptcy, and the ability to exercise this right is unconditional—i.e. offsetting only occurs after a future event. A company must intend to settle net, i.e. with a single payment, or simultaneously. If all of these requirements are met, offsetting is mandatory. This would also change industry conventions.

The Exposure Draft is Offsetting Financial Assets and Financial Liabilities [FASB Proposed Accounting Standards Update, Balance Sheet (Topic 210): Offsetting]. Comments are due April 28.

On Impairment, changes introduce an expected loss model that is more forward-looking in accounting for credit losses, and is said to better reflect the economics of lending decisions. IFRS and U.S. GAAP currently account for credit losses using an incurred loss model, which requires evidence of a loss (known as a trigger event) before loans can be written down.

“The FASB and IASB are seeking comment on the changes, i.e. whether they agree conceptually and whether the changes can be practically applied.

Some advocate that a more forward-looking approach to loan losses would have made loan provisions show up earlier than before, and may have held off or mitigated the credit crisis by giving earlier warnings about the health of financial institutions.

Comments on the document Accounting for Financial Instruments and Revisions to the Accounting for Derivative Instruments and Hedging Activities, are due April 1.

If you need a nap, the IASB is hosting a webcast on the impairment of financial assets proposal on Friday, Feb. 4, with sessions timed for Europe and the U.S. Also “FASB in Focus” has overviews on the new rules netting on FASB’s website and another FASB in Focus on the impairment model.

FASB Reversal a Major Step Toward International Convergence

The FASB has made a major compromise in the area of impairment of financial instruments. Full details will be released later, but this is a major concession to U.S. and European banks. It is also a major step toward convergence of U.S. accounting rules with IFRS and the end to what what previously called a "religious war" over fair value accounting. As well, political influence over accounting may be resolved by the compromise.

This new FASB approach is similar to the International Accounting Standards Board’s model in IFRS 9. FASB has agreed that at least some assets should qualify for cost accounting, whereas banks were forced to use a fair value model for all loans under the new rules. Existing rules forced fair value on portions of banks’ loan portfolios.

The FASB’s original proposal was opposed by the banking industry as being pro-cyclical (making problems worse as business cycles worsened). Banks say that proposed the fair value approach is a danger to the survival of marginal financial institutions that could have their capital called by bank regulators because the rules have and would continue to force banks to take large and inappropriate write-downs on temporary market declines. They also lobbied that the rules would hurt lending and unfairly reduce banks' book value. They argued that banks would not make loans if the value of the loan could be written down immediately due to temporary market fluctuations.

Supporters of the FASB fair-value proposals say it would have improved transparency and unmasked potential weaknesses at banks. Proponents of fair value accounting, including the CFA Institute, argue it is what is needed to make the financial statements of banks reflect their true financial positions and operations more clearly to investors.

FASB said that financial statement users, including preparers, auditors and others would prefer to have loans held for collection recorded on the balance sheet at amortized cost, but with a more robust impairment test.

The FASB will go back to users for input toward an impairment model for loans. The original proposal required a fully fair value-based approach that the banks have lobbied against for years. The new approach would recognize a portion of the estimated loan losses over time unless greater losses are expected in the foreseeable future, in which case that larger floor amount would be recognized currently. Some loans, including loans traded actively by banks instead of held to collect payments will be valued at market prices.

The changes are partly the result of a fierce lobbying campaign by the American Bankers’ Association and others and seen as a major victory for the banking industry. However it was not solely the banks in opposition to the proposals. The FASB reported an overwhelmingly negative reaction to its proposal from companies and investors, who wrote more than more than 2,800 comment letters.

Looking for Work? Try FASB or IASB

If you are an accounant with a converged accounting skillset, perhaps there are a couple of jobs youu might be interected in. Both Robert Herz, and Sir David Tweedie, respectively the chairman of the U.A. Financial Accounting Standards Board (FASB) and the head of the International Accounting Standards Board (IASB) are due to retire shortly. Despite the departures of Sir David and Mr Herz, big accounting firms and their clients still expect convergence of standards to top the agenda of their successors.

Both men have had to deal with controversial issues in financial reporting. In particular, fair value accounting for financial assets: and liabilities is a particularly cumbersome issue. In fact, the two men and their accounting bodies have butted heads over this issue, with both business people and politicialns sticking their oars in to the dispute. Recently, the FASB has taken a more principles-based approach, calling for most measurements to be at fair value. IASB has taken a two-category approach, saying that loans and loan-like equivalents held to maturity may be marked at amortised cost, whereas frequently traded instruments should be marked to market. Comments to date are leaning more toward the IASB approach, with “Big Four” accounting firms and many companies on the IASB’s side. Conjecture is that Herz’s replacement may be a pragmatic consensus-builder rather that the principles-based stalwart that herz was.

At IASB, meanwhile, the skills of a politician or diplomat may be required as the EU politicians have in some cases refused to agree to the IASB's proposed standards.

"Own Credit" Liability Rules Explained

What is the own credit issue?

The accounting effect of changes in the credit risk of a financial liability is referred to “own credit”.

Changes in a financial liability’s credit risk affect the fair value of that financial liability. This means that when an entity’s creditworthiness deteriorates, the fair value of its issued debt will decrease (and vice versa). For financial liabilities measured using the fair value option, this causes a gain (or loss) to be recognized in the P&L.

Many investors find this result counter-intuitive and confusing.

This was confirmed in responses to the IASB’s June 2009 discussion paper Credit Risk in Liability Measurement and in the user questionnaire on own credit that the IASB issued as part of its outreach activities.

The IASB undertook outreach on the issue of own credit in preparation for the publication of this ED, including discussions with preparers, audit firms, regulators and investors.

What did investors tell the IASB?--Extensive input was obtained from investors, including a questionnaire to which there were more than 90 responses. Whilst there was a range of responses, in general investors confirmed that:

• P&L volatility caused by own credit does not provide useful information (except for derivatives and liabilities held for trading);
• they did not want us to develop a new measurement method; but • information on the effects of own credit can still be useful.

In response to the input received, the ED proposes a limited change that addresses the issue of own credit for financial liabilities that an entity chooses to measure at fair value by introducing a two-step approach.

The two-step approach proposed in the ED would address the P&L volatility arising from own credit as follows:
• the fair value change of liabilities under the FVO would be recognized in P&L;
• the portion of the fair value change due to own credit would be reversed out of P&L and recognized in other comprehensive income.

Current Requirement
Income statement (P&L)
Liabilities under fair value option
100 total change in fair value
100 Profit for the year
===================

Proposed Two-Step Approach
Income statement (P&L)
Liabilities under fair value option
100 Step 1 – Total change in fair value
(10) Step 2 – Change in fair value from own credit
90 Profit for the year
===================

Statement of comprehensive income
Liabilities under fair value option
10 Step 2 – Change in fair value from own credit
===================

No other changes are proposed for financial liabilities.

The current requirements for the measurement of financial liabilities would not be changed in any other way.

Importantly, the current requirements to split structured debt into a ‘vanilla’ instrument measured at amortized cost and a derivative component measured at fair value (bifurcation) would remain. As a result, those who prefer to bifurcate financial liabilities when relevant could continue to do so.

P&L volatility will no longer result from changes in own credit while information on own credit will still be available for investors.

IASB Restricts Gains form "Own Credit" Changes

Previous posts in this blog have noted that current accounting rules on financial instruments have a counter-intuitive result when a company’s credit rating is lowered. In theory, any liability should be recorded on a company’s books at the amount that is reasonably expected to be paid. If the liability is to be paid over the long-term, it should be discounted. The amount od a discounted liability on a company’s balance sheet would vary as the discount rate change. The discount rate reflects the risls associated with the liability, and as the risks increase, so does the discount rate. A higher discount rate means a lower liability. The company then reduces the liability (debit to liability) and to balance the books, requires a credit entry, which results in a gain to a company’s income statement. And that I show the counterintuitive result occurs—a drop in a company’s credit rating means a gain in earnings.

The liability treatment follows asset treatment—for example if a company thought that a debt was uncollectible, it would write the debt down to what it thought it would recover. So that the principle of fair value is maintained across the balance sheet, the same theory applies to liabilities.

The International Accounting Standards Board (IASB) has proposed changing the way banks measure their liabilities so they can no longer book the gain noted above and confuse investors after a ratings downgrade.

The IASB acknowledged that there are theoretical arguments for treating financial assets and liabilities in the same way, it is hard to defend the accounting as providing useful information when a company suffering deterioration in credit quality is able to book a corresponding gain.

The "counter intuitive" rule angered policymakers during the financial crisis when profits were being booked by banks despite ratings downgrades"

The proposal is part of an overall revamp of the IASB's fair value or marking to market rule which will be finalized by the end of this year but it is unclear when it comes into force.

HSBC Europe's biggest bank, recently reported that It had both a $5 billion hit from bad debts on U.S. home loans and asset writedowns while at the same time recording a fair value gain of $2.7 billion on its own debt during the period due to a widening in credit spreads.

Earlier in May, UBS recorded a gain of 2.1 billion Swiss francs ($2 billion) due to the widening of its own credit spread.

The debate about whether banks should allow for fair value gains on liabilities is not new, but has assumed fresh importance after a hugely volatile first quarter in credit markets, which saw bank debt trading at a discount in some cases to non-financial bonds.

Some analysts argue that if banks are taking mark-to-market losses on their assets and on hedging instruments, they should also be allowed to account for gains on their liabilities even if the underlying credit quality has not changed.

One of the practical problems with the theoretical approach noted above , however, is that a bank is unlikely to repay the debt early. A bank would usually wait until the debt matures and then buy it back at par.

Politics and Accounting: EU Delays Adoption of Fair Value Accounting Rule Changes

Politicians in the European Union have held up a radical overhaul of accounting rules for banks and insurers which came into force yesterday across most of the non-U.S. accounting world.

Politics comes to the fore in this as the rules have been postponed at a time when the commission itself is a lame duck because the commissioner’s job will come open with the new Commission beginning next year. Diplomats in Brussels say France is interested in the internal market commissioner's job in the next Commission.

The move highlights a major split among European financial institutions over the fair value new rules.

Analysts say some French, German and Italian banks with large investment banking activities would be hit disproportionately by the changes, forcing them to book losses on large holdings of derivatives.

The decision by the European Commission to delay the changes within Europe has angered other banks in the region who fear they will be put at a disadvantage compared to international peers.

The International Accounting Standards Board recently published major changes to the rules on fair value accounting, where assets are marked to market prices. Supporters of the new rules say this makes reporting more transparent. Critics believe fair value rules made the financial crisis worse by forcing banks to take losses on assets when markets fell.

The IASB fast-tracked the changes in response to calls by the G20 to make the changes by the end of the year. The European Commission said it would not adopt the changes until it had carried out an in-depth analysis, and would consider adoption in the new year.

The decision means that European banks and insurers will not use the new rules for their 2009 accounts while companies in more than 80 countries outside the EU will be required to do so.

IASB Issues New Standard on Financial Instruments

The International Accounting Standards Board (IASB) issued today a new International Financial Reporting Standard (IFRS) on the classification and measurement of financial assets.

Publication of the IFRS represents the completion of the first part of a three-part project to replace IAS 39 Financial Instruments: Recognition and Measurement with a new standard—IFRS 9 Financial Instruments.

The second part, the impairment methodology for financial assets has been exposed for public comment, and proposals on the third part, on hedge accounting, continue to be developed.

The new standard enhances the ability of investors and other users of financial information to understand the accounting of financial assets and reduces complexity – an objective endorsed by the Group of 20 leaders (G20) and other stakeholders internationally.

IFRS 9 uses a single approach to determine whether a financial asset is measured at amortised cost or fair value, replacing the many different rules in IAS 39. The approach in IFRS 9 is based on how an entity manages its financial instruments (its business model) and the contractual cash flow characteristics of the financial assets.

The new standard also requires a single impairment method to be used, replacing the many different impairment methods in IAS 39. Thus IFRS 9 improves comparability and makes financial statements easier to understand for investors and other users.

The effective date for mandatory adoption of IFRS 9 Financial Instruments is 1 January 2013. Consistent with requests by the G20 leaders and others, early adoption is permitted for 2009 year-end financial statements.

To read the standard, interested parties wilI need to purchase it hard copy from the IASB or subscribe to eIFRSs at www.iasb.org.

New IFRS Fair Value Standard will be released In November

International Accounting Standards Board chairman, Sir David Tweedie, said thath the IASB will release a new fair value accounting rule by November.

In an address to a meeting of European Finance Ministers, which have in the past been critical of the IASB’s response to the financial crisis, Tweedie has sought to ease concerns by announcing that he is on track to deliver a new fair value standard by the end of this year.

“I gave a commitment to deliver on this timetable. We will publish the new standard in November,” he said.

Fair value accounting came under fire from banks and governments in the European Union and the U.S. after the financial crisis.

Tweedie said he will not require loan books to be held at fair value which has now become a potential sticking point between the IASB and the FASB.

FASB's proposal will see all assets measured at fair value. The IASB's mixed measurement model would see banks' loan books valued on an amortized cost basis.

The two standard setters are trying to converge US and international accounting rules, in the hope that the US will eventually adopt the new rules. But the fair value standard has now emerged as a significant obstacle, highlighted by Tweedie who said he simply did have the time to co-ordinate efforts with FASB in the revision of fair value, in the wake of the financial crisis.

“As I said in June, given the urgency of the fundamental issues surrounding IAS 39, none of us can afford the potential protracted back-and-forth resulting from piecemeal changes in international and US standards that would undermine the comprehensive and desperately needed reform that is under way,” he said.

“In our discussions with the FASB aiming to reach a common global approach, we will emphasise our position in favour of a mixed measurement model over one that requires full fair value measurement on the balance sheet… I remain optimistic that we can overcome our current differences.”

American Bankers' Association Criticizes FASB, IASB over mark to Market Changes

The American bankers Association (“ABA”) has written to Robert Herz, Chairman of the FASB and Sir David Tweedie Chairman of IASB, about their concerns around the process being taken on the FASB and IASB projects relating to financial instruments.

The ABA has lobbied against mark to market accounting for years and their response is no surprise.

The ABA says that the changes that the FASB and IASB are considering represent the most significant accounting changes the ABA has ever experienced. The ABA encourages the FASB and IASB to make such changes only "with utmost caution and the appropriate level of due process to correspond with the magnitude of the changes."

The ABA agrees that a certain amount of change is urgently needed, but that the FASB and IASB direction may cause significant disruption, with both preparers and users of financial statements.

They state that rule-makers must be very careful in this effort to ensure that any changes:
1) represent solid and meaningful change that is valuable and understandable to financial statement users;
2) focus on the business models used by entities that prepare the financial statements, and
3) can be implemented and maintained at a reasonable cost.

Other points made:

• The rapid paces at which both organizations are working, as well as the paths being taken, are causing some to question whether there is due process in evaluating these important issues.
• Some bankers also question whether such efforts are driven by a search for simplicity, transparency, and accuracy or by an appetite to expand fair value accounting, no matter the implications.
• A major concern is that the current directions in which the FASB and IASB are moving appear to be similarly requiring more mark to market accounting (MTM) within the financial statements, more capital for many existing banking activities, and more operational challenges to comply with these rules for banks of all sizes.
• The cost of accounting compliance puts continued participation in certain market activities at risk for some smaller institutions.
• Concern over the current divergence between the FASB and IASB proposed models and time frames for completion. The IASB plans to finalize its accounting standard in 2009, and the FASB's completion date will be subsequent to that date. In such case, the FASB will have only one of two choices: (1) to follow the IASB model – which will not provide U.S. companies with appropriate due process for providing input, or (2) a lack of international convergence – which should be avoided.

ABA says that the IASB appears to be solving the accounting puzzle on a piecemeal basis, which may result in pre-determining the outcome for subsequent parts of the puzzle that may not fit.

ABA feels that it is extremely important that new standards be developed jointly by the FASB and IASB, with proper due process and open consultation with a wide range of constituents that ensures a holistic review.

ABA's points for consideration when making substantial changes to the accounting model:

• Serious consideration must be give to field testing proposals prior to implementation, and sufficient transition time must be provided.
• Regulatory accounting rules should be consistent with GAAP.
• Accounting changes must meet a “costs vs. benefits” test.
  

FASB Issues Financial Instruments Proposals

The Financial Accounting Standards Board (FASB) this week announced it will issue an exposure draft proposing that more financial instruments (including loans held by banks and held-to-maturity securities) be recognized at fair value on the balance sheet.

The proposals don't line up perfectly with what the IASB proposed earlier in the week, so this is the newest "fasb vs iasb" scenario, and next year should be interesting as to how the two proposals converge. As per an earlier post, IASB proposals focus on whether a financial instrument has "basic loan features" or is managed on a contractual yield basis. Basic loan features meant that the instrument bears market interest and repays original principal only. To put it bluntly FASB likes fair value better than IASB. The FASB proposals will result in more financial instruments at fair value than the IASB proposals.

Changes in fair value would be recognized either in net income for trading instruments or in other comprehensive income (OCI) for non-trading instruments.

Key aspects of the proposal:

• Fair value changes on derivatives, equity securities, and hybrid instruments containing embedded derivatives requiring bifurcation under FAS 133 (i.e., those not clearly and closely related to the host contract) will be recognized in net income.
  
• For all financial instruments, interest and dividends will continue to be recognized in net income.
  
• Credit impairments and realized gains and losses arising from sales or settlement of financial instruments will be recognized in net income.
  
• The classification of financial instruments will be determined at initial recognition with no subsequent reclassification allowed.
  
• One statement of financial performance will be required, with subtotals presented for net income and OCI. However, only earnings per share for net income will be required.
  

While an exposure draft is planned to be released for public comment in the fourth quarter of 2009, it is possible that it will be issued sooner. At future meetings, the FASB plans to discuss related matters to be included in the exposure draft, including measurement of demand deposits, a credit impairment model based on expected losses, whether to allow nonpublic entities to measure certain financial instruments at amortized cost, and the proposed effective date and transition provisions for a final standard.

This proposal represents a significant change to the existing fair value accounting model and substantial debate is expected, including how the FASB's proposal will align with the International Accounting Standards Board's (IASB) recent exposure draft on financial instrument classification and measurement.

(content from PWC)