“New financial instruments accounting: Toward reduced complexity?” by Aris C. Malantic (August 23, 2010)

SUITS THE C-SUITE By Aris C. Malantic
Business World (08/23/2010)

The global financial crisis brought about financial reporting issues that focused on financial instruments.

In response, the International Accounting Standards Board (IASB) published in November last year the standard on classification and measurement of financial assets, called International Financial Reporting Standards (IFRS) 9, to replace International Accounting Standards (IAS) 39.

The IASB expects to complete by 2011 the other phases that include financial liabilities, impairment of financial instruments, hedge accounting, and derecognition.

Locally, just last May, the Securities and Exchange Commission, as endorsed by the Financial Reporting Standards Council, adopted the local equivalent known as Philippine Financial Reporting Standards 9.

The Bangko Sentral ng Pilipinas will also issue the related regulations.

The current IAS 39

Under IAS 39, there are four categories of financial instruments, namely: loans and receivables (L&R), held-to-maturity (HTM), available-for-sale (AFS) and fair-value through profit or loss (FVTPL).

The interplay of these classifications has become challenging to those preparing financial statements.

L&R and HTM apply to assets that have fixed or determinable payments and are accounted for at amortized cost using the effective interest rate (EIR) method.

In addition, HTM securities have fixed maturities, are quoted in the market, and are positively intended and are able to be held by the entity until maturity.

Except for certain situations specified in IAS 39, any sale of HTM prior to maturity will cause a “tainting” violation. This forces an entity to reclassify its entire HTM portfolio to AFS, and prohibits the entity from classifying subsequent investment purchases as HTM for a period of two years after the year of tainting.

The tainting rule has been viewed as too restrictive from an investment management perspective.

Both AFS and FVTPL are measured at fair value. Fair value changes of FVTPL are taken to P&L, while those of AFS go directly to equity until such AFS are disposed of or impaired, at which point the accumulated FV gains or losses are recycled to P&L.

An accounting “inequity” results when reversals of previous impairment losses happen for AFS equity securities, since such reversals are not allowed to be recouped through the P&L but are credited to equity. Whether an AFS equity security is impaired or not involves a lot of judgment on whether there is a “significant or prolonged” decline in value.

Identifying and separating embedded derivatives is another complex area where the rules are quite difficult to apply.

Hedge accounting rules are also very prescriptive and no less complicated.

The replacement: IFRS 9

To reduce the complexity under IAS 39, IFRS 9 limits the financial assets measurement categories into two: at amortized cost and at fair value.

Upon recognition, all financial assets are accounted for at fair value.

Subsequently, an entity can measure its financial assets at amortized cost if:

• the asset is held within a “business model” whose objective is to hold assets in order to collect contractual cash flows; and

• the “contractual terms of the financial asset” give rise on specified dates to cash flows that are solely payments of principal and interest on the principal amount outstanding.

Financial assets not accounted for at amortized cost are accounted for as FVTPL. These include derivatives, equity instruments and debt instruments that do not satisfy the above conditions.

However, equity instruments not held for trading may, by irrevocable election and on an instrument-by-instrument basis, be accounted for at fair value through other comprehensive income (FVTOCI).

IFRS 9 also removed the requirement for financial assets to separate derivatives embedded in financial host instruments.

Instead, the entire asset is measured at amortized cost or fair value, depending on the business model and the instrument’s cash flows characteristics.

The tests

For amortized cost measurement, an entity has to pass the “business model” and “characteristics of the financial assets” tests.

The classifications of financial assets should be consistent with its business model. The business model assessment need not be made at the reporting entity level (i.e., to be determined at portfolio level and not on instrument by instrument) since an entity may have more than one business model (i.e., an entity may have two portfolios: one managed on a contractual yield basis and the other on a trading basis that realizes fair value gains).

In addition, the assessment is based on how key management personnel actually manage the business, rather than management’s intent for specific financial assets.

To qualify under the business model test, an entity need not hold all of those instruments until maturity.

However, if more than an infrequent number of sales are made, an entity needs to evaluate the portfolio’s model. As there are only a few exceptions to this, an entity needs to embed in its policies when sales prior to maturity are justified under the business model test.

The other hurdle is ensuring that the contractual cash flows are solely payments of principal and interest on the principal amount outstanding. Certain contractual terms that change the timing or amount of payments of principal or interest do not result in contractual cash flows that are solely payments of principal and interest. Due care must be exercised in looking into the contractual terms of financial instruments.

Following is the synopsis of the classification and measurement under IFRS 9:

Transition reliefs prior to January 1, 2013 (the mandatory effective date of IFRS 9) follow:

• If adopted in 2009 and 2010, initial application date may be any date (after 12 November 2009) within the reporting period and comparative figures are permitted, but not required to be restated.

• If adopted in 2011, initial application date is the beginning of the reporting period and comparative figures are permitted, but not required to be restated.

• If adopted from 2012, initial application date is the beginning of the reporting period and comparative figures are required to be restated.

On the surface, IFRS 9 looks simpler. The financial asset categories have now been limited to two instead of four. Since there is no more HTM category, the tainting provision has been eliminated. The impairment issue on equity securities has been addressed.

However, IFRS 39 will require the careful use of judgment and planning since it is principles-based with relatively less extensive rules and guidance than IAS 39.

The other phases of IFRS (financial liabilities, derecognition, impairment, hedge accounting) are expected to be finalized by June 2011.

It will be prudent for entities to start assessing the impact of this new standard to their operations, policies, processes, systems and people.

(As of publication, Aris C. Malantic is an Assurance Partner of SGV & Co.)

This article was originally published in the BusinessWorld newspaper. It is for general information only and is not a substitute for professional advice where the facts and circumstances warrant. The views and opinion expressed above are those of the author and do not necessarily represent the views of SGV & Co.