Companies following international accounting rules have a new standard on how to account for financial instruments, and it differs in a number of important ways from the standard that is expected to emerge in the United States by the end of the year.
The International Accounting Standards Board finalized its comprehensive revisions of the accounting rules for financial instruments when it issued IFRS 9 Financial Instruments in July, taking effect in 2018. “The biggest change is the new model for credit losses,” says Osman Sattar, an accounting specialist and director at Standard & Poor’s in London. “It is much more forward looking than what we currently have in existing standards.”
The Financial Accounting Standards Board expects to release its final standards on financial instruments by the end of the year, and the rules on credit impairment also will have a more forward-looking approach to provide investors with an earlier warning when a company is facing losses.
FASB’s planned approach, however, will be different from the one IASB adopted. “Convergence appears very unlikely unless FASB has a change of heart, and there’s no reason to believe they will,” says Faye Miller, a partner at McGladrey. “Both are moving to an expected loss model, but under FASB’s model you will estimate a lifetime expected credit loss, regardless of whether credit loss increased significantly, and establish an allowance accordingly on day one,” she says.
IFRS 9 will require companies to assess the creditworthiness of credit instruments and establish an allowance based on an estimate of expected losses for a 12-month period. When there’s significant deterioration in the performance of a particular instrument, then the company would estimate and book an allowance for the lifetime expected loss on that instrument. FASB, however, plans to forego the 12-month estimate and require all instruments to be assessed for their expected lifetime losses from the very beginning, with the allowance booked immediately.
Analysts like Sattar prefer the FASB model because it involves less judgment, less subjectivity, and less likelihood for differences in interpretation. “FASB’s lifetime loss model leads to what we think is more timely recognition of credit losses,” he says. “That definition of ‘significant deterioration’ is going to be subject to a lot of management judgment.” He worries not all entities will interpret and apply the new guidance in the same way, leading to different accounting outcomes.
“It’s critical for companies to understand both how the standards will affect the company’s reporting and, likewise, how they will affect the company’s systems and internal control processes.”
Steve Kane, Partner, EY
Jonathan Nus, a senior director at S&P, says the major difference between the FASB and IASB models is the timing of recognition of expected losses. The IASB model will delay recognition of expected losses compared with the FASB model, he says. He has concerns that the IASB model enables companies to move instruments in and out of the lifetime bucket based on their ongoing assessments of creditworthiness. “FASB’s model mitigates the potential abuses,” he says.
The IASB standard also establishes some different methods of classifying and measuring financial instruments to determine how they will be accounted for in financial statements. IFRS 9 tells companies to classify and measure financial instruments based on two separate tests—a business model test and a cash flow characteristics test. Depending on the outcome of those tests, companies would book a value on a given instrument following amortized cost (or historical cost written down over time for depreciation), fair value with changes in value recorded in net income, or fair value with changes recorded in “other comprehensive income,” a component of equity on the balance sheet.
FASB, by contrast, is planning to retain much of its existing guidance on how to classify and measure financial instruments, says Miller. FASB proposed the cash flow characteristics test in its 2013 exposure draft but then abandoned it based on U.S. feedback that it was unnecessarily complicated. An important difference between U.S. and international rules will be the treatment of equity securities, she says. “FASB is going to require fair value through net income for substantially all equity securities, with a practicability exception,” she says. “If a security doesn’t have a readily determinable fair value, you can elect amortized cost but you’ll have to adjust it if there are observable price changes or impairments.”
IFRS 9 EXPLAINED
Below is an excerpt from IASB’s press release on IFRS 9, which describes what has changed in the new standard.
Classification and Measurement
Classification determines how financial assets and financial liabilities are accounted for in financial statements and, in particular, how they are measured on an ongoing basis. IFRS 9 introduces a logical approach for the classification of financial assets, which is driven by cash flow characteristics and the business model in which an asset is held. This single, principle-based approach replaces existing rule-based requirements that are generally considered to be overly complex and difficult to apply. The new model also results in a single impairment model being applied to all financial instruments, thereby removing a source of complexity associated with previous accounting requirements.
During the financial crisis, the delayed recognition of credit losses on loans (and other financial instruments) was identified as a weakness in existing accounting standards. As part of IFRS 9, the IASB has introduced a new, expected-loss impairment model that will require more timely recognition of expected credit losses. Specifically, the new Standard requires entities to account for expected credit losses from when financial instruments are first recognised and to recognise full lifetime expected losses on a more timely basis. The IASB has already announced its intention to create a transition resource group to support stakeholders in the transition to the new impairment requirements.
IFRS 9 introduces a substantially-reformed model for hedge accounting, with enhanced disclosures about risk management activity. The new model represents a significant overhaul of hedge accounting that aligns the accounting treatment with risk management activities, enabling entities to better reflect these activities in their financial statements. In addition, as a result of these changes, users of the financial statements will be provided with better information about risk management and the effect of hedge accounting on the financial statements.
IFRS 9 also removes the volatility in profit or loss that was caused by changes in the credit risk of liabilities elected to be measured at fair value. This change in accounting means that gains caused by the deterioration of an entity’s own credit risk on such liabilities are no longer recognized in profit or loss. Early application of this improvement to financial reporting, prior to any other changes in the accounting for financial instruments, is permitted by IFRS 9.
A Project Summary providing an overview of the new Standard is available to download here.
Experts say the cash flow test is meant to determine whether an instrument consists solely of principal and interest, while the business model test is meant to determine whether an instrument is held strictly to collect principal and interest, or whether it is held with the intent to sell it, or some combination. Nus says FASB’s different approach—relying more on existing methods of classifying and measuring instruments—is likely to lead to comparability issues. “We may have similar types of instruments being accounted for differently under U.S. GAAP than under IFRS,” he says. “That may be somewhat of a sleeper in terms of the implications.”
IFRS 9 also includes some provisions that are intended to make it easier for companies to achieve hedge accounting, says John Boulton, a director at Fitch Ratings. “It ties hedge accounting more intuitively to the risk management of an entity,” he says. The downside, he says, is that IASB’s guidance so far only applies to individual hedges, not open portfolios. IASB is working on further guidance, he says. FASB has taken little action on hedge accounting in the past few years, but the topic is still on the board’s research agenda.
The differences between IFRS 9 and FASB’s expected standard are going to make it difficult for users of financial statements to draw direct comparisons between entities reporting under the different standards, some accountants say. “FASB hasn’t finalized its disclosure requirements yet, so it’s hard to judge how the disclosures might help reconcile the two,” says John Althoff, a partner with PwC. “Both standards will have extensive disclosure requirements to provide greater insights into how a company has applied the models and determined their impairment allowances. But I don’t believe you will have a direct reconciliation between the two models.”
Steve Kane, a partner with EY, says companies should begin assessing their readiness to adopt the new standards. “It’s critical for companies to understand both how the standards will affect the company’s reporting and, likewise, how they will affect the company’s systems and internal control processes,” he says.