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September 29, 2009

Financial instruments review: The most complex standard

The consultation period for the first stage of the International Accounting Standards Board’s comprehensive review of IAS 39 has come to an end. Carolyn Canham reports on some of the issues that have been raised.

The International Accounting Standards Board (IASB) has its work cut out as it finalises its new financial instruments classification and measurement standard. The two-month consultation on the exposure draft and a series of round tables have revealed polarised views and varying priorities.

Stakeholders are divided on issues including whether conversion with US GAAP is an overriding priority and how extensively fair value measurement should be used.

The classification and measurement project is the first stage of a three-part comprehensive review of IAS 39, a standard so complex that IASB chairman David Tweedie is fond of saying ‘if you understand it, you are not reading it right’.

Mixed measurement

The IASB exposure draft Financial Instruments: Classification and Measurement proposes a mixed measurement model with two primary measurement categories: fair value with changes in profit or loss and amortised cost.

A financial asset or liability must be measured at amortised cost if the instrument has basic loan features and is managed on a contractual yield basis. Fair value through profit or loss must be used in all other cases.

The vast majority of attendants at two round tables hosted by the IASB in London this month supported the mixed measurement model. However, some stakeholders had reservations about the details.

The European Commission and Didier Elbaum from the Committee of European Banking Supervisors are concerned amortised cost is defined too narrowly and the proposals would lead to increased use of fair value through profit and loss.

Elbaum said this would indicate lessons from the crisis have not been fully taken into account.

The EC said it has received “overwhelming support” for the mixed measurement model, but there are two major issues.

One is the line drawn between amortised cost and fair value is not appropriate for some types of instruments. The commission said it is inconsistent with a principles-based approach and does not adequately take into account market liquidity.

The EC said significantly greater emphasis should also be given to the business model as a classification criterion.

“The classification of financial instruments should be based primarily on the business model and only then should the characteristics of the financial instrument be taken into account,” the commission wrote.

The argument that greater emphasis should be given to the business model was echoed by many participants at the round tables and in comment letters.

The fair value debate

Elbaum and the EC are not the only stakeholders to warn the proposals could lead to greater use of fair value through profit and loss.

Richard Martin from the Association of Chartered Certified Accountants (ACCA) said the proposed standard could tip more financial instruments into fair value.

“We would prefer that the use of fair value was not expanded significantly from where we are,” he said.

Frank Lafforgue from BNP Paribas does not like fair value being used as the default measurement.

“We think it should be limited,” he said.

Representatives from the Basel Committee on Banking Supervision and HSBC argued that fair value measurement is not suitable for traditional banking activity.

IASB member Bob Garnett, who chaired the round tables, protested that there is no evidence to indicate the IASB’s approach could lead to extended use of fair value measurement.

Some stakeholders also argued that fair value should be more widely used. Joanna Perry from the said fair value is the appropriate measurement for all financial instruments, although she conceded that could not be introduced at this time.

Representatives from the Canadian and Australian accounting standards boards agreed with Perry’s assertion that users should be allowed to use fair value measurement even when instruments meet the criteria for amortised cost.

Charlotte Pissaridou from Goldman Sachs was one representative from the banking community who said all financial instruments should be at fair value.

Representatives from the Committee of European Securities Regulators and JP Morgan said that all derivatives should be at fair value.

Conversion concerns

The financial instruments review was initially part of the IASB and FASB’s memorandum of understanding on convergence.

However, while the IASB decided it was necessary to spilt the project into three stages to fast track the classification and measurement component, the FASB will address all financial instrument components together.

The break from the convergence plan has been met with protests from some parties, including the American Bankers Association, while others insist the priority is high quality IFRS. Tony Clifford said Ernst & Young feels very strongly that the financial instruments standard should be the same between US GAAP and IFRS. In a similar vein, the ACCA said it “regrets the lack of co-ordination on this the most critical project for a new accounting standard”.

“There are highly significant differences in the proposals which cannot be skated over,” Martin said. “It also seems possible that IASB will have issued the first part of its new standard on financial instruments before FASB has consulted in the US on any proposals. This turn 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.”

The EC and the UK ASB said that while convergence with the FASB is desirable, a high quality standard is more important than one that is compromised to achieve convergence.

Comments on the IASB draft were due on 14 September and the board is now busy finalising the standard. Whatever the result, not everyone will be happy and the fallout remains to be seen.

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