The Goal Posts Are Moving: Financial Reporting Readies for Change

(Bloomberg) -- The London-based International Accounting Standards Board published the final version of a new standard covering how financial instruments are reported on financial statements in 2014. Known as IFRS 9, the standard will become effective at the beginning of 2018 and can be applied before then. Treasurers and accountants have started to analyze its impact, not only in their accounting but also in its implications for risk management, tax, internal controls, processes, and whether existing data and systems are sufficient to adapt to the new standard.

IFRS 9 is important. The standard, which replaces the existing IAS 39, was drawn up with the aim of increasing transparency in accounting practices. The standard includes requirements for classification and measurement, impairment, and general hedge accounting. One key area, for example, is booking losses on loans. During the financial crisis, some firms were able to delay reporting losses under the old standard. IFRS 9 was designed to make recognition of such losses more timely.

How an asset such as a loan or swap is treated on financial statements depends on its classification, and that in turn determines how its value is measured on an ongoing basis. Under IFRS 9 financial assets are, broadly speaking, sorted into two buckets: those measured at amortized cost and those measured at fair value.

Derivatives and equity investments covered by IFRS 9 are to be measured at fair value in the statement of financial position, with value changes recognized in profit or loss. There are some exceptions for specific equity investments.

For debt instruments, measurement depends on two criteria. First, what is the entity’s business model for managing the assets? (See chart.) This test seeks to determine the reasons for holding the assets. Is the entity holding them only to collect cash flows­—as a lender, for example, typically would do? Or is it holding them also to sell—as, say, a broker-dealer would do?

The second criterion is the so-called SPPI test: Do the asset’s contractual cash flows represent “solely payments of principal and interest”? The SPPI criteria are based on principles rather than rules and thus can require expert interpretation. The test itself is highly data-intensive and draws on many different characteristics of the instruments. Implementing SPPI testing in the daily running of a corporate treasury could become a significant operational burden.

To help address that, Bloomberg for Enterprise has created an IFRS 9 SPPI solution that provides an automated classification to determine whether securities pass or fail the SPPI test and includes the reasoning behind that conclusion. For more information, check out {BPS L#2821908 }.

When it comes to reporting credit losses, IFRS 9 is forward-looking. That’s a significant change from IAS 39, which was based on an incurred-loss model. The new standard requires a single expected-loss impairment model to be applied for all covered items, including financial assets, lease receivables, and contract assets, among others.

The new impairment model in effect quantifies potential credit losses. A key feature of this model is “staging.” In Stage 1, impairment is recognized using “12-month expected credit losses.” For example, let’s say a firm buys an investment-grade bond. At transaction date, the bond’s loss allowance is related to its perceived credit risk—that is, the probability of default or other credit event—over a 12-month horizon. After that initial assessment, if there is a significant increase in credit risk, the allowance becomes based on its “lifetime expected credit losses.” That’s Stage 2. In Stage 3, the issuer of the security is in default.

Bloomberg is developing an impairment solution that will automate expected credit risk loss modeling for securities. Among its key features are calculations of the 12-month and lifetime probabilities of default.

The application of hedge accounting under IFRS 9 remains optional, as it was under IAS 39. Under IFRS 9, hedge accounting should reflect in the financial statements the true economic effect of an entity’s risk-management activities. Each individual relationship must meet the hedge-effectiveness criteria.

In the details of IFRS 9, there are some major changes that bring both opportunities and demands. An entity may exclude the forward points of a forward contract, time value of an option, or foreign currency basis spread from a designated hedging instrument—provided it’s described as a cost of hedging. Another change is proving popular. IFRS 9 drops the strict quantitative threshold that IAS 39 required for qualifying hedge relationships. Instead, the IFRS 9 hedge-accounting model employs a more principles-based, forward-looking assessment.

Finally, under IFRS 9, it’s possible to designate specific risk for both financial and nonfinancial items if such risk is identifiable and reliably measurable. Some risk components of nonfinancial items—the crude oil component of jet fuel, for example—couldn’t be separately hedged under IAS 39.
 
Pereira is a corporate treasury application specialist at Bloomberg in London. Bozdemir is a product manager at Bloomberg for Enterprise in London. 

To contact the authors of this story: Andre Pereira in London at apereira42@bloomberg.net, Murat Bozdemir in London at mbozdemir@bloomberg.net.

To contact the editor responsible for this story: Jon Asmundsson at jasmundsson@bloomberg.net.