08 March 2014

IASB/Hoogervorst: Closing the accounting chapter of the financial crisis

In the next few months the IASB will publish the Impairment and Classification and Measurement chapters of IFRS 9 'Financial Instruments'. They represent the final elements of the IASB’s response to the global financial crisis. That response was guided largely by the recommendations of the Financial Crisis Advisory Group, or FCAG.

One of the key findings of the FCAG was to emphasise the role of financial reporting in providing unbiased, transparent and relevant information. However, the FCAG also recognised that only so much can be expected of accounting. Accounting standards could contribute to financial stability by providing transparency. It should not expect accounting standards to provide a veneer of stability by ignoring volatility when it is really there.

The FCAG also made more specific recommendations with regard to IFRSs. The most important were the following:

• improving the accounting for what is on or off balance sheet and the related disclosures;

• fixing the so called ‘own-credit’-problem: the counterintuitive result of entities booking gains when the value of their own liabilities fall as they become more likely to default; and

• devising a more forward-looking impairment model for loan loss provisions.

• Finally, the FCAG urged the FASB and IASB to come to converged solutions.

How has the IASB responded to the financial crisis? The IASB undertook a variety of projects to look at areas that needed improvement.

First, Fair Value Measurement: The fundamental question was how to apply mark-to-market accounting when there is no active or well-functioning market. In IFRS 13 Fair Value Measurement the IASB provided more guidance on how to determine fair value in illiquid markets. While fair values are often seen to be equivalent with exuberance, this Standard actually requires risk adjustments when mark-to-model valuations are used.

Second, the IASB improved accounting for off balance sheet items: The main issue in this area was to do with Qualifying Special Purpose Entities in US GAAP, which had led to widespread off balance sheet financing in the United States. IFRS did not have such a concept and the IASB´s off balance sheet requirements held up well. Still, the IASB decided that disclosure about exposures to off balance sheet items could be improved. The IASB decided that if entities have a relationship with an off balance sheet structured entity then disclosures are required about the risks and the nature of the relationship. And, in a related project on consolidation, the IASB affirmed control—not just majority ownership—as the basis for consolidation.

Third, the IASB set out to reform financial instruments accounting: This has been the IASB´s main response to the financial crisis. The IASB´s work on classification and measurement of financial instruments focused on when such instruments should be measured at fair value, and when amortised cost should be used.

The IASB introduced a more logical approach for determining the way in which a financial instrument is classified. The new model bases classification partly on an entity’s business model for managing their financial assets.

The IASB has recently made incremental improvements to this approach introducing the concept of a business model where assets may be held either to sell or to collect contractual cash flows. This change will not narrow the amortised cost business model in IFRS 9. Furthermore, the IASB has made it clear that financial instruments with interest rates set by government rather than being directly linked to market interest rates are eligible for amortised cost measurement.

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