Financial Instruments: Reducing Complexity
Author:
Sarah Lane
Current financial market conditions have brought financial instruments into the spotlight. Sarah Lane takes an objective look at the IASB’s Discussion Paper on reducing complexity in reporting financial instruments.
With the advent of International Financial Reporting Standards (IFRS), users of financial statements are facing a wide array of information on financial instruments yet it is becoming increasingly difficult to extract and understand what is most important. To address this issue, the International Accounting Standards Board (IASB) issued a discussion paper (DP) on 19th March 2008. Reducing Complexity in Reporting Financial Instruments sets out the main causes of, and possible solutions to, that complexity. It is the first step towards a new standard for reporting financial instruments that would replace .
This DP focuses on how financial instruments should be measured and, to a lesser extent, addresses how to account for derivative instruments. It begins by discussing the main causes of complexity in reporting financial instruments.1 The paper goes on to examine the long-term solution of measuring all financial instruments at fair value. An intermediate approach is required to reduce the current complexity of IAS 39, whilst remaining consistent with the longterm objective. The paper considers a number of suggestions, for example the elimination of either the held-tomaturity (HTM) or available-for-sale (AFS) category.
The DP is organised as follows:
- Section 1 – Problems related to measurement
- Section 2 – Intermediate approaches to measurement and related problems
- Section 3 – A long-term solution – a single measurement method for all types of financial instruments
- Appendices
A – Scope issues to be resolved
B – Measurement issues to be resolved
C – Overview of relevant IASB and joint IASB-FASB projects
D– Overview of FASB project on hedge accounting
E – Questions for respondents
Section 1 – Problems related to measurement
This section sets out some of the problems caused by the measurement methods currently used for financial instruments in IAS 39. The key problem with the current accounting standards is the diversity of methods available to value financial instruments. The classification of the asset determines the required measurement method. The current asset classifications in IAS 39 include:
- fair value (changes in fair value accounted for through profit and loss);
- AFS instruments (measured at fair value but with unrealised gains and losses recognised in other comprehensive income);
- HTM instruments (measured on an amortised cost basis).
The DP suggests that this range of valuation methods causes unnecessary complexity in financial instrument accounting. Further complexity is added by adjustments for impairment, and by hedge accounting, with its detailed hedge criteria. It is proposed that the longterm solution is to use fair value to measure all financial instruments. This would facilitate comparisons between accounting periods for the same entity and across different entities.
Commentary
The paper indicates that it is vital to include fair value changes in the income statement. However, there is no suggestion as to how this should be done. The IASB has to be careful that it doesn’t simply transfer the problem of classification of gains and losses from different types of instruments onto the Income Statement.
Section 2 – Intermediate approaches to measurement and related problems
Section 1 of the DP suggests that fair value for all financial instruments is the long-term solution to reducing complexity. However, it might take a long time to resolve all the issues and concerns involved in implementation. Consequently, an intermediate solution is required.
Section 2 sets out possible intermediate approaches to simplify measurement and accounting. Section 2 of the IASB’s DP lays out four criteria which must be met by the mediumterm solution, most notably consistency with the longterm goal (of complete fair value measurement basis). The paper suggests possible intermediate approaches that would improve and simplify measurement and hedge accounting requirements relatively quickly – including any or a combination of:
Option 1
Amending the existing measurement requirements by abolishing the HTM or the AFS category or removing the tainting rules in HTM.
Option 2
Replacing the existing IAS 39 measurement requirements with a fair value measurement principle and some optional exceptions to fair value measurement.
Option 3
Changing Hedge Accounting
- Remove hedge accounting and replace it with a more general fair value option, or
- Simplify the existing hedge accounting.
Commentary:
Option 1 above is dismissed in the paper as it would take considerable time and resources. Options 2 or 3 are suggested as being useable.
However, it is important to think about whether there is any alternative measurement basis that should be considered which is not looked at by the DP paper. Would supplementary information explain measurement uncertainty (additional disclosures)? If not, how can uncertainty be reflected in an accounting measure of fair value?
Section 3 – Long-Term Solution
This section discusses the use of fair value as a long-term approach to reducing existing complexity. The DP acknowledges that arguments can be made for measuring some types of instruments differently but concludes that fair value is the only measurement attribute suitable for all types of financial instruments. Many issues and concerns must be addressed, however, before fair value measurement could be introduced as a general requirement.
Part A of Section 3 presents the arguments in favour of the use of fair value as the measurement basis for all types of financial instruments (including those with highly variable and fixed cash flows). The DP argues that fair value is the only suitable measurement method for derivatives with variable cash flows (e.g. equities). It proposes that, as there is little correlation between the initial and ultimate cash flows of a derivative, cost-based measures do not include the value of future cash flows.
The DP accepts that for derivatives with fixed cash flows (e.g. bonds), a cost-based approach would be feasible; especially if they are held to maturity (since there is no likelihood of the cash flows being impaired). Arguments for fair value The paper includes the following arguments for using fair value:
- The measurement basis is consistent with the IASB’s longterm goal.
- It would provide more relevant information for users of financial statements.
- No impairment rules are required. This would simplify reporting.
- The need for hedge accounting would be reduced.
Concerns about Fair Value
The concerns about fair value measurement are looked at in Part B.
They include:
- The relevance of reporting fair value changes is questionable,
- Artificial volatility and stability would be caused as a result of unrealised gains and losses affecting earnings,
- There is difficulty in determining fair value, particularly in inactive markets,
- Greater use of fair value might result in more complexity.
Implementing fair value
The various steps that are required before fair value can be required for all financial instruments are considered in Part C.
The steps include:
- a requirement to define fair value (there is currently a number of definitions)2,
- presentation of fair value changes in earnings and additional disclosures.
Issues relating to the derecognition of financial instruments and the classification of financial instruments that have characteristics of debt and equity are outside the scope of the DP and are being addressed as separate projects.3
Commentary:
Although embedded derivatives4 and demand for cash flow hedging (CFH)5 are mentioned in the introductory section, they are not discussed in Section 3. The difficulty in estimating fair values in inactive markets is briefly mentioned (paragraphs 3.78- 3.80) but is not considered in detail. Fair value is an effective measure for assets and liabilities that are held for trading purposes. However, in relation to assets and liabilities where the intention is to hold them for a long period or the market is illiquid, the use of fair value is more complex. It is important to consider whether the fair value solution is more complex than the DP implies.
FASB Response
The Financial Accounting Standards Board (FASB) in the US issued an Invitation to Comment (number 1560-100) on the 28th March 2008. The appendix to this FASB Invitation to Comment is the DP issued by the IASB. The FASB has requested responses to the Invitation to Comment by 19th September, 2008. The FASB also issued an Exposure Draft (ED) of a proposed statement Accounting for Hedging Activities an amendment of FASB statement No. 133 (number 1590-300) on the 6th June 2008. The purpose of the ED is to obtain feedback from constituents on a proposed Statement intended to simplify hedge accounting, resulting in increased comparability of financial results for entities that apply hedge accounting. Specifically, the proposed statement would eliminate the multiple methods of hedge accounting currently being used for the same transaction. The FASB has requested responses to the Exposure Draft 19th September, 2008. International Banking Federation Response
In response to this DP, the International Banking Federation (IBFED) published a conceptual paper in April 2008, Accounting for Financial Instruments. This document sets out the position of the International Banking Federation on whether the measurement of all financial instruments in external primary financial statements is more relevant if prepared on a fair value basis than if prepared under the current mixed measurement model.
IBFED states that fair value measurement provides an appropriate accounting base for financial instruments held for trading purposes or otherwise managed on a fair value basis.
However, IBFED is of the opinion that reality is more complex than can be communicated in a fair value model. IBFED concludes that relevant performance reporting will never be achieved if the framework for financial reporting sticks rigidly to either an amortised cost model or a fair value model. Instead, IBFED suggests that a mixed measurement model (amortised cost and fair value) is more likely to result in useful reporting.
Conclusion
It is clear from this review of the IASB’s DP that no simple solution exists to immediately reduce the complexity of financial instrument accounting. None of the intermediate solutions presented in Section 2 are conclusively superior in approach.
There are also difficulties in implementing the proposed longterm goal of full fair value accounting. The IASB seeks views on both the possible long-term and intermediate approaches. It is critical that all users make their views on the DP known, to ensure the IASB receives balanced feedback. Comments on the paper are to be submitted by 19 September 2008.
Notes
1 Note that much of the information in the IASB’s Discussion Paper has been included in other forms in papers previously published by the Financial Accounting Standards Board (Discussion Memorandum – Recognition and Measurement of financial Instruments Nov 1991, Preliminary Views – Reporting Financial Instruments and Certain Related Assets and Liabilities at Fair Value Dec 1999), the International Accounting Standards Committee IASC/Canadian Institute of Chartered Accountants (Discussion Paper – Accounting for Financial Assets and Financial Liabilities, March 2007), and the Joint Working Group of Standard Setters (Draft Standard – Financial Instruments and Similar Items, Dec 2000).
2 IASB defines fair value as: the price that would be received for an asset or paid to transfer a liability in a current transaction betweenmarketplace participants in the reference market for the asset or liability. IAS 39, pp 9 defines fair value as: the amount for which an asset could be exchanged, or a liability settled between knowledgeable, willing parties in an arm’s length transaction. FASB defines fair value as: the price that would be received for an asset or paid to transfer a liability in a transaction between market participants at measurement date.
3 Dealt with in the IASB Discussion Paper Financial Instruments with Characteristics of Equity.
4 Preparers and users of financial statements would benefit from simplification of the provisions as to when embedded derivatives must be separated.
5 Cash Flow Hedging – the demand for this will remain for future unrecognised cash flows.
Sarah Lane, ACA, is Financial Services Manager at the Institute of Chartered Accountants in Ireland.