Regulation & Standards

Crunch time

Published: Apr 2013

Corporates today are experiencing a degree of ‘uncertainty fatigue’, as they have waited for more than a decade for the convergence of the two main accounting standards – the International Financial Reporting Standards (IFRS) and the US Generally Accepted Accounting Principles (US GAAP).

The corporate number crunchers want the rules to be laid out so that they can take the necessary measures to become compliant.

“I think the corporate community just wants clarity. They have been waiting for a long time and now want a standardised accounting model so they can start adjusting their systems and get on with it,” says Mark Vaessen, Global IFRS Leader at KPMG.

Since the signing of the Norwalk Agreement in 2002, the US Financial Accounting Standards Board (FASB) and the International Accounting Standards Board (IASB) have been working towards converging the standards. Most of the short-term and several of the longer term convergence projects have either been completed or are nearing completion.

A single international accounting standard, however, will not signal the end to this journey. Its implementation will be watched closely by many, and future reviews will no longer involve just the FASB and IASB but the rest of the world.

Where do things stand now?

Convergence has been achieved for revenue recognition accounting and accounting for leases, but there have been “some challenges to developing completely converged solutions, especially for the impairment and insurance contracts project,” stated the IASB and FASB in their joint update in February.

The IASB is making limited amendments to IFRS 9 Financial Instruments, while the FASB is proposing completely new guidance, and as such, their exposure documents will differ.

The joint project to improve financial reporting on financial instruments is being conducted in three phases:

  1. Hedge accounting.
  2. Expected credit loss accounting.
  3. Recognition and measurement of financial assets and liabilities.

For financial instruments, both boards have eliminated differences in their respective classification and measurement models, and have converged standards on contractual cash flow characteristics assessment, business model assessment, fair value through other comprehensive income and fair value through profit or loss.

Impairment or loan-loss provisioning

Overhauling the accounting for financial instruments has been the most important phase to date and aims to develop a more forward-looking provisioning model which recognises expected credit losses on a timelier basis. Currently, both standards use an incurred loss model to determine when impairment is recognised on financial instruments, which entails a loss event to take place before a provision can be made. This model was criticised following the financial crisis as it delayed recognition of losses and failed to reflect accurately credit losses that were expected to occur.

In a March statement, IASB Chairman Hans Hoogervorst said: “We believe the model leads to a more timely recognition of credit losses. At the same time, it avoids excessive front-loading of losses, which we think would not properly reflect economic reality.”

All entities that hold financial assets that are not accounted for at fair value through net income and are exposed to potential credit risk would be affected by the proposed changes covering loans, debt securities, trade, lease and reinsurance receivables, loan commitments and other receivables.

While the aim continues to be a converged standard, the extent of future convergence will depend, in part, on feedback. The boards spent time in developing a three-bucket impairment model, but after considering views by stakeholders, the FASB decided to modify its proposal to include only a one measure approach – the current estimate of contractual cash flows not expected to be collected on financial assets held at the reporting date. The IASB will maintain the ‘three-bucket’ approach but it will be revised to address concerns on which lifetime expected losses should be recognised.

Both proposed models remove any threshold for the recognition of expected credit losses and the information used to estimate and measure this is consistent for both models. The FASB has published a separate document for public comment on an alternative expected credit loss model. The comment deadline for IASB’s draft is 5th July and for FASB, 30th April, with deliberations expected to be completed in 2013.

Hedge accounting

The IASB’s move to improve hedge accounting by aligning it more closely with a company’s risk management activities is not a joint project with the FASB. The FASB, however, has sought comments from its stakeholders on IASB’s Hedge Accounting Exposure Draft but has not yet begun deliberations, in conjunction with feedback on its own proposals.

The IASB, on the other hand, has agreed to grant relief from the requirement to discontinue hedge accounting where a derivative is required by law or regulation to be novated to a central counterparty (CCP). An exposure draft has been prepared with a comment deadline of 2nd April (see below).


Lease obligations are widely considered a significant source of off-balance sheet financing and the aim is to improve financial reporting by both lessors and lessees by recognising leases on the balance sheet.

For capital/finance leases, the IASB and FASB decided to provide specific transition relief for existing finance, capital, sales-type and direct financing leases. Both bodies will publish exposure drafts on lease accounting in the second quarter of 2013 and jointly redeliberate the proposals later this year. As with impairment, the timing of the issue of final requirements will depend on feedback.

Revenue recognition

The aim is to create identical standards on revenue recognition and to clarify the principles that can be applied consistently across various transactions, industries and capital markets.

Both Boards completed the substantive redeliberations of the recognition and measurement principles in December 2012 and plan to take another look at the remaining topics, which include the scope, disclosure, transition and effective date, in 1Q13 and issue final standards in mid-2013, according to the joint report.

Insurance contracts

Both Boards acknowledge the difficulties in reaching convergence for insurance contracts, blaming this on the different starting points – the IFRS currently does not include accounting requirements for insurance contracts, while the FASB is proposing amendments to its own longstanding insurance model.

They have reached different decisions on the model, including recognition of changes in estimate, inclusion of a risk margin in the measurement of liability and the treatment of acquisition costs.

The IASB decided to seek feedback on only five key issues:

  1. Treatment of participating contracts.
  2. Premiums presentation and claims in the comprehensive income statement.
  3. Treatment of unearned profit in an insurance contract.
  4. Presenting, in other comprehensive income, the effect of changes in the discount rate used to measure insurance contract liability.
  5. The approach to transition.

The IASB plans to publish this in the first half of 2013, whereas the FASB is targeting mid-2013.

Investment entities

Although the investment entity project was, in most part, jointly deliberated by the IASB and FASB, the final requirements will be similar but not identical. The IASB issued final requirements in October 2012 and the FASB will issue a final standard in the first half of 2013.

The FASB is addressing the accounting for investment entities more broadly than the IASB. Joint deliberations on the feedback will commence later this year.

Philippe Danjou, IASB Board Member, has tried to clarify some misconceptions on the convergence in Europe. He says the IFRS do not require – nor are there plans to require – all assets and liabilities to be stated at fair value, and notes a mixed model used under IAS 39, will be maintained under IFRS 9. Also, he says, for derivative financial instruments, there are hedge accounting provisions which neutralise any volatility when the use of derivative instruments is part of a hedging strategy and its effectiveness can be demonstrated.

Will the US embrace IFRS?

KPMG’s Vaessen says the key question going forward will be whether there is enough political will in the US to adopt IFRS. “It has proved very difficult to make decisions with the two Boards trying to agree on everything.”

Despite this, IFRS is accepted in more than 100 countries and, as such, considered to be the global standard setter.

“Large international companies in the US are in favour of IFRS. They have reporting obligations in numerous countries and it is cheaper if they can do it as a group. They will have less reconciliation and bookkeeping to do. Whether you are a treasurer or an accountant, it is easier if just one standard is used.”

“Obviously US companies with a more domestic focus are reluctant to switch to IFRS. The transition would be costly, so they need to know what the benefits are.”

The global economic uncertainty has resulted in a focus on costs, especially in the US where there are other new regulations such as the Dodd-Frank Act. Therefore, this may not be the best time to ask for a big change in accounting rules.

Vaessen does not think a decision will be forthcoming soon. “The expectation now is the US will not decide until perhaps late this year or early next year, at the earliest.”

Gurpreet Banwait, Product Manager at derivatives and hedge accounting solutions company, Fincad, agrees that although there is some convergence, the official convergence is probably still many years away.

So what will happen if the US decides against adopting the IFRS? “It will be unfortunate. But we would still have one world with two standards,” Vaessen says. However, there is a risk that in the absence of a US decision on the adoption of IFRS, a decade of convergence may be followed by a new period of divergence.

On whether China, Japan and India will embrace IFRS fully, Vaessen believes this is very likely. “A US decision would certainly push other countries to decide. Even if the US decides not to proceed, I believe China, Japan and India will in the end choose IFRS.”

The three countries have already made significant moves towards IFRS but have yet to adopt the standards fully, with China and India adapting the IFRS to their own needs.

Challenges going forward – application of the standards

The next challenge going forward for the accounting community will be the consistent application of the IFRS globally.

“Despite it being in only one language, so to speak, there are a lot of different dialects. People are coming to the international standards and are sometimes pushing for their own interpretations.

The IASB set up the Standing Interpretations Committee in 2002 (renamed IFRS Interpretation Committee in 2010) to interpret and “provide timely guidance on financial reporting issues not specifically addressed in IAS and IFRS”. Vaessen questions whether the committee is geared to handle all these enquiries.

The committee recently changed its approach so as to handle more issues but it still needs to step up, especially on the already converged standards and even more so if the US were to come on board.

“There will however be a limit in terms of giving guidance. With principles-based standards, you have to leave room for professional judgement under the particular fact and circumstances, rather than try to give guidance for every conceivable fact pattern. The latter approach runs the risk of ending up with rules, rather than with principles, which would be undesirable. So, overall it is a matter of finding the right balance,” concludes Vaessen.

Hedge accounting

The IASB’s Novation of Derivatives and Continuation of Hedge Accounting’ proposes changes to IAS 39 and the proposed chapter in IFRS 9 to allow hedge accounting where hedging instruments are novated to a central counterparty (CCP) in line with laws or regulations introduced on over-the-counter (OTC) derivatives.

The European Market Infrastructure Regulation (EMIR) was passed in 2012 but technical standards on OTC derivatives, reporting to trade repositories and requirements for trade repositories and CCP took effect on 15th March 2013.

Hedge accounting in a treasury environment could lead to reduced volatility in profit or loss. However, the rules as they stand now are complex and time consuming, with onerous documentation requirements, says Amit Bhana, Manager, Capital Markets Division, Deloitte South Africa, where he heads the hedge accounting function for the IFRS Advisory Service Line.

The changes proposed in IFRS 9 include:

  • Hedge accounting to be aligned to risk management activities.
  • Removal of the requirement for a retrospective test, although a prospective test is still required.
  • The threshold for hedge effectiveness testing being removed – replacing the current quantitative requirements and arbitrary bright lines for assessing hedge effectiveness with a qualitative assessment on the basis that ensuring the hedging relationship results in an unbiased hedge, with a second requirement that the hedging relationship achieves more than accidental offset.
  • Proof is required of a correlation between hedged item and hedging instrument.
  • Hedge ratios could be rebalanced to improve hedge effectiveness.
  • Risk components of non-financial items can now be hedged.
  • Relief is provided for hedging with options.

Treasuries should consider how this will impact their hedge accounting processes and their financial statements, says Bhana. “The application guidance remains complex in some areas, and significant cost and effort may be needed to analyse the requirements and determine how best to apply them. To complement a more principle-based approach, additional disclosures will be required of how a treasury is managing its risks.”

The changes are intended to align the presentation of these risk management strategies with the way that treasurers run their business. Designating hedging relationships without careful consideration of the entity’s documented risk management strategy may result in the entity not achieving hedge accounting. The changes aim to reflect all hedging-related activities in other comprehensive income.

“Ahead of IFRS 9, treasuries should review their current risk management and hedge accounting policies. It is expected that existing hedging relationships will continue to qualify under IFRS 9. However, the criteria to achieve hedge accounting will be significantly different compared to IAS 39, particularly with effectiveness testing. Potentially, hedge accounting can now be applied to relationships that were not possible under IAS 39,” says Bhana.

Finally, treasurers should assess their treasury management systems (TMS) and departmental readiness. Additional system and data requirements include the ability to track rebalancing of hedge relationships, measurement of risk components of non-financial hedged items and hedge effectiveness assessments with more statistical rigor.

Fincad’s Banwait warns if corporates apply all these new charges from EMIR and Dodd-Frank, then this may impact non-financial organisations using derivative contracts to reduce their risks.

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