14th May 2010:

An accounting proposal that makes sense

The IASB has issued its anticipated, and welcome, exposure draft that proposes changes to the accounting for some financial liabilities.  This follows its decision in the first phase of IFRS 9, the accounting standard for financial instruments that will ultimately replace IAS 39, to restrict the scope of changes in phase 1 to financial assets.  We, in common with some other respondents, had called for this approach so that the IASB could give fuller consideration to financial liabilities, in particular in the context of changes in an entity’s own credit risk.

The proposals would result in the elimination of what the IASB itself has described in its press release as ‘counter intuitive’ effects that result from a decline in the credit status of an entity that uses the option in IAS 39 to measure financial liabilities at fair value through profit or loss.  Because fair value includes the effect of changes in an entity’s own credit status, under the existing guidance a credit rating downgrade results in a reduction in the carrying amount of those liabilities, and a gain in the income statement.

So the worse the credit rating gets, the larger the gain that is recorded in the income statement; while (arguably) this is technically pure, it makes little sense from a commercial perspective.  Anecdotally, some banks have even suggested that, during the financial crisis, the remeasurement of their financial liabilities to fair value was one of the more profitable parts of their business.

Sensibly, the IASB has not proposed a new measurement category, so liabilities to be measured at fair value will still include the effect of changes in credit rating in their balance sheet carrying amount.  While superficially attractive, a new category would have brought the introduction of a new measure that was neither amortised cost nor fair value, with little conceptual merit.  However, the element of changes in value that relates to changes in credit rating will now be excluded from the income statement, instead being recorded separately within Other Comprehensive Income.

I am pleased that the IASB has listened and responded in the way it has.  While I will criticise where this is due, IASB’s outreach to, and consultation with, its constituents during the development of its proposals and new requirements for financial instrument accounting has been excellent.  As we move forward, I hope that this level of engagement and responsiveness will continue in order that the IASB has the best chance of retaining the support that it will need to complete current significant, and in some cases controversial, projects.

 Standards & Regulators  0 Comments May 14th, 2010