Author: IFRS-Resource

Conflict between management and external user needs

The following article was originally published by Wiley.

Conflict is inherent between management’s use of historical financial statements for interpreting and explaining the financial position and performance of an entity and investors’ use which includes comparability between entities.

The ultimate decision to be made is in answer to the question: Should management be permitted to incorporate their discussion and analysis into the general purpose financial statements prepared in accordance with IFRS® Standards?

In raising this question, the staff of the International Accounting Standards Board (the Board or IASB®) are blurring the distinction between non-GAAP and additional GAAP measures which may also make global regulatory differences more apparent.

A note on terminology and source

The Board has adopted the terminology of Alternative Performance Measures (APMs) and describes those measures as “competing with” IFRS Standards measures, and as typically receiving more emphasis than the IFRS Standards measures. The equivalent term, non-GAAP measures, is used in this article, and also by the Canadian regulator.

IAS 1 distinguishes between information that is specifically required to be included in financial statements because it is necessary for an understanding of financial position or performance (additional GAAP measures), and any other information that is not required for an understanding or non-GAAP.

The agenda papers in which the staff discuss these and related issues can be found at the end of the article.

Inclusion of non-GAAP information in financial statements

The staff papers contemplate allowing the inclusion of non-GAAP information in general purpose financial statements prepared in accordance with IFRS Standards. Examples include sales per square metre, churn rates and capital expenditure.

IASB staff do appear to be addressing investor needs:

“placing some types of information together, such as management’s plans and strategy together with actual results, can help an entity to tell an integrated story about its financial position and financial performance.”

The Canadian regulators specifically disallow a reporting issuer from including non-GAAP measures in financial statements. Therefore, the change would go well beyond the Canadian rules and be a fundamental shift in international financial reporting.

The change would also bring financial statements more into line with – and indeed, competing with – management’s discussion and analysis (MD&A) which is intended to be written from management’s perspective, “through the eyes of management.”

Issues arising

Under current rules, entities must determine which information is above and beyond what is actually required by IFRS Standards to make the financial position and performance understandable. That is a judgment call. If non-GAAP information is permitted, or required, to be included in financial statements then the difference between GAAP measures and non-GAAP measures becomes academic.

Gross profit and operating profit

It seems clear that presenting non-GAAP information in financial statements would make such differences apparent. For example, the staff provide examples such as gross profit and operating profit as non-IFRS. Global differences in what are considered non-GAAP as opposed to additional GAAP measures already exist. In some jurisdictions those sub-totals would be considered non-GAAP measures by regulators. To avoid regional versions of financial reporting any disclosure standard would have to provide detailed guidance and examples.

Presentation and prominence of non IFRS metrics

Other concerns include that the additional information would draw attention away from the IFRS Standards compliant information, or that it may be “given undue prominence or credibility merely because of its location.” Ultimately, the staff paper concludes that the benefits of bringing MD&A-type discussion and metrics into the financial statements would provide better information for users and would outweigh the concerns.

Audit costs and requirements

The IASB staff consider including such MD&A type discussion and information in the financial statements, but excluding certain information from the audit requirement. This gives rise to a concern about being able to “identify a complete set of financial statements, including, in a set of audited financial statements, whether the information is audited or not.”

Annual financial statements of reporting issuers are subject to audit. The paper points out that audit cost and the sensitivity of disclosing information to competitors would act to control the volume of such information included in financial statements.

What is required to make this happen

The IASB staff considers that the primary financial statements act as a high altitude overview of the financial position and performance of an entity and allow a user of the financial statements to go into more detail in certain areas of interest. In addition, the consistency of presentation also allows a comparison of financial position and performance between different entities.

The information included in the primary statements has a “summary and signposting role” which may be given “undue prominence” by management and “hence receive excessive attention” by users. Therefore the IASB staff recommend that a new disclosure standard would be necessary.

The Board has approved narrow focus amendments to IAS 1 which are effective for annual periods commencing on or after 1 January 2016 with earlier adoption permitted. Those amendments provide standards that need to me met for an entity to include additional subtotals on the face of the statement of financial position and comprehensive income. The broader discussion over non-GAAP measures continues.

Criteria for inclusion

In serving the needs of the investor community and making historical financial statements more relevant and useful, the Board is looking to identify the criteria that would need to be in place to allow non-GAAP information to be included in the financial statements or in the notes. Possible criteria suggested by the IASB staff could include:

“(a) be reconciled (where possible) to the most directly comparable measure defined or specified in IFRS and presented in the statement of financial position or performance;

(b) explain why the APM provides relevant information about an entity’s financial position or performance and why the adjustments to the most directly comparable measure …have been made;

(c) be presented and labelled in a manner that makes it clear and understandable what the APMs show and how they are constructed;

(d) provide comparatives and be clear and consistent…from period to period and explain if adjustments have been made…;

(e) not be displayed with more prominence than the subtotals and totals required in IFRS for that statement; and

(f) be clear whether the APM forms part of the financial statements and whether it is audited…on the same basis as the IFRS information.”

Similarly, guidance could also be put in place regarding the presentation or disclosure of items that are non-recurring or that only occur infrequently. And that guidance would include definitions of those terms which are currently not provided in IFRS Standards.

In conclusion

The staff paper concedes that investors find additional measures useful in analysing financial position and performance. At the extreme the IASB staff note that “even APMs that are viewed as being biased can provide information that is useful in assessing management’s character.”

The needs of investors are driving the IASB staff argument for including such information in financial statements, and the Board is looking to expand the IFRS Standards framework to not only allow, but to encourage, their use within the confines of new reporting rules.

Such a shift in the IFRS Standards would require the Canadian regulators to change their position to allow non-GAAP measures in the financial statements of reporting issuers.

In the Canadian market the regulators have consistently raised concerns over the biased way in which certain entities have reported results outside of the audited financial statements. It seems clear that requiring an audit opinion to cover all the information included in the financial statements would act as a control over the quality of that information in addition to acting to limit the volume of such content.

Related material

IASB staff papers (February 2015): Disclosure Initiative: Principles of Disclosure

IASB staff paper on the Performance Reporting project (Global Preparers Forum Meeting) March 2015

http://www.ifrs.org/Meetings/MeetingDocs/Other%20Meeting/2015/March/AP9-Performance-Reporting-GPF-March-2015.pdf

Mind the Gap (Between non-GAAP and GAAP) – Speech by Hans Hoogervorst

Korean Accounting Review International Symposium, Seoul, Korea, 31 March 2015 http://www.ifrs.org/Alerts/Conference/Documents/2015/Speech-Hans-Mind-the-Gap-speech-Korea-March-2015.pdf

Neutrality, relevance and comparability of non-GAAP and additional GAAP measures

In the first of a two-part article, originally published by Wiley, Paul Rhodes, partner at Crowe Soberman, Ontario, examines the use of non-GAAP and additional GAAP measures in Canada and highlights how the relevance, comparability and understandability of a company’s financial statements can be compromised.

Since the adoption of IFRS® Standards by Canadian publicly accountable entities with effect from 2011, there has been an increase in the use of non-GAAP and additional GAAP measures. In some cases this is a necessary side effect of the IFRS Standards financial reporting framework objective of ‘general purpose’ financial statements, as a one-size-fits-all approach is unlikely to do just that.

Non-GAAP financial measures

These have been defined by the Ontario Securities Commission (OSC) in Staff Notice 52-722 as a “numerical measure of an issuer’s historical or future financial performance, financial position or cash flow, that does not meet one or more of the criteria of an issuer’s GAAP for presentation in financial statements, and either:

  1. excludes amounts that are included in the most directly comparable measure calculated and presented in accordance with the issuer’s GAAP, or
  2. includes amounts that are excluded from the most directly comparable measure calculated and presented in accordance with the issuer’s GAAP.”

In some jurisdictions, non-GAAP financial measures are also referred to as alternative performance measures.

Additional GAAP measures

IAS 1 defines additional GAAP measures presented in financial statements as:

  1. a line item, heading or subtotal that is relevant to an understanding of the financial statements and is not a minimum line item mandated by IFRS Standards (paragraphs 55 & 85), or
  2. a financial measure provided in the notes to the financial statements that is relevant to an understanding of the financial statements and is a measure not presented elsewhere in the financial statements (paragraph 112c).

Qualities desirable of the MD&A

Neutrality is required for a faithful representation of economic events in financial statements. Management’s Discussion & Analysis (MD&A) should complement and supplement financial statements. The objective of MD&A is to provide a narrative explanation, through the eyes of management, of how an entity has performed in the past, its financial condition, and its future prospects. Therefore some qualities desirable of the MD&A are the same as those for financial statements. These include, in particular, the requirements that the financial and narrative information presented should be fair, balanced, understandable, relevant and comparable.

The risk posed by the increasing use of non-GAAP and additional GAAP financial measures is that these desirable qualities may be jeopardised. For example, there may be a lack of comparability of financial information between entities, or for the same entity for different periods, meaning that users are potentially unable to identify and understand similarities in, and differences between, items. In a worst case scenario information may not be neutral due to a biased presentation.

To put the issue into context: a study was conducted by the OSC, the results of which were published in 2013, in which the disclosures made by 50 reporting issuers with head offices in Ontario were reviewed. The study revealed that 82 per cent of those reviewed committed to enhancing their disclosures. 

Problems with additional GAAP measures

Operating income

The 1997 vintage of IAS 1 required the income statement to present the results of operating activities as a line item in the income statement. Even though that requirement was subsequently dropped because operating income is not a defined concept in IFRS Standards, it still has a well understood meaning. Some issuers present operating income as an additional GAAP measure but exclude components that would be considered part of operating results. Examples include the exclusion of amortization of acquired intangible assets that are used in operating activities and the exclusion of inventory write-downs.

Gross profit

Other financial statement line items with well understood meanings can also be incorrectly reported (a common example being gross profit), by excluding components that are typically a part of the measure, and conversely, including components that are not part of the measure. 

“Income before the undernoted”

Using terminology that is neither descriptive nor relevant to understanding the financial performance or position, such as ”income before the undernoted” or “income before operating expenses”. Similarly, the inclusion of unlabeled subtotals in the financial statements is unlikely to contribute to an investors’ understanding.

Boilerplate language

The use of boilerplate language, instead of explaining why the additional GAAP or non-GAAP measure is relevant to investors’ understanding of the financial statements, is problematic. A reporting issuer often makes no reference to the measure in either the notes to the financial statements or in MD&A, which casts doubt on the relevance of the measure to understanding financial position and performance.

Problems with non-GAAP measures

”Weighted average yield”

The use of undefined or ambiguous performance measures can be confusing and potentially misleading to investors. For example, disclosing, in MD&A or press release, undefined measures of performance, such as a “weighted average yield” applied to financial instrument receivables accounted for as loans and receivables at amortized cost using the effective interest method.

Furthermore, the inclusion of such a measure in the financial statements may reasonably lead investors to conclude that the measure is a standard GAAP measure that is required to be disclosed, especially in other public documents when there is inadequate disclosure and no reconciliation is provided between the measure and the entity’s GAAP financial statements.

Reconciliation issues

Not providing a clear quantitative reconciliation between the non-GAAP financial measure and the most directly comparable GAAP measure. Such omissions leave investors having to make assumptions about the composition of the non-GAAP measure.

Management bias

Clear management bias in presenting non-GAAP measures, such as including one-time gains but excluding one-time losses in other periods, or by describing measures as excluding non-recurring items when those items are seen to recur within a short timeframe. When items are removed from the GAAP measure of performance to arrive at the non-GAAP measure the nature of the item removed and why it is not expected to recur is rarely provided.

Management bias can also occur where the non-GAAP earnings measure is presented more prominently than the equivalent GAAP measure, or where the GAAP measure is excluded entirely. Earnings releases often include a level of analysis applied to non-GAAP measures that is not applied to the equivalent GAAP measure.

Sheer volume

Investor confusion may be increased by issuers including many non-GAAP measures of performance in a public document with only slight differences between each.

The problems identified above are not new to the IFRS Standards world in Canada. Clearly, there is a need for reporting issuers to be allowed to present measures of financial performance or position suitable to their respective business. However, the Canadian market regulators have had issues with the use of non-GAAP and additional GAAP measures for many years. A subsequent white paper will review in detail the IFRS Standards and Canadian regulatory rules on the use of these measures, and also position that guidance within the global context.

Identifying the amount of an entity’s liabilities that should be classified as current

The following scenarios and questions were initially published by Wiley

Scenario One

At the reporting date, Entity A enters into an interest only loan of CU1 million repayable in ten years’ time with interest of CU 100,000 payable annually. Under IFRS, the loan would be recorded at the reporting date at CU1 million (ignoring transaction costs). Assume that the present value at the reporting date of the CU 100,000 interest payable at the end of the reporting period is CU 92,500.

Scenario Two

At the reporting date, Entity B borrows CU5 billion over 30 years. Payments of CU600 million, comprising principal and interest are due at the end of each year. Under IFRS, the loan would be recorded at the reporting date at CU5 billion (ignoring transaction costs). At the end of the first year, the principal component of the payment of CU600 million is CU60 million. Assume that the present value at the reporting date of the CU600 million payable at the end of the reporting period is CU550 million and the present value at the reporting date of the principal component of the payment is CU55 million.

  1. In Scenario One, what portion, if any, of the CU1 million should Entity A classify as a current liability at the reporting date?
  1. For both scenarios can you identify, based on your experience, the amount that reporting entities would typically classify as current?

Debt that is accounted for at amortised cost requires that the interest cost of the debt be allocated to periods using the effective interest rate, which is the rate that exactly discounts estimated future cash payments through the life of the financial instrument to the net carrying amount of the liability. Therefore at any time, the current carrying amount of the liability is equal to the present value of all future cash payments. To consider this from the opposite direction of time, the principal amount of the debt compounds at the effective interest rate during the life of the instrument.

On each anniversary date when the interest is paid, the present value of all future cash flows will be CU1 million. In the example, since the interest is only paid annually, this relationship will not hold true – assume interest for the year is paid on December 31. Between January 1 and December 30 of the following calendar year the future cash outflows remain the same in nominal dollars, however, the time period over which they are discounted changes (the time period decreases as the year progresses).

Therefore the effect of the discount becomes less, and the carrying amount of the liability increases. This increase in the liability is the interest cost which is accrued but not yet paid. This change in the carrying amount of the liability only occurs because the interest is paid annually (this effect would disappear if interest was paid daily). At all times the CU1 million loan will be presented as long term, and the difference between the CU1 million and the present value of the instrument, namely the accrued interest, will be shown as current.

The amount of the accrued interest will not be the same as the present value of the next interest payment. Instead, the carrying amount of the debt at the reporting date will be the present value of all future cash flows. Individual cash flows are not discounted. This can be seen in the response below to Scenario Two.

  1. In Scenario Two, what portion, if any, of the CU5 billion should Entity B classify as a current liability at the reporting date?
  2. For both scenarios can you identify, based on your experience, the amount that reporting entities would typically classify as current?

Assuming the calculation as presented in the scenario is correct, the CU60 million portion of the combined principle and interest payment should be presented as the current component of the debt. The present value of this amount is not relevant to the current versus long term classification question. Recall the effective interest method described above: the total of the cash flows are discounted to determine the carrying amount of the debt. Therefore the CU5 billion on initial recognition is the discounted amount of those total cash flows. The CU60 million principle component is a portion of that principle balance, that is, it is discounted already. If it was discounted again to determine the classification, then we would be doubly discounting the amount.

By constructing an amortization table for the loan it can proved that the effective interest rate is approximately 11.547776%. I am clarifying the scenario by assuming the loan is entered into on the last day of one reporting period and the first repayment is made on the last day of the following reporting period (year 1 in the table following).

 

year

 initial loan interest repayment closing

balance
1 5,000,000,000 577,388,800 (600,000,000) 4,977,388,800
2 4,977,388,800 574,777,709 (600,000,000) 4,952,166,509
3 4,952,166,509 571,865,096 (600,000,000) 4,924,031,605
>>>
28 1,452,373,314 167,716,817 (600,000,000) 1,020,090,131
29 1,020,090,131 117,797,723 (600,000,000) 537,887,854
30 537,887,854 62,114,085 (600,000,000) 1,939

The table illustrates the effective interest method: interest calculated at this effective rate on the opening balance each period with combined principle and interest payments of CU600 million at the end of each year leaves a zero balance after 30 years.

From the table the closing principle balance at the end of the first year, after making the first repayment, is CU4,977 million. Therefore of the CU5 billion initial debt, CU23 million is due within one year and is presented as current, and the remaining CU4,977 million is presented as long term. The principle and interest components of the CU600 million payments are not individually discounted.

  1. For both scenarios state the amount you believe should be classified as current in accordance with the requirements of the standard. Please provide a rationale for your view.

The current balances for each of these instruments have previously been referred to.

From my experience, reporting entities in the Canadian jurisdiction would also take the approach described above in measuring current liabilities. The rationale, which I agree with, is based on the principle stated in the preamble, and that principle represents the definition of the amortised cost of a financial liability. The definition from IAS 39 paragraph 9 reads, “The amortised cost of a financial asset or financial liability is the amount at which the financial asset or financial liability is measured at initial recognition minus principle repayments, plus or minus the cumulative amortisation using the effective interest method of any difference between the initial amount and the maturity amount…”

Applying this calculation method to the future cash flows for Scenario Two is a proof (effectively performing the calculation in reverse) of the amortization table presented above. Performing the calculation at the opening and closing dates for any year proves the amounts presented in the table. Logically, the difference between those two amounts is the amount of principle repaid during the period which should therefore be presented as current on the statement of financial position.

Presentation of Debt vs Equity in International Financial Reporting Standards

The nature of an instrument is used to determine both its presentation in the statement of financial position and the presentation of related payments or distributions.

In many financing transactions, it is clear that the instrument is either debt or equity, such as common shares or a plain vanilla term loan. However, when the terms differ from the plain vanilla variety the preparer of the financial statements needs to take a closer look to determine the appropriate presentation.

The concept of distinguishing between debt and equity, which is the primary purpose behind International Accounting Standard (IAS) 32, Financial Instruments: Presentation, is often overlooked.

In some cases, what appears to be equity should actually be classified as debt and in other cases the same instrument may contain both debt and equity components (known as hybrid instruments) and each component should be measured and accounted for separately.

The consequences of getting this wrong are clearly significant.

The simplest definition of a financial liability is a contractual obligation to deliver cash or another financial asset to someone else. It also includes a contract that will or may be settled by either: issuing a variable number of the entity’s own equity instruments in exchange for a fixed (meaning non-derivative) obligation; or issuing a fixed number of the entity’s own equity instruments in exchange for a variable (derivative) obligation.

An equity instrument is an instrument that represents an interest in the entity’s residual net assets, which is therefore after deducting all of its liabilities.

Application of this definition can be a thorny exercise. By way of illustration, this article considers some common examples:

Equity that should properly be classified as debt

Some company’s issue instruments that give the holder of the instrument the right to put it back to the issuer for cash or for another financial asset. Such contracts are referred to as puttable instruments. The put is either exercisable at the option of the holder, or is automatically exercised as a result of some future event, such as the death or retirement of the holder.

Consider shares that are held by a member of management, where the shareholder agreement automatically requires the company to repurchase them in the event of the death of the individual. Such a clause is commonly included in shareholder agreements to retain the close ownership of the company by avoiding shares passing to a spouse or other beneficiary of the estate.

The shareholder agreement therefore creates an obligation for the company to deliver cash. The company has no unconditional ability to avoid delivering cash in this case, meaning these shares now meet the definition of a liability. The effect of this treatment is that any dividends paid on those shares are treated as an expense through profit and loss instead of as a distribution out of retained earnings.

Significantly, the instruments are classified as debt even though the triggering event (the death of the holder) has not yet occurred. This could be considered as something of an exception to IAS 10, Events after the Reporting Period, because the actual obligation of the entity to make the payment did not exist at the reporting period.

Instruments that consist of debt and equity components – Hybrid instruments

Many companies issue debt with an added conversion feature which allows the holder to receive a fixed number of shares of the company in settlement of the debt. Such instruments are often used by early stage companies to entice the lender to enter into the financing by also enabling the lender to share in the future growth in the company.

IAS 32 explicitly states that the component parts of a financial instrument must be considered for classification. In this case, the proceeds received are allocated between the liability and the equity components.

Economically, the addition of the conversion feature means the issuer can pay a lower interest rate for the financing because the conversion feature itself has some value to the lender. Therefore, a market interest rate must be identified for a liability instrument that has the same terms (such as maturity, security, and so on) but with no conversion feature. The present value of the cash flows under the convertible instrument discounted with this market interest rate represents the carrying amount of the liability on initial recognition. The difference between this amount and the proceeds received is the equity component. Any costs of issuing the convertible instrument are also allocated between the two components.

Entities without equity instruments and the classification exception

The effect of IAS 32 is, in some cases, to classify all financial instruments as liabilities such that there is no equity presented on the statement of financial position. This can be the case for certain vehicles where the holder of the instrument has the right to put the instrument back to the entity in exchange for cash.

An exception to the definition of a liability exists for puttable instruments and instruments that entitle the holder to a pro rata share of the net assets on a winding up if certain conditions are met.

Impairment losses of financial instruments, current and future

Consider a financial instrument asset accounted for at amortized cost in accordance with IAS 39. The allowance rules under IAS 39 mean:

  • No loss is allowed to be recognized when a financial instrument is initially recorded; and
  • After initial recognition, a loss is allowed only if (i) there is objective evidence of impairment; and (ii) that evidence has to be due to a past event (that is, after the asset was recognized and before the balance sheet date).

Therefore, losses as a result of future events, even events that have already occurred in the period subsequent to the report date, are not allowed to be included in the provision.

An impairment loss under IFRS® Standards is calculated as the difference between the present value of the future cash flows expected from the asset (discounted at the effective interest rate) and its carrying amount at the report date.

The above criteria for recognizing an impairment loss under Accounting Standards for Private Enterprises (ASPE) is consistent, in that an entity must only consider “whether a significant adverse change has occurred during the period in the expected timing or amount of future cash flows.”

When the new IFRS 9 is adopted, which is for years commencing after January 1, 2018 at the latest, the loss provision will look quite different and the new standard will mean a significant divergence in IFRS Standards from ASPE.

Without getting bogged-down in the details, under IFRS 9:

  • An impairment allowance is recognized for all financial instrument assets, and not just after their initial recognition. For an asset recognized on the last day of the reporting period, an impairment allowance is also required to be set up.
  • The impairment loss calculated is based on the credit risk, or more accurately changes in credit risk, since the asset was initially recognized:
    • If the credit risk has not increased significantly since the asset was recognized, then the allowance set up is equal to the 12-month expected credit loss.
    • If the credit risk has increased significantly, then the allowance is equal to the lifetime expected credit loss.
  • The assessment of changes in credit risk between initial recognition and the report date is based on the change in the risk of default occurring over the expected life of the asset, and that assessment must consider:
    • reasonable and supportable information;
    • including forward looking information;
    • that is available without undue cost or effort; and
    • that is indicative of significant increases in credit risk.
  • If reasonable and supportable information is available, an entity cannot rely solely on past-due information.
  • There is a rebuttable presumption that risk has increased significantly when contractual payments are more than 30 days past due.

Our observations of the new impairment rules are:

  • Recognition of impairments under the new rules are aligned with the business model and the pricing of risk.
  • The new test is future looking, which is explicitly disallowed under the current rules.
  • Furthermore, the impairment must be based on ‘evidence,’ so there has to be some fact or information that proves or corroborates the impairment – management cannot hide behind an estimate.
  • In looking for indicative information entities are required to look for data that is correlated with historical losses and to use that information in IFRS 9 loss allowances. For example, if there is an upswing in unemployment rates in advance of increased credit losses historically, then forecasts of future unemployment could be identified as the relevant forward looking information on which to base impairment losses under IFRS 9.

When entities are adopting the new rules in a downward economic cycle impairment losses could be expected to increase. Clearly, however, this depends on what factors an entity identifies as being correlated with its historic losses.

Application of Events after the Reporting Period (IAS 10)

The basis for recognizing adjustments to the financial statements for events occurring after the reporting period and before the financial statements are authorized for issue (subsequent events) is that the event must provide evidence of conditions that existed at the reporting date.

A going concern exception must be applied, such that the going concern basis is not used if events after the reporting period lead to a conclusion that the entity is not a going concern, even if that condition did not exist at the report date.

If an event provides evidence of a condition arising after the reporting date, consideration should be given to whether it is material and requires disclosure. In some cases the distinction is clear, for example the destruction of plant by fire.

Guidance is provided, in the context of subsequent events, for the following examples in the respective standard:

  • Closing a business combination – the criterion for whether a subsidiary is accounted for in the period or in the subsequent period is the date that the acquirer obtains control. In most cases, the date that control is acquired is the same as the closing date for legal purposes, however, it could be earlier or later than the legal closing date depending on the facts and circumstances.
  • Announcing a plan to discontinue an operation and classifying a non-current asset as available for sale – the condition that must exist at the reporting date includes the commitment of senior management to the plan to sell.
  • Announcing a restructuring – to recognize a provision for the restructuring at the reporting date a ‘present obligation’ has to exist at that date as a result of a past event. A present obligation requires that the entity has no realistic alternative but to settle the obligation. Therefore, the obligation may be enforceable by law or by a constructive obligation (meaning that other parties have a valid expectation that the obligation will be settled).
  • Recognizing tax liabilities and assets – the tax rates to be used in measuring tax balances are those that are enacted or substantively enacted by the end of the reporting period. The exact date that rates become substantively enacted depends on the legislative process which can therefore vary between jurisdictions.

Dealing with other events requires application of the principle to the facts and circumstances of the case, and the term ‘conditions at the balance sheet date’ is strictly applied under IFRS® Standards. Consider an entity that has debt outstanding that has become payable on demand due to the breach of a financial covenant at the report date.

Prior to the financial statements being issued, the lender will often provide a waiver of the breach. However, because the breach existed at the balance sheet date, the debt should still be classified as current on the statement of financial position. The fact that the lender has waived its rights after the reporting date would be disclosed but does not affect the classification of the debt.

Under Canada’s Accounting Standards for Private Enterprises (ASPE) the debt would be classified as long term in this same scenario. This point is therefore a significant difference between the two frameworks and is often overlooked by preparers of financial statements under IFRS Standards.

Controversy Surrounding the Credit Risk of Liabilities and the Counterintuitive Effect on Performance Measures

This article was originally published by Wiley.

1) Do you think that non-performance risk should be considered in the measurement of financial liabilities at fair value through profit or loss?

Note that the standard refers to the credit risk (or non-performance risk) specific to the liability and not to the credit risk of the entity itself, usually referred to as “own credit risk”. Changes in the credit risk of the entity will not necessarily be mirrored by changes in the credit risk of its liabilities, for example, liabilities that are secured by collateral may be unaffected.

IFRS 13 defines the fair value of a liability as the price that would be paid to transfer the liability in an orderly transaction between market participants at a specific date. The standard clarifies that the valuation measurement takes place in the principal market for the liability or in the absence of a principal market, in the most advantageous market.

Applying the definition of fair value from IFRS 13 means the fair value measurement takes into account the effect of non-performance risk related to the liability. There are problems with such an outcome, however, such as: in what sense is there a market or market participant here given that such liabilities are rarely, if ever, traded? These practical problems of measurement are ignored in this response to Global Insights.

Despite the theoretical feel of taking into account the credit risk of the liability in measuring liabilities at fair value, in my opinion, this is the correct accounting in order to reflect an accurate financial position of the entity at a point in time. The alternative would be to exclude this credit risk effect from the carrying amount of the liability, which would effectively be a change in the definition of “fair value” used for financial reporting purposes versus fair value in other valuation applications. Furthermore, as pointed out in the Basis for Conclusions to IFRS 9, paragraph BCZ 5.31(d), such a change would be inconsistent with the measurement of liabilities at initial recognition because the fair value at that point in time reflects the liability’s credit risk.

2) If so do you think that the outcome generated by the accounting for financial liabilities at fair value through profit or loss provides useful information to investors?

Under IFRS® Standards, an entity’s overall performance is measured by comprehensive income, within which entities can use other additional GAAP performance measures. Profit and loss is also a required GAAP performance measure. The International Accounting Standards Board (the Board) has not defined a principle for which items are presented in profit and loss and which are included in other comprehensive income (OCI).

The previous accounting for financial liabilities at fair value through profit and loss under IAS 39, presented the total change in fair value in profit and loss. If the credit risk related to the liability deteriorates then the entity recognizes a reduction in liabilities and an increase to profit/reduction in loss, hence the counterintuitive financial reporting. This is clearly a distortion of profit and loss, a key performance measure under IFRS Standards, which thereby diminishes the usefulness of this measure to investors.

In an earlier round of amendments to IAS 39, the Board attempted to fix this issue, by requiring disclosure of the amount of the fair value change that relates to changes in the credit risk of the liability. It seems ironic that an entity is not permitted to use additional disclosures to rectify a departure from an accounting standard, while the Board took exactly this approach in an attempt to rectify a presentation issue!

Clearly the effect of credit risk on the fair values of liabilities is not relevant to how the entity has performed, as measured by profit and loss, and, if this amount is to be recognized, it should not be included in that measure.

3) Do you think that the solution proposed by the Board of accounting for changes in an entity’s own credit worthiness in other comprehensive income resolves the counterintuitive outcomes generated by the current accounting treatment?

Under IFRS 9, paragraphs 5.7.1(c) and 5.7.7, the change in fair value of a financial instrument liability designated as at fair value through profit and loss attributable to changes in the credit risk of that liability is recognized in OCI. The remaining change in fair value of the liability is recognized in profit and loss, unless that presentation would create or enlarge an accounting mismatch in profit or loss, in which case the entire change in fair value is recognized in profit and loss.

Given the opinion that the statement of financial position should reflect the credit risk specific to liabilities at fair value through profit and loss, there are two alternatives to present the other side of the entry. One is to record the change directly in equity, and the second alternative is to present the change in OCI. The former was considered in the exposure draft on own credit risk in 2010, however, almost all respondents to the draft did not support it and the Board agreed. Therefore inclusion in OCI appears to be the best option remaining.

The IFRS 9 solution is an improvement in financial reporting because the profit and loss performance measure is not distorted. A definitive conclusion with respect to inclusion in OCI is difficult to reach in the absence of clear principles of what, exactly, OCI represents and what the objective of the measure is.

4) Do you think that recycling between OCI and profit or loss for changes in own credit risk is appropriate?  If so, under what circumstances?

The premise behind the “no recycling” rule set out by the Board is that any adjustments will net off to zero once the debt is settled for the contractual consideration at the instrument’s maturity date. The fair value of the debt between initial recognition and maturity is likely to deviate from the contractual liability of the instrument. Therefore such a liability settled at maturity would not give rise to any amount to be recycled from OCI to profit and loss. An amount to be recycled only exists if the liability is settled during the term.

In the event that a liability is settled early, it seems reasonable that the difference that is crystalized should be recycled because it then represents a realized gain or loss. This view arises from the opinion that OCI represents recognized but unrealised gains and losses that should be moved to profit and loss when realized. The Board took issue with this approach on the grounds of a comparison with investments in equity instruments measured at fair value with changes presented in OCI for which recycling is prohibited.

Related to the lack of a principal behind OCI, there is no clearly defined principal as to what items should be recycled and which should not. Some clarity around this topic would help to achieve a consistent treatment that is justified on theoretical grounds. The IASB has included a requirement to disclose the amount of accumulated OCI that has been realized during the period. In addition, IFRS 9 gives an entity the option to transfer the accumulated gain or loss within equity in the event of an early settlement.

5) Do you think own credit risk is specific to financial liabilities measured at fair value through profit or loss or should IFRS® Standards provide clearer guidance on the role of own credit risk in other standards such as the ones dealing with insurance contracts or provisions?

Insurance contract accounting is the subject of an ongoing project. Therefore, in answering this question, only provisions have been considered.

Paragraph 47 of IAS 37, states that the discount rate to be used should reflect the current market assessment of the risks specific to the liability, in addition to the time value of money. This is consistent with the requirement in paragraph 37 of that standard of measuring the liability as the best estimate of the expenditure required to settle the present obligation at the end of the reporting period or to transfer it to a third party at that time.

The practice in the Canadian market is to exclude the effect of changes in own credit risk related to the entity itself when measuring provisions. This is consistent with the measurement of financial liabilities at fair value through profit and loss under IFRS 9. The accounting treatment of the change related to the change in credit risk of the liability is not consistent because there is no requirement under IAS 37 to recognize that amount through OCI. The nature of these two types of liability does not appear to justify different treatment on the comprehensive income side of the entry. This inconsistency warrants attention by the Board as part of a project on OCI.