IFRS – basics and risk approach to financial instruments

IFRS – basics and risk approach to financial instruments

By Sergey Moderov, ACCA

The Institute for Enterprise Issues

Hereby we present the approach of IFRSs to some risks and disclosure of financial instruments and other interesting matters arising in application of IFRS’s

1. Introduction

The complexities of the corporate and investment world are not helped by the fact that different countries apply different regulations and accounting rules making comparisons between companies difficult. In one famous case, an international company, with stock exchange listings in America and Europe reporting under European accounting standards recorded a loss of $1,300 million. The same entity recorded a profit of $800 million under the American accounting rules for the same year! A potential solution to this problem is to have an international system of accounting rules that would apply across borders so that investors can more easily compare companies, perhaps in the same industry but in different geographical locations. International auditors would of course benefit by having a single stream of audit rules to work from The International Accounting Standards Board (IASB) has achieved success in rolling out a common set of standards known as the International Financial Reporting Standards (IFRS) across the globe. In 2002, the European Union adopted legislation that required listed companies in Europe to apply IFRS to almost 10,000 companies and banks in 28 countries. The IASB was also successful outside Europe. For instance, in Africa, countries like Egypt, Kenya, Malawi, South Africa and Tanzania are amongst those that have adopted IFRS. IFRS rules are also strong in Asia. As regards North America, at the time of writing, there is a convergence project between the American accounting standards board and the IFRS. In addition, there is the prospect that American companies may be allowed to adopt IFRS for American stock exchange filing purposes. From this perspective, the IASB are achieving their objective of having a single and consistent set of rules operating across the globe. While in theory this may sound good, the practicalities of implementing a consistent set of accounting rules globally has proved challenging. The IASB are continuously issuing standards to cope with international events. In 2002, following the Enron scandal where investors were unaware of substantial hidden losses, a number of new standards were issued. The recent global credit crisis has put further pressure on the IASB to respond with more rule changes. The result is that new standards are published very frequently and existing standards are amended. Those on the front line, auditors and financial directors can see first hand the challenges that these new changes create. Keeping up to date with these new standards is hard enough, trying to implement them in practice is in many cases proving to be more difficult. Few in the financial world could doubt that financial instruments, as used by treasurers of large global companies, insurance entities, pension funds and banks have become more complex and difficult to understand. Trying to apply a global set of accounting standards to these complex transactions has proved challenging. One of the controversies facing the IASB is that their rules have permitted financial institutions to record substantial profits literally weeks before the same entities filed for bankruptcy. The problems are not confined to Wall Street and the City of London. Large manufacturing firms, particularly those with overseas entities have to grapple with the thorny subject of group accounts, consolidation and other ‘off balance sheet’ issues. Even areas like accounting for foreign exchange operations have proved difficult. Practitioners whether auditors, financial controllers, investment analysts or regulators need to identify precisely what the IASB are trying to achieve. To do this, a good understanding of the economics of various business transactions and financial instruments is essential. Many practitioners are at risk of applying the accounting standards blindly, leading to instances where the investor is mislead. From a legal perspective, this could cause problems. Accountants must not only comply with IFRS, they also need to keep in mind the accounting requirements of Company Law as well as the regulatory requirements imposed on financial institutions such Basel 3 (soon to be Basel 3). Insurance companies need to keep a close eye on the Solvency 2 issues and how these rules interact with the accounting requirements.

2. Overview
1. Introduction – Overview of IFRS standards 2. IAS 1 Presentation of Income Statement, Balance Sheet and Cash Flow Statement. 3. Treasury Accounting and Fair Value/IFRS 7 4. Consolidation/Off Balance Sheet 5. Revenue Recognition and Accounting for Leases 6. Share Issue, IFRS 2 and Pensions 7. Non Financial Assets Accounting and Impairment 8. Specialist Accounting, Insurance, Hedge Funds and Banking 9. Specialist Accounting Hedge Funds

Rather than list the accounting standards and explain what they contain, this course will look at the standards from a practitioners’ perspective, focusing on some of the more complex but common transactions that accountants face in real life. Using examples from published accounts we will examine the economic substance of the transaction and how the IFRS rules tackle it. In many cases, the accounting standards are not tailor made to every situation. For instance, the standards that apply to simple and straightforward Module One present an overview of the IFRS standards and in particular how they have changed the landscape in financial reporting. Prior to IFRS, creative accountants exploited a number of loopholes ranging from concealed loans to overstating profits and understating expenses and liabilities. There were inconsistencies across the world with different standard setters applying inconsistent rules to the same type of transactions. We will see in Module One how IFRS changed this and closed at least some of the loopholes that previously existed. Module Two looks at the format of the various accounting statements. Prior to IFRS we had the Profit & Loss account, Balance Sheet, Cash flow statement and Notes to the Account. The IFRS has changed the title of the first two to ‘the statement of comprehensive income’ and ‘the statement of financial position’. The format for the presentation is now more standardised and clearer. The objective of the IASB is to provide information that is relevant, reliable, comparable and understandable. The standard setters also require additional information if it will enable users to understand the impact of transactions and other events. Few could doubt that the world of the treasurer, particularly as it applies to international companies and financial institutions. Companies often raise funds overseas either using shares or loans and this exposes them to foreign exchange as well as interest rate risk. Many companies use financial instruments such as derivatives to hedge this exposure. Not only must accountants calculate the profit or loss on these financial instruments, they must also disclose the risk profile – a difficult task if accountants don’t understand these financial instruments in the first place. Module 3 covers this area in depth and in particular focuses on IAS 39 Financial Instruments – Recognition and Measurement along with its proposed replacement IFRS 9 Financial Instruments as well as IFRS 7 Financial Instruments, Disclosures. The credit crisis of the last few years has revealed that even under IFRS the difficult task of avoiding ‘off balance sheet’ accounting is still something that will tax the brains of accountants and financial regulators for many years to come. Many banks for instance failed because of poor regulation – the regulators had depended on information contained in published accounts only to find that the balance sheets concealed the extent to which these entities invested in toxic structured products. The IASB has come a long way in developing accounting standards that curtail Off Balance Sheet abuse, particularly after the Enron scandal in 2002. However, a lot remains to be done. In Module 4 we examine the current rules and how they may change in the short-term and long term. We also look at the problem of defining ‘control’ and the rules concerning non current assets available for sale. Revenue recognition and leases are covered in Module 5. In this module we examine how companies decide on their revenue policy and how it complies with IAS 18 Revenue. The revenue figure is probably the most important figure in a set of financial statements. However, its calculation must be consistent from year to year, otherwise comparisons are very difficult. Many companies of course try to inflate their sales revenue figure either to conceal problems or to simply make the entity look more profitable. We examine IAS 18 in detail and see how it is applied in practice. We also cover the controversial area of leasing and in particular how to distinguish between Operating and Finance leases. Module 6 covers share issues and in particular the complexities of share based payments and share option schemes. The problem of pension deficits and how to account for them are also explored. Module 7 covers Non Financial assets, their accounting and impairment. While Modules 1 to 7 are compulsory, delegates can choose either module 8a which covers insurance accounting or module 8b, investment and hedge funds. In both of these modules, we bring together all that was discussed in the earlier modules but focus on how they are adopted to suit specialized areas.

3. Areas of Concern – Mark-to-Market v Cost Accounting

3.1 Illustration Balance Sheet.

Consolidated statement of financial position at 31 December 2011, (£000) An entities’ balance sheet can be broken down between assets, liabilities and equities. Obviously, as the illustration above shows, the assets must equal both the liabilities plus equity. The accounting equation is relatively straightforward but the practical implementation has proven to be both difficult and controversial. Questions that the IASB has yet to resolve completely are whether the assets should be shown at cost or market value. The same applies to liabilities. The ‘Shareholders’ Funds’ section has a different set of complexities, not unrelated to the debate surrounding Mark to market accounting.

Assets = Liabilities + Equity £281,800 = £102,800 + £179,000

Illustration Balance Sheet From an investors’ perspective, life would be ideal if all assets and liabilities were shown at economic or market value. The investor would then be able to see the amount of economic resources needed to generate profits and would be in a good position to determine if the company was run well and if the profits justified the resources used. Naturally, the investor is not only interested in the economic value of the assets used, but also the risks that the entity takes to generate the profits. There are a few reasons why the accounting standards, even those prepared under IFRS cannot meet these investor requirements. However, trends in the development of accounting standards suggest that the IASB, along with other accounting standard setters are moving towards this objective. One of the challenges that the IASB face is whether they should move towards Markto- Market accounting. This means showing assets and liabilities at their current market value as opposed to cost or some other measure. For the moment, the IASB has adopted a mixed model, some assets shown at cost and others at market value. In general, if an entity buys an asset which it intends to keep to maturity i.e. plant and equipment, bonds and inventory, cost accounting is generally used whereas if an entity buys an asset that is temporary in nature i.e. shares bought with then intention of reselling very soon, market value applies. For financial instruments like derivatives, the IASB, fearful of the accounting abuses that these instruments can create, require all entities to show these instruments at market value. This in theory prevents entities from hiding losses but as we shall see it does introduce a new set of problems. Many banks and corporates for instance have shown artificial profits based on the market value of derivatives which were difficult to value. Unfortunately, the rules are not black and white and are constantly changing. Very recently, the IASB has rolled out IFRS 9 which attempts to offer guidance on when assets should be shown at cost or at market value but even here, a lot of guesswork is required. Looking at the balance sheet in illustration one above, property tends to be shown at a value close to market value (particularly when revalued) but plant and equipment is shown at cost less amortization/depreciation. Goodwill, is normally shown at cost, even though its fair value could be much higher. Investments, trade debtors and derivative financial instruments are, on the other hand shown at their current market value, or a value close to that figure. Inventories are normally shown at cost on the balance sheet. Many accountants argue, that the move to mark-to-market accounting, which in general the IASB is moving towards, is fraught with danger. In the past, accountants made a distinction between ‘realised’ and ‘unrealised’ profits. Realised profits are the profits made when an asset is sold. The figure can normally be calculated with certainty. Unrealised profits are profits that the entity has not yet made, because the asset is not yet sold. Nevertheless, the entity expects to make them in the future. Often there is an element of subjectivity or grayness as to how these profits are calculated. Accountants, being prudent, often ignored unrealized profits until they were more certain ie became realised. However, under IFRS, entities are permitted (and sometimes even forced!) to recognise unrealized profits. One of the contributors of the banking crises was that banks claimed they were making profits, while they were bankrupt. They did this by assuming that certain assets had a value which was well above market value and so they were able to take an unrealized profit to the Profit & Loss account. The ‘mixed model’ problem is not confined to the assets on a balance sheet. The liability side of the balance sheet is also unclear. If an entity borrows money, this is normally shown at cost on the balance sheet (subject to interest charges and repayments). Derivatives such as interest rate swaps (often linked to liabilities) are, on the other hand shown at market value. The pension deficit/Retirement Benefit Obligation is extraordinarily complex but tends to be shown at market value. That is to say, the deficit is calculated based on the market value of assets in the pension fund and the present value of liabilities. Shareholders funds in broad terms comprises cash that shareholders have put into the firm together with profits that the shareholders are entitled to but have not yet received as dividends. These profits are known as retained earnings. Shareholders funds also includes, reserves such as the gain on the valuation of property and gains/losses on foreign exchange movements. These are in effect profits/losses but, unlike retained earnings, the entity is not allowed to treat them as available for distribution ie use them to finance dividends. There are a variety of reasons for this but the main one is that the profits are not ‘realised’ and therefore not certain. Later on, we will see how the IASB has improved the accounting standards to reflect economic reality but, so that we can better understand why the accounting standards are as complex as they are, we examine the ‘cost’ accounting model, its strengths and weaknesses, and analyse the ‘mark-to-market’ model in the same way. From this we will be able to see why the IASB has chosen the ‘mixed’ model and how the complexities of the accounting standards, evolved from this decision.

3.2 Cost Accounting and Cherry Picking

Traditionally assets on an entity’s balance sheet were shown at ‘cost’. In simple terms, if a company paid Euro 10 million for an asset it appeared on the balance sheet at Euro 10 million. This approach was straightforward and simple from an auditors’ perspective. The auditor simply had to check the invoice against the asset to confirm its value. A variation on cost accounting is ‘amortised’ cost. Here, the asset may have a useful life of ten years so, at the end of year four the asset would appear in the annual report at 6 million, the remaining 4 million treated as a depreciation expense in the Income statement. The advantage of this approach is that the treatment is black and white, there is no uncertainty but it does have two important disadvantages. Firstly, the asset does not reflect current economic value, and therefore the information is of limited use to the shareholder who would of course be interested in what the asset would get today if sold. More importantly, showing assets at cost creates a cherry picking opportunity. Illustration 2 Cherry Picking To illustrate, imagine a company bought four assets at the start of the year for Euro 1,000,000 each. At the end of the year, assets one, two and three fell in value to 300,000 while asset four climbed in value to 1,200,000. The entity sells the fourth asset to realise cash of 1,200,000 and records an accounting profit of 200,000 and leaves the remaining three assets on the books at Euro 1,000,000 each, despite the fact that they are only worth 300,000 each. Economically, it is clear to see that the entity has made a substantial loss of 1,900,000 though it is allowed to record an accounting profit of 300,000. Many directors, anxious to earn bonuses therefore deliberately bought assets which allowed them to realise profits and hide losses. In effect, these directors could exploit accounting rules and award themselves bonuses based on accounting profits when in reality the entities were loss making. Illustration 1.2 Cherry Picking

Seasoned accountants might argue that there are many rules on impairment both for financial assets and non financial assets that prevent this type of abuse from taking place. The IFRS certainly has complex rules on impairment both for non financial assets such as inventory, plant & machinery etc. and non-financial assets such as bonds, equities. However, as we shall see later, accountants often face practical problems when implementing these rules leaving a lot of loopholes open. The impairment of non-financial assets is covered by IAS 36 while the impairment of financial assets is covered in a different manner by the more controversial IAS 39 standard.

Foreign Exchange Illustration

A corporate trader working for a company that exports from Europe to American enters into two forward foreign currency contracts. Under contract 1 he agrees to deliver 14,000,000 dollars and receive Euro 10,000,0000 (assume that the market forward rate is $1.40 dollars equals Euro 1). Under contract 2, he does the exact opposite, ie agrees to deliver Euro 10,000,000 and receive $14,000,000. A month later the Euro becomes stronger moving to a new forward rate of $1.50 to Euro 1. The treasurer makes a profit on the first transaction of $1,000,000 but loses $1,000,000 under the second. As a result, the treasurer cashes in the first contract but leaves the second ‘off balance sheet’ which in effect means he ignores it for accounting purposes. Although the trader has not made an economic profit, contract one cancels contract 2, the trader was able to record an accounting profit of $1,000,000. IAS 39 now prevents this.

Prior to IAS 39 the accounting standard for financial instrument, traders were able to award themselves bonuses in this way and many tried it!. IAS 39, (described as one of the most controversial accounting standards ever written) was designed to curtail this practice. Under these rules, all forward contracts must be valued and appear on the balance sheet at the current market value. Treasurer were therefore unable to hide losses or fabricate profits – at least in theory.

3.3 Mark-to-Market accounting and ‘phantom’ profits

A potential solution to this problem is to require entities to show most, if not all their assets and liabilities at market value. In the above example, the assets were purchased for Euro 4 million and their market value at year end is only Euro 2,100,000. The result is that, under this simple example, the entity’s economic loss would be the same as its accounting loss. This would give shareholders a more realistic picture of what happened during the year and more importantly, it would avoid instances where company directors received an incentive based on accounting profits when in reality directors are being rewarded for entering into loss making transactions! Unfortunately, as with ‘cost’ accounting, ‘mark-to-market’ accounting brings about its own set of problems. For instance, entities like Enron were accused of artificially inflating the market value of an asset so that directors could record an accounting profit even though the entity was, in reality making a loss. In the financial world, the ‘Enron’ problem was compounded. A large number of banks across the world, bought complex structured securitisations which were difficult to value. The banks nevertheless claimed that, based on their valuation models, the market value of these complicated instruments had risen substantially in value. The result was that these entities were able to record an accounting profit even though the complicated instruments, (or ‘weapons of mass destruction’ as Warren Buffet referred to them) were making losses of such magnitude that they caused many banks to go bankrupt. Mark-to-market accounting therefore, instead of solving the problem of hidden losses, instead throws up additional problems.

3.4 Compromise

The IASB, along with virtually every standard setter across the world, have come up with a compromise solution. They have allowed entities to record some assets at ‘cost’ subject to amortization or depreciation and others at market value. While this might solve some of the problems outlined above, there is the risk that the ‘compromise’ will retain the disadvantages of both models above and in addition add confusion. Even for a seasoned accounting practitioner, it is not always clear whether an entity should show assets and market value or at cost. Naturally, some financial directors will attempt to fabricate profits and hide losses by selecting some assets for market value treatment and others for cost. Few could doubt that many of the IFRS rules are complex and difficult to implement. The complexity is necessary where we have this ‘mixed model’ or ‘compromise’ system. The challenges facing the IASB are herculean in nature.

4. Improvements under IFRS

4.1 Introduction

Accounting anomalies are created if a transaction, recorded in published accounts do not represent economic reality. Recording assets at cost on the balance sheet, when the market value is something different, allows and often encourages accounting manipulation (or creative accounting as it is sometimes known). The IFRS rules has certainly eliminated some of these creative accounting opportunities, by looking at the economic substance of the transaction before designing the most appropriate accounting standard. The list below, highlights some of the improvements that the IFRS project has encouraged.
• Share-based payments (employee benefits) IFRS 2
• Goodwill (business combinations) IFRS 3
• Pension accounting (employee benefits) IAS 19
• Consolidation IAS 27
• Debt vs equity classification IAS 32
• Loan impairment IAS 39
• Arrangement fees (effective interest rate) IAS 39
• Hedge & derivative accounting IAS 39
• Classification of financial instruments IAS 39

4.2 Share Based Payments IFRS 2

During the dot com era many companies which were loss making were able to record an accounting profit and therefore conceal from the shareholders the huge transfer of wealth that took place from shareholder to employee when companies issued their employees with shares for free or generous share option schemes. The illustration below shows how the abuse took place.
– Share Based Payment Scheme Company X has a staff member on a salary of £100,000 a year. A consulting firm ‘Firm Y’ reaches an agreement with Company X whereby the staff member works through Firm Y but is hired out to Company X for £86,000. Firm Y then agrees to pay the staff member a salary of £70,000 but issues the staff member with shares in Firm Y worth £40,000 which the staff member sells immediately. It would appear that everyone benefits under this proposal. The company reduces its costs by £14,000. The consulting firm records a profit of £16,000 and the staff member concerned sees an effective increase in his salary of 10,000 ie he receives £70,000 salary plus £40,000 cash from shares in place of his old salary of £100,000. In reality the existing shareholders of the consulting firm suffer a loss of £40,000, since the issue of new shares for free means that the shareholders suffer a dilution in their investment. Under the IFRS 2 rules, the consulting firm must effectively increase shareholders funds by 40,000 and show the 40,000 as an expense in the Income statement. When the IFRS rule was introduced (along with its equivalent in America) there was a huge backlash from lobby groups who although successfully delayed the introduction of this rule, eventually capitulated.

Apart from recognising the expense in the income statement, the new rules require entities to disclose how employee share option schemes are calculated including details of any assumptions made.

4.3 Goodwill IFRS 3

Goodwill was another area where creative accountants saw loads of opportunities to fabricate profits and hide losses. Many companies found that they could hide their difficulties by taking over other companies and using confused accounting to conceal what was really happening.

Illustration Goodwill Company X is expected to announce losses of £10 million. It approaches Company Y whose physical assets are worth £40 million and offers to pay £55 million. Immediately prior to the takeover, Company X claims that the valuation of Y’s assets are not conservative enough and so revises the value down to £28 million. Company X nevertheless argues that the goodwill of Company Y is very valuable and so decides not to alter the purchase price. Immediately after the purchase, Company X consolidates the assets of Y into its books as follows ‘physical assets £28 million and goodwill £27 million. The total consideration £55 million is financed through loans of £55 million. Prior to the year end, the company sells the assets with a book value of £28 million for £40 million and records an accounting profit of £12 million. At the year end, instead of announcing a loss of £10 million as expected, the company records a profit of £2 million. The economics of the transaction are quite different from the accounting treatment. Company X has effectively overpaid by £15 million, since the company’s assets are only worth £40 million. However, instead of recording a loss of £15 million the company records a profit of £12 million, or to put it in other words, a loss of £27 million was buried in Goodwill.

IFRS 3’s solution to the problem is two-fold. Firstly, the assets taken over must be recorded at their correct market value. Under IFRS 3 therefore, Company X in the illustration above would not be able to revalue the physical assets down from £40 million to £28 million. Secondly, if Company X overpaid for Company Y (in this case it did by £15 million) the entity must write goodwill down to zero. Prior to IFRS Company X was allowed to keep the £15 million in Goodwill and amortise it over a number of years in the future. The net effect of IFRS 3 therefore is that Company X above is forced to record an accounting loss of £15 million instead of an accounting profit of £12 million. IFRS 3 therefore discouraged many takeovers where the focus of attention was an opportunity to enhance accounting profits rather than enter into transactions that were beneficial to shareholders. While the theory behind IFRS 3 is clear, the practical realities of implementing these rules are proving to be a lot more difficult. This is primarily due to the fact that the calculation of Goodwill is very subjective and auditors are often reluctant to write down Goodwill particularly when put under pressure by directors of the takeover entity. In the UK, major takeover deals by Lloyds TSB and Royal Bank of Scotland possibly recorded accounting profits in the year of takeover. It became clear however that both entities had overpaid significantly for their respective target companies, so much so that these transactions lead to the effective bankruptcy of both banks.

4.4 Pensions IAS 19

Pension accounting is an important area principally because, throughout the world, people are living longer and so pension promises offered by entities to current and former employees are more and more expensive to maintain. Prior to IAS 19 many companies offered very generous pensions to employees without bothering to inform the shareholder of the commitment that they were entering into. The result was that companies were building up huge hidden liabilities. Indeed, so generous were some of the promises that, governments around the world set up pension regulators to force companies to put sufficient money aside to meet future pension obligations. The IASB wisely decided that it was time for companies to treat as a liability, any promises made to employees. For instance, if an entity promised to pay a pension of Euro 30,000 to an employee for each year he survived after retirement, then the entity would have to estimate today, the value of that promise. If the employee was expected to live for another 20 years after retiring, the value of the pension and hence the liability that the company faces would be approximately Euro 600,000 subject to discounting. Of course many entities put aside money to meet these promises. Very often this money is invested in long-term investments such as shares. However, the money put aside, which we refer to as the pension asset, is often insufficient to meet the liability. The difference is known as the ‘pension deficit’. Although, IAS 19, the pension standard is very complex, where there is a deficit, it must generally appear as a liability on the balance sheet. Furthermore, if the pension deficit increases over the year, the increase must be treated as an expense in the Income statement. A lot of companies, worried about the impact that this would have on their Income statement have now decided to move away from giving generous promises. Instead, they promise to put money aside for their employee and then give this money to the employee when he retires. In other words, employers have stopped making generous promises to employees where they guarantee a fixed payment every year after retirement. They have done this in response to pension regulator concerns that these promises are too generous. The requirements of IAS 19 have also played a part as well in exposing the true cost to the shareholder of such generous promises. 4.5 Consolidation and Off Balance Sheet The problem of ‘Off Balance Sheet’ accounting is well over thirty years old. Complexities in the financial world and of global companies means that standard setters like the IFRS find it very difficult to deal with instances when companies should or should not consolidate. A major problem with off-balance sheet accounting is that entities can not only hide instances of where they borrowed money (keeping liabilities off the balance sheet) but also hide losses. A key feature of the recent banking crises was that entities borrowed money to buy assets that subsequently turned out to be loss making. The company hid both losses and assets. In the case of Lehman Brothers for instance approximately $50 billion of assets along with associated liabilities were concealed from the balance sheet and therefore from shareholders. The IASB is responding to this issue by trying to tighten up the rules on when entities are required to consolidate. It may be that the IASB will reintroduce the ‘prudence’ rules, discussed below. This will force auditors to recognise losses even on those assets which IAS 27 permit to be kept off the balance sheet.

4.6 Debt v Equity Classification

There are broadly two ways to fund a company, one is through equity (ie ordinary shares) and the other is through loans. Naturally, equity is the safest form of finance. Once money is invested in a company it cannot be returned to its shareholders and so the equity can be used to ‘absorb’ losses. Loans are different. If a bank or lender sees that a company is in difficulty and is making huge losses, the bank can force the company to repay its debt (or at least recover most of it). Although equity is a safer form of finance it is generally more expensive and does not offer the tax breaks that loan financing offers. Shareholders often prefer to have as little equity in the company as possible as this means that the profits are shared by fewer people. A controversy facing the IASB is that many companies want to use loan financing but conceal the amount of borrowing that they have taken on since they want to appear to be safe to the outside world. Corporate financers have seen an opportunity to meet this demand through what are known as ‘hybrid financial instruments’. In short, many of these instruments appear to be equity and therefore makes the company looks safe but in reality are loans and liabilities. IAS 32 is designed to ensure that these hybrid instruments are appropriately classified as either debt or equity. In comes cases the hybrid instrument is broken down between the debt component and the equity component.

Example- Convertible Bond

An entity is set up with ordinary shares of Euro 2 and issues a hybrid instrument, a convertible bond. Under the terms of the convertible bond, the entity pays a coupon of 6% on a notional of 1,000,000. The bond is expected to last for three years. The terms of the bond are that the investor is allowed to convert the bond to equity after three years. The entity uses the bond to buy a building which it rents out at 8%. If the company did not issue a convertible bond, its cost of borrowing would be 13%. Should the company treat this as equity or debt or a combination of both.? Prior to IAS 32, the guidance was unclear. Although some companies may have treated the funding as loans, some might have argued that the Convertible Bond had a high chance of being converted to shares and so would have treated the instrument as equity and it would have appeared under shareholders funds. IAS 32 has cleared up this confusion and, more importantly, along with IAS 39 (financial instruments) has ensured that the correct finance charge appears in the Income Statement. This transaction would probably have appeared profitable prior to IAS 32 but is in fact economically loss making. The company is effectively borrowing at 13% to buy an asset that has a yield of only 8%. Illustration 4 below illustrates how IAS 32 has an impact on the Income Statement. Prior to IAS 32, the investment in rental property, financed by borrowed money would have recorded an accounting profit, even though economically, it was loss making. IAS 32 makes the appropriate distinction between Equity and Liability. Under IAS 32, the cash flows associated with the loan (which has a coupon of 6%) are discounted at the entity’s true cost of capital 13%. The present value of the loan is therefore 834,719 and not 1,000,000. The remainder, 165,281 is treated as the proceeds that the entity receives on the sale of an option on its own shares and is therefore classified under ‘Shareholders Funds’ in the balance sheet. The interest on the loan is 834,719 at 13% = 108,514. The effective borrowing rate of 13% is used rather than the coupon of 6%. The result is that the IFRS approach is close to economic reality. This deal is of course loss making because the rental yield is 6% but the true cost of financing is 13%. The IFRS approach is therefore closer to economic reality.

Illustration 4 – Impact of IAS 32 on Income Statement

4.7 Loan Impairment

Pre IAS 39

One of the most controversial areas of IFRS is the treatment of ‘impaired loans’. Prior to IAS 39 accountants adopted a prudent principal when evaluating loans that got into difficulty or defaulted. IAS 39 has the effect of ‘overriding’ prudence concept with the result that the bad debts charge in the income statement is delayed, often by a few years, when a bank engages in reckless lending. An illustration will show where the difference arises. Bank X lends 1,000 3 year loans at Euro 1,000,000 each at the start of the year. During the year, 20 of the lenders default, the banks nevertheless recover 30% of the loans and a further 81 obligors are considered to be in difficulty but have not yet defaulted. Assume that the bank has initiated all loans at an interest rate of 5%. The 81 obligors who are in difficulty can still borrow money from other banks but must pay a high rate of interest of 16% to reflect the credit risk that they now pose. Prior to IAS 39, the bank would charge to the Income Statement, a specific charge of Euro 700,000 on each of the 20 loans that did default ie 1,000,000 less the 30% recovered. The total specific charge for the year would be Euro 14,000,000. The bank would also make a ‘general’ provision for the 81 loans that have not yet defaulted but are clearly in difficulty. The procedure would vary from bank to bank but in this case, the entity is only receiving 5% per year on loans whereas the market rate is 16%. So, ignoring discounting, the bank is effectively losing 11% for each of the three years, about 33% in total. The notional outstanding on the 81 loans is 81,000,000 but because of the 33% reduction, their combined ‘fair value’ is 54,000,000 therefore the bank needs to charge a further 27,000,000 to the income statement for the year. The combined specific charge of 14,000,000 and 27,000,000 is = 41,000,000 in the Income Statement.

Post IAS 39

The IASB has not changed the way that the 14,000,000 above is calculated but was concerned about the ‘general’ provision ie 27,000,000. The calculation of this figure is very subjective. In the past, banks exploited this by ‘smoothing’ the income statement. For instance in good years they would charge a very high general provision and in bad years they would release this general provision to the Income Statement claiming that they no longer needed it. The problem became very acute during takeovers. Suppose bank X took over bank Y. Bank X would create a huge general provision for bad debts and then release the general provision immediately after takeover, creating an artificial accounting profit. The controversial solution that the IASB adopted was not to allow a general provision. In the above case, the bank is not permitted to charge more than Euro 14,000,000 in the Income Statement even though the bank is aware that the remaining loans are likely to lose Euro 27,000,000 in value. Banks are in effect prevented from applying the ‘prudence’ concept which states that if an asset’s value is overstated, it must be impaired down to ‘fair value’. While this has removed the ability of banks to ‘smooth’ the Income Statement, it has introduced additional problems. For instance, prior to IAS 39 if a bank lent recklessly, ie charged a customer interest of 4% when it should have charged 20% given the risky nature of the loan, the auditor would, under the prudence principle, force the entity to charge as an expense to the Income Statement, the inherent loss on the loan. Under IAS 39 theauditor is prevented from doing so. According to the House of Lords in the UK, this abolition of the prudence principle has lead to reckless lending. Bankers in effect lent recklessly knowing that in the short-term, their bonuses would benefit from this form of lending. The House of Lords has called on the IASB to reexamine IAS 39 to remove this defect.

5. Prudence

Prior to the IFRS rules, local accounting standards which came into existance in most countries around 2005, virtually all accounting systems had to comply with Compnay Law. UK Company Law for instance required companies to be appropriately prudent and to apply substance over form. Prudence is contained in the law to protect creditors and shareholders from abuse by directors. Companies were required to make sure that any money invested by shareholders in the firm was maintained. In practice this meant that company law prevented entities from paying dividends unless the company had sufficient profits to finance these dividends. Without these capital maintenance rules, companies could easily turn into ‘ponzi’ type schemes whereby shareholders receive dividends which were financed from money that they originally invested in the company as opposed to profits.

6. Case Study Madoff Capital Maintenance

The IASB Framework, defines ‘capital’ and its relationship to the calculation of profit. To recap, an entity’s capital or equity is equal to its net assets and the framework defines income and expenses in terms of changes to net assets. An entity therefore that increases its capital over a period without injecting new capital or paying a dividend can record income as the change in capital over the period. It follows therefore that if the calculation of an entity’s capital is wrong ie by overstating assets or understating liabilities (the opposite of prudence) the company’s income statement will be wrong and the company may end up paying a dividend illegally. A loss making company that pays a dividend is of course fraudulent and ends up becoming like a ‘ponzi’ scheme, ie an entity finances a dividend not from profits but from the cash that the investor originally injected into the firm. As discussed previously, the IASB has reduced the importance of ‘prudence’ on the grounds that it may lead to inaccuracies. In doing so however, they may have permitted loss making entities to pay dividends. An entity is deemed to have ‘maintained’ its capita if it has as much capital at the end of an accounting period as it had at the start of that period. The amount of capital at the end of the period which exceeds the amount required to maintain the opening capital is profit or income. Bernard Madoff an American investment advisor who was a non-executive chairman of NASDAQ raised billions of dollars from investors and fabricated profits. In March 2009 he pleaded guilty to 11 federal crimes. In effect he misled shareholders leading them to believe that he made substantial profits. Based on these profits, Madoff awarded dividends to his customers. In reality, the profits were non existent, Madoff simply returned some of the money that the investor had already paid in. This of course was illegal from a number of fronts not least from a capital maintenance perspective. Under the Capital Maintenance rules contained in Company Law, companies are generally not permitted to return shareholders funds back to shareholders. The money must instead be used to cover potential losses and protect borrowers who are of course able to force the company to return any loans that they have made. IFRS was introduced to European Union listed companies in 2005. In many cases, but not all, the IFRS rules may not be in line with Company Law. There are strict capital maintenance rules contained in Company Law, which in effect require companies and banks to apply the Prudence concept. This is certainly true in the case of Ireland and the United Kingdom but may not be so in other European countries. For banks that record profits on complicated structured products or do not contain provisions for risky or questionable lending, auditors and accountants must make sure that they are in compliance both with Company Law and the IFRS rules. Where there is a clash, the accountant may have to make additional disclosures in the accounts. The underlying principle of prudence is that losses should be booked at the earliest opportunity and profits should not be recognised until earned. In practice this means that an entity must not understate its liabilities or overstate its assets. The adoption of IAS 39, the accounting standard that deals with financial instruments created controversy because it effectively abandoned the prudence concept. This standard allowed companies to record a profit on assets even though these assets were not yet sold. In many cases some of these assets acquired an artificially high value allowing companies to record profits that proved to be non existent. IAS 39 also allowed entities to overstate the value of certain financial instruments, including straightforward loans. Under the prudence rules, if an entity lends money recklessly ie lends to someone who ability to repay is doubtful, the entity must make a provision for potential losses. Under IAS 39 the entity is generally prevented, even it wants to, from recording a provision as IAS 39 used an ‘incurred loss’ instead of an ‘expected loss’ model. In plain English, this means that the borrower must default before the bank can write down the loan. There is the danger therefore that with IAS 39 some profits are overstated and some losses are hidden. In the UK, the House of Lords examined the IFRS rules in light of the recent banking crises. They concluded that the prudence concept should be restored as it allowed entities to hide losses and fabricate profits. Presently, in the UK IFRS is only applied to large listed companies and the intention is to eventually roll this out to smaller private companies. The House of Lords however has recommended that the government and regulators should not extend application of IFRS beyond the larger listed companies until the problem of prudence is resolved.

7. IFRS 7 Risk Disclosure

A potential investors is not only interested in past profits but also the risks that the entity faces. Pension fund managers have a different level of risk tolerance to that of many hedge fund managers. As the recent banking crises has shown, entities that are heavy users of financial instruments such as currency forwards, interest rate swaps, credit derivatives along with bonds and loans. In addition, entities that are heavily dependent on borrowings are much more risky than those entities financed predominantly from shareholders funds. The risks that these entities face can be broken down as follows: • Market Risk, • Credit Risk • Liquidity Risk and • Operational Risk Market risk is essentially the risk that an entity loses money through changes in interest rates, foreign exchange, commodity prices and equity prices. A small change in each of these variables can lead to a substantial swing in the Income statement, particularly if the entity concerned has borrowed heavily. Market risk is more important for hedge funds, pension funds, investment funds and banks and perhaps less important for straightforward manufacturing companies. Credit Risk is the risk that an entity loses money because a borrower defaults, but it also includes instances where a borrower does not default but gets into difficulty and the credit rating agencies downgrade their loans/bonds. This credit migration will obviously reduce the value of any loans that the troubled entity issues and it has an impact on the lender’s Income statement. Finally, credit concentration risks, covers the risk that an entity suffers a concentration of bad debts all at the same time, in many cases forcing bankruptcy. If a manufacturing entity lends too much money to the same customer or the same group of customers then a single default by a customer can trigger a number of defaults with the result that the lending entity too becomes bankrupt. Liquidity risk arises when an entity is solvent ie has more assets than liabilities but cannot liquidate their assets in time to meet their liabilities. A building form for instance might finance the building of a major shopping centre using bank overdraft facilities. This form of financing is of course inappropriate as the bank could call in its loan at short notice but the builder might not be able to liquidate its assets quickly enough to meet the bank’s demand. Ironically, although bank managers qre quick to remind their customers to manage their liquidity properly it was the failure of the banks themselves to finance themselves properly that lead to their collapse in many cases recently. Bankers borrowed money on the interbank market (the equivalent to overdrafts with other banks) and used this money to issue 20-30 year mortgages which proved to be very illiquid. Under IFRS 7 companies along with banks are required to disclose their policies on measuring and managing liquidity risk. Operational Risk is the risk that an entity loses money through a breakdown in procedures and can include fraud. This is often a major source of risk because, with the complexities of the treasury and financial world. many treasurers do not fully understand what they are buying and very often buy financial instruments that are too complicated to value and therefore incur the risk not only of buying loss making products but hiding those losses for a long period of time. There are numerous examples of local authorities, entities like Enron and even sophisticated banks, buying financial instruments that were loss making to begin worth. A real problem arises when traders award themselves bonuses on transactions that are loss making. This is an automatic recipe for bankruptcy and a major source of financial risk. The objectives of IFRS 7 is to require entities to provide disclosures in their financial statements that enable users to evaluate the significance of financial instruments for the entity’s financial position and performance and the nature and extent of risks arising from financial instruments to which the entity is exposed. The entity must also reveal how to manage those risks. Many accounting practitioners believe that IFRS 7 is a ‘tall order’. Auditors would really need to understand the risks of even the most complex of financial instruments before satisfying themselves that what the entity says under IFRS 7 represents a ‘true and fair’ view. In reality, auditors are not always fully conversant with the complexities of toxic structured products or credit derivatives to evaluate how risky they are and so tend to rely on the entity concerned to reveal the risks under IFRS 7. Another practical problem with the implementation of IFRS 7 is that it is a broad based standard that both financial institutions such as hedge funds and international banks must follow but also applies to more straightforward manufacturing entities with relatively simple treasury operations. Some companies find these requirements too onerous and difficult to apply.

8. Categories of Financial Assets and Financial Liabilities

A practical problem that many readers of accounts face is the ‘mixed model’ that is used not only by the IASB but also by the American accounting standard setters. Some assets are shown at cost on the balance sheet and others are shown at market value. For a non accountant, (and even for an accountant) trying to understand the financial risks an entity faces, this mixed model poses problems. IFRS 7, the standard on disclosures attempts to resolve this problem by requiring an entity to disclose information that enables users of its financial statements to evaluate the significance of financial instruments for its financial position and performance. In essence, entities enable users of accounts to understand this by revealing which assets are shown at cost and which are shown at market value. The same applies to liabilities. IFRS 7 (paragraphs 9 -11) deals with financial assets and liabilities that are shown at market value on the balance sheet. Normally a change in the value of these items will have an impact on the Income statement. In broad terms, IFRS requires disclosure on the maximum exposure to credit risk and market risk that these assets contain. The entity must also reveal the extent to which these risks are ‘mitigated’ ie insured against. The entity must also reveal the market risk that are contained in these items.

9. Conclusion

This introductory module was designed to give you a broad brush overview of the challenges facing the accounting profession and how the International Accounting Standards Board, through the IFRS is trying to develop rules that are more consistent with economic reality. The IASB has successfully persuaded many countries to join up to the IASB system in the hope of encouraging greater consistency and clarity. They have also improved some of the standards to reduce the creative accounting opportunities exploited by entities that have subsequently failed, such as Enron. The recent turmoil in the financial markets however has revealed that many financial institutions are not operating as efficiently or as profitable as the publish accounts have lead their investors to believe. The House of Lords in the UK, examining the role of auditors in the recent credit crises has included recommendations, particularly in relation to prudence which should resolve some of the problems that have recently come to light. In the next seven modules we examine the accounting standards in more detail and give examples along with more detailed illustrations and practical case studies. The IFRS rules are changing at a fairly rapid pace. Changes are necessary to comply with Company Law and in America the Financial Advisory Crisis Group are examining ways in which the accounting standards can be improved, particularly in light of the recent credit crises. Throughout the course we will keep you up to date with all these changes and explain the significance of them in annual reports.

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