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Reducing Complexity in Reporting Financial Instruments
Comments from ACCA
September 2008
ACCA is pleased to have this opportunity to comment on the Discussion Paper (DP) on the above subject, which was considered by ACCA's Financial Reporting Committee. I am writing to give you their views.
General comments
We agree that there is significant complexity in the current reporting of financial instruments, and we strongly believe that there is a need for the Board to tackle this complexity by working towards a long term solution. The DP is a welcome addition to the debate on complexity in financial reporting and offers some insightful contributions as to how to progress with regards to simplifying the reporting of financial instruments.
We do however have concerns about the long term objectives of the Board in relation to adopting a single measurement basis for all financial instruments. While we believe that the number of measurement bases does impact complexity, we do not believe that a single basis of measurement would be appropriate. Moreover, we do not consider that this would reflect how businesses are actually managed. A 'mixed model' of measurement bases would better reflect the various risk strategies management employ, a fact that financial reporting standards should allow entities to report. In our previous letter to the IASB, dated 5 May 2007, we set out our reservations about the use of fair value. As many of these issues remain unresolved and are being considered by other IASB projects, we would not support the Board's objective of moving towards a full fair value model for the measurement of all financial instruments.
We note that IAS39 was originally seen as an 'interim' standard, and therefore any further intermediate changes to that standard should certainly demonstrate a positive cost/benefit to all interested parties and should be geared towards a long term solution. While we remain strongly opposed to continual piecemeal changes to accounting standards, in order to be as helpful as possible to the Board, we have highlighted in the body of this letter, some areas relating to both measurement and hedge accounting which could be amended in the short term. We believe that these would meet the broader criteria suggested in the DP, and would be a move towards the mixed approach that we would like to see in reporting financial instruments.
Specific questions posed by the IASBProblems related to measurement
Q1
Do current requirements for reporting financial instruments, derivative instruments and similar items require significant change to meet the concerns of preparers and their auditors and the needs of users of financial statements? If not, how should the IASB respond to assertions that the current requirements are too complex?
There has been considerable investment made in the understanding and application of the current standards relating to financial instruments and to some extent we do believe they are sufficient to meet the concerns of interested stakeholders. With the potential negative impact on preparers coupled with our opposition to continual amendments to standards, we would suggest that only well analysed short term changes should be considered in order to avoid diminishing the benefits of recent efforts to apply the existing IAS39 requirements.
We do strongly believe that the application of some of the current requirements are complex and that not all this difficulty is due to the inherent complexity of the financial instruments themselves. While we understand that there is a pressing need to resolve some of the complexity which is solely a result of the financial reporting standards, we believe that the Board should seek to resolve this as part of a more concerted long term effort to improve or replace IAS39, with a more principles-based standard. We would agree that this process should commence immediately, and that some of the proposals in the DP do offer solutions that would simplify the accounting for financial instruments.
Intermediate approaches to measurement and related problems
Q2
(a) Should the IASB consider intermediate approaches to address complexity arising from measurement and hedge accounting? Why or why not? If you believe that the IASB should not make any intermediate changes, please answer questions 5 and 6, and the questions set out in Section 3.
As mentioned in our general comments, we do not agree with the Board's long term objective of introducing a full fair value measurement bases. As such, we do not believe that the Board should consider any short term solutions to measurement of financial instruments which are solely intended to lead to that long term goal.
We are not convinced that the benefits of making intermediate amendments to IAS39 would necessary outweigh the costs of understanding and applying them. However, in order provide the Board with helpful suggestions should they feel such amendments are necessary, we acknowledge that there could be some intermediate simplifications to measurement. These would not necessarily point to the Board's ultimate objective, but would meet the supportable criteria outlined in paragraph 2.2. They could also form the basis for a long term solution to reporting financial instruments, which we reiterate should be the overriding goal for the Board.
In this context, we also believe that there is certainly scope to make intermediate simplifications in the area of hedge accounting, especially in relation to documentation and effectiveness testing.
(b) Do you agree with the criteria set out in paragraph 2.2? If not, what criteria would you use and why?
We agree with the criteria set out in paragraph in 2.2 other than for 2.2(b). As we have previously mentioned, we do not agree that fair value for all financial instruments is an appropriate long term objective, and therefore we cannot support the conditions of 2.2(b) which assumes support for this objective.
Q3
Approach 1 is to amend the existing measurement requirements. How would you suggest existing measurement requirements should be amended? How are your suggestions consistent with the criteria for any proposed intermediate changes as set out in paragraph 2.2?
Please see our response to question 4, for the joint response to both question 3 and 4.
Q4
Approach 2 is to replace the existing measurement requirements with a fair value measurement principle with some optional exceptions.
(a) What restrictions would you suggest on the instruments eligible to be measured at something other than fair value? How are your suggestions consistent with the criteria set out in paragraph 2.2?
(b) How should instruments that are not measured at fair value be measured?
(c) When should impairment losses be recognised and how should the amount of impairment losses be measured?
(d) Where should unrealised gains and losses be recognised on instruments measured at fair value? Why? How are your suggestions consistent with the criteria set out in paragraph 2.2?
(e) Should reclassifications be permitted? What types of reclassifications should be permitted and how should they be accounted for? How are your suggestions consistent with the criteria set out in paragraph 2.2?
We believe that part of the aim of a system of measurement bases should be to try to reduce unnecessary complexity of accounting standards and that this could be achieved through limiting the number of measurement categories for financial instruments. Equally we believe that much of the current complications actually arise from the application of detailed rules within IAS39 surrounding those categories, and the Board should take positive short term measures to keep the measurement more straightforward and easier to apply and understand. We agree that both approaches 1 and 2 do offer some supportable solutions to these areas of complexity which would meet the criteria set out in paragraph 2.2.
It is clear that both approaches also point to full fair value measurement as being the preferred basis for valuing all financial instruments, which will ultimately lead to the Board's long term objective. We believe that a single measurement basis such as fair value does not reflect the commercial reality of the varying business models that drive a business. It is imperative that accounting standards allow entities to reflect their individual business models in order to provide the most useful decision-making information.
As mentioned above, we are of the opinion that there is scope for IAS39 (or its ultimate replacement) to be a more principles-based standard. Therefore, of the four measurement categories within IAS39, we believe that the 'loans and receivables' and 'held to maturity' categories would be most conducive to being replaced by a more principles-based approach. By accepting the Board's proposals on eliminating the 'available for sale' category, we could support a mixed model of measurement which would effectively be reduced to two categories: a merged amortised cost basis and fair value measurement (with optional exceptions). This could serve as the basis for the long term accounting for financial instruments.
We would also note that while we broadly support the elimination of the 'available for sale' category with a fair value approach, we believe that before that happens further work would need to be done in terms of recognition of gains and losses and presentation in the income statement for such instruments. It would be vital to ensure that no added complexity arises from the user perspective in interpreting the resulting information.
With regards Approach 2, we also hold reservations about the eligibility for cost-based measurement depending on the variability of an instrument's cash flows, as outlined in paragraph 2.19. We believe that this would not fit well with a principles based standard and other possible criteria for exceptions should be explored.
Q5
Approach 3 sets out possible simplifications of hedge accounting.
(a) Should hedge accounting be eliminated? Why or why not?
Hedges are used by companies to manage their risk, and we strongly believe that the economic reality of the effects of those activities should be reported by companies.
(b) Should fair value hedge accounting be replaced? Approach 3 sets out three possible approaches to replacing fair value hedge accounting.
(i) Which method(s) should the IASB consider, and why? (paras 2.37 to 2.54)
(ii) Are there any other methods not discussed that should be considered by the IASB? If so, what are they and how are they consistent with the criteria set out in paragraph 2.2? If you suggest changing measurement requirements under approach 1 or approach 2, please ensure your comments are consistent with your suggested approach to changing measurement requirements.
We believe the Board should aim to develop principles-based requirements to hedge accounting. We believe that this would encourage companies who are currently put off from adopting hedge accounting due to the complexity of the rules relating to it. As mentioned in our response to part (a) of this question, hedging activities should be reflected in financial reporting. They are used to manage earnings and their removal would cause volatility to those earnings that do not reflect economic reality.
With regards the three specific proposals in the DP to replace current hedge accounting, we can see some merits in all three methods. Method (c) which proposes to permit recognition outside earnings of gains and losses on financial instruments is clearly the most compatible with the Board's own long term objective of a fair value basis to measuring all financial instruments. As set out throughout the body of this response, we do not believe that fair value should be the primary basis for measuring financial instruments and therefore would not support this method.
Method (a) proposes an extension to the fair value option for those (non-financial) assets and liabilities not permitted to use fair value hedge accounting. As described in paragraph 2.40, this would resolve some of the issues of the current fair value options. We also believe that this could form the basis for a more principles-based approach and do away with some of the restrictions in fair value options and fair value hedge accounting. Companies would be better able reflect those instruments that are managed on a fair value basis, including entire or partial items, and we would see this as resulting in more useful information.
The DP rightly suggests that this could still lead to some of the issues in current accounting, such as financial engineering and added complexity. However, we believe that there is merit in further exploring this approach.
Method (b) proposes recognition outside of gains and losses on hedged items. As outlined in paragraph 2.46, this approach does have a number of benefits. Thus in the context of realising a principles-based solution, this method offers the potential to merge cash flow hedging and fair value hedging into one principle for reflecting hedging strategies – potentially reducing complexity and simplifying the understanding in this area of financial instrument accounting. Again, we would qualify the benefits of this approach by acknowledging the DPs concerns that such an approach would need further development, especially in terms reporting ineffectiveness and recycling profits and losses from equity to profit.
Q6
Section 2 also discusses how the existing hedge accounting models might be simplified. At present, there are several restrictions in the existing hedge accounting models to maintain discipline over when a hedging relationship can qualify for hedge accounting and how the application of the hedge accounting models affects earnings. This section also explains why those restrictions are required.
(a) What suggestions would you make to the IASB regarding how the existing hedge accounting models could be simplified?
(b) Would your suggestions include restrictions that exist today? If not, why are those restrictions unnecessary?
(c) Existing hedge accounting requirements could be simplified if partial hedges were not permitted. Should partial hedges be permitted and, if so, why? Please also explain why you believe the benefits of allowing partial hedges justify the complexity.
(d) What other comments or suggestions do you have with regard to how hedge accounting might be simplified while maintaining discipline over when a hedging relationship can qualify for hedge accounting and how the application of the hedge accounting models affects earnings?
As noted throughout our responses, we believe that a long term principle-based solution to hedge accounting should be the objective of the Board. That said, there are evidently a number of areas in the current hedge accounting models which we believe are causing complexity to preparers.
In particular we would support simplification of the current documentation requirements. These are unnecessarily burdensome and failure to comply with their every detail can lead to failed hedge accounting (despite the hedge itself being effective). Simplification of the way the effectiveness of the hedge is documented including the exclusion of information on the ongoing assessment of the effectiveness of the hedging instrument could be considered by the Board.
We also believe that effectiveness testing itself could be simplified. For example, subsequent effectiveness tests are unnecessary if all ineffectiveness is reflected in the income statement anyway. Whilst 'bright line' rules such as the 80%/125% effectiveness test makes it difficult for companies to consistently apply hedge accounting. Similarly the rules on requiring retrospective effectiveness testing as well as prospective testing appear to be excessive. It does not seem appropriate to penalise management for changes in circumstances beyond their control, especially when the prospective test was effective.
With regards the question on partial hedging, we believe that such accounting should continue to be permitted. Again, entities often use partial hedges to manage their risk, and this commercial reality should be reflected.
Q7
Do you have any other intermediate approaches for the IASB to consider other than those set out in Section 2? If so, what are they and why should the IASB consider them?
We have no additional comments.
A long-term solution - a single measurement method for all types of financial instruments
Q8
To reduce today's measurement-related problems, Section 3 suggests that the long-term solution is to use a single method to measure all types of financial instruments within the scope of a standard for financial instruments. Do you believe that using a single method to measure all types of financial instruments within the scope of a standard for financial instruments is appropriate? Why or why not? If you do not believe that all types of financial instruments should be measured using only one method in the long term, is there another approach to address measurement-related problems in the long term? If so, what is it?
As previously mentioned, we believe that limiting the number of measurement bases would simplify the application and understanding of financial reporting standards. While the Board's long term solution of fair value as the single long term method for measuring all financial instruments would initially appear consistent with that view, we believe that it is equally important for accounting to reflect business reality. As discussed in our response to question 4, we would therefore advocate a reduced number of measurement bases, but a mixed model which allows businesses to provide decision-useful information to their users.
As was pointed out in our letter to the IASB dated 5 May 2007, we continue to hold significant reservations about the definitions of fair value measurement and the extent of its use in IFRS.
Furthermore, we believe that the Board should also take note of the increasing concerns from various parties and especially banks about the difficulty in measuring many financial instruments in the current market situations. There is in particular unease at applying fair values in illiquid markets, a point which also poses questions for emerging economies that may lack active markets, let alone deep and liquid ones.
Subject to a thorough analysis of the costs and benefits of applying a single measurement basis, we are content that there should be a 'mixed model'. Not only is this consistent with the current Framework, but such a model does provide useful information and is appropriate for the various types of financial instruments held by entities. As set out in our response to question 4, we believe that this mixed model would include a reduced number of measurement bases, could be achievable in the short term and would form an effective basis for the long term accounting for financial instruments.
Q9
Part A of Section 3 suggests that fair value seems to be the only measurement attribute that is appropriate for all types of financial instruments within the scope of a standard for financial instruments.
(a) Do you believe that fair value is the only measurement attribute that is appropriate for all types of financial instruments within the scope of a standard for financial instruments?
(b) If not, what measurement attribute other than fair value is appropriate for all types of financial instruments within the scope of a standard for financial instruments? Why do you think that measurement attribute is appropriate for all types of financial instruments within the scope of a standard for financial instruments? Does that measurement attribute reduce today's measurement-related complexity and provide users with information that is necessary to assess the cash flow prospects for all types of financial instruments?
Please refer to our response to Question 8.
Q10
Part B of Section 3 sets out concerns about fair value measurement of financial instruments. Are there any significant concerns about fair value measurement of financial instruments other than those identified in Section 3? If so, what are they and why are they matters for concern?
We generally agree with the practical difficulties as outlined in part B. In addition to those concerns, we believe that financial reporting should reflect an individual entity's business models. Entities will hold financial instruments for various purposes, such as short term trading or long term investment, and the use of a single fair value measurement would not reflect the risk strategies of those different entities. Even banks themselves do not manage the entirety of their financial instruments on a full fair value model, and therefore we cannot see how a full fair value model would appropriately represent the way management perceive their businesses.
We would also stress here the importance of considering performance reporting and presentation when considering fair value measurement. We believe that the income statement should be a key indicator of business performance, and therefore would question how satisfactory it might be for all fair value movements to be recorded therein. If on the other hand, further classification in the income statement was required, this could then result in more complexity. It is therefore essential that the Board, considers any project on measurement in conjunction with other projects on presentation and effectively evaluate the usefulness of resulting information, before proceeding.
In our response to question 8 we mentioned the problems of applying fair value measurement in illiquid markets. We believe that the current credit crisis is likely to result in more financial instruments being based on internal valuation models, rather than actual market-based 'fair' values. Not only are we not comfortable with the extensive use of such valuation models, but the necessary disclosures that should accompany them, are in our opinion a cause of complexity in themselves.
The credit crisis has also emphasised another area of fair value measurement that we have previously raised concerns about – the fair value of liabilities. We are also surprised that the DP itself does not consider this aspect of financial instrument measurement in any detail. We continue to oppose the inclusion in reported profits of the effects of changes in a company's credit risk reflected via the fair value of its liabilities. Such profits have been recorded in the financial statements of a number of financial institutions in recent months, and we fail to understand why such counterintuitive results can be reflected in the financial statements of an entity that has not performed accordingly.
We therefore believe that a mixed measurement approach, with limited bases, would not only better reflect differing business models, but also mitigate some of the issues relating to fair value measurement.
Q11
Part C of Section 3 identifies four issues that the IASB needs to resolve before proposing fair value measurement as a general requirement for all types of financial instruments within the scope of a standard for financial instruments.
(a) Are there other issues that you believe the IASB should address before proposing a general fair value measurement requirement for financial instruments? If so, what are they? How should the IASB address them?
(b) Are there any issues identified in part C of Section 3 that do not have to be resolved before proposing a general fair value measurement requirement? If so, what are they and why do they not need to be resolved before proposing fair value as a general measurement requirement?
We agree with the issues the Board has identified. We would however, emphasise the importance of coordination with other IASB projects, such as that on the Framework, financial statement presentation and derecognition of financial instruments.
As reflected in our response to Question 10, we believe there are a number of issues which would need to be resolved before a general fair value measurement requirement could be perceived for all financial instruments. Many of these are being highlighted in the current economic climate, and it is vital the Board take on the concerns of preparers and user alike, both to the impact on reporting of the current market situation, as well as to the other more long-standing misgivings of applying fair value measurement to all assets and liabilities.
Q12
Do you have any other comments for the IASB on how it could improve and simplify the accounting for financial instruments?
We have no comments to make other than the ones in the main body of our letter.