Fair Value, Hedge Accounting and Other Controversies
For ten years until June 2011, Tatsumi Yamada had a ringside view into the inner workings of the International Accounting Standards Board (IASB), which effectively sets international accounting standards for most of the world, except the US. Indeed, he was a decision-maker himself, having been appointed IASB’s first Asian board member in 2001.
Now Asia Pacific head of IFRS at KPMG, Yamada brings unique insights into what the future holds for international accounting standards, which have been adopted in whole or in part across Asia.
He spoke to CFO Innovation’s Cesar Bacani about upcoming changes in the valuation of biological assets, hedge accounting, the dream of unified international standards and US GAAP, and other issues. Excerpts:
One controversial issue is IFRS 9: Financial Instruments, which is replacing IAS 39. Specifically, Paragraph B6.5.5 (click here to read this section) has raised questions because it was inserted into the review draft released in September last year; it was never discussed before.
IASB has said that it would clarify the meaning of the paragraph at a board meeting in January 2013. Many people are waiting for that interpretation.
The [controversial] point is the phrase in B6.5.5 that says “a ‘hypothetical derivative’ cannot be used to include features in the value of the hedged item that only exist in the hedging instrument (but not in the hedged item).”
This is taken to mean that, in the case of cross-currency interest rate swaps, a charge for exchanging different currencies should not be included [in the hedge accounting] because the hedged item of debt is denominated in a foreign currency and the feature of exchanging to a different currency is not included in the hedged item.
For example, suppose an entity whose functional currency is the Japanese yen holds a three-year US dollar bond with a face value of US$1,000. If there is an interest payment of US$100 [annually] and payment of the principal of US$1,000 in the third year, the entity may use forward contracts – sell US dollars and buy Japanese yen – to hedge the payments in the first and second year. In addition, it may also have a forward contract for the payment of $1,100 in the third year.
The exact matching of the forward contracts [with the underlying asset] is the current practice, but this practice might not meet the requirement of B6.5.5. A charge for exchanging US dollars to Japanese yen that is included in the forward contracts is not a feature that is included in the US dollar bond. This interpretation of B6.5.5 could lead to [companies no longer using] forward contracts as hedging instruments.
Another accounting standard that is also lately in the news is IAS 41: Agriculture. Singapore commodities company Olam had been attacked by short-seller Muddy Waters for supposedly being overly aggressive in valuing biological assets; Olam counters that it has no choice because it is required by IAS 41 to fair-value its almond orchards, dairy farms and other biological assets. The Malaysian standard setters had suggested that this standard be reviewed a while back. What’s been happening?
In the last four or five years, the Malaysian Accounting Standards Board suggested to IASB to amend IAS 41 [as it pertains to bearer biological assets]. It takes five years for an oil palm tree to bear fruit. During those five years, under IAS 41, it should be measured at fair value. But many plantation operators such as Sime Darby [in Malaysia] strongly believe that during those five years, that palm tree is like PPE – property, plant and equipment. It should be treated as PPE; that means acquisition cost should be applied.
Are we talking about just bearer assets here?
The scope of the amendment suggest that only bearer-type biological assets will be measured at acquisition cost, and the rest of the biological assets will be measured at fair value less costs-to-sell . . . At least that is the direction. The IASB has not yet decided the scope of the amendment.
IASB has agreed with [the plantation operators’] point, and they have made this issue part of their narrow-scope amendments project.
That means that IASB will discuss it in 2013 and hopefully the exposure draft will be issued by the end of 2013.
So things like dairy farms and cattle herds will still be measured at fair value?
Yes. The valuers should make an estimation of the future cash flow and it should be discounted in order to be fair value because it might be unlikely that the valuers will find the quoted prices in the markets for them.
Who will decide what the discount rate should be?
That is an issue. The net cash flow estimation might be very difficult and also what kind of discount rate should be applied, so if the DCF [discounted cash flow] method is used, it might be very difficult to find out the fair value. Please note that this part of IAS 41 was moved to IFRS 13: Fair Value, issued in May 2011
Does IAS 41 contain the criteria for who the independent assessor should be?
IAS 41 does not specify who should make an assessment of fair value. But in normal cases in each jurisdiction, [there are existing assessors], so IAS 41 doesn’t say anything about that.
Is it possible, depending on who the independent assessor, for the assessed fair value of similar biological assets to be widely different?
It could happen in some cases, but I believe there would not be so much difference in the same jurisdiction.
So the onus falls on the external auditors? When they look at the valuation by the preparer, then they would say, tell us how you arrived at this valuation?
Yes, the auditor must make an assessment whether that estimation of the fair value less costs to sell is appropriate or not. That is part of the audit function. Please note that this is not only unique to a biological asset, but it has some communality with other assets that need a level 3 input.
Let’s move on to another issue. You’re on record as ‘regretting’ an amendment made to IAS 39 Financial Instruments in 2008, during the global financial crisis, when you were a member of the IASB board. Why?
As you know, IFRS 39 was changed without any exposure . . . The reason why I so much regret it is that IASB should have exposed the exposure draft even for five days. Without hearing any comment, that is not the right way.
By amending IAS 39, [IASB allowed] financial institutions to reclassify [financial assets such as equity instruments and debt instruments] from trading securities to held-to-maturity or available-for-sale. By doing so, they could avoid recognising changes in fair value as part of net income. The changes in fair value would be recognised as OCI (Other Comprehensive Income) in the case of the available-for-sale category.
Some argued that at that time fair value was not reliable because there were very scarce transactions in the market.
This was a request by Europe. Under US GAAP, such kind of reclassification was allowed, but only in rare cases. In fact, according to US practice, such kind of reclassification has never ever occurred.
Some prime ministers and presidents [in Europe], including President Nicholas Sarkozy, were so worried about what would happen that they asked IASB to change IAS 39 to make a level playing field with the US accounting standards.
Why didn’t IASB stand up to the political pressure?
Even though following due process is the essential part of setting up standards for the world, I understand there was no other choice.
The IASB was afraid that Europe would take a carve-out and we would lose the requirement on the prohibition on reclassification. Without any further disclosure of what items and how much the amount should be reclassified, what amount should be recognised, or affected, in net income – that kind of information will be lost. The IASB was so worried that kind of situation could happen if it didn’t do anything.
Before IASB made the decision, IASB got the approval from the trustees, IFRS Foundation, which said this is an unusual case, and so IASB was allowed not to follow the due process. So that is why IASB decided to make the change and that the effective date should be back-dated to the first of July. In normal cases, a decision made on 13 October, the effective date should not go back to 1 July.
So what did Europe’s financial institutions do?
Some of the financial institutions in Europe reclassified to available for sale. The balance sheet amount is at fair value, but the change in fair value did not affect net income . . . [and therefore did not affect] earnings per share, which is an important metric [for listed companies] . . . The change in fair value was recognised as part of OCI, which is outside net income.
What happens if you reclassify as held to maturity?
Held to maturity applies only to debt instruments, not to equity instruments. And the entity must have an intention to hold them until maturity. If they have equity, it should be reclassified to available for sale.
IAS 39 has been superseded by IFRS 9, right?
In November 2010, the IASB amended IAS 39 and created IFRS 9 in replacement of IAS 39, and this treatment was removed. The new IFRS 9 recognises only two categories. One is the acquisition cost; the other one is measure of fair value, with the change in fair value recognised as net income. OCI is out.
But IASB is now in the process of changing IFRS 9 again. They would like to reintroduce the OCI category for debt instruments that meet specific requirements
Why is that?
One factor is the insurance contract project of the IASB. The IASB is in the process of setting the insurance contract accounting standard. This IFRS will deal with the insurance liability of insurance companies.
Within that project, IASB is considering whether the change in interest rate (discount rate) should be recognised as part of OCI, rather than as part of net income. If the changes in the fair value of debt instruments held by the insurance companies are recognised as part of OCI; they offset to some extent the changes in the insurance liabilities that are recognised as part of OCI.
Is FASB, the US accounting standards-setter, part of this conversation?
Yes, together with FASB, IASB is trying to amend in line with what US GAAP is . . . IASB is trying to incorporate the US thinking into IFRS. This is the second factor driving the IASB’s proposal to introduce the third category.
FASB is reviewing its financial instrument accounting standard. As part of that, fair value measurement should be categorised into two: one is that the change in the fair value should be recognised as OCI; the other is net income.
That change IASB is thinking about is requested by the financial institutions of the world, which strongly require that US GAAP and IFRS should be the same for financial instrument accounting standard. Financial institution in Europe would like to have the corresponding information from the US financial institutions’ financial statements.
There seems to be a divergence between FASB and IASB now; they don’t seem to be as close as they were before.
After the Norwalk Agreement in 2002, IASB and FASB worked very hard to achieve convergence between US GAAP and IFRS. Things have progressed very well from 2002 to 2009.
But the standards that IASB and FASB are [now] grappling with, in terms of financial instrument accounting standard including impairment or insurance accounting standard, are very sensitive standards. The American constituents realise that to converge with IFRS sometimes will result in big changes in the practice currently accepted in the US.
Last December 2011, IASB and FASB made up standards for offsetting of financial asset and financial liabilities, but their decision was not the same. The amended US GAAP allows financial institutions to offset their financial assets and liabilities to the same counterparty based on the master netting agreement that is a conditional offsetting agreement.
However, IASB believes that, in order to achieve offsetting of financial assets and liabilities, financial institutions must have an unconditional rights of offset. That means the master netting agreement is not allowed to be the basis for offsetting.
Is the dream of having one set of accounting standards across the globe not happening anytime soon, then?
Yes, and it’s unfortunate. However, please note that the IASB and FASB decided to provide information that allows users to adjust the amounts on the statement of financial position in order to get comparable numbers.
Where are we today with IFRS conversion in Asia?
China moved to IFRS in 2007. Taiwan moved in 2012. Hong Kong and Singapore have also already applied almost all of IFRS. Korea started applying from 2011. Indonesia will start applying IFRS in 2015.
Are Asian countries adopting IFRS completely? Hasn’t China, for example, decided to dispense with some standards?
As far as I know, the only big difference [in China] is the reversal of impairment. Once a loss is recognised, IAS 36 requires that it should be reversed afterwards if the cause of the impairment is now gone.
But under the China version of IFRS, [reversion] is not allowed. In China, if a listed company has consistent losses for more than two years, it will face possibility of delisting. So this might be why management might recognise [impairment].
If in the past year [a listed company] has to recognise impairment, it might recognise a huge amount of impairment in the first year and reverse it in the second year. This could happen if the reveal of impairment loss is allowed.
Japan itself is still not IFRS?
In August 2007, IASB and ASBJ [Accounting Standards Board of Japan] made a contract that the Japanese accounting standards should be converged with IFRS. We call it the Tokyo Agreement and based on that agreement, Japanese accounting standards have been converged with IFRS, with some limited exceptions.
Japan is on the way, but it is not clear when Japan will make a decision. Japan is waiting for a decision which will be made by the US SEC to incorporate IFRS into US GAAP, but allegedly saying that it will not happen in 2013.
India is not yet there, either?
No, but as India clearly mentioned, they will adopt in a short period of time.
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