Sue Lloyd, Vice-Chair of the International Accounting Standards Board (Board), discusses IFRS 9 and explains the Board's thinking behind the requirements for equity instruments in the Standard.
This is the first year that companies around the world are using the new financial instruments accounting Standard, IFRS 9 Financial Instruments. IFRS 9 was the main response of the International Accounting Standards Board to the global financial crisis, and it introduces many enhancements to financial instruments accounting.
While we believe that we ended up in the right place, accounting for financial instruments has always generated a lot of controversy and IFRS 9 is no exception. One of the areas of concern to some stakeholders is how the new requirements for equity investments can impact long-term investment. The European Commission has asked the European Financial Reporting Advisory Group (EFRAG) to conduct further research on this topic and, as a result, EFRAG has recently published a Discussion Paper that is currently open for consultation.
During discussions that I've had with stakeholders on the topic of equity investments, it has become apparent to me that it might be useful to reflect back on the Board's reasoning when it developed the new requirements for equity investments. In this paper, I will summarise the approach we took and hope to clarify the Board's rationale for the decisions taken.
Some stakeholders have suggested that the requirements for equity investments in IFRS 9 could discourage long-term investment. They say that the default requirement to measure those investments at fair value with value changes recognised in profit or loss (P&L) may not reflect the business model of long-term investors. In the view of these stakeholders, the choice to recognise those value changes in other comprehensive income (OCI) instead is not likely to be an appealing alternative because those amounts cannot be subsequently taken out of OCI and recognised in P&L (‘recycled') when the investment is sold, and they believe this prohibition means that the investor's performance will not be properly reflected. This gives rise to a concern that if neither of these accounting treatments is appealing, then long-term investors may be disincentivised to hold equity investments on a long-term basis. As a result, some have suggested that the Board consider changing the requirements in IFRS 9 for equity investments.
Against that background, the European Commission called for close monitoring of the impact of IFRS 9 on long-term investors and asked EFRAG to investigate the potential effects of the requirements in IFRS 9 for equity investments. As previously mentioned, as part of that work, on 1 March 2018, EFRAG published the Discussion Paper (DP) Equity Instruments—Impairment and Recycling in order to gather its stakeholders' views on the accounting for equity investments that are measured at fair value with changes recognised in OCI, in particular whether the requirements in IFRS 9 could be improved by introducing recycling and impairment for those investments.
IAS 39 already required that almost all equity investments are measured at fair value on the balance sheet.1 The main effect of IFRS 9 on the accounting for these investments is to change the location of the information about changes in their value.
In our view, clearly visible information about changes in the value of an equity investment is always important, even if the investment is not going to be sold in the near term. Value appreciation is probably the most important goal of any long-term investor. This is why the default in IFRS 9 is to recognise changes in the value of equity investments in P&L. If an equity investment is relevant to an entity's performance, then the most useful information about that investment is provided by measuring it at fair value with value changes recognised in P&L, as those changes occur period by period. This will result in movements in P&L, but those movements reflect economic reality.
For example, consider a share that an investor purchases for CU100 and sells 20 years later for CU210. That value appreciation took place over an investment period of 20 years. It distorts the investor's performance to recognise a gain of CU110 in P&L at one point in time; ie when the investor sells the share. That treatment does not properly portray the investor's performance in any period—neither over the life, nor in year 20—because it affects performance in a single period when, in fact, the gain arose over an investment period of 20 years. Better information is provided about value appreciation and the investor's performance when value changes are recognised period by period as they arise.2
However, the Board acknowledges that in some unusual cases, presenting changes in the fair value of an equity investment in P&L may not be indicative of the investor's performance. That may be the case when an investor holds ordinary shares in a company for ‘strategic' reasons such as to strengthen a business relationship or to gain access to a particular market. In such cases, the investor is holding the investment for non-contractual benefits rather than for increases in its value, and therefore changes in the value of such an investment do not reflect the investor's performance vis-à-vis that investment.
Because such circumstances exist, IFRS 9 allows companies to choose to recognise changes in the value of equity investments in OCI as long as the investment is not held for trading purposes. While it is not further limited in scope, the Board consciously designed this election for a narrow population of equity investments that are held for such strategic reasons or benefits. During the development of this election, the Board discussed circumstances such as cross-shareholding in Japan where companies invest in each other in order to strengthen and solidify their long-term business relationships. This election in IFRS 9 was not designed for financial investments that are held for value appreciation or dividend payments. Changes in the value of such strategic equity investments are arguably never indicative of the investor's performance—neither period by period as they arise nor on crystallisation when they are sold. Consistent with this view, the OCI election for equities does not include recycling.
We consulted extensively when we developed IFRS 9. There was broad support for having an OCI election for such strategic equity investments. Users of financial statements said that they distinguish between fair value changes arising from equity investments held for such strategic purposes and fair value changes arising from investments held for investment returns.
In addition, the requirements for equity investments in IFRS 9 are consistent with the Board's revised Conceptual Framework for Financial Reporting (Conceptual Framework), which states that the statement of profit or loss is the primary source of information about an entity's financial performance for the reporting period. Consequently, in principle, all income and expenses are included in that statement unless the Board decides, in exceptional circumstances, that including income or expenses arising from changes in the current value of an asset or liability in OCI would result in the statement of profit or loss providing more relevant information, or providing a more faithful representation of the entity's financial performance for that period. In this case, as previously noted, we believe that an investor's performance in a reporting period is best portrayed using P&L—by including all fair value changes on equity investments in P&L as they occur period by period.
When a company using IFRS 9 chooses to recognise changes in the value of equity investments in OCI, those amounts are not subsequently recycled to P&L when the equity investment is sold. This is consistent with the Board's view that when an investment is held for strategic purposes (ie the intended narrow population), these gains and losses are not part of an investor's performance.
It is also consistent with the principle in the Conceptual Framework that amounts included in OCI in one period are recycled to P&L in a future period only when doing so provides more relevant information, or provides a more faithful representation of the company's performance for that future period. The Board designed the election in IFRS 9 to recognise value changes on particular equity investments in OCI specifically for circumstances in which such changes are not indicative of the investor's performance. In other words, for these investments, such gains and losses are never indicative of the investor's performance; they do not become so in the future period when the strategic investment is sold.
In addition, recycling provides an incomplete picture in P&L of the investor's performance because only the effects of investments that are sold and any impairment are recognised in P&L. As a result, an investor may show a profit in P&L from the sale of ‘good' assets even when its investment portfolio is loss-making overall.
This incomplete picture provided in P&L of performance also gives rise to a serious lack of prudence in accounting because a company can delay loss recognition by holding loss-making investments and mask the deterioration of its performance by selling profit-making investments. We note that such earnings management, particularly deciding to sell profit-making investments in order to avoid or reduce negative earnings, is possible even if equity investments are subject to impairment requirements, which is discussed later in this paper. Identifying an impairment model for equity investments that is capable of broad acceptance and that results in timely recognition of impairment is fraught with difficulty and prone to complexity.
Indeed, academic research has shown that there is robust and significant evidence that companies use the discretion that is provided to them by accounting standards to selectively recycle gains and losses on available for sale (AFS) investments in order to manage earnings. Depending on their circumstances, such as the amount of gains and losses that they have accumulated in OCI and whether they otherwise have positive or negative earnings, companies choose to recycle in order to smooth earnings, avoid or reduce losses, or take ‘a big bath' (ie make poor results look even worse so that future results look better). The research suggests that recognising gains or losses in P&L as they arise is necessary in order to eliminate recycling as an earnings management tool.3
IFRS 9 requires particular (simple) debt investments to be measured at fair value with value changes recognised in OCI. In that case, both impairment accounting and recycling applies. Some stakeholders may wonder how we reconcile these accounting requirements for debt investments with the accounting for the OCI election for equity investments.
The Board believes that amortised cost accounting provides the most relevant information about some debt investments in some circumstances because, for those assets, it provides information about the amount, timing and uncertainty of future cash flows. Accordingly, IFRS 9 requires a company to measure simple debt investments at amortised cost when it holds those investments in order to collect their contractual cash flows. In contrast, if the company holds the same simple debt investment for sale, then IFRS 9 requires the company to measure it at fair value with value changes recognised in P&L. The Board believes these measurement outcomes provide the most relevant information about future cash flows.
If a company has a business model that combines both holding simple debt investments to collect their contractual cash flows and holding simple debt investments for sale, then both fair value and amortised cost information is relevant. Consequently, IFRS 9 provides both sets of information by requiring companies to measure such investments at fair value through OCI, which provides fair value information on the balance sheet and amortised cost information (including impairment information) in P&L.
In contrast, the Board's longstanding view has been that recognising cost-based information in P&L does not provide relevant information about any equity investments, irrespective of why a company holds such an investment.
Introducing recycling to IFRS 9 for equity investments would make it necessary to add an impairment test. This would require introducing a new impairment test because the current impairment test in IFRS 9 applies to the collectability of contractual payments so is relevant for debt investments. This would make the requirements more complex. In fact, during the development of IFRS 9, the Financial Crisis Advisory Group (FCAG) highlighted in its report about the standard-setting implications of the recent global financial crisis the complexity of the multiple and inconsistent impairment models in IAS 39 Financial Instruments: Recognition and Measurement. FCAG identified that matter as one of the primary weaknesses in accounting standards and their application that the Board needed to consider. The Board resolved that weakness: IFRS 9 has a single impairment model.
The impairment test in IAS 39 for equity investments was notoriously ineffective and practice has long cited those requirements as a problematic area. History shows that companies can be very reluctant to recognise losses indicated by market prices and the question of identifying the point in time when equity investments are impaired (ie when losses must be recognised in P&L) has been a vexed one that was a source of great complexity during the recent global financial crisis. Deciding when equity investments are impaired is highly subjective and that determination is made inconsistently in practice.
Applying IAS 39, in order to determine whether an equity investment is impaired, a company must decide whether a decline in the investment's value is ‘significant' or ‘prolonged'. EFRAG found in its public consultation and review of annual financial statements that a range of quantitative thresholds was used to determine whether a decline in the investment's value is ‘significant' or ‘prolonged'. Indeed, EFRAG reports evidence that some companies used a threshold as high as 80% to determine whether a decline in the asset's value is considered to be ‘significant'. It is easy to see why, in practice, losses were often recognised too late. In fact, it is exactly the same problem that the ‘incurred loss' impairment model in IAS 39 has more generally: losses get recognised ‘too little, too late'. There is no doubt that these inconsistent thresholds can affect significantly the timing of when an impairment loss is reported in P&L applying IAS 39.
Applying IFRS 9 and recognising all value changes (upwards and downwards), or none of those changes, in P&L removes this complexity and inconsistency because there is no need for an impairment model.
EFRAG presented arguments in its DP that if recycling is introduced to IFRS 9 for equity investments, then it should be accompanied by an impairment model. The DP also said that having some form of impairment model would be consistent with other IFRS Standards, which generally have some form of impairment (or equivalent) for assets other than those measured at fair value with changes recognised in P&L. Accordingly, that DP describes two possible impairment models—the first model would immediately recognise in P&L all declines in value below the investment's acquisition cost (while changes in value above the acquisition cost would be recognised in OCI and recycled when the investment is sold) and the second model would use the impairment model for equity investments in IAS 39 as a starting point and add guidance to reduce subjectivity.
While the second model is more mechanistic than the impairment model for equity investments in IAS 39, we think complexity will continue to be a challenge for any model that uses these IAS 39 requirements as a starting point. In addition, both models in the DP recognise losses indicated by market prices, and indeed the first model would recognise all declines in value below the acquisition price in P&L. We think that there are likely to be significant issues with acceptability of impairment models driven by market prices. As previously discussed, history shows that companies can be very reluctant to identify impairment losses by reference to the market. In fact, the Final Report by the EU High-Level Expert Group on Sustainable Finance Financing a Sustainable European Economy published in January 2018 discusses some concerns related to the requirements to measure equity investments at fair value and to consider equity investments to be impaired when there is a large downward market movement. Against that background, the report recommends that other measurement approaches, ie instead of using market prices, are investigated for long-term equity investments. We believe that moving away from fair value measurement for equity investments would be highly problematic. Investors would likely find alternatives from market pricing unacceptable especially when equities are quoted on active markets.
Our analysis of a sample of 120 European companies shows us that significant holdings of equity investments classified as AFS applying IAS 39 are limited to a relatively small group of companies, primarily in the insurance and utilities industry. In other industry sectors, on the basis of a sample of the 10 largest European companies (by market capitalisation) in each sector, equity investments classified as AFS are an insignificant proportion of total assets. And we note that the result for the utilities industry sector is largely driven by a single company; ie excluding that company, the average proportion of AFS equity investments to total assets in our sample drops to about 1%. In addition, we observe that 23 of the 120 companies in our sample (or 19%) did not disclose any equity investments classified as AFS in their latest financial reports and therefore it appears that they had an immaterial (or perhaps nil) balance of such investments.
Our research is consistent with the evidence that EFRAG summarises in its DP. In its summary of key messages from evidence collected, EFRAG observes that the aggregate value of equity investments classified as AFS applying IAS 39 by entities that consider themselves to be long-term investors is substantial. However, EFRAG goes on to say that its findings indicate that holdings of such equity investments are concentrated in a relatively small number of entities.4 Indeed, based on their findings, EFRAG notes that the importance of AFS accounting varies even among entities that consider themselves to be long-term investors, with some entities making little or no use of the AFS classification but instead classifying most or all of their equity investments at fair value with value changes recognised in P&L.
We think EFRAG's findings are particularly helpful in assessing the breadth of the concerns about the impact of the new requirements because respondents to the public consultation were self-selected. Generally speaking, we would expect a company to be more likely to respond to such a consultation if it is concerned about, or objects to, the requirements in IFRS 9 for equity investments. Consequently, a possible risk of such a self-selected sample is that it could exaggerate the extent, or scale, of a problem. But actually there was a relatively modest response to the public consultation—26 respondents—and, as previously explained, not all of those respondents reported a high proportion of equity investments classified as AFS applying IAS 39. EFRAG's review of annual financial statements appeared to yield similar findings. In addition, consistent with our view that the concerns are concentrated in specific companies and primarily in the insurance industry, 11 of the 26 respondents to EFRAG's public consultation were from the insurance industry and the majority of respondents were from just two jurisdictions—France and Germany.
The findings show that the incidence of recognising value changes on equity investments in OCI and related concerns are not widespread. Moreover, the evidence indicates that concerns are concentrated in the insurance industry and related to the ability to properly reflect performance. In that regard we observe that IFRS 17 Insurance Contracts will significantly improve how insurance companies present their performance. That Standard requires a clear distinction between a company's investment results and its underwriting results (compared to the typical accounting for insurance contracts today, which comingles those amounts), and as a result, it will be much easier for insurance companies to explain, and for users of financial statements to understand, any volatility in their earnings that is due to holdings of equity investments. And many insurance companies are able to defer the application of IFRS 9 until 2021 and thus can apply IFRS 9 and IFRS 17 at the same time.
In this paper I have sought to provide a brief recap on the requirements in IFRS 9 for equity investments and how we considered the concerns of some stakeholders about the effect of those requirements on long-term investment. In developing IFRS 9, the Board responded to stakeholders' long-standing criticisms about the complexity of the requirements in IAS 39 and, ultimately, that IFRS 9 results in better and more useful information in the financial statements. In our view, the concerns expressed about the requirements for equity investments are not widespread and therefore there is not a compelling reason for the Board to reconsider those requirements at this point in time.
In addition, while accounting is a consideration in making investment decisions, companies make those decisions on the basis of a variety of economic or other business considerations. The aim of accounting is simply to report those investments in a transparent way that provides useful information to the companies' existing and potential investors and creditors. Indeed, the Board is responsible for developing accounting requirements that provide relevant information to users of financial statements. In that regard, we believe that, when reading the financial statements of companies that are long-term investors, users are interested in the performance of those companies' investments period by period as value changes occur and the best place to present such performance with the appropriate prominence is in P&L.
We acknowledge that IFRS 9 may not be perfect. In particular, while the Board intended that companies would apply the OCI election for equity investments only to those investments that are held for strategic purposes, we were unable to develop a satisfactory description to limit the scope in this way. We also know that many users of financial statements would like additional information that distinguishes between realised and unrealised gains and losses on equity investments, both when those fair value changes are recognised in P&L and when such value changes are recognised in OCI. Only limited information is currently required in that respect.
However, it is important to remember that IFRS 9 is brand new. Most entities have just completed implementation. The Board has an established process for assessing the effect of new requirements on users of financial statements, preparers and auditors; it is required to conduct a post-implementation review (PIR) of each new Standard or major amendment. The PIR normally begins after new requirements have been applied internationally for two years and during the review, the Board considers issues that were important or contentious during the development of the requirements, as well as issues that subsequently come to the Board's attention. We think the PIR of IFRS 9 is an appropriate mechanism to address concerns about the effect of IFRS 9 on long-term investment. It will enable us to consider these questions using evidence from the actual application of IFRS 9. If that evidence shows that IFRS 9 has had a detrimental effect on equity investment, the Board would take that information seriously.
1IAS 39 has a limited exception for equity investments that do not have a quoted price in an active market and whose fair value cannot be reliably determined.
2We note that the US Financial Accounting Standards Board also eliminated the AFS category for equity investments. As a result, applying US GAAP, all changes in the value of equity investments are recognised in P&L; there is no longer an option to recognise these changes in OCI.
3Barth, M., Gomez-Biscarri, J., Kasznik, R. & López-Espinosa, G. (2017). Bank earnings and regulatory capital management using available for sale securities. Review of Accounting Studies 22(4) 1761-1792
4For example, EFRAG notes that respondents to its public consultation came from three industries: insurance, financial institutions and non-financial institutions. The two entities from each group with the largest holdings of equity investments classified as AFS hold 59%, 77% and 90% of the total equity investments classified as AFS for their group. Three entities in the insurance group hold at least 70% of the total equity investments classified as AFS for that group.