Globalization is the dominant driving force of world economy. With growing numbers of economies are joining the parade, the finance markets are becoming more global. It is increasingly evident that a combined world financial market should speak a unified language when talking about financial positions, performance or liquidity situation, so that people could compare different companies with an identical scale and make their decisions accordingly.
A single set of high-quality international standards will enhance comparability of financial information and should make the allocation of capital across borders more efficient. The development and acceptance of international standards should also reduce compliance costs for corporations and improve consistency in audit quality. This unified language, through recent development within the past decade, is more likely to be the International Financial Reporting Standards (IFRS) . The article will discuss about the IFRS and their publishing body, global adoption and usage of the IFRS, and some outstanding issues.
Part I. Introduction of IFRS and IASB
IFRS refer to a set of principles-based standards, interpretations and the framework, adopted by the International Accounting Standards Board (IASB). They comprise:
• International Financial Reporting Standards (IFRS)—standards issued after 2001 by the IASB, currently 9 standards;
• International Accounting Standards (IAS)—standards issued before 2001 by the IASC, 29 standard remain valid;
• International Financial Reporting Interpretations Committee (IFRIC) —issued after 2001, 15 interpretations so far;
• Standing Interpretations Committee (SIC)—issued before 2001, at present 10 interpretations still effective;
• Conceptual Framework for the Preparation and Presentation of Financial Statements (September, 2010).
As shown above, many of the standards forming part of IFRS are known by the older name of IAS, which were issued between 1973 and 2001 by the International Accounting Standards Committee (IASC). The IASC was founded in June 1973 in London and later on 1 April 2001 was restructured into the IASB. The IASB took over the responsibility for setting international accounting standards. During its first meeting, the IASB adopted existing IAS and SICs. The IASB continues to develop standards calling the new standards IFRS.
The IASB is the independent standard-setting body of the IFRS Foundation, responsible for the development and publication of IFRS, including the IFRS for SMEs and for approving Interpretations of IFRSs as developed by the IFRS Interpretations Committee (formerly called the IFRIC). The IASB has no authority to require compliance with its accounting standards; however, many countries require that the financial statements of listed companies be prepared in accordance with IFRS.
The IFRS Foundation is an independent, not-for-profit private sector organisation working in the public interest. Its principal objectives, along with the IASB, are to develop a single set of high quality globally accepted IFRS and to promote the use and rigorous application of those standards.
Part II. Organization of IFRS Foundation and IFRS Due Process
1. The Three-tier Organization Structure of IFRS Foundation
The IFRS Foundation now has a three-tier system of governance: the Monitoring Board acting on behalf of public authorities, the Trustees of the IFRS Foundation as overseers, and the IASB as the standard-setting body. The current structure is, to a large extent, modeled after the US accounting practice. In the US, the Financial Accounting Foundation (FAF), the parent of the FASB, is overseen by the US Security and Exchange Commission (SEC). The IFRS Foundation has not historically had a similar link with any national securities regulators. With the idea to enhance public accountability of the IFRS Foundation, its Trustees decided to amend its Constitution to establish a connection between the IFRS Foundation and a Monitoring Group composed of securities authorities charged with the adoption or recognition of accounting standards used in their respective jurisdictions.
Diagram: Organization Structure of the IFRS Foundation
As shown in the diagram above, the governance and oversight of the activities undertaken by the IFRS Foundation and its standard-setting body rests with its Trustees, who are also responsible for safeguarding the independence of the IASB and ensuring the financing of the organisation. The Trustees are publicly accountable to a Monitoring Board of public authorities.
The Monitoring Board’s main responsibilities are to ensure that the Trustees continue to discharge their duties as defined by the IFRS Foundation Constitution, as well as appointing Trustees. Through the Monitoring Board, capital markets authorities will be able to more effectively carry out their mandates regarding investor protection, market integrity, and capital formation. The decision to establish a Monitoring Board was made in January 2009 to enhance the organization’s public accountability by establishing a link to a Monitoring Board of public authorities. The members of the Monitoring Board are, at this moment, the International Organization of Securities Commissions (IOSCO), the European Commission, Financial Services Agency of Japan (JFSA), and the SEC. The Basel Committee on Banking Supervision (BCBS) participates in the Monitoring Board as an observer.
The IASB, comprised by experts with an appropriate mix of recent practical experience, is an independent group responsible for setting accounting standards. The IFRS Interpretations Committee is the interpretative body of the IASB, with a mandate to review on a timely basis widespread accounting issues that have arisen within the context of current IFRSs and to provide authoritative guidance (IFRICs) on those issues. The IFRS Advisory Council provides strategic advices to the IASB, and offers important channels for the IASB to receive valuable input and to consult interested parties.
The organizational structure of the IRFS Foundation is under constant evolving state. The IASB was founded in 1973 by professional accountancy bodies in Australia, Canada, France, Germany, Japan, Mexico, Netherlands, United Kingdom and Ireland, and the United States. Since then, there has been a drift towards international representation. Currently, the International Accounting Standards Committee Foundation has six trustees from the Asia/Oceania region, six from Europe, six from North America and four from any region of the world. In spite of this drift, IFRS currently reflect a strong common-law philosophy. On top of that, the current membership representation and philosophy of the IASB seem likely to face challenges in the longer term. Over time, each of the 100-plus IFRS-adopting jurisdictions will have a politically-legitimate argument that they deserve some sort of representation in the standard-setting process. They seem to have a very convincing argument that the standards that are chose by the IASB affect their economies.
To date, there are some concerns about institutional arrangement, in particular about the status, roles and functions about the Monitoring Board, its relationship with the Trustees, and as well as the composition of the Board itself. Some people argue for an expanded Monitoring Board in order to better represent and serve the global investment community.
The Monitoring Board, which oversees the Foundation, began in April 2010 a review of the governance structure and processes underpinning IFRS standard setting. The aim is to establish whether the governance structure effectively promotes the standard setter’s primary mission of setting high quality globally accepted standards and whether the standard-setter is appropriately independent yet accountable. In February 2011, the Monitoring Board published a Consultative Report t setting out proposals for governance reform.
2. Standard Setting Process
The IFRS Foundation is a unique example of international co-operation in the financial arena. Unlike other bodies that establish international rules, the IASB is composed of full-time professionals, not serving as representatives of particular jurisdictions and interests. The IFRS Foundation’s Constitution establishes an independent standard-setting process, subject to extensive due process requirements, but protected from special and parochial interests. This independence has been a fundamental strength of the IFRS Foundation and the IASB, giving credibility to the standards.
A thorough and transparent due process is essential to developing high quality, globally accepted accounting standards, which involves interested individuals and organizations from around the world. The due process comprises six stages, with the Trustees having the opportunity to ensure compliance at various points throughout:
• Setting the agenda;
• Planning the project;
• Developing and publishing the discussion paper;
• Developing and publishing the exposure draft;
• Developing and publishing the standard, and
• After the standard is issued.
The IASB’s due process is reviewed and further enhanced regularly, benefiting from regular benchmarking against other organizations and from stakeholder advice. The Trustees’ Due Process Oversight Committee reviews and discusses due process compliance regularly throughout the standard-setting process and at the end of the process before a standard is finalized.
In addition, all meetings of the IASB are held in public and through webcast. In fulfilling its standard-setting duties the IASB follows a thorough, open and transparent due process of which the publication of consultative documents, such as discussion papers and exposure drafts, for public comment is an important component. Besides, Interpretation Committee meetings are also open to the public and webcast. In developing interpretations, the Interpretations Committee works closely with similar national committees and follows a transparent, thorough and open due process.
The IFRS Foundation and the IASB keep close links with of a network of national and other accounting standard-setting bodies as an integral part of the global standard-setting process. In addition to performing functions within their mandates, national and other accounting standard-setting bodies are encouraged to undertake research, provide guidance on the IASB’s priorities, encourage stakeholder input from their own jurisdiction into the IASB’s due process and identify emerging issues.
The IASB engages closely with stakeholders around the world, including investors, analysts, regulators, business leaders, industry associations, accounting standard-setters and the accountancy profession . In addition to the existing enhanced technical dialogue, the IASB meets these groups regularly, most often on a bilateral basis.
3. Maintaining Transparency, Public Accountability and Independence
In carrying out the IFRS Foundation’s mission as the standard-setting body, the IASB should develop financial reporting standards that provide a faithful presentation of an entity’s financial position and performance, as well as give information relevant to economic and resource allocation decisions for investors and other market participants. The confidence of all users of financial statements in the transparency and integrity of financial reporting is critically important to the effective functioning of capital markets, efficient capital allocation, global financial stability and sound economic growth.
Independence is a prized asset for the IFRS Foundation. The IFRS Foundation has financed IASB operations largely through voluntary contributions from a wide range of market participants from across the world’s capital markets, including from a number of firms in the accounting profession, companies, international organizations, central banks and governments. In June 2006, the IFRS Foundation Trustees agreed on four elements that should govern the establishment of a funding approach designed to enable the IFRS Foundation to remain a private-sector organization with the necessary resources to conduct its work in a timely fashion. Those four elements should be broad-based, compelling, open-ended and country-specific. The funding system should maintain the independence of the standard-setting process, while providing organizational accountability. The existing base of financing should be expanded to enable the IFRS Foundation to serve the global community better and to fulfill the strategy described above.
However independence comes with the requirement of public accountability. A form of public accountability was provided from the outset insofar as the binding character of IFRS depended on their validation by local authorities. Subsequently, following two formal reviews of the Constitution, the Trustees have enhanced their oversight function, increased the transparency of their operations and made a number of institutional reforms to expand representation. In 2009 a Monitoring Board was created and a Memorandum of Understanding linking it to the Trustees provided a formal public component to the governance structure for the first time. The creation of the Monitoring Board and the emergence of publicly sanctioned financing regimes for the IFRS Foundation anchored the organisation more formally with those responsible for serving the public interest.
Part III. IFRS Is Becoming More Global
The increasing acceptance and use of IFRS in major capital markets throughout the world over the past several years, and its anticipated use in other countries in the near future, indicate that IFRS will become the set of accounting standards that best provide a common platform on which companies can report and investors can compare financial information. According to Deloitte , at the moment, there are over 120 jurisdictions that permit or require IFRSs for domestic listed companies. The IASB has marked solid progress in reaching its goal to deliver a set of high quality globally acceptable accounting standards, but the goal is not a reality yet.
Different jurisdictions often have internal processes through which they incorporate IFRS into their national accounting standards. Decisions made during those processes may result in discrepancies from IFRS as issued by the IASB.
1. Approaches to Incorporating IFRS
In some jurisdictions, local accounting principles are applied for regular companies but listed or large companies must conform to IFRS, so statutory reporting is comparable internationally. Many jurisdictions that maintain their own local principles claim that their local standards are “based on” or “similar to” or “converged with” IFRSs. Sometimes, the local principles are not in English. Often, not all IFRS have been adopted locally. Often there is a time lag in adopting an IFRS as local Standards. Generally, jurisdictions have incorporated IFRS by the following ways:
• Full adoption approach, use of IFRS as issued by the IASB without a national incorporation process,
• Endorsement approach, IFRS incorporated into local accounting standards with a firm commitment to adopt fully IFRS as issued by the IASB,
• Convergence approach, converging local standards with IFRS without a firm commitment, or
• Hybrid of above.
The first category could be viewed as representing the purest form of incorporating IFRS. Under this approach, jurisdictions make no changes to the standards issued by the IASB, and the standards are applicable once issued without approval by any local body. While this approach, if adopted by all jurisdictions, would seem to result in the most consistent application of IFRS, it also results in a much greater degree of relegation of the local regulator’s authority and responsibility for investor protection to a global private sector and independent standard-setting body with a multinational constituent base. Understandably the IASB is firmly behind this approach and strongly support the need to maintain the long-term goal of full adoption of IFRS. However no major jurisdiction currently follows this approach.
The second category consists of economies (national or regional) that use IFRS after some form of a national incorporation process with a commitment of full future IFRS adoption. A good example is the European Union. The European Parliament in March 2002 passed the resolution with a wide margin requiring all firms listed on stock exchanges in the EU to apply IFRS by 2005. However, the EU endorsed all extant IFRS then except IAS 39. Instead of adopting IAS 39 as issued by the IASB, a carve-out version of IAS 39 was adopted, sometimes this practice is referred to as the IASB by the EU, and the practice caused much controversy. Endorsing IAS 39 with this carve-out would mean that IFRS as applied in Europe would differ from IFRS applied elsewhere in the world, thereby thwarting the goal of global convergence.
Convergence refers to the process of narrowing differences between IFRS and the accounting standards of countries that retain their own standards. Depending on local political and economic factors, these countries could require financial reporting to comply with their own standards without formally recognizing IFRS, they could explicitly prohibit reporting under IFRS, they could permit all companies to report under either IFRS or domestic standards, or they could require domestic companies to comply with domestic standards and permit only cross-listed foreign companies to comply with either. Convergence can offer advantages, whatever the reason for retaining domestic standards. It is a modified version of adoption.
Convergence by definition will not lead to a common set of global standards. Convergence may narrow differences, but will not produce identical results because each set of standards has a different starting point and convergence will not address all of the details. Having once converged, standards could well diverge again. Furthermore, in a world of standards that have converged, issues of mutual recognition are raised. Countries will seek acceptance of their ‘equivalent’ but different standards for access to capital markets. The benefits of IFRS adoption, particularly in relation to comparability for investors, are partially lost in favoring convergence rather than adoption. Therefore the IASB changed its previous position and now states that convergence is not an objective in itself but is a means to achieve the adoption of IFRS .
2. Critical Success Factors and Challenge Ahead
Nowadays, more firms seeking to be listed in an offshore exchange will choose to prepare their financial statements in line with the IFRS. The IFRS has replaced the US GAAP as the prevalent international accounting standards for cross-border listing and capital-raising. It is expected that more companies will be likely to follow suit. All those changes take place with the past 10 years.
Much of the success of IFRSs to date is a result of following factors:
• The IASB’s strength as an organisation and the quality of IFRSs;
• IOSCO recognition and decision to recommend IFRS for cross-border listing;
• The European Union’s decision to elect the IASB as its standard-setting body, which served as a catalyst for the adoption of IFRSs elsewhere internationally; and
• The willingness of the United States to engage in convergence, accept IFRSs for non-US companies and consider possible adoption for US companies.
In 1973, the IASC (the predecessor body to the IASB) was established by the AICPA and its counterparts in 8 other countries. Its mission was to formulate and publish, in the public interest, basic standards to be observed in the presentation of audited accounts and financial statements and to promote their worldwide acceptance. Prior to the inception of the 21st century, this effort didn’t bear much fruit. Until 2002, only a few economies decided to use IASC standards. Many of those lacked their own standard-setting infrastructure.
On July 11th 1995, the IASC and the IOSCO agreed on what constitutes a comprehensive set of core standards, and upon successful completion, the IOSCO agreed that if it found those core standards acceptable, it would recommend endorsement of IASC standards for cross-border capital and listing purposes in all capital markets. The IASC undertook a project to complete those core standards by 1999.
In May 2000, the IOSCO President’s Committee passed a resolution on the IASC standards, stating: “…the IASC’s work to date has succeeded in effecting significant improvements in the quality of the IASC standards. Accordingly, the Presidents’ Committee recommends that IOSCO members permit incoming multinational issuers to use the 30 IASC 2000 standards to prepare their financial statements for cross-border offerings and listings, as supplemented in the manner described below where necessary to address outstanding substantive issues at a national or regional level…”. The endorsement from the IOSCO greatly facilitated wide international use of IFRS.
The European Union soon became the catalyst for IFRS adoption worldwide, making IFRSs an alternative to US GAAP for international capital-raising. In 2002 the European Union decided to adopt IFRSs for its publicly traded companies as part of the effort to create a common European capital market. Due to the well-publicized “carve-outs” it legislated, however, this did not result in full IFRS adoption. Apart from a limited waiver granted by the SEC, this means that foreign private issuers using “EU-endorsed IFRS” will not be granted exemption from the SEC’s reconciliation requirements, a fact that may cause the European Union to reconsider the wisdom of the carve-out strategy. Since 2005, the European decision has spurred the advancement of IFRSs across Asia-Oceania, Africa and the Americas.
After the Enron scandal, the US reconsidered its stance on adopting the IFRS and began to take concrete measure to promote adoption process. Beginning with the 2002 Norwalk agreement, an intensive and joint convergence programme has been a dominant feature of the US Financial Accounting Standards Board (FASB) and the IASB’s agenda. Importantly, the convergence process has led to improvements of the inherited standards, reduced differences with US GAAP, and the removal of the reconciliation requirement by the SEC. At the same time, the United States has yet to make a final decision on adopting IFRSs. A recent SEC staff work plan indicates that the SEC expects to make a determination in 2011 on the use of IFRSs. This determination will have an impact on the consideration of IFRSs by other major economies (e.g. China, India and Japan) and the growing number of emerging markets that are implementing IFRSs as their chosen accounting standards.
While these factors have spurred the organization’s success, a number of challenges remain for the organisation:
• Convergence and adoption: In an effort to facilitate adoption of its standards, the IASB has devoted considerable energy to convergence. But convergence alone will not produce a single set of global standards. A number of countries still need to make decisions to adopt IFRSs for domestic use.
• Quality and implementation of the standards: Two tensions have arisen in this area. First, the IASB must continue to demonstrate the quality and relevance of its standards to ensure global acceptance, including a need to reflect the lessons learned from the financial crisis. Second, even as the standards are adopted universally, there is a risk that practices related to implementation and adoption will diverge.
• Governance and accountability: As adoption of IFRSs has extended to more and more countries, public authorities around the world have paid increasing attention to the accountability and governance of the institution. While the IASB’s independence has been a source of strength, it is widely understood that those arrangements may need to evolve further, in order to enhance the IFRS Foundation’s public accountability.
3. Case Study of Chinese Accounting Convergence
One example of a country using the convergence approach is the China, which is moving its standards closer to IFRS without incorporating IFRS fully into its national financial reporting framework.
Since its economic reform programme, China has sought to transition its accounting system from one based on the needs of a planned economy towards international accounting standards based on market economic principles. The new Chinese Accounting Standards for Business Enterprises (CAS) were published by the Ministry of Finance (MoF) in 2006 and became effective on January 1, 2007. These standards are substantially converged with IFRSs, except for certain modifications (e.g. disallow the reversal of impairment loss on long term assets) which reflect China’s unique circumstances and environment.
In April 2010, the MoF released the roadmap for continuing convergence of CAS with IFRSs. China has made a commitment to convergence with IFRSs. Standard convergence is an ongoing process and the MoF is continuing to spend significant effort on the ongoing convergence between CASs and IFRSs.
The CASs are now mandatory for entities including PRC-listed companies, financial institutions (including entities engaging in securities business permitted by China Securities Regulatory Commission), certain state-owned enterprises, private companies in certain provinces. In the roadmap, the MoF has indicated its intention to have all large and medium-sized enterprises (regardless whether they are listed companies or private companies) adopt the new CAS by 2012.
The CAS has won equivalent recognition from other jurisdictions. In December 2007, the HKICPA recognized CAS equivalence to HKFRS, which are identical to IFRSs, including all recognition and measurement options, but have in some cases different effective dates and transition requirements. From then the CASC and HKICPA together with IASB created an ongoing mechanism to reinforce continuously such equivalence. In December 2010, the Hong Kong Stock Exchange decided to allow mainland-incorporated companies listed in Hong Kong to have an option to present financial statements using CASs and audited by an approved mainland audit firm. A number of such companies have chosen to present financial statements using CASs for annual reporting. The EU Commission permits Chinese issuers to use CAS when they enter the EU market without adjusting financial statement in accordance with IFRS endorsed by EU.
In September 2009, the World Bank released an assessment report of “Report on the observance of Standard and code (ROSC)- accounting and auditing: People’s Republic of China”. According to this report , the CAS and IFRS are basically comparable. The memorandum signed between CASC and IASB in 2005 identified two major differences between the two sets of standards. These are (a) reversal of impairment losses and (b) disclosure of related party relationships and transactions. In January 2008, CASC and IASB established a continuing convergence mechanism. Meetings between the two parties in April and October 2009 helped to identify and eliminate some differences between CAS and IFRS. In August 2009, the IASB decided to exempt from the disclosure requirements for transactions between a government-controlled reporting entity and that government or other entities controlled by that government. This exemption would ensure CAS convergence with IFRS in respect of related party relationships and transactions.
In July 2011, the new chairman of IASB, Mr. Hans Hoogervost paid a brief visit to Beijing and exchanged view with the MOF. He acknowledged that China has made tremendous progress by building an accounting profession and setting in place a process of continuous convergence with IFRS, and he also admitted that for companies with dual listings in Shanghai (using Chinese GAAP) and Hong Kong (using IFRSs) the average difference in reported profit is 0.6%, thee difference in term of net assets is even as smaller as around 0.2%. In his view, this closeness is not from perfect. The term “principally in line with IFRS” does China no favors. There is a lingering suspicion among the broader international financial reporting community about closeness between IFRSs and Chinese accounting standards. He suggested that Chinese should move a step forward for a full adoption of the IFRS.
4. Convergence between IRFS and US GAAP
In October 2002, the FASB and the IASB announced the issuance of a memorandum of understanding, called the Norwalk Agreement. The two bodies acknowledged their joint commitment to the development, “as soon as practicable,” of high-quality, compatible accounting standards that could be used for both domestic and cross-border financial reporting. At that time, the FASB and the IASB pledged to use their best efforts to make their existing financial reporting standards fully compatible as soon as is practicable and to co-ordinate their future work programs to ensure that once achieved, compatibility is maintained.
In a 2006 Memorandum of Understanding, the FASB and the IASB indicated that a common set of high-quality global standards remains the long-term strategic priority of both the FASB and the IASB. As part of this commitment, the IASB and the FASB set out a work plan covering several projects and coordinated agendas so that major projects that one board takes up may also be taken up by the other board. That plan covered specific long- and short-term projects for work into 2008.
In November 2007, the Trustees of the IASC Foundation reiterated their support for continuing the work program described in these memoranda, noting that future work is largely focused on areas in which the objective is to develop new world-class international standards. The FASB and the IASB have updated the timetable for their joint work under the 2006 Memorandum of Understanding. The next phase of the joint work plan goes through 2011.
The full adoption of the IFRS will face strong political pressures. Some people have objected that the incorporation of IFRS for U.S. issuers means the United States would cede its sovereignty to the IASB. Any incorporation approach will not affect the SEC’s responsibility to protect investors, maintain fair orderly and efficient markets, and facilitate capital formation through its regulation, and it will not alter the SEC’s ultimate authority under the federal securities laws to prescribe accounting principles and standards to be followed by U.S. issuers and other entities that provide financial information to the SEC and investors. The SEC will always be the decision-maker over financial reporting standards in the United States.
Most significantly, the FASB would participate in the process for developing IFRS, rather than serving as the principal body responsible for developing new accounting standards or modifying existing standards under U.S. GAAP. The FASB would play an instrumental role in global standard setting by providing input and support to the IASB in developing and promoting high-quality, globally accepted standards; by advancing the consideration of U.S. perspectives in those standards; and by incorporating those standards, by way of an endorsement process, into U.S. GAAP. Additionally, the FASB would become an educational resource for U.S. constituents to facilitate the understanding and proper application of IFRS and promote ongoing improvement in the quality of financial reporting in the United States.
The FASB would continue to promulgate U.S. GAAP primarily through its endorsement of standards promulgated by the IASB. Under the framework, due to the FASB’s participation in the IASB’s standard setting process, the FASB should be in a position to readily endorse (i.e., incorporate directly into U.S. GAAP) the vast majority of the IASB’s modifications to IFRS. However, the FASB would retain the authority to modify or add to the requirements of the IFRSs incorporated into U.S. GAAP, similar to other jurisdictions, and such U.S.-specific modifications would be subject to an established incorporation protocol. Such a protocol could entail the FASB determining whether the IASB’s modification to IFRS (either by means of issuance of a new standard or amendment of an existing standard) met a pre-established threshold—for example, a threshold that incorporates the consideration of the public interest and the protection of investors.
Part IV. Outstanding IFRS Issues
As an organisation that serves the public interest and promotes economic progress, the IASB must deliver its main output, financial reporting standards, with the highest quality. They must be developed following a robust process that takes into consideration the requirements of those who use them, and must be recognised, understood and accepted internationally. However, many standards are not free of controversies. For example, netting/offsetting is a big issue that still results in the largest balance sheet difference between IFRS and US GAAP banks. The IASB and FASB tried to converge on this topic earlier in recent years but are unable to reach a joint conclusion. The following is just a few examples open for debate.
1. Insurance Contracts
Insurance contracts often expose entities to long term and uncertain obligations. However, current insurance accounting does not provide investors, analysts and others with the information they need to understand an insurer’s financial position and performance and to make meaningful comparisons between insurers. Many users describe insurance accounting today as a ‘black box’, especially in life insurance.
In July 2010 the IASB published an exposure draft (ED) containing proposals on the recognition, measurement, presentation and disclosure of insurance contracts. The exposure draft is part of the IASB’s project on insurance contracts, which intends to replace IFRS 4 Insurance Contracts issued in 2004.
Although IFRS 4 addressed some of the more urgent issues in insurance contract accounting, it was only a temporary solution. It permits a wide variety of existing accounting practices to continue, hindering comparability for users. In 2004 the IASB established a working group of senior financial executives to help it analyze accounting issues related to insurance contracts. Users find it difficult to understand insurers’ financial statements. Accounting methods are complex and vary by product and country.
Proposed change includes:
The measurement model focuses on the key drivers of insurance contract profitability, and would provide users with a clearer insight than they gain from today’s patchwork of different models for different types of contract.
The same model would apply to all insurance contracts.
A modified version would apply to most short duration insurance contracts.
Insurers would present information in the financial statements that focuses on the drivers of performance, i.e.:
o release from risk, as the risk adjustment decreases
o what insurers expect to earn from providing insurance services
o investment returns on invested premiums, and the investment returns provided to policyholders (either implicitly through pricing or explicitly)
o differences between expected and actual cash flows and
o changes in estimates and the discount rate.
This information would be supplemented by disclosures of important headline indicators, such as premiums, claims and expenses.
The exposure draft has been developed following a rigorous and comprehensive due process.
The exposure draft builds on proposals contained in the IASB’s discussion paper. The proposed standard would apply to all insurance contracts (i.e. both life and non-life) that meet the existing definition in IFRS 4, which is based on the transfer of significant insurance risk. The proposals would improve financial reporting by providing more understandable and relevant information for users as well as eliminating accounting mismatches.
The exposure draft proposes to replace IFRS 4 with a high quality standard that better meets the needs of users. Building on the proposals in the discussion paper that arise today because assets reflect current market rates, while liabilities often reflect ‘locked-in’ rates
In addition, the ED proposes a modified measurement approach for short duration contracts. The modified model combines the advantages of the proposed model with the benefits of existing practice. A principle-based standard reflects the economics of insurance contracts. The exposure draft proposes:
a measurement model that focuses on the drivers of insurance contract profitability and uses current estimates of cash flows
presentation of information about insurance contracts that reflects changes in those drivers
consistent accounting for embedded options and guarantees in insurance contracts
consistency with market prices for financial market inputs, such as interest rates
a coherent framework for dealing with more complex insurance contracts, including those that might be developed in the future.
2. Fair Value Accounting to Financial Instruments
The past financial crisis has reinvigorated a debate on the effectiveness of the existing accounting and regulatory frameworks for banks. In particular, the focal point of the debate centers around the pros and cons of fair value accounting, where fair value is meant to value amount for which an asset could be exchanged, or a liability settled, between knowledgeable willing parties in an arm’s length transaction, other than in a liquidation. IAS 39 Financial Instruments: Recognition and Measurement is the clear target for banks, and many people argued for the standard’ suspension during the crisis.
Accounting standards stipulate that as a guiding principle, the quoted market price in an active market should be used as the basis for the measurement of the fair value of an asset. The problem is that such a price is not always available, for example, in illiquid markets. In such cases, fair values need to be estimated based on available information. A related concern is the potential procyclical nature of fair value accounting, which could magnify fluctuations in bank lending and economic activity. A broader concern is that the current “mixed attribute” model of accounting, in which some financial instruments are measured at historical cost and some at fair value, together with discretion over how financial instruments are measured, gives rise to accounting arbitrage.
Despite difficulties of determining fair values in illiquid markets, advocates of fair value accounting maintain that fair value is the most relevant measure for financial instruments. They argue that financial assets, even complex instruments, tend to trade continuously in markets and it should therefore be possible to use information embedded in market prices to compute fair values of financial assets.
Some large US securities firms (mainly broker dealers, which manages their portfolio on fair-value basis) is supportive to that fair value accounting. This view is based on the belief that fair valuation is significantly more relevant than historical cost for financial instruments and is sufficiently reliable if appropriate policies, governance, controls and disclosure are in place. Further and importantly, fair value has been standard practice among US securities firms for many years, without adverse consequences, and those firms believe that its use has encouraged a disciplined approach to risk management that, if more broadly applied, could engender greater market discipline and greater financial stability.
However some bankers disagree. They still maintain a tradition commercial banking model, focused on lending and depositing services. They claim that most of their assets are currently not impaired, that they intend to hold them to maturity anyway, and that market prices reflect distressed sales into an illiquid market. On top of that, some financial instruments, particularly the book of loans carried by banks (especially loans to consumers and small businesses) are not suited to fair valuation and the traditional approach, historical cost less provision for incurred impairment, should be maintained. In their views, the relevance of historical cost valuations to the lend-and-hold-to-maturity philosophy still holds that has characterized bank lending for decades.
The Basel Committee and the US Federal Reserve Board have cautioned against a move to comprehensive fair valuation without resolving significant implementation issues or providing rigorous guidance on valuation of such financial instruments. They are concerned about the practical difficulty of valuing loans or some other financial instruments when most do not have readily observable prices.
IFRS and US GAAP provide similar guidance related to the recognition of impairment losses on originated loans and receivables. For other financial assets, the timing of impairment loss recognition and the measurement of that loss may differ under the two sets of standards.
Under IAS 39 “Financial Instruments: Recognition and Measurement”, a financial asset is deemed impaired, requiring recognition of an impairment loss, if its carrying amount is greater than its estimated recoverable amount, and evidence must be evaluated at each balance sheet date to determine whether financial assets are impaired. In contrast, for investment securities classified as HTM or AFS under US GAAP, an impairment exists when fair value has declined below amortized cost basis, but an impairment is only recognized when it is deemed to be “other than temporary.” For example, an other-than-temporary impairment shall be considered to have occurred if it is probable that the investor will be unable to collect all amounts due according to the contractual terms of a debt security not impaired at acquisition. The differing standards for recognition of an impairment loss for investment securities under IAS and US GAAP could cause differences in the timing of recognition of an impairment loss.
In terms of measurement, IAS and US GAAP differ a bit. IFRS requires that an impairment of an HTM investment be measured based upon the difference between the asset’s carrying amount and the present value of expected future cash flows, discounted at the instrument’s original effective interest rate. Under US GAAP, an impairment of a security (including an HTM security) is measured based on the difference between the security’s amortized cost basis and its fair value, where a fair value calculation would be based on current market interest rates, as opposed to the security’s original effective interest rate.
4. Derivatives and Hedging
Derivatives are financial instruments that derive their cash flows, and hence their value, by incorporating in their terms references to other financial instruments or financial or non-financial indexes (e.g., spot oil prices). Accounting for derivatives is among the most difficult areas in financial reporting.
When a contract is a derivative, it must be recorded on the balance sheet as an asset or a liability at its current fair value. Changes in fair value are recorded in income unless the derivative is designated and effective as a hedge in cash flow hedge strategies. In these instances changes in the value of the derivative are excluded from income until the hedged transaction occurs or affects income. The objective of hedge accounting can be summarized as neutralizing the impact on income, to the extent that the hedge is effective, of the consequences of the hedged risk.
Derivatives in a hedging relationship are used to offset the risk profile of designated assets, liabilities, firm commitments or probable forecasted, although not committed, transactions. The common risks in financial instruments are interest rate, credit, market and foreign currency. The accounting standards are largely designed to closely link the derivative to the position being hedged (via specific documentation requirements) and to ensure that the derivative is expected to be, and has achieved, high effectiveness in altering the risk profile of the hedged item. Note that neither IAS nor US GAAP requires that a derivative reduce the hedger’s exposure to the risk, only that it effectively offset changes in the fair value or cash flows of the hedged item. It is possible that a hedger would utilize derivatives to alter risk profiles but not to account for the derivative as a hedge either because (1) the derivative was not sufficiently effective in altering the risk profile or (2) the hedger did not document the derivative as a hedge.
There are a number of differences in the detailed rules on hedge accounting between IAS and US GAAP, which may increase as a result of the IASB’s recent tentative decisions in its IAS 32 and IAS 39 improvements project. These differences can result in hedge accounting being achieved under one regime but denied under the other. In the new IFRS 9 that replaces IAS 39, there is no bifurcation of embedded derivatives for financial assets. For liabilities the treatment is similar to current IAS 39.
On Nov 4th 2011, the leaders of G20 convened in Cannes France, and in the Cannes Summit Final Declaration, there are the following observations in relation to accounting standards:
“…We reaffirm our objective to achieve a single set of high quality global accounting standards and meet the objectives set at the London summit in April 2009, notably as regards the improvement of standards for the valuation of financial instruments. We call on the IASB and the FASB to complete their convergence project and look forward to a progress report at the Finance Ministers and Central Bank governors meeting in April 2012. We look forward to the completion of proposals to reform the IASB governance framework…..”
It is not easy to have genuine cross-border comparability of financial statements. It is not an easy task that IASB or IFRS Foundation is trying to promote global accounting standards. With the strong commitment from G20 for a single set of global financial reporting standards, the IASB should seek the momentum to push forward and complete the remaining convergence projects with the US standard-setter to the highest possible standard, and to do so in a way that benefits from the input that we receive from the entire global financial reporting community. These remaining convergence projects address some of the most difficult and important areas of financial reporting. Without any coherent global representation of investors, the dream could never come true. This challenge could be ameliorated through further structure within IFRS Foundation and better cooperating efforts with national policy bodies as well as international entities.
However, we do believe that with the future efforts from the IASB, FASB and support from world investment community, the goal of achieving a single set of high-quality globally accepted international financial reporting standard will be within reach for a foreseeable future; however the path will not be easy or short.
4. G20: Cannes Summit Final Declaration, Nov 4, 2011
5. Hans Hoogervost, new IASB Chairman speech in Beijing, July 2011, http://www.ifrs.org/NR/…32B5…/HansHoogervorstBeijingJuly2011.pdf
6. Basel Committee on Banking Supervision: “Supervisory guidance for assessing banks’ financial instrument fair value practices”, April 2009
7. Harry Huizinga and Luc Laeven, “Accounting discretion of banks during a financial crisis”, IMF Working Paper, WP/09/207, September 2009
8. SEC Commissioner Kathleen L. Casey, “Keynote Address at the Society of Corporate Secretaries and Governance Professionals 65th Annual Conference”, June 29, 2011
9. US SEC Staff Paper, “Work Plan for the Consideration of Incorporating International Financial Reporting Standards into the Financial Reporting System for U.S. Issuers: Exploring a Possible Method of Incorporation”, May 26, 2011
10. US SEC, “Work Plan for the Consideration of Incorporating International Financial Reporting Standards into the Financial Reporting System for US Issuers Progress Report”, division of corporation finance, office of the chief accountant, October 29, 2010
11. US SEC: “Roadmap for the potential use of financial statements prepared in accordance with international financial reporting standards by US issuers”, Release Nos. 33-8982; 34-58960; File No. S7-27-08, 2008
12. World Bank: “Report on the Observance of Standards and Codes (ROSC)- Accounting and Auditing: People’s Republic of China”, October 2009
13. IFRS Foundation: “Report of the Trustees’ Strategy Review IFRSs as the Global Standard: Setting a Strategy for the Foundation’s Second Decade”, April 2011
14. IFRS Monitor Board: “Consultative Report on the Review of the IFRS Foundation’s Governance”, February 7, 2011
15. IOSCO: “A Resolution on IASC Standards Passed by the Presidents’ Committee”, May 2000
16. Group of 30, “Enhancing Public Confidence in Financial Reporting”, 2003
17. Nicolas Véron, “Suggestions for Reforming the Governance of Global Accounting Standards”, Bruegel Policy Contribution, issue2011/04, May 2011