Banking And Capital Markets Insight, September 2009

Welcome to the September 2009 edition of Banking and Capital Markets Insight, which focuses on technical issues currently coming out of the banking, capital markets, securities and fund management arenas. This issue again is a wide ranging one, covering significant issues in respect of the regulation of regulatory capital, client money, European regulation of funds and the responsibilities going forward of the Senior Accounting Officer for relevant tax balances.

Our articles cover the following diverse areas:

Kush Patel on the discussion paper produced by the IASB on IAS 39 Financial Instruments: Classification and Measurement (IAS 39) on reducing the complexity in reporting financial instruments, which is due for finalisation as a standard by the end of 2009 and for mandatory adoption by 2012; Eric Wooding on the proposals being worked on by the International Accounting Standards Board for an expected cash flow approach to expected loss provisioning, and by the European Commission for a dynamic provisioning approach to expected losses; Mike Williams on the current deliberations by the FSA and HM Treasury on the potential improvements to the current UK client money and asset regime and the potential changes to the clarity of customer disclosures, reporting, speed of access to assets post administration but also the maintenance of sufficient flexibility in contract terms where it is appropriate; Paul Leech on the greater opportunities under UCITS IV for the passporting of traditional funds in Europe, but at the same time the potentially significantly greater burden of capital requirements and restrictions on alternative investments funds which are operated within the requirements of the proposed Alternative Investment Funds Directive; and Mark Kennedy and Brigit Lucas on the significant responsibilities placed on the Senior Accounting Officer under HM Treasury requirements to oversee the calculation of tax liabilities within qualifying UK corporate entities from 2009/2010 year ends. The role is an executive one and may well not fall to the tax director. We look forward to your comments on the current edition and your suggestions for future articles.

IAS 39 re-written The International Accounting Standards Board (IASB) has long intended to simplify the reporting of financial instruments. In March 2008 it issued a discussion paper on reducing complexity in reporting financial instruments setting out for comment various thoughts and considerations on how IAS 39 Financial Instruments: Classification and Measurement (IAS 39) could be simplified. However, momentum for the project to replace IAS 39 gained pace with the onset of the financial crisis with criticisms of the standard coming from all angles, most notably politicians, due to instability in the world's banking system. This culminated in a clear message from the G20 Leaders for the IASB to take action to improve and simplify the accounting of financial instruments by the end of 2009.

Responding to the G20 Leaders comments the IASB has committed to a timetable for a phased replacement of IAS 39 with a new financial instruments standard. The phases that breakdown the project in to more manageable chunks cover (1) classification and measurement; (2) impairment and (3) hedge accounting. Replacing the derecognition rules of IAS 39 is formally part of a separate project, but the revised rules will be included in the new standard. The timetable for each phase is summarised on the following page, illustrating that a final new standard is expected in 2010.

The objective of the first phase, which got underway with the issue of the exposure draft (ED) in July 2009, is to have a new classification and measurement model finalised and available for early adoption by the end of 2009. The IASB have indicated that mandatory application of the whole new financial instruments standard would not be before 2012. However, what is currently unclear is whether an entity early adopting the classification and measurement model would be required to early adopt other parts of the standard once they are finalised.

Classifications removed The Board did not hold back the red pen when it revisited the past wisdom on which the current classification and measurement model is based, casting a number of now familiar terms and concepts to the history books. The first cut of the new model sees the number of classifications reduced.

Available-for-sale (AFS) was always first in line to go. A source of significant complexity with its split recognition of gains and losses part in equity and part in profit or loss, the classification was further exposed in the downturn for its shortfall in measuring and recognising impairment losses.

For debt instruments the AFS classification combines fair value measurement for the balance sheet with amortised cost and effective interest rate (EIR) for recognising interest in profit or loss. This combination ran into difficulty in the downturn as impairment is recognised based on fair value which includes discounts for other factors such as liquidity. Yet confusingly post impairment the EIR for income recognition resumes.

This gave rise to significant differences to the impaired carrying values determined under the amortised cost measure. For AFS equity investments it has long been challenging to assess whether a decline in fair value below its cost is "significant or prolonged" – the criteria for recognising impairment – resulting in divergence in practice. The rules on reversing impairment charges through profit or loss for both debt and equity investments, which will become increasingly relevant in a recovery, are also unpopular, especially for equity investments where no reversals are permitted.

Another classification to disappear is held-to-maturity (HTM). Not used by many its unlikely to be missed by most, particularly because it is replaced by a broader classification that results in the same amortised cost measurement but without the unpopular restrictions (such as the tainting rules that can force all HTM assets to be reclassified to AFS if they are sold before maturity and the restrictions on hedging such assets). However, the criteria for classifying an instrument at amortised cost are different to that for HTM and therefore there is no guarantee that all current HTM assets will be measured on the same basis under the new model.

The new model

So what have the classifications been replaced with? The ED proposes a three-classification model applicable to all financial assets and financial liabilities in the scope of IAS 39. The classifications available for an instrument depend on a combination of the characteristics of the instrument, the entity's business model and elections made by the entity at initial recognition of the instrument. The model, which can be summarised in many different ways, is summarised left by type of nonderivative instrument showing the classifications currently permitted by IAS 39 against the proposed permissible classifications in the ED. This shows the reduction in possible measurement and recognition bases including a single requirement for measuring and recognising impairment which applies only to debt instruments measured at amortised cost. The proposals introduce further simplification by prohibiting reclassifications after initial recognition.

Equity investments Of the proposed three classifications, one introduces a new measurement and recognition basis that is permitted, by election on initial recognition, for equity investments that are not held for trading. This classification, called fair value through other comprehensive income (FVTOCI) results in an equity investment being measured at fair value on the balance sheet with all fair value gains or losses (including dividend income and impairment losses) recognised in equity permanently with no recycling to profit or loss – not even on disposal. This classification provides an alternative to the otherwise mandatory classification of fair value through profit or loss (FVTPL).

The ED also proposes that no equity investments may be held at cost less impairment as currently required for some unquoted equity investments – all must be recorded on balance sheet at fair value. This change is another simplification, however, some have commented that the cost of producing fair value information that may be not sufficiently reliable will outweigh the benefit.

Debt instruments

For debt instruments (both assets and liabilities) the model requires all those with non-basic loan features or those that are not managed on a contractual yield basis to be recorded at FVTPL. All other debt instruments must be held at amortised cost unless the fair value option, available if FVTPL significantly reduces an accounting mismatch, is elected on initial recognition. The ED provides some guidance on these new criteria.

Basic loan features are terms that result in the payment of principal and interest on principal outstanding. Examples cited include single, unleveraged market rates of interest (eg. UK LIBOR), fixed rates of interest and combinations of the two such as floating rates with caps, floors or fixed margins. The ED implies that inflation linked instruments may qualify for amortised cost accounting depending on the specific terms of the instrument. Controversially instruments issued from entities as part of multiple contractually subordinated interests (ie tranches), that are not the most senior (ie. not at the top of the waterfall) will automatically fail the basic loan features test. This is due to the credit risk leverage that is considered to arise in these instruments by virtue of them providing credit risk protection to other tranches.

Managed on a contractual yield basis includes those instruments whose performance is managed and reported to key personnel on a contractual yield basis and excludes those instruments that are held for trading. Unlike the basic loan feature...