INTERNATIONAL IFRS ACADEMY

Tokyo, 28-29 July 2010

A global approach to financial reporting and

accounting for financial instruments

Roger Kaiser European Banking Federation

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Set up in 1960, the EBF is the voice of the European banking sector (European Union & European Free Trade Association countries)

It represents the interests of some 5000 European banks: large and small, wholesale and retail, local and cross-border financial institutions

It is committed to supporting EU policies to promote the single market in financial services in general and in banking activities in particular

It advocates free and fair competition in the EU and world markets and supports the banks' efforts to increase their efficiency and competitiveness.

GLOBAL APPROACH TO FINANCIAL REPORTINGNeed for Cross-border Transparency of Financial Statements

To enhance corporate performance’s comparability To improve quality of financial reporting To enhance investors’ protection To increase the possibilities to raise capital To create efficient, deep and liquid securities markets and

enhance their international competitivenessNeed for adopting a single set of accounting standards for

companies willing to raise capital …

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GLOBAL APPROACH TO FINANCIAL REPORTINGKey Players in Accounting Standard-Setting

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ACCOUNTINGSTANDARDS

STANDARD-SETTERS

REGULATORS

IAS / IFRS

IASB

EC

Local GAAPe.g. J-GAAP

N’al Std-Setter(NSS)

e.g. ASBJ

JFSA

US-GAAP

FASB

SEC

INTERNATIONALe.a. EU

NATIONAL US

GLOBAL APPROACH TO FINANCIAL REPORTING US Convergence Strategy

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ACCOUNTINGSTANDARDS

STANDARD-SETTERS

REGULATORS

IAS / IFRS

IASB

EC

Local GAAPe.g. J-GAAP

N’al Std-Setter(NSS)

e.g. ASBJ

US-GAAP

FASB

SEC

INTERNATIONALe.a. EU

NATIONAL US

JFSA

Convergence on Accounting Standards

GLOBAL APPROACH TO FINANCIAL REPORTING US Mutual Recognition Strategy

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ACCOUNTINGSTANDARDS

STANDARD-SETTERS

REGULATORS

IAS / IFRS

IASB

EC

Local GAAPe.g. J-GAAP

N’al Std-Setter(NSS)

e.g. ASBJ

US-GAAP

FASB

SEC

INTERNATIONALe.a. EU

NATIONAL US

JFSA

Mutual Recognition on Accounting Standards

Lisbon European Council

EC Communication“EU Financial

reporting strategy: the way forward”

IAS Regulation

March 2000 June 2000 July 2002

GLOBAL APPROACH TO FINANCIAL REPORTING EU Strategy Towards a Single Set of Accounting Rules

Modernisation Directive

2003

4th and 7th Accounting Directives

1978-1983

Fair Value Directive

Sept. 2001 6

listed companieslisted companies unlisted companiesunlisted companies

consolidated accounts

consolidated accounts

individual accounts

individual accounts

IAS/IFRS required

individual accounts

individual accounts

IAS/IFRS permitted (optionality for member states)

Regulation (EC) No 1606/2002

GLOBAL APPROACH TO FINANCIAL REPORTING EU Strategy : IAS Regulation & Modernisation Directive

consolidated accounts

consolidated accounts

Directive 2003/51/EC: Modernization & updating of accounting rulesDirective 2003/51/EC: Modernization & updating of accounting rules7

IASB

IFRIC

EFRAG

technical level

ARC

political level

Endorsement procedure

EUROPEAN

PARLIAMENT

MEMBER STATES

transpositionMEMBER STATES

transposition

EUROPEAN COMMISSION

Regulations

EUROPEAN COMMISSION

Regulations

GLOBAL APPROACH TO FINANCIAL REPORTING EU Strategy: Endorsement process for IFRS

SARGSARG

Monitoring BoardMonitoring Board

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EU’s Actions Japan’s Actions

Adoption of EU Directives (‘03, ‘04)

CESR Advice (Jul ‘05)

Establishment of Japan-EU Monitoring (Nov ‘06)Meeting

Decision on Equivalence of Japanese (Dec ‘08)GAAP with IFRSs

(Jan ‘05) ASBJ – IASB launched joint program for convergence

(Jul ‘06) BAC(*) report “Towards International Convergence of Accounting Standards”

(Oct ‘06) ASBJ published the project plan

(Aug ‘07) Tokyo Agreement

(Dec ‘07) ASBJ published the revised project plan based on the Tokyo Agreement

(*) BAC (Business Accounting Council) is an advisory body on accounting matters to the JFSA

Tokyo Agreement ASBJ agreed with IASB to accelerate convergence between J-GAAP and IFRSs• Eliminate the major differences or provide compatible accounting standards for the items

which CESR advised in 2005, by 2008• Set a target date of 30 June 2011 for resolving other issues• Enhance cooperation to facilitate Japan’s greater contribution to the international

standard-setting process

(Oct ‘02) Norwalk Agreement of IASB-FASB

GLOBAL APPROACH TO FINANCIAL REPORTING Japan’s Strategy: Convergence Process

Source: JFSA

Around 2012: Decision regarding mandatory application of IFRSs

Preparation period: Minimum 3 years

2015 or 2016: Beginning of mandatory application (if decided in 2012)

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2009 2010 2011 2012 2013 2014 2015 2016

Publication of Japan’s Roadmap

(June 30, 2009)

Voluntary Application

Scope: Certain listed companies whose financial or business activities are conducted internationally

Applied to: Consolidated Financial Statements

From: Fiscal year ending 31 March 2010

Minimum 3 years

Decision on Mandatory Application

Possible Start of Mandatory Application

GLOBAL APPROACH TO FINANCIAL REPORTING Japan’s Strategy: Roadmap for IFRS Application

Source: JFSA

ACCOUNTING FOR FINANCIAL INSTRUMENTSKey accounting issues highlighted during the crisis

The G20 reaffirmed in June the need for a single set of high quality improved global accounting standards

Key accounting issues highlighted during the crisis:• Lack of transparency in financial statements and issues relating to the

accounting for off-balance sheet structures → addressed through disclosure requirements

• Difficulties, uncertainties and pro-cyclicality associated with classification and measurement of financial instruments→ IFRS 9 Phase 1

• Insufficient provisioning model (“too little, to late”)→ IFRS 9 Phase 2

• Shortcomings of the hedge accounting rules → IFRS 9 Phase 3

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ACCOUNTING FOR FINANCIAL INSTRUMENTSCriticisms of Classification & Measurement in IAS 39

Complexity • Categories of financial instruments

o Held-for-trading (HFT)o Held-to-maturity (HTM)o Loans and receivables (L&R)o Available for sale (AFS)

• Mixed measuremento HFT FV through P&Lo HTM + LAR amortized costo AFS FV through other comprehensive income (OCI)

Impairment rules HTM and tainting rules

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ACCOUNTING FOR FINANCIAL INSTRUMENTSClassification & Measurement of Assets in IFRS 9

Basically two categories and Mixed measurement maintained:• Amortised cost for assets held for contractual cash flows and managed

on this basis• Fair value for everything else

Financial instrument characteristics and business model to shape boundary between categories→ Too restrictive definition of basic loan feature

Fair Value changes through P&L Elimination of bifurcation of embedded derivatives in hybrid

financial assets (on the asset side only)→ risk of measurement mismatches resulting in artificial volatility

No recycling of gains & losses equity instruments not held for trading

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ACCOUNTING FOR FINANCIAL INSTRUMENTSLiabilities under IFRS 9

Liabilities scoped out of IFRS9-phase 1 because of difficulties with own credit risk

Exposure Draft on Fair Value Option for Financial Liabilities• No recognition of changes in credit spread of own debt

instruments• Option to recognize the full change in fair value of financial

liability if that reduces a measurement mismatch• EBF calls for non inclusion of subsequent changes in own

credit through P&L o Frozen credit spread approacho Alternative solution: isolation of credit element of FV

changes and posting through OCI

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ACCOUNTING FOR FINANCIAL INSTRUMENTSCriticisms of Impairment in IAS 39

IFRS currently allow provisioning on actual losses incurred IFRS currently do not allow provisioning on expected losses The Basel II framework has been perceived as pro-cyclical and

has led to calls for through-the-cycle provisioning starting at the point when loans are originated

EBF agrees on the “too little, to late” argument EBF considers that new provisioning model under IFRS should

be:• more forward-looking • consistent with risk management practices• based on information generated for regulatory purposes• cost efficient• aligned with the other components of the revised IAS 39

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ACCOUNTING FOR FINANCIAL INSTRUMENTSCriticisms of Impairment in IFRS 9 (Expected Cash Flow Method)

Significant conceptual concerns of the Expected Cash Flow Model (ECFM)• Inclusion of expected credit losses in Effective Interest Rate (EIR)• Inconsistency with risk management practices and inapplicability of the

model on open portfolios• Asymmetrical treatment of original estimations of expected losses and

changes in expectations Significant operational concerns of the ECFM

• extremely complex proposal• implementation costs would significantly outweigh the perceived

benefits Exacerbation of pro-cyclicality

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ACCOUNTING FOR FINANCIAL INSTRUMENTSAlternative Impairment Model proposed by EBF

The EBF has developed the Expected Loss over the Life of the Portfolio (ELLP) model • Determination of expected loss on a portfolio level• New model should not change the definition of amortized cost or the

EIR calculationo It should separate the methodology for the recognition and presentation

of interest income and credit losseso It should exclude credit losses from the application on the EIR

• Methodology based on expected loss over the life of each portfolio• Treatment of impaired loans as in the current IAS 39• Impairment allowances built up to be used (not simply buffers)

Impairment allowances must be properly considered in the capital framework

ELLP model: a credible alternative to ECFM17

ACCOUNTING FOR FINANCIAL INSTRUMENTSCriticisms of Hedge Accounting in IAS 39

The hedge accounting rules contained in IAS 39 are not in line with ALM practices used in many European countries

In particular, they do not enable banks to designate core/demand deposits as hedged items

Complex and restrictive effectiveness testing EU hedge carve-out motivated by:

• disproportionate and costly changes to ALM and accounting systems• resulting unwarranted volatility

Carve-out does not prohibit application:• individual companies may apply the ‘carved out’ provisions• EU Member State may make these provisions domestically mandatory

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ACCOUNTING FOR FINANCIAL INSTRUMENTSHedge Accounting in IFRS 9

Crucial need for Hedge accounting principles to reflect consistently ALM practices and economic impact of hedging activities

Not yet a clear view of IASB proposals• Splitting approach

o general hedging and financial itemso portfolio hedge accounting and non-financial hedged items

• Bifurcation by risks• Tentative “full” cash flow hedge accounting approach• A number of simplifications (documentation, etc) under examination

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ACCOUNTING FOR FINANCIAL INSTRUMENTSUS-GAAP Update in a Nutshell

FASB has published a proposed Accounting Standards Update Full Fair Value for all financial instruments with limited

options for amortized cost• with FV changes reported in P&L or OCI• with OCI method differing from OCI under IFRS

Incurred loss + Allowances for credit losses to be applied to loans and debt securities held for long-term investment and to be estimated based on "expected losses“

Hedge accounting allowing hedging of specific risks• “Reasonably effective" hedging instrument• Qualitative analysis of effectiveness at inception

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ACCOUNTING FOR FINANCIAL INSTRUMENTSClosing Remarks

Impairment and hedging likely to be delayed under IFRS ⇨ Is 2011 a realistic deadline for IASB?

Fragmented approach in development of IFRS 9 (3 phases)⇨ EU endorsement process should commence only when

all phases are complete ⇨ Need for appropriate lead-time for companies to start implementing

systems ⇨ IASB should ensure as simple transition as possible IASB and FASB announced revised convergence strategy and work plan

⇨ Convergence may not be sustainable in the short term IASB and FASB are going in different directions and at different speeds

⇨ Need for equivalence and mutual recognition andacceptance by stock exchanges

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