What is IFRS?

International Financial Reporting Standards.

Formerly known as International Accounting
Standards (IAS).
Adopted by EU for:
All companies with quoted equity from financial years
beginning after 31/12/04.
All companies with quoted debt from financial years
beginning after 31/12/06.
Most countries will converge onto IFRS,
including US, Australia & China.
 IFRS Approach I
IFRS is designed to be a principles-based
approach.
In comparison US GAAP:
was also originally a principles based
approach.
has had a multitude of specific rules added to
its core principles to deal with particular
circumstances encountered by auditors.
 IFRS Approach II
Within EU:
UK & Ireland have local accounting standards which
are principles-based and are closer to IFRS.
Most of Continental Europe has local accounting rules
driven by law which are more detailed and specific.
Many large EU corporates have used US GAAP or
IAS to report their financials for many years.
Many large banks have produced US GAAP or IAS
for a long time.
Recent changes to IAS39 and possible changes to
IAS19 could still raise significant issues for banks
which already use IAS.
 IFRS Approach III
IFRS includes two key concepts which are
not addressed under US GAAP:
Substance over form:
Transactions should be accounted for in
accordance with their substance NOT their strict
legal form.
Fair value exception
If the application of an accounting principle would
make the financial statement misleading, it should
not be applied.
 IFRS Future Development
The International Accounting Standards
Board (IASB) is responsible for general
development of IFRS.
The International Financial Reporting
Interpretations Committee (IFRIC) will
issue detailed interpretations of IASB, still
following the principles based approach.
It is important that the IFRIC does not follow
the approach of FASB in the US of using
detailed rules to give interpretations.
 General Impact On Auditors
Under IFRS, auditors must provide more
guidance on how principles must be applied.
Auditors in some EU countries will no longer be
able to point to detailed rules to support their
decisions.
The lack of detailed rules might make it difficult
for auditors to convince their clients to make
changes to their accounting framework which
would be detrimental to their results.
 IAS19 Employee Benefits
Amongst other benefits, IAS19 critically applies
to pensions.
Defined contribution (money purchase)
schemes:
Costs recognised in period in which the contribution is
paid.
These schemes are likely to gain in popularity.
Defined benefit (final salary) schemes:
See next slide
 IAS19 (Continued)
Defined benefit (final salary) schemes:
Requirements are similar to those in Canadian, Japanese and
US standards
Some gains and losses in the plan (actuarial gains and losses) do
not have to be recognised in the period in which they occur but can
be spread forward over the service lives of the employees.
UK standard FRS 17 Retirement Benefits requires actuarial
gains and losses to be recognised immediately outside profit or
loss in a statement of total recognised gains and losses.
December 2004 amendment to IFRS introduced the option to use a
similar technique to the UK technique.
Over time, IFRS is likely to move closer to the UK FRS 17
approach.
Banks with deficits in such schemes should ideally quantify the
impact on regulatory capital.
 IAS39
IAS39 Financial Instruments: Recognition
and Measurement.
IAS39 is an amalgamation of US GAAP
rules on accounting for financial
instruments and the best features of
similar guidelines from other countries.
 IAS39 - Objective
IAS39 requires fair value accounting for financial
assets where the institution does not intend to
hold the asset to maturity.
Financial assets are classified into 4 categories:
Financial assets at fair value through profit & loss.
Available for sale financial assets.
Loans & Receivables.
Held-to-maturity investments.
These categories will be discussed in more depth.
 IAS39 - Categorisation
Financial Assets at fair value through profit &
loss
Designated (EU terminology Full Fair Value Option)
Any financial asset that is designated on initial recognition as
one measured at fair value with fair values changes reflected
in P&L.
Held for Trading
Derivatives (except those designated as hedging
instruments)
Financial assets held for selling in the short term or for which
there is a recent pattern of short-term profit taking.
 IAS39 - Categorisation
Available for sale financial assets (AFS)
Any non-derivative financial assets
designated on initial recognition as available
for sale.
Measured at fair value on balance sheet.
Changes in fair value are recognised directly in
equity, through the statement of changes in equity.
 IAS39 - Categorisation
Loans & Receivables
Non derivative financial assets with fixed or
determinable payments which an entity intends to
hold to maturity.
Not quoted in an active market
Not held for trading
Not designated on initial recognition into another
category.
Loans & Receivables should still be measured at
amortised cost.
 IAS39 - Categorisation
Held-to-maturity investments
Non derivative financial assets with fixed or
determinable payments which an entity intends to
hold to maturity, which do not meet the requirements
for Loans & Receivables.
Held-to-maturity investments are measured at
amortised cost.
If an entity makes a significant sale of a held-to-
maturity investment, all other such investments must
be reclassified as available-for-sale for the current
and the next two financial years.
 IAS39 - Categorisation
Classification of financial liabilities:
Financial Liabilities at fair value through profit
and loss.
Designated upon initial recognition.
Held for trading e.g. securities borrowed in a
short sale which must be returned in the future.
Other financial liabilities, measured at
amortised cost.
 IAS39 - Definition of Fair Value
Fair value is an amount:
At which an asset could be exchanged, or a
liability settled, between knowledgeable,
willing parties in an arms length transaction.
It is not a liquidation value.
IAS39 provides a hierarchy of how to
determine the fair value of a financial
instrument.
 IAS39 Definition of Fair Value
Hierarchy of how to determine fair value:
Quoted market prices in an active market.
In absence of an active market, use a valuation
technique which makes maximum use of market
inputs, including:
Recent arms length market transactions.
Reference to the current fair value of an instrument which is
substantially the same.
Discounted cash flow analysis.
Option pricing models.
If there is no active market for an equity instrument
and a wide range of estimated fair values, the equity
instrument must be measured at cost less
impairment.
 IAS39 Definition of Fair Value
If available, a quoted market price in an active
market is the best evidence of fair value and
should be used for accounting purposes.
If not available, an estimate of fair value should
be made using the best information available in
the circumstances.
Due to the relative shortage of active markets,
market prices are often not available.
Other valuation techniques are increasing
important for a variety of financial instruments.
 IAS39 - Definitions
IAS 39 applies to all financial instruments,
unless explicitly excluded.
A financial instrument is a contract which
gives rise to a financial asset of one entity and
a financial liability (or equity instrument) of
another entity.
 IAS39 Definitions
A financial asset is any asset that is:
Cash
An equity instrument of another equity (i.e. not
a companys own equity)
A contractual right to receive a financial asset
from another entity or to exchange financial
assets under potentially favourable
conditions.
A contract that can be settled in the
companys own equity.
 IAS39 Definitions
A financial liability is any liability that is:
A contractual obligation:
To deliver cash or another financial assets to
another company.
A contact that can be settled in the companys own
equity.
 IAS39 - Definitions
Common examples of financial instruments:
Cash.
Demand & Time Deposits.
Commercial Paper.
Loans receivable and payable.
Debt & Equity Securities.
Asset Backed Securities.
Derivatives.
Forwards, Swaps, Futures, Options, Warrants, etc
Leases.
 IAS39 Definitions
Embedded Derivatives
Some contracts which are NOT financial instruments
may have financial instruments EMBEDDED in them.
An embedded derivative must be separated from its
host contract and accounted for as a derivative when:
The risks of the embedded derivative are not related to those
of the host contract.
A separate instrument with the same terms as the embedded
contract would be treated as a derivative.
A entire instrument is not measured at fair value.
 IAS39 Examples of Embedded
Derivatives
Equity conversion option in debt
convertible to ordinary shares.
Leveraged inflation adjustments to lease
payments.
Currency derivatives in purchase or sale
contracts for non-financial items where the
currency is not that of the counterparties
or is routinely used in the trading of that
specific good.
 IAS39 - Hedging
IAS39 permits hedge accounting under
certain circumstance, when the hedging
relationship is:
Formally designated & documented in line
with the entitys risk management objectives.
Expected to be highly effective in achieving
offsetting changes in the fair value or cash
flows attributable to the hedged risk and that
effectiveness can be readily measured
(usually within 80% to 125%).
IAS39 Example of Banks
Balance Sheet I

Source: PricewaterhouseCoopers
Illustrative Consolidated Financial
Statements Banks - 2004
IAS39 Example of Banks
Balance Sheet II

Source: PricewaterhouseCoopers
Illustrative Consolidated Financial
Statements Banks - 2004
IAS39 Example of Profit & Loss

Source: PricewaterhouseCoopers
Illustrative Consolidated Financial
Statements Banks - 2004
IAS39 Example of Notes on
Derivatives I
IAS39 Example of Notes on
Derivatives II
Impact on Bank Risk Analysis
Interaction with Capital Adequacy Rules
Direct.
More precise loan loss provisioning?
De-recognition how easy is it for banks to
move securitized assets off balance sheet?
Indirect.
Impact on financials of banks corporate
customers.
 Interaction with Capital
Adequacy Rules
Banks apply the capital adequacy rules
specified by their own regulator.
BUT the calculation also depends on the
accounting standards used to prepare the
inputs to the calculation.
If IFRS results in a bank restating its
capital base downward, its capital
adequacy ratio will fall accordingly.
 Loan Loss Provisioning
The new rules assume that over-reserving for problem
assets is as fraudulent as under-reserving.
Over-reserving is a direct charge to earnings which result in
reported profits being too low, hurting shareholders.
Reserves can only be made for losses which have already
materialised or which statistically are very likely to materialise.
It will allow a model based approach to recognition of problems in
retail portfolios, but these will have to be more accurate than in past
and will need more evidence to back them up.
Provisions made on the basis of risk management
experience (judgemental provisions) will become more
difficult to justify.
Danger for analysts is that loan loss provisions are made
much later than at present and this will make problem
loan recognition even more cyclical than at present.
 De-recognition
When does a bank still own something?
Very tight rules will govern when a bank can remove an
asset sold off-balance sheet.
If a bank retains just part of an asset and securitizes the
rest, it will probably have to remain on-balance sheet.
If there is residual risk, it is helpful that this will be
clarified, but the size of assets on the balance sheet
might be over-inflated.
This will make it difficult to assess the capacity of the
bank to increase lending or other asset based
businesses.
 Indirect effects
Corporate customers of banks will usually
restate their financials upon adoption of
IFRS.
This might change the banks risk
assessment of their exposure to those
customers.
This could affect future willingness to
conduct business, or the pricing of such
business.
 The EU Carve-Out On IAS 39
In October 2004, the EU decided to adopt IAS
39 with two carve-outs:
The Full Fair Value Option (for liabilities only).
i.e recognition of assets irrevocably on initial recognition and
gains & losses recognised via P&L.
Hedging Accounting.
EU felt that both these areas required more work
before implementation.
Individual countries may still opt to introduce
these rules in their own local implementation of
IFRS.