The International Accounting Standards Board (IASB) today published for public comment an exposure draft of proposed amendments to IAS 19 Employee Benefits.
The proposals would amend the accounting for defined benefit plans through which some employers provide long-term employee benefits, such as pensions and post-employment medical care. In defined benefit plans, employers bear the risk of increases in costs and of possible poor investment performance.
The amendments would address deficiencies in IAS 19 by requiring entities:
* to account immediately for all estimated changes in the cost of providing these benefits and all changes in the value of plan assets (often referred to as removal of the ‘corridor’ method);
* to use a new presentation approach that would clearly distinguish between different components of the cost of these benefits; and
* to disclose clearer information about the risks arising from defined benefit plans.
The proposals have been developed following a rigorous and comprehensive due process. A discussion paper Preliminary Views on Amendments to IAS 19 was published for public comment in 2008 with 150 comment letters received. The Board then met on 13 occasions to consider the responses and further refine the proposals, seeking input from a broad range of interested parties (including the IASB’s Employee Benefits Working Group). The Board and staff will undertake further outreach during the comment period to ensure that the views of all interested parties are taken in to consideration.
Introducing the exposure draft, Sir David Tweedie, Chairman of the IASB, said:
IAS 19 was inherited from our predecessor body and an overhaul of pensions accounting is long overdue. The proposals, if adopted, will significantly improve the transparency and comparability of pension obligations.
We now seek input from interested parties in order to refine the proposals further, with the aim of publishing a final standard in 2011.
The exposure draft Defined Benefit Plans is open for comment until 6 September 2010. It can be accessed via the ‘Comment on a proposal’ section on www.iasb.org from today.
An IASB ‘Snapshot’, a high level summary of the proposals, is available to download free of charge from the IASB website: http://go.iasb.org/pensions.
Thursday, April 29, 2010
Accounting Checklist - IFRS
Check list - Accounts - IFRS by KPMG
http://www.megaupload.com/?d=SG69IS39
http://www.megaupload.com/?d=SG69IS39
Wednesday, April 28, 2010
IFRS Financial Statements
Besides the numerous measurement and disclosure differences that exist between U.S. Generally Accepted Accounting Principles (GAAP) and International Financial Reporting Standards (IFRS), there are also significant presentation differences.
When opening a set of IFRS financial statements for the first time, CPA Insider™ readers may not immediately notice that the IFRS primary statements contain much less information and have a multitude of notes, which are considered to be an integral part of the financial statements.
The presentation requirements for IFRS financial statements are contained in IAS 1 Financial Statement Presentation. This standard requires a complete set of financial statements to comprise of: two statements of financial position (previously titled the balance sheet), two statements of comprehensive income (previously the income statement and the statement of recognised income and expense), two statements of cash-flows, two years of changes in equity and accounting policies and notes. Three statements of financial position and related notes are only required where there is a retrospective application of an accounting standard or there is a retrospective restatement of items.
This contrasts with the requirements in the U.S. for three years of financial information required for U.S. Securities and Exchange Commission (SEC) registrants for all statements except the balance sheet. All other preparers need only present two years’ worth of information.
The Statement of Financial Position
IFRS does not prescribe a particular format for the statement of financial position. A current/noncurrent presentation of assets and liabilities is by far the most popular method of presentation used. However, a liquidity presentation of assets and liabilities may be used in cases where this provides more relevant and reliable information.
IAS 1 contains lists of the minimum line headings that are to be presented on the face of the relevant primary statement (see table).
A couple of areas to highlight are:
* Deferred tax — Under IFRS, deferred tax assets and liabilities are always classified as noncurrent. Whereas, under U.S. GAAP, classification of deferred tax balances as either current or noncurrent is based on the classification of the related nontax asset or liability for financial reporting.
* Equity — Under IFRS, capital instruments are classified, depending on the substance of the issuer’s contractual obligations, either as liability or equity. Mandatorily redeemable preference shares are classified as liabilities. IFRS does not use the ‘mezzanine equity’ classification that is used in U.S. GAAP for certain redeemable instruments.
The Statement of Comprehensive Income
The concept of total comprehensive income is one that is common between U.S. GAAP and IFRS, with both accounting regimes requiring like information to be presented as part of the primary statements. Under both IFRS and U.S. GAAP, total comprehensive income is required to be presented in the statement of comprehensive income, which may be either one statement or two. However, U.S. GAAP also permits a third option for the presentation of total comprehensive income in the statement of changes in equity, which is not permitted by IFRS. With regard to the format of the income statement, IFRS requires that expenditure is presented by either function or by nature. The choice of presentation should be based on which method provides information that is reliable and more relevant to industry practice and the nature of the company.
Under the nature of expense method, expenses are classified according to their nature (for example, depreciation, purchases of materials, transport costs, employee benefits and advertising costs) and are not reallocated among various functions within the entity.
The Statement of changes in Equity
Under IFRS, the statement of changes in equity shows the total comprehensive income for the period, showing separately the total amounts attributable to owners of the parent and to non-controlling interests and for each component of equity, a reconciliation between the carrying amount at the beginning and the end of the period. The reconciliation of changes is equity is required for the current and the prior period.
Under IFRS, there is no requirement to have a separate reserve for other comprehensive income. Items are generally either allocated to a separate named reserve, when they are non-distributable or subject to recycling or posted directly to retained earnings.
The Statement of Cash-flows
The statement of cash-flows under IFRS allocates cash movements into three categories: operating activities, investing activities and financing activities. The format under IFRS is generally similar to that under U.S. GAAP, although there is more specific guidance for allocation of items to categories under U.S. GAAP.
Both accounting regimes currently permit the use of the direct and indirect method.
Conclusion
U.S. preparers and users of accounts should not lose sight of the presentational differences that they may need to be careful of, when interpreting IFRS financial information. In addition while measurement differences will inevitably continue to grab the headlines, CPA firms should not underestimate the differences in presentation and disclosure, which is where a significant amount your firm’s time and costs may incur when drafting a set of IFRS-compliant financial statements for the first-time.
While current differences in presentation exist users and preparers also need to be aware that the International Accounting Standards Board (IASB) and the Financial Accounting Standards Board (FASB) have commenced a joint project looking at financial statement presentation that aims to improve the usefulness of information provided. The release of an amendment to current reporting requirements is intended for the second half of 2010 with further amendments in the second half of 2011. Thus, considerable future changes to the presentation are likely to be on the way for GAAP and existing IFRS financial statements.
IASB - Impairment user questionnaire
The International Accounting Standards Board (IASB) is seeking input from users of financial statements in the form of a questionnaire on the proposals regarding amortized cost measurement and impairment of financial instruments. The feedback will assist the Board in its deliberations by helping it to better understand the views and preferences of users of the financial statements. (Read the IASB Web Announcement and the Exposure Draft User Questionnaire.)
Click below for the Questionnaire
http://www.iasb.org/Current+Projects/IASB+Projects/Financial+Instruments+Impairment+of+Financial+Assetseplacement+of+IAS+39+Financial+Instruments+Recog/F+I+User+questionnaire.htm
Click below for the Questionnaire
http://www.iasb.org/Current+Projects/IASB+Projects/Financial+Instruments+Impairment+of+Financial+Assetseplacement+of+IAS+39+Financial+Instruments+Recog/F+I+User+questionnaire.htm
IFRS to effect small SMEs
Recast financial statements will help large Co’s gain increased & trust of investors.
The Institute of Chartered Accountants of India (ICAI) has decided the strategy for adoption of International Financial Reporting Standards (IFRS) in India with effect from April 1, 2011. At present over a 110 countries in the European Union, Africa, West Asia and Asia-Pacific regions either require or permit the use of IFRS. Even in the US, there is an ongoing debate regarding the adoption of IFRS replacing the US GAAP. Now, the International Accounting Standards Board (IASB) that issues IFRS and the Financial Accounting Standards Board (FASB) that issues the US GAAP are cooperating and they have long term projects and short term projects to converge US GAAP into IFRS.
Indian corporates are likely to reap significant benefits from adopting IFRS. The European Union’s experience highlights many perceived benefits as a result of adopting IFRS.
There is adverse impact on small and medium size entities (SMEs) in India. Convergence to IFRS is a costly exercise that includes an overhaul of operational and IT processes apart from training costs. The SMEs cannot bear such huge costs. Therefore, a core panel constituted by the government on IFRS decided to exempt SMEs from the first phase of IFRS convergence falling due in 2011. The SMEs sector will continue to follow existing Indian Accounting Standards, which may be modified from time to time to make the sector more competent in the international arena.
However, it will have positive impact on big Indian corporates. These include:
Improvement in comparability of financial information and financial performance with global peers and industry standards. IFRS enhances uniformity in the accounting principles. Foreign investors rely only on IFRS financial statements, hence Indian financial statements will be liked by the foreign investors. The adoption of IFRS is expected to result in better quality of financial reporting. Low cost of raising funds in abroad. Implementation of IFRS in India, will lead to increased trust and reliance placed by investors, analysts and other stakeholders in a company’s financial statements. Better access to and reduction in the cost of capital raised from global capital markets arises as IFRS is now accepted as a standard financial reporting framework for businesses seeking to raise funds overseas.
The above cited benefits will accrue only to the big corporates in India. The SMEs sector will not benefit much as they do not have necessary set up to cope with the problems that may arise by switching to the more rigorous IFRS.
In December 2007, the US Securities and Exchange Commission (SEC) permitted foreign companies listed in the US to present financial statements in accordance with IFRS. This benefits Indian companies listed in the US, as they have to prepare only a single set of IFRS compliant financial statements, reducing financial and compliance costs.
However, the perceived benefits from IFRS adoption are based on the experience of IFRS compliant countries in a period of mild economic conditions. The current decline in market confidence in India due to big corporate failure (Satyam) as well as overseas, coupled with tougher economic conditions, may present significant challenges to Indian companies.
Two separate sets of accounting standards under section 211(3c) of the Companies Act have been agreed upon by the core group for convergence of Indian Accounting Standards with IFRS. For banking and insurance companies there will be a separate roadmap.
The core group committee of the government finalised the road map for IFRS convergence in India. The ICAI said that all entities having net worth in excess of Rs 1,000 crore will have to follow IFRS. The list also includes all NSE and BSE listed companies, insurance entities, mutual funds, venture capital funds and all scheduled banks having operations outside India.
In addition to the above, there are several impediments and practical challenges to adoption of and full compliance with IFRS in India.
Several laws and regulations governing financial accounting and reporting in India need to be amended. In addition to accounting standards, there are legal and regulatory requirements that determine the manner in which financial information is reported or presented in financial statements. For example, the Companies Act, 1956 determines the classification and accounting treatment for redeemable preference shares as equity instruments of a company, whereas these may be considered to be a financial liability under IFRS. There are certain sections in the Indian Companies Act that override the provisions of IFRS.
There is a shortage of professionals with practical IFRS conversion experience and therefore many companies will have to rely on external advisers and their auditors.
There is an urgent need to address these challenges and work towards full adoption of IFRS in India. The most significant need is to build adequate IFRS skills and an expansive knowledge base among Indian accounting professionals to manage the conversion projects for Indian corporates.
Elements for intervention on accounting issues
Speaking notes by Gertrude Tumpel-Gugerell, Member of the Executive Board of the ECB, at the colloquium “La juste valeur dans tous ses Etats” organised by Académie des Sciences et Techniques Comptables et Financières, Paris, 27 April 2010
Which are the issues related to the fair value for companies?
Fair value is an appropriate measurement for certain financial instruments, notably those that are held for trading (i.e. business model is to generate profits by buying/selling in the short term) and for which reliable market prices are readily available, as well as for derivatives. Indeed, given that many derivative contracts have a zero cost at inception, fair value accounting is crucial as it recognises the potential leveraged exposure on the balance sheet.
Fair value accounting mainly raises two issues: first, when to apply fair value measurement (conceptual considerations) and second, how to apply fair value measurement (operational challenges).
First, in our view fair value accounting does not provide decision-useful information to investors if the intention of an entity is to hold the assets until maturity or to settle the liabilities at their nominal amount at maturity. In these cases, recognising interim fair value changes simply heightens the volatility of the financial accounts, without providing actual “information content”. This is typically the case for the loan book of commercial banks.
Moreover, the ECB does not agree that an entity is required to record a gain when the fair value of its own debt falls due to a decrease in its creditworthiness. The rationale being that the entity could buy back the debt and realise the profit. However, in reality and especially in times of distress, an entity does not have readily available the extra cash to buy back their debt. The recognition of such misleading gains was particularly prevalent in the case of Lehman that used it to net against the mounting losses, which simply blurred the entity’s actual performance. As referred to in the recent book “Too big to fail” by Andrew Sorkin: “ It means that the day before you go bankrupt is the most profitable day in the history of your company, because you’ll say all the debt was worthless. You get to call it revenue. And literally (…) pay bonuses off this.” I think we can all agree that there is something fundamentally wrong with this argument.
Second, with regard to its application, fair value accounting poses certain operational challenges, namely when markets become illiquid and reliable market prices are no longer available. What is the use of marking-to-market when there is no market? The relevance and reliability of fair values based on market prices require a functioning market where prices adequately reflect the underlying fundamentals of the financial instrument. When the market is significantly disrupted, the use of market values may be utterly meaningless. In these cases, appropriate valuation techniques coupled with adequate guidance on the application of these techniques are needed in order to arrive at a reasonable estimate of the price at which an orderly transaction would currently take place between market participants. An entity should have in place adequate models that have been tested for accuracy in case the market is severely disrupted. Moreover, in rare circumstances, if the market dynamics are such that an institution may be forced to change its respective business model (i.e. shifting from a “day trading” to a “buy and hold” business model), then it should be able to reclassify financial instruments at amortised cost. These are important lessons to be learnt from the financial crisis.
Hence the ECB is of the opinion that fair value measurement should only be required if it is consistent with the institution’s business model and the characteristics of the particular underlying asset or liability.
Which would be the worst drawbacks, if any, deriving from applying fair value in the light of the events happened in the last two years? Which are the positive aspects?
In my view, the financial crisis has clearly highlighted the heightened pro-cyclicality stemming from two mutually reinforcing channels in the accounting framework: fair value accounting and the current loan loss provisioning practices (impairment methodologies)
Fair value accounting – while certainly not being the “root cause” – served as an amplifier of stress in the financial system. Fair value measurement – by its nature – tends to introduce pro-cyclicality into the accounting framework. It requires the immediate reflection of market-related information in the financial accounts (thus providing a “snapshot” of the reporting entity’s economic condition). In doing so, all fluctuations in fair value (even if only temporary) are to be reflected, thereby increasing accounting volatility.
Downward swings in fair valuations of assets cause entities to sell these assets; these “fire sales” may themselves add to further downward pressure on respective market prices. As a result, further adjustments to the fair values of these assets become necessary, thereby perpetuating the “downward dynamics”. [1] These dynamics may in the end have adverse implications for the “real economy”, e.g. banks may further curb their lending to the economy.
In this context, the potential impact of fair value accounting on behaviour, asset price dynamics and subsequently on financial stability should not be underestimated.
Pre-crisis provisioning practices delayed the recognition of credit losses inherent in loans. Accounting rules require a specific trigger event, such as a default in payment to take place before allowing an entity to create provisions for credit losses. As a result, major write-offs usually accumulate during severe downturns when the inherent credit losses actually materialise, adding further stress to the financial system.
Hence, a more forward-looking provisioning methodology should be developed. This has also been a recommendation of the G20 Leaders. In this context, the ECB welcomes the recent IASB proposal for an expected cash flow approach. Despite some operational challenges that need to be resolved before its final adoption, this approach allows for a timelier recognition of expected credit losses, thereby contributing to mitigating pro-cyclicality. In this context, it should be noted that the Basel Committee has recently developed an approach which aims at reducing the complexity of the IASB’s approach. The ECB urges the IASB to work together with the Basel Committee with a view to developing a workable solution to a more forward-looking provisioning approach.
This is also a good example of where the objectives of high quality accounting and safeguarding financial stability complement each other.
On that note, let me finally underline that the ECB acknowledges the work of the IASB and welcomes the progress that has been achieved in the accounting framework. We look forward to continuing the intense dialogue with the IASB on the remaining phases of the financial instruments’ project, as well as other accounting areas that may be of importance from a regulatory perspective.
As regards the convergence between the American implementation and the IFRS rules, which is your general view? More precisely, on which technical/conceptual points Europe will not give up?
One of the key lessons to be learnt from this crisis is the need for international accounting convergence. Towards this aim, G20 Leaders have urged accounting standard setters to develop a single set of high-quality accounting standards.
A global set of accounting standards is desirable from the perspective of both investors and regulators since it improves the comparability and transparency on a global basis. This contributes towards sounder investment decisions and thus to a more efficient allocation of resources as well as overall functioning of capital markets. Moreover, the financial crisis clearly revealed the shortcomings of different accounting rules on both sides of the Atlantic, as differences in rules contributed towards a lower degree of confidence in financial reporting.
For all these reasons, the ECB welcomes the ongoing efforts of the accounting standard setters to achieve fully compatible, high-quality accounting standards in a direct response to the G20 request. However, we are concerned to hear that the FASB and the IASB are still far from reaching a consensus on key accounting concepts, such as the classification and measurement of financial instruments. The IASB has confirmed a “mixed measurement model” that measures financial instruments both at amortised cost and fair value. In contrast, the US standard setter, the FASB, is determined to move towards a “full fair value model”, claiming that only fair value provides decision-useful information to investors.
I have already mentioned in my intervention how the financial crisis has blatantly revealed the flaws with this measurement and how in certain circumstances, namely when markets are dislocated, applying full fair value accounting to the financial statements of the banking sector raises financial stability concerns and does not provide decision-useful information to investors.
Just to re-emphasise, the ECB strongly opposes a full fair value approach. In this context, convergence should not come at the expense of high-quality accounting standards.
Finally, with regard to recent assertions made by the IASB and FASB that convergence is on track, I would like to highlight that we are not so optimistic. In this regard, putting in place a reconciliation mechanism that simply discloses figures at amortised cost and fair value for each item on the balance sheet would certainly not achieve the aim of convergence.
As regards governance, which improvements do you envisage in relation to the elaboration of accounting rules?
First, I would like to stress that the ECB fully supports the concept of “independent accounting standard setting”. In their April 2009 DECLARATION ON STRENGTHENING THE FINANCIAL SYSTEM, when identifying the main areas of concern in the accounting area, the Leaders of the G20 never challenged this concept.
Second, the ECB very much welcomes the recent efforts of the IASB with a view to enhancing their public accountability. We appreciate the open dialogue between the IASB and various stakeholders, including prudential supervisors, on various accounting issues.
Having said that, the ECB would still like to see accounting standard setters take better account of financial stability implications when revising existing or creating new accounting standards, as for instance indicated by the IASB on the occasion of setting up the “enhanced technical dialogue” with prudential supervisors in 2009. One concrete and important area where the IASB can prove that it takes duly into account financial stability implications would be the on-going discussions on introducing more forward-looking provisioning.
In this sense, the ECB looks forward to continuing the close dialogue with the IASB on the accounting projects that lie ahead.
More generally, please indicate two essential measures for financial regulation in the current debate.
The ECB firmly believes that momentum should be maintained with regard to the global regulatory reform agenda. We need to ensure we put in place a regulatory framework that will enhance the resilience and stability of the global financial system. Under the aegis of the G20, the international community has agreed on a comprehensive set of measures that reflect a substantive revamp of the regulatory framework. Going forward, I would mention three key priority areas.
First, the global community should commit to implementing the so-called Basel III proposals on capital and liquidity issued in December of last year. The ECB supports these proposals which are designed to put banks in the position to better withstand the effects of future crises. At the same time, it is crucial to carefully assess the macro-economic impact of the measures. In this context, the outcome of the quantitative impact assessment that is currently being conducted needs to be awaited before taking any final decisions. Inappropriate calibration of the measures may impact on the provision of credit to the real economy. This is particularly relevant for the EU financial system which is more bank-dependent and where the substitutability between market finance and bank finance is more limited when compared to, for example, the US. The main challenge consists in ensuring a more resilient and stable financial system that neither compromises economic recovery nor unduly impinges on financial innovation.
Second, we need to ensure that we effectively capture all systemically important financial institutions, products, markets and infrastructures within the scope of regulation. One of the lessons from the crisis was the need to make the shadow banking sector more transparent. This becomes more urgent as we tighten the regulatory net for the banking sector. Otherwise we may simply shift risks to unregulated or more loosely regulated entities.
In this respect let me mention the OTC derivative markets. These markets should be subject to greater transparency by promoting the reporting of non-centralised trades to trade repositories. Additionally, we should promote the clearing of eligible OTC derivatives transactions through central counterparties, which should be themselves subject to high prudential and operational standards.
Finally, we need to effectively address the risks posed by systemically important financial institutions. In particular, we need to define a regulatory framework addressing the risks posed by large and complex financial institutions, and to discuss possible measures aimed to ensure a smooth winding-up of ailing systemically important financial institutions. It is crucial that a consistent framework is agreed at international level to avoid conflicting national regimes applied to multinational institutions and regulatory arbitrage. In this context, I strongly support the current work being carried out by the Financial Stability Board and the Basel Committee.
Which are the issues related to the fair value for companies?
Fair value is an appropriate measurement for certain financial instruments, notably those that are held for trading (i.e. business model is to generate profits by buying/selling in the short term) and for which reliable market prices are readily available, as well as for derivatives. Indeed, given that many derivative contracts have a zero cost at inception, fair value accounting is crucial as it recognises the potential leveraged exposure on the balance sheet.
Fair value accounting mainly raises two issues: first, when to apply fair value measurement (conceptual considerations) and second, how to apply fair value measurement (operational challenges).
First, in our view fair value accounting does not provide decision-useful information to investors if the intention of an entity is to hold the assets until maturity or to settle the liabilities at their nominal amount at maturity. In these cases, recognising interim fair value changes simply heightens the volatility of the financial accounts, without providing actual “information content”. This is typically the case for the loan book of commercial banks.
Moreover, the ECB does not agree that an entity is required to record a gain when the fair value of its own debt falls due to a decrease in its creditworthiness. The rationale being that the entity could buy back the debt and realise the profit. However, in reality and especially in times of distress, an entity does not have readily available the extra cash to buy back their debt. The recognition of such misleading gains was particularly prevalent in the case of Lehman that used it to net against the mounting losses, which simply blurred the entity’s actual performance. As referred to in the recent book “Too big to fail” by Andrew Sorkin: “ It means that the day before you go bankrupt is the most profitable day in the history of your company, because you’ll say all the debt was worthless. You get to call it revenue. And literally (…) pay bonuses off this.” I think we can all agree that there is something fundamentally wrong with this argument.
Second, with regard to its application, fair value accounting poses certain operational challenges, namely when markets become illiquid and reliable market prices are no longer available. What is the use of marking-to-market when there is no market? The relevance and reliability of fair values based on market prices require a functioning market where prices adequately reflect the underlying fundamentals of the financial instrument. When the market is significantly disrupted, the use of market values may be utterly meaningless. In these cases, appropriate valuation techniques coupled with adequate guidance on the application of these techniques are needed in order to arrive at a reasonable estimate of the price at which an orderly transaction would currently take place between market participants. An entity should have in place adequate models that have been tested for accuracy in case the market is severely disrupted. Moreover, in rare circumstances, if the market dynamics are such that an institution may be forced to change its respective business model (i.e. shifting from a “day trading” to a “buy and hold” business model), then it should be able to reclassify financial instruments at amortised cost. These are important lessons to be learnt from the financial crisis.
Hence the ECB is of the opinion that fair value measurement should only be required if it is consistent with the institution’s business model and the characteristics of the particular underlying asset or liability.
Which would be the worst drawbacks, if any, deriving from applying fair value in the light of the events happened in the last two years? Which are the positive aspects?
In my view, the financial crisis has clearly highlighted the heightened pro-cyclicality stemming from two mutually reinforcing channels in the accounting framework: fair value accounting and the current loan loss provisioning practices (impairment methodologies)
Fair value accounting – while certainly not being the “root cause” – served as an amplifier of stress in the financial system. Fair value measurement – by its nature – tends to introduce pro-cyclicality into the accounting framework. It requires the immediate reflection of market-related information in the financial accounts (thus providing a “snapshot” of the reporting entity’s economic condition). In doing so, all fluctuations in fair value (even if only temporary) are to be reflected, thereby increasing accounting volatility.
Downward swings in fair valuations of assets cause entities to sell these assets; these “fire sales” may themselves add to further downward pressure on respective market prices. As a result, further adjustments to the fair values of these assets become necessary, thereby perpetuating the “downward dynamics”. [1] These dynamics may in the end have adverse implications for the “real economy”, e.g. banks may further curb their lending to the economy.
In this context, the potential impact of fair value accounting on behaviour, asset price dynamics and subsequently on financial stability should not be underestimated.
Pre-crisis provisioning practices delayed the recognition of credit losses inherent in loans. Accounting rules require a specific trigger event, such as a default in payment to take place before allowing an entity to create provisions for credit losses. As a result, major write-offs usually accumulate during severe downturns when the inherent credit losses actually materialise, adding further stress to the financial system.
Hence, a more forward-looking provisioning methodology should be developed. This has also been a recommendation of the G20 Leaders. In this context, the ECB welcomes the recent IASB proposal for an expected cash flow approach. Despite some operational challenges that need to be resolved before its final adoption, this approach allows for a timelier recognition of expected credit losses, thereby contributing to mitigating pro-cyclicality. In this context, it should be noted that the Basel Committee has recently developed an approach which aims at reducing the complexity of the IASB’s approach. The ECB urges the IASB to work together with the Basel Committee with a view to developing a workable solution to a more forward-looking provisioning approach.
This is also a good example of where the objectives of high quality accounting and safeguarding financial stability complement each other.
On that note, let me finally underline that the ECB acknowledges the work of the IASB and welcomes the progress that has been achieved in the accounting framework. We look forward to continuing the intense dialogue with the IASB on the remaining phases of the financial instruments’ project, as well as other accounting areas that may be of importance from a regulatory perspective.
As regards the convergence between the American implementation and the IFRS rules, which is your general view? More precisely, on which technical/conceptual points Europe will not give up?
One of the key lessons to be learnt from this crisis is the need for international accounting convergence. Towards this aim, G20 Leaders have urged accounting standard setters to develop a single set of high-quality accounting standards.
A global set of accounting standards is desirable from the perspective of both investors and regulators since it improves the comparability and transparency on a global basis. This contributes towards sounder investment decisions and thus to a more efficient allocation of resources as well as overall functioning of capital markets. Moreover, the financial crisis clearly revealed the shortcomings of different accounting rules on both sides of the Atlantic, as differences in rules contributed towards a lower degree of confidence in financial reporting.
For all these reasons, the ECB welcomes the ongoing efforts of the accounting standard setters to achieve fully compatible, high-quality accounting standards in a direct response to the G20 request. However, we are concerned to hear that the FASB and the IASB are still far from reaching a consensus on key accounting concepts, such as the classification and measurement of financial instruments. The IASB has confirmed a “mixed measurement model” that measures financial instruments both at amortised cost and fair value. In contrast, the US standard setter, the FASB, is determined to move towards a “full fair value model”, claiming that only fair value provides decision-useful information to investors.
I have already mentioned in my intervention how the financial crisis has blatantly revealed the flaws with this measurement and how in certain circumstances, namely when markets are dislocated, applying full fair value accounting to the financial statements of the banking sector raises financial stability concerns and does not provide decision-useful information to investors.
Just to re-emphasise, the ECB strongly opposes a full fair value approach. In this context, convergence should not come at the expense of high-quality accounting standards.
Finally, with regard to recent assertions made by the IASB and FASB that convergence is on track, I would like to highlight that we are not so optimistic. In this regard, putting in place a reconciliation mechanism that simply discloses figures at amortised cost and fair value for each item on the balance sheet would certainly not achieve the aim of convergence.
As regards governance, which improvements do you envisage in relation to the elaboration of accounting rules?
First, I would like to stress that the ECB fully supports the concept of “independent accounting standard setting”. In their April 2009 DECLARATION ON STRENGTHENING THE FINANCIAL SYSTEM, when identifying the main areas of concern in the accounting area, the Leaders of the G20 never challenged this concept.
Second, the ECB very much welcomes the recent efforts of the IASB with a view to enhancing their public accountability. We appreciate the open dialogue between the IASB and various stakeholders, including prudential supervisors, on various accounting issues.
Having said that, the ECB would still like to see accounting standard setters take better account of financial stability implications when revising existing or creating new accounting standards, as for instance indicated by the IASB on the occasion of setting up the “enhanced technical dialogue” with prudential supervisors in 2009. One concrete and important area where the IASB can prove that it takes duly into account financial stability implications would be the on-going discussions on introducing more forward-looking provisioning.
In this sense, the ECB looks forward to continuing the close dialogue with the IASB on the accounting projects that lie ahead.
More generally, please indicate two essential measures for financial regulation in the current debate.
The ECB firmly believes that momentum should be maintained with regard to the global regulatory reform agenda. We need to ensure we put in place a regulatory framework that will enhance the resilience and stability of the global financial system. Under the aegis of the G20, the international community has agreed on a comprehensive set of measures that reflect a substantive revamp of the regulatory framework. Going forward, I would mention three key priority areas.
First, the global community should commit to implementing the so-called Basel III proposals on capital and liquidity issued in December of last year. The ECB supports these proposals which are designed to put banks in the position to better withstand the effects of future crises. At the same time, it is crucial to carefully assess the macro-economic impact of the measures. In this context, the outcome of the quantitative impact assessment that is currently being conducted needs to be awaited before taking any final decisions. Inappropriate calibration of the measures may impact on the provision of credit to the real economy. This is particularly relevant for the EU financial system which is more bank-dependent and where the substitutability between market finance and bank finance is more limited when compared to, for example, the US. The main challenge consists in ensuring a more resilient and stable financial system that neither compromises economic recovery nor unduly impinges on financial innovation.
Second, we need to ensure that we effectively capture all systemically important financial institutions, products, markets and infrastructures within the scope of regulation. One of the lessons from the crisis was the need to make the shadow banking sector more transparent. This becomes more urgent as we tighten the regulatory net for the banking sector. Otherwise we may simply shift risks to unregulated or more loosely regulated entities.
In this respect let me mention the OTC derivative markets. These markets should be subject to greater transparency by promoting the reporting of non-centralised trades to trade repositories. Additionally, we should promote the clearing of eligible OTC derivatives transactions through central counterparties, which should be themselves subject to high prudential and operational standards.
Finally, we need to effectively address the risks posed by systemically important financial institutions. In particular, we need to define a regulatory framework addressing the risks posed by large and complex financial institutions, and to discuss possible measures aimed to ensure a smooth winding-up of ailing systemically important financial institutions. It is crucial that a consistent framework is agreed at international level to avoid conflicting national regimes applied to multinational institutions and regulatory arbitrage. In this context, I strongly support the current work being carried out by the Financial Stability Board and the Basel Committee.
Deciding Between the Cash and Accrual Methods of Accounting
While the IFRS v. U.S. GAAP rages (or stalls) a far simpler (yet no less important) decision with regard to accounting methods is considered by many small businesses every year.
The cash versus accrual decision is one that all businesses have to make but small businesses have to make and depending on an entrepreneur’s familiarity with the issue, this could be a very simple decision or a “HELP!” moment.
First, a quick refresher:
Cash – You get cash; you record the transaction. You pay cash, you record the transaction. Simple.
Accrual – This is what your copy of Kieso, Weygandt, & Warfield harped on in college. Accounts receivable, accounts payable, deferrals, revenue is recorded when earned; expenses are recorded when incurred, the matching principle, you know the drill.
Before we get to the pros, let’s consider a simple example. If you and some friends want to pool your money together and buy a piece of commercial property, it doesn’t make a lot of sense to go the accrual route. Your tenants pay rent, you record revenue. You pay for supplies to make improvements, you record the expense. In general, don’t make something complicated that is inherently easy.
However, depending on the entity structure of your business, you may be disqualified from using the cash method. Generally, C Corporations, partnership with one C Corp partner, and tax shelters are not allowed to use the cash method. So if any of these apply, hello accrual.
Enough with the elementary crap though, amiright? Thought so. To get some additional insight, we called on a couple of partners who have no problem sharing their opinions: Scott Heintzelman of McKonly & Asbury in Camp Hill, PA and our own Joe Kristan of Roth & Company, P.C. in Des Moines, IA.
Since Scott is effectively the visitors, he’ll get first at bat. He told us that he encourages clients to adopt accrual right away for three reasons:
1) Fewer surprises. I just met with a prospect and the number 1 frustration they had about [their] prior accountant was that CPA encouraged [c]ash but things fell wrong that next year and they got killed with a tax liability.
2) It helps to prevents “games” being played with year end cash receipts and cash disbursements.
3) It helps the company to think like a “grown up” business. Too often a small business thinks and acts small (cash basis is thinking little) when I encourage them to think bigger.
So, according to Scott, if you’re thinking about getting into business you should think BIG, thus, accrual is the way to go.
Is it that simple? Well, maybe but Joe has some other considerations including – what else – taxes, “For tax, cash is normally preferred because of the ability to control taxable income at year-end. Farmers are notorious for stocking up on feed at year-end to manage taxable income, but being able to manage income by paying off A/P at year end is useful for anybody.”
Of course, the more complex your business gets, the cash method is less available:
Where it becomes a disadvantage is in mixed structures or large entities. If you have related entities doing business with one another, accrual is nice because you eliminate a lot of Sec. 267 related party problems. You don’t have to worry about paying a related party for A/P by year-end to get the deduction because they have to accrue the income.
For a simple structure without a lot of related entities, you will want to do your tax returns on a cash basis. As the structure gets more complicated, accrual method becomes more attractive, and likely mandatory under Sec. 448 or in medium to large entities with inventories.
But for anyone that has to produce GAAP financial statements Joe concedes, “I have no idea why anybody would be cash basis. You can’t be GAAP on a cash basis, and lenders don’t like that.”
The lesson? Like everything in this world, it depends. Do you have a complex entity structure with several related parties engaging in business? Accrual might be better. If you want to be the next Google (or even a fraction of Google), then you might as well be on accrual. If your bank requires GAAP financials to get a loan, you’ll be on accrual.
But on the other hand, if you’ve got no use for GAAP and a simple business not looking to get crazy, the cash method may be the way to go. If you’re still nervous about checking one box or the other, don’t worry, nothing is written in stone. Just consult your business or tax advisor and they’ll help you figure this out. Anyone got more advice? Feel free to chime in.
The cash versus accrual decision is one that all businesses have to make but small businesses have to make and depending on an entrepreneur’s familiarity with the issue, this could be a very simple decision or a “HELP!” moment.
First, a quick refresher:
Cash – You get cash; you record the transaction. You pay cash, you record the transaction. Simple.
Accrual – This is what your copy of Kieso, Weygandt, & Warfield harped on in college. Accounts receivable, accounts payable, deferrals, revenue is recorded when earned; expenses are recorded when incurred, the matching principle, you know the drill.
Before we get to the pros, let’s consider a simple example. If you and some friends want to pool your money together and buy a piece of commercial property, it doesn’t make a lot of sense to go the accrual route. Your tenants pay rent, you record revenue. You pay for supplies to make improvements, you record the expense. In general, don’t make something complicated that is inherently easy.
However, depending on the entity structure of your business, you may be disqualified from using the cash method. Generally, C Corporations, partnership with one C Corp partner, and tax shelters are not allowed to use the cash method. So if any of these apply, hello accrual.
Enough with the elementary crap though, amiright? Thought so. To get some additional insight, we called on a couple of partners who have no problem sharing their opinions: Scott Heintzelman of McKonly & Asbury in Camp Hill, PA and our own Joe Kristan of Roth & Company, P.C. in Des Moines, IA.
Since Scott is effectively the visitors, he’ll get first at bat. He told us that he encourages clients to adopt accrual right away for three reasons:
1) Fewer surprises. I just met with a prospect and the number 1 frustration they had about [their] prior accountant was that CPA encouraged [c]ash but things fell wrong that next year and they got killed with a tax liability.
2) It helps to prevents “games” being played with year end cash receipts and cash disbursements.
3) It helps the company to think like a “grown up” business. Too often a small business thinks and acts small (cash basis is thinking little) when I encourage them to think bigger.
So, according to Scott, if you’re thinking about getting into business you should think BIG, thus, accrual is the way to go.
Is it that simple? Well, maybe but Joe has some other considerations including – what else – taxes, “For tax, cash is normally preferred because of the ability to control taxable income at year-end. Farmers are notorious for stocking up on feed at year-end to manage taxable income, but being able to manage income by paying off A/P at year end is useful for anybody.”
Of course, the more complex your business gets, the cash method is less available:
Where it becomes a disadvantage is in mixed structures or large entities. If you have related entities doing business with one another, accrual is nice because you eliminate a lot of Sec. 267 related party problems. You don’t have to worry about paying a related party for A/P by year-end to get the deduction because they have to accrue the income.
For a simple structure without a lot of related entities, you will want to do your tax returns on a cash basis. As the structure gets more complicated, accrual method becomes more attractive, and likely mandatory under Sec. 448 or in medium to large entities with inventories.
But for anyone that has to produce GAAP financial statements Joe concedes, “I have no idea why anybody would be cash basis. You can’t be GAAP on a cash basis, and lenders don’t like that.”
The lesson? Like everything in this world, it depends. Do you have a complex entity structure with several related parties engaging in business? Accrual might be better. If you want to be the next Google (or even a fraction of Google), then you might as well be on accrual. If your bank requires GAAP financials to get a loan, you’ll be on accrual.
But on the other hand, if you’ve got no use for GAAP and a simple business not looking to get crazy, the cash method may be the way to go. If you’re still nervous about checking one box or the other, don’t worry, nothing is written in stone. Just consult your business or tax advisor and they’ll help you figure this out. Anyone got more advice? Feel free to chime in.
Making the most of share and quota leasing
April 28 2010
Corporate aspects
Tax aspects
The Bank of Italy,(1) the tax authorities and corporate law experts agree that financial leasing operations may involve shares in joint stock companies, quotas in limited liability companies and other equity instruments issued by corporate entities.
Share leasing gives a company considerable financing opportunities, particularly when seeking to increase its corporate equity, acquire controlling shares in a target or execute family or management buy-outs.
Corporate aspects
Under a typical share leasing scheme, a corporate entity (typically a bank or financial institution) subscribes to the shares derived from an increase in corporate equity and subsequently leases them to another company. The lessee pays periodical fees to the lessor and retains the option of purchasing the shares on the expiry of the leasing arrangement.
The lessee may be the company that issued the shares or it may be a different entity. However, if a leasing arrangement involves quotas in a limited liability company, the issuer and the lessee cannot be the same entity, as Section 2474 of the Civil Code prohibits a limited liability company from entering into transactions involving its own quotas.
Share leasing generally falls within the scope of provisions regarding a company's right to purchase its own shares. Section 2357 of the code(2) provides that joint stock companies may purchase their own fully paid-up shares only within the limits of their distributable profits and available reserves (as evidenced by their own regularly approved financial statements). In addition, the shareholders' meeting must approve the purchase and set the legal conditions on which the company may execute the transaction, including the price.
In the case of a company with shares traded on a regulated market, the value of the shares held by the company may not exceed 20% of the corporate equity.(3) Thus, joint stock companies whose shares are not traded on a regulated market can use leasing arrangements to increase their corporate equity beyond this threshold.
A leasing agreement should address the question of whether the lessor or the lessee is entitled to exercise the rights pertaining to the leased shares or quotas. Italian law states that the exercise of rights related to shares or quotas resides with the holder, unless a specific provision states otherwise. The Notarial Council has suggested the application by analogy of the provisions governing carry-over transactions and agreements for deferred sale of securities,(4) whereby rights in relation to dividend distribution and the exercise of options are transferred to the lessee, whereas voting rights in the shareholders' or quotaholders' meeting reside with the lessor.
A lessor and a lessee may sign specific agreements governing the exercise of voting rights - for instance, the lessor may agree to exercise its voting rights in the shareholders' or quotaholders' meeting on the lessee's instructions. However, such agreements have no effect in respect of the company. The lessor can also grant the lessee the proxy authority to participate directly in meetings. Another option is for the parties to agree to assign the shares or quotas in question to a trust company, which will manage them in the best interests of both entities.
Tax aspects
The tax authorities have previously considered the tax treatment of share lease agreements.(5) The lessee may not deduct leasing payments from its corporate tax base because shares and quotas are not subject to an amortization process. It may deduct only the interest expenses related to the agreement.(6) However, such expenses are subject to regional tax.
If the lessee applies international accountancy standards (IAS) and international financial reporting standards (IFRS), the holding period for the application of the participation exemption regime(7) on the gains deriving from the disposal of the shares or quotas accrues from the signing of the leasing agreement, and the lessee accounts for the shares or quotas in its financial statements as immovable financial assets from that point. However, if the lessee does not apply IAS/IFRS principles, the holding period runs from the point at which the lessee exercises the purchase option on shares or quotas on the expiry of the leasing arrangement.
For further information on this topic please contact Antonello Lupo or Giuseppe Battaglia at Portolano Colella Cavallo Studio Legale by telephone (+39 066 976 541), fax (+39 066 976 544) or email (alupo@portolano.it or gbattaglia@portolano.it).
Endnotes
(1) Regulation of August 4 2000.
(2) As amended by Legislative Decree 142/2008.
(3) For the purposes of the code, this includes shares held by a controlled company.
(4) Sections 1550 and 1531.
(5) Ruling 69/2004 and Circular 10/2005.
(6) Section 96 of the Income Tax Code (on the deductibility of interest expenses for corporate tax purposes) will apply.
(7) Under the participation exemption regime, gains deriving from the disposal of shares or quotas are subject to corporate tax at only 1.375% if certain conditions are met.
Comment or question for author
ILO provides online commentaries as specialist Legal Newsletters. Written in collaboration with over 500 of the world's leading experts and covering more than 100 jurisdictions, it delivers individually requested information via email to an influential global audience of law firm partners and international corporate counsel. Please click here to register for the service.
The materials contained on this website are for general information purposes only and are subject to the disclaimer.
Corporate aspects
Tax aspects
The Bank of Italy,(1) the tax authorities and corporate law experts agree that financial leasing operations may involve shares in joint stock companies, quotas in limited liability companies and other equity instruments issued by corporate entities.
Share leasing gives a company considerable financing opportunities, particularly when seeking to increase its corporate equity, acquire controlling shares in a target or execute family or management buy-outs.
Corporate aspects
Under a typical share leasing scheme, a corporate entity (typically a bank or financial institution) subscribes to the shares derived from an increase in corporate equity and subsequently leases them to another company. The lessee pays periodical fees to the lessor and retains the option of purchasing the shares on the expiry of the leasing arrangement.
The lessee may be the company that issued the shares or it may be a different entity. However, if a leasing arrangement involves quotas in a limited liability company, the issuer and the lessee cannot be the same entity, as Section 2474 of the Civil Code prohibits a limited liability company from entering into transactions involving its own quotas.
Share leasing generally falls within the scope of provisions regarding a company's right to purchase its own shares. Section 2357 of the code(2) provides that joint stock companies may purchase their own fully paid-up shares only within the limits of their distributable profits and available reserves (as evidenced by their own regularly approved financial statements). In addition, the shareholders' meeting must approve the purchase and set the legal conditions on which the company may execute the transaction, including the price.
In the case of a company with shares traded on a regulated market, the value of the shares held by the company may not exceed 20% of the corporate equity.(3) Thus, joint stock companies whose shares are not traded on a regulated market can use leasing arrangements to increase their corporate equity beyond this threshold.
A leasing agreement should address the question of whether the lessor or the lessee is entitled to exercise the rights pertaining to the leased shares or quotas. Italian law states that the exercise of rights related to shares or quotas resides with the holder, unless a specific provision states otherwise. The Notarial Council has suggested the application by analogy of the provisions governing carry-over transactions and agreements for deferred sale of securities,(4) whereby rights in relation to dividend distribution and the exercise of options are transferred to the lessee, whereas voting rights in the shareholders' or quotaholders' meeting reside with the lessor.
A lessor and a lessee may sign specific agreements governing the exercise of voting rights - for instance, the lessor may agree to exercise its voting rights in the shareholders' or quotaholders' meeting on the lessee's instructions. However, such agreements have no effect in respect of the company. The lessor can also grant the lessee the proxy authority to participate directly in meetings. Another option is for the parties to agree to assign the shares or quotas in question to a trust company, which will manage them in the best interests of both entities.
Tax aspects
The tax authorities have previously considered the tax treatment of share lease agreements.(5) The lessee may not deduct leasing payments from its corporate tax base because shares and quotas are not subject to an amortization process. It may deduct only the interest expenses related to the agreement.(6) However, such expenses are subject to regional tax.
If the lessee applies international accountancy standards (IAS) and international financial reporting standards (IFRS), the holding period for the application of the participation exemption regime(7) on the gains deriving from the disposal of the shares or quotas accrues from the signing of the leasing agreement, and the lessee accounts for the shares or quotas in its financial statements as immovable financial assets from that point. However, if the lessee does not apply IAS/IFRS principles, the holding period runs from the point at which the lessee exercises the purchase option on shares or quotas on the expiry of the leasing arrangement.
For further information on this topic please contact Antonello Lupo or Giuseppe Battaglia at Portolano Colella Cavallo Studio Legale by telephone (+39 066 976 541), fax (+39 066 976 544) or email (alupo@portolano.it or gbattaglia@portolano.it).
Endnotes
(1) Regulation of August 4 2000.
(2) As amended by Legislative Decree 142/2008.
(3) For the purposes of the code, this includes shares held by a controlled company.
(4) Sections 1550 and 1531.
(5) Ruling 69/2004 and Circular 10/2005.
(6) Section 96 of the Income Tax Code (on the deductibility of interest expenses for corporate tax purposes) will apply.
(7) Under the participation exemption regime, gains deriving from the disposal of shares or quotas are subject to corporate tax at only 1.375% if certain conditions are met.
Comment or question for author
ILO provides online commentaries as specialist Legal Newsletters. Written in collaboration with over 500 of the world's leading experts and covering more than 100 jurisdictions, it delivers individually requested information via email to an influential global audience of law firm partners and international corporate counsel. Please click here to register for the service.
The materials contained on this website are for general information purposes only and are subject to the disclaimer.
IFRS Delay Helps Some Companies
The uncertain state of U.S. adoption of International Financial Reporting Standards could be helping a number of companies by giving them extra time to make the adjustment.
That was one of the points raised during a discussion of global accounting standards on Tuesday hosted by Pace University’s Lubin School of Business in New York. The Securities and Exchange Commission recently ruled that IFRS won’t be incorporated into U.S. financial standards until 2015 at the earliest, depending on a decision next year on whether to go forward with the transition.
“We know we have time between now and when the SEC mandates it,” said IBM director of IFRS policy and implementation Aaron Anderson. “We can do a brisk walk instead of a sprint.”
John McGinniss, executive vice president and chief accounting officer at HSBC North America Holdings, said the delay could benefit smaller community banks.
Several of the speakers disputed the notion that IFRS is more principles based than U.S. GAAP. “U.S. GAAP is founded upon principles,” said SEC Chief Accountant James L. Kroeker. “That’s what the P is supposed to stand for.” However, he noted that principles-based regulations “don’t work if the people behind them aren’t principled.”
Tom Jones, director of Lubin’s Center for the Study of International Accounting Standards, believes that adoption of IFRS is inevitable, and he sees limitations in the convergence process of U.S. GAAP with IFRS. “You can’t converge 17,000 pages with 2,000 pages,” he said. “You have to adopt at some point.”
That was one of the points raised during a discussion of global accounting standards on Tuesday hosted by Pace University’s Lubin School of Business in New York. The Securities and Exchange Commission recently ruled that IFRS won’t be incorporated into U.S. financial standards until 2015 at the earliest, depending on a decision next year on whether to go forward with the transition.
“We know we have time between now and when the SEC mandates it,” said IBM director of IFRS policy and implementation Aaron Anderson. “We can do a brisk walk instead of a sprint.”
John McGinniss, executive vice president and chief accounting officer at HSBC North America Holdings, said the delay could benefit smaller community banks.
Several of the speakers disputed the notion that IFRS is more principles based than U.S. GAAP. “U.S. GAAP is founded upon principles,” said SEC Chief Accountant James L. Kroeker. “That’s what the P is supposed to stand for.” However, he noted that principles-based regulations “don’t work if the people behind them aren’t principled.”
Tom Jones, director of Lubin’s Center for the Study of International Accounting Standards, believes that adoption of IFRS is inevitable, and he sees limitations in the convergence process of U.S. GAAP with IFRS. “You can’t converge 17,000 pages with 2,000 pages,” he said. “You have to adopt at some point.”
Convergence to IFRS - Financial System Cosniderations
The below link provides the challenges and opportunities in smooth convergence to IFRS from Financial System point of view.
http://www.ifrs.com/pdf/10414-378_IFRS_IT_White_Paper_WEB_FINAL.pdf
http://www.ifrs.com/pdf/10414-378_IFRS_IT_White_Paper_WEB_FINAL.pdf
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