Executive Summary
The world experienced one of its worst recession which commenced in late 2007. One of the issues that emerged was criticism on the then accounting standards which prompted standard setters to respond. The G20 countries recommended the formation of financial crises advisory committee which developed various recommendations that led to the improvement of specific International financial reporting standards namely IFRS 10, 11, 7 and 9. Also, the recommendation led to the development of IFRS 12. These development were the key responses by the standard setters which are reviewed to demonstrate how they positively impacted the financial statements
Introduction
Towards the end 2007, the global financial crises were triggered by the US subprime mortgages. The crises had a devastating effect on the world major markets. Within a period of one year, many institutions had a large chunk of assets whose value was being rapidly depleted and their market liquidity declining (Needles and Powers, 2011). The phenomenon resulted in various changes both at government level and organizational level. One of the changes that were realized was in relation to international financial reporting standards which were instituted by the International Accounting Standards Board. As such, the paper shall examine these changes and the effect that they have had in improving the quality of information presented in the reporting firm financial statements.
Discussion
International Financial Reporting Standard ten, eleven and twelve (IFRS 10, 11 and12)
One of the recommendations that were advanced by the financial crises advisory committee was an improvement on the improving accounting for off-balance sheet items. In response to this recommendation the International Accounting Standards Board (IASB) which has the mandate to develop international financial reporting standards issues developed various standards to this effect.
The first standard is IFRS 10, Consolidated Financial Statements, which mainly addressed issues that relate to power and control. IFRS 10 was issued to replace IAS 27 which governed Consolidated and Separate Financial Statements and SIC 12 which covered consolidations pertaining to special purpose entities. However, IFRS 10 did not replace IAS 27 in totality since the section that governs the separate financial statement was retained but was rebranded as IAS 27, separate financial statements (ACCA, 2014).
A notable instance of improvement from IAS 27 due to the adoption of IFRS 10 is the understanding of the concept of control. Similar to the prior standard, IFRS 10, the definition of control will be the guiding principle to determine whether an entity will be included in the consolidated financial statement of the investor entity. According to IFRS 10 and IAS 27 standard, the investing firm must have both the power over another entity and must also have the right to receive variable return from the other entity for the investor firm to be deemed to have control over the investee company (ACCA, 2014: Deloitte(a), n.d.: Deloitte (e) n.d.: ICAEW n.d.). However, the understanding of control improves on the previous definition of control as provided by IAS 27 since it integrates the evaluation of whether the firm is controlled by other rights other than voting rights. Consequently, the investor firm will need to consider other elements such as de facto control structures and other contractual agreement in determining the extent of power thus control as opposed to the IAS 27 requirement where control was primarily guaranteed by ownership (Voting Right) (ACCA, 2014: Deloitte (a), n.d.: Deloitte (e) n.d.). For instance, if the investing firm has invested in a venture and has a voting agreement with other voters that is not based on one share to one vote agreement, this will mean that influence will not be based on the number of shares thus ownership but on the agreed power structure. Therefore, it will be misleading to report on the firm’s control based on the one share to one vote structure. As such, the definition of control is a positive development on the usability of the financial statement since it captures the reality that governs the control since it considers other elements that affect power which may not entirely be defined in the overall legal form of the investee enterprise. In addition, IFRS 10 introduces a single consolidation model as opposed to IAS 27 which allowed the application of two models thus creating consistency in consolidation (ACCA, 2014: Deloitte (a), n.d.: Deloitte(e) n.d.).
Another example of regulation that improves the quality of financial statement is an enhancement of IFRS 11 which addresses aspects in Joint Arrangement. The standard replaces IAS 31 which guides on consolidated and separate financial statement and SIC 12 which covers controlled entities – nonmonetary contribution by ventures (ACCA, 2014: Deloitte (f), n.d.: Deloitte (g) n.d.). According to this standard, the standard focuses on the rights and obligation as opposed to the form of the entity. The standard stipulates that all the parties in a joint venture must recognize their rights and obligations that arise from the joint venture and also must assess the terms and conditions agreed by the involved parties, other relevant facts and circumstances that have an effect on the rights and obligations of the involved parties. The requirement broadens the previous legal form restriction. The introduction of this method means that the application of proportionate consolidation cannot be applied any longer. Consequently, it follows that all firm must apply the equity method in reporting joint ventures which in effect, eliminates the inconsistencies associated with the earlier consolidation since it allows for only one method as opposed to the prior two acceptable methods (Deloitte n.d.: Christian and Lüdenbach, 2013). As such, this means that a joint venture must be recognized as an investment under IAS 28 unless there is sufficient ground to exempt the joint venture from applying the equity method. The exception can only be founded under IFRS 9 which stipulates that if an investor is only a participant in the joint venture but lacks any joint control of the venture, the joint venture must record such a joint venture as per the terms provided by IFRS 9 on financial instruments (ACCA, 2014: Deloitte, n.d.: Deloitte n.d.). Therefore, this assist in differentiating financial assets from joint ventures hence elaborating on the financial position of the firm since the two class of asset will affect the firm position in different ways.
Finally, IFRS 12 which covers Disclosure of Interests in Other Entities was adopted to replace IAS 28 which addresses matters relating to Investments in Associates and Joint Ventures is another example which shows how financial statement reporting was positively influenced by changes made after the 2008 crises. The standard is structured to be a supportive standard to IFRS 11 and IFRS 10. The adoption of IFRS 12 strengthens the financial statement since they increase transparency in the values that are presented by the firm (Earnest and Young, 2013: Needles and Powers, 2011). Primarily, the standard requires that a firm must disclose the assumption and significant judgments to determine the control a firm has in the investee entity for the users of the financial statement to be aware of the extent of control the firm has on investee entity based on rights and obligations. Second, the firm must disclose the interest in subsidiaries so that users, for instance, shareholders, can manage to evaluate the structure of the group. Third, the firm must disclose its interest in joint ventures so that the users can manage to observe the effect that such joint ventures would have on the firm’s financial position based on whether these ventures will be financial instruments or investments. Finally, the firm must disclose the interest it has in non-consolidated structured entities. The new requirements are an improvement on the firm’s financial statement transparency thus they are highly welcomed (ACCA, 2014: Deloitte, n.d.: Deloitte n.d.: Earnest and Young, 2013).
International Financial Reporting Standard Seven (IFRS 7)
International Accounting Standards Board initiatives to improve the quality of financial report by issuing IFRS 7 Financial Instruments: Disclosures amendments. The standard existed previously. However, due to the crises, the standard was amended. Furthermore, the standard has undergone various amendments since 2008 to the current state it is in now. The adoption of the standard replaced the IAS 30, Disclosures in the Financial Statements of Banks and Similar Financial Institutions (Deloitte (c), n.d.), and IAS 32, Financial Instruments: Disclosure and Presentation. However, some elements of IAS 32 were not changed entirely but were reduced to deal with matters that relates to the presentation of financial instruments (Deloitte (d), n.d.).
According to the IFRS 7, the reporting entity must disclose the instrument as per their classes as defined by IAS 39. The standards, therefore, leads to two major categories of information that must be disclosed namely information that relates to the nature and the extent of risks that is associated with the firm financial instruments and the significance of the financial instruments held thus improving on the level of corporate transparency (ACCA, 2008).
Considering significance of financial instrument held, the standard provides that the firm’s statement of financial position should disclose loans and receivables, instruments available for sale, financial liabilities at amortized cost, held to maturity investment, financial asset valued at fair value and financial liabilities at fair value clearly showing the liabilities designated for initial recognition and those held for trading. In addition, the firm must disclose any reclassification of financial instrument, any information that relates to compounded financial instruments, breaches of loan agreement terms, if any, asset reclassification, information that relates to any assets that is used as collateral and the assets and liabilities whose value is measured through profit and loss (ACCA, 2008: Deloitte (b) n.d.: European Commission, 2008). In relation to the statement of financial performance, notable disclosures include description of each hedge, the period in which the firm will receive cash flows from items of income, hedges, fair value of hedges, hedging inconsistencies that have been recognized, and information on fair value, accounting policy for financial instruments (ACCA, 2008: Deloitte n.d. :European Commission, 2008).
In relation to nature and extent of risk exposure that arises from the financial statements, the standard provides that the firm must disclose qualitative aspects of risk where the firm evaluates the risk exposure relating to each type of financial instrument, management initiative in generating measures to counter the risk and the risks from the previous period. Also, the standard provides that the reporting firm must disclose quantitative risk dimensions, credit risk, liquidity risk and market risk. Furthermore, the standard compels the reporting entity to disclose all the information that will have the effect of enabling a user to understand the effect of financial assets transfers on the firm (ACCA, 2008: Deloitte n.d.: European Commission, 2008).
The financial instruments were at the heart of the 2008 crises. As such, increasing the disclosures and aligning them to other newly adopted standards such as fair value computation was a commendable act. For instance, the standard created an avenue where investors will understand the extent of risks that the firm is exposed as a result of holding financial instruments by requiring the reporting entity to structure the disclosure of the risk and the mitigating actions that have been taken to counter the risk. Considering the liquidity risk aspect, a firm is not limited to just carrying out a maturity analysis to determine its liquid risk based on contractual obligation since the firm is given a leeway to evaluate its liquidity risk in different approaches that will assist the firm to better manage the risk unless the maturity analysis is the fundamental to this analysis (Deloitte n.d.: Anon. 2008: European Commission, 2008). In addition, the standard improves on the use of fair value since it provides a hierarchy of inputs to be used in determining the fair value which was not in effect prior to the crises.
International Financial Reporting Standard Seven (IFRS 9)
IFRS 9, Financial Instruments, is one of the standards that will be replacing IAS 39, Financial Instruments, further improves the quality of financial reports. According to this method, any assets that were within the scope of IAS 39 will be measured at either amortized or fair value before the IFRS 9 was developed. However, IFRS differs with IAS 39 since it scraps IAS 39 categories of hold to maturity, receivables, loans and available for sale. The standard devised two classes. First, any debt whose objective is to collect the contractual cash flow and the cash flows relates to the payment of interest and principle will be measured using amortized cost method. Any other debt that does not meet the definition will be measured at fair value through profit or loss (Pricewaterhousecoopers 2014: Deloitte n.d.: Greuning, et al. 2011: ACCA, 2010: Pricewaterhousecoopers, n.d.). For instance, a convertible loan will not be measured at an amortized value since it does not primarily involve payment of interests and principle.
IFRS 9 provides that all equity instruments must be recognized at fair value in the financial statement with any gain or losses recognized as profit or loss for that period. The standard further provides that an equity investment will only be valued using fair value through other comprehensive income (FVTOCI) if the equity investment is not held for trading (Pricewaterhousecoopers 2014: Deloitte n.d.: ACCA, 2010). The standard in effect will be eliminating the exception that was accorded to unlisted equity instruments which allowed these instruments to be measured at cost. Nonetheless, the standard was quick to provide a guide in appreciating that the historical cost may still be applicable as a good estimate of fair value in some cases thus the development of the guide.
The standard further requires financial instrument to be classified on initial recognition. Although the standard allows for reclassification, the reclassification must be infrequent and based upon the change of business model since IFRS 9 is dependent on the business model adopted by the firm which is an improvement from IAS 39 which was insensitive to business model (Deloitte n.d.: ACCA, 2010). In addition, the classification is only allowed on the first day of the reporting period.
Finally, the standard requires the reporting entity to measure the assets that have been disaggregated into host financial assets which cannot be measured at fair value through profit or loss should be measured should be measured at fair value through profit or loss in entirely. In addition, the standard eliminates impairment in relation to assets that are considered as available for sale (AFS) category since it eliminates this category entirely (ACCA, 2010). Lastly, this standard allows the reversion of losses by debt securities that are valued using the amortized model and equity that are measured at fair value through profit or loss. The reversion is made by recognizing profit and loss in the income statement once the fair value changes (Deloitte n.d.: Mackenzie, 2013: ACCA, 2010). The implication here is that profit or loss on such investment can be transferred to the statement of financial performance.
According to the financial crises response committee, embedded derivatives received significant concern from many stakeholders. In response to this peculiarity, IFRS 9 provides all derivatives under IAS 39 should be accounted for using fair values. However, in relation to embedded derivatives, IFRS 9 does not allow for valuation of embedded derivatives since the standard does not allow the separation from the financial asset host (Deloitte n.d.: ACCA, 2010). Consequently, the standard provides that the contractual cash flow should be assessed as a whole and the measurement should be fair value through profit or loss. Also, special consideration was given to the issue of own credit. According to IFRS 9, the reporting entity can no longer report gains that are as a result of the firm worsening credit risk in relation to its liabilities (Deloitte n.d.: ACCA, 2010).
Conclusion
The amendment shows the seriousness in which standard setters took the credit crises. Therefore, although the standard setters were accused of not been proactive during the crises, from the response, there were far-reaching reactive measures that were adopted. These measures are meant to increase transparency in the financial statements of the reporting company thus giving the users of the financial statement a better insight into the reporting firm financial position. Therefore, the improvement in the accounting standards promotes better financial reporting since it gives a clear view of the firm compared to the accounting reporting standards that were in existence prior to the financial crises.
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