Stephen Sheen: “The most complicated accounting standard ever published”

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IFRS 9: “If you come across someone who claims to have read and understood everything, they are not the kind of person to trust with your fidget spinner collection or your investment property portfolio.”

Changes to accounting requirements of local authorities are often of interest to specialists. Each year, new provisions are introduced to improve the presentation of the annual accounts or refine the information provided so that it reveals more effectively the real financial performance and the financial situation of a local authority.

But the lack of any dedicated readership means the bookkeeper’s job of implementing the changes is tantamount to endlessly rearranging chairs and blowing up more balloons for a party that no guest will ever come to.

However, a number of accounting changes are looming on the horizon that could have a real financial effect and need to be enjoyed by a much wider audience than accounting standards usually require.

The rules for recognizing revenue from contracts are about to become much more scientific, which could shift the date of recognition of revenue. Lease accounting will change to focus more on recognizing the pattern of benefits that tenants obtain from leases (and accrued liabilities), rather than the stream of lease payments.

The most urgent change, however, concerns the implementation of IFRS 9 Financial Instruments. The impact was featured in a Room 151 article in August, but there will never be a bad time over the next 18 months to reiterate the key messages.

IFRS 9 is probably the most complicated accounting standard ever issued, written to address accounting weaknesses that allegedly contributed to the global financial crisis and intended to be tailored to the needs of the most complex banking and financial services companies. If you come across someone who claims to have read and understood everything, they are not the kind of person to trust with your fidget spinner collection or your investment property portfolio.

Implementation will therefore be quite a challenge for local authorities, who must overcome this complexity to account for the substantial but relatively simple involvement that most authorities have in lending and borrowing money and in granting and receiving credit.

The problem is that the implementation is scheduled for April 1, 2018. Usually, accounting changes can be a concern at the end of the year, when it comes time to put the financial statements together. The possibility of a real financial effect means that you will need some risk insurance long before that.

There are three main areas of risk:

Dismantling of the available-for-sale financial assets category

The current default classification for financial assets is the (unnecessarily named) Available-for-Sale category. The accounting policy for these is that fair value gains and losses should be retained on the balance sheet and recognized only in the general fund balance when they are realized at maturity or by way of sale.

The new default classification will be “fair value” through profit or loss, for which gains and losses are charged to I+E as they arise. This will mean the earlier recognition of losses and, in particular, the inability to carry forward losses so that they can be offset by offsetting future gains.

Certain available-for-sale assets will be excluded from fair value recognition if they have the characteristics of a basic loan arrangement (eg bonds). Gains and losses accrued on the balance sheet prior to April 1, 2018 will simply be deducted from the book value of the assets. Otherwise, accumulated gains and losses will be credited or debited to the general fund balance.

This will not be an immediate issue for assets covered by the prudential framework (e.g. share capital), as a statutory inversion will be available for the General Fund shot. The greater visibility of losses could, however, prompt a review of the capital financing plans for these assets. There may be no reasonable and prudent justification for reversing.

If legal protection is not available, it is possible to irrevocably choose which equity instruments to treat as fair value through ‘other comprehensive income’ (i.e. in the same way as assets available for sale are currently available). However, the assets must be equity instruments according to the definition of IFRS, and not in the legal sense; thus, for example, shares which can be exchanged by the holder for cash are excluded. As a choice of accounting policy, the choice must also result in a treatment that reliably reflects the substance of the transaction.

Provisions for depreciation

Impairment of financial assets is a measure of credit risk: the risk that contractual payments will not occur as expected. The way in which IFRS 9 models this risk and imposes its coverage is a fundamental change.

Currently we have an incurred loss model, where no provision is made for impairment until there is evidence that an asset has actually been impaired. So far, no loss has been recorded, regardless of its probability. From April 1, 2018, we will be working on an expected loss model. Provisions will be made for all assets based on losses that can reasonably be expected to occur in the future.

Every instrument that has a risk (however low) that payments due to an authority will not be received and therefore every instrument should have a loss provision to cover expected losses, from the date on which it is acquired by authority. However, the less risky the instrument, the smaller the provision, so it is likely that many instruments will have such low risk that the provision for loss will be negligible.

Greater problems will arise with instruments that have high credit risk but are not yet truly depreciated, such as loans of last resort to businesses and voluntary organizations.

Consideration should be given to the effect of all possible defaults in the future, weighted by the probability of occurrence and the amount that would be lost. Although in some cases the allowance may be limited to cover only events that may occur within the next 12 months, a significant sum may need to be provided when up-front.

Where the provision relates to an asset within the scope of the prudential framework, statutory write-offs will be available to isolate the general fund balance from the impact of loss provisions. However, as with the reclassification of available-for-sale assets, it will need to be considered whether it would be prudent to leave some or all of the charge on the general fund balance.

Investments in companies

The concession that equity instruments must be measured at cost if a fair value cannot be reliably measured should be removed. Cost can now only be used if it is the best estimate available for fair value. For material participations, efforts will now be required to at least establish if there can be better estimates (even if they are still unreliable), which could involve the purchase of some expert resources.

Stephen Sheen is the Managing Director of Ichabod’s Industries, a consultancy providing accounting technical support to local government.

This article is a summary of a more detailed briefing made available to subscribers to Ichabod’s Technical Accounts Service –

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