Stephen Sheen: ‘The most complicated accounting standard ever issued’
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IFRS 9: “If you meet someone who claims grandly to have read it all and understood it, this is not the sort of person to trust with either your fidget spinner collection, or your investment property portfolio.”
Changes to local authority accounting requirements are often of specialist interest. Every year new provisions are introduced that improve the presentation of the annual accounts, or refine the information provided so that it reveals more effectively the real financial performance and financial position of an authority.
But the absence of any dedicated readership means that the work of the accountant in implementing the changes is equivalent to endlessly rearranging the chairs and blowing up more balloons for a party to which no guests will ever come.
However, there are a number of accounting changes breaking the horizon that could have a real financial effect and need to be appreciated by a far wider audience than accounting standards usually command.
The rules for recognising revenues from contracts are about to become a lot more scientific, which could shift the date that income is recognised. Accounting for leases will change to put more focus on recognising the pattern of benefits that lessees obtain from leases (and the liabilities accrued), rather than the stream of rental payments.
The most pressing change, though, relates to the implementation of IFRS 9 Financial Instruments. The impact was headlined 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 the accounting weaknesses claimed to have contributed to the global financial crisis and intended to be fit for purpose for the most complex banking and financial services companies. If you meet someone who claims grandly to have read it all and understood it, this is not the sort of person to trust with either your fidget spinner collection, or your investment property portfolio.
Implementation will therefore be quite a challenge in local government, working through this complexity to report on the substantial but relatively straightforward involvement that most authorities have in lending and borrowing money and giving and receiving credit.
Trouble is, implementation is due with a big bang on 1 April 2018. Usually accounting changes can be worried about at the end of the year when it comes time to pull the financial statements together. The possibility of real financial effect means that you will need some assurance about the risks much earlier than that.
There are three main risk areas:
Dismantling the Available for Sale category of financial assets
The current default classification for financial assets is the (unhelpfully named) Available for Sale category. The accounting policy for these is for gains and losses in fair value to be held on the balance sheet and only posted to the general fund balance when they are realised on maturity or through sale.
The new default classification will be “fair value” through profit or loss, for which gains and losses are posted to I+E as they arise. This will mean the earlier recognition of losses and, in particular, the inability to defer losses so that they can be offset against compensating future gains.
Some Available for Sale assets will be taken outside the scope of fair value accounting if they have the characteristic of a basic lending arrangement (eg, bonds). Gains and losses accumulated on the balance sheet before 1 April, 2018, will simply be written off against the carrying amount of the assets. Otherwise, accumulated gains and losses will be credited, or debited, to the general fund balance.
This will not be an immediate problem for assets covered by the Prudential Framework (eg, share capital), as a statutory reversal will be available for the General Fund hit. The greater visibility of losses might, though, prompt a revision of the capital financing plans for those assets. It might be that there is no reasonable and prudent justification for making a reversal.
If statutory protection is not available, there is some scope for an irrevocable election for equity instruments to be treated as Fair Value through “other comprehensive income” (ie, in the same way as Available for Sale assets currently are). However, assets have to be equity instruments per the IFRS definition, not in a legal sense; so, for example, shares that can be exchanged by the holder for cash are excluded. As a choice of accounting policy, election must also result in a treatment that reliably reflects the substance of the transaction.
Impairment loss allowances
Impairment of financial assets is a measurement of credit risk: the risk that contractual payments will not take place as programmed. The way in which IFRS 9 models this risk and requires it to be covered is a fundamental change.
Currently we have an incurred losses model, where no provision is made for impairment until there is evidence that an asset is actually impaired. Up to this point, no losses were recognised, no matter how likely they might be. From 1 April 2018, we will be working to an expected losses model. Allowances will be made for all assets based on the losses that might reasonably be expected to arise in the future.
Every instrument that has some risk (no matter how small) that payments due to an authority will not be forthcoming and thus every instrument should have a loss allowance to cover expected losses, from the date that it is acquired by the authority. However, the less risky the instrument, the smaller the allowance, so there is a likelihood that many instruments will be of such low risk that the loss allowance will be immaterial.
Bigger problems will arise with instruments that have high credit risk but that are not yet actually credit-impaired, such as lender of last resort loans to companies and voluntary organisations.
Allowance will have to be made for the effect of all possibilities for default in the future, weighted by probability of occurrence and the amount that would be lost. Even though in some cases, the allowance can be restricted to cover only those events that could happen in the next 12 months, a sizeable sum might need to be provided for when the advance is made.
Where the allowance relates to an asset within the scope of the Prudential Framework, statutory reversals will be available to insulate the general fund balance from the impact of loss allowances. However, as with reclassification of Available for Sale assets, consideration will need to be made as to whether it would be prudent to leave some or all of the charge against the general fund balance.
Investments in companies
The concession for equity instruments to be measured at cost if a fair value could not be measured reliably is to be removed. Cost can now only be used if it is the best estimate available for fair value. For material shareholdings, some effort will now be needed to at least establish whether there may be better (if still unreliable) estimates, which might involve buying in some expert resources.
Stephen Sheen is the managing director of Ichabod’s Industries, a consultancy providing technical accounting support to local government.
This article is a summary of a more detailed briefing made available to subscribers to the Ichabod’s Technical Accounting Service – www.ichabods.co.uk.
