After IFRS 9 Financial Instruments amended the accounting treatment of equity investments, the International Accounting Standards Board (IASB) decided that such investments are, by default, to be measured at fair value with value changes recognised in the profit and loss (P&L) column.
However, entities can, if they choose, recognise value changes as fair value through other comprehensive income (OCI or FVOCI). Such a decision, which is irrevocable, must happen at the start of the investment. If this option is taken, impairment losses cannot be recognised in P&L, nor will there be any recycling of gains or losses through P&L upon derecognition.
Stakeholders have expressed concerns over these new requirements, as they could lead to fewer investments in long-term equity instruments. They also worry because the recognition of fair value changes in P&L may not reflect the business model of long-term investors due to possible volatility, and because the option to recognise fair value changes in OCI. The popular opinion is that investor performance will not be properly reflected, as amounts allocated in OCI cannot be recycled through P&L, which would remove the incentive for investors to invest in long-term equity instruments.
Investigation by EFRAG
As a result of all these concerns, the European Commission (EC) asked the European Financial Reporting Advisory Group (EFRAG) in May 2017 to investigate the potential accounting effects of IFRS 9 on long-term equity investments and to gather quantitative information on equity portfolios. EFRAG was requested to perform its research in two phases, an assessment phase and a possible solution phase.
In January 2018 EFRAG published its final assessment, containing observations from its self-selected consultations and reviews of 2015 and 2016 financial statements. The group's key finding was that some—not many—entities were erroneously classifying equity investments in aggregate as available for sale (AFS) under IAS 39 Financial Instruments: Recognition and Measurement.
In March 2018 EFRAG published a discussion paper, which includes an analysis of the relevance of recycling in the context of long-term equity investments and illustrates two models for those investments carried at FVOCI.
Statement of the IASB
In April, the International Accounting Standards Board (IASB) published its considerations for setting the requirements for the accounting treatment of equity instruments. The crucial aspects were, firstly, to provide investors with better information regarding the changes in values of an equity investment—the IASB is convinced that changes can be presented most transparently by recognising the appreciation or depreciation of value period-by-period in the P&L to reflect the economic reality. Secondly, the option to recognise value changes in OCI is in the standard because it reflects investor performance best, by noting holdings in investments for strategic purposes or benefits. When using this option, entities are prohibited from recycling any gains or losses through P&L, which also applies when selling the investment. The IASB states that their reason for this rule is that if entities are opting for this accounting treatment, then the investment is not held for value appreciation and therefore is not indicative of the entities performance—not even if selling it is considered to be a strategic investment.
Research shows that entities have been misusing the earnings management tool when selectively recycling the profit-making investments of a portfolio and delaying the loss-making investments. These methods provide an incomplete picture of the P&L as companies could smooth out variations in earnings, manage recognised losses, or even modify results.
The IASB further emphasised that the above approach is clearly in line with the Conceptual Framework for Financial Reporting, which has recently been revised. This conceptual framework determines that the P&L is the primary source of information about an entity's financial performance for its financial period. That is why the IASB finds it would be the best place for value changes.
Ultimately, the IASB decided not to include a recycling option in the standard for value changes recognised in OCI as it would add much more complexity, given that recycling requires impairment testing. In the past, issuers of financial statements have been confused by the requirements of IAS 39 with its multiple and inconsistent impairment models. Therefore, the aim of the standard setter was to introduce only one single impairment model.
As IFRS 9 is quite a young standard, its implementation will be closely monitored. The IASB will perform a post-implementation review (PIR), probably after the standard has been applied for two years, as is the norm. For the moment, the IASB is not considering amending the accounting requirements for equity investments. Maybe the board will change its mind once EFRAG publishes its final report?
Watch this blog for more on technical advice and possible solutions. We will address concerns about the current treatment requirements in another post—in the meantime, find the latest IFRS articles here.
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