Since last contributing to ASA in May 2007 (IFRS, Cold Comfort at Minus 40), I have continued my travels to deliver the IFRS message. Last year took me to Russia, to South East Asia and to one of the new EU states in Eastern Europe. All three had different reasons for having or wanting to implement IFRS,
This article describes my attempts to encourage;
- Russian female accountants to recognise and value biological assets,
- the staff of the Ministry of Finance on the Mekong that a Directive on Accounting for Financial Instruments under IAS 39 cannot be condensed into three pages, even if we miss the spaces between the words; and
- the state supervisors of insurance companies on the Black Sea that IFRS might help rather than hinder them in their task of prudential reporting.
The latter part of the year was not a good time for IFRS missionaries. The sub-prime mortgage losses and consequential banking credit crises created doubts as to the value from retrospective accounting reports.
Mission 1 – Russia – Down on the Farm.
Russia has become a prosperous place, very different to when I first worked there in 1993. Many farms have been privatised and are exporting their produce. Financial Statements that comply with IFRS, help obtain external finance and encourage foreign investor to invest in the agriculture industry.
Fair Value of Pears, Pigs and other Biological Produce.
Much of the mission in Russia was spent digging up the facts from agricultural enterprises required, but not convinced, to implement IAS 41 (Agriculture). Wonderful to forget about financial derivatives and spend time determining:
- the current value of orchards, which would bear fruit only in five years time;
- the fair value of a prize bull, which sadly had failed to produce an offspring in two seasons of trying;
- the present value of the future revenue from the sale of milk, estimated to be produced over the life of any one cow;
- the fair value of calves, yet to be born, from these same cows;
- the fair value of tons of obsolete powdered milk, to be used to feed pigs, also yet to be born, (IAS 2 inputs to IAS 41 future assets); and
- the fair value of a series of canned food recipes, to appear in the balance sheet as major intangible assets (IAS 38 for those who care).
“These are serious biological-asset accounting matters”, I told my Russian female accountants.
Their eyes lifted to the sky, hoping to see the arrival of the aircraft that would take me away and allow sanity to return to the farm yard – the pigs and the cows
Fair Value of Government Grants – Farms, Fertilisers and Finance. – IAS 20.
The Russian state always assisted its farmers when they were state collective institutions, and still does. Grants are given to help finance new farm building construction and major renovations. Subsidies are provided for the purchase of fertilisers, bought and we hope applied. There are subsidised interest rates when purchasing equipment on credit and even subsidies relating to insurance of crops
In the old days, the cost and cash accounting models were used for grants and subsidies. You waited till you got it, and recorded what you got. The engineers that ran the place understood this and
Now IFRS required that state grants be recognised at their fair value, i.e. the present value of what you expect to receive and matched to the costs to which they relate. Prudence has lost its charm.
Mission 2 – Developing an Accounting Directive for IAS 39 – Mission Impossible in South East Asia.
States brought up with the continental system of accounting love to produce directives. The assumption is that the government knows best and its needs are rather more important than those of business and the private sector.
So I had to assist the Ministry in a South East Asian country write a complete directive to tell financial institutions how they should recognise and measure financial instruments under IAS 39. That it took the IASB some years and well over 300 pages to prepare the guidance, somewhat short of a directive, was not relevant -I was given three weeks to complete this task. In addition, the range of financial instruments, including derivatives, was always expanding, making any directive obsolete as we wrote it.
I suggested that perhaps it would be more effective to ask the financial institutions to submit their recognitions and measurement processes, and the Ministry assess compliance with IFRS. This is not a way of thinking under a command and control philosophy, however, so I have retreated to reconsider an alternate approach. Meanwhile, without a recognition and measurement directive in place, reporting under the new IFRS 7 will definitely need some direction.
Mission 3 – IFRS the Insurance Company Supervisors – Standards at a Premium.
Here I am, back in Eastern Europe, and at home with the regulators and supervisors of insurance companies and pension funds.
Liquidity and solvency are the big issues for the insurance company supervisors. An IFRS based report prepared for owners, seven months old, is not much comfort to savers and pensioners now facing ruin. Northern Rock Bank in the UK looked fine at the end of 2006, but not as great by mid November 2007. Certain major US banks, all with activities in my three mission countries, were in good financial order mid-year, but very short of Tier 1 capital by December 16, when, unlike Napoleon, I retreated before the heavy snow arrived.
Accounting for Insurance Contracts – IFRS 4.
IFRS 4 was a must for at least a few days. We studied the success of its implementation in most EU countries, particularly Austria, which are re-establishing old links with Eastern Europe, lost when their empire disappeared in 1917.
IFRS 4 is one of those standards that impact all four phases of the accounting process – recognition, measurement, recording and reporting. From 2005, accountants had to fine comb through each policy, dividing policies into those that had significant risks (pure life) and those that were part savings, defined as investment contracts. Of course, there were lots of hybrid policies, particularly with the insurance companies led by marketing people, rather than actuaries.
For supervisors, the fact that certain contacts could no longer be considered to be insurance contracts, would or could have an impact on the level of technical provisions and thus the required solvency margin.
Accountants are not the only group that has a vested interest in recognising and measuring financial events. Here we had the EU 4th and 7th accounting directives still around, as well as EU Prudential Directives, of which I knew very little and CEIOPS (European Committee of Insurance and Occupational Pensions Supervisors) of which I knew nothing at all.
The actuarial profession also issues guidance on insurance provisions and valuations. So one can end up with five different views of the value of things, a worry for any pensioner whose main wealth is somewhere in the asset side of a doubtful liability picture.
Consolidation or otherwise of Special Purpose Entities/Special Investment Vehicles (SPEs or SIVs). IAS SIC 12.
Throughout this mission from October to December 2007, the local and international press was full of the stories of the billions lost by major US banks. They were required to bring back on to their balance sheet, financial assets that had previously been recorded as a sale or transfer to SPEs or SVIs.
Readers to asa will be well aware by now of the existence and operation by banks and others financial institutions of SPE’s. Banks originate client loans, warehousing them for a short time and then sell (distribute) these in the form of colateralised debt obligations (CDOs) to SPEs or SVIs created for the purpose. This takes them off the balance sheet and provides the bank with liquidity to make more loans and keep a safe solvency regime.
The question we addressed as supervisors – were these special appendages controlled or independent entities? Should they be consolidated with their creator, even if they were legally separate; and where did one stop? If a small farmer sells all his produce to a supermarket chain, he/she is de facto under the chains control and perhaps are “ Variable Interest Entities.” Everyone had a ‘variable interest’ where we were.
A keen participant brought to our attention the US Financial Accounting Standards Board Interpretation FIN 46R on Variable Interest Entities.
We sought some guidance on this “Variable Interest Entities” in the publications on US FASB FIN 46R from the major accounting firms. The shortest document was 236 pages and the longest 466 pages. We finished early that day, not just because it was snowing, but mainly to avoid my further study of these somewhat extensive documents.
However, I did notice in the FIN 46R technical material the word “silo”. Being somewhat of an expert in IAS 41 (Agriculture), I thought that there was something here for me. Not so – its seems that silos are:
“Accounting allocations of assets and liabilities and equity extracted from a particular entity.”
I decided, reluctantly, not to send this definition to my Russian female accountants at the collective farms.
Classification of Equity Instruments – IAS 32.
Capital adequacy is the big thing for Prudential Regulator and Supervisors. So the assumption is that shares, including preference shares, are equity and Tier 1. We had an interesting example of a hybrid preference share, which had a redemption option by the holder within the issue documents.
This required “split accounting” and to reclassify, all or part of the shares, as a financial liability and not an equity instrument. We had some fun trying to establish the probable fair value of this liability component – to reach the value of the equity bit.
Northern Rock and the Depositor Queues. – IAS Somewhere.
Television channels throughout the world showed (for days) the same line of depositors waiting to recover their money at a branch of the Northern Rock Bank. It was a total public relations disaster for the UK financial sector.
We thus spent time studying the equity and liability components of local insurance, bank and financial investment quoted companies. How many were currently dependent on short-term finance and how do we know what the position is today.
Someone proposed that supervisors have a full-time presence in all major banks and insurance companies they monitor. As their offices are more elegant than those provided by the state, this proposal was met with enthusiasm by my participants.
Presentation of Financial Statements – IAS 1
EU Insurance Accounting Directive provides specific formats for both Balance Sheets and Profit and Loss accounts. IAS 1 leaves the enterprise to determine the suitable format of its own financial statements. Thus, for many, two sets of reports are prepared.
For supervisors, uniform formats make comparison easier between companies and among member states. As many of our local insurance companies were part of international groups, we were dealing with a very mixed bag, making uniform reporting more attractive.
We drew lots and preferred the uniform format, to make our life easier, and to be able to have cross-border co-operation with other European national supervisors. We might even manage a foreign trip or two out of all this.
On this positive and happy note we closed with the traditional drinks and local delicacies.
When I first started traveling, most nation states set their own laws and regulations. I have worked in forty countries and seen this autonomy disappear, whatever a politically based entity may say or believe.
IFRS is part of the glue to help hold together and control the new global structures and processes that safeguard the wealth and savings of the citizens in this new world. It’s worth the journeys and the airports at midnight.
Colin Sutherland CA, CA.(SA), CA (Z).is an international Independent Consultant.