The accounting mismatch

An accounting mismatch could occur where, in the absence of the fair value option, a financial asset would be classified as available for sale (with most changes in fair value recognised directly in equity) while a related liability is measured at amortised cost (with changes in fair value not recognised). In such circumstances, an entity may conclude that the financial statements provide more relevant information if both items are measured at fair value through profit or loss (FVTPL). Designations as at FVTPL shall be made at initial recognition and are irrevocable.

The entity need not enter into the assets and liabilities at the same time provided that the time gap is reasonable and the remaining transactions are expected to occur. This elective classification was introduced because investments in equity instruments (for example ordinary listed shares) would otherwise always be classified as FVTPL. This means that as the relevant share price rises and falls, fair value gains or losses would be recognised in ‘profit or loss’.

However, if an entity has no intention to trade in its equity investments, it would generally prefer to present the related fair value gains or losses in ‘other comprehensive income’ so as to avoid its ‘profit or loss’ from being needlessly affected. In this case, the entity may thus prefer to classify its equity instrument as fair value through other comprehensive income (FVOCI equity) instead.

Example

SABT Ltd’s intention in respect of the portfolio of shares is to hold them for a long period as a strategic investment. Because the shares are not held for trading, SABT Ltd is allowed to elect irrevocably to present gains and losses on these equity investments in OCI. This means that SABT Ltd never needs to assess whether the shares are impaired, as it will not be able to record any gains on sale through profit or loss. If SABT Ltd were actively buying and selling the shares with the objective of realising short-term fluctuations in their price, the shares would be held for trading and would be required to be classified and measured at FVTPL.

An accounting mismatch may also arise where a non-financial asset is measured at fair value and the related financial liability is measured at amortised cost. The amendment allows an entity to designate the related financial liability as at FVTPL provided that the entity concludes that the changes in fair value of both items are subject to the same risk and an accounting mismatch will be eliminated or significantly reduced by the designation.

Example

SABT Ltd, an investment property company, adopts the fair value model to measure its investment properties. The fair value of the investment properties is highly dependent on interest rates. On 31 December 2018, SABT Ltd took out a R5 000 000 bank loan specifically to finance the purchase of some new investment properties. Fixed interest at the market rate of 6% is charged for the eight-year term of the loan. Transaction costs of R120 000 were incurred. A bank loan would normally be initially measured at fair value less transaction costs and subsequently at amortised cost. In the case of SABT Ltd, the initial measurement at fair value less transaction costs on 31 December 2018 would result in a financial liability of R4 880 000      (R5 000 000 – R120 000).

Subsequent measurement would then be at amortised cost. An effective interest rate would then need to be calculated to incorporate the 6% interest and the R120 000 transaction costs. This effective interest would be recognised as an expense in profit or loss for the year ended 31 December 2018.

However, IFRS 9 offers an option to designate a financial liability on initial recognition as at FVTPL in order to eliminate or significantly reduce a measurement or recognition inconsistency (an ‘accounting mismatch’). This option is available to SABT Ltd because the bank loan is being used specifically to finance the purchase of investment properties. Under the accounting policy of SABT Ltd, these investment properties will be measured at fair value with gains or losses recognised in profit or loss. Therefore, if the loan were measured at amortised cost, there would be a measurement inconsistency.

To eliminate this accounting mismatch, SABT Ltd may choose to designate the bank loan on initial recognition on 31 December 2018 as at FVTPL. If this option is chosen, the loan will be initially recognised at its fair value of R5 000 000 and the transaction costs of R120 000 will be expensed through profit or loss. Subsequently, the loan will be measured at fair value with any gains or losses being recognised in profit or loss, in line with the accounting treatment of the investment properties it was used to finance.

The contractual cash flow and business models are there simply to classify financial assets and financial liabilities. The accounting mismatch is not related to the classification process directly but is a consequence of the classification process. In other words, if one follows the IFRS 9 classification process, the outcome will be a debit and a credit.  Where the debit and credit are classified differently, which results in different measurement bases and different profit or loss implications, you have identified a potential accounting mismatch.

In order to eliminate or reduce these differences, management may choose to measure the debit and the credit on the fair value through profit or loss basis.  The importance of the classification process cannot be underestimated as if the classification is wrong the ability to identify an accounting mismatch is negligible. If all financial assets and financial liabilities could be designated fair value through profit or loss there would never be an accounting mismatch.

However, the classification process contains a mix of a number of classification bases where fair value through profit or loss will never be allowed, thereby creating the potential for the accounting mismatch.

AUTHOR | Dr Steven Firer, Technical Expert – Nexia SABT: Centurion Office