Accounting standards: It’s all about perspective
Does IFRS 9 help or hinder long-term investment?
• The European Commission has decided to review the effect of the IFRS 9 accounting standard on long-term investment
• Regulators and investors are considering sustainable business in the framework of conventional accounting standards
• Long-term investment is equated with sustainability
A rare four-letter acronym appeared in a paper published earlier this year by the European Commission (EC). It is often encountered in consultations on finance policy but seldom in plans relating to the environment or human welfare.
The abbreviation in question is that of the framework that for decades has governed much financial reporting, now known as International Financial Reporting Standards (IFRS). Disagreements about one of those standards, IFRS 9, have found their way into the EC’s new proposals, known as the Sustainable Finance Action Plan and containing objectives to reduce pressure for short-term performance in financial decision-making.
Although the unpopular standard only came into force this year, stakeholders have already asked the EC to review the accounting requirements for equity instruments. A decision is scheduled for December. The question? To assess whether it discourages long-term equity investment. IFRS 9 addresses in particular the criticisms against ‘too little, too late’ credit loss provisioning in loan instrument accounting that led to bank crashes in 2008, relating in to certain loan instruments. But several companies object to some of these changes in the context of equity instruments too. One reason may be that equity investments can be higher risk and more volatile than loans.
“They say this will mean they stay away from investment in equity with a long-term payback period, such as infrastructure,” says Filippo Poli, research director at the European Financial Reporting Advisory Group (EFRAG), which is conducting the review for the EC. “If they have gained on the investment, they don’t like the idea that they should show it.”
Resistance to the standard is considerable. Under its predecessor, IAS 39, companies could move changes to the fair value of shareholdings to a reserve standing outside the profit and loss account. They then had the choice to move it to profit and loss when the shares were sold. By contrast, companies now have to show share movements immediately in profit and loss or hold them indefinitely in the reserve – known as Other Comprehensive Income (OCI) – without ever reposting them to profit and loss. This makes their ongoing activities, gains and losses on equity, more transparent. Hence many companies claim the standard exposes volatility in their equity investments.
“Entities can’t use the reserve for earnings management,” says Alan Chapman, head of financial instruments reporting at Grant Thornton. “They don’t know when fair value is going to go up and down. In IAS 39, you could delay the profit and loss impact to when you sell the investment.”
Companies that want to hold their equity investments over a longer period have to make a decision as to where to display the investment when they acquire it. “They have to send it either to the reserve or to profit and loss. The problem is you might want to hold it even if it is loss-making but it would never go to profit and loss, so the gain would never show there if it became profitable in the end,” he says. One concern is that this might hit long-term investments because it could create a short-term impact on changes to fair value. This could disincentivise long-term holdings in equity.
Transparency is best
A competing view is that the standard encourages long-term investment because it provides more visibility. “There are arguments that transparency in accounting is the best thing you can aim for. Good information leads to good decisions. If the volatility shows, it allows investors to appreciate the risk,” says Poli.
As far as sustainability is concerned, the arguments are pertinent to certain types of long-term equity investments in infrastructure, for example. But beneath the controversy is a deeper ethic – how to avoid encouraging short-termism in investment.
Certainly, in the case of the banking crisis, IAS 39 enabled banks to hide losses, and the new standard aims to change certain aspects of accounting practice for loans. “IFRS 9 is now causing a massive change for banks, especially to long-term loans, because they now have to recognise the expected losses”, says Alan Chapman. This should, presumably, make them more aware of the risk of longer-term loan investments.
But there is a counterargument: because of IFRS 9, banks now have to mark assets up to profit and loss as they occur, they are even more governed by cycles in the market. “As the cycle turns, you mark the asset down, and the capital you thought you had has disappeared,” says Natasha Landell-Mills, head of stewardship at Sarasin & Partners, a specialist asset manager. Conversely, some suggest the standard could help encourage longer-term loan investments through better assessments of bad debt.
Some trade-offs appear to be found in the differing principles of stewardship or transparency. By expecting greater visibility in investment value fluctuations, the standard could impose restrictions on particular types of business judgements. Sarasin & Partners is among a group of organisations that has mounted a high-profile campaign against the IFRS.
“IFRS does not support long-term stewardship, and IFRS 9 is one of its most harmful standards,” says Landell-Mills. “There’s a religion that the market price tells you everything you need. If you think the purpose of accounting is to show the latest market volatility, fine. But if you prefer it to support capital potential and long-term stewardship, marking changes to market all the time is not that helpful.” Clearly, contradictory interests are at play.
Some asset managers may be less affected by the new standard, as far as equity investments are concerned. Chapman suggests there may be little change to some of their disclosures, and a few advantages to their business. “In the previous system, many equity portfolio managers moved changes in fair value to profit and loss anyway. At the same time, asset managers investing in money lenders might benefit from a clearer view”, he suggests.
Looking to the long term
At the same time, he indicates all companies reporting on the basis of the standard could adopt a longer-term approach by being less in thrall to profit and loss. “There’s a question as to how much investors are looking at OCI. It’s an area that has to evolve; the role of OCI needs engagement with investors,” he says. Less obsession with immediate profit could, of course, also help discourage a short-term viewpoint.
IFRS barely featured in the report by the High Level Expert Group on Sustainable Finance, which generated the EC’s Sustainable Finance Action Plan. Later, it was the EC that decided to introduce the review of the standard because of its potential interplay with investment decisions and how the information provided may affect them.
The issue is not going to go away. In its plan, the EC pledges to consider new standards if they raise specific concerns for sustainability in investment, such as standards covering insurance contracts. Specific existing standards could also be assessed in the same light on an case-by-case basis where potential concerns are identified. For now, the IFRS 9 debate continues unresolved. “The question as to how this affects long-term investment is unproven. We have not seen direct evidence of that yet,” says Chapman.