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XYZ Co. Ltd. purchased publicly purchased financial securities A & B on January 1st. These financial securities were both classified under similar groups of assets, and where recorded initially at Amortized Cost. The investments' purchase price and fair values are as follows:
Cost FMV
(Jan.1) (Dec.31)
Financial Instrument A $100,000 $150,000
Financial Instrument B $200,000 $160,000
How to Classify Under IFRS 9?
As Consultants to the IASB, what would we propose to curb the Incentives of Managers to Reclassify Financial Assets?
How Classification is Determined under IFRS 9
IAS 39 to IFRS 9
Managers' Incentives
The Bigger Picture
Suggestion # 1 to IASB:
Audit Rotation
Does IFRS 9 solve all the issues?
Audit Rotation
No assurances services (full audit) should be performed by the same auditing firm for all public companies for longer than 3 consecutive years .
Suggestion # 1 to IASB: Audit Rotation
Suggestion 2 to IASB: Increased Government Supervision of the Auditing Procedure
Subsequently, firms must wait at least two rotation periods before returning to a previous auditor.
That is, a firm cannot return to the same auditing for within a space of 6 years.
The IASB should propose to the Government to establish a unit of well-paid, experienced, independent auditors that will review and examine the work of auditors; with emphasis on potential moral hazards, and fraudulent practices.
The Business Model
The Standard positively defines two such business models:
- A Business Model is to hold the financial asset in order to collect the contractual cash flows ('hold to collect')
A Business model in which assets are managed to achieve a particular objective by both collecting contractul cash flows and selling financial assets ('hold to collect')
The classification is determined by:
(1) The business model under which the Financial asset is managed.
(2) The contractual cash flow characteristics of the financial asset.
The Cash Flow Characteristic Test
Solely payments of principal and interest. The SPPI Test
The requirement is that the contractual terms of the financial asset give rise on specified dates to cash flows that are solely payments of principal and interest on the principal amount outstanding.
How Classification is Determined under IFRS 9
Through choice of reclassification, managers can potentially conceal private information from the market about the condition of their financial assets (INFORMATION ASSYMETRY).
Consequently, stakeholders' perceptions of management stewardship compared to the market's performance can be severely distorted.
The classification is determined by:
- The business model under which the Financial asset is managed.
- The contractual cash flow characteristics of the financial asset.
IFRS 9 VS IAS 39
Classes Under IFRS 9
1) FVTPL
2) FVTOCI
3) Amortized Cost
Classes Under IAS 39
1) FVTPL
2) Held to Maturity
3) Loans and Receivables
4) Available for Sale
Financial Assets
How Reclassification Takes Place
Moral Hazard
Management may be tempted to reduce effort, blaming negative performance on factors beyond their control.
OR
Biasing reported earnings to cover up.
Incentives of Managers
Other Incentives
In this way, the Managers would be able to:
- Improve the appearance of their Financial Statements
- Make it seem as though they are Managing the business better
- Be able to obtain higher bonuses
Thank You!
FVTPL to AC
If the assets are reclassified from FVTPL to AC, no future losses resulting from changes in Fair Value will be reported on the IS.
AC to FVTPL
If the assets are reclassified from AC to FVTPL, all future fluctuations in Fair Value will be cycled through the IS.
What would you do as the Manager?
XYZ Company Ltd.
Reclassify A
Reclassify
Both
Reclassify
Neither
Example 1 Reclassification from FVTPL to AC
Reclassy B
How to Classify Under IFRS 9?
Reclassify investment A from AC to FVTPL
Keep investment B at Amortized Cost.
Example 1:
Revenues $100,000
COGS (75,000)
Gross Profit 25,000
Operating Expenses (12,000)
Operating Income $18,000
Other income/losses
Unrealized loss -
Unrealized gain 50,000
Net Income $68,000
$100,000
(75,000)
25,000
(12,000)
$18,000
(40,000)
-
$(22,000)
$100,000
(75,000)
25,000
(12,000)
$18,000
(40,000)
50,000
$28,000
$100,000
(75,000)
25,000
(12,000)
$18,000
-
-
$18,000
Why?
Because we can now report a gain for A and hide the unrealized loss for B.
Balance Sheet
Categories of Classification under IFRS 9
As Accountants What Can we Learn From this Case?
IAS 39 to IFRS 9
#1
The Accountant's Dilema
# 2
#5
#4
# 3
Under IFRS 9, each financial asset is classified into one of three main classification categories:
- Amortized Cost (AC)
- Fair Value Through Comprehensive Income (FVTOCI)
- Fair Value through Profit and Loss (FVTPL)
Increased Legal Liability?
Management is unlikely to acceppt responsibility in troubled times for the company (despite being paid handsomely)
Regulatory Capture
Be extra-speculative of banks' reported earnings
Will we EVER learn from history?
OR
(Cooper, 2013)
(Cooper, 2013)
What is REPO 105?
Background to IFRS 9
Why IFRS 9?
Strong Criticism from Investors of IAS 39 after the Financial Crisis of 2008
When will IFRS 9 Begin?
Officially on January 1st, 2018
Background to IFRS 9
What was wrong with IAS 39?
IAS 39 allowed companies to easily reclassify Financial Assets, thereby hiding unrealized losses from the market.
IFRS 9
Suggestion # 2 to IASB: Government Audit Unit
Why Should the Government Audit Auditing Firms?
Sarbanes-Oxley Act
Prevent possible collusion between Auditors and Management
Reduce Moral Hazard
Purpose # 2: Auditing of Audit Firms
Why?
Which firms?
Which Firms?
Firms which audit public companies with a market capitalization of 80bil.
or greater.
Suggestion # 2 to IASB: Government Audit Unit
Purpose 1: Audit of Selected Public Companies
Which public companies?
Public Companies which have a Market Capitalization of Greater than or Equal to
$80 billion dollars
PriceWaterHouseCoopers Report:
Top 100 Companies in the World by Market
Cap
http://www.pwc.com/gx/en/audit-services/capital-market/publications/assets/document/pwc-global-top-100-march-update.pdf
When Will They Do the Audit?
Which Public Companies?
When will they do the audit?
What is the Reason?
This audit will be done immediate after the year end close of these companies
What is the Reason for the Audit?
Suggestion # 2 to IASB: Government
Audit Unit
This Unit of Auditors will serve 2 Purposes
(1) To Conduct a supplementary audit of selected public companies
(2) To audit auditing firms.
Mandate