As the economic crisis in Europe continues to play out, an important question for investors is how sovereign debt exposure may have affected the recently reported performance of systemically important banks. They need to pay attention to reclassified financial assets in particular. That’s because banks may use existing accounting requirements related to reclassification to avoid loss recognition and to minimize both net income and balance sheet volatility.
Under existing International Financial Reporting Standards (IFRS) financial instrument accounting requirements (i.e. IAS 39, Financial Instruments, Recognition and Measurement) there are four key measurement categories:
- Financial assets at fair value through profit or loss (FVTPL): measured at fair value
- Available for sale (AFS) financial assets: measured at fair value with unrealized gains or losses going through “other comprehensive income” (OCI)
- Loans and receivables (L&R): measured at amortized cost
- Held to maturity (HTM): measured at amortized cost
At the onset of the financial crisis in late 2008, the International Accounting Standards Board (IASB) made a key amendment to IAS 39 expanding instances of allowed reclassification of financial assets. The amendment allowed the reclassification of FVTPL items (with the exception of derivatives) under “rare” circumstances and when the intention was to hold instruments for the foreseeable future or until maturity. For example, at the time of the amendment, illiquidity of financial instruments was considered one of those rare circumstances that warranted reclassification of instruments recognized at fair value.
Nevertheless, the IAS 39 reclassification amendment raised a whole host of questions for investors:
- How rare were the circumstances that were prompting reclassification? How does one objectively determine rarity and would such a definition hold over multiple reporting periods?
- Would the reclassification rule open the door for banks to opportunistically avoid loss recognition through the income statement? To its credit, the IASB required that reporting companies disclose the impact on profit or loss recognition if reclassification had not occurred.
- If the basis for reclassification was that management intended or expected to hold financial instruments to maturity, would such management intention be fulfilled?
As the dust associated with the financial crisis continues to settle, these concerns remain. Judging by recent history, crisis factors — such as frequent instances of illiquidity across different asset classes — are the “new normal” of the economic environment, and it only becomes harder to define truly rare circumstances.
In 2011, the European Securities Market Authority (ESMA) voiced concerns regarding the inconsistency in how several banks holding Greek sovereign bonds were applying IFRS requirements including reclassification and impairment rules to avoid loss recognition. At the time, it appeared that certain European banks were effectively ignoring real, albeit unrealized, losses at a time when Greek bonds were trading at a significant discount.
The flexibility to avoid loss recognition through reclassification also was highlighted in a 2012 JPMorgan Cazenove sell-side publication, Financial Instruments Disclosure Analysis, which analyzed the 2011 financial statements of a sample of 44 European banks. The JPMorgan paper found that, on average, the banks analyzed would have further written down 11% of reclassified assets if they had been shown at fair value and not reclassified. In the analyzed sample, there were individual banks that would have required significant additional write-downs of the reclassified assets. For example, Greek banks Alpha Bank and National Bank of Greece would have respectively written down 62% and 52% of reclassified assets.
The paper also illustrates the significant loss avoidance that can occur during a single reporting period. For example, during the 2011 reporting period, German bank Commerzbank AG had a loss avoidance of the magnitude of 17% of equity.
The Impact of Reclassification on Select European Banks
To assess the ongoing impact of reclassification, we examined the 2012 financial statements of a few large European banks in the U.K, France, and Germany. For some of these banks, there were significant amounts not recognized on income statements due to reclassification, when compared to overall net income or loss. Examples, based on a percentage of reported net income or loss, include:
- Barclays (104%)
- Royal Bank of Scotland (18%)
- Societe Generale (19%)
- Credit Agricole (6%)
There also were puzzling reclassification issues related to some of the banks, as highlighted below:
Deutsche Bank: At December 2011, the carrying value of securitized assets that had been reclassified from financial assets at fair value through profit or loss (FVTPL) to loans and receivables (L&R) was worth €6.7 billion. The reclassification was presumably justified because management intended to hold and collect the contractual cash flows from these securities. However, during 2012, €3 billion worth of the securitized assets were sold, for which Deutsche provided the following disclosure:
“The aforementioned governance and approval process determined that assets sold were due to circumstances that were not foreseeable at the time of reclassification, including amendments to capital rules that led to higher capital requirements for the group as a whole,”
This begs the question: How relevant and sustainable was management’s intention at the time of reclassification?
Lloyds Banking Group: In 2010, Lloyds reclassified government securities with a fair value of £3.62 from “available for sale” (AFS) to “held to maturity” (HTM). In 2012, government securities with a fair value of £11.97 billion were then reclassified from HTM to AFS due to a change in management intention to hold the securities to maturity. The related disclosures do not adequately shed light on the factors influencing the changes in management intention across different reporting periods, as evidenced by the reclassification choices for government securities in 2010 and 2012.
BNP Paribas: At June 2011, BNP Paribas reclassified €6.3 billion worth of sovereign securities, including Greek bonds, from AFS to L&R, presumably with the intention of holding these securities to collect contractual cash flows. Subsequently, a bond restructuring by Greek public authorities, including a bond buyback in December 2012, forced BNP Paribas to sell some of the government securities that it had reclassified from AFS into L&R. Again, this situation raises the question regarding the durability of management intention as a basis of accounting.
Comparability Challenges and Distorted Performance Reporting Due to Accounting Exceptions
The observed impact of reclassification under IAS 39 epitomizes the analytical challenge that investors face under a reporting framework with multiple exceptions. Making meaningful comparisons is challenging when management intention can result in different accounting for similar instruments — especially when management intention varies from period to period and across banks with the same business model. Investors should be on alert to significant adjustments to reported numbers due to reclassification choices that distort performance reporting, and to situations where these reported numbers are not comparable across different reporting companies.
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