IFRS Interpretations Committee: More Relevant and Active Than Investors Might Expect

After my first meeting as a member of the International Financial Reporting Standards Interpretations Committee (IFRS IC) in July, it was apparent to me that the activities and decisions of the IFRS IC are more relevant to investors than they might anticipate. To investors who are familiar with its existence, their basic understanding that the Committee “interprets IFRSs” conjures up images of highly technical and esoteric accounting topics raised by a narrow constituency (i.e., accountants) concerned with how a specific rule in the accounting literature might be applied rather than whether the economics of a transaction — something investors would find useful — are being properly reflected in the financial statements. My experience over the last six months has only made it more evident that the IFRS IC’s activities are highly relevant to investors. In striving to address issues of interest to IFRS stakeholders, the Committee is also more active than one might anticipate with the recent two-day meeting covering nearly 600 pages of analysis, on approximately 25 different topics, and touching at least 18 different IFRSs.

The IFRS IC’s Important Role in Interpreting IFRS

The IFRS IC plays an important role in the due process of creating or modifying IFRSs. Committee members review newly identified financial reporting issues not specifically addressed in IFRSs or issues where unsatisfactory or conflicting interpretations have developed or seem likely to develop in the absence of authoritative guidance. The goal is to reach a consensus on the appropriate treatment. From its deliberations, a recommendation for broader input and ultimately possible change is put to the International Accounting Standards Board (IASB) for its consideration. This is an important step in the due process.

Current Interpretations of Particular Interest to Investors

What’s probably not well known to investors is that the IFRS IC is deliberating emerging issues that are economically relevant to investors that need consideration under existing accounting guidance. The interpretations seek to reduce incomparability in application of IFRS and interpret issues which investors may not even be aware exists. Take for instance:

1)      Going Concern Disclosures: During the financial crisis many enterprises failed within a year, or less, of the issuance of the financial statements despite having been prepared under a going concern assumption. This has prompted reconsideration of whether improvements in disclosures associated with the going concern basis of preparation are needed. Such disclosures would be added to alert investors of uncertainties which could comprise the existence of the enterprise. The IFRS IC discussed, and will be exposing for comment, improvements to IAS 1, Presentation of Financial Statements, with the objective of improving disclosures to investors of risks and uncertainties which might compromise the going concern assumption.

2)      Discount Rate on Pension Liabilities: The IFRS IC is deliberating the application of the requirement in IAS 19, Employee Benefits, to utilize a high-quality corporate bond rate to discount pension liabilities when there ceases to be a deep market for high-quality corporate bonds of necessary duration in certain countries. IAS 19 requires the use of high-quality corporate bond rates in the same currency as the pension liability. If such a rate is unavailable, the standard requires applicable government rates be utilized. IAS 19 established this principle to minimize the inclusion of credit risk in the discounting of pension liabilities. However, with no deep market for high-quality corporate bonds available in certain countries — and governments in these same countries without high-quality debt ratings — preparers are left with a conundrum regarding how to comply with the principle in IAS 19. This is an emerging economic circumstance which impacts what these liabilities will be measured at in the financial statements. Use of lower-quality bond rates will result in a higher discount rate and, correspondingly, lower pension obligation. Further, the issue highlights that in certain markets there may not be an observable risk-free rate. When analyzing and valuing an enterprise, any possible change in the principle or application of the principle could make valuation and comparisons between periods and among entities challenging for investors.

3)      OTC Derivatives Becoming Exchange-Traded Derivatives: With the passage of the European Market Infrastructure Regulation (EMIR) certain previously over-the-counter derivatives will become exchange-traded derivatives (similar to the Dodd-Frank requirement in the U.S.). The accounting question presented to the IFRS IC is whether the change requires discontinuance of the previous hedging relationship under IAS 39, Financial Instruments: Recognition and Measurement. The IFRS IC staff analysis suggests that under the terms of IAS 39, all of the hedging relationships involving such derivatives would be required to be discontinued and re-established. The impact to the financial statements would be most pronounced with respect to cash flow hedges where derivatives which had a significant fair value might no longer be effective accounting hedges. The IFRS IC has proposed that the IASB undertake a narrow scope amendment to IAS 39 to address the change in legislation and allow continuation of these hedging relationships.

4)      Negative Interest Rates: Also of interest to investors is an issue under consideration regarding how financial assets with negative effective interest rates (i.e., a deflationary scenario) should present their returns in the income statement. IFRSs do not provide guidance to address such an economic condition. Should the return be: a) netted against interest revenue; b) included in interest expense; or c) presented as some other type of other expense (e.g., safekeeping fee)? This issue has the potential to become increasingly important given current macroeconomic trends, and a lack of transparency and comparable presentation could be important to investors.

Addressing the SEC’s Observations about the IFRS IC

Consideration of these issues by the IFRS IC reflects the IASB’s and IFRS IC’s willingness to address emerging interpretative issues to enhance the application and comparability of IFRS. On Page 65 of the Work Plan for Consideration of Incorporation of IFRS into the Financial Reporting System for U.S. Issuers: Final Report, the SEC staff made the observation that the IFRS IC needed to be more active and robust in its interpretative process to enhance financial analysis. The aforementioned topics demonstrate progress in addressing this observation broadly and in considering issues relevant to investors and comparable financial analysis more specifically.