The evidence presented in the preceding sections, as well as in several of the pre- ceding chapters, should leave the reader in no doubt that fair value is superior to book value and accruals. This is true both in regard to the support provided by an internal accounting management information system (IAMIS), and in regard to market information by means of financial reporting.
More irrefutable evidence is provided by the fact that in all major countries accounting standards setters have adopted the fair value principle. The down- side lies in the fact that the norms are not quite homogeneous – though this may be changing, as we saw in Chapters 2 and 3. The case study in this section dram- atizes the impact differences in fair value standards have on compliance.
Bank Beta is a global financial institution operating in all major markets of the world. Because of its activities in North America, years ago, it adopted US GAAP in parallel to the accounting system prevailing in its country of origin. To pre- pare itself for the new accounting rules in its home market, Bank Beta did a dry run with IFRS, including IAS 39. The case study in this section is concerned with five issues:
● Restructuring provisions
● Financial investments
● Employee benefit plans
● Retained earnings adjustments
● Derivative instruments and hedging.
Under IFRS, restructuring provisions are recognized when a legal or constructive obligation has been incurred. Restructuring provisions, for instance, may cover personnel, IT, the entity’s premises, and other costs associated with combining and restructuring operations. They may also reflect the impact of increased pre- cision in the estimation of certain leased and owned property costs.
In its home country, prior to IAS 39, financial investments were classified as being either current or long-term. Management considered current financial investments to be held for sale and carried them at lower cost or market value (LOCOM), discussed in section 4. By contrast, Bank Beta accounted for long-term financial investments at cost, less any permanent impairments.
Under US GAAP, the credit institution’s financial investments have been classi- fied as available for sale under ‘debt and marketable equity securities’. They were accounted for at fair value, with changes in fair value recorded in the bal- ance sheet with:
● Gains and losses recognized in net profit in the period sold, and
● Losses recognized in the period of permanent impairment.
After January 2005, for IFRS to US GAAP reconciliation, debt and marketable equity securities have been adjusted from LOCOM to fair value, and classified as
available-for-sale investments. Unrealized gains or unrealized losses relating to these investments are also recorded in the balance sheet.
Under IFRS the bank’s private equity investments and non-marketable equity financial investments are included in financial investments. For US GAAP, how- ever, non-marketable equity financial investments are reclassified to assets, and private equity investments are shown separately on the balance sheet.
This is an interesting case in terms of conversion and diversion characterizing the two standards. The accounting for financial investments classified as avail- able for sale is now generally the same under IFRS and US GAAP. There are, however, two exceptions:
● Private equity investments and non-marketable equity financial invest- ments, are classified as available for sale and carried at cost less other than temporary impairments under US GAAP, and
● Write-downs on impaired assets can be fully or partially reversed under IFRS ifthe value of the impaired assets increases. Such reversals of impair- ment write-downs are not allowed under US GAAP.
Another important reference concerns retirement benefit plans and generally employee benefits. Under IFRS the entity must recognize pension expense based on a specific method of actuarial valuation. This is used to determine the pro- jected plan liabilities for:
● Accrued services
● Future expected salary increases, and
● Expected return on pension plan assets.
Pension plan assets are recorded at fair value, and are held in a separate trust, to satisfy plan liabilities. Under IFRS, the recognition of a prepaid asset is subject to certain limitations, and any unrecognized prepaid asset is recorded as pension expense.
Notice that under US GAAP, pension expense is based on the same actuarial method of valuation of liabilities and assets as under IFRS, but there are differ- ences in the amounts of expense and liabilities, due to different transition date rules, and stricter US GAAP provisions for recognition of prepaid assets.
Moreover, under US GAAP, if the fair value of employee plan assets falls below the accumulated benefit obligation, an additional minimum liability must be
shown in the balance sheet. And if an additional minimum liability is recog- nized, then an equal amount will be recognized as an intangible past service cost.
In regard to other employee benefits, under IFRS Bank Beta recorded expenses and liabilities for post-retirement medical and life insurance benefits. These have been determined under a method similar to the one described under retire- ment benefit plans.
Under US GAAP, expenses and liabilities for post-retirement medical and life insurance benefits are determined under the same methodology as under IFRS.
Here again, however, there are differences in the levels of expenses and liabili- ties incurred due to different transition date rules and the treatment of other activities.
The handling of retained earnings adjustments should also attract the reader’s attention. With IAS 39, an opening adjustment has to be made to reduce retained earnings by reflecting the impact of new hedge accounting rules, re-measuring assets to either amortized cost or fair value as required under the standard. For US GAAP purposes, the first adjustment has not been required because all deriv- atives were previously recorded in the income statement. By contrast, the second adjustment has been recorded in profits and losses.
In connection to derivative instruments held or issued for hedging activities, Bank Beta applied no hedge accounting under US GAAP reporting. Therefore, all derivative instruments were carried on the balance sheet at fair value, with changes in fair value recorded in the income statement. In the course of a dry run, the bank first accounted for derivative instruments hedging non-trading positions in the profit and loss statement, using the accrual or deferral method.
Then it experimented with IAS 39 and SFAS 133.
Under IAS 39, the bank has been permitted to hedge interest rate risk based on forecasted cash inflows and outflows on a group basis. For this purpose, account- ing accumulated information about financial assets, financial liabilities, and for- ward commitments. Such information has been used to estimate and aggregate cash flows. Also, to schedule the future periods in which these cash flows are expected to occur.
Amounts deferred under previous hedging relationships that no longer qualify as hedges under IAS 39 were amortized against net profit over the remaining life of the hedging relationship. Such amounts had to be reversed for US GAAP as they have never been treated as hedges.
Appropriate derivative instruments were used to hedge the estimated future cash flows. Notice that SFAS 133 does not permit hedge accounting for hedges of future cash flows determined by this methodology. Accordingly, for US GAAP such items continue to be carried at fair value, with changes in fair value recog- nized in net trading income.
Finally, in addition to differences in valuation and income recognition, there are also other differences between IFRS and US GAAP. These are essentially related to presentation. One of the differences is settlement datevs trade date account- ing. The bank’s transactions from securities activities are recorded under IFRS on:
● Settlement date for balance sheet, and
● Trade date for P&L statement purposes.
This results in recording a forward transaction during the period between trade date and settlement date. Forward positions relating to trading activities are reval- ued to fair value and any unrealized profits and losses recognized in net profit.
By contrast, under US GAAP, trade date accounting is required for spot pur- chases and sales of securities. Hence, all transactions with a trade date on or before the balance sheet date, and with a settlement date after the balance sheet date, must be recorded at trade date for financial reporting purposes.