Banks must meet challenges, make adjustments

The effort to fully adopt International Financial Reporting Standards (IFRS), also known as International Accounting Standards (IAS), in the Philippines has far-reaching implications for banks. Spearheaded by the International Accounting Standards Board (IASB), the IFRS project seeks to harmonize accounting principles worldwide to provide a common language for the world’s capital markets and make it easier for financial statement users to understand and compare financial information.

The IASB initiatives have been endorse by the International Organization of Securities Commissions (IOSCO), which supports the use of IFRS. The Securities and Exchange Commission (SEC), as a member of IOSCO, has committed to adopt IFRS in the Philippines to ensure greater transparency and globally accepted quality in local financial reporting and to promote credibility and efficiency in the capital markets.

The Philippine Accounting Standards Council (ASC) has issued Exposure Draft (ED) 54 on the adoption of IAS 32, Financial Instruments: Disclosure and Presentation, and ED 55 on the adoption of IAS 39, Financial Instruments: Recognition and Measurement. These EDs are expected to take effect in the Philippines for financial statements covering periods beginning on or after Jan. 1, 2005. In addition, the ASC is expected to adopt IAS 30, Disclosure in the Financial Statements of Banks and Similar Financial Institutions, which will also affect the financial reporting requirements of banks and other financial services companies. Another ED with a significant impact on the financial statements of banks is ED 52, Income Taxes, which will take effect on Jan. 1, 2004.

These EDs will introduce significant changes in accounting standards for banks in the Philippines. At the heart of proposed standards is the concept of fair value. With the requirements for fair value accounting, ED 55 presents an approach that differs from current accounting practices. As a result, implementing the new reporting framework may prove to be a challenge for banks.

Increased financial statement volatility IAS 39 permits those securities classified as trading and available-for-sale to be carried at market value, with changes in unrealized gains and losses reported through income for trading account and through equity for availability-for-sale. On the other hand, financial liabilities that are not held for trading are required to be measured at amortized cost. A case in point is the arbitrage employed by banks where the strategy is to buy and hold government securities, fund these with term funding, and hold these until maturity.

The play is to take advantage of the market mis-pricing the default risk of government papers. The treasury desk takes the view that the government will not default on the debt; therefore, if they can match-fund these, there will be a positive profit-and-loss result at the end of the term regardless of what happens in terms of mark-to-market value of the paper.

Let us say, for example, that the accounting treatment under IAS 39 will be to treat the government papers as available-for-sale. The asset therefore will be accounted for at fair value, and changes in the fair value will be recognized directly in equity. The funding, on the other hand, will be accounted for on an accrual basis unless at origination it is designated as held in trading, in which case, the said financial liability should be marked to market, and changes in fair value will be recognized in income. This will result in a mismatch on the valuation on these items on the balance sheet, with the difference between the changes in fair value and the funding reflected in equity.

Unless these IAS 39 requirements are modified, banks will find themselves in a quandary. Most of their invested assets will be carried on their balance sheets at fair value, whereas most of their financial liabilities are carrier either at original cost or at amortized cost. This scenario will have a significant impact on the level and volatility of reported earnings, making it more difficult to understand the results and explain them to senior management, the board of directors, investors, and other stakeholders.

Changes in classification of financial assets Before IAS 39, companies had relative freedom to manage the timing of gains and losses on investments. Certain investments could be carried at cost or amortized cost, with unrealized gains and losses disclosed only in the note disclosures to financial statements. Alternatively, these investments could be measured at fair value with unrealized gains and losses reported directly in equity.

IAS 39 regards fair value as a more appropriate measure than amortized cost. It treats the held-to-maturity classification as an exception and imposes significant restrictions on its use. These are strict criteria to be met before financial assets can be classified as held-in-maturity, such as "positive intent and ability" to hold such asset to maturity. The intent and ability must be assessed not only at the time of acquisition but also at every reporting date.

Banks will need to consider carefully what assets are to be classified as "held-to-maturity" rather than "available-for-sale." Transfers out of the held-to-maturity classification and the potential for "tainting" the entire portfolio will make it extremely difficult to justify transferring assets out of the "held-to-maturity" category. The sale, transfer, or exercise of put option on held-to-maturity investments during the current financial year or during the two preceding financial years may "taint" the whole portfolio, thereby precluding the held-to-maturity classification until the "two preceding years" test has passed. (To be continued)

(Reprinted from The SGV Review, December 2003 issue)