Chairman of the IASB provides update to ECOFIN on reform of IAS 39

Opening remarks by Sir Bryan Nicholson, Trustee of the IASC Foundation

Sir David and I welcome the opportunity to appear before you today. Sir David is accompanied by Gavin Francis, director of capital markets, the lead IASB staff director on the IAS 39 reform project.

Gerrit Zalm, our chairman and your former colleague, apologises for not being able to attend. As one of the eight European-based trustees, I have been asked to accompany Sir David today.

Since the beginning of the global economic crisis, the trustees have been actively engaged with the issues raised. We have committed ourselves to taking urgently all the actions necessary within our sphere of responsibility to respond to these issues.

As the crisis unfolded, the negotiations leading to the establishment of a public accountability link to the Monitoring Board were concluded. The Monitoring Board came into being early this year and has played its part in encouraging and supporting swift action by the IASCF. Whilst the European Commission has been present and has participated in our meetings with the Monitoring Board, we would greatly value its full participation in a body it helped to create and hope that may soon be possible.

Conscious of the urgency placed on the reform of IAS 39, the Trustees have strongly supported the need to complete the first part of the reform by year end. We have received regular updates in public meetings to ensure timely completion and fair consideration of stakeholder input.

Before handing over to Sir David, I would make four points from the Trustee standpoint about the work to reform IAS 39.

One, the trustees are pleased with the unprecedented scale of the stakeholder engagement that the IASB has undertaken to complete its work, including with prudential supervisors and those tasked with co-ordinating the global regulatory response to the crisis.

Two, the IASB has made real substantive adjustments to its original proposals to address issues raised by stakeholders. The Trustees believe these have improved the proposals and aided transparency.

Three, the Trustees have been impressed with the pragmatic and listening approach that the IASB has taken.

Four, the Trustees believe that the IASB’s developing proposals on a reformed IAS 39 represent a major step forward on a matter that has been contentious for years.

Prepared statement by Sir David Tweedie, Chairman of the IASB

I greatly appreciate the opportunity to speak to you regarding the status of the IASB’s revision of IAS 39. When I appeared before you in June, the Council emphasised the need to have a revised standard available for use this year. I gave a commitment to deliver on this timetable. We will publish the new standard in November.

The new standard on classification and measurement responds directly to the call of the G20 Leaders to ‘reduce the complexity of accounting standards for financial instruments’. As urged by the G20 Finance Ministers in September, we have taken ‘account of the Basel Committee guiding principles on IAS 39 and the report of the Financial Crisis Advisory Group’. Additionally, we have responded to issues raised by this Council regarding impairment and the fair value option and to subsequent concerns raised in the European Commission comment letter of 15 September on our proposals.

We are working closely with the European Commission and the European Financial Reporting Advisory Group (EFRAG) to facilitate a smooth endorsement. We have also briefed and received the advice of the Economic and Monetary Affairs (ECON) Committee of the European Parliament.

Enhanced stakeholder dialogue to respond appropriately

We carried out an enhanced global consultation to ensure the input of all stakeholders was taken into account. In that regard, one clear message that we have heard from this Council and others is the need for broad stakeholder engagement in the standard-setting process to ensure a high-quality and broadly-respected outcome.

We believe that the standard to be published in November has benefited greatly from the advice that we have received in Europe and elsewhere. The IASB is making changes to its original proposals to address the issues that have been raised.

Indeed, the scope of our international outreach across borders and perspectives following the publication of our proposal in July has been unprecedented. First, we established an enhanced technical dialogue with prudential supervisors and other market regulators. We met with this group in late August to discuss our proposals. We held more than 80 meetings with investors, prudential supervisors, capital market authorities and other stakeholders in Europe and elsewhere to discuss the possible impact of our proposals. We hosted round table meetings in Asia, Europe and the United States. Finally, we received comment letters from nearly 250 individuals and organisations, including the European Commission.

To consider the views of interested parties, we have held additional board meetings and will continue to schedule as many meetings as required in order to complete the project in time for November publication.

Addressing the issues raised by stakeholders

Without going into great technical detail, I would like to explain briefly the IASB’s current position on our classification and measurement proposal and how we have responded to the major issues raised in Europe and elsewhere.

At the heart of our proposal is defining when fair value and cost-based accounting should be applied to financial instruments. Members of this Council and many commentators have expressed concern about any increased use of fair value. I can confirm that extending the use of fair value has not been our motive or intent in developing a new standard.

We believe, as the Basel Committee and the Financial Crisis Advisory Group recommended, that cost-based accounting is appropriate for some financial instruments. The IASB’s emphasis has been to define in a balanced and transparent way the appropriate criteria for classifying instruments to be measured at cost and at fair value - not to increase or decrease arbitrarily the use of fair value.

Under our model, whether there is an increase or a decrease of fair value for a particular institution will depend on that institution’s business model and holdings. Let me state clearly: the IASB will not require that the loan book of banks be held at fair value. As a result, the final standard will likely result in financial institutions that undertake traditional banking activities of raising deposits and making basic loans applying less fair value accounting rather than more. Furthermore, respondents to the exposure draft including EFRAG and the European Commission provided examples of some instruments that they felt were inappropriately classified at fair value. In finalising the classification and measurement requirements the IASB has responded to these comments. This has resulted in more instruments being eligible for measurement at cost than was proposed in the exposure draft.

Many commentators, including the European Commission and the Basel Committee, have noted the need to reflect the business model of the reporting entity in classifying financial instruments. Our proposal always incorporated the business model as one of the two criteria to determine the classification and measurement of financial instruments. However, we have now further emphasised this point by deciding that the assessment of the business model should be the first factor in determining the classification of financial instruments.

The IASB has also addressed the issues related to reclassification of financial instruments. First, we have removed the prohibition on reclassification of financial instruments that was in the original proposal. We have responded to the suggestion made by many that a change in business model should result in reclassification. Second, as part of the transition provisions of the new standard, we have proposed that companies will be able to reclassify financial instruments out of the fair value option when making their new designations. To ensure full transparency, we will require appropriate disclosures and presentation of any reclassifications.

We are addressing the treatment of ‘own credit’. We have proposed the elimination of the counterintuitive result that a company can receive a gain from its own liabilities when the quality of their own credit deteriorates. This is an issue that was raised at the last ECOFIN meeting.

Finally, we know that the new standard will apply to all companies with financial instruments, not just to banks. Insurance companies have expressed some concern regarding the immediate impact of the standard. We have always said that we will address any implications for the accounting for financial instruments by insurance companies once the insurance contracts project is nearer completion. Insurance companies would not be required to adopt the new standard until 2013 or 2014 at the earliest. At the same time, we have made important improvements to our original proposal to address the issue of dividends on equity investments and the measurement of unquoted equity investments—issues that the European Commission and insurance companies cited in their comment letters.

Towards a high-quality, globally-accepted standard

The G20 has emphasised the need for convergence towards a single set of high-quality, global, independent accounting standards. To this end, the IASB has been, and is committed to, working with the US Financial Accounting Standards Board (FASB), to reach a common approach on financial instruments and to the other areas outlined in the Memorandum of Understanding between the two organisations. The IASB is also committed to the June 2011 timeline for convergence outlined in the Memorandum of Understanding and endorsed by the G20 Leaders in Pittsburgh.

Next week, we will meet the FASB to seek to agree an approach leading to a common international standard on financial instruments. While it may have been preferable to have had common timelines with the FASB on financial instruments, the IASB believed that the commitment made to this Council and the conclusion of the G20 overrode this timing consideration.

I want to emphasise that the alternative of adopting a portion of the FASB approach to impairment, promulgated in April, would not bring about a level playing field. Furthermore, on many issues, EU financial institutions would not want us to adopt the US approach on impairment. As I said in June, given the urgency of the fundamental issues surrounding IAS 39, none of us can afford the potential protracted back-and-forth resulting from piecemeal changes in international and US standards that would undermine the comprehensive and desperately needed reform that is under way.

In our discussions with the FASB aiming to reach a common global approach, we will emphasise our position in favour of a mixed measurement model over one that requires full fair value measurement on the balance sheet. We will seek to reach common agreement on a forward-looking model for loan-loss provisioning and a simplified hedging methodology. I remain optimistic that we can overcome our current differences. I know that my counterpart at the FASB, Bob Herz, is equally committed to reconciling any differences. To this end, we have enhanced our co operation over recent months and have stepped up the joint meetings of our boards and staff.

We at the IASB recognise the importance of our work on financial instruments, not only in Europe, but globally. The financial crisis has highlighted the critical nature of financial reporting to the functioning of markets and the importance of achieving a single set of high-quality accounting standards. I am pleased today to report that by taking urgent action, and by listening to stakeholders in Europe and elsewhere, the IASB will deliver a significantly improved financial instruments standard dealing with the classification and measurement of financial assets in November.