IFRS 9. Institutional investors perspective

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Hollie Lester
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20th November 2015 IFRS 9 Institutional investors perspective In July 2014, the IASB launched a new version of the IFRS 9 standard related to the accounting of financial instruments, specifically

Since then, this new standard has continued to be a talking point among financial managers, whether working with banks or concerning all companies investing in assets and subjects to IFRS standards.

asset management industry and for the safety of financial markets.

1 20th November 2015 IFRS 9 Institutional investors perspective In July 2014, the IASB launched a new version of the IFRS 9 standard related to the accounting of financial instruments, specifically including a new classification of instruments. Since then, this new standard has continued to be a talking point among financial managers, whether working with banks or concerning all companies investing in assets and subjects to IFRS standards. This is a strategic issue, not only for public or private entities that are structurally involved in substantial asset management activities, aiming to make long-term investments, but also for the asset management industry and for the safety of financial markets. IFRS 9 covers the lion s share of financial instruments as it seeks to categorise all of them according to one or more economic models. The aim of this document is not to discuss the standard itself in depth. Rather it intends to focus on how the new classification can and will significantly change the reasoning of those entities subject to IFRS and lead most of them to drastically revise their investment policies. It ends with a proposed adjustment to the standard. Before / After Af2i 36, rue de l Arcade F Paris Tel.: +33 (0) Fax: +33(0) af2i@af2i.org French Association of Institutional Investors (Association Française des Investisseurs Institutionnels) - Association under the Law of 1 July Approval No issued 26 July 2002 in Paris - Siret:

2 A standard that is deliberately more simple but simplistic... The people behind the standard sought to reduce the complexities of IAS 39 and remove some of its pitfalls. The approach is laudable and investors approve it. In accordance with the economic model of the category, debt instruments will fall under the "fair value through profit or loss", fair value through OCI categories or may be recognised under amortised cost, if the aim is to hold these securities until maturity. IFRS9 will more easily allow the de-recognition of debt securities categorised under amortised cost, specifically in the event of a deterioration in their credit quality, without affecting the recognition of all instruments in this category, as was required until now under IAS 39 (tainting rules). But IFRS 9 also introduces a complex ex-ante provisioning mechanism for credit risk (expected credit loss model) that has been much discussed and faces a strong opposition by institutional investors, who focus their assets on "investment grade" papers, whose defaults are very rare. Even if it is implemented with intelligence and a comprehensive global approach by portfolios and sub-portfolios and if there is a gradual and adjustable-provisioning in the long term, it is not satisfactory for operators, as it goes even against the efforts of investors to increase research and internal credit analysis. It will lead to increase the volatility of earnings and reduce potentially distributable returns because of non sounded provisions. Regarding equity instruments, IFRS 9 classifies variable-income and similar stocks, units and shares as "equities" within the meaning of IAS 32. IFRS 9 distinguishes three possible ways of classification: If such securities are acquired for trading purposes, they must be recognised under "fair value through profit or loss". Any change in the value, whether realised or unrealised, thus affects the current profit and loss statement. For the others, the company can choose to classify each instrument: either in a portfolio valued at "fair value through profit or loss" whereby changes in value and dividends are recognised in income; or in a portfolio valued at fair value through OCI. In this case, any changes in value are recognised under an Reserves for OCI (Other Comprehensive Income) entry. Realised capital gains or losses are then not recognised in the profit and loss account. They will thus be considered as "non-recyclable in technical accounting terms. Dividends received will nonetheless be recognised as income. This choice must be made per instrument upon initial recognition and cannot subsequently be changed. For securities recognised as "fair value through OCI", no depreciation mechanism is scheduled and the famous impairment tests will disappear. This really does make things simpler. IFRS 9 considers the fair value through profit or loss category as the default category. However, IASB acknowledged that the change in fair value of certain investments does not always reflect the profitability of the investor. For this reason, the standard in theory allows a choice to be made to recognise changes in fair value either through profit or loss or through OCI, on an instrument-byinstrument basis, except in the event of trading of securities from entities to be consolidated. Some entities do not intent to distribute any income, such as private equity funds....and which does not take into account the varied economic models of institutional investors. Institutional investors First, it is worth remembering that institutional investors are public or private entities whose liabilities and/or assets are regulated by law, regulation, or a central body with one fundamental mission: to hedge their liabilities by way of congruent, secured and diversified assets which they manage and make prosper in order to deliver a pension or a capital for the exclusive benefit of their beneficiaries. 2

3 Each institutional family - of which there are around twenty in France - has its own economic and development model. A paid-leave fund for the building industry and a nuclear operator have little in common. The model for non-life insurers is very different from that of life insurers and pension funds. Of course not all institutional families are subject to IFRS and several institutional investors are listed on the stock market. From a very schematic standpoint, institutional portfolios may have common or distinct goals: to cover an identifiable liability, to build up financial reserves to balance the profit and loss account over years, to ensure a regular income so as to cover operating costs and top up any management charges, to fund investments and projects of all kinds or the various activities provided by status. To achieve this, they use portfolios composed with diversified assets and financial instruments, taken from distinct asset classes, for the most part bonds, directly managed or via collective schemes 1. In this context, capital gains and income are used alternatively or jointly to achieve their goals and missions, facing short, medium or long term horizons. As such, the fact that only dividends received could be included in the profit and loss account is not realistic or acceptable. Admittedly, dividends represent a rather substantial portion of share performance quoted over a long period. However, the companies with the most sustainable growth deemed satisfactory by long-term investors are those whose distribution rates are moderate, growing slowly but surely, and above all are compatible with intensive self-financing. As such, though the dividend does represent a significant portion of stock market performance (30-50 %), the capital gain expressed in the long term is the main result of an investment. All things being equal, investors may thus wish to prioritise high-yield stocks at the expense of companies with more sustained growth and a lower distribution level. To give another example, Af2i members are private equity investors. However, this asset class generates mainly capital gain and rarely dividends. The classification of private equity assets under the "fair value through OCI" option would lead to never recognise the fruits of these assets in the profit and loss account, and this would dissuade institutional investors, whereas French and European authorities are very keen on encouraging capital investment in SMEs. Companies must be able to cover their costs and balance their profit and loss account... Investors recognise structural or management costs that affect their results each year: standard operating expenses (staff, offices and equipment, IT, data costs, depreciation, etc.), valuation and custody of assets, financial research, hedging strategies, as well as potential financial expenses related to the discounts accretion, unwinding of their liabilities or to finance their investments. In that perspective, a company cannot rely on portfolio income to offset such costs. With the fall in bond and monetary yields, bond revenues have undergone a downturn in all portfolios. This situation is set to continue and will most likely lead to a revaluation of shares and a downward adjustment of interest rates and dividend yields. The balance of the current profit and loss account is thus at stake, and whatever happens, we must provide all possible helps to institutions. 1 Each year, in its survey Af2i has noted ever rising use of collective management. 3

4 The graph below shows that equities yields being higher than bonds yields is not constant in the long term. As such, we can expect the average yield of equities to decrease gradually, more by an expansion of multiples than by growth in corporate profits.... without facing or creating abnormal volatility If all changes in the value of long-term investments and assets are only recognised at fair value through profit and loss, this will be reflected in the volatility of corporate results for the companies in question, unrelated to the actual long-term performance of these companies and their portfolios. According to estimates from the relevant Af2i members, the potential impact is between % of annual variation in their current result. In other words, a business with a current result of around 100 could see, all things being equal, its current result fluctuate between depending on the year, simply because of the impact of unrealised value changes in its portfolio. For listed companies, this volatility would be unsustainable and would result in: an instant drop in their share price as soon as the market becomes difficult, representing an additional pro-cyclical factor; and ongoing undervaluation, due to the increasing difficulty for the financial community to forecast results on an biannual or annual basis. It is worth remembering that industrial companies subject to IFRS have always said that their industrial and business results should not be depending on, or polluted by, external entities managing their listed assets. They have always wanted to maintain some control over their results, their industrial profiles and 4

5 their expectations, and to make adjustments to their profit and loss accounts through the disposal of assets. The possibility for an institutional investor to present the results of transactions with some degree of stability is thus not a matter of cheating or comfort, but rather part of the proper performance of its fiduciary mission to avoid causing fluctuations in results that can be damaging for policyholders and savers due to their varying levels of information and understanding. Net income is and will long remain a central factor in financial communication the main concern of financial analysts 2. It is unlikely that OCI reserves, composed of unrealised gains and losses arising from changes in share prices, which are at times fleeting, will be appreciated in the near future. Corporate performance will continue to be analysed chiefly from net income, as evidenced by such indicators as ROE (Return On Equity), and the PER (Price Earnings Ratio). For this reason, despite some complexity of its impairment tests, IAS39 offered a better solution in particular for equity investments and collective schemes than IFRS 9, and enabled the company to focus not on the instant consequences of market volatility, but on the pace of performance of its assets in the medium term. The problem with Collective investment schemes Up to now, Bond or equity schemes (UCITS and AIFs) and other AIFs (real estate investment schemes or OPCI, venture capital funds, etc.) could be classified, in the same way as securities, via the trading account, as AFS through profit and loss or as AFS securities through equity. This allowed the proceeds of these placements or investments to be allocated to the correct area, depending on the objective assigned to these assets. Only impairment tests or the decision to consolidate 3 were matters for concern. The future IFRS 9 will no longer allow collective schemes to be allocated via fair value through equity All income from capital gains or losses, whether realised or unrealised, will thus be allocated to income ( fair value through profit and loss ). This provision will create high volatility in terms of results, similar to that created by equity instruments classified in the same category. How will investors subject to IFRS react? A first solution to the problem would be to seek to create only dedicated schemes designed to be consolidated from an accounting perspective 4 so they can fall into the "fair value through OCI" category, but the recycling of previous results will not be allowed. This would serve no purpose for private equity funds for instance, since their performance is only reflected in capital gains or losses. These funds do not pay dividends or very small ones. As a result, under the IFRS 9 system, consolidation is only of interest to bond funds whose securities could thus be valued at amortised cost. However, in such a scenario, we see no reason for creating a collective scheme envelope. 2 IMA France conference on 29 September 2015 between Jacques de Greling and Bertrand Allard, joint chairmen of the SFAF Accounting Commission: "Financial analysts are obsessed with the profit and loss account." 3 See CNC Progress Report by the Working Group on UCITS Consolidation on the recognition of UCITS in investors individual and consolidated accounts August For each fund, this implies significant variable amounts, depending on the manager, going from several million to several hundred million euros. 5

6 If CIS are classified as "fair value through profit or loss", with all what that implies in terms of volatility, then investors will have to choose between: sell their share-based UCITS and FIAs and convert them into management mandates in order to potentially allocate the new securities at "fair value through OCI" though they will thus be unable to incorporate any capital gains realised in the P&L account; reduce investments in the most risky UCITS or FIAs and look for less risky investments, what would imply a drastic change in their investment policy, with possible impacts for their profitability and a strong effect on financial markets if this choice is operated by many investors; opt for accumulation shares or distribution shares, with the former used to improve their ability to express an unrealised gain in the long term thanks to the systematic reinvestment of income. However, this choice will lead to a significant increase in the volatility of the profit and loss account or to widespread disinvestment. In addition, due to the increased volatility of their profit and loss account, the concerned investors would have to review all the references indexed on P&L, or certain contractual clauses, which would then be hazardous corporate mechanisms due to this variability as it becomes unpredictable (profit sharing, bonus, etc.). Ultimately, regardless the scenario, we can see that this new mechanism under IFRS 9 intending to simplify does not present any truly viable, easy solution for investors. This standard does not, in any way, solve the difficulties of the economic model for long-term investments based on a proper balance over a long period between income and capital gains, net of expenses. Several other solutions have been put forward 5 to comply with their business model: either recognition through historical cost with an impairment calculated based on a value in use via a multi-criteria basis, an approach inspired by French accounting standards; However, this proposal was rejected, only vanilla debt instruments managed to collect cash flows of interest and principal, allowed classification in this category; or maintaining the current AFS portfolio rules, but introducing the option of processing impairments through profit or loss in the event of an improvement in the stock price. This proposal was also rejected because of the apparent complexity of the impairment model to determine and implement. What are the other consequences? As part of their dialogue with the listed companies 6 in which they are shareholders, some investors may seek to maximise dividend policies at the expense of self-financing, for instance by encouraging companies to create preference shares. It may also be the case that some instruments such as convertible bonds could be left by the wayside due to their treatment under IFRS 9, and as a result by issuers whereas they respond to specific issues. Conclusions It appears from discussions with our members that the new classification of financial instruments under IFRS 9 will have direct and substantial impacts, if nothing is done to mitigate them: causing permanently high volatility in the current results of the concerned companies (within a range of % of their results) if they choose to classify equities and Collective investment schemes assets, excluding fixed income instruments, according to the standard default option (fair value through profit and loss); 5 Dominique Crost Treatment of equity instruments under IFRS 9 Bank Review May Engagement policy which the European authorities seek to encourage. 6

7 in the perspective to reduce this volatility, forcing them to make in depth asset reallocations adverse to their economic interests, which is not the direct or indirect role of an accounting standard; leading to the long-term disruption of the legibility of the financial statements of these companies for both analysts and investors; producing an unnecessarily complex image of business, whilee supervision usually falls within the scope of prudential framework; increasing the divergence in legibility between company accounts and consolidated financial statements; in addition, and in particular for insurance activities such as casualty and life insurance, there could be a change of investment strategies and even an amendment of liability commitments; leading to require the substantial use of Non-GAAP Indicators, which would contradict the goal sought. The European accounting standards issued by IASB are adopted by the European Commission if they: give a true and fair view of the entity s position; are consistent with European public interest; enable intelligible, relevant reliable and comparable financial information. Today, there is still a lack of real consideration for long-term investment, through equity instruments or collective schemes, whether in France in terms of taxation or in Europe in terms of prudential or accounting standards, though the subject of many speeches made by the French and European authorities. The Af2i regrets that the IASB did not explain its intentions in dealing in real terms with the various stakeholders (investors, banks, industrial partners) and the various asset classes, and that no response has been given to the many voices of criticism raised by professionals. Relatively simple solutions do exist that embody the spirit of the new standard, whose great merits we acknowledge regarding its quest for simplicity, and the changes made to correct defects identified by institutional investors. In particular, the recycling of realised capital gains in the event of asset allocation in the "fair value through OCI" category should be recognised in principle, even if this means reintroducing provisioning principles which are consistent with the methods used to manage these assets. Furthermore, regarding the insurance activities, account for investments under IFRS 9 in 2018 as the future standard for their liabilities (IFRS 4 Phase 2) would apply in 2021 would create inappropriate volatility in earnings during this interim period while forcing to revisit the classification of assets in the application of IFRS 4 Phase 2 and would result in difficulties in understanding of insurers' accounts by the financial community. EFRAG has taken stock of this situation and believes that IFRS 9 may be adopted for these activities until the IASB has finalized its proposals on the subject which at this stage are still far from satisfactory. We consider that It is not too late to examine, in a responsible way, how to quickly correct some points that were unsatisfactory covered by IFRS 9, which may well destabilise both the financial management of the companies concerned, the asset management industry, in particular in France and consequently, the financial markets. As we have demonstrated, many arguments also exist to encourage the European Commission to postpone the adoption of IFRS 9 until a recognition method is drafted that is tailored to the needs of long-term and institutional investors. Jean EYRAUD Chairman of Af2i +33 (0) Jean.eyraud@af2i.org 7

8 About Af2i AF2i Association française des investisseurs institutionnels Af2i is the French association of institutional investors, created in 2002 to gather and represent the different families of Institutional Investors (insurance companies (Axa, Allianz, Aviva, BNP Paribas Cardif, Credit Agricole Assurances ), pension institutions and funds, foundations, corporate with special status (EDF, etc.), special and public institutions (Caisse des Dépôts, FRR, etc.), to promote institutional asset management techniques, to organize training and transmission of best practices. Af2i wishes also to defend interests of its members in France and in Europe. Af2i gathers 75 major institutional investors as members representing more than 2 trillion of assets under management and 66 asset management companies, asset servicers or providers as associate members. Each year, Af2i publishes a global survey on investments and assets. Af2i 36, rue de l Arcade F Paris Tél : 33(0) Fax : 33(0) af2i@af2i.org Association Française des Investisseurs Institutionnels - Association régie par la loi du 1er juillet Agrément n délivré le 26 juillet 2002, à Paris - Siret :

The LIAJ s Comments on the ED. Classification and Measurement: Limited Amendments to IFRS 9

The LIAJ s Comments on the ED. Classification and Measurement: Limited Amendments to IFRS 9 The LIAJ s Comments on the ED Classification and Measurement: Limited Amendments to IFRS 9 Proposed amendments to IFRS 9 (2010) 28 March 2013 The Life Insurance Association of Japan (LIAJ) The Life Insurance