07 December 2004
Key Points:
APRA will align its prudential and reporting standards with Australian accounting standards and principles to the greatest extent possible, but in some cases its prudential framework will depart from accounting standards.
On 3 November 2004 the Australian Prudential Regulation Authority (APRA) released an overview paper,"Adoption of International Financial Reporting Standards: Prudential Implications".
In this, APRA outlines its approach, from a prudential and regulatory perspective, regarding the effect of the introduction of International Financial Reporting Standards (IFRS) on the entities it supervises, particularly authorised deposit taking institutions (ADIs), general insurers, life companies and friendly societies.
The introduction of IFRS in Australia
Commencing from 1 January 2005, Australian reporting entities must adopt the Australian equivalents of IFRS. This will alter the existing accounting standards, particularly in relation to the recognition and measurement of assets, liabilities, equity, revenue and expenses.
Consultation on impact of IFRS
APRA plans to consult extensively with its regulated institutions for it to better understand the quantitative impact of IFRS. As part of this process, a comprehensive assessment of specific accounting changes and their prudential implications will be the subject of a series of discussion papers to be released by APRA in the coming months.
Interim prudential and statistical reporting arrangements
APRA has advised that it will not be making any IFRS-related changes to the prudential and reporting standards until 1 July 2005 at the earliest. In the meantime, regulated institutions should continue to report in terms of current requirements. APRA has advised that it will make determinations preserving the use of existing Australian accounting standards as at 31 December 2004 until any changes to the prudential and reporting standards are finalised.
APRA's approach to IFRS adoption
APRA's objective in its approach to IFRS will be to align its prudential and reporting standards with Australian accounting standards and principles to the greatest extent possible, as APRA believes that the latter provides a widely accepted basis for the recognition and measurement of assets, liabilities and capital.
In some circumstances, however, APRA indicates that its prudential framework will depart from accounting standards. One reason for this is that APRA's prudential framework and supervisory functions are prospective and risk-based, whereas accounting standards primarily focus on verification and reporting on past transactions.
In addition, APRA's prudential requirements are aimed at protecting the interests of beneficiaries (eg. deposit holders), while general financial reporting focuses on the interests of the economic owners of an institution on a going concern basis. For example, identifiable intangible assets are recognised as assets under accounting principles, but for the determination of regulatory capital under prudential standards.
In developing its response to IFRS adoption, APRA intends to consider the position of other prudential regulators and concurrent regulatory developments such as the introduction of the Basel II Framework and general insurance reform.
Key issues arising from IFRS
Classification of equity instruments: IFRS will introduce a stricter definition of equity that could result in certain preference shares and hybrid instruments currently classified as equity being reclassified as liabilities. As a consequence, the adoption of IFRS may restrict the range of instruments that qualify as Tier 1 capital for ADIs and general insurers. Until further notice, however, APRA will preserve Australian accounting standards in place as at 31 December 2004 in considering Tier 1 instruments.
Derecognition of financial assets and consolidation of SPVs: IFRS will introduce more stringent requirements on the removal from the balance sheet of financial assets sold to securitisation Special Purpose Vehicles (SPVs). Existing securitisation structures will, therefore, be at risk of failing the clean sale and separation requirements of Prudential Standard APS 120 which are linked to the derecognition and consolidation tests in the accounting standards. As a result, ADIs may not be entitled to capital relief on their securitised loans after 1 January 2004 (being the date the transitional arrangements for derecognition under IFRS expired). In response to this issue, APRA has announced that ADIs should continue to apply Australian accounting standards in place as at 31 December 2004. The result will be that the introduction of IFRS will not result in such assets being included on the balance sheet of ADIs for prudential purposes.
Derivative instruments and hedge accounting: With the introduction of IFRS, all derivative instruments, including loan portfolios will be measured at fair value and be recognised on-balance sheet instead of off-balance sheet. IFRS will also introduce more demanding requirements for derivatives used to hedge risk exposures to qualify for hedge accounting. Hedges that qualify for hedge accounting are likely to be accounted for as either fair value hedges or cash flow hedges. The accounting treatment for hedges under IFRS is a significant departure from current accounting practice. APRA has advised that it will evaluate the implications of the new hedge accounting treatment for ADIs and the recording of unrealised fair value gains and losses directly in equity. In the interim, APRA will maintain the status quo and remove the gains and losses from cash flow hedges from equity and regulatory capital.
Measurement of financial assets and financial liabilities: The introduction of IFRS will provide scope for institutions to select specific classifications, with different accounting rules, for financial assets and financial liabilities. General insurers, life companies and friendly societies, however, will only be able to select a classification basis for financial assets that are not backing insurance liabilities. Financial assets that are backing insurance liabilities are required to be measured at net realisable market value in most cases. APRA advises that the implications for prudential and reporting standards of the new classification system are not expected to be significant for APRA-regulated institutions. Until the new reporting requirements are finalised, however, maintenance of the status quo may entail a degree of dual reporting. APRA is currently evaluating the prudential implications of including unrealised fair value gains and losses on financial assets and liabilities in equity.
Capitalisation of acquisition costs: IFRS will limit the costs associated with the acquisition of financial assets, financial liabilities and investment contracts that can be capitalised. Although amended capitalisation rules may have financial implications for general insurers and ADIs, they are not expected to have a prudential impact. APRA has advised that it will liaise with the Life Insurance Actuarial Standards Board in considering the implications of IFRS for actuarial standards under the Life Insurance Act 1995 and for Prudential Rule 35.
Excess of market value over net assets: At present, AASB 1038 requires any excess of the market value of a life company's investment in a life company subsidiary over the identifiable net assets of that subsidiary to be recognised as a separate asset and profit and loss item in the consolidated financial statements of the parent life company, as well as in the consolidated accounts of any ultimate parent company. This is generally termed EMVONA. With the introduction of IFRS the recognition of EMVONA will be prohibited. IFRS will require consolidated groups that have recognised EMVONA to write it off against retained earnings to the extent that it represents internally generated intangible assets. Some EMVONA may be reclassified as an intangible asset, which must be tested for impairment annually.
APRA has advised that it does not expect these changes to be material for capital and solvency requirements for life companies. However, this accounting change may create material prudential capital adjustments for ADIs which own life companies and have recognised EMVONA in their consolidated accounts and prudential reports.
General provisions: IFRS will require provisions for impairment to be recognised on an incurred and incurred-but-not-reported basis. This means that provisions for impairment must be based on loss experience and only recognised after an event on which the loss experience is based has occurred.
The adoption of IFRS also contrasts APRA's general provisioning model. The adoption of IFRS may require ADIs to write back general provisions and some prescribed provisions recognised in accordance with APS 220 in their financial statements.
APRA proposes to consult on methods to reconcile the prudential and accounting objectives associated with general provisions. Such provisions have been an important element in the prudential capital regime and the concept of expected loss will remain important in the Basel II Framework. There may also be some provisions held by general insurers with respect to premium receivables and reinsurance recoverables that may require review as a result of IFRS changes.
Treatment of defined benefit fund surpluses and deficits by employer sponsor: AASB 119, which will apply for reporting periods beginning on or after 1 January 2006, will require all surpluses and deficits of defined benefit funs to be recognised on the balance sheet of the funds' employer sponsors and movements to be recorded in their profit and loss statement. This is a significant departure from current accounting standards which do not have any such requirement. There may also be financial and prudential implications for institutions that are employer sponsors of defined benefit funds which have significant fund deficits.
