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Value appreciation is probably the most important goal of any long-term investor. For example, consider a share that an investor purchases for CU and sells 20 years later for CU That value appreciation took place over an investment period of 20 years.
Because such circumstances exist, IFRS 9 allows companies to choose to recognise changes in the value of equity investments in OCI as long as the investment is not held for trading purposes. While it is not further limited in scope, the Board consciously designed this election for a narrow population of equity investments that are held for such strategic reasons or benefits.
During the development of this election, the Board discussed circumstances such as cross-shareholding in Japan where companies invest in each other in order to strengthen and solidify their long-term business relationships. This election in IFRS 9 was not designed for financial investments that are held for value appreciation or dividend payments.
Consistent with this view, the OCI election for equities does not include recycling. We consulted extensively when we developed IFRS 9. There was broad support for having an OCI election for such strategic equity investments. Users of financial statements said that they distinguish between fair value changes arising from equity investments held for such strategic purposes and fair value changes arising from investments held for investment returns.
We note that such earnings management, particularly deciding to sell profit-making investments in order to avoid or reduce negative earnings, is possible even if equity investments are subject to impairment requirements, which is discussed later in this paper.
Identifying an impairment model for equity investments that is capable of broad acceptance and that results in timely recognition of impairment is fraught with difficulty and prone to complexity. Indeed, academic research has shown that there is robust and significant evidence that companies use the discretion that is provided to them by accounting standards to selectively recycle gains and losses on available for sale AFS investments in order to manage earnings. In that case, both impairment accounting and recycling applies.
Some stakeholders may wonder how we reconcile these accounting requirements for debt investments with the accounting for the OCI election for equity investments. The Board believes that amortised cost accounting provides the most relevant information about some debt investments in some circumstances because, for those assets, it provides information about the amount, timing and uncertainty of future cash flows.
Accordingly, IFRS 9 requires a company to measure simple debt investments at amortised cost when it holds those investments in order to collect their contractual cash flows. The Board believes these measurement outcomes provide the most relevant information about future cash flows. If a company has a business model that combines both holding simple debt investments to collect their contractual cash flows and holding simple debt investments for sale, then both fair value and amortised cost information is relevant.
Introducing recycling to IFRS 9 for equity investments would make it necessary to add an impairment test. This would require introducing a new impairment test because the current impairment test in IFRS 9 applies to the collectability of contractual payments so is relevant for debt investments. This would make the requirements more complex. FCAG identified that matter as one of the primary weaknesses in accounting standards and their application that the Board needed to consider.
Deciding when equity investments are impaired is highly subjective and that determination is made inconsistently in practice. It is easy to see why, in practice, losses were often recognised too late. While the second model is more mechanistic than the impairment model for equity investments in IAS 39, we think complexity will continue to be a challenge for any model that uses these IAS 39 requirements as a starting point.
We think that there are likely to be significant issues with acceptability of impairment models driven by market prices. As previously discussed, history shows that companies can be very reluctant to identify impairment losses by reference to the market. In fact, the Final Report by the EU High-Level Expert Group on Sustainable Finance Financing a Sustainable European Economy published in January discusses some concerns related to the requirements to measure equity investments at fair value and to consider equity investments to be impaired when there is a large downward market movement.
Against that background, the report recommends that other measurement approaches, ie instead of using market prices, are investigated for long-term equity investments. We believe that moving away from fair value measurement for equity investments would be highly problematic. Investors would likely find alternatives from market pricing unacceptable especially when equities are quoted on active markets. Our analysis of a sample of European companies shows us that significant holdings of equity investments classified as AFS applying IAS 39 are limited to a relatively small group of companies, primarily in the insurance and utilities industry.
In other industry sectors, on the basis of a sample of the 10 largest European companies by market capitalisation in each sector, equity investments classified as AFS are an insignificant proportion of total assets.
In its summary of key messages from evidence collected, EFRAG observes that the aggregate value of equity investments classified as AFS applying IAS 39 by entities that consider themselves to be long-term investors is substantial. However, EFRAG goes on to say that its findings indicate that holdings of such equity investments are concentrated in a relatively small number of entities. Generally speaking, we would expect a company to be more likely to respond to such a consultation if it is concerned about, or objects to, the requirements in IFRS 9 for equity investments.
Consequently, a possible risk of such a self-selected sample is that it could exaggerate the extent, or scale, of a problem. But actually there was a relatively modest response to the public consultation—26 respondents—and, as previously explained, not all of those respondents reported a high proportion of equity investments classified as AFS applying IAS The findings show that the incidence of recognising value changes on equity investments in OCI and related concerns are not widespread.
Moreover, the evidence indicates that concerns are concentrated in the insurance industry and related to the ability to properly reflect performance. In this paper I have sought to provide a brief recap on the requirements in IFRS 9 for equity investments and how we considered the concerns of some stakeholders about the effect of those requirements on long-term investment.
In our view, the concerns expressed about the requirements for equity investments are not widespread and therefore there is not a compelling reason for the Board to reconsider those requirements at this point in time. In addition, while accounting is a consideration in making investment decisions, companies make those decisions on the basis of a variety of economic or other business considerations.
Indeed, the Board is responsible for developing accounting requirements that provide relevant information to users of financial statements. In particular, under the new category, on disposal of the investment the cumulative change in fair value must remain in OCI and is not recycled to profit or loss. However, entities have the ability to transfer amounts between reserves within equity ie between the FVOCI reserve and retained earnings. IAS 39 requires investments in equity instruments that do not have a quoted price in an active market and whose fair value cannot be reliably measured, to be measured at cost.
This requirement for unquoted equity investments is not replicated in IFRS 9. Instead, all equity investments quoted or unquoted must be measured at fair value using the framework within IFRS 13 Fair Value Measurement. Business Edge Index. In practice, the most common types of equity instruments that are classified AFS financial asset are: Direct equity investments that do not meet the criteria to be accounted for as an subsidiary, joint arrangement or associate, and Investments in unit trusts or money market funds that themselves invest in a pool of debt and equity instruments.
How will this change on adoption of IFRS 9? Will measurement change?
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