A European example of how disagreements might arise in classifying financial instruments

As part of its activities, the European Securities and Markets Authority (ESMA) organizes a forum of enforcers from 30 different European jurisdictions, all of whom carry out monitoring and review programs similar to those carried out here by the Canadian Securities Administrators. ESMA recently published some extracts from its confidential database of enforcement decisions on financial statements, covering twelve cases arising in the period from July 2012 to March 2013, “with the aim of providing issuers and users of financial statements with relevant information on the appropriate application of IFRS.” There’s no way of knowing whether these are purely one-off issues or more widespread, but some of them certainly have some relevance to matters discussed within Canadian entities once in a while. Here’s one:

• “The issuer issued bonds to third party investors and invested the proceeds in its parent company through a ‘silent contribution’ arrangement. The terms and conditions of the silent contribution were as follows:
• The silent contribution has a right to profit participation on the nominal contribution amount at a rate of 7.25%.
• Profit participation does not accrue if the parent company has or will have an annual loss.
• The silent contribution will share in a loss in the parent company that shall be subsequently replenished if it does not cause or increase a loss of the parent company.
• The silent contribution may only be terminated by the parent company with a two year’s notice period and only if the book value of the silent contribution at the time of the notification is equal to the nominal contribution amount and the parent company’s solvency ratio exceeds 9%. Profit or loss participation continues during those two years.
• The issuer classified the silent contribution within ‘loans and receivables’ using the criteria of paragraph 9 of IAS 39. Condition (c) of this paragraph prohibits an entity from classifying a financial instrument as a loan or receivable if the holder may not recover substantially all of its investment, other than because of credit deterioration. If that is the case, the financial instrument shall be classified as ‘available for sale’.
• The issuer argued that the term ‘credit deterioration’ in paragraph 9 of IAS 39 should not be linked to the definition of ‘credit risk’ described in Appendix A of IFRS 7 as the risk that one party to a financial instrument causes a financial loss for the other party by failing to discharge an obligation. According to the issuer, ‘credit risk’ is related to a certain point in time whereas ‘credit deterioration’ occurs over time.
• The issuer noted that a company that suffers a loss is likely to see a reduction in its creditworthiness. According to the issuer, a loss in the parent that causes loss participation by the subsidiary and ‘credit deterioration’ are inseparable aspects of one scenario.”

Credit deterioration versus participating in a loss

The enforcer (as ESMA likes to term it, as if relishing the Eastwoodian connotations) disagreed with classifying the silent contribution within loans and receivables, concluding it should have been classified as ‘available for sale’. As the above summary of terms indicates, the agreement contained defined situations where the entire amount might not be contractually recoverable as a matter of applying a formula driven by the parent’s losses. However, a loan or receivable, as IFRS conceives it, doesn’t as a contractual matter suffer a reduction in its face amount when the borrower incurs a loss. As the decision puts it: “Credit deterioration and participation in a loss are two different matters, even if there may be a certain level of interaction between them. In fact, a company may suffer a loss not resulting in credit deterioration.”

I assume I’m not the only Canadian reader of this summary who wasn’t initially familiar with the term “silent contribution.” The underlying principles are certainly applicable to situations that might arise here though. In broad terms, cases might exist where one entity lends money to another, but where the repayment of that “loan” (as to the amount or the timing of the repayments or both) depends on the borrower’s cash flow or on other factors, to the extent that makes those repayments neither fixed nor determinable. Even so, it might not seem intuitively necessary to preparers to measure the assets at available for sale or at fair value through profit or loss, because those categories generally seem more associated with “investments” of inherently greater volatility. On close examination though, this may be a matter of form rather than substance.

Defining loans and receivables

The basis for conclusions to IAS 39 indicates some debate in the past about the best way to define the “loans and receivables” category, indicating specific concern that a debt instrument “in which the purchaser may not recover its investment” shouldn’t be measured at amortized cost. As an example of this it cites “a fixed rate interest-only strip created in a securitization and subject to prepayment risk.” Because that example clearly arises from financial engineering to create structured products, it may not strike all practitioners – as ESMA’s example demonstrates – that the same concern might apply in less esoteric situations. But just as a matter of day to day negotiation, a lender might accept terms from a borrower which go far beyond simply earning a return on the amount outstanding, and where the fair value of the arrangement provides the most relevant information about what it represents.

Of course, this is just one of the many definitional difficulties that one can expect from operating a mixed measurement model, and while the implementation of IFRS 9 (whenever that may be) might remove some of these, it will also introduce new ones. In other words, we’ll be dealing with this general kind of issue for a long time to come.

The opinions expressed are solely those of the author.