As part of its activities, the European Securities and Markets Authority (ESMA) organizes a forum of enforcers from 38 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 December 2020 to January 2023, with the aim of “strengthening supervisory convergence and 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, a bank, disclosed in its interim financial report for the first half of 2022 a change in business model for managing a sub-portfolio of private corporate bonds from “held to collect and sell” to “held to collect”. The bonds, which were measured at fair value through other comprehensive income (FVOCI) up to the end of the first half of 2022, were consequently reclassified into the amortized cost category on the first day of the following interim period (second half of 2022). Hence, the issuer removed material net losses from these bonds accumulated in OCI from equity and adjusted the fair value of the bonds on the reclassification date…
• The issuer gave two main reasons for changing the business model: (i) a change in its business structure and (ii) the need for stability of the available excess of capital. In 2021, the group disposed of a significant interest in a group insurance company, reducing its share in the company’s capital and losing the control over the company. This meant ceasing a relevant group activity with recurring income from insurance policies.
• … According to the issuer, the prudential regulator expressed its concern as to the need to keep the available excess of capital stable over time, especially after the disposal of the insurance business line. The issuer considered that there was a higher structural volatility in its remaining business activities, since it had become less diversified and with lower steady income.
• The issuer explained that these circumstances as well as the legal and economic need to adapt to the new risk and income profile caused the change in the business model for managing a sub-portfolio of private corporate debt with a maturity of more than 3.5 years, held within a business model with the objective of both collecting contractual cash flows and selling financial assets. The decision to keep these instruments on the statement of financial position until their maturity with the aim of collecting the contractual cash flows was approved by the issuer’s Assets and Liabilities Committee, which comprised the chairman and executive members of the Board of Directors and some of the issuer’s senior management members. This was the first time that the issuer changed its business model for managing financial assets since IFRS 9 became effective.

The enforcer (as ESMA likes to term it) disagreed, concluding that the issuer’s changes in the management of financial assets didn’t meet the requirements of IFRS 9 and that the conditions for reclassification weren’t fulfilled. The IASB’s original thinking in its 2009 exposure draft was to prohibit such reclassifications altogether, largely on the basis that reclassifications would increase complexity and wouldn’t make the financial statements easier to understand. It ultimately concluded that reclassification was appropriate when triggered by a change in the business model, but emphasized that this would be “very infrequent,” limited to changes determined by the entity’s senior management as a result of external or internal changes, significant to the entity’s operations and demonstrable to external parties. In the above case though, the change in the management of financial assets didn’t result directly from disposing of the interest in the insurance subsidiary, and the financial assets identified by the issuer as being subject to the change in business model didn’t constitute a clearly distinguishable sub-portfolio affected by the disposal; the issuer lacked the kind of evidence that renders a change in model demonstrable to external parties, such as modifications to its internal evaluation and reporting system or to the managers’ remuneration policy. Overall then, the enforcer took the view that the change in strategy was primarily driven by accounting regulatory capital considerations.

All of that said though, some might still have argued that amortized cost measurement would be appropriate in the issuer’s revised circumstances (if it ever is), and that its situation was sufficiently “infrequent” to be in line with the spirit of the standard, even if not quite conforming to the letter of it. The example illustrates then the extreme interpretative precision required in working through such matters…

The opinions expressed are solely those of the author.