The International Financial Reporting Standards (IFRS) are a set of accounting principles for listed European companies. In 2018 the introduction of IFRS 9, the accounting principles for financial instruments, had a profound impact. Shares in open-end investment funds were then typically reclassified to fair value through profit and loss (P&L), regardless of the type of investments within these funds. This can create substantial P&L volatility, especially when related liabilities on the balance sheet are still reported on book value. In this article, we explain how a special purpose vehicle enables a more flexible accounting treatment under IFRS 9, providing an alternative to an open-end investment fund.
We will focus on the following IFRS standards:
- IFRS 4: Insurance Contracts, will be superseded by IFRS 17 on January 1, 2022
- IFRS 9: Financial Instruments, in force since January 1, 2018 (for insurance companies as of January 1, 2022)
- IFRS 10: Consolidated Financial Statements, in force since January 1, 2013
- IFRS 17: Insurance Contracts, will replace IFRS 4 on January 1, 2022
Classifications under IFRS 9
IFRS 9 contains the accounting principles for financial instruments. Under IFRS 9, all financial instruments should be classified according to the following scheme:
Figure 1: Classification scheme for financial assets under IFRS 9. Source: PWC.
Four different classifications are possible:
- Amortized cost. In this case the initial (cost) value of the instrument increases or decreases to the nominal value at the maturity date. This can be applied for 'plain vanilla' fixed income instruments - solely payments of principal and interest (SPPI) - where the objective is to collect the cash flows of the instrument over time.
- Fair value other comprehensive income (FVOCI), with recycling. The valuation is based on fair (market) value, but fluctuations of the fair value do not have an immediate impact on the profit and loss statement (P&L). Realizations go through the P&L account, however. This classification can be used for fixed income portfolios which are possibly traded over time.
- Fair value through profit and loss (FVTPL). In this case fluctuations of the fair value directly affect the P&L account. This classification is mandatory for derivatives and stock portfolios which are held for trading.
- Fair value other comprehensive income (FVOCI), no recycling. The valuation is based on fair value but fluctuations of the fair value do not affect the P&L account. The term 'no recycling' means that realized gains or losses are not visible in the P&L account either. This classification is appropriate for passively-managed stock portfolios.
The impairment model for debt instruments (i.e., classification 1 or 2 above) has also changed under IFRS 9. The new impairment model is based on forward-looking expected losses instead of realized losses in the past.
For listed insurance companies, IFRS 9 will come into force later (1 January 2022). The main reason for this delay is planned changes to IFRS 4, the accounting rules for insurance contracts. IFRS 4 is currently in effect and gives insurance companies the possibility to value their insurance liabilities at book value. IFRS 4 will be replaced by IFRS 17 as of January 1, 2022. Under IFRS 17 the valuation of the insurance liabilities will be based to a greater extent on fair value.
Treatment of open-end investment funds
What are the implications for institutional investors who participate in an open-end investment fund and have the right to exchange the fund shares for a pro rata share of the net assets?
Such 'puttable' shares in open-end investment funds are typically classified as FVTPL under IFRS 9. This can create substantial P&L volatility, for instance when the liability side of the balance sheet is still on book value. The FVTPL classification will probably become less of an issue for insurance companies once IFRS 17 is been introduced. The valuation of the insurance liabilities will then be based on fair value as well, which matches better with an FVTPL classification on the asset side of the balance sheet.
Segregated mandates or SPVs
In a segregated mandate, a hold-to-collect and plain vanilla fixed income portfolio could be classified as amortized cost because in this case accounting is done on an individual security basis. Such a segregated mandate will thus offer more flexibility under IFRS.
Another approach is to set up an SPV, in which the instruments are collected for a specific investor. According to IFRS 10 an investor in an SPV should consolidate the holdings of the SPV on its (consolidated) balance sheet if the investor has control over the SPV. If the investor can dissolve the contract with the SPV at any time, he would be likely to have power over the SPV and should thus consolidate. The individual holdings can then be classified on a line-by-line basis on the consolidated balance sheet.
If the investor does not consolidate the investments in the SPV, the SPPI test does not always fail (as is the case for an open-end investment fund). The reason is that a SPV is a more closed-end structure, meaning that there is a direct link between the underlying investments and the note issued by the SPV. Depending on the characteristics of the underlying instruments, the investor can thus argue that a FVTPL valuation is not appropriate if the underlying instruments are hold-to-collect and pass the SPPI test. This enables a more flexible accounting treatment under IFRS 9, providing an alternative to an open-end investment fund.
For open-end investment funds, the classification under IFRS 9 is not flexible and is based on fair value, with all fair value fluctuations going through the P&L account. Companies that need more flexibility under IFRS should thus consider a segregated investment mandate or an SPV structure instead of an investment fund. A consequence of IFRS 9 could thus well be that more investors will structure their investments as SPVs in the coming years.