Holdings of Cryptocurrencies – Accounting and financial reporting guidance has tentatively been reached by the IFRS Interpretations Committee

The required accounting for the holdings of cryptocurrencies, such as Bitcoin, Ripple or Litecoin, has recently caused much difficulty and divergence in practice, and with the ever rapidly-growing use of cryptocurrencies around the world, this issue is becoming much more pertinent. This is because, as yet, there are no specific requirements written into IFRS Standards (or UK GAAP or US GAAP).

However, during its March meeting, the IFRS Interpretations Committee (“Committee”) discussed how IFRS Standards should currently be applied to the holdings of cryptocurrencies, and as such the Committee has made some tentative decisions regarding how they should be treated for accounting and financial reporting purposes. The Committee acknowledges that the conclusions reached are so far tentative and hence invites comments to be submitted by 15 May 2019. After this time, the Committee will reconsider the tentative decisions, including the reasons for not adding this matter to a standard-setting agenda.

Summary – Tentative decisions made so far

The tentative conclusions reached by the Committee are:

  • Holdings of cryptocurrencies do not meet the definition of a financial asset, nor cash under IAS 32 Financial Instruments: Presentation;
  • Holdings of cryptocurrencies do meet the definition of inventory and should be accounted for under IAS 2 Inventories when they are held for sale in the ordinary course of business, which includes a broker-trader business; and
  • Holdings of cryptocurrencies do meet the definition of an intangible asset and should be accounted for under IAS 38 Intangible Assets when they do not fall within the scope of IAS 2.

Scope – What are the characteristics of cryptocurrencies?

The Committee considered that cryptocurrencies have the following characteristics:

  1. A cryptocurrency is a digital or virtual currency that is recorded on a distributed ledger and uses cryptography for security.
  2. A cryptocurrency is not issued by a jurisdictional authority or other party.
  3. A holding of a cryptocurrency does not give rise to a contract between the holder and another party.

Where to begin – Cash?

The, seemingly, most obvious IFRS Standard to consider first is IAS 32 Financial Instruments: Presentation (“IAS 32”), which contains the definition of a financial asset. This is because, by the nature of the word, a cryptocurrency may suggest a form of cash. IAS 32.11 defines a financial asset as “any asset that is:

  1. cash;
  2. an equity instrument of another entity;
  3. a contractual right to receive cash or another financial asset from another entity;
  4. a contractual right to exchange financial assets or financial liabilities with another entity under particular conditions; or
  5. a particular contract that will or may be settled in the entity’s own equity instruments.”

And IAS 32.AG3 states that: “currency (cash) is a financial asset because it represents the medium of exchange and is therefore the basis on which all transactions are measured and recognised in financial statements. A deposit of cash with a bank or similar financial institution is a financial asset because it represents the contractual right of the depositor to obtain cash from the institution or to draw a cheque or similar instrument against the balance in favour of a creditor in payment of a financial liability.”

However, when considering a holding of cryptocurrency, the Committee tentative concluded that it does not meet any of the definition’s criteria to be a financial asset, nor does it meet the full definition of cash. Specifically, it does not meet the definition to be cash because, even though some cryptocurrencies can be, and are, used as a medium of exchange (i.e. used in exchange for goods or services), the Committee is not aware of any cryptocurrencies that are used as the monetary unit in pricing goods and services to such an extent that it would be the basis on which all transactions are measured and recognised in financial statements. Accordingly, cryptocurrencies represent some, but not all, of the characteristics of cash.

Where next – What is the nature of cryptocurrencies?

Cryptocurrencies are purely digital in nature and understandably do not have physical substance, therefore an obvious next step is whether they meet the definition of an intangible asset under IAS 38 Intangible Assets (“IAS 38”). IAS 38.8 states an intangible asset is: “an identifiable non-monetary asset without physical substance”, and IAS 38.12 states: “an asset is identifiable if it is separable (i.e. is capable of being separated or divided from the entity and sold, transferred, licensed, rented or exchanged, either individually or together with a related contract, identifiable asset or liability), or arises from contractual or other legal rights.”

The Committee tentatively concluded that, along with the guidance provided in IAS 21 The Effects of Changes in Foreign Exchange Rates (“IAS 21”), the holding of cryptocurrency meets the definition of an intangible asset on the grounds that: (a) it is capable of being separated from the holder and sold or transferred individually; and (b) it does not give the holder a right to receive a fixed or determinable number of units of currency.

However, IAS 38 applies to the accounting for all intangible assets except:

  1. those that are within the scope of another Standard;
  2. financial assets, as defined in IAS 32 Financial Instruments: Presentation;
  3. the recognition and measurement of exploration and evaluation assets; and
  4. expenditure on the development and extraction of minerals, oil, natural gas and similar non-regenerative resources.

The Committee therefore also needed to consider whether there were any other IFRS Standards that cryptocurrencies may fall into the scope of; namely IAS 2 Inventories (“IAS 2”). Given that cryptocurrencies are often purchased with the intention of reselling or are mined, and the fact that IAS 2 does not scope out intangible assets, then consideration under this Standard does seem logical as well.

IAS 2.6 defines inventories as “assets:

  1. held for sale in the ordinary course of business;
  2. in the process of production for such sale; or
  3. in the form of materials or supplies to be consumed in the production process or in the rendering of services.”

The Committee tentatively decided therefore that IAS 2 may be the applicable Standard to account for holdings of cryptocurrencies, depending upon the nature in which they are held, for instance if the cryptocurrencies are held for the purpose of:

  1. selling in the ordinary course of business, then IAS 2 will apply; or
  2. buying or selling in the near future and for generating a profit from fluctuations in price or broker-traders’ margin (i.e. a broker-trader purpose), then the specific requirements in IAS 2.3(b) will apply to account for the inventories at fair value less costs to sell.

 

Conclusions – What are the next steps?

The Committee are inviting comments to their tentative decisions to be submitted by 15 May 2019.

Accordingly, this means that even though the Committee believe that the existing requirements of IFRS Standards are currently adequate in establishing appropriate accounting policies for the holdings of cryptocurrencies, this is subject to discussion. It also means that, whilst the Committee believes that the appropriate accounting policy should depend upon the purpose of the cryptocurrencies being held, and so they may be held at cost or fair value, they should never be accounted for as cash or another financial asset, but do you agree?

 

By Jessica Howard, Financial Reporting Advisory Director

 

Progress on IASB the development of IFRS 17 Insurance Contracts – IASB planning amendments

At the January meeting, the IASB decided to make amendments to IFRS 17 Insurance Contracts, relating to the following topics:

  • reinsurance contracts purchased by a primary insurer (reinsurance contracts held); and
  • amortisation of the contractual service margin (CSM) in profit or loss for contracts that include an investment return service.These changes are intended to address criticisms raised by stakeholders, and therefore to result in financial statements that more faithfully represent the performance of insurance contracts. Each of these three topics is addressed in more detail below:
  • Click here for the official announcement of these decisions on the IASB’s website.

These changes are intended to address criticisms raised by stakeholders, and therefore to result in financial statements that more faithfully represent the performance of insurance contracts. Each of these three topics is addressed in more detail below:

 

  1. Cash flows related to the acquisition of insurance contracts

The IASB has tentatively decided to clarify the accounting treatment of insurance acquisition cash flows attributable to expected future renewals of newly issued contracts:

  • On initial recognition of insurance contracts, insurers shall allocate the insurance acquisition cash flows between:(b) the future contracts that are expected to result from the renewal of these contracts.
  • (a) the contracts newly entered on the balance sheet; and
  • The insurance acquisition cash flows allocated to future contracts shall be recognised as assets, in accordance with IFRS 17.27, until the date of initial recognition of the contracts resulting from the expected renewals. If the insurer expects that the original contract (with, say, an initial term of one year) will be renewed several times consecutively, this portion of the cash flows could continue to be recognised as an asset for several years, depending on how many times the insurer expects to renew the original contract that gave rise to the costs.
  • At the end of each reporting period, the insurer shall assess the recoverability of these costs. This assessment shall be based on the fulfilment cash flows of the related group of contracts (i.e. the assessment is performed on a group of insurance contracts basis, rather than for each contract individually).
  • If the recoverability assessment shows that any portion of the asset recognised is unrecoverable, it shall be derecognised and an expense shall be recorded in profit or loss.
  • Subsequently some, or all, of this expense may be reversed (and a gain recorded in profit or loss) if a subsequent recoverability assessment shows that some, or all, of the costs previously recognised, and then recorded as an expense because they were assessed as non-recoverable, are now recoverable again.

 

2. Reinsurance contracts held

At its January meeting, the IASB tentatively decided to make amendments to some specific points of IFRS 17 relating to reinsurance contracts held (i.e. the accounting treatment in the financial statements of a primary insurer that is using reinsurance to reduce its risk exposure to the underlying insurance contracts it has underwritten).

The proposed amendments relate to the following two topics:

  • onerous underlying contracts; and
  • ineligibility for the variable fee approach (VFA) when the underlying contracts are eligible for the VFA.

Topic 1: Onerous underlying contracts

In accordance with IFRS 17.66(c) (ii) (the scope of which will be expanded), insurers will be required to immediately recognise a gain for reinsurance contracts held when they recognise losses on onerous underlying insurance contracts (including at initial recognition).

This gain shall only be recognised to the extent that these reinsurance contracts cover the losses of each contract on a proportionate basis (it is understood that this amendment relates only to proportional reinsurance treaties).

This amendment is intended to address stakeholders’ criticisms of the accounting treatment at initial recognition of reinsurance contracts held, and should reduce accounting mismatches in profit or loss that could have resulted from the existence of onerous underlying insurance contracts.

The IASB has also decided to extend the principle described above to contracts recognised in accordance with the (simpler) premium allocation approach (PPA).

Topic 2: Ineligibility for the variable fee approach (VFA) when the underlying contracts are eligible for the VFA

Reinsurance contracts held will still not be eligible for the VFA[1].

However, stakeholders raised concerns about the potential accounting mismatches that could result from this ineligibility (as insurance contracts issued would be accounted for using the VFA, while reinsurance contracts held to reduce exposure to the underlying contracts would be accounted for using the general model set out in IFRS 17). To address these concerns, the IASB decided to expand the scope of the risk mitigation exception set out in IFRS 17.B115, which is intended to reduce accounting mismatches in profit or loss resulting from the use of different measurement approaches for the underlying insurance contracts issued and the instruments used to mitigate financial risks.

An entity will therefore have the option of applying this exception when the instrument used to mitigate risk is a reinsurance contract held; provided that this reinsurance contract meets the eligibility criteria set out in IFRS 17.B116. IFRS 17 originally stipulated that the risk mitigation exception only applied when an entity used derivatives to manage exposure to insurance contracts issued that were accounted for using the VFA.

As a final point, reinsurance contracts issued were not mentioned in the IASB Update; however, agenda paper 2D, which deals primarily with reinsurance contracts held, also includes a proposal that reinsurance contracts issued should continue to be ineligible for the VFA.

 

3. Amortisation of the CSM

The IASB has tentatively decided to amend IFRS 17 to modify the pattern of amortisation in profit or loss of the contractual service margin (CSM) for contracts that are accounted for under the general model and that include both insurance coverage and an investment return service:

  • in the general model, the CSM shall be recognised in profit or loss on the basis of coverage units that are determined by considering both insurance coverage and any investment return service;
  • the standard will also be amended to clarify that an investment return service exists only when an insurance contract includes an investment component. The standard will not include a definition or criteria to help entities identify when an investment return service exists. Insurers must use their judgement, and must do so consistently. However, the IASB has not ruled out the possibility of including an explanation of what such judgements might involve in the IFRS 17 Basis for Conclusions;
  • the standard will also stipulate that the period of investment return services should be regarded as ending when the entity has made all investment component payments to the policyholder and should not include any period of payments to future policyholders;
  • the amended IFRS 17 will also require assessments of:

(a) the relative weighting of the benefits provided by insurance coverage and investment return services; and

(b) their pattern of delivery to be made on a systematic and rational basis;

  • the amendments will confirm that cash flows relating to fulfilling the investment return service (e.g. the costs of managing underlying assets) shall be included in the measurement of the insurance contract;
  • no changes will be made to IFRS 17 relating to fulfilment cash flows that adjust the CSM (i.e. the impacts of changes in financial assumptions will continue to be treated differently under the general model and the VFA); and
  • finally, the amendments will establish that eligibility for the premium allocation approach (PAA) should be assessed by considering both the insurance coverage period and the period over which any investment return service is provided.

 

4. What are the next steps?

The other topics identified by the staff in October (of which there were 25), on which the IASB has not yet reached a decision, will continue to be discussed at future Board meetings. Further amendments to IFRS 17 could therefore be proposed. Once all the topics have been discussed, the package of amendments as a whole will be reviewed by the IASB, to ensure that:

  • the benefits of amending IFRS 17 outweigh the costs; and
  • the proposed amendments would not unduly disrupt implementation processes already under way.

At this point, the IASB will also consider whether the various amendments will require any changes to the disclosure requirements of IFRS 17. The IASB therefore still has some work left to do before it can draw up the final list of proposed amendments. It will, however, need to work fast, as it has already announced the publication of an exposure draft of the amendments in the second quarter of 2019.

[1] The variable fee approach is one of the models that can be used to recognise insurance contracts under IFRS 17. Only insurance contracts with direct participation features are eligible for the variable fee approach.

TRG Insights on IFRS 17 for Mutuals and Associations

1.      Group insurance policies

Under a group insurance policy an entity provides insurance coverage to members of an association or to customers of a bank (members or customers that purchase insurance coverage are referred to as ‘certificate holders’). Some of those policies give the entity the right to terminate the coverage for all certificate holders at any time with a fixed notice period e.g. 90 days. The following three-step approach was found to be helpful in identifying the right accounting treatment for the specified policies:

Identify the policyholder: it may not be clear whether the policyholder is the association/bank or each certificate holder for a group creditor policy. Does it matter if the claims are paid directly to the association/bank rather than to each certificate shareholder?

  • Insight: The certificate holder is likely to be the policyholder, because the certificate holder’s debt is paid, i.e. the certificate holder is ultimately compensated for a loss event even if the association/bank received the claims on its behalf.
Identify the insurance contract: is it a single insurance contract or multiple contracts with each certificate holder? Is it a single contract because the bank can terminate the coverage for all certificate holders?

  • Insight: It depends on the following factors:

    Whether the insurance coverage is priced and sold separately;

    Whether the certificate holders are related to one another (other than by virtue of being members/customers of the same association/bank); and
    Whether purchasing the insurance coverage is optional for each individual.

Determine the contract boundary: is it the fixed notice period (e.g. 90 days) or should it be based on the expectation of the certificate holder’s that the group policy will not be terminated early by the association/bank?

  • Insight: The initial contract boundary is likely to be the fixed notice period (e.g. 90 days) because the entity’s substantive obligation ends there.

Practical aspect: Many TRG members discussed what it means for insurance coverage to be priced and sold separately (‘separate pricing factor’). One TRG member noted that in assessing the separate pricing factor, the price of the individual arrangement should be compared when sold on a standalone basis or as part of the group policy.

2.      Industry pools managed by an association

In specific jurisdictions, automobile insurance contracts must be issued by members of an association by law, so that coverage may be provided to the contract holders in the event that the risk cannot be covered in the voluntary market. The association mentioned in the agenda paper comprises two pools: one with members that issue contracts and one with members that hold contracts. In this form of the association, the issuer can be a) the association or 2) the individual member or 3) each member entity for its respective share in the pool. The following topics were discussed:

Is such an arrangement an insurance contract even if it issued by more than one entity?

  • Insight: Yes, if it meets the definition of an insurance contract. However, IFRS 11 may apply if the arrangement meets the definition of a joint arrangement. Even if the arrangement does not meet the IFRS 11 definition of a joint arrangement, an accounting policy should be developed in the absence of specific requirements in IFRS 17 for insurance contracts issued by more than one entities. One TRG member also noted that some of the arrangements may need to be considered under IFRS 15’s principal vs agent requirements.

Contracts that are transferred amongst members could be accounted for in two ways depending on the circumstances: either as reinsurance contracts issued if they meet the reinsurance contract definition or as an extinguishment of the obligation towards the policyholder-members.

The risk adjustment could be determined at an appropriate level that reflects the diversification benefits achieved within the association. However, some TRG members interpret the risk adjustment as being determined at an individual member level rather at an association level on the basis that different reporting entities (association vs individual members) should reflect different diversification benefits.

Practical aspect: the risk adjustment could be determined at an association level (one risk adjustment) if the issuer is the association and the compensation charged for the uncertainty reflects the diversification benefits achieved by all the members together (‘togetherness’). However ‘togetherness’ could be interpreted either way, ie one risk adjustment for the association and each member or risk adjustment based on the joint information gathered from individual member-to-member assessment.

3.      Annual cohorts for contracts that share in the return of a specified pool of underlying items

By annual cohorts the Standard requires IFRS 17 groups to include insurance contracts written no more than a year apart. Annual cohort requirement shall be applied unless the same accounting outcome can be achieved based on a different methodology, including aggregation at a higher level.

Practical aspect: Where another methodology is applied, it should be demonstrated how the same accounting outcome has been achieved with and without annual cohorts.

Future discussions

The challenges brought about by IFRS 17 are significant and many insurers are looking for solutions that capitalise on existing practice. The extent to which these solutions and implementation approaches will reflect IFRS 17’s new principles is an area of much interest. It is expected that many of these views and approaches will be deliberated and positions clarified through discussion forums and as implementation experience develops.

With the application date of IFRS 17 approaching, insurers are trying to understand what changes need to be made in order to be IFRS 17-ready. If you would like to discuss your transition to IFRS 17, please feel free to contact Maria Karamanou or any other member of the Mazars Financial Reporting Advisory team.

Blog author: Maria Karamanou, Insurance specialist, Mazars Financial Reporting Advisory

More industry clarity on the IFRS 17 implementation road

The September Transition Resource Group (TRG) meeting provided further clarity in a range of areas related to insurance under IFRS 17. Our analysis addresses the points that we expect will affect most insurers. Other topics discussed applicable to mutuals and associations will be analysed in a separate blog.

1.      Factors that can affect the length of the coverage period

Consequential insurance coverage:

Insurance liability is the insurer’s obligation to investigate and pay valid claims arising from insured events and is split into two components based on whether the insured event has already occurred:

When does the insured event occur if the insurance risk is consequent to an incurred claim? For example, in the case of disability coverage in the form of an annuity for the period in which the policyholder is disabled: is the insured event a) the accident or illness that made the policyholder disabled or b) the policyholder becoming disabled following an accident or illness specified in the contract?

Practical aspect: In reality either interpretation could apply. Different interpretations will give rise to different coverage periods, ie the coverage period will be longer in the case of disability coverage if b) is the insured event rather than a). A longer coverage period means that in the case of view b) revenue is recognised over an extended period. Judgement is required to determine the accounting policy that will provide the most useful information to the users of the insurer’s financial statements.

Premium waiver:

Premium waiver can be in the form of a contractual term that allows a policyholder not to pay premiums in specified circumstances. For example, a term life contract that provides primary coverage for mortality risk might allow the policyholder not to pay premiums for that contract if the policyholder becomes unable to work due to a disability.

Practical aspect: The premium waiver does not depend on the death of the policyholder (primary coverage – mortality risk) but on an additional insurance risk of the policyholder becoming disabled. The additional adverse effect of the policyholder becoming disabled suggests the insurer provide the same benefits without receiving consideration, ie additional coverage. Additionally, coverage units for mortality and disability risk can lead to a different coverage period over which the contractual service margin will be recognised when the coverage period with the waiver differs from the coverage period related to the base contract without the waiver.

2.      Discount Rates:  top down approach for non-VFA contracts

Under the top down approach, the starting point to determine the IFRS 17 discount rate is an asset rate that is adjusted to exclude factors present in the assets but not present in the group of insurance contracts, for example expected credit losses and differences in amount, timing or uncertainty of cash flows.

However, there is a simplification in the standard not to adjust the asset rate for differences in liquidity between a reference portfolio of assets and the group of insurance contracts. The simplification is available on the basis that the asset rate will be derived from a reference portfolio that is expected to have similar liquidity characteristics to the group of insurance contracts.

Practical aspect: if the simplification is used, measurement will be easier on initial recognition, but, subsequently, more disclosures may be required. That is because small fluctuations in the liquidity of the reference portfolio may lead to discount rate changes. Discount rate changes, even if small, may lead to material changes to the insurance liabilities measured.

Disclosure point: any material effect of a change in the composition of the reference portfolio of assets on the discount rates would be required to be disclosed in accordance with paragraph 117 of IFRS 17.

3.      Premium and acquisition cash flow experience adjustments

Premium experience adjustments are differences between expected and actual premiums. Judgment should be applied in deciding whether the premium experience adjustments relate to current, past or future service. For example, in the case of workers’ compensation coverage, if the premium is based on the expected headcount and the expected headcount differs from the actual one, then the difference between expected vs actual premiums should:

  • be recognised as revenue if it relates to current or past service.
  • adjust the contractual service margin if it relates to future service. That could happen when the actual premium received in the current period for coverage to be provided in the future differs from the expected premium because lapses differ from those expected.

Consistently with premium experience adjustments, acquisition cash flows might be settled in an amount different from the one originally expected (acquisition cash flows experience adjustments). Acquisition cash flow experience variances adjust the contractual service margin if they relate to future coverage or affect insurance revenue and insurance service expense if they relate to current or past service.

Practical aspect: The additional premium recognised as revenue in the current period because the actual headcount was higher than the expected does not affect the release of CSM, i.e. CSM is based on expected coverage units. Instead the premium experience adjustment is an additional component of revenue based on paragraph B124 of IFRS 17.

4.      Acquisition cash flows and their recoverability

Not all commissions meet the definition of IFRS 17 insurance acquisition cash flows. For example, policy administration and maintenance costs in the form of recurring commissions due to intermediaries do not meet the definition of insurance acquisition cash flows, instead they are treated as administrative or maintenance costs.

Those cash flows that are insurance acquisition cash flows under IFRS 17 may also be higher than the premiums, i.e. not fully recoverable. In this regard, the Standard does not require entities to separately identify the recoverable amount of insurance acquisition cash flows at each reporting date. The remeasurement of fulfilment cash flows at each reporting date will capture any lack of recoverability arising from all expected cash flows including acquisition cash flows.

Practical aspect: The insurance revenue cannot exceed the amount the entity is expected to receive as consideration for services provided. If, for example, the acquisition cash flows cannot be recovered from premiums, they should be expensed in profit or loss because the CSM cannot be negative. Insurance revenue, in other words, will be the total reduction of the liability for remaining coverage (closing LRC minus opening LRC) relating to services for which the entity expects to receive consideration, excluding the loss component (that will reflect the irrecoverable cash flows)

5.      Contract boundary considerations

Contract boundary determines which cash flows pertain to existing contracts and which to future contracts. Cash flows that pertain to expected claims or premiums arising from future contracts are outside the initial contract boundary.

Practical aspect: a proportional reinsurance contract held that covers all risks arising from underlying insurance contracts issued in a 24-month period and provides the unilateral right to both the entity and the reinsurer to terminate the contract with a three month notice period has a contract boundary of 3 months (1 January – 31 March). This is because the cedant has no substantive right to receive services with respect to new business that may be ceded in the following 21 months.

Contract boundaries are reassessed in each reporting period if there are changes in circumstances on the entity’s substantive rights and obligations. The contract boundary reassessment should be based on ‘changes in circumstances’ that are ‘narrow’, such as changes in the economic environment (debt spiral situations) or contract term whose commercial substance status has changed from one reporting period to the other.

Practical aspect: a restriction previously assessed as having no commercial substance, could in later years begin to have commercial substance. For example, in the case of a five year health insurance contract which can be re-priced annually, the insurer may initially determine the contract boundary as 1 year, but at the end of the year restrictions on re-pricing that had no commercial substance initially, may have commercial substance at the reporting date. In that case, at the end of the reporting period, the contract boundary is no longer 1 year but reassessed to be 5 years.

6.      Commissions and reinstatement premiums

Commissions due to a policyholder and reinstatement premiums charged to a policyholder are amounts exchanged between the (re)insurer and the policyholder and should be accounted for under IFRS 17 based on their economic substance and not based on what they are called in the contract.

In this regard the following two questions are relevant:

Question 1: Is the amount contingent on claims?

  • Yes. For example, an additional ‘premium’ is charged to the cedant as claims incur. In this case the extra amount charged should be part of the claims and not of the premiums. One TRG member interpreted differently the additional premium charged to the cedant as buying additional coverage to increase the cover, ie as a pricing consideration once you have ‘exhausted’ the first claims’ capacity, ie as part of the premiums.
  • No. For example, profit ‘commission’ due to a cedant does not change as claims incur. In this regard the amount paid to the cedant is effectively a deduction from the premium. The economic effect is a lower premium charge.

Question 2: Is the amount repaid in all circumstances (eg even if the contract is cancelled or the maximum claim limit is reached)?

  • Yes. For example, part of premiums in a retroactively rated insurance contract is refunded to the policyholder in all circumstances. Under these circumstances the amount meets the definition of an investment component and is presented as financial income or expenses and not as part of insurance revenue.

KPI point: the above guidance applies to both insurance (property/casualty contracts with experience-rating provisions or similar features) and reinsurance contracts issued (where the cedant is the policyholder) and is different from existing practice. It is expected to have an impact on important metrics, eg loss ratio and may have an impact on the information provided on the claims development tables.

Future discussions

The challenges brought about by IFRS 17 are significant and many insurers are looking for solutions that capitalise on existing practice. The extent to which these solutions and implementation approaches will reflect IFRS 17’s new principles is an area of much interest. It is expected that many of these views and approaches will be deliberated and positions clarified through discussion forums and as implementation experience develops.

With the application date of IFRS 17 approaching, insurers are trying to understand what changes need to be made in order to be IFRS 17-ready. If you would like to discuss your transition to IFRS 17, please feel free to contact Maria Karamanou or any other member of the Mazars Financial Reporting Advisory team.

Blog author: Maria Karamanou, Insurance specialist, Mazars Financial Reporting Advisory

IFRS 17: 3 early lessons and practical insights

A year and a few months after the issue of the new insurance contracts standard, insurers (issuers of insurance contracts) are recalibrating their IFRS 17 implementation approaches based on the latest technical developments and positions adopted by their peers.

Latest developments include the IASB’s transition resource group discussions, the recent clarifications to IFRS 17 discussed at the June IASB meeting and the standard’s endorsement status in the jurisdictions in which the insurers operate. Below we list three early lessons and practical insights regarding IFRS 17 implementation approaches our clients and their peers have shared with us.

Lesson 1: Leveraging off Solvency II

Maximising the overlap between Solvency II and IFRS 17 will help insurers reduce the implementation costs because both frameworks have a few common measurement principles. However, care must be taken to ensure that the “shared” features that you intend leveraging for IFRS 17 do actually exist in practice for your organisation. There will be differences between the two reporting frameworks that may not be easily reconcilable. These differences arise from different requirements in the two frameworks, regarding, for example, the contractual service margin, the level of aggregation, contract boundaries and discount rates, that reflect the different lenses through which IFRS (IFRS 17 and IFRS 9) and Solvency II look at contracts issued by insurers.

Practical insight: Under IFRS 17, contracts may be grouped at a more granular level than under Solvency II. Under IFRS 17, there is a two-step approach to grouping contracts. The first step is identifying portfolios, i.e. contracts subject to similar risks and managed together as a pool. Lines of business data under Solvency II could meet the IFRS 17 definition of portfolios, but this is not necessarily the case. Even at this step, there may be differences between IFRS 17 and Solvency II. In practice contracts subject to similar or homogeneous risks are not always managed together as a pool.  Insurers need to determine and then document their interpretation of “managed together”.

Lesson 2: Simplified approach may not be that simple

Under IFRS 17, there is an optional simplified approach applicable to contracts that have a coverage period of one year or less. This simplification, known as the “premium allocation approach”, is also optionally applicable to groups of contracts where the insurer reasonably expects the liability for remaining coverage (‘pre-claims liability’) under both the simplified and the default general model not to be materially different (“immaterial difference test”). This eligibility assessment is conducted at the inception of the group and requires consideration of the variability in the fulfilment cash flows. If an insurer expects significant variability in the fulfilment cash flows, this will cause the contract group to fail the immaterial difference test.   Non-life insurers in particular may consider that implementing IFRS 17 will not be unduly challenging for them because the simplified approach is broadly similar to their existing accounting under IFRS 4 / old UK GAAP.  It would be a mistake, however, to assume that the simplified approach will apply to all their contracts.

Practical insight: There will almost inevitably be some contracts with a coverage period in excess of one year and it should not simply be assumed that these are eligible for the simplified approach.  An analysis of the variability of the fulfilment cash flows of these contracts needs to be carried out and the entity will have to try to set objective benchmarks to determine what constitutes “significant variability”.

Another potentially tricky area of the simplified approach relates to onerous contracts. Although entities applying the simplified approach can assume that there are no onerous contracts in the portfolio at initial recognition, this is only the case if there are no facts or circumstances that indicate otherwise.  If there are such facts, the insurer will need to book to profit or loss the amount of the difference between the carrying amount of the liability for remaining coverage based on the simplified approach and the fulfilment cash flows relating to the remaining coverage based on the general model. Many insurers are currently trying to identify which ‘facts and circumstances’ might constitute indicators of onerous contracts.

Practical insight: Some insurers are considering using initial estimated loss ratios to decide whether contracts are onerous and if this approach is taken, entities need to establish, justify and then document how this threshold loss ratio is determined.  For example, is it based on a projected loss ratio for the portfolio?  Or the loss ratio for a less granular line of business?

Lesson 3: Treatment of reinsurance contracts held on a risk-attaching basis

Reinsurance contracts held on a risk-attaching basis, covering underlying contracts with coverage periods of a year or less, might not fall under the scope of the premium allocation approach, subject to the immaterial difference test, because the risk-attaching basis means all claims from ceded underlying policies incepting during the period of the reinsurance contract are covered, even if they occur after the expiration date of the reinsurance contract. As a consequence, the coverage period of the reinsurance is arguably in excess of one year.

Practical insight: Entities will need to consider whether it makes sense to opt for a simplified approach for the inwards business if it is not possible to follow the same approach for the related outwards reinsurance protection. Users may find the financial statements more informative if this potential mismatch is avoided and the general model is applied to both inwards and outwards contracts.

Future discussions

The challenges brought about by IFRS 17 are significant and many insurers are looking for solutions that capitalise on existing practice. The extent to which these solutions and implementation approaches will reflect IFRS 17’s new principals is an area of much interest. It is expected that many of these views and approaches will be deliberated and positions clarified through discussion forums and as implementation experience develops.

With the application date of IFRS 17 fast approaching, insurers are trying to understand what changes need to be made in order to be IFRS 17-ready. If you would like to discuss your transition to IFRS 17, please feel free to contact Maria Karamanou or any other member of the Mazars Financial Reporting Advisory team.

Blog author: Maria Karamanou, Insurance specialist, Mazars Financial Reporting Advisory

4 Hidden challenges and pitfalls when classifying cryptocurrencies and other investments as cash for accounting purposes

The advent of cryptocurrencies has disrupted conventional thinking around cash and cash equivalents, with accounting policies for such instruments still being analysed. Below we take a look at challenges around cryptocurrencies and other pitfalls to look out for when applying the definition of cash and cash equivalents in IAS 7 Statement of Cash Flows and interactions with IFRS 9 Financial Instruments

1.  Cryptocurrencies

Although the relatively new terms “cryptocurrency” or “Bitcoin” may suggest a form of cash, this does not necessarily mean cash for accounting purposes. Based on the fact that this type of investment doesn’t have a short-term life, often has significant fluctuations in value and typically has liquidity constraints it does not meet the definition of cash and cash equivalents.

There is currently some uncertainty on how to appropriately account for investments in cryptocurrencies. Possible classifications currently being considered include intangible asset under IAS 38 Intangible Assets and inventory under IAS 2 Inventories. Companies will need to apply judgement in determining the appropriate accounting classification and treatment of these types of investments, which may be dependent on their business model.

2.  Money market funds

Investments in units of money market funds, although redeemable at any time, typically aren’t cash and cash equivalents for accounting purposes. This is because the definition of cash and cash equivalents requires that the amount of cash that will be received must be known at the time of the initial investment and that the amount must be subject to an insignificant risk of changes in value.

Depending on the business model and the contractual terms and conditions, such investments may be appropriately classified and measured at fair value through profit or loss under IFRS 9.

  3.  Fixed deposits

Investments in fixed term deposits that are not considered to be short-term at acquisition date won’t meet the definition of cash and cash equivalents. This is because the definition requires the investment to be short-term. IAS 7 suggests a maturity of three months or less from the date of acquisition as being short-term.

Depending on the business model and the contractual terms and conditions, such investments may be appropriately classified and measured at amortised cost under IFRS 9.

4.  Overdrafts

Where short-term loans and credit facilities, such as overdrafts, have a notice period (i.e. are not repayable on demand) and do not often fluctuate from being negative to positive, they are a form of financing rather than being an integral part of the entity’s cash management. In this case such arrangements would not be considered cash for accounting purposes. This is the view held by a recent IFRIC decision, which can be accessed here.

Depending on the contractual terms and conditions, these types of overdrafts may be appropriately classified and measured as financial liabilities at amortised cost under IFRS 9.

Companies are also reminded that these overdrafts may fall under the new IAS 7 disclosure requirement to provide information that enables users to evaluate changes in liabilities arising from financing activities.

In the above summary, we have highlighted some of the challenges and pitfalls companies should look out for when applying the definition of cash and cash equivalents under IAS 7. If you would like to discuss the application of this or other financial reporting requirements to your business, please feel free to contact Steve Brice or any other member of the Mazars’ Financial Reporting Advisory team.

5 IFRS errors by EU listed companies we can all stop making

When well-resourced listed companies get aspects of their financial reporting wrong, there is often a good chance that the rest of us could learn something from their mistakes. We provide 5 common errors that are relevant to all IFRS reporters (listed or not), which were included in ESMA’s (the European Securities and Markets Authority) recently published annual report on the activities of European regulators.

1.  Key Performance indicators

UK reporters (except for small private companies) are required to include in their strategic reports an analysis of the development, performance or position of the company’s business using financial and other key performance indicators to aid understanding. When these indicators are not IFRS measures, there are lessons from the experience of listed companies which stem from enforcement actions related to presentation of alternative performance measures. These lessons include ensuring that non-IFRS performance measures are defined, using an appropriate label, and possibly providing reconciliations to the most directly reconcilable IFRS line item, as considered appropriate.

2.  Non-recurring, unusual or infrequent transactions?

A few listed companies incorrectly labelled items in the statement of comprehensive income as non-recurring, unusual or infrequent. Items that affected past periods and/or are expected to affect future periods can rarely be presented as non-recurring or similar.

Quick reminder: it is not permissible under IFRS to label subtotals or line items as “exceptional”.

3.  Debt vs equity judgements

Certain listed companies made incorrect conclusions as to the debt versus equity classification of their issued financial instruments. Although often a complex area, in 2 cases listed companies got the classification of relatively basic instruments wrong. For example, despite a lack of contractual obligation to pay interest and redeem the principal, one instrument was incorrectly classified as a liability. In another instance, an instrument was classified as equity despite a contingent settlement provision effectively requiring classification as a financial liability.

Where significant judgement is applied for debt versus equity classification, the accounting policy and analysis made of the classification should be disclosed, which was inadequately addressed by 16 listed companies.

4.  Presenting the statement of comprehensive income by function?

An instance was also reported where a listed company, who presented its statement of comprehensive income by function (e.g. containing cost of sales, operating and administration expenses line items), neglected to disclose additional information on the nature of the expenses. Under these circumstances, IAS 1 requires disclosure of the amount of depreciation and employee benefit expense to be presented amongst other things.

5.  Consistency in sub-totals

The composition of a sub-total should be consistent with its label and should not be misleading. A couple of listed companies incorrectly excluded operating items from sub-totals relating to operating activities. The presentation of sub-totals is also required to be consistent from period to period in line with the requirements of IAS 1, which was not the case for another listed.

The 2017 activity report can be consulted here.

If you would like to discuss the application of these or other financial reporting requirements to your business, please feel free to contact Steve Brice or any other member of the Mazars Financial Reporting Advisory team.

Do developers need to book revenue separately for the transfer of land in a construction contract under IFRS 15?

land

A recent decision by the IFRS Interpretations Committee (IFRIC) looked at whether or not the new revenue standard (IFRS 15) requires developers to recognise revenue from the sale of land separately from revenue from the construction of a building on that land.

IFRS 15 contains a new unit of account called a ‘performance obligation’ and requires revenue to be accounted for separately for each performance obligation identified in a contract. To determine whether or not the sale of land is to be accounted for as a separate performance obligation, there are two criteria to be assessed:

1. Can the customer benefit from the land on its own or together with other resources readily available to the customer (i.e. the land is capable of being distinct)?

IFRIC guidance: For a contract that transfers both an area of land and an entire building to be constructed on the land, the land is capable of being distinct from the building. This is because contractual limitations are ignored when making the assessment e.g. notwithstanding any contractual limitations, the customer could typically use another developer to construct the building.

2. Is the developer’s promise to transfer the land is separately identifiable from other promises in the contract (i.e. the promise to transfer the land is distinct within the context of the contract)?

IFRIC guidance: The promise to transfer the land is distinct within the context of the contract if it can be shown that:

  • the performance of constructing the building is the same regardless of whether the land is also transferred; and
  • the promise to construct the building is able to be fulfilled even if the land is not also transferred and vice versa.

Practical implication: If a developer concludes that both the above criteria are satisfied, the sale of the land becomes a performance obligation which is treated separately to the performance obligation for the construction of the building. Accounting for revenue relating to the sale of land as a separate performance obligation will require a developer to allocate an amount of the contract price to the sale of the land in accordance with the requirements of IFRS 15 and then to recognise such an amount separately in line with the said requirements.

The above guidance is expected to be useful for developers, many of whom are still coming to terms with the implications of IFRS 15 for their businesses which is effective for years beginning on or after 1 January 2018. Further details regarding the March IFRIC update can be found here.

If you would like to discuss the application of the requirements of IFRS 15 to your business, please feel free to contact Steve Brice or any other member of the Mazars Financial Reporting Advisory team.

In Brief: more answers to industry questions on the new IFRS 17 insurance standard

answers

On 2 May 2018, the second technical meeting of the Transition Resource Group (TRG) was held to discuss questions raised on implementation of the new insurance standard, IFRS 17. We provide a brief summary of some of the key questions and answers. (Click here for our summary of the previous meeting.)

The IASB’s TRG comprises insurance experts directly involved in the implementation of IFRS 17 and provides a public forum for stakeholders to follow the discussion of questions raised by interested parties on implementation of IFRS 17.

Combination of insurance contracts

Treating a set or series of contracts as one contract is not an accounting policy choice. It is only applicable when the legal form of the contracts does not reflect the economic substance i.e. when contracts combined achieve or are designed to achieve an overall commercial effect. A combination of the following factors may be relevant in assessing whether the overall commercial effect is being achieved individually or in combination with other insurance contracts:

  1. Are the rights and obligations similar when contracts are looked together versus individually?
  2. Are the risks covered interdependent?
  3. Does the lapse or maturity of one contract cause the lapse or maturity of the other contracts?
  4. Can you measure one contract without considering the others?

Practical aspect: A discount provided to the policyholder for buying multiple insurance covers that can be allocated to multiple insurance covers is not considered a relevant factor when determining whether the overall commercial effect is being achieved individually or in combination.

Risk adjustment

The risk adjustment is the compensation required and charged by the insurer (issuer of the contract) for the uncertainty arising from non-financial risk about the amount and timing of cash flows and is an entity-specific measure that also reflects diversification benefits. Practically, that means that the risk adjustment for a group of contracts will be the actual amount charged for bearing the financial risk regardless of individual or consolidated reporting i.e.

RA INDIVIDUAL ACCOUNTS = RA CONSOLIDATED ACCOUNTS

Practical aspect: Evidence of what the insurer has ‘charged’ for the non-financial risk can be indirectly found in pricing (component of the price charged) or cost analysis (e.g. cost borne that helps the insurer decide whether or not to write a contract).

Contract boundary

Another significant area of judgement is determining the contract boundary and, more specifically, determining which cash flows relate to existing and which to future contracts. Three aspects of the contract boundary requirements were discussed:

  1. Market constraints, on top of contractual, legal and regulatory constraints, should be considered to assess insurer’s practical ability to reassess policyholder risks and reprice if those constraints have commercial substance and solely apply to new policyholders (future contracts) and not to existing policyholders. A market constraint can be, for example, the expectation of policyholders switching to a competitor, if the insurer increases the price (or decreases the level of benefits) of the contract to reflect an increase in policyholder risks.
  2. Option to add insurance coverage: whether the cash flows arising from the exercised option are within the contract boundary or should be treated as a new contract depends on 1) whether the option is a separate contract and, if not, 2) whether at the option exercise date, the insurer has the practical ability to reprice the whole contract.
  3. When the cedant’s substantive right to receive services from the reinsurer ends before the cedant’s substantive obligation to pay premiums to the reinsurer, then the contract boundary should reflect all the cash flows arising from both cedant’s substantive rights and obligations, ie should not only include the cash flows up to the point the cedant no longer receives services.

Practical aspects: An option is of commercial substance when it guarantees future insurability. Additionally, an option to provide additional services is a current obligation depending on whether the option is exercisable or not on the designated future date.

Determination of coverage units

Determining the coverage units involves judgement to best reflect the provision of service and is not an accounting policy choice. Coverage units establish the amount of the contractual service margin recognised in profit or loss in the period and should reflect the services provided under the group of insurance contracts in that period. The services provided under the group should include the quantity of benefits provided under each contract of the group and each contract’s expected duration.

Practical aspect: Possible methods for identifying the quantity of benefits provided in the period include the maximum contractual cover in each period and the amount the insurer expects the policyholder to validly claim in each period if an insured event occurs. For contracts with investment-related services, i.e. containing investment components treated under the variable fee approach, the coverage provided should also reflect the investment-related services.

A few TRG members considered that the probability of claims can affect coverage units and that maximum contractual cover does not always have commercial substance and may not be appropriate as a method when there are contracts in a group with relatively high and low coverage limits.

Implementation challenges

Discussions also highlighted those requirements that may prove to be more challenging to apply in practice, particularly for general insurers:

  • identifying premiums received related to groups of insurance contracts and the liability for incurred claims related to groups of insurance contracts.
  • the treatment of contracts acquired in their settlement period is a significant change from existing practice because under current practice they are accounted for as liability for incurred claims of the acquirer. Under IFRS 17, those contracts acquired in their settlement period will be accounted for as liability for remaining coverage because they provide coverage for the adverse development of claims. General insurers applying the Premium Allocation Approach may need to apply the general model for those contracts acquired in the settlement period which could have wide ranging accounting and systems implications.

Future meetings: The TRG will continue to meet to discuss industry questions on IFRS 17. The next meeting is scheduled to take place on 26 September 2018.

If you would like to discuss your transition to IFRS 17, please feel free to contact Maria Karamanou or any other member of the Mazars Financial Reporting Advisory team.

 

Blog author: Maria Karamanou, Senior, Mazars Financial Reporting Advisory

Investments in shares: Is a change in the making to EU endorsed IFRS 9?

stocks

For companies holding investments in equity instruments, the default treatment under IFRS 9 (the new standard on financial instruments currently effective) is measurement at fair value with changes in fair value recognised in profit or loss. However, IFRS 9 also allows on option for these types of investments to be measured at fair value with changes in fair value recognised in other comprehensive income i.e. outside profit or loss. Differences characterising this new option from the IAS 39 “Available for sale” category are:

  • gains or losses in OCI are allocated directly to retained earnings and never recognised in profit or loss; and
  • no impairment model.

The European Commission picked up on these differences during the IFRS 9 European adoption process and as part of its work requested technical advice on whether the existence of an impairment model is an important element in the re-introduction of recycling of gains and losses.

In a recent discussion paper, European Financial reporting Advisory Group (“EFRAG”) presents arguments for the importance of an impairment model for re-introducing recycling of gains and losses. It also proposes two possible models: a “revaluation model” and an “impairment model” similar to IAS 39. (The comment period for the paper is open until 25 May 2018).

In addition to the Discussion Paper, EFRAG has also published an academic literature review on the interaction of IFRS 9 and long-term investment decisions. The review focuses primarily on papers published in accounting and finance journals since 2005 and identifies several themes, including the pros and cons of recycling and the factors that influence investment strategies.

From the above papers, it is clear that the debate on how to treat investments in equity instruments is not over yet in the EU. However, there is still a long road ahead and many hurdles to overcome before the possibility of recycling and impairment for investments in equity instruments becomes a reality under EU endorsed IFRS 9.

If you would like to discuss the application of IFRS 9 to your business, please feel free to contact Steve Brice or any other member of the Mazars Financial Reporting Advisory team.