Article_Learning to live with IFRS Gold and Currency Issues.docx

http://www.centralbanking.com/central-banking-journal/feature/2069712/learning-live-ifrs

Learning to live with IFRSHow central banks are facing up to – or ducking – their obligation to implement international accounting standards. By Kenneth Sullivan.

Author: Kenneth Sullivan

Source: Central Banking Journal | 15 Aug 2005

Categories: Financial Stability

For central banks, the significant consequences of adopting International Financial Reporting Standards FRS are two-fold. First, they are likely to experience increased volatility in reported income as revaluation gains and losses on both unhedged foreign exchange and financial instruments are recognised in the profit and loss statements as required under the standards IAS 21 for foreign exchange and IAS 39 for financial instruments. These issues require specific provisions in a central bank's law to enable it to comply with IFRS without negative consequences for policy outcomes and central bank capital. They do not inherently make it impossible for central banks to adopt IFRS.

As managers of foreign exchange reserves, central banks are particularly exposed to the effects of exchange rate movements. For most central banks the requirement to carry a portfolio of highly liquid foreign currency assets that comprise the country's foreign exchange reserves leaves them with a large open foreign exchange position on their balance sheet. Few central banks are in a position to cover this position with foreign currency liabilities and so are exposed to the volatility of exchange rate movements1. Under IAS 21, an entity must report assets and liabilities at closing exchange rates, and report any foreign exchange revaluations through the profit and loss statement2.

Income volatility

The exposure to foreign currency volatility has two major impacts on central banks. First, foreign currency revaluations are probably the greatest source of volatility for a central bank's reported income. Assumptions that central bank earnings are constant, or display a steady trend over time, need modification. This means that the central bank needs to manage and modify the reader's expectations of the financial statements. This is important as fluctuating profit levels provide opportunities for opponents of central bank policies to raise questions of competence or propriety.

Second, the inclusion of unrealised revaluation gains in the income statement makes them available as dividends in many current central bank laws. This itself leads to two further problems. First, the distribution of unrealised revaluation gains may directly conflict with the central bank's monetary policy. Distribution of unrealised revaluation gains represents an emission of credit for which no offsetting transfer of resources to the central bank has occurred. When the government spends the money, the resulting increase in the money supply will have an


inflationary impact that may conflict with the central bank's current monetary policy stance. Second, the distribution of unrealised gains may expose the central bank's capital as the gains, being unrealised, may reverse on an exchange rate correction. If the central bank has distributed the revaluation profits, its equity needs to absorb the losses arising from the reversal.

This volatility in the income statement can affect the level of capital the central bank requires. If it is to report under IFRS it needs capital buffers sufficient to absorb the cyclical volatilities that may arise. The size of these buffers will vary with the central bank's functions and balance-sheet construction. For example, the currency volatility will be less for a central bank that does not have responsibility for reserve management than for one carrying a large open foreign currency position. One usual way of creating capital buffers and neutralising the adverse effects on monetary policy of distributing unrealised dividends is to limit dividends to realised profits.

Accounting for financial instruments

Financial instruments, comprise the bulk of a central bank's balance sheet. Under IFRS, IAS 39 provides the guidance on financial instrument recognition and measurement, though the requirements of IAS 32 covering disclosure and presentation of financial instruments are equally important for central banks. IFRS provides a mixed-measurements basis for financial instruments. The presumption is that fair-value adjustments will be reported through profit and loss. The presumption of IAS 39 is that demand assets and most liabilities (except derivatives) will be measured at face value (net of impairment), but non-current financial assets and all derivatives will be measured at fair value, with the valuation changes reported in profit and loss3. Important exceptions exist enabling financial instruments that an entity intends to hold to maturity to be reported at amortised cost. IAS 39 only covers the price revaluations of financial instruments.

Another important element in IAS 39 is the requirement to test all financial assets for impairment and to make provisions for any impairment losses. This provides no exception for the nature of the issuer and particularly affects central banks where the issuer of the non-performing asset is the debt issued by their own government. In these situations, central banks are required to make impairment provisions (and therefore a judgment about the creditworthiness) of their major shareholder. It is not difficult to see how IFRS places greater responsibility on governments to ensure the integrity of any securities that they issue.

A further complication with IAS 39 is its requirement to initially recognise all financial instruments at their fair value. This invalidates the traditional form of central bank recapitalisation binds, under which the government issued undated, unremunerated promissory notes to the central bank. Under IFRS, these are more of a contingent asset and carry a fair value close to zero. Hence, any central bank recapitalisation now requires the use of dated securities that carry a market-related interest coupon. This carries real fiscal costs for the government.

The areas of IAS 39 that have featured most in the press are accounting for derivatives and hedging. While these also apply to central banks they are less significant given the nature of central bank balance sheets and their currently limited use of derivatives and hedging strategies.


More on show

Disclosures in the notes to the accounts rank equally with any information recognised on the face of the financial statements. Here IAS 30 Disclosures in the Financial Statements of Banks and Similar Financial Institutions and IAS 32 Financial Instruments: Disclosure and Presentation are important as they expand the range of disclosures expected concerning financial instruments and activities4.

IAS 30 specifies minimum disclosures for banks regarding statement of accounting policies, contingencies and commitments, concentration of assets, losses on loans and advances, assets pledged as securities and related parties disclosures. A combination of IAS 30 and 32 requires both a statement of general banking risks and extensive disclosure about the bank's risk management policies and procedures that cover interest rate, currency and credit risk, and fair value of those financial instruments not reported at fair value. Properly implemented, this results in enhanced transparency within the financial statements. As with commercial entities, within central banks this has resulted in much greater attention being given to the issues reported on, with a consequential improvement in risk management policies and practices.

IAS 30 specifies the order of disclosure of assets and liabilities in the balance sheet. Specifically, the standard requires disclosure "by nature and in order that reflects their nature and liquidity." This enables central banks to adopt a foreign and national currency split as the primary classification for assets and liabilities. Central banks' open foreign exchange positions make this a more important classification than for commercial banks, but reflect the flexibility possible within principles-based IFRS5.

Problems for central banks

The move by central banks to adopt IFRS carries some problems. The principal one is the requirement to include unrealised revaluations in net income. A chapter I have written6 acknowledges this and identifies the need for changes to central bank law and the calculation of distributable earnings required to address this problem.

Another frequent criticism of IFRS for central banks is the requirement to produce a statement of cash flows as part of the financial statements. Given that central banks are able to print money, the argument is that they will never be illiquid or insolvent. This is an extension of the arguments, adopted by commercial banks, that the standard statement combines its basic inventory, customer's deposits, with their own liquidity. While less critical for central banks than other entities, the statement of cash flows explains changes in the liquidity of a central bank's balance sheet and identifies the amount of "realised" earnings produced by operations in the preceding year. This can help explain the composition of the pool of distributable earnings and reconcile the situation where a large net income, generated by large revaluation gains is not supported by, large distributable earnings. So while not as critical for a central bank as for other entities, they are useful. Given that most sectors find some problems with aspects of achieving full IFRS compliance, central bank's difficulty with the statement of cash flows is not unique and, upon reflection, they should find that the benefits of preparing one outweigh the costs of a qualification in the audit report.


Policy concerns

Another concern expressed is that information disclosed in the financial statements will compromise the bank's ability to achieve its policy objectives. This concern applies specifically in two areas: the level of foreign exchange reserves, and the central bank's position as lender of last resort. In reserve management the argument runs that disclosing the level of a country's reserves provides important information to those who wish to mount a speculative attack on the currency. Experience seems to be to the contrary to that: an open disclosure of the level of reserves is seen as part of an effective exchange rate policy. Pressure on a nation's currency arises from structural problems within the economy or the macroeconomic framework and not from the degree of disclosure within the central bank financial statements.

For financial system stability, the argument runs that the central bank needs to provide liquidity to a financially stretched entity. This may be in the form of advances, borrowing facilities or guarantees. Because the entity needed the funding as a last resort they may be judged to be unable to repay the full amount of the credit support at market rates, thus requiring the lender to make an allowance for impairment. Disclosure of information regarding the credit or their impairment in the central bank financial statements risks triggering a run on the institution or a withdrawal of credit that would precipitate its collapse or a more serious financial system crisis.

Under IFRS, a central bank should disclose sufficient information to enable a user to form a clear understanding of its operations. This would include separately disclosing items that have different elements of risks attached to them. Lender-of-last-resort credits are different from credits granted as part of normal market or monetary policy operations and the value of such loans, in aggregate, should be separately disclosed within the notes to the financial statements, where material. Similarly, the amount of losses resulting from operations as lender of last resort should be disclosed. However, IFRS does not require the identification of the specific institutions involved in any lending, and the natural delays in publication of a central bank's audited financial statements generally mean that the disclosure of any information regarding financial support to a distressed entity would be several months old. It is reasonable to expect that the financial market's own intelligence networks will have identified the recipients of financial support from the central bank long before the central bank discloses any aggregate information in its own financial statements.

A more material issue may be the need for the central bank to produce consolidated financial statements. While there may be a technical argument that allows a central bank not to produce consolidated statements, it is a public-interest company and so should produce them if it has one or more subsidiaries. The important issue for a central bank is the need to include in its financial statements any distressed bank which it has taken over in order to stabilise the financial system. IFRS no longer allows the nonconsolidation of entities where the intention is to dispose of them in the near future. This potentially creates some difficulties for a central bank in a country suffering from an extensive financial crisis where several major banks have failed and been taken over by the central bank. Here the central bank would need to give careful consideration to identifying the consolidation issues and ensure that the parent and consolidated accounts clearly present the separate elements of the situation.


Gold and old notes

Within IFRS, two technical issues exist that cause real compliance problems for central banks: accounting for monetary gold and de-recognition of currency in circulation. IFRS treats precious metals as an item of inventory not a financial asset, and values them at the lower of cost or net realisable value not at fair value. Central banks hold gold as part of their reserves and consider it a financial asset. Many central banks acquired their gold some time ago, so valuing it at cost considerably understates its value. IFRS also applies a different treatment to this reserve asset than to the other assets in the portfolio, resulting in a loss of transparency. Currently, central banks which adopt IFRS value their gold at fair value (which is not how inventory is accounted for) and avoid an audit qualification on grounds of immateriality7. However, it remains an outstanding issue to be resolved.

The second issue is the technical difficulty of derecognising currency in circulation. IFRS prevents the de-recognition of a liability that an entity retains an obligation to honour, which for central banks includes currency in circulation. As part of currency maintenance or reform, the central bank may withdraw a currency series from circulation. Even though a currency series may be demonetised and no longer qualify as legal tender, the central bank usually retains an obligation to redeem it if it is presented at the central bank. Knowing that a proportion of currency will never be returned, some banks have a programme of amortising a proportion of the liability of currency in circulation each year. A strict interpretation of IFRS does not allow this. Because the central bank continues to redeem currency after it has been demonetised, the liability must remain on the books forever. To date, auditors have been willing to accept central bank assurances that the liability is a conceptual one and that the bulk of the money will never find its way back. Consequently, central banks have been able to remove the demonetised currency from the balance sheet and disclose it as a contingent liability in the notes to the accounts. However, it remains a specific issue that requires resolution.

Notes1 Those that are, do so by borrowing the foreign currency, usually from the government, to purchase the reserves, or they hold large foreign currency liabilities in the form of governmet deposits or borrowing obligations from the IMF or other international financial institutions. Alternatively, the government holds the reserves on its balance sheet and the central bank provides an agency service to manage the reserves.2 Limited exceptions to this requirement exist but do not usually apply to central banks.3 The exception is available-for-sale assets that allow revaluations to be reported directly to an equity revaluation reserve until the asset matures or is sold, when any revaluations are reported in profit and loss.4 Extracted from IAS 32, Financial Instruments: Disclosure and Presentation.5 An IMF Working Paper, WP 05/80 "Transparency in Central Bank Financial Statement Disclosures", provides an example of the types of disclosures this requires for central banks. It may be found at http://www.imf.org/external/pubs/cats/longres.cfm?sk=17959.0.6 See "Improving financial transparency" by Kenneth Sullivan, in Nicholl, P. and Courtis N. eds, Central Bank Modernisation. Central Banking Publications 2005 (forthcoming).7 Alternatively, the central bank may classify itself as a bullion trader, allowing it to report the gold at fair value.


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Article_Learning to live with IFRS Gold and Currency Issues.docx