IFRS 9

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Investment management companies worldwide have to consider the impact of the new IFRS 9 accounting standard on their financial reporting and accounting procedures. This article describes how one Australian company is prepared to meet the IFRS 9 challenge head-on with the support of its financial software solution.

By David Mackaway, General Manager, Challenger, Australia

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The International Accounting Standards Board (IASB) issued International Financial Reporting Standard (IFRS) 9, Financial Instruments, to simplify the classification and measurement of financial assets effective 1 January 2013. IFRS 9 permits adoption for financial statements starting from 2009, and requires that financial assets are classified into one of two measurement models: (1) the amortised cost model, or (2) the fair value model. The classification requirement is based on an entity’s business model for managing financial assets.

The new IFRS standard is designed to remove many of the complex and rule-based provisions of tainting, reclassification and impairment requirements of the current International Accounting Standard (IAS) 39. Moving on in October 2010, the IASB issued additions to IFRS 9 to include accounting for financial liabilities. The additions retain many of the provisions of IAS 39, except that fair value changes of liabilities due to an entity’s own credit risk are to be recognised in other comprehensive income. Furthermore, there shall be no recycling or subsequent recycling to profit or loss even when the liabilities are derecognised.

As the investment management industry continues to become more of a global market place in search of alpha, fund complexes are considering adoption and implementation of IFRS 9 is more appropriate for their ever-growing global investor base. At a certain point, a fund management company is bound to select IFRS financial reporting for one or another of its funds.

But many corporate treasurers and chief financial officers remain uncertain about how and when to adopt IFRS 9. The new standard is partially a consequence of the financial crisis of 2008-09, as investors and regulators demanded to know what kind of assets and liabilities companies have in their books at any given time, what they were worth 'in the market', the risks involved and the gains or losses in the value of those items, and they want that shown in the financial statements.

IFRS 9 aims to achieve just that – make the accounting of financial instruments simpler, clearer and easier to use. Companies were given the option of adopting the standard as early as November 2009 but are not required to do so until 2013. However, the common argument is that the stakes are high and that companies should prepare for the standard as early as possible.

A DIFFERENT STORY

In Challenger’s case, the story is a little different. Like everyone else, Challenger has to consider the impact of IFRS 9, but for other business reasons had already moved on to the stage of needing to account on both an amortised cost and fair value basis long before the IFRS changes were introduced. Using the right asset software solution in the form of SimCorp Dimension was a key factor allowing us to already be in a position where adoption of IFRS 9 will not be a significant operational issue.

A key advantage for us is that we use one software solution as our primary source of truth for asset valuations across the entire business. The system also has the essential flexibility we need to be able to value assets in multiple ways for varying parts of our business.

Challenger was fortunate to have strategically made the decision to have a centralised and very flexible asset system to cater for its business needs and the SimCorp Dimension system met that need. Over the past five to six years a great deal of effort has been put in to the implementation of this system; and this has meant that a very limited amount of additional effort will need to be put into implementing IFRS 9, which was precisely why we wanted a system giving us a high degree of flexibility.

HISTORY IN THE MAKING

Challenger is a large Australian financial services company and the foremost issuer of retail annuities in Australia. Challenger is the only financial services company in Australia dedicated to providing guaranteed, certain-return income stream products to both institutional and retail clients. Today, the investment team in Challenger‘s life company, Challenger Life, which is regulated by the Australian Prudential Regulation Authority (APRA), manages over A $7 billion in assets to secure income for approximately 60,000 clients.

Challenger also operates a funds management business of approximately A$20 billion (see Figure 1), applying a multi-boutique strategy with 10 boutique partners within the organisation servicing over 55,000 investors in managed funds and 75 institutional clients. The boutiques cover a diverse range of asset classes, ranging from Australian and international equities, traditional fixed income products, all the way through to alternative funds. We have a diverse range of asset classes and a diverse range of client needs, effectively servicing 11 distinct businesses. Having one core asset system affords us a lot of efficiencies and control.

Fig. 1. Australian industry FUM growth projections (A$ billions).
Source: Rainmaker Roundup, December 2009.

Challenger has used the same software solution for assets since 2003. At that time it effectively transitioned the entire business so that all of its assets are administered through the same system. We use the system in a holistic way for investment administration; trade entry and execution, portfolio valuation and unit pricing, performance and attribution and compliance. With it all carried out within the one system, we gain a lot of operational efficiency and strong management control over our entire book of assets.

A GOLDEN OPPORTUNITY

There is little doubt that conversion to IFRS represents a golden opportunity for investment management to revise its accounting policies. Present standards require financial assets to be classified as one of the following:

• at fair value through profit or loss;
• held-to-maturity investments;
• loans and receivables; or
• available-for-sale financial assets.

Alternatively, investment management companies can adopt IFRS 9 early with only two financial asset categories. Debt instruments can be held at amortised cost if the fund’s business model is to hold debt to maturity and the payments received are solely for principal and interest. Debt not at amortised cost and all equity and derivatives would be at fair value.

Gains or losses on debt instruments at amortised cost are recognised in profit or loss when sold, impaired, reclassified to fair value and through amortisation. Gains or losses on financial assets held at fair value are generally recognised in profit or loss (comprehensive income for certain equities).

Financial liabilities will be classified as a) at amortised cost using the effective interest method, b) fair value through profit or loss, c) financial liabilities that arise when a transfer of a financial asset does not qualify for derecognition or when the continuing involvement approach applies, d) certain financial guarantee contracts, or e) commitments to provide a loan at a below-market interest rate.

Financial asset and liability classifications, which define measurement and profit or loss recognition, are made using IAS 39 or IFRS 9 requirements. Management will also be able to define and document valuation methods, inputs and levels within the IFRS fair value hierarchy for different types of investments.

Financial instruments held as assets or liabilities will be tagged by specific categories for aggregation and disclosure in the statements of financial position and comprehensive income. Statement notes will include IFRS 9 fair value hierarchy disclosures with levels based on the observability of inputs and valuation methods, as well as risk disclosures for financial instruments.

The costs of financial instruments at fair value through profit or loss will have to be segregated from transaction or commission costs, which will be expensed. Management and the administrator will want to track activity over a period of time using IFRS indicators and prepare sample financial statements to be assured that IFRS reporting is accurate and comprehensive.

REDUCING COMPLEXITY

To date, IFRS 9 covers financial assets and represents only the first phase of the overhaul of IAS 39; the treatment of liabilities and hedge accounting remain under consideration. The most benefit from IFRS 9 is really to simplify the classification of different categories of financial assets. According to a global survey of financial professionals released by the CFA Institute, half of the respondents indicated that IFRS 9 improves decision-usefulness of financial reports; 38% believed it reduced the complexity of financial instrument accounting.

IFRS 9 narrows down financial instruments into two measurement categories: amortised cost or fair value, thus eliminating the held-to-maturity, available-for-sale, and loans and receivables categories. The classification hinges on two criteria: the entity’s business model for managing its financial instruments and the contractual cash flow from that instrument.

An instrument is measured at amortised cost only if the entity’s objective is to hold the asset to collect cash flows and if the contractual cash flows are solely payments of principal and interest. Assets that fail to meet the two criteria (for example, equities, convertible bonds, forwards or swap contracts) should be measured at fair value through profit or loss.

STATUTORY REPORTING

In Challenger’s case, IFRS 9’s requirement of either treating financial instruments on an amortised cost basis or a fair value basis has been one effectively in place for many years. As the regulator overseeing Challenger’s annuity business, APRA requires the assets and liabilities held in the life company to be valued on a mark-to-market basis and this forms the statutory reporting for the business. I n addition, Challenger for management reporting purposes looks at cash operating earnings on an amortised cost basis to show the level of cash flow being generated to support the payments made to its annuitants.

In relation to Challenger’s managed funds’ business, there has always been a requirement to value these portfolios on a fair value basis. It’s fundamental to the business: many of the funds operate with the idea of buying and selling securities on an ongoing basis to generate performance and there is a constant need to have assets valued at their current fair value to ensure equitable treatment of all unit holders and to deal with the ebb and flow of investors applying for and redeeming into the funds.

Whereas with IAS 39 everything had to be treated on a security-by-security basis, now the focus is on the entire business. The whole idea is to generate a return for the investor, and typically managed funds – and certainly the ones Challenger operates – operate in a trust structure. What this means is that unit-holders can apply and redeem from the trust at any point in time and we need to ensure this is done at the fair value of the assets.

In view of all these diverging requirements in a complex statutory environment, it is very hard to be in a scalable position if you require five or six systems to deal with all these requirements. And so strategically for Challenger, when it was going through the process of picking a new asset software system, we were looking for a contender with proven ability to be highly flexible in accounting for and running assets for different businesses within one system.

This type of flexibility is extremely valuable and very powerful. What it meant for Challenger is that it could have these diverse business models all operated off one central system and not have to worry about managing multiple versions of the same system doing different things.

BEEN THERE, DONE THAT

For many years we have had the requirement of valuing according to a fair value method while also needing a reporting framework based on amortised costs. About three years ago, we undertook a project to fully achieve this within our software solution. As we now move forward in our investigation of IFRS 9, we take a great deal of comfort in the fact that from an operational perspective, the exercise amounts to no more than just looking back to the future because we had already been there and done it.

If we have parts of our business that may need to move to amortised costs from a statutory perspective, our view is that this will not be a significant operational hurdle because we know the system can do it – the system has actually been operating this way already – and for those particular assets or portfolios that are affected, we can just literally switch the methodology back.

CASH FLOWS AS BUILDING BLOCKS

One of the fundamental strategic building blocks that Challenger believes its investment management solution has right was to build a system that thinks about securities based on their cash flows. Securities in the system are literally made up of a bundle of cash flows, and once all these cash flows are gathered and assembled, each and every one can then be valued at varying rates. That is a real strategic difference compared with some of the other systems that are available in Australia.

David Mackaway, Challenger’s General Manager, Operations, outlines how an optimal software solution can improve an investment management company’s ability to meet the needs of being innovative, adaptable to change and responsive in speed-to-market.

The ability to slice and dice a security and break its valuation down into cash flow components clears the way to proceed along many different paths. This has allowed inordinate amounts of flexibility in our business, not only to deal with legislative changes but also to effectively handle the complexities of some of the instruments we trade in.

For example, Challenger administers numerous complex structured assets, but here again they all boil down to a bundle of cash flows that need to be broken up into their constituent parts to decide how to value them. Because the software is able to break down securities in this manner, it is possible to represent very complex securities using standard bond functionality and associated customised cash flows to the extent that the system represents a very real competitive advantage for us.

THE HOLISTIC WAY

One of the important features in using the system in a holistic way is that we do not run into the problem of having to duplicate work processes. For example, if the underlying value given to a security has to be changed in one system and then different changes have to be made within the compliance system, this requires duplicate effort and workload. For Challenger, having it all in one system – while it does not remove the need to make changes as instruments change – it does allow us to do it in a streamlined and efficient way.

In Australia there is always the debate whether investment management companies should conduct their administration in-house or outsource to a third-party provider, which is larger and can potentially add the economies of scale that may not otherwise be present. We have carried out the function in-house for many years, and one of the key reasons for that is retaining control and having a high degree of flexibility to be able to work with our investment teams in designing and structuring new products.

Challenger considers itself as somewhat of an industry leader in being innovative and designing product that meets the needs of its clients, and we also consider ourselves as being responsive in speed-to-market. Being innovative, dealing with constant change and being able to bring that to the market place very quickly means that you need a lot of control, not only in terms of the investment management perspective but also the administration and operation of the product as well. With the type of software solution we have, it really increases our ability to support all these needs and is a key reason we retain the function in-house.

David Mackaway has held the post of General Manager, Operations, at Challenger since 2007 and is responsible for all investment and registry operations supporting the Challenger business. He has worked in the financial services industry for over 17 years and prior to joining Challenger was an Executive Director of MMC Asset Management Limited and Chief Financial Officer of ASX-listed MMC Contrarian Limited. Prior to MMC, David was based in the USA as Global Head of Operations for Principal Global Investors. He also worked in Australia for BT Funds Management for over 10 years in various operational roles, including running BT’s fixed interest and currency business.