Public sector accounting normally flies under the radar, unnoticed and unremarkable. But one area of financial reporting causing a stir for governments, their agencies and municipalities is financial instruments.
The principles are set out in IPSAS 41, Financial Instruments, launched in January by the International Public Sector Accounting Standards Board (IPSASB), a body that has developed accruals-based accounting for use by governments and other public sector bodies around the world.
The European debt crisis of 2009-10 laid bare concerns about the quality of accounting by some EU member states
While not every country will be using IPSAS 41, some see huge advantages in the new standard and its potential for increasing transparency in public sector accounting.
‘It really is a major improvement,’ declares Jens Heiling, a senior manager with EY Germany.
IPSAS 41 is the most recent chapter in the development of public sector accounting standards. The European Union (EU) even embraced IPSAS 41 as an early adopter, though some member states have so far lagged behind.
That should be no surprise. Public sector finances have been through their share of ups and downs since the European debt crisis of 2009-10, which laid bare concerns about the quality of accounting by some member states.
That was prompted by the diversity of accounting approaches used by EU member states. They could be applying either cash-based or accrual accounting, along with different frameworks – such as national principles or those based on International Accounting Standards (now IFRS Standards) – making comparisons near impossible and financial decisions potentially more difficult.
‘The main improvement is facilitating discussion involving completely new perspectives’
Aware of the disparity among accounting methods, the European Commission has dabbled with its own standard-setting project since 2014 to develop European Public Sector Accounting Standards, based on IPSAS. Meanwhile, IPSASB has forged ahead, refining its own standards. Where possible, it works to achieve convergence between public sector standards and IFRS Standards, with IPSAS 41 drawn mainly from IFRS 9 and replacing a previous standard criticised for failing to prompt reporting of financial risks at an early stage.
Reacting to risk
Accounting for financial instruments is complex and a long-running bone of contention, but the new standard is viewed by many as resolving many of the issues with previous practices.
‘The main improvement,’ says Thomas Müller-Marqués Berger, an EY partner based in Stuttgart, Germany, ‘is facilitating discussion involving completely new perspectives, which provides the ability to react earlier and take measures against risk.’
That discussion comes about, however, because IPSAS 41 makes progress in three key areas. The first might be described as a management benefit because the standard demands that financial assets be classified in a new way that is more likely to be in tune with management accounts. This method asks preparers to decide whether assets are being held for ‘operational’ capacity or for ‘financial’ gain.
‘The new standard much better connects the management intention and the accounting consequences’
The advantage, Müller-Marqués Berger says, is that it triggers the accounting treatment that follows, an important factor in ensuring that accounts reflect the intentions of managers.
‘If you hold an asset for operational aspects,’ he says, ‘the fair value, or market value, is less of an interest than the carrying amount or the acquisition sum. If you’re holding an asset as an investment, obviously the current market value is much more important.’ The decision raises the question for managers of whether outcomes should be shown in profit and loss or in capital assets.
‘The new standard much better connects the management intention and the accounting consequences,’ Heiling notes.
Elsewhere, IPSAS 41 makes strides by improving measures for hedge accounting. Previous financial reporting requirements were criticised for not allowing readers to understand the risks faced by an organisation and its financial investments, the hedging strategy used to manage risks or the efficacy of risk strategies.
The model for hedge accounting tightens the link between risk management strategies and accounting
By comparison, IPSAS 41 makes a leap forward by stipulating that hedge accounting only applies broadly when the ‘hedge’ matches the value of the original investment and the time period over which it is due to run.
The precise requirements involve more detail, but the new standard offers readers more transparency and, potentially, the chance to ask why hedging arrangements fail to match the investment risks. As Heiling and Mueller-Marqués Berger both highlight, the model of hedge accounting tightens the link between risk management strategies and the accounting for financial instruments obtained as part of risk management policy.
Transparency in government accounting is the bedrock of democracy
Perhaps the biggest difference made by IPSAS 41 comes in its treatment of impaired assets. This sees accounting for financial instruments switch from a backward-looking incurred-loss model to a forward-looking expected-credit-loss model. The difference is between asking whether losses on assets such as loans were crystallised, and whether losses can be expected in the future given the financial environment and the position of the counterpart.
An example illustrates the point. Under the previous incurred-loss model, the EU never recognised a loss in its accounts on loans. In 2021, using the new approach, the EU booked a loss of €50m.
‘You must actually try to look into the future to see what possible events could happen and make an assessment of the credit risk,’ Heiling says. ‘Based on that, you recognise an impairment.’
Transparency in government accounting – and, as a consequence, financial accountability – are the bedrock of democracy. IPSAS 41 may just help provide firmer foundations.