POLICY POSITION PAPER ON THE PRUDENTIAL TREATMENT OF CAPITALISED EXPENSES

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1 POLICY POSITION PAPER ON THE PRUDENTIAL TREATMENT OF CAPITALISED EXPENSES RESULTS OF A SURVEY OF AUTHORISED DEPOSIT-TAKING INSTITIONS, UNDERTAKEN BY THE AUSTRALIAN PRUDENTIAL REGULATION AUTHORITY June 2003 Lyndon Kingston Hillary Maddox

2 TABLE OF CONTENTS EXECUTIVE SUMMARY...3 INTRODUCTION SURVEY RESULTS ACCOUNTING STANDARDS PRUDENTIAL STANDARDS DISCUSSION AND RECOMMENDATIONS CONCLUSIONS CONSULTATION AND APPLICATION Page 2

3 Executive Summary This report presents the results and analysis of a survey of Australian Authorised Deposit Taking Institutions (ADIs) 1 undertaken by the Australian Prudential Regulation Authority (APRA). The purpose of the survey was to examine and quantify the accounting policy, nature and materiality of capitalised expenses and intangible assets recognised by ADIs for financial and regulatory reporting purposes. From this APRA assessed whether the prudential definition of intangible assets needed to be clarified, to achieve better consistency in prudential reporting and application of the capital adequacy framework. The review of the survey responses highlights the following: 1. General consistency across ADIs in the classification and treatment of intangible assets for financial reporting, however some key exceptions exist. In addition there is a degree of inconsistency in the accounting policy adopted by ADIs for the recognition and treatment of capitalised expenses for financial reporting and regulatory reporting purposes. This introduces differences and inconsistencies between ADIs in financial reporting and the application of the capital adequacy framework. 2. The amount of capitalised expenses recognised and deferred as assets by ADIs is relatively modest at the industry level in proportion to total assets and regulatory capital, but it is evident that this rate of contribution is growing. In addition there are a number of ADIs where the relevant items comprise up to and exceed 10% of the ADI s regulatory capital base. APRA does not consider it prudentially appropriate for such material proportions of capital to be represented by capitalised expenses. APRA proposes to clarify the definition of intangible assets for prudential reporting purposes to include certain capitalised expenses, thereby deducting these from Tier 1 capital in accordance with Prudential Standard APS 111 Adequacy: Measurement of, paragraph 9. 1 Comprising Australian owned banks, foreign bank subsidiaries, building societies and credit unions. Page 3

4 Introduction is the cornerstone of an ADI s strength and a strong capital position helps to ensure that an ADI has the capability to absorb a reasonable level of unexpected losses from its activities. A measure of the capital strength of an ADI is the capital adequacy ratio, the amount of an ADI s regulatory capital expressed as a percentage of its risk weighted exposures (i.e. on-balance sheet assets and off-balance sheet exposures). According to Prudential Standard APS 110 Adequacy, three main elements determine an ADI s capital adequacy: credit risk associated with exposures; market risk arising from trading activities; and the form and quality of capital held to support these exposures. This capital adequacy framework serves to protect depositors and promote the stability and confidence in, the financial soundness of ADIs and the Australian financial system. The prudential profile of the ADI industry as at 30 September 2002 is provided in Table 1. Table 1 Prudential Profile of the ADI Industry ADI Total Assets $M % of Total Assets to Total Industry Assets Regulatory $M % of Regulatory to Total Industry Total Risk Weighted Exposures $M % of Total Risk Weighted Exposures to Total Assets % of Total Base to Total Assets % of Total Base to Total Risk Weighted Exposures Australian Owned Banks 1,145, % 73, % 737, % 6.4% 10.01% Foreign Subsidiary Banks 75, % 6, % 48, % 9.0% 14.18% Building Societies 13, % 1, % 7, % 7.8% 14.15% Credit Unions 26, % 2, % 15, % 8.6% 14.43% Other ADIs 4, % % % 4.5% 27.40% TOTAL 1,266, % 84, % 809,960 Note: Data is based on APRA statistical returns as at 30 September 2002 for the ADI consolidated group. The measurement of the capital adequacy of an ADI is directly linked to the recognition and measurement of its assets and capital. Accordingly, standards are a necessary prerequisite to ensure an accurate and consistent interpretation of the capital adequacy framework is applied. Standards governing the Page 4

5 recognition and measurement requirements of regulatory capital and regulatory assets incorporate the recognition and measurement requirements of the accounting standards. Accounting standards are used in the capital adequacy framework as they establish widely accepted rules for the recognition and measurement of revenues, expenses, assets, liabilities and capital. Accordingly accounting standards establish a framework that increases the understanding of and confidence in financial information, which is essential for investors, depositors, regulators and others to be able to rely on credible and comparable financial information. The conceptual basis of accounting standards is predominantly structured on a going concern basis for the operations of an entity, which is reflected in the accounting recognition and measurement requirements. The prudential standards of the capital adequacy framework however, is biased more heavily towards a liquidation basis, which seeks to ascribe a realisable recognition and measurement basis for assets and capital supporting an ADI s operations. This difference in conceptual basis is the most fundamental and important difference between accounting standards and prudential standards in terms of the capital adequacy framework. This important difference can result in divergent application of recognition and measurement requirements of the accounting standards for certain asset and capital items for capital adequacy purposes. Goodwill and identifiable intangible assets are an example of this. Values for these items are recognised as assets and therefore capital under the accounting standards, but are not recognised as regulatory assets and therefore regulatory capital under the capital adequacy framework. Tension has emerged between accounting standards and prudential standards in terms of the accounting policy adopted by ADIs for the recognition of certain expenses as assets and deferring the recognition of these expenses over a number of years for both financial and prudential reporting. APRA has been monitoring the growth in the recognition of capitalised expenses by ADIs over a number of financial years and is increasingly concerned about the potential growth in value of these assets relative to regulatory capital and the consistency of accounting treatment across ADIs. For prudential purposes, the main concern is that, like goodwill and identifiable intangible assets, capitalised expenses may not be realisable if need to protect policyholders. To aid in quantifying the magnitude and consistency of this accounting practice across ADIs, and to understand the practice in recognition and measurement of intangible assets and capitalised expenses, APRA sent a survey to all Australian ADIs in September 2002 requesting details on their exposure to, and accounting policy for, the recognition and measurement of capitalised expenses, up-front loan fees and commissions received and intangible assets. In total, surveys were sent to 243 ADIs. The response rate across all ADIs was 64% with responding ADIs accounting for 99% of total assets and 98% of total prudential capital. The sector coverage (in terms of total assets) of responding ADIs is set out in Table 2. It is considered that the ADIs that did not respond would not have a material influence on the survey Page 5

6 results (materiality of ADI sectors is highlighted in table 1). APRA is grateful to all ADIs who participated and provided the information necessary for this review. Table 2 Response Rate Response Rate of ADIs to Survey Australian Owned Banks Foreign Bank Subsidiaries Building Societies Credit Unions Total Industry Number of ADIs responding Percentage of Total Assets 100% 98% 72% 70% 99% Percentage of Total Regulatory 100% 96% 63% 70% 98% The remainder of this report is structured into the following sections: 1. Survey Results 2. Accounting Standards Overviews accounting principles used to recognise assets. 3. Prudential Standards Overviews the capital adequacy requirements. 4. Recommendations Outlines the proposed prudential accounting treatment. 5. Conclusions Outlines the impact on regulatory capital of the proposed prudential accounting treatment. This report does not encompass a policy discussion of capitalised expenses or intangible assets relating to life and general insurance businesses which are controlled by ADI s, but it does include such assets as part of the discussion of the results of the survey. Assets in the nature of capitalised expenses and intangible assets attributable to APRA regulated insurance businesses will be the subject of a future review specific to the insurance industry. Assets of general insurers in the nature of capitalised expenses (i.e. Deferred Acquisition Costs and Deferred Reinsurance Expenses), are permitted by AASB 1023 Financial Reporting of General Insurance Activities to be capitalised as assets for financial reporting purposes, however, they do not qualify for recognition as regulatory assets and must be fully expensed when incurred under the revised prudential accounting framework of the Prudential Standards for APRA regulated general insurers introduced from 1 July Page 6

7 1. Survey Results In September 2002, APRA sent a survey to all Australian owned banks, subsidiaries of foreign banks, credit unions and building societies. This survey requested each ADI to list for the licensed ADI and the consolidated ADI group, the value of assets recognised in the nature of capitalised expenses, intangible assets and up front loan fees received recognised as revenue and as unearned income for its last financial year. The survey information is summarised below into capitalised expenses and intangible assets and is based on the values reported for the consolidated ADI group. ised Expenses Table 3 summarise the survey results in terms of the proportion of capitalised expenses to total regulatory capital of responding ADIs. Table 3 shows that the bulk of the value of capitalised expenses recognised by ADIs is attributable to Australian owned banks, as 85% have exposure to capitalised expenses of greater than 2.5% of regulatory capital, compared to 23% for responding foreign bank subsidiaries, 33% for responding building societies and 5% for responding credit unions. For the purposes of the analysis in Table 3 the value of capitalised expenses has been adjusted for certain Australian owned banks. The adjustment removed capitalised expenses attributable to insurance subsidiaries (i.e. deferred acquisition costs) that were included in the total value of capitalised expenses reported in the surveys (refer to Table 4 for the total value). This was done because the analysis conducted in Table 3 and 4 is based on the regulatory capital base of Australian owned banks, which excludes retained earnings and reserves of these insurance subsidiaries. If the above adjustment was not made this may have incorrectly increased the percentage of capitalised expenses to Total Regulatory. Table 3 ised Expenses as a Percentage of Total Regulatory Base of Responding ADIs Percentage of Total Regulatory Base % Band Australian Owned Banks (Number) Foreign Bank Subsidiaries (Number) Building Societies (Number) Credit Unions (Number) 0% % % % % % % >15.0% Total Regulatory Base is based on the consolidated group reported in the APRA statistical data as at 30 September 2002 and only include ADIs that responded to the survey as highlighted in Table 1 'Response Rate'. Page 7

8 Based on Table 4, capitalised expenses of the ADI industry make up about 4% of regulatory capital after excluding deferred acquisition costs relating to insurance businesses of ADI group subsidiaries and certain prepayments. Prepayments have been excluded as they differ in nature to other forms of capitalised expenses. ised expenses relating to loan and lease origination broker fees / commissions are more material in terms of the percentage exposure to regulatory capital base for foreign bank subsidiaries and building societies. This result is consistent with the survey conducted by APRA on the use of brokers for loan origination in 2002 and is also reflective of the distribution profile of these ADIs. By far the most material capitalised expense relates to software development costs, with the combined exposure to software development costs WIP (1.3%) and software development costs In use (1.1%) to total regulatory capital represents 2.4% for the entire ADI industry and 2.7% for Australian owned banks. For Australian owned banks the bulk of this total expenditure comprises costs associated with staff salaries and consultants, which on average constitute roughly 80% of the total capitalised software development costs (this ranges from 95% 73%). Costs associated with software application and hardware account for the residual. This type of information was only collected for Australian owned banks as it was not seen to be material for other ADIs. Table 4 Classification of ised Expenses Classification of Total ised Expenses $M % of Total Base $M Subsidiaries Building Societies Credit Unions Industry Total % of Total % of Total % of Total Base $M Base $M Base $M % of Total Base Total ised Expenses 4, % % % % 4, % Total capitalised expenses classified into: Australian Owned Banks Foreign Bank Loan origination fees / commissions % % % % % Software development costs - WIP 1, % , % Software Development Costs - In use % % % % % Securitisation establishment costs % % % % % Debt / capital raising costs % % % % % Deferred acquisition costs - insurance % % Prepayments % 0.2 0% % All Other ised Expenses % % % % % 1 Total Base' refers to Total Regulatory Base as reported for the consolidated group in the APRA statistical data as at 30 September 2002 and only include the regulatory capital of ADIs that responded to the survey as highlighted in Table 1 'Response Rate'. 2 Software development costs are classified into 'Work in Progress' (comprising feasibility and development stages) and 'In Use' (completed and operational stage). Only Australian owned banks reported the details of both classifications as they have the most material balances in the development stages. For the purpose of this analysis all other ADI's software costs were considered as 'In Use' unless specifically advised. This was due to immaterially. 3 Survey information is based on the financial year of the consolidated group ending in The prudential data is based at 30 September Page 8

9 The following additional points are noted from the review of survey responses. A. Accounting policy Loan and lease origination fees / commissions The following differences were noted in the accounting policy adopted by ADIs: While the majority of ADIs recognise and capitalise these as assets, others recognise these fully as an expense when incurred. Disclosure of these assets in the statement of financial position was either reported or included under the heading Other Assets, Other Financial Assets, or Loans and Advances. Those ADIs adopting an accounting policy of capitalising these expenses generally deferred the expense recognition in line with matching the recognition of the income stream from the underlying asset. From a financial accounting perspective this more appropriately reflects the annual return on these assets over their life. This is a similar position for capitalising initial set up transaction costs associated with the raising of debt / capital and securitisation vehicles. Instances have been highlighted where the amortisation policy for the expense recognition of capitalised fees paid to loan originators and brokers does not appropriately accommodate the impact of loan prepayments in terms of early pay out or refinancing of the underlying loans originated. Software development costs. There tends to be a more established and recognised principle for accounting policy on capitalising software development costs. The accounting basis adopted by ADIs for capitalising such costs as an asset is generally consistent and is based on the premise that the costs are a necessary investment to enhance or upgrade the utilisation or functionality of the asset, or the cost extends the useful life of the information systems of the ADI and therefore the value in use to the ADI. Amortisation periods ranged from 3 years to 10 years. In terms of the classification of software development related costs for financial reporting purposes, disclosure was commonly under the heading Fixed Assets, Property, Plant & Equipment or Other Assets in the statement of financial position. Page 9

10 isation of securitisation establishment costs; costs associated with debt / capital raisings and all other similar transaction related costs The majority of responding ADIs recognise and capitalise these as assets and defer expense recognition over a period of time (e.g. maturity of debt raised), while others recognise these fully as an expense when incurred. B. Other general points noted. Australian owned banks Banks were consistent in classifying the type of assets representing capitalised expenses. A relatively broad interpretation of what items of expenses are appropriate to capitalise and defer as an asset has been adopted by a few banks. Foreign subsidiary banks Foreign bank subsidiaries were consistent in terms of classifying the type of assets representing capitalised expenses in the survey. The total value of capitalised expenses recorded for loan and lease origination and broker commissions / fees is essentially concentrated in 3 foreign bank subsidiaries out of the 13 respondents. Building societies Classification of items in the nature of capitalised expenses for the purpose of the survey was generally consistent across responding building societies. However, an important point noted was that capitalised software development costs were reported as a capitalised expense asset by only 3 of the 12 responding building societies. This fact contributes to the relative low percentage exposure recorded in Table 4 for building societie s. The 3 responding building societies that did consider software development costs as a capitalised expense classified this asset for financial reporting purposes as either Property, Plant & Equipment or Fixed Assets. Building societies have a signif icantly higher relative percentage exposure to capitalised expenses associated with securitisation establishment costs than other ADIs. In both relative and absolute terms they have a lower exposure to capitalised transaction costs associated with Page 10

11 debt / capital raising than other ADIs. Given the differences in accounting treatment it is difficult to draw definitive conclusions from this, but in relative terms this result is likely to be attributable to securitisation being a preferred source of funding for building societies. Credit unions As noted in the review of the survey results for intangible assets, there was inconsistency among responding credit unions as to the classification of software and information technology related expenses. They were either reported as an intangible asset or as a capitalised expense. The largest capitalised expense for credit unions relates to software development. Credit unions have a higher relative exposure to software development costs in terms of percentage of regulatory capital base than foreign bank subsidiaries and building societies. This result may in part be due to the fact that the majority of responding building societies did not report software development costs as capitalised expenses on the survey. Intangible Assets An analysis of the results of the survey responses are summarised in Table 5. Table 5 Survey Summary for Intangible Assets Australian Owned Banks % of Total Composition of Intangible Assets $M Base $M % of Total Base $M % of Total Base $M % of Total Base $M % of Total Base Total Intangible Assets 20, % % % % 21, % Comprising: Goodwill 9, % % % % 9, % FITBs % % % % % Excess of net market value over net assets of life insurance controlled entities Foreign Bank Subsidiaries Building Societies Credit Unions Industry Total 10, % , % Intellectual property % % Information Technology related costs % % Other capitalised expenses % % % 1. Total intangible assets based on survey results for the consolidated group. 2. Total Base. Total Base' represents total regulatory capital base of ADIs recorded in APRA's statistical data as at 30 September 2002 for responding ADIs only. 'Total Base' is adjusted for the purposes of this analysis by adding back the reported value of goodwill and other intangible assets deducted from regulatory capital base for the purposes of determining the capital adequacy ratio as at 30 September Only the prudential value of goodwill and intangible assets are added back to total regulatory capital base. 3 Survey information is based on the last financial year of the consolidated group at the date of the survey. Page 11

12 As highlighted in this table the bulk of intangible assets are attributable to the operations of the Australian owned consolidated banking groups concentrated in the recognition of goodwill and excess of net market value over net assets of life insurance controlled entities. The value recognised for goodwill predominantly relates to 4 Australian owned banks and the value recognised for excess of net market value over net assets of life insurance controlled entities predominantly relates to 2 Australian owned banks. As expected the materiality of goodwill reduces significantly outside the banking sector. In overall terms the bulk of intangible assets are concentrated with 2 Australian owned banks. Table 5 also highlights some inconsistencies in the type of asset items that ADIs consider to be intangible in nature for the purposes of the survey. Assets in the nature of information technology related expenses and certain types of capitalised expenses are considered to be intangible by some responding credit unions and building societies respectfully but not by any responding bank. Those capitalised expenses considered intangible in nature by the minority of building societies relate to loan origination broker fees and transaction costs associated with debt / capital raisings and securitisation establishment. Disclosure of these capitalised expenses as intangible assets for financial reporting and prudential reporting purposes (i.e. deduction from regulatory capital base) was inconsistent between the applicable building societies. The following are also highlighted from the review. A. Accounting policy Accounting policy adopted by ADIs for the recognition, amortisation and disclosure of goodwill and excess of net market value over net assets of life insurance controlled entities for financial reporting purposes was consistent. Disclosure of goodwill in the statement of financial position for financial reporting purposes was under the heading of Goodwill and Intangible Assets. While being considered as intangible in nature, the value of excess of market value of net assets of life insurance business recognised in accordance with AASB 1038 Life Insurance Business, was classified under Other Assets for financial reporting purposes. This classification was consistently adopted by applicable Australian owned consolidated banking groups. The Australian accounting disclosure requirements for this item do not seem consistent or logical when comparing the materiality of this item against both the materiality and disclosure requirements for goodwill, which is generally disclosed separately or under the heading of intangible assets. Page 12

13 B. Other general points. Australian owned banks There was consistency in terms of the type of asset items each considered intangible in nature for the purposes of the survey. The exception was future income tax benefits (FITBs) where a minority of banks considered these assets intangible in nature. Foreign bank subsidiaries There was consistency in terms of the type of assets each considered intangible in nature except for FITBs where most did not consider these assets intangible in nature. There was general consistency between the types of assets classified as intangible for the survey and those assets classified as intangible for capital adequacy purposes (i.e. goodwill). Building societies FITBs were not considered by any responding building society to be an intangible asset. Classification of goodwill as intangible assets for financial reporting and prudential purposes was consistent. Certain items of capitalised expenses were considered to be intangible in nature for both the survey and for prudential reporting purposes, but other similar items of capitalised expenses were not considered to constitute intangible assets by the same building societies. In addition, other building societies did not consider the same type of capitalised expenses to be intangible in nature for the purpose of the survey and financial reporting, but do for prudential reporting. Credit unions The majority of responding credit unions considered FITBs to be intangible in nature. There was no consistency in the classification of information technology related expenses. These were either reported in the survey as an intangible asset or as a capitalised expense. Credit unions classifying information technology related expenses as intangible in nature for the purpose of the survey did not adopt the same classification for prudential reporting purposes. Apart from this, there was consistency in the classification of intangible assets for the purposes of the survey, financial reporting and prudential reporting (i.e. goodwill). Page 13

14 The survey shows that there is general consistency in classification and treatment of intangible assets for financial reporting and prudential reporting across ADIs. However some key inconsistencies are highlighted, mainly in relation to the treatment and classification of certain capitalised expenses. This introduces inconsistency between ADIs in the application of the capital adequacy framework. The impact on regulatory capital of intangible assets deducted under the capital adequacy framework is shown in Table 6. This information is based on APRA statistical data as at 30 September 2002 and is not based on the survey information, but it is considered relevant to this topic. Table 6 Impact of Intangible Assets on Regulatory Adequacy Intangible Assets Australian Owned Banks % Foreign Bank Subsidiaries % Building Societies % Credit Unions % Percentage of Intangible Assets to Total Assets 1.82% 0.18% 0.06% 0.02% Percentage of Intangible Assets to adjusted Total Regulatory Base 22.86% 2.01% 0.75% 0.18% Adequacy Ratio 10.01% 14.18% 14.15% 14.43% Adjusted Adequacy Ratio (adjusted by adding back intangibles deducted from Base) % 14.43% 14.25% 14.45% 1. The value of 'Intangible Assets' is based APRA statistical data as at 30 September 2002 and includes all ADIs. 2. The value of 'Total Assets' based on APRA statistical data as at 30 September 2002 and includes all ADIs. 3. Total Regulatory Base. Total Regulatory Base' represents total regulatory capital base as recorded in APRA statistical returns as at 30 September 2002 for all ADIs. 'Total Regulatory Base' is adjusted for the purposes of this analysis by adding back the value of goodwill and other intangible assets that are deducted from regulatory capital base for purposes of calculating an ADI's capital adequacy as recorded in APRA statistical data as at 30 September The value of goodwill and intangible assets reported in the survey are not added back to total regulatory capital base. The value of intangible assets as a percentage of adjusted total regulatory capital base for Australian owned consolidated banking groups largely relates to goodwill (11.17%) and to excess of net market value over net assets of life insurance controlled entities (10.96%). The bulk of the intangible assets deducted from regulatory capital (75%) are attributable to two Australian owned consolidated banking groups. For foreign bank subsidiaries the intangible asset deduction is due to goodwill which is attributable to two foreign bank subsidiaries. The value of intangible assets as a percentage of adjusted total regulatory capital base for building societies relate to goodwill (0.19%) and to certain capitalised expenses (0.56%): which is largely attributable to one building society. Apart from one other building society capitalised expenses are not deducted as intangible assets from regulatory capital by any other ADI. This highlights inconsistency in terms of the type of intangible assets that are de ducted from regulatory capital. Page 14

15 2. Accounting Standards APRA s purpose in reviewing the accounting requirements is not to debate the interpretation and application of accounting standards by ADIs, but is aimed at understanding the accounting basis or policy adopted by ADIs in the recognition and measurement as assets, items constituting capitalised expenses. There are generally accepted accounting principles governing the requirements for recognising and measuring assets. Whether expenditure is recognised as an asset or an expense may have a material effect on an ADI s reported financial performance and position. In terms of the ability of ADIs to recognise and capitalise as assets items of expenditure and defer the recognition of the expense over a period, there are non-mandatory generally accepted accounting principles that ADI s are able to reference, in particular Statement of Accounting Concepts 4 Definition and Recognition of the Elements of Financial Statements (SAC 4). SAC 4 sets out non-mandatory principles for the three essential characteristics that are to be satisfied as a prerequisite for an asset to be recognised: 1. It must represent future economic benefits to the entity; 2. The entity must have control over those future economic benefits so that it can enjoy the benefits and regulate the access to others; and 3. The event giving rise to the entity s control over the future economic benefit must have occurred. A future economic benefit is the capacity to provide benefits to the ADI that uses the asset. An asset should only be recognised when it is probable that the future economic benefits embodied in the asset will eventuate, and the asset possesses a cost or other value that can be measured reliably. isation is the recognition of the cost of creating or enhancing an asset as defined above. isation occurs for new assets constructed; asset acquired and for asset enhancements when work is complete. Expenditure on an asset is considered an enhancement or upgrade where the expenditure results in an increase in the utilisation or functionality of the asset, or extends its useful life. isation of such expenditure occurs under two conditions; capitalisation is at its actual cost, and expenditure is written off over the estimated useful life of the asset. Apart from this non-mandatory guidance on the recognition requirements for assets provided in SAC 4, there are accounting standards and mandatory requirements applicable for ADIs, including the following: Page 15

16 AASB 1021 Depreciation requires that the amortised amount of an asset must be allocated on a systemic basis over its useful life. The depreciation method applied to the asset must reflect the pattern in which the future economic benefits are consumed by the entity. These costs should only be deferred to future periods to the extent that benefits are expected to equal or exceed the costs. The depreciable amount must be allocated from the time when the asset is first put into use. The accounting policy of most ADIs is to amortise fees and commissions paid to loan and lease brokers / originators over the expected life of the applicable underlying loan and lease portfolios, with amortisation periods generally ranging from 3 to 5 years among ADIs. This indicates that ADIs consider the useful life of the applicable underlying loan portfolio to be 3 to 5 years. Instances have been highlighted where the amortisation period adopted was not appropriately structured to accommodate the impact of loan prepayments in terms of payouts / refinancing prior to contractual maturity of the underlying loans originated. For software development costs, amortisation periods ranged from 3 to 10 years depending on the ADI s assessment of the useful life of the asset. AASB 1036 Borrowing Costs This standard provides that when it is probable that the incurrence of borrowing costs will result in future economic benefits and they can be reliably measured, they may be capitalised and included in the carrying amount of an asset, subject to the asset meeting the definition of a qualifying asset in AASB Te standard provides that financial assets are not qualifying assets. Borrowing costs that are incurred for purposes other than to acquire the future economic benefits embodied in qualifying assets are to be expensed as part of the periodic expenses of financing the entity's operations. This would include borrowing costs relating to working capital and the holding of equity securities. The standard provides that borrowing costs include: (a) (b) (c) (d) (e) Interest on overdrafts and short-term and long-term borrowings; Amortisation of discounts or premiums relating to borrowings; Amortisation of ancillary costs incurred in connection with the arrangement of borrowings. Ancillary costs include non-refundable costs associated with originating or acquiring a loan / finance. Such costs are typically accrued and amortised over the period of a loan / financing; Finance charges in respect of finance leases recognised in accordance with Accounting Standard AASB 1008 Accounting for Leases ; and Exchange differences arising from foreign currency borrowings net of the effects of any hedge of the borrowings. Page 16

17 Additionally, while ADIs incorporated in Australia are required to adhere to Australian accounting standards, international accounting standards may also provide guidance. In particular the Exposure Draft of International accounting standards IAS 39 Financial Instruments: Recognition and Measurement. This standard requires that transaction costs directly associated with a financial instrument are required to be included in the initial recognition of the cost of the financial instrument. Depending on the classification of the financial instrument and therefore the measurement basis (i.e. fair value or amortised cost), transaction costs will be accounted for differently after initial recognition. Under the fair value measurement framework transaction costs recognised initially in the cost of the financial instrument will be expensed on initial restatement to fair value most likely in the form of a revaluation loss, whereas under amortised cost measurement transaction costs will be recognised as an expense over the life of the financial instrument. There are accounting standards and mandatory requirements applicable for other industries that may be viewed as providing some form of precedence or support from a financial reporting perspective for ADI s to capitalise expenses associated with the acquisition of assets or the sourcing of liabilities. These accounting precedents relate to the following: AASB 1023 Financial Reporting of General Insurance Activities allows direct and indirect costs associated with acquiring or writing insurance business to be capitalised as an asset and expensed on a basis consistent with the recognition of income from the insurance policy acquired or written. Costs can range from acquisition costs to salaries and other administrative costs, as long as they are associated with future economic benefits of the policy. Urgent Issues Group abstract ruling 42, which is applicable for the telecommunications industry. The ruling requires subscriber acquisition costs directly attributable to establishing specific subscriber contracts, to be recognised as an asset where the asset definition and recognition criteria are satisfied. ised acquisition costs are required to be amortised over the period of expected benefit (for example, up to the contract period, where specified). Page 17

18 3. Prudential Standards According to Prudential Standards APS 110 Adequacy, the capital adequacy framework requires ADIs on both a licensed entity basis, and a prudential consolidated ADI group basis, to maintain a level of regulatory capital that is adequate and consistent with the risks to which they are exposed from their activities. The minimum capital requirement is expressed as the capital adequacy ratio, which is the amount of regulatory capital as a percentage of total risk weighted exposures (comprising assets recognised on-balance and off-balance sheet exposures of the ADI). The reported values of on-balance sheet assets and off-balance sheet exposures are risk weighted according to a nominal risk profile, with higher risk weights (and therefore capital requirements) applied to assets and exposures reflecting a deemed higher risk. The risk weights incorporate credit and market risk factors. This measurement methodology for risk has been in place since 1988 and is currently being reexamined by the Basel Committee on Banking Supervision and its proposed Basel II capital framework. The other crucial aspect in the measurement of an ADI s capital adequacy ratio is the amount and type of capital held by the ADI (i.e. the regulatory capital base). Two types of capital comprise the regulatory capital base of an ADI; Tier One and Tier Two capital. Tier One capital of an ADI is capital that is permanent and available to absorb losses and safeguards both the survival of the ADI and the stability of the financial system. As a consequence Tier One includes (with certain exceptions) ordinary share capital, reserves and retained earnings / losses. Tier Two capital on the other hand, includes other forms of capital such as perpetual and term subordinated debt. Tier Two capital absorbs losses only in the event of a wind-up, and provides a lower level of protection for depositors and other creditors. All incorporated ADIs must maintain, at all times: A ratio of total regulatory capital to total risk weighted exposures of at least 8% or such higher level as determined by APRA; A ratio of tier one capital to total risk weighted assets of no less than four percent; and Tier two capital must not exceed one hundred percent of tier one capital. The prudential capital adequacy framework adopts a conservative measure of capital due to its objective and underlying conceptual basis. As a result adjustments are required to be made to regulatory capital to derive the eligible regulatory capital base, which is then used for the purpose of calculating the capital adequacy ratio. The values of the following assets that are recognised under accounting standards are required to be deducted from Tier One capital to determine the eligible regulatory capital base: Page 18

19 Goodwill; Other identifiable intangible assets; Future income tax benefits (other than those associated with general provisions for doubtful debts) net of any provisions for deferred income tax liabilities; and Equity and other capital investments in associated lenders mortgage insurers. These assets are also excluded from the value of assets when calculating the total risk weighted exposures of the ADI for the purpose of calculating the capital adequacy ratio. Consequently the calculation of eligible regulatory capital base will be less than the value of shareholders equity calculated under the accounting standards. The impact on ADIs of the deduction of goodwill and other identifiable intangible assets for regulatory capital purposes is highlighted in Table 6 in section 1 Survey Results. The non-recognition of these assets as regulatory assets (certainly the first three in the above list) further highlights the difference in the conceptual basis between the going concern premise underlying the recognition and measurement requirements of the accounting standards and the bias towards a liquidation basis underlying the capital adequacy framework. While these assets are recognised in accordance with the accounting standards, under the conceptual basis of the capital adequacy framework they are not considered to meet the recognition requirements in terms of substance and realisability, necessary for recognition as a regulatory asset and therefore regulatory capital. There are no specific definitions for intangible assets (goodwill and other identifiable intangible assets) in the prudential standards or the capital adequacy framework. Rather, the definition is based on the terms defined by accounting concepts and standards. ised expenses are not specifically covered in the prudential standards or the capital adequacy framework and are generally risk weighted by ADIs for the purposes of calculating capital adequacy. However as noted previously in this report some ADIs deduct certain capitalised expenses from regulatory capital as a form of intangible asset. Given the conceptual basis of the capital adequacy framework is biased towards excluding assets of uncertain realisable value, it is arguable that a realisable measurement basis should be applied consistently to all assets rather than selectively, such as happens with a fair value measurement framework. The complexities and uncertainties associated with prescribing such a framework consistently and accurately for all assets and liabilities is well documented and has to date prevented both accounting standards makers and regulators from implementing this for financial reporting and prudential reporting purposes. Importantly a fair value measurement framework may still not necessarily align with the conceptual basis of the capital adequacy framework. Page 19

20 4. Recommendations APRA has been monitoring the growth in the recognition of capitalised expenses in the ADI industry over the past few financial years and is concerned about the growth in value of these assets and the degree of consistency of the accounting treatment across ADIs and the implications these represent for the application of the capital adequacy framework. APRA s concerns in this area are not allayed by the impending adoption by Australia of international accounting standard IAS 39 Financial Instrument: Recognition and Measurement. The accounting policy prescribed by this standard is that transaction costs directly associated with the acquisition of financial assets and financial liabilities are to be capitalised. This generates differences in the pattern and timing of expense recognition of these capitalised transaction costs depending on which measurement basis is applied to the underlying financial asset or liability. Consistency was generally noted in the accounting policy and disclosure adopted by ADIs for the recognition and classification of goodwill and identifiable intangible assets for both financial and prudential reporting purposes. However, some key differences in classification were noted in relation to capitalised expenses such as certain software development costs, securitisation establishment costs, loan and lease origination broker fees, costs associated with debt / capital raisings and the nature of other specific capitalised expenses. Most ADIs classified none of these capitalised expenses as intangible assets for prudential reporting purposes, however some ADIs do. Accordingly APRA sees this as further reason to clarify the definition of intangible assets for regulatory reporting purposes to ensure the capital adequacy framework is consistently applied to all ADIs. Within the accounting framework the capitalisation of expenses as assets and deferral of the expense recognition over a period, which may span a number of financial years, may more appropriately recognise or match the emergence of income and expense streams. However comparative to an accounting policy that fully expenses these items when incurred the treatment improves the reported financial performance and financial position of an ADI and as a result represents a favourable flow on effect on stated capital adequacy. The main prudential concerns are: consistency in the application of the capital adequacy framework across ADIs; and like goodwill and identifiable intangible assets, certain types of capitalised expenses are not considered to be available to protect depositors in an ADI failure scenario. Page 20

21 APRA does not support, for capital adequacy purposes, an accounting policy allowing capitalisation of certain types of expenses as assets. In light of this, APRA proposes that certain types of expenses that are capitalised as assets, specifically those listed below (excluding those in the nature of prepayments) are to be included in the definition of intangible assets for prudential purposes and deducted from Tier 1 capital in accordance with paragraph 9 of Prudential Standard APS 111 Adequacy: Measurement of. APRA will implement changes to the appropriate prudential reporting forms to separately capture the value of capitalised expenses and the composition of the value of intangible assets deducted from Tier 1 capital. This policy proposal for the treatment of capitalised expenses within the capital adequacy framework is outlined individually below for each main type of capitalised expense concerned. Loan and lease origination fees and commissions paid to mortgage originators and brokers The accounting policy adopted by ADIs to capitalise the value of fees or commissions paid to loan broker and originators in relation to loans and leases originated through those distribution channels, has changed, or at least differentiated the pattern and timing of expense recognition between loans / leases sourced through this distribution channel and loans / leases sourced through distribution channels such as an ADI s branch network. The expenses incurred with sourcing loans from mortgage originators are being capitalised and the expense recognition deferred over a period of between 3 to 5 years on average. Conversely the expense incurred in sourcing loans / leases through other channels such as the ADI s branch network is expensed fully when incurred as these predominantly comprise internal salary and staff costs. There are aspects of the accounting framework that require and justify this differential treatment. Also, under a going concern basis of accounting, capitalising as an asset loan / lease origination fees and deferring the expense recognition over a period more appropriately and accurately allows the matching or emergence of the cost or return on the loan / lease portfolios to be reported. However, it is APRA s view that these capitalised expenses do not satisfy the recognition requirements for regulatory assets in terms of substance and realisability under the objective and basis of the capital adequacy framework. Accordingly APRA is proposing the following prudential treatment: Permit loan / lease origination / broker fees and commissions that are capitalised as an asset by an ADI to be set off against the balance of upfront loan / lease fees (this does not extent to on-going account fees) associated with the lending portfolios that are deferred as unearned income and recognised as a liability. The positive balance of net loan / lease origination fees and commissions must be deducted from Tier 1 capital in accordance with Page 21

22 Prudential Standard APS 111 Adequacy: Measurement of, paragraph 9. A negative balance must not be added to Tier 1 capital. This treatment will harmonise the application of the capital adequacy framework for all ADI irrespective of the differing financial accounting policy adopted in relation to these type of expenses, while also seeking to accommodate those ADIs that adopt the matching principle for the recognition and deferral of both upfront loan / lease fee income and loan fee expense. This approach recognises the potential inequity in requiring ADIs to deduct capitalised expenses whilst not recognising unearned income associated with the lending portfolios. isation of securitisation establishment costs; costs associated with debt / capital raisings and other similar transaction related costs For financial reporting purposes and for regulatory reporting purposes, some ADIs classify these items as intangible assets where the majority do not. This results in differences in the treatment of these assets in the calculation of regulatory capital. It may be appropriate under a going concern basis of accounting for costs associated with establishing securitisation schemes and debt / capital raisings to be recognised as an asset and the expense recognition deferred and matched in line with the earning of economic benefit (e.g. for securitisation schemes recoupment may be via management and servicing fees and / or spread accounts). However under the capital adequacy framework APRA considers these costs do not satisfy the recognition requirements for a regulatory asset and therefore regulatory capital and proposes the following prudential treatment for these types of capitalised costs: (i). The balance of securitisation establishment costs that are capitalised and deferred as an asset by ADIs may be set off against the balance of unearned fee income relating to securitisation schemes that is recognised and deferred as a liability by the ADI. Any positive net balance of capitalised securitisation establishment costs is to be deducted from Tier 1 capital in accordance with Prudential Standard APS 111 Adequacy: Measurement of, paragraph 9. In accordance with AGN 120.3, any excess unearned fee income over capitalised securitisation establishment costs must not be added to Tier 1 capital. (ii). Debt / capital raisings and all similar direct transaction related costs that are capitalised as an asset by ADIs must be deducted from Tier 1 capital in accordance with Prudential Standard APS 111 Adequacy: Measurement of, paragraph 9. Page 22

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