Distinction between Debt and Equity

The principles contained in the exposure draft are that an instrument is an equity instrument if and only if:

• there is no obligation to transfer cash or another financial instrument, and
• settlement is by
  — a fixed number of shares, or
  — a fixed number of shares in exchange for a fixed amount of cash.
  

Areas of concern arising from comments received mentioned by the staff were:

• The role of past practice and management intent in determining the classification of derivatives on own shares where the entity has a choice in the manner of settlement.
• The role of economic compulsion in the absence of a contractual obligation and where there is considered to be an economic compulsion to distribute or redeem.
• The reclassification of redemption amounts from equity to liabilities in contracts on own shares.

Comments made by individual SAC members were:

• Disagree with the use of past practice and management intent in classification as this is dependent upon an assessment of current economic conditions. If these conditions change the assessment may be incorrect. If the assessment remains it should rather be based on expected future economic conditions.
• Would like the principle to be that any instrument that is share-settled to be equity.
• Would like the principle to be that any instrument is a liability until the entity is not obligated to settle in cash.
• Would like equity-settled derivatives to be marked-to-market through the income statement.
• If the entity has the ability to settle in a fixed number of shares it should be equity. If the holder has the option it should be a liability.
• Mutual funds should not have their "equity" classified as liabilities.
• If an exemption is made for mutual funds, the Board needs to understand how these are set up in different legal jurisdictions to ensure that the exemption can be applied consistently everywhere.

Derecognition

The principle proposed in the exposure draft, to which there would be no exception, was that an item is derecognised to the extent that there is no continuing involvement in the transferred asset. Continuing involvement is:

• the possible reacquisition of contractual rights, and/or
• exposure to performance of the asset.

Comments made by individual SAC members were:

• In certain cases what remains, or what is recorded as a liability, may not meet the conceptual definitions of assets and liabilities.
• Transactions that appear to be similar may be treated differently depending upon whether the underlying asset was owned by the entity or not.
• There is grossing up of the balance sheet.
• This new approach has not yet been tested and will cause additional cost to entities and add complexity.
• This approach does not converge to any existing GAAP.

Pass-Through Arrangements

These are the collection of cash flows that are passed on to the ultimate investor. These can be derecognised if:

• there is no obligation to pay unless the cash flow is collected,
• the collector has no right to sell, repledge or otherwise use the assets for its benefit, and
• there is an obligation to remit the cash flows without any material delay.

Areas of concern arising from comments received mentioned by the staff were:

• The conditions are vague and in particular the following questions were raised:
• To what extent can the entity manage the assets?
• To what extent can the assets be sold or repledged if it is not for the benefit of the collector?
• What is a material delay?
• What is the interaction with SIC 12?

Commentators suggested the following alternatives:

• Control / Components Approach
• Linked Presentation
• US GAAP (particularly in respect of Qualifying SPEs)
• Risks and Rewards Approach
• The original IAS 39 Requirements ( both with and without the IGC guidance)

Comments made by individual SAC members were:

• Believed that the continuing involvement approach encompassed both the control approach and the risks and rewards approach.
• Believed that due to the uncertainties going forward and that the continuing involvement approach was not clearly thought through, the current IAS 39 approach should be retained, further research should be done and once completed the resultant proposals should be exposed for comment.
• Why does the Board not converge and what are the views of the Liaison Standard Setters?
• If the continuing involvement approach is retained it should be expanded upon and further explained.
• The risks and rewards approach and the control approach are irreconcilable. The control approach needs detailed rules or guidance to apply. Believed that users wanted a risks and rewards approach.
• The risks and rewards approach should be retained.

Hedging (including derivatives)

The principles contained in the exposure draft are:

• Derivatives are assets and liabilities that should be measured at fair value. Fair value is the relevant measure because of the disconnect between cost and exposure for derivatives.
• Hedge accounting needs to link the mixed attribute model of some items at amortised cost and some items at fair value.
• If a derivative is embedded within something else, it should be separated out and accounted for as a derivative.
• Because hedge accounting is a departure from the normal accounting treatment it is elective and achieves same period income recognition of offsetting gains and losses.
• Because hedge accounting is a departure from the normal accounting treatment it needs discipline, being:
• The conditions set out in IAS 39, and
• Ineffectiveness is recognised immediately in the income statement.

Areas of concern arising from comments received mentioned by the staff were:

• Net positions should be allowed to be designated as a hedge (macro-hedging).
• Internal hedge positions should be allowed.
• There should only be one type of hedge accounting.
• Firm commitments should be cash flow hedges.
• Basis adjustment should be allowed for all hedges where assets and liabilities ultimately arise.

The chairman asked SAC members to comment first on the principles before commenting on macro-hedging. Individual SAC members' comments were:

Are the principles right? Generally this was answered in the affirmative with the following points made:

• There is no consensus on internal contracts.
• All financial instruments should be measured at fair value and then there would be no need for hedging. Whilst the mixed attribute model exists, the hedging croteria requirements is the lesser of the evils.
• Elimination of intercompany/ group transactions is a principle that applies equally here
• Would support the use of allowing designation of individual assets and liabilities despite generally not favouring the use of accounting options.
• Basis adjustment should be allowed. It is merely another cost incurred to determine the cost of an asset and should be treated in the same manner as other costs such as freight.
• The ED proposals in respect of cash flow hedge gains and losses in equity, makes it difficult to analyse the entity and consequently basis adjustment is supported.
• The principles are fine but there should be a pragmatic approach.

Macro-Hedging

• This is the pure form of hedging as businesses manage margins and risks on a macro basis. Correlation analysis can be designed to test effectiveness and any ineffectiveness should go immediately to the income statement. IAS 39 is an impractical standard.
• Various Board members noted that they believe that considerable ineffectiveness will arise in macro-hedging, if it was possible, which would need to be reported in earnings. They added that they have not seen any measures of effectiveness for macro-hedging positions that work. They further noted that portfolio hedging of like risks is permitted in IGC 121.
• A further concern expressed by Board members was that they do not know how to release the deferred derivative gain or loss arising from hedging when there is a disposal of a portion of the portfolio.
• It was proposed that provided the hedge is effective after disposal of a portion of the portfolio no portion of the deferred derivative gain or loss would be released. If the hedge is no longer effective after the disposal a portion of the deferred derivative gain or loss would be released so as to restore effectiveness.
• There should be a corridor approach to measuring effectiveness and ineffectiveness would only be released to the income statement to the extent it is outside the corridor.

Loan Impairment

The principles contained in the exposure draft were detailed for both amortised cost assets and fair value assets:

Amortised Cost

• Originated loans should be held at amortised cost.
• Impairment should be recognised when there is objective evidence that the asset is impaired:
• Recoverable amount is the present value of expected cash flows.
• The discount rate to be used is the original interest rate in the contract.
• Group assessment of impairment includes:
• assets that are not individually impaired, and
• assets that are individually assessed and found not to be impaired.
• The discount rate excludes pricing for the expected loss rate.

Areas of concern arising from comments received mentioned by the staff were:

• Lack of available data particularly concerning the expected loss rate.
• Confusion as to what conditions could be included in expectations of future cash flows.
• Consistency with Basle proposals.

Fair Value

• No reversals of impairment should be made through the income statement.

Areas of concern arising from comments received mentioned by the staff were:

• Impairment losses should be reversed where appropriate.

Comments made by individual SAC members were:

• Including tested unimpaired loans in group assessment may mask impairments in other loans.
• At what point does an expected future loss become a current loss? A reply was received that there should be a change in circumstances from those that existed at the time of origination or acquisition.
• Support was expressed for reversal of impairment.

Fair Value Measurement Option

Comments made by individual SAC members were:

• Does inception include First Time Application? A reply was received that this would include FTA.
• Designation should be on a class of asset or liability basis and not individually.
• The result of this decision could influence the types of assets held by insurance entities.
• Concern was expressed that fair valuing liabilities would include gains as a result of deterioration in own credit risk in the income statement.
• The proposed performance reporting matrix would clearly show the results of this option.

Other Financial Instrument Issues

The sensitivity analysis disclosures should be mandatory. It was noted that this issue is been considered in the revisions to IAS 30 and that the Board is considering widening the scope of the revisions to include all financial instruments and not only financial institutions

Insurance

SAC members were invited to make comments on the insurance projects:

• Phase 2 needs to take into account the business linkage between assets and liabilities.
• The lack of secondary markets for insurance liabilities makes fair valuing them difficult.

This summary is based on notes taken by observers at the IASB meeting and should not be regarded as an official or final summary.