Tuesday 29 September 2009

• Financial Instruments: Classification and Measurement
• Financial Instruments: Impairment

Tuesday 29 September 2009

The Board met for a special meeting relating to the IAS 39 replacement project. Several Board members, FASB members and FASB staff joined the meeting via video link.

Financial Instruments: Classification and Measurement

Scope

The staff introduced the session by summarising the feedback to the Exposure Draft (ED) received from constituents. Preparers and auditors, in particular, challenged the scope as defined by the Board in the ED. They proposed an alternative by splitting the classification and measurement phase into two sub-phases. The first phase would cover only financial assets, and financial liabilities would be addressed as part of a second phase. These constituents believed that fundamental questions regarding own-credit-risk for liabilities, embedded derivatives, and financial instruments with characteristics of equity have to be answered first before the second phase could be completed.

The staff recommended retaining financial liabilities in the scope as proposed in the ED as staff believed that separate guidance for liabilities would create a very complex set of principles and rules with unintended consequences. A Board member questioned that recommendation because fundamental issues of bifurcation of hybrid financial instruments and reflection of credit risk in subsequent measurement of financial liabilities had to be resolved first. The staff clarified that it just wanted guidance on how to proceed and not a fundamental decision on the aforementioned issues. Staff said that discussion on own credit risk and bifurcation of hybrid instruments will be scheduled for a later stage.

The Board tentatively agreed with the staff recommendation that the new IFRS would address classification and measurement of both financial assets and financial liabilities.

Classification Conditions

The Board discussed classification conditions. In their comment letters, constituents generally agreed with the proposed classification conditions. Nonetheless, they asked the Board to articulate the principles and guidance more clearly. The Board agreed to retain the two basic conditions as proposed by the ED, which were:

Basic Loan Features

The Board agreed that the standard should articulate the guidance more clearly by including some parts of the application guidance in the standard itself and by providing more complex examples of basic loan features in the application guidance. The Board also agreed with a staff proposal to include a discussion of leverage in the application guidance (and not including it just in the Basis for Conclusion as proposed in the ED).

Nonetheless, much of the subsequent discussion focussed on the logic and guidance for the proposed examples, with several Board members proposing different views on how the principles should be articulated. For example, one Board member proposed to include the notion of 'true lending relationship' into the definition of basic loan feature. Another stressed that the loan terms must be substantive. Several examples were briefly discussed, especially when basic loan features were applied only to the debt host of a convertible instrument. The Board agreed that particular examples would be discussed off-line as they relate to very detailed issues as well as drafting. If needed, these would be re-discussed at the next Board meeting. In general the Board agreed that the discussion of the examples and the basis for conclusions should be expanded, and the language of the examples could be improved.

Another contentious issue in the discussion was the notion of materiality. The staff discussed in its paper two aspects of materiality (features with significant effect on cash flows but unlikely to occur and features with insignificant effect on cash flows very likely to occur). Several Board members raised doubts about whether and how the notion of materiality should be articulated at all in the new standard.

Several Board members pointed out the need for the principles to be clearly defined and articulated to be operational. A FASB member noted that the language used in the ED could be confusing, mainly as basic loan features combine the notion of cash flow including principal and interest as well as discussion of additional features that may be included in the financial instrument (leverage, subordination, etc.) and suggested the Board articulated it as two separate conditions. He also suggested that both IASB and FASB staff should work to articulate the guidance as consistently as possible in their respective standards.

Managed on a contractual yield basis

In response to the received feedback from constituents, the staff proposed to revise the description of the contractual yield basis condition as follows: 'the objective of an entity's business model to hold the instruments to collect (or pay) contractual cash flows rather than to sell (or settle) the instruments prior to their contractual maturity to realise fair value changes'. The staff also proposed to provide additional examples and include more guidance defining those principles.

Most members of the Board agreed.

Two Board members disagreed with the principles. One Board member was particularly concerned that the proposed principle was not compatible with the Framework, and it reduced comparability across reporting entities. Moreover, he was concerned about whether the notion was operational.

Another Board member was concerned by the lack of representational faithfulness of the proposal, as the reality of how financial institutions manage their portfolios was different from the proposal. He suggested that the staff and the Board should consider the notion of 'manage the portfolio to optimise the yield' (as major financial institutions manage their financial instruments portfolios on total return basis).

The staff noted that it would explore this possibility but that the standards are addressed to a wider audience, not just financial institutions. Hence the definition based on management of portfolio in order to optimise the yield would be inconsistent with the practice in industry generally (such as trade receivables).

A FASB member urged convergence on this issue. He welcomed the change of in guidance in this area, with moving of the definition closer to the FASB proposal. He noted that in this area already a high degree of convergence was achieved between the proposals.

Exemption from fair value for some unquoted equity instruments

The Board re-discussed a possible exemption from fair value requirements to some entities. In a previous meeting the Board discussed retaining the cost exemption for some entities that have neither data nor ability to value unquoted equity instruments. At that meeting, the Board's tentative view was that such an exemption should not apply to financial institutions or venture capitalists.

The Board first discussed the staff proposal to provide a limited cost exception in case where it was impracticable to determine fair value. The Chairman noted that, for example, venture capital entities use a methodology for valuing investment in unquoted equity instruments. The staff would provide an overview of the methodology to Board members shortly. Several Board members believed that fair value should be provided at all times, even if that means a Level 3 valuation technique based on management estimates. They pointed out that often stock options were based on such equity instruments, and there is no exemption for them. Other Board members wanted more time for assessing the methodology that could become a part of the standard. Still others remained unconvinced because, for them, the availability of data remained the concern even when an appropriate valuation methodology was found. The Board decided to revisit the decision based on the methodology guidance on the next meeting.

The Board then discussed a proposed impairment methodology for a potential cost exemption (without prejudice as to the outcome of the next meeting). Most of the Board members saw logical inconsistencies in the proposal to base a separate impairment model on the value-in-use notion in IAS 36. They felt it was contradictory that a value-in-use could be calculated if a fair value measurement based on a valuation technique was impracticable. Some Board members were concerned that by introducing a different impairment model, no simplification was achieved in comparison with current IAS 39 requirements.

The Board considered also the proposal of the staff to value all derivatives linked to unquoted instruments at fair value. Despite potential inconsistencies with the decision on shares themselves (how to value a derivative linked to a stock whose fair value is impracticable to be determined), the Board narrowly approved this staff recommendation.

Financial Instruments: Impairment

Transition and Effective Date

The staff presented two approaches to transition that are in addition to the approaches discussed at the 22 September 2009 Board Meeting:

• Effective interest rate (EIR) collar approach, which would involve determining on transition a new effective interest rate on the basis of the expected cash flows over the remaining life of the financial instrument that would be subject to a floor (the risk free interest rate) and a ceiling/cap (the contractual interest rate).
• EIR margin adjustment approach, whose objective was to determine an adjustment to the EIR under IAS 39 that resulted in an adjusted EIR that approximated the EIR that would have been determined under the expected cash flow approach.

The Board agreed that EIR collar approach would be too complex and challenging to implement. The Board was split between the customised transition approach discussed during the last meeting (that would lead to a reduction of reserves and increasing interest income over the remaining life of the instrument) and EIR margin adjustment approach (that would be more challenging to implement). The Board decided to include both approaches in the invitation to comment in the forthcoming ED.

The Board discussed the proposed effective date of the new standard (1 January 2014). The Board tentatively agreed to propose this date in the ED. The Board decided to propose that full comparative information should be provided. Some Board members noted that such a decision might delay the effective date even further. The Board decided that early application was to be allowed. Nonetheless, some Board members were concerned about comparability of the data across reporting entities given the long lead time until adoption.

A FASB member informed the meeting that the FASB would prefer to wait to finalise the impairment approach for its ED based on the forthcoming Expert Advisory Panel recommendations and suggested that, given the 2014 expected effective date, the Boards could discuss a possible converged solution to impairment before the Standard was finalised. The IASB Chairman referred to the political sensitivities and the commitment of IASB to publish its ED in October. Nonetheless, he suggested that based on responses of constituents to the ED and Expert Advisory Panel recommendations a converged final standard would be discussed as part of re-deliberations.

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