Tuesday 6 October 2009

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

Financial Instruments: Classification and Measurement

Reflecting changes in own credit risk for financial liabilities not measured at amortised cosst

The staff introduced the session by summarising the proposals in the ED and the feedback received from constituents. The staff proposed to require a frozen credit spread measurement method as discussed in the DP on Credit Risk in Liability Measurement for some liabilities not measured at amortised cost. The Board agreed.

Nonetheless, some Board members were concerned that by using this alternative the Board introduced another current measurement attribute that was not decision-useful. Some of the Board members believed that bifurcation of the fair value changes, and presentation of changes on fair value related to changes in own credit risk outside of profit or loss, would have been a more appropriate solution. One Board member was concerned that a third measurement attribute in this IFRS would make the standard complex and thus would fail objectives of the project. The staff responded that a majority of constituents in the outreach questioned the decision-usefulness of including changes in own credit risk in subsequent measurement of financial liabilities.

The Board continued to discuss the subset of financial liabilities to which the new measurement attribute would apply. The Board agreed to require a frozen spread measurement method for all financial liabilities that are not eligible for amortised cost measurement (but are managed as part of a contractual cash flow business model). The Board clarified that this new measurement attribute would not apply to instruments to which a fair value option was applied. Decision on the future of the fair value option would be made during the hedge accounting phase of the IAS 39 replacement project as well as in Phase II of the Insurance Contracts project, and it was felt that until those issues were tackled, no changes to application criteria and measurement of the fair value option should be made. Some Board members expressed their concerns about the application of this decision to embedded derivatives with financial liabilities as a host. Discussion on this topic continued later in the day.

The Board decided to provide a default method to isolate the initial credit spread (the approximation approach that is required in the context of disclosure requirements of IFRS 7). But the Board decided not to prescribe a method for isolating the initial credit risk spread and not to provide any additional guidance for more complex instruments. The Board felt that the variety of financial instruments is so great that it is impossible to cover all the instruments in any guidance. Nonetheless, several Board members were concerned by this lack of application guidance for more complex instruments, as it may lead to diversity in practise.

The Board approved the requirement to disclose methods and inputs used to isolate the credit spread by the reporting entity. The Board also agreed to require fair value disclosures for those instruments in the notes in accordance with IFRS 7.

Accounting for embedded derivatives

The Board was presented with the alternative to eliminate bifurcation of embedded derivatives. Several Board members were concerned that this decision together with the frozen spread approach adopted for measurement of financial liabilities would lead to hybrid instruments with a financial liability as a host not to be valued at fair value. By implication this means that the derivative part of the hybrid instruments would be valued at the frozen spread approach and not fair value. The staff defended this position by arguing that the credit adjustment to the derivative portion of the hybrid contract would not be significant. One Board member was particularly concerned about the effect of this decision on convergence – a point reinforced by a FASB member who expressed his view that such IASB decision would make convergence in this area next to impossible.

Nonetheless, the Board narrowly approved the elimination of bifurcation of financial liabilities as well as financial assets.

Interaction of classification conditions

The Board discussed the interaction of the two classification conditions proposed in the ED – basic loan features of the instrument and business model of the entity. Constituents were of the opinion that the test would be applied in the reversed order, as first an entity would determine the subset of instruments to which the business model applied and then test the characteristics of the instruments.

Some Board members were concerned by such changes to the proposal as it could send a wrong type of signal. That could mean that there would be a greater risk of slippage to the sole business model conditions by some of the practitioners, even though this was not the intention of the Board.

The staff supported by other Board members replied that the final wording of the standard would reinforce the message that the two classification conditions are cumulative and there is no hierarchy embedded in them. The Board agreed.

The 'other' measurement attribute

The Board discussed how the 'other' attribute should be defined. Most Board members agreed that amortised cost is the proper category. One Board member was concerned about how requirements for the other measurement category would interact with the 'adjusted fair value' measurement attribute determined by the frozen spread approach.

The Board decided that it would not require disclosure of fair value of financial instruments not measured at fair value on the face of the statement of financial position. The Board decided that this was not the proper time to adopt such a decision, given it had not been exposed in the ED and based on the outreach activities there were two divergent views on this issue among constituents.

The FASB member expressed his dismay that the Board seemed to be losing an opportunity to converge, as the FASB and IASB staff were discussing an approach that could potentially align presentation of financial instruments on the face of primary financial statements. The staff and the IASB Board members replied that this decision could be reversed in the future when convergence was discussed and assured the FASB member that this tentative decision did not preclude any agreement on this issue during the joint meeting later in October.

Fair value option

The Board decided to retain the fair value option requirements and guidance in IAS 39 if such designation eliminated or significantly reduced a measurement or recognition inconsistency. The majority of the Board members decided that fair value option guidance should not be changed until decisions on hedge accounting and insurance contracts were finalised.

One Board member seemed to be concerned about the apparent lack of convergence with the FASB on the fair value option requirements. He also felt that given the business model overlay, fair value option might not be necessary at all.

Elimination of cost exemption for unquoted equities

The Board revisited again this contentious issue. Board members reiterated their respective positions already discussed during previous Board meetings. The choice for the Board was between:

• elimination of the cost exemption and providing for more application guidance to determine a level 3 fair value for unquoted equities, or
• retaining the cost exemption in some form.

On this issue the Board was unable to adopt a final decision. The Board directed the staff to analyse this issue and to propose a guidance that could be accepted by both camps. An additional Board meeting was scheduled for the week of 12 October 2009 (timing yet to be confirmed) to address this issue again.

Financial Instruments: Impairment

Guidance for variable interest rates

The Board decided to provide application guidance on variable rate instruments that requires a catch-up adjustment (a mechanism that is used to ensure that the carrying amount of a variable rate instrument unwinds to the remaining expected cash flows by an adjustment to profit or loss, which changes the carrying amount of the instrument).

Presentation and disclosures

The Board discussed in detail the requirements for presentation and disclosure resulting from the change to the expected losses model of impairment. Some Board members expressed their concerns that the proposed disclosures were overly burdensome and would be too complex and costly to implement. On the other hand, the majority of Board members thought that the disclosures were necessary for the decision-usefulness of the financial statements.

The Board decided to require the following disclosures:

1. interest revenue based on contractual cash flows, adjustment for allocation of initial expected losses and changes in expectations of expected losses on the face of statement of comprehensive income
2. reconciliation of the provision account for credit losses by class of financial instruments
3. vintage information of financial assets held at amortised cost
4. loss triangle in table format and qualitative information in case of significant changes in loss estimates
5. disaggregation of the change in expectations of expected losses
6. management's assumptions and methodology in determining expected losses
7. high level 'sensitivity analysis' on key assumptions and effect of using reasonably possible alternatives
8. stress testing information if management performed stress testing for the internal risk management purposes
9. reconciliation of non-performing financial assets held at amortised cost
10. additional disclosures on transition from incurred loss model to expected loss model

The most significant discussion of disclosures focussed on the requirement to provide information on stress testing (#8 above). Some Board members felt that such disclosures are not appropriate as they would reduce comparability (not all entities would perform stress testing) and would not provide useful information (boilerplate disclosures). Other Board members disagreed. They argued that merely disclosing that the entity performed stress testing was potentially useful. Moreover, most of financial intermediaries may be required to perform stress-testing by the regulators.

Some discussion was directed also to the vintage and loss triangle disclosures (#3 and #4 above). Some Board members felt that those disclosures were not cost beneficial, and on an aggregate level as proposed would not provide the intended information. They pointed out that practices in risk management might differ among entities, and thus the quality of the portfolio was very much influenced not only by the date when the financial instruments were originated but also by the type and quality of an entity's risk management practices. Most Board members disagreed. They noted that these data should be available to any institution as they are based on contractual cash flows and are necessary to assess the risk profile of any portfolio for internal risk management purposes.

Interaction with other IFRSs (IAS 28 and IFRS 4)

The Board considered the consequential amendments to IAS 28 and IFRS 4 resulting from the change of the impairment model.

The Board decided to use the impairment indicators in IAS 36 to determine whether additional impairment testing was required for an investment in associate. The Board considered this approach appropriate, as the amount of impairment loss is measured in accordance with IAS 36 under current IAS 28 requirements.

The Board also agreed to retain the existing requirement for reinsurance assets in IFRS 4 as it felt that eliminating the loss event guidance in IAS 39 would not result in a change in accounting policies for entities applying IFRS 4 to reinsurance assets.

Comment period

The Board briefly discussed the expected comment period. The staff re-affirmed the intention to publish the Impairment ED in October. The staff proposed an extended 180-day comment period for the ED so the Expert Advisory Panel would have a sufficient time to finalise its application guidance for re-deliberations. Some Board members proposed an even longer comment period (9 months). The Board agreed that an extended comment period is desirable given the complex nature of the proposal but deferred a final decision on the comment period to a future Board meeting.

Financial Instruments: Hedge Accounting

Application of cash flow hedge accounting mechanics to fair value hedges

The Board considered the application of the Board's September 2009 decision to replace fair value hedge accounting with a mechanism that permitted recognition outside profit or loss of gains and losses on financial instruments designated as hedging instruments – that is, applying the mechanics of cash flow hedge accounting also to fair value hedges. The major implication would be the application of the so-called 'lower-of test' to fair value hedges. The 'lower-of test', currently applied to cash flow hedges only, ensures that only ineffectiveness due to excess cash flows on the hedging instrument (that is, the derivative) is recognised in profit or loss.

The Board members disagreed with the extension of the 'lower-of test' to fair value hedges. The Board was concerned that it was inconsistent with the nature of fair value hedging, could lead to changes in eligibility of portions, could have unintended consequences in the area of deliberately under-hedging, and in effect would lead to a situation that there would be no ineffectiveness in fair value hedges as such. A FASB member clarified that in the FASB approach to hedge accounting (given the recent discussions over the issue) the 'lower of test' would not be applied to fair value hedges.

After a short debate the Board decided by a bare majority (8 votes) to retain the 'lower-of test' for cash flow hedges only. A third of the Board members abstained in this vote.

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