• Discussed at June 2009 IASB Meeting
• Exposure Draft published 14 July 2009. Comment deadline 14 September 2009. Click for More Information.
• Discussed at the September 2009 IASB Meeting
• Discussed at the Special 22 September 2009 IASB Meeting
• Discussed at the Special 29 September 2009 IASB Meeting
• Discussed at the Special 6 October 2009 IASB Meeting
• Discussed at the Special 15 October 2009 IASB Meeting
• Discussed at the Special 16 October 2009 IASB Meeting
• Discussed at the October 2009 IASB Meeting
• 12 November 2009 IFRS 9 Issued
• Discussed at December 2009 IASB Meeting – Liabilities
• Discussed at January 2010 Joint IASB-FASB Meeting
• Discussed at 10 February 2010 Special IASB-FASB Joint Meeting – Liabilities
• Discussed at February 2010 Joint IASB-FASB Meeting – Liabilities

Timetable

• Click for IASB Project Timetable

Discussion at the Special IASB Meeting 1 June 2009

The staff opened the meeting by summarising the tentative decisions reached by the Board in last month's meetings. These included:

• A working premise of two measurement bases of fair value and amortised cost.
• A starting point for classification based on the approach adopted by the forthcoming IFRS for SMEs.
• Retention of a fair value option in some form (although not intended to be discussed at this meeting).
• Not permitting any reclassifications.
• Removal of tainting rules and replacement with additional disclosure requirements.

Classification - principles that govern characteristics of financial instruments

The staff then presented their principles based, two-step approach to classifying financial instruments that entails first characterising financial instruments that qualify for amortised cost accounting and then applying a business model overlay to override amortised cost accounting with mandatory fair value accounting. This approach is based on the IFRS for SMEs as a starting point with changes to derive a principle for classification based on cash flow variability of a financial instrument.

Some Board members raised concerns that principles developed could not be operational. They said that characterising instruments based on cash flow variability added complexity and ignored fair value variability. One Board member particularly objected to the consequence of applying the two-step approach to a loan asset with a written cap, which would result in amortised cost accounting for the instrument as a whole. The Board member preferred an approach that considered all terms of the instrument (not just cash flow variability), which in this case should result in the instrument to be accounted for at fair value through profit or loss in its entirety. Not to do so would ignore the instrument's fair value variability introduced by the written option. Another Board member, who supported the staff's proposal, suggested such fair value variability existed for 'vanilla' fixed-rate instruments and hence should not be of concern in itself. However, the concern was more based on the asymmetrical fair value variability, as opposed to just variability.

Some Board members supported the staff's approach and considered a principle based on cash flow variability favourable over an approach that started with a list of instruments for each classification.

When asked by the Chairman, a majority of Board members agreed with the general thrust of the staff's proposal of amortised cost for certain 'vanilla lending instruments' and fair value for all other instruments.

Classification - implications of the business model

The Chairman introduced the next staff paper dealing with the business model overlay. He drew the Board's attention to the staff recommendation that the business model overlay require mandatory fair value measurement for those instruments that are managed and their performance assessed on a fair value basis (which is intended to include all financial instruments held for trading). The staff explained that this would broaden the fair value measurement requirement.

The Board discussed whether a very liquid financial asset (such as a traded treasury bond) available as a liquidity reserve should ever qualify for measurement at amortised cost. Most Board members felt that it should not.

Some Board members felt uncomfortable with the staff's recommendation that could result in an entity recording, at the same time, some liquid treasury bonds at fair value (if held for trading) and some at amortised cost (if held for non-trading purposes and not managed or assessed on a fair value basis).

Some Board members approved of the business model overlay as they felt it was based on fact (the business model) as opposed to management intention or any chosen designation.

One Board member disagreed with the notion that classification based on a business model would result in decision useful information.

The Chairman summarised the Board's views as supportive of a version of an overlay that would require fair value accounting for certain instruments, which would at least include instruments held for trading. He proposed the staff consider the Board's comments and come back with a refined approach.

Classification - Implication for embedded derivatives

The staff presented three alternatives to deal with embedded derivatives in the revised standard as follows:

• Alternative one: Maintain the existing requirements
• Alternative two: Eliminate the concept of embedded derivative accounting
• Alternative three: Change the bifurcation criteria

The Chairman explained he instinctively would support alternative two. The staff's view was that this would be a significant change and would be difficult to implement in the time frame given that the rules for assessing derivatives embedded in non-financial instruments would have to be retained. The staff felt that changes to the rules on embedded derivatives would require wider consultation.

One Board member disagreed with the staff's recommendation for alternative one. He felt that a classification principle could be designed to accommodate embedded derivatives in financial instruments which would result in the entire instrument being classified as fair value through profit or loss.

Another Board member felt uncomfortable dealing with embedded derivatives at a later stage as this would result in a piecemeal approach to overhauling IAS 39.

The staff agreed to reconsider its views based on the Board's comments.

Equity Instruments: OCI method

The staff reminded the Board of its tentative decision in the May meetings to consider a fair value measurement basis where gains and losses were recorded in other comprehensive income with no subsequent recycling.

The staff's recommendation put forward was to allow an entity, on initial recognition, a free choice to designate equity investments at fair value with gains and losses recorded in other comprehensive income. The designation would be irrevocable.

The Board was divided, with some not supporting the free choice and others happy that the irrevocable designation and enhanced disclosure requirements would impose sufficient discipline. Those that opposed the free choice wanted the designation to be restricted to specific situations where the benefit of holding the investment was to fulfil a wider business objective and not for income or capital gain purposes. The staff explained they set out with the intention to limit the designation but then found it too difficult to set definitive criteria.

Some Board members were uncomfortable with the possibility that under the staff's recommendation different purchases of the same equity investment could be given different classifications (that is some at fair value through profit or loss and some at fair value through other comprehensive income).

Transitional provisions and equity instruments cost exemption

The meeting continued past the scheduled time and four Board members left the meeting. The Chairman proposed that the meeting continue to discuss the remaining papers with no decisions to be made until the next meeting.

The staff put forward their recommendation for retrospective application of the proposed changes, in accordance with IAS 8, along with additional disclosure. The basis for this recommendation was to enhance comparability with the comparative period and avoid changes in measurement basis part-way through a reporting period (which could be the case if prospective application was permitted from, say, November 2009).

Some Board members were concerned that preparers may use the benefit of hindsight to determine fair values. Others felt this would not arise as fair values would have already been reported.

The staff agreed with the Board's concern that computations of amortised cost could be costly and time consuming.

As the meeting drew to a close the staff's recommendation of removing the cost exemption for certain unquoted equity investments was briefly tabled to gauge from the remaining Board members whether there were any objections. None were raised.

Discussion at the Special IASB Meeting 5 June 2009

The staff began the meeting by summarising the current classification model that is being pursued. In summary, financial instruments will be measured at fair value or amortised cost. Amortised cost will apply to debt instrument assets that are not held for trading that are deemed 'basic' and are managed on a contracted yield basis (the detailed criteria to be determined at the next Board meeting). Equity instrument assets not held for trading that meet a specified principle (to be determined at next meeting) will be fair valued through other comprehensive income (OCI) with no recycling and no impairment assessment. Other financial instruments will be fair valued through profit or loss. It is expected there will be a fair value option in the case of an accounting mismatch.

The following areas will also be discussed at the next meeting (week of 15-19 June 2009):

• Embedded derivatives – whether to retain the existing guidance for financial host contracts or to remove the guidance and instead look to the amortised cost definition to identify characteristics of those debt instruments that will be at amortised cost and those that will be at fair value through profit or loss.
• How the classification model will deal with debt instruments that have a concentration of credit risk.
• Use of the fair value option.
• Use of other comprehensive income (OCI) to record fair value gains and losses for equity instruments. The staff indicated that if a principle was developed for the use of OCI to record gains and losses for certain equity investments, there should be a discussion of whether reclassification may be required. This is because the principle allowing the OCI treatment may become applicable or cease to be applicable to a given equity investment subsequent to initial classification.

Before proceeding, the Chairman asked each Board member whether they broadly agreed with the direction in which the project was heading with regard to classification. All members except one agreed.

Transitional provisions

The staff summarised the view with which Board members present at the meeting on 1 June 2009 broadly agreed, basically a retrospective application approach subject to exceptions that would be addressed in more detail at the regular June Board meeting.

The Chairman requested views from the Board members who were not present at the last meeting when transitional provisions were discussed.

One Board member accepted that IAS 8 establishes a general principle for retrospective application which he agreed with. However, he felt that the appropriateness of that principle in this scenario depended on the robustness of the chosen classification model. For example, a loose classification model allowing an entity to effectively choose a measurement basis for each financial instrument may not be suitable for retrospective application because of the ability to be selective over the reversal of past recognised losses.

One Board member noted that entities selecting amortised cost accounting over fair value accounting to reverse past recognised losses would also restrict themselves from recognising future fair value gains.

Another Board member raised concern that they could not comment on the appropriateness of retrospective application without knowing the impact of the chosen classification model.

The staff felt that one of the main impacts of a revised classification model would likely be that some debt instruments currently classified as available for sale (AFS) would instead be measured at amortised cost (because of the removal of the tainting rules). Other impacts would depend on decisions made at the June Board meeting, such as the treatment of hybrid instruments.

The Chairman reiterated that the objective of the current meeting was to establish whether any Board members opposed to the staff pursuing further retrospective application. When put to the vote all except one agreed that the staff should proceed with preparing a more detailed paper on retrospective application for the main June Board meeting.

Board members requested that any staff paper on the matter include a cost benefit analysis of retrospective application and include examples of application. The staff stated that there were a number of areas to address with respect to retrospective application, including hedge accounting, impairment, and previous application of the fair value option/reclassifications amendment, which would be covered in their paper.

Equity investments: cost exemption

The staff began by summarising that the Board members who discussed the equity investment cost exemption at the last meeting broadly agreed with the proposal to remove it. The Chairman then asked each Board member who was not present at that meeting to provide their view. Of all the Board members, two did not agree with the proposal to remove this exemption. The reason given was the impact it would have on non-financial institutions holding significant unquoted equity investments. One Board member felt that fair values calculated would be unreliable and difficult to audit.

Another Board member suggested whether the criteria for fair value through OCI should be different for unquoted equities.

Timetable

The staff provided a summary of upcoming documents and meetings:

• The staff will be presenting educational webcasts next week to provide information on the project to date.
• An invitation to comment staff paper is due to be issued in June 2009 regarding the incorporation of credit risk in liability measurement.
• The classification and measurement exposure draft is planned to be issued in July 2009, with a minimum of a two month comment period. Comments would then be deliberated with the expectation of a final standard issued by December 2009. The staff confirmed that there was no intention to a make any final standard on classification mandatory for December 2009 year end financial statements, that is, it would be available for early adoption.
• A request for views would be issued on impairment in July 2009 which would ask specific questions on the implementation challenges of different models. Comments received would provide input into Board discussions in September with an exposure draft planned for October 2009. At the June Board meeting, BNP Paribas will present to the Board the challenges of amortised cost accounting based on an expected loss model. Bank of Spain would also present their dynamic provisioning model.
• An exposure draft dealing with hedge accounting is planned for issue in December 2009.

Discussion at the Regular June 2009 Board Meeting

Monday 15 June 2009 – Educational Session: Operational Challenges of an Expected Loss Provisioning Model

Four representatives from BNP Paribas appeared before the IASB 'as fellow thinkers' to discuss the operational challenges of the expected loss provisioning model. They based their assessment on the expected loss model put forward by the IASB staff in May 2009, and in particular Agenda Paper 5D. The BNP team attempted to illustrate how such a provisioning model might be applied in their circumstances.

A key question for financial institutions would be whether the expected loss method reduced pro-cyclicality in financial reporting or whether it would be counter-cyclical. Their initial reaction was that the expected loss model was less pro-cyclical than the incurred loss model, but was not counter-cyclical.

BNP Paribas had estimated that the cost of implementing an expected loss approach to loan loss provisioning would be significant and would extend for three years: one year for development of systems and two years for deployment. Variable rate assets were problematic, and the systems consequences of such instruments still needed to be explored. Speaking personally, one of the presenters thought that banks would be prepared to incur these significant costs if the approach reduced pro-cyclicality. However, the banks would probably not want to incur those costs if they also had to deal with an additional regulatory loss provision.

One problem with using the Basel II data is that it is very crude: the cut is short-term versus long-term, whereas the expected loss model would require more granularity in the data captured by the systems. Some operational efficiency could be achieved by being able to monitor portfolios of similar loans rather than individual loans, but that would also involve systems challenges, given the sheer volume of different types and maturities of loans involved. Again, this still needed to be explored.

Board members probed various aspects of the model with the presenters and clarified certain points. It was clear from the presenters that it would simplify their lives as preparers if there was a high degree of consistency between the data needed for loan loss provisioning for financial reporting and prudential regulatory purposes. However, it was also obvious that some Board members were still uncomfortable with some of the smoothing consequences of the expected loss model.

Both sides expressed a desire to continue to work collaboratively on exploring the expected loss model. The IASB staff reminded constituents that a Request for Views document is expected to be released later in June or very early in July 2009 and would explore the expected loss model in an attempt to gauge its feasibility.

Tuesday 16 June 2009 – Discussion of Comprehensive Project to Replace IAS 39

The staff opened the meeting by laying out the agenda which would consist of board discussion and vote on the seven items below relating to the proposed new classification structure and transitional provisions.

Embedded derivative accounting

The staff summarised their paper on the subject which contained three alternatives for the board to consider. They were as follows:

• Alternative 1A: Use the embedded derivative assessment as a filter for classification. Under this alternative embedded derivative assessment and any bifurcations would take place as under existing requirements in IAS 39, and in a second step the bifurcated derivatives, host contracts and hybrid contracts which had not been bifurcated would be classified using the new criteria.

• Alternative 1B: Use the embedded derivative assessment as currently exists in IAS 39 as the classification assessment itself. Under this approach embedded derivatives which are separated would be automatically classified at fair value, and the host at amortised cost. If no bifurcation takes place the instrument automatically qualifies for amortised cost in its entirety.

• Alternative 2: Eliminate the concept of embedded derivatives altogether. Under this approach a hybrid instrument would be classified according to the new criteria in its entirety. Thus a derivative embedded in a debt instrument, for example a commodity price indexation, could result in a cashflow stream which disqualified the instrument from being classified at amortised cost under the new criteria and the entire instrument would be classified at fair value. However features such as interest rate caps, floors or collars which would result in an instrument's yield being switched from fixed to floating rate or vice versa would not preclude an instrument from being classified at amortised cost. This is because, since both fixed rate instruments and floating rate instruments would qualify for amortised cost, the staff viewed an instrument which combined the two elements should also qualify for amortised cost accounting in the absence of any other features. Given that a potential weakness of this approach is that a relatively insignificant embedded feature could result in an instrument being classified at fair value in its entirety, the staff recommended the introduction of a materiality overlay to assess the significance of such features on the variability of cash flows from the instrument as a whole for classification purposes.

Two board members voiced strong support for alternative 2 as the cleanest and simplest approach, and therefore the approach most in line with the objective of reducing complexity. It was pointed out that there would be no interaction between the embedded derivative provisions laid out here and the proposed treatment of the fair value option since it was proposed that the latter would only be retained for elimination of accounting mismatches. One board member believed the materiality overlay suggested as part of alternative 2 should not be retained as materiality should be a consideration in interpreting all standards. Three other board members voiced support for this opinion.

In response to concerns that alternative 2 would lead to change on a large scale, one board member commented that there would be sufficient lead time if an adoption date of 1 January 2011 was adopted. One board member commented that there could be potential for financial engineering given that some instruments containing embedded derivatives would be measured at amortised cost. Another board member responded to this concern by stating that it would be doubtful that instruments containing complex or multiple embedded derivatives would qualify for amortised cost treatment.

11 board members voted in favour of alternative 2. A majority voted against inclusion of the materiality overlay, with 2 votes in favour.

Concentrations of credit risk

The staff summarised their recommendations in this area. The issue relates to concentrations of credit risk at the individual financial instrument level due to subordination, that is, the existence of a priority of payments structure for different instruments issued by the same debtor. The implication of this is that senior and secured creditors are not usually leveraged and thus would meet the criterion of 'having only basic loan features'. However junior instruments held within a waterfall structure would be contractually leveraged, providing credit protection for more senior tranches. Instruments which provide protection for other tranches would not be basic lending transactions and so would be required to be measured at fair value. However subordinated debt instruments within a general creditor structure which is not a waterfall would not be contractually leveraged since they reflect the default ranking established under commercial law. As such they would satisfy the criterion of having only basic loan features.

There was some discussion as to whether this would contradict the tentative agreement that basic loan features would be defined as having only principal and interest cashflows, since all tranches including junior instruments issued would satisfy this criterion. However the board agreed that the element of contractual leverage and consequent differential in credit risk between senior and junior debt adds another factor to cashflow profile and so there is no inconsistency.

The board agreed (13 votes in favour) that application guidance should be included on concentration of credit risk, and also concurred with the staff position differentiating waterfall structures and creditor ranking as a basis.

Fair value option

The staff presented their position that the fair value option should be restricted to the eligibility criterion that the designation eliminates or significantly reduces an accounting mismatch. As such two of the criteria currently permissible under IAS 39, namely:

• Where a group of financial assets or liabilities is managed and its performance evaluated on a fair value basis, and
• Where a hybrid contract contains an embedded derivative, unless that embedded derivative does not significantly affect the cash flows or is closely related to the hybrid contract

One board member, agreeing with the staff position, noted that it should be made clear within the literature that the two criteria which would be dropped were already dealt with elsewhere by the new measurement criteria.

The board voted in favour of the staff position.

OCI method for equity instruments

The staff referred to the board's tentative position that fair value changes for certain equity instruments would be allowed to be presented through other comprehensive income (OCI) but that and subsequent transfers to profit or loss, including on disposal, would be prohibited. The staff presented two possible approaches with regard to when OCI treatment would be permissible:

• Approach 1. An entity would have the option on initial recognition of designating any equity instrument as at fair value through OCI. The designation would be irrevocable and made on an instrument-by-instrument basis. On derecognition of an instrument the amount in OCI would be transferred to retained earnings. Disclosures would be required to make transparent why an entity has invoked the option and what the effect on the financial statements has been.

• Approach 2. Designation as at fair value through OCI would be governed by a principle. A possible starting point for such a principle would be as follows:

  An equity instrument that is held in a broader business context and not primarily for realising the financial benefits inherent in it shall be accounted for as at fair value through other comprehensive income.

The staff recommended the second approach, with reclassifications in and out of the OCI category required if the strategic relationship in relation to an equity investment changes, such that the principle no longer applies or only begins to apply at a date after initial recognition.

One board member disagreed with the staff position on the basis that the reclassification criteria would introduce added complexity. It was noted that the OCI category is a concession by the board and it would be inappropriate to introduce a new principle. Furthermore it was noted that reclassification criteria could be abused if entities anticipated gains or losses in certain instruments. There was some discussion as to whether a sufficiently robust reclassification model would prevent such abuse. Some board members also commented that the proposed principle lacked clarity.

One board member opined that the prohibiting of reclassifications would introduce sufficient discipline when entities designate which instruments to classify at fair value through OCI and limit the potential for abuse.

Another board member noted the example of an entity which is a venture capital company with a variety of investments. A free choice in designating some investments as at fair value through OCI and others as at fair value through the income statement would result in lack of transparency, and users would need to look at the entire statement of comprehensive income in order to understand results.

However several board members pointed out the fact that appropriate wording for any principle was problematic and may result in the need for copious guidance going forward.

The board voted against a principle-based approach in designating which instruments should be at fair value through OCI. 4 members voted in favour. The board also voted in favour of assessment on an instrument-by-instrument basis in designating.

The staff recommended that IAS 18 should be amended in order to exclude dividends receivable for equity instruments at fair value through OCI from the revenue recognition guidance. There was some discussion as to whether transfers to retained earnings for dividend income could be permissible and IAS 16.41 was cited as a parallel. One board member also noted that guidance would be required in relation to areas such as EPS disclosure and the statement of cash flows. The board agreed with the staff's view with regard to IAS 18.

Transition: retrospective application

The staff took the board through its recommendations around retrospective/prospective application in 12 different areas.

1. Classification model and assessment whether an instrument is managed on a contractual yield basis – the staff recommended retrospective application, however assessment of the contractual yield basis criterion should be based on facts and circumstances as at the date of transition to the new guidance. The board agreed with this approach.

2. Designation of equity instruments fair valued using the OCI method – the staff recommended full retrospective application. The problem of obtaining fair values for equity instruments held at cost is addressed in (8) below. There was no board disagreement to this recommendation.

3. Treatment of available-for-sale reserves for instruments measured at AFS under the current guidance – the staff recommended full retrospective application with amounts in OCI relating to AFS instruments should be reclassified to opening retained earnings if they relate to instruments shown at fair value through the income statement under the new guidance. For instruments treated as AFS under the current criteria which will be required to be measured at amortised cost under the new guidance, issues around impairment calculation are addressed at (7) below. The board agreed with the staff recommendation.

4. Hybrid contracts where an embedded derivative was separated under the old guidance and where the hybrid contract is required to be at fair value under the new guidance – the staff recommended full retrospective application. The fair value of the hybrid contract would be the sum of the FV of the previously separated embedded derivative and the FV of the host which had been disclosed previously under IFRS 7. For treatment of hybrids requiring amortised cost treatment under the new guidance and consequent impairment issues see (7) below. Two board members voiced the opinion that there should be consistency in application across the different areas to as great an extent as possible. The board agreed with the staff's recommendation (9 votes in favour).

5. Fair value option – the staff recommended that the assessment for designation and dedesignation should be required on the date of transition, and that the accounting consequences should be applied retrospectively. There was no board disagreement to this proposal.

6. Effective interest rate – the staff recommended retrospective application for instruments which are measured at amortised cost under the new criteria where there had been a different measurement basis previously. This would involve determining the estimated future cash flows considering all contractual terms of the instrument, fees, transaction costs and premium/discounts and generating an internal rate of return. The staff believed that this would be essential for the requirement to report financial instruments at amortised costs going forward. The board agreed with the staff recommendation.

7. Impairment – the staff recommended prospective application with a requirement for an impairment test at the date of transition, and any impairment charge recognised in profit or loss. The board considered whether retrospective application might be possible. One board member opined that a stream of cashflows would be available from previous fair value calculations in order to perform a retrospective impairment assessment, however it was pointed out that some fair values are derived from quoted prices where there is no stream of cashflows used in the calculation. Another board member noted that there may be a large adjustment if there is prospective application. Another board member suggested an alternative treatment whereby the fair value of an instrument as a proxy for the impaired amount for the purposes of recording impairment retrospectively. There was some discussion about whether cash flows should be used where available for a retrospective calculation and, where this was not possible, fair value should be used as a proxy. It was noted that reversals in periods prior to presentation would not cause problems as any current impairment calculation would override previous impairments. It was concluded that the staff should explore the possibility of using fair value in this context.

8. Financial instruments measured at cost – the board had already agreed that the exemption for unquoted equities from fair value measurement should not be retained under the new classification system. The staff suggested that the fair value for these instruments should be determined at the date of transition and the difference recognised in profit or loss on transition. The question was raised by two board members why the difference should not be taken to retained earnings on transition as an adjustment of the opening position as per an IAS 8 change in accounting policy. However it was pointed out that it would be too difficult to fix which periods the change in FV would belong to.

9. Hedge accounting – the staff proposed the view that any hedge relationship which has to be dedesignated under the new criteria should be treated as a discontinuation of hedge accounting. This would provide transitional relief for preparers as it would not be necessary to identify and reverse any hedge accounting effect retrospectively. One board member commented that it would be difficult to interpret this transitional provision given that the guidance on hedge accounting would not be out in July 2009. The staff noted that the fair value option was still available to eliminate mismatches in cases where hedges were discontinued and hedged items would otherwise have been required to be measured at amortised cost. There was no board disagreement to the staff proposal.

10. Disclosure – the staff proposed no transitional relief in the requirement to disclose comparative amounts under IFRS 7 relating to the new classification and measurement system. The board agreed and there were no dissenting opinions.

11. Disclosure on transition – the staff did not propose any requirements additional to the provisions already included in IAS 8.28 for initial application of an IFRS. The board agreed with the staff view and there were no dissenting opinions.

12. Comprehensive additional disclosures for early adopters – in order to ensure comparability between entities the staff proposed the following disclosure requirements for early adopters:
    • An additional statement of financial position in accordance with current IAS 39 for all periods presented
    • An additional statement of comprehensive income in accordance with current IAS 39 for all periods presented
    • A table comparing the carrying amount under the current version of IAS 39 with the carrying amount under the new guidance per class, for each period presented
    • Narrative information on how the entity applied the new classification model and how the model impacts the entity's financial position and performance in the current and preceding periods

All of the above disclosures would be required for each period until the new guidance becomes effective for all entities reporting under IFRSs.

The staff explained that there had been a high level of correspondence and consultation on the subject of disclosure for early adopters. The rules in effect would produce a high barrier to early adoption. On board member commented that the requirements appeared excessive; however, he understood the need for them.

The staff suggested an alternative view whereby disclosure requirements for early adopters would be limited to disclosure on the effect of choices made, as compared to the position pre-transition. The chairman suggested that this could be published as an alternative view within the exposure draft.

Another board member commented that, if the new requirements are superior, the board ought not to place high barriers to early adoption. This view was supported by another board member. The staff commented that comparability was the only reason for the proposed disclosure requirements. The chairman suggested that views should be passed to the staff in the week of 15 June 2009 in relation to the potential alternative view.

Consequential amendments to IFRS 1

The staff proposed some consequential amendments to IFRS 1 in relation to designation date option (that is, the option to designate financial instruments either at the date of initial recognition or the date of transition to IFRSs) and some implementation guidance-related issues, including guidance on embedded derivatives as well as classification and measurement issues. Board members asked whether it was necessary to include this in the first phase of the project, or whether it would be more sensible to postpone IFRS 1 amendments to the second phase.

Consequential amendments to IFRS 7

The staff presented consequential IFRS 7 amendments to reflect the new categories and eliminate disclosure for areas no longer relevant (such as reclassifications). There were no dissenting opinions from the board.

Sweep issues

The staff presented four other issues to the board as follows:

1. The staff did not propose to address the issue of scope of IAS 39 in this phase of the project. The board agreed with the staff suggestion.
2. The staff recommended that there should be no changes proposed to the requirements around day 1 gains and losses in the exposure draft. The board agreed with the staff recommendation.
3. The staff noted that two of the annual improvements to IAS 39 to be included in the forthcoming exposure draft, in relation to effective interest rate and bifurcation of embedded derivatives, may no longer be relevant. It was noted that the exposure draft for the annual improvements would have an effective date of 1 January 2011, and that the effective date for the revised classification and measurement requirements may be 1 January 2011 or 1 January 2012. One board member voiced support for an effective date of 1 January 2012, since all of the proposed amendments ought to apply at the same time. It was decided to include the question in the September exposure draft for annual improvements.
4. The staff did not recommend any changes to the IAS 39 measurement guidance in relation to financial guarantee contracts, loan commitments or financial liabilities with a demand feature. The board agreed with the staff position.

Final discussions

The chairman stressed that, if appropriate, alternative views could be expressed in the exposure draft in relation to the new classification and measurement rules. One board member held an alternative view which was supported by another board member. The chairman suggested that the alternative view should be discussed between the board member and the staff and that a further discussion would be held on Friday, 19h June 2009.

The board member gave a brief outline of the alternative view. This was that, for certain debt instruments which were not loans and receivables, income could be presented in the income statement but fair value movements through OCI. Thus fair value information would be given on the balance sheet and also an amortised cost-based income stream in the income statement whilst preserving the fair value basis. As such the amortised cost model would only be retained for loans and receivables. However the same criteria would exist for classification at amortised cost (i.e. managed on a contractual yield basis). It was concluded that a paper would be produced, summarising this view.

The chairman noted that this alternative view and that for disclosures on early adoption should be discussed on Friday, 19 June 2009.

Wednesday 17 June 2009 – Education Session by Bank of Spain (BdE) Representatives: the BdE Provisioning Model

Two representatives from the Bank of Spain (regulator of Spanish banks) presented the statistical provisioning approach which the BdE requires from entities regulated by them. The representatives explained that, in their opinion, the model incorporates losses incurred due to under-pricing of credit in times of boom in the lending cycle due to market over-optimism. The lending cycle per the model is closely correlated with the economic cycle as a whole.

The model is based on a statistical formula which incorporates an element of collective impairment relating to the point in the lending cycle ('alpha') and incurred losses relating to individual assets ('beta'). The alpha component is a collective assessment and applied to the change in the portfolio of assets at each date of assessment. Thus in times of boom in the lending cycle, the alpha component is high relative to the beta component, whereas this trend is reversed in times of slump as incurred losses relating to the general cycle are in effect transferred to individual assets; the alpha element can be negative, reflecting over-conservative pricing of credit. The representatives explained that they believe the advantage of the model is the early detection of credit losses.

The Bank has around 6 asset classes which it views as homogeneous, for each of which an alpha (effect on asset class of stage of the lending cycle) and beta (historical incurred losses relating to individual assets) are kept. In order to assess the lending cycle, the BdE holds data from the Spanish national credit register dating back to 1988 for each of the asset classes, which equates roughly to 2 full lending cycles. The representatives stressed that this is an incurred loss model as the inputs to the model are derived only from historic experience.

Board members asked questions around various aspects of the model. One member asked what approach the BdE takes for new products where there is little historic data. The representatives replied that this was not an issue that had caused much difficulty in Spanish banking given the relative absence of new products – for example, credit cards represented only around 1% of total lending in Spain. Another member pointed out that, for loans given out during periods of boom, the model effectively results in a large 'day 1'-type loss for lenders. The representatives replied that this was a necessary reflection of credit pricing in these times.

Another member asked whether BdE was aware of how much credit data other central banks held, and thus how practicable a system such as this would be for banks from other countries. The representatives replied that they were aware of some central banks holding extensive credit data; however it was unlikely that many would hold data in sufficient detail going back as far as 1988. Another board member asked whether, if an expected loss model were incorporated within IFRS, the bank would continue to use its model. The representatives replied that, in their opinion, it was possible to use the model to estimate expected losses, however it would be a relatively simple approach. The representatives agreed with board members' views that, were this model adopted more widely, more active involvement would be required from banking supervisors in assessing provisioning than is currently the case given the complex nature of the model and underlying data. The representatives put forward the view that, in times of economic difficulty such as the present time, banks would be less likely to voice the view that an approach such as their model would lead to competitive disadvantage. This had been their experience in Spain.

The chairman thanked the representatives for their presentation.

Friday 19 June 2009 – Transition: Disclosure Requirements for Early Adopters

The staff noted that the Board's forthcoming proposed amendments to IAS 39 would be effective for annual financial years beginning on or after 1 January 2012, with early adoption permitted.

The Board considered staff proposals designed to address Board members' concerns that disclosures would be required for early adopters to increase comparability with entities that do not adopt early. The staff noted that IAS 8.28 already requires extensive disclosure in the year of initial application of an IFRS. However, they maintained their view that additional disclosures for early adopters were necessary to assist users in comparing the financial position and performance of entities adopting the amendments before the mandatory application date. However, they acknowledged a need for a balanced approach, so that any disclosure was not overly onerous so as to discourage early adoption.

The staff clarified that these proposed disclosures would not apply to first time adopters, and that an amendment to IFRS 1 would be made to clarify this (the disclosures address the transition from the current IAS 32/39 model to the proposed model, not adopting the new model from a previous GAAP).

The Board agreed (one opposed) that the following disclosures (additional to those required by IAS 8.28) should be made in the year of adoption if the final requirements are adopted before the mandatory application date.

• (a) A table displaying all financial instruments, aggregated by class as defined in IFRS 7, whose measurement basis or the presentation of gains or losses had changed as a result of applying the new guidance, disclosing:
  • (i) the original and new measurement basis
  • (ii) the original and new carrying amount
  • (iii) the reasons for the change in the measurement basis or presentation method.
• (b) a table displaying the reclassified amounts as a result of any:
  • (i) designations into the fair value option including the original measurement bases (and presentation method) and carrying amounts;
  • (ii) designations out of the fair value option distinguishing between permitted and required dedesignations including the original measurement bases (and presentation method) and carrying amounts; and
  • (iii) the reasons for any such designation and dedesignation.

One Board member thought that, while he understood the intention of the proposed disclosure, the result would be ineffectual boilerplate. The revised standard would permit changes in presentation and measurement, and a preparer might legitimately state in the footnote that the entity had adopted a new accounting policy because the IASB allowed it to do so! Other Board members thought that this position was extreme, and that a sensible application of the requirements would yield the appropriate disclosure.

There was some concern among Board members about how the proposed disclosure would apply to interim reporting. The staff agreed to confirm the implications of their proposals on interim reporting and revert to the Board if necessary. If no Board decision was necessary, the interim reporting consequences would be explained in the exposure draft.

Friday 19 June 2009 – Description of Possible Alternative Features to the Exposure Draft Model

The Board discussed a proposal put forward by a Board member describing some additional features (variants) of the classification model developed by the Board. Under this variant:

• (a) Financial assets with basic loan features that are managed on a contractual yield basis would be measured at fair value in the balance sheet, unless they meet the definition of loans and receivables in IAS 39.
• (b) Such financial assets would:
  • (i) be measured on an amortised cost basis in profit or loss (including recognition of impairment using the incurred loss provision requirements in IAS 39); with
  • (ii) any difference between that amortised costs measure and the fair value change being recognised in other comprehensive income. There would be no recycling between OCI and profit and loss.

The effect of this proposal was that potentially more financial instruments would be measured at fair value on the balance sheet, but the value change would be allocated between profit and loss and other comprehensive income in the statement of comprehensive income.

Board members discussed this variant for a while, suggesting other possible variations. At least one member thought the variant as 'dead on arrival' and would not support it. Another Board member thought that it was unhelpful to mix the measurement of financial instruments between the statement of financial position and the statement of comprehensive income. If an item was reported on the statement of financial position at fair value, changes in that measure should be reported in profit and loss. A mixed allocation method, such as proposed with the amortised cost component being reported in profit and loss and the 'plug' between that amount and the value change being reported in other comprehensive income was likely to lead to problems and the Board developed other aspects of the revised financial instruments package.

In particular, some Board members were concerned about the consequences of this variant on hedge accounting, especially that the mixed allocation might add rather than reduce complexity in some situations. If hedging is designed to manage what is recognised in profit and loss, allocating some of the exposure being hedged to other comprehensive income would create challenges in hedge accounting, in particular assessing effectiveness.

While not commenting on its merits, the Board agreed that the variant should be discussed in the forthcoming exposure draft's Basis for Conclusions (as will all the alternatives considered in detail by the Board) and that comments should be invited on it.

July 2009: ED on financial instruments classification and measurement

On 14 July 2009, the IASB published an exposure draft (ED) on Financial Instruments: Classification and Measurement as the first part of its three-phase project to replace IAS 39 Financial Instruments: Recognition and Measurement. The Board decided to address classification and measurement of financial assets and financial liabilities first because they form the foundation of a standard on reporting financial instruments. Moreover, many of the concerns about IAS 39 that have been expressed during the financial crisis relate to its classification and measurement requirements. The other two phases of the IAS 39 project are addressing Impairment and Provisioning and Hedge Accounting. Additionally, the Board's project on Derecognition of Financial Instrument will also result in amendments to IAS 39. Comments on the ED on Classification and Measurement are due by 14 September 2009. Click for IASB Press Release (PDF 101k). Here is an overview of the ED:

July 2009: ED on financial instruments classification and measurement

On 14 July 2009, the IASB published an exposure draft (ED) on Financial Instruments: Classification and Measurement as the first part of its three-phase project to replace IAS 39 Financial Instruments: Recognition and Measurement. The Board decided to address classification and measurement of financial assets and financial liabilities first because they form the foundation of a standard on reporting financial instruments. Moreover, many of the concerns about IAS 39 that have been expressed during the financial crisis relate to its classification and measurement requirements. The IASB plans to finalise the classification and measurement proposals in time for non-mandatory application in 2009 year-end financial statements. The other two phases of the IAS 39 project are addressing Impairment and Provisioning and Hedge Accounting. Additionally, the Board's project on Derecognition of Financial Instrument will also result in amendments to IAS 39. The IASB plans to complete the replacement of IAS 39 during 2010, although mandatory application will not be before January 2012. Comments on the ED on Classification and Measurement are due by 14 September 2009.

Click for IASB Press Release (PDF 102k). Here is an overview of the ED:

The IASB will host two live Web presentations to introduce the ED on Wednesday 15 July 2009, one at 9:30am London time and the second at 3:00pm London time. Click for Details.

July 2009: IAS Plus Update Newsletter Explaining the ED

Deloitte's IFRS Global Office has published an IAS Plus Update Newsletter – Simplified Financial Reporting - New Classification and Measurement Guidance for Financial Instruments (PDF 383k) explaining the proposed standard.

August 2009: Financial instruments classification and measurement newsletter

Deloitte LLP (UK) has issued a Comprehensive Newsletter - Time for New Measures (PDF 241k) on the IASB's proposals to replace the financial instruments classification and measurement requirements in IAS 39. The newsletter includes an illustrative statement of financial position for a corporate, bank, and insurer showing the potential impact of the proposals compared with the current classification and measurement requirements.

September 2009: Notes from the financial instruments roundtable

The IASB conducted a Roundtable on Financial Instruments at the Board's offices in London on Thursday 10 September 2009. Board member Robert Garnett chaired the sessions, and Board members Stephen Cooper, Amaro Gomes, Jim Leisenring, John Smith, and Wei-Guo Zhang, and FASB Chairman Robert Herz, were at the table. Presented below are the preliminary and unofficial notes taken by Deloitte observers at the Roundtable.

September 2009: Notes from the North American financial instruments roundtable

The IASB and the US FASB jointly held a Roundtable on Financial Instruments – Classification and Measurement at the FASB's offices in Norwalk, Connecticut, on Monday, 14 September 2009. Participating in the discussion were representatives of the FASB and the IASB and a range of their constituents, including banks, insurers, broker-dealers, audit firms, financial analysts, and insurance and securities regulators. FASB Technical Director Russ Golden chaired the session. At the table were FASB Board members Bob Herz, Tom Linsmeier, Mark Siegel, and Larry Smith, and IASB Board members Steve Cooper (by videolink), Patrick Finnegan, Jim Leisenring, Patricia McConnell, and John T Smith. Presented below are notes taken by Deloitte observers at the roundtable. No decisions were reached at this meeting.

Discussion at the September 2009 IASB Meeting

Comment letter analysis

The Board was joined in its discussion by FASB Board and staff members via video link. The staff presented to the Board a preliminary comment letter analysis (as the comment deadline expired this week only and comment letters are still arriving). The Board did not take any decisions during this session.

Constituents seem to support the basic idea behind the Classification and Measurement ED requirements. Nonetheless, they raised significant concerns about speed of the project, interaction of the project with other projects of the Board, as well as lack of convergence with FASB.

Most of constituents support a mixed attribute approach for measurement of financial instruments and the proposed criteria for the measurement cut. Nonetheless, significant majority of constituents believe that the interaction between the criteria was not well defined and understood and there was a need for clearer articulation of both of the conditions.

Additional concerns were raised regarding accounting for hybrid contracts (especially application for liabilities), lack of recognition of dividends in income in the FVTOCI category, lack of reclassification, and elimination of the cost exception for unquoted equities. The Board briefly discussed the possibility of reclassification between the categories and noted that what could be understood as 'change in business model' varied greatly among constituents.

The Board will address all of these issues on later meetings. Regarding the plan for the project, the Board announced that from the next week on, the Board would deliberate on these issues on a weekly basis, with special meetings announced for 22 and 29 September.

Discussion at the Special 22 September 2009 IASB Meeting

Exception from fair value measurement for some equity instruments

The staff introduced the session by first setting out the objective of the of their agenda paper, which was to address the proposed elimination of the cost exception for some unquoted equity instruments and related derivatives.

The staff briefly touched on the comments received from constituents in response to the ED's proposals to remove the cost exception. Many respondents agreed that cost does not provide useful information about future cash flows arising from equity instruments and that conceptually fair value is the right answer. Some respondents generally agreed with the removal of the cost exception. However, many others disagreed on the grounds of

• fair values being less reliable in certain cases;
• the cost and difficulty in determining fair value on a recurring basis; and
• difficulty in verification and impaired comparability due to subjectivity of measurement

One of the staff members set out the feedback they had received first hand from constituents which indicated that the concern about the removal of the cost exception came mainly from companies that had occasional or limited number of investments in unquoted entities. Their concerns included:

• lack of guidance on fair value measurement of equity instruments;
• lack of in-house expertise to perform valuations;
• lack of reliable input data to perform valuations; and
• questions over the usefulness of fair values.

The staff then set out the options that they feel the Board has for finalising the proposals as:

• Option 1: Finalise the proposals without modification, but consider whether there are ways in which the cost to preparers might be reduced.
• Option 2: Keep the existing exception in IAS 39 without modification.
• Option 3: Keep the existing exception in IAS 39 with modifications.

Before handing over to the Board for their comments the staff set out their recommendation to measure all equity investments and derivatives at fair value and to remove, as proposed in the ED, the cost exception that currently exists in IAS 39.

In their discussion most Board members acknowledged that this was a difficult area to address because the issue is more about the cost/benefit analysis rather than the conceptual question about the relevance of fair values as there is agreement that fair values is the most decision useful measure for equity instruments and related derivatives.

Some Board members expressed support for the staff's proposals (ie Option 1) including support for additional guidance in the standard about materiality considerations and guidance on the efforts an entity would be required to go to in order to derive a fair value. In cases where fair value simply could not be determined with any degree of reliability, a limited number of Board members proposed that the investments should not be recognised at all with the investment amount written off as an expense.

Some other Board members expressed support for retaining the existing cost exception that exists in IAS 39 but with additional detailed guidance on when it would be appropriate in order to address the perceived current inappropriate over-use of the exception (Option 3). The rationale put forward for this was that the cost in certain circumstances outweighed the benefit.

The debate moved on to considering where the line should be drawn if there were to be some kind of relief from fair valuing certain equity instruments and in those circumstances what relief should be available.

In defining the subset of instances where it could be appropriate to use a measurement other than fair value the Board considered materiality of the investment, the practicability of calculating fair value, and the business model of the reporting entity. Some Board members questioned whether any exception to fair would be only for strategic investments while others noted the difficulty in defining strategic investments.

It was generally agreed that all equity investments held by certain entities such as financial institutions, private equity houses and venture capitalists should always be measured at fair value. Further, all quoted equity investments, all equity investments held for trading, all material equity investments, and all equity investments for which it is practicable to derive fair value should also be measured at fair value. There was some debate as to how materiality would be defined for this purpose with some Board members stating that they did not think an exception based on materiality would be operational or indeed necessary leaving the main test as one of practicability of determining fair value.

For the subset of unquoted equity investments for which it could be appropriate to use a measure other than fair value the potential alternative measures included valuations based on management judgement, percentage of net assets, and cost, all of which could also be equivalent to fair value in certain cases.

It was agreed that the staff would come back with an alternative proposal for consideration that stated that the principle measurement for equity investments would be fair vale except in certain limited cases where an alternative may be used. This alternative would also include proposals on what the alternative measure would be.

The staff then moved on to their second question in this area about whether there should be certain voluntary relief from determining fair values of equity investments for interim reporting.

Questions were raised as to which equity investments this relief should apply to. The Board were asked to vote whether they would accept this relief for the subset of unquoted equity investments discussed above. All but four Board members voted that they would support such a relief.

Discussion at the Special 29 September 2009 IASB Meeting

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.

Discussion at the Special IASB Meeting 6 October 2009

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

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.

Discussion at the Special IASB Meeting 15 October 2009

Elimination of cost exemption for unquoted equity instruments

The staff introduced the session by summarising the discussion the Board had held at previous three meetings on this topic.

After a short discussion, the Board tentatively agreed to eliminate the cost exemption for unquoted equity instruments. Nonetheless, the Board agreed to include in the final IFRS guidance on when cost might be representative of fair value for subsequent measurement.

The staff noted that any additional guidance should be applicable only to a limited subset of instruments (when the entity has no reliable inputs or ability to perform a valuation), as already discussed at previous meetings. Most of the discussion focussed on linking the guidance in the IFRS with the guidance in the fair value measurement (FVM) project as well as wording of the additional guidance.

The staff explained that the aim of the proposal was to provide guidance when cost might be indicative of an estimate of fair value after initial recognition, in case no new information indicating the opposite was present. Several Board members were concerned that the proposal would be inconsistent with the FVM project as it implied a notion of entry price and the FMV standard would be based on exit price. However, other Board members and the FMV project team did not see any fundamental difference between this guidance and the guidance already proposed in the FVM project.

Some Board members were concerned that the language employed could lead to a more widespread use of cost measurement than the Board intended (in effect creating a rebuttable presumption that cost is used in these circumstances). The staff agreed to tighten the definition to indicate that fair value should be estimated in all cases and, as part of the estimation of Level 3 fair value, cost is one of the inputs influencing valuation.

One Board member was concerned that such guidance would decrease comparability as the valuation methods will diverge between the firms. The Board disagreed.

Several Board members expressed their concern in relation to disclosure. They proposed additional disclosures on measurement as well as measurement uncertainty. The staff replied that current requirements of IFRS relating to Level 3 measurement should be a starting point for any disclosures, and it believed that such disclosures were appropriate. The staff also noted that it would bring a separate paper on presentation of changes in level 3 measurements in profit or loss next week, when these issues might be reconsidered.

Reclassification between fair value through profit and loss (FVTPL) and other measurement categories

In light of the feedback received from constituents the Board reconsidered its proposal in the ED to prohibit any reclassification between the FVTPL category and other measurement categories. Constituents strongly disagreed with the proposal and asked the Board to require reclassification when business model of the reporting entity changes. They admitted that such changes might be rare but were adamant in that inability to reclassify was contrary to the proposed classification model, as it would lead to instruments being classified in an inappropriate category.

Three Board members were concerned that allowing such reclassifications would lead to cherry-picking and free choice between measurement categories. Consequently, the Board agreed to tighten the wording of the proposed standard and to provide additional guidance and examples indicating that changes in the business model were very infrequent. The Board agreed to add additional disclosures on reclassification to provide the users with a comprehensive record on reclassifications. The Board finally agreed to require reclassification if and only if and entity changes its business model.

One Board member discussed possible reclassification based on changes in the cash flow characteristics. The staff replied that classification on initial recognition was based in the contractual terms over the whole life of the instrument. Otherwise these reclassifications could be very frequent, which would be inconsistent with the objective of the model. The Board agreed to include such reasoning in the basis for conclusion of the final standard.

After a short discussion, the Board agreed to account for reclassifications prospectively.

The Board agreed that if an instrument was reclassified from another category to FVTPL, the instrument should be remeasured at the classification date, and any difference between previous carrying amount and fair value would be recognised as a separate line item in profit or loss. The Board discussed where to recognise such difference, with majority of the Board favouring profit or loss and a minority requiring retained earnings. A majority of the Board was of the opinion that recognition of the difference in retained earnings would lead to structuring opportunities (recognise the loss in retained earnings when markets fall to capture the fair value effect on recovery in profit or loss).

The Board also agreed that if an instrument was reclassified from FVTPL to another category, the fair value of the instrument on the date of the reclassification would become its new carrying amount.

The Board agreed that the proposed disclosures on reclassifications were based on modified requirements of current IFRS 7. Those requirements would encompass reclassification disclosures in interim periods and in the following annual period, but would not require disclosure of fair value gain/loss that would have been recognised in profit or loss until derecognition.

Equity instruments measured at fair value through other comprehensive income ('OCI exemption')

The Board discussed the OCI presentation exemption. After a short discussion the Board confirmed the proposal in the ED to provide an OCI presentation exemption for any equity investment that is not classified as held for trading. Such election must be made at initial recognition and is irrevocable.

Several Board members expressed their preference for tighter criteria for equity instruments to be eligible for OCI presentation exemption. However, the Board was reminded that it tried to find a principle for OCI presentation exemption before the ED was published and could not agree on a general principle. The Chairman noted that trying to limit the scope of OCI exemption at this stage would be very sensitive and might even trigger re-exposure. Nonetheless, he noted that when FASB finalised its model, the IASB might expose some of the FASB proposals as amendments to its final standard as part of a convergence project, and this might be a way to discuss any changes to the OCI exemption.

The Board agreed to require dividends on such equity instruments to be presented in profit or loss as long as they represented return on investment. On the other hand, the Board decided that recycling of other gains and losses should be prohibited under the OCI exemption.

Most Board members agreed with these proposals. Nonetheless, one Board member was particularly concerned that this decision was inconsistent with the theory of finance. He argued that such a decision would be based on no general principle and would create a divergence between treatment of capital appreciation and dividends. Another Board member was concerned that the Board is very close to re-creating the 'available-for-sale' portfolio and not a limited presentation exemption to a measurement category.

Finally, the Board agreed to retain all the disclosures proposed in the ED and to disclose separately dividends presented in profit or loss related to the investments classified as fair value through OCI.

The Board will continue its discussions on classification and measurement phase of the project and deliberate hedge accounting phase on its additional meeting on 16 October 2009.

Discussion at the Special IASB Meeting 16 October 2009

Concentrations of credit risk

The staff introduced the session by summarising the proposals in the Classification and Measurement exposure draft (ED) and the feedback from constituents who disagreed with the proposals. The ED contained specific guidance for transactions where concentrations of credit risk were effected by tranches and proposed that only the most senior tranche might have basic loan features as that tranche received credit protection in any situation. Constituents argued that such guidance was an exception from a proposed classification model and could lead to structuring opportunities.

Responding to the feedback, the Board first clarified that it required separate assessment of the classification criteria by an issuer of contractually linked instruments that affect concentration of credit risk (as the notion of a 'waterfall structure' does not apply to the issuer when looking at its overall obligation).

The Board thoroughly discussed two proposals relating to the holder's accounting:

• first, to require fair value for all instruments that reallocate credit risk (as it is not a basic loan feature), and
• second to require a look-through approach to assess the underlying cash flow characteristics of the instrument and to assess the credit risk of the instrument relative to the underlying pool of instruments.

A majority of the Board supported the look-through approach as they believed that it ensured the same accounting treatment for the underlying assets as well as a proportionate interest in the same assets that received a credit protection. The Board agreed that an entity would have to look through until it identified the assets generating the cash flows (rather than passing them through). If such look-through was not practicable, the instrument would be measured at fair value.

Nonetheless, a significant minority of Board members disagreed with such a decision as they believed it would be contrary to the conceptual definition of basic loan feature (based on contractual cash flows). They also argued that economic substance of an investment in underlying assets and an investment in a securitisation vehicle based on those same assets is fundamentally different, and thus requiring the same accounting treatment for both is inappropriate.

In response to concerns of one Board member, the staff clarified that reassessment would not be required. However, if the pool of instruments could change so as to contain instruments that would be inconsistent with the structure having basic loan features over its entire life, any such structure would have to be measured at fair value.

One Board member expressed his preference for convergence with the FASB on accounting for securitisation vehicles. In response, the Chairman explained that to meet the deadline to publish the final IFRS in November, the staff needed the decision on this issue now, and discussions during the joint meeting would delay timetable of the project. Nonetheless, he noted that after the FASB model is finalised, convergence would be discussed, and thus subsequent changes to the IASB model developed for the IFRS would be possible.

Financial assets acquired at a discount that reflects incurred credit losses

The ED stated that a financial asset that was acquired at a discount that reflects incurred credit losses cannot be subsequently measured at amortised cost as it was not managed at a contractual cash flow basis and exhibited variability in actual cash flows that was not interest.

Constituents largely disagreed with such a decision as they believed that it represented an exception from the approach proposed and would pose operational challenges (for instance, to identify instruments with incurred credit losses when acquiring a portfolio).

The Board agreed with such arguments and reconsidered its earlier decision. Consequently, the Board decided that the fact that an asset was acquired at a discount that reflected incurred credit losses did not in itself disqualify it from being measured at amortised cost.

Discussion at the October 2009 IASB Meeting

Gains and losses related to fair value measurements in level 3 of the hierarchy

The Board considered the requirement for separate presentation on the face of the statement of comprehensive income of the total gains and losses for the period related to fair value measurement in Level 3 of the hierarchy.

In the outreach related to the Classification and Measurement ED, the Board was told by some constituents (mainly regulators) that separate presentation of gains and losses related to unreliable fair value measurement was superior to a mere disclosure in the notes, as data presented on the face of the statement of comprehensive income were seen to carry more weight.

Most of the Board members disagreed, as they felt that such information was already available under the requirements of IFRS 7, and regulators had enough powers to require any disclosures desired in prudential reporting. Moreover, some Board members were concerned that such separate presentation would not address the true issues as valuation uncertainly as well as earnings volatility had less predictive power for future financial performance for users.

The Board finally decided not to require such separate presentation as part of Financial Instruments project. Some Board members suggested that Financial Statement Presentation project was the right place to address such an issue. Moreover, the Board agreed to discuss this issue together with the FASB during the October joint meeting along with the proposal to disclose both fair value and amortised cost of financial instruments on the face of the statement of financial position.

The IASB's plan is to publish a final IFRS on classification and measurement of financial instruments in November 2009

Scope

The Board revisited its earlier tentative decision on the scope of the forthcoming IFRS. Many Board members had become increasingly concerned that introduction of the frozen credit spread for financial liabilities would create severe unintended consequences (for instance, measurement of derivatives embedded in financial hosts and implications for fair value option). Moreover, this particular decision would make convergence with FASB increasingly difficult.

The Board expressed its desire to rediscuss this issue and consider additional outreach activities. Therefore, the Board unanimously decided to exclude financial liabilities from the scope of the forthcoming IFRS. The Board would rediscuss this issue immediately after the IFRS is issued and try to come with a common solution with the FASB on treatment of financial liabilities.

Effective Date

The Board discussed the proposed mandatory effective date for the IFRS. Some Board members thought that the IFRS should be mandatorily adopted only as a whole package at the same time (with all the other parts of the IAS 39 replacement) and preferably at the same time as the second phase of the insurance contracts project. On the other hand, some Board members felt that in this way comparability would be impeded for a relatively long period of time. Finally, the Board agreed that a mandatory effective date of the finalised guidance on classification and measurement of financial instruments would be for annual periods beginning on 1 January 2013 or later. The Board noted that until then, constituents should have sufficient time to prepare for all the phases of the IAS 39 replacement project. Nonetheless, the Board noted that if there was a need to delay further the mandatory effective date, for example due to the Impairment phase adoption, that would be possible.

The Board agreed without much discussion to permit early application of the final IFRS and to require the transition disclosures for all entities adopting the new IFRS (not just for entities adopting them early as proposed in the ED).

Nevertheless, some Board members expressed their concerns that permitting early adoption might lead to lack of comparability and consistency in financial reporting.

Transition

The Board discussed transition requirements. As the discussion progressed, some of the Board members become increasingly concerned that proposed transition could lead to a complete free choice and would lead to window-dressing of financial statements.

After a substantial discussion the Board agreed to permit determining the date of initial application of this IFRS at any date between issue of the IFRS and 31 December 2010. Thereafter, an entity could determine the date of initial application at the beginning of the reporting period only.

The Board agreed not to require restatement of comparative periods in 2009-2011 period. However, for all the periods after 1 January 2012 comparative information would have to be provided. The Board also agreed with the principle (consequential amendment to IFRS 1) that first-time adopters should not be in a more onerous position in restating comparative periods that entities already applying current IAS 39. The Board also decided not to require early adoption of subsequent guidance (other phases of IAS 39 replacement project) if any previous guidance was adopted. Nonetheless, the Board agreed to limit the number of choices by requiring early adoption of any preceding final guidance if subsequent guidance was early adopted.

Some Board members were concerned that requiring restating of comparative periods would lead to lower quality of the data as well as practical problems (for example, with financial instruments already derecognised). Nonetheless, the majority of the Board were of the opinion that such a requirement is necessary to ensure a basic level of comparability and consistency.

On the other issues the Board decided to finalise the guidance as proposed in the ED on impracticability of retrospective application and disclosure requirements.

The Board decided not to permit 'grandfathering' of the accounting for hybrid contracts with financial hosts given its decision on scoping liabilities out of the IFRS.

The Board also agreed to remove the provision for discontinuance of hedge accounting relationships that did not qualify under the new classification model as they would be effectively a null set.

Finally, the Board decided not to provide any guidance on potential transition relief for future phases of IAS 39 replacement project.

Transitional insurance issues

The Board considered the interaction between classification and measurement phase of the IAS 39 replacement project and Phase II of the project on insurance contracts. The Board agreed that if the effective dates of these projects are different, additional accounting mismatches might occur. Nonetheless, as the Board believed that mandatory adoption in 2013 might be achievable for both of these projects, it did not provide any additional relief for insurance companies (such as temporary exemption to maintain an AFS portfolio). The Board agreed that as part of the transitional requirements of the insurance contracts IFRS, a transitional option to reclassify financial assets on adoption of Phase II of insurance contracts should be considered. The Board also agreed to include such discussion in the Basis for Conclusions of the Classification and Measurement IFRS.

The Board also considered consequential amendment of IFRS 4 to modify shadow accounting for insurance contracts or financial instruments containing a discretionary participation feature (allow adjustment to the insurance liability to be recognised in other comprehensive income (OCI) if a realised gain or loss on an asset is recognised in OCI). The Board decided against such a change as it believed that OCI presentation for equity instruments was a choice, and thus an accounting mismatch might be avoided by not using the option.

Interaction between decisions on concentration of credit risk and other non-recourse instruments

The Board discussed the accounting for proportionate non-recourse instruments from the perspective of the holder. The majority of the Board agreed that the IFRS should include additional guidance that an entity had to ensure that any payments arising under the contract were consistent with the principle of all payments being payments of principal and interest (representing time value of money and credit risk). This required 'looking through' the non-recourse instruments to the underlying ring-fenced assets.

The Board discussed this principle in detail. Some Board members were concerned that the words did not reflect the principle that should have been articulated (in effect the difference between the credit risk and owner risk). The Board asked the staff to draft the principle to reflect that the holder always had to assess the repayment and its source. In case of non-recourse loans that meant that the promised return was evaluated for whether it represented compensation for credit risk or another economic substance.

One Board member in particular was concerned about this principle as he considered a non-recourse loan to be a loan with an embedded option. Consequently he would deny amortised cost accounting for all non-recourse loans as they did not exhibit basic loan features.

Summary of decisions

The Board considered the decisions taken during the process of redeliberation of the classification and measurement phase of the Financial Instruments project.

The Board clarified that with respect to underlying portfolio of investments in contractually linked instruments, additional credit protection (such as guarantees) for the underlying instruments would not prohibit amortised cost accounting.

With regards to reclassifications, the Board specified that following the identification of a change in the business model, an entity should reclassify the financial instruments in question from the start of the following period (including interim periods).

At least three Board members (and an additional Board member tentatively) indicated that they would dissent to the ED on the basis of the approach being adopted.

Discussion at the December 2009 IASB Meeting

The staff presented a summary of the outreach activities and opinions expressed by constituents on classification and measurement of financial liabilities with the emphasis on the own-credit-risk issue.

The staff clarified that this discussion applies to those financial liabilities that are managed on the contractual cash flow basis but do not fulfil the criteria for classification as basic loans. In addition, the staff noted that this discussion did not relate to the financial liabilities to which the fair value option was applied.

The staff presented four basic approaches to classification and measurement of those financial liabilities:

• (a) Fair value measurement with separate presentation of changes related to own credit in the OCI
• (b) An adjusted fair value measurement attribute (frozen credit spread)
• (c) Bifurcation (either based on criteria in IAS 39 or based on criteria in IFRS 9)
• (d) Amortised cost measurement with parenthetical presentation of fair value

The Board will hold an educational session on mechanics and potential effects of all the identified approaches in January.

Discussion at the January 2010 Joint IASB-FASB Meeting

The Boards briefly considered the status of the project on classification and measurement of financial liabilities. The purpose of the session was to update Boards, and no decisions were taken.

The staff summarised the approaches so far discussed by both Boards. The FASB gave update on its tentative decision to require a separate measurement attribute for core deposits (present value of the average core deposits amount discounted by the difference between alternative funds rate and the all-in-cost-to-service rate over the implied maturity).

From the initial discussion the FASB seemed to prefer fair value measurement of liabilities as the FASB believed that it better captured the risks embedded in financial assets and liabilities.

The Boards will start joint deliberation of this topic in February.

Discussion at the Joint IASB-FASB Special Meeting 10 February 2010

Classification and measurement of financial liabilities

The Boards considered both IASB and FASB models of classifying financial liabilities to establish common categories that under both models. These categories are:

• Category A - instruments that are not held to pay contractual cash flows (this would include all standalone derivatives and all liabilities held for trading);
• Category B - instruments that are held to pay contractual cash flows and have 'non-vanilla' (structured) contractual cash flow characteristics. (such as issued bonds with leveraged interest or index-linked issued bonds); and
• Category C - instruments that are held to pay contractual cash flows and have vanilla contractual cash flow characteristics.

The discussion then focussed on categories A and B, with the Boards acknowledging that there is a difference in accounting for category C instruments under the current IASB and FASB models. The Boards confirmed unanimously that instruments in category A should be accounted for at fair value through profit or loss (FVTPL).

The instruments falling into category B would be slightly different under IASB and FASB models. The IASB would include instruments with cash flows that are not solely payments of interest and principal, while the FASB would include instruments with embedded features not 'clearly and closely related'. However, overall the two models overlap sufficiently to look at measurement jointly for this category. Based on the results of the users questionnaire, the Boards were presented with four potential measurement models, all aiming to avoid accounting for own credit risk in profit or loss:

• Isolate the effects of changes in own credit risk and account for that amount differently than other components of fair value (for example, account for this amount in OCI or using 'adjusted' fair value (the 'frozen credit spread' approach));
• Bifurcate the instrument into a host and the embedded features;
• Measure the entire instrument at amortised cost and disclose fair value on the face of the balance sheet in brackets;
• Measure the entire instrument at fair value through OCI;

Measurement of the instrument at amortised cost presented some practical difficulties for instruments with 'non-vanilla' features. Recycling questions arose if the entire instrument is measured through OCI. Results of the questionnaire showed little support for splitting out portion of fair value relating to own credit risk. The staff therefore recommended to bifurcate the liability into a host and embedded features. Whether to base bifurcation on existing IFRS and US GAAP requirements or to develop a new method using the 'basic features' and 'entity business model' concepts of IFRS 9 was not yet discussed. Further, under IAS 39, many entities avoid bifurcation by using the fair value option. Fair value option accounting also has not yet been discussed. The staff was looking for directional guidance and will develop a more detailed approach at a later stage. They will also consider specifically the accounting for regulatory instruments with deferred interest payments and whether these should be at amortised cost.

The IASB has unanimously approved the staff's recommendation to pursue bifurcation.

The FASB members pointed out that the current proposal is based more on the IASB rather than on FASB's model. The FASB would await the decision on the fair value option and look at this issue again then.

Discussion at the February 2010 Joint IASB-FASB Meeting

This session was primarily an IASB session. The FASB will discuss measuring liabilities held to pay contractual cash flows together at a later separate FASB meeting.

Without much discussion the IASB agreed that financial liabilities held to pay contractual cash flows that have pain vanilla contractual cash flow characteristics should be measured at amortized costs unless the fair value option is elected.

Bifurcation methodology

The Board continued its discussion about the bifurcation methodology for the financial liabilities that are held to pay contractual cash flows and have non-vanilla contractual cash flows. (At the meeting on February 10, 2010 the IASB decided that such liabilities should be bifurcated into a host and the embedded features.)

The Board discussed two possible alternatives: maintaining the criteria of IAS 39 Financial Instruments: Recognition and Measurement or using bifurcation approach based on classification conditions in IFRS 9 Financial Instruments.

Although, many IASB members noted that IFRS 9 approach might be conceptually more sound (for instance, due to symmetry question), most of the IASB members agreed that retaining IAS 39 criteria to bifurcation would be less disruptive. Moreover, the IASB members liked the focus on the nature of the embedded feature rather than contractual approach.

The Board agreed that for most of the instruments the results of application of any of these bifurcation methods would be the same. However, one of the IASB members also expressed his doubts how operational would the IFRS 9 approach be for liabilities paying a market interest rate, but payment of the interest cannot be made unless the issuer is able to remain solvent immediately afterwards. He noted that valuation of compliance with prudential rules would be overly complex.

Finally, the IASB unanimously agreed to apply the IAS 39 bifurcation requirements for financial liabilities.

The FASB noted that the bifurcation methodology is very close with the FASB methodology for embedded derivatives.

Fair Value Option

The Board discussed the application of fair value option to financial liabilities.

The Board unanimously agreed to retain the fair value option for financial liabilities. As one of the IASB members noted, the fair value option was specifically designed for financial liabilities in the first place. In addition, the Board also confirmed all three eligibility conditions in IAS 39 for application of the fair value option (accounting mismatch, financial liabilities being managed at a fair value basis, financial liabilities containing one or more embedded features being accounted for in their entirety).

The Boards had a rather significant discussion on how to address the issue of the changes in own credit in the context of financial liabilities to which the fair value option is applied.

In effect, the Board discussed two alternatives of isolation of the effects of changes in own credit risk – either present the change in own credit risk a separate item directly in equity or in other comprehensive income.

The Board was relatively split in the discussion which solution was more appropriate. Some Board members preferred the presentation directly in equity as they believed that the change in credit risk represents a kind of a wealth transfer between creditors and owners. As one Board member noted, conceptually a debt instrument contains a put option on own equity and thus equity is the most appropriate place. On the other hand, other Board members stressed that nature of the changes in own credit risk does not represent a transaction between the entity and the owners and thus should not pre presented directly in equity but rather in a performance statement. They also cited potential problems with this approach – implication for company law in many jurisdictions (as this component might not be eligible to be 'equity' in some jurisdictions).

Finally, the Board narrowly approved the isolation of the changes in own credit risk in other comprehensive income.

Most of the Board members agreed that the mechanics of the isolation should include recognition of the total fair value change in profit or loss and separate recognition of the portion attributable in own credit risk in other comprehensive income with the offsetting entry to profit or loss. Some of the Board members questioned complexity of this mechanics, even though they acknowledged the benefits of enhanced transparency. The staff will provide additional analysis on the benefits of this approach to presentation.

The Board continued with a discussion whether to recycle the amount related to changes in own credit from other comprehensive income to profit or loss if the liability was derecognised before maturity. Even though some Board members noted that recycling might provide more useful information a narrow majority of the Board members agreed that the amounts should not be recycled.

Some Board members expressed their view that the approved model is overly complex and one of the objectives of the changes to financial instruments accounting was to reduce complexity.

One Board member said that isolation of the changes in own credit is not appropriate for all liabilities to which fair value option can be applied. According to this Board member, the presentation of the change in own credit in other comprehensive income is appropriate only for fair value option applied to a financial liability containing one or more embedded features being accounted for in its entirety. In the other two cases (accounting mismatch, management on a fair value basis), such separate presentation might exacerbate the mismatches that the fair value option was designed to minimise and would thus defeat the purpose of fair value option.