Amendments to IAS 32 and IAS 39 Financial Instruments – 2004-2006

Chronology

IAS Plus Newsletters

Important: The revised IAS 39 was issued by the IASB in December 2003. Several additional modifications have been considered by the Board in 2004. The information on this page reflects the Board's discussions of these further revisions to IAS 39. A summary of the final IAS 39 as adopted in December 2003 and subsequent amendments can be found Here.

Timetable

Project Summary

Further Revisions to IAS 39 Considered by the Board in 2004

This page addresses the following components of the IASB project to amend IAS 39 that have arisen after the December 2003 revisions to IAS 39 were published:

MACRO HEDGING

Discussion at the Board's June 2003 Meeting (Macro Hedging)

The Board agreed (14-0) to permit an entity to use fair value hedge accounting for a portfolio hedge of interest rate risk. This would be a modification of the June 2002 Exposure draft. The key elements of the proposed approach are as follows:

1. The entity identifies a portfolio of items whose interest rate risk it wishes to hedge. The portfolio may comprise both assets and liabilities.

2. The items are grouped into time categories based on their expected (not contractual) re-pricing dates.

3. The net position in each time period is established and the entity decides how much of that net position it wishes to hedge. The entity designates assets (or liabilities, but not both) equal to the amount it wishes to hedge as the hedged item, rather than the net amount. The designation is of an amount of a specific currency rather than of individual assets. The assets (or liabilities) from which the hedged amount is drawn must be items:

  • Whose fair value changes in response to the risk being hedged,
  • That could have qualified for fair value hedge accounting under IAS 39 had they been hedged individually, and
  • Included in narrowly defined and consistently determined time buckets.
4. The entity designates what interest rate risk it is hedging. This risk could be a portion of the interest rate risk in each of the items in the portfolio, such as a benchmark interest rate like LIBOR.

5. The entity designates a hedging instrument for each time period. The hedging instrument may be a portfolio of derivatives containing offsetting risk positions.

6. The entity measures the change in the fair value of the hedged item that is attributable to the hedged risk. This gain or loss is reported in the income statement and in one of two separate line items in the balance sheet. The change in value is not allocated to individual assets.

7. The entity measures the change in the fair value of the hedging instrument and reports this gain or loss in the income statement and as an adjustment to the carrying amount of the hedging instrument in the balance sheet.

8. Ineffectiveness is reported in the income statement as the difference between the amount determined in 6 and that referred to in 7.

As noted from earlier discussions, the Board decided to require liabilities with demand features (such as demand deposits) to be measured at the higher of its fair value or amount that could be demanded. A liability measured at the amount that could be demanded today does not have interest rate risk and therefore, some Board members believe cannot be subject to a fair value hedge. The Board did not make a decision on this matter and has asked to staff to develop this issue further.

The representative of the Federation Bancaire de l'Union Europeenne (FBE) expressed concern that ineffectiveness of an under hedge (for example, a hedge 100 of a portfolio of 150 because 50 is expected to be prepaid; however only 25 is prepaid) would be taken through income the same as an overhedge. The Board confirmed its conclusion, noting the fact that the use of expected time buckets does not appear to permit any other choice. The staff and Board will continue to work on the mechanics of applying this approach and will readdress this at the next Board meeting.

The Board discussed several issues related to how to make this approach workable. Additionally, the Board decided that this issue must be re-exposed. The staff will undertake the task of preparing a pre-ballot draft for the July 2003 meeting.

Discussion at the Board's July 2003 Meeting (Macro Hedging)

Hedge accounting for a portfolio hedge of interest rate risk

The Board agreed (vote 10-4) that the hedge instrument should be designated as hedging a percentage of the net exposure. Therefore, ineffectiveness may occur when the fair value of the net exposure increases (under hedged) or decreases (over hedged).

Core deposits

The Board concluded that core deposit liabilities may be included in the time bucket management expects the deposits to repay if that time bucket is in a net asset position. The Board decided (vote 11-3) that demand time deposits can be subjected to a fair value hedge only until the earliest date on which the customer can demand repayment. The reasons behind these conclusions will be added in the basis of conclusion.

Measuring effectiveness

The Board discussed methods to assess hedge effectiveness and decided on the following. The initial hedge ratio is applied to the revised estimate of the amount in the time period. For example, assume an entity had estimated that it had 100 of assets in a time period and had decided to hedge an amount of 20. It then re-estimates the assets in this time period as being 120. Under this method, the initial hedge ratio is 20% (20/100 x 100). This percentage is applied to the revised estimate of the assets in the time period of 120, to give a revised hedged item of 24. Ineffectiveness arises on the change in fair value of this revised hedged item (24) that is attributable to the hedged risk, and the change in fair value of the hedging derivative (that would likely have a notional principal of 20).

Effective date

The Board agreed the effective date should be for financial years beginning or after 1 January 2005, with early adoption be permitted. The effects of transition to the Standard should be applied prospectively.

Comment period

The staff proposed a 60 days comment period in order to have comment in by November 2003. The Board realised that it was a short period but said it was the only one possible to meet the Board's March 2004 deadline for issuance of the final IFRS. The Board decided it will put the ED on its website as soon as it is ready to achieve a comment period closer to 90 days.

Macro Hedging Exposure draft

An Exposure draft on Fair Value Hedge Accounting for a Portfolio Hedge of Interest Rate Risk issued for public comment 21 August 2003:

Discussion at the Board's December 2003 Meeting (Macro Hedging)

The Board considered an initial analysis of the comment letters received on the macro hedging Exposure draft. It was noted that commentators in general were supportive of the Board's addressing the issue, but many believed the Board had not gone far enough in the proposals.

Question 1: Designation and effectiveness

Question 1 in the ED was on the designation of the hedged item and the resulting measurement of ineffectiveness. The ED proposed that the hedged item be designated in terms of an amount of currency (rather than in terms of individual items) and be expressed as a percentage of assets or liabilities in a time period (rather than as a layer, or as the net position of assets and liabilities). As a result, ineffectiveness would arise both if a change in prepayment expectations caused the entity to be over-hedged (because hedged items were now expected to prepay earlier than expected) and if such a change caused it to be under-hedged (because hedged items were now expected to prepay earlier than expected).The ED also proposed that the change in the fair value of the hedged item may be reported in one of two line items in the balance sheet, and need not be allocated to the many individual assets or liabilities that comprise the hedged position.

The main points made in the responses were as follows:

  • All who commented supported the proposal that the hedged item be designated in terms of an amount of currency (rather than in terms of individual items).
  • Similarly, all who commented supported the proposal that the change in the fair value of the hedged item may be reported in one of two line items in the balance sheet (rather than being allocated to the many individual assets or liabilities that comprise the hedged position).
The staff noted that a minority of those who commented on the issue supported the Board's proposal to designate the hedged item as a percentage of the assets of liabilities in a time period but many did not.

The main views expressed by those who disagreed included:

  • The Board should not specify a method of designation. Rather entities should be allowed to choose whichever method best reflects their risk management strategies and objectives, or that minimises systems changes.
  • The net position should be designated as the hedged item, at least for the purpose of testing effectiveness, since this reflects how interest rate risk is assessed and managed by the entity.
  • A top layer of assets or liabilities (approach B/C in the ED) should be designated as the hedged item, since this most closely reflects the risk management objective. This objective is to take account of the extent to which liabilities form a natural offset to assets, and to hedge only (some or all of) the resulting net position with derivatives.

Many stated that no ineffectiveness should arise if a change in prepayment expectations caused the entity to be under-hedged (because hedged items are now expected to prepay earlier than expected). The main reasons given were:

  • The entity is hedging only interest rate risk and not prepayment risk. Prepayment risk may be managed by deliberately hedging less than the full risk position, but it is not hedged. Accordingly, any changes in prepayment risk are changes in a risk that is not hedged and should not give rise to ineffectiveness, unless they cause the amount of the derivative to exceed the amount of the hedged position.
  • The entity is hedging the assets (or liabilities) for a part of their life - the period up to the expected repayment date. Such partial term hedging is explicitly permitted by the implementation guidance to IAS 39. The entity is not hedging interest rate risk for the period after the expected repricing date. Accordingly, if prepayment expectations for this unhedged period change, there is no ineffectiveness.

Question 2: Core deposits

The ED proposed that a financial liability that the counterparty can redeem on demand cannot qualify for fair value hedge accounting for any time period beyond the shortest period in which the counterparty can demand payment.

A minority of respondents of those who commented on this proposal agreed with it. However, most did not. The main reasons given by those disagreeing were:

  • The Ed's proposal does not reflect the 'economic reality', supported by historical data, that core deposits are a stable source of long-term funding.
  • It is inconsistent to schedule prepayable assets based on their expected prepayment dates, but not to schedule demand deposits based on their expected withdrawal dates.
  • The Ed's proposals could result in a bank being able to adopt fair value hedge accounting for some time periods (those for which it has more fixed rate assets than fixed rate liabilities) but not for others. This could result in the bank using a mix of fair value hedge accounting and cash flow hedge accounting for a single macro hedge, that would be both impractical to apply and difficult for users to understand.
  • Portfolios are different from individual items. It is the economic behaviour of the portfolio that is being hedged and the hedge is successful as long as there are sufficient amounts, on a portfolio basis, to cover the hedging derivative. When viewed on a portfolio basis, core deposits behave as a liability with a repricing profile that is longer than that defined by the contractual terms. Furthermore, the details of individual transactions are lost at a portfolio level and the distinction between 'old' and 'new' money has no real meaning.
  • The Ed's proposals do not reflect the way that banks manage interest rate risk.

The staff noted that a few respondents urged the Board to continue to work on how to fair value core deposits and similar items in its measurement project. Some of these support the Ed's proposals in the meantime, whilst others do not.

The Board members provided comment to assist the staff in preparing a more detailed analysis of the comments.

The staff noted a number of other issues raised and requested guidance from the Board on which issues should be addressed. The issues together with the staff's recommendations were:

Portfolio hedges of other risks

Some respondents suggest that the scope of the proposals be expanded to cover portfolio hedges of other risks, including foreign currency risk (this is the risk that was mentioned most often), commodity price risk, precious metal price risk, equity price risk, credit risk, energy price risk and the currency risk of portfolios of commercial bids.

The staff believes these reasons for limiting any amendment to only portfolio hedges of interest rate risk as set out in paragraph BC4 of the ED still hold, and proposes that the Board should not address these issues in finalising the Ed's proposals.

Amortisation of balance sheet amounts

A significant number of comments were received on when or how to amortise any amounts reported in the balance sheet for changes in the fair value of the hedged item (ie the amounts that would be reported in the proposed separate line items). The ED was silent on this issue, though guidance is given in IAS 39.

The staff believes that the comments revealed considerable confusion over when amortisation is needed in order for an economically hedged position to be reported as such and recommends that this issue be addressed in finalising the ED' s proposals, perhaps by extending the application guidance or the illustrative example.

IAS 39's effectiveness requirements

IAS 39 requires that a hedge can qualify for hedge accounting only if it is expected to be highly effective (the 'prospective effectiveness test') and is determined actually to have been highly effective (the 'retrospective effectiveness test'). For the purposes of the prospective effectiveness test, the changes in the fair value or cash flows of the hedging instrument must be expected to "almost fully offset" those of the hedged item arising from the hedged risk. For the purposes of the retrospective effectiveness test, a 80-125 per cent range is applied. Some respondents request clarification of how these requirements apply to a macro hedge.

The staff recommends that this issue be considered by the Board in finalising the ED so that it is clear what the effectiveness requirements are for a macro hedge, and whether macro hedges will meet them.

Transitional provisions

The ED proposed that it be applied prospectively. Comments raised on this proposal ask that it be clarified whether 'prospectively' means the amendments can be applied to accounting periods after the effective date, or only to new transactions occurring after that date, and that the Board address how an entity that already reports under IAS 39 and that uses cash flow hedge accounting for its macro hedges should transition to using fair value hedge accounting.

The staff recommends that the Board should address these issues in finalising the Ed's proposals.

Other points

A large number of smaller points were raised.

The staff recommends that these smaller points be considered in the first instance by the Board members assigned to the project, and that their proposed resolution be presented to the full Board for approval on an exceptions-only basis.

The Board agreed with the staff's recommendations.

The staff noted that the project plan proposed discussing designation and effectiveness and core deposits in January and all other issues in February.

Discussion at the January 2004 IASB Meeting

Core Deposits

The ED proposed that a core deposit cannot qualify for fair value hedge accounting for any time period beyond the shortest period in which the counterparty can demand payment.

The staff noted that many respondents requested that core deposits be included in a portfolio hedge by scheduling them to the date when, based on conservative assumptions, the entity expects the total amount of core deposits in the portfolio to fall because of net withdrawals. This expected repayment date is typically a period several years into the future.

The Board considered an alternative approach of including core deposits in a portfolio hedge based on the expected repayment date of the existing balance (ignoring any replacements of existing deposits by future new deposits). The Board also considered under this approach whether the expected repayment date of the existing balance should be determined by:

  • attributing outflows of cash to the oldest deposits making up the existing balance (a 'FIFO approach'). Applied to a chequing account, this approach would likely give an expected life of a few months; or
  • attributing outflows of cash to the most recent deposits making up the existing balance (a 'LIFO approach'). Applied to a chequing account, this approach would likely give an expected life for a 'base level' or 'minimum balance' on the account of many years.

The Board also considered whether the above would imply it should also change in its view as to what is the fair value of such a core deposit or whether the fair value of a core deposit cannot be less than the present value of the amount that the depositor can demand (which is the present requirement of IAS 39), but that there is also an intangible asset for the customer relationship (a 'core deposit intangible') whose value changes as interest rates move and hence that might qualify as the hedged item in a fair value hedge of interest rate risk.

The staff recommended that:

  • a. The proposal in the ED that a core deposit cannot qualify for fair value hedge accounting for any time period beyond the shortest period in which the counterparty can demand payment be reconsidered.
  • b. A core deposit be permitted to be included in a portfolio hedge of interest rate risk based on the expected repayment date of the existing balance. Rollovers or replacements of existing deposits by new deposits would not be included in the expected repayment date.
  • c. Consistent with (b), the expected repayment date of the existing balance is determined using a FIFO approach.
  • d. Consistent with (b), the requirement in IAS 39.49 for fair valuing core deposits be changed to read as follows:
    "The fair value of a financial liability with a demand feature (eg a demand deposit) is not less than the amount payable on demand, discounted from the first date that the amount could be required to be paid reflects when the amounts payable are expected to be paid. Rollovers or replacements of existing liabilities by new liabilities (eg from new deposits being made into a demand deposit account) are excluded in estimating when the amounts payable are expected to be paid."
  • e. IAS 39 requires that any difference between the fair value on initial recognition of a core deposit and the amount deposited is recognised as a separate liability, being prepaid servicing costs, and is amortised on a systematic and rational basis over the expected life of the deposit.

The Board did not support the staff's recommendations and retained the approach to core deposits as exposed. They reiterated that cash flow hedging remained available and requested the staff to continue working on the core deposit measurement issue.

The Board further agreed that hedging of fixed term accounts should also be considered further.

Designation and Hedge Effectiveness

The staff gave a brief recap of the Exposure draft's proposals as follows:

  • The hedged item may be designated as an amount of assets or liabilities rather than as individual assets or liabilities.
  • Although the portfolio may include, for risk-management purposes, assets and liabilities, the hedged item is designated is an amount of assets or liabilities. Designation of a net amount including assets and liabilities is not permitted.
  • When the hedged item is based on expected repricing dates, the effect that changes in the hedged interest rate have on those expected repricing dates shall be included when determining the change in the fair value of the hedged item. Accordingly, when interest rate changes cause prepayment estimates to change, hedge ineffectiveness will arise, both when such changes cause the entity to become over-hedged and when they cause it to become under-hedged.

The staff provided details of comments on those issues.

The staff recommended the following:

  • a. The proposal that the net position cannot be designated as the hedged item be retained.

    The Board agreed.

  • b. When the hedged item is designated as an amount, guidance on how that amount is to be determined is retained. The method for designating the hedged item and measuring effectiveness should not be left completely open .

    The Board agreed.

  • c. A method of designation that results in ineffectiveness when interest rate changes cause prepayment estimates to change, regardless of whether such changes cause the entity to become over-hedged or under-hedged should be retained. That is, the requirement that the change in the value of a hedged prepayable asset that is attributable to interest rates should include the effect that interest rates have on prepayment rates should be retained. However, this may be achieved in one of two ways:
    • If the prepayment option is required to be separated and measured at fair value, or if the entity is able to separately measure the fair value of a non-separated prepayment option, it should use this method. (It was clarified that this would merely be a more precise measure than what is allowed below.)
    • In other cases, the entity should use the percentage method proposed in the Exposure draft.

    The Board agreed. It was noted that this meant that prepayments as a result of interest rate changes needed to be included in the hedge.

  • d. It should be clarified that when prepayment estimates change because of factors other than changes in interest rates, no ineffectiveness arises.

    The Board deferred a decision on (d) unless the staff provided further details and proposed wording.

3 Board members indicated that they may dissent based on decisions to date.

Discussion at the February 2004 IASB Meeting - Macro Hedging

Hedge Effectiveness

The Board considered the following issues:

  • Should IAS 39's effectiveness tests apply to a macro hedge?
  • How should IAS 39's effectiveness tests be applied to a macro hedge?
  • Should the Board change or clarify IAS 39's effectiveness tests?

In respect of applying the effectiveness tests the staff recommended:

  • IAS 39's effectiveness requirements should apply to a macro hedge. That is, the proposals in the ED are not an alternative to, and do not overrule, IAS 39's effectiveness tests.

  • The final standard should clarify that if the entity's strategy is to 'rebalance' a hedge periodically by altering the amount of the hedging derivative to reflect changes in the hedged position, the entity, when assessing if the hedge is expected to be highly effective, needs to demonstrate an expectation that the hedge will be highly effective only for the period to when the hedge is next adjusted.

  • The final standard should clarify that the retrospective effectiveness test should be assessed for all time buckets in aggregate and not individually for each time bucket.

  • The words 'almost fully offset' should be removed from IAS 39's prospective effectiveness test and be replaced by a requirement that the hedge is expected to be highly effective (the same words as are used in US GAAP). Also, the final Standard should clarify that such an expectation may demonstrated in a number of ways, including a comparison of past changes in the fair value or cash flows of the hedging instrument and those of the hedged item, or by demonstrating a high statistical correlation.

  • The final standard should clarify that when the hedged item is designated as a portion, ineffectiveness should be measured by looking at only changes in that designated portion. The Board should also consider referring other issues about hedging a portion to the IFRIC or addressing them in a separate amendment to IAS 39.

  • The final standard should clarify that an entity cannot deliberately hedge less than 100% of the exposure on an item and designate the hedge as a hedge of 100% of the exposure. Rather, if an entity hedges less than 100% of the exposure on an item, such as 85%, it shall designate the hedged item as being 85% of the exposure and shall measure ineffectiveness based on the change in that designated 85% exposure.

The Board agreed that the prospective requirements would apply to these hedges. They clarified that this would not prevent hedging from being applied and a policy of adjusting hedges could be considered in order to achieve the prospective requirements. They further noted that these adjustments would require an ineffectiveness determination for the retrospective test. It was noted that even if the retrospective test was failed, prospective designation for remaining periods could occur provided suitable changes were made to address the reasons for the retrospective test failing.

The Board agreed to amend the wording in the application guidance in respect of prospective hedge determination. This would involve deleting the words 'almost fully offset', allowing various techniques to determine this and stating that deliberate underhedging is not permitted.

The Board further agreed to clarify that portions can be designated and that hedge effectiveness will be determined based on the portion designated. It was agreed to clarify that in designating portions in a fair value hedge, the fair value of the hedge components is determined at the time of designation.

Amortisation

The Board discussed how entities should amortise the separate balance sheet line item in either assets or liabilities that arise as a result of using fair value hedge accounting for a portfolio hedge of interest rate risk. The line item contains the change in the fair value of the hedged item.

The staff proposed that:

  • The proposal in the ED that 'amounts included in these line items shall be removed from the balance sheet when the assets or liabilities to which they relate are derecognised' be retained.
  • The amortisation of the line item using a systematic basis that is consistently applied throughout the period of the hedge be allowed.

The staff presented an example using a constant effective yield but noted this may be extremely difficult in practice. They therefore did not propose requiring this method.

The Board agreed with the staff's proposals but concluded that the standard should state that the principle is a constant effective yield amortisation. The standard should acknowledge that this may not be possible and state that a straight-line amortisation is the minimum.

It was noted that where the underlying hedged item is derecognised, no further amortisation in respect of that item would be necessary.

Transition

The staff recommended that:

  • The final standard should contain guidance on how to transition from cash flow hedge accounting under the original IAS 39 and fair value hedge accounting. More specifically, the Application Guidance should confirm that an entity wishing to apply fair value hedge accounting to a portfolio that has been accounted for using cash flow hedge accounting should apply IAS 39.101(d) to discontinue cash flow hedge accounting and should designate a new hedge in accordance with the proposed amendments for future accounting periods.

  • The final standard should not permit a fair value hedge of a portfolio of interest rate risk to be designated retrospectively, through a one-time election either on the date the amendments become effective (ie before 1 January 2005), or, alternatively, before a predetermined period expires (such as before the start of the accounting period in which the entity first applies the revised IAS 39).

  • The final standard should not give explicit guidance for entities that wish to apply fair value hedge accounting for their portfolio hedges where possible, but do not meet the conditions to do so for all time buckets. Rather the usual requirements in IAS 39 for discontinuing fair value (or cash flow) hedge accounting and for re-designating a hedge should apply.

  • Entities should adopt the amendments at the same time as they adopt the revised IAS 39.

The Board agreed with the staff proposals.

Other Issues

The Board considered various other issues on an exception basis.

No Board members indicated that they intended dissenting from the standard.

Discussion at March 2004 IASB Meeting

Changes in Prepayment Estimates

The Board decided that when prepayment estimates change, the entity should assume the change was a result of movements in interest rates, unless the entity can prove otherwise.

Hedging

The Board decided to remove a paragraph from the Exposure draft related to the application of hedging portions. The Board was undecided about whether a UK pound overdraft could be hedged with a US dollar instrument. That is, if a bank charges a rate on UK pound-denominated debt greater than a US dollar treasury rate, is that US dollar treasury rate a portion of the larger UK pound-denominated rate? The Board has decided to take this issue up with the FASB as a matter of priority for convergence.

The Board also discussed problems with the mechanics of the approach and the abilities to manage earnings. One Board member suggested he would dissent on this issue.

What should be included in the final Standard about hedging a portion of a financial asset or financial liability?

Earlier in the meeting the Board discussed whether a designated portion need have some relationship to the instrument being hedged. The Board decided that it should not give any guidance on portions beyond that already contained in IAS 39 and the macro hedging Exposure draft.

The staff proposed retaining the proposed new paragraph AG99A but removing the rest of the proposed new guidance on portions.

AG99A would state:

"If a portion of the cash flows of a financial asset or financial liability is designated as the hedged item, that designated portion must be less than the total cash flows of the asset or liability. For example, in the case of a liability whose effective interest rate is below LIBOR, an entity cannot designate (a) a portion of the liability equal to the principal amount plus interest at LIBOR and (b) a negative residual portion. However, the entity may designate as the hedged item the change in fair value or cash flows of the entire liability that is attributable to the hedged risk (eg that is attributable to changes in LIBOR). In addition, if a…"

The Board agreed.

What are the implications of the decision made at the last meeting that an entity cannot designate, as a hedged item, a portion of a financial asset or financial liability that is bigger than the total exposure on the asset or liability?

The staff proposed clarifying this issue by amending AG99A as follows:

"If a portion of the exposure on cash flows of a financial asset or financial liability is designated as the hedged item, that designated exposure portion must be less than the total exposure inherent in cash flows of the asset or liability. For example, in the case of a liability whose effective interest rate is below LIBOR, an entity cannot designate (a) a portion of the liability equal to the principal amount plus interest at LIBOR portion and (b) a negative residual portion. However, the entity may designate as the hedged item the change in fair value or cash flows of the entire liability that is attributable to the hedged risk (eg that is attributable to changes in LIBOR). In addition, if a…"

The Board agreed.

Whether to give implementation guidance on how cash flow hedges may be presented in the balance sheet.

The Board discussed three possible presentation formats and agreed to include these within an appendix as guidance. It was noted that further wording should be added to clarify what would not be permitted and that there may be other possible presentation formats.

Proposals put forward by the European Banking Federation (FBE) for a new kind of hedge accounting for hedges of interest rate margin.

In summary, the proposal is that:

The staff noted that the approach has the following features:

  • a. It results in amounts being recognised as assets and liabilities that do not meet the Framework's definitions. In the above example in which the entity recognises a liability of CU100 for 'interest rate margin hedge', there is no liability as defined in the Framework. That is, there is no present obligation that is expected to result in an outflow of economic benefits.

  • b. The hedged exposure is an accounting exposure (ie the potential variability in accrual accounted interest margin). Under the fair value hedge accounting and cash flow hedge accounting models in IAS 39, the hedged exposure is an economic exposure (to changes in fair values or cash flows).

  • c. It follows from (b) that the proposed effectiveness test is rather different from the effectiveness tests in IAS 39. The tests in IAS 39 compare the change in fair value of the hedging instrument with the change in fair value or cash flows of the hedged item. The test proposed for this new kind of hedge would compare how the recognised (accrual accounted) interest rate margin varies with movements in interest rates before and after the hedge.

  • d. The hedge would be judged to be effective to the extent it reduces the variability of recognised (accrual accounted) interest margin. Thus no ineffectiveness arises if changes in the hedged portfolio result in the entity becoming under-hedged.

  • e. The hedged portfolio may include (i) core deposits that are assumed to be fixed rate liabilities up to the date that, on a portfolio basis, they are expected to be withdrawn, and (ii) held-to-maturity assets. IAS 39 would not permit fair value hedge accounting for the former and would not permit either fair value hedge accounting or cash flow hedge accounting for the latter. Hence the proposed approach would permit hedge accounting to be applied in cases when IAS 39 would not.

The Board noted that the FBE did not see this as an alternative to macro hedging, and wanted those proposals to continue, but rather as a proposal to assist in accounting for demand deposits.

The Board noted that work needed to be done to determine how effectiveness testing would be done.

The Board expressed concern as to the inclusion of items that would not meet the framework definitions on the balance sheet. The Board agreed that further work would continue in this area.

Concerns raised earlier at the Board meeting about entities 'ability to game' the macro hedging requirements.

The Board discussed an example that demonstrated how this could be done and acknowledged that it was possible.

The staff recommended that the final Standard retain the proposals in the Exposure draft that prepayment dates should be re-estimated when interest rates change and that those re-estimates should be in accordance with the entity's risk management procedures and objectives.

The Board agreed with the staff's proposals.

FAIR VALUE OPTION

Discussion at the February 2004 IASB Meeting - Fair Value Option

The Board noted that it has received comments from regulators about the permission in IAS 39 to designate any financial asset or financial liability as one to be measured at fair value with changes in fair value reported in profit or loss (the 'fair value option').

Consequently the Board considered amending IAS 39 so that the fair value option could be applied only in specified circumstances. The specified circumstances would be those that the Board had in mind when it developed the option, ie for a financial asset or financial liability that is reliably measurable and meets one of the following:

  • i. The item is a financial asset or financial liability that contains one or more embedded derivatives as described in paragraph 10 of IAS 39.
  • ii. The item is a financial liability whose amount is contractually linked to the performance of assets that are measured at fair value.
  • iii. The exposure to a change in the fair value of the financial asset or financial liability is substantially offset by the exposure to the change in the fair value of another financial asset or financial liability, including a derivative.

The staff proposed that the fair value option could be limited by requiring that the fair value be verifiable. This would only occur if the variability in the range of reasonable fair value estimates made in accordance with paragraphs 48, 48A, 49 and AG 69-82 is not significant. This requirement is met, if for example, the fair value estimate is based on:

  • a. Observable current market transactions in the same instrument (that is, without modification or repackaging)
  • b. a valuation technique that is calibrated regularly to observable current market transactions in the same instrument (ie. without modification or repackaging) or to other observable current market data
  • c. a valuation technique commonly used by market participants to price the instrument that has been demonstrated to provide reliable estimates of prices obtained in actual market transactions, or
  • d. a range of possible outcomes whose probability can be reasonably assessed.

In the case of (ii) and (iii), the Board discussed a requirement that the fair value option be applied to both the financial asset and the related financial liability, unless classified as held for trading. This would ensure that both 'legs' of a matched position are measured at fair value through profit or loss and thus prevent entities from reporting volatility from applying the fair value option to only one leg of a matched position.

The Board discussed various concerns expressed by the European Central Bank which resulted in wording amendments.

The Board approved proceeding with an Exposure draft. (Vote 11-3)

Discussion at March 2004 IASB Meeting

The IASB further discussed a draft Exposure draft that would propose to limit the application of the new fair value option in IAS 39 to the following four situations, the first three of which it had previously discussed:

  • (a) The item is a financial asset or financial liability that contains one or more embedded derivatives.
  • (b) The item is a financial liability whose amount is contractually linked to the performance of assets that are measured at fair value.
  • (c) The exposure to changes in the fair value of the financial asset or financial liability is substantially offset by the exposure to the changes in the fair value of another financial asset or financial liability, including a derivative.
  • (d) The Board decided to add a fourth category to which the option may be applied as follows: 'By designation on initial recognition only, any available-for-sale financial asset other than a loan or receivable, on an asset-by asset basis'. (Note: This decision is irrevocable.)

The Board also clarified that criterion (a) applies to all financial instruments that contain an embedded derivatives. The Board acknowledged this would encompass mortgage loans since the holder generally has a prepayment option (considered an embedded that is closely related).

The Board discussed some drafting issues, including questions to ask in the Exposure draft. The Exposure draft will have a 90 day comment period.

Fair-Value Option Exposure Draft Issued April 2004

On 21 April 2004 the IASB issued an Exposure draft proposing to limit the option in IAS 39 Financial Instruments Recognition and Measurement to measure individual financial assets and financial assets at fair value, with value changes through profit and loss. The option was added to IAS 39 when it was amended in December 2003. Following dialogue with banking supervisory authorities, who expressed concern that the fair value option might be used inappropriately, the IASB has issued an Exposure draft, Amendments to IAS 39 Financial Instruments: Recognition and Measurement - The Fair Value Option, that proposes to limit the option's availability by:

  • Limiting the types of financial assets and financial liabilities to which the option may be applied to the following five specified categories:
    • Financial assets and financial liabilities that contain embedded derivatives.
    • Financial liabilities whose cash flows are contractually linked to the performance of assets that are measured at fair value.
    • Cases when the exposure to changes in the fair value of the financial asset or financial liability is substantially offset by the exposure to the changes in the fair value of another financial asset or financial liability, including a derivative.
    • Financial assets other than loans and receivables.
    • Items that other Standards allow or require to be designated as at fair value through profit or loss.
  • Requiring that the option may be applied only to financial assets and financial liabilities whose fair value is verifiable.

Click for Press Release (PDF 29k).

Discussion at the September 2004 IASB Meeting

At this meeting, the Board considered an analysis of the 115 comment letters received on the Exposure Draft and began to debate possible ways in which the Board might proceed in the light of these comments.

Summary analysis of letters:

  • 115 letters were received, with 65% from Europe, and 51% from preparers.
  • Only 15% of respondents agreed with restricting the fair value option. The majority of respondents (76%) did not agree with restricting the fair value option. 9% did not express a clear view, in the main because they chose to address only one or two specific proposals without expressing a general view.
  • Of the respondents that did not agree with restricting the fair value option, most did not want any change to the existing IAS 39 (60% of all comment letters). The rest would retain the fair value option with some changes, most frequently with requiring additional disclosures of when and why the fair value option was used. 19 respondents (17%) explicitly stated that they concurred with part or all of the Alternative Views.
  • Of those that agreed in general terms that the fair value option should be restricted, none agreed with substantially all the proposals in the Exposure Draft. Some would make the criteria stricter, so that fewer instruments would qualify for the fair value option (including 8 that would restrict the permission to use the option for instruments containing embedded derivatives - criterion (a) - to only those instruments that IAS 39 requires to be separated). Others would amend the criteria proposed, especially because they disagreed with the introduction of the 'verifiability' criterion (criterion (b)).

The Board noted the level of disagreement with the Exposure Draft as well as the fact that where suggestions had been made as alternatives, it appeared that those suggestions would not be workable.

Some Board members reiterated the initial intentions and rationale that led to the introduction of the fair value option; primarily to provide an alternative to hedge accounting, as well as promote the use of fair value in financial reporting. The Board noted that South Africa had been using the unrestricted fair value option since 2002 with no adverse effects and that Australia was in the process of implementing it.

The position of the FASB on this issue was discussed and noted to be as follows:

  • The FASB were intending to introduce the fair value option into its literature without any limitations but stopped work on that project once the IASB had issued the Exposure Draft proposing the limitation.
  • The FASB position was generally understood to be in favour of IAS 39 with the unrestricted fair value option.

In addition, FASB staff indicated that they were concerned about the operability of the limitation on the fair value option.

The Board also noted that this issue was not on the joint meeting agenda, and proposed that joint discussion with the FASB would be useful.

The Board decided to proceed as follows on this issue:

  • Seek views on alternative solutions. This process would include seeking input from Regulators and Banks.
  • Seek input from the Financial Instruments Task Force

Discussion at the December 2004 IASB Meeting

The Board considered a proposal for how to proceed with this project, following on from consideration of 116 comment letters received, most of which were in disagreement with the proposals contained in the exposure draft issued in April 2004. The overwhelming majority of respondents had expressed a preference for retaining the full fair value option as currently contained in IAS 39. However, a number of regulators do not support this, and reverting to the full fair value option would not solve the regulators' concerns that Board had tried to resolve through the exposure draft. The Board noted, however, that not all regulators in Europe disagree with the full fair value option.

Some of the regulators had proposed an alternative approach under which items could be measured at fair value when they are part of a group of financial assets and financial liabilities managed together on a fair value basis in accordance with a documented risk management policy. The Board agreed that it was not able to make such a suggestion operational, for a number of reasons. These include defining when a group of assets and liabilities is considered to be 'managed together' and providing guidance on the interpretation of the phrase 'documented risk management policy'. Furthermore, such a proposal would not work for activities where it is not possible for both the assets and liabilities to be measured on a fair value basis, for example the insurance industry. It was also noted that this proposal would be more restrictive than the existing 'carve-out' version of IAS 39, because it would restrict the application of the fair value option to assets as well as liabilities.

It was noted that in South Africa, the full fair value option had been implemented early. While some difficulties have been experienced, in general it has been found that the full fair value option as is currently in IAS 39 is workable. It was noted that because IAS 39 requires designation at inception, designating something at fair value through profit and loss is not done spuriously because it has long term consequences. Therefore the reality has been that it is not possible to designate something at fair value through profit and loss to simply effect the recognition of a short term gain.

Staff noted that one of the major concerns that has been expressed is around the issue of 'admission' - that is, when is an entity eligible to adopt the fair value option. The Board considered a proposal that the entity is able to adopt the fair value option when the following criteria are met:

  • Use of the fair value option corrects a measurement mismatch; or
  • The nature of the entity's activities is such that the use of the fair value options provides more useful information; or
  • The fair value option is simpler to apply than the accounting requirements that would otherwise apply, for example, accounting for embedded derivatives.

It was noted that this proposal had been published on the IASB's website and widely circulated for comment by 1 January 2005, as part of the IASB's extended due process. Comments received to date from regulators indicate that they are not supportive of this proposal.

Some respondents to the revised option had suggested the inclusion of more examples, with some even proposing that the examples form an exhaustive list of when the full fair value option is allowed. The Board disagreed, believing that there would always be one more example to be discovered, and that they could not justify an approach whereby the examples given were considered to be exhaustive. The Board agreed further examples should be considered for inclusion, and should be used to 'road-test' the revised criteria as proposed above. The Board agreed to proceed with endeavouring to operationalise the criteria described above, and to use the examples as assistance to do this rather than replacement criteria.

The Board noted that prima facie there appear to be internal inconsistencies between the objections raised by regulators in respect of the full fair value option and the proposals from the regulators to fix the problem. Concern was expressed that the Board appeared to be caught in the middle of what is ultimately a political debate, and that the perceived inconsistencies suggested to some Board members that they may not fully understand the concerns raised. It was noted that Board members have access to all documents sent to the Board highlighting concerns, but it appears the communication channels between regulators and the Board are such that the documents being received are not adequately illustrating to the Board the concerns. It was agreed that there was a need for round-table discussions in which regulators who object to the option could discuss with other parties who support the option and try to come to an understanding of each others' views and how those parties together would wish the Board to proceed.

The exposure draft proposed that the fair value option could only be used where fair value is 'verifiable' - this was the most criticised aspect of the Exposure Draft. Respondents felt that it was an unnecessary extra test, the nature of responses indicated that the word 'verifiable' had not been consistently understood, and would therefore be unlikely to be consistently applied, and a 'verifiability' criteria might result in entity's going around in circles in respect of instruments that contain embedded derivatives. The Board noted that reliability underlies all IFRS, and there was no justification for an increase in the threshold in IAS 39. The Board believed the existing guidance on fair value (including that it should be free from bias) was sufficient to ensure an appropriate degree of reliability, but that paragraph 48A as exposed should be retained - this effectively brings the guidance from the application guidance into the standard.

The Board also noted that significant concerns had been expressed about 'own credit risk', and the fact that where an entity's own credit rating declines, application of the fair value option would result in a gain arising from the decrease in the fair value of its own liabilities. The Board acknowledged that this is of concern, but noted that no robust, readily implementable solution had been identified. The Board also noted that it seemed highly unlikely that an entity would designate a liability at fair value through profit and loss at inception simply to take advantage of its own expected future credit deterioration. Accordingly they agreed the existing disclosure requirement in IAS 32 in respect of this was a sufficient proxy of the effect of own credit risk, but was not sufficiently accurate to justify requiring it to be recognised in the accounts. Therefore the disclosure will continue to be required, but until a method of determining the effects of own credit risk can be determined that is capable of being made operational as part of an accounting standard, no recognition criteria will be introduced. The Board agreed a robust discussion of this issue and the reasons recognition requirements in respect of this are not addresses would be needed in the basis for conclusions.

A large proportion of constituents had objected to the inclusion of the reference to the role of the regulator in the exposure draft. The Board had agreed to include this reference at the request of certain regulators, believing it to be a gratuitous statement. However, a number of constituents were concerned that this sentence was bestowing on regulators a power to 'meddle' in the accounting policies used in general purpose financial statements by regulated entities. The Board noted that in some jurisdictions the regulator does have that power, but where the result of using that is non-compliance with IFRSs to meet regulatory requirements, the entity could not claim to be IFRS compliant.

A number of regulators had indicated that the inclusion of this sentence is considered a deal-breaker, and without it endorsement would not be possible. This concerned the Board greatly, as they did not understand how a sentence that they had understood as gratuitous could be a deal-breaker, and therefore believed that regulators are placing greater importance on this sentence than the Board did. Accordingly the Board agreed they need to obtain a greater understanding from both regulators and constituents as to what was meant by this sentence before proceeding. It was proposed that this should be raised in the roundtable discussions. Subject to anything that might be uncovered by obtaining this greater understanding, eight Board members agreed to retain the sentence as exposed with a more robust explanation in the exposure draft. The comments received on the revised criteria will be brought to the next Board meeting, and the Board would aim to hold roundtable discussions with invited constituents in February 2005.

Discussion at the January 2005 IASB Meeting

Summary of Comments Received on the Preliminary First Draft of a Possible New Approach

A clarification was made at the outset to consider the responses to the exposed paper as 'reactions' and not comments in the normal sense, due to the process followed in obtaining those responses. It was also pointed out, that due to this process, the reactions received which included oral and email communication, none of the responses had been posted onto the IASB website.

It was indicated that the wide variety of needs in this area results in difficulty when determining the appropriateness of the fair value option to those that can and want to use it, whilst trying to place restrictions on it in order to address the needs of others.

After some discussion, some Board members expressed their concern at the lack of clarity of the bank regulators' concerns as regards the fair value option, and underscored that there was a possibility that there might in fact, be nothing wrong with the fair value option. Some Board members pointed out that the 'roundtable discussions' should be replaced by a public education session at which the bank regulators, particularly the European Central Bank, would be provided the opportunity to put forward their concerns to the full Board.

A general concern was raised regarding the reason why a particular constituency's concerns, which appeared contrary to the majority's view, were being considered so extensively by the Board. It was also pointed out that an overwhelming majority of respondents disagreed with the 'possible new approach' and fully supported IAS 39 with the unrestricted fair value option.

The issues raised by the bank regulators at the round-table discussions were noted as follows:

  • The fair value option introduced risks in situations where internal controls, systems etc are not operating adequately, leading to an incorrect application of the fair value option.
  • Certain instruments which could only be measured by valuation models would present an opportunity for entities to manage earnings by 'cherry picking' those instruments that would give the desired outcome.
  • The inadvertent measurement at fair value of only one side of the balance sheet, thereby creating a mismatch in measurement basis across the balance sheet.

Responses to these concerns by Board members highlighted the following:

  • Application guidance is already in place that addresses the criteria and circumstances under which valuation models can be used under IAS 39.
  • Disclosure requirements already in place address the earnings management concerns.
  • The risks that the bank regulators are trying to manage do not arise from the accounting, but rather the terms and conditions of the contracts entered into by management.
  • The fair value option is an irrevocable choice at the point of initial recognition; therefore, there is no risk of cherry picking as the future performance is unknown at that point in time.

The point was made, that it appeared as though the concerns raised by the bank regulators were in fact issues that they themselves, could manage given their mandate and that the debate around the fair value option was not really an accounting debate, but possibly something else.

It was pointed out that another paper would be considered at the February meeting which would incorporate the reactions received to date on the proposed new approach.

Discussion at the February 2005 IASB Meeting

Since the Board's last discussion in January, the staff redrafted the possible new approach in the light of constituents' comments, and this was presented to the Board. The redrafted document will be taken to the round-table discussion scheduled to take place in London on Wednesday 16 March 2005, in public session. Due to time constraints, only certain constituents (approximately 30) would be invited to participate at those round-table discussions.

It was indicated that some discussions had taken place with representatives of the Basel Committee and the ECB during which useful clarifications had been made of the concerns expressed previously with regards to the fair value option in IAS 39. Those clarifications had been incorporated into the redrafted document. The purpose of the round-table discussions was to solicit input from other constituents to ensure that the proposal was appropriate for all.

Some Board members questioned whether the regulators had provided assurances that the redrafted document adequately addressed their concerns such that the Board could expect for the round-table discussions to be conclusive.

As regards the actual redrafting, the Board debated at length whether some of the terminology and the examples could be misinterpreted (for example, the word 'mismatch' and the example in paragraph AGX5 which was viewed by some as unclear regarding the level of reduction required of the mismatch, that is, whether it is a 'greater reduction' or just a 'reduction'). An inconsistency was identified in this paragraph with the requirements in the redrafted paragraph 9 which refers to 'eliminates or significantly reduces a measurement or recognition inconsistency'.

After much debate, there was general agreement that the proposals should refer to an 'accounting mismatch'.

Discussion at the March 2005 IASB Meeting

The staff presented the effective date and transition requirements issues to the Board on the basis that the fair value option debate would be finalised in substantively the same form as currently drafted. The staff recommended the following:

  • the effective date is annual periods beginning on or after 1 January 2006, with earlier application encouraged.
  • entities be permitted to change their designations of which financial assets and financial liabilities the fair value option will and will not be applied to on the application date of the amendment.
  • when entities do change their designations, entities should be required to restate comparative financial statements.

The Board discussed this issue at length, going through a number of scenarios including those posed by the 'carve out' adopted in Europe. The Board concluded that on the effective date of the restricted fair value option, an entity will be required to 'de-designate' any instrument that does not meet the new criteria for the fair value option. The fair value of that instrument on that date will become the deemed cost and the subsequent accounting will be on the basis of IAS 39.

A first-time adopter whose transition date coincides with the effective date of the restricted fair value option, or a first-time adopter of IFRS that also early adopts the restricted fair value option will be required to comply with IFRS 1 in this regard.

Discussion at the 16 March 2005 Public Round-Tables

Insurance Session

There was general support for the latest draft of the restricted fair value option in comparison to the first draft of the same. Some participants made the point that they preferred the original unrestricted fair value option although they could work with the restricted version.

Some participants congratulated the IASB for listening to responds and developing the revised approach.

Various comments were made regarding detailed issues related to the fair value option, which suggested that there would be some difficulty in applying the new approach to certain specific situations, but it did not seem as though those challenges would undermine the proposals.

Some participants suggested that where the unrestricted fair value option had been applied, that for those instruments, entities should be allowed to continue with that designation after the new approach becomes effective so as not to create a mismatch going forward.

The IASB staff provided an overview of the discussions regarding the transitional provisions agreed upon by the Board (see notes from 15 March 2005 Board meeting).

Banking Session

There was general support for the new approach as drafted. Participants encouraged the IASB to proceed with the finalisation of the restricted fair value option as currently drafted subjected to any minor editorial amendments.

The point was made that in South Africa, the unrestricted fair value option has been applied already for some time and that an assessment of the instances in which it had been used indicated that use of fair value measurement would continue under the restricted option. Consequently, there was general support for the proposal on that basis.

There was some discussion of the detailed issues related to the proposal with some participants requesting additional guidance to cover areas of application difficulty.

Other Session

The point was made as to why if an entity manages its financial instruments on a fair value basis it should not be required to use fair value accounting (not just an option to do so, or a restricted one for that matter).

Concern was raised regarding the words 'significantly reduces' in paragraph 9(b)(i) of the proposals as it is not clear on what basis this would be measured - that is 'significantly reduces' in comparison to what? In the same paragraph, the notion of 'an accounting mismatch' is introduced where as in the Basis for Conclusions, the notion of a mismatch in an economic hedge is discussed. The issue raised was whether these two notions are supposed to refer to the issue, and what that issue really is.

It was clarified that on first-time adoption of IFRS, an entity can designate any instrument for fair value measurement under the new approach, not just new instruments arising after first-time adoption.

Board session

After the round-table sessions, the Board convened to discuss and summarise the issues raised as well as to map out the way forward. The following issues were identified for consideration:

  • Transition problems particularly for entities subject to the 'carve out'.
  • What is an accounting mismatch in comparison to what is a mismatch of an economic hedge? The point was made that guidance could be drafted on the basis of clarifying that an accounting mismatch is a broader concept than just the mismatch in an economic hedge. In addition, the Board would be careful not to introduce a type of effectiveness test to this area of IAS 39.
  • The meaning of a 'significant reduction' in a measurement or recognition inconsistency.
  • Can an entity designate or de-designate into or out off the fair value through profit or loss category?
  • There was a request for guidance on the level of documentation that would be required to fulfil paragraph 9(b)(ii) as regards a 'documented risk management or investment strategy'. The Board indicated that such documentation would not be at the same level required for hedge accounting.
  • Whether the fair value option can be applied to a component of a financial instrument (for instance, interest rate risk).

Regarding some of those issues, the Board seemed to identify the need for additional guidance on how to tackle specific issues facing preparers as the underlying concerns. The staff was requested to formulate proposed solutions for the Board to consider at the April meeting.

Discussion at the April 2005 IASB Meeting

Following the public round-table meeting in March on this issue, the IASB staff posted a paper on the IASB website and requested comments on three proposed Alternatives regarding effective date and transition issues.

The staff provided an overview of comments received, with many respondents noting that Alternative A would unfairly penalise existing IFRS preparers. In addition, many respondents expressed a preference for Alternative C over Alternative B. Alternative C was widely viewed as 'permissive' in that it allowed more entities to have a 'free choice' over designation of financial instruments.

Respondents also encouraged the Board to reconsider its tentative decision not to permit the restatement of comparatives.

It was indicated that letters of support for the current proposals had been received from various regulators.

The staff proposed Alternative C on the basis that it was the 'fairest' in terms of effect on existing IFRS preparers and first-time adopters. The Board agreed with Alternative C (vote 13-1) on the basis that existing IFRS preparers should not be prejudiced for applying the original guidance. A 'free-choice' would therefore be granted to early adopters of the amended fair value option.

In reacting to the overall proposals, some Board members indicated:

  • preference for the original unrestricted fair value option as that was conceptually superior but would vote for the current proposals as they are better than the proposals contained in the first exposure draft and given the current situation coupled with the fact that this issue had to be resolved;
  • some concern over certain jurisdictions in which regulators require management of certain financial assets and liabilities on a fair value basis as well as fair value accounting and the impact that the restricted fair value option, which is viewed as a retrospective step, would have on financial reporting;
  • the restrictions placed on the fair value option were introducing unnecessary complexity into an already complex standard.

Following the general discussion, three Board members indicated their intention to vote against the restricted fair value option, some citing the fact that accounting is better served with an unrestricted fair value option as currently drafted in IAS 39. The amended fair value option would therefore proceed as an amendment to IAS 39 (vote 11-3).

The Board confirmed that the effective date of the amendment to IAS 39 would be 1 January 2006, with earlier application permitted. The period in which the 'free-choice' would be applied would be set as the three months following the date of publication of the amendment. The proposed publication date is June 2005. The staff indicated that this three month window was a subjective timeframe guided by IFRIC practise on Interpretations. It would be during this time that preparers would designate financial instruments as at fair value through profit and loss as well as consider those instruments that do not meet the criteria in the restricted guidance resulting in de-designation.

The Board agreed that pre-existing financial instruments at 1 January 2005 would be eligible for a three month window period in which the 'free-choice' could be applied. In addition, the Board agreed that instruments could be de-designated as at 1 January 2005, from fair value hedges, only if the reason for it is to apply the amended fair value option.

The Board indicated that the drafting of the amendment as regards the 'free-choice' would be so as not to prejudice quarterly reporters.

As regards restatement, the Board was persuaded by respondents and the staff and therefore agreed to allow restatement of comparative information. An entity can therefore apply the amended fair value option as at 1 January 2004 (transition date for a number of first-time adopters in Europe) provided they met the criteria of the amended fair value option at that time.

Where an entity, in adopting IAS 39, chooses to restate comparatives as permitted in that Standard, it would be required to restate that comparative information taking into account the requirements of the amended fair value option.

Discussion at the May 2005 IASB Meeting

The staff made a viva voce presentation (that is, there were no papers, either for the Board or Observers) on an issue that several insurance companies had asked to have highlighted. The staff noted that the issue was not a new matter and had been discussed at the time the Fair Value Option had been approved.

The issue had to do with the restatement of comparatives and affected first-time adopters especially. There was a potential problem between the definitions in IAS 39 paragraphs 9(b)(i) and 9(b)(ii) and the look-back period permitted when an entity adopts IAS 39 for the first time. The insurance companies were concerned about 'undue restrictions' on designation and a lack of comparability between current and comparative periods.

Board members held a brief discussion on the topic, but agreed that the issue was one of which they were aware when they approved the amendment to the Fair Value Option in April 2005. There was no appetite to re-open the decisions, especially because to do so might necessitate additional due process, which would delay the issue of an amendment that was considered important by constituents.

June 2005: IASB Issues Final IAS 39 Fair Value Option Amendment

On 15 June 2005 the IASB issued its final amendment to IAS 39 Financial Instruments: Recognition and Measurement to restrict the use of the option to designate any financial asset or any financial liability to be measured at fair value through profit and loss (the 'fair value option'). The IASB developed this amendment after commentators, particularly prudential supervisors of banks, securities companies, and insurers, raised concerns that the fair value option contained in the 2003 revisions of IAS 39 might be used inappropriately. The new revisions limit the use of the option to those financial instruments that meet certain conditions. Those conditions are that:

  • the fair value option designation eliminates or significantly reduces an accounting mismatch,
  • a group of financial assets, financial liabilities, or both are managed and their performance is evaluated on a fair value basis in accordance with a documented risk management or investment strategy, and
  • an instrument contains an embedded derivative that meets particular conditions.

The amendment is effective 1 January 2006, with earlier application encouraged. Click for Press Release (PDF 55k).

TRANSITION PROVISIONS ('DAY 1 PROFIT RECOGNITION')
GUARANTEES AND CREDIT INSURANCE
FORECAST INTRA-GROUP TRANSACTIONS

Discussion at the April 2004 IASB Meeting - Transition Provisions and Day 1 Profit Recognition

The Board was made aware of difficulties in the transition requirements in IAS 39 for first-time adopters using IFRS 1 to apply fully the retrospective approach without the impracticability exception for day one profit previously recognised. The Board also noted this was contradictory to US GAAP which limits the retrospective approach to 25 October 2002. The Board therefore decided to converge with US GAAP to only require retrospective application back to 25 October 2002. Companies would have the choice to retrospectively apply earlier.

The Board will effect this amendment by adding it to the IAS 39 guarantees exposure draft due out very shortly. There was concern as to the moving of the stable platform; however, the Board noted this change will make first-time adoption easier.

The Board also decided to add guidance to prevent 'day 2' gains from being recognised.

Discussion at the May 2004 IASB Meeting - Forecast Intra-group Transactions

IGC 137-13 had allowed an intra-group monetary item that is not eliminated in consolidation, and therefore is reported as an asset or liability in the group balance sheet, to be a hedged item. IGC 137-14 had allowed a forecast intra-group transaction also to be a hedged item. In revising IAS 39 in December 2003, the Board incorporated the provisions of IGC 137-13 but not those of 137-14. This apparent prohibition against using a forecast intra-group transaction as a hedged item is causing concerns in practice, and constituents have questioned whether the Board intended such a prohibition, which is a difference with US GAAP.

The Board acknowledged this concern. It noted, however, that a general principle in IAS 39 is that entities can obtain hedge accounting only for external transactions. The rationale for allowing an intra-group monetary balance to be a hedged item does not apply to a forecast transaction because such a transaction is not recognised in the group accounts at all. The Board intends to clarify, however, that a group may use a forecast external transaction as the hedged item at the group level. This clarification will be exposed in the forthcoming exposure draft on guarantees and credit insurance due out in June 2004.

8 July 2004: IASB proposes three amendments to IAS 39

On 8 July 2004 the IASB published three short exposure drafts proposing limited amendments to IAS 39 Financial Instruments: Recognition and Measurement. Comment deadline on all is 8 October 2004. The EDs are available on the IASB's website starting 19 July. Click for Press Release (PDF 41k). Summaries of the three EDs:


Transition and Initial Recognition of Financial Assets and Financial Liabilities

The ED proposes an amendment that would apply when entities first adopt IAS 39. It would give an entity a choice of applying the "day one gain and loss" recognition requirements either prospectively to transactions entered into after 25 October 2002 or retrospectively under IAS 39.104. "Day one gains and losses" arise when the transaction price differs from fair values calculated by using, for example, a valuation model. These gains and losses can only be recognised in certain circumstances – when variables in the valuation model include only data from observable markets. This change would allow entities conform their treatment under IAS 39 to US GAAP. Proposed effective date: Annual periods beginning on or after 1 January 2005.


Cash Flow Hedges Accounting of Forecast Intragroup Transactions

The ED Cash Flow Hedge Accounting of Forecast Intragroup Transactions addresses whether forecast intragroup transactions can be considered hedged items in cash flow hedges. Under IAS 39 prior to the December 2003 revisions, forecast intragroup transactions could be designated as a hedged item if the criteria in IGC 137-14 were met. That approach was consistent with US GAAP. However, IAS 39 as revised in December 2003 removed IGC 137-14 without including its guidance in the standard. The Exposure Draft confirms that the forecast intragroup transactions cannot be considered hedged items. However, the ED provides guidance that in the consolidated accounts, a highly probable forecasted external transaction designated in the functional currency of the entity entering into the transaction can be designated as the hedged item provided that it gives rise to an exposure that will have an effect on consolidated profit or loss. In order to have an effect on profit or loss the transaction must be designated in a currency other than the group's presentation currency. Proposed effective date: Annual periods beginning on or after 1 January 2006.


Financial Guarantee Contracts and Credit Insurance

The ED proposes that the issuer of a financial guarantee contract should measure the contract initially at fair value. If the financial guarantee contract was issued in a stand-alone arm's length transaction to an unrelated party, its fair value at inception is likely to equal the premium received. The ED also addresses the subsequent measurement of those guarantees:

  • A financial guarantee that meets the IFRS 4 definition of an insurance contract (guarantee against failure of a specific debtor to pay) would initially be measured at fair value and subsequently at the higher of (a) the amount initially recognised minus amortisation under IAS 18 and (b) IAS 37.
  • A guarantee arising on derecognition would be accounted for under IAS 39's derecognition requirements, even if it is like an insurance contract.
  • A guarantee that is indexed based on a credit index or other variable would be treated as a derivative under IAS 39 (mark to market through profit or loss).

Proposed effective date: Annual periods beginning on or after 1 January 2006.

Discussion at the December 2004 IASB Meeting

Financial Guarantees and Credit Insurance [Education Session]

This was a public education session and therefore no decisions were made.

The session was led by representatives of:

  • The International Credit Insurance & Surety Association (ICISA); and
  • The Association of Financial Guaranty Insurers (AFGI)

The background to this session was that the Board issued an Exposure Draft in July 2004 proposing amendment to IAS 39 and IFRS 4. The comment deadline was 8 October. ICISA and AFGI both submitted comment letters.

ICISA and AFGI addressed the Board and explained the following areas:

  • (a) What their credit insurance / financial guaranty business is and how it operates.
  • (b) Similarities and differences between credit insurance, financial guaranty business and products offered by banks.
  • (c) Current accounting practice for these contracts and implication of applying IFRS 4.
  • (d) Practical implications of applying the proposals in the ED if the Board confirms them.

ICISA addressed the Board first and highlighted the main differences between credit insurance and products offered by banks. The main points highlighted included:

  • Banks give guarantees over known specified debtors whereas credit insurance covers wide portfolios of unspecified debtors;
  • Credit insurance policies include maximum liability clauses, e.g. of a €9 billion portfolio, the maximum liability of the credit insurers may be capped at €335 million, whereas banks provide guarantees for the full amount.

The differences were discussed. A Board member suggested that the first was merely an 'operational' difference in the two products that would not necessarily result in different accounting treatments, whereas the second was a difference in contractual arrangements rather than a difference per se between banks and insurers. However, the Board reached no conclusion, as the purpose of this session was purely educational.

The AFGI then highlighted the impact of the proposed accounting treatment in the ED. AFGI recommended that financial guarantees should be included within the scope of IFRS 4 pending the outcome of phase II of the Insurance Project. The three key issues of concern to the AFGI going forward are:

  • The treatment of deferred acquisition costs (and the potential for differences to US GAAP).
  • The need for symmetry in treatment of financial guarantee contracts and contracts that are reinsurance of financial guarantee contracts.
  • The treatment of salvage provisions within financial guarantee contracts.

The staff expects to ask the Board to discuss the comment letters in January.

IAS 39 – Cash Flow Hedge Accounting of Forecast Intra-group Transactions [Education Session]

This session was held as an educational session - no decisions were made.

The issues discussed relate to the fact that the old version of IAS 39 contained an exception to the principle that entities can obtain hedge accounting only for transactions that involve transferring risk to a party external to the entity. The old version of IAS 39 allowed the foreign currency risk in an intra-group monetary item to be designated as a hedged item in consolidated financial statements as long as the intra-group item results in an exposure to foreign exchange rate gains or losses that are not fully eliminated on consolidation under IAS 21. This is retained in the revised version of the standard.

However, IGC 137-14 under the old standard also allowed a forecast intra-group transaction to be designated as the hedged item in a foreign currency cash flow hedge in consolidated financial statements. The revised IAS 39 does not allow this.

The Board issued an exposure draft in July 2004 with proposals to allow a group to obtain hedge accounting in the consolidated financial statements by designating the hedge as a hedge of a highly probable forecast external transaction, and the linked forecast intra-group transaction could form part of the tracking mechanism for associating the hedging instrument with an external transaction.

Two issues arising from this were highlighted to the Board by the staff:

Issue 1

The first issue affects existing adopters of IAS 39. The version of IAS 39 (which includes IGC 137-14) currently being applied by existing users of IAS 39 allows hedge accounting for a hedge of foreign exchange risk of a highly probable forecast intra-group transaction. However, in 2005 groups will not be able to use hedge accounting for such transactions in consolidated financial statements. Moreover, they will also have to unwind the hedge accounting applied in previous periods, since the improved IAS 39 requires full retrospective application for existing adopters. The impact of this will be significant for many adopters.

An issue of communication arises because shortly after releasing 2004 financial statements, companies intend to let analysts know how the 2004 figures will be restated to comply with the revised IAS 39 and the other new Standards. Board members noted that the issue of communication to analysts was not the key issue (depending for instance on whether IGC 137-14 is reinstated).

Furthermore, the July 2004 ED will not have been agreed by 1 January 2005 and therefore cannot be implemented, with the potential impact that these entities will have to change their hedge accounting for a second time in six months if they are allowed to use the 'tracking mechanism' described above.

The Board stated that it was sympathetic to this problem. Various options were considered by the board including:

  • Reinstatement of the exception of the old version of IAS 39 (i.e. IGC 137-14).
  • Redesignation of hedges only prospectively, i.e. not restate the 2004 comparatives.

It was agreed that no decision would be made by the Board in this session as the ED has not yet been agreed by the Board.

Issue 2

This issue relates to both existing users and first time adopters of IAS 39. This issue arises because all hedging relations have to be designated at the inception of the hedge. In the absence of the final Standard on Cash Flow Hedge Accounting of Forecast Intragroup Transactions, the question arises as to what should groups designate as the hedge item at 1 Jan 2005 - highly probably forecast external transactions or highly probably forecast intra-group transactions? If a group does not designate a hedge in the 'right' way, it will not be able to obtain hedge accounting and will experience volatility in its consolidated profit or loss accounts.

The Board acknowledged that this is an issue and that it is sympathetic to this problem. However, it is unable to make a decision at this time, and the objective of this session was for the staff to alert the Board to some of the issues highlighted by the comment letters. The Board discussed the possibility of inserting in the December IASB Update an appropriately worded statement expressing the fact that the Board is sympathetic to the concerns of constituents on this issue.

It was agreed that the staff would perform their comment letter analysis and report to the Board in the February meeting when the issue would be discussed again by the Board. The staff expressed the view that it might be difficult for the Board to finalise amendments to the standard arising out of the Exposure Draft before the third quarter of 2005. Board members expressed the view that the Board should, if at all possible, try to finalise the amendment by 30 June 2005.

Amendments to IAS 39 – Transition and Initial Recognition of Financial Assets and Liabilities - Sweep Issues

(i) Straight-line amortisation

This discussion related to whether straight-line amortisation is an appropriate mechanism of recognising any difference between a transaction price (used as fair value in accordance with paragraph AG 76) and a valuation made at the time of the transaction.

A commentator on the fatal flaw draft had noted that companies have attempted to use the following statement in the November IASB Update, and in the Basis for Conclusions in the near final draft published on the subscriber website, as a justification for using straight-line amortisation when in his view, that would not be appropriate:

[The Board] "...concluded that although straight-line amortisation may be an appropriate method in some cases, it will not be appropriate in others".

The commentator had requested that any reference to straight-line amortisation be removed.

The Staff put forward its view that it was not convinced that removing the explanation in the Basis would rectify this problem. In the absence of any guidance, the argument that straight-line is acceptable in a given circumstance can still be made, and this is a matter for professional judgement.

One Board member asked if anyone could think of an example where straight-line amortisation would be appropriate.

In the absence of any examples, another Board member suggested that a more appropriate method should be used if possible, but if not, the straight-line method could be used.

The Board agreed with the Staff that the guidance should be retained as it is and that it is not practicable for more detailed guidance to be given at this time. However, it was agreed with Staff that it would be advisable to add a sentence to the guidance to the effect that it is outside the scope of the IASB's current project to state when it would be appropriate to use straight-line amortisation.

December 2004: IASB Amends IAS 39 Transition

On 17 December 2004 the IASB published limited amendments to IAS 39 Financial Instruments: Recognition and Measurement on the initial recognition of financial assets and financial liabilities. The amendments provide transitional relief from retrospective application of the 'day 1' gain and loss recognition requirements. They allow, but do not require, entities to adopt an approach to transition that is easier to implement than that in the previous version of IAS 39, and will enable entities to eliminate differences between the IASB's Standards and US requirements. Specifically, the amendments give entities a choice of applying the 'day 1' gain or loss recognition requirements in IAS 39:

  • retrospectively (as previously required by IAS 39);
  • prospectively to transactions entered into after 25 October 2002 (the effective date of similar requirements in US GAAP); or
  • prospectively to transactions entered into after 1 January 2004 (the date of transition to IFRSs for many entities).
Click for IASB Press Release (PDF 73k).

Discussion at January 2005 Meeting

Amendment to IAS 39 – Cash Flow Hedge Accounting of Forecast Intra-group Transactions [Education Session]

Representatives of Philips made a presentation to the Board. The presentation covered a series of transactions, including inter-group sales, that created risk exposures that require hedging as per the entity's policy. These illustrations highlighted the difficulty of applying the proposed amendment of IAS 39 to exposures that are generally common in practice. It also highlighted the difference between transaction risk and translation risk exposures.

One view expressed is that these issues arise in part because the IASB's proposed amendments have not gone far enough in converging with US GAAP.

Amendments to IAS 39 and IFRS 4 – Financial Guarantees and Credit Insurance

The purpose of the Board's discussion was to assess whether the Board should proceed, in general terms, with the proposals in the ED on Financial Guarantee Contracts and Credit Insurance.

On the balance of considerations arising from the comment letter analysis and the deliberations regarding Insurance Contracts (Phase II), the Staff recommended that the proposal be withdrawn. The Board discussed this issue at length and reached some consensus that this issue should be brought back to the Board at a later date, whilst in the interim, the Staff would work on a proposal along the following lines:

  • Clarify in the scope of IFRS 4 that financial guarantees are within the scope of IAS 39 whereas credit insurance contracts are dealt with in IFRS 4. This was generally viewed as providing a free choice as the 'labelling' of a contract could drive the accounting treatment.
  • The revised guidance in the exposure draft would be incorporated into IAS 39.
  • The IAS 39 scope paragraph would clarify that it applies to financial guarantees.
  • The loss adequacy test in IFRS 4 would apply to credit insurance contracts on the basis of IAS 37.

It was noted that the accounting outcome for both types of contracts (financial guarantees and credit insurance contracts) would be substantially the same, regardless of which option is chosen.

Discussion at the February 2005 IASB Meeting – Forecast Intragroup Transactions

The staff gave an overview of the comment letter analysis. In response to the question of whether respondents agreed with the proposals in the ED:

  • 28 (48% of all comment letters, 50% of those who responded) agreed with the proposals.
  • 28 (48% of all comment letters, 50% of those who responded) disagreed.
  • 2 (4%) did not express a clear view or did not respond.

The staff identified and presented the following possible ways forward (some of which were suggested by respondents):

  • Do nothing, that is, reject the proposals in the exposure draft and retain the current version of IAS 39.

    The staff did not recommend this approach as it was clear that respondents were in need of clarity on this issue.

  • Proceed with the proposed amendment, possibly with some alterations to address some of the main concerns of respondents.

    The staff did not recommend this approach as it would not address the conceptual issues identified during the development of the exposure draft.

  • Proceed with an amendment that allows a highly probable intra-group forecast transaction to be designated as the hedged item at a group level. The amounts relating to the hedging instrument initially recognised in equity would be included in profit or loss when the hedged exposure affects consolidated profit or loss.

    The staff recommended this approach and the Board agreed. This approach would entail that the IASB proceed with an amendment that allows a highly probable intra-group forecast transaction to be designated as the hedged item for the purposes of the consolidated financial statements, as allowed by the previous version of IAS 39 as interpreted by IGC 137-14 Forecasted intra-group foreign currency transactions that will affect consolidated net income.

    The Board indicated that this solution was the only way around the IAS 21 concept that does not allow for a group functional currency. In addition, the staff proposed that re-exposure was not necessary.

The staff went on to present the following 'transition recommendations':

Effective date

The staff recommended that the effective date of the proposed amendment would be accounting periods beginning on or after 1 January 2006, with earlier application encouraged.

Restatement of comparatives

For existing users of IAS 39, the amendment will not require restatement of comparatives as, in substance, the staff recommendation is consistent with IGC 137-14. Specifically with regard to the Staff proposal requiring recycling of any gain/loss from the hedging instrument held in equity to profit or loss whenever consolidated profit or loss is affected by the hedged exposure, the Staff recommends that given the practical considerations of requiring restatement of comparatives for this requirement alone, that groups should apply this requirement prospectively from the date of application of this amendment.

For first-time adopters of IAS 39, the issue of restatement of comparatives does not arise because they are exempt from restating comparatives in the first year of adoption. This means that IFRS 1 will not require amendment.

Application of Amendments from 1 January 2005

All hedging relationships have to be designated at the inception of a hedge. This means that from 1 January 2005 groups will not have known what the hedged item should be in order to obtain hedge accounting in the consolidated financial statements.

Given the practical difficulties being faced by constituents, to provide groups with relief for the period between 1 January 2005 and the application date of the amendment the staff recommends the following solution:

  • The Board permits an entity that designated a forecast intra-group transaction as a hedged item at the start of the annual period beginning on or after 1 January 2005, in a hedge that would otherwise qualify for hedge accounting, to use that designation to apply hedge accounting in consolidated financial statements from the start of the annual period beginning on or after 1 January 2005.

  • When an entity designated an external forecast transaction, denominated in the functional currency of the entity entering into the transaction, the Board allows the entity to obtain hedge accounting in the consolidated financial statements in the period from the start of the annual period beginning on or after 1 January 2005 to the date of application of this amendment, provided that the hedge would otherwise have qualified for hedge accounting.

Some Board members expressed concern that whilst the above proposals were necessary in this particular case (as the Board had given indications that through the exposure draft, it was merely clarifying the existing IAS 39 requirements), it should not be viewed as tacit approval for constituents to apply the principles contained in exposure drafts. Those Board members reiterated the point that only the principles contained in final pronouncements should be applied.

Discussion at the February 2005 IASB Meeting – Financial Guarantees and Credit Insurance

The purpose of the discussion was to explore the implications of the Board's decision in January, including the key issues raised in comment letters as well as consider re-exposure and a proposed time-table for the rest of the project.

At the January meeting, the Board tentatively decided to permit two approaches:

  • The approach proposed in the Exposure Draft; or
  • Applying IFRS 4, but with a more rigorous liability adequacy test. In particular, in addition to meeting the minimum requirements specified in paragraph 16 of IFRS 4, the net liability recognised should not be less than the amount determined under IAS 37. This additional requirement would not apply to other types of insurance contracts.

The following implications of this decision were discussed:

  • Cash flows from subrogation. The Board questioned why subrogation rights would be considered to be reimbursement rights under IAS 37 and not as contractual rights in terms of the original contract. There was general disagreement with the analysis presented and the Board agreed to consider the other implications before making a final decision.
  • Intra-group guarantees. The Board noted the issue raised had broader implications about measurement of related party transactions that is currently not dealt with under IFRS and which would continue to arise for as long as this lack of measurement guidance exists. After some discussion, the Board noted the difficulties in providing guidance in this area. Some Board members pointed out that IAS 18 would not apply to the contracts (financial guarantees that are in substance, insurance contracts) as that Standard scopes out insurance contracts within the scope of IFRS 4.
  • Whether the option to apply IFRS 4 or IAS 39 should be an accounting policy choice or apply instrument by instrument.
  • Whether the benefits of the proposed approach outweigh the costs.

The Board considered these issues holistically together with proposals to overcome the problems presented in the context of the 'stable platform' and limited changes to insurance accounting that were intended when developing IFRS 4. The Board considered discontinuing with this project but decided to reconsider the issues at the next meeting to allow three Board members that were not present to consider the arguments put forward.

It was suggested that should the Board decide to discontinue with this project, it may be appropriate for Example 9 in Appendix C to IAS 37 to be moved to IFRS 4.

Discussion at the March 2005 IASB Meeting – Financial Guarantees and Credit Insurance

Background

In previous meetings, the topic of whether accounting for financial guarantee contracts should be in accordance with IAS 39 or IFRS 4 has been discussed at length, with different possible approaches considered. However, the costs and benefits of this project, had in the past, led to a proposal to drop the project. However, the project was re-discussed by the Board.

The approach considered was to apply IFRS 4 if certain 'insurance' characteristics are significant, otherwise default to IAS 39.

The insurance characteristics are those that are commonly found in credit insurance contracts, but less commonly found in financial guarantees issued by banks; and those that generate accounting issues that are difficult to resolve in the short term (eg regular premiums, subrogation rights, significant origination costs, participation features).

The proposed features are as follows:

  • Relatively significant direct acquisition costs.
  • The overall final premium for the contract can be determined only at the end of the contract period because the contract contains:
    • profit sharing features or premium adjustments based on experience.
    • discretionary participation features (as defined in IFRS 4).
    • a method for determining the premium that depends on the total sales for the period.
  • The premium is paid in instalments over the term of the contract rather than at inception.
  • Payments to the counterparty are reduced by deductibles.
  • Reinsurance contracts may be available to mitigate risk.

Whilst several Board members still believed the project should be dropped, the following reasons to keep the project were raised:

  • It deals more with accounting issues (than contract details), which is useful.
  • It gives guidance to non-insurance companies on how to account for guarantees.
  • If dropped, entities will revert to the guidance given by the local regulators, which vary all over the world.

The Board voted 7 - 5 to make one last attempt at this project, with certain concerns being addressed:

  • More rigorous criteria (the current insurance characteristics noted above are too open). Wording to be amended to try and push banks into applying IAS 39, and insurance companies towards IFRS 4.
  • Disclosures in the respective standards to be followed. (The original proposal was to have a catch all disclosure regardless of which standard was applied).

The possible exemption for inter-company guarantees is to be re-discussed at the next meeting.

April 2005 Amendment to IAS 39 on Intragroup Hedges of Forecast Transactions

On 14 April 2005, the IASB issued an amendment to IAS 39 to permit the foreign currency risk of a highly probable intragroup forecast transaction to qualify as the hedged item in consolidated financial statements provided that the transaction is denominated in a currency other than the functional currency of the entity entering into that transaction and the foreign currency risk will affect consolidated financial statements. The amendment also specifies that if the hedge of a forecast intragroup transaction qualifies for hedge accounting, any gain or loss that is recognised directly in equity in accordance with the hedge accounting rules in IAS 39 must be reclassified into profit or loss in the same period or periods during which the foreign currency risk of the hedged transaction affects consolidated profit or loss.

The amendment is effective 1 January 2006, although earlier application is encouraged.

This amendment removes a difference with US GAAP that was created when IAS 39 was amended in December 2003, because that amendment did not permit hedge accounting for forecast intragroup transactions.

Discussion at April 2005 IASB Meeting: Financial Guarantees and Credit Insurance

At the March meeting, a suggestion was made that would result in guidance prepared using a business model-approach, that is, if the issuer of a contract within the scope of the exposure draft had previously asserted that such contracts were insurance contracts and had used accounting applicable to insurance contracts, the issuer could apply either the approach proposed in the exposure draft or IFRS 4.

The Board discussed the fact that it would not be clear in which way an entity had to 'assert' that such contracts were insurance contracts. The staff indicated that in practice, it may be sufficient that the entity treated the contracts as insurance contracts in the last financial statements or, for example, it has to prove that it sold those contracts under the name 'insurance contract' or called itself an 'insurance company'.

Board members indicated that the proposal was not 'pretty' but this was probably the only way to achieve the Board's objectives, which are to have insurance contracts accounted for in accordance with IFRS 4, and the rest in accordance with IAS 39.

The staff recommended that the Board discontinues this project. The Board decided (vote 8-6) to continue with the project using the business model-approach.

August 2005 Amendment to IAS 39 and IFRS 4 - Financial Guarantee Contracts

On 18 August 2005, the IASB amended the scope of IAS 39 to include financial guarantee contracts issued. However, if an issuer of financial guarantee contracts has previously asserted explicitly that it regards such contracts as insurance contracts and has used accounting applicable to insurance contracts, the issuer may elect to apply either IAS 39 or IFRS 4 Insurance Contracts to such financial guarantee contracts.

A financial guarantee contract is a contract that requires the issuer to make specified payments to reimburse the holder for a loss it incurs because a specified debtor fails to make payment when due.

Under IAS 39 as amended, financial guarantee contracts are initially recognised at fair value and are subsequently measured at the greater of (a) the amount determined in accordance with IAS 37 and (b) the amount initially recognised less, where appropriate, cumulative amortisation recognised in accordance with IAS 18. The issuer may make that election contract by contract, but the election for each contract is irrevocable.

The amendments to IAS 39 and IFRS 4 are effective for annual periods beginning on or after 1 January 2006, with earlier application encouraged.

FINANCIAL INSTRUMENT PUTTABLE AT FAIR VALUE AND OBLIGATIONS ARISING ON LIQUIDATION

Discussion at the June 2004 IASB Meeting

The Board discussed creating an exception to the liability classification for shares that evidence a residual interest in the assets of an entity and that are puttable to the entity at fair value. It was noted that IAS 32 currently requires classifying these instruments as liabilities. If the fair value exceeds the recorded net asset value, this results in a recorded net liability position.

The Board expressed mixed views. Some were concerned about reporting a net liability position, and they favoured an immediate solution. Others believe that the issue is more fundamental because it relates to the definitions of equity and liabilities; they want to wait for that project to be finalised. The Board asked the staff to explore the issue further and consider whether a short-term solution that can be restricted to solving the immediate problem is apparent.

Discussion at the July 2004 IASB Meeting

At its June meeting, the Board had a preliminary discussion on the classification as liabilities or equity of financial instruments puttable at a pro rata share of the fair value of the residual interest in the issuer ('financial instruments puttable at fair value'). The Board noted that the application of IAS 32 to financial instruments puttable at fair value gives rise to anomalous accounting because, assuming that the fair value of the entity is higher than the entity's net asset value, the balance sheet will always show net liabilities, and those net liabilities will increase the better the entity performs.

The Board agreed to explore whether it should propose an amendment to IAS 32 in the short term through one of the following possible approaches:

(a) An exception so that instruments puttable at fair value are classified as equity;

(b) Continuing to classify such instruments as liabilities but amending their measurement so that changes in their fair value would not be recognised;

(c) Considering whether all puttable instruments (and not only those puttable at fair value) should be separated into a put option and a host instrument.

(d) Do nothing (staff recommendation).

Concerns were raised regarding amendments to IAS 32 at this stage, but if an amendment were to be made, the Board leaned toward approach (a).

Approach (a)

If the Board decides to use approach (a), the staff proposed the following drafting:

A financial instrument that will or may require the entity to redeem it and that otherwise evidences a residual interest in the assets of an entity after deducting all of its liabilities shall be classified as a liability unless all of the following criteria are met:
  • there is no other instrument classified as equity.
  • the instrument is the most subordinated class of all instruments issued by the issuer and has no preferential rights relative to other instruments of the issuer.
  • the redemption price is a pro-rata share of the fair value (or, in the absence of an otherwise determinable fair value, a formula that all the shareholders agree represents a reasonably close approximation of fair value) of the residual interest in the assets of the issuer at the redemption date.
  • the redemption event is the same for all of the instruments.
  • holders of the instrument participate in the issuer's net assets and distributions of profit on a prorate basis."

More detailed guidance would be provided in the Application Guidance. It was also suggested that an additional restriction be added making it clear that this exception would only be available to non-public entities.

Approach (b)

If the Board decides to use approach (b), the staff recommends that the Board:

  • introduce a fifth category of financial instruments in the definitions (eg 'financial liabilities that evidence a residual interest in the entity'. Such a category would be defined along the lines of the exception proposed in approach (a);
  • amend paragraph 47 of IAS 39 to specify that financial liabilities in this fifth category are measured at the amount initially recognised and not re-measured, as follows:

    "After initial recognition, an entity shall measure all financial liabilities at amortised cost using the effective interest method, except for:

    (c) financial liabilities that evidence a residual interest in the entity, which shall be not be re-measured subsequent to initial recognition."

Staff were asked to continue work on approach (a) by considering as many examples as possible that would then be discussed at the September meeting, so the Board can assess the extent of the impact of such an amendment.

Discussion at the March 2005 IASB Meeting

Background

The Board considered the issue of financial instruments that are puttable at a pro rata share of the fair value of the residual interest in the issuer. An example would be an open ended mutual fund, which gives unit holders the right to redeem their interests in the enterprise at any time for an amount of cash equal to their proportionate share of the net asset value of the entity.

The Board noted that financial instruments puttable at fair value are classified as liabilities under IAS 32, but this gives rise to strange accounting whereby the fair value of the entity differs from the reported carrying amount of the entity's net assets, for example, because of unrecognised assets (such as goodwill) and the measurement of some assets at cost.

At its July 2004 meeting, the Board rejected two possible solutions to this issue. The rejected options were:

  • to continue to classify these instruments as liabilities but amend their measurement so that changes in their fair value would not be recognised; and
  • to separate all puttable instruments into a put option and a host instrument.

The proposal

The Board's proposed solution is an amendment to IAS 32 to classify puttable instruments at fair value as equity. The proposed amendment will allow the entity to have other instruments classified as equity so long as the instruments rank above the puttable instruments and do not have an interest in the residual net assets of the issuer.

A board member pointed out that this solution would mean, for example, that 10-year bonds puttable at fair value are classified as equity, which is not really an acceptable answer. Whether the words of the proposal actually implied this, however, was debatable according to other board members.

Treatment of mandatorily redeemable instruments was considered due to feedback indicating that there is some confusion over whether 'puttable instruments' include puttable instruments with a fixed term.

IAS 32.18(b) suggests that a 'puttable instrument' does not include an instrument mandatorily redeemable on a fixed date. This contrasts with IAS 32.BC7, which argues that it makes no difference whether an instrument is puttable on only one date or on a variety of dates for deciding its classification as a financial liability. The latter view is the basis of the proposal.

As per the proposal, there are many examples of fixed period activities where the equity holders are sharing the residual risk of the activity. In the present case, allowing for a fixed date redemption should not increase the risk of financial engineering because the redemption event must be the same for all of the instruments.

Therefore the proposal suggested a consequential amendment to the definition of 'puttable instruments' in IAS 32.18(b) to clarify that the term 'puttable instrument' includes puttable instruments that have a fixed term such as mandatorily redeemable with a fixed term.

The Board accepted the need for guidance but raised several points for consideration:

  • An entity could potentially end in a negative equity position if it has puttable options on equity also classified as such.
  • The proposal was too rules-based, and could, therefore still lead to financial engineering.
  • The FASB and the IASB are currently working on a project which considered classification between debt and equity issues. This proposal is not consistent with FASB's thinking so far.
  • Perhaps the amendment should wait until the debt vs. equity project is finalised, or should be included in that project rather than considered separately.
  • Why should only the lowest ranking classes apply the options? What if they were all similar, except for the redemption feature? There is no guidance in the proposal on which rank higher.

Staff were instructed to extend the scope to consider:

  • Puttable minority interests.
  • Partnership entities.
  • Limited life entities.
  • Different classes of shares.

Also, staff should consider the FASB project on debt vs equity.

Discussion at the IASB's September 2005 Meeting

Scope of the project

At its March 2005 meeting, the Board agreed to give further consideration to accounting for financial instruments puttable at a pro rata share of the fair value of the residual interest in the issuer ('financial instruments puttable at fair value'). As IAS 32 currently stands, these instruments are classified as financial liabilities. The Board noted that the application of IAS 32 and IAS 39 to financial instruments puttable at fair value, when those shares are the common shares of the entity, gives rise to anomalous accounting.

As a result of the Board's decisions in March 2005, the staff recommended two categories of amendments to IAS 32:

  • 1. The first category encompasses the definition and classification of a 'financial instrument puttable at fair value' and is aimed at shares, partnership interests, and minority interest puttable at fair value. Those classes of instruments have similar features, giving the holder the right to put the instrument back to the entity in exchange for its fair value, which is the instrument's pro rata share of the fair value of the issuer.
  • 2. The second category addresses instruments that have an obligation arising on liquidation. Instruments in limited life entities do not normally contain the right to put the instrument back to the issuer during the life of the entity. Instead, such instruments confer the right to receive cash or other assets on liquidation of the entity, with liquidation being a certain event. Put another way, shares in limited life entities establish an obligation that arises on liquidation, and liquidation will occur at a known date.

The amendments would result in all of the following being classified and presented as equity: shares, partnership interests, and minority interests puttable at fair value, and shares in limited life entities.

For discussion purposes, the issues were analysed as follows:

  • 1. Instruments puttable at fair value.
  • 2. Instruments with obligations arising on liquidation, and liquidation is certain (affects limited life entities).
  • 3. Instruments with obligations arising on liquidation, and liquidation is at the option of the holder (affects partnership interests).
  • 4. Classification of minority interests in consolidated financial statements, when minority interests are puttable at fair value or an obligation arises on liquidation (and liquidation is certain or at the option of the holder).

The Board decided to tackle issue 1 first, to set the guidelines from which the more complex issues down the list could be addressed. The Board discussed the staff's proposals at length, noting that whether the put option is a separate instrument from the shares should not result in different accounting. If this is not achieved, the result would be the creation of structuring opportunities.

The Board agreed that the only short-term solution to this issue would be to create exceptions until the long-term project dealing with equity and liabilities has been completed. This exception would specify that it would only be available for all of the equity that is the subject of the put option (that is, there would be no opportunity for other types of contracts to be written over similar equity instruments). In addition, that class of equity must be the 'absolute residual' – the 'most subordinated' class of equity. Additional work would be performed to adequately ring-fence these exceptions.

The Board discussed what would constitute different classes of equity (for example, where different voting or participation rights attach to the same category of shares) but did not make decisions on this issue. The Board seemed to agree that in the consolidated financial statements, a non-controlling interest (minority interest) would be considered to be the same class of equity to that of the parent entity (that is, the existence of a non-controlling interest would not disqualify an entity from applying the exception).

Items 2 through 4 above were not addressed as distinct issues but were referred to at various points throughout the Board's discussions.

The Board noted the reservations of some members about the additional complexity that would be introduced into the accounting for financial instruments if these proposals are adopted. The Board agreed to proceed with this project, as it has already been taken onto the agenda and because the issue is significant.

Determining whether a share puttable at the fair value of the residual interest in the entity should be split into an ordinary share and a put option with approximately zero value

On this issue, the staff recommended the following:

A compound financial instrument should be split into components when it is clear that the components exist, that the components can be separated and when separating the components results in faithful representation of the financial position of the entity. In the case of the put option in a puttable share, the staff found that it was not possible to separate a component as it was not possible to economically identify those situations in which the put option would be exercised. In addition the put option component is not identifiable based on separate cash flows.

The staff also found that shares puttable at a fixed strike price are economically similar to convertible debt. Consequently the staff believes that classifying a puttable share as equity while classifying convertible debt principally as liability does not result in the faithful representation of what are economically similar obligations. In other words, the put option changes the nature but not necessarily the value of the obligation to shareholders.

Consequently, the staff did not recommend that a puttable share be split into an ordinary share and put option with a floating strike price.

Some Board members indicated support for the staff recommendation and others for an alternative approach that acknowledges that IAS 32's classification scheme is 'fundamentally flawed'. Supporters of the alternatives conclude that the composite instrument described as a puttable share does not satisfy the definition of a liability, and presenting it as a liability does not enhance the relevance of the financial statements. Proponents of this view acknowledge that there is a liability component of the instrument, but measuring that liability based on redemption amount described in IAS 32 is not the fair value of that component on initial recognition. Such measurement is inconsistent with how virtually all other financial instruments and most non-financial liabilities are measured (excepting, perhaps, employee benefit obligations).

The Board was asked to vote on whether (a) to continue a separate project on financial instruments puttable at fair value or (b) to address the issue in the broader and longer-term liabilities and equity project. The Board agreed to add this issue to the broader liabilities and equity project whilst continuing with the separate project on financial instruments puttable at fair value.

Discussion at the December 2005 IASB Meeting

The Board was asked to confirm proposed amendments to IAS 32, as a correct reflection of the Board's decisions at its September 2005 meeting (the proposals are set out in the observer notes).

The Board debated how best to narrow the amendment so as to ensure that the return over a period of time is the same for all instrument holders within the most subordinated class. The concern raised by some Board members related to the fact that the entry price of acquiring the instrument could be manipulated by adding premiums or discounts that could distort the return to individual holders. The staff was asked to add a condition to this effect along the lines of requiring entry and exit from the most subordinated class of equity at fair value.

In order to apply the proposed amendments, the staff noted that an entity must determine fair value in accordance with the IAS 39 application guidance. Partnerships or non-public companies, which calculate the fair value of the redemption price of the puttable instruments using a proxy measure (for example, book values or a pre-set formula based on book values), might not be able to apply the proposed amendments. This is because such proxy measures might not be consistent with the measurement of fair value under IAS 39, paragraphs AG69 to AG82. The Board agreed to allow the use of the proposed amendment in the above instances only where the share is not listed and the formula or proxy measure is an approximation of fair value.

The Board reiterated that the objective here is to reach fair value at entry and exit and that a formula designed to penalise early exit may not qualify as a fair value proxy.

The Board asked the staff to consider supplementary disclosures (as well as presentation issues) regarding the fair values of instruments captured by these amendments even though they are classified as equity. The rationale for supplementary disclosure requirements being that such instruments have potential claims on assets. Limited life entities The Board agreed to include within the proposed amendments to IAS 32, the issue of classification of instruments puttable at fair value in limited life entities. The Board also agreed to include a table of examples in the guidance clarifying that for limited life entities, the instruments are not puttable.

Liquidation at the option of the holder

The proposed amendments would allow equity classification of instruments that contain an obligation entitling the holder to a pro rata share of the net assets of the entity upon liquidation of the entity, including instruments that give the holder the option to require the entity to liquidate. Therefore, partnership interests that include a condition that requires the partnership to liquidate upon the exit of any partner will be classified as equity, if it has the required characteristics.

The Board discussed whether the requirements to liquidate upon the withdrawal of a partner are substantive. The concern was raised because in practice, the effect of a partner withdrawing would result in mere book entries.

The Board also registered concerns about extending the requirements to any instrument that allows the holder the ability to liquidate if that holder feels aggrieved in any way. The Board seemed to agree that the answer to this issue was to require that all the parties should have the same ability to require liquidation, therefore in the case of a partnership, every partner must be able to put to the partnership, his/her interest.

Consolidated financial statements

The Board considered the consequences of its decisions for consolidated financial statements. The Board agreed that the non-controlling interests must be regarded as being not in the most subordinated class of instruments from the group's perspective. The rationale for this view is that the claims of non-controlling interests to the net assets of the subsidiary have to be satisfied first, before the parent's share of the net assets of the subsidiary could be distributed to the parent's residual interest holders. Hence, non-controlling interests are not in the most subordinated class of instruments at the group level.

For limited life entities, the Board agreed that at the group level, non-controlling interests in a limited life subsidiary will be classified as financial liabilities. This is because the proposed amendments are based on the view that non-controlling interests are not in the most subordinated class of instruments at the group level. The Board also came to a similar view on the issue of obligations arising on liquidation when liquidation is at the option of the holder.

In considering the entire package of proposed amendments, the Board agreed by vote to proceed with the amendments with some Board members dissenting on the basis that these amendments were merely an exception to the principles of IAS 32 designed to address the specific concerns of certain constituents and as a consequence, sets a bad precedent.

Discussion at the February 2006 IASB Meeting

The Board continued its discussion from December 2005 on the proposed amendments to IAS 32 Financial Instruments: Presentation. At the previous meeting the Board decided that financial instruments puttable at fair value and certain obligations arising on liquidation would be classified as equity if certain conditions were met. Under those conditions, in general, shares, partnership interests, and minority interests puttable at fair value, and shares in limited life entities, would generally be classified as equity. At the February meeting the Board was asked to decide on proposed disclosures.

The staff proposed that four categories of new disclosures be added to IAS 1 and not IFRS 7. The Board agreed to the proposal.

The four proposed categories of new disclosures, and Board decisions on each, are as follows:

Disclosure by limited-life entities

As IAS 1 does not currently require limited-life entities to disclose the fact that they have a limited life, the staff proposed adding an explicit requirement by amending paragraph 126 of IAS 1.

The Board agreed.

Disclosure of reclassifications

The staff proposed that disclosures about the nature, amount, and timing of reclassifications of instruments between liabilities and equity, and the reasons therefor, be added to IAS 1.

No discussion. The Board agreed with the staff proposal.

Capital Disclosures

Staff proposed certain amendments to the capital disclosure requirements in paragraph 124 of IAS 1 so that an entity will disclose enough information about financial instruments puttable at fair value to enable users of financial statements to evaluate the entity's objectives, policies, and processes for managing capital.

The Board generally agreed with the staff proposal, though they asked the staff to do some additional research regarding one of the proposed disclosure items.

Disclosures about fair values

Staff proposed:

  • disclosures about an instrument's fair value disclosures should be presented in a way that permits comparison with the instrument's carrying amount;
  • disclosure of information on how fair value was determined; and
  • additional disclosure items for companies who determine fair value based on a formula.

The Board discussed the cost of compliance against the benefits of the user if requirement was set out as in the proposals.

The Board decided to require the disclosures proposed by the staff, but that those disclosures would be required only in an entity's annual accounts, not in its interim accounts.

Discussion at the March 2006 IASB Meeting

The Board continued its discussion of a draft ED of proposed amendments to IAS 32 Financial Instruments: Presentation.

New project title

Financial Instruments Puttable at Fair Value and Obligations Arising on Liquidation

Sweep issues arising from the pre-ballot draft

A formula to determine fair value of financial instruments puttable at fair value by an entity that is not publicly accountable

The Board had previously allowed use of a formula to estimate fair value of financial instruments puttable at fair value upon issuance, redemption or repurchase of the instruments, provided that the formula is intended to approximate fair value. A national standard-setter had requested clarification about whether an instrument's pro rata share of the entity at book value qualifies as a formula.

The Board agreed that an amendment setting out that using the pro rata share of net assets of the entity at book value is not considered to be a formula that approximates fair value, except in rare cases when there is no material difference.

Appropriate guidance for determining fair value

A national standard-setter had requested that the exception in subparagraph 46(c) of IAS 39 be included in reference to guidance on determining fair value in the proposed amendments to IAS 32. This would imply that non-public entities would be allowed to redeem or repurchase puttable instruments at the instrument's cost and to classify these as equity.

The Board agreed that such a reference as the sub paragraph is only relevant for the measurement of the equity instruments of other entities, and not for when an entity measures its own equity instruments.

The issue price of an ordinary share puttable at fair value issued upon conversion of a convertible bond

The staff had been asked to consider whether the price of an ordinary share puttable at fair value issued upon conversion of a convertible debt instrument is considered to be at fair value. If not, the shares will not qualify for equity classification.

The staff identified two issues. The first issue was that this scenario would create an option embedded in the convertible bond that would have to be separated and accounted for as a derivative that meets the definition of a financial liability. The second issue the staff identified was that financial instruments puttable at fair value would only be considered issued at fair value if the fair value of the consideration received equals the fair value of the instruments issued (and thereby be qualified for equity classification).

The Board decided that the staff should draft application guidance for this issue.

Analysis of benefits and costs

The Board decided that they would consider this analysis at a later meeting.

Transition and effective date

The Board decided: on three staff proposals:

  • The ED should not specify a proposed effective date. This issue will be left open for the moment.
  • Early adoption will be permitted.
  • The amendments will be applied retrospectively for both first time adopters as well as current users of IFRS.
  • The Board agreed to provide an exemption from applying the requirement of IAS 32 retrospectively for compound financial instruments. Because the proposal was to apply the amendments retrospectively, a compound instrument with an obligation for a pro rata share of net assets arising on liquidation would have to be separated into a liability and an equity component from the instrument's inception (ref to point c) under sweep issues). At the date of application it could be that the liability component (the derivative) no longer is outstanding, that is, separation would have no benefit. This is the exact same reason there already is an exemption for applying the requirements in IAS 32 retrospectively for compound financial instruments under IFRS 1.

Discussion at the April 2006 IASB Meeting

This was a continuation of the discussion the Board had in its March meeting on proposed amendments to IAS 32, whereby financial instruments puttable at fair value and certain obligations arising on liquidation would be classified as equity, provided certain conditions are met. This discussion focussed on a staff analysis of the costs and benefits of the proposed amendments.

The staff analysis was that the main costs associated with the proposed amendments include:

  • requiring a new analysis of various financial instruments;
  • an increase in the complexity of IAS 32;
  • an increase in financial structuring opportunities; and
  • the costs of complying with the equity classification.

The staff analysis was that the main benefits associated with the proposed amendments include;

  • it addresses constituents' concerns about the classification of certain financial instruments;
  • it increases comparability between entities (for example between entities with financial instruments puttable at fair value that meet the requirements for equity classification and entities with ordinary shares); and
  • the classification is more relevant and more understandable.

The Board noted that whilst they liked the proposed accounting for financial instruments puttable at fair value, they did not believe that the proposed amendments were principle-based, and that the main benefit was that the classification was more relevant and understandable to users. They further noted that care would be needed in describing comparability as a benefit, as financial instruments puttable at fair value are different from ordinary equity shares in that they allow the holder to require redemption for a cash amount. Furthermore, the equity classification is only available to the most subordinated class of instrument. As such, very similar instruments may get a different classification where one is the most subordinated class of instrument and the other is not.

The Board then discussed the proposed amendments to IAS 1. These changes require three new disclosures, as follows:

  • 1. disclose information about the reclassification of instruments between equity and financial liabilities of the instruments affected by the amendments;
  • 2. disclose fair values of financial instruments puttable at fair value classified as equity; and
  • 3. disclose information about length of the life of a limited life entity.

As no new issues were raised, this should be the final discussion by the Board on this matter prior to issuance of an exposure draft.

June 2006: IASB ED on Puttable Shares

On 22 June 2006, the IASB published an exposure draft on Financial Instruments Puttable at Fair Value and Obligations Arising on Liquidation. The proposals would amend IAS 32 Financial Instruments: Presentation and IAS 1 Presentation of Financial Statements. The ED would require:

  • An obligation to redeem or repurchase a financial instrument puttable at fair value would be classified as equity provided that specified criteria are met, particularly that all financial instruments in the most subordinated class of instruments with a claim to the assets of the entity are financial instruments puttable at fair value.
  • An instrument that imposes an obligation to deliver to another entity a pro rata share of the net assets of the entity upon its liquidation to be classified as equity, provided specified criteria are met. Thus, for example, ordinary shares of limited life entities and partners' interests in a partnership that must liquidate upon exit of a partner (eg on retirement or death) would be equity.

Comments are due by 23 October 2006. The ED is available on the IASB's website. Click for Press Release (PDF 67k).

Discussion at the September 2006 IASB Meeting

The Board discussed various issues related to the operation of derecognition principles in IAS 39 paragraphs 15-37 and illustrated in IAS 39 AG36.

Groups of assets

The Board discussed the possible meanings of the phrase 'group of similar assets' contained in IAS 39 paragraph 16. The Board agreed that IAS 39 does requires the derecognition tests to be applied to transfers of groups of financial assets (such as loans, mortgages, etc) that include the following derivative contracts:

  • Credit insurance contracts/financial guarantees that are originated with certain loans.
  • Interest rate swaps and currency swaps.
  • Credit insurance contracts/financial guarantees that are not originated with the loans

In particular, the Board noted that because a bundle of assets (such as mortgage loans and mortgage indemnity guarantees) was transferred in a single transaction does not imply that the bundle was 'one asset'. In other words, the transferor had to assess the mortgage loans and the mortgage indemnity guarantees separately for the purposes assessing 'similar' in the derecognition tests.

Board members noted that the IFRIC might be uncomfortable with the consequence of this conclusion: that a derivative that can be either an asset or a liability must pass both derecognition tests before it can be removed from the balance sheet.

Pass-through arrangements

The Board which transfers of financial assets are required to satisfy the 'pass through' tests in IAS 39 paragraph 19. The Board noted that IAS 39 paragraph 18(b) states the pass-through tests in paragraph 19 have to be met when an entity transfers a financial asset and 'retains the contractual rights to receive cash flows of the financial asset, but assumes a contractual obligation to pay the cash flows to one or more recipients'. Conversely, the pass-through tests are not applicable when the entity 'transfers the contractual rights to receive the cash flows of the financial asset' (paragraph 18 (a)).

The Board agreed that IAS 39 did not require the pass-through test to be applied to transfers of financial assets in which (a) the legal ownership has not changed; and (b) the transfer is conditional.

Report to IFRIC

The Board noted that the topics discussed in this session had been referred to the IFRIC and asked the staff to make a complete report to the IFRIC, together with the Board's basis (essentially the Board papers), so that the IFRIC could make an informed decision as to how to proceed.

Discussion at the December 2006 IASB Meeting

Hedging of portions of cash flow or fair value exposure

The Board previously concluded that additional guidance is required regarding what can be designated as a hedged portion under IAS 39. IAS 39 permits an entity to hedge all cash flows of a financial instrument for one or more specific risks, but does not specify what risks are eligible for hedge accounting. The Board therefore addressed two issues at the December meeting:

  • The first issue was whether IAS 39 should be amended to specify risks that are eligible to be designated for hedge accounting.
  • The second issue was, since IAS 39 permits 'other portions' of the future cash flows on a financial instrument for its whole life or part of its time period to maturity to be designated as a hedged item, should the Board amend IAS 39 to clarify which specific 'other portions' of a financial instrument that are eligible for designation as a hedged item.

On the first issue the Board decided that IAS 39 should be amended to specify those risks which are eligible for designation as a hedged item.

On the second issue the Board voted and agreed to specify which 'other portions' of a financial instrument that would be permitted for designation as a hedged portion under IAS 39.

The Board also decided that these amendments should be developed directly through the Board as a stand-alone amendment to IAS 39.

Discussion at the January 2007 IASB Meeting

Analysis of Comment Letters on the Exposure Draft

The staff presented an analysis of comment letters received on the Exposure Draft of Proposed Amendments to IAS 32 Financial Instruments: Presentation and IAS 1 Presentation of Financial Statements (ED).

The Board discussed certain aspects of the comments received but no decisions with regard to amendments of the ED were made.

Project Plan

The Board discussed whether to proceed with this project or to await the outcome of the long-term project on Liability and Equity.

About half of the respondents had suggested widening the scope of the project in order to classify as equity additional instruments such as:

  • Financial instruments puttable at no more that its fair value (for example, financial instruments puttable at book value and co-operative capital)
  • Minority interests puttable at fair value
  • Financial instruments puttable at fair value that are not in the most subordinated class but are subordinated to creditors, or financial instruments puttable at fair value that are in the most subordinated class but there exists another class of shares in the most subordinated class without the right to put
  • Warrants (and other derivatives) to be settled by the issue of financial instruments puttable at fair value
  • Financial instruments puttable at fair value with the right to mandatory dividend distribution or partnership remuneration.

The Board members pointed out that the scope of the project is the most critical issue and agreed to keep the scope narrow since otherwise this project could prejudice the outcome of the Liability and Equity project. The Board acknowledged that, accordingly, the project could only resolve the problems in some jurisdictions.

The Board decided to go forward with this project and directed the staff to prepare a paper on the scope issue for discussion at a future meeting.

Discussion at the April 2007 IASB Meeting

The staff informed the Board about its intended next steps in this project.

The staff proposed to separate the issues raised in the comment letters on the Exposure Draft (ED) Financial Instruments Puttable at Fair Value and Obligations arising on Liquidation into two work streams:

1. Finalisation of the ED by addressing those issues raised in the comment letters that would not require a re-exposure of the ED

This will relate to issues such as:

  • Clarification of what is meant by reference to fair value in the equity classification criteria
  • Clarification of 'the most subordinated class' requirement
  • Whether the issue price of financial instruments puttable at fair value must be at fair value, and whether transitional guidance needs to be included as to what that means
  • The disclosure of the fair values of financial instruments puttable at fair value
  • The effective date of amendments

Staff intends to bring a paper to the May 2007 meeting requesting decisions on these issues.

2. Research on those issues raised in the comment letters that might require a re-exposure of the ED

These issues relate to the scope of the amendments. Some respondents noted that criteria for equity classification within the ED are too restrictive and do not cover a number of instruments (such as partnership interests, membership interests in co-operatives, and development banks).

It is intended to bring preliminary considerations on these issues to the Board in June 2007.

Some Board pointed out that the narrow scope of the project had been well-considered and that under no circumstances it should be widened. Other Board members expressed the view that no further research should be performed on issues outside the scope but that this should be part of the equity and liabilities project.

With a majority of 9 votes the Board decided to go ahead with the current scope and to bring back in May 2007 a revised ED addressing the issues outlined under (1) above. In addition, the Board directed the staff to further investigate the issues outlined under (2) above for discussion at a future meeting.

The issues raised in the comment letters were not discussed at this meeting.

Discussion at the May 2007 IASB Meeting

Based on issues raised in the comment letters the Board continued its discussion on the Exposure Draft Financial Instruments Puttable at Fair Value and Obligations arising on Liquidation (ED).

The discussion focussed on the basic characteristics (principles) underlying the ED.

The staff outlined that an instrument addressed in the ED:

  • a. has a residual interest in that entity throughout the life of the instrument, and
  • b. participates fully in the performance of the entity throughout the life of the instrument.

In this context the Board raised the question what fair value is being referenced to in the ED; the fair value of the instrument or the fair value of the entity.

After a thorough discussion there seemed to be a consensus that the fair value referenced to in the ED should be the fair value of the instrument and that this fair value does not necessarily reflect the pro-rata share of the fair value of the entity. It was noted that in many cases in an 'ongoing business' (that is, not a limited life entity at the point of liquidation) the fair value of the instrument is determined based on a formula. The fair value of the entity is not determined or not determinable since the instruments are not listed. Accordingly, the 'formula value' is the only relevant market value to determine fair value.

The Board pointed out that in case the fair value of the instrument differs from the pro-rata share of the fair value of the entity the instrument does not participate fully in the performance of the entity and therefore characteristic b) would not be fulfilled. One Board member noted that the initial wording was discussed in relation to limited life entities only.

The Board decided to stick with the basic characteristics but to improve the wording in the ED; in particular to clarify the fair value implications discussed at this meeting. Senior staff noted that in summary the ED should make clear for the instruments in question that 'absent the put we have an equity instrument'.

In addition the Board agreed the following:

  • Partnership interests

    Personal guarantees by partners (either general or limited) should be disregarded for classification purposes and with regard to the ranking among the holders of the most residual class of instrument. Such personal guarantees should be considered to be separate contractual arrangements.

  • Presence of non-puttable instruments

    The Board decided to maintain the criteria set out in the ED relating to the presence of non-puttable instruments, that is, one feature of being most residual is that if an instrument is puttable at fair value, then all other instruments in that class must also be puttable.

  • Minority interests

    The Board agreed to maintain the guidance in AG 29A of the ED with regard to the treatment of minority interest at consolidation level.

  • Identification of issue price for old instruments / transition guidance

    To be discussed at the June 2007 meeting.

The staff was directed to redraft the ED accordingly for discussion at a future meeting.

Discussion at the June 2007 IASB Meeting

The Board held a very brief discussion with the staff on the project. As a result of discussions between staff and individual Board members, it was apparent to the staff that additional analysis was necessary before the staff was in a position to bring a revised proposal to the Board. A brief discussion followed that summarised some of the challenges to the IAS 39 definition of equity that the staff is analysing. The staff expects to present its analysis at the July 2007 meeting.

Discussion at the July 2007 IASB Meeting

In May 2007, the Board tentatively decided that for a puttable instrument to qualify for equity classification, the instrument must, among other requirements, participate fully in the performance of the issuing entity in the period the instrument is outstanding (hereafter referred to as 'the Requirement'). The Board tentatively agreed that the full participation in the performance of the issuer can be best demonstrated when the instrument is issued and puttable at the fair value of the instrument.

Demand for an exception to the Requirement

Some constituents noted that the Requirement makes the scope of the proposed amendment too narrow because, in many situations, the issue price and/or the strike price of the put option of a puttable instrument is not simply defined as the fair value of the instrument. Instead those prices are the result of applying a formula or some other method, for example, the result of negotiation between the interested parties. They argue that if there is no exception to the Requirement, the proposed amendment will affect only a very limited number of entities.

In the view of those constituents, 'something less than full economic participation' would be sufficient for a puttable instrument to qualify for equity classification – for instance, participation based on a formula.

The Board decided that any exception should be within the boundaries of paragraph AG 14A of the ED, that is, any exception would not apply to publicly listed companies and entities that hold assets in fiduciary capacity.

Scope of an exception to the Requirement

The Board then discussed what level of participation in the performance of the entity should be demonstrated by the formula to qualify for equity classification.

The staff presented various alternatives, but stated a preference for an approach under which full participation in the accounting performance of the entity (that is, the effect of items that are not recognised for accounting purposes are not taken into consideration) would be required for a puttable instrument to qualify for equity classification should the exception to the Requirement apply, as follows:

  • 1. Instrument is both issued and redeemed at the pro rata share of the book value of the entity (as calculated under IFRS).
  • 2. Instrument is issued at a fixed price, the comprehensive income of the entity is distributed in its entirety annually, or if not distributed allocated to the partners' or shareholders' capital account (that is, full profit sharing), and the instrument is redeemed at the same fixed price as it was issued at. (If losses have been incurred in excess of other reserves over the period the instrument is outstanding the fixed redemption price would be adjusted accordingly).
  • 3. Instrument is both issued and redeemed at the pro rata share of the book value, however that book value is not calculated under IFRS, but instead under local law or local GAAP as dictated by the charter or the instruments terms and conditions.

The Board had a lengthy discussion without concluding on a preferred approach. Some Board members were concerned about widening the scope at all. Others were reluctant to allow book values under local law or GAAP (alternative 3 above). Finally, the staff was directed to try to find a reasonable scope of exceptions taking into account staff views and the statements made at this meeting. If it would not be possible to find a solution the Board intends to release the amendments as currently drafted.

This issue will be discussed again at the September meeting.

Discussion at the September 2007 IASB Meeting

The Board re-examined the characteristics that result in puttable instruments being considered as the residual interest, i.e. to qualify for equity classification.

The Exposure Draft Financial Instruments Puttable at Fair Value and Obligations arising on Liquidation (ED) identified the residual interest in the net assets of an entity by requiring all individual puttable instruments

  • a) to be in the most subordinate class of instrument,
  • b) to be issued and puttable at the fair value of the pro-rata share of the net assets of the entity, and
  • c) to have neither a limited nor guaranteed return.

With regard to requirement b) above the Board tentatively agreed that the full participation in the performance of the issuer can be best demonstrated when the instruments are issued and puttable at the fair value of the instruments.

Some constituents noted that, in particular, requirement b) makes the scope of the proposed amendment too narrow.

The 'Revised Approach'

In response to these comments the staff presented the Revised Approach. The main feature of this approach is that the class of puttable instruments as a whole is required to represent the residual interest in the entity. Accordingly, the put price of the individual instrument would be of little relevance for classification of the class of puttable instruments as long as the class as a whole represents the residual interest in the entity. However, all individual instruments still need to be equal in all other respects.

The Revised Approach eliminates requirement b) and, accordingly, the definition of residual interest much more relies on requirement c) above.

The staff proposed that the ED should be modified to describe what type of return is characteristic of equity rather than only stating what type of return does not qualify for equity classification. The following amendment was proposed:

'The total return of the puttable instrument is based substantially on the net earnings or the change in net assets of the entity (excluding any possible effect the puttable instrument may have on net earnings or net assets). An example of a puttable instrument with a return that is not based substantially on the net earnings or the change in net assets of the entity is a puttable instrument that has a fixed or guaranteed total return to any extent, before or at liquidation'.

The staff drew to the attention of the Board that the definition of returns does not address the issue that there might other (less subordinated) instruments that are absorbing most of the variability in the performance of the entity and leaving only a predetermined (but slightly variable) amount of net earnings or net assets for the class of puttable instruments. To address this potential flaw the staff suggested including the following guidance in the ED:

'The variability of the total return to the class of puttable instruments is not substantially absorbed by another contract or financial instrument, or some combination thereof. If a determination cannot be made that these conditions are met, the puttable instruments are classified as liabilities.

Ordinary commercial contracts, like leases, mortgages, and franchise and license agreements may include provisions based on elements of the entity's performance (for example, a percentage of gross revenue). Contracts entered into on normal commercial terms with unrelated parties are unlikely to fall within the meaning of this test. For example, if commercial practice for lessors is to base rentals in part on a percentage of gross sales, and the percentage in the entity's lease is consistent with amounts charged in the are area, then the lease should not be considered to absorb substantial variability in net earnings or net assets.'

The Board agreed to proceed with the Revised Approach.

Mandatory dividends and partnership remuneration

The staff suggested that the ED should not provide guidance as to whether a mandatory dividend is a contractual obligation.

The Board agreed to this by majority vote but pointed out that the following principle should be clarified in the ED:

  • If a mandatory dividend is required to be paid in the absence of profit the instrument does not qualify as equity classification.
  • If a mandatory dividend is required to be paid only if sufficient profit is available such a clause should not prevent the instrument from being classified as equity.

Derivatives on puttable instruments and limited life obligations The Board unanimously decided to retain the guidance in the ED that derivatives on puttable instruments or limited life entity shares are not equity.

Reclassification of instruments

The Board decided to include the following guidance on how to reclassify an instrument under the ED:

  • On reclassification from liability to equity the instrument is classified as equity with a carrying value equal to its previous carrying value. There should be no gain or loss.
  • On reclassification from equity to liability the equity instrument will be carried at cost while IAS 39 Financial Instruments: Recognition and Measurement requires initial recognition of a liability to be at fair value (paragraph 43). Any difference between the carrying value of the equity instrument and the fair value of the newly recognised financial liability should be recognised in equity.

Mandatory redemption

The staff noted that the ED does not address this issue explicitly but that the criteria in the ED (also under the Revised Approach) would not prohibit an instrument in which the embedded put is automatically exercised on the occurrence of specific certain or uncertain events (such as death or retirement) from being classified as equity.

There seemed to be a consensus that mandatory redemption on death or retirement does not prohibit an instrument from being classified as equity. One Board member noted that such clauses have been used for decades and that any change to this principle would have massive implications for many instruments currently classified as equity under IFRSs, i.e. would go far beyond this project.

Implications of the re-deliberations to obligations arising on liquidation of limited life entities

The Board unanimously agreed to the staff proposal to provide separate guidance for puttable instruments and obligations arising on liquidation of limited life entities to reduce complexity of the ED. Constituents had indicated that they have problems in identifying what criteria relates to which type of obligation.

Effective date and transition requirements

The Board tentatively decided the effective date to be 1 January 2009 with early adoption being permitted. The proposed amendments should be applied retrospectively with an exception relating to compound instruments in which the liability component is no longer outstanding.

Next steps

The staff was asked to prepare a revised ED including the Revised Approach and the decisions made on the other issues. The Board intends to hold roundtable discussions on the revised ED in November 2007 in London. Based on the outcome of the roundtables the Board will decide whether re-exposure is required.

Discussion at the October 2007 IASB Meeting

Arrangements for Roundtables

At its September 2007 meeting, the Board decided to proceed with a revised approach to the Exposure Draft Financial Instruments Puttable at Fair Value and Obligations Arising on Liquidation and to discuss the proposed amendments at a public roundtable meeting. You can find Deloitte's report on that meeting Here.

The Board agreed that the roundtable discussions will take place in London on 12 November 2007. The discussions will be open to the public.

Participants will be asked to respond to the following questions:

  • Does the staff draft address the types of financial instruments that should be addressed in a short-term limited-scope project? If not, what instruments should be addressed and why?
  • Are the proposals operational? If not, why not and what changes would you propose?
  • Are there any issues that are not addressed in the staff draft that should be addressed? If so, what are they and why should they be addressed?

One Board member noted that it was important to clarify that the purpose of the roundtable was exclusively to discuss the proposed amendments and not to raise additional issues. No Board member objected to that statement.

November 2007: IASB holds roundtable on puttable instruments

On Monday 12 November 2007, the IASB conducted a public roundtable on a revised staff draft of an amendment to IAS 32 on whether financial instruments puttable at fair value and obligations arising on liquidation should be classified as debt or equity. Here is a brief report:

  • Thirty-three individuals and organisations participated in the roundtable, as did eight IASB members and several staff.
  • The revised draft amendment can be downloaded from the IASB's Website (PDF 888k).
  • During the roundtable, the IASB indicated that it does not consider the changes from the June 2006 Exposure Draft significant enough to warrant re-exposure.
  • While most participants agreed that amendment of IAS 32 for puttable instruments is needed, and many spoke in favour of the revised draft amendment, numerous technical issues were raised with respect to the proposal. Staff indicated that it plans to consider whether and how to reflect the views expressed at the roundtable in a revised draft of amendments to IAS 32 that it plans to present at the Board's December 2007 meeting.
  • The IASB is aware of the need to finalise the amendment as soon as it can to allow early adoption for many entities. The Board intends to post a near-final draft of the final amendments on its website when available.

Discussion at the November 2007 IASB Meeting

On 12 November the Board held two round table discussions on a revised Exposure Draft (the Staff Draft).

The staff presented a summary of the issues raised at these meetings. The staff concluded that the majority of participants supported the Staff Draft and that most of the issues can be resolved by revising the wording. The staff proposed the following ways forward:

  • Incorporate in the Staff Draft the comments made by constituents
  • Send a pre-ballot draft to Board members before the December meeting
  • Board to discuss and vote on the pre-ballot draft at the December meeting
  • Send a ballot draft to Board members after the December meeting

The Board agreed.

Discussion at the December 2007 IASB Meeting

The purpose of this session was to discuss with the Board issues that arose during the roundtables on the staff draft on puttable instruments and to summarise significant drafting changes. The discussions were based on a pre-ballot draft that was not available to the public.

In the first part of the session the following issues were discussed:

  • Financial instruments that include other contractual obligations

    Constituents questioned why paragraphs 16A and 16C of the staff draft were different, especially with respect to the condition in 16A(d) that the instrument 'must not include any other contractual obligation to deliver cash' whilst paragraph 16C does not include that condition. The staff noted that believes that it is appropriate to have different conditions, but changed the title of the section containing 16C to 'components of instruments' to clarify that such instruments can have other contractual obligations that would need to be separated. The Board agreed.

    Another issue was if mandatory dividends and partnership remuneration meet the definition of a contractual obligation. The Board agreed in September 2007 not to deal with this issue and decided not to revise its decision.

  • An instrument holder in the role of owner and non-owner

    Constituents described situations where part of the remuneration is for services and hence they do not compensate the holder for the role as owner, but this would not automatically lead to liability treatment of the whole instrument and analysed separately. The Board agreed this is correct, but as suggested by one Board member this must be ring-fenced to avoid abuse, i.e. prohibit excessive 'service remuneration'. The draft will be amended to make clear that this remuneration must be an appropriate return for the services provided.

  • The meaning of 'fixed', 'guaranteed' or 'restricted' to describe an instrument's return

    The staff draft caused some confusion with regard to the meaning of 'fixed', 'guaranteed' or 'restricted' return. As a result the last sentence of paragraph 16A(e) has been removed in the pre-ballot draft. The Board agreed to the deletion.

  • Interaction of the proposed amendment and the requirements in IFRS 2 Share-based Payment

    Constituents also asked about the interaction of IFRS 2 and the proposed amendment. There might be situations where the provisions in IAS 32 lead to an equity balance sheet presentation while they would be a liability in accordance with IFRS 2. Some Board members expressed concerns about the apparent conflict with the Framework of the proposed amendments. After being reminded by the Chairmen of the Board that this was not meant to be a major project the Board members agreed to the revised wording in the ballot draft.

  • The proposed disclosure requirements

    The staff was split on the disclosure of the fair value of those instruments. One Board member said from the perspective of users this information is useful. The Board agreed to keep this disclosure requirement. Additionally, it was agreed to include a consequential amendment to IFRS 7 Financial Instruments: Disclosure to make clear that the instruments captured by the IAS 32 amendment are scoped out of IFRS 7.

  • Application of the proposed amendment's requirements to specific mutual fund structures

    The staff asked the Board if they have any questions on the application of the amendments to mutual funds. The Board decided not to address this issue specifically.

  • Whether it is appropriate to analogise to the exception in the proposed amendment

    The staff asked the Board if the standard text should contain guidance that the exceptions resulting from the amendment shall not be analogised. Some Board members questioned if such an amendment should better be made to IAS 8 as it seems to be a principle that exceptions should not be analogised. It was noted that this is more than a minor amendment. Nevertheless that clarification should be included within this amendment due to the dynamics in the structuring industry. The Board agreed.

  • Amend the draft to deal with situations in which significant amount of the profit is distributed via rebate (not mentioned in the Agenda Paper)

    This was an additional item brought up by the staff with regard to rebates being granted to owners. It was suggested amending the application guidance to make clear the Boards intentions. The Board agreed. After this, the staff presented to the Board significant drafting changes made to the published staff draft. The Board accepted all changes made.

Staff then asked if the Basis for Conclusions should contain a cost-benefit analysis. Staff noted it is standard procedure to include such an analysis. The Board agreed.

The Chairman then took an indicative vote. Two Board members indicated they would dissent.

The staff informed the Board they will circulate a ballot draft and if that is accepted a Near-final Draft will be published in the subscribers' area of the IASB's website by 24th of December latest.

Discussion at the January 2008 AISB Meeting

No papers were available for this session.

The Board held a brief discussion of a drafting issue on puttable financial instruments. The issue involved a proposed change from the staff draft used at the December 2007 public roundtable. After discussion, the Board agreed to return to the principle in the staff draft.

IDENTIFICATION OF EXPOSURES QUALIFYING FOR HEDGE ACCOUNTING

Discussion at the June 2007 IASB Meeting

The Board discussed a first pre-ballot draft of a proposed amendment to IAS 39. (The pre-ballot draft was omitted from the observer notes.)

The proposed amendments specify:

  • the risks that qualify for designation as hedged risks when an entity hedges its exposure to a financial asset or financial liability
  • when an entity may designate a portion of the cash flows of a financial instrument as a hedged item.

With regard to the first issue it appeared from the discussion that the following risks will be specified in the amendment:

  • Market interest rate risk
  • Foreign currency risk
  • Credit risk
  • Prepayment risk
  • The risks associated with the cash flows of a financial instrument that are contractually specified and are independent from the other cash flows of the same financial instrument.

With regard to the second issue the amendment appears to identify the following "other portions" as eligible for designation:

  • The risk-free or LIBOR portion of an interest bearing financial instrument;
  • The prepayment portion of an interest bearing financial instrument;
  • The remaining portion of an interest bearing financial instrument once the interest rate or prepayment risk portion has been excluded (labelled as a 'credit portion').

The Board clarified that, while it was moving in the direction of the FASB, it was not going for full convergence, as the

IASB proposals provide more restrictions on hedged portions.

No Board member indicated to dissent from issuing the current version of the pre-ballot draft.

September 2007: Exposure Draft on Hedged Risk Exposures

On 6 September 2007, the IASB published for public comment an exposure draft of proposed amendments to IAS 39 Financial Instruments: Recognition and Measurement. The proposal, titled IAS 39 – Exposures Qualifying for Hedge Accounting, addresses:

  • What can be designated as a hedged item in a hedge accounting relationship – that is, which risks qualify for designation as hedged risks when an entity hedges its exposure to a financial instrument.
  • Circumstances in which an entity may designate a portion of the cash flows of a financial instrument as a hedged item.

The ED may be downloaded from the IASB's website. Comment deadline is 11 January 2008.

Click for Press Release (PDF 15k).

Discussion at the March 2008 IASB Meeting

Responses to ED on exposures qualifying for hedge accounting

The staff presented the Board with an analysis of the comment letters received on the Exposure Draft (ED) on proposed amendments to IAS 39 Financial Instruments: Recognition and Measurement – Exposures Qualifying for Hedge Accounting. The exposure draft aims to clarify the Board's original intentions regarding risks and portions of financial instruments that are eligible for hedge accounting.

The staff informed the Board that it would provide an overview of the main issues raised by respondents, but that it would not express recommendations or ask the Board to make decisions. It noted that this would be part of a future Board meeting.

The staff provided the Board with some background information to the amendments and informed the Board that it commentators expressed overall support for the aim to clarify the requirements for hedge accounting under IAS 39. The staff noted that whilst most respondents supported the ED, they did so only as it represented a practical and interim solution, but would prefer a principle-based approach.

Further areas of concern were non-financial items and impact of the requirements in AG99E in the exposure draft on using purchased options.

On the issue of principles versus rules, one Board member noted that no one could really articulate a principle, and that this would be the reason one needs rules. The IFRIC chairman highlighted that IFRIC was not looking for a new principle but for the principle underlying the Board's original intentions when drafting IAS 39.

The staff noted that many entities would apply the requirements in IAS 39 regarding portions appropriately with the possible exception of hedge accounting with an option.

The staff then turned to the questions asked in the ED. The first question asked if constituents agree with the restriction of the risks eligible for hedge accounting. The main concerns were:

  • Having a closed list of risks
  • Contradiction with the IASB's goal of principle-based standard-setting
  • 'Missing' items: equity price risk denominated in foreign currency, inflation risk, and risks in non-financial items

Some Board members expressed their concern about extending the list and that some of the issues were very fact-specific.

The second question asked constituents to comment on the ED specifying the portion of cash flows that can be designated. Many constituents expressed concerns about the exclusion of non-financial items and proposed possible 'principles' in their comment letters. One Board member noted that those commentators would like to have a principle that would only require the existence of a correlation to qualify for hedge accounting.

The staff then proceeded to the third question in the ED. Constituents were asked if they expected major impacts on existing practice. The staff noted that overall respondents would not expect a major impact with the exception of the use of purchased options for hedge accounting (aswsuming the ED makes clear that the time value of the purchased option could not be deferred).

The fourth question asked constituents on the appropriateness of the transition provisions of the ED. Constituents commented that instead of full retrospective application it would be desirable to have prospective or limited retrospective application for the amendments.

One Board member pointed out that the only real issues were hedging with purchased options and inflation hedging. This Board member noted that the approach to hedging with purchased options that has evolved in practice was wrong in the first place and that this means retrospective application would be appropriate. The Board member noted further that the issue on inflation hedging was raised when such product were developed so the impact from retrospective application should be low.

The staff informed the Board that it would return at the April meeting to give the Board a plan how to proceed with the ED.

Discussion at the April 2008 IASB Meeting

Amendment to IAS 39: Exposures Qualifying for Hedge Accounting

At the March Board meeting, the staff presented the Board with a preliminary comment letter analysis on the proposed amendments to IAS 39 on what risks can be hedged and what can be designated as a hedged item. No decisions were made at that meeting. The purpose of this meeting's session was to present possible ways forward along with a staff recommendation.

The staff presented three possible ways forward with one approach having further possible alternatives:

  • Approach A: Wait for the responses to the Discussion Paper on reducing complexity in reporting financial instruments before deciding what, if anything, to do on hedge accounting
  • Approach B: Move forward with a short-term amendment using the rules-based approach of the ED
    • Approach B1: Move forward with a limited amendment to IAS 39 that addresses only issues where there is diversity in practice
    • Approach B2: Move forward with an amendment based on scope of the ED (hedged financial items)
    • Approach B3: Move forward with an amendment based on the ED but extend the scope to include non-financial hedged items.
  • Approach C: Move forward with a short-term amendment but develop a principle-based approach to address financial (and possibly non-financial) hedged items

The staff recommended Approach B1, that is, to continue with the ED to address the issues that created diversity in practice.

The Chairman questioned whether it would be sensible to defer the ED to await the outcome of the FASB's project on simplifying hedge accounting. One Board member noted that waiting for completion of FASB's project would be tantamount to accepting approaches the Board does not consider appropriate. The staff noted that approach B1 could lead to further submissions to IFRIC on similar issues.

The Board agreed to continue with approach B1.

Discussion at the May 2008 IASB Meeting

At the April 2008 meeting the Board discussed how to proceed with this project. The Board decided to make limited amendments to IAS 39 addressing two issues:

  • the hedging of inflation risk in particular situations, and
  • the designation of a purchased option in its entirety as a hedging instrument for risk in an item that contains no optionality, in such a way that no effectiveness results.

Designation of inflation risk in particular situations

The issue originally raised to the IASB was whether it was possible under IAS 39 to designate as a hedged item the inflation risk associated with a fixed rate financial liability.

The Board discussed this issue as part of the deliberations that resulted in the publication of the ED of amendments to IAS 39. The ED clarifies that fixed rate debt cannot be fair-value hedged for inflation risk, yet floating rate debt can, but only if the contractual floating rate cash flows of that recognised debt instrument are linked to changes in inflation. Inflation risk was not specified as an eligible risk in paragraph 80Y of the ED. However, if inflation (a) was a contractually specified cash flow and (b) the remaining cash flows of the instrument would not be a residual amount, paragraph 80Y(e) of the ED permitted designation of the inflation component.

At this meeting the Board members confirmed their decision as they believed this reflected its original intentions that only risks and cash flows that were separately identifiable and measurable should be eligible for designation. The Board also believed that this decision reflected existing practice and this was largely confirmed by respondents to the ED. Paragraph 80Y will be moved to the application guidance of IAS 39.

Designation of purchased option as hedging instrument

The ED also provides clarity on a previous IFRIC discussion on cash flow hedge effectiveness using options. If an entity hedges a non-optional exposure (for example, floating rate interest payments on issued floating rate debt) with an option (for example, by buying an interest rate cap), the entity cannot claim that the debt has optionality that is equivalent to that in the option and thereby defer all the fair value movements of the option in equity under a cash flow hedge.

The decision of the Board in developing the ED (paragraph AG99E) was consistent with the view of the IFRIC. Paragraph AG99E states that: 'In designating as a hedged item a portion of a financial instrument, an entity cannot specify as the hedged item a cash flow that does not exist in the financial instrument as a whole. For example, in designating a one-sided risk (such as the decrease in the fair value of a financial asset) as a hedged portion, an entity cannot include any cash flows that are imputed or inferred in the designated hedged portion (for example, inferring the cash flows arising from the time value of a hypothetical written option in a non-derivative financial asset).'

The Board decided to retain the approach in the ED as they believed that this decision reflected their original intentions. However, the Board acknowledged that diversity in practice exists and that paragraph AG99E may result in a change in practice for some entities.

Effective date on transition requirements for the proposed amendments

The ED proposed retrospective application. The Board believed that restating comparative information on first-time application of this proposed amendment should not entail significant cost or effort because the requirement in IAS 39 to document hedging relationships should mean that the information required to make any restatement is readily available. If an entity has previously deferred both the time value and intrinsic value of a purchased option and the amendment would disqualify such a designation, the entity would be required to restate to the position had hedge accounting not been applied at all. In such a case, an entity cannot retrospectively present the effects of an alternative hedge designation that was not actually applied in practice. This decision reflects the principle that hedge accounting can only be undertaken if the designation and documentation are done at inception of the hedge.

Regarding the proposed effective date, the staff proposed that the amendments should be applied for annual periods beginning on or after 1 January 2009, with earlier application permitted. A few Board members raised some concerns about whether the proposed effective date leaves enough time for the preparers to adopt the proposed amendments. The proposed effective date was approved by the affirmative vote of 11 Board members.


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