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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

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 e-mail 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. I