Chronology
- Project Started Under Auspices of Old IASC Board: July 2001
- JWG Proposal Completed: December 2000
- IASC Invited Comments on JWG Proposal: December 2000
- Discussed with SAC: July 2001
In mid-1997, when it embarked on the project that led to IAS 39, Financial Instruments: Recognition and Measurement, IASC agreed to continue to explore the possibility of requiring full fair value measurements in the primary financial statements (sometimes called mark-to-market) for all financial assets and financial liabilities. As part of that exploration, IASC has, for the past three-and-a-half years, participated in a Joint Working Group (JWG) of International Standard Setters on Financial Instruments, comprised of standard setters representing 13 countries.
The JWG has now completed a 'draft standard' and turned it over to its participating bodies. In December 2000, the IASC Board issued it for comment (click for IASC Press Release). Comment deadline is 30 September 2001, though IASC is strongly encouraging comments by 30 June. The other participating standard-setters either have already done the same thing or have agreed to do so. Although the Board of IASC has discussed most aspects of the draft standard, the views expressed in the document do not necessarily reflect the views of the IASC Board. And while written in the form of a draft standard, it is not an IASC draft standard or exposure draft. Nonetheless, it represents three and a half years of hard work by representatives of over a dozen countries and, as such, is likely to command considerable attention by the new IASC and by national accounting standard-setters.
IASC and the other standard setters participating in the Joint Working Group on Financial Instruments have posted on their websites an electronic version of the JWG Draft Standard and Basis for Conclusions. Click to download the JWG Draft Standard, Basis, and Application Guidance (ZIP 957k).
Printed copies are still available for purchase from IASB.
Key Conclusions of the Joint Working Group
Scope
- The JWG proposal would apply to all enterprises, regardless of size or whether their securities are publicly traded
- Its scope would be similar to IAS 39, but:
-- it includes financial guarantee contracts
-- it includes weather derivatives
-- it applies to acquired mortgage and loan servicing assets and liabilities
-- it applies to any obligation that either party can settle in cash
Recognition and Derecognition
- Recognition of financial instruments: similar to IAS 39 -- all financial assets and all financial liabilities must be on the balance sheet, including all derivatives.
- The JWG's embedded derivative provisions are similar to those in IAS 39 -- except, of course, there will be fewer separations because more hybrids will be measured at fair value under the JWG proposal. Separation (some call it bifurcation) of the embedded derivative from the host contract is not required if the combined hybrid is itself measured at fair value.
- Derecognition: when an enterprise is no longer a party to the contractual rights or obligations, (that is, the transferor has no continuing interest in the financial asset or liability), it should be derecognised.
--The JWG would derecognise in most repurchase agreements and securities lending transactions.
--Note: Under the JWG tentative thinking, the transferee must have substance in its own right or the transferred asset must be isolated in bankruptcy.
Measurement
- Measure all financial instruments at fair value when recognised initially.
- Remeasure to fair value at each reporting date.
- Fair value is exit price based on market transactions
-- Fair value is best determined from an observed market price
-- If the financial instrument is exchange traded, fair value is the closing price minus commissions
-- If the financial instrument is dealer traded, fair value is the bid price for assets, and the asked price for liabilities
- The best measure of fair value is the market price for an identical instrument.
-- If that is not available, use the price for a similar instrument.
-- If the instrument trades in more than one market, use the most advantageous price from the perspective of the reporting enterprise.
-- If no there is no established market price for an identical or similar financial instrument, use a Discounted Present Value cash flow model based on general market information (including interest rates, FX rates, and commodity prices) risk-adjusted as necessary to reflect the particular risks of that financial instrument.
- If an enterprise is not able to make a reliable fair value estimate currently, it should use the most recent reliable fair value estimate. (Presumably this might be acquisition cost, which is fair value at date of acquisition.)
- Ignore any non-contractual aspects of financial instruments, such as future deposits by depositors and additional purchases by credit card holders, in valuing a financial instrument. That is, the bank would not assume renewals of time deposits and the credit card company would not assume additional purchases.
- However, behavioural expectations (such as prepayments) should be considered in making fair value estimates.
- If financial instrument is denominated in foreign currency:
-- For a forward contract use forward rate.
-- For all others use the spot rate.
- Do not adjust market price for size of holding.
- An enterprise's procedures for determining fair value must be documented.
- Fair values are generally determinable, at reasonable cost, and are practicably implementable.
- Reported value of liabilities should reflect changes in an enterprise's own creditworthiness.
Reporting Fair Value Changes
- All gains and losses arising from changes in fair value of financial instruments would be reported in net income when they arise.
Hedge Accounting Prohibited
- All forms of hedge accounting would be prohibited, including hedges of commitments and forecasted transactions. Certain 'hedging' note disclosures would be allowed.
Disclosure
- Interest revenue and interest expense should be calculated on a fair value basis using current yield to maturity (YTM), not contractual.
- An enterprise would report separately the fair value changes relating to impaired loan assets.
Next Step
- While the participating JWG countries are inviting comments, none has said they accept or reject the JWG conclusions.
- The IASB is considering comments received on the JWG proposal. The Canadian Institute of Chartered Accountants is preparing an analysis of the comment letters received in response to the draft.
Discussion of Responses to JWG Report with National Standard Setters
At its meeting with liaison national standard setters in January 2002, IASB discussed an analysis of the responses to the JWG proposals. Below is a summary of points discussed.
Overall
The mandate of the JWG was to develop a draft comprehensive standard on accounting for financial instruments at fair value. 284 responses were received. Two thirds of these were from preparers, the remainder from a wide variety of groups, but responses from users were few in number.
About 75% of respondents were opposed to the proposals in the paper. Of the 25% for the proposals, the vast majority of these were non-preparers. Of the objections, there were 2 main types: problems of principle, and practical problems.
The problems of principle included:
the role of management intentions (i.e. intention shouldn't affect measurement);
the need for the immediate recognition of changes in fair value; and
financial instruments being measured at fair value and non-financial instruments being measured at cost.
Practical problems included:
volatility (especially of fair values of instruments for which there is no active market);
cost benefits (especially for banks);
the risk of major adverse effects from subjectivity; and
transitional concerns.
There were no new views offered. The only peculiarity of the responses is that views are not changing. There was high level agreement that much more work (field-testing) is needed. Also, many of the concerns were similar to objections raised in response to IAS 39 and putting derivatives on the balance sheet. Most banks felt that users both didn't want and wouldn't understand financial statements prepared with all financial instruments at fair value.
Overall, preparers were against the proposals, users for them and regulators split. Also, there was a general feeling that there was too much material to comment on it all in any great detail.
Measurement
In general, using exit prices was accepted, although it was felt that more work is needed and more explanation as to why it was chosen (as opposed to for example entry price or some other current value) is needed. There was concern over the treatment of large block holdings and over situations with large bid/offer spreads.
Several respondents felt that the hierarchy given was the major contribution of the paper. Others felt that increased flexibility is required, especially in the area of using a price for a similar instrument versus using a valuation technique. Many felt that it would be preferable to use valuation techniques rather than take the price of a similar instrument and then adjust it, especially as this is what they currently do.
On policies, procedures and controls in place, most agreed with the proposals in the paper and felt that these are essential for any fair value model. However, they felt that it was perhaps not the role of the standard setter to set these.
On fair valuing loans, lenders in general rejected the proposals to use valuation techniques based on internal data as being too subjective and also pointed out that many do not have the systems in place to implement this. Investment banks in general thought the proposals were feasible and acceptable. All agreed that loan loss provisioning needed to be re-examined.
With regard to values not attributable to financial instruments (e.g. credit card intangibles), opinion was very strongly divided, but no new views were offered.
With regard to including own credit worthiness in valuing own debt, there was a hardening of views against this proposal on the grounds of the counter intuitive income statement result, but again, no new views were offered.
It was agreed that more work must be done, by way of field testing, by speaking to entities that currently use fair values. Also, regard needed to be given to other projects that are also looking at this area (e.g. the insurance project) to ensure consistency.
In general, 80% of respondents felt that it would be difficult to fair value all financial instruments and half of those felt that it would be difficult when there was no liquid market.
Income Statement
There was significant opposition for the proposal to recognise all gains and losses, with a wide range of suggestions for exclusions. The main areas of opposition were:
volatility;
users not understanding the financial statements;
the consequences for tax, dividends and covenants; and
unfamiliarity.
Many did not address with issue of whether the financial reporting project will tackle any of these concerns. Very few addressed the issue of disaggregating the income statement, but those who did pointed out that combining fair values with historical cost interest would produce very strange results and also that they were unsure of what fair value interest is. It was noted that the Joint Working Group had their time working on the income statement curtailed, so were not fully able to address all issues in the time they had.
Hedging
85% of respondents disagreed with the proposals and wanted some sort of hedge accounting allowed. Very few accepted there being no hedge accounting for future transactions. It was pointed out that if you disaggregate the hedging instrument from the future transaction, then there will be increased volatility shown in the financial statements, but the underlying volatility will have decreased.
Again this was an area where no new arguments were given, but there was a general lack of support for the proposals. With hindsight, this area was poorly written as it says that no hedging is allowed, whereas in fact most fair value hedges are still recognised. Additionally, there was insufficient explanation as to the decisions made.
It was pointed out that the hedge accounting that most respondents wanted was for forecasted transactions, and they don't get that under IAS 39 either.
Recognition and Derecognition
This area accounted for approximately one third of the paper. The main area that these sections did not address was consolidation, but this is on the IASB's agenda. This area was developed by looking at the IASC framework and it was decided that a components-based approach was best. Recognition and derecognition criteria concentrate on contractual rights and obligations and on who controls these.
There was a reasonable favourable response, although some respondents were unclear on what was meant by components and/or contractual rights and obligations. There was worry that concentrating on components would result in missing the overall effect of a transaction, and that the approach adopted was overly mechanical.
The main areas of discussion were:
legal isolation. Some respondents wanted more, some less;
continuing involvement. There was agreement that if there is no continuing involvement, then the instrument should be derecognised and accounted for as a sale, but more explanation was needed of what constituted continuing involvement; and
there was general disagreement of the treatment where the transferor has continuing obligations or a call option as it was felt that too many liabilities would be recognised and that the measurement of the liability at its maximum amount is too high. 75% of respondents didn't like that the test was by the transferor only, and not the transferee, so there was not mirror accounting.
Other
There was general agreement with the disclosures required. Most agreed with the proposition that risk sensitivity be encouraged but not required. The most notable exception was the AIMR who felt that this should be required. This was the only area of the paper that they did not agree with.
Only a few respondents addressed the issue of balance sheet disclosure, and they were evenly divided. Some agreed with the proposals, and some felt that it was not useful to separately classify impaired loans.
On scope and definitions, cost/benefit for smaller entities was an issue. Also, it was felt that insurance business and financial instruments should be accounted for on a consistent basis.
Most ignored the question of implementation and transitional requirements. There was very little support for supplementary accounts as they would be overly onerous. Most felt more field testing is required before proceeding further, and that this should commence sooner rather than later to prevent the project from grinding to a halt.
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