Financial Instruments: Recognition and Measurement
The Board discussed circumstances in which financial instruments could be measured on a basis other than fair value.
The staff presented their paper to begin the discussion about possible classification criteria for financial instruments which would subsequently drive their measurement basis.
The three possible criteria put forward were:
- the characteristics of the instrument
- the business model of the entity; and
- the intent and or ability to trade the instrument.
Board members debated each criterion. Some Board members objected to a criterion based on management intent in part due to the potential for this intent to change over time based on market conditions. However, some Board members felt that management intent was relevant to predict the cash flows that would be realised from any financial instrument. These Board members also suggested that changes in intent could be highlighted to users through appropriate disclosure.
Board members considered the notion of distinguishing between instruments based on the predictability of their cash flows. This would distinguish between instruments with predictable cash flows and instruments with volatile cash flows. Some Board members questioned whether such criteria could apply to derivatives. One Board member highlighted that the cash flows on forward foreign currency contracts have a high degree of predictability and question whether this could result in it being grouped with vanilla instruments with predictable cash flows (such as loans) and potentially measured on a basis other than fair value. Other Board members suggested a distinction would need to be drawn between leveraged and unleveraged instruments which would result in derivatives being categorised differently. Some Board members stated that they did not believe the measurement basis for derivatives was up for debate and would remain at fair value.
Board members questioned whether the criteria for characterising instruments would be done only at inception or on a continuous basis.
One Board member felt strongly that instruments should not be characterised solely on the predictability of its cash flows. He believed a distinction should be drawn based on whether the instrument could be traded. Some board members felt that most instruments could be traded which would result in no clear distinction. Other Board members noted that the ability to trade an instrument will not necessarily mean that an entity would realise the cash flows of that instrument by selling it but instead could realise the cash flows by holding the instrument to maturity. In such a case characterising the instrument as traded would conflict with management intent.
Some felt there was congruence in practice between the characteristics of an instrument and the way in which the cash flows of that instrument was realised. The implication was that plain vanilla instruments tended to be realised through their contractual cash flows whilst more complex instruments tended to be realised by sale. As a consequence the focus on management intent was overdone.
One Board member suggested that an amortised cost measurement basis should be used for instruments with predictable contractual cash flows. Another Board member objected to this on the basis that it would introduce measurement complexities for instruments that met this criterion but were traded in an active market from which a single measure of fair value could easily be obtained, for example an investment in a government bond.
A number of Board members indicated their preference for fair value measurement for equity instruments. This was the case even where equities were held for strategic purposes on a long term basis. Questions were raised as to whether this would be fair value via profit or loss or fair value via other comprehensive income.
Starting point for a classification approach
The discussion moved on to considering a possible starting point to determine a classification approach between fair value and amortised cost. Three approaches were put forward.
- Approach one – based on current IAS 39 amortised cost categories, that is, whether the instrument has fixed and determinable payments
- Approach two – based on an approach used in the forthcoming IFRS for Small and Medium-sized Entities, that is, a distinction between basic and non-basic financial instruments
- Approach three – based on whether the asset was originated by the entity.
On a straw poll a majority of Board members broadly supported approach two, however, some Board members felt that additional modifications would be needed to this approach, for example in relation to excluding actively traded instruments from amortised cost measurement. In the absence of modifications those board members would support approach three. Therefore, a majority of Board members would allow certain highly liquid instruments that were deemed basic to be accounted for at amortised cost.
Board members were asked whether they would support the removal of tainting rules for assets classified as amortised cost based on an entity's intention to hold the instrument to maturity, in support for additional disclosures if the asset was subsequently sold. Board members were generally in favour of this.
One Board member put forward the idea that a distinction could be drawn between basic instruments under approach two based on whether their fair values could be determined on a level one, two or three basis and allowing at least level 3 instruments not to be fair valued. Some board members felt that level two instruments should also be excluded from fair value measurement if they were considered basic under approach two.
When asked, no board members objected to the notion of a fair value option for instruments that were traded. Therefore, the key consideration for the Board was over whether fair value should be mandatory for certain instruments, and if so, which instruments.
The Chairman moved discussion on to the recognition of gains and losses for instruments measured at fair value. Board members were asked whether they would consider an approach where fair value gains and losses would either be (1) recognised in profit or loss or (2) recognised in other comprehensive income and never recycled to profit or loss. A majority of the Board agreed they would consider such a treatment.
The Chairman summarised the debate as follows:
- There was support for simplifying the categorisation of financial instruments into two buckets: fair value and amortised cost. The majority supported an approach that builds on the approach used in the forthcoming IFRS for Small and Medium-sized Entities.
- There was support for a fair value option to permit fair value for an asset that would meet otherwise meet the requirements of amortised cost.
- Within the fair value category, changes in the value of some instruments could be recognised in other comprehensive income.
- No reclassifications between categories would be permitted.
Dividing the Financial Instrument project into parts
The Chairman then suggested that, given that it was possible that the Board had a workable model for the classification of financial instruments, many impairment issues existing in IAS 39 would be removed. It was suggested that, if the staff concentrated on developing this classification model, it would be possible to issue an exposure draft by July 2009 with a 2 to 2.5 month comment period. The expectation would be an IFRS would be issued by the end of 2009.
In addition, the Board would issue a Request for Views on the impairment issues remaining given the classification model in the exposure draft. The expectation is to issue this concurrently with the classification ED. The Board would use that input to develop an exposure draft that would be issued in the final quarter 2009. Also, proposals on hedge accounting would also be issued in the final quarter 2009.
Board members expressed concerns about transition and implementation issues. The Chairman stated that these would be addressed at their special meeting on 5th June.