Financial Instruments – Comprehensive Project to Replace IAS 39
The staff opened the meeting by laying out the agenda which would consist of board discussion and vote on the seven items below relating to the proposed new classification structure and transitional provisions.
Embedded derivative accounting
The staff summarised their paper on the subject which contained three alternatives for the board to consider. They were as follows:
- Alternative 1A: Use the embedded derivative assessment as a filter for classification. Under this alternative embedded derivative assessment and any bifurcations would take place as under existing requirements in IAS 39, and in a second step the bifurcated derivatives, host contracts and hybrid contracts which had not been bifurcated would be classified using the new criteria.
- Alternative 1B: Use the embedded derivative assessment as currently exists in IAS 39 as the classification assessment itself. Under this approach embedded derivatives which are separated would be automatically classified at fair value, and the host at amortised cost. If no bifurcation takes place the instrument automatically qualifies for amortised cost in its entirety.
- Alternative 2: Eliminate the concept of embedded derivatives altogether. Under this approach a hybrid instrument would be classified according to the new criteria in its entirety. Thus a derivative embedded in a debt instrument, for example a commodity price indexation, could result in a cashflow stream which disqualified the instrument from being classified at amortised cost under the new criteria and the entire instrument would be classified at fair value. However features such as interest rate caps, floors or collars which would result in an instrument's yield being switched from fixed to floating rate or vice versa would not preclude an instrument from being classified at amortised cost. This is because, since both fixed rate instruments and floating rate instruments would qualify for amortised cost, the staff viewed an instrument which combined the two elements should also qualify for amortised cost accounting in the absence of any other features. Given that a potential weakness of this approach is that a relatively insignificant embedded feature could result in an instrument being classified at fair value in its entirety, the staff recommended the introduction of a materiality overlay to assess the significance of such features on the variability of cash flows from the instrument as a whole for classification purposes.
Two board members voiced strong support for alternative 2 as the cleanest and simplest approach, and therefore the approach most in line with the objective of reducing complexity. It was pointed out that there would be no interaction between the embedded derivative provisions laid out here and the proposed treatment of the fair value option since it was proposed that the latter would only be retained for elimination of accounting mismatches. One board member believed the materiality overlay suggested as part of alternative 2 should not be retained as materiality should be a consideration in interpreting all standards. Three other board members voiced support for this opinion.
In response to concerns that alternative 2 would lead to change on a large scale, one board member commented that there would be sufficient lead time if an adoption date of 1 January 2011 was adopted. One board member commented that there could be potential for financial engineering given that some instruments containing embedded derivatives would be measured at amortised cost. Another board member responded to this concern by stating that it would be doubtful that instruments containing complex or multiple embedded derivatives would qualify for amortised cost treatment.
Eleven board members voted in favour of alternative 2. A majority voted against inclusion of the materiality overlay, with 2 votes in favour.
Concentrations of credit risk
The staff summarised their recommendations in this area. The issue relates to concentrations of credit risk at the individual financial instrument level due to subordination, that is, the existence of a priority of payments structure for different instruments issued by the same debtor. The implication of this is that senior and secured creditors are not usually leveraged and thus would meet the criterion of 'having only basic loan features'. However junior instruments held within a waterfall structure would be contractually leveraged, providing credit protection for more senior tranches. Instruments which provide protection for other tranches would not be basic lending transactions and so would be required to be measured at fair value. However subordinated debt instruments within a general creditor structure which is not a waterfall would not be contractually leveraged since they reflect the default ranking established under commercial law. As such they would satisfy the criterion of having only basic loan features.
There was some discussion as to whether this would contradict the tentative agreement that basic loan features would be defined as having only principal and interest cashflows, since all tranches including junior instruments issued would satisfy this criterion. However the board agreed that the element of contractual leverage and consequent differential in credit risk between senior and junior debt adds another factor to cashflow profile and so there is no inconsistency.
The board agreed (13 votes in favour) that application guidance should be included on concentration of credit risk, and also concurred with the staff position differentiating waterfall structures and creditor ranking as a basis.
Fair value option
The staff presented their position that the fair value option should be restricted to the eligibility criterion that the designation eliminates or significantly reduces an accounting mismatch. As such two of the criteria currently permissible under IAS 39, namely:
- Where a group of financial assets or liabilities is managed and its performance evaluated on a fair value basis, and
- Where a hybrid contract contains an embedded derivative, unless that embedded derivative does not significantly affect the cash flows or is closely related to the hybrid contract
would be discontinued under the new guidance. It was note that, since the board had already voted in favour of eliminating the embedded derivative criteria, the second point above was now no longer relevant.
One board member, agreeing with the staff position, noted that it should be made clear within the literature that the two criteria which would be dropped were already dealt with elsewhere by the new measurement criteria.
The board voted in favour of the staff position.
OCI method for equity instruments
The staff referred to the board's tentative position that fair value changes for certain equity instruments would be allowed to be presented through other comprehensive income (OCI) but that and subsequent transfers to profit or loss, including on disposal, would be prohibited. The staff presented two possible approaches with regard to when OCI treatment would be permissible:
- Approach 1. An entity would have the option on initial recognition of designating any equity instrument as at fair value through OCI. The designation would be irrevocable and made on an instrument-by-instrument basis. On derecognition of an instrument the amount in OCI would be transferred to retained earnings. Disclosures would be required to make transparent why an entity has invoked the option and what the effect on the financial statements has been.
- Approach 2. Designation as at fair value through OCI would be governed by a principle. A possible starting point for such a principle would be as follows:
An equity instrument that is held in a broader business context and not primarily for realising the financial benefits inherent in it shall be accounted for as at fair value through other comprehensive income.
The staff recommended the second approach, with reclassifications in and out of the OCI category required if the strategic relationship in relation to an equity investment changes, such that the principle no longer applies or only begins to apply at a date after initial recognition.
One board member disagreed with the staff position on the basis that the reclassification criteria would introduce added complexity. It was noted that the OCI category is a concession by the board and it would be inappropriate to introduce a new principle. Furthermore it was noted that reclassification criteria could be abused if entities anticipated gains or losses in certain instruments. There was some discussion as to whether a sufficiently robust reclassification model would prevent such abuse. Some board members also commented that the proposed principle lacked clarity.
One board member opined that the prohibiting of reclassifications would introduce sufficient discipline when entities designate which instruments to classify at fair value through OCI and limit the potential for abuse.
Another board member noted the example of an entity which is a venture capital company with a variety of investments. A free choice in designating some investments as at fair value through OCI and others as at fair value through the income statement would result in lack of transparency, and users would need to look at the entire statement of comprehensive income in order to understand results.
However several board members pointed out the fact that appropriate wording for any principle was problematic and may result in the need for copious guidance going forward.
The board voted against a principle-based approach in designating which instruments should be at fair value through OCI. 4 members voted in favour. The board also voted in favour of assessment on an instrument-by-instrument basis in designating.
The staff recommended that IAS 18 should be amended in order to exclude dividends receivable for equity instruments at fair value through OCI from the revenue recognition guidance. There was some discussion as to whether transfers to retained earnings for dividend income could be permissible and IAS 16.41 was cited as a parallel. One board member also noted that guidance would be required in relation to areas such as EPS disclosure and the statement of cash flows. The board agreed with the staff's view with regard to IAS 18.
Transition: retrospective application
The staff took the board through its recommendations around retrospective/prospective application in 12 different areas.
- Classification model and assessment whether an instrument is managed on a contractual yield basis - the staff recommended retrospective application, however assessment of the contractual yield basis criterion should be based on facts and circumstances as at the date of transition to the new guidance. The board agreed with this approach.
- Designation of equity instruments fair valued using the OCI method - the staff recommended full retrospective application. The problem of obtaining fair values for equity instruments held at cost is addressed in (8) below. There was no board disagreement to this recommendation.
- Treatment of available-for-sale reserves for instruments measured at AFS under the current guidance - the staff recommended full retrospective application with amounts in OCI relating to AFS instruments should be reclassified to opening retained earnings if they relate to instruments shown at fair value through the income statement under the new guidance. For instruments treated as AFS under the current criteria which will be required to be measured at amortised cost under the new guidance, issues around impairment calculation are addressed at (7) below. The board agreed with the staff recommendation.
- Hybrid contracts where an embedded derivative was separated under the old guidance and where the hybrid contract is required to be at fair value under the new guidance - the staff recommended full retrospective application. The fair value of the hybrid contract would be the sum of the FV of the previously separated embedded derivative and the FV of the host which had been disclosed previously under IFRS 7. For treatment of hybrids requiring amortised cost treatment under the new guidance and consequent impairment issues see (7) below. Two board members voiced the opinion that there should be consistency in application across the different areas to as great an extent as possible. The board agreed with the staff's recommendation (9 votes in favour).
- Fair value option - the staff recommended that the assessment for designation and dedesignation should be required on the date of transition, and that the accounting consequences should be applied retrospectively. There was no board disagreement to this proposal.
- Effective interest rate - the staff recommended retrospective application for instruments which are measured at amortised cost under the new criteria where there had been a different measurement basis previously. This would involve determining the estimated future cash flows considering all contractual terms of the instrument, fees, transaction costs and premium/discounts and generating an internal rate of return. The staff believed that this would be essential for the requirement to report financial instruments at amortised costs going forward. The board agreed with the staff recommendation.
- Impairment - the staff recommended prospective application with a requirement for an impairment test at the date of transition, and any impairment charge recognised in profit or loss. The board considered whether retrospective application might be possible. One board member opined that a stream of cashflows would be available from previous fair value calculations in order to perform a retrospective impairment assessment, however it was pointed out that some fair values are derived from quoted prices where there is no stream of cashflows used in the calculation. Another board member noted that there may be a large adjustment if there is prospective application. Another board member suggested an alternative treatment whereby the fair value of an instrument as a proxy for the impaired amount for the purposes of recording impairment retrospectively. There was some discussion about whether cash flows should be used where available for a retrospective calculation and, where this was not possible, fair value should be used as a proxy. It was noted that reversals in periods prior to presentation would not cause problems as any current impairment calculation would override previous impairments. It was concluded that the staff should explore the possibility of using fair value in this context.
- Financial instruments measured at cost - the board had already agreed that the exemption for unquoted equities from fair value measurement should not be retained under the new classification system. The staff suggested that the fair value for these instruments should be determined at the date of transition and the difference recognised in profit or loss on transition. The question was raised by two board members why the difference should not be taken to retained earnings on transition as an adjustment of the opening position as per an IAS 8 change in accounting policy. However it was pointed out that it would be too difficult to fix which periods the change in FV would belong to.
- Hedge accounting - the staff proposed the view that any hedge relationship which has to be dedesignated under the new criteria should be treated as a discontinuation of hedge accounting. This would provide transitional relief for preparers as it would not be necessary to identify and reverse any hedge accounting effect retrospectively. One board member commented that it would be difficult to interpret this transitional provision given that the guidance on hedge accounting would not be out in July 2009. The staff noted that the fair value option was still available to eliminate mismatches in cases where hedges were discontinued and hedged items would otherwise have been required to be measured at amortised cost. There was no board disagreement to the staff proposal.
- Disclosure - the staff proposed no transitional relief in the requirement to disclose comparative amounts under IFRS 7 relating to the new classification and measurement system. The board agreed and there were no dissenting opinions.
- Disclosure on transition - the staff did not propose any requirements additional to the provisions already included in IAS 8.28 for initial application of an IFRS. The board agreed with the staff view and there were no dissenting opinions.
- Comprehensive additional disclosures for early adopters - in order to ensure comparability between entities the staff proposed the following disclosure requirements for early adopters:
- An additional statement of financial position in accordance with current IAS 39 for all periods presented
- An additional statement of comprehensive income in accordance with current IAS 39 for all periods presented
- A table comparing the carrying amount under the current version of IAS 39 with the carrying amount under the new guidance per class, for each period presented
- Narrative information on how the entity applied the new classification model and how the model impacts the entity's financial position and performance in the current and preceding periods
All of the above disclosures would be required for each period until the new guidance becomes effective for all entities reporting under IFRSs.
The staff explained that there had been a high level of correspondence and consultation on the subject of disclosure for early adopters. The rules in effect would produce a high barrier to early adoption. On board member commented that the requirements appeared excessive; however, he understood the need for them.
The staff suggested an alternative view whereby disclosure requirements for early adopters would be limited to disclosure on the effect of choices made, as compared to the position pre-transition. The chairman suggested that this could be published as an alternative view within the exposure draft.
Another board member commented that, if the new requirements are superior, the board ought not to place high barriers to early adoption. This view was supported by another board member. The staff commented that comparability was the only reason for the proposed disclosure requirements. The chairman suggested that views should be passed to the staff in the week of 15 June 2009 in relation to the potential alternative view.
Consequential amendments to IFRS 1
The staff proposed some consequential amendments to IFRS 1 in relation to designation date option (that is, the option to designate financial instruments either at the date of initial recognition or the date of transition to IFRSs) and some implementation guidance-related issues, including guidance on embedded derivatives as well as classification and measurement issues. Board members asked whether it was necessary to include this in the first phase of the project, or whether it would be more sensible to postpone IFRS 1 amendments to the second phase.
Consequential amendments to IFRS 7
The staff presented consequential IFRS 7 amendments to reflect the new categories and eliminate disclosure for areas no longer relevant (such as reclassifications). There were no dissenting opinions from the board.
The staff presented four other issues to the board as follows:
- The staff did not propose to address the issue of scope of IAS 39 in this phase of the project. The board agreed with the staff suggestion.
- The staff recommended that there should be no changes proposed to the requirements around day 1 gains and losses in the exposure draft. The board agreed with the staff recommendation.
- The staff noted that two of the annual improvements to IAS 39 to be included in the forthcoming exposure draft, in relation to effective interest rate and bifurcation of embedded derivatives, may no longer be relevant. It was noted that the exposure draft for the annual improvements would have an effective date of 1 January 2011, and that the effective date for the revised classification and measurement requirements may be 1 January 2011 or 1 January 2012. One board member voiced support for an effective date of 1 January 2012, since all of the proposed amendments ought to apply at the same time. It was decided to include the question in the September exposure draft for annual improvements.
- The staff did not recommend any changes to the IAS 39 measurement guidance in relation to financial guarantee contracts, loan commitments or financial liabilities with a demand feature. The board agreed with the staff position.
The chairman stressed that, if appropriate, alternative views could be expressed in the exposure draft in relation to the new classification and measurement rules. One board member held an alternative view which was supported by another board member. The chairman suggested that the alternative view should be discussed between the board member and the staff and that a further discussion would be held on Friday, 19 June 2009.
The board member gave a brief outline of the alternative view. This was that, for certain debt instruments which were not loans and receivables, income could be presented in the income statement but fair value movements through OCI. Thus fair value information would be given on the balance sheet and also an amortised cost-based income stream in the income statement whilst preserving the fair value basis. As such the amortised cost model would only be retained for loans and receivables. However the same criteria would exist for classification at amortised cost (i.e. managed on a contractual yield basis). It was concluded that a paper would be produced, summarising this view.
The chairman noted that this alternative view and that for disclosures on early adoption should be discussed on Friday, 19 June 2009.
- IAS 18 — Revenue
- IFRS 1 — First-time Adoption of International Financial Reporting Standards
- IFRS 7 — Financial Instruments: Disclosures
- IAS 39 — Financial Instruments: Recognition and Measurement
- IAS 8 — Accounting Policies, Changes in Accounting Estimates and Errors
- IAS 16 — Property, Plant and Equipment