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Financial Instruments: Recognition and Measurement

Date recorded:

The staff opened the meeting by summarising the tentative decisions reached by the Board in last month's meetings. These included:

  • A working premise of two measurement bases of fair value and amortised cost.
  • A starting point for classification based on the approach adopted by the forthcoming IFRS for SMEs.
  • Retention of a fair value option in some form (although not intended to be discussed at this meeting).
  • Not permitting any reclassifications.
  • Removal of tainting rules and replacement with additional disclosure requirements.

Classification - principles that govern characteristics of financial instruments

The staff then presented their principles based, two-step approach to classifying financial instruments that entails first characterising financial instruments that qualify for amortised cost accounting and then applying a business model overlay to override amortised cost accounting with mandatory fair value accounting. This approach is based on the IFRS for SMEs as a starting point with changes to derive a principle for classification based on cash flow variability of a financial instrument.

Some Board members raised concerns that principles developed could not be operational. They said that characterising instruments based on cash flow variability added complexity and ignored fair value variability. One Board member particularly objected to the consequence of applying the two-step approach to a loan asset with a written cap, which would result in amortised cost accounting for the instrument as a whole. The Board member preferred an approach that considered all terms of the instrument (not just cash flow variability), which in this case should result in the instrument to be accounted for at fair value through profit or loss in its entirety. Not to do so would ignore the instrument's fair value variability introduced by the written option. Another Board member, who supported the staff's proposal, suggested such fair value variability existed for 'vanilla' fixed-rate instruments and hence should not be of concern in itself. However, the concern was more based on the asymmetrical fair value variability, as opposed to just variability.

Some Board members supported the staff's approach and considered a principle based on cash flow variability favourable over an approach that started with a list of instruments for each classification.

When asked by the Chairman, a majority of Board members agreed with the general thrust of the staff's proposal of amortised cost for certain 'vanilla lending instruments' and fair value for all other instruments.

Classification - implications of the business model

The Chairman introduced the next staff paper dealing with the business model overlay. He drew the Board's attention to the staff recommendation that the business model overlay require mandatory fair value measurement for those instruments that are managed and their performance assessed on a fair value basis (which is intended to include all financial instruments held for trading). The staff explained that this would broaden the fair value measurement requirement.

The Board discussed whether a very liquid financial asset (such as a traded treasury bond) available as a liquidity reserve should ever qualify for measurement at amortised cost. Most Board members felt that it should not.

Some Board members felt uncomfortable with the staff's recommendation that could result in an entity recording, at the same time, some liquid treasury bonds at fair value (if held for trading) and some at amortised cost (if held for non-trading purposes and not managed or assessed on a fair value basis).

Some Board members approved of the business model overlay as they felt it was based on fact (the business model) as opposed to management intention or any chosen designation.

One Board member disagreed with the notion that classification based on a business model would result in decision useful information.

The Chairman summarised the Board's views as supportive of a version of an overlay that would require fair value accounting for certain instruments, which would at least include instruments held for trading. He proposed the staff consider the Board's comments and come back with a refined approach.

Classification - Implication for embedded derivatives

The staff presented three alternatives to deal with embedded derivatives in the revised standard as follows:

  • Alternative one: Maintain the existing requirements
  • Alternative two: Eliminate the concept of embedded derivative accounting
  • Alternative three: Change the bifurcation criteria

The Chairman explained he instinctively would support alternative two. The staff's view was that this would be a significant change and would be difficult to implement in the time frame given that the rules for assessing derivatives embedded in non-financial instruments would have to be retained. The staff felt that changes to the rules on embedded derivatives would require wider consultation.

One Board member disagreed with the staff's recommendation for alternative one. He felt that a classification principle could be designed to accommodate embedded derivatives in financial instruments which would result in the entire instrument being classified as fair value through profit or loss.

Another Board member felt uncomfortable dealing with embedded derivatives at a later stage as this would result in a piecemeal approach to overhauling IAS 39.

The staff agreed to reconsider its views based on the Board's comments.

Equity Instruments: OCI method

The staff reminded the Board of its tentative decision in the May meetings to consider a fair value measurement basis where gains and losses were recorded in other comprehensive income with no subsequent recycling.

The staff's recommendation put forward was to allow an entity, on initial recognition, a free choice to designate equity investments at fair value with gains and losses recorded in other comprehensive income. The designation would be irrevocable.

The Board was divided, with some not supporting the free choice and others happy that the irrevocable designation and enhanced disclosure requirements would impose sufficient discipline. Those that opposed the free choice wanted the designation to be restricted to specific situations where the benefit of holding the investment was to fulfil a wider business objective and not for income or capital gain purposes. The staff explained they set out with the intention to limit the designation but then found it too difficult to set definitive criteria.

Some Board members were uncomfortable with the possibility that under the staff's recommendation different purchases of the same equity investment could be given different classifications (that is some at fair value through profit or loss and some at fair value through other comprehensive income).

Transitional provisions and equity instruments cost exemption

The meeting continued past the scheduled time and four Board members left the meeting. The Chairman proposed that the meeting continue to discuss the remaining papers with no decisions to be made until the next meeting.

The staff put forward their recommendation for retrospective application of the proposed changes, in accordance with IAS 8, along with additional disclosure. The basis for this recommendation was to enhance comparability with the comparative period and avoid changes in measurement basis part-way through a reporting period (which could be the case if prospective application was permitted from, say, November 2009).

Some Board members were concerned that preparers may use the benefit of hindsight to determine fair values. Others felt this would not arise as fair values would have already been reported.

The staff agreed with the Board's concern that computations of amortised cost could be costly and time consuming.

As the meeting drew to a close the staff's recommendation of removing the cost exemption for certain unquoted equity investments was briefly tabled to gauge from the remaining Board members whether there were any objections. None were raised.