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Financial Instruments: Classification and Measurement

Date recorded:

The Board met for a special meeting relating to the IAS 39 replacement project.

Reflecting changes in own credit risk for financial liabilities not measured at amortised cost

The staff introduced the session by summarising the proposals in the ED and the feedback received from constituents. The staff proposed to require a frozen credit spread measurement method as discussed in the DP on Credit Risk in Liability Measurement for some liabilities not measured at amortised cost. The Board agreed.

Nonetheless, some Board members were concerned that by using this alternative the Board introduced another current measurement attribute that was not decision-useful. Some of the Board members believed that bifurcation of the fair value changes, and presentation of changes on fair value related to changes in own credit risk outside of profit or loss, would have been a more appropriate solution. One Board member was concerned that a third measurement attribute in this IFRS would make the standard complex and thus would fail objectives of the project. The staff responded that a majority of constituents in the outreach questioned the decision-usefulness of including changes in own credit risk in subsequent measurement of financial liabilities.

The Board continued to discuss the subset of financial liabilities to which the new measurement attribute would apply. The Board agreed to require a frozen spread measurement method for all financial liabilities that are not eligible for amortised cost measurement (but are managed as part of a contractual cash flow business model). The Board clarified that this new measurement attribute would not apply to instruments to which a fair value option was applied. Decision on the future of the fair value option would be made during the hedge accounting phase of the IAS 39 replacement project as well as in Phase II of the Insurance Contracts project, and it was felt that until those issues were tackled, no changes to application criteria and measurement of the fair value option should be made. Some Board members expressed their concerns about the application of this decision to embedded derivatives with financial liabilities as a host. Discussion on this topic continued later in the day.

The Board decided to provide a default method to isolate the initial credit spread (the approximation approach that is required in the context of disclosure requirements of IFRS 7). But the Board decided not to prescribe a method for isolating the initial credit risk spread and not to provide any additional guidance for more complex instruments. The Board felt that the variety of financial instruments is so great that it is impossible to cover all the instruments in any guidance. Nonetheless, several Board members were concerned by this lack of application guidance for more complex instruments, as it may lead to diversity in practise.

The Board approved the requirement to disclose methods and inputs used to isolate the credit spread by the reporting entity. The Board also agreed to require fair value disclosures for those instruments in the notes in accordance with IFRS 7.

Accounting for embedded derivatives

The Board was presented with the alternative to eliminate bifurcation of embedded derivatives. Several Board members were concerned that this decision together with the frozen spread approach adopted for measurement of financial liabilities would lead to hybrid instruments with a financial liability as a host not to be valued at fair value. By implication this means that the derivative part of the hybrid instruments would be valued at the frozen spread approach and not fair value. The staff defended this position by arguing that the credit adjustment to the derivative portion of the hybrid contract would not be significant. One Board member was particularly concerned about the effect of this decision on convergence - a point reinforced by a FASB member who expressed his view that such IASB decision would make convergence in this area next to impossible.

Nonetheless, the Board narrowly approved the elimination of bifurcation of financial liabilities as well as financial assets.

Interaction of classification conditions

The Board discussed the interaction of the two classification conditions proposed in the ED - basic loan features of the instrument and business model of the entity. Constituents were of the opinion that the test would be applied in the reversed order, as first an entity would determine the subset of instruments to which the business model applied and then test the characteristics of the instruments.

Some Board members were concerned by such changes to the proposal as it could send a wrong type of signal. That could mean that there would be a greater risk of slippage to the sole business model conditions by some of the practitioners, even though this was not the intention of the Board.

The staff supported by other Board members replied that the final wording of the standard would reinforce the message that the two classification conditions are cumulative and there is no hierarchy embedded in them. The Board agreed.

The 'other' measurement attribute

The Board discussed how the 'other' attribute should be defined. Most Board members agreed that amortised cost is the proper category. One Board member was concerned about how requirements for the other measurement category would interact with the 'adjusted fair value' measurement attribute determined by the frozen spread approach.

The Board decided that it would not require disclosure of fair value of financial instruments not measured at fair value on the face of the statement of financial position. The Board decided that this was not the proper time to adopt such a decision, given it had not been exposed in the ED and based on the outreach activities there were two divergent views on this issue among constituents.

The FASB member expressed his dismay that the Board seemed to be losing an opportunity to converge, as the FASB and IASB staff were discussing an approach that could potentially align presentation of financial instruments on the face of primary financial statements. The staff and the IASB Board members replied that this decision could be reversed in the future when convergence was discussed and assured the FASB member that this tentative decision did not preclude any agreement on this issue during the joint meeting later in October.

Fair value option

The Board decided to retain the fair value option requirements and guidance in IAS 39 if such designation eliminated or significantly reduced a measurement or recognition inconsistency. The majority of the Board members decided that fair value option guidance should not be changed until decisions on hedge accounting and insurance contracts were finalised.

One Board member seemed to be concerned about the apparent lack of convergence with the FASB on the fair value option requirements. He also felt that given the business model overlay, fair value option might not be necessary at all.

Elimination of cost exemption for unquoted equities

The Board revisited again this contentious issue. Board members reiterated their respective positions already discussed during previous Board meetings. The choice for the Board was between:

  • elimination of the cost exemption and providing for more application guidance to determine a level 3 fair value for unquoted equities, or
  • retaining the cost exemption in some form.
Some Board members felt that if a cost exemption is retained and an impairment test in accordance with IAS 36 is prescribed based on value in use, then in effect the entity should have all the data required to determine the fair value.

On this issue the Board was unable to adopt a final decision. The Board directed the staff to analyse this issue and to propose a guidance that could be accepted by both camps. An additional Board meeting was scheduled for the week of 12 October 2009 (timing yet to be confirmed) to address this issue again.

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