Financial instruments: Classification and measurement
The Boards continued their joint discussions on financial instrument classification and measurement and the limited amendments to IFRS 9 and the FASB’s revisions to their original proposals.
Business model assessment
Under IFRS 9, the business model assessment permits a financial asset to be classified at amortised cost if the asset is held within a business model whose objective is to hold assets in order to collect contractual cash flows with the fair value through profit or loss as the residual category for financial instruments. The concept of ‘hold to collect’ does not depend on management’s intent for a specific financial instrument but rather of the overall business model as determined by the entity’s key management personnel. IFRS 9 permits sales of financial assets classified as ‘held to collect’ when the asset no longer meets the investment policy (eg, because of credit rating declines), when an insurer adjusts its investment portfolio for duration changes or to fund capital expenditures, but in doing so the entity is required to consider how such sales are consistent with the objective of collecting contractual cash flows.
Under the FASB’s tentative approach, the business model for assets to be classified at amortised cost would be that an entity manages the instrument through lending or customer financing activities. Lending or customer financing activities involve financial assets that are being held to earn a return on the initial outlay of cash through the return of principal plus interest over the effective life of the instrument. The key components of lending or customer financing activities include collection of substantially all of the contractual cash flows and the ability to manage credit risk by negotiating any potential adjustment of contractual cash flows with the counterparty in the event of a potential credit loss.
The FASB’s business model approach would limit loan-type instruments to the amortised cost category while the IASB’s business model would permit both loans and debt securities to qualify for amortised cost (assuming the contractual cash flow tests are met). To attempt to converge their respective approaches, the Boards considered three possible alternatives.
The first alternative is consistent with the IFRS 9 approach and focuses on the objective of holding for collection of contractual cash flows. An entity would need to consider prior and anticipated future selling activity to determine whether assets are held for collection and this alternative would supplement the existing guidance in IFRS 9 with additional guidance on when sales are consistent with a ‘hold to collect’ business model by discussing the ‘frequency’ of such sales.
The second alternative also has a primary objective of holding for collection of contractual cash flows but also includes relevant factors an entity would consider in making this assessment. The considerations under this approach would include 1) the primary exposure/risk the entity is managing and how it is managed, 2) how it expects to realise the contractual cash flows, 3) specified indicators (such as term of the instrument, readily determinable fair value or liquidity and management compensation) and 4) the nature of sales.
The third alternative is similar to the FASB’s tentative model and focuses on instruments generated through a lending or customer financing business activity. This approach does not focus on how an entity expect to realise the contractual cash flows but rather the business activity utilised in acquiring and managing those financial assets. The primary risk assessed under this approach is credit risk, as such entities would be permitted to manage credit risk by negotiating with the counterparty and sales due to management of credit exposure would be consistent with the amortised cost business model. However, other sales, such as rebalancing a portfolio to manage liquidity or interest rate exposures would not be consistent with this business model.
One IASB member started the discussions by stating that he didn’t support any of the proposed approaches preferring instead to start with an objective that both Boards could agree on rather than getting in to the granularities of the specific approaches.
A FASB member noted that both alternatives one and two focused on value realisation concepts which exist in current GAAP and have led to practice issues around subsequent sales and tainting considerations. He noted support for the approach in alternative three but suggested an openness revising the specific language used. Another FASB member stated his belief that alternative three is a better way of communicating a business strategy and had concerns with alternatives one and two because they focused on value realisation of an individual instrument whereas alternative three permits a portfolio level view.
The FASB Chair stated her view that the alternatives are actually fairly similar but by focusing too much on the words she can understand why there is a perception of bigger differences. She suggested that alternative one could be enhanced by adding the ‘why’ certain sales should be permitted, for example sales changes in tax or regulatory requirements could be acceptable reasons to sale rather than using a volume notion.
Several IASB members stated their preferences for alternative one. Some noted they couldn’t support alternative two because it was too rules based while others mentioned they could support that alternative.
The FASB chair noted that there appeared to be agreement that sales should be permitted to manage credit risk and that perhaps alternative one could be supplemented with additional guidance.
The Boards tentatively decided that financial assets would qualify for amortised cost if the assets are held within a business model whose objective is to hold the assets in order to collect contractual cash flows. The Boards also tentatively decided to include additional implementation guidance on the types of business activities and the frequency and nature of sales that would and would not qualify for amortised cost measurement.
Bifurcation of financial instruments
IFRS 9 does not permit bifurcation of financial assets but retained the classification and measurement guidance in IAS 39 for financial liabilities which included the ability to bifurcate financial liabilities. However, the IASB did alter the recognition of financial liabilities designated under the fair value option so that changes in one’s own credit risk would be recognised in other comprehensive income rather than profit or loss.
The FASB’s original proposals on financial instruments proposed not permitting bifurcation of either financial assets or financial liabilities. However, constituent feedback to the proposals requested retention of the ability to bifurcate embedded derivates from hybrid financial liabilities. The FASB felt that allowing asymmetry in accounting for financial assets and financial liabilities would increase complexity therefore have tentatively decided to require bifurcation of both financial assets and financial liabilities.
During this meeting the Board discussed how to resolve the differences in their respective positions on bifurcation. The staff presented the Boards with three possible alternatives.
The first alternative would not permit bifurcation of either financial assets or financial liabilities and instead require classification of the instrument in its entirety. This alternative could result in additional financial liabilities being classified at fair value through profit or loss and therefore consideration of the ‘own credit’ issue may have to be reconsidered (for the IASB extending the other comprehensive income recognition beyond the fair value option, for the FASB a consideration of recognising own credit in other comprehensive income). Additionally, because the both Boards’ approaches included bifurcating financial liabilities there currently is no guidance on applying the contractual cash flow test to financial liabilities so this would have to be reconsidered.
The second alternative would not allow bifurcation of financial assets but would require bifurcation of financial liabilities using the closely related bifurcation methodology. This approach is consistent with the approach in IFRS 9 and is consistent with the FASB’s current tentative decision for financial liabilities but would eliminate the bifurcation requirement for financial assets. However, this alternative results in asymmetrical accounting for financial assets and financial liabilities.
The third alternative would provide for symmetrical accounting by using a principal and interest bifurcation methodology for both financial asset and financial liabilities. The principal and interest bifurcation methodology would be a principles-based approach and replace the existing rules-based closely related bifurcation methodology; this would also eliminate the existing differences in IFRS and US GAAP related to ‘closely related’. However, developing a principal and interest bifurcation model would require the creation of new application guidance.
The staffs recommended the Boards pursue the first alternative to not permit bifurcation of either financial assets or financial liabilities.
One of the IASB members mentioned that he would not support an approach that changes the decision in IFRS 9 to allow for bifurcation of financial liabilities noting that bifurcation concepts would still exist in other parts of accounting guidance such as revenue recognition, leases, insurance, etc. He noted that his preference would be for the third alternative. Another IASB member also noted that he could not support the staff proposal because the IASB had decided in IFRS 9 that the accounting for liabilities was not broken, except for the own credit issue which was subsequently resolved. He would prefer symmetrical treatment for financial assets and financial liabilities and therefore also supports the third alternative. The IASB Vice-chair stated that he also strongly agreed that the IASB should not go back and revisit the accounting for financial liabilities. For symmetry he mentioned he would entertain a discussion on permitting bifurcation for financial assets.
One IASB member stated that he sees bifurcation of financial liabilities as a separate issue from financial assets and therefore is comfortable with not having symmetry. Another IASB member said he struggled with the lack of symmetry when IFRS 9 was originally issued but no longer has those concerns and is supportive of the second alternative.
A FASB member said he supports the staff recommendation of not permitting bifurcation for either financial assets or financial liabilities. He noted that they have already been criticised for the complexity involved in the financial instruments project and that permitting bifurcation just exacerbates that complexity. Another FASB member asked what disclosures would be considered to assist financial statement users in putting bifurcated instruments back together and stated that he does not believe that bifurcation provides users any relevant information. Another IASB member agreed that users get very little benefit from bifurcation and stated a preference for the first alternative.
The Boards tentatively decided not to permit bifurcation for financial assets but require bifurcation of financial liabilities using the closely related approach that currently exists under both IFRS and US GAAP.