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Financial instruments — Limited reconsideration of IFRS 9 (classification and measurement) (IASB-FASB)

Date recorded:

The IASB and FASB discussed:

Definition of principal

The IASB and FASB discussed the meaning of “principal” in the context of the solely principal and interest (P&I) condition under the contractual cash flows test for financial assets. Principal is not defined in IFRS 9 Financial Instruments but the FASB’s proposed ASU (specifically ASC 825-10-15-18) describes it as ‘the amount transferred by the holder on initial recognition’. However, paragraph BC4.23 of IFRS 9 states that ‘cash flows that are interest always have a close relation to the amount advanced to the debtor’. In the staff’s view, the wording in paragraph BC4.23 of IFRS 9 and the wording in the FASB’s proposed ASU are different because they were designed for different purposes.

The concern  is that divergent views already exist among interested parties and staff acknowledge that different meanings of principal will result in different classification outcomes for particular instruments and hence clarifying  the meaning of principal is fundamental to the application of the solely P&I condition.

The three alternatives that the staff provided for describing the meaning of principal are:

  • Alternative A — the amount that is contractually defined as ‘principal’
  • Alternative B — the amount that was advanced to the debtor when the debtor originally issued the instrument
  • Alternative C — the amount that was transferred by the current holder for the asset.

The staff think that Alternative C is consistent with the boards’ logic that underlies the current description of principal in both IFRS 9 and the FASB’s proposed ASU—and indeed is consistent with both boards’ intention that principal is the amount that the current holder transferred for the financial asset.

All board members agreed with the staff proposal and no disagreement was noted.

De minimis

The boards further discussed concerns raised over the de minimis features i.e. features that could only impact the cash flows on a financial asset by a de minimis amount both on a period by period basis and cumulatively, and the impact that these features can have on the classification of financial assets. The staff noted that such features should not impact the result of the contractual cash flows test regardless of their nature and that this treatment would not be viewed as inconsistent with the solely P&I condition.

The boards agreed that it is not necessary to quantify the de minimis or require that an entity performs a numerical assessment as it should be clear when a feature would meet this definition but also noted that this exercise may be required by a regulator.

Components of interest

The staff acknowledged that concerns have been raised on the interpretation of the word “solely” in the solely P&I condition particularly around the definition of interest. It was noted that there is confusion in the market place as to whether interest could include anything other than consideration for time value of money and credit risk.

The staff expressed the view that the application guidance should clarify that consideration for liquidity risk should not be viewed as violating the solely P&I condition but do not think that the boards should provide an exhaustive list of possible elements of interest as this would not be in line with a principle-based standard approach. The intention should rather be to identify assets with simple cash flows that clearly represent a basic lending-type return where amortised cost measurement would provide useful information by allocating those cash flows over time.

One board member raised the issue of whether leverage would be assessed as a component of interest but it was agreed that leverage would be assessed under the de minimis considerations.

Several board members discussed on the timing of this assessment and agreed that this should form part of the day 1 consideration that should not subsequently be revisited as a result of market conditions changing.

The boards agreed with staff’s views expressed above and no further concerns were raised.

Time value of money

The staff acknowledged that many questions have been raised as to the meaning of time value of money and whether it should provide consideration for just the passage of time in line with economic theory which views it as a measure of the risk-free rate. The staff believes that the link between the interest rate and the currency as well as the period for which it is set should be considered and in the case of a mismatch this should not necessarily violate the solely P&I condition.

In determining whether the objective of the time value of money is achieved the staff noted that this could be done through a qualitative assessment or a quantitative assessment but staff did not agree on prescribing when each method should be used. It was agreed that although the quantitative assessment could add operational complexities to entities, a clarification of the definition of time value of money would narrow the population of instruments to which the quantitative assessment would apply.

The boards agreed not to allow the fair value option in lieu of the quantitative assessment of the time value component of the interest rate but disagreements were noted on whether regulated interest rates should be accepted as proxy for consideration for the time value of money - although it was noted that the regulators’ intention would be to protect investors and borrowers rather than to manipulate the markets.

Lastly the majority of the board members agreed that more analysis is needed in determining whether to provide additional guidance on how and why the quantitative assessment should be performed.

Contingent features

The concern raised in respect of contingent features is that some of those that are commonly included in financial assets such as prepayment and conversion options could result in the instrument not meeting the solely P&I condition even if its value is insignificant. The problem arises in assessing whether the nature of the contingent trigger event, that may or may not be external to the instrument, should be considered in assessing the solely P&I condition.

It was decided that the nature of the trigger should be a helpful indicator but not a determinative factor itself and therefore should not be completely disregarded. Further guidance in terms of examples will be provided, however this will not be in the form of an exhaustive list of every possible scenario.

Contingent features resulting in cash flows that are not solely P&I

The staff provided three possible alternatives for contingent features that result in cash flows that are not solely P&I:

  • Alternative A – If the contractual cash flows are not solely P&I, the financial asset does not meet the solely P&I condition regardless of how likely it is that the non-P&I cash flows will occur (except if they are non-genuine)
  • Alternative B – The holder would be required to consider the probability of occurrence of contingent contractual cash flows that are not solely P&I for all types of contingent features and the current ‘non-genuine’ threshold would be replaced with the lower probability threshold of ‘remote’. Under this alternative, the probability of the contingent non-P&I cash flows would affect the classification, but the nature of the trigger event would not. If the probability of the non-P&I cash flows occurring is no longer remote, the financial asset would be reclassified to FVTPL
  • Alternative C – The holder would be required to consider the probability of occurrence of contingent contractual cash flows that are not solely P&I for specific contingent features that result in cash flows that are not solely P&I and the current ‘non-genuine’ threshold would be replaced with the lower probability threshold of ‘remote’ only for specific contingencies (bail-in instruments). Under this alternative, both the probability and the nature of the contingent trigger event would affect the classification of financial assets.

Some board members supported alternative A on the basis that it is pure and simple and therefore in line with the boards intention on IFRS 9 to simplify the rules and that the introduction of an additional “remote” threshold does not help move towards that direction.

In light of different views no decision was reached and the staff were asked to further investigate and clarify the meaning of “protective rights” and how they can affect the solely P&I assessment.

Nature of the contingent trigger event

For prepayment and extension options the staff proposed that the nature of the trigger event as well as the resulting cash flows should be considered in assessing the solely P&I condition. The nature of the trigger, however, should be a helpful indicator but not a determinative factor itself. The boards agreed with the staff recommendations and no disagreements were noted.

Prepayment features resulting in cash flows that are not solely P&I

The staff provided three possible alternatives for prepayment features that result in cash flows that are not solely P&I (in line with the alternatives provided for the contingent features):

  • Alternative A – If the contractual cash flows that result from the prepayment feature are not solely P&I, the financial asset does not meet the solely P&I condition and will be classified at FVPL. Under this alternative, the probability of the occurrence of contractual cash flows that are not solely P&I (i.e. the probability of the prepayment feature being exercised) does not matter, unless the prepayment feature is non-genuine.
  • Alternative B – The holder would be required to consider the probability of occurrence of contractual cash flows that are not solely P&I in assessing a financial asset with a prepayment feature. This would apply to all prepayment features that could result in non-P&I cash flows regardless of the prepayment amount. Essentially, under this alternative the current “non-genuine” probability threshold in IFRS 9 and the FASB’s proposed ASU would be replaced with the lower threshold of “remote”.
  • Alternative C – Under this alternative, the guidance in IFRS 9 and the FASB’s proposed ASU would be amended to require financial assets with prepayment features at the contractually stated par amount plus accrued and unpaid interest to be classified at amortised cost, provided that the fair value of the prepayment feature on initial recognition (by the current holder) is insignificant. This alternative also implicitly considers the probability that the non-P&I cash flows will occur because it looks to the fair value of the prepayment feature on initial recognition. This is because the fair value of the prepayment features captured under this alternative would be insignificant if prepayment is not likely to occur.

The boards expressed mixed views on the above alternatives. The IASB voted in favour of alternative C and agreed to broaden its scope so that assets with these features purchased at a significant premium or discount would pass the contractual cash flows test and thus qualify to be classified at amortised cost. The FASB voted in favour of alternative B introducing a “remote” threshold in the assessment of the solely P&I condition but agreed to reconsider its decision later once the staffs clarify the meaning of “protective rights” (see contingent features above).

Correction list for hyphenation

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