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Prepayment features with negative compensation

Date recorded:

Prepayment Features with Negative Compensation - Agenda paper 3

The purpose of this session is to discuss:

  • Technical re-deliberation: eligibility conditions: AP 3A
  • Modifications or exchanges of financial liabilities: The IFRS Interpretations Committee’s decision: AP 3B
  • Summary of staff recommendations and questions for the Board: AP 3C
  • Effective date and transition provisions: AP 3D
  • Due Process steps and permission for balloting: AP 3E

APs 3A and 3B set out the Staff’s analysis of the respective matters. The Staff’s recommendations are presented in AP 3C.

Recap

AP 3A to the June 2017 Board meeting contains a summary of the feedback received on the exposure draft Prepayment Features with Negative Compensation (proposed amendments to IFRS 9).

In the ED, the Board proposed a narrow-scope exception to IFRS 9 so that a prepayable financial asset would be eligible to be measured at amortised cost (or at FVTOCI subject to the business model condition) if:

  • (a) the financial asset would otherwise meet the requirements of IFRS 9.B4.1.11(b) but fails it only because the party exercising the prepayment option may receive compensation for terminating the contract (the first condition); and
  • (b) the fair value of the prepayment feature is insignificant on initial recognition of the financial asset (the second condition).

In the ED, the Board proposed an effective date of 1 January 2018 for the amendments. The Board also proposed retrospective application of the amendments with specific transition provisions.

Next steps

The Staff plan to issue the amendments to IFRS 9 in October 2017.

Technical re-deliberation: eligibility conditions - Agenda paper 3A

Staff analysis of the feedback received

The first condition

As nearly all respondents agreed with this condition, the Staff recommend that the Board confirm this eligibility condition in the final amendments.

Some respondents found the explanation in the Basis for Conclusions on the notion of ‘reasonable compensation for the early termination of the contract’ to be unnecessary and outside the scope of the amendments.

The Staff, however, think that a proper understanding of this notion is vital to achieving consistency in its application, both in relation to the proposed amendments as well as the existing guidance regarding positive compensation prepayment features. Moreover, the Staff believe that this explanation would be even more important if the Board were to remove the second condition (see below) as the scope of the amendments would then depend entirely upon the first condition. Having said that, the Staff will amend the wording in the BC to acknowledge that there may be circumstances in which the types of prepayment described in the BC may be consistent with the notion of reasonable compensation for early termination.

The second condition

There was mixed feedback on this issue. Those who disagreed said that there should be alignment in the accounting for prepayment features with negative compensation and those with positive compensation. Furthermore, some respondents said that the second condition is unduly restrictive in some cases yet it may not scope out otherwise non-eligible financial instruments in other cases.

The objective of the second eligibility condition is to ensure that the scope of the amendments is sufficiently narrow so that amortised cost measurement is not extended beyond the population of financial assets for which the effective interest method can provide useful information. In particular, the second eligibility condition seeks to limit the scope so that financial assets are eligible to be measured at amortised cost only if it is unlikely that prepayment, and thus, negative compensation, will occur.

Given this objective, the Staff point out that the key is not to achieve symmetry between positive and negative prepayment options, but to assess whether amortised cost measurement would provide meaningful information about the cash flows of a financial asset with negative compensation prepayment features. The Staff reiterate that BC21 to the proposed amendments already indicates that the frequency of catch-up adjustments is likely to increase when a prepayment feature includes both negative and positive compensation. Although the frequency of catch-up adjustments is not a determinative factor in assessing whether particular contractual cash flows meet the SPPI criterion, recognising frequent catch-up adjustments would arguably decrease the usefulness of amortised cost information.

The Staff also analysed various examples provided by the respondents who commented that the second condition is unduly restrictive. The Staff concluded that in those cases, the instruments are appropriately scoped out of the amendments because they have a more than insignificant probability of being prepaid. In other words, the second condition is effective in achieving its intended objective, at least in some cases.

Having said that, the Staff acknowledge that the second condition does not achieve its intended objective in all cases. The Staff considered the following circumstances:

  1. The fair value of a prepayment feature will reflect the fair value of negative and positive compensation. In certain instances, it is possible that the fair value of the prepayment feature may be more than insignificant largely (or entirely) due to the positive compensation. This outcome would be inconsistent with the existing requirement of IFRS 9.B4.1.11(b), which does not require a holder to assess the fair value of a prepayment feature that may give rise to positive compensation.
  2. If the fair value attributable to positive compensation and negative compensation were equally significant, then the fair value of the prepayment feature as a whole could be insignificant because the opposing components offset each other. This would not restrict the instrument from being measured at amortised cost even if there is a high probability of prepayment.
  3. An option to prepay a financial asset at an amount close to its current fair value would have an intrinsic value of, or close to, nil. In such cases, the second condition would again not prevent such an instrument from being measured at amortised cost even if there is a high probability of prepayment.

In light of the above, the Staff acknowledge that the effectiveness of the second condition to achieving the Board’s intended objective is limited.

The Staff also considered but rejected various alternatives to replace the second condition due to the challenges and limitations of the respective alternatives. Moreover, those alternatives have not been exposed for comment especially with regard to their operationality, effectiveness or appropriateness.

Staff recommendation (included in AP 3C)

The Staff recommend that the Board:

  1. confirm the first condition and retain the explanation of its application in the Basis for Conclusions, subjecting to drafting changes as indicated above;
  2. remove the second condition and its related transition provisions and disclosure requirements; and
  3. to accommodate reasonable negative compensation for the early termination of the contract in IFRS 9.B4.1.12 (which contains an exception for prepayable financial asset to be measured at amortised cost if it was acquired at a premium or discount but is prepayable at par).

Modifications or exchanges of financial liabilities: The IFRS Interpretations Committee’s decision - Agenda paper 3B

Background

Previously, the IC discussed the accounting for a modification or exchange of a financial liability measured at amortised cost that does not result in the derecognition of the financial liability. The IC concluded that an entity applies IFRS 9.B5.4.6 to such transactions.

The Board agreed with this technical conclusion in its February 2017 meeting. The Board also concluded that since the requirements in IFRS 9 provide an adequate basis for an entity to account for such transactions, no standards-setting activities were required.

The IC issued a tentative agenda decision to this effect in March 2017 and discussed the feedback received in its June 2017 meeting (AP 6E). At that meeting, the IC re-affirmed its previous technical conclusion; however, a number of IC members were concerned about the lack of transition provisions and the structuring opportunities that could arise as a result of the different accounting treatment between costs and fees incurred on modification (which is not taken into account when calculating the modification gain/loss) and a modification to the future contractual cash flows (which is taken into account when calculating the modification gain/loss). They were also concerned with using an agenda decision as a means to communicating what is in effect a significant and unexpected change to current accounting practice.

As a result, the IC decided not to finalise the agenda decision and instead to refer the matter to the Board.

Staff analysis and recommendation (included in AP 3C)

As the respondents did not provide any new information about the need for standard-setting, the Staff continue to agree with the Board’s previous decision that such activity is not required.

However, given that the Board is currently finalising the proposed amendments to IFRS 9 regarding prepayment options with negative compensation, the Staff recommend that, as part of that package, the Board highlight in the Basis for Conclusions the relevant accounting requirements for a modification of financial liabilities that does not result in derecognition.

Effective date and transition provisions - Agenda paper 3D

This paper discusses the effective date and transition provisions in relation to the prepayment features with negative compensation ED.

Staff analysis of feedback received and recommendation

The respondents had mixed views about the proposed effective date of 1 January 2018.

On balance, the Staff recommend that the Board:

  • postpone the effective date to 1 January 2019 with earlier application permitted;
  • require retrospective application of the amendments, with specific transition provisions if an entity applies the amendments after it applies IFRS 9.

Due Process steps and permission for balloting - Agenda paper 3E

The Staff recommend that the Board finalise the amendments to IFRS 9 without re-exposure and ask for permission to ballot.

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