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IBOR reform and the effects on financial reporting

Date recorded:

Cover Paper (Agenda Paper 14)

The Board published the Exposure draft (ED) Interest Rate Benchmark Reform—Phase 2 (Proposed Amendments to IFRS 9, IAS 39, IFRS 7, IFRS 4 and IFRS 16) in April 2020 with the comment period until 25 May 2020. The objective of this meeting was to summarise the feedback on the ED and provide staff analysis and recommendations in order to finalise the ED. The papers do not include feedback and analysis on Question 3 which related to proposals on accounting for qualifying hedging relationships and groups of items. This will be provided in July 2020 (Agenda Paper 14C).

The Board received 80 comment letters on the ED. Almost all expressed support for the project and broadly agreed with the ED. Most highlighted the urgency for this project to ensure the final amendments are issued on a timely basis, noting the time required for the EU endorsement process.

The staff plan to discuss Agenda Paper 14C as well as any sweep issues that may be identified, and seek the Board’s permission to begin the balloting process, at the July 2020 Board meeting.

Feedback analysis—Modifications of financial assets and financial liabilities (Agenda Paper 14A)

Question 1 in the ED relates to modification of financial assets and financial liabilities. Overall the staff did not recommend any substantial changes to the ED, however they have identified some drafting suggestions. The feedback and analysis has been split into five topics:

  • (a) What constitutes a ‘modification’ of financial assets and financial liabilities—no changes will be made as the staff believe describing what constitutes a modification in the context of the interest rate benchmark reform is helpful and ensures consistent accounting outcomes such that the economic effects of a change arising as a result of the interest rate benchmark reform are not hidden or obscured by the form of the change. However the staff believe that the description of the scope in the relevant paragraphs (IFRS9:6.9.2 & 6.9.5) could be articulated more clearly.
  • (b) Practical expedient in IFRS 9—no changes will be made, however wording suggestions provided by some respondents will be considered when drafting the final amendments;
  • (c) Conditions for applying the practical expedient—Almost all respondents agreed with the proposals but requested the Board to develop more examples, application guidance or clarify aspects of those conditions. The staff noted that the Board intended this to be principle-based. The Board acknowledged that the interest rate benchmark reform would be effected differently in different jurisdictions and hence they would not be able to address every situation. The staff believe some drafting improvements could include an acknowledgement that, depending on the particular changes required by the interest rate benchmark reform, a qualitative assessment may be sufficient and any significant judgements made in relation to this should be disclosed.
  • (d) Amendments to IFRS 4 and IFRS 16Almost all respondents agreed with the relevant amendments. The staff recommend the Board finalise these amendments.
  • (e) Other comments—the staff have provided an appendix of other comments (which represent a mixture of different suggestions, clarifying or editorial in nature), which, based on the staff analysis, will not result in any substantial changes. However the staff will consider drafting improvements.

The staff asked the Board whether they have any questions on the above and whether they agree with the staff recommendations to finalise without substantial changes the proposals set out in the draft amendments to IFRS 9, IFRS 4 and IFRS 16 in the ED with respect to modifications of financial assets and financial liabilities.

Board discussion

The Vice-Chair agreed with the staff analysis and recommendation to finalise the amendments and provided suggestions for drafting the final wording. The comment letters included a number of comments around whether the word ‘required’ meant compulsory. When drafting the final amendments, she suggested that the word ‘necessary’ should be used instead of ‘required’, i.e. changes that are necessary as a result of IBOR reform. The second point she raised was in relation to the term ‘economic equivalence’. This is a core part of the proposals. The amendments provide a list of example of changes that will be necessary as a result of the reform, and for these changes, she confirmed no further detailed analysis is required in relation to economic equivalence. She confirmed that she does not expect a present value analysis or a check to ensure the fair value of the instrument before or after the reform is the same. However, she said that some level of analysis is required. For example, when moving from an IBOR to a risk free rate, entities will need to understand what margin will be required to ensure economic equivalence between the two rates.

A Board member asked whether it was necessary to have the second criterion around economic equivalence. The Vice-Chair confirmed it is important and the principle should be understood. In laymen’s terms she explained that for a financial instrument with an IBOR rate, the assessment would be whether it is the same instrument with the only change that it is no longer referenced to IBOR. Hence the old rate is replaced with a new rate plus a margin. Board members would not expect entities to be required to make any other changes beyond this as a result of the reform.

All Board members voted in favour of the staff’s recommendations.

Feedback analysis—Amendments to hedging relationships (Agenda Paper 14B)

This paper related to Question 2 of the ED regarding the proposed amendments to hedging relationships required by the interest rate benchmark reform.

The staff did not recommend any substantial changes to the amendments proposed in the ED that would require an entity to amend the formal designation of a hedging relationship to incorporate the changes required as a result of the reform. However, the staff are recommending the following minor drafting changes to the proposed amendments:

  • (a) refer to the examples of modifications required by the reform as part of the changes required to the hedging relationship;
  • (b) include the designated hedged portion as a required change to the hedged item; and
  • (c) clarify that entities must make the changes to hedging relationships by the end of the reporting period during which uncertainty with respect to a specific element of the relationship has been resolved.

The staff asked the Board whether they agree with the staff recommendations to finalise the relevant proposals in the ED subject to the above clarifications.

Board discussion

The Vice-Chair agreed with the staff analysis and recommendation. She noted that it may be helpful to reinforce that the only changes to the hedge allowed will be as a result of the reform. The intention would be to achieve consistency of the hedge before and after the reform, so for example a hedge with reference to IBOR would only need to change IBOR to the economically equivalent rate (for example risk free rate plus margin).

One Board member asked for clarification on the timing for amending the hedge documentation. He wanted to confirm that the amendments will allow preparers extra time to make the adjustments to the hedge documentation (i.e. by end of the reporting during which uncertainty has been resolved). He stated that this is different to the current version of IFRS 9 which requires you to make changes to the hedge documentation as and when the adjustments are made or at the point the entity enters into the hedge. The staff said that the focus is on the designation of the hedge, and as a significant number of hedges could be impacted at the same time, implementing those changes by the end of reporting period would ensure accurate effectiveness testing is performed at the reporting period.

All Board members voted in favour of the staff’s recommendations.

Feedback analysis—Designation of risk components (Agenda Paper 14D)

This paper relates to Question 4 of the ED relating to the designation of risk components. Specifically, an alternative benchmark rate is deemed to be separately identifiable if an entity has a reasonable expectation that it will satisfy the requirement within 24 months from the date it is designated.

The staff recommends finalising the proposals in the ED, subject to clarifying that the 24-month period applies to the individual alternative benchmark rate and hence, begins from the date that an entity designates a particular alternative benchmark rate as the hedged risk for the first time.

The staff asked the Board whether they have any questions and whether they agree with the staff recommendations to finalise the relevant proposals in the ED subject to the above clarification.

Board discussion

The Vice-Chair said she does not have a strong view on this topic either way, as when deciding on the 24-months period it was relatively arbitrary but designed to be helpful. She wanted to confirm that when the Board proposed the relief it was intended to be on a hedge-by-hedge basis which will provide more relief than a finite 24 months. She asked the staff whether preparers really wanted less relief. The staff confirmed that from their perspective preparers did not feel too strongly about this, but found that there is good reason to apply it on a rate-by-rate basis as it provides a natural end date and ensures the relief is temporary as intended in the ED.

The Vice-Chair then mentioned that if the amendments are revised to be a rate-by-rate method, the Board will need to be specific about when the 24-month period begins, especially when reinstating old hedges. For example, it needs to be clarified whether this is at the date of reinstating the old hedge or at the date of initial application of the requirements. She confirmed that she agrees if it is the latter but the amendments will need to be clear.

A Board member asked whether there would be any disclosure requirements around the 24-month period. The staff confirmed there were no plans to add any specific disclosure requirements around this but it may be covered by the overall disclosures, which includes the progress an entity has made.

12 of the 14 Board members voted in favour of the staff’s recommendations.

Feedback on the Exposure Draft—Effective date and transition (Agenda Paper 14E)

This paper related to the effective date and transition requirements proposed in the ED.

The staff recommended finalising the effective date and transition requirements proposed in the ED with one change as follows (underlined text indicates the change):

“An entity would reinstate a discontinued hedging relationship if and only if:

  • (a) the entity discontinued that hedging relationship solely due to changes required by interest rate benchmark reform and, therefore, the entity would not have been required to discontinue that hedging relationship if the amendments had been applied at that time; and
  • (b) at the date of initial application of the amendments, that discontinued hedging relationship: (i) still meets the risk management objective on the basis of which it qualified for hedge accounting (ie the entity still pursues the risk management objective for that hedging relationship); and (ii) continues to meet all other qualifying criteria (after taking into account the amendments).

The staff asked the Board whether they agree to finalise the effective date and whether they agree with the staff recommendations to finalise the transition requirements in the ED with the proposed change.

Board discussion

The Vice-Chair agreed with the staff analysis and recommendation. The amendment was intended to be helpful rather than harmful. She requested one further amendment, i.e. that it should be explicit that when a hedge is reinstated and there is a question regarding the separately identifiable component, the 24-month period would start at the date of initial application of the requirements.

All Board members voted in favour of the staff’s recommendations including the additional amendment added by the Vice-Chair.

Feedback analysis—Disclosures (Agenda Paper 14F)

The paper related to Question 6 of the ED, which relates to the proposed amendments to IFRS 7 for additional disclosures related to the interest rate benchmark reform. The feedback received comprises feedback from both comment letters and additional outreach with users of financial statements (investors).

They recommended that the Board finalise the proposed disclosures in the ED subject to the following two changes:

  • (a) Amend IFRS 7:24J(b) to require disclosure of quantitative information about non-derivative financial assets, non-derivative financial liabilities and derivatives (each shown separately) that, at the end of the reporting period, remain referenced to interest rate benchmarks subject to the reform. This information would be disaggregated by significant interest rate benchmark. For the purposes of this disclosure, an entity would choose the representative basis (e.g. carrying amount or nominal amount) for disclosing the quantitative information and explain the basis applied in the financial statements.
  • (b) Delete the proposed disclosure in IFRS 7:24J(c), which required a description of how the entity determined the base rate and relevant adjustments to that rate, including any significant judgements the entity made. This has been removed as entities might be unable to provide this information in a way that would be sufficiently granular and entity-specific for it to be useful to investors.

The staff asked the Board whether they agree with the staff recommendation to finalise the proposed amendments to IFRS 7:24I-24J with the two changes described above.

Board discussion

One Board member asked whether there will be a certain criterion (i.e. will preparers follow a hierarchy with information consistent with those provided to key management personal as a last option if providing carrying value or nominal value is not practical without undue cost and effort) or whether it is a free choice.

The staff confirmed that the objective of this disclosure was to provide information that allows users to understand the magnitude of the financial assets and financial liabilities that still reference a rate that is subject to the reform. To meet that objective, preparers said they might not be able to provide the carrying amount without undue cost or effort, but could provide it in a basis consistent with information provided to key management personal. The users of the account had stated that even if they are provided with carrying amounts, it represents a subset of the total amounts and will not tie through to the annual accounts, hence the basis of the information does not matter to them. The important information to meet the objective is the magnitude of what is left to transition to alternative benchmark rates. In response to the Board member’s question, the entity would be able to select the most representative basis and explain why they have selected that basis.

The Vice-Chair agreed with the staff that the amendments should not be prescriptive. It is important to establish the objective of the disclosure. In her view there are two items to consider:

  • 1) The disclosures should enable users to understand how much work in relation to transition to alternative benchmark rates is still left to do, especially in the context of total population. The information therefore should be provided relative to the size of the total population of the financial instruments.
  • 2) The other objective is to provide users with an idea of the progress compared to total population and information that provides an idea of how much work that would involve (i.e. “we have transitioned £xm of contracts in the last 6 months, with £xm remaining”).

A Board member agreed with removal of proposed IFRS 7:24j(c) and the concerns that would only provide boiler plate disclosures. For IFRS 7:24j(b), the same Board member agreed with the Vice-Chair and believes it is about providing a sense of progress (i.e. how much work has been done and how much is left to do).

Another Board member agreed with the disclosures showing measures of progress. He asked the staff whether the disclosures apply to all financial instruments or only those in hedging relationships. The staff confirmed the scope includes all financial instruments impacted by the reform. IFRS 7:24j(d) is more specific to those in hedging relationships and to the extent that Phase 1 disclosures apply, these would still be required.

Another Board member mentioned that entities would need to know the quantum of financial instruments required to transition on day 1 in order to measure progress against that. She mentioned a key word is ‘proportion’ and in the drafting of the amendments the staff need to ensure that this is emphasised.

All Board members voted in favour of the staff’s recommendations.

Feedback analysis—Modification/replacement of derivatives (Agenda Paper 14G)

This paper related to matters raised by respondents in their feedback on the ED and specifically how the requirements proposed in the ED would apply to particular approaches that are expected to be used in practice to replace, rather than modify derivatives designated as hedging instruments. It was noted that instead of modifying the contractual terms of derivatives, central clearing parties may facilitate the transition to alternative benchmark rates using approaches that result in the termination and replacement of derivatives on an economically equivalent basis. This is because such approaches would result in a similar economic outcome compared to modifying the original contracts but would be easier to execute.

The staff recommended the Board clarify that, for the purpose of the changes required to a hedging instrument, modifications required by the reform could be effected in ways other than modifying the contractual terms of the hedging instrument as long as the outcome is economically equivalent to modifying the hedging instrument to refer to an alternative benchmark rate.

The staff asked the Board whether they agree with the staff recommendation.

Board discussion

The Vice-Chair agreed with the staff analysis and recommendation however provided drafting suggestions. It is implicit in the recommendation that the modification would need to be economically equivalent and would not result in derecognition of the hedging instrument. These need to be included explicitly in order to prevent tension with current wording in IFRS 9/IAS 39 on novation. The staff agreed with this.

A Board member asked that if a basis swap is issued, on an individual swap basis rather than on an aggregated basis, on an economically equivalent basis, whether this would fall in the scope of the amendments. The staff mentioned that in their analysis they normally understood that basis swaps are issued on an aggregate basis, which is not attached to a specific hedge and therefore would not be within the scope. However if done on an individual basis, and on an economically equivalent basis, then the staff recommendation would apply.

Some Board members requested whether the staff could include a few examples of different situations in order to help preparers understand what would be within or outside the scope of the staff recommendation.

All Board members voted in favour of the staff’s recommendation.

Feedback analysis—Other comments (Agenda Paper 14H)

This paper summarised comments on areas that were not directly addressed by the ED and relates to feedback relating to:

  • Classification of financial assets—SPPI;
  • Embedded derivatives; and
  • End of application of the Phase 1 exceptions.

The staff recommended no substantial changes to the proposed amendments and have identified some drafting suggestions which will be considered when drafting the final amendments.

The staff asked the Board whether they have any questions on above and whether they agree with the staff’s recommendation.

Board discussion

The Vice-Chair agreed with the staff analysis and recommendations. She did not see any need to make changes to IFRS 9 in relation to SPPI as there is sufficient information included in the current Standard. It is principle-based in this area, specifically in relation to interest and not prescriptive. She appreciates that preparers will have to do some analysis, but this will be only at the time the rate is changed.

All Board members voted in favour of the staff’s recommendations.

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