Financial Instruments – IAS 32 and IAS 39

Date recorded:

The Board discussed the following issues related to IAS 32 and IAS 39:

  • Pass-through arrangements
  • Fair value measurement guidance
  • Macro hedging
  • Cash instrument hedging
  • Contracts on own equity-definitions and principle
  • Sensitivity disclosures
  • Other finalisation issues
Pass-through arrangements

The Board discussed whether to permit an obligation to pay a disproportionate share of the cash flows of the original asset to qualify for pass-through accounting (portion) or whether as a condition for pass-through accounting, the entity retains no or a fully proportionate interest in the original asset.

The Board noted that IAS 39 as drafted is not clear and that additional guidance must be given on how to apply the requirements to pass-through arrangements. The observer notes contained a Flowchart of the staff's proposal that is integral in understanding the Board's proposal. It should be noted that the first step of the process is to determine the reporting entity-which could include an SPE that is consolidated as a result of SIC 12. Therefore, the test would be conducted through the viewpoint of the consolidated entity, and not the individual entity that "sold" the assets to the SPE.

The Board agreed 12 to 1 (with one abstention) to approve the decision tree in the flowchart. The Board did not believe this change would require re-exposure.

Fair value measurement guidance

The Board discussed several issues related to determining fair value when (a) a quoted price in an active market exists, (b) recent market transactions when no active market exist, and (c) the use of valuation techniques when no active market exists. The Board made the following decisions related to when a quoted price in an active market exists:

  • Valuation techniques may not be used to measure fair value when an active market exists.
  • IAS 39 will be clarified to require the use of quoted rates when an active market for that rate exists.
  • Bid-ask prices should be used in determining fair value. Mid-market prices should not be used since they may result in immediate gains.
  • When more than one active market exists for which an asset or liability can be disposed of immediately without cost or risk (that is without bundling or any modification), the most advantageous market price should be used. The most advantageous market price is the one that results in the highest price.
  • Blockage factors should not be considered, as it is uncertain whether they exist and, even if they exist, whether their value could be determined reliably.
  • The final standard will clarify that entities may adjust the quoted market prices for changes in factors that affect the price of the instrument at the balance sheet date.
  • The final standard will not contain guidance on what constitutes an active market.
The Board decided the following when an active market does not exist:
  • The Board agreed to remove the second level of the fair value hierarchy so that when an active market does not exist, a valuation technique should be used. The Board clarified that one input to the valuation technique may be to look at recent market transactions for similar items.
  • The price received in an inactive market should be the best indicator of the fair value as proposed in the Exposure Draft. Therefore, an entity that purchases assets in an active market, packages these assets, and sells the package in an inactive market could have a gain on the transaction.

Macro Hedging

The Board agreed (14-0) to change the Exposure Draft to permit an entity to use fair value hedge accounting for a portfolio hedge of interest rate risk. The key elements of the proposed approach are as follows:

1. The entity identifies a portfolio of items whose interest rate risk it wishes to hedge. The portfolio may comprise both assets and liabilities.

2. The items are grouped into time categories based on their expected (not contractual) re-pricing dates.

3. The net position in each timer period is established and the entity decides how much of that net position it wishes to hedge. The entity designates assets (or liabilities, but not both) equal to the amount it wishes to hedge as the hedged item, rather than the net amount. The designation is of an amount of a specific currency rather than of individual assets. The assets (or liabilities) from which the hedged amount is drawn must be items:

  • Whose fair value changes in response to the risk being hedged,
  • That could have qualified for fair value hedge accounting under IAS 39 had they been hedged individually, and
  • Included in narrowly defined and consistently determined time buckets.
4. The entity designates what interest rate risk it is hedging. This risk could be a portion of the interest rate risk in each of the items in the portfolio, such as a benchmark interest rate like LIBOR.

5. The entity designates a hedging instrument for each time period. The hedging instrument may be a portfolio of derivatives containing offsetting risk positions.

6. The entity measures the change in the fair value of the hedged item that is attributable to the hedged risk. This gain or loss is reported in the income statement and in one of two separate line items in the balance sheet. The change in value is not allocated to individual assets.

7. The entity measures the change in the fair value of the hedging instrument and reports this gain or loss in the income statement and as an adjustment to the carrying amount of the hedging instrument in the balance sheet.

8. Ineffectiveness is reported in the income statement as the difference between the amount determined in 6 and that referred to in 7.

As noted from earlier discussions, the Board decided to require liabilities with demand features (such as demand deposits) to be measured at the higher of its fair value or amount that could be demanded. A liability measured at the amount that could be demanded today does not have interest rate risk and therefore, some Board members believe cannot be subject to a fair value hedge. The Board did not make a decision on this matter and has asked to staff to develop this issue further.

The representative of the Federation Bancaire de l'Union Europeenne (FBE) expressed concern that ineffectiveness of an under hedge (for example, a hedge 100 of a portfolio of 150 because 50 is expected to be prepaid; however only 25 is prepaid) would be taken through income the same as an overhedge. The Board confirmed its conclusion, noting the fact that the use of expected time buckets does not appear to permit any other choice. The staff and Board will continue to work on the mechanics of applying this approach and will readdress this at the next Board meeting.

The Board discussed several issues related to how to make this approach workable. Additionally, the Board decided that this issue must be re-exposed. The staff will undertake the task of preparing a pre-ballot draft for the July 2003 meeting.

Cash instrument hedging

The Board concluded that financial instruments other than a derivative (a "cash instrument") should not be designated as a hedging instrument other than for foreign currency risk.

Contracts on own equity

At its April 2003 meeting, the Board determined that contracts that either (a) involve an obligation to deliver cash or other assets or (b) may be settled using a variable number of own shares as a means for payment should be classified as a liability, not equity. The result of this decision requires amendments to the definitions of financial assets, financial liabilities, and equity instruments in IAS 32. The Board finalised changes to these definitions to incorporate the April decision.

Sensitivity disclosures

The Board tentatively decided (8 to 3) that sensitivity disclosures should be provided for fair values estimated using a valuation technique for each valuation assumption not supported by observable market prices. Certain Board members are concerned that the requirement for sensitivity disclosures could be quite onerous, for example when 100 models with 4 different variables each that are not supported by observable market prices exist. The Board will discuss this issue further at its September 2003 meeting.

Finalisation issues

The Board decided that the final amendments to IAS 32 and IAS 39 should be issued in two stages. The first versions of IAS 32 and 39 will be those that include the all decisions that are not being re-exposed. The second and final versions will include the decisions from issues re-exposed. The Board is taking this approach to try to ensure users in countries adopting IFRS in 2005 have as much of the final standard as possible in hand when preparing for 2005.

As a result of a letter received from the Japanese Accounting Standards Board, the Board reconsidered its recent decision on the impairment of available-for-sale equity securities. The Board reversed its earlier decision to stay with the proposal in the Exposure Draft. That is, an impairment of an available-for-sale equity instrument would create a new cost basis. Therefore, increases in value should be recognised as equity. The Board also clarified that the decrease in fair value must be prolonged in order for an impairment loss to be recognised - consistent with existing implementation guidance. The Board confirmed that the impairment of debt securities should be accounted for similarly to the impairment of originated loans.

The Board noted that the work of the EITF on Issue 02-03 should be followed, and if EITF makes a decision the IFRIC may want to look at issuing similar guidance.

Currently, there is one issue the Board has determined requires re-exposure (macro hedging). However, the Board noted one other issue to be discussed in July that may require re-exposure - that is, the conflict between IAS 32/39 and the Exposure Draft on share based payments. One Board member expressed his intent to dissent to both IAS 32 and IAS 39, while one additional Board member expressed his intent to dissent to IAS 39.

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