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Financial Instruments: Classification and Measurement

Date recorded:

The Board met for a special meeting relating to the IAS 39 replacement project. Several Board members, FASB members and FASB staff joined the meeting via video link.

Scope

The staff introduced the session by summarising the feedback to the Exposure Draft (ED) received from constituents. Preparers and auditors, in particular, challenged the scope as defined by the Board in the ED. They proposed an alternative by splitting the classification and measurement phase into two sub-phases. The first phase would cover only financial assets, and financial liabilities would be addressed as part of a second phase. These constituents believed that fundamental questions regarding own-credit-risk for liabilities, embedded derivatives, and financial instruments with characteristics of equity have to be answered first before the second phase could be completed.

The staff recommended retaining financial liabilities in the scope as proposed in the ED as staff believed that separate guidance for liabilities would create a very complex set of principles and rules with unintended consequences. A Board member questioned that recommendation because fundamental issues of bifurcation of hybrid financial instruments and reflection of credit risk in subsequent measurement of financial liabilities had to be resolved first. The staff clarified that it just wanted guidance on how to proceed and not a fundamental decision on the aforementioned issues. Staff said that discussion on own credit risk and bifurcation of hybrid instruments will be scheduled for a later stage.

The Board tentatively agreed with the staff recommendation that the new IFRS would address classification and measurement of both financial assets and financial liabilities.

Classification Conditions

The Board discussed classification conditions. In their comment letters, constituents generally agreed with the proposed classification conditions. Nonetheless, they asked the Board to articulate the principles and guidance more clearly. The Board agreed to retain the two basic conditions as proposed by the ED, which were:

A financial asset or financial liability would be measured at amortised cost if two conditions are met:
  • The instrument has basic loan features. A debt instrument has basic loan features if the return to the holder is a fixed amount, fixed over the life, variable over the life due to changes in a single referenced quoted or observable interest rate, or a combination of a fixed and variable return (such as LIBOR plus a fixed spread).
  • The instrument is managed on a contractual yield basis. While this condition is similar to the 'held to maturity' condition in the existing IAS 39, there are no 'tainting provisions' comparable to those in IAS 39 that would prohibit an entity from measuring a financial asset at amortised cost if it has recently sold other financial assets measured at amortised cost before maturity. However, special disclosures would be required for derecognition of a financial asset or financial liability measured at amortised cost.
A financial asset or financial liability that does not meet both conditions would be measured at fair value. This would include all investments in equity instruments (and derivatives on those equity instruments) - including those that do not have a quoted market price in an active market. That is, there would be no 'measurement reliability' exception for equity instruments such as now exists in IAS 39.

Basic Loan Features

The Board agreed that the standard should articulate the guidance more clearly by including some parts of the application guidance in the standard itself and by providing more complex examples of basic loan features in the application guidance. The Board also agreed with a staff proposal to include a discussion of leverage in the application guidance (and not including it just in the Basis for Conclusion as proposed in the ED).

Nonetheless, much of the subsequent discussion focussed on the logic and guidance for the proposed examples, with several Board members proposing different views on how the principles should be articulated. For example, one Board member proposed to include the notion of 'true lending relationship' into the definition of basic loan feature. Another stressed that the loan terms must be substantive. Several examples were briefly discussed, especially when basic loan features were applied only to the debt host of a convertible instrument. The Board agreed that particular examples would be discussed off-line as they relate to very detailed issues as well as drafting. If needed, these would be re-discussed at the next Board meeting. In general the Board agreed that the discussion of the examples and the basis for conclusions should be expanded, and the language of the examples could be improved.

Another contentious issue in the discussion was the notion of materiality. The staff discussed in its paper two aspects of materiality (features with significant effect on cash flows but unlikely to occur and features with insignificant effect on cash flows very likely to occur). Several Board members raised doubts about whether and how the notion of materiality should be articulated at all in the new standard.

Several Board members pointed out the need for the principles to be clearly defined and articulated to be operational. A FASB member noted that the language used in the ED could be confusing, mainly as basic loan features combine the notion of cash flow including principal and interest as well as discussion of additional features that may be included in the financial instrument (leverage, subordination, etc.) and suggested the Board articulated it as two separate conditions. He also suggested that both IASB and FASB staff should work to articulate the guidance as consistently as possible in their respective standards.

Managed on a contractual yield basis

In response to the received feedback from constituents, the staff proposed to revise the description of the contractual yield basis condition as follows: 'the objective of an entity's business model to hold the instruments to collect (or pay) contractual cash flows rather than to sell (or settle) the instruments prior to their contractual maturity to realise fair value changes'. The staff also proposed to provide additional examples and include more guidance defining those principles.

Most members of the Board agreed.

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