Financial Instruments: Classification and Measurement

Date recorded:

Elimination of cost exemption for unquoted equity instruments

The staff introduced the session by summarising the discussion the Board had held at previous three meetings on this topic.

After a short discussion, the Board tentatively agreed to eliminate the cost exemption for unquoted equity instruments. Nonetheless, the Board agreed to include in the final IFRS guidance on when cost might be representative of fair value for subsequent measurement.

The staff noted that any additional guidance should be applicable only to a limited subset of instruments (when the entity has no reliable inputs or ability to perform a valuation), as already discussed at previous meetings. Most of the discussion focussed on linking the guidance in the IFRS with the guidance in the fair value measurement (FVM) project as well as wording of the additional guidance.

The staff explained that the aim of the proposal was to provide guidance when cost might be indicative of an estimate of fair value after initial recognition, in case no new information indicating the opposite was present. Several Board members were concerned that the proposal would be inconsistent with the FVM project as it implied a notion of entry price and the FMV standard would be based on exit price. However, other Board members and the FMV project team did not see any fundamental difference between this guidance and the guidance already proposed in the FVM project.

Some Board members were concerned that the language employed could lead to a more widespread use of cost measurement than the Board intended (in effect creating a rebuttable presumption that cost is used in these circumstances). The staff agreed to tighten the definition to indicate that fair value should be estimated in all cases and, as part of the estimation of Level 3 fair value, cost is one of the inputs influencing valuation.

One Board member was concerned that such guidance would decrease comparability as the valuation methods will diverge between the firms. The Board disagreed.

Several Board members expressed their concern in relation to disclosure. They proposed additional disclosures on measurement as well as measurement uncertainty. The staff replied that current requirements of IFRS relating to Level 3 measurement should be a starting point for any disclosures, and it believed that such disclosures were appropriate. The staff also noted that it would bring a separate paper on presentation of changes in level 3 measurements in profit or loss next week, when these issues might be reconsidered.

Reclassification between fair value through profit and loss (FVTPL) and other measurement categories

In light of the feedback received from constituents the Board reconsidered its proposal in the ED to prohibit any reclassification between the FVTPL category and other measurement categories. Constituents strongly disagreed with the proposal and asked the Board to require reclassification when business model of the reporting entity changes. They admitted that such changes might be rare but were adamant in that inability to reclassify was contrary to the proposed classification model, as it would lead to instruments being classified in an inappropriate category.

Three Board members were concerned that allowing such reclassifications would lead to cherry-picking and free choice between measurement categories. Consequently, the Board agreed to tighten the wording of the proposed standard and to provide additional guidance and examples indicating that changes in the business model were very infrequent. The Board agreed to add additional disclosures on reclassification to provide the users with a comprehensive record on reclassifications. The Board finally agreed to require reclassification if and only if and entity changes its business model.

One Board member discussed possible reclassification based on changes in the cash flow characteristics. The staff replied that classification on initial recognition was based in the contractual terms over the whole life of the instrument. Otherwise these reclassifications could be very frequent, which would be inconsistent with the objective of the model. The Board agreed to include such reasoning in the basis for conclusion of the final standard.

After a short discussion, the Board agreed to account for reclassifications prospectively.

The Board agreed that if an instrument was reclassified from another category to FVTPL, the instrument should be remeasured at the classification date, and any difference between previous carrying amount and fair value would be recognised as a separate line item in profit or loss. The Board discussed where to recognise such difference, with majority of the Board favouring profit or loss and a minority requiring retained earnings. A majority of the Board was of the opinion that recognition of the difference in retained earnings would lead to structuring opportunities (recognise the loss in retained earnings when markets fall to capture the fair value effect on recovery in profit or loss).

The Board also agreed that if an instrument was reclassified from FVTPL to another category, the fair value of the instrument on the date of the reclassification would become its new carrying amount.

The Board agreed that the proposed disclosures on reclassifications were based on modified requirements of current IFRS 7. Those requirements would encompass reclassification disclosures in interim periods and in the following annual period, but would not require disclosure of fair value gain/loss that would have been recognised in profit or loss until derecognition.

Equity instruments measured at fair value through other comprehensive income ('OCI exemption')

The Board discussed the OCI presentation exemption. After a short discussion the Board confirmed the proposal in the ED to provide an OCI presentation exemption for any equity investment that is not classified as held for trading. Such election must be made at initial recognition and is irrevocable.

Several Board members expressed their preference for tighter criteria for equity instruments to be eligible for OCI presentation exemption. However, the Board was reminded that it tried to find a principle for OCI presentation exemption before the ED was published and could not agree on a general principle. The Chairman noted that trying to limit the scope of OCI exemption at this stage would be very sensitive and might even trigger re-exposure. Nonetheless, he noted that when FASB finalised its model, the IASB might expose some of the FASB proposals as amendments to its final standard as part of a convergence project, and this might be a way to discuss any changes to the OCI exemption.

The Board agreed to require dividends on such equity instruments to be presented in profit or loss as long as they represented return on investment. On the other hand, the Board decided that recycling of other gains and losses should be prohibited under the OCI exemption.

Most Board members agreed with these proposals. Nonetheless, one Board member was particularly concerned that this decision was inconsistent with the theory of finance. He argued that such a decision would be based on no general principle and would create a divergence between treatment of capital appreciation and dividends. Another Board member was concerned that the Board is very close to re-creating the 'available-for-sale' portfolio and not a limited presentation exemption to a measurement category.

Finally, the Board agreed to retain all the disclosures proposed in the ED and to disclose separately dividends presented in profit or loss related to the investments classified as fair value through OCI.

The Board will continue its discussions on classification and measurement phase of the project and deliberate hedge accounting phase on its additional meeting on 16 October 2009.

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