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Prepayment features with negative compensation

Date recorded:

The purpose of this session was to discuss the following:

  • Summary of comment letters: AP 3A
  • Project direction and plan: AP 3B

Prepayment Features with Negative Compensation - Summary of comment letters - Agenda paper 3A

Background

The Board issued Exposure Draft Prepayment Features with Negative Compensation (Proposed amendments to IFRS 9) in April 2017 with a 30-day comment period. The purpose of this session is to present the Board with the feedback received on the ED.

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:

  1. 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
  2. the fair value of the prepayment feature is insignificant on initial recognition of the financial asset (the second condition).

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

Summary of feedback received

Overall, most respondents supported the proposed amendments and urged the Board to finalise them as soon as possible.

Many respondents also believe that the proposals in the ED are not an ‘exception’ to the requirements in IFRS 9. In their view, negative compensation can still be consistent with the notion of a basic lending arrangement and the resulting cash flows can meet the SPPI criterion.

Other specific comments are summarised below.

The first condition

Nearly all respondents agreed with this condition.

Many respondents disagreed though with the inclusion of additional interpretative guidance in the Basis for Conclusions on the meaning of ‘reasonable compensation for the early termination of the contract’. This is an existing notion used in IFRS 9.B4.1.11(b) and the respondents were concerned that providing guidance at this late stage would be disruptive as it might affect the judgements already made by many entities on how to apply this notion. These respondents also believe that the guidance is unnecessary, is outside the scope of the amendments and could have unintended consequences.

Some respondents also took issue with BC18. This paragraph gives an example of two types of prepayable instruments that would not meet the SPPI criterion. The respondents disagreed with such a blanket exclusion as they believed that there are instances in which the illustrative instruments might meet the SPPI criterion.

In addition, many respondents could not understand the Board’s view in BC19 that the proposed exceptions and the ones in IFRS 9.B4.1.12 are mutually exclusive. Paragraph B4.1.12 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. The respondents saw no substantive reason to justify the mutual exclusivity.

The second condition

There was mixed feedback on this issue. While some respondents supported it, more than half of the respondents disagreed with it and recommended that it be deleted.

Those who disagreed believe that the amendments should reflect the principle that prepayment features with negative compensation and those with positive compensation should be accounted for in the same way. Since IFRS 9 does not require entities to assess the fair value of prepayment features with positive compensation, no such assessment should be required for prepayment features with negative compensation.

Furthermore, some respondents disagreed with the Board’s view that it would be inappropriate if the proposed exception significantly increased the frequency of catch-up adjustments required in terms of IFRS 9.B5.4.6. They disagreed on the grounds that: (1) such catch-up adjustments are an inherent feature of the amortised cost measurement; (2) they are already required for prepayment features with positive compensation; and (3) the frequency of such adjustments are not taken into account in determining whether a financial asset meets the SPPI condition.

Some respondents also disagreed that the second condition would achieve the Board’s objective of restricting the scope of the amendments to cases in which it is unlikely that the prepayment option will be exercised. These respondents noted that the fair value of the prepayment option is affected by many variables and gave examples indicating that there is no direct correlation between the fair value of the option and the likelihood of exercising the option. They further noted that the fair value of the prepayment feature also reflects the probability that positive compensation will occur. In some circumstances, the fair value of the prepayment feature may be more than insignificant largely due to the fair value of positive compensation. These respondents questioned how the second condition is to be assessed in this case.

Effective date

This aspect also attracted mixed views from the respondents. Many agree with the proposal. Those who disagreed recited the translation and/or endorsement concerns as previously discussed by the Board. These respondents would prefer an effective date of 1 January 2019 with early application permitted.

Transition

Most respondents supported retrospective application and the specific transition provisions.

Discussion

Quite a few members appeared frustrated that the respondents did not respond to the Board’s arguments of why special conditions were needed in the first place (referring to the prepayment option having a negligible fair value at inception). They were disappointed that the respondents simply repeated what they wanted to see done in practice and did not provide any new arguments to support their requests. The Vice-Chair was also disappointed at the lack of suggestions as to what types of transition provisions the stakeholders would require if the effective date of the proposed amendments was deferred. She was also determined that the amendments should address prepayments at fair value – though toning down the all-inclusive language used in the BC – because that was one of the questions of the original submission.

The Vice-Chair and Staff also defended including additional interpretative guidance on the meaning of ‘reasonable compensation for the early termination’ in the amendments. They believe that if the second condition were to be removed as suggested by the respondents, the test would then hinge entirely on the notion of what is reasonable additional compensation, and so the guidance is necessary to pre-empt an incorrect interpretation of the existing requirements of IFRS 9.

The discussion drifted onto how SPPI should be applied and interpreted and the Staff doing a deeper analysis of whether amortised cost measurement is really suitable for these instruments. Some Board members said they have noticed an increased use of the basic lending arrangement notion as a test for amortised cost measurement instead of doing a full SPPI assessment. These members believe it is time to remind people of the fundamentals of amortised cost and what its boundaries are in terms of usefulness and relevance.

A couple of Board members reminded the Board that the original intention of the amendment was to do a surgical fix on a relatively narrow issue, and the discussion returned to that issue. The Board told the Staff to think about whether the responses received indicate that the population of affected instruments might be bigger than the Board originally had in mind, and whether this would lead to unintended consequences. If so, the Board could consider deferring the effective date of the amendments in order to define a tighter scope for the amendments. They believe that it would not be helpful to redeliberate SPPI now, and that the Board should limit their discussion on the specific matters identified by the respondents.

Prepayment Features with Negative Compensation – Project direction and plan - Agenda paper 3B

The Staff plan to address the comments received on the ED Prepayment Features with Negative Compensation (Proposed amendments to IFRS 9) (see AP 3A) by analysing the following issues:

  1. whether any amendments should be made to the proposed eligibility conditions;
  2. whether any clarification is needed in relation to the Board’s observations relating to the meaning of ‘reasonable compensation for early termination of the contract’;
  3. whether any amendment is needed with regard to the mutual exclusivity of the proposed amendments and the exception in IFRS 9.B4.1.12 provided to financial assets acquired at a premium or discount but is repayable at par;
  4. whether the proposed effective date of 1 January 2018 should be postponed to 1 January 2019 with early application permitted; and
  5. whether any additional transition provisions and disclosure requirements are needed for entities that apply IFRS 9 before they apply the amendments.

The Staff expect to bring back further analysis on the above issues for deliberation by the Board in the July Board meeting. The Staff also plan to seek permission to ballot at that meeting with the aim of publishing the final amendments in October 2017.

Discussion

No substantive comments were raised by the Board on this paper.

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