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Primary financial statements

Date recorded:

Classification of income and expenses in the financing category of the statement of profit or loss (Agenda Paper 21A)

Background

In May 2021, the Board agreed to explore the approach for classifying items of income and expenses in the financing category of the statement of profit or loss. This paper sets out the staff analysis of that approach.

Staff recommendations

The staff asked the Board to confirm the approach discussed in the previous meeting to require all income and expenses from liabilities that arise from transactions that involve only the raising of finance and interest income and expenses from other liabilities to be classified in the financing category of profit or loss (Recommendation 1).

In addition, the staff recommend that the Board describe “transactions that involve only the raising of finance” as transactions that involve the receipt by the entity of cash, a reduction in a financial liability or an entity’s own equity and the return by the entity of cash or an entity's own equity (Recommendation 2).

For hybrid contracts with host liabilities and embedded derivatives, the staff recommend the Board require:

  • Income and expenses relating to separated host liabilities to be classified in the same way as income and expenses on other liabilities (Recommendation 3)
  • Income and expenses relating to separated embedded derivatives to be classified in the same way as income and expenses on stand-alone derivatives (Recommendation 4)
  • Income and expenses related to contracts that are not separated to be classified in the same way as income and expenses on other liabilities (Recommendation 5)

Board discussion

The Vice Chair expressed some concerns about structuring opportunities that may arise with embedded derivatives. If it is a simple cash instrument, the income and expenses would go into the financing category, however, if complex derivatives are embedded, the income and expenses could potentially go into the operating category, which might be desirable for preparers. Disclosures should be required to explain this in order to limit structuring.

The Vice Chair also suggested that for financial liabilities measured at amortised cost that have embedded derivatives that are closely related, and therefore do not need to be separated when applying IFRS 9, all income and expenses related to them should be in financing. In her view closely related embedded derivatives are “benign” features, for example a prepayment option or an inflation link, and the Board should provide a simplification for those. As these are included in the amortised cost mechanics, they should be in the financing category. This would mean that preparers would not have to assess each closely related embedded derivative. Some Board members expressed support for this suggestion but said that the drafting needs to be very clear as to how to identify this population and that examples would be helpful to understand the mechanics and the interaction with other requirements.

The staff agreed that they would examine this population and bring this back in a future Board meeting. However, staff were concerned that for some areas, like this, the Board would provide specific guidance while guidance for other areas was more general. The Chairman acknowledged that concern but said that the exception is justified as IFRS 9 has already clear guidance on when a derivative is closely related, so preparers would not have to do an additional assessment.

One Board member was concerned that interest income and expense on cash and cash equivalents could end up in the operating category when following the staff recommendation, although the staff said that this should always be captured in financing.

It was agreed between Board members that the ideas contained in the staff recommendation should be tested with the treasury departments of preparers, rather than the accounting departments. The treasurers usually understand best why certain liabilities have embedded derivatives.

All Board members supported the staff recommendations 1, 3 and 4.

For staff recommendation 2 one Board member voted against as he was concerned that interest income and expense on cash and cash equivalents may not be captured as financing.

For staff recommendation 5, the Board voted on derivatives except those that are embedded in financial liabilities measured at amortised cost and are not separated based on the requirements in IFRS 9. All Board members supported that recommendation.

Classification of fair value gains or losses on derivatives and hedging instruments (Agenda Paper 21B)

Background

This paper set out staff analysis and recommendations relating to the proposals in the Exposure Draft ED/2019/7 General Presentation and Disclosures on the classification in the categories in the statement of profit or loss of fair value gains or losses on derivative and non-derivative instruments designated in a hedging relationship to which hedge accounting is applied in accordance with IAS 39 or IFRS 9, derivatives used for risk management to which hedge accounting is not applied and derivatives not used for risk management purposes.

Staff recommendations

The staff recommended the Board require an entity to classify gains or losses on financial instruments designated as hedging instruments in accordance with IFRS 9 or IAS 39, in the category of statement of profit or loss affected by the risk the entity manages, except when it would involve grossing up gains or losses. The staff proposes that if the classification would involve grossing up of gains or losses that an entity would classify all gains or losses on the derivative in the operating category.

In addition, the staff recommended the Board apply the same requirements above to derivatives used for risk management even if those derivatives are not designated as hedging instruments applying IFRS 9 or IAS 39, except when doing so would involve undue cost or effort. If the classification would involve undue cost or effort, an entity would classify all gains or losses on the derivative in the operating category.

Lastly, the staff asks the Board to require an entity to classify gains or losses on derivatives not used for risk management in the operating category, unless a derivative relates to financing activities and is not used in the course of the entity’s main business activities. In this case, an entity would classify all gains or losses on the derivative in the financing category.

Board discussion

Some Board members disagreed or expressed discomfort with classifying gains or losses on derivatives not used for risk management in the operating category as a default. They thought that those would usually meet the criteria for inclusion in the investment category as they are entered into with a look to make an investment gain and they are unrelated to the entity’s main business activities. It would also further shrink the investment category and create more volatility in the operating category. The staff replied to these concerns by saying that this population would be very limited and therefore a pragmatic approach was favoured. Also, their inclusion in operating was not based on main business activities, but on the operating category being the residual category.

One Board member mentioned that the drafting should be very clear about what is risk management and what is not. He suggested using the term “reasonable and supportable information”.

The Chairman agreed with the staff recommendation but suggested that staff should look into the articulation of the requirements with regard to non-derivative financial instruments. The staff responded that the Board had made a conscious decision when publishing the ED to not include non-derivatives in the requirements as it would be difficult to determine whether those are held for risk management purposes or for other purposes. The assessment is much clearer for derivatives as they are often attached to a hedged item.

10 of the 12 Board members supported the staff recommendation. Two Board members disagreed with operating being the default category for gains or losses on derivatives not used for risk management. They agreed with all other aspects of the staff recommendations.

Classification of foreign exchange differences (Agenda Paper 21C)

Background

This paper sets out staff analysis and recommendations relating to the proposals in the ED on the classification in the categories in the statement of profit or loss of foreign exchange (FX) differences.

Staff recommendations

The staff recommended the Board require an entity to classify FX differences in the same category of the statement of profit or loss as the income and expenses from the items that gave rise to the FX differences unless there is undue cost or effort, in which case the entity would classify the FX differences on the item in the operating category. The staff believe this should address the cost concerns raised by some respondents.

Board discussion

Several Board members agreed that the staff recommendation was conceptually sound but expressed concern about the practicality of the approach. One Board member, for example, would allow a classification that is consistent with the entity’s way of managing FX risk. Another Board member proposed allocating all FX related income and expense into the financing category. The staff asked whether that proposal would also include asset-related FX income and expense, as consistent with other decisions made by the Board, those would have to go into investing or operating. The Board member confirmed that he would propose financing for all FX-related items on the grounds of simplicity. He also said that this should be accompanied by disclosure, so that users can analyse whether some of the items are operating or investing. One Board member highlighted that she had heard from a systems provider that the staff approach would be difficult from a system perspective.

The Chairman acknowledged and partially shared these concerns but said that it would be challenging to find a practical solution for all of these issues. The staff recommendation might be the smallest common denominator. This was supported by several Board members, acknowledging that there was no perfect answer to the practicality issues and the ‘undue cost or effort’ exemption recommended by the staff would capture most of them.

When called to vote, 11 of the 12 Board members supported the staff’s recommendation.

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