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Financial instruments — Joint Working Group proposal

Background

In mid-1997, when it embarked on the project that led to IAS 39 Financial Instruments: Recognition and Measurement, IASC agreed to continue to explore the possibility of requiring full fair value measurements in the primary financial statements (sometimes called mark-to-market) for all financial assets and financial liabilities. As part of that exploration, IASC had, for the past three-and-a-half years, participated in a Joint Working Group (JWG) of International Standard Setters on Financial Instruments, comprised of standard setters representing 13 countries.

The JWG completed a 'draft standard' and turned it over to its participating bodies. In December 2000, the IASC Board issued it for comment (click for IASC press release), with a comment deadline of 30 September 2001, though IASC strongly encouraged comments by 30 June. The other participating standard-setters either had already done the same thing or agreed to do so. Although the Board of IASC has discussed most aspects of the draft standard, the views expressed in the document do not necessarily reflect the views of the IASC Board. And while written in the form of a draft standard, it is not an IASC draft standard or exposure draft. Nonetheless, it represents three and a half years of hard work by representatives of over a dozen countries and, as such, is likely to command considerable attention by the new IASC and by national accounting standard-setters.

IASC and the other standard setters participating in the Joint Working Group on Financial Instruments have posted on their websites an electronic version of the JWG draft standard and basis for conclusions.

 

Key conclusions of the Joint Working Group

Scope

  • The JWG proposal would apply to all enterprises, regardless of size or whether their securities are publicly traded
  • Its scope would be similar to IAS 39, but:
    • it includes financial guarantee contracts
    • it includes weather derivatives
    • it applies to acquired mortgage and loan servicing assets and liabilities
    • it applies to any obligation that either party can settle in cash

Recognition and derecognition

  • Recognition of financial instruments: similar to IAS 39 -- all financial assets and all financial liabilities must be on the balance sheet, including all derivatives.
  • The JWG's embedded derivative provisions are similar to those in IAS 39 -- except, of course, there will be fewer separations because more hybrids will be measured at fair value under the JWG proposal. Separation (some call it bifurcation) of the embedded derivative from the host contract is not required if the combined hybrid is itself measured at fair value.
  • Derecognition: when an enterprise is no longer a party to the contractual rights or obligations, (that is, the transferor has no continuing interest in the financial asset or liability), it should be derecognised.
    • The JWG would derecognise in most repurchase agreements and securities lending transactions.
    • Note: Under the JWG tentative thinking, the transferee must have substance in its own right or the transferred asset must be isolated in bankruptcy.

Measurement

  • Measure all financial instruments at fair value when recognised initially.
  • Remeasure to fair value at each reporting date.
  • Fair value is exit price based on market transactions
    • Fair value is best determined from an observed market price
    • If the financial instrument is exchange traded, fair value is the closing price minus commissions
    • If the financial instrument is dealer traded, fair value is the bid price for assets, and the asked price for liabilities
  • The best measure of fair value is the market price for an identical instrument.
    • If that is not available, use the price for a similar instrument.
    • If the instrument trades in more than one market, use the most advantageous price from the perspective of the reporting enterprise.
    • If no there is no established market price for an identical or similar financial instrument, use a Discounted Present Value cash flow model based on general market information (including interest rates, FX rates, and commodity prices) risk-adjusted as necessary to reflect the particular risks of that financial instrument.
  • If an enterprise is not able to make a reliable fair value estimate currently, it should use the most recent reliable fair value estimate. (Presumably this might be acquisition cost, which is fair value at date of acquisition.)
  • Ignore any non-contractual aspects of financial instruments, such as future deposits by depositors and additional purchases by credit card holders, in valuing a financial instrument. That is, the bank would not assume renewals of time deposits and the credit card company would not assume additional purchases.
  • However, behavioural expectations (such as prepayments) should be considered in making fair value estimates.
  • If financial instrument is denominated in foreign currency:
    • For a forward contract use forward rate.
    • For all others use the spot rate.
  • Do not adjust market price for size of holding.
  • An enterprise's procedures for determining fair value must be documented.
  • Fair values are generally determinable, at reasonable cost, and are practicably implementable.
  • Reported value of liabilities should reflect changes in an enterprise's own creditworthiness.

Reporting fair value changes

  • All gains and losses arising from changes in fair value of financial instruments would be reported in net income when they arise.

Hedge accounting prohibited

  • All forms of hedge accounting would be prohibited, including hedges of commitments and forecasted transactions. Certain 'hedging' note disclosures would be allowed.

Disclosure

  • Interest revenue and interest expense should be calculated on a fair value basis using current yield to maturity (YTM), not contractual.
  • An enterprise would report separately the fair value changes relating to impaired loan assets.

Next steps

  • While the participating JWG countries are inviting comments, none has said they accept or reject the JWG conclusions.
  • The IASB is considering comments received on the JWG proposal. The Canadian Institute of Chartered Accountants is preparing an analysis of the comment letters received in response to the draft.

 

Correction list for hyphenation

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