FINANCIAL INSTRUMENTS. The future of IFRS financial instruments accounting IFRS NEWSLETTER

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1 IFRS NEWSLETTER FINANCIAL INSTRUMENTS Issue 3, June 2012 In June, the IASB decided to extend the existing fair value option for financial assets in IFRS 9 to financial assets in the new FVOCI measurement category. This would be based on the accounting mismatch criterion that is used today under IFRS. However, the FASB chose not to adopt the same criterion into its tentative model. Chris Spall, KPMG s global IFRS Financial Instruments deputy leader KPMG International Standards Group The future of IFRS financial instruments accounting This edition of IFRS Newsletter: Financial Instruments highlights the discussions and tentative decisions of the IASB in June 2012 on the financial instruments (IAS 39 replacement) project. Highlights Classification and measurement l The IASB and the FASB (the Boards ) re-affirmed their previous decisions that the fair value through other comprehensive income (FVOCI) category is only available for financial assets that: pass the contractual cash flow characteristics assessment; and are managed within a business model whose objective is both to hold financial assets to collect contractual cash flows and to sell financial assets. l The IASB decided to extend the fair value option (FVO) for financial assets that meet the accounting mismatch eligibility criterion as included in IFRS 9 Financial Instruments to financial assets in the FVOCI measurement category. l The FASB decided to retain the FVO eligibility criteria related to management of a group of financial assets and liabilities on a net exposure basis that was included in its tentative classification and measurement model; this is different from the accounting mismatch and managed on a fair value basis FVO eligibility criteria included in IFRS 9. Impairment and hedge accounting l The Boards did not discuss impairment or hedge accounting.

2 IASB AND FASB DIFFER ON FAIR VALUE OPTION ELIGIBILITY CONDITIONS The story so far... Since vember 2008, the IASB has been working to replace its financial instruments standard (IAS 39) with an improved and simplified standard. The IASB structured its project in three phases: Phase 1: Classification and measurement of financial assets and financial liabilities Phase 2: Impairment methodology Phase 3: Hedge accounting In December 2008, the FASB added a similar project to its agenda; however, the FASB has not followed the same phased approach as the IASB. The IASB issued IFRS 9 (2009) and IFRS 9 (2010), which contain the requirements for the classification and measurement of financial assets and financial liabilities. Those standards have an effective date of 1 January The IASB is currently considering limited changes to the classification and measurement requirements of IFRS 9 to address application questions, and to provide an opportunity for the Boards to reduce key differences between their models. At the May 2012 meeting, the IASB decided to add an FVOCI category for some investments in debt instruments. The Boards are also working jointly on a three-bucket model for the impairment of financial assets based on expected credit losses, which will replace the current incurred loss model in IAS 39. The Boards previously published their own differing proposals in vember 2009 (the IASB) and in May 2010 (the FASB), and published a joint supplementary document on recognising impairment in open portfolios in January The IASB has split the hedge accounting phase into two parts: general hedging and macro hedging. It is close to issuing a review draft of a general hedging standard and is working towards issuing a discussion paper on macro hedging towards the end of What happened in June? At the June 2012 meeting, the Boards met jointly to continue their deliberations on classification and measurement. The Boards did not discuss impairment or hedge accounting at this meeting. The Boards reaffirmed their previous decisions that the FVOCI measurement category should only be available for financial assets that: pass the contractual cash flow characteristics assessment; and are managed within a business model whose objective is both to hold the financial assets to collect contractual cash flows and to sell the financial assets. The IASB also decided to extend the accounting mismatch FVO eligibility criterion as stated in IFRS 9 to financial assets in the FVOCI measurement category. The FASB decided not to adopt the same accounting mismatch criterion. However, it did decide to extend the fair value option to certain hybrid financial liabilities in a manner similar to IFRS 9. 2

3 CLASSIFICATION AND MEASUREMENT The FVOCI measurement category is only available for financial assets that pass the contractual cash flow characteristics assessment and are managed within the relevant business model. What happened in June? At the June 2012 meeting, the IASB continued its joint deliberations with the FASB. At this meeting, the topics discussed were: the scope of the FVOCI measurement category for debt instruments; and the fair value option. (See Appendix A for a summary of the IASB s decisions to date on its limited reconsideration of IFRS 9.) Scope of the FVOCI measurement category Previously, the Boards had tentatively decided that: financial assets that do not pass the contractual cash flow characteristics assessment would not be eligible for a measurement category other than FVTPL; and an eligible debt instrument would qualify for FVOCI classification if it was held within a business model whose objective is both to hold financial assets to collect contractual cash flows and to sell financial assets. In this meeting, the Boards discussed and confirmed the scope of the FVOCI measurement category. What did the staff recommend? Although the scope has been implicit in the decisions previously taken, the staff recommended that the Boards reaffirm their decision that the FVOCI category should only be available for financial assets that: pass the contractual cash flow characteristics assessment (i.e. the contractual terms give rise on specified dates to cash flows that are solely principal and interest); and are managed within the relevant business model. 1 The staff believed that if the use of the FVOCI category were expanded to financial assets that do not pass the contractual cash flow characteristics assessment, then this would involve a major overhaul of both IFRS 9 and the FASB s model. Such a major overhaul would be inconsistent with the limited scope and objectives of the Boards redeliberations on classification and measurement. It would also give rise to unwanted implications that could, for example, result in gains and losses on stand-alone or embedded derivatives being presented in other comprehensive income the staff did not believe that such an outcome would provide useful information for users of financial statements. The staff noted that the FVOCI classification would result in profit or loss information based on amortised cost measurement. They argued that this attribute was suited only to instruments whose cash flows are solely principal and interest, and not to financial assets with volatile or leveraged cash flows. What did the Boards decide? The Boards tentatively agreed with the staff recommendation i.e. that the FVOCI category should only be available for financial assets that: pass the contractual cash flow characteristics assessment; and are managed within the relevant business model. 1 IFRS 9 allows an election for equity instruments that are not held for trading to be measured at FVOCI. This election is outside the scope of the Boards discussion. 3

4 The accounting mismatch eligibility criterion for the fair value option included in IFRS 9 is extended to financial assets in the FVOCI measurement category. Fair value option The discussion of the FVO was divided into FASB-only and IASB-only sessions. The FASB-only session considered whether the FASB wished to incorporate the FVO requirements in IFRS 9 into its own tentative model. Because the FASB chose not to adopt the IFRS 9 requirements related to financial assets, the IASB alone discussed whether those requirements should be extended to financial assets in the FVOCI measurement category. Under IFRS 9, an entity may, at initial recognition, irrevocably designate a financial asset or a financial liability as measured at FVTPL if doing so eliminates or significantly reduces a measurement or recognition inconsistency (sometimes referred to as an accounting mismatch ) that would otherwise arise from measuring assets or liabilities, or recognising the gains and losses on them, on different bases. Also, an entity may similarly designate a financial liability as measured at FVTPL if the liability is either: part of a group that is managed, and whose performance is evaluated, on a fair value basis in accordance with a documented strategy, with information about the group being provided on that basis to the entity s key management personnel; or a hybrid financial liability that contains an embedded derivative unless: (a) the embedded derivative does not significantly modify the cash flows that would otherwise be required by the contract; or (b) it is clear with little or no analysis that, when a similar hybrid instrument is first considered, separation of the embedded derivative is prohibited. What did the FASB decide? The FASB decided not to adopt IFRS 9 s accounting mismatch or managed on a fair value basis eligibility criteria for the fair value option. Instead, it decided to retain the FVO eligibility criteria in its tentative classification and measurement model; this would allow an entity to apply the FVO to a group of financial assets and liabilities when it both: manages the net exposure relating to those financial assets and financial liabilities (which may be derivative instruments); and provides information on that basis to the reporting entity s management. However, the FASB decided to extend the fair value option to certain hybrid financial liabilities in a manner similar to IFRS 9. What did the staff recommend to the IASB? IFRS 9 discusses accounting mismatches for financial assets only in the context of the two measurement categories amortised cost and FVTPL that are currently available in the standard. In May 2012, the IASB tentatively decided to introduce a FVOCI measurement category into IFRS 9. Accounting mismatches can similarly arise as a result of measuring a financial asset at FVOCI. Two possible scenarios are as follows. Scenario An asset is measured at FVOCI and a liability is measured at FVTPL How an accounting mismatch arises An accounting mismatch arises because some of the gains or losses on the asset would be recognised in OCI, whereas all of the gains and losses on the liability would be recognised in profit or loss. 4

5 Scenario An asset is measured at FVOCI and a liability is measured at amortised cost How an accounting mismatch arises An accounting mismatch arises because the instruments are measured in the statement of financial position on different bases. Moreover, although both instruments would have an amortised cost profile in profit or loss, other fair value gains or losses on the asset would be recognised in OCI. The staff believed that if the eligibility condition for designating a financial asset as at FVTPL to avoid an accounting mismatch was available for financial assets measured at FVOCI, then both the asset and the liability in the above scenarios could be measured at FVTPL 2, thus providing more relevant information. Therefore, the staff recommended that the IASB extend the accounting mismatch eligibility criterion as stated in IFRS 9 to financial assets in the FVOCI measurement category. What did the IASB decide? The IASB tentatively agreed with the staff recommendation i.e. that the current eligibility condition (the accounting mismatch condition) in IFRS 9 for designating financial assets under the fair value option would be extended to financial assets in the FVOCI measurement category. In other words, a financial asset that would otherwise be measured at FVOCI may be designated on initial recognition as measured at FVTPL if doing so eliminates or significantly reduces an accounting mismatch. Next steps At future meetings on the classification and measurement of financial instruments, the IASB will consider any further inter-related issues, including the accounting mechanics of reclassifications, transition, disclosures and other sweep issues. Some of these discussions may need to be held jointly with the FASB, while others may be separate. The Boards will also consider what further changes, if any, they would like to make to their respective models. The IASB expects to issue an exposure draft on changes to IFRS 9 in the fourth quarter of Under the second scenario, the entity would also have to designate the financial liability under the FVO. 5

6 PROJECT MILESTONES AND TIMELINE FOR COMPLETION The current work plan anticipates significant progress in 2012, which will be necessary to maintain an effective date for IFRS 9 of 1 January Classification & measurement Standard Standard Deferral of on assets: on liabilities: effective date IFRS 9 (2009) IFRS 9 (2010) Exposure draft limited revisions (Q4) Effective date 1/1/2015 Revised standard? Impairment Exposure draft 4 5 Supplementary document Exposure draft (Q4) Final standard? Hedge accounting General Exposure draft 6 Review draft (Q2) Final standard (H2) Macro Discussion paper (H2) Exposure draft? Final standard? Effective date? Asset and liability offsetting 7 Amendments to IFRS 7 and IAS 32 Effective dates 1/1/2013 and 1/1/ Source: IASB work plan projected targets as at 14 June ? Our suite of publications considers the different aspects of the work plan, and provides a comparison to IAS 39 where relevant. KPMG publications First Impressions: IFRS 9 Financial Instruments (December 2009) For KPMG s most recent and comprehensive views on IFRS 9, refer to Insights into IFRS: Chapter 7A Financial instruments: IFRS 9. First Impressions: Additions to IFRS 9 Financial Instruments (December 2010) For KPMG s most recent and comprehensive views on IFRS 9, refer to Insights into IFRS: Chapter 7A Financial instruments: IFRS 9. In the Headlines: Amendments to IFRS 9 Mandatory effective date of IFRS 9 deferred to 1 January 2015 (December 2011) New on the Horizon: ED/2009/12 Financial Instruments: Amortised Cost and Impairment (vember 2009) New on the Horizon: Impairment of financial assets measured in an open portfolio (February 2011) 6 New on the Horizon: Hedge Accounting (January 2011) 7 First Impressions: Offsetting financial assets and financial liabilities (February 2012) For more information on the project see our website. The IASB s website and the FASB s website contain summaries of the Boards meetings, meeting materials, project summaries and status updates. 6

7 APPENDIX A: SUMMARY OF IASB S REDELIBERATIONS ON CLASSIFICATION AND MEASUREMENT te: Decisions made in June 2012 are shaded. What did the IASB discuss? What did the IASB tentatively decide? Is there an identified change to IFRS 9? If yes, then what? Business model assessment for amortised cost classification for financial assets Business model assessment for fair value through other comprehensive income (FVOCI) classification for financial assets Scope of the FVOCI category for debt instruments Proposed approach to the contractual cash flows characteristics assessment An eligible debt instrument (i.e. a financial asset that passes the contractual cash flows characteristics assessment) would qualify for amortised cost classification if it was held within a business model whose objective was to hold the assets to collect contractual cash flows. (April 2012) An eligible debt instrument would qualify for FVOCI classification if it was held within a business model whose objective is both to hold financial assets to collect contractual cash flows and to sell financial assets. (May 2012) Eligible debt instruments that do not meet the business model assessment for FVOCI or amortised cost would be classified at FVTPL i.e. FVTPL is the residual business model. (May 2012) The FVOCI category is only available for financial assets that: pass the contractual cash flow characteristics assessment; and are managed within the relevant business model. (June 2012) A financial asset could qualify for a measurement category other than FVTPL if its contractual terms give rise, on specified dates, to cash flows that are solely payments of P&I. (February 2012) Interest is consideration for the time value of money and for the credit risk associated with the principal amount outstanding during a particular period of time. (February 2012) Principal is understood as the amount transferred by the holder on initial recognition. (February 2012) To clarify the primary objective of hold to collect, the Boards will provide additional implementation guidance on the types of business activities and the frequency and nature of sales that would prohibit financial assets from qualifying for amortised cost measurement. Yes there is currently no FVOCI measurement category for eligible debt instruments in IFRS 9. The Boards have also tentatively decided to provide application guidance on the types of business activities that would qualify for the FVOCI business model. Yes there is currently no FVOCI measurement category for eligible debt instruments in IFRS 9. Principal is not currently defined in IFRS 9. However, the basis of conclusions states that cash flows that are interest always have a close relation to the amount advanced to the debtor (the funded amount). 7

8 What did the IASB discuss? What did the IASB tentatively decide? Is there an identified change to IFRS 9? If yes, then what? Although the IASB did not describe this as a change from IFRS 9, we believe that the new description of principal may have implications in practice. For example, based on this new perspective, bonds originally issued at par but acquired by the holder at a substantial premium in secondary markets and (contingently) prepayable at par would appear not to be consistent with the notion of solely P&I; this is because the holder might not recover all of its initial investment. Assessment of economic relationship between P&I Contingent cash flows If a financial asset contains a component other than principal and interest, then it is required to be measured at FVTPL. (February 2012) If a financial asset only contains components of principal and interest, but the relationship between them is modified, then an entity needs to consider the effect of the modification when assessing whether the cash flows on the financial asset are solely P&I. (February 2012) An entity would need to compare the financial asset under assessment to a benchmark instrument that contained cash flows that were solely P&I to assess the effect of the modification in the economic relationship between P&I. An appropriate benchmark instrument would be a contract of the same credit quality and with the same terms, except for the contractual term under evaluation. (February 2012) If the difference between the cash flows of the benchmark instrument and the instrument under assessment is more than insignificant, then the instrument is required to be measured at FVTPL; this is because its contractual cash flows are not solely P&I. (February 2012) A contractual term that changes the timing or amount of payments of P&I would not preclude the financial asset from a measurement category other than FVTPL. This is true as long as any variability only reflects the change in the time value of money and the credit risk of the instrument. (February 2012) The probability of contingent cash flows that are not solely P&I should not be considered. Financial assets that contain contingent cash flows that are not solely P&I are required to be measured at FVTPL. There is an exception only for extremely rare scenarios. (February 2012) Yes this is an amendment to the application guidance in IFRS 9. The IASB believes that this change will address application issues that have arisen in the application of IFRS 9. 8

9 What did the IASB discuss? What did the IASB tentatively decide? Is there an identified change to IFRS 9? If yes, then what? Prepayment and extension options Bifurcation of financial assets and financial liabilities Mechanics of the FVOCI category for eligible debt instruments Reclassification Fair value option (FVO) A prepayment or extension option, including those that are contingent, does not preclude a financial asset from a measurement category other than FVTPL. This is true as long as these features are consistent with the notion of solely P&I. (February 2012) Financial assets that contain cash flows that are not solely P&I would not be eligible for bifurcation. Instead, they would be classified and measured in their entirety at FVTPL. (April 2012) Financial liabilities would be bifurcated using the existing closely related bifurcation requirements currently in IFRS 9 and US GAAP. (April 2012) The IASB also confirmed that the own credit guidance in IFRS 9 would be retained. (April 2012) Interest income and credit impairment losses/ reversals on FVOCI assets should be recognised in profit or loss using the same methods as for financial assets measured at amortised cost. (May 2012) The cumulative fair value gain or loss recognised in OCI should be recycled from OCI to profit or loss when these financial assets are derecognised. (May 2012) The existing reclassification requirements in IFRS 9 will be extended to the FVOCI category. (May 2012) The accounting mismatch FVO eligibility criterion as stated in IFRS 9 will be extended to financial assets in the FVOCI measurement category. (June 2012) Yes there is currently no FVOCI measurement category for eligible debt instruments in IFRS 9. Yes there is currently no FVOCI measurement category for eligible debt instruments in IFRS 9. Yes and there is currently no FVOCI measurement category for eligible debt instruments in IFRS 9, so in this sense there is an identified change to IFRS 9. However, the existing reclassification requirements in IFRS 9 (e.g. when reclassification occurs) are not expected to change, subject to further consideration by the Boards at a future meeting on how to account for reclassifications. Yes and there is currently no FVOCI measurement category for eligible debt instruments in IFRS 9, so in this sense there is an identified change to IFRS 9. However, the accounting mismatch FVO eligibility criterion as stated in IFRS 9 remains unchanged and is merely extended to financial assets in the FVOCI measurement category. 9

10 KPMG CONTACTS Americas Michael Hall T: E: Asia-Pacific Reinhard Klemmer T: E: Europe, Middle East, and Africa Colin Martin T: E: Tracy Benard T: E: Yoshihiro Kurokawa T: x.6595 E: yoshihiro.kurokawa@jp.kpmg.com Venkataramanan Vishwanath T: E: vv@kpmg.com Acknowledgements We would like to acknowledge the efforts of the principal authors of this publication: Nicolle Pietsch, Robert Sledge and Sze Yen Tan. KPMG International Standards Group is part of KPMG IFRG Limited. Publication name: IFRS Newsletter: Financial Instruments Publication number: Issue 3 Publication date: June 2012 The KPMG name, logo and cutting through complexity are registered trademarks or trademarks of KPMG International. KPMG International Cooperative ( KPMG International ) is a Swiss entity. Member firms of the KPMG network of independent firms are affiliated with KPMG International. KPMG International provides no client services. member firm has any authority to obligate or bind KPMG International or any other member firm vis-à-vis third parties, nor does KPMG International have any such authority to obligate or bind any member firm. The information contained herein is of a general nature and is not intended to address the circumstances of any particular individual or entity. Although we endeavour to provide accurate and timely information, there can be no guarantee that such information is accurate as of the date it is received or that it will continue to be accurate in the future. one should act upon such information without appropriate professional advice after a thorough examination of the particular situation. The IFRS Newsletter: Financial Instruments contains links to third party websites not controlled by KPMG IFRG Limited. KPMG IFRG Limited accepts no responsibility for the content of such sites or that these links will continue to function. The use of third party content is to be governed by the terms of the site on which it is hosted and KPMG IFRG Limited accepts no responsibility for this. Descriptive and summary statements in this newsletter may be based on notes that have been taken in observing various Board meetings. They are not intended to be a substitute for the final texts of the relevant documents or the official summaries of Board decisions which may not be available at the time of publication and which may differ. Companies should consult the texts of any requirements they apply, the official summaries of Board meetings, and seek the advice of their accounting and legal advisors. kpmg.com/ifrs IFRS Newsletter: Financial Instruments is KPMG s update on the IASB s financial instruments project. If you would like further information on any of the matters discussed in this Newsletter, please talk to your usual local KPMG contact or call any of KPMG firms offices.