Exposure Draft ED/2012/4 - Financial Instruments: Classification and Measurement (Limited Amendments to IFRS 9)

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1 March 18 th, 2013 International Accounting Standards Board 30 Cannon Street, London EC4M 6XH United Kingdom Dear Madam/Sir, Exposure Draft ED/2012/4 - Financial Instruments: Classification and Measurement (Limited Amendments to IFRS 9) The Israel Accounting Standards Board is pleased to have this opportunity to comment on the IASB's Exposure Draft ED/2012/4 Financial Instruments: Classification and Measurement (Limited Amendments to IFRS 9) published in November We concur with the opinion of Messrs Cooper and Engstrom and believe that the proposal to introduce the fair value through other comprehensive income measurement category would increase complexity and would result in diversity in practice. Furthermore, we believe that the IASB should put more emphasis on the stability of IFRSs. It should be mentioned that IFRS 9 was published on October 2010 and will become effective on January 1 st IFRS 9 allows early application and some entities have already adopted it. Therefore, we recommend that the IASB abandon the proposal for the following reasons: (a) adding a new measurement category would unnecessarily increase complexity for the reporting of financial instruments; (b) the distinction between the supposed different business models that justify measurement at fair value through other comprehensive income rather than at fair value through profit or loss is unclear, would lead to diversity in practice and is insufficient to justify a difference in accounting treatment; (c) The new measurement category is inconsistent with the concepts in IFRS 9. רח' גרוזנברג 14 ת, "א,65811 טל., Tel 14 Gruzenberg st., Tel-Aviv 65811, פקס.,Fax iasb@iasb.org.il

2 In our opinion, the existing IFRS 9's classification at either amortised cost or fair value through profit or loss should be retained. As stated by the IASB, one of the main objectives for replacing IAS 39 with IFRS 9 is to reduce the complexity of accounting for financial instruments. An important component of that is to reduce the number of measurement categories of financial instruments that were included in IAS 39. As a result of this proposal, that objective would not be achieved. We believe that both the amortised cost and the fair value measurements should be applied consistently throughout the financial statements. The new measurement category of fair value through other comprehensive income is a confusing mixture of amortised cost and fair value measurement that will make financial statements more complex and not understandable. If the ED would be adopted by the Board as a final IFRS, both categories of some investments in equity instruments (IFRS 9 - paragraph 5.7.5) and some debt instruments (this ED) would be measured at fair value through other comprehensive income. However, the cumulative amount recognised in other comprehensive income related to investments in equity instruments would not be transferred to profit or loss on disposal of the investment, while that cumulative amount related to debt instruments would be transferred to profit or loss on disposal. Furthermore, we do not believe that there are distinct business models that justify different accounting for debt instruments using either fair value through other comprehensive income or fair value through profit or loss. We believe that making an artificial distinction of business models would lead to diversity in practice in the application by entities. Although differentiating between different business models is subjective, we believe that it is possible to distinct between the hold to collect business model (for which earning an interest margin is the primary objective and where the realisation of fair value changes through the sales of assets is not a significant factor in assessing performance) and the 'fair value' business model (for which the primary objective is to realise fair value changes). However, the distinction between the 'hold to collect' and 'hold to collect and sale' is too subjective and requires excessive judgements and therefore would lead to diversity in practice. 2

3 Furthermore, the use of the 'fair value through other comprehensive income' category allows an entity to manage profit or loss through the selective decision to sell some assets and to retain others. If the Board decides to proceed with the proposal and to finalize the ED, despite all of the abovementioned, we would like to comment on question 3. Question 3: Do you believe that this proposed amendment to IFRS 9 will achieve the IASB s objective of clarifying the application of the contractual cash flow characteristics assessment to financial assets that contain interest rate mismatch features? Will it result in more appropriate identification of financial assets with contractual cash flows that should be considered solely payments of principal and interest? If not, why and what would you propose instead?? We believe that there are some application issues with respect to solely payments of principal and interest (SPPI) criterion mentioned in IFRS 9 that are not addressed in the ED, which we believe the IASB should address. We would like the guidance on the SPPI criterion to be further explained, with more explicit guidance, to make it better understood and consistently applied. Specifically, the guidance on the SPPI criterion is too reliant on detailed examples, technical provisions, and detailed rules, which may not leave enough scope for judgment of specific circumstances. Consider, for example, the specific statements in IFRS 9.B that contractual provisions that permit prepayments are consistent with the SPPI criterion only if they are not contingent on future events other than to protect the holder against credit deterioration of the issuer or changes in relevant taxation, or if the prepayment amount substantially represents unpaid amounts of principal and interest on the principal amount outstanding. In addition, IFRS 9.B states that any feature that changes the amounts or timing of payments of principal and interest fails the SPPI criterion unless it complies with the provision of IFRS 9.B or other specific exceptions. It is therefore unclear whether mandatory prepayment features that are not covered by IFRS 9.B can be compliant with the SPPI criterion. 3

4 It seems like IFRS 9.B effectively prohibits features that might change the cash flows of an instrument, unless it is specifically permitted in the paragraph. The absolute nature of guidance appears to be a narrow and technical specification. Consequently, there is a risk that features that are insignificant or that are reasonably included to protect borrowers or lenders from exogenous events, but are not specifically mentioned in the standard, could inappropriately be interpreted as disqualifying an instrument from amortised cost accounting, although in the substance the instrument meets the SPPI criterion as defined by IFRS We believe that these inconsistencies require further, more robust application guidance and consideration of other features that might modify payments of principal and interest, as lacking such guidance will cause fair value measurement that does not reflects the true economic essence of instruments. In our opinion, IFRS 9.B should state only the features that qualify as SPPI without noting specifically which features necessarily do not qualify the SPPI criterion. Implications of the above for Israel The State of Israel and insurance companies signed agreements under which the companies were obligated to invest virtually all reserve funds of guaranteed return insurance policies in bonds issued by the State (hereafter Hetz bonds). According to the agreement, the State is obliged to issue such bonds as long as there is an insured liability. The Hetz bonds cannot be traded and their coupon rate is the predetermined guaranteed return of the underlying policies plus a margin that compensates insurance companies for their involvement in the process. For each type of guaranteed return policy, the State guaranteed a predetermined ratio between the actual holdings of Hetz bonds and the reserves ("contractual coverage rates"). Because there are changes in reserves (due to retirements, deaths etc.), actual holdings of Hetz bonds as a fraction of reserves ("actual coverage rates") may differ from the contractual coverage rates. Thus, as part of the bonds' recycling procedure, the State annually compares actual coverage rates to contractual coverage rates, separately for each insurance company, when the actual coverage rate exceeds the contractual one, early redemption may occur. 4

5 Economically, Hetz Bonds are designated by the government to back life insurance, guaranteed yield plans for the duration of the contract, paying annually fixed interest on the principal amount outstanding. We believe that according to IFRS 9 and to ensure that financial statements faithfully present the economic nature of these bonds, the bonds should be measured at amortized cost and not at fair value. Therefore, we believe that SPPI criterion is met conceptually as explained below. IFRS 9.BC30 states that the objective of the effective interest method for amortised cost accounting is to allocate interest payments to the relevant periods. It also mentions the goal of ensuring that reported financial information provides useful information. Insurance companies that own Hetz bonds accrue interest but have no right to realize capital gains on them. This is because they are forbidden to sell the bonds to a third party and when Hetz bods are prematurely redeemed by the government it is always at par value, even if markets rates have changed. Hence, in this case, accruing effective interest better reflects the true financial information than "mark-to-market", since there is no relevance to fair value. Instrument G in IFRS 9.B4.14 is a perpetual bond with no specified date for the repayment of the principal that accrues interest on the principal amount outstanding. The analysis presented states that, if interest accrued on deferred amounts, the contractual cash flows could be payments of principal and interest. Hetz bonds also constantly accrue interest on the principal amount outstanding. In particular, the same interest rate for a specific Hetz issue is paid to all insurance policies, with no differentiation between long duration policies (of young people) or short duration policies (of old people). Thus, accrual of interest is based on constant accumulation of interest on the principal amount outstanding. However, IFRS 9.B states that a contractual term that changes the timing or amount of payments does not result in contractual cash flows that are solely principal and interest unless it is a variable interest rate compensating holders for time value of money and credit risk. As the deferral of interest feature in Instrument G would change the timing and amounts of principal and interest but would not meet these exceptions, the analysis of Instrument G appears inconsistent with paragraph B

6 According to example (b) in IFRS9.B4.3, an insurer may adjust its investment portfolio to reflect a change in expected duration (i.e. expected timing of payouts) and still meet the Business model criterion, which represents a necessary step to measure financial assets at amortised cost. In other words, the IASB acknowledged that changing maturity date as a function of the duration of the insurance policy" is part of the normal course of business of an insurer that should not disqualify from the amortised cost method. As mentioned above, it is unclear whether mandatory prepayment features (in particular, those that are not based on economic conditions but on demographic ones) can be compliant with the SPPI criterion in accordance with IFRS 9.B We believe that exogenous events such as retirement, death etc, that are not contemplated in the standard, should not disqualify Hetz bonds from being measured at amortised cost, because in substance such instruments qualify SPPI criterion as defined by IFRS We appreciate the opportunity to provide our comments. Sincerely, Dov Sapir, CPA, Chairman Israel Accounting Standards Board 6