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

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1 IFRS NEWSLETTER FINANCIAL INSTRUMENTS Issue 4, July 2012 In July, differences in approach emerged between the IASB and FASB on the way forward to achieving a converged impairment model; these are a cause for serious concern. Andrew Vials, KPMG s global IFRS Financial Instruments 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 July 2012 on the financial instruments (IAS 39 replacement) project. Highlights Classification and measurement l The Boards tentatively agreed on the reclassification mechanics for the FVOCI category. l The assessment of contractual cash flow characteristics is an example of the use of judgement that will be required to be disclosed. l A clean slate for the fair value option for new accounting mismatches arising from the transition to the limited amendments to IFRS 9 will be available for entities. Impairment l A different presentation of interest revenue will be required for deteriorated credit-impaired assets. l The presentation of interest revenue of purchased credit-impaired financial assets will be extended to originated credit-impaired assets. l The proposed model will apply to loan commitments and financial guarantee contracts. l Additional disclosures will be required on estimates of expected losses and credit quality migration. l Transition relief will be available if obtaining credit quality information at initial recognition requires undue cost or effort. Hedge accounting l Entities use of an equity model book approach to interest rate risk management is a key consideration in developing a new macro hedge accounting model.

2 HEADLINE DISAGREEMENT, BUT CONVERGENCE IN MANY DETAILS The story so far... Since November 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 Financial Instruments (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 Financial Instruments: Recognition and Measurement. The Boards previously published their own differing proposals in November 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 July? The Boards meetings in July were overshadowed by the discussion at the end of the joint impairment meeting, which underscored differences of opinion between the Boards on the way forward. This development raised doubts about whether the Boards would be able to agree on a converged impairment model by their mid-2013 deadline. This is a concerning development, because achieving a converged impairment model that incorporates more forward-looking information was one of the primary objectives of the broader financial instruments project. However, the Boards did reach converged decisions on a range of classification and measurement and impairment issues. In addition, the IASB continued its discussions on macro hedging. The IASB is poised to finalise exposure drafts for classification and measurement and impairment, as well as a discussion paper on macro hedging, over the coming months. 2

3 CLASSIFICATION AND MEASUREMENT What happened in July? At the July 2012 meeting, the IASB concluded its deliberations on classification and measurement. The topics discussed were: accounting for reclassifications of financial assets; additional presentation and disclosure requirements; and transitional issues. (See Appendix A for a summary of the IASB s decisions to date on its limited reconsideration of IFRS 9.) The IASB and the FASB tentatively agreed on the reclassification mechanics for the FVOCI category. Accounting for reclassifications of financial assets Previously, the IASB had tentatively decided to introduce a fair value through other comprehensive income (FVOCI) measurement category 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 held within a business model whose objective is both to hold financial assets to collect contractual cash flows and to sell financial assets. The IASB had also tentatively decided to extend the existing reclassification requirements in IFRS 9 to the FVOCI category i.e. the financial assets will be reclassified prospectively when the business model changes. At this meeting, the IASB discussed the mechanics of the reclassification i.e. how reclassification into and out of the FVOCI category should be accounted for. This was the last joint session with the FASB before the Boards proceed with the finalisation of their respective classification and measurement proposals. What did the staff recommend? Scenario A: Reclassification from FVOCI to FVTPL The staff noted that when a financial asset is reclassified from FVOCI to fair value through profit or loss (FVTPL), it will have the same carrying amount (fair value) before and after the reclassification. The question was how to treat the accumulated fair value changes in other comprehensive income (OCI) when the reclassification occurs. The staff recommended that those accumulated OCI balances should be recycled from OCI to profit or loss on the date of reclassification. This is consistent with the existing requirements in IFRS 9 relating to the reclassification from amortised cost to FVTPL (on reclassification, the difference between the previous carrying amount and fair value is recognised in profit or loss) and also with the IASB s previous tentative decision that financial assets measured at FVOCI should have the same profit or loss profile as financial assets measured at amortised cost. Scenario B: Reclassification from FVTPL to FVOCI Similar to Scenario A, when a financial asset is reclassified from FVTPL to FVOCI, it will have the same carrying amount (fair value) before and after the reclassification. Unlike Scenario A, however, there is not an accumulated OCI balance at the reclassification date. The staff recommended that the financial asset should continue to be measured at fair value and that changes in fair value subsequent to the reclassification date should be recognised in OCI. At the reclassification date, an effective interest rate (EIR) would be calculated based on the 3

4 carrying amount (i.e. the fair value) and the new impairment requirements would be applied (e.g. recognition of an impairment loss for expected losses see Impairment section). The staff acknowledged that another alternative would be to reverse prior periods profit or loss amounts and recognise them in OCI on the reclassification date. However, they believed that this would be inconsistent with the notion of prospective accounting for the change in classification. Scenario C: Reclassification from amortised cost to FVOCI The staff recommended that when a financial asset is reclassified from amortised cost to FVOCI, the financial asset should be measured at fair value at the reclassification date. Any difference between the previous carrying amount and the fair value would be recognised in OCI. This is consistent with the existing requirement in IFRS 9 for reclassifying a financial asset from amortised cost to FVTPL except that, in that case, the difference between the previous carrying amount and the fair value is recognised in profit or loss. As discussed above, the IASB had tentatively decided that financial assets measured at FVOCI should have the same profit or loss profile as financial assets measured at amortised cost. This means that the entity would continue to use the same EIR that was established when the financial asset was initially recognised, to calculate interest income subsequent to the reclassification. Scenario D: Reclassification from FVOCI to amortised cost The staff identified the following three alternatives for reclassifying a financial asset from FVOCI to amortised cost. Alternative Measurement of financial asset at the reclassification date Accounting for the fair value changes that have been accumulated in OCI 1 Fair value + accumulated OCI balance (this would result in the financial asset being measured at amortised cost as if it had always been classified in that way) Derecognise accumulated OCI balance with offsetting entry recognised against the financial asset. 2 Fair value Freeze and maintain accumulated OCI balance until the financial asset is derecognised. 3 Fair value Amortise accumulated OCI balance over the remaining life of the financial asset. The staff recommended Alternative 1 because they believed that the accumulated OCI balance should be eliminated when the financial asset is reclassified, as it is neither relevant nor related to the reclassified asset that is now measured at amortised cost. This approach is also consistent with their recommendation in Scenario A to recycle the accumulated OCI balance when a financial asset is reclassified from FVOCI to FVTPL. The staff rejected the other alternatives for the following reasons. Alternative 2: Maintaining the accumulated OCI balance is inconsistent with both the financial asset s former measurement category of FVOCI (the balance remains static and is not updated with subsequent fair value changes over its remaining life) and its new measurement category of amortised cost (there is otherwise no accumulated OCI balance for amortised cost assets). 4

5 Alternative 3: Amortising the accumulated OCI balance over the remaining life of the financial asset would result in a carrying amount that is neither amortised cost nor fair value. What did the Boards decide? The Boards tentatively agreed with the staff recommendations as follows. Scenario A: Reclassification from FVOCI to FVTPL B: Reclassification from FVTPL to FVOCI C: Reclassification from amortised cost to FVOCI D: Reclassification from FVOCI to amortised cost Tentative decisions The financial assets should continue to be measured at fair value. Any accumulated OCI balances should be derecognised from OCI and recognised in profit or loss on the date of the reclassification. The financial assets should continue to be measured at fair value. Changes in fair value subsequent to the reclassification date should be recognised in OCI. The financial assets should be measured at fair value on the reclassification date. Any difference between the previous carrying amounts and the fair values should be recognised in OCI. The financial assets should be measured at fair value on the reclassification date. The accumulated OCI balance at the reclassification date should be derecognised through OCI, with an offsetting entry against the financial assets carrying amounts. This would result in the financial assets being measured at the reclassification date at amortised cost as if they had always been classified in that way. The existing disclosure requirements in IFRS 7 for reclassifications between FVTPL and amortised cost are extended to reclassifications into and out of FVOCI. Disclosures related to reclassifications into and out of the FVOCI measurement category What did the staff recommend to the IASB? The staff recommended that the following existing disclosure requirements in IFRS 7 Financial Instruments: Disclosures (as amended by IFRS 9) for reclassifications between FVTPL and amortised cost should be extended, as relevant, to reclassifications into and out of FVOCI caused by a change in the business model for managing the financial assets. 5

6 IFRS 7 reference 12B 12C 12D Nature of disclosure General information about the reclassification Information related to: the new EIR determined on the date of the reclassification the resulting interest income Fair value information to be provided for a limited time Disclosure requirements (quoted from IFRS 7) An entity shall disclose if, in the current or previous reporting periods, it has reclassified any financial assets in accordance with paragraph of IFRS 9. For each such event, an entity shall disclose: a) the date of reclassification. b) a detailed explanation of the change in business model and a qualitative description of its effect on the entity s financial statements. c) the amount reclassified into and out of each category. For each reporting period following reclassification until derecognition, an entity shall disclose for assets reclassified so that they are measured at amortised cost in accordance with paragraph of IFRS 9: a) the effective interest rate determined on the date of reclassification; and b) the interest income or expense recognised. If an entity has reclassified financial assets so that they are measured at amortised cost since its last annual reporting date, it shall disclose: a) the fair value of the financial assets at the end of the reporting period; and b) the fair value gain or loss that would have been recognised in profit or loss during the reporting period if the financial assets had not been reclassified. The staff also noted that paragraph 51 of IAS 1 requires separate presentation in the statement of comprehensive income of any gain or loss arising from a difference between the asset s previous carrying amount and its fair value on the reclassification date. The staff believed paragraph 82A of IAS 1 already requires a similar presentation relating to the amounts recognised in OCI as the result of reclassifying financial assets from amortised cost to FVOCI. This is because such an amount is different in nature from other amounts recognised in OCI, particularly since such reclassifications are expected to be infrequent. What did the IASB decide? The IASB tentatively agreed with the staff recommendations that: paragraph 12B of IFRS 7 should be extended to all reclassifications into and out of FVOCI; paragraph 12C of IFRS 7 should be extended to reclassifications from FVTPL to FVOCI; and paragraph 12D of IFRS 7 should be extended to apply to all reclassifications from FVTPL to FVOCI and from FVOCI to amortised cost. 6

7 Judgement in the assessment of contractual cash flow characteristics is an example of a judgement that could have a significant effect on the amounts recognised in the financial statements that is required to be disclosed. No new presentation requirements were added for the derecognition of FVOCI debt instruments. Additional presentation and disclosure requirements The IASB discussed additional presentation and disclosure requirements in light of the proposed limited amendments to IFRS 9, as well as the interaction with the disclosures proposed in the impairment project. Amendment to the contractual cash flow characteristics assessment What did the staff recommend to the IASB? The staff noted that the proposed amendment to the contractual cash flow characteristics assessment introduces more judgement. This is because an entity may need to assess whether a modification in the economic relationship between principal and interest is more than insignificant. The staff recommended that the IASB reinforce and supplement the general requirement in paragraph 122 of IAS 1 Presentation of Financial Statements to disclose information about the judgements made. This could be achieved by adding to the existing list of examples in paragraph 123 of IAS 1, judgement involved in the assessment of contractual cash flow characteristics. What did the IASB decide? The IASB tentatively agreed with the staff recommendation. The IASB also tentatively decided that no specific quantitative disclosures would be required in those cases where the assessment could have a significant effect on the amounts recognised in the financial statements. Proposed addition of an FVOCI category for eligible debt instruments What did the staff recommend to the IASB? The staff noted that the underlying premise for the FVOCI measurement category is that for financial assets managed within the relevant business model, two sets of information amortised cost and fair value are relevant. Accordingly, the mechanics of the accounting for the FVOCI category would result in fair value information on the balance sheet and amortised cost information in profit or loss. In terms of presentation, paragraph 82(aa) of IAS 1 (as amended by IFRS 9) requires separate presentation of gains or losses arising from the derecognition of financial assets measured at amortised cost. The purpose of this requirement is two-fold: to enable users of financial statements to understand the effects of derecognising before maturity instruments that are measured at amortised cost; and to instil discipline in situations where an entity measures financial assets at amortised cost (on the basis that it holds the financial assets to collect contractual cash flows) but regularly sells them. The staff did not think it necessary to provide separate presentation of gains or losses arising from sales of financial assets held within the FVOCI category. This is because by definition FVOCI debt instruments are held within a business model whose objective includes selling the financial assets. Moreover, the staff noted that information on gains or losses from derecognition of FVOCI debt instruments would be required to be made available to users of financial statements under existing presentation and disclosure requirements: 7

8 Total reclassification adjustments for FVOCI debt instruments a Interest revenue b Impairment b Gains or losses from derecognition of FVOCI debt instruments a Separate presentation of reclassification adjustments of components of OCI (one of which will be FVOCI debt instruments) required by IAS 1. b Separate disclosure of interest revenue and of impairment for FVOCI debt instruments required by IFRS 7. The staff therefore recommended that no new requirements should be added in relation to gains or losses arising from the derecognition of FVOCI debt instruments. What did the IASB decide? The IASB tentatively agreed with the staff recommendation i.e. that no new requirements should be added in relation to the presentation of gains or losses arising from the derecognition of debt instruments measured at FVOCI. The impairment allowance balance for FVOCI debt instruments cannot be presented on the face of the statement of financial position, but is required to be disclosed in the notes. Interaction with impairment disclosure proposals What did the staff recommend to the IASB? The staff believed that the same disclosures relating to the measurement of expected losses should generally be applied to amortised cost and FVOCI financial assets. This is because the two groups of financial assets have the same profit or loss profile. However, the balance sheet objective for the two measurement categories is different (i.e. amortised cost versus fair value). The staff believed that this gives rise to different considerations for the impairment allowance balance. In particular, presentation of an accumulated impairment amount for FVOCI debt instruments would be a departure from their fair value carrying amounts; this would be complicated and potentially confusing. The staff therefore recommended that presentation of an allowance account on the face of the balance sheet should be prohibited for FVOCI debt instruments. The staff also recommended that a roll-forward of the accumulated impairment amount should not be required for FVOCI debt instruments. They believe that the fair value adjustment for FVOCI debt instruments is effectively adjusting both for market movements and movements in expected losses, in order to establish an overall fair value carrying amount. Requiring separation of these two components could therefore be confusing. What did the IASB decide? The IASB tentatively agreed with the staff recommendation that presentation of an impairment allowance balance on the face of the statement of financial position should be prohibited for debt instruments measured at FVOCI. However, in contrast to the staff recommendation, the IASB tentatively decided that impairment disclosures for debt instruments measured at FVOCI should be consistent with those for assets measured at amortised cost, including disclosure of an accumulated impairment amount. 8

9 The existing IFRS 9 transition requirements remain largely unchanged. Where it is impracticable to apply the amended cash flow characteristics assessment retrospectively, an entity will be required to apply the assessment as set out in IFRS 9 (2010). Transition Initial application of the amended requirements What did the staff recommend to the IASB? The staff identified the following key proposed limited amendments to IFRS 9 that are relevant for transition: amendment to the contractual cash flow characteristics assessment (see Appendix A, under Assessment of economic relationship between P&I); modifications to the business model assessment, notably the introduction of the FVOCI category for eligible debt instruments (see Appendix A, under Business model assessment for FVOCI classification for financial assets); and the extension of the existing IFRS 9 fair value option requirements to debt instruments measured at FVOCI (see Appendix A, under Fair value option). Amendment to the contractual cash flow characteristics assessment The staff noted that although the application of the contractual cash flow characteristics assessment under current IFRS 9 already requires judgement, the proposed amendment (i.e. the assessment of whether a modification in the economic relationship between the principal, the time value of money and credit risk is more than insignificant) introduces an even greater degree of judgement. This presents a greater risk of hindsight in applying requirements retrospectively. Currently under IFRS 9, in line with the principles set out in IAS 8 Accounting Policies, Changes in Accounting Estimates and Errors, the contractual cash flow characteristics assessment and the resultant measurement attribute are applied retrospectively at the date of initial application of IFRS 9 1. In other words, the contractual cash flows are assessed on the basis of facts and circumstances at the time the financial asset was initially recognised. In view of the greater risk of hindsight introduced by the proposed amendment, the staff believed that a modification to the requirement for retrospective application is necessary for cases in which retrospective application is impracticable. Therefore, the staff recommended that on transition to the revised IFRS 9 when it is impracticable to apply the amended cash flow characteristics assessment retrospectively, an entity should instead be required to apply retrospectively the contractual cash flow characteristics assessment as set out currently in IFRS 9 (2010). In addition, the staff recommended that the IASB require disclosure of the carrying amounts of the financial assets whose contractual cash flows have been assessed under IFRS 9 (2010) rather than the amended standard until the affected assets are derecognised. This would be in line with the disclosure requirements in IAS 8 relating to circumstances when retrospective application is impracticable upon initial application of an IFRS. Modifications to the business model assessment The staff noted that in accordance with the existing transition provisions in IFRS 9, the assessment of the business model of financial assets held on the date of initial application is not performed retrospectively but is instead performed on the basis of the facts and circumstances that exist on the date of initial application. This is because it would be difficult, and perhaps impossible, to base the assessment on facts and circumstances at the time when the financial asset was initially recognised. However, the resulting measurement attribute would be applied retrospectively 2. Because of the modifications to the business model assessment (i.e. the introduction of the FVOCI measurement category), an entity performing the assessment on the date of initial application of IFRS 9 would classify eligible debt instruments into one of three, rather than two, 1 Except for financial assets that have already been derecognised at the date of initial application. 2 Except for circumstances where IFRS 9 provides specific relief from retrospective application. 9

10 business models. The staff did not believe that introducing an additional business model had any implications on an entity s ability to assess the business model or the requirement to make that assessment as at the date of initial application. Accordingly, the staff did not propose any modifications to the existing IFRS 9 transition requirements with respect to the timing of the business model assessment. The staff also noted that debt instruments measured at FVOCI will be subject to the same interest income recognition (i.e. the effective interest rate method) and credit impairment methodology 3 as those applied to financial assets measured at amortised cost. IFRS 9 already contains a limited impracticability exception from retrospective application of the effective interest rate method, and the staff recommended that no modification to this relief is necessary. Extension of the existing IFRS 9 fair value option requirements to debt instruments measured at FVOCI In accordance with the existing transition requirements in IFRS 9, there is a clean slate for the fair value option (FVO) for accounting mismatches (of financial assets and financial liabilities) at the date of initial application for financial assets. This means that entities are both: permitted to revisit their FVO elections made under IAS 39; and required to revoke their FVO elections if an accounting mismatch no longer exists at the date of initial application. Any designation or revocation of financial assets measured at fair value through profit or loss is made on the basis of the facts and circumstances that exist at the date of initial application. The resulting measurement attributes are then applied retrospectively, except when specific reliefs are applicable. The staff believed that no new transition implications arise from the ability to designate as at FVTPL debt instruments that otherwise would be measured at FVOCI. Accordingly, they recommended that no modification to the existing IFRS 9 transition requirements with respect to the fair value option for accounting mismatches is necessary for entities that newly adopt IFRS 9 when it becomes effective 4. What did the IASB decide? The IASB tentatively agreed with the staff recommendations i.e. that on transition to the amended IFRS 9, an entity should be required to: retrospectively apply the contractual cash flow characteristics assessment as set out in IFRS 9 (2010) where it is impracticable to apply the amended contractual cash flows characteristics assessment retrospectively; and disclose the carrying values of the financial assets whose contractual cash flows have been assessed under IFRS 9 (2010) rather than the amended requirements due to impracticability until the affected financial assets are derecognised. The IASB also tentatively agreed that no amendments to the existing IFRS 9 transition requirements are necessary in respect of the: proposed amendments to the business model assessment; and proposed extension of the fair value option for accounting mismatches to debt instruments that would be otherwise be measured at FVOCI. 3 See Impairment section for discussion of the transition to the new credit impairment methodology. 4 The staff noted that there would be implications for entities that early adopt an interim version of IFRS 9. This is discussed in the section Transition Fair value option for early appliers. 10

11 A clean slate for the fair value option for new accounting mismatches arising from the transition to the limited amendments to IFRS 9 will be available for entities that have already applied IFRS 9 (2009) and/ or IFRS 9 (2010). Transition Fair value option for early appliers What did the staff recommend to the IASB? The staff noted that the clean slate for the fair value option for accounting mismatches as discussed in the previous section is available to an entity only once i.e. when it initially applies the IFRS 9 classification and measurement requirements for financial assets. Entities that have already applied IFRS 9 (2009) and/or IFRS 9 (2010) before they apply the limited amendments to IFRS 9 ( early appliers ) would have already applied the fair value option clean slate. However, the application of the limited amendments will cause the measurement attribute of some financial assets to change, and consequently the nature and extent of accounting mismatches will also change. Accordingly, the staff recommended that early appliers should be: required to revoke previous fair value option elections if an accounting mismatch no longer exists at initial application of the limited amendments to IFRS 9; and permitted to apply the fair value option to new accounting mismatches that are created by the initial application of the limited amendments to IFRS 9. Early appliers will not be permitted to: revoke previous fair value option elections if an accounting mismatch continues to exist; or apply the fair value option to accounting mismatches that already existed before the initial application of the limited amendments to IFRS 9. What did the IASB decide? The IASB tentatively agreed with the staff recommendations i.e. that entities which have already applied IFRS 9 (2009) and/or IFRS 9 (2010) before they apply the limited amendments to IFRS 9 would be: required to revoke previous fair value option elections if an accounting mismatch no longer exists at initial application of the amended requirements; and permitted to apply the fair value option to new accounting mismatches created by the initial application of the amended requirements. Once the limited amendments to IFRS 9 and/ or impairment requirements are finalised, entities will no longer be permitted to apply previous versions of IFRS 9. Transition phased early application of IFRS 9 The staff identified that the following packages will be available for early application once the general hedge accounting requirements are added to IFRS 9 5 : IFRS 9 (2009) classification and measurement of financial assets IFRS 9 (2010) classification and measurement of financial assets and financial liabilities IFRS 9 (2012) classification and measurement of financial assets and financial liabilities and hedge accounting. The question was whether to allow the limited amendments to IFRS 9 to be early applied prior to application of the new impairment model. What did the staff recommend to the IASB? The staff recommended that phased early application of the limited amendments to IFRS 9 and the new impairment model should not be allowed i.e. an entity should not be permitted to early 5 Targeted to be issued in H

12 apply the limited amendments to IFRS 9 prior to applying the new impairment model. This would reduce the number of versions of IFRS 9 that are available for early application at a given point of time and that otherwise could significantly undermine comparability between entities. Moreover, the limited amendments to IFRS 9 have been developed in the context of the tentative decisions made in the impairment project. However, the staff also recommended that the amendment to the contractual cash flow characteristics assessment should be incorporated on its own into the versions of IFRS 9 already available for early application at the time the limited amendments are published. Entities that have already been applying a version of IFRS 9 before the limited modifications can continue to apply that previous version. The staff considered such an approach to be appropriate for the following reasons. The proposed amendment to the contractual cash flow characteristics assessment is designed to address application questions from constituents. Therefore, incorporating this amendment into the versions of IFRS 9 available for early application at the time the limited amendments are published would help to ensure consistency of application and comparability across entities. The proposed amendment clarifies the principle that already exists in IFRS 9. Therefore, from a conceptual standpoint, the clarification should be applied together with the principle. The proposed amendment can be applied before a new impairment model is applied because there is little interaction with the expected loss model. What did the IASB decide? The IASB tentatively agreed with some, but not all, of the staff recommendations. The IASB tentatively decided that once the limited amendments to IFRS 9 and/or the impairment project are finalised, entities should no longer be permitted to apply early previous versions of IFRS 9. Entities that have already applied a previous version of IFRS 9 should be able to continue applying that version and should not be required to apply the final requirements until the mandatory effective date. Earlier application of the revised IFRS 9 in its entirety will be permitted once all the requirements are issued. Transition Early application of IFRS 9 in its entirety (all phases) What did the staff recommend to the IASB? The staff recommended that early application of the completed IFRS 9 package (including the limited amendments to current IFRS 9, hedge accounting and impairment requirements) should be permitted. A key reason is that entities would benefit from the improved accounting for financial instruments more quickly. What did the IASB decide? The IASB tentatively agreed with the staff s recommendation. 12

13 Comparative classification and measurement information will be permitted, but not required, to be restated. Transition Comparative financial statements The IASB discussed the presentation of comparative information by entities that apply a version of IFRS 9 after the limited amendments are published. What did the staff recommend to the IASB? The staff recommended that restatement of comparative classification and measurement information should be prohibited when an entity initially applies IFRS 9 in its entirety. This is consistent with their recommendation to prohibit restatement of comparative information under the impairment model, since the proposed amendments to the business model assessment have been designed to be applied with a consistent impairment model for both amortised cost and FVOCI financial assets. What did the IASB decide? Instead of prohibiting restatement of comparative classification and measurement information, the IASB tentatively decided to re-affirm that comparative classification and measurement information should be permitted, but not required, to be restated. This is similar to their tentative decision for impairment, and is conditional on the information being available without the use of hindsight. Next steps This meeting concludes the IASB s deliberations on classification and measurement. The IASB expects to issue an exposure draft on limited amendments to IFRS 9 in the fourth quarter of

14 IMPAIRMENT What happened in July? At the July 2012 meeting, the IASB continued its deliberations on impairment. Topics jointly discussed with the FASB were: application of the proposed expected loss model to loan commitments and financial guarantee contracts; and disclosures to accompany the proposed expected loss model. Other impairment topics discussed by the IASB alone were: presentation of interest revenue; application of the proposed expected loss model to assets reclassified from FVTPL to amortised cost or FVOCI; disclosures specific to IFRS; and transition requirements. (See Appendix B: Summary of IASB s redeliberations on impairment for a summary of the IASB s decisions to date.) Presentation of interest revenue General interest rate approach Under the proposed impairment approach interest revenue is generally calculated using an effective interest rate based on the contractual cash flows that is: not adjusted for initial credit loss expectations; and always computed on the carrying amount without deduction of the impairment allowance. There is an exception for purchased financial assets with an explicit expectation of credit losses at acquisition. Due to this decoupling of interest revenue and impairment, the presentation of interest revenue does not reflect deteriorations in credit quality. Therefore the Board discussed how the model should treat interest revenue for: originated credit-impaired financial assets; and deteriorated credit-impaired financial assets (after initial recognition). The accounting treatment of purchased creditimpaired financial assets should be extended to originated creditimpaired assets. Presentation of interest revenue for originated credit-impaired assets Credit-adjusted effective interest rate for purchased credit-impaired financial assets In a previous meeting the Board decided that, for purchased credit-impaired financial assets, an entity should adjust the effective interest rate based on the expected cash flows estimated on initial recognition i.e. considering initial credit loss expectations. Any subsequent changes, favourable and unfavourable, in expected cash flows would be recognised as an impairment loss on the basis of changes in expected lifetime loss from period to period. 14

15 Effective interest rate for originated credit-impaired assets Originated credit-impaired assets are considered to be rare, but they are not impossible. For example, some modifications of contractual terms can result in derecognition of the original asset and recognition of a new asset under IAS 39. In those circumstances, the event may be associated with financial distress so the new asset may be considered credit-impaired for accounting purposes at the date of origination. What did the staff recommend? Under the Boards previous tentative decision: interest revenue would be calculated on the gross carrying amount; and an impairment allowance would be measured at 12 months expected losses if there has not been a more than insignificant deterioration in credit quality since initial recognition. In the IASB staff s view, such an approach would not result in a faithful representation of the economic yield and would not be comparable with purchased credit-impaired financial assets. The staff recommended that the approach used for purchased credit-impaired financial assets should be extended to all financial assets subject to impairment accounting that are creditimpaired on initial recognition. Accordingly, entities would be required to: use a credit-adjusted effective interest rate; and recognise an allowance balance for changes in expected lifetime losses. What did the Boards decide? The IASB agreed with the staff recommendation. If assets are credit-impaired at the reporting date, then an entity should present interest revenue calculated on the carrying amount net of the impairment allowance. Alternative presentation of interest revenue for deteriorated credit-impaired assets This discussion related to deteriorated credit-impaired financial assets. These are financial assets that were not credit-impaired at initial recognition but have subsequently deteriorated to or below the credit-impaired level. Based on tentative decisions to date, the effective interest rate for these assets is: not adjusted for initial credit loss expectations; and always computed on the gross carrying amount without deduction of the impairment allowance. The discussion focused on whether the presentation of interest revenue should be changed if the credit quality of these assets deteriorates to or below the credit-impaired level. In the IASB staff s view, an alternative interest revenue presentation approach should be required in order to represent better the economic yield and to maintain the Boards objective of reflecting the pattern of deterioration. 15

16 The staff identified the following alternatives for calculating the interest revenue to be presented for deteriorated credit-impaired financial assets. Requirement Advantage Disadvantage Net interest approach Interest revenue calculated on the carrying amount net of the impairment allowance. Represents more faithfully the unwinding of the present value of expected cash flows at the effective interest rate. More comparable with the yield on purchased and originated creditimpaired financial assets than presenting nil interest revenue. Need to adjust interest revenue calculations. Need to identify a subset of creditimpaired financial assets and their related impairment allowances. Nil interest approach Nil interest revenue presentation. Offset interest revenue on the subset of assets with an equal amount of impairment loss. Operationally simple, because only interest revenue on the subset of financial assets but not the related impairment allowance would need to be identified. Combines the reversal of the discounting of the expected cash flows (i.e. the effect on the present value caused by the passage of time) with other impairment losses. Does not improve the presentation of interest revenue. What did the staff recommend? The IASB staff recommended the net interest approach. What did the Boards decide? The IASB agreed with the staff recommendation. This means that for financial assets subject to the general deterioration impairment model, an entity would present interest revenue calculated on the carrying amount net of the impairment allowance if the asset is credit-impaired at the end of the reporting period. This evaluation should be made at the end of each reporting period, and would be applicable for the following reporting period. Financial assets are creditimpaired if there is objective evidence of meeting IAS 39 criteria. Definition of credit-impaired The IASB considered how the term credit-impaired should be defined for the purpose of identifying those assets to which the net interest approach should be applied. The staff identified the following alternative approaches: likelihood of loss event e.g. whether a loss event is more probable than not; 90 days past due (non-performing/non-accrual); or 16

17 objective evidence of meeting IAS 39 impairment criteria e.g. significant financial difficulty of borrower or a breach of contract such as default or delinquency. What did the staff recommend? The staff recommended that financial assets should be considered to be credit-impaired if there is objective evidence of the criteria in paragraphs 59(a) (e) of IAS 39 Financial Instruments: Recognition and Measurement. What did the Boards decide? The IASB agreed with the staff recommendation. The IASB noted that credit-impaired assets will be a subset of those financial assets with an impairment allowance measured based on lifetime expected losses. Summary of IASB s tentative decisions on interest revenue presentation The IASB s decisions on presentation of interest revenue for financial assets that are not creditimpaired at initial recognition are summarised below. Interest EIR based on contractual cash flows, calculated on gross carrying amount i.e. not reduced for impairment allowance Impairment lifetime expected losses when loss event expected in the next 12 months Move out of Bucket 1 when more than insignificant deterioration in credit quality and reasonable possibility that cash flows may not be collected Interest calculated on gross carrying amount Credit-impaired subset Impairment lifetime expected losses if there is objective evidence of the criteria in IAS 39.59(a) (e) Interest calculated on carrying amount net of impairment allowance Impairment lifetime expected losses 17

18 The proposed expected loss impairment model should apply to loan commitments and financial guarantee contracts. Application of the expected loss model to loan commitments and financial guarantee contracts (joint discussion) The Boards discussed: whether to include within the scope of the proposed model loan commitments and financial guarantee contracts that are not accounted for at FVTPL; and if so, then how the impairment model would apply. What did the staff recommend? Issue Staff recommendation Advantage Disadvantage Whether to apply the impairment model to loan commitments and financial guarantee contracts (joint) The proposed expected loss impairment model should apply to loan commitments and financial guarantee contracts to which IAS 37 Provisions, Contingent Liabilities and Contingent Assets applies (or that are not accounted for at fair value through net income and not accounted for as insurance in accordance with US GAAP). Eliminates the purely accounting-driven effects of changing between the scope of two different standards when loan commitments are drawn. Consistent measurement for credit exposures irrespective of whether they are funded or not (i.e. align the accounting for loans, loan commitments and financial guarantee contracts). Impairment would be recognised before the associated financial asset is recognised on the statement of financial position. Type of loan The proposed expected Consistent with Operationally more commitment loss impairment complex for banks definition of a liability and time model should apply to that consider the in the Conceptual horizon for instruments that create a behavioural life for Framework and IAS 37 expected present legal obligation to credit risk management (and FASB Concept losses (joint) extend credit. purposes (e.g. some Statement 6); and banks that apply the When estimating loan commitments Basel II advanced internal expected losses, an that are captured in rating-based approach entity should consider IAS 37 today. and banks that do not the maximum contractual distinguish between period over which it is Scope is limited irrevocable and revocable exposed to credit risk. to irrevocable loan facilities from a credit commitments. risk perspective because they tend not to cancel revocable facilities). Estimating The usage behaviour Consistent expected loss Additional complexity future draw should be estimated model for on-balance in estimating the credit downs (joint) over the lifetime of a loan commitment when estimating expected lifetime losses. and off-balance sheet exposures. conversion factor (CCF), which is the amount drawn down upon default, over the lifetime of the instrument. 18

19 Issue Staff recommendation Advantage Disadvantage Discount rate to be applied (IASB only) The discount rate to be applied to discount the expected losses cannot be the effective interest rate, because these contracts have not yet been funded. Instead, the discount rate should be the rate that reflects: Expected credit losses should be discounted to be consistent with the overall impairment model and conceptual considerations (timing of a cash flow affects its present value). Operationally burdensome for banks using the same rate to discount loans and loan commitments. current market assessments of the time value of money (i.e. risk free rate); and the risks specific to the cash flows (but only if, and to the extent that, the risks are taken into account by adjusting the discount rate rather than by adjusting the cash shortfalls being discounted). Commitment fees (IASB only) As part of the impairment project, the accounting for revenue arising from loan commitments or financial guarantee contracts should not be changed. There will be a future discussion on interaction with the revenue recognition project. Presentation (joint) Expected losses arising from undrawn loan commitments or financial guarantee contracts should be recognised separately as a liability. Expected credit losses do not represent a reduction in the value of an asset; the asset does not yet exist. What did the Boards decide? The Boards agreed with all the staff s recommendations. 19

20 The proposed impairment model should be applied to a financial asset on the date of reclassification. Application to financial assets reclassified from fair value through profit or loss (IASB only) The IASB discussed how the proposed impairment model would be applied to financial assets reclassified from the FVTPL classification to the amortised cost or FVOCI classifications. What did the staff recommend? The staff recommended that the proposed impairment model should be applied at the date of reclassification and should be the same as for a financial asset at initial recognition. Accordingly, at the date of reclassification an entity would be required to determine an impairment allowance of 12 months expected losses, unless the financial asset meets the definition of credit-impaired. What did the Board decide? The IASB agreed with the staff recommendation. Additional disclosures required on estimates of expected losses and credit quality migration. Disclosure to accompany the impairment proposals (joint) The Boards discussed disclosure requirements for the three-bucket impairment model. What did the staff recommend? The staff recommended new qualitative and quantitative disclosure requirements to complement the current requirements and to enable users to understand: an entity s estimate of expected losses; and the credit quality migration of financial assets. See Appendix C for a list of proposed joint and IASB-only disclosure requirements, how they compare to IFRS 7, and the Boards decisions. What did the Boards decide? The IASB and the FASB agreed with the staff recommendations, and tentatively decided to require an entity to disclose the following. Joint proposal Expected loss objective Expected loss calculation Transfer criteria Collateral disclosures Inputs, assumptions and techniques used in: estimating expected losses; and assessing whether the recognition of lifetime expected losses have been met. Information regarding the quality of collateral. Quantitative information related to collateral for financial assets for which lifetime expected losses are recognised*. * The IASB decided at the IASB-only meeting to limit this disclosure to financial assets that are credit-impaired. 20

21 Joint proposal Credit migration objective Allowance roll-forward narrative disclosures Risk disaggregation Purchased creditimpaired financial asset disclosures Financial asset ending balances Reconciliation of the beginning and ending balances, disaggregated by whether the impairment allowance is measured using 12 months' expected losses and lifetime expected losses, of: gross carrying amounts; and impairment allowance balances. Narrative discussion of changes in the impairment allowance balance. Disaggregation of the gross carrying amount by credit quality for both financial assets with an impairment allowance measured at 12 months' expected losses and lifetime expected losses (including a description of how the entity determines the categories of credit quality). For the IASB, these disclosures would be required only if other more detailed disclosures related to credit risk profiles are not already required by regulators (e.g. Basel III). The FASB directed its staff to explore how this would be integrated into existing disclosures of credit quality information, including disclosures relating to credit quality indicators. Amounts related to purchased credit-impaired financial assets. The balance of financial assets evaluated on an individual basis and for which impairment is measured at lifetime expected losses, and the allowance balance related to these financial assets. IASB-only disclosures Discount rate Modifications Financial assets with 100% probability of default Financial assets 90 days past due Interest revenue Qualitative information related to the discount rate elected. Information regarding financial assets for which an impairment allowance of lifetime expected losses is required that have been modified at any time in their life. Gross carrying amount and related allowance, if any, of financial assets measured under the impairment model if a default has occurred. The balance of financial assets 90 days past due with an impairment allowance measured at 12 months' expected losses. Amount of interest revenue, and how it is calculated (i.e. gross, net, credit-adjusted effective interest rate). The IASB noted that if the joint disclosures above are satisfied by disclosures required by other applicable regulations (such as prudential regulations), then an entity will be permitted to crossrefer to those disclosures. In addition, the IASB and the FASB asked the staff to consider the application of the joint disclosures to non-financial institutions (including entities applying the simplified model for trade receivables and lease receivables) when drafting the proposals. 21

22 Transition relief if obtaining credit quality information at initial recognition requires undue cost or effort. Transition (IASB only) Applying the model using initial credit quality data Under IAS 8, as a general principle, retrospective application of changes in accounting policies is the preferred approach to transition to new standards unless it is impracticable to determine the period-specific effect and/or the cumulative effect of the change. The definition of impracticability would include situations in which it is not possible to distinguish objectively historical information relevant for estimating expected losses from information that would not have been available at that date (hindsight). The staff identified two main challenges with respect to retrospective application of the proposed impairment model. Issue The proposed impairment model relies on entities assessing whether there has been a deterioration or improvement in credit quality since the initial recognition of a financial asset to determine whether an allowance balance is required to be established to reflect lifetime expected credit losses. Entities have not previously been required to recognise or disclose expected losses for accounting purposes. Risk Making this assessment on transition may be difficult because information about initial credit quality is not typically retained. There is a risk that hindsight would be used to determine the amount of expected losses in prior periods. Applying the model without initial credit quality data The IASB staff identified the following possible transition reliefs that could be applied for financial assets if obtaining initial credit quality information is impracticable: resetting or deeming the initial credit quality to be the credit quality at the date on which the new model is initially applied; categorising these financial assets in Buckets 2 or 3 until derecognition; or modifying the transfer notion so that the transition provisions require these assets to be evaluated only on the basis of the notion s second criterion i.e. these assets would be included in Buckets 2 or 3 if it is at least reasonably possible that the contractual cash flows may not be recoverable. Restatement of comparative periods is permitted. Comparative periods The IASB discussed whether the retrospective application should be permitted, but not required, or prohibited considering that restatement of comparative periods is the preferred approach to transition and the risk of hindsight being used. Disclosures under IAS 8 When the initial application of an IFRS has an effect on the current period or on any prior period, paragraph 28(f) of IAS 8 requires an entity to disclose, for the current and each prior period presented, the amount of any adjustment on the initial application of an IFRS for each financial statement line item. The IASB discussed whether these disclosures should be required. 22

23 Disclosure with respect to the amount of the adjustment permitted for prior periods and required for the current period. What did the staff recommend? Transition relief Applying the model without initial credit quality data The staff recommended that the transition notion for relevant assets should be modified so that it is based only on the second criterion of the transfer notion. The staff did not specify the situations in which the transition relief should be applicable. The staff outlined the conflict between: the burden on preparers in being required to use initial credit quality data that is available, but that would be very burdensome to use at transition because it has not previously been required to be collected for accounting purposes; and the reduced comparability that would result from allowing entities to ignore the initial credit quality; this would in effect delay the full application of the new impairment model, potentially for a significant period of time. Restatement The staff recommended that the restatement of comparative periods should be prohibited. Disclosures under IAS 8 The staff recommended that the disclosures in paragraph 28(f) of IAS 8 should be: prohibited for prior periods; and required for the current period. What did the Boards decide? Transition requirement under IAS 8 Applying the model using initial credit quality data The IASB tentatively decided that an entity should be required to use the credit quality at initial recognition for existing financial assets when initially applying the new impairment model, unless obtaining such credit quality information requires undue cost or effort. Transition relief Applying the model without initial credit quality data The IASB tentatively decided that if the credit quality at initial recognition is not used at the date of initial application, then the transition provisions should require these financial assets to be evaluated only on the basis of the second criterion in the transfer notion (i.e. include in Bucket 2 or 3 if the likelihood that the contractual cash flows may not be collected is at least reasonably possible). Restatement and disclosures under IAS 8 The IASB did not agree with the staff recommendations. Instead, it tentatively decided that the restatement of comparative periods should be permitted, but not required, if the information is available without the use of hindsight. The disclosures in paragraph 28(f) of IAS 8 should: be permitted, but not required, for prior periods if the information is available without the use of hindsight; and be required for the current period. 23

24 Next steps IASB The IASB stated that it has taken all the technical decisions for developing an IASB exposure draft for the new impairment model, subject to any further issues being identified. Before publishing the impairment proposals, the IASB will discuss the comment period and permission to ballot at future meetings. A new IASB exposure draft on the impairment proposals is expected in the fourth quarter of FASB The FASB staff explained that there were still a number of FASB-only issues to be discussed, including: the scope of purchased credit-impaired financial assets; the application of the model to debt securities; and non-accrual accounting. In addition, the FASB staff explained that they also wanted to develop more thorough application guidance in response to constituents concerns. The FASB staff intended to present a summary of the concerns raised and recommendations of how best to address them in the near future. The FASB staff emphasised that constituents had raised major concerns that the three-bucket approach might be difficult to operationalise, audit and understand. The primary concerns related to the transfer notion and Bucket 1 measurement. As part of its due process, the FASB believed that the issues raised needed to be addressed now, before an exposure draft was issued. The FASB thought that this could be achieved within the current timetable, and that the project would stay on track. The IASB chairman responded that both Boards had been working on this project since 2009 with the aim of reaching agreement on a converged solution, and that the discussions had been very difficult. The IASB chairman was concerned that the FASB s decision could reopen the Boards hard work again, despite so many alternatives having been considered. The FASB chairman replied that the FASB still wanted to produce a converged solution as quickly as possible. 24

25 HEDGE ACCOUNTING A review draft of the revised general hedge accounting model is (still) expected soon. General hedging The IASB s target for release of a review draft of the revised general hedge accounting model slipped from the second quarter of The IASB is now targeting the third quarter of The review draft will be available for around 90 days. During this 90-day period, the IASB plans to undertake an extended fatal flaw review process and additional outreach. This will also give the FASB the opportunity to consider the IASB s revised proposals. The IASB will not be formally asking for comments on the draft. The IASB is still targeting the release of a final standard in the fourth quarter of However, further delays in the release of the review draft could push the release of a final standard into Entities use of an equity model book approach to interest rate risk management is a key consideration in developing a new macro hedge accounting model. Macro hedging (For an introduction to the topic of macro hedging see our IFRS Newsletter: Financial Instruments Issue 2, May 2012.) In July, the IASB continued its series of educational meetings as it develops a tentative macro hedging model for interest rate risk. The discussions held before the July meeting had been based on two implicit assumptions i.e. that: business activities (financial assets) are entirely funded with liabilities (i.e. the funding does not include any equity); and the objective of risk management activities is simply to balance the entire portfolio with respect to the hedged risk (e.g. the entire net risk position is to be swapped from fixed interest rates to floating interest rates). However, some entities include equity as a source of funding as part of their interest rate risk management model. This is known as using an equity model book. The idea behind the equity model book approach is that the return required by equity investors can be viewed as a combination of: a fixed-rate base return that is similar to interest, which compensates equity holders for providing funding; and a variable residual return that results from the total net income (less the base return) that accrues to equity holders; this is the gain or loss that equity holders receive because they provide loss absorption. When banks that use an equity model book approach undertake risk management activities to hedge interest rate risk, they include the required fixed-rate base return on their equity funding as part of their open portfolio, subject to interest rate risk. Some banks use funds obtained through capital transactions and retained earnings to invest in a portfolio of fixed rate bonds with different maturities in an attempt to generate the fixed-rate base return required by their equity investors. However, other banks use their equity and retained earnings as part of the overall funding for their business activities. In an effort to achieve a similar fixed-rate base return, transfer pricing mechanisms that have maturity and interest structures like a separate bond portfolio are used as funds are distributed to business units. Therefore, instead of investing directly in a portfolio of fixed rate bonds, a replicated bond portfolio is modelled using transfer prices. 25

26 Some banks consideration of equity funding as part of their risk management of interest rate exposures creates difficult issues for the IASB in developing a new macro hedging model. On one hand, the IASB is attempting to develop a model that aligns the accounting as closely as possible with actual risk management practices. This has several possible perceived benefits: there may be less duplication of effort (e.g. having one set of numbers for risk management purposes and another set of numbers for accounting purposes); financial statements may better reflect the economics of management s actual risk management activities; users may be able to evaluate better the success or failure of management s risk management strategies. On the other hand, incorporating elements of the equity model book into the approach for macro hedge accounting raises a number of possible concerns: remeasurement of the hedged open portfolio to reflect interest rate risk may involve the remeasurement of items that do not meet the definitions of an asset or a liability in the Conceptual Framework; some users of financial statements may not view equity as comprising a fixed-rate base return and a residual return; and permitting management to incorporate a fixed-rate base return on equity into presenting financial performance may create arbitrage opportunities. At the July meeting, the IASB discussed the possible trade-offs of incorporating equity model book approaches into the new macro hedge accounting model. Board members supported including a discussion of the equity model book and its implications in the forthcoming discussion paper to solicit input from constituents. Next steps The staff plan to hold additional education sessions over the next few months, to continue to develop a tentative macro hedging model for interest rate risk. The staff anticipate that a tentative model will be developed by the end of the third quarter of At that point, the staff plan to move forward along two tracks: engaging in extensive constituent outreach on a tentative macro hedging model for interest rate risk; and 26