IFRS Project Insights Financial Instruments: Classification and Measurement

IFRS Project Insights Financial Instruments: Classification and Measurement 2 October 2012 The IASB s financial instrument project will replace IAS 39 Financial Instruments: Recognition and Measurement. The financial instruments project is being addressed by the IASB (the Board) in phases: classification and measurement, impairment, hedge accounting and offsetting of financial assets and liabilities. In November 2009, the IASB published IFRS 9 Financial Instruments which addresses the classification and measurement of financial assets. In October 2010, the requirements for classifying and measuring financial liabilities were added to IFRS 9. In November 2011, the IASB decided to make targeted improvements to IFRS 9. In December 2011, the IASB amended the effective date and transition requirements of IFRS 9 to provide the Board more time to make the improvements to IFRS 9, complete the remaining phases of the financial instruments project and finalise the insurance project. The objective of the targeted improvements to IFRS 9 is to address specific application questions raised by constituents, consider the interaction of the classification and measurement model for financial assets with the insurance project, and to consider differences with the FASB s tentative decisions on classification and measurement. In January 2012, the IASB and FASB (the Boards) agreed to jointly redeliberate selected aspects of their respective classification and measurement models. Their efforts have focused on: the contractual cash flow characteristics of financial assets; the need, and basis for, bifurcating financial assets; the basis for and the scope of a possible third classification category to measure debt instruments at fair value through other comprehensive income; and interrelated issues from these topics. The July 2012 joint meeting was likely the final joint meeting between the Boards prior to the publishing of an exposure draft. The IASB intends to publish an exposure draft during the fourth quarter of 2012. Tentative decisions reached during redeliberations Topic discussed at the September 2012 meeting Transition: o Presentation of gains or losses on financial liabilities arising from changes in own credit risk o Limited amendments to classification and measurement Prior-period disclosures for classification and measurement Current-period disclosures for classification and measurement o IFRS 9 as a whole Phased early application of IFRS 9 New or amended tentative decisions as a result of the September 2012 meeting have been referenced below. 1

Contractual cash flow criteria The Boards tentatively decided that a financial asset could be eligible for a measurement category other than fair value through profit or loss ( FVTPL ) (presuming the business model criterion is also met) if the contractual terms of the financial asset result in cash flows that are solely payments of principal and interest on the principal amount outstanding. Principal is considered the amount transferred at initial recognition while interest is consideration for the time value of money and the associated credit risk. If a financial asset contains a component other than principal or compensation for time value of money and credit risk, then the financial asset must be measured at FVTPL. If the financial asset only contains components that are principal and consideration for the time value of money and credit risk, but the relationship between the components is modified, an entity would need to consider the effect of the modification when assessing whether the cash flows on the financial asset are still consistent with the notion of being solely principal and interest. The Boards tentatively decided that contractual terms which change the timing or amount of payments of principal and interest would not preclude the financial asset from being eligible for a measurement category other than FVTPL if the variability reflects only changes in the time value of money and the associated credit risk of the instrument. The Boards also tentatively decided that the probability of contingent cash flows that are not solely principal and interest should not be considered. Financial assets that contain contingent cash flows that are not solely principal and interest would be measured at FVTPL unless they relate to non-genuine features. For the IASB, this does not represent a change to IFRS 9. The Boards tentatively decided an entity would need to compare a financial asset with modified features (e.g., a variable interest rate that does not match the interest rate reset period) to a benchmark instrument that contains features that are solely principal and interest to assess the effect of the modification. 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. The Boards also tentatively decided that if the difference between the cash flows of the benchmark instrument and the instrument under assessment is more than insignificant, the instrument must be measured at FVTPL as its contractual cash flows do not represent solely principal and interest. The Boards tentatively decided that a prepayment or extension option, including those whose exercise are based on contingencies, would not preclude a financial asset from being eligible for a measurement category other than FVTPL as long as these features are consistent with the notions of solely principal and interest. No changes to IFRS 9 would be needed based on this tentative decision but for the FASB, this guidance will be included as part of the contractual cash flow characteristics assessment. Introduction of a FVTOCI category for debt investments The IASB tentatively decided to introduce a fair value through other comprehensive income ( FVTOCI ) classification category for debt investments to IFRS 9. The Board decided that interest income would be recognised in profit or loss utilising the effective interest method and credit impairment losses and reversals would be recognised in profit or loss using the same methodology as those instruments measured at amortised cost. The Board also tentatively decided the cumulative fair value gains or losses recognised in other comprehensive income would be recycled to profit or loss upon derecognition. The IASB and the FASB then discussed the scope of the FVTOCI measurement category for debt instruments and reaffirmed that a debt instrument would be measured at FVTOCI only if: The debt instrument passes the contractual cash flow characteristics assessment (see the Contractual cash flow criteria section above); and The debt instrument is managed within the relevant business model (see the Business model assessment for FVTPL and FVTOCI for financial assets section below). 2

Business model assessment for amortised cost classification for financial assets An entity assesses both the cash flow characteristics of financial assets and its business model to determine which financial assets should be classified and measured at amortised cost. The Boards tentatively decided that financial assets would qualify for amortised cost if the assets are held within a business model whose objective is to hold the assets in order to collect contractual cash flows. The Boards tentatively decided to provide 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. Business model assessment for FVTPL and FVTOCI for financial assets The Board tentatively decided to define the objective of the business model that results in classifying financial assets at FVTOCI and as a result, those business models which do not qualify for either amortised cost or FVTOCI would be measured at FVTPL (the residual category). The business model for classifying financial assets at FVTOCI would be a portfolio of financial assets managed with the objective of both collecting contractual cash flows and selling financial assets. Reclassification of financial assets between measurement categories Scope of reclassifications of financial assets between measurement categories The IASB agreed to extend the current reclassification requirements in IFRS 9 to the FVTOCI category with the disclosure requirements in IFRS 7 Financial Instruments: Disclosures applying to all reclassifications. The FASB also agreed to require reclassification of financial assets when the business model changes. IFRS 9 currently requires that the reclassification occurs at the beginning of the period following the change in business model. Reclassification date The IASB did not consider this issue given current requirements in IFRS 9 to recognise reclassifications as of the first day of the period beginning immediately after the period in which the change in business model that results in a reclassification occurs. The FASB tentatively decided not to converge with the current IFRS 9 requirement. Rather, the FASB tentatively decided that entities should recognise reclassifications between any of the categories as of the last day of the period in which the change in business model that results in a reclassification occurs. The FASB will discuss disclosures related to reclassifications under its model at a later date. IFRS 9 does not require disclosures describing the reclassification or financial statement impact until the reclassification is recognised. Reclassification mechanics Both Boards tentatively agreed that entities should account for reclassifications between categories as follows: For reclassifications from FVTOCI to FVTPL, amounts accumulated in other comprehensive income ( OCI ) are recycled from OCI to profit or loss, and the financial asset continues to be measured at fair value. For reclassifications from FVTPL to FVTOCI, changes in fair value occurring after the reclassification date are recognised in OCI, and the financial asset continues to be measured at fair value. On the date a reclassification is recognised, an entity should calculate an effective interest rate ( EIR ) on the basis of the new carrying amount (i.e., fair value on the reclassification date) to determine the amounts of interest and amortisation it should recognise in profit or loss going forward. For reclassifications from amortised cost to FVTOCI, the financial asset is remeasured at fair value, and any difference between the amortised cost and fair value is recognised in OCI. 3

For reclassifications from FVTOCI to amortised cost, the financial asset is transferred at fair value, but amounts accumulated in OCI are derecognised with an offsetting entry to the financial asset balance (i.e., the new carrying amount is treated as though it had always been classified at amortised cost). The FASB alone tentatively decided that entities should account for reclassifications between categories as follows: For reclassifications from FVTPL to amortised cost, the fair value of the financial instrument becomes the amortised cost on the reclassification date, and an entity would calculate the EIR on the basis of this new carrying amount. This accounting is consistent with existing requirements in IFRS 9. For reclassifications from amortised cost to FVTPL, an entity remeasures the asset at fair value and recognises the difference between amortised cost and fair value in profit or loss. This accounting is also consistent with IFRS 9. Bifurcation of financial assets and financial liabilities The Boards tentatively decided that financial assets that contain cash flows that are not solely principal and interest would not be eligible for bifurcation. Instead, the entire instrument would be classified and measured at fair value through profit or loss. This tentative decision is consistent with the current classification and measurement model in IFRS 9 but eliminates the bifurcation requirements for financial assets in the FASB s tentative model. The Boards tentatively decided that financial liabilities would be bifurcated using the existing requirements in IFRS 9 and US GAAP. Under this approach, the cash flow characteristics assessment would not be applied to financial liabilities. The 'own credit' requirements in IFRS 9 will be retained. Fair value option The FASB discussed the fair value option for financial assets and financial liabilities and tentatively decided to provide an irrevocable fair value option to designate hybrid financial liabilities at FVTPL unless the embedded derivative or derivatives do not significantly modify the cash flows that otherwise would be required by the contract or it is clear with little or no analysis when a similar hybrid instrument is first considered that separation of the embedded derivative or derivatives is prohibited. The FASB also tentatively decided to provide an irrevocable fair value option at initial recognition to designate a group of financial assets and liabilities at FVTPL if the entity manages the net exposure relating to those financial assets and financial liabilities (which may be derivative instruments) on a fair value basis and the entity provides information on that basis to the reporting entity s management. The IASB discussed the fair value option for debt investments measured at FVTOCI and tentatively decided to extend the current eligibility condition in IFRS 9 for designating financial assets under the accounting mismatch fair value option to debt investments that would otherwise be measured at FVTOCI if doing so eliminates or significantly reduces an accounting mismatch. Disclosure The IASB discussed disclosures related to reclassifying eligible debt investments into and out of the FVTOCI measurement category. The IASB tentatively decided that the reclassification disclosures in: paragraph 12B of IFRS 7 should be extended to all reclassifications into and out of FVTOCI. paragraph 12C of IFRS 7 should be extended to reclassifications from FVTPL to FVTOCI. paragraph 12D of IFRS 7 should be extended to apply to reclassifications from FVTPL to FVTOCI and from FVTOCI to amortised cost. The IASB also discussed presentation and disclosure requirements due to the proposed limited amendments to IFRS 9 and the interaction of proposed disclosures in the classification and measurement project with disclosures proposed in the impairment project. 4

Regarding the amended contractual cash flow characteristics assessment, the IASB tentatively decided: The judgement involved in the assessment of contractual cash flow characteristics should be added to IAS 1 Presentation of Financial Statements as an example of a judgement that could have a significant effect on the amounts recognised in the financial statements. Quantitative disclosures should not be required when the assessment of contractual cash flow characteristics could have a significant effect on the amounts recognised in the financial statements. Relating to the proposed addition of a FVTOCI category for eligible debt instruments, the IASB tentatively decided: No new requirements should be added related to the presentation of gains or losses arising from the derecognition of debt instruments measured at FVTOCI. The impairment disclosures for debt instruments measured at FVTOCI should be consistent with those for assets measured at amortised cost, including disclosure of an accumulated impairment amount. Presentation of an allowance balance on the face of the statement of financial position should be prohibited for debt instruments measured at FVTOCI. Transition The IASB discussed how and when the classification and measurement requirements in IFRS 9 should be applied. The IASB also discussed the transition to IFRS 9 as a whole considering the interaction between its phases, as well as disclosure requirements when an entity first applies IFRS 9. Presentation of gains or losses on financial liabilities arising from changes in own credit New The Board discussed relief to accelerate the application of the own credit requirements introduced by IFRS 9. Those requirements necessitate presentation of fair value gains or losses attributable to changes in the issuer s own credit risk for financial liabilities measured under the fair value option in the statement of other comprehensive income. The IASB tentatively decided to amend IFRS 9 to allow early application of the requirement for the presentation of fair value gains or losses attributable to changes in the issuer s own credit risk without the need to early apply IFRS 9 in its entirety. Limited amendments to classification and measurement Updated The IASB tentatively decided that on transition to the amended classification and measurement requirements, an entity would 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 flow characteristics assessment retrospectively; and disclose the carrying values of the financial assets whose contractual cash flows have been assessed under IFRS 9 (2010) as opposed to the amended classification and measurement 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 required as a result of: the proposed amendments to the business model assessment, or the proposed extension of the fair value option for accounting mismatches to debt instruments that would otherwise be measured at FVTOCI. 5

The IASB tentatively decided to confirm that in the period in which IFRS 9 is initially applied, disclosure of the line item amounts that would have been reported in prior periods in accordance with the classification and measurement model in IFRS 9 would not be required. Similarly, disclosure of the current-period line item amounts that would have been reported in accordance with the classification and measurement model in IAS 39 would not be required. IFRS 9 as a whole Updated The IASB tentatively decided that entities which have applied IFRS 9 (2009) or IFRS 9 (2010) before applying the limited amendments to IFRS 9 must revoke previous fair value option elections if an accounting mismatch no longer exists at initial application of the amended classification and measurement requirements. Entities would be permitted to apply the fair value option to new accounting mismatches created by the initial application of the amended classification and measurement requirements. The IASB tentatively decided that earlier versions of IFRS 9 should be withdrawn for early application six months after the publication of the final version of IFRS 9. For example, if all chapters of IFRS 9 were finalised on 30 June 2013, entities would no longer be permitted to early apply previous versions of IFRS 9 in reporting periods beginning on or after 1 January 2014. Those entities which applied a previous version of IFRS 9 prior to the publication of the complete version of IFRS 9 would be permitted to continue applying that version until the mandatory effective date of IFRS 9. The IASB also tentatively decided that early application of the entire IFRS 9 would be permitted once all of the requirements are issued. Finally, the IASB tentatively decided to reaffirm that restatement of comparative classification and measurement information would not be required. Entities would be permitted to restate comparative information only if the information is available without the use of hindsight. Next steps The IASB intends to publish an exposure draft in the fourth quarter of 2012. Deloitte refers to one or more of Deloitte Touche Tohmatsu Limited, a UK private company limited by guarantee, and its network of member firms, each of which is a legally separate and independent entity. Please see www.deloitte.com/about for a detailed description of the legal structure of Deloitte Touche Tohmatsu Limited and its member firms. Deloitte provides audit, tax, consulting, and financial advisory services to public and private clients spanning multiple industries. With a globally connected network of member firms in more than 150 countries, Deloitte brings world-class capabilities and high-quality service to clients, delivering the insights they need to address their most complex business challenges. Deloitte's more than 195,000 professionals are committed to becoming the standard of excellence. This publication contains general information only, and none of Deloitte Touche Tohmatsu Limited, its member firms, or their related entities (collectively the Deloitte Network ) is, by means of this publication, rendering professional advice or services. Before making any decision or taking any action that may affect your finances or your business, you should consult a qualified professional adviser. No entity in the Deloitte Network shall be responsible for any loss whatsoever sustained by any person who relies on this publication. 2012 Deloitte Global Services Limited 6