The Future Of IFRS Financial Instruments Accounting
IFRS NEWSLETTERIssue 2, May 2012FINANCIAL INSTRUMENTSIn May, the IASB made amajor decision to add a fair valuethrough other comprehensiveincome (FVOCI) measurementcategory to IFRS 9 for somedebt investments. Thisdecision represents anothersignificant step towardsconvergence.Andrew Vials,KPMG’s global IFRS FinancialInstruments leaderKPMG International StandardsGroupThe future of IFRS financialinstruments accountingThis edition of IFRS Newsletter: Financial Instruments highlightsthe discussions and tentative decisions of the IASB in May 2012 onthe financial instruments (IAS 39 replacement) project.HighlightsClassification and measurementlllThe IASB introduced a fair value through other comprehensive income (FVOCI)measurement category for eligible debt investments.FVOCI debt instruments will be measured on the statement of financial position at fair valuebut the income statement will reflect amortised cost accounting, with recycling of realisedgains/losses.Eligible debt instruments will be measured at FVOCI if they are held within a business modelwhose objective is both to hold financial assets to collect contractual cash flows and to sellfinancial assets.ImpairmentlllFor discounting expected impairment losses, an entity may use a rate between, and including, therisk-free rate and the effective interest rate.Modified financial assets will be considered for transfer between ‘buckets’ in the same way as otherfinancial assets and any impairment losses will be recognised against the gross carrying value of the asset.Impairment allowances for lease receivables may be measured similarly to trade receivables with asignificant financing component.Hedge accountingllA review draft of the revised general hedge accounting model is expected soon.The IASB has carved the macro hedging project out from the development of IFRS 9 and will prepare adiscussion paper towards the end of 2012. 2012 KPMG IFRG Limited, a UK company, limited by guarantee. All rights reserved.
THE RESURRECTION OF FVOCIThe 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 initially structured its project toreplace IAS 39 in three phases:Phase 1: Classification and measurement of financial assets and financial liabilitiesPhase 2: Impairment methodologyPhase 3: Hedge accountingIn December 2008, the FASB added a similar project to its agenda; however, the FASB has notfollowed the same phased approach as the IASB.The IASB issued IFRS 9 (2009) and IFRS 9 (2010), which contain the requirements for theclassification and measurement of financial assets and financial liabilities. Those standards havean effective date of 1 January 2015. The IASB is currently considering limited changes to theclassification and measurement requirements of IFRS 9 to address application questions, and toprovide an opportunity for the IASB and the FASB (the ‘Boards’) to reduce key differences betweentheir models.The Boards are also working jointly on a ‘three-bucket’ model for the impairment of financial assetsbased on expected credit losses – a model which represents a change from the Boards’ previouslyissued exposure documents. This is the third attempt by the Boards to define an impairmentmodel based on an expected loss approach, which will replace the current incurred loss model inIAS 39. The Boards originally published their own differing proposals in November 2009 (the IASB)and in May 2010 (the FASB). They next published a joint supplementary document on recognisingimpairment in open portfolios in January 2011.The IASB has split the hedge accounting phase into two parts: general hedging and macrohedging. It is close to issuing a review draft of a general hedging standard and is continuing to holdeducation sessions to develop a macro hedging model.What happened inMay?At the May 2012 meeting, the Boards met jointly to consider including a FVOCI measurementcategory for some investments in debt instruments. This was a significant convergence pointbecause today IFRS 9 only has two measurement categories: amortised cost and FVTPL, withan option to account for fair value changes on investments in equity instruments through othercomprehensive income (OCI). The IASB decided to add a FVOCI category in line with the FASB’stentative conclusion. After that decision, the Boards discussed the mechanics of the FVOCIcategory and reclassifications among categories.The Boards continued to develop a common impairment model. The Boards made a joint decisionto apply the ‘three-bucket’ model to lease receivables subject to practical expedients. The IASBdiscussed the discount rates used to measure expected losses and the treatment of modificationsof financial assets.The IASB also decided that it would work towards issuing a discussion paper on macro hedgingtowards the end of 2012.2 2012 KPMG IFRG Limited, a UK company, limited by guarantee. All rights reserved.
CLASSIFICATION AND MEASUREMENTWhat happened inMay?At the May 2012 meeting, the IASB continued its joint deliberations with the FASB. At thismeeting, topics discussed were: whether to introduce a FVOCI measurement category for some debt instruments in IFRS 9; how to determine the business model for the classification of eligible debt instruments atFVOCI; and reclassification of financial assets between measurement categories.(See Appendix A: Summary of IASB’s redeliberations on classification and measurement for asummary of the IASB’s decisions to date on its limited reconsideration of IFRS 9.)FVOCI debtinstruments willbe measured onthe statement offinancial positionat fair valuebut the incomestatement willreflect amortisedcost accounting,with recycling ofrealised gains/losses.Introducing a FVOCI measurement categoryThis was an IASB-only discussion because the FASB tentative model already includes a FVOCImeasurement category for financial assets that are debt instruments.Currently, under both IFRS 9 and the FASB’s tentative model, a financial asset is required to meettwo tests to be eligible for classification at other than fair value through profit or loss. The firsttest relates to the entity’s business model and the second test relates to the asset’s cash flowcharacteristics.Previously, the Boards had tentatively decided that – consistent with current IFRS 9: financial assets that contain cash flows that are not solely payments of principal and interest(P&I) would be classified and measured in their entirety at FVTPL; and financial assets with contractual cash flows that are solely payments of P&I (‘eligible debtinstruments’) would qualify for amortised cost measurement if the assets are held within abusiness model whose objective is to hold the assets to collect the contractual cash flows.In this meeting, the IASB discussed: whether to introduce a third measurement category to IFRS 9 such that some eligible debtinstruments are measured at FVOCI on the basis of the business model within which they areheld; and if so the ‘mechanics’ (i.e. how interest income and impairment should be recognised) of FVOCI debtinstruments.What did the staff recommend?The staff recommended that the IASB introduce a FVOCI measurement category to IFRS 9 foreligible debt instruments for the three reasons set out on the next page. 2012 KPMG IFRG Limited, a UK company, limited by guarantee. All rights reserved.3
1. Existence of abusiness modelwhere bothamortised costand fair valueinformation arerelevantThere are cases where a portfolio is ‘rebalanced’ more than infrequently– e.g. ‘liquidity portfolios’ within which financial assets are bought andsold to achieve a desired profile – and the portfolio as a whole wouldnot qualify for amortised cost accounting under IFRS 9. If so, it wouldbe required to be classified and measured at FVTPL. However, somefinancial assets within this portfolio might be held for substantial periodsof time for the collection of contractual cash flows. Classifying andmeasuring such portfolios in the same way as those that are activelymanaged to realise fair value changes may not provide the most relevantinformation to users of financial statements.The staff believe that both amortised cost and fair value informationare relevant for portfolios of financial assets that are held both for thecollection of the contractual cash flows and selling. A FVOCI categorywith recycling and recognition of interest income and credit impairmentin profit or loss (see later discussion on the ‘mechanics’) would provideboth types of information – i.e. amortised cost information in profit orloss and fair value information in the statement of financial position.2. Reducing keydifferenceswith the FASB’smodelThe FASB’s tentative model already contains a FVOCI category foreligible debt instruments. Introducing a FVOCI measurement categoryin IFRS 9 would meet the objective of reducing key differences with theFASB’s tentative model.3. Interaction withthe InsurancecontractsprojectIn response to the Insurance contracts exposure draft (ED), insurershave raised a concern about the potential accounting mismatch that mayarise in profit or loss due to the interaction between the accounting forfinancial assets under IFRS 9 and the accounting for insurance liabilitiesunder the ED. The introduction of a FVOCI measurement category foreligible debt instruments, in conjunction with recognising the effect ofchanges in the interest rate associated with insurance liabilities in OCI,may help to reduce such a mismatch.In terms of the ‘mechanics’ of a FVOCI category, the staff recommended that: the financial asset is recognised at fair value on the statement of financial position; interest income is recognised in profit or loss using the effective interest method that is appliedto financial assets measured at amortised cost; impairment losses and reversals are recognised in profit or loss using the same impairmentmethodology as for financial assets measured at amortised cost; and fair value gains and losses are recognised in OCI over the life of the financial asset and thecumulative fair value gain or loss is reclassified to profit or loss (i.e. recycled) when the financialasset is derecognised.What did the Boards decide?The IASB tentatively decided that an FVOCI measurement category for eligible debt instrumentsshould be added to IFRS 9.In respect of eligible debt instruments within this new measurement category, the Board alsoagreed with the staff’s recommendations and tentatively decided that: interest income on such instruments should be recognised in profit or loss using the effectiveinterest method that is applied to financial assets measured at amortised cost;4 2012 KPMG IFRG Limited, a UK company, limited by guarantee. All rights reserved.
credit impairment losses/reversals on such instruments should be recognised in profit or lossusing the same impairment methodology as for financial assets measured at amortised cost;and the cumulative fair value gain or loss recognised in OCI should be recycled from OCI to profit orloss when these financial assets are derecognised.Eligible debtinstruments willbe measured atFVOCI if they areheld within abusiness modelwhose objectiveis both to holdfinancial assets tocollect contractualcash flows andto sell financialassets.FVTPL will bethe residualmeasurementcategory forfinancial assets.FVOCI and FVTPL business model assessment for financialassetsThe Boards discussed the business model assessment for FVOCI and FVTPL in respect of eligibledebt instruments, including which measurement category should be defined and which should bea residual category.What did the staff recommend?The staff outlined two approaches for the Boards’ consideration.Approach 1:Define FVOCI, withFVTPL being theresidual categoryUnder this approach, the primary objective of a business model thatresults in classifying financial assets at FVOCI can be articulated asa business model for a portfolio of financial assets that is managedwith the objective of both collecting contractual cash flows and sellingfinancial assets.As discussed above, for such a business model, both amortised cost andfair value information are relevant and therefore FVOCI is the appropriatemeasurement attribute. Under this approach, eligible debt instrumentsthat do not meet the business model assessment for FVOCI oramortised cost classification would be classified at FVTPL – i.e. FVTPL isthe residual category.Approach 2:Define FVTPL, withFVOCI being theresidual categoryUnder this approach, eligible debt instruments that do not meet thebusiness model assessment for amortised cost measurement or a (tobe defined) business model assessment for FVTPL measurement wouldbe classified at FVOCI – i.e. FVOCI is the residual category.The staff identified two potential alternatives as to how the objective of abusiness model that results in classifying financial instruments at FVTPLcould be articulated.Alternative A: Financial assets are held-for-sale at initial recognition (thisalternative would entail defining the term ‘held-for-sale’).Alternative B: Financial assets are actively managed on a fair value basiswith the objective to realise cash flows through sales, including financialassets held for trading.The staff recommended Approach 1 for the Boards’ consideration. In their view, the advantageof Approach 1 is that it would strengthen and further clarify the objective of the business modelthat results in classifying financial assets at amortised cost. In their view, defining FVOCI wouldalso explicitly capture business models for which both amortised cost and fair value informationare relevant and therefore results in providing decision-useful information to users of financialstatements. 2012 KPMG IFRG Limited, a UK company, limited by guarantee. All rights reserved.5
What did the Boards decide?The Boards tentatively decided on Approach 1 – i.e. financial assets will be measured at FVOCI ifthey are eligible debt instruments and are held within a business model whose objective is bothto hold financial assets to collect contractual cash flows and to sell financial assets. Under thisapproach, eligible debt instruments that do not meet the business model assessment for FVOCIor amortised cost classification would be classified at FVTPL – i.e. FVTPL is the residual businessmodel.The Boards tentatively decided to provide application guidance on the types of business activitiesthat would qualify for the FVOCI business model.Existingreclassificationrequirementsunder IFRS 9are extendedto the FVOCImeasurementcategory.Reclassification of financial assetsThe Boards discussed whether, and in what circumstances, financial assets should be reclassified.What did the staff recommend?Currently, under IFRS 9, an entity is required to reclassify all affected financial assets when itchanges its business model for managing financial assets. Such changes: are expected to be very infrequent; have to be determined by the entity’s senior management as a result of external or internalchanges; and have to be significant to the entity’s operations and demonstrable to external parties.Such reclassifications are applied prospectively – i.e. all affected financial assets are reclassifiedfrom the reclassification date (first day of the next reporting period). A change in the objective ofthe entity’s business model has to be effected before the reclassification date.The staff recommended that the IASB extend the current reclassification requirements in IFRS 9to the FVOCI measurement category. The disclosure requirements in IFRS 7 would apply to allreclassifications.What did the Boards decide?The IASB tentatively decided that the current reclassification requirements in IFRS 9 shouldbe extended to the FVOCI measurement category. The FASB tentatively decided to adoptreclassification requirements like those in IFRS 9 – although it deferred discussion as to whetherreclassifications following a change in business model should be accounted for prospectively as ofthe first day of the entity’s next reporting period or the last day of its current reporting period.At a future meeting, the Boards will further consider how to account for reclassifications.Next stepsAt future meetings on the classification and measurement of financial instruments, the IASBwill consider any further inter-related issues, including transition, disclosures and other sweepissues. Some of these discussions may need to be held jointly with the FASB, while others maybe separate. The Boards will also consider what further changes, if any, they would like to make totheir respective models.The IASB expects to issue an exposure draft on changes to IFRS 9 in the second half of 2012.6 2012 KPMG IFRG Limited, a UK company, limited by guarantee. All rights reserved.
FVOCI is not thesame as AFS.KPMG Insight:Is FVOCI a return to AFS accounting?The IASB’s recent tentative decision to add a FVOCI classification to IFRS 9 may come asa surprise to many, given IFRS 9’s focus on reducing complexity by cutting the number ofmeasurement categories. To what extent is the new FVOCI classification a return to theavailable-for-sale (AFS) measurement category in IAS 39?Here we take a look at similarities and differences between the AFS category under IAS 39 asit applies to debt instruments and the new FVOCI category proposed by the Board.1IAS 39 AFS categoryNew FVOCI categoryIs there adifference?Applicable to non-derivative debtinstruments generally – althoughembedded derivatives might requirebifurcation.Applicable to eligible debt instrumentsonly (i.e. financial assets thatpass the cash flow characteristicsassessment).1 An entity may designate anon-derivative financial assetas available-for-sale on initialrecognition.FVOCI is a defined category andassets are classified as FVOCI if andonly if they meet specified criteria –i.e. eligible debt instruments mustbe measured at FVOCI if they areheld within a business model whoseobjective is both to hold financialassets to collect contractual cashflows and to sell financial assets. AFS is the residual category fornon-derivative financial assetsthat are not classified as loansand receivables, held to maturityinvestments or financial assets atfair value through profit or loss.FVTPL – not FVOCI – is the residualcategory for eligible debt instrumentsthat do not meet the business modelassessment for another classification.The financial asset is measuredat fair value on the statement offinancial position.The financial asset is measured at fairvalue on the statement of financialposition. Under IFRS 9, an equity investment that is not held for trading can be measured at FVOCI; however, the‘mechanics’ of the FVOCI model for equity investment are different and are not discussed here. 2012 KPMG IFRG Limited, a UK company, limited by guarantee. All rights reserved.7
8IAS 39 AFS categoryNew FVOCI categoryFair value gains and losses arerecognised in OCI over the life ofthe financial asset – except forimpairment losses and foreignexchange gains and losses that arerecognised in profit or loss.Fair value gains and losses arerecognised in OCI over the life of thefinancial asset – except for creditimpairment losses that are recognisedin profit or loss. The IASB did notdiscuss the treatment of foreignexchange gains and losses – but,based on the requirements of IAS 21The Effects of Changes in ForeignExchange Rates for monetary itemsand the apparent principle behindthe FVOCI category that profit or lossinformation would reflect amortisedcost accounting for the asset, wewould expect a similar approach toforeign exchange gains and losses.Impairment losses are assessedusing an incurred loss model andmeasured on a fair value basis.Credit impairment losses andreversals are recognised usingthe same credit impairmentmethodology as for financial assetsmeasured at amortised cost. TheIASB is developing an expected lossimpairment model.Interest
The future of IFRS financial instruments accounting This edition of IFRS Newsletter: Financial Instruments highlights . This is the third attempt by the Boards to define an impairment model based on an expected loss approa
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