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Financial Instruments, Issue 18, December 2013 PDF

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Preview Financial Instruments, Issue 18, December 2013

Issue 18, December 2013 IFRS NEWSLETTER FINANCIAL INSTRUMENTS During 2013, signifcant progress has been made on the fnancial instruments project. We look forward to the classifcation and measurement and impairment phases being fnalised in 2014. Chris Spall The future of IFRS fnancial KPMG’s global IFRS fnancial instruments leader instruments accounting This edition of IFRS Newsletter: Financial Instruments highlights the discussions of the IASB in December 2013 on the fnancial instruments (IAS 39 replacement) project. Highlights Classifcation and measurement l    The IASB and the FASB (the Boards) decided that the fair value option in IFRS 9 Financial Instruments would also apply to fnancial assets that would otherwise be mandatorily measured at fair value through other comprehensive income (FVOCI). Impairment l    The IASB reached tentative decisions on: –    the measurement and presentation of expected credit losses on fnancial guarantee contracts and loan commitments other than revolving credit facilities; and –    transition requirements. Fair value measurement l    The IASB reached a tentative decision on applying the portfolio measurement exception when the portfolio is fully made up of Level 1 fnancial instruments. © 2013 KPMG IFRG Limited, a UK company, limited by guarantee. All rights reserved. REDELIBERATIONS WILL EXTEND INTO 2014 The story so far … What happened in December 2013? Since November 2008, the IASB has been working to At the December 2013 meeting, the IASB continued its replace its fnancial instruments standard (IAS 39 Financial redeliberations on the classifcation and measurement and Instruments: Recognition and Measurement) with an impairment phases of IFRS 9, and also discussed an issue improved and simplifed standard. The IASB structured its related to IFRS 13 Fair Value Measurement on measuring project in three phases: portfolios of fnancial instruments. • Phase 1: Classifcation and measurement of fnancial assets and fnancial liabilities In the classifcation and measurement project, the Boards • Phase 2: Impairment methodology extended the scope of the fair value option to fnancial assets • Phase 3: Hedge accounting. that would otherwise be mandatorily measured at FVOCI. In December 2008, the FASB added a similar project to In the impairment project, the IASB discussed the its agenda; however, the FASB has not followed the same measurement and presentation of expected credit losses on phased approach as the IASB. fnancial guarantee contracts and loan commitments other than revolving credit facilities. It also discussed transition Classifcation and measurement requirements. The IASB issued IFRS 9 Financial Instruments (2009) and Finally, the IASB considered the application of the portfolio IFRS 9 (2010), which contain the requirements for the measurement exception in measuring fair value when the classifcation and measurement of fnancial assets and portfolio is fully made up of Level 1 fnancial instruments. This fnancial liabilities. In November 2012, the IASB issued discussion forms part of its project to clarify: an exposure draft (ED) on limited amendments to the classifcation and measurement requirements of IFRS 9 • the unit of account for measuring the fair value of fnancial (the C&M ED). assets that are investments in a subsidiary, joint venture or The FASB issued a revised ED in February 2013 – the associate, and proposed Accounting Standards Update, Financial • the interaction with the use of Level 1 inputs. Instruments—Overall (Subtopic 825-10): Recognition and Measurement of Financial Assets and Financial Liabilities This meeting concluded a busy 2013 for the IASB’s work on (the proposed ASU). Separate and joint redeliberations the fnancial instruments project. Over the past few months, by the Boards on the classifcation and measurement the IASB has made signifcant progress on its redeliberations proposals are ongoing. The IASB plans to issue a fnal for the classifcation and measurement and impairment standard by mid-2014. phases of IFRS 9. However, several items remain open for discussion in 2014. Impairment The Boards were working jointly on a model for the impairment of fnancial assets based on expected credit losses, which would replace the current incurred loss model in IAS 39. 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 2011. However, at the July 2012 joint meeting the FASB Contents expressed concern about the direction of the joint project and in December 2012 issued an ED of its own impairment model, the current expected credit loss model. Meanwhile, the IASB continued to develop separately its three-bucket impairment model, and issued a new ED in March 2013 (the impairment ED). Separate and joint redeliberations by the Boards on the impairment proposals are ongoing, and the IASB plans to issue a fnal standard by mid-2014. Hedge accounting The IASB has split the hedge accounting phase into two parts: general hedging and macro hedging. The IASB issued a new general hedging standard as part of IFRS 9 (2013) in November 2013, and is working towards issuing a discussion paper (DP) on macro hedging in early 2014. 2 © 2013 KPMG IFRG Limited, a UK company, limited by guarantee. All rights reserved. KEY DECISIONS MADE THIS MONTH Classifcation and measurement The fair value option in IFRS 9 would apply to fnancial assets that would otherwise be mandatorily measured at FVOCI. Impairment • The IASB reached the following tentative decisions on the measurement and presentation of expected credit losses on fnancial guarantee contracts and loan commitments other than revolving credit facilities: – the maximum period over which expected credit losses should be estimated is the contractual period over which the entity is committed to provide credit; – the same discount rate would be applied to the drawn and undrawn component of the balance, unless the effective interest rate (EIR) cannot be determined, in which case the discount rate should be determined as proposed in the impairment ED; and – the provision for expected credit losses on the undrawn balance would be presented together with the loss allowance on the drawn amount if an entity cannot separately identify the expected credit losses associated with the undrawn balance. • In respect of the transitional requirements the IASB tentatively: – decided to retain the proposal to apply the fnal requirements retrospectively; – confrmed that the ‘low credit risk exception’ may be used to identify fnancial instruments for which there has been no signifcant increase in credit risk; – clarifed that entities could approximate credit risk at initial recognition by using the best available information that is available without undue cost or effort; – confrmed that if an entity is not able to determine or approximate credit risk on initial recognition it would measure the loss allowance based on the credit quality at each reporting date until the asset is derecognised; and – decided to provide, in the fnal standard, application guidance or examples to describe how an entity would assess whether there has been a signifcant increase in credit risk where it uses: - the ‘more than 30 days past due rebuttable presumption’ if the entity identifes increases in credit risk according to days past due; and - a comparison of the credit risk at the date of transition to the initial maximum credit risk (by product type and/or region). Fair value measurement • The IASB tentatively decided that the portfolio measurement exception can be applied to portfolios made up of Level 1 fnancial instruments. The fair value should be measured on the basis of the Level 1 prices for the individual instruments that comprise the net risk exposure. © 2013 KPMG IFRG Limited, a UK company, limited by guarantee. All rights reserved. 3 CLASSIFICATION AND MEASUREMENT The fair value Fair value option extension option in IFRS 9 What’s the issue? would also apply to fnancial IFRS 9 has two measurement categories – amortised cost and fair value through proft or loss (FVTPL). The standard provides an irrevocable option to designate a fnancial asset at initial assets that recognition as measured at FVTPL if doing so eliminates or signifcantly reduces a measurement would otherwise or recognition inconsistency – referred to as ‘an accounting mismatch’. This fair value option be mandatorily applies only to fnancial assets that would otherwise be mandatorily measured at amortised cost. measured at In the C&M ED, the IASB proposed: FVOCI. • introducing a third mandatory measurement category – FVOCI; and • extending the fair value option in IFRS 9 so that it would also apply to fnancial assets that would otherwise be mandatorily measured at FVOCI. What did the staff recommend? The staff noted that nearly all respondents agreed with the C&M ED’s proposal to extend the fair value option to fnancial assets that would otherwise be mandatorily measured at FVOCI. Some respondents advocated an unrestricted fair value option for assets that would otherwise be measured at amortised cost or FVOCI. The staff believed that if assets and liabilities have an economic relationship that gives rise to an offsetting effect in their valuation, then accounting for them using the same measurement attribute – i.e. FVTPL – may provide the most relevant information to users of fnancial statements. The staff recommended that the IASB confrm its proposals in the C&M ED. In accordance with the existing fair value option in IFRS 9, the designation would need to be performed at initial recognition and would be irrevocable. What did the Boards decide? The Boards agreed with the staff recommendation. Next steps At forthcoming meetings, the IASB will discuss the following topics, which will complete the IASB’s redeliberations of the proposals in the C&M ED: • the interaction between the accounting for fnancial assets and insurance contract liabilities under the IASB’s insurance contracts project and various related issues; • the presentation and disclosure requirements proposed in the C&M ED; and • transition. 4 © 2013 KPMG IFRG Limited, a UK company, limited by guarantee. All rights reserved. IMPAIRMENT The IASB Financial guarantee contracts and loan commitments reached tentative What’s the issue? decisions on the measurement Under the impairment ED, an entity would recognise a provision for expected credit losses on loan commitments and fnancial guarantees when it has a present contractual obligation to extend and presentation credit. The provision would be calculated using the estimated usage behaviour over a period during of expected which a present legal obligation exists to extend credit. credit losses An entity would measure expected credit losses on these instruments using a discount rate on fnancial that refects the current market assessment of the time value of money and the risks that are guarantee specifc to the cash fows. By contrast, expected credit losses on drawn-down amounts would be measured using a discount rate that is any reasonable rate between, and including, the risk-free contracts rate and the EIR1. and loan commitments In its November 2013 meeting, the IASB tentatively decided that, for revolving credit facilities: other than • expected credit losses – including those on the undrawn facility – would be estimated for the revolving credit period over which an entity is exposed to credit risk and future draw-downs cannot be avoided – i.e. considering the behavioural life; facilities. • expected credit losses on the undrawn component of the facility would be discounted using the same EIR, or an approximation thereof, as would be used to discount the drawn component; and • the provision for expected credit losses on the undrawn component of the facility would be presented together with the loss allowance on the drawn facility if an entity cannot separately identify the expected credit losses associated with the undrawn facility. In November, the Board requested that the staff perform further analysis to assess whether the tentative decisions above should apply also to fnancial guarantee contracts and loan commitments other than revolving credit facilities. What did the staff recommend? The staff recommended that: • the Board reconfrm the proposals in the impairment ED that – for fnancial guarantee contracts and loan commitments other than revolving credit facilities – the maximum period over which expected credit losses should be estimated is the contractual period over which the entity is committed to provide credit; • the following November 2013 tentative decisions in respect of revolving credit facilities be extended to all fnancial guarantee contracts and loan commitments: – expected credit losses on the undrawn part of the balance would be discounted using the same EIR, or an approximation thereof, as would be used to discount the drawn part, unless the EIR cannot be determined, in which case the discount rate should be determined as proposed in the impairment ED – i.e. it should refect the current market assessment of the time value of money and the risks that are specifc to the cash fows; and – the provision for expected credit losses on the undrawn balance would be presented together with the loss allowance on the drawn amount if an entity cannot separately identify the expected credit losses associated with the undrawn balance. 1 The impairment ED proposed that the discount rate to be used to determine expected credit losses on fnancial assets could be any reasonable rate that is between, and including, the risk-free rate and the EIR. Subsequently, at its October 2013 meeting, the IASB tentatively decided to require that the expected credit losses be determined using the EIR or an approximation thereof. © 2013 KPMG IFRG Limited, a UK company, limited by guarantee. All rights reserved. 5 What did the IASB decide? The Board agreed with the staff recommendations. KPMG Insights The IASB’s tentative decisions are a welcome development, as they would ease the operability of the proposals by aligning them more closely with the way banks manage their credit risk. Similarly, many constituents would support the tentative decision to present a provision for expected credit losses on the undrawn balance together with the loss allowance on the drawn amount if the expected credit losses associated with the undrawn balance cannot be identifed. The IASB Transition requirements provided What’s the issue? clarifcation on Under the impairment ED, an entity would apply the proposed standard retrospectively in the transition accordance with IAS 8 Accounting Policies, Changes in Accounting Estimates and Errors. This requirements. would mean that the new requirements would be applied as if they had always been applied. The impairment ED contained the following exemptions from full retrospective application. • If determining the credit risk of an asset at initial recognition would require undue cost or effort, then an entity would determine the loss allowance or provision only on the basis of whether the fnancial asset has a low credit risk at each reporting date until that fnancial asset is derecognised. • The restatement of prior periods would not be required, but permitted if the information is available without the use of hindsight. The majority of respondents supported the transition proposals, arguing that they achieve a balance between the cost and presentation of relevant information. However, some asked the IASB to consider practical approaches to assess increases in credit risk at transition, if the information is not available retrospectively. Others requested clarifcation of: • the interaction between the more than 30 days past due rebuttable presumption and the transition proposals; and • whether delinquency and other relevant information can be considered in assessing signifcant increases in credit risk at transition. Some respondents asked for the same requirements to apply to frst-time adoption of IFRS. Proposals for frst-time adoption will be considered by the IASB at a future meeting. What did the staff recommend? The staff recommended that some proposed transition requirements in the impairment ED be clarifed. They recommended that the Board reconfrm that: • the fnal requirements would be applied retrospectively in accordance with IAS 8; and • the following exemptions from full retrospective application would be available: – the low credit risk exception to identify fnancial instruments for which the credit risk has not increased signifcantly; and 6 © 2013 KPMG IFRG Limited, a UK company, limited by guarantee. All rights reserved. – the more than 30 days past due rebuttable presumption if the entity identifes increases in credit risk according to days past due. The staff also recommended that the Board acknowledge that – consistent with its October 2013 tentative decision on the general principles of the impairment model – entities could assess signifcant increases in credit risk by comparing: • the maximum credit risk for a particular portfolio (by product type and/or region) of fnancial instruments with similar credit risk – the ‘origination’ credit risk; with • the credit risk of the fnancial instruments in that portfolio on transition. For the remaining fnancial assets – for which an assessment of whether credit risk has increased signifcantly would be required at transition – the staff recommended that the transition requirements be clarifed to state that the loss allowance should be measured using lifetime expected credit losses until the fnancial instrument is derecognised – unless an entity is able to obtain or approximate the credit risk on initial recognition using the best information that is available without undue cost or effort. The best available information is information that is: • reasonably available and does not require the entity to undertake an exhaustive search; and • relevant in determining or approximating the credit risk at initial recognition. What did the IASB decide? The Board agreed with the staff recommendations and confrmed the proposed requirements on retrospective application and the low credit risk exception. The Board also tentatively decided that an entity could approximate the credit risk at initial recognition by considering the best information that is available without undue cost or effort. If an entity is not able to determine or approximate the credit risk on initial recognition, then it would measure the loss allowance based on the credit quality at each reporting date until the asset is derecognised. Furthermore, the IASB tentatively decided to provide, in the fnal standard, application guidance or examples to describe how an entity would assess whether there has been a signifcant increase in credit risk where it uses: • the more than 30 days past due rebuttable presumption if the entity identifes increases in credit risk according to days past due; and • a comparison of the credit risk at the date of transition to the initial maximum credit risk (by product type and/or region). Next steps At forthcoming meetings, the IASB intends to discuss the following topics: • disclosures; • frst-time adoption of IFRS; and • any potential sweep issues. The staff proposed summarising the model – including tentative decisions made during deliberations. In addition, the staff will provide the IASB with an update on the FASB’s discussions. © 2013 KPMG IFRG Limited, a UK company, limited by guarantee. All rights reserved. 7 FAIR VALUE MEASUREMENT – PORTFOLIO MEASUREMENT EXCEPTION The portfolio What’s the issue? measurement The IASB has begun a project to clarify the unit of account for measuring the fair value of fnancial exception can assets that are investments in a subsidiary, joint venture or associate – i.e. whether the unit of be applied account should be: to portfolios • the investment as a whole; accordingly, the valuation may include a premium – e.g. a control made up of premium; or Level 1 fnancial • the individual shares making up the investment; accordingly, the valuation could not include a instruments. Fair premium, due to the size of the investment. value should be The project would also clarify the interaction between the unit of account and the use of Level 1 measured on inputs. the basis of the At its March 2013 meeting, the IASB tentatively decided that: Level 1 prices for • the unit of account for investments in subsidiaries, joint ventures or associates would be the the individual investment as a whole; but instruments that • the fair value measurement of an investment composed of quoted fnancial instruments should comprise the net be the product (P × Q) of the quoted price of the fnancial instrument (P) and the quantity (Q) of risk exposure. instruments held. The second decision was made on the basis that quoted prices in an active market provide the most reliable evidence of fair value. A similar issue arises in the interaction between the unit of account and the use of Level 1 prices when applying the portfolio measurement exception to a group of fnancial instruments, when permitted by IFRS 13 Fair Value Measurement. This issue was discussed at the December 2013 meeting. What did the staff recommend? The staff discussed the following questions in respect of the interaction between the application of the portfolio measurement exception and the use of Level 1 inputs: • whether the portfolio measurement exception can be applied to a portfolio fully made up of Level 1 fnancial instruments; and; • if so, whether the entity would: – be required to measure the net risk exposure on the basis of the Level 1 prices for the individual instruments that comprise the net risk exposure; or – be allowed to consider the net risk exposure as a whole, and consequently adjust the fair value measurement for any relevant premium or discounts that refect the size of the net position. The staff considered the following example in the discussion. Entity A has a long position of 10,000 individual fnancial assets and a short position of 9,500 individual fnancial liabilities for which the market risks are substantially the same. All fnancial instruments are categorised in Level 1 of the fair value hierarchy. The entity applies the portfolio measurement exception for measuring its net position. 8 © 2013 KPMG IFRG Limited, a UK company, limited by guarantee. All rights reserved. Bid and ask prices and most representative exit prices within the bid-ask spread are as follows. Bid Mid Ask Prices 98 100 102 Most representative exit price 99 (for assets) 101 (for liabilities) The most representative exit price for the net position of 500 fnancial assets is 45,000 – i.e. a discount of 5,000 to the mid-market price. The staff considered the following views on how to measure the fair value of the net position in the portfolio. View A The portfolio Under this view, the guidance that restricts adjustment to measurement Level 1 inputs would over-ride the application of the portfolio exception measurement exception. The fair value of the net position in the cannot be portfolio would be 30,500, calculated as follows. applied to Quantity held Most P × Q portfolios (Q) representative made up of quoted market Level 1 fnancial price (P) instruments Financial assets 10,000 99 990,000 Financial liabilities 9,500 101 (959,500) Net long position 500 30,500 B The portfolio Under this view: measurement • the offsetting of assets and liabilities in the portfolio would be exception can measured using the same price within the bid-ask spread – be applied assuming that the market risks are substantially the same; and to portfolios made up of • the individual instruments comprising the net exposure would Level 1 fnancial be measured using the Level 1 price – the most representative instruments, price within the bid-ask spread – without further adjustments. and the fair The fair value of the net position in the portfolio would be 49,500, value should be calculated as follows. measured on the basis of the Quantity held Quoted market P × Q Level 1 prices for (Q) price (P) the individual Financial assets 10,000 99 990,000 instruments that 2 comprise the net Financial liabilities 9,500 99 (940,500) risk exposure Net long position 500 49,500 2 2 The measurement of the fair value of the liabilities uses the same price as for the fnancial assets, because they are fully offset by the assets. © 2013 KPMG IFRG Limited, a UK company, limited by guarantee. All rights reserved. 9 View C The unit of Under this view, the portfolio measurement exception can be measurement applied to portfolios made up of Level 1 fnancial instruments, but, in is the net risk contrast to View B, size is a characteristic that should be considered exposure, and when measuring the fair value of the net position as a whole. therefore the However, the portfolio measurement exception is intended to refect size of the net circumstances where portfolio management maximises value. risk exposure is Therefore, fair value under the portfolio exception should not be a characteristic lower than if the portfolio measurement exception were not applied. to be The fair value of the net position in the portfolio would be 45,000 considered – the fair value would equate to the valuation of the net position of in measuring 500 fnancial assets (49,500 as in View B) adjusted by a discount for the fair value. size of 4,500. This is the most representative exit price for the net However, position as a whole when sold as a block, which is higher than the the fair value fair value when the portfolio measurement exception is not applied should not be – i.e. 30,500, as in View A. lower than if the portfolio measurement exception were not applied The staff recommended View B, for the following reasons. • They believed that the IASB’s intention was not to restrict the application of the portfolio measurement exception to portfolios exclusively made up of Level 2 and/or Level 3 fnancial instruments. 3 • View B would be consistent with practice under IAS 39 , which the IASB did not intend to change. • IFRS 13 does not allow adjustments to Level 1 prices, except in specifc circumstances. • Blockage factors are not permitted under IFRS 13. • They believed that the measurement resulting from View B would represent the way in which market participants would price the net risk exposure. • View B would maximise value for the entity. The staff also believed that View B results from direct application of IFRS 13, and that no amendment to IFRS 13 is therefore needed to clarify this issue. However, because the submission refects the existence of different views, the staff recommended including a non-authoritative illustrative example as part of the forthcoming ED on this project. Its aim would be to illustrate the use of the portfolio measurement exception for a portfolio fully comprising Level 1 instruments. 33 Based on paragraph AG72 of IAS 39, which has been deleted by IFRS 13. 10 © 2013 KPMG IFRG Limited, a UK company, limited by guarantee. All rights reserved.

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