the future of ifrs financial instruments accounting...the iasb issued ifrs 9 (2009) and ifrs 9...

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© 2012 KPMG IFRG Limited, a UK company, limited by guarantee. All rights reserved. The future of IFRS financial instruments accounting This edition of IFRS Newsletter: Financial Instruments highlights the discussions and tentative decisions of the IASB in May 2012 on the financial instruments (IAS 39 replacement) project. Highlights Classification and measurement l   The IASB introduced a fair value through other comprehensive income (FVOCI) measurement category for eligible debt investments. l   FVOCI debt instruments will be measured on the statement of financial position at fair value but the income statement will reflect amortised cost accounting, with recycling of realised gains/losses. l   Eligible debt instruments will be measured at FVOCI if they are held within a business model whose objective is both to hold financial assets to collect contractual cash flows and to sell financial assets. Impairment l   For discounting expected impairment losses, an entity may use a rate between, and including, the risk-free rate and the effective interest rate. l   Modified financial assets will be considered for transfer between ‘buckets’ in the same way as other financial assets and any impairment losses will be recognised against the gross carrying value of the asset. l   Impairment allowances for lease receivables may be measured similarly to trade receivables with a significant financing component. Hedge accounting l   A review draft of the revised general hedge accounting model is expected soon. l   The IASB has carved the macro hedging project out from the development of IFRS 9 and will prepare a discussion paper towards the end of 2012. In May, the IASB made a major decision to add a fair value through other comprehensive income (FVOCI) measurement category to IFRS 9 for some debt investments. This decision represents another significant step towards convergence. Andrew Vials, KPMG’s global IFRS Financial Instruments leader KPMG International Standards Group IFRS NEWSLETTER FINANCIAL INSTRUMENTS Issue 2, May 2012

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Page 1: The future of IFRS financial instruments accounting...The IASB issued IFRS 9 (2009) and IFRS 9 (2010), which contain the requirements for the classification and measurement of financial

© 2012 KPMG IFRG Limited, a UK company, limited by guarantee. All rights reserved.

The future of IFRS financial instruments accounting

This edition of IFRS Newsletter: Financial Instruments highlights the discussions and tentative decisions of the IASB in May 2012 on

the financial instruments (IAS 39 replacement) project.

Highlights

Classification and measurement

l   The IASB introduced a fair value through other comprehensive income (FVOCI) measurement category for eligible debt investments.

l   FVOCI debt instruments will be measured on the statement of financial position at fair value but the income statement will reflect amortised cost accounting, with recycling of realised

gains/losses.

l   Eligible debt instruments will be measured at FVOCI if they are held within a business model whose objective is both to hold financial assets to collect contractual cash flows and to sell

financial assets.

Impairment

l   For discounting expected impairment losses, an entity may use a rate between, and including, the risk-free rate and the effective interest rate.

l   Modified financial assets will be considered for transfer between ‘buckets’ in the same way as other financial assets and any impairment losses will be recognised against the gross carrying value of the asset.

l   Impairment allowances for lease receivables may be measured similarly to trade receivables with a significant financing component.

Hedge accounting

l   A review draft of the revised general hedge accounting model is expected soon.

l   The IASB has carved the macro hedging project out from the development of IFRS 9 and will prepare a discussion paper towards the end of 2012.

In May, the IASB made a major decision to add a fair value through other comprehensive income (FVOCI) measurement category to IFRS 9 for some debt investments. This decision represents another significant step towards convergence.

Andrew Vials,KPMG’s global IFRS Financial Instruments leader KPMG International Standards Group

IFRS NEWSLETTER FINANCIAL INSTRUMENTS

Issue 2, May 2012

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THE RESURRECTION OF FVOCI

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 initially structured its project to replace IAS 39 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 (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 2015. 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 IASB and the FASB (the ‘Boards’) to reduce key differences between their models.

The Boards are also working jointly on a ‘three-bucket’ model for the impairment of financial assets based on expected credit losses – a model which represents a change from the Boards’ previously issued exposure documents. This is the third attempt by the Boards to define an impairment model based on an expected loss approach, which will replace the current incurred loss model in IAS 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 recognising impairment in open portfolios in January 2011.

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 continuing to hold education sessions to develop a macro hedging model.

What happened in May?

At the May 2012 meeting, the Boards met jointly to consider including a FVOCI measurement category for some investments in debt instruments. This was a significant convergence point because today IFRS 9 only has two measurement categories: amortised cost and FVTPL, with an option to account for fair value changes on investments in equity instruments through other comprehensive income (OCI). The IASB decided to add a FVOCI category in line with the FASB’s tentative conclusion. After that decision, the Boards discussed the mechanics of the FVOCI category and reclassifications among categories.

The Boards continued to develop a common impairment model. The Boards made a joint decision to apply the ‘three-bucket’ model to lease receivables subject to practical expedients. The IASB discussed the discount rates used to measure expected losses and the treatment of modifications of financial assets.

The IASB also decided that it would work towards issuing a discussion paper on macro hedging towards the end of 2012.

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CLASSIFICATION AND MEASUREMENT

What happened in May?

At the May 2012 meeting, the IASB continued its joint deliberations with the FASB. At this meeting, 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 at FVOCI; and

• reclassification of financial assets between measurement categories.

(See Appendix A: Summary of IASB’s redeliberations on classification and measurement for a summary of the IASB’s decisions to date on its limited reconsideration of IFRS 9.)

FVOCI debt instruments will be measured on the statement of financial position at fair value but the income statement will reflect amortised cost accounting, with recycling of realised gains/losses.

Introducing a FVOCI measurement categoryThis was an IASB-only discussion because the FASB tentative model already includes a FVOCI measurement 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 meet two tests to be eligible for classification at other than fair value through profit or loss. The first test relates to the entity’s business model and the second test relates to the asset’s cash flow characteristics.

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 debt instruments’) would qualify for amortised cost measurement if the assets are held within a business 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 debt instruments are measured at FVOCI on the basis of the business model within which they are held; and if so

• the ‘mechanics’ (i.e. how interest income and impairment should be recognised) of FVOCI debt instruments.

What did the staff recommend?

The staff recommended that the IASB introduce a FVOCI measurement category to IFRS 9 for eligible debt instruments for the three reasons set out on the next page.

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1. Existence of a business model where both amortised cost and fair value information are relevant

There are cases where a portfolio is ‘rebalanced’ more than infrequently – e.g. ‘liquidity portfolios’ within which financial assets are bought and sold to achieve a desired profile – and the portfolio as a whole would not qualify for amortised cost accounting under IFRS 9. If so, it would be required to be classified and measured at FVTPL. However, some financial assets within this portfolio might be held for substantial periods of time for the collection of contractual cash flows. Classifying and measuring such portfolios in the same way as those that are actively managed to realise fair value changes may not provide the most relevant information to users of financial statements.

The staff believe that both amortised cost and fair value information are relevant for portfolios of financial assets that are held both for the collection of the contractual cash flows and selling. A FVOCI category with recycling and recognition of interest income and credit impairment in profit or loss (see later discussion on the ‘mechanics’) would provide both types of information – i.e. amortised cost information in profit or loss and fair value information in the statement of financial position.

2. Reducing key differences with the FASB’s model

The FASB’s tentative model already contains a FVOCI category for eligible debt instruments. Introducing a FVOCI measurement category in IFRS 9 would meet the objective of reducing key differences with the FASB’s tentative model.

3. Interaction with the Insurance contracts project

In response to the Insurance contracts exposure draft (ED), insurers have raised a concern about the potential accounting mismatch that may arise in profit or loss due to the interaction between the accounting for financial assets under IFRS 9 and the accounting for insurance liabilities under the ED. The introduction of a FVOCI measurement category for eligible debt instruments, in conjunction with recognising the effect of changes 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 applied to financial assets measured at amortised cost;

• impairment losses and reversals are recognised in profit or loss using the same impairment methodology 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 the cumulative fair value gain or loss is reclassified to profit or loss (i.e. recycled) when the financial asset is derecognised.

What did the Boards decide?

The IASB tentatively decided that an FVOCI measurement category for eligible debt instruments should be added to IFRS 9.

In respect of eligible debt instruments within this new measurement category, the Board also agreed with the staff’s recommendations and tentatively decided that:

• interest income on such instruments should be recognised in profit or loss using the effective interest method that is applied to financial assets measured at amortised cost;

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• credit impairment losses/reversals on such instruments should be recognised in profit or loss using 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 or loss when these financial assets are derecognised.

Eligible debt instruments will be measured at FVOCI if they are held within a business model whose objective is both to hold financial assets to collect contractual cash flows and to sell financial assets.

FVOCI and FVTPL business model assessment for financial assetsThe Boards discussed the business model assessment for FVOCI and FVTPL in respect of eligible debt instruments, including which measurement category should be defined and which should be a residual category.

What did the staff recommend?

The staff outlined two approaches for the Boards’ consideration.

Approach 1:

Define FVOCI, with FVTPL being the residual category

Under this approach, the primary objective of a business model that results in classifying financial assets at FVOCI can be articulated as a business model for a portfolio of financial assets that is managed with the objective of both collecting contractual cash flows and selling financial assets.

As discussed above, for such a business model, both amortised cost and fair value information are relevant and therefore FVOCI is the appropriate measurement attribute. Under this approach, eligible debt instruments that do not meet the business model assessment for FVOCI or amortised cost classification would be classified at FVTPL – i.e. FVTPL is the residual category.

Approach 2:

Define FVTPL, with FVOCI being the residual category

Under this approach, eligible debt instruments that do not meet the business model assessment for amortised cost measurement or a (to be defined) business model assessment for FVTPL measurement would be classified at FVOCI – i.e. FVOCI is the residual category.

The staff identified two potential alternatives as to how the objective of a business model that results in classifying financial instruments at FVTPL could be articulated.

Alternative A: Financial assets are held-for-sale at initial recognition (this alternative would entail defining the term ‘held-for-sale’).

Alternative B: Financial assets are actively managed on a fair value basis with the objective to realise cash flows through sales, including financial assets held for trading.

FVTPL will be the residual measurement category for financial assets.

The staff recommended Approach 1 for the Boards’ consideration. In their view, the advantage of Approach 1 is that it would strengthen and further clarify the objective of the business model that results in classifying financial assets at amortised cost. In their view, defining FVOCI would also explicitly capture business models for which both amortised cost and fair value information are relevant and therefore results in providing decision-useful information to users of financial statements.

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What did the Boards decide?

The Boards tentatively decided on Approach 1 – i.e. financial assets will be measured at FVOCI if they are eligible debt instruments 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. Under this approach, eligible debt instruments that do not meet the business model assessment for FVOCI or amortised cost classification would be classified at FVTPL – i.e. FVTPL is the residual business model.

The Boards tentatively decided to provide application guidance on the types of business activities that would qualify for the FVOCI business model.

Existing reclassification requirements under IFRS 9 are extended to the FVOCI measurement category.

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 it changes 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 internal changes; 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 reclassified from the reclassification date (first day of the next reporting period). A change in the objective of the 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 9 to the FVOCI measurement category. The disclosure requirements in IFRS 7 would apply to all reclassifications.

What did the Boards decide?

The IASB tentatively decided that the current reclassification requirements in IFRS 9 should be extended to the FVOCI measurement category. The FASB tentatively decided to adopt reclassification requirements like those in IFRS 9 – although it deferred discussion as to whether reclassifications following a change in business model should be accounted for prospectively as of the 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 IASB will consider any further inter-related issues, including transition, disclosures and other sweep issues. Some of these discussions may need to be held jointly with the FASB, while others may be separate. The Boards will also consider what further changes, if any, they would like to make to their respective models.

The IASB expects to issue an exposure draft on changes to IFRS 9 in the second half of 2012.

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FVOCI is not the same 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 as a surprise to many, given IFRS 9’s focus on reducing complexity by cutting the number of measurement categories. To what extent is the new FVOCI classification a return to the available-for-sale (AFS) measurement category in IAS 39?

Here we take a look at similarities and differences between the AFS category under IAS 39 as it applies to debt instruments and the new FVOCI category proposed by the Board.

IAS 39 AFS category New FVOCI category Is there a difference?

Applicable to non-derivative debt instruments generally – although embedded derivatives might require bifurcation.

Applicable to eligible debt instruments only (i.e. financial assets that pass the cash flow characteristics assessment).1

An entity may designate a non-derivative financial asset as available-for-sale on initial recognition.

FVOCI is a defined category and assets are classified as FVOCI if and only if they meet specified criteria – i.e. eligible debt instruments must be measured at FVOCI if they are held within a business model whose objective is both to hold financial assets to collect contractual cash flows and to sell financial assets.

AFS is the residual category for non-derivative financial assets that are not classified as loans and receivables, held to maturity investments or financial assets at fair value through profit or loss.

FVTPL – not FVOCI – is the residual category for eligible debt instruments that do not meet the business model assessment for another classification.

The financial asset is measured at fair value on the statement of financial position.

The financial asset is measured at fair value on the statement of financial position.

1 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.

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IAS 39 AFS category New FVOCI category Is there a difference?

Fair value gains and losses are recognised in OCI over the life of the financial asset – except for impairment losses and foreign exchange gains and losses that are recognised in profit or loss.

Fair value gains and losses are recognised in OCI over the life of the financial asset – except for credit impairment losses that are recognised in profit or loss. The IASB did not discuss the treatment of foreign exchange gains and losses – but, based on the requirements of IAS 21 The Effects of Changes in Foreign Exchange Rates for monetary items and the apparent principle behind the FVOCI category that profit or loss information would reflect amortised cost accounting for the asset, we would expect a similar approach to foreign exchange gains and losses.

?

Impairment losses are assessed using an incurred loss model and measured on a fair value basis.

Credit impairment losses and reversals are recognised using the same credit impairment methodology as for financial assets measured at amortised cost. The IASB is developing an expected loss impairment model.

Interest income is recognised in profit or loss using the effective interest method that is applied to financial assets measured at amortised cost.

Interest income is recognised in profit or loss using the effective interest method that is applied to financial assets measured at amortised cost.

The cumulative fair value gain or loss recognised in OCI is recycled to profit or loss when the financial assets are derecognised.

The cumulative fair value gain or loss recognised in OCI is recycled to profit or loss when the financial assets are derecognised.

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IMPAIRMENT

What happened in May?

At the May 2012 meeting, the IASB continued its joint deliberations with the FASB. At this meeting, topics discussed were:

• the discount rate that should be used to discount expected losses;

• application of the impairment model to modifications of financial assets; and

• application of the impairment model to lease receivables.

(See Appendix B: Summary of IASB’s redeliberations on impairment for a summary of the IASB’s decisions to date.)

An entity may use a rate between, and including, t

the risk-free rate c

and the effective ainterest rate to t

idiscount expected t

losses.

Discount rate used when discounting expected lossesThe three-bucket impairment model uses a ‘decoupled’ effective interest rate. This means that he effect of expected credit losses on a loan would not be integrated into the calculation of the

effective interest rate. Instead, the effective interest rate generally is based on the full contractual ash flows without reduction for expected credit losses with interest revenue and impairment llowances being determined and recognised separately. The measurement of expected losses for he impairment allowance calculation should reflect all shortfalls in cash flows (both principal and nterest) on a discounted basis. The IASB discussed in their May 2012 meeting the discount rate hat should be used when discounting expected losses.

What did the staff recommend?

Conceptually, credit losses should be discounted using the original non-credit-adjusted effective interest rate. However, considering the practical challenges of estimating an accurate effective interest rate for an open portfolio and so as to make discounting operationally feasible, the staff recommended confirming the proposal of the supplementary document. This would allow entities to use a discount rate between, and including, the risk-free rate and the effective interest rate (as used in the effective interest method in IAS 39).

What did the Boards decide?

The IASB agreed with the staff recommendation. They also clarified that the risk-free rate should be a benchmark rate and that the entity should apply the chosen discount rate consistently.

Modified financial assets will be considered for transfer between ‘buckets’ in the same way as other financial assets and any impairment losses will be recognised against the gross carrying value of the asset.

Modifications of financial assetsThe IASB discussion covered financial assets measured at amortised cost that are renegotiated or otherwise modified but where the modification does not result in derecognition of the financial asset. Modifications that result in derecognition of the original financial asset were not discussed, because the modified asset would be recognised as a new asset that the staff believed would be treated consistently with all other new assets – i.e. initially recognised at fair value and categorised in bucket 1 with a 12-month expected loss impairment allowance.

The following specific questions were discussed.

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Issue discussed Background Staff recommendation

A Symmetry of model

Should modified financial assets be considered for transfer between buckets in the same way as other assets?

The staff recommended that modified assets that do not result in derecognition should be considered for transfer in the same way as other assets. This means that:

• originated and purchased non-credit-impaired financial assets that have been modified should move up to bucket 1 if the downward transfer notion is no longer met; and

• purchased credit-impaired assets that are modified should remain outside bucket 1 throughout their lives.

B Evaluating the transfer notion

The IASB had previously made tentative decisions on the transfer between buckets of originated and purchased non-credit-impaired assets. Those assets move out of bucket 1 when:

• there has been a more than insignificant deterioration in credit quality; and

• there is a reasonable possibility that cash flows may not be collected.

Conversely, they move back into bucket 1 if this downward transfer notion is no longer met.

For the purpose of determining the extent of credit quality deterioration for modified financial assets, should an entity compare current credit quality to the credit quality at the date of modification, or to the original credit quality?

For the purpose of evaluating the likelihood that some or all cash flows may not be collected, should an entity consider the collectability of the original contractual cash flows or the modified contractual cash flows?

The staff recommended that, when evaluating whether the downward transfer notion is no longer met after a financial asset has been modified, an entity should:

• evaluate the current credit quality against the original credit quality. The staff contended that an asset should only be moved to bucket 1 when its credit quality improves towards the initial expectation of credit losses that was included in the pricing of the original instrument – the same as for all other assets. The alternative (i.e. evaluate against the credit quality at the date of modification) would require by definition a movement back to bucket 1 upon modification, since the asset would not have experienced any credit deterioration since the date of modification; and

• consider the cash flows of the modified instrument when evaluating whether the likelihood of default is such that it is at least reasonably possible that some or all of the contractual cash flows may not be recoverable. The staff believed that the original contractual terms are no longer relevant in this regard since they have been replaced, and therefore the cash flows of the modified instrument should be considered.

C Presentation of modifications

Under IAS 39 an impairment loss is recognised for the difference between (i) the present value of the cash flows of the modified asset and (ii) the carrying value of the asset before modification.

Should the impairment loss be recognised as an adjustment to the impairment allowance or should the carrying value of the asset be directly adjusted?

IAS 39 is silent on the question. However, under IAS 39 it is not necessary to be specific, since interest revenue is calculated as the effective interest rate multiplied by the net carrying amount – i.e. the amount that includes a reduction for the impairment allowance. In contrast the proposed three-bucket impairment model follows a decoupled approach. Consequently, interest revenue would be calculated by multiplying the effective interest rate by the gross amortised cost, which does not include a reduction for the impairment allowance.

The staff recommended that the impairment loss for modifications should be required to be recognised by adjusting the gross carrying value of the asset. Not adjusting the carrying amount on modification would fail to take into account the fact that losses (or gains) have been crystallised.

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What did the Boards decide?

The IASB agreed with all the staff recommendations.

Impairment allowances for lease receivables may be measured similarly to trade receivables with a significant financing component.

Impairment of lease receivablesThe IASB and the FASB have tentatively decided in the leases project that an entity would be required to assess the impairment of lease receivables consistent with existing financial instruments standards. The Boards discussed whether an entity should apply the three-bucket impairment model or whether a practical expedient similar to that for trade receivables with a significant financing component should be allowed.

Because IFRS 9 will have to be applied before the new leases standard, the Boards differentiated in their discussion between the application of the impairment model to:

1) lease receivables recognised under the proposed leases model; and

2) those recognised under the existing leases standards (i.e. IAS 17 Leases and Topic 840 Leases).

What did the staff recommend?

1) Applying the impairment model to the proposed leases model

The staff recommended that an entity should assess and measure the impairment allowance in accordance with the three-bucket impairment model. The staff believed that the benefit of achieving comparability between the accounting for lease receivables and the accounting for financial assets at amortised cost would outweigh the cost to implement the recommendation.

2) Applying the impairment model to existing leases standards (i.e. IAS 17 and Topic 840)

For the existing leases standards the staff recommend that an entity should:

• for finance lease receivables, assess and measure the impairment allowance in accordance with the proposed three-bucket impairment model; and

• for operating lease receivables, measure the impairment allowance at lifetime expected losses.

What did the Boards decide?

The Boards tentatively decided that an approach similar to that for trade receivables with a significant financing component should be allowed under the new leases model and also under the existing standards. Accordingly, they tentatively decided that an entity should make a policy election to either fully apply the three-bucket impairment model or to apply a simplified model with an allowance of lifetime expected losses.

Next stepsDuring the meeting in April, the staff explained that, based on the Boards’ decisions made so far, the general framework of the expected credit loss measurement model was now complete. However, future meetings on the impairment of financial assets will consider:

• application to off-balance sheet items, including loan commitments and financial guarantees;

• disclosure requirements;

• any knock-on effects resulting from future decisions in the classification and measurement project (e.g. debt securities); and

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• selected issues to be considered separately by each Board to address their respective stakeholders’ concerns.

The expected timing of a new exposure draft on the impairment proposals has been revised and is now the second half of 2012.

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HEDGE ACCOUNTING

A review draft of the revised general hedge accounting model is expected soon.

General hedgingThe IASB still plans to release its review draft of the revised general hedge accounting model in the second quarter of 2012. The draft will be available for around 90 days, and the final standard is expected in the second half of 2012. 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 story so far? Macro hedgingFor an introduction to the topic of ‘macro hedging’ see Appendix C: Frequently asked questions about the IASB’s macro hedging project.

The IASB began discussing macro hedging in September 2010 in conjunction with developing its new general hedging model. Because of the complexity of the issues, the IASB decided not to include any proposals related to macro hedging in the December 2010 exposure draft of its new general hedge accounting model.

Many respondents to the exposure draft encouraged the IASB to continue to develop a new macro hedging model. As a result, in April 2011 the IASB began holding regular education sessions on macro hedging, which have continued into 2012.

Early in the process the IASB gave the staff two key guidelines that have shaped the direction of the project to date:

Guideline Reason

Explore the development of a model that would more closely align hedge accounting with actual risk management strategies for macro hedges.

Similar to the approach taken for the new general hedging model; the model seeks to reduce perceived conflicts between the accounting and the economics.

Focus first on developing a model based on how banks manage interest rate risk.

A good place to start because banks apply macro hedging the most; model potentially could be expanded to other risks/industries later.

Based on research and outreach activities to date, four key features of risk management practices in the financial services industry that the staff have identified are:

• risk management strategies are based on a net open portfolio as the unit of account;

• the focus is on net interest margin as the hedged risk;

• management of cash flow optionality (e.g. prepayments) is based on expected cash flows and economic layer approaches at a portfolio level; and

• multi-dimensional targets are set for risk management activities.

Through the education sessions, the IASB is exploring what they call a ‘valuation approach’ to macro hedging. Under that approach, for accounting purposes the hedged risk position is identified and remeasured for changes in the hedged risk (e.g. interest rate risk) with the resulting

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gain or loss recognised in profit or loss, matching the offsetting gain or loss on the hedging instrument.

As the discussions have progressed, the difficult question facing the IASB seems to be:

To what degree should ‘risk management’ drive hedge accounting?

Risk managementpractices New macro hedging

model

IAS 39 / Generalhedge accounting

Hedging on a ‘net risk’basisStrategies designed andmanaged based on openportfoliosUse of internal transferprices to value riskpositionsDemand depositshedged for interestrate riskInterest rate risk hedgedbased on internal,entity-specific yieldcurve

Restrictions on hedging‘net risks’Hedged items must bespecifically identifiedValuations based on‘fair value’ conceptsDemand depositscannot be hedged forinterest rate riskHedges of interest raterisk based on‘benchmark rates’

TBD ??

The IASB has carved the macro hedging project out from the development of IFRS 9 and will prepare a discussion paper towards the end of 2012.

Next due process stepIn May the IASB paused the development of its new macro hedging model to consider whether the next due process step for the project should be a discussion paper or an exposure draft. The IASB had previously stated that it would issue either a discussion paper or an exposure draft in the second half of 2012.

What did the staff recommend?

The staff recommended proceeding to a discussion paper as the first due process document for the project, instead of trying to issue an exposure draft. The staff noted that the macro hedging project involves fundamental accounting questions and is not simply a modification to existing hedge accounting models. The staff also noted that:

• macro hedging in practice is a complex area;

• this type of hedging covers a broad range of risk management strategies, techniques, and approaches – especially for sectors other than financial services and risks other than interest rate risk;

• macro hedging may have a pervasive impact on an entity’s financial position and performance because it can affect many different assets and liabilities;

• macro hedging typically has significant operational aspects involving systems to capture and model risk profiles representing large groups of items; and

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• because macro hedging is so specialised, obtaining user input is more difficult than for other well-established accounting concepts and debates.

The staff also recommended that macro hedging be carved out from the development of IFRS 9. That would allow development of IFRS 9 to continue without jeopardising its effective date of 1 January 2015. Also, from a technical standpoint, the existing guidance in IAS 39 for fair value hedges of a portfolio for interest rate risk would be retained pending the development of the new macro hedging model.

What did the IASB decide?

The IASB unanimously agreed with the staff recommendation to develop a discussion paper as the first due process document.

Individual IASB members noted during the discussion that:

• issuing a discussion paper first is ‘typical’ due process, which may reduce the risk of multiple exposure drafts being required;

• there was a strong desire to understand users’ views on what financial reporting models would provide useful information about an entity’s macro hedging activities;

• the discussion paper would present the IASB’s tentative views on a macro hedging model (if there was a majority view), but other views/models may be included to solicit constituent feedback; and

• they wanted to signal that the IASB is not any ‘less committed’ to the macro hedging project by pursuing a discussion paper first.

The IASB and staff also noted that some companies designate financial assets and liabilities at fair value through profit and loss so that their financial reporting might better reflect their macro hedging activities. Because the new macro hedging standard will not be ready to adopt along with IFRS 9 on 1 January 2015, some companies may be concerned that they will have to make their fair value designation and de-designation elections on adoption of IFRS 9 without the final macro hedging model being in place. Individual IASB members signalled that they would support companies having another opportunity to reset their fair value option elections upon adoption of the new macro hedging standard; however, no formal decision was made.

Next stepsThe 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 2012. 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

• holding education sessions with the IASB on the potential application of a tentative model to hedges of other risks by other industries (e.g. commodity price risk and foreign exchange risk).

A discussion paper may be issued towards the end of 2012, but it could be delayed into 2013 depending on how quickly the IASB progresses with developing a model and the constituent feedback received from the staff’s outreach efforts.

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PROJECT MILESTONES AND TIMELINE FOR COMPLETION

The current work plan anticipates significant progress in 2012, which will be necessary to maintain an effective date for IFRS 9 of 1 January 2015.

Revisedstandard?

201220102009

Asset andliability

offsetting

Impairment

Classification&

measurement

Hedgeaccounting

?Source: IASB work plan – projected targets as at 23 March 2012

Standardon assets:

IFRS 9 (2009)

Supplementarydocument

Exposuredraft(H2)

Exposuredraft

2011

Effective

1/1/2015date

Effectivedates 1/1/2013and 1/1/2014

Gen

eral

Mac

ro

Exposuredraft

Standardon liabilities:IFRS 9 (2010)

Discussionpaper(H2)

Amendmentsto IFRS 7 and

IAS 32

Finalstandard?

Deferral ofeffective date

Exposuredraft – limited

revisions(H2)

Review draft(Q2)

Final standard(H2)

1 2 3

4 5

6

7

Finalstandard?

Exposuredraft? Effective

date?

Our suite of publications considers the different aspects of the work plan, and provides a comparison to IAS 39 where relevant.

1

2

3

4

5

6

7

KPMG publications

First Impressions: IFRS 9 Financial Instruments (December 2009)

• For KPMG’s most recent and comprehensive views on IFRS 9, refer to Insights into IFRS: Chapter 7A – Financial instruments: IFRS 9.

First Impressions: Additions to IFRS 9 Financial Instruments (December 2010)

• For KPMG’s most recent and comprehensive views on IFRS 9, refer to Insights into IFRS: Chapter 7A – Financial instruments: IFRS 9.

In the Headlines: Amendments to IFRS 9 – Mandatory effective date of IFRS 9 deferred to 1 January 2015 (December 2011)

New on the Horizon: ED/2009/12 Financial Instruments: Amortised Cost and Impairment (November 2009)

New on the Horizon: Impairment of financial assets measured in an open portfolio (February 2011)

New on the Horizon: Hedge Accounting (January 2011)

First Impressions: Offsetting financial assets and financial liabilities (February 2012)

For more information on the project see our website.

The IASB’s website and the FASB’s website contain summaries of the Boards’ meetings, meeting materials, project summaries and status updates.

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APPENDIX A: SUMMARY OF IASB’S REDELIBERATIONS ON CLASSIFICATION AND MEASUREMENT

Note: Decisions made in May 2012 are shaded.

What did the IASB discuss?

What did the IASB tentatively decide? Is there an identified change to IFRS 9? If yes, then what?

Business model assessment for amortised cost classification for financial assets

An eligible debt instrument (i.e. a financial asset that passes the contractual cash flows characteristics assessment) would qualify for amortised cost classification if it was held within a business model whose objective was to hold the assets to collect contractual cash flows. (April 2012)

To clarify the primary objective of ‘hold to collect’, the Boards will provide additional 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 fair value through other comprehensive income (FVOCI) classification for financial assets

An eligible debt instrument would qualify for FVOCI classification if it was held within a business model whose objective is to both hold financial assets to collect contractual cash flows and to sell financial assets. (May 2012)

Eligible debt instruments that do not meet the business model assessment for FVOCI or amortised cost would be classified at FVTPL – i.e. FVTPL is the residual business model. (May 2012)

Yes – there is currently no FVOCI measurement category for eligible debt instruments in IFRS 9.

The Boards have also tentatively decided to provide application guidance on the types of business activities that would qualify for the FVOCI business model.

Proposed approach to the contractual cash flows characteristics assessment

A financial asset could qualify for a measurement category other than FVTPL if its contractual terms give rise, on specified dates, to cash flows that are solely payments of P&I. (February 2012)

No

‘Interest’ is consideration for the time value of money and for the credit risk associated with the principal amount outstanding during a particular period of time. (February 2012)

No

‘Principal’ is understood as the amount transferred by the holder on initial recognition. (February 2012)

No

‘Principal’ is not currently defined in IFRS 9. However, the basis of conclusions states that ”cash flows that are interest always have a close relation to the amount advanced to the debtor (the ‘funded’ amount).”

Although the IASB did not describe this as a change from IFRS 9, we believe that the new description of ‘principal’ may have implications in practice. For example, based on this new perspective, bonds originally issued at par but acquired by the holder at a substantial premium in secondary markets and (contingently) prepayable at par would appear not to be consistent with the notion of solely P&I; this is because the holder might not recover all of its initial investment.

If a financial asset contains a component other than principal and interest, then it is required to be measured at FVTPL. (February 2012)

No

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What did the IASB discuss?

What did the IASB tentatively decide? Is there an identified change to IFRS 9? If yes, then what?

Assessment of economic relationship between P&I

If a financial asset only contains components of principal and interest, but the relationship between them is modified, then an entity needs to consider the effect of the modification when assessing whether the cash flows on the financial asset are solely P&I. (February 2012)

Yes – this is an amendment to the application guidance in IFRS 9.

The IASB believes that this change will address application issues that have arisen in the application of IFRS 9.

An entity would need to compare the financial asset under assessment to a benchmark instrument that contained cash flows that were solely P&I to assess the effect of the modification in the economic relationship between P&I. 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. (February 2012)

If the difference between the cash flows of the benchmark instrument and the instrument under assessment is more than insignificant, then the instrument is required to be measured at FVTPL; this is because its contractual cash flows are not solely P&I. (February 2012)

Contingent cash flows

A contractual term that changes the timing or amount of payments of P&I would not preclude the financial asset from a measurement category other than FVTPL. This is true as long as any variability only reflects the change in the time value of money and the credit risk of the instrument. (February 2012)

No

The probability of contingent cash flows that are not solely P&I should not be considered. Financial assets that contain contingent cash flows that are not solely P&I are required to be measured at FVTPL. There is an exception only for extremely rare scenarios. (February 2012)

No

Prepayment and extension options

A prepayment or extension option, including those that are contingent, does not preclude a financial asset from a measurement category other than FVTPL. This is true as long as these features are consistent with the notion of solely P&I. (February 2012)

No

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What did the IASB discuss?

What did the IASB tentatively decide? Is there an identified change to IFRS 9? If yes, then what?

Bifurcation of financial assets and financial liabilities

Financial assets that contain cash flows that are not solely P&I would not be eligible for bifurcation. Instead, they would be classified and measured in their entirety at FVTPL. (April 2012)

No

Financial liabilities would be bifurcated using the existing ‘closely related’ bifurcation requirements currently in IFRS 9 and US GAAP. (April 2012)

The IASB also confirmed that the ‘own credit’ guidance in IFRS 9 would be retained. (April 2012)

No

Mechanics of the FVOCI category for eligible debt instruments

Interest income and credit impairment losses/reversals on FVOCI assets should be recognised in profit or loss using the same methods as for financial assets measured at amortised cost. (May 2012)

Yes – there is currently no FVOCI measurement category for eligible debt instruments in IFRS 9.

The cumulative fair value gain or loss recognised in OCI should be recycled from OCI to profit or loss when these financial assets are derecognised. (May 2012)

Yes – there is currently no FVOCI measurement category for eligible debt instruments in IFRS 9.

Reclassification The existing reclassification requirements in IFRS 9 will be extended to the FVOCI category. (May 2012)

Yes and No – there is currently no FVOCI measurement category for eligible debt instruments in IFRS 9, so in this sense there is an identified change to IFRS 9. However, the existing reclassification requirements in IFRS 9 (e.g. when reclassification occurs) are not expected to change, subject to further considerations on how to account for reclassifications by the Boards at a future meeting.

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APPENDIX B: SUMMARY OF IASB’S REDELIBERATIONS ON IMPAIRMENT

The ‘three-bucket approach’ model currently discussed is based on tentative decisions reached following the issue of the joint supplementary document. The diagram below summarises the Boards’ tentative decisions on the three-bucket impairment model.

All assets (other thanthose purchased withan explicit expectation

of credit losses) tobe included in this

bucket on initialrecognition

1 2 3

Impairment: Lifetimeexpected losseswhen loss eventexpected in thenext 12 months

Move out ofbucket 1 when morethan insignificantdeterioration in creditquality and reasonablepossibility that cashflows may not becollected

Only assets originallyincluded in bucket 1 are

able to move back iftransfer notion above

is no longer met Collectivemeasurement

Individualmeasurement

Impairment: Lifetimeexpected losses

Includes assets transferredfrom bucket 1 and assets

purchased with an explicitexpectation of credit losses

The Boards have also discussed how the expected loss model might be applied to trade receivables.

Trade receivables

... a significant financing componentwith ... a significant financing componentwithout

Policy election to apply: On initial recognition measured attransaction price as defined in therevenue recognition exposure draftAlways categorised in bucket 2 or 3an allowance of lifetime expected losses

with

the full ‘three-bucket’ impairmentmodel; ora simplified model with an allowance oflifetime expected losses

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APPENDIX C: FREQUENTLY ASKED QUESTIONS ABOUT THE IASB’S MACRO HEDGING PROJECT

What is ‘macro hedging’?

Don’t IAS 39 & IFRS 9 already address macro hedging, so why do companies want a new model?

IAS 39 only provides for limited accommodation of macro hedging strategies. When entities manage their exposure to a risk (e.g. interest risk) on a net exposure basis, those hedging practices generally do not qualify for hedge accounting under IAS 39.

However, as an exception, IAS 39.81A permits an entity to designate the interest rate exposure of a portfolio of financial assets or financial liabilities as the hedged item in a portfolio fair value hedge. The hedged item is designated in terms of an amount of currency rather than as individual assets or liabilities. Although the portfolio may, for risk management purposes, include only assets, only liabilities, or both assets and liabilities, the amount designated under IAS 39 is an amount of assets or an amount of liabilities. Designation of a net amount, comprising both assets and liabilities, is not permitted. The entity may hedge a portion of the interest rate risk associated with the designated amount.

The new general hedging model for IFRS 9 carries forward the exception permitted by IAS 39.81A. Although the new model is generally more permissive than IAS 39, it does not permit hedge accounting for many macro hedging strategies.

Some companies want a new macro hedging model that permits a form of hedge accounting for a wider variety of risk management strategies that are applied to open portfolios than is presently allowed.

‘Macro hedging’ is a broad term for risk management strategies that seek to reduce one or more risks associated with an ‘open portfolio’. The main difference between an open portfolio and a closed portfolio is that there are constant additions to (e.g. new business or replacements) or subtractions from (e.g. sales or maturities) an open portfolio. Therefore, the portfolio’s value and risk position are subject to ongoing changes, which require risk management approaches that reflect those dynamics.

For example, a bank may manage its interest rate risk on an open portfolio basis when the bank manages its net interest risk exposure across wide groups of financial assets and financial liabilities, including demand deposits.

Is the macro hedging project only relevant for banks?

No. The IASB’s focus to date has been on developing a model that banks could apply to account for their macro hedges of interest rate risk. However, it intends to explore whether the model can be generalised to apply to other risks (e.g. foreign exchange risk or commodity price risk) by entities in other industries (e.g. power & utilities, oil & gas or manufacturing).

For non-banks, the message is ‘stay tuned’.

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KPMG CONTACTS

Americas Asia-Pacific Europe, Middle East, and AfricaMichael Hall Reinhard Klemmer Colin MartinT: +1 212 872 5665 T: +65 6213 2333 T: +44 20 7311 5184E: [email protected] E: [email protected] E: [email protected]

Tracy Benard Yoshihiro Kurokawa Venkataramanan VishwanathT: +1 212 872 6073 T: +81 3 3548 5555 x.6595 T: +91 22 3090 1944E: [email protected] E: [email protected] E: [email protected]

AcknowledgementsWe would like to acknowledge the efforts of the principal authors of this publication: Nicolle Pietsch, Robert Sledge, and Sze Yen Tan.

Descriptive and summary statements in this newsletter may be based on notes that have been taken in observing various Board meetings. They are not intended to be a substitute for the final texts of the relevant documents or the official summaries of Board decisions which may not be available at the time of publication and which may differ. Companies should consult the texts of any requirements they apply, the official summaries of Board meetings, and seek the advice of their accounting and legal advisors.

© 2012 KPMG IFRG Limited, a UK company, limited by guarantee. All rights reserved.

KPMG International Standards Group is part of KPMG IFRG Limited.

Publication name: IFRS Newsletter: Financial Instruments

Publication number: Issue 2

Publication date: May 2012

The KPMG name, logo and “cutting through complexity” are registered trademarks or trademarks of KPMG International.

KPMG International Cooperative (“KPMG International”) is a Swiss entity. Member firms of the KPMG network of independent firms are affiliated with KPMG International. KPMG International provides no client services. No member firm has any authority to obligate or bind KPMG International or any other member firm vis-à-vis third parties, nor does KPMG International have any such authority to obligate or bind any member firm.

The information contained herein is of a general nature and is not intended to address the circumstances of any particular individual or entity. Although we endeavour to provide accurate and timely information, there can be no guarantee that such information is accurate as of the date it is received or that it will continue to be accurate in the future. No one should act upon such information without appropriate professional advice after a thorough examination of the particular situation.

kpmg.com/ifrs

IFRS Newsletter: Financial Instruments is KPMG’s update on the IASB’s financial instruments project.

If you would like further information on any of the matters discussed in this Newsletter, please talk to your usual local KPMG contact or call any of KPMG firms’ offices.