BC208 Accordingly, the Board decided that two line items should be presented, as follows:
(a) for those repricing time periods for which the hedged item is an asset, the change in its fair value is presented in a single separate line item within assets; and
(b) for those repricing time periods for which the hedged item is a liability, the change in its fair value is presented in a single separate line item within liabilities.
BC209 The Board noted that these line items represent changes in the fair value of the hedged item. For this reason, the Board decided that they should be presented next to financial assets or financial liabilities.
Derecognition of amounts included in the separate line items
Derecognition of an asset (or liability) in the hedged portfolio
BC210 The Board discussed how and when amounts recognised in the separate balance sheet line items should be removed from the balance sheet. The Board noted that the objective is to remove such amounts from the balance sheet in the same periods as they would have been removed had individual assets or liabilities (rather than an amount) been designated as the hedged item.
BC211 The Board noted that this objective could be fully met only if the entity schedules individual assets or liabilities into repricing time periods and tracks both for how long the scheduled individual items have been hedged and how much of each item was hedged in each time period. In the absence of such scheduling and tracking, some assumptions would need to be made about these matters and, hence, about how much should be removed from the separate balance sheet line items when an asset (or liability) in the hedged portfolio is derecognised. In addition, some safeguards would be needed to ensure that amounts included in the separate balance sheet line items are removed from the balance sheet over a reasonable period and do not remain in the balance sheet indefinitely. With these points in mind, the Board decided to require that:
(a) whenever an asset (or liability) in the hedged portfolio is derecognised— whether through earlier than expected prepayment, sale or write-off from impairment—any amount included in the separate balance sheet line item relating to that derecognised asset (or liability) should be removed from the balance sheet and included in the gain or loss on derecognition.
(b) if an entity cannot determine into which time period(s) a derecognised asset (or liability) was scheduled:
(i) it should assume that higher than expected prepayments occur on assets scheduled into the first available time period; and
(ii) it should allocate sales and impairments to assets scheduled into all time periods containing the derecognised item on a systematic and rational basis.
(c) the entity should track how much of the total amount included in the separate line items relates to each repricing time period, and should remove the amount that relates to a particular time period from the balance sheet no later than when that time period expires.
Amortisation
BC212 The Board also noted that if the designated hedged amount for a repricing time period is reduced, IAS 39* requires that the separate balance sheet line item described in paragraph 89A relating to that reduction is amortised on the basis of a recalculated effective interest rate. The Board noted that for a portfolio hedge of interest rate risk, amortisation based on a recalculated effective interest rate could be complex to determine and could demand significant additional systems requirements. Consequently, the Board decided that in the case of a portfolio hedge of interest rate risk (and only in such a hedge), the line item balance may be amortised using a straight-line method when a method based on a recalculated effective interest rate is not practicable.
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* see paragraph 92
The hedging instrument
BC213 The Board was asked by commentators to clarify whether the hedging instrument may be a portfolio of derivatives containing offsetting risk positions. Commentators noted that previous versions of IAS 39 were unclear on this point.
BC214 The issue arises because the assets and liabilities in each repricing time period change over time as prepayment expectations change, as items are derecognised and as new items are originated. Thus the net position, and the amount the entity wishes to designate as the hedged item, also changes over time. If the hedged item decreases, the hedging instrument needs to be reduced. However, entities do not normally reduce the hedging instrument by disposing of some of the derivatives contained in it. Instead, entities adjust the hedging instrument by entering into new derivatives with an offsetting risk profile.
BC215 The Board decided to permit the hedging instrument to be a portfolio of derivatives containing offsetting risk positions for both individual and portfolio hedges. It noted that all of the derivatives concerned are measured at fair value. It also noted that the two ways of adjusting the hedging instrument described in the previous paragraph can achieve substantially the same effect. Therefore the Board clarified paragraph 77 to this effect.
Hedge effectiveness for a portfolio hedge of interest rate risk
BC216 Some respondents to the Exposure Draft questioned whether IAS 39’s effectiveness tests* should apply to a portfolio hedge of interest rate risk. The Board noted that its objective in amending IAS 39 for a portfolio hedge of interest rate risk is to permit fair value hedge accounting to be used more easily, whilst continuing to meet the principles of hedge accounting. One of these principles is that the hedge is highly effective. Thus, the Board concluded that the effectiveness requirements in IAS 39 apply equally to a portfolio hedge of interest rate risk.
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* see paragraph AG105
BC217 Some respondents to the Exposure Draft sought guidance on how the effectiveness tests are to be applied to a portfolio hedge. In particular, they asked how the prospective effectiveness test is to be applied when an entity periodically ‘rebalances’ a hedge (ie adjusts the amount of the hedging instrument to reflect changes in the hedged item). The Board decided that if the entity’s risk management strategy is to change the amount of the hedging instrument periodically to reflect changes in the hedged position, that strategy affects the determination of the term of the hedge. Thus, the entity needs to demonstrate that the hedge is expected to be highly effective only for the period until the amount of the hedging instrument is next adjusted. The Board noted that this decision does not conflict with the requirement in paragraph 75 that ‘a hedging relationship may not be designated for only a portion of the time period during which a hedging instrument remains outstanding’. This is because the entire hedging instrument is designated (and not only some of its cash flows, for example, those to the time when the hedge is next adjusted). However, expected effectiveness is assessed by considering the change in the fair value of the entire hedging instrument only for the period until it is next adjusted.
BC218 A third issue raised in the comment letters was whether, for a portfolio hedge, the retrospective effectiveness test should be assessed for all time buckets in aggregate or individually for each time bucket. The Board decided that entities could use any method to assess retrospective effectiveness, but noted that the chosen method would form part of the documentation of the hedging relationship made at the inception of the hedge in accordance with paragraph 88(a) and hence could not be decided at the time the retrospective effectiveness test is performed.
Transition to fair value hedge accounting for portfolios of interest rate risk
BC219 In finalising the amendments to IAS 39, the Board considered whether to provide additional guidance for entities wishing to apply fair value hedge accounting to a portfolio hedge that had previously been accounted for using cash flow hedge accounting. The Board noted that such entities could apply paragraph 101(d) to revoke the designation of a cash flow hedge and re-designate a new fair value hedge using the same hedged item and hedging instrument, and decided to clarify this in the Application Guidance. Additionally, the Board concluded that clarification was not required for first-time adopters because IFRS 1 already contained sufficient guidance.
BC220 The Board also considered whether to permit retrospective designation of a portfolio hedge. The Board noted that this would conflict with the principle in paragraph 88(a) that ‘at the inception of the hedge there is formal designation and documentation of the hedging relationship’ and accordingly, decided not to permit retrospective designation.
Elimination of selected differences from US GAAP___
BC221 The Board considered opportunities to eliminate differences between IAS 39 and US GAAP. The guidance on measurement and hedge accounting under revised IAS 39 is generally similar to that under US GAAP. The amendments will further reduce or eliminate differences between IAS 39 and US GAAP in the areas listed below. In some other areas, a difference will remain. For example, US GAAP in many, but not all, areas is more detailed, which may result in a difference in accounting when an entity applies an accounting approach under IAS 39 that would not be permitted under US GAAP.
Contracts to buy or sell a non-financial item
(a) The Board decided that a contract to buy or sell a non-financial item is a derivative within the scope of IAS 39 if the non-financial item that is the subject of the contract is readily convertible to cash and the contract is not a ‘normal’ purchase or sale. This requirement is comparable to the definition of a derivative in SFAS 133, which also includes contracts for which the underlying is readily convertible to cash, and to the scope exclusion in SFAS 133 for ‘normal’ purchases and sales.
Scope: loan commitments
(b) The Board decided to add a paragraph to IAS 39 to exclude particular loan commitments that are not settled net. Such loan commitments were within the scope of the original IAS 39. The amendment moves IAS 39 closer to US GAAP.
Unrealised gains and losses on available-for-sale financial assets
(c) The Board decided to eliminate the option to recognise in profit or loss gains and losses on available-for-sale financial assets (IAS 39, paragraph 55(b)), and thus require such gains and losses to be recognised in equity. The change is consistent with SFAS 115, which does not provide the option in the original IAS 39 to recognise gains and losses on available-for-sale financial assets in profit or loss. SFAS 115 requires those unrealised gains and losses to be recognised in other comprehensive income (not profit or loss).
Fair value in active markets
(d) The Board decided to amend the wording in IAS 39, paragraph AG71, to state that, instead of a quoted market price normally being the best evidence of fair value, a quoted market price is the best evidence of fair value. This is similar to SFAS 107 Disclosures about Fair Value of Financial Instruments.
Fair value in inactive markets
(e) The Board decided to include in IAS 39 a requirement that the best evidence of the fair value of an instrument that is not traded in an active market is the transaction price, unless the fair value is evidenced by comparison with other observable current market transactions in the same instrument (ie without modification or repackaging) or based on a valuation technique incorporating only observable market data. This is similar to the requirements of EITF 023 Issues Involved in Accounting for Derivative Contracts Held for Trading Purposes and Contracts Involved in Energy Trading and Risk Management Activities.
Impaired fixed rate loans: observable market price.
(f) The Board decided to permit an impaired fixed interest rate loan to be measured using an observable market price. SFAS 114 allows impairment to be measured on the basis of a loan’s observable market price.
Reversal of impairment losses on investments in equity instruments
(g) The Board decided that if an entity recognises an impairment loss on an available-for-sale equity investment and the fair value of the investment subsequently increases, the increase in fair value should be recognised in equity. This is comparable to US GAAP under which reversals of impairment losses are not permitted.
Hedges of firm commitments
(h) The Board decided to require hedges of firm commitments to be treated as fair value hedges instead of cash flow hedges as was required under the original IAS 39 (except foreign currency risk when the hedge may be designated as either a cash flow hedge or a fair value hedge). This change brings IAS 39 closer to SFAS 133.
Basis adjustments to financial assets or financial liabilities resulting from hedges of forecast transactions
(i) Basis adjustments to financial assets or financial liabilities resulting from hedges of forecast transactions are not permitted under SFAS 133. The revised IAS 39 also precludes such basis adjustments.
Basis adjustments to non-financial assets or non-financial liabilities resulting from hedges of forecast transactions
(j) The Board decided to permit entities to apply basis adjustments to non-financial assets or non-financial liabilities that result from hedges of forecast transactions. Although US GAAP precludes basis adjustments, permitting a choice in IAS 39 allows entities to meet the US GAAP requirements.
Summary of changes from the Exposure Draft__
BC222 The main changes from the Exposure Draft’s proposals are as follows:
Scope
(a) The Standard adopts the proposal in the Exposure Draft that loan commitments that cannot be settled net and are not classified at fair value through profit or loss are excluded from the scope of the Standard. The Standard requires, however, that a commitment to extend a loan at a below-market interest rate is initially recognised at fair value, and subsequently measured at the higher of (i) the amount determined under IAS 37 and (ii) the amount initially recognised, less where appropriate, cumulative amortisation recognised in accordance with IAS 18.
(b) The Standard adopts the proposal in the Exposure Draft that financial guarantees are initially recognised at fair value, but clarifies that subsequently they are measured at the higher of (a) the amount determined under IAS 37 and (b) the amount initially recognised, less, where appropriate, cumulative amortisation recognised in accordance with IAS 18.
Definitions
(c) The Standard amends the definition of ‘originated loans and receivables’ to ‘loans and receivables’. Under the revised definition, an entity is permitted to classify as loans and receivables purchased loans that are not quoted in an active market.
(d) The Standard amends the definition of transaction costs in the Exposure Draft to include internal costs, provided they are incremental and directly attributable to the acquisition, issue or disposal of a financial asset or financial liability.
(e) The Standard amends the definition of the effective interest rate proposed in the Exposure Draft so that the effective interest rate is calculated using estimated cash flows for all instruments. An exception is made for those rare cases in which it is not possible to estimate cash flows reliably, when the Standard requires the use of contractual cash flows over the contractual life of the instrument. The Standard further stipulates that when accounting for a change in estimates, entities adjust the carrying amount of the instrument in the period of change with a corresponding gain or loss recognised in profit or loss. To calculate the new carrying amount, entities discount revised estimated cash flows at the original effective rate.
Derecognition of a financial asset
(f) The Exposure Draft proposed that an entity would continue to recognise a financial asset to the extent of its continuing involvement in that asset. Hence, an entity would derecognise a financial asset only if it did not have any continuing involvement in that asset. The Standard uses the concepts of control and of risks and rewards of ownership to determine whether, and to what extent, a financial asset is derecognised. The continuing involvement approach applies only if an entity retains some, but not substantially all, the risks and rewards of ownership and also retains control (see also (i) below).
(g) Unlike the Exposure Draft, the Standard clarifies when a part of a larger financial asset should be considered for derecognition. The Standard requires a part of a larger financial asset to be considered for derecognition if, and only if, the part is one of:
• only specifically identified cash flows from a financial asset;
• only a fully proportionate (pro rata) share of the cash flows from a financial asset; or
• only a fully proportionate (pro rata) share of specifically identified cash flows from a financial asset.
In all other cases, the Standard requires the financial asset to be considered for derecognition in its entirety.
(h) The Standard retains the conditions proposed in the Exposure Draft for ‘pass-through arrangements’ in which an entity retains the contractual rights to receive cash flows of a financial asset, but assumes a contractual obligation to pay those cash flows to one or more entities. However, because of confusion over the meaning of the term ‘pass-through arrangements’, the Standard does not use this term.
(i) The Standard requires that an entity first assesses whether it has transferred substantially all the risks and rewards of ownership. If an entity has retained substantially all such risks and rewards, it continues to recognise the transferred asset. If it has transferred substantially all such risks and rewards, it derecognises the transferred asset. If an entity has neither transferred nor retained substantially all the risks and rewards of ownership of the transferred asset, it assesses whether it has retained control over the transferred asset. If it has retained control, the Standard requires the entity to continue recognising the transferred asset to the extent of its continuing involvement in the transferred asset. If it has not retained control, the entity derecognises the transferred asset.
(j) The Standard provides guidance on how to evaluate the concepts of risks and rewards and of control for derecognition purposes.
Measurement
(k) The Standard adopts the option proposed in the Exposure Draft to permit designation of any financial asset or financial liability on initial recognition as one to be measured at fair value, with changes in fair value recognised in profit or loss. However, the Standard clarifies that the fair value of liabilities with a demand feature, for example, demand deposits, is not less than the amount payable on demand discounted from the first date that the amount could be required to be paid.
(l) The Standard adopts the proposal in the Exposure Draft that quoted prices in active markets should be used to determine fair value in preference to other valuation techniques. The Standard adds guidance that if a rate (rather than a price) is quoted, these quoted rates are used as inputs into valuation techniques to determine the fair value. The Standard further clarifies that if an entity operates in more than one active market, the entity uses the price at which a transaction would occur at the balance sheet date in the same instrument (ie without modification or repackaging) in the most advantageous active market to which the entity has immediate access.
(m) The Standard simplifies the fair value measurement hierarchy in an inactive market so that recent market transactions do not take precedence over a valuation technique. Rather, when there is not a price in an active market, a valuation technique is used. Such valuation techniques include using recent arm’s length market transactions.
(n) The Standard also clarifies that the best estimate of fair value at initial recognition of a financial instrument that is not quoted in an active market is the transaction price, unless the fair value of the instrument is evidenced by other observable market transactions or is based on a valuation technique whose variables include only data from observable markets.
Impairment of financial assets
(o) The Standard clarifies that an impairment loss is recognised only when it has been incurred. The Standard eliminates some of the detailed guidance in the Exposure Draft, in particular, the example of how to calculate the discount rate for the purpose of measuring impairment in a group of financial assets.
(p) The Exposure Draft proposed that impairment losses recognised on investments in debt or equity instruments that are classified as available for sale cannot be reversed through profit or loss. The Standard requires that for available-for-sale debt instruments, an impairment loss is reversed through profit or loss when fair value increases and the increase can be objectively related to an event occurring after the loss was recognised. Impairment losses recognised on available-for-sale equity instruments cannot be reversed through profit or loss, ie any subsequent increase in fair value is recognised in equity.
Hedge accounting
(q) The Standard requires that when a hedged forecast transaction actually occurs and results in the recognition of a financial asset or a financial liability, the gain or loss deferred in equity does not adjust the initial carrying amount of the asset or liability (ie ‘basis adjustment’ is prohibited), but remains in equity and is recognised in profit or loss consistently with the recognition of gains and losses on the asset or liability. For hedges of forecast transactions that will result in the recognition of a non-financial asset or a non-financial liability, the entity has a choice of whether to apply basis adjustment or retain the hedging gain or loss in equity and recognise it in profit or loss when the asset or liability affects profit or loss.
(r) The Exposure Draft proposed to treat hedges of firm commitments as fair value hedges (rather than as cash flow hedges). The Standard adopts this requirement but clarifies that a hedge of the foreign currency risk of a firm commitment may be accounted for as either a fair value hedge or a cash flow hedge.
(s) The Exposure Draft maintained the prior guidance that a forecast intragroup transaction may be designated as the hedged item in a foreign currency cash flow hedge provided the transaction is highly probable, meets all other hedge accounting criteria, and will result in the recognition of an intragroup monetary item. The Standard (as revised in 2003) did not include this guidance in the light of comments received from some constituents questioning its conceptual basis. After the revised Standard was issued, constituents raised concerns that it was common practice for entities to designate a forecast intragroup transaction as the hedged item and that the revised IAS 39 created a difference from US GAAP. In response to these concerns, the Board published an Exposure Draft in July 2004. That Exposure Draft proposed to allow an entity to apply hedge accounting in the consolidated financial statements to a highly probable forecast external transaction denominated in the functional currency of the entity entering into the transaction, provided the transaction gave rise to an exposure that would have an effect on the consolidated profit or loss (ie was denominated in a currency other than the group’s presentation currency). After discussing the comment letters received on that Exposure Draft, the Board decided to permit the foreign currency risk of a forecast intragroup transaction to be the hedged item in a cash flow hedge in consolidated financial statements provided the transaction is denominated in a currency other than the functional currency of the entity entering into that transaction and the foreign currency risk will affect consolidated profit or loss. In issuing this amendment the Board concluded that:
(i) allowing a forecast intragroup transaction to be designated as the hedged item in consolidated financial statements is consistent with the functional currency framework in IAS 21 The Effects of Changes in Foreign Exchange Rates, which recognises a functional currency exposure whenever a transaction (including a forecast transaction) is denominated in a currency different from the functional currency of the entity entering into the transaction.
(ii) allowing a forecast transaction (intragroup or external) to be designated as the hedged item in consolidated financial statements would not be consistent with the functional currency framework in IAS 21 if the transaction is denominated in the functional currency of the entity entering into it. Accordingly, such transactions should not be permitted to be designated as hedged items in a foreign currency cash flow hedge.
(iii) it is consistent with paragraphs 97 and 98 that any gain or loss that is recognised directly in equity in a cash flow hedge of a forecast intragroup transaction should be reclassified into consolidated profit or loss in the same period or periods during which the foreign currency risk of the hedged transaction affects consolidated profit or loss.
Transition
(t) The revised Standard adopts the proposal in the Exposure Draft that, on transition, an entity is permitted to designate a previously recognised financial asset or financial liability as a financial asset or a financial liability at fair value through profit or loss or available for sale. However, a disclosure requirement has been added to IAS 32* to provide information about the fair value of the financial assets or financial liabilities designated into each category and the classification and carrying amount in the previous financial statements.
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* In August 2005, the IASB relocated all disclosures relating to financial instruments to IFRS 7 Financial Instruments: Disclosures.
(u) The Exposure Draft proposed retrospective application of the derecognition provisions of the revised IAS 39 to financial assets derecognised under the original IAS 39. The Standard requires prospective application, namely that entities do not recognise those assets that were derecognised under the original Standard, but permits retrospective application from a date of the entity’s choosing, provided that the information needed to apply IAS 39 to assets and liabilities derecognised as a result of past transactions was obtained at the time of initially accounting for those transactions.
(v) The Exposure Draft proposed, and the revised Standard originally required, retrospective application of the ‘day 1’ gain or loss recognition requirements in paragraph AG76. After the revised Standard was issued, constituents raised concerns that retrospective application would diverge from the requirements of US GAAP, would be difficult and expensive to implement, and might require subjective assumptions about what was observable and what was not. In response to these concerns, the Board decided:
(i) to permit entities to apply the requirements in the last sentence of paragraph AG76 in any one of the following ways:
• retrospectively, as previously required by IAS 39
• prospectively to transactions entered into after 25 October 2002, the effective date of equivalent US GAAP requirements
• prospectively to transactions entered into after 1 January 2004, the date of transition to IFRSs for many entities.
(ii) to clarify that a gain or loss should be recognised after initial recognition only to the extent that it arises from a change in a factor (including time) that market participants would consider in setting a price. Some constituents asked the Board to clarify that straight-line amortisation is an appropriate method of recognising the difference between a transaction price (used as fair value in accordance with paragraph AG76) and a valuation made at the time of the transaction that was not based solely on data from observable markets. The Board decided not to do this. It concluded that although straight-line amortisation may be an appropriate method in some cases, it will not be appropriate in others.
Dissenting opinions
Dissent of Anthony T Cope, James J Leisenring and Warren J McGregor from the issue of IAS 39 in December 2003
DO1 Messrs Cope, Leisenring and McGregor dissent from the issue of this Standard.
DO2 Mr Leisenring dissents because he disagrees with the conclusions concerning derecognition, impairment of certain assets and the adoption of basis adjustment hedge accounting in certain circumstances.
DO3 The Standard requires in paragraphs 30 and 31 that to the extent of an entity’s continuing involvement in an asset, a liability should be recognised for the consideration received. Mr Leisenring believes that the result of that accounting is to recognise assets that fail to meet the definition of assets and to record liabilities that fail to meet the definition of liabilities. Furthermore, the Standard fails to recognise forward contracts, puts or call options and guarantees that are created, but instead records a fictitious ‘borrowing’ as a result of rights and obligations created by those contracts. There are other consequences of the continuing involvement approach that has been adopted. For transferors, it results in very different accounting by two entities when they have identical contractual rights and obligations only because one entity once owned the transferred financial asset. Furthermore, the ‘borrowing’ that is recognised is not accounted for like other loans, so no interest expense may be recorded. Indeed, implementing the proposed approach requires the specific override of measurement and presentation standards applicable to other similar financial instruments that do not arise from derecognition transactions. For example, derivatives created by derecognition transactions are not accounted for at fair value. For transferees, the approach also requires the override of the recognition and measurement requirements applicable to other similar financial instruments. If an instrument is acquired in a transfer transaction that fails the derecognition criteria, the transferee recognises and measures it differently from an instrument that is acquired from the same counterparty separately.
DO4 Mr Leisenring also disagrees with the requirement in paragraph 64 to include an asset that has been individually judged not to be impaired in a portfolio of similar assets for an additional portfolio assessment of impairment. Once an asset is judged not to be impaired, it is irrelevant whether the entity owns one or more similar assets as those assets have no implications for whether the asset that was individually considered for impairment is or is not impaired. The result of this accounting is that two entities could each own 50 per cent of a single loan. Both entities could conclude the loan is not impaired. However, if one of the two entities happens to have other loans that are similar, it would be allowed to recognise an impairment with respect to the loan where the other entity is not. Accounting for identical exposures differently is unacceptable. Mr Leisenring believes that the arguments in paragraph BC115 are compelling.
DO5 Mr Leisenring also dissents from paragraph 98 which allows but does not require basis adjustment for hedges of forecast transactions that result in the recognition of non-financial assets or liabilities. This accounting results in always adjusting the recorded asset or liability at the date of initial recognition away from its fair value. It also records an asset, if the basis adjustment alternative is selected, at an amount other than its cost as defined in IAS 16 Property, Plant and Equipment and further described in paragraph 16 of that Standard. If a derivative were to be considered a part of the cost of acquiring an asset, hedge accounting in these circumstances should not be elective to be consistent with IAS 16. Mr Leisenring also objects to creating this alternative as a result of an improvement project that ostensibly had as an objective the reduction of alternatives. The non-comparability that results from this alternative is both undesirable and unnecessary.
DO6 Mr Leisenring also dissents from the application guidance in paragraph AG71 and in particular the conclusion contained in paragraph BC98. He does not believe that an entity that originates a contract in one market should measure the fair value of the contract by reference to a different market in which the transaction did not take place. If prices change in the transacting market, that price change should be recognised when subsequently measuring the fair value of the contract. However, there are many implications of switching between markets when measuring fair value that the Board has not yet addressed. Mr Leisenring believes a gain or loss should not be recognised based on the fact a transaction could occur in a different market.
