BC23D The Board issued the amendments for financial guarantee contracts in August 2005. After those amendments, the recognition and measurement requirements for financial guarantee contracts within the scope of IAS 39 are consistent with FI№ 45 in some areas, but differ in others:
(a) Like FI№ 45, IAS 39 requires initial recognition at fair value.
(b) IAS 39 requires systematic amortisation, in accordance with IAS 18, of the liability recognised initially. This is compatible with FI№ 45, though FI№ 45 contains less prescriptive requirements on subsequent measurement. Both IAS 39 and FI№ 45 include a liability adequacy (or loss recognition) test, although the tests differ because of underlying differences in the Standards to which those tests refer (IAS 37 and SFAS 5).
(c) Like FI№ 45, IAS 39 permits a different treatment for financial guarantee contracts issued by insurers.
(d) Unlike FI№ 45, IAS 39 does not contain exemptions for parents, subsidiaries or other entities under common control. However, any differences are reflected only in the separate or individual financial statements of the parent, subsidiaries or common control entities.
BC23E Some respondents to the Exposure Draft of July 2004 asked for guidance on the treatment of financial guarantee contracts by the holder. However, this was beyond the limited scope of the project.
Contracts to buy or sell a non-financial item (paragraphs 5-7 and AG10)
BC24 Before the amendments, IAS 39 and IAS 32 were not consistent with respect to the circumstances in which a commodity-based contract meets the definition of a financial instrument and is accounted for as a derivative. The Board concluded that the amendments should make them consistent on the basis of the notion that a contract to buy or sell a non-financial item should be accounted for as a derivative when it (i) can be settled net or by exchanging financial instruments and (ii) is not held for the purpose of receipt or delivery of the non-financial item in accordance with the entity’s expected purchase, sale or usage requirements (a ‘normal’ purchase or sale). In addition, the Board concluded that the notion of when a contract can be settled net should include contracts:
(a) where the entity has a practice of settling similar contracts net in cash or another financial instrument or by exchanging financial instruments;
(b) for which the entity has a practice of taking delivery of the underlying and selling it within a short period after delivery for the purpose of generating a profit from short-term fluctuations in price or dealer’s margin; and
(c) in which the non-financial item that is the subject of the contract is readily convertible to cash.
Because practices of settling net or taking delivery of the underlying and selling it within a short period after delivery also indicate that the contracts are not ‘normal’ purchases or sales, such contracts are within the scope of IAS 39 and are accounted for as derivatives. The Board also decided to clarify that a written option that can be settled net in cash or another financial instrument, or by exchanging financial instruments, is within the scope of the Standard and cannot qualify as a ‘normal’ purchase or sale.
Definitions___
Loans and receivables (paragraphs 9, 46(a) and AG26)
BC25 The principal difference between loans and receivables and other financial assets is that loans and receivables are not subject to the tainting provisions that apply to held-to-maturity investments. Loans and receivables that are not held for trading may be measured at amortised cost even if an entity does not have the positive intention and ability to hold the loan asset until maturity.
BC26 The Board decided that the ability to measure a financial asset at amortised cost without consideration of the entity’s intention and ability to hold the asset until maturity is most appropriate when there is no liquid market for the asset. It is less appropriate to extend the category to debt instruments traded in liquid markets. The distinction for measurement purposes between liquid debt instruments that are acquired upon issue and liquid debt instruments that are acquired shortly afterwards is difficult to justify on conceptual grounds. Why should a liquid debt instrument that is purchased on the day of issue be treated differently from a liquid debt instrument that is purchased one week after issue? Why should it not be possible to classify a liquid debt instrument that is acquired directly from the issuer as available for sale, with fair value gains and losses recognised in equity? Why should a liquid debt instrument that is bought shortly after it is issued be subject to tainting provisions, if a liquid debt instrument that is bought at the time of issue is not subject to tainting provisions?
BC27 The Board therefore decided to add a condition to the definition of a loan or receivable. More specifically, an entity should not be permitted to classify as a loan or receivable an investment in a debt instrument that is quoted in an active market. For such an investment, an entity should be required to demonstrate its positive intention and ability to hold the investment until maturity to be permitted to measure the investment at amortised cost by classifying it as held to maturity.
BC28 The Board considered comments received on the proposal in the Exposure Draft (which was unchanged from the requirement in the original IAS 39) that ‘loans and receivables’ must be originated (rather than purchased) to meet that classification. Such comments suggested that purchased loans should be eligible for classification as loans and receivables, for example, if an entity buys a loan portfolio, and the purchased loans meet the definition other than the fact that they were purchased. Such comments also noted that (a) some entities typically manage purchased and originated loans together, and (b) there are systems problems of segregating purchased loans from originated loans given that a distinction between them is likely to be made only for accounting purposes. In the light of these concerns, the Board decided to remove the requirement that loans or receivables must be originated by the entity to meet the definition of ‘loans and receivables’.
BC29 However, the Board was concerned that removing this requirement might result in some instruments that should be measured at fair value meeting the definition of loans and receivables and thus being measured at amortised cost. In particular, the Board was concerned that this would be the case for a debt instrument in which the purchaser may not recover its investment, for example a fixed rate interest-only strip created in a securitisation and subject to prepayment risk. The Board therefore decided to exclude from the definition of loans and receivables instruments for which the holder may not recover substantially all of its initial investment, other than because of credit deterioration. Such assets are accounted for as available for sale or at fair value through profit or loss.
Effective interest rate (paragraphs 9 and AG5-AG8)
BC30 The Board considered whether the effective interest rate for all financial instruments should be calculated on the basis of estimated cash flows (consistently with the original IAS 39) or whether the use of estimated cash flows should be restricted to groups of financial instruments with contractual cash flows being used for individual financial instruments. The Board agreed to reconfirm the position in the original IAS 39 because it achieves consistent application of the effective interest method throughout the Standard.
BC31 The Board noted that future cash flows and the expected life can be reliably estimated for most financial assets and financial liabilities, in particular for a group of similar financial assets or similar financial liabilities. However, the Board acknowledged that in some rare cases it might not be possible to estimate the timing or amount of future cash flows reliably. It therefore decided to require that if it is not possible to estimate reliably the future cash flows or the expected life of a financial instrument, the entity should use contractual cash flows over the full contractual term of the financial instrument.
BC32 The Board also decided to clarify that expected future defaults should not be included in estimates of cash flows because this would be a departure from the incurred loss model for impairment recognition. At the same time, the Board noted that in some cases, for example, when a financial asset is acquired at a deep discount, credit losses have occurred and are reflected in the price. If an entity does not take into account such credit losses in the calculation of the effective interest rate, the entity would recognise a higher interest income than that inherent in the price paid. The Board therefore decided to clarify that such credit losses are included in the estimated cash flows when computing the effective interest rate.
BC33 The revised IAS 39 refers to all fees ‘that are an integral part of the effective interest rate’. The Board included this reference to clarify that IAS 39 relates only to those fees that are determined to be an integral part of the effective interest rate in accordance with IAS 18.
BC34 Some commentators noted that it was not always clear how to interpret the requirement in the original IAS 39 that the effective interest rate must be based on discounting cash flows through maturity or the next market-based repricing date. In particular, it was not always clear whether fees, transaction costs and other premiums or discounts included in the calculation of the effective interest rate should be amortised over the period until maturity or the period to the next market-based repricing date.
BC35 For consistency with the estimated cash flows approach, the Board decided to clarify that the effective interest rate is calculated over the expected life of the instrument or, when applicable, a shorter period. A shorter period is used when the variable (eg interest rates) to which the fee, transaction costs, discount or premium relates is repriced to market rates before the expected maturity of the instrument. In such a case, the appropriate amortisation period is the period to the next such repricing date.
Accounting for a change in estimates
BC36 The Board considered the accounting for a change in the estimates used in calculating the effective interest rate. The Board agreed that if an entity revises its estimates of payments or receipts, it should adjust the carrying amount of the financial instrument to reflect actual and revised estimated cash flows. The adjustment is recognised as income or expense in profit or loss. The entity recalculates the carrying amount by computing the present value of remaining cash flows at the original effective interest rate of the financial instrument. The Board noted that this approach has the practical advantage that it does not require recalculation of the effective interest rate, ie the entity simply recognises the remaining cash flows at the original rate. As a result, this approach avoids a possible conflict with the requirement when assessing impairment to discount estimated cash flows using the original effective interest rate.
Embedded derivatives__
Embedded foreign currency derivatives (paragraphs 10 and AG33(d))
BC37 A rationale for the embedded derivatives requirements is that an entity should not be able to circumvent the recognition and measurement requirements for derivatives merely by embedding a derivative in a non-derivative financial instrument or other contract, for example, a commodity forward in a debt instrument. To achieve consistency in accounting for such embedded derivatives, all derivatives embedded in financial instruments that are not measured at fair value with gains and losses recognised in profit or loss ought to be accounted for separately as derivatives. However, as a practical expedient IAS 39 provides that an embedded derivative need not be separated if it is regarded as closely related to its host contract. When the embedded derivative bears a close economic relationship to the host contract, such as a cap or a floor on the interest rate on a loan, it is less likely that the derivative was embedded to achieve a desired accounting result.
BC38 The original IAS 39 specified that a foreign currency derivative embedded in a non-financial host contract (such as a supply contract denominated in a foreign currency) was not separated if it required payments denominated in the currency of the primary economic environment in which any substantial party to the contract operates (their functional currencies) or the currency in which the price of the related good or service that is acquired or delivered is routinely denominated in international commerce (such as the US dollar for crude oil transactions). Such foreign currency derivatives are regarded as bearing such a close economic relationship to their host contracts that they do not have to be separated.
BC39 The requirement to separate embedded foreign currency derivatives may be burdensome for entities that operate in economies in which business contracts denominated in a foreign currency are common. For example, entities domiciled in small countries may find it convenient to denominate business contracts with entities from other small countries in an internationally liquid currency (such as the US dollar, euro or yen) rather than the local currency of any of the parties to the transaction. In addition, an entity operating in a hyperinflationary economy may use a price list in a hard currency to protect against inflation, for example, an entity that has a foreign operation in a hyperinflationary economy that denominates local contracts in the functional currency of the parent.
BC40 In revising IAS 39, the Board concluded that an embedded foreign currency derivative may be integral to the contractual arrangements in the cases mentioned in the previous paragraph. It decided that a foreign currency derivative in a contract should not be required to be separated if it is denominated in a currency that is commonly used in business transactions (that are not financial instruments) in the environment in which the transaction takes place. A foreign currency derivative would be viewed as closely related to the host contract if the currency is commonly used in local business transactions, for example, when monetary amounts are viewed by the general population not in terms of the local currency but in terms of a relatively stable foreign currency, and prices may be quoted in that foreign currency (see IAS 29 Financial Reporting in Hyperinflationary Economies).
Recognition and derecognition__
Derecognition of a financial asset (paragraphs 15-37)
The original IAS 39
BC41 Under the original IAS 39, several concepts governed when a financial asset should be derecognised. It was not always clear when and in what order to apply these concepts. As a result, the derecognition requirements in the original IAS 39 were not applied consistently in practice.
BC42 As an example, the original IAS 39 was unclear about the extent to which risks and rewards of a transferred asset should be considered for the purpose of determining whether derecognition is appropriate and how risks and rewards should be assessed. In some cases (eg transfers with total returns swaps or unconditional written put options), the Standard specifically indicated whether derecognition was appropriate, whereas in others (eg credit guarantees) it was unclear. Also, some questioned whether the assessment should focus on risks and rewards or only risks and how different risks and rewards should be aggregated and weighed.
BC43 To illustrate, assume an entity sells a portfolio of short-term receivables of CU100* and provides a guarantee to the buyer for credit losses up to a specified amount (say CU20) that is less than the total amount of the receivables, but higher than the amount of expected losses (say CU5). In this case, should (a) the entire portfolio continue to be recognised, (b) the portion that is guaranteed continue to be recognised or (c) the portfolio be derecognised in full and a guarantee be recognised as a financial liability? The original IAS 39 did not give a clear answer and the IAS 39 Implementation Guidance Committee—a group set up by the Board’s predecessor body to resolve interpretative issues raised in practice—was unable to reach an agreement on how IAS 39 should be applied in this case. In developing proposals for improvements to IAS 39, the Board concluded that it was important that IAS 39 should provide clear and consistent guidance on how to account for such a transaction.
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* In this Basis for Conclusions, monetary amounts are denominated in ‘currency units’ (CU).
Exposure draft
BC44 To resolve the problems, the Exposure Draft proposed an approach to derecognition under which a transferor of a financial asset continues to recognise that asset to the extent the transferor has a continuing involvement in it. Continuing involvement could be established in two ways: (a) a reacquisition provision (such as a call option, put option or repurchase agreement) and (b) a provision to pay or receive compensation based on changes in value of the transferred asset (such as a credit guarantee or net cash settled option).
BC45 The purpose of the approach proposed in the Exposure Draft was to facilitate consistent implementation and application of IAS 39 by eliminating conflicting concepts and establishing an unambiguous, more internally consistent and workable approach to derecognition. The main benefits of the proposed approach were that it would greatly clarify IAS 39 and provide transparency on the face of the balance sheet about any continuing involvement in a transferred asset.
Comments received
BC46 Many respondents agreed that there were inconsistencies in the existing derecognition requirements in IAS 39. However, there was limited support for the continuing involvement approach proposed in the Exposure Draft. Respondents expressed conceptual and practical concerns, including:
(a) any benefits of the proposed changes did not outweigh the burden of adopting a different approach that had its own set of (as yet unidentified and unsolved) problems;
(b) the proposed approach was a fundamental change from that in the original IAS 39;
(c) the proposal did not achieve convergence with US GAAP;
(d) the proposal was untested; and
(e) the proposal was not consistent with the Framework.
BC47 Many respondents expressed the view that the basic approach in the original IAS 39 should be retained in the revised Standard and the inconsistencies removed. The reasons included: (a) the existing IAS 39 was proven to be reasonable in concept and operational in practice and (b) the approach should not be changed until the Board developed an alternative comprehensive approach.
Revisions to IAS 39
BC48 In response to the comments received, the Board decided to revert to the derecognition concepts in the original IAS 39 and to clarify how and in what order the concepts should be applied. In particular, the Board decided that an evaluation of the transfer of risks and rewards should precede an evaluation of the transfer of control for all types of transactions.
BC49 Although the structure and wording of the derecognition requirements have been substantially amended, the Board concluded that the requirements in the revised IAS 39 are not substantially different from those in the original IAS 39. In support of this conclusion, it noted that the application of the requirements in the revised IAS 39 generally results in answers that could have been obtained under the original IAS 39. In addition, although there will be a need to apply judgement to evaluate whether substantially all risks and rewards have been retained, this type of judgement is not new compared with the original IAS 39. However, the revised requirements clarify the application of the concepts in circumstances in which it was previously unclear how IAS 39 should be applied. The Board concluded that it would be inappropriate to revert to the original IAS 39 without such clarifications.
BC50 The Board also decided to include guidance in the Standard that clarifies how to evaluate the concepts of risks and rewards and of control. The Board regards such guidance as important to provide a framework for applying the concepts in IAS 39. Although judgement is still necessary to apply the concepts in practice, the guidance should increase consistency in how the concepts are applied.
BC51 More specifically, the Board decided that the transfer of risks and rewards should be evaluated by comparing the entity’s exposure before and after the transfer to the variability in the amounts and timing of the net cash flows of the transferred asset. If the entity’s exposure, on a present value basis, has not changed significantly, the entity would conclude that it has retained substantially all risks and rewards. In this case, the Board concluded that the asset should continue to be recognised. This accounting treatment is consistent with the treatment of repurchase transactions and some assets subject to deep in-the-money options under the original IAS 39. It is also consistent with how some interpreted the original IAS 39 when an entity sells a portfolio of short-term receivables but retains all substantive risks through the issue of a guarantee to compensate for all expected credit losses (see the example in paragraph BC43).
BC52 The Board decided that control should be evaluated by looking to whether the transferee has the practical ability to sell the asset. If the transferee can sell the asset (eg because the asset is readily obtainable in the market and the transferee can obtain a replacement asset should it need to return the asset to the transferor), the transferor has not retained control because the transferor does not control the transferee’s use of the asset. If the transferee cannot sell the asset (eg because the transferor has a call option and the asset is not readily obtainable in the market, so that the transferee cannot obtain a replacement asset), the transferor has retained control because the transferee is not free to use the asset as its own.
BC53 The original IAS 39 also did not contain guidance on when a part of a financial asset could be considered for derecognition. The Board decided to include such guidance in the Standard to clarify the issue. It decided that an entity should apply the derecognition principles to a part of a financial asset only if that part contains no risks and rewards relating to the part not being considered for derecognition. Accordingly, a part of a financial asset is considered for derecognition only if it comprises:
(a) only specifically identified cash flows from a financial asset (or a group of similar financial assets);
(b) only a fully proportionate (pro rata) share of the cash flows from a financial asset (or a group of similar financial assets); or
(c) only a fully proportionate (pro rata) share of specifically identified cash flows from a financial asset (or a group of similar financial assets).
In all other cases the derecognition principles are applied to the financial asset in its entirety.
Arrangements under which an entity retains the contractual rights to receive the cash flows of a financial asset but assumes a contractual obligation to pay the cash flows to one or more recipients (paragraph 19)
BC54 The original IAS 39 did not provide explicit guidance about the extent to which derecognition is appropriate for contractual arrangements in which an entity retains its contractual right to receive the cash flows from an asset, but assumes a contractual obligation to pay those cash flows to another entity (a ‘pass-through arrangement’). Questions were raised in practice about the appropriate accounting treatment and divergent interpretations evolved for more complex structures.
BC55 To illustrate the issue using a simple example, assume the following. Entity A makes a five-year interest-bearing loan (the ‘original asset’) of CU100 to Entity B. Entity A then enters into an agreement with Entity C in which, in exchange for a cash payment of CU90, Entity A agrees to pass to Entity C 90 per cent of all principal and interest payments collected from Entity B (as, when and if collected). Entity A accepts no obligation to make any payments to Entity C other than 90 per cent of exactly what has been received from Entity B. Entity A provides no guarantee to Entity C about the performance of the loan and has no rights to retain 90 per cent of the cash collected from Entity B nor any obligation to pay cash to Entity C if cash has not been received from Entity B. In the example above, does Entity A have a loan asset of CU100 and a liability of CU90 or does it have an asset of CU10? To make the example more complex, what if Entity A first transfers the loan to a consolidated special purpose entity (SPE), which in turn passes through to investors the cash flows from the asset? Does the accounting treatment change because Entity A first sold the asset to an SPE?
BC56 To address these issues, the Exposure Draft of proposed amendments to IAS 39 included guidance to clarify under which conditions pass-through arrangements can be treated as a transfer of the underlying financial asset. The Board concluded that an entity does not have an asset and a liability, as defined in the Framework, when it enters into an arrangement to pass through cash flows from an asset and that arrangement meets specified conditions. In these cases, the entity acts more as an agent of the eventual recipients of the cash flows than as an owner of the asset. Accordingly, to the extent that those conditions are met the arrangement is treated as a transfer and considered for derecognition even though the entity may continue to collect cash flows from the asset. Conversely, to the extent the conditions are not met, the entity acts more as an owner of the asset with the result that the asset should continue to be recognised.
BC57 Respondents to the Exposure Draft were generally supportive of the proposed changes. Some respondents asked for further clarification of the requirements and the interaction with the requirements for consolidation of special purpose entities (in SIC-12). Respondents in the securitisation industry noted that under the proposed guidance many securitisation structures would not qualify for derecognition.
BC58 Considering these and other comments, the Board decided to proceed with its proposals to issue guidance on pass-through arrangements and to clarify that guidance in finalising the revised IAS 39.
BC59 The Board concluded that the following three conditions must be met for treating a contractual arrangement to pass through cash flows from a financial asset as a transfer of that asset:
(a) The entity has no obligation to pay amounts to the eventual recipients unless it collects equivalent amounts from the original asset. However, the entity is allowed to make short-term advances to the eventual recipient so long as it has the right of full recovery of the amount lent plus accrued interest.
(b) The entity is prohibited by the terms of the transfer contract from selling or pledging the original asset other than as security to the eventual recipients for the obligation to pay them cash flows.
(c) The entity has an obligation to remit any cash flows it collects on behalf of the eventual recipients without material delay. In addition, during the short settlement period, the entity is not entitled to reinvest such cash flows except for investments in cash or cash equivalents and where any interest earned from such investments is remitted to the eventual recipients.
BC60 These conditions follow from the definitions of assets and liabilities in the Framework. Condition (a) indicates that the transferor has no liability (because there is no present obligation to pay cash), and conditions (b) and (c) indicate that the transferor has no asset (because the transferor does not control the future economic benefits associated with the transferred asset).
BC61 The Board decided that the derecognition tests that apply to other transfers of financial assets (ie the tests of transferring substantially all the risks and rewards and control) should also apply to arrangements to pass through cash flows that meet the three conditions but do not involve a fully proportional share of all or specifically identified cash flows. Thus, if the three conditions are met and the entity passes on a fully proportional share, either of all cash flows (as in the example in paragraph BC55) or of specifically identified cash flows (eg 10 per cent of all interest cash flows), the proportion sold is derecognised, provided the entity has transferred substantially all the risks and rewards of ownership. Thus, in the example in paragraph BC55, Entity A would report a loan asset of CU10 and derecognise CU90. Similarly, if an entity enters into an arrangement that meets the three conditions above, but the arrangement is not on a fully proportionate basis, the contractual arrangement would have to meet the general derecognition conditions to qualify for derecognition. This ensures consistency in the application of the derecognition model, whether a transaction is structured as a transfer of the contractual right to receive the cash flows of a financial asset or as an arrangement to pass through cash flows.
BC62 To illustrate a disproportionate arrangement using a simple example, assume the following. Entity A originates a portfolio of five-year interest-bearing loans of CU10,000. Entity A then enters into an agreement with Entity C in which, in exchange for a cash payment of CU9,000, Entity A agrees to pay to Entity C the first CU9,000 (plus interest) of cash collected from the loan portfolio. Entity A retains rights to the last CU1,000 (plus interest), ie it retains a subordinated residual interest. If Entity A collects, say, only CU8,000 of its loans of CU10,000 because some debtors default, Entity A would pass on to Entity C all of the CU8,000 collected and Entity A keeps nothing of the CU8,000 collected. If Entity A collects CU9,500, it passes CU9,000 to Entity C and retains CU500. In this case, if Entity A retains substantially all the risks and rewards of ownership because the subordinated retained interest absorbs all of the likely variability in net cash flows, the loans continue to be recognised in their entirety even if the three pass-through conditions are met.
BC63 The Board recognises that many securitisations may fail to qualify for derecognition either because one or more of the three conditions in paragraph 19 are not met or because the entity has retained substantially all the risks and rewards of ownership.
BC64 Whether a transfer of a financial asset qualifies for derecognition does not differ depending on whether the transfer is direct to investors or through a consolidated SPE or trust that obtains the financial assets and, in turn, transfers a portion of those financial assets to third party investors.
Transfers that do not qualify for derecognition (paragraph 29)
BC65 The original IAS 39 did not provide guidance about how to account for a transfer of a financial asset that does not qualify for derecognition. The amendments include such guidance. To ensure that the accounting reflects the rights and obligations that the transferor has in relation to the transferred asset, there is a need to consider the accounting for the asset as well as the accounting for the associated liability.
BC66 When an entity retains substantially all the risks and rewards of the asset (eg in a repurchase transaction), there are generally no special accounting considerations because the entity retains upside and downside exposure to gains and losses resulting from the transferred asset. Therefore, the asset continues to be recognised in its entirety and the proceeds received are recognised as a liability. Similarly, the entity continues to recognise any income from the asset along with any expense incurred on the associated liability.
Continuing involvement in a transferred asset (paragraphs 30-35)
BC67 The Board decided that if the entity determines that it has neither retained nor transferred substantially all of the risks and rewards of an asset and that it has retained control, the entity should continue to recognise the asset to the extent of its continuing involvement. This is to reflect the transferor’s continuing exposure to the risks and rewards of the asset and that this exposure is not related to the entire asset, but is limited in amount. The Board noted that precluding derecognition to the extent of the continuing involvement is useful to users of financial statements in such cases, because it reflects the entity’s retained exposure to the risks and rewards of the financial asset better than full derecognition.
