International GAAP® 2019: Generally Accepted Accounting Practice under International Financial Reporting Standards
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tranche (CU 80), mezzanine tranche (CU 90) and senior tranche (CU 10). The probability weight of 25% for Scenario IV
is then applied to the expected losses allocated to each tranche.
The junior notes have an expected loss which is, in percentage terms, greater than the overall expected loss
on the underlying portfolio. Therefore, these notes must be accounted for at fair value through profit or loss.
Similarly, the mezzanine notes have a greater expected loss than the underlying pool and would not pass the
contractual cash flow characteristics test.
Financial
instruments:
Classification
3643
The expected losses on the senior notes and the super senior notes are lower than the overall expected loss
on the underlying pool of instruments and may qualify for amortised cost or fair value through other
comprehensive income treatment, provided all other IFRS 9 requirements are met and the instruments are
not held for trading.
In this example, it might have been possible to come to the same conclusion without a
numerical calculation for the junior and super senior tranches, but the technique is helpful
to determine the treatment of the intermediary notes. In practice, it may also be necessary
to apply judgment through a qualitative assessment of specific facts and circumstances.
7
DESIGNATION AT FAIR VALUE THROUGH PROFIT OR
LOSS
Financial assets or financial liabilities may be designated as measured at fair value
through profit or loss at initial recognition if doing so eliminates or significantly reduces
a measurement or recognition inconsistency (sometimes referred to as an ‘accounting
mismatch’) that would otherwise arise. [IFRS 9.4.1.5, 4.2.2(a)].
Financial liabilities may also be designated at fair value through profit or loss where a
group of financial liabilities or financial assets and financial liabilities is managed and its
performance is evaluated on a fair value basis. [IFRS 9.4.2.2(b)]. Financial assets that are
managed on a fair value basis will always be classified at fair value through profit or loss
(see 5.4 above), hence, a designation option is not needed.
Designation at fair value through profit or loss in the two situations described above is
permitted provided doing so results in the financial statements presenting more relevant
information. [IFRS 9.B4.1.27]. Such a designation can be made only at initial recognition
and cannot be revoked subsequently.
In addition, a hybrid contract with a host that is not an asset within the scope of IFRS 9
that contains one or more embedded derivatives meeting particular conditions may be
designated, in its entirety, at fair value through profit or loss. [IFRS 9.4.3.5]. These
conditions are discussed in detail at 7.3 below.
The decision to designate a financial asset or financial liability as measured at fair value
through profit or loss is similar to an accounting policy choice, although, unlike an
accounting policy choice, it is not required in all cases to be applied consistently to all
similar transactions. However, for a group of financial assets and financial liabilities that
is managed and its performance is evaluated on a fair value basis, all eligible financial
liabilities that are managed together should be designated. [IFRS 9.B4.1.35]. When an entity
has such a choice, IAS 8 requires the chosen policy to result in the financial statements
providing reliable and more relevant information about the effects of transactions, other
events and conditions on the entity’s financial position, financial performance or cash
flows. For example, in designating a financial liability at fair value through profit or loss,
an entity needs to demonstrate that it falls within at least one of the circumstances set
out above. [IFRS 9.B4.1.28].
The fair value option cannot be applied to a portion or component of a financial
instrument, e.g. changes in the fair value of a debt instrument attributable to one risk
such as changes in a benchmark interest rate, but not credit risk. Further, it cannot be
applied to proportions of an instrument. However, if an entity simultaneously issues
3644 Chapter 44
two or more identical financial instruments, it is not precluded from designating only
some of those instruments as being subject to the fair value option (e.g. if doing so
achieves a significant reduction in an accounting mismatch). Therefore, if an entity
issued a bond totalling US$100 million in the form of 100 certificates each of
US$1 million, the entity could designate 10 specified certificates if to do so would meet
at least one of the criteria noted above. [IFRS 9.BCZ4.74-76].
The conditions under which financial instruments may be designated at fair value
through profit or loss are discussed further at 7.1 to 7.3 below.
7.1
Designation eliminates or significantly reduces a measurement
or recognition inconsistency (accounting mismatch) that would
otherwise arise
The notion of an accounting mismatch necessarily involves two propositions. First, that
an entity has particular assets and liabilities that are measured, or on which gains and
losses are recognised, on different bases; and second, that there is a perceived economic
relationship between those assets and liabilities. [IFRS 9.BCZ4.61].
For example, absent any designation, a financial asset might be classified as
subsequently measured at fair value and a liability the entity considers related would be
subsequently measured at amortised cost (with changes in fair value not recognised). In
such circumstances, an entity may conclude that its financial statements would provide
more relevant information if both the asset and the liability were measured as at fair
value through profit or loss. [IFRS 9.B4.1.29].
IFRS 9 gives the following examples of situations in which designation of a financial
asset or financial liability as measured at fair value through profit or loss might eliminate
or significantly reduce an accounting mismatch and produce more relevant information:
[IFRS 9.B4.1.30]
(a) an entity has liabilities under insurance contracts whose measurement
incorporates current information (as permitted by IFRS 4 – Insurance Contracts),
and financial assets it considers related that would otherwise be measured at fair
value through other comprehensive income or amortised cost;
(b) an entity has financial assets, financial liabilities or both that share a risk, such as
interest rate risk, that gives rise to changes in fair value that tend to offset each
other. However, only some of the instruments would be measured at fair value
through profit or loss (e.g. derivatives or those classified as held for trading). It may
also be the case that the requirements for hedge accounting are not met, for
example because the requirements for hedge effectiveness are not met;
(c) an entity has financial assets, financial liabilities or both that share a risk, such as
interest rate risk, that gives rise to changes in fair value that tend to offset each
other and the entity does not use hedge accounting. This could be for different
reasons, for example, because items giving rise to the accounting mismatch would
not qualify for hedge accounting or because th
e entity does not want to use hedge
accounting because of operational complexity. Furthermore, in the absence of
hedge accounting there is a significant inconsistency in the recognition of gains
and losses. For example, the entity has financed a specified group of loans by
Financial
instruments:
Classification
3645
issuing traded bonds, the changes in the fair value of which tend to offset each
other. If, in addition, the entity regularly buys and sells the bonds but rarely, if ever,
buys and sells the loans, reporting both the loans and the bonds at fair value
through profit or loss eliminates the inconsistency in the timing of recognition of
gains and losses that would otherwise result from measuring them both at
amortised cost and recognising a gain or loss each time a bond is repurchased.
For practical purposes, an entity need not acquire all the assets and incur all the
liabilities giving rise to the measurement or recognition inconsistency at exactly the
same time. A reasonable delay is permitted provided that each transaction is designated
as at fair value through profit or loss at its initial recognition and, at that time, any
remaining transactions are expected to occur. [IFRS 9.B4.1.31].
It would not be acceptable to designate only some of the financial assets giving rise to
the inconsistency as at fair value through profit or loss if to do so would not eliminate
or significantly reduce the inconsistency and would therefore not result in more
relevant information. However, it would be acceptable to designate only some of a
number of similar financial assets if doing so does achieve a significant reduction (and
possibly a greater reduction than other allowable designations) in the inconsistency.
[IFRS 9.B4.1.32].
For example, assume an entity has a number of similar financial assets totalling €100
and a number of similar financial liabilities totalling €50, but these are measured on a
different basis. The entity may significantly reduce the measurement inconsistency by
designating at initial recognition all of the liabilities but only some of the assets (for
example, individual assets with a combined total of €45) as at fair value through profit
or loss. However, because designation as at fair value through profit or loss can be
applied only to the whole of a financial instrument, the entity in this example must
designate one or more assets in their entirety. It could not designate either a component
of an asset (e.g. changes in value attributable to only one risk, such as changes in a
benchmark interest rate) or a proportion (i.e. percentage) of an asset. [IFRS 9.B4.1.32].
7.2
A group of financial liabilities or financial assets and financial
liabilities is managed and its performance is evaluated on a fair
value basis
The second situation in which the fair value option may be used (for financial liabilities)
is where a group of financial liabilities or financial assets and financial liabilities is
managed, and its performance evaluated, on a fair value basis. In order to meet this
condition, it is necessary for the group of instruments to be managed in accordance with
a documented risk management or investment strategy and for information, prepared
on a fair value basis, about the group of instruments to be provided internally to the
entity’s key management personnel (as defined in IAS 24 – see Chapter 35 at 2.2.1.D),
for example the entity’s board of directors and chief executive officer. [IFRS 9.4.2.2(b)].
If an entity manages and evaluates the performance of a group of financial liabilities or
financial assets and financial liabilities in such a way, measuring that group at fair value
through profit or loss results in more relevant information. The focus in this instance is
on the way the entity manages and evaluates performance, rather than on the nature of
its financial instruments. [IFRS 9.B4.1.33]. Accordingly, subject to the requirement of
3646 Chapter 44
designation at initial recognition, an entity that designates financial instruments as at
fair value through profit or loss on the basis of this condition should so designate all
eligible financial instruments that are managed and evaluated together. [IFRS 9.B4.1.35].
An entity may designate financial liabilities as at fair value through profit or loss if it has
financial assets and financial liabilities that share one or more risks and those risks are
managed and evaluated on a fair value basis in accordance with a documented policy of
asset and liability management. For example, the entity may issue ‘structured products’
containing multiple embedded derivatives and manage the resulting risks on a fair value
basis using a mix of derivative and non-derivative financial instruments. [IFRS 9.B4.1.34].
An entity’s documentation of its strategy need not be extensive (e.g. it need not be at
the level of detail required for hedge accounting) but should be sufficient to
demonstrate that using the fair value option is consistent with the entity’s risk
management or investment strategy. Such documentation is not required for each
individual item, but may be on a portfolio basis. The IASB notes that in many cases, the
entity’s existing documentation, as approved by its key management personnel, should
be sufficient for this purpose. For example, if the performance management system for
a department (as approved by the entity’s key management personnel) clearly
demonstrates that its performance is evaluated on a total return basis, no further
documentation is required. [IFRS 9.B4.1.36].
The IASB made it clear in its basis for conclusions that in looking to an entity’s
documented risk management or investment strategy, it makes no judgement on what
an entity’s strategy should be. However, the IASB believes that users, in making
economic decisions, would find useful a description both of the chosen strategy and of
how designation at fair value through profit or loss is consistent with that strategy.
Accordingly, IFRS 7 – Financial Instruments: Disclosures – requires these to be
disclosed (see Chapter 50 at 4.1). [IFRS 9.BCZ4.66].
7.3
Hybrid contracts with a host that is not a financial asset within
the scope of IFRS 9
If a contract contains one or more embedded derivatives, and the host is not a financial
asset within the scope of IFRS 9, an entity may designate the entire hybrid contract as
at fair value through profit or loss unless:
(a) the embedded derivative does not significantly modify the cash flows that
otherwise would be required by the contract; or
(b) it is clear with little or no analysis when a similar hybrid (combined) instrument is
first considered that separation of the embedded derivative(s) is prohibited, such
as a prepayment option embedded in a loan that permits the holder to prepay the
loan for approximately its amortised cost. [IFRS 9.4.3.5].
As discussed in Chapter 42 at 4 to 6, when an entity becomes a party to a hybrid financial
instrument that contains one or more embedded derivatives and the host is not a financial
asset within the scope of IFRS 9, the entity is required to identify any such embedded
derivative, assess whether it is required t
o be separated from the host contract and, if so,
measure it at fair value at initial recognition and subsequently. These requirements can
be more complex, or result in less reliable measures, than measuring the entire instrument
Financial
instruments:
Classification
3647
at fair value through profit or loss. For that reason the entire instrument is normally
permitted to be designated as at fair value through profit or loss. [IFRS 9.B4.3.9].
Such designation may be used whether the entity is required to, or prohibited from,
separating the embedded derivative from the host contract, except for those situations
in (a) or (b) above – this is because doing so would not reduce complexity or increase
reliability. [IFRS 9.B4.3.10].
Little further guidance is given on what instruments might fall within (a) and (b) above.
The basis for conclusions explains that, at one extreme, the terms of a prepayment
option in an ordinary residential mortgage is likely to mean that the fair value option is
unavailable to such a mortgage (unless it met one of the conditions in 7.1 and 7.2 above).
At the other, it is likely to be available for ‘structured products’ that contain several
embedded derivatives which are typically hedged with derivatives that offset all (or
nearly all) of the risks they contain irrespective of the accounting treatment applied to
the embedded derivatives. [IFRS 9.BCZ4.68-70].
Essentially, the IASB explains, the standard seeks to strike a balance between reducing
the costs of complying with the embedded derivatives provisions and the need to respond
to concerns expressed regarding possible inappropriate use of the fair value option.
Allowing the fair value option to be used for any instrument with an embedded derivative
would make other restrictions on the use of the option ineffective, because many financial
instruments include an embedded derivative. In contrast, limiting the use of the fair value
option to situations in which the embedded derivative must otherwise be separated
would not significantly reduce the costs of compliance and could result in less reliable
measures being included in the financial statements. [IFRS 9.BCZ4.70].
8
DESIGNATION OF NON-DERIVATIVE EQUITY