International Accounting Standard 39 requires all financial assets and liabilities, including derivatives, to be measured depending on their classification at either fair value, or amortised cost so as to record a constant effective yield.
The International Accounting Standards Board (IASB) issued amendments to IAS 39 in December and provided five different categories of financial instruments which dictate the accounting treatment:
The amendments introduced the option for an entity to designate at inception any financial asset or financial liability as Fair Value Through Profit or Loss ("FVTPL"), in addition to all derivatives and items held for trading. This is known as the Fair Value Option (FVO). It simplified the application of the standard by mitigating some of the anomalies that result from the different measurement rules. For example, if a borrowing is used to fund the trading book, the amendments allow the liability to be measured on the same basis as the financial assets and designated at FVTPL, rather than being recorded at its amortised cost.
April's Exposure Draft
The IASB issued an Exposure Draft of further amendments to IAS 39 on the FVO, which proposes to limit the type of instruments to which the FVO may be applied last month. Furthermore, an instrument would only qualify to be designated at FVTPL, if its fair value is verifiable. The changes were proposed in response to concerns raised by European regulators that the FVO will increase the volatility of an entity's reported earnings and that entities might apply the FVO to financial assets or financial liabilities when the fair value is not verifiable.
The types of instruments to which the FVO may now be applied are:
* A financial instrument that contains an embedded derivative;
* A financial liability in which cash flows are contractually
linked to the performance of specific assets that are
measured at fair value;
* A financial asset or financial liability (or portfolio) whose
exposure to fair value changes is substantially offset by the
exposure to the changes in fair value of another financial
asset or liability (or portfolio), including a derivative;
* Any financial asset which is not a loan or a receivable;
* An item that IAS 39 or another standard allows or requires
to be designated at FVTPL.
Embedded Derivatives
One of the most common uses of the fair value option is for structured products that contain embedded derivatives. The separation and measurement of such embedded derivatives is both difficult and subjective and the valuation of the entire instrument is less prone to error and reflects the way these instruments are managed by a bank. Also, by recording the entire instrument at fair value, hedge accounting is not necessary to obtain profit or loss symmetry.
By allowing the FVO to continue to be applied to any financial instrument that contains an embedded derivative, even when the embedded derivative is "closely related", it will still be possible to fair value a substantial number of financial instruments. This will allow, as currently drafted, all issued structured products to be held at FVTPL. This is a matter on which the Board has specifically asked for comments and we expect the European regulators to ask for this category to be restricted and only applied to financial instruments that contain an embedded derivative that is not closely related. If this further restriction is made to the option, certain products issued by fixed income departments of banks may not qualify. For example if a bank issues a debt instrument with a cap and floor, the embedded derivative would normally be considered closely related and should not be separated. The instrument would therefore have to be held at its amortised cost, even though the bank might fair value the product for risk management purposes.
Substantially Offset
The FVO will still be available if the exposure to changes in fair value of a financial instrument is substantially offset by that of another financial instrument. The term "substantially offset" is not further defined or clarified. Definitions include phases such as "of real importance" or "considerably", which have implications of absolute as much as relative size. It is probably a lower threshold than the "substantially all" used in the derecognition rules and the basis for conclusions to the Exposure Draft show that the Board believes it to be a lower hurdle than that required for hedge accounting, when "highly effective" is defined as between 80% and 125%. The term is probably too imprecise to be capable of being applied, however, without further clarification from the IASB. It is hoped that any clarification supports the notion that this test is significantly less onerous than for hedge accounting, otherwise the FVO could be of limited use.
Loans & Receivables
Loans and receivables which are actively traded can still be fair valued. For loans and receivables that are not traded, there is also the potential to use the FVO when they contain an embedded derivative, even if it is "closely related."
Otherwise, loans and receivables will only qualify for the FVO if their exposure to fair value changes are "substantially offset" by the exposure to changes in fair value of a liability or a derivative. Not only do we need to understand what is meant by "substantially offset," but also it is not clear what level of documentary evidence will be required to establish that the change in the fair value of the portfolio of loans will offset the change in the fair value of the derivatives. This is an area that the IASB presumably intends to leave to entities and their auditors to determine.
Verifiable
The FVO is only available for financial instruments when fair value is "verifiable". This is a stricter requirement than "reliably measurable" which is used generally in IAS 39 as a requirement for an item to be included at fair value. This creates two different fair value measurement rules as trading instruments and available for sale assets are required to be recorded at fair value without satisfying the verifiability criteria. The Board illustrated the term with an example also used in U.S. GAAP: if several independent and knowledgeable observers were asked to estimate the fair value of a particular instrument and they all arrive at approximately the same amount, the fair value of the instrument would be considered verifiable. This would be the case if the fair value estimate is based on:
* observable current market transactions in the same instrument;
* a valuation technique in which variables include primarily
observable market data and is calibrated periodically to
current market transactions or other observable data;
* a valuation technique that is commonly used by market
participants to price the instrument and has been
demonstrated to provide realistic estimates of prices
obtained in actual market transactions.
It is unclear how mutual funds, unit trusts and similar instruments that, upon initial recognition, are designated as held at fair value through profit or loss would meet the verifiable requirement. Further, it may be difficult for any entity to use the FVO for a non-listed equity. Also, it will often be difficult to value an instrument with an embedded derivative due to problems in valuing the derivative, yet IAS 39 requires an embedded derivative to be recorded at fair value.
Definition Of Held For Trading
Part of the problem that the FVO was designed to resolve is the narrow definition of Held-for-Trading. If it is possible to record any item at fair value with gains taken through profit or loss, the definition is irrelevant, and most respondents to the revised IAS 39 proposals did not focus on it. It is probably necessary to re-examine the definition of Held-for-Trading because it refers to instruments which are held for the short term, it does not cope well with much of the activities of a bank in which assets and liabilities are held for the long term in conjunction with derivatives, in order to arbitrage the derivatives or to manage their risk. The definition should be reconsidered, to make it consistent with what most banks record in their trading books.
Conclusion
The decision to restrict the use of the FVO will not find favour with most financial institutions who consider it enables them to present their financial statements consistently with the way the instruments are managed by the bank and its risk management practices. The regulators have assumed that the FVO will increase the volatility of banks' reported profits; whereas we believe it is more likely to reduce it. This is because it enables items which are entered into as a natural hedge to be measured on a consistent basis and so avoids the need to comply with complex hedge accounting rules. t is important to highlight that banks will go to considerable lengths to reduce the volatility of reported earnings, as analysts generally regard trading profits as lower quality earnings which impact the price at which the shares will trade.
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| Tony Clifford |
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| Neville Gray |
This week's Learning Curve was written by Tony Clifford, partner, and Neville Gray, senior manager, in Ernst & Young's banking and capital markets group in London.
