Practical guide to IFRS edition 1 Practical guide to IFRS

18 June 2010 18 June 2010

Accounting for financial liabilities unchanged except for those designated at fair value through profit or loss
The IASB issued an ED in May 2009 on accounting for financial liabilities. What would the proposed changes mean?
There is no change to the general requirements for financial liability accounting. There will continue to be two measurement categories for financial liabilities: amortised cost and fair value through profit or loss. Entities should still separate derivatives embedded in financial liabilities where they are not closely related to the host contract. Entities that designate financial liabilities at fair value through profit or loss will be required to show fair value changes due to own credit in other comprehensive income.

Practical guide to IFRS financial liabilities

18 June 2010

Background
The IASB is undertaking a comprehensive review of financial instrument accounting. It is approaching this project in phases: classification and measurement, impairment and hedging. Its proposals for changing the accounting for financial liabilities were contained in the May 2010 exposure draft Fair value option for financial liabilities. The IASB has already published guidance on accounting for financial assets, in IFRS 9, Financial instruments, in 2009. The main concern regarding accounting for financial liabilities is showing, in the income statement, the impact of own credit for liabilities recognised at fair value that is, fluctuations in value due to changes in the liabilitys credit risk. This can result in gains being recognised in income when the liability has had a credit downgrade, and losses being recognised when the liabilitys credit risk improves. Many users find this result counterintuitive, especially when there is no expectation that the change in the liabilitys credit risk will be realised. This issue would have been more problematic if the IASB had adopted an approach similar to IFRS 9 where hybrid instruments (that is, those financial instruments that contain embedded derivatives) were accounted for at fair value. However, except for those liabilities where the fair value option has been elected, the IASB intends to retain the existing guidance in IAS 39, Financial instruments: Recognition and measurement, regarding the classification and measurement of financial liabilities. The Board believes that the existing requirements for liabilities generally work well, and none of the other alternative approaches considered would be less complex or provide more useful information.

What are the proposals?

The classification and measurement of financial liabilities under IFRS will remain the same except where an entity has chosen to measure a liability at fair value through profit or loss (FVTPL). There will continue to be two measurement categories for financial liabilities: FVTPL and amortised cost. Certain liabilities are required to be at FVTPL, such as liabilities held for trading and derivatives. Other liabilities are measured at amortised cost unless the liability has embedded derivatives or the entity elects the fair value option. Existing guidance for embedded derivatives is also retained. Entities will continue to be required to separate derivatives embedded in financial liabilities where they are not closely related to the host contract for example, a structured note where the interest is linked to an equity index. The separated embedded derivative will continue to be measured at FVTPL, and the residual debt host will continue to be measured at amortised cost. This is summarised in the following flow chart.

Summary of how financial liabilities are measured under IAS 39

Yes

Is the liability held for trading or has the fair value option been elected? No No Is the liability a hybrid instrument? No

Yes

Separate embedded derivative

Host Amortised cost

Embedded derivative Fair value through profit or loss

Practical guide to IFRS financial liabilities

18 June 2010

However, entities with financial liabilities designated at FVTPL would follow a two-step measurement approach: 1. All changes in fair value of the financial liability would be recognised in the profit or loss. 2. The change in value due to changes in the liabilitys credit risk would be recognised in other comprehensive income (OCI) with an offsetting entry to profit or loss. There would be no subsequent recycling of the amounts in OCI to profit or loss. Which liabilities are affected? The proposals only affect financial liabilities that an entity chooses to account for at FVTPL using the fair value option (FVO). The eligibility criteria for the FVO remain the same and are based on whether: The liability is managed on a fair value basis; Electing fair value will eliminate or reduce an accounting mismatch; or The instrument is a hybrid that would require separation of an embedded derivative. A common reason for electing the FVO is where entities have embedded derivatives that they do not wish to separate. In addition, entities elect the FVO where they have accounting mismatches with assets that are required to be held at FVTPL. Financial liabilities that are required to be measured at FVTPL (as distinct from those that the entity has chosen to measure at FVTPL) will continue to have all fair value movements recognised in profit or loss with no transfer to OCI. This includes all derivatives, such as foreign currency forwards or interest rate swaps, or an entitys own liabilities that it considers as trading. How are the financial statements impacted? There is no impact on the balance sheet because a liability is recognised under the FVO at its fair value. There is also no overall impact on the amount that will be recorded in total comprehensive income. However, the proposals would result in elements of the fair value movement being presented in different parts of the performance statement using a two-step approach. First, all changes in fair value of the financial liability would be recognised in the profit or loss. Second, the change in value due to changes in the liabilitys credit risk would be recognised in other comprehensive income (OCI), with an offsetting entry to profit or loss as in the following example. Assume a liability recognised under the FVO has a fair value movement of 100 for the period. Of that 100, 10 relates to changes in own credit. This would be presented as follows:

Income statement Total change in fair value Change in fair value from own credit Profit for the year 100 (10) 90

Statement of other comprehensive income Change in fair value from own credit 10

Practical guide to IFRS financial liabilities

18 June 2010

How is own credit calculated? The proposals do not specify a method for calculating own credit but refer to existing guidance in IFRS 7 Financial instruments: Disclosures. IFRS 7 allows own credit to be determined as either: The amount of fair value change that is not attributable to changes in market conditions that give rise to market risk (for example changes in benchmark interest rates); or An alternative method that the entity believes more faithfully represents the amount of change in fair value that is attributable to changes in credit risk of the liability ( for example a method that computes credit risk directly based on credit default swap rates). Can the amounts in OCI be recycled to profit or loss when the liability is settled? The proposals prohibit subsequent recycling of the amounts in OCI to profit or loss. However, the IASB believes that, where the entity repays the liability on maturity in accordance with the contractual terms, the cumulative fair value change including changes relating to own credit will net to zero, resulting in no remaining balances in OCI to recycle. Although recycling to the profit or loss would be prohibited, the proposals do allow transfers within equity. If a liability was settled early, resulting in a realised own credit balance in OCI, the entity could transfer that balance to another equity account for example, to retained earnings. Are there any new disclosures? In addition to the requirement to present own credit separately in profit or loss and in OCI, any realised amounts in OCI for own credit for liabilities that have been derecognised would have to be disclosed for example, where a borrowing has been settled early. What are the transition rules? The proposals require full retrospective application, including comparative information. In addition, if entities choose to adopt the proposals (when finalised) before the mandatory application date, they are also subject to the requirements of IFRS 9 that they did not previously apply. However, there are some differences between the transition provisions of these proposals and IFRS 9. These proposals require full retrospective application; however, there is an exemption from full retrospective application for IFRS 9 where an entity adopts it before 1 January 2012, as comparatives are not required. On transition to IFRS 9, entities may revoke previous FVO elections, or designate existing assets and liabilities at FVTPL using the FVO. In contrast, the proposals for liabilities do not allow any revocation or new designation of the FVO for existing liabilities. Entities adopting IFRS 9 for financial assets may therefore want to consider the proposals for financial liabilities when making their FVO elections on transition.

Am I affected?
The proposals impact entities that have designated financial liabilities at FVTPL. For example, they will impact entities that have designated liabilities at FVTPL to eliminate an accounting mismatch with financial assets that are held at FVTPL, or to avoid separating an embedded derivative. It appears there will be no significant impact for entities that do not choose to account for financial liabilities at FVTPL using the FVO.

Practical guide to IFRS financial liabilities

18 June 2010

Entities that use the FVO to measure financial liabilities at FVTPL will need to consider the impact on the presentation of their performance statements. IFRS 7 requires disclosure of the amount of fair value change that is attributable to changes in own credit for such liabilities. The proposals would therefore not call for any new data or systems changes, as these should already be in place to meet the IFRS 7 requirements, unless the entity is electing the FVO for the first time. If the proposals are agreed, they will be applicable for financial periods beginning on or after 1 January 2013.

What do I need to do?

The comment period closes on 16 July 2010. Management should decide if they wish to comment on the proposals. Specifically, management should consider: Should the existing classification and measurement guidance in IAS 39 be retained except for only those liabilities recognised at fair value under the FVO? Should the portion of the change in the fair value of a liability recognised under the FVO related to changes in the liabilities credit risk be recorded in other comprehensive income instead of profit or loss? Should the change in the fair value of a liability recognised under the FVO be presented using the two-step approach? Should a method for determining the change in fair value of a liability related to changes in the liabilitys credit risk be specified or should the current guidance in IFRS 7 that allows alternative methods to be used, be retained? Should the proposed transition guidance, including the limitation on the ability to revoke previous FVO elections or designate new elections for existing financial instruments, be retained?

How can PwC help?

PricewaterhouseCoopers has teams of specialists around the world who can assist management in assessing the impact of these proposals and the impact of the IASBs wider review of financial instruments on the business. PwC can: Perform an individual assessment of the likely impact of the proposals on financial statements; Assess the impact on data collection, processes, controls and IT systems; Provide project planning support, training and investor relations advice; Assist in updating accounting manuals and providing staff training; Discuss the advantages and disadvantages of adopting the new standards prior to their mandatory application date.

If you would like further information on the proposals for financial liabilities or financial instruments more widely, or assistance in determining how it might affect your business, please speak to your regular PwC contact.

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