Rechnungslegungs Interpretations
Accounting Interpretations Committee
MEASUREMENT OF FINANCIAL INSTRUMENTS
Questions and Answers (Q&A)
- regarding the accounting treatment to be applied under IAS 39
in light of the ‘subprime crisis’, and with a particular focus on the criteria for the
existence of an ‘active market’ -
BACKGROUND TO THE ISSUES ......................................................................... 2
Q1:
How does an entity DETERMINE FAIR VALUE when MEASURING
FINANCIAL INSTRUMENTS in accordance with IAS 39?........................ 4
Q2:
How does an entity account for IMPAIRMENT LOSSES ON
FINANCIAL INSTRUMENTS IN ACCORDANCE WITH IAS 39? ............... 6
Q3:
What is the definition of an ‘ACTIVE MARKET’?..................................... 8
Q4:
When is a market (still) an ACTIVE MARKET and what
are the consequences for the reporting entity? ...................................... 9
Q5:
What are the consequences for the reporting entity if
a MARKET is NO LONGER ACTIVE?...................................................... 11
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Rechnungslegungs Interpretations
Accounting Interpretations Committee e. V.
BACKGROUND TO THE ISSUES
1
Starting around mid-2007, payment problems started emerging in the USA relating to
mortgage loans to private individuals with poor credit ratings (‘subprime mortgages’).
The global impact of this crisis has prompted questions about the recognition and
measurement in accordance with IFRSs specifically of asset-backed securities
(ABSs), commercial mortgage-backed securities (CMBSs), residential mortgagebacked securities (RMBSs, or MBSs as the generic term for CMBSs and RMBSs)
and collateralised debt obligations (CDOs), as well as similar securities. The number
of securitisations has dropped sharply as a consequence of the subprime crisis. In
addition, trading in securitised instruments in certain markets and product segments
has dried up in some cases, starting with subprime mortgages and subsequently
spreading to other securitisation products as well. This document addresses selected
questions surrounding IFRS accounting policies for financial instruments that are
related to these issues.
2
An entity that applies IFRSs must generally recognise purchased securities as
financial instruments in one of the required or optional categories in accordance with
IAS 39. In the case of the classification of securitised instruments, the investor
must decide at the acquisition date on the category of financial instruments
(financial assets at fair value through profit or loss, held-to-maturity investments,
loans and receivables, available-for-sale financial assets) to which the relevant
securitised instruments must be allocated. Allocation to the categories must be
decided separately for each financial instrument, and it may be necessary to consider
product- and market-driven criteria. Financial instruments with a fixed maturity and
a current yield (fixed or variable rate plus spread) – which will normally be the case
with securitised instruments – may be allocated to the held-to-maturity
investments and loans and receivables categories. When deciding whether to
allocate a financial instrument to the held-to-maturity investments or loans and
receivables category, the existence of an active market must be assessed because
securitised instruments can only be allocated to the loans and receivables category if
they are not quoted in an active market. Another criterion for the allocation of
securities to the loans and receivables category is that there may be no expectation
of losses other than because of a deterioration in the obligor’s creditworthiness.
3
As a rule, financial instruments are initially and subsequently measured in
accordance with the category to which they are allocated. Particular requirements for
measurement at fair value must be observed (see Q&A 1).
4
IAS 39.58 ff. requires a financial instrument allocated to the loans and receivables,
held-to-maturity investments, or available-for-sale financial assets categories to be
tested for impairment (see Q&A 2). The assessment whether an impairment loss
must be recognised uses a two-stage process. In the first stage, the reporting entity
must assess at each reporting date whether there is any objective evidence that the
estimated future cash flows of the financial asset are impaired (impairment trigger). If
there is such objective evidence that an impairment loss has been incurred, the
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second stage examines whether an impairment loss must be recognised in the
current period and, if so, the amount of that loss.
5
In this context, the disappearance of an active market because the financial
instruments in question are no longer publicly traded is not in itself evidence of
impairment (IAS 39.60; see also para. 38).
6
If trading in securities diminishes or dries up in a crisis, the question arises – in
particular for the securities mentioned in para. 1 – of how these securities should be
measured subsequent to initial recognition and whether – and to what extent –
entities must recognise an impairment loss for these instruments. One of the core
questions when classifying financial instruments and measuring fair value is whether
an active market (still) exists (see Q&A 3) and whether market prices resulting from
that active market must be used to measure the amount of the impairment loss (see
Q&A 4). If there is no longer an active market, the fair value of the financial
instruments must be measured using a different valuation technique (see Q&A 5).
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Q1: How does an entity DETERMINE FAIR VALUE when MEASURING
FINANCIAL INSTRUMENTS in accordance with IAS 39?
7
A1: Financial assets in all categories are always measured at fair value on
initial recognition – IAS 39.AG64 indicates that fair value will normally be the
transaction price. For this reason, and because of the required disclosures
(IFRS 7.25-30), the guidance on determining fair value presented in the following is
relevant for all categories.
8
Determining the fair value of securitised instruments classified as financial assets at
fair value through profit or loss and available-for-sale financial assets in the
course of subsequent measurement is of crucial importance in light of the subprime
crisis.
9
The fair value of financial instruments is the amount for which an asset could be
exchanged or a liability settled between knowledgeable, willing parties in an arm’s
length transaction (IAS 32.11, IAS 39.9). Prices that have arisen because of forced
transactions, involuntary liquidations, or distress sales may not be used to
determine fair value without being adjusted (IAS 39.AG69 in conjunction with
IAS 39.AG72); however, they can be used in the same way as indicative prices to
test the reasonableness of fair values determined using valuation techniques,
although they do not take priority over such fair values.
10
The hierarchy for determining fair value in accordance with IAS 39.48 f. is as follows:

IAS 39.AG71-73: quoted prices in an active market:
o Level 1: price at the reporting date.
o Level 2: price shortly before the reporting date, which must be
adjusted if there has been a significant change in economic
circumstances since the date when the price was determined.

IAS 39.AG74-79: establish fair value using valuation techniques if there is no
active market:
o Level 3: use recent arm’s length market transactions for identical
financial instruments between knowledgeable, willing parties.
o Level 4: compare with the current fair value of another financial
instrument that is substantially the same.
o Level 5: use valuation techniques (e.g. discounted cash flow analysis,
option pricing models, or other valuation techniques commonly used by
market participants to price this financial instrument).
11
When measuring financial instruments at fair value, the question of whether a market
is considered active is therefore of crucial importance for the subsequent
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measurement of financial instruments in the financial assets at fair value through
profit or loss and available-for-sale financial assets categories in accordance with
IAS 39.46. Q&A 2 addresses the significance of this issue in impairment testing.
12
A distinctive feature of the available-for-sale financial assets category is that gains
and losses on the subsequent measurement of such instruments are recognised
directly in equity (IAS 39.46 in conjunction with IAS 39.55(b)). However, if a decline in
fair value has been recognised directly in equity and there is objective evidence of
impairment, the cumulative loss is removed from equity and recognised in profit or
loss (IAS 39.58 in conjunction with IAS 39.67). The assessment of whether a market
is considered to be active is crucial for fair value measurement in this context.
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Q2: How does an entity account for IMPAIRMENT LOSSES ON FINANCIAL
INSTRUMENTS IN ACCORDANCE WITH IAS 39?
13
A2: Under IAS 39.58 ff., allocation of purchased securities to the held-to-maturity
investments, loans and receivables, or available-for-sale financial assets categories
requires the entity to assess at each reporting date whether there is any objective
evidence of impairment. If there is objective evidence that held-to-maturity
investments or loans and receivables are impaired as a result of an event that
occurred after the initial recognition of the asset (‘trigger event’ or ‘loss event’), and
that loss event has an impact on the estimated future cash flows of the financial
asset, an impairment loss is recognised if the carrying amount of the financial
instrument is higher than the present value of expected future cash flows.
14
Examples of objective evidence of impairment are given in IAS 39.59 ff. The loss
events listed in IAS 39.59 include: significant financial difficulty of the obligor, breach
of contract and a strong probability of bankruptcy.
15
It is not necessary for the entity to identify or know the details of ‘incurred but not
reported’ losses (IAS 39.AG90, IAS 39.BC108-110). Loss events that only become
known after the reporting date can only be recognised if it can be demonstrated that
they occurred before the reporting date. The reporting entity must document the
objective evidence it has defined (as a rule separately for each product), for example
in an accounting manual. In the case of securitised instruments, impairment is
determined by reference to the transactions underlying the securitisation, for example
based on the trustee reports (look-through approach / “Durchschauprinzip”). In
addition, the analysis should also consider the individual tranches of the
securitisation transaction because any defaults are normally not charged to the
individual tranches on a percentage basis, but incrementally.
16
Because impairment in IAS 39 is based on the incurred loss model described
above, only losses that have been incurred by the reporting date may be recognised.
In other words, defaults of future interest and principal payments resulting from
events that have occurred before the reporting date may be recognised, but not
future expected losses. However, when determining impairment, objective evidence
of events that become known after the reporting date but that actually occurred
before the reporting date must be reflected (adjusting events, IAS 10.3(a) in
conjunction with IAS 10.8 f.).
17
If there is objective evidence of the impairment of securitised instruments in the heldto-maturity investments and loans and receivables categories with an impact on
the estimated future cash flows of those assets, the difference between the carrying
amount and the present value of expected future cash flows discounted at the asset’s
original effective interest rate is recognised in profit or loss (IAS 39.63). This means
that only credit risks are generally reflected for these two categories. However, IAS
39.AG84 also allows impairment to be measured using observable market prices
as a practical expedient.
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18
In addition to reducing the carrying amount directly or by using an allowance account
(specific valuation allowance), securitised instruments in the held-to-maturity
investments and loans and receivables categories are also assessed to determine
whether a portfolio valuation allowance (collective valuation allowance) can be
used. This can be based on historical loss experience, provided that it is adjusted to
reflect the effects of current estimates of future defaults (IAS 39.AG89).
19
If an available-for-sale security is determined to be impaired on the basis of
objective evidence (i.e. the credit risk has increased – see IAS 39.58-62 in
conjunction with IAS 39.67-70), the entire cumulative loss that was previously
recognised directly in equity is removed from equity and recognised in profit or loss
(IAS 39.67). Here, too, an analysis based on individual tranches must be made.
20
In the context of the subprime crisis, it should be noted that a decline in the fair
value of a financial instrument due to market illiquidity or increased interest rates
is not by itself a sufficient indication that there is objective evidence of impairment in
accordance with IAS 39.58 ff. This is particularly relevant for the subsequent
measurement of available-for-sale financial instruments because such changes in
fair value due to illiquid markets or interest rates are recognised directly in equity in
the course of subsequent measurement. For securitised instruments in this
measurement category, only the probable (partial) default of a tranche (credit risk)
results in the recognition of an impairment loss in profit or loss. The procedure for
determining whether there is objective evidence of the impairment of financial
instruments in the held-to-maturity investments and loans and receivables
categories uses the same basic rules applied to determining whether there is
objective evidence that available-for-sale financial instruments are impaired.
However, market prices are normally only used as a practical expedient (IAS
39.AG84) to determine impairment losses for held-to-maturity financial instruments;
loans and receivables are by definition not quoted in an active market (IAS 39.9).
21
If financial instruments are designated as financial assets at fair value through
profit or loss, they must be subsequently measured at fair value through profit or
loss, and there are therefore no special rules for recognising impairment losses in
this case.
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Q3:
What is the definition of an ‘ACTIVE MARKET’?
22
A3: Guidance on how to determine the fair value of financial instruments quoted in
an active market is provided in IAS 39.AG71 ff. By contrast, the term ‘active
market’ is not defined directly in either IAS 32 or IAS 39, although there are many
occurrences of the term itself in IAS 39, for example in guidance addressing the
impairment of financial instruments1.
23
In accordance with IAS 39.AG71, a financial instrument is regarded as quoted in an
active market if quoted prices are readily and regularly available from an
exchange, dealer, broker, industry group, pricing service (e.g. Reuters and
Bloomberg), or regulatory agency, and those prices represent actual and regularly
occurring market transactions on an arm’s length basis.
24
The question of whether quoted prices are readily and regularly available in an
active market must be assessed by considering how recent the available price
quotations are at the reporting date in question. Because no concrete cut-off date
can be stipulated to decide whether less current price quotations are acceptable, this
issue must be assessed on a case-by-case basis.
25
The concept of an ‘active market’ and the criteria inherent in that concept must
generally be defined by reference to specific market(s) and product(s).
26
If prices are quoted in a ‘regulated market’ as defined by section 2(5) of the
Wertpapierhandelsgesetz (WpHG – German Securities Trading Act), there is a
general presumption that this market is active because prices are regularly available
and they are based on actual and regularly occurring market transactions. However,
if the volume of trading on a regulated market is, exceptionally, very low, the
reporting entity must examine in each specific instance whether the prices quoted on
that market can be regarded as quoted in an active market. ‘OTC’ markets are not
generally regulated markets, although they may well satisfy the criteria for active
markets.
27
Market makers provide binding bid and asking prices for trading in certain financial
instruments. If one or more market makers are operating in a market, it can normally
be presumed that this market is active. However, this presumption must always be
assessed on a case-by-case basis, in particular to establish if there are pre-emptive
prices at which no transactions are seriously considered. Binding bid and asking
prices provided by market makers must be distinguished from indicative prices that
are published in particular by pricing services. Indicative prices are not based on
market transactions, nor do they meet the requirement of being binding. The
reporting entity must therefore always validate the source of prices on a case-bycase basis, i.e. for specific products and markets.
1
In accordance with IAS 36.6, IAS 38.8 and IAS 41.8, an active market is a market in which the items
traded are homogeneous, willing buyers and sellers can normally be found at any time and prices
are available to the public. This definition can also be applied in accounting for financial instruments.
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Q4: When is a market (still) an ACTIVE MARKET and what are the
consequences for the reporting entity?
28
A4: A decline in market transactions leads directly to reduced liquidity in the
market. However, the question of whether this fact means that a market must
already be regarded as ‘not active’ (or no longer active) within the meaning of
IAS 39.AG71 ff. and of the method that must then be used to determine fair value in
an impairment test can normally only be resolved by analysing and evaluating
additional factors.
29
IAS 39.AG71 indicates that the existence of published price quotations in an
active market is the best evidence of fair value. Using quoted prices in an active
market results in consistent measurement across entities and meets the definition of
fair value in IAS 39, which states that fair value does not depend on entity-specific
factors (IAS 39.BC97). The general rule is that a reporting entity cannot decide not to
use a quoted price in an active market even if fair value determined using a valuation
technique differs from the quoted market price – marking-to-market always takes
priority over marking-to-model. A quoted price must be used – and this rule also
applies to the financial instruments listed in para. 1, for which only a very small
volume of market transactions may be observed in certain cases – unless the
reporting entity can demonstrate that the market is no longer active or that the last
transaction price is not fair value, for example because it merely reflects the amount
that an entity would receive or pay in a forced transaction, involuntary liquidation, or
distress sale.
30
The prices provided by market makers for certain financial instruments may be used
for fair value measurement purposes because of the obligation on the market makers
to execute a trade with a counterparty at that price – as a rule, this principle also
applies unchanged to reduced market liquidity situations.
31
The quoted price in an active market for a transaction in a financial instrument at the
(interim) reporting date must be used to measure that financial instrument. The prices
quoted on the last exchange trading day are used to measure fair value if the
exchanges are closed on the reporting date.
32
The question of whether less current transaction prices can be used can only be
answered on a case-by-case basis. If no current price quotations are available in a
‘thin’ market for the financial instrument to be measured (for example price
quotations only once a week), the price of the most recent transaction provides
evidence of the current fair value as long as there has not been a significant change
in economic circumstances since the time of the transaction. If economic
circumstances have changed since the most recent transaction, the historical
transaction price for the financial instrument to be measured must be adjusted
appropriately (IAS 39.AG72).
33
However, it may well happen that transactions are not entered into by
knowledgeable, willing parties on an arm’s length basis on the last trading day – or
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for some time before the reporting date – because the marginal prices of buyers
and sellers do not overlap, even though there are sufficient market participants on
both the buy and the sell side1. In such a case (Level 2), it might be possible to derive
fair value from the prices obtained in the most recent transactions. A requirement for
this, however, is that there has been no significant change in economic
circumstances since the time of transaction. If such a significant change is evident
since the time of the transaction, fair value must be determined by reflecting the
change in conditions, e.g. by reference to changes in the prices for similar financial
instruments or relevant indices such as the ABX index (individually for each tranche –
see para. 40) – see IAS 39.AG72. If the reporting entity can demonstrate in
accordance with IAS 39.AG72 that the last transaction price is not fair value, for
example because of forced transactions, involuntary liquidations, or distress
sales, that price is adjusted. This does not rule out a situation where – because of a
lack of market transparency – a transaction represents a forced transaction,
involuntary liquidation, or distress sale from the perspective of one entity, but from
the perspective of another entity the same transaction represents or influences the
market price in an active market and will not be adjusted by the second entity.
34
Other than the forced transactions, involuntary liquidations, or distress sales
described above, adjustments to the market price are only possible for similar
reasons. If prices are distorted because of exaggerated behaviour and
overreactions by market participants, this sort of price adjustment is not normally
permitted because those market prices represent the best evidence of fair value.
35
By contrast, a market is no longer active if the complete withdrawal of buyers and/or
sellers from the market over a longer period means that it is no longer possible to
observe any market liquidity. Only if such market changes are sustained it can be
presumed that the criteria for an active market are no longer met. This would be the
case, for example, if trading dries up because a market maker no longer provides
binding prices over a longer period and no market transactions are observed.
1
The lowest asking price on the sell side is so high that it exceeds the highest marginal price that
buyers are willing to pay. Although it must be analysed on a case-by-case basis, however, the
existence of an active market must generally be presumed in this type of market scenario where no
transactions are observed because there are still participants in the market. A situation in which no
market transactions are observed for the time being is not by itself a sufficient indication that the
criteria for an active market are no longer met. The fact that no transactions are entered into in such
a market situation may be attributable to information asymmetries between buyers and sellers,
among other reasons.
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Q5: What are the consequences for the reporting entity if a MARKET is NO
LONGER ACTIVE?
36
A5: Valuation techniques can only be used in those exceptional cases where a
market is no longer active. If a market is no longer active, the reporting entity
establishes the fair value of the financial instrument by using another valuation
technique, for example using a Level 4 input by comparing it with the current fair
value of another financial instrument that is substantially the same, or using a Level 5
input by discounted cash flow analysis or option pricing models (IAS 39.AG74 ff.).
However, because of the different methodologies used and variations in the
parameters applied to the same methodology by different reporting entities, it is
common for estimates of fair value to differ.
37
If an active market disappears after financial assets have been allocated to a
category in accordance with IAS 39.9, the financial instruments concerned are not
reclassified. Reclassifications are only permitted in the situations described in
IAS 39.50 ff.
38
The disappearance of an active market because an entity’s financial instruments are
no longer publicly traded does not necessarily indicate the occurrence of a loss
(trigger) event for impairment (IAS 39.60). By contrast, the disappearance of an
active market for the financial assets in question because of financial difficulties
(IAS 39.59(e)) is objective evidence that the financial assets are impaired – this
situation is (was) evident in the course of the subprime crisis in more than purely
isolated instances. In such cases, however, the reporting entity must demonstrate for
each product that an active market does not exist or no longer exists.
39
Market inputs must be used if the use of valuation techniques is required in
accordance with IAS 39.48 f. and IAS 39.AG74 ff. Examples of key inputs include
market prices in past transactions in the financial instrument in question, as well as
current market prices for comparable financial instruments. If the cash flows of the
financial instrument are discounted, the current decline in the liquidity of the market
should be reflected by a premium to the risk-free rate for matching maturities. If the
observed state of the market indicates a higher rate of interest, this must be used
when discounting cash flows.
40
In the context of the subprime crisis, financial instruments cannot be measured
directly using ABX indices, which are based on residential mortgages. Rather, if
they are measured using these indices, the ‘vintage’ (the year in which the loan was
originally extended) and the rating of the securitised loans must be reflected for each
tranche.
41
The reporting entity must periodically calibrate and validate the valuation
techniques (IAS 39.AG76) using prices from observable current market transactions
in the same financial instrument or based on available observable market data. The
entity must obtain market data consistently in the same market where the instrument
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was originated or purchased (consistency requirement). In this context, the
disclosure requirements in IFRS 7.27 in particular must also be complied with.
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