September 14, 2009
International Accounting Standards Board
30 Cannon Street
London EC4M 6XH
United Kingdom
Comments on Exposure Draft - Financial Instruments: Classification and Measurement
We welcome and support the IASB’s initiative to make proposals in order to respond to the need
for improvements that have been highlighted by the financial crisis.
As financial instruments are the basis of our business, any change to the accounting for those
instruments has fundamental and severe effects on our financial reporting, hence potentially on
our business models in as much as corporate behavior is influenced by financial reporting.
We appreciate that the IASB has recognized the need for a mixed measurement model, which
recognizes the relevance of amortized cost accounting for debt instruments managed in the
context of a cash flow business model and the removal of the tainting rule for the HTM category.
Although we agree with the need of an in depth revision of IAS 39, we are concerned that
splitting the project into three phases will result in a piecemeal development of the standard and
fragment the approach to the consultation process.
We disagree with the IASB’s decision to retain the fair value through the profit and loss
measurement basis as a measurement by default. Fair value through profit and loss is an
appropriate measurement basis only when the instruments are managed based on their value and
when this value is realizable (e.g. trading activities).
The proposed accounting treatment in the ED is primarily based on the characteristics of the
instruments, which will result in measuring at fair value through profit and loss some financial
instruments that are not used in a trading business model because they would not be eligible for
the amortized cost measurement. This proposal does not address requirements expressed by the
G20 to “improve standards for the valuation of financial instruments based on their liquidity and
investors’ holding horizons” and “for valuation uncertainty”. The proposal is also in
contradiction on that issue with the ”guiding principles for the revision of accounting standards
for financial instruments” issued by the Basel Committee on Banking Supervision which
recognizes “that fair value is not effective when markets become dislocated or are illiquid”.
This representation of the performance of the entity will then be biased and it will be a source of
inconsistency and complexity for the future improvements of the related accounting
developments such as hedge accounting, impairment of financial instruments or insurance
accounting.
The business model criteria should prevail over the characteristics of the instruments (cash and
plain vanilla derivatives as well) to determine the appropriate measurement basis and it should
provide an appropriate reporting framework adapted to the various financial activities that use
financial instruments on a cash flow basis (Banks excluding trading activities, insurance
companies excluding unit linked contracts, corporate treasury departments…).
Equity instruments, other than those held in a trading business model, could be measured at fair
value through OCI with recycling of realized gains and losses in profit and loss and be impaired
based on the investor’s holding horizon. Unlike the proposed approach this would allow for the
presentation of the performance of this activity and the relevance of the choices of management.
In some specific situations, there is rationale to measure financial instruments at fair value
through OCI with recycling, in the cases where they don’t fit into one or the other business
models (e.g. certain instruments with optional features).
Because we believe the business model should be the primary criteria to define the appropriate
measurement basis for the accounting of financial instruments, we believe that accounting
standards should recognize the change of the business model for a particular instrument and
should therefore allow the change from one accounting category to another with appropriate
disclosure.
Yours Sincerely,
Gérard Gil
Deputy Chief Financial Officer
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Appendix – Responses to specific questions raised by the IASB
We set out below our comments relating to specific questions outlined in the invitation to
comment.
Question 1:
Does amortized cost provide decision-useful information for a financial asset or financial
liability that has basic loan features and is managed on a contractual yield basis? If not, why?
For the instruments that are managed with the objective of collecting cash flows through their
use (cash flow business model i.e. Banking Book for a bank) the most relevant measurement
basis is the amortized cost. It is indeed the most relevant approach to present the cash flows that
are received by the entity through the use of the assets.
This is the only measurement basis that provides the users of financial statements with a view on
the cash inflows in the entity and hence enables the users to estimate the beneficiary capacity of
the entity. Indeed, it is the only measurement basis that has predictive value which allows
analysts and users to know if the entity has the capacity to reproduce past performance on a
recurring basis.
We however do not believe that the definition of the Business model is clear enough and neither
that only those instruments that would meet the definition of “basic loan features” could be
measured at amortized cost.
Question 2:
Do you believe that the exposure draft proposes sufficient, operational guidance on the
application of whether an instrument has ‘basic loan features’ and ‘is managed on a contractual
yield basis’? If not, why? What additional guidance would you propose and why?
We do not believe the classification criteria are well defined. We do not agree that fair value
measurement should be defined as a measurement basis by default. We believe that gains from
the changes in fair value should not be recognized in the profit and loss if they are not realizable
by the entity1. This results in restricting the use of fair value through the profit and loss to
instruments held in a trading business model and traded on an active market, i.e. either i) the
1
Ref. Chapter 2.10. Discussion Paper Preliminary Views on Revenue Recognition in Contracts with
Customers issued in December quoting FASB Concepts Statement No. 5 Recognition and Measurement in
Financial Statements of Business Enterprises§84.e “If products or other assets are readily realizable
because they are salable at reliably determinable prices without significant effort(for example, certain
agricultural products, precious metals, and marketable securities), revenues and some gains or losses
may be recognized at completion of production or when prices of the assets change.“ and §83.a.
“Revenues and gains generally are not recognized until realized or realizable. Revenues and gains are
realized when products (goods or services), merchandise, or other assets are exchanged for cash or
claims to cash. Revenues and gains are realizable when related assets received or held are readily
convertible to known amounts of cash or claims to cash. Readily convertible assets have
(i)interchangeable(fungible)units and (ii) quoted prices available in an active market that can rapidly
absorb the quantity held by the entity without significantly affecting the price.”
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instrument itself is traded on an active market or ii) the risks of the instrument can be hedged
with instruments that are traded on an active market.
Business Model:
The business model in which the instrument is managed should be the predominant criteria to
determine which measurement basis is applicable.
Each business activity has an economic logic, specific to that activity. Different business
activities have different business models, each based on a different economic logic. The value of
a resource to an activity depends on the way it contributes to net cash inflows, in the context of
the economic logic of the activity in progress (i.e. depending on its function and use). A more
informative indicator for an investor is the income statement, provided that it reflects
expectations about changes in an entity’s cash flows and forecasts the entity’s long term capacity
to generate profit under a given business model. Although the value of the balance sheet may
interest an investor, it is of lesser importance to the extent that it is not representative of how the
entity actually uses its resources.
Whether it is through its use, or in conjunction with other assets and liabilities, an asset can
produce benefits in different ways. To simplify, an asset’s contribution to net cash inflows can be
broken down into two basic forms of logic: contribution by its use and contribution by its
exchange. Contribution by its use refers to an economic logic in which an asset’s value is derived
through the use of a resource and any additional inputs. Conversely, when a resource contributes
to net cash inflows by its exchange, the cash flow contribution under this model is achieved by
giving up the resource.
Because an item can be used in those different ways, financial reporting must recognize the
differences inherent in those business models and reflect them in the financial statements.
For the instruments that are managed with the objective of collecting cash flows through their
use (cash flow business model i.e. Banking Book for a bank) the most relevant measurement
basis is the amortized cost. It is indeed the most relevant approach to present the cash flows that
are received by the entity through the use of the assets.
We therefore believe that the classification of one instrument in one or the other business models
should follow a positive approach between the cash flow business model if the instrument is
expected to contribute to the net cash inflow by its use and the trading book if the instrument is
expected to contribute to the net cash inflow by its exchange.
There is a very clear difference between the two kinds of activities of a bank. They follow
different management practices and different prudential rules and they are easily identifiable by
management and auditors.
Because the business model is built on the realization of the value it creates, financial reporting
should follow this criteria to avoid the recognition of unsubstantiated profit and loss. The
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classification in a business model should therefore be dependent upon the capacity of the entity
to use the instrument in the business model in which the entity intends to use it.
In some specific situations, there is rationale to measure financial instruments at fair value
through OCI with recycling.
Examples of those situations are:
- The entity operates a trading business model with instruments that are not traded on an
active market or the risks of which cannot be hedged with liquid instruments; because of
their illiquidity, the instruments are not readily convertible to cash.
- The instrument cannot be managed in a cash flow business model. It is for example the
case of some non-trading financial instruments with particular optional features (e.g.
purchased debt instrument that are convertible into equity instruments of the issuer).
However, because for those instruments the entity may be exposed to a loss on disposal or
through their future cash flows, they should be impaired to their fair value when this value is
lower than cost.
The business model criteria should also provide an appropriate reporting framework adapted to
the various financial activities that use financial instruments (insurance, corporate treasury
departments, fund managers…). For example:
-
-
Financial instruments that must be held by insurance companies to comply with
contractual or regulatory commitments with a third party which are required to be settled
and measured on the liability side of the balance sheet at the fair value of the underlying
financial instruments, should be recognized at fair value through profit and loss.
Banking and corporate institutions may hold portfolios of debt instruments to realize their
value by their exchange to meet their liquidity needs. However, this activity is not
comparable with the trading business model of financial institutions and therefore, those
portfolios should be measured at fair value through OCI with recycling from a sale or in
the case of impairment.
Instruments with basic loan features:
The definition of basic loan features is too restrictive and has irrelevant consequences in the
following cases:
-
“A financial asset that is acquired at a discount that reflects incurred credit losses” does
not meet the definition of a basic loan feature:
There is no conceptual reason to make a distinction between originated loans (becoming
doubtful) and purchased doubtful loans in a classification model (see IAS 39BC28).
-
Only the most senior interest in a securitization could be eligible to the amortized cost
category:
Credit risk (including concentration of credit risk) is an integral part of loan features.
Uncertainty related to credit risk of a loan at amortized cost is managed by impairment.
Hence, similar to any loan, credit risks related to subordinated interest could be
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appropriately represented through an amortized cost measurement model as long as the
investor’s risk is limited to its initial investment.
-
Perpetual instruments (e.g. tier-one instruments) with mandatory coupons do not meet the
definition of basic loan features:
Those instruments are standard funding instruments that are used to fund activities whose
purpose is to collect cash flows. There is no rationale to measure them at fair value.
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Question 3:
Do you believe that other conditions would be more appropriate to identify which financial
assets or liabilities should be measured at amortized costs? If so,
(a) What alternative conditions would you propose? Why are those conditions more
appropriate?
(b) If additional financial assets or financial liabilities would be measured at amortized cost
using those conditions, what are those additional financial assets or financial liabilities?
Why does measurement at amortized cost result in more decision useful information than
measurement at fair value?
(c) If financial assets or financial liabilities that the exposure draft would measure at amortized
cost do not meet your proposed conditions, do you think those financial assets or financial
liabilities should be measured at fair value? If not, what measurement attribute is
appropriate and why?
See our response to Question 2.
Question 4:
(a) Do you agree that the embedded derivative requirements for a hybrid contract with a
financial host should be eliminated? If not, please describe any alternative proposal and
explain how it simplifies the accounting requirements and how it would improve the
decision usefulness of information about hybrid contracts.
(b) Do you agree with the proposed application of the proposed classification approach to
contractually subordinated interests (i.e. tranches)? If not, what approach would you
propose for such contractually subordinated interests? How is that approach consistent with
the proposed classification approach? How would that approach simplify the accounting
requirements and improve the decision usefulness of the information about contractually
subordinated interests?
Embedded derivatives:
The primary criteria to determine the reporting measurement basis should be the business model
in which the instrument is managed rather than its characteristics. Some contracts with leverage
are necessary to operate properly the business model. For example, a financial institution needs
derivative instruments, embedded in a host contract or not, to hedge the risks inherent in its cash
flow business model.
For instruments that are used with the view to hedge the risks inherent in the cash flow business
model, the fair value measurement does not provide a relevant representation of the performance
of the entity. Indeed, the approach proposed in the ED, will result in reporting fair value gains
and losses in the profit and loss, which will make it impossible for a user of the financial
statements to determine the cash inflows in the entity.
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Some other measurement methodologies are however possible to account for financial
derivatives held in a cash flow business model. For example, an interest rate swap could be
measured at the amortized cost of its two legs and presented net in the balance sheet.
Appropriate qualitative documentation should be required to justify why a given leveraged
instrument is eligible for the cash flow business model.
If a hybrid leveraged financial instrument is neither compatible with a cash flow business model
nor with a trading business model, the entity should report it at fair value through OCI and report
in the profit and loss only unrealized losses and realized gains and losses.
A particular case is financial instruments that are used in two different business models. For
example a bank creates a funded structured product whose risk will be dynamically risk
managed. This instrument will contribute to both the trading book as the structured component
will be dynamically risk managed in the trading book and the cash flow business model as the
funded component will serve to fund the activities of the cash flow business model. In that case,
we think that the separation of the structured component should be mandatory and each
component of the instrument should be presented according to the measurement basis
appropriate to the business model.
Securitization tranches:
We see the proposed rule as rather arbitrary and easy to circumvent. Why would it be mandatory to
measure at fair value a non-senior tranche of an SPV composed of low risk assets while it would be
possible to measure at amortized cost a senior tranche of an SPV composed of highly risky assets?
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Question 5:
Do you agree that entities should continue to be permitted to designate any financial asset or
financial liability at fair value through profit or loss if such designation eliminates or
significantly reduces an accounting mismatch? If not, why?
If the Business model of the entity was the primary driver for defining which accounting
measurement basis should be used, there is normally no need for a fair value option as long as
there should normally be no accounting mismatches.
Question 6:
Should the fair value option be allowed under any other circumstances? If so, under what other
circumstances should it be allowed and why?
See Q5
Question 7:
Do you agree that reclassification should be prohibited? If not, in what circumstances do you
believe reclassification is appropriate and why do such reclassifications provide understandable
and useful information to users of financial statements? How would you account for such
reclassifications, and why?
No, we definitely do not agree. There is a very clear difference between the two activities of a
bank.
 They follow different management practices and different prudential rules
 They are easily identifiable by management and auditors.
The separation between the two books is easy to audit. At some point in time, it may
occasionally make sense for the entity to transfer an asset or a liability from one book to the
other. It may be a trading book asset, whose market becomes suddenly illiquid, due to a
financial crisis. As it is now impossible to sell it, the bank will keep it in the cash flow business
model book. According to the business model criteria, the reclassification from the trading
portfolio to a cash flow business model portfolio should be mandatory. However, from a
practical point of view the capacity to transfer an asset is only useful for assets that are in a
trading book. We concede that there is rationale for allowing only reclassifications from the
trading book for avoiding abuses but financial reporting should recognize these exceptional
transfers and allow the entity to reflect and disclose them in the reporting of the entity’s
performance. These transfers are easy to control and justify.
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Question 8:
Do you believe that more decision-useful information about investments in equity instruments
(and derivatives on those equity instruments) results if all such investments are measured at fair
value? If not, why?
We do not agree with the proposal to measure at option equity instruments at fair value through
OCI without recycling. This measurement basis cannot reflect the performance of the
management of a medium to long term equity investment business.
Fair value through profit and loss is an appropriate measurement basis only for equity
instruments traded on active markets that are held in a trading business model.
In all other cases, we believe that neither cost, nor fair value (through profit and loss or OCI
without recycling) provide an ideal measurement basis. Indeed, if we believe that in most cases,
a cost measurement will provide a relevant measurement basis to present the performance of the
entity in the profit and loss, it is also true that, in many cases, it will not provide a relevant
measurement of the economic value of an asset.
Although imperfect, fair value through OCI with recycling provides an acceptable short-term
compromise solution. We however believe that accounting standard setters should foster
discussions and carry out academic studies to define a relevant measurement basis, which would
reflect the investor’s holding horizon.
Question 9:
Are there any circumstances in which the benefits of improved decision usefulness do not
outweigh the costs of providing this information? What are those circumstances and why? In
such circumstances, what impairment test would you require and why?
See Q8
Question 10:
Do you believe that presenting fair value changes (and dividends) for particular investments in
equity instruments in other comprehensive income would improve financial reporting? If not,
why?
We do not see the exemption proposed by the IASB to represent the performance of equity
instruments in OCI as a relevant proposal.
First, because of the mismatch with the recognition of the costs of funding of those instruments,
this will not provide a relevant representation of the performance in the OCI. Second,
comprehensive income is meaningless, since items reported in OCI are precisely there to be
outside the income statement. Furthermore, analysts and other users do not use the total
comprehensive income and it is therefore not decision useful.
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Question 11:
Do you agree that the entity should be permitted to present in other comprehensive income
changes in the fair value (and dividends) of any investment in equity instruments (other than
those that are held for trading), only if it elects to do so at initial recognition? If not,
(a)
(b)
How do you propose to identify those investments for which presentation in other
comprehensive income is appropriate? Why?
Should entities present changes in fair value in other comprehensive income only in the
periods in which the investments in equity instruments meet the proposed identification
principle in (a)? Why?
Please refer to our response to question 10.
Question 12:
Do you agree with the additional disclosure requirements proposed for entities that apply the
proposed IFRS before its mandated effective date? If not, what would you propose instead and
why?
From our point of view, an early application of such an important standard before 2012 is not
realistic.
Question 13 :
Do you agree with applying the proposals retrospectively and the related proposed transition
guidance? If not, why? What transition guidance would you propose instead and why?
It is particularly difficult to determine whether the standard should be applied prospectively or
retrospectively as long as we have no clear view on the future standard on hedge accounting or
impairment. In any case, a retrospective application will have an extremely large cost for our
institution.
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Question 14 :
Do you believe that this alternative approach provides more decision useful information than
measuring those financial assets at amortized cost, specifically:
(a)
(b)
In the statement of financial position?
In the statement of comprehensive income?
If so, why?
As explained previously, we believe that accounting standards should follow business models.
We do not think the alternative proposal is designed to provide a relevant representation of the
performance of a financial institution.
Question 15 :
Do you believe that either of the possible variants of the alternative approach provides more
decision useful information than the alternative approach and the approach proposed in the
exposure draft? If so, which variant and why?
See answer in Q14
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