comment-letter-Fair-Value-Option-for-Financial-Liabilities

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KPMG IFRG Limited Tel [phone] Dorset Rise Fax [phone] London EC4Y 8EN [e-mail] United Kingdom mmmm Sir David Tweedie International Accounting Standards Board st1 Floor 30 Cannon Street Our ref MT/288 London Contact Mary Tokar EC4M 6XH 16 July 2010 Dear Sir David Comment letter on Exposure Draft ED/2010/4 Fair Value Option for Financial Liabilities We appreciate the opportunity to comment on the International Accounting Standards Board’s (IASB or the Board) Exposure Draft (ED/2010/4) Fair Value Option for Financial Liabilities. This letter expresses the views of the international network of KPMG member firms. Please note that our comments in this letter are restricted to the proposals contained in the ED for financial liabilities designated as fair value through profit or loss under the fair value option. As requested by the Board, we offer no comment in this letter on the decision of the IASB generally to retain the guidance on accounting for financial liabilities in IAS 39 Financial Instruments: Recognition and Measurement. In our comment letter on the Discussion Paper Credit Risk in Liability Measurement, we recommended that the Board seek and evaluate input from users of financial statements as to the decision-usefulness of including or excluding gains and losses that arise from changes in an entity’s own credit risk from profit or loss. We ...

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KPMG IFRG Limited 1-2 Dorset Rise London EC4Y 8EN United Kingdom

Sir David Tweedie International Accounting Standards Board st 1 Floor 30 Cannon Street London EC4M 6XH

16 July 2010

Dear Sir David

Our ref Contact

Tel [phone] Fax [phone] [e-mail]

MT/288 Mary Tokar

Comment letter on Exposure Draft ED/2010/4Fair Value Option for Financial Liabilities We appreciate the opportunity to comment on the International Accounting Standards Board’s (IASB or the Board) Exposure Draft (ED/2010/4)Fair Value Option for Financial Liabilities. This letter expresses the views of the international network of KPMG member firms.

Please note that our comments in this letter are restricted to the proposals contained in the ED for financial liabilities designated as fair value through profit or loss under the fair value option. As requested by the Board, we offer no comment in this letter on the decision of the IASB generally to retain the guidance on accounting for financial liabilities inIAS 39 Financial Instruments: Recognition and Measurement.

In our comment letter on the Discussion PaperCredit Risk in Liability Measurement, we recommended that the Board seek and evaluate input from users of financial statements as to the decisionusefulness of including or excluding gains and losses that arise from changes in an entity’s own credit risk from profit or loss. We understand that the Board has now undertaken outreach to users of financial statements to enquire about their views on this subject. We acknowledge that the exposure draft reflects the views of users as perceived by the Board during the outreach program. On this basis, we generally support the proposal in the ED that such gains should be excluded from profit or loss and included in other comprehensive income. Since we believe that the views of users are central in making a decision about the accounting for own credit risk, we believe that the Board should attach substantial weight to the comments on the ED received from this group of constituents, not only from the Board’s outreach but also in responses to this ED that the Board receives from users. We are uncertain whether the views obtained to date from users clearly indicate that realised gains and losses crystallised on early settlement or repurchase of debt, rather than just unrealised gains and losses, should be excluded from profit or loss.

KPMG IFRG Limited, a UK company limited by guarantee, is a member of KPMG International Cooperative, a Swiss entity.

R Registered in England No 5253019 Registered office: Tricor Suite, 7th Floor, 52-54 Gracechurch Street, London, EC3V 0EH

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KPMG IFRG Limited Comment letter on Exposure Draft ED/2010/4 Fair Value Option for Financial Liabilities 16 July 2010

Although we support the general direction of the exposure draft, we think that the twostep approach for recognising changes in own credit risk has no merit in principle and is overly complex. Therefore we believe that the Board should pursue a onestep approach, which provides the same information content in a less complex and cluttered manner.

To date the purpose of determining the amount of the change in fair value of a liability that is attributable to changes in credit risk has been to provide footnote disclosure whereas under the ED it would have a direct impact on reported profit or loss. Given this different impact, and the potentially more significant effect of any diversity in practice, we believe that the guidance in IFRS 7Financial Instruments: Disclosureon the methods to be used should be expanded to clarify the underlying principles and their application.

As we have emphasised in other comment letters, we believe that convergence between IFRSs and U.S. GAAP is an important objective for financial instruments accounting. The FASB published its Proposed Accounting Standards Update Accounting for Financial Instruments and Revisions to the Accounting for Derivative Instruments and Hedging Activities  Financial Instruments (Topic 825) and Derivatives and Hedging (Topic 815)in May 2010. This exposure document proposes a different accounting model for financial instruments as compared with that which the IASB is pursuing. In particular, there would be differences as to whether financial liabilities are measured at amortised cost or at fair value or a mixture of the two, and as to whether fair value gains and losses would be reported in profit or loss or in other comprehensive income. Also, the method that the FASB proposes for determining the portion of changes in fair value that is attributable to changes in credit risk is different to that included in the ED. You have asked the IASB’s constituents to provide feedback to the FASB on its proposals by the FASB’s comment deadline of 30 September 2010. We urge the Boards to work towards further convergence in financial instruments accounting.

Appendix 1 to this letter contains our response to the specific questions asked by the Board.

Please contact Mary Tokar or Chris Spall on [phone] if you wish to discuss any of the issues raised in this letter.

Yours sincerely

KPMG IFRG Limited

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Appendix 1

Question 1

KPMG IFRG Limited Comment letter on Exposure Draft ED/2010/4 Fair Value Option for Financial Liabilities 16 July 2010

Do you agree that for all liabilities designated under the fair value option, changes in the credit risk of the liability should not affect profit or loss? If you disagree, why?

We agree that changes in the credit risk of financial liabilities designated as at fair value through profit or loss should not impact profit or loss. In our comment letter on the Discussion Paper Credit Risk in Liability MeasurementDP), we acknowledged the merits of the various (the arguments presented in the DP on this question. In the absence of any single meritorious conceptual answer, we encouraged the Board to seek and evaluate input from users as to the decisionusefulness of including or excluding such gains and losses from profit or loss. But we outlined also that any suggestions would have to be weighed against the competing goal of avoiding additional complexity in reporting financial instruments.

We acknowledge that the Board undertook an extensive outreach program to gather the views of users of financial statements. This includes a questionnairesurvey of users of financial statements regarding how they use the information about changes in own credit risk today and what their preferred method of accounting is for selected financial liabilities.  The findings of this outreach program form the basis for the ED. Therefore the ED reflects the needs of users of financial statements as perceived by the Board. For that reason we generally support the proposals.

However, different users may have different views on the issue of recognition and presentation of gains and losses arising from changes in own credit risk. Therefore we believe that the Board should analyse carefully any comments received from users and ensure that any different emerging consensus is taken account of in developing a final standard.

See also our response to Question 7.

Question 2

Or alternatively, do you believe that changes in the credit risk of the liability should not affect profit or loss unless such treatment would create a mismatch in profit or loss (in which case, the entire fair value change would be required to be presented in profit or loss)? Why?

We do not believe that an additional exception for such mismatches should be included in a new standard. We do not perceive any significant relevant preference of users for a different presentation of gains and losses arising from changes in the credit risk of the liability in these circumstances. An additional exception would make the guidance more complex. This would contradict the overall objective to reduce complexity in financial instruments accounting. We see no compelling arguments to introduce a further exception.

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Furthermore we believe that the concept of accounting mismatches for purposes of accounting for fair value changes due to own credit risk, if pursued further, would need additional elaboration. The ED does not provide any supplementary discussion as to how an entity would evaluate whether there actually is a mismatch under the alternative approach. The ED suggests that the exception might be applicable when liabilities designated at fair value through profit or loss are managed together with financial assets measured at fair value through profit or loss. We note that gains and losses on the assets would reflect the effect of changes in the credit risk of those specific assets. It is unclear whether the alternative approach would require any evaluation as to whether there was any actual or expected correlation between the effect of changes in the assets’ credit risk and the effect of changes in the liabilities’ credit risk and, if so, how this might be done. In many cases there might be little or no positive correlation in which case the notion of a “mismatch” in this respect seems misplaced. If the Board were to develop the alternative approach, we believe that it should reconsider whether fair value changes due to changes in credit risk still should be recognised in OCI if the accounting mismatch no longer exists, for example, if the related assets are sold. We note further that the question of what constitutes an accounting mismatch for purposes of the alternative approach may depend on how the effect of changes in credit risk is defined and determined. Please refer to our response to Question 8 below.

Question 3 and question 6

Do you agree that the portion of the fair value change that is attributable to changes in the credit risk of the liability should be presented in other comprehensive income? If not, why?

Do you believe that the effects of changes in the credit risk of the liability should be presented in equity (rather than in other comprehensive income)? If so, why?

We agree that the change in fair value that is attributable to changes in the credit risk of the liability should be presented in other comprehensive income (OCI). These changes meet the definition of gains and losses as set out in theFramework for the Preparation and Presentation of Financial Statements.

We do not believe that the effects of changes in the credit risk of the liability should be presented directly in equity. We see no conceptual reason for this. Even if the effects could be viewed as a wealth transfer from debt to equity holders, such transfers are not transactions with shareholders from the entity’s perspective.

We acknowledge that the Board intends to address issues around OCI comprehensively. We do not believe that this warrants in the meantime excluding the gains or losses under discussion from OCI or creating another category of changes in equity that would have no basis in principle.

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Question 4 and question 5

Do you agree that the twostep approach provides useful information to users of financial statements? If not, what would you propose instead and why?

Do you believe that the onestep approach is preferable to the twostep approach? If so, why?

We agree that the chosen approach provides useful information to users of financial statements.

We believe also that a onestep approach is preferable to the twostep approach.

The twostep approach provides useful information to users in accordance with the feedback received insofar as it separately presents the effects of changes in the credit risk of liabilities designated under the fair value option and excludes those effects from reported net income. However, we believe that the twostepapproach is not the best way to provide relevant information to the users of financial statements. Grossing up line items within profit or loss for gains or losses that are in effect excluded from profit or loss seems to be an inconsistent approach within IFRSs. No other standard requires recognition of items first in profit or loss and then mandates simultaneous reclassification to OCI. This new approach is not necessary since the information that the Board intends to be provided can be given more simply using a onestep approach. Additionally there appears to be a contradiction between the twostep approach (i.e. recognising the credit risk effect both in profit and loss and in OCI) and the Board’s stated view in the ED that gains and losses should be recognised only once (i.e. either in profit or loss or in OCI).

The twostepapproach renders the guidance unnecessarily complex. It conflicts with the objective of simplifying the accounting for financial instruments without providing any benefit.

Therefore we support a onestep approach that recognises changes in the fair value of financial liabilities due to credit risk directly in OCI. This approach is consistent with all other scenarios in which gains or losses are recognised in OCI.

The onestep approach can provide the same information for users of financial statements but reduces the complexity as compared with the twostep approach. Changes in the fair value of financial liabilities would be split into two components, i.e. gains and losses arising from changes in own credit risk and gains and losses arising from changes in other factors, which may be presented in separate line items in OCI and profit or loss respectively.

If the Board nevertheless chooses to proceed with a twostepapproach, we believe that the two proposed line items in profit or loss (i.e. “net gains or losses on financial liabilities designated as at fair value through profit or loss” and “the portion … that is attributable to changes in the liabilities’ credit risk”) should be presented adjacently together with the net amount directly below. This would improve the clarity of presentation in the statement of comprehensive income and avoid any misunderstanding that might arise from presenting the proposed two line items in different places as if they were not related.

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Question 7

KPMG IFRG Limited Comment letter on Exposure Draft ED/2010/4 Fair Value Option for Financial Liabilities 16 July 2010

Do you agree that gains or losses resulting from changes in a liability’s credit risk included in other comprehensive income (or included in equity if you responded ‘yes’ to Question 6) should not be reclassified to profit or loss? If not, why and in what circumstances should they be reclassified?

We are uncertain whether the views obtained to date from users clearly indicate that realised gains and losses crystallised on repurchase of debt, rather than only unrealised gains and losses, should be excluded from profit or loss. The user survey of the IASB as published in the Board’s agenda papers for April 2010 did not specifically address the question of whether gains or losses recognised in OCI should be reclassified to profit or loss upon realisation, e.g. in the case of an actual buy back of debt instruments. The agenda papers state that the “general message” of the responses was that “[i]nformation about changes in own credit risk should be included in profit or lossonly ifthe entity has the ability and opportunity to buy back its own debt.” This sentiment is reflected in the continuing treatment of liabilities held for trading and also echoes the concerns expressed in the July 2009Report of the Financial Crisis Advisory Group.We note that this general message might suggest that users would prefer that gains or losses arising from changes in own credit risk that are realised as a result of actual repurchases of debt should be included in profit or loss by means of reclassification from OCI. We note that this would provide a result consistent with the treatment of such gains and losses arising on extinguishment of liabilities measured at amortised cost. We therefore encourage the Board to ensure that it obtains and considers feedback from users on this question prior to finalising its proposals.

We believe that the final standard should make clear that the cumulative amounts recognised in OCI for changes in credit risk are presented as a separate component of equity. If the Board concludes that the final standard should not permit or require reclassification of gains and losses recognised in OCI to profit or loss, then we believe that reclassification to another component within equity should be required upon realisation. This approach would enable users to immediately ascertain the cumulative posttax effect of unrealised gains and losses arising from own credit risk from the face of the statement of financial position or statement of changes in equity.

In paragraph BC39 of the Basis for Conclusions of the ED the Board states that if an entity repays the contractual amount, then the cumulative effect over the life of the instrument of any changes in the liability’s credit risk will net to zero because its fair value will equal the contractual amount. Although this conclusion may be correct in most situations, we do not believe that it is necessarily true in all situations or that it is consistent with the proposed guidance on determining the effects of changes in the liability’s credit risk. For example, an entity may have a liability that pays a floating rate of interest plus a fixed credit spread that is prepayable subject to payment of a fixed penalty fee. The entity chooses to prepay the loan because its credit risk has declined and it can obtain replacement funding at a lower credit spread. In this case, the penalty fee paid represents a monetisation of the effect of changes in the credit risk of the liability. Furthermore, if the default method under IFRS 7 were applied to

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determine the fair value changes due to own credit risk, then it is arguable that there would be an impact in OCI which does not reverse since payment of the penalty fee is not “attributable to changes in market conditions.” Consistent with our response to Question 8 below, we believe that the position expressed in paragraph BC39 should be explained further and clarified and included in application guidance on determining the amount of change in fair value attributable to changes in a liability’s credit risk.

Question 8

For the purposes of the proposals in this exposure draft, do you agree that the guidance in IFRS 7 should be used for determining the amount of the change in fair value that is attributable to changes in a liability’s credit risk? If not, what would you propose instead and why?

We agree that the guidance in IFRS 7Financial Instruments: Disclosuresbe used as a should basis for determining the amount of the change in fair value that is attributable to changes in a liability’s credit risk. We believe that this guidance, which currently is applied in practice, has proven to be operational. However, we note that to date the purpose of the determination in IFRS 7 has been to provide footnote disclosure whereas, under the proposals, it would have a direct impact on reported profit or loss. Given this different impact, and the potentially more prominent effect of different approaches to determination, we recommend that the Board include in the final standard further clarification of the concepts and their application in order to avoid diversity in practice.

For example, it would be useful to address the following issues :

Benchmark interest rates:The default method under IFRS 7 treats a benchmark interest rate as akin to a riskfree rate and excludes all changes in the benchmark rate as unrelated to and not part of changes in the liability’s credit risk. However, neither IFRS 7 nor the proposals define what a benchmark rate is. In practice, it is commonly understood to include inter bank rates such as LIBOR for US dollar or sterling liabilities or EURIBOR for euro liabilities. However, these rates may include a creditrisk premium above the highestquality government bond rates for the same term and currency. During the financial crisis, gaps between these interbank rates and the highestquality government rates both increased and became more volatile.

Creditsensitive payments: Some debt agreements contain features that are intended to protect the creditor against increases in the issuer’s own credit risk by increasing the rate of contractual interest payable if the issuer’s credit rating deteriorates. The proposals do not discuss how the effect of actual or expected changes in contractual cash flows arising from such clauses should be considered.

Interest stopper clauses: By contrast, some subordinated debt instruments or preference shares accounted for as liabilities may allow the issuer to avoid or defer payments of interest or principal if it fails to achieve some measure of financial health, e.g. a deficit of statutory

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reserves or inadequate regulatory capital. Again, the proposals do not discuss whether consequent changes in contractual cash flows should be considered part of the own credit component.

Assetbacked securities and other passthroughtype and nonrecourse arrangements: Entities, especially specialpurpose entities, may issue instruments that are intended to “pass through” to an investor some or all of the cash flows of specified assets. Such instruments may have stated principal and interest amounts but the amount of the issuer’s obligation may be reduced if the specified assets fail to generate sufficient cash. Alternatively, the investor may have no recourse to other assets of the issuer in the event of the issuer’s default. When such an instrument is accounted for as a liability, we envisage that there might be difficult practical issues in identifying and measuring the own credit risk component.

See also our response to Question 7 above regarding penalties payable on redemption.

We note that under the proposals in the FASB ED an entity would present separately on the face of the statement of comprehensive income the amount of significant changes in the fair value of its financial liabilities arising from changes in the entity’s own credit standing during the period, excluding changes related to changes in the “price of credit.” We understand that under the IASB’s ED changes in the fair value of a financial liability due to own credit risk would include this “price of credit.” This would mean that on a conceptual level the changes in fair value due to own credit risk would be determined differently under US GAAP and IFRSs. As well as reducing comparability, this difference and its effect might be neither obvious nor understandable to many users. We note that the FASB has asked users for feedback on its different approach. Again, we urge the Boards to work together to reduce differences between their approaches or, failing that, to make the effect of differences clearer to and understandable by users.

Question 9

Do you agree with the proposals related to early adoption? If not, what would you propose instead and why? How would those proposals address concerns about comparability?

We agree in principle with the proposals related to early adoption. We think that if an entity elects to apply early any finalised requirements of IFRS 9Financial Instruments, it also should apply any preceding requirements in IFRS 9 that it does not already apply, as stated in paragraph BC48 of the Basis for Conclusions. We believe that this approach strikes the right balance between flexibility for preparers and the qualitative characteristic of comparability.

However, we note that the wording used in paragraph 4 of theProposals for the fair value option for financial liabilitiesin the ED that an entity has to apply “any requirements in IFRS 9 it does not already apply” upon early adoption of theProposalswould contradict the objective

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in the Basis for Conclusions if “any” were interpreted as “all”. We suggest clarifying the wording consistent with the Basis for Conclusions and the Board’s previously stated intention that any future additions to IFRS 9 as published in November 2009 could be applied only if “requirements published before them” also were applied, rather than all requirements whenever published.

Question 10

Do you agree with the proposed transition requirements? If not, what transition approach would you propose instead and why?

We agree generally with the proposal for full retrospective application of the new guidance since this approach provides the most useful information to financial statement users. In most cases, this approach is demonstrably practicable since entities have the relevant information about fair value changes attributable to changes in the credit risk of liabilities designated under the fair value option due to the fact that these amounts are required to be disclosed in annual financial statements under IFRS 7.

However, as the final standard resulting from the ED would become an integral part of IFRS 9, we believe that the transition requirements should be amended to dovetail with the transition requirements included in the first chapters of IFRS 9 published in November 2009. These chapters grant an exemption allowing early adopters not to restate prior periods if the standard is applied for reporting periods beginning before 1 January 2012. IFRS 1 contains a similar exemption from restatement of prior periods for first time adopters that adopt IFRSs for periods beginning before 1 January 2012. We believe that these exemptions should be extended to financial liabilities within the scope of the ED. We see no significant benefit, but additional cost and potential for confusion, if an entity is required to restate prior periods for changes in the accounting for financial liabilities but does not restate prior periods for changes in the accounting for financial assets, especially when the changes result from the adoption of a single integrated new standard.

We also note that the current chapters of IFRS 9 allow an entity at the date of its initial application of those chapters to designate a financial liability as at fair value through profit or loss to avoid an accounting mismatch which might result from adoption of the new requirements for accounting for financial assets. This designation is applied retrospectively but subject to the exemption described above. This interdependency strengthens the case for extending the exemption to liabilities within the scope of the ED. Also, in the case of designation at the date of initial application, information about past fair value changes attributable to changes in the liability’s credit risk may not be readily available since the entity would not have been required to disclose these amounts under IFRS 7 before. Extending the exemption to these cases would significantly mitigate concerns regarding the practicability of retrospective adoption.

IFRS 1Firsttime Adoption of International Financial Reporting Standardsallows a firsttime adopter to designate an existing financial liability under the fair value option at its date of transition, provided the relevant criteria in IAS 39 are met. We note that the exposure draft

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would retain this exception. However, it does not discuss whether a gain or loss arising from a change in the liability’s credit risk between the liability’s issuance and the entity’s date of transition to IFRSs should be identified and included in accumulated other comprehensive income at that time or recorded in retained earnings. Similarly, it does not discuss specifically whether the effective reversal of such a gain or loss (as the fair value of the instrument is pulled to the amount repayable on maturity) should be presented in profit or loss or other comprehensive income. We believe that the Board should clarify these points in the final standard.

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