Issue 16 October 2008

Supplement to IFRS outlook

Reclassification of
financial assets

Background
On 13 October 2008, the International Accounting Standards Board (the IASB or the
Board) approved and published amendments to IAS 39 Financial Instruments: Recognition
and Measurement and IFRS 7 Financial Instruments: Disclosures to allow reclassifications
of certain financial instruments held for trading to either the held to maturity, loans and
receivables or available for sale categories. The amendment also allows the transfer of
certain instruments from available for sale to loans and receivables. The IASB made use of
the International Accounting Standards Committee Foundation Trustees agreement to
suspend normal due process and consequently there was no exposure or comment period.
The amendments were endorsed by the European Union on 15 October 2008. The
effective date is 1 July 2008.
The amendments were made in response to requests by regulators to enable banks to
record instruments which are no longer traded in an active market at amortised cost,
thereby reducing reported profit and loss volatility. They will apply also to non-banks that
have financial assets recorded as held for trading or available for sale.
The amendments introduce concepts already present in US GAAP, which allows loans to be
transferred from held for sale to held for investment if there is a change in holding
intent, and in rare circumstances the transfer of securities from held for trading to
available for sale or held to maturity.
Because of the accelerated amendment process, it was stated at the 13 October 2008
Board meeting that corrections will be made to the amendments if found to be necessary.
A summary of the changes is as follows:
1. Entities are allowed to reclassify certain financial instruments out of the held for
trading category if they are no longer held for the purpose of selling or repurchasing
them in the near term. Entities still cannot reclassify instruments that were designated
at fair value through profit or loss using the fair value option, nor derivatives.
2. The amendments distinguish between those financial assets which would be eligible
for classification as loans and receivables and those which would not. The former are
those instruments which, apart from not being held with the intent of sale in the near
term, have fixed or determinable payments, are not quoted in an active market and
contain no features that could cause the holder not to recover substantially all of its
initial investment, except through credit deterioration.
3. Financial assets that are not eligible for classification as loans and receivables, may be
transferred from held for trading to available for sale or to held to maturity, only in
rare circumstances. Rare is not defined, although the Basis for Conclusions states
that rare circumstances arise from a single event that is unusual and highly unlikely to
recur in the near term. Also, the IASB has stated on its website: The deterioration of
worlds markets that has occurred during the third quarter of this year is a possible

example of rare circumstances cited in the IFRS amendments

and therefore justifies their immediate publication. Todays
action enables companies reporting according to IFRSs to
use the reclassification amendments, if they so wish, from
1 July 2008.
4. Financial assets that would now meet the criteria to be
classified as loans and receivables, may be transferred from
held for trading to loans and receivables, if the entity has the
intention and the ability to hold them for the foreseeable future.
Foreseeable future is not defined.
5. In addition, financial assets that would now meet the criteria to
be classified as loans and receivables may be classified out of
the available for sale category to loans and receivables, if the
entity has the intention and the ability to hold them for the
foreseeable future.
6. The reclassification should take place at the fair value as at the
date of reclassification. For example, an instrument that was
acquired at its par value of 100, had declined in fair value to 60
and is now reclassified to held to maturity, will have a new
amortised cost of 60.
7. Through the effective interest method, the new cost would be
amortised to the instruments expected recoverable amount
over the expected remaining life. Therefore, using the example
in 6 above, the loss of 40 recognised in prior periods will not be
reversed through profit or loss, either on reclassification or in
future, except through interest income. This is achieved by an
amendment of paragraph AG 8 of IAS 39.
8. If the instrument is reclassified into the available for sale
category, any subsequent change in fair value (other than
amortisation of interest through the new effective interest rate)
from the fair value at the date of reclassification will be
recorded in the available for sale revaluation reserve until the
instrument is derecognised or impaired.
9. Any reclassified instruments should subsequently be reviewed
for impairment using the IAS 39 impairment rules for the
categories into which they are reclassified.
10. The effective date of the amended standard is 1 July 2008
and reclassifications before 1 July 2008 are not permitted.
This means that, on first application, entities can go back to
1 July 2008 and make transfers as of that date. Any
subsequent reclassifications made in periods beginning on
or after 1 November 2008 will be effective from the date
that the reclassification is made. (See below for comment
on this wording).
11. The disclosure requirements are substantial and are intended to
permit a user of the financial statements to determine what
would have been the accounting result had the reclassification
not been made. They include:
a. the amount reclassified into and out of each category;
b. for each reporting period until derecognition, the carrying
amounts and fair values of all financial assets that have been
reclassified in the current reporting period and previous
reporting periods;
c. for financial assets reclassified in rare circumstances (see 3.
above), the specific situation and the facts and circumstances
indicating that it was rare;
d. in the reporting period in which financial assets are reclassified,
the fair value gains or losses on those assets recognised either
in profit or loss or in equity (other comprehensive income) in
that reporting period and in the previous reporting period

e. over the remainder of the instruments lives, the gains or losses

that would have been recognised in profit or loss or equity had
they not been reclassified, together with the gains, losses,
income and expenses now recognised;
f.

as at the date of reclassification, the effective interest rates

and estimated amounts of cash flows the entity expects
to recover.

The amendments have only just been published so it is not possible

to foresee all the potential consequences, but a first analysis of the
amendments has raised the following observations:
1. A reclassification out of held for trading can only be made if the
entity no longer has any trading intent with respect to that
instrument. Therefore, despite the transition rules,
reclassification is only possible from the date of cessation of
trading intent. While the amendments do not specifically refer
to reclassification of a financial instrument which was originally
classified as held for trading because it was part of a portfolio
of identified instruments that are managed together and for
which there is evidence of a recent actual pattern of short term
profit-taking (paragraph (a) (ii) of the definition of held for
trading), in practice we believe that the amendments will be
applied to such financial instruments if they are no longer held
with trading intent.
2. The amendments only apply to non-derivative financial assets
and so cannot be applied to a loan commitment. This means
that any commitments to lend that were recorded as derivatives
can only be reclassified as of the date the loans were drawn
down, at their fair values on those dates.
3. A financial asset may be reclassified from available for sale to
loans and receivables if it now meets the definition of loans and
receivables and the entity has the intention to hold the asset for
at least the foreseeable future. Foreseeable future is not
defined. Given the current market uncertainties this is unlikely
to be viewed as a very restrictive criterion.
4. If an asset is reclassified from available for sale to held to
maturity or loans and receivables, any previous gain or loss
recorded in equity will be amortised to profit or loss over the
remaining life of the asset as a component of the effective
interest rate.
5. It is probable that financial assets which are now being
reclassified were, while recorded in held for trading,
economically hedged for some of their risks, such as
movements in LIBOR, by derivatives that were also recorded at
fair value through profit or loss. Hedge accounting was not
previously necessary to obtain consistency of measurement.
While the assets can be reclassified as loans and receivables as
of 1 July 2008, the hedging derivatives cannot. Gains or losses
on the derivatives will continue to be recorded in profit or loss
subsequent to 1 July 2008 and these will not be offset by
similar recorded gains or losses on the transferred assets.
Hedge accounting cannot be applied retrospectively, so the
derivatives can only be treated as hedges of the transferred
assets for accounting purposes once the hedges have been
documented and the hedge effectiveness demonstrated. Also
as the derivatives will no longer have a fair value of zero, it is
probable that there will be some hedge ineffectiveness going
forward, especially for cash flow hedges.
6. Financial assets may only be transferred into the held to
maturity category if the entity has the positive intention and
ability to hold them to maturity. Also, entities must not forget
that, from an accounting perspective, they are not allowed to

sell the asset before its maturity. If they sell the asset before
maturity then (with only a few exceptions) this will taint the
remaining portfolio, resulting in reclassification of the entire
portfolio to the available for sale category.
7. If an instrument is reclassified into the held to maturity
category it is not eligible for hedge accounting for interest
rate risk.
8. As mentioned earlier, instruments where the holder may not
recover substantially all of their initial investment, other than
because of credit deterioration, may not be reclassified to
loans and receivables. These will include, for example, assets
whose principal repayments are referenced to equity or
commodity prices.
9. An issue that was discussed at some length at the Board
meeting to approve the amendments was how, in practice, to
determine the new effective interest rate once the asset has
been reclassified. The effective interest rate will depend on the
level of cash flows expected, so a higher level of expected cash
flows will result in a higher effective rate. This calculation will
necessarily be judgmental, but the amendments to paragraph
AG 8, which require any increase in expected recoveries to be
reflected in a revised effective interest rate rather than a
change in carrying amount, and the requirement to disclose the
expected cash flows, will help to reduce the effect on reported
profit of changes in estimates and provide information to users
of the financial information on how the judgment has been
applied.
10. There is no need to assess for impairment for a financial asset
included in the held for trading category. However, if an asset is
reclassified either to loans and receivables or to held to
maturity, the level of impairment will, subsequently, need to be
determined. It may be a significant exercise to calculate
individual and collective loan loss amounts on application of the
amendments. For an asset reclassified to available for sale, if it
is deemed impaired then any subsequent decline in fair value
may need to be recorded as an impairment loss. For an asset
reclassified from available for sale to held to maturity or loans
and receivables, if the asset is subsequently considered
impaired, then any gain or loss that is recorded in equity will
need to be recognised in profit or loss.
11. The transition rules state that application may be implemented
retrospectively but not before 1 July 2008. Any reclassification
of a financial asset made in periods beginning on or after 1
November 2008 shall take effect only from the date when the
reclassification was made. We believe that this wording does
not reflect the intention of the Board and expect that it will be
adjusted to delete the words: in periods beginning on or in the
standard, thereby making 1 November 2008 the last possible
date when an entity could look back to 1 July 2008. This would
mean that if entities are not able to make the reclassifications
in time for the publication of their results for the third quarter
of 2008, the reclassifications can still be made in their fourth
quarter financial statements, as of 1 July 2008, as long as the
amendments are applied before 1 November 2008. If the
adjustment is only made in the fourth quarter, presumably the
application would require restatement of the previously
reported third quarter financial information, since this would
represent a change in accounting policy rather than a change of
estimate. Any reclassifications made after 1 November 2008
would need to be made at the fair value as on the date of
reclassification.

12. We believe that if assets are reclassified due to rare

circumstances, then all such assets would need to be
reclassified as of the same date, since there has been only one
rare event. However, if the reclassification has been based on a
change in intent, then we believe the entity can select different
dates for different assets, if it has evidence of the date of
change of intent not to sell the asset in the near term. In
practice, entities will presumably only reclassify based on a
change in intent as of one of the following: i) prior to 1 July
2008, ii) when the amendment is first applied, or iii) a
contemporaneously documented change of trading intent.
13. Reclassifications out of the available for sale category into the
held to maturity category were already permitted for debt
instruments before the amendment, whenever there was a
change in intention or ability. The 1 July 2008 effective date
applies only to the newly permitted reclassifications. Therefore,
an entity may not reclassify from available for sale into held to
maturity as of 1 July 2008 unless it had changed its intention
as at that date.
14. For instruments in the held for trading category there is no
need to separate an embedded derivative, because the entire
instrument is recorded at fair value through profit or loss.
However, when an instrument is not recorded at fair value
through profit or loss it is necessary to determine whether to
separate, and report at fair value through profit or loss, any
embedded derivative if its economic characteristics and risks
are not closely related to those of the host instrument. The
amendments do not indicate whether a reassessment should be
made on reclassification, which would have a bearing on
whether an embedded derivative must now be recognised.
Examples include any prepayment option or credit derivative in
a synthetic collateralised debt obligation (CDO), ie,, a CDO in
which the special purpose entity is not required to hold the
reference asset, but may be exposed to it through a derivative.
Clarification has been requested from the IASB on this issue.
The IASB has also been requested to change the guidance on the
separation of embedded derivatives, to treat any credit derivative
embedded in a note issued in a securitisation as closely related to
the note, even if the CDO is not required to hold the reference
asset, in line with US GAAP.
If embedded derivatives are not separated, as mentioned above it is
not possible to classify as a loan or receivable an instrument for
which the entity may not recover substantially all of its initial
investment other than because of credit deterioration. The
application of AG8 of IAS 39 also means that any changes in
expected cash flows will result in an immediate recognition in profit
or loss. The amendment to AG 8 complicates this further, since any
downward revision in expected recoveries would need to be
reflected in profit or loss immediately according to AG 8, while any
increase in expected recoveries will need to be recognised in an
increase in the effective interest rate.
Any embedded derivative which was already separated in a financial
asset that was previously recorded as available for sale will continue
to be recorded at fair value through profit or loss
Example 1:
On 5 October 2007, Bank A originates a 6%, 10 year loan for Euro
100 million with the intention to syndicate 80% after origination. At
the date of origination it therefore classifies part of the loan as held
for trading as it intends to sell the loan in a month. The other part
(20%) is classified in loans and receivables, because the loan is not
quoted in an active market. However due to the current market

situation, the syndication fails and the loan

is retained by the bank, with the intention to
hold it for the long term. The part of the
loan that was classified as held for trading
(80%) decreased in fair value to Euro 65
million by 30 June 2008. Using the
amendment, the bank reclassifies the part
of the loan recorded as held for trading to
loans and receivables in its third quarter
financial statements, as of 1 July 2008. For
the reclassified part of the loan, the
amortised cost is recorded at Euro 65
million and the effective interest rate is
revised to 11%.
Example 2:
A security that was originally quoted in an
active market was acquired at a cost of Euro
80 million. Its fair value has declined to
Euro 17.4 million at 30 June 2008 because
principal and interest are no longer
expected to be fully recovered, and the
market rate for an instrument with similar
risk characteristics is significantly higher
than the securitys coupon. At the date of
reclassification, i.e., 1 July 2008, the
amortised cost is now Euro 17.4 million. In
this example, assume the bank no longer
expects to receive any interest and just Euro
75 million of principal repayment. The
revised effective interest rate is calculated
at 20%. If, as of 30 June 2010, the bank
subsequently expects to recover 100% of
principal, it would not write up the recorded
value of the security but, instead, would
increase the effective interest rate from
20% to 21%.
Example 3:
In 2006, a bank purchases a cash CDO (i.e.,
a collateralised debt obligation in which the
special purpose entity (SPE) which issues
the security is required to hold the
underlying reference assets, rather than
derivatives referenced to those assets) with
a 2020 maturity date which, at that time, is
quoted in an active market, for Euro 1
million. It classifies the CDO as held for
trading. Although the legal maturity is
2020, the CDO could mature earlier if the
underlying assets prepay earlier. At the date
of the purchase the bank estimates that the
CDO will prepay at par in 2014. Two years
later, on 1 July 2008, the CDO has declined
in fair value to Euro 450,000 and it is no
longer traded in an active market.
Consequently, the bank determines that it
no longer has the intent to trade the CDO
and reclassifies the CDO out of the held for
trading category, applying the amendment.
If the CDO is classified as held to maturity,
then the bank would record it at its
amortised cost of Euro 450,000, and
through the effective interest rate
amortisation process, would amortise it up
to the level of the expected cash flows over

its remaining expected life. The bank may

not sell the CDO without tainting the entire
held to maturity portfolio. If, alternatively,
the CDO is transferred to the available for
sale category, then it would be recorded at
fair value with any change in fair value
(except for amortisation through the
effective interest rate) recorded in the
available for sale revaluation reserve until
the CDO is impaired or derecognised. It is
currently not clear whether the prepayment
option would need to be separated and
recorded at fair value through profit or loss.
Example 4
In 2006, a bank purchases a cash CDO with
a 2020 maturity date for Euro 1 million
which equals par value. It classifies the CDO
as available for sale. Although the legal
maturity is 2020, the CDO could mature
earlier if the underlying assets prepay
earlier. At the date of the purchase the bank
estimates that the CDO will prepay at par in
2014. Two years later, on 30 June 2008
the CDO has declined in fair value to Euro
750,000 and by 15 October 2008 to Euro
600,000, which is recognised as an
unrealised loss in equity. At this time the
bank changes its intention and decides that
it can and will hold the CDO until maturity.
Therefore it reclassifies the CDO out of
available for sale and into the held to
maturity category. The bank appreciates
that it may not sell the CDO without tainting
the entire held to maturity portfolio.
Applying the guidance in paragraph 54 of
IAS 39, the reclassification is based on the
fair value as at 15 October 2008, since the
entity cannot apply the 1 July 2008 value
for a transfer from available for sale to held
to maturity. The bank does not consider
the CDO to be impaired. It would record
the CDO at its deemed amortised cost of
Euro 600,000 and, through the effective
interest rate, will amortise this up to the
level of the expected cash flows, over the
assets remaining expected life. The
negative revaluation reserve is, at the
same time, amortised through profit or
loss. The amortisation of both the CDO
and the revaluation reserve are both
recorded as part of interest income and
will largely offset.
One year later, the CDO is determined to
be impaired. At this time, the fair value of
CDO has declined to Euro 400,000 and the
present value of the expected cash flows
discounted at the new effective interest
rate is Euro 450,000. The bank must
recognise a loss equal to the remaining
revaluation reserve recorded in equity for
this instrument and the difference between
the carrying amount and Euro 450,000.
The total loss will therefore be nearly
Euro 550,000.

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