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ED Amendments to FRS 39 - Financial Guarantee Contracts and Credit ---

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ED Amendments to FRS 39 - Financial Guarantee Contracts and Credit ---

    PROPOSED FINANCIAL

    ED/FRS

    REPORTING STANDARD

    Exposure Draft of proposed

    AMENDMENTS TO

    FRS 39 FINANCIAL INSTRUMENTS:

    RECOGNITION AND MEASUREMENT

    AND FRS 104 INSURANCE CONTRACTS

    FINANCIAL GUARANTEE

    CONTRACTS AND

    CREDIT INSURANCE

    Comments to be received by 8 September 2004

This exposure draft (ED) contains proposed amendments to FRS 39

    Financial Instruments: Recognition and Measurement and FRS 104

    Insurance Contracts on “Financial Guarantee Contracts and Credit Insurance”.

This ED should be read in the context of the Preface to Financial

    Reporting Standards published by the Council on Corporate Disclosure

    and Governance.

This ED is issued by the Council on Corporate Disclosure and

    Governance for comment only and does not necessarily represent the

    views of the Council.

Since this ED may be modified as a result of comments received, the

    Council on Corporate Disclosure and Governance would like to hear both

    from those who agree with the proposals contained in the ED and from

    those who do not.

Comments are most helpful if they indicate the specific paragraph or

    group of paragraphs to which they relate, clearly explain the problem and

    provide a suggestion for alternative wording with supporting reasoning.

Comments should be submitted in writing, so as to be received by

    8 September 2004, preferably by email to: accounting_stds@acra.gov.sg or addressed to:

    Council on Corporate Disclosure and Governance

    c/o Accounting and Corporate Regulatory Authority

    10 Anson Road #05-01/15

    International Plaza

    Singapore 079903

    Fax: 6225 1676

    Contents

     Pages INTRODUCTION 3

    INVITATION TO COMMENT 5

    PROPOSED AMENDMENTS TO FRS 39 AND FRS 104 7

    Proposed amendments to FRS 39 7

    Proposed amendments to FRS 104 11

    Effective date and transition 13

    Proposed consequential amendments 13

    2

Introduction

IN1. Financial guarantee contracts (sometimes known as „credit insurance‟) require the issuer to

    make specified payments to reimburse the holder for a loss it incurs if a specified debtor fails

    to make payment when due under the original or modified terms of a debt instrument. These

    contracts can have various legal forms, such as that of a financial guarantee, letter of credit,

    credit default contract or insurance contract. Some financial guarantee contracts result in the

    transfer of significant insurance risk and thus meet the definition of „insurance contract‟ in FRS

    104 Insurance Contracts.

IN2. This Exposure Draft contains proposals to amend FRS 39 Financial Instruments: Recognition

    and Measurement to define „financial guarantee contracts‟ and amend the requirements for

    their treatment by the issuer. Under the proposals, the legal form of such contracts would not

    affect their accounting treatment.

IN3. The proposals would require the issuer of a financial guarantee contract (other than those

    contracts described in paragraph IN6) to measure the contract:

    (a) initially at fair value. If the financial guarantee contract was issued in a stand-alone

    arm‟s length transaction to an unrelated party, its fair value at inception is likely to

    equal the premium received, unless there is evidence to the contrary.

    (b) subsequently at the higher of (i) the amount determined in accordance with FRS 37

    Provisions, Contingent Liabilities and Contingent Assets and (ii) the amount initially

    recognised less, when appropriate, cumulative amortisation recognised in

    accordance with FRS 18 Revenue.

    These requirements would apply even if the contract meets the definition of an insurance

    contract in FRS 104.

IN4. For a stand-alone financial guarantee contract issued in an arm‟s length transaction to an

    unrelated party, the main practical effect of the proposals is the requirement to use FRS 37 to

    determine whether an additional liability should be recognised. Without the requirements

    proposed in this Exposure Draft, if the issuer carries out a liability adequacy test meeting

    minimum requirements described in paragraph 16 of FRS 104, the issuer need not use FRS

    37 to determine whether an additional liability should be recognised.

IN5. The proposals could have a more significant effect for financial guarantee contracts that are

    not issued in an arm‟s length transaction to an unrelated party and for financial guarantee

    contracts embedded in other contracts.

IN6. Financial guarantee contracts that were entered into or retained on transferring financial

    assets or financial liabilities to another party would be measured:

    (a) in accordance with paragraphs 29-37 and AG47-AG52 of FRS 39 if the financial

    guarantee contract prevents derecognition or results in continuing involvement; or

    (b) as a derivative in all other cases.

IN7. The substance of the proposals is consistent with requirements included in the revised version

    of FRS 39 issued in July 2004. In finalizing FRS 104 in early 2004, the need to expose its

    conclusions in this area for comment was acknowledged. Pending completion of amendments

    resulting from this Exposure Draft, these financial guarantee contracts are within the scope of

    FRS 104.

IN8. Although the scope section of FRS 39 excluded financial guarantee contracts from the scope

    of FRS 39, it specified their measurement. For clarity, the Exposure Draft proposes to address

    the measurement of these contracts in the measurement section of FRS 39, not in its scope

    section.

    3

IN9. Similarly, the proposals in the Exposure Draft would transfer the requirements for measuring

    some loan commitments from the scope section of FRS 39 to its measurement section.

    However, the measurement basis for these loan commitments remains unchanged.

IN10. If confirmed in a Standard, the proposals in this Exposure Draft would apply for annual

    periods beginning on or after 1 January 2006. Earlier application would be encouraged.

IN11. This Exposure Draft does not address accounting by the holder of financial guarantee

    contracts. This subject is outside the scope of FRS 104.

    4

Invitation to Comment

The Council on Corporate Disclosure and Governance (CCDG) invites comments on the changes

    proposed in this Exposure Draft. It would particularly welcome answers to the questions set out below.

    Comments are most helpful if they indicate the specific paragraph or group of paragraphs to which

    they relate, contain a clear rationale and, when applicable, provide a suggestion for alternative

    wording.

Comments should be submitted in writing so as to be received no later than 8 September 2004.

    Question 1 Form of contract

The Exposure Draft deals with contracts that require the issuer to make specified payments to

    reimburse the holder for a loss it incurs if a specified debtor fails to make payment when due under

    the original or modified terms of a debt instrument (financial guarantee contracts). These contracts

    can have various legal forms, such as that of a financial guarantee, letter of credit, credit default

    contract or insurance contract. Under the proposals in the Exposure Draft the legal form of such

    contracts would not affect their accounting treatment.

Do you agree that the legal form of such contracts should not affect their accounting treatment?

If not, what differences in legal form justify differences in accounting treatments? Please be specific

    about the nature of the differences and explain clearly how they influence the selection of appropriate

    accounting requirements.

    Question 2 Scope

The Exposure Draft proposes that all financial guarantee contracts should be within the scope of FRS

    39 (see paragraph 2 of FRS 39 and paragraph 4 of FRS 104), and defines a financial guarantee

    contract as “a contract that requires the issuer to make specified payments to reimburse the holder for

    a loss it incurs because a specified debtor fails to make payment when due in accordance with the

    original or modified terms of a debt instrument” (see paragraph 9 of FRS 39).

Is the proposed scope appropriate?

If not, what changes do you propose, and why?

    Question 3 Subsequent measurement

The Exposure Draft proposes that financial guarantee contracts, other than those that were entered

    into or retained on transferring financial assets or financial liabilities within the scope of FRS 39 to

    another party, should be measured subsequently at the higher of:

(a) the amount recognised in accordance with FRS 37 Provisions, Contingent Liabilities and

    Contingent Assets; and

(b) the amount initially recognised (ie fair value) less, when appropriate, cumulative amortisation

    recognised in accordance with FRS 18 Revenue (see paragraph 47(c) of FRS 39).

Is this proposal appropriate? If not, what changes do you propose, and why?

    Question 4 Effective date and transition

The proposals would apply to periods beginning on or after 1 January 2006, with earlier application

    encouraged . The proposals would be applied retrospectively.

Are the proposed effective date and transition appropriate? If not, what do you propose, and why?

    5

Question 5 Other comments

Do you have any other comments on the proposals?

6

Proposed Amendments to FRS 39 and FRS 104

In this Exposure Draft, the proposed amendments are shown with new text underlined and deleted

    text struck through.

Proposed amendments to FRS 39

    (as previously amended by FRS 104)

In the Introduction to FRS 39, paragraphs IN5 and IN6 are amended and paragraph IN5A is added.

IN5. The scope of the Standard includes financial guarantee contracts that were previously within

    the scope of FRS 104 Insurance Contracts. A financial guarantee contract is defined as a

    contract that requires the issuer to make specified payments to reimburse the holder for a loss

    it incurs because a specified debtor fails to make payment when due in accordance with the

    original or modified terms of a debt instrument. Financial guarantee contracts are initially

    recognised at fair value. Other than those described in paragraph IN5A, financial guarantee

    contracts are subsequently measured at the higher of (a) the amount determined in

    accordance with FRS 37 Provisions, Contingent Liabilities and Contingent Assets and (b) the

    amount initially recognised less, when appropriate, cumulative amortisation recognized in

    accordance with FRS 18 Revenue. The treatment of financial guarantee contracts has been

    reviewed. Such a contract is within the scope of this Standard if it is not an insurance contract,

    as defined in FRS 104 Insurance Contracts. Furthermore, if an entity entered into, or retained,

    a financial guarantee on transferring to another party financial assets or financial liabilities

    within the scope of the Standard, the entity applies the Standard to that contract, even if the

    contract meets the definition of an insurance contract. TAn Exposure Draft proposing

    amendments to the treatment of financial guarantees within the scope of FRS 104 was

    expected to be issued in the near future.

IN5A. Financial guarantee contracts that were entered into or retained on transferring to another

    party financial assets or financial liabilities within the scope of this Standard are subsequently

    measured:

    (a) in accordance with paragraphs 29-37 and AG47-AG52 of FRS 39 if the financial

    guarantee contract prevents derecognition or results in continuing involvement; or

    (b) as a derivative in all other cases.

    IN6. A second scope exclusion has been added made for loan commitments that are not classified

    as at fair value through profit or loss and cannot be settled net. A commitment to provide a

    loan at a below-market interest rate is initially recognised at fair value, and subsequently

    measured at the higher of (a) the amount that would be recognised under FRS 37 and (b) the

    amount initially recognised less, where when appropriate, cumulative amortisation recognised

    in accordance with FRS 18 Revenue.

In the Standard, paragraphs 2(e), 2(h), 4, 47 and AG4A are amended and paragraph 3 is deleted. In

    paragraph 9, a new definition is added immediately after the definition of a derivative, and the

    definition of a financial liability at fair value through profit or loss is amended as set out below.

    Paragraph 43 is included here for reference, but is not amended.

The amendments to paragraphs 2(h) and 47(d) would transfer measurement requirements for some

    loan commitments from the scope section of the Standard to the measurement section, but would not

    change those requirements.

2. This Standard shall be applied by all entities to all types of financial instruments except:

    

    (e) rights and obligations arising under (i) an insurance contract as defined in FRS

    104 Insurance Contracts, other than an insurance contract that meets the

    7

    definition of a financial guarantee contract in paragraph 9, or (ii) under a

    contract that is within the scope of FRS 104 because it contains a discretionary

    participation feature. However, this Standard applies to a derivative that is

    embedded in a contract within the scope of FRS 104 if the derivative is not itself

    a contract within the scope of FRS 104 (see paragraphs 10-13 and Appendix A

    paragraphs AG23-AG33). Furthermore, if an insurance contract is a financial

    guarantee contract entered into, or retained, on transferring to another party

    financial assets or financial liabilities within the scope of this Standard, the

    issuer shall apply this Standard to the contract (see paragraph 3 and Appendix

    A paragraph AG4A).

(h) except as described in paragraph 4, loan commitments that cannot be settled

    net in cash or another financial instrument. A loan commitment is not regarded

    as settled net merely because the loan is paid out in instalments (for example,

    a mortgage construction loan that is paid out in instalments in line with the

    progress of construction). An issuer of a commitment to provide a loan at a

    below-market interest rate shall initially recognise it at fair value, and

    subsequently measure it at the higher of (i) the amount recognised under FRS

    37 and (ii) the amount initially recognised less, where appropriate, cumulative

    amortisation recognised in accordance with FRS 18. loan commitments other

    than those loan commitments described in paragraph 4. An issuer of loan

    commitments shall apply FRS 37 to other loan commitments that are not within

    the scope of this Standard. Loan However, all loan commitments are subject to

    the derecognition provisions of this Standard (see paragraphs 15-42 and

    Appendix A paragraphs AG36-AG63).

    3. Some financial guarantee contracts require the issuer to make specified payments to

    reimburse the holder for a loss it incurs because a specified debtor fails to make payment

    when due under the original or modified terms of a debt instrument. If that requirement

    transfers significant risk to the issuer, the contract is an insurance contract as defined in FRS

    104 (see paragraphs 2(e) and AG4A). Other financial guarantee contracts require payments

    to be made in response to changes in a specified interest rate, financial instrument price, commodity price, foreign exchange rate, index of prices or rates, credit rating or credit index,

    or other variable, provided in the case of a non-financial variable that the variable is not specific to a party to the contract. Such contracts are within the scope of this Standard.

    3. [Deleted]

    4. The following loan commitments are within the scope of this Standard:

(a) Loanloan commitments that the entity designates as financial liabilities at fair

    value through profit or loss are within the scope of this Standard. An entity that

    has a past practice of selling the assets resulting from its loan commitments

    shortly after origination shall apply this Standard to all its loan commitments in

    the same class.

(b) loan commitments that can be settled net in cash or by delivering or issuing

    another financial instrument. These loan commitments are derivatives. A loan

    commitment is not regarded as settled net merely because the loan is paid out

    in instalments (for example, a mortgage construction loan that is paid out in

    instalments in line with the progress of construction).

(c) commitments to provide a loan at a below-market interest rate. Paragraph 47(d)

    specifies the subsequent measurement of liabilities arising from these loan

    commitments.

    9.

    8

Definition of a Financial Guarantee Contract

A financial guarantee contract is a contract that requires the issuer to make specified

    payments to reimburse the holder for a loss it incurs because a specified debtor fails to

    make payment when due in accordance with the original or modified terms of a debt

    instrument.

Definitions of Four Categories of Financial Instruments

A financial asset or financial liability at fair value through profit or loss is a financial

    asset or financial liability that meets either of the following conditions.

(a) It is classified as held for trading. A financial asset or financial liability is

    classified as held for trading if it is:

    (iii) a derivative (except for a derivative that is a financial guarantee

    contract or a designated and effective hedging instrument).

    Initial Measurement of Financial Assets and Financial Liabilities

    43. When a financial asset or financial liability is recognised initially, an entity shall

    measure it at its fair value plus, in the case of a financial asset or financial liability not

    at fair value through profit or loss, transaction costs that are directly attributable to the

    acquisition or issue of the financial asset or financial liability.

    Subsequent Measurement of Financial Liabilities

    47. After initial recognition, an entity shall measure all financial liabilities at amortised cost

    using the effective interest method, except for:

(a) financial liabilities at fair value through profit or loss. Such liabilities, including

    derivatives that are liabilities, shall be measured at fair value except for a

    financial guarantee contract (which shall be measured in accordance with (c))

    or a derivative liability that is linked to and must be settled by delivery of an

    unquoted equity instrument whose fair value cannot be reliably measured

    (which shall be measured at cost).

(b) financial liabilities that arise when a transfer of a financial asset does not

    qualify for derecognition or is accounted for using the continuing involvement

    approach. Paragraphs 29 and 31 apply to the measurement of such financial

    liabilities.

(c) financial guarantee contracts as defined in paragraph 9, other than those that

    were entered into or retained on transferring to another party financial assets

    or financial liabilities within the scope of this Standard (see also Appendix A

    paragraph AG4A). After initial recognition, an issuer of a financial guarantee

    contract that was not entered into or retained on transferring to another party

    financial assets or financial liabilities within the scope of this Standard shall

    measure it at the higher of:

    (i) the amount determined in accordance with FRS 37 Provisions,

    Contingent Liabilities and Contingent Assets; and

    (ii) the amount initially recognised (see paragraph 43) less, when

    appropriate, cumulative amortization recognised in accordance with

    FRS 18 Revenue.

    9

(d) commitments to provide a loan at a below-market interest rate. After initial

    recognition, the issuer of such a commitment shall measure it at the higher of:

    (i) the amount determined in accordance with FRS 37; and

    (ii) the amount initially recognised (see paragraph 43) less, when

    appropriate, cumulative amortisation recognized in accordance with

    FRS 18.

Financial liabilities that are designated as hedged items are subject to measurement

    under the hedge accounting requirements in paragraphs 89-102.

    AG4A. Financial guarantee contracts may have various legal forms, such as a financial guarantee,

    letter of credit, credit default contract or insurance contract. Their accounting treatment does

    not depend on their legal form. The following are examples of the appropriate treatment (see

    paragraphs 2(e) and 3):

(a) Although a financial guarantee contract meets the definition of If the contract is not an

    insurance contract, as defined in FRS 104, the issuer applies this Standard. Thus, a

    financial guarantee contract that requires payments if the credit rating of a debtor falls

    below a particular level is within the scope of this Standard. Paragraph 43 requires

    the issuer to recognise a financial guarantee contract initially at fair value. If the

    financial guarantee contract was issued in a stand-alone arm‟s length transaction to

    an unrelated party, its fair value at inception is likely to equal the premium received,

    unless there is evidence to the contrary. Subsequently:

    (i)(b) If the issuer incurred unless the financial guarantee contract was entered into

    or retained the financial guarantee on transferring to another party financial

    assets or financial liabilities within the scope of this Standard, the issuer

    applies this Standard measures it at the higher of:

     the amount determined in accordance with FRS 37; and

     the amount initially recognised less, when appropriate, cumulative

    amortisation recognised in accordance with FRS 18 (see paragraph

    47(c)).

    (ii) if the financial guarantee contract was entered into or retained on transferring

    to another party financial assets or financial liabilities within the scope of this

    Standard, the issuer measures it:

     in accordance with paragraphs 29-37 and AG47-AG52 of this

    Standard if the financial guarantee contract prevents derecognition or

    results in continuing involvement; and

     as a derivative in all other cases.

    (c) If the contract is an insurance contract, as defined in FRS 104, the issuer applies

    FRS 104 unless (b) applies.

    (db) If the issuer gave a financial guarantee contract is issued in connection with the sale

    of goods, the issuer applies FRS 18 in determining when it recognises the resulting

    revenue from the guarantee and from the sale of goods.

(c) If a credit guarantee (eg a contract that requires payments if the credit rating of a

    debtor falls below a particular level) meets neither the definition of a financial

    guarantee contract in this Standard nor the definition of an insurance contract in FRS

    104, the issuer applies this Standard. Such a contract is a derivative.

    10

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