IASB Exposure Draft ED/2017/3 Prepayment Features with Negative Compensation – Proposed Amendments to IFRS 9

Our Ref.: C/FRSCSent electronically through the IASB Website (www.ifrs.org)

7 June 2017Mr Hans HoogervorstInternational Accounting Standards Board30 Cannon StreetLondon EC4M 6XHUnited KingdomDear Hans,IASB Exposure Draft ED/2017/3Prepayment Features with Negative Compensation– Proposed Amendments to IFRS 9The Hong Kong Institute of Certified Public Accountants ("HKICPA") is the only bodyauthorised by law to set and promulgate standards relating to financial reporting,auditing and ethics for professional accountants, in Hong Kong. We are grateful for theopportunity to provide you with our comments on this Exposure Draft.The HKICPA supports the IASB's initiative to address the concerns about prepaymentfeatures with negative compensation. Stakeholders from the banking industry informedus that loans with prepayment features that may result in negative compensation arecommon in Hong Kong.The HKICPA considers that financial assets with prepayment options that result inpositive or negative compensation could still reflect 'interest' in a lending arrangement.This is because the change in market interest rate that leads to positive or negativecompensation upon early termination could be considered other basic lending risks.Viewed in another light, prepayment terms that are linked to changes to market interestrate may not necessarily introduce volatility or exposure to risks in the contractual cashflows that are unrelated to basic lending arrangements. Changing the sign of thecompensation does not change the characteristics of the cash flows of the financialassets. On this basis, the HKICPA thinks that the principle of 'Solely Payments ofPrincipal and Interest' (SPPI) could still be met.Having said that, the HKICPA does not support the IASB's proposal to create anexception to a principles-based standard. The HKICPA believes that doing so wouldundermine the conceptual underpinning of the classification principles and wouldcreate confusion on the application of the principles. Instead of creating an exception,the HKICPA strongly recommends that the IASB clarifies the application of theclassification principles to prepayment features with negative compensation, forexample by clarifying in paragraph B4.1.11(b) that the reasonable additionalcompensation for early contract termination can be both positive or negative, andexplain the IASB's rationale in the Basis for Conclusions.Page 2 of 8If the IASB were to retain its proposal to create an exception to IFRS 9, the HKICPAwould support the first eligibility condition as proposed in paragraph B4.1.12A(a) of theED. The HKICPA does not support the second eligibility condition because thereseems to be little justification for it.The HKICPA's and our stakeholders' responses to the questions raised in this ED areexplained in more detail in the Appendix.If you have any questions regarding the matters raised in this letter, please contact meorEkyLiu,AssociateDirectoroftheStandardSettingDepartment(eky@hkicpa.org.hk).Yours sincerely,Christina NgDirector, Standard Setting DepartmentEnclPage 3 of 8Work undertaken by the HKICPAIn forming its views, the HKICPA:

(i) issued an Invitation to Comment on ED/2017/3 on 27 April 2017 to our membersand other stakeholders;

(ii) reached out to the Hong Kong Association of Banks (HKAB);

(iii)sought input from its Financial Instruments Advisory Panel and Banking RegulatoryAdvisory Panel, which comprise technical and industry experts from largeaccounting firms (practitioner) and bank representatives; and(iv)developed its views through its Financial Reporting Standards Committee, havingreflected on its stakeholder views. The Committee comprises academics, preparerrepresentatives from various industry sectors, regulators, as well as technical andindustry experts from small, medium and large accounting firms.This submission outlines HKICPA's views as well as most of our stakeholders'comments on ED/2017/3.Detailed comments on IASB ED/2017/3Question 1 – Addressing the concerns raisedParagraphs BC3 – BC6 describe the concerns raised about the classification offinancial assets with particular prepayment features applying IFRS 9. Theproposals in this Exposure Draft are designed to address these concerns.Do you agree that the Board should seek to address these concerns? Why orwhy not?(A) Stakeholders' viewsThe HKAB observes that it is a pervasive market practice in Hong Kong for loans tocontain prepayment features with negative compensation. Most of these loans areregarded as relatively simple and 'plain vanilla' instruments, and accordingly measuringperformance of such loans at fair value through profit or loss would not be useful andmeaningful to users of financial statements. Therefore, the HKAB agrees that the IASBshould address the concerns raised.Most other stakeholders also agree that the concerns raised about prepaymentfeatures with negative compensation should be addressed. They think that it isnecessary to provide clear guidance in the standard as to whether prepayable financialassets with negative compensation could be measured at amortised cost or fair valuethrough other comprehensive come (FVOCI) in order to avoid diversity in practice.One practitioner considers that it is clear that the requirements of IFRS 9 would leadfinancial assets with negative compensation prepayment features to be measured atfair value through profit or loss. This practitioner considers such measurement basis tobe appropriate and does not see any compelling reasons for amending the standard toaddress the concerns raised.APPENDIXPage 4 of 8(B) HKICPA's analysis and recommendationThe HKICPA notes that paragraph B4.1.11 of IFRS 9 addresses situations wherefinancial assets have prepayment options. However, it is not clear whether and howparagraph B4.1.11 applies to financial assets containing prepayment features withnegative compensation, in particular, whether 'reasonable additional compensation'could include negative compensation.In light of the above, the HKICPA supports the IASB's initiative to address theconcerns raised about the classification of prepayable financial assets with negativecompensation.Question 2 – The proposed exceptionThe Exposure Draft proposes a narrow exception to IFRS 9 for particularfinancial assets that would otherwise have contractual cash flows that are solelypayments of principal and interest but do not meet that condition only as a resultof a prepayment feature. Specifically, the Exposure Draft proposes that such afinancial asset would be eligible to be measured at amortised cost or at fairvalue through other comprehensive income, subject to the assessment of thebusiness model in which it is held, if the following two conditions are met:

(a) The prepayment amount is inconsistent with paragraph B4.1.11(b) of IFRS 9only because the party that chooses to terminate the contract early (orotherwise causes the early termination to occur) may receive reasonableadditional compensation for doing so; and(b) When the entity initially recognises the financial asset, the fair value of theprepayment feature is insignificant.Do you agree with these conditions? Why or why not? If not, what conditionswould you propose instead, and why?(A) Stakeholders' viewsWhether amortised cost is the relevant measure for prepayable financial assets withnegative compensation?Most stakeholders, including the HKAB, consider that amortised cost is the morerelevant measure for prepayable financial assets with negative compensation as itdoes not change the characteristics of the contractual cash flows. They consider thatthe negative sign of the cash flows arising from the prepayment features should not bethe sole reason preventing financial assets from being measured at amortised cost.Accordingly, these stakeholders support the rationale underlying the first eligibilitycondition in paragraph B4.1.12A(a) of the ED.One practitioner believes that the financial assets discussed in the ED meet the SPPItest under IFRS 9 and are basic lending arrangements. Therefore, amortised cost isthe relevant measure for such financial assets and that the proposed amendmentsshould be an application of SPPI principle.Another practitioner does not support the proposal as he sees little grounds to supportthe ED as compared to the alternative view in the ED. In addition, he found it hard toconclude whether effective interest method, and thus amortised cost measurementPage 5 of 8provides useful information of the financial assets as discussed in the ED while thediscussion about the application of effective interest method to floating rate instrumentsis still pending.Second eligibility condition – the fair value of the prepayment feature is insignificant atinitial recognitionThe HKAB disagrees with the second eligibility condition proposed in paragraphB4.1.12A(b) of the ED because it is not convinced by the IASB's rationale. ParagraphBC 21 of the ED states that the purpose of the second eligibility condition is tominimise the likelihood of prepayment and therefore the occurrence of catch-upadjustments. However, the HKAB notes that even without the prepayment features,there could be multiple catch-up adjustments over the term of a loan when applying theeffective interest method. This is the case for products with stepped interest ratefeatures or where changes in actuarial life assumptions impact the period over whichthe loan is amortised. Therefore, it does not find the reason in paragraph BC 21 to bestrong enough to support the second eligibility condition.The HKAB notes that paragraph B4.1.11(b) of IFRS 9 already addressed theclassification of financial assets with prepayment options. It believes that all contingentfeatures, no matter whether it is positive or negative compensation, should beassessed in a consistent manner.One practitioner also disagrees with the second eligibility condition for the followingreasons:

․On the basis that the proposal is an application of the underlying principles ofIFRS 9, there should not be any restrictions of applying the principles.․Catch-up adjustments are an inherent feature of the amortised cost measurementand are commonly applied to loans today. The frequency of catch-up adjustmentsshould not be a sole indicator of whether amortised cost provides a relevantmeasurement of the prepayable financial assets addressed in the ED.․Depending on particular economic environment and the contractual terms of thefinancial assets, there may be scenarios in which fair value of a prepaymentfeature is significant at initial recognition even though the prepayment amount isconsistent with SPPI principle. For example, a fixed rate loan with symmetricprepayment feature that compensates for a change in market interest rate may beable to meet the second eligibility condition when a bank originates it. However,this may not be the case when a bank acquires such a loan, either in a businesscombination or an asset acquisition, some time later. If the market interest rateshave changed since origination, the fair value of the prepayment feature will likelybe no longer insignificant when the loan is acquired. The bank may originate andmanage similar loans in the same way as its acquired loans. However, becausethe fair value of the prepayment features of the acquired loans are notinsignificant at initial recognition, they are measured differently. This would resultin a lack of comparability between originated and acquired loans, which in turnreduce the usefulness of financial statements and may lead to practicalimplementation problems.Page 6 of 8Additional guidance about reasonable additional compensation in BC 18One practitioner disagrees with the following statements in paragraph BC 18 of the ED:

"the Board concluded that a fair value amount is not reasonablecompensation for the early termination of the contract……The sameconclusion would also apply to a financial asset that is prepayable at anamount that includes the fair value cost to terminate an associated hedginginstrument……"This practitioner thinks that a prepayment at fair value or at the cost for terminating anassociated hedging instrument, in some situations, may meet the SPPI principle. Thisis the case if the change in fair value reflects only changes in market interest ratesbecause there have been no significant movements in credit spread. Furthermore, insome contracts, the compensation element is limited to the effect of a change in onlythe benchmark component of market interest rate, which would be considered asreasonable additional compensation. This practitioner is also concerned that theconclusion made in BC 18 seems to apply equally to prepayment features with positivecompensation and this could disrupt the implementation of the standard given theimpending effective date of IFRS 9. Therefore, he recommended that the IASBremoves such guidance.Another practitioner and the HKAB also find the same statement in BC 18 confusingand not helpful because it does not explain clearly whether the contractual term of 'fairvalue cost to terminate an associated hedging instrument' is or is not compatible withthe SPPI principle. In particular, the HKAB would like to understand further how theconclusion in BC 18 applies to products that include two-way hedge unwind costclauses1 that are common in Hong Kong.Whether the classification is mandatory or a choiceOne practitioner is confused about the phrase 'is eligible to be measured at' inparagraph B4.1.12 and B4.1.12A of the ED. That practitioner thinks that theclassification of a prepayable financial asset should be mandatory if it meets theconditions set out in the ED. However, the phrase 'is eligible to' implies that it is achoice. Therefore, he thinks that the IASB should clarify this clearly in the standard.(B) HKICPA's analysis and recommendationThe HKICPA considers that financial assets with prepayment options that result inpositive or negative compensation could still reflect 'interest' in a lending arrangement.This is because the change in market interest rate that leads to positive or negativecompensation upon early termination could be considered other basic lending risks.Viewed in another light, prepayment terms that are linked to changes to market interestrate may not necessarily introduce volatility or exposure to risks in the contractual cashflows that are unrelated to basic lending arrangements. Changing the sign of thecompensation does not change the characteristics of the cash flows of the financialassets. On this basis, the HKICPA thinks that the SPPI test could still be met.

1.Two-way hedges refer to situations where gains or losses associated with the unwinding of a hedginginstrument is passed on to the borrower. The unwinding may be triggered by a prepayment in theunderlying loan.Page 7 of 8Having said that, the HKICPA does not support the IASB's proposal of creating anexception to a principles-based standard. The HKICPA believes that doing so wouldundermine the conceptual underpinning of the classification principles. Instead ofcreating an exception, the HKICPA strongly recommends that the IASB clarifies theapplication of the classification principles to prepayment features with negativecompensation. The IASB could do so by clarifying in paragraph B4.1.11(b) that thereasonable additional compensation for early termination of contract can be bothpositive or negative. The IASB should also explain in the Basis for Conclusions thejustification for why amortised cost is a relevant measure of prepayable financial assetswith negative compensation.If the IASB were to retain its proposal to create an exception to IFRS 9, we wouldsupport the first eligibility condition as proposed in paragraph B4.1.12A(a) of the EDbased on the reasons stated above.However, the HKICPA does not support the second eligibility condition because thereseems to be little justification for it. The HKICPA understands that the second eligibilitycondition aims to limit the scope of the proposed amendment to financial assets thatare unlikely to result in prepayment with negative compensation. However, theHKICPA notes that such restriction currently only applies to prepayable financial assetsthat were acquired or originated at a premium or discount to the contractual paramount in paragraph B4.1.12 of IFRS 9 which has been justified based on thecircumstances of the financial assets. This condition does not apply to prepaymentfeatures with positive compensation in paragraph B4.1.11(b). In addition, the HKICPAis aware of its stakeholders' comments that there may be situations where fair value ofa prepayment feature is not insignificant at initial recognition but amortised cost maystill be a relevant measure of the financial asset.If the IASB were to retain the proposed second eligibility condition, the HKICPA urgesthe IASB to obtain sufficient evidence to make sure that the second eligibility conditiondoes not inappropriately exclude financial assets for which amortised cost is a relevantmeasurement. The IASB should also explain in the Basis for Conclusions how theconcerns raised above will not result in unintended consequences.In addition, the HKICPA strongly recommends that the IASB clarifies the concernsraised by its stakeholders about paragraph BC 18 of the ED and whether themeasurement is a choice.Page 8 of 8Question 3 – Effective dateFor the reasons set out in paragraphs BC25-BC26, the Exposure Draft proposesthat the effective date of the exception would be the same as the effective date ofIFRS 9; that is, annual periods beginning on or after 1 January 2018 with earlyadoption permitted.Do you agree with this proposal? Why or why not? If you do not agree with theproposed effective date, what date would you propose instead and why? Inparticular, do you think a later effective date is more appropriate (with earlyapplication permitted) and, if so, why?Stakeholders' views and HKICPA's analysis and recommendationThe HKICPA and our stakeholders agree with the proposed effective date. It would beinefficient for entities to change the classification and measurement of financial assetscontaining prepayment features with negative compensation after IFRS 9 is effective.Question 4 – TransitionFor the reasons set out in paragraphs BC27-BC28, the Exposure Draft proposesthat the exception would be applied retrospectively, subject to a specifictransition provision if doing so is impracticable.(a) Do you agree with this proposal? Why or why not? If not, what would youpropose instead and why?As described in paragraphs BC30-BC31, the Exposure Draft does not proposeany specific transition provisions for entities that apply IFRS 9 before they applythe exception.(b) Do you think there are additional transition considerations that need to bespecifically addressed for entities that apply IFRS 9 before they apply theamendments set out in the Exposure Draft? If so, what are thoseconsiderations?Stakeholders' views and HKICPA's analysis and recommendationThe HKICPA and our stakeholders agree with the proposed retrospective application ofthe amendments and the proposed transition provision if the IASB retains its proposals.We do not have any comments on additional transition considerations for entities thathave already applied IFRS 9 before they apply the proposed amendments.~ End ~