Financial Instruments Accounting

Transcription

1 IFRS REPORTING Financial Instruments Accounting AUDIT AUDIT TAX ADVISORY

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3 Preface IAS 39 Financial Instruments: Recognition and Measurement has been in effect for several years and most entities reporting under International Financial Reporting Standards (IFRSs) have issued two annual reports using IAS 39 to account for their investments, loans, receivables, borrowings and derivative and hedging activities. Many have found that experience in working with the standard does little to ease the pain. During 2000 and 2001, the IAS 39 Implementation Guidance Committee issued more than 200 Q&A interpretations of the standard based on questions and issues raised by entities and their auditors. The complexity and the volume of the guidance continues to provide a challenge for entities as their understanding of the basic requirements increases. The more you know, the more you realise how much you don t know seems particularly relevant to IAS 39. Requirements for entities in the European Union (EU), Australia, Russia and elsewhere to report under IFRS by 2005 create the same challenges for a brand new group of IFRS users, of which there will be some 7,000 in Europe alone. In December 2003 the IASB issued revised versions of IAS 32 Financial Instruments: Disclosure and Presentation and IAS 39 incorporating significant and wide-ranging changes to both standards, effective for reporting periods beginning on or after 1 January With the exceptions of portfolio hedging for interest rate risk, the scope of the fair value option and one or two amendments that may flow from the IASB s insurance project, the 2005 requirements are now set in stone. For European companies, the only remaining hurdle is EU endorsement during the course of Both existing IFRS reporters and first-time adopters will need to spend significant amounts of time in 2004 preparing to implement the standards. First-time adopters in particular will need to have a complete and thorough implementation process in place to enable a successful transition to IFRS. Our experience is that the implementation challenge is a tough one, but is achievable as long as sufficient time and the right resources are devoted to it. Implementing IAS 39 requires a structured process. This could well require a dedicated team to identify and address the entity s major issues and potential changes to current business practices as well as to information systems. Preparers and users will have to develop a fundamental understanding of the concepts and principles of accounting for financial instruments. This will involve training personnel and developing expertise and understanding of the way in which IFRS collectively deal with financial instruments. This publication provides a comprehensive overview of the existing IAS 32 and IAS 39 to address accounting for financial instruments with an emphasis on practical application issues. It provides an update to the first edition issued in September 2000, taking into account guidance issued subsequently as well as examples based on practical experience from working with KPMG member firms clients. At the same time we have incorporated guidance

4 on the likely impact of the December 2003 amendments. KPMG member firms welcome the opportunity to help entities in understanding and implementing these standards. For information on how a KPMG member firm can assist you, please contact your regular KPMG business adviser or any of our offices worldwide ( (to be updated shortly, at the date of this publication, to KPMG

5 About this publication Content Information in this publication is current up to December This publication has been updated for additional interpretations of IAS 39 based on guidance issued subsequent to September 2000 when the first edition of this publication was released. This publication considers standards and interpretative guidance that are in force at December 2003, and also provides a commentary on the likely impact of the amendments issued in December 2003 which are not required to be adopted until financial years commencing on or after 1 January Further interpretations of the amended standards are likely to develop during the course of 2004 as companies work with their advisers to implement them. Readers should be aware that the amended standards are applicable for periods beginning on or after 1 January Earlier adoption is permitted, but an entity must then adopt all the requirements of both amended standards. Piecemeal early adoption is not permitted. Future updates to this publication will provide practical guidance and interpretation on the amendments. Organisation of the text Throughout this publication we have made reference to current IFRS literature and interpretations of that literature. Direct quotations from IFRS are shaded in blue within the text. A column noted as is included in the left margin of Sections 2 to 11 to enable users to identify the relevant paragraphs of the standards or other interpretative literature. s are to the amended standards issued in December A glossary of frequently used terms is included as Appendix A to the publication. In addition, a summarised comparison between IFRS and US GAAP is included as Appendix B and abbreviations used throughout the text are identified in Appendix C. Case studies and examples are included throughout the text to elaborate or clarify the more complex principles of the financial instruments standards. A list of all case studies is included as Appendix D. Commentary on the December 2003 amendments to the standards is provided separately in red where applicable within each Section. Keep in contact and stay up-to-date IFRS literature on financial instruments is intended to cover all types of industries and transactions. The interpretive guidance, and in some respects, IAS 39 itself, are by their nature based on narrowly defined facts and circumstances. In most instances, further interpretation will be needed in order for an entity to apply these standards to its own facts, circumstances

6 and individual transactions. Further, some of the information contained in this publication is based on KPMG s International Financial Reporting Group s (IFR Group s) interpretations of the current literature, which may change as practice and implementation guidance continue to develop in these areas. Users are cautioned to read this publication in conjunction with the actual text of the standards and implementation guidance issued, and to consult their professional advisers before concluding on accounting treatments for their own transactions. This publication has been produced by KPMG s IFR Group. For more information, please visit (to be updated shortly, as at the date of this publication, to where you will find up-to-date technical information and a briefing on KPMG s IFRS conversion resources.

7 Contents Page 1. Introduction to the financial instruments standards The need for financial instruments standards Development of the standards Highlights of the standards 5 2. Scope and definitions Scope of the standards Definitions relating to financial instruments Financial risks Embedded derivatives Overview Economic characteristics and risks Separation of the embedded derivative Recognition and derecognition Overview Initial measurement Recognition Derecognition Special purpose entities and derecognition Classification Overview Classification of financial assets Classification of financial liabilities 63

8 Page 6. Subsequent measurement Overview Classification determines subsequent measurement Valuation issues Impairment of financial assets Reclassifications of financial assets Deferred tax assets and liabilities Subsequent measurement examples Overview Interest rate risk Foreign currency risk Equity price risk Credit risk Hedge accounting Overview Hedge accounting basic concepts The hedge accounting models Hedged items Hedging instruments Criteria for hedge accounting Termination of a hedge relationship Net position hedging and internal derivatives Other considerations Hedge accounting for each type of financial risk Overview Interest rate risk Foreign currency risk Hedging a net investment Hedging commodity price risk 175

9 Page 10. Presentation and disclosure Overview Balance sheet presentation Liability versus equity Income statement presentation Required disclosures Transition and implementation of IAS Overview First-time adoption of IFRS Transition requirements for existing users of IFRS First time implementation: practical considerations 212 A. Glossary 214 B. IFRS and US GAAP financial instruments comparison 221 C. Abbreviations 228 D. List of cases 229

10 1. Introduction to the financial instruments standards 1.1 The need for financial instruments standards In the past two decades there has been a dramatic increase in the sophistication of financial markets. With the globalisation of markets many entities face increasing challenges in controlling risks to which they are exposed. This changing environment has been the impetus for a constant stream of innovative and often complex financial products. The use of derivative instruments has become a common practice for many entities of all sizes and throughout all industries. The accounting profession as a whole has made efforts during recent years to develop accounting literature to address financial instruments. The International Accounting Standards Committee (IASC) issued two standards that specifically address accounting for financial instruments. These are International Accounting Standard (IAS) 32 Financial Instruments: Disclosure and Presentation and IAS 39 Financial Instruments: Recognition and Measurement, collectively referred to throughout this publication as the financial instruments standards. When the International Accounting Standards Board (IASB), the successor organisation to the IASC, was formed in 2001, this body adopted all of the then-current standards and interpretations of the IASC, including IAS 32 and IAS 39. With these standards, all entities reporting under IFRS, regardless of their size or industry, or whether public or non-public, must account for and make disclosures about financial instruments in a similar manner. There are other standards and interpretations that are relevant to a discussion of financial instruments accounting, most notably IAS 21 The Effects of Changes in Foreign Exchange Rates and SIC 12 Consolidation Special Purpose Entities. The IASB is currently addressing certain aspects of insurance accounting with a view to introducing interim requirements that would be effective in These interim requirements would be limited to defining insurance risk and distinguishing it from financial risks dealt with under the financial instruments standards, and prohibiting certain industry practices such as catastrophe provisions and equalisation reserves. Insurance contracts, in the interim, would continue to be dealt with under an entity s existing accounting framework. The proposals are not dealt with further in this publication. In the longer term the IASB expects to issue a comprehensive standard on insurance contracts. The IASB is also undertaking a project to develop a new standard for disclosure of risks arising from financial instruments (this scope of this project was originally to update IAS 30 Disclosures in the Financial Statements of Banks and Similar Financial Institutions, but was later expanded to cover all entities). When the project is completed, IAS 30 will be withdrawn together with the financial risk disclosure requirements in IAS 32. Both projects will affect the accounting for and disclosure of financial instruments in due course, but neither will be effective before Development of the standards The IASC began its project to develop a comprehensive set of standards addressing financial instruments in In 1994 the IASC divided this project into two phases. The first phase addressed disclosure and financial statement presentation, and resulted in the issuance of IAS 32 in The second phase of the project addressed recognition and measurement Development of the standards

11 IAS 39 was originally intended to be an interim standard. At the same time that the standard became effective in 2001, the IASC was working with a collaboration of national standard setters from 13 countries to develop a completely new standard on financial instruments accounting. This group, called the Joint Working Group (JWG), released their Exposure Draft in December 2000 for public comment. Their proposals and the results of comments received from the public were presented to the IASB in early It is now a long-term project of the IASB to develop a new standard for financial instruments. Such a new standard is not expected prior to An Exposure Draft of proposed amendments to IAS 32 and IAS 39 was released in June 2002 for public comment. In issuing the proposed amendments to IAS 32 and IAS 39 the Board stated that it expected the amended standards to be in place for a considerable period. The IASB released the revised versions of IAS 32 and IAS 39 in December In October 2003, the IASB issued an Exposure Draft Fair Value Hedge Accounting for a Portfolio Hedge of Interest Rate Risk, dealing with certain aspects of hedge accounting which are particularly relevant for financial institutions. 1.3 Highlights of the standards Prior to the issuance of IAS 32 and IAS 39 there was no comprehensive guidance in IFRS addressing financial instruments, particularly so for derivatives. IAS 39 introduced new requirements for the recognition, derecognition and measurement of an entity s financial instruments and for hedge accounting. It also introduced some changes to the disclosure and presentation requirements of IAS 32. Figure 1.1 is a basic overview of the financial instruments standards dealt with in this publication. Figure 1.1 Overview of the financial instruments standards The requirements of the financial instruments standards are summarised at a very high level below Recognition and derecognition All financial assets and financial liabilities, including derivative instruments, should be recognised in the balance sheet. In order to remove (i.e. derecognise) assets from its balance sheet, an entity must lose control over those financial assets. In addition, a substantive risk from the assets must be transferred. IAS Highlights of the standards 5

12 is complex and restrictive in this area. It provides guidance for transactions such as factoring and securitisations. Entities converting to IFRS may find assets that were derecognised under previous GAAP may have to be included on balance sheet in their IFRS financial statements. In order to derecognise a liability, a debtor must be legally released from its primary obligation related to that liability Measurement Financial assets must be classified into one of four categories: trading; originated loans and receivables; held-to-maturity; and available-for-sale. Financial liabilities are categorised as either trading or non-trading. The categorisation determines whether and where any remeasurement to fair value is recognised in an entity s financial statements. Many financial assets are carried at fair value, with the exceptions being originated loans and receivables, held-to-maturity assets, and in the rare circumstances where the fair value of an unlisted equity instrument cannot be reliably measured. Remeasurement to fair value must be performed at each financial reporting date. The effect of remeasurement to fair value must be recognised and consistently applied in one of two ways. An entity can choose to recognise all changes in fair value in the income statement. Alternatively, it can choose to recognise changes in fair value of trading instruments in the income statement, and available-for-sale instruments as a component of equity. Fair value changes deferred in equity are recycled to the income statement when the instrument is sold or becomes impaired Derivatives and hedge accounting Under IAS 39, all derivatives (including some embedded derivatives) must be measured at fair value in the balance sheet. This is regardless of whether they are categorised as trading or as hedging instruments. Unless they qualify as hedging instruments, all fair value gains and losses are recognised immediately in the income statement. A non-derivative financial instrument can have certain characteristics that cause it to behave like a derivative. These characteristics need to be evaluated to determine whether they should be separated from the financial instrument and accounted for separately as a stand-alone derivative. Hedge accounting is a choice that each entity makes for each economic hedge that it has in place. The choice reflects a trade-off between the cost of achieving hedge accounting and the potential benefit achieved by reducing the income statement volatility that would otherwise arise. In some circumstances, the standard prohibits hedge accounting. In order to qualify for hedge accounting, an entity must designate its hedge relationships and document how it will measure effectiveness. Each individual relationship between a derivative and its hedged asset, liability or future cash flow must be documented separately. Hedge accounting is permitted provided that the entity can establish that each hedge has been highly effective in each reporting period. In order to continue hedge accounting, there must be an expectation that future gains and losses on the hedged item and hedging instrument will almost fully offset. There are three hedge accounting models under IAS 39, which are the fair value hedge, the cash flow hedge and the hedge of a net investment in a foreign entity. The appropriate accounting model for a hedge relationship depends on the nature of the item being hedged Highlights of the standards

13 Implementing these requirements can involve significant systems amendments, particularly when large numbers of derivatives are used as hedging instruments Disclosure and presentation Guidance is provided on the classification of financial instruments as equity or debt, and accounting for compound instruments with characteristics of both equity and debt instruments, such as convertible bonds. Criteria are specified for the netting of financial assets and financial liabilities. Netting requires a legal right of set off as well as the intention to offset the assets and liabilities or settle simultaneously. Significant qualitative and quantitative disclosures about financial instruments, financial risk management and hedging activities are required. Required disclosures include how fair value is determined, as well as methods and significant assumptions, and risk management objectives and policies for hedging. Disclosures should note the significant terms and conditions of instruments as well as information about interest rate risk and credit risk of financial instruments. In addition, fair value information and other quantitative disclosures of income and expense, and gains and losses from financial instruments are required. December 2003 amendments At a very high level, the amendments to the standards introduce the following changes: The requirements on derecognition of financial assets are significantly reworded and to some extent revised (although for certain transactions the resulting changes to the accounting are substantial), retaining elements of both risks and rewards and control criteria. The standard should now be simpler to apply under the decision tree approach, except in limited numbers of transactions where a new continuing involvement approach is adopted, resulting in partial derecognition. A new category of financial assets measured at fair value through profit or loss is introduced. An entity may choose to include any financial asset or financial liability in this category on the day the asset or liability is first recognised, or on the date the amended standards are first applied. Subsequent transfers in or out of the new category are prohibited. The option to recognise fair value changes on available-for-sale financial assets in profit or loss is consequently removed. Similarly, an entity may choose, on initial recognition or when the standards are first applied, to classify any non-derivative financial asset as available-for-sale, with fair value changes subsequently being recognised as a component of equity. The requirement to separate certain embedded foreign currency derivatives has been relaxed in certain cases, where the currency in which the sale is denominated is not the functional currency of either of the parties to the contract. New guidance is provided on the application of the impairment requirements, emphasising that the standards follow an incurred loss model. Impairment losses recognised on equity instruments classified as available-for-sale are prohibited from being reversed through profit or loss. Any subsequent increase in fair value is instead recognised in equity. 1.3 Highlights of the standards 7

14 Further guidance is also provided on how to calculate amortised cost using the effective yield method and on fair value measurement techniques. Additional restrictions are placed on the use of hedge accounting in some circumstances, particularly on the use of internal transactions in hedging relationships. Some hedging relationships involving firm commitments that were previously accounted for as cash flow hedges will be accounted for as fair value hedges. The cash flow hedge accounting model has in some cases prohibited basis adjustments and in others made them optional. The requirements on classification of issued instruments such as preference shares and convertible bonds between liabilities and equity are amended slightly and new requirements are provided on how to account for derivatives on an entity s own equity. New disclosures are added, in particular on the sensitivity of fair value estimates to key inputs to a valuation model. IASB Board meeting February 2004 At this meeting the IASB tentatively concluded that it should make two further amendments to the standards. The first would be to limit the use of the fair value through profit or loss option, described above, to four circumstances: the item is an available-for-sale asset (but not a loan or receivable); the item contains one or more embedded derivatives; the item is a financial liability whose amount is contractually linked to the performance of assets that are measured at fair value; or the exposure to fair value changes in the item is substantially offset by corresponding changes in the value of another financial asset or liability, including a derivative. This proposal is expected to be exposed for public comment during the second quarter of 2004 and finalised in the third quarter. The second amendment would be to remove the requirement, in respect of the prospective effectiveness test for hedge accounting, that changes in fair value or cash flows of the hedged item should be expected to almost fully offset. In practice, this change is likely to mean that as long as the entity is not deliberately under-hedging, the degree of correlation required to achieve hedge accounting will be closer to the 80 to 125 per cent range required for retrospective testing. This amendment is likely to be issued without further exposure in April Highlights of the standards

15 2. Scope and definitions Key topics covered in this Section: Financial instruments included and excluded from the scope Financial instruments defined Financial risks defined 2.1 Scope of the standards The standards on financial instruments apply to all financial instruments, except for those specifically excluded from the scope of IAS 32 or IAS 39. It is important first to understand what items are considered to be financial instruments under IFRS. Table 2.1 shows summary balance sheets for a corporate and a financial institution, including typical financial assets and liabilities of each. The definitions of financial assets and financial liabilities are discussed later in Section 2.2. Table 2.1 Effect of financial instruments on a corporate / financial institution Corporate balance sheet Assets Property, plant and equipment Investments Deferred tax assets Total non-current assets Inventories Other receivables Cash and cash equivalents Total current assets Total assets Equity and liabilities Issued capital Reserves Retained earnings Total capital and reserves Interest-bearing loans and borrowings Pension obligations Provisions Total non-current liabilities Bank overdraft Other payables Total current liabilities Total equity and liabilities Financial institution balance sheet Assets Cash and bank balances Cash collateral on securities Trading portfolio assets Loans, net of allowances Financial investments Accrued income Property, plant and equipment Other assets Total assets Equity and liabilities Issued capital Reserves Retained earnings Total capital and reserves Money market paper Due to banks Repurchase agreements Trading portfolio liabilities Due to customers Long-term debt Other liabilities Total equity and liabilities 2.1 Scope of the standards 9

16 The items in italics in Table 2.1 are those figures that may contain financial instruments that fall within the scope of the financial instruments standards. This table demonstrates that many of the accounts of a typical corporate or financial institution are subject to these standards Certain instruments and contracts are excluded from the scope of the financial instruments standards, even though they may possess all of the required characteristics of a financial instrument. For the financial assets and liabilities listed in Table 2.2, entities should refer to other existing standards, if applicable. Table 2.2 Items excluded from the financial instruments standards Applicable IAS 32 IAS 39 standard Interests in subsidiaries IAS 27 Interests in associates IAS 28 Interests in joint ventures IAS 31 Employers assets and liabilities under employee benefit plans IAS 19 Employers assets and liabilities in respect of post-employment employee benefits IAS 19 Employers obligations in respect of employee stock option and stock purchase plans IAS 19 Disclosures of employee benefit plans obligations for post-employment benefits IAS 26 Rights and obligations under insurance contracts (except embedded derivatives) IASB s insurance project Rights and obligations under leases (other than securitised lease receivables and embedded derivatives) IAS 17 Equity instruments issued by the entity, including warrants and options, classified as shareholders equity IFRS 2 * Financial guarantee contracts, including letters of credit IAS 37 Contracts for contingent consideration in a business combination IAS 22 Weather derivatives : contracts that require a payment based on climatic, geological or some other physical variables IASB s insurance project Indicates a specific exclusion from the standard. * There are two current standards that address aspects of equity instruments issued by the entity (IAS 32 (revised December 2003) and IFRS 2 on share-based payment transactions) Scope of the standards

17 As noted in Table 2.2, a number of items are excluded from the scope of IAS 39. However, derivatives embedded within excluded instruments, for example, within leases or insurance contracts, still are within the scope of the financial instruments standards. Finance lease receivables are subject to the derecognition provisions of IAS 39. While most financial instruments, contracts and obligations under share-based payment transactions to which IFRS 2 Share-based Payment applies are excluded from the scope of IAS 39, they are included where they are in relation to commodity contracts which fall within the scope of IAS 39 (see Section 2.1.2). Additionally, many financial instruments excluded from the scope of IAS 39 still are subject to the disclosure and presentation requirements of IAS 32. The financial instruments standards do not change the accounting with respect to investments in subsidiaries, associates and joint ventures. The applicable standard for each of these investments is noted above. All other investments in equity securities are within the scope of the financial instruments standards. Options to buy and sell interests in subsidiaries, associates or joint ventures may meet the definition of a derivative. These would also be accounted for as financial instruments. Certain types of investors or investment vehicles may hold a large equity interest in another entity so that consolidation or associate accounting is applicable. These investors (e.g. venture capital funds, private equity funds) view the equity stake as a strategic investment that is intended to be disposed of in the future. Generally, the investor s preference is to account for this interest as a financial instrument rather than as a subsidiary or associate. However, the intention of the investor is not the relevant consideration for determining whether the holding is within the scope of IAS 39. IAS 28 Investments in Associates (revised 2003) allows these venture capitalists and similar entities to apply fair value accounting under IAS 39 rather than accounting for the holding as an associate. This requires changes in fair value to be recognised in the income statement. IAS 31 Interests in Joint Ventures allows a similar approach to be taken for jointly controlled entities. However, there is no similar amendment in respect of consolidation under IAS 27 Consolidated and Separate Financial Statements (revised 2003). 39.2(i) December 2003 amendments The amendments will exclude from the scope of the standards loan commitments (e.g. an agreement by a bank to grant a loan at a fixed interest rate), except those when the entity has a history of settling such commitments in cash or of trading the loan shortly after its issue. Loan commitments were previously exempt from derivative accounting when they qualified as regular way transactions Additional guidance is provided on the accounting for issued financial guarantee contracts and loan commitments that are excluded from the scope of the standard. Such guarantees and commitments are initially measured at fair value and subsequently measured at the higher of the amount initially recognised (less amounts recognised as revenue under IAS 18 Revenue) and the provision that would be required under IAS 37 Provisions, Contingent Liabilities and Contingent Assets. On completion of the Phase I Insurance standard, expected in late, it is anticipated that the scope exclusion in IAS 39 for weather derivatives will be removed. 2.1 Scope of the standards 11

18 2.1.1 Insurance-like contracts 39.AG4 Obligations arising under insurance contracts are excluded from the scope of both financial instruments standards. However, the other financial assets and liabilities of insurance 32.6 entities are not. If a financial instrument takes the form of an insurance contract, but involves the transfer of financial risks, as opposed to insurance risks, the contract would 39.2(d) fall within the scope of the financial instruments standards. The same principle applies to reinsurance contracts where the underlying risk is financial risk. In practice, there may be difficulty in determining whether or not contracts that take the form of insurance also 39.2(d) have financial risks. Regardless of whether an insurance or reinsurance contract is included within the scope of IAS 39, it may contain an embedded derivative that must be separated and accounted for as a derivative in accordance with IAS (d) December 2003 amendments The amendments do not change the guidance on how to distinguish between an insurance contract and a financial instrument. However, the standard on insurance contracts, expected in late, will include a new definition of insurance contracts and will, in most respects, permit an entity to continue its existing accounting for insurance contracts. The new definition will need to be applied in determining whether a contract is an insurance contract or a financial instrument. Contracts that may be described as insurance contracts but that do not contain significant insurance risk will be accounted for under IAS 39, as will non-insurance derivatives embedded in insurance contracts Commodities contracts and normal purchases and sales A contract that is based on a commodity (e.g. a forward or option to purchase or sell a commodity) may meet the definition of a derivative. Commodity-based contracts that give a right to either party to settle in cash or some other financial instrument are included in the scope of the financial instruments standards unless these are (a) entered into with the purpose of meeting the entity s purchase or sales needs and (b) expected to be settled physically by delivery of the commodities (i.e. not net settled). Those contracts should be treated as executory contracts rather than as derivatives Intention and past practice of the entity are important considerations when evaluating a commodities contract that can be settled net. If the terms of the contracts are such that they can only be settled by delivery and there is no practice of settling net, the contracts are not accounted for as derivatives. However, if an entity has a pattern of settling commodity-based contracts on a net basis, the contracts are deemed to not be for the purpose of meeting the entity s expected purchase, sale or usage requirements and fall within the scope of the financial instruments standards. The intention to settle net may be evidenced by a historical pattern of entering into offsetting agreements. Likewise, entities that enter into offsetting contracts that effectively achieve net settlement would not qualify for this exemption. IG A.2 and B.1 Commodities are viewed broadly under the financial instruments standards, meaning that they may be any type of goods on which derivative contracts may be based that give rights to one party to receive or deliver these types of goods to another party. For example, derivative contracts based on non-financial assets such as real estate could fall within the scope of IAS 39. Derivative contracts based on gold could also fall within the financial Scope of the standards

19 instruments standards, even though gold itself is not a financial instrument and is therefore outside the scope of the standards. December 2003 amendments 39.5 and 6 The amendments clarify the circumstances in which a commodities contract should be accounted for as a financial instrument, introducing two further restrictions on an entity s ability to use the scope exemptions for commodities contracts: Although the standard still applies only to those contracts that may be settled in cash (or other financial assets) the amendments increase significantly the meaning of may be settled in cash. Commodity and similar contracts will be accounted for as derivatives if the entity has a practice of trading the commodity shortly after delivery or if the product is readily convertible to cash. Many commodity contracts are therefore likely to be included in the scope of the standards, even if the terms of the contract require settlement by physical delivery; and Under the amendments, a written option, under which an entity might be required to purchase or sell a commodity or other non-financial asset, can never qualify for the normal purchases and sales exclusion, because the entity cannot control whether or not the purchase or sale will take place. Therefore, it cannot be a normal purchase or sale requirement. The normal purchases / sales exemption is retained for contracts other than written options that meet the requirement above. 2.2 Definitions relating to financial instruments Financial instruments embrace a broad range of assets and liabilities. They include both primary financial instruments (e.g. receivables, debt and shares in another entity) and derivative financial instruments (e.g. financial options and forwards, including futures, as well as interest rate swaps and currency swaps) and A financial instrument is any contract that gives rise to both a financial asset of one enterprise and a financial liability or equity instrument of another enterprise Financial assets and financial liabilities 39.9 and A financial asset is any asset that is: (a) cash; (b) a contractual right to receive cash or another financial asset from another enterprise; (c) a contractual right to exchange financial instruments with another enterprise under conditions that are potentially favourable; or (d) an equity instrument of another enterprise. A financial liability is any liability that is a contractual obligation: (a) to deliver cash or another financial asset to another enterprise; or (b) to exchange financial instruments with another enterprise under conditions that are potentially unfavourable The terms contract and contractual in the above definitions refer to an agreement between two or more parties that has clear economic consequences and that the parties have little, if any, discretion to avoid, usually because the agreement is enforceable by law. Contracts defining financial instruments may take a variety of forms and do not need 2.2 Definitions relating to financial instruments 13

20 to be in writing. An example of an item not meeting the definitions would be a tax liability, as it is not based on a contract between two or more parties. December 2003 amendments and 39.2(e) The amendments expand the definitions of financial asset and financial liability to cover contracts that will or may be settled in an entity s own equity instruments. The amended definition clarifies that a liability settled by delivering a variable number of the entity s own equity instruments with a fixed or determinable value (in other words where shares are used as a settlement currency) is a financial liability. This change is likely to have little impact in practice as similar requirements were already included in the existing standards, although not in the definitions. The other reason for amending the definitions is to cover derivatives whose underlying is the entity s own equity share price Equity instruments and 39.9 An equity instrument is any contract that evidences a residual interest in the assets of an enterprise after deducting all of its liabilities. SIC-16 The current versions of the financial instruments standards do not address accounting for transactions in own equity other than treasury shares. The topic of classification of instruments (by an issuer) as liabilities versus equity is covered in Section 10. December 2003 amendments The amendments provide a comprehensive framework on the accounting for transactions in own equity, including derivatives whose underlying is an entity s own equity shares, and they discuss when these derivatives are to be accounted for as an entity s own equity and when they are to be accounted for as assets or liabilities. The requirements are covered in Section Derivatives 39.9 A derivative is a financial instrument: (a) whose value changes in response to the change in a specified interest rate, security price, commodity price, foreign exchange rate, index of prices or rates, a credit rating or credit index, or similar variable (sometimes called the underlying); (b) that requires no initial net investment or little initial net investment relative to other types of contracts that have similar responses to changes in market conditions; and (c) that is settled at a future date. All of the above must be met in order for a financial instrument to be a derivative Definitions relating to financial instruments

21 December 2003 amendments 39.9 The revised standards include an amendment to part (b) of the definition. The amended definition requires only an initial net investment that is smaller than would be required for a similar non-derivative contract with similar responses to changes in market conditions. This is explained further in Section The amendment is not a substantive change to the definition. IG B.8 39.AG9 IG B.2 and B Change in value based on an underlying A derivative financial instrument is a financial instrument that provides the holder (or writer) with the right (or obligation) to receive (or pay) cash or another financial instrument in amounts determined by reference to price changes in an underlying price or index, or changes in foreign exchange or interest rates, at a future date. A derivative may have more than one underlying variable. Common types of derivatives are options, swaps and forwards. Examples include interest rate swaps, foreign currency forward contracts or equity call options. An interest rate swap is a contract that results in the exchange of cash flows based on different (i.e. fixed or floating) interest rates. A foreign currency forward contract is an agreement to exchange at some future date an amount of one currency for an amount of another currency at a set forward exchange rate. An equity call option gives the holder the right to receive a financial instrument and will be exercised if the price of the equity security rises above the exercise price of the call option. Another example of a derivative is a forward contract to acquire a bond at some future date at an agreed price. The forward contract has a positive fair value if the price of the bond increases and a negative fair value if the price of the bond decreases compared to the agreed upon price. A derivative usually has a notional amount, which can be an amount of currency, a number of shares, a number of units of weight or volume or other units specified in the contract. However, the holder or writer is not required to invest in or receive the notional amount at the inception of the contract. Alternatively, a derivative could require a fixed payment as a result of some future event that is unrelated to a notional amount. For example, an entity may enter into a contract whereby it will receive a fixed payment of 1,000 if a specified index increases by a determined number of points in the next month. The settlement amount is not based on and does not need to change proportionally with an underlying. The underlying price change upon which a derivative financial instrument is based may be that of a primary financial instrument (such as a bond or equity security) or a commodity (such as gold, oil or wheat), a rate (such as an interest rate), an index of prices (such as a stock exchange index) or some other indicator that has a measurable value. A key element of a derivative is that the transaction must allow for settlement in the form of cash or the right to another financial instrument. Settlement of a derivative, such as an interest rate swap, may be either a gross or net exchange of cash or other financial instruments. 39.AG Little or no initial net investment There is no quantified guidance as to what constitutes little or no initial net investment. The initial net investment should be less than the investment needed to acquire a primary financial instrument that has a similar response to changes in market 2.2 Definitions relating to financial instruments 15

22 conditions. However, less than does not necessarily mean insignificant in relation to the overall investment and needs to be interpreted on a relative basis. For example: IG B.10 A margin account is not considered to be an initial net investment. Rather, margin accounts are funds required to be deposited as collateral with a broker in order to have transactions executed by that broker. 39.AG11 If there is an exchange of amounts when entering into a contract, for example, the exchange of one currency for another is a cross currency swap, which is not seen as an initial net investment provided the amounts of cash are of equal fair value. IG B.6 If two offsetting loans are entered into that have equal terms and conditions except for their interest rates, which in substance form an interest rate swap, these loans are considered to be a derivative and should be accounted for as such if all of the defining characteristics of a derivative are met. There are exceptions to this, such as when an entity can demonstrate an economic need or a substantive business purpose for structuring transactions separately that could not have been accomplished in a single transaction. 39.AG11 IG B.9 An example of a derivative instrument is an option that gives the holder the right to buy another financial instrument at a strike price on or before a specified date. The premium paid for an option fulfils the requirement of little or no initial investment as it is less than the amount required to obtain the underlying instrument outright, except when the option is so deep in the money that the premium paid is equivalent to making an investment in the underlying. In the latter case under IAS 39 the instrument would not be accounted for as a derivative, but rather as an investment in the underlying itself. Similarly, when an entity enters into a forward contract to purchase an investment which will be settled in the future, but prepays the contract based on the current market price, the entity does not have a derivative contract as this does not meet the criteria of little or no initial net investment. Rather the entity would record the investment itself as a non-derivative financial asset. Sometimes part of a derivative is prepaid. The question then arises as to whether the remaining part still constitutes a derivative. This depends on whether all of the criteria of the definition are still met. IG B.4 If a party to an interest rate swap transaction prepays its pay-fixed obligation at inception, the floating rate leg of the swap is still a derivative instrument. To illustrate, an entity enters into an interest rate swap contract where it pays fixed and receives variable rates based on a notional amount. The entity prepays its fixed obligation by paying the counterparty the fixed obligation discounted using the current market rate. The entity will continue to receive the variable rates over the life of the swap. In this circumstance, all of the criteria for being a derivative are still met. The initial net investment (i.e. the amount prepaid by the entity) is still significantly less than investing in a similar primary financial instrument that responds equally to changes in the underlying interest rate. Also, the instrument s fair value changes in response to changes in interest rates and the instrument is settled at a future date. If the party prepays the pay-fixed obligation at a subsequent date, this is considered to be a termination of the old swap and an origination of a new swap Definitions relating to financial instruments

23 IG B.5 In the reverse situation, if a party to an interest rate swap transaction prepays its payvariable obligation at inception using current market rates, the swap is no longer a derivative instrument because the prepaid amount now provides a return that is the same as that of an amortising fixed rate debt instrument of the amount of the prepayment. Therefore, the initial net investment equals that of other financial instruments with fixed annuities. 39.2(f) Settlement at a future date Derivatives require settlement at a future date. A forward contract is settled on a specified future date, an option has a future exercise date and interest rate swaps have several dates on which interest is settled. An option is considered to be settled upon exercise or at its maturity. Therefore, even though the option may not be expected to be exercised when it is out-of-the-money, the option still meets the criteria of settlement at a future date. Any contract where there is a time period between the trade date and the settlement date would be a derivative if the other criteria are also met. A related consideration when determining whether an instrument must be accounted for as a derivative is the exemption for so-called regular way transactions. This topic is covered in Section Summary of key concepts concerning derivatives There are several key concepts relating to derivatives which are considered in detail in later Sections. Derivatives should be recognised on an entity s balance sheet, initially at their cost, which is the fair value of the related consideration given or received (Section 4). Derivatives are thereafter measured at their fair value at each reporting date with changes recognised in the income statement (Section 6). Derivatives are often used to hedge the risks related to other financial and non-financial assets and liabilities. If specific hedging criteria are met, the derivative and the related item being hedged qualify for hedge accounting treatment (Sections 8 and 9) Financial guarantee contracts and credit derivatives Financial guarantee contracts where a payment is made if a debtor fails to make payment when due are outside the scope of IAS 39. The form of the contract (e.g. guarantee, letter of credit, derivative etc.) is not an important factor when determining whether IAS 39 is applicable. To be excluded from IAS 39, payment on the contract should only be triggered if the holder of the contract experiences a financial loss from a debtor s failure to make a payment when due. This should be a pre-condition for payment under the contract. The amount of the payment should be proportional to that loss (e.g. not leveraged) Some contracts that are labelled as financial guarantees provide for a payment to be made if events other than an actual financial loss occur. For instance in some standard credit default agreements, a payment is triggered if the debtor s credit rating is downgraded below a specified level. A contract triggered by a change in an underlying rate or index, such as a rating downgrade, is considered a derivative that is within the scope of IAS Definitions relating to financial instruments 17

24 39.2(f) To be excluded from IAS 39, the holder of the financial guarantee contract must be the party that is exposed to the risk of loss from the debtor s failure to make payment. A guarantee must be treated as a derivative if the holder of the contract is not the party exposed to risk of loss. That is because the event of default merely acts as the underlying variable in a derivative contract. This is the case for both the holder and the issuer of the guarantee contract. Case 2.1 Guarantee contract versus credit derivative 39.2(f) Entity B makes a loan to Entity C. Entity B also enters into a guarantee contract issued by Bank A that is triggered by the default of designated payments of Entity C to Entity B. This contract would be accounted for as a financial guarantee, not a derivative, in the financial statements of Bank A and Entity B However, assume the same structure is in place except that Bank A will make payments to Entity B based on a change of the credit rating of Entity C. In such a case, the contract should be accounted for as a derivative in the financial statements of Bank A and Entity B. Case 2.2 Guarantee contract held by a third party A guarantee contract issued by Bank A to Entity B is triggered by the default of designated payments by Entity C to Entity D. Because Entity B is not exposed to a risk of financial loss (only Entity D has this risk) the contract is a derivative, both in the financial statements of Bank A (issuer) and Entity B (holder). December 2003 amendments 39.2(f) The distinction between financial guarantee contracts and credit derivatives remains as described above. The amendments provide additional guidance on the initial and subsequent measurement of issued financial guarantee contracts and loan commitments that are excluded from the scope of the standard. Such instruments are initially measured at fair value and subsequently measured at the higher of the amount initially recognised (less amounts recognised as revenue under IAS 18) and the provision that would be required under IAS Embedded derivatives A non-derivative financial instrument can have certain characteristics that cause it to behave like a derivative. An embedded derivative must be evaluated to determine whether it must be separated from the financial instrument, and accounted for as a stand-alone derivative. Section 3 is devoted to this topic Definitions relating to financial instruments

25 2.3 Financial risks Risk can be viewed as uncertainty in cash flows. The uncertainty in cash flows influences the fair value of recognised assets and liabilities or the level of cash flows relating to future transactions. The following are financial risks that are related to financial instruments: Interest rate risk the risk that future changes in prevailing interest rates will affect the fair value or cash flows of a financial right or obligation. Changes in market interest rates may affect an entity s right to receive or obligation to pay cash or another financial instrument at a future date, or the fair value of that right or obligation. Currency risk (also referred to as foreign exchange (FX) rate risk) the risk that changes in foreign exchange rates will affect the fair value or cash flows of a recognised financial instrument, firm commitment or forecasted transaction. Market risk (also referred to as commodity or price risk) the risk that the fair value or cash flows of an instrument will be affected by factors specific to the particular instrument or to the issuer of the instrument, or by general market conditions. An example of this is the risk of price changes of an equity instrument. Credit risk the risk that one party to a financial instrument will fail to discharge an obligation and cause the other party to incur a financial loss. An entity may reduce its exposure to credit risk through policy measures such as imposing credit limitations or requiring collateral from counterparties, or it may use credit derivatives. Liquidity risk the risk that an entity will encounter difficulty in raising funds to meet commitments, which may result in a loss being incurred because a position cannot be liquidated quickly at close to its fair value. A common strategy in risk management is hedging, where risks that an entity faces are reduced or eliminated by entering into transactions that give an offsetting risk profile. Essentially hedging means matching the characteristics of incoming and outgoing cash flows in such a way that the effects of changes in market prices or rates are reduced or have no impact on the future net cash flows for the entity and therefore have no impact on the income or value of the entity. The distinction between economic financial risk management and hedge accounting is important to understand. The use of hedge accounting allows an entity to reflect the economics of a hedge relationship in the financial statements by matching offsetting gains and losses in the income statement in the same reporting period. However, not all economic financial risk management practices will qualify for hedge accounting. The use of hedge accounting is restricted under IAS 39 and can be costly to achieve. Sections 8 and 9 are devoted to hedge accounting topics. 2.3 Financial risks 19

26 3. Embedded derivatives Key topics covered in this Section: What are embedded derivatives Distinguishing characteristics Separate accounting 3.1 Overview Derivatives are typically stand-alone instruments, but they may also be found as components embedded in a financial instrument or in a non-financial contract. A host contract may, for example, be a financial instrument, an insurance contract, a lease, a purchase agreement, a service agreement, a construction contract, a royalty agreement or a franchise agreement The component that is a derivative instrument is referred to as an embedded derivative. An embedded derivative is one or more implicit or explicit terms in a contract that affect the cash flows of the contract in a manner similar to a stand-alone derivative instrument. If a contract or set of contracts contains derivative features that may be transferred separately, these are not considered to be embedded derivatives, but rather freestanding derivatives. Such derivatives could be attached at inception or at a later stage by a party to the contract or by a third party. An embedded derivative that meets the definition must be separated from its host contract and measured as if it were a stand-alone derivative if its economic characteristics are not closely related to those of the host contract. If the economic characteristics of an embedded derivative are closely related to those of the host contract, then it may not be separated. The standards include detailed examples of host contracts and derivatives that require separation and those that do not and 11 If an embedded derivative is separated, the host contract is accounted for under IAS 39 if it is itself a financial instrument, or in accordance with other appropriate IFRS if it is not a financial instrument. This is intended to achieve consistent treatment of transactions of similar substance, whatever the form, and to prevent entities from circumventing the requirement to measure derivatives at their fair value in the balance sheet If the combined instrument is carried at fair value with changes in fair value recognised in the income statement, separate accounting is not necessary, nor is it permitted. Determining whether an embedded derivative should be accounted for separately can be a complex process, as shown in the decision tree in Figure 3.1 and in Table 3.2 later in this Section. The process of reviewing a range of contracts to identify those that might contain embedded derivatives is an important and time-consuming aspect of IAS Overview

27 Figure 3.1 Decision tree for hybrid financial instruments December 2003 amendments 39.9 One of the amendments will be to introduce a choice, in respect of each purchase, origination or issue of a financial instrument, to designate the instrument on initial recognition as fair value through profit or loss. An entity may, therefore, avoid the complexity of separating and measuring embedded derivatives by measuring the entire instrument at fair value through profit or loss. For example, prior to the amendments, the equity call option embedded in an availablefor-sale investment in a convertible bond would be separated and measured at fair value (if changes in the value of available-for-sale assets were recognised in equity, as permitted by the previous standard as an accounting policy choice). If the convertible is listed, it will be simpler for the entity to designate the entire bond as fair value through profit or loss and measure it at its market price, thereby avoiding the need separately to value and account for the option. Another example may be a complex investment product issued by a bank or insurer that contains a host deposit contract and a number of embedded derivatives based on interest rates, equity prices, etc. It may be simpler for the entity to determine a fair value for the instrument as a whole than separately for the embedded derivative components. 3.1 Overview 21

28 39.AG30 and Economic characteristics and risks IAS 39 sets out examples of when the characteristics and risks are and when they are not closely related. The table below outlines the key characteristics of common host contracts. Table 3.1 Key characteristics of common host contracts Host contract Debt contract Equity contract Insurance contract Lease contract Key characteristics The value of a debt contract is driven by the interest rates associated with the contract, which comprise the factors of: risk-free interest rate; expectations of future interest rates and inflation (forward rates); credit risk (specific and sector spread); and expected liquidity / maturity. The value of an equity contract is associated with the underlying equity price or index. The value of an insurance contract is dependent on: level of future premiums; interest rates; inflation rates; and actuarial assumptions (e.g. expected claims, mortality). The value of a lease contract is dependent on: inflation rates; interest rates; and revenues generated from the leased asset (e.g. lease rentals). Contracts for The value of supply contracts is dependent on: goods and services the price of the goods or services sold; inflation rates; and the currency in which payment is denominated. 39.AG33 39.AG33 Any feature that leverages the exposure of the host contract to more than an insignificant extent constitutes an embedded derivative that must be separated. Leverage in this context (for contracts other than options) means that the value of the hybrid instrument changes in proportion to the underlying by more than 100 per cent, either positively or negatively. In certain circumstances the currency of cash flows generated by committed future sales and purchases of an entity may differ from the reporting or measurement currency of either the supplier or the customer. Such contracts are likely to contain embedded derivatives which should be accounted for separately. For example, Entity A has Euro as its measurement currency, and sells goods or services to Asia priced in USD. Entity A should account for the supply contract as the host contract in Euro with an embedded foreign currency forward. Changes in fair value of the foreign currency component of the contract should be included in the income statement (unless hedge accounting can be applied) Economic characteristics and risks

29 39.AG30 and 33 IAS 39 also provides examples of when the economic characteristics and risks of an embedded derivative are and are not considered to be closely related to the host contract. Table 3.2 presents examples of typical host contracts and embedded derivative components. This is followed by a list of features of the derivative component that are considered to be closely related and those that are not. Where no separation is required, this assumes there is no leverage nor inverse leverage. December 2003 amendments As noted above and in Table 3.2, a committed purchase or sales contract in a foreign currency contains an embedded derivative. Under the existing standard, that embedded derivative must be separated unless the currency of the contract is the functional currency of another party to the contract or is the currency in which the product is routinely denominated in international commerce. Routinely denominated is interpreted extremely narrowly, so that an oil transaction denominated in USD is one of the few transactions that qualifies for this exemption. 39.AG33(f) The amendments introduce a further exemption, that the embedded derivative should not be separated if the contract requires payment in a currency that is commonly used in contracts in that economic environment. In the example above, the embedded derivative would not be separated as long as Entity A can demonstrate that it is common for this type of product or service to be priced in USD in, for example, the Asian country in which it is sold. 3.3 Separation of the embedded derivative An embedded derivative that meets all of the criteria needs to be accounted for separately from its host. IAS 39 does not require separate presentation of embedded derivatives in the balance sheet. However, an entity is required to disclose separately its financial instruments carried at cost and those carried at fair value. Therefore, at a minimum, embedded derivatives that are not presented separately in the balance sheet should be disclosed If an embedded derivative cannot be measured reliably although the characteristics are such that separation would be required, the entire combined contract (host and embedded derivative) is to be treated as a financial instrument held for trading. In the case of multiple embedded derivative components the embedded derivatives are only separated individually if they: are clearly present in the hybrid instrument as evidenced by the contractual terms and the economic substance of the hybrid instrument; relate to different risk exposures; and are readily separable and independent of each other. 3.3 Separation of the embedded derivative 23

30 Table 3.2 Host contracts and embedded derivative components Type of Type of embedded Features closely related Features not closely related host contract derivative component (no separation) (separation required) Instrument Instrument Equity-linked interest or Never closely related to a debt host contract. principal payments When interest or principal payments are dependent on equity prices (indexed). Commodity-linked or Never closely related to a debt host contract. other non-financialindexed interest or principal payments When interest or principal payments are dependent on commodity prices or other non-financial assets (indexed). Equity conversion feature Never closely related to a debt host contract. When the debt instrument may be converted to equity shares of the issuer or another entity. 1 Option or automatic provision to extend maturity When the option to extend the maturity is made at prevailing market terms at the time of the extension. When the option or automatic provision to extend the maturity is on terms which differ from market terms at the time of extension. Debt Call or put option to repay before final maturity When exercisable at the accreted or amortised amount or when the exercise price of the option does not result in a significant gain or loss, such as when debt is issued or purchased at an insignificant discount or premium. When exercisable for other than the accreted or amortised amount of the debt, or when the exercise price results in a significant gain or loss. Equity kicker Never closely related to a debt host contract. When a subordinated loan entitles the grantor of the loan to receive shares of the borrowing entity for free or at a very low price. 1 Interest rates of a debt instrument and the changes in fair value of an equity instrument are not closely related, therefore, the conversion option must be accounted for separately Separation of the embedded derivative

31 Table 3.2 Host contracts and embedded derivative components (continued) Type of Type of embedded Features closely related Features not closely related host contract derivative component (no separation) (separation required) Instrument Instrument Credit derivative When the payments depend on the credit risk of the issuer of the debt instrument itself. When the payments depend on the credit risk of a reference item other than the debt instrument itself. Index-linked (floating) rates of interest When the indexing relates to future interest or inflation, resulting in a situation where: the holder of the instrument would recover substantially all of its recorded investment; or When the indexing is not in a one-to-one proportion to the debt, for example, significantly leveraged through a different notional reference or a significant inverse relation to the market rate, resulting in a situation where: the issuer would not pay more than twice the market rate at inception. From the holder s perspective, this also applies when the contract permits, but does not require that not all of the recorded investment is recovered. the holder of the instrument would not recover substantially all of its recorded investment; or the issuer would pay more than twice the market rate at inception. 2 Inflation-indexed interest payments When the inflation index is one commonly used for this purpose in the economic environment in which the debt is denominated. When the inflation index relates to a different economic environment or the index is not one that is commonly used for this purpose. Debt Interest caps and floors When the embedded cap or floor is at or out-of-the money at the time of issue, i.e. the exercise interest rate of the cap is at or above market rates and the floor is at or below market rates. When the embedded cap is below the market rate of interest (in-the-money cap) or the floor is above the market rate of interest (in-the-money floor) at the time of issue. Foreign currency debt instruments When cash flows are denominated in a foreign currency and: When a foreign currency option is included on debt repayment. either the principal and interest are denominated in the same foreign currency; or the principal and interest are denominated in different foreign currencies. Foreign currency gains and losses are accounted for under IAS The assessment of the effect of these features should be made when the contract is entered into. There should be a high expectation at inception that these limits will not be exceeded. Determination of these limits involves the estimation of future movements in the relevant indices. As objective indications of future movements are generally not available it would be relevant to apply historic movements for this purpose. 3.3 Separation of the embedded derivative 25

32 Table 3.2 Host contracts and embedded derivative components (continued) Type of Type of embedded Features closely related Features not closely related host contract derivative component (no separation) (separation required) Instrument Instrument Equity call and put options Inflation-indexed lease payments Contingent rentals Never closely related to a host contract. When lease payments are adjusted based on an inflation-related index, provided that the indexing is not significantly leveraged and that the index relates to inflation in an economic environment that is relevant to the lease contract. When contingent rentals are based on: related sales or variable interest rates; or Always separated when held by an entity. When lease payments are adjusted according to a leveraged inflation index, or the index is unrelated to inflation in the entity s own economic environment. When contingent rentals are based on: leveraged sales or variable interest rates; or Lease Equity (held by an entity) indices that are closely related to the lease. indices that are not closely related to the lease. Foreign currency component When rentals are denominated in a foreign currency that is the currency of the primary economic environment in which any substantial party to that contract operates (measurement currency). When rentals are not denominated in a foreign currency that is the currency of the primary economic environment in which any substantial party to that contract operates (measurement currency) Separation of the embedded derivative

33 Table 3.2 Host contracts and embedded derivative components (continued) Type of Type of embedded Features closely related Features not closely related host contract derivative component (no separation) (separation required) Instrument Instrument Foreign currency component When a commercial contract involves payment for goods or services denominated in a foreign currency: When commercial contracts require payment denominated in a currency that is not: Price clauses related to indices Commercial contracts (purchase, sale) Combination of call and put option, resulting in a price range (a collar) that is the currency of the primary economic environment in which any substantial party to that contract operates (measurement currency); or that is the currency in which the price of the related good or service that is acquired or delivered is routinely denominated in international commerce worldwide. 3 When commercial contracts are based on prices or indices that are closely related to the contract (e.g. related to the price of the purchased or sold goods or services). When the purchased call and the written put are at or out-of-the money, i.e. the exercise price of the call is at or above market rates and of the put is at or below market rates at the time the contract is entered into. the currency of the primary economic environment in which any substantial party to that contract operates (measurement currency); and the currency in which the price of the related good or service that is acquired or delivered is routinely denominated in international commerce worldwide. When commercial contracts are based on prices or indices unrelated to the contract (e.g. unrelated to the price of the purchased or sold goods or services). When the purchased call and written put are in-the-money at the time the contract is entered into. 3 Note that: Routinely denominated is very narrowly defined. It is only a currency that is used for similar transactions all around the world, not just in one local area. 3.3 Separation of the embedded derivative 27

34 39.AG29 39.AG33 In many cases, multiple embedded derivatives should not be separated individually. For example, if a debt instrument has a principal amount related to an equity index and that amount doubles if the equity index exceeds a certain level, it is not appropriate to separate both a forward and an option on the equity index because those derivative features relate to the same risk exposure. Instead the forward and the option elements are treated as a single compound embedded derivative. On the other hand, if a hybrid debt instrument contains, for example, two options that give the holder a right to choose both the interest rate index on which interest payments are determined and the currency in which the principal is repaid, those two options may qualify for separation as two separate embedded derivatives as they relate to different risk exposures and are readily separable and independent of each other. If an embedded derivative is not required to be separated, IAS 39 does not permit an entity to separate the hybrid instrument. In other words, separation is not optional How to split fair values at initial recognition 39.AG28 and As the derivative component is measured separately at fair value upon initial recognition, the carrying amount of the host contract at initial recognition is the difference between the cost of the hybrid instrument and the fair value of the embedded derivative. Where more reliable fair values exist for the hybrid instrument and the host contract (e.g. through quoted market prices) than for the derivative component, it may be acceptable to use those values to determine the fair value of the derivative upon initial recognition. IG C.1 and C.2 When separating an instrument that is a forward, the forward price is set such that the fair value of the embedded derivative is zero at the inception of the contract. This means that the forward price should be at market rates. When separating an embedded feature that is an option, the separation should be based on the stated terms of the option feature documented in the hybrid instrument. As a result the embedded derivative would not necessarily have a fair value or intrinsic value equal to zero at the initial recognition of the hybrid instrument. However, the embedded derivative must be valued based on terms that are clearly present in the hybrid instrument Designating embedded derivatives as hedging instruments Embedded derivatives that are accounted for separately may be designated as hedging instruments. The normal hedge accounting criteria as outlined in Section 8 apply to embedded derivatives used as hedging instruments Separation of the embedded derivative

35 4. Recognition and derecognition Key topics covered in this Section: Initial measurement Transaction costs Recognition Trade date versus settlement date accounting Derecognition of: financial assets financial liabilities Issues relating to special purpose entities 4.1 Overview An entity must consider both the amount to be recognised as well as the timing of recognition. An instrument is recognised in the balance sheet when the entity becomes party to a contract that comprises a financial instrument. There are specific rules governing when an entity may remove financial assets and financial liabilities from its balance sheet. For financial assets these rules are based on whether an entity has given up control over the contractual rights of the financial asset. For financial liabilities derecognition depends on whether an entity has settled, or has been legally relieved of, its obligation. In both situations when derecognising a financial instrument, parts of that instrument can be retained or new instruments may need to be recognised. 4.2 Initial measurement and At initial measurement, a financial instrument is included in the balance sheet at cost, 39.AG64 which should equal its fair value, i.e. the consideration given or received. The consideration given or received is normally the transaction price or the market price. It can also be the fair value of financial instruments (other than cash) given or received in exchange for the financial instrument to be recognised. If the transaction is not based on market terms, or if a market price cannot be readily determined, then an estimate of future cash payments or receipts, discounted using the current market interest rate for a similar financial instrument, should be used to approximate the fair value. 39.AG64 If a bank makes a low interest or interest-free loan to a customer, the cost amount given by the bank (which recognises an asset) and the amount received by the customer (which recognises a liability) is often interpreted to be the cash transferred. This same issue often arises in relation to low or no interest inter-company loans or inter-company current accounts. In both cases, the initial carrying amount of the loan is not the amount lent, but 4.2 Initial measurement 29

36 rather the fair value of the consideration given to obtain the right to payment in the future. A low interest or interest-free loan discounted at a market rate of interest results in a present value that is less than the amount lent. The difference is not a financial asset. However, if this difference qualifies for recognition under another applicable IFRS (e.g. a recognisable intangible benefit) then it is recognised as an asset. If the difference does not qualify for recognition, it must be expensed. 39.AG13 IG E.1.1 Case 4.1 Low interest loan Bank Q grants a three-year loan of 50,000 to an important new customer. The interest rate on the loan is four per cent, while the current market lending rates for similar loans to customers with a similar credit risk profile is six per cent. Bank Q believes that the future business to be generated with this new customer will lead to a profitable lending relationship. On initial recognition Bank Q should recognise the carrying amount of the loan as the fair value of the payments that it will receive from the customer. Discounting the interest and principal repayments using the market rate of six per cent, Bank Q will recognise an originated loan of 47,328. The difference of 2,672 is expensed immediately as the expectation about future lending relationships does not qualify for recognition as an intangible asset Transaction costs Transaction costs are included in the initial measurement of financial assets and liabilities. These may be incurred when an entity enters into a contractual arrangement. Transaction costs that are included in the initial measurement are those costs paid to external parties, such as fees and commissions paid to agents, advisers, brokers and dealers, as well as levies paid to regulatory agencies and securities exchanges, and transfer taxes and duties. Transaction costs may include internal costs, but both internal and external costs must be incremental. Transaction costs do not include internal financing, holding and administrative costs, nor do they include debt premiums or discounts. The treatment of transaction costs after initial recognition depends on the subsequent measurement of the instrument of which they are a part: for financial assets and liabilities that are carried at amortised cost, the transaction costs are amortised to the income statement as part of the recognition of the effective interest; for financial assets carried at cost, but with no set maturity, the transaction costs are recognised in the income statement at the time of sale; for financial assets that are carried at fair value with changes in fair value recognised in the income statement, the transaction costs are expensed upon subsequent measurement; and for financial assets that are carried at fair value with changes in fair value recognised directly in equity, the transaction costs for debt instruments are amortised to the income statement as part of the recognition of the effective interest on such instruments, but for equity instruments they are recognised only at the time of sale Transaction costs, incurred or expected to be incurred at a subsequent date related to the transfer or disposal of a financial instrument, should not be considered in the subsequent Initial measurement

37 measurement of the financial instrument. Disposal costs are only included in the income statement when a financial instrument is derecognised. December 2003 amendments The amended standards specify more clearly that the amount at which a financial asset or liability is recognised initially is its fair value plus, in the case of a financial asset or financial liability that is not at fair value through profit or loss, transaction costs The amended standards confirm that transaction costs must be incremental and directly attributable to the acquisition, issue or disposal of an instrument. Incremental costs are those that would not have been incurred if the instrument had not been acquired, issued or disposed of. In practice, few internal costs are likely to meet this requirement. The requirement is also applied on an instrument-by-instrument basis. It will not, for example, be permitted to treat as transaction costs the internal costs associated with developing a new investment product Transaction costs on financial instruments measured at fair value through profit or loss are not included in the amount at which the instrument is measured initially, instead they are charged immediately to the income statement. 4.3 Recognition When to recognise An enterprise should recognise a financial asset or liability in its balance sheet when, and only when, it becomes a party to the contractual provisions of the instrument. 39.AG35 Situations where an entity has become a party to contractual provisions include committing to a purchase of securities or committing to write a derivative option. In contrast, planned but not committed future transactions, no matter how likely, are not financial assets or liabilities as they do not represent situations where the entity becomes a party to a contract requiring future receipt or delivery of assets. For example, an entity s estimated but uncommitted sales do not qualify as financial assets or liabilities Trade date versus settlement date accounting 39.AG55 and AG12 The trade date is the date an entity enters into a contract for the purchase or sale of an asset. The settlement date is the date that the financial instrument is delivered to or transferred from the entity. The recognition principle in IAS 39 would result in all transactions that occur in regulated markets to be accounted for on the trade date. However, the standard recognises that practice by many financial institutions and corporates is to use settlement date accounting, and that it would be cumbersome to account for such transactions as derivatives between the trade and settlement date. Because of the short duration between the trade date and the settlement date in these types of regulated market situations, such regular way contracts are not recognised as derivative contracts under IAS 39. A regular way contract may be a purchase or a sale that requires delivery of assets within a period of time generally 4.3 Recognition 31

38 IG B.30 IG B.28 IG B AG54 recognised to be the market convention or established by regulation in the marketplace in which the transaction actually takes place. This exception is a practical approach taken in IAS 39 to prevent the recognition of derivatives in many situations, and for very short periods, where the constraints in the marketplace prevent immediate settlement at the trade or commitment date. In order for a financial asset purchase to be regular way, it is not required that an organised market exists (e.g. a formal stock exchange, organised over-the-counter market, etc). Rather, the term marketplace means the environment in which the financial asset is customarily traded. For example, a commitment for a standard three-day settlement (assumed to be the norm for a particular marketplace) of a security purchase transaction would not be treated as a derivative as this is a regular way transaction. However, a commitment for a three-month settlement (assuming that this is not the norm in the marketplace of these instruments) for the same security transaction would meet the definition of a derivative because it is not considered to be a regular way transaction. The regular way exception requires that the transaction will be fulfilled through actual delivery of the financial instrument. Therefore, if a contract allows for or requires net cash settlement it does not qualify as a regular way contract , AG53 When accounting for regular way purchases and sales of a financial asset, an entity may and IG B.32 choose either trade date or settlement date accounting. The approach should be applied consistently for both purchases and sales of the different categories of financial assets. There are no specific requirements about trade date and settlement date accounting in respect of financial liabilities, therefore the general recognition and derecognition requirements apply. Under trade date accounting, the asset to be received and related obligation to pay for it are recognised on the date the contract is entered into. If settlement date accounting is chosen, the asset is recognised on the actual date of settlement, i.e. the date that the instruments are exchanged. In the case of a purchase under settlement date accounting, changes in the fair value of the financial instrument between the date of trade and settlement should be recognised if the financial instrument is carried at fair value. In the case of a sale under settlement date accounting the opposite occurs: changes in the fair value after the trade date are not taken into account, as there is a set sale price agreed upon at the trade date, making subsequent changes in fair value irrelevant from the seller s perspective. Case 4.2 Purchase of a bond, comparing trade date and settlement date accounting On 28 June 20X1, Entity X agrees to purchase a bond for settlement on 1 July 20X1. The purchase price of the bond is 10.0 million. On 30 June 20X1, the fair value of the bond is 10.1 million. On 1 July, the bond purchase is settled for 10.0 million and the fair value remains as 10.1 million. What would be the impact on the balance sheet of the bond purchase at each of the dates of 28 June, 30 June and 1 July? The balance sheet impact is shown below for both the settlement date approach and the trade date approach. The example illustrates initial measurement of the bond purchase under two scenarios: (1) a bond subsequently carried at fair value and (2) a bond subsequently carried at amortised cost Recognition

39 IG D.2.1 Settlement date accounting Trade date accounting (amounts in millions) Fair value Amortised cost Fair value Amortised cost 28 June 20X1 Financial asset-bond Financial liability (10.0) (10.0) 30 June 20X1 Financial asset-receivable (revaluation gain) 0.1 Financial asset-bond Financial liability (10.0) (10.0) Equity (0.1) (0.1) 1 July 20X1 Financial asset-receivable (revaluation gain) Financial asset-bond Cash paid (10.0) (10.0) (10.0) (10.0) Equity a (0.1) (0.1) a This is recognised either in the income statement (i.e. retained earnings) or directly in equity, depending on the classification of the bond. As noted in the example, the effect on the income statement and on equity is the same under settlement date and trade date accounting for purchases. However, the use of trade date accounting versus settlement date accounting could have a significant temporary impact on the balance sheet of an entity. Case 4.3 Sale of a bond, comparing trade date and settlement date accounting On 28 November 20X1, Entity X agrees to sell the bond for 9.6 million, its fair value at that date, with a settlement date of 1 December 20X1. On 30 November 20X1, the bond is worth 9.5 million. On 1 December 20X1, the bond is settled at a price of 9.6 million and the fair value of the bond is still 9.5 million. What would be the impact on the balance sheet of the bond sale at 28 November, 30 November and 1 December? 4.3 Recognition 33

40 39.AG56 Settlement date accounting Trade date accounting (amounts in millions) Fair value Amortised cost Fair value Amortised cost 28 November 20X1 Financial asset-bond Financial asset-receivable Retained earnings b Equity c November 20X1 Financial asset-bond Financial asset-receivable b Retained earnings c Equity December 20X1 Cash Financial asset-bond Financial asset-receivable d Retained earnings b For trade date accounting the loss is recognised in the income statement (i.e. retained earnings) on the trade date. c For settlement date accounting the revaluation adjustment is recognised in equity until actual settlement, assuming fair value changes on this instrument are recognised in equity. d For both trade date and settlement date accounting the effect is ultimately the same (i.e. the loss is reflected in the income statement). Despite the change in fair value of the bond between the trade date and settlement date, Entity X does not record the additional 0.1 million loss as it will receive 9.6 million on the settlement date from the purchaser. As can be seen above, when accounting for sales, the effect on equity, the presentation of the transaction in the income statement and in the balance sheet may be temporarily different under trade date versus settlement date accounting. 4.4 Derecognition Derecognition of a financial asset and AG36 Derecognition of a financial asset or a portion of a financial asset occurs under the current standards when, and only when, the entity loses control of the contractual rights that comprise the financial asset (or portion thereof). An entity loses control if it realises the rights to benefits specified in the contract, those rights expire or the entity surrenders those rights. The derecognition provisions in IAS 39 take a financial components approach. The financial components approach focuses on control of the financial assets or portions thereof that are transferred to another party. A transfer can be broken down into its various financial components, which are then recognised by the parties to the transfer that control those components. Examples of components of a financial asset are its cash flows from principal Derecognition

41 repayment and cash flows from interest coupons. These cash flows can be segregated and potentially transferred to other parties. Determining control over a financial asset under the current standards requires identifying the risks and benefits of the asset and evaluating which party has exposure to and / or benefits from these. Thus the principles in IAS 39 on derecognition are regarded as a mixed approach that on one hand uses a financial components approach and on the other hand employs a risks and rewards approach. Within IAS 39 there are several examples of situations where a transferor has not lost control of a transferred financial asset (or portion thereof) by retaining the risks and rewards related to such asset (or portion thereof). The examples are when: 39.AG51 The transferor has the right to reacquire the asset (or has a right of first refusal to purchase the asset) unless either (i) the reacquisition price is fair value; or (ii) the assets are readily obtainable in the market. 39.AG51 The transferor is both entitled and obliged to repurchase or redeem the transferred asset on terms that effectively provide the transferee with a rate of return similar to that on a loan secured by the transferred asset and The transferor has retained substantially all of the risks and returns of ownership AG39-41 through a total return swap with the transferee (and the asset is not readily obtainable in the market). 39.AG51 The transferor has retained substantially all of the risks of ownership through an unconditional put option on a transferred asset held by the transferee (and the asset is not readily obtainable). 39.AG42-44 Both the position of the transferor and the position of the transferee must be considered. After transferring the assets, the transferor should not be able to sell or pledge the assets to another party and should not be able to use the cash flows generated by the assets for its own benefit. The transferor has generally not lost control unless the transferee has the ability to obtain the benefits of the transferred asset and 20 Derecognition is not limited to the situations noted above. If, for example, neither the transferee nor the transferor has the right to sell or pledge a portfolio of loans (which often is the case when only a portion of the assets is transferred), the transferred portion of the loans may be derecognised if it is demonstrated that the transferee has the ability to obtain the benefits of its portion of the assets, that is to say, the transferee may sell or pledge its interests in its portion of the loans. December 2003 amendments Derecognition requirements for assets have been significantly reworded and to an extent revised (although for certain transactions the resulting changes to the accounting are substantial). Elements of both the components / control, and risks and rewards, approaches are retained but a new continuing involvement approach is introduced, resulting in partial derecognition in a number of more complex transactions where previously no derecognition would have been permitted. These are dealt with further in the Sections below. 4.4 Derecognition 35

42 39.AG36 The amendments also clarify the requirements considerably by introducing a step-bystep approach to analysing transactions, thus placing the various steps to be taken in determining whether a transaction qualifies for derecognition in a mandatory hierarchy. In the existing standard it is often difficult to establish when one requirement takes precedence over another. A decision tree outlining the new approach, with paragraph references to the revised IAS 39, is as follows: Derecognition

43 The steps involved in the analysis under the amended standard are, in summary: 1. What is the reporting entity? If the reporting entity is a group, the purpose of this step is to ensure, for example, that all controlled special purpose entities (SPEs) are consolidated before considering derecognition. Essentially there is no benefit in analysing whether an entity achieves derecognition when transferring financial assets to an SPE if the SPE is then consolidated under SIC 12 and only the group financial statements are prepared using IFRS. 2. Should the analysis be applied to a component of a financial asset or to the asset in its entirety? A component is permitted to be considered for derecognition separately only if it represents: (a) specifically identified contractual cash flows, such as a stream of interest-only or principal only cash flows; (b) a fully proportionate share of the cash flows from the asset, for example, 50 per cent of all the interest and principal payments received on a loan; or (c) a fully proportionate share of specifically identified contractual cash flows, for example, 30 per cent of the interest cash flows received on a bond. The analysis may be applied either to an individual asset or to a portfolio of similar assets. The remaining steps are then applied to the portfolio, asset or qualifying part or proportion identified in this step. This is referred to in the steps below as the asset. 3. Have the rights to the cash flows from the asset expired? This would be the case, for example, when a debt instrument has been repaid or a purchased option expires unexercised. If yes, the asset is derecognised. 4. Have the rights to the cash flows from the asset been transferred? This would apply in a legal sale of the asset, or a legal assignment of the rights to its cash flows. 5. If the entity has not transferred the rights to cash flows from the asset, has the entity assumed an obligation to pass through the cash flows from the asset to another party? Does that pass-through meet all of the following conditions? The entity has no obligation to pay amounts to the other party unless it collects equivalent amounts from the original asset; The entity is prohibited by the terms of the transfer contract from selling or pledging the original asset other than as security to the other party for the obligation to pay that party cash flows; and The entity has an obligation to remit any cash flows it collects on behalf of the other party without material delay. In addition, during any short period between collection by the entity and payment to the other party, the funds may not be reinvested other than in cash and cash equivalents (as defined by IAS 7 Cash Flow Statements) and any interest earned must be passed to the other party. If there is neither a legal sale nor a qualifying pass-through arrangement, no derecognition is permitted. The transaction is treated as a secured borrowing. 4.4 Derecognition 37

44 The requirements for pass-through are considered further in Section and in the securitisation example in Section If the asset has been transferred, either through a legal sale or a qualifying passthrough arrangement, have substantially all the risks and rewards been transferred? This would apply either to a clean sale with no strings attached, or to a qualifying arrangement to pass through all cash flows with no further interest by the entity in any of the future economic outcomes from the asset. If yes, the asset is derecognised. The transfer of risks and rewards is evaluated by comparing the entity s exposure, before and after the transfer, to the variability in the amounts and timing of the net cash flows of the assets. 7. Have substantially all the risks and rewards been retained? This would be the case, for example, in a sale with a fixed price repurchase agreement or a sale with a total return swap. If yes, no derecognition is permitted and the transaction is treated as a secured borrowing. 8. If the asset has been transferred, but substantially all its risks and rewards have been neither transferred nor retained (in other words, some risks and rewards are retained, and some are transferred), has the entity transferred control of the asset? Examples would be a sale with a retained call option or a sale with a written put option. Control in this context means the practical ability to sell the asset. If the buyer has an unfettered and practical ability to sell the asset, for example, because the asset is listed and therefore the buyer could sell it and subsequently repurchase it if required, then control has been transferred and the asset is derecognised. 9. If control has not been transferred, then the entity continues to recognise the asset to the extent of its continuing involvement. This concept has been introduced to deal with those circumstances where an entity has neither transferred nor retained substantially all the risks and rewards relating to the transferred asset, but has retained control. Essentially, the asset is derecognised to the extent the entity has no continuing exposure to the asset. The asset remains on balance sheet to the extent of the maximum potential exposure and a corresponding liability is recognised. The detailed requirements are complex, but the principle is that the net amount recognised for the asset and the liability reflects the entity s remaining net potential maximum exposure to the asset. If the asset is measured at amortised cost, the corresponding liability is measured at amortised cost. If the asset is measured at fair value, the liability is measured at fair value. Alternatively, the continuing involvement may be in the form of an option or guarantee. In such cases, under continuing involvement derecognition will be precluded to the extent of the amount which might become payable under the option or guarantee. In the examples given in the rest of this Section, the outcomes under the amended standard are likely to be the same as under the existing standard unless otherwise stated Evaluating the risks associated with a transferred asset For financial assets with relatively short maturities, such as trade receivables, the only substantive risk to consider generally is credit risk. If the transferor retains the credit risk on short-term financial assets through a guarantee then derecognition would not be appropriate Derecognition

45 An entity might transfer part, but not all, of a risk that it considers to be a substantive risk of the transferred assets. In order for derecognition to be appropriate, the entity needs to transfer a significant exposure to loss from that substantive risk. A risk of loss is considered to be significant when it is based on historical loss experience for an entity and considering the type of asset transferred. For example, if a transfer of credit risk (which is considered to be a substantive risk of the assets transferred) will only occur in a catastrophe or similar situation because historical losses are covered through a guarantee by the transferor, this is considered to be outside the range of likely loss outcomes. This would not be considered a transfer of a significant exposure to loss from credit risk. Consequently, in such cases, derecognition would not be appropriate Transfer of a financial asset with no derecognition Transfers of financial assets that do not satisfy the conditions for derecognition are accounted for as collateralised borrowings. In other words, the financial assets stay on the books of the transferor and a borrowing is recognised for the proceeds received from the transferee. The financial assets act as collateral for the transferee in the event of 39.AG49 non-payment on the borrowing. If derecognition is prevented due to the existence of a derivative (whether stand-alone or embedded in a contract), the derivative itself would not be recognised if recognising both the derivative and the borrowing result in double counting in the transferor s balance sheet. 39.AG50 39.AG51(a-c) IG D AG51(e) The most common example of a collateralised borrowing is a standard repurchase (repo) transaction, where a seller transfers assets and agrees to repurchase the same assets at a later date and at a specified price. Effectively the seller / transferor has a call option and the buyer / transferee has a put option on the transferred assets. In this situation, the seller should continue to recognise the financial assets and should not recognise the options. Because only one entity can control a financial asset (or component thereof), if the transferor cannot derecognise a financial asset then the transferee should not recognise the financial asset on its balance sheet. Instead the transferee recognises a receivable from the transferor for the repayment of the cash proceeds or other consideration. In some repo transactions, when returning transferred assets to the transferor, the transferee may substitute similar assets of equal fair value. If this occurs, upon substitution the transferor derecognises the assets originally transferred and recognises the assets actually returned by the transferee. A securities lending transaction that requires the borrower to return the transferred financial asset at a later date and for a specified price would be accounted for in a similar way to that described above for repo transactions. Typically in a securities lending transaction, there is collateral given by the securities borrower / transferee to the securities lender / transferor. If cash is given as collateral and is not legally separated from the lender s assets, the lender recognises the cash and a payable to the borrower. The borrower recognises a receivable from the lender. A wash sale transaction is one where an entity purchases a financial asset either immediately before or after the sale of the same asset. A wash sale may qualify for derecognition as long as there is not a contractual commitment to repurchase the assets sold. In such cases the sale and purchase are viewed as two separate transactions under IAS Derecognition 39

46 39.AG51(i) Case 4.4 Receivables sold with full recourse Entity A (the transferor) sells receivables to Entity B (the transferee). The receivables, which are due in six months and have a carrying value of 100,000 are sold for a cash payment of 95,000 subject to full recourse. Under the right of recourse, the transferor is obligated to compensate the transferee for the failure of the debtors to pay when due. In addition to the recourse, the transferee is entitled to sell the receivables back to the transferor in the event of unfavourable changes in interest rates or the credit ratings of the underlying debtors. How should the transaction be accounted for? The transaction is accounted for by the transferor as a secured loan as it does not qualify for derecognition. This is because the transferor has retained substantially all of the risks associated with the assets. Although the transferee has the ability to sell or pledge approximately the full value of the assets transferred, the transferor has granted the transferee a put option on the transferred assets allowing the transferee to sell the receivables back to the transferor in the event of actual credit losses and changes in underlying credit ratings or interest rates. Consequently the transferor is regarded as having retained substantially all the risks of ownership of the receivables. The transferor recognises 95,000 as a liability. The liability is measured at amortised cost with an interest expense of 5,000 being recognised over the six-month period until maturity. The transferor continues to recognise the receivables as assets. Cash received on the receivables by either the transferor or transferee reduces both the receivables and the liability. If uncollected receivables are returned to the transferor for cash, the liability is reduced and an impairment loss recognised if not previously recognised by the transferor (a) December 2003 amendments Under the amended standards, the result in this case remains unchanged. Assuming the rights to all of the cash flows in the receivables are legally transferred, then Step 7 in the new approach described on page 38 will result in the transaction being treated as a secured borrowing because substantially all the risks and rewards associated with the asset have been retained by the transferor Derecognition of a part of a financial asset If an entity transfers less than all of the financial asset, derecognition involves determining the legal contractual rights and obligations arising from a contract, and recognising the retained components based on the fair values of the assets retained and the liabilities incurred. For example, a bank may sell a portfolio of loans, but retain the right to receive 50 per cent of the interest on the loans. Using a financial components approach, the bank may be able to derecognise the loans, but would recognise the value of the right to the 50 per cent of interest revenues as an asset. The carrying amount of the asset sold is allocated between the part retained and the part sold, based on their relative fair values at the date of sale , 28 and When determining fair value of the retained interest the best evidence is obtained by AG52 reference to a market quotation. However, when market quotations do not exist, valuation models with inputs based on market information may generally be used. In the rare Derecognition

47 circumstances where the fair value of the part of the asset that is retained cannot be reliably measured, the asset should be measured at zero, and the entire carrying amount should be allocated to the part of the asset sold and 25 There may also be instances when an entity transfers control of a financial asset and, in doing so, creates a new financial asset or assumes a new financial liability. For example, a bank may sell a portfolio of loans but still act as the servicer of the portfolio, for which it receives a fee. In this case, the entity should recognise the servicing rights as an asset or liability (a, i), 24 and AG45 Servicing activity must be taken into account when an entity transfers financial assets to another party. Servicing generally involves activities such as collecting payments from debtors, remitting cash to the transferee, providing reports to the transferee on the payment status of the transferred assets and performing collection activities for non-performing assets / debtors. All of these activities may occur without the debtor knowing that its receivable / loan has been transferred to a third party. When the transferor has an obligation to perform servicing activities, the entity determines whether a servicing asset or a servicing liability should be recognised. This is done through a net present value calculation comparing the servicing fees to be received, if any, by the transferor with the normal expected costs to perform these services. If the servicing fees to be received will exceed the costs of servicing, the entity records a servicing asset. If the costs of servicing exceed the servicing fees to be received, the entity records a servicing liability. Servicing contracts often are transferable, meaning that if the entity does not adequately perform its servicing duties, the transferee may find a new party to take over the servicing activity. The servicing fees to consider are only those cash flows that the servicer would lose upon termination or transfer of the servicing contract. For example, if a transferor retains an interest spread on transferred receivables and performs the servicing, the interest spread must be analysed to determine what portion should be allocated to a servicing asset (or liability) and what portion allocated to an interest-only strip receivable. The latter would be only those cash flows that would not be lost upon termination or transfer of the servicing contract. If derecognition occurs, the gain or loss is recognised based on the following formula: Proceeds received - Carrying amount of the financial asset (or portion thereof) sold - Fair value of any new financial liability (or portion thereof) assumed + Fair value of any new financial asset (or portion thereof) acquired - Service liability (if any) +/- Fair value adjustment previously recorded in equity = Gain or loss on derecognition As shown in the formula, one component of the calculation of the gain or loss is any cumulative balance of revaluation gains and losses previously reported in equity, which is removed from equity and recognised as part of the gain or loss in the income statement. 4.4 Derecognition 41

48 In the rare circumstance that a new financial asset is acquired or a new financial liability is assumed but cannot be measured reliably, the initial carrying amounts: for a financial asset, should be set at zero; and for a financial liability, should be such that no gain is recognised on the transaction. In this case, any excess proceeds over the carrying amount of the asset sold would be recognised as a liability in the balance sheet rather than recognised as a gain in the income statement. If the proceeds are less than the carrying amount sold, a loss should be recognised in the income statement immediately. Case 4.5 Transfer of a portfolio of loans North Bank originates mortgage loans in its normal course of business. North Bank enters into a transaction to sell a portfolio of loans to a third party. The loans in this portfolio yield a fixed 10 per cent rate of interest for their estimated lives of nine years. North Bank sells loans with principal of 1,000,000 plus the right to receive interest income of eight per cent. The sales proceeds received are 1,000,000. In order to preserve the relationships with bank customers, North Bank will continue to service the loans. For this activity, North Bank will be compensated for performing the servicing through a right to receive one half of the interest income not sold (i.e. 100 of the 200 basis points). The remaining 100 basis points (i.e. one per cent) is considered to be an interest-only strip retained by North Bank. It then determines the fair value of the new assets to be as follows: Servicing asset = 40,000; Interest-only strip = 60,000. The servicing asset s fair value is calculated as the present value of expected future cash flows (i.e. servicing fees less the cost of performing the servicing). The carrying amount of the financial asset (in this case, the portfolio of loans) should be allocated between the part of the asset retained and the part sold. This calculation is based on the relative fair values of the assets. North Bank performs the following calculation to determine the allocated carrying amounts of each asset. Percentage Allocated of total carrying Fair value fair value amount Loans sold 1,000, % 910,000 Servicing asset 40, % 36,000 Interest-only strip 60, % 54,000 Total 1,100, % 1,000, Derecognition

49 North Bank records the sale transaction with the following journal entry: Debit Credit 31 December 20X1 Proceeds on sale (cash or receivable) 1,000,000 Interest-only strip 54,000 Servicing asset 36,000 Loans 1,000,000 Gain on sale of loans 90,000 December 2003 amendments 39.AG36 The steps referred to below are set out on pages 37 and 38. In this case there is no SPE involved in the structure (Step 1). Consequently, under the amended standard, the first test to be applied is whether the revised derecognition requirements should be applied to the transferred asset in its entirety or to separate portions (Step 2). It is assumed that the 80 per cent of interest cash flows to be transferred to the third party represent a fully proportionate share of the interest cash flows received. This means that North Bank will consider two portions, being the principal element and 80 per cent of the interest cash flows, separately for the purposes of derecognition. Clearly, the rights to cash flows from the assets have not expired as the mortgage loans still exist (Step 3) and so the next stage is to consider whether or not the legal rights to cash flows have been transferred (Step 4). The effect of the servicing arrangement is that the legal rights to cash flows have not been transferred and North Bank therefore needs to consider whether its obligation to collect cash on behalf of the third party and pass it on meets the criteria for a pass through arrangement (Step 5). Those criteria are: the entity has no obligation to pay cash flows to the buyer unless it collects equivalent cash flows on the transferred asset; the entity is prohibited from selling or pledging the original assets other than as security to the buyer; and the entity is required to remit any cash flows received on the asset without material delay. Whether or not these requirements are met will depend on the details of the arrangement. However, if North Bank has not achieved qualifying pass through with regard to the principal or interest portion, or both portions, there will be no derecognition of the respective portion. Instead, the related proceeds will be treated as a secured borrowing. If North Bank has structured the contract to meet the pass-through requirements, then the transferred portion(s) will be derecognised as long as substantially all the risks and rewards of those components have been transferred (Step 6). The accounting would then be as described above under the previous IAS Derecognition 43

50 It is possible that North Bank will have retained some risks and rewards relating to the transferred portions, meaning that Step 6 will not be met. However, it is assumed that North Bank has not retained substantially all of the risks and rewards of the portions that have been transferred and therefore will not be required to continue to recognise the asset sold to the third party in its entirety (Step 7). While this may not be entirely clear from the example, it would be likely to be the case if, for example, the terms of the arrangement were such that North Bank retained the entitlement to a portion (e.g. 100,000) of the principal element, with any defaults being shared on a pari passu basis with the transferee. North Bank might then determine that it has retained some significant risks and rewards of ownership (the retained interest), but transferred others (e.g. significant prepayment risk relating to the fixed rate loans). North Bank then needs to consider whether it has retained control over the transferred portions (Step 8). In this case, it is assumed that the third party does not unilaterally have the practical ability to sell the assets without needing to impose additional restrictions on that transfer. In consequence, North Bank needs to consider Step 9. (Note that if the third party was able to sell the transferred assets without restriction, derecognition by North Bank would be appropriate.) Where substantially all the risks and rewards in the transferred components are neither transferred nor retained and the buyer is not able to sell those components (Step 8), the continuing involvement rules apply (Step 9). In such circumstances, if the modified terms set out above applied (the retention of an entitlement to 100,000 of the principal element with any defaults being shared on a pari passu basis with the transferee), in addition to recognising the balances set out in the case, North Bank would recognise an asset of 100,000 (its retained interest) and a liability of the same amount (the maximum amount of cash flows it would not receive) Derecognition of a financial liability Derecognition of a financial liability occurs when, and only when, it is extinguished, i.e. when the obligation specified in the contract is discharged, cancelled or expired. This condition is met when: 39.AG58 39.AG57 and AG59 the debtor discharges the liability by paying the creditor, normally with cash, other financial assets, goods or services; or the debtor is legally released from primary responsibility for the liability (or part thereof) either by process of law or by the creditor. The conditions are also met and a liability is derecognised when an entity repurchases its own bonds issued previously, irrespective of whether the entity intends to resell the bonds to other parties. This is consistent with the treatment of treasury shares reacquired by an entity, except that in the case of extinguishing a liability, a gain or loss may be recognised. It is not possible for an entity to extinguish a liability through an in-substance defeasance of its debt. In-substance defeasance occurs when an entity makes payments related to its obligations to a third party (typically a trust or similar vehicle), that then makes payments to the lender, without having legally assumed the responsibility for the liability and without the lender being part of the contractual arrangements relating to the third party vehicle and having rights thereto. However, the entity is not legally released from the obligation, Derecognition

51 39.AG60 and AG61 therefore derecognition of the liability would be inappropriate. An entity may arrange for a third party to assume the primary responsibility for the obligation for a fee while continuing to make the contractual payments on behalf of the third party. In addition, the creditor must also agree to accept the third party as the new primary obligor in order for the entity to derecognise its liability Certain transactions or modifications between borrowers and lenders may give rise to derecognition issues. If the borrower and lender exchange instruments with terms substantially different from the original transaction, derecognition of the old debt and recognition of a new debt instrument would result. Similarly, a substantial modification of the terms of an existing debt instrument should be accounted for as an extinguishment of the old debt. The circumstances of these modifications (such as due to financial difficulties of the borrower) are not relevant in determining whether the modification is an extinguishment of debt. 39.AG62 Terms are substantially different if the discounted present value of the cash flows under the new terms, including any fees paid (net of any fees received), is at least 10 per cent different from the discounted present value of the remaining cash flows of the original debt instrument. The discount rate to use for both calculations is not specifically addressed in the standard, therefore the entity may use either the effective interest rate under the old terms or under the new terms (applied consistently to both transactions). If an extinguishment does occur, any costs or fees incurred are recognised as a gain or loss immediately. If the exchange or modification is not accounted for as an extinguishment, costs and fees incurred are recognised as an adjustment to the carrying value of the liability and amortised over the remaining term of the modified instrument. The issue of exchange and modification of debt terms is illustrated by the following: Case 4.6 Modification of the terms of a loan On 1 January 20X1, Bank D grants a loan to Entity U of 200,000, with a contractual interest rate of eight per cent, which is the market interest rate at that time. The term of the loan is five years, with a maturity date of 31 December 20X5. On 31 December 20X4, Entity U negotiates with Bank D to extend the term of the loan by an additional two years so that the loan will mature on 31 December 20X7. The contractual interest rate is increased to 12 per cent for the remaining term to maturity, representing the current interest rate for Entity U, given the increase in market interest rates and the current credit standing of Entity U. No fees are paid or received. What accounting entries would Entity U record on 31 December 20X4? For accounting purposes, Entity U must assess whether the terms of the modified loan are substantially different from the original loan. Entity U calculates the present value of the modified loan of 220,617 by discounting the modified cash flows at the historical effective rate of eight per cent. The present value differs by more than 10 per cent from the present value of the original cash flows of the loan calculated on the same basis. Therefore, an extinguishment of debt has occurred and the original loan should be derecognised. 4.4 Derecognition 45

52 The accounting entries for Entity U would be as follows: Debit Credit 31 December 20X3 Original borrowing (at eight per cent) 200,000 Modified borrowing (at 12 per cent) 200,000 To record the extinguishment of the former liability and to record the new obligation The modified loan is recognised at its fair value, calculated at the current market interest rate, and the carrying value of the original loan is derecognised. No loss is recognised since the carrying amount of the loan equals the fair value of the modified loan, as both loans were originally issued at market interest rates. The only impact would be any fees incurred by Entity U, which would have to be expensed. Similar to a financial asset, when transferring (part of) a financial liability, parts of the financial liability could be retained and new financial instruments (either assets or liabilities) could be created. The accounting is similar to the accounting for derecognition of parts of financial assets with the creation of new instruments, as discussed in Section Special purpose entities and derecognition 39.AG51(f-h) Typical transactions In some instances transactions involving the transfer of financial instruments are conducted with special purpose entities (SPEs), set up with a specific intent, such as the securitisation of financial assets. Entities commonly use securitisations to monetise financial assets such as homogeneous consumer loans, credit card receivables, trade receivables or mortgage loans by selling newly created securities collateralised by these assets to investors. Securitisation of assets and sales to investors often occur through an SPE. An SPE generally will be a legal entity with limited activities, whose purpose is to hold the beneficial interests in securitised assets and to pass through monies earned on those assets to the investors in its securities. In a securitisation the transferring entity sells financial assets to the SPE in return for cash proceeds. Generally all of these steps occur simultaneously (i.e. transfer of financial assets, issuance of securities to investors and payment of proceeds to the transferor). Transfers to an SPE must meet the derecognition criteria described in this Section in order for the transferor to record a sale. In situations where all of the benefits of the assets are transferred to such an SPE, derecognition by the transferor is appropriate if there are no additional constraints imposed by the transferor. Such constraints would include options or forward agreements held by the transferor on the residual interests of the SPE. In situations where less than all of the benefits are transferred, for example, when a transferor retains the residual gains associated with the transferred assets or residual interests in the SPE, the determination is not so straightforward. The factors noted in Section must be considered for both the transferred assets and the residual interests in the SPE Special purpose entities and derecognition

53 In order to qualify for derecognition of, for example, loans where the transferor is also the servicer and has custody over the assets, the transferor should not have substantive benefits from reinvestment of the cash flows from the interest and principal payments. These should be transferred to the transferee or the SPE under the terms of the servicing agreement. 39.AG36 December 2003 amendments Under the amended standards, whether or not an SPE should be consolidated under SIC 12 (see Section below) is specifically required to be considered before analysing the transaction for derecognition under IAS 39. If an SPE is consolidated, then the transaction to be considered for derecognition at the group level is the possible transfer of assets by the group, including the SPE, to its beneficial interest holders. An SPE is unlikely to transfer legal rights to the cash flows from its assets to its investors. In many cases, therefore, the critical issue may be whether or not the cash flows from the assets, and only the cash flows from the assets, are passed through without material delay in an arrangement that meets the new pass-through requirements. Essentially, this requires that any cash flows arising from the assets are not retained by the group, instead being transferred either immediately or within a short period (no more than a matter of days) to the external beneficial interest holders. The group also needs to have no obligation to pay any amounts to the external beneficial interest holders unless equivalent amounts are collected from the original assets. However, this last requirement does not preclude the group from making short-term advances, with the right of full recovery of the amount lent plus accrued interest at market rates In cases where cash flows are reinvested by the SPE in new assets under a revolving structure, the pass-through requirements will not be met. In many other cases meeting the pass-through requirements will also be difficult to achieve and some arrangements may need to be restructured (e.g. those where the transferring entity has other than a fully proportionate share in the cash flows) Even in those cases where the pass-through test is met, it is likely that the SPE will have retained control of the transferred assets. Partial derecognition may then be appropriate under the continuing involvement approach in the amended standards. If the SPE is not consolidated, then the potential derecognition transaction is the transfer of assets by the originator into the SPE. However, given current structures, in the majority of cases it is unlikely that consolidation by the originator can be avoided Consolidation of special purpose entities 27.4 and 13 The issue of consolidation is an important consideration to entities that use SPEs. The general principles addressing consolidation are found in IAS 27. That standard requires consolidation based on control over an entity. 4.5 Special purpose entities and derecognition 47

54 SIC-12.3 The particular problem with applying IAS 27 to an SPE is that the typical control features discussed above may not be evident due to the entity s nature. Typically there is no substantive equity holder in the SPE, therefore consolidation based on voting powers is not meaningful. SPEs often have limited activities so that day-to-day financial and operating policies may be predetermined. In this case the SPE is set up to run virtually on autopilot from its inception. SIC 12, an interpretation of IAS 27, directly addresses these types of entities by providing guidance for when an entity should consolidate an SPE. Often the creator or sponsor of an SPE retains significant beneficial interest in the SPE s activities that would give it effective control of the SPE when applying SIC 12. Whereas IAS 39 takes a mixed approach of financial components and risks and rewards in addressing control over financial instruments or portions thereof, SIC 12 takes a pure risks and rewards approach when making the determination of control over an SPE. As discussed earlier in this Section, IAS 39 effectively requires there to be some substantive risk transfer to achieve derecognition, whereas SIC 12 indicates that a majority of risk should be transferred to avoid consolidation. Therefore, it is not uncommon for a transferor to derecognise transferred assets, but have to consolidate the SPE into which the assets are transferred. SIC SIC 12 notes several factors that may indicate that an entity has control over an SPE, and in effect, over the transferred assets as well. These are examples, meaning that other factors not specifically stated in SIC 12 may also indicate control. The examples are when, in substance: SIC-12.10(a) The activities of the SPE are on behalf of the entity where the entity obtains benefits from the SPE s operation. Commentary: This requires evaluating the SPE s purpose, its activities and what entity benefits most from them. An example is when the SPE is engaged in an activity that supports one entity s ongoing major or central operations. This factor is often difficult to evaluate as there may be more than one party that derives some benefits from an SPE. In that case, an evaluation of majority of benefits is necessary. SIC-12.10(b) The entity has decision-making powers to obtain the majority of the benefits of the activities of the SPE, or through an autopilot mechanism achieves the same effect. Commentary: An SPE being on autopilot does not necessarily mean that the sponsor or another entity must be in control. There must also be the objective of obtaining benefits from the SPE s activities. Likewise, an SPE being set up with limited ongoing decisions to be made does not automatically mean the entity has operational substance on its own. SIC-12.10(c) The entity has rights to obtain the majority of benefits of the SPE (and therefore may be exposed to risks incident to the SPE s activities). Commentary: This factor and the next (majority of risks) are often the most crucial to evaluate when determining if consolidation is necessary. Majority of should be interpreted as more than half. However, the benefits to be evaluated are not the gross cash flows of all of the assets in the SPE. Rather it is the residual benefits that are important. Residual benefits are the positive variability in net cash flows within a reasonably likely range of outcomes. For example, if there are reserves or equity that Special purpose entities and derecognition

55 would be distributed when the SPE is wound up, an entity entitled to the majority of this potential upside may be required to consolidate the SPE. SIC-12.10(d) The entity retains the majority of the residual or ownership risks related to the SPE or its assets in order to obtain benefits from its activities. Commentary: Along with analysing the majority of benefits, this factor is often decisive when determining consolidation. Again it is not gross cash flows but residual cash flow risks that are important. Similar to the above, residual risks are the negative variability in net cash flows within a reasonably likely range of outcomes. For example, if there are senior and subordinated cash flows in an SPE, the senior cash flows should be disregarded and the evaluation should focus on the subordinated cash flows and any equity (being real equity or some type of reserve). An entity with the majority of this exposure may be required to consolidate the SPE. The factors noted above should be analysed independently meaning that if an entity has any one of the four indicators above, it should consolidate the SPE. It would be inappropriate to conclude that because a situation does not encompass all four of the above factors, the entity does not need to consolidate the SPE. Retention of benefits or risks by a transferor may occur if the transferor keeps a subordinated position on the transferred assets or by taking subordinated notes issued by the SPE. This may also occur through put options granted to the SPE to take back defaulted or non-performing assets, or through other forms of guarantees, derivatives or insurancelike agreements. Securitisation transactions often have substantial guarantees or credit enhancements in order to receive a higher rating on the related securities issued by the SPE. These must be included in an entity s analysis of the risks and rewards that result from a transaction. When entering into transactions with an SPE, an entity must consider carefully: first, whether derecognition criteria in IAS 39 are met when transferring instruments to the SPE; and second, whether there are indicators that the entity has control over the SPE under SIC 12, and therefore should consolidate the entity. December 2003 amendments 39.AG36 As noted above, it is often the case under the existing standards that an entity could achieve derecognition for financial assets transferred into an SPE (by achieving some substantive transfer of risk), but that the SPE was then consolidated into the group financial statements under SIC 12. The IASB has addressed this apparent inconsistency in the amendments by requiring SIC 12 to be considered in the hierarchy of rules before the derecognition requirements of IAS 39. Therefore, for the purposes of the group financial statements, the consolidation issue is dealt with first. For the stand-alone financial statements of the transferor entity, SIC 12 is not a concern. The remainder of this discussion considers the position from the perspective of the consolidated financial statements. 4.5 Special purpose entities and derecognition 49

56 If the SPE is not consolidated, then the derecognition transaction to be considered under IAS 39 is the transfer of assets from the group to the SPE. If the SPE is consolidated, then the derecognition transaction to be analysed under IAS 39 is the transfer of rights from the group (including the SPE) to the external beneficial interestholders in the SPE. The discussion below sets out the evaluation procedure to be followed if the SPE is consolidated The first issue to consider is whether to perform the evaluation for assets in their entirety or for components of assets. In many common securitisation transactions, the asset transferred (see Step 2 in the analysis under Section above) will be neither specifically identified components of the assets nor a fully proportionate share of any component of the asset. This is because, typically, the group will retain an interest in the residual cash flows, so that the first (say) 90 per cent of cash flows pass outside the group and the last (say) 10 per cent are retained within the group. The asset considered for derecognition will be the entire portfolio of assets held by the SPE The next consideration is whether there is a transfer that might qualify for derecognition. In most cases, the legal rights to cash flows will not be passed to beneficial interest holders in the SPE. Therefore, it will be necessary to consider whether the SPE s obligation to pass the cash flows to the external beneficial interest holders meet the pass-through criteria. Some transactions may be structured so that all of the cash flows due to external beneficial interest holders are passed through without material delay. If so, a possible outcome, as long as substantive risks and rewards are also transferred, is that the assets of the (consolidated) SPE will be partly derecognised under the continuing involvement rules in the amended standards. In many cases it will be impossible to meet the pass-through requirements and no derecognition by the SPE will be possible. In some cases the group will retain an interest in an SPE not by retaining beneficial interests, but rather by providing credit risk guarantees to the external beneficial interest holders. Such arrangements will fail to meet the pass-through criteria because the guarantee creates an obligation on the part of the group to pay cash to the external beneficial interest holders under the guarantee if cash is not collected on the securitised assets. As under the existing standards, it is likely to be difficult to achieve off balance sheet treatment for securitisation transactions, although partial derecognition under a continuing involvement approach may, in a limited number of cases, be possible Special purpose entities and derecognition

57 5. Classification Key topics covered in this Section: Categories and classification of financial assets and financial liabilities Criteria for the held-to-maturity category 5.1 Overview IAS 39 establishes specific categories into which all financial assets and liabilities must be classified. The classification of financial instruments dictates how these assets and liabilities are subsequently measured in the financial statements of an entity. There are four categories of financial assets: trading, loans and receivables originated by the entity, held-to-maturity and available-for-sale. There are two categories of financial liabilities: trading liabilities and other financial liabilities. The assessment of which category financial assets and financial liabilities belong to should be performed in the same order as outlined in the discussion and figures below. Figure 5.1 Classification of financial assets and liabilities 5.1 Overview 51

58 5.2 Classification of financial assets Trading assets IAS 39 defines financial instruments, both assets and liabilities, held for trading as follows: 39.9 A financial asset or liability held for trading is one that was acquired or incurred principally for the purpose of generating a profit from short-term fluctuations in price or dealer s margin. A financial asset should be classified as held for trading if, regardless of why it was acquired, it is part of a portfolio for which there is evidence of a recent actual pattern of short-term profit-taking. Derivative financial assets and derivative financial liabilities are always deemed held for trading unless they are designated and effective hedging instruments and The intention to profit from short-term fluctuations in price or dealer s margin need not be IG B.11 explicitly stated by the entity. Other evidence may indicate that a financial asset is being held for trading purposes. Evidence of trading may be inferred based on the turnover and the average holding period of financial assets included in the portfolio. For instance, an entity may buy and sell shares for a specific portfolio, based on movements in those entities share prices. When this is done on a frequent basis, the entity has established a pattern of trading for the purpose of generating profits from fluctuations in price. Additional purchases of shares into this portfolio would also be designated as held for trading. IG B AG15 On the other hand, a fund manager of an investment portfolio might buy and sell investments in order to rebalance the portfolio in line with a fund s parameters. This activity would not necessarily require the investments to be classified as trading because the activity may not be related to generating profits from short-term fluctuations in prices. Furthermore, if an entity acquires a non-derivative financial asset with an intention to hold it for a long period irrespective of short-term fluctuations in price, such an instrument cannot be classified as held for trading. Financial assets for which there is the intent to sell in the short-term or evidence that they are expected to be resold in the near term should be classified as trading at the date of purchase. The standard does not define short-term. It also does not limit the period for which an instrument that is designated as being held-for-trading can be held. An entity should adopt a definition of short-term and apply a consistent approach to the definition used. When there is the intention of generating a profit from short-term fluctuations in price or dealer s margin the financial asset is appropriately classified as trading, even if the asset is not subsequently sold within a short period of time. To generate short-term profits, traders may actively trade an asset s risks rather than the asset itself. For example, a bank may invest in a 30-day money market instrument for the purpose of generating profit from short-term fluctuations in the interest rate. When the favourable movement in the interest rate occurs, instead of selling the instrument, the bank will issue an offsetting liability instrument. The 30-day money market instrument should be classified as held for trading in spite of the fact that there is no intention to physically sell the instrument. The offsetting liability instrument should be classified as trading as well because it was issued for trading purposes to earn arbitrage profits Classification of financial assets

59 In summary, financial assets held for trading include: financial assets acquired for the purpose of generating a profit from short-term fluctuations in price or dealer s margin; financial assets that are part of a portfolio of similar assets for which there is a recent actual pattern of short-term profit-taking; all derivative financial assets that are not designated and effective hedging instruments; and hybrid instruments that include an embedded derivative that cannot be separately measured but that otherwise would have been separated based on the criteria of IAS 39. December 2003 amendments 39.9 Under the amended standards an entity will have a free choice, on initial recognition (and on adoption of the revised standard) to designate any financial asset or financial liability as at fair value through profit or loss. The trading assets category has therefore been redefined to include both trading assets as defined above, and those assets that an entity has chosen to measure at fair value through profit or loss. Separate disclosure is required of the amounts included in the two sub-categories. One of the main benefits of the new category is that it may allow an entity, in some cases, to avoid the cost and complexity of meeting the criteria for hedge accounting (see Section 8.6). For example, an entity that purchases a fixed rate bond and immediately enters into an interest rate swap to convert the interest to floating rate might, instead of claiming hedge accounting, designate the bond as at fair value through profit or loss. Since both the bond and the swap will be measured at fair value through profit or loss, the offsetting effects of changes in market interest rates on the fair value of each instrument will be recognised in profit or loss without the need for hedge accounting. However, there are some important consequences of using the new designation for this purpose. In particular, the designation of an instrument as fair value through profit or loss may only be used on day one and is not reversible. This alternative to hedge accounting therefore cannot be used if an entity buys or issues an instrument and later wishes to put a hedge in place. It may also result in excessive earnings volatility if the hedge is put in place for only part of the life of the instrument, or if the entity s strategy will involve subsequent de-designation of some or all of the economic hedge it puts in place initially. Another likely use of the new designation is to avoid the need to measure separately the fair value of a separable embedded derivative, as described in Section 3. It might also be used to achieve consistent measurement of matching asset and liability positions. There is no requirement for consistency in the use of the fair value through income designation, meaning that an entity can choose which (if any) of its financial assets and liabilities are to be included in this category, although the amounts included in it must be disclosed. IASB Board meeting February 2004 As explained more fully in Section 1, the IASB is proposing to limit the use of the fair value through profit or loss option to four specific circumstances. 5.2 Classification of financial assets 53

60 5.2.2 Loans and receivables 39.9 IAS 39 defines loans and receivables originated by the entity as follows: Loans and receivables originated by the enterprise are financial assets that are created by the enterprise by providing money, goods, or services directly to a debtor, other than those that are originated with the intent to be sold immediately or in the short-term, which should be classified as held for trading. Loans and receivables originated by the enterprise are not included in held-to-maturity investments but, rather, are classified separately under this standard. Loans and receivables originated by the entity thus are financial assets: that have been directly provided by the lender to a respective borrower or that result from the sale of goods and services; and that are not trading instruments. IG B.22 Since the definition uses the words loans and receivables and debtor, equity instruments are excluded from this classification. Exceptions to this are certain types of shares that must be redeemed at a specified date, pay a fixed or determinable return and are in substance debt instruments. The holder can potentially classify such instruments as originated loans. The essential requirement of IAS 39 for loans and receivables originated by the entity is that the lender must contribute funds when the financial asset is first created. However, it is not necessary that the lender is involved in setting the terms of the contract, as may be the case in a syndication or participation. Loans and receivables originated by the entity, but intended to be resold for purposes of short-term profit-taking, should not be included in this category, but rather classified as financial assets held for trading. Loans and receivables originated by the entity may not be classified as held-to-maturity or available-for-sale. Any loans or receivables purchased by an entity (such as a loan or receivable resulting from a transfer of an existing financial instrument from one holder to another) cannot be accounted for as being originated by the entity. Case 5.1 Origination of a loan Entity M participates in a loan at the date of origination via an investment bank and plans to classify the loan as originated by the entity. Is this classification appropriate? This classification is appropriate as Entity M participates in the loan at its origination. The fact that there is an intermediary does not change the substance of the transaction. Had Entity M entered the participation even one day after its original issuance, it would not be considered as originated, but rather purchased from the investment bank. In that case classification as originated by the entity would not be appropriate, as Entity M would not be providing the funds directly to the debtor Classification of financial assets

61 December 2003 amendments 39.9 Under the amendments the requirement for loans to be originated by the entity is removed. The category is redefined simply as loans and receivables and therefore includes both purchased and originated loans. The main requirements for a financial asset to be classified as a loan or receivable is that it has fixed or determinable payments and is not a derivative. However, the revised definition excludes any instrument that is quoted in an active market. This means that a listed debt security cannot be classified within loans and receivables, even if it is acquired at original issuance by providing funds directly to the issuer. The amendments are designed to provide a solution to two issues raised by financial institutions. The first is that, under the existing standards, a bank could own two identical portfolios of loans, one originated and one purchased, and be required to account for each in a different way. The second is that a bank might own two portfolios of bonds, one purchased from the issuer on the date of issue, and therefore included in the originated loans category, and the other purchased in the market. Again, each is required, under the existing standards, to be accounted for differently. In addition, an entity has a free choice to classify any loan or receivable as availablefor-sale at initial recognition, or on adoption of the revised standard Held-to-maturity investments Held-to-maturity investments are defined as follows: 39.9 Held-to-maturity investments are financial assets with fixed or determinable payments and fixed maturity that an enterprise has the positive intent and ability to hold to maturity other than loans and receivables originated by the enterprise. Classification of instruments as held-to-maturity therefore depends on: the terms and characteristics of the financial asset; and the ability and actual intent of the entity to hold those instruments to maturity. 5.2 Classification of financial assets 55

62 Figure 5.2 Decision tree for reviewing the classification of assets as held-to-maturity 39.AG25 A prerequisite for the classification of a financial asset as held-to-maturity is the entity s intent and ability to actually hold that asset until maturity. An entity should assess its intent and ability to hold its held-to-maturity investments not only at initial acquisition but again at each balance sheet date. The potential benefit of using the held-to-maturity category is that the assets are carried at amortised cost. Generally this category would be used for fixed rate instruments whose fair values may change significantly in response to changes in interest rates. However, significant penalties exist for an entity that classifies an instrument as held-to-maturity, but sells the instrument before its maturity. These so-called tainting rules are discussed later in this Section Fixed maturity and determinable payments 39.9 Instruments classified as held-to-maturity must have a fixed maturity and fixed or determinable payments, meaning a contractual arrangement that defines both the amounts and dates of payments to the holder, such as interest and principal payments on debt. 39.AG17 39.AG17 Typical equity contracts (e.g. common shares) usually have an unlimited maturity and therefore cannot be held-to-maturity financial assets. Other types of equity securities (e.g. share options or warrants) cannot be held-to-maturity investments because the amounts the holder receives may vary in a manner that cannot be determined at the purchase of the contract. Exceptions to this are certain types of preference shares that must be redeemed at a specified date, pay a fixed or determinable return and are in substance debt instruments. Since held-to-maturity instruments should have a fixed maturity, it is mainly debt contracts that are classified as held-to-maturity. Nevertheless, even certain debt instruments may have an unlimited or unspecified maturity. For example, perpetual bonds that provide for interest payments for an indefinite period would not qualify as held-to-maturity instruments Classification of financial assets

63 A financial asset whose maturity is fixed still might not qualify as a held-to-maturity investment if its payments are not determinable. For example, profit-sharing rights do not have determinable payments, even though there may be an agreed term. The most obvious example of a financial instrument with determinable payments is a fixed rate bond, as both interest and principal payments are fixed. A floating rate interest asset also could qualify as a held-to-maturity investment since its payments are either fixed (the principal) or specified by reference to a market rate or benchmark rate. In many cases, however, there will be little advantage in using the held-to-maturity category for floating rate assets as their fair values will not change significantly in response to changes in market interest rates. Case 5.2 Held-to-maturity classification IG B.13 and Bank Q wants to categorise a bond issued by an oil company as held-to-maturity. B.14 The interest on the bond is indexed to the price of oil. Can Bank Q categorise this bond as held-to-maturity? 39.AG16 39.AG21 39.AG18, AG19 and 39.9 The fact that the return is dependent on the price of oil means that this bond includes an embedded derivative that is not closely related to the host contract. The embedded derivative and host contract should be separated, resulting in an embedded commodity contract to be measured at fair value and a host debt instrument. If Bank Q has the intent and ability to hold the host to maturity, it may categorise the bond as held-to-maturity Intent to hold to maturity If an entity only has the intent to hold an instrument for some period, but has not actually defined that period to be to maturity, the positive intent to hold to maturity does not exist. Likewise if the issuer has the right to settle the financial asset at an amount that is significantly below the carrying amount, and therefore is expected to exercise that right, the entity cannot demonstrate a positive intent to hold the asset until maturity. However, if the issuer may call the instrument at or above its carrying amount, this does not affect the investor s intent to hold the security until maturity. The demonstration of positive intent to hold an instrument to maturity would not be negated by a highly unusual and unlikely occurrence, such as a run on a bank or a similar situation, which could not be anticipated by the entity when deciding whether it has the positive intent (and ability) to hold an asset until maturity. An embedded option that may shorten the stated maturity of a debt instrument casts doubt on an entity s intent to hold a financial asset until maturity. Thus, the purchase of an instrument with a put feature is inconsistent with the positive intent to hold the asset until maturity. In the case of a call option held by the issuer, the holder should demonstrate that substantially all of the carrying amount would be recovered if the instrument were called before maturity to be able to classify the asset as held-to-maturity and A debt instrument with an equity conversion option generally cannot be classified as held- IG C.3 to-maturity. This is because payment for a right to convert would be inconsistent with an intention to hold to maturity, unless the conversion option is exercisable only at maturity. 5.2 Classification of financial assets 57

64 39.AG17 IG B.15 Also, the risk profile of a particular financial asset may raise similar questions on the intention. For example, the high risk and volatility of a mortgage-backed interest-only certificate makes active management of such strips more likely than holding these to maturity. The same reasoning may apply to debt instruments with high credit risk, for example, high yield (junk) bonds and subordinated bonds. A significant risk of non-payment of interest and principal on a bond is not in itself a consideration in qualifying for the heldto-maturity category as long as there is an intent and ability to hold the instrument until maturity. However, an entity would taint its held-to-maturity portfolio if it subsequently sold such a bond as a result of a credit rating downgrade that could have been foreseen. 39.AG Ability to hold to maturity An entity needs to demonstrate its ability to hold a financial asset to maturity to categorise it as such. The entity cannot demonstrate the ability if: financial resources are not available to the entity to finance the asset to maturity. For example, if it is expected or likely that an entity will acquire another business and will need all of its funding for this investment, the resources may not be available to continue to hold certain debt instruments; or legal or other constraints could frustrate the intention of the entity to hold the investment to maturity. An example is the expectation that a regulator will exercise its right in certain industries like the banking and insurance industry to force an entity to sell certain assets in the event of a credit risk change Tainting of the held-to-maturity portfolio 39.9 If an entity sells, transfers or exercises a put option on more than an insignificant amount of the portfolio of held-to-maturity financial assets, the entity may not classify any financial assets as held-to-maturity for a period of two financial years after the occurrence of this event. IAS 39 does not stipulate what is considered more than an insignificant amount, but rather this should be assessed by an entity any time a potential tainting situation arises. It is important to also consider the reasons for an entity s actions when determining if the portfolio has been tainted. Case 5.3 Tainting of held-to-maturity assets Entity T sells 1,000,000 of bonds from its held-to-maturity portfolio on 15 April 20X1. The fair value of the bonds has appreciated significantly over the carrying value and management decides that Entity T should realise the gains through a sale. In these circumstances, the action of selling investments from the held-to-maturity portfolio taints the entire portfolio and all remaining investments in that category must be reclassified. Entity T will be prohibited from classifying any assets as held-to-maturity for two full financial years. Assuming that Entity T s financial reporting year-end is 31 December, the entity cannot use the held-to-maturity classification for its assets until at least 1 January 20X Classification of financial assets

65 IG B The tainting rules are intended to test an entity s assertion that it intends and is able to hold an instrument until maturity. Tainting requires a reclassification of the total remaining held-to-maturity portfolio in the (consolidated) financial statements into either the trading or available-for-sale categories. Reclassifications of financial instruments are discussed in Section 6.5. The tainting requirements apply group-wide, so that a subsidiary that sells more than an insignificant amount from its held-to-maturity portfolio can preclude the entire group from using the held-to-maturity category. If an entity has various portfolios of held-tomaturity instruments, for example, by industry or by country of issuance, the sale or transfer of instruments from one of the portfolio taints all the other held-to-maturity portfolios of the entity. IG B.18 Selling securities classified as held-to-maturity under repurchase agreements does not constrain the entity s intent and ability to hold those financial assets until maturity, unless the entity does not expect to be able to maintain or recover access to those financial assets. For example, if an entity is expected to receive back other comparable securities, but not the securities lent, classification as held-to-maturity is not appropriate. In practice, entities are advised to consider carefully any plans for sales, transfers or exercises of put options before classifying an asset as held-to-maturity to avoid a forced reclassification of the whole portfolio. Many entities adopting IAS 39 have decided either not to use the held-to-maturity category or to use it only at the parent company level where the intention and ability can be properly tested for each transaction at the onset and ongoing Exceptions from tainting 39.9 There are a limited number of exceptions to the tainting rules. Firstly, the tainting rules do not apply if only an insignificant amount of held-to-maturity investments is sold or reclassified. The standard does not define what an insignificant amount means. Therefore, a judgement will be required in each particular situation. Any sale or reclassification should be a one-off event. If an entity periodically sells or transfers insignificant portions this may cast a doubt on the entity s intent and ability with regard to its held-to-maturity portfolio. In cases where the sales are not isolated, the amount sold or reclassified should be assessed on a cumulative basis in assessing whether the sales are insignificant. Sales or reclassifications do not result in tainting if they occur: very close to maturity or call exercise date; after substantially all of the original principal is already collected; or due to an isolated non-recurring event beyond the entity s control Sales of held-to-maturity investments close to maturity or call exercise date usually do not result in significant gains or losses, because the fair value and the amortised cost are both equal to the face value of the financial asset. Interest rate risk is substantially eliminated as a pricing factor at that point. 5.2 Classification of financial assets 59

66 39.9 Similarly, when almost the entire principal has been collected through scheduled payments or through prepayments, the remaining part would not be materially affected by changes in the interest rate and therefore the sale would not result in a significant gain or loss. IAS 39 does not define the phrase substantially all of the principal investment, however, when 90 per cent or more of the principal investment has been collected through scheduled payments or prepayments, a sale of the remaining principal would generally qualify for this exception In very rare instances, circumstances may arise that the entity could not have reasonably foreseen or anticipated. If, in such a situation, an entity has to sell held-to-maturity investments, the remaining portfolio is not tainted if the event leading to sales of investments is isolated and non-recurring. If the event is not isolated or is potentially recurring, and the entity anticipates further sales of held-to-maturity investments, this inevitably casts doubt IG B.16 on its ability to hold the remaining portfolio until maturity. Also, if the event could have been reasonably anticipated at the date the held-to-maturity classification was made the instrument should not have been classified as such. If an entity has control over or initiated the isolated or non-recurring event, for example, sales made after a change in senior management, this will also call into question the entity s intent to hold the remaining portfolio until maturity. 39.AG22 Situations that may not have been anticipated when instruments were included in the held-to-maturity category and would not question the entity s intent and ability to hold investments to maturity may result, for example, from: IG B.15 a significant deterioration in the creditworthiness of the issuer of the instrument that could not have been anticipated when the instrument was acquired; significant changes in tax laws, affecting specific investments in the portfolio; major business combinations or dispositions with consequences for the interest rate risk position and credit risk policies of an entity; or significant changes in statutory or regulatory requirements. IG B AG22(a) Deterioration in creditworthiness Although IAS 39 does not provide a definition of a significant deterioration of an issuer s creditworthiness, an example of this is a significant downgrade by a credit rating agency. Given the scarceness of external credit ratings for debt for borrowers outside the United States, downgrades as reflected in an entity s proprietary internal credit rating system may support the demonstration of significant deterioration. However, the initial quality of the asset must have been such that the deterioration could not have been reasonably foreseen. A credit downgrade of a notch within a class or from one rating class to an immediately lower rating class often could be considered reasonably anticipated. Therefore, a sale triggered by such a downgrading would result in tainting. Changes in tax laws A significant change in tax laws, such as the elimination or the significant reduction of the tax-exempt status of an investment that affects the investment specifically, may not cast doubt on the intention or ability of the entity with respect to the held-to-maturity category Classification of financial assets

67 If, for example, an entity has a captive finance company in a tax haven and, due to changes in tax laws that affect the whole group, intends to relocate its treasury activities and in that process liquidate part of the held-to-maturity portfolio in order to restore the interest rate risk position, the classification as held-to-maturity would not be violated, since the entity could not have foreseen the change in tax laws. The exemption regarding changes in tax laws is not always applicable. For example, an entity may have a history of entering into schemes for tax related purposes then subsequently reversing or terminating the transaction due to changes in tax laws. In this case it would not be acceptable to use the change in tax laws as an exception from tainting. A change in the applicable marginal tax rate for interest income is not sufficient justification for sales of held-to-maturity investments, since this change impacts all debt instruments held by the entity. IG B AG22 and IG B.16 Major business combination or disposition Although a major business combination or the sale of a significant segment of the entity is a controllable event, it may have a consequence on the entity s interest rate risk and credit risk positions. In such situations, sales that are necessary to maintain the entity s existing risk positions and that support proper risk management do not taint the held-tomaturity portfolio. Although sales subsequent to business combinations and segment disposals may not taint the held-to-maturity portfolio, sales of held-to-maturity investments prior to a business combination or disposal, or in response to an unsolicited tender offer, will cast doubt on the entity s intent to hold its remaining investments until maturity. Case 5.4 Held-to-maturity portfolio acquired in a business combination Bank Y has acquired Bank X. The new management wants to transfer some held-tomaturity securities of Bank X to available-for-sale securities because the management believes that the time to maturity of certain securities is too long and the held-tomaturity portfolio after the business combination is unreasonably large. At the date of the acquisition, Bank Y will have to classify the securities acquired as a result of the business combination applying corresponding rules in IAS 39 without regard to how these securities were classified by Bank X before the acquisition. Thus, if Bank X classified certain securities as held-to-maturity, but Bank Y does not have an ability and intent to hold these securities until maturity, Bank Y should not continue to treat these securities as held-to-maturity. The tainting rules would not be relevant in this case at the group level because there is no transfer on the group balance sheet. At the level of Bank X (which would be relevant if Bank X continues to prepare separate financial statements under IFRS) the transfers from the held-to-maturity portfolio would not be considered tainting if the transfers were necessitated by the business combination as a result of which the held-to-maturity portfolio of Bank X had to be brought in line with the policies of Bank Y. However, a business combination cannot be regarded as a possibility for transferring securities from the held-to-maturity portfolio that Bank Y had before the acquisition. 5.2 Classification of financial assets 61

68 For example, if as a result of the acquisition the business strategy of the group changed and Bank Y transferred some of its existing securities out of the held-to-maturity portfolio, such transfers would trigger tainting of the whole portfolio. A change in business strategy is not a valid reason for transferring securities out of the held-to-maturity portfolio. It would call into question the intent to hold the rest of the securities until maturity and would result in tainting. IG B.17 Changes in statutory or regulatory requirements Examples of changes in statutory or regulatory requirements that do not have tainting implications for the held-to-maturity portfolio are: changes either in the statutes or in regulations affecting the entity that modify what constitutes a permissible investment or the maximum level of certain types of investments. As a result the entity would need to sell (part of) these investments; and significant increases in capital requirements or in the risk weightings as a result of which the size of the held-to-maturity portfolio has to be decreased. The exceptions are intended to shield entities operating in regulated industries from potential tainting situations resulting from actions taken by the industry s regulator. These are actions applicable to the industry as a whole, and not to a specific entity. However, sales could occur in response to an entity-specific increase in capital requirements set by the industry s regulator. In that case it will be difficult to demonstrate that the regulator s action could not have been reasonably anticipated by the entity, unless the increase in entity-specific capital requirements represents a significant change in the regulator s policy for setting entity-specific capital requirements. December 2003 amendments 39.9 There are no significant changes in the amended standards with respect to the held-tomaturity classification Available-for-sale assets 39.9 Available-for-sale financial assets are assets that are not trading, held-to-maturity investments or originated loans or receivables. This is essentially a residual category for all of those financial assets that do not fit the criteria of the other categories. December 2003 amendments 39.9 The amended standards introduce a free choice, on initial recognition (and on adoption of the amendments), to classify any non-derivative financial asset as available-for-sale and, therefore, to measure it at fair value with fair value changes recognised in a separate category of equity. When an entity originates a loan, for example, then under the amended standards it will have a free choice to classify that loan as either: fair value through profit or loss; Classification of financial assets

69 available-for-sale (fair value through equity); or loans (measured at amortised cost). IASB Board meeting February 2004 As explained more fully in Section 1, the IASB is proposing to limit the use of the fair value through income option to exclude loans and receivables Categorising types of financial assets Certain types of financial assets may be eligible for inclusion in more than one category of financial assets, as noted in Table 5.1. Table 5.1 Types of financial assets Financial instrument Held for Originated by Held-to- Availabletrading the entity maturity for-sale Derivatives (not in a hedge relationship) Loans and receivables Bonds and notes (listed) Equity securities 5.3 Classification of financial liabilities Trading 39.9 A financial liability is categorised as held for trading if it is a trading instrument as described in Section dealing with trading assets. Except in the case of derivatives, this category is generally more applicable to financial institutions than to corporates due to the nature of their respective operations. 39.AG15 39.AG15 Liabilities held for trading include derivatives with a negative fair value, except those that are hedging instruments, and obligations to deliver securities borrowed by a short seller. A short seller is an entity that sells securities or another type of financial instruments that it does not yet hold, creating an obligation to deliver securities. Although only securities that are sold short are specifically mentioned as an example of liabilities that are classified as held for trading, this treatment is also appropriate for other non-derivative financial instruments sold short, as the definition of trading assets and liabilities relates to all financial instruments. A liability that is used to fund trading activities is not necessarily a trading instrument itself. Therefore, funding activities for trading portfolios would not be automatically classified as liabilities held for trading. 5.3 Classification of financial liabilities 63

70 December 2003 amendments 39.9 As with financial assets (see Section 5.2.1), an entity will have a free choice under the amended standards, on initial recognition and on first adopting the amendments, to classify any financial liability (including own borrowings) as fair value through profit or loss. The new designation may allow an entity, in some cases, to avoid the cost and complexity of meeting the criteria for hedge accounting (see Section 8.6). For example, an entity that issues a fixed rate bond and immediately enters into an interest rate swap to convert the interest to a floating rate might, instead of claiming hedge accounting, designate the bond as fair value through profit or loss. Since both the bond and the swap will be measured at fair value through profit or loss, the offsetting effects of changes in market interest rates on the fair value of each instrument will be recognised in profit or loss without the need for hedge accounting. However, there are some important consequences of using this designation (see Section 5.2.1). In addition to those considerations relating to financial assets, in the example above the bond will be remeasured, through profit or loss, not just for changes in market interest rates, but also for changes in the entity s own credit risk. For liabilities designated as fair value through profit or loss, separate disclosure is required of the amount of the change in fair value that is attributable to changes in the benchmark interest rate. IASB Board meeting February 2004 As explained more fully in Section 1, the IASB is proposing to limit the use of the fair value through income option to four specific circumstances Other liabilities Other liabilities constitute the residual category similar to the available-for-sale category of financial assets. All liabilities other than trading liabilities and derivatives that are hedging instruments automatically fall into this category. Common examples are an entity s trade payables, borrowings and customer deposit accounts Classification of financial liabilities

71 6. Subsequent measurement Key topics covered in this Section: Subsequent measurement Fair value Amortised cost Foreign currency transactions Impairment issues Reclassifications and transfers between portfolios Deferred tax assets and liabilities Abbreviations used in this Section: MC = measurement currency; FC = foreign currency 6.1 Overview The measurement approach to be applied under IAS 39 depends upon the classification of an instrument into one of the four categories of financial assets or one of the two categories of financial liabilities discussed in Section 5. Initially all financial instruments are recognised at cost, which is the fair value of the consideration given or received. Subsequently: derivatives are always measured at fair value; all other financial assets are measured at fair value, except for loans and receivables originated by the entity and held-to-maturity assets, which are measured at amortised cost. Financial assets held for trading and available-for-sale are measured at fair value in the balance sheet with changes in the fair value included in the income statement or, for available-for-sale instruments, with changes in the fair value included in either the income statement or as a separate component of equity; and financial liabilities are measured at amortised cost, except for those instruments that are held for trading, which are measured at fair value with changes in fair value included in the income statement. It is presumed that fair value can be reliably measured for most financial assets. When the fair value of an instrument cannot be reliably measured, the instrument is stated at cost. The concepts of fair value and amortised cost, including use of the effective interest method, are discussed in Section Overview 65

72 December 2003 amendments 39.9 As explained in Section 5, the amended standards will introduce a free choice, on initial recognition of a financial asset or financial liability, to classify the instrument either as fair value through profit or loss or as available-for-sale. In addition, the originated loans category is extended to cover also purchased loans, and at the same time narrowed to exclude instruments that are quoted in an active market Generally, although the classification of instruments between categories (and therefore the measurement basis applied) may change significantly under the amended standards, the measurement of amounts in each category, on initial recognition and subsequently, will not change. The exception is that the amendments remove the policy choice for an entity to measure available-for-sale financial assets at fair value with fair value changes recognised in profit or loss. This policy choice is considered unnecessary because of the fair value through profit or loss election that is now available on an instrument-by-instrument basis. One consequence, however, is that an entity wishing to measure its available-forsale financial assets at fair value through profit or loss will need to put in place a system to ensure that each is designated as such on the date of purchase or origination , Additional guidance is provided on how fair value is to be determined. A mandatory 39.AG69-AG82 hierarchy has been introduced, with a quoted price in an active market being applied first, followed by the price obtained in a similar market transaction (where there is no direct market price), with valuation techniques being applied where there is no active market. However, where a market is inactive, the value obtained through the use of valuation techniques should be tested and validated by comparing it to recent market transactions for similar items. The use of valuation techniques and models may not be used to override an observable market price. Where market prices are used, bid and offer prices are to be used, as appropriate with mid prices being used only where there are matching asset and liability positions. Extensive disclosures are required about how fair values are determined, including the methods and significant assumptions applied, the extent to which market prices and valuation models have been applied in determining fair values and the total change in fair value recognised in profit or loss that is derived from the use of valuation models. The amended standards also provide new guidance on how to measure amortised cost using the effective yield method. It is clarified that transaction costs, fees, discounts and premiums are generally amortised over the expected life of an instrument. For a group of prepayable mortgage loans, for example, any discount, transaction costs and related fees would be amortised over a period shorter than the contractual maturity. Historical prepayment patterns would be used to estimate expected lives. Revised prepayment estimates will give rise to gains and losses in the income statement. Where the classification of a financial asset or financial liability results in it being measured at fair value through profit or loss, transaction costs are taken to profit or loss on initial recognition. IASB Board meeting February 2004 As explained more fully in Section 1, the IASB is proposing to limit the use of the fair value through income option to four specific circumstances Overview

73 Figure 6.1 Measurement of financial instruments 6.2 Classification determines subsequent measurement Trading assets and liabilities and 47 Financial assets and liabilities held for trading, including derivatives, are measured at fair value. Transaction costs that will be incurred upon sale or disposal of a financial asset are not deducted from the measurement. Changes in the fair value of financial assets and liabilities held for trading (including derivatives) are recognised in the income statement. Fair value of these financial instruments should be reliably measurable. In respect of nonderivative financial instruments classified as held for trading, if fair value is not considered to be reliably measurable, it is questionable whether such an instrument should be included in the trading portfolio. A lack of a reliably measurable fair value could indicate that there is no possibility for trading with the intent of short-term profit-taking Loans and receivables originated by the entity Subsequent measurement of loans and receivables originated by the entity is at amortised cost Loans and receivables originated by the entity that have a fixed maturity should be measured at amortised cost using the effective interest rate method. The fair value of the loan at the date of acquisition is its cost. Any difference between cost and the amount repayable at maturity is recognised as interest income over the remaining period to maturity. The amortised cost method of accounting is further discussed in Section IG B.24 Loans and receivables originated by the entity that do not have a fixed maturity (e.g. perpetual floating rate loans) should be measured at cost. Because there are no repayments of principal, there is no amortisation of a difference between the initial amount 6.2 Classification determines subsequent measurement 67

74 39.AG79 and AG84 and a maturity amount. Also, short-duration receivables with no stated interest rate may be measured at original invoice amount unless the effect of imputing interest would be significant (e.g. in high-inflation countries) Held-to-maturity Held-to-maturity assets, like loans and receivables originated by the entity with a fixed maturity, should be measured at amortised cost using the effective interest rate method Available-for-sale Available-for-sale financial assets are measured at fair value on the balance sheet. There is an exception from measurement at fair value of an available-for-sale asset if its fair value cannot be reliably measured. This exemption only applies to unlisted equity instruments or derivative contracts based on those instruments where there is insufficient history of profits or cash flows to support a reliable fair value measurement. The exemption would apply mainly to start-up entities Fair value changes may either be: included in income, which is a similar treatment to the subsequent measurement of financial assets held for trading; or recognised directly in equity through the statement of changes in equity. When changes in fair value are recognised directly in equity, such amounts are recycled to the income statement upon sale, disposal or impairment of the asset. For a partial disposal, a proportional share of the fair value gains and losses previously recognised in equity must be recycled to the income statement. Such gains and losses must include all fair value changes up to the date of disposal (b) 32.94(h) The subsequent measurement of available-for-sale debt instruments with fair value changes recognised directly in equity is complicated by the fact that interest income is recognised in the income statement each period. The basis for recording interest income is the historical effective interest rate. For the correct measurement of the debt instrument, the clean price of the instrument (i.e. the fair value of the debt instrument excluding accrued interest) should be compared with the amortised cost of the debt instrument at the measurement date, also excluding accrued interest. Therefore, even though the debt instrument is measured at fair value, the holder must apply the effective interest method and calculate the amortised cost of the instrument to determine interest income. December 2003 amendments As noted above, the fair value through income policy choice for available-for-sale financial assets is not available under the amended standards Classification determines subsequent measurement

75 6.2.5 In summary Subsequent measurement of financial instruments is summarised in Figure 6.1. Figure 6.1 Classification of financial assets and liabilities determines the measurement 6.3 Valuation issues Fair value General considerations 39.9, and Fair value is defined as the amount for which an asset could be exchanged, or a liability IG E.1.1 settled, between knowledgeable and willing parties in an arm s length transaction. Fair value does not take into consideration transaction costs expected to be incurred on transfer or disposal of a financial instrument. 39.AG69 39.AG80 and AG81 Underlying the concept of fair value is the presumption that the entity is a going concern, and does not have an intention or a need to liquidate instruments, nor undertake a transaction on adverse terms. Therefore, fair value normally is not an amount that an entity would receive or pay in a forced transaction, involuntary liquidation or distress sale. The fair value of a financial instrument should be reliably measurable. If an entity cannot obtain an exact fair value, it instead may determine a range of reasonable fair value estimates. The variability within the range should not be significant and the probabilities of various estimates within the range should be estimable. 6.3 Valuation issues 69

76 Sources of fair value Fair values may be obtained from various sources, such as: an active public market that makes available a published market price quotation (e.g. an equity security listed on a well-developed stock market where quoted prices are readily and regularly available from an exchange, dealer, broker, industry group, pricing service or regulatory agency); 39.AG72 and by reference to prices available from recent transactions or for similar instruments AG74 (e.g. making reference to a debt instrument that is rated by an independent rating agency and whose cash flows can be reasonably estimated and discounted based on market rates for estimating the fair value of another bond); and 39.AG74-76 appropriate valuation models with data inputs that can be measured reliably because such data is available from active markets (e.g. valuing an interest rate swap through discounting cash flows based on the contractual terms and rates obtained from published sources). 39.AG71 and AG72 IG E AG74, AG79 and IG E.2.2 The methods used to determine fair value should be consistently applied during and between reporting periods for similar types of instruments. For a financial asset held or a financial liability to be issued, the appropriate quoted market price is usually the current bid price. For a financial asset to be acquired or a financial liability held, the appropriate quoted market price is usually the current offer or asking price. When an entity has matching asset and liability positions, it may use mid-market prices as a basis for establishing fair values. It is presumed that such matching positions would be settled within a similar time period. An entity may not depart from using bid and ask / offer prices in order to comply with regulatory requirements. Quoted market prices may not be indicative of the fair value of an instrument if the activity in the market is infrequent, the market is not well-established or only small volumes are traded relative to the number of units of the financial instrument outstanding. Adjustments to the quoted price may be possible only if an entity can present objective, reliable evidence validating a higher or lower amount. For example, if an entity entered into a contract with a third party to sell the shares at a fixed price in the immediate future, that might justify an adjustment to the quoted price. However, it would be generally inappropriate to make adjustments when valuing large holdings. For example, an entity cannot depart from the quoted market price solely because independent estimates indicate that the entity would obtain a higher or lower price by selling the holding as a block. Where an active, liquid, well-established market does not exist for a particular financial instrument, estimation methods and valuation models may be used to calculate fair value, providing that they are sufficiently reliable and the inputs are based on market data. Estimation methods that may be used include: methods based on the valuation of quoted instruments that are substantially the same as the instruments being valued; discounted cash flows calculations; and option pricing models Valuation issues

77 As mentioned above, valuation models based on data inputs that are reliably measurable can be used as a method of valuation when published market prices for instruments are not available. This would be the case for an interest rate swap (IRS). The following case demonstrates a basic fair value calculation for an IRS. Case 6.1 Determining the fair value of an interest rate swap On 1 January 20X1, XYZ Co. enters into an IRS with a notional value of 100 million. The terms of the IRS are to pay a fixed rate of six per cent and receive a variable rate of six-month LIBOR. The IRS has a maturity of five years and settlement of net cash flows is done semi-annually. At inception the fair value of the IRS is zero. At 30 June 20X1, interest rates have increased. The increase in interest rates changes the cash flows of the variable leg of the swap. The variable interest rate for the period from 1 July 20X1 to 31 December 20X1 is set at 6.7 per cent. In order to determine the fair value of the IRS at 30 June 20X1, XYZ Co. performs a discounted cash flow calculation. Fixed leg of the IRS Discounting of the fixed leg of cash flows is performed on the remaining nine fixed rate payments that will occur every six months from 31 December 20X1 to 31 December 20X5. These cash flows are three million every six months, based on the agreed fixed rate of six per cent (the annual fixed rate on the IRS). The discount rate to be used is the applicable LIBOR theoretical spot rate calculated from Euro futures or swap quotes. For the purpose of this example, the same effective rate is used throughout the term of the transaction for discounting cash flows. In an actual situation, however, the yield curve usually would not be flat. The future fixed rate cash flows and the related present value at 30 June 20X1 are as follows: Present value Settlement date Cash flows of cash flows 31 December 20X1 (3,000,000) (2,902,758) 30 June 20X2 (3,000,000) (2,808,667) 31 December 20X2 (3,000,000) (2,717,627) 30 June 20X3 (3,000,000) (2,629,537) 31 December 20X3 (3,000,000) (2,544,303) 30 June 20X4 (3,000,000) (2,461,832) 31 December 20X4 (3,000,000) (2,382,034) 30 June 20X5 (3,000,000) (2,304,822) 31 December 20X5 (103,000,000) (76,567,223) Total discounted cash flows (97,318,803) 6.3 Valuation issues 71

78 Variable leg of the IRS The variable rate receipts are calculated using the LIBOR forward rates. The discount rate is the same rate used to discount fixed rate payments. Generally, at the repricing date the present value of the variable leg will be par unless there is a change in the credit spread which is not factored into the repriced interest rate. However, if the valuation is made between repricing dates, the value of the variable leg may be different from its par value because its fair value will be subject to the short-term interest rates fluctuation until the next repricing date. Fair value of the IRS To determine the fair value of the IRS, the present value of the fixed rate payments obligation of 97,318,803 is netted against the present value of the variable rate receipts of 100 million: Cash flows Present value Receipts based on variable rates 100,000,000 Payments based on fixed rates (97,318,803) Net 2,681,197 December 2003 amendments 39.48, The amended standards provide much clearer guidance on how an entity might go 39.AG69-82 about measuring fair value, particularly for an instrument that is not traded in an active market. The main features of the enhanced guidance are: the objective is stated as being to establish what a transaction price would have been on the measurement date in an arm s length exchange motivated by normal business considerations. Any valuation technique must be developed with that aim in mind; to require that a valuation technique should incorporate all factors that market participants would consider and be consistent with accepted economic methodologies; a hierarchy for the approach to apply in determining a fair value. The first step is to use a market value. Thereafter market prices for similar instruments and valuation models are given equal prominence in the hierarchy of techniques; to clarify that the fair value of a transaction on the date of the transaction is the market price unless fair value is evidenced by other observable market transactions or is based on a valuation technique based only on market data. In other words, a valuation model may not be used to recognise a profit or loss on initial recognition unless the model uses only market data. Market data can include historical data as long as the entity can demonstrate that the result from the model provides a more reliable estimate of fair value than the transaction price; the maximum possible use should be made of market inputs; Valuation issues

79 if an entity operates in more than one active market, the price at the balance sheet date for the instrument (without repackaging or modification) in the most advantageous market to which the entity has access should be used as fair value; and it is clarified that the appropriate market price for an asset held or liability to be issued is normally the current bid price and for an asset to be acquired or liability held the asking price. An exception to this is where an entity has assets and liabilities with offsetting market risks, in which case the mid prices can be used for the offsetting risk positions; bid and asking prices are applied to the net open position as appropriate. The standards also clarify that the fair value of a liability that is repayable on demand is not less than the present value of the amount repayable on demand, discounted from the first date at which the investor could require repayment. 39.AG When is fair value not reliably measurable? IAS 39 has a presumption that fair value can be reliably determined for most financial assets. There is only one exception noted, which is for an investment in an equity instrument that does not have a quoted market price in an active market and for which other methods of reasonably estimating fair value are clearly inappropriate or unworkable. This exception includes derivatives that are linked to, and that must be settled by, delivery of such an unquoted equity instrument, and applies to both trading and available-for-sale instruments. There may also be situations in which the fair value of such instruments can be estimated. If an entity estimates the value of a financial instrument, it should use a supportable methodology rather than arbitrarily choose a fair value within a range of reasonable estimates , 66 and If the fair value cannot be reliably measured, the instruments should be stated at cost until AG81 a fair value can be reliably established. These instruments are subject to normal impairment recognition requirements In rare circumstances, it may be the case that fair value is no longer reliably measurable for a financial instrument that has been measured at fair value. In that situation the last reliably estimated fair value becomes the new cost basis. A previous gain or loss on that asset that has been recognised directly in equity should be left in equity until the financial asset has been sold or otherwise disposed of, at which time it should be recognised in the income statement. IG C.11 If an embedded derivative that is required to be separated cannot be reliably measured, the entire combined contract should be treated as a financial instrument held for trading. The entity might conclude, however, that the equity component of the combined instrument may be sufficiently significant to preclude it from obtaining a reliable estimate of the entire instrument. In that case, the combined instrument is measured at cost less impairment If a reliable fair value subsequently becomes available, the difference between cost and the fair value at that time should be: recognised in the income statement if the instrument is held for trading; or accounted for in accordance with the entity s accounting policy for available-for-sale securities if the instrument is not held for trading (i.e. recognised in the income statement or directly in equity). 6.3 Valuation issues 73

80 6.3.2 Amortised cost General considerations Amortised cost applies to both financial assets and financial liabilities. The effective interest rate method should be used for amortising premiums, discounts and transaction costs for both financial assets and liabilities The amortised cost of a financial asset or financial liability is the amount at which the financial asset or liability was measured at initial recognition minus principal repayments, plus or minus the cumulative amortisation of any difference between that initial amount and the maturity amount, and minus any write-down (directly or through the use of an allowance account) for impairment or uncollectability Fixed rate instruments 39.9 The effective interest method is a method of calculating amortisation or accretion using the effective interest rate of an interest-bearing financial asset or liability. The effective interest rate (or internal rate of return) is the rate that exactly discounts the expected stream of future cash payments through maturity or the next market-based repricing date to the current net carrying amount of the financial asset or financial liability. That computation should include all fees and points paid or received between parties to the contract. IG B.27 Sometimes entities purchase or issue debt instruments with a predetermined rate of interest that increases or decreases progressively (i.e. stepped interest) over the term of the debt instrument. In this case, the entity should use the effective interest method to allocate interest income or expense over the term of the debt instrument to achieve a level yield to maturity, that is a constant interest rate on the carrying amount of the instrument in each reporting period. 39.AG Floating rate financial instruments Calculating the effective interest rate and amortised cost is different for floating rate financial instruments that have been acquired or issued at a discount or premium. The periodic re-estimation of determinable cash flows to reflect movements in market rates of interest will change the instrument s effective yield. Whether the discount, premium or transaction costs are recognised in the income statement over the remaining term of the instrument or over the remaining term to the next repricing date depends on the reason for the existence of the premium or discount. The period to next interest repricing date is used when a discount or premium results because interest payments are in arrears, have accrued since the most recent interest payment date or market rates of interest have changed since the debt instrument was most recently repriced. For example, an investor purchases directly from the issuer a five-year floating rate note paying three-month LIBOR at a discount to reflect the difference between the variable rate set one month before at four per cent and the current yield of five per cent. In this case the amortisation period should be the period until the next repricing. 74

81 The remaining term of the instrument is used in a situation when the discount or premium arises because the credit spread required by the market for the instrument is higher or lower than the credit spread that is implicit in the variable rate. For example, if a five-year floating rate note paying three-month LIBOR trades at a discount due to deterioration in the credit quality of the issuer subsequent to the issuance of the note, the amortisation period should be to the maturity of the instrument and not to the next repricing date because the repricing will not reflect the change in the credit spread. The remaining term of the instrument is also used for amortisation of transaction costs. IAS 39 does not prescribe any specific methodology about how transaction costs should be amortised for a floating rate loan. Any methodology that would establish a reasonable basis for amortisation of the transaction costs may be used. For example, it would be reasonable to determine an amortisation schedule of the transaction costs based on the interest rate in effect at inception ignoring subsequent changes in the interest rate. December 2003 amendments 39.9 The amendments clarify that it is the expected and not the contractual cash flows that should be used to determine the effective yield on an instrument. For example, for a portfolio of prepayable mortgage loans, an entity would need to estimate prepayment patterns based on historical data and build the cash flows arising on early settlements into the effective yield calculations. The impact will be to amortise any initial discounts or transaction costs over the period to expected maturity rather than over the period to the contractual maturity of the loans (where the expected period to maturity is shorter than the contractual maturity). Contractual cash flows would be used only in the rare cases where expected cash flows cannot be estimated reliably. If there is a change in estimated future cash flows (other than due to impairment), the carrying amount of the instrument is adjusted in the period of change with a corresponding gain or loss being recognised in the income statement. The revised carrying amount should equal the amount that would have been recognised if the change in estimate had been known from the outset (cumulative catch up approach). Note that the use of expected cash flows specifically excludes the effect of expected future credit losses. The amortised cost calculation cannot therefore be used to remove credit spread from interest income to cover future losses. In the examples below, the calculations under the revised standard are likely to be the same as those illustrated. 6.3 Valuation issues 75

82 Case 6.2 Calculation of (amortised) cost An entity purchases a government-issued treasury note with a 100,000 notional amount, six per cent coupon rate, and maturity in five years for a discounted purchase price of 95,900. The market rate at the time of issuance (i.e. effective interest rate) is seven per cent. Using the effective interest rate method, the fair value of the treasury note at the beginning of year one is calculated as follows: Discount Present value Year Cash flows factor of cash flows 1 6,000 (1.07) 5, ,000 (1.07) 2 5, ,000 (1.07) 3 4, ,000 (1.07) 4 4, ,000 (1.07) 5 75,577 Amortised cost at beginning of year one 95,900 The effective interest rate of seven per cent is used to calculate the amortised cost of the treasury note at the beginning of year two as follows: Discount Present value Year Cash flows factor of cash flows 2 6,000 (1.07) 5, ,000 (1.07) 2 5, ,000 (1.07) 3 4, ,000 (1.07) 4 80,867 Amortised cost at beginning of year two 96,613 The interest income recorded in the income statement in year one is 6,713 (being 6,000 interest coupon plus 713 related to amortisation of the discount at the beginning of year). The total interest income is seven per cent of the opening balance of 95,900. Case 6.3 Effective interest rate calculation On 1 January 20X1, Bank Y grants a five-year loan of 50 million to Entity Z with an annual coupon of 10 per cent. The issue price of the loan is 98 per cent of the redemption value. Bank Y classifies the loan as originated by the entity. How should Bank Y account for the interest and the amortisation of the loan at 31 December assuming annual compounding? To calculate the amortised cost, the effective interest rate should be determined first. Based on the cash flows of the loan, the effective yield is per cent (rounded to per cent herein) Valuation issues

83 The amortisation schedule is as follows: Amortised Interest income Date cost Coupon Amortisation (at 10.53%) 1 January 20X1 49,000, December 20X1 49,162,063 5,000, ,063 5,162, December 20X2 49,341,199 5,000, ,136 5,179, December 20X3 49,539,207 5,000, ,008 5,198, December 20X4 49,758,075 5,000, ,868 5,218, December 20X5 50,000,000 5,000, ,925 5,241,925 Total 25,000,000 1,000,000 26,000,000 To calculate the effective interest income, the effective interest rate is applied to the amortised cost of the loan at the end of the previous reporting period. The difference between the calculated effective interest for a given reporting period and the asset s coupon is the amortisation of the discount during that reporting period. Thus the amortised cost of the loan at the end of the previous reporting period plus amortisation in the current reporting period gives the amortised cost at the end of the current reporting period. The journal entries for recording the loan and the interest income are as follows: Debit Credit 1 January 20X1 Loan receivable (notional) 50,000,000 Loan receivable (discount) 1,000,000 Cash 49,000,000 To record the loan On the balance sheet, the loan receivable is presented net of the discount amount (i.e. 49 million). Debit Credit 31 December 20X1 Accrued interest receivable 5,000,000 Loan receivable (discount) 162,063 Interest income 5,162,063 To record the effective interest income on the loan at 31 December At maturity the discount will be completely amortised and the carrying amount is equal to the face value of the loan. Contrary to straight-line amortisation, which was used often in practice prior to IAS 39, the amortisation is not constant at 200,000 (1,000,000 divided by five years). The amortised amount increases each reporting period as the carrying amount of the loan increases. Interest income may be calculated on a daily, monthly or quarterly basis, depending on the reporting frequency of the entity. Figure 6.2 demonstrates the impact of amortising the discount using the straight-line method and using the effective interest method. 6.3 Valuation issues 77

84 Figure 6.2 Straight-line versus effective interest method Foreign currency transactions General considerations Entities may have exposure to foreign currency risk, either from transactions in foreign currencies or from investments in foreign operations. Accounting for changes in foreign exchange rates is covered by IAS 21, which includes the accounting for: transactions in foreign currencies; and translation of the financial statements of foreign operations that are included in the financial statements of the entity by consolidation, proportionate consolidation or use of the equity method. The measurement principles of IAS 39 generally do not affect these rules, but merely refer to and supplement the requirements in IAS 21, most notably in the area of hedge accounting where IAS 21 has very limited provisions. This Section deals with interactions between IAS 39 and IAS 21 when measuring financial instruments denominated in a foreign currency. Hedging of foreign currency exposures is covered in Sections 8 and Recording foreign currency transactions All transactions in currencies other than the functional currency of the entity must be initially recognised using the spot rate at the date of the transaction. The spot rate is determined as the price of a foreign currency purchased or sold with immediate delivery (for practical reasons immediate is often agreed to be two days after the transaction date) Valuation issues

85 18.30(a) Interest amounts, amortisation of premiums and discounts and impairment losses in foreign currency are recognised in the income statement as they accrue and are translated at the foreign exchange rate at the date of accrual. Impairment losses in a foreign currency are recognised in the income statement when they are incurred and are translated at the spot rate at that date. Normally it would be acceptable to calculate amortisation and interest amounts on a monthly basis and translate those amounts at an average foreign exchange rate. However, when foreign exchange rates fluctuate significantly it may be necessary to translate foreign currency interest and amortisation amounts more frequently (c) Dividends should be recognised in income when the shareholder s right to receive payment is established. This is generally at the time of declaration. Therefore, the foreign exchange rate used should be the foreign exchange rate at that date Subsequent reporting of foreign currency trading instruments Non-derivative instruments that are held for trading purposes and all derivatives are measured at fair value in the foreign currency. This value is then translated into the functional currency at the foreign exchange rate at the reporting rate. Gains and losses recognised in the income statement include the effect of changes in foreign exchange rates Subsequent reporting of other foreign currency financial instruments Monetary financial instruments 21.8 Monetary items are money held and assets and liabilities to be received or paid in fixed or determinable amounts of money. This definition is narrower than the definition of a financial instrument, which implies that not all financial instruments are monetary. Consequently, contractual rights / obligations to receive / pay cash where the amount of money is not fixed nor determinable are nonmonetary financial instruments. This is the case, for example, with equity shares where the holder has no right to a determinable amount of money and Derivative contracts are settled at amounts which are determinable at the settlement 39.AG83 date in accordance with the terms of the contract and the price of the underlying. All derivatives that are settled in cash are monetary items, even if the underlying is a nonmonetary item At subsequent balance sheet dates, all monetary items in foreign currencies are translated at the closing spot rates with any gains or losses resulting from changes in the foreign exchange rates included in net income. All exchange differences on translation of monetary items should be recognised in the income statement in the period in which they arise. The example below demonstrates the accounting for monetary financial instruments measured at amortised cost and fair value. 6.3 Valuation issues 79

86 Case 6.4 Measurement of monetary financial instruments denominated in a foreign currency Foreign currency loan At 1 January 20X1, an entity originates a loan of foreign currency (FC) 150 million with an eight per cent fixed rate of interest and measures the loan at amortised cost. The loan is at par and matures on 31 December 20X4. At 1 January 20X1, the spot rate is 1.5, therefore, the entity records an asset of measurement currency (MC) 100 million. The cash flows are discounted at the original effective interest rate, in conformity with measurement at amortised cost. The carrying values at 1 January and at 31 December 20X1, when the spot rate has increased to 1.6, are presented below: Cash flows at 1 January 31 December 20X1 20X1 Present value Present value (amounts in FC) Cash flows of cash flows Cash flows of cash flows 31 December 20X1 12,000,000 11,111, December 20X2 12,000,000 10,288,066 12,000,000 11,111, December 20X3 12,000,000 9,525,987 12,000,000 10,288, December 20X4 162,000, ,074, ,000, ,600,823 Carrying value in FC 150,000, ,000,000 Carrying value in MC (at a spot rate of 1.5 and 1.6, respectively) 100,000,000 93,750,000 The foreign exchange rate difference based on changes in the spot rate amounts to MC 6,250,000 and is recognised in the income statement. Foreign currency debt security At 1 January 20X1, an entity purchases a debt security of foreign currency (FC) 150 million with an eight per cent fixed rate of interest. The entity classifies the security as available-for-sale and measures the security at fair value. The entity records fair value changes on available-for-sale securities in equity. The security is purchased at par and matures on 31 December 20X4. At 1 January 20X1, the spot rate is 1.5, therefore, the entity records an asset of measurement currency (MC) 100 million. At 31 December 20X2, the interest rates decreased so that the fair value of the security became FC 150,100,000. The spot rate at 31 December 20X1 has increased to 1.6. The total fair value change in the measurement currency is calculated as follows: Date Spot rate Fair value Fair value (in FC) (in MC) 1 January 20X ,000, ,000, December 20X ,100,000 93,812,500 Fair value change 100,000 (6,187,500) Valuation issues

87 IG E.3.2 The entity has to distinguish between: changes in fair value due to changes in interest rates (and credit spread, if applicable) which are to be included in equity; and changes in fair value due to changes in the foreign exchange rate which must be recognised in the income statement. In order to determine the fair value changes related to foreign exchange changes to be recognised in the income statement, the instrument is treated as an asset measured at amortised cost in the foreign currency. The amortised cost at 31 December 20X1 is FC 150,000,000, which is equal to MC 93,750,000. Thus, the foreign exchange loss to be included in the income statement is equal to MC 6,250,000. The cumulative gain or loss to be included directly in equity is the difference between the fair value and the amortised cost at the reporting date, which is a MC 62,500 gain. Case 7.3 in Section 7 illustrates calculations of exchange gains and losses included in the income statement for monetary items issued or acquired at a premium or discount. Dual currency loans A dual currency loan is an instrument where the principal and interest are denominated in different currencies. A dual currency loan with principal denominated in the measurement currency and interest payments denominated in a foreign currency contains an embedded foreign currency derivative. However, the embedded derivative is not separated because changes in the spot rate on the foreign currency denominated element (the interest or the principal) should be measured under IAS 21 at the closing rate with any resulting foreign exchange gains or losses recognised in the income statement. Non-monetary financial instruments Non-monetary items generally are not translated subsequent to initial recognition. However, most non-monetary financial instruments, such as equity securities, are measured at fair value. Such instruments should be reported using the foreign exchange rates that existed when the fair values were determined. Thus, the fair value is first determined in the foreign currency, which is then translated into the measurement currency. Foreign exchange gains and losses are not separated from the total fair value changes. Therefore, for available-for-sale equity instruments remeasured through equity the entire change in fair value is recognised in equity. Table 6.1 below indicates whether fair value changes resulting from foreign currency and other risks should be included in the income statement or as a separate component of equity. Changes due to impairment losses have been disregarded in this summary. 6.3 Valuation issues 81

88 Table 6.1 Where to record changes in fair value Change in fair value from: To be included in: Separate Foreign Income component Financial instrument currency Other risks statement of equity Trading instruments For all changes Originated loans and receivables N/a For all changes Held-to-maturity N/a For all changes Non-monetary available-for-sale Changes in instruments fair value, including FX changes Monetary available-for-sale FX changes Other instruments changes in fair value 6.4 Impairment of financial assets Addressing impairment of financial assets is a two-step process. The entity must first assess whether there is objective evidence that impairment exists for a financial asset. This assessment should be done at least at each reporting period. If there is no objective evidence of impairment no further action need be taken at that time for that instrument. However, if there is objective evidence of impairment, the entity should record an impairment loss during the reporting period so that the financial asset is recognised at its recoverable amount. December 2003 amendments 39.58, 63 and 66 The amendments clarify that an impairment loss is recognised only when it is incurred. Impairment losses are not recognised for losses expected to take place as a result of future events. Therefore, in estimating cash flows for the purpose of estimating the recoverable amount of a portfolio of loans, the contractual cash flows are adjusted only for the impact, based on historical data, of bankruptcy, death, unemployment, etc. of borrowers that is estimated to have occurred at the balance sheet date. Consequently, no loss should be recognised on the day that a loan is granted. IG E.4.10 In addition, the amendments clarify that in the case of available-for-sale financial assets, the recoverable amount is fair value, so that where it is assessed that an available-forsale asset has become impaired estimating a recoverable amount based on discounted future cash flows is unnecessary. Additional guidance is included for the recognition of impairment of available-for-sale equity investments. Overall, although the implementation guidance to IAS 39 continues to acknowledge that it is possible for the available-for-sale reserve in equity to become negative, the scope for judgement in determining whether a decline in fair value of available-for-sale investments represents an impairment is therefore reduced Impairment of financial assets

89 6.4.1 Objective evidence of impairment Indicators of objective evidence of impairment include: financial difficulties of the issuer; breach of a contract, such as default or delinquency in interest or principal payments; concessions granted from the lender to the borrower that the lender would not have considered normally; high probability of bankruptcy; recognition of an impairment loss on that asset in a previous reporting period; disappearance of an active market for the financial asset due to financial difficulties of the issuer; or a decrease in the market value of an issuer s debt securities significantly beyond factors explainable by changes in market interest rates A change in the credit rating is not of itself evidence of impairment. However, it may be evidence of impairment when considered with other available information, such as one of IG E.4.1 the indicators noted above. In addition, the entity should take into account information about the debtor s / issuer s liquidity and solvency, as well as trends for similar financial assets, and local economic trends and conditions when evaluating for evidence of impairment and For equity instruments, impairment cannot be identified based on analysing cash flows, as IG E.4.10 it can with debt instruments. Instead impairment is based on the identification of indicators such as those characteristics described above. An additional indicator is the magnitude of the difference between the original cost and the current value of the equity instrument. The greater this difference, the greater also is the evidence of potential impairment. However, on its own the fact that the fair value of an equity security is below its cost does not necessarily indicate impairment. In practice there are a number of additional indicators and sources of evidence of impairment of equity securities that an entity may look to, including: a decline in the fair value of the equity instrument that seems to be related to issuer conditions rather than general market or industry conditions; market and industry conditions, to the extent that they influence the recoverable amount of the financial asset. For example, if the fair value at the acquisition date had been extremely high due to a market level which is unlikely to be recovered in the future, this may be an impairment indicator due to pure market and / or industry conditions; a declining relationship of market price per share to net asset value per share at the date of evaluation compared to the relationship at acquisition; a declining price / earnings ratio at time of evaluation compared to at the date of acquisition; financial conditions and near term prospects of the issuer, including any specific adverse events that may influence the issuer s operations; recent losses of the issuer; 6.4 Impairment of financial assets 83

90 qualified independent auditor s report on the issuer s most recent financial statements; negative changes in the dividend policy of the issuer, such as a decision to suspend or decrease dividend payments; or realisation of a loss on subsequent disposal of the investment. December 2003 amendments The amended standards include additional indicators of objective evidence of impairment for investments in equity instruments, similar to those described above. Specifically a significant or prolonged decline in value below cost is objective evidence of impairment under the amended standards. Although there remains some scope for judgement on whether a decline in the market value of an equity share represents an impairment, there is a strong presumption that a significant or prolonged decline in market value below cost is objective evidence of impairment. There is no quantified guidance on what is significant or prolonged and this evaluation will require judgement. However, only in rare cases, for example, when market prices have subsequently recovered, might it be possible to demonstrate that a significant decline in value is not an impairment Measuring impairment For a financial asset that is impaired, the entity must determine its recoverable amount. The recoverable amount, and therefore measurement of the impairment loss, differs between assets carried at amortised cost and those carried at fair value. These differences are summarised as follows: and AG84 Financial assets carried at amortised cost: Impairment has occurred if it is probable that an entity will not be able to collect all amounts due (principal and interest) according to the contractual terms. The loss recognised in the income statement is the difference between the carrying amount and the recoverable amount. The recoverable amount is the present value of expected future cash flows discounted at the financial instrument s original effective interest rate. Impairment is measured using the asset s original effective interest rate because discounting at the current market rate of interest would, in effect, impose fair value measurement on the financial asset. This would not be appropriate as such assets are measured at amortised cost Financial assets carried at fair value: Impairment is only an issue for availablefor-sale instruments in which changes in fair value are recognised as a component of equity rather than in the income statement. For such instruments, the impairment loss as well as any net cumulative unrealised loss previously recognised in equity must be recycled to the income statement In the case of an equity instrument included in the available-for-sale category, if a charge for an impairment loss is required, the impairment loss to be recognised is the difference between cost and fair value of the instrument. In the case of impairment of a debt instrument included in the available-for-sale category, the loss is the difference between amortised cost and fair value. The recoverable amount of a debt instrument is the present Impairment of financial assets

91 IG E AG84 value of expected future cash flows discounted at the current market rate of interest for a similar financial asset. For a variable rate loan measured at amortised cost, the discount rate used is the current variable rate applicable to the next repricing date, which represents its inherent effective interest rate. The carrying amount of a fixed rate instrument measured at amortised cost may be adjusted for fair value changes in a fair value hedge (hedge accounting is discussed in Section 8). The adjusted carrying amount is the basis for the determination of impairment losses. If the fair value hedge was in respect of interest rate risk, the hedge adjustment also changes the effective interest rate. The adjusted effective interest rate is used as the discount rate for measuring the impairment loss. Generally the current market rate for a similar financial asset should be interpreted as the original effective interest rate, adjusted for changes in the benchmark or risk-free interest rate for that financial asset. In other words, in order to avoid double counting, the appropriate current market rate should consider adjustments for interest rates, however, the original credit risk spread should be held constant and not adjusted to reflect the current credit risk spread. The expected cash flows that are included in the calculation are the contractual cash flows of the instrument itself, decreased or postponed based on the current expectations for amount and timing of these cash flows as a result of losses incurred at the balance sheet date. Even where cash flows are delayed for a period of time, even though all of the principal will be recovered, impairment must be recognised unless there is full compensation (i.e. interest paid) during the period of the delinquency. If the holder expects that recovery on the instrument will come from the cash flows of the collateral, then the fair value of the collateral is taken into account when calculating the impairment loss. Case 6.5 Impairment of a loan The following case is partially based on the earlier Case 6.3. Assume that Bank Y grants a loan in the year 20X1 to Entity Z. The interest rate on the loan is 10 per cent and the loan is issued at 98 per cent of its face value. The maturity date is 31 December 20X5. The effective yield at the date of origination is per cent (rounded to per cent for the rest of this Case). At 31 December 20X3, it becomes clear Entity Z is experiencing severe financial difficulties and will not be able to meet its obligations of principal and interest according to the contractual terms. At that date the carrying amount of the loan at amortised cost is 49,539,207. Bank Y expects that it will receive the contractual interest payment of 10 per cent due at 31 December 20X4. However, on maturity of the loan, Bank Y expects to recover only 25 million of the 50 million principal due and does not expect to receive the interest payment due at 31 December 20X5. What would be the calculated impairment loss if the loan is categorised as originated by the Bank Y? 6.4 Impairment of financial assets 85

92 The impairment loss is measured based on discounting the expected cash flows at the original effective interest rate of per cent. Given that only 25 million in principal and the 31 December 20X4 interest payment are expected to be received, the present value based on this original effective interest rate is 24,985,165. Assume that accrued interest is paid at 31 December 20X3 and thus is not included in the calculation. The discounted remaining cash flows are calculated as follows: 5,000,000 25,000,000 24,985,165 = (1.1053) 2 As such, an impairment loss of 24,554,042 (49,539,207 24,985,165) should be recognised in the income statement. Bank Y should reassess the impairment loss at each reporting date. How would Bank Y calculate the impairment loss if this instead is a purchased loan categorised as available-for-sale with changes in fair value recognised as a component of equity? The recoverable amount would be calculated based on discounting the expected cash flows using the current effective interest rate. The current effective interest rate is determined by reference to the change in the benchmark rate or the risk-free interest rate, which is part of the effective interest rate of per cent. The change in the credit spread from initial recognition of the loan is not taken into account. Assume that the risk-free effective interest rate at the date of the loan acquisition by Bank Y was 6.53 per cent for a debt instrument with the same terms as the Entity Z loan. Thus, the credit risk premium for such a term and structure of a loan for Entity Z was 400 basis points. At 31 December 20X3, the effective risk-free interest rate is 8.5 per cent for a similar type of debt instrument. Therefore, a rate of 12.5 per cent (8.5 per cent basis points) is used to discount the expected cash flows related to the Entity Z loan if it is included in the available-forsale category. This discounted cash flow is calculated as follows: 5,000,000 25,000,000 24,197,531 = (1.125) 2 The calculated recoverable amount of 24,197,531 results in an impairment loss of 25,341,676 (49,539,207 24,197,531). In this case, the recoverable amount is also the fair value of the loan because the current market interest rate is being applied to the expected cash flows. In addition, any unrealised gains or losses relating to this loan are recycled out of equity and recognised in the income statement at the time the impairment loss is recognised. Assume the same information as above, except that the loan is collateralised by liquid securities. Bank Y expects that it will only be able to recover the amount owed on the loan by taking legal possession of the securities. How is the impairment loss then calculated? Impairment of financial assets

93 39.AG84 IG E.4.8 In this case, the estimated recoverable amount of the loan equals the fair value of the securities less any costs expected to obtain the collateral. The loss is calculated as the difference between the carrying amount and this recoverable amount. However, the collateral itself should not be recognised on Bank Y s balance sheet until the securities meet the recognition criteria for financial assets An impairment loss may be recognised by writing down the asset or recording an allowance provision to be deducted from the carrying amount of the asset. If the impairment loss relates to an available-for-sale asset where a deferred tax liability or deferred tax asset was previously recognised for an unrealised gain or loss on the instrument, the deferred tax amount should also be recognised in the income statement. 39.AG Interest income recognition on impaired assets After an impairment loss has been recognised in the income statement, interest income is recognised based on the rate used to discount the future cash flows when measuring the recoverable amount (i.e. either the original effective interest rate or the current effective interest rate). It is inappropriate to simply suspend interest recognition on a non-performing interest-bearing instrument, such as an originated loan or receivable. Future interest receipts should be taken into account when the entity estimates the future cash flows of the instrument. If no contractual interest payments will be collected, then the only interest income recognised is the unwinding of the discount on those cash flows expected to be received Types of impairment measurement individual or portfolio Impairment losses should be measured and recognised individually for financial assets that are individually significant. Impairment losses may be measured on a portfolio basis IG E.4.7 for a group of similar assets that are not individually significant. However, if an entity knows that an individual financial asset carried at amortised cost is impaired, then the impairment of that particular asset should be recognised. For example, assume that an entity performs an impairment analysis of its receivables portfolio of 500 million. Those receivables are normally considered to be similar in nature. Based on a statistical analysis, the entity estimates that an impairment loss of 20 million should be recognised based on the whole portfolio Now assume that within that portfolio, one particular client is known to have financial difficulties and the impairment loss on the receivables due from that client is calculated at eight million. The impairment loss of eight million would be recognised separately as an impairment loss. A new impairment analysis would then be prepared excluding the receivables of this client from the analysis and 61 One of the circumstances that provides objective evidence of impairment is the existence of a historical pattern of collections of accounts receivable that indicates that less than the entire amount will be collected. This could be an indicator that a write-down is required for a group of similar financial assets. 6.4 Impairment of financial assets 87

94 IG E.4.5 IG E.4.2 A reasonable approach to impairment provisioning is to determine impairment losses that are probable based on the current environment combined with historical experience such as, for example, patterns of non-payment on a portfolio of homogeneous consumer loans or credit card receivables. Even though the provision cannot yet be allocated to individual financial assets, an entity may be able accurately to determine the future expected cash flows of the portfolio of similar interest-bearing assets. These cash flows should then be discounted at a rate that approximates the original effective interest rate. For portfolios of similar assets, these assets will have a range of interest rates, therefore, judgement is necessary to determine a discounting methodology appropriate to that portfolio. An entity may employ various methodologies for determining impairment as long as they take into account the net present value of future expected cash flows based on losses incurred at the balance sheet date. As discussed above it is allowable to calculate impairment losses and record a provision using a portfolio methodology for groups of similar assets. However, this does not mean that an entity is allowed to take an immediate write-down upon originating a new financial asset, such as an originated loan by a bank, based on historical experience. This is because there is no evidence of impairment of the loan upon origination. It is only when that loan is included in a portfolio of similar loans that the bank determines inherent losses in the portfolio based on historical experience. A portfolio approach to impairment is not appropriate for individual equity instruments because equity instruments of different issuers are not considered to have similar risk characteristics (i.e. equity price risk). In the case of shares in an investment fund, it is likely that a decrease in the fair value of an investment fund is due to an impairment of at least some of the underlying assets held by the fund. However, an investment fund should be evaluated based on the fair value of the investment fund itself rather than on the underlying investments held by the fund. This approach is different from applying a portfolio approach to a group of individual equity instruments. December 2003 amendments As noted above, the amended standards clarify that the impairment model is an incurred loss model. Further guidance is also provided on how to assess impairment for a group of loans or receivables. Specifically: If a loan is tested individually for impairment and found to be impaired, it should not be included in a portfolio test for impairment. Conversely, if a loan is tested individually and is found not to be impaired, it nevertheless should be included in a portfolio of similar loans for the purpose of a portfolio-based impairment test; Historical loss experience, adjusted for observable data reflecting economic conditions at the reporting date, is the basis for estimating losses that have been incurred within the portfolio, but which have not been reported or allocated to specific loan balances; and The methodology used should ensure that an impairment loss is not recognised on the initial recognition of an asset Impairment of financial assets

95 6.4.5 Reversal of impairment losses 39.65, 69 and 70 Impairment should be assessed at each reporting date. If in a subsequent reporting period the amount of an impairment or bad debt loss decreases and the decrease can be objectively related to an event occurring after the write-down, the write-down of the financial asset should be reversed either directly through the income statement or by adjusting a previously established allowance account through the income statement. An illustration of such a situation would be an entity that has successfully improved its credit rating, for example, through a reorganisation or after having received important sales orders. In the case of an impairment reversal, the write-up in value of a financial asset through the income statement is limited to the amount previously recognised in the write-down. For an available-for-sale instrument that is measured at fair value with changes in equity, any appreciation above (amortised) cost, taking into account any repayments of principal, is recognised as an adjustment to equity in line with the accounting policy on the instrument. For a held-to-maturity asset and for originated loans and receivables, any appreciation above (amortised) cost is not recognised. December 2003 amendments The amendments do not change the requirements on available-for-sale debt instruments. However, in respect of available-for-sale equity investments, the amended standards state that an impairment loss may not be reversed through the income statement. Consequently, any subsequent increase in the carrying amount of an available-for-sale equity security is a fair value change that is recognised in equity. IG E General provisions for credit risk Impairment provisions relate to situations where provisions are calculated for known risks of impairment. There should be objective evidence that the carrying amounts of individually significant financial assets or groups of comparable financial assets are greater than their recoverable amounts. The term general provision is used differently in different parts of the world. In some places, general provisions are portfolio-based provisions, as described above, for losses inherent in a group of assets and based on historical loss experiences. In other places, a general provision refers to one that is not specifically related to expected losses in a group of assets, but rather is an unallocated reserve to be used for unplanned and unexpected losses. General provisions that are in excess of such portfolio-based amounts, or bad debt losses that are in addition to those necessary for individually significant financial assets or groups of similar financial assets are not allowed under IFRS. Any general provision that is an unallocated reserve established through a charge to the income statement should be reversed and 50 Certain entities, such as banks, may set aside amounts for general banking risks through an appropriation of retained earnings. However, it is important to note that this is not a general provision. The appropriation of retained earnings is an equity-only movement, and any charges or reversals are not included in the entity s income statement. 6.4 Impairment of financial assets 89

96 6.4.7 Measuring impairment of financial assets denominated in a foreign currency For financial assets denominated in a foreign currency, there is no specific guidance on how to measure impairment losses. Typically the recoverable amount of the asset is first determined in the foreign currency. The recoverable amount should be translated into the measurement currency using the foreign exchange rate at the date when the impairment is recognised. The difference between the recoverable amount and the carrying amount in the measurement currency is recognised in the income statement Foreign exchange gains and losses on an impaired monetary asset should continue to be recognised in the income statement. If by a subsequent improvement in circumstances an entity is able to reverse the impairment loss, in part or in whole, such reversal should be recognised at the spot rate at the date when the reversal is recognised For non-monetary assets held as available-for-sale with changes in fair value recognised in equity, the situation is different. The amount of loss to be removed from equity and IG E.4.9 included in the income statement is the total net difference between the asset s acquisition cost and current fair value in the measurement currency and 70 An impairment loss recognised on an available-for-sale debt instrument can be reversed. Again in this case, no guidance is given regarding the treatment of exchange differences relating to the reversal. In our view, it is advisable to record the impairment loss and any subsequent reversal at the spot rate in effect on the date when the reversal is recognised. Any subsequent reversal should be limited to the amount of loss previously recognised, denominated in foreign currency. It is our view that until the previously recognised loss denominated in foreign currency is fully reversed, the related foreign exchange differences 32.94(i) should be recognised in the income statement. At a minimum, the accounting treatment applied should be disclosed along with the nature and the amount of any impairment loss or reversal. There may be situations where the fair value of an asset in its currency of denomination is affected by foreign exchange rates. This may occur if there is a sudden and severe devaluation of a foreign currency. The devaluation of the foreign currency may influence the credit risk and country risk associated with entities operating in that environment. Therefore, an entity that has foreign currency loans or receivables, or holds debt securities denominated in a foreign currency that becomes devalued, should consider whether the decline should be treated as an impairment loss rather than as a normal foreign exchange translation loss. Only in such instances should changes in foreign exchange rates be a factor for determining whether a further impairment loss or reversal of an impairment loss should be recognised in the income statement. 6.5 Reclassifications of financial assets Transfers between categories An entity may wish to or need to transfer a financial asset from one category to another. However, for certain categories transfers should be very rare or may not be allowed at all without tainting implications. Such limitations are imposed due to the concept in IAS 39 that asset classification should generally be clear as of the moment the asset is acquired or originated. Table 6.2, all possible transfers between categories are outlined, including an indication of whether such a transfer is permitted or why such transfers may take place Reclassifications of financial assets

97 Table 6.2 Rules for transfers between financial assets categories Transfer to: Originated loans Held-to- Available-for- Trading and receivables maturity sale Transfer from: Trading N/a Not permitted Not permitted Not permitted Originated loans If pattern of short- N/a N/a N/a and receivables term profit-taking Held-to-maturity Results in tainting N/a N/a Results in tainting Available-for-sale If pattern of short- N/a In case of change N/a term profit-taking in intent and if all criteria are met From trading IAS 39 is clear in regard to transfers from the trading portfolio such transfers are not allowed. The rationale is that the designation of a financial asset as held for trading is based on the objective for initially acquiring it (which is for trading purposes) From originated loans and receivables 39.9 and 50 Originated loans and receivables should be classified as trading at the origination date if the intent is to sell such loans immediately, or in the short-term, or if they are part of a portfolio of loans for which there is an actual pattern of profit-taking. A transfer from the originated loans and receivables portfolio to the trading portfolio at a later stage may happen only if there is evidence of a recent pattern of short-term profit-taking that justifies such a reclassification. An example is when responsibility for a portfolio of loans is transferred from the banking division to the trading division and when the objective for holding the loans has clearly changed, and not just because the entity has decided to sell the loans in the near future. Upon transfer to the trading portfolio, the assets are remeasured to fair value with differences between (amortised) cost and fair value recognised in the income statement. Reclassifications and sales of originated loans and receivables are possible without any of the tainting issues applicable to the held-to-maturity category. However, such transfers should not be common. 39.AG From held-to-maturity Transfers from the held-to-maturity category should be rare. Unless a transfer meets one of the exceptions described in greater detail in Section 5.2.3, it would be viewed in the same way as a sale and could thus taint the portfolio. If the held-to-maturity category is tainted, all assets in this category are remeasured at fair value and reclassified either to the available-for-sale or trading portfolios. Differences between the amortised cost and fair value at the date of transfer are included either in equity or in the income statement depending upon the new classification of the assets. Entities should not reclassify to trading a tainted portfolio of held-to-maturity investments if after the tainting period (i.e. two full financial years) the entity plans to reinstate the portfolio in held-to-maturity, as this objective would not be consistent with the intent of a 6.5 Reclassifications of financial assets 91

98 trading portfolio. Instead the entity should reclassify the tainted portfolio to available-forsale for the duration of the tainting period From available-for-sale Instruments may be transferred from available-for-sale to trading. This may only be done if there is recent evidence of a pattern of short-term profit-taking that justifies such a reclassification. If such a transfer occurs, any cumulative gain or loss included as a fair value component of equity should remain there until derecognition of the reclassified asset. The fair value at the transfer date represents the new basis for recognising changes in fair value for the trading asset. Upon derecognition of the asset, the cumulative gain or loss included as a component of equity at the date of the reclassification is removed and recognised in the income statement. A decision to sell a financial asset that is not classified as held for trading in the near future does not make that asset a financial asset held for trading Transfers from available-for-sale to held-to-maturity can occur if there has been a change in the intent and ability of the entity. For instance, such a transfer could occur if the tainting prohibition period on held-to-maturity assets has passed, and the entity decides to reclassify assets back to that category. In case of a transfer from available-for-sale to held-to-maturity, the fair value at the date of transfer becomes the new amortised cost basis for the held-to-maturity assets. Any fair value component included in equity remains there and is amortised as an adjustment to the yield in a similar manner to a premium or discount, using the effective interest rate method. Conversely, any difference between the new amortised cost amount and the maturity amount is also recognised as a yield adjustment in the income statement. The amortisation of these two amounts should offset over the remaining life of the financial instrument Internal transfers of financial instruments Internal transactions, which involve transfers of financial instruments between group entities, are not transactions that are recognised in the consolidated financial statements. The effects of such transactions are eliminated upon consolidation. However, such transfers could be an indication that there has been a change in the group s intent for holding the portfolios concerned. December 2003 amendments 39.9 and 50 As noted above, the amended standards allow an entity much more flexibility to use a fair value through income measure for any financial asset or financial liability, and to designate loans and held-to-maturity assets as available-for-sale. However, the fair value through profit or loss, or available-for-sale, choice is only available when a financial asset or liability is first recognised (or when the amended standards are first applied). Furthermore, an entity is prohibited from transferring a financial asset or liability into or out of the fair value through profit or loss category. Similar restrictions on reclassification do not apply to the available-for-sale category Reclassifications of financial assets

99 6.6 Deferred tax assets and liabilities Under IAS 12 Income Taxes, deferred tax assets or liabilities are recognised for all temporary differences between the carrying amount of an asset or liability in the balance sheet and its tax base. Depending on the tax legislation in various countries, measurement of financial instruments may give rise to deferred taxes. The accounting for the effects of deferred taxes of a transaction should be consistent with the accounting for the transaction itself. In other words, for a transaction whose effect is recognised in equity, the related deferred tax effect should also be recognised in equity. With respect to financial instruments measurement, deferred tax assets or liabilities may arise from instruments valued at fair value and from hedge accounting, and also from other adjustments to the carrying amount, for example, from the amortised cost method differing from the tax measurement basis or from differences in the treatment of transaction costs between IFRS and the applicable statutory tax regulations For changes in fair value that are recognised as a component of equity, the revaluation component in equity should be shown net of deferred taxes, if applicable, and a corresponding deferred tax asset or liability is established on the balance sheet. These same concepts may also be applicable to hedging transactions, where there is a change in fair value of hedging instruments and the hedged items. In the majority of examples and cases in this publication, the effects of deferred taxes have been disregarded. Cases 7.2 and 7.4 in Section 7 illustrate the effect of deferred taxes when remeasuring a financial asset to fair value. 6.6 Deferred tax assets and liabilities 93

100 7. Subsequent measurement examples Key topics covered in this Section: This Section contains cases that demonstrate the measurement principles for various financial assets and financial liabilities. The cases are presented by type of financial risk. The cases build upon the discussion of classification of financial assets and financial liabilities (Section 5) and of measurement and valuation issues (Section 6). Abbreviations used in this Section: MC = measurement currency; FC = foreign currency 7.1 Overview Table 7.1 indicates the possible risk positions associated with each category of financial instrument and how they should be measured. Table 7.1 Risk positions Foreign Interest exchange Price Credit rate risk (FX) risk risk risk Measurement Trading Fair value, with changes in income Originated loans FX at fair value, credit and receivables risk and interest rate risk at amortised cost Held-to-maturity FX at fair value, credit risk and interest rate risk at amortised cost Available-for-sale Fair value, with changes in income or equity Non-trading FX risk at fair value, liabilities interest rate risk at amortised cost An entity may manage these risk positions by entering into hedging transactions, which are discussed in Section Overview

101 7.2 Interest rate risk Case 7.1 Transfer and subsequent remeasurement of held-to-maturity investments Entity T buys 100 million in bonds issued by a triple A credit rated financial institution. The bonds have a remaining life of four years, and Entity T intends and is able to hold these bonds to maturity. For this example, assume there is no related premium or discount. However, two years after it acquired the bonds at par, Entity T sells 10 per cent of the bond portfolio for 9.5 million. The amortised cost and the fair value of the remaining held-to-maturity portfolio is 90.0 million and 85.5 million, respectively Because Entity T sells more than an insignificant amount of its held-to-maturity portfolio, the tainting rules require the entity to reclassify the remaining held-to-maturity portfolio to either available-for-sale or trading. The difference between the carrying amount and the fair value is recognised either in the income statement or in equity, depending upon where the entity opts to record fair value changes (applies to available-for-sale only). The journal entries are as follows: Debit Credit Cash 9,500,000 Loss on sale of bonds 500,000 Held-to-maturity investment 10,000,000 To account for the sale of bonds If the remainder of the portfolio is classified as available-for-sale and movements in fair value are reflected in the income statement, Entity T would record: Debit Credit Available-for-sale investments 85,500,000 Loss on investments (income statement) 4,500,000 Held-to-maturity investments 90,000,000 To account for the transfer of the remainder of the portfolio If the remainder of the portfolio is classified as available-for-sale with movements in fair value reflected as a component of equity until sold, Entity T would record: Debit Credit Available-for-sale investments 85,500,000 Loss on investments (equity) 4,500,000 Held-to-maturity investments 90,000,000 To account for the transfer of the remainder of the portfolio 7.2 Interest rate risk 95

102 If the remainder of the portfolio is classified as trading, Entity T would record: Debit Credit Trading assets 85,500,000 Loss on investments (income statement) 4,500,000 Held-to-maturity investments 90,000,00 To account for the transfer of the remainder of the portfolio Case 7.2 Remeasurement of an available-for-sale asset On 1 January 20X1, Inter Bank acquires a loan to Entity Z with an annual coupon of 10 per cent and a face amount of 50,000,000. The purchase price of the loan is 98 per cent of the redemption value. In this case, assume Inter Bank classifies the loan as available-for-sale with fair value changes recognised as a component of equity. At 30 June 20X1, the interest on comparable loans to borrowers with the same creditworthiness is 10 per cent. Since the loan is classified as available-for-sale, the measurement of the loan is at fair value. Interest on the loan is recognised on the basis of the effective interest method. Effective Amortised interest Date cost Coupon Amortisation (10.53%) 1 January 20X1 49,000, December 20X1 49,162,063 5,000, ,063 5,162, December 20X2 49,341,199 5,000, ,136 5,179, December 20X3 49,539,207 5,000, ,008 5,198, December 20X4 49,758,075 5,000, ,868 5,218, December 20X5 50,000,000 5,000, ,925 5,241,925 Total 25,000,000 1,000,000 26,000,000 The amortisation for the half year ended 30 June 20X1 is calculated (in this example) by taking half of the cost to be amortised in the year 20X1, which is 81,032. This was to simplify this case, as amortisation should be on an effective yield basis. The amortised cost at 30 June 20X1 therefore amounts to 49,081,032. Given an interest rate on comparable loans with the same credit risk of 10 per cent at 30 June 20X1, the fair value of the loan at that date can then be calculated by discounting the cash flows: 52,440,442 = 5,000,000 5,000,000 5,000,000 5,000,000 55,000, (1.10) 0.5 (1.10) 1.5 (1.10) 2.5 (1.10) 3.5 (1.10) 4.5 The amount of 52,440,442 includes accrued interest. To calculate the applicable clean price of the loan, the accrued coupon interest of 2.5 million at 30 June is subtracted from the fair value. The clean price amounts to 49,940, Interest rate risk

103 A comparison of the clean price and amortised cost at 30 June 20X1 results in a positive change in fair value of: Fair value at 30 June 49,940,442 Amortised cost at 30 June 49,081,032 Change in value 859,410 Assume that the measurement for tax purposes is amortised cost and the applicable tax rate is 40 per cent. A deferred tax liability of 343,764 related to the change in fair value should be recognised. The journal entries recognised by Inter Bank are as follows: Debit Credit 1 January 20X1 Available-for-sale assets (notional) 50,000,000 Available-for-sale assets (discount) 1,000,000 Cash 49,000,000 To record the initial amortised cost, being the fair value at that time of the loan 30 June 20X1 Available-for-sale assets (accrued interest) 2,500,000 Available-for-sale assets (discount) 81,032 Interest income 2,581,032 To recognise the effective interest income (coupon plus amortisation) The accrued interest is presented as an increase in the fair value of the instrument in the balance sheet, since it is a component of the fair value. Debit Credit 30 June 20X1 Available-for-sale assets 859,410 Equity 859,410 To record the fair value change during the reporting period Equity 343,764 Deferred taxes (balance sheet) 343,764 To record the related deferred tax liability Continuation of the case (to 20X5): At 1 January 20X5, Inter Bank sells the loan to another financial institution. The fair value of the loan at 1 January 20X5 equals the fair value of the loan at 31 December 20X4, and amounts to 49,549,550 based on the current interest rate of 11 per cent on loans with similar maturity and credit risk. Assume that Inter Bank recognised its fair value adjustment and accrual of interest at 31 December 20X4 and this value has not changed. 7.2 Interest rate risk 97

104 The journal entries to record this transaction are as follows: Debit Credit 1 January 20X5 Cash 49,549,550 Available-for-sale assets 49,549,550 To record the proceeds on sale of the loan Inter Bank must also recognise the change in fair value that was previously recognised in equity in the income statement. This difference between the fair value and amortised cost at 1 January 20X5 is a loss of 208,025 (the fair value of 49,549,550 less the amortised cost of 49,758,075). Debit Credit 1 January 20X5 Realised loss on sale 208,025 Deferred taxes (balance sheet) 83,210 Equity 124,815 To recycle the fair value changes from equity to the income statement Current taxes (balance sheet) 83,210 Tax expense (income statement) 83,210 To record the impact on tax expense of the realised loss 7.3 Foreign currency risk The example below illustrates how changes in foreign exchange rates affect a debt security held as available-for-sale with changes in fair value recognised directly in equity. Except for the measurement at fair value in the underlying foreign currency, the other aspects of this example are also applicable to: monetary assets accounted for as originated loans and receivables; monetary assets accounted for as held-to-maturity; and monetary liabilities that are not held for trading. Case 7.3 Available-for-sale debt security in a foreign currency including amortisation On 1 January 20X1, Bank A buys a foreign currency (FC) 100 million unlisted bond with a fixed annual interest coupon of six per cent, maturing at 31 December 20X4. Bank A pays the market price of FC 90,280,840 for this bond. The discount is due to the market yield for similar bonds at 1 January 20X1 being nine per cent. Bank A will classify the bond as available-for-sale with changes in fair value recognised directly in equity. Assume there are no transaction costs. Therefore, the effective interest rate is nine per cent. Bank A will record interest income at nine per cent of amortised cost using the effective interest rate method on a historical cost basis. For purpose Foreign currency risk

105 of this illustrative example, it is assumed that the use of the average foreign exchange rate provides a reliable approximation of the spot rate applicable to the accrual of interest income during the reporting period. The amortisation schedules in foreign currency (FC) and in measurement currency (MC) are as follows: Interest Effective Amortised cash flow Discount interest cost (6%) accretion (9%) Date (in FC) (in FC) (in FC) (in FC) 1 January 20X1 90,280, December 20X1 92,406,116 6,000,000 2,125,276 8,125, December 20X2 94,722,666 6,000,000 2,316,550 8,316, December 20X3 97,247,706 6,000,000 2,525,040 8,525, December 20X4 100,000,000 6,000,000 2,752,294 8,752,294 Exchange gain/(loss) Average Interest Effective in income exchange Amortised cash flow Discount interest on debt rate cost (6%) accretion (9%) security a Date (in MC) (in MC) (in MC) (in MC) (in MC) 1 January 20X1 135,421, December 20X ,368,562 8,700,000 3,081,650 11,781,650 (9,134,348) 31 December 20X ,347,866 8,550,000 3,301,084 11,851,084 4,678, December 20X ,871,559 8,850,000 3,724,434 12,574,434 4,799, December 20X ,000,000 9,150,000 4,197,248 13,347,248 4,931,193 a Calculated by comparing amortised cost at beginning of the period and amortised cost at end of the period, excluding accretion of the discount during the reporting period. At 31 December 20X1, the market interest rate for similar bonds (in terms of currency, credit rating and maturity) is 8.5 per cent. Assuming no further changes in interest rates, the fair value in FC and MC (using spot rates) until the redemption of the bond is as follows: Fair value Fair value Date Spot rate (in FC) (in MC) 1 January 20X ,280, ,421, December 20X ,614, ,060, December 20X ,572, ,579, December 20X ,695, ,543, December 20X ,000, ,000, , IG E.3.2 Because the bond is a monetary item, foreign exchange differences must be recognised and E.3.4 in the income statement. For this purpose, the security is treated as an asset measured at amortised cost in the foreign currency. The difference between the amortised 7.3 Foreign currency risk 99

106 cost and fair value in the measurement currency is the cumulative gain or loss reported in equity. The exchange differences on the debt security to report in the income statement and the fair value changes to report in equity are calculated as follows: Exchange Change in Fair value gain/(loss) fair value, Fair value at beginning on debt excluding at end of reporting Discount security FX of reporting period accretion (income) b (equity) period Date (in MC) (in MC) (in MC) (in MC) (in MC) 20X1 135,421,260 3,081,650 (9,134,348) 1,692, ,060,922 20X2 131,060,922 3,301,084 4,678,220 (460,516) 138,579,710 20X3 138,579,710 3,724,434 4,799,259 (559,623) 146,543,780 20X4 146,543,780 4,197,248 4,931,193 (672,221) 155,000,000 b Calculated by comparing the change in fair value from the beginning of the reporting period to end of the reporting period, less the discount accretion, less the effect of foreign exchange differences (see a above). The required journal entries for the first two years are as follows (amounts are in MC, ignoring tax effects): Debit Credit 1 January 20X1 AFS debt security 135,421,260 Cash 135,421,260 To record the purchase of the bond: FC 90,280,840 at the spot rate of 1.50 During 20X1 Accrued interest receivable 8,700,000 AFS debt security (accretion) 3,081,650 Interest income (income statement) 11,781,650 To record the receivable coupon interest at six per cent (FC 6,000,000) and amortisation of FC 2,125,276. These amounts are recognised at an average FX rate of December 20X1 AFS debt security 1,692,360 AFS revaluation allowance (equity) 1,692,360 To record the increase in fair value above the amortised cost in the measurement currency Exchange loss (income statement) 9,434,348 AFS debt security 9,134,348 Accrued interest receivable 300,000 To record the FX adjustment of balance sheet items from opening and average FX rate to the closing spot rate Foreign currency risk

107 Debit Credit Cash 8,400,000 Accrued interest receivable 8,400,000 To record the receipt of interest coupon FC 6,000,000 at the spot rate of 1.40 During 20X2 Accrued interest receivable 8,550,000 AFS debt security (accretion) 3,301,084 Interest income (income statement) 11,851,084 To record the receivable coupon interest at six per cent (FC 6,000,000) and amortisation of FC 2,316,550. These amounts were recognised at an average FX rate of December 20X2 AFS revaluation allowance (equity) 460,516 AFS debt security 460,516 To record the increase in fair value above the amortised cost in the measurement currency AFS debt security 4,678,220 Accrued interest receivable 150,000 Exchange gain (income statement) 4,828,220 To record the FX adjustment of balance sheet items from opening and average FX rates to the closing spot rate Cash 8,700,000 Accrued interest receivable 8,700,000 To record the receipt of interest coupon FC 6,000,000 at the spot rate of 1.45 Similar journal entries will be made in 20X3 and 20X Equity price risk Case 7.4 Measurement of available-for-sale equity securities On 4 January, Entity M buys 100,000 units of an equity security for 10 million and classifies these securities as available-for-sale, with changes in fair value recognised directly in equity. On 15 January, the fair value of the securities increases from 100 to 115. At that date the entity purchases another 50,000 units. Assuming that the measurement for tax purposes is cost and the applicable tax rate is 40 per cent. 7.4 Equity price risk 101

108 The journal entries for the above series of transactions are as follows: Debit Credit 4 January Available-for-sale assets 10,000,000 Cash 10,000,000 To record the purchase of the securities 15 January Available-for-sale assets 1,500,000 Equity 1,500,000 To record the change in fair value from 100 to 115 on 100,000 units Equity 600,000 Deferred taxes (balance sheet) 600,000 To record the related deferred tax liability Available-for-sale assets 5,750,000 Cash 5,750,000 To record the purchase of 50,000 securities At 31 January, the fair value of the securities increases from 115 to 125. The journal entry to record the change in fair value is: Debit Credit 31 January Available-for-sale assets 1,500,000 Equity 1,500,000 For the increase in fair value from 115 to 125 on 150,000 units Equity 600,000 Deferred tax (balance sheet) 600,000 To record the related deferred tax liability Entity M decides to sell 25,000 of the units for 125 on 1 February. The financial instruments standards do not specify what method, e.g. FIFO, average purchase price or specific identification, should be used to calculate the gain (or loss) on the partial disposal. Therefore, Entity M may opt for any one of these methods. The method used should be applied consistently and disclosed as an accounting policy note. If Entity M applies the FIFO method, the profit would be = 25 per share, i.e. 625,000 for the sale of 25,000 shares Equity price risk

109 The journal entries are as follows: Debit Credit 1 February Cash 3,125,000 Available-for-sale assets 3,125,000 To record the proceeds from the sales Deferred taxes (balance sheet) 250,000 Equity 375,000 Gain on sale of securities (income statement) 625,000 To record the realisation of the gain on the sale, recycled from equity Tax expense (income statement) 250,000 Current taxes 250,000 To record the impact on tax expense of the realised gain 7.5 Credit risk The calculation of the impact of credit risk on the measurement of financial assets that are measured at fair value is similar to the impact of interest rate risk. Therefore, the cases included in Section 7.2 may be used as reference when remeasuring a financial asset for changes in credit risk. 7.5 Credit risk 103

110 8. Hedge accounting Key topics covered in this Section: Hedging versus hedge accounting The hedge accounting models: Fair value hedge Cash flow hedge Hedge of a net investment in a foreign entity Hedged items and hedging instruments Hedge documentation Hedge effectiveness Highly probable transactions Termination of a hedge relationship Net position hedges Abbreviations used in this Section: MC = measurement currency; FC = foreign currency 8.1 Overview This Section provides an overview of the general principles for hedge accounting. Specific issues relating to hedging of different types of risks (currency risk, interest rate risk etc.) as well as examples of hedge accounting are included in Section 9. Entities carry out hedging activities in order to limit their exposure to different financial risks such as currency risk, interest rate risk, price risk etc. These activities often consist of entering into a derivative contract with a counterparty to eliminate or limit the risk. IAS 39 does not change the principles that underpin entities hedging activities, but sets out the requirements related to the accounting for such activities. The term hedging refers to a risk management strategy, while hedge accounting refers to the accounting method entities may choose to reflect hedging activities in their financial statements. Application of hedge accounting is not mandatory and in principle can be chosen on a transaction-by-transaction basis. In determining whether and to what extent hedge accounting should be applied, entities may need to consider the possible trade-off between the cost of implementing hedge accounting (i.e. changes to systems and processes) and the potential volatility in reported earnings when hedge accounting is not applied. Some entities may find it useful to apply hedge accounting only to a small number of significant transactions, yet by doing so significantly reduce the volatility in earnings. For other entities, especially financial institutions, the ability to apply hedge accounting may be a necessity Overview

111 Regardless of the type of financial risk exposure, hedge accounting usually involves a number of the same key steps in order to comply with IAS 39 requirements. These will each be described in detail in the Sections noted. Table 8.1 Steps in the hedging process At inception of a hedge Step 1 Determine the need for hedging Section 8.2 Step 2 Choose a hedge accounting model Section 8.3 Step 3 Determine whether hedge criteria are met Section 8.6 Step 4 Prepare hedge documentation Section 8.6 Ongoing (at least each reporting date) Step 5 Measure actual hedge effectiveness Section 8.6 Step 6 Reassess prospective hedge effectiveness Section 8.6 Step 7 Reassess hedge relationships and need for de-designation Section 8.7 Step 8 Prepare hedge accounting journal entries Section Hedge accounting basic concepts Terminology 39.9 IAS 32 and IAS 39 use a variety of terms to describe the components in a hedge relationship where hedge accounting is applied: Hedged item: An asset, liability, firm commitment, or forecasted transaction that exposes the entity to risk of changes in fair value or future cash flows, and that has been designated by an entity as being hedged. Hedging instrument: A designated derivative or, in limited circumstances, another financial instrument whose changes in fair value or cash flows are expected to offset changes in the fair value or cash flows of a designated hedged item. Hedge effectiveness: The degree to which changes in a hedged item s fair value or cash flows attributable to a hedged risk are offset by changes in the fair value or cash flows of the hedging instrument and Derivatives and certain foreign currency denominated non-derivative financial instruments, or proportions thereof, can be hedging instruments. A hedged item can be a single instrument, a portfolio or an entire position or part of a position, where the part is a proportion, a measurable risk or an amount Hedge accounting may only be applied if the following strict criteria, discussed in more detail later in this Section, are met: the hedge relationship is designated and documented at inception; 8.2 Hedge accounting basic concepts 105

112 the hedge is expected to be highly effective at inception and throughout the life of the hedge relationship; hedge effectiveness can be reliably measured on an ongoing basis; and in the case of hedging of a future cash flow, cash flows are highly probable of occurring. When a hedge does not meet the hedge accounting criteria, the hedging instrument and the hedged position must be accounted for in accordance with the normal requirements for each particular instrument. For derivatives this means measurement at fair value with changes recognised in the income statement The hedge accounting models specified in IAS 39 are: the fair value hedge accounting model, to be applied when hedging the fair value of assets and liabilities already recognised in the balance sheet; the cash flow hedge accounting model, to be applied when hedging future contracted or expected cash flows; and the hedge of a net investment in a foreign entity The need for hedge accounting Hedge accounting is sometimes necessary due to accounting mismatches in: Measurement some financial instruments (non-derivative) are not measured at fair value with changes being recognised in the income statement whereas all derivatives (which are commonly used as hedging instruments) are measured at fair value; and Recognition future transactions that may be hedged are not recognised in the balance sheet or are included in the income statement only in a future reporting period. Examples of measurement mismatches include the hedge of interest rate risk on fixed rate debt instruments that are not held for trading and the hedge of foreign currency and other price risk on equity shares that are held as available-for-sale with fair value changes recognised directly in equity. Recognition mismatches include the hedge of contracted or expected but not yet recognised sale, purchase or financing transactions in foreign currencies and future (committed) variable interest payments. In order for the income statement to reflect the effect of the hedge, it is necessary to have matching in the recognition of gains and losses on the hedging instrument and the hedged item. Matching can be achieved in principle by delaying the recording of certain gains and losses on the hedging instrument or by accelerating the recording of certain gains and losses on the hedged item in the income statement. Both of these techniques are used under IAS 39, depending on the nature of the hedging relationship Hedge accounting basic concepts

113 8.3 The hedge accounting models Fair value hedge accounting model A fair value hedge seeks to offset certain risks of changes in the fair value of an existing asset or liability that will give rise to a gain or loss being recognised in the income statement. IAS 39 defines a fair value hedge as: A hedge of the exposure to changes in the fair value of a recognised asset or liability, or an identified portion of such an asset or liability; and that is attributable to a particular risk and that will affect reported net income. 39.AG102 An example of a fair value hedge is the hedge of a fixed rate bond with an interest rate swap, changing the interest rate from fixed to floating. Another example is the hedge of the changes in value of inventory using commodity forwards. The accounting for a fair value hedge essentially overrides the normal measurement principles for financial instruments discussed in earlier Sections. The adjusted carrying amounts of assets in a fair value hedging relationship are subject to impairment testing. The applicable standards are IAS 39 for financial assets and IAS 36 Impairment of Assets for non-financial assets. Figure 8.1 Fair value hedge accounting The fair value hedge accounting method can be summarised as follows: The hedging instrument is measured at fair value, with fair value changes recognised in the income statement A hedged item otherwise carried at (amortised) cost is adjusted by the change in fair value that is attributable to the risk being hedged. This adjustment is recognised in the income statement to offset the effect of the gain or loss on the hedging instrument An available-for-sale hedged item whose fair value changes are otherwise recognised in equity continues to be adjusted for fair value changes. However, the part of the fair value change that is attributable to the risk being hedged is recognised in the income statement rather than in equity. 8.3 The hedge accounting models 107

114 IG E.4.4 The adjustment of the carrying amount of the hedged item changes the effective interest rate of interest-bearing hedged items. As a result the income or expense relating to those hedged items includes the original amortisation of any discount or premium as well as the amortisation of the adjustment to the carrying amount resulting from the fair value hedge. Amortisation of the adjustment should begin no later than when the hedged item ceases to be adjusted for changes in the fair value attributable to the risk being hedged. The net effect of the hedge in the income statement represents: the ineffective portion of the fair value hedge; and changes in fair value of the derivative that have been excluded by the entity s choice from the hedge relationship (e.g. time value of options and forward points of foreign currency forward contracts) The gains and losses attributable to risks other than the hedged risk follow the normal measurement principles (e.g. a bond hedged for interest rate risk is not adjusted for fair value changes due to changes in credit risk). December 2003 amendments The amended standard requires that a hedge of a firm commitment should be accounted for as a fair value hedge. This means that changes in value of the (as yet unrecognised) contract will be recognised on balance sheet. The existing standard recognises that a firm commitment gives rise to a fair value exposure, but requires cash flow hedge accounting. The definition of a fair value hedge in the amended standard is amended accordingly However, under the amended standard, a hedge of the foreign currency risk on a firm commitment in a foreign currency may be accounted for as a cash flow hedge Cash flow hedge accounting model A cash flow hedge is defined as: A hedge of the exposure to variability in cash flows that: (i) is attributable to a particular risk associated with a recognised asset or liability (such as all or some future interest payments on variable rate debt) or a forecasted transaction (such as an anticipated purchase or sale); and that (ii) will affect reported net profit or loss. An example of a cash flow hedge is the hedge of future expected sales in a foreign currency or of future floating interest payments on a recognised liability The hedging instrument is measured under the normal IFRS principles, but any gain or loss that is determined to be an effective hedge is recognised in equity. This is intended to avoid volatility in the income statement in a period when the gains and losses on the hedged item are not (yet) recognised in the income statement. Any ineffective part of the hedge is recognised in the income statement The hedge accounting models

115 39.97 In order to match the gains and losses of the hedged item and the hedging instrument in the income statement, the changes in fair value of the hedging instrument recognised in equity must be removed from equity and recognised in the income statement at the same time that the cash flows from the hedged item are recognised in the income statement (sometimes referred to as recycling) and 98 However, when the hedged item is an expected future transaction that results in the recognition of an asset or a liability, the gain or loss on the hedging instrument will be recognised as an adjustment to the initial recognition amount of the asset or liability (often referred to as a basis adjustment). For example, an entity may hedge the foreign currency risk from an expected purchase of inventory in a foreign currency using a forward contract. When the inventory is recognised in the balance sheet the gain or loss on the forward contract is recognised as part of the carrying amount of the inventory. Once the expected future transaction occurs, assets arising from the hedge may be subject to other standards, for example, IAS 36 for impairment testing or IAS 2 Inventories for testing net realisable value The basis adjustment will affect the income statement either through amortisation, depreciation, impairment or on disposal / derecognition. For example, a basis adjustment included in the carrying amount of inventory would be recognised in the income statement as part of the cost of sales when the inventory is sold. Figure 8.2 Cash flow hedge accounting The cash flow hedge accounting method can be summarised as follows: No accounting entries are required in respect of the hedged future cash flow, whether this is the expected cash flow from a future purchase or sales transaction or from future interest cash flows related to an existing asset or liability The hedging instrument is measured at fair value (for a foreign currency hedging instrument that is not a derivative, this applies only to changes in foreign exchange rates) and 96 The change in fair value that relates to the effective part of the hedge is recognised directly in equity. The ineffective part and the fair value changes of the derivative that have been excluded by the entity s choice from the hedge relationship (e.g. time value of options and forward points of forward contracts) are recognised in the income statement. 8.3 The hedge accounting models 109

116 Fair value changes remain in equity until the hedged cash flow is recognised. The gains and losses recognised in equity are included in the income statement in the same period(s) as the cash flows of the hedged item. December 2003 amendments As noted above, the fair value hedging model will be required, under the amended standards, to be used for most hedges of firm commitments. The exception is a firm commitment in a foreign currency, which may be accounted for as a cash flow hedge. The amendments limit the use of basis adjustment. Under the existing standard, basis adjustment is required for a cash flow hedge in which the hedged cash flow results in a recognised asset or liability Under the amended standards, basis adjustment will be prohibited for cash flow hedges that result in a recognised financial asset or financial liability. An example would be a hedge of the interest rate risk in a forecast issuance of a bond, using an interest rate swap. Under the existing standards, fair value changes on the swap would be initially deferred in equity, to the extent the hedge is effective, until the date of issue of the bond. At that date, the accumulated amount deferred in equity would be adjusted against the initial carrying amount of the bond and would subsequently be amortised as part of the effective yield calculation. Under the amended standards, the amount deferred in equity would remain there, but would be amortised from equity into the income statement over the life of the bond, also on an effective yield basis In respect of hedged purchases of non-financial assets such as inventory or property, plant and equipment, basis adjustment will be permitted under the amended standards, but not required. The approach adopted must be applied consistently as an accounting policy choice to all cash flow hedges that result in the acquisition of a non-financial asset or non-financial liability. In most cases, basis adjustment will be more straightforward as it does not require tracking of the amount deferred in equity over long periods. If a basis adjustment approach is not followed, such tracking would be required in order to calculate the amount to be released into profit or loss in each reporting period and for impairment testing purposes. On the other hand, US GAAP does not permit basis adjustment, and therefore an entity that also reports under US GAAP may avoid a reconciling item in this respect by choosing not to apply basis adjustment Net investment hedging , An investor in a foreign entity is exposed to changes in value of the net assets of the and SIC-19.4 foreign entity (i.e. the net investment) arising from the translation of the net assets into the group s measurement currency. Such exposures are often hedged through borrowings denominated in the foreign entity s measurement currency or (in more limited circumstances) derivative foreign currency contracts. Principles relating to hedging of net investments in a foreign entity are: gains and losses on a net investment in a foreign entity are recognised directly in equity; corresponding gains and losses on related foreign currency liabilities used as hedging instruments are also recognised directly in equity; and The hedge accounting models

117 21.48 any net deferred foreign currency gains and losses are recognised in the income statement at the time of disposal of the foreign entity and 102 IAS 39 does not override the principles of IAS 21. However, IAS 39 introduces the hedge accounting criteria to hedging of net investments. This means that all the criteria discussed in Section 8.6, such as documentation and effectiveness assessment, must be met for the hedge of a net investment in a foreign entity. An entity must still adhere to the criteria for designation and assessing effectiveness even when using non-derivative hedging instruments When is hedge accounting not required? When the hedging instrument and the hedged item are already accounted for in the same manner, the effects of the hedge relationship will automatically be reflected in the income statement or in equity, making hedge accounting unnecessary. However, the application of hedge accounting is not prohibited, provided that all hedge accounting criteria are met. Hedge accounting generally is not required for: hedging of trading items when changes in fair value are recognised directly in the income statement. In this case both items are already recognised at fair value with gains and losses included in the income statement; and hedging of foreign currency risk of monetary items. For example, when a financial liability in a foreign currency is hedged with a deposit placement in the same currency, the liability as well as the deposit is required to be measured at the applicable closing spot rates with changes recognised in the income statement However, hedge accounting is not prohibited and may be advantageous in some circumstances. For example, an entity may wish to hedge the foreign currency risk on a long-term foreign currency trade payable due in one year s time. To do this the entity takes out a forward with a maturity of one year. The trade payable is translated into the entity s measurement currency at each reporting date at the closing spot rate while the forward is measured at its fair value based on the forward rate (not spot rate). In cases where the spot / forward differential is significant and volatile, this difference in rates may cause undesirable volatility in the income statement. 39.AG110 and IG F.2.8 Overall business risks cannot qualify for hedge accounting, as they cannot be separately and reliably measured. For instance, the risk of obsolescence in inventory or expropriation by a government cannot be hedged since those risks are not measurable. Also the risk of transactions not occurring falls into this category of overall business risks. December 2003 amendments 39.9 The amended standard permits an entity, on initial recognition, to designate any financial asset or liability at fair value through profit or loss. As noted in Sections and 5.3.1, this may allow an entity to avoid the cost and complexity of meeting the criteria for hedge accounting. 8.3 The hedge accounting models 111

118 8.4 Hedged items 39.9 The hedged item is the underlying item that is exposed to the specific financial risk that an entity has chosen to hedge What qualifies as a hedged item? In general the hedged item can be: a recognised asset or liability; an unrecognised firm commitment; or an uncommitted but highly probable anticipated future transaction (forecasted transaction) , 86, AG110 Hedge accounting may only be applied to hedges of exposures that can affect the income and SIC-16 statement. Most transactions can affect the income statement. Exceptions are transactions with shareholders such as share issuances, dividend payments etc. as well as most intragroup transactions. 39.AG110 IG F.2.10 and F.2.11 IG F.2.19 A key requirement is that the hedged item exposes the entity to a risk that can be separately identified and reliably measured throughout the period of the hedge. Exposures to financial market risks such as interest rate risk and foreign currency risk in financial instruments can usually be separately identified and reliably measured. Also, exposure from items with commodity price risk or credit risk may be hedged. The forecasted purchase of an asset to be classified as held-to-maturity may be hedged for the period until the asset is recognised on the balance sheet. Although a held-tomaturity instrument may not be hedged for interest rate risk, the reinvestments of cash flows generated by a held-to-maturity instrument may be hedged. Additionally, a held-tomaturity investment can be hedged with respect to credit risk and foreign currency risk. Non-monetary items (such as equity shares) denominated in a foreign currency and held as available-for-sale with changes in fair value recognised in equity also may be the hedged item. Case 8.1 Hedge of a non-monetary item Entity A acquires equity shares in Entity B on a foreign stock exchange (shares are denominated in a foreign currency). Entity A classifies the shares as available-for-sale instruments with changes in the fair value recognised in equity. To hedge against foreign currency risk, Entity A enters into a forward currency contract. Entity A plans to rollover the contracts as they expire until the shares are later sold. In this situation the forward contract may be designated as a hedging instrument for the fair value changes relating to foreign currency risk of the shares provided that: the acquired shares are not traded on a stock exchange on which trades are denominated in the same currency as Entity A s own measurement currency. This might be the case if Entity B s shares are dual-listed and one of the listings is on an exchange where trades are denominated in Entity A s measurement currency; and dividends to Entity A are not denominated in Entity A s (but rather Entity B s) measurement currency Hedged items

119 8.4.2 Items that do not qualify as hedged items There are a number of items that for different reasons do not qualify for hedge accounting. In these cases the normal recognition and measurement principles in IAS 39 must be applied , 79 and IAS 39 generally precludes derivatives from being the hedged item and as such IG F.2.1 derivatives can only serve as hedging instruments and 79 Unlike originated loans and receivables, a held-to-maturity investment cannot be a hedged item with respect to interest rate risk. In theory, for fixed rate held-to-maturity instruments, an entity should be indifferent to changes in interest rates since the entity does not intend to dispose of the investment before its maturity. The fair value at maturity is unaffected by changes in interest rates. Because prepayment risk on interest-bearing instruments is primarily a function of interest rate changes this risk is akin to interest rate risk and hence cannot be hedged when the hedged item is a held-to-maturity investment. IG F.2.10 The prohibition against hedging interest rate risk on held-to-maturity investments relates to both hedging the risk of fair value changes of a fixed rate instrument and the risk of variability in the interest cash flows of variable rate instruments and AG100 When the hedged item is a non-financial asset or liability, the hedge must either be designated for the foreign currency risk only or for the entire risk of the asset, liability or cash flow. This is because of the difficulty of isolating and measuring the appropriate portion of the cash flows or fair value changes attributable to specific risks other than foreign currency risks. 39.AG99 An equity investment accounted for under the equity method (joint venture or associate) cannot be a hedged item in a fair value hedge. The reason is that the equity method of accounting recognises the investor s share of the investee s net income or loss, rather than its fair value changes, in the income statement. The same reasoning applies to an investment in a consolidated subsidiary, which also cannot be a hedged item in a fair value hedge. Through consolidation the parent entity recognises its share of the subsidiary s net income rather than the fair value changes in its investment in the subsidiary. To allow the subsidiary to be a hedged item would result in double counting, as both the income from the investment in the subsidiary and the full fair value changes would be recognised in the consolidated income statement Groups with foreign entities may wish to hedge the foreign currency exposure from the expected profits from the foreign entities using derivatives or other financial instruments. However, expected net profits from a foreign entity do not qualify as hedged items since they are not subject to a cash flow risk exposure From a foreign entity s own perspective, cash flows generated from its operations are in its own measurement currency and hence do not give rise to a foreign currency risk exposure at the foreign entity reporting level. SIC-16 An entity s own equity instruments cannot be the hedged item since there is no risk exposure that affects the income statement because transactions in own shares are IG F.2.7 recognised directly in equity. Likewise forecasted transactions in an entity s own equity cannot be a hedged item. 8.4 Hedged items 113

120 8.4.3 Hedging a portfolio of items A hedge relationship may be established not only for a single asset, liability or expected transaction, but also for a portfolio of items. Hedging a portfolio requires that: the individual assets, liabilities or future transactions in the portfolio share the same characteristics with respect to the hedged risk; and the change in fair value attributable to the hedged risk for each individual item in the portfolio is expected to be approximately proportional to the overall change in fair value attributable to the hedged risk of the group. IG F.2.20 This means that the portfolio of items must have shared risk characteristics with respect to the risk being hedged. It is not necessary that each item in the portfolio shares all of the same risks and is correlated with respect to all risks, as long as the hedged risk is a common risk characteristic. Examples of items that may be hedge accounted for on a portfolio basis include the following: A portfolio of short-term corporate bonds may be hedged as one portfolio with respect to a shared risk-free interest rate. To achieve the required correlation, the bonds would need to have the same or very similar maturity or repricing date and exposure to the same underlying interest rate. A group of expected future sales may be hedged as one portfolio with respect to foreign currency risk. Such correlation usually requires that the individual sales are denominated in the same foreign currency and are expected to take place in the same time period. An example of a portfolio that would not qualify as a hedged item is a portfolio of different shares that replicates a particular stock index. An entity may hold such a portfolio and economically hedge this with a put option on the stock index. However, in this scenario, it cannot be expected that the fair value changes of individual items in the portfolio would be approximately proportional to the fair value change of the entire group. Future amendments to IAS 39 At the date of this publication, the IASB is finalising its deliberations in respect of Fair Value Hedge Accounting for a Portfolio Hedge of Interest Rate Risk. It is anticipated that, when issued, this will introduce a number of additional requirements for this form of hedge accounting Hedging risk components and proportions of items Hedging a risk component of a financial instrument Financial assets or liabilities may be hedged with respect to a particular financial risk component, provided that the exposure to the particular risk component is separable and can be reliably measured. Examples of such risk components include: and Hedging exposure to interest rates or credit risk spread of a bond (rather than hedging IG F.3.5 the full market risk). Hedging exposure to the risk-free interest rate in a fixed or floating rate liability (rather than hedging the entire interest rate risk) Hedged items

121 IG F.2.19 Hedging foreign currency exposure only in a portfolio of foreign currency denominated equity instruments (rather than hedging the full market price risk). IG F.3.5 A floating rate debt instrument is normally considered not to have fair value exposure because of periodic resetting of its interest rate. However, such an instrument could be hedged in a fair value hedge for credit spread or for interest rate risk exposure that can occur between interest reset dates. Hedging a risk component of a non-financial item Non-financial items may not be hedged for separable risk components other than foreign currency risk. That is because only foreign currency risk is assumed to be a separately measurable risk component. 39.AG100 A price risk relating to a non-financial component may not be hedged. For example, a producer of chocolate bars may wish to hedge the fair value of its inventory in respect of changes in the sugar price (a major ingredient in chocolate bars) by taking out a sugar forward in the commodity market. It would not be permissible in this situation to designate as the hedged item the price risk relating only to the price of sugar. As an alternative the producer may designate the sugar forward as a hedge of the entire fair value changes of the chocolate bar inventory. However, this hedge is only likely to be effective if the price fluctuations on sugar and chocolate bars have been highly correlated in the past and are expected to remain so in the future. As chocolate bars consist of other ingredients than sugar (e.g. cocoa, milk etc.), the hedge is unlikely to be highly effective, and in that case hedge accounting would not be permissible. Hedging a proportion of a hedged item IAS 39 also allows a proportion of the fair value or cash flows of an item to be hedged. Examples of such designations would be: IG F.2.17 Hedging the interest rate risk for the first five years of a 10-year fixed rate bond with a five-year pay-fixed receive-floating interest rate swap. In this situation the bond is hedged for a period of time less than its full term. IG F.3.10 Hedging the price or foreign currency risk of a proportion of a forecasted purchase or sale. This can be done either by specifying the number of units expected to be purchased / sold (e.g. the first 500 units out of expected purchases / sales of 800 units) or by specifying the monetary value of the purchase or sale (e.g. the first 25 million). It would not be permissible to designate the first 50 per cent of sales as the hedged item as this designation would not lead to an identifiable amount being hedged (i.e. the first 50 per cent of sales would depend on the total amount of sales in the period, which is not known until after the fact) and hedge effectiveness testing would not be possible. Hedging the interest rate risk of half of the notional amount of a bond. 8.4 Hedged items 115

122 39.AG100 December 2003 amendments Several comments on the proposed amendments had proposed that separate components of a non-financial item should qualify for hedge accounting as long as changes in the fair value of the hedged component could be measured reliably. The Board rejected this suggestion, but has clarified in the amended standards that hedge accounting might be achieved by adjusting the hedge ratio to maximise effectiveness. For example, a regression analysis might be performed to establish a statistical relationship between the price of a transaction in Brazilian coffee (the hedged item) and a hedging instrument whose underlying is the price of Columbian coffee. If there is a valid statistical relationship between the two prices, the slope of the regression line can be used to establish the hedge ratio that will maximise expected effectiveness. For example, if the slope of the line of best fit is 1.02, then a derivative with a notional amount of 1.02 tons of Columbian coffee would be designated as a hedge of the purchase of one ton of Brazilian coffee. This approach will give rise to some ineffectiveness in practice, although it may be sufficient to ensure that hedge accounting can be achieved. The amended standards will continue, however, to prohibit the hedged item to be designated as the Columbian coffee component of the Brazilian coffee price, even if that component can be proven to exist and can be measured reliably Intragroup balances or transactions as the hedged item and Although intragroup transactions are eliminated on consolidation, intragroup monetary items can be designated as hedged items at the group level in situations where foreign exchange rate exposure cannot be eliminated on consolidation. Intragroup monetary items lead to a group exposure that affects the group income statement in instances when: items have been transacted between group entities with different measurement currencies; the item is denominated in one of these measurement currencies; and at least one of the group entities is a foreign entity. For example, an intragroup payable / receivable between a parent with measurement currency (MC) and its foreign subsidiary is denominated in foreign currency (FC). The transaction itself is eliminated on consolidation. However, the parent still has foreign exchange rate differences since the item is denominated in FC. Therefore, the foreign exchange difference cannot be eliminated. Such an intragroup monetary item could qualify as a hedged item for purposes of hedge accounting if all other criteria are met Hedged items

123 December 2003 amendments In amending the standards, the guidance permitting a forecasted intragroup transaction to qualify as a hedged item in a cash flow hedge has been withdrawn. The reason for this amendment would seem to be that the foreign exchange risk in most forecasted intragroup transactions will affect group profit or loss only indirectly as a result of translating the income statement of a foreign entity for consolidation purposes into the reporting currency of the group. A forecast intragroup transaction, or an intragroup firm commitment, cannot qualify as a hedged item at the group level if there is no potential impact on the profit or loss of the group. At the group level, a forecast external transaction by a foreign entity in its own functional currency cannot generally qualify as a hedged item because the group has no exposure to foreign currency cash flow risk. However, where the group is able to demonstrate, for example, that cash flows from the forecast external transaction are passed directly to an entity with a different functional currency, such that the forecast external transaction does create a foreign currency cash flow exposure to the group, then the standard may not preclude a forecast external foreign currency cash flow from qualifying as a hedged item, at the group level only, as long as the other criteria for hedge accounting are met. 8.5 Hedging instruments What qualifies as a hedging instrument? Derivatives are generally the only instruments that can be used as hedging instruments. Some of the derivatives that are commonly used in hedging transactions and may qualify for hedge accounting include: forward and futures contracts; swaps; options; and compound derivatives (such as cross currency interest rate swaps and collars). Non-derivative financial assets or liabilities may be designated as hedging instruments for hedges of foreign currency risk only. For example, a borrowing denominated in a foreign currency can be designated to hedge a sales commitment in the same foreign currency It is possible to use two or more derivatives, or proportions thereof, as the hedging instrument for the same hedged item. The derivatives do not have to be entered into with the same counterparty. For example, an interest rate swap and a currency forward could be designated together to hedge a loan in a foreign currency. 39.AG96 Generally financial assets and liabilities whose fair value cannot be reliably measured also cannot be hedging instruments. An exception is a non-derivative instrument that is denominated in a foreign currency, that is designated as a hedge of foreign currency risk, and whose foreign currency component is reliably measurable. 8.5 Hedging instruments 117

124 39.AG97 An entity s own equity securities cannot be hedging instruments since they are not financial assets or financial liabilities of the issuing entity Using options as hedging instruments and AG94 Purchased options may be used as hedging instruments provided that the criteria in Section 8.6 are met. Options, in contrast to forward and futures contracts, contain both an intrinsic value and a time value due to the nature of the instrument, i.e. the holder has a right, but not an obligation, to use the derivative. For example, a forecasted transaction in a foreign currency may be hedged with an option. In this situation the cash flows of the forecasted transaction do not include a time value component while the option does. If the option is designated in its entirety (including time value) hedge effectiveness testing must be based on the full fair value change of the option and the change in cash flows of the forecasted transaction. The change in fair value of the option and the change in cash flows of the forecasted transaction will not be the same, since the change in the time value element of the option is not offset by an equal and opposite change in the forecasted transaction IAS 39 allows for the time value of an option to be excluded from the effectiveness assessment. In this case the option is more likely to be effective in matching the changes in the hedged item. Changes in time value would not be included in the hedge relationship and as a result would be recognised directly in the income statement regardless of which hedging model is used. 39.AG94 IG F Written options Written options generally increase risk exposure and, accordingly, cannot be used as hedging instruments unless they are designated as an offsetting hedge of a purchased option. For example, hedge accounting may be applied when a written option is related to a purchased option embedded in a contract, such as callable debt, that is closely related and for that reason not separated from the host contract. If the embedded purchased option were to be separated, hedge accounting would not need to be applied, since both the separated purchased option and the written option would be measured at fair value in the income statement. Some hedging strategies involve a written call option and a purchased put option with different strike prices, in combination forming a collar. Such a strategy may be used in situations where an entity wants to limit its hedging costs by reducing the hedge protection to a certain range of prices or rates. For example, an entity may hedge a bond held as available-for-sale with fair value changes recognised directly in equity, by buying a put option to sell at 90 and writing a call option to sell at 100. The effect of the strategy is that the entity is protected against decreases in value below 90, but has given up the upside potential of a price increase above 100. This is demonstrated in Figure Hedging instruments

125 Figure 8.3 Using a collar as the hedging instrument 39.AG94 and IG F.1.3 Hedge accounting may be applied to such a hedging strategy provided that: no net premium is received either at inception or over the life of the combination of options (if a premium was received it would be evidence that the instrument was a net written option); the options have similar critical terms and conditions, with the exception of strike prices (same underlying variable or variables, currency, denomination and maturity date); and the notional amount of the written option component is not greater than the notional amount of the purchased option component Using a part of an instrument as the hedging instrument A proportion of a financial instrument may be designated as the hedging instrument (i.e. a percentage of the whole instrument). For example, 50 per cent of the fair value changes on a forward contract may be designated as the hedging instrument in a hedge of a forecasted sale and Derivatives as well as non-derivatives must be designated as hedging instruments for the IG F.6.2(i) entire remaining period in which they are outstanding. For instance, an instrument with a maturity of 10 years cannot be designated as a hedging instrument for only its first eight years A hedging instrument, or a proportion thereof, should be designated in its entirety, since there is normally a single fair value measure for a hedging instrument and the factors (i.e. risk components) that cause changes in fair value are co-dependent. While using an entire instrument or a proportion of an instrument is acceptable for hedge accounting, using only a portion (e.g. a risk component) generally is not allowed. For example, a cross 8.5 Hedging instruments 119

126 currency interest rate swap must be designated both with respect to foreign currency risk and interest rate risk. There are a few exceptions to consider: A non-derivative instrument may be designated as a hedging instrument for foreign currency risk only. To allow non-derivatives to be used in situations other than hedging foreign currency risk would create difficulties, since in many instances these instruments are not measured at fair value The interest element of a foreign currency forward contract may be excluded from a hedge relationship when measuring hedge effectiveness. The time value of an option likewise may be excluded from a hedge relationship A derivative hedging instrument may be designated for a particular risk providing that the other parts of the hedging instrument are designated as hedging other risks of the IG F.1.12 hedged item and all other hedge criteria are met. For example, a cross currency interest rate swap may be designated as a cash flow hedge with respect to interest IG F.2.18 rate risk and fair value hedge with respect to foreign currency risk. However, this may create practical difficulties in separating fair values between risks that are interrelated. Where possible a cross currency interest rate swap should be designated in its entirety as a fair value or cash flow hedge. Case 8.2 Hedging with a cross currency interest rate swap (CCIRS) Entity A with EUR as its measurement currency issues a floating rate GBP denominated bond. Entity A also has a fixed rate USD financial asset with the same maturity and payment dates. In order to offset the currency and interest rate risk on the financial asset and liability Entity A enters into a swap to pay USD fixed and receive GBP floating. IG F.2.18 The swap may be designated as a hedging instrument of the USD financial assets against the fair value exposure from changes in the US interest rates and the foreign currency risk between USD and GBP. Alternatively, it could be designated as a cash flow hedge of the cash flow exposure from the variable cash outflows of the GBP bond and the foreign currency risk between USD and GBP. Both of these designations would be permissible under IAS 39, although the hedge does not convert the currency exposure to the entity s measurement currency EUR. In our view, this type of hedge is appropriate only as long as an entity has both foreign currency exposures and is not creating a new foreign currency position but rather decreasing its risk exposure. Both currency exposures should be referred to in the hedge documentation Hedging instruments

127 8.6 Criteria for hedge accounting The hedge relationship must meet the following criteria in order for the hedging instrument and the hedged item to qualify for hedge accounting: the hedge is formally documented at inception; the hedge is expected to be highly effective; the effectiveness of the hedge can be reliably measured; the hedge is assessed prospectively on an ongoing basis, and determined to have been highly effective over the full period; and for cash flow hedges, a forecasted transaction must be highly probable and must present an exposure to variations in cash flows that could ultimately affect reported net income. The hedge relationship should be evidenced and driven by management s approach to risk management and the decision to hedge the particular risk. The designation and effectiveness assessment should principally follow the methodologies that management has in place for risk identification and measurement Formal documentation at inception At the inception of the hedge, formal documentation of the hedge relationship must be established. The hedge documentation prepared at inception of the hedge must include a description of the following: the entity s risk management objective and strategy for undertaking the hedge; the nature of the risk being hedged; clear identification of the hedged item (asset, liability or cash flows) and the hedging instrument; and how hedge effectiveness will be assessed prospectively and measured on an ongoing basis. The method and procedures should be described in sufficient detail to establish a firm basis for measurement at subsequent dates in order to be consistently applied for the particular hedge. IAS 39 does not mandate a specific format for the documentation and in practice hedge documentation may vary in terms of lay-out, technology used etc. The important thing is that the documentation includes the basic content noted above. The following examples of hedge documentation would meet the requirements of IAS 39. Note, however, that in practical terms an entity may be able to standardise its documentation forms in such a way that narrative descriptions are minimised or not necessary, since they are included by reference to other documentation. Entities generally wish to base their hedge documentation on reports already prepared for risk management purposes and limit the amount of additional work required by IAS 39. What is important is that a system is established that links the details of the hedged item and hedging instrument with standardised information from other sources in such a way that full documentation is 8.6 Criteria for hedge accounting 121

128 available to demonstrate the existence of a qualifying hedge relationship at any time during its life. Case 8.3 Documentation of an FX cash flow hedge Global Tech Company (GTC) has made a firm commitment to purchase a machine from a foreign manufacturer in foreign currency (FC) 10,000 in 12 months. GTC wants to hedge the foreign currency exposure of the firm commitment. GTC enters into a 12- month forward contract to exchange a fixed amount of measurement currency (MC) for a fixed amount of FC. Based on this background information, the following documentation is prepared on 1 January 20X1: Risk management objective and strategy and nature of the hedged risk On 1 January 20X1, GTC entered into a commitment to purchase a machine from a foreign manufacturer for FC 10,000 in 12 months. As a result, GTC is exposed to changes in the MC / FC exchange rate. To reduce this exposure so as to be in compliance with risk management requirements to limit exposures to foreign currency risk, on 1 January 20X1 GTC also entered into a 12-month forward contract to exchange a fixed amount of MC for a fixed amount of FC. Changes in the expected value of the forward contract are expected to be highly effective in offsetting the exposure to changes in fair value of the firm commitment. Derivative hedging instrument Identification: [Trade # 12345]; 12-month forward contract to exchange a fixed amount of MC for the amount of FC. Notional amount FC 10,000 at the forward exchange rate of FC 1.5 : MC 1 at inception of the contract. Hedged item Changes in the fair value of the future cash flows of the firm commitment [contract # 67890] to purchase a machine from a foreign manufacturer for FC 10,000 in 12 months caused by fluctuations in the foreign exchange rate between the MC and FC. The gain or loss on the firm commitment will be measured based on the present value of the changes in FC forward exchange rates. Method for recognising the forward contract Any changes in the fair value of the forward contract during the period in which the hedge is in effect will be reflected as a component of equity to the extent that the hedge is effective. When the forward contract is closed and the machine is purchased (31 December 20X1), the effective part of the forward will be reclassified as an addition to, or subtraction from, the carrying amount of the machine at acquisition Criteria for hedge accounting

129 Hedge effectiveness Management expects the hedge relationship will continue to be highly effective during the next 12 months, which is the period of the hedge relationship. Expected cash flows on the forward and firm commitment are for the same currency and amount, and are expected to occur at the same time. On a quarterly basis, GTC will assess hedge effectiveness on a cumulative basis by comparing the changes in fair value of the forward contract that are due to changes in forward rates with changes in the present value of cash flows. As long as the timing of the cash flows does not change, effectiveness should be close to 100 per cent. Note that if an entity enters into similar types of hedge transactions regularly, most of hedge documentation could be provided in a standardised form as part of its risk management policy manual. Specific transaction documentation then could be limited to contract numbers, amounts, currencies, dates, rates and a reference to the appropriate policies in the manual. Case 8.4 Documentation of a fair value hedge relationship On 1 January 20X1, Bank A purchases a bond with a maturity of five years. The bond is purchased at a par value of 100 million and is included in the bank s available-forsale portfolio, with changes in fair value recognised in equity. The interest rate on the bond is fixed at six per cent. Bank A simultaneously enters into a five-year interest rate swap (IRS) with a notional amount of 100 million to receive interest at LIBOR and pay interest at a fixed rate of six per cent. The combination of the IRS and the purchased bond results in Bank A being hedged against changes in the fair value of the purchased bond due to changes in interest rates. The swap reprices twice a year and requires payments to be made or received on 1 July and 1 January of each year. No premium was paid for the IRS. Bank A designates the IRS as a fair value hedge of the interest rate risk inherent in the fixed rate bond. The following documentation is prepared on 1 January 20X1: Risk management objective and strategy On 1 January 20X1, Bank A purchased a five-year 100 million fixed rate bond [reference ABCDE] which is carried in the available-for-sale portfolio. The interest rate on the purchased bond is six per cent. As a result, Bank A is exposed to changes in the fair value of the purchased bond due to changes in market interest rates. Due to the bank s overall interest rate risk position and funding structure, its risk management policies require that the bank should minimise its exposure to fair value changes in the price of the bond due to changes in market interest rates. Bank A meets this objective by entering into a five-year IRS with a notional amount of 100 million to receive interest at a variable rate equal to LIBOR and to pay interest at a fixed rate of six per cent. The hedge relationship results in the bank being hedged against changes in the fair value of the purchased bond due to changes in interest rate. 8.6 Criteria for hedge accounting 123

130 The derivative hedging instrument IRS [contract XYZ] will be used as the hedging instrument: Notional amount: 100 million Premium paid: none Fixed leg: six per cent per annum Fixed leg payer: Bank A Floating leg: LIBOR, repricing 1 July and 1 January of each year Floating leg payer: Bank B Settlement: net cash due in arrears on 1 July and 1 January of each year The fair value changes of the IRS due to changes in interest rates will be recognised in the income statement. The hedged item Bank A designates the five-year bond, purchased 1 January 20X1 and paying a fixed rate of interest of six per cent, as the hedged item. The changes in the fair value of the bond relating to the hedged risk are also included in the income statement. Hedge effectiveness The critical terms of the IRS and the purchased bond are identical. The following conditions have been met: the notional amount of the IRS equals the principal amount of the bond purchased; both the interest received on the bond and paid on the IRS are fixed; the maturity date of the IRS matches the maturity date of the purchased bond; the formula for computing net settlements under the IRS is the same for each net settlement. The fixed rate is the same throughout the term and the variable rate equals LIBOR throughout the term; there is no floor or cap on the variable interest rate of the swap; the fair value of the swap at its inception is zero; it is unlikely that the purchased bond will be repaid prior to maturity; the fair value changes of the bond due to changes in market interest rates are designated as hedged; and all other terms of the purchased bond and the IRS are typical of those instruments and do not invalidate the assumption of no ineffectiveness. Due to the above, Bank A concludes that at inception the hedge relationship is expected to be highly effective in achieving offsetting fair value changes of the IRS and the purchased bond due to changes in interest rates Criteria for hedge accounting

131 Ongoing effectiveness testing will be performed through comparison of the cumulative changes in the fair value of the bond to cumulative changes in the clean fair value of the IRS (i.e. accrued interest will be excluded from the fair value). This analysis will exclude changes in fair value of the bond due to risks and factors other than interest rates. Changes in the fair values of each instrument will be modelled by Bank A on a quarterly basis and assessed on a cumulative basis. Management believes this effectiveness can be reliably measured. IG F Hedge effectiveness An entity must adopt a method for assessing hedge effectiveness that is consistently applied for similar types of hedges unless different methods are explicitly justified. For example, an entity would generally use the same methods for prospectively assessing as well as for measuring actual hedge effectiveness for forecasted sales to the same export market in each period. The method chosen will depend on the entity s risk management strategy. A summary of the requirements for prospective assessment and measurement of hedge effectiveness can be illustrated as follows: Figure 8.4 Different requirements for effectiveness assessment and measurement Prospective assessment of effectiveness In order for hedge accounting to be applied, the hedge transaction must be expected to be highly effective in achieving offsetting changes in the fair value or cash flows attributable to the hedged item. This offsetting must be expected to occur in a manner consistent with the originally documented risk management strategy for that particular type of hedge relationship. IAS 39 states that: and AG105 A hedge is normally regarded as highly effective if, at inception and throughout the life of the hedge, the entity can expect changes in the fair value or cash flows of the hedged item to be almost fully offset by the changes in the fair value or cash flows of the hedging instrument. 8.6 Criteria for hedge accounting 125

132 39.AG AG107 and AG108 IG F.4.4 Expectation of an almost perfect offset at inception is necessary to allow for unexpected imperfections in the hedge relationship during the hedge period that might otherwise require early termination of hedge accounting. IAS 39 does not prescribe a single method for the assessment of effectiveness, but rather emphasises that the method must follow the risk management methodologies of the entity. The prospective effectiveness assessment can be performed in several ways, such as: matching critical terms of the hedging instrument and the entire hedged item may support a conclusion that changes in fair value or cash flows attributable to the risk being hedged are expected to completely offset at inception and on an ongoing basis; using a scenario analysis of historical data; or using a statistical model, such as a regression analysis that analyses the correlation between changes in value or cash flows of the hedged item and the hedging instrument for a given historic period. An example of the first bullet point above would be hedging a specific bond held by entering into a forward contract to sell an equivalent bond with the same notional amount, currency and maturity. Another example would be the hedge of a fixed rate borrowing with a receive-fixed pay-floating interest rate swap where the notional amount, currency, maturity, interest basis and interest repricing terms are identical. This direct approach to assessing hedge effectiveness can be applied for prospective assessment. However, a formal measurement of the actual effectiveness results must be performed. When the critical terms are not exactly the same or only a portion of the asset, liability or transaction is being hedged, prospective hedge effectiveness must be assessed and documented. When a statistical model is used, the hedge documentation must specify how the results of the analysis are to be interpreted. IASB Board meeting February 2004 As explained more fully in Section 1, the IASB has tentatively agreed to remove the requirement that, prospectively, gains and losses should almost fully offset. If confirmed, this amendment is likely to mean that some hedging relationships that previously failed to qualify for hedge accounting will qualify in the future Ongoing assessment and measurement and Effectiveness must be measured on an ongoing basis and the hedge relationship proved AG actually to have been highly effective throughout the financial reporting period. At a minimum, the frequency of this should be whenever interim or annual financial statements are prepared. Entities may be inclined to perform hedge effectiveness testing more frequently in order to minimise the time period where hedge accounting cannot be applied IG F.4.7 due to ineffectiveness and in order to better manage the risk exposure. IAS 39 does not allow the use of a short-cut method and as a result effectiveness assessment and measurement must be performed at a minimum at each reporting date. 39.AG105 The actual results of hedge effectiveness must be within a range of 80 to 125 per cent offset for hedge accounting to be applied. Hedge effectiveness measurement may be based on either a period by period or on a cumulative basis depending on what has been Criteria for hedge accounting

133 IG F AG and IG F.4.4 IG F.4.3 established in the hedge documentation. For the latter, even if a hedge is not highly effective in a particular period, hedge accounting is not precluded if the effectiveness remains sufficient on a cumulative basis. Measuring effectiveness on a cumulative basis may reduce the risk of a hedge becoming ineffective, and is therefore the more common method in practice. The gain or loss on the hedged item must be measured independently from that of the hedging instrument (i.e. it cannot just be assumed that the change in fair value or cash flows of the hedged item in respect of the hedged risk equals the fair value change of the hedging instrument). The reason for this is that any ineffectiveness of the hedging instrument must be recognised in the income statement. A single method for the prospective assessment of effectiveness is not prescribed and the method applied may be different for different types of hedges. However, the periodic measurement of hedge effectiveness would usually involve a method that compares the actual change in fair value of the hedged asset or liability or in cash flows with respect to the hedged risk to the change in the fair value of the hedging instrument (an offset method). This means that some of the methods used for prospective hedge assessment (e.g. statistical analysis) would not be used for measuring actual hedge effectiveness. Both when assessing prospectively and when measuring actual effectiveness, the creditworthiness of the counterparty to the hedging instrument and the likelihood of default should be considered. The value of a swap could be affected by changes in the respective swap counterparty s credit rating. Prepayment risk will impact the effectiveness of fair value hedges. If the hedged item is repaid before expected, this will lead to a situation where the entity is over-hedged, as the notional amount of the hedging instrument may be more than the remaining outstanding amount of the hedged item. In that case it is likely that the hedge relationship would no longer be effective. The same applies to expectations about changed timing of future cash flows. Therefore, the risk of prepayment or changes to timing of future cash flows should be considered when an entity designates its hedge relationships , The time value of an option or the interest element of a forward may be excluded from 39.AG the ongoing effectiveness assessment. For an option, the hedge relationship would be and IG F.1.9 designated only for the price range when the option is in-the-money. Therefore, when the option is out-of-the-money, no effectiveness measurement is necessary, however prospective assessment is still required. The excluded portion of the option or forward is recognised immediately in the income statement. When the time value of an option or the interest element of a forward is excluded from the hedge, the measurement of hedge effectiveness is based only on the changes in the intrinsic value of the option or the spot rate of the forward. A dynamic strategy including intrinsic value and time value may also be applied, though there is little elaboration in IAS 39 about what is acceptable. A deltaneutral hedging strategy, where the hedging instrument is constantly adjusted in order to maintain a desired hedge ratio, may qualify for hedge accounting. 39.AG111 The assessment of hedge effectiveness for interest rate risk can be performed using a maturity schedule. Such a maturity schedule would show the net position for each strip of the maturity schedule resulting from the aggregation of the assets and liabilities maturing or repricing of cash flows at that time. The net exposure hedged must then be associated with an asset, liability or cash inflow or outflow in order to apply hedge accounting, provided that the correlation of the changes of the hedging instrument and the designated hedged item can be assessed. Further discussion of this methodology is included in Section Criteria for hedge accounting 127

134 IG F.4.1 Hedge effectiveness may be measured on either a pre-tax or post-tax basis. This should be noted in the hedge documentation. Case 8.5 Effectiveness testing On 1 January 20X1, ABCorp a commodities dealer, anticipates its sales at market rates of precious metals that will occur in early May 20X1. In order to hedge the commodity price risk of the transaction, ABCorp enters into a forward (the hedging instrument) maturing on 1 May 20X1 to hedge the anticipated sales of precious metals (the hedged item). The fair value of the hedging instrument is zero at inception. ABCorp determines and documents that the hedge is an effective cash flow hedge at inception. As part of monitoring the ongoing effectiveness of the hedge relationship, each month ABCorp determines the change in the discounted cash flows expected from the anticipated sales and the change in the fair value of the forward. During the hedging period in 20X1, the fair values and the changes in discounted cash flows of the hedging instrument and the hedged item respectively are as follows: 31 January 28 February 31 March 30 April Section 1 Periodic effectiveness Change in fair value for the month: Hedging instrument (100) (50) Hedged item (110) (140) Effectiveness for the month 111% 71% 100% 100% Section 2 Cumulative effectiveness Cumulative change in fair value: Hedging instrument (100) (150) (40) 100 Hedged item (90) Cumulative effectiveness 111% 94% 80% 111% Section 3 Determination of effectiveness Cumulative effective portion of the hedging instrument revaluation included as a component of equity (90) (150) (40) 90 Change in the effective portion of the hedging instrument revaluation for the month (90) (60) Change in the hedging instrument revaluation for the month (100) (50) Ineffective portion of hedging instrument revaluation for each month recognised in the income statement (10) Criteria for hedge accounting

135 Section 1 illustrates the effectiveness measured on a period-by-period basis while Section 2 illustrates a cumulative basis. This is for demonstration purposes only an entity should choose only one of these two methods at the inception of the hedge, and include this choice in its documentation of the hedge relationship. The analysis consists of three main sections. Section 1 details the monthly effectiveness and fair value changes of the hedging instrument and changes in discounted cash flows of the hedged item. The hedge remains within the 80 to 125 per cent range, therefore the relationship qualifies for hedge accounting until the month of February 20X1, when the monthly effectiveness is 71 per cent. Section 2 details the cumulative change in fair values of the hedging instrument and hedged item. The hedge relationship continues to be maintained as IAS 39 allows hedge effectiveness to be measured on a cumulative basis when consistently applied. During the hedging period, the cumulative effectiveness remains within the range of 80 to 125 per cent, which supports the effectiveness of the hedge relationship for the period. Section 3 details the analysis for determining the effective portion of the hedging instrument revaluation that should be included as a component of equity. The change in value of the hedging instrument is divided into the portion that is effective, to which hedge accounting is applied, and the portion that is ineffective, which is immediately recognised in the income statement. For example, at 31 January 20X1 the effective portion of the hedging instrument revaluation is only that amount that offsets the revaluation of the hedged item. The hedging instrument is revalued at a loss of However, as the revaluation gain on the hedged item is only 90, there is an ineffective portion of -10 for the hedging instrument that must be recognised in the income statement and the remaining -90 is recognised as a component of equity. At 28 February 20X1, the cumulative revaluation loss on the hedging instrument increases to However, the cumulative revaluation gain on the hedged item increases to 160. The cumulative loss on the hedging instrument is now less than the cumulative gain on the hedged item. As such, on a cumulative basis, no portion of the hedging instrument revaluation is ineffective. Thus, the full revaluation loss of the hedging instrument of -150 is included as a component of equity. At 31 March 20X1, the cumulative change in fair value of the hedging instrument remains less than the change in fair value of the hedged item. As such, the revaluation component in equity would be a loss of -40, but no ineffective portion is recognised in the income statement as the cumulative revaluation gain on the hedged item is 50. Lastly, at 30 April 20X1, the cumulative revaluation on the hedging instrument increases to a gain of 100 which more than offsets the revaluation loss of -90 on the hedged item. As such, the revaluation component in equity would be 90 and an ineffectiveness gain of 10 is recognised in the income statement. (Note: The numbers used in the above example are illustrative. The example does not consider the ongoing assessment of prospective effectiveness that is also required at each reporting date.) 8.6 Criteria for hedge accounting 129

136 Hedge ineffectiveness and 95 Even when a hedge relationship meets the effectiveness criteria, the fair value change on the hedged item and the hedging instrument often will not offset completely. Ineffectiveness of the hedging instrument must be recognised in the income statement, except when a non-derivative instrument is used to hedge a foreign net investment. The effective portion of a cash flow hedge is the lesser of: the cumulative gain or loss on the hedging instrument necessary to offset the cumulative change in expected future cash flows on the hedged item from inception of the hedge excluding the ineffective component; and the cumulative change in the fair value of the expected future cash flows on the hedged item from inception In a cash flow hedge, if the full cumulative gain or loss on the hedging instrument is more than the cumulative expected future cash flows on the hedged item, the difference must be recognised in the income statement as hedge ineffectiveness. December 2003 amendments In amending the standards, the Board has taken the opportunity to simplify its explanation of the effective portion of a cash flow hedge. It is now described more simply as the lesser of: the cumulative gain or loss on the hedging instrument from the inception of the hedge; and the cumulative change in fair value (present value) of the expected future cash flows from the hedged item from inception of the hedge. The impact of this change is unlikely to be significant in practice Forecasted transactions must be highly probable Forecasted transactions must be highly probable and must present an exposure to variations in cash flows that ultimately could affect the income statement. In practice, an indicator of a transaction being highly probable is a likelihood of more than 90 per cent. Management s intent, forecasts and budgets as well as historical data may be used as the basis to assess the highly probable assumption. IG F.3.7 For groups of similar transactions the probability criterion may be met by designating a lower and therefore more certain amount of risk exposure as being hedged. For example, a bank may enter into fixed rate mortgage loan commitments with potential customers, which give the customer 90 days to lock in a mortgage at a specified rate. To reduce the interest rate risk inherent in the anticipated mortgage transactions, the bank enters into forward starting interest rate swaps on the expected acceptances. When evaluating the probability of acceptance by only a single customer, a high probability would be difficult to demonstrate. On the other hand, when evaluating the probability of a group of commitments, it is possible that the bank may estimate with high probability the amount of mortgages that will eventually be closed. In this case, the bank would apply cash flow hedge accounting for the hedge of interest rate risk on the amount of mortgages that are highly probable of closing Criteria for hedge accounting

137 Similarly, when assessing the probability of hedging certain instruments with prepayment risk, assessing the probability of interest cash flows for the portfolio rather than for a single instrument could result in an acceptable hedge of these instruments for a bottom layer of the interest cash flows. Hedging anticipated transactions with purchased options might raise questions about management s assessment of whether the transaction will actually occur. For example, an entity purchases an option on a particular foreign currency because the entity has made a bid for a large contract in that foreign currency. The entity wants to hedge the potential foreign currency income from that contract although the income is not yet certain. The foreign currency cash flows in this case might not be highly probable as they depend on the entity first winning the bid for the contract. IG F.3.10 and F Defining the time period in which the forecasted transaction is expected to occur IAS 39 requires that the forecasted transaction must be identified and documented with sufficient specificity so that when the transaction occurs, it is clear whether the transaction is or is not the hedged transaction. An entity is not required to predict and document the exact date a forecasted transaction is expected to occur. But the documentation should identify a time period in which the forecasted transaction is expected to occur within a reasonably specific and generally narrow range of time, as a basis for assessing hedge effectiveness. In order to determine the proper time periods for hedge accounting purposes an entity may look to: Forecasts and budgets: The expectation is that entities generally would not identify longer time periods for hedge accounting purposes than those used for forecasting and budgeting. The nature of the business / industry: The forecasting and budgeting periods used by an entity are influenced by the entity s ability reliably to forecast the timing of its transactions. Generally one would expect the forecast periods for manufacturers of ships or aircraft to be longer than those of retail stores because retailers usually sell smaller items in large quantities and can usually more easily forecast the timing of sales over shorter periods of time. Although the above factors provide an indication of what may be the appropriate time period in which the transaction is expected to occur, the actual time period should always be determined on a case-by-case basis and will involve some degree of judgement. 8.7 Termination of a hedge relationship There are several circumstances that could lead to the termination of a hedge relationship. Examples of situations that would cause a hedge relationship to be terminated include: the hedging instrument expires, or is sold, terminated or exercised; the hedged item is derecognised; the forecasted transaction is no longer highly probable; the effectiveness criteria are no longer met; or management chooses to de-designate the hedge relationship. 8.7 Termination of a hedge relationship 131

138 39.91, 92 and 101 A replacement of a hedging instrument or rollover is not deemed to be a termination if the new instrument has the same characteristics as the instrument being replaced, it continues to meet the hedge criteria and the rollover strategy is properly documented at inception. Using a rollover hedge strategy, the entity may continue to perform hedge effectiveness testing on a cumulative basis from the beginning of the period in which the first hedging instrument was rolled over. Also amortisation of any fair value adjustment made to the hedged item under a fair value hedge may continue to be deferred until the rollover hedge strategy is discontinued (c) The notion of a highly probable forecasted transaction is a higher degree of probability than one that is merely expected to occur. If a forecasted transaction is no longer highly probable but is still expected to occur, the net cumulative gain or loss that was recognised in equity during the effective period of the hedge remains in equity until the transaction actually occurs. However, prospectively the entity can no longer apply hedge accounting Hedge accounting for a forecasted transaction that is no longer expected to occur must be terminated. It may not be replaced by another expected transaction. If a forecasted transaction is not expected to occur in the initially forecasted period or within a relatively short period thereafter, it is not considered to be the same hedge, and the hedge relationship should be terminated. The effect of delays of forecasted transactions is considered in more detail in Section When an effective hedge relationship no longer exists, the accounting for the hedging instrument and the hedged item must revert to accounting under the normal principles. If the forecasted transaction that the instrument was originally intended to hedge is no longer expected to occur, any gains or losses on the hedging instrument that have been recognised in equity are recognised in the income statement immediately. Figure 8.5 summarises the accounting treatment for a forecasted transaction where the probability of the transaction occurring changes. Figure 8.5 Accounting impact of a change in expectation of a forecasted transaction If the hedge effectiveness criteria are no longer met, hedge accounting must be terminated. Termination of a hedge must have effect prospectively as of the date when the hedge was last proved effective, which may be the previous interim or annual reporting date Termination of a hedge relationship

139 For this reason testing hedge effectiveness more regularly is a way to reduce the impact of the unexpected termination of a hedge relationship and If a hedging instrument ceases to be part of a hedge relationship, the instrument may be IG F.6.2(i) re-designated to a new hedge relationship, as long as this is for the entire remaining term of the instrument. This would once again fulfil the requirement of being designated as a hedging instrument for the entire outstanding period. For example, a forward contract of 100 designated to hedge a forecasted transaction of 100 may no longer be expected to be effective if new forecasts indicate the forecasted transaction may now only involve expected cash flows of 80. In this situation, the original hedge designation would be discontinued. A new relationship under which a proportion (80) of the forward is designated as a hedge of the new expected cash flow of 80 would be allowed. The changes in fair value of the remaining unused portion of the forward (20) must be recognised in the income statement. Table 8.2 Accounting consequences of hedge termination Reason for termination Fair value hedge Cash flow hedge Hedged item: Derecognition of the hedged item. A gain or loss on the derecognised item is recorded in the income statement based on the carrying amount, including the adjustments resulting from the hedge. The hedging instrument continues to be measured at fair value with changes recorded in the income statement. The gain or loss on the hedging instrument previously recorded in equity is recorded in the income statement immediately. The hedging instrument continues to be measured at fair value with changes recorded in the income statement. Expected transaction or firm commitment no longer expected to occur. Not applicable. The gain or loss on the hedging instrument previously recorded in equity is recorded in the income statement immediately Expected transaction or firm commitment no longer highly probable but still expected to occur. Not applicable. Hedge accounting is terminated prospectively. Further changes in the fair value of the hedging instrument must be recorded in the income statement. Any gain or loss previously recognised in equity remains in equity until the transaction occurs or is no longer expected to occur. 8.7 Termination of a hedge relationship 133

140 Reason for termination Fair value hedge Cash flow hedge 39.91, 92 and 101 Hedging instrument: Derecognition of the hedging instrument other than replacements and rollovers. The gain or loss on derecognition of the hedging instrument is recorded in the income statement. The hedged item must revert to the applicable accounting requirements from the date of derecognition of the hedging instrument, i.e. cease to be adjusted for changes resulting from the hedged risk. If the hedged item is a debt instrument and the maturity is determinable, the adjustment recorded as part of the carrying amount of the hedged item should be amortised to the income statement from that date onwards using the effective interest method. A gain or loss on the hedging instrument previously recorded in equity remains in equity until the forecasted transaction occurs , 92 and 101 The hedge no longer meets the hedge criteria (effectiveness) or management decides to dedesignate the hedge. Same accounting as in derecognition of the hedging instrument except that instead of derecognising the hedging instrument it should be prospectively remeasured through the income statement, unless the hedging instrument is redesignated as a hedge of another hedged item. Same accounting as in derecognition of the hedging instrument except that instead of derecognising the hedging instrument it should be prospectively remeasured through the income statement, unless the hedging instrument is redesignated as a hedge of another hedged item. 8.8 Net position hedging and internal derivatives Net positions Many financial institutions and corporates use net position hedging strategies under which a centralised treasury function accumulates risk originated in the operational subsidiaries or divisions. The treasury function hedges the net exposure in accordance with the group s risk policies by entering into a hedge transaction with a party external to the group Net position hedging and internal derivatives

141 Net position hedging does not by itself qualify for hedge accounting treatment because of the inability to: associate hedging gains and losses with a specific item being hedged when measuring effectiveness; and determine the reporting period in which such gains and losses should be recognised in the income statement and AG101 However, an entity is not necessarily precluded from hedge accounting by hedging net positions. That is, an entity may choose to manage and (economically) hedge risk on a net basis, but for hedge accounting purposes designate a specific item within the net position as the hedged item. Hedging interest rate net positions is discussed in Section 9.2. Hedging foreign currency net positions is discussed in Section 9.3. Future amendments to IAS 39 At the date of this publication, the IASB is finalising its deliberations in respect of Fair Value Hedge Accounting for a Portfolio Hedge of Interest Rate Risk. It is anticipated that, when issued, this will introduce a number of additional requirements for this form of hedge accounting Internal derivatives Derivatives between entities within the same reporting group may be used to control and monitor risks through a central treasury function, as well as potentially to benefit from pricing advantages of being able to group smaller individual transactions for offsetting by larger transactions done with external third parties, or for netting of opposite exposures Accounting for internal derivative transactions should be viewed in light of IFRS consolidation requirements. This requires the elimination of all transactions and balances between group entities. Therefore, only derivatives involving external third parties can be designated as hedging instruments in the consolidated financial statements. However, hedge accounting can be achieved in such cases if a one-to-one relationship of the internal IG F.1.5 and F.1.6 transactions to related external transactions is documented. In general, unless this oneto-one relationship can be established, the effects of the internal transactions must be eliminated on consolidation. 8.9 Other considerations There are a variety of issues directly or indirectly related to or impacted by the hedge accounting principles. This Section gives a brief overview of some of these issues Risk reduction and hedge accounting and IAS 39 does not require an overall risk reduction in order to apply hedge accounting. IG F.2.6 For example, an entity may have fixed rate assets and liabilities that provide a natural economic hedge that leaves the entity with no exposure to interest rate risk. This entity may decide to enter into a pay-fixed receive-floating swap and designate this as a hedge of either the assets or liabilities. Although this would increase the entity s overall interest rate risk exposure, hedge accounting may be applied to this transaction provided that the relevant hedge accounting criteria are met. 8.9 Other considerations 135

142 IG F.2.18 IAS 39 does not specifically require that a hedge of foreign currency risk is designated so as to convert a foreign currency into the entity s measurement currency. As described earlier is Section 8.5.4, an entity may wish to use a cross currency interest rate swap to eliminate the currency and interest exposure of an asset and a liability in two different foreign currencies. This is permissible under IFRS, provided that the entity has corresponding asset and liability positions denominated in the foreign currencies that are hedged by the cross currency interest rate swap. Therefore, when designating the hedge, it is important to clearly specify in the hedge documentation the risks that are being hedged Deferred tax issues In accordance with IAS 12 for transactions recognised directly in equity, all current and deferred tax should also be recognised in equity. In respect of hedge accounting this means that current and deferred taxes on gains or losses on hedging instruments deferred in equity also should be recognised in equity until such time when the gain or loss is recycled to the income statement Impairment of an asset that is hedged and The principles for hedge accounting do not override the accounting treatment under IAS or IAS 39 if there is impairment of the hedged item. Therefore, if a hedged item is impaired, this impairment should be recognised even if the risk that causes the impairment is being hedged and hedge accounting is applied. However, the hedge accounting principles may require that a gain on a hedging instrument used to hedge the risk that gave rise to the impairment will be recognised simultaneously in the income statement and may (partly) offset the recognised impairment and 61 For example, an entity may hold a portfolio of securities that are classified as availablefor-sale with fair value adjustments recognised in equity. The fair value at a given point is 300. The entity has a put option to put the securities to a third party at 250. The entity may apply hedge accounting to this transaction provided that the hedge relationship meets the relevant criteria. The entity designates the option as a hedge of the cash flows from an expected future sale of the securities. Assume that the fair value of the portfolio subsequently decreases by 120 and there is objective evidence of impairment. This impairment must be recognised in the income statement. The amount of impairment to record would be the difference between the original cost of the securities (300) and the new fair value (180), not taking into account the existence of the put option. However, since at this point the impairment on the hedged item affects the income statement, the related and 98 gain on the put option would also be recognised in the income statement. This means that a gain of 70 ( ) ignoring time value, will be recognised in the income statement and will partly offset the loss on the securities. December 2003 amendments and 98 The restrictions introduced in respect of basis adjustments mean that amounts relating to a cash flow hedge of an asset that has been acquired may be retained in equity. In such cases, it will be necessary to ensure that if the related asset becomes impaired, an appropriate amount is also recycled from equity to profit or loss Other considerations

143 9. Hedge accounting for each type of financial risk Key topics covered in this Section: Interest rate risk hedging Foreign currency risk hedging Hedges of net investments in foreign entities Commodity and equity price risk hedging Abbreviations used in this Section: MC = measurement currency; FC = foreign currency 9.1 Overview Section 8 explained the basic requirements, the accounting models and criteria for hedge accounting under IAS 39. This Section focuses on some of the most common financial risks that an entity may hedge and how applying hedge accounting to these risks will affect the income statement and balance sheet. It also provides examples of the journal entries needed to record the hedge accounting transactions. 39.AG Interest rate risk Identifying the hedged risk and the hedging models Interest rate risk arises from entities holding interest-bearing financial assets and / or liabilities or from forecasted or committed future transactions with an interest-bearing element in them. Interest-bearing instruments bear either: Fixed interest: Since the interest rate is fixed, future interest payments are also fixed. In this case the interest rate risk relates to the fair value change of the financial asset or liability in response to changing market interest rates; or Floating interest: In this case the future interest payments will depend on an underlying interest index (e.g. LIBOR) and hence the interest rate risk relates to variations in future cash flows. Possible hedged items in fair value hedges include: IG F.2.13 fixed rate loans and receivables originated by the entity; fixed rate assets categorised as available-for-sale with fair value changes recognised directly in equity; and fixed rate financial liabilities not held for trading. 9.2 Interest rate risk 137

144 39.AG103 Possible hedged items in cash flow hedges include cash flows from: floating rate loans and receivables originated by the entity; floating rate assets categorised as available-for-sale with fair value changes recognised directly in equity; floating rate financial liabilities not held for trading; firm commitments that have an interest rate exposure; and highly probable anticipated transactions that have an interest rate exposure. In some cases the same interest rate risk exposure may be hedged with either a fair value hedge or a cash flow hedge. For example, an entity with an overall (net) interest rate risk exposure to floating rate liabilities may choose to hedge this exposure with a pay-fixed receive-floating swap. This swap may be designated as the hedging instrument of either: a fixed rate asset in a fair value hedge; or a floating rate liability in a cash flow hedge. IG F.6.1 and F.6.2 The derivative has the same economic effect of reducing the interest rate exposure, but the accounting differs depending on whether the hedge relationship is designated as either a fair value or cash flow hedge. Entities can make their own assessment as to which of these two hedge models can be best applied in their circumstances. This is especially important to entities such as banks and corporate treasuries that need to account for multiple hedge transactions. The decision about which hedge accounting model to use may depend upon the information systems and reporting that the entity has available. The entity must assess whether existing information systems are best set up to manage and track the information required under a fair value model or a cash flow model. This decision also may depend upon the characteristics of the hedged items and whether hedge accounting criteria can be met, e.g. prepayment risk in mortgage loans may be an issue, as discussed in Section on effectiveness testing of interest rate hedges. IG F.6.2 Under a fair value model, assets and liabilities designated as the hedged item must be remeasured for fair value changes attributable to the hedged risk, and normally result in an adjustment of the effective interest yield. This usually requires a system that is able to track changes in fair value of the hedged risk, and that can associate these changes with the hedged items. Also the system should be able to recompute the effective yield of the hedged item and amortise the changes to the income statement over the remaining life of the hedged item Under a cash flow model the fair value changes of the hedging instruments are recognised in equity and are later released to the income statement when the cash flows from the hedged items are recognised in the income statement. This requires a system that enables the entity to track the timing of the cash flows, as well as the timing of the reversal of the hedging gains and losses from equity. Although this may impose a challenge, for many entities such information can be based on the cash flow information already captured in risk management systems of the entity Interest rate risk

145 9.2.2 Hedging expected interest cash flows An entity may choose to hedge the interest cash flows from interest-bearing assets and liabilities including: floating rate assets (e.g. debt securities, originated loans); and IG F.2.2 and F.6.2 floating rate liabilities (e.g. customer deposits at a bank, bonds issued by a corporate). An entity also may hedge its interest rate risk exposure from forecasted interest payments such as: an expected debt issuance; an expected purchase of financial assets; expected rollovers of existing loans; or expected draw-downs under revolving credit facilities. An entity may apply hedge accounting to an anticipated debt issuance. The appropriate hedge accounting model in this case would be a cash flow hedge. The gains or losses resulting from the hedging instrument until the debt is issued would be deferred in equity, and then would adjust the initial carrying amount of the debt. The subsequent amortisation of the basis adjustment would be recognised by adjusting the instrument s future interest expense. For example, an entity in the process of issuing a bond may wish to hedge the risk of changes in interest rates from the time the entity decides to issue the bond until it is issued. This could be done using an interest future or another derivative instrument. To the extent it is effective, the gain or loss on the derivative would be deferred in equity until the bond is issued, at which point the deferred gain or loss would adjust the initial carrying amount of the bond (as a basis adjustment). The gain or loss is recognised in the income statement as interest payments are made and effectively adjusts the interest expense recognised on the debt To meet the hedge accounting criteria a forecasted debt issuance must be highly probable. This would be the case once the entity enters into an agreement to issue the bond, but may already be evidenced at an earlier stage when management decides upon a debt issuance as part of the entity s funding strategy. Another example of a hedge of forecasted interest payments is that of an entity which plans to issue a series of floating rate notes, each with a maturity of three years. The entity intends to issue similar notes immediately after the maturity of the initial notes. In this situation the entity may enter into a six-year swap to hedge the variability in expected interest cash flows on both notes. For hedge accounting purposes the hedge could be designated as a hedge of the expected interest payments in different periods including interest payments arising from the forecasted refinancing of the debt. At inception of the hedge the criteria for hedge accounting must be met, including the criteria that the hedge would be highly effective, and that the re-issue after three years is highly probable. 9.2 Interest rate risk 139

146 December 2003 amendments As noted above, the amendments will prohibit the use of basis adjustment in a hedge of a forecast purchase or issuance of a financial asset or liability. The effect of the hedge is achieved, instead, by amortising the amount deferred in equity under the cash flow hedge into income over the life of the hedged item. The income statement effect should be the same as using basis adjustment, but the separate tracking of the amount deferred in equity may be more complex. An added complication will be the need to take into account separately any debit deferred in equity when assessing impairment of an asset whose cash flows have previously been hedged. IG F Effectiveness testing of interest rate risk hedges The effectiveness requirements discussed in Section 8 are applicable for hedges of interest rate risk. For interest-bearing assets that are on balance sheet, prepayment options could have a significant impact on whether a hedge relationship is effective. Examples of prepayable assets include originated loans that may be prepaid by the borrower and debt securities that may be repaid early by the issuer. Prepayment risk affects the timing as well as the amount of cash flows, therefore this risk may impact effectiveness results for fair value hedges, as well as the requirement of high probability for forecasted cash flows. A prepayable hedged item will generally experience smaller fair value changes than a hedged item that is not prepayable. Effectiveness is likely to be more difficult to demonstrate for a fair value hedge than for a cash flow hedge when hedging a portfolio. In a fair value hedge it may be difficult to achieve a highly effective offset of fair values of the hedged item and the hedging instrument when the hedged item terminates early due to prepayment. Moreover, it may be difficult to group a portfolio of fixed rate assets subject to prepayment risk since it may be difficult to prove that the changes in fair value of the individual assets are approximately proportional to the overall change in fair value of the portfolio. As a result fixed rate assets subject to prepayment risk may have to be hedged on a one-to-one basis. Hence the likelihood of ineffectiveness due to prepayment is larger since the effect on the fair value is not absorbed by a portfolio Prepayment risk may also affect whether a cash flow hedge is considered to be highly probable of occurring. However, when the hedged item is designated as a portion of gross cash flows of a portfolio in a given period, the effect of a prepayment is less likely to cause the hedge not to be highly probable as long as there are sufficient cash flows in the period. This could be demonstrated by the entity preparing a cash flow maturity schedule that shows sufficient gross levels of expected cash flows in each period to support a highly probable assertion. For example, a bank may be able to accurately determine what levels of prepayments are expected for a particular class of its originated loans. The bank might hedge only a portion of the contractual cash flows from that portfolio of loans, as the bank expects a number of the borrowers to pay off their loans early. IG F.5.5 Forecasted transactions create a cash flow exposure to interest rate changes because related interest payments will be based on the actual market rate when the transaction occurs. In these situations the hedge effectiveness assessment would be based on the Interest rate risk

147 IG F.2.17 expected interest payments, calculated using the forward interest rate on the applicable yield curve, which should be highly probable in order to qualify for hedge accounting. For forecasted transactions such as anticipated debt issuances, it is not possible to determine what the actual market interest rate will be for the debt issuance. In these situations hedge effectiveness may be measured based on the changes in the interest rates that have occurred between the designation of the hedge and the date that effectiveness testing is performed. The forward interest rates that should be used are those that correspond with the term of the expected transaction at inception and at the date of the effectiveness testing. IG F.5.5 has a detailed example about how hedge effectiveness may be measured for a forecasted transaction in a debt instrument. When only a portion of an interest-bearing instrument is hedged, effectiveness testing usually becomes more difficult. For example, an entity may choose to hedge the interest rate risk of an acquired 10-year fixed rate bond only for the first five years. The entity may designate a pay-fixed and receive-floating interest rate swap with five years to maturity as the hedging instrument. This swap could be designated as a hedge of the fair value of the first five years of interest payments and the change in fair value of the principal payments in year 10, but only to the extent affected by changes in the yield curve relating to the five years of the swap. For effectiveness testing purposes the loan is treated as if it had a synthetic principal repayment in year five. Any fair value difference resulting from changes between the five-year and 10-year yield curve would not be considered part of the hedge relationship and the carrying amount of the loan would not be adjusted by this amount. The same is true for fair value changes of the interest payments after year five. The following cases demonstrate a number of the issues that have been discussed in Section 9.2 about hedging interest rate risk. Case 9.1 Fair value hedge of a fixed interest rate liability Global Tech Company (GTC) requires financing of 100 million for five years. On 1 January 20X1, GTC issues non-callable five-year 100 million of bonds. The interest rate on the bonds is fixed at six per cent and is payable semi-annually. The bonds are issued at par. GTC s overall risk management strategy and current position is to have variable rate funding. Therefore, GTC enters into a five-year interest rate swap (IRS) with a notional amount of 100 million. The IRS pays a floating interest rate based on LIBOR and receives a six per cent fixed interest rate. The floating rate of interest for the first six months is 5.7 per cent. The timing of the IRS cash flows equals those of the bond s interest expense. The fair value of the IRS at inception is zero. Management designates and documents the IRS as a fair value hedge of interest rate risk for the issued bonds. The hedge relationship is determined to be effective based on the offsetting effect of the fair value changes of the IRS to the fair value changes of the bond. 9.2 Interest rate risk 141

148 The following entries are made to record the transactions: Debit Credit 1 January 20X1 No entry is necessary related to the IRS, as the cost is zero at inception Cash 100,000,000 Bonds payable 100,000,000 To record the proceeds from the bond issuance At 30 June 20X1, interest rates have increased. The interest rates for the next six months of the variable leg of the swap have repriced from 5.7 per cent to 6.7 per cent. Due to this general increase in market interest rates, a fair value gain on the bonds payable and a loss on the IRS have resulted. The fair value of the bond (after settlement of interest) has changed from 100,000,000 to 96,196,000. GTC separately revalues the IRS and has determined that its fair value is 3,804,000. Based on the offsetting effect of the fair value changes of the IRS and the fair value changes of the bond, management determines that the hedge is still effective. The following accounting entries are recorded at 30 June 20X1: Debit Credit 30 June 20X1 Interest expense 3,000,000 Cash 3,000,000 To record the payment of six per cent fixed interest on the bonds Bonds payable 3,804,000 Hedging revaluation gain (income statement) 3,804,000 To record the change in the fair value of the bonds attributable to the hedged risk Cash 150,000 Interest income 150,000 To record the settlement of net interest accruals on the IRS for the period 1 January 20X1 to 30 June 20X1 (Receive six per cent fixed 3,000,000; pay 5.7 per cent floating 2,850,000) Hedging revaluation loss (income statement) 3,804,000 IRS liability 3,804,000 To record the change in the fair value of the IRS after settlement of interest As can be seen from the above entries, the net interest expense shown in the income statement is 2,850,000, which represents the floating interest of 5.7 per cent Interest rate risk

149 At 31 December 20X1, interest rates have not changed, therefore, the interest rate on the variable leg of the swap remains at 6.7 per cent. The fair value (after settlement of interest) of the bond is 96,563,000. GTC separately revalues the IRS and has determined that its fair value is 3,437,000. Based on the offsetting effect of the fair value changes of the IRS to the fair value changes of the bond, management determines that the hedge is still effective. The following accounting entries are recorded at 31 December 20X1: Debit Credit 31 December 20X1 Interest expense 3,000,000 Cash 3,000,000 To record the payment of six per cent fixed interest on the bonds Hedging revaluation loss (income statement) 367,000 Bonds payable 367,000 To record the change in the fair value of the bonds attributable to the hedged risk Interest expense 350,000 Cash 350,000 To record the settlement of the IRS for the period 30 June 20X1 to 31 December 20X1 (Receive six per cent fixed 3,000,000; pay 6.7 per cent floating 3,350,000) IRS liability 367,000 Hedging revaluation gain (income statement) 367,000 To record the change in the fair value of the interest rate swap The interest expense shown in the income statement is 3,350,000, which represents the floating interest of 6.7 per cent for this six-month period. The balance sheet at 31 December 20X1 will be as follows: Assets Liabilities and equity Cash 93,800,000 Retained earnings (6,200,000) Bonds payable 96,563,000 IRS liability 3,437,000 93,800,000 93,800, Interest rate risk 143

150 The income statement shows interest expense related to the transactions as follows: First half year at 5.7 per cent 2,850,000 Second half year at 6.7 per cent 3,350,000 Total 20X1 6,200,000 Termination of the hedge Assume that on 31 December 20X1, GTC determines that it should end the IRS hedge due to a change in its risk position. GTC terminates the IRS and pays 3,437,000 to the counterparty for settlement. The following entry is made: Debit Credit IRS liability 3,437,000 Cash 3,437,000 To record the settlement of the IRS for fair value at 31 December 20X1 As can be seen from the balance sheet at 31 December 20X1, the bonds payable are carried at 96,563,000. This results in a discount of 3,437,000 from the par value of 100 million. This discount would be amortised over the remaining life of the bonds as a yield adjustment to the interest expense on the bonds payable. In this example the hedge is found to be 100 per cent effective. This is due to the designation of the hedge. The hedge is designated such that the bond is hedged only with respect to changes in six-month LIBOR. Fair value changes due to other factors such as credit risk are excluded from the hedge relationship and therefore do not give rise to any ineffectiveness. As a result the only possible ineffectiveness would be due to changes in credit risk from the counterparty to the swap since this would affect the fair value of the swap (remember that derivatives have to be designated in their entirety). Case 9.2 Cash flow hedge of a variable rate liability GTC requires financing for its operations of 100 million for five years. On 1 January 20X1, GTC issues non-callable five-year 100 million floating rate bonds. The floating interest of LIBOR plus 50 basis points (0.5 per cent) is payable semi-annually. The bonds are issued at par. As part of GTC s risk management policy, it determines that it does not wish to expose itself to fluctuations in market interest rates. After the issue of the bonds, GTC immediately enters into a five-year interest rate swap (IRS) with a notional amount of 100 million. The IRS pays six per cent fixed and receives floating cash flows based on LIBOR (set at 5.7 per cent for the period from 1 January to 30 June 20X1). The timing of the IRS cash flows equals those of the bond interest expense. The fair value of the IRS at inception is zero. The IRS is designated and documented as a cash flow hedge of the future interest payments on the bond. This is determined based on the offsetting effect of the cash flows of the IRS and the interest expense cash flows of the bond. The hedge relationship is determined to be effective Interest rate risk

151 The effective interest payable is fixed at 6.5 per cent (6 per cent fixed from the IRS plus the additional 0.5 per cent on the bond). GTC records the following entries: Debit Credit 1 January 20X1 No entry is necessary related to the IRS, as the cost is zero at inception Cash 100,000,000 Bonds payable 100,000,000 To record the proceeds from the bond issuance At 30 June 20X1, interest rates have increased compared to 1 January 20X1. The swap rate for the remaining term has increased from six per cent to seven per cent. Due to this general increase in market interest rates, a fair value gain on the IRS results. LIBOR increases to 6.7 per cent for the next six months of the variable leg. However, during this time the credit risk of the swap counterparty worsens and the applicable interest rate associated with the counterparty has increased beyond the general increase in market interest rates. The increased credit risk of the counterparty results in a specific credit spread of 0.75 per cent. The discount rate to be used for discounting the receivable (floating) leg of the swap is therefore 7.45 per cent at 30 June 20X1. As such the fair value of the IRS is determined to be 3,442,000 after the settlement of interest due on 30 June 20X1. The change in expected future cash flows on the bonds is 3,804,000. The fair value changes of the IRS during the period from 1 January 20X1 to 30 June 20X1 are summarised below: 1 January 20X1 30 June 20X1 Change Fixed leg (100,000,000) (96,196,000) 3,804,000 Floating leg 100,000,000 99,638,000 (362,000) IRS 3,442,000 3,442,000 To assess the effectiveness of the hedge, the change in the fair value of the floating leg of the IRS is compared with the change in the fair value of the bond, as the hedged risk is the variability of interest cash flows from the bond. Since the interest on the bond is variable and the interest rate for the next period has been set at the same date the hedge effectiveness is assessed, the change in the fair value of the bond is zero, resulting in a hedge ineffectiveness of 362,000. However, based on the expected cash flows from the IRS, GTC determines that the relationship is still an effective hedge of the interest expense cash flows on the bond. Therefore, the full change in the fair value of the IRS is recognised in the hedge revaluation reserve as a component of equity. This adjustment is limited to the lesser of the cumulative gain or loss on the hedging instrument (3,442,000) and 9.2 Interest rate risk 145

152 the fair value of the cumulative change in expected future cash flows on the hedged item (3,804,000). The following accounting entries are made at 30 June 20X1: Debit Credit 30 June 20X1 Interest expense 3,100,000 Cash 3,100,000 To record the payment of 6.2 per cent floating interest on the bonds payable (LIBOR 5.7 per cent plus premium of 0.5 per cent) Interest expense 150,000 Cash 150,000 To record the net settlement of the IRS for the period from 1 January 20X1 to 30 June 20X1 (Pay six per cent fixed 3,000,000; receive 5.7 per cent floating 2,850,000) IRS 3,442,000 Hedge revaluation reserve (equity) 3,442,000 To record the change in the fair value of the IRS after settlement of interest As can be seen from the above entries, the interest expense shown in the income statement is 3,250,000, which represents the fixed interest of 6.5 per cent. At 31 December 20X1, interest rates have not changed since 30 June 20X1, however, the credit risk associated with the counterparty to the IRS has changed since that date. The counterparty specific credit spread has decreased from 0.75 per cent to 0.5 per cent. The fair value (after settlement of interest) of the IRS is now 3,196,000. The expected future cash flows of the bond are now 3,437,000. Based on the offsetting of the change in expected cash flows on the IRS and the change in interest expense cash flows on the bond, the hedge is still deemed to be effective. The following accounting entries are recorded: Debit Credit 31 December 20X1 Interest expense 3,600,000 Cash 3,600,000 To record the payment of 7.2 per cent floating interest on the notes (LIBOR of 6.7 per cent plus a premium of 0.5 per cent) Interest rate risk

153 Debit Credit Cash 350,000 Interest income 350,000 To record the settlement of the IRS for the period from 1 July 20X1 to 31 December 20X1 (Pay six per cent fixed 3,000,000; receive 6.7 per cent floating 3,350,000) Hedge revaluation reserve (equity) 246,000 IRS 246,000 To adjust the fair value of the cash flow hedge As can be seen from the above entries, the interest expense shown in the income statement is again 3,250,000, which represents the fixed interest of 6.5 per cent. The balance sheet at 31 December 20X1 will be as follows: Assets Liabilities Cash 93,500,000 Retained earnings (6,500,000) IRS asset 3,196,000 Equity (hedge revaluation reserve) 3,196,000 Bonds payable 100,000,000 96,696,000 96,696,000 Case 9.3 Cash flow hedge using an interest rate cap At 1 January 20X1, DEBTCO obtains a three-year loan of 10,000,000. The interest rate on the loan is variable at LIBOR plus two per cent. DEBTCO is concerned that interest rates may rise during the next three years, but wants to retain the ability to benefit from LIBOR rates below eight per cent. In order to protect itself from this exposure, DEBTCO purchases for 300,000 an out-of-the-money interest rate cap from a bank. When LIBOR exceeds eight per cent for a particular year DEBTCO receives from the bank under the cap an amount calculated as 10,000,000 * (LIBOR eight per cent). The combination of the cap and the loan results in DEBTCO paying interest at a variable rate (LIBOR plus two per cent) not exceeding 10 per cent. On both the variable-rate loan and the interest rate cap, rates are reset at 1 January and interest amounts are settled at 31 December. DEBTCO designates and documents the intrinsic value of the purchased interest rate cap as a cash flow hedge of the interest rate risk attributable to the future interest payments on the loan for changes in LIBOR above eight per cent. Changes in the time value of the option will be excluded from the assessment of hedge effectiveness. Therefore, time value changes are recognised in the income statement as they arise. The critical terms of the cap are identical to those of the loan and DEBTCO concludes that, both at inception of the hedge and on an ongoing basis, the hedge relationship is expected to be highly effective in achieving offsetting cash flows attributable to changes 9.2 Interest rate risk 147

154 in LIBOR when LIBOR is greater than eight per cent. As the cap is being used to purchase one-way protection against any increase in LIBOR, DEBTCO does not need to assess effectiveness in instances where LIBOR is less than eight per cent. The cumulative gains or losses on the interest rate cap, adjusted to remove time value gains and losses, can reasonably be expected to equal the present value of the cumulative change in expected future cash flows on the debt obligation when LIBOR is greater than eight per cent. This should be reassessed each reporting period. During the three-year period LIBOR rates and related amounts are as follows: Receivable Interest under payable on Net interest Net interest Date Rate cap loan payable payable 20X1 7% 900, ,000 9% 20X2 9% (100,000) 1,100,000 1,000,000 10% 20X3 10% (200,000) 1,200,000 1,000,000 10% The fair value, intrinsic value and time value of the interest rate cap and changes therein at the end of each reporting period, but before cash settlement of interest are as follows: Change in Change in Intrinsic fair value time value Date Fair value value Time value gain/(loss) gain/(loss) 1 January 20X1 300, , December 20X1 280, ,000 (20,000) (20,000) 31 December 20X2 350, , ,000 70,000 (130,000) 31 December 20X3 200, ,000 (150,000) (150,000) IAS 39 does not specify how to compute the intrinsic value of a cap option where the option involves a series of payments. In this example, the intrinsic value of the cap is assumed to equal the expected future cash flows holding constant the cap s current reporting period cash flow of one per cent (nine per cent eight per cent) for the remaining term of the cap and excluding the time value of money. Alternatively, the intrinsic value of the cap might be calculated for each reporting period by comparing the cap rate with the market s expectations of movements in LIBOR using the LIBOR forward yield curve. Assuming that all criteria for hedge accounting have been met, the following journal entries must be made on 1 January 20X1 and 31 December 20X1, 20X2, and 20X3: Debit Credit 1 January 20X1 Cash 10,000,000 Loan payable 10,000,000 To record the initial borrowing Interest rate cap (asset) 300,000 Cash 300,000 To record the purchase of interest rate cap Interest rate risk

155 Debit Credit 31 December 20X1 Interest expense (income statement) 900,000 Cash 900,000 To record interest expense on the loan (LIBOR + two per cent) Hedge expense (income statement) 20,000 Interest rate cap (asset) 20,000 To record the change in the fair value of the interest rate cap time value change 31 December 20X2 Interest expense (income statement) 1,100,000 Cash 1,100,000 To record interest expense on the loan (LIBOR + two per cent) Hedge expense (income statement) 130,000 Interest rate cap (asset) 70,000 Hedging reserve (equity) 200,000 To record the change in the fair value of the interest rate cap. 130,000 represents the change in time value, which is excluded from the assessment of hedge effectiveness, and 200,000 represents the increase in the interest rate cap s intrinsic value Hedging reserve (equity) 100,000 Hedge income (or interest income) (income statement) 100,000 Represents the release to the income statement of the proportion of the increase in intrinsic value of the cap which relates to the realised cash flow through interest expense incurred in 20X2 Cash 100,000 Interest rate cap (asset) 100,000 To record the cash received upon settlement of the interest rate cap 31 December 20X3 Interest expense (income statement) 1,200,000 Cash 1,200,000 To record interest expense on the loan (LIBOR + two per cent) Hedge expense (income statement) 150,000 Interest rate cap (asset) 50,000 Hedging reserve (equity) 100,000 To record the change in the fair value of the interest rate cap 150,000 loss represents the time value change; 100,000 gain represents the intrinsic value change 9.2 Interest rate risk 149

156 Debit Credit Hedging reserve (equity) 200,000 Hedge income (or interest income) (income statement) 200,000 To record the release to the income statement of the proportion of the increase in intrinsic value of the cap which relates to the realised cash flow through interest expense incurred in 20X3 Cash 200,000 Interest rate cap (asset) 200,000 To record the cash received upon final settlement of the interest rate cap As a result of the hedge, DEBTCO has effectively capped its interest expense on the three-year loan at 10 per cent. Specifically, during those periods where the contractual terms of this loan would result in an interest expense greater than 10 per cent or 1,000,000 (i.e. in instances where LIBOR exceeded eight per cent), the payments received from the interest rate cap effectively reduce interest expense to 10 per cent as illustrated below. However, recognition in earnings of changes in the fair value of the cap due to changes in time value results in variability of total interest expense during each year: 20X1 20X2 20X3 Interest on LIBOR + two per cent debt 900,000 1,100,000 1,200,000 Reclassified from equity (effect of cap) (100,000) (200,000) Interest expense adjusted by effect of hedge 900,000 1,000,000 1,000,000 Change in time value of cap 20, , ,000 Total expense 920,000 1,130,000 1,150, Net position hedging of interest rate risk Banks and similar financial institutions often manage this risk on a net basis, usually in time buckets which group assets and liabilities by the earlier of expected maturity or repricing date. Such entities assess the interest rate risk in all interest-bearing financial assets and liabilities and determine the net exposures. This is because there may be some natural offsets within an entity s balance sheet already, particularly so for banks and other financial institutions. Therefore, it is only for the net risk positions that the entity may decide to obtain derivatives or other instruments to provide an economic hedge , AG101 For hedge accounting purposes, a net position may not be designated as the hedged item. and IG F.2.21 However, an entity still may be able to apply hedge accounting if the hedge relationship is designated in a way that meets the criteria set forth in IAS 39. Generally the entity needs to select (one or a group of) specified assets or liabilities, cash flows or forecasted transactions that are part of the net position, and designate these as the hedged item. Case 9.4 gives a basic example of this approach. The above approach may be useful in some cases, although it is arbitrary in that the hedged item (for accounting purposes) is not the net position (i.e. the real economic risk) Interest rate risk

157 that the entity wants to manage. Further, this approach may not be practical for entities that have an ongoing interest rate risk management program and have large volumes of netted interest rate positions. This is typically the case for financial institutions. An entity may tailor its own method to satisfy the basic criteria in IAS 39 while utilising existing risk management systems. One such method, which is a further extension of the basic approach above, is provided in IG F.6.3, which is an illustrative example of applying Question IG F.6.2 Hedge accounting considerations when interest rate risk is managed on a net basis. This example illustrates a method for hedging interest rate risk in a portfolio of interest-bearing assets and liabilities using interest rate swaps. The method involves scheduling out all of the entity s interest rate cash flow exposures (hedged items) and all of its interest rate swaps (hedging instruments) over a period of time. A typical schedule / gap analysis might use one-month time periods for up to several years in the future. For longer-term assets and liabilities, the schedule might use one-year or even longer time periods. A summary of this method is described in the following steps, and should be read in conjunction with the IGC s illustrative example. Step 1: The entity should identify for each reporting period: the forecasted principal and interest cash inflows and outflows (from both fixed and variable rate assets and liabilities); and the interest repricing exposures (from variable rate assets and liabilities), explained in the note below. All of the identified cash flows are scheduled out in a maturity schedule. The schedule should reflect estimates about prepayments and defaults. The cash inflows and outflows and the repricing of variable rate assets and liabilities create a net exposure in each period either a net cash inflow that needs to be reinvested, or a net cash outflow that needs to be paid. The net exposure identified for each period may be used as the starting point for assessing the entity s overall cash flow exposure to interest rates. Note: For fixed rate instruments, the fixed interest to be received or paid and the principal are included in the analysis in each period in which they are expected to be received or paid. There is presumed to be an exposure to interest rates in that period because the cash flows will need to be reinvested or refinanced during that period. For variable rate instruments, the entire notional amount and estimated interest amounts are included in each period that the instruments are expected to reprice. Interest amounts for variable rate instruments can be estimated using forward rates. For both the fixed rate and variable rate instruments, there is a common exposure to interest rate changes created by the reinvestment, refinancing or repricing of the instruments cash flows. Step 2: If the entity already has pre-existing interest rate swaps that would meet hedge accounting criteria, these should be included in the analysis in each period that they are outstanding to determine the entity s actual net exposure. The notional amounts of existing interest rate swap contracts are compared to the net exposures determined in Step 1. Any difference between the two is the amount of remaining exposure that the entity may want to hedge. Note: Similar to variable rate instruments, the notional amounts of the interest rate swaps are included in each period that they remain outstanding. The swaps notional amounts 9.2 Interest rate risk 151

158 create an interest rate exposure because interest is computed based on the notional amount each period, and the variable component of the swap is repriced each period. Step 3: At this point the entity has identified its actual net exposure to interest rate risk. The entity s risk management policies usually will identify what is a tolerable interest exposure to leave unhedged. To the extent that the net exposure exceeds risk management limits, the entity may hedge the balance by entering into additional interest rate swaps (or other interest rate derivatives) to reduce that part of the exposure. Note: Steps 1 to 3 above are procedures an entity may follow in doing economic hedging. This may even be how the entity addresses interest rate risk already. However, further steps are needed to qualify for hedge accounting. Step 4: In order to apply hedge accounting, the hedging instruments in each period now need to be associated with a gross cash flow position. Steps 1 to 3 identified the net exposures that the entity wants to hedge. However, the interest rate swaps now need to be specifically related to cash flow interest risks, for both effectiveness testing and for accounting purposes. (a) The entity determines the expected interest from the reinvestment of the cash inflows and repricing of assets by multiplying the gross amounts of exposure for each period by the forward rate for each period. (This assumes that the actual net exposure determined in Step 3 is an inflow exposure. If the actual net exposure is an outflow, the entity determines the expected interest based on refinancing of cash outflows and repricing of liabilities.) (b) The designated hedged item is the expected interest from the reinvestment of the cash inflows or repricing of the gross amount for the first period after the forecasted transaction occurs. Because of this designation, it does not matter that the cash flows from that period are from both fixed and from variable instruments or from rollovers of short-term debt, nor for what period of time the cash flows will be reinvested. The key feature is that all of these instruments share the same exposure to changes in the forward interest rate during that one period. There is interest rate exposure in subsequent periods as well, however, that is not designated as being hedged as that would require knowing the number of periods of reinvestment, refinance or repricing for all items. (c) The entity determines the portion of its gross cash flows that are being hedged (expressed in terms of a percentage). This is simply the notional amount of the interest rate swaps designated as hedging instruments in each period divided by the gross amounts of exposure for each period. This percentage is applied to the gross interest calculated in Step 4(b) above to determine the hedged expected interest. Step 5: Hedge effectiveness of the net position needs to be tested at least each reporting period. However, this process is simplified due to the designation of the hedged item as a portion (expressed as a percentage) of expected interest for the first period only after the forecasted transaction. Therefore, to the extent that total expected interest cash inflows exceed the hedged interest cash inflows in each of the periods being hedged by the swaps, the entity only need compare the cumulative changes in the present value of the hedged interest cash inflows with the cumulative change in the fair value of the interest rate swaps Interest rate risk

159 Note: The interest rate hedged should be defined as the benchmark interest rate. In that case the effectiveness test results would be very highly effective. Figure 9.1 Steps 1 to 3 illustrated: Identify the interest rate exposure and swaps used for hedging Figure 9.2 Step 4 illustrated: Identify gross cash flows as the hedged positions By following the approach suggested in the illustrative example set out in IG F.6.3, the requirements in IAS 39 are met in respect of what qualifies as a hedging instrument and hedged item. Namely: Hedged item: The hedged expected interest is a portion of the total cash flows. For financial assets and liabilities, an entity may designate a portion of a cash flow as the hedged item. In this example that portion is the cash flows occurring in the first period after the reinvestment / repricing date Hedging instrument: The interest rate swaps are designated as hedging the expected interest cash inflows for each remaining period in which the swaps are outstanding. 9.2 Interest rate risk 153

160 Case 9.4 Net position hedging interest rate risk A bank monitors its interest rate risk exposures through reviewing gaps within repricing bands of net asset or liability positions of a single currency. For illustration purposes, only the first three months are illustrated. (Normally the maturity breakdown would include periods up to, for example, 10 years, with a detailed breakdown in the first year and wider bands in subsequent years.) Less than 1 month 1 to 2 months 2 to 3 months Assets Treasury bills Placements with banks Loans 5,000 5,200 6,500 Bonds Assets in the repricing band 5,600 6,100 7,400 Liabilities Customer deposits 4,000 2,500 3,500 Deposits from banks 2,000 3,200 3,000 Bills, commercial paper issued Liabilities in the repricing band 6,300 5,800 7,000 Net position for the currency (700) Under a net position-hedging scenario, if the bank wishes to hedge the entire 700 net liability exposure in the first time band, it could do so through a derivative instrument for the repricing band of less than one month. However, rather than documenting the net position as the hedged item, the bank could designate 700 of customer deposits in the less than one-month band, and hedge accounting could be applied. In order to illustrate this, suppose that the bank designates a swap (pay-fixed, receivevariable) as a cash flow hedge of the interest payable on 700 of liabilities that reprice each month, such as the bottom layer of the customer deposits. The bank must establish that it is highly probable that greater than 700 of customer deposits with similar characteristics will be available each month the swap is outstanding. The customer deposits designated should share the same exposure to the risk that is being hedged, e.g. the exposure to a benchmark interest rate risk. The bank could perform statistical analysis to document this shared risk basis. Forecasting of cash flows should be part of the asset and liability management process of forecasting the repricing cash flows of the bank, and supported by the history of actual repricing cash flows. High probability of the expected cash flows could be supported if customer deposits of far more than 700 are available. The same approach described here may be used for the other repricing bands noted above Interest rate risk

161 IG F Case 9.5 Hedging on a group basis interest rate risk Assume that a bank has both a trading desk and a banking desk. The banking desk manages the interest, liquidity and other risk exposures from the bank s lending and funding operations. Financial assets and liabilities of these operations are generally carried at amortised cost. In order to manage its interest rate risk exposures, the banking desk enters into interest rate swap agreements with the trading desk to swap a floating rate of interest for a fixed rate (cash flow hedge). These transactions with the trading desk are documented as hedging transactions and the banking desk would like to apply hedge accounting. The trading desk enters into various other derivative agreements with external parties as part of its trading activities, in addition to the transactions with the banking desk. In the accounting records of the trading desk, all such instruments are trading instruments and are carried at fair value with changes recognised in the income statement. Hedge accounting is not appropriate for internal transactions unless it can be demonstrated that for each instrument that the banking desk has entered into with the trading desk, there is an equivalent contract that the trading desk entered into with an external party. In practice, this can be achieved, for example, by setting up a separate book for the transactions of the trading desk with the banking desk and the related external party transactions. The transactions that would be entered into by the bank in order to apply hedge accounting are noted below. The example assumes an exposure to a floating rate liability, with the rate based on the six-month inter-bank rate: Banking desk internal swap Receive variable at the six-month inter-bank rate notional 100 million. Pay-fixed at eight per cent notional 100 million. Trading desk internal swap Receive-fixed at eight per cent notional 100 million. Pay-variable at the six-month inter-bank rate notional 100 million. Trading desk external swap Receive variable at the six-month inter-bank rate notional 100 million. Pay-fixed at eight per cent notional 100 million. Term and payment dates of external swap mirror those of the banking desk s internal swap. The swap with the external party is effective in offsetting the exposure of the banking desk. Therefore, in the above case, hedge accounting is appropriate, provided the other hedge criteria are met. However, if instead an interest rate swap with a notional 75 million was outstanding with a third party, the accounting treatment would be different. In such a case, no more than 75 million could be designated as a hedge and would qualify for hedge accounting. 9.2 Interest rate risk 155

162 It is possible to achieve hedge accounting when the trading desk aggregates several internal swaps, or portions thereof, and enters into one offsetting external contract. The aggregated internal swaps must be a gross amount, i.e. they should not be used to offset each other. This approach can be done provided that the external swap is identified and is effective in hedging the aggregate exposure of the banking desk. Fair value hedging accounting for interest rate risk on a portfolio basis The IASB is in the process of considering amendments that might allow financial institutions in particular more easily to apply fair value hedge accounting for hedges of interest rate risk when its risk management approach is to hedge a net balance sheet position. At the date of this publication, certain issues such as the measurement of ineffectiveness, the amortisation of the fair value hedge adjustments to the portfolio and the treatment of demand deposits in such a model remain under discussion. The IASB expects to issue limited amendments to the standards in this respect in. 9.3 Foreign currency risk Identifying the hedged risk and the hedging models IG F.6.5 Hedge accounting for hedges of foreign currency risk is commonly used for: hedging the future cash flows or value (foreign currency component) of non-monetary financial assets or liabilities when fair value changes are not recognised in the income statement (fair value or cash flow hedge); and hedging forecasted future transactions in foreign currency (cash flow hedge) whether a firm / contractual commitment or a highly probable anticipated transaction. Accounting for the hedge of foreign currency risk on a non-financial asset as a fair value hedge requires that the hedged item itself is denominated in a foreign currency, as opposed to an asset that is expected to be sold in a foreign currency. That is, it must have a separately measurable foreign currency component in its pricing. An example of this is an investment property located in a country with a different currency and that is measured at fair value at each balance sheet date. The fair value of this property will include a currency component equal to the changes in the spot rate between the foreign currency and the owner s measurement currency. Application of hedge accounting principles to this currency exposure will not change the measurement of the hedged item or the hedging instrument as gains or losses resulting from changes in foreign exchange rates would be recognised in the income statement. Property, plant and equipment carried at historical cost cannot be hedged for foreign currency risk since the assets are not remeasured for changes in foreign exchange rates. However, if these assets are expected to be sold, the expected cash flows from this sale could be a hedged item under a cash flow hedge provided that the transaction is highly probable and the other criteria for hedge accounting are met Foreign currency risk

163 9.3.2 The effect of delays or prepayments of hedged cash flows Delays or prepayments of hedged cash flows frequently occur when hedging foreign currency risk in a cash flow hedge. However, these issues are also applicable any time an entity is hedging other types of financial risks in forecasted transactions. Determining the timing of forecasted cash flows involves making estimates. Sometimes cash flows do not occur when they are expected. In determining the appropriate accounting treatment for delayed transactions it is useful initially to distinguish between hedged cash flows related to: a firm commitment; a forecasted transaction with an identified counterparty; and forecasted transactions with unidentified counterparties Firm commitments and forecasted transactions with identified counterparties Whenever the timing of delivery, payments or other terms under a firm commitment are changed, an entity must evaluate whether the original firm commitment still exists, or whether a new firm commitment with new terms has been created. The latter situation would result in the original hedge relationship being terminated and the gains or losses on the hedging instrument previously recognised in equity would be recognised in the income statement. IG F.5.4 IG F.3.11 IG F.5.4 A firm commitment could be delayed for a number of reasons such as a breach of the contract, liquidity problems on the part of the counterparty, delayed delivery or complaints about delivery. Alternatively, it may be due to customers changing specifications for the ordered product or a change in a customer s production schedule. If the firm commitment is delayed, but will still occur, it is important to determine the cause and duration of the delay. When delays of cash flows occur, it is our view that hedge accounting may be continued under certain circumstances. These circumstances are that the firm commitment can still be uniquely identified, a binding agreement still exists and the cash flows are still expected to occur within a relatively short period of time after the original transaction date. For a firm commitment, this last item should be interpreted rather narrowly because the contract supporting a firm commitment generally will specify a date or range of dates. If a date (e.g. delivery date, completion date) is not specified, the transaction is unlikely to meet the definition of a firm commitment; rather it should be hedged as a forecasted transaction with an identified counterparty. For a forecasted (highly probable) transaction with an identified counterparty, there may be a little more flexibility in what is regarded as a relatively short period of time because there is no firm commitment that establishes a delivery date. The key issue is, when taking into account all the facts and circumstances surrounding the delay, whether the entity can demonstrate that the delayed transaction is the same transaction as the one that was originally hedged. When the timing of a firm commitment or a highly probable forecasted transaction is delayed, some degree of ineffectiveness is likely to occur, since the timing of the hedged item and the hedging instrument will no longer be the same. 9.3 Foreign currency risk 157

164 IG F.5.4 and In other cases the timing of a hedged cash flow may change to be earlier than originally expected. Since the hedging instrument would expire later than the hedged cash flows, some ineffectiveness is likely to occur in this situation as well. However, the hedging instrument may not be re-designated for a shorter period (i.e. until the cash flow is now expected to occur), as there is still the requirement that a hedging instrument must be designated for its entire remaining time outstanding Cash flows from forecasted transactions with unidentified counterparties Cash flows from forecasted transactions with unidentified counterparties are designated with reference to the time period in which the transactions are expected to occur. This is because these forecasted transactions do not yet have any identified counterparties that would otherwise allow them to be identified with respect to a specific expected transaction. When forecasted cash flows in one period do not occur, an entity may be able to demonstrate that such a shortfall will be offset by increased cash flows in a later period. For example, an entity initially forecasts sales of FC 100 in each of the first two quarters of the next year. At a later point the entity revises its forecast to expected sales of FC 75 in the first quarter and FC 125 in the second quarter. The total amount of sales in the two quarters remains unchanged at FC , For hedge accounting to be continued the original forecasted transaction must still exist and IG F.3.7 and be highly probable of occurring. When the hedged item is designated as cash flows from forecasted transactions (e.g. forecasted sales) with unidentified counterparties within a certain time period, it would be very unlikely that an entity would be able to demonstrate that sales in later periods are due to a shortfall in an earlier period. In that case hedge accounting should be discontinued. In addition, a history of designating hedges of forecasted transactions and then determining they are no longer expected to occur may call into question the entity s ability to accurately predict forecasted transactions, as well as the propriety of using hedge accounting in the future for similar transactions. IG F.3.11 The transactions must take place within a narrow range of time from a most probable date. In determining the length of such a period, the industry and environment that the entity operates in should be considered. Our view is that for forecasted transactions with unidentified counterparties, this narrow range of time should be more strictly interpreted (i.e. a shorter time period) than for forecasted transactions with identified counterparties. IG F Effectiveness testing of foreign currency hedging transactions The principles described in Section also are applicable when hedging foreign currency risk. Entities often hedge foreign currency risk from forecasted transactions using forward contracts. In performing hedge effectiveness testing, the changes in the fair value of the forward and the change in expected cash flows from the forecasted transactions must be measured. A hedge relationship between a forecasted transaction and a forward contract used to hedge the foreign currency risk may be measured based on either spot rates or forward rates. The method used must be included in the hedge documentation. Both approaches have potential benefits and drawbacks. If effectiveness is measured based on forward rates, the forward points on the forward contract will not be recognised in the income statement to the extent the forward is fully effective. However, regardless of whether Foreign currency risk

165 forward rates or spots rates are applied, timing differences between the settlement of the forecasted transaction and the derivative will cause some ineffectiveness. This ineffectiveness must be measured whenever the entity performs its effectiveness testing, and recognised in the income statement. The following cases demonstrate a number of the issues that have been discussed in Section 9.3 about hedging foreign currency risk. Case 9.6 Cash flow hedge of foreign currency sales transactions Components Manufacturer produces components that are sold to domestic and foreign customers. Export sales are denominated in the customers measurement currency. In order to reduce the currency risk from the export sales, Components Manufacturer has the following hedging policy: a transaction is committed when the pricing, quantity and timing are fixed; committed transactions are hedged 100 per cent; anticipated transactions that are highly probable are hedged 50 per cent; and only transactions anticipated to occur within six months are hedged. For export sales, cash payment falls due one month after the invoice date. Components Manufacturer projects sales to its foreign customers during April 20X1 will be 100,000 units, amounting to sales revenue of foreign currency (FC) 10,000,000. At 28 February 20X1, all of the FC 10,000,000 of sales in April 20X1 are still anticipated but uncommitted. Therefore, only 50 per cent of the total anticipated sales are hedged. The hedge is transacted by entering into a foreign currency forward contract (forward 1) to sell FC 5,000,000 for measurement currency (MC) at at 15 May 20X1 and is documented as a cash flow hedge. The hedge is expected to be highly effective. Hedge effectiveness will be assessed by comparing the changes in the discounted cash flows of the incoming amounts of FC to the changes in fair value of the forward contract. Components Manufacturer includes the time value of foreign currency forward contracts when measuring hedge effectiveness. This is expected to give a nearly 100 per cent effective cash flow hedge as the fair value of the sales transactions during the period of the hedge will be affected by FC interest rates as well as the spot rates. A review of the sales order book at 31 March 20X1 shows that all of the anticipated sale contracts for invoicing in April are now signed. In accordance with the hedging policy, a further foreign currency forward contract (forward 2) is entered to sell FC 5,000,000 for MC at at 15 May 20X1, in order to hedge the currency inflow from the remaining 50 per cent of the sales. 9.3 Foreign currency risk 159

166 The spot and forward exchange rates and the fair value of the forward contracts are as follows: Fair value Fair value of forward of forward sale of sale of Forward FC 5,000,000 FC 5,000,000 Spot rate rate (forward 1) (forward 2) Date (1 FC = MC) (1 FC = MC) (in MC) (in MC) 28 February N/a 31 March (134,491) 30 April (139,152) (3,990) 15 May N/a (189,500) (54,000) The fair value of the forward is the present value of the expected settlement amount, which is the difference between the contract rate and the forward rate multiplied by the notional foreign currency amount. The discount rate used is six per cent. During April export sales of FC 10,000,000 are invoiced and recognised in the income statement. The deferred gain or loss is released from equity and recognised in the income statement. The cash flows being hedged are now recognised in the balance sheet as receivables of FC 10,000,000. As a result hedge accounting is no longer necessary because foreign currency gains and losses on the amounts receivable are recognised in the income statement and will be offset by the revaluation gains and losses on the forwards. Assuming that all criteria for hedge accounting have been met, the required journal entries are as follows (amounts in MC): Debit Credit 28 February 20X1 No entries in income statement or balance sheet are required. The fair value of the forward contract is zero 31 March 20X1 Hedging reserve (equity) 134,491 Derivatives (liabilities) 134,491 To record the change in fair value of forward 1 1 to 30 April 20X1 Trade receivables 7,115,000 Export sales 7,115,000 To record the sales transactions at the prevailing rate on the date the sales are recognised (on average assumed to be ) 30 April 20X1 Trade receivables 2,000 FX gain on trade receivables (income statement) 2,000 To record the trade receivables at the closing spot rate; FC 10,000,000*( ) Foreign currency risk

167 Debit Credit Hedging reserve (equity) 4,661 Derivatives (liabilities) 4,661 To record the change in fair value of forward 1 Hedging reserve (equity) 3,990 Derivatives (liabilities) 3,990 To record the change in fair value of forward 2 Export sales (income statement) 143,142 Hedging reserve (equity) 143,142 To record the release of the deferred hedge results upon recording the sales (MC 139,152 + MC 3,990) 1 to 15 May 20X1 Cash 3,575,000 Trade receivables 3,575,000 To record the payments from receivables at the spot rate at the day of payment (on average ) Trade receivables 16,500 FX gain on trade receivables (income statement) 16,500 To record the FX gain on trade receivables; FC 5,000,000*( ) 15 May 20X1 Cash 29,000 FX gain on cash (income statement) 29,000 To record the revaluation of the bank balance to 15 May spot rate; FC 5,000,000*( ) Trade receivables 45,500 FX gain on trade receivables (income statement) 45,500 To record the FX gain on trade receivables; FC 5,000,000*( ) FX loss on forward (income statement) 50,348 Derivatives (liabilities) 50,348 To record the change in fair value of forward 1 for the period from 1 to 15 May FX loss on forward (income statement) 50,010 Derivatives (liabilities) 50,010 To record the change in fair value of forward 2 for the period from 1 to 15 May Derivatives (liabilities) 189,500 Cash 189,500 To record the settlement of forward 1 Derivatives (liabilities) 54,000 Cash 54,000 To record the settlement of forward Foreign currency risk 161

168 Debit Credit 15 to 31 May 20X1 Cash 3,655,000 Trade receivables 3,655,000 To record the payments from receivables at the spot rate at the day of payment (on average ) FX loss on cash (income statement) 51,000 Cash 51,000 To record the FX loss on forwards settled before all receivables were paid. The FC bank account was overdrawn for a period; FC 5,000,000*( ) Trade receivables 51,000 FX gain on trade receivables (income statement) 51,000 To record the FX gain on payments of receivables; FC 5,000,000*( ) Summary At 31 May 20X1, after all these transactions have settled, the balance sheet, including the income statement impact, is as follows (amounts in MC): Assets Equity Cash 6,964,500 Export sales (retained earnings) 6,971,858 FX loss (retained earnings) (7,358) Total assets 6,964,500 Total equity 6,964,500 The bank balance reflects the settlement of the two forward contracts (amounts in MC): Forward 1: FC 5,000,000 at ,414,500 Forward 2: FC 5,000,000 at ,550,000 Total 6,964,500 The FX loss in this example is caused by: Timing mismatches: Receivables and sales are recognised at the spot rate at the date of the transaction (on average ) during April; whereas the release from the hedge revaluation reserve is recognised at the end of April (for practical reasons) when the rate was Furthermore, receivables are collected during the month of May and recognised at the relevant spot rates, whereas the forward contracts are settled on 15 May. Interest element on the forward contracts for the period where hedge accounting is not applied (1 to 15 May): From 30 April the cash flow hedge is de-designated, but the forward contracts remain as an economic hedge of the receivables to be collected during May. The FX results on the receivables are recognised in the income statement, as are the results on the forward contracts. A perfect offset is not achieved due to the interest element included in the changes in fair value of the forward contracts Foreign currency risk

169 Termination of hedge accounting Assume the same scenario as above except that on 31 March 20X1 the committed transactions are actually only FC 3,000,000 and there are no more anticipated transactions for April 20X1. In such a case it is now unlikely that the anticipated sales transactions will occur, and hedge accounting for FC 2,000,000 of the originally anticipated sales of FC 5,000,000 must be discontinued. However, Components Manufacturer may continue to have a hedge relationship for FC 3,000,000. The unrealised FX loss on the FC 2,000,000 should be recognised immediately in the income statement as the cash flow is no longer expected to occur. The unrealised FX loss relating to the FC 3,000,000 that is still expected remains in equity. Fair value changes on the foreign currency forward contract must be recognised in the income statement to the extent the anticipated sales will not occur. The following journal entries are required (amounts in MC): Debit Credit 31 March 20X1 FX losses (income statement) 53,796 Hedging reserve (equity) 53,796 To record in the income statement the portion of deferred losses that reflects the cash flows that are no longer expected to occur (134,491*2/5) Case 9.7 Cash flow hedge of foreign currency purchase transactions Components Manufacturer purchases certain subcomponents in the Far East. At 28 February 20X1, Components Manufacturer signs a contract to purchase one million units of subcomponents from a foreign supplier for delivery at 31 March. The price is foreign currency (FC) 750 million which falls due at 30 April 20X1. The entity s risk management policy is to hedge foreign currency transactions of more than measurement currency (MC) 2.5 million. Components Manufacturer hedges the foreign currency risk by entering into a forward contract to purchase FC 750 million for MC on 30 April 20X1 at The hedge is documented and accounted for as a cash flow hedge. Effectiveness testing is based on changes in forward rates. Forward rate for Fair value of 30 April forward Spot rate settlement contract Date (1 MC = FC) (1 MC = FC) (in MC) 28 February March (211,070) 30 April N/a (120,160) 9.3 Foreign currency risk 163

170 Assuming that all criteria for hedge accounting have been met, the required journal entries are as follows (amounts in MC): Debit Credit 28 February 20X1 No entries in the income statement or balance sheet are required. The fair value of the forward contract is zero at that date 31 March 20X1 Hedging reserve (equity) 211,070 Derivatives (liabilities) 211,070 To record the change in fair value of the forward Inventories 7,090,187 Trade liabilities 7,090,187 To record the purchase transaction at the spot rate on the delivery date (FC 750,000,000/ spot rate) Inventories 211,070 Hedging reserve (equity) 211,070 To record the release of the deferred hedge results upon de-designation of the hedge 30 April 20X1 FX loss on trade liabilities (income statement) 109,583 Trade liabilities 109,583 To record the FX loss on the liability Derivatives (liabilities) 90,910 FX gain (income statement) 90,910 To record the change in fair value of the forward Trade liabilities 7,199,770 Cash 7,199,770 To record payment of the liability at the spot rate on the payment date Derivatives (liabilities) 120,160 Cash 120,160 To record the settlement of the forward The effect of the hedge is recognised as a basis adjustment to the cost of inventory. The adjustment to inventory is recognised in the income statement in cost of sales when the inventory is sold Foreign currency risk

171 Case 9.8 Fair value hedge of foreign currency risk on available-for-sale equities Safeinvestor is a large pension fund set up for the employees of a brewery. In recent years the pension fund assets have grown and management is finding it increasingly difficult to achieve a sufficient diversification in the domestic equity market. Also, management believes that it is possible to earn a higher return on equity shares in certain foreign markets. Consequently, management decides to invest in a large foreign equity market. However, all of Safeinvestor s pension obligations are denominated in its measurement currency (MC), and as part of the investment strategy Safeinvestor seeks to hedge all significant exposure to foreign currency risk beyond certain limits. At 1 April 20X1, Safeinvestor buys a portfolio of foreign currency denominated equity shares for foreign currency (FC) 30 million. The shares are treated as available-forsale securities with changes in the fair value being recognised directly in equity. Although a steady growth in the value of the portfolio is expected in the medium to long-term, and accordingly an increased foreign currency exposure, Safeinvestor decides to hedge only 85 per cent of the market value of the portfolio. This is because of the uncertainty about the short-term development in the market value (and therefore the exposure). Safeinvestor enters into a foreign currency forward contract to sell FC 25.5 million for MC at 15 October 20X1. This contract will then be rolled for as long as the position is outstanding. If the value of the portfolio increases significantly, Safeinvestor s policy is to adjust the hedge by entering into additional foreign currency forward contracts so that at least 75 per cent of the foreign currency risk is hedged. The forward contract is designated as a fair value hedge of the currency risk associated with the first FC 25.5 million of shares. The time value of the forward contract is excluded from the assessment of hedge effectiveness. The hedge is expected to be highly effective and hedge effectiveness will be assessed by comparing the changes in the fair value of the first FC 25.5 million of equity shares due to changes in spot rates to the changes in the value of the forward contract also due to changes in spot rates, i.e. the time value is excluded from the hedge relationship. The terms of the forward contract are as follows: sell FC 25,500,000 buy MC 64,359,915 maturity 15 October 20X1 (This implies a forward rate of 2.52). 9.3 Foreign currency risk 165

172 During the period of the hedge value of the forward is as follows (amounts in MC): Value Spot rate of forward Value Spot Forward Date (1 FC = MC) contract change element element 1 April June ,031,769 3,031,769 3,570,000 (538,231) 30 September ,406, , ,000 (135,021) 15 October ,884,915 (1,521,833) (1,530,000) 8,167 1,884,915 2,550,000 (665,085) The value of the foreign equity portfolio changes as follows, as a result of changes in equity prices and changes in the spot rate: Value Value Value change Date (in FC) (in MC) (in MC) 1 April 30,000,000 76,500, June 35,000,000 84,350,000 7,850, September 28,000,000 66,920,000 (17,430,000) 15 October 32,000,000 78,400,000 11,480,000 Assuming that all criteria for hedge accounting have been met, the required journal entries are as follows (amounts in MC): Debit Credit 1 April 20X1 Securities available-for-sale 76,500,000 Cash 76,500,000 To record the purchase of securities; MC 30 million at No entries are required for the forward contract 30 June 20X1 Securities available-for-sale 7,850,000 AFS revaluation reserve (equity) 7,850,000 To record the change in fair value of securities Derivatives (assets) 3,031,769 Derivative revaluation gain (income statement) 3,031,769 To record the change in fair value of forward Hedge revaluation loss (income statement) 3,570,000 AFS revaluation reserve (equity) 3,570,000 To transfer the fair value change of securities in respect of the hedged risk to the income statement; FC 25.5 million * ( ) Foreign currency risk

173 Debit Credit 30 September 20X1 AFS revaluation reserve (equity) 17,430,000 Securities available-for-sale 17,430,000 To record the change in fair value of securities Derivatives (assets) 374,979 Derivative revaluation gain (income statement) 374,979 To record the change in fair value of forward Hedge revaluation loss (income statement) 510,000 AFS revaluation reserve (equity) 510,000 To transfer the fair value change of securities in respect of the hedged risk to the income statement; FC 25.5 million * ( ) 15 October 20X1 Securities available-for-sale 11,480,000 AFS revaluation reserve (equity) 11,480,000 To record the change in fair value of securities Derivative revaluation loss (income statement) 1,521,833 Derivatives (assets) 1,521,833 To record the change in fair value of forward AFS revaluation reserve (equity) 1,530,000 Hedge revaluation gain (income statement) 1,530,000 To transfer the fair value change of securities in respect of the hedged risk to the income statement; FC 25.5 million * ( ) Cash 1,884,915 Derivatives (assets) 1,884,915 To record the settlement of forward contract The hedge stays effective for the full period as the changes in fair value of the forward contract, due to changes in spot rates, perfectly offset changes in the value of FC 25.5 million of the equity portfolio due to the same spot rates. The increase in the value of the equity shares at 30 June 20X1 would, in accordance with the hedging policy, result in an additional hedge transaction being entered into. However, due to the market movements through 30 September 20X1 this hedge would need to be unwound as the value of the portfolio (and therefore the foreign currency risk) decreased. In order for fair value hedge accounting to be applied, the portfolio of shares that was designated as the hedged item at 1 April 20X1 must continue to be the hedged item for the entire period of the hedge. This means that active management of the portfolio may preclude fair value hedge accounting. 9.3 Foreign currency risk 167

174 As an alternative approach, management may designate the hedge as a hedge of the anticipated disposal of the shares providing that the timing of such disposal is highly probable, and apply cash flow hedge accounting. Cash flow hedge accounting requires specification of the size and timing of the cash flow being hedged. The model that is more appropriate may depend also on the entity s ability to collect the relevant information required under each model. 39.AG Net position hedging of foreign currency risk Net position hedging strategies for foreign currency risk often include the use of a central treasury that accumulates foreign currency risk exposures from group entities and then hedges the net risk exposure with a third party such as a bank. The central treasury often will enter into internal derivatives with other group entities or divisions to effectively transfer the foreign currency risk to the central treasury. Based on overall risk management objectives and policies the central treasury will determine how best to manage the risk exposure. As mentioned in Section 8, a net position generally does not qualify as a hedged item for hedge accounting purposes. However, an entity may choose to manage risk on a net basis while for hedge accounting purposes designate the hedge in such a way so as to comply with the requirements in IAS 39. Depending on the entity s risk management policies and internal procedures the entity may: 39AG101 document and designate a hedge between the external derivatives and a gross position in a group entity that matches the net position; or IG F.1.6 in some circumstances designate offsetting exposures as the hedging instruments in cash flow hedges using internal derivatives to build a documentation trail The internal derivatives between a central treasury and the individual entities must be eliminated on consolidation and cannot be designated as hedging instruments in the consolidated financial statements. IG F.1.6 and F.1.7 However, if all other hedge accounting criteria are met, hedge accounting may still be used for cash flow hedges as well as for fair value hedges. Although the effects of internal derivatives would have to be eliminated in consolidation, in some cases it will be possible to apply hedge accounting in the group financial statements, due to the ability to designate a non-derivative financial asset or liability as a hedging instrument for foreign currency risk. This process may be more in line with the risk management procedures already used by the treasury department. In this situation the individual foreign currency positions hedged still must be linked using internal contracts, thus ensuring that each qualifying hedging instrument is linked to a qualifying hedged position. To achieve hedge accounting, it is crucial that the individual subsidiaries properly document their internal hedge transactions, and that the central treasury department can demonstrate that each bundle of risk by currency and time period is netted and fully offset externally. Gains and losses from the internal hedging instrument are recognised in the income statement by the central treasury department, and in equity or in the income statement by the individual subsidiaries, depending on whether cash flow hedging or fair value hedging is applied. Hedge accounting at the subsidiary s financial reporting level is possible if the hedge with the parent is properly documented at that reporting level, and all other hedge criteria are met Foreign currency risk

175 IG F.2.14 The group treasury may hedge the exposure of another operating unit without entering into an internal transaction with that unit as long as the hedge relationship is properly documented at the group level. Case 9.9 Net position hedging foreign currency risk Assume a corporate has foreign currency cash outflows for payments of goods and services and the same foreign currency cash inflows from sales of its products. The corporate monitors this foreign currency risk by analysing the net foreign currency outflows and inflows expected within each cash flow time band. Assume that the cash inflows and outflows are all highly probable or committed transactions. The cash flow bands used should be based on the business cycle of the corporate and the period over which it chooses to hedge the cash flows (which would generally cover a longer period than those used in the example below). Less than 1 month 1 to 2 months 2 to 3 months FC inflows Sales 2,200 2,100 3,000 Cash inflows 2,200 2,100 3,000 FC outflows Purchases of goods 1,000 1,500 2,300 Purchases of services Cash outflows 1,300 1,600 2,500 Net cash flows in FC Under net position hedging the net expected cash flow in each time band could be hedged. For example, for the cash flows expected in the period of two to three months, the exposure of FC 500 could be hedged with a forward. To achieve hedge accounting treatment under IFRS, the corporate could designate the first FC 500 of highly probable anticipated and committed sales in that month as the hedged item, and could designate a derivative or a non-derivative foreign currency instrument as the hedging instrument. IG F.3.10 As demonstrated in the example, hedging a net exposure is possible, provided that an entity documents the hedge relationship as a hedge of part of a gross position that itself forms part of the net position. It is important that the hedged item is the first FC 500 of sales in that time band so that it is clear when the hedged item affects the income statement. 9.3 Foreign currency risk 169

176 Case 9.10 Hedging on a group basis foreign currency risk and AG101 A group consists of a parent entity (including corporate treasury) and its subsidiaries A and B. Subsidiary A has highly probable cash inflows from future revenues of FC 200 that it expects to receive in 60 days. To hedge this exposure, Subsidiary A enters into a forward contract with the corporate treasury to pay FC 200 in 60 days. Subsidiary B has highly probable forecasted purchases of FC 500 that it expects to pay in 60 days. Subsidiary B hedges this exposure by entering into a forward contract with the corporate treasury to receive FC 500 in 60 days. The parent entity itself has no expected exposure to that foreign currency during this period. Figure 9.3 Group hedging of foreign currency risk The effect of the internal derivatives with the subsidiaries is to transfer the foreign currency risk to the corporate treasury. The net currency exposure from FC in the next time period is a FC 300 outflow. The corporate treasury will hedge this exposure by entering into a forward contract with an external third party. In order to apply hedge accounting to this transaction the group will designate the external forward contract as a hedge of a gross exposure in one of the subsidiaries rather than the net exposure. The group does this by designating the first FC 300 of cash outflows from purchases in Subsidiary B as the hedged item and the external forward contract as the hedging instrument. This in effect means that the group has hedged its net exposure of FC 300 in accordance with its risk policies and that hedge accounting can be applied to this hedging strategy provided that the other hedge accounting criteria are met Foreign currency risk

177 IG F.1.6 December 2003 amendments In finalising the amendments, the Board has made changes to the existing guidance (IGC b) for entities using internal derivatives that are netted through a treasury centre. The changes are likely to make it more difficult to apply the approach described. In particular, it is clear from the amendments that a portfolio of cash flows in a particular currency and within a narrow time-band must also affect profit or loss in the same period. For example, consider Case 9.10 above. The forecast sale by Subsidiary A of FC 200 in July 20X5 might be expected to generate cash in August 20X5. The forecast purchase of FC 500 by Subsidiary B, also expected to be paid for in August 20X5, might be recognised in the income statement in June 20X5. Under the existing standards, only the cash flows need occur within the same reporting period, and so these two transactions would be netted using internal derivatives, through the group corporate treasury to an external derivative covering the net position of FC 300. The hedge accounting claimed by Subsidiaries A and B in their individual financial statements would not be reversed or adjusted at the group level. Under the amended standards, the group would need to make adjustments to the hedge accounting entries made by Subsidiaries A and B. If it continued to use the same netting process, it would need to reflect in the financial statements that, at the group level, the hedged item is FC 300 of the expected payments by Subsidiary B. If this transaction affects profit or loss as expected in June, it will not be appropriate, under the amended standards, to defer in equity at the end of June 20X5 an amount related to the expected revenue transaction in Subsidiary A in July 20X5. An adjustment will need to be made on consolidation. The alternative approach under the amended standards would be to: (a) enter into external derivatives to hedge aggregate long positions and short positions in each FC and each time period separately (in other words, by aggregating, but not netting internal derivatives in the treasury centre); then (b) designate the external derivatives as hedging instruments at the group level; and (c) put in place additional documentation at the group level to link each external derivative to its associated group of internal derivatives, so that the chain of hedge documentation is completed, via the internal contracts, between each hedged cash flow within the group and a portion of the related external derivative. Under this approach, the internal derivatives are hedging instruments for each of the subsidiary entities stand-alone financial statements, and at the group level provide part of the linkage of documentation to the external derivative transaction. 9.4 Hedging a net investment Identifying the hedged risk and the hedging model Net investment hedge accounting is available only for a foreign entity, that is a subsidiary whose functional currency is different from the reporting currency of the group. In other cases, the foreign currency exposure is hedged like any other foreign currency transaction 9.4 Hedging a net investment 171

178 exposures. The net investment hedging model can only be applied at the group level, i.e. the subsidiary, associate etc., that is itself the foreign net investment cannot apply net investment hedge accounting in its own books, and neither can the parent entity. It is the carrying amount of the total net assets (assets less liabilities) that is designated as the hedged item in a net investment hedge regardless of whether individual assets or liabilities in that foreign entity are denominated in a currency different from the foreign entity s measurement currency. Case 9.11 Hedged item in a net investment hedge Entity A, with EUR as its measurement currency, includes in its consolidated financial statements the foreign Subsidiary B with USD as its measurement currency. The carrying amount of Subsidiary B s net assets is USD 100. Part of Subsidiary B s net assets consists of loans denominated in GBP. Nevertheless Entity A will identify the net assets of Subsidiary B of USD 100 as the hedged item in a net investment hedge. This is because the loans denominated in GBP will be translated into USD in Subsidiary B s own financial statements before Subsidiary B is consolidated into Entity A. Subsidiary B may separately decide to hedge the foreign currency risk of the GBP loans. In some instances the future cash flows from the investment may be expected to exceed the net asset value, such as when there is significant unrecognised goodwill or unrecognised value changes in assets or liabilities. Such fair value adjustments resulting from internally generated goodwill do not qualify for hedge accounting under the net investment hedge model. These additional cash flows from the net investment could be designated, for example, as a cash flow hedge of the proceeds from sale of the foreign entity. However, this still must meet the general criteria for cash flow hedges. This means that the future cash flows would have to be highly probable, and the timing and amount must be known. This is only likely to be the case if sale negotiations for the entity have been completed Loans to or from a foreign entity that are neither planned nor intended to be settled in the foreseeable future should be treated as part of the investment in the foreign entity. Table 9.1 Components of a net investment in a foreign entity Carrying amount of net assets of the foreign entity +/- Other consolidation adjustments to carrying amounts + Carrying amount of goodwill paid in an acquisition +/- Loans to or from a foreign entity not planned or intended to be settled in the foreseeable future Amount that can be the hedged item in a net investment hedge Case 9.12 Hedgeable components of a net investment in a foreign entity In 20X0 Entity A bought Entity B for MC 100. The carrying amount of Entity B s net assets was MC 60 and Entity A recognised fair value adjustments to specific assets and liabilities of MC 30 and goodwill of MC 10. During 20X2 Entity A extended a loan to Entity B of MC Hedging a net investment

179 In 20X3 the carrying amount (not including fair value adjustment from the acquisition) of Entity B s assets and liabilities is MC 70. The remaining fair value adjustments are MC 25 and goodwill is MC 7. The loan has not been repaid and is not intended to be repaid. The carrying amount of the net investment that Entity A may designate as the hedged item is equal to the amount of Entity A s net investment in Entity B including goodwill. This amount would be MC 122 ( ) Expected net profit or loss of a net investment in a foreign entity The hedged item may be all or a portion of the carrying amount of the foreign entity at the beginning of a given reporting period. This means that expected profits from the foreign entity in that period cannot be the hedged item under a net investment hedge model. Translation risk arises once the net profit is recognised as an increase in net assets of the foreign entity. The additional net assets could be designated as a hedged item in a net investment hedge as they arise, although in practice most groups would revisit their net investment hedges only quarterly or semi-annually and 40 Expected net profits from a foreign entity expose a reporting group to potential volatility in the consolidated income statement as transactions in the foreign entity are translated into the group s measurement currency at spot rates at the date of the transactions or average rates, as an approximation of spot rates. Entities may want to hedge this translation risk exposure. However, since expected net profits in future reporting periods do not constitute recognised assets, liabilities or forecasted transactions that lead to actual cash flows and that will ultimately affect the income statement at the consolidated level, they cannot be accounted for under either a fair value hedge or a cash flow hedge model. Expected net losses in a foreign entity would reduce the year-end net investment balance, which could result in an over-hedged position. Therefore, if a group expects its foreign entity could make losses the group may decide to hedge less than the full carrying amount of the net assets, as otherwise it would not be able to satisfy the hedge accounting criteria that the hedge relationship is expected to be highly effective on an ongoing basis. Entities also might wish to hedge anticipated dividends from foreign entities. However, expected dividends do not give rise to an exposure that will be recognised in the income statement. Therefore, these cannot be hedged in a cash flow hedge or a net investment hedge. It is only once dividends are declared and become a receivable that hedge accounting may be applied Hedge effectiveness IAS 21 does not set any criteria for when hedge accounting can be applied. Therefore, the same hedge effectiveness criteria described earlier in this Section and in Section 8 is also applicable for hedges of net investments in foreign entities. Although the accounting is similar, the nature of this type of hedge is different from a normal cash flow hedge. The exposure being hedged is the closing spot rate translation exposure under IAS 21. Therefore, it would be reasonable to determine hedge effectiveness using changes in spot rates. Where the hedging instrument is a derivative, the changes in value relating to the spot-forward differential would be excluded from the hedge relationship and recognised in the income statement. 9.4 Hedging a net investment 173

180 Case 9.13 Hedge of a net investment in a foreign entity GlobalTechCo has a net investment in a foreign subsidiary of foreign currency (FC) 50 million. At 1 October 20X1, GlobalTechCo enters into a foreign currency forward contract to sell FC 50 million for measurement currency (MC) at 1 April 20X2. GlobalTechCo will review the net investment balance on a quarterly basis and adjust the hedge to the value of the net investment. The time value of the forward contract is excluded from the assessment of hedge effectiveness. The foreign exchange rate and fair value of the forward contract move as follows: Forward Fair value Spot rate exchange rate of forward Date (1 FC = MC) (1 FC = MC) contract 1 October 20X December 20X ,430, March 20X N/a 5,000,000 Assuming that all criteria for hedge accounting have been met, the required journal entries are as follows (amounts in MC): Debit Credit 1 October 20X1 No entries in the income statement nor the balance sheet are required. The fair value of the forward contract is zero 31 December 20X1 Derivatives (asset) 3,430,000 Foreign exchange losses (income statement) 70,000 Foreign currency translation reserve (equity) 3,500,000 To record the change in fair value of the forward Foreign currency translation reserve (equity) 3,500,000 Net investment in subsidiary (asset) 3,500,000 To record the foreign exchange losses of the subsidiary (The adjustment to the net investment would be derived by translating the subsidiary s balance sheet at the spot rate at the balance sheet date) 31 March 20X2 Derivatives (asset) 1,570,000 Foreign exchange losses (income statement) 430,000 Foreign currency translation reserve (equity) 2,000,000 To record the change in fair value of the forward Foreign currency translation reserve (equity) 2,000,000 Net investment in subsidiary (asset) 2,000,000 To record the change in foreign exchange losses of the subsidiary Hedging a net investment

181 Debit Credit Cash 5,000,000 Derivatives (asset) 5,000,000 To record the settlement of the forward The gain on the hedging transaction will remain in equity until the subsidiary is disposed. 9.5 Hedging commodity price risk Identifying the hedged risk and the hedging models This and the following Sections discuss the hedge accounting principles for a situation where an entity purchases a commodity contract that is accounted for under IAS 39 as a derivative used to hedge an expected purchase or sale of the underlying commodity An entity may enter into commodity contracts through a broker on a commodity exchange. The commodity contract is to be used to lock into a price for the commodity that the entity expects to purchase. The situation is illustrated in Figure 9.4. Figure 9.4 Hedging with commodity contracts In practice a number of issues arise regarding commodity hedging where derivatives such as futures on that commodity are traded in a standardised form on a commodity exchange or where only an ingredient or component is hedged. For certain commodities, exchange-traded derivatives are based on a standard quality or grade of these commodities. This is because the actual product that will be obtained depends on specific circumstances in the future, such as where the commodity comes from, purity of the actual product, harvest yield, or even consumer demand. Entities often enter into derivatives for a standard commodity prior to determining the actual quality of product they require for production. Examples of commodities that are traded in a standardised form are wheat, corn and other agricultural products, as well as coffee beans and metals. 9.5 Hedging commodity price risk 175