Topics to be discussed. HKAS 32 and 39 Part 2. Nelson Lam CFA FCCA FCPA(Practising) MBA MSc BBA CPA(US) ACA. Simple but Comprehensive

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1 HKAS 32 and 39 Part 2 18 May 2006 Nelson Lam CFA FCCA FCPA(Practising) MBA MSc BBA CPA(US) ACA Nelson 1 Topics to be discussed A. Recap on recognition and measurement (HKAS 39) B. Definitions of derivatives (HKAS 32 and 39) C. Embedded derivatives (HKAS 39) D. Hedging and hedge accounting (HKAS 39) E. Transitional arrangement (HKAS 39) F. Amendments to HKAS 39 and disclosures amended by HKFRS 7 Simple but Comprehensive Key Issues Cases and Examples Nelson 2 1

2 A. Recap on Recognition & Measurement Nelson 3 A. Recap on Recognition & Measurement FA at FV through P/L 1. Financial assets at fair value through profit or loss Financial instrument Financial asset Financial liability AFS financial assets HTM investments Loans and receivables 2. Available-for-sale financial assets 3. Held-to-maturity investments 4. Loans and receivables Initial recognition and measurement principle for financial assets and financial liabilities are the same But, HKAS 39 further defines financial asset into 4 categories for subsequent measurement (financial liability to be discussed later) The 4-category classification will affect the subsequent measurement of of financial assets, but not the initial measurement Nelson 4 2

3 A. Recap on Recognition & Measurement A Financial Held for trading (or Yes Asset derivative)? No Upon initial recognition, Yes designated at FA at FV through P/L? No Designated as AFS Yes financial assets? No With fixed/determinable No payments? Yes No With fixed maturity? Yes Has positive intention and ability to hold to No maturity and fulfils tainting rule? With quote in Yes an active market? No May recover With quote in No substantially all an active market? initial investments Yes Yes Yes No Derivative? No Yes Designated and effective hedging instrument? No Yes Hedge Accounting To be discussed later Has a quote at active No No Has a quote at active market or fair value can market or fair value can be reliably measured? be reliably measured? Yes Yes HTM Loans and AFS financial Cost FA at FV investments at receivables at assets at less Impairment through P/L Nelson amortised cost amortised cost fair value 5 Measurement A. Recap on Recognition & Measurement FA at FV through P/L AFS financial assets HTM investments Subsequent Measurement at Fair Value to P/L at Fair Value to Equity From Equity to P/L at Cost To P/L at Amortised Cost Impairment Not required To P/L Reversal N/A Related objectively to an event for debt instrument only Related objectively to an event Reclassification Not allowed To HTM or AFS at Cost To AFS at Fair Value To AFS Loans and receivables at Amortised Cost To P/L Related objectively to an event Not described in HKAS 39; implicitly, not feasible Nelson 6 3

4 B. Definitions Derivative Financial instrument Financial asset Financial liability or Equity instrument of one entity of another entity Nelson 7 B. Definitions Derivative Derivative Value change based on on an an underlying Little or or no no initial net investment Settled at at a future date Financial instrument is a financial instrument or other contract within the scope of HKAS 39 with all 3 of the following characteristics: a) its value changes in response to the change in a specified interest rate, financial instrument price, commodity price, foreign exchange rate, index of prices or rates, credit rating or credit index, or other variable (sometimes called the underlying ); b) it requires no initial net investment or an initial net investment that is smaller than would be required for other types of contracts that would be expected to have a similar response to changes in market factors; and c) it is settled at a future date. Financial asset Financial liability or Equity instrument Derivative Nelson 8 4

5 B. Definitions Derivative Derivative Typical example: Future and forward Swap and options Value change based on on an an underlying Little or or no no initial net investment Settled at at a future date Type of contract Interest Rate Swap Currency Swap (Foreign Exchange Swap) Commodity Swap Equity Swap Credit Swap Total Return Swap Purchased or Written Treasury Bond Option Purchased or Written Currency Option Currency Futures/Forward Commodity Futures/Forward Equity Forward Underlying variable Interest rates Currency rates Currency rates Currency rates Commodity prices Example Commodity prices Equity prices (equity of another entity) Credit rating, credit index or credit price Total fair value of the reference asset and interest rates Interest rates Equity prices Nelson 9 B. Definitions Derivative Example Value change based on on an an underlying Little or or no no initial net investment Settled at at a future date 2 Non-Derivative Transactions Entity A makes a 5-year fixed rate loan to Entity B Entity B at the same time makes a 5-year variable rate loan for the same amount to Entity A. There are no transfers of principal at inception of the 2 loans, since A and B have a netting agreement Is this a derivative under HKAS 39? Yes, it it meets the the definition of of a derivative. The contractual effect of of the the loans is is the the equivalent of of an an interest rate swap arrangement with no no initial net net investment Nelson 10 5

6 B. Definitions Derivative Example Value change based on on an an underlying Little or or no no initial net investment Settled at at a future date Non-derivative transactions are are aggregated and and treated as as a derivative when the the transactions result, in in substance, in in a derivative. Indicators of of this this would include: They are are entered into into at at the the same time and and in in contemplation of of one one another They have the the same counterparty They relate to to the the same risk risk There is is no no apparent economic need or or substantive business purpose for for structuring the the transactions separately that that could not not also have been accomplished in in a single transaction The same answer would apply if if Entity A and and Entity B did did not not have a netting agreement, because the the definition of of a derivative instrument in in HKAS does not not require net net settlement Nelson 11 B. Definitions Derivative Value change based on on an an underlying Little or or no no initial net investment Settled at at a future date Example Prepaid forward An entity enters into a forward contract to purchase shares of stock in 1 year at the forward price. It prepays at inception based on the current price of the shares. Is the forward contract a derivative? No. No. The The forward contract fails fails the the little or or no no initial net net investment test test for for a derivative Nelson 12 6

7 B. Definitions Derivative Value change based on on an an underlying Little or or no no initial net investment Settled at at a future date Example Margin deposit (or account) Many derivative instruments, such as futures contracts and exchange traded written options, require margin accounts. Is the margin account part of the initial net investment? No! No! The The margin account is is not not part part of of the the initial net net investment in in a derivative instrument. Margin accounts are are a form form of of collateral for for the the counterparty or or clearing house and and may may take take the the form form of of cash, securities or or other specified assets, typically liquid assets. Margin accounts are are separate assets that that are are accounted for for separately Nelson 13 C. Embedded Derivatives A Financial Asset Held for trading (or derivative)? No Upon initial recognition, designated at FA at FV through P/L? No Designated as AFS financial assets? No With fixed/determinable payments? Yes Yes Yes No Derivative? No Yes Designated and effective hedging instrument? Yes No Hedge Accounting To be discussed later Yes With fixed maturity? No Yes Has positive intention and ability to hold to maturity and fulfils tainting rule? Yes No With quote in an active market? Yes With quote in an active market? Yes No No May recover substantially all initial investments Yes No HTM investments Loans and receivables AFS financial assets FA at FV through P/L Will derivative elements in in the the financial assets affect the the classification? Nelson 14 7

8 C. Embedded Derivatives HKAS 39 introduce Embedded Derivative it is a component of a hybrid (combined) instrument that also include a non-derivative host contract with the effect that some of the cash flows of the combined instrument vary in a way similar to a stand-alone derivative Hybrid (Combined) Contract Host Contract Embedded Derivative An embedded derivative causes some or all of the cash flows that otherwise would be required by the contract to be modified according to a variable, say specified interest rate, financial instrument price, commodity price, foreign exchange rate, index of prices or rates, credit rating or credit index, or other variable. A derivative that Remember what derivative is? is attached to a financial instrument but is contractually transferable independently of that instrument, or has a different counterparty from that instrument is NOT an embedded derivative, BUT a separate financial instrument Nelson 15 C. Embedded Derivatives Investments in convertible bonds (with equity conversion feature) Equity-indexed interest or principal payments embedded in a host debt instrument (equitylinked interest or principal payments) An option or automatic provision to extend the remaining term to maturity of a debt instrument A call, put, surrender or prepayment option embedded in a host debt instrument Equity kicker Equity-linked notes Equity call and put options Inflation-indexed lease payments Contingent rentals More but so? Example Host Contract Embedded Derivative Nelson 16 8

9 C. Embedded Derivatives HKAS requires an an embedded derivative shall be be separated from the host contract and accounted for for as as a derivative under HKAS if, if, and only if: if: a. a. the economic characteristics and risks of of the embedded derivative are not closely related to to the economic characteristics and risks of of the host contract b. b. a separate instrument with the same terms as as the embedded derivative would meet the definition of of a derivative; and c. c. the hybrid (combined) instrument is is not measured at at fair value with changes in in fair value recognised in in profit or or loss Hybrid (Combined) Contract Host Contract Embedded Derivative Nelson 17 C. Embedded Derivatives Economic characteristics and risks NOT closely related Hybrid (Combined) Contract Host Contract Embedded derivative meets the definition of derivative Hybrid instruments NOT measured at FV through P/L Separate the the Embedded Derivative and accounted for for under HKAS Not to the Embedded Require to Separate the Derivative Embedded Derivative Nelson 18 9

10 C. Embedded Derivatives If separation is required and can be measured Host Contract shall be accounted for under applicable HKFRS Embedded Derivative shall be accounted under HKAS 39 as a derivative If separation is required but cannot be measured Entire Hybrid (Combined) Contract is classified as financial instrument that is held for trading If separation is not required Hybrid (combined) contract shall be accounted for under applicable HKFRS Separate the the Embedded Derivative and accounted for for under HKAS Not to the Embedded Require to Separate the Derivative Nelson 19 C. Embedded Derivatives To separate embedded derivative An embedded non-option derivative (such as an embedded forward or swap) is separated from its host contract on the basis of its stated or implied substantive terms, so as to result in it having a fair value of zero at initial recognition. An embedded option-based derivative (such as an embedded put, call, cap, floor or swaption) is separated from its host contract on the basis of the stated terms of the option feature. The initial carrying amount of the host instrument is the residual amount after separating the embedded derivative. Host Contract Hybrid (Combined) Contract = - Hybrid (Combined) Contract Host Contract Embedded Derivative Embedded Derivative Nelson 20 10

11 C. Embedded Derivatives To separate embedded derivative If an entity is unable to determine reliably the fair value of an embedded derivative on the basis of its terms and conditions (for example, because the embedded derivative is based on an unquoted equity instrument) the fair value of the embedded derivative is the difference between the fair value of the hybrid instrument, and the fair value of the host contract, if those can be determined under HKAS 39. Hybrid (Combined) Contract Host Contract Embedded Derivative Embedded Derivative Hybrid (Combined) Contract = - Host Contract If the entity is still unable to determine the fair value of the embedded derivative using the above method, the combined instrument is treated as held for trading Nelson 21 C. Embedded Derivatives Example Fair value cannot be reliably measured If an embedded derivative that is required to be separated cannot be reliably measured because it will be settled by an unquoted equity instrument whose fair value cannot be reliably measured, is the embedded derivative measured at cost? No. No. In In this this case, the the entire combined contract is is treated as as a financial instrument held held for for trading. If If the the fair fair value of of the the combined instrument can can be be reliably measured, the the combined contract is is measured at at fair fair value. The The entity might conclude, however, that that the the equity component of of the the combined instrument may may be be sufficiently significant to to preclude it it from from obtaining a reliable estimate of of the the entire instrument. In In that that case, the the combined instrument is is measured at at cost cost less less impairment Nelson 22 11

12 C. Embedded Derivatives Convertible bond Example What is the accounting treatment (and classification) of an investment in a bond (financial asset) that is convertible into shares of the issuing entity or another entity before maturity (i.e convertible bond)? Nelson 23 C. Embedded Derivatives Convertible bond Example An An investment in in a convertible bond bond that that is is convertible before before maturity generally cannot cannot be be classified as as a HTM HTM investment because that that would would be be inconsistent with with paying paying for for the the conversion feature feature the the right right to to convert convert into into equity equity shares shares before before maturity. Such Such bond bond can can be be classified as as an an AFS AFS financial asset asset provided it it is is not not purchased for for trading trading purposes and and the the equity equity conversion option option is is an an embedded derivative. If If such such bond bond is is so so classified, the the equity equity conversion option option (the (theembedded derivative) is is separated. The The amount amount paid paid for for the the bond bond is is split split between the the debt debt instrument without without the the conversion option option and and the the equity equity conversion option option Changes in in the the fair fair value value of of the the equity equity conversion option option are are recognised in in profit profit or or loss loss unless unless the the option option is is part part of of a cash cash flow flow hedging relationship. If If the the convertible bond bond is is measured at at fair fair value value with with changes in in fair fair value value recognised in in profit profit or or loss, loss, separating the the embedded derivative from from the the host host bond bond is is not not permitted Nelson 24 12

13 C. Embedded Derivatives Economic characteristics and risks NOT closely related Hybrid (Combined) Contract Host Contract Embedded derivative meets the definition of derivative Hybrid instruments NOT measured at FV through P/L Embedded Derivative Implies: So So long as as the Hybrid (Combined) Contract is is measured at at FV through P/L No separation is is required Separate the the Embedded Derivative and accounted for for under HKAS Not to the Embedded Require to Separate the Derivative Management can choose it to avoid separation Nelson 25 C. Embedded Derivatives Case HKEX (Consolidated financial statements published on 28 Feb. 2005) HKEX From 1 January 2004, investments of the Group are classified under the following categories: Financial assets at fair value through profit or loss This category comprises financial assets held for trading and those designated as fair value through profit or loss at inception Debt securities and bank deposits with embedded derivatives for yield enhancement whose economic characteristics and risks are not closely related to the host securities and deposits are designated as financial assets at fair value through profit or loss. Available-for-sale financial assets This category comprises financial assets which are non-derivatives and are designated as available-for-sale financial assets or not classified under other investment categories. Loans and receivables Loans and receivables are non-derivative financial assets with fixed or determinable payments that are not quoted in an active market, and with no intention of trading the receivables. Bank deposits are treated as loans and receivables and are disclosed as time deposits and cash equivalents Nelson 26 13

14 D. Hedging and Hedge Accounting Nelson 27 Hedging Introduction A Hedge under HKAS 39 involves 2 components Hedging Instrument Hedged Item Strict conditions must be fulfilled before Hedge Accounting can be used. But even qualified, an entity can also choose not to to use it, it, but HKAS 39 sets out Hedge Accounting which recognises the offsetting effects on profit or loss of changes in the fair values of these 2 components. Hedge Accounting seeks to match the 2 sides of a Hedging Relationship, so as to ensure both sides are offset and not to affect the income statements from one side only Nelson 28 14

15 Hedging Introduction A Financial Asset Held for trading (or derivative)? Yes Derivative? Yes Designated and effective hedging instrument? Yes No Hedge Accounting Discuss Now Yes FA at FV Nelson through P/L 29 Hedging Introduction Hedging Instrument Hedged Item HKAS 39 defines and restricts the items qualified as Hedging Instruments and Hedged Items Hedging Relationship Conditions for Hedge Accounting Hedge Accounting Sets out the types of Hedge Relationship Requires Conditions for Hedging Accounting must be fulfilled to qualify a hedge accounting Sets out the Hedge Accounting If there is a designated Hedging Relationship, accounting for gain or loss on the Hedging Instruments and Hedged Item shall follow Hedge Accounting Nelson 30 15

16 Hedging Hedging Instruments Hedging Instrument Hedged Item Hedging Relationship Conditions for Hedge Accounting Hedge Accounting Nelson 31 Hedging Hedging Instruments Hedging Instrument Derivative Nonderivative Hedging Instrument is a) a designated derivative, or b) a designated non-derivative financial asset or non-derivative financial liability (for a hedge of the risk of changes in foreign currency exchange rates only) whose fair value or cash flows are expected to offset changes in the fair value or cash flows of a designated hedged item A non-derivative financial asset or non-derivative financial liability may be designated as a hedging instrument only for a hedge of a foreign currency risk. No restriction on the circumstances in which a derivative may be designated as a hedging instrument provided the conditions for hedging accounting are met, except for Some Written Options Nelson 32 16

17 Hedging Hedging Instruments Example Entity A, whose functional currency is the Japanese yen has issued 5 million 5-year US$ fixed rate debt. owns a 5 million 5-year US$ fixed rate bond which is classified as AFS. 1. Can Entity A designate its US$ liability as a hedging instrument in a fair value hedge of the entire fair value exposure of its US$ bond? 2. Alternatively, can the US$ liability be designated as a fair value hedge or cash flow hedge of the foreign currency component of the bond? No. No. HKAS HKAS permits permits a non-derivative to to be be used used as as a hedging instrument only only for for a hedge hedge of of a foreign foreign currency risk. risk. Entity Entity A s A s bond bond has has a fair fair value value exposure to: to: foreign foreign currency risk, risk, interest interest rate rate changes and and credit credit risk. risk Yes Yes However, hedge hedge accounting is is unnecessary because the the amortised cost cost of of the the hedging instrument and and the the hedged hedged item item are are both both remeasured using using closing closing rates. rates Nelson 33 Hedging Hedged Item Hedging Instrument Hedged Item Hedging Relationship Conditions for Hedge Accounting Hedge Accounting Nelson 34 17

18 Hedging Hedged Item Hedged item is an asset, a liability, a firm commitment, a highly probable forecast transaction, or a net investment in a foreign operation, that exposes the entity to risk of changes in fair value or future cash flows and is designated as being hedged. Hedged Item A hedged item is an exposure to risk to an entity that attempt to hedge. A hedged item can be a recognised asset or liability, an unrecognised firm commitment, a highly probable forecast transaction or a net investment in a foreign operation Nelson 35 Hedging Hedged Item Example Is hedge accounting permitted for a currency borrowing that hedges an expected but not contractual revenue stream in foreign currency? Yes, Yes, if if the the revenues are are highly probable. Under Under HKAS HKAS 39, 39, a hedge hedge of of an an anticipated sale sale (highly (highly probable forecast transaction) may may qualify qualify as as a Cash Cash Flow Flow Hedge. Hedge. For For example: An An airline airline entity entity may may use use sophisticated models models based based on on experience and and economic data data to to project project its its revenues in in various various currencies. If If it it can can demonstrate that that forecast revenues for for a period period of of time time into into the the future future in in a particular currency are are highly highly probable, as as required by by HKAS HKAS 39, 39, it it may may designate a currency borrowing as as a Cash Cash Flow Flow Hedge Hedge of of the the future future revenue stream. stream. It It is is unlikely unlikely that that it it can can reliably reliably predict predict 100% 100% revenues for for a future future year. year. However, it it is is possible that that a portion portion of of predicted revenues, normally those those expected in in the the short short term, term, will will meet meet the the highly highly probable criterion Nelson 36 18

19 Hedging Hedged Relationship Hedging Instrument Hedged Item Hedging Relationship HKAS 39 sets out 3 types of Hedging Relationships to which Hedge Accounting may be applied Fair Value Hedge Cash Flow Hedge Hedge of Net Investment in a Foreign Operation Nelson 37 Hedging Hedged Relationship Fair Value Hedge A hedge of the exposure to changes in fair value of a recognised asset or liability or an unrecognised firm commitment, or an identified portion of such items that is attributable to a particular risk and could affect P/L Cash Flow Hedge Hedge of Net Investment in a Foreign Operation 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, or a highly probable forecast transaction and ii) could affect profit or loss A hedge of the foreign currency risk of a firm commitment may be accounted for as a fair value hedge or as a cash flow hedge Hedge of a net investment in a foreign operation is as defined in HKAS 21 The Effects of Changes in Foreign Exchange Rates Nelson 38 19

20 Hedging Hedged Relationship Example Fair Value Hedge Cash Flow Hedge Determine the classification for the following hedge: Entity A has a floating rate bond and enters into an interest rate swap by receiving fixed and paying float Entity B has a fixed rate bond and enters into an interest rate swap by receiving float and paying fixed Entity C issues a floating rate bond and enters into an interest rate swap by paying fixed and receiving float Hedge of Net Investment in a Foreign Operation Entity D issues a floating rate bond and buys an interest rate cap Nelson 39 Hedging Hedged Relationship Example Company 2066 has a foreign currency liability payable in 6 months time. It wishes to hedge the amount payable on settlement against foreign currency fluctuations. To that end, it takes out a forward contract to buy the foreign currency in 6 months time. Should the hedge be treated as: a) Fair Value Hedge of the foreign currency liability with gains and losses on revaluing the liability and the forward contract at the yearend both recognised in the income statement; or b) Cash Flow Hedge of the amount to be settled in the future with gains and losses on revaluing the forward contract recognised in equity? HKAS does not not preclude either of of these 2 methods. (Hedge (Hedge Accounting to to be be discussed later) later) Nelson 40 20

21 Hedging Case Esprit Holdings Limited Accounting policy on derivative financial instruments The method of recognising the resulting gain or loss where the derivative is designated as a hedging instrument depends on the nature of the item being hedged. The Group can designate certain derivatives as either: i) hedges of the fair value of recognised assets or liabilities or a firm commitment (Fair Value Hedges); or ii) hedges of highly probable forecast transactions (Cash Flow Hedges) Nelson 41 Hedging Hedge Accounting Conditions Hedging Instrument Hedged Item Hedging Relationship Conditions for Hedge Accounting A Hedging Relationship qualifies for Hedge Accounting if and only if all the Conditions for Hedge Accounting are met Nelson 42 21

22 Hedging Hedge Accounting Conditions All 5 Conditions for Hedge Accounting must be met: Formal documentation at inception Highly effective and consistent with originally documented risk Forecasted transaction to be highly probable (for cash flow hedge) Hedge effectiveness can be reliably measured Conditions for Hedge Accounting Ongoing-assessed and actually highly effective Nelson 43 Hedging Hedge Accounting Conditions Formal documentation at inception At the inception of the hedge, there is formal designation and documentation of: the hedging relationship and the entity s risk management objective and strategy for undertaking the hedge. That documentation shall include: identification of the hedging instrument, the hedged item or transaction, the nature of the risk being hedged and howthe entity will assess the hedging instrument s effectiveness in offsetting the Hedge exposure to changes in the hedged item s fair value or cash flows attributable to the hedged risk. Effectiveness Nelson 44 22

23 Hedging Hedge Accounting Conditions Forecasted transaction to be highly probable (for cash flow hedge) For Cash Flow Hedges, a forecast transaction that is the subject of the hedge must be highly probable and must present an exposure to variations in cash flows that could ultimately affect profit or loss Nelson 45 Hedging Hedge Accounting Conditions Measurable and highly effective hedge from the beginning to the end The hedge is expected to be highly effective in achieving offsetting changes in fair value or cash Highly flows attributable to the hedged risk, consistently effective and consistent with the originally documented risk management with originally documented strategy for that particular hedging relationship. risk The effectiveness of the hedge can be reliably measured, i.e. the fair value or cash flows of the hedged item that are attributable to the hedged risk and the fair value of the hedging instrument Hedge effectiveness can can be reliably measured. be reliably measured Ongoing-assessed and actually highly effective The hedge is assessed on an ongoing basis and determined actually to have been highly Hedge effective throughout the financial reporting Effectiveness periods for which the hedge was designated Nelson 46 23

24 Hedging Assess Hedge Effectiveness Hedging Instrument Hedged Item Hedging Relationship Conditions for Hedge Accounting Hedge Effectiveness Nelson 47 Hedging Assess Hedge Effectiveness Hedge effectiveness is the degree to which changes in the fair value or cash flows of the hedged item that are attributable to a hedged risk are offset by changes in the fair value or cash flows of the hedging instrument. Hedge Effectiveness Nelson 48 24

25 Hedging Assess Hedge Effectiveness A hedge is regarded as highly effective only if both of the following conditions are met: Inception and Ongoing Prospective testing a) At the inception of the hedge and in subsequent periods the hedge is expected to be highly effective in achieving offsetting changes in fair value or cash flows attributable to the hedged risk during the period for which the hedge is designated. Actual results b) The actual results of the hedge are within a range of 80% 125%. Retrospective testing Effectiveness is assessed, at a minimum, at the time an entity prepares its annual financial statements or interim financial statements Nelson 49 Hedging Assess Hedge Effectiveness Inception and Ongoing Prospective testing In some cases, matching critical terms is also allowed Such expectation (at the inception and in subsequent periods) can be demonstrated in various ways, including: a comparison of past changes in the fair value or cash flows of the hedged item that are attributable to the hedged risk with past changes in the fair value or cash flows of the hedging instrument (i.e. analysis of historical data), or by demonstrating a high statistical correlation between the fair value or cash flows of the hedged item and those of the hedging instrument (i.e. using statistical model, say regression analysis). The entity may choose a hedge ratio of other than one to one in order to improve the effectiveness of the hedge (as described in HKAS 39.AG100) Nelson 50 25

26 Hedging Assess Hedge Effectiveness Example Inception and Ongoing Prospective testing How do we assess the expected hedge effectiveness, say cash flow hedge on purchase of machine in foreign currency by buying call option? Prospective test test is is performed at at the the inception of of the the hedge and and at at each reporting date. The The hedge is is highly effective if if the the changes in in the the cash cash flows flows of of the the hedged hedged item item that that are are attributable to to the the hedged risk risk are are expected to to be be offset offset by by the the changes in in the the cash cash flows flows of of the the hedging instrument. Prospective test test can can be be performed by by comparing the the numerical effects of of a shift shift in in the the hedged interest rate rate on on both both the the present value of of the the cash flows being hedged and and the the fair fair value of of the the hedging instrument. Different interest rate rate scenarios would be be used (it (it may may be be reduced if if the the critical terms of of the the swap and and the the hedged items are are the the same) Nelson 51 Hedging Assess Hedge Effectiveness Example Inception and Ongoing Prospective testing In some cases, matching critical terms is also allowed An interest rate swap is likely to be an effective hedge if the following critical terms are the same for both the the hedging instrument and the hedged item: the notional and principal amounts, term, repricing dates, dates of interest and principal receipts and payments, and basis for measuring interest rates. Then, matching critical terms may be used as a prospective test and other quantitative prospective test may not be required in such extensive manner Nelson 52 26

27 Hedging Assess Hedge Effectiveness The actual hedge effectiveness measurement may be based on either: A period by period basis, or A cumulative basis Such basis should be established in the hedge documentation and properly followed afterward. If a cumulative basis is used, hedge accounting will not be ceased even the hedge is not effective for a particular period. Actual results Retrospective testing b) The actual results of the hedge are within a range of 80% 125% Nelson 53 Hedging Assess Hedge Effectiveness Hedging Instrument Hedged Item Gain is $125 The degree of offset can be measured by either $125 $100, which is 125%, or $100 $125, which is 80% Loss is $100 within 80% to 125% range Example Actual results Retrospective testing b) The actual results of the hedge are within a range of 80% 125% Nelson 54 27

28 Hedging Assess Hedge Effectiveness Example What should be placed attention on option type hedging instruments, say cap? Actual results Retrospective testing How do we assess the actual hedge effectiveness (cash flow hedge) on interest rate swap or interest rate cap (or caplets)? Value changes of of option-type hedging instruments consist of: of: time time value value changes and and intrinsic value value changes Normally, time time value changes would be be excluded from from the the hedge relationship (as (as established in in hedge documentation. If If it it is is not not excluded, the the hedge may may not not be be highly effective. As As a result, the the hedge accounting may may not not be be applied Nelson 55 Hedging Hedge Accounting Hedging Instrument Hedged Item Hedging Relationship Conditions for Hedge Accounting Hedge Accounting If a Hedging Relationship meets all the Conditions for Hedge Accounting, the Hedge Accounting in respect of that Hedge Relationship can be used Nelson 56 28

29 Hedging Hedge Accounting Hedging Instrument Hedged Item Hedging Relationship Conditions for Hedge Accounting Hedge Accounting Fair Value Hedge Cash Flow Hedge Hedge of Net Investment in a Foreign Operation Nelson 57 Hedging Hedge Accounting Fair Value Hedge Hedging Instrument Hedged Item Meets the Condition for Hedging Accounting, then: a) the gain or loss from re-measuring the Hedging Instrument at fair value (for a derivative hedging instrument) or the foreign currency component of its carrying amount measured in accordance with HKAS 21 (for a non-derivative hedging instrument) shall be recognised in profit or loss b) the gain or loss on the Hedged Item attributable to the hedged risk shall adjust the carrying amount of the Hedged Item and be recognised in profit or loss. This applies if the hedged item is otherwise measured at cost. Recognition of the gain or loss attributable to the hedged risk in P/L applies if the hedged item is an available-for-sale financial asset Nelson 58 29

30 Hedging Hedge Accounting Fair Value Hedge Hedging Instrument Hedging instrument s change in fair value recognised in P/L Income Statement Hedged Item adjust its carrying amount Hedged item s gain or loss attributable to the hedged risk shall adjust its carrying amount and be recognised in P/L Even the Hedged Item is measured at Cost (say HTM investment) or Fair Value through Equity (AFS financial assets) Nelson 59 Hedging Hedge Accounting Example Hedge of Inventory Can Entity A designate its inventories, say copper, as the hedged item in a Fair Value Hedge of the exposure to changes in the copper price? However, inventories are measured at the lower of cost and net realisable value under HKAS 2 Inventories. Yes. Yes. The The inventories may may be be hedged for for changes in in fair fair value value due due to to changes in in the the copper copper price. price. Because the the change change in in fair fair value value of of inventories will will affect affect profit profit or or loss loss when when the the inventories are are sold sold or or their their carrying amount is is written written down. down. The The adjusted carrying amount becomes the the cost cost basis basis for for the the purpose of of applying the the lower lower of of cost cost and and net net realisable value value test test under under HKAS HKAS The The Hedging Instrument used used in in a Fair Fair Value Value Hedge Hedge of of inventories may may alternatively qualify qualify as as a Cash Cash Flow Flow Hedge Hedge of of the the future future sale sale of ofthe inventory Nelson 60 30

31 Hedging Hedge Accounting Example Interest Rate Swap on A Fixed Rate Financial Asset Company A purchases a bond that has a principal amount of $1 million at a fixed interest rate of 6% per year. is classified as an available-for-sale financial asset. has a fair value of $1 million. The company enters into an interest rate swap. It exchanges the fixed interest rate payments it receives on the bond for floating interest rate payments, in order to offset the risk of a decline in fair value. It designates and documents the swap as a hedging instrument. The swap has a fair value of zero at the inception of hedge. Assuming The market interest rates have increased to 7% and the fair value of the bond will have decreased to $960,000. The fair value of the swap has increased by $40, Nelson 61 Hedging Hedge Accounting Example The The instrument is is classified as as available-for-sale, therefore the the decrease in in fair fair value value would would normally be be recorded directly directly in in reserves. However, since since the the instrument is is a Hedged Item Item in in a Fair Fair Value Value Hedge, Hedge, this this change change in in fair fair value value of of the the instrument is is recognised in in profit profit or or loss, loss, as as follows: follows: Dr Dr Income Income statement $40,000 Cr Cr Available-for-sale financial asset asset $40,000 While While the the swap swap is is a derivative, it it is is measured at at fair fair value value with with changes in in fair fair value value recognised in in profit profit or or loss. loss. Dr Dr Swap Swap receivables $40,000 Cr Cr Income Income statement $40,000 The The changes in in fair fair value value of of the the Hedged Item Item and and the the Hedging Instrument exactly exactly offset offset each each other: other: the the hedge hedge is is 100% 100% effective and and the the net net effect effect on on profit profit or or loss lossis is zero. zero Nelson 62 31

32 Hedging Hedge Accounting Cash Flow Hedge Meets the Condition for Hedging Accounting, then: Hedging Instrument Effective Portion Ineffective Portion a) the portion of the gain or loss on the Hedging Instrument that is determined to be an effective hedge shall be recognised directly in equity through the statement of changes in equity; and b) the ineffective portion of the gain or loss on the Hedging Instrument shall be recognised in profit or loss Nelson 63 Hedging Hedge Accounting Cash Flow Hedge Hedging Instrument Effective Portion Ineffective Portion gain or loss to equity gain or loss to P/L Statement of of Change in in Equity Income Statement How s the treatment, if it is.. Hedge of of a forecast transaction Hedge of of forecast transaction resulting in in recognition of of resulting in in recognition of of Financial Asset or Non-Financial Asset or Financial Liability Non-Financial Liability Nelson 64 32

33 Hedging Hedge Accounting Cash Flow Hedge If a Hedge of a Forecast Transaction subsequently results in the recognition of a financial asset or a financial liability the associated gains or losses that were recognised directly in equity shall be reclassified into profit or loss in the same period(s) during which the asset acquired or liability assumed affects profit or loss (such as in the periods that interest income or interest expense is recognised) If any loss recognised directly in equity is expected not to be recovered in one or more future periods it shall reclassify such loss into profit or loss. Hedge of of a forecast transaction resulting in in recognition of of Financial Asset or Financial Liability Nelson 65 Hedging Hedge Accounting Cash Flow Hedge Hedging Instrument Effective Portion Ineffective Portion Statement of of Change in in Equity Income Statement Reclassified associated gain or loss recognised in equity to P/L in case of Hedge of of a forecast transaction Final recognition of financial assets resulting in in recognition of of or financial liabilities, or Financial Asset or Loss recognised directly in equity is Financial Liability expected not to be recovered Nelson 66 33

34 Hedging Hedge Accounting Example Company 2066 has a foreign currency liability payable in 6 months time. It wishes to hedge the amount payable on settlement against foreign currency fluctuations. To that end, it takes out a forward contract to buy the foreign currency in 6 months time. Should the hedge be treated as: a) Fair Value Hedge of the foreign currency liability with gains and losses on revaluing the liability and the forward contract at the yearend both recognised in the income statement; or b) Cash Flow Hedge of the amount to be settled in the future with gains and losses on revaluing the forward contract recognised in equity? HKAS does not not preclude either of of these 2 methods discussed Hedge Accounting discuss now now Nelson 67 Hedging Hedge Accounting Example Hedge Accounting If If the the hedge hedge is is treated treated as as a Fair Fair Value Value Hedge Hedge the the gain gain or or loss loss on on the the fair fair value value remeasurement of of the the hedging and and of of the the hedged item item for for the the hedged risk risk are are recognised immediately in in profit profit or or loss. loss. If If the the hedge hedge is is treated treated as as a Cash Cash Flow Flow Hedge Hedge with with the the gain gain or or loss loss on on remeasuring the the forward forward contract recognised in in equity equity that that amount amount is is recognised in in profit profit or or loss loss in in the the same same period(s) during during which which the the hedged item item (the (the liability) affects affects profit profit or or loss, loss, i.e. i.e. when when the the liability liability is is remeasured for for changes in in foreign foreign exchange rates. rates. Thus, Thus, if if the the hedge hedge is is effective, the the gain gain or or loss loss on on the the derivative is is released to to profit profit or or loss loss in in the the Any choice here? same same periods periods during during which which the the liability liability is is remeasured, not not when when the the payment occurs. occurs Nelson 68 34

35 Hedging Hedge Accounting Cash Flow Hedge If a Hedge of a Forecast Transaction subsequently results in the recognition of a non-financial asset or a non-financial liability, or a forecast transaction for such non-financial item becomes a firm commitment for which fair value hedge accounting is applied Then an entity shall adopt (a) or (b) below: a) Reclassifies the associated gains b) Removes the associated gains and and losses recognised in equity into losses recognised directly in equity, P/L in the same period(s) during and includes them in the initial cost or which the asset acquired or liability other carrying amount of the asset or assumed affects P/L (such as in the liability. periods that depreciation expense or Once adopt either (a) or (b), apply cost of sales is recognised). consistently If any loss recognised directly in equity is expected not to be Hedge of of forecast transaction recovered in one or more future resulting in in recognition of of periods, it shall reclassify into P/L Non-Financial Asset or such loss. Non-Financial Liability Nelson 69 Hedging Hedge Accounting Cash Flow Hedge Effective Portion Statement of of Change in in Equity (b) Cost of asset or liability Hedging (a) Instrument Once adopt either (a) or (b) Ineffective Income Portion Statement then, apply consistently Still reclassified associated gain or loss recognised in equity to P/L when Loss recognised directly in equity is expected not to be recovered Hedge of of forecast transaction Associated gain or loss will also be either resulting in in recognition of of a) reclassified to P/L, or Non-Financial Asset or b) included in cost of assets or liabilities Non-Financial Liability Nelson 70 35

36 Hedging Hedge Accounting Cash Flow Hedge For cash flow hedges other than those discussed amounts that had been recognised directly in equity shall be recognised in profit or loss in the same period(s) during which the hedged forecast transaction affects P/L (for example, when a forecast sale occurs). Hedge of of a forecast transaction Other Cash Flow Hedges of of forecast transaction resulting in in recognition of of resulting in in recognition of of Financial Asset or Non-Financial Asset or Financial Liability Non-Financial Liability Nelson 71 Hedging Hedge Accounting Cash Flow Hedge Hedging Instrument Effective Portion Ineffective Portion Statement of of Change in in Equity Income Statement Recognise in P/L when hedged forecast transaction affects P/L Other Cash Flow Hedges Nelson 72 36

37 Hedging Hedge Accounting Example Hedge of Forecast Transaction Entity A trades in UK mainly in UK Sterling. It expects to purchase a machine for 1 million Euros in one year from 1 May In order to offset the risk of increases in the Euro rate, Entity A enters into a forward contract to purchase 1 million Euros in 1 year for a fixed amount ( 650,000). The forward contract is designated as a Cash Flow Hedge. At inception, the forward contract has a fair value of zero. At the year-end of 31 October 2006 the Euro has appreciated and the value of 1 million Euros is 660,000. The fair value of the forward contract rises to 10,000. The machine will still cost 1 million Euros so the company concludes that the hedge is 100% effective Nelson 73 Hedging Hedge Accounting Example The The entire change in in the the fair fair value of of the the hedging instrument is is recognised directly in in reserves. Dr Dr Forward contract 10,000 Cr Cr Reserves 10,000 How to treat this amount finally? The The forward contract is is settled with with no no further change in in the the exchange rate: rate: Dr Dr Cash Cash 10,000 Cr Cr Forward contract 10,000 The The company purchases the the machine for for 1 million euros and and makes the the following journal entry: Dr Dr Machine 660,000 Cr Cr Accounts Payable 660,000 The gain of 10,000 recognised in reserve (equity) should either be reclassified from equity into P/L, or be reclassified from equity and included in the initial carrying amount of the machine (for non-financial assets or liabilities only) once this policy is chosen, it must be used consistently Nelson 74 37

38 Hedging Hedge Accounting Case In its 2005 Interim Report, full set of HKFRS was adopted and the report set out that: The effective portion of changes in the fair value of derivatives that are designated and qualify as cash flow hedges are recognized in hedging reserve. The gain or loss relating to the ineffective portion is recognized immediately in the consolidated profit and loss account. Amounts accumulated in hedging reserve are recycled in the consolidated profit and loss account in the periods when the hedged item will affect profit or loss (for instance when the forecast sale that is hedged takes place). However, when the forecast transaction that is hedged results in the recognition of a non-financial asset (for example, inventory) or a liability, the gains and losses previously deferred in hedging reserve are transferred from hedging reserve and included in the initial measurement of the cost of the asset or liability Nelson 75 Hedging Hedge Accounting Hedge of Net Investment in a Foreign Operation Effective Portion Hedging Instrument Ineffective Portion Including a hedge of a monetary item that is accounted for as part of the net investment, shall be accounted for similarly to Cash Flow Hedges: a) the portion of the gain or loss on the Hedging Instrument that is determined to be an effective hedge shall be recognised directly in equity through the statement of changes in equity; and b) the ineffective portion shall be recognised in profit or loss. The gain or loss on the hedging instrument relating to the effective portion of the hedge that has been recognised directly in equity shall be recognised in profit or loss on disposal of the foreign operation Nelson 76 38

39 Hedging Hedge Accounting Hedge of Net Investment in a Foreign Operation Hedging Instrument Effective Portion Statement of of Change in in Equity Recognise in P/L on disposal of the foreign operation Ineffective Portion Income Statement Nelson 77 Hedge Cease Hedge Accounting An entity shall discontinue prospectively the Hedge Accounting if: a) the hedging instrument expires or is sold, terminated or exercised; b) the hedge no longer meets the Conditions for Hedge Accounting; c) the entity revokes the designation; or d) in case of a Cash Flow Hedge, the forecast transaction that is hedged is no longer expected to occur. When the Hedge Accounting is discontinued (for Cash Flow Hedge), the cumulative gain or loss on the Hedging Instrument that remains recognised directly in equity shall: a) remain separately recognised in equity until the forecast transaction occurs; or b) be recognised in profit or loss if the forecast transaction is no longer expected to occur Nelson 78 39

40 Hedge Cease Hedge Accounting Case In its 2005 Interim Report, full set of HKFRS was adopted and the report set out that: When a hedging instrument expires or is sold, or when a hedge no longer meets the criteria for hedge accounting, any cumulative gain or loss existing in hedging reserve at that time remains in hedging reserve and is recognized when the forecast transaction is ultimately recognized in the consolidated profit and loss account. When a forecast transaction is no longer expected to occur, the cumulative gain or loss that was reported in hedging reserve is immediately transferred to the consolidated profit and loss account. Certain derivative instruments do not qualify for hedge accounting. Changes in the fair value of any derivative instruments that do not qualify for hedge accounting are recognized immediately in the consolidated profit and loss account Nelson 79 E. Transitional Arrangements Nelson 80 40

41 E. Transitional Arrangements Early application is permitted (revised in Nov. 2004) At the beginning of the year in which HKAS 39 is initially applied: Classification of financial assets and financial liabilities All assets should apply the criteria in classification and remeasure them in accordance with HKAS 39 accordingly Any adjustment of the previous carrying amount should be recognised as an adjustment of the balance of retained earnings, or if appropriate, another category of equity at the beginning of the financial year in which HKAS 39 is initially applied (revised in Jan. 2006) Nelson 81 E. Transitional Arrangements Early application is permitted (revised in Nov. 2004) At the beginning of the year in which HKAS 39 is initially applied: Initial designation Permitted to designate a previously recognised financial asset or financial liability as a financial asset or financial liability at fair value through profit or loss or available for sale despite the requirement under HKAS 39 to make such designation upon initial recognition For any such financial asset previously designated as available for sale, the entity shall recognise all cumulative changes in fair value in a separate component of equity until subsequent derecognition or impairment Nelson 82 41

42 E. Transitional Arrangements Early application is permitted (revised in Nov. 2004) At the beginning of the year in which HKAS 39 is initially applied: Held-to-maturity investments Sales or transfers of held-to-maturity investments before the beginning of the year in which HKAS 39 is initially applied do not trigger the tainting rules If an entity has sold or transferred held-to-maturity investments previously so designated under SSAP 24 in the two preceding financial years, it is not prevented to continue to classify such financial assets as held-to-maturity investments Nelson 83 E. Transitional Arrangements Early application is permitted (revised in Nov. 2004) At the beginning of the year in which HKAS 39 is initially applied: Derecognition If a securitisation, transfer, or other derecognition transaction was entered into prior to the beginning of the year in which HKAS 39 is initially applied, the accounting for that transaction shall not be retrospectively changed to conform to the requirements of HKAS 39; Nelson 84 42

43 E. Transitional Arrangements Early application is permitted (revised in Nov. 2004) At the beginning of the year in which HKAS 39 is initially applied: Derivative Recognise all derivatives in its balance sheet as either assets or liabilities and should measure them at fair value (subject to exemption) Hedging If the previously designated hedge does not meet the conditions for an effective hedge under HKAS 39 and the hedging instrument is still held, hedge accounting will no longer be appropriate starting with the adoption of HKAS 39. Accounting in prior years should not be retrospectively changed to conform to the requirements of HKAS 39 Transactions entered into before the beginning of the financial year in which HKAS 39 is initially applied should not be retrospectively designated as hedges Nelson 85 E. Transitional Arrangements Early application is permitted (revised in Nov. 2004) At the beginning of the year in which HKAS 39 is initially applied: Fair value hedge Any balance sheet positions in Fair Value Hedges of existing assets and liabilities should be accounted for by adjusting their carrying amounts to reflect the fair value of the hedging instrument Cash flow hedge Any deferred gains and losses on Cash Flow Hedge should be reclassified as a separate component of equity to the extent that the transactions meet the criteria in HKAS Nelson 86 43

44 E. Transitional Arrangements Case HKEX (Consolidated financial statements of 28 Feb. 2005) All relevant changes in the accounting policies have been made in accordance with the provisions of the respective standards, which require retrospective application to prior year comparatives other than HKAS 39: recognise all derivatives at fair value in the balance sheet on 1 January 2004 and adjust the balance to retained earnings; redesignate all investments into available-for-sale financial assets, financial assets at fair value through profit or loss and loans and receivables (which include bank deposits and cash and cash equivalents) on 1 January 2004; remeasure those financial assets or financial liabilities that should be measured at fair value and those that should be measured at amortised cost and adjust the balance to retained earnings at 1 January 2004; prospective application for the derecognition of financial assets Nelson 87 E. Transitional Arrangements Case Esprit Holdings Limited 2004 Annual Report During the years ended June 30, 2004 and 2003, the Group s derivative instruments did not qualify for hedge accounting as the Group was not permitted to retrospectively meet the documentation requirements for hedging under IAS Nelson 88 44

45 F. Any more Amendments Amendments and New Standard issued in 2005 Transition and Initial Recognition of Financial Assets and Financial Liabilities (Feb. 2005) Cash Flow Hedge Accounting of Forecast Intragroup Transactions (Jul. 2005) The Fair Value Option (Jul. 2005) Financial Instruments: Recognition and Measurement and Insurance Contracts Financial Guarantee Contracts (Sep. 2005) IFRS 7 Financial Instruments: Disclosures (Sep. 2005) Effective for annual periods beginning on or after 1 Jan Jan Jan Jan Jan Discussed last time This time This time Nelson 89 Financial Guarantee Contracts The amended requirements for financial guarantee contracts are issued in the form of limited amendments to HKAS 39 Financial Instruments: Recognition and Measurement and HKFRS 4 Insurance Contracts Nelson 90 45

46 Financial Guarantee Contracts The amendments are intended to ensure that issuers of financial guarantee contracts include the resulting liabilities in their balance sheet. Before these amendments, financial guarantee contracts were within the scope of HKFRS 4 HKAS 39 para. BC 22 states that IASB finalised IFRS 4 in early 2004 without specifying the accounting for these contracts (the financial guarantee contracts) and then published an exposure draft (of this amendment) Nelson 91 Financial Guarantee Contracts Financial guarantee contract is defined as: a contract that requires the issuer to make specified payments to reimburse the holder for a loss it incurs because a specified debtor fails to make payment when due in accordance with the original or modified terms of a debt instrument. Financial guarantee contracts may have various legal forms, such as a guarantee some types of letter of credit a credit default contract or an insurance contract Nelson 92 46

47 Financial Guarantee Contracts The amendments set out that: Although a financial guarantee contract meets the definition of an insurance contract in HKFRS 4 if the risk transferred is significant, the issuer applies HKAS 39. Nevertheless, if the issuer has previously asserted explicitly that it regards such contracts as insurance contracts and has used accounting applicable to insurance contracts, the issuer may elect to apply either HKAS 39 or HKFRS 4 to such financial guarantee contracts Nelson 93 Financial Guarantee Contracts HKAS 39 (para. 47c and AG4) requires the issuer of a financial guarantee contract to measure the contract: Initially, at fair value. If the financial guarantee contract was issued to an unrelated party in a stand-alone arm s length transaction, its fair value at inception is likely to equal the premium received, unless there is evidence to the contrary. Subsequently, at the higher of: i) the amount determined in accordance with HKAS 37 Provisions, Contingent Liabilities and Contingent Assets; and ii) the amount initially recognised less, when appropriate, cumulative amortisation recognised in accordance with HKAS 18 Revenue. unless the financial guarantee contract was designated at inception as at fair value through profit or loss or unless paragraphs and AG47-AG52 apply (when a transfer of a financial asset does not qualify for derecognition or the continuing involvement approach applies), Nelson 94 47

48 Financial Guarantee Contracts HKAS 39 does not contain exemptions for parents, subsidiaries or other entities under common control. However, any differences are reflected only in the separate or individual financial statements of the parent, subsidiaries or common control entities An entity shall apply the amendment for annual periods beginning on or after 1 January Earlier application is encouraged. If an entity applies these changes for an earlier period, it shall disclose that fact and apply the related amendments to HKAS 32 and HKFRS 4 at the same time Nelson 95 Disclosure Amended by HKFRS Nelson 96 48

49 Disclosure Amended by HKFRS 7 The objective of HKFRS 7 is to require entities to provide disclosures in their financial statements that enable users to evaluate: 1) the significance of financial instruments for the entity s financial position and financial performance; and 2) the nature and extent of risks arising from financial instruments to which the entity is exposed during the period and at the reporting date, and how the entity manages those risks. Significance Balance sheet Income statement Other disclosures Nature and Extent Qualitative disclosures Quantitative disclosures Nelson 97 Disclosure Amended by HKFRS 7 HKFRS 7 supersedes (from 1 Jan. 2007) Full HKAS 30 Para. 51 to 95 of HKAS 32 As compared with HKAS 30 and 32, HKFRS 7 has the following attributes: 1. Apply to all entities while HKAS 30 applies to financial institution only 2. Is more correlation with the categories of financial instruments as defined in HKAS Aim at simplifying the disclosure requirements of HKAS 32 on risks but introduced some new disclosures 4. HKAS 32 has exemption for comparative on first year of adoption but HKFRS 7 only provides exemption on the nature and extent of risks. Significance Nature and Extent Nelson 98 49

50 1. Significance of Financial Instruments Significance An entity shall disclose information that enables users of its financial statements to evaluate the significance of financial instruments for its financial position and performance Nelson Significance of Financial Instruments Significance Balance Sheet The carrying amounts of each of the following categories, as defined in HKAS 39, shall be disclosed either on the face of the balance sheet or in the notes: a) financial assets at fair value through P/L, showing separately i) those designated as such upon initial recognition and ii) those classified as held for trading in accordance with HKAS 39; b) held-to-maturity investments; New c) loans and receivables; in in HKFRS 7 d) available-for-sale financial assets; e) financial liabilities at fair value through P/L, showing separately i) those designated as such upon initial recognition and ii) those classified as held for trading in accordance with HKAS 32 only HKAS 39; and requires such New f) financial liabilities measured at amortized cost. in in disclosures HKFRS Nelson

51 1. Significance of Financial Instruments Significance Balance Sheet Additional information is required to disclose on: Loan and receivable designated as at fair value through profit or loss (HKFRS 7.9) Financial liability designated as at fair value through profit and loss (HKFRS 7.10) Allowance account for credit losses (say bad debt) When financial assets are impaired by credit losses and the entity records the impairment in a separate account (e.g. an allowance account used) rather than directly reducing the carrying amount of the asset, it shall disclose a reconciliation of changes in that account during the period for each class of financial assets. No reconciliation required in in HKAS 32.94(i) Nelson Significance of Financial Instruments Significance Income Statement An entity shall disclose the following items either on the face of the financial statements or in the notes: a) net gains or net losses on: i) financial assets or financial liabilities at fair value through P/L, showing separately those on financial assets or financial liabilities designated as such upon initial recognition, and those on financial assets or financial liabilities that are classified as held for trading in accordance with HKAS 39; ii) available-for-sale financial assets, showing separately the amount of gain or loss recognised directly in equity during the period and the amount removed from equity and recognised in profit or loss for the period; iii) held-to-maturity investments; iv) loans and receivables; and v) financial liabilities measured at amortized cost New in in HKFRS 7 HKAS 32 requires this only New in in HKFRS Nelson

52 1. Significance of Financial Instruments Significance Income Statement An entity shall disclose the following items either on the face of the financial statements or in the notes: b) total interest income and total interest expense for financial assets or financial liabilities that are not at fair value through P/L; c) fee income and expense (other than amounts included in determining the effective interest rate) arising from: i) financial assets or financial liabilities that are not at fair value through profit or loss; and ii) trust and other fiduciary activities that result in the holding or investing of assets on behalf of individuals, trusts, retirement benefit plans, and other institutions; d) interest income on impaired financial assets accrued in accordance with paragraph AG93 of HKAS 39, and e) the amount of any impairment loss for each class of financial asset. New in in HKFRS Nelson Significance of Financial Instruments Significance Other Disclosures Disclosure requirements on accounting policies, hedge accounting and fair value are similar to HKAS 32. HKFRS 7 additionally requires: a) in fair value hedges, gains or losses: i) on the hedging instrument; and ii) on the hedged item attributable to the hedged risk. b) the ineffectiveness recognised in profit or loss that arises from cash flow hedges; and c) the ineffectiveness recognised in profit or loss that arises from hedges of net investments in foreign operations. New in in HKFRS Nelson

53 2. Nature and Extent of Risks Nature Significance and Extent An entity shall disclose information that enables users of its financial statements to evaluate the nature and extent of risks arising from financial instruments to which the entity is exposed at the reporting date. The disclosures required focus on the risks that arise from financial instruments and how they have been managed. These risks typically include, but are not limited to credit risk, liquidity risk and market risk. Currency risk, interest rate risk and other price risk Nelson Nature and Extent of Risks Nature and Extent In HKAS 32 Market Risk In HKFRS 7 Market Risk Currency Risk Risk FV FV Interest Rate Risk Risk Price Risk Risk Credit Risk Currency Risk Risk Interest Rate Risk Risk Other Price Risk Risk Credit Risk Liquidity Risk Liquidity Risk Cash Flow Interest Rate Risk Risk Nelson

54 2. Nature and Extent of Risks Nature and Extent Qualitative Disclosures For each type of risk arising from financial instruments, an entity shall disclose: a) The exposures to risk and how they arise; b) Its objectives, policies and processes for managing the risk and the methods used to measure the risk c) Any changes in (a) or (b) from the previous period Nelson Nature and Extent of Risks Nature and Extent Quantitative Disclosures For each type of risk arising from financial instruments, an entity shall disclose: Summary quantitative data about its exposure to that risk at the reporting date. The level of detail of such disclosure is based on: The information provided internally to key management personnel of the entity (as defined in HKAS 24 Related Party Disclosures), for example the entity s board of directors or chief executive officer. If the quantitative data disclosed as at the reporting date are unrepresentative of an entity s exposure to risk during the period, an entity shall provide further information that is representative Nelson

55 2. Nature and Extent of Risks Nature and Extent Quantitative Disclosures Credit risk An entity shall disclose by class of financial instrument: a) the amount that best represents its maximum exposure to credit risk at the reporting date without taking account of any collateral held or other credit enhancements (e.g. netting agreements that do not qualify for offset in accordance with HKAS 32); b) in respect of the amount disclosed in (a), a description of collateral held as security and other credit enhancements; c) information about the credit quality of financial assets that are neither past due nor impaired; and d) the carrying amount of financial assets that would otherwise be past due or impaired whose terms have been renegotiated Nelson Nature and Extent of Risks Nature and Extent Quantitative Disclosures Credit risk For financial assets that are either past due or impaired, an entity shall disclose by class of financial asset: a) an analysis of the age of financial assets that are past due as at the reporting date but not impaired; b) an analysis of financial assets that are individually determined to be impaired as at the reporting date, including the factors the entity considered in determining that they are impaired; and c) for the amounts disclosed in (a) and (b), a description of collateral held by the entity as security and other credit enhancements and, unless impracticable, an estimate of their fair value Nelson

56 2. Nature and Extent of Risks Case Early adopted HKFRS 7 in 2005 and its annual report states that (extract only): Exposure to credit risk - as at 31 Dec. 2005, the financial assets and financial liabilities of the Group and HKEx that were exposed to credit risk and their maximum exposure were as follows: Nelson Nature and Extent of Risks Nature and Extent Quantitative Disclosures Liquidity risk An entity shall disclose: a) a maturity analysis for financial liabilities that shows the remaining contractual maturities; and b) a description of how it manages the liquidity risk inherent in (a) Nelson

57 2. Nature and Extent of Risks Case Early adopted HKFRS 7 in 2005 and its annual report states that (extract only): The financial liabilities of the Group and HKEx as at 31 December 2005 are analysed into relevant maturity buckets based on their contractual maturity dates in the table below: Nelson Nature and Extent of Risks Nature and Extent Quantitative Disclosures Market risk HKFRS 7 requires the disclosures of sensitivity analysis. The disclosures of sensitivity analysis can be achieved by 2 approaches: 1. Sensitivity analysis for each type of market risk 2. Sensitivity analysis that reflects interdependencies between risks variables Sensitivity analysis Nelson