INFORMATION FOR OBSERVERS

Transcription

1 30 Cannon Street, London EC4M 6XH, United Kingdom Tel: +44 (0) Fax: +44 (0) Website: International Accounting Standards Board This document is provided as a convenience to observers at IASB meetings, to assist them in following the Board s discussion. It does not represent an official position of the IASB. Board positions are set out in Standards. These notes are based on the staff papers prepared for the IASB. Paragraph numbers correspond to paragraph numbers used in the IASB papers. However, because these notes are less detailed, some paragraph numbers are not used. INFORMATION FOR OBSERVERS Board Meeting: Project: Subject: 16 October 2008, London IAS 39 Financial Instruments: Recognition and Measurement Reclassifications out of the held for trading part of the Fair Value through Profit or Loss (FVTPL) Category (Agenda Paper 12) Background 1. A number of banks and others have asked the IASB to reconsider (and possibly eliminate) the prohibition reclassifying a financial asset from the held-for-trading part of the FVTPL category to another category. Based on staff discussions with some banks, it appears that the types of assets in the held for trading part of the FVTPL category that some banks would like to reclassify include asset-backed securities and possibly some leveraged loans. 2. Some have made this request in the context of converging with practice under US GAAP (and ensuring that US GAAP practice confers no competitive advantage). For example, at the recent Paris meeting of some EU leaders, this issue was included in the 19-point document issued at the end of those discussions: 9. We will ensure that European financial institutions are not disadvantaged vis-à-vis their international competitors in

2 terms of accounting rules and of their interpretation. In this regard, European financial institutions should be given the same rules to reclassify financial instruments from the trading book to the banking book including those already held or issued. We urge the IASB and the FASB to work quickly together on this issue in accordance with their recent announcement. We also welcome the readiness of the Commission to bring forward appropriate measures as soon as possible. This issue must be resolved by the end of the month 3. Others believe that reclassifications of financial instruments should be permitted regardless of US GAAP convergence related issues. Many comment letters from preparers to the IASB discussion paper Reducing Complexity in Reporting Financial Instruments stated that in situations that there has been a clear change of management intent, an entity should be allowed to make a reclassification from the held-fortrading category to another category (such as loans and receivables). Such respondents stated that any such transfer should be made at the fair value on the transfer date, with the amortised cost basis being that fair value. Respondents also recommended extensive disclosure requirements to explain why the reclassification has taken place, its impact and scope. 4. The staff would like to highlight that in discussions with users of financial statements, users have always stated that reclassifications out of the FVTPL category (which includes the held for trading category) should not be permitted. Reasons advanced include concern over entities gaming the rules, avoiding future fair value losses and that such a change to IFRS would increase uncertainty and decrease transparency. Reclassifications between categories of financial instruments 5. Paragraphs of IAS 39 set out the reclassification requirements. For the purpose of this paper, only paragraph 50 is relevant. 6. That paragraph prohibits transfers into or out of the FVTPL category. The Board re-deliberated an issue related to paragraph 50 of IAS 39 in June 2007 as part of the last Annual Improvements process. The IASB Update for that meeting stated that:

3 Reclassification of derivatives into or out of the classification as at fair value through profit or loss Paragraph 50 of IAS 39 prohibits the reclassification of financial instruments into or out of the fair value through profit or loss (FVTPL) category after initial recognition. However, some financial instruments meet the criteria for classification as at FVTPL after initial recognition and vice versa. This specifically relates to derivatives that become or cease to be designated and effective hedging instruments. It also relates to financial instruments that are held within a portfolio for which evidence arises for the first time of a recent actual pattern of short-term profit-taking, or for which there is evidence of cessation of such activity. The Board supported the view that meeting or ceasing to meet the criteria included in the definition of FVTPL as set out in paragraph 9 of IAS 39 is not a reclassification for the purposes of paragraph 50. The Board expressed concern that any amendment to the standard should not permit an entity to choose to move a financial instrument out of the category of FVTPL. It therefore asked the staff to prepare wording for an amendment to reflect this view. 7. As a result, paragraph 50A was added to IAS 39: The following changes in circumstances are not reclassifications for the purposes of paragraph 50: (a) a derivative that was previously a designated and effective hedging instrument in a cash flow hedge or net investment hedge no longer qualifies as such; (b) (c) a derivative becomes a designated and effective hedging instrument in a cash flow hedge or net investment hedge; financial assets are reclassified when an insurance company changes its accounting policies in accordance with paragraph 45 of IFRS 4. Summary of US GAAP 8. The following paragraphs summarise the staff s understanding of US GAAP requirements in this area, and how practice applies those requirements. That understanding reflects numerous informal discussions with FASB staff, some US regulators and US accounting firms. 9. Relevant US GAAP includes: a. SFAS 159 The Fair Value Option for Financial Assets and Financial Liabilities Including an amendment of FASB Statement No. 115 b. SFAS 115 Accounting for Certain Investments in Debt and Equity Instruments

4 c. SFAS 65 Accounting for Certain Mortgage Banking Activities and AICPA SOP 01-6 Accounting by Certain Entities that lend to or finance the activities of others SFAS 159 The Fair Value Option for Financial Assets and Financial Liabilities 10. Like IAS 39, SFAS 159 does not permit reclassification of any item designated using the fair value option (FVO). Paragraph 4 of SFAS 159 states that the decision to elect the FVO is irrevocable (unless a new election date occurs, as discussed in paragraph 9 of that Statement). (Note: the scope of SAFAS 159 is wider than IAS 39, and SFAS 159 has no eligibility criteria. However, those issues are beyond the limited scope of this paper). SFAS 115 Accounting for Certain Investments in Debt and Equity Instruments 11. The scope of SFAS 115 is set out in paragraphs 3 and 4 of that Statement. To summarise, SFAS 115 applies to investments in equity securities that have readily determinable fair values and to all investments in debt securities. SFAS 115 does not apply to other types of financial assets (and so is much narrower in scope than IAS 39). 12. A security is defined in the Glossary (Appendix C) to SFAS Paragraph 15 of SFAS 115 addresses transfers between categories. That paragraph permits transfers into or from the trading category but states that such transfers should be rare. Any such transfers are accounted at the fair value on the date of transfer. 14. Based on discussions with US accounting firms, some US regulators and FASB staff, it is the staff s understanding that rare, in practice, means never. 15. In remarks before the 2004 AICPA National Conference on Current SEC and PCAOB Developments, a SEC staff person commented on the meaning of rare. In that speech, it was stated, transfers might be

5 appropriate if a significant business combination or other event greatly alters the company's liquidity position or investing strategy. 16. However, following extensive discussions the IASB staff is not aware of any particular situation in which a transfer out of the trading category has occurred. That is, no situation has arisen that meets the hurdle of rare. The IASB staff will continue to research this issue. SFAS 65 Accounting for Certain Mortgage Banking Activities and AICPA SOP 01-6 Accounting by Certain Entities that lend to or finance the activities of others 17. The scope of SFAS 65 is set out in paragraph 3 of that Statement. To summarise, the Statement applies primarily to mortgage loans. 18. SFAS 65 sets out two categories Held for Sale (HFS) and Held for Investment (HFI). 19. HFS assets are measured at the lower of cost or market value, with any changes below cost being recognised in earnings in the period they occur. HFI assets are measured using amortised cost. 20. Transfers from HFS to HFI are permitted if the entity has the ability and intent to hold the loan for the foreseeable future or until maturity (paragraph 6 of SFAS 65). Any transfer is made at the lower of cost or market value at the transfer date. 21. SOP 01-6 sets out similar accounting to non-mortgage loans. 22. The staff understands that such transfers do occur in practice because of a change in intent by the reporting entity. Other relevant considerations 23. If the IFRS requirements for reclassifications are changed to converge with US practice, then other related important areas of accounting for financial instruments should arguably be considered to ensure that the classification and measurement requirements are conformed.

6 24. One obvious area is the accounting for impairment. If an entity is permitted to reclassify assets out of FVTPL under IFRS, more assets will be assessed for impairment than today. 25. IFRS and US GAAP practice on impairment are different in some respects. 26. One important difference relates to the other than temporary test in US GAAP (that test does not exist in IFRS). 27. Temporary declines in the value of held-to-maturity debt securities are not recognized in earnings under SFAS115. However, a decline in fair value below amortized cost that is other than temporary is accounted for as a realized loss. Paragraph 16 of SFAS 115 specifies that " [i]f the decline in fair value is judged to be other than temporary, the cost basis of the individual security shall be written down to fair value and the amount of the write down shall be included in earnings. That write down results in a new cost basis for the security, which cannot be recovered if the fair value subsequently increases. 28. The determination of whether a decline is other than temporary are made using all evidence that is available to the investor - not just evidence that is related to the registrant such as its financial condition and near-term prospects. The investor also must consider the severity and duration of the decline in fair value and the investor s intent and ability to hold the investment for a period sufficient for a forecasted recovery. 29. This means that if interest rates have risen (and thus the fair value of an investment in a debt security has declined), in assessing whether that decline in fair value is other than temporary the investor must consider its intent and ability to hold the investment for the period of time it will take for it to recover. (See SEC Staff Accounting Bulletin: Codification: Topic 5M Other Than Temporary Impairment of Certain Investments in Debt and Equity Securities). 30. Compare that guidance to the impairment requirements in IAS 39. Paragraph 60 of IAS 39 states that [a] decline in the fair value of a

7 financial asset below its cost or amortised cost is not necessarily evidence of impairment (for example, a decline in the fair value of an investment in a debt instrument that results from an increase in the risk-free rate). 31. Hence, an increase in (risk-free) rates does not determine whether a debt instrument is impaired in IAS 39. However, an increase in interest rates that results in the fair value of a debt security declining would result in impairment under US GAAP (if that decline were judged to be other than temporary). 32. Other differences may also need to be considered that are not addressed in this paper; for example, reclassifications between other categories of financial instruments. Possible approaches 33. If the Board decides to address reclassifications out of the FVTPL category there are two broad (and overlapping) approaches that might be taken: a. to converge IFRS requirements with US GAAP practice as much as possible; or b. to permit reclassifications based on a change in management intent in particular situations. To converge IFRS requirements with US GAAP practice The Fair Value Option 34. No difference exists for financial instruments designated under the FVO. SFAS 115 Securities 35. As noted previously, classifications are permitted in rare situations. 36. As noted previously, following extensive discussions this staff person is not aware of any particular situation in which a transfer out has occurred. The staff will continue to research this issue to determine

8 whether a transfer has occurred and in what situation any such transfer has occurred. 37. The staff considers the term rare to be vague and, given the number of jurisdictions that apply IFRS believe that is such a term was used, significant additional guidance would be required or the situations in which such a transfer could occur should be made explicit. For example, any proposed amendment could state that a transfer could only occur if: a. a significant business combination or other event greatly alters the acquirer s liquidity position or investing strategy and so the acquirer is permitted to change the classification of instruments of its existing financial instruments. (Note that Paragraph 16 (a) of IFRS 3 Business Combinations and US GAAP already permit an acquirer to change the financial instrument classifications acquired financial instruments based on conditions that exist at the acquisition date); or b. as a result of a change in statutory or regulatory requirements. 38. If the Board decided to do this, then the issue would also be whether to permit this for only financial instruments in the held for trading part of the FVTPL category that meet the US GAAP definition of a security, or for all types of financial instruments in the held for trading part of the FVTPL category. 39. However, the approach of setting out the situations in which a transfer can occur may result in greater flexibility for entities under IFRS than is the case for entities applying US GAAP; specifying situations that reclassifications can occur does not reflect US practice that such transfers never appear to occur. 40. A different approach would be to ask the FASB to consider changing US literature and either to: a. state the situations that a transfer can be made; or b. to eliminate rare except for business combinations.

9 SFAS As noted previously, SFAS 65 and SOP 01-6 allow loans to be transferred from HFS to HFI in some situations. Such transfers do happen in practice. IFRS has no equivalent categories. 42. It is difficult to replicate US GAAP practice in this area, short of importing SFAS 65 (or something similar) into IFRS. Some also note that SFAS 65 is an old standard that probably needs to be replaced. 43. One possibility might be to create a held for sale category for loans and receivables and allow transfers in particular situations. The accounting for all loans thus transferred would be at the lower of the transferred value or cost. (The staff notes that creating such a category would not be consistent with the discussions in Reducing Complexity in Reporting Financial Instruments.) Other parts of SFAS 65 might need to be incorporated into IAS 39 as well. To permit reclassifications based on a change in management intent in particular situations 44. As noted in paragraph 3 of this paper, some believe that reclassifications of financial instruments should be permitted regardless of US GAAP convergence related issues. 45. Many comment letters to the IASB discussion paper Reducing Complexity in Reporting Financial Instruments stated that in situations that there has been a clear change of management intent, an entity should be allowed to make a reclassification from the held-fortrading category to another category (such as loans and receivables). 46. Such respondents stated that any such transfer should be made at the fair value on the transfer date, with the amortised cost basis being that fair value. Respondents also recommended extensive disclosure requirements to explain why the reclassification has taken place, its impact and scope. 47. The reclassifications in SFAS 65 are based on a change in management intent.

10 48. One possible approach is to permit reclassification if a class of assets was initially recognised as part of an originate-to-distribute business model (a bank originated assets with the purpose of selling them in the near term), but that business model no longer exists. Such assets are classified as held for trading in IAS 39 (assuming that they would have been derecognised on transfer). 49. Such an approach would address the concerns of some banks. It would not distinguish between securities and loans, but might go some way to converging with SFAS 65. It would also not result in the same rules as advocated by the EU leaders at their recent meeting (see extract in paragraph 3 of this paper). 50. Any approach based on management intent would require extensive disclosures. Question for the Board: How would you like to proceed?

11 IAS 32 and IAS 39 IFRS 7 Financial Instruments IBR 13 oktober 2008 Accounting for financial instruments - 1 Disclaimer The information contained herein is of a general nature and is not intended to address the circumstances of any particular individual or entity. Although we endeavor to provide accurate and timely information, there can be no guarantee that such information is accurate as of the date it is received or that it will continue to be accurate in the future. No one should act on such information without appropriate professional advice after a thorough examination of the particular situation. Accounting for financial instruments - 2

12 Agenda Financial instruments Recognition and measurement Impairment Derecognition Hedge accounting Presentation Disclosure (IFRS 7) Transitional provisions Forthcoming Accounting for financial instruments - 3 Market trends as reflected in IAS 32 & IAS 39 Harmonisation of markets Key principles of the Standard Increased complexity Detailed disclosures All derivatives are recognised on the balance sheet Most financial assets measured at fair value Use of fair values Reduction of options Measurement of the hedging instrument is the basis for hedge accounting Accounting for financial instruments - 4

13 Scope exclusions Interests in subsidiaries, associates and jointventures accounted for under IAS 27, 28 and 31 respectively Certain rights and obligations under leases accounted under IAS 17 (except for impairment/derecognition requirements and derivatives embedded in leases) Employers rights and obligations under employee benefit plans accounted for under IAS 19 Financial instruments issued by the entity that meet the definition of an equity instrument under IAS 32 Accounting for financial instruments - 5 Scope exclusions (continued) Rights & obligations under insurance contracts as defined in IFRS 4 Contracts for contingent consideration in a business combination (this exception applies only to the acquirer) Accounting for financial instruments - 6

14 Scope exclusions (continued) Financial instruments, contracts and obligations under share-based payment transactions to which IFRS 2 applies Certain contracts to buy or sell a non-financial item (e.g. commodity contracts, see next slide) Note that the scope exclusions in IAS 32 and IAS 39 are not identical. For example, even if a contract or transaction is excluded from the scope of IAS 39, the disclosure requirements in IAS 32 may still apply. Accounting for financial instruments - 7 Scope - Commodity contracts IAS 39 applies to contracts to buy or sell a non-financial item that can be settled net in cash ( ) unless the contract was entered into (and continues to be held) for the purpose of the receipt or delivery of a non-financial item in accordance with the entity s expected purchase, sale or usage requirements Ways for net settlement include: Terms permit either party to settle net Entity has a practice of settling similar contracts net in cash Entity has a practice of taking delivery of the underlying and selling it within a short period after delivery to generate a profit from short-term price fluctuations When the non-financial item is readily convertible to cash Accounting for financial instruments - 8

15 Scope Financial Instruments vs. Insurance Contracts A financial guarantee contract is a contract that requires the issuer to make specified payments to reimburse the holder for a loss it incurs because a specified debtor fails to make payments when due in accordance with the original or modified terms of a debt instrument However, a contract requiring payment eg. due to changes in a credit rating is not a financial guarantee contract but a derivative within the scope of IAS 39. Accounting for financial instruments - 9 Financial guarantee contracts and credit insurance General requirements for financial guarantees Initial recognition at fair value Subsequent measurement at the higher of Amount determined under IAS 37 Initial amount less any cumulative amortisation Accounting for financial instruments - 10

16 Definition of financial instruments A financial instrument is a contract that gives rise to: - a financial asset of one entity and - a financial liability or equity instrument of another entity Financial asset Financial liability Equity instrument Cash Equity instrument of another entity Contractual right to receive cash or another financial asset or to exchange financial assets or liabilities under potentially favourable conditions Certain contracts settled in the entity s own equity Contractual obligation to deliver cash or another financial asset or to exchange financial asset or liabilities under potentially unfavourable conditions Certain contracts settled in the entity s own equity Contract evidencing a residual interest in the assets of an entity after deducting all of its liabilities Accounting for financial instruments - 11 Exercise: what about? Receivables Payables Property, plant and equipment Foreign currency forward contract Put and call options Inventories Equity investments Operating lease Income taxes due Accounting for financial instruments - 12

17 Categories of financial instruments 4 categories of financial instruments A financial asset or financial liability at fair value through profit or loss Held-to-maturity investments Loans and receivables Available-for-sale financial assets Accounting for financial instruments - 13 Categories of financial assets Category Financial assets at fair value through profit or loss Loans and receivables Held-to-maturity nonderivative investments Available-for-sale financial assets Definition Financial assets held for trading Derivatives, unless accounted for as hedges Financial asset designated to this category under the fair value option Non-derivative financial assets with fixed or determinable payments that are not quoted in an active market Financial assets with fixed or determinable payments and fixed maturity that the entity has the positive intent and ability to hold to maturity All financial assets that are not classified in another category are classified as available-for-sale Any financial asset designated to this category on initial recognition Accounting for financial instruments - 14

18 Categories of financial liabilities Category Financial liabilities at fair value through profit or loss Other financial liabilities at amortised cost Definition Financial liabilities held for trading Financial liability designated as at fair value through profit or loss on initial recognition All financial liabilities that are not classified at fair value through profit or loss Accounting for financial instruments - 15 Fair value option conditions Designation of financial assets or liabilities at fair value through P&L possible only if: Designation results in more relevant information Eliminates or significantly reduces accounting mismatches A group of financial assets and/or liabilities is managed on a fair value basis A contract contains one (or more) substantive embedded derivative, unless the embedded derivative: Does not significantly modify the host contract cash flows Is clearly prohibited for separation with little or no analysis Accounting for financial instruments - 16

19 Derivatives Derivatives are contracts with the following characteristics: Changes in value in response to changes in a specified underlying Requires no or little initial net investment Settled at a future date Accounting for financial instruments - 17 Embedded derivatives How to identify? An implicit or explicit term in a contract that makes it behave like a derivative Instruments with conversion features Instruments with option to extend the term of debt Transactions in third currency Index linked payments When to separate? The embedded derivative is not closely related to economic characteristics and risks of the host contract (e.g. leverage, optionality feature) Embedded derivative would be derivative if it was freestanding The host contract is not carried at fair value through profit or loss Accounting for financial instruments - 18

20 Embedded derivatives (continued) Accounting following separation: Apply rules of IAS 32/39 (or other applicable IAS if host is not a financial instrument) to the host contract Measure the separated derivative at fair value through profit or loss Accounting when separation is difficult: If it is difficult to separate the embedded derivative, may choose to fair value through profit or loss for the entire combined contract Accounting when impossible to separate: If the embedded derivative cannot be reliably identified and measured, the entire combined contract is accounted for as a financial instrument at fair value Accounting for financial instruments - 19 Embedded derivatives: re-assessment Assessment of separation when entity first becomes party to a contract Re-assessment of embedded derivatives Subsequent reassessment only if significant modification to cash flows First-time adopter assesses on the conditions when first becoming party to the contract Purchaser of hybrid contract assesses based on the conditions at that date Accounting for financial instruments - 20

21 Agenda Financial instruments Recognition and measurement Impairment Derecognition Hedge accounting Presentation Disclosure (IFRS 7) Transitional provisions Forthcoming Accounting for financial instruments - 21 Recognition and initial measurement All financial assets and financial liabilities, including derivatives, should be recognised on the balance sheet when the entity becomes party to the contractual provisions of the instrument Financial fair value of consideration given Financial fair value of consideration received Transaction costs are incremental cost that are directly attributable to the acquisition, issue or disposal of a financial asset or financial liability Accounting for financial instruments - 22

22 Subsequent measurement of financial instruments Instrument Measurement Value changes Financial assets at fair value through profit or loss Fair value P&L Held-to-maturity investments Loans and receivables Available-for-sale Financial liabilities at fair value through profit or loss or designated as such Amortised cost (effective interest rate) Amortised cost (effective interest rate) Fair value Fair value Not relevant (unless impaired) Not relevant (unless impaired) Equity (unless impaired) P&L Other liabilities Amortised cost Not relevant Derivatives Fair value P&L Accounting for financial instruments - 23 Guidance on fair values Active market: unadjusted published price quotations No active market: valuation techniques using maximum market input and minimum entity specific input Fair values of equity instruments: in the absence of market quotation are to be based on estimates or cost less impairment (as a last resort and only if impossible to make reliable estimates) Accounting for financial instruments - 24

23 Amortised cost and effective interest method Amortised cost = Initial recognition amount - Principal repayments -/+ Accumulated interest - Impairment reduction Amortisation is calculated using the effective interest rate method At each reporting date apply the effective interest rate to carrying amount to determine interest income and interest expense Accounting for financial instruments - 25 Calculation of effective yield for a fixed rate loan on inception Projected NPV Book Total Interest Fees cash flow value income portion portion Year 0 (9,200) (9,200) 9,200 Year , Year , Year 3 10,450 8,393 10, , ,150 1, Fixed rate loan of 10,000 granted at the end of year 0 at 4.5%. Fees received 1,000 and transaction costs incurred of 200. Internal rate of return calculated from the cash flows above is 7.581%. Accounting for financial instruments - 26

24 Reclassifications from held-to-maturity category Sales before maturity reclassify ALL instruments Change of intent or ability reclassify ALL instruments Tainting leads to measurement at fair value And classification as AFS assets for two years Accounting for financial instruments - 27 Agenda Financial instruments Recognition and measurement Impairment Derecognition Hedge accounting Presentation Disclosure (IFRS 7) Transitional provisions Forthcoming Accounting for financial instruments - 28

25 Subsequent measurement of financial instruments Instrument Measurement Value changes Financial assets at fair value through profit or loss Fair value P&L Held-to-maturity investments Loans and receivables Available-for-sale Financial liabilities at fair value through profit or loss or designated as such Amortised cost (effective interest rate) Amortised cost (effective interest rate) Fair value Fair value Not relevant (unless impaired) Not relevant (unless impaired) Equity (unless impaired) P&L Other liabilities Amortised cost Not relevant Derivatives Fair value P&L Accounting for financial instruments - 29 Impairment requirements A financial asset or a group of financial assets is impaired if, and only if, there is objective evidence of impairment as a result of one or more events that occurred after initial recognition; and the loss event has an impact on estimated future cash flows An impairment loss is measured as the difference between: the asset s carrying amount and the present value of estimated future cash flows - for loans and receivables or held-to-maturity investments; and the acquisition cost (net of any principal repayment and amortisation) and current fair value, less any impairment losses previously recognised for available-for-sale financial assets Accounting for financial instruments - 30

26 Loans and receivables: objective evidence of impairment At each balance sheet date, the entity should assess whether there is objective evidence of impairment for an asset or group of financial assets Significant financial difficulty of the issuer/obligor Default or breach of contract Granting of a concession by the lender Bankruptcy or financial reorganisation of the borrower Disappearance of an active market for the assets concerned Measurable decrease in the estimated future cash flows Accounting for financial instruments - 31 Loans and receivables: impairment assessment Objective evidence of impairment of individually significant assets, and individually or collectively for assets that are not individually significant? Yes Assess impairment N o Credit risk characteristics similar to portfolio of assets? Yes Assess impairment collectively N o Continue to assess individually Accounting for financial instruments - 32

27 Loans and receivables: evaluation of impairment on a portfolio basis Future cash flows Estimated cash flows Historic loss experience Changes in related observable data Discount rate Original effective interest rate Losses incurred but not reported At each year end the present value of the estimated cash flows is re-calculated and impairment loss recognised for the difference between this amount and the carrying value of the portfolio. The estimated cash flows take into account incurred losses, not expected future losses When loans are identified as individually impaired they are removed from the portfolio Accounting for financial instruments - 33 Impairment of available-for-sale equity securities Additional indicators of impairment for equity securities Adverse effects of changes in technological, market, economic or legal environment, in which the entity operates Significant or prolonged decline in the fair value of an investment in the equity instrument Equity instruments Impairment loss can not be reversed through profit or loss as long as the asset continues to be recognised Accounting for financial instruments - 34

28 Impairment of available-for-sale debt securities Indicators of impairment for debt securities (similar to those for loans and receivables) Significant financial difficulty of the issuer Bankruptcy or financial reorganisation of the issuer Disappearance of an active market for the bonds concerned Measurable decrease in the estimated future cash flows Debt instruments Impairment loss can be reversed through profit or loss if the increase can be objectively related to an event occurring after the loss was recognised Accounting for financial instruments - 35 Agenda Financial instruments Recognition and measurement Impairment Derecognition Hedge accounting Presentation Disclosure (IFRS 7) Transitional provisions Forthcoming Accounting for financial instruments - 36

29 Derecognition of a financial asset First, consolidate all subsidiaries (including all SPEs) Derecognition provisions are applied on a consolidated level Then, consider the subject of the derecognition provisions (financial asset, group of similar financial assets or a portion of a financial instruments or a group of similar financial instruments) Then, apply derecognition rules: Derecognise when contractual rights to cash flows expire or There is a transfer of a financial asset and That transfer qualifies for derecognition Accounting for financial instruments - 37 Derecognition of a financial asset Transfer of a financial asset requires A transfer of the contractual rights to receive the Cash Flows; or Meeting the pass-through requirements in IAS If financial asset has been transferred, then assess whether transfer qualifies for derecognition If substantially all risks and rewards are retained If substantially all risks and rewards are transferred If some but not substantially all risks and rewards have been transferred: Control -> Continuing involvement A very mixed model! Accounting for financial instruments - 38

30 Types of risks inherent in financial assets Price risk Disputes risk/ Legal risks Credit risk Liquidity risk Types of Risks Interest rate risk Currency risk Other risks Late payment risk Debt instruments Equity instruments Both instruments Accounting for financial instruments - 39 Derecognition of a financial liability Financial liability (or part thereof) is removed from the balance sheet when it is extinguished, i.e. when the obligation is discharged or cancelled or expires Accounting for financial instruments - 40

31 Agenda Financial instruments Recognition and measurement Impairment Derecognition Hedge accounting Presentation Disclosure (IFRS 7) Transitional provisions Forthcoming Accounting for financial instruments - 41 Introduction to hedge accounting To hedge or not to hedge is not the question Whether to apply hedge accounting that is the issue Accounting for financial instruments - 42

32 How are financial risk management and hedge accounting related? Financial Risk Management Risk identification Risk Management Strategy Types of Financial Risks Risk objects and exposure Accept risks RM tactics Mitigate risks Hedging Other RM Instruments Hedge accounting Accounting for financial instruments - 43 Reasons for Special Hedge Accounting Recognition mismatches between hedged item and hedging instruments i.e. because the hedged item is not yet recognised in the balance sheet or in the income statement Measurement mismatches between hedged item and hedging instruments i.e. because the hedged item is not measured at fair value Accounting for financial instruments - 44

33 Accounting mismatches: measurement Solution is hedge accounting Liability SWAP amortised cost hedge accounting fair value P&L Accounting for financial instruments - 45 Accounting mismatches: recognition Solution is hedge accounting Forecast or committed foreign exchange transaction Forward contract not recognised hedge accounting fair value P&L Accounting for financial instruments - 46

34 Need for hedge accounting Hedgeable risks on financial asset/liability: Interest rate risk Foreign currency risk Credit risk Equity price risk Hedgeable risks on nonfinancial asset/non-financial liability: Entire risk Foreign currency risk component Accounting for financial instruments - 47 Need for hedge accounting 1 2 Cum Hedged item 0 A Hedging instrument 20 B A Accelerate recognition of gain or loss on hedged item B Defer recognition of gain or loss on hedging instrument Accounting for financial instruments - 48

35 Hedging instruments and hedged items The following can be designated as a hedging instrument: All derivatives with third parties Non-derivatives for a hedge of foreign currency risk Combination of two or more derivatives or non-derivatives, except for net written options Proportion of hedging instrument can be used as well (say 50% of the notional) Hedging instrument could not be designated for a portion of its life To qualify for designation the hedged item should create an exposure to risk that ultimately affects profit or loss The following can be designated as a hedged item: A single or group of assets/liabilities Firm commitments or highly probable forecast transactions Non-financial assets/liabilities for a hedge of foreign currency risk or the entire risk A portion of risk or cash flows on any financial asset/liability Net investments in foreign operations Net positions cannot be designated as hedged items Accounting for financial instruments - 49 Types of hedges Fair value hedges Hedge of exposure to changes in fair value of: a recognised asset or liability; an unrecognised firm commitment; or an identified portion of any of the above two, that is attributable to a particular risk And could affect P&L Cash flow hedges Hedge of exposure to variability in cash flows that is: 1. attributable to a particular risk associated with a recognised asset or liability or a highly probable forecast transaction (also an intercompany one); and 2. could affect profit or loss. Hedges of a net investment Hedge of a net investment in a foreign operation (including a hedge of a monetary item that is accounted for as part of the net investment), as defined in IAS 21. Accounting for financial instruments - 50

36 Fair value hedge accounting model Measurement of hedging instrument Changes in fair value Fair value Measurement of hedged item Fair value with respect to risk being hedged (*) Profit or loss (*) This applies even if a hedged item is otherwise measured at cost Accounting for financial instruments - 51 Cash flow hedge accounting model Measurement of hedging instrument Fair value Effective Changes in fair value Equity Ineffective (*) Profit or loss (*) Based on timing of earnings impact of hedged item (e.g. cost of sales, depreciation, interest) Accounting for financial instruments - 52

37 Hedges of a net investment Must meet requirements for hedge accounting Accounting treatment similar to that of cash flow hedges Effective portion of gain or loss on hedging instrument recorded in the same manner as the foreign currency translation gain or loss Ineffective portion of gain or loss on hedging instrument recorded in P&L Release to P&L when subsidiary is sold Accounting for financial instruments - 53 Hedge accounting criteria Exposure must be due to specific hedgeable risk that ultimately affects earnings At inception, the hedge must be expected to be highly effective and effectiveness must be reliably measurable The hedge must remain highly effective during the whole period of the hedge The hedging relationship should be formally designated Formal documentation is required at the inception of the hedge and must include: Identification of the hedging instrument and the hedged item or transaction The nature of the risk being hedged The risk management objective and strategy for undertaking the hedge How effectiveness will be assessed The rules are strict, thus costs/benefits of hedge accounting should be considered Accounting for financial instruments - 54

38 Assessment of hedge effectiveness Prospective assessment At inception and throughout the life of the hedge Be highly effective in offsetting changes Testing methods (e.g. regression analysis, riskreduction test, etc.) Discontinue hedge accounting Retrospective assessment At each reporting date throughout the life of the hedge Testing methods (e.g. dollar-offset, regression analysis, etc.) Hedging results within the range of % 125% 100% 80% Hedge accounting; ineffectiveness to profit or loss Hedge accounting; ineffectiveness to profit or loss Discontinue hedge accounting Accounting for financial instruments - 55 Cash flow hedge Effectiveness Test On 1 January 2004 Dotcom enters into a qualifying cash flow hedge of an anticipated transaction expected to occur on or about 1 May Every month Dotcom calculates the present value of the expected cash flows of this anticipated transaction. Corporate Treasury of Dotcom reports the fair value of the forward used to hedge the FX exposure. 31/1 28/2 31/3 30/4 Fair value derivative Fair Value forecasted Cash Flow Accounting for financial instruments - 56

39 Cash flow hedge Effectiveness Test Question:Determine on a monthly basis whether the hedge is considered highly effective? 31/01 28/02 31/03 30/04 Cumulative result on forward contract Cumulative result on expected future cash flows Cumulative dollar offset 111% 94% 80% 111% Accounting for financial instruments - 57 Cash flow hedge Effectiveness Test Question:Determine the ineffective portion of the hedge by month. 31/01 28/02 31/03 30/04 Cumulative effective portion Actual change in value of forward Change in effective portion Ineffective portion Accounting for financial instruments - 58

40 Cash Flow Hedge Accounting of Forecast Intragroup Transaction A highly probable forecasted internal transaction can be designated as a hedged item in consolidated financial statements if: The transaction is denominated in a currency other than the functional currency of the entity entering into the transaction; and It will affect the group P&L Accounting for financial instruments - 59 Portfolio hedging To hedge a group of similar assets/liabilities: Each individual item must share the hedged risk exposure (e.g. interest, FX, price, credit rating etc.) Changes in value due to the hedged risk must affect each item in a manner generally proportionate to the aggregate portfolio Accounting for financial instruments - 60

41 Example Hedging a net position Is it possible to apply hedge accounting? Forecast sales $100 Forecast purchases $80 Forward contract $20 Accounting for financial instruments - 61 Solution Hedging a net position IAS 39 requires hedged item to be identified Therefore cannot hedge a net position BUT - can designate $20 of the forecast sales as the hedged item and achieve hedge accounting Forecast sales $100 Hedged sales $20 Forecast purchases $80 Forward contract $20 Accounting for financial instruments - 62

42 Example 1: Offsetting internal positions Questions Receivables $100 A Forward A $100 Central treasury Payables $50 B Forward B $50 Can A and B apply hedge accounting? Do A and B need to apply hedge accounting? Can the group apply hedge accounting? Forward X $50 Bank Accounting for financial instruments - 63 Example 1: Offsetting internal positions Solution Receivables $100 A Forward A $100 Central treasury Bank Payables $50 B Forward B $50 Forward X $50 A and B can apply hedge accounting in their own financial statements The internal contracts eliminate on consolidation The group has an external contract of $50 that can be designated as a hedge of $50 of the receivables in A The payables in B can be designated as a hedge of $50 of the receivables in A BUT there is no mismatch at a group or subsidiary level so hedge accounting is not necessary (ignoring time value) Accounting for financial instruments - 64

43 Discontinuation of hedge accounting Future changes in fair value of hedging instrument Changes in fair value of hedged item Amounts recorded to date in equity: a) hedged item still exist or still expected to occur b) hedged item or transaction sold or no longer expected to occur Fair value hedges Continue to be taken to profit or loss Treat as if not hedged For hedges of interest bearing assets, adjustments to date is amortised to profit or loss over the period to maturity N/A Cash flow hedges Recognised immediately in profit or loss N/A a) Transferred to profit or loss at the same time as the change in the hedged cash flows is recognised in profit or loss b) Transferred to profit or loss immediately Accounting for financial instruments - 65 Agenda Financial instruments Recognition and measurement Impairment Derecognition Hedge accounting Presentation Disclosure (IFRS 7) Transitional provisions Forthcoming Accounting for financial instruments - 66

44 Liability or equity? Is there a contractual obligation that the issuer cannot avoid? Yes No Part Liability Equity Compound instrument Assess at initial recognition Classification continues until disposal Determine liability component fair value include embedded derivatives Equity is residual No gain or loss Accounting for financial instruments - 67 IFRIC 2 Members Shares in Co-operative Entities and Similar Instruments Members shares that would be classified as equity if members did not have the right to request redemption are equity if: The entity has the unconditional right to refuse redemption of the members shares; or Redemption is unconditionally prohibited by local law, regulation or the entity s governing charter Accounting for financial instruments - 68

45 Amendment to IAS 32 Puttable instruments Objective and background The amendment provides exemptions for two categories of instruments: puttable financial instruments that meet certain criteria; instruments, or components of instruments, that impose on the entity an obligation to deliver to another party a pro rata share of the net assets of the entity only on liquidation (obligation only on liquidation) Accounting for financial instruments - 69 Puttable financial instrument (1/4) Amended paragraph 11 of IAS 32 defines a puttable financial instruments as...a financial instrument that gives the holder the right to put the instrument back to the issuer for cash or another financial asset or is automatically put back to the issuer on the occurrence of an uncertain future event or the death or retirement of the instrument holder. Accounting for financial instruments - 70

46 Puttable financial instrument (2/4) Conditions to be met in the terms of a puttable financial instrument in order to be classified as equity: the holder is entitled to a pro rata share of the net assets on the entity s liquidation the instrument belongs to a class of instruments that is subordinated to all other classes of instruments issued by the entity all financial instruments within this most subordinated class of instruments must have identical features, e.g., no instrument holder in that class can have preferential terms or conditions the instrument contains no other contractual obligations other than the repurchase or redemption obligation, and the total expected cash flows attributable to the instrument over its life should be based substantially on the P&L, the change in the recognised net assets or the change in the FV of the recognised and unrecognised net assets of the entity Accounting for financial instruments - 71 Puttable financial instrument (3/4) Conditions to be met by the issuer of a puttable financial instrument in order to be classified as equity No other instrument or contract exists that has: total cash flows based substantially on the profit or loss, the change in the recognised net assets or the change in the fair value of the recognised and unrecognised net assets of the entity; and the effect of substantially restricting or fixing the residual return to the puttable instrument holders Accounting for financial instruments - 72

47 Puttable financial instrument (4/4) - Holder only as an owner of the entity Only cash flows and contractual terms and conditions of the instrument that relate to the instrument holder as an owner of the entity are considered when evaluating whether an instrument meets such exemption Accounting for financial instruments - 73 Obligation only on liquidation (1/2) Obligation arises because liquidation date is either fixed or is at the option of the instrument holder In order to be classified as equity the instrument must have the following conditions: the holder is entitled to a pro rata share of the net assets on the entity s liquidation; the instrument belongs to a class that is the most subordinated to all other classes of instruments issued by the entity all financial instruments within this most subordinated class of instruments must have identical features; Accounting for financial instruments - 74

48 Obligation only on liquidation (2/2) The issuer of the instrument must have no other financial instrument or contract that has: total cash flows based substantially on the profit or loss, the change in the recognised net assets or the change in the fair value of the recognised and unrecognised net assets of the entity; and the effect of substantially restricting or fixing the residual return to the puttable instrument holders Accounting for financial instruments - 75 Offsetting a financial asset and a financial liability A legally enforceable right to set off An intention to settle net or to realise the asset and settle the liability simultaneously & Master netting agreements Several instruments used to emulate a single instrument (synthetic instrument) Items with the same risk, but different counterparties Financial assets pledged as collateral for non-recourse liabilities Assets set aside in a trust to discharge a liability that have not been accepted by the creditor (sinking fund arrangements) Obligations as a result of losses recoverable via insurance Accounting for financial instruments - 76

49 Agenda Financial instruments Recognition and measurement Impairment Derecognition Hedge accounting Presentation Disclosure (IFRS 7) Transitional provisions Forthcoming Accounting for financial instruments - 77 Overview IFRS 7 Classes of financial instruments and level of disclosure Significance of financial instruments for financial position and performance Nature and extent of risks arising from financial instruments Appendices Balance sheet Other Income statement and equity Qualitative Quantitative Application guidance Defined terms Amendments to other IFRSs (plus IFRS 7 if IAS 39 fair value option not applied) Accounting for financial instruments - 78

50 Overview (cont.) Effective for annual periods beginning on or after 1 January 2007 (earlier application is encouraged) Supersedes IAS 30 and the disclosure requirements in IAS 32 (the classification requirements remained unchanged) Shall be applied by all entities to all risks arising from all financial instruments ( some exceptions apply) Applicable to recognised and unrecognised financial instruments within the scope of IFRS 7, even when outside the scope of IAS 39 (e.g., loan commitments) Accounting for financial instruments - 79 Scope IFRS 7 to be applied by all entities and to all types of financial instruments except: Interest in subsidiaries, associates and joint ventures if accounted in accordance with IAS 27, IAS 28 or IAS 31. Employers rights and obligations from employee benefit plans under IAS 19. Insurance contracts as defined in IFRS 4. An acquirer s interest in contracts for contingent consideration in a business combination. Financial Instruments, contracts and obligations under IFRS 2. Accounting for financial instruments - 80

51 Classes of Financial Instruments and Level of Disclosure Entity to determine classes of financial instruments. Must be appropriate to nature of information disclosed. Take into account characteristics of financial instruments. Reconcile to balance sheet. Accounting for financial instruments - 81 Categories of financial assets Category Financial assets at fair value through profit or loss Loans and receivables Held-to-maturity nonderivative investments Available-for-sale financial assets Definition Financial assets held for trading Derivatives, unless accounted for as hedges Financial asset designated to this category under the fair value option Non-derivative financial assets with fixed or determinable payments that are not quoted in an active market Financial assets with fixed or determinable payments and fixed maturity that the entity has the positive intent and ability to hold to maturity All financial assets that are not classified in another category are classified as available-for-sale Any financial asset designated to this category on initial recognition Accounting for financial instruments - 82

52 Categories of financial liabilities Category Financial liabilities at fair value through profit or loss Other financial liabilities at amortised cost Definition Financial liabilities held for trading Financial liability designated as at fair value through profit or loss on initial recognition All financial liabilities that are not classified at fair value through profit or loss Accounting for financial instruments - 83 Significance of Financial Instruments for Financial Position and Performance Balance Sheet Carrying value of the four categories of financial assets and financial liabilities (as defined by IAS 39). Loans or receivables designated at FV through P&L, disclose maximum exposure to credit risk and FV changes attributable to credit risk. Financial liability designated at FV through P&L, disclose change in fair value due to its credit risk and difference between carrying amount and maturity amount. Amount of reclassification from fair value to amortised cost or vice versa. Accounting for financial instruments - 84

53 Significance of Financial Instruments for Financial Position and Performance Balance Sheet (cont.) Information about transferred financial assets that don t qualify for derecognition. Information about collateral pledged and collateral received. Reconciliation of changes in the allowance for credit losses account, for each class of financial asset. Features of compound instruments with multiple embedded derivatives. Information about defaults and breach of loans payable. Accounting for financial instruments - 85 Significance of Financial Instruments for Financial Position and Performance Income Statement and Equity Net gains and net losses on the four categories of financial assets and financial liabilities. Total interest income & expense for financial assets & liabilities not at fair value through the P&L. Fee income and expense arising from financial assets & liabilities not at fair value through the P&L and trust and other fiduciary liabilities. Interest income on impaired financial assets. Amount of impairment losses for each class of financial asset. Accounting for financial instruments - 86

54 Significance of Financial Instruments for Financial Position and Performance Other Disclosures Accounting policies Requirements for disclosure of accounting policies from IAS 1 Presentation of Financial Statements. Disclose: measurement basis (or bases) used in preparing financial statements; and Other accounting policies used. Accounting for financial instruments - 87 Significance of Financial Instruments for Financial Position and Performance Other Disclosures (cont.) Hedge accounting Description of hedge types, instruments designated as hedging instruments and nature of risks. For cash flow hedges: when cashflow is expected to occur; forecast transactions no longer expected to occur; amount recognised in equity; amount removed from equity; and amount removed from equity and included in cost of non-financial asset. For fair value hedges: gain / loss on hedging instrument; and gain / loss on hedged item. Ineffectiveness recognised in the P&L for cash flow and net investment hedges. Accounting for financial instruments - 88

55 Significance of Financial Instruments for Financial Position and Performance Other Disclosures (cont.) Fair value For each class of financial asset and liability disclose fair values so as to enable comparison with carrying amount. Methods/valuation techniques to determine fair values per class. Accounting policy and amortisation of the day 1 profit reserve. Limited exemption for some unquoted equities and contracts containing discretionary participation features. Accounting for financial instruments - 89 Nature and Extent of Risk Arising from Financial Instruments Qualitative Disclosures For each type of risk (e.g., credit, liquidity and market) arising from financial instruments, disclose: The exposures and how they were generated. Objectives, policies and processes for managing the risks and methods to measure the risk. Any changes to the above from the previous period. Accounting for financial instruments - 90

56 Nature and Extent of Risk Arising from Financial Instruments Quantitative disclosures For each risk arising from financial instruments, disclose: Quantitative data about the risk exposure as provided to key management personnel. Detailed disclosures to the extent not disclosed already from the point above. Concentration of risk if not included above. Accounting for financial instruments - 91 Nature and Extent of Risk Arising from Financial Instruments Quantitative disclosures (cont.) Credit risk By class of financial instruments: Maximum credit exposure (without collateral or credit enhancements). In respect of the above, description of collateral and credit enhancements. Information about credit quality (not passed due or impaired). Carrying amount of renegotiated financial assets. Analysis of financial assets past due and impaired. Collateral and credit enhancements obtained. Accounting for financial instruments - 92

57 Nature and Extent of Risk Arising from Financial Instruments Quantitative disclosures (cont.) Liquidity risk Maturity analysis of financial liabilities showing remaining contractual maturities. Description of how liquidity risk is managed. Expected maturities can also be disclosed if different from contractual maturities (e.g. demand deposits). Accounting for financial instruments - 93 Nature and Extent of Risk Arising from Financial Instruments Quantitative disclosures (cont.) Market risk (including interest rate risk, currency risk, other price risk) Sensitivity analysis for each type of market risk. Effect on profit and loss and equity. Explain methodology and assumptions of analysis. Changes in methods and assumptions from those in previous years. Sensitivity analysis that reflects interdependencies (e.g. value at risk) can replace the sensitivity analysis above Explain methodology and assumptions of analysis. Objectives of the method and limitations in achieving FV. Accounting for financial instruments - 94

58 Agenda Financial instruments Recognition and measurement Impairment Derecognition Hedge accounting Presentation Disclosure (IFRS 7) Transitional provisions Forthcoming Accounting for financial instruments - 95 Transition rules: First time adopters For first-time adopter, the transition to IAS 39 is specified in IFRS 1 The transitional requirements are to be applied retrospectively, except for: Split accounting requirements compound financial instruments do not have to be separated, provided such instruments have been settled or converted prior to the date of transition Designation of previously recognised financial instruments entities are allowed to make such a designation at the date of transition Derecognition requirements financial instruments derecognised under previous GAAP before 1 January 2004 are not required to be recognised, unless they qualify for recognition as a result of a later transaction or event Hedge accounting requirements if an entity designated a net position as a hedged item under previous GAAP, it may designate an individual item within that net position as a hedged item under IFRS, provided that it does so no later than the date of transition to IFRS Comparative information 2005 first time adopters are not required to restate comparative financial statements to incorporate the requirements of IAS 32/39, however they would be required to provide certain reconciliation Accounting for financial instruments - 96

59 Agenda Financial instruments Recognition and measurement Impairment Derecognition Hedge accounting Presentation Disclosure (IFRS 7) Transitional provisions Forthcoming Accounting for financial instruments - 97 Forthcoming Fair value measurements (DP) More amendments, guidance & IFRICs Total re-write of the Standard(s) Accounting for financial instruments - 98

60 Agenda Financial instruments Recognition and measurement Impairment Derecognition Hedge accounting Presentation Disclosure (IFRS 7) Transitional provisions Forthcoming Accounting for financial instruments - 99

61 ABCD IAS 32/39 Financial Instruments Case study 1 - Embedded derivatives Question 1 A German company agrees to sell and deliver its produced cars to a car retailer in Uzbekistan in two months time. The contract is denominated in USD. USD is the commonly used currency in Uzbekistan for transactions of this kind since the local currency is relatively unstable. Does the contract contain an embedded derivative that should be separated under IAS 39? Question 2 A Norwegian company agrees to sell oil to a company in France. The oil contract is denominated in Swiss francs (oil contracts are routinely denominated in U.S. dollars in international commerce). The functional currency of the Norwegian company is Norwegian kroner and that the functional currency of the French company is Euro. Is there an embedded derivative that should be separated under IAS 39? Question 3 A manufacturer enters into a long-term contract to purchase a specified quantity of a commodity from a supplier. In future periods, the supplier will provide the commodity at the current market price but within a specified range, for example, the purchase price may not exceed 120 per unit or fall below 100 per unit. The current market price at the inception of the contract is 110 per unit. Is there an embedded derivative, which would require separation? Question 4 Company A issues a debt instrument on which it pays interest indexed to the price of gold. Is there an embedded derivative that should be separated and accounted for as a derivative under IAS 39? Question 5 Company B provides a loan to a privately held company. The loan contract entitles Company B to receive shares of the borrowing enterprise for free or at a very low price (an equity kicker) in addition to interest and repayment of principal if the borrower lists its shares on a stock exchange. As a result of the equity kicker feature, the interest on the loan is lower than it would otherwise be. Does the equity kicker feature meet the definition of an embedded derivative even though it is contingent upon the future listing of the borrower? KPMG and the KPMG logo are registered trademarks of KPMG International, a Swiss cooperative. 1

62 IAS 39 conditions for that classification (see paragraphs 9 and AG16 AG25). On initial recognition of a financial asset that would otherwise be classified as a loan or receivable, an entity may designate it as a financial asset at fair value through profit or loss, or available for sale. Embedded derivatives (paragraphs 10 13) AG27 AG28 AG29 AG30 If a host contract has no stated or predetermined maturity and represents a residual interest in the net assets of an entity, then its economic characteristics and risks are those of an equity instrument, and an embedded derivative would need to possess equity characteristics related to the same entity to be regarded as closely related. If the host contract is not an equity instrument and meets the definition of a financial instrument, then its economic characteristics and risks are those of a debt instrument. 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. Generally, multiple embedded derivatives in a single instrument are treated as a single compound embedded derivative. However, embedded derivatives that are classified as equity (see IAS 32) are accounted for separately from those classified as assets or liabilities. In addition, if an instrument has more than one embedded derivative and those derivatives relate to different risk exposures and are readily separable and independent of each other, they are accounted for separately from each other. The economic characteristics and risks of an embedded derivative are not closely related to the host contract (paragraph 11(a)) in the following examples. In these examples, assuming the conditions in paragraph 11(b) and (c) are met, an entity accounts for the embedded derivative separately from the host contract. (a) (b) (c) A put option embedded in an instrument that enables the holder to require the issuer to reacquire the instrument for an amount of cash or other assets that varies on the basis of the change in an equity or commodity price or index is not closely related to a host debt instrument. A call option embedded in an equity instrument that enables the issuer to reacquire that equity instrument at a specified price is not closely related to the host equity instrument from the perspective of the holder (from the issuer s perspective, the call option is an equity instrument provided it meets the conditions for that classification under IAS 32, in which case it is excluded from the scope of this Standard). An option or automatic provision to extend the remaining term to maturity of a debt instrument is not closely related to the host debt instrument unless there is a concurrent adjustment to the approximate current market rate of interest at the time of the extension. If an entity issues a debt 1984 IASCF

63 IAS 39 instrument and the holder of that debt instrument writes a call option on the debt instrument to a third party, the issuer regards the call option as extending the term to maturity of the debt instrument provided the issuer can be required to participate in or facilitate the remarketing of the debt instrument as a result of the call option being exercised. (d) (e) (f) (g) (h) Equity-indexed interest or principal payments embedded in a host debt instrument or insurance contract by which the amount of interest or principal is indexed to the value of equity instruments are not closely related to the host instrument because the risks inherent in the host and the embedded derivative are dissimilar. Commodity-indexed interest or principal payments embedded in a host debt instrument or insurance contract by which the amount of interest or principal is indexed to the price of a commodity (such as gold) are not closely related to the host instrument because the risks inherent in the host and the embedded derivative are dissimilar. An equity conversion feature embedded in a convertible debt instrument is not closely related to the host debt instrument from the perspective of the holder of the instrument (from the issuer s perspective, the equity conversion option is an equity instrument and excluded from the scope of this Standard provided it meets the conditions for that classification under IAS 32). A call, put, or prepayment option embedded in a host debt contract or host insurance contract is not closely related to the host contract unless the option s exercise price is approximately equal on each exercise date to the amortised cost of the host debt instrument or the carrying amount of the host insurance contract. From the perspective of the issuer of a convertible debt instrument with an embedded call or put option feature, the assessment of whether the call or put option is closely related to the host debt contract is made before separating the equity element under IAS 32. Credit derivatives that are embedded in a host debt instrument and allow one party (the beneficiary ) to transfer the credit risk of a particular reference asset, which it may not own, to another party (the guarantor ) are not closely related to the host debt instrument. Such credit derivatives allow the guarantor to assume the credit risk associated with the reference asset without directly owning it. AG31 An example of a hybrid instrument is a financial instrument that gives the holder a right to put the financial instrument back to the issuer in exchange for an amount of cash or other financial assets that varies on the basis of the change in an equity or commodity index that may increase or decrease (a puttable instrument ). Unless the issuer on initial recognition designates the puttable instrument as a financial liability at fair value through profit or loss, it is required to separate an embedded derivative (ie the indexed principal payment) under paragraph 11 because the host contract is a debt instrument under paragraph AG27 and the indexed principal payment is not closely related to a host debt instrument under paragraph AG30(a). Because the principal payment can increase and decrease, the embedded derivative is a non-option derivative whose value is indexed to the underlying variable. IASCF 1985

64 IAS 39 AG32 AG33 In the case of a puttable instrument that can be put back at any time for cash equal to a proportionate share of the net asset value of an entity (such as units of an open-ended mutual fund or some unit-linked investment products), the effect of separating an embedded derivative and accounting for each component is to measure the combined instrument at the redemption amount that is payable at the end of the reporting period if the holder exercised its right to put the instrument back to the issuer. The economic characteristics and risks of an embedded derivative are closely related to the economic characteristics and risks of the host contract in the following examples. In these examples, an entity does not account for the embedded derivative separately from the host contract. (a) (b) (c) (d) An embedded derivative in which the underlying is an interest rate or interest rate index that can change the amount of interest that would otherwise be paid or received on an interest-bearing host debt contract or insurance contract is closely related to the host contract unless the combined instrument can be settled in such a way that the holder would not recover substantially all of its recognised investment or the embedded derivative could at least double the holder s initial rate of return on the host contract and could result in a rate of return that is at least twice what the market return would be for a contract with the same terms as the host contract. An embedded floor or cap on the interest rate on a debt contract or insurance contract is closely related to the host contract, provided the cap is at or above the market rate of interest and the floor is at or below the market rate of interest when the contract is issued, and the cap or floor is not leveraged in relation to the host contract. Similarly, provisions included in a contract to purchase or sell an asset (eg a commodity) that establish a cap and a floor on the price to be paid or received for the asset are closely related to the host contract if both the cap and floor were out of the money at inception and are not leveraged. An embedded foreign currency derivative that provides a stream of principal or interest payments that are denominated in a foreign currency and is embedded in a host debt instrument (eg a dual currency bond) is closely related to the host debt instrument. Such a derivative is not separated from the host instrument because IAS 21 requires foreign currency gains and losses on monetary items to be recognised in profit or loss. An embedded foreign currency derivative in a host contract that is an insurance contract or not a financial instrument (such as a contract for the purchase or sale of a non-financial item where the price is denominated in a foreign currency is closely related to the host contract provided it is not leveraged, does not contain an option feature, and requires payments denominated in one of the following currencies: (i) (ii) the functional currency of any substantial party to that contract; the currency in which the price of the related good or service that is acquired or delivered is routinely denominated in commercial 1986 IASCF

65 IAS 39 transactions around the world (such as the US dollar for crude oil transactions); or (iii) a currency that is commonly used in contracts to purchase or sell non-financial items in the economic environment in which the transaction takes place (eg a relatively stable and liquid currency that is commonly used in local business transactions or external trade). (e) (f) (g) (h) An embedded prepayment option in an interest-only or principal-only strip is closely related to the host contract provided the host contract (i) initially resulted from separating the right to receive contractual cash flows of a financial instrument that, in and of itself, did not contain an embedded derivative, and (ii) does not contain any terms not present in the original host debt contract. An embedded derivative in a host lease contract is closely related to the host contract if the embedded derivative is (i) an inflation-related index such as an index of lease payments to a consumer price index (provided that the lease is not leveraged and the index relates to inflation in the entity s own economic environment), (ii) contingent rentals based on related sales or (iii) contingent rentals based on variable interest rates. A unit-linking feature embedded in a host financial instrument or host insurance contract is closely related to the host instrument or host contract if the unit-denominated payments are measured at current unit values that reflect the fair values of the assets of the fund. A unit-linking feature is a contractual term that requires payments denominated in units of an internal or external investment fund. A derivative embedded in an insurance contract is closely related to the host insurance contract if the embedded derivative and host insurance contract are so interdependent that an entity cannot measure the embedded derivative separately (ie without considering the host contract). Instruments containing embedded derivatives AG33A AG33B When an entity becomes a party to a hybrid (combined) instrument that contains one or more embedded derivatives, paragraph 11 requires the entity to identify any such embedded derivative, assess whether it is required to be separated from the host contract and, for those that are required to be separated, measure the derivatives at fair value at initial recognition and subsequently. These requirements can be more complex, or result in less reliable measures, than measuring the entire instrument at fair value through profit or loss. For that reason this Standard permits the entire instrument to be designated as at fair value through profit or loss. Such designation may be used whether paragraph 11 requires the embedded derivatives to be separated from the host contract or prohibits such separation. However, paragraph 11A would not justify designating the hybrid (combined) instrument as at fair value through profit or loss in the cases set out in paragraph 11A(a) and (b) because doing so would not reduce complexity or increase reliability. IASCF 1987

66 ABCD IAS 32/39 Financial Instruments Solution to case study 1 - Embedded derivatives Solution 1 No. The contract will not contain an embedded derivative that needs to be separated out under the Standard. This is because (of the assumption that) sales of cars and other durables in Uzbekistan are commonly denominated in USD (as a relatively stable and liquid) due to the country s own currency being unstable (see IAS 39.AG33(d)(iii)). Solution 2 Yes. The Norwegian company regards the supply contract as a host contract in Norwegian kroner with an embedded foreign currency forward to sell Norwegian kroner and purchase Swiss francs. The French company regards the supply contract as a host contract with an embedded foreign currency forward to sell Swiss francs and purchase Euro (see IAS 39.IGC7 and IAS 39.AG33(d)(i) and (ii)). Solution 3 No. From the manufacturer s perspective, the price limits specified in the purchase contract can be viewed as a purchased call on the commodity with a strike price of 120 per unit (a cap) and a written put on the commodity with a strike price of 100 per unit (a floor). At inception, both the cap and floor on the purchase price are out of the money. Therefore, they are considered closely related to the host purchase contract and are not separately recognised as embedded derivatives (see IAS 39.AG33(b)). Solution 4 Yes. According to the Standard, a commodity-indexed interest would not be considered closely related to a host debt instrument. Therefore, Company A separates the embedded derivative, a forward indexed to the price of gold, from the host debt instrument and measures the derivative at fair value (see IAS 39.AG30(e)). Solution 5 Yes. The economic characteristics and risks of an equity return are not closely related to the economic characteristics and risks of a host debt instrument. The equity kicker meets the definition of a derivative because it has a value that changes in response to the change in the price of the shares of the borrower, it requires no or little initial net investment, and it is settled at a future date. The equity kicker feature meets the definition of a derivative even though the right to receive shares is contingent upon the future listing of the borrower. KPMG and the KPMG logo are registered trademarks of KPMG International, a Swiss cooperative. 1

67 ABCD IAS 32/39 Financial Instruments Case study 2 - Derecognition The derecognition flowchart is to be used for answering the posted questions. Question 1 Company A is a manufacturing entity that has several arrangements whereby it sells trade receivables to financial institutions for cash with no conditions attached. The Company favors these arrangements as it receives cash more quickly than waiting for customers to pay their outstanding in the normal 30 or 60 day terms. The customers are notified of the sale and pay directly to the bank. There is no recourse for the bank and Company A only guarantees the existence of the trade receivables, but not creditworthiness of the customers etc. Does the described transaction qualify for derecognition? Question 2 Company B sells 100 of short-term receivables to a Bank for cash by guaranteeing to buy back first 20% of defaulted receivables, while the historic default rates on such receivables are up to 5%. The customers are notified of the sale and pay directly to the bank. Does the described transaction qualify for derecognition? Question 3 Company C sells 100 of short-term receivables to a Bank for 98 and at the same time C guarantees to buy back first 5% of defaulted receivables. The credit losses on the portfolio of receivables range between 3% to 7% with a confidence interval of 99% and an expected loss of 5%. The fair value of the guarantee at the date of transaction is 4. The customers are notified of the sale and pay directly to the bank. According to the terms of the sale, the Bank cannot sell or pledge the purchased receivables. Does the described transaction qualify for derecognition? KPMG and the KPMG logo are registered trademarks of KPMG International, a Swiss cooperative. 1

68 IAS 39 FINANCIAL INSTRUMENTS: RECOGNITION AND MEASUREMENT Derecognition of a Financial Asset (paragraphs 15-37) AG36. The following flow chart illustrates the evaluation of whether and to what extent a financial asset is derecognised. Consolidate all subsidiaries (including any SPE) [Paragraph 15] Determine whether the derecognition principles below are applied to a part or all of an asset (or group of similar assets) [Paragraph 16] Have the rights to the cash flows from the asset expired? [Paragraph 17(a)] Yes Derecognise the asset No Yes Has the entity transferred its rights to receive the cash flows from the asset? [Paragraph 18(a)] No Has the entity assumed an obligation to pay the cash flows from the asset that meets the conditions in paragraph 19? [Paragraph 18(b)] Yes Has the entity transferred substantially all risks and rewards? [Paragraph 20(a)] No No Yes Continue to recognise the asset Derecognise the asset Has the entity retained substantially all risks and rewards? [Paragraph 20(b)] Yes Continue to recognise the asset No Has the entity retained control of the asset? [Paragraph 20(c)] Yes Continue to recognise the asset to the extent of the entity s continuing involvement No Derecognise the asset Copyright IASCF

69 ABCD IAS 32/39 Financial Instruments Solution to case study 2 Derecognition Solution to Question 1 Using the derecognition flowchart: Step 1 - Should Company A consolidate any subsidiary or SPE? Not applicable, as there are no subsidiaries or SPE s to be considered for consolidation in this question. Step 2 - Should the derecognition principles be applied to a part or all of the individual trade receivables (or to the group of trade receivables)? Based on the facts, it seems that the derecognition rules should be applied to the individual trade receivables, because there is nothing in the fact pattern that indicates that the risks and rewards of the individual receivables are linked (e.g. by credit enhancement or by the pricing mechanism) or that only a component or portion of the financial asset is being sold. Note that in more complex scenarios (e.g. those involving financial guarantees provided to SPE's) it may be necessary to apply the derecognition rules to a portfolio of receivables in their entirety or to a part of a financial asset or portfolio. From a practical point of view, it would not make much of a difference in this case whether the derecognition rules are applied to the individual receivables or to the portfolio of receivables in their entirety. However, it is necessary to make such an evaluation as it may influence derecognition in more complex structures. Step 3 - Have the rights to the cash flows from the assets (i.e. trade receivables) expired? No, the rights to cash flows from the assets have not expired. Step 4 - Has the Company transferred its rights to receive cash flows from the asset? Yes, since the bank now has the right to receive the cash flows directly from the customers. Since the rights to receive the cash flows have been transferred, there is no need to consider the pass-through conditions in IAS Step 6 - Has Company A transferred substantially all risk and rewards? The Company has effectively passed to a third party substantially all of the risks of ownership of the transferred assets (e.g. credit risk, FX risk, early payment risk, etc.) together with the related future benefits. Therefore, Company A would derecognise the transferred receivables. KPMG and the KPMG logo are registered trademarks of KPMG International, a Swiss cooperative. 1

70 ABCD IAS 32/39 Financial Instruments Solution to Question 2 Using the derecognition flowchart: Step 1 - Should Company B consolidate any subsidiary or SPE? Not applicable, as there are no subsidiaries or SPE s to be considered for consolidation in this question. Step 2 - Should the derecognition principles be applied to a part or all of the short-term receivables (or to the group of trade receivables)? In this case, the derecognition rules should be applied to the entire portfolio of receivables (rather than the individual receivables) because of the financial guarantee provided by B that covers all of the transferred receivables and thus provides a linkage of the risks and rewards of the individual receivables and influences the pricing of the portfolio of receivables. Step 3 - Have the rights to the cash flows from the assets (i.e. trade receivables) expired? No, the rights to cash flows from the assets have not expired. Step 4 - Has Company B transferred its rights to receive cash flows from the asset? Yes, since the bank now has the right to receive the cash flows directly from the customers. Since the rights to receive the cash flows have been transferred, there is no need to consider the pass-through conditions in IAS Step 6 - Has the Company transferred substantially all risk and rewards? Assuming that the main risk associated with short-term receivables is credit risk (risk of default by customers) Company B has retained substantially all of the exposure to this risk by committing to reimburse the Bank up to 20% of defaults, while historically only 5% of customers did not pay. Therefore, even though a financial asset has been transferred, receivables cannot be derecognised from Company B s financial statements because it has retained substantially all risks and rewards of ownership. KPMG and the KPMG logo are registered trademarks of KPMG International, a Swiss cooperative. 2

71 ABCD Handout 2 IAS 32/39 Financial Instruments Basic Baseline Solution to Question 3 Using the derecognition flowchart: Step 1 - Should Company C consolidate any subsidiary or SPE? Not applicable, as there are no subsidiaries or SPE s to be considered for consolidation in this question. Step 2 - Should the derecognition principles be applied to a part or all of the short-term receivables (or to the group of trade receivables)? In this case, the same considerations apply as in the solution to Question 2. Accordingly, the derecognition rules should be applied to the entire portfolio of receivables (rather than the individual receivables) because of the financial guarantee provided by B that covers all of the transferred receivables and thus provides a linkage of the risks and rewards of the individual receivables and influences the pricing of the portfolio of receivables. Step 3 - Have the rights to the cash flows from the assets (i.e. trade receivables) expired? No, the rights to cash flows from the assets have not expired. Step 4 - Has the Company transferred its rights to receive cash flows from the asset? Yes, since the bank now has the right to receive the cash flows directly from the customers. Since the rights to receive the cash flows have been transferred, there is no need to consider the pass-through conditions in IAS Step 6 - Has the Company transferred substantially all risk and rewards? No. The fact pattern indicates that credit risk is the major risk attached to the short-term receivables. Therefore, the following analysis focuses on credit risk only. The risk inherent in the transferred receivables is that actual credit losses will exceed expected credit losses of 5%. As the credit losses (with a 99% confidence) will range between 3% and 7%, company C has transferred substantively all risks, as the bank will bear credit losses above 5%. The reward inherent in the receivables is that actual credit losses is less than expected credit losses of 5%. If actual credit losses are less than expected (say 4%), this means that C only has to pays 4% under the guarantee. The Bank on the other hand does not benefit from less than expected credit losses as the Bank will always receive 100 as long as credit losses are below 5%. Accordingly, Company C benefits from less than expected credit losses and thus has retained substantively all rewards inherent in the receivables. Consequently, C has transferred substantially all risks, but retained substantially all rewards. Step 7 - Has Company C retained substantially all risks and rewards? No, because C has transferred substantially all risks (see analysis in Step 6). Step 8 - Has the Company retained control over the assets? KPMG and the KPMG logo are registered trademarks of KPMG International, a Swiss cooperative. 3

72 ABCD Handout 2 IAS 32/39 Financial Instruments Basic Baseline Yes, given the facts of this sale, the Bank will be unable to sell or pledge the receivables. Step 9 - Is there any continuing involvement in the assets by Company C following the sale? Yes, as the Company has neither transferred nor retained substantially all of the risks and rewards and retained control over the receivables. Consequently, the receivables cannot be derecognised from Company C s financial statements to the extent of its continuing involvement in the transferred receivables. KPMG and the KPMG logo are registered trademarks of KPMG International, a Swiss cooperative. 4

73 ABCD IAS 32/39 Financial Instruments Case study 3 - Hedge accounting Questions For each of the scenarios listed below, state what type of hedging relationship is appropriate i.e., cash flow, fair value or net investment hedging. Fact pattern Type of hedging relationship 1 A Dutch company (the Company) buys an equity investment in an American entity (hereinafter referred to as the Entity ), which it classifies as available-for-sale investments. The management does not want to be exposed to a potential future loss if the USD weakens against the Euro. It is the Company s intention to hold the investment for two years, thus it enters into a forward contract to sell USD and buy Euros in two years, at a notional amount equal to USD investment in the Entity. 2 A British company (the Company) requires financing of GBP 100 million for five years. It issues non-callable five-year GBP 100 million of bonds, with the interest rate on the fixed at 6%. The Company s overall risk management strategy is to have variable rate funding, therefore the Company enters into a five-year interest rate swap (IRS) with a notional amount of GBP 100 million. The IRS pays a floating interest rate based on LIBOR and receives a 6% fixed interest rate. 3 A French entity (the Entity) owns equity shares of another French company listed on Paris stock exchange. The securities are classified as available-for-sale investments with changes in fair value recorded in equity. Due to volatility in the price risk of the securities and to comply with internal risk management policies, the Entity decided to purchase a European put option on the securities with a strike price equal to the current market price of EUR 130 million. KPMG and the KPMG logo are registered trademarks of KPMG International, a Swiss cooperative. 1

74 ABCD IAS 32/39 Financial Instruments Fact pattern Type of hedging relationship 4 The management of a German company (the Company) enters into an agreement with an American supplier on 30 September 2005 to purchase an item of equipment for USD 1 million. The equipment is to be delivered on 31 March 2006 and the price is payable on 30 June In order to hedge the foreign exchange risk, the Company enters into a forward exchange contract on 30 September 2005 to purchase USD 1 million on 30 June 2006 at a fixed exchange rate. 5 A British entity (the Entity) requires financing for its operations of GBP 100 million for five years. The Entity issues a non-callable five-year GBP 100 million floating rate notes. As required by the Entity s risk management policy, following the issue of the bonds it immediately enters into a five-year interest rate swap (IRS) with a notional amount of GBP 100 million. The IRS pays 6% fixed and receives floating based on LIBOR. 6 On 1 January 2004, a British company (the Company) obtains a three-year loan of GBP 10 million. The interest rate on the loan is variable at a rate of LIBOR plus 2%. The Company is concerned that interest rates may rise during the three years the loan is outstanding, but at the same time it wants to retain the ability to benefit from LIBOR rates below 8%. In order to protect itself from this exposure, the Company purchases for GBP three hundred thousand an out-of-the-money interest rate cap from a bank. When LIBOR exceeds 8% for a particular year, the Company will receive from the bank under the cap an amount equal to GBP 10 million x (LIBOR 8%). The combination of the cap and the loan results in the Company paying interest at a variable rate (LIBOR + 2%) not exceeding 10%. On both the variable-rate loan and the interest rate cap, rates are reset on 1 January and interest amounts are settled on 31 December. 7 An American manufacturing company (the Company) purchases certain sub-components from Japan. On 31 January 2005 the Company signs a contract to purchase 1 million units of sub-components from a Japanese supplier for delivery on 29 February The price is JPY 750 million, which falls due on 31 March In accordance with the Company s risk management policies, it hedges the foreign currency risk by entering into a forward contract to purchase JPY 750 million for USD on 31 March KPMG and the KPMG logo are registered trademarks of KPMG International, a Swiss cooperative. 2

75 ABCD IAS 32/39 Financial Instruments Fact pattern Type of hedging relationship 8 A Russian entity (the Entity), which produces silver candlesticks, has 1 million ounces of silver in inventory. The Entity s risk management policies require mitigation of a decline in silver prices, thus it enters into a contract by selling silver futures for 1 million ounces of silver. The futures contracts mature at the date on which the management expects to sell the candlesticks. 9 A Danish entity (the Entity) with DKK as its measurement currency issues a floating rate GBP denominated bond. The Entity 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, the Entity enters into a Cross Currency Interest Rate Swap to pay USD fixed and receive GBP floating. 10 A European parent (the Parent) is based in Germany and has the Euro as its functional currency. The Parent has an American subsidiary (the Subsidiary) with USD functional currency. The value of Subsidiary s net assets is USD 50 million and the Subsidiary also has an intercompany borrowing of USD 5 million from the Parent, which has no contractual maturity, and is not planned to settle in the foreseeable future. The parent enters into a forward contract to sell USD 60 million in 5 years at a fixed USD/EUR rate. 11 An European parent (the Parent) is based in England and has the Pound as its functional currency. The Parent has a net investment in a Swiss subsidiary (the Subsidiary). The Parent translates the Subsidiary s financial statements into GBP using the closing rate method and reports all exchange differences arising on translation directly in equity. The Parent enters into a CHF loan, the amount of which is based on the equity accounted carrying amount of its net investment in the Subsidiary at that date. 12 A British manufacturing company (the Sub) with Sterling as its functional currency regularly purchases from its US parent (the Parent) component parts that it pays for in US $s. The Sub concludes that its planned future purchases from the Parent are highly probable. The Sub also makes regular royalty payments to the Parent which are also denominated in US $s and are also deemed to be highly probable. To hedge its foreign currency risk the Sub enters into separate foreign exchange forward contracts to buy US $s. KPMG and the KPMG logo are registered trademarks of KPMG International, a Swiss cooperative. 3

76 ABCD IAS 32/39 Financial Instruments Solution to case study 3 - Hedge accounting Solution Fact pattern 1 A Dutch company (the Company) buys an equity investment in an American entity (hereinafter referred to as the Entity ), which it classifies as available-forsale investments. The management does not want to be exposed to a potential future loss if the USD weakens against the Euro. It is the Company s intention to hold the investment for two years, thus it enters into a forward contract to sell USD and buy Euros in two years, at a notional amount equal to USD investment in the Entity. 2 A British company (the Company) requires financing of GBP 100 million for five years. It issues non-callable five-year GBP 100 million of bonds, with the interest rate on the fixed at 6%. The Company s overall risk management strategy is to have variable rate funding, therefore the Company enters into a five-year interest rate swap (IRS) with a notional amount of GBP 100 million. The IRS pays a floating interest rate based on LIBOR and receives a 6% fixed interest rate. 3 A French entity (the Entity) owns equity shares of another French company listed on Paris stock exchange. The securities are classified as available-for-sale investments with changes in fair value recorded in equity. Due to volatility in the price risk of the securities and to comply with internal risk management policies, the Entity decided to purchase a European put option on the securities with a strike price equal to the current market price of EUR 130 million. Type of hedging relationship The management documents the hedging relationship as a fair value hedge of the FX risk and tests the effectiveness of the hedge by comparing the changes in the fair value of the forward due to changes in the FX spot exchange rate and the changes in the fair value of the equity investment due to changes in the FX spot exchange rate. (please also refer to Implementation Guidance IAS 39 F 2.19) The management designates the IRS as a fair value hedge of interest rate risk for the issued bonds and tests the effectiveness of the hedge based on the offsetting effect of the fair value changes of the IRS to the fair value changes of the bond. The management designates the purchased put option as a fair value hedge of equity investments and tests the effectiveness of the hedge based on the offsetting decreases in the fair value of the equity securities below EUR 130 million (the time value component is not included in determining the effectiveness of the hedge). KPMG and the KPMG logo are registered trademarks of KPMG International, a Swiss cooperative. 1

77 ABCD IAS 32/39 Financial Instruments Fact pattern 4 The management of a German company (the Company) enters into an agreement with an American supplier on 30 September 2005 to purchase an item of equipment for USD 1 million. The equipment is to be delivered on 31 March 2006 and the price is payable on 30 June In order to hedge the foreign exchange risk, the Company enters into a forward exchange contract on 30 September 2005 to purchase USD 1 million on 30 June 2006 at a fixed exchange rate. 5 A British entity (the Entity) requires financing for its operations of GBP 100 million for five years. The Entity issues a non-callable five-year GBP 100 million floating rate notes. As required by the Entity s risk management policy, following the issue of the bonds it immediately enters into a five-year interest rate swap (IRS) with a notional amount of GBP 100 million. The IRS pays 6% fixed and receives floating based on LIBOR. 6 On 1 January 2005, a British company (the Company) obtains a three-year loan of GBP 10 million. The interest rate on the loan is variable at a rate of LIBOR plus 2%. The Company is concerned that interest rates may rise during the three years the loan is outstanding, but at the same time it wants to retain the ability to benefit from LIBOR rates below 8%. In order to protect itself from this exposure, the Company purchases for GBP three hundred thousand an out-ofthe-money interest rate cap from a bank. When LIBOR exceeds 8% for a particular year, the Company will receive from the bank under the cap an amount equal to GBP 10 million x (LIBOR 8%). The combination of the cap and the loan results in the Company paying interest at a variable rate (LIBOR + 2%) not exceeding 10%. On both the variable-rate loan and the interest rate cap, rates are reset on 1 January and interest amounts are settled on 31 December. Type of hedging relationship The management designates the forward contract as a cash flow hedge of the foreign currency exposure of an unrecognised firm commitment. OR The management designates the forward contract as a fair value hedge of the foreign currency exposure of an unrecognised firm commitment. The management designates the IRS as a cash flow hedge of the interest rate risk attributable to the future interest payments on the loan related to changes in LIBOR and tests for the effectiveness based on the offsetting effect of the cash flows of the IRS and the interest expense cash flows of the bond. The management designates the purchased interest rate cap as a cash flow hedge of the interest rate risk attributable to the future interest payments on the loan related to changes in LIBOR at rates above 8% (the changes in the time value of the option are not included in the assessment of the hedge effectiveness). KPMG and the KPMG logo are registered trademarks of KPMG International, a Swiss cooperative. 2

78 ABCD IAS 32/39 Financial Instruments Fact pattern 7 An American manufacturing company (the Company) purchases certain sub-components from Japan. On 31 January 2005 the Company signs a contract to purchase 1 million units of sub-components from a Japanese supplier for delivery on 29 February The price is JPY 750 million, which falls due on 31 March In accordance with the Company s risk management policies, it hedges the foreign currency risk by entering into a forward contract to purchase JPY 750 million for USD on 31 March A Russian entity (the Entity), which produces silver candlesticks, has 1 million ounces of silver in inventory. The Entity s risk management policies require mitigation of a decline in silver prices, thus it enters into a contract by selling silver futures for 1 million ounces of silver. The futures contracts mature at the date on which the management expects to sell the candlesticks. Type of hedging relationship The management designates this forward as a cash flow hedge and tests for effectiveness based on changes in forward rates. OR The management designates the forward contract as a fair value hedge of the foreign currency exposure of an unrecognised firm commitment. As substantially all of the value of the candlesticks is determined by the value of the silver, the management designates the futures contracts as a fair value hedge of the total value of silver inventory. OR The management designates the futures contracts as a cash flow hedge of the highly probable forecast sales of inventory. Although the management does not have a contract to sell candlesticks in March, it believes that it is highly probable that the sale will occur, based on the sales histories with its regional customers. KPMG and the KPMG logo are registered trademarks of KPMG International, a Swiss cooperative. 3

79 ABCD IAS 32/39 Financial Instruments Fact pattern 9 A Danish entity (the Entity) with DKK as its measurement currency issues a floating rate GBP denominated bond. The Entity 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, the Entity enters into a Cross Currency Interest Rate Swap to pay USD fixed and receive GBP floating. Type of hedging relationship The management may designate the swap 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. OR a hedging instrument in 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, although the hedge does not convert the currency exposure to the Entity s measurement currency DKK. The described hedging strategy is appropriate only as long as the Entity has both foreign currency exposures and is not creating a new foreign currency position but rather decreasing its risk exposure. 10 A European parent (the Parent) is based in Germany and has the Euro as its functional currency. The Parent has an American subsidiary (the Subsidiary) with USD functional currency. The value of Subsidiary s net assets is USD 50 million and the Subsidiary also has an intercompany borrowing of USD 5 million from the Parent, which has no contractual maturity, and is not planned to settle in the foreseeable future. The parent enters into a forward contract to sell USD 60 million in 5 years at a fixed USD/EUR rate. The Parent may hedge its net investment in the Subsidiary only to the extent of the value of its net investment, i.e. USD 55 million, at the date of hedge designation, designating a (pro)portion of the forward as hedging instrument. The USD 50 million equity investment may be designated as a hedged item because this is consistent with IAS 21 definition of a net investment in a foreign operation. The USD 5 million intercompany loan due from the Subsidiary may be designated as a hedged item in the hedge of a net investment, because this amount is not expected to be settled in the foreseeable future. The forecast profits of the Subsidiary cannot be designated as hedged items in the hedge of a net investment in entity as a forecast transaction. The intercompany dividend payments from the Subsidiary to the Parent do not qualify as a hedged item as these will not affect the income statement. KPMG and the KPMG logo are registered trademarks of KPMG International, a Swiss cooperative. 4

80 ABCD IAS 32/39 Financial Instruments Fact pattern 11 An European parent (the Parent) is based in England and has the Pound as its functional currency. The Parent has a net investment in a Swiss subsidiary (the Subsidiary). The Parent translates the Subsidiary s financial statements into GBP using the closing rate method and reports all exchange differences arising on translation directly in equity. The Parent enters into a CHF loan, the amount of which is based on the equity accounted carrying amount of its net investment in the Subsidiary at that date. 12 A British manufacturing company (the Sub) with Sterling as its functional currency regularly purchases from its US parent (the Parent) component parts that it pays for in US $s. The Sub concludes that its planned future purchases from the Parent are highly probable. The Sub also makes regular royalty payments to the Parent which are also denominated in US $s and are also deemed to be highly probable. To hedge its foreign currency risk the Sub enters into separate foreign exchange forward contracts to buy US $s. Type of hedging relationship The management of the Parent designates the loan as a hedge of its net investment in the Subsidiary and expects that the loan will be fully effective (due to the matching amounts and currencies of denomination) in offsetting exchange rate translation differences arising on its investment in the Subsidiary. The highly probable purchase of components from the parent qualifies for hedge accounting in consolidated financial statements because the forecast transaction will affect consolidated profit or loss on sale of the final product including the purchased components by the Sub to external parties. The management of the Sub documents the relationship as a cash flow hedge of a highly probable forecast transaction with the variability in cash flows arising from changes in forward exchange rates being designated as the hedged risk. The management tests for effectiveness based on changes in forward rates. All change in fair value of the forward contract due to changes in spot rates is taken to profit or loss account. The Sub cannot designate the highly probable royalty payment as the hedged item in consolidated financial statements as the foreign exchange risk does not affect consolidated profit or loss. KPMG and the KPMG logo are registered trademarks of KPMG International, a Swiss cooperative. 5

81 kpmg IAS 39 Hedge accounting cash flow hedge Case study 4 Hedge accounting cash flow hedge On 1 January Company C enters into a variable rate loan of 100 million. To hedge the cash flow exposure associated with its future interest payments, C enters into a receive variable, pay fixed swap at 7% with a notional amount of 100 million. C Pay interest at variable rate Bank C Pay fixed at 7% Receive variable Bank Assumptions: Variable rate loan 100 million Variable rate to 30 June 6.6% Swap notional amount 100 million Fair value of swap: 1 January 0 30 June (4.5 million) Swap rates: Fixed rate 7% 30 June market rate 6% What journal entries are required 1 January and 30 June? KPMG and the KPMG logo are registered trademarks of KPMG International, a Swiss cooperative. 1.

82 kpmg IAS 39 Cash flow hedge Case study 4 solution Hedge Accounting: cash flow hedge 1 January Dr Cash 100 Cr Liability 100 To record the loan The SWAP has a zero fair value at inception therefore no entry is necessary to record it. 30 June Dr Interest expense 3.3 Cr Accrued interest 3.3 To record interest payable on 6.6% Dr Interest expense 0.2 Cr Interest payable 0.2 To record net amount payable under swap (7.0%-6.6%) Dr Equity 4.5 Cr SWAP liability 4.5 To record swap at fair value The first journal entry records the interest expense for 6 months on the liability at the variable rate of 6.6%. The second journal entry is to record the amount payable under the swap. The net interest expense recognised is 7% on 100 million for 6 months = 3.5: Variable interest on the loan 3.3 Net swap amount payable 0.2 Total 3.5 The third entry records the change in the swap fair value. Market rates have decreased, therefore the swap results in a liability. The loss on remeasurement of the swap to fair value is all recognised in equity because the swap is a cash flow hedge and the hedge is fully effective. The amount will be recycled from equity in future periods as the interest accrues on the liability. KPMG and the KPMG logo are registered trademarks of KPMG International, a Swiss cooperative.

83 kpmg IAS 39 Hedge accounting Fair Value hedge Case study 5 Hedge accounting Fair Value hedge On 1 January Bank A invests in a fixed rate bond of 100 million at 90%, which the bank classifies as Available for Sale. To hedge the fair value exposure, A enters into a receive variable, pay fixed swap at 7% with a notional amount of 100 million. Assume no accrued interests. Additional information: Carrying amount Bond: 1 January 90 million 30 June 91 million Fair value of swap: 1 January 0 30 June 5 million Fair Value Bond: 30 June 86 million Due to risk free interest rate changes -4,7 million What journal entries are required 1 January and 30 June? KPMG and the KPMG logo are registered trademarks of KPMG International, a Swiss cooperative.

84 kpmg IAS 39 Fair Value hedge Case study 5 solution Hedge Accounting: Fair Value hedge 1 January Dr Bond AFS 90 Cr Cash 90 To record the bond The SWAP has a zero fair value at inception therefore no entry is necessary to record it. 30 June Dr Bond 1 Cr Interest income 1 To record amortisation of discount Dr Equity 5 Cr Bond 5 To record the bond at fair value Dr Income statement 4.7 Cr Equity 4.7 To record the effective portion Dr Derivative financial asset 5 Cr Income statement 5 To record the swap at fair value KPMG and the KPMG logo are registered trademarks of KPMG International, a Swiss cooperative..

85 October 2008 IAS 39 & IFRS 7 Amendments Reclassification of Financial Assets Amendments to IAS 39 Financial Instruments: Recognition and Measurement and IFRS 7 Financial Instruments: Disclosures