IFRS student manual 2010

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1 IFRS student manual 2010 Global Accounting Consulting Services PricewaterhouseCoopers LLP Published by 145 London Road Kingston-upon-Thames Surrey KT2 6SR Tel: +44 (0) Fax: +44 (0) Website:

2 This book has been prepared for general guidance on matters of interest only, and does not constitute professional advice. You should not act upon the information contained in this book without obtaining specific professional advice. Accordingly, to the extent permitted by law, PricewaterhouseCoopers LLP (and its members, employees and agents) and publisher accept no liability, and disclaim all responsibility, for the consequences of you or anyone else acting, or refraining from acting, in reliance on the information contained in this document or for any decision based on it, or for any consequential, special or similar damages even if advised of the possibility of such damages. ISBN Printed and bound in the UK by Hobbs the Printers Ltd. Typeset by YHT Limited, London. British Library Cataloguing-in-Publication Data. A catalogue record for this book is available from the British Library. # 2010 PricewaterhouseCoopers LLP No part of this publication may be reproduced, stored in any system, or transmitted in any form or by any means, electronic, mechanical, photocopying, recording, or otherwise without the prior permission of PricewaterhouseCoopers LLP. P002 # 2010 PricewaterhouseCoopers LLP. All rights reserved.

3 Foreword International Financial Reporting Standards (IFRS) issued by the International Accounting Standards Board are now recognised as a sound global set of accounting standards. A growing number of counties around the world use IFRS as either their adopted national generally accepted accounting principles (GAAP) or require listed companies in the country to comply with IFRS. This trend is still growing with notable countries such as Canada and India adopting IFRS over the next few years. With the ever increasing number of companies that report using IFRS, there is a need for new accountants to understand and to be trained in IFRS. Many universities run accounting degrees that teach international accounting standards and professional accounting qualifications in many countries are now based on IFRS. In PricewaterhouseCoopers, we have been working with companies and groups that report using IFRS since the inception of international standards and have gained considerable practical experience in their application. We are delighted that this student book benefits from that experience and makes excellent use of the material from our more comprehensive professional guidance included in Manual of Accounting IFRS We are grateful to Professor Chris Nobes for compiling this book from the firm s Manual of Accounting Barry Johnson, Peter Holgate PricewaterhouseCoopers LLP London February 2010 # 2010 PricewaterhouseCoopers LLP. All rights reserved. P003

4 Preface The IFRS student manual 2010 is intended for researchers, teachers, students and those studying for professional exams. It is designed as a practical guide to the requirements of International Financial Reporting Standards (IFRS). The book is based on the popular and well established global guide to IFRS, Manual of accounting IFRS 2010, written by PricewaterhouseCoopers Accounting Consulting Services team. This student guide compiles information from the Manual that is most relevant to the intended readers, providing the benefits of the extensive experience and professional judgement of this leading accountancy firm. The IFRS student manual 2010 follows a basic approach of: introducing a topic; outlining all the main IFRS requirements; giving explanations of them; providing numerical and other examples; and including illustrations from real IFRS company reports. This book explains the IFRS standards and interpretations in issue as at January In general, then, it is up-to-date for financial statements relating to 2010 or I am grateful for technical help and advice from Peter Holgate and Barry Johnson, and for production help from Gemma Barratt (all of PricewaterhouseCoopers, London). Christopher Nobes Professor of Accounting Royal Holloway, University of London February 2010 P004 # 2010 PricewaterhouseCoopers LLP. All rights reserved.

5 Contents Part I Introduction, concepts and basic standards 1. Introduction and applicability of IFRS The IASB s Framework Presentation of financial statements Cash flow statements Accounting policies, accounting estimates and errors Events after the reporting period Part II Assets 7. Inventories Property, plant and equipment Intangible assets Lease accounting Impairment of assets Part III Financial instruments 12. Definition and classification of financial instruments Recognition and measurement of financial instruments Presentation and disclosure of financial instruments Part IV Liabilities, equity and revenue 15. Revenue and construction contracts Provisions and contingencies Employee benefits Share-based payment Taxation Part V Consolidated statements 20. Consolidated and separate financial statements Business combinations Associates and joint ventures Foreign currencies Part VI Disclosures and first-time adoption 24. Related party disclosures Segment reporting Earnings per share First-time adoption of IFRS Abbreviations and terms used... Index... A001 I001 # 2010 PricewaterhouseCoopers LLP. All rights reserved. P005

6 Chapter 12 Definition and classification of financial instruments 12.1 Introduction Financial instruments embrace a broad range of assets and liabilities. They include both primary financial instruments financial assets such as cash, receivables and equity securities of another entity and financial liabilities such as debt and derivative financial instruments such as financial options, forwards, swaps and futures. This chapter examines the definitions and classifications of these various types of instruments, and gives examples of how to tell which ones are which. Chapter 13 then looks at the recognition and measurement of financial instruments. Chapter 14 examines presentation in financial statements and disclosures. In this chapter, we start with general definitions (section 12.2); then focus on derivatives (sections 12.3 and 12.4). Next, we look at the classification of financial assets (sections 12.5 and 12.6). Section 12.7 examines the distinction between liabilities and equity, and section 12.8 looks at the classification of liabilities. In 2009, the IASB issued IFRS 9 which is designed to replace the classification and measurement requirements of IAS 39. However, the effective date for compulsory application is not until In the EU, there is no sign yet of IFRS 9 being endorsed. So, this chapter does not cover IFRS Definitions relating to financial instruments The definitions relating to financial instruments that appear in paragraph 11 of IAS 32 are common to the three financial instrument standards, that is, IAS 32, IAS 39 and IFRS 7. A financial instrument is any contract that gives rise to a financial asset of one entity and a financial liability or equity instrument of another entity. The definitions of a financial asset and financial liability stated below include some derivative and nonderivative contracts that will or may be settled in the entity s own equity instruments. This is because a contract is not necessarily an equity instrument just because it may result in the receipt or delivery of the entity s own equity instruments. [IAS 32 para 21]. A financial asset is any asset that is: Cash. An equity instrument of another entity. A contractual right: to receive cash or another financial asset from another entity; or to exchange financial assets or financial liabilities with another entity under conditions that are potentially favourable to the entity. A contract that will or may be settled in the entity s own equity instruments and is: a non-derivative for which the entity is or may be obliged to receive a variable number of the entity s own equity instruments; or a derivative that will or may be settled other than by the exchange of a fixed amount of cash or another financial asset for a fixed number of the entity s own equity instruments. For this purpose the entity s own equity instruments do not include puttable instruments and obligations arising on liquidation that are classified as equity or instruments that are contracts for the future receipt or delivery of the entity s own equity instruments. A financial liability is any liability that is: # 2010 PricewaterhouseCoopers LLP. All rights reserved

7 A contractual obligation: to deliver cash or another financial asset from another entity; or to exchange financial assets or financial liabilities with another entity under conditions that are potentially unfavourable to the entity. A contract that will or may be settled in the entity s own equity instruments and is: a non-derivative for which the entity is or may be obliged to deliver a variable number of the entity s own equity instruments; or a derivative that will or may be settled other than by the exchange of a fixed amount of cash or another financial asset for a fixed number of the entity s own equity instruments. For this purpose the entity s own equity instruments do not include puttable instruments and obligations arising on liquidation that are classified as equity or instruments that are themselves contracts for the future receipt or delivery of the entity s own equity instruments. An equity instrument is any contract that evidences a residual interest in an entity s assets after deducting all of its liabilities. [IAS 32 para 11]. The term entity includes individuals, partnerships, incorporated bodies and government agencies. [IAS 32 para 14]. Examples of equity instruments include non-puttable ordinary shares, some types of preference shares and share warrants or written call options that allow the holder to subscribe for or purchase a fixed number of non-puttable ordinary shares in the issuing entity in exchange for a fixed amount of cash or another financial asset. Some of the important concepts associated with the various terms that are included in the above definitions are considered below. An understanding of these concepts is particularly important and relevant in evaluating instruments that might qualify as financial instruments including derivatives. Contractual basis All financial instruments are defined by contracts. The rights or obligations that comprise financial assets or financial liabilities are derived from the contractual provisions that underlie them. The terms contract and contractual refer to an agreement between two or more parties that has clear economic consequences that the parties have little, if any, discretion to avoid, usually because the agreement is enforceable by law. Contracts defining financial instruments may take a variety of forms and need not be in writing. [IAS 32 para 13]. An example of an item that would not meet the definition of a financial instrument is an entity s tax liability, as it is not based on a contract between the entity and the tax authority, but arising through statute. Similarly, constructive obligations, as defined in IAS 37, Provisions, contingent liabilities and contingent assets, do not arise from contracts and are not financial liabilities. [IAS 32 para AG 12]. On the other hand, a provision for an onerous contract (for example, provision for vacant leasehold property that is being sublet) is a financial liability as it arises from the unavoidable cost of meeting the obligations under the contract. Nevertheless, such provisions are scoped out of IAS 39 and are accounted for in accordance with IAS 37. [IAS 37 para 66]. A contractual right or contractual obligation to receive, deliver or exchange financial instruments is itself a financial instrument. This is evident from the definitions of financial assets and liabilities that include the terms financial assets and financial instruments within them. However, the terms are not circular. They envisage the possibility that a chain of contractual rights or contractual obligations may be established, but this chain must end ultimately with the receipt or payment of cash or to the acquisition or issue of an equity instrument. [IAS 32 para AG 7]. As the IAS 32 definitions require all financial instruments to be contracts, some question whether cash can be considered to be a contract. However, this concern is overcome because the definition of a financial asset stated above specifically states that cash is a financial instrument. IAS 32 application guidance also clarifies that currency (cash) is a financial asset because it represents the medium of exchange and is, therefore, the basis on which all transactions are measured and recognised in financial statements. A deposit of cash with a bank or similar financial institution is a financial asset because it represents the contractual right of the depositor to obtain cash from the institution or to draw a cheque or similar instrument against the balance in favour of a creditor in payment of a financial liability. [IAS 32 para AG 3]. On the other hand gold bullion is not a financial instrument but a commodity. Although the bullion market is highly liquid, there is no contractual right to receive cash or another financial instrument inherent in bullion. [IAS 39 para IG B1] # 2010 PricewaterhouseCoopers LLP. All rights reserved.

8 Some common examples of financial instruments that give rise to financial assets representing a contractual right to receive cash in the future for the holder and corresponding financial liabilities representing a contractual obligation to deliver cash in the future for the issuer are as follows: Trade accounts receivable and payable. Notes receivable and payable. Loans receivable and payable. Bonds receivable and payable. In each case, one party s contractual right to receive (or obligation to pay) cash is matched by the other party s corresponding obligation to pay (or right to receive). [IAS 32 para AG 4]. Another type of financial instrument is one for which the economic benefit to be received or given up is a financial asset other than cash. For example, a note payable in government bonds gives the holder the contractual right to receive and the issuer the contractual obligation to deliver government bonds, not cash. The bonds are financial assets because they represent obligations of the issuing government to pay cash. The note is, therefore, a financial asset of the note holder and a financial liability of the note issuer. [IAS 32 para AG 5]. Conditional (contingent) rights and obligations The ability to exercise a contractual right or the requirement to satisfy a contractual obligation may be absolute, or it may be contingent on the occurrence of a future event. A note receivable or payable is an unconditional promise to pay, but a financial guarantee is a conditional financial instrument as it results in a contractual right of the lender to receive cash from the guarantor and a corresponding contractual obligation of the guarantor to pay the lender, if the borrower defaults. The contractual right and obligation exist because of a past transaction or event (assumption of the guarantee), even though the lender s ability to exercise its right and the requirement for the guarantor to perform under its obligation are both contingent on a future act of default by the borrower. [IAS 32 para AG 8]. Even though a contingent right and obligation can meet the definition of a financial asset and a financial liability, they are not always recognised in the financial statements. Some of these contingent rights and obligations may be insurance contracts within IFRS 4 s scope, whilst others may be excluded from the standard s scope. [IAS 32 para AG 8]. Other contingencies that may require the payment of cash but do not as yet arise from a contract, such as a contingent receivable or payable for a court judgment, are not financial instruments. However, when those judgments become enforceable by a government or a court of law, and are thereby contractually reduced to fixed payment schedules, the judgment would be a financial instrument. To elaborate, if and when the parties agree to payment terms and those payment terms are reduced to a contract, then a financial instrument exists. Contrast this with a fine, which is not contractual. Exchange under potentially favourable or unfavourable terms The definitions of financial assets and financial liabilities make references to exchanges under conditions that are potentially favourable or potentially unfavourable. The meaning of these terms and the way they work in practice are illustrated in case 12.A. Case 12.A Exchange under potentially favourable or unfavourable terms Entity A holds an option to purchase equity shares in a listed entity B for C5 per share at the end of a 90-day period. The above call option gives entity A a contractual right to exchange cash of C5 for an equity share in another entity and will be exercised if the market value of the share exceeds C5 at the end of the 90-day period. This is because as the terms will be favourable to entity A at the end of term, it will exercise the call option. Since entity A stands to gain if the call option is exercised, the exchange is potentially favourable to the entity. Therefore, the option is a derivative financial asset from the time the entity becomes a party to the option contract. # 2010 PricewaterhouseCoopers LLP. All rights reserved

9 On the other hand, if entity A writes an option under which the counterparty can force the entity to sell equity shares in the listed entity B for C5 per share at any time in the next 90-days, entity A has a contractual obligation to exchange equity shares in another entity for cash of C5 per share on potentially unfavourable terms if the holder exercises the option, because the market price per share exceeds the exercise price of C5 per share at the end of the 90-day period. Since entity A stands to lose if the option is exercised, the exchange is potentially unfavourable and the option is a derivative financial liability from the time the entity becomes a party to the option contract. Comparison with non-financial assets and liabilities As discussed above, financial instruments represent contractual rights or obligations to receive or pay cash or other financial assets. Non-financial items have a more indirect, non-contractual relationship to future cash flows. The non-financial assets of a business (such as inventories, property, plant and equipment and intangibles) are inputs to some productive process. They are expected to contribute, along with other inputs, to the production and sale of goods or services. They must be used in a productive activity, and effectively transformed into goods or service, which must be sold, before there is any right to receive cash. Control of such physical and intangible assets creates an opportunity to generate an inflow of cash or another financial asset, but it does not give rise to a present right to receive cash or another financial asset. [IAS 32 para AG 10]. Even where physical assets, such as properties, are held as investments rather than as inventories, they are not financial instruments. A contract to acquire or sell a non-financial asset at a specified price at a future date is not a financial instrument, because the contractual right of one party to receive a non-financial asset and the corresponding obligation of the other party do not establish a present right or obligation of either party to receive, deliver or exchange a financial asset. For example, contracts that provide for settlement only by the receipt or delivery of a non-financial item (for example, an option or forward contract on silver) are not financial instruments. Many commodity contracts are of this type. However, contracts to buy or sell non-financial items that can be settled net or by exchanging financial instruments, or in which the non-financial item is readily convertible to cash, are treated as if they are financial instruments. [IAS 32 para AG 20]. For the same reasons as stated above, a firm commitment that involves the receipt or delivery of a physical asset is not a financial instrument. [IAS 32 para AG 21]. Another example is an operating lease to rent an office building. Under the lease, the lessor has committed to provide office space in future periods for consideration similar to a fee for a service. The contractual right of the lessee to receive the service and the corresponding obligation of the lessor do not establish a present right or obligation of either party to receive, deliver or exchange a financial asset. On the other hand, a finance lease is regarded as primarily an entitlement of the lessor to receive, and an obligation of the lessee to pay, a stream of payments that are substantially the same as a loan agreement. The lessor accounts for its investment in the amount receivable under the lease contract rather than the leased asset itself. [IAS 32 para AG 9]. Accordingly, an operating lease is not regarded as a financial instrument (except as regards individual payments currently due and payable), but a finance lease is regarded as one. Assets (such as pre-paid expenses) for which the future economic benefit is the receipt of goods or services, rather than the right to receive cash or another financial asset, are not financial assets. Similarly, items such as deferred revenue and most warranty obligations are not financial liabilities, because the outflow of economic benefits associated with them is the delivery of goods and services, rather than a contractual obligation to pay cash or another financial asset. [IAS 32 para AG 11]. Identification of financial instruments Table 12.1 provides a list of common balance sheet items and applies the concepts discussed above to determine whether the items meet the definition of a financial instrument. Paragraph references are included where applicable. The list is by no means exhaustive, but provides an aide-me moire to help in identifying primary financial instruments. For the sake of completeness, the last two columns also establish whether the instruments so identified fall within or outside the scope of IAS 32, IFRS 7 or IAS # 2010 PricewaterhouseCoopers LLP. All rights reserved.

10 Table 12.1 Classifying instruments Balance sheet item Financial instrument? Included within the scope of IAS 32 and IFRS 7 Included within the scope of IAS 39 Yes = P Yes = P Yes = P No = O No = O No = O Intangible assets O n/a n/a Property, plant and equipment O n/a n/a Investment property O n/a n/a Interests in subsidiaries, associates and joint ventures accounted for under IAS 27, IAS 28 or IAS 31 respectively P O O Interests in subsidiaries, associates and joint ventures held for sale under IFRS 5 P O O Interests in subsidiaries, associates and joint ventures accounted for under IAS 39 (in accordance with IAS 27 para 37(b)) P P P Inter-company trading balances with subsidiaries, associates and joint ventures P P P Investments in other entities (available-for-sale and held for trading) P P P Inventories O n/a n/a Construction contract work in progress O n/a n/a Construction contract receivables P P P Finance lease receivables (recognised by a lessor) P P O Trade receivables P P P Pre-payments goods and services O n/a n/a Cash and cash equivalents P P P Trade payables P P P Contingent consideration in a business combination (acquirer only) P O (P under IFRS 3) O (P under IFRS 3) Accruals goods and services (settlement in cash) P P P Deferred income O n/a n/a Debt instruments P P P Derivative instruments P P P Net settled commodity-based contracts P P P Retirement benefit obligations P O O Provisions for constructive obligations (as defined in IAS 37) O n/a n/a Vacant leasehold property provision P P O Warranty obligations (settled by delivery of goods or service) O n/a n/a Warranty obligations (settled by delivery of cash or other financial asset) P P P Financial guarantee contracts P P P Operating lease O n/a n/a Finance lease obligations P P O Dividend payable note 1 note 1 note 1 # 2010 PricewaterhouseCoopers LLP. All rights reserved

11 Current and deferred tax O n/a n/a Redeemable preference shares (debt) P P P Entity s own equity shares P P O Employee share options P O O Other options over own equity shares P P O Non-controlling interest P note 2 P note 2 n/a Notes: 1 Dividend payable on the balance sheet is a financial liability when the dividend has been formally declared by the members in a general meeting and becomes a legal obligation of the entity to deliver cash to shareholders for the amount of the declared dividend. [IAS 32 para AG 13]. 2 The non-controlling interest that may arise on consolidating a subsidiary is presented in the consolidated balance sheet within equity, separately from the equity of the owners of the parent. [IAS 27 (revised) para 27; IAS 32 para AG 29]. However, where the parent or any fellow subsidiary undertaking has an obligation to deliver cash or another financial asset in respect of a subsidiary s shares (for example, by virtue of a written put option), they are treated as financial liabilities in consolidated financial statements under IAS 32. [IAS 32 para AG 29] Derivative financial instruments Definition Derivatives are financial instruments that derive their value from an underlying price or index, which could be for example, an interest rate, a foreign exchange rate or commodity price. Their primary purpose is to create rights and obligations that have the effect of transferring between the parties to the instrument one or more of the financial risks inherent in an underlying primary instrument. Consequently, they may be used for trading purposes to generate profits from risk transfers or they may be used as a hedging instrument for managing risks. Generally, there is no transfer of the underlying instrument between the parties either at inception or at maturity, but there are some exceptions. A derivative instrument gives one party a contractual right to exchange financial assets or financial liabilities with another party under conditions that are potentially favourable, or a contractual obligation to exchange financial assets or financial liabilities with another party under conditions that are potentially unfavourable. Because the terms of the exchange are determined at inception, as prices in the financial markets change, those terms may become favourable or unfavourable (see section 12.2). Derivative instruments may either be freestanding or embedded in a financial instrument or in a non-financial contract. IAS 39 defines a derivative as a financial instrument or other contract with all of the following characteristics: its value changes in response to the change in a specified interest rate, financial instrument price, commodity price, foreign exchange rate, index of prices or rates, credit rating or credit index, or other variable, provided in the case of a non-financial variable that the variable is not specific to a party to the contract (sometimes called the underlying ); it requires no initial net investment or an initial net investment that is smaller than would be required for other types of contracts that would be expected to have a similar response to changes in market factors; and it is settled at a future date. [IAS 39 para 9]. Key features of the definition The characteristics referred to above make the definition of a derivative not only complex but fairly wide. For example, many contracts such as loan commitments, certain contracts to buy or sell a non-financial item and regular way trades (see below) meet the definition of a derivative, in addition to the more commonly used and typical derivative instruments such as forwards, swaps, futures and options. Therefore, an understanding of these characteristics is particularly important and relevant in evaluating instruments that might qualify as, or # 2010 PricewaterhouseCoopers LLP. All rights reserved.

12 contain, a derivative instrument. The paragraphs that follow examine some of the important concepts associated with these characteristics. Underlying Definition and classification of financial instruments As evident from the first characteristic stated above, an underlying is a variable, such as: An interest rate (for example, LIBOR). A security price (for example, the price of an XYZ entity equity share listed on a regulated market). A commodity price (for example, the price of a bushel of wheat). A foreign exchange rate (for example, e/$ spot rate). An index (for example, FTSE 100, a retail price index). A credit rating or a credit index (for example, Moody s credit rating). An insurance index or catastrophe-loss index. Other variable (for example, sales volume indices specifically created for settlement of derivatives). Non financial variable (for example, a climatic or geological condition such as temperature, rainfall, or earthquake severity). Generally, an underlying may be any variable whose changes are observable or otherwise objectively verifiable. It may be the price or rate of an asset or liability that changes in response to changes in the market factors, but it is not the asset or the liability itself in most instances. Accordingly, the underlying will generally be the referenced index that determines whether or not the derivative instrument has a positive or a negative value. If the underlying is a non-financial variable as referred to in the last bullet point above, it must not be specific to a party to the contract in order for the derivative definition to be met. In other words, the terms of the contract must be sufficiently generic in nature to qualify as a derivative. For example, such variables might include an index of earthquake losses in a particular region or an index of temperatures in a particular city. On the other hand, non-financial variables that are specific to a party to the contract can include the occurrence or non-occurrence of a fire that damages or destroys an asset of a party to the contract, or EBITDA or revenue. A change in the fair value of a non-financial asset is specific to the owner if the fair value reflects not only changes in market prices for such assets (a financial variable) but also the condition of the specific nonfinancial asset held (a non-financial variable). [IAS 39 para AG 12A]. Such contracts may fall to be treated as insurance contracts. A derivative instrument may have more than one underlying or variable. A typical example is a cross-currency interest rate swap that has one underlying based on a foreign exchange rate and another underlying based on an interest rate. A complex option may have two such variables, one based on an interest rate and the other based on the price of a commodity such as oil. Another example based on IAS 39 s implementation guidance is given as case 12.B Case 12.B Foreign currency contract based on sales volume Entity XYZ, whose functional currency is the US dollar, sells products in France denominated in euros. XYZ enters into a contract with an investment bank to convert euros to US dollars at a fixed exchange rate. The contract requires XYZ to remit euros based on its sales volume in France in exchange for US dollars at a fixed exchange rate of The contract has two underlying variables (the foreign exchange rate and the volume of sales), no initial net investment or an initial net investment that is smaller than would be required for other types of contracts that would be expected to have a similar response to changes in market factors and a payment provision. If a contract has two or more underlyings, and at least one of those underlyings is not a non-financial variable specific to a party to a contract, the entire contract is accounted for as a derivative (assuming the rest of the definition of a derivative is met). Therefore, the contact is a derivative even though one of the variables (sales volume) is a non-financial variable that is specific to a party to the contract. IAS 39 does not exclude from its scope derivatives that are based on sales volume. [IAS 39 para IG B8]. # 2010 PricewaterhouseCoopers LLP. All rights reserved

13 Notional amounts and payment provisions A derivative usually has a notional amount, which is an amount of currency, a number of shares, a number of units of weight or volume or other units specified in the contract. However, a derivative instrument does not require the holder or writer to invest or receive the notional amount at the inception of the contract. The interaction of the notional amount and the underlying determines the settlement amount under a derivative instrument. The interaction may consist of a simple multiplication (for example, price 6 number of shares), or it may involve a formula that has leverage factors or other constants (for example, notional amount 6 interest rate where interest rate = LIBOR; the effect of any change in LIBOR is magnified by two and a half times). Alternatively, a derivative could contain a payment provision specifying a fixed payment or payment of an amount that can change (but not proportionally with a change in the underlying) as a result of some future event that is unrelated to a notional amount. For example, a contract may require a fixed payment of C1,000 if six month LIBOR increases by 100 basis points. Such a contract is a derivative even though a notional amount is not specified. [IAS 39 para AG 9]. Another example is where an entity receives C10 million if the share price of another entity decreases by more than five per cent during a six month period, but pays C10 million if the share price increases by more than five per cent during the same six month period. No payment is made if the share price is less than five per cent up or down. This is a derivative contract where there is no notional amount to determine the settlement amount. Instead, there is a payment provision that is based on changes in the underlying. Initial net investment The second characteristic of a derivative instrument is that it has no initial net investment, or one that is smaller than would be required for other types of contracts that would be expected to have a similar response to changes in market factors. Professional judgement is required in interpreting the term in italic as it does not necessarily mean insignificant in relation to the overall investment. It is a relative measure and needs to be interpreted with care. This reflects the inherent leverage features typical of derivative instruments compared to the underlying instruments. Cases 12.C to 12.G illustrate how initial net investment is determined in various circumstances. Case 12.C No initial net investment of the notional amount Forward-based derivative contracts such as forward foreign exchange contracts and interest rate swaps are typical derivative instruments that do not require an initial net investment. This is because they are priced at-the-money at inception, which means that the fair value of the contracts is zero. If the fair value of the contract is not zero at inception, the contract is recognised as an asset or liability. Under a forward foreign exchange contract the two parties agree to purchase or sell a foreign currency at a specified price, with delivery or settlement at a specified future date. Although the forward contract has a notional amount equal to the amount of the foreign currency, it does not require the holder or the writer to invest or receive the notional amount at the inception of the contract. Indeed, forward contracts do not have cash flows during the contract term. Settlement takes place at maturity of the contract. Similarly, an interest rate swap may be viewed as a variation of a forward contract in which the two parties agree to exchange one set of interest cash flows calculated with reference to a fixed interest rate for another set of interest cash flows calculated with reference to a floating interest rate. No exchange of principal takes place. Typically, the rates are set so that the fair values of the fixed and floating legs are equal and opposite at inception with the result that the fair value of the swap on initial recognition is nil. As no money changes hands at inception, there is no initial net investment. Swap cash flows occur at regular intervals over the life of the swap contract based on a notional principal amount and fixed and floating rates specified in the swap. Case 12.D Initial net investment less than the notional amount Option contracts are derivative instruments that do require an initial net investment. An option is a contractual agreement that gives the buyer of the option the right, but not the obligation, to purchase (call) or sell (put) a specified security, currency or commodity (the underlying) at a specified price (exercise price) during a specified period of time (or on a specified date). For this right, the buyer pays a premium, which is the amount the seller requires to take on the risk involved in writing the option. Although this premium can be significant, it is often less than the amount that # 2010 PricewaterhouseCoopers LLP. All rights reserved.

14 would be required to buy the underlying financial instrument to which the contract is linked. As such, the option fulfils the initial net investment criterion. [IAS 39 para AG 11]. On the other hand, if the option premium is so deep in-the-money that the premium paid is close to making an investment in the underlying, then the option contract will fail the initial net investment criterion. In that situation, the instrument would not be accounted for as a derivative under IAS 39, but rather as an investment in the underlying asset itself. Case 12.E Exchange of currencies Some contracts may require a mutual exchange of currencies or other assets, in which case the net investment is the difference between the fair values of the assets exchanged. An example is a currency swap that requires the exchange of currencies at both inception and at maturity. The initial exchange of currencies at fair values in those arrangements (zero net investment) is not seen as an initial net investment. Instead, it is an exchange of one kind of cash for another kind of cash. [IAS 39 para AG 11]. Case 12.F Margin accounts Many derivative instruments, such as futures contracts and exchange traded written options, require a margin payment an initial amount that must be deposited before trading begins and which approximately equals the daily price fluctuation permitted for the contract being traded. Such payments are not part of the initial net investment. Rather, they are a form of collateral for the counterparty or clearing house to ensure that traders will perform on their contractual obligations. The initial margin may take the form of cash, securities or other specified assets, typically liquid assets. These are separate assets that are accounted for separately. [IAS 39 para IG B10]. Any variation in margin payments would be adjusted against the asset. Case 12.G Pre-paid interest rate swap (fixed leg pre-paid) Entity S enters into a C100m notional amount five-year pay-fixed, receive-variable interest rate swap. The interest rate of the variable part of the swap is reset on a quarterly basis to three month LIBOR. The interest rate of the fixed leg of the swap is 10% per year. At inception of the swap, Entity S pre-pays its fixed obligation of C50m (C100m 6 10% 6 5 years) discounted using market interest rates, while retaining the right to receive interest payments on the C100m reset quarterly based on three-month LIBOR over the life of the swap. As stated in example 1 above at the money interest rate swap has a zero fair value at inception. Since entity S has prepaid the fixed leg of the swap at inception at its fair value, the amount pre-paid is also equal to the fair value of the variable leg of the swap. This amount is however significantly less than the notional amount (C100m) on which the variable payments under the variable leg will be calculated. In other words, the initial net investment (the amount prepaid) is still smaller than investing in a similar primary instrument, such as a variable rate bond, that responds equally to changes in the underlying interest rate. Therefore, a pre-paid fixed leg swap fulfils the initial net investment criterion of IAS 39. Even though entity S has no future performance obligation, the ultimate settlement of the contract is at a future date and the value of the contract changes in response to changes in the LIBOR index. Accordingly, the contract is a derivative instrument. On the other hand, if the fixed rate payment obligation is pre-paid subsequent to initial recognition, that is, during the term of the swap, then that would be regarded as a termination of the old swap and an origination of a new instrument that is evaluated under IAS 39. [IAS 39 para IG B4]. There is no explanation in the implementation guidance as to why this is so. Presumably this is because a significant fall in LIBOR between inception date and pre-payment date would cause the amount pre-paid (that is, the fair value of the fixed leg at the date of the pre-payment) to be significantly higher than the fair value of the fixed leg at date of inception. Therefore, the entity receiving the variable payments may not recover substantially all of its pre-paid investment under the contractual terms resulting in the termination of the old swap and the creation of a new instrument. Settlement at a future date Definition and classification of financial instruments The final part of the definition relates to settlement at a future date. All derivatives are settled at a future date. As explained in case 12.C above, forward contracts are settled at a specified date in the future, whilst for an interest rate swap settlement occurs at regular intervals over the swap s life. An option is settled upon exercise or at maturity. Therefore, even if an option is expected not to be exercised, for example, because it is out-ofthe-money and no additional exchange of consideration is expected to take place, the option still meets the settlement criterion, because expiry at maturity is a form of settlement. [IAS 39 para IG B7]. # 2010 PricewaterhouseCoopers LLP. All rights reserved

15 A derivative can be settled net in cash (that is, the entity has the right to receive or the obligation to pay a single net amount) or gross in cash/other financial asset (exchange of cash/other financial asset). Consider case 12.H. Case 12.H Interest rate swap with net or gross settlement Entity ABC enters into an interest rate swap with a counterparty (XYZ) that requires ABC to pay a fixed rate of 8% and receive a variable amount based on three month LIBOR, reset on a quarterly basis. The fixed and variable amounts are determined based on a C100m notional amount. ABC and XYZ do not exchange the notional amount. ABC pays or receives a net cash amount each quarter based on the difference between 8% and three-month LIBOR. Alternatively, settlement may be on a gross basis. As the swap contract is settled on a periodical basis, each interest payment can be viewed as a series of forward contracts to exchange and receive cash on potentially favourable or unfavourable terms. The contract meets the definition of a derivative regardless of whether each interest payment is settled net or gross, because its value changes in response to changes in an underlying variable (LIBOR). There is no initial net investment and settlements occur at future dates. In other words, it makes no difference whether ABC and XYZ actually make the interest payment to each other (gross settlement). [IAS 39 para IG B3]. Settlement may also occur gross through physical delivery of the underlying financial item. An example is a forward contract to purchase C100 million of five per cent fixed rate bond at a specified fixed date in the future. In this situation, at settlement date the entity would exchange cash for physical delivery of the bond (the underlying financial item) whose nominal value is equal to the notional amount of the contract and the market interest rate is the underlying. [IAS 39 para AG10]. Specific examples of derivative instruments The key characteristics of a derivative contract were explained and illustrated above, where relevant, with examples. Table 12.2 provides typical examples of contracts that normally qualify as derivatives together with the relevant underlying, notional and settlement amounts. Table 12.2 Examples of derivatives Derivative Underlying Notional amount Settlement amount Stock options Market price of share Number of shares (Market price at settlement Strike Price) 6 Number of shares Currency forward Currency rate Number of currency units Commodity future Interest rate swap Fixed payment contract Commodity price per unit Interest rate index (receive 5% fixed and pay LIBOR) 6-month LIBOR increases by 100 points Number of commodity units Amounts in C s Not specified (Spot rate at settlement Forward rate) 6 number of currency units Net settlement occurs daily and is determined by the change in the futures price and discounted to reflect the time to maturity Net settlement occurs periodically throughout the contract s term based on the formula: (Current interest rate index fixed rate specified in the contract) 6 Amounts in C s Settlement amount based on payment provision in the contract. An entity may also have a contract to buy or sell a non-financial item that can be settled net in cash or another financial instrument, or by exchanging financial instruments. Such contracts may fall within the definition of a derivative if they meet certain criteria. [IAS 39 para AG 10]. Non-derivative transactions should be aggregated and treated as a derivative when, in substance, the transactions result in a derivative instrument. Indicators of this would include circumstances where the transactions: # 2010 PricewaterhouseCoopers LLP. All rights reserved.

16 Are entered into at the same time and in contemplation of one another. Have the same counterparty. Relate to the same risk. Have no substantive business purpose or there is no apparent economic need for structuring the transactions separately that could not also have been accomplished in a single transaction. [IAS 39 para IG B6]. Case 12.I illustrates. Case 12.I In-substance derivatives Entity A makes a five-year fixed rate loan to entity B, while entity B at the same time makes a five-year variable rate loan for the same amount to entity A. There are no transfers of principal at inception of the two loans, since entities A and B have a netting agreement. The contractual effect is that the loans are, in substance, equivalent to an interest rate swap arrangement that meets the definition of a derivative there is an underlying variable, no initial net investment and future settlement. The same answer would apply if entity A and entity B did not have a netting agreement, because the definition of a derivative instrument does not require net settlement. [IAS 39 para IG B6]. A regular way purchase or sale is a purchase or sale of a financial asset under a contract whose terms require delivery of the asset within the time frame established generally by regulation or convention in the marketplace concerned. [IAS 39 para 9]. Such contracts give rise to a fixed price commitment between trade date and settlement date that meets the definition of a derivative. However, because of the commitment s short duration, it is not recognised as a derivative financial instrument. Rather, IAS 39 provides for special accounting for such regular way contracts which is dealt with in chapter 13. [IAS 39 para AG 12] Embedded derivatives in host contracts Introduction A derivative instrument that falls within IAS 39 s scope need not be free-standing. Terms and conditions may also be embedded in a financial instrument or in a non-financial contract (referred to as the host contract) that behave like a derivative. These terms and conditions are referred to as embedded derivatives. The combination of the host contract and the embedded derivative is referred to as a hybrid instrument. An embedded derivative can arise from deliberate financial engineering, for example to make low interest-rate debt more attractive by including an equity-linked return. However, in other cases, they arise inadvertently through market practices and common contractual arrangements, such as leases and insurance contracts. Even purchase and sale contracts that qualify as executory contracts may contain embedded derivatives. In fact, they may occur in all sorts of contracts and instruments the objective being to change the nature of cash flows that otherwise would be required by the host contract and effectively shift financial risks between the parties. Analysing non-derivative financial instruments and executory contracts for potential embedded derivatives is one of the more challenging aspects of IAS 39. However, the challenge does not end there. As will be apparent later, a derivative identified in a host contract needs further evaluation to determine whether it should be accounted for separately as a stand alone derivative at fair value. Not all embedded derivatives would fall to be accounted for separately from the host contract in which they reside. An embedded derivative is a component of a hybrid instrument that also includes a non-derivative host contract with the effect that some of the cash flows of the hybrid instrument vary in a way similar to a standalone derivative. An embedded derivative causes some or all of the cash flows that otherwise would be required by the contract to be modified according to a specified interest rate, financial instrument price, commodity price, foreign exchange rate, index of prices or rates, credit rating or credit index, or other variable, provided in the case of a non-financial variable that the variable is not specific to a party to the contract. [IAS 39 para 10]. Variation of the cash flows over the contract s term is a critical indicator of the # 2010 PricewaterhouseCoopers LLP. All rights reserved