Financial instruments Gavin Aspden FCA ICAEW Director, Qualifications Introduction Accounting for financial instruments IAS 32 Presentation (1995) IAS 39 Recognition and measurement (1998) IFRS 7 Disclosures (2005) Recognition and measurement (2010) 1
Financial instruments latest position Recognition & measurement ED proposes delaying effective date from 2013 to 2015 Impairment Expected loss model favoured Re-exposure or review draft expected soon Hedging General hedge accounting standard due soon Macro hedge accounting ED due soon Offsetting Will not proceed with proposals in recent ED Will enhance disclosures & tackle diversity in practice Introduction and contents Hedging Impairment Disclosures Derecognition Accounting for financial assets and financial liabilities Compound Instruments Equity or liability Definitions 2
Financial assets Loans & receivables Fixed or determinable payments Not quoted in an active market Held to maturity Long-term Fixed maturity Positive intent & ability Available for sale Medium to long-term Sell as and when At FV through P/L Short-term Held for trading Initial measurement Fair value Include transaction costs Fair value Exclude transaction costs Subsequent measurement Amortised cost Fair value with gains & losses to OCI Fair value with gains & losses to profit or loss IAS 39 IAS 39 Calculation of fair value (based on FAS 157) (1) Quoted market price (active market) (2) Most recent price (no active market) (3) FV of similar instrument (4) Discounted cash flow IFRS 13 will replace this guidance from 1 January 2013 3
IFRS 13 A new definition of fair value Based on exit price rather than entry price, regardless of whether the entity plans to hold or sell the asset The price that would be received to sell an asset or paid to transfer a liability in an orderly transaction between market participants at the measurement date Principal or most advantageous market Highest and best use IFRS 13 A fair value hierarchy The hierarchy categorises the inputs used in valuation techniques into three levels 1. Quoted market prices for identical assets or liabilities in active market eg, unadjusted quoted market prices for traded securities 2. Directly or indirectly observable inputs other than market prices within level 1 eg, quoted prices for similar assets or liabilities in active markets 3. Unobservable inputs eg, use the best information available in the circumstances Fair value measurement is categorised in its entirety in the level of the lowest level input that is significant to the entire measurement 4
IAS 399 Subsequent measurement FINANCIAL LIABILITIES Most financial liabilities FL at FV through P/L Amortised cost FV (changes in P/L) Financial assets: summary Contractual cash flow characteristics + Business model test Amortised cost One impairment method Fair value option for accounting mismatches only All other instruments Equities, derivatives & some hybrid contracts Fair value through P&L No impairments Option to take gains & losses to OCI for equities Classify into a measurement category at inception Reclassification required where business model changes. 5
Financial liabilities Retain IAS 39 measurement requirements Held for trading Fair value through P&L Vanilla liabilities Amortised cost Hybrid instruments Bifurcation Maintain fair value option but with one amendment regarding own credit risk Financial liabilities: Own credit risk What is own credit risk? Arises when an issuer has its own debt measured at fair value If the issuer s credit rating decreases, the fair value of its debt will fall Currently this gain goes direct to the income statement Similarly if the issuer s credit rating improves, a loss is taken to the income statement Why the concern? During the credit crunch a number of entities in significant financial difficulty reported large gains via P&L to reflect the decrease in fair value of their own debt Reporting such gains is not useful Solution Any change in fair value due to changes in the entity s own credit risk will be taken to other comprehensive income rather to the income statement 6
IAS 39 Financial assets - impairments Investments need to be reviewed for impairment Held for trading Available for sale Held to maturity Already measured at fair value, therefore not an issue Already measured at fair value, but any loss has been taken to OCI If impairment arises transfer loss to profit or loss If indication of impairment, compare carrying amount to present value of future cash flows. Loss to profit or loss Exposure draft: Impairment of financial assets Incurred loss model Currently used by IAS 39 Credit losses are recognised only if an event has occurred that has a negative effect on future cash flows & that effect can be reliably estimated An entity is not permitted to consider the effects of future expected losses Expected loss model Proposed in this ED Requires an entity to make an ongoing assessment of expected credit losses May require earlier recognition of credit losses Would better reflect the way that financial assets are priced and the way some companies manage their business. 7
Exposure draft: A new alternative Relative credit risk model Split into three buckets The bucket would determine the amount and timing of the credit losses recognised Additional guidance of when transfers between buckets should occur Incorporates the effects of rating agencies but without the too little, too late concerns of the US approach Exposure draft almost certain to be reissued IAS 39 Hedging Hedged item An asset, liability, firm commitment, highly probable forecast transaction or net investment in a foreign operation that exposes the entity to risks of changes in fair value or future cash flows and is designated as being hedged Hedging instrument Designated derivative or other financial asset or liability whose fair value or cash flows are expected to offset changes in the fair value of the designated hedged item Most often a derivative Gains and losses on hedged items and hedged instruments can be accounted for under hedge accounting rules provided the hedging relationship is formally designated & documented and expected to be highly effective. 8
IAS 39 Hedging types Fair Value Hedge Hedge of fair value of a recognised asset or liability or unrecognised firm commitment Hedged item & hedging instrument re-measured to fair value via profit or loss Cash Flow Hedge Hedge of cash flow volatility associated with a recognised asset or liability or highly probable forecast transaction Effective gain or loss on hedging instrument to equity until hedged item affects profit or loss Outcome is that gains & losses on hedged item and hedged instrument matched in P/L in same period Hedging proposals Simplification of complex hedging rules Two stages, the first exposure draft covers general hedges Key proposals Relaxation of rules covering what items can qualify for hedge accounting, what instruments can be designated and effectiveness testing requirements Presentation of fair value hedges amended Effectiveness testing is limited to a forward looking test (no bright line 80 to125% test removed) Most likely a qualitative rather than quantitative assessment will be required Hedge accounting for net positions and groups of items is extended 9
Hedging types Now re-measure via OCI NOT profit or loss Fair Value Hedge Hedge of fair value of a recognised asset or liability or unrecognised firm commitment Hedged item & hedging instrument re-measured to fair value via OCI Cash Flow Hedge Hedge of cash flow volatility associated with a recognised asset or liability or highly probable forecast transaction Effective gain or loss on hedging instrument to equity until hedged item affects profit or loss Outcome is that gains & losses on hedged item and hedged instrument matched in P&L in same period A world leader of the accountancy and finance profession 10