Financial Instruments Standards (Part 2) 18 June PDF Free Download

Financial Instruments Standards (Part 2) 18 June 2015 LAM Chi Yuen Nelson 林智遠 MBA MSc BBA ACS ACIS CFA CGMA CPA(US) CTA FCA FCCA FCPA FCPA(Aust.) FHKIoD FTIHK MHKSI MSCA 2006-15 Nelson Consulting Limited 1 Background IAS 32 IAS 39 and (from 2018) Presentation Liabilities and Equity Compound Financial Instruments Offsetting IFRS 7 Disclosure requirements Classification of financial instruments Recognition and derecognition of financial instruments Measurement of financial instruments Derivatives and embedded derivatives Hedging and hedge accounting 2006-15 Nelson Consulting Limited 2 1

Today s Agenda Impairment Derivatives Derecognition Hedging New expected credit loss model Accounting for derivatives and embedded derivatives Derecognition is allowed if conditions are met Type of hedge and hedge accounting Presentation Presentation of financial instruments, incl. to separate financial liabilities from equity 2006-15 Nelson Consulting Limited 3 Today s Agenda Impairment New expected credit loss model 2006-15 Nelson Consulting Limited 4 2

IAS 39: Impairment Two-Stage Assessment of Objective Evidence Before an impairment loss is measured and recognised, an entity is required to assess whether objective evidence of impairment exists for those financial assets measured at amortised cost using a twostage assessment approach as follows: 1. First stage (individual assessment) an entity is required to firstly assesses whether objective evidence of impairment exists individually for the financial assets that are individually significant, and individually or collectively for the financial assets that are not individually significant. 2. Second stage (collective assessment) If an entity determines that no objective evidence of impairment exists for an individually assessed financial asset, whether significant or not, it includes the asset in a group of financial assets with similar credit risk characteristics and collectively assesses them for impairment. 2006-15 Nelson Consulting Limited Sourced from Intermediate Financial Reporting (2012) by Nelson Lam and Peter Lau 5 : Chapter 5.5 Impairment Topics Covered 1. Recognition of Expected Credit Losses General approach Determining significant increases in credit risk Modified financial assets Purchased or originated creditimpaired financial assets 2. Simplified Approach for Trade Receivables, Contract Assets and Lease Receivables 3. Measurement of Expected Credit Losses 2006-15 Nelson Consulting Limited 6 3

: Chapter 5.5 Impairment Recognition of Expected Credit Losses General Approach An entity shall recognise a loss allowance for expected credit losses on a financial asset that is measured in accordance with para. 4.1.2 or 4.1.2A, a lease receivable, a contract asset or a loan commitment and a financial guarantee contract to which the impairment requirements apply in accordance with para. 2.1(g), 4.2.1(c) or 4.2.1(d). (para. 5.5.1) defines expected credit losses as: The weighted average of credit losses with the respective risks of a default occurring as the weights. 2006-15 Nelson Consulting Limited 7 : Chapter 5.5 Impairment Recognition of Expected Credit Losses General Approach defines credit losses as: The difference between all contractual cash flows that are due to an entity in accordance with the contract and all the cash flows that the entity expects to receive (i.e. all cash shortfalls), discounted at the original effective interest rate (or credit adjusted effective interest rate for purchased or originated credit impaired financial assets). 2006-15 Nelson Consulting Limited 8 4

: Chapter 5.5 Impairment Recognition of Expected Credit Losses General Approach defines credit losses as: An entity shall estimate cash flows by considering all contractual terms of the financial instrument (for example, prepayment, extension, call and similar options) through the expected life of that financial instrument. The cash flows that are considered shall include cash flows from the sale of collateral held or other credit enhancements that are integral to the contractual terms. There is a presumption that the expected life of a financial instrument can be estimated reliably. However, in those rare cases when it is not possible to reliably estimate the expected life of a financial instrument, the entity shall use the remaining contractual term of the financial instrument. 2006-15 Nelson Consulting Limited 9 : Chapter 5.5 Impairment Recognition of Expected Credit Losses General Approach defines Lifetime expected credit losses as: The expected credit losses that result from all possible default events over the expected life of a financial instrument. 12 month expected credit losses as: The portion of lifetime expected credit losses that represent the expected credit losses that result from default events on a financial instrument that are possible within the 12 months after the reporting date. 2006-15 Nelson Consulting Limited 10 5

: Chapter 5.5 Impairment Initial recognition Credit risk increases significantly Credit impaired 2006-15 Nelson Consulting Limited Adapted from the IASB s Project Summary issued in July 2014 11 : Chapter 5.5 Impairment Performing Underperforming n Performing 2006-15 Nelson Consulting Limited Adapted from the IASB s Project Summary issued in July 2014 12 6

: Chapter 5.5 Impairment Is the financial instrument a purchased or originated creditimpaired financial asset? Is the simplified approach for trade receivables, contract assets and lease receivables applicable? Does the financial instrument have low credit risk at the reporting date? Has there been a significant increase in credit risk since initial recognition? Is the low credit risk simplification applied? Calculate a credit adjusted effective interest rate, and Always recognise a loss allowance for changes in lifetime expected credit losses Recognise 12 month expected credit losses, and Calculate interest revenue on gross carrying amount Recognise lifetime expected credit losses Is the financial instrument a credit impaired financial asset? Calculate interest revenue on Calculate interest revenue on the gross carrying amount amortised cost 2006-15 Nelson Consulting Limited Adapted from the flowchart after.ie102 13 : Chapter 5.5 Impairment Recognition of Expected Credit Losses Purchased or Originated Credit Impaired Financial Assets Despite para. 5.5.3 and 5.5.5, at the reporting date, an entity shall only recognise the cumulative changes in lifetime expected credit losses since initial recognition as a loss allowance for purchased or originated credit impaired financial assets. (para. 5.5.13) At each reporting date, an entity shall recognise in profit or loss the amount of the change in lifetime expected credit losses as an impairment gain or loss. An entity shall recognise favourable changes in lifetime expected credit losses as an impairment gain, even if the lifetime expected credit losses are less than the amount of expected credit losses that were included in the estimated cash flows on initial recognition. (para.5.5.14) 2006-15 Nelson Consulting Limited 14 7

: Chapter 5.5 Impairment Is the financial instrument a purchased or originated creditimpaired financial asset? Calculate a credit adjusted effective interest rate, and Always recognise a loss allowance for changes in lifetime expected credit losses 2006-15 Nelson Consulting Limited Adapted from the flowchart after.ie102 15 : Chapter 5.5 Impairment Simplified Approach for Trade Receivables, Contract Assets and Lease Receivables Despite para. 5.5.3 & 5.5.5, an entity shall always measure the loss allowance at an amount equal to lifetime expected credit losses for: a. trade receivables or contract assets that result from transactions that are within the scope of IFRS 15, and that: i. do not contain a significant financing component (or when the entity applies the practical expedient for contracts that are one year or less) in accordance with IFRS 15; or ii. contain a significant financing component in accordance with IFRS 15, if the entity chooses as its accounting policy to measure the loss allowance at an amount equal to lifetime expected credit losses. That accounting policy shall be applied to all such trade receivables or contract assets but may be applied separately to trade receivables and contract assets. 2006-15 Nelson Consulting Limited 16 8

: Chapter 5.5 Impairment Simplified Approach for Trade Receivables, Contract Assets and Lease Receivables Despite para. 5.5.3 & 5.5.5, an entity shall always measure the loss allowance at an amount equal to lifetime expected credit losses for: b. lease receivables that result from transactions that are within the scope of IAS 17, if the entity chooses as its accounting policy to measure the loss allowance at an amount equal to lifetime expected credit losses. That accounting policy shall be applied to all lease receivables but may be applied separately to finance and operating lease receivables. (para. 5.5.15) An entity may select its accounting policy for trade receivables, lease receivables and contract assets independently of each other. (para. 5.5.16) 2006-15 Nelson Consulting Limited 17 : Chapter 5.5 Impairment Is the financial instrument a purchased or originated creditimpaired financial asset? Is the simplified approach for trade receivables, contract assets and lease receivables applicable? Recognise lifetime expected credit losses Is the financial instrument a credit impaired financial asset? Calculate interest revenue on Calculate interest revenue on the gross carrying amount amortised cost 2006-15 Nelson Consulting Limited Adapted from the flowchart after.ie102 18 9

: Chapter 5.5 Impairment Recognition of Expected Credit Losses General Approach Subject to para. 5.5.13 5.5.16, if, at the reporting date, the credit risk on a financial instrument has not increased significantly since initial recognition, an entity shall measure the loss allowance for that financial instrument at an amount equal to 12 month expected credit losses. (para. 5.5.5) For loan commitments and financial guarantee contracts, the date that the entity becomes a party to the irrevocable commitment shall be considered to be the date of initial recognition for the purposes of applying the impairment requirements. (para. 5.5.6) 2006-15 Nelson Consulting Limited 19 : Chapter 5.5 Impairment Recognition of Expected Credit Losses General Approach If an entity has measured the loss allowance for a financial instrument at an amount equal to lifetime expected credit losses in the previous reporting period, but determines at the current reporting date that para. 5.5.3 is no longer met, the entity shall measure the loss allowance at an amount equal to 12 month expected credit losses at the current reporting date. (para.5.5.7) An entity shall recognise in profit or loss, as an impairment gain or loss, the amount of expected credit losses (or reversal) that is required to adjust the loss allowance at the reporting date to the amount that is required to be recognised in accordance with. (para. 5.5.8) 2006-15 Nelson Consulting Limited 20 10

: Chapter 5.5 Impairment Example Entity A originates a single 10 year amortising loan for $1 million. Taking into consideration the expectations for instruments with similar credit risk (using reasonable and supportable information that is available without undue cost or effort), the credit risk of the borrower, and the economic outlook for the next 12 months, Entity A estimates that the loan at initial recognition has a probability of default (PD) of 0.5 per cent over the next 12 months. Entity A also determines that changes in the 12 month PD are a reasonable approximation of the changes in the lifetime PD for determining whether there has been a significant increase in credit risk since initial recognition. 2006-15 Nelson Consulting Limited 21 : Chapter 5.5 Impairment Example At the reporting date (which is before payment on the loan is due), there has been no change in the 12 month PD and Entity A determines that there was no significant increase in credit risk since initial recognition. Entity A determines that 25 per cent of the gross carrying amount will be lost if the loan defaults (i.e. the LGD is 25 per cent). Entity A measures the loss allowance at an amount equal to 12 month expected credit losses using the 12 month PD of 0.5 per cent. Implicit in that calculation is the 99.5 per cent probability that there is no default. At the reporting date the loss allowance for the 12 month expected credit losses is $1,250 (0.5% 25% $1,000,000). 2006-15 Nelson Consulting Limited 22 11

: Chapter 5.5 Impairment Recognition of Expected Credit Losses Determining Significant Increases in Credit Risk At each reporting date, an entity shall assess whether the credit risk on a financial instrument has increased significantly since initial recognition. When making the assessment, an entity shall use the change in the risk of a default occurring over the expected life of the financial instrument instead of the change in the amount of expected credit losses. 2006-15 Nelson Consulting Limited 23 : Chapter 5.5 Impairment Recognition of Expected Credit Losses Determining Significant Increases in Credit Risk To make that assessment, an entity shall compare the risk of a default occurring on the financial instrument as at the reporting date with the risk of a default occurring on the financial instrument as at the date of initial recognition and consider reasonable and supportable information, that is available without undue cost or effort, that is indicative of significant increases in credit risk since initial recognition. (para.5.5.9) 2006-15 Nelson Consulting Limited 24 12

: Chapter 5.5 Impairment Recognition of Expected Credit Losses Determining Significant Increases in Credit Risk An entity may assume that the credit risk on a financial instrument has not increased significantly since initial recognition if the financial instrument is determined to have low credit risk at the reporting date (see para. B5.5.22 B5.5.24). (para.5.5.10) 2006-15 Nelson Consulting Limited 25 : Chapter 5.5 Impairment Recognition of Expected Credit Losses Modified Financial Assets If the contractual cash flows on a financial asset have been renegotiated or modified and the financial asset was not derecognised, an entity shall assess whether there has been a significant increase in the credit risk of the financial instrument in accordance with para. 5.5.3 by comparing: a. the risk of a default occurring at the reporting date (based on the modified contractual terms); and b. the risk of a default occurring at initial recognition (based on the original, unmodified contractual terms). (para.5.5.12) 2006-15 Nelson Consulting Limited 26 13

: Chapter 5.5 Impairment Is the financial instrument a purchased or originated creditimpaired financial asset? Is the simplified approach for trade receivables, contract assets and lease receivables applicable? Does the financial instrument have low credit risk at the reporting date? Has there been a significant increase in credit risk since initial recognition? Is the low credit risk simplification applied? Recognise 12 month expected credit losses, and Calculate interest revenue on gross carrying amount 2006-15 Nelson Consulting Limited Adapted from the flowchart after.ie102 27 : Chapter 5.5 Impairment Recognition of Expected Credit Losses General Approach Subject to para. 5.5.13 5.5.16, at each reporting date, an entity shall measure the loss allowance for a financial instrument at an amount equal to the lifetime expected credit losses if the credit risk on that financial instrument has increased significantly since initial recognition. (para. 5.5.3) The objective of the impairment requirements is to recognise lifetime expected credit losses for all financial instruments for which there have been significant increases in credit risk since initial recognition whether assessed on an individual or collective basis considering all reasonable and supportable information, including that which is forward looking. (para. 5.5.4) 2006-15 Nelson Consulting Limited 28 14

: Chapter 5.5 Impairment Is the financial instrument a purchased or originated creditimpaired financial asset? Is the simplified approach for trade receivables, contract assets and lease receivables applicable? Does the financial instrument have low credit risk at the reporting date? Has there been a significant increase in credit risk since initial recognition? Is the low credit risk simplification applied? Calculate a credit adjusted effective interest rate, and Always recognise a loss allowance for changes in lifetime expected credit losses Recognise 12 month expected credit losses, and Calculate interest revenue on gross carrying amount Recognise lifetime expected credit losses Is the financial instrument a credit impaired financial asset? Calculate interest revenue on Calculate interest revenue on the gross carrying amount amortised cost 2006-15 Nelson Consulting Limited Adapted from the flowchart after.ie102 31 : Chapter 5.5 Impairment Measurement of Expected Credit Losses An entity shall measure expected credit losses of a financial instrument in a way that reflects: a. an unbiased and probability weighted amount that is determined by evaluating a range of possible outcomes; b. the time value of money; and c. reasonable and supportable information that is available without undue cost or effort at the reporting date about past events, current conditions and forecasts of future economic conditions. (para. 5.5.17) 2006-15 Nelson Consulting Limited 32 16

: Chapter 5.5 Impairment Measurement of Expected Credit Losses When measuring expected credit losses, an entity need not necessarily identify every possible scenario. However, it shall consider the risk or probability that a credit loss occurs by reflecting the possibility that a credit loss occurs and the possibility that no credit loss occurs, even if the possibility of a credit loss occurring is very low. (para. 5.5.18) The maximum period to consider when measuring expected credit losses is the maximum contractual period (including extension options) over which the entity is exposed to credit risk and not a longer period, even if that longer period is consistent with business practice. (para. 5.5.19) 2006-15 Nelson Consulting Limited 33 : Chapter 5.5 Impairment Measurement of Expected Credit Losses However, some financial instruments include both a loan and an undrawn commitment component and the entity s contractual ability to demand repayment and cancel the undrawn commitment does not limit the entity s exposure to credit losses to the contractual notice period. For such financial instruments, and only those financial instruments, the entity shall measure expected credit losses over the period that the entity is exposed to credit risk and expected credit losses would not be mitigated by credit risk management actions, even if that period extends beyond the maximum contractual period. (para. 5.5.20) 2006-15 Nelson Consulting Limited 34 17

IAS 39: Impairment Amortised Cost on Low Interest Loan Example Advance Finance Inc. granted a 3 year loan of $50,000 to an important new customer in 1 Jan. 2018. The interest rate on the loan is 4% The current market lending rates for similar loans is 6% At initial recognition, Entity A recognised $47,327. End of first year, the amortised cost was $48,167. The repayment schedule: Balance b/f Effective interest (6%) Interest received (4%) Balance c/f 31.12.2018 $ 47,327 $ 2,840 ($ 2,000) $ 48,167 31.12.2019 $ 48,167 $ 2,890 ($ 2,000) $ 49,057 31.12.2020 $ 49,057 $ 2,943 ($ 2,000) $ 50,000 At 2 Jan. 2019, Advance agreed a loan restructure, and waived all the interest payments in 2019 and 2020. 2006-15 Nelson Consulting Limited 35 IAS 39: Impairment Example Cash to be received as estimated at 2.1.2019 Discount factor Present value 31.12.2019 $ 0 1 / (1 + 6%) 1 $ 0 31.12.2020 $ 50,000 1 / (1 + 6%) 2 $ 44,500 Carrying amount (per the balance as at 31.12.2019) $ 48,167 Present Value of estimated future cash flows discounted at original effective interest rate as at 2.1.2019 44,500 Impairment loss $ 3,667 Dr Impairment loss (in income statement) $3,667 Cr Allowance on impairment loss (alternatively, Loans and receivables) $3,667 2006-15 Nelson Consulting Limited 36 18

How will it be affected by? Example Amortised Cost on Low Interest Loan Advance Finance Inc. granted a 3 year loan of $50,000 to an important new customer in 1 Jan. 2018. The interest rate on the loan is 4% The current market lending rates for similar loans is 6% At initial recognition, Entity A recognised $47,327. Stage 1 End of first year, the amortised cost was $48,167. Stage 2? The repayment schedule: Balance b/f Effective interest (6%) Interest received (4%) Balance c/f 31.12.2018 $ 47,327 $ 2,840 ($ 2,000) $ 48,167 31.12.2019 $ 48,167 $ 2,890 ($ 2,000) $ 49,057 31.12.2020 $ 49,057 $ 2,943 ($ 2,000) $ 50,000 At 2 Jan. 2019, Advance agreed a loan restructure, and waived all the interest payments in 2019 and 2020. Stage 3? 2006-15 Nelson Consulting Limited 37 How will it be affected by? Stage 1 Stage 2 Stage 3 Lifetime expected credit losses () 2006-15 Nelson Consulting Limited 38 19

Today s Agenda Derivatives Accounting for derivatives and embedded derivatives 2006-15 Nelson Consulting Limited 39 Derivative & Embedded Derivative Derivative Value change based on an underlying Little or no initial net investment Settled at a future date Financial instrument is a financial instrument or other contract within the scope of IAS 39 with all 3 of the following characteristics: a) its value changes in response to the change in a specified interest rate, financial instrument price, commodity price, foreign exchange rate, index of prices or rates, credit rating or credit index, or other variable (sometimes called the underlying ); b) it requires no initial net investment or an initial net investment that is smaller than would be required for other types of contracts that would be expected to have a similar response to changes in market factors; and c) it is settled at a future date. Financial asset Financial liability or Equity instrument Derivative 2006-15 Nelson Consulting Limited 40 20

Derivative & Embedded Derivative Derivative Typical example: Future and forward Swap and options Value change based on an underlying Little or no initial net investment Settled at a future date Type of contract Interest Rate Swap Currency Swap (Foreign Exchange Swap) Commodity Swap Equity Swap Credit Swap Total Return Swap Purchased or Written Treasury Bond Option Purchased or Written Currency Option Currency Futures/Forward Commodity Futures/Forward Equity Forward Underlying variable Interest rates Example Currency rates Commodity prices Equity prices (equity of another entity) Credit rating, credit index or credit price Total fair value of the reference asset and interest rates Interest rates Currency rates Currency rates Commodity prices Equity prices 2006-15 Nelson Consulting Limited 41 Derivative & Embedded Derivative Derivative What is the initial measurement and subsequent measurement on derivative? Initial measurement Similar to other financial assets and liabilities Fair value plus transaction cost, except for those classified at fair value through profit or loss But, a derivative (except for a derivative that is a financial guarantee contract or a designated and effective hedging instrument) is classified as fair value through profit or loss Implies fair value only Subsequent measurement As above, derivative, other than a financial guarantee contract or a designated and effective hedging instrument, is classified and measured at fair value through profit or loss 2006-15 Nelson Consulting Limited 42 21

Derivative & Embedded Derivative A hybrid instrument includes a non-derivative host contract and an embedded derivative with the effect that some of the cash flows of the hybrid instrument vary in a way similar to a stand-alone derivative. However, a derivative that is attached to a financial instrument but is contractually transferable independently of that instrument, or has a different counterparty from that instrument, is not an embedded derivative, but a separate financial instrument. (para 4.3.1) Hybrid (Combined) Contract Host Contract Embedded Derivative 2006-15 Nelson Consulting Limited Sourced from Intermediate Financial Reporting (2012) by Nelson Lam and Peter Lau 43 IAS 39: Embedded Derivative IAS 39 requires an entity to separate an embedded derivative from the host contract and account for such embedded derivative as a derivative if, and only if: 1. the economic characteristics and risks of the embedded derivative are not closely related to the economic characteristics and risks of the host contract; 2. a separate instrument with the same terms as the embedded derivative would meet the definition of a derivative; and 3. the hybrid instrument is not measured at fair value with changes in fair value recognised in profit or loss (i.e. a derivative that is embedded in a financial asset or financial liability at fair value through profit or loss is not separated). Hybrid (Combined) Contract Host Contract Embedded Derivative 2006-15 Nelson Consulting Limited Sourced from Intermediate Financial Reporting (2012) by Nelson Lam and Peter Lau 44 22

IAS 39: Embedded Derivatives Economic characteristics and risks NOT closely related Hybrid (Combined) Contract Host Contract Embedded derivative meets the definition of derivative Hybrid instruments NOT measured at FV through P/L Separate the Embedded Derivative and accounted for under t Require to Separate the Embedded Derivative Embedded Derivative 2006-15 Nelson Consulting Limited Sourced from Intermediate Financial Reporting (2012) by Nelson Lam and Peter Lau 45 : Embeded Derivatives If a hybrid contract contains a host that is an asset within the scope of, an entity shall apply the requirements in para. 4.1.1-4.1.5 (as discussed above) to the entire hybrid contract. (para. 4.3.2) If a hybrid contract contains a host that is not an asset within the scope of, an embedded derivative shall be separated from the host and accounted for as a derivative under if, and only if: All 3 conditions are met (same as those set out in IAS 39), including: a. Economic characteristics & risks not closely related b. Embedded derivative meets the definition of derivative c. Hybrid contract is not measured at FV through P/L. (para. 4.3.3) Host is an assets within Other Contracts 2006-15 Nelson Consulting Limited 46 23

Embeded Derivatives If an embedded derivative is separated, the host contract shall be accounted for in accordance with the appropriate IFRSs. does not address whether an embedded derivative shall be presented separately in the statement of financial position. (para. 4.3.4) Hybrid (Combined) Contract Host Contract Embedded Derivative Separate the Embedded Derivative and accounted for under 2006-15 Nelson Consulting Limited 47 Embeded Derivatives Despite para. 4.3.3 and 4.3.4, if a contract contains one or more embedded derivatives and the host is not an asset within the scope of, an entity may designate the entire hybrid contract as at fair value through profit or loss unless: a) the embedded derivative(s) do(es) not significantly modify the cash flows that otherwise would be required by the contract; or b) it is clear with little or no analysis when a similar hybrid instrument is first considered that separation of the embedded derivative(s) is prohibited, such as a prepayment option embedded in a loan that permits the holder to prepay the loan for approximately its amortised cost. (para. 4.3.5) Hybrid (Combined) Contract Host Contract Embedded Derivative 2006-15 Nelson Consulting Limited 48 24

Embeded Derivatives If an entity is required by to separate an embedded derivative from its host, but is unable to measure the embedded derivative separately either at acquisition or at the end of a subsequent financial reporting period, it shall designate the entire hybrid contract as at fair value through profit or loss. (para. 4.3.6) Hybrid (Combined) Contract Host Contract Embedded Derivative 2006-15 Nelson Consulting Limited 49 Today s Agenda Derecognition Derecognition is allowed if conditions are met 2006-15 Nelson Consulting Limited 50 25

Derecognition of Financial Asset Derecognition is the removal of a previously recognised financial asset or financial liability from an entity s balance sheet. Derecognition of an asset or a liability is originally a simple concept. Practically, it is not that simple for financial assets and financial liabilities. Even a financial asset or a financial liability had been transferred, either or both the risk and reward and control of the financial asset or the obligation of the financial liability might have not been transferred. IAS 39 sets out detailed derecognition criteria and requirements on financial assets and financial liabilities separately. 2006-15 Nelson Consulting Limited Sourced from Intermediate Financial Reporting (2012) by Nelson Lam and Peter Lau 51 Derecognition of Financial Asset The general derecognition criteria in accordance with IAS 39 require an entity to derecognise a financial asset when, and only when: 1. the contractual rights to the cash flows from the financial asset expire; or 2. the entity transfers the financial asset that meet the conditions set out in IAS 39 (i.e. asset transfer test ) and the transfer qualifies for derecognition in accordance with IAS 39 (i.e. the risks and rewards test, and the control test ) 2006-15 Nelson Consulting Limited Sourced from Intermediate Financial Reporting (2012) by Nelson Lam and Peter Lau 52 26

Derecognition of Financial Asset Consider derecognition on consolidation level and on a part or all of an financial asset (or group of financial assets) Rights to cash flows from asset expired? Asset transfer test Transferred rights to receive cash flows from the asset? Assumed obligations to pay cash flows that meet 3 conditions? Transferred substantially all risks and rewards? Retained substantially all risks and rewards? Risks and rewards test Retained control of the asset? Control test Accounting treatments Continue to recognise the asset Derecognise the asset 2006-15 Nelson Consulting Limited Sourced from Intermediate Financial Reporting (2012) by Nelson Lam and Peter Lau 53 Continuing involvement Derecognition of Financial Asset Example a) an unconditional sale of a financial asset; b) a sale of a financial asset together with an option to repurchase the financial asset at its fair value at the time of repurchase; and c) a sale of a financial asset together with a put or call option that is deeply out of the money (i.e. an option that is so far out of the money it is highly unlikely to go into the money before expiry). Transferred substantially all risks and rewards? Retained substantially all risks and rewards? a) a sale & repurchase transaction where the repurchase price is a fixed price or a sale price plus a lender s return; b) a securities lending agreement c) a sale of a financial asset together with a total return swap that transfers the market risk exposure back to the entity d) a sale of a financial asset together with a deep in-the-money put/call option e) a sale of short-term receivables in which the entity guarantees to compensate the buyer for any credit losses 2006-15 Nelson Consulting Limited 54 27

Derecognition of Financial Asset By applying the risks and rewards test together with the control test on a derecognition transaction: Findings of risks & rewards test and control test 1. Transfers substantially all the risks and rewards of ownership 2. Retains substantially all the risks and rewards of ownership 3. Neither transfers nor retains substantially all the risks and rewards of ownership and not retained control 4. Neither transfers nor retains substantially all the risks and rewards of ownership but retained control Corresponding accounting treatments Transfer qualified for derecognition To derecognise the financial asset To recognise separately as assets/liabilities any rights & obligations created/retained in the transfer Transfer not qualified for derecognition To continue to recognise the financial asset Transfer qualified for derecognition To derecognise the financial asset To recognise separately as assets/liabilities any rights & obligations created/retained in the transfer Continuing involvement To continuously recognise the financial asset to the extent of its continuing involvement in the asset To recognise an associate liability 2006-15 Nelson Consulting Limited Sourced from Intermediate Financial Reporting (2012) by Nelson Lam and Peter Lau 55 Derecognition of Financial Asset Requirements for All Transfers If a transferred asset continues to be recognised, the asset and the associated liability cannot be offset. Similarly, the entity is not allowed to offset any income arising from the transferred asset with any expense incurred on the associated liability. If a transferor provides non-cash collateral (such as debt or equity instruments) to the transferee, the accounting for the collateral by the transferor and the transferee depends on whether the transferee has the right to sell or repledge the collateral and on whether the transferor has defaulted. 2006-15 Nelson Consulting Limited Sourced from Intermediate Financial Reporting (2012) by Nelson Lam and Peter Lau 56 28

Derecognition of Financial Liability An entity is required to remove a financial liability (or a part of a financial liability) from its balance sheet (i.e. derecognise a financial liability) when, and only when, it is extinguished. IAS 39 explains that a financial liability is extinguished when the obligation specified in the contract is discharged or cancelled or expires. A financial liability or part of it is extinguished when the debtor either: 1. discharges the liability or part of it by paying the creditor, normally with cash, other financial assets, goods or services; or 2. is legally released from primary responsibility for the liability (or part of it) either by process of law or by the creditor. 2006-15 Nelson Consulting Limited Sourced from Intermediate Financial Reporting (2012) by Nelson Lam and Peter Lau 57 Derecognition of Financial Liability When there is an exchange between an existing borrower and lender of debt instruments with substantially different terms or a substantial modification of the terms of an existing financial liability or a part of it (whether or not attributable to the financial difficulty of the debtor), such an exchange of debt instruments or substantial modification of terms is accounted for as: an extinguishment of the original financial liability and the recognition of a new financial liability. 2006-15 Nelson Consulting Limited Sourced from Intermediate Financial Reporting (2012) by Nelson Lam and Peter Lau 58 29

Derecognition of Financial Liability The recognition of a new financial liability implies that the new liability is measured at fair value plus transaction costs at the date of extinguishment. The difference between the carrying amount of a financial liability (or part of it) extinguished or transferred to another party and the consideration paid, including any non-cash assets transferred or liabilities assumed, is recognised in profit or loss. 2006-15 Nelson Consulting Limited Sourced from Intermediate Financial Reporting (2012) by Nelson Lam and Peter Lau 59 Today s Agenda Hedging Compare (brief update) with New Hedging Requirements in issued in Dec. 2013 A more principles-based standard will align hedge accounting more closely with risk management 2006-15 Nelson Consulting Limited 60 30

Hedging Introduction A Hedge under IAS 39 involves 2 components Hedging Instrument Hedged Item Strict conditions must be fulfilled before Hedge Accounting can be used. But even qualified, an entity can also choose not to use it, but IAS 39 sets out Hedge Accounting which recognises the offsetting effects on profit or loss of changes in the fair values of these 2 components. Hedge Accounting seeks to match the 2 sides of a Hedging Relationship, so as to ensure both sides are offset and not to affect the income statements from one side only. has a choice for an entity to use the hegding model in or IAS 39 2006-15 Nelson Consulting Limited 61 Hedging Introduction Hedging Instrument Hedged Item IAS 39 defines and restricts the items qualified as Hedging Instruments and Hedged Items Hedging Relationship Conditions for Hedge Accounting Hedge Accounting Sets out the types of Hedge Relationship Requires Conditions for Hedging Accounting must be fulfilled to qualify a hedge accounting Sets out the Hedge Accounting If there is a designated Hedging Relationship, accounting for gain or loss on the Hedging Instruments and Hedged Item shall follow Hedge Accounting. 2006-15 Nelson Consulting Limited 62 31

Hedging Hedging Instruments Hedging Instrument Hedged Item Hedging Relationship 2006-15 Nelson Consulting Limited 63 Hedging Hedging Instruments Hedging Instrument Derivative nderivative Hedging Instrument is a) a designated derivative, or b) a designated non-derivative financial asset or non-derivative financial liability (for a hedge of the risk of changes in foreign currency exchange rates only) whose fair value or cash flows are expected to offset changes in the fair value or cash flows of a designated hedged item A non-derivative financial asset or non-derivative financial liability may be designated as a hedging instrument only for a hedge of a foreign currency risk. t specified Defined but implied in t specified stated but implied in restriction on the circumstances in which a derivative may be designated as a hedging instrument provided the conditions for hedging accounting are met, except for Some Written Options. 2006-15 Nelson Consulting Limited 64 32

Hedging Hedged Item Hedging Instrument Hedged Item Hedging Relationship 2006-15 Nelson Consulting Limited 65 Hedging Hedged Item Hedged item is an asset, a liability, a firm commitment, a highly probable forecast transaction, or a net investment in a foreign operation, that exposes the entity to risk of changes in fair value or future cash flows and is designated as being hedged. Hedged Item A hedged item is an exposure to risk to an entity that attempt to hedge. A hedged item can be a recognised asset or liability, an unrecognised firm commitment, a highly probable forecast transaction or a net investment in a foreign operation. 2006-15 Nelson Consulting Limited 66 33

Hedging Hedge Relationship Hedging Instrument Hedged Item Hedging Relationship IAS 39 sets out 3 types of Hedging Relationships to which Hedge Accounting may be applied Fair Value Hedge retains 3 types of hedge accounting and additional judgement will be required Cash Flow Hedge Hedge of Net Investment in a Foreign Operation 2006-15 Nelson Consulting Limited 67 Hedging Hedge Relationship Fair Value Hedge A hedge of the exposure to changes in fair value of a recognised asset or liability or an unrecognised firm commitment, or an identified portion of such items that is attributable to a particular risk and could affect P/L Cash Flow Hedge Hedge of Net Investment in a Foreign Operation A hedge of the exposure to variability in cash flows that i) is attributable to a particular risk associated with a recognised asset or liability, or a highly probable forecast transaction and ii) could affect profit or loss A hedge of the foreign currency risk of a firm commitment may be accounted for as a fair value hedge or as a cash flow hedge Hedge of a net investment in a foreign operation is as defined in IAS 21 The Effects of Changes in Foreign Exchange Rates 2006-15 Nelson Consulting Limited 68 34

Hedging Hedge Relationship Example Fair Value Hedge Cash Flow Hedge Determine the classification for the following hedge: Entity A has a floating rate bond and enters into an interest rate swap by receiving fixed and paying float Entity B has a fixed rate bond and enters into an interest rate swap by receiving float and paying fixed Entity C issues a floating rate bond and enters into an interest rate swap by paying fixed and receiving float Hedge of Net Investment in a Foreign Operation Entity D issues a floating rate bond and buys an interest rate cap 2006-15 Nelson Consulting Limited 69 Hedging Hedge Accounting Conditions Hedging Instrument Hedging Relationship Hedged Item Conditions for Hedge Accounting introduces significant changes to effectiveness test Hedge qualification has been overhauled and now based on principle of an economic relationship Effectiveness assessments are now qualitative and forward looking, rather than cumbersome bright lines A Hedging Relationship qualifies for Hedge Accounting if and only if all the Conditions for Hedge Accounting are met 2006-15 Nelson Consulting Limited 70 35

Hedging Hedge Accounting Conditions IAS 39 All 5 Conditions for Hedge Accounting must be met: Formal documentation at inception Highly effective and consistent with originally documented risk Forecasted transaction to be highly probable (for cash flow hedge) Hedge effectiveness can be reliably measured Conditions for Hedge Accounting Ongoing-assessed and actually highly effective 2006-15 Nelson Consulting Limited 71 Hedging Hedge Accounting Conditions IAS 39 Formal documentation at inception At the inception of the hedge, there is formal designation and documentation of: the hedging relationship and the entity s risk management objective and strategy for undertaking the hedge. That documentation shall include: identification of the hedging instrument, the hedged item or transaction, the nature of the risk being hedged and how the entity will assess the hedging instrument s effectiveness in offsetting the exposure to changes in the hedged item s fair value or cash flows attributable to the hedged risk. Hedge Effectiveness 2006-15 Nelson Consulting Limited 72 36

Hedging Hedge Accounting Conditions IAS 39 Forecasted transaction to be highly probable (for cash flow hedge) For Cash Flow Hedges, a forecast transaction that is the subject of the hedge must be highly probable and must present an exposure to variations in cash flows that could ultimately affect profit or loss. 2006-15 Nelson Consulting Limited 73 Hedging Hedge Accounting Conditions IAS 39 Measurable and highly effective hedge from the beginning to the end Highly effective and consistent with originally documented risk The hedge is expected to be highly effective in achieving offsetting changes in fair value or cash flows attributable to the hedged risk, consistently with the originally documented risk management strategy for that particular hedging relationship. Hedge effectiveness can be reliably measured Ongoing-assessed and actually highly effective The effectiveness of the hedge can be reliably measured, i.e. the fair value or cash flows of the hedged item that are attributable to the hedged risk and the fair value of the hedging instrument can be reliably measured. The hedge is assessed on an ongoing basis and determined actually to have been highly effective Hedge throughout the financial reporting periods Effectiveness for which the hedge was designated. 2006-15 Nelson Consulting Limited 74 37

Hedging Hedge Accounting Conditions revises the conditions Hedging relationship The hedging relationship consists only of eligible hedging instruments and eligible hedged items Formal documentation at inception Meets all hedge effectiveness requirements At the inception of the hedging relationship there is formal designation and documentation of the hedging relationship and the entity s risk management objective and strategy for undertaking the hedge That documentation shall include identification of the hedging instrument, the hedged item, the nature of the risk being hedged and how the entity will assess whether the hedging relationship meets the hedge effectiveness requirements (including its analysis of the sources of hedge ineffectiveness and how it determines the hedge ratio) 2006-15 Nelson Consulting Limited 75 Hedging Hedge Accounting Conditions revises the conditions Meets all hedge effectiveness requirements i) there is an economic relationship between the hedged item and the hedging instrument; ii) the effect of credit risk does not dominate the value changes that result from that economic relationship; and iii) the hedge ratio of the hedging relationship is the same as that resulting from the quantity of the hedged item that the entity actually hedges and the quantity of the hedging instrument that the entity actually uses to hedge that quantity of hedged item. However, that designation shall not reflect an imbalance between the weightings of the hedged item and the hedging instrument that would create hedge ineffectiveness (irrespective of whether recognised or not) that could result in an accounting outcome that would be inconsistent with the purpose of hedge accounting 2006-15 Nelson Consulting Limited 76 38

Hedging Hedge Accounting Hedging Instrument Hedging Relationship Hedged Item retains the mechanics of 3 types of hedge accounting Conditions for Hedge Accounting Hedge Accounting If a Hedging Relationship meets all the Conditions for Hedge Accounting, the Hedge Accounting in respect of that Hedge Relationship can be used. Fair Value Hedge Cash Flow Hedge Hedge of Net Investment in a Foreign Operation 2006-15 Nelson Consulting Limited 77 Hedging Hedge Accounting Fair Value Hedge Hedging Instrument Hedging instrument s change in fair value recognised in P/L Income Statement Hedged Item adjust its carrying amount Hedged item s gain or loss attributable to the hedged risk shall adjust its carrying amount and be recognised in P/L Even the Hedged Item is measured at Cost (say HTM investment) or Fair Value through other comprehensive income (AFS financial assets) 2006-15 Nelson Consulting Limited 78 39

Hedging Hedge Accounting Example Interest Rate Swap on A Fixed Rate Financial Asset Company A purchases a bond that has a principal amount of $1 million at a fixed interest rate of 6% per year. is classified as an available-for-sale financial asset. has a fair value of $1 million. The company enters into an interest rate swap. It exchanges the fixed interest rate payments it receives on the bond for floating interest rate payments, in order to offset the risk of a decline in fair value. It designates and documents the swap as a hedging instrument. The swap has a fair value of zero at the inception of hedge. Assuming The market interest rates have increased to 7% and the fair value of the bond will have decreased to $960,000. The fair value of the swap has increased by $40,000. 2006-15 Nelson Consulting Limited 79 Hedging Hedge Accounting Example The instrument is classified as available-for-sale, therefore the decrease in fair value would normally be recorded directly in reserves. However, since the instrument is a Hedged Item in a Fair Value Hedge, this change in fair value of the instrument is recognised in profit or loss, as follows: Dr Income statement $40,000 Cr Available-for-sale financial asset $40,000 While the swap is a derivative, it is measured at fair value with changes in fair value recognised in profit or loss. Dr Swap receivables $40,000 Cr Income statement $40,000 The changes in fair value of the Hedged Item and the Hedging Instrument exactly offset each other: the hedge is 100% effective and the net effect on profit or loss is zero. 2006-15 Nelson Consulting Limited 80 40

Hedging Hedge Accounting Cash Flow Hedge Hedging Instrument gain or loss to other comprehensive income Statement Other of Effective Comprehensive Change in Portion income Equity Ineffective Portion gain or loss to P/L Income Statement How s the treatment, if it is.. Hedge of a forecast transaction resulting in recognition of Financial Asset or Financial Liability Hedge of forecast transaction resulting in recognition of n-financial Asset or n-financial Liability 2006-15 Nelson Consulting Limited 81 Hedging Hedge Accounting Cash Flow Hedge Effective Portion Other Comprehensive income Hedging Instrument Ineffective Portion Income Statement Hedge of a forecast transaction resulting in recognition of Financial Asset or Financial Liability Reclassified associated gain or loss recognised in OCI to P/L in case of Final recognition of financial assets or financial liabilities, or Loss recognised other comprehensive income is expected not to be recovered 2006-15 Nelson Consulting Limited 82 41

Hedging Hedge Accounting Cash Flow Hedge Hedging Instrument Effective Portion Ineffective Portion Still reclassified associated gain or loss recognised in OCI to P/L when Loss recognised in other comprehensive income is expected not to be recovered Associated gain or loss will also be either a) reclassified to P/L, or b) included in cost of assets or liabilities Other Comprehensive income Income Statement Hedge of forecast transaction resulting in recognition of n-financial Asset or n-financial Liability Cost of asset or liability 2006-15 Nelson Consulting Limited 83 (a) (b) Once adopt either (a) or (b) then, apply consistently Hedging Hedge Accounting HKFRS 9 Cash Flow Hedge Hedging Instrument Effective Portion Ineffective Portion Still reclassified associated gain or loss recognised in OCI to P/L when Loss recognised in other comprehensive income is expected not to be recovered Associated gain or loss will be included in cost of assets or liabilities Other Comprehensive income Income Statement Hedge of forecast transaction resulting in recognition of n-financial Asset or n-financial Liability Cost of asset or liability Accounting policy choice to reclassify OCI to P/L is abolished OCI can only be included in cost of asset/liability 2006-15 Nelson Consulting Limited 84 42

Hedging Hedge Accounting Cash Flow Hedge For cash flow hedges other than those discussed amounts that had been recognised in other comprehensive income shall be recognised in profit or loss in the same period(s) during which the hedged forecast transaction affects P/L (for example, when a forecast sale occurs). Hedge of a forecast transaction Other Cash Flow Hedges of forecast transaction resulting in recognition of resulting in recognition of Financial Asset or n-financial Asset or Financial Liability n-financial Liability 2006-15 Nelson Consulting Limited 85 Hedging Hedge Accounting Example Hedge of Forecast Transaction Entity A trades in UK mainly in UK Sterling. It expects to purchase a machine for 1 million Euros in one year from 1 May 2006. In order to offset the risk of increases in the Euro rate, Entity A enters into a forward contract to purchase 1 million Euros in 1 year for a fixed amount ( 650,000). The forward contract is designated as a Cash Flow Hedge. At inception, the forward contract has a fair value of zero. At the year-end of 31 October 2006 the Euro has appreciated and the value of 1 million Euros is 660,000. The fair value of the forward contract rises to 10,000. The machine will still cost 1 million Euros so the company concludes that the hedge is 100% effective. 2006-15 Nelson Consulting Limited 86 43

Hedging Hedge Accounting Example The entire change in the fair value of the hedging instrument is recognised directly in reserves. Dr Forward contract 10,000 Cr Other comprehensive income 10,000 How to treat this amount finally? The forward contract is settled with no further change in the exchange rate: Dr Cash 10,000 Cr Forward contract 10,000 The company purchases the machine for 1 million euros and makes the following journal entry: Dr Machine 660,000 Cr Accounts Payable 660,000 The gain of 10,000 recognised in OCI should either be reclassified from OCI (equity) into P/L, or be reclassified from OCI (equity) and included in the initial carrying amount of the machine (for non-financial assets or liabilities only) once this policy is chosen, it must be used consistently 2006-15 Nelson Consulting Limited 87 Hedging Hedge Accounting Hedge of Net Investment in a Foreign Operation Hedging Instrument Effective Portion Ineffective Portion Including a hedge of a monetary item that is accounted for as part of the net investment, shall be accounted for similarly to Cash Flow Hedges: a) the portion of the gain or loss on the Hedging Instrument that is determined to be an effective hedge shall be recognised in other comprehensive income; and b) the ineffective portion shall be recognised in profit or loss. The gain or loss on the hedging instrument relating to the effective portion of the hedge that has been recognised in other comprehensive income shall be reclassified from equity to profit or loss as a reclassification adjustment in accordance with IAS 21.48-49 on the disposal or partial disposal of the foreign operation. 2006-15 Nelson Consulting Limited 88 44

Hedging Hedge Accounting Hedge of Net Investment in a Foreign Operation Effective Portion Other Comprehensive income Hedging Instrument Ineffective Portion Income Statement Recognise in P/L on disposal of the foreign operation 2006-15 Nelson Consulting Limited 89 Hedge Cease Hedge Accounting An entity shall discontinue prospectively the Hedge Accounting if: a) the hedging instrument expires or is sold, terminated or exercised; b) the hedge no longer meets the Conditions for Hedge Accounting; c) the entity revokes the designation; or d) in case of a Cash Flow Hedge, the forecast transaction that is hedged is no longer expected to occur. When the Hedge Accounting is discontinued (for Cash Flow Hedge), the cumulative gain or loss on the Hedging Instrument that remains recognised in other comprehensive income shall: a) remain separately in equity until the forecast transaction occurs; or b) be reclassified from equity to profit or loss as a reclassification adjustment if the forecast transaction is no longer expected to occur. 2006-15 Nelson Consulting Limited 90 45

Today s Agenda Presentation Presentation of financial instruments, incl. to separate financial liabilities from equity 2006-15 Nelson Consulting Limited 91 IAS 32 Presentation Presentation from the perspective of the issuer on Liability and equity Compound financial instruments Treasury shares Interests, dividends, losses and gains The issuer of a financial instrument shall classify the instrument, or its component parts, on initial recognition as a financial liability, a financial asset or an equity instrument in accordance with the substance of the contractual arrangement and the definitions of a financial liability, a financial asset and an equity instrument. (assess the substance) Offsetting 2006-15 Nelson Consulting Limited 92 46

IAS 32 Presentation An issuer applies the definitions of financial instruments to determine Liability and equity Contractual obligations to deliver cash or another financial assets Contractual obligations to exchange financial assets or financial liabilities with another entity under conditions that are potentially unfavourable to the issuer Under a non-derivative that includes contractual obligation to deliver a variable no. of its own equity instrument Under a derivative that will be settled only by the issuer exchanging a fixed amount of cash or another financial asset for a fixed no. of its own equity instrument Equity instrument Financial liability 2006-15 Nelson Consulting Limited Sourced from Intermediate Financial Reporting (2012) by Nelson Lam and Peter Lau 93 IAS 32 Presentation Presentation from the perspective of the issuer on Example Liability and equity Are the following financial liabilities or equity instruments? A contract to deliver as many of the entity s own equity instruments as are equal in value to $10,000. A contract to deliver as many of the entity s own equity instruments as are equal in value to the value of 100 ounces of gold. Financial liability Financial liability Such a contract is a financial liability of the entity even though the entity must or can settle it by delivering its own equity instruments. It is not an equity instrument because the entity uses a variable number of its own equity instruments as a means to settle the contract. 2006-15 Nelson Consulting Limited 94 47