Investments for NPO/NGO 24 May 2006 Nelson Lam CFA FCCA FCPA(Practising) MBA MSc BBA CPA(US) ACA 2005-06 Nelson 1 Before 2005 / 2006 Case Accounting policy (2004/05) on long-term (partial): Unlisted guaranteed funds and listed equity securities which are intended to be held on a continuing basis, and which are held for an identified long term purpose documented at the time of acquisition or change of purpose and are clearly identifiable for the documented purpose. They are stated at cost less any provision for impairment loss, assessed on an individual basis. Dated debt securities that the Council has the ability and intention to hold to maturity are classified as held-to-maturity securities. Held-to-maturity securities are stated in the balance sheet at cost plus/less any discount or premium amortised to date less any provision for impairment loss. Certificates of deposit are stated at cost. 2005-06 Nelson 2 1
Measurement Before 2005 / 2006 SSAP 24 Held-to-maturity debt securities at Amortised Cost less provision Investments were originally accounted for in accordance with SSAP 24 Accounting for investment in securities Benchmark treatment Investment securities Other Alternative treatment Trading securities at Cost less provision Effective for the period beginning on or after 1 Jan. 2005, all are termed as financial, which should be accounted for and presented in accordance with HKAS 32 and HKAS 39 n-trading securities through Equity 2005-06 Nelson 3 Before 2005 / 2006 But w HKAS 32 Disclosure and presentation HKAS 39 Recognition and measurement The most interesting standards The most lengthiest standards The most complex standards Cover some unusual or more complex contracts But also cover some very simple elements in the financial statements, for example: Cash, trade receivable Share capital, trade payable, bank loans Many addition and amendments as well, including HKFRS 7 Disclosure 2005-06 Nelson 4 2
Today s Agenda Summary of Changes Scope Definitions Initial Recognition Measurement Extended the scope to all contract to buy and sell of non-financial items that meet the scope. instruments, including derivatives, are clearly defined. All financial instruments, including derivatives, are recognised in the balance sheet (on balance sheet). Except for strict conditions are fulfilled, all financial are measured at fair value Presentation and Disclosure Specific rules and requirements To be amended in 2007 / 2008 Simple but Comprehensive Key Issues Cases and Examples 2005-06 Nelson 5 Investments for NPO/NGO Case Hang Seng Bank (2004 Annual Report) On 1 January 2005, the Group has reclassified most of its Held-to-Maturity debt securities as Available-for-Sale securities. The change in fair value will cause volatility to the shareholders' equity. Why reclassified most? Why volatility to equity? 2005-06 Nelson 6 3
Scope of HKAS 32 and 39 Scope 2005-06 Nelson 7 Scope Excluded from HKAS 32 and 39 Interests in subsidiaries, associates and joint ventures accounted for under HKAS 27, 28 and 31 Rights and obligations under leases to which HKAS 17 applies except for derecognition and embedded derivatives Employers rights and obligations under employee benefit plans, to which HKAS 19 applies instruments issued by the entity that meet the definition of an equity instrument in HKAS 32 Rights and obligations under an insurance contract as defined in HKFRS 4, except for embedded derivatives Contracts for contingent consideration in a business combination (see HKFRS 3) for the acquirer only Contracts between an acquirer and a vendor in a business combination to buy or sell an acquiree at a future date Certain loan commitments (HKAS 37 and 18) Instruments and obligations under share-based payment transactions (HKFRS 2), except for some contracts Rights to payment to reimburse a recognised provision under HKAS 37 HKFRS 7 HKAS 32 HKAS 39 2005-06 Nelson 8 4
Definitions Scope Definitions instruments, including derivatives, are clearly defined. 2005-06 Nelson 9 Definitions A financial instrument is is any any contract that that gives rise rise to to 1. 1. a financial asset of of one one entity, and and 2. 2. a financial liability or or equity instrument of of another equity instrument asset liability or Equity instrument of one entity of another entity 2005-06 Nelson 10 5
Definitions Instruments asset is any asset that is: Cash An equity instrument of another entity A contractual right i) to receive cash or another financial asset from another entity ii) to exchange financial or financial liabilities with another entity under conditions that are potentially favourable to the entity A contract that will or may settled in the entity s own equity instruments and is i) 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 ii) 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 instruments that are themselves contracts for the future receipt or delivery of the entity s own equity instruments.) instrument asset liability or Equity instrument Derivative 2005-06 Nelson 11 Definitions Instruments liability is any liability that is A contractual right i) to deliver cash or another financial asset from another entity ii) to exchange financial or financial liabilities with another entity under conditions that are potentially unfavourable to the entity A contract that will or may settled in the entity s own equity instruments and is i) 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 ii) 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 instruments that are themselves contracts for the future receipt or delivery of the entity s own equity instruments.) instrument asset liability or Equity instrument Derivative 2005-06 Nelson 12 6
Definitions Instruments Equity instruments is any contract that evidences a residual interest in the of an entity after deducting all of its liabilities instrument asset liability or Derivative Equity instrument 2005-06 Nelson 13 Definitions Instruments Derivative Value change based on on an an underlying Little or or no no initial net investment Settled at at a future date instrument is a financial instrument or other contract within the scope of HKAS 39 with all 3 of the following characteristics: a) its value changes in response to the change in a specified interest rate, financial instrument price, commodity price, foreign exchange rate, index of prices or rates, credit rating or credit index, or other variable (sometimes called the underlying ); b) it requires no initial net investment or an initial net investment that is smaller than would be required for other types of contracts that would be expected to have a similar response to changes in market factors; and c) it is settled at a future date. asset liability or Equity instrument Derivative 2005-06 Nelson 14 7
Definitions Instruments Derivative Typical example: Future and forward Swap and options Value change based on on an an underlying Little or or no no initial net investment Settled at at a future date Type of contract Interest Rate Swap Currency Swap (Foreign Exchange Swap) Commodity Swap Equity Swap Credit Swap Total Return Swap Purchased or Written Treasury Bond Option Purchased or Written Currency Option Currency Futures/Forward Commodity Futures/Forward Equity Forward Underlying variable Interest rates Currency rates Currency rates Currency rates Commodity prices Example Commodity prices Equity prices (equity of another entity) Credit rating, credit index or credit price Total fair value of the reference asset and interest rates Interest rates Equity prices 2005-06 Nelson 15 Initial Recognition Scope Definitions Initial Recognition All financial instruments, including derivatives, are recognised in the balance sheet (on balance sheet). 2005-06 Nelson 16 8
Initial Recognition instrument asset liability An entity shall recognise a financial asset or a financial liability on its balance sheet when and only when the entity becomes a party to the contractual provisions of the instruments Implies trade date accounting Except for a regular way purchase or sale of financial (to be discussed) Initial Recognition Trade Date Accounting Regular Way of Assets As a consequence of this principle, an entity recognise all of its contractual rights and obligations under derivatives in its balance sheet as and liabilities respectively. Examples: Committing to a purchase of equity securities Committing to write a derivative option 2005-06 Nelson 17 Initial Recognition instrument asset liability When a financial asset or financial liability is recognised initially, an entity shall measure the financial asset or a financial liability at its fair value,plus transaction costs except for those classified at fair value through profit or loss Why? Initial Recognition Trade Date Accounting transaction cost will be initially recognised for financial instruments at fair value through profit or loss Regular Way of Assets Initial Measurement Fair Value 2005-06 Nelson 18 + Transaction Cost 9
Initial Recognition asset 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. A regular way purchase or sale of financial shall be recognised (and derecognised) using either trade date accounting, or settlement date accounting The method used is applied consistently for all purchases and sales of financial that belong to the same category of financial Derivative A contract that requires or permits net settlement of the change in the value of the contract is NOT a regular way contract. Initial Recognition Instead, such a contract is accounted for as Regular Way Trade Date of a derivative Accounting the period Assets between the trade date and the settlement date 2005-06 Nelson 19 Initial Recognition asset Derivative Example Regular Way Contract Entity ABC enters into a forward contract, which allows ABC to purchase 1 million M s ordinary shares in 2 months for $10 per share is with an individual person and is not an exchange-traded contract requires ABC to take physical delivery of the shares and pay the counterparty $10 million in cash M s shares trade in an active public market at an average of 100,000 shares a day and regular way delivery is 3 days. Is the forward contract regarded as a regular way contract?.. The The contract must be be accounted for for as as a derivative. Because it it is is not not settled in in the the way way established by by regulation or or convention in in the the marketplace concerned. 2005-06 Nelson 20 10
Initial Recognition Example Fair value at Initial Recognition Low Interest Loan Entity A grants a 3-year loan of $50,000 to an important new customer The interest rate on the loan is 4%, while the current market lending rates for similar loans to customers with a similar credit risk profile is 6% Entity A believes that the future business to be generated with this new customer will lead to a profitable lending relationship. On On initial recognition, Entity A should recognise the the carrying amount of of the the loan loan at at the the fair fair value of of the the payments that that it it will will receive from from the the customer. Discounting the the interest and and principal repayments using the the market rate rate of of 6%, 6%, Entity A will will recognise an an originated loan loan of of $47,328. The The difference of of $2,672 is is expensed immediately as as the the expectation about future lending relationships does not not qualify for for recognition as as an an intangible asset. 2005-06 Nelson 21 Measurement after Recognition Scope Definitions Initial Recognition Measurement For measurement after recognition, except for strict conditions are fulfilled, all financial are measured at fair value 4-category classification will affect the subsequent measurement of of financial (but not the initial measurement). 2005-06 Nelson 22 11
Classification for Measurement Loans and receivables instrument asset liability 1. Classification 2. Measurement after recognition 3. Impairment 4. Reclassification 4-category classification will affect the subsequent measurement of of financial (but not the initial measurement). 2005-06 Nelson 23 Classification for Measurement asset Definition for Assets A financial asset that meets one of the following 2 conditions. a. It is classified as held for trading, if it is: An entity has NO choice i. acquired or incurred principally for the purpose of selling or repurchasing it in the near term; ii. part of a portfolio of identified financial instruments that are managed together and for which there is evidence of a recent actual pattern of short-term profittaking; or iii.a derivative (except for a derivative that is a designated and effective hedging instrument). b. Upon initial recognition it is designated by the entity An entity has a choice as at fair value through profit or loss, except for in equity instruments that do not have a quoted price in an active market, But new requirements and whose fair value cannot be reliably measured. for 2006 2005-06 Nelson 24 12
Classification for Measurement asset A Held for trading (or Asset derivative)? Upon initial recognition, designated at through (if P/L? allowed)? Derivative? Designated and effective hedging instrument? Hedge Accounting New requirements in 2006 The Fair Value Option (Jul. 2005) To be discussed later Restrict a company s option in designating a financial asset (or financial liability) at FV Only allow to designate if conditions are met 3 Conditions to Designate 2005-06 Nelson 25 Classification for Measurement asset Definition for Assets Effective from 1.1.2006: Upon initial recognition, an entity may designate a financial asset or financial liability as at fair value through profit or loss only: when permitted by paragraph 11A of HKAS 39 (in order to avoid separation of embedded derivative from hybrid contract), or when doing so results in more relevant information, because either i) it eliminates or significantly reduces a measurement or recognition inconsistency ii) financial, financial liabilities or both is managed and its performance is evaluated on a fair value basis 1. Embedded Derivative Condition 2. Eliminates Inconsistency 3. Managed on Fair Value Basis 3 Conditions to Designate 2005-06 Nelson 26 13
Classification for Measurement asset Definition for Available-for-sale financial Those non-derivative financial that are designated as available for sale, or An entity has a choice Those not classified into other categories Implies Except for those held for trading, all the remaining financial can be designated as Loans and receivables and can also be initially designated as 2005-06 Nelson 27 Classification for Measurement Case asset In its 2005 Interim Report, full set of HKFRS was adopted and the report set out that: Available-for-sale financial are non-derivatives that are either designated in this category or not classified in any of the other categories (i.e. loans and receivables, financial at fair value through profit or loss and held-to-maturity ). They are included in non-current unless management intends to dispose of the investment within 12 months of the balance sheet date. 2005-06 Nelson 28 14
Classification for Measurement asset A Held for trading (or Asset derivative)? Upon initial recognition, designated at (if allowed)? Designated as AFS financial? Derivative? Designated and effective hedging instrument? Hedge Accounting To be discussed later 2005-06 Nelson 29 Classification for Measurement asset Definition for Held-to-Maturity Investments n-derivative financial with fixed or determinable payments and fixed maturity That the entity has the positive intention and ability to hold to maturity, other than those initially designated as those designated as those that meet the definition of loans and receivables A debt instrument with a variable interest rate can satisfy the criteria for a investment. Equity instruments cannot be either because they have an indefinite life (such as ordinary shares) or because the amounts the holder may receive can vary in a manner that is not predetermined (such as for share options, warrants and similar rights). 2005-06 Nelson 30 15
Classification for Measurement asset Example Definition for Held-to-Maturity Investments ABC Co. buys the following listed notes and intends to hold them to maturity: 5% 5-Year note HIBOR 3-Year bank note 10% 1-year equity-linked note (at maturity, ABC co. can receive either principal with interest or HSBC shares if the price of HSBC shares falls below $120 each) but the put option element shall be separated and accounted for as Embedded Derivative (not to be discussed today) 2005-06 Nelson 31 Classification for Measurement asset Example Definition for Held-to-Maturity Investments Bond with index-linked interest Entity A buys a bond with a fixed payment at maturity and a fixed maturity date. The bond s interest payments are indexed to the price of a commodity or equity. Entity A has positive intention and ability to hold the bond to maturity. Can Entity A classify the bond as a investment?.. However, the the commodity-indexed or or equity-indexed interest payments result in in an an Embedded Derivative that that is is separated and and accounted for for as as a derivative at at fair fair value. 2005-06 Nelson 32 16
Classification for Measurement asset Subject to to Tainting Rule below Definition for Held-to-Maturity Investments An entity shall not classify any financial as held to maturity if the entity has, during the current financial year or during the two preceding financial years, sold or reclassified more than an insignificant amount of held-tomaturity before maturity (more than insignificant in relation to the total amount of held-tomaturity ) The sales or reclassifications are exempted from the above Tainting Rule if they: are so close to maturity or the financial asset s call date (for example, less than 3 months before maturity) that changes in the market rate of interest would not have a significant effect on the financial asset s fair value; occur after the entity has collected substantially all of the financial asset s original principal through scheduled payments or prepayments; or are attributable to an isolated event that is beyond the entity's control, is nonrecurring and could not have been reasonably anticipated by the entity. 2005-06 Nelson 33 Classification for Measurement Subject to to Tainting Rule below asset Example Definition for Held-to-Maturity Investments Sale of Entity A sells $1,000 bonds from its portfolio with $5,000 bonds on interim date of 2003 before the bonds will be matured in 2007. Since Entity A wants to realise the appreciation in market price of the bonds. The The disposed bonds would be be over over an an insignificant amount of of the the whole portfolio and and it it is is not not an an exemption from from Tainting Rule. The The sale sale of of part part of of the the portfolio taints that that the the entire portfolio and and all all remaining in in the the category must be be reclassified. Entity A will will be be prohibited from from classifying any any as as for for 2 full full financial years, until until the the year year of of 2006. 2005-06 Nelson 34 17
Classification for Measurement Subject to to Tainting Rule below asset Example Definition for Held-to-Maturity Investments Downgrade of Credit Rating Would a sale of a held-to-maturity investment following a downgrade of the issuer s credit rating by a rating agency raise a question about the entity s intention to hold other to maturity? t t necessarily A downgrade is is likely likely to to indicate a decline decline in in the the issuer s creditworthiness. HKAS HKAS 39 39 specifies that that a sale sale due due to to a significant deterioration in in the the issuer s creditworthiness could could satisfy satisfy the the condition in in HKAS HKAS 39 39 and and therefore not not raise raise a question about about the the entity s entity s intention to to hold hold other other to to maturity. However, the the deterioration in in creditworthiness must must be be significant judged judged by by reference to to the the credit credit rating rating at at initial initial recognition. Also, Also, the the rating rating downgrade must must not not have have been been reasonably anticipated when when the the entity entity classified the the investment as as held held to to maturity in inorder to to meet meet the the condition in in HKAS HKAS 39. 39. 2005-06 Nelson 35 Classification for Measurement Subject to to Tainting Rule below asset Example Definition for Held-to-Maturity Investments Different categories of Investments Can an entity apply the Tainting Rule for held-to-maturity classification separately to different categories of, such as debt instruments denominated in US dollars and debt instruments denominated in Euro?.. The The Tainting Rule is is clear if if an an entity has has sold sold or or reclassified more than than an an insignificant amount of of, it it cannot classify any any financial as as. 2005-06 Nelson 36 18
Classification for Measurement Subject to to Tainting Rule below asset Example Definition for Held-to-Maturity Investments Different entities in a group Can an entity apply the Tainting Rule separately to held by different entities in a consolidated group, for example, if those group entities are in different countries with different legal or economic environments?.. If If an an entity has has sold sold or or reclassified more than than an an insignificant amount of of classified as as held-to-maturity in in the the consolidated financial statements, it it cannot classify any any financial as as in in the the consolidated financial statements unless the the exemption conditions in in HKAS 39 39 are are met. met. 2005-06 Nelson 37 Classification for Measurement Case Hang Seng Bank (2004 Annual Report) asset On 1 January 2005, the Group has reclassified most of its Held-to-Maturity debt securities as Available-for-Sale securities. The change in fair value will cause volatility to the shareholders' equity. On transition, the revaluation gain or loss will be adjusted through a reserve in the shareholder s equity. restatement of the 2004 accounts is required. Explained why! Why volatility to equity? to be discussed later 2005-06 Nelson 38 19
Classification for Measurement asset A Held for trading (or Asset derivative)? Upon initial recognition, designated at (if allowed)? Designated as AFS financial? With fixed/determinable payments? With fixed maturity? Has positive intention and ability to hold to maturity and fulfils tainting rule? Derivative? Designated and effective hedging instrument? Hedge Accounting To be discussed later 2005-06 Nelson 39 Classification for Measurement asset Loans and receivables Definition n-derivative financial with fixed or determinable payments that are not quoted in an active market, other than those the entity intends to sell immediately or in the near term (which shall be classified as held for trading) those initially designated as those initially designated as those for which the holder may not recover substantially all of its the initial investment, other than because of credit deterioration, which shall be classified as An interest acquired in a pool of that are not loans or receivables is not a loan or receivable (for example, an interest in a mutual fund or a similar fund). Examples include: loan, trade receivables, rental deposits, deposits held by banks 2005-06 Nelson 40 20
Classification for Measurement asset Loans and receivables Definition Example Classification of Investment in Preference Share Can an equity instrument, such as a preference share, with fixed or determinable payments be classified within loans and receivables by the holder?.. If If a non-derivative equity equity instrument would would be be recorded as as a liability liability by bythe issuer, issuer, and and it it has has fixed fixed or or determinable payments and and is is not not quoted quoted in in an an active active market, market, it it can can be be classified within within loans loans and and receivables by by the the holder, holder, provided the the definition is is otherwise met. met. HKAS HKAS 32 32 provides guidance about about the the classification of of a financial instrument as as a liability liability or or as as equity equity from from the the perspective of of the the issuer issuer of of a financial instrument. If If an an instrument meets meets the the definition of of an an equity equity instrument under under HKAS HKAS 32, 32, it it cannot cannot be be classified within within loans loans and and receivables by by the the holder. holder. 2005-06 Nelson 41 Classification for Measurement asset A Asset Held for trading (or derivative)? Upon initial recognition, designated at (if allowed)? Designated as AFS financial? With fixed/determinable payments? With fixed maturity? Has positive intention and ability to hold to maturity and fulfils tainting rule? With quote in an active market? May recover With quote in substantially all an active market? initial Derivative? Designated and effective hedging instrument? Hedge Accounting To be discussed later Loans and 2005-06 Nelson receivables 42 21
Measurement after Recognition Scope Definitions Initial Recognition Measurement Except for strict conditions are fulfilled, all financial are measured at fair value 2005-06 Nelson 43 Measurement after Recognition Classification determine Subsequent Measurement Loans and receivables at Cost at Amortised Cost at Amortised Cost Except for in equity instruments that do not have a quoted market price in an active market, and whose fair value cannot be reliably measured How does such classification affect the subsequent measurement? 2005-06 Nelson 44 22
Measurement after Recognition A Held for trading (or Asset derivative)? Upon initial recognition, designated at? Designated as AFS financial? With fixed/determinable payments? With fixed maturity? Has positive intention and ability to hold to maturity and fulfils tainting rule? With quote in an active market? May recover With quote in substantially all an active market? initial Derivative? Designated and effective hedging instrument? Hedge Accounting To be discussed later Has a quote at active Has a quote at active market or fair value can market or fair value can be reliably measured? be reliably measured? Loans and Cost at receivables at at less Impairment 2005-06 Nelson amortised cost amortised cost fair value 45 Measurement after Recognition Subsequent Measurement Loans and receivables Gain or loss to Profit or loss Gain or loss to Equity at Cost at Amortised Cost using the effective interest method at Amortised Cost using the effective interest method 2005-06 Nelson 46 23
Measurement after Recognition Subsequent Measurement Loans and receivables Gain or loss shall be recognised in profit or loss Gain or loss recognised directly in equity at Cost Except for Impairment losses and at Amortised Cost Foreign exchange gains and losses (financial asset is treated as if it were at Amortised Cost carried at amortised cost in the foreign currency for translation purpose) Cumulative gain or loss recognised directly in equity shall be transferred to profit or loss on derecognition of the financial asset 2005-06 Nelson 47 Measurement after Recognition Fair value is the amount for which an asset could be exchanged, or a liability settled, between knowledgeable, willing parties in an arm s length transaction. Active market exists A financial instrument is regarded as quoted in an active market if quoted prices are readily and regularly available from an exchange and similar entities. The existence of published price quotations in an active market is the best evidence of fair value and when they exist they should be used to measure the financial asset (or financial liability) For an asset held (or liability to be issued) Current bid price For an asset to be acquired (liability held) Current ask price If the current bid and asking prices not available Price of most recent transaction 2005-06 Nelson 48 24
Measurement after Recognition Fair value is the amount for which an asset could be exchanged, or a liability settled, between knowledgeable, willing parties in an arm s length transaction. active market An entity establishes fair value by using a valuation technique To establish what the transaction price would have been on the measurement date in an arm s length exchange motivated by normal business considerations Valuation techniques include Using recent arm s length market transactions between knowledgeable, willing parties Discounted cash flow analysis Option pricing models 2005-06 Nelson 49 Measurement after Recognition Example Fair Value of Quoted Price Controller, Ms. Luk, manages a fund and the rules applicable to the fund require net asset values to be reported to investors on the basis of mid-market prices. In these circumstances, would it be appropriate for an investment fund to measure its on that basis in the balance sheet of the fund?.. The The existence of of regulations that that require require a different measurement for for specific purposes does does not not justify justify a departure from from the the general requirement in in HKAS HKAS 39 39 to to use use the the current current bid bid price pricein in the the absence of of a matching liability liability position. In In its its financial statements, an an investment fund fund measures its its at at current current bid bid prices. prices. In In reporting its its net net asset asset value value to to investors, an an investment fund fund may may wish wish to to provide provide a reconciliation between the the fair fair values values recognised on on its its balance sheet sheet and and the the prices prices used used for for the the net net asset asset value value calculation. 2005-06 Nelson 50 25
Measurement after Recognition Case Accounting policy on (annual report 2004/05): Investments of the Endowment Funds, Operations Fund, Liquid Fund and donated pending realisation are stated at their fair values based on their quoted market prices at the balance sheet date without any deduction for estimated future selling costs. Listed securities are priced at last traded prices while unlisted securities are priced at quoted market price available from a broker or dealer for non-exchange-traded financial instruments. Investments in unlisted open-ended investment funds are recorded at the net asset value per share as reported by the managers of such funds. Changes in fair value are recognised in the Income and Expenditure Statement as they arise. Any changes required? 2005-06 Nelson 51 Measurement after Recognition Case In its 2005 Interim Report, full set of HKFRS was adopted and the report set out that: The fair values of quoted are based on current bid prices. If the market for a financial asset is not active (and for unlisted securities), the Group establishes fair value by using valuation techniques. These include the use of recent arm s length transactions, reference to other instruments that are substantially the same, discounted cash flow analysis, and option pricing models refined to reflect the issuer s specific circumstances. 2005-06 Nelson 52 26
Measurement after Recognition Subsequent Measurement Loans and receivables at Cost at Amortised Cost at Amortised Cost Amortised cost of a financial instrument is: the amount at which the financial instrument is measured at initial recognition minus principal repayments, plus or minus the cumulative amortisation using the effective interest method of any difference between that initial amount and the maturity amount, and minus any reduction (directly or through the use of an allowance account) for impairment or uncollectibility. 2005-06 Nelson 53 Measurement Impairment Loans and receivables Subsequent Measurement at Cost at Amortised Cost at Amortised Cost Impairment At each balance sheet date assess whether there is any objective evidence that a financial asset (or group of financial ) is impaired. Conditions must be fulfilled in recognising impairment loss 2005-06 Nelson 54 27
Measurement Impairment Conditions for Impairment Outside Outside the the scope scope of of HKAS HKAS 36 36 A financial asset (or a group of financial ) is impaired and impairment losses are incurred if, and only if there is objective evidence of impairment as a result of one or more events that occurred after the initial recognition of the asset (a loss event ) and that loss event (or events) has an impact on the estimated future cash flows of the financial asset (or group of financial that) can be reliably estimated. It may not be possible to identify a single, discrete event that caused the impairment. Rather the combined effect of several events may have caused the impairment. Losses expected as a result of future events, no matter how likely, are not recognised. 2005-06 Nelson 55 Measurement Impairment Outside Outside the the scope scope of of HKAS HKAS 36 36 Impairment (if there is objective evidence) Loans and receivables Implicitly, no impairment review is needed as gain or loss on change in fair value is recognised in profit or loss 2005-06 Nelson 56 28
Measurement Impairment Loans and receivables at Cost at Amortised Cost at Amortised Cost Outside Outside the the scope scope of of HKAS HKAS 36 36 Impairment (if there is objective evidence) The amount of impairment loss is measured as the difference between the asset s carrying amount and the present value of estimated future cash flows (excluding future credit losses that have not been incurred) discounted at the financial asset s original effective interest rate (i.e. the effective interest rate computed at initial recognition) The carrying amount of the asset shall be reduced either directlyor through use of an allowance account. The amount of the loss shall be recognised in profit or loss. 2005-06 Nelson 57 Measurement Impairment Loans and receivables at Cost at Amortised Cost at Amortised Cost Outside Outside the the scope scope of of HKAS HKAS 36 36 Impairment (if there is objective evidence) Sequence of Impairment Assessment First assesses whether objective evidence of impairment exists individually for financial that are individually significant, and individually or collectively for financial that are not individually significant. 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 with similar credit risk characteristics and collectively assesses them for impairment. Assets that are individually assessed for impairment and for which an impairment loss is or continues to be recognised are not included in a collective assessment of impairment. 2005-06 Nelson 58 29
Measurement Impairment Outside Outside the the scope scope of of HKAS HKAS 36 36 Impairment (if there is objective evidence) Loans and receivables at Cost The amount of the impairment loss is measured as the difference between the carrying amount of the financial asset and the present value of estimated future cash flows discounted at the current market rate of return for a similar financial asset. 2005-06 Nelson 59 Measurement Impairment Loans and receivables Implication? Outside Outside the the scope scope of of HKAS HKAS 36 36 Impairment (if there is objective evidence) 2 conditions to effect impairment loss when a decline in the fair value of an AFS financial asset has been recognised directly in equity and there is objective evidence that the asset is impaired Then, the cumulative loss that had been recognised directly in equity shall be removed from equity and recognised in profit or loss even the asset has not been derecognised. The amount of the cumulative loss that is removed from equity and recognised in profit or loss shall be the difference between the acquisition cost (net of any principal repayment and amortisation) and the current fair value less any impairment loss on that financial asset previously recognised in profit or loss. 2005-06 Nelson 60 30
Measurement Impairment Example Impairment at Initial Recognition Entity A lends $2,000 to Customer B Based on past experience, Entity A expects that 1% of the principal amount of loans given will not be collectable. Can Entity A recognise an immediate impairment loss of $20?.. HKAS 39 39 requires financial asset to to be be initially measured at at fair fair value. For For a loan loan asset, the the fair fair value is is the the amount of of cash lent lent adjusted for for any any fees fees and and costs (unless a portion of of the the amount lent lent is is compensation for for other stated or or implied rights or or privileges). In In addition, HKAS 39 39 further requires that that an an impairment loss loss is is recognised only only if if there is is objective evidence of of impairment as as a result of of a past past event that that occurred after after initial recognition. Thus, it it is is inconsistent with with HKAS 39 39 to to reduce the the carrying amount of of a loan loan asset on on initial recognition through the the recognition of of an an immediate impairment loss. loss. 2005-06 Nelson 61 Measurement Impairment Example Impairment Based on Ageing Analysis Entity A calculates impairment in the unsecured portion of loans and receivables on the basis of a provision matrix that specifies fixed provision rates for the number of days a loan has been classified as non-performing as follows: 0% if less than 90 days 20% if 90-180 days 50% if 181-365 days, and 100% if more than 365 days Can the results be considered to be appropriate for the purpose of calculating the impairment loss on loans and receivables? t t necessarily. HKAS 39 39 requires impairment or or bad bad debt debt losses to to be be calculated as as the the difference between the the asset s carrying amount and and the the present value of of estimated future cash flows discounted at at the the financial instrument s original effective interest rate. rate. 2005-06 Nelson 62 31
Measurement Impairment Example Impairment on Portfolio Basis If one loan in Entity A is impaired but the fair value of another loan in Entity A is above its amortised cost. Does HKAS 39 allow non-recognition of the impairment of the first loan?.. If If an an entity entity knows knows that that an an individual financial asset asset carried carried at atamortised cost cost is is impaired, HKAS HKAS 39 39 requires that that the the impairment of of that that asset asset should should be be recognised. HKAS HKAS 39 39 states: states: the the amount amount of of the the loss loss is is measured as as the the difference between the the asset s carrying amount amount and and the the present present value value of of estimated future future cash cash flows flows (excluding future future credit credit losses losses that that have have not not been been incurred) discounted at at the the financial asset s asset s original original effective interest interest rate. rate. Measurement of of impairment on on a portfolio basis basis under under HKAS HKAS 39 39 may maybe be applied applied to to groups groups of of small small balance items items and and to to financial that that are are individually assessed and and found found not not to to be be impaired when when there there is is indication of of impairment in in a group group of of similar similar and and impairment cannot cannot be beidentified with with an an individual asset asset in in that that group. group. 2005-06 Nelson 63 Measurement Impairment Example Aggregate Fair Value Less Than Carrying Amount HKAS 39 requires that gains and losses arising from changes in fair value on are recognised directly in equity. If the aggregate fair value of such is less than their carrying amount, should the aggregate net loss that has been recognised directly in equity be removed from equity and recognised in profit or loss? t t necessarily. The The relevant criterion is is not not whether the the aggregate fair fair value value is is less less than than the the carrying amount, but but whether there there is is objective evidence that that a financial asset asset or or group group of of is is impaired. An An entity entity assesses at at each each balance sheet sheet date date whether there there is is any any objective evidence that that a financial asset asset or or group group of of may may be be impaired. HKAS HKAS 39 39 states states that that a downgrade of of an an entity s entity s credit credit rating rating is is not, not, of of itself, itself, evidence of of impairment, although it it may may be be evidence of of impairment when when considered with with other other available information. Additionally, a decline decline in in the the fair fair value value of of a financial asset asset below below its its cost cost or or amortised cost cost is is not not necessarily evidence of of impairment (e.g. (e.g. a decline decline in in the the fair fair value value of of a bond bond resulting from from an an increase in in the the basic basic risk-free interest interest rate). rate). 2005-06 Nelson 64 32
Measurement Impairment Case Hang Seng Bank (2004 Annual Report) Provisions for bad and doubtful debts The current accounting policy on provisions for bad and doubtful debts is set out in note 3(c) above. te 3(c) states that: It is the Group s policy to make provisions for bad and doubtful debts promptly where required and on a prudent and consistent basis. There are two basic types of provisions, specific and general, each of which is considered in terms of the charge and the amount outstanding. 2005-06 Nelson 65 Measurement Impairment Case Hang Seng Bank (2004 Annual Report) Provisions for bad and doubtful debts On adoption of HKAS 39, Impairment provisions for advances assessed individually are calculated using a discounted cash flow analysis for the impaired advances. Collective assessment of impairment for individually insignificant items or items where no impairment has been identified on an individual basis is made using formula-based approaches or statistical methods. Impairment provisions for advances will be presented as individually assessed and collectively assessed instead of specific provisions and general provisions. There will be no significant change in the net charge for provisions to profit and loss account. 2005-06 Nelson 66 33
Measurement Impairment Case 2005 Interim Report set out the impairment loss policy as follows: The Group assesses at each balance sheet date whether there is objective evidence that a financial asset or a group of financial is impaired. In the case of equity securities classified as available for sale, a significant or prolonged decline in the fair value of the security below its cost is considered in determining whether the securities are impaired. If any such evidence exists for available-for-sale financial, the cumulative loss measured as the difference between the acquisition cost and the current fair value, less any impairment loss on that financial asset previously recognized in the consolidated profit and loss account is removed from equity and recognized in the consolidated profit and loss account. Impairment losses recognized in the consolidated profit and loss account on equity instruments are not reversed through the consolidated profit and loss account. 2005-06 Nelson 67 Measurement Impairment Impairment Is Reversal allowed? Outside Outside the the scope scope of of HKAS HKAS 36 36 Loans and receivables at Cost at Amortised Cost at Amortised Cost Impairment losses on equity instrument shall NOT be reversed through profit or loss. Impairment losses on debt instrument If, in a subsequent period the fair value of a debt instrument classified as increases, and the increase can be objectively related to an event occurring after the impairment loss was recognised in profit or loss Then, the impairment loss shall be reversed, with the amount of the reversal recognised in profit or loss 2005-06 Nelson 68 34
Measurement Impairment Impairment Is Reversal allowed? Outside Outside the the scope scope of of HKAS HKAS 36 36 Loans and receivables at Cost at Amortised Cost at Amortised Cost Such impairment losses shall NOT be reversed 2005-06 Nelson 69 Measurement Impairment Loans and receivables at Cost at Amortised Cost at Amortised Cost Impairment Is Reversal allowed? Outside Outside the the scope scope of of HKAS HKAS 36 36 If, in a subsequent period the amount of the impairment loss decreases, and the decrease can be related objectively to an event occurring after the impairment was recognised (such as an improvement in the debtor s credit rating) Then, the previously recognised impairment loss shall be reversed either directly or by adjusting an allowance account. The reversal shall not result in a carrying amount of the financial asset that exceeds what the amortised cost would have been had the impairment not been recognised at the date the impairment is reversed. The amount of the reversal shall be recognised in profit or loss. 2005-06 Nelson 70 35
Measurement Reclassification Reclassification Loans and receivables at Cost at Amortised Cost at Amortised Cost An entity shall NOT reclassify a financial instrument into or out of the fair value through profit or loss category while it is held or issued. 2005-06 Nelson 71 Measurement Reclassification Loans and receivables at Cost at Amortised Cost at Amortised Cost Reclassification A change in intention or ability shall be reclassified as re-measured at fair value, and the difference between its carrying amount and fair value shall be recognised directly in equity Tainting rule triggered Any remaining shall be reclassified as. On such reclassification, the difference between their carrying amount and fair value shall be recognised directly in equity 2005-06 Nelson 72 36
Measurement Reclassification Reclassification Loans and receivables at Cost at Amortised Cost at Amortised Cost If a reliable measure becomes available on fair value the asset shall be re-measured at fair value, and the difference between its carrying amount and fair value shall be accounted for depending the classification of such asset as, or 2005-06 Nelson 73 Measurement Reclassification Loans and receivables at Cost at Amortised Cost at Amortised Cost Reclassification In case of a change in intention or ability in the rare circumstance, a reliable measure of fair value is no longer available, or tainting rule expires Then, it becomes appropriate to carry a financial asset at cost or amortised cost rather than at fair value 2005-06 Nelson 74 37
Measurement Reclassification Loans and receivables at Cost at Amortised Cost at Amortised Cost Reclassification The fair value carrying amount of the asset on that date becomes its new cost or amortised cost, as applicable Any previous gain or loss on that asset that has been recognised directly in equity shall be accounted for as follows: a) In the case of a financial asset with a fixed maturity the gain or loss shall be amortised to P/L over the remaining life of the investment using the effective interest method. b) In the case of a financial asset that does not have a fixed maturity the gain or loss shall remain in equity until the financial asset is sold or otherwise disposed of, when it shall be recognised in P/L. 2005-06 Nelson 75 Measurement Summary Subsequent Measurement to P/L to Equity From Equity to P/L at Cost To P/L at Amortised Cost Impairment t required To P/L Reversal N/A Related objectively to an event for debt instrument only Related objectively to an event Reclassification t allowed To or AFS at Cost To AFS To AFS Loans and receivables at Amortised Cost To P/L Related objectively to an event t described in HKAS 39; implicitly, not feasible 2005-06 Nelson 76 38
Measurement From SSAP 24 SSAP 24 Held-to-maturity debt securities Benchmark treatment Investment securities at Amortised Cost less provision at Cost less provision HKAS 39 or At amortised cost Follow tainting rules SSAP 24 not cover Loans and receivables or At Fair Value through Equity or Other or Alternative treatment Trading securities n-trading securities through Equity AFS FA financial at FV through P/L or 2005-06 Nelson 77 Measurement From SSAP 24 SSAP 24 Held-to-maturity debt securities Benchmark treatment Investment securities at Amortised Cost less provision at Cost less provision HKAS 39 At amortised cost Follow tainting rules Is Is there any choice with minimum impact? SSAP 24 not cover Loans and receivables AFS or or financial At Fair Value through Equity or Other or Alternative treatment Trading securities n-trading securities through Equity or 2005-06 Nelson 78 39
Measurement From SSAP 24 SSAP 24 Held-to-maturity debt securities Benchmark treatment Investment securities Other Alternative treatment Trading securities n-trading securities at Amortised Cost less provision at Cost less provision through Equity HKAS 39 SSAP 24 Loans and not cover receivables At the beginning of the year of first adoption or or Tainting rules through waived on P/L reclassifying debt At securities amortised cost under SSAP 24 to At Fair Value through Observe under HKAS strict 39 Equity, unless no tainting rules reliable fair value Even an entity sold or transferred debt Observe impairment Observe impairment securities in the 2 preceding years, it does not trigger the tainting FA rules at FV and or would not prevent an entity to classify debt securities as or Initial designation rule waived Allow entities to designate its instruments as or FA at FV at the date of transition Any adjustment AFS of FA the financial at carrying FV amount should be recognised to the through opening P/L balance or of retained earnings 2005-06 Nelson 79 Measurement From SSAP 24 SSAP 24 HKAS 39 Benchmark treatment Investment securities at Cost less provision or Other or 2005-06 Nelson 80 40