ias 32 & 39 overview.pdf

7/27/2019 ias 32 & 39 overview.pdf

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IFRS for Financial Instruments

An overview of IAS 32 and 39


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IFRS for Financial Instruments An overview of IAS 32 and 39

Introduction 1

Definitions 3

Scope 4

Embedded derivatives 6

Classification and measurement of financial instruments 9

Amortised cost 12

Fair value 14

Impairment 16

Hedge accounting 18

Derecognition of financial instruments 24

Debt vs equity 30

Presentation 35

First time adoption 36

Concluding remarks 37

Contents


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1IFRS for Financial Instruments An overview of IAS 32 and 39

This is the second edition of our overview of IAS

32 Financial Instruments: Presentationand IAS 39

Financial Instruments: Recognition and Measurement.

The rst edition was published in January 2004,

shortly after the International Accounting Standards

Board (IASB or the Board) released signicant

amendments to the two Standards. Since then,

there have been a number of further changes.

In 2004, the European Commission approved the text of IAS 32

and IAS 39 to be used by European listed entities, with two

carve-outs. The rst related to the ability to designate any

nancial liability to be recorded at fair value through prot or

loss using the Fair Value Option (FVO). The FVO was subsequently

amended, to set criteria as to when a nancial instrument can be

so designated, which enabled the carve-out to be removed.

The second carve out relates to the practice by many European

banks of hedging their demand deposits, to lock in their interest

rate spread. This activity is not eligible for fair value hedgeaccounting under IAS 39. The European Commission carved out

from IAS 39 this restriction, together with a substantial part of

the rules on hedge effectiveness. At the time of writing, this

issue has still not been resolved, with the effect that a number

of European banks are applying the European Union version

of IAS 39.

A revised IFRS 3 Business Combinations (IFRS 3R)was issued

in January 2008, with some important consequences for the

accounting for nancial instruments, effective for nancial

periods beginning on or after 1 July 2009. Also, in February 2008,

IAS 32 was amended to allow a limited range of entities whose

capital instruments did not meet the denition of equity, to recordtheir most junior instruments as equity, as long as they meet

certain requirements.

The number of changes to IAS 39 since it was revised in late 2003

has provoked mixed feelings. On the one hand, the changes have

been, for the most part, welcome amendments but, on the other

hand, the continually evolving nature of the Standard has made

implementation more difcult. The perceived need to stabilise the

Standard, combined with the limited staff resources of the IASB,

mean that, in the short term, further changes will be limited.

Introduction

Instead an annual omnibus standard will be issued containing

minor corrections to various standards. The rst Improvement

standard, published in May 2008, contained three minor

amendments to IAS 39, effective January 2009. The second

ED was issued in August 2008, with another four.

In the longer term, there is a plan to converge with Generally

Accepted Accounting Principles in the United States (US GAAP).

In September 2006, the United States Financial Accounting

Standards Board (FASB) published a new Standard on how fairvalues should be calculated, Statement of Financial Accounting

Standard No 157 (SFAS 157) Fair Value Measurements. The IASB

issued the text of SFAS 157 as a Discussion Paper (DP), together

with its preliminary views, for comment in February 2008 and an

ED on the subject is expected to be published in 2009.

In March 2008, the IASB issued a discussion paper to explore ideas

for a successor to IAS 39, Reducing Complexity in Reporting

Financial Instruments. The Boards preferred long-term approach is

to record all nancial instruments at fair value through prot or

loss. This would end available-for-sale accounting for nancial

instruments through equity and fair value hedge accounting.

However, it is likely that it will not be possible to move to a full fairvalue approach, in which case the plan is to simplify the accounting

requirements, especially for hedge accounting. Derecognition

will be considered separately; the results of an initial research

project were reported to the Board in the fourth quarter of 2007

and will be discussed further by the Board during the fourth

quarter of 2008.

The FASB is leading a project to upgrade the accounting

treatment under US GAAP for nancial instruments that have

equity-like features. The FASB issued a preliminary views

document in the fourth quarter of 2007 and the IASB then

issued an invitation to comment on this document, with a view

to replacing IAS 32 in due course.

In the meantime, there is much about IAS 32 and IAS 39 that

remains controversial and, for many, counter-intuitive. Also,

in many areas, despite more than 200 pages of Application

and Implementation Guidance, the Standards are often unclear.

The ofcial body charged with interpreting the Standards is the

International Financial Reporting Interpretation Committee

(IFRIC or the Committee). However, since December 2003,

it has only issued four interpretations relating to nancial

instruments. Of more value, so far, are IFRICs agenda decisions


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2 IFRS for Financial Instruments An overview of IAS 32 and 39

(also referred to as non-interpretations), when it decides that

issues do not require interpretation because the treatment

is already clear enough from the Standards. Although these

decisions do not have the same authority as formal

interpretations, they are, nevertheless, an important form

of guidance. Some of the more important IFRIC decisions

are described in this publication.

IAS 32 and IAS 39 have had enormous impact on many

organisations. Apart from the signicant systems and proceduralrequirements, they have necessitated signicant changes in the

way that nancial results are communicated to stakeholders.

The extra volatility of prot and loss due to the application of

IAS 39 has led many entities to revise the types of nancial

instruments they hold and the types of hedging programmes they

carry out. Furthermore, in order to avoid a disconnection between

their activities and nancial reporting, many organisations have

incorporated the Standards into their management reporting

process, including budgeting, monitoring and staff remuneration.

Introduction continued

This publication is only an overview of the two Standards. It is

not intended to discuss all of the complex accounting rules and

guidance contained in them, nor does it cover the disclosure

requirements of IFRS 7 Financial Instruments: Disclosure,

which is the subject of separate Ernst & Young publications.

Ongoing changes in the accounting for nancial instruments

under IFRS are described in our monthly newsletter, IFRS outlook,

and Supplements to IFRS outlook, addressing nancial instruments

issues. These can be obtained from ey.com/ifrs. In addition, a morein-depth analysis of the two Standards is contained in our

International GAAPbook.


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The ve key denitions are:

A nancial instrumentis widely dened, as any contract that gives

rise to both a nancial asset of one entity and a nancial liability or

equity instrument of another entity.

A nancial assetis dened as:

cash,

an equity instrument of another entity,

a contractual right to receive cash or another nancial assetfrom another entity (including trade receivables, although the

application of IAS 39 will normally be immaterial, unless

payment is deferred), or

a contractual right to exchange nancial instruments with

another entity under conditions that are potentially favourable

(such as a swap with a positive fair value).

A nancial liabilityis dened as any contractual obligation:

to deliver cash or another nancial asset to another entity, or

to exchange nancial instruments with another entity under

conditions that are potentially unfavourable (e.g., a swap with

a negative fair value).Also included in the denition of nancial asset and nancial

liability are contracts that will be settled in the entitys own equity,

but which are:

non-derivatives, when the entity is or may be obliged to receive

or deliver a variable number of its equity instruments, or

derivatives that can be settled other than by the exchange of

a xed amount of cash or another nancial asset for a xed

number of the entitys own equity instruments.

Denitions

An equity instrumentis any contract that evidences a residual

interest in the assets of an entity after deducting all of its liabilities.

Finally, a derivativeis a nancial instrument with the following

three characteristics:

its value changes in response to a change in price of, or index

on, a specied underlying nancial or non-nancial item or

other variable,

it requires no, or comparatively little, initial investment, and

it is to be settled at a future date.

Importantly, it should be noted that a contract can meet the

denition of a derivative regardless of whether it is settled net

or gross.

The denition of a derivative currently excludes contracts

where the value changes in response to a non-nancial variable

specic to a party to the contract. The IASB intends to delete

this exclusion (see the section, Embedded derivatives, below).


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Scope

IAS 32 and IAS 39 are very wide in scope and cover all nancial

instruments except when specically addressed by another

Standard, such as:

Interests in subsidiaries, associates and joint ventures (IAS 27

Consolidated and Separate Financial Statements, IAS 28

Investments in Associatesand IAS 31 Interests in Joint

Ventures) unless, according to those Standards, they should be

accounted for under IAS 39;

Interests in leases (IAS 17 Leases), except for any embeddedderivatives and the derecognition and impairment provisions of

IAS 39 relating to receivables and nance lease payables;

Assets and liabilities under employee benet plans (IAS 19

Employee Benefts);

For the acquirer, contracts for contingent consideration in a

business combination (IFRS 3 Business Combinations)

(although the revised version of IFRS 3 removes this exclusion,

with effect from 1 July 2009);

Contracts between an acquirer and a vendor in a business

combination to buy or sell an acquiree at a future date;

Financial instruments, contracts and obligations under share-

based payment transactions (IFRS 2 Share-based Payment);

and

Insurance contracts (IFRS 4 Insurance Contracts).

Loan commitments

Certain loan commitments are within the scope of IAS 39:

Those that are designated as nancial liabilities at fair value

through prot or loss (FVPL);

When the entity has a past practice of selling the resulting

assets shortly after origination;

Commitments that can be settled net in cash (which are,

in effect, interest rate derivatives); and Commitments to provide loans at below-market interest rates.

Otherwise, they are accounted for in accordance with IAS 37

Provisions, Contingent Liabilities and Contingent Assets.

Financial guarantees

The denition of a nancial guarantee contract is a contract that

requires the issuer to make specied payments to reimburse the

holder for a loss it incurs because a specied debtor fails to make

payment when due in accordance with the original or modied

terms of a debt instrument. The issuer of a nancial guarantee

contract must initially record it at fair value, and thereafter

measure it at the higher of:

The amount that would be recorded under IAS 37; or

The amount initially recognised less cumulative amortisation

recognised in accordance with IAS 18 Revenue.

However, if the issuer is required to make payments to the holder

whether or not it actually incurs a loss on the specied asset, it is

likely that the contract will be a derivative and will need to be

accounted for at fair value through prot or loss.

If an issuer of nancial guarantee contracts has previouslyasserted explicitly that it regards such contracts as insurance

contracts and has, in the past, used accounting policies applicable

to insurance contracts, the issuer may elect to apply either IAS 39

or IFRS 4 Insurance Contractsto such contracts. The issuer makes

this election contract by contract and it is irrevocable. Otherwise it

should apply IAS 39.

There are no specic requirements for the holder of a nancial

guarantee contract.

Warning

In the standalone IFRS accounts of a parent entity,

any guarantees given on behalf of its subsidiaries

will need to be recorded, when rst given, as liabilities,

at their fair value.

Commodity contracts

IAS 39 must be applied to anycontract to buy or sell a

non-nancial item if:

The entity has a practice of settling similar contracts net in cash

or another nancial instrument (whether with the counterparty,

or by entering into offsetting contracts or by settling the

contract before its exercise or lapse); or

For similar contracts, the entity has a practice of taking delivery

of the underlying and selling it within a short period after

delivery for the purpose of generating a prot from short-term

uctuations in price or dealers margin.

IAS 39 should also be applied to a contract to buy or sell

a non-nancial item if:

The terms of the contract allow either party to settle it net in

cash or another nancial instrument or by exchanging nancial

instruments; or

The non-nancial item that is the subject of the contract is

readily convertible to cash, which will include manycommodities which are actively traded;


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unlessthe contracts were entered into, and continue to be held

for the purpose of the receipt or delivery of a non-nancial item

in accordance with the entitys expected purchase, sale or

usage requirements.

IAS 39 goes on to say that a written option to buy or sell a

non-nancial item that meets one of the above criteria can never

be considered to be entered into in accordance with the entitys

expected purchase, sale or usage requirements and so will

always be a derivative, to be accounted for in accordancewith IAS 39.

This is one of the most difcult sections of the Standard to

interpret and apply and many organisations, such as utilities

and oil companies, have had to look closely at their activities

to examine whether they need to classify forward contracts as

derivatives within the scope of IAS 39, which must be fair valued

through prot or loss.

In our view, a xed price contract where the other party has the

option to increase or decrease the delivered quantity may be

treated either as a derivative in its entirety, or as a non-nancial

contract (to deliver the default volume), together with an

embedded derivative that must be separated. However, we are

aware that others would treat the entire contract only as a

derivative nancial instrument. Related problem areas include

the scenarios where entities are uncertain as to their usage

requirements and order more of a physical commodity than

they may use, subsequently, selling the surplus, and when

entities have a mixture of purchase, sale or usage business

and trading activities.

An issue considered by IFRIC is whether a normal electricity

supply contact to a retail customer is a derivative, because

electricity is actively traded and the customer has the option to

decide on the volume it will consume. The Committee eventuallyconcluded that there is no nancial instrument as the electricity

is not readily convertible to cash by the customer, implying that

this assessment needs to be based on the practical ability to

convert to cash by both parties to the option.

Also difcult is the situation where an entity takes delivery of a

non-nancial item and sells it soon after, but as a distributor rather

than a trader where do you draw the line? Factors to consider

include how the entity manages its business and how it intends to

prot from the contract, whether the counterparties are regular

customers and the level of price risk taken by the entity.

IFRS for private entities

In February 2007, the IASB issued an ED on IFRS for small and

medium-sized entities (SMEs), although the title has now been

changed to refer to private entities. The comment period ended

on 1 October 2007.

This proposed guidance will allow private entities to prepare theirnancial statements in accordance with a simplied IFRS

framework. Entities may choose to apply the provisions of the

private entity framework or alternatively, they can adopt IAS 32,

IAS 39 and IFRS 7 in full to account for their nancial instruments.

Generally, the private entity framework follows a simplied

approach for measurement, hedging, derecognition and disclosure.

For instance:

Instead of having four categories of nancial assets and two

categories of nancial liabilities, the ED proposes two models:

amortised cost (for loans and other simple debt instruments)

and fair value through prot or loss (for nearly everything

else). The available-for-sale category is not used.

The ED restricts the scope of hedge accounting. For example,

it is not possible to hedge credit or prepayment risk, foreign

currency risk cannot be hedged using non-derivative

instruments, hedging strategies based on options are not

permitted and the two IAS 39 macro hedging models cannot

be used.

The ED derecognition principles do not include the pass-

through and continuing involvement provisions used in IAS 39.

The new private entity standard is expected to be issued during the

rst half of 2009.

Warning

Commodity contracts are in the scope of IAS 39 if:

the entity has a history of closing out or trading the

contracts, or

either party can net settle the contract or the

commodity is actively traded, unless the transaction is

for the entitys purchase, sale or usage requirements.

A xed price contract to buy or sell a commodity that is

actively traded gives rise to a nancial instrument if the

quantity to be bought or sold is variable at the option of

the other party to the contract.


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An embedded derivative is a component of a hybrid

instrument that includes both a derivative and a host

contract with the effect that some of the cash ows

of the combined instrument vary in a similar way to a

stand-alone derivative. Examples would include bonds

with call or put options, or which are convertible into

equity (at least for the holder, see the section, Debt vs

equity, for the accounting treatment for the issuer), orwhen interest payments on a bond are linked to equity

or commodity prices, or certain non-nancial purchase

or sale contracts are denominated in a currency that is

foreign to any of the parties to the contract.

The embedded derivative is required to be separated and recorded

at fair value, with gains and losses recognised in prot or loss, if:

The hybrid instrument is not already recorded at fair value with

gains and losses recognised in prot or loss;

A separate instrument with the same terms as the embedded

derivative would meet the denition of a derivative, and

The economic characteristics and risks of the embedded

derivative are not closely related to those of the

host instrument.

When an embedded derivative is closely related to its host

contract, no separate accounting or reporting is required.

Embedded derivatives

What does closely related mean?

The IASB has included illustrative examples in the Application

Guidance of IAS 39 of instruments in which the characteristics

and risks of the embedded derivative are notregarded as closely

related. These include:

The terms in a debt or insurance contract whereby interest or

principal payments are, or can be, based upon a commodity or

equity price;

An equity conversion feature embedded in a debt instrumentheld as an asset;

A call, put or prepayment option embedded in a debt

instrument, unless the options exercise price is approximately

equal to the debt instruments amortised cost on each

exercise date;

An option or other provision to extend the term of a debt

instrument, unless there is a concurrent adjustment of the

interest rate to reect market prices; or

Credit derivatives embedded in debt instruments that are

linked to the credit risk of a reference asset that the issuer

may not own.

Note the lack of symmetry in the treatment of prepayment and

extension options, so that an extension option is more likely to

need to be separated than a prepayment option.

The Standard also provides examples of instruments in

which embedded derivatives areregarded as closely related.

These include:

Interest rates or interest rate index terms in a debt instrument

that can change the amount of interest that is paid on an

interest-bearing debt instrument, unless the instrument is

leveraged so that the investor will potentially not recover

substantially all of its recorded investment, or could at least

double the initial rate of return and obtain a return that is atleast twice the market return on a similar debt instrument

without the embedded derivative. (Financial instruments such

as range accrual notes are usually designed to just meet this

requirement.); or

An interest rate oor or cap on a debt instrument, as long as it

is at, or out of, the money when the instrument is issued.


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Embedded foreign currency derivatives

An embedded foreign currency derivative in a non-nancial

instrument (for example, a contract for the purchase or sale

of a non-nancial item or an operating lease priced in a foreign

currency) is considered to be closely related, provided that it is

not leveraged and contains no option features, and as long as the

contract requires payments denominated in:

The functional currency of one of the substantial parties

to the contract;

The currency in which the price of the good or service

is routinely denominated for international commerce

(for example, US dollars for crude oil transactions); or

A currency that is commonly used in the economic environment

in which the transaction takes place (e.g., when the local

currency is unstable or illiquid).

In practice, there are relatively few goods or services that are

globally, routinely denominated in one currency, so it is the third of

these exemptions which is the most frequently discussed what is

meant by the economic environment in this context? Cross-

border transactions, such as a US dollar trade between entities in

two African countries, are generally regarded as covered by thisclause, but what about transactions in euros between two entities

within an eastern European country that has not yet adopted

the euro? Interpretations differ, depending upon the specic

circumstances. The IASB intends to amend IAS 39 to clarify the

meaning as part of the 2008 annual improvements process.

Our view is that the economic environment should normally be

viewed as the national economy. However, there will be cases

where this is fragmented, for instance, into an imported, luxury

goods sub-economy where goods are denominated in a foreign

currency, and a more local sub-economy, in which goods are

traded in the local currency.

Commodity pricing features

Another example of an embedded derivative that is closely related

is when a commodity contract has a pricing feature which is linked

to a more actively traded commodity, when the market for the

contract is undeveloped. For instance, a natural gas contract

entered into when the market rst started may have been based

on an oil price. At the outset, given that there was no other pricing

mechanism available, the oil price linkage would be regarded as

closely related.

When are embedded derivatives assessed?

IFRIC Interpretation 9 Reassessment of Embedded Derivatives

addresses when an entity is required to assess whether an

embedded derivative needs to be separated. This concludes that

an entity needs to assess the existence and separation of an

embedded derivative only when it rst becomes party to it

and this decision does not subsequently need to be revised,

unless the terms of the contract are changed.

Hence, the oil price basis in the gas contract mentioned above

would continue to be considered to be closely related even if an

active gas market subsequently develops. But if the contract wasthen sold, the new party to the contract would not be permitted to

treat the derivative as closely related, and it would have to be

separated and recorded at fair value through prot or loss (FVPL).

IFRIC chose not to consider whether it is necessary to reassess

embedded derivatives held by the acquiree in a business

combination but IFRS 3R, issued in January 2008, does now

require reassessment. Until IFRS 3R becomes effective, there is

likely to be a variety of practice on this issue.

Warning

Many non-nancial contracts contain embedded

derivatives that are required to be separated and

recorded at fair value through prot or loss. Some of

the most common examples are contracts denominated

in a currency other than the functional currency of

either party to the contract, such as where the contract

is priced to reect the source of components orraw materials.


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Non-nancial variables

The summary denition of a derivative contract is given in the

Defnitionssection on page 3. The detailed denition in IAS 39

currently goes on to say that the transaction is a derivative within

the scope of IAS 39 even if the underlying is a non-nancial

variable as long as it is not specic to a party to the contract.

What this means is not particularly clear; is a loan to develop a

property, when the amounts to be repaid on the loan is linked to

the eventual sale value of the property, deemed to be referenced

to a non-nancial variable specic to the entity? Or does the loan

contain an embedded derivative that is required to be separated?

What about contracts indexed to an entitys own revenue or

earnings before interest, tax, depreciation and amortisation

(EBITDA)? The issue was examined by the IFRIC and referred to

the IASB which conrmed that it had intended this exclusion only

to cover insurance contracts within the scope of IFRS 4. The IASB

decided to delete this exclusion as part of the 2007 annual

improvements project but, in response to the comments received,

is seeking to make this amendment as a separate project.

If this change is made, all the examples referred to above would be

considered to contain embedded derivatives that are required to

be separated.

Accounting for embedded derivatives

IAS 39 makes it clear that, when an embedded derivative is

separated from its host it is measured, at inception, at fair value

and the residual value is assigned to the host, so that no immediate

gain or loss is created. The effect is that, when a bank or other

dealer issues a structured note containing embedded derivatives,

it will never be able to record a day one prot, unless it records

the entire instrument at FVPL.

If the entity is unable to measure reliably the fair value of anembedded derivative (e.g., the embedded derivative is based on

an unquoted equity instrument), the fair value is deemed to be the

difference between the fair value of the hybrid instrument and the

fair value of the host contract. In those rare circumstances, when

the entity is unable to determine the fair value of the embedded

derivative in this manner, the entire hybrid instrument must be

designated as a nancial instrument at FVPL.

Warning

Pricing features in non-nancial instrument contracts

can contain embedded derivatives that are required to

be separated and recorded at fair value through prot

or loss. Entities need to examine very carefully all their

contracts to ensure that there are no embedded

derivatives that need to be accounted for separately and

modify any such contract unless they are prepared to

suffer prot or loss volatility.

Embedded derivatives continued


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Classication and measurement

of nancial instruments

IAS 39 requires that nancial assets and nancial liabilities are all classied into one of ve

categories, which dictate the accounting treatment, as shown below in Figure 1.

Figure 1: Classication and measurement

Category Description Measured at fair value Measured at amortised cost

Held-to-maturity (HTM) Debt securities acquired by the

entity, to be held to maturity

Loans and Receivables Unquoted loan assets when there

is no intent to sell the asset in the

short term

Fair value through prot or loss

(FVPL)

All derivatives (except for those

designated for hedge accounting)

Other items intended to be

actively traded

Any item that meets certain

criteria and is designated as

such at initial recognition

Through prot or loss

Recorded at cost only if fair value

cannot be reliably measured (very

limited restricted to certain

unquoted equity instruments and

derivatives thereon)

Available-for-sale (AFS) All assets not in the

above categories

Through equity unless Impaired

but interest is recorded in prot

or loss, based on the assets

effective yield

As for FVPL

Other nancial liabilities Non-trading liabilities

Financial instruments are measured either at fair value or

at amortised cost so as to record a constant effective yield.

Both of these approaches are explained in more detail, later in

this publication.

Held to maturity

The held-to-maturity (HTM) category, recorded at amortised cost,

is limited in its application. It is available only for debt securities

that will be held to maturity. If the entity sells or reclassies more

than an insignicant amount of held-to-maturity investments, the

portfolio becomes tainted and the entity is banned from using the

category for at least a two-year period. Puttable securities cannot

be classied as HTM, but a call option held by the issuer does not

prevent the use of the HTM classication unless the security can

be called at an amount signicantly below its amortised cost.

Also, it is not possible to apply hedge accounting to a hedge of

the interest rate risk of an HTM nancial asset.

Warning

If securities are recorded as held-to-maturity and

an entity sells or reclassies more than an insignicant

amount, then the entity cannot use the category

for two years.


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Loans and receivables

Loans and receivables may be recorded at amortised cost,

but only if:

They are not quoted in an active market (if they are, then they

must be treated as HTM, at FVPL or AFS);

They are not entered into with the intention of sale in the short

term(if so, they must be classied as FVPL); and

There is no risk the holder may not recover substantially all of

its initial investment other than due to credit deterioration(in which case, they must be classied as FVPL or AFS).

Financial instruments at fair value

Financial instruments classied as held at fair value through prot

or loss or available-for-sale are normally recorded at fair value,

with the gains or losses on FVPL items recorded in prot or loss,

and the gains or losses on AFS items recorded in a separate

component of equity. The circumstance in which they should be

held at cost, because the fair value cannot be reliably measured,

is very limited. It is reserved for unquoted equity instruments and

derivatives thereon, when a valuation methodology cannot be

applied as the range of fair value estimates is signicant, or the

probabilities of the various estimates within the range cannot

be reasonably assessed. Modelling techniques that are well

established, such as those used by private equity houses, would

normally be considered to provide a reliable estimate of fair value.

It should also be noted that certain private equity investments can

only escape being accounted for as associates, in accordance with

IAS 28 Investments in Associates, when they are treated as FVPL

under IAS 39, and so will not be eligible for this exclusion.

Fair value through prot or loss

Derivatives and items held as part of a trading portfolio are

required to be recorded at FVPL. The category is also available

for any nancial asset or liability as long as it meets certaincriteria and it is designated as such at initial recognition.

An IAS 39 amendment issued in June 2005 restricts the use

of the fair value option to when the nancial instrument meets

one of the following criteria:

It eliminates or signicantly reduces a measurement or

recognition inconsistency (sometimes referred to as an

accounting mismatch) that would otherwise arise from

measuring assets or liabilities or recognising the gains and

losses on them on different bases;

When a group of nancial assets, nancial liabilities or both is

managed and its performance is evaluated on a fair value basis,

in accordance with a documented risk management orinvestment strategy, and information about the group is

provided internally on that basis to the entitys key management

personnel; or

Classication and measurement

of nancial instruments continued

In certain cases, when a hybrid contract contains one or more

embedded derivatives.

The fair value option can be used as an alternative to hedge accounting

(see later), to deal with situations when, for instance, a bond is hedged

by a derivative. But it can also be used when hedge accounting would

not be possible, such as when an entity holds AFS xed rate bonds as

a natural hedge of xed rate liabilities. Without using the fair value

designation option, gains and losses due to changes in interest rates on

the bonds would have to be recorded in equity while the liabilitiesremain recorded at amortised cost. Use of the option would enable both

the bonds and the liabilities to be recorded at FVPL and the gains and

losses offset.

The fair value option may also be applied to structured nancial

liabilities such as credit or equity linked notes that contain embedded

derivatives and pay xed rate interest. Without the use of the option the

host liability would be recorded at amortised cost, which may lead to a

mismatch if the interest rate risk is hedged by other nancial

instruments that are required to be recorded at fair value.

There is no numerical guidance as to what would be deemed to

signicantly reduce a measurement or recognition inconsistency.

Warning

Financial instruments can only be designated at fair value

on original recognition and the designation is irrevocable.

Despite the restrictions, the fair value option still enables nancial

instruments to be fair valued in most instances when entities wish to apply

it. However, because of the restrictions, the fair value designation option

is, in principle, more limited than that now available under US GAAP in

Statement of Financial Accounting Standard No 159 (SFAS 159).

IFRIC has been asked whether the fair value option is available

for non-nancial instruments that contain embedded derivatives.

It decided to refer the question to the IASB, to amend the wording of

IAS 39 to clarify the meaning and the Board has tentatively decided

as part of the 2008 annual improvements project, to propose an

amendment to make it clear that the fair value option is not available

for contracts outside the scope of IAS 39.

The Standard contains the controversial requirement for the fair value

of a liability to include the instruments credit spread, so an issuer that

recognises a liability at fair value through prot and loss will record a

prot on such an instrument if its credit rating deteriorates.

Financial instruments can only be designated at FVPL on initialrecognition and the designation is irrevocable. Consequently,

it is less exible than hedge accounting, which can be turned

on and off.


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Available-for-sale

The general rule for AFS securities (i.e., all assets that are not

HTM, FVPL or classied as loans and receivables) is that gains

or losses due to changes in fair value are recorded in a separate

component of equity. However, a number of points should

be noted:

Interest on an AFS debt security needs to be recognised in

prot or loss on an effective interest basis, which will be

complicated when the security was issued at a premium or

discount, when there are step ups in the interest rate, or if the

security is convertible or has other embedded derivatives.

The amount recorded in equity will be the difference between

the fair value and the amortised cost of the AFS debt security.

If the AFS asset is a monetary item (such as a debt security, but

not an equity investment) denominated in a foreign currency,

any gains or losses due to changes in the foreign exchange rate

will need to be recorded in prot or loss. (This will often be a

signicant difference between the results of an entity reporting

under IFRS compared with US GAAP).

Impairment of an AFS asset must be recorded in prot or loss.

Note that an equity investment is considered impaired if

(among other indicators) there has been a decline in fair

value below cost that is signicant orprolonged. Also, note that

impairment charges taken on an AFS equity investment cannot

be reversed if the equity investment subsequently increases

in value.

Warning

Although available-for-sale securities are revalued

through equity, the following are recorded in prot

or loss:

Interest, which is accrued at the effective interest rate Foreign currency revaluation gains and losses on

debt securities

Impairment

Also, deferred tax may need to be provided on the gains

and losses recorded in equity.

On initial recognition

All nancial instruments, even those recorded on an amortised

cost basis, are required to be recorded on initial recognition at fair

value. In most cases, this will be the same as the consideration

paid or received, but this requirement can cause problems for anytransactions which are not on market terms, such as intragroup

loans or guarantees recorded in single entity accounts prepared

under IFRS. Normally the extent to which a nancial instrument is

transacted at a price that is different from fair value should be

recorded immediately in prot or loss, but this might not be

appropriate in group situations. For example, if a parent lends on

interest free terms to a subsidiary, the subsidy should presumably

be accounted for as a capital investment in the subsidiary, while an

interest free loan from a subsidiary to its parent should perhaps be

recorded as containing a distribution. However, it can be difcult

to calculate the fair value of non-arms length transactions.

A bank or other dealer in nancial instruments will often be able to

buy or sell at a price which is more favourable than the fair value

and so make a day one prot. However, if the nancial instrument

is not traded in an active market and the inputs to the valuation

model are not observable in the market then IAS 39 does not

permit a prot or a loss to be recorded on initial recognition the

transaction price is deemed to be the best evidence of fair value

(see the later section on Fair value).

Except when a nancial asset or liability is classied as FVPL,

the amount initially recognised should include incremental costs

(and fees) that are directly attributable to its acquisition or issue.

This means that for items recorded at amortised cost, suchexpenses will be reected in the effective interest rate. The fair

value at which AFS assets are recorded subsequent to initial

recognition excludes transaction costs, so the costs will be included

in the net debit or credit to the separate component of equity as

soon as the assets are rst revalued. In the case of debt

instruments this will subsequently be reected in prot or loss

through the EIR.

Warning

Interest-free loans and loans at below-market rates

granted by a parent to a subsidiary should be recordedat fair value. The difference between the fair value and

the consideration received should normally be accounted

for as a capital contribution.

Reclassications between categories

The restrictions on the use of the HTM category mean that

nancial instruments will rarely be transferred from HTM to

another category. Meanwhile, IAS 39 does not permit nancial

instruments to be transferred into or out of the FVPL category,

except for derivatives that become designated or re-designated

from effective hedging relationships.

All reclassications must be recorded at fair value as at the

date of reclassication.


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The amortised cost of a nancial asset or liability

is dened as the amount at which it is measured at

initial recognition less 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 less

any reduction for impairment or uncollectibility.

The effective interest rate (EIR) is dened as the rate that exactly

discounts estimated future cash payments or receipts through

the expected life of the nancial instrument or, when appropriate,

a shorter period, to the net carrying amount of the nancial asset

or liability. For instance, if a 5-year bond is purchased on 1 January

2005 at a price of 92 (i.e., at a discount of 8%) and pays a 5%

coupon, the effective yield is just under 6.95% and the

Amortised cost

amortised cost at the end of each year can be calculated as shown

in Figure 2.

Generally, any associated fees received, or directly attributable

and incremental costs (such as legal fees or commissions), or an

initial premium or discount, will need to be amortised over an

instruments life as part of the EIR calculation. A shorter period

should be used if this is the period to which the fee costs,

premiums or discounts relate, as may be the case if the instrument

is variable rate and reprices to market.

For a bank or other nancial institution, important rules on the

denition of the EIR are contained in the appendix to IAS 18

Revenue. IAS 18 requires that the effective yield on a loan includes

commitment fees (less any related, direct costs) and syndication

fees when the syndicator retains a portion of the loan package at

an effective yield which is lower than that earned by other

participants who are exposed to comparable risks.

Figure 2: Illustration of amortised cost

Date Brought forwardamortised cost

Payment Interestat 6.95%

Carried forwardamortised cost

01/01/05 92,000,000 (5,000,000) 6,392,558 93,392,558

01/01/06 93,392,558 (5,000,000) 6,489,319 94,881,877

01/01/07 94,881,877 (5,000,000) 6,592,803 96,474,680

01/01/08 96,474,680 (5,000,000) 6,703,478 98,178,158

01/01/09 98,178,158 (105,000,000) 6,821,843 0

IAS 39 species that:

Expected, but not yet incurred, credit losses should not beincluded in the EIR calculation. However, if an entity purchases

a nancial asset at a discount, because of previously incurred

credit losses, these should be included in the estimated cash

ows; and

For assets held at amortised cost which are subject to call,

prepayment, or extension options, entities should calculate the

EIR using estimated, rather than contractual, future cash ows.

Although there is a presumption that future cash ows can be

estimated reliably, contractual cash ows should be used when

reliable estimation is not possible.

For nancial instruments that pay interest at a variable rate, the

EIR is amended to reect movements in market rates each timethe contractual rate is reset. In contrast, whether the contractual

interest rate is variable or xed, when there is a change in

estimates of the cash ows (as may occur, for instance, when an

asset has an uncertain expected maturity due to the issuer having

a prepayment option), the EIR is not amended. Instead, the entity

should adjust the amortised cost of the instrument to reect

actual and revised estimated cash ows, discounting the remaining

estimated cash ows using the original EIR. This means that

there will be a catch-up adjustment whenever there is a change

in estimates, which will be reported as an immediate income

or expense.


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Example Change in estimation of the expected life of a bond recorded at amortised cost

As an illustrative example of when estimates used to calculate the EIR are adjusted, take a bond with a principal value of 100,000

which pays 5% coupon per year for the rst two years and 7% thereafter, but has an option to prepay or extend at the end of year 4.

If the holder of the bond originally does not anticipate the cash ows extending beyond year 4, the EIR would be 5.942% and the

interest income for each period would be as follows:

Balance brought

forward

Expected

cash ows

Interest income

at effective rate

Balance carried

forward

Year 1 100,000 5,000 5,942 100,942

Year 2 100,942 5,000 5,999 101,941

Year 3 101,941 7,000 6,057 100,998

Year 4 100,998 107,000 6,002 0

Next, assume that at the end of year 2, the expected cash ows are revised so that the bond life is re-estimated to the end of

year 5. The EIR is required to be kept constant at 5.942%, which means that the holder would recognise a catch up credit to

income, at the end of year 2, of 889.

Balance broughtforward

Expectedcash ows

Interest incomeat effective rate

Catch-up Balance carriedforward

Year 1 100,000 5,000 5,942 100,942

Year 2 100,942 5,000 5,999 889 102,830

Year 3 102,830 7,000 6,111 101,941

Year 4 101,941 7,000 6,057 100,998

Year 5 100,998 107,000 6,002 0

Business impact amortised costs

Calculation of the effective interest rate can be a practical challenge for large portfolios of nancial instruments.

Also, it is not easy to automate the solution when information needs to be derived from more than one system (to include

fees and costs) and if there are limits on what can be done to modify legacy systems.

Deferral of initial fees as part of the EIR means that recorded prot may no longer reect how the income has traditionally

been budgeted, measured and rewarded. These processes will need to be brought in line with the IFRS reporting, unless the

entity is prepared to maintain information on two separate bases.


16/40


Fair value is dened as the amount for which an asset

could be exchanged, or a liability settled, between

knowledgeable, willing parties in an arms length

transaction. The Application Guidance of IAS 39

claries that fair value is not the amount that an

entity would receive or pay in a forced transaction

or distressed sale. IAS 39 distinguishes between

nancial instruments quoted in an active market andwhen there is no active market, and provides guidance

on these terms.

Active markets

Many nancial instruments, including most quoted securities, are

traded in active markets. According to IAS 39, there is an active

market if quoted prices are readily available and representative of

the prices of actual and regularly occurring transactions on an

arms-length basis. In an active market, the best evidence of fair

value is deemed to be the published price quotation. When there

is more than one quoted market price for an instrument, e.g., in

the wholesale and the retail markets, an entity should use the price

quoted in the most advantageous market to which it has immediate

access. Consequently, not all entities will use the same price as the

fair value.

IAS 39 requires the use of bid prices for long positions (nancial

assets owned by the entity) and ask price for short positions

(when the entity sells an instrument that it does not already own).

This is true even if the entity is a market maker and so can buy or

sell within the bid-ask spread. Inconsistently, commission costs to

sell an asset should not be deducted from the fair value; as a

result, the recorded value will depend on the market convention

as to how a dealer or broker is remunerated. (If the guidance inSFAS 157 becomes part of IFRS, then it will be possible to record

nancial instruments at the price within the bid-ask spread at

which the entity expects to transact.)

Bid-ask spreads may be sourced directly from quoted prices

or may need to be estimated if the market convention is to

quote mid-market prices.

Fair value

When an entity has a portfolio of offsetting market risks, mid-

market prices may be used as a basis for determining fair values

and the bid or ask price may be applied to the net open position

rather than transaction by transaction. This is important for

dealers who hold portfolios of transactions and manage the

exposure on a net basis, and is consistent with market practice.

IAS 39 acknowledges that there may be circumstances when

current prices are unavailable and the most recent traded price

may be stale, for example, if market conditions have changedor the price represented a forced sale transaction. In such

circumstances, the price should be adjusted. However, if the

market becomes relatively illiquid, it will not normally be

appropriate to assume that all transactions are forced sales.

For a nancial instrument traded in an active market, it is

important to note that an adjustment (typically referred to as

a block discount) is not allowed simply because an entity has

such a large holding of a particular instrument that is actively

traded, even if the market price would almost certainly change

if the entire position was sold.

For many over-the-counter (OTC) derivative nancial

instruments the market convention is to quote rates which are

used as model inputs, rather than prices, When prices are not

available for an instrument in its entirety, the instrument is still

regarded as actively traded if there is an active market for all of

its component parts.

Warning

IAS 39 requires securities traded in an active market to

be recorded at the quoted price, even if the entity holds

a signicant position whose sale in its entirety would

change the price that could be achieved.


17/40


Inactive markets

When there is no active market for a nancial instrument,

fair value has to be established using a valuation technique,

such as recent transaction prices, the current fair value of similar

instruments, discounted cash ow analysis or option pricing

models. If there is a technique commonly used in the market,

which has been demonstrated to provide reliable price estimates,

that particular approach should be used.

As the purpose of a valuation technique is to calculate the fairvalue at the measurement date, it is necessary to consider current

market conditions and liquidity. Consequently, if there is an

imbalance of supply and demand, it may be necessary to record

gains or losses, even though they are expected to reverse once

the market returns to normal.

As already mentioned, unless the fair value of the nancial

instrument can be evidenced by comparison to other market

transactions, IAS 39 states that, on initial recognition, the best

evidence of fair value is the transaction price. Hence, a day one

prot or loss made by a dealer i.e., the difference between the

transaction price and an alternative measure of the instruments

fair value may be recognised only if the alternative valuation isbased on the prices of other observable market transactions or

a valuation technique when all model inputs are observable in

the market. When this is not the case, the day one prot must

be deferred.

Subsequent to initial recognition, IAS 39 requires that the

valuation technique must make the maximum use of market

inputs and rely as little as possible on entity specic inputs.

This allows the valuation to be driven by a model even if not all

inputs are observable. However, it also requires that the valuation

is consistent with how prices are determined in the market and the

model must be calibrated against observable market prices.

Any deferred day one prot or loss cannot simply be recognised

on day two. The Standard is not clear as to when it can be

recognised, except that entities are entitled to consider the effect

of the passage of time in recognising gains or losses after initial

recognition. This is an area in need of further guidance, but it is

unlikely to be forthcoming now that US GAAP has changed in

this area. SFAS 157, effective for periods beginning on or after

1 January 2008, requires that fair values are calculated based on

market prices that would be achieved to exitan instrument, by sale

or transfer to a market participant. This allows allday one prots

to be recognised, whether or not model inputs are observable,

although the calculation needs to take into account the prot

margin that would be charged by the market participant.

Consequently, the day one prot recognised under SFAS 157

may be lower than the day one prot deferred under IAS 39.

As mentioned in the Introduction, the requirements of SFAS 157

may be introduced into IFRS within a few years.

Meanwhile, the inability to recognise day one prots has reduced

the recorded protability of many trading operations in the short

term and created challenges as to how their results should be

measured for management reporting and bonus purposes.

Business impact fair values

The requirement to defer day one prot to the extent

that inputs to valuation models are not all observable

creates challenges for performance measurement and

remuneration. Either the deferral is made only at a high

level, for external reporting purposes, so there are

differences between nancial and management reporting,

with the potential for misalignment of strategy and its

execution, or the adjustments are pushed down to the

operating level, in which case, the challenge is how toreward traders for earning prots that will only be

recorded over a number of years.

It is not sufcient that IFRS valuation adjustments are

made just for external nancial reporting, but will need

to be embedded into the daily accounting processes,

if management is to be able to understand and manage

performance as measured on an IFRS basis.


18/40


Impairment losses should be recognised when, and

only when: 1) there is objective evidence, 2) due to

the occurrence of one or more events subsequent to

the initial recognition of the nancial asset, which

3) have an impact on the estimated future cash ows,

and 4) can be reliably estimated.

Although much of the requirements in IAS 39 relating toimpairment are particularly relevant for loans and securities,

they are also applicable to trade receivables.

Objective evidence of impairment of an asset will include indicators

of nancial difculty or delinquency on the part of the debtor, any

concessions made by the lender, a high probability of bankruptcy

or nancial reorganisation of the debtor, or disappearance of an

active market in the investment arising from a nancial problem.

Additional impairment indicators for equity instruments include

signicant, adverse changes in the technological, market,

economic or legal environment in which the issuer operates,

or a signicant orprolonged decline in fair value.

IAS 39 also requires a loss to be recorded when there are

observable data indicating a measurable decrease in the

estimated future cash ows from a group of nancial assets,

even if the decrease cannot yet be identied for individual assets

in the group. Indicators of this include:

adverse changes in the payment status of borrowers (for

example, increased delays in payment or full utilisation of credit

limits by credit card holders who are only paying the minimum

monthly amount)

national or local economic conditions that correlate with

defaults in the group (for example, an increase in the

unemployment rate in the borrowers geographical area,

a decrease in property prices for mortgages in the relevant

areas, or adverse changes in industry conditions).

Impairment of amortised cost assets

When there is objective evidence of impairment, the carrying

amount of an asset should be reduced to the present value of

expected future cash ows, discounted at the instruments original

EIR. When the interest rate is variable, the discount rate would be

the current EIR determined under the contract. This means that

provisions will be greater for loans advanced at higher rates of

interest, even if the expected level of recovery is the same as for

a loan with a lower EIR.

Impairment

The determination of whether an asset is impaired should be

carried out separately for each individually signicant asset, but

may be made collectively for groups of similar assets that are not

individually signicant. However, assets that are individually

signicant and have been tested and no impairment is indicated,

are required to be tested again for impairment through their

inclusion in a further, collective assessment.

Post-impairment, interest income is recognised based on the

original EIR applied to the adjusted carrying value. This accretesthe carrying value of the loan to the level of the expected future

cash ows.

Collective assessment

The requirement to subject individually assessed assets to a

second, collective assessment is designed to allow recognition of

losses believed to exist in the portfolio but are not yet evident(sometimes referred to as incurred but not reported). This has

been the stated purpose of most banks general provisions in the

past, although banks are no longer permitted to record such

general provisions against loan losses under IAS 39. This loan

allowance can only be made under IAS 39 to the extent that there

are adverse changes in the payment status of borrowers, or

economic conditions that can be shown, using historical loss

experience, to correlate with defaults on the assets. Finding the

data and establishing the correlations has proven a considerable

challenge for many banks but the standard allows the use of peer

group experience when entities have no, or limited, entity-specic

loss experience.

Figure 3: Impairment of amortised cost assets

Segmentation of

the portfolio

Is there objective

evidence of

impairment?

Determination of

the amount of

impairment


19/40

In practice, banks have developed a range of methods to calculate

their collective impairment allowances. For instance, some banks

are using what is called the emergence period approach: if it can

be shown that it takes three months for a bank to become aware

that a borrower has died, and historically, it experiences an

average 5% loss rate when its debtors die, current mortality data

can be used to estimate a provision for the losses that the bank

may face due to loss events that have occurred, but of which the

bank is not yet directly aware. This logic is applied to other causes

of loss, such as unemployment.

Warning

The impairment requirements of IAS 39 differ from those

established for banks capital requirement calculations

under Basel II, as IAS 39 only allows provisions against

incurred losses.

Any provision must relate to incurred lossesarising from specic

impairment events or circumstances which have arisen since the

loans were rst advanced. A provision cannot be made when a

loan is rst advanced, or against expected losses, no matter

how likely, if they have yet to be incurred. Consequently,

the impairment rules of IAS 39 differ from those in the Basel II

regulatory capital guidelines. Nevertheless, banks will seek to

harmonise, when possible, the methods they use for IAS 39 and

regulatory reporting, using common data and processes, even if

the way in which the data is used differs so as to meet the

different requirements.

It is fair to say that, for nancial institutions, the impairment

rules have been among the most difcult to interpret and is

the area where there is likely to be the greatest level of disparity

in application.

Impairment of available-for-sale assets

IAS 39 requires that, once there is objective evidence that an AFS

asset is impaired, any fair value losses recorded in equity must be

transferred to prot or loss. However, it is important to distinguish

between impairment and a decline in market value; a decline in

market value below cost is not conclusive evidence of impairment.

For instance, an increase in the risk free rate would not normally be

regarded as evidence of impairment for xed rate loans.

Warning

Available-for-sale equity securities are deemed to be

impaired if there is a signicant orprolonged decline in

fair value.

Impairment losses for an available-for-sale equity

security cannot be reversed through prot or loss.

If the AFS asset is an equity instrument, a recognised impairment

loss cannot be reversed through prot or loss as long as the

asset continues to be recognised. Hence, any increase in fair value

after impairment has been recorded can only be recognised in

equity. However, impairment losses on debt instruments can be

reversed through the prot or loss account if the increase can be

objectively related to an event occurring after the impairment

loss was recognised.

IFRIC Interpretation 10 Interim Financial Reporting and Impairment

ruled that provisions against AFS equity securities made in interim

accounts cannot be reversed in the annual nancial statements,

even if the fair value recovers by year end.

For equity investments, a signicant orprolonged decline in fair

value below its cost represents objective evidence of impairment.

This means that a signicant equity price fall would automatically

result in impairment, even if only temporary. Given that

impairment provisions cannot be reversed through prot or loss,

this has a serious implication. IAS 39 provides no quantiable

indication as to what is considered either signicant or prolonged.

What is signicant should be determined on a case-by-case

basis and is dependent on the market in which the instrument

actively trades.

Business impact loan impairment

The use of the EIR to discount recoveries in the calculation of

loan impairment means that impairment charges and

provisions and the interest margin will all be higher than

under most local GAAPs. This will especially be the case for

higher risk loans with higher EIRs.

Also, because of discounting, impaired loans are likely

to be carried under IFRS at closer to the value at which they

are traded in the secondary market. Consequently, banks will

record a lower loss if they sell distressed loans, which may

lead to increased interest in the secondary debt market.



20/40


All derivatives must normally be recognised at fair

value on the balance sheet, with all changes in fair

value recorded in current year prot or loss.

However, if the derivative is entered into as a hedge,

the accounting treatment of the derivative may not

be symmetrical with the recognition of gains and

losses on the hedged item, unless it is held at fair

value with gains or losses recognised in prot orloss. Hedge accounting tries to match the timing of

prot or loss recognition on the derivative with that

of the item being hedged, but it can only be applied

when the hedge relationship meets specic criteria.

The key steps to achieve hedge accounting are

summarised in Figure 4.

Figure 4: Key steps to achieving hedge accounting

Hedge accounting

There are three types of hedge:

Fair value hedges

A fair value hedge is dened as the hedge of the exposure to

changes in the fair value of a recognised asset or liability, or a

previously unrecognised rm commitment to buy or sell at a xed

price, or an identied portion of such an asset or liability or rm

commitment, that is attributable to a particular risk and could

affect reported prot and loss.

In each case, the entity wishes to protect itself from changes in the

fair value of the asset or liability arising from market price

movements because its price or cash ows are xed.

Examples include:

a receive xed, pay oating, interest rate swap used to hedge

a xed rate liability

a purchased put option used to hedge an AFS equity instrument

a forward foreign exchange contract used to hedge the foreign

currency exposure on an AFS equity instrument, or

an oil forward contract used to hedge oil inventory.

Cash ow hedgesA cash ow hedge is dened as a hedge of the exposure to

variability in cash ows attributable to a particular risk associated

with a recognised asset or liability, or a highly probable forecast

transaction, which could affect prot or loss.

This is used when, for instance, the cash ows on an asset or

liability are not xed (e.g., a oating rate note), such that the

entity is at risk not to changes in fair value but, instead, to changes

in cash ows.

Examples include:

a pay xed, receive oating, interest rate swap used to lock

in the cost of a oating rate liability

a foreign exchange forward contract used to hedge the currency

exposure of a highly probable purchase of oil, or an operating

lease denominated in a foreign currency

a foreign exchange forward contract entered into to hedge

highly probable forecast sales

a pay xed, receive oating, interest rate swap used to lock

in the cost of a future, highly probable, borrowing.

Net investment hedges

In addition to the two main types of hedge already described,

IAS 39 adds the traditional process of matching foreign currency

gains or losses on a derivative or liability against the revaluation

of a foreign operation.

1. Identify the risk being hedged and the period

of the hedge

2. Identify the type of hedge fair value, cash ow,

or net investment

3. Identify the hedged item(s) and ensure they

qualify under IAS 39

4. Identify the hedging instrument(s) and ensure

they qualify under IAS 39

5. Identify the method to be used to test

hedge effectiveness

6. Demonstrate that the hedge will be highly effective

7. Document all the above from the start of the

hedge relationship

8. Monitor to ensure that the hedge continues to be highly

effective in accordance with the hedge documentation

9. Account for the hedge relationships, including

the measurement and recording of any

hedge ineffectiveness.


21/40


Accounting treatment of qualifying hedges

Depending upon whether the hedge is a fair value or cash ow

hedge, the accounting treatment is very different, as summarised

in Figure 5.

Gains and losses on fair value hedges are offset (if the hedge is

highly effective) by adjusting the value of the hedged item for the

effect of changes in the hedged risk. To the extent that the change

in value of the hedging instrument is different from the adjustment

to the hedged item, this difference will be automatically recorded

in prot or loss as ineffectiveness.

In comparison, the gain or loss on the hedging instrument in

a highly effective cash ow hedge is recorded in a separate

component of equity, as long as the gain or loss is less than the

change in expected cash ows on the hedged item. This gain or

loss is subsequently transferred to prot or loss so as to offset the

impact on prot or loss of the change in value of the hedged item

when it affects reported prot or loss. Therefore, while the income

statement is protected by cash ow hedging, the entity will still

record signicant increases or decreases in its net assets in the

short term, with an impact on such measures as gearing ratios

and return on equity.

One elective exception is available when a forecast transaction

results in a rm commitment to buy or sell a non-nancial asset or

liability, such as plant and machinery. The amount deferred in

equity can be transferred to the recorded value of the asset or

liability when it is initially recognised and so recorded in prot

or loss as the non-nancial item is derecognised or depreciated.

For net investment hedges, the gain or loss on the hedging

instrument is recorded in equity to offset the gains and losses on

the net investment, to the extent that the hedge is highly effective.

Constraints on hedge accounting

Hedged items

The hedged item can be a recognised asset or liability,

an unrecognised rm commitment, an uncommitted but highly

probable forecast transaction, or a net investment in a foreign

operation. It can be a single asset, liability, commitment or

transaction, or a group of such items as long as they have similar

risk characteristics. The denition of similar risks characteristics

is very restrictive and is limited to occasions when the change in

fair value attributable to the hedged risk for each individual item

in the group is expected to be approximately proportional to the

overall change in fair value attributable to the hedged risk of the

group as a whole.

This precludes (for instance) hedge accounting for a purchased

index put option or an index future used to protect the fair value of

a portfolio of equity securities making up the index. Even though

the instrument may give an effective (nearly perfect) economic

hedge of the portfolio, because the fair value of the individual

securities in the portfolio do not move in an approximately

proportional manner to the fair value of the portfolio as a whole,

the portfolio cannot be designated as a hedged item.

In addition, a portfolio of both assets and liabilities is not normally

permitted to be a hedged item. As a result, a hedge of a net

position has to be treated as a hedge of specic assets or liabilities

within the overall portfolio.

The exception to the constraints on hedging groups of items and

portfolios are the two types of macro hedge designed for nancial

institutions, each of which has its own particular rules. Macro fair

value hedges are designed for hedging a portfolio of prepayable

xed rate assets. Macro cash ow hedges provide a exible way to

hedge a portfolio of future expected cash ows.

Warning

The amount of the gain or loss on a nancial instrument

designated as a cash ow hedge that is recorded in equity

is the lower of the change in the fair value of the hedging

instrument and the change in fair value of the hedged

cash ow.

Figure 5: Accounting treatment for qualifying hedges

Fair value hedges Cash ow hedges

1. Gain or loss on

hedginginstrument

Recognised

immediately in protor loss

To the extent the

hedge is effective,in equity, residual in

prot or loss

2. Adjustment to

hedged item

Change in fair value

due to the hedged

risk is recognised

immediately in prot

or loss

N/A

3. Hedge

ineffectiveness is

recorded in prot

or loss

By default Calculated

4. Gain or loss inequity is

transferred to

prot or loss

N/A At the same time asthe change in the

hedged cash ows or

related non-nancial

asset or liability is

recognised in prot

or loss


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Another constraint on hedge accounting is the rule in the Standard

that the recorded value of a nancial liability with a demand

feature (e.g., a demand deposit) cannot be less than the amount

payable on demand, discounted from the rst date that the

amount could be required to be paid. This means that demand

deposits are not considered to be subject to changes in fair value

and are not, therefore, eligible for fair value hedge accounting.

This presents a challenge for banks that recognise that demand

deposits do change in value with interest rate movements and build

such expectations into their hedging strategy. Financial institutions

that, from a risk management perspective, lock in the interest

spread on their deposits, are not permitted by IAS 39 to use fair

value hedge accounting and have to accept increased volatility in

income or equity.

At the time of writing, the version of IAS 39 adopted by the

European Union still has a carve out of parts of the hedge

accounting rules in IAS 39 to permit banks to achieve fair value

hedge accounting for deposits that are payable on demand and to

avoid recording ineffectiveness. Attempts to amend IAS 39 to deal

with this controversy have, to date, been unsuccessful.

A rm commitment to acquire a business in a businesscombination cannot be a hedged item, except for hedges of foreign

exchange risk. Meanwhile, an equity method investment, such as

an associate, cannot be the hedged item in a fair value hedge,

as the equity investor does not recognise changes in fair value in

earnings, but accounts for its share of the investees prot or loss.

Warning

Non-nancial items can only be designated as hedges

for foreign currency risk or in their entirety.

A non-nancial asset or liability can only be designated as a

hedged item in its entirety, or for a hedge of foreign currency risk.

This signicantly reduces the likelihood of achieving an effective

hedge for non-nancial items such as purchase or sales of

commodities (see section on Hedge effectiveness, below).

Normally, an intragroup balance or transaction may not be the

hedged item in a set of consolidated nancial statements. The

main exception to this is a balance between two group entities that

have different functional currencies, as there will be retranslation

differences which affect consolidated prot or loss. In addition,

Hedge accounting continued

the amendment to IAS 39 issued in April 2005 permits a forecast

intra-group foreign exchange transaction to be designated

as a hedged item in a foreign currency cash ow hedge,

if the transaction:

is highly probable and meets all the other hedge

accounting criteria;

is denominated in a currency other then the functional

currency of the entity entering into the hedge; and

will affect consolidated prot or loss.

To affect consolidated prot or loss, the hedge will usually

need to be of a transfer of inventory within a group to meet a

forecast external sale, or the transfer of a xed asset. A hedge

of a management or royalty charge between group entities will

not qualify.

In September 2007, the Board issued a new ED of proposed

amendments to IAS 39 Financial Instruments: Recognition and

Measurement: Exposures Qualifying for Hedge Accounting.The ED

specied the risks that qualify for designation as hedged risks and

set out the circumstances in which a portion of a nancial

instruments cash ows may be designated as the hedged item

under IAS 39.

Following concerns raised by respondents to the ED, in particular,

the fact that it was rules rather principles-based, the IASB decided

during its April 2008 meeting to limit the scope of this project.

Going forward, this project will only address issues related to:

i) whether a purchased option, in its entirety, may be designated

as a hedging instrument of the variability of future cash ows in a

cash ow hedge, even if the hedged cash ows do not contain any

optionality; and ii) hedges of ination risk.

Hedging instruments

All derivatives can be treated as hedging instruments, except fornet written options (unless they are designated as an offset to

purchased options). The reference to net written options is

designed to permit nancial instruments such as collars, that

contain both a purchased and a written option, to be designated as

hedges, if they are not a net written option, i.e., as long as there is

no net premium received, the notional amount of the written

option is no greater than that of the purchased option component,

and all other critical terms of the offsetting options match.

A non-derivative nancial asset or liability can only be designated

as a hedge of foreign currency risk.


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A derivative embedded in another contract may be designated

as a hedging instrument, but only if it is required to be separated

(see the section Embedded derivatives, above).

A key requirement is that all hedging instruments must involve a

third party. Intra-group transactions are not eligible hedges in a set

of consolidated nancial statements, causing signicant difculties

when a group operates through a separate treasury function.

In these circumstances it is usually necessary to identify, on a

case-by-case basis, external derivative trades that may bedesignated as hedges of assets, liabilities, commitments or

forecast transactions.

It is possible to designate only a portion of a hedging instrument,

such as 50% of its notional amount as the hedge, as long as the

designated portion is less than the total cash ows of the asset or

liability being hedged. However, it is not possible to designate a

hedging instrument only for a portion of its life.

The Standard allows the segregation of time value from the

intrinsic value of an option, or the interest element and spot price

of a forward contract and the designation of only the intrinsic

value or spot price as part of the hedge relationship. The effect will

be to record the change in fair value of the time value or forward

points in prot or loss.

Two or more derivatives, or proportions thereof, may be viewed in

combination and jointly designated as a hedging instrument.

However, if the combination involves a written option component

and a purchased option component it will not qualify as a hedging

instrument if it is, in effect, a net written option, so that a net

premium is received. In addition, a single hedging instrument may

be designated as a hedge of more than one type of risk, provided

that the hedged risks can be clearly identied and the

effectiveness of the hedges can be demonstrated.

Warning

The following are noteligible as hedging instruments:

non-derivatives (except for hedges of foreign

currency risk)

net written options, which will include swaps that can

be extended or terminated at the other partys option

intra-group transactions, in group accounts.

Net investment hedges

IFRIC 16 Hedges of a Net Investment in a Foreign Operation, issued

in July 2008, claries their accounting treatment. This states that

the risk that may be designated in the hedge is the foreign

currency exposure arising between the functional currency of the

foreign operation and the functional currency of the parent entity

designated in the hedged documentation, i.e., an entity cannot

hedge the foreign currency exposure arising from its presentation

currency, if this differs from the parents functional currency.

Note that any parent in the group can be the designated parent

not just the ultimate parent.

When hedging a net investment, the interpretation states that a

hedging instrument can be held by any entity within the group.

To assess the effectiveness of the hedging instrument in

the consolidated nancial statements, the change in value of the

hedging instrument is calculated in terms of the functional

currency of whichever parent is hedging its risk. Hence, the

functional currency of the entity holding the hedging instrument

is ignored.

Hedge effectiveness

In order to achieve hedge accounting, a hedge must meet two tests

of effectiveness:

Prospectively, at inception and throughout its life, each hedge

must be expected to be highly effective in achieving offsetting

changes in the fair value or cash ows of the hedged risk; and

Retrospectively, measured each period, the hedge must have

been highly effective, so that actual results are within a range

of 80 to 125%.


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This means that the change in the fair value of the hedging

instrument cannot be greater than 125% or less than 80% of the

change in value of the hedged item attributable to the hedged

designated risk. Although a numerical threshold is not contained

in the Standard for prospective effectiveness tests, the 80-125%

retrospective range is often, in practice, applied.

It should be noted that in assessing effectiveness, it is not

sufcient for a cash ow hedge just to compare the expected cash

ows of the hedging instrument and the hedged item. Despite thedenition that a cash ow hedge is a hedge of future cash ows,

it is clear in the Standard (and has been conrmed by IFRIC) that

it is necessary to c

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