International Financial Reporting Standards (IFRS)
2 day IFRS course December 2007
Steven Brice, Partner - Mazars
Day 2
Agenda
Course programme – Day 2 Course programme – Day 2
Financial instruments – Recognition and Financial instruments – Recognition and measurement
measurement
IFRS 7 disclosures IFRS 7 disclosures
IFRS– Case study (Vitalise Plc) IFRS– Case study (Vitalise Plc)
Consolidated financial statements Consolidated financial statements
Share-based payment Share-based payment
Indian GAAP and IFRS – Key differences Indian GAAP and IFRS – Key differences
Overview of other areas (pensions, leases, FX) Overview of other areas (pensions, leases, FX)
Managing an IFRS project Managing an IFRS project
Practical issues and potential pitfalls Practical issues and potential pitfalls
Future plans and IASB projects Future plans and IASB projects
Summation and close Summation and close
IAS 39 Financial instruments
IAS 39 ‘Financial instruments’
Why is it such a big deal?
304 pages long
Application guidance - 49 pages
Basis of conclusion - 73 pages
Illustrative examples - 8 pages
Implementation guidance - 112 pages + amendments to IAS 39
IAS 32 – 71 pages
IFRS 7 – 67 pages on disclosure
Development of IAS 39
Historical cost Historical cost
IAS 39 (Mixed model) IAS 39 (Mixed model)
Fair value (full) Fair value (full)
2003 - 2006 Past
Future?
Time line
Amendment to IAS 39 (revised Standard) Amendment to IAS 39
(revised Standard)
1998
What is a financial instrument?
Financial instruments
Contract Financial asset
Financial liability What is a
financial
instrument ?
Financial asset
Any asset that is:
Cash;
A contractual right to receive cash or other financial asset;
A contractual right to exchange financial instruments (potentially favourable); or
An equity instrument of another enterprise
Financial liability
Any liability that is a contractual obligation:
to deliver cash or a financial asset to another enterprise; or
to exchange financial instruments with another enterprise (potentially unfavourable)
Scope - Action needed
1. Firstly, decide whether the item in question is inside or outside of the scope of IAS 39
Scope of IAS 32/39
The scope of IAS 32/39 is very wide ranging
Scope
Categories of financial instruments and
measurement options under IAS 39
The current IAS 39 measurement model
Amortised cost Fair value
Mixed model
Classification of financial assets
Each financial asset that falls within the scope of IAS 39 must be classified into one of the following four primary categories
1. At fair value through profit or loss (FVTPL)
2. Available-for-sale (AFS)
3. Loans and receivables
4. Held-to-maturity (HtM)
Fair value through profit or loss (FVTPL)
Designation is irrevocable
May help to provide a natural offset and avoid burden of fair value hedge accounting
Amendment to IAS 39 re fair value option
All assets held for trading
All derivative assets (except those designated as a cash flow hedge or hedge of a net foreign investment)
Designated as FVTPL
Held for
trading
Designated at fair value through profit and loss
Action needed
1. Need to determine if assets are held for trading. This is a matter of judgement that depends on the relevant facts and circumstances
Indicators of trading activities
The term ‘trading’ generally reflects active and frequent buying an selling.
Indicators:
1. Organisational characteristics
Primary assets are financial instruments
2. Customers, counterparties and competitors
Majority of counterparties are banks or fund managers
Volume of transactions (buying/selling)
3. Management and controls
Performance tied to short term results (Trading profits)
Management reports contractual positions, risk exposure, fair values
4. Transactions/contracts
Fair value - Hierarchy
Fair Value
Amount for which an asset could be exchanged, or liability settled, between knowledgeable, willing parties in an arms length transaction
Published price quotation in an active market is best evidence of fair value and should be used when available:
• ‘Quoted’ - available from an exchange, dealer, broker, industry group, pricing service
• Bid (entry) price for assets held & liabilities to be issued
• Ask/offer (exit) price for assets to be acquired & liabilities held
• Mid-market price may only be used in the case of matching asset and liability positions
Available-for-sale (AFS) financial assets
AFS financial assets are non-derivative financial assets that are designated as AFS, or are not classified as loans and receivables or held to maturity (htM) and are not held for trading
Measurement
AFS assets are measured at fair value with fair value movements taken to equity (through statement of changes in equity)
Gain or loss is recycled into the income statement upon sale or impairment
Held-to-maturity (HtM) investments
HtM investments are financial instruments with fixed or determinable payments and fixed maturity that the entity has the positive intention and ability to hold to maturity, other than those upon initial recognition that the entity elects to designate at FV through profit or loss or AFS or that meet the definition of loans and receivables
HtM investments are measured at amortised cost using the effective interest rate method
In some instances it may be necessary to separate an embedded derivative so that the host contract can be treated as HtM
Amortised cost - example
On 1 January 20X0, a entity acquires a bond for consideration of £90, incurring transaction costs of £5. Interest of £4 p.a. is receivable over the next 5 years (31 December 20X0 to 31 December 20X4). The bond has a mandatory redemption of £110 on 31 December 20X4.
Amortised cost - answer
The effective interest rate of 6.96 per cent is the rate that discounts the expected cash flows on the bond to initial carrying amount
Tainting
What is tainting
“Tainting” is the term used to describe the effect of disposing of or reclassifying a held-to-maturity investment before its maturity date on the remaining portfolio of securities held
Impact of tainting
All HtM assets must be reclassified into the available for sale category
Prevented from using the category for the next two financial years!
Scenario
All the group is tainted
Parent
Sub 1 Sub 2 Sub 3
Originated Loans and Receivables (OLR)
Financial assets:
• with fixed or determinable payments
• not quoted in an active market (debt securities)
• created by providing money, goods or services directly to a debtor
Can be designated as AFS or FVTPL on initial recognition
If intend to sell in the short-term - HFT
Measured at amortised cost
Quiz
Financial Asset Classification
Financial liability categories
Fair value through Fair value through
profit and loss profit and loss -Held for trading; orHeld for trading; or
-Designated on Designated on initial recognition initial recognition
Other Other
- Amortised costAmortised cost
Subsequent Measurement of Financial Liabilities
After initial recognition, an entity shall measure all financial liabilities at amortised cost using the effective interest method, except for:
(a) financial liabilities at fair value through profit or loss. Such liabilities, including derivatives that are liabilities, shall be measured at fair value except for a derivative liability that is linked to and must be settled by delivery of an unquoted equity instrument whose fair value cannot be reliably measured, which shall be measured at cost.
(b) financial liabilities that arise when a transfer of a financial asset does not qualify for derecognition or is accounted for using the continuing involvement approach.
Initial recognition
On initial measurement, IAS 39 requires that financial assets and liabilities are measured at 'fair value'.
The concept of fair value is central to the approach of the standard
Assuming transactions are conducted on arm's length terms, the fair value of a financial instrument acquired should normally be equal to the fair value of the consideration given or received (the 'transaction price').
Consequently, IAS 39 states that for initial recognition purposes, the transaction price is normally the best evidence of the fair value of a financial instrument
Day 1 profits
An immediate gain may be recognised on the acquisition of a financial instrument only where there is strong, market-based evidence of the fair value of the said instrument.
Recognition of deferred day one profit or loss
Example Example
Movement in deferred day 1 profits
Low interest or interest free loans - Example
An entity grants an interest-free loan of £100 to an employee. It is repayable in 12 months time. The market rate of interest for a loan to this individual would be 8 per cent.
The principal amount should be split into two elements.
(i) £92.59 being the fair value of the acquired financial asset (i.e. £100/1.08).
(ii) £7.41 being employee remuneration. This amount represents the fair value of the entity providing its employee with interest-free finance and is accounted for under IAS 19 Employee Benefits.
Transaction costs
Transaction costs are defined as follows:
'Transaction costs are incremental costs that are directly attributable to the acquisition, issue or disposal of a financial asset or financial liability. An incremental cost is one that would not have been incurred if the entity had not acquired, issued or disposed of the financial instrument.'
IAS 39 indicates that transaction costs should be interpreted as including fees and commissions paid to agents, advisers, etc., as well as levies, taxes and duties.
However, debt premiums/discounts, financing costs, internal administrative costs and holding costs should not be included. In practice, the interpretation of this definition may require significant judgement.
Transaction costs
For a financial asset or liability that is not classified as 'at fair value through profit or loss' (FVTPL), transaction costs that are directly attributable to the acquisition or issue of the asset or liability should be added or deducted to the fair value on initial recognition.
(a) For financial instruments that are carried at amortised cost, transaction costs are included in the calculation of the effective interest rate - in effect, they will be amortised through profit or loss over the term of the instrument.
(b) For available-for-sale financial assets where the effective interest method is applied, transaction costs will initially be recognised as part of the carrying value of the financial asset. The transaction costs will be amortised through profit or loss over the term of the instrument under the effective interest method as with assets and liabilities measured at amortised cost.
If the available-for-sale asset does not have fixed or determinable payments or has an indefinite life, and therefore the effective interest rate is not applied, (e.g. the asset is an investment in an equity security) transaction costs are recognised in profit or loss only upon impairment or derecognition.
(c) For financial instruments classified as FVTPL, transaction costs are immediately recognised in profit or loss on initial recognition.
Summary - Measurement and recognition of financial instruments
Financial Assets Measurement Changes in carrying amount
Financial assets at fair
value through P&L Fair value Income statement
Loans and receivables Amortised cost Income statement
Held-to-maturity
investments Amortised cost Income statement Available-for-sale
financial assets Fair value Equity
Financial liabilities Measurement Changes in carrying amount
IFRS 7: Financial instruments: disclosures
IFRS 7 - Content
IFRS 7 ‘Financial instruments: Disclosures’
Introduction
In August 2005, the IASB issued IFRS 7 Financial Instruments: Disclosures ('IFRS 7'). IFRS 7 is effective for annual periods beginning on or after 1 January 2007
An entity that adopts IFRS 7 for an accounting period beginning on or after 1 January 2006 must apply the standard in full to both current and comparative information.
Objective
The objective of IFRS 7 is to require entities to provide disclosures in their financial instruments that enable users to evaluate:
(i) the significance of financial instruments for the entity's financial position
Scope
IFRS 7 is applicable to all entities and to all risks arising from all financial instruments, whether recognised or unrecognised, except where specifically mentioned.
IFRS 7 applies to financial statements of subsidiaries. (There is no exemption even if full disclosures provided in the consolidated financial statements in which the subsidiary is included. The IASB has stated that where an entity prepares any financial statements in accordance with IFRSs, users of those financial statements should receive information of the same quality as users of general purpose financial statements prepared in accordance with IFRSs.)
IFRS 7 - Breaks down into 3 core categories
IFRS 7
Classes of financial instrument
and level of disclosure
Significance of financial instruments
and level of disclosure
Nature and extent of risks
arising from
financial
instruments
Categories vs classes of financial instruments
IFRS 7 requires some disclosures based on classes of financial assets and liabilities and other disclosures based on categories of financial instruments. Carrying amounts of financial instruments and net gains and losses, for example, need to be disclosed by category. Credit risk and fair values, on the other hand, need to be analysed by class.
Categories of financial instruments are determined in accordance with IAS 39. The category determines the way an entity measures its financial assets and liabilities as well as whether resulting income and expenses are presented in equity or in profit or loss.
Classes of financial instruments
IFRS 7 requires an entity to group financial instruments into classes that are appropriate to the nature of the information disclosed and take into account the characteristics of those financial instruments.
The classes shall be reconciled to the line items presented in the balance sheet. [IFRS 7(6)]
The classes shall be determined by the entity and are distinct from the categories of financial instruments, as specified by IAS 39.
Q:
When disclosure is required by class what is the minimum that one needs to disclose?Classes of financial instruments
The preparer of the financial statements must strike a balance between providing excessive detail and obscuring information as a result of too much aggregation. [IFRS 7(BC3)]
At a minimum the classes are required to distinguish between those financial instruments that are measured at:
amortised cost
fair value
However, ……….
In many instances classes of financial instruments will be more granular than the categories of financial instruments.
For example, loans and receivables is a financial instrument category that could comprise various classes like home loans, credit card loans, unsecured medium term loans etc.
Disclosure by class
A number of disclosures are required to be given by class of financial instrument including
derecognition of financial assets;
allowance account for credit losses (if an entity chooses under IAS 39 to have a separate allowance account);
impairment losses recognised for financial assets in profit or loss;
fair value of all financial instruments;
'day 1 profit or loss'; and
credit risk.
Categories of financial assets and financial liabilities
An entity is required to disclose the carrying amount for each financial instrument category as defined by IAS 39 either on the face of the balance sheet or in the notes to the financial statements. [IFRS 7(8)]
The financial asset categories are held-to-maturity financial assets, loans and receivables, available-for-sale financial assets and financial assets carried at fair value through profit or loss.
The financial liabilities categories are those financial liabilities carried at fair value through profit or loss and other financial liabilities.
Information relating to categories
Nordia
Categories of financial assets and financial liabilities
These disclosures are intended to assist users in understanding the extent to which accounting policies affect the amounts at which financial assets
and financial liabilities are recognised.
[IFRS 7(BC14)]
Together with the disclosures of the gains and losses by category of financial instrument, the disclosure of the carrying amounts for each category of financial instrument allows users to appraise management on its decisions to buy, sell or hold financial assets and to incur, maintain or discharge financial liabilities.
Significance of financial instruments
One of the two key objectives of IFRS 7 is to require entities to provide disclosures in its financial statements that enable users to evaluate the significance of financial instruments for the entity's financial position and performance.
To achieve this, disclosures must be provided for
balance sheet,
income statement and
equity
Income statement disclosures
New
* *
Financial result by category
Finance costs
New income statement disclosures introduced by IFRS 7
Net gains or losses for each category of financial asset or financial liability
Impairment losses for each class of financial asset
As already noted, a class of financial instruments is (often) a lower level of aggregation than a category.
For example, a company would probably disclose impairment losses for available-for-sale debt securities separately from impairment losses for available-for-sale equity securities if the classes are material.
Balance sheet
IFRS 7 requires disclosures for each categories of financial assets and liabilities
Specific disclosures on assets and liabilities at fair value through profit and loss
Information about the significance of financial instruments
Balance Sheet
Disclosure of the significance of financial instruments for an entity's financial position and performance. [IFRS 7.7] This includes disclosures for each of the following categories: [IFRS 7.8]
Financial assets measured at fair value through profit and loss, showing separately those held for trading and those designated at initial recognition.
Held-to-maturity investments.
Loans and receivables.
Available-for-sale assets.
Financial liabilities at fair value through profit and loss, showing separately those held for trading and those designated at initial recognition.
Financial liabilities measured at amortised cost.
Example – by category (HTM)
Financial assets at fair value through profit or loss
IFRS 7(9) requires extensive disclosure where an entity has designated loans and receivables as at fair value through profit or loss, since applying the fair value option to these instruments may result in a significant impact on the financial statements caused by fair value movements, and in particular those movements caused by changes in credit risk.
Financial liabilities at fair value through profit and loss
Disclosures on fair value
Information about the fair values of each class of financial asset and financial liability, along with: [IFRS 7.25-30]
Comparable carrying amounts.
Description of how fair value was determined.
Detailed information if fair value cannot be reliably measured.
Note that disclosure of fair values is not required when the carrying amount is a reasonable approximation of fair value, such as short-term trade receivables and payables, or for instruments whose fair value cannot be measured reliably. [IFRS 7.29]
IFRS 7 – Fair value disclosures
Danske Bank
Nature and extent of exposure to risks arising from financial instruments
Qualitative disclosures
The qualitative disclosures describe:
Risk exposures for each type of financial instrument.
Management's objectives, policies, and processes for managing those risks.
Changes from the prior period.
Quantitative disclosures
The quantitative disclosures provide information about the extent to which the entity is exposed to risk, based on information provided internally to the entity's key management personnel. These disclosures include:
Credit Risk
Disclosures about credit risk include:
Maximum amount of exposure (before deducting the value of collateral), description of collateral, information about credit quality of financial assets that are neither past due nor impaired, and information about credit quality of financial assets whose terms have been renegotiated.
For financial assets that are past due or impaired, analytical disclosures are required.
Information about collateral or other credit enhancements obtained or called.
Financial assets that are either past due or impaired
IFRS 7 introduces disclosure of information relating to financial assets that are either past due or impaired. This includes (1) an analysis of the age of financial assets that are past due but not impaired, (2) an analysis of those financial assets that are impaired, and (3) a description and the fair value, unless impracticable, of collateral held against financial assets that are either past due or impaired.
Other disclosures: Collateral the company has taken control
of during the period
Market Risk
Market risk is the risk that the fair value or cash flows of a financial instrument will fluctuate due to changes in market prices. Market risk reflects interest rate risk, currency risk, and other price risks.
Disclosures about market risk include:
A sensitivity analysis of each type of market risk to which the entity is exposed.
IFRS 7 provides that if an entity prepares a sensitivity analysis for management purposes that reflects interdependencies of more than one component of market risk (for instance, interest risk and foreign currency risk combined), it may disclose that analysis instead of a separate sensitivity analysis for each type of market risk.
IFRS 7 distinguishes three types of market risk
1. Currency exchange risk, i.e. the risk that the fair value or future cash flows of a financial instrument will fluctuate because of changes in exchange rates;
2. Interest rate risk, i.e. the risk that the fair value or future cash flows of a financial instrument will fluctuate because of changes in market interest rates; and
3. Other price risk, i.e. the risk that the fair value or future cash flow of a financial instrument will fluctuate because of changes in market conditions not related to interest rate risk or currency exchange risk.
Each sensitivity analysis should identify how "reasonably possible" changes in market conditions would have affected the entity's reported equity and profit or loss. "Reasonably possible" is not defined and professional judgement will be required in selecting the appropriate changes in conditions. The assumptions underlying the sensitivity analysis and how these were determined should be disclosed.
Foreign currency sensitivity
Foreign currency sensitivity
Sensitivities (FX) example - Brit
Interest rate sensitivity - example
The Group’s policy is to minimise interest rate cash flow risk exposures on our long-term financing. Longer-term borrowings are therefore usually at fixed rates. At 31 December 2007, the Group is exposed to changes in market interest rates through its bank borrowings, which are subject to variable interest rates. As in the previous year, all other financial assets and liabilities have fixed rates.
The following table illustrates the sensitivity of the net result for the year and equity to a reasonably possible change in interest rates of +X% and -X%
(2006: +/-X%), with effect from the beginning of the year. These changes are considered to be reasonably possible based on observation of current market conditions. The calculations are based on Group’s financial instruments held at each balance sheet date. All other variables are held constant.
Sensitivities example - Brit
Other price risk sensitivity (example requirements)
The Group is exposed to other price risk in respect of its listed equity securities, the participation in XY Ltd. and debentures
For the listed equity securities, an average volatility of X% has been observed during 2007 (2006: X%). If the quoted stock price for these securities had increased or decreased by that amount, the net result for the year would have been reduced/increased by TEUR XXX (2006: TEUR XX). Equity would have changed by TEUR XXX (2006: TEUR XXX)
The investments in listed equity securities and in XY Ltd. are considered long-term, strategic investments. In accordance with the Group’s policies, no specific hedging activities are undertaken in relation to these investments. The investments are continuously monitored and voting rights arising from these equity instruments are utilised in the Group’s favour.
The average volatility of the market price of the debentures was X% in 2007 (2006: X%).
If the market price had increased or decreased by this amount, equity would have been increased/decreased by TEUR XX (2006: TEUR XXX). As none of these available-for- sale financial assets were sold during any of the periods under review, no effect on the income statement would have occurred.
Liquidity Risk
Disclosures about liquidity risk include:
A maturity analysis of financial liabilities.
Description of approach to risk management.
Liquidity risk
Liquidity risk
Liquidity risk – Some of the issues to consider (1)
IFRS 7 has a wider scope than IAS 39. The maturity analysis therefore encompasses all financial liabilities within the scope of IAS 39, and certain other liabilities e.g. those arising from lease arrangements or from contracts to buy or sell a business at a future date. Obligations from other types of liabilities such as pension or current tax liabilities are not subject to the maturity analysis.
The maturity analysis shows gross and undiscounted cash flows. The amounts therefore usually differ from the amounts in the balance sheet.
IFRS 7 does mandate the time bands that should be featured in the maturity analysis. IFRS 7.B11 does suggest certain time bands. In our view, however, the entity should at least distinguish current and non-current obligations.
Liquidity risk – Some of the issues to consider (2)
Payments arising from financial liabilities should be allocated to the time band that includes the earliest date possible at which the entity may be required to pay (IFRS 7.B12).
Payable amounts that are not contractually fixed, but are yet to be determined (e.g. when a derivative is yet to become effective due to characteristics in its underlying) should be assigned to the time band they are most likely to fall into, based on the conditions existing at the reporting date.
If an entity is a party to derivative financial instruments which give rise to financial liabilities, a maturity analysis should be prepared that separates contractual cash flows arising from derivative financial instruments from non-derivative financial instruments.
Liquidity – Financial assets and Financial liabilities
Novartis discloses the contractual maturities of its financial assets, as well as the contractual maturities for financial liabilities in the notes to the financial statements. This disclosure is supplemented by a discussion of how the company manages its liquidity risk, also located in the notes to the financial statements:
Description of how liquidity risk inherent in financial liabilities is managed
Factors mentioned in the Implementation Guidance that the “company might consider”
in describing how it manages its liquidity risks include whether the company:
expects some liabilities may be paid later than the earliest contractual due date
has undrawn loan commitments that are not expected to be drawn
holds financial assets for which there is a liquid market and are, therefore, readily saleable to meet liquidity needs
has committed borrowing facilities which it could use to help provide liquidity
holds deposits at central banks that it can use to meet liquidity needs
holds financial assets which are not traded in a liquid market, but which can be expected to generate cash inflows that will be available to meet cash outflows on liabilities
Hedge accounting disclosures
The following table summarises the hedge accounting disclosures required by IFRS 7
Other IFRS 7 disclosures
Reclassifications of financial instruments from fair value to amortised cost or vice versa [IFRS 7.12]
Disclosures about derecognitions, including transfers of financial assets for which derecogntion accounting is not permitted by IAS 39 [IFRS 7.13]
Information about financial assets pledged as collateral and about financial or non-financial assets held as collateral [IFRS 7.14-15]
Reconciliation of the allowance account for credit losses (bad debts). [IFRS 7.16]
Information about compound financial instruments with multiple embedded derivatives. [IFRS 7.17]
IAS 39 – Other key issues
Financial assets – Impairment
Impairment - Examples of factors to consider
Example: recognition of impairment of securities measured at fair value
Rationale:
(A) Unrealised capital gain recognised under equity (144-100=44)
(B) Unrealised capital loss recognised under equity (78-100=-22)
No objective evidence that the unrealised capital loss represents an impairment
Volatility in equity over the period: 78-144=-66
(C) Share price remains at 78: in light of objective evidence of conditions in the issuer’s business segment,
Derivatives
Derivatives
“Derivatives have been likened to aspirin: taken as prescribed for a headache, they will make
the pain go away. If you take the whole bottle at once you
may kill yourself”
Definition of a derivative
IAS 39 defines a derivative as a financial instrument or other contract within the scope of the standard with all three of the following characteristics:
its value changes in response to the change in a specified interest rate, financial instrument price, commodity price, foreign exchange contract, index of prices or rates, credit rating or credit index, or other variable, provided in the case of a non-financial variable that the variable is not specific to a party to the contract (the rate, price, index or other variable is sometimes called the 'underlying');
it requires no initial net investment or an initial net investment that is smaller than would be required for other types of contracts that would be expected to have a similar response to changes in market factors; and
it is settled at a future date. [IAS 39(9)]
Underlying
An underlying is a variable that, along with either a notional amount or a payment provision, determines the settlement amount of a derivative.
Examples of underlyings include:
a security price or security price index;
a commodity price or commodity price index;
an interest rate or interest rate index;
a credit rating or credit index;
a foreign exchange rate or foreign exchange rate index;
an insurance index or catastrophe loss index;
No initial net investment
Example - Interest rate swaps
Company B enters into a contract with a counterparty that requires it to pay a LIBOR-based variable rate of interest, and receive a fixed rate of 8 per cent.
The contract is an interest rate swap with a notional amount of ¥10 billion.
The contract is at market at inception and therefore does not require an initial net investment by either party.
In some instances, the terms of the interest rate swap may be favourable or unfavourable and would require one of the parties to make an up-front initial investment in the contract. If the initial investment represents a premium or discount for market conditions, the initial net investment would normally still be smaller than the notional on the debt instrument from which the interest rate cash flows are derived, so would satisfy the initial net investment criterion of a derivative.
Future settlement
The third part of the definition of a derivative is that it is settled at a future date. Settlement can occur in different ways, and does not just mean exchange of cash.
For example, it may be expected that an out-of-the-money option will not be exercised. However, expiry of the contract is a form of settlement, even if at maturity of the instrument no cash or underlying changes hands.
Embedded derivatives – Detecting and
recording
IAS 39 – Derivatives and embedded derivatives
IAS 39 applies to both freestanding and embedded financial instruments that meet the definition of a derivative*
*A derivative is a financial instrument with all three 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, provided in the case of a non-financial variable that the variable is not specific to a party to the contract (sometimes called the ‘underlying’);
(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
The hybrid instrument
It is possible for a derivative financial instrument and a non derivative financial instrument to be combined into a single contract referred to in IAS 39 as a “hybrid” instrument.
IAS 39 adopts the view that such a hybrid instrument consists on two components
Non- derivative
contract
Derivative contract Hybrid
instrument
HOST CONTRACT
Hybrid contracts
Embedded derivative
•FX forward
•Inflation factor
•Conversion option
•Leverage features
•Commodity index
•Equity index Debt
Lease Sales
Purchase Insurance
Equity
Embedded derivatives
HOST CONTRACT Embedded
derivative Embedded
derivative
Split out if not “clearly
and closely” related to
host contract
Is the instrument measured at fair value with changes in fair value reported in net profit or loss?
Would a separate instrument with the same terms as the embedded derivative meet the definition of a derivative?
Are the economic characteristics and risks of the embedded derivative are closely related to the economic characteristics and
risks of the host contract?
NO
YES
NO
The embedded derivative should
not be separately accounted for
YES
NO
YES
When should an embedded derivative be accounted for
separately?
What is meant by “clearly-and-closely related”
Clearly-and-closely related
means that the economic characteristics and risks of the host instrument and the embedded derivatives are similar so the payoffs and values of both instruments are related to the same economic factors Considerable judgement is required to make this determination
Most of the guidance is provided in the form of examples
RPI – Clearly and closely related - example
Company A, a UK company, enters into a long-term service contract under which it agrees to clean and maintain specified buildings owned by Company B for the next 10 years. All the buildings are located within the UK.
A receives a fixed annual fee. Embedded in the contract is a clause providing for a one-off adjustment half-way through the contract such that the fee receivable is adjusted for changes in RPI from the beginning of the contract. Thereafter, the fee remains fixed at the new amount.
The embedded inflation indexed payment is closely related to the host service contract because the rate of inflation is not leveraged, and the inflation index is in the local economic environment.
Embedded foreign currency provisions
Company X, a UK company, leases assets under an operating lease from Company Y, an Australian company. The lease payments are denominated in US dollars. The primary currency of X is Sterling (£) and the primary currency of Y is the Australian dollar (A$).
The provision to pay US $ would require separate accounting
{Note: No requirement to separate if finance lease}
Contracts for goods and services and other arrangements in foreign currency
One area where IAS 39 may have an impact is on sales, purchases and other arrangements that are not in the reporting currency of either party
IAS 39 (normally) requires the embedded derivative (e.g. forward FX contract) to be separated and accounted for separately by both parties to the contract
Embedded derivatives - FX
Action needed
1. Need to identify and split out if necessary any embedded derivatives
2. Need to ensure risk is managed
3. Need to include embedded derivative in review policy for new contracts
Hedge accounting – Meeting the IAS 39
requirements
Hedge accounting in an IAS 39 world
IAS 39 does not mandate the use of hedge accounting. Hedge accounting is purely voluntary
IFRS Approach
Derivatives on balance sheet at fair value is a fundamental principle
Due to requirement to hold derivatives at fair value, hedge accounting is achieved by:
Altering how the hedged item is measured; or
Deferring gains and losses on the hedging instrument
Three types of hedge
Fair value and cash flow hedges
A fair value hedge is a hedge of the exposure to changes in the fair value of a recognised asset or liability or a previously unrecognised firm commitment to buy or to sell an asset at a fixed price
A cash flow hedge is a hedge of the exposure to variability in cash flows that:
(i) is attributable to a particular risk associated with a recognised asset or liability or a forecast transaction and
(ii) could affect reported profit or loss.
Hedges of the foreign currency risk associated with firm commitments may be designated as cash flow hedges.
Mechanics of fair value hedge accounting under IAS 39
Hedging Hedging instrument instrument
The hedged instrument (derivative) is The hedged instrument (derivative) is carried at fair value
carried at fair value
Fair value the hedged item for hedged risk Fair value the hedged item for hedged risk
Match gains and losses in Match gains and losses in
income statement income statement
Mechanics of cash flow value hedge accounting under IAS 39
Hedging Hedging instrument instrument
Hedged item Hedged item
(T+1) (T+1) The hedged instrument (derivative) is
The hedged instrument (derivative) is carried at fair value
carried at fair value
Fair value movements Fair value movements taken to equity to the extent taken to equity to the extent
effective effective
Release gain or loss to Release gain or loss to income statement as cash income statement as cash flows that are subject to the flows that are subject to the hedge affect profit/loss
hedge affect profit/loss
Cash flow hedge -example
Qualifying for hedge accounting under IAS 39
5 key elements to qualify for hedge accounting:
At the inception of the hedge there is formal designation and documentation
The hedge is expected to be highly effective
For cash flow hedges, a forecast transaction must be highly probable
The effectiveness of the hedge can be reliably measured
The hedge is assessed on an ongoing basis and is determined to have been highly effective
1. Hedge documentation
Hedge documentation
Broadly, hedge documentation requirements fall into two categories:
specific documentation for every hedge entered into. This will give details of the hedged item, hedged risk, hedging instrument, how effectiveness will be assessed prospectively and retrospectively, and how effectiveness will be measured retrospectively; and
overall risk management objectives and strategies.
Spreadsheet or system solution ?
Example documentation 1 of 2
Example documentation 2 of 2
2. The hedge is expected to be highly effective
To qualify for hedge accounting, revised IAS 39 requires the hedge to be highly effective. There are separate tests to be applied prospectively and retrospectively and these tests are mandatory.
IAS 39 does not prescribe a specific method for assessing effectiveness
However, the method applied must be used consistently throughout and the method specified must be consistent with the management’s risk management strategy and objective
2a. Prospective effectiveness testing
Prospective effectiveness testing has to be performed at inception of the hedge and at each subsequent reporting date during the life of the hedge. This testing consists of demonstrating that the entity expects changes in the fair value or cash flows of the hedged item to be almost fully offset (i.e. nearly 100%) by the changes in the fair value or cash flows of the hedging instrument.
Testing
2 Main methods:
Ratio analysis – Ratio analysis establishes, as a percentage, the extent of the effectiveness of the hedging instrument in offsetting the hedged item for the hedged risk
Regression analysis – is a more statistical measurement technique for determining the validity and extent of the relationship between an independent and dependant variable
2b Retrospective effectiveness testing
Retrospective effectiveness testing is performed at each reporting date throughout the life of the hedge in accordance with a methodology set out in the hedge documentation. The objective is to demonstrate that the hedging relationship has been highly effective by showing that actual results of the hedge are within the range of 80-125%. Hedge ineffectiveness is systematically and immediately reported in the income statement.
When actual results are within the range of 80 – 125%, but not When actual results are within the range of 80 – 125%, but not
100% exactly, any deviation from 100% means the hedge is 100% exactly, any deviation from 100% means the hedge is
partly ineffective and this must be recognisedpartly ineffective and this must be recognised
Effectiveness testing
Retrospective testing
Discontinuing hedge accounting
Hedge accounting must be discontinued prospectively if any of the following occurs:
a hedge fails the effectiveness tests
the hedging instrument is sold, terminated or exercised
the hedged position is settled
management decides to revoke the hedge relationship, or
in a cash flow hedge, the forecast transaction that is hedged is no longer expected to take place.
Highly probable – Forecast transactions
Probability is based upon observable facts
the frequency of similar past transactions;
the financial and operational ability of the entity to carry out the transaction;
substantial commitments of resources to a particular activity (for example, a manufacturing facility that can be used in the short run only to process a particular type of commodity);
the extent of loss or disruption of operations that could result if the transaction does not occur;
the likelihood that transactions with substantially different characteristics might be used to achieve the same
Unless you are ‘in the zone’ – Coffee break
Vitalise Plc – Case Study
Case study
• IAS case study on income statement &
balance sheet covering:
– Sale and repurchase – Extraordinary items – P,P and E
– IAS 40 “Investment property”
– IAS 39 - Convertible loan
IAS 27 - Consolidated and separate
financial statements
Objectives of IAS 27
IAS 27 has the twin objectives of setting standards to be applied:
in the preparation and presentation of consolidated financial statements for a group of entities under the control of a parent; and
in accounting for investments in subsidiaries, jointly controlled entities, and associates when an entity elects, or is required by local regulations, to present separate (non-consolidated) financial statements.
Key Definitions
Consolidated financial statements: The financial statements of a group presented as those of a single economic entity.
Subsidiary: An entity, including an unincorporated entity such as a partnership, that is controlled by another entity (known as the parent).
Parent: An entity that has one or more subsidiaries.
Control: The power to govern the financial and operating policies of an enterprise so as to obtain benefits from its activities.
Identification of Subsidiaries
Control is presumed when the parent acquires more than half of the voting rights of the enterprise. Even when more than one half of the voting rights is not acquired, control may be evidenced by power: [IAS 27.13]
over more than one half of the voting rights by virtue of an agreement with other investors; or
to govern the financial and operating policies of the other enterprise under a statute or an agreement; or
to appoint or remove the majority of the members of the board of directors;
or
to cast the majority of votes at a meeting of the board of directors.
Exemptions from consolidated financial
A parent need not present consolidated financial statements if and only if all of the following four conditions are met: [IAS 27.10]
1. the parent is itself a wholly-owned subsidiary, or is a partially owned subsidiary of another entity and its other owners, including those not otherwise entitled to vote, have been informed about, and do not object to, the parent not presenting consolidated financial statements;
2. the parent's debt or equity instruments are not traded in a public market;
3. the parent did not file, nor is it in the process of filing, its financial statements with a securities commission or other regulatory organisation for the purpose of issuing any class of instruments in a public market; and
4. the ultimate or any intermediate parent of the parent produces
