Full text

(1)

International Financial Reporting Standards (IFRS)

2 day IFRS course December 2007

Steven Brice, Partner - Mazars

Day 2

(2)

Agenda

(3)

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

(4)

IAS 39 Financial instruments

(5)

IAS 39 ‘Financial instruments’

(6)

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

(7)

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

(8)

What is a financial instrument?

(9)

Financial instruments

Contract Financial asset

Financial liability What is a

financial

instrument ?

(10)

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

(11)

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)

(12)

Scope - Action needed

1. Firstly, decide whether the item in question is inside or outside of the scope of IAS 39

(13)

Scope of IAS 32/39

(14)

The scope of IAS 32/39 is very wide ranging

(15)

Scope

(16)

Categories of financial instruments and

measurement options under IAS 39

(17)

The current IAS 39 measurement model

Amortised cost Fair value

Mixed model

(18)

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)

(19)

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

(20)

Designated at fair value through profit and loss

(21)

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

(22)

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

(23)

Fair value - Hierarchy

(24)

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

(25)

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

(26)

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

(27)

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.

(28)

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

(29)

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!

(30)

Scenario

All the group is tainted

Parent

Sub 1 Sub 2 Sub 3

(31)

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

(32)

Quiz

Financial Asset Classification

(33)

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

(34)

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.

(35)

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

(36)

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.

(37)

Recognition of deferred day one profit or loss

Example Example

(38)

Movement in deferred day 1 profits

(39)

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.

(40)

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.

(41)

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.

(42)

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

(43)

IFRS 7: Financial instruments: disclosures

(44)
(45)

IFRS 7 - Content

(46)

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

(47)

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.)

(48)

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

(49)

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.

(50)

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?

(51)

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.

(52)

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.

(53)

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.

(54)

Information relating to categories

Nordia

(55)

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.

(56)

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

(57)

Income statement disclosures

New

* *

(58)

Financial result by category

(59)

Finance costs

(60)

New income statement disclosures introduced by IFRS 7

Net gains or losses for each category of financial asset or financial liability

(61)

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.

(62)

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

(63)

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.

(64)

Example – by category (HTM)

(65)

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.

(66)

Financial liabilities at fair value through profit and loss

(67)

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]

(68)

IFRS 7 – Fair value disclosures

Danske Bank

(69)
(70)

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:

(71)

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.

(72)

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.

(73)

Other disclosures: Collateral the company has taken control

of during the period

(74)

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.

(75)

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.

(76)

Foreign currency sensitivity

(77)

Foreign currency sensitivity

(78)

Sensitivities (FX) example - Brit

(79)

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.

(80)

Sensitivities example - Brit

(81)

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.

(82)

Liquidity Risk

Disclosures about liquidity risk include:

A maturity analysis of financial liabilities.

Description of approach to risk management.

(83)

Liquidity risk

(84)

Liquidity risk

(85)

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.

(86)

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.

(87)

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:

(88)

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

(89)

Hedge accounting disclosures

The following table summarises the hedge accounting disclosures required by IFRS 7

(90)

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]

(91)

IAS 39 – Other key issues

(92)

Financial assets – Impairment

(93)

Impairment - Examples of factors to consider

(94)

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,

(95)

Derivatives

(96)

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”

(97)

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)]

(98)

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;

(99)

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.

(100)

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.

(101)

Embedded derivatives – Detecting and

recording

(102)

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

(103)

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

(104)

HOST CONTRACT

Hybrid contracts

Embedded derivative

•FX forward

•Inflation factor

•Conversion option

•Leverage features

•Commodity index

•Equity index Debt

Lease Sales

Purchase Insurance

Equity

(105)

Embedded derivatives

HOST CONTRACT Embedded

derivative Embedded

derivative

Split out if not “clearly

and closely” related to

host contract

(106)

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?

(107)

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

(108)

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.

(109)

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}

(110)

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

(111)

Embedded derivatives - FX

(112)

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

(113)

Hedge accounting – Meeting the IAS 39

requirements

(114)

Hedge accounting in an IAS 39 world

IAS 39 does not mandate the use of hedge accounting. Hedge accounting is purely voluntary

(115)

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

(116)

Three types of hedge

(117)

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.

(118)

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

(119)

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

(120)

Cash flow hedge -example

(121)

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

(122)

1. Hedge documentation

(123)

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.

(124)

Spreadsheet or system solution ?

(125)

Example documentation 1 of 2

(126)

Example documentation 2 of 2

(127)

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

(128)

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.

(129)

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

(130)

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

(131)

Effectiveness testing

(132)

Retrospective testing

(133)

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.

(134)

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

(135)

Unless you are ‘in the zone’ – Coffee break

(136)

Vitalise Plc – Case Study

(137)

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

(138)

IAS 27 - Consolidated and separate

financial statements

(139)

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.

(140)

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.

(141)

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.

(142)

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

Figure

Updating...

References

Related subjects :