International Accounting Standards

1
International Accounting Standards

• IAS 39 Financial Instruments Measurement and
  Recognition

2
IAS 39 Overview

• Establishes principles for recognising, measuring
  and disclosing information about financial assets
  and financial liabilities.
• A first step towards recognising all financial
  instruments, including derivatives, at their fair
  values.

3
IAS 39 Scope

• All financial instruments other than
• interests in subsidiaries, associates and joint
  ventures
• rights/obligations under leases
• employer assets/liabilities under employee
  benefit plans
• rights/obligations under insurance contracts
• enterprises own equity instruments
• contracts for contingent consideration in a
  business combination
• contracts requiring payment based on climatic,
  geological or other physical variables (but does
  apply to derivatives embedded in such contracts)
  and
• financial guarantee contracts that provide for
  payments if debtor fails to make payment when due.

4
IAS 39 Key Principles

• Four Categories of Financial Assets
• 1. Held for trading
• i.e., held for purpose of generating profit from
  short-term fluctuation in price or dealers
  margin
• all derivatives deemed held for trading unless
  designated as hedges.
• 2. Held-to-maturity investment
• fixed or determinable payments and fixed
  maturity
• entity has positive intent and ability to hold to
  maturity (Standard contains requirements and
  guidance for assessing)
• excludes items falling into category 3.

5
IAS 39 Key Principles

• Four Categories of Financial Assets (cont.)
• 3. Loans and receivables originated by the
  enterprise
• created by providing money, goods or services
  directly to a debtor, other than those originated
  with intent to be sold immediately or in the
  short term (which should be classified as held
  for trading).
• 4. Available-for-sale
• instruments not falling within categories 1 to 3.
  

6
IAS 39 Key Principles

• Embedded Derivative
• Derivative component of a financial instrument
  that includes both a derivative and a host
  contract.
• Causes some or all of the cash flows of the
  combined instrument to vary in similar way to
  stand-alone derivative.

7
IAS 39 Key Principles

• Embedded Derivative (cont.)
• Commentary in Standard provides examples
• e.g., 1. an equity conversion option embedded
  in debt instrument (convertible
  note)
• 2. A credit derivative in a host debt
  instrument that allows 1 party (the beneficiary)
  to transfer the credit risk of an asset (which
  it may or may not own) to a guarantor who does
  not purchase the asset itself.

8
IAS 39 Key Principles

• Embedded Derivative (cont.)
• Must be separated from host contract and
  accounted for as derivative if
• economic characteristics and risks of embedded
  derivative not closely related to those of host
  contract
• separate instrument with same terms would meet
  definition of derivative and
• combined instrument not measured at fair value
  with changes in fair value reported in net
  profit/loss.
• If unable to separately measure embedded
  derivative, treat combined financial instrument
  as held for trading (and mark to market).

9
IAS 39 Initial Recognition

• General Rule
• Enterprise must recognise financial
  asset/liability (including derivative) when it
  becomes a party to the instruments contractual
  provisions.
• Regular Way Contracts
• contract for purchase or sale of financial
  asset that requires delivery of asset within time
  frame generally established by regulation or
  market place convention.

10
IAS 39 Initial Recognition

• Regular Way Contracts (cont.)
• Fixed price commitment between trade date and
  settlement date is a forward contract
  (derivative), but special recognition rules
  apply.
• For regular way contract, use either trade
  date or settlement date accounting.
• Method chosen must be consistently applied to 4
  categories of financial assets.

11
IAS 39 Initial Recognition

• Regular Way Contracts (cont.)
• Trade date accounting financial asset and
  liability recognised on date enterprise commits
  to purchase.
• Settlement date accounting financial asset
  recognised on date delivered.
• Treatment of any change in fair value of
  financial asset during period between trade date
  and settlement date depends on subsequent
  measurement requirements for financial asset.
• Eg, if asset subsequently carried at cost, value
  change not recognised. If asset subsequently
  carried at fair value, recognise value change in
  net profit or loss (or equity as appropriate).

12
IAS 39 Derecognition

• Financial Assets
• Derecognise only when enterprise loses control.
• Control of transferred asset lost if transferee
  has ability to obtain benefits of transferred
  asset. Generally has such ability if, for
  example
• transferee free to either sell or pledge
  approximately full fair value of transferred
  asset or
• transferee is an SPE whose activities are limited
  and either SPE or its beneficiaries have ability
  to obtain substantially all benefits of
  transferred asset.
• Note even if transferor derecognises, may still
  be required to consolidate SPE (See IAS 27,
  SIC-12)

13
IAS 39 Derecognition

• Financial Assets (cont.)
• Control of transferred financial asset not lost
  if
• transferor has right to reacquire (unless asset
  readily obtainable in the market or reacquisition
  price fair value at time of reacquisition)
• transferor obligated to repurchase/redeem on
  terms effectively providing transferee with
  lenders return
• asset not readily obtainable in the market and
  transferor retains substantially all risks of
  ownership through
• total return swap with transferee (provides
  market returns and credit risks in exchange for
  interest index (e.g., LIBOR)) or
• unconditional put option held by transferee.

14
IAS 39 Derecognition

• Financial Assets (cont.)
• Net profit/loss on derecognition difference
  between
• carrying amount and
• sum of proceeds and prior fair value adjustments
  (if any) reported directly in equity.
• Results in recycling of fair value adjustments
  recognised directly in equity.
• They are recognised first in equity and then in
  the income statement.

15
IAS 39 Derecognition

• Derecognition of Part of a Financial Asset
• Where only part of financial asset transferred,
  carrying amount allocated between part sold and
  part retained based on relative fair values at
  date of sale.
• If fair value of retained part cannot be reliably
  measured, attribute entire carrying amount to
  part transferred.
• Eg, separating principal and interest cash flows
  on bonds and selling one of them.
• Net profit/loss on derecognition difference
  between
• proceeds and
• carrying amount plus or minus prior fair value
  adjustments (if any) reported directly in equity.

16
IAS 39 Derecognition

• Financial Asset Derecognition Coupled with New
  Financial Asset or Liability
• If transfer of financial asset results in
  creation of new financial asset or assumption of
  new financial liability, recognise new
  asset/liability at fair value.
• Eg, selling receivables and assuming obligation
  to compensate purchaser if collections below
  specified level.
• Net profit/loss on derecognition difference
  between
• proceeds and
• carrying amount of sold asset plus or minus prior
  fair value adjustments (if any) reported directly
  in equity fair value of any new liability
  fair value of any new financial asset.

17
IAS 39 Derecognition

• Financial Asset Derecognition Coupled with New
  Financial Asset or Liability (cont.)
• If fair value of new financial asset/liability
  cannot be reliably measured, then
• if new financial asset created, initial carrying
  amount zero. Net profit/loss proceeds
  carrying amount of sold asset plus or minus
  prior fair value adjustments (if any) reported
  directly in equity
• if new financial liability assumed, initial
  carrying amount should be such that no gain
  recognised and, if IAS 37 requires recognition of
  a provision, a loss is recognised.

18
IAS 39 Derecognition

• Financial Liabilities
• Derecognise only when extinguished (i.e.,
  obligation discharged, cancelled or expires).
• Extinguished when enterprise either
• pays creditor or
• is legally released from primary responsibility.
• In-substance defeasance does not, of itself,
  result in extinguishment.

19
IAS 39 Derecognition

• Financial Liabilities (cont.)
• Exchange between existing borrower and lender of
  debt instruments with substantially different
  terms is an extinguishment.
• Substantial modification of terms of existing
  debt instrument should be treated as
  extinguishment.
• Include difference between carrying amount of
  liability extinguished and amount paid in net
  profit/loss.

20
IAS 39 Derecognition

• Financial Liabilities (cont.)
• Derecognition of part of a financial liability or
  coupled with creation of new financial asset or
  assumption of new financial liability
• account for transaction as per treatment of
  financial assets outlined above.

21
IAS 39 Measurement

• Initial Recognition
• Measure at cost (including transaction costs).
• Subsequent Measurement Financial Assets not
  Designated as Hedges
• Loans and receivables originated by the
  enterprise and held-to-maturity investments
• if fixed maturity measure at amortised cost
  using effective interest rate (i.e., rate that
  causes present value of future cash payments to
  equal current net carrying amount). Annual
  impairment test
• if no fixed maturity measure at cost. Annual
  impairment test.

22
IAS 39 Measurement

• Subsequent Measurement Financial Assets not
  Designated as Hedges (cont.)
• Held for trading and available-for-sale
• if fair value can be reliably measured measure
  at fair value (without deduction of disposal
  costs)
• if no quoted market price in active market and
  fair value cannot be reliably measured
• if fixed maturity measure at amortised cost
  using effective interest rate. Annual impairment
  test
• if no fixed maturity measure at cost. Annual
  impairment test.

23
IAS 39 Measurement

• Subsequent Measurement Financial Assets not
  Designated as Hedges (cont.)
• If held-to-maturity investment changes status
  to held for trading or available-for-sale,
  remeasure to fair value.
• If reliable measure of fair value becomes
  available for held for trading or
  available-for-sale asset where such measure not
  previously available, remeasure to fair value.

24
IAS 39 Measurement

• Subsequent Measurement Financial Assets not
  Designated as Hedges (cont.)
• If held for trading or available-for-sale
  asset changes status such that it becomes
  appropriate to carry at amortised cost or if
  reliable measure of fair value no longer
  available, fair value carrying amount deemed to
  be new amortised cost.
• If fixed maturity prior fair value adjustments
  (if any) reported directly in equity are
  amortised over remaining life of investment. Any
  difference between new amortised cost and
  maturity amount is amortised over remaining life
  as yield adjustment.
• If no fixed maturity - prior fair value
  adjustments (if any) reported directly in equity
  remain in equity until asset derecognised.

25
IAS 39 Measurement

• Subsequent Measurement Financial Liabilities
  not Designated as Hedges
• Financial liabilities other than held for
  trading measure at amortised cost.
• Derivative liability linked to, and required to
  be settled by delivery of, unquoted equity
  instrument whose fair value cannot be reliably
  measured measure at cost.
• Financial liabilities that are held for trading
  (including derivative liabilities other than
  covered by second dot point above) measure at
  fair value.

26
IAS 39 Measurement

• Gains and Losses on Remeasurement to Fair Value
• Held for trading financial assets/liabilities
  recognise gains/losses in net profit/loss in
  period they arise.
• Available-for-sale financial assets can elect
  to recognise gains/losses either
• in net profit/loss in period they arise or
• directly in equity until asset derecognised or
  impaired, at which time cumulative gain/loss
  recycled in net profit/loss.
• Same policy must be consistently applied to all
  available-for-sale financial assets.

27
IAS 39 Measurement

• Testing for Impairment
• At each reporting date, assess whether any
  objective evidence indicating that financial
  asset may be impaired. If evidence exists,
  estimate recoverable amount.
• Impairment loss excess of carrying amount over
  recoverable amount.
• Impairment loss must be recognised in net
  profit/loss for period.

28
IAS 39 Measurement

• Testing for Impairment (cont.)
• For loans and receivables and held-to-maturity
  investments carried at amortised cost,
  recoverable amount measured as present value of
  expected future cash flows, discounted at
  instruments original effective interest rate.
• For financial asset carried at cost/amortised
  cost because fair value cannot be reliably
  measured, recoverable amount measured as present
  value of expected future cash flows discounted at
  current market rate for similar financial asset.

29
IAS 39 Measurement

• Testing for Impairment (cont.)
• Where loss on financial asset carried at fair
  value has been recognised directly in equity and
  there is objective evidence that asset is
  impaired, cumulative loss must be removed from
  equity and recycled as impairment loss through
  net profit/loss for period.
• Amount recycled difference between
  acquisition cost and fair value, less any
  impairment loss previously recognised for that
  asset.

30
IAS 39 Hedging

• Hedging designating a financial instrument as
  an offset, in whole or in part, to changes in
  fair value or cash flows of a hedged item.
• Financial instruments can, provided certain
  criteria met, be designated as hedges of
  recognised assets or liabilities firm
  commitments or forecasted transactions.
• Hedge accounting recognises symmetrically the
  offsetting effects on net profit/loss of changes
  in the fair values of the hedging instrument and
  the hedged item.

31
IAS 39 Hedging

• If hedged item is non-financial asset or
  liability, can only qualify for hedge accounting
  in respect of either foreign currency risks or
  all risks.
• Why? Difficulty in isolating cash flows or fair
  value changes attributable to specific risks
  other than foreign currency risk.

32
IAS 39 Hedging

• 3 types of hedging relationships
• fair value hedge (hedge of exposure to changes in
  fair value of recognised assets or liabilities)
• cash flow hedge (hedge of exposure to cash flow
  variability of recognised assets or liabilities
  or forecasted transaction. Hedge of firm
  commitment to buy/sell asset at fixed price in
  enterprises reporting currency also treated as
  cash flow hedge) and
• hedge of net investment in foreign entity (see
  IAS 21).

33
IAS 39 Hedging

• Hedge relationship qualifies for hedge accounting
  only when
• certain formal documentation is in place at
  inception
• hedge expected to be highly effective in
  offsetting changes in fair value or cash flows of
  hedged item, and hedge effectiveness can be
  reliably measured
• hedge must be assessed on ongoing basis and
  determined actually to have been highly effective
  during reporting period (Standard includes
  guidance for assessing hedge effectiveness) and
• for cash flow hedges of forecasted transaction,
  forecasted transaction must be highly probable
  and represent exposure to variations in cash
  flows that could ultimately affect net
  profit/loss.

34
IAS 39 Hedging

• Hedge Accounting - Fair Value Hedge
• Remeasure hedging instrument to fair value.
  Gain/loss recognised immediately in net
  profit/loss.
• Adjust carrying amount of hedged item for
  gain/loss attributable to hedged risk and
  recognise immediately in net profit/loss.
• Applies even if hedged item is financial
  instrument otherwise measured at cost or
  financial instrument otherwise measured at fair
  value with changes in fair value recognised
  directly in equity.
• Discontinue hedge accounting prospectively if no
  longer meets criteria or hedging instrument
  expired, sold, terminated or exercised.

35
IAS 39 Hedging

• Hedge Accounting Cash Flow Hedge
• Recognise portion of gain/loss on hedging
  instrument determined to be effective hedge
  directly in equity.
• Recognise ineffective portion
• immediately in net profit/loss if hedging
  instrument is a derivative or
• in accordance with requirements for recognising
  gains and losses on remeasurement to fair value
  (see earlier slide) if hedging instrument not a
  derivative.

36
IAS 39 Hedging

• Hedge Accounting Cash Flow Hedge (cont.)
• If hedged firm commitment or forecasted
  transaction results in recognition of asset or
  liability, gains/losses recognised directly in
  equity removed from equity and included in
  initial measurement of asset or liability .
• Otherwise, gains/losses recognised directly in
  equity must be recycled in net profit/loss in
  same periods hedged firm commitment or forecasted
  transaction affects net profit/loss.

37
IAS 39 Hedging

• Hedge Accounting Cash Flow Hedge (cont.)
• Discontinue hedge accounting prospectively if
• hedge no longer meets criteria for hedge
  accounting
• hedging instrument expired, sold, terminated or
  exercised or
• committed or forecasted transaction no longer
  expected to occur.

38
IAS 39 Hedging

• Hedge Accounting Net Investment in Foreign
  Entity
• Treated similarly to cash flow hedges.
• Recognise portion of gain/loss on hedging
  instrument determined to be effective hedge
  directly in equity.
• Recognise ineffective portion
• immediately in net profit/loss if hedging
  instrument is a derivative or
• directly in equity until disposal of net
  investment if hedging instrument not a
  derivative. On disposal, recycle in net
  profit/loss.