2004_ias39e

AUDIT ■■■■■ TAX ■■■■■ ADVISORY

IFRS REPORTING

FinancialInstrumentsAccountingMarch 2004

AUDIT

Preface

IAS 39 Financial Instruments: Recognition and Measurement has been in effect for severalyears and most entities reporting under International Financial Reporting Standards (IFRSs)have issued two annual reports using IAS 39 to account for their investments, loans,receivables, borrowings and derivative and hedging activities. Many have found thatexperience in working with the standard does little to ease the pain. During 2000 and 2001,the IAS 39 Implementation Guidance Committee issued more than 200 Q&A interpretationsof the standard based on questions and issues raised by entities and their auditors.The complexity and the volume of the guidance continues to provide a challenge for entitiesas their understanding of the basic requirements increases. “The more you know, the moreyou realise how much you don’t know” seems particularly relevant to IAS 39.

Requirements for entities in the European Union (EU), Australia, Russia and elsewhere toreport under IFRS by 2005 create the same challenges for a brand new group of IFRS users,of which there will be some 7,000 in Europe alone.

In December 2003 the IASB issued revised versions of IAS 32 Financial Instruments:Disclosure and Presentation and IAS 39 incorporating significant and wide-ranging changesto both standards, effective for reporting periods beginning on or after 1 January 2005. Withthe exceptions of portfolio hedging for interest rate risk, the scope of the fair value optionand one or two amendments that may flow from the IASB’s insurance project, the 2005requirements are now set in stone. For European companies, the only remaining hurdle isEU endorsement during the course of 2004.

Both existing IFRS reporters and first-time adopters will need to spend significant amountsof time in 2004 preparing to implement the standards. First-time adopters in particular willneed to have a complete and thorough implementation process in place to enable asuccessful transition to IFRS. Our experience is that the implementation challenge is a toughone, but is achievable as long as sufficient time and the right resources are devoted to it.

Implementing IAS 39 requires a structured process. This could well require a dedicated teamto identify and address the entity’s major issues and potential changes to current businesspractices as well as to information systems. Preparers and users will have to develop afundamental understanding of the concepts and principles of accounting for financialinstruments. This will involve training personnel and developing expertise and understandingof the way in which IFRS collectively deal with financial instruments.

This publication provides a comprehensive overview of the existing IAS 32 and IAS 39 toaddress accounting for financial instruments with an emphasis on practical applicationissues. It provides an update to the first edition issued in September 2000, taking into accountguidance issued subsequently as well as examples based on practical experience fromworking with KPMG member firms’ clients. At the same time we have incorporated guidance

© 2004 KPMG International. KPMG International is a Swiss cooperative of which all KPMG firms are members. KPMG International providesno services to clients. Each member firm is a separate and independent legal entity and each describes itself as such. All rights reserved.

on the likely impact of the December 2003 amendments. KPMG member firms welcome theopportunity to help entities in understanding and implementing these standards. Forinformation on how a KPMG member firm can assist you, please contact your regular KPMGbusiness adviser or any of our offices worldwide (www.kpmg.co.uk/ias (to be updated shortly,at the date of this publication, to www.kpmg.co.uk/ifrs)).

KPMGMarch 2004


About this publication

Content

Information in this publication is current up to December 2003. This publication has beenupdated for additional interpretations of IAS 39 based on guidance issued subsequent toSeptember 2000 when the first edition of this publication was released. This publicationconsiders standards and interpretative guidance that are in force at December 2003, and alsoprovides a commentary on the likely impact of the amendments issued in December 2003which are not required to be adopted until financial years commencing on or after 1 January2005. Further interpretations of the amended standards are likely to develop during the courseof 2004 as companies work with their advisers to implement them. Readers should be awarethat the amended standards are applicable for periods beginning on or after 1 January 2005.Earlier adoption is permitted, but an entity must then adopt all the requirements of bothamended standards. Piecemeal early adoption is not permitted. Future updates to thispublication will provide practical guidance and interpretation on the amendments.

Organisation of the text

Throughout this publication we have made reference to current IFRS literature and interpretationsof that literature. Direct quotations from IFRS are shaded in blue within the text.

A column noted as Reference is included in the left margin of Sections 2 to 11 to enable usersto identify the relevant paragraphs of the standards or other interpretative literature. Referencesare to the amended standards issued in December 2003.

A glossary of frequently used terms is included as Appendix A to the publication. In addition,a summarised comparison between IFRS and US GAAP is included as Appendix B andabbreviations used throughout the text are identified in Appendix C.

Case studies and examples are included throughout the text to elaborate or clarify the morecomplex principles of the financial instruments standards. A list of all case studies is includedas Appendix D.

Commentary on the December 2003 amendments to the standards is provided separately inred where applicable within each Section.

Keep in contact and stay up-to-date

IFRS literature on financial instruments is intended to cover all types of industries andtransactions. The interpretive guidance, and in some respects, IAS 39 itself, are by their naturebased on narrowly defined facts and circumstances. In most instances, further interpretationwill be needed in order for an entity to apply these standards to its own facts, circumstances


and individual transactions. Further, some of the information contained in this publication isbased on KPMG’s International Financial Reporting Group’s (IFR Group’s) interpretations ofthe current literature, which may change as practice and implementation guidance continueto develop in these areas. Users are cautioned to read this publication in conjunction with theactual text of the standards and implementation guidance issued, and to consult theirprofessional advisers before concluding on accounting treatments for their own transactions.

This publication has been produced by KPMG’s IFR Group. For more information, please visitwww.kpmg.co.uk/ias (to be updated shortly, as at the date of this publication, towww.kpmg.co.uk/ifrs), where you will find up-to-date technical information and a briefing onKPMG’s IFRS conversion resources.


Contents

Page

1. Introduction to the financial instruments standards 4

1.1 The need for financial instruments standards 4

1.2 Development of the standards 4

1.3 Highlights of the standards 5

2. Scope and definitions 9

2.1 Scope of the standards 9

2.2 Definitions relating to financial instruments 13

2.3 Financial risks 19

3. Embedded derivatives 20

3.1 Overview 20

3.2 Economic characteristics and risks 22

3.3 Separation of the embedded derivative 23

4. Recognition and derecognition 29

4.1 Overview 29

4.2 Initial measurement 29

4.3 Recognition 31

4.4 Derecognition 34

4.5 Special purpose entities and derecognition 46

5. Classification 51

5.1 Overview 51

5.2 Classification of financial assets 52

5.3 Classification of financial liabilities 63


Subsequent measurement 65

6.1 Overview 65

6.2 Classification determines subsequent measurement 67

6.3 Valuation issues 69

6.4 Impairment of financial assets 82

6.5 Reclassifications of financial assets 90

6.6 Deferred tax assets and liabilities 93

7. Subsequent measurement – examples 94

7.1 Overview 94

7.2 Interest rate risk 95

7.3 Foreign currency risk 98

7.4 Equity price risk 101

7.5 Credit risk 103

8. Hedge accounting 104

8.1 Overview 104

8.2 Hedge accounting basic concepts 105

8.3 The hedge accounting models 107

8.4 Hedged items 112

8.5 Hedging instruments 117

8.6 Criteria for hedge accounting 121

8.7 Termination of a hedge relationship 131

8.8 Net position hedging and internal derivatives 134

8.9 Other considerations 135

9. Hedge accounting for each type of financial risk 137

9.1 Overview 137

9.2 Interest rate risk 137

9.3 Foreign currency risk 156

9.4 Hedging a net investment 171

9.5 Hedging commodity price risk 175


Presentation and disclosure 184

10.1 Overview 184

10.2 Balance sheet presentation 184

10.3 Liability versus equity 186

10.4 Income statement presentation 194

10.5 Required disclosures 195

11. Transition and implementation of IAS 39 206

11.1 Overview 206

11.2 First-time adoption of IFRS 206

11.3 Transition requirements for existing users of IFRS 211

11.4 First time implementation: practical considerations 212

A. Glossary 214

B. IFRS and US GAAP financial instruments comparison 221

C. Abbreviations 228

D. List of cases 229


IFRS Financial Instruments AccountingMarch 2004


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1. Introduction to the financial instruments standards

1.1 The need for financial instruments standards

In the past two decades there has been a dramatic increase in the sophistication of financial markets.With the globalisation of markets many entities face increasing challenges in controlling risks to whichthey are exposed. This changing environment has been the impetus for a constant stream of innovativeand often complex financial products. The use of derivative instruments has become a common practicefor many entities of all sizes and throughout all industries. The accounting profession as a whole hasmade efforts during recent years to develop accounting literature to address financial instruments.

The International Accounting Standards Committee (IASC) issued two standards that specificallyaddress accounting for financial instruments. These are International Accounting Standard (IAS) 32Financial Instruments: Disclosure and Presentation and IAS 39 Financial Instruments: Recognitionand Measurement, collectively referred to throughout this publication as the financial instrumentsstandards. When the International Accounting Standards Board (IASB), the successor organisation tothe IASC, was formed in 2001, this body adopted all of the then-current standards and interpretationsof the IASC, including IAS 32 and IAS 39. With these standards, all entities reporting under IFRS,regardless of their size or industry, or whether public or non-public, must account for and make disclosuresabout financial instruments in a similar manner.

There are other standards and interpretations that are relevant to a discussion of financial instrumentsaccounting, most notably IAS 21 The Effects of Changes in Foreign Exchange Rates and SIC–12Consolidation – Special Purpose Entities.

The IASB is currently addressing certain aspects of insurance accounting with a view to introducinginterim requirements that would be effective in 2005. These interim requirements would be limited todefining insurance risk and distinguishing it from financial risks dealt with under the financial instrumentsstandards, and prohibiting certain industry practices such as catastrophe provisions and equalisationreserves. Insurance contracts, in the interim, would continue to be dealt with under an entity’s existingaccounting framework. The proposals are not dealt with further in this publication.

In the longer term the IASB expects to issue a comprehensive standard on insurance contracts.The IASB is also undertaking a project to develop a new standard for disclosure of risks arising fromfinancial instruments (this scope of this project was originally to update IAS 30 Disclosures in theFinancial Statements of Banks and Similar Financial Institutions, but was later expanded to coverall entities). When the project is completed, IAS 30 will be withdrawn together with the financial riskdisclosure requirements in IAS 32. Both projects will affect the accounting for and disclosure offinancial instruments in due course, but neither will be effective before 2005.

1.2 Development of the standards

The IASC began its project to develop a comprehensive set of standards addressing financial instrumentsin 1989. In 1994 the IASC divided this project into two phases. The first phase addressed disclosureand financial statement presentation, and resulted in the issuance of IAS 32 in 1995. The second phaseof the project addressed recognition and measurement.

1.2 Development of the standards


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IAS 39 was originally intended to be an interim standard. At the same time that the standard becameeffective in 2001, the IASC was working with a collaboration of national standard setters from13 countries to develop a completely new standard on financial instruments accounting. This group,called the Joint Working Group (JWG), released their Exposure Draft in December 2000 for publiccomment. Their proposals and the results of comments received from the public were presented to theIASB in early 2002. It is now a long-term project of the IASB to develop a new standard for financialinstruments. Such a new standard is not expected prior to 2005.

An Exposure Draft of proposed amendments to IAS 32 and IAS 39 was released in June 2002 forpublic comment. In issuing the proposed amendments to IAS 32 and IAS 39 the Board stated that itexpected the amended standards to be in place for “a considerable period”. The IASB released therevised versions of IAS 32 and IAS 39 in December 2003.

In October 2003, the IASB issued an Exposure Draft Fair Value Hedge Accounting for a PortfolioHedge of Interest Rate Risk, dealing with certain aspects of hedge accounting which are particularlyrelevant for financial institutions.

1.3 Highlights of the standards

Prior to the issuance of IAS 32 and IAS 39 there was no comprehensive guidance in IFRS addressingfinancial instruments, particularly so for derivatives. IAS 39 introduced new requirements for therecognition, derecognition and measurement of an entity’s financial instruments and for hedgeaccounting. It also introduced some changes to the disclosure and presentation requirements of IAS 32.Figure 1.1 is a basic overview of the financial instruments standards dealt with in this publication.

Figure 1.1 Overview of the financial instruments standards

The requirements of the financial instruments standards are summarised at a very high level below.

1.3.1 Recognition and derecognition

■ All financial assets and financial liabilities, including derivative instruments, should be recognised inthe balance sheet.

■ In order to remove (i.e. derecognise) assets from its balance sheet, an entity must lose control overthose financial assets. In addition, a substantive risk from the assets must be transferred. IAS 39




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is complex and restrictive in this area. It provides guidance for transactions such as factoring andsecuritisations. Entities converting to IFRS may find assets that were derecognised under previousGAAP may have to be included on balance sheet in their IFRS financial statements.

■ In order to derecognise a liability, a debtor must be legally released from its primary obligationrelated to that liability.

1.3.2 Measurement

■ Financial assets must be classified into one of four categories: trading; originated loans andreceivables; held-to-maturity; and available-for-sale. Financial liabilities are categorised as eithertrading or non-trading. The categorisation determines whether and where any remeasurement tofair value is recognised in an entity’s financial statements.

■ Many financial assets are carried at fair value, with the exceptions being originated loans andreceivables, held-to-maturity assets, and in the rare circumstances where the fair value of anunlisted equity instrument cannot be reliably measured. Remeasurement to fair value must beperformed at each financial reporting date.

■ The effect of remeasurement to fair value must be recognised and consistently applied in one oftwo ways. An entity can choose to recognise all changes in fair value in the income statement.Alternatively, it can choose to recognise changes in fair value of trading instruments in the incomestatement, and available-for-sale instruments as a component of equity. Fair value changes deferredin equity are recycled to the income statement when the instrument is sold or becomes impaired.

1.3.3 Derivatives and hedge accounting

■ Under IAS 39, all derivatives (including some embedded derivatives) must be measured at fairvalue in the balance sheet. This is regardless of whether they are categorised as trading or ashedging instruments. Unless they qualify as hedging instruments, all fair value gains and losses arerecognised immediately in the income statement.

■ A non-derivative financial instrument can have certain characteristics that cause it to behave likea derivative. These characteristics need to be evaluated to determine whether they should beseparated from the financial instrument and accounted for separately as a stand-alone derivative.

■ Hedge accounting is a choice that each entity makes for each economic hedge that it has in place.The choice reflects a trade-off between the cost of achieving hedge accounting and the potentialbenefit achieved by reducing the income statement volatility that would otherwise arise. In somecircumstances, the standard prohibits hedge accounting.

■ In order to qualify for hedge accounting, an entity must designate its hedge relationships anddocument how it will measure effectiveness. Each individual relationship between a derivative andits hedged asset, liability or future cash flow must be documented separately.

■ Hedge accounting is permitted provided that the entity can establish that each hedge has beenhighly effective in each reporting period. In order to continue hedge accounting, there must be anexpectation that future gains and losses on the hedged item and hedging instrument will almostfully offset.

■ There are three hedge accounting models under IAS 39, which are the fair value hedge, the cashflow hedge and the hedge of a net investment in a foreign entity. The appropriate accounting modelfor a hedge relationship depends on the nature of the item being hedged.



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■ Implementing these requirements can involve significant systems amendments, particularly whenlarge numbers of derivatives are used as hedging instruments.

1.3.4 Disclosure and presentation

■ Guidance is provided on the classification of financial instruments as equity or debt, and accountingfor compound instruments with characteristics of both equity and debt instruments, such asconvertible bonds.

■ Criteria are specified for the netting of financial assets and financial liabilities. Netting requires alegal right of set off as well as the intention to offset the assets and liabilities or settle simultaneously.

■ Significant qualitative and quantitative disclosures about financial instruments, financial riskmanagement and hedging activities are required.

■ Required disclosures include how fair value is determined, as well as methods and significantassumptions, and risk management objectives and policies for hedging. Disclosures should note thesignificant terms and conditions of instruments as well as information about interest rate risk andcredit risk of financial instruments.

■ In addition, fair value information and other quantitative disclosures of income and expense, andgains and losses from financial instruments are required.

December 2003 amendments

At a very high level, the amendments to the standards introduce the following changes:

■ The requirements on derecognition of financial assets are significantly reworded and to some extentrevised (although for certain transactions the resulting changes to the accounting are substantial),retaining elements of both risks and rewards and control criteria. The standard should now besimpler to apply under the decision tree approach, except in limited numbers of transactions wherea new ‘continuing involvement’ approach is adopted, resulting in partial derecognition.

■ A new category of ‘financial assets measured at fair value through profit or loss’ is introduced.An entity may choose to include any financial asset or financial liability in this category on the daythe asset or liability is first recognised, or on the date the amended standards are first applied.Subsequent transfers in or out of the new category are prohibited. The option to recognise fairvalue changes on available-for-sale financial assets in profit or loss is consequently removed.

■ Similarly, an entity may choose, on initial recognition or when the standards are first applied, toclassify any non-derivative financial asset as available-for-sale, with fair value changessubsequently being recognised as a component of equity.

■ The requirement to separate certain embedded foreign currency derivatives has been relaxed incertain cases, where the currency in which the sale is denominated is not the functional currencyof either of the parties to the contract.

■ New guidance is provided on the application of the impairment requirements, emphasising thatthe standards follow an incurred loss model. Impairment losses recognised on equity instrumentsclassified as ‘available-for-sale’ are prohibited from being reversed through profit or loss.Any subsequent increase in fair value is instead recognised in equity.




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■ Further guidance is also provided on how to calculate amortised cost using the effective yieldmethod and on fair value measurement techniques.

■ Additional restrictions are placed on the use of hedge accounting in some circumstances, particularlyon the use of internal transactions in hedging relationships. Some hedging relationships involvingfirm commitments that were previously accounted for as cash flow hedges will be accounted foras fair value hedges. The cash flow hedge accounting model has in some cases prohibited basisadjustments and in others made them optional.

■ The requirements on classification of issued instruments such as preference shares and convertiblebonds between liabilities and equity are amended slightly and new requirements are provided onhow to account for derivatives on an entity’s own equity.

■ New disclosures are added, in particular on the sensitivity of fair value estimates to key inputs toa valuation model.

IASB Board meeting February 2004

At this meeting the IASB tentatively concluded that it should make two further amendments to thestandards. The first would be to limit the use of the fair value through profit or loss option, describedabove, to four circumstances:

■ the item is an available-for-sale asset (but not a loan or receivable);

■ the item contains one or more embedded derivatives;

■ the item is a financial liability whose amount is contractually linked to the performance of assetsthat are measured at fair value; or

■ the exposure to fair value changes in the item is substantially offset by corresponding changes inthe value of another financial asset or liability, including a derivative.

This proposal is expected to be exposed for public comment during the second quarter of 2004 andfinalised in the third quarter.

The second amendment would be to remove the requirement, in respect of the prospective effectivenesstest for hedge accounting, that changes in fair value or cash flows of the hedged item should beexpected to ‘almost fully offset’. In practice, this change is likely to mean that as long as the entity isnot deliberately under-hedging, the degree of correlation required to achieve hedge accounting will becloser to the 80 to 125 per cent range required for retrospective testing. This amendment is likely tobe issued without further exposure in April 2004.



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2. Scope and definitions

Key topics covered in this Section:

■■■■■ Financial instruments included and excluded from the scope

■■■■■ Financial instruments defined

■■■■■ Financial risks defined

2.1 Scope of the standards

The standards on financial instruments apply to all financial instruments, except for thosespecifically excluded from the scope of IAS 32 or IAS 39. It is important first to understandwhat items are considered to be financial instruments under IFRS. Table 2.1 showssummary balance sheets for a corporate and a financial institution, including typical financialassets and liabilities of each. The definitions of financial assets and financial liabilities arediscussed later in Section 2.2.

Table 2.1 Effect of financial instruments on a corporate / financial institution

Reference

Corporate balance sheet

AssetsProperty, plant and equipmentInvestmentsDeferred tax assetsTotal non-current assetsInventoriesOther receivablesCash and cash equivalentsTotal current assetsTotal assetsEquity and liabilitiesIssued capitalReservesRetained earningsTotal capital and reservesInterest-bearing loans and borrowingsPension obligationsProvisionsTotal non-current liabilitiesBank overdraftOther payablesTotal current liabilitiesTotal equity and liabilities

Financial institution balance sheet

AssetsCash and bank balancesCash collateral on securitiesTrading portfolio assetsLoans, net of allowancesFinancial investmentsAccrued incomeProperty, plant and equipmentOther assetsTotal assetsEquity and liabilitiesIssued capitalReservesRetained earningsTotal capital and reservesMoney market paperDue to banksRepurchase agreementsTrading portfolio liabilitiesDue to customersLong-term debtOther liabilitiesTotal equity and liabilities



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The items in italics in Table 2.1 are those figures that may contain financial instrumentsthat fall within the scope of the financial instruments standards. This table demonstratesthat many of the accounts of a typical corporate or financial institution are subject tothese standards.

39.2 Certain instruments and contracts are excluded from the scope of the financial instrumentsstandards, even though they may possess all of the required characteristics of a financialinstrument. For the financial assets and liabilities listed in Table 2.2, entities should referto other existing standards, if applicable.

Table 2.2 Items excluded from the financial instruments standards

ApplicableIAS 32 IAS 39 standard

Interests in subsidiaries ✗ ✗ IAS 27

Interests in associates ✗ ✗ IAS 28

Interests in joint ventures – ✗ IAS 31

Employers’ assets and liabilities underemployee benefit plans – ✗ IAS 19

Employers’ assets and liabilities in respect ofpost-employment employee benefits ✗ – IAS 19

Employers’ obligations in respect of employeestock option and stock purchase plans ✗ – IAS 19

Disclosures of employee benefit plans’obligations for post-employment benefits ✗ – IAS 26

Rights and obligations under insurance contracts(except embedded derivatives) ✗ ✗ IASB’s insurance

project

Rights and obligations under leases (otherthan securitised lease receivables andembedded derivatives) – ✗ IAS 17

Equity instruments issued by the entity,including warrants and options, classified asshareholders’ equity – ✗ IFRS 2 *

Financial guarantee contracts, includingletters of credit – ✗ IAS 37

Contracts for contingent consideration in abusiness combination – ✗ IAS 22

‘Weather derivatives’: contracts that require apayment based on climatic, geological or someother physical variables – ✗ IASB’s insurance

project

“✗ ” Indicates a specific exclusion from the standard.* There are two current standards that address aspects of equity instruments issued by the

entity (IAS 32 (revised December 2003) and IFRS 2 on share-based payment transactions).



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As noted in Table 2.2, a number of items are excluded from the scope of IAS 39.However, derivatives embedded within excluded instruments, for example, within leasesor insurance contracts, still are within the scope of the financial instruments standards.Finance lease receivables are subject to the derecognition provisions of IAS 39.While most financial instruments, contracts and obligations under share-based paymenttransactions to which IFRS 2 Share-based Payment applies are excluded from thescope of IAS 39, they are included where they are in relation to commodity contractswhich fall within the scope of IAS 39 (see Section 2.1.2). Additionally, many financialinstruments excluded from the scope of IAS 39 still are subject to the disclosure andpresentation requirements of IAS 32.

The financial instruments standards do not change the accounting with respect toinvestments in subsidiaries, associates and joint ventures. The applicable standard foreach of these investments is noted above. All other investments in equity securities arewithin the scope of the financial instruments standards. Options to buy and sell interestsin subsidiaries, associates or joint ventures may meet the definition of a derivative.These would also be accounted for as financial instruments.

Certain types of investors or investment vehicles may hold a large equity interest inanother entity so that consolidation or associate accounting is applicable. These investors(e.g. venture capital funds, private equity funds) view the equity stake as a strategicinvestment that is intended to be disposed of in the future. Generally, the investor’spreference is to account for this interest as a financial instrument rather than as a subsidiaryor associate. However, the intention of the investor is not the relevant consideration fordetermining whether the holding is within the scope of IAS 39. IAS 28 Investments inAssociates (revised 2003) allows these venture capitalists and similar entities to applyfair value accounting under IAS 39 rather than accounting for the holding as an associate.This requires changes in fair value to be recognised in the income statement. IAS 31Interests in Joint Ventures allows a similar approach to be taken for jointly controlledentities. However, there is no similar amendment in respect of consolidation under IAS 27Consolidated and Separate Financial Statements (revised 2003).


39.2(i) The amendments will exclude from the scope of the standards loan commitments(e.g. an agreement by a bank to grant a loan at a fixed interest rate), except thosewhen the entity has a history of settling such commitments in cash or of trading theloan shortly after its issue. Loan commitments were previously exempt from derivativeaccounting when they qualified as ‘regular way’ transactions.

39.3 Additional guidance is provided on the accounting for issued financial guarantee contractsand loan commitments that are excluded from the scope of the standard. Such guaranteesand commitments are initially measured at fair value and subsequently measured at thehigher of the amount initially recognised (less amounts recognised as revenue underIAS 18 Revenue) and the provision that would be required under IAS 37 Provisions,Contingent Liabilities and Contingent Assets.

On completion of the Phase I Insurance standard, expected in late March 2004, it isanticipated that the scope exclusion in IAS 39 for weather derivatives will be removed.



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2.1.1 Insurance-like contracts

39.AG4 Obligations arising under insurance contracts are excluded from the scope of both financialinstruments standards. However, the other financial assets and liabilities of insurance

32.6 entities are not. If a financial instrument takes the form of an insurance contract, butinvolves the transfer of financial risks, as opposed to insurance risks, the contract would

39.2(d) fall within the scope of the financial instruments standards. The same principle applies toreinsurance contracts where the underlying risk is financial risk. In practice, there maybe difficulty in determining whether or not contracts that take the form of insurance also

39.2(d) have financial risks. Regardless of whether an insurance or reinsurance contract is includedwithin the scope of IAS 39, it may contain an embedded derivative that must be separatedand accounted for as a derivative in accordance with IAS 39.


39.2(d) The amendments do not change the guidance on how to distinguish between an insurancecontract and a financial instrument. However, the standard on insurance contracts,expected in late March 2004, will include a new definition of insurance contracts andwill, in most respects, permit an entity to continue its existing accounting for insurancecontracts. The new definition will need to be applied in determining whether a contractis an insurance contract or a financial instrument. Contracts that may be described asinsurance contracts but that do not contain significant insurance risk will be accountedfor under IAS 39, as will non-insurance derivatives embedded in insurance contracts.

2.1.2 Commodities contracts and normal purchases and sales

39.5-7 A contract that is based on a commodity (e.g. a forward or option to purchase or sell acommodity) may meet the definition of a derivative. Commodity-based contracts thatgive a right to either party to settle in cash or some other financial instrument are includedin the scope of the financial instruments standards unless these are (a) entered into withthe purpose of meeting the entity’s purchase or sales needs and (b) expected to be settledphysically by delivery of the commodities (i.e. not net settled). Those contracts should betreated as executory contracts rather than as derivatives.

39.6 Intention and past practice of the entity are important considerations when evaluating acommodities contract that can be settled net. If the terms of the contracts are such thatthey can only be settled by delivery and there is no practice of settling net, the contractsare not accounted for as derivatives. However, if an entity has a pattern of settlingcommodity-based contracts on a net basis, the contracts are deemed to not be for thepurpose of meeting the entity’s expected purchase, sale or usage requirements and fallwithin the scope of the financial instruments standards. The intention to settle net may beevidenced by a historical pattern of entering into offsetting agreements. Likewise, entitiesthat enter into offsetting contracts that effectively achieve net settlement would not qualifyfor this exemption.

IG A.2 and B.1 Commodities are viewed broadly under the financial instruments standards, meaning thatthey may be any type of goods on which derivative contracts may be based that giverights to one party to receive or deliver these types of goods to another party. For example,derivative contracts based on non-financial assets such as real estate could fall within thescope of IAS 39. Derivative contracts based on gold could also fall within the financial



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Reference


instruments standards, even though gold itself is not a financial instrument and is thereforeoutside the scope of the standards.


39.5 and 6 The amendments clarify the circumstances in which a commodities contract should beaccounted for as a financial instrument, introducing two further restrictions on an entity’sability to use the scope exemptions for commodities contracts:

■ Although the standard still applies only to those contracts that may be settled incash (or other financial assets) the amendments increase significantly the meaningof ‘may be settled in cash’. Commodity and similar contracts will be accounted foras derivatives if the entity has a practice of trading the commodity shortly afterdelivery or if the product is readily convertible to cash. Many commodity contractsare therefore likely to be included in the scope of the standards, even if the termsof the contract require settlement by physical delivery; and

■ Under the amendments, a written option, under which an entity might be requiredto purchase or sell a commodity or other non-financial asset, can never qualify forthe ‘normal purchases and sales’ exclusion, because the entity cannot controlwhether or not the purchase or sale will take place. Therefore, it cannot be a‘normal’ purchase or sale requirement. The normal purchases / sales exemption isretained for contracts other than written options that meet the requirement above.

2.2 Definitions relating to financial instruments

Financial instruments embrace a broad range of assets and liabilities. They include bothprimary financial instruments (e.g. receivables, debt and shares in another entity) andderivative financial instruments (e.g. financial options and forwards, including futures, aswell as interest rate swaps and currency swaps).

39.9 and 32.11 A financial instrument is any contract that gives rise to both a financial asset of oneenterprise and a financial liability or equity instrument of another enterprise.

2.2.1 Financial assets and financial liabilities

39.9 and 32.11 A financial asset is any asset that is: (a) cash; (b) a contractual right to receive cashor another financial asset from another enterprise; (c) a contractual right to exchangefinancial instruments with another enterprise under conditions that are potentiallyfavourable; or (d) an equity instrument of another enterprise.

A financial liability is any liability that is a contractual obligation: (a) to deliver cash oranother financial asset to another enterprise; or (b) to exchange financial instrumentswith another enterprise under conditions that are potentially unfavourable.

32.13 The terms contract and contractual in the above definitions refer to an agreementbetween two or more parties that has clear economic consequences and that the partieshave little, if any, discretion to avoid, usually because the agreement is enforceable bylaw. Contracts defining financial instruments may take a variety of forms and do not need



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to be in writing. An example of an item not meeting the definitions would be a tax liability,as it is not based on a contract between two or more parties.


32.11 and 39.2(e) The amendments expand the definitions of financial asset and financial liability to covercontracts that will or may be settled in an entity’s own equity instruments. The amendeddefinition clarifies that a liability settled by delivering a variable number of the entity’sown equity instruments with a fixed or determinable value (in other words whereshares are used as a settlement currency) is a financial liability. This change is likely tohave little impact in practice as similar requirements were already included in theexisting standards, although not in the definitions.

The other reason for amending the definitions is to cover derivatives whose underlyingis the entity’s own equity share price.

2.2.2 Equity instruments

32.11 and 39.9 An equity instrument is any contract that evidences a residual interest in the assetsof an enterprise after deducting all of its liabilities.

SIC-16 The current versions of the financial instruments standards do not address accounting fortransactions in own equity other than treasury shares. The topic of classification ofinstruments (by an issuer) as liabilities versus equity is covered in Section 10.


32.21-24 The amendments provide a comprehensive framework on the accounting for transactionsin own equity, including derivatives whose underlying is an entity’s own equity shares,and they discuss when these derivatives are to be accounted for as an entity’s ownequity and when they are to be accounted for as assets or liabilities. The requirementsare covered in Section 10.

2.2.3 Derivatives

39.9 A derivative is a financial instrument:(a) whose value changes in response to the change in a specified interest rate, security

price, commodity price, foreign exchange rate, index of prices or rates, a creditrating or credit index, or similar variable (sometimes called the underlying);

(b) that requires no initial net investment or little initial net investment relative to othertypes of contracts that have similar responses to changes in market conditions; and

(c) that is settled at a future date.

All of the above must be met in order for a financial instrument to be a derivative.



15

Reference



39.9 The revised standards include an amendment to part (b) of the definition. The amendeddefinition requires only an initial net investment that is smaller than would be requiredfor a similar non-derivative contract with similar responses to changes in marketconditions. This is explained further in Section 2.2.3.2. The amendment is not asubstantive change to the definition.

2.2.3.1 Change in value based on an underlying

IG B.8 A derivative financial instrument is a financial instrument that provides the holder (orwriter) with the right (or obligation) to receive (or pay) cash or another financial instrumentin amounts determined by reference to price changes in an underlying price or index, orchanges in foreign exchange or interest rates, at a future date. A derivative may havemore than one underlying variable.

Common types of derivatives are options, swaps and forwards. Examples include interestrate swaps, foreign currency forward contracts or equity call options. An interest rateswap is a contract that results in the exchange of cash flows based on different (i.e. fixedor floating) interest rates. A foreign currency forward contract is an agreement to exchangeat some future date an amount of one currency for an amount of another currency at aset forward exchange rate. An equity call option gives the holder the right to receive afinancial instrument and will be exercised if the price of the equity security rises abovethe exercise price of the call option. Another example of a derivative is a forward contractto acquire a bond at some future date at an agreed price. The forward contract has apositive fair value if the price of the bond increases and a negative fair value if the priceof the bond decreases compared to the agreed upon price.

39.AG9 A derivative usually has a notional amount, which can be an amount of currency, a numberof shares, a number of units of weight or volume or other units specified in the contract.However, the holder or writer is not required to invest in or receive the notional amount atthe inception of the contract. Alternatively, a derivative could require a fixed payment asa result of some future event that is unrelated to a notional amount. For example, an entitymay enter into a contract whereby it will receive a fixed payment of 1,000 if a specifiedindex increases by a determined number of points in the next month. The settlementamount is not based on and does not need to change proportionally with an underlying.

IG B.2 and B.3 The underlying price change upon which a derivative financial instrument is based may bethat of a primary financial instrument (such as a bond or equity security) or a commodity(such as gold, oil or wheat), a rate (such as an interest rate), an index of prices (such as astock exchange index) or some other indicator that has a measurable value. A key elementof a derivative is that the transaction must allow for settlement in the form of cash or theright to another financial instrument. Settlement of a derivative, such as an interest rateswap, may be either a gross or net exchange of cash or other financial instruments.

2.2.3.2 Little or no initial net investment

39.AG11 There is no quantified guidance as to what constitutes little or no initial netinvestment. The initial net investment should be less than the investment needed toacquire a primary financial instrument that has a similar response to changes in market



16

Reference


conditions. However, less than does not necessarily mean insignificant in relationto the overall investment and needs to be interpreted on a relative basis.

For example:

IG B.10 ■ A margin account is not considered to be an initial net investment. Rather, marginaccounts are funds required to be deposited as collateral with a broker in order tohave transactions executed by that broker.

39.AG11 ■ If there is an exchange of amounts when entering into a contract, for example, theexchange of one currency for another is a cross currency swap, which is not seen asan initial net investment provided the amounts of cash are of equal fair value.

IG B.6 ■ If two offsetting loans are entered into that have equal terms and conditions except fortheir interest rates, which in substance form an interest rate swap, these loans are consideredto be a derivative and should be accounted for as such if all of the defining characteristicsof a derivative are met. There are exceptions to this, such as when an entity can demonstratean economic need or a substantive business purpose for structuring transactions separatelythat could not have been accomplished in a single transaction.

39.AG11 An example of a derivative instrument is an option that gives the holder the right to buyanother financial instrument at a strike price on or before a specified date. The premiumpaid for an option fulfils the requirement of little or no initial investment as it is less thanthe amount required to obtain the underlying instrument outright, except when the optionis so deep in the money that the premium paid is equivalent to making an investment in the

IG B.9 underlying. In the latter case under IAS 39 the instrument would not be accounted for asa derivative, but rather as an investment in the underlying itself. Similarly, when an entityenters into a forward contract to purchase an investment which will be settled in thefuture, but prepays the contract based on the current market price, the entity does nothave a derivative contract as this does not meet the criteria of little or no initial netinvestment. Rather the entity would record the investment itself as a non-derivativefinancial asset.

Sometimes part of a derivative is prepaid. The question then arises as to whether theremaining part still constitutes a derivative. This depends on whether all of the criteria ofthe definition are still met.

IG B.4 ■ If a party to an interest rate swap transaction prepays its pay-fixed obligation atinception, the floating rate leg of the swap is still a derivative instrument. To illustrate,an entity enters into an interest rate swap contract where it pays fixed and receivesvariable rates based on a notional amount. The entity prepays its fixed obligation bypaying the counterparty the fixed obligation discounted using the current market rate.The entity will continue to receive the variable rates over the life of the swap. In thiscircumstance, all of the criteria for being a derivative are still met. The initial netinvestment (i.e. the amount prepaid by the entity) is still significantly less than investingin a similar primary financial instrument that responds equally to changes in theunderlying interest rate. Also, the instrument’s fair value changes in response tochanges in interest rates and the instrument is settled at a future date. If the partyprepays the pay-fixed obligation at a subsequent date, this is considered to be atermination of the old swap and an origination of a new swap.



17

Reference


IG B.5 ■ In the reverse situation, if a party to an interest rate swap transaction prepays its pay-variable obligation at inception using current market rates, the swap is no longer aderivative instrument because the prepaid amount now provides a return that is thesame as that of an amortising fixed rate debt instrument of the amount of theprepayment. Therefore, the initial net investment equals that of other financialinstruments with fixed annuities.

2.2.3.3 Settlement at a future date

Derivatives require settlement at a future date. A forward contract is settled on a specifiedfuture date, an option has a future exercise date and interest rate swaps have severaldates on which interest is settled. An option is considered to be settled upon exercise or atits maturity. Therefore, even though the option may not be expected to be exercisedwhen it is out-of-the-money, the option still meets the criteria of settlement at a futuredate. Any contract where there is a time period between the trade date and the settlementdate would be a derivative if the other criteria are also met.

A related consideration when determining whether an instrument must be accounted foras a derivative is the exemption for so-called regular way transactions. This topic iscovered in Section 4.3.2.

2.2.3.4 Summary of key concepts concerning derivatives

There are several key concepts relating to derivatives which are considered in detail inlater Sections.

■ Derivatives should be recognised on an entity’s balance sheet, initially at their cost,which is the fair value of the related consideration given or received (Section 4).

■ Derivatives are thereafter measured at their fair value at each reporting date withchanges recognised in the income statement (Section 6).

■ Derivatives are often used to hedge the risks related to other financial and non-financialassets and liabilities. If specific hedging criteria are met, the derivative and the relateditem being hedged qualify for hedge accounting treatment (Sections 8 and 9).

2.2.4 Financial guarantee contracts and credit derivatives

39.2(f) Financial guarantee contracts where a payment is made if a debtor fails to make paymentwhen due are outside the scope of IAS 39. The form of the contract (e.g. guarantee, letterof credit, derivative etc.) is not an important factor when determining whether IAS 39 isapplicable. To be excluded from IAS 39, payment on the contract should only be triggeredif the holder of the contract experiences a financial loss from a debtor’s failure to make apayment when due. This should be a pre-condition for payment under the contract.The amount of the payment should be proportional to that loss (e.g. not leveraged).

39.3 Some contracts that are labelled as financial guarantees provide for a payment to bemade if events other than an actual financial loss occur. For instance in some standardcredit default agreements, a payment is triggered if the debtor’s credit rating is downgradedbelow a specified level. A contract triggered by a change in an underlying rate or index,such as a rating downgrade, is considered a derivative that is within the scope of IAS 39.



18

Reference


39.2(f) To be excluded from IAS 39, the holder of the financial guarantee contract must be theparty that is exposed to the risk of loss from the debtor’s failure to make payment.A guarantee must be treated as a derivative if the holder of the contract is not the partyexposed to risk of loss. That is because the event of default merely acts as the underlyingvariable in a derivative contract. This is the case for both the holder and the issuer of theguarantee contract.

Case 2.1 Guarantee contract versus credit derivative

39.2(f) Entity B makes a loan to Entity C. Entity B also enters into a guarantee contract issuedby Bank A that is triggered by the default of designated payments of Entity C toEntity B. This contract would be accounted for as a financial guarantee, not a derivative,in the financial statements of Bank A and Entity B.

39.3 However, assume the same structure is in place except that Bank A will makepayments to Entity B based on a change of the credit rating of Entity C. In such acase, the contract should be accounted for as a derivative in the financial statementsof Bank A and Entity B.

Case 2.2 Guarantee contract held by a third party

A guarantee contract issued by Bank A to Entity B is triggered by the default ofdesignated payments by Entity C to Entity D. Because Entity B is not exposed to a riskof financial loss (only Entity D has this risk) the contract is a derivative, both in thefinancial statements of Bank A (issuer) and Entity B (holder).


39.2(f) The distinction between financial guarantee contracts and credit derivatives remainsas described above. The amendments provide additional guidance on the initial andsubsequent measurement of issued financial guarantee contracts and loan commitmentsthat are excluded from the scope of the standard. Such instruments are initially measuredat fair value and subsequently measured at the higher of the amount initially recognised(less amounts recognised as revenue under IAS 18) and the provision that would berequired under IAS 37.

2.2.5 Embedded derivatives

A non-derivative financial instrument can have certain characteristics that cause it tobehave like a derivative. An embedded derivative must be evaluated to determine whetherit must be separated from the financial instrument, and accounted for as a stand-alonederivative. Section 3 is devoted to this topic.



19

Reference


2.3 Financial risks

Risk can be viewed as uncertainty in cash flows. The uncertainty in cash flows influencesthe fair value of recognised assets and liabilities or the level of cash flows relating tofuture transactions. The following are financial risks that are related to financial instruments:

32.52 Interest rate risk – the risk that future changes in prevailing interest rates will affect thefair value or cash flows of a financial right or obligation. Changes in market interest ratesmay affect an entity’s right to receive or obligation to pay cash or another financialinstrument at a future date, or the fair value of that right or obligation.

Currency risk (also referred to as foreign exchange (FX) rate risk) – the risk thatchanges in foreign exchange rates will affect the fair value or cash flows of a recognisedfinancial instrument, firm commitment or forecasted transaction.

Market risk (also referred to as commodity or price risk) – the risk that the fair valueor cash flows of an instrument will be affected by factors specific to the particularinstrument or to the issuer of the instrument, or by general market conditions. An exampleof this is the risk of price changes of an equity instrument.

Credit risk – the risk that one party to a financial instrument will fail to discharge anobligation and cause the other party to incur a financial loss. An entity may reduce itsexposure to credit risk through policy measures such as imposing credit limitations orrequiring collateral from counterparties, or it may use credit derivatives.

Liquidity risk – the risk that an entity will encounter difficulty in raising funds to meetcommitments, which may result in a loss being incurred because a position cannot beliquidated quickly at close to its fair value.

A common strategy in risk management is hedging, where risks that an entity faces arereduced or eliminated by entering into transactions that give an offsetting risk profile.Essentially hedging means matching the characteristics of incoming and outgoing cashflows in such a way that the effects of changes in market prices or rates are reduced orhave no impact on the future net cash flows for the entity and therefore have no impacton the income or value of the entity.

The distinction between economic financial risk management and hedge accounting isimportant to understand. The use of hedge accounting allows an entity to reflect theeconomics of a hedge relationship in the financial statements by matching offsetting gainsand losses in the income statement in the same reporting period. However, not all economicfinancial risk management practices will qualify for hedge accounting. The use of hedgeaccounting is restricted under IAS 39 and can be costly to achieve. Sections 8 and 9 aredevoted to hedge accounting topics.

2.3 Financial risks



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Reference

3. Embedded derivatives


■■■■■ What are embedded derivatives

■■■■■ Distinguishing characteristics

■■■■■ Separate accounting

3.1 Overview

39.10 Derivatives are typically stand-alone instruments, but they may also be found ascomponents embedded in a financial instrument or in a non-financial contract. A hostcontract may, for example, be a financial instrument, an insurance contract, a lease, apurchase agreement, a service agreement, a construction contract, a royalty agreementor a franchise agreement.

39.10 The component that is a derivative instrument is referred to as an embedded derivative.An embedded derivative is one or more implicit or explicit terms in a contract that affectthe cash flows of the contract in a manner similar to a stand-alone derivative instrument.If a contract or set of contracts contains derivative features that may be transferredseparately, these are not considered to be embedded derivatives, but rather freestandingderivatives. Such derivatives could be attached at inception or at a later stage by a partyto the contract or by a third party.

An embedded derivative that meets the definition must be separated from its host contractand measured as if it were a stand-alone derivative if its economic characteristics are notclosely related to those of the host contract. If the economic characteristics of an embeddedderivative are closely related to those of the host contract, then it may not be separated.The standards include detailed examples of host contracts and derivatives that requireseparation and those that do not.

39.10 and 11 If an embedded derivative is separated, the host contract is accounted for under IAS 39if it is itself a financial instrument, or in accordance with other appropriate IFRS if it is nota financial instrument. This is intended to achieve consistent treatment of transactions ofsimilar substance, whatever the form, and to prevent entities from circumventing therequirement to measure derivatives at their fair value in the balance sheet.

39.11 If the combined instrument is carried at fair value with changes in fair value recognised inthe income statement, separate accounting is not necessary, nor is it permitted.

Determining whether an embedded derivative should be accounted for separately can bea complex process, as shown in the decision tree in Figure 3.1 and in Table 3.2 later in thisSection. The process of reviewing a range of contracts to identify those that might containembedded derivatives is an important and time-consuming aspect of IAS 39.

3.1 Overview


21

Reference


Figure 3.1 Decision tree for hybrid financial instruments


39.9 One of the amendments will be to introduce a choice, in respect of each purchase,origination or issue of a financial instrument, to designate the instrument on initialrecognition as ‘fair value through profit or loss’. An entity may, therefore, avoid thecomplexity of separating and measuring embedded derivatives by measuring the entireinstrument at fair value through profit or loss.

For example, prior to the amendments, the equity call option embedded in an available-for-sale investment in a convertible bond would be separated and measured at fairvalue (if changes in the value of available-for-sale assets were recognised in equity, aspermitted by the previous standard as an accounting policy choice). If the convertibleis listed, it will be simpler for the entity to designate the entire bond as fair valuethrough profit or loss and measure it at its market price, thereby avoiding the needseparately to value and account for the option.

Another example may be a complex investment product issued by a bank or insurer thatcontains a host deposit contract and a number of embedded derivatives based on interestrates, equity prices, etc. It may be simpler for the entity to determine a fair value for theinstrument as a whole than separately for the embedded derivative components.

3.1 Overview


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Reference


3.2 Economic characteristics and risks

39.AG30 and 33 IAS 39 sets out examples of when the characteristics and risks are and when they arenot closely related.

The table below outlines the key characteristics of common host contracts.

Table 3.1 Key characteristics of common host contracts

Host contract Key characteristics

Debt contract The value of a debt contract is driven by the interest rates associatedwith the contract, which comprise the factors of:■ risk-free interest rate;■ expectations of future interest rates and inflation (forward rates);■ credit risk (specific and sector spread); and■ expected liquidity / maturity.

Equity contract The value of an equity contract is associated with the underlyingequity price or index.

Insurance contract The value of an insurance contract is dependent on:■ level of future premiums;■ interest rates;■ inflation rates; and■ actuarial assumptions (e.g. expected claims, mortality).

Lease contract The value of a lease contract is dependent on:■ inflation rates;■ interest rates; and■ revenues generated from the leased asset (e.g. lease rentals).

Contracts for The value of supply contracts is dependent on:goods and services ■ the price of the goods or services sold;

■ inflation rates; and■ the currency in which payment is denominated.

39.AG33 Any feature that leverages the exposure of the host contract to more than an insignificantextent constitutes an embedded derivative that must be separated. Leverage in this context(for contracts other than options) means that the value of the hybrid instrument changesin proportion to the underlying by more than 100 per cent, either positively or negatively.

39.AG33 In certain circumstances the currency of cash flows generated by committed future salesand purchases of an entity may differ from the reporting or measurement currency of eitherthe supplier or the customer. Such contracts are likely to contain embedded derivativeswhich should be accounted for separately. For example, Entity A has Euro as its measurementcurrency, and sells goods or services to Asia priced in USD. Entity A should account for thesupply contract as the host contract in Euro with an embedded foreign currency forward.Changes in fair value of the foreign currency component of the contract should be includedin the income statement (unless hedge accounting can be applied).

3.2 Economic characteristics and risks


23

Reference


39.AG30 and 33 IAS 39 also provides examples of when the economic characteristics and risks of anembedded derivative are and are not considered to be closely related to the host contract.Table 3.2 presents examples of typical host contracts and embedded derivative components.This is followed by a list of features of the derivative component that are considered to beclosely related and those that are not. Where no separation is required, this assumesthere is no leverage nor inverse leverage.


As noted above and in Table 3.2, a committed purchase or sales contract in a foreigncurrency contains an embedded derivative. Under the existing standard, that embeddedderivative must be separated unless the currency of the contract is the functionalcurrency of another party to the contract or is the currency in which the product isroutinely denominated in international commerce. ‘Routinely denominated’ is interpretedextremely narrowly, so that an oil transaction denominated in USD is one of the fewtransactions that qualifies for this exemption.

39.AG33(f) The amendments introduce a further exemption, that the embedded derivative shouldnot be separated if the contract requires payment in a currency that is commonly usedin contracts in that economic environment. In the example above, the embeddedderivative would not be separated as long as Entity A can demonstrate that it is commonfor this type of product or service to be priced in USD in, for example, the Asiancountry in which it is sold.

3.3 Separation of the embedded derivative

39.11 An embedded derivative that meets all of the criteria needs to be accounted for separatelyfrom its host. IAS 39 does not require separate presentation of embedded derivatives in thebalance sheet. However, an entity is required to disclose separately its financial instrumentscarried at cost and those carried at fair value. Therefore, at a minimum, embedded derivativesthat are not presented separately in the balance sheet should be disclosed.

39.12 If an embedded derivative cannot be measured reliably although the characteristics aresuch that separation would be required, the entire combined contract (host and embeddedderivative) is to be treated as a financial instrument held for trading.

In the case of multiple embedded derivative components the embedded derivatives areonly separated individually if they:

■ are clearly present in the hybrid instrument as evidenced by the contractual termsand the economic substance of the hybrid instrument;

■ relate to different risk exposures; and

■ are readily separable and independent of each other.




24

Tabl

e 3.

2 H

ost

cont

ract

s an

d em

bedd

ed d

eriv

ativ

e co

mpo

nent

s

Type

of

Type

of e

mbe

dded

Feat

ures

clo

sely

rel

ated

Feat

ures

not

clo

sely

rel

ated

host

con

trac

tde

riva

tive

com

pone

nt(n

o se

para

tion

)(s

epar

atio

n re

quir

ed)

Inst

rum

ent

Inst

rum

ent

Debt

Equi

ty-li

nked

inte

rest

or

prin

cipa

l pa

ymen

ts

Com

mod

ity-li

nked

or

othe

r no

n-fin

anci

al-

inde

xed

inte

rest

or

prin

cipa

l pa

ymen

ts

Equi

ty c

onve

rsio

n fe

atur

e

Opt

ion

or a

utom

atic

prov

isio

n to

exte

nd m

atur

ity

Cal

l or

put o

ptio

n to

repa

y be

fore

final

mat

urity

Equi

ty k

icke

r

Nev

er c

lose

ly r

elat

ed to

a d

ebt h

ost c

ontra

ct.

Nev

er c

lose

ly r

elat

ed to

a d

ebt h

ost c

ontra

ct.

Nev

er c

lose

ly r

elat

ed to

a d

ebt h

ost c

ontra

ct.

Whe

n th

e op

tion

to e

xten

d th

e m

atur

ity is

mad

e at

pre

vaili

ng m

arke

tte

rms

at th

e tim

e of

the

exte

nsio

n.

Whe

n ex

erci

sabl

e at t

he ac

cret

ed o

r am

ortis

ed am

ount

or w

hen

the e

xerc

isepr

ice o

f the

opt

ion

does

not

resu

lt in

a sig

nific

ant g

ain

or lo

ss, s

uch

as w

hen

debt

is is

sued

or p

urch

ased

at a

n in

signi

fican

t disc

ount

or p

rem

ium

.

Nev

er c

lose

ly r

elat

ed to

a d

ebt h

ost c

ontra

ct.

Whe

n in

tere

st o

r pr

inci

pal

paym

ents

are

dep

ende

nt o

neq

uity

pric

es (i

ndex

ed).

Whe

n in

tere

st o

r pr

inci

pal

paym

ents

are

dep

ende

nt o

nco

mm

odity

pric

es o

r ot

her

non-

finan

cial

ass

ets

(inde

xed)

.

Whe

n th

e deb

t ins

trum

ent m

ay b

e con

verte

d to

equi

ty sh

ares

of th

e is

suer

or

anot

her

entit

y.1

Whe

n th

e op

tion

or a

utom

atic

pro

visi

on t

o ex

tend

the

mat

urity

is o

n te

rms

whi

ch d

iffer

from

mar

ket t

erm

s at

the

time

of e

xten

sion

.

Whe

n ex

erci

sabl

e fo

r oth

er th

an th

e ac

cret

ed o

r am

ortis

edam

ount

of t

he d

ebt,

or w

hen

the

exer

cise

pric

e re

sults

in a

sign

ifica

nt g

ain

or lo

ss.

Whe

n a

subo

rdin

ated

loan

ent

itles

the

gran

tor

of th

e lo

anto

rec

eive

sha

res

of th

e bo

rrow

ing

entit

y fo

r fr

ee o

r at

ave

ry lo

w p

rice.

1In

tere

st r

ates

of

a de

bt i

nstr

umen

t an

d th

e ch

ange

s in

fai

r va

lue

of a

n eq

uity

ins

trum

ent

are

not

clos

ely

rela

ted,

the

refo

re, t

he c

onve

rsio

n op

tion

mus

t be

acc

ount

ed f

or s

epar

atel

y.



25



Tabl

e 3.

2 H

ost

cont

ract

s an

d em

bedd

ed d

eriv

ativ

e co

mpo

nent

s (c

ontin

ued)

Type

of

Type

of e

mbe

dded

Feat

ures

clo

sely

rel

ated

Feat

ures

not

clo

sely

rel

ated

host

con

trac

tde

riva

tive

com

pone

nt(n

o se

para

tion

)(s

epar

atio

n re

quir

ed)

Inst

rum

ent

Inst

rum

ent

Debt

Cre

dit d

eriv

ativ

e

Inde

x-lin

ked

(flo

atin

g) r

ates

of i

nter

est

Infla

tion-

inde

xed

inte

rest

pay

men

ts

Inte

rest

cap

s an

d flo

ors

Fore

ign

curr

ency

debt

inst

rum

ents

Whe

n th

e pa

ymen

ts d

epen

d on

the

cred

it ris

k of

the

issu

er o

f the

deb

tin

stru

men

t its

elf.

Whe

n th

e in

dexi

ng r

elat

es to

fut

ure

inte

rest

or

infla

tion,

res

ultin

g in

asi

tuat

ion

whe

re:

■th

e ho

lder

of

the

inst

rum

ent w

ould

rec

over

sub

stan

tially

all

of it

sre

cord

ed in

vest

men

t; or

■th

e iss

uer w

ould

not

pay

mor

e tha

n tw

ice t

he m

arke

t rat

e at i

ncep

tion.

From

the h

olde

r’s p

ersp

ectiv

e, th

is al

so ap

plie

s whe

n th

e con

tract

per

mits

,bu

t doe

s not

requ

ire th

at n

ot a

ll of

the

reco

rded

inve

stm

ent i

s rec

over

ed.

Whe

n th

e in

flatio

n in

dex

is on

e co

mm

only

use

d fo

r thi

s pu

rpos

e in

the

econ

omic

env

ironm

ent i

n w

hich

the

debt

is d

enom

inat

ed.

Whe

n th

e em

bedd

ed c

ap o

r flo

or is

at o

r out

-of-t

he m

oney

at t

he ti

me

ofiss

ue, i

.e. t

he e

xerc

ise in

tere

st ra

te o

f the

cap

is a

t or a

bove

mar

ket r

ates

and

the

floor

is a

t or b

elow

mar

ket r

ates

.

Whe

n ca

sh fl

ows

are

deno

min

ated

in a

fore

ign

curr

ency

and

:■

eith

er th

e pr

inci

pal a

nd in

tere

st a

re d

enom

inat

ed in

the

sam

e fo

reig

ncu

rren

cy; o

r■

the

prin

cipa

l an

d in

tere

st a

re d

enom

inat

ed i

n di

ffer

ent

fore

ign

curre

ncie

s. Fo

reig

n cu

rrenc

y ga

ins a

nd lo

sses

are a

ccou

nted

for u

nder

IAS

21.

Whe

n th

e pay

men

ts d

epen

d on

the c

redi

t ris

k of

a re

fere

nce

item

oth

er th

an th

e de

bt in

stru

men

t its

elf.

Whe

n th

e in

dexi

ng is

not

in a

one

-to-o

ne p

ropo

rtion

toth

e de

bt, f

or e

xam

ple,

sig

nific

antly

leve

rage

d th

roug

h a

diff

eren

t no

tiona

l re

fere

nce

or a

sig

nifi

cant

inv

erse

rela

tion

to th

e m

arke

t rat

e, re

sulti

ng in

a s

ituat

ion

whe

re:

■th

e ho

lder

of

the

inst

rum

ent

wou

ld n

ot r

ecov

ersu

bsta

ntia

lly a

ll of

its

reco

rded

inve

stm

ent;

or■

the

issu

er w

ould

pay

mor

e th

an tw

ice

the

mar

ket r

ate

at i

ncep

tion.

2

Whe

n th

e in

flatio

n in

dex

rela

tes

to a

diff

eren

t eco

nom

icen

viro

nmen

t or

the

ind

ex i

s no

t on

e th

at i

s co

mm

only

used

for t

his p

urpo

se.

Whe

n th

e em

bedd

ed ca

p is

bel

ow th

e mar

ket r

ate o

f int

eres

t(in

-the-

mon

ey c

ap)

or th

e flo

or is

abo

ve th

e m

arke

t rat

eof

inte

rest

(in

-the-

mon

ey f

loor

) at

the

time

of is

sue.

Whe

n a fo

reig

n cur

renc

y opt

ion i

s inc

lude

d on d

ebt r

epay

men

t.

2Th

e as

sess

men

t of t

he e

ffect

of t

hese

feat

ures

sho

uld

be m

ade

whe

n th

e co

ntra

ct is

ent

ered

into

. The

re s

houl

d be

a h

igh

expe

ctat

ion

at in

cept

ion

that

thes

e lim

its w

ill n

ot b

e ex

ceed

ed.

Det

erm

inat

ion

of t

hese

lim

its i

nvol

ves

the

estim

atio

n of

fut

ure

mov

emen

ts i

n th

e re

leva

nt i

ndic

es. A

s ob

ject

ive

indi

catio

ns o

f fu

ture

mov

emen

ts a

re g

ener

ally

not

ava

ilabl

e it

wou

ldbe

rel

evan

t to

app

ly h

isto

ric

mov

emen

ts f

or t

his

purp

ose.



26 3.3 Separation of the embedded derivative

Tabl

e 3.

2 H

ost

cont

ract

s an

d em

bedd

ed d

eriv

ativ

e co

mpo

nent

s (c

ontin

ued)

Type

of

Type

of e

mbe

dded

Feat

ures

clo

sely

rel

ated

Feat

ures

not

clo

sely

rel

ated

host

con

trac

tde

riva

tive

com

pone

nt(n

o se

para

tion

)(s

epar

atio

n re

quir

ed)

Inst

rum

ent

Inst

rum

ent

LeaseEquity (held byan entity)

Equi

ty c

all a

ndpu

t op

tions

Infla

tion-

inde

xed

leas

e pa

ymen

ts

Con

tinge

nt r

enta

ls

Fore

ign

curre

ncy

com

pone

nt

Nev

er c

lose

ly r

elat

ed to

a h

ost c

ontra

ct.

Whe

n le

ase

paym

ents

are

adj

uste

d ba

sed

on a

n in

flatio

n-re

late

d in

dex,

prov

ided

tha

t th

e in

dexi

ng i

s no

t si

gnifi

cant

ly l

ever

aged

and

tha

t th

ein

dex

rela

tes

to in

flatio

n in

an

econ

omic

env

ironm

ent t

hat i

s re

leva

ntto

the

lea

se c

ontra

ct.

Whe

n co

ntin

gent

rent

als

are

base

d on

:■

rela

ted

sale

s or

var

iabl

e in

tere

st ra

tes;

or

■in

dice

s th

at a

re c

lose

ly re

late

d to

the

leas

e.

Whe

n re

ntal

s are

den

omin

ated

in a

fore

ign

curr

ency

that

is th

e cu

rren

cyof

the

prim

ary

econ

omic

env

ironm

ent i

n w

hich

any

sub

stan

tial p

arty

toth

at c

ontra

ct o

pera

tes

(mea

sure

men

t cu

rren

cy).

Alw

ays s

epar

ated

whe

n he

ld b

y an

ent

ity.

Whe

n le

ase p

aym

ents

are a

djus

ted

acco

rdin

g to

a le

vera

ged

infla

tion

inde

x, o

r the

inde

x is

unr

elat

ed to

infla

tion

in th

een

tity’

s ow

n ec

onom

ic e

nviro

nmen

t.

Whe

n co

ntin

gent

rent

als

are

base

d on

:■

leve

rage

d sa

les

or v

aria

ble

inte

rest

rate

s; o

r

■in

dice

s th

at a

re n

ot c

lose

ly re

late

d to

the

leas

e.

Whe

n re

ntal

s ar

e no

t den

omin

ated

in a

for

eign

cur

renc

yth

at is

the

curr

ency

of t

he p

rimar

y ec

onom

ic e

nviro

nmen

tin

whi

ch a

ny s

ubst

antia

l pa

rty t

o th

at c

ontra

ct o

pera

tes

(mea

sure

men

t cu

rren

cy).


27


3 N

ote

that

: ‘R

outin

ely

deno

min

ated

’ is

ver

y na

rrow

ly d

efin

ed. I

t is

onl

y a

curr

ency

tha

t is

use

d fo

r si

mila

r tr

ansa

ctio

ns a

ll ar

ound

the

wor

ld, n

ot j

ust

in o

ne l

ocal

are

a.


Tabl

e 3.

2 H

ost

cont

ract

s an

d em

bedd

ed d

eriv

ativ

e co

mpo

nent

s (c

ontin

ued)

Type

of

Type

of e

mbe

dded

Feat

ures

clo

sely

rel

ated

Feat

ures

not

clo

sely

rel

ated

host

con

trac

tde

riva

tive

com

pone

nt(n

o se

para

tion

)(s

epar

atio

n re

quir

ed)

Inst

rum

ent

Inst

rum

ent

Commercial contracts (purchase, sale)

Fore

ign

curre

ncy

com

pone

nt

Pric

e cla

uses

rela

ted

to in

dice

s

Com

bina

tion

of c

all a

nd p

utop

tion,

resu

lting

in a

pric

era

nge

(a c

olla

r)

Whe

n a

com

mer

cial

con

tract

inv

olve

s pa

ymen

t fo

r go

ods

or s

ervi

ces

deno

min

ated

in a

fore

ign

curr

ency

:■

that

is th

e cu

rren

cy o

f the

prim

ary

econ

omic

env

ironm

ent i

n w

hich

any

subs

tant

ial

part

y to

tha

t co

ntra

ct o

pera

tes

(mea

sure

men

tcu

rren

cy);

or

■th

at is

the

curr

ency

in w

hich

the

pric

e of

the

rela

ted

good

or s

ervi

ceth

at is

acqu

ired

or d

eliv

ered

is ro

utin

ely

deno

min

ated

in in

tern

atio

nal

com

mer

ce w

orld

wid

e.3

Whe

n co

mm

erci

al c

ontra

cts

are

base

d on

pric

es o

r in

dice

s th

at a

recl

osel

y re

late

d to

the

cont

ract

(e.g

. rel

ated

to th

e pr

ice

of th

e pu

rcha

sed

or so

ld g

oods

or s

ervi

ces)

.

Whe

n th

e pu

rcha

sed

call

and

the

writ

ten

put a

re a

t or o

ut-o

f-th

e m

oney

,i.e

. the

exe

rcis

e pr

ice

of th

e ca

ll is

at o

r abo

ve m

arke

t rat

es a

nd o

f the

put i

s at

or b

elow

mar

ket r

ates

at t

he ti

me

the

cont

ract

is e

nter

ed in

to.

Whe

n co

mm

erci

al c

ontra

cts r

equi

re p

aym

ent d

enom

inat

edin

a c

urre

ncy

that

is n

ot:

■th

e cu

rren

cy o

f the

prim

ary

econ

omic

env

ironm

ent i

nw

hich

any

sub

stan

tial p

arty

to th

at c

ontra

ct o

pera

tes

(mea

sure

men

t cur

renc

y); a

nd

■th

e cu

rren

cy in

whi

ch th

e pr

ice

of th

e re

late

d go

od o

rse

rvic

e th

at i

s ac

quir

ed o

r de

liver

ed i

s ro

utin

ely

deno

min

ated

in in

tern

atio

nal c

omm

erce

wor

ldw

ide.

Whe

n co

mm

erci

al c

ontra

cts a

re b

ased

on

pric

es o

r ind

ices

unre

late

d to

the

cont

ract

(e.g

. unr

elat

ed to

the

pric

e of

the

purc

hase

d or

sold

goo

ds o

r ser

vice

s).

Whe

n th

e pu

rcha

sed

call

and

writ

ten

put a

re in

-the-

mon

eyat

the

time

the

cont

ract

is e

nter

ed in

to.


28

Reference


In many cases, multiple embedded derivatives should not be separated individually.For example, if a debt instrument has a principal amount related to an equity index andthat amount doubles if the equity index exceeds a certain level, it is not appropriate toseparate both a forward and an option on the equity index because those derivativefeatures relate to the same risk exposure. Instead the forward and the option elementsare treated as a single compound embedded derivative.

39.AG29 On the other hand, if a hybrid debt instrument contains, for example, two options that givethe holder a right to choose both the interest rate index on which interest payments aredetermined and the currency in which the principal is repaid, those two options mayqualify for separation as two separate embedded derivatives as they relate to differentrisk exposures and are readily separable and independent of each other.

39.AG33 If an embedded derivative is not required to be separated, IAS 39 does not permit anentity to separate the hybrid instrument. In other words, separation is not optional.

3.3.1 How to split fair values at initial recognition

39.AG28 and As the derivative component is measured separately at fair value upon initial recognition,32.31 the carrying amount of the host contract at initial recognition is the difference between

the cost of the hybrid instrument and the fair value of the embedded derivative. Where morereliable fair values exist for the hybrid instrument and the host contract (e.g. throughquoted market prices) than for the derivative component, it may be acceptable to usethose values to determine the fair value of the derivative upon initial recognition.

IG C.1 and C.2 When separating an instrument that is a forward, the forward price is set such that thefair value of the embedded derivative is zero at the inception of the contract. This meansthat the forward price should be at market rates. When separating an embedded featurethat is an option, the separation should be based on the stated terms of the option featuredocumented in the hybrid instrument. As a result the embedded derivative would notnecessarily have a fair value or intrinsic value equal to zero at the initial recognition of thehybrid instrument. However, the embedded derivative must be valued based on termsthat are clearly present in the hybrid instrument.

3.3.2 Designating embedded derivatives as hedging instruments

Embedded derivatives that are accounted for separately may be designated as hedginginstruments. The normal hedge accounting criteria as outlined in Section 8 apply toembedded derivatives used as hedging instruments.



29


Reference

4. Recognition and derecognition


■■■■■ Initial measurement

■■■■■ Transaction costs

■■■■■ Recognition

■■■■■ Trade date versus settlement date accounting

■■■■■ Derecognition of:

– financial assets

– financial liabilities

■■■■■ Issues relating to special purpose entities

4.1 Overview

39.14 An entity must consider both the amount to be recognised as well as the timing ofrecognition. An instrument is recognised in the balance sheet when the entity becomesparty to a contract that comprises a financial instrument.

There are specific rules governing when an entity may remove financial assets and financialliabilities from its balance sheet. For financial assets these rules are based on whether anentity has given up control over the contractual rights of the financial asset. For financialliabilities derecognition depends on whether an entity has settled, or has been legallyrelieved of, its obligation. In both situations when derecognising a financial instrument,parts of that instrument can be retained or new instruments may need to be recognised.

4.2 Initial measurement

39.43 and At initial measurement, a financial instrument is included in the balance sheet at cost,39.AG64 which should equal its fair value, i.e. the consideration given or received. The consideration

given or received is normally the transaction price or the market price. It can also be thefair value of financial instruments (other than cash) given or received in exchange for thefinancial instrument to be recognised. If the transaction is not based on market terms, orif a market price cannot be readily determined, then an estimate of future cash paymentsor receipts, discounted using the current market interest rate for a similar financialinstrument, should be used to approximate the fair value.

39.AG64 If a bank makes a low interest or interest-free loan to a customer, the cost amount givenby the bank (which recognises an asset) and the amount received by the customer (whichrecognises a liability) is often interpreted to be the cash transferred. This same issueoften arises in relation to low or no interest inter-company loans or inter-company currentaccounts. In both cases, the initial carrying amount of the loan is not the amount lent, but



30

Reference


rather the fair value of the consideration given to obtain the right to payment in the future.A low interest or interest-free loan discounted at a market rate of interest results in apresent value that is less than the amount lent. The difference is not a financial asset.However, if this difference qualifies for recognition under another applicable IFRS (e.g. arecognisable intangible benefit) then it is recognised as an asset. If the difference doesnot qualify for recognition, it must be expensed.

Case 4.1 Low interest loan

Bank Q grants a three-year loan of 50,000 to an important new customer. The interest rateon the loan is four per cent, while the current market lending rates for similar loans tocustomers with a similar credit risk profile is six per cent. Bank Q believes that the futurebusiness to be generated with this new customer will lead to a profitable lending relationship.

On initial recognition Bank Q should recognise the carrying amount of the loan as thefair value of the payments that it will receive from the customer. Discounting theinterest and principal repayments using the market rate of six per cent, Bank Q willrecognise an originated loan of 47,328. The difference of 2,672 is expensed immediatelyas the expectation about future lending relationships does not qualify for recognition asan intangible asset.

4.2.1 Transaction costs

39.AG13 Transaction costs are included in the initial measurement of financial assets and liabilities.These may be incurred when an entity enters into a contractual arrangement.Transaction costs that are included in the initial measurement are those costs paid toexternal parties, such as fees and commissions paid to agents, advisers, brokers anddealers, as well as levies paid to regulatory agencies and securities exchanges, and transfertaxes and duties. Transaction costs may include internal costs, but both internal and externalcosts must be incremental. Transaction costs do not include internal financing, holdingand administrative costs, nor do they include debt premiums or discounts.

IG E.1.1 The treatment of transaction costs after initial recognition depends on the subsequentmeasurement of the instrument of which they are a part:

■ for financial assets and liabilities that are carried at amortised cost, the transaction costsare amortised to the income statement as part of the recognition of the effective interest;

■ for financial assets carried at cost, but with no set maturity, the transaction costs arerecognised in the income statement at the time of sale;

■ for financial assets that are carried at fair value with changes in fair value recognisedin the income statement, the transaction costs are expensed upon subsequentmeasurement; and

■ for financial assets that are carried at fair value with changes in fair value recogniseddirectly in equity, the transaction costs for debt instruments are amortised to theincome statement as part of the recognition of the effective interest on suchinstruments, but for equity instruments they are recognised only at the time of sale.

39.46 Transaction costs, incurred or expected to be incurred at a subsequent date related to thetransfer or disposal of a financial instrument, should not be considered in the subsequent



31

Reference


measurement of the financial instrument. Disposal costs are only included in the incomestatement when a financial instrument is derecognised.


39.43 The amended standards specify more clearly that the amount at which a financial assetor liability is recognised initially is its fair value plus, in the case of a financial asset orfinancial liability that is not at fair value through profit or loss, transaction costs.

39.9 The amended standards confirm that transaction costs must be incremental and directlyattributable to the acquisition, issue or disposal of an instrument. Incremental costs arethose that would not have been incurred if the instrument had not been acquired, issuedor disposed of. In practice, few internal costs are likely to meet this requirement.The requirement is also applied on an instrument-by-instrument basis. It will not, forexample, be permitted to treat as transaction costs the internal costs associated withdeveloping a new investment product.

39.43 Transaction costs on financial instruments measured at fair value through profit or lossare not included in the amount at which the instrument is measured initially, insteadthey are charged immediately to the income statement.

4.3 Recognition

4.3.1 When to recognise

39.14 An enterprise should recognise a financial asset or liability in its balance sheet when,and only when, it becomes a party to the contractual provisions of the instrument.

39.AG35 Situations where an entity has become a party to contractual provisions include committingto a purchase of securities or committing to write a derivative option. In contrast, plannedbut not committed future transactions, no matter how likely, are not financial assets orliabilities as they do not represent situations where the entity becomes a party to a contractrequiring future receipt or delivery of assets. For example, an entity’s estimated butuncommitted sales do not qualify as financial assets or liabilities.

4.3.2 Trade date versus settlement date accounting

39.AG55 and 56 The trade date is the date an entity enters into a contract for the purchase or sale of anasset. The settlement date is the date that the financial instrument is delivered to ortransferred from the entity.

The recognition principle in IAS 39 would result in all transactions that occur in regulatedmarkets to be accounted for on the trade date. However, the standard recognises thatpractice by many financial institutions and corporates is to use settlement date accounting,and that it would be cumbersome to account for such transactions as derivatives betweenthe trade and settlement date.

39.AG12 Because of the short duration between the trade date and the settlement date inthese types of regulated market situations, such regular way contracts are notrecognised as derivative contracts under IAS 39. A regular way contract may be apurchase or a sale that requires delivery of assets within a period of time generally

4.3 Recognition


32

Reference


recognised to be the market convention or established by regulation in the marketplaceIG B.30 in which the transaction actually takes place. This exception is a practical approach

taken in IAS 39 to prevent the recognition of derivatives in many situations, and forvery short periods, where the constraints in the marketplace prevent immediatesettlement at the trade or commitment date.

IG B.28 In order for a financial asset purchase to be regular way, it is not required that an organisedmarket exists (e.g. a formal stock exchange, organised over-the-counter market, etc).Rather, the term ‘marketplace’ means the environment in which the financial asset iscustomarily traded. For example, a commitment for a standard three-day settlement(assumed to be the norm for a particular marketplace) of a security purchase transactionwould not be treated as a derivative as this is a regular way transaction. However, acommitment for a three-month settlement (assuming that this is not the norm in the

IG B.29 marketplace of these instruments) for the same security transaction would meet thedefinition of a derivative because it is not considered to be a regular way transaction.

39.AG54 The regular way exception requires that the transaction will be fulfilled through actualdelivery of the financial instrument. Therefore, if a contract allows for or requires netcash settlement it does not qualify as a regular way contract.

39.38, AG53 When accounting for regular way purchases and sales of a financial asset, an entity mayand IG B.32 choose either trade date or settlement date accounting. The approach should be applied

consistently for both purchases and sales of the different categories of financial assets.There are no specific requirements about trade date and settlement date accounting inrespect of financial liabilities, therefore the general recognition and derecognitionrequirements apply. Under trade date accounting, the asset to be received and relatedobligation to pay for it are recognised on the date the contract is entered into. If settlementdate accounting is chosen, the asset is recognised on the actual date of settlement, i.e. thedate that the instruments are exchanged. In the case of a purchase under settlement dateaccounting, changes in the fair value of the financial instrument between the date of tradeand settlement should be recognised if the financial instrument is carried at fair

39.57 value. In the case of a sale under settlement date accounting the opposite occurs: changesin the fair value after the trade date are not taken into account, as there is a set sale priceagreed upon at the trade date, making subsequent changes in fair value irrelevant fromthe seller’s perspective.

Case 4.2 Purchase of a bond, comparing trade date and settlement date accounting

On 28 June 20X1, Entity X agrees to purchase a bond for settlement on 1 July 20X1.The purchase price of the bond is 10.0 million. On 30 June 20X1, the fair value of thebond is 10.1 million. On 1 July, the bond purchase is settled for 10.0 million and the fairvalue remains as 10.1 million.

What would be the impact on the balance sheet of the bond purchase at each of thedates of 28 June, 30 June and 1 July?

The balance sheet impact is shown below for both the settlement date approach andthe trade date approach. The example illustrates initial measurement of the bond purchaseunder two scenarios: (1) a bond subsequently carried at fair value and (2) a bondsubsequently carried at amortised cost.

4.3 Recognition


33

Reference


IG D.2.1 Settlement date accounting Trade date accounting(amounts in millions) Fair value Amortised cost Fair value Amortised cost

28 June 20X1Financial asset-bond – – 10.0 10.0Financial liability – – (10.0) (10.0)

30 June 20X1Financial asset-receivable(revaluation gain) 0.1 – – –Financial asset-bond – – 10.1 10.0Financial liability – – (10.0) (10.0)Equity (0.1) – (0.1) –

1 July 20X1Financial asset-receivable(revaluation gain) – – – –Financial asset-bond 10.1 10.0 10.1 10.0Cash paid (10.0) (10.0) (10.0) (10.0)Equity a (0.1) – (0.1) –a This is recognised either in the income statement (i.e. retained earnings) or directly in equity, depending

on the classification of the bond.

As noted in the example, the effect on the income statement and on equity is the sameunder settlement date and trade date accounting for purchases. However, the use oftrade date accounting versus settlement date accounting could have a significant temporaryimpact on the balance sheet of an entity.

Case 4.3 Sale of a bond, comparing trade date and settlement date accounting

On 28 November 20X1, Entity X agrees to sell the bond for 9.6 million, its fair value atthat date, with a settlement date of 1 December 20X1. On 30 November 20X1, thebond is worth 9.5 million. On 1 December 20X1, the bond is settled at a price of9.6 million and the fair value of the bond is still 9.5 million.

What would be the impact on the balance sheet of the bond sale at 28 November,30 November and 1 December?

4.3 Recognition


34

Reference


39.AG56 Settlement date accounting Trade date accounting(amounts in millions) Fair value Amortised cost Fair value Amortised cost

28 November 20X1Financial asset-bond 9.6 10.0 – –Financial asset-receivable – – 9.6 9.6Retained earnings b – – 0.4 0.4Equity c 0.4 – – –

30 November 20X1Financial asset-bond 9.6 10.0 – –Financial asset-receivable – – 9.6 9.6Retained earnings b – – 0.4 0.4Equity c 0.4 – – –

1 December 20X1Cash 9.6 9.6 9.6 9.6Financial asset-bond – – – –Financial asset-receivable – – – –Retained earnings d 0.4 0.4 0.4 0.4b For trade date accounting the loss is recognised in the income statement (i.e. retained earnings) on the

trade date.c For settlement date accounting the revaluation adjustment is recognised in equity until actual settlement,

assuming fair value changes on this instrument are recognised in equity.d For both trade date and settlement date accounting the effect is ultimately the same (i.e. the loss is reflected

in the income statement).

Despite the change in fair value of the bond between the trade date and settlementdate, Entity X does not record the additional 0.1 million loss as it will receive 9.6 millionon the settlement date from the purchaser.

As can be seen above, when accounting for sales, the effect on equity, the presentationof the transaction in the income statement and in the balance sheet may be temporarilydifferent under trade date versus settlement date accounting.

4.4 Derecognition

4.4.1 Derecognition of a financial asset

39.17 and AG36 Derecognition of a financial asset or a portion of a financial asset occurs under thecurrent standards when, and only when, the entity loses control of the contractual rightsthat comprise the financial asset (or portion thereof). An entity loses control if it realisesthe rights to benefits specified in the contract, those rights expire or the entity surrendersthose rights.

The derecognition provisions in IAS 39 take a financial components approach. The financialcomponents approach focuses on control of the financial assets or portions thereof thatare transferred to another party. A transfer can be broken down into its various financialcomponents, which are then recognised by the parties to the transfer that control thosecomponents. Examples of components of a financial asset are its cash flows from principal

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repayment and cash flows from interest coupons. These cash flows can be segregatedand potentially transferred to other parties.

Determining control over a financial asset under the current standards requires identifyingthe risks and benefits of the asset and evaluating which party has exposure to and / orbenefits from these. Thus the principles in IAS 39 on derecognition are regarded as amixed approach that on one hand uses a financial components approach and on the otherhand employs a risks and rewards approach.

Within IAS 39 there are several examples of situations where a transferor has not lostcontrol of a transferred financial asset (or portion thereof) by retaining the risks andrewards related to such asset (or portion thereof). The examples are when:

39.AG51 ■ The transferor has the right to reacquire the asset (or has a right of first refusal topurchase the asset) unless either (i) the reacquisition price is fair value; or (ii) theassets are readily obtainable in the market.

39.AG51 ■ The transferor is both entitled and obliged to repurchase or redeem the transferredasset on terms that effectively provide the transferee with a rate of return similar tothat on a loan secured by the transferred asset.

39.20 and ■ The transferor has retained substantially all of the risks and returns of ownershipAG39-41 through a total return swap with the transferee (and the asset is not readily obtainable

in the market).

39.AG51 ■ The transferor has retained substantially all of the risks of ownership through anunconditional put option on a transferred asset held by the transferee (and the asset isnot readily obtainable).

39.AG42-44 Both the position of the transferor and the position of the transferee must be considered.After transferring the assets, the transferor should not be able to sell or pledge the assetsto another party and should not be able to use the cash flows generated by the assets forits own benefit. The transferor has generally not lost control unless the transferee has theability to obtain the benefits of the transferred asset.

39.16 and 20 Derecognition is not limited to the situations noted above. If, for example, neither thetransferee nor the transferor has the right to sell or pledge a portfolio of loans (whichoften is the case when only a portion of the assets is transferred), the transferred portionof the loans may be derecognised if it is demonstrated that the transferee has the abilityto obtain the benefits of its portion of the assets, that is to say, the transferee may sell orpledge its interests in its portion of the loans.


39.15-42 Derecognition requirements for assets have been significantly reworded and to anextent revised (although for certain transactions the resulting changes to the accountingare substantial). Elements of both the components / control, and risks and rewards,approaches are retained but a new ‘continuing involvement’ approach is introduced,resulting in partial derecognition in a number of more complex transactions wherepreviously no derecognition would have been permitted. These are dealt with further inthe Sections below.

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The amendments also clarify the requirements considerably by introducing a step-by-step approach to analysing transactions, thus placing the various steps to be taken indetermining whether a transaction qualifies for derecognition in a mandatory hierarchy.In the existing standard it is often difficult to establish when one requirement takesprecedence over another.

39.AG36 A decision tree outlining the new approach, with paragraph references to the revisedIAS 39, is as follows:

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The steps involved in the analysis under the amended standard are, in summary:

1. What is the reporting entity? If the reporting entity is a group, the purpose of thisstep is to ensure, for example, that all controlled special purpose entities (SPEs)are consolidated before considering derecognition. Essentially there is no benefit inanalysing whether an entity achieves derecognition when transferring financialassets to an SPE if the SPE is then consolidated under SIC–12 and only the groupfinancial statements are prepared using IFRS.

2. Should the analysis be applied to a component of a financial asset or to the asset inits entirety? A component is permitted to be considered for derecognition separatelyonly if it represents:

(a) specifically identified contractual cash flows, such as a stream of interest-onlyor principal only cash flows;

(b) a fully proportionate share of the cash flows from the asset, for example, 50 percent of all the interest and principal payments received on a loan; or

(c) a fully proportionate share of specifically identified contractual cash flows, forexample, 30 per cent of the interest cash flows received on a bond.

The analysis may be applied either to an individual asset or to a portfolio of similarassets. The remaining steps are then applied to the portfolio, asset or qualifyingpart or proportion identified in this step. This is referred to in the steps below as‘the asset’.

3. Have the rights to the cash flows from the asset expired? This would be the case,for example, when a debt instrument has been repaid or a purchased option expiresunexercised. If yes, the asset is derecognised.

4. Have the rights to the cash flows from the asset been transferred? This would applyin a legal sale of the asset, or a legal assignment of the rights to its cash flows.

5. If the entity has not transferred the rights to cash flows from the asset, has theentity assumed an obligation to ‘pass through’ the cash flows from the asset toanother party? Does that pass-through meet all of the following conditions?

■ The entity has no obligation to pay amounts to the other party unless it collectsequivalent amounts from the original asset;

■ The entity is prohibited by the terms of the transfer contract from selling orpledging the original asset other than as security to the other party for theobligation to pay that party cash flows; and

■ The entity has an obligation to remit any cash flows it collects on behalf of theother party without material delay. In addition, during any short period betweencollection by the entity and payment to the other party, the funds may not bereinvested other than in cash and cash equivalents (as defined by IAS 7 CashFlow Statements) and any interest earned must be passed to the other party.

If there is neither a legal sale nor a qualifying pass-through arrangement, noderecognition is permitted. The transaction is treated as a secured borrowing.

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The requirements for pass-through are considered further in Section 4.4.1.3 and inthe securitisation example in Section 4.5.

6. If the asset has been transferred, either through a legal sale or a qualifying pass-through arrangement, have substantially all the risks and rewards been transferred?This would apply either to a clean sale with no ‘strings’ attached, or to a qualifyingarrangement to pass through all cash flows with no further interest by the entity inany of the future economic outcomes from the asset. If yes, the asset isderecognised. The transfer of risks and rewards is evaluated by comparing theentity’s exposure, before and after the transfer, to the variability in the amountsand timing of the net cash flows of the assets.

7. Have substantially all the risks and rewards been retained? This would be thecase, for example, in a sale with a fixed price repurchase agreement or a sale witha total return swap. If yes, no derecognition is permitted and the transaction istreated as a secured borrowing.

8. If the asset has been transferred, but substantially all its risks and rewards havebeen neither transferred nor retained (in other words, some risks and rewards areretained, and some are transferred), has the entity transferred control of the asset?Examples would be a sale with a retained call option or a sale with a written putoption. Control in this context means the practical ability to sell the asset. If thebuyer has an unfettered and practical ability to sell the asset, for example, becausethe asset is listed and therefore the buyer could sell it and subsequently repurchaseit if required, then control has been transferred and the asset is derecognised.

9. If control has not been transferred, then the entity continues to recognise the assetto the extent of its continuing involvement. This concept has been introduced todeal with those circumstances where an entity has neither transferred nor retainedsubstantially all the risks and rewards relating to the transferred asset, but hasretained control. Essentially, the asset is derecognised to the extent the entity hasno continuing exposure to the asset. The asset remains on balance sheet to theextent of the maximum potential exposure and a corresponding liability is recognised.The detailed requirements are complex, but the principle is that the net amountrecognised for the asset and the liability reflects the entity’s remaining net potentialmaximum exposure to the asset. If the asset is measured at amortised cost, thecorresponding liability is measured at amortised cost. If the asset is measured atfair value, the liability is measured at fair value. Alternatively, the continuinginvolvement may be in the form of an option or guarantee. In such cases, undercontinuing involvement derecognition will be precluded to the extent of the amountwhich might become payable under the option or guarantee.

In the examples given in the rest of this Section, the outcomes under the amendedstandard are likely to be the same as under the existing standard unlessotherwise stated.

4.4.1.1 Evaluating the risks associated with a transferred asset

For financial assets with relatively short maturities, such as trade receivables, theonly substantive risk to consider generally is credit risk. If the transferor retains thecredit risk on short-term financial assets through a guarantee then derecognition wouldnot be appropriate.

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An entity might transfer part, but not all, of a risk that it considers to be a substantive riskof the transferred assets. In order for derecognition to be appropriate, the entity needs totransfer a significant exposure to loss from that substantive risk. A risk of loss isconsidered to be significant when it is based on historical loss experience for an entity andconsidering the type of asset transferred. For example, if a transfer of credit risk (whichis considered to be a substantive risk of the assets transferred) will only occur in acatastrophe or similar situation because historical losses are covered through a guaranteeby the transferor, this is considered to be outside the range of likely loss outcomes. Thiswould not be considered a transfer of a significant exposure to loss from credit risk.Consequently, in such cases, derecognition would not be appropriate.

4.4.1.2 Transfer of a financial asset with no derecognition

39.29 Transfers of financial assets that do not satisfy the conditions for derecognition areaccounted for as collateralised borrowings. In other words, the financial assets stay onthe books of the transferor and a borrowing is recognised for the proceeds received fromthe transferee. The financial assets act as collateral for the transferee in the event of

39.AG49 non-payment on the borrowing. If derecognition is prevented due to the existence of aderivative (whether stand-alone or embedded in a contract), the derivative itself wouldnot be recognised if recognising both the derivative and the borrowing result in doublecounting in the transferor’s balance sheet.

39.AG50 The most common example of a collateralised borrowing is a standard repurchase (repo)transaction, where a seller transfers assets and agrees to repurchase the same assets ata later date and at a specified price. Effectively the seller / transferor has a call optionand the buyer / transferee has a put option on the transferred assets. In this situation, theseller should continue to recognise the financial assets and should not recognise the options.Because only one entity can control a financial asset (or component thereof), if thetransferor cannot derecognise a financial asset then the transferee should not recognisethe financial asset on its balance sheet. Instead the transferee recognises a receivablefrom the transferor for the repayment of the cash proceeds or other consideration.

39.AG51(a-c) In some repo transactions, when returning transferred assets to the transferor, thetransferee may substitute similar assets of equal fair value. If this occurs, upon substitutionthe transferor derecognises the assets originally transferred and recognises the assetsactually returned by the transferee.

IG D.1.1 A securities lending transaction that requires the borrower to return the transferred financialasset at a later date and for a specified price would be accounted for in a similar way tothat described above for repo transactions. Typically in a securities lending transaction,there is collateral given by the securities borrower / transferee to the securities lender /transferor. If cash is given as collateral and is not legally separated from the lender’sassets, the lender recognises the cash and a payable to the borrower. The borrowerrecognises a receivable from the lender.

39.AG51(e) A wash sale transaction is one where an entity purchases a financial asset either immediatelybefore or after the sale of the same asset. A wash sale may qualify for derecognition aslong as there is not a contractual commitment to repurchase the assets sold. In suchcases the sale and purchase are viewed as two separate transactions under IAS 39.

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Case 4.4 Receivables sold with full recourse

39.AG51(i) Entity A (the transferor) sells receivables to Entity B (the transferee). The receivables,which are due in six months and have a carrying value of 100,000 are sold for a cashpayment of 95,000 subject to full recourse. Under the right of recourse, the transferoris obligated to compensate the transferee for the failure of the debtors to pay whendue. In addition to the recourse, the transferee is entitled to sell the receivables back tothe transferor in the event of unfavourable changes in interest rates or the credit ratingsof the underlying debtors.

How should the transaction be accounted for? The transaction is accounted for by thetransferor as a secured loan as it does not qualify for derecognition. This is becausethe transferor has retained substantially all of the risks associated with the assets.Although the transferee has the ability to sell or pledge approximately the full value ofthe assets transferred, the transferor has granted the transferee a put option on thetransferred assets allowing the transferee to sell the receivables back to the transferorin the event of actual credit losses and changes in underlying credit ratings or interestrates. Consequently the transferor is regarded as having retained substantially all therisks of ownership of the receivables.

The transferor recognises 95,000 as a liability. The liability is measured at amortised costwith an interest expense of 5,000 being recognised over the six-month period until maturity.The transferor continues to recognise the receivables as assets. Cash received on thereceivables by either the transferor or transferee reduces both the receivables and theliability. If uncollected receivables are returned to the transferor for cash, the liability isreduced and an impairment loss recognised if not previously recognised by the transferor.


Under the amended standards, the result in this case remains unchanged. Assumingthe rights to all of the cash flows in the receivables are legally transferred, then Step 7in the new approach described on page 38 will result in the transaction being treated asa secured borrowing because substantially all the risks and rewards associated withthe asset have been retained by the transferor.

4.4.1.3 Derecognition of a part of a financial asset

39.16(a) If an entity transfers less than all of the financial asset, derecognition involves determiningthe legal contractual rights and obligations arising from a contract, and recognising theretained components based on the fair values of the assets retained and the liabilitiesincurred. For example, a bank may sell a portfolio of loans, but retain the right to receive50 per cent of the interest on the loans. Using a financial components approach, the bankmay be able to derecognise the loans, but would recognise the value of the right to the50 per cent of interest revenues as an asset. The carrying amount of the asset sold isallocated between the part retained and the part sold, based on their relative fair values atthe date of sale.

39.27, 28 and When determining fair value of the retained interest the best evidence is obtained byAG52 reference to a market quotation. However, when market quotations do not exist, valuation

models with inputs based on market information may generally be used. In the rare

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circumstances where the fair value of the part of the asset that is retained cannot bereliably measured, the asset should be measured at zero, and the entire carrying amountshould be allocated to the part of the asset sold.

39.24 and 25 There may also be instances when an entity transfers control of a financial asset and, indoing so, creates a new financial asset or assumes a new financial liability. For example,a bank may sell a portfolio of loans but still act as the servicer of the portfolio, for whichit receives a fee. In this case, the entity should recognise the servicing rights as an assetor liability.

Servicing activity must be taken into account when an entity transfers financial assets toanother party. Servicing generally involves activities such as collecting payments fromdebtors, remitting cash to the transferee, providing reports to the transferee on the paymentstatus of the transferred assets and performing collection activities for non-performingassets / debtors. All of these activities may occur without the debtor knowing that itsreceivable / loan has been transferred to a third party. When the transferor has an obligationto perform servicing activities, the entity determines whether a servicing asset or a servicingliability should be recognised. This is done through a net present value calculation comparingthe servicing fees to be received, if any, by the transferor with the normal expected coststo perform these services. If the servicing fees to be received will exceed the costs ofservicing, the entity records a servicing asset. If the costs of servicing exceed the servicingfees to be received, the entity records a servicing liability. Servicing contracts often aretransferable, meaning that if the entity does not adequately perform its servicing duties,the transferee may find a new party to take over the servicing activity.

39.16(a, i), 24 The servicing fees to consider are only those cash flows that the servicer would loseand AG45 upon termination or transfer of the servicing contract. For example, if a transferor retains

an interest spread on transferred receivables and performs the servicing, the interestspread must be analysed to determine what portion should be allocated to a servicingasset (or liability) and what portion allocated to an interest-only strip receivable. The latterwould be only those cash flows that would not be lost upon termination or transfer of theservicing contract.

If derecognition occurs, the gain or loss is recognised based on the following formula:

Proceeds received

- Carrying amount of the financial asset (or portion thereof) sold

- Fair value of any new financial liability (or portion thereof) assumed

+ Fair value of any new financial asset (or portion thereof) acquired

- Service liability (if any)

+/- Fair value adjustment previously recorded in equity

= Gain or loss on derecognition

As shown in the formula, one component of the calculation of the gain or loss is anycumulative balance of revaluation gains and losses previously reported in equity, which isremoved from equity and recognised as part of the gain or loss in the income statement.

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In the rare circumstance that a new financial asset is acquired or a new financial liabilityis assumed but cannot be measured reliably, the initial carrying amounts:

■ for a financial asset, should be set at zero; and

■ for a financial liability, should be such that no gain is recognised on the transaction.In this case, any excess proceeds over the carrying amount of the asset sold wouldbe recognised as a liability in the balance sheet rather than recognised as a gain in theincome statement. If the proceeds are less than the carrying amount sold, a lossshould be recognised in the income statement immediately.

Case 4.5 Transfer of a portfolio of loans

North Bank originates mortgage loans in its normal course of business. North Bankenters into a transaction to sell a portfolio of loans to a third party. The loans in thisportfolio yield a fixed 10 per cent rate of interest for their estimated lives of nine years.North Bank sells loans with principal of 1,000,000 plus the right to receive interestincome of eight per cent. The sales proceeds received are 1,000,000.

In order to preserve the relationships with bank customers, North Bank will continue toservice the loans. For this activity, North Bank will be compensated for performing theservicing through a right to receive one half of the interest income not sold (i.e. 100 ofthe 200 basis points).

The remaining 100 basis points (i.e. one per cent) is considered to be an interest-onlystrip retained by North Bank. It then determines the fair value of the new assets tobe as follows: Servicing asset = 40,000; Interest-only strip = 60,000. The servicingasset’s fair value is calculated as the present value of expected future cash flows(i.e. servicing fees less the cost of performing the servicing).

The carrying amount of the financial asset (in this case, the portfolio of loans) shouldbe allocated between the part of the asset retained and the part sold. This calculationis based on the relative fair values of the assets. North Bank performs the followingcalculation to determine the allocated carrying amounts of each asset.

Percentage Allocatedof total carrying

Fair value fair value amount

Loans sold 1,000,000 91.0% 910,000Servicing asset 40,000 3.6% 36,000Interest-only strip 60,000 5.4% 54,000

Total 1,100,000 100.0% 1,000,000

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North Bank records the sale transaction with the following journal entry:

Debit Credit

31 December 20X1Proceeds on sale (cash or receivable) 1,000,000Interest-only strip 54,000Servicing asset 36,000Loans 1,000,000Gain on sale of loans 90,000


39.AG36 The steps referred to below are set out on pages 37 and 38.

In this case there is no SPE involved in the structure (Step 1). Consequently, under theamended standard, the first test to be applied is whether the revised derecognitionrequirements should be applied to the transferred asset in its entirety or to separateportions (Step 2).

It is assumed that the 80 per cent of interest cash flows to be transferred to the thirdparty represent a fully proportionate share of the interest cash flows received.This means that North Bank will consider two portions, being the principal element and80 per cent of the interest cash flows, separately for the purposes of derecognition.

Clearly, the rights to cash flows from the assets have not expired as the mortgageloans still exist (Step 3) and so the next stage is to consider whether or not the legalrights to cash flows have been transferred (Step 4).

The effect of the servicing arrangement is that the legal rights to cash flows have notbeen transferred and North Bank therefore needs to consider whether its obligation tocollect cash on behalf of the third party and pass it on meets the criteria for a passthrough arrangement (Step 5). Those criteria are:

■ the entity has no obligation to pay cash flows to the buyer unless it collects equivalentcash flows on the transferred asset;

■ the entity is prohibited from selling or pledging the original assets other than assecurity to the buyer; and

■ the entity is required to remit any cash flows received on the asset withoutmaterial delay.

Whether or not these requirements are met will depend on the details of the arrangement.However, if North Bank has not achieved qualifying pass through with regard to theprincipal or interest portion, or both portions, there will be no derecognition of therespective portion. Instead, the related proceeds will be treated as a secured borrowing.

If North Bank has structured the contract to meet the pass-through requirements, thenthe transferred portion(s) will be derecognised as long as substantially all the risks andrewards of those components have been transferred (Step 6). The accounting wouldthen be as described above under the previous IAS 39.

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It is possible that North Bank will have retained some risks and rewards relating to thetransferred portions, meaning that Step 6 will not be met. However, it is assumed thatNorth Bank has not retained substantially all of the risks and rewards of the portionsthat have been transferred and therefore will not be required to continue to recognisethe asset sold to the third party in its entirety (Step 7). While this may not be entirelyclear from the example, it would be likely to be the case if, for example, the terms ofthe arrangement were such that North Bank retained the entitlement to a portion(e.g. 100,000) of the principal element, with any defaults being shared on a pari passubasis with the transferee. North Bank might then determine that it has retained somesignificant risks and rewards of ownership (the retained interest), but transferred others(e.g. significant prepayment risk relating to the fixed rate loans).

North Bank then needs to consider whether it has retained control over the transferredportions (Step 8). In this case, it is assumed that the third party does not unilaterallyhave the practical ability to sell the assets without needing to impose additional restrictionson that transfer. In consequence, North Bank needs to consider Step 9. (Note that ifthe third party was able to sell the transferred assets without restriction, derecognitionby North Bank would be appropriate.)

Where substantially all the risks and rewards in the transferred components are neithertransferred nor retained and the buyer is not able to sell those components (Step 8), thecontinuing involvement rules apply (Step 9). In such circumstances, if the modifiedterms set out above applied (the retention of an entitlement to 100,000 of the principalelement with any defaults being shared on a pari passu basis with the transferee), inaddition to recognising the balances set out in the case, North Bank would recognisean asset of 100,000 (its retained interest) and a liability of the same amount (the maximumamount of cash flows it would not receive).

4.4.2 Derecognition of a financial liability

39.39-42 Derecognition of a financial liability occurs when, and only when, it is extinguished, i.e. whenthe obligation specified in the contract is discharged, cancelled or expired. This conditionis met when:

■ the debtor discharges the liability by paying the creditor, normally with cash, otherfinancial assets, goods or services; or

■ the debtor is legally released from primary responsibility for the liability (or part thereof)either by process of law or by the creditor.

39.AG58 The conditions are also met and a liability is derecognised when an entity repurchases itsown bonds issued previously, irrespective of whether the entity intends to resell the bondsto other parties. This is consistent with the treatment of treasury shares reacquired by anentity, except that in the case of extinguishing a liability, a gain or loss may be recognised.

39.AG57 and It is not possible for an entity to extinguish a liability through an in-substance defeasanceAG59 of its debt. In-substance defeasance occurs when an entity makes payments related to its

obligations to a third party (typically a trust or similar vehicle), that then makes paymentsto the lender, without having legally assumed the responsibility for the liability and withoutthe lender being part of the contractual arrangements relating to the third party vehicleand having rights thereto. However, the entity is not legally released from the obligation,

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therefore derecognition of the liability would be inappropriate. An entity may arrange fora third party to assume the primary responsibility for the obligation for a fee while continuing

39.AG60 and to make the contractual payments on behalf of the third party. In addition, the creditorAG61 must also agree to accept the third party as the new primary obligor in order for the entity

to derecognise its liability.

39.40 Certain transactions or modifications between borrowers and lenders may give rise toderecognition issues. If the borrower and lender exchange instruments with termssubstantially different from the original transaction, derecognition of the old debt andrecognition of a new debt instrument would result. Similarly, a substantial modification ofthe terms of an existing debt instrument should be accounted for as an extinguishment ofthe old debt. The circumstances of these modifications (such as due to financial difficultiesof the borrower) are not relevant in determining whether the modification is anextinguishment of debt.

39.AG62 Terms are substantially different if the discounted present value of the cash flows underthe new terms, including any fees paid (net of any fees received), is at least 10 per centdifferent from the discounted present value of the remaining cash flows of the originaldebt instrument. The discount rate to use for both calculations is not specifically addressedin the standard, therefore the entity may use either the effective interest rate under the

39.41 old terms or under the new terms (applied consistently to both transactions). If anextinguishment does occur, any costs or fees incurred are recognised as a gain or lossimmediately. If the exchange or modification is not accounted for as an extinguishment,costs and fees incurred are recognised as an adjustment to the carrying value of theliability and amortised over the remaining term of the modified instrument.

The issue of exchange and modification of debt terms is illustrated by the following:

Case 4.6 Modification of the terms of a loan

On 1 January 20X1, Bank D grants a loan to Entity U of 200,000, with a contractualinterest rate of eight per cent, which is the market interest rate at that time. The termof the loan is five years, with a maturity date of 31 December 20X5.

On 31 December 20X4, Entity U negotiates with Bank D to extend the term of theloan by an additional two years so that the loan will mature on 31 December 20X7.The contractual interest rate is increased to 12 per cent for the remaining term tomaturity, representing the current interest rate for Entity U, given the increase in marketinterest rates and the current credit standing of Entity U. No fees are paid or received.

What accounting entries would Entity U record on 31 December 20X4?

For accounting purposes, Entity U must assess whether the terms of the modifiedloan are substantially different from the original loan. Entity U calculates the presentvalue of the modified loan of 220,617 by discounting the modified cash flows at thehistorical effective rate of eight per cent. The present value differs by more than10 per cent from the present value of the original cash flows of the loan calculatedon the same basis. Therefore, an extinguishment of debt has occurred and the originalloan should be derecognised.

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The accounting entries for Entity U would be as follows:

Debit Credit

31 December 20X3Original borrowing (at eight per cent) 200,000Modified borrowing (at 12 per cent) 200,000To record the extinguishment of the former liabilityand to record the new obligation

The modified loan is recognised at its fair value, calculated at the current marketinterest rate, and the carrying value of the original loan is derecognised. No loss isrecognised since the carrying amount of the loan equals the fair value of the modifiedloan, as both loans were originally issued at market interest rates. The only impactwould be any fees incurred by Entity U, which would have to be expensed.

Similar to a financial asset, when transferring (part of) a financial liability, parts of thefinancial liability could be retained and new financial instruments (either assets or liabilities)could be created. The accounting is similar to the accounting for derecognition of parts offinancial assets with the creation of new instruments, as discussed in Section 4.4.1.

4.5 Special purpose entities and derecognition

4.5.1 Typical transactions

In some instances transactions involving the transfer of financial instruments are conductedwith special purpose entities (SPEs), set up with a specific intent, such as the securitisationof financial assets.

Entities commonly use securitisations to monetise financial assets such as homogeneousconsumer loans, credit card receivables, trade receivables or mortgage loans by sellingnewly created securities collateralised by these assets to investors. Securitisation of assetsand sales to investors often occur through an SPE. An SPE generally will be a legal entitywith limited activities, whose purpose is to hold the beneficial interests in securitisedassets and to pass through monies earned on those assets to the investors in its securities.In a securitisation the transferring entity sells financial assets to the SPE in return forcash proceeds. Generally all of these steps occur simultaneously (i.e. transfer of financialassets, issuance of securities to investors and payment of proceeds to the transferor).

39.AG51(f-h) Transfers to an SPE must meet the derecognition criteria described in this Section inorder for the transferor to record a sale. In situations where all of the benefits of theassets are transferred to such an SPE, derecognition by the transferor is appropriate ifthere are no additional constraints imposed by the transferor. Such constraints wouldinclude options or forward agreements held by the transferor on the residual interests ofthe SPE. In situations where less than all of the benefits are transferred, for example,when a transferor retains the residual gains associated with the transferred assets orresidual interests in the SPE, the determination is not so straightforward. The factorsnoted in Section 4.4.1 must be considered for both the transferred assets and the residualinterests in the SPE.



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In order to qualify for derecognition of, for example, loans where the transferor isalso the servicer and has custody over the assets, the transferor should not havesubstantive benefits from reinvestment of the cash flows from the interest and principalpayments. These should be transferred to the transferee or the SPE under the termsof the servicing agreement.


39.AG36 Under the amended standards, whether or not an SPE should be consolidated underSIC–12 (see Section 4.5.2 below) is specifically required to be considered beforeanalysing the transaction for derecognition under IAS 39. If an SPE is consolidated,then the transaction to be considered for derecognition at the group level is the possibletransfer of assets by the group, including the SPE, to its beneficial interest holders.

An SPE is unlikely to transfer legal rights to the cash flows from its assets to itsinvestors. In many cases, therefore, the critical issue may be whether or not the cashflows from the assets, and only the cash flows from the assets, are passed throughwithout material delay in an arrangement that meets the new ‘pass-through’requirements. Essentially, this requires that any cash flows arising from the assets arenot retained by the group, instead being transferred either immediately or within a shortperiod (no more than a matter of days) to the external beneficial interest holders.The group also needs to have no obligation to pay any amounts to the external beneficialinterest holders unless equivalent amounts are collected from the original assets.However, this last requirement does not preclude the group from making short-termadvances, with the right of full recovery of the amount lent plus accrued interest atmarket rates.

39.19 In cases where cash flows are reinvested by the SPE in new assets under a ‘revolving’structure, the pass-through requirements will not be met. In many other cases meetingthe pass-through requirements will also be difficult to achieve and some arrangementsmay need to be restructured (e.g. those where the transferring entity has other than afully proportionate share in the cash flows).

39.20 Even in those cases where the pass-through test is met, it is likely that the SPE willhave retained control of the transferred assets. Partial derecognition may then beappropriate under the continuing involvement approach in the amended standards.

If the SPE is not consolidated, then the potential derecognition transaction is the transferof assets by the originator into the SPE. However, given current structures, in themajority of cases it is unlikely that consolidation by the originator can be avoided.

4.5.2 Consolidation of special purpose entities

27.4 and 13 The issue of consolidation is an important consideration to entities that use SPEs.The general principles addressing consolidation are found in IAS 27. That standard requiresconsolidation based on control over an entity.



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SIC-12.3 The particular problem with applying IAS 27 to an SPE is that the typical controlfeatures discussed above may not be evident due to the entity’s nature. Typically thereis no substantive equity holder in the SPE, therefore consolidation based on votingpowers is not meaningful. SPEs often have limited activities so that day-to-day financialand operating policies may be predetermined. In this case the SPE is set up to runvirtually on autopilot from its inception. SIC–12, an interpretation of IAS 27, directlyaddresses these types of entities by providing guidance for when an entity shouldconsolidate an SPE. Often the creator or sponsor of an SPE retains significantbeneficial interest in the SPE’s activities that would give it effective control of theSPE when applying SIC–12.

Whereas IAS 39 takes a mixed approach of financial components and risks and rewardsin addressing control over financial instruments or portions thereof, SIC–12 takes a purerisks and rewards approach when making the determination of control over an SPE.As discussed earlier in this Section, IAS 39 effectively requires there to be somesubstantive risk transfer to achieve derecognition, whereas SIC–12 indicates that amajority of risk should be transferred to avoid consolidation. Therefore, it is not uncommonfor a transferor to derecognise transferred assets, but have to consolidate the SPE intowhich the assets are transferred.

SIC-12.10 SIC–12 notes several factors that may indicate that an entity has control over an SPE,and in effect, over the transferred assets as well. These are examples, meaning thatother factors not specifically stated in SIC–12 may also indicate control. The examplesare when, in substance:

SIC-12.10(a) ■ The activities of the SPE are on behalf of the entity where the entity obtains benefitsfrom the SPE’s operation.

Commentary: This requires evaluating the SPE’s purpose, its activities and whatentity benefits most from them. An example is when the SPE is engaged in an activitythat supports one entity’s ongoing major or central operations. This factor is oftendifficult to evaluate as there may be more than one party that derives some benefitsfrom an SPE. In that case, an evaluation of majority of benefits is necessary.

SIC-12.10(b) ■ The entity has decision-making powers to obtain the majority of the benefits of theactivities of the SPE, or through an autopilot mechanism achieves the same effect.

Commentary: An SPE being on autopilot does not necessarily mean that the sponsoror another entity must be in control. There must also be the objective of obtainingbenefits from the SPE’s activities. Likewise, an SPE being set up with limited ongoingdecisions to be made does not automatically mean the entity has operational substanceon its own.

SIC-12.10(c) ■ The entity has rights to obtain the majority of benefits of the SPE (and therefore maybe exposed to risks incident to the SPE’s activities).

Commentary: This factor and the next (majority of risks) are often the most crucialto evaluate when determining if consolidation is necessary. Majority of should beinterpreted as more than half. However, the benefits to be evaluated are not the grosscash flows of all of the assets in the SPE. Rather it is the residual benefits that areimportant. Residual benefits are the positive variability in net cash flows within areasonably likely range of outcomes. For example, if there are reserves or equity that



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would be distributed when the SPE is wound up, an entity entitled to the majority ofthis potential upside may be required to consolidate the SPE.

SIC-12.10(d) ■ The entity retains the majority of the residual or ownership risks related to the SPE orits assets in order to obtain benefits from its activities.

Commentary: Along with analysing the majority of benefits, this factor is often decisivewhen determining consolidation. Again it is not gross cash flows but residual cashflow risks that are important. Similar to the above, residual risks are the negativevariability in net cash flows within a reasonably likely range of outcomes. For example,if there are senior and subordinated cash flows in an SPE, the senior cash flowsshould be disregarded and the evaluation should focus on the subordinated cash flowsand any equity (being real equity or some type of reserve). An entity with the majorityof this exposure may be required to consolidate the SPE.

The factors noted above should be analysed independently meaning that if an entity hasany one of the four indicators above, it should consolidate the SPE. It would be inappropriateto conclude that because a situation does not encompass all four of the above factors, theentity does not need to consolidate the SPE.

Retention of benefits or risks by a transferor may occur if the transferor keeps asubordinated position on the transferred assets or by taking subordinated notes issued bythe SPE. This may also occur through put options granted to the SPE to take back defaultedor non-performing assets, or through other forms of guarantees, derivatives or insurance-like agreements. Securitisation transactions often have substantial guarantees or creditenhancements in order to receive a higher rating on the related securities issued by theSPE. These must be included in an entity’s analysis of the risks and rewards that resultfrom a transaction.

When entering into transactions with an SPE, an entity must consider carefully:

■ first, whether derecognition criteria in IAS 39 are met when transferring instrumentsto the SPE; and

■ second, whether there are indicators that the entity has control over the SPE underSIC–12, and therefore should consolidate the entity.


As noted above, it is often the case under the existing standards that an entity couldachieve derecognition for financial assets transferred into an SPE (by achieving somesubstantive transfer of risk), but that the SPE was then consolidated into the groupfinancial statements under SIC–12.

39.AG36 The IASB has addressed this apparent inconsistency in the amendments by requiringSIC–12 to be considered in the hierarchy of rules before the derecognition requirementsof IAS 39. Therefore, for the purposes of the group financial statements, the consolidationissue is dealt with first. For the stand-alone financial statements of the transferor entity,SIC–12 is not a concern. The remainder of this discussion considers the position fromthe perspective of the consolidated financial statements.



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If the SPE is not consolidated, then the derecognition transaction to be consideredunder IAS 39 is the transfer of assets from the group to the SPE. If the SPE isconsolidated, then the derecognition transaction to be analysed under IAS 39 is thetransfer of rights from the group (including the SPE) to the external beneficial interest-holders in the SPE. The discussion below sets out the evaluation procedure to befollowed if the SPE is consolidated.

39.16 The first issue to consider is whether to perform the evaluation for assets in theirentirety or for components of assets. In many common securitisation transactions, theasset transferred (see Step 2 in the analysis under Section 4.4.1 above) will be neitherspecifically identified components of the assets nor a fully proportionate share of anycomponent of the asset. This is because, typically, the group will retain an interest inthe residual cash flows, so that the first (say) 90 per cent of cash flows pass outsidethe group and the last (say) 10 per cent are retained within the group. The assetconsidered for derecognition will be the entire portfolio of assets held by the SPE.

39.17-19 The next consideration is whether there is a transfer that might qualify for derecognition.In most cases, the legal rights to cash flows will not be passed to beneficial interestholders in the SPE. Therefore, it will be necessary to consider whether the SPE’sobligation to pass the cash flows to the external beneficial interest holders meet thepass-through criteria. Some transactions may be structured so that all of the cashflows due to external beneficial interest holders are passed through without materialdelay. If so, a possible outcome, as long as substantive risks and rewards are alsotransferred, is that the assets of the (consolidated) SPE will be partly derecognisedunder the continuing involvement rules in the amended standards. In many cases it willbe impossible to meet the pass-through requirements and no derecognition by the SPEwill be possible.

In some cases the group will retain an interest in an SPE not by retaining beneficialinterests, but rather by providing credit risk guarantees to the external beneficial interestholders. Such arrangements will fail to meet the pass-through criteria because the guaranteecreates an obligation on the part of the group to pay cash to the external beneficialinterest holders under the guarantee if cash is not collected on the securitised assets.

As under the existing standards, it is likely to be difficult to achieve off balance sheettreatment for securitisation transactions, although partial derecognition under a continuinginvolvement approach may, in a limited number of cases, be possible.



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5. Classification


■■■■■ Categories and classification of financial assets and financial liabilities

■■■■■ Criteria for the held-to-maturity category

5.1 Overview

39.45 IAS 39 establishes specific categories into which all financial assets and liabilities mustbe classified. The classification of financial instruments dictates how these assets andliabilities are subsequently measured in the financial statements of an entity. There arefour categories of financial assets: trading, loans and receivables originated by the entity,held-to-maturity and available-for-sale. There are two categories of financial liabilities:trading liabilities and other financial liabilities.

The assessment of which category financial assets and financial liabilities belong to shouldbe performed in the same order as outlined in the discussion and figures below.

Figure 5.1 Classification of financial assets and liabilities

5.1 Overview


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5.2 Classification of financial assets

5.2.1 Trading assets

IAS 39 defines financial instruments, both assets and liabilities, held for trading as follows:

39.9 A financial asset or liability held for trading is one that was acquired or incurred principallyfor the purpose of generating a profit from short-term fluctuations in price or dealer’smargin. A financial asset should be classified as held for trading if, regardless of why itwas acquired, it is part of a portfolio for which there is evidence of a recent actualpattern of short-term profit-taking. Derivative financial assets and derivative financialliabilities are always deemed held for trading unless they are designated and effectivehedging instruments.

39.9 and The intention to profit from short-term fluctuations in price or dealer’s margin need not beIG B.11 explicitly stated by the entity. Other evidence may indicate that a financial asset is being

held for trading purposes. Evidence of trading may be inferred based on the turnover andthe average holding period of financial assets included in the portfolio. For instance, anentity may buy and sell shares for a specific portfolio, based on movements in those entities’share prices. When this is done on a frequent basis, the entity has established a pattern oftrading for the purpose of generating profits from fluctuations in price. Additional purchasesof shares into this portfolio would also be designated as held for trading.

IG B.12 On the other hand, a fund manager of an investment portfolio might buy and sell investmentsin order to rebalance the portfolio in line with a fund’s parameters. This activity would notnecessarily require the investments to be classified as trading because the activity maynot be related to generating profits from short-term fluctuations in prices. Furthermore, ifan entity acquires a non-derivative financial asset with an intention to hold it for a longperiod irrespective of short-term fluctuations in price, such an instrument cannot beclassified as held for trading.

Financial assets for which there is the intent to sell in the short-term or evidence that theyare expected to be resold in the near term should be classified as trading at the date ofpurchase. The standard does not define short-term. It also does not limit the period forwhich an instrument that is designated as being held-for-trading can be held. An entityshould adopt a definition of short-term and apply a consistent approach to the definitionused. When there is the intention of generating a profit from short-term fluctuations inprice or dealer’s margin the financial asset is appropriately classified as trading, even ifthe asset is not subsequently sold within a short period of time.

39.AG15 To generate short-term profits, traders may actively trade an asset’s risks rather than theasset itself. For example, a bank may invest in a 30-day money market instrument for thepurpose of generating profit from short-term fluctuations in the interest rate. When thefavourable movement in the interest rate occurs, instead of selling the instrument, thebank will issue an offsetting liability instrument. The 30-day money market instrumentshould be classified as held for trading in spite of the fact that there is no intention tophysically sell the instrument. The offsetting liability instrument should be classified astrading as well because it was issued for trading purposes to earn arbitrage profits.



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In summary, financial assets held for trading include:

■ financial assets acquired for the purpose of generating a profit from short-termfluctuations in price or dealer’s margin;

■ financial assets that are part of a portfolio of similar assets for which there is a recentactual pattern of short-term profit-taking;

■ all derivative financial assets that are not designated and effective hedginginstruments; and

■ hybrid instruments that include an embedded derivative that cannot be separatelymeasured but that otherwise would have been separated based on the criteria of IAS 39.


39.9 Under the amended standards an entity will have a free choice, on initial recognition(and on adoption of the revised standard) to designate any financial asset or financialliability as ‘at fair value through profit or loss’. The trading assets category has thereforebeen redefined to include both trading assets as defined above, and those assets thatan entity has chosen to measure at fair value through profit or loss. Separate disclosureis required of the amounts included in the two sub-categories.

One of the main benefits of the new category is that it may allow an entity, in somecases, to avoid the cost and complexity of meeting the criteria for hedge accounting(see Section 8.6). For example, an entity that purchases a fixed rate bond and immediatelyenters into an interest rate swap to ‘convert’ the interest to floating rate might, insteadof claiming hedge accounting, designate the bond as ‘at fair value through profit orloss’. Since both the bond and the swap will be measured at fair value through profit orloss, the offsetting effects of changes in market interest rates on the fair value of eachinstrument will be recognised in profit or loss without the need for hedge accounting.

However, there are some important consequences of using the new designation for thispurpose. In particular, the designation of an instrument as fair value through profit or lossmay only be used on day one and is not reversible. This alternative to hedge accountingtherefore cannot be used if an entity buys or issues an instrument and later wishes to puta hedge in place. It may also result in excessive earnings volatility if the hedge is put inplace for only part of the life of the instrument, or if the entity’s strategy will involvesubsequent de-designation of some or all of the economic hedge it puts in place initially.

Another likely use of the new designation is to avoid the need to measure separatelythe fair value of a separable embedded derivative, as described in Section 3. It mightalso be used to achieve consistent measurement of matching asset and liability positions.

There is no requirement for consistency in the use of the fair value through income designation,meaning that an entity can choose which (if any) of its financial assets and liabilitiesare to be included in this category, although the amounts included in it must be disclosed.


As explained more fully in Section 1, the IASB is proposing to limit the use of the fairvalue through profit or loss option to four specific circumstances.



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5.2.2 Loans and receivables

39.9 IAS 39 defines loans and receivables originated by the entity as follows:

Loans and receivables originated by the enterprise are financial assets that are createdby the enterprise by providing money, goods, or services directly to a debtor, other thanthose that are originated with the intent to be sold immediately or in the short-term,which should be classified as held for trading. Loans and receivables originated by theenterprise are not included in held-to-maturity investments but, rather, are classifiedseparately under this standard.

Loans and receivables originated by the entity thus are financial assets:

■ that have been directly provided by the lender to a respective borrower or that resultfrom the sale of goods and services; and

■ that are not trading instruments.

IG B.22 Since the definition uses the words loans and receivables and debtor, equity instrumentsare excluded from this classification. Exceptions to this are certain types of shares thatmust be redeemed at a specified date, pay a fixed or determinable return and are insubstance debt instruments. The holder can potentially classify such instruments asoriginated loans.

The essential requirement of IAS 39 for loans and receivables originated by the entity isthat the lender must contribute funds when the financial asset is first created. However,it is not necessary that the lender is involved in setting the terms of the contract, as maybe the case in a syndication or participation.

Loans and receivables originated by the entity, but intended to be resold for purposes ofshort-term profit-taking, should not be included in this category, but rather classified asfinancial assets held for trading. Loans and receivables originated by the entity may notbe classified as held-to-maturity or available-for-sale.

Any loans or receivables purchased by an entity (such as a loan or receivable resultingfrom a transfer of an existing financial instrument from one holder to another) cannot beaccounted for as being originated by the entity.

Case 5.1 Origination of a loan

Entity M participates in a loan at the date of origination via an investment bank andplans to classify the loan as originated by the entity. Is this classification appropriate?

This classification is appropriate as Entity M participates in the loan at its origination.The fact that there is an intermediary does not change the substance of the transaction.Had Entity M entered the participation even one day after its original issuance, it wouldnot be considered as originated, but rather purchased from the investment bank. In thatcase classification as originated by the entity would not be appropriate, as Entity Mwould not be providing the funds directly to the debtor.



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39.9 Under the amendments the requirement for loans to be ‘originated by the entity’ isremoved. The category is redefined simply as ‘loans and receivables’ and thereforeincludes both purchased and originated loans. The main requirements for a financialasset to be classified as a loan or receivable is that it has fixed or determinable paymentsand is not a derivative. However, the revised definition excludes any instrument that isquoted in an active market. This means that a listed debt security cannot be classifiedwithin ‘loans and receivables’, even if it is acquired at original issuance by providingfunds directly to the issuer.

The amendments are designed to provide a solution to two issues raised by financialinstitutions. The first is that, under the existing standards, a bank could own two identicalportfolios of loans, one originated and one purchased, and be required to account foreach in a different way. The second is that a bank might own two portfolios of bonds,one purchased from the issuer on the date of issue, and therefore included in theoriginated loans category, and the other purchased in the market. Again, each is required,under the existing standards, to be accounted for differently.

In addition, an entity has a free choice to classify any loan or receivable as ‘available-for-sale’ at initial recognition, or on adoption of the revised standard.

5.2.3 Held-to-maturity investments

Held-to-maturity investments are defined as follows:

39.9 Held-to-maturity investments are financial assets with fixed or determinable paymentsand fixed maturity that an enterprise has the positive intent and ability to hold to maturityother than loans and receivables originated by the enterprise.

Classification of instruments as held-to-maturity therefore depends on:

■ the terms and characteristics of the financial asset; and

■ the ability and actual intent of the entity to hold those instruments to maturity.



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Figure 5.2 Decision tree for reviewing the classification of assets as held-to-maturity

39.AG25 A prerequisite for the classification of a financial asset as held-to-maturity is the entity’sintent and ability to actually hold that asset until maturity. An entity should assess its intentand ability to hold its held-to-maturity investments not only at initial acquisition but againat each balance sheet date.

The potential benefit of using the held-to-maturity category is that the assets are carried atamortised cost. Generally this category would be used for fixed rate instruments whose fairvalues may change significantly in response to changes in interest rates. However, significantpenalties exist for an entity that classifies an instrument as held-to-maturity, but sells theinstrument before its maturity. These so-called tainting rules are discussed later in this Section.

5.2.3.1 Fixed maturity and determinable payments

39.9 Instruments classified as held-to-maturity must have a fixed maturity and fixed ordeterminable payments, meaning a contractual arrangement that defines both the amountsand dates of payments to the holder, such as interest and principal payments on debt.

39.AG17 Typical equity contracts (e.g. common shares) usually have an unlimited maturity andtherefore cannot be held-to-maturity financial assets. Other types of equity securities(e.g. share options or warrants) cannot be held-to-maturity investments because theamounts the holder receives may vary in a manner that cannot be determined at thepurchase of the contract. Exceptions to this are certain types of preference shares thatmust be redeemed at a specified date, pay a fixed or determinable return and are insubstance debt instruments.

39.AG17 Since held-to-maturity instruments should have a fixed maturity, it is mainly debt contractsthat are classified as held-to-maturity. Nevertheless, even certain debt instruments mayhave an unlimited or unspecified maturity. For example, perpetual bonds that provide forinterest payments for an indefinite period would not qualify as held-to-maturity instruments.



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A financial asset whose maturity is fixed still might not qualify as a held-to-maturityinvestment if its payments are not determinable. For example, profit-sharing rights do nothave determinable payments, even though there may be an agreed term.

The most obvious example of a financial instrument with determinable payments is afixed rate bond, as both interest and principal payments are fixed. A floating rate interestasset also could qualify as a held-to-maturity investment since its payments are eitherfixed (the principal) or specified by reference to a market rate or benchmark rate. In manycases, however, there will be little advantage in using the held-to-maturity category forfloating rate assets as their fair values will not change significantly in response to changesin market interest rates.

Case 5.2 Held-to-maturity classification

IG B.13 and Bank Q wants to categorise a bond issued by an oil company as held-to-maturity.B.14 The interest on the bond is indexed to the price of oil. Can Bank Q categorise this bond

as held-to-maturity?

The fact that the return is dependent on the price of oil means that this bond includes anembedded derivative that is not closely related to the host contract. The embeddedderivative and host contract should be separated, resulting in an embedded commoditycontract to be measured at fair value and a host debt instrument. If Bank Q has the intentand ability to hold the host to maturity, it may categorise the bond as held-to-maturity.

5.2.3.2 Intent to hold to maturity

39.AG16 If an entity only has the intent to hold an instrument for some period, but has not actuallydefined that period to be to maturity, the positive intent to hold to maturity does not exist.Likewise if the issuer has the right to settle the financial asset at an amount that issignificantly below the carrying amount, and therefore is expected to exercise that right,the entity cannot demonstrate a positive intent to hold the asset until maturity. However, ifthe issuer may call the instrument at or above its carrying amount, this does not affect theinvestor’s intent to hold the security until maturity.

39.AG21 The demonstration of positive intent to hold an instrument to maturity would not be negatedby a highly unusual and unlikely occurrence, such as a run on a bank or a similar situation,which could not be anticipated by the entity when deciding whether it has the positiveintent (and ability) to hold an asset until maturity.

39.AG18, AG19 An embedded option that may shorten the stated maturity of a debt instrument castsand 39.9 doubt on an entity’s intent to hold a financial asset until maturity. Thus, the purchase of an

instrument with a put feature is inconsistent with the positive intent to hold the asset untilmaturity. In the case of a call option held by the issuer, the holder should demonstrate thatsubstantially all of the carrying amount would be recovered if the instrument were calledbefore maturity to be able to classify the asset as held-to-maturity.

39.10 and A debt instrument with an equity conversion option generally cannot be classified as held-IG C.3 to-maturity. This is because payment for a right to convert would be inconsistent with an

intention to hold to maturity, unless the conversion option is exercisable only at maturity.



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39.AG17 Also, the risk profile of a particular financial asset may raise similar questions on theintention. For example, the high risk and volatility of a mortgage-backed interest-onlycertificate makes active management of such strips more likely than holding these to

IG B.15 maturity. The same reasoning may apply to debt instruments with high credit risk, forexample, high yield (junk) bonds and subordinated bonds. A significant risk of non-paymentof interest and principal on a bond is not in itself a consideration in qualifying for the held-to-maturity category as long as there is an intent and ability to hold the instrument untilmaturity. However, an entity would taint its held-to-maturity portfolio if it subsequentlysold such a bond as a result of a credit rating downgrade that could have been foreseen.

5.2.3.3 Ability to hold to maturity

39.AG23 An entity needs to demonstrate its ability to hold a financial asset to maturity to categoriseit as such. The entity cannot demonstrate the ability if:

■ financial resources are not available to the entity to finance the asset to maturity.For example, if it is expected or likely that an entity will acquire another business andwill need all of its funding for this investment, the resources may not be available tocontinue to hold certain debt instruments; or

■ legal or other constraints could frustrate the intention of the entity to hold the investmentto maturity. An example is the expectation that a regulator will exercise its right incertain industries like the banking and insurance industry to force an entity to sellcertain assets in the event of a credit risk change.

5.2.3.4 Tainting of the held-to-maturity portfolio

39.9 If an entity sells, transfers or exercises a put option on more than an insignificant amountof the portfolio of held-to-maturity financial assets, the entity may not classify any financialassets as held-to-maturity for a period of two financial years after the occurrence of thisevent. IAS 39 does not stipulate what is considered more than an insignificant amount,but rather this should be assessed by an entity any time a potential tainting situationarises. It is important to also consider the reasons for an entity’s actions when determiningif the portfolio has been tainted.

Case 5.3 Tainting of held-to-maturity assets

Entity T sells 1,000,000 of bonds from its held-to-maturity portfolio on 15 April 20X1.The fair value of the bonds has appreciated significantly over the carrying value andmanagement decides that Entity T should realise the gains through a sale. In thesecircumstances, the action of selling investments from the held-to-maturity portfoliotaints the entire portfolio and all remaining investments in that category must bereclassified. Entity T will be prohibited from classifying any assets as held-to-maturityfor two full financial years. Assuming that Entity T’s financial reporting year-end is31 December, the entity cannot use the held-to-maturity classification for its assetsuntil at least 1 January 20X4.



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IG B.19-21 The tainting rules are intended to test an entity’s assertion that it intends and is able tohold an instrument until maturity. Tainting requires a reclassification of the total remainingheld-to-maturity portfolio in the (consolidated) financial statements into either the tradingor available-for-sale categories. Reclassifications of financial instruments are discussedin Section 6.5.

The tainting requirements apply group-wide, so that a subsidiary that sells more than aninsignificant amount from its held-to-maturity portfolio can preclude the entire groupfrom using the held-to-maturity category. If an entity has various portfolios of held-to-maturity instruments, for example, by industry or by country of issuance, the sale ortransfer of instruments from one of the portfolio taints all the other held-to-maturityportfolios of the entity.

IG B.18 Selling securities classified as held-to-maturity under repurchase agreements does notconstrain the entity’s intent and ability to hold those financial assets until maturity, unlessthe entity does not expect to be able to maintain or recover access to those financialassets. For example, if an entity is expected to receive back other comparable securities,but not the securities lent, classification as held-to-maturity is not appropriate.

In practice, entities are advised to consider carefully any plans for sales, transfers orexercises of put options before classifying an asset as held-to-maturity to avoid a forcedreclassification of the whole portfolio. Many entities adopting IAS 39 have decided eithernot to use the held-to-maturity category or to use it only at the parent company levelwhere the intention and ability can be properly tested for each transaction at the onsetand ongoing.

5.2.3.5 Exceptions from tainting

39.9 There are a limited number of exceptions to the tainting rules. Firstly, the tainting rules donot apply if only an insignificant amount of held-to-maturity investments is sold orreclassified. The standard does not define what an insignificant amount means. Therefore, ajudgement will be required in each particular situation. Any sale or reclassification shouldbe a one-off event. If an entity periodically sells or transfers insignificant portions thismay cast a doubt on the entity’s intent and ability with regard to its held-to-maturityportfolio. In cases where the sales are not isolated, the amount sold or reclassified shouldbe assessed on a cumulative basis in assessing whether the sales are insignificant.

Sales or reclassifications do not result in tainting if they occur:

■ very close to maturity or call exercise date;

■ after substantially all of the original principal is already collected; or

■ due to an isolated non-recurring event beyond the entity’s control.

39.9 Sales of held-to-maturity investments close to maturity or call exercise date usually donot result in significant gains or losses, because the fair value and the amortised cost areboth equal to the face value of the financial asset. Interest rate risk is substantially eliminatedas a pricing factor at that point.



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39.9 Similarly, when almost the entire principal has been collected through scheduled paymentsor through prepayments, the remaining part would not be materially affected by changesin the interest rate and therefore the sale would not result in a significant gain or loss.IAS 39 does not define the phrase substantially all of the principal investment, however,when 90 per cent or more of the principal investment has been collected through scheduledpayments or prepayments, a sale of the remaining principal would generally qualify forthis exception.

39.9 In very rare instances, circumstances may arise that the entity could not have reasonablyforeseen or anticipated. If, in such a situation, an entity has to sell held-to-maturityinvestments, the remaining portfolio is not tainted if the event leading to sales of investmentsis isolated and non-recurring. If the event is not isolated or is potentially recurring, and theentity anticipates further sales of held-to-maturity investments, this inevitably casts doubt

IG B.16 on its ability to hold the remaining portfolio until maturity. Also, if the event could havebeen reasonably anticipated at the date the held-to-maturity classification was made theinstrument should not have been classified as such. If an entity has control over or initiatedthe isolated or non-recurring event, for example, sales made after a change in seniormanagement, this will also call into question the entity’s intent to hold the remaining portfoliountil maturity.

39.AG22 Situations that may not have been anticipated when instruments were included in theheld-to-maturity category and would not question the entity’s intent and ability to holdinvestments to maturity may result, for example, from:

IG B.15 ■ a significant deterioration in the creditworthiness of the issuer of the instrument thatcould not have been anticipated when the instrument was acquired;

■ significant changes in tax laws, affecting specific investments in the portfolio;

■ major business combinations or dispositions with consequences for the interest raterisk position and credit risk policies of an entity; or

■ significant changes in statutory or regulatory requirements.

Deterioration in creditworthiness

IG B.15 Although IAS 39 does not provide a definition of a significant deterioration of an issuer’screditworthiness, an example of this is a significant downgrade by a credit rating agency.

39.AG22(a) Given the scarceness of external credit ratings for debt for borrowers outside the UnitedStates, downgrades as reflected in an entity’s proprietary internal credit rating systemmay support the demonstration of significant deterioration. However, the initial quality ofthe asset must have been such that the deterioration could not have been reasonablyforeseen. A credit downgrade of a notch within a class or from one rating class to animmediately lower rating class often could be considered reasonably anticipated. Therefore,a sale triggered by such a downgrading would result in tainting.

Changes in tax laws

A significant change in tax laws, such as the elimination or the significant reduction of thetax-exempt status of an investment that affects the investment specifically, may not castdoubt on the intention or ability of the entity with respect to the held-to-maturity category.



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If, for example, an entity has a captive finance company in a tax haven and, due tochanges in tax laws that affect the whole group, intends to relocate its treasury activitiesand in that process liquidate part of the held-to-maturity portfolio in order to restore theinterest rate risk position, the classification as held-to-maturity would not be violated,since the entity could not have foreseen the change in tax laws.

The exemption regarding changes in tax laws is not always applicable. For example, anentity may have a history of entering into schemes for tax related purposes then subsequentlyreversing or terminating the transaction due to changes in tax laws. In this case it would notbe acceptable to use the change in tax laws as an exception from tainting.

A change in the applicable marginal tax rate for interest income is not sufficient justificationfor sales of held-to-maturity investments, since this change impacts all debt instrumentsheld by the entity.

Major business combination or disposition

Although a major business combination or the sale of a significant segment of the entity isa controllable event, it may have a consequence on the entity’s interest rate risk andcredit risk positions. In such situations, sales that are necessary to maintain the entity’sexisting risk positions and that support proper risk management do not taint the held-to-maturity portfolio.

IG B.19 Although sales subsequent to business combinations and segment disposals may not taintthe held-to-maturity portfolio, sales of held-to-maturity investments prior to a businesscombination or disposal, or in response to an unsolicited tender offer, will cast doubt onthe entity’s intent to hold its remaining investments until maturity.

Case 5.4 Held-to-maturity portfolio acquired in a business combination

39.AG22 and Bank Y has acquired Bank X. The new management wants to transfer some held-to-IG B.16 maturity securities of Bank X to available-for-sale securities because the management

believes that the time to maturity of certain securities is too long and the held-to-maturity portfolio after the business combination is unreasonably large.

At the date of the acquisition, Bank Y will have to classify the securities acquired as aresult of the business combination applying corresponding rules in IAS 39 withoutregard to how these securities were classified by Bank X before the acquisition. Thus, ifBank X classified certain securities as held-to-maturity, but Bank Y does not have anability and intent to hold these securities until maturity, Bank Y should not continue totreat these securities as held-to-maturity. The tainting rules would not be relevant inthis case at the group level because there is no transfer on the group balance sheet.

At the level of Bank X (which would be relevant if Bank X continues to prepareseparate financial statements under IFRS) the transfers from the held-to-maturityportfolio would not be considered tainting if the transfers were necessitated by thebusiness combination as a result of which the held-to-maturity portfolio of Bank X hadto be brought in line with the policies of Bank Y.

However, a business combination cannot be regarded as a possibility for transferringsecurities from the held-to-maturity portfolio that Bank Y had before the acquisition.



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For example, if as a result of the acquisition the business strategy of the group changedand Bank Y transferred some of its existing securities out of the held-to-maturity portfolio,such transfers would trigger tainting of the whole portfolio. A change in business strategyis not a valid reason for transferring securities out of the held-to-maturity portfolio.It would call into question the intent to hold the rest of the securities until maturity andwould result in tainting.

Changes in statutory or regulatory requirements

Examples of changes in statutory or regulatory requirements that do not have taintingimplications for the held-to-maturity portfolio are:

■ changes either in the statutes or in regulations affecting the entity that modify whatconstitutes a permissible investment or the maximum level of certain types ofinvestments. As a result the entity would need to sell (part of) these investments; and

■ significant increases in capital requirements or in the risk weightings as a result ofwhich the size of the held-to-maturity portfolio has to be decreased.

IG B.17 The exceptions are intended to shield entities operating in regulated industries from potentialtainting situations resulting from actions taken by the industry’s regulator. These are actionsapplicable to the industry as a whole, and not to a specific entity. However, sales couldoccur in response to an entity-specific increase in capital requirements set by the industry’sregulator. In that case it will be difficult to demonstrate that the regulator’s action couldnot have been reasonably anticipated by the entity, unless the increase in entity-specificcapital requirements represents a significant change in the regulator’s policy for settingentity-specific capital requirements.


39.9 There are no significant changes in the amended standards with respect to the held-to-maturity classification.

5.2.4 Available-for-sale assets

39.9 Available-for-sale financial assets are assets that are not trading, held-to-maturityinvestments or originated loans or receivables. This is essentially a residual category forall of those financial assets that do not fit the criteria of the other categories.


39.9 The amended standards introduce a free choice, on initial recognition (and on adoptionof the amendments), to classify any non-derivative financial asset as available-for-saleand, therefore, to measure it at fair value with fair value changes recognised in aseparate category of equity.

When an entity originates a loan, for example, then under the amended standards it willhave a free choice to classify that loan as either:

■ fair value through profit or loss;


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■ available-for-sale (fair value through equity); or

■ loans (measured at amortised cost).


As explained more fully in Section 1, the IASB is proposing to limit the use of the fairvalue through income option to exclude loans and receivables.

5.2.5 Categorising types of financial assets

Certain types of financial assets may be eligible for inclusion in more than one categoryof financial assets, as noted in Table 5.1.

Table 5.1 Types of financial assets

Financial instrument Held for Originated by Held-to- Available-trading the entity maturity for-sale

Derivatives (not in ahedge relationship) ✔ – – –Loans and receivables ✔ ✔ ✔ ✔

Bonds and notes (listed) ✔ – ✔ ✔

Equity securities ✔ – – ✔

5.3 Classification of financial liabilities

5.3.1 Trading

39.9 A financial liability is categorised as held for trading if it is a trading instrument as describedin Section 5.2.1 dealing with trading assets. Except in the case of derivatives, this categoryis generally more applicable to financial institutions than to corporates due to the nature oftheir respective operations.

39.AG15 Liabilities held for trading include derivatives with a negative fair value, except thosethat are hedging instruments, and obligations to deliver securities borrowed by a shortseller. A short seller is an entity that sells securities or another type of financial instrumentsthat it does not yet hold, creating an obligation to deliver securities. Although onlysecurities that are sold short are specifically mentioned as an example of liabilities thatare classified as held for trading, this treatment is also appropriate for other non-derivativefinancial instruments sold short, as the definition of trading assets and liabilities relatesto all financial instruments.

39.AG15 A liability that is used to fund trading activities is not necessarily a trading instrumentitself. Therefore, funding activities for trading portfolios would not be automaticallyclassified as liabilities held for trading.



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39.9 As with financial assets (see Section 5.2.1), an entity will have a free choice under theamended standards, on initial recognition and on first adopting the amendments, toclassify any financial liability (including own borrowings) as ‘fair value through profitor loss’.

The new designation may allow an entity, in some cases, to avoid the cost and complexityof meeting the criteria for hedge accounting (see Section 8.6). For example, an entitythat issues a fixed rate bond and immediately enters into an interest rate swap to‘convert’ the interest to a floating rate might, instead of claiming hedge accounting,designate the bond as ‘fair value through profit or loss’. Since both the bond and theswap will be measured at fair value through profit or loss, the offsetting effects ofchanges in market interest rates on the fair value of each instrument will be recognisedin profit or loss without the need for hedge accounting.

However, there are some important consequences of using this designation (seeSection 5.2.1). In addition to those considerations relating to financial assets, in theexample above the bond will be remeasured, through profit or loss, not just for changesin market interest rates, but also for changes in the entity’s own credit risk.

For liabilities designated as ‘fair value through profit or loss’, separate disclosure isrequired of the amount of the change in fair value that is attributable to changes in thebenchmark interest rate.


As explained more fully in Section 1, the IASB is proposing to limit the use of the fairvalue through income option to four specific circumstances.

5.3.2 Other liabilities

Other liabilities constitute the residual category similar to the available-for-sale categoryof financial assets. All liabilities other than trading liabilities and derivatives that are hedginginstruments automatically fall into this category. Common examples are an entity’s tradepayables, borrowings and customer deposit accounts.



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6. Subsequent measurement


■■■■■ Subsequent measurement

■■■■■ Fair value

■■■■■ Amortised cost

■■■■■ Foreign currency transactions

■■■■■ Impairment issues

■■■■■ Reclassifications and transfers between portfolios

■■■■■ Deferred tax assets and liabilities

Abbreviations used in this Section: MC = measurement currency; FC = foreign currency

6.1 Overview

The measurement approach to be applied under IAS 39 depends upon the classificationof an instrument into one of the four categories of financial assets or one of the twocategories of financial liabilities discussed in Section 5.

Initially all financial instruments are recognised at cost, which is the fair value of theconsideration given or received. Subsequently:

■ derivatives are always measured at fair value;

■ all other financial assets are measured at fair value, except for loans and receivablesoriginated by the entity and held-to-maturity assets, which are measured at amortisedcost. Financial assets held for trading and available-for-sale are measured at fairvalue in the balance sheet with changes in the fair value included in the incomestatement or, for available-for-sale instruments, with changes in the fair value includedin either the income statement or as a separate component of equity; and

■ financial liabilities are measured at amortised cost, except for those instruments thatare held for trading, which are measured at fair value with changes in fair valueincluded in the income statement.

It is presumed that fair value can be reliably measured for most financial assets.When the fair value of an instrument cannot be reliably measured, the instrument isstated at cost.

The concepts of fair value and amortised cost, including use of the effective interestmethod, are discussed in Section 6.3.

6.1 Overview


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39.9 As explained in Section 5, the amended standards will introduce a free choice, on initialrecognition of a financial asset or financial liability, to classify the instrument either as‘fair value through profit or loss’ or as ‘available-for-sale’. In addition, the originatedloans category is extended to cover also purchased loans, and at the same time narrowedto exclude instruments that are quoted in an active market.

39.55 Generally, although the classification of instruments between categories (and thereforethe measurement basis applied) may change significantly under the amended standards,the measurement of amounts in each category, on initial recognition and subsequently,will not change. The exception is that the amendments remove the policy choice for anentity to measure available-for-sale financial assets at fair value with fair value changesrecognised in profit or loss. This policy choice is considered unnecessary because of thefair value through profit or loss election that is now available on an instrument-by-instrumentbasis. One consequence, however, is that an entity wishing to measure its available-for-sale financial assets at fair value through profit or loss will need to put in place a systemto ensure that each is designated as such on the date of purchase or origination.

39.48, Additional guidance is provided on how fair value is to be determined. A mandatory39.AG69-AG82 hierarchy has been introduced, with a quoted price in an active market being applied

first, followed by the price obtained in a similar market transaction (where there is nodirect market price), with valuation techniques being applied where there is no activemarket. However, where a market is inactive, the value obtained through the use ofvaluation techniques should be tested and validated by comparing it to recent markettransactions for similar items. The use of valuation techniques and models may not beused to ‘override’ an observable market price. Where market prices are used, bid andoffer prices are to be used, as appropriate with mid prices being used only where thereare matching asset and liability positions. Extensive disclosures are required about howfair values are determined, including the methods and significant assumptions applied,the extent to which market prices and valuation models have been applied in determiningfair values and the total change in fair value recognised in profit or loss that is derivedfrom the use of valuation models.

The amended standards also provide new guidance on how to measure amortised costusing the effective yield method. It is clarified that transaction costs, fees, discountsand premiums are generally amortised over the expected life of an instrument. For agroup of prepayable mortgage loans, for example, any discount, transaction costs andrelated fees would be amortised over a period shorter than the contractual maturity.Historical prepayment patterns would be used to estimate expected lives.Revised prepayment estimates will give rise to gains and losses in the income statement.

Where the classification of a financial asset or financial liability results in it beingmeasured at fair value through profit or loss, transaction costs are taken to profit orloss on initial recognition.


As explained more fully in Section 1, the IASB is proposing to limit the use of the fairvalue through income option to four specific circumstances.

6.1 Overview


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Figure 6.1 Measurement of financial instruments

6.2 Classification determines subsequent measurement

6.2.1 Trading assets and liabilities

39.46 and 47 Financial assets and liabilities held for trading, including derivatives, are measured at fairvalue. Transaction costs that will be incurred upon sale or disposal of a financial asset arenot deducted from the measurement. Changes in the fair value of financial assets andliabilities held for trading (including derivatives) are recognised in the income statement.

Fair value of these financial instruments should be reliably measurable. In respect of non-derivative financial instruments classified as held for trading, if fair value is not consideredto be reliably measurable, it is questionable whether such an instrument should be includedin the trading portfolio. A lack of a reliably measurable fair value could indicate that thereis no possibility for trading with the intent of short-term profit-taking.

6.2.2 Loans and receivables originated by the entity

Subsequent measurement of loans and receivables originated by the entity is atamortised cost.

39.46 Loans and receivables originated by the entity that have a fixed maturity should be measuredat amortised cost using the effective interest rate method. The fair value of the loan at thedate of acquisition is its cost. Any difference between cost and the amount repayable atmaturity is recognised as interest income over the remaining period to maturity.The amortised cost method of accounting is further discussed in Section 6.3.2.

IG B.24 Loans and receivables originated by the entity that do not have a fixed maturity(e.g. perpetual floating rate loans) should be measured at cost. Because there are norepayments of principal, there is no amortisation of a difference between the initial amount



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39.AG79 and and a maturity amount. Also, short-duration receivables with no stated interest rate mayAG84 be measured at original invoice amount unless the effect of imputing interest would be

significant (e.g. in high-inflation countries).

6.2.3 Held-to-maturity

39.46 Held-to-maturity assets, like loans and receivables originated by the entity with a fixedmaturity, should be measured at amortised cost using the effective interest rate method.

6.2.4 Available-for-sale

39.46 Available-for-sale financial assets are measured at fair value on the balance sheet. There isan exception from measurement at fair value of an available-for-sale asset if its fair valuecannot be reliably measured. This exemption only applies to unlisted equity instruments orderivative contracts based on those instruments where there is insufficient history ofprofits or cash flows to support a reliable fair value measurement. The exemption wouldapply mainly to start-up entities.

39.55 Fair value changes may either be:

■ included in income, which is a similar treatment to the subsequent measurement offinancial assets held for trading; or

39.27 ■ recognised directly in equity through the statement of changes in equity. When changesin fair value are recognised directly in equity, such amounts are recycled to the incomestatement upon sale, disposal or impairment of the asset. For a partial disposal, aproportional share of the fair value gains and losses previously recognised in equitymust be recycled to the income statement. Such gains and losses must include all fairvalue changes up to the date of disposal.

39.55(b) The subsequent measurement of available-for-sale debt instruments with fair value changesrecognised directly in equity is complicated by the fact that interest income is recognisedin the income statement each period. The basis for recording interest income is the historical

32.94(h) effective interest rate. For the correct measurement of the debt instrument, the cleanprice of the instrument (i.e. the fair value of the debt instrument excluding accrued interest)should be compared with the amortised cost of the debt instrument at the measurementdate, also excluding accrued interest. Therefore, even though the debt instrument ismeasured at fair value, the holder must apply the effective interest method and calculatethe amortised cost of the instrument to determine interest income.


39.55 As noted above, the fair value through income policy choice for available-for-salefinancial assets is not available under the amended standards.



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6.2.5 In summary

Subsequent measurement of financial instruments is summarised in Figure 6.1.

Figure 6.1 Classification of financial assets and liabilities determines the measurement

6.3 Valuation issues

6.3.1 Fair value

6.3.1.1 General considerations

39.9, 32.11 and Fair value is defined as the amount for which an asset could be exchanged, or a liabilityIG E.1.1 settled, between knowledgeable and willing parties in an arm’s length transaction. Fair value

does not take into consideration transaction costs expected to be incurred on transfer ordisposal of a financial instrument.

39.AG69 Underlying the concept of fair value is the presumption that the entity is a going concern,and does not have an intention or a need to liquidate instruments, nor undertake a transactionon adverse terms. Therefore, fair value normally is not an amount that an entity wouldreceive or pay in a forced transaction, involuntary liquidation or distress sale.

39.AG80 and The fair value of a financial instrument should be reliably measurable. If an entity cannotAG81 obtain an exact fair value, it instead may determine a range of reasonable fair value

estimates. The variability within the range should not be significant and the probabilitiesof various estimates within the range should be estimable.



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6.3.1.2 Sources of fair value

Fair values may be obtained from various sources, such as:

■ an active public market that makes available a published market price quotation (e.g. anequity security listed on a well-developed stock market where quoted prices arereadily and regularly available from an exchange, dealer, broker, industry group, pricingservice or regulatory agency);

39.AG72 and ■ by reference to prices available from recent transactions or for similar instrumentsAG74 (e.g. making reference to a debt instrument that is rated by an independent rating

agency and whose cash flows can be reasonably estimated and discounted based onmarket rates for estimating the fair value of another bond); and

39.AG74-76 ■ appropriate valuation models with data inputs that can be measured reliably becausesuch data is available from active markets (e.g. valuing an interest rate swap throughdiscounting cash flows based on the contractual terms and rates obtained frompublished sources).

The methods used to determine fair value should be consistently applied during and betweenreporting periods for similar types of instruments.

39.AG71 and For a financial asset held or a financial liability to be issued, the appropriate quoted marketAG72 price is usually the current bid price. For a financial asset to be acquired or a financial

liability held, the appropriate quoted market price is usually the current offer or askingprice. When an entity has matching asset and liability positions, it may use mid-marketprices as a basis for establishing fair values. It is presumed that such matching positions

IG E.2.1 would be settled within a similar time period. An entity may not depart from using bid andask / offer prices in order to comply with regulatory requirements.

39.AG74, AG79 Quoted market prices may not be indicative of the fair value of an instrument if theand IG E.2.2 activity in the market is infrequent, the market is not well-established or only small volumes

are traded relative to the number of units of the financial instrument outstanding.Adjustments to the quoted price may be possible only if an entity can present objective,reliable evidence validating a higher or lower amount. For example, if an entity enteredinto a contract with a third party to sell the shares at a fixed price in the immediate future,that might justify an adjustment to the quoted price. However, it would be generallyinappropriate to make adjustments when valuing large holdings. For example, an entitycannot depart from the quoted market price solely because independent estimates indicatethat the entity would obtain a higher or lower price by selling the holding as a block.

Where an active, liquid, well-established market does not exist for a particular financialinstrument, estimation methods and valuation models may be used to calculate fair value,providing that they are sufficiently reliable and the inputs are based on market data.Estimation methods that may be used include:

■ methods based on the valuation of quoted instruments that are substantially the sameas the instruments being valued;

■ discounted cash flows calculations; and

■ option pricing models.



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As mentioned above, valuation models based on data inputs that are reliably measurablecan be used as a method of valuation when published market prices for instruments arenot available. This would be the case for an interest rate swap (IRS). The following casedemonstrates a basic fair value calculation for an IRS.

Case 6.1 Determining the fair value of an interest rate swap

On 1 January 20X1, XYZ Co. enters into an IRS with a notional value of 100 million.The terms of the IRS are to pay a fixed rate of six per cent and receive a variable rateof six-month LIBOR. The IRS has a maturity of five years and settlement of net cashflows is done semi-annually. At inception the fair value of the IRS is zero.

At 30 June 20X1, interest rates have increased. The increase in interest rates changesthe cash flows of the variable leg of the swap. The variable interest rate for the periodfrom 1 July 20X1 to 31 December 20X1 is set at 6.7 per cent.

In order to determine the fair value of the IRS at 30 June 20X1, XYZ Co. performs adiscounted cash flow calculation.

Fixed leg of the IRS

Discounting of the fixed leg of cash flows is performed on the remaining nine fixedrate payments that will occur every six months from 31 December 20X1 to 31 December20X5. These cash flows are three million every six months, based on the agreed fixedrate of six per cent (the annual fixed rate on the IRS). The discount rate to be used isthe applicable LIBOR theoretical spot rate calculated from Euro futures or swap quotes.For the purpose of this example, the same effective rate is used throughout the term ofthe transaction for discounting cash flows. In an actual situation, however, the yieldcurve usually would not be flat.

The future fixed rate cash flows and the related present value at 30 June 20X1 areas follows:

Present valueSettlement date Cash flows of cash flows

31 December 20X1 (3,000,000) (2,902,758)30 June 20X2 (3,000,000) (2,808,667)31 December 20X2 (3,000,000) (2,717,627)30 June 20X3 (3,000,000) (2,629,537)31 December 20X3 (3,000,000) (2,544,303)30 June 20X4 (3,000,000) (2,461,832)31 December 20X4 (3,000,000) (2,382,034)30 June 20X5 (3,000,000) (2,304,822)31 December 20X5 (103,000,000) (76,567,223)

Total discounted cash flows (97,318,803)



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Variable leg of the IRS

The variable rate receipts are calculated using the LIBOR forward rates. The discountrate is the same rate used to discount fixed rate payments. Generally, at the repricingdate the present value of the variable leg will be par unless there is a change in thecredit spread which is not factored into the repriced interest rate. However, if thevaluation is made between repricing dates, the value of the variable leg may be differentfrom its par value because its fair value will be subject to the short-term interest ratesfluctuation until the next repricing date.

Fair value of the IRS

To determine the fair value of the IRS, the present value of the fixed rate paymentsobligation of 97,318,803 is netted against the present value of the variable rate receiptsof 100 million:

Cash flows Present value

Receipts – based on variable rates 100,000,000Payments – based on fixed rates (97,318,803)

Net 2,681,197


39.48, The amended standards provide much clearer guidance on how an entity might go39.AG69-82 about measuring fair value, particularly for an instrument that is not traded in an active

market. The main features of the enhanced guidance are:

■ the objective is stated as being to establish what a transaction price would havebeen on the measurement date in an arm’s length exchange motivated by normalbusiness considerations. Any valuation technique must be developed with that aimin mind;

■ to require that a valuation technique should incorporate all factors that marketparticipants would consider and be consistent with accepted economic methodologies;

■ a hierarchy for the approach to apply in determining a fair value. The first step is touse a market value. Thereafter market prices for similar instruments and valuationmodels are given equal prominence in the hierarchy of techniques;

■ to clarify that the fair value of a transaction on the date of the transaction is themarket price unless fair value is evidenced by other observable market transactionsor is based on a valuation technique based only on market data. In other words, avaluation model may not be used to recognise a profit or loss on initial recognitionunless the model uses only market data. Market data can include historical data aslong as the entity can demonstrate that the result from the model provides a morereliable estimate of fair value than the transaction price;

■ the maximum possible use should be made of market inputs;



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■ if an entity operates in more than one active market, the price at the balance sheetdate for the instrument (without repackaging or modification) in the most advantageousmarket to which the entity has access should be used as fair value; and

■ it is clarified that the appropriate market price for an asset held or liability to be issuedis normally the current bid price and for an asset to be acquired or liability held theasking price. An exception to this is where an entity has assets and liabilities withoffsetting market risks, in which case the mid prices can be used for the offsettingrisk positions; bid and asking prices are applied to the net open position as appropriate.

The standards also clarify that the fair value of a liability that is repayable on demandis not less than the present value of the amount repayable on demand, discounted fromthe first date at which the investor could require repayment.

6.3.1.3 When is fair value not reliably measurable?

IAS 39 has a presumption that fair value can be reliably determined for most financialassets. There is only one exception noted, which is for an investment in an equity instrumentthat does not have a quoted market price in an active market and for which other methodsof reasonably estimating fair value are clearly inappropriate or unworkable.

39.AG81 This exception includes derivatives that are linked to, and that must be settled by, delivery ofsuch an unquoted equity instrument, and applies to both trading and available-for-saleinstruments. There may also be situations in which the fair value of such instruments can beestimated. If an entity estimates the value of a financial instrument, it should use a supportablemethodology rather than arbitrarily choose a fair value within a range of reasonable estimates.

39.46, 66 and If the fair value cannot be reliably measured, the instruments should be stated at cost untilAG81 a fair value can be reliably established. These instruments are subject to normal impairment

recognition requirements.

39.54 In rare circumstances, it may be the case that fair value is no longer reliably measurablefor a financial instrument that has been measured at fair value. In that situation the lastreliably estimated fair value becomes the new cost basis. A previous gain or loss on thatasset that has been recognised directly in equity should be left in equity until the financialasset has been sold or otherwise disposed of, at which time it should be recognised in theincome statement.

IG C.11 If an embedded derivative that is required to be separated cannot be reliably measured,the entire combined contract should be treated as a financial instrument held for trading.The entity might conclude, however, that the equity component of the combined instrumentmay be sufficiently significant to preclude it from obtaining a reliable estimate of theentire instrument. In that case, the combined instrument is measured at cost less impairment.

39.53 If a reliable fair value subsequently becomes available, the difference between cost andthe fair value at that time should be:

■ recognised in the income statement if the instrument is held for trading; or

■ accounted for in accordance with the entity’s accounting policy for available-for-salesecurities if the instrument is not held for trading (i.e. recognised in the income statementor directly in equity).



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6.3.2 Amortised cost


39.47 Amortised cost applies to both financial assets and financial liabilities. The effective interestrate method should be used for amortising premiums, discounts and transaction costs forboth financial assets and liabilities.

39.9 The amortised cost of a financial asset or financial liability is the amount at which thefinancial asset or liability was measured at initial recognition minus principal repayments,plus or minus the cumulative amortisation of any difference between that initial amountand the maturity amount, and minus any write-down (directly or through the use of anallowance account) for impairment or uncollectability.

6.3.2.2 Fixed rate instruments

39.9 The effective interest method is a method of calculating amortisation or accretion using theeffective interest rate of an interest-bearing financial asset or liability. The effective interestrate (or internal rate of return) is the rate that exactly discounts the expected stream offuture cash payments through maturity or the next market-based repricing date to the currentnet carrying amount of the financial asset or financial liability. That computation shouldinclude all fees and points paid or received between parties to the contract.

IG B.27 Sometimes entities purchase or issue debt instruments with a predetermined rate ofinterest that increases or decreases progressively (i.e. stepped interest) over the termof the debt instrument. In this case, the entity should use the effective interest methodto allocate interest income or expense over the term of the debt instrument to achievea level yield to maturity, that is a constant interest rate on the carrying amount of theinstrument in each reporting period.

6.3.2.3 Floating rate financial instruments

39.AG6-8 Calculating the effective interest rate and amortised cost is different for floating ratefinancial instruments that have been acquired or issued at a discount or premium.The periodic re-estimation of determinable cash flows to reflect movements in marketrates of interest will change the instrument’s effective yield. Whether the discount, premiumor transaction costs are recognised in the income statement over the remaining term ofthe instrument or over the remaining term to the next repricing date depends on thereason for the existence of the premium or discount.

■ The period to next interest repricing date is used when a discount or premium resultsbecause interest payments are in arrears, have accrued since the most recent interestpayment date or market rates of interest have changed since the debt instrument wasmost recently repriced. For example, an investor purchases directly from the issuer afive-year floating rate note paying three-month LIBOR at a discount to reflect thedifference between the variable rate set one month before at four per cent and thecurrent yield of five per cent. In this case the amortisation period should be the perioduntil the next repricing.


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■ The remaining term of the instrument is used in a situation when the discount orpremium arises because the credit spread required by the market for the instrumentis higher or lower than the credit spread that is implicit in the variable rate. For example,if a five-year floating rate note paying three-month LIBOR trades at a discount dueto deterioration in the credit quality of the issuer subsequent to the issuance of thenote, the amortisation period should be to the maturity of the instrument and not to thenext repricing date because the repricing will not reflect the change in the creditspread. The remaining term of the instrument is also used for amortisation oftransaction costs.

IAS 39 does not prescribe any specific methodology about how transaction costs shouldbe amortised for a floating rate loan. Any methodology that would establish a reasonablebasis for amortisation of the transaction costs may be used. For example, it would bereasonable to determine an amortisation schedule of the transaction costs based on theinterest rate in effect at inception ignoring subsequent changes in the interest rate.


39.9 The amendments clarify that it is the expected and not the contractual cash flows thatshould be used to determine the effective yield on an instrument. For example, for aportfolio of prepayable mortgage loans, an entity would need to estimate prepaymentpatterns based on historical data and build the cash flows arising on early settlementsinto the effective yield calculations. The impact will be to amortise any initial discountsor transaction costs over the period to expected maturity rather than over the period tothe contractual maturity of the loans (where the expected period to maturity is shorterthan the contractual maturity). Contractual cash flows would be used only in the rarecases where expected cash flows cannot be estimated reliably.

If there is a change in estimated future cash flows (other than due to impairment), thecarrying amount of the instrument is adjusted in the period of change with a correspondinggain or loss being recognised in the income statement. The revised carrying amountshould equal the amount that would have been recognised if the change in estimate hadbeen known from the outset (cumulative catch up approach).

Note that the use of expected cash flows specifically excludes the effect of expectedfuture credit losses. The amortised cost calculation cannot therefore be used to removecredit spread from interest income to cover future losses.

In the examples below, the calculations under the revised standard are likely to be thesame as those illustrated.



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Case 6.2 Calculation of (amortised) cost

An entity purchases a government-issued treasury note with a 100,000 notional amount,six per cent coupon rate, and maturity in five years for a discounted purchase price of95,900. The market rate at the time of issuance (i.e. effective interest rate) isseven per cent. Using the effective interest rate method, the fair value of the treasurynote at the beginning of year one is calculated as follows:

Discount Present valueYear Cash flows factor of cash flows

1 6,000 (1.07) 5,6072 6,000 (1.07)2 5,2413 6,000 (1.07)3 4,8984 6,000 (1.07)4 4,5775 106,000 (1.07)5 75,577

Amortised cost at beginning of year one 95,900

The effective interest rate of seven per cent is used to calculate the amortised cost ofthe treasury note at the beginning of year two as follows:

Discount Present valueYear Cash flows factor of cash flows

2 6,000 (1.07) 5,6073 6,000 (1.07)2 5,2414 6,000 (1.07)3 4,8985 106,000 (1.07)4 80,867

Amortised cost at beginning of year two 96,613

The interest income recorded in the income statement in year one is 6,713 (being 6,000interest coupon plus 713 related to amortisation of the discount at the beginning ofyear). The total interest income is seven per cent of the opening balance of 95,900.

Case 6.3 Effective interest rate calculation

On 1 January 20X1, Bank Y grants a five-year loan of 50 million to Entity Z with anannual coupon of 10 per cent. The issue price of the loan is 98 per cent of the redemptionvalue. Bank Y classifies the loan as originated by the entity.

How should Bank Y account for the interest and the amortisation of the loan at31 December assuming annual compounding?

To calculate the amortised cost, the effective interest rate should be determined first.Based on the cash flows of the loan, the effective yield is 10.53482 per cent (roundedto 10.53 per cent herein).



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The amortisation schedule is as follows:

Amortised Interest incomeDate cost Coupon Amortisation (at 10.53%)

1 January 20X1 49,000,000 – – –31 December 20X1 49,162,063 5,000,000 162,063 5,162,06331 December 20X2 49,341,199 5,000,000 179,136 5,179,13631 December 20X3 49,539,207 5,000,000 198,008 5,198,00831 December 20X4 49,758,075 5,000,000 218,868 5,218,86831 December 20X5 50,000,000 5,000,000 241,925 5,241,925

Total 25,000,000 1,000,000 26,000,000

To calculate the effective interest income, the effective interest rate is applied to theamortised cost of the loan at the end of the previous reporting period. The differencebetween the calculated effective interest for a given reporting period and the asset’scoupon is the amortisation of the discount during that reporting period. Thus the amortisedcost of the loan at the end of the previous reporting period plus amortisation in thecurrent reporting period gives the amortised cost at the end of the current reportingperiod. The journal entries for recording the loan and the interest income are as follows:

Debit Credit

1 January 20X1Loan receivable (notional) 50,000,000Loan receivable (discount) 1,000,000Cash 49,000,000To record the loan

On the balance sheet, the loan receivable is presented net of the discount amount(i.e. 49 million).

Debit Credit

31 December 20X1Accrued interest receivable 5,000,000Loan receivable (discount) 162,063Interest income 5,162,063To record the effective interest income on the loanat 31 December

At maturity the discount will be completely amortised and the carrying amount is equalto the face value of the loan. Contrary to straight-line amortisation, which was usedoften in practice prior to IAS 39, the amortisation is not constant at 200,000 (1,000,000divided by five years). The amortised amount increases each reporting period as thecarrying amount of the loan increases. Interest income may be calculated on a daily,monthly or quarterly basis, depending on the reporting frequency of the entity. Figure 6.2demonstrates the impact of amortising the discount using the straight-line method andusing the effective interest method.



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Figure 6.2 Straight-line versus effective interest method

6.3.3 Foreign currency transactions


Entities may have exposure to foreign currency risk, either from transactions in foreigncurrencies or from investments in foreign operations. Accounting for changes in foreignexchange rates is covered by IAS 21, which includes the accounting for:

■ transactions in foreign currencies; and

■ translation of the financial statements of foreign operations that are included in thefinancial statements of the entity by consolidation, proportionate consolidation or useof the equity method.

The measurement principles of IAS 39 generally do not affect these rules, but merelyrefer to and supplement the requirements in IAS 21, most notably in the area of hedgeaccounting where IAS 21 has very limited provisions. This Section deals with interactionsbetween IAS 39 and IAS 21 when measuring financial instruments denominated in aforeign currency. Hedging of foreign currency exposures is covered in Sections 8 and 9.

6.3.3.2 Recording foreign currency transactions

21.21 All transactions in currencies other than the functional currency of the entity must beinitially recognised using the spot rate at the date of the transaction. The spot rate isdetermined as the price of a foreign currency purchased or sold with immediatedelivery (for practical reasons immediate is often agreed to be two days after thetransaction date).



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18.30(a) Interest amounts, amortisation of premiums and discounts and impairment losses in foreigncurrency are recognised in the income statement as they accrue and are translated at theforeign exchange rate at the date of accrual. Impairment losses in a foreign currency arerecognised in the income statement when they are incurred and are translated at the spot

21.22 rate at that date. Normally it would be acceptable to calculate amortisation and interestamounts on a monthly basis and translate those amounts at an average foreign exchangerate. However, when foreign exchange rates fluctuate significantly it may be necessaryto translate foreign currency interest and amortisation amounts more frequently.

18.30(c) Dividends should be recognised in income when the shareholder’s right to receive paymentis established. This is generally at the time of declaration. Therefore, the foreign exchangerate used should be the foreign exchange rate at that date.

6.3.3.3 Subsequent reporting of foreign currency trading instruments

Non-derivative instruments that are held for trading purposes and all derivatives are measuredat fair value in the foreign currency. This value is then translated into the functionalcurrency at the foreign exchange rate at the reporting rate. Gains and losses recognisedin the income statement include the effect of changes in foreign exchange rates.

6.3.3.4 Subsequent reporting of other foreign currency financial instruments

Monetary financial instruments

21.8 Monetary items are money held and assets and liabilities to be received or paid in fixedor determinable amounts of money.

This definition is narrower than the definition of a financial instrument, which implies thatnot all financial instruments are monetary. Consequently, contractual rights / obligationsto receive / pay cash where the amount of money is not fixed nor determinable are non-monetary financial instruments. This is the case, for example, with equity shares wherethe holder has no right to a determinable amount of money.

21.28 and Derivative contracts are settled at amounts which are determinable at the settlement39.AG83 date in accordance with the terms of the contract and the price of the underlying.

All derivatives that are settled in cash are monetary items, even if the underlying is a non-monetary item.

21.23 At subsequent balance sheet dates, all monetary items in foreign currencies are translatedat the closing spot rates with any gains or losses resulting from changes in the foreignexchange rates included in net income. All exchange differences on translation of monetaryitems should be recognised in the income statement in the period in which they arise.The example below demonstrates the accounting for monetary financial instrumentsmeasured at amortised cost and fair value.



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Case 6.4 Measurement of monetary financial instruments denominated in aforeign currency

Foreign currency loan

At 1 January 20X1, an entity originates a loan of foreign currency (FC) 150 million withan eight per cent fixed rate of interest and measures the loan at amortised cost. The loanis at par and matures on 31 December 20X4. At 1 January 20X1, the spot rate is 1.5,therefore, the entity records an asset of measurement currency (MC) 100 million. Thecash flows are discounted at the original effective interest rate, in conformity withmeasurement at amortised cost. The carrying values at 1 January and at 31 December20X1, when the spot rate has increased to 1.6, are presented below:

Cash flows at 1 January 31 December20X1 20X1

Present value Present value(amounts in FC) Cash flows of cash flows Cash flows of cash flows

31 December 20X1 12,000,000 11,111,111 – –31 December 20X2 12,000,000 10,288,066 12,000,000 11,111,11131 December 20X3 12,000,000 9,525,987 12,000,000 10,288,06631 December 20X4 162,000,000 119,074,836 162,000,000 128,600,823

Carrying value in FC 150,000,000 150,000,000

Carrying value in MC (at a spotrate of 1.5 and 1.6, respectively) 100,000,000 93,750,000

The foreign exchange rate difference based on changes in the spot rate amounts toMC 6,250,000 and is recognised in the income statement.

Foreign currency debt security

At 1 January 20X1, an entity purchases a debt security of foreign currency (FC)150 million with an eight per cent fixed rate of interest. The entity classifies the securityas available-for-sale and measures the security at fair value. The entity records fairvalue changes on available-for-sale securities in equity.

The security is purchased at par and matures on 31 December 20X4. At 1 January20X1, the spot rate is 1.5, therefore, the entity records an asset of measurement currency(MC) 100 million. At 31 December 20X2, the interest rates decreased so that the fairvalue of the security became FC 150,100,000. The spot rate at 31 December 20X1 hasincreased to 1.6.

The total fair value change in the measurement currency is calculated as follows:

Date Spot rate Fair value Fair value(in FC) (in MC)

1 January 20X1 1.5 150,000,000 100,000,00031 December 20X1 1.6 150,100,000 93,812,500

Fair value change 100,000 (6,187,500)



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The entity has to distinguish between:

■ changes in fair value due to changes in interest rates (and credit spread, if applicable)which are to be included in equity; and

■ changes in fair value due to changes in the foreign exchange rate which must berecognised in the income statement.

IG E.3.2 In order to determine the fair value changes related to foreign exchange changes to berecognised in the income statement, the instrument is treated as an asset measured atamortised cost in the foreign currency. The amortised cost at 31 December 20X1 isFC 150,000,000, which is equal to MC 93,750,000. Thus, the foreign exchange loss tobe included in the income statement is equal to MC 6,250,000. The cumulative gain orloss to be included directly in equity is the difference between the fair value and theamortised cost at the reporting date, which is a MC 62,500 gain.

Case 7.3 in Section 7 illustrates calculations of exchange gains and losses included in theincome statement for monetary items issued or acquired at a premium or discount.

Dual currency loans

A dual currency loan is an instrument where the principal and interest are denominated indifferent currencies. A dual currency loan with principal denominated in the measurementcurrency and interest payments denominated in a foreign currency contains an embeddedforeign currency derivative. However, the embedded derivative is not separated becausechanges in the spot rate on the foreign currency denominated element (the interest or theprincipal) should be measured under IAS 21 at the closing rate with any resulting foreignexchange gains or losses recognised in the income statement.

Non-monetary financial instruments

21.23 Non-monetary items generally are not translated subsequent to initial recognition.However, most non-monetary financial instruments, such as equity securities, are measuredat fair value. Such instruments should be reported using the foreign exchange rates thatexisted when the fair values were determined. Thus, the fair value is first determined inthe foreign currency, which is then translated into the measurement currency. Foreignexchange gains and losses are not separated from the total fair value changes. Therefore,for available-for-sale equity instruments remeasured through equity the entire change infair value is recognised in equity.

Table 6.1 below indicates whether fair value changes resulting from foreign currency andother risks should be included in the income statement or as a separate component ofequity. Changes due to impairment losses have been disregarded in this summary.



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Table 6.1 Where to record changes in fair value

Change in fair value from: To be included in:

SeparateForeign Income component

Financial instrument currency Other risks statement of equity

Trading instruments ✔ ✔ For all changes –

Originated loans and receivables ✔ N/a For all changes –Held-to-maturity ✔ N/a For all changes –

Non-monetary available-for-sale ✔ ✔ – Changes ininstruments fair value,

includingFX changes

Monetary available-for-sale ✔ ✔ FX changes Otherinstruments changes in

fair value

6.4 Impairment of financial assets

Addressing impairment of financial assets is a two-step process. The entity must firstassess whether there is objective evidence that impairment exists for a financial asset.This assessment should be done at least at each reporting period. If there is no objectiveevidence of impairment no further action need be taken at that time for that instrument.However, if there is objective evidence of impairment, the entity should record animpairment loss during the reporting period so that the financial asset is recognised at itsrecoverable amount.


39.58, 63 and 66 The amendments clarify that an impairment loss is recognised only when it is incurred.Impairment losses are not recognised for losses expected to take place as a result offuture events. Therefore, in estimating cash flows for the purpose of estimating therecoverable amount of a portfolio of loans, the contractual cash flows are adjustedonly for the impact, based on historical data, of bankruptcy, death, unemployment, etc.of borrowers that is estimated to have occurred at the balance sheet date.Consequently, no loss should be recognised on the day that a loan is granted.

IG E.4.10 In addition, the amendments clarify that in the case of available-for-sale financial assets,the recoverable amount is fair value, so that where it is assessed that an available-for-sale asset has become impaired estimating a recoverable amount based on discountedfuture cash flows is unnecessary. Additional guidance is included for the recognition ofimpairment of available-for-sale equity investments.

Overall, although the implementation guidance to IAS 39 continues to acknowledgethat it is possible for the available-for-sale reserve in equity to become negative, thescope for judgement in determining whether a decline in fair value of available-for-saleinvestments represents an impairment is therefore reduced.



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6.4.1 Objective evidence of impairment

39.60 Indicators of objective evidence of impairment include:

■ financial difficulties of the issuer;

■ breach of a contract, such as default or delinquency in interest or principal payments;

■ concessions granted from the lender to the borrower that the lender would not haveconsidered normally;

■ high probability of bankruptcy;

■ recognition of an impairment loss on that asset in a previous reporting period;

■ disappearance of an active market for the financial asset due to financial difficultiesof the issuer; or

■ a decrease in the market value of an issuer’s debt securities significantly beyondfactors explainable by changes in market interest rates.

39.60 A change in the credit rating is not of itself evidence of impairment. However, it may beevidence of impairment when considered with other available information, such as one of

IG E.4.1 the indicators noted above. In addition, the entity should take into account information aboutthe debtor’s / issuer’s liquidity and solvency, as well as trends for similar financial assets,and local economic trends and conditions when evaluating for evidence of impairment.

39.61 and For equity instruments, impairment cannot be identified based on analysing cash flows, asIG E.4.10 it can with debt instruments. Instead impairment is based on the identification of indicators

such as those characteristics described above. An additional indicator is the magnitude ofthe difference between the original cost and the current value of the equity instrument.The greater this difference, the greater also is the evidence of potential impairment.However, on its own the fact that the fair value of an equity security is below its cost doesnot necessarily indicate impairment.

In practice there are a number of additional indicators and sources of evidence ofimpairment of equity securities that an entity may look to, including:

■ a decline in the fair value of the equity instrument that seems to be related to issuerconditions rather than general market or industry conditions;

■ market and industry conditions, to the extent that they influence the recoverable amountof the financial asset. For example, if the fair value at the acquisition date had beenextremely high due to a market level which is unlikely to be recovered in the future,this may be an impairment indicator due to pure market and / or industry conditions;

■ a declining relationship of market price per share to net asset value per share at thedate of evaluation compared to the relationship at acquisition;

■ a declining price / earnings ratio at time of evaluation compared to at the date of acquisition;

■ financial conditions and near term prospects of the issuer, including any specific adverseevents that may influence the issuer’s operations;

■ recent losses of the issuer;



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■ qualified independent auditor’s report on the issuer’s most recent financial statements;

■ negative changes in the dividend policy of the issuer, such as a decision to suspend ordecrease dividend payments; or

■ realisation of a loss on subsequent disposal of the investment.


39.61 The amended standards include additional indicators of objective evidence of impairmentfor investments in equity instruments, similar to those described above. Specifically asignificant or prolonged decline in value below cost is objective evidence of impairmentunder the amended standards.

Although there remains some scope for judgement on whether a decline in the marketvalue of an equity share represents an impairment, there is a strong presumption that asignificant or prolonged decline in market value below cost is objective evidence ofimpairment. There is no quantified guidance on what is ‘significant’ or ‘prolonged’ andthis evaluation will require judgement. However, only in rare cases, for example, whenmarket prices have subsequently recovered, might it be possible to demonstrate that asignificant decline in value is not an impairment.

6.4.2 Measuring impairment

For a financial asset that is impaired, the entity must determine its recoverable amount.The recoverable amount, and therefore measurement of the impairment loss, differsbetween assets carried at amortised cost and those carried at fair value. These differencesare summarised as follows:

39.63 and AG84 ■ Financial assets carried at amortised cost: Impairment has occurred if it is probablethat an entity will not be able to collect all amounts due (principal and interest) accordingto the contractual terms. The loss recognised in the income statement is the differencebetween the carrying amount and the recoverable amount. The recoverable amountis the present value of expected future cash flows discounted at the financialinstrument’s original effective interest rate. Impairment is measured using the asset’soriginal effective interest rate because discounting at the current market rate ofinterest would, in effect, impose fair value measurement on the financial asset.This would not be appropriate as such assets are measured at amortised cost.

39.67 ■ Financial assets carried at fair value: Impairment is only an issue for available-for-sale instruments in which changes in fair value are recognised as a component ofequity rather than in the income statement. For such instruments, the impairment lossas well as any net cumulative unrealised loss previously recognised in equity must berecycled to the income statement.

39.68 In the case of an equity instrument included in the available-for-sale category, if a chargefor an impairment loss is required, the impairment loss to be recognised is the differencebetween cost and fair value of the instrument. In the case of impairment of a debtinstrument included in the available-for-sale category, the loss is the difference betweenamortised cost and fair value. The recoverable amount of a debt instrument is the present



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value of expected future cash flows discounted at the current market rate of interest fora similar financial asset.

IG E.4.4 For a variable rate loan measured at amortised cost, the discount rate used is the currentvariable rate applicable to the next repricing date, which represents its inherent effectiveinterest rate. The carrying amount of a fixed rate instrument measured at amortised costmay be adjusted for fair value changes in a fair value hedge (hedge accounting is discussedin Section 8). The adjusted carrying amount is the basis for the determination of impairmentlosses. If the fair value hedge was in respect of interest rate risk, the hedge adjustmentalso changes the effective interest rate. The adjusted effective interest rate is used as thediscount rate for measuring the impairment loss.

Generally the current market rate for a similar financial asset should be interpreted as theoriginal effective interest rate, adjusted for changes in the benchmark or risk-free interestrate for that financial asset. In other words, in order to avoid double counting, the appropriatecurrent market rate should consider adjustments for interest rates, however, the originalcredit risk spread should be held constant and not adjusted to reflect the current creditrisk spread.

The expected cash flows that are included in the calculation are the contractual cashflows of the instrument itself, decreased or postponed based on the current expectationsfor amount and timing of these cash flows as a result of losses incurred at the balancesheet date. Even where cash flows are delayed for a period of time, even though all ofthe principal will be recovered, impairment must be recognised unless there is fullcompensation (i.e. interest paid) during the period of the delinquency.

39.AG84 If the holder expects that recovery on the instrument will come from the cash flows ofthe collateral, then the fair value of the collateral is taken into account when calculatingthe impairment loss.

Case 6.5 Impairment of a loan

The following case is partially based on the earlier Case 6.3. Assume that Bank Ygrants a loan in the year 20X1 to Entity Z. The interest rate on the loan is 10 per centand the loan is issued at 98 per cent of its face value. The maturity date is 31 December20X5. The effective yield at the date of origination is 10.53482 per cent (rounded to10.53 per cent for the rest of this Case).

At 31 December 20X3, it becomes clear Entity Z is experiencing severe financialdifficulties and will not be able to meet its obligations of principal and interest accordingto the contractual terms. At that date the carrying amount of the loan at amortised costis 49,539,207.

Bank Y expects that it will receive the contractual interest payment of 10 per cent dueat 31 December 20X4. However, on maturity of the loan, Bank Y expects to recoveronly 25 million of the 50 million principal due and does not expect to receive the interestpayment due at 31 December 20X5.

What would be the calculated impairment loss if the loan is categorised as originatedby the Bank Y?



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The impairment loss is measured based on discounting the expected cash flows at theoriginal effective interest rate of 10.53 per cent. Given that only 25 million in principaland the 31 December 20X4 interest payment are expected to be received, the presentvalue based on this original effective interest rate is 24,985,165. Assume that accruedinterest is paid at 31 December 20X3 and thus is not included in the calculation.The discounted remaining cash flows are calculated as follows:

24,985,165 =

As such, an impairment loss of 24,554,042 (49,539,207 – 24,985,165) should berecognised in the income statement. Bank Y should reassess the impairment loss ateach reporting date.

How would Bank Y calculate the impairment loss if this instead is a purchased loancategorised as available-for-sale with changes in fair value recognised as a componentof equity?

The recoverable amount would be calculated based on discounting the expected cashflows using the current effective interest rate.

The current effective interest rate is determined by reference to the change in thebenchmark rate or the risk-free interest rate, which is part of the effective interest rateof 10.53 per cent. The change in the credit spread from initial recognition of the loan isnot taken into account.

Assume that the risk-free effective interest rate at the date of the loan acquisition byBank Y was 6.53 per cent for a debt instrument with the same terms as the Entity Zloan. Thus, the credit risk premium for such a term and structure of a loan for Entity Zwas 400 basis points. At 31 December 20X3, the effective risk-free interest rate is8.5 per cent for a similar type of debt instrument.

Therefore, a rate of 12.5 per cent (8.5 per cent + 400 basis points) is used to discountthe expected cash flows related to the Entity Z loan if it is included in the available-for-sale category. This discounted cash flow is calculated as follows:

24,197,531 =

The calculated recoverable amount of 24,197,531 results in an impairment loss of25,341,676 (49,539,207 – 24,197,531). In this case, the recoverable amount is also thefair value of the loan because the current market interest rate is being applied to theexpected cash flows. In addition, any unrealised gains or losses relating to this loan arerecycled out of equity and recognised in the income statement at the time the impairmentloss is recognised.

Assume the same information as above, except that the loan is collateralised byliquid securities. Bank Y expects that it will only be able to recover the amount owedon the loan by taking legal possession of the securities. How is the impairment lossthen calculated?


5,000,000 +

25,000,000 1.1053 (1.1053)2

5,000,000 +

25,000,000 1.125 (1.125)2


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39.AG84 In this case, the estimated recoverable amount of the loan equals the fair value of thesecurities less any costs expected to obtain the collateral. The loss is calculated as the

IG E.4.8 difference between the carrying amount and this recoverable amount. However, thecollateral itself should not be recognised on Bank Y’s balance sheet until the securitiesmeet the recognition criteria for financial assets.

12.58 An impairment loss may be recognised by writing down the asset or recording an allowanceprovision to be deducted from the carrying amount of the asset. If the impairment lossrelates to an available-for-sale asset where a deferred tax liability or deferred tax assetwas previously recognised for an unrealised gain or loss on the instrument, the deferredtax amount should also be recognised in the income statement.

6.4.3 Interest income recognition on impaired assets

39.AG93 After an impairment loss has been recognised in the income statement, interest income isrecognised based on the rate used to discount the future cash flows when measuring therecoverable amount (i.e. either the original effective interest rate or the current effectiveinterest rate).

It is inappropriate to simply suspend interest recognition on a non-performing interest-bearinginstrument, such as an originated loan or receivable. Future interest receipts should be takeninto account when the entity estimates the future cash flows of the instrument. If nocontractual interest payments will be collected, then the only interest income recognised isthe unwinding of the discount on those cash flows expected to be received.

6.4.4 Types of impairment measurement – individual or portfolio

39.64 Impairment losses should be measured and recognised individually for financial assetsthat are individually significant. Impairment losses may be measured on a portfolio basis

IG E.4.7 for a group of similar assets that are not individually significant. However, if an entityknows that an individual financial asset carried at amortised cost is impaired, then theimpairment of that particular asset should be recognised.

For example, assume that an entity performs an impairment analysis of its receivablesportfolio of 500 million. Those receivables are normally considered to be similar in nature.Based on a statistical analysis, the entity estimates that an impairment loss of 20 millionshould be recognised based on the whole portfolio.

39.64 Now assume that within that portfolio, one particular client is known to have financialdifficulties and the impairment loss on the receivables due from that client is calculated ateight million. The impairment loss of eight million would be recognised separately as animpairment loss. A new impairment analysis would then be prepared excluding thereceivables of this client from the analysis.

39.59 and 61 One of the circumstances that provides objective evidence of impairment is the existenceof a historical pattern of collections of accounts receivable that indicates that less thanthe entire amount will be collected. This could be an indicator that a write-down is requiredfor a group of similar financial assets.



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IG E.4.5 A reasonable approach to impairment provisioning is to determine impairment losses thatare probable based on the current environment combined with historical experience suchas, for example, patterns of non-payment on a portfolio of homogeneous consumer loansor credit card receivables. Even though the provision cannot yet be allocated to individualfinancial assets, an entity may be able accurately to determine the future expected cashflows of the portfolio of similar interest-bearing assets. These cash flows should then bediscounted at a rate that approximates the original effective interest rate. For portfolios ofsimilar assets, these assets will have a range of interest rates, therefore, judgement isnecessary to determine a discounting methodology appropriate to that portfolio. An entitymay employ various methodologies for determining impairment as long as they take intoaccount the net present value of future expected cash flows based on losses incurred atthe balance sheet date.

IG E.4.2 As discussed above it is allowable to calculate impairment losses and record a provisionusing a portfolio methodology for groups of similar assets. However, this does not meanthat an entity is allowed to take an immediate write-down upon originating a new financialasset, such as an originated loan by a bank, based on historical experience. This is becausethere is no evidence of impairment of the loan upon origination. It is only when that loanis included in a portfolio of similar loans that the bank determines inherent losses in theportfolio based on historical experience.

A portfolio approach to impairment is not appropriate for individual equity instrumentsbecause equity instruments of different issuers are not considered to have similar riskcharacteristics (i.e. equity price risk). In the case of shares in an investment fund, it islikely that a decrease in the fair value of an investment fund is due to an impairment of atleast some of the underlying assets held by the fund. However, an investment fund shouldbe evaluated based on the fair value of the investment fund itself rather than on theunderlying investments held by the fund. This approach is different from applying a portfolioapproach to a group of individual equity instruments.


39.64 As noted above, the amended standards clarify that the impairment model is an incurredloss model. Further guidance is also provided on how to assess impairment for a groupof loans or receivables. Specifically:

■ If a loan is tested individually for impairment and found to be impaired, it should notbe included in a portfolio test for impairment. Conversely, if a loan is testedindividually and is found not to be impaired, it nevertheless should be included in aportfolio of similar loans for the purpose of a portfolio-based impairment test;

■ Historical loss experience, adjusted for observable data reflecting economicconditions at the reporting date, is the basis for estimating losses that have beenincurred within the portfolio, but which have not been reported or allocated tospecific loan balances; and

■ The methodology used should ensure that an impairment loss is not recognised onthe initial recognition of an asset.



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6.4.5 Reversal of impairment losses

39.65, 69 and 70 Impairment should be assessed at each reporting date. If in a subsequent reporting periodthe amount of an impairment or bad debt loss decreases and the decrease can be objectivelyrelated to an event occurring after the write-down, the write-down of the financial assetshould be reversed either directly through the income statement or by adjusting a previouslyestablished allowance account through the income statement. An illustration of such asituation would be an entity that has successfully improved its credit rating, for example,through a reorganisation or after having received important sales orders.

In the case of an impairment reversal, the write-up in value of a financial asset throughthe income statement is limited to the amount previously recognised in the write-down.For an available-for-sale instrument that is measured at fair value with changes in equity,any appreciation above (amortised) cost, taking into account any repayments of principal,is recognised as an adjustment to equity in line with the accounting policy on the instrument.For a held-to-maturity asset and for originated loans and receivables, any appreciationabove (amortised) cost is not recognised.


39.69 The amendments do not change the requirements on available-for-sale debt instruments.However, in respect of available-for-sale equity investments, the amended standardsstate that an impairment loss may not be reversed through the income statement.Consequently, any subsequent increase in the carrying amount of an available-for-saleequity security is a fair value change that is recognised in equity.

6.4.6 General provisions for credit risk

Impairment provisions relate to situations where provisions are calculated for knownrisks of impairment. There should be objective evidence that the carrying amounts ofindividually significant financial assets or groups of comparable financial assets are greaterthan their recoverable amounts.

IG E.4.6 The term general provision is used differently in different parts of the world. In someplaces, general provisions are portfolio-based provisions, as described above, for lossesinherent in a group of assets and based on historical loss experiences. In other places,a general provision refers to one that is not specifically related to expected losses in agroup of assets, but rather is an unallocated reserve to be used for unplanned andunexpected losses. General provisions that are in excess of such portfolio-based amounts,or bad debt losses that are in addition to those necessary for individually significantfinancial assets or groups of similar financial assets are not allowed under IFRS.Any general provision that is an unallocated reserve established through a charge tothe income statement should be reversed.

30.44 and 50 Certain entities, such as banks, may set aside amounts for general banking risks throughan appropriation of retained earnings. However, it is important to note that this is not ageneral provision. The appropriation of retained earnings is an equity-only movement,and any charges or reversals are not included in the entity’s income statement.



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6.4.7 Measuring impairment of financial assets denominated in a foreign currency

For financial assets denominated in a foreign currency, there is no specific guidance onhow to measure impairment losses. Typically the recoverable amount of the asset is firstdetermined in the foreign currency. The recoverable amount should be translated into themeasurement currency using the foreign exchange rate at the date when the impairmentis recognised. The difference between the recoverable amount and the carrying amountin the measurement currency is recognised in the income statement.

39.65 Foreign exchange gains and losses on an impaired monetary asset should continue to berecognised in the income statement. If by a subsequent improvement in circumstances anentity is able to reverse the impairment loss, in part or in whole, such reversal should berecognised at the spot rate at the date when the reversal is recognised.

21.23 For non-monetary assets held as available-for-sale with changes in fair value recognised39.68 in equity, the situation is different. The amount of loss to be removed from equity andIG E.4.9 included in the income statement is the total net difference between the asset’s acquisition

cost and current fair value in the measurement currency.

39.69 and 70 An impairment loss recognised on an available-for-sale debt instrument can be reversed.Again in this case, no guidance is given regarding the treatment of exchange differencesrelating to the reversal. In our view, it is advisable to record the impairment loss and anysubsequent reversal at the spot rate in effect on the date when the reversal is recognised.Any subsequent reversal should be limited to the amount of loss previously recognised,denominated in foreign currency. It is our view that until the previously recognised lossdenominated in foreign currency is fully reversed, the related foreign exchange differences

32.94(i) should be recognised in the income statement. At a minimum, the accounting treatment appliedshould be disclosed along with the nature and the amount of any impairment loss or reversal.

There may be situations where the fair value of an asset in its currency of denominationis affected by foreign exchange rates. This may occur if there is a sudden and severedevaluation of a foreign currency. The devaluation of the foreign currency may influencethe credit risk and country risk associated with entities operating in that environment.Therefore, an entity that has foreign currency loans or receivables, or holds debt securitiesdenominated in a foreign currency that becomes devalued, should consider whether thedecline should be treated as an impairment loss rather than as a normal foreign exchangetranslation loss. Only in such instances should changes in foreign exchange rates be afactor for determining whether a further impairment loss or reversal of an impairmentloss should be recognised in the income statement.

6.5 Reclassifications of financial assets

6.5.1 Transfers between categories

An entity may wish to or need to transfer a financial asset from one category to another.However, for certain categories transfers should be very rare or may not be allowed at allwithout tainting implications. Such limitations are imposed due to the concept in IAS 39that asset classification should generally be clear as of the moment the asset is acquiredor originated.

Table 6.2, all possible transfers between categories are outlined, including an indication ofwhether such a transfer is permitted or why such transfers may take place.



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Table 6.2 Rules for transfers between financial assets categories

Transfer to: Originated loans Held-to- Available-for-Trading and receivables maturity sale

Transfer from:Trading N/a Not permitted Not permitted Not permitted

Originated loans If pattern of short- N/a N/a N/aand receivables term profit-taking

Held-to-maturity Results in tainting N/a N/a Results in tainting

Available-for-sale If pattern of short- N/a In case of change N/aterm profit-taking in intent and if all

criteria are met

6.5.1.1 From trading

39.50 IAS 39 is clear in regard to transfers from the trading portfolio – such transfers are notallowed. The rationale is that the designation of a financial asset as held for trading isbased on the objective for initially acquiring it (which is for trading purposes).

6.5.1.2 From originated loans and receivables

39.9 and 50 Originated loans and receivables should be classified as trading at the origination date if theintent is to sell such loans immediately, or in the short-term, or if they are part of a portfolioof loans for which there is an actual pattern of profit-taking. A transfer from the originatedloans and receivables portfolio to the trading portfolio at a later stage may happen only ifthere is evidence of a recent pattern of short-term profit-taking that justifies such areclassification. An example is when responsibility for a portfolio of loans is transferredfrom the banking division to the trading division and when the objective for holding the loanshas clearly changed, and not just because the entity has decided to sell the loans in the nearfuture. Upon transfer to the trading portfolio, the assets are remeasured to fair value withdifferences between (amortised) cost and fair value recognised in the income statement.

Reclassifications and sales of originated loans and receivables are possible without anyof the tainting issues applicable to the held-to-maturity category. However, such transfersshould not be common.

6.5.1.3 From held-to-maturity

39.AG22 Transfers from the held-to-maturity category should be rare. Unless a transfer meets oneof the exceptions described in greater detail in Section 5.2.3, it would be viewed in thesame way as a sale and could thus taint the portfolio. If the held-to-maturity category istainted, all assets in this category are remeasured at fair value and reclassified either tothe available-for-sale or trading portfolios. Differences between the amortised cost andfair value at the date of transfer are included either in equity or in the income statementdepending upon the new classification of the assets.

Entities should not reclassify to trading a tainted portfolio of held-to-maturity investmentsif after the tainting period (i.e. two full financial years) the entity plans to reinstate theportfolio in held-to-maturity, as this objective would not be consistent with the intent of a



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trading portfolio. Instead the entity should reclassify the tainted portfolio to available-for-sale for the duration of the tainting period.

6.5.1.4 From available-for-sale

39.50 Instruments may be transferred from available-for-sale to trading. This may only be doneif there is recent evidence of a pattern of short-term profit-taking that justifies such areclassification. If such a transfer occurs, any cumulative gain or loss included as a fairvalue component of equity should remain there until derecognition of the reclassifiedasset. The fair value at the transfer date represents the new basis for recognising changesin fair value for the trading asset. Upon derecognition of the asset, the cumulative gain orloss included as a component of equity at the date of the reclassification is removed andrecognised in the income statement.

A decision to sell a financial asset that is not classified as held for trading in the nearfuture does not make that asset a financial asset held for trading.

39.54 Transfers from available-for-sale to held-to-maturity can occur if there has been a changein the intent and ability of the entity. For instance, such a transfer could occur if thetainting prohibition period on held-to-maturity assets has passed, and the entity decides toreclassify assets back to that category. In case of a transfer from available-for-sale toheld-to-maturity, the fair value at the date of transfer becomes the new amortised costbasis for the held-to-maturity assets. Any fair value component included in equity remainsthere and is amortised as an adjustment to the yield in a similar manner to a premium ordiscount, using the effective interest rate method. Conversely, any difference betweenthe new amortised cost amount and the maturity amount is also recognised as a yieldadjustment in the income statement. The amortisation of these two amounts should offsetover the remaining life of the financial instrument.

6.5.2 Internal transfers of financial instruments

Internal transactions, which involve transfers of financial instruments between groupentities, are not transactions that are recognised in the consolidated financial statements.The effects of such transactions are eliminated upon consolidation. However, suchtransfers could be an indication that there has been a change in the group’s intent forholding the portfolios concerned.


39.9 and 50 As noted above, the amended standards allow an entity much more flexibility to use afair value through income measure for any financial asset or financial liability, and todesignate loans and held-to-maturity assets as available-for-sale. However, the fairvalue through profit or loss, or available-for-sale, choice is only available when a financialasset or liability is first recognised (or when the amended standards are first applied).Furthermore, an entity is prohibited from transferring a financial asset or liability into orout of the fair value through profit or loss category. Similar restrictions on reclassificationdo not apply to the available-for-sale category.



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6.6 Deferred tax assets and liabilities

12.57 Under IAS 12 Income Taxes, deferred tax assets or liabilities are recognised for alltemporary differences between the carrying amount of an asset or liability in the balancesheet and its tax base. Depending on the tax legislation in various countries, measurementof financial instruments may give rise to deferred taxes. The accounting for the effects ofdeferred taxes of a transaction should be consistent with the accounting for the transactionitself. In other words, for a transaction whose effect is recognised in equity, the relateddeferred tax effect should also be recognised in equity.

With respect to financial instruments measurement, deferred tax assets or liabilities mayarise from instruments valued at fair value and from hedge accounting, and also fromother adjustments to the carrying amount, for example, from the amortised cost methoddiffering from the tax measurement basis or from differences in the treatment of transactioncosts between IFRS and the applicable statutory tax regulations.

12.61 For changes in fair value that are recognised as a component of equity, the revaluationcomponent in equity should be shown net of deferred taxes, if applicable, and acorresponding deferred tax asset or liability is established on the balance sheet. Thesesame concepts may also be applicable to hedging transactions, where there is a change infair value of hedging instruments and the hedged items.

In the majority of examples and cases in this publication, the effects of deferred taxeshave been disregarded. Cases 7.2 and 7.4 in Section 7 illustrate the effect of deferredtaxes when remeasuring a financial asset to fair value.

6.6 Deferred tax assets and liabilities



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7. Subsequent measurement – examples


This Section contains cases that demonstrate the measurement principles for various financial assetsand financial liabilities. The cases are presented by type of financial risk. The cases build upon thediscussion of classification of financial assets and financial liabilities (Section 5) and of measurementand valuation issues (Section 6).


7.1 Overview

7.1 Overview

Table 7.1 indicates the possible risk positions associated with each category of financialinstrument and how they should be measured.

Table 7.1 Risk positions

ForeignInterest exchange Price Creditrate risk (FX) risk risk risk Measurement

Trading ✔ ✔ ✔ ✔ Fair value, withchanges in income

Originated loans ✔ ✔ – ✔ FX at fair value, creditand receivables risk and interest rate

risk at amortised costHeld-to-maturity ✔ ✔ – ✔ FX at fair value, credit

risk and interest raterisk at amortised cost

Available-for-sale ✔ ✔ ✔ ✔ Fair value, withchanges in incomeor equity

Non-trading ✔ ✔ – – FX risk at fair value,liabilities interest rate risk at

amortised cost

An entity may manage these risk positions by entering into hedging transactions, whichare discussed in Section 8.


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7.2 Interest rate risk

Case 7.1 Transfer and subsequent remeasurement of held-to-maturity investments

Entity T buys 100 million in bonds issued by a triple A credit rated financial institution.The bonds have a remaining life of four years, and Entity T intends and is able to holdthese bonds to maturity. For this example, assume there is no related premium or discount.

However, two years after it acquired the bonds at par, Entity T sells 10 per cent of thebond portfolio for 9.5 million. The amortised cost and the fair value of the remainingheld-to-maturity portfolio is 90.0 million and 85.5 million, respectively.

39.9 Because Entity T sells more than an insignificant amount of its held-to-maturity portfolio,the tainting rules require the entity to reclassify the remaining held-to-maturity portfolioto either available-for-sale or trading. The difference between the carrying amountand the fair value is recognised either in the income statement or in equity, dependingupon where the entity opts to record fair value changes (applies to available-for-saleonly). The journal entries are as follows:

Debit Credit

Cash 9,500,000Loss on sale of bonds 500,000Held-to-maturity investment 10,000,000To account for the sale of bonds

39.51 If the remainder of the portfolio is classified as available-for-sale and movements infair value are reflected in the income statement, Entity T would record:

Debit Credit

Available-for-sale investments 85,500,000Loss on investments (income statement) 4,500,000Held-to-maturity investments 90,000,000To account for the transfer of the remainder ofthe portfolio

If the remainder of the portfolio is classified as available-for-sale with movements infair value reflected as a component of equity until sold, Entity T would record:

Debit Credit

Available-for-sale investments 85,500,000Loss on investments (equity) 4,500,000Held-to-maturity investments 90,000,000To account for the transfer of the remainder ofthe portfolio



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If the remainder of the portfolio is classified as trading, Entity T would record:

Debit Credit

Trading assets 85,500,000Loss on investments (income statement) 4,500,000Held-to-maturity investments 90,000,00To account for the transfer of the remainder ofthe portfolio

Case 7.2 Remeasurement of an available-for-sale asset

On 1 January 20X1, Inter Bank acquires a loan to Entity Z with an annual coupon of10 per cent and a face amount of 50,000,000. The purchase price of the loan is98 per cent of the redemption value. In this case, assume Inter Bank classifies theloan as available-for-sale with fair value changes recognised as a component ofequity. At 30 June 20X1, the interest on comparable loans to borrowers with thesame creditworthiness is 10 per cent.

Since the loan is classified as available-for-sale, the measurement of the loan is at fairvalue. Interest on the loan is recognised on the basis of the effective interest method.

EffectiveAmortised interest

Date cost Coupon Amortisation (10.53%)

1 January 20X1 49,000,000 – – –31 December 20X1 49,162,063 5,000,000 162,063 5,162,06331 December 20X2 49,341,199 5,000,000 179,136 5,179,13631 December 20X3 49,539,207 5,000,000 198,008 5,198,00831 December 20X4 49,758,075 5,000,000 218,868 5,218,86831 December 20X5 50,000,000 5,000,000 241,925 5,241,925

Total 25,000,000 1,000,000 26,000,000

The amortisation for the half year ended 30 June 20X1 is calculated (in this example)by taking half of the cost to be amortised in the year 20X1, which is 81,032. This wasto simplify this case, as amortisation should be on an effective yield basis. The amortisedcost at 30 June 20X1 therefore amounts to 49,081,032.

Given an interest rate on comparable loans with the same credit risk of 10 per cent at30 June 20X1, the fair value of the loan at that date can then be calculated by discountingthe cash flows:

52,440,442 =

The amount of 52,440,442 includes accrued interest. To calculate the applicable cleanprice of the loan, the accrued coupon interest of 2.5 million at 30 June is subtractedfrom the fair value. The clean price amounts to 49,940,442.


5,000,000 +

5,000,000 +

5,000,000 +

5,000,000 +

55,000,000 (1.10)0.5 (1.10)1.5 (1.10)2.5 (1.10)3.5 (1.10)4.5


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A comparison of the clean price and amortised cost at 30 June 20X1 results in apositive change in fair value of:

Fair value at 30 June 49,940,442Amortised cost at 30 June 49,081,032

Change in value 859,410

Assume that the measurement for tax purposes is amortised cost and the applicabletax rate is 40 per cent. A deferred tax liability of 343,764 related to the change in fairvalue should be recognised.

The journal entries recognised by Inter Bank are as follows:

Debit Credit

1 January 20X1Available-for-sale assets (notional) 50,000,000Available-for-sale assets (discount) 1,000,000Cash 49,000,000To record the initial amortised cost, being the fair valueat that time of the loan 30 June 20X1

Available-for-sale assets (accrued interest) 2,500,000Available-for-sale assets (discount) 81,032Interest income 2,581,032To recognise the effective interest income (couponplus amortisation)

The accrued interest is presented as an increase in the fair value of the instrument inthe balance sheet, since it is a component of the fair value.

Debit Credit

30 June 20X1Available-for-sale assets 859,410Equity 859,410To record the fair value change during the reporting period

Equity 343,764Deferred taxes (balance sheet) 343,764To record the related deferred tax liability

Continuation of the case (to 20X5):

At 1 January 20X5, Inter Bank sells the loan to another financial institution. The fairvalue of the loan at 1 January 20X5 equals the fair value of the loan at 31 December20X4, and amounts to 49,549,550 based on the current interest rate of 11 per cent onloans with similar maturity and credit risk. Assume that Inter Bank recognised itsfair value adjustment and accrual of interest at 31 December 20X4 and this valuehas not changed.



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The journal entries to record this transaction are as follows:

Debit Credit

1 January 20X5Cash 49,549,550Available-for-sale assets 49,549,550To record the proceeds on sale of the loan

Inter Bank must also recognise the change in fair value that was previously recognisedin equity in the income statement. This difference between the fair value and amortisedcost at 1 January 20X5 is a loss of 208,025 (the fair value of 49,549,550 less theamortised cost of 49,758,075).

Debit Credit

1 January 20X5Realised loss on sale 208,025Deferred taxes (balance sheet) 83,210Equity 124,815To recycle the fair value changes from equity to theincome statement

Current taxes (balance sheet) 83,210Tax expense (income statement) 83,210To record the impact on tax expense of the realised loss

7.3 Foreign currency risk

The example below illustrates how changes in foreign exchange rates affect a debt securityheld as available-for-sale with changes in fair value recognised directly in equity. Exceptfor the measurement at fair value in the underlying foreign currency, the other aspects ofthis example are also applicable to:

■ monetary assets accounted for as originated loans and receivables;

■ monetary assets accounted for as held-to-maturity; and

■ monetary liabilities that are not held for trading.

Case 7.3 Available-for-sale debt security in a foreign currency including amortisation

On 1 January 20X1, Bank A buys a foreign currency (FC) 100 million unlisted bondwith a fixed annual interest coupon of six per cent, maturing at 31 December 20X4.Bank A pays the market price of FC 90,280,840 for this bond. The discount is due tothe market yield for similar bonds at 1 January 20X1 being nine per cent. Bank A willclassify the bond as available-for-sale with changes in fair value recognised directlyin equity. Assume there are no transaction costs. Therefore, the effective interestrate is nine per cent. Bank A will record interest income at nine per cent of amortisedcost using the effective interest rate method on a historical cost basis. For purpose



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of this illustrative example, it is assumed that the use of the average foreign exchangerate provides a reliable approximation of the spot rate applicable to the accrual ofinterest income during the reporting period.

The amortisation schedules in foreign currency (FC) and in measurement currency(MC) are as follows:

Interest EffectiveAmortised cash flow Discount interest

cost (6%) accretion (9%)Date (in FC) (in FC) (in FC) (in FC)

1 January 20X1 90,280,84031 December 20X1 92,406,116 6,000,000 2,125,276 8,125,27631 December 20X2 94,722,666 6,000,000 2,316,550 8,316,55031 December 20X3 97,247,706 6,000,000 2,525,040 8,525,04031 December 20X4 100,000,000 6,000,000 2,752,294 8,752,294

Exchangegain/(loss)

Average Interest Effective in incomeexchange Amortised cash flow Discount interest on debt

rate cost (6%) accretion (9%) security a

Date (in MC) (in MC) (in MC) (in MC) (in MC)

1 January 20X1 – 135,421,260 –31 December 20X1 1.450 129,368,562 8,700,000 3,081,650 11,781,650 (9,134,348)31 December 20X2 1.425 137,347,866 8,550,000 3,301,084 11,851,084 4,678,22031 December 20X3 1.475 145,871,559 8,850,000 3,724,434 12,574,434 4,799,25931 December 20X4 1.525 155,000,000 9,150,000 4,197,248 13,347,248 4,931,193

a Calculated by comparing amortised cost at beginning of the period and amortised cost at end of the period,excluding accretion of the discount during the reporting period.

At 31 December 20X1, the market interest rate for similar bonds (in terms of currency,credit rating and maturity) is 8.5 per cent. Assuming no further changes in interestrates, the fair value in FC and MC (using spot rates) until the redemption of the bond isas follows:

Fair value Fair valueDate Spot rate (in FC) (in MC)

1 January 20X1 1.50 90,280,840 135,421,26031 December 20X1 1.40 93,614,944 131,060,92231 December 20X2 1.45 95,572,214 138,579,71031 December 20X3 1.50 97,695,853 146,543,78031 December 20X4 1.55 100,000,000 155,000,000

21.23, IG E.3.2 Because the bond is a monetary item, foreign exchange differences must be recognisedand E.3.4 in the income statement. For this purpose, the security is treated as an asset measured

at amortised cost in the foreign currency. The difference between the amortised



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cost and fair value in the measurement currency is the cumulative gain or loss reportedin equity.

The exchange differences on the debt security to report in the income statement andthe fair value changes to report in equity are calculated as follows:

Exchange Change inFair value gain/(loss) fair value, Fair value

at beginning on debt excluding at endof reporting Discount security FX of reporting

period accretion (income) (equity) b periodDate (in MC) (in MC) (in MC) (in MC) (in MC)

20X1 135,421,260 3,081,650 (9,134,348) 1,692,360 131,060,92220X2 131,060,922 3,301,084 4,678,220 (460,516) 138,579,71020X3 138,579,710 3,724,434 4,799,259 (559,623) 146,543,78020X4 146,543,780 4,197,248 4,931,193 (672,221) 155,000,000b Calculated by comparing the change in fair value from the beginning of the reporting period to end of the

reporting period, less the discount accretion, less the effect of foreign exchange differences (see a above).

The required journal entries for the first two years are as follows (amounts are in MC,ignoring tax effects):

Debit Credit

1 January 20X1AFS debt security 135,421,260Cash 135,421,260To record the purchase of the bond: FC 90,280,840 atthe spot rate of 1.50

During 20X1Accrued interest receivable 8,700,000AFS debt security (accretion) 3,081,650Interest income (income statement) 11,781,650To record the receivable coupon interest at six per cent(FC 6,000,000) and amortisation of FC 2,125,276.These amounts are recognised at an average FX rateof 1.45

31 December 20X1AFS debt security 1,692,360AFS revaluation allowance (equity) 1,692,360To record the increase in fair value above theamortised cost in the measurement currency

Exchange loss (income statement) 9,434,348AFS debt security 9,134,348Accrued interest receivable 300,000To record the FX adjustment of balance sheet items fromopening and average FX rate to the closing spot rate



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Debit Credit

Cash 8,400,000Accrued interest receivable 8,400,000To record the receipt of interest coupon FC 6,000,000 atthe spot rate of 1.40

During 20X2Accrued interest receivable 8,550,000AFS debt security (accretion) 3,301,084Interest income (income statement) 11,851,084To record the receivable coupon interest at six per cent(FC 6,000,000) and amortisation of FC 2,316,550. Theseamounts were recognised at an average FX rate of 1.425

31 December 20X2AFS revaluation allowance (equity) 460,516AFS debt security 460,516To record the increase in fair value above the amortisedcost in the measurement currency

AFS debt security 4,678,220Accrued interest receivable 150,000Exchange gain (income statement) 4,828,220To record the FX adjustment of balance sheet items fromopening and average FX rates to the closing spot rate

Cash 8,700,000Accrued interest receivable 8,700,000To record the receipt of interest coupon FC 6,000,000at the spot rate of 1.45

Similar journal entries will be made in 20X3 and 20X4.

7.4 Equity price risk

Case 7.4 Measurement of available-for-sale equity securities

On 4 January, Entity M buys 100,000 units of an equity security for 10 million andclassifies these securities as available-for-sale, with changes in fair value recogniseddirectly in equity.

On 15 January, the fair value of the securities increases from 100 to 115. At that datethe entity purchases another 50,000 units. Assuming that the measurement for taxpurposes is cost and the applicable tax rate is 40 per cent.



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The journal entries for the above series of transactions are as follows:

Debit Credit

4 JanuaryAvailable-for-sale assets 10,000,000Cash 10,000,000To record the purchase of the securities

15 JanuaryAvailable-for-sale assets 1,500,000Equity 1,500,000To record the change in fair value from 100 to 115 on100,000 units

Equity 600,000Deferred taxes (balance sheet) 600,000To record the related deferred tax liability

Available-for-sale assets 5,750,000Cash 5,750,000To record the purchase of 50,000 securities

At 31 January, the fair value of the securities increases from 115 to 125. The journalentry to record the change in fair value is:

Debit Credit

31 JanuaryAvailable-for-sale assets 1,500,000Equity 1,500,000For the increase in fair value from 115 to 125 on150,000 units

Equity 600,000Deferred tax (balance sheet) 600,000To record the related deferred tax liability

Entity M decides to sell 25,000 of the units for 125 on 1 February. The financialinstruments standards do not specify what method, e.g. FIFO, average purchase priceor specific identification, should be used to calculate the gain (or loss) on the partialdisposal. Therefore, Entity M may opt for any one of these methods. The method usedshould be applied consistently and disclosed as an accounting policy note.

If Entity M applies the FIFO method, the profit would be 125 – 100 = 25 per share, i.e.625,000 for the sale of 25,000 shares.



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The journal entries are as follows:

Debit Credit

1 FebruaryCash 3,125,000Available-for-sale assets 3,125,000To record the proceeds from the sales

Deferred taxes (balance sheet) 250,000Equity 375,000Gain on sale of securities (income statement) 625,000To record the realisation of the gain on the sale, recycledfrom equity

Tax expense (income statement) 250,000Current taxes 250,000To record the impact on tax expense of the realised gain

7.5 Credit risk

The calculation of the impact of credit risk on the measurement of financial assets thatare measured at fair value is similar to the impact of interest rate risk. Therefore, thecases included in Section 7.2 may be used as reference when remeasuring a financialasset for changes in credit risk.

7.5 Credit risk



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8.1 Overview

8. Hedge accounting


■■■■■ Hedging versus hedge accounting

■■■■■ The hedge accounting models:

– Fair value hedge

– Cash flow hedge

– Hedge of a net investment in a foreign entity

■■■■■ Hedged items and hedging instruments

■■■■■ Hedge documentation

■■■■■ Hedge effectiveness

■■■■■ Highly probable transactions

■■■■■ Termination of a hedge relationship

■■■■■ Net position hedges


8.1 Overview

This Section provides an overview of the general principles for hedge accounting. Specificissues relating to hedging of different types of risks (currency risk, interest rate risk etc.)as well as examples of hedge accounting are included in Section 9.

Entities carry out hedging activities in order to limit their exposure to different financialrisks such as currency risk, interest rate risk, price risk etc. These activities often consistof entering into a derivative contract with a counterparty to eliminate or limit the risk.

IAS 39 does not change the principles that underpin entities’ hedging activities, but setsout the requirements related to the accounting for such activities. The term hedgingrefers to a risk management strategy, while hedge accounting refers to the accountingmethod entities may choose to reflect hedging activities in their financial statements.

Application of hedge accounting is not mandatory and in principle can be chosen on atransaction-by-transaction basis. In determining whether and to what extent hedgeaccounting should be applied, entities may need to consider the possible trade-off betweenthe cost of implementing hedge accounting (i.e. changes to systems and processes) andthe potential volatility in reported earnings when hedge accounting is not applied. Someentities may find it useful to apply hedge accounting only to a small number of significanttransactions, yet by doing so significantly reduce the volatility in earnings. For other entities,especially financial institutions, the ability to apply hedge accounting may be a necessity.


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8.2 Hedge accounting basic concepts

Regardless of the type of financial risk exposure, hedge accounting usually involves anumber of the same key steps in order to comply with IAS 39 requirements. These willeach be described in detail in the Sections noted.

Table 8.1 Steps in the hedging process

At inception of a hedge

Step 1 – Determine the need for hedging Section 8.2

Step 2 – Choose a hedge accounting model Section 8.3

Step 3 – Determine whether hedge criteria are met Section 8.6

Step 4 – Prepare hedge documentation Section 8.6

Ongoing (at least each reporting date)

Step 5 – Measure actual hedge effectiveness Section 8.6

Step 6 – Reassess prospective hedge effectiveness Section 8.6

Step 7 – Reassess hedge relationships and need for de-designation Section 8.7

Step 8 – Prepare hedge accounting journal entries Section 9


8.2.1 Terminology

39.9 IAS 32 and IAS 39 use a variety of terms to describe the components in a hedge relationshipwhere hedge accounting is applied:

■ Hedged item: An asset, liability, firm commitment, or forecasted transaction thatexposes the entity to risk of changes in fair value or future cash flows, and that hasbeen designated by an entity as being hedged.

■ Hedging instrument: A designated derivative or, in limited circumstances, anotherfinancial instrument whose changes in fair value or cash flows are expected to offsetchanges in the fair value or cash flows of a designated hedged item.

■ Hedge effectiveness: The degree to which changes in a hedged item’s fair value orcash flows attributable to a hedged risk are offset by changes in the fair value or cashflows of the hedging instrument.

39.72 and 78-80 Derivatives and certain foreign currency denominated non-derivative financial instruments,or proportions thereof, can be hedging instruments. A hedged item can be a singleinstrument, a portfolio or an entire position or part of a position, where the part is aproportion, a measurable risk or an amount.

39.88 Hedge accounting may only be applied if the following strict criteria, discussed in moredetail later in this Section, are met:

■ the hedge relationship is designated and documented at inception;


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■ the hedge is expected to be highly effective at inception and throughout the life of thehedge relationship;

■ hedge effectiveness can be reliably measured on an ongoing basis; and

■ in the case of hedging of a future cash flow, cash flows are highly probable of occurring.

When a hedge does not meet the hedge accounting criteria, the hedging instrument andthe hedged position must be accounted for in accordance with the normal requirementsfor each particular instrument. For derivatives this means measurement at fair value withchanges recognised in the income statement.

39.86 The hedge accounting models specified in IAS 39 are:

■ the fair value hedge accounting model, to be applied when hedging the fair value ofassets and liabilities already recognised in the balance sheet;

■ the cash flow hedge accounting model, to be applied when hedging future contractedor expected cash flows; and

■ the hedge of a net investment in a foreign entity.

8.2.2 The need for hedge accounting

Hedge accounting is sometimes necessary due to accounting mismatches in:

■ Measurement – some financial instruments (non-derivative) are not measured at fairvalue with changes being recognised in the income statement whereas all derivatives(which are commonly used as hedging instruments) are measured at fair value; and

■ Recognition – future transactions that may be hedged are not recognised in the balancesheet or are included in the income statement only in a future reporting period.

Examples of measurement mismatches include the hedge of interest rate risk on fixedrate debt instruments that are not held for trading and the hedge of foreign currency andother price risk on equity shares that are held as available-for-sale with fair value changesrecognised directly in equity. Recognition mismatches include the hedge of contracted orexpected but not yet recognised sale, purchase or financing transactions in foreigncurrencies and future (committed) variable interest payments.

In order for the income statement to reflect the effect of the hedge, it is necessary tohave matching in the recognition of gains and losses on the hedging instrument and thehedged item. Matching can be achieved in principle by delaying the recording of certaingains and losses on the hedging instrument or by accelerating the recording of certaingains and losses on the hedged item in the income statement. Both of these techniquesare used under IAS 39, depending on the nature of the hedging relationship.


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8.3 The hedge accounting models


8.3.1 Fair value hedge accounting model

A fair value hedge seeks to offset certain risks of changes in the fair value of an existingasset or liability that will give rise to a gain or loss being recognised in the income statement.IAS 39 defines a fair value hedge as:

39.86 A hedge of the exposure to changes in the fair value of a recognised asset or liability,or an identified portion of such an asset or liability; and that is attributable to a particularrisk and that will affect reported net income.

39.AG102 An example of a fair value hedge is the hedge of a fixed rate bond with an interest rateswap, changing the interest rate from fixed to floating. Another example is the hedge ofthe changes in value of inventory using commodity forwards.

The accounting for a fair value hedge essentially overrides the normal measurementprinciples for financial instruments discussed in earlier Sections. The adjusted carryingamounts of assets in a fair value hedging relationship are subject to impairment testing.The applicable standards are IAS 39 for financial assets and IAS 36 Impairment ofAssets for non-financial assets.

Figure 8.1 Fair value hedge accounting

The fair value hedge accounting method can be summarised as follows:

39.89 ■ The hedging instrument is measured at fair value, with fair value changes recognisedin the income statement.

39.89 ■ A hedged item otherwise carried at (amortised) cost is adjusted by the change in fairvalue that is attributable to the risk being hedged. This adjustment is recognised in theincome statement to offset the effect of the gain or loss on the hedging instrument.

39.89 ■ An available-for-sale hedged item whose fair value changes are otherwise recognisedin equity continues to be adjusted for fair value changes. However, the part of the fairvalue change that is attributable to the risk being hedged is recognised in the incomestatement rather than in equity.


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IG E.4.4 ■ The adjustment of the carrying amount of the hedged item changes the effectiveinterest rate of interest-bearing hedged items. As a result the income or expenserelating to those hedged items includes the original amortisation of any discount orpremium as well as the amortisation of the adjustment to the carrying amount resulting

39.92 from the fair value hedge. Amortisation of the adjustment should begin no later thanwhen the hedged item ceases to be adjusted for changes in the fair value attributableto the risk being hedged.

■ The net effect of the hedge in the income statement represents:

– the ineffective portion of the fair value hedge; and

39.74 – changes in fair value of the derivative that have been excluded by the entity’schoice from the hedge relationship (e.g. time value of options and forward pointsof foreign currency forward contracts).

39.90 ■ The gains and losses attributable to risks other than the hedged risk follow the normalmeasurement principles (e.g. a bond hedged for interest rate risk is not adjusted forfair value changes due to changes in credit risk).


39.86 The amended standard requires that a hedge of a firm commitment should beaccounted for as a fair value hedge. This means that changes in value of the (as yetunrecognised) contract will be recognised on balance sheet. The existing standardrecognises that a firm commitment gives rise to a fair value exposure, but requirescash flow hedge accounting. The definition of a fair value hedge in the amendedstandard is amended accordingly.

39.87 However, under the amended standard, a hedge of the foreign currency risk on a firmcommitment in a foreign currency may be accounted for as a cash flow hedge.

8.3.2 Cash flow hedge accounting model

A cash flow hedge is defined as:

39.86 A hedge of the exposure to variability in cash flows that: (i) is attributable to a particularrisk associated with a recognised asset or liability (such as all or some future interestpayments on variable rate debt) or a forecasted transaction (such as an anticipatedpurchase or sale); and that (ii) will affect reported net profit or loss.

An example of a cash flow hedge is the hedge of future expected sales in a foreigncurrency or of future floating interest payments on a recognised liability.

39.95 The hedging instrument is measured under the normal IFRS principles, but any gain orloss that is determined to be an effective hedge is recognised in equity. This is intended toavoid volatility in the income statement in a period when the gains and losses on thehedged item are not (yet) recognised in the income statement. Any ineffective part of thehedge is recognised in the income statement.


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39.97 In order to match the gains and losses of the hedged item and the hedging instrument inthe income statement, the changes in fair value of the hedging instrument recognised inequity must be removed from equity and recognised in the income statement at the sametime that the cash flows from the hedged item are recognised in the income statement(sometimes referred to as recycling).

39.97 and 98 However, when the hedged item is an expected future transaction that results in therecognition of an asset or a liability, the gain or loss on the hedging instrument will berecognised as an adjustment to the initial recognition amount of the asset or liability (oftenreferred to as a basis adjustment). For example, an entity may hedge the foreign currencyrisk from an expected purchase of inventory in a foreign currency using a forward contract.When the inventory is recognised in the balance sheet the gain or loss on the forwardcontract is recognised as part of the carrying amount of the inventory.

Once the expected future transaction occurs, assets arising from the hedge may be subjectto other standards, for example, IAS 36 for impairment testing or IAS 2 Inventories fortesting net realisable value.

39.97 The basis adjustment will affect the income statement either through amortisation,depreciation, impairment or on disposal / derecognition. For example, a basis adjustmentincluded in the carrying amount of inventory would be recognised in the income statementas part of the cost of sales when the inventory is sold.

Figure 8.2 Cash flow hedge accounting

The cash flow hedge accounting method can be summarised as follows:

■ No accounting entries are required in respect of the hedged future cash flow, whetherthis is the expected cash flow from a future purchase or sales transaction or fromfuture interest cash flows related to an existing asset or liability.

21.23 ■ The hedging instrument is measured at fair value (for a foreign currency hedging instrumentthat is not a derivative, this applies only to changes in foreign exchange rates).

39.95 and 96 ■ The change in fair value that relates to the effective part of the hedge is recogniseddirectly in equity. The ineffective part and the fair value changes of the derivativethat have been excluded by the entity’s choice from the hedge relationship (e.g. timevalue of options and forward points of forward contracts) are recognised in theincome statement.


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39.100 ■ Fair value changes remain in equity until the hedged cash flow is recognised. The gainsand losses recognised in equity are included in the income statement in the sameperiod(s) as the cash flows of the hedged item.


39.86 As noted above, the fair value hedging model will be required, under the amendedstandards, to be used for most hedges of firm commitments. The exception is a firmcommitment in a foreign currency, which may be accounted for as a cash flow hedge.

The amendments limit the use of ‘basis adjustment’. Under the existing standard, basisadjustment is required for a cash flow hedge in which the hedged cash flow results ina recognised asset or liability.

39.97 Under the amended standards, basis adjustment will be prohibited for cash flow hedgesthat result in a recognised financial asset or financial liability. An example would be ahedge of the interest rate risk in a forecast issuance of a bond, using an interest rateswap. Under the existing standards, fair value changes on the swap would be initiallydeferred in equity, to the extent the hedge is effective, until the date of issue of thebond. At that date, the accumulated amount deferred in equity would be adjusted againstthe initial carrying amount of the bond and would subsequently be amortised as part ofthe effective yield calculation. Under the amended standards, the amount deferred inequity would remain there, but would be amortised from equity into the income statementover the life of the bond, also on an effective yield basis.

39.98 In respect of hedged purchases of non-financial assets such as inventory or property,plant and equipment, basis adjustment will be permitted under the amended standards,but not required. The approach adopted must be applied consistently as an accountingpolicy choice to all cash flow hedges that result in the acquisition of a non-financialasset or non-financial liability. In most cases, basis adjustment will be more straightforwardas it does not require tracking of the amount deferred in equity over long periods. If abasis adjustment approach is not followed, such tracking would be required in order tocalculate the amount to be released into profit or loss in each reporting period and forimpairment testing purposes. On the other hand, US GAAP does not permit basisadjustment, and therefore an entity that also reports under US GAAP may avoid areconciling item in this respect by choosing not to apply basis adjustment.

8.3.3 Net investment hedging

39.102, 21.39 An investor in a foreign entity is exposed to changes in value of the net assets of theand SIC-19.4 foreign entity (i.e. the net investment) arising from the translation of the net assets into

the group’s measurement currency. Such exposures are often hedged through borrowingsdenominated in the foreign entity’s measurement currency or (in more limitedcircumstances) derivative foreign currency contracts. Principles relating to hedging ofnet investments in a foreign entity are:

21.39 ■ gains and losses on a net investment in a foreign entity are recognised directly in equity;

■ corresponding gains and losses on related foreign currency liabilities used as hedginginstruments are also recognised directly in equity; and


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21.48 ■ any net deferred foreign currency gains and losses are recognised in the incomestatement at the time of disposal of the foreign entity.

39.88 and 102 IAS 39 does not override the principles of IAS 21. However, IAS 39 introduces the hedgeaccounting criteria to hedging of net investments. This means that all the criteria discussedin Section 8.6, such as documentation and effectiveness assessment, must be met for thehedge of a net investment in a foreign entity. An entity must still adhere to the criteria fordesignation and assessing effectiveness even when using non-derivative hedging instruments.

8.3.4 When is hedge accounting not required?

When the hedging instrument and the hedged item are already accounted for in the samemanner, the effects of the hedge relationship will automatically be reflected in the incomestatement or in equity, making hedge accounting unnecessary. However, the applicationof hedge accounting is not prohibited, provided that all hedge accounting criteria are met.

Hedge accounting generally is not required for:

■ hedging of trading items when changes in fair value are recognised directly in theincome statement. In this case both items are already recognised at fair value withgains and losses included in the income statement; and

21.39 ■ hedging of foreign currency risk of monetary items. For example, when a financialliability in a foreign currency is hedged with a deposit placement in the same currency,the liability as well as the deposit is required to be measured at the applicable closingspot rates with changes recognised in the income statement.

21.23 However, hedge accounting is not prohibited and may be advantageous in somecircumstances. For example, an entity may wish to hedge the foreign currency risk on along-term foreign currency trade payable due in one year’s time. To do this the entitytakes out a forward with a maturity of one year. The trade payable is translated into theentity’s measurement currency at each reporting date at the closing spot rate while theforward is measured at its fair value based on the forward rate (not spot rate). In caseswhere the spot / forward differential is significant and volatile, this difference in ratesmay cause undesirable volatility in the income statement.

39.AG110 and Overall business risks cannot qualify for hedge accounting, as they cannot be separatelyIG F.2.8 and reliably measured. For instance, the risk of obsolescence in inventory or expropriation

by a government cannot be hedged since those risks are not measurable. Also the risk oftransactions not occurring falls into this category of overall business risks.


39.9 The amended standard permits an entity, on initial recognition, to designate any financialasset or liability at ‘fair value through profit or loss’. As noted in Sections 5.2.1 and5.3.1, this may allow an entity to avoid the cost and complexity of meeting the criteriafor hedge accounting.


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8.4 Hedged items

8.4 Hedged items

39.9 The hedged item is the underlying item that is exposed to the specific financial risk that anentity has chosen to hedge.

8.4.1 What qualifies as a hedged item?

In general the hedged item can be:

39.78 ■ a recognised asset or liability;

■ an unrecognised firm commitment; or

■ an uncommitted but highly probable anticipated future transaction (forecasted transaction).

39.80, 86, AG110 Hedge accounting may only be applied to hedges of exposures that can affect the incomeand SIC-16 statement. Most transactions can affect the income statement. Exceptions are transactions

with shareholders such as share issuances, dividend payments etc. as well as mostintragroup transactions.

39.AG110 A key requirement is that the hedged item exposes the entity to a risk that can be separatelyidentified and reliably measured throughout the period of the hedge. Exposures to financialmarket risks such as interest rate risk and foreign currency risk in financial instrumentscan usually be separately identified and reliably measured. Also, exposure from itemswith commodity price risk or credit risk may be hedged.

IG F.2.10 and The forecasted purchase of an asset to be classified as held-to-maturity may be hedgedF.2.11 for the period until the asset is recognised on the balance sheet. Although a held-to-

maturity instrument may not be hedged for interest rate risk, the reinvestments of cashflows generated by a held-to-maturity instrument may be hedged. Additionally, a held-to-maturity investment can be hedged with respect to credit risk and foreign currency risk.

IG F.2.19 Non-monetary items (such as equity shares) denominated in a foreign currency and heldas available-for-sale with changes in fair value recognised in equity also may be thehedged item.

Case 8.1 Hedge of a non-monetary item

Entity A acquires equity shares in Entity B on a foreign stock exchange (shares aredenominated in a foreign currency). Entity A classifies the shares as available-for-saleinstruments with changes in the fair value recognised in equity. To hedge against foreigncurrency risk, Entity A enters into a forward currency contract. Entity A plans torollover the contracts as they expire until the shares are later sold. In this situation theforward contract may be designated as a hedging instrument for the fair value changesrelating to foreign currency risk of the shares provided that:

■ the acquired shares are not traded on a stock exchange on which trades aredenominated in the same currency as Entity A’s own measurement currency. Thismight be the case if Entity B’s shares are dual-listed and one of the listings is on anexchange where trades are denominated in Entity A’s measurement currency; and

■ dividends to Entity A are not denominated in Entity A’s (but rather Entity B’s)measurement currency.


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8.4 Hedged items

8.4.2 Items that do not qualify as hedged items

There are a number of items that for different reasons do not qualify for hedgeaccounting. In these cases the normal recognition and measurement principles in IAS 39must be applied.

39.78, 79 and ■ IAS 39 generally precludes derivatives from being the hedged item and as suchIG F.2.1 derivatives can only serve as hedging instruments.

39.78 and 79 ■ Unlike originated loans and receivables, a held-to-maturity investment cannot be ahedged item with respect to interest rate risk. In theory, for fixed rate held-to-maturityinstruments, an entity should be indifferent to changes in interest rates since the entitydoes not intend to dispose of the investment before its maturity. The fair value atmaturity is unaffected by changes in interest rates.

■ Because prepayment risk on interest-bearing instruments is primarily a function ofinterest rate changes this risk is akin to interest rate risk and hence cannot be hedgedwhen the hedged item is a held-to-maturity investment.

IG F.2.10 ■ The prohibition against hedging interest rate risk on held-to-maturity investments relatesto both hedging the risk of fair value changes of a fixed rate instrument and the risk ofvariability in the interest cash flows of variable rate instruments.

39.82 and AG100 ■ When the hedged item is a non-financial asset or liability, the hedge must either bedesignated for the foreign currency risk only or for the entire risk of the asset, liabilityor cash flow. This is because of the difficulty of isolating and measuring the appropriateportion of the cash flows or fair value changes attributable to specific risks other thanforeign currency risks.

39.AG99 ■ An equity investment accounted for under the equity method (joint venture or associate)cannot be a hedged item in a fair value hedge. The reason is that the equity method ofaccounting recognises the investor’s share of the investee’s net income or loss, ratherthan its fair value changes, in the income statement.

■ The same reasoning applies to an investment in a consolidated subsidiary, which alsocannot be a hedged item in a fair value hedge. Through consolidation the parent entityrecognises its share of the subsidiary’s net income rather than the fair value changes inits investment in the subsidiary. To allow the subsidiary to be a hedged item would resultin double counting, as both the income from the investment in the subsidiary and the fullfair value changes would be recognised in the consolidated income statement.

39.88 ■ Groups with foreign entities may wish to hedge the foreign currency exposure fromthe expected profits from the foreign entities using derivatives or other financialinstruments. However, expected net profits from a foreign entity do not qualify ashedged items since they are not subject to a cash flow risk exposure.

21.39 ■ From a foreign entity’s own perspective, cash flows generated from its operationsare in its own measurement currency and hence do not give rise to a foreign currencyrisk exposure at the foreign entity reporting level.

SIC-16 ■ An entity’s own equity instruments cannot be the hedged item since there is no riskexposure that affects the income statement because transactions in own shares are

IG F.2.7 recognised directly in equity. Likewise forecasted transactions in an entity’s ownequity cannot be a hedged item.


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8.4 Hedged items

8.4.3 Hedging a portfolio of items

A hedge relationship may be established not only for a single asset, liability or expectedtransaction, but also for a portfolio of items. Hedging a portfolio requires that:

■ the individual assets, liabilities or future transactions in the portfolio share the samecharacteristics with respect to the hedged risk; and

39.83 ■ the change in fair value attributable to the hedged risk for each individual item in theportfolio is expected to be approximately proportional to the overall change in fairvalue attributable to the hedged risk of the group.

This means that the portfolio of items must have shared risk characteristics with respectto the risk being hedged. It is not necessary that each item in the portfolio shares all of thesame risks and is correlated with respect to all risks, as long as the hedged risk is acommon risk characteristic.

Examples of items that may be hedge accounted for on a portfolio basis include the following:

■ A portfolio of short-term corporate bonds may be hedged as one portfolio with respectto a shared risk-free interest rate. To achieve the required correlation, the bondswould need to have the same or very similar maturity or repricing date and exposureto the same underlying interest rate.

■ A group of expected future sales may be hedged as one portfolio with respect to foreigncurrency risk. Such correlation usually requires that the individual sales are denominatedin the same foreign currency and are expected to take place in the same time period.

IG F.2.20 An example of a portfolio that would not qualify as a hedged item is a portfolio of differentshares that replicates a particular stock index. An entity may hold such a portfolio andeconomically hedge this with a put option on the stock index. However, in this scenario, itcannot be expected that the fair value changes of individual items in the portfolio wouldbe approximately proportional to the fair value change of the entire group.

Future amendments to IAS 39

At the date of this publication, the IASB is finalising its deliberations in respect of FairValue Hedge Accounting for a Portfolio Hedge of Interest Rate Risk. It is anticipatedthat, when issued, this will introduce a number of additional requirements for this formof hedge accounting.

8.4.4 Hedging risk components and proportions of items

Hedging a risk component of a financial instrument

39.81 Financial assets or liabilities may be hedged with respect to a particular financial riskcomponent, provided that the exposure to the particular risk component is separable andcan be reliably measured. Examples of such risk components include:

39.81 and ■ Hedging exposure to interest rates or credit risk spread of a bond (rather than hedgingIG F.3.5 the full market risk).

■ Hedging exposure to the risk-free interest rate in a fixed or floating rate liability(rather than hedging the entire interest rate risk).


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8.4 Hedged items

IG F.2.19 ■ Hedging foreign currency exposure only in a portfolio of foreign currency denominatedequity instruments (rather than hedging the full market price risk).

IG F.3.5 ■ A floating rate debt instrument is normally considered not to have fair value exposurebecause of periodic resetting of its interest rate. However, such an instrument couldbe hedged in a fair value hedge for credit spread or for interest rate risk exposure thatcan occur between interest reset dates.

Hedging a risk component of a non-financial item

39.82 Non-financial items may not be hedged for separable risk components other than foreigncurrency risk. That is because only foreign currency risk is assumed to be a separatelymeasurable risk component.

39.AG100 A price risk relating to a non-financial component may not be hedged. For example, aproducer of chocolate bars may wish to hedge the fair value of its inventory in respect ofchanges in the sugar price (a major ingredient in chocolate bars) by taking out a sugarforward in the commodity market. It would not be permissible in this situation to designateas the hedged item the price risk relating only to the price of sugar. As an alternative theproducer may designate the sugar forward as a hedge of the entire fair value changes ofthe chocolate bar inventory. However, this hedge is only likely to be effective if the pricefluctuations on sugar and chocolate bars have been highly correlated in the past and areexpected to remain so in the future. As chocolate bars consist of other ingredients thansugar (e.g. cocoa, milk etc.), the hedge is unlikely to be highly effective, and in that casehedge accounting would not be permissible.

Hedging a proportion of a hedged item

39.81 IAS 39 also allows a proportion of the fair value or cash flows of an item to be hedged.Examples of such designations would be:

IG F.2.17 ■ Hedging the interest rate risk for the first five years of a 10-year fixed rate bond witha five-year pay-fixed receive-floating interest rate swap. In this situation the bond ishedged for a period of time less than its full term.

IG F.3.10 ■ Hedging the price or foreign currency risk of a proportion of a forecasted purchaseor sale. This can be done either by specifying the number of units expected to bepurchased / sold (e.g. the first 500 units out of expected purchases / sales of800 units) or by specifying the monetary value of the purchase or sale (e.g. the first25 million). It would not be permissible to designate the first 50 per cent of sales asthe hedged item as this designation would not lead to an identifiable amount beinghedged (i.e. the first 50 per cent of sales would depend on the total amount of salesin the period, which is not known until after the fact) and hedge effectivenesstesting would not be possible.

■ Hedging the interest rate risk of half of the notional amount of a bond.


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8.4 Hedged items


39.AG100 Several comments on the proposed amendments had proposed that separate componentsof a non-financial item should qualify for hedge accounting as long as changes in thefair value of the hedged component could be measured reliably. The Board rejectedthis suggestion, but has clarified in the amended standards that hedge accounting mightbe achieved by adjusting the hedge ratio to maximise effectiveness.

For example, a regression analysis might be performed to establish a statistical relationshipbetween the price of a transaction in Brazilian coffee (the hedged item) and a hedginginstrument whose underlying is the price of Columbian coffee. If there is a valid statisticalrelationship between the two prices, the slope of the regression line can be used toestablish the hedge ratio that will maximise expected effectiveness. For example, if theslope of the ‘line of best fit’ is 1.02, then a derivative with a notional amount of 1.02tons of Columbian coffee would be designated as a hedge of the purchase of one tonof Brazilian coffee.

This approach will give rise to some ineffectiveness in practice, although it may besufficient to ensure that hedge accounting can be achieved. The amended standardswill continue, however, to prohibit the hedged item to be designated as the Columbiancoffee component of the Brazilian coffee price, even if that component can be provento exist and can be measured reliably.

8.4.5 Intragroup balances or transactions as the hedged item

39.80 and 21.45 Although intragroup transactions are eliminated on consolidation, intragroup monetaryitems can be designated as hedged items at the group level in situations where foreignexchange rate exposure cannot be eliminated on consolidation. Intragroup monetary itemslead to a group exposure that affects the group income statement in instances when:

■ items have been transacted between group entities with different measurement currencies;

■ the item is denominated in one of these measurement currencies; and

■ at least one of the group entities is a foreign entity.

For example, an intragroup payable / receivable between a parent with measurementcurrency (MC) and its foreign subsidiary is denominated in foreign currency (FC).The transaction itself is eliminated on consolidation. However, the parent still has foreignexchange rate differences since the item is denominated in FC. Therefore, the foreignexchange difference cannot be eliminated. Such an intragroup monetary item could qualifyas a hedged item for purposes of hedge accounting if all other criteria are met.


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8.5 Hedging instruments


In amending the standards, the guidance permitting a forecasted intragroup transactionto qualify as a hedged item in a cash flow hedge has been withdrawn. The reason forthis amendment would seem to be that the foreign exchange risk in most forecastedintragroup transactions will affect group profit or loss only indirectly as a result oftranslating the income statement of a foreign entity for consolidation purposes into thereporting currency of the group.

A forecast intragroup transaction, or an intragroup firm commitment, cannot qualify asa hedged item at the group level if there is no potential impact on the profit or loss ofthe group. At the group level, a forecast external transaction by a foreign entity in itsown functional currency cannot generally qualify as a hedged item because the grouphas no exposure to foreign currency cash flow risk. However, where the group is ableto demonstrate, for example, that cash flows from the forecast external transactionare passed directly to an entity with a different functional currency, such that theforecast external transaction does create a foreign currency cash flow exposure to thegroup, then the standard may not preclude a forecast external foreign currency cashflow from qualifying as a hedged item, at the group level only, as long as the othercriteria for hedge accounting are met.


8.5.1 What qualifies as a hedging instrument?

39.72 Derivatives are generally the only instruments that can be used as hedging instruments.Some of the derivatives that are commonly used in hedging transactions and may qualifyfor hedge accounting include:

■ forward and futures contracts;

■ swaps;

■ options; and

■ compound derivatives (such as cross currency interest rate swaps and collars).

Non-derivative financial assets or liabilities may be designated as hedging instruments forhedges of foreign currency risk only. For example, a borrowing denominated in a foreigncurrency can be designated to hedge a sales commitment in the same foreign currency.

39.77 It is possible to use two or more derivatives, or proportions thereof, as the hedging instrumentfor the same hedged item. The derivatives do not have to be entered into with the samecounterparty. For example, an interest rate swap and a currency forward could bedesignated together to hedge a loan in a foreign currency.

39.AG96 Generally financial assets and liabilities whose fair value cannot be reliably measuredalso cannot be hedging instruments. An exception is a non-derivative instrument that isdenominated in a foreign currency, that is designated as a hedge of foreign currency risk,and whose foreign currency component is reliably measurable.


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39.AG97 An entity’s own equity securities cannot be hedging instruments since they are not financialassets or financial liabilities of the issuing entity.

8.5.2 Using options as hedging instruments

39.74 and AG94 Purchased options may be used as hedging instruments provided that the criteria inSection 8.6 are met. Options, in contrast to forward and futures contracts, contain bothan intrinsic value and a time value due to the nature of the instrument, i.e. the holder hasa right, but not an obligation, to use the derivative.

For example, a forecasted transaction in a foreign currency may be hedged with anoption. In this situation the cash flows of the forecasted transaction do not include a timevalue component while the option does. If the option is designated in its entirety (includingtime value) hedge effectiveness testing must be based on the full fair value change of theoption and the change in cash flows of the forecasted transaction. The change in fairvalue of the option and the change in cash flows of the forecasted transaction will not bethe same, since the change in the time value element of the option is not offset by anequal and opposite change in the forecasted transaction.

39.74 IAS 39 allows for the time value of an option to be excluded from the effectivenessassessment. In this case the option is more likely to be effective in matching the changesin the hedged item. Changes in time value would not be included in the hedge relationshipand as a result would be recognised directly in the income statement regardless of whichhedging model is used.

8.5.3 Written options

39.AG94 Written options generally increase risk exposure and, accordingly, cannot be used ashedging instruments unless they are designated as an offsetting hedge of a purchased

IG F.1.3 option. For example, hedge accounting may be applied when a written option is related toa purchased option embedded in a contract, such as callable debt, that is closely relatedand for that reason not separated from the host contract. If the embedded purchasedoption were to be separated, hedge accounting would not need to be applied, since boththe separated purchased option and the written option would be measured at fair value inthe income statement.

Some hedging strategies involve a written call option and a purchased put option withdifferent strike prices, in combination forming a collar. Such a strategy may be used insituations where an entity wants to limit its hedging costs by reducing the hedge protectionto a certain range of prices or rates. For example, an entity may hedge a bond held asavailable-for-sale with fair value changes recognised directly in equity, by buying a putoption to sell at 90 and writing a call option to sell at 100. The effect of the strategy is thatthe entity is protected against decreases in value below 90, but has given up the upsidepotential of a price increase above 100. This is demonstrated in Figure 8.3.



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Figure 8.3 Using a collar as the hedging instrument

39.AG94 and Hedge accounting may be applied to such a hedging strategy provided that:IG F.1.3

■ no net premium is received either at inception or over the life of the combination ofoptions (if a premium was received it would be evidence that the instrument was anet written option);

■ the options have similar critical terms and conditions, with the exception of strikeprices (same underlying variable or variables, currency, denomination and maturitydate); and

■ the notional amount of the written option component is not greater than the notionalamount of the purchased option component.

8.5.4 Using a part of an instrument as the hedging instrument

39.75 A proportion of a financial instrument may be designated as the hedging instrument(i.e. a percentage of the whole instrument). For example, 50 per cent of the fair valuechanges on a forward contract may be designated as the hedging instrument in a hedgeof a forecasted sale.

39.75 and Derivatives as well as non-derivatives must be designated as hedging instruments for theIG F.6.2(i) entire remaining period in which they are outstanding. For instance, an instrument

with a maturity of 10 years cannot be designated as a hedging instrument for only itsfirst eight years.

39.75 A hedging instrument, or a proportion thereof, should be designated in its entirety, sincethere is normally a single fair value measure for a hedging instrument and the factors(i.e. risk components) that cause changes in fair value are co-dependent. While using anentire instrument or a proportion of an instrument is acceptable for hedge accounting,using only a portion (e.g. a risk component) generally is not allowed. For example, a cross



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currency interest rate swap must be designated both with respect to foreign currency riskand interest rate risk.

There are a few exceptions to consider:

39.72 ■ A non-derivative instrument may be designated as a hedging instrument for foreigncurrency risk only. To allow non-derivatives to be used in situations other than hedgingforeign currency risk would create difficulties, since in many instances theseinstruments are not measured at fair value.

39.74 ■ The interest element of a foreign currency forward contract may be excluded from ahedge relationship when measuring hedge effectiveness. The time value of an optionlikewise may be excluded from a hedge relationship.

39.76 ■ A derivative hedging instrument may be designated for a particular risk providing thatthe other parts of the hedging instrument are designated as hedging other risks of the

IG F.1.12 hedged item and all other hedge criteria are met. For example, a cross currencyinterest rate swap may be designated as a cash flow hedge with respect to interest

IG F.2.18 rate risk and fair value hedge with respect to foreign currency risk. However, thismay create practical difficulties in separating fair values between risks that are inter-related. Where possible a cross currency interest rate swap should be designated inits entirety as a fair value or cash flow hedge.

Case 8.2 Hedging with a cross currency interest rate swap (CCIRS)

Entity A with EUR as its measurement currency issues a floating rate GBPdenominated bond. Entity A also has a fixed rate USD financial asset with the samematurity and payment dates. In order to offset the currency and interest rate risk onthe financial asset and liability Entity A enters into a swap to pay USD fixed andreceive GBP floating.

IG F.2.18 The swap may be designated as a hedging instrument of the USD financial assetsagainst the fair value exposure from changes in the US interest rates and the foreigncurrency risk between USD and GBP. Alternatively, it could be designated as a cashflow hedge of the cash flow exposure from the variable cash outflows of the GBPbond and the foreign currency risk between USD and GBP. Both of these designationswould be permissible under IAS 39, although the hedge does not convert the currencyexposure to the entity’s measurement currency EUR. In our view, this type of hedge isappropriate only as long as an entity has both foreign currency exposures and is notcreating a new foreign currency position but rather decreasing its risk exposure.Both currency exposures should be referred to in the hedge documentation.


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8.6 Criteria for hedge accounting

39.88 The hedge relationship must meet the following criteria in order for the hedging instrumentand the hedged item to qualify for hedge accounting:

■ the hedge is formally documented at inception;

■ the hedge is expected to be highly effective;

■ the effectiveness of the hedge can be reliably measured;

■ the hedge is assessed prospectively on an ongoing basis, and determined to havebeen highly effective over the full period; and

■ for cash flow hedges, a forecasted transaction must be highly probable and mustpresent an exposure to variations in cash flows that could ultimately affect reportednet income.

The hedge relationship should be evidenced and driven by management’s approach torisk management and the decision to hedge the particular risk. The designation andeffectiveness assessment should principally follow the methodologies that managementhas in place for risk identification and measurement.

8.6.1 Formal documentation at inception

39.88 At the inception of the hedge, formal documentation of the hedge relationship mustbe established.

The hedge documentation prepared at inception of the hedge must include a descriptionof the following:

■ the entity’s risk management objective and strategy for undertaking the hedge;

■ the nature of the risk being hedged;

■ clear identification of the hedged item (asset, liability or cash flows) and the hedginginstrument; and

■ how hedge effectiveness will be assessed prospectively and measured on an ongoingbasis. The method and procedures should be described in sufficient detail to establisha firm basis for measurement at subsequent dates in order to be consistently appliedfor the particular hedge.

IAS 39 does not mandate a specific format for the documentation and in practice hedgedocumentation may vary in terms of lay-out, technology used etc. The important thing isthat the documentation includes the basic content noted above.

The following examples of hedge documentation would meet the requirements of IAS 39.Note, however, that in practical terms an entity may be able to standardise its documentationforms in such a way that narrative descriptions are minimised or not necessary, sincethey are included by reference to other documentation. Entities generally wish to basetheir hedge documentation on reports already prepared for risk management purposesand limit the amount of additional work required by IAS 39. What is important is that asystem is established that links the details of the hedged item and hedging instrument withstandardised information from other sources in such a way that full documentation is



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available to demonstrate the existence of a qualifying hedge relationship at any timeduring its life.

Case 8.3 Documentation of an FX cash flow hedge

Global Tech Company (GTC) has made a firm commitment to purchase a machinefrom a foreign manufacturer in foreign currency (FC) 10,000 in 12 months. GTC wantsto hedge the foreign currency exposure of the firm commitment. GTC enters into a 12-month forward contract to exchange a fixed amount of measurement currency (MC)for a fixed amount of FC. Based on this background information, the followingdocumentation is prepared on 1 January 20X1:

Risk management objective and strategy and nature of the hedged risk

On 1 January 20X1, GTC entered into a commitment to purchase a machine from aforeign manufacturer for FC 10,000 in 12 months. As a result, GTC is exposed tochanges in the MC / FC exchange rate. To reduce this exposure so as to be incompliance with risk management requirements to limit exposures to foreign currencyrisk, on 1 January 20X1 GTC also entered into a 12-month forward contract to exchangea fixed amount of MC for a fixed amount of FC. Changes in the expected value of theforward contract are expected to be highly effective in offsetting the exposure tochanges in fair value of the firm commitment.

Derivative hedging instrument

Identification: [Trade # 12345]; 12-month forward contract to exchange a fixed amountof MC for the amount of FC.

Notional amount FC 10,000 at the forward exchange rate of FC 1.5 : MC 1 at inceptionof the contract.

Hedged item

Changes in the fair value of the future cash flows of the firm commitment [contract# 67890] to purchase a machine from a foreign manufacturer for FC 10,000 in 12 monthscaused by fluctuations in the foreign exchange rate between the MC and FC. The gainor loss on the firm commitment will be measured based on the present value of thechanges in FC forward exchange rates.

Method for recognising the forward contract

Any changes in the fair value of the forward contract during the period in which thehedge is in effect will be reflected as a component of equity to the extent that thehedge is effective. When the forward contract is closed and the machine is purchased(31 December 20X1), the effective part of the forward will be reclassified as an additionto, or subtraction from, the carrying amount of the machine at acquisition.


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Hedge effectiveness

Management expects the hedge relationship will continue to be highly effective duringthe next 12 months, which is the period of the hedge relationship. Expected cash flowson the forward and firm commitment are for the same currency and amount, and areexpected to occur at the same time.

On a quarterly basis, GTC will assess hedge effectiveness on a cumulative basis bycomparing the changes in fair value of the forward contract that are due to changes inforward rates with changes in the present value of cash flows. As long as the timing ofthe cash flows does not change, effectiveness should be close to 100 per cent.

Note that if an entity enters into similar types of hedge transactions regularly, most ofhedge documentation could be provided in a standardised form as part of its riskmanagement policy manual. Specific transaction documentation then could be limited tocontract numbers, amounts, currencies, dates, rates and a reference to the appropriatepolicies in the manual.

Case 8.4 Documentation of a fair value hedge relationship

On 1 January 20X1, Bank A purchases a bond with a maturity of five years. The bondis purchased at a par value of 100 million and is included in the bank’s available-for-sale portfolio, with changes in fair value recognised in equity. The interest rate on thebond is fixed at six per cent. Bank A simultaneously enters into a five-year interestrate swap (IRS) with a notional amount of 100 million to receive interest at LIBORand pay interest at a fixed rate of six per cent. The combination of the IRS and thepurchased bond results in Bank A being hedged against changes in the fair value ofthe purchased bond due to changes in interest rates. The swap reprices twice a yearand requires payments to be made or received on 1 July and 1 January of each year.No premium was paid for the IRS. Bank A designates the IRS as a fair value hedgeof the interest rate risk inherent in the fixed rate bond. The following documentationis prepared on 1 January 20X1:

Risk management objective and strategy

On 1 January 20X1, Bank A purchased a five-year 100 million fixed rate bond [referenceABCDE] which is carried in the available-for-sale portfolio. The interest rate on thepurchased bond is six per cent. As a result, Bank A is exposed to changes in the fairvalue of the purchased bond due to changes in market interest rates.

Due to the bank’s overall interest rate risk position and funding structure, its riskmanagement policies require that the bank should minimise its exposure to fair valuechanges in the price of the bond due to changes in market interest rates. Bank A meetsthis objective by entering into a five-year IRS with a notional amount of 100 million toreceive interest at a variable rate equal to LIBOR and to pay interest at a fixed rate ofsix per cent. The hedge relationship results in the bank being hedged against changesin the fair value of the purchased bond due to changes in interest rate.


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The derivative hedging instrument

IRS [contract XYZ] will be used as the hedging instrument:

■ Notional amount: 100 million

■ Premium paid: none

■ Fixed leg: six per cent per annum

■ Fixed leg payer: Bank A

■ Floating leg: LIBOR, repricing 1 July and 1 January of each year

■ Floating leg payer: Bank B

■ Settlement: net cash due in arrears on 1 July and 1 January of each year

The fair value changes of the IRS due to changes in interest rates will be recognised inthe income statement.

The hedged item

Bank A designates the five-year bond, purchased 1 January 20X1 and paying a fixedrate of interest of six per cent, as the hedged item. The changes in the fair value of thebond relating to the hedged risk are also included in the income statement.

Hedge effectiveness

The critical terms of the IRS and the purchased bond are identical. The followingconditions have been met:

■ the notional amount of the IRS equals the principal amount of the bond purchased;

■ both the interest received on the bond and paid on the IRS are fixed;

■ the maturity date of the IRS matches the maturity date of the purchased bond;

■ the formula for computing net settlements under the IRS is the same for each netsettlement. The fixed rate is the same throughout the term and the variable rateequals LIBOR throughout the term;

■ there is no floor or cap on the variable interest rate of the swap;

■ the fair value of the swap at its inception is zero;

■ it is unlikely that the purchased bond will be repaid prior to maturity;

■ the fair value changes of the bond due to changes in market interest rates aredesignated as hedged; and

■ all other terms of the purchased bond and the IRS are typical of those instrumentsand do not invalidate the assumption of no ineffectiveness.

Due to the above, Bank A concludes that at inception the hedge relationship is expectedto be highly effective in achieving offsetting fair value changes of the IRS and thepurchased bond due to changes in interest rates.


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Ongoing effectiveness testing will be performed through comparison of the cumulativechanges in the fair value of the bond to cumulative changes in the clean fair value ofthe IRS (i.e. accrued interest will be excluded from the fair value). This analysis willexclude changes in fair value of the bond due to risks and factors other than interestrates. Changes in the fair values of each instrument will be modelled by Bank A on aquarterly basis and assessed on a cumulative basis. Management believes thiseffectiveness can be reliably measured.

8.6.2 Hedge effectiveness

IG F.4.4 An entity must adopt a method for assessing hedge effectiveness that is consistentlyapplied for similar types of hedges unless different methods are explicitly justified.For example, an entity would generally use the same methods for prospectively assessingas well as for measuring actual hedge effectiveness for forecasted sales to the sameexport market in each period. The method chosen will depend on the entity’s riskmanagement strategy.

A summary of the requirements for prospective assessment and measurement of hedgeeffectiveness can be illustrated as follows:

Figure 8.4 Different requirements for effectiveness assessment and measurement

8.6.2.1 Prospective assessment of effectiveness

39.88 In order for hedge accounting to be applied, the hedge transaction must be expected to behighly effective in achieving offsetting changes in the fair value or cash flows attributableto the hedged item. This offsetting must be expected to occur in a manner consistent withthe originally documented risk management strategy for that particular type of hedgerelationship. IAS 39 states that:

39.88 and AG105 A hedge is normally regarded as highly effective if, at inception and throughout the lifeof the hedge, the entity can expect changes in the fair value or cash flows of thehedged item to be almost fully offset by the changes in the fair value or cash flows ofthe hedging instrument.


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Expectation of an almost perfect offset at inception is necessary to allow for unexpectedimperfections in the hedge relationship during the hedge period that might otherwise requireearly termination of hedge accounting.

39.AG106-108 IAS 39 does not prescribe a single method for the assessment of effectiveness, but ratheremphasises that the method must follow the risk management methodologies of the entity.The prospective effectiveness assessment can be performed in several ways, such as:

■ matching critical terms of the hedging instrument and the entire hedged item maysupport a conclusion that changes in fair value or cash flows attributable to the riskbeing hedged are expected to completely offset at inception and on an ongoing basis;

■ using a scenario analysis of historical data; or

■ using a statistical model, such as a regression analysis that analyses the correlationbetween changes in value or cash flows of the hedged item and the hedging instrumentfor a given historic period.

39.AG107 and An example of the first bullet point above would be hedging a specific bond held byAG108 entering into a forward contract to sell an equivalent bond with the same notional amount,

currency and maturity. Another example would be the hedge of a fixed rate borrowingwith a receive-fixed pay-floating interest rate swap where the notional amount, currency,maturity, interest basis and interest repricing terms are identical. This direct approach toassessing hedge effectiveness can be applied for prospective assessment. However, aformal measurement of the actual effectiveness results must be performed.

IG F.4.4 When the critical terms are not exactly the same or only a portion of the asset, liability ortransaction is being hedged, prospective hedge effectiveness must be assessed anddocumented. When a statistical model is used, the hedge documentation must specifyhow the results of the analysis are to be interpreted.


As explained more fully in Section 1, the IASB has tentatively agreed to remove therequirement that, prospectively, gains and losses should ‘almost fully offset’.If confirmed, this amendment is likely to mean that some hedging relationships thatpreviously failed to qualify for hedge accounting will qualify in the future.

8.6.2.2 Ongoing assessment and measurement

39.88 and Effectiveness must be measured on an ongoing basis and the hedge relationship provedAG105-108 actually to have been highly effective throughout the financial reporting period. At a

minimum, the frequency of this should be whenever interim or annual financial statementsare prepared. Entities may be inclined to perform hedge effectiveness testing morefrequently in order to minimise the time period where hedge accounting cannot be applied

IG F.4.7 due to ineffectiveness and in order to better manage the risk exposure. IAS 39 does notallow the use of a short-cut method and as a result effectiveness assessment andmeasurement must be performed at a minimum at each reporting date.

39.AG105 The actual results of hedge effectiveness must be within a range of 80 to 125 per centoffset for hedge accounting to be applied. Hedge effectiveness measurement may bebased on either a period by period or on a cumulative basis depending on what has been


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established in the hedge documentation. For the latter, even if a hedge is not highly effectivein a particular period, hedge accounting is not precluded if the effectiveness remains

IG F.4.2 sufficient on a cumulative basis. Measuring effectiveness on a cumulative basis may reducethe risk of a hedge becoming ineffective, and is therefore the more common method in practice.

The gain or loss on the hedged item must be measured independently from that of thehedging instrument (i.e. it cannot just be assumed that the change in fair value or cashflows of the hedged item in respect of the hedged risk equals the fair value change of thehedging instrument). The reason for this is that any ineffectiveness of the hedginginstrument must be recognised in the income statement.

39.AG106-108 A single method for the prospective assessment of effectiveness is not prescribed andand IG F.4.4 the method applied may be different for different types of hedges. However, the periodic

measurement of hedge effectiveness would usually involve a method that compares theactual change in fair value of the hedged asset or liability or in cash flows with respect tothe hedged risk to the change in the fair value of the hedging instrument (an offset method).This means that some of the methods used for prospective hedge assessment (e.g. statisticalanalysis) would not be used for measuring actual hedge effectiveness.

IG F.4.3 Both when assessing prospectively and when measuring actual effectiveness, thecreditworthiness of the counterparty to the hedging instrument and the likelihood of defaultshould be considered. The value of a swap could be affected by changes in the respectiveswap counterparty’s credit rating.

Prepayment risk will impact the effectiveness of fair value hedges. If the hedged item isrepaid before expected, this will lead to a situation where the entity is over-hedged, as thenotional amount of the hedging instrument may be more than the remaining outstandingamount of the hedged item. In that case it is likely that the hedge relationship would nolonger be effective. The same applies to expectations about changed timing of futurecash flows. Therefore, the risk of prepayment or changes to timing of future cash flowsshould be considered when an entity designates its hedge relationships.

39.74, The time value of an option or the interest element of a forward may be excluded from39.AG106-108 the ongoing effectiveness assessment. For an option, the hedge relationship would beand IG F.1.9 designated only for the price range when the option is in-the-money. Therefore, when the

option is out-of-the-money, no effectiveness measurement is necessary, howeverprospective assessment is still required. The excluded portion of the option or forward isrecognised immediately in the income statement. When the time value of an option or theinterest element of a forward is excluded from the hedge, the measurement of hedgeeffectiveness is based only on the changes in the intrinsic value of the option or the spotrate of the forward. A dynamic strategy including intrinsic value and time value may alsobe applied, though there is little elaboration in IAS 39 about what is acceptable. A delta-neutral hedging strategy, where the hedging instrument is constantly adjusted in order tomaintain a desired hedge ratio, may qualify for hedge accounting.

39.AG111 The assessment of hedge effectiveness for interest rate risk can be performed using amaturity schedule. Such a maturity schedule would show the net position for each strip ofthe maturity schedule resulting from the aggregation of the assets and liabilities maturing orrepricing of cash flows at that time. The net exposure hedged must then be associated withan asset, liability or cash inflow or outflow in order to apply hedge accounting, provided thatthe correlation of the changes of the hedging instrument and the designated hedged itemcan be assessed. Further discussion of this methodology is included in Section 9.2.



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IG F.4.1 Hedge effectiveness may be measured on either a pre-tax or post-tax basis. This shouldbe noted in the hedge documentation.

Case 8.5 Effectiveness testing

On 1 January 20X1, ABCorp a commodities dealer, anticipates its sales at marketrates of precious metals that will occur in early May 20X1. In order to hedge thecommodity price risk of the transaction, ABCorp enters into a forward (the hedginginstrument) maturing on 1 May 20X1 to hedge the anticipated sales of precious metals(the hedged item). The fair value of the hedging instrument is zero at inception. ABCorpdetermines and documents that the hedge is an effective cash flow hedge at inception.

As part of monitoring the ongoing effectiveness of the hedge relationship, each monthABCorp determines the change in the discounted cash flows expected from theanticipated sales and the change in the fair value of the forward.

During the hedging period in 20X1, the fair values and the changes in discounted cashflows of the hedging instrument and the hedged item respectively are as follows:

31 January 28 February 31 March 30 April

Section 1 – Periodic effectiveness

Change in fair value for the month:Hedging instrument (100) (50) 110 140Hedged item 90 70 (110) (140)

Effectiveness for the month 111% 71% 100% 100%

Section 2 – Cumulative effectiveness

Cumulative change in fair value:Hedging instrument (100) (150) (40) 100Hedged item 90 160 50 (90)

Cumulative effectiveness 111% 94% 80% 111%

Section 3 – Determination of effectiveness

Cumulative effective portion of thehedging instrument revaluationincluded as a component of equity (90) (150) (40) 90

Change in the effective portion of thehedging instrument revaluationfor the month (90) (60) 110 130

Change in the hedging instrumentrevaluation for the month (100) (50) 110 140

Ineffective portion of hedginginstrument revaluation for eachmonth recognised in theincome statement (10) 10 – 10



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Section 1 illustrates the effectiveness measured on a period-by-period basis whileSection 2 illustrates a cumulative basis. This is for demonstration purposes only – anentity should choose only one of these two methods at the inception of the hedge, andinclude this choice in its documentation of the hedge relationship.

The analysis consists of three main sections. Section 1 details the monthly effectivenessand fair value changes of the hedging instrument and changes in discounted cash flowsof the hedged item. The hedge remains within the 80 to 125 per cent range, thereforethe relationship qualifies for hedge accounting until the month of February 20X1, whenthe monthly effectiveness is 71 per cent.

Section 2 details the cumulative change in fair values of the hedging instrument andhedged item. The hedge relationship continues to be maintained as IAS 39 allows hedgeeffectiveness to be measured on a cumulative basis when consistently applied. Duringthe hedging period, the cumulative effectiveness remains within the range of 80 to 125 percent, which supports the effectiveness of the hedge relationship for the period.

Section 3 details the analysis for determining the effective portion of the hedginginstrument revaluation that should be included as a component of equity.

The change in value of the hedging instrument is divided into the portion that is effective,to which hedge accounting is applied, and the portion that is ineffective, which isimmediately recognised in the income statement.

For example, at 31 January 20X1 the effective portion of the hedging instrumentrevaluation is only that amount that offsets the revaluation of the hedged item. Thehedging instrument is revalued at a loss of -100. However, as the revaluation gain onthe hedged item is only 90, there is an ineffective portion of -10 for the hedging instrumentthat must be recognised in the income statement and the remaining -90 is recognisedas a component of equity.

At 28 February 20X1, the cumulative revaluation loss on the hedging instrument increasesto -150. However, the cumulative revaluation gain on the hedged item increases to160. The cumulative loss on the hedging instrument is now less than the cumulativegain on the hedged item. As such, on a cumulative basis, no portion of the hedginginstrument revaluation is ineffective. Thus, the full revaluation loss of the hedginginstrument of -150 is included as a component of equity.

At 31 March 20X1, the cumulative change in fair value of the hedging instrumentremains less than the change in fair value of the hedged item. As such, the revaluationcomponent in equity would be a loss of -40, but no ineffective portion is recognised inthe income statement as the cumulative revaluation gain on the hedged item is 50.

Lastly, at 30 April 20X1, the cumulative revaluation on the hedging instrument increasesto a gain of 100 which more than offsets the revaluation loss of -90 on the hedged item.As such, the revaluation component in equity would be 90 and an ineffectiveness gainof 10 is recognised in the income statement.

(Note: The numbers used in the above example are illustrative. The example does notconsider the ongoing assessment of prospective effectiveness that is also required ateach reporting date.)


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8.6.2.3 Hedge ineffectiveness

39.89 and 95 Even when a hedge relationship meets the effectiveness criteria, the fair value change onthe hedged item and the hedging instrument often will not offset completely. Ineffectivenessof the hedging instrument must be recognised in the income statement, except when anon-derivative instrument is used to hedge a foreign net investment.

The effective portion of a cash flow hedge is the lesser of:

■ the cumulative gain or loss on the hedging instrument necessary to offset the cumulativechange in expected future cash flows on the hedged item from inception of the hedgeexcluding the ineffective component; and

39.96 ■ the cumulative change in the fair value of the expected future cash flows on thehedged item from inception.

39.96 In a cash flow hedge, if the full cumulative gain or loss on the hedging instrument is morethan the cumulative expected future cash flows on the hedged item, the difference mustbe recognised in the income statement as hedge ineffectiveness.


39.96 In amending the standards, the Board has taken the opportunity to simplify its explanationof the effective portion of a cash flow hedge. It is now described more simply as thelesser of:

■ the cumulative gain or loss on the hedging instrument from the inception of thehedge; and

■ the cumulative change in fair value (present value) of the expected future cashflows from the hedged item from inception of the hedge.

The impact of this change is unlikely to be significant in practice.

8.6.3 Forecasted transactions must be highly probable

39.88 Forecasted transactions must be highly probable and must present an exposure tovariations in cash flows that ultimately could affect the income statement. In practice, anindicator of a transaction being highly probable is a likelihood of more than 90 per cent.Management’s intent, forecasts and budgets as well as historical data may be used as thebasis to assess the highly probable assumption.

IG F.3.7 For groups of similar transactions the probability criterion may be met by designating alower and therefore more certain amount of risk exposure as being hedged. For example, abank may enter into fixed rate mortgage loan commitments with potential customers, whichgive the customer 90 days to lock in a mortgage at a specified rate. To reduce the interestrate risk inherent in the anticipated mortgage transactions, the bank enters into forwardstarting interest rate swaps on the expected acceptances. When evaluating the probabilityof acceptance by only a single customer, a high probability would be difficult to demonstrate.On the other hand, when evaluating the probability of a group of commitments, it is possiblethat the bank may estimate with high probability the amount of mortgages that will eventuallybe closed. In this case, the bank would apply cash flow hedge accounting for the hedge ofinterest rate risk on the amount of mortgages that are highly probable of closing.


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8.7 Termination of a hedge relationship

Similarly, when assessing the probability of hedging certain instruments with prepaymentrisk, assessing the probability of interest cash flows for the portfolio rather than for asingle instrument could result in an acceptable hedge of these instruments for a bottomlayer of the interest cash flows.

Hedging anticipated transactions with purchased options might raise questions aboutmanagement’s assessment of whether the transaction will actually occur. For example,an entity purchases an option on a particular foreign currency because the entity hasmade a bid for a large contract in that foreign currency. The entity wants to hedge thepotential foreign currency income from that contract although the income is not yet certain.The foreign currency cash flows in this case might not be highly probable as they dependon the entity first winning the bid for the contract.

8.6.3.1 Defining the time period in which the forecasted transaction is expected to occur

IG F.3.10 and IAS 39 requires that the forecasted transaction must be identified and documentedF.3.11 with sufficient specificity so that when the transaction occurs, it is clear whether the

transaction is or is not the hedged transaction. An entity is not required to predict anddocument the exact date a forecasted transaction is expected to occur. But thedocumentation should identify a time period in which the forecasted transaction isexpected to occur within a reasonably specific and generally narrow range of time, asa basis for assessing hedge effectiveness.

In order to determine the proper time periods for hedge accounting purposes an entitymay look to:

■ Forecasts and budgets: The expectation is that entities generally would not identifylonger time periods for hedge accounting purposes than those used for forecastingand budgeting.

■ The nature of the business / industry: The forecasting and budgeting periods usedby an entity are influenced by the entity’s ability reliably to forecast the timing of itstransactions. Generally one would expect the forecast periods for manufacturers ofships or aircraft to be longer than those of retail stores because retailers usually sellsmaller items in large quantities and can usually more easily forecast the timing ofsales over shorter periods of time.

Although the above factors provide an indication of what may be the appropriate timeperiod in which the transaction is expected to occur, the actual time period should alwaysbe determined on a case-by-case basis and will involve some degree of judgement.


39.101 There are several circumstances that could lead to the termination of a hedge relationship.Examples of situations that would cause a hedge relationship to be terminated include:

■ the hedging instrument expires, or is sold, terminated or exercised;

■ the hedged item is derecognised;

■ the forecasted transaction is no longer highly probable;

■ the effectiveness criteria are no longer met; or

■ management chooses to de-designate the hedge relationship.


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39.91, 92 and 101 A replacement of a hedging instrument or rollover is not deemed to be a termination if thenew instrument has the same characteristics as the instrument being replaced, it continuesto meet the hedge criteria and the rollover strategy is properly documented at inception.Using a rollover hedge strategy, the entity may continue to perform hedge effectivenesstesting on a cumulative basis from the beginning of the period in which the first hedginginstrument was rolled over. Also amortisation of any fair value adjustment made to thehedged item under a fair value hedge may continue to be deferred until the rollover hedgestrategy is discontinued.

39.101(c) The notion of a highly probable forecasted transaction is a higher degree of probabilitythan one that is merely expected to occur. If a forecasted transaction is no longer highlyprobable but is still expected to occur, the net cumulative gain or loss that was recognisedin equity during the effective period of the hedge remains in equity until the transactionactually occurs. However, prospectively the entity can no longer apply hedge accounting.

39.88 Hedge accounting for a forecasted transaction that is no longer expected to occur mustbe terminated. It may not be replaced by another expected transaction. If a forecastedtransaction is not expected to occur in the initially forecasted period or within a relativelyshort period thereafter, it is not considered to be the same hedge, and the hedge relationshipshould be terminated. The effect of delays of forecasted transactions is considered inmore detail in Section 9.3.2.

When an effective hedge relationship no longer exists, the accounting for the hedginginstrument and the hedged item must revert to accounting under the normal principles.If the forecasted transaction that the instrument was originally intended to hedge is nolonger expected to occur, any gains or losses on the hedging instrument that have beenrecognised in equity are recognised in the income statement immediately.

Figure 8.5 summarises the accounting treatment for a forecasted transaction where theprobability of the transaction occurring changes.

Figure 8.5 Accounting impact of a change in expectation of a forecasted transaction

39.91 If the hedge effectiveness criteria are no longer met, hedge accounting must be terminated.Termination of a hedge must have effect prospectively as of the date when the hedgewas last proved effective, which may be the previous interim or annual reporting date.


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Table 8.2 Accounting consequences of hedge termination


For this reason testing hedge effectiveness more regularly is a way to reduce the impactof the unexpected termination of a hedge relationship.

39.75 and If a hedging instrument ceases to be part of a hedge relationship, the instrument may beIG F.6.2(i) re-designated to a new hedge relationship, as long as this is for the entire remaining term

of the instrument. This would once again fulfil the requirement of being designated as ahedging instrument for the entire outstanding period. For example, a forward contract of100 designated to hedge a forecasted transaction of 100 may no longer be expected to beeffective if new forecasts indicate the forecasted transaction may now only involveexpected cash flows of 80. In this situation, the original hedge designation would bediscontinued. A new relationship under which a proportion (80) of the forward is designatedas a hedge of the new expected cash flow of 80 would be allowed. The changes in fairvalue of the remaining unused portion of the forward (20) must be recognised in theincome statement.

39.101

39.101

Cash flow hedge

The gain or loss on thehedging instrumentpreviously recorded inequity is recorded in theincome statementimmediately. The hedginginstrument continues to bemeasured at fair value withchanges recorded in theincome statement.

The gain or loss on thehedging instrumentpreviously recorded in equityis recorded in the incomestatement immediately.

Hedge accounting isterminated prospectively.Further changes in the fairvalue of the hedginginstrument must be recordedin the income statement.Any gain or loss previouslyrecognised in equity remainsin equity until thetransaction occurs or is nolonger expected to occur.

Fair value hedge

A gain or loss on thederecognised item isrecorded in the incomestatement based on thecarrying amount, includingthe adjustments resultingfrom the hedge. The hedginginstrument continues to bemeasured at fair value withchanges recorded in theincome statement.

Not applicable.

Not applicable.

Reason for termination

Hedged item:Derecognition of thehedged item.

Expected transaction or firmcommitment no longerexpected to occur.

Expected transaction or firmcommitment no longerhighly probable but stillexpected to occur.


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8.8 Net position hedging and internal derivatives

Reason for termination

Hedging instrument:Derecognition of the hedginginstrument other thanreplacements and rollovers.

The hedge no longer meetsthe hedge criteria(effectiveness) ormanagement decides to de-designate the hedge.

Fair value hedge

The gain or loss onderecognition of the hedginginstrument is recorded in theincome statement.

The hedged item must revertto the applicable accountingrequirements from the date ofderecognition of the hedginginstrument, i.e. cease to beadjusted for changesresulting from the hedgedrisk. If the hedged item is adebt instrument and thematurity is determinable, theadjustment recorded as partof the carrying amount of thehedged item should beamortised to the incomestatement from that dateonwards using the effectiveinterest method.

Same accounting as inderecognition of the hedginginstrument except thatinstead of derecognising thehedging instrument it shouldbe prospectively remeasuredthrough the incomestatement, unless thehedging instrument is re-designated as a hedge ofanother hedged item.

Cash flow hedge

A gain or loss on thehedging instrumentpreviously recorded inequity remains in equityuntil the forecastedtransaction occurs.

Same accounting as inderecognition of thehedging instrument exceptthat instead ofderecognising the hedginginstrument it should beprospectively remeasuredthrough the incomestatement, unless thehedging instrument is re-designated as a hedge ofanother hedged item.

39.91, 92 and 101

39.91, 92 and 101

8.8 Net position hedging and internal derivatives

8.8.1 Net positions

Many financial institutions and corporates use net position hedging strategies underwhich a centralised treasury function accumulates risk originated in the operationalsubsidiaries or divisions. The treasury function hedges the net exposure in accordancewith the group’s risk policies by entering into a hedge transaction with a party externalto the group.


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8.9 Other considerations

Net position hedging does not by itself qualify for hedge accounting treatment because ofthe inability to:

■ associate hedging gains and losses with a specific item being hedged when measuringeffectiveness; and

■ determine the reporting period in which such gains and losses should be recognised inthe income statement.

39.84 and AG101 However, an entity is not necessarily precluded from hedge accounting by hedging netpositions. That is, an entity may choose to manage and (economically) hedge risk on a netbasis, but for hedge accounting purposes designate a specific item within the net positionas the hedged item. Hedging interest rate net positions is discussed in Section 9.2.Hedging foreign currency net positions is discussed in Section 9.3.

Future amendments to IAS 39

At the date of this publication, the IASB is finalising its deliberations in respect of FairValue Hedge Accounting for a Portfolio Hedge of Interest Rate Risk. It is anticipatedthat, when issued, this will introduce a number of additional requirements for this formof hedge accounting.

8.8.2 Internal derivatives

Derivatives between entities within the same reporting group may be used to control andmonitor risks through a central treasury function, as well as potentially to benefit frompricing advantages of being able to group smaller individual transactions for offsetting bylarger transactions done with external third parties, or for netting of opposite exposures.

39.73 Accounting for internal derivative transactions should be viewed in light of IFRSconsolidation requirements. This requires the elimination of all transactions and balancesbetween group entities. Therefore, only derivatives involving external third parties can bedesignated as hedging instruments in the consolidated financial statements. However, hedgeaccounting can be achieved in such cases if a one-to-one relationship of the internal

IG F.1.5 and transactions to related external transactions is documented. In general, unless this one-F.1.6 to-one relationship can be established, the effects of the internal transactions must be

eliminated on consolidation.


There are a variety of issues directly or indirectly related to or impacted by the hedgeaccounting principles. This Section gives a brief overview of some of these issues.

8.9.1 Risk reduction and hedge accounting

39.72 and IAS 39 does not require an overall risk reduction in order to apply hedge accounting.IG F.2.6 For example, an entity may have fixed rate assets and liabilities that provide a natural

economic hedge that leaves the entity with no exposure to interest rate risk. This entitymay decide to enter into a pay-fixed receive-floating swap and designate this as a hedgeof either the assets or liabilities. Although this would increase the entity’s overall interestrate risk exposure, hedge accounting may be applied to this transaction provided that therelevant hedge accounting criteria are met.


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IG F.2.18 IAS 39 does not specifically require that a hedge of foreign currency risk is designated so asto convert a foreign currency into the entity’s measurement currency. As described earlieris Section 8.5.4, an entity may wish to use a cross currency interest rate swap to eliminatethe currency and interest exposure of an asset and a liability in two different foreigncurrencies. This is permissible under IFRS, provided that the entity has corresponding assetand liability positions denominated in the foreign currencies that are hedged by the crosscurrency interest rate swap. Therefore, when designating the hedge, it is important to clearlyspecify in the hedge documentation the risks that are being hedged.

8.9.2 Deferred tax issues

12.61 In accordance with IAS 12 for transactions recognised directly in equity, all current anddeferred tax should also be recognised in equity. In respect of hedge accounting thismeans that current and deferred taxes on gains or losses on hedging instruments deferredin equity also should be recognised in equity until such time when the gain or loss isrecycled to the income statement.

8.9.3 Impairment of an asset that is hedged

36.58 and The principles for hedge accounting do not override the accounting treatment under IAS 3639.58-70 or IAS 39 if there is impairment of the hedged item. Therefore, if a hedged item is

impaired, this impairment should be recognised even if the risk that causes the impairmentis being hedged and hedge accounting is applied. However, the hedge accounting principlesmay require that a gain on a hedging instrument used to hedge the risk that gave rise tothe impairment will be recognised simultaneously in the income statement and may (partly)offset the recognised impairment.

39.59 and 61 For example, an entity may hold a portfolio of securities that are classified as available-for-sale with fair value adjustments recognised in equity. The fair value at a given point is300. The entity has a put option to put the securities to a third party at 250. The entity mayapply hedge accounting to this transaction provided that the hedge relationship meets therelevant criteria. The entity designates the option as a hedge of the cash flows from anexpected future sale of the securities. Assume that the fair value of the portfoliosubsequently decreases by 120 and there is objective evidence of impairment.This impairment must be recognised in the income statement. The amount of impairmentto record would be the difference between the original cost of the securities (300) and thenew fair value (180), not taking into account the existence of the put option. However, sinceat this point the impairment on the hedged item affects the income statement, the related

39.97 and 98 gain on the put option would also be recognised in the income statement. This means thata gain of 70 (250 – 180) ignoring time value, will be recognised in the income statementand will partly offset the loss on the securities.


39.97 and 98 The restrictions introduced in respect of basis adjustments mean that amounts relatingto a cash flow hedge of an asset that has been acquired may be retained in equity.In such cases, it will be necessary to ensure that if the related asset becomes impaired,an appropriate amount is also recycled from equity to profit or loss.



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9. Hedge accounting for each type of financial risk


■■■■■ Interest rate risk hedging

■■■■■ Foreign currency risk hedging

■■■■■ Hedges of net investments in foreign entities

■■■■■ Commodity and equity price risk hedging


9.1 Overview

Section 8 explained the basic requirements, the accounting models and criteria for hedgeaccounting under IAS 39. This Section focuses on some of the most common financialrisks that an entity may hedge and how applying hedge accounting to these risks willaffect the income statement and balance sheet. It also provides examples of the journalentries needed to record the hedge accounting transactions.


9.2.1 Identifying the hedged risk and the hedging models

Interest rate risk arises from entities holding interest-bearing financial assets and / orliabilities or from forecasted or committed future transactions with an interest-bearingelement in them. Interest-bearing instruments bear either:

■ Fixed interest: Since the interest rate is fixed, future interest payments are alsofixed. In this case the interest rate risk relates to the fair value change of the financialasset or liability in response to changing market interest rates; or

■ Floating interest: In this case the future interest payments will depend on an underlyinginterest index (e.g. LIBOR) and hence the interest rate risk relates to variations infuture cash flows.

39.AG102 Possible hedged items in fair value hedges include:

IG F.2.13 ■ fixed rate loans and receivables originated by the entity;

■ fixed rate assets categorised as available-for-sale with fair value changes recogniseddirectly in equity; and

■ fixed rate financial liabilities not held for trading.



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39.AG103 Possible hedged items in cash flow hedges include cash flows from:

■ floating rate loans and receivables originated by the entity;

■ floating rate assets categorised as available-for-sale with fair value changes recogniseddirectly in equity;

■ floating rate financial liabilities not held for trading;

■ firm commitments that have an interest rate exposure; and

■ highly probable anticipated transactions that have an interest rate exposure.

In some cases the same interest rate risk exposure may be hedged with either a fair valuehedge or a cash flow hedge. For example, an entity with an overall (net) interest rate riskexposure to floating rate liabilities may choose to hedge this exposure with a pay-fixedreceive-floating swap. This swap may be designated as the hedging instrument of either:

■ a fixed rate asset in a fair value hedge; or

■ a floating rate liability in a cash flow hedge.

IG F.6.1 and F.6.2 The derivative has the same economic effect of reducing the interest rate exposure, butthe accounting differs depending on whether the hedge relationship is designated as eithera fair value or cash flow hedge. Entities can make their own assessment as to which ofthese two hedge models can be best applied in their circumstances. This is especiallyimportant to entities such as banks and corporate treasuries that need to account formultiple hedge transactions.

The decision about which hedge accounting model to use may depend upon the informationsystems and reporting that the entity has available. The entity must assess whether existinginformation systems are best set up to manage and track the information required undera fair value model or a cash flow model. This decision also may depend upon thecharacteristics of the hedged items and whether hedge accounting criteria can be met,e.g. prepayment risk in mortgage loans may be an issue, as discussed in Section 9.2.3 oneffectiveness testing of interest rate hedges.

IG F.6.2 Under a fair value model, assets and liabilities designated as the hedged item must beremeasured for fair value changes attributable to the hedged risk, and normally result inan adjustment of the effective interest yield. This usually requires a system that is able totrack changes in fair value of the hedged risk, and that can associate these changes withthe hedged items. Also the system should be able to recompute the effective yield of thehedged item and amortise the changes to the income statement over the remaining life ofthe hedged item.

39.95-100 Under a cash flow model the fair value changes of the hedging instruments are recognisedin equity and are later released to the income statement when the cash flows from thehedged items are recognised in the income statement. This requires a system that enablesthe entity to track the timing of the cash flows, as well as the timing of the reversal of thehedging gains and losses from equity. Although this may impose a challenge, for manyentities such information can be based on the cash flow information already captured inrisk management systems of the entity.



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9.2.2 Hedging expected interest cash flows

An entity may choose to hedge the interest cash flows from interest-bearing assets andliabilities including:

■ floating rate assets (e.g. debt securities, originated loans); and

■ floating rate liabilities (e.g. customer deposits at a bank, bonds issued by a corporate).

An entity also may hedge its interest rate risk exposure from forecasted interest paymentssuch as:

■ an expected debt issuance;

■ an expected purchase of financial assets;

■ expected rollovers of existing loans; or

■ expected draw-downs under revolving credit facilities.

IG F.2.2 and F.6.2 An entity may apply hedge accounting to an anticipated debt issuance. The appropriatehedge accounting model in this case would be a cash flow hedge. The gains or lossesresulting from the hedging instrument until the debt is issued would be deferred inequity, and then would adjust the initial carrying amount of the debt. The subsequentamortisation of the basis adjustment would be recognised by adjusting the instrument’sfuture interest expense.

For example, an entity in the process of issuing a bond may wish to hedge the risk ofchanges in interest rates from the time the entity decides to issue the bond until it isissued. This could be done using an interest future or another derivative instrument. To theextent it is effective, the gain or loss on the derivative would be deferred in equity until thebond is issued, at which point the deferred gain or loss would adjust the initial carryingamount of the bond (as a basis adjustment). The gain or loss is recognised in the incomestatement as interest payments are made and effectively adjusts the interest expenserecognised on the debt.

39.88 To meet the hedge accounting criteria a forecasted debt issuance must be highly probable.This would be the case once the entity enters into an agreement to issue the bond, butmay already be evidenced at an earlier stage when management decides upon a debtissuance as part of the entity’s funding strategy.

Another example of a hedge of forecasted interest payments is that of an entity whichplans to issue a series of floating rate notes, each with a maturity of three years. The entityintends to issue similar notes immediately after the maturity of the initial notes. In thissituation the entity may enter into a six-year swap to hedge the variability in expectedinterest cash flows on both notes. For hedge accounting purposes the hedge could bedesignated as a hedge of the expected interest payments in different periods includinginterest payments arising from the forecasted refinancing of the debt. At inception of thehedge the criteria for hedge accounting must be met, including the criteria that the hedgewould be highly effective, and that the re-issue after three years is highly probable.



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39.97 As noted above, the amendments will prohibit the use of basis adjustment in a hedge ofa forecast purchase or issuance of a financial asset or liability. The effect of the hedgeis achieved, instead, by amortising the amount deferred in equity under the cash flowhedge into income over the life of the hedged item. The income statement effectshould be the same as using basis adjustment, but the separate tracking of the amountdeferred in equity may be more complex. An added complication will be the need totake into account separately any debit deferred in equity when assessing impairmentof an asset whose cash flows have previously been hedged.

9.2.3 Effectiveness testing of interest rate risk hedges

The effectiveness requirements discussed in Section 8 are applicable for hedges of interestrate risk.

For interest-bearing assets that are on balance sheet, prepayment options could have asignificant impact on whether a hedge relationship is effective. Examples of prepayableassets include originated loans that may be prepaid by the borrower and debt securitiesthat may be repaid early by the issuer.

IG F.6.2 Prepayment risk affects the timing as well as the amount of cash flows, therefore thisrisk may impact effectiveness results for fair value hedges, as well as the requirement ofhigh probability for forecasted cash flows. A prepayable hedged item will generallyexperience smaller fair value changes than a hedged item that is not prepayable.Effectiveness is likely to be more difficult to demonstrate for a fair value hedge than fora cash flow hedge when hedging a portfolio. In a fair value hedge it may be difficult toachieve a highly effective offset of fair values of the hedged item and the hedging instrumentwhen the hedged item terminates early due to prepayment. Moreover, it may be difficultto group a portfolio of fixed rate assets subject to prepayment risk since it may be difficultto prove that the changes in fair value of the individual assets are approximately proportionalto the overall change in fair value of the portfolio. As a result fixed rate assets subject toprepayment risk may have to be hedged on a one-to-one basis. Hence the likelihood ofineffectiveness due to prepayment is larger since the effect on the fair value is not absorbedby a portfolio.

39.88 Prepayment risk may also affect whether a cash flow hedge is considered to be highlyprobable of occurring. However, when the hedged item is designated as a portion of grosscash flows of a portfolio in a given period, the effect of a prepayment is less likely to causethe hedge not to be highly probable as long as there are sufficient cash flows in the period.This could be demonstrated by the entity preparing a cash flow maturity schedule thatshows sufficient gross levels of expected cash flows in each period to support a highlyprobable assertion. For example, a bank may be able to accurately determine what levels ofprepayments are expected for a particular class of its originated loans. The bank mighthedge only a portion of the contractual cash flows from that portfolio of loans, as the bankexpects a number of the borrowers to pay off their loans early.

IG F.5.5 Forecasted transactions create a cash flow exposure to interest rate changes becauserelated interest payments will be based on the actual market rate when the transactionoccurs. In these situations the hedge effectiveness assessment would be based on the



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expected interest payments, calculated using the forward interest rate on the applicableyield curve, which should be highly probable in order to qualify for hedge accounting.For forecasted transactions such as anticipated debt issuances, it is not possible todetermine what the actual market interest rate will be for the debt issuance. In thesesituations hedge effectiveness may be measured based on the changes in the interestrates that have occurred between the designation of the hedge and the date thateffectiveness testing is performed. The forward interest rates that should be used arethose that correspond with the term of the expected transaction at inception and at thedate of the effectiveness testing. IG F.5.5 has a detailed example about how hedgeeffectiveness may be measured for a forecasted transaction in a debt instrument.

IG F.2.17 When only a portion of an interest-bearing instrument is hedged, effectiveness testingusually becomes more difficult. For example, an entity may choose to hedge the interestrate risk of an acquired 10-year fixed rate bond only for the first five years. The entitymay designate a pay-fixed and receive-floating interest rate swap with five years tomaturity as the hedging instrument. This swap could be designated as a hedge of the fairvalue of the first five years of interest payments and the change in fair value of theprincipal payments in year 10, but only to the extent affected by changes in the yieldcurve relating to the five years of the swap. For effectiveness testing purposes the loan istreated as if it had a synthetic principal repayment in year five. Any fair value differenceresulting from changes between the five-year and 10-year yield curve would not beconsidered part of the hedge relationship and the carrying amount of the loan would notbe adjusted by this amount. The same is true for fair value changes of the interest paymentsafter year five.

The following cases demonstrate a number of the issues that have been discussed inSection 9.2 about hedging interest rate risk.

Case 9.1 Fair value hedge of a fixed interest rate liability

Global Tech Company (GTC) requires financing of 100 million for five years. On 1 January20X1, GTC issues non-callable five-year 100 million of bonds. The interest rate on thebonds is fixed at six per cent and is payable semi-annually. The bonds are issued at par.

GTC’s overall risk management strategy and current position is to have variable ratefunding. Therefore, GTC enters into a five-year interest rate swap (IRS) with a notionalamount of 100 million. The IRS pays a floating interest rate based on LIBOR andreceives a six per cent fixed interest rate. The floating rate of interest for the first sixmonths is 5.7 per cent. The timing of the IRS cash flows equals those of the bond’sinterest expense. The fair value of the IRS at inception is zero.

Management designates and documents the IRS as a fair value hedge of interest raterisk for the issued bonds. The hedge relationship is determined to be effective based onthe offsetting effect of the fair value changes of the IRS to the fair value changes ofthe bond.



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The following entries are made to record the transactions:

Debit Credit

1 January 20X1No entry is necessary related to the IRS, as the costis zero at inceptionCash 100,000,000Bonds payable 100,000,000To record the proceeds from the bond issuance

At 30 June 20X1, interest rates have increased. The interest rates for the next sixmonths of the variable leg of the swap have repriced from 5.7 per cent to 6.7 per cent.Due to this general increase in market interest rates, a fair value gain on the bondspayable and a loss on the IRS have resulted. The fair value of the bond (after settlementof interest) has changed from 100,000,000 to 96,196,000.

GTC separately revalues the IRS and has determined that its fair value is 3,804,000.Based on the offsetting effect of the fair value changes of the IRS and the fair valuechanges of the bond, management determines that the hedge is still effective.

The following accounting entries are recorded at 30 June 20X1:

Debit Credit

30 June 20X1Interest expense 3,000,000Cash 3,000,000To record the payment of six per cent fixed intereston the bonds

Bonds payable 3,804,000Hedging revaluation gain (income statement) 3,804,000To record the change in the fair value of the bondsattributable to the hedged risk

Cash 150,000Interest income 150,000To record the settlement of net interest accruals on theIRS for the period 1 January 20X1 to 30 June 20X1(Receive six per cent fixed 3,000,000; pay 5.7 per centfloating 2,850,000)

Hedging revaluation loss (income statement) 3,804,000IRS liability 3,804,000To record the change in the fair value of the IRS aftersettlement of interest

As can be seen from the above entries, the net interest expense shown in the incomestatement is 2,850,000, which represents the floating interest of 5.7 per cent.



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At 31 December 20X1, interest rates have not changed, therefore, the interest rate onthe variable leg of the swap remains at 6.7 per cent. The fair value (after settlement ofinterest) of the bond is 96,563,000.

GTC separately revalues the IRS and has determined that its fair value is 3,437,000.Based on the offsetting effect of the fair value changes of the IRS to the fair valuechanges of the bond, management determines that the hedge is still effective.

The following accounting entries are recorded at 31 December 20X1:

Debit Credit

31 December 20X1Interest expense 3,000,000Cash 3,000,000To record the payment of six per cent fixed intereston the bonds

Hedging revaluation loss (income statement) 367,000Bonds payable 367,000To record the change in the fair value of the bondsattributable to the hedged risk

Interest expense 350,000Cash 350,000To record the settlement of the IRS for the period30 June 20X1 to 31 December 20X1(Receive six per cent fixed 3,000,000;pay 6.7 per cent floating 3,350,000)

IRS liability 367,000Hedging revaluation gain (income statement) 367,000To record the change in the fair value of the interestrate swap

The interest expense shown in the income statement is 3,350,000, which representsthe floating interest of 6.7 per cent for this six-month period.

The balance sheet at 31 December 20X1 will be as follows:

Assets Liabilities and equity

Cash 93,800,000 Retained earnings (6,200,000)Bonds payable 96,563,000IRS liability 3,437,000

93,800,000 93,800,000



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The income statement shows interest expense related to the transactions as follows:

First half year at 5.7 per cent 2,850,000Second half year at 6.7 per cent 3,350,000

Total 20X1 6,200,000

Termination of the hedge

Assume that on 31 December 20X1, GTC determines that it should end the IRS hedgedue to a change in its risk position. GTC terminates the IRS and pays 3,437,000 to thecounterparty for settlement. The following entry is made:

Debit Credit

IRS liability 3,437,000Cash 3,437,000To record the settlement of the IRS for fair value at31 December 20X1

As can be seen from the balance sheet at 31 December 20X1, the bonds payable arecarried at 96,563,000. This results in a discount of 3,437,000 from the par value of100 million. This discount would be amortised over the remaining life of the bonds as ayield adjustment to the interest expense on the bonds payable.

In this example the hedge is found to be 100 per cent effective. This is due to thedesignation of the hedge. The hedge is designated such that the bond is hedged onlywith respect to changes in six-month LIBOR. Fair value changes due to other factorssuch as credit risk are excluded from the hedge relationship and therefore do not giverise to any ineffectiveness. As a result the only possible ineffectiveness would be dueto changes in credit risk from the counterparty to the swap since this would affect thefair value of the swap (remember that derivatives have to be designated in their entirety).

Case 9.2 Cash flow hedge of a variable rate liability

GTC requires financing for its operations of 100 million for five years. On 1 January20X1, GTC issues non-callable five-year 100 million floating rate bonds. The floatinginterest of LIBOR plus 50 basis points (0.5 per cent) is payable semi-annually. The bondsare issued at par.

As part of GTC’s risk management policy, it determines that it does not wish to exposeitself to fluctuations in market interest rates. After the issue of the bonds, GTCimmediately enters into a five-year interest rate swap (IRS) with a notional amount of100 million. The IRS pays six per cent fixed and receives floating cash flows based onLIBOR (set at 5.7 per cent for the period from 1 January to 30 June 20X1). The timingof the IRS cash flows equals those of the bond interest expense. The fair value of theIRS at inception is zero.

The IRS is designated and documented as a cash flow hedge of the future interestpayments on the bond. This is determined based on the offsetting effect of the cashflows of the IRS and the interest expense cash flows of the bond. The hedge relationshipis determined to be effective.



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The effective interest payable is fixed at 6.5 per cent (6 per cent fixed from the IRSplus the additional 0.5 per cent on the bond).

GTC records the following entries:

Debit Credit

1 January 20X1No entry is necessary related to the IRS, as the costis zero at inception

Cash 100,000,000Bonds payable 100,000,000To record the proceeds from the bond issuance

At 30 June 20X1, interest rates have increased compared to 1 January 20X1. The swaprate for the remaining term has increased from six per cent to seven per cent. Due tothis general increase in market interest rates, a fair value gain on the IRS results.

LIBOR increases to 6.7 per cent for the next six months of the variable leg. However,during this time the credit risk of the swap counterparty worsens and the applicableinterest rate associated with the counterparty has increased beyond the generalincrease in market interest rates. The increased credit risk of the counterparty resultsin a specific credit spread of 0.75 per cent. The discount rate to be used for discountingthe receivable (floating) leg of the swap is therefore 7.45 per cent at 30 June 20X1.As such the fair value of the IRS is determined to be 3,442,000 after the settlementof interest due on 30 June 20X1. The change in expected future cash flows on thebonds is 3,804,000.

The fair value changes of the IRS during the period from 1 January 20X1 to 30 June20X1 are summarised below:

1 January 20X1 30 June 20X1 Change

Fixed leg (100,000,000) (96,196,000) 3,804,000Floating leg 100,000,000 99,638,000 (362,000)

IRS – 3,442,000 3,442,000

To assess the effectiveness of the hedge, the change in the fair value of the floating legof the IRS is compared with the change in the fair value of the bond, as the hedged riskis the variability of interest cash flows from the bond. Since the interest on the bond isvariable and the interest rate for the next period has been set at the same date thehedge effectiveness is assessed, the change in the fair value of the bond is zero, resultingin a hedge ineffectiveness of 362,000.

However, based on the expected cash flows from the IRS, GTC determines thatthe relationship is still an effective hedge of the interest expense cash flows on thebond. Therefore, the full change in the fair value of the IRS is recognised in thehedge revaluation reserve as a component of equity. This adjustment is limited tothe lesser of the cumulative gain or loss on the hedging instrument (3,442,000) and



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the fair value of the cumulative change in expected future cash flows on the hedgeditem (3,804,000).

The following accounting entries are made at 30 June 20X1:

Debit Credit

30 June 20X1Interest expense 3,100,000Cash 3,100,000To record the payment of 6.2 per cent floating intereston the bonds payable (LIBOR 5.7 per cent pluspremium of 0.5 per cent)

Interest expense 150,000Cash 150,000To record the net settlement of the IRS for the period from1 January 20X1 to 30 June 20X1 (Pay six per cent fixed3,000,000; receive 5.7 per cent floating 2,850,000)

IRS 3,442,000Hedge revaluation reserve (equity) 3,442,000To record the change in the fair value of the IRS aftersettlement of interest

As can be seen from the above entries, the interest expense shown in the incomestatement is 3,250,000, which represents the fixed interest of 6.5 per cent.

At 31 December 20X1, interest rates have not changed since 30 June 20X1, however,the credit risk associated with the counterparty to the IRS has changed since that date.The counterparty specific credit spread has decreased from 0.75 per cent to 0.5 percent. The fair value (after settlement of interest) of the IRS is now 3,196,000.The expected future cash flows of the bond are now 3,437,000. Based on the offsettingof the change in expected cash flows on the IRS and the change in interest expensecash flows on the bond, the hedge is still deemed to be effective.

The following accounting entries are recorded:

Debit Credit

31 December 20X1Interest expense 3,600,000Cash 3,600,000To record the payment of 7.2 per cent floatinginterest on the notes (LIBOR of 6.7 per cent plusa premium of 0.5 per cent)



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Debit Credit

Cash 350,000Interest income 350,000To record the settlement of the IRS for the period from1 July 20X1 to 31 December 20X1(Pay six per cent fixed 3,000,000;receive 6.7 per cent floating 3,350,000)

Hedge revaluation reserve (equity) 246,000IRS 246,000To adjust the fair value of the cash flow hedge

As can be seen from the above entries, the interest expense shown in the incomestatement is again 3,250,000, which represents the fixed interest of 6.5 per cent.

The balance sheet at 31 December 20X1 will be as follows:

Assets Liabilities

Cash 93,500,000 Retained earnings (6,500,000)IRS asset 3,196,000 Equity (hedge revaluation

reserve) 3,196,000Bonds payable 100,000,000

96,696,000 96,696,000

Case 9.3 Cash flow hedge using an interest rate cap

At 1 January 20X1, DEBTCO obtains a three-year loan of 10,000,000. The interest rateon the loan is variable at LIBOR plus two per cent. DEBTCO is concerned that interestrates may rise during the next three years, but wants to retain the ability to benefit fromLIBOR rates below eight per cent. In order to protect itself from this exposure, DEBTCOpurchases for 300,000 an out-of-the-money interest rate cap from a bank. When LIBORexceeds eight per cent for a particular year DEBTCO receives from the bank under thecap an amount calculated as 10,000,000 * (LIBOR – eight per cent).

The combination of the cap and the loan results in DEBTCO paying interest at avariable rate (LIBOR plus two per cent) not exceeding 10 per cent. On both thevariable-rate loan and the interest rate cap, rates are reset at 1 January and interestamounts are settled at 31 December.

DEBTCO designates and documents the intrinsic value of the purchased interest ratecap as a cash flow hedge of the interest rate risk attributable to the future interestpayments on the loan for changes in LIBOR above eight per cent. Changes in the timevalue of the option will be excluded from the assessment of hedge effectiveness.Therefore, time value changes are recognised in the income statement as they arise.

The critical terms of the cap are identical to those of the loan and DEBTCO concludesthat, both at inception of the hedge and on an ongoing basis, the hedge relationship isexpected to be highly effective in achieving offsetting cash flows attributable to changes



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in LIBOR when LIBOR is greater than eight per cent. As the cap is being used topurchase one-way protection against any increase in LIBOR, DEBTCO does notneed to assess effectiveness in instances where LIBOR is less than eight per cent.The cumulative gains or losses on the interest rate cap, adjusted to remove time valuegains and losses, can reasonably be expected to equal the present value of the cumulativechange in expected future cash flows on the debt obligation when LIBOR is greaterthan eight per cent. This should be reassessed each reporting period.

During the three-year period LIBOR rates and related amounts are as follows:

Receivable Interestunder payable on Net interest Net interest

Date Rate cap loan payable payable

20X1 7% – 900,000 900,000 9%20X2 9% (100,000) 1,100,000 1,000,000 10%20X3 10% (200,000) 1,200,000 1,000,000 10%

The fair value, intrinsic value and time value of the interest rate cap and changes thereinat the end of each reporting period, but before cash settlement of interest are as follows:

Change in Change inIntrinsic fair value time value

Date Fair value value Time value gain/(loss) gain/(loss)

1 January 20X1 300,000 – 300,000 – –31 December 20X1 280,000 – 280,000 (20,000) (20,000)31 December 20X2 350,000 200,000 150,000 70,000 (130,000)31 December 20X3 200,000 200,000 – (150,000) (150,000)

IAS 39 does not specify how to compute the intrinsic value of a cap option where theoption involves a series of payments. In this example, the intrinsic value of the cap isassumed to equal the expected future cash flows holding constant the cap’s currentreporting period cash flow of one per cent (nine per cent – eight per cent) for theremaining term of the cap and excluding the time value of money. Alternatively, theintrinsic value of the cap might be calculated for each reporting period by comparingthe cap rate with the market’s expectations of movements in LIBOR using the LIBORforward yield curve.

Assuming that all criteria for hedge accounting have been met, the following journalentries must be made on 1 January 20X1 and 31 December 20X1, 20X2, and 20X3:

Debit Credit

1 January 20X1Cash 10,000,000Loan payable 10,000,000To record the initial borrowing

Interest rate cap (asset) 300,000Cash 300,000To record the purchase of interest rate cap



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Debit Credit

31 December 20X1Interest expense (income statement) 900,000Cash 900,000To record interest expense on the loan(LIBOR + two per cent)

Hedge expense (income statement) 20,000Interest rate cap (asset) 20,000To record the change in the fair value of the interestrate cap – time value change

31 December 20X2Interest expense (income statement) 1,100,000Cash 1,100,000To record interest expense on the loan(LIBOR + two per cent)

Hedge expense (income statement) 130,000Interest rate cap (asset) 70,000Hedging reserve (equity) 200,000To record the change in the fair value of the interest ratecap. 130,000 represents the change in time value,which is excluded from the assessment of hedgeeffectiveness, and 200,000 represents the increasein the interest rate cap’s intrinsic value

Hedging reserve (equity) 100,000Hedge income (or interest income) (income statement) 100,000Represents the release to the income statement of theproportion of the increase in intrinsic value of the capwhich relates to the realised cash flow through interestexpense incurred in 20X2

Cash 100,000Interest rate cap (asset) 100,000To record the cash received upon settlement of theinterest rate cap

31 December 20X3Interest expense (income statement) 1,200,000Cash 1,200,000To record interest expense on the loan(LIBOR + two per cent)

Hedge expense (income statement) 150,000Interest rate cap (asset) 50,000Hedging reserve (equity) 100,000To record the change in the fair value of the interest ratecap – 150,000 loss represents the time value change;100,000 gain represents the intrinsic value change



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Debit Credit

Hedging reserve (equity) 200,000Hedge income (or interest income) (income statement) 200,000To record the release to the income statement of theproportion of the increase in intrinsic value of the capwhich relates to the realised cash flow through interestexpense incurred in 20X3

Cash 200,000Interest rate cap (asset) 200,000To record the cash received upon final settlement of theinterest rate cap

As a result of the hedge, DEBTCO has effectively capped its interest expense on thethree-year loan at 10 per cent. Specifically, during those periods where the contractualterms of this loan would result in an interest expense greater than 10 per cent or 1,000,000(i.e. in instances where LIBOR exceeded eight per cent), the payments received fromthe interest rate cap effectively reduce interest expense to 10 per cent as illustratedbelow. However, recognition in earnings of changes in the fair value of the cap due tochanges in time value results in variability of total interest expense during each year:

20X1 20X2 20X3

Interest on LIBOR + two per cent debt 900,000 1,100,000 1,200,000Reclassified from equity (effect of cap) – (100,000) (200,000)

Interest expense adjusted by effectof hedge 900,000 1,000,000 1,000,000Change in time value of cap 20,000 130,000 150,000

Total expense 920,000 1,130,000 1,150,000

9.2.4 Net position hedging of interest rate risk

Banks and similar financial institutions often manage this risk on a net basis, usually intime buckets which group assets and liabilities by the earlier of expected maturity orrepricing date. Such entities assess the interest rate risk in all interest-bearing financialassets and liabilities and determine the net exposures. This is because there may be somenatural offsets within an entity’s balance sheet already, particularly so for banks andother financial institutions. Therefore, it is only for the net risk positions that the entitymay decide to obtain derivatives or other instruments to provide an economic hedge.

39.84, AG101 For hedge accounting purposes, a net position may not be designated as the hedged item.and IG F.2.21 However, an entity still may be able to apply hedge accounting if the hedge relationship is

designated in a way that meets the criteria set forth in IAS 39. Generally the entity needsto select (one or a group of) specified assets or liabilities, cash flows or forecastedtransactions that are part of the net position, and designate these as the hedged item.Case 9.4 gives a basic example of this approach.

The above approach may be useful in some cases, although it is arbitrary in that thehedged item (for accounting purposes) is not the net position (i.e. the real economic risk)



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that the entity wants to manage. Further, this approach may not be practical for entitiesthat have an ongoing interest rate risk management program and have large volumes ofnetted interest rate positions. This is typically the case for financial institutions.

An entity may tailor its own method to satisfy the basic criteria in IAS 39 while utilisingexisting risk management systems. One such method, which is a further extension of thebasic approach above, is provided in IG F.6.3, which is an illustrative example of applyingQuestion IG F.6.2 Hedge accounting considerations when interest rate risk is managedon a net basis. This example illustrates a method for hedging interest rate risk in aportfolio of interest-bearing assets and liabilities using interest rate swaps. The methodinvolves scheduling out all of the entity’s interest rate cash flow exposures (hedged items)and all of its interest rate swaps (hedging instruments) over a period of time. A typicalschedule / gap analysis might use one-month time periods for up to several years in thefuture. For longer-term assets and liabilities, the schedule might use one-year or evenlonger time periods. A summary of this method is described in the following steps, andshould be read in conjunction with the IGC’s illustrative example.

Step 1: The entity should identify for each reporting period:

■ the forecasted principal and interest cash inflows and outflows (from both fixedand variable rate assets and liabilities); and

■ the interest repricing exposures (from variable rate assets and liabilities), explainedin the note below.

All of the identified cash flows are scheduled out in a maturity schedule. The scheduleshould reflect estimates about prepayments and defaults. The cash inflows and outflowsand the repricing of variable rate assets and liabilities create a net exposure in eachperiod – either a net cash inflow that needs to be reinvested, or a net cash outflow thatneeds to be paid. The net exposure identified for each period may be used as thestarting point for assessing the entity’s overall cash flow exposure to interest rates.

Note: For fixed rate instruments, the fixed interest to be received or paid and theprincipal are included in the analysis in each period in which they are expected to bereceived or paid. There is presumed to be an exposure to interest rates in that periodbecause the cash flows will need to be reinvested or refinanced during that period.For variable rate instruments, the entire notional amount and estimated interest amountsare included in each period that the instruments are expected to reprice. Interest amountsfor variable rate instruments can be estimated using forward rates. For both the fixedrate and variable rate instruments, there is a common exposure to interest rate changescreated by the reinvestment, refinancing or repricing of the instruments’ cash flows.

Step 2: If the entity already has pre-existing interest rate swaps that would meethedge accounting criteria, these should be included in the analysis in each period thatthey are outstanding to determine the entity’s actual net exposure. The notional amountsof existing interest rate swap contracts are compared to the net exposures determinedin Step 1. Any difference between the two is the amount of remaining exposure thatthe entity may want to hedge.

Note: Similar to variable rate instruments, the notional amounts of the interest rate swapsare included in each period that they remain outstanding. The swaps’ notional amounts



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create an interest rate exposure because interest is computed based on the notionalamount each period, and the variable component of the swap is repriced each period.

Step 3: At this point the entity has identified its actual net exposure to interest rate risk.The entity’s risk management policies usually will identify what is a tolerable interestexposure to leave unhedged. To the extent that the net exposure exceeds riskmanagement limits, the entity may hedge the balance by entering into additional interestrate swaps (or other interest rate derivatives) to reduce that part of the exposure.

Note: Steps 1 to 3 above are procedures an entity may follow in doing economichedging. This may even be how the entity addresses interest rate risk already. However,further steps are needed to qualify for hedge accounting.

Step 4: In order to apply hedge accounting, the hedging instruments in each periodnow need to be associated with a gross cash flow position. Steps 1 to 3 identified thenet exposures that the entity wants to hedge. However, the interest rate swaps nowneed to be specifically related to cash flow interest risks, for both effectiveness testingand for accounting purposes.

(a) The entity determines the expected interest from the reinvestment of the cashinflows and repricing of assets by multiplying the gross amounts of exposure foreach period by the forward rate for each period. (This assumes that the actual netexposure determined in Step 3 is an inflow exposure. If the actual net exposure isan outflow, the entity determines the expected interest based on refinancing ofcash outflows and repricing of liabilities.)

(b) The designated hedged item is the expected interest from the reinvestment of thecash inflows or repricing of the gross amount for the first period after theforecasted transaction occurs. Because of this designation, it does not matterthat the cash flows from that period are from both fixed and from variable instrumentsor from rollovers of short-term debt, nor for what period of time the cash flows willbe reinvested. The key feature is that all of these instruments share the sameexposure to changes in the forward interest rate during that one period. There isinterest rate exposure in subsequent periods as well, however, that is not designatedas being hedged as that would require knowing the number of periods ofreinvestment, refinance or repricing for all items.

(c) The entity determines the portion of its gross cash flows that are being hedged(expressed in terms of a percentage). This is simply the notional amount of theinterest rate swaps designated as hedging instruments in each period divided by thegross amounts of exposure for each period. This percentage is applied to the grossinterest calculated in Step 4(b) above to determine the hedged expected interest.

Step 5: Hedge effectiveness of the net position needs to be tested at least each reportingperiod. However, this process is simplified due to the designation of the hedged item asa portion (expressed as a percentage) of expected interest for the first period onlyafter the forecasted transaction. Therefore, to the extent that total expected interestcash inflows exceed the hedged interest cash inflows in each of the periods beinghedged by the swaps, the entity only need compare the cumulative changes in thepresent value of the hedged interest cash inflows with the cumulative change in thefair value of the interest rate swaps.



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Note: The interest rate hedged should be defined as the benchmark interest rate.In that case the effectiveness test results would be very highly effective.

Figure 9.1 Steps 1 to 3 illustrated: Identify the interest rate exposure and swapsused for hedging

Figure 9.2 Step 4 illustrated: Identify gross cash flows as the hedged positions

By following the approach suggested in the illustrative example set out in IG F.6.3, therequirements in IAS 39 are met in respect of what qualifies as a hedging instrumentand hedged item. Namely:

39.81 ■ Hedged item: The hedged expected interest is a portion of the total cash flows.For financial assets and liabilities, an entity may designate a portion of a cash flowas the hedged item. In this example that portion is the cash flows occurring in thefirst period after the reinvestment / repricing date.

39.75 ■ Hedging instrument: The interest rate swaps are designated as hedging the expectedinterest cash inflows for each remaining period in which the swaps are outstanding.



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Case 9.4 Net position hedging – interest rate risk

A bank monitors its interest rate risk exposures through reviewing gaps within repricingbands of net asset or liability positions of a single currency. For illustration purposes,only the first three months are illustrated. (Normally the maturity breakdown wouldinclude periods up to, for example, 10 years, with a detailed breakdown in the first yearand wider bands in subsequent years.)

Less than 1 month 1 to 2 months 2 to 3 months

AssetsTreasury bills 100 300 200Placements with banks 300 500 400Loans 5,000 5,200 6,500Bonds 200 100 300

Assets in the repricing band 5,600 6,100 7,400

LiabilitiesCustomer deposits 4,000 2,500 3,500Deposits from banks 2,000 3,200 3,000Bills, commercial paper issued 300 100 500

Liabilities in the repricing band 6,300 5,800 7,000

Net position for the currency (700) 300 400

Under a net position-hedging scenario, if the bank wishes to hedge the entire 700 netliability exposure in the first time band, it could do so through a derivative instrumentfor the repricing band of less than one month. However, rather than documenting thenet position as the hedged item, the bank could designate 700 of customer deposits inthe less than one-month band, and hedge accounting could be applied.

In order to illustrate this, suppose that the bank designates a swap (pay-fixed, receive-variable) as a cash flow hedge of the interest payable on 700 of liabilities that repriceeach month, such as the bottom layer of the customer deposits. The bank must establishthat it is highly probable that greater than 700 of customer deposits with similarcharacteristics will be available each month the swap is outstanding. The customerdeposits designated should share the same exposure to the risk that is being hedged,e.g. the exposure to a benchmark interest rate risk. The bank could perform statisticalanalysis to document this shared risk basis. Forecasting of cash flows should be part ofthe asset and liability management process of forecasting the repricing cash flows ofthe bank, and supported by the history of actual repricing cash flows. High probabilityof the expected cash flows could be supported if customer deposits of far more than700 are available. The same approach described here may be used for the other repricingbands noted above.



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Case 9.5 Hedging on a group basis – interest rate risk

Assume that a bank has both a trading desk and a banking desk. The banking deskmanages the interest, liquidity and other risk exposures from the bank’s lending andfunding operations. Financial assets and liabilities of these operations are generallycarried at amortised cost. In order to manage its interest rate risk exposures, the bankingdesk enters into interest rate swap agreements with the trading desk to swap a floatingrate of interest for a fixed rate (cash flow hedge). These transactions with the tradingdesk are documented as hedging transactions and the banking desk would like to applyhedge accounting.

The trading desk enters into various other derivative agreements with external partiesas part of its trading activities, in addition to the transactions with the banking desk. Inthe accounting records of the trading desk, all such instruments are trading instrumentsand are carried at fair value with changes recognised in the income statement.

IG F.1.5-7 Hedge accounting is not appropriate for internal transactions unless it can bedemonstrated that for each instrument that the banking desk has entered into with thetrading desk, there is an equivalent contract that the trading desk entered into with anexternal party. In practice, this can be achieved, for example, by setting up a separatebook for the transactions of the trading desk with the banking desk and the relatedexternal party transactions.

The transactions that would be entered into by the bank in order to apply hedge accountingare noted below. The example assumes an exposure to a floating rate liability, with therate based on the six-month inter-bank rate:

Banking desk – internal swap

■ Receive variable at the six-month inter-bank rate – notional 100 million.

■ Pay-fixed at eight per cent – notional 100 million.

Trading desk – internal swap

■ Receive-fixed at eight per cent – notional 100 million.

■ Pay-variable at the six-month inter-bank rate – notional 100 million.

Trading desk – external swap

■ Receive variable at the six-month inter-bank rate – notional 100 million.

■ Pay-fixed at eight per cent – notional 100 million.

■ Term and payment dates of external swap mirror those of the banking desk’sinternal swap.

The swap with the external party is effective in offsetting the exposure of the bankingdesk. Therefore, in the above case, hedge accounting is appropriate, provided theother hedge criteria are met. However, if instead an interest rate swap with a notional75 million was outstanding with a third party, the accounting treatment would be different.In such a case, no more than 75 million could be designated as a hedge and wouldqualify for hedge accounting.



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It is possible to achieve hedge accounting when the trading desk aggregates severalinternal swaps, or portions thereof, and enters into one offsetting external contract.The aggregated internal swaps must be a gross amount, i.e. they should not be used tooffset each other. This approach can be done provided that the external swap is identifiedand is effective in hedging the aggregate exposure of the banking desk.

Fair value hedging accounting for interest rate risk on a portfolio basis

The IASB is in the process of considering amendments that might allow financial institutionsin particular more easily to apply fair value hedge accounting for hedges of interest raterisk when its risk management approach is to hedge a net balance sheet position. At thedate of this publication, certain issues such as the measurement of ineffectiveness, theamortisation of the fair value hedge adjustments to the portfolio and the treatment ofdemand deposits in such a model remain under discussion. The IASB expects to issuelimited amendments to the standards in this respect in March 2004.



Hedge accounting for hedges of foreign currency risk is commonly used for:

■ hedging the future cash flows or value (foreign currency component) of non-monetaryfinancial assets or liabilities when fair value changes are not recognised in the incomestatement (fair value or cash flow hedge); and

■ hedging forecasted future transactions in foreign currency (cash flow hedge) whethera firm / contractual commitment or a highly probable anticipated transaction.

Accounting for the hedge of foreign currency risk on a non-financial asset as a fair valuehedge requires that the hedged item itself is denominated in a foreign currency, as opposedto an asset that is expected to be sold in a foreign currency. That is, it must have aseparately measurable foreign currency component in its pricing. An example of this is aninvestment property located in a country with a different currency and that is measuredat fair value at each balance sheet date. The fair value of this property will include acurrency component equal to the changes in the spot rate between the foreign currencyand the owner’s measurement currency. Application of hedge accounting principles tothis currency exposure will not change the measurement of the hedged item or the hedginginstrument as gains or losses resulting from changes in foreign exchange rates would berecognised in the income statement.

IG F.6.5 Property, plant and equipment carried at historical cost cannot be hedged for foreigncurrency risk since the assets are not remeasured for changes in foreign exchange rates.However, if these assets are expected to be sold, the expected cash flows from this salecould be a hedged item under a cash flow hedge provided that the transaction is highlyprobable and the other criteria for hedge accounting are met.



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9.3.2 The effect of delays or prepayments of hedged cash flows

Delays or prepayments of hedged cash flows frequently occur when hedging foreigncurrency risk in a cash flow hedge. However, these issues are also applicable any time anentity is hedging other types of financial risks in forecasted transactions.

Determining the timing of forecasted cash flows involves making estimates.Sometimes cash flows do not occur when they are expected. In determining the appropriateaccounting treatment for delayed transactions it is useful initially to distinguish betweenhedged cash flows related to:

■ a firm commitment;

■ a forecasted transaction with an identified counterparty; and

■ forecasted transactions with unidentified counterparties.

9.3.2.1 Firm commitments and forecasted transactions with identified counterparties

39.101 Whenever the timing of delivery, payments or other terms under a firm commitment arechanged, an entity must evaluate whether the original firm commitment still exists, or whethera new firm commitment with new terms has been created. The latter situation would resultin the original hedge relationship being terminated and the gains or losses on the hedginginstrument previously recognised in equity would be recognised in the income statement.

A firm commitment could be delayed for a number of reasons such as a breach of thecontract, liquidity problems on the part of the counterparty, delayed delivery or complaintsabout delivery. Alternatively, it may be due to customers’ changing specifications for theordered product or a change in a customer’s production schedule. If the firm commitmentis delayed, but will still occur, it is important to determine the cause and duration of the delay.

IG F.5.4 When delays of cash flows occur, it is our view that hedge accounting may be continuedunder certain circumstances. These circumstances are that the firm commitment can stillbe uniquely identified, a binding agreement still exists and the cash flows are still expectedto occur within a relatively short period of time after the original transaction date. For afirm commitment, this last item should be interpreted rather narrowly because the contractsupporting a firm commitment generally will specify a date or range of dates. If a date(e.g. delivery date, completion date) is not specified, the transaction is unlikely to meetthe definition of a firm commitment; rather it should be hedged as a forecasted transactionwith an identified counterparty.

IG F.3.11 For a forecasted (highly probable) transaction with an identified counterparty, there maybe a little more flexibility in what is regarded as a relatively short period of time becausethere is no firm commitment that establishes a delivery date.

The key issue is, when taking into account all the facts and circumstances surroundingthe delay, whether the entity can demonstrate that the delayed transaction is the sametransaction as the one that was originally hedged.

IG F.5.4 When the timing of a firm commitment or a highly probable forecasted transaction isdelayed, some degree of ineffectiveness is likely to occur, since the timing of the hedgeditem and the hedging instrument will no longer be the same.



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IG F.5.4 and In other cases the timing of a hedged cash flow may change to be earlier than originally39.75 expected. Since the hedging instrument would expire later than the hedged cash flows,

some ineffectiveness is likely to occur in this situation as well. However, the hedginginstrument may not be re-designated for a shorter period (i.e. until the cash flow is nowexpected to occur), as there is still the requirement that a hedging instrument must bedesignated for its entire remaining time outstanding.

9.3.2.2 Cash flows from forecasted transactions with unidentified counterparties

Cash flows from forecasted transactions with unidentified counterparties are designatedwith reference to the time period in which the transactions are expected to occur. This isbecause these forecasted transactions do not yet have any identified counterparties thatwould otherwise allow them to be identified with respect to a specific expected transaction.

When forecasted cash flows in one period do not occur, an entity may be able todemonstrate that such a shortfall will be offset by increased cash flows in a later period.For example, an entity initially forecasts sales of FC 100 in each of the first two quartersof the next year. At a later point the entity revises its forecast to expected sales of FC 75in the first quarter and FC 125 in the second quarter. The total amount of sales in the twoquarters remains unchanged at FC 200.

39.88, 39.101 For hedge accounting to be continued the original forecasted transaction must still existand IG F.3.7 and be highly probable of occurring. When the hedged item is designated as cash flows

from forecasted transactions (e.g. forecasted sales) with unidentified counterparties withina certain time period, it would be very unlikely that an entity would be able to demonstratethat sales in later periods are due to a shortfall in an earlier period. In that case hedgeaccounting should be discontinued. In addition, a history of designating hedges offorecasted transactions and then determining they are no longer expected to occur maycall into question the entity’s ability to accurately predict forecasted transactions, as wellas the propriety of using hedge accounting in the future for similar transactions.

IG F.3.11 The transactions must take place within a narrow range of time from a most probabledate. In determining the length of such a period, the industry and environment that theentity operates in should be considered. Our view is that for forecasted transactions withunidentified counterparties, this narrow range of time should be more strictly interpreted(i.e. a shorter time period) than for forecasted transactions with identified counterparties.

9.3.3 Effectiveness testing of foreign currency hedging transactions

The principles described in Section 8.6.2 also are applicable when hedging foreigncurrency risk. Entities often hedge foreign currency risk from forecasted transactionsusing forward contracts. In performing hedge effectiveness testing, the changes in thefair value of the forward and the change in expected cash flows from the forecastedtransactions must be measured.

IG F.5.6 A hedge relationship between a forecasted transaction and a forward contract used tohedge the foreign currency risk may be measured based on either spot rates or forwardrates. The method used must be included in the hedge documentation. Both approacheshave potential benefits and drawbacks. If effectiveness is measured based on forwardrates, the forward points on the forward contract will not be recognised in the incomestatement to the extent the forward is fully effective. However, regardless of whether



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forward rates or spots rates are applied, timing differences between the settlement of theforecasted transaction and the derivative will cause some ineffectiveness.This ineffectiveness must be measured whenever the entity performs its effectivenesstesting, and recognised in the income statement.

The following cases demonstrate a number of the issues that have been discussed inSection 9.3 about hedging foreign currency risk.

Case 9.6 Cash flow hedge of foreign currency sales transactions

Components Manufacturer produces components that are sold to domestic and foreigncustomers. Export sales are denominated in the customers’ measurement currency.In order to reduce the currency risk from the export sales, Components Manufacturerhas the following hedging policy:

■ a transaction is committed when the pricing, quantity and timing are fixed;

■ committed transactions are hedged 100 per cent;

■ anticipated transactions that are highly probable are hedged 50 per cent; and

■ only transactions anticipated to occur within six months are hedged.

For export sales, cash payment falls due one month after the invoice date. ComponentsManufacturer projects sales to its foreign customers during April 20X1 will be 100,000units, amounting to sales revenue of foreign currency (FC) 10,000,000.

At 28 February 20X1, all of the FC 10,000,000 of sales in April 20X1 are still anticipatedbut uncommitted. Therefore, only 50 per cent of the total anticipated sales are hedged.The hedge is transacted by entering into a foreign currency forward contract (forward 1)to sell FC 5,000,000 for measurement currency (MC) at 0.6829 at 15 May 20X1 and isdocumented as a cash flow hedge. The hedge is expected to be highly effective.Hedge effectiveness will be assessed by comparing the changes in the discounted cashflows of the incoming amounts of FC to the changes in fair value of the forward contract.Components Manufacturer includes the time value of foreign currency forward contractswhen measuring hedge effectiveness. This is expected to give a nearly 100 per centeffective cash flow hedge as the fair value of the sales transactions during the period ofthe hedge will be affected by FC interest rates as well as the spot rates.

A review of the sales order book at 31 March 20X1 shows that all of the anticipatedsale contracts for invoicing in April are now signed. In accordance with the hedgingpolicy, a further foreign currency forward contract (forward 2) is entered to sellFC 5,000,000 for MC at 0.7100 at 15 May 20X1, in order to hedge the currency inflowfrom the remaining 50 per cent of the sales.



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The spot and forward exchange rates and the fair value of the forward contracts areas follows:

Fair value Fair valueof forward of forward

sale of sale ofForward FC 5,000,000 FC 5,000,000

Spot rate rate (forward 1) (forward 2)Date (1 FC = MC) (1 FC = MC) (in MC) (in MC)

28 February 0.6860 0.6829 – N/a31 March 0.7120 0.7100 (134,491) –30 April 0.7117 0.7108 (139,152) (3,990)15 May 0.7208 N/a (189,500) (54,000)

The fair value of the forward is the present value of the expected settlement amount,which is the difference between the contract rate and the forward rate multiplied bythe notional foreign currency amount. The discount rate used is six per cent.

During April export sales of FC 10,000,000 are invoiced and recognised in the incomestatement. The deferred gain or loss is released from equity and recognised in the incomestatement. The cash flows being hedged are now recognised in the balance sheet asreceivables of FC 10,000,000. As a result hedge accounting is no longer necessary becauseforeign currency gains and losses on the amounts receivable are recognised in the incomestatement and will be offset by the revaluation gains and losses on the forwards.

Assuming that all criteria for hedge accounting have been met, the required journalentries are as follows (amounts in MC):

Debit Credit

28 February 20X1No entries in income statement or balance sheet arerequired. The fair value of the forward contract is zero

31 March 20X1Hedging reserve (equity) 134,491Derivatives (liabilities) 134,491To record the change in fair value of forward 1

1 to 30 April 20X1Trade receivables 7,115,000Export sales 7,115,000To record the sales transactions at the prevailing rate onthe date the sales are recognised (on average assumedto be 0.7115)

30 April 20X1Trade receivables 2,000FX gain on trade receivables (income statement) 2,000To record the trade receivables at the closing spot rate;FC 10,000,000*(0.7117 – 0.7115)



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Debit Credit

Hedging reserve (equity) 4,661Derivatives (liabilities) 4,661To record the change in fair value of forward 1

Hedging reserve (equity) 3,990Derivatives (liabilities) 3,990To record the change in fair value of forward 2

Export sales (income statement) 143,142Hedging reserve (equity) 143,142To record the release of the deferred hedge resultsupon recording the sales (MC 139,152 + MC 3,990)

1 to 15 May 20X1Cash 3,575,000Trade receivables 3,575,000To record the payments from receivables at the spot rateat the day of payment (on average 0.7150)

Trade receivables 16,500FX gain on trade receivables (income statement) 16,500To record the FX gain on trade receivables;FC 5,000,000*(0.7150 – 0.7117)

15 May 20X1Cash 29,000FX gain on cash (income statement) 29,000To record the revaluation of the bank balance to15 May spot rate; FC 5,000,000*(0.7208 – 0.7150)

Trade receivables 45,500FX gain on trade receivables (income statement) 45,500To record the FX gain on trade receivables;FC 5,000,000*(0.7208 – 0.7117)

FX loss on forward (income statement) 50,348Derivatives (liabilities) 50,348To record the change in fair value of forward 1 for theperiod from 1 to 15 May

FX loss on forward (income statement) 50,010Derivatives (liabilities) 50,010To record the change in fair value of forward 2 forthe period from 1 to 15 May

Derivatives (liabilities) 189,500Cash 189,500To record the settlement of forward 1

Derivatives (liabilities) 54,000Cash 54,000To record the settlement of forward 2



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Debit Credit

15 to 31 May 20X1Cash 3,655,000Trade receivables 3,655,000To record the payments from receivables at the spot rateat the day of payment (on average 0.7310)

FX loss on cash (income statement) 51,000Cash 51,000To record the FX loss on forwards settled before allreceivables were paid. The FC bank account was over-drawn for a period; FC 5,000,000*(0.7310 – 0.7208)

Trade receivables 51,000FX gain on trade receivables (income statement) 51,000To record the FX gain on payments of receivables;FC 5,000,000*(0.7310 – 0.7208)

Summary

At 31 May 20X1, after all these transactions have settled, the balance sheet, includingthe income statement impact, is as follows (amounts in MC):

Assets Equity

Cash 6,964,500 Export sales (retained earnings) 6,971,858FX loss (retained earnings) (7,358)

Total assets 6,964,500 Total equity 6,964,500

The bank balance reflects the settlement of the two forward contracts (amounts in MC):

Forward 1: FC 5,000,000 at 0.6829 3,414,500Forward 2: FC 5,000,000 at 0.7100 3,550,000

Total 6,964,500

The FX loss in this example is caused by:

■ Timing mismatches: Receivables and sales are recognised at the spot rate at thedate of the transaction (on average 0.7115) during April; whereas the release fromthe hedge revaluation reserve is recognised at the end of April (for practical reasons)when the rate was 0.7117. Furthermore, receivables are collected during the monthof May and recognised at the relevant spot rates, whereas the forward contractsare settled on 15 May.

■ Interest element on the forward contracts for the period where hedge accounting isnot applied (1 to 15 May): From 30 April the cash flow hedge is de-designated, butthe forward contracts remain as an economic hedge of the receivables to be collectedduring May. The FX results on the receivables are recognised in the income statement,as are the results on the forward contracts. A perfect offset is not achieved due tothe interest element included in the changes in fair value of the forward contracts.



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Termination of hedge accounting

Assume the same scenario as above except that on 31 March 20X1 the committedtransactions are actually only FC 3,000,000 and there are no more anticipatedtransactions for April 20X1. In such a case it is now unlikely that the anticipated salestransactions will occur, and hedge accounting for FC 2,000,000 of the originallyanticipated sales of FC 5,000,000 must be discontinued. However, ComponentsManufacturer may continue to have a hedge relationship for FC 3,000,000.The unrealised FX loss on the FC 2,000,000 should be recognised immediately in theincome statement as the cash flow is no longer expected to occur. The unrealised FXloss relating to the FC 3,000,000 that is still expected remains in equity. Fair valuechanges on the foreign currency forward contract must be recognised in the incomestatement to the extent the anticipated sales will not occur.

The following journal entries are required (amounts in MC):

Debit Credit

31 March 20X1FX losses (income statement) 53,796Hedging reserve (equity) 53,796To record in the income statement the portion ofdeferred losses that reflects the cash flows that areno longer expected to occur (134,491*2/5)

Case 9.7 Cash flow hedge of foreign currency purchase transactions

Components Manufacturer purchases certain subcomponents in the Far East.At 28 February 20X1, Components Manufacturer signs a contract to purchase onemillion units of subcomponents from a foreign supplier for delivery at 31 March. Theprice is foreign currency (FC) 750 million which falls due at 30 April 20X1. The entity’srisk management policy is to hedge foreign currency transactions of more thanmeasurement currency (MC) 2.5 million. Components Manufacturer hedges the foreigncurrency risk by entering into a forward contract to purchase FC 750 million for MCon 30 April 20X1 at 102.46. The hedge is documented and accounted for as a cashflow hedge. Effectiveness testing is based on changes in forward rates.

Forward rate for Fair value of30 April forward

Spot rate settlement contractDate (1 MC = FC) (1 MC = FC) (in MC)

28 February 102.75 102.46 –31 March 105.78 105.51 (211,070)30 April 104.17 N/a (120,160)



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Debit Credit

28 February 20X1No entries in the income statement or balance sheet arerequired. The fair value of the forward contract is zeroat that date

31 March 20X1Hedging reserve (equity) 211,070Derivatives (liabilities) 211,070To record the change in fair value of the forward

Inventories 7,090,187Trade liabilities 7,090,187To record the purchase transaction at the spot rate onthe delivery date (FC 750,000,000/105.78 spot rate)

Inventories 211,070Hedging reserve (equity) 211,070To record the release of the deferred hedge results uponde-designation of the hedge

30 April 20X1FX loss on trade liabilities (income statement) 109,583Trade liabilities 109,583To record the FX loss on the liability

Derivatives (liabilities) 90,910FX gain (income statement) 90,910To record the change in fair value of the forward

Trade liabilities 7,199,770Cash 7,199,770To record payment of the liability at the spot rateon the payment date

Derivatives (liabilities) 120,160Cash 120,160To record the settlement of the forward

The effect of the hedge is recognised as a basis adjustment to the cost of inventory.The adjustment to inventory is recognised in the income statement in cost of saleswhen the inventory is sold.



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Case 9.8 Fair value hedge of foreign currency risk on available-for-sale equities

Safeinvestor is a large pension fund set up for the employees of a brewery. In recentyears the pension fund assets have grown and management is finding it increasinglydifficult to achieve a sufficient diversification in the domestic equity market. Also, management believes that it is possible to earn a higher return on equity shares incertain foreign markets. Consequently, management decides to invest in a large foreignequity market. However, all of Safeinvestor’s pension obligations are denominated inits measurement currency (MC), and as part of the investment strategy Safeinvestorseeks to hedge all significant exposure to foreign currency risk beyond certain limits.

At 1 April 20X1, Safeinvestor buys a portfolio of foreign currency denominated equityshares for foreign currency (FC) 30 million. The shares are treated as available-for-sale securities with changes in the fair value being recognised directly in equity.

Although a steady growth in the value of the portfolio is expected in the medium tolong-term, and accordingly an increased foreign currency exposure, Safeinvestor decidesto hedge only 85 per cent of the market value of the portfolio. This is because of theuncertainty about the short-term development in the market value (and therefore theexposure). Safeinvestor enters into a foreign currency forward contract to sellFC 25.5 million for MC at 15 October 20X1. This contract will then be rolled for aslong as the position is outstanding. If the value of the portfolio increases significantly,Safeinvestor’s policy is to adjust the hedge by entering into additional foreign currencyforward contracts so that at least 75 per cent of the foreign currency risk is hedged.

The forward contract is designated as a fair value hedge of the currency risk associatedwith the first FC 25.5 million of shares. The time value of the forward contract isexcluded from the assessment of hedge effectiveness. The hedge is expected to behighly effective and hedge effectiveness will be assessed by comparing the changes inthe fair value of the first FC 25.5 million of equity shares due to changes in spot ratesto the changes in the value of the forward contract also due to changes in spot rates,i.e. the time value is excluded from the hedge relationship.

The terms of the forward contract are as follows:

■ sell FC 25,500,000

■ buy MC 64,359,915

■ maturity 15 October 20X1

(This implies a forward rate of 2.52).



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During the period of the hedge value of the forward is as follows (amounts in MC):

ValueSpot rate of forward Value Spot Forward

Date (1 FC = MC) contract change element element

1 April 2.55 – – – –30 June 2.41 3,031,769 3,031,769 3,570,000 (538,231)30 September 2.39 3,406,748 374,979 510,000 (135,021)15 October 2.45 1,884,915 (1,521,833) (1,530,000) 8,167

1,884,915 2,550,000 (665,085)

The value of the foreign equity portfolio changes as follows, as a result of changes inequity prices and changes in the spot rate:

ValueValue Value change

Date (in FC) (in MC) (in MC)

1 April 30,000,000 76,500,000 –30 June 35,000,000 84,350,000 7,850,00030 September 28,000,000 66,920,000 (17,430,000)15 October 32,000,000 78,400,000 11,480,000


Debit Credit

1 April 20X1Securities available-for-sale 76,500,000Cash 76,500,000To record the purchase of securities; MC 30 millionat 2.55. No entries are required for the forward contract

30 June 20X1Securities available-for-sale 7,850,000AFS revaluation reserve (equity) 7,850,000To record the change in fair value of securities

Derivatives (assets) 3,031,769Derivative revaluation gain (income statement) 3,031,769To record the change in fair value of forward

Hedge revaluation loss (income statement) 3,570,000AFS revaluation reserve (equity) 3,570,000To transfer the fair value change of securities inrespect of the hedged risk to the income statement;FC 25.5 million * (2.41 – 2.55)



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Debit Credit

30 September 20X1AFS revaluation reserve (equity) 17,430,000Securities available-for-sale 17,430,000To record the change in fair value of securities

Derivatives (assets) 374,979Derivative revaluation gain (income statement) 374,979To record the change in fair value of forward

Hedge revaluation loss (income statement) 510,000AFS revaluation reserve (equity) 510,000To transfer the fair value change of securities inrespect of the hedged risk to the income statement;FC 25.5 million * (2.39 – 2.41)

15 October 20X1Securities available-for-sale 11,480,000AFS revaluation reserve (equity) 11,480,000To record the change in fair value of securities

Derivative revaluation loss (income statement) 1,521,833Derivatives (assets) 1,521,833To record the change in fair value of forward

AFS revaluation reserve (equity) 1,530,000Hedge revaluation gain (income statement) 1,530,000To transfer the fair value change of securities inrespect of the hedged risk to the income statement;FC 25.5 million * (2.45 – 2.39)

Cash 1,884,915Derivatives (assets) 1,884,915To record the settlement of forward contract

The hedge stays effective for the full period as the changes in fair value of the forwardcontract, due to changes in spot rates, perfectly offset changes in the value ofFC 25.5 million of the equity portfolio due to the same spot rates.

The increase in the value of the equity shares at 30 June 20X1 would, in accordancewith the hedging policy, result in an additional hedge transaction being entered into.However, due to the market movements through 30 September 20X1 this hedge wouldneed to be unwound as the value of the portfolio (and therefore the foreign currencyrisk) decreased.

In order for fair value hedge accounting to be applied, the portfolio of shares that wasdesignated as the hedged item at 1 April 20X1 must continue to be the hedged item forthe entire period of the hedge. This means that active management of the portfoliomay preclude fair value hedge accounting.



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As an alternative approach, management may designate the hedge as a hedge of theanticipated disposal of the shares providing that the timing of such disposal is highlyprobable, and apply cash flow hedge accounting. Cash flow hedge accounting requiresspecification of the size and timing of the cash flow being hedged. The model that ismore appropriate may depend also on the entity’s ability to collect the relevantinformation required under each model.

9.3.4 Net position hedging of foreign currency risk

Net position hedging strategies for foreign currency risk often include the use of a centraltreasury that accumulates foreign currency risk exposures from group entities and thenhedges the net risk exposure with a third party such as a bank. The central treasury oftenwill enter into internal derivatives with other group entities or divisions to effectively transferthe foreign currency risk to the central treasury. Based on overall risk management objectivesand policies the central treasury will determine how best to manage the risk exposure.

39.AG101 As mentioned in Section 8, a net position generally does not qualify as a hedged item forhedge accounting purposes. However, an entity may choose to manage risk on a netbasis while for hedge accounting purposes designate the hedge in such a way so as tocomply with the requirements in IAS 39.

Depending on the entity’s risk management policies and internal procedures the entity may:

39AG101 ■ document and designate a hedge between the external derivatives and a gross positionin a group entity that matches the net position; or

IG F.1.6 ■ in some circumstances designate offsetting exposures as the hedging instruments incash flow hedges using internal derivatives to build a documentation trail.

39.73 The internal derivatives between a central treasury and the individual entities must beeliminated on consolidation and cannot be designated as hedging instruments in theconsolidated financial statements.

IG F.1.6 and F.1.7 However, if all other hedge accounting criteria are met, hedge accounting may still beused for cash flow hedges as well as for fair value hedges. Although the effects ofinternal derivatives would have to be eliminated in consolidation, in some cases it will bepossible to apply hedge accounting in the group financial statements, due to the ability todesignate a non-derivative financial asset or liability as a hedging instrument for foreigncurrency risk. This process may be more in line with the risk management proceduresalready used by the treasury department. In this situation the individual foreign currencypositions hedged still must be linked using internal contracts, thus ensuring that eachqualifying hedging instrument is linked to a qualifying hedged position.

To achieve hedge accounting, it is crucial that the individual subsidiaries properly documenttheir internal hedge transactions, and that the central treasury department can demonstratethat each bundle of risk by currency and time period is netted and fully offset externally.Gains and losses from the internal hedging instrument are recognised in the income statementby the central treasury department, and in equity or in the income statement by the individualsubsidiaries, depending on whether cash flow hedging or fair value hedging is applied.

Hedge accounting at the subsidiary’s financial reporting level is possible if the hedge with theparent is properly documented at that reporting level, and all other hedge criteria are met.



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IG F.2.14 The group treasury may hedge the exposure of another operating unit without enteringinto an internal transaction with that unit as long as the hedge relationship is properlydocumented at the group level.

Case 9.9 Net position hedging – foreign currency risk

Assume a corporate has foreign currency cash outflows for payments of goods andservices and the same foreign currency cash inflows from sales of its products.The corporate monitors this foreign currency risk by analysing the net foreign currencyoutflows and inflows expected within each cash flow time band. Assume that the cashinflows and outflows are all highly probable or committed transactions. The cash flowbands used should be based on the business cycle of the corporate and the period overwhich it chooses to hedge the cash flows (which would generally cover a longer periodthan those used in the example below).

Less than1 month 1 to 2 months 2 to 3 months

FC inflowsSales 2,200 2,100 3,000

Cash inflows 2,200 2,100 3,000

FC outflowsPurchases of goods 1,000 1,500 2,300Purchases of services 300 100 200

Cash outflows 1,300 1,600 2,500

Net cash flows in FC 900 500 500

Under net position hedging the net expected cash flow in each time band could behedged. For example, for the cash flows expected in the period of two to three months,the exposure of FC 500 could be hedged with a forward. To achieve hedge accountingtreatment under IFRS, the corporate could designate the first FC 500 of highly probableanticipated and committed sales in that month as the hedged item, and could designatea derivative or a non-derivative foreign currency instrument as the hedging instrument.

IG F.3.10 As demonstrated in the example, hedging a net exposure is possible, provided that anentity documents the hedge relationship as a hedge of part of a gross position thatitself forms part of the net position. It is important that the hedged item is the firstFC 500 of sales in that time band so that it is clear when the hedged item affects theincome statement.



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Case 9.10 Hedging on a group basis – foreign currency risk

39.84 and AG101 A group consists of a parent entity (including corporate treasury) and its subsidiaries Aand B. Subsidiary A has highly probable cash inflows from future revenues of FC 200that it expects to receive in 60 days. To hedge this exposure, Subsidiary A enters into aforward contract with the corporate treasury to pay FC 200 in 60 days.

Subsidiary B has highly probable forecasted purchases of FC 500 that it expects to payin 60 days. Subsidiary B hedges this exposure by entering into a forward contract withthe corporate treasury to receive FC 500 in 60 days.

The parent entity itself has no expected exposure to that foreign currency duringthis period.

Figure 9.3 Group hedging of foreign currency risk

The effect of the internal derivatives with the subsidiaries is to transfer the foreigncurrency risk to the corporate treasury. The net currency exposure from FC in thenext time period is a FC 300 outflow. The corporate treasury will hedge this exposureby entering into a forward contract with an external third party.

In order to apply hedge accounting to this transaction the group will designate theexternal forward contract as a hedge of a gross exposure in one of the subsidiariesrather than the net exposure. The group does this by designating the first FC 300 ofcash outflows from purchases in Subsidiary B as the hedged item and the externalforward contract as the hedging instrument. This in effect means that the group hashedged its net exposure of FC 300 in accordance with its risk policies and that hedgeaccounting can be applied to this hedging strategy provided that the other hedgeaccounting criteria are met.



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IG F.1.6 In finalising the amendments, the Board has made changes to the existing guidance(IGC 134-1-b) for entities using internal derivatives that are netted through a treasurycentre. The changes are likely to make it more difficult to apply the approach described.In particular, it is clear from the amendments that a portfolio of cash flows in aparticular currency and within a narrow time-band must also affect profit or loss inthe same period.

For example, consider Case 9.10 above. The forecast sale by Subsidiary A of FC 200 inJuly 20X5 might be expected to generate cash in August 20X5. The forecast purchase ofFC 500 by Subsidiary B, also expected to be paid for in August 20X5, might be recognisedin the income statement in June 20X5. Under the existing standards, only the cash flowsneed occur within the same reporting period, and so these two transactions would benetted using internal derivatives, through the group corporate treasury to an externalderivative covering the net position of FC 300. The hedge accounting claimed bySubsidiaries A and B in their individual financial statements would not be reversed oradjusted at the group level.

Under the amended standards, the group would need to make adjustments to the hedgeaccounting entries made by Subsidiaries A and B. If it continued to use the samenetting process, it would need to reflect in the financial statements that, at the grouplevel, the hedged item is FC 300 of the expected payments by Subsidiary B. If thistransaction affects profit or loss as expected in June, it will not be appropriate, underthe amended standards, to defer in equity at the end of June 20X5 an amount related tothe expected revenue transaction in Subsidiary A in July 20X5. An adjustment willneed to be made on consolidation.

The alternative approach under the amended standards would be to:

(a) enter into external derivatives to hedge aggregate long positions and short positionsin each FC and each time period separately (in other words, by aggregating, butnot netting internal derivatives in the treasury centre); then

(b) designate the external derivatives as hedging instruments at the group level; and

(c) put in place additional documentation at the group level to link each external derivativeto its associated group of internal derivatives, so that the chain of hedgedocumentation is completed, via the internal contracts, between each hedged cashflow within the group and a portion of the related external derivative.

Under this approach, the internal derivatives are hedging instruments for each of thesubsidiary entities’ stand-alone financial statements, and at the group level provide partof the linkage of documentation to the external derivative transaction.

9.4 Hedging a net investment

9.4.1 Identifying the hedged risk and the hedging model

Net investment hedge accounting is available only for a foreign entity, that is a subsidiarywhose functional currency is different from the reporting currency of the group. In othercases, the foreign currency exposure is hedged like any other foreign currency transaction



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exposures. The net investment hedging model can only be applied at the group level,i.e. the subsidiary, associate etc., that is itself the foreign net investment cannot applynet investment hedge accounting in its own books, and neither can the parent entity.

It is the carrying amount of the total net assets (assets less liabilities) that is designated asthe hedged item in a net investment hedge regardless of whether individual assets orliabilities in that foreign entity are denominated in a currency different from the foreignentity’s measurement currency.

Case 9.11 Hedged item in a net investment hedge

Entity A, with EUR as its measurement currency, includes in its consolidated financialstatements the foreign Subsidiary B with USD as its measurement currency.The carrying amount of Subsidiary B’s net assets is USD 100.

Part of Subsidiary B’s net assets consists of loans denominated in GBP. NeverthelessEntity A will identify the net assets of Subsidiary B of USD 100 as the hedged item ina net investment hedge. This is because the loans denominated in GBP will be translatedinto USD in Subsidiary B’s own financial statements before Subsidiary B is consolidatedinto Entity A. Subsidiary B may separately decide to hedge the foreign currency risk ofthe GBP loans.

In some instances the future cash flows from the investment may be expected to exceedthe net asset value, such as when there is significant unrecognised goodwill or unrecognisedvalue changes in assets or liabilities. Such fair value adjustments resulting from internallygenerated goodwill do not qualify for hedge accounting under the net investment hedgemodel. These additional cash flows from the net investment could be designated, forexample, as a cash flow hedge of the proceeds from sale of the foreign entity. However, thisstill must meet the general criteria for cash flow hedges. This means that the future cashflows would have to be highly probable, and the timing and amount must be known.This is only likely to be the case if sale negotiations for the entity have been completed.

21.15 Loans to or from a foreign entity that are neither planned nor intended to be settled in theforeseeable future should be treated as part of the investment in the foreign entity.

Table 9.1 Components of a net investment in a foreign entity

Carrying amount of net assets of the foreign entity+/- Other consolidation adjustments to carrying amounts+ Carrying amount of goodwill paid in an acquisition+/- Loans to or from a foreign entity not planned or intended to be settled in the foreseeable future

Amount that can be the hedged item in a net investment hedge

Case 9.12 Hedgeable components of a net investment in a foreign entity

In 20X0 Entity A bought Entity B for MC 100. The carrying amount of Entity B’s netassets was MC 60 and Entity A recognised fair value adjustments to specific assetsand liabilities of MC 30 and goodwill of MC 10. During 20X2 Entity A extended a loanto Entity B of MC 20.


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In 20X3 the carrying amount (not including fair value adjustment from the acquisition)of Entity B’s assets and liabilities is MC 70. The remaining fair value adjustments areMC 25 and goodwill is MC 7. The loan has not been repaid and is not intended to berepaid. The carrying amount of the net investment that Entity A may designate as thehedged item is equal to the amount of Entity A’s net investment in Entity B includinggoodwill. This amount would be MC 122 (70 + 25 + 7 + 20).

9.4.2 Expected net profit or loss of a net investment in a foreign entity

39.81 The hedged item may be all or a portion of the carrying amount of the foreign entity at thebeginning of a given reporting period. This means that expected profits from the foreignentity in that period cannot be the hedged item under a net investment hedge model.Translation risk arises once the net profit is recognised as an increase in net assets of theforeign entity. The additional net assets could be designated as a hedged item in a netinvestment hedge as they arise, although in practice most groups would revisit their netinvestment hedges only quarterly or semi-annually.

21.39 and 40 Expected net profits from a foreign entity expose a reporting group to potential volatilityin the consolidated income statement as transactions in the foreign entity are translatedinto the group’s measurement currency at spot rates at the date of the transactions oraverage rates, as an approximation of spot rates. Entities may want to hedge this translation

39.86 risk exposure. However, since expected net profits in future reporting periods do notconstitute recognised assets, liabilities or forecasted transactions that lead to actual cashflows and that will ultimately affect the income statement at the consolidated level, theycannot be accounted for under either a fair value hedge or a cash flow hedge model.

Expected net losses in a foreign entity would reduce the year-end net investment balance,which could result in an over-hedged position. Therefore, if a group expects its foreignentity could make losses the group may decide to hedge less than the full carrying amountof the net assets, as otherwise it would not be able to satisfy the hedge accounting criteriathat the hedge relationship is expected to be highly effective on an ongoing basis.

Entities also might wish to hedge anticipated dividends from foreign entities.However, expected dividends do not give rise to an exposure that will be recognised inthe income statement. Therefore, these cannot be hedged in a cash flow hedge or a netinvestment hedge. It is only once dividends are declared and become a receivable thathedge accounting may be applied.

9.4.3 Hedge effectiveness

39.88 IAS 21 does not set any criteria for when hedge accounting can be applied. Therefore, thesame hedge effectiveness criteria described earlier in this Section and in Section 8 is alsoapplicable for hedges of net investments in foreign entities.

Although the accounting is similar, the nature of this type of hedge is different from anormal cash flow hedge. The exposure being hedged is the closing spot rate translationexposure under IAS 21. Therefore, it would be reasonable to determine hedge effectivenessusing changes in spot rates. Where the hedging instrument is a derivative, the changes invalue relating to the spot-forward differential would be excluded from the hedge relationshipand recognised in the income statement.



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Case 9.13 Hedge of a net investment in a foreign entity

GlobalTechCo has a net investment in a foreign subsidiary of foreign currency (FC)50 million. At 1 October 20X1, GlobalTechCo enters into a foreign currency forwardcontract to sell FC 50 million for measurement currency (MC) at 1 April 20X2.

GlobalTechCo will review the net investment balance on a quarterly basis and adjustthe hedge to the value of the net investment. The time value of the forward contract isexcluded from the assessment of hedge effectiveness.

The foreign exchange rate and fair value of the forward contract move as follows:

Forward Fair valueSpot rate exchange rate of forward

Date (1 FC = MC) (1 FC = MC) contract

1 October 20X1 1.71 1.70 –31 December 20X1 1.64 1.63 3,430,00031 March 20X2 1.60 N/a 5,000,000


Debit Credit

1 October 20X1No entries in the income statement nor the balance sheetare required. The fair value of the forward contract is zero

31 December 20X1Derivatives (asset) 3,430,000Foreign exchange losses (income statement) 70,000Foreign currency translation reserve (equity) 3,500,000To record the change in fair value of the forward

Foreign currency translation reserve (equity) 3,500,000Net investment in subsidiary (asset) 3,500,000To record the foreign exchange losses of the subsidiary(The adjustment to the net investment would be derivedby translating the subsidiary’s balance sheet at the spotrate at the balance sheet date)

31 March 20X2Derivatives (asset) 1,570,000Foreign exchange losses (income statement) 430,000Foreign currency translation reserve (equity) 2,000,000To record the change in fair value of the forward

Foreign currency translation reserve (equity) 2,000,000Net investment in subsidiary (asset) 2,000,000To record the change in foreign exchange lossesof the subsidiary



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Debit Credit

Cash 5,000,000Derivatives (asset) 5,000,000To record the settlement of the forward

The gain on the hedging transaction will remain in equity until the subsidiary is disposed.

9.5 Hedging commodity price risk


This and the following Sections discuss the hedge accounting principles for a situationwhere an entity purchases a commodity contract that is accounted for under IAS 39 as aderivative used to hedge an expected purchase or sale of the underlying commodity.

39.5 An entity may enter into commodity contracts through a broker on a commodity exchange.The commodity contract is to be used to lock into a price for the commodity that the entityexpects to purchase. The situation is illustrated in Figure 9.4.

Figure 9.4 Hedging with commodity contracts

In practice a number of issues arise regarding commodity hedging where derivativessuch as futures on that commodity are traded in a standardised form on a commodityexchange or where only an ingredient or component is hedged.

For certain commodities, exchange-traded derivatives are based on a standard quality orgrade of these commodities. This is because the actual product that will be obtaineddepends on specific circumstances in the future, such as where the commodity comesfrom, purity of the actual product, harvest yield, or even consumer demand. Entities oftenenter into derivatives for a standard commodity prior to determining the actual quality ofproduct they require for production. Examples of commodities that are traded in astandardised form are wheat, corn and other agricultural products, as well as coffeebeans and metals.



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39.82 IAS 39 requires that the item that is being hedged can be identified. In these cases only astandard commodity can be identified at the time the futures contract is entered into.The price of the standard commodity is a surrogate for the price of the actual commodity.The price risk of a standard commodity can often be isolated and measured becausecommodity derivative markets are well developed in many places. However, IAS 39does not allow entities to designate only a component of price risk of a commodity as thehedged item. When hedging with a standardised derivative, although the purchase or saleof the underlying commodity may be highly probable, the quality of the actual commodityto be purchased generally will differ from the standard quality. As a result of therequirement to only hedge commodities in their entirety, entities cannot designate astandardised commodity component as the hedged item. The actual item to be purchasedmust be designated as the hedged item. Because of the differences in the hedging instrument(futures contract based on the standard commodity) and hedged item (actual product tobe purchased / sold), hedge ineffectiveness may arise. Additionally, it may be difficult todemonstrate on a prospective basis that the hedge relationship is expected to be highlyeffective throughout the hedging period.

A similar issue arises when an entity hedges an ingredient of a non-financial item.For example, when hedging the purchase of jet fuel an entity may want to hedge itsentire jet fuel price exposure, or only a component of the price exposure. The price ofjet fuel is derived from the prices of the various components that make up jet fuel.Each of the components is traded and market prices are available for each of thecomponents. The quantity of each of the components in a metric ton of jet fuel isalways fixed. However, the relative value of each of the components differs as theprices of the components move more or less independently. Various strategies arepossible when hedging a transaction such as jet fuel purchases. However, not all wouldqualify for hedge accounting.

■ Hedging components of the jet fuel price: An entity may choose to hedge only itsexposure to certain of the jet fuel components (e.g. brent or gas oil) and to retain anexposure to the price of the other components. This may be due to the costs ofhedging, the relatively more liquid nature of these components, the fact thesecomponents are the most significant components of jet fuel prices, or the independentnature of the pricing of the various components. The brent and gas oil swapsrespectively will be economic hedges of the corresponding brent or gas oil componentof the jet fuel purchases. This may result in perfect effectiveness of those components,as the critical terms of the derivative and the critical terms of the component match,the prices change in parallel and the notional amount of the derivative equates to thequantity of the component in the jet fuel that will be purchased. However, as notedabove, IAS 39 prohibits hedge accounting for components of risk for non-financialitems such as jet fuel purchases. Therefore, in order for this hedging strategy toqualify for hedge accounting, the entire price risk of the jet fuel purchase must bedesignated as the hedged item. A high degree of correlation must be demonstratedbetween the price of the hedged ingredient and the jet fuel price. But because theprices of the individual components move more or less independently it may not bepossible to demonstrate on a prospective basis that the hedge relationship is expectedto be highly effective throughout the hedging period. Even if an effective relationshipis demonstrated initially, the extent of ineffectiveness later may result in the hedge nolonger qualifying as highly effective.



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■ Hedging the entire price of jet fuel: In order to meet the requirements of IAS 39regarding hedging of commodity price risk, an entity may use a jet fuel derivative tohedge the entire price risk exposure from the purchase of jet fuel. This hedging strategywould qualify for hedge accounting assuming all other criteria have been met.


39.AG100 Several comments on the proposed amendments had proposed that separate componentsof a non-financial item should qualify for hedge accounting as long as changes in thefair value of the hedged component could be measured reliably. The Board rejectedthis suggestion, but has clarified in the amended standards that hedge accounting mightbe achieved by adjusting the hedge ratio to maximise effectiveness.

For example, a regression analysis might be performed to establish a statistical relationshipbetween the price of a transaction in Brazilian coffee (the hedged item) and a hedginginstrument whose underlying is the price of Columbian coffee. If there is a valid statisticalrelationship between the two prices, the slope of the regression line can be used to establishthe hedge ratio that will maximise expected effectiveness. For example, if the slope of the‘line of best fit’ is 1.02, then a derivative with a notional amount of 1.02 tons of Columbiancoffee would be designated as a hedge of the purchase of one ton of Brazilian coffee.

This approach will give rise to some ineffectiveness in practice, although it may besufficient to ensure that hedge accounting can be achieved. The amended standardswill continue, however, to prohibit the hedged item to be designated as the Columbiancoffee component of the Brazilian coffee price, even if that component can be provento exist and can be measured reliably.

Case 9.14 Fair value hedge of commodity price risk

Big Metal is a refiner and wholesaler of metals. The entity maintains an inventory ofmetals that it obtains directly from various mining companies, refines and then sells toend-users. One of these metals is zinc, which it refines to a high-grade quality and thensells wholesale, primarily to industrial manufacturers.

Big Metal wishes to hedge a portion of its zinc inventory. On 1 July 20X1, Big Metalenters into a non-deliverable forward with a metals broker to sell 2,000 tons of zinc ata price of 1,100 per ton with a maturity of 31 August 20X1. The cost of this hedgedinventory under the FIFO method is 900 per ton for a recognised cost of 1,800,000.The forward is designated as a hedging instrument in a fair value hedge of the inventory.

Management determines and documents that the forward will be highly effective inoffsetting the fair value change in the inventory of zinc. The zinc spot and forwardprices are as follows:

Fair value of theSpot rates Non-deliverable non-deliverable

Date per ton forward price forward

1 July 1,050 1,100 –31 July 1,100 1,125 (48,000)31 August 1,150 1,150 (100,000)



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On 31 July 20X1, the fair value of the forward is (48,000). The value of the 2,000tons of the hedged zinc inventory has increased by 45,000 since the date of hedgeinception. The value of the zinc inventory is affected by other factors in addition tozinc spot prices.

The accounting entries on these dates are as follows:

Debit Credit

1 July 20X1No entries are made related to the forwardas the cost is zero

31 July 20X1Hedging revaluation loss (income statement) 48,000Forward liability 48,000To record the revaluation of the forwardfor the period from 1 to 31 July 20X1

Inventory 45,000Hedging revaluation gain (income statement) 45,000To record the change in the fair value of the zincinventory for the period from 1 to 31 July 20X1

Based on the change in the fair value of the forward and the change in the fair value ofthe inventory, it is determined that the hedge remains highly effective.

On 31 August 20X1, the fair value of the forward is (100,000). The forward has alsomatured at that time and is settled through net cash payment to the broker of 100,000.

The value of the inventory increased by 46,000 from 31 July 20X1 resulting in a totalfair value increase in the inventory for the hedging period of 91,000. The accountingentries are as follows:

Debit Credit

31 August 20X1Hedging revaluation loss (income statement) 52,000Forward liability 52,000To record the revaluation of the forward forthe period from 31 July to 31 August 20X1

Inventory 46,000Hedging revaluation gain (income statement) 46,000To record the change in the fair value of the zincinventory for the period from 31 July to 31 August 20X1

Forward liability 100,000Cash 100,000To record the settlement of the forward



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On 31 August 20X1, Big Metal sells 2,000 tons of zinc to a steel producer at a price of1,150 per ton for a total value of 2,300,000.

Debit Credit

31 August 20X1Accounts receivable 2,300,000Sales 2,300,000To record the sale of 2,000 tons of zinc at 1,150 per ton

Cost of sales 1,891,000Inventory 1,891,000To record the cost of the sale of the inventory(1,800,000 + 45,000 + 46,000)

The following table summarises the change in the inventory value during the hedgedperiod prior to the eventual sale:

Recorded carrying amount of hedgedDate inventory, net of adjustments:

1 July 1,800,00031 July 1,845,00031 August 1,891,000

The adjusted inventory value should be tested for the lower of cost or net realisablevalue under IAS 2. In this example, the carrying value does not exceed the net realisablevalue. Based on the adjusted inventory value, the gross margin for the sale of thehedged 2,000 tons of zinc is calculated as follows:

Financial statement item Amount

Sales 2,300,000Cost of sales (1,891,000)

Gross margin 409,000

Case 9.15 Cash flow hedge of commodity price risk

This case is intended to demonstrate the different journal entries required whenusing a cash flow hedge. Assume the same fact pattern as above regarding BigMetal. However, instead of designating a fair value hedge for the inventory, Big Metaldesignates a cash flow hedge of future anticipated sales of 2,000 tons of zinc expectedto occur in August 20X1. It is highly probable that the sale will occur based on thehistorical and expected sales. On 1 July 20X1, Big Metal enters into a non-deliverableforward with a metals broker for 2,000 tons of zinc at a sale price of 1,100 per ton witha maturity of 31 August 20X1.

Big Metal documents that the hedge relationship is between the changes in fair valueof the forward and the changes in expected future cash flows from expected sales of2,000 tons of zinc inventory in August 20X1. Management determines and documents



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that the forward is expected to be highly effective in offsetting the cash flow changesfrom the expected sales.

The zinc spot and forward prices are as follows:Fair value of the

Spot rates Non-deliverable non-deliverableDate per ton forward price forward

1 July 1,050 1,100 –31 July 1,100 1,125 (48,000)31 August 1,150 1,150 (100,000)

On 31 July 20X1, the fair value of the forward is (48,000). Assume that the expectedcash flows from the highly probable sale of 2,000 tons of zinc inventory have increasedby 45,000 since the date of hedge inception.

The accounting entries on these dates are as follows:Debit Credit

1 July 20X1No entries are made related to the forward asthe cost is zero

31 July 20X1Hedge reserve (equity) 45,000Hedge ineffectiveness (income statement) 3,000Forward liability 48,000To record the revaluation of the forward for the periodfrom 1 to 31 July 20X1 including the ineffective portionof the forward

Management determines that the hedge relationship remains effective.

On 31 August 20X1, the fair value of the forward is (100,000). The forward has alsomatured at that time and is settled through net cash payment to the broker of 100,000.The expected cash flows from forecasted sales of zinc change by a further 46,000.The accounting entries are as follows:

Debit Credit

31 August 20X1Hedge reserve (equity) 46,000Hedge ineffectiveness (income statement) 6,000Forward liability 52,000To record the revaluation of the forward for the periodfrom 31 July 20X1 to 31 August 20X1 including theineffective portion of the forward

Forward liability 100,000Cash 100,000To record the settlement of the forward



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On 31 August 20X1, Big Metal sells 2,000 tons of zinc to a steel producer at a price of1,150 per ton for a total value of 2,300,000.

Debit Credit

31 August 20X1Accounts receivable 2,300,000Cost of sales 1,800,000Sales 2,300,000Inventory 1,800,000To record the sale of 2,000 tons of zinc at 1,150 per ton

Sales 91,000Hedge reserve (equity) 91,000To recognise the hedge reserve in the income statementdue to the recognition of the hedged cash flows

The gross margin on the sale of the zinc is calculated as follows:

Financial statement item Amount

Sales 2,300,000Hedge adjustment (91,000)Cost of sales (1,800,000)

Gross margin 409,000

9.5.2 Other market price risks

Entities that hold equity securities as investments are exposed to market price risk.Hedge accounting for the price risk of securities is relevant only for securities held asavailable-for-sale with changes in fair value recognised in equity. The actual mechanicsof hedge accounting of equity price risk are similar to those demonstrated above forcommodity price risk.

Case 9.16 Fair value hedge of equity securities

The following is an example of hedging with a purchased put option to hedge price riskon equity securities classified as available-for-sale.

Entity X owns equity shares of an entity listed on a domestic stock exchange.The securities are classified as available-for-sale with changes in fair value recognisedin equity. At 1 January 20X1, the fair value of the securities is 120 million, with atotal cost basis 115 million. The revaluation gain of five million is recognised as acomponent of equity.

At 30 June 20X1, the value of the securities has increased from 120 million to 130 million.The securities are remeasured at fair value with the cumulative change of 15 millionrecognised as a component of equity.



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At 30 June 20X1, due to volatility in the price risk of the securities and to comply withinternal risk management policies, management decides to purchase a European putoption on the securities with a strike price equal to the current market price of 130 millionand a maturity date of 30 June 20X2. The option premium paid is 12 million.

Management has documented and assessed the purchased put option as an effectivehedge in offsetting decreases in the fair value of the equity securities below 130 million.The time value component will not be included in determining the effectiveness ofthe hedge.

The fair value of the securities and the put option during the period are as follows:

Value of the Total optionDate securities value Intrinsic value Time value

1 January 20X1 120,000,000 – – –30 June 20X1 130,000,000 12,000,000 – 12,000,00030 September 20X1 136,000,000 7,000,000 – 7,000,00031 December 20X1 126,000,000 9,000,000 4,000,000 5,000,000

The following journal entries are made to record the remeasurement of the securitiesand the payment of the option premium:

Debit Credit

30 June 20X1Available-for-sale securities 10,000,000AFS revaluation reserve (equity) 10,000,000To remeasure the available-for-sale securities tofair value of 130 million

Hedging derivatives (assets) 12,000,000Cash 12,000,000To record the option at its fair value

At 30 September 20X1, the fair value of the securities increases to 136 million.Therefore, the option is out-of-the-money (i.e. the option has no intrinsic value).There are no hedge accounting entries to be made for this period, as the risk beinghedged was designated as being declines in fair value of the securities below 130 million.

The value of the option decreases to seven million all due to the decrease in its timevalue. The following entries are made to record the change in fair value of the available-for-sale securities, and to record the decrease in the value of the option.



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Debit Credit

30 September 20X1Available-for-sale securities 6,000,000AFS revaluation reserve (equity) 6,000,000To record the remeasurement gain on theavailable-for-sale securities

Hedging costs (income statement) 5,000,000Hedging derivatives (assets) 5,000,000To record the remeasurement loss on the optiondue to change in time value (which is not part ofthe hedge relationship)

The option is still expected to be effective as a hedge of decreases in the fair value ofthe available-for-sale securities below the strike price of the option.

At 31 December 20X1, the value of the hedged securities decreases to 126 million.The value of the put option increases to nine million (of that amount, four millionrepresents intrinsic value and five million represents time value). As such, the followingentries are made to recognise the change in the fair value of the available-for-salesecurities and the changes in the fair value of the option.

For illustrative purposes, these entries have been separated into two parts todemonstrate the accounting for the changes in value of the securities that are notbeing hedged (i.e. decrease down to 130 million) and the changes in value that arebeing hedged (i.e. decrease below 130 million). Likewise the changes in value of theoption are separated to demonstrate changes in the time value, which have beenexcluded from the hedge relationship, and changes in the option’s intrinsic value.

Debit Credit

31 December 20X1AFS revaluation reserve (equity) 6,000,000Available-for-sale securities 6,000,000To record the unhedged decrease in fair value of theavailable-for-sale securities(from 136 million to 130 million)

Hedge results (income statement) 4,000,000Available-for-sale securities 4,000,000To record the hedged decrease in fair value of theavailable-for-sale securities(from 130 million to 126 million)

Hedging costs (income statement) 2,000,000Hedging derivatives (assets) 2,000,000To record the changes in time value of the option,which is excluded from the hedge relationship

Hedging derivatives (assets) 4,000,000Hedge results (income statement) 4,000,000To record the change in the intrinsic value ofthe option – i.e. the effective part of the hedge




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10. Presentation and disclosure


■■■■■ Balance sheet presentation

■■■■■ Liability versus equity

■■■■■ Income statement presentation

■■■■■ Required disclosures


Reference 10.1 Overview

IAS 32 and IAS 39 set out the required disclosures and presentation of financial instruments.The objective of the disclosures is to enhance financial statement users’ understanding ofthe significance of on and off balance sheet financial instruments to an entity’s overallfinancial position and performance.

Although some disclosures of IAS 32 were eliminated upon implementation of IAS 39,the latter contains significant additional disclosure requirements relating to hedge accounting,use of derivatives and risk management strategies.

10.1.1 Presentation and disclosures for financial institutions

Banks and similar financial institutions have to comply with IAS 30 in addition to IAS 32and IAS 39. Since the time IAS 30 was issued, there have been significant developmentsin the financial services environment and IAS 32 and IAS 39 subsequently came intoeffect. As a result IAS 30 is not up-to-date and IAS 32 and IAS 39 have made some ofits requirements redundant. There is a current IASB project that addresses disclosuresabout financial activities and financial instruments. This will eventually replace IAS 30,however the requirements of that standard remain in effect until a new standard isissued. The revisions are expected to be extensive and the new standard is expected toapply to all entities that have financial instruments, not just to financial institutions.Given the present status of IAS 30, this Section does not cover in detail the requirementsof IAS 30.

10.2 Balance sheet presentation

10.2.1 Presentation of classes of financial instruments

IAS 32 and IAS 39 do not address the balance sheet presentation of financial instruments.

1.68 IAS 1 requires that financial assets be presented on the face of the balance sheet,with separate presentation of cash and cash equivalents, trade and other receivables

10.1 Overview


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and investments accounted for under the equity method. Non-current interest-bearingliabilities should also be presented on the balance sheet. Additional lines items maybe used.

1.51 If an entity makes a distinction between current and non-current assets and liabilities onthe face of the balance sheet, instruments within the four financial asset categories oftrading, held-to-maturity, originated loans and receivables, and available-for-sale shouldbe classified as current or non-current, with trading assets and liabilities classified as

1.52 current. Further, an entity should disclose the balance of the financial assets in each ofthese four financial asset categories, either on the face of the balance sheet or in thenotes to the financial statements.

Derivative assets and liabilities should be presented separately if they are significant.If derivative instruments are not significant these instruments may be included (gross)within other financial assets and other financial liabilities, respectively, with additionaldetails disclosed in the notes to the financial statements.


The ability to designate any financial asset or financial liability at fair value throughprofit or loss means that not all financial instruments in this category will be current.No guidance has been included in the amended standards on how to present theseinstruments. We consider that they should be shown as a separate category.

10.2.2 Remeasurement gains and losses as a component of equity

32.59 Fair value adjustments on available-for-sale securities that are reported in equity andremeasurement gains and losses on cash flow hedging instruments and net investment

32.94 hedges are each included as separate components of equity. However, it is not requiredto present such balances as separate components of equity on the face of the balancesheet itself.

10.2.3 Netting

32.42 Financial assets and liabilities should be offset and the net amount reported in the balancesheet only if both of the following conditions are met:

■ there is a legally enforceable right to set off the recognised amounts; and

■ there is the intention to settle on a net basis or to realise the asset and settle theliability simultaneously.

These requirements may apply to instruments such as receivables and payableswith the same counterparty if a legal right of offset is agreed between the parties.It would not be appropriate to offset assets and liabilities that the entity has withunrelated counterparties. Neither of the conditions noted above is likely to be metin these circumstances.

The offset conditions are not met for derivative instruments simply because they areissued by the same counterparty, even if there are master netting agreements in place.Therefore, derivatives with positive and negative fair values are generally reported gross

10.2 Balance sheet presentation


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as assets and liabilities, respectively. Master netting agreements are discussed later inSection 10.5.4.2.

Hedging instruments and the related items being hedged generally do not meet theconditions for offset. Therefore, the fair values of hedging derivative instruments shouldbe shown as separate assets or liabilities in the balance sheet and not presented in thesame balance sheet line item as the hedged item.

10.3 Liability versus equity

32.18 Classifying instruments as either liabilities or equity in the financial statements of theissuer often presents difficulties. In determining the classification, the substance of theinstrument rather than its legal form takes precedence. There could be situations whereinstruments that qualify as equity for legal or regulatory purposes (such as certain preferredshares) are recognised as liabilities for financial reporting purposes. This differs fromaccounting practice in many countries and can have a significant impact on the financialstatements. Instruments commonly affected by this requirement include preference shares,other classes of shares that have special terms and conditions, subordinated instruments,convertible instruments and perpetual instruments.

The balance sheet classification determines the treatment of distributions as interest or asdividends. If an instrument is classified as a liability under IFRS, its coupon payments andany amortisation of discounts or premiums are recognised as finance costs in the incomestatement. If an instrument is classified as equity, the dividends declared and paid areaccounted for in equity and do not flow through the income statement.

32.17 and 19(a) The primary factor in distinguishing a financial liability and an equity instrument is whetherthere exists a contractual obligation for the issuer to make payments (either principal,interest or dividends, or both).

Any instrument that an issuer may be obliged to settle in cash or another financial instrumentis a liability regardless of the manner in which it otherwise could be settled, the financialability of the issuer or the probability of settlement being required. An obligation may arisefrom a liability to repay principal or to pay interest or dividends. Only when an instrumentdoes not give rise to a contractual obligation on the part of the issuer is it equity.

Equity instruments include shares, options, warrants and any other instruments that evidencea residual interest in an entity and that do not incorporate contractual obligations for theissuer to deliver cash or another financial asset or to exchange financial instrumentsunder potentially unfavourable conditions.

32.15 The equity or liability classification is made at initial recognition and is not revised as aresult of subsequent changes in circumstances.

Figure 10.1 provides guidance on classifying an instrument as equity or as a liability.



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Figure 10.1 Decision tree for classification as a liability or equity

10.3.1 Discretionary payments

Dividends or other payments are discretionary only when the entity has no obligation todeclare and pay the dividends or similar payments. For example, dividends paid on ordinaryshares vary depending on the level of profitability. However, there is no requirement byan entity’s board to declare a dividend on ordinary shares. Although there may be ashareholder expectation that dividends will be declared and paid if a certain level ofprofitability is achieved, this does not give rise to a contractual obligation.

On the other hand, dividends that are obliged to be paid at an agreed rate (e.g. annualsix per cent mandatorily payable dividend) give rise to a contractual obligation. The factthat the issuer may be unable to pay the dividends does not take away the obligation.

Examples of the application of the principles of IAS 32 to some common types ofinstruments are illustrated listed in Table 10.1.



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Table 10.1 Classification of issued instruments

Liability

Perpetual debt instrumentsRedeemable preference sharesNon-redeemable preference shares with mandatory dividendsPuttable instrumentsBond or share with a contingent settlement provision that may require the issuer tosettle in cash or other financial assetsSubordinated liabilitiesContractual obligations that will be settled in cash or by issuing a variable numberof shares

Equity

Non-redeemable preference shares with discretionary dividendsOrdinary share capital

Compound instrument

Convertible bondsConvertible preference shares

An instrument that does not establish an explicit contractual obligation to repay mayestablish it indirectly through its terms and conditions. The idea of economic compulsionis that by the terms and conditions set out in the instrument, the issuer and the holder havetacitly agreed that the instrument will be repaid. For example, Entity A issues an instrumentthat may be settled for (a) cash of 100 or (b) delivery of 50 of Entity A’s own shares(which have a current price of 10 per share). At inception of the instrument there is a highexpectation that Entity A is economically compelled to settle for cash. In this case, theinstrument is classified as a financial liability.


32.17-20 The amended standards place more emphasis than the existing standards on the notionof discretion to avoid payment. If an entity does not have an unconditional right toavoid a contractual obligation, that obligation meets the definition of a financial liabilityunder the amendments.

32.25 This extends to instruments that contain a contractual obligation to deliver cash (oranother financial asset) depending on the outcome of an event which is beyond thecontrol of the issuer. Such an event would include the issuer’s revenue, profit or reservesreaching, or failing to reach, a certain level. If the issuer does not have an unconditionalright to avoid payment, the instrument is classified as a liability. The only exceptionsare circumstances when the cash settlement clause is not ‘genuine’ or when cashsettlement is required only in the event of the issuer’s liquidation.



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10.3.2 Compound instruments

32.28 A financial instrument may include both liability and equity components. In such cases,the instrument should be classified into its component parts. These must be presentedseparately in the balance sheet. As noted previously, the classification of the equity andthe liability components of an instrument is based on the substance rather than the formof the components.

The allocation of the instrument into its component parts should be performed on initialrecognition of the compound instrument such that no gain or loss is recognised.The recommended approach to perform the allocation is as follows:

32.31 ■ Determine the amount to allocate to the liability element. This is the future interestand principal cash flows on the liability component, discounted at a rate applicable toa similar liability without an equity component. The value of any embedded derivatives,other than the equity feature, are included in the amount allocated to the liability.

■ Allocate the remaining amount of the issue proceeds to the equity element.


32.31 The amendments require that, because equity is a residual amount, the approach toallocating the instrument into its component parts should be first to measure the liability,including any non-equity derivatives such as issuer call options or prepayment options,and then to allocate the remaining proceeds to the equity component.

The amended standards clarify that no gain or loss arises on initial recognition of acompound instrument, nor on conversion at maturity. When an instrument is settledbefore maturity, the proceeds are allocated between the liability and equity components,using a methodology consistent with that required on initial recognition to determine theliability component.

32.27 Some convertible bonds may contain an option allowing the issuer, if the conversionoption is exercised, to settle the instrument in cash. Even though such a clause wouldnot appear to create an obligation for the issuer, the standards are clear that anysettlement possibility other than delivery of a fixed number of shares for a fixedamount of cash will result in the conversion feature (an equity call option) beingclassified as a derivative liability. The only solution would appear to be for an issuerto notify all its bond-holders that it has waived its right to cash settle and therefore torender the cash settlement alternative invalid.

10.3.2.1 Convertible bonds

32.29 A common example of a compound instrument is convertible debt issued by an entity.The instrument consists of a financial liability plus an option issued to the holder to convertthe instrument into equity shares of the issuer. The economic effect of this instrument (in-substance) is the same as simultaneously issuing a debt instrument with an early settlementprovision and issuing warrants to purchase shares of the issuer.

Convertible bonds typically are issued with a low interest coupon because investorsview the ability to convert the instrument to the issuer’s shares as an opportunity toparticipate in the potential upside from an increase in share price. By separating the



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convertible bond into its equity component (i.e. the conversion feature) and liabilitycomponent, this creates an additional discount on the liability that is amortised andrecognised in the income statement as interest expense until the date of redemption (orconversion if that occurs earlier).

Case 10.1 Income statement impact of a convertible bond

Co X issues a bond convertible into the entity’s own shares in five years. The convertiblebond has a face amount of 100 and bears a stated coupon rate of three per cent, whichis below the current market rate for non-convertible debt instruments of similar entities.

Co X must determine the liability and equity components of the instrument. The liabilitycomponent is determined to be 85. The equity component is assigned the remainingamount of 15. In addition to the three per cent interest expense recognised, Co X mustalso amortise the discount of 15 over the term of the bond. This amortisation also isincluded in interest expense. The coupon interest plus the amortisation amount shouldresult in Co X recognising interest expense on the liability at or around the market rateof interest for bonds with similar terms, but without the conversion feature, when thebond was issued.

10.3.3 Perpetual instruments

32.AG6 Perpetual debt instruments normally provide the holder with a contractual right to receiveinterest payments extending into the indefinite future, with no right to a return of principal.Even though the holder may not receive a return of principal, such instruments are aliability of the issuer as there is a contractual obligation to make a stream of future interestpayments to the holder. The face value or the carrying amount of the instrument reflectsthe present value of the holder’s right to receive a stream of interest in perpetuity.

10.3.4 Preference shares

32.19, AG25 Preference shares provide the holder with certain rights. Preference shares could haveand AG26 rights or characteristics that meet the definition of a liability rather than equity; therefore,

these must be considered when determining the appropriate classification.

Preference shares that provide for redemption at the option of the holder give rise to acontractual obligation and should be classified as a liability. Where preference shares arenot redeemable at the option of the holder the appropriate classification depends on theother terms of the preference shares, in particular the dividend rights attaching to theshares. If the dividends are not discretionary, then the obligation to pay dividends givesrise to a contractual obligation. Preference dividends that are payable at a specified raterequire special attention, and in many cases are not discretionary.

A typical example is a cumulative perpetual preference share where the issuer: (a) mustpay a dividend on the preference shares if it pays a dividend on its ordinary shares; and(b) if it does not pay a dividend on its ordinary shares, the preference dividend may bedeferred (i.e. it is cumulative). This so-called dividend stopper feature does not by itselfcreate an obligation. However, the deferral feature will allow the instrument to be classifiedas equity only if: (a) the accumulated dividends can be deferred indefinitely, even until theentity is liquidated; and (b) there is no other feature of the instrument that would indicate



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its substance is a liability. For example, if the deferred accumulated dividends accrueinterest to compensate the holder for the deferral period, then the substance of theinstrument still is a liability.

10.3.5 Instruments to be settled in own equity

10.3.5.1 Obligation to settle in cash or a variable number of own equity shares

32.11 and 21 If an entity has an obligation that it can settle either by payment of financial assets or bypayment in the form of its own equity shares, there may be an issue as to whether theobligation is a liability or equity. If the number of equity shares required to settle theobligation varies with changes in fair value such that the total fair value of the equityshares transferred always equals the amount of the contractual obligation, then the holderof the obligation is not exposed to a gain or loss from the price of the equity shares.Therefore, such an obligation should be accounted for as a liability of the issuer.

For example, an entity issues an obligation for 100 to be paid in cash or own equity sharesto the holder in six months. At issuance the entity’s shares have a value of 1.0 per share.Due to changes in value of the entity over the six-month holding period, the shares havea value of 0.8 per share by the settlement date. If the entity settles in shares, it is obligatedto settle by delivering 125 shares to the holder (rather than the 100 shares owed at thetime the obligation was entered). The holder of the instrument in this situation is notexposed to the market risk of the equity securities. The instrument would be classified asa liability in this case.

Similarly, an entity may hold a forward, option, or other derivative instrument whose valuechanges in response to something other than the market price of the entity’s own equitysecurities, but that the entity can choose to settle in its own shares. This would not beaccounted for as an equity instrument, but rather as a derivative instrument, as the value ofthe instrument is unrelated to the changes in fair value of the entity’s own shares. For example,Entity A enters into a forward contract with a bank that it intends to settle in its own sharesin six months. The number of shares to be delivered at that time is based on the change inshare price of Entity B during the same period. If Entity B’s share price is lower at the endof six months, Entity A will deliver fewer of its own shares to the bank. In this case, thenumber of Entity A shares to be delivered always equals the value of the derivative basedon Entity B’s share price. As a result the instrument is classified as a derivative.

10.3.5.2 Share warrants or options

An option or warrant on an entity’s own equity is not accounted for as an obligation whenissued if there is no requirement for repayment in cash or other financial assets and thecontract will be settled by the entity issuing a fixed number of its own shares. In suchcases the entity does not have a contractual obligation to settle in a financial asset or toexchange financial instruments under conditions that are potentially unfavourable.

If an entity issues a warrant or option on its own shares and the holder has a right torequest cash settlement, or the transaction must be settled in cash, the instrument is aliability. The entity is either required to settle in cash, or can be compelled by the holderto settle in cash. As a result, the entity has an obligation to deliver cash or exchangefinancial instruments (i.e. receive shares and deliver cash in this case) under conditions



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that are potentially unfavourable. Therefore, the instrument is a liability. It is accountedfor as a derivative liability.

10.3.5.3 Obligation to settle in cash or shares, depending on the outcome of uncertain events

32.25 If an instrument will be settled by an entity issuing its own shares or in cash depending onthe outcome of uncertain future events that are beyond the control of the holder or theissuer, the instrument should be classified as a liability (as a default treatment) unless theprobability of settlement in cash or another financial asset is remote. It is only in caseswhere settlement in cash or another financial asset is extremely unlikely that such aninstrument is not treated as a liability.

In our view, in each of the following situations it would not be reasonable to conclude thatthe possibility of cash settlement is remote; therefore, the instrument should be classifiedas a liability:

■ an instrument that is convertible or redeemable at the option of the holder;

■ an instrument that is redeemable if the share price reaches a certain level; and

■ an instrument that is redeemable if an anticipated initial public offering does not occur.


The amended standards clarify certain existing guidance and at the same time bringtighter requirements that must be met before an instrument can be classified as equity.

32.AG27 The amended standards confirm that an instrument that is settled for a fixed ordeterminable value, but in the form of a variable number of the entity’s own shares isa liability. The entity’s equity instruments are then used only as a currency in which thetransaction is settled. Examples are:

(a) a contract to deliver as many of an entity’s own equity instruments as are equal invalue, at the date of settlement, to 100; or

(b) a contract to deliver as many of an entity’s own equity instruments as are equal invalue, at the date of settlement, to 100 ounces of gold.

Derivative instruments, such as share options, whose underlying is the entity’s own equityare classified as equity only if they will and can only be settled by the entity exchanginga fixed number of its own equity instruments for a fixed amount of cash. Any othersettlement possibility, even at the discretion of the entity itself, will result in the instrumentbeing classified as a financial asset or financial liability, often as a derivative instrument.However, despite its classification as a derivative liability, this will be measured as if itwere a financial liability (i.e. at the present value of the gross future cash flow).

Some instruments, such as a forward purchase of own shares or a written put optionon own shares, may or will require the entity to deliver cash (or another financial asset)to repurchase its own shares. Any instrument that creates a potential obligation for anentity to settle in cash (or other financial assets) is required to be treated as a financialliability measured at the present value of the gross obligation. For example, even thoughthe derivative itself may be an equity instrument (if it is fixed cash for fixed shares



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only), an entity is required to recognise a liability for the present value of the redemptionamount, with a corresponding debit to equity. In effect, a reclassification is made fromequity to reflect the obligation to repurchase the shares in the future. If the contractexpires without the obligation being settled, for example, if a put option is not exercised,then the carrying amount of the liability at that time is reclassified to equity.

32.18 The amended standards also deal specifically with puttable instruments. Typically theseare instruments issued by investment funds, cooperatives and similar entities, that areredeemable by the holder at net asset value. Although the legal form of such financialinstruments often includes the right to a residual interest in the assets of an entity, theinclusion of an option for the holder to put the instrument back for cash or anotherfinancial asset means that the instrument meets the definition of a financial liability.The classification as a financial liability is independent of considerations such as whenthe right is exercisable, how the amount payable on exercise is determined and whetherthe instrument has a fixed maturity. They are measured at the amount that would bepayable if the instrument was redeemed at the balance sheet date. The amended standardsrequire that such instruments are presented as liabilities, but do not preclude such items,on the balance sheet, from being included within a ‘total members’ interests’ sub-total.

32.33 Finally, the amended standards confirm a requirement previously in SIC–16 Share Capital– Reacquired Own Equity Instruments (Treasury Shares) that treasury shares heldby an entity are treated as equity instruments, and that no gain or loss arises on theacquisition or disposal of treasury shares. The requirements have been extended to applyto all treasury shares, including those relating to equity compensation plans.

32.26 and 27 SIC–5 Classification of Financial Instruments – Contingent Settlement Provisionshas been withdrawn. Therefore, under the amended standards, any instrument thatcreates a potential obligation for an entity to settle in cash (or other financial assets) isclassified as a liability, even if the obligation is contingent on uncertain future events,unless the cash settlement provision is not genuine.

The approach to be taken in determining whether a transaction in an entity’s ownequity gives rise to a liability, derivative or transaction in equity is as follows:



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10.4 Income statement presentation

There is currently no specific guidance on the income statement presentation of gains orlosses on financial instruments. We expect this issue to be addressed during the IASB’sproject on performance reporting. In the meantime we recommend that gains and losseson financial instruments be reported in the most appropriate line item according to theirnature. For example, it is common practice for foreign currency gains and losses thatarise from operating activities to be presented as part of operating income or expenditureand exchange gains and losses related to financing activities to be presented as part offinancial income or expenditure.

10.4.1 Presentation of gains and losses on hedging activities

Gains and losses on derivative hedging instruments have three possible elements, whichare: (a) the effective portion; (b) the ineffective portion; and (c) the portion excludedfrom the assessment of effectiveness.

As the financial instruments standards are silent as to the presentation of these items inthe income statement, there are several alternatives to consider when recording suchgains and losses. The following alternatives relate to a fair value hedge. The samepossibilities exist for a cash flow hedge (although the timing of recognition of the effectiveportion of the hedging instrument would be different):

■ present the entire change in fair value of the derivative hedging instrument in thesame line item as gains and losses from the hedged item;

■ present the effective and ineffective portions of the derivative hedging instrument inthe same line item as gains and losses from the hedged item. Present the portionexcluded from the assessment of hedge effectiveness in the same line item as gainsor losses on non-hedging derivative instruments; or

■ present only the effective portion of the derivative hedging instrument in the sameline item as the hedged item. Present the ineffective portion and the excluded portionin the same line item as gains or losses on non-hedging derivative instruments. In ourview, this is the preferred alternative.

If hedge accounting is not applied to a derivative instrument, it is preferable that the gainsor losses on the derivative instrument are not presented as an adjustment to revenues,cost of sales or other line items related the hedged item, even if the derivative instrumentis intended to be an economic hedge of these items. However, there are no specificrequirements in IFRS addressing the presentation of derivatives.

10.4.2 Presentation of gains and losses on trading activities

1.35 and 32.94(h) Gains and losses arising from disposals of trading instruments and changes in the carryingamount of trading instruments, including foreign currency gains and losses and investmentincome from trading instruments are normally reported on a net basis. A split of realisedand unrealised gains and losses on instruments held for trading is not required.

10.4 Income statement presentation


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32.94 The amendments clarify that there is no requirement separately to disclose interestincome or expense arising from other fair value changes on instruments carried at fairvalue through profit or loss.

10.4.3 Presentation of changes in equity

If a statement of changes in equity is presented as a primary financial statement, theavailable-for-sale revaluation reserve, cash flow hedge reserve, and foreign currencytranslation reserve should each be presented separately in the statement. If instead anentity presents a statement of total recognised gains and losses, then the amountsrecognised in equity and the amounts removed from equity should be disclosed ascomponents of the total recognised gains and losses. In addition, a reconciliation of themovements in each of these components of equity should be shown in the notes to thefinancial statements.

10.5 Required disclosures

10.5.1 General

32.51 The disclosure requirements are focused on providing information that enhances a user’sunderstanding of the impact of financial instruments on the entity’s financial position,

32.56 and 57 performance and cash flows. In addition to specific disclosures regarding particularinstruments, entities are required to provide a discussion of financial risk managementobjectives and policies, including hedging policies.

32.53 and 55 To the extent that required information for financial instruments is presented on the faceof the balance sheet or income statement, it is not necessary to repeat such information inthe notes to the financial statements. When amounts stated in note disclosures relate toline items in the balance sheet and income statement, sufficient information should beprovided to permit a reconciliation to these relevant line items.

32.90 and 93 Disclosure requirements also focus on providing fair value information for instrumentsnot carried at fair value.

KPMG’s IFRS Illustrative Financial Statements series contains example IFRSdisclosures. As such, example disclosures on financial instruments are not given in thispublication, with the exception of example hedging disclosures. The discussion belowfocuses on the most common disclosures. Full details of disclosure requirements aredocumented in the standards and in KPMG’s IFRS Disclosure Checklist.

10.5.2 Accounting policy notes

32.60 and 66 Significant accounting policies must be disclosed for each class of financial instrument.These accounting policy notes should address the following:

■ the criteria applied in determining when to recognise a financial asset or financialliability on the balance sheet and when to cease to recognise it;

■ the basis of measurement applied to financial assets and financial liabilities both oninitial recognition and subsequently;



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■ the basis on which income and expense arising from financial assets and financialliabilities is recognised and measured;

32.61 ■ whether regular way transactions are accounted for at trade date or settlement datefor each category of financial asset; and

■ whether gains and losses arising from changes in the fair value of available-for-sale financial assets are recognised in the income statement or as a separatecomponent of equity.

10.5.3 Terms and conditions of financial instruments

32.60 For each class of financial asset, financial liability and equity instrument an entity shoulddisclose information about the extent and nature of the instruments, including significantterms and conditions that may affect the amount, timing and certainty of future cash flows.

32.62 For example, the foreign currency in which instruments are denominated should be disclosedas well as maturities of instruments.

If no single instrument is individually significant, the disclosures should be given forappropriate groupings of like instruments.

32.55 Financial instruments are grouped into classes based on such information as thecharacteristics of the instruments, whether they are carried at fair value or cost and theirclassification according to IAS 39.

When derivative financial instruments, either individually or as a class, create a potentiallysignificant exposure to risks, specific information to illustrate the terms and conditionsshould be disclosed. Examples of the type of information that should be disclosed forderivative instruments include:

■ the principal / notional amount i.e. the amount on which future payments are based;

■ the fair values i.e. the amounts included in the balance sheet in assets or liabilities,respectively; and

32.60 ■ maturities based on the remaining period at the balance sheet date to the contractualmaturity date.

10.5.4 Disclosures of risk management policies

32.56 and 57 The risk management disclosure requirements in IAS 32 are expressed in general terms.That standard does not prescribe either the format in which the information must bedisclosed or its location in the financial statements. Disclosures may include a combinationof narrative descriptions and specific quantified data, as appropriate to the nature of thefinancial instruments. In addition, IAS 39 requires specific disclosures about hedgeaccounting activities and specific quantitative information. Determining the level of detailto be disclosed in each circumstance is an issue of judgement taking into account thesignificance of each type of financial instrument.

32.60 Although the specific requirements of IAS 32 only refer directly to interest rate risk andcredit risk disclosures, the general disclosure requirements of the standard are sufficientlybroad to encompass all financial risks, including foreign currency risk and liquidity risk.



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Therefore, appropriate disclosures regarding all financial risks should be provided.Information normally would be provided about the existence and roles of risk managementcommittees and the process used by the entity to manage risk. Entities may also wish todisclose details of management of non-financial risk (e.g. operational risks) if these risksare significant.

The risk management disclosures usually will be preceded by a general discussion of theentity’s activities, structure and financing that considers the financial risk profile of theentity as a whole. In addition, management generally provides additional commentary onthe risk management activities in a financial review.

10.5.4.1 Interest rate risk

32.67 For each class of financial asset and financial liability an entity should disclose informationabout its exposure to interest rate risk, including:

■ contractual repricing or contractual maturity dates, whichever dates are earlier; and

■ effective interest rates, when applicable.

Appropriate maturity groupings should be determined based on the characteristics ofoutstanding contracts. Financial instruments that do not have a contractual maturitydate are usually allocated to maturity groupings based on the expected maturity date orrepricing date.

32.70 To supplement information about contractual repricing and maturity dates, an entity mayelect also to disclose information about expected repricing or maturity dates when thosedates differ significantly from the contractual dates.

32.71 The disclosures should include an indication of which financial assets and financialliabilities are:

■ exposed to interest rate price risk – such as fixed interest rate financial assets and liabilities;

■ exposed to interest rate cash flow risk – such as floating rate financial assets andliabilities; and

■ not exposed to interest rate risk – such as certain equity investments.

32.72 Effective interest rates only need to be disclosed for interest-bearing instruments orthose where interest can be imputed, such as zero-coupon bonds. Therefore, therequirement applies to debentures, notes and similar monetary financial instrumentsinvolving future payments that create a return to the holder and a cost to the issuer thatreflects the time value of money. The requirement does not apply to financial instrumentssuch as non-monetary instruments and derivatives that do not bear a determinableeffective interest rate.

The effective interest rates to be disclosed for floating rate instruments are the rates atthe balance sheet date. These are normally expressed in terms of the underlying indexand the margin, e.g. three-month LIBOR plus 0.5 per cent.



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10.5.4.2 Credit risk

32.76 For each class of financial asset, both recognised and unrecognised, an entity shoulddisclose information about its exposure to credit risk, including:

■ the amount that best represents its maximum credit risk exposure at the balancesheet date, without taking account of the fair value of any collateral, in the event thatother parties fail to perform their obligations under financial instruments; and

■ significant concentrations of credit risk.

Such information is intended to enable users of the financial statements to assess theextent to which failures by counterparties could reduce the amount of future cash flowsfrom financial assets on hand at the balance sheet date.

32.83 Concentrations of credit risk should be disclosed when they are not apparent from otherdisclosures about the nature and financial position of the business and they result insignificant exposure to loss in the event of default by other parties. Concentrations ofcredit risk may arise from exposure to a single debtor or groups of debtors having asimilar characteristic. A description of the shared characteristic that distinguishes eachconcentration and the maximum credit risk exposure associated with all recognised andunrecognised financial instruments sharing that characteristic should be disclosed.

32.81 Entities may be involved in one or more master netting agreements that serve to mitigateexposures to credit losses but do not meet the criteria for offsetting. When these masternetting agreements significantly reduce credit risk associated with financial assets thatare not offset in the financial statements with financial liabilities related to the samecounterparty, additional disclosure should be provided. This disclosure should indicate:

■ that the credit risk of the financial assets subject to the master netting arrangement iseliminated only to the extent that financial liabilities due to the same counterparty willbe settled after the assets are realised; and

■ the extent to which the overall credit risk exposure is reduced through a masternetting agreement may change substantially within a short period following thebalance sheet date because the exposure is affected by each transaction subject tothe agreement.

10.5.5 Hedging

32.56, 58 and 59 The disclosures relating to hedging and hedge accounting activities can be viewed as atop-down approach to disclosure through the combination of the risk and the more specifictransactional disclosures in IAS 32. This approach can be further described as follows.

An entity would satisfy the broader disclosure requirements by describing its overallfinancial risk management objectives, including its approach towards managing financialrisks. Disclosures should explain what are the financial risks, how the entity manages therisk and why the entity enters into various hedging instruments.

At the next level of detail, the entity should disclose its risk management policies. This wouldinclude more specifically the hedging strategies used to mitigate financial risks.



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This may include a discussion of:

■ how specific financial risks are identified, monitored and measured;

■ what specific types of hedging instrument are entered into, and how these instrumentsmodify or eliminate risk; and

■ details of the extent of transactions that are hedged.

Lastly, an entity is required to make specific disclosures about its outstanding hedgeaccounting relationships. The following disclosures are made separately for fair valuehedges, cash flow hedges and hedges of net investments in foreign entities:

■ a description of the hedge;

■ a description of the financial instruments designated as hedging instruments for thehedge and their fair values;

■ the nature of the risks being hedged;

■ for hedges of forecasted transactions, the periods in which the transactions are expectedto occur, when they are expected to affect net income, and a description of anyforecasted transactions that were originally hedged, but are now no longer expectedto occur. IAS 32 does not specify the future time bands for which the disclosuresshould be made. Management should decide on appropriate groupings based on thecharacteristics of the forecasted transactions;

■ if a gain or loss on derivative or non-derivative financial assets and liabilities designatedas hedging instruments in cash flow hedges has been directly recognised in equity, thefollowing should be disclosed:

– the amount recognised in equity during the reporting period;

– the amount removed from equity and reported in the income statement; and

– the amount removed from equity and added to the initial measurement of thebalance sheet amount for a hedged forecasted transaction; and

32.58 and ■ if an instrument is used to hedge one risk in a cash flow hedge and another risk underIG F.1.12 a fair value hedge, separate disclosures for the two hedges should be provided.

The cases below are intended to provide examples of typical disclosures of hedgingactivities. The level of detail of disclosures will vary depending on an entity’s use ofhedges and derivative financial instruments. Therefore, entities should not view theexamples below to be boilerplate disclosures, but rather illustrative guidance of theabove disclosure requirements.

Case 10.2 Example disclosure of risk management objectives and policies

32.56 AB Corp (ABC) uses derivative financial instruments to reduce exposure to fluctuations ininterest rates and foreign exchange rates. The entity does not enter into derivative financialinstruments for any purpose other than hedging. ABC has a risk management committee,including members of senior management, that continually monitors the entity’s exposuresto interest rate risk and foreign currency risk as well as its use of derivative instruments.



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ABC uses variable rate debt to finance its operations. ABC issues variable rate medium-term notes and commercial paper depending on the entity’s financing needs. The entityis exposed to variability in interest payments due to changes in interest rates.Management has established the policy of limiting the entity’s exposure to variability ininterest rates to 60 to 70 per cent of its anticipated interest payments in each period.ABC achieves this through the use of interest rate swaps and caps.

The interest rate swaps change the variable rate cash flow exposure from the medium-term notes so that ABC is in a pay-fixed, receive-variable position. ABC makes fixedinterest payments to the counterparty and receives variable interest payments, whichare settled on a net basis. The interest rate caps limit the entity’s exposure to increasesin interest rates above a certain amount on its commercial paper liabilities.

ABC has several subsidiaries in foreign countries that operate using the local currenciesof those countries. ABC is exposed to foreign currency risk arising from foreign-currency denominated forecasted transactions and net investments in foreign operations.Management uses certain derivative instruments with the specific intention of minimisingthe impact of foreign currency fluctuations on income. ABC enters into foreign currencyforward contracts on its forecasted sales transactions in foreign countries. The riskmanagement policy requires at least 50 per cent of sales anticipated for a period ofsix months in advance to be hedged. However, this percentage may be higher in certaincountries where management perceives there is greater exposure to foreign currencyfluctuations. In all cases the level of anticipated sales hedged is considered highlyprobable of occurring based on historic sales levels and current budgets and forecasts.

ABC has net investments in foreign subsidiaries in Country A and Country J forwhich ABC enters into foreign currency forward contracts to sell foreign currencyof those countries. ABC reviews the net investment balances in the subsidiaries andadjusts the hedge on a quarterly basis to the respective values of the net investmentsin the subsidiaries.

Case 10.3 Example disclosures of types of hedges

Fair value hedge

32.58 Corporate A has designated a fair value hedge of its fixed rate liabilities of 5,000,000.Corporate A has entered into an interest rate swap with a notional amount of 5,000,000whereby it receives a fixed rate of eight per cent and pays a variable rate based onLIBOR. It is Corporate A’s policy to limit overall exposure to interest rate risk byentering into interest rate swaps to enable it to match its funding with its variable rateinterest-bearing assets. At 31 December 20X1, the fair value of interest rate swapsis (47,000).

Cash flow hedge

Manufacturer B has designated cash flow hedges of its export sales since export salesgenerally are denominated in the customers’ measurement currency. Manufacturer Bhas entered into foreign currency forward contracts to hedge its exposure to foreigncurrency fluctuations. Manufacturer B hedges at least 70 per cent of anticipated export



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sales for a period of three months in advance. Manufacturer B considers theseanticipated sales to be highly probable based on past experience and considering budgetsand forecasts. At 31 December 20X1, all hedged export sales are still expected tooccur. At this date, Manufacturer B has several foreign currency forwards to sellforeign currency, which are summarised as follows:

Fair value at 31 December

Notional Transaction 20X1Contract amount date (in MC)

FC-1 4,000,000 15 January 20X2 (215,000)FC-2 2,000,000 15 February 20X2 (132,000)FC-3 1,000,000 15 March 20X2 (45,000)

Case 10.4 Example disclosure of gains or losses on hedging instrumentsrecognised in equity

32.59 The table below shows changes in the cash flow hedging reserve (a component ofequity) during the year ended 31 December 20X1.

Balance of cash flow hedging reserve at 1 January 20X1 XEffective portion of gains or losses on hedging instruments used in cash flow hedges XGains or losses on hedging instruments transferred to the income statement (X)Gains or losses transferred to adjust the initial measurement of the hedged asset (X)

Balance of cash flow hedging reserve at 31 December 20X1 X

32.58 and 59 The following table shows when the gains and losses reported directly in equity areexpected to enter into the determination of net profit or loss. Where the derivativeshedge anticipated acquisitions of assets, the amounts will adjust the initial measurementof the underlying asset, and will affect net profit or loss only when the underlying assetdoes so. Otherwise the gains and losses will be reported in net profit or loss when theforecasted transaction occurs and is recognised in the income statement.

Gains 20X1 Losses 20X1

Adjustments reported in income when the forecastedtransaction occurs:Less than three monthsBetween three months and one yearMore than one year

Adjustments to initial measurement of an asset:Less than one yearBetween one and two yearsBetween two and five yearsMore than five years



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The expected timing of recognition of those gains andlosses that will adjust the initial measurement of assetsand liabilities is as follows:Less than one yearBetween two and three yearsMore than three years

10.5.6 Income statement disclosures

32.94 Disclosure of significant items of income, expense, gains and losses resulting from financialassets and liabilities should be made. These disclosures should be made regardless ofwhether such items are recognised in the income statement or included as a separatecomponent of equity, such as for certain available-for-sale assets and cash flow hedges.

IG G.1 To comply with this requirement, details of significant fair value changes should be providedfor each of the following categories of instruments, distinguishing between changes thatare reported in net profit or loss and changes that are included in equity:

■ available-for-sale assets;

■ trading assets and liabilities; and

■ hedging instruments.

In addition, details of the components of changes in fair value may be disclosed based onmanagements’ classification for internal purposes. For example, an entity may choose todisclose separately the change in the fair value of derivatives that do not qualify as hedginginstruments under IAS 39, but which are used by an entity as economic hedges.

Total interest income and expense must be disclosed separately on an historical cost basis.Thus, if interest income from trading financial assets is included in a trading gain or loss lineon the face of the income statement, then the interest income should be disclosed separately.If the interest income on such assets is accounted for as interest income on the face of theincome statement, then there is no need for separate disclosure. The requirement to discloseinterest income on a historical cost basis applies equally to interest-bearing available-for-sale assets. Therefore, even if available-for-sale assets are remeasured to fair value throughequity, interest income on these instruments must be calculated using the original effectiveinterest rates of the instruments. This interest income should be recognised in the incomestatement and disclosed as part of the total interest income.


32.94 The amendments do not require separate disclosure of interest income for instrumentsthat are measured at fair value through profit or loss. We recommend that gains andlosses on trading instruments, and gains and losses on instruments classified as fairvalue through profit or loss are disclosed separately.



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10.5.7 Fair value disclosures

Methods and significant assumptions applied in estimating fair values of financial assetsand liabilities must be disclosed. This should be done for each significant class of financialasset and liability. As part of this disclosure it is necessary to disclose

32.92 and 93 ■ how fair value is determined, e.g. quoted market prices, discounted cash flows andother valuation techniques; and

■ significant assumptions used in the calculation, e.g. prepayment rates, rates of estimatedcredit losses and interest or discount rates.

32.86 For each class of financial asset and financial liability an entity should disclose informationabout fair value. This fair value need not be separately disclosed if the financial instrumentsare carried at fair value. For example, a separate disclosure of the fair value of available-for-sale securities generally would not be considered necessary as these instruments arecarried at fair value.

32.90 When it is not practicable within constraints of timeliness or cost to determine the fairvalue of a financial asset or financial liability with sufficient reliability, that fact should bedisclosed together with information about the principal characteristics of the underlyingfinancial instrument that are pertinent to its fair value.

32.90 As described in Section 6 on subsequent measurement, IAS 39 presumes that a reliablefair value can be determined for almost all financial assets. The only exception to this iscertain unquoted equity instruments or derivatives linked to such equity instruments forwhich a reliable fair value cannot be obtained. If any trading or available-for-sale financialassets are not stated at fair value because their fair value cannot be measured reliably,the entity must instead disclose:

■ the fact that these assets cannot be reliably measured;

■ a description of the financial assets;

■ the carrying amount;

■ an explanation of why fair value cannot be measured reliably; and

■ if possible, the range of estimates within which fair value is likely to lie.

32.90 If any financial assets that were not stated at fair value because their fair value could notbe measured reliably are sold, disclose:

■ the fact that they have been sold;

■ their carrying amount at the time of sale; and

■ the gain or loss recognised.

If financial assets are carried in the balance sheet at an amount in excess of fair value, theentity should disclose the carrying amount of the financial assets and the reasons for notreducing the carrying amount, including the nature of the evidence that provides the basisfor management’s belief that the carrying amount will be recovered. Generally this will onlybe the case for either originated loans and receivables and held-to-maturity assets thatmanagement has determined to be not impaired under IAS 39’s impairment principles.



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10.5.8 Other disclosures

32.94(h) If the change in fair values of available-for-sale financial assets is recognised as acomponent of equity, a reconciliation of the movements in this component of equity duringthe reporting period should be disclosed.

12.81 Revaluations of financial instruments often give rise to deferred tax temporary differences.The amount of deferred tax relating to each category of temporary difference must bedisclosed. Therefore, deferred tax relating to each category of financial instruments shouldbe separately disclosed. Current and deferred tax that arises on available-for-sale financialassets that are revalued through equity, as well as derivatives used in cash flow hedges,will be reported directly in equity. This deferred tax should be included in the disclosure ofthe total amount of current and deferred tax reported directly in equity.

32.94(g) The reason for reclassifications into the held-to-maturity category should be disclosed, ifany have occurred.

32.94(a) If securitisations or repurchase agreements have occurred in the current reporting periodor there are remaining interests from such transactions in previous reporting periods, thefollowing should be disclosed:

■ the nature and extent of such transactions; and

■ whether the financial assets have been derecognised.

32.94(i) For each significant financial asset, the nature and amount of any impairment loss orreversal of impairment provision balance should be disclosed – effectively a roll forwardof the impairment loss. The amount of interest income that has been accrued on impairedloans, but has not yet been received, should also be disclosed.

32.94(b) The aggregate carrying amount of secured liabilities and the nature and carrying amountof the assets pledged as security as well as any significant terms and conditions relatingto the pledged assets should be disclosed.

A lender should disclose:

32.94(c) ■ the fair value of collateral that it has accepted and is permitted to sell or repledge;

■ the fair value of collateral that it has sold or repledged; and

■ any significant terms and conditions associated with its use of the collateral.

32.94(e) The following disclosures are encouraged when they are likely to enhance the financialstatement user’s understanding:

■ the total amount of the change in the fair value of financial assets and financialliabilities that has been recognised as income or expense for the reporting period; and

■ the average aggregate fair value during the reporting period of all financial assets andfinancial liabilities, particularly when the amounts on hand at the balance sheet dateare unrepresentative of amounts on hand during the reporting period.



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The amended standards will introduce the following additional disclosure requirements:

■ information about the use of valuation techniques, including the sensitivities of fairvalue estimates to changes in key assumptions;

■ information about assets retained in transactions that do not qualify for derecognitionin their entirety;

■ the carrying amounts of trading assets and liabilities and, separately, those designatedon initial recognition as fair value through profit or loss;

■ the amount of the fair value change of a financial liability designated as fair valuethrough profit or loss that arises from factors other than changes in market interestrates (e.g. changes in the entity’s own credit risk);

■ information about compound instruments that have multiple embedded derivativefeatures; and

■ information about defaults by the entity on loans payable and other breaches ofloan agreements.



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11. Transition and implementation of IAS 39


■■■■■ Transition rules for first-time adopters and for existing IFRS users

■■■■■ Practical considerations when adopting IAS 39

11.1 Overview

The amended IAS 32 and IAS 39 become operative for financial years beginning on orafter 1 January 2005. Early application is permitted, but an entity must then apply all therequirements of both standards. Piecemeal application of the amendments is not permitted.

For entities that will be adopting IFRS for the first time, the IASB has clarified the requiredtransition adjustments for all existing IFRS and SIC interpretations in its standard IFRS 1First-time Adoption of IFRSs.

For entities currently using the existing IAS 39, the transitional requirements are broadlyretrospective, with one or two exceptions. For first-time adopters of IFRS an openingbalance sheet adjustment is made, but comparatives are not required to be restated.

11.2 First-time adoption of IFRS

IFRS 1 generally requires full retrospective application of all IFRS effective at the reportingdate for an entity’s first IFRS financial statements. There are certain limited exemptionsto this principle, including in the area of financial instruments.

The most significant exception to the principles in IFRS 1 for financial instruments is thatan entity applying IFRS for the first time before 1 January 2006 need not restate itscomparative information with respect to IAS 32 and IAS 39. The date of transition, inrespect of these two standards only, becomes the first day of the entity’s first IFRSreporting period, not the first day of the comparative period. At that date, the entity will berequired to make a number of adjustments, depending on its previous accounting forfinancial instruments. Some of the possibilities are considered in Steps 1 to 9 below.

A significant exemption is available for transactions that took place before 1 January2004 and resulted in the derecognition of one or more financial instruments under previousGAAP. These are not required to be re-evaluated under the principles of IAS 39, althoughpartial or fully retrospective application is available.

Another exemption is that an entity that has issued instruments with liability and equitycomponents, such as convertible bonds, need not apply the ‘split accounting’ requirementsin IAS 32 if the instrument has been settled or converted before the date of transition.In such cases, a fully retrospective application of IAS 32 would require no more than areclassification of amounts within equity, possibly between retained earnings and paid-in capital.



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39.105 Set out below is a step-by-step approach to transitional accounting adjustments that mightbe followed by entities adopting the revised financial instruments standards as part of awider IFRS conversion project. Further adjustments may be necessary following a moredetailed analysis of the facts and circumstances of each particular entity and the differencesbetween its existing accounting policies and the requirements of IFRS:

Step 1

An entity should consider whether it should recognise financial assets that werederecognised under previous GAAP. Derecognition transactions taking place before1 January 2004 are not required to be re-evaluated. Transactions taking place on or after1 January 2004 that resulted in derecognition of one or more financial instruments mustbe re-evaluated under IAS 39. If the instrument(s) would not have been derecognisedunder IAS 39, they must be included in the opening IFRS balance sheet. Note, however,that there is no exemption for first-time adopters from the requirement to consolidate anyspecial purpose entity into which financial assets may have been transferred.

39.105 Having recognised all financial instruments as appropriate, upon initial adoption an entityshould classify financial assets in accordance with one of the four categories specified inIAS 39 (see Section 5). The process of classification will include designating financialassets as held-to-maturity where appropriate, and also taking advantage of the free choiceat the date of transition to designate any non-derivative financial asset as available-for-sale and any financial asset or financial liability as fair value through profit or loss. Note thatthis last designation cannot be reversed.

Step 2

Instruments issued by an entity should be classified as either equity or as liabilities inaccordance with the criteria of the financial instruments standards (see Section 10).IAS 32 requires that the entity considers the facts and circumstances at the time theinstrument was issued when determining classification as a financial liability or equity, notthe facts and circumstances at the date of transition.

32.15 Financial liabilities should be classified as either trading or non-trading liabilities, againtaking advantage of the free choice to classify liabilities as fair value through profit orloss, where appropriate.

Step 3

For a compound instrument where the liability component is still outstanding at the transitiondate, the entity must separately identify the liability and equity components. The equitycomponent must be split between the retained earnings component (i.e. cumulative intereston the liability portion) and the true equity component. Again, the allocation betweenliabilities and equity should be based on the circumstances at the date of issue of theinstrument, and the subsequent interest expense on the liability component should becalculated using the effective yield method required by the standards.



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Step 4

An entity identifies those financial assets and liabilities that should be measured at fairvalue and those that should be measured at amortised cost, based on their classification(determined in Steps 1 and 2 above), and it should remeasure these as appropriate.Any adjustment to the previous carrying amounts should be recognised as an adjustmentto the opening balance of retained earnings.

As an exception, the difference between the amortised cost and the fair value of anavailable-for-sale financial asset is recognised in an available-for-sale fair value reserverather than in retained earnings. Upon subsequent disposal or impairment of the asset, theamounts recognised in the reserve are released to the income statement.

In measuring financial assets and financial liabilities, fair value must be estimated usingthe guidance in the standards and amortised cost must be measured using the guidanceon the effective yield method based on the estimated maturities of assets and liabilities.

Step 5

IFRS 1.IG59 The entity should assess whether any impairment write-downs, provisions or generalreserves under existing requirements need to be reversed and / or whether new impairmentwrite-downs should be provided under the incurred losses model in the standards.Any adjustments should be recognised against retained earnings.

Step 6

39.105 The entity should recognise all derivatives, including embedded derivatives, in its balancesheet as either assets or liabilities and should measure them at fair value. The differencebetween the previous carrying amount (which may have been zero) and the fair value ofderivatives should be recognised as an adjustment to the opening balance of retainedearnings at this time. Any gains and losses on derivatives that are deferred amongstassets and liabilities should be eliminated against retained earnings. As with otheradjustments, the separation of embedded derivatives from a host contract should be basedon the circumstances in place when the combined instrument was purchased or issued.Further adjustments to establish transitional balances related to hedge accounting aredealt with separately below.

Step 7

This stage will first involve determining whether hedge accounting has been applied underthe entity’s previous GAAP and, if so, how hedge accounting has been applied. This willhave a corresponding impact on the transitional adjustments.

In many cases, the entity’s previous GAAP may have little, if any, formal (or even informal)guidance for hedge accounting. As a result, hedging relationships may not be documented;in some cases it may be impossible to determine the precise purpose for which derivativeswere acquired under previous GAAP, and therefore to identify a hedged item underprevious GAAP. In such cases, no transitional hedge accounting adjustments will bemade. However, it may be clear from the accounting, particularly in respect of the hedginginstrument, that hedge accounting has previously been applied. For example, under certain



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Reference


GAAPs, where a derivative is used to hedge forecast transactions all changes in value ofthat derivative, which are to be applied to the forecast transactions when they occur, arekept off balance sheet with accrual accounting being applied to the derivative. In contrast,where a derivative is not being used as a hedging instrument, it is held on balance sheet atfair value with changes in value being included in profit or loss, or being taken to equity. Inother cases the entity may have documented the purpose for which a derivative wasacquired so that a hedged item can be identified under previous GAAP. However,irrespective of the precise accounting, in each jurisdiction a review will be required todetermine whether or not hedge accounting has previously been applied.

Where hedge accounting has been applied under previous GAAP, the next step is toconsider whether the type of hedge accounting that has been applied is permitted byIAS 39. This will be the case where the hedge falls within the IAS 39 definitions of fairvalue or cash flow. Where the hedge does fall within one of these definitions, the transitionalrules set out below will apply. It is not necessary to determine at this stage whether thehedge would or would not have met the hedge accounting requirements of IAS 39 as thiswill apply only from the date of transition onwards (see Step 9 below).

IFRS 1.29 Where the type of hedge accounting applied under previous GAAP is not permitted byIAS 39 (e.g. the use of a written option as the hedging instrument or, perhaps morecommonly found, the hedge of a net position), the derivative will be treated as a stand-alone financial instrument on transition date. However, it might be possible, before transitiondate, to re-designate hedging relationships to those which are permitted under IAS 39(e.g. a hedge of a net position could be re-designated as a hedge of an underlying grossposition before the transition date), meaning that advantage could then be taken of thetransitional rules.

IFRS 1.IG60 Where a hedge does not meet the requirements of IAS 39 at the transition date, the entitymay then wish to consider whether it can document and, if necessary, re-designate thehedge in order that it will comply with IAS 39 going forward (see Step 9 below).

Where a hedge can be identified under previous GAAP, and does fall within the fair valueor cash flow categories permitted by IAS 39, the following adjustments are required onthe date of transition, regardless of whether hedge accounting is to be claimed goingforward under IAS 39:

Fair value hedging relationships

The entity will adjust the carrying amount of the hedged asset or liability by the lower of:

IFRS 1.IG60A (a) the cumulative change in the fair value of the hedged item since inception of thehedge that is due to the hedged risk and was not recognised under the entity’s previousGAAP; and

(b) the cumulative change in fair value of the hedging instrument that is in respect of thedesignated hedged risk and, under previous GAAP, was either not recognised or wasdeferred in the balance sheet as an asset or liability.



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Cash flow hedging relationships

IFRS 1.IG60B The entity will reflect the entire cumulative gain or loss on the hedging derivative sincethe inception of the hedging relationship in equity (under Step 4 this will already havebeen dealt with, the full amount of any change in value having been taken to retainedearnings). To the extent that the related forecast transaction is either highly probable orexpected to occur at the transition date, an amount will be transferred out of retainedearnings and recognised in a separate cash flow hedging reserve. Any excess amountwhich, at the transition date, represents transactions which are not expected to takeplace, will remain in retained earnings.

Net investment hedging relationships

IFRS 1.22 These are not dealt with specifically by the transitional guidance. However, it is noted inIAS 39 that net investment hedges are accounted for in a similar manner to cash flowhedges. In our view the same basic process as set out above should be followed.However, where advantage is taken of the transitional relief included in IFRS 1 to set thetranslation reserve to nil on transition date, the related hedge reserve will also be set at nilwith any adjustment arising from the recognition of the derivative or non-derivative hedginginstrument being taken to retained earnings.

Step 8

An entity may, on transition to IFRS, take the opportunity to review one or more of its riskmanagement policies or processes, or to change the types of hedging instrument in orderto be able to apply hedge accounting in the most cost-effective way under IFRS.

Step 9

IFRS 1.IG60 An entity will then consider which of its hedging relationships it wishes to designate ashedges under IAS 39 from the date of transition and, if so, whether these meet the strictcriteria for hedge accounting. Retrospective designation is not permitted, meaning that onthe date of transition those relationships will need to be formally documented and meetthe prospective effectiveness test. As noted in Step 7 above, some hedging relationshipsthat existed under the entity’s previous GAAP may not qualify for hedge accounting at allunder IAS 39, meaning that a change in hedging strategy may be required.

IFRS 1.IG60, Where adjustments were made in respect of existing hedging relationship on the date ofIFRS 1.IG60B transition under Step 7, but hedge accounting is not claimed going forward under IAS 39,and 39.101 hedge accounting will be discontinued prospectively with the normal IAS 39 rules applying

to the related balances that arose on transition.

Comparative information and disclosure

IFRS 1.36A As noted above, an entity applying IFRS for the first time before 1 January 2006 need notrestate its comparative information with respect to IAS 32 and IAS 39. The date oftransition, in respect of these two standards only, becomes the first day of the entity’s first

IFRS 1.IG53 and IFRS reporting period, not the first day of the comparative period. However, as notedIFRS 1.27 above, derecognition transactions entered into on or after 1 January 2004 may need to be

restated, with associated disclosure being made.



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IFRS 1.36A An entity that chooses to present comparative information that does not comply withIAS 32 and IAS 39 in its first year of transition is required to apply its previous GAAP tofinancial instruments within the scope of IAS 32 and IAS 39 in its comparative informationand disclose that fact. In addition, disclosure is required of the nature (but not the amount)of the main adjustments that would be required to make the information comply withIAS 32 and IAS 39.

IFRS 1.36A(c) A reconciliation is required between the balance sheet at the date of transition (for theIAS 8.28 purposes of IAS 32 and IAS 39) and the comparative period’s reporting date with

disclosures required by IAS 8 Accounting Policies, Changes in Accounting Estimatesand Errors on a change in accounting policy. This disclosure includes the nature of thechange in policy, a description of transitional provisions and the amount of the adjustmentrequired to each financial statement line item.

IFRS 1.25A In addition, an entity may choose to designate a previously recognised financial asset orliability as a financial asset or liability at fair value through profit or loss, or as available-for-sale. In such cases, disclosure is required of the fair value of the assets and liabilitiesclassified into each category and the classification and carrying amount in the previousfinancial statements.

11.3 Transition requirements for existing users of IFRS

The amendments described throughout this publication highlight the areas whereadjustments may be required. The choice of which, if any, financial instruments an entitywill designate, by choice, as either fair value through profit or loss or available-for-sale aspermitted under the amended standards may be one of the most significant changes.Reclassification of transactions in own equity may also have a significant impact.

The standards should be applied retrospectively by adjusting the opening balance of retainedearnings in the earliest period presented, and other comparative amounts as necessary.The exceptions are:

■ if an entity derecognised a financial asset under the existing standards before 1 January2004, it need not consider whether that asset should be reinstated under the amendedstandards. It may, however, choose a date earlier than 1 January 2004 and restate forderecognition transactions that took place after that earlier date; and

IFRS 1.IG59 and ■ any ‘basis adjustment’ made to a non-financial asset or liability should not be reversed,IFRS 1.29 even if the entity does not intend to use that method in the future. However, any basis

adjustment recognised to a financial asset or liability should be restated, and anyamounts deferred in a cash flow hedge reserve for hedges of firm commitments(except those in a foreign currency) should be adjusted against the related assetsfollowing the fair value hedging model.

11.3 Transition requirements for existing users of IFRS


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11.4 First time implementation: practical considerations

11.4.1 Organising the implementation effort

Due to the far-reaching impact of IAS 39 on an entity’s day-to-day operations, theimplementation effort must reach across functions and involve a multi-disciplinary group.An effective implementation team would generally include the following functions:

■ treasury;

■ financial controllers, internal accounting policy makers, and external financial reporting;

■ internal and external audit;

■ financial risk management department;

■ legal and tax departments;

■ compliance department; and

■ information technology.

The implementation effort should include those knowledgeable about the entity’s currentstrategies and usage of financial instruments and hedging; current accounting practices;treatment under IFRS requirements; systems capabilities and legal contracts.

The level of resources required for the implementation effort is dependent on thestructure and size of the entity. An entity that operates in distinct business units mustensure that all of these units are included in the implementation effort to foster consistentadoption across the entity. An entity with centralised functions might require only asmaller implementation team.

11.4.2 Analysing the entity’s exposure to financial instruments

The entity must first identify all of its financial assets and liabilities and classify thesebased on their purpose and term prior to determining which should be carried at fairvalue and which at amortised cost. Instruments classified as liabilities or as equityunder the previous GAAP may need to be reclassified under IAS 32. The entity mustalso identify all contracts that meet the definition of a derivative under IAS 39 andidentify all embedded derivatives.

Consideration must be given to potential changes in policies resulting from recognitionand derecognition criteria, especially with respect to securitisations, securities lending,repurchase agreements, transfers relating to components of assets or liabilities and wherenew assets or liabilities arise.

For existing hedge relationships that qualify for hedge accounting under IAS 39, the entityshould determine whether the ongoing relationship represents a fair value hedge or acash flow hedge. There may be instances where either hedging model can be used.The entity should determine which model to use, as this will drive the ongoing accountingfor that relationship.



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Lastly, it is important to understand the impact that adoption of IAS 39 will have onthe entity’s financial statements, including its income statement, changes in equityand balance sheet.

11.4.3 Amend internal policies and procedures

The entity should ensure that its documented policies and procedures on financialinstruments meet the requirements of IAS 39 in relation to recognition, derecognition,measurement, and hedge accounting.

A hedge relationship must be documented from its inception, and meet the minimumrequirements that the relationship is clearly defined, measurable and effective.The entity should determine and document how it expects to measure effectivenessin its hedge relationships.

Certain hedging practices under the entity’s current strategies may no longer receivehedge accounting treatment. As a result the entity must determine whether certain hedgingstrategies should be modified. Also, changes to current practice may be required in orderto avoid forced reclassifications under the tainting rules for held-to-maturity assets.

11.4.4 Systems considerations

An assessment of current systems capabilities should be performed well in advance ofthe transition date. The adoption of IAS 39 may create the need for enhancements to thetreasury systems as well as to accounting systems. Systems should be capable of:

■ interest and amortisation calculations using the effective interest method;

■ discounted cash flow calculations;

■ impairment calculations;

■ classification and reporting of financial instruments;

■ fair value calculations for all financial instruments, including derivative instruments;

■ identification of hedge relationships, including hedging model used;

■ hedge effectiveness calculations;

■ tracking amounts in equity in respect of fair value adjustments of available-for-saleinstruments, cash flow hedge adjustments, and recycling amounts out of equitywhen appropriate;

■ accounting for basis adjustments to hedged transactions that result in assets andliabilities; and

■ providing the necessary internal and external reporting information.




214

A. Glossary

Amortised cost The amount at which a financial asset or liability is measured at initialrecognition minus principal repayments, plus or minus the cumulativeamortisation / accretion of any premium / discount, and minus any write-down for impairment.

Anticipated future transaction See forecasted transaction below.

Available-for-sale Financial assets that are not held for trading, loans and receivablesoriginated by the entity, or held-to-maturity investments, or are designatedas available-for-sale on initial recognition.

Call option An option contract giving the holder the right, but not the obligation, tobuy a specific quantity of an asset for a fixed price during a specific timeperiod (or on a specified date).

Cap An option contract that protects the holder from a rise in interest rates orsome other underlying index beyond a certain point.

Cash flow hedge A hedge of the exposure to variability in the cash flows of a recognisedasset or liability, or forecasted transaction, that is attributable to changesin variable rates or prices.

Central treasury hedging A risk management strategy whereby one central unit of an entity transactshedging activities on behalf of some or all entities within the group.

Collar A combination of a purchased cap and a written floor that protects againsta movement outside a range of interest rates or some other underlying.

Continuing involvement The extent to which an entity remains exposed to changes in the value ofa transferred asset where the entity has neither transferred nor retainedsubstantially all of the risks and rewards of the transferred asset.

Commodity-based contract A contract for delivery of a commodity that also allows for settlement incash or some other financial instrument.

Compound instrument A financial instrument that, from the issuer’s perspective, includes both aliability and an equity element.

Counterparty A principal party to a transaction.

Credit risk The risk that one party to a financial instrument will fail to discharge anobligation and cause the other party to incur a financial loss.

Default risk See credit risk above.

Appendix A Glossary


215


Derecognition The act of removing a recognised financial asset or liability from theentity’s balance sheet. This may be accomplished through the sale, transferor expiration of a financial asset or through the legal settlement of orrelease from a financial liability.

Derivative A financial instrument whose value changes in response to a change in aspecified underlying, for which there is little or no initial net investment,and that is settled at a future date.

Dual currency instrument A financial instrument (usually a bond) where the principal and interestpayments are made in different currencies. A typical example is a bondwhere principal payments are made in the measurement currency of theholder, and interest payments are made in a foreign currency.

Effective interest method A method of calculating amortisation using the effective interest rateof a financial instrument. The effective interest rate is the rate thatdiscounts the expected stream of future cash payments to theinstrument’s carrying amount.

Embedded derivative Implicit or explicit terms in a contract that affect some or all of the cashflows of a contract in a manner similar to a freestanding derivative instrument.

Equity A contract evidencing a residual interest in the assets of an entity afterdeducting all of its liabilities.

Exercise price The price at which an underlying instrument may be bought, sold, orsettled upon exercise of an option.

Fair value The amount at which an asset (liability) could be bought (incurred) orsold (settled) in an arm’s length transaction between knowledgeable,willing parties.

Fair value hedge A hedge of the exposure to changes in the fair value of a recognisedasset or liability or a portion thereof, or a firm commitment, that isattributable to a particular risk, and that will affect reported net income.

Financial asset An asset that is cash, a contractual right to receive cash or anotherfinancial asset from another entity, a contractual right to exchange financialinstruments with another entity under potentially favourable conditions,an equity instrument of another entity, or a contract that will or may besettled in the entity’s own equity instruments and is either a non-derivativefor which the entity is or may be obliged to receive a variable number ofthe entity’s own equity instruments or a derivative that will or may besettled other than by the exchange of a fixed amount of cash or anotherfinancial asset for a fixed number of the entity’s own equity instruments(for this latter purpose the entity’s own equity instruments do not includecontracts that are themselves contracts for the future receipt or deliveryof the entity’s own equity instruments).

Appendix A Glossary



216

Financial asset or financial A financial asset or liability that meets either of the following conditions:liability at fair value throughprofit or loss A financial asset or financial liability that is classified as held for trading.

Such assets or liabilities are acquired or incurred principally for the purposeof generating a profit from short-term fluctuations in price or dealer’smargin, or are part of a portfolio of identified financial instruments thatare managed together and for which there is evidence of a recent actualpattern of short-term profit-taking. All derivatives are deemed to be tradinginstruments unless they qualify for hedge accounting.

or

Upon initial recognition it is designated by the entity at fair value throughprofit or loss. Any financial asset or liability within the scope of IAS 39(revised) may be designated when initially recognised as a financial assetor financial liability through profit or loss except for investments in equityinvestments that do not have a quoted market price in an active marketand whose fair value cannot be reliably measured.

Financial components approach An approach whereby the recognition or derecognition of a financialasset or liability is viewed in terms of its financial components that comprisethat asset or liability. This approach requires that the party that controlsthe individual financial components should record those assets or liabilities.

Financial instrument Any contract that gives rise to both a financial asset of one entity and afinancial liability or equity instrument of another entity.

Financial liability A liability that is a contractual obligation to deliver cash or another financialasset to another entity, or to exchange financial instruments with anotherentity under conditions that are potentially unfavourable to the entity, or acontract that will or may be settled in the entity’s own equity instrumentsand is either a non-derivative for which the entity is or may be obliged todeliver a variable number of the entity’s own equity instruments or aderivative that will or may be settled other than by the exchange of afixed amount of cash or another financial asset for a fixed number of theentity’s own equity instruments (for this latter purpose the entity’s ownequity instruments do not include instruments that are themselves contractsfor the future receipt or delivery of the entity’s own equity instruments).

Firm commitment An agreement with another party that binds both parties and is usuallylegally enforceable, whereby the significant terms of the transaction,including quantity, price, and timing of settlement are specified.

Floor An option contract that protects the holder against a decline in interestrates or some other underlying below a certain point.

Forecasted transaction A transaction that is expected to occur for which there is no firmcommitment. Also referred to as an anticipated future transaction.

Foreign currency A currency other than the measurement currency of an entity.

Appendix A Glossary


217


Foreign exchange risk The risk that changes in foreign exchange rates will affect the fair valueor cash flows of a recognised financial instrument, firm commitment orforecasted transaction. Also referred to as currency risk.

Foreign operation An entity that is a subsidiary, associate, joint venture or branch of areporting entity, the activities of which are based or conducted in a countryor currency other than those of the reporting entity.

Forward contract A non-exchange-traded contract that obligates one party to buy, and theother party to sell a specific asset for a fixed price at a future date.

Forward rate The foreign exchange rate used in an agreement to exchange at a specifiedfuture date a specified amount of a commodity, currency or other asset.

Functional currency The currency of the primary economic environment in which anentity operates.

Futures contract A forward contract that is standardised and exchange-traded.

Guidance on Implementing Guidance which has been developed from, and has superseded in theIAS 39: Financial Instruments: revised IAS 39, Implementation Guidance issued by the ImplementationRecognition and Measurement Guidance Committee (IGC Q&A – see below) in respect of the

previous IAS 39.

Hedge effectiveness The degree to which changes in fair value or cash flows attributable to ahedged risk are offset by changes in the fair value or cash flows of thehedging instrument.

Hedged item An asset, liability, firm commitment, or forecasted transaction that exposesthe entity to a risk of changes in fair value or future cash flows, and thathas been designated by an entity as being hedged. A hedged item may bea group of similar assets or liabilities, or a portion thereof.

Hedging A strategy used in risk management whereby an entity seeks to reduceor eliminate financial risks by entering into transactions that give anoffsetting risk profile. This may or may not allow an entity to use hedgeaccounting, whereby special accounting rules may be used if specifichedge effectiveness and other criteria are met.

Hedging instrument A designated derivative or, in limited circumstances, another financialinstrument whose changes in fair value or cash flows are expected tooffset changes in the fair value or cash flows of a designated hedged item.

Held-to-maturity asset Financial assets that have fixed or determinable payments and a fixedmaturity and that an entity has the positive intent and ability to holduntil maturity.

Host contract The portion of a hybrid instrument that is the host to an embedded derivative.The host contract may be, but is not necessarily, a financial instrument.

Hybrid instrument A contract that comprises an embedded derivative component and ahost contract.

Appendix A Glossary



218

IAS International Accounting Standards, a body of accounting standards andinterpretations issued by the International Accounting StandardsCommittee (IASC). In 2002, this became known as IFRS (see below).

IASB and IFRIC International Accounting Standards Board; International FinancialReporting Interpretations Committee. From 2002, these are the successororganisations to the IASC and SIC respectively.

IFRS International Financial Reporting Standards, the body of accountingstandards and interpretations issued or endorsed by the IASB. IFRS isan acceptable GAAP (generally accepted accounting principles) in manycountries and on many stock exchanges around the world.

IGC Q&A Implementation guidance developed by the Implementation GuidanceCommittee of the IASC in the form of questions and answers. In thispublication, implementation guidance that is relevant to specific topic areasis referenced in the margin. Note that in the revised financial instrumentstandards, this guidance has in some cases been deleted or amended,with this guidance then either having been incorporated into the standardsthemselves or published separately as ‘Guidance on Implementing IAS 39Financial Instruments: Recognition and Measurement’.

Impairment A situation where the estimated recoverable amount of a financial assethas declined below its carrying amount.

Interest rate risk The risk that changes in market interest rates may affect the fair valueor cash flows of a financial instrument.

In-the-money option A call option whose exercise price is lower than the spot price of theunderlying instrument, or a put option whose exercise price is greaterthan the spot price of the underlying instrument.

Intrinsic value The positive difference between the current price of the underlying andthe exercise price in those situations when an option is in-the-money. Anoption that is not in-the-money has no intrinsic value.

Lease contract An agreement whereby the lessor conveys to the lessee in return for apayment or series of payments the right to use an asset for an agreedperiod of time.

Market risk The risk that fair values or cash flows will be affected by factors specificto a particular instrument or to the issuer of an instrument, or by generalmarket conditions.

Measurement currency The currency used by an entity in preparing its financial statements.This is the currency of the primary economic exposure of the entity.(This definition was included in the original IAS 21 and was deleted onthat standard’s revision in 2003.)

Monetary item Money held and assets to be received or liabilities to be paid in fixed ordeterminable amounts of money.

Net investment hedge A hedge of the exposure to changes in value of a net investment in aforeign entity arising from changes in foreign exchange rates.

Appendix A Glossary


219


Net investment in a foreign entity A reporting entity’s share in the net assets of a foreign entity.

Net position hedging A risk management strategy whereby an entity hedges its net riskpositions / exposures.

Notional amount An amount of currency, number of shares, a number of units of weightor volume or other units specified in a derivative contract.

Option A contract between two parties, which gives one party the right, but notthe obligation, to buy or sell an asset, currency, or rate for a specific price.

Out-of-the-money option A call option whose exercise price is greater than the spot price of theunderlying instrument, or a put option whose exercise price is lower thanthe spot price of the underlying instrument.

Put option An option contract giving the holder the right, but not the obligation, tosell a specific quantity of an asset for a fixed price during a specificperiod of time or at a set date.

Regular way transaction A contract for a purchase or sale of financial assets that requires deliveryof the assets within a period of time that is generally established either byregulation or convention in that marketplace.

Risks and rewards approach An approach whereby the recognition or derecognition of a financialasset or liability depends upon whether the party to a transfer of financialinstruments is deemed to have retained the risks in order to obtain therelated benefits.

Settlement date The date that a financial instrument is delivered to or transferred froman entity.

Spot rate The foreign exchange rate between two currencies on a given date.

Swap An agreement by two parties to exchange a series of cash flows inthe future.

Time value The difference between the total value (i.e. fair value) of an option andthe option’s intrinsic value.

Total return swap A contract that provides the actual returns and credit risks of a transactionto one party in return for a specified interest index to the other party. Theparty receiving the return based on the interest index is considered toreceive a lender’s return.

Trade date The date that an entity enters into a contract for the purchase or sale ofa financial instrument.

Trading assets and liabilities A financial instrument that is acquired or incurred principally for thepurpose of generating a profit from short-term fluctuations in price ordealer’s margin. All derivatives are deemed to be trading instrumentsunless they qualify for hedge accounting.

Note that this category has been subsumed within ‘Financial asset orfinancial liability at fair value through profit or loss’.

Appendix A Glossary



220

Transaction costs Incremental costs that are directly attributable to the acquisition or disposalof a financial asset or liability.

Underlying A specified interest rate, security price, commodity price, foreignexchange rate, index of prices or rates, or other variables. An underlyingmay be a price or rate of an asset or liability, but is not the asset orliability itself.

US GAAP Generally accepted accounting principles of the United States. Theseprinciples are primarily set by a national accounting body, the FinancialAccounting Standards Board, or FASB.

Volatility The degree of price fluctuation for a given asset, rate, or index.

Weather derivative A contract that requires payment based on climatic, geological, or otherphysical variables. These are insurance-type policies used by entities,but may or may not be directly related to an amount of loss incurred bythe entity.

Written option An option contract for which a net premium is received.

Yield curve A figure demonstrating the relationship between interest rates and timeto maturity.

Appendix A Glossary


221


B. IFRS and US GAAP financial instruments comparison

The following summary highlights the major principles related to accounting for financial instruments under IASand under US GAAP, as well as certain similarities and differences. The main sources for comparison areIAS 32 and IAS 39 and FASB (Financial Accounting Standards Board) Statements No. 115, 133, 138 and 140.There are more differences (especially as to the finer points) than those indicated below. In addition, interpretationsmade under IFRS could differ from those that would be made under US GAAP.

IFRS

General

The literature addressing financial instruments ismostly contained in IAS 32, IAS 39 and IAS 21 (forforeign currency accounting). The standards do notaim to provide industry-specific requirements.The standards form a comprehensive set of principlesfor financial instruments accounting.

Scope

IAS 39 is a comprehensive standard that deals withall aspects of recognition and measurement offinancial instruments. This includes fair valueconsiderations, derecognition, impairment and hedgeaccounting. All types of financial instruments arewithin its scope.

Questions and Answers (Q&A) on IAS 39 have beenissued by the Implementation Guidance Committee(IGC). The IGC Q&A are guidance, but do not havethe standing of an IASB standard or interpretation.

Derivatives

All derivative instruments are deemed to be trading,unless they are part of an effective hedge relationship.All derivatives are measured on the balance sheet atfair value.

US GAAP

The US GAAP body of literature is far more detailedand complex in terms of its hierarchy. Guidance hasdeveloped over a much longer period of time, oftenin response to new financial products introduced inthe markets. There are over a dozen FASB standardsthat address various aspects of financial instruments.

SFAS 133 (and amendments SFAS 138 andSFAS 149) deal specifically with recognition andmeasurement of derivatives and hedge accounting.Recognition and measurement and derecognitionissues for other financial instruments are dealt within different standards (primarily SFAS 115 and 140).

Implementation Issues on SFAS 133 have been issuedby the Derivatives Implementation Group (DIG). DIGIssues are interpretative guidance based on issuesraised in practice. The FASB has issued Q&A forSFAS 115 and 140.

Derivatives are either hedging or non-hedginginstruments under SFAS 133. All derivatives aremeasured on the balance sheet at fair value.

Appendix B IFRS and US GAAP financial instruments comparison



222

IFRS

A contract with an embedded derivative not closelyrelated should generally be separated into its host andderivative components. The embedded derivative isthen accounted for as a freestanding derivative.

Derivatives may have ei ther net or grosssettlement provisions.

Recognition

Financial assets and liabilities are initially measuredat cost, which is defined in terms of the fair value ofthe consideration exchanged. Transaction costsincurred to acquire a financial asset are capitalisedas part of the initial recognition.

Classification as equity or as a liability is based onthe substance of the contractual arrangement ratherthan its legal form.

A compound instrument that has both liability andequity characteristics must be separated, with theliability and equity components separately recognised.

Regular way purchases and sales of financial assetsmay be recognised on either the trade date or thesettlement date.

Derecognition

IAS 39 follows a financial components model forderecognition, but also contains certain risks andrewards aspects.

Surrender of control over the transferred financialasset is the key criterion for derecognition of assets.This is exhibited by the transfer of a substantive riskof the assets to the transferee.

US GAAP

Similar approach under US GAAP.

Generally, the terms of a derivative instrument shouldeither require or permit net settlement. Instrumentsthat can readily be settled net outside the contract orthat require the delivery of an asset that is convertibleto cash also meet this criterion.


There are some instruments classified as equityunder US GAAP that would be classified as liabilitiesunder IFRS.

The FASB has a current project that is expected toaddress classification of compound instruments.


The approach under US GAAP is a financialcomponents model that focuses on control.

Similar principle under US GAAP. US GAAP hasspecific criteria that must be met to demonstrate thesurrender of control. One such criterion not in IAS 39is that the transferred assets must be legally isolatedfrom the transferor.



223


IFRS

If the transfer involves a special purpose entity(SPE), assets subject to a securitisation may bederecognised from the transferor’s balance sheet,however as a result of SIC–12 the assets of an SPEcould be consolidated and separately recognised inthe consolidated balance sheet.

For derecognition of a financial liability to occur, anentity must have legal release from being the primaryobligor. In-substance defeasance alone will not leadto derecognition.

Measurement

The following categories cover all financial assetsand liabilities other than hedging instruments:

■ amortised cost is used for held-to-maturity assets,originated loans and receivables and non-tradingliabilities; and

■ fair value is used for available-for-sale assets andtrading assets and liabilities.

Fair value adjustments on trading items are recognisedin the income statement.

For changes in fair value of available-for-sale financialassets, either immediate income statementrecognition or a recycling system is used: in the latteradjustments are reported in equity and aresubsequently recycled out of equity and recognisedin the income statement when realised.

US GAAP

If the transfer involves:

■ a qualifying special purpose entity (QSPE), asecuritisation may be off balance sheet altogether;

■ a non-QSPE that is adequately capitalised, basicconsolidation criteria should be considered; or

■ a variable interest entity (VIE) that is not a QSPE,parties should evaluate whether they have themajority of variable interests in the entity fordetermining consolidation of the VIE.


The following categories are used only for debt securitiesand marketable equity securities and derivatives:

■ amortised cost is used for held-to-maturity debtsecurities; and

■ fair value is used for available-for-sale andtrading securities.

Mortgage loans held for sale are carried at the lowerof cost or fair value. An entity’s own debt is stated atamortised cost. All other financial instruments fallunder other rules of US GAAP, and are generallycarried at amortised cost.


For changes in fair value of available-for-sale securities,a similar recycling system is used: adjustments arereported in other comprehensive income (a componentof equity); they are subsequently recycled from othercomprehensive income and recognised in the incomestatement when realised.




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IFRS

For available-for-sale monetary financial assets,change in fair value attributable to foreign exchangedifferences is always recognised in the incomestatement. Any remaining change is in equity, if theentity has chosen to present fair value changes there(see above). For non-monetary available-for-saleassets, the entire change is recognised in equity.

Impairment should be assessed at each balance sheetdate, and required write-downs in the financial asset’scarrying amount are recognised in the incomestatement. Impairment losses may be reversedsubsequently, also through the income statement, ifcircumstances warrant this.

For available-for-sale instruments, subsequentincreases or decreases in fair value that are notdeemed to be impairment are included as a separatecomponent of equity (if that is the option chosen bythe entity to recognise fair value changes).

Measurement currency is the currency in which thefinancial statements are measured, and should bethe currency that reflects the economic substanceof the underlying events and circumstances relevantto the entity.

Hedging

A highly effective hedge is one where changes infair value or cash flows of the hedged item areexpected to be almost fully offset by the changes infair value or cash flows of the hedging instrument,both at inception and throughout the life of the hedge.Actual results should be in a range of 80 to 125 percent offset.

A hedge effectiveness test must be performedat inception and on an ongoing basis at eachreporting period.

A fair value hedge may be used to hedge the exposureto changes in the fair value of a hedged itemattributable to its fixed terms. A cash flow hedge maybe used to hedge the exposure to variability in cashflows of a hedged item attributable to changes invariable rates or prices.

US GAAP

For available-for-sale securities the entire change infair value including foreign exchange differences isrecognised in other comprehensive income, acomponent of equity.

If impairment is other than temporary, a write-down in the financial asset’s carrying basis isrecognised in the income statement. No subsequentreversals are permitted.

Similar approach under US GAAP. Subsequentchanges (that are not other than temporaryimpairment) are included in other comprehensiveincome (OCI).

Functional currency is used to describe the currencyof the primary economic environment in which anentity operates. This is normally the currency of theenvironment in which the entity generates andexpends cash.

Practice has developed where both future expectationand actual results should be in a range of 80 to 125 percent offset.

Similar approach under US GAAP, except that ashort-cut method is allowed for certain hedges ofinterest rate risk where 100 per cent effectivenesscan be assumed if certain criteria are met.




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IFRS

For fair value hedges, the change in fair value of thehedging instrument is recognised in the income statement,as is the hedged item in respect of the hedged risk.

For cash flow hedges, the effective part of the changein fair value of the hedging instrument is recognisedin equity, and is recycled as and when the hedgedtransaction affects the income statement. If an assetor liability results from the hedged transaction, hedgeresults are included in the cost basis of the asset orliability (i.e. basis adjustment).

A hedge of any future transaction, committed orotherwise, is a cash flow hedge.

Recognised foreign currency denominated assets andliabilities may be the hedged item in a fair value orcash flow hedge.

A derivative or non-derivative may be used to hedgeforeign currency risk in a fair value hedge or a cashflow hedge of a recognised asset or liability.

The hedge of a net investment in a foreign entity isaccounted for in a manner similar to a cash flow hedge.

The ineffective portion of a net investment hedge isrecognised in equity when the hedging instrument isa non-derivative. When the hedging instrument is aderivative, the ineffective portion is recognised in theincome statement.

There is no requirement that a subsidiary within agroup of consolidated accounts that holds a foreigncurrency exposure must be a party to the hedge ofthat exposure.

Internal derivatives may be used as hedginginstruments in a hedge of foreign currency risk forpurposes of hedge accounting, if such derivatives areoffset by third party contracts on a net basis. Theymay not be used as hedging instruments for purposesof hedging other than foreign currency risks, unlessthere is an offset with a third party contract.

US GAAP


For cash flow hedges, the effective part of the changein fair value of the hedging instrument is recognisedin other comprehensive income or equity, and isrecycled as and when the hedged transaction affectsthe income statement. A basis adjustment to the assetor liability is not allowed.

A foreign currency hedge of a firm commitment maybe a fair value or a cash flow hedge; other hedges offirm commitments are fair value hedges; hedges offorecasted transactions are cash flow hedges.


A non-derivative may be used to hedge foreigncurrency risk in an unrecognised firm commitmentor the hedge of a net investment, but not to hedgeany other exposures.


The ineffective portion of a net investment hedge isrecognised in the income statement.

Foreign currency hedges are not permitted inconsolidated accounts unless the subsidiary holdingthe exposure is also a party to the hedge. Therefore,a group treasury department that holds a hedge mustwrite an offsetting instrument with the group memberholding the exposure.

Similar approach under US GAAP. However, onlycertain cash flow hedges of foreign currency riskqualify for a netting approach.




226

IFRS

Presentation and disclosure

Financial assets and liabilities should be offset andreported net only when an entity has both the legalright to set off the amounts, as well as the intent todo so.

Accounting principles applied as well as significantterms and conditions of financial instruments shouldbe disclosed.

Information about interest rate risk exposuresshould be disclosed for each type of financial assetand liability.

Maximum credit risk exposures as well asconcentrations of credit risk should be disclosed,including the maximum credit exposure of eachconcentration and their shared characteristics.

Fair value of all financial instruments should bedisclosed either in the notes or on the face of thebalance sheet.

The methods and significant assumptions applied toestimate fair values are required to be disclosed.

Gains and losses that are recognised directly in equityare disclosed. These include changes in fair value ofavailable-for-sale assets (when an entity records thesechanges in equity rather than in the income statement)and the effective portion of the change in value of ahedging instrument in a cash flow hedge.

Amounts recycled from equity to the incomestatement must be disclosed.

Disclosures of the nature and amount of animpairment loss or reversal of an impairment lossshould be made.

Disclosure of management’s objectives and policiesis required for those instruments held for riskmanagement purposes.

Hedging relationships should be disclosed by type ofhedge. Disclosure includes a description of therelationship, including the hedging instrument, the riskbeing hedged, and in the case of forecasted transactionswhen the transactions are expected to occur.

US GAAP


Similar disclosures under US GAAP.

Similar disclosures under US GAAP for derivativeinstruments and retained interests.







Disclosure of management’s objectives and policiesis required for derivatives held or issued.




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In the area of derecognition, the amendments have added to the differences between IFRS and US GAAP.As noted in Section 4, the amendments to IFRS first require consideration of whether an SPE should beconsolidated into the reporting entity before consideration of derecognition, and then place the previousrequirements in a hierarchy, with the transfer of risks and rewards generally being considered first, and theassessment of control being considered only when substantially all the risks and rewards related to transferredassets have been neither transferred nor retained. If control has not been transferred in these circumstances,IFRS switches to a continuing involvement model which results in partial derecognition. With respect to theconsolidation of SPEs, SIC–12 remains in place. None of the amendments bring IFRS closer to US GAAP.In addition, US GAAP has been subject to further developments, few of which converge towards IFRS.

Furthermore, the option in the amendments to designate any financial asset or financial liability as fair valuethrough profit or loss or as available-for-sale, the new exemption for embedded derivatives denominated in acurrency which is ‘commonly used in that economic environment’ and the new restrictions on the use ofinternal transactions as hedged items and hedging instruments create new differences with US GAAP.

The new rules for derivatives on own equity are, in certain respects, similar to new rules for those instrumentsunder US GAAP. However, some significant differences remain.

In other respects the amendments have moved IFRS closer to US GAAP. For example:

■ the widening of the scope of the amended standards to include commodity contracts where the underlyingis readily convertible to cash;

■ the scope exclusion for certain loan commitments;

■ eliminating the previous policy choice to measure available-for-sale financial assets at fair value throughprofit or loss;

■ the clarification that a market price in an active market is the best evidence of fair value, and that thetransaction price is the best evidence of fair value when the instrument is not traded in an active market;

■ the prohibition on reversals of impairment losses on available-for-sale equity instruments;

■ the requirement to account for most firm commitment hedges as fair value hedges;

■ the prohibition on basis adjustment for a cash flow hedge of the purchase or issuance of a financial assetor liability; and

■ the option not to include a basis adjustment for a cash flow hedge of the purchase of a non-financial asset.



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C. Abbreviations

AFS Available-for-sale

CCIRS Cross currency interest rate swap

FC Foreign currency

FIFO First-in first-out method (for inventory)

FX Foreign exchange (risk)

GAAP Generally accepted accounting principles

HTM Held-to-maturity

IASB International Accounting Standards Board

IFRIC International Financial Reporting Interpretations Committee

IFRS International Financial Reporting Standard

IGC Implementation Guidance Committee

IRS Interest rate swap

LIBOR London inter bank offered rate

MC Measurement currency

SIC Standing Interpretations Committee

SPE Special purpose entity

Appendix C Abbreviations


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D. List of cases

Page

Section 2

Case 2.1 Guarantee contract versus credit derivative 18

Case 2.2 Guarantee contract held by a third party 18

Section 4

Case 4.1 Low interest loan 30

Case 4.2 Purchase of a bond, comparing trade date and settlement date accounting 32

Case 4.3 Sale of a bond, comparing trade date and settlement date accounting 33

Case 4.4 Receivables sold with full recourse 40

Case 4.5 Transfer of a portfolio of loans 42

Case 4.6 Modification of the terms of a loan 45

Section 5

Case 5.1 Origination of a loan 54

Case 5.2 Held-to-maturity classification 57

Case 5.3 Tainting of held-to-maturity assets 58

Case 5.4 Held-to-maturity portfolio acquired in a business combination 61

Section 6

Case 6.1 Determining the fair value of an interest rate swap 71

Case 6.2 Calculation of (amortised) cost 76

Case 6.3 Effective interest rate calculation 76

Case 6.4 Measurement of monetary financial instruments denominated in a foreign currency 80

Case 6.5 Impairment of a loan 85

Appendix D List of cases



230

Page

Section 7

Case 7.1 Transfer and subsequent remeasurement of held-to-maturity investments 95

Case 7.2 Remeasurement of an available-for-sale asset 96

Case 7.3 Available-for-sale debt security in a foreign currency including amortisation 98

Case 7.4 Measurement of available-for-sale equity securities 101

Section 8

Case 8.1 Hedge of a non-monetary item 112

Case 8.2 Hedging with a cross currency interest rate swap (CCIRS) 120

Case 8.3 Documentation of an FX cash flow hedge 122

Case 8.4 Documentation of a fair value hedge relationship 123

Case 8.5 Effectiveness testing 128

Section 9

Case 9.1 Fair value hedge of a fixed interest rate liability 141

Case 9.2 Cash flow hedge of a variable rate liability 144

Case 9.3 Cash flow hedge using an interest rate cap 147

Case 9.4 Net position hedging – interest rate risk 154

Case 9.5 Hedging on a group basis – interest rate risk 155

Case 9.6 Cash flow hedge of foreign currency sales transactions 159

Case 9.7 Cash flow hedge of foreign currency purchase transactions 163

Case 9.8 Fair value hedge of foreign currency risk on available-for-sale equities 165

Case 9.9 Net position hedging – foreign currency risk 169

Case 9.10 Hedging on a group basis – foreign currency risk 170

Case 9.11 Hedged item in a net investment hedge 172

Case 9.12 Hedgeable components of a net investment in a foreign entity 172

Case 9.13 Hedge of a net investment in a foreign entity 174

Case 9.14 Fair value hedge of commodity price risk 177

Case 9.15 Cash flow hedge of commodity price risk 179

Case 9.16 Fair value hedge of equity securities 181



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Page

Section 10

Case 10.1 Income statement impact of a convertible bond 190

Case 10.2 Example disclosure of risk management objectives and policies 199

Case 10.3 Example disclosures of types of hedges 200

Case 10.4 Example disclosure of gains or losses on hedging instruments recognised in equity 201


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