financial instruments pooja gupta mumbai

CA CA CA CA PoojaPoojaPoojaPooja GuptaGuptaGuptaGupta

Mumbai 21 Mumbai 21 Mumbai 21 Mumbai 21 August 2010August 2010August 2010August 2010

IAS 32, IAS 39, IFRS 7 & IFRS 9

Financial Instruments Standards

IAS

32

IAS

39

IFRS 7IAS 32

IAS 39

IFRS 9

Replacement of

IAS 39

Replacement of

IAS 39

Replacement of

IAS 39

20-Aug-10Prepared & Presented by CA Pooja Gupta

InsideInside

Financial instruments

Recognition and measurement

Derecognition

Hedge accounting

Presentation

Disclosures

New IFRS 920-Aug-10Prepared & Presented by CA Pooja Gupta

Key principles

Global accounting convergence

Enhanced disclosures

Use of fair values

Benchmark treatment

Harmonisation of markets

All derivatives are recognised on the balance sheet

Most financial assets measuredat fair value

Measurement of the hedging instrument is the basis for

hedge accounting


Financial Instruments StandardsFinancial Instruments Standards

IAS 32 Presentation

(Debt v/s Equity)

IAS 39 Recognition /

Derecognition/ Measurement/ Derivatives &

Hedge Accounting

IFRS 7

Disclosures of Financial

Instruments

IFRS 9

Classification & Measurement of Financial Assets


Scope - IAS 39 applies to all entities, but not

all financial instruments

Financial instruments are defined as any contract that

gives rise to:

- a financial asset of one entity and

- a financial liability or equity instrument of another

entity

Financial Instruments: Scope & DefinitionFinancial Instruments: Scope & Definition


Financial asset

Cash

Equity instrument of another entity

Contractual right to receive cash or another financial asset or to exchange financial assets or liabilities under potentially favourable conditions

Certain contracts settled in the entity’s own equity

Financial liability Equity instrument

Contract evidencing

a residual interest in

the assets of an entity

after deducting all of

its liabilities

Contractual obligation to deliver cash or another financial asset or to ex-change financial asset or liabilities under potentially unfavourable conditions

Certain contracts settled in the entity’s own equity

A financial asset is not always a monetary asset

Financial assets and liabilitiesFinancial assets and liabilities


� Assess at initial recognition

� Classification continues until disposal

� Determine liability component

� Equity is residual

� No gain or loss

Yes

Liability

No

Equity

Part

Compound instrument

Is there a contractual obligation that the issuer cannot avoid?


� IStaR Ltd. issues 1000 bondsconvertible into its own shares in 3years. The bonds are issued at parwith a face value of INR 100/- perbond. Interest is payable annually atnominal interest at 6% p.a. Each bondis convertible at anytime up to maturityin 125 equity shares. When bonds areissued the prevailing market interestrate for similar debt without conversionoptions is 9% p.a.

� Solution:

Under this approach, the liabilityelement is valued first, and thedifference between the proceeds ofthe bond issue and the fair value of theliability is assigned to the equitycomponent. The present value of theliability component is calculated usinga discount rate of 9%, the market ratefor similar bonds with no conversionrights.

� PV of the principal 100,000/-payable at the end of 3 yrs (77,200)

PV of the interest 6,000/-payable annually for 3 years (15,186)

------------Total Liability Component (92,386)

� Proceeds of the Bond 100,000------------

� Equity component (bal. fig) 7,614=======

� Discounting factor @ 9% 1 year 0.917 2 year 0.842 3 year 0.772


Categories of Financial Assets

CategoryCategoryCategoryCategory DefinitionDefinitionDefinitionDefinition

Financial assets at fair Financial assets at fair Financial assets at fair Financial assets at fair

value through profit value through profit value through profit value through profit

or loss (FvPL)or loss (FvPL)or loss (FvPL)or loss (FvPL)

• Financial assets held for trading

• Derivatives (unless accounted for as hedges)

• Financial assets designated to this category under the fair value option

Loans and receivables Loans and receivables Loans and receivables Loans and receivables

(L&R)(L&R)(L&R)(L&R)

Non-derivative financial assets with fixed or determinable payments that are not quoted in an active market

HeldHeldHeldHeld----totototo----maturity maturity maturity maturity

(HTM)(HTM)(HTM)(HTM)

Non-derivative financial assets with fixed or determinable payments and fixed maturity that the entity has the positive intent and ability to hold to maturity

AvailableAvailableAvailableAvailable----forforforfor----salesalesalesale

(AFS)(AFS)(AFS)(AFS)

• All financial assets that are not classified in another category. Called the ‘residual’ category


Categories of Financial LiabilitiesCategories of Financial Liabilities

CategoryCategoryCategoryCategory DefinitionDefinitionDefinitionDefinition

Financial liabilities at Financial liabilities at Financial liabilities at Financial liabilities at

fair value through fair value through fair value through fair value through

profit or loss (FvPL)profit or loss (FvPL)profit or loss (FvPL)profit or loss (FvPL)

• Financial liabilities held for trading

• Derivatives (unless accounted for as hedges)

• Financial liability designated to this category under the fair value option

Other financial Other financial Other financial Other financial

liabilitiesliabilitiesliabilitiesliabilities

All financial liabilities that are not classified at fair value through profit or loss. ‘Residual’ category


DerivativesDerivatives

Derivatives are instruments with all three of the following characteristics

� Value changes in response to changes in specified underlying price/ index (e.g. interest rate, FX rate, share price)

� Requires no or little net investment

� Settled at a future date

Examples of derivatives

� Forward FX contract

� Interest rate swap

� Collar and Caps


Component of hybrid instrument that includes a non-derivative host contract

Host Contract

Embedded derivative

FX Option

Commodity index

Inflation index

Equity index

Debt

Executorycontract

Equity

InsuranceLease


Conditions for separation

Is the contract

carried at fair value

through profit or loss

Will it be a derivative if it

was a freestanding?

Is it closely related to the host contract

Do not split the embedded derivative

NoNo YesYes NoNo

NoNoYesYes YesYes

Sp

lit an

d a

cc

ou

nt s

ep

ara

tely


Accounting following separation:

Host: apply rules of IAS 39 or other applicable IAS/IFRS if host is not afinancial instrumentDerivative: measure the separated derivative at fair value throughprofit or loss

Accounting when separation is difficult:

If it is difficult to determine the fair value of the embedded derivative, itis deemed to be the difference between the fair value of the combined(hybrid) instrument and the fair value of the host contract

Accounting when impossible to separate:

If the embedded derivative cannot be reliably identified and measured,the entire combined contract is accounted for as a financialinstrument at fair value


All financial assets and financial liabilities, including derivatives,

should be recognised on the balance sheet at fair value when the entity becomes party to the contractual provisions of the

instrument

Financial assets

@

“fair value of consideration

given”

Financial liabilities

@

“fair value of consideration

received”

Fair value is the amount for which an asset could be exchanged or a liability settled, between knowledgeable, willing parties in an arm’s length transaction


Instrument Measurement Value changes

Not relevant

(unless impaired)

Profit &Loss

Profit & Loss

Held-to-maturityinvestments

Amortised cost

(Effective Interest Rate)

Not relevant

(unless impaired)

Amortised costAmortised cost

(Effective Interest Rate)Loans and receivables

Available-for-sale Fair value

Financial assets at fairvalue through profit or loss Fair value

Financial liabilities at fairvalue through profit or loss

Fair value

Other liabilities Not relevantAmortised cost

(effective interest rate)

Equity

(unless impaired)


Amortisation is calculated using the effective interest rate method

Initial recognition amount -

Amortised cost =

Principal repayments -/+

Accumulated interest -

Impairment reduction

The effective interest rate is defined as “the rate that exactly discounts estimated future cash flows through the expected life of the financial instrument or, where appropriate, a shorter period to the net carrying amount of the financial asset or financial liability”.


Effective Interest RateEffective Interest Rate

Product Auto Loan

Tenor (Contractual Life) 5 years

Expected life (Actuarial Life) 3 years

Loan Amount 500,000/-

Transaction Costs & Fees 5,000/-

Interest rate 10%

EMI (Yearly) 131,899/-

EIR (calculated) 9.53%


Effective Interest RateEffective Interest Rate

No EIR EIR

Interest Prin EMI O/s Interest Prin EMI O/s Txn Costs

1 50,000 81,899 131,899 418,101 48,106 83,793 131,899 421,207 1,894

2 41,810 90,089 131,899 328,013 40,124 91,775 131,899 329,432 1,686

3 32,801 99,097 131,899 228,915 31,382 100,517 131,899 228,915 1,424

4 22,892 109,007 131,899 119,908 22,892 109,007 131,899 119,908 0

5 11,991 119,908 131,899 0 11,991 119,908 131,899 0 0

159,494 154,494


Active market: unadjusted published price quotations

No active market: valuation techniques

No active market: Unquoted Equity investments (-) impairment loss

How do you define an active market

is subject to judgement and hence

the guidance issued by the expert

panel of the IASB in September’08


Transferto:

Transferfrom

Trading Loans andreceivables

Held-to-maturity

Availablefor sale

Trading NotApplicable

Notpermitted

Notpermitted

Notpermitted

Loans andreceivables

If pattern ofshort termprofit making

NotApplicable

NotApplicable

Notpermitted

Held-to-maturity

Tainting NotApplicable

NotApplicable

Tainting

Available forsale

If pattern ofshort termprofit making

Notpermitted

Change inintent and ifall criteriamet

NotApplicable


And classification as AFS assets for two full financial years

Change of intent or ability

reclassify ALL HTM instruments

“Tainting” leads to measurement at fair value

Sales before maturity

reclassify ALL HTM instruments


� De-recognition rules were developed to deal with ‘offbalance sheet financing’

� The standard combines the ‘risk and rewardsapproach’ and ‘control approach’

� IAS 39 details principles for:

� Complete de-recognition

� Partial de-recognition (e.g. servicing rightsretained)

� De-recognition combined with recognition of a newliability (e.g. credit risk guaranteed)


� The part comprises only specifically identified cash flows from a financial asset (e.g. sale of an interest only strip)

� The part comprises only a fully proportionate (pro rata) share of the cash flows from a financial asset (e.g. sale of 90% of the asset)

� The part comprises only a fully proportionate share of specifically identified cash flows from a financial asset (e.g. sale of 90% of an interest only strip)


Part or entire asset?

Rights to cash flows expired? Derecognition

Rights to cash flows transferred?

Pass through arrangement? No derecognition

DerecognitionSubstantially all risks and rewards transferred?

Substantially all risks and rewards retained?

Control retained?

Continuing involvement

Consolidation

No derecognition

Derecognition

NO

YES

NO

YES

NO

NO

YES

NO

YES

YES

NO

YES


� First, consolidate all subsidiaries (including all SPEs)� Derecognition provisions are applied on a consolidated level

� Then, consider the subject of the derecognition provisions (financial asset, group of similar financial assets or a portion of a financial instruments or a group of similar financial instruments)

� Then, apply derecognition rules:

Derecognise when contractual rights to cash flows expire or� There is a “transfer of a financial asset” and � That transfer qualifies for derecognition


“Transfer of a financial asset” requires

� A transfer of the contractual rights to receive the Cash Flows; or

� Meeting the “pass-through requirements” in IAS 39.19

If financial asset has been transferred, then assess whether transfer qualifies for derecognition

� If substantially all risks and rewards are retained

� If substantially all risks and rewards are transferred

� If some but not substantially all risks and rewards have been transferred:

� Control -> Continuing involvement

Risk- Rewards & Control model !20-Aug-10Prepared & Presented by CA Pooja Gupta

� Financial liability (or part thereof) is removedfrom the balance sheet when it is extinguished,i.e. when the obligation is discharged or cancelledor expires


� Securitisations

� Securities lending

� Repurchase agreements

� Partial transfers of assets/liabilities

� Transfers involving special purpose entities

� Derecognition coupled with a new asset or liability

Derecognition rules are strict!!!


� A securitisation is a transaction that transforms afinancial asset(s) into securities

� Intent is often to achieve derecognition of thefinancial assets securitized

� Securitised assets often are transferred to aspecial purpose entity (SPE)


To match the timing differences of recognising theeffect of hedging instrument and hedged item ormeasurement differences if hedged item not at FV

Recognition mismatches

between hedged item and hedging instruments

i.e.because the hedged item is

not yet recognised in the balance

sheet or in the income statement

Measurement mismatches

between hedged itemand hedging instruments

i.e.because the hedged item is

notmeasured at fair value


What can qualify as a hedged item ?

A HTM investment for interest rate risk

A general business risk

Investment in associate or subsidiary

Non financial asset or liability

An exposure to a risk that affects the income statement

An AFS security

A loan / receivable

Foreign currency monetary item

What can be used as a hedging instrument?

• External instruments only for Group hedging• Generally derivatives• May be a portion of the instrument (eg 50%) but not a portion of time


– Risk management objective and strategy for the hedge

– Identification of the hedging instrument

– The related hedged item or transaction

– The nature of the risk being hedged

– How hedging instrument’s effectiveness will be assessed

1.

2(a) Hedge must be expected to be highly effective at inception andsubsequent periods

2(b) Hedge effectiveness must be tested regularly throughout its life

3. In the case of hedging future cash flows, there must be a high probabilityof that cash flow occurring

2(c) Effectiveness must fall within the range of 80% - 125% over the life of thehedge

Hedge relationship must be documented at inception


The criteria for hedge accounting is onerous and have system implicationsfor all entities. Hedge Accounting is OPTIONAL and management shouldconsider the cost and benefits to use it.

� IAS 39 does not specify a single method forassessing hedge effectiveness prospectively orretrospectively.

� The method an entity adopts depends on its riskmanagement strategy and should be included inthe documentation at the inception of the hedge.

� The most common methods used are:

• critical terms comparison;

• dollar offset method; and

• regression analysis.


� Comparing the critical terms of the hedging instrument with thoseof the hedged item.

� Hedge relationship is expected to be highly effective where allthe principal terms of the hedging instrument and the hedgeditem match exactly – for example, notional and principalamounts, credit risk (AA), term, pricing, re-pricing dates (alignedto test date), timing, quantum and currency of cash flows – andthere are no features (such as optionality) that would invalidatean assumption of perfect effectiveness.

� Does not require any calculations.

� May only be used in the limited cases, but in such cases it is thesimplest way to demonstrate that a hedge is expected to behighly effective (prospective effectiveness testing).


� The dollar offset method can be performed using different approaches, including thefollowing:

• Hypothetical derivative approach. The hedged risk is modelled as a derivativecalled a ‘hypothetical derivative’ (as it does not exist). The hypothetical derivativeapproach compares the change in the fair value or cash flows of the hedginginstrument with the change in the fair value or cash flows of the hypotheticalderivative.

• Benchmark rate approach: ‘target’ rate established for the hedge. In an interestrate hedge of a variable rate debt instrument using an interest rate swap, thebenchmark rate is usually the fixed rate of the swap at the inception of the hedge.The benchmark rate approach first identifies the difference between the actual cashflows of the hedging item and the benchmark rate. It then compares the change inthe amount or value of this difference with the change in the cash flow or fair valueof the hedging instrument.

• Sensitivity analysis approach: assess the effectiveness of a hedge prospectively.This method consists of measuring the effect of a hypothetical shift in the underlyinghedged risk (for example, a 10% shift in the foreign currency exchange rate beinghedged) on both the hedging instrument and the hedged item.


� This statistical method investigates the strength of thestatistical relationship between the hedged item and thehedging instrument.

� Provides a means of expressing, in a systematic fashion,the extent by which one variable, ‘the dependent’, will varywith changes in another variable, ‘the independent’.

� The independent variable reflects the change in the valueof the hedged item, and the dependent variable reflects thechange in the value of the hedging instrument.


FX InterestCredit CommodityEquity

Types of risks which can be hedged

Exposure to risk can arise from changes in

IAS 39 recognizes 3 types of relationship

Fair valueFuture cash flows

Probable future cash flows

1. Fair Value Hedge

2. Cash Flow Hedge

3. Hedges of Net Investment in Foreign Entity

A common strategy in risk management is hedging, where risks thatan entity faces are reduced or eliminated by entering intotransactions that give an offsetting risk profile


Hedge of exposure to changes in fair value of a recognised asset or liability, anunrecognised firm commitment or an identified portion of either of these that isattributable to a particular risk and could affect P&L

Measurement of derivative hedging

instrument

FV through P&L

Measurement of hedged item

Amortised cost or

Available-for-sale (FVthrough equity)Measurement or

performance reporting mismatch

Without hedge accounting


0

1 2 Total

Hedged item 0 (20) (20)

Hedging instrument 20 20

20 (20) 0

Accelerate recognition of gain or loss on hedged item

The use of hedge accounting allows an entity to reflect the economics of a hedge relationship in the financial statements by matching offsetting gains and losses in

P&L in the same period


Risk being hedged is the change in the ‘fair value’ ofor identified portion of an asset, liability orunrecognized firm commitment

Hedging instrument –

Change in fair value

Hedged item –Adjust the carrying amount

INCOME

STATEMENT


Hedge of exposure to variability in cash flows that is:

1. Attributable to a particular risk associated with a recognised asset or liability or a highly probable forecast transaction; and

2. Could affect profit or loss

Measurement of derivative hedging

instrument

FV through P&L


Not yet recognised inthe accounts

Recognition mismatch



0

1 2 Total

Hedged item 0 (20) (20)

Hedging instrument 20 20

20 (20) 0

Defer recognition of gains or losses on hedging

instrument


Risk being hedged is exposure to variability in ‘cash flows’ of an asset,

liability or unrecognized firm commitment

Hedging instrument – Change in fair value

Effective Ineffective

EQUITY

(Hedging Reserve)

INCOME STATEMENT

Recycled when hedged items affect earnings


Hedge of a net investment in a foreign operation, as defined in IAS 21

Measurement of hedging instrument

FV through P&L (derivatives)

OR

FX gain/loss through P&L

(foreign currency loan)


FX gains / lossesthrough equity

Performance reporting mismatch



0

Income Statement Equity

Hedged item 0 (20)

Hedging instrument 20

20 (20)

Match recognition (in equity) of gains or losses on the hedging instrument


Total

(20)

20

0

� Hedge of a net investment in a foreignoperation (including a hedge of a monetaryitem that is accounted for as part of the netinvestment)

� Hedging instruments can be foreign currencymonetary items or derivatives

� Accounting similar to cash flow hedges


� PP Bank issues $100m of debt at a fixed interest rate e.g. at 8%. To avoid amismatch between the interest it pays for funding and the floating interest rate itreceives on loans, the bank takes out an interest rate swap. The swap has theaffect of PP paying a floating rate of interest on the issued debt, say at 11%instead of the 8% fixed (PP continues to pay fixed interest to the debt holders,but receives fixed interest from, and pays floating to, the swap counterparty)

PP’s Issued debt at a fixed rate

PP’s Assets with $ floating interest rates

IRS - PP pay $ floating interest

to swap counterparty receives $

fixed interest from swap

ASSETS LIABILITIES

• Impact on financials:

When the interest on debt increases leading to decrease in the carrying amount ofthe debt by $10m. This has equal corresponding effect on notional amount of swap.


IAS Achieve Hedge Accounting

IAS Fail Hedge Accounting

BALANCE SHEET USD Mio USD Mio

Derivative Asset / (Liability) (13) (13)

Issued Debt (100) (100)

Fair value adjustment to Issued debt (increase) / decrease 10 Nil

Net issued debt Liability (90) (100)

P & L ACCOUNT

Net Interest Income COUPON (8) (8)

SWAP ACCRUAL (3) 0

NET (11) (8)

DEAL PROFIT AND LOSS SWAP MTM (10) (13)

ISSUED DEBT FV ADJUSTMENT 10 NIL

NET PROFIT AND LOSS (11) (21) 20-Aug-10Prepared & Presented by CA Pooja Gupta

Hedge accounting must be discontinued prospectively if:

� The hedging instrument expires or is sold, terminated or exercised

� The hedge no longer meets the IAS 39 criteria for hedge accounting (e.g. forecast transaction no longer highly probable)

� The entity revokes the designation


An intention to settle net or to realise the asset and settle the liability

simultaneously

&Master netting agreements

Several instruments used to emulate a single instrument (synthetic instrument)

Items with the same risk, but different counterparties

Financial assets pledged as collateral for non-recourse liabilities

Assets set aside in a trust to discharge a liability that have not been accepted by the creditor (sinking fund arrangements)

Obligations as a result of losses recoverable via insurance

A legally enforceable right to set off


� Objectives� Improvement of existing requirements as regards

exposure and management of risks arising fromfinancial instruments

� Removing unnecessarily onerous or duplicativedisclosures

� Relocating in one place all disclosurerequirements on financial instruments

� Scope� All risks arising from financial instruments

� All entities


Significance of financial instruments for financial

position and performance

Classes of financial instruments and level

of disclosure

Nature and extent of risks arising from

financial instruments

Qualitative disclosures

Other disclosures

Income statement and equity

Quantitative disclosures

IFRS 7

Balance sheet


� Balance sheet� Carrying amounts by “Classes” of financial

instruments

� Impact of credit risk on financial liabilitiesdesignated as at fair value through P&L

� Credit risk disclosure on loans and receivablesdesignated as at fair value through P&L

� Reconciliation of changes in allowanceaccounts for credit losses


� Income statement

� Net gains and losses for all categories offinancial assets and liabilities

� Fee income and expense arising from financialinstruments and trust/fiduciary activities

� Other disclosures

� Impact in the period P&L of hedges by category

� Accounting policy and net position of Day 1differences when fair value is determined usingnon observable market data.


� Issued by the IASB on 12 November 2009

� Impacts banks and insurance companies most significantly, but all

entities that hold financial assets will be affected.

� The effective date of the new classification and measurement

guidance is 1 January 2013; early application is permitted.

� IFRS 9 should be applied retrospectively; however, if adopted

before 1 January 2012, comparative periods do not need to be

restated.

� In addition, entities adopting before 1 January 2011 are allowed

to designate any date between then and the date of issuance of

IFRS 9, as the date of initial application that will be the date

upon which the classification of financial assets will be

determined.


� IFRS 9 replaces the multiple classification and measurement

models in IAS 39 with a single model that has only two

classification categories: amortized cost and fair value.

� Classification is driven by the entity’s business model for

managing the financial assets and the contractual characteristics

of the financial assets.

� A financial asset is measured at amortized cost if two criteria are

met: a) the objective of the business model is to hold the

financial asset for the collection of the contractual cash flows,

and b) the contractual cash flows under the instrument solely

represent payments of principal and interest.

� Requirement to separate embedded derivatives from financial

asset hosts removed. It requires a hybrid contract to be classified

in its entirety at either amortized cost or fair value. 20-Aug-10Prepared & Presented by CA Pooja Gupta

� Two of the existing three fair value option criteria become

obsolete, as a fair value driven business model requires fair value

accounting, and hybrid contracts are classified in their entirety.

Accounting mismatch condition carried forward to the new

standard.

� Prohibits reclassifications except in rare circumstances when the

entity’s business model changes; in this case, the entity is

required to reclassify affected financial assets prospectively.

� All equity investments should be measured at fair value.

� Removes the cost exemption for unquoted equities and

derivatives on unquoted equities .


� IFRS 9 first milestone in the IASB’s planned replacement of IAS 39.

� The next steps involve:

- Reconsideration and re-exposure of the Classification and

measurement requirements for financial liabilities

- Exploration and field testing of the proposed Impairment approach

for financial assets; and

- Development of enhanced guidance on Hedge Accounting.

� IASB aims to fully replace IAS 39 by the end of 2010.

� Indication that the effective date of IFRS 9 may be pushed back to

align the mandatory adoption of the standard with the effective

dates for IAS 39 replacement stage II – ‘Amortized cost and

impairment’ and ‘Insurance’ projects.


Experiences!!!

Comments!!!

Questions!!


Questions / Comments / Feedback

www.capoojagupta.blogspot.com

Presenter’s contact details

CA Pooja Gupta

+91 – 9821504041

[email protected]


financial instruments pooja gupta mumbai

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