IAS 32/39 Financial Instruments: Disclosure and Presentation Recognition and Measurement

Agenda Scope and definitions IAS 32 IAS 39 Liability and equity Offsetting a financial asset and financial liability IAS 39 Classification of financial instruments Measurement of financial assets and liabilities Derivatives and embedded derivatives Recognition and derecognition Hedging and hedge accounting IAS 32 – Disclosure requirements Case study

History and Effective Date IAS 32 Effective for accounting periods beginning on or after 1 January 1996. Other related interpretations SIC 5 Classification of Financial Instruments – Contingent Settlement Provisions. SIC 16 Share Capital – Reacquired Own Equity Instruments (Treasury Shares). SIC 17 Equity – Costs of an Equity Transaction. IAS 39 Effective for accounting periods beginning on or after 1 January 2001 Other related guidance Interpretation Guidance issued by IGC. IAS 32/39 (Revised 2003 and 2004 for Portfolio Hedge of Interest Rate Risk) Effective for accounting period beginning on or after 1 January 2005. Draft Amendments to IAS 39 Financial Instruments: Recognition and Measurement: The Fair Value Option. Issued on 21 April 2004.

Objective IAS 32 To enhance financial statement users’ understanding of the significance of financial instruments to an entity’s financial position, performance and cash flows. IAS 39 The objective of this Statement is to establish principles for recognising, measuring financial assets, financial liabilities and some contracts to buy and sell non-financial items.

Scope and Definitions

x Scope Exclusion: IAS 32 IAS 39 Interests in subsidiaries, associates and joint ventures in consolidated accounts (IAS 27, 28 and 31) x Rights and obligations under leases (IAS 17) except for derecognition and embedded derivatives Employers’ assets and liabilities under employee benefit plans (IAS 19) Rights and obligations under insurance contracts (IFRS 4) Instruments issued by the reporting enterprise that meet the definition of equity (IAS 32) Certain loans commitments and financial guarantee contracts (IAS 37 and 18) Contracts for contingent consideration in a business combination for the acquirer (IAS 22/IFRS 3) Contracts that require payment based on climatic, geological or other physical variables (IFRS 4) .

Scope : Non-financial item contracts Contracts to buy or sell a non-financial item that can be settled net in cash or another financial instrument are treated as financial instruments: unless the non-financial item contracts: were entered into and continue to be held for the purpose of the receipt or delivery of a non-financial item in accordance with the entity’s expected purchase, sale or usage requirements.

Definition : What is a Financial Instrument? A contract that gives rise to: Financial Asset FINANSAL ENSTRÜMANLARIN TANIMI TARAFLARDAN BİRİNDE FINANSAL BIR AKTIF KARSI TARAFTA ISE FINANSAL BIR YÜKÜMLÜLÜK OLUSUR ÖRNEK A BANKASI B BANKASINA PLASMAN YAPARSA A DA FINANSAL AKTIF OLAN PLASMAN B DE ISE FINANSAL YÜKÜMLÜLÜK OLAN BANKALAR MEVDUATI OLUSUR VEYA A BANKASI X SIRKETINE KREDI VERIRSE A BANKASINDA FINANSAL AKTIF OLAN KREDI, X SIRKETINDE ISE FINANSAL YÜKÜMLÜLÜK OLAN BANKA KREDISI OLUSUR in one enterprise and Financial Liability or Equity Instrument in another enterprise

Definition of Financial Asset Any asset that is: cash; a contractual right to receive cash or another financial asset from another entity; a contractual right to exchange financial instruments with another enterprise under conditions that are potentially favourable; an equity instrument of another entity; a contract that will or may be settled in the entity’s own equity instruments and is: A non-derivative for which the entity is or may be obliged to receive a variable number of the entity’s own equity instruments; A derivative that will or may be settled other than by the exchange of a fixed amount of cash or another financial asset for a fixed number of the entity’s own equity instruments.

Definitions of Financial Liability/Equity Any liability that is a contractual obligation: to deliver cash or another financial asset to another enterprise; or to exchange financial instruments with another enterprise under conditions that are potentially unfavourable a contract that will or may be settled in the entity’s own equity instrument and is: A non-derivative for which the entity is or may be obliged to deliver a variable number of the entity’s own equity instruments; A derivative that will or may be settled other than by the exchange of a fixed amount of cash or another financial asset for a fixed number of the entity’s own equity instruments. Equity instrument Any contract that evidences a residual interest in the assets of an enterprise after deducting all of its liabilities

Types of Financial Instruments Primary Deposits of cash Bonds, loans, borrowings Receivables / payables (including finance leases) Equity instruments Derivatives Forwards / futures Financial options Swaps Caps and collars Financial guarantees Letters of credit Combinations Convertible debt Exchangeable debt Dual currency bond CAPS AND COLLARS CONVERTIBLE DEBT - SERMAYEYE DÖNÜSEBILEN TAHVILLER EXCHANGEABLE DEBT - DUAL CURRENCY BOND -

IAS 32 - Presentation

IAS 32 – Presentation Liability and equity Offsetting a financial asset and a financial liability

IAS 32 – Liability and Equity Classify the instrument, or its component parts, on initial recognition as a financial liability, a financial asset or an equity instrument in accordance with the substance of the contractual arrangement and the definitions of a financial liability, a financial asset and an equity instrument. If a financial instrument contains both a liability and an equity element, the instrument’s component parts should be classified separately. Debt Securities with an embedded conversion option, such as a convertible bond, should be separated into the liability component and the equity component on the balance sheet.

IAS 32 – Liability and Equity Contractual obligation to deliver cash or another financial asset. Mandatory redeemable preference shares. A “puttable instrument” by the holder. Liability if the obligation is conditional. Conditional upon approval by regulatory authority. Conditional upon the counter-party exercising its right to redeem.

IAS 32 – Liability and Equity Settlement in the entity’s own equity instrument. Not an equity instrument solely because settlement is through delivery or receipt of the entity’s own equity. Liability if the contractual obligation is a fixed amount so that the value of the equity instrument equals the amount of contractual obligation. Settlement options When a derivative financial instrument gives one party a choice over how it is settled (eg. the issuer or the holder can choose settlement net in cash or by exchanging shares for cash), it is a financial asset or a financial liability unless all settlement alternatives would result in it being an equity instrument.

IAS 32 – Liability and Equity Contingent settlement provision Liability if the obligation to deliver cash or another financial instrument arises only on the occurrence or non-occurrence of uncertain future events that are beyond the control of both the issuer and holder, unless The contingent event is restricted only in the event of liquidation of the issuer; or The contingent event that trigger the obligation is considered to be not genuine.

IAS 32 – Liability and Equity Treasury Shares Acquisition of own equity instruments (treasury shares) should be deducted from equity. No gain or loss shall be recognised in profit or loss on the purchase, sale, issue or cancellation of an entity’s own equity instruments. However, an obligation to purchase own equity instruments for cash or another financial asset gives rise to a financial liability for the present value of the redemption amount.

IAS 32 – Liability and Equity Compound Instrument An financial instrument that contains both liability and equity components should be classified and presented separately. Example: A bond that is convertible, either mandatory or at the option of the holder into equity shares of the issuer. Method of separating the liability and equity component The liability component is fair valued first, and this provides the initial carrying amount of the liability component. The fair value of the liability component is then deducted from the fair value of the instrument with the residual amount representing the equity component. Transaction costs are usually allocated to the liability and equity components based on proportion of fair value.

IAS 32 – Liability and Equity Interest, Dividends, Losses and Gains Interest, dividends, losses and gains relating to a financial instrument or a component that is a financial liability shall be recognised as income or expense in profit and loss. Distributions to holders of an equity instrument shall be debited by the entity directly to equity.

IAS 32 – Offsetting of a financial asset and a financial liability A financial asset and a financial liability shall be offset and the net amount presented in the balance sheet when, and only when, an entity: Currently has a legally enforceable right to set off the recognised amounts; and Intends either to settle on a net basis, or to realise the asset and settle the liability simultaneously.

IAS 39 Classification of Financial Assets and Liabilities

Financial Assets : Held for Trading Acquired or incurred principally for the purpose of selling or repurchasing it in the near term. Regardless of why it was acquired, the financial asset is a part of a portfolio for which there is evidence of a recent actual pattern of short-term profit-taking.

Financial Assets : Held for Trading (Continued) Derivative financial assets and derivative financial liabilities are: - always deemed held for trading UNLESS - they are designated and are effective hedging instruments.

Financial Assets : Designated upon initial recognition Any financial asset or financial liability within the scope of this Standard may be designated when initially recognised as a financial asset or financial liability at fair value thru P&L; except for: investments in equity instruments that do not have a quoted market price in an active market and whose fair value cannot be reliably measured. Note: ED issued on 21 April 2004 potentially will limit the types of financial assets and financial liabilities to which this option may be applied.

Financial Assets : Held-to-Maturity Assets with fixed or determinable payments and fixed maturity: which the enterprise has the positive intent and ability to hold to maturity other than loans and receivables; and those that the entity upon initial recognition designates as at fair value through profit & loss or those that the entity designates as available for sale.

Financial Assets : Held-to-Maturity (Continued) An enterprise should not classify any financial assets as held-to-maturity if it (IAS 39R.9): sold, transferred or exercised put options on more than an insignificant amount of held-to-maturity investments before maturity during the current year or two preceding years (TAINTING) OTHER THAN sales close enough to maturity or the exercised call date so that interest rate changes did not have significant effect on fair value; sales after the enterprise has already collected substantially all of the financial asset’s original principal; or sales due to an isolated event that is beyond the enterprise’s control, is non-recurring and could not have been reasonably anticipated.

Financial Assets : Loans and Receivables Financial assets with fixed or determinable payments that are not quoted in an active market, other than: those that are intended for sale immediately or in the near term, which should be classified as held for trading; and those that are designated upon initial recognition as fair value thru P&L; or those that are designated upon initial recognition as available for sale; or those for which the holder may not recover substantially all of its initial investment, other than because of credit deterioration, which shall be classified as available for sale.

Financial Assets : Available-for-Sale Those financial assets that are designated as available for sale or are not classified as: a) loans and receivables; b) held-to-maturity investments, or c) financial assets at fair value thru P&L

Financial Liabilities : At fair value thru P&L Comprises a) Financial liabilities held for trading: derivative liabilities that are not hedging instruments the obligation to deliver securities borrowed by a short seller (an enterprise that sells securities that it does not yet own) Financial liabilities that are incurred with an intention to repurchase them in the near term Financial liabilities that are part of a portfolio of identified financial instruments that are managed together and for which there is evidence of a recent pattern of short-term profit-taking b) Designated as “fair value thru P/L” upon initial recognition The fact that a liability is used to fund trading activities does not make that liability one held for trading

IAS 39 Measurement of Financial Assets and Liabilities

Initial Measurement On initial recognition: financial assets and financial liabilities should be measured at fair value, PLUS in the case of financial assets / liabilities not at fair value thru P&L, transaction costs that are directly attributable to the acquisition or issue of the financial asset or financial liability. Initial Measurement of financial assets and liabilities When a financial asset or financial liability is recognized initially, an enterprise should measure it at its cost, which is the fair value of the consideration given (in the case of an asset) or received (in the case of a liability) for it. Transaction costs are included in the initial measurement of all financial assets and liabilities. The fair value of the consideration given or received normally is determinable by reference to the transaction price or other market prices. İf such market prices are not reliably determinable, the fair value of the consideration is estimated as the some of all future cash payments or receipts, discounted, if the effect of doing so would be material, using the prevailing market rates of interests for a similar instruments (similar as to currency, term, type of interest rate, and other factors) of an insurer with a similar credit rating.

Initial Measurement The fair value of a financial instrument on initial recognition is normally the transaction price. However, if part of the consideration given or received is for something other than the financial instrument, the fair value is estimated using a valuation technique.

Initial Measurement The fair value of a long-term loan that carried no interest can be estimated as the PV of all future cash receipts discounted using the prevailing market rate of interest for a similar instrument (similar as to currency, term, type of interest rate and other factors) with a similar credit rating. The fair value of a financial liability with a demand feature (e.g. a demand deposit) is not less than the amount payable on demand, discounted from the first date that the amount could be required to be paid.

Write-down for impairment or uncollectibility Subsequent Measurement : Held-to-Maturity Investments 1. Held-to-Maturity Investments: Amortised Cost Financial assets with fixed or determinable payments and fixed maturity that an enterprise has the positive intent and ability to hold to maturity Amortised cost is: Cumulative amortisation of difference between initial amount and maturity amount Write-down for impairment or uncollectibility Principal repayments Initial cost - +/- - Gain/loss from amortisation is recognised in net profit/loss

Subsequent Measurement : Loans and Receivables 2. Loans and Receivables : Cost or Amortised Cost Created by the enterprise by providing money, goods, or services directly to a debtor, other than those intended for sale in the short term Examples: receivables from sales of goods, originated mortgage loans, credit card loans, government or corporate securities acquired at origination Gain/loss from amortisation is recognised in net profit/loss Loans and receivables originated by an enterprise and not held for trading are measured at amortised cost without regard to the enterprise’s intent to hold them to maturity.

Subsequent Measurement : Fair Value thru Profit and Loss 3. Fair value thru profit and loss : Fair Value Acquired or incurred principally for the purpose of generating a profit from short-term fluctuations in price or dealer’s margin; OR Part of a portfolio with a recent pattern of short-term profit-taking; Designated upon initial recognition. Examples: trading portfolio of marketable securities, all derivatives unless qualifying as a hedge Gain/loss from fair value changes is recognised in net profit/loss Loans and receivables originated by an enterprise and not held for trading are measured at amortised cost without regard to the enterprise’s intent to hold them to maturity.

Subsequent Measurement : Available-for-Sale 4. Available-for-Sale : Fair value Financial assets which are designated as available for sale or not in one of the other three categories. Example: equities not held for trading, including strategic investments; debt securities with no positive intent/ability to hold to maturity Gain/loss from fair value changes is recognised directly in equity until sold, collected, disposed, at which time include in profit or loss. Interest calculated using effective interest rate method is recognised in the P&L. Loans and receivables originated by an enterprise and not held for trading are measured at amortised cost without regard to the enterprise’s intent to hold them to maturity.

Subsequent Measurement: Exception from Fair Value Requirement Presumption: Fair value can be reliably determined for most financial assets classified as available for sale or held for trading. But: Presumption can be overcome for: investment in equity instrument that does not have a quoted market price in an active market and for which other methods of estimating fair value are clearly inappropriate/unworkable derivatives linked to and settled by delivery of such an investment Loans and receivables originated by an enterprise and not held for trading are measured at amortised cost without regard to the enterprise’s intent to hold them to maturity.

Subsequent Measurement : Impairment PW: Subsequent Measurement : Impairment At each balance sheet date, the enterprise should assess whether there is any objective evidence of impairment (eg. financial difficulty of issuer, breach of contract, historical pattern of non-collectibility etc). If any evidence exists, the enterprise should provide for any impairment to recoverable amount for debt instruments (ie. the present value of expected future cash flows discounted at the financial instrument’s original effective interest rate) or to their estimated fair values (for equity instruments).

Subsequent Measurement : Impairment Assess existence of any objective evidence of impairment: significant financial difficulty of issuer actual breach of contract such as failure to make interest/principal payments high probability of bankruptcy disappearance of active market for financial asset historical pattern indicating entire face value of portfolio will not be collected Discount expected future cash flows at original effective interest rate to determine recoverable amount. Write down to recoverable amount through net profit/loss. Impairment loss for financial assets carried at cost (unquoted equity) should not be reversed. Impairment loss for available for sale equity instrument cannot be reversed thru P&L, any subsequent increase in fair value is recognised in equity. Loans and receivables originated by an enterprise and not held for trading are measured at amortised cost without regard to the enterprise’s intent to hold them to maturity.

IAS 39 Derivatives and Embedded Derivatives

Derivatives: Definition and Classification

Definition of Derivatives A derivative is a financial instrument: a) whose value changes in response to the change in a specified underlying; b) that requires no initial net investment or an initial net investment that is smaller than would be required for other types of contracts that would be expected to have a similar response to changes in market factors; AND c) that is settled at a future date.

Definition of Derivatives : Response to Changes in Underlyings A financial instrument whose value changes in response to the change in a specified underlying: Underlyings are defined as: specified interest rate security price commodity price foreign exchange rate index of prices or rates a credit rating or credit index other variables

Definition of Derivatives: Examples Type of Contract 1) Interest Rate Swap 2) Currency Swap 3) Commodity Swap 4) Equity Swap 5) Credit Swap 6) Purchased/written Treasury Bond Option (call/put) 7) Purchased/written Currency 8) Purchased/written Commodity Option (call/put) Underlying Variable Interest Rates Currency Rates Commodity Prices Equity Prices (equity of another enterprise) Credit Rating, Credit index or Credit price Interest Rate

Definition of Derivatives : Examples (Continued) Underlying Variable Equity Prices (equity of another Enterprise) Interest Rates Currency Rates Commodity Prices Equity Prices (equity of another enterprise) Type of Contract 9) Purchased/written Stock Option (call/put) 10) Interest Rate Futures Linked to Government Debt (Treasury Futures) 11) Currency Futures 12) Commodity Futures 13) Currency Forward 14) Commodity Forward 15) Equity Forward

Definition of Derivatives: Response to Changes in Underlyings Derivative normally has a notional amount which is an amount of currency, a number of shares, units of weight or volume or other units specified in contract Alternatively could require a fixed payment as a result of some future event that is unrelated to a notional amount (eg. pay CU1 million if interest rates increase by 100 basis points)

Definition of Derivatives : Initial Net Investment A financial instrument that requires no initial net investment or an initial net investment that is smaller than would be required for other types of contracts that would be expected to have a similar response to changes in market factors: Little initial net investment has wide interpretation and requires professional judgement Focus is on relativity between initial net investment and comparable primary financial instrument Criterion failed if investment is “equal or close to” equivalent investment

Definition of Derivatives : Future Settlement A financial instrument that is settled at a future date: No requirement for settlement to be net Commitments to buy or sell other non-financial assets and liabilities are excluded if: They are intended to be settled by the reporting enterprise by making or taking delivery in the normal course of business; and There is no practice of settling such contracts net either directly with counterparty or through offsetting contracts

Embedded Derivatives: Definition and Treatment

Definition : Embedded Derivatives A component of a hybrid instrument that combines the derivative and a host contract Example : Convertible bond host contract = the bond embedded derivative = call option on share A derivative may be a component of a hybrid (combined) financial instrument. An embedded derivative should be separated from the host contract and accounted for as a derivative under this Standard if all of the following conditions are met: Should you separate out the embedded and account for the two elements separately?

Embedded Derivatives Separate Measurement is Appropriate When: The economic characteristics and risks of the embedded derivative are not closely related to the economic characteristics and risks of the host contract, A separate instrument with the same terms as the embedded derivative would meet the definition of a derivative; and The hybrid (combined) instrument is not measured at fair value with changes in fair value reported in net profit or loss.

Embedded Derivatives: Evaluating When to Separate from a Host Contract Is the contract carried at fair value through earnings? Would it be a derivative if it were freestanding? Is it closely related to the host contract? Apply IAS 39* No Yes No Yes No Yes Do Not Apply IAS 39* * to the embedded derivative

Embedded Derivatives: What are the Consequences of Separation? If separated: Host contract: apply applicable IAS Derivative: apply IAS 39 ie. fair value the derivative and it may qualify as a hedging instrument If not required to separate: Apply applicable IAS to the combined contract If required to separate, but unable to measure the derivative: The combined contract is treated as a financial instrument held for trading, carried at fair value, and does not qualify for hedge accounting

Embedded Derivatives : Impact of Separation How should the initial carrying amounts of a host and embedded derivative be determined if separation is required? Initial Carrying = Cost for the Hybrid - Fair Value of Embedded Amount of Host Instrument Derivative Note: More than one embedded derivative may be separated from a host contract provided that they represent different risks. Since the embedded derivative must be recorded at fair value with changes in fair value reported in net profit or loss, the initial carrying amount assigned to the host contract on separation is determined as the difference between the cost (fair value of the consideration given) for the hybrid (combined) instrument and the fair value of the embedded derivative. It would be inappropriate to allocate the basis in the hybrid under IAS 39 to the derivative and non- derivative components based on their relative fair values, since that might result in an immediate gain or loss being recognised in net profit or loss on the subsequent measurement of the derivative at fair value.

IAS 39 Recognition

Recognition An enterprise should recognise a financial asset or a financial liability on its balance sheet when, and only when, it becomes a party to the contractual provisions of the instrument. Consequence: An enterprise recognises all of its contractual rights or obligations under derivative contracts in its balance sheet as assets or liabilities Exception required for “regular way” purchases and sales since period between trade date and settlement date meets the definition of a derivative

Recognition : “Regular Way” Purchases and Sales A “regular way” contract for the purchase or sale of financial assets requires delivery of the assets within the time frame generally established by regulation or convention in the market place concerned If the fixed price commitment between trade date and settlement date meets the definition of a derivative it is a forward contract In view of the short duration of the derivative contract, “regular way” contracts are specifically exempted from IAS 39 A “regular way” purchase or sale of financial assets should therefore be recognised using either trade date accounting or settlement date accounting, with consistent application for each category of financial assets

IAS 39 Derecognition

IAS 39: Derecognition Provides guidance/conditions on derecognition of financial assets/liabilities. Applicable to: Securitisation transactions. Debts/receivables factoring. Refinancing of loans.

IAS 39: Derecognition of Financial assets Derecognise a financial asset when and only when: Primary Condition - Transfer of Assets Contractual rights to the cash flows expire; or Entity transfers the financial assets Transfers the contractual rights to receive cash flows; or Retains the contractual rights to receive cash flows, but assumes a contractual obligation to pay cash flows to eventual recipients. In such case, if and only if, all of the following conditions are met: Entity is not obligated to pay amounts to eventual recipients unless it collects equivalent amounts from the original asset; Entity is prohibited from selling/pledging the original asset other than as security Entity is obligated to remit any cash flows it collects on behalf of the eventual recipients without material delay.

IAS 39: Derecognition - transfers of financial asset Secondary Condition – Significant Qualify for derecognition if the entity: Has transferred substantially all the risks and rewards of ownership; or Has not retained control of the asset, in the case if entity has neither transferred nor retained substantially all the risks and rewards of ownership Do not qualify for derecognition if the entity: Has retained substantially all the risks and rewards of ownership; or Has retained control of the asset, in the case if entity has neither transferred nor retained substantially all the risks and rewards of ownership (also known as continuing involvement)

Derecognition : Financial Liabilities The conditions for derecognition are met when either: (i) the debtor discharges the liability by paying the creditor, normally with cash, other financial assets, goods, or services; or (ii) the debtor is legally released from primary responsibility for the liability (or part thereof) either by process of law or by the creditor (the fact that the debtor may have given a guarantee does not necessarily mean that this condition is not met). The condition is not met when payment is made to a third party (in substance defeasance) unless there is legal release of the debtor’s obligation to the creditor. Derecognition of a financial liability An enterprise should remove a financial liability (or a part of a financial liability) from its balance sheet when, and only when, it is extinguished – that is, when the obligation specified in the contract is discharged, cancelled, or expires.

Derecognition : Financial Liabilities An exchange between an existing borrower and lender of debt instruments with substantially different terms/modification of terms should be accounted for as an extinguishment of the original financial liability and the recognition of new liability. The terms are substantially different if the discounted present value of the cash flows under the new terms, including any fees paid net of any fees received and discounted using the original effective interest rate is at least 10% different from the discounted PV of the remaining cash flows of the original liability. If accounted as extinguishment, any costs and fees incurred are recognised as part of the gain or loss on the extinguishment. If not accounted as extinguishment, any costs or fees incurred adjust the carrying value of the liability and are amortised over the remaining term of the modified liability. Derecognition of a financial liability An enterprise should remove a financial liability (or a part of a financial liability) from its balance sheet when, and only when, it is extinguished – that is, when the obligation specified in the contract is discharged, cancelled, or expires.

IAS 39 Hedging and Hedge Accounting

Hedging : Definitions Hedging for accounting purposes means designating one or more hedging instruments so that their change in fair value is an offset, in whole or in part, to the change in fair value or cash flows of a hedged item. Hedge effectiveness is the degree to which offsetting changes in fair value or cash flows attributable to a hedged risk are achieved by the hedging instrument.

Hedging Instrument : Definition A hedging instrument for hedge accounting purposes is: a designated derivative; OR (in limited circumstances) another financial asset or liability whose fair value or cash flows are expected to offset changes in the fair value or cash flows of a designated hedged item. Under this Standard, a non-derivative financial asset or liability may be designated as a hedging instrument for hedge accounting purposes only if it hedges the risk of changes in foreign currency exchange rates.

Hedged Item : Definition A hedged item is an asset, liability, firm commitment, or forecasted future transaction that : exposes the enterprise to risk of changes in fair value or changes in future cash flows; and that for hedge accounting purposes, is designated as being hedged.

Hedged Item : What Items Can Be Hedged? Recognised assets and liabilities - eg. bonds, loans Unrecognised firm commitments - eg. lease rentals, firm contracts Highly probable future transactions - eg. future sales and purchases A net investment in a foreign operation

Hedging : What Items Cannot Be Hedged? Examples of items that do not qualify for hedge accounting: Transactions that do not affect earnings Equity method investments in consolidated accounts Minority interests Investments in consolidated subsidiaries Firm commitments to enter business combinations (except foreign currency component) Equity instruments, such as forwards or options, classified in stockholders’ equity Interest rate risk in a held-to-maturity investment

Hedging : Permitted Hedging Strategies Transaction based hedging: single risk (ie. foreign exchange or interest rate risk) hedged by a single hedging instrument Single hedging instrument hedging more than one identifiable type of risk (eg. cross-currency interest rate swaps) Portfolios of assets or liabilities which share the same risk exposure Combinations of hedging instruments (provided that they only offset the risks of the hedged items) Dynamic hedging strategies (eg. delta hedging)

Hedging : Prohibited Hedging Strategies Macro hedging (except for a portfolio hedge of interest rate risk under certain conditions) Intra-group or intra-division hedging strategies (eg. between banking book and trading book) Portfolio hedging where assets or liabilities do not share the same risk Use of written options (other than to hedge purchased options) Hedging of interest rate risk on held-to-maturity financial assets

Hedge Accounting : What Conditions Are Necessary? Formal documentation (hedging relationship and risk management objectives and strategy) Hedge is expected to be highly effective Effectiveness of the hedge can be measured and is assessed on an ongoing basis throughout the financial reporting period Hedged forecasted transactions must be highly probable and must present an exposure to variations in cash flows that ultimately affect reported net profit or loss Hedge accounting is allowed if and only if all of the following conditions are met : a) At the inception of the hedge there is formal documentation of:company’s risk management objectives, goals (fair value hedge, cash flow hedge, firm commitment, forecasted transactions) the enterprise plans to accomplish through undertaking hedge transactions, strategy for undertaking the hedge (hedging e.g. X% of sales during the period T when employing specific instruments/ strategies) b) Expectation that hedging will be: highly effective in achieving offsetting changes in fair value or cash flows attributable to the hedged risk, consistent with the originally documented risk management strategy for that particular hedging relationship; c) The effectiveness of the hedge can be reliably measured, that is, the fair value or cash flows of the hedged item and the fair value of the hedging instrument can be reliably measured; hedging relationships (they must be clearly defined - hedged risk should be offset by derivative and hedging relationships must be reliably measured). d) The effectiveness of the hedge was assessed on an ongoing basis and determined actually to have been highly effective throughout the financial reporting period (at least at the end of the year and dates on which half year reports are prepared) - (principal 80/125); e) In case of cash flow hedge the hedging forecasted transaction should be: highly probable, must present an exposure to variations in cash flows that could ultimately affect reported net profit or loss.

Hedge Accounting : Documentation Requirements The hedging documentation dealing with hedges against particular risks should be formal and include the following elements: nature of hedging relationship risk management objective and strategy for undertaking hedge identification of the hedging instrument identification of the related hedged item or transaction the nature of the risk being hedged (particular risk) description of how the enterprise will assess the hedging instrument’s effectiveness in offsetting the exposure to changes in the hedged item’s fair value or the hedged transaction’s cash flows that is attributable to the hedged risk.

Hedge Accounting : Assessing Hedge Effectiveness A hedge is highly effective if changes in the fair value or cash flows of the hedging instrument changes in fair value or cash flows of the hedged item HIGHLY OFFSET Initial expectation must be that they “almost fully offset” Actual offsetting within a range of 80% to 125% is acceptable Method of assessing hedge effectiveness depends on the documented risk management strategy No single method for assessing hedge effectiveness is prescribed, but time value of money should be considered

Types of Hedging Relationships

Hedge Accounting : Types of Hedging Relationships 1. Fair value hedge - hedge of the variability of changes in fair value of a recognised asset or liability or a firm commitment (e.g. an interest rate swap that hedges the risk that the fair value of a fixed rate bond will fluctuate, or a hedge of a firm commitment to buy an asset at a fixed price) 2. Cash flow hedge - hedge of exposure to variability in cash flows on a recognised asset or liability, or a forecasted transaction (e.g.. an interest rate swap that hedges the risk that the cash flows on a variable rate bond will fluctuate, or a hedge of a forecasted purchase /sale of asset) 3. Hedge of a net investment in foreign operations (IAS 21)

Definition of a Fair Value Hedge A fair value hedge is: “a hedge of the exposure to changes in the fair value of a recognised asset or liability or a firm commitment, or an identified portion of such an asset or liability, that is attributable to a particular risk and that will affect reported net income” Key issues: hedged asset or liability must be recognised on balance sheet hedged risk must give rise to a risk of changes in fair value of hedged asset or liability

Definition of a Cash Flow Hedge a hedge of the exposure to variability in cash flows that: is attributable to a particular risk associated with a recognised asset or liability (such as all or some future interest payments on variable rate debt) or a forecasted transaction (such as an anticipated purchase or sale) and that will affect reported net profit or loss.

Hedge of a Firm Commitment A hedge of a firm commitment: Represents a fair value exposure Except for A hedge of the foreign currency risk of a firm commitment which could be accounted for as a fair value hedge or as a cash flows hedge.

Hedge accounting: Hedges of a Net Investment in a Foreign Operations Hedges of net investments in a foreign operations, including a hedge of a monetary item that is accounted for as part of the net investment, should be accounted for in the same way as cash flow hedges: the portion of the gain or loss on the hedging instrument that is effective should be recognised in equity the ineffective portion should be reported immediately in net profit or loss The effective portion’s gain / loss recognised in equity should be recognised in profit or loss upon disposal of foreign operations

Hedge Accounting - Summary Hedge accounting is a privilege not a right Designation and documentation are essential prior to beginning hedge accounting Common hedging strategies, including macro hedging and use of internal derivatives, may not be permitted Only derivatives can be designated as hedging instruments other than for foreign exchange risk, where non-derivative instruments can be used Hedge accounting is available for recognised assets and liabilities, firm commitments and forecasted transactions

Disclosure Requirements

IAS 32: Disclosure Requirements Objective To provide information to enhance understanding of financial instruments to an entity’s financial position, performance and cash flows, and assist in assessing the amounts, timing and certainty of future cash flows. Format, location and classes of financial instruments IAS 32 does not prescribe either the format of information required or its location within the financial statements. Key disclosure requirements Risk management policies and hedging activities. Terms, conditions and accounting policies. Interest rate risk. Credit risk. Fair value. Other disclosures.

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