1. Financial Instruments – Recognition and Measurement: IAS 39 Wiecek and Young IFRS Primer Chapter 18

2. 2 Financial Instruments – Recognition and Measurement: IAS 39 Related standards IAS 39 Current GAAP comparisons Looking ahead End-of-chapter practice

3. 3 Related Standards FAS 115 Accounting for Certain Investments in Debt and Equity Securities FAS 130 Reporting Comprehensive Income FAS 133 Accounting for Derivative Instruments and Hedging Activities FAS 138 Accounting for Certain Derivative Instruments and Certain Hedging Activities—an amendment of FASB Statement No. 133 FAS 140 and 156 Accounting for the Transfer and Servicing of Financial Assets and Extinguishment of Financial Liabilities FAS 155 Accounting for Certain Hybrid Financial Instruments FAS 157 Fair Value Measurements FAS 159 The Fair Value Option for Financial Assets and Financial Liabilities FIN 45 Guarantor’s Accounting and Disclosure Requirements for Guarantees, Including Indirect Guarantees of Indebtedness of Others

4. 4 Related Standards IFRS 7 Financial Instruments: Disclosures IAS 1 Presentation of Financial Statements IAS 32 Financial Instruments: Presentation

5. 5 IAS 39 – Overview Objective and scope Derivatives Derecognition Hedging

6. 6 IAS 39 – Objective and Scope This standard deals with recognition and measurement of financial assets and liabilities and is part of a suite of standards dealing with financial instruments This chapter will go into a bit more depth on some of the more complex areas such as: – Derivatives (including embedded derivatives) – Guarantees – Loan commitments – Expected use contracts – Derecognition – Hedging

7. 7 IAS 39 – Derivatives A derivative has three essential characteristics: Its value changes in response to the change in an underlying primary instrument/index exchange rate or other, called an “underlying”  The underlying may not be specific party to the contract if it relates to a non- financial variable There is little or no initial investment It is settled (or may be settled) in the future Typical examples of derivatives are options, forwards, futures, and swaps

8. 8 IAS 39 – Derivatives Options: Options may be purchased or written (issued), transferring the right to do something to the holder of the option Call options give the right to buy something, whereas put options give the right to sell something Priced using models such as the Black-Scholes and binomial tree models Futures and Forwards: Forward contracts lock the parties to the contract into buying or selling something in the future Futures are just standardized forwards Forward contracts are normally priced so that the forward price equals the current spot price plus carrying costs (sometimes referred to as cost of capital)

9. 9 IAS 39 – Derivatives Swaps: Swaps are a series of forward contracts to exchange currencies or interest payments (fixed interest payment for variable interest)

10. 10 IAS 39 – Derivatives When calculating the fair value of derivatives, generally two components make up the value: – The intrinsic value (relating to the current spot price of the underlying) and – A time value (relating to the fact that the contract will be settled in the future) Derivatives are accounted for as follows: 1. They are recognized in the financial statements 2. They are presented as fair value through profit and loss 3. They are measured and remeasured at fair value with related gains/losses being booked through profit or loss

11. 11 IAS 39 – Derivatives Derivatives Versus Insurance Contracts How do insurance contracts differ from derivatives? – Derivatives may be used for instance to lock in a price of a share/foreign currency (sometimes to guarantee against a loss) – Similar to insurance contracts that are entered into to guarantee against a loss – The main difference: insurance contracts usually deal with non-financial assets such as buildings and machinery that are owned by the insured (assets are specific to the insured party) As noted in the definition of a derivative, the value of a derivative varies with an “underlying” – Examples include share prices, interest rates, and credit ratings The definition of an underlying excludes non-financial variables where the variable is specific to one of the parties to the contract. – Example: the change in the physical condition of a building owned by one of the parties to the contract

12. 12 IAS 39 – Derivatives Derivatives Versus Insurance Versus Financial Guarantee Contracts A financial guarantee contract is defined as follows: “a contract that requires the issuer to make specified payments to reimburse the holder for a loss it incurs because a specified debtor fails to make payment when due in accordance with the original or modified terms of a debt instrument” Examples of financial guarantee contracts are identified in the following: 1. Bank guarantee by vendor - A vendor might guarantee the bank loan of a customer (to facilitate the sale of inventory to the customer) 2. Guarantee by unrelated party - An unrelated third party might guarantee the same customer’s bank loan (for a fee) 3. Standby letters of credit - A bank might guarantee payment of a specific financial obligation if the customer does not pay The standby letter of credit may be cashed on demand if the customer fails to pay

13. 13 IAS 39 – Derivatives Derivatives Versus Insurance Versus Financial Guarantee Contracts There are four ways to account for financial guarantee contracts depending on the nature of the contract and the business of the entity – The substance of the transaction must be analyzed to determine if it is an insurance contract The four options for accounting for financial guarantees are as follows: 1. Under IAS 39—fair value through profit and loss (FVTPL), if more relevant 2. Under IFRS 4—as an insurance contract if the contract represents insurance in substance and the entity has accounted for it as insurance in the past 3. Under IAS 39—where the transfer of a financial asset/liability does not qualify for derecognition because substantially all of the risks and rewards are retained or there is continuing involvement 4. Under IAS 39—all other financial guarantee contracts

14. 14 IAS 39 – Derivatives Accounting for Guarantees Note that there is no specific GAAP for holders of guarantee contracts

15. 15 IAS 39 – Derivatives Derivatives Versus Loan Commitments Loan commitments are agreements to provide loans in the future Are loan commitments derivatives? – Some are and some are not Loan commitments that can be settled net in cash (or other financial assets) are derivatives and treated as such Loan commitments that extend a loan at below market interest rates are onerous contracts and should be measured at the higher of the amount determined in accordance with IAS 37 and the initial amount less amortization under IAS 18 Revenues Any loan commitment that is classified as FVTPL is covered by IAS 39 All loan commitments are subject to the derecognition standards in IAS 39.9

16. 16 IAS 39 – Derivatives Non-financial Derivatives Many derivative contracts deal with non-financial underlyings such as commodities (wheat, oil, gold) Should these contracts be covered by the standard? – Because the accounting issues are the same and because derivatives relating to non-financial underlyings often trade in very liquid markets, they are covered by IAS 39 when the contracts can be settled net in cash or other financial instruments In general, commodities derivatives such as futures and options are recognized when the contract is entered into, are measured at fair value (and continually remeasured), and the resulting gains and losses are booked to profit and loss

17. 17 IAS 39 – Derivatives Non-financial Derivatives Various ways that an entity may settle a contract net in cash: 1. Where the terms of the contract allow either party to get out of the contract by paying the net difference between the contract price and the market price of the underlying 2. Where the terms of the contract do not explicitly allow net settlement but the entity has a past practice of settling similar contracts net 3. Where the entity has a past practice of taking delivery of the underlying and then immediately reselling it for profit as opposed to using it 4. Where the underlying is readily convertible to cash “Expected Use” Contracts: – even if it is able to settle the contract net in cash, as long as the entity can prove that it intends to use the commodity for its own expected use then the contract is scoped out of the standard

18. 18 IAS 39 – Derivatives Non-financial Derivatives

19. 19 IAS 39 – Derivatives Embedded Derivatives An embedded derivative is defined as “a component of a hybrid (combined) instrument that also includes a non-derivative host contract—with the effect that some of the cash flows of the combined instrument vary in a way similar to a stand-alone derivative” They essentially have two components—the host non-derivative contract and the embedded derivative Should the derivative contract be bifurcated (separated) from the host contract and accounted for as a derivative? – The IASB intended for all derivatives that are within the scope of IAS 39 to be accounted for as derivatives and therefore deals with the special case of derivatives that are included within other contracts

20. 20 IAS 39 – Derivatives Embedded Derivatives In general, embedded derivatives are separated from the host instrument and accounted for as derivatives if all of the following conditions are met: The economic characteristics and risks of the derivatives are not closely related to those of the host If the embedded derivative were stand-alone, it would meet the derivative definition The combined instrument is not already accounted for as FVTPL An investment in convertible debt is most likely a hybrid instrument – The debt is the host instrument and the option to convert to shares is the embedded derivative – The option is not closely related to the debt because it is an equity feature that allows the holder to participate in the risks and rewards of owning shares – Therefore, investments in convertible debt would be bifurcated where the investment is not already classified as FVTPL

21. 21 IAS 39 – Derivatives Regular Way Purchase or Sale of a Financial Asset As shares are bought and sold, it normally takes a few days to settle the deal In the meantime, these contracts meet the definition of a derivative However, they are accounted for using trade date accounting (where a receivable and payable are booked the minute the trade is entered into) or settlement date accounting (where only the net position is booked until the shares actually change hands)

22. 22 IAS 39 – Derecognition Transfers Revisited Where substantially all of the risks and rewards of ownership are transferred and there is no continuing involvement, derecognition takes place and often a gain or loss is recognized Determining whether the entity has retained control is a matter of judgment and depends on whether the entity can sell the asset or not – If the transferee is able to sell the asset (without involving other parties) and without imposing any restrictions on the transfer, then control has passed from the entity (transferor) to the other party (transferee)

23. 23 IAS 39 – Derecognition Transfers Revisited In some cases, the contractual rights to receive cash flows may be retained but the entity assumes a contractual obligation to pay those cash flows to another party – The asset is retained, but because a liability is assumed, the transaction must be examined to determine its economic substance – It may be a transfer in substance If the following criteria are met, this type of transaction would be accounted for as a transfer and may also qualify for derecognition: There is no requirement for the entity to pay the contractual obligation unless it collects equivalent amounts from the original asset The entity is prohibited from selling the original asset, and Any cash flows collected on behalf of the eventual recipient must be remitted to the eventual recipient without material delay

24. 24 IAS 39 – Derecognition Transfers Revisited When collateral is pledged under the arrangement, then care should be taken to determine how to account for the collateral In general, the transferor carries the collateral as an asset except as noted below

25. 25 IAS 39 – Derecognition Debt Extinguishment Versus Debt Modification When an entity repays its debt, the liability is extinguished and the debt derecognized However, what about when it refinances the debt? – If the new debt is substantially different, it is treated as an extinguishment – In terms of a benchmark, per IAS 39, AG62 the new debt is substantially different when: The present value of the cash flows under the new debt is different by more than 10% of the present value of the cash flows under the old debt (using the original effective rate)

26. 26 IAS 39 – Hedging IAS 39 includes the following definition with respect to hedge accounting: Hedge effectiveness is the degree to which changes in the fair value or cash flows of the hedged item that are attributable to a hedged risk are offset by changes in the fair value or cash flows of the hedging instrument Entities enter into hedges to protect themselves from economic losses (or to reduce uncertainty) In a perfect hedge, gains/losses on the item/risk hedged are offset by the gains/losses on the item used to effect the hedge Hedge accounting is a special type of accounting that is optional Hedge accounting may be used when the entity has economic hedges to ensure that there is no mismatch in the bookkeeping when an economic hedge exists (that is, that the gains and losses on the hedged and hedging items are offset in the financial statements)

27. 27 IAS 39 – Hedging When hedging from an economic perspective, an entity must first determine which risks it would like to hedge and in which transactions. – It then designs a hedge by identifying which additional transactions it would like to enter into in order to modify the risk profile of the transactions – This is referred to as a hedging relationship If there is a designated hedging relationship between hedging instruments and a hedged item, then hedge accounting may be used Hedging Instruments A hedging instrument is defined in IAS 39.9 as follows:... a designated derivative or (for a hedge of the risk of changes in foreign currency exchange rates only) a designated non-derivative financial asset or non-derivative financial liability whose fair value or cash flows are expected to offset changes in the fair value or cash flows of a designated hedged item Most hedging instruments are derivatives such as forwards, options, futures, or swaps

28. 28 IAS 39 – Hedging Hedged Items A hedged item is defined in IAS 39.9 as follows:... an asset, liability, firm commitment, highly probable forecast transaction or net investment in a foreign operation that (a) Exposes the entity to risk of changes in fair value or future cash flows and (b) Is designated as being hedged A hedged item is the item that is exposing the entity to some unwanted risk where the entity chooses to get rid of that risk A firm commitment is a binding agreement for the exchange of a specified quantity of resources at a specified price on a specified future date or dates A forecast transaction is an uncommitted but anticipated future transaction

29. 29 IAS 39 – Hedging Hedge Accounting Is optional and recognizes the offsetting profits and losses on hedging relationships in the statement of profit and loss in the same period Hedge accounting is complex and costly There are 3 types of hedging relationships under hedge accounting: (a) Fair value hedge: a hedge of the exposure to changes in fair value of a recognized asset or liability or an unrecognized firm commitment, or an identified portion of such an asset, liability or firm commitment, that is attributable to a particular risk and could affect profit or loss. (b) Cash flow hedge: a hedge of the exposure to variability in cash flows that (i) is attributable to a particular risk associated with a recognized asset or liability or a highly probable forecast transaction and (ii) could affect profit or loss. (c) Hedge of a net investment in a foreign operation

30. 30 IAS 39 – Hedging Fair Value Hedges A fair value hedge is accounted for as follows: – Gains/losses from the hedging item are recognized in profit and loss – Gains/losses on the hedged item are recognized (by adjusting the carrying value of the hedged item) and are recognized through profit and loss This way the gains and losses on both the hedged and hedging items are booked through profit and loss at the same time and are therefore matched Cash Flow Hedges Difference: the hedged item may not yet be on the balance sheet – It may relate to a future transaction Cash flow hedges are accounted for as follows: – Gains/losses on the hedging instrument are booked to other comprehensive income. When the forecasted transaction actually occurs, it is recognized on the balance sheet and the gains/losses sitting in OCI are reclassified to profit and loss when, for example, the inventory acquired is sold

31. 31 IAS 39 – Hedging Hedges of a Net Investment These hedges are essentially cash flow hedges and the accounting is therefore the same (gains and losses on the hedged item are booked through OCI) Formalization of Hedging Relationship To qualify for hedge accounting, the following conditions/criteria must be met: 1. The relationship must be designated and documented at the inception of the hedge 2. The hedge is expected to be highly effective in offsetting the changes in cash flows/fair values of the hedged item 3. For cash flow hedges, the forecasted transaction must be highly probable and must present an exposure to cash flows that will affect the profit and loss statement 4. The effectiveness of the hedge must be reliably measurable 5. The hedge must be assessed on an ongoing basis and must be highly effective throughout the hedge period

32. 32 Current GAAP Comparisons Pages 70, 76, 86 & 122 of 164 of http://www.kpmg.co.uk/pubs/IFRScomparedtoU.S.GAAPAnOverview(2008).pdf

33. 33 Looking Ahead The IASB and FASB are working on simplifying the accounting for financial instruments, especially for derivatives and hedging

34. 34 End-of-Chapter Practice

35. 35 End-of-Chapter Practice

36. 36 End-of-Chapter Practice

37. Copyright © 2010 John Wiley & Sons, Inc. All rights reserved. Reproduction or translation of this work beyond that permitted by Access Copyright is unlawful. Requests for further information should be addressed to the Permissions Department, John Wiley & Sons Inc., 111 River Street, Hoboken, NJ 07030-5774, (201) 748-6011, fax (201) 748-6008, website http://www.wiley.com/go/permissions. The purchaser may make back-up copies for his or her own use only and not for distribution or resale. The author and the publisher assume no responsibility for errors, omissions, or damages caused by the use of these programs or from the use of the information contained herein. http://www.wiley.com/go/permissions