IAS 32/39 Financial Instruments: Disclosure and PresentationRecognition and MeasurementUP-DATE
Agenda • Scope and definitions • IAS 32 • 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
Definition : What is a Financial Instrument? and A contract that gives rise to: Financial Asset in one enterprise Financial Liability or Equity Instrument in another enterprise
Types of Financial Instruments Financial Instruments Combinations • Convertible debt • Exchangeable debt • Dual currency bond 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
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 Liability • 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.
Classification of Financial Assets Financial Assets At fair value thru P&L ( NEW ) Held-to-maturity Available-for-sale Loans and receivables Designated upon initial recognition Held for trading
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: There is a limit to 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.
Classification of Financial Liabilities Financial liabilities At fair value thru P&L That arise when a transfer of a financial asset does not qualify for de-recognition or is accounted for using the continuing involvement approach REPOS &/OR SALE OF ASSETS W RECOURSE Others Held for trading Designated upon initial recognition* * Precluded from reclassifying into or out of this category
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 ( NEW ) • 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
Initial Measurement Financial asset or financial liability is initially recognised at fair value Financial assets/ liabilities at fair value thru P&L Held-to-maturity financial asset/ liabilities plus transaction costs Loans and receivables Transaction costs: • on purchase are included • that may be incurred on disposal are excluded • Are directly attributable to the acquisition/ issue of the financial asset/ liability • ( NEW ) Available for sale financial assets
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.( NEW )
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. ( APPLICABLE TO DEBT RESTRUCTURING OR COMMERCIAL TRANSACTIONS ) • 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.
Subsequent Measurement : Financial Assets Financial assets are subsequently recognised at amortised cost Loans and receivables Held-to-maturity investments at fair value Available-for- sale securities At fair value thru P&L at cost Unquoted equity instruments and related derivatives
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 amortization is recognised in net profit/loss
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; OR • 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
Subsequent Measurement : Available-for-Sale 4. Available-for-Sale : Fair value Financial assets which are designated as available for sale ornot 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. ( NEW ) Interest calculated using effective interest rate method is recognised in the P&L.
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
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. ( NEW ) • Impairment loss for available for sale equity instrument cannot be reversed thru P&L, any subsequent increase in fair value is recognized in equity.( NEW )
Subsequent Measurement: Financial Liabilities Financial liabilities are subsequently recognized All derivative liabilities except those linked to unquoted equity instrument at amortized cost at fair value Transfers that do not qualify for de-recognition Those designated at fair value thru P&L Those continuing involvement in transferred asset, which is at amortized cost Those arising from a continuing involvement in transferred asset, which is at fair value All other financial liabilities (eg. trade payable, bank loan)
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 Bond Option (call/put) 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 Currency Rates Commodity Prices
Definition of Derivatives : Examples (Continued) Underlying Variable Equity Prices (equity of another Enterprise) Interest Rates Currency Rates Commodity Prices 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
Classification of Derivatives Derivatives Instruments held for trading Hedging instruments Assets held for trading Liabilities held for trading
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 Should you separate out the embedded and account for the two elements separately?
Embedded Derivatives:Evaluating When to Separate from a Host Contract * to the embedded derivative 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*
Embedded Derivatives:“Not Closely Related” - Examples • Asset linked bond: Debt host + credit derivative based on performance of asset • FX sales contract: Euro sales contract + foreign exchange swap (where currency in which contract is denominated is not functional currency of either party or currency in which commodity is generally traded)
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:What are the Consequences of Separation?
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.