IAS 32/39 Financial Instruments: Disclosure and PresentationRecognition and Measurement
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 • 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 : 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? and A contract that gives rise to: Financial Asset in one enterprise 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 Financial Liability 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 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.
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
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 • 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.
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
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. 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 • derivatives linked to and settled by delivery of such an investment
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.
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
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