Financial Instruments, Interim Reporting and Disclosure Standards. On completion of this module, you should be able to:

Transcription

1 Module 6 Financial Instruments, Interim Reporting and Disclosure Standards Learning Objectives On completion of this module, you should be able to: Define a financial instrument Distinguish between debt and equity instruments and, in hybrid instruments, account for both elements, taking account of the presentation requirements of IAS 32 Financial Instruments: Presentation Understand the recognition, classification, de-recognition and measurement principles in IAS 39 Financial Instruments: Recognition and Measurement and IFRS 9 Financial Instruments Understand how to measure and account for impairment losses Explain how to account for hedging contracts Understand the scope and extent of disclosure requirements and the nature of both qualitative and quantitative disclosures required by IFRS 7 Financial Instruments: Disclosures Explain the objective of preparing interim reports Outline the main contents to be included in the report Apply the recognition and measurement principles in IAS 34 Interim Financial Reporting to specific applications Distinguish between adjusting and non-adjusting events under IAS 10 Events after the Reporting Period Illustrate the disclosure required for non-adjusting events Understand the need for the disclosure of related party transactions Define related parties listed under the standard Outline the disclosure required for related parties and the need to disclose the name of the ultimate parent company 6/1

2 Module 6 Introduction Introduction and Overview of Module Students often find the topic of financial instruments very difficult to understand, particularly if they have not been involved in treasury activity. This module presents an overview of the standards dealing with financial instruments so that participants are better able to understand how financial instruments might be recognised and measured within financial statements and how they might impact on risk management within an organisation. A large body of IFRS 7 Financial Instruments: Disclosure, in particular, requires extensive disclosure. Participants are not expected to memorise these requirements but should be aware of why certain disclosures are required. It is also important to understand where financial instruments are presented, particularly in terms of debt and equity. In particular, participants must be able to apply the accounting split methodology when dealing with hybrid financial instruments. Participants should also be able to understand the basics of hedge accounting and how to account for more complex financial instruments such as derivatives and how to derecognise them when they expire or are cancelled. Although not required in the Annual Reports, IAS 34 Interim Financial Reporting outlines the minimum content required in the preparation of interim reports. Participants should be able to explain why interim reports are necessary and what differences emerge in their preparation compared to full Annual Reports. A standard that poses potential concerns is IAS 10 Events After the Reporting Period, particularly for those entities required to disclose non adjusting events which have nothing to do with the current year but are required to be disclosed as they could have a major impact on future years results and position. The final section in the module covers the close relationship that builds up between the reporting entity and certain other related parties. Disclosure of material transactions between the reporting entity and its related parties is essential in order to provide a true and fair view of the financial statements. It ensures openness and clear transparency in situations where transactions may well not be at arm s length. 6/2

3 Module 6 Section 1 Section Financial Instruments This section of the module covers one of the most difficult and controversial topics currently occupying the minds of the international standard setters. Due to the recent financial crisis the IASB has spent a large part of its time attempting to strengthen the existing standards. There is a major project to replace the original standards IAS 32 Financial Instruments: Presentation and IAS 39 Financial Instruments: Recognition and Measurement with a new standard IFRS 9 Financial Instruments. This is being achieved through a number of separate phases with a final implementation date commencing on 1 st January These changes are covered briefly throughout this section. The main reason for the creation of complicated accounting standards has been the dynamic nature of financial markets, both locally and internationally, and particularly the need for financial institutions to develop new products which are competitive and which also minimise their impact on clients Statements of Financial Position. In particular, the creative accounting technique of off-balance-sheet financing has been encouraged by these new products. As a result, stakeholders are now being exposed to significant additional risks and the financial statements themselves no longer provide a fair representation. The project was so large that, in order to create acceptable standards, the IASB had to publish a presentation and disclosure standard first (IAS 32) before tackling the more complicated areas of recognition and measurement (IAS 39). Since these were first published, further revisions have taken place IAS 32 has lost its disclosure role and that has now gone to a new standard, IFRS 7 issued in 2005, leaving IAS 32 with presentational issues only. IAS 39 is currently being revised on a piecemeal basis and part of that revision has found its way into another new standard, IFRS 9. Eventually IFRS 9 will become the main, if not the only standard, once the complete review of IAS 39 has taken place. 6/3

4 Module 6 Section 1 Key Summary Point Financial instruments are covered in a number of IASs/IFRSs but ultimately will probably all be combined into IFRS 9. At present the position is as follows: IAS 32 Presentation Financial Instruments (FI) IAS 39 Recognition and Measurement IFRS 7 Disclosures IFRS 9 Financial Instruments (To replace all FI in the future) At present, IFRS 9 includes only the classification and measurement of financial assets and financial liabilities, both of which are only applied to accounting periods commencing on or after the 1 st January Presentation of Financial Instruments (IAS 32) IAS 32 was originally designed to cover both presentation and disclosure issues. However, since the publication of IFRS 7 in 2005, IAS 32 now only covers the presentational aspects of the topic and particularly how to distinguish equity from liabilities. Before embarking on the distinction it is important to understand the definitions of each of the elements in reporting financial instruments. Definitions Financial asset Cash, equity investments, trade receivables, contractual right to receive cash or exchange under potentially favourable conditions Financial instrument (contract giving rise to both a financial asset in one entity and a financial liability or equity in another entity) Financial liability Contractual obligation to deliver cash or exchange under potentially unfavourable conditions or settle with own equity Equityinstrument Residual interest after deducting liabilities from assets 6/4

5 Module 6 Section 1 Example Financial assets Financial liabilities Equity instruments Cash Bank overdraft Own ordinary shares Trade receivables Trade payables Non-cumulative preference shares Equity investments Loans Non-puttable equity shares Derivatives at profit Derivatives at loss Warrants Options Presentation of Liabilities and Equity Under IAS 32 all entities must classify their financial instruments into one of the three classes shown above. The decision is based on the substance of the transaction and not its legal form. For a liability, there must be a contractual obligation to deliver cash or another financial asset to the holder or a contractual obligation to exchange the liability under potentially unfavourable conditions. This does pose problems in deciding whether a particular instrument is a liability or is an equity instrument. An example is shown below: Example Identify the nature of each of the following financial instruments: 1. Rory issues 10m equity shares of 10 each at 120m for cash Equity 2. Ruari enters a contract to buy back 1m of its own shares Equity at 120 each for cash 3. Penny issues 15m redeemable preference shares for cash Liability 4. Pauline enters a contract to buy back its own shares from Liability Pearl against loans of 120m due from Pearl number of shares to be based on the price of equity after 6 months Compound/Hybrid Instruments Where a financial instrument has been issued with aspects of both equity and debt it is known as a compound financial instrument or hybrid. IAS 32 requires entities to split the net proceeds received between their debt and equity components. This can be carried out only at the date the instrument is issued, not subsequently. In these cases the debt element must be calculated first so that equity remains the residual interest. To achieve this, an entity must identify a similar loan agreement but with no convertible element attached and determine an appropriate interest rate accordingly for a straight loan. That rate is then used to discount the total payments throughout the life of the instrument back to present value (both principal and interest). Once that has been calculated it is taken away from the net proceeds to leave a residual interest. The latter is then recorded as a separate reserve in the 6/5

6 Module 6 Section 1 equity part of the Statement of Financial Position and the debt would normally be recorded both in current and non-current liabilities depending on when the principal is to be repaid. An example of the process is provided below: Example Assume XYZ issues 200,000 of 7% convertible loan stock at par on 1 st January Interest is payable on the 31 st December each year. The loan is due for redemption at par on 31 st December 2014 but may be converted into ordinary shares on that date instead. Assuming the market rate of interest on a similar loan but with no convertibility is 9% per annum, calculate the liability and equity components. Solution Principal 200,000 discounted at 9% for 4 years ,800 Interest 14,000 discounted at 9% using annuity tables ,374 Debt element 187,174 Total net proceeds 200,000 Equity element 12,826 Amount borrowed At 1 st January Finance (9%) Repayment charge 187,174 16,846 14, , ,020 17,102 14, , ,122 17,381 14, , ,503 17,497 14, ,000 The journal entries required in the first year are: Amount borrowed at 31 st December Dr Bank 200,000 Cr Non-current liabilities (convertible loan) 187,174 Equity reserve 12,826 The loan is then increased each year by the excess finance charge over the interest paid until it reaches 200,000 at the date of redemption. If the holders wish their loan to be repaid the following entries will take place: Dr Convertible loan 200,000 Cr Bank 200,000 and Dr Equity reserve 12,826 Cr Retained earnings 12,826 If the holders wish to convert then the loan will be closed as well as the equity reserve and transferred into share capital and share premium accordingly. (Continued) 6/6

7 Module 6 Section 1 If the loans are converted into shares, the following entries are made to the financial records, assuming they are convertible into 100,000 1 ordinary shares: Dr Convertible loan 200,000 Equity reserve 12,826 Cr Ordinary share capital 100,000 Share premium 112, Treasury Shares If a reporting entity wishes to buy back its own shares (called treasury shares) they must be deducted from equity. No gain or loss is recorded on the purchase nor subsequent sale of those shares Puttable Financial Instruments These provide the holder with the right to put the instrument back to the issuer for cash or the instrument is automatically put back on the occurrence of an uncertain future event or the death or retirement of the holder. Generally these are regarded as financial liabilities. However, if the puttable instrument contains all of the following five features, it is classified as equity: the holder is entitled to a pro rata share of the entity s net assets on liquidation; the instrument is subordinate to all other instruments; all instruments falling in the class have similar features; there is only a redemption or repurchase obligation no other; and the total cash flows over its life are based substantially on the profit or loss, the change in recognised net assets or the change in the fair value of the recognised and unrecognised net assets over its life. Key Summary Point IAS 32 requires all financial instruments, particularly debt and equity, to be reported according to their substance if that conflicts with the legal form of the transaction. This may require compound financial instruments to be split at inception between their debt and equity components. 6/7

8 Module 6 Section Recognition of Financial Instruments (IAS 39 Financial Instruments:Recognition and Measurement and IFRS 9 Financial Instruments) Financial instruments may only be recognised in the Statement of Financial Position when the reporting entity becomes a party to the contractual provisions of the instrument. This includes complex instruments such as derivatives even if no consideration passes at their inception. Key Summary Point Recognition is permitted only when an entity becomes party to the contractual provisions of an instrument Classification of Financial Assets Until the 1 st January 2015 reporting entities may classify their financial assets into one of four different categories as follows: Financial asset Financial asset at fair value through profit or loss (FVTPL)/held for traders Held to maturity Loans and receivables Available for sale Financial assets at fair value through profit or loss Financial assets are classified into this category if: they are acquired principally for selling in the near future (e.g. purchasing equity shares quoted from the market with the intention of profiting from short term price fluctuations); they are part of a portfolio of identified financial instruments that are managed together and there is recent evidence of short-term and actual profit-taking (e.g. venture capital company invests in a portfolio of financial assets with a view to profiting from their total return in the form of interest or dividends and changes in fair value and evaluates its performance on that basis); or they are derivatives, other than a financial guarantee contract, that is not designated as an effective hedging instrument (e.g. forward and options contracts) 6/8

9 Module 6 Section 1 Held-to-maturity financial assets These are rarer assets with fixed or determinable payments and fixed maturity for which the reporting entity has a positive intent and ability to hold until maturity. There are tainting rules which will not permit an asset to be recorded under this heading if there is past evidence of selling or reclassification of a significant portion of such assets. Those tainting rules are likely to be abolished under the proposed replacement of IAS 39. (e.g. bonds with fixed payment at maturity and fixed maturity date) Loans and receivables These are non-derivative financial assets with fixed or determinable payments that are not quoted in an active market (e.g. monies lent to other reporting entities in the normal course of business). Available-for-sale financial assets These are non-derivative financial assets which do not fit into any of the above three categories (i.e. the default category) (e.g. Ryanair s investment in Aer Lingus, which is long-term but if the price was right it could sell its investment but it does not have to). Classification from 1 st January 2015 This means of classification has proved to be cumbersome and unclear for both users and preparers and so IFRS 9 has altered the classification to make it simpler by replacing IAS 39 with only two classifications the Business Model and all others. Business model The business model test requires an entity to assess whether its business objective for a debt instrument is to collect the contractual cash flows of the instrument as opposed to realising its fair value change from sale prior to its contractual maturity. This is determined at a higher level than the individual financial instrument level (e.g. portfolio or business unit level). This is not based on management s intent for individual instruments. IFRS 9 acknowledges that an entity may have different business units that are managed differently. For example, an entity may have a retail banking business where the objective is to collect the contractual cash flows of loan assets and an investment banking business where the objective is to realise fair value changes through the sale of loan assets prior to their maturity. In this case, assuming that the financial instruments give rise to cash flows that are payments of principal and interest (see cash flow characteristic test below), in the retail banking business they may qualify for amortised cost measurement even if similar financial instruments in the investment banking business do not. Instruments that would meet the existing held for trading definition in IAS 39 would be measured at FVTPL as they are not held to collect the contractual cash flows of the instrument. Although the objective of an entity s business model may be to hold financial assets in order to collect contractual cash flows, the entity need not hold all of those 6/9

10 Module 6 Section 1 assets until maturity. Thus an entity s business model can be to hold financial assets to collect contractual cash flows even when sales of financial assets occur. For example, an entity s assessment that it holds investments to collect their contractual cash flows is still valid even if they would sell the investments to fund capital expenditure. However, if more than an infrequent number of sales are made out of a portfolio, the entity needs to assess whether and how such sales are consistent with an objective of collecting contractual cash flows. The contractual cash flow characteristics test concept is that only instruments with contractual cash flows of principal and interest on principal may qualify for amortised cost measurement. IFRS 9 describes interest as consideration for the time value of money and the credit risk associated with the principal outstanding during a particular period of time. Therefore, an investment in a convertible loan note would not qualify because of the inclusion of the conversion option which is not deemed to represent payments of principal and interest. This criterion will permit amortised cost measurement when the cash flows on a loan are entirely fixed (e.g. a fixed interest rate loan or zero coupon bond), or where interest is floating (e.g. a GBP loan where interest is contractually linked to GBP LIBOR), or combination of fixed and floating (e.g. where interest is LIBOR plus a fixed spread). Other examples provided in the Standard of instruments that satisfy this criterion include: a variable rate instrument with a stated maturity date that permits the borrower to choose to pay three month LIBOR for a three-month term or one-month LIBOR for a one-month term; a fixed term variable market interest rate bond where the variable interest rate is capped; and a fixed term bond where the payments of principal and interest are linked to an unleveraged inflation index of the currency in which the instrument is issued. This is effective from the 1 st January 2015 but earlier application is permitted. Key Summary Point Financial assets are currently classified into four separate categories under IAS 39 but this will be reduced to two on the implementation of IFRS Classification of Financial Liabilities (IAS 39 and IFRS 9) There are only two categories of financial liabilities in IAS 39 those measured at amortised cost and those at fair value through profit or loss (FVPL). That categorisation is retained in the revised version of IFRS 9. Examples include: Fair value - derivative liabilities with a negative fair value, obligations to deliver financial assets borrowed by a short seller, financial liabilities incurred with an intention to repurchase them in the near future (e.g. quoted debt instrument that 6/10

11 Module 6 Section 1 the issuer may buy back in the near future depending on changes in its fair value). Amortised cost all other liabilities not classified as FVPL (e.g. trade payables, borrowings and customer deposits). Key Summary Point There are two categories of financial liabilities those recorded at fair value through profit and loss and those recorded at amortised cost Derecognition (IAS 39 and IFRS 9 Derecognition) Financial assets can, at present, only be derecognised from the Statement of Financial Position if either of the following occurs: the contractual rights to future cash flows have expired as the customer has paid or the option has expired; or the financial asset has been transferred along with substantially all of the risks and rewards of ownership of the asset. Under the changes in the October 2010 revised IFRS 9 (effective from 1 st January 2015) a financial asset will only be derecognised if: the contractual rights to the cash flows have expired; the entity transfers the asset and has no continuing involvement in it; or the entity transfers the asset and retains a continuing involvement in it BUT the transferee has the practical ability to transfer the asset for its own benefit, not the entity s. Example (a) Factoring of receivables without recourse Entity X has a portfolio of receivables of 800,000. It enters a factoring arrangement with entity Y under which it transfers the portfolio to Y in exchange for 700,000 cash. Y has no recourse to X for any bad debts arising. In this situation X has no longer any contractual rights to the cash flows from the portfolio nor continuing involvement, thus the entire portfolio of receivables should be derecognised in X s books. (b) Factoring of receivables with full recourse Entity A has a portfolio of 600,000. It enters into a factoring arrangement with entity B under which it transfers the portfolio to B in exchange for 550,000 cash. B has full recourse to A for any bad debts arising. In this situation A still has retained the credit risk and thus the contractual rights have not expired and it still has continuing involvement in the portfolio. A should therefore still retain the receivables on its balance sheet and record a liability for funds received it is really a secured borrowing. 6/11

12 Module 6 Section 1 Financial liabilities are derecognised under IAS 39 when the obligation is discharged. Effectively that means it has been paid off, it has been cancelled or it has expired. Where part of a financial liability is discharged, that part is derecognised. The latest version of IFRS 9 (effective from 1 st January 2015) has slightly changed the rules as follows: An entity must derecognise a financial liability when it no longer qualifies as a liability of the entity. It ceases to qualify if the obligation is eliminated and the entity is no longer required to transfer economic resources in respect of that obligation. Example If an entity repurchases a financial liability that liability is extinguished even if the issuer is a market maker in that instrument and intends to sell it in the near future. If an entity exchanges one debt instrument with a creditor for another debt instrument, it must derecognise the financial liability associated with the previous debt instrument and recognise a new financial liability if the terms of the debt instruments are substantially different. This could be caused by the entity having financial difficulties. Similarly, if an entity and a creditor agree to modify substantially the terms of an existing debt instrument, the entity must derecognise the associated financial liability and recognise a new financial liability. Example A creditor releases a debtor B from its present obligation but B now assumes a guarantee obligation to pay if the party assuming the primary responsibility defaults. This creates a new liability for B based on the fair value of its guarantee obligation and B also recognises a gain or loss on the difference between any proceeds paid and the carrying amount of the original liability less the fair value of the new liability. Key Summary Point The rules on derecognition have been tightened up by the publication of the latest version of IFRS 9 and clearly financial liabilities must be derecognised only if the obligation has been eliminated Measurement (IAS 39 and IFRS 9) Under IAS 39 all financial instruments are measured initially by reference to the fair value of the consideration received or receivable, which is normally the transaction price. Subsequently a mixed value approach is adopted measuring some 6/12

13 Module 6 Section 1 instruments at cost and others at fair value. The methodology adopted depends on their initial classification. Initial measurement Financial instruments should be initially measured at fair value i.e. the amount for which an asset could be exchanged or liability settled between knowledgeable willing parties in an arm s-length transaction. However, as this would be the initial transaction-price in routine transactions, that price is normally adopted. Transaction costs are recorded as part of the transaction price if incurred for financial assets not held at fair value through profit and loss (FVTPL) but they are expensed in FVTPL transactions. Subsequent measurement of financial assets (IAS 39 and IFRS 9) IAS 39 requires the following subsequent remeasurements: IAS 39 Flowchart Subsequent measurement Financial assets at FVTPL Loans and receivables Held to maturity Available for sale Fair value including in profit Amortised cost Amortised cost Fair value included in other comprehensive income (OCI) Amortised cost approach This method requires the calculation of the effective interest rate a rate which exactly discounts estimated future cash payments or receipts through the expected life of the instrument. In calculating this figure an entity should estimate cash flows considering all contractual terms but not future credit losses. It is illustrated below: 6/13

14 Module 6 Section 1 Example On 1 st January 2011 a company acquires 200,000 6% loan stock for 187,867. Interest is payable in arrears on 31 st December each year and the stock is redeemable at par on 31 st December The stock is intended to be held to maturity. The effective rate is calculated at 7.5% (based on the amount that exactly discounts estimated future cash payments or receipts through the expected life of the instrument). The calculation of the amortised cost would be as follows: Year Balance at 1.1 Interest at 7.5% Amount received Amortised cost ,867 14,090 (12,000) 189, ,950 14,246 (12,000) 192, ,196 14,414 (12,000) 194, ,610 14,596 (12,000) 197, ,206 14,794 (212,000) IFRS 9 has only two classifications of financial assets although there is an option to adopt fair value for equity instruments that are not held for trading. These are accounted for as follows: IFRS 9 Flowchart Financial assets Business Model Basic loan features; and Managed on a contractual yield basis All other assets Election through OCI Amortised cost Fair value All others through profit Under IFRS 9 effectively the former held to maturity investments and loans and receivables are amalgamated into one class amortised cost. Normally all other financial assets are fair valued with gains and losses being recorded in profit and loss. Fair value approach The best measure of fair value is the price that can be obtained in an active market for a specific financial asset. However, that may not be available and thus market 6/14

15 Module 6 Section 1 prices of similar assets may be used as a second best alternative. Where there are no active markets then they may be valued using a valuation technique. Various techniques are available but most require projections of future cash flows. The IASB has recently introduced a new standard IFRS 13 Fair Value Measurement which applies to all fair values, not just those involved in financial instruments and tries to introduce some consistency into their adoption. It introduces a three-level hierarchy with Level 1 representing the best evidence of fair value (i.e. current market prices of identical assets) and Level 3 being the weakest (i.e. using valuation techniques based on unobserverable inputs). Obviously, entities should maximise the use of Level 1 and minimise the use of Level 3. In all cases, it is important to disclose in the notes to the financial statements the level which is being adopted. However, the exception to the principle of recording fair-value gains and losses in the profit and loss is the opportunity for reporting entities to elect irrevocably to present subsequent remeasurements in the fair value of an investment in an equity instrument not held for trading to be incorporated in other comprehensive income (OCI) with no recycling required on derecognition. Example Examples Characteristics IAS 39 IFRS 9 Government bonds Positive intention Held-to-maturity Amortised cost Corporate bonds and ability to hold Investments until maturity Fixed term debentures Interest rate swaps Held for trading Financial asset Fair value at fair value through profit through profit or and loss loss (FVTPL) Forward exchange contracts Share portfolio for short term gain Accounts receivable Loans to other entities Equity investments in other entities other than associates/joint ventures Non-derivative financial assets with fixed or determinable payments Do not fall into other three categories and could be sold at any time Loans and receivables Available-for-sale financial assets Amortised cost Fair value through profit and loss but irrevocable right to elect through OCI 6/15

16 Module 6 Section 1 Key Summary Point Financial Instruments are normally initially measured by reference to fair value of consideration received or receivable. Subsequent measurement is normally at fair value or amortised cost depending on the instrument and whether IAS 39 or IFRS 9 applies (later on is effective from 1 January 2015 but earlier application is permitted) Measurement of Financial Liabilities (IAS 39 and IFRS 9) Most financial liabilities are measured at amortised cost but those liabilities which fall under the category fair value through profit or loss (FVTPL) are measured at fair value. Under both IAS 39 and IFRS 9 (effective 1 January 2015) there is an option to elect to measure financial liabilities at fair value through profit and loss provided certain criteria are met e.g. could measure a structured financial liability at fair value in its entirety rather than being split into its component parts (referred to as the fair value option (FVO)). Under IAS 39 the portion of the change in the fair value of a liability under the FVO that is due to own credit must be recognised in profit and loss. IFRS 9, however, has now changed that rule and requires it to be presented in other comprehensive income (OCI). The change was caused by the counter intuitive result in IAS 39 when a deterioration in a company s credit worthiness would result in a gain being recorded in profit. Example XYZ Plc has recorded a gain on the revaluation of its financial liabilities falling under the FVTPL category as these have fallen in value due to the company being in severe financial difficulty and being able to book a large profit based on its theoretical ability to buy back its own debt at a reduced cost. This is clearly counterintuitive and thus assuming a gain of 100 is recorded that part belonging to own credit risk must be credited to OCI not profit as follows: Dr Financial liability 100 Cr Statement of Profit or Loss 90 Reserves (OCI) 10 with portion belonging to own credit risk Key Summary Point 6/16 Most financial liabilities are amortised at cost but FVTPL liabilities are measured at fair value. Fair value option ( FVO ) can also be opted for with the change in value recognised in P&L under IAS 39 and in Other Comprehensive Income where it is due to own credit under IFRS 9.

17 Module 6 Section Fair Value Measurement Fair value is measured using the following hierarchy: quoted market prices in an active market of exactly the same instrument; quoted market prices of similar instruments; discounted cash flow and other valuation techniques. Active market (quoted prices) No active market (valuation techniques) No active market (unquoted equity) at cost less impairment The best measure of fair value is the price in an active market. However, fair value can be measured using valuation techniques if there is no active market e.g. interest bearing financial assets can be valued at the present value of future cash flows with current market yield as the discount factor. Investments in unquoted equity instruments that have no active market and whose fair value cannot be reliably measured may be measured at cost. These will have to be assessed, however, for possible impairment. In March 2010 the IASB completed its initial discussions with the Financial Accounting Standards Board (FASB) in the United States to develop common requirements for measuring fair value and for disclosing information about fair-value measurements. The result of the IASB s discussions with the FASB was an International Financial Reporting Standard (IFRS) on fair-value measurement (IFRS 13) that is almost the same as Topic 820, as amended. This IFRS applies when other IFRSs require or permit fairvalue measurements or disclosures. It does not introduce new fair-value measurements. The IFRS specifies how an entity should measure fair-value and disclose fair-value information. It does not specify when an entity should measure an asset, a liability or its own equity instrument at fair value. The fair value measurement framework is based on a core principle that defines fair value as an exit price, as follows: The price that would be received to sell an asset or paid to transfer a liability in an orderly transaction between market participants at the measurement date. That definition retains the exchange price notion contained in the existing definition of fair value in IFRSs: 6/17

18 Module 6 Section 1 The amount for which an asset could be exchanged, a liability settled, or an equity instrument granted, between knowledgeable, willing parties in an arm s length transaction. Like the existing definition of fair value in IFRSs, the new definition assumes that the exchange transaction is hypothetical and is orderly (i.e. it is not a forced liquidation nor a distress sale). However, the existing definition of fair value: does not specify whether an entity is buying or selling the asset; is unclear about what is meant by settling a liability because it does not refer to the creditor, but to knowledgeable, willing parties; and does not explicitly state whether the exchange or settlement takes place at the measurement date or at some other date. In the IASB s view, the new definition of fair-value remedies these deficiencies. It also conveys more clearly that fair value assumes an orderly transaction between market participants, and thus is a market-based measurement, not an entity-specific measurement. The additional disclosures will increase transparency about fair-value measurements, including the valuation techniques and inputs used to measure fair-value. The IASB believes this increased transparency will benefit users of financial statements, particularly when assessing the fair-value measurements of assets and liabilities without active markets. Key Summary Point Ideally, quoted market prices of the same instrument should be used to measure fair value but, if they are not available, quoted prices of similar instruments or other valuation techniques can be used which is dealt with in a new IFRS 13 on Fair-Value Measurement which merely codifies how to measure fair values consistently where fair value is currently required. There is no attempt to expand its use into new territory Reclassification Under the original IAS 39 there were a number of fairly complex rules, determining whether or not a financial asset could be reclassified from one category to another. Normally a reclassification from FVTPL to loans and receivables is rare. However it was possible for an asset held to maturity to be reclassified as available for sale if there were no longer an intention to hold it until maturity. The new standard, IFRS 9, has eliminated these rules and now permits financial assets to be reclassified only when there is a change in its business model. If that occurs, any switch from amortised cost to fair value will result in an initial gain or loss occurring between the previous carrying amount and the fair value. 6/18

19 Module 6 Section 1 That must be charged/credited immediately to profit and loss. If the switch is in the opposite direction, then the fair-value at the date of reclassification becomes the new carrying amount under the amortised cost approach. Key Summary Point Under IFRS 9, financial assets can be reclassified only where there is a change in business model Impairment Financial assets measured at amortised cost must be reviewed annually for possible impairment. That is not required for fair-value assets as the fair-value automatically takes into account any impairment. However, under IAS 39 s available for sale category, because gains and losses go through reserves and other comprehensive income, there is also a need to carry out a review of those assets and recycle any impairment back through profit. Considerable judgment is required when deciding whether or not an impairment exists. IAS 39 provides the following examples of objective evidence of a likely impairment: significant financial difficulty of the issuer; a breach of contract, e.g. default in interest or principal payments; the lender has granted the borrower a concession not normally considered; it is likely that the borrower will enter bankruptcy; an active market has disappeared due to overall financial difficulties; or there is evidence of a measurable decrease in the estimated future cash flows from a group of financial assets. Measurement of impairment losses Financial assets carried at amortised cost The impairment loss is the difference between the asset s carrying amount and the present value of estimated future cash flows. The latter must exclude future credit losses and be discounted at the asset s original effective interest rate. The impairment must be recorded in profit, either directly or via an allowance account and the asset is then recorded in the Statement of Financial Position net of any related allowances. Financial assets carried at cost Unquoted investments (with no reliable fair value) are carried at cost and need to be reviewed for possible impairment. The impairment loss is measured as the difference between the carrying value of the asset and the present value of the estimated future cash flows discounted at the current market rate of return for a similar asset. 6/19

20 Module 6 Section 1 Financial assets held at fair value as available-for-sale Where a decline in the fair value of an available-for-sale asset has been recognised directly in OCI and there is objective evidence that the asset is impaired, then the cumulative loss should be recycled to profit or loss. Any subsequent losses are also written off to profit or loss. Where there is a change in circumstances which indicate that the fair value has increased then the loss may be reversed. It will go through profit if it relates to a debt instrument but through equity if it relates to an equity instrument. Example On 1 st January 2012 Downton Plc invested in a financial instrument. The cost and fair value at that date were 1.5m. It was classified as available for sale and thus measured at fair value with gains/losses being recorded in the OCI. Changes in the fair value are set out below: Year Fair-value changes Nature of change 2013 (150,000) No evidence of impairment 2014 (400,000) Objective evidence of impairment ,000 Objective evidence of reversal of impairment The accounting can be illustrated as follows: (a) Debt instrument (b) Equity instrument On 1 st January 2012 Dr Available-for-sale investments 1,500,000 1,500,000 Cr Bank 1,500,000 1,500,000 Change in fair value for 2013 Dr OCI 150, ,000 Cr Available-for-sale investments 150, ,000 Impairment loss 2014 Dr Statement of Profit or Loss 550, ,000 Cr OCI 150, ,000 Available-for-sale investments 400, ,000 Reversal of impairment loss 2015 Dr Available-for-sale investments 300, ,000 Cr Statement of Profit or Loss 300,000 OCI 300,000 Key Summary Point 6/20 Impairment reviews must be carried out for all financial instruments carried at cost or amortised cost and for financial assets classified as available for sale where there is evidence of an impairment. For the latter, losses must be recycled from OCI into profit or loss.

21 Module 6 Section Derivatives Where an entity has an embedded derivative (i.e. a host contract which has embedded within it a component whose cash flows vary in a similar way to a standalone derivative), the net proceeds must be split between their debt and equity components as per compound financial instruments (see Section above). The host contract can be an equity or debt instrument and the embedded derivative can cause some of the cash flows to be modified as they are based on a specified interest rate, commodity price, foreign exchange rate or price index. Example A bank has granted a 15 year subordinated loan of 150m to enable a company to start up, at an interest rate of 5%, which is below market rates. The company must issue 2% of its equity shares at 80% of the list price as well as the normal interest and principal repayments. This is an embedded derivative as the host contract is a debt instrument and it is an option based derivative to exercise 2% of the equity shares at a specific price. The option must be valued on a current valuation of equity. For an embedded derivative to be segregated from its host contract the following preconditions must exist: the economic characteristics and risks of the embedded derivative are not closely related to those of the host contract; a separate instrument having the same terms as the embedded derivative would be characterised as an independent derivative; and the hybrid instrument is not accounted for as FVTPL. If these are applied above all three would suggest the need for segregation of the above example. This assessment can only be made when the contract is first entered into. It may not be subsequently reassessed unless there is a signification modification of the cash flows. IFRS 9 does not require separation if the host contract is a financial instrument within its scope. Key Summary Point Embedded derivatives must be segregated from their host contract when certain preconditions exist. 6/21

22 Module 6 Section Hedging (IAS 39) Many companies enter hedging agreements as a defence against financial risk using either derivative or non-derivative financial instruments. Where future cash flows or assets are subject to potentially large fluctuations in their value that could harm the business, then a hedging transaction may be entered into. IAS 39 prescribes the special rules on how to account for gains and losses arising out of a hedged instrument if a designated hedging relationship exists. There are three types of hedging relationships as follows: 1. Fair value hedge This hedges the exposure arising out of changes in the fair value of the hedged item 2. Cash flow hedge This hedges the exposure arising out of cash flow volatility of the hedged item 3. Hedge of a net investment in foreign operations This hedges the foreign currency risk of the net investment in the foreign operation. Designation of hedging relationship and documentation At the inception of a hedging agreement there must be formal designation and documentation of the hedging relationship and the entity s risk-management objective and strategy for undertaking the hedge. The documentation should include: identification of the hedging instrument details of the hedged item details of the nature of the risk being hedged; and an explanation of how the entity will assess the hedging instrument s effectiveness in offsetting the exposure to changes in the hedged item s fair value or cash flows attributable to the hedged risk. Effectiveness of hedging The hedge is expected to be highly effective in offsetting changes in fair value or cash flows attributable to the hedged risk consistent with the risk-management strategy for that particular relationship. It must be effective not just at inception but throughout the period for which the hedge is designated. There are different ways to demonstrate effectiveness, such as, comparing past changes in the fair value or cash flows of the hedged item with past changes in the fair value or cash flows of the hedging instrument, or by demonstrating a strong relaionship between the fair values and cash flows of the hedged item and the hedging instrument. The actual results should fall within the range of 80% 125%. 6/22

23 Module 6 Section 1 Example 1 Forlorn Plc has 200m investments in equity shares of other companies classified as available-for-sale financial assets (AFS). It has designated stock index futures as a fair-value hedge that qualifies as a hedge under IAS 39. At the end of the year the fair-value of the financial asset has fallen to 190m and stock index futures was 9m (i.e. 90% of fair-value changes in the hedged item) This is clearly within the hedge effectiveness limits. The investments have fallen by 10m but fair value of stock index futures has risen by 9m. The following are the journal entries: Dr Fair value loss on AFS financial assets (OCI) 1m Statement of Profit or Loss 9m Cr Financial assets 10m Dr Derivative financial asset (stock index futures) 9m Cr Fair value gain on derivative financial asset (Income) 9m Example 2 Assume a hedge has been properly set up with the appropriate documentation and hedge effectiveness ensured at the commencement of the agreement. During the first year the hedge item has a loss of 60 and the hedging instrument a gain of 40. Is the hedge effective i.e. working. Under IAS 39 this is tested as follows: Loss % above 125% therefore hedge has failed HEDGE IS Gain 40 INEFFECTIVE And Gain % below 80% therefore hedge failed twice Loss 60 Contrast that example with hedge loss of 60 BUT hedging instrument a gain of 50 Loss % below 125% therefore hedge is effective HEDGE Gain 50 IS EFFECTIVE Gain % above 80% so still effective Loss 60 Accounting for a fair-value hedge A fair-value hedge is a hedge of the exposure to changes in the fair value of a recognised asset, liability or firm commitment. Some examples are shown below: 6/23

24 Module 6 Section 1 Hedges of market price exposure An entity fixes the value of its commodity inventory by entering into a commodity futures contract It purchases a put option to protect against a fall in value of its quoted investments Hedges of interest rate exposures An entity with fixed-rate debt converts the debt into a floating rate using an interest rate swap Hedges of foreign currency exposures An entity enters into a binding contract to purchase machinery for a fixed amount in foreign currency at a future date and hedges the amount in its functional currency by entering into a forward foreign-exchange contract The entity enters into a forward contract to hedge a foreign currency receivable or payable due for settlement at a future date Fair-value exposure An entity is hedging the risk of changes in the inventory s overall fair value The entity is hedging the risk of a fall in the fair value of the equity securities below the options striking price The entity is hedging the risk of changes in the fair value of the debt due to changes in interest rates The entity is hedging the risk of changes in the purchase price of machinery due to changes in foreign exchange rates The entity is hedging the risk of changes in the carrying amount of the receivable or payable due to changes in foreign exchange rates Provided the entity meets the hedging criteria identified earlier, then gains and losses must be reported as follows for fair-value hedges: gains/losses from remeasuring the hedging instrument at fair value should be recognised immediately in profit and loss; gains/losses on the hedged item attributable to the hedged risk should adjust the carrying amount of the hedged item and be recognised immediately in profit or loss. Example Yardbirds plc issued 10m fixed-interest debt on 1 January 2011 at 7.5% (12 month rate). It is concerned about possible changes in the value of the liability so it enters into an interest rate swap (fixed to floating). Assume from 1 January 2011 to 31 December 2011 the LIBOR is 6% At 31 December 2011: Fair value of the liability 10,125,000 Fair value of the interest rate swap (125,000) Yardbirds plc is now exposed to variable rates. As the required rate of return on the market changes, the value of the fixed rate debt and interest rate swap will change in tandem. 6/24

25 Module 6 Section 1 Lender Pay 7.5% Yardbirds plc Receive 7.5% Pay variable Swap The value of the liability has increased because it is now in demand. The fair value of the swap is an asset as it gives Yardbirds plc the right to pay 6% for 7.5%. Cash flows Gross Net Yardbirds pays 7.5% to the lender 750, ,000 Yardbirds receives 7.5% from the counterparty to the swap (750,000) Yardbirds pays 6% to the counterparty to the swap 600,000 (150,000) Outflow 600, ,000 Journal entries Dr Bank 10,000,000 Cr Liability 10,000,000 Initial recognition on the issue of fixed interest debt Dr Interest rate swap 125,000 Statement of Profit or Loss 125,000 Cr Liability 125,000 Statement of Profit or Loss 125,000 Fair-value changes for the year ended 31 December 2011 Dr Bank 750,000 Statement of Profit or Loss 600,000 Cr Bank 750,000 Bank 600,000 Cash flows for the year Cash flow hedges A cash flow hedge is a hedge of the exposure to variability in cash flows that is attributable to a particular risk associated with a recognised asset or liability or a highly-probable forecast transaction which could affect profit or loss. Examples are as follows: 6/25