International Accounting Standard 39 (IAS 39), Financial Instruments: Recognition and Measurement By STEPHEN SPECTOR, MA, FCGA This article is part of a series by Brian & Laura Friedrich and Stephen Spector on International Financial Reporting Standards published on PD Net. Snapshot History Overview of IAS 39 Overview of the standard Hedging Differences from Canadian GAAP Snapshot Latest revision December, 2003 Subsequent amendments Effective date per IASB Effective date per Canadian Standards 2004, 2005, 2007, 2008, 2009 (to reflect changes in a variety of standards) fiscal periods beginning on or after January 1, 2005 fiscal periods beginning on or after October 1, 2007 1 Outstanding Exposure Drafts and issues under consideration The IASB has a project 2 underway to revise accounting for financial instruments. Changes to recognition and measurement will follow. CGA-Canada 2009 1 2 Technically, IAS 39 will not be required until fiscal periods beginning on or after January 1, 2011. However, except for matters identified at the end of this article, Handbook sections 3855 and 3865 are the same as IAS 39. As this article was being completed, the IASB released IFRS 9 Financial Instruments. The IASB will replace IAS 39 over the next three years. IFRS 9 will be updated as the next stages in the process are approved, eventually superseding IAS 39. The date of initial application date of IFRS 9 will be: a) any date between the issue of IFRS 9 (November 2009) and December 31, 2010, for entities initially applying IFRS 9 before January 1, 2011; or b) the beginning of the first reporting period in which the entity adopts IFRS 9, for entities initially applying this IFRS on or after January 1, 2011.
History The International Accounting Standards Board s predecessor body, the International Accounting Standards Committee (IASC), began its work on financial instruments in 1988 and the subject has remained on the active international standard-setting agenda ever since. Unable to reach consensus on measurement issues, the IASC limited its initial standard to aspects of presentation and disclosure when it released International Accounting Standard 32 (IAS 32) Financial Instruments: Disclosure and Presentation in 1995. After a further period of effort, IAS 39 Financial Instruments: Recognition and Measurement was issued in 1999 to deal with the matters not covered in IAS 32. The International Accounting Standards Board (IASB) succeeded the IASC in 2001. In 2002, in response to practice issues identified by audit firms, national standard-setters, regulators [especially the U.S. Securities and Exchange Commission (SEC) and its experience with their Financial Reporting Release No. 48 (FRR 48)] and others, and issues identified in the IAS 39 implementation guidance process, the IASB proposed changes to both IAS 32 and 39. It issued revised versions of those standards in December 2003. Further deliberations resulted in several amendments to those standards, and in August 2005, the IASB expanded the disclosure aspects of IAS 32 and IAS 39 by issuing International Financial Reporting Standard 7 (IFRS 7) Financial Instruments: Disclosures. It is safe to say that IAS 39 is probably the most complex and demanding standard ever issued by the International Accounting Standards Board. The standard and its accompanying application guidance are more than 350 pages in the 2009 IASB Handbook. In part, this is a consequence of the ever-increasing complexity of financial instruments. As soon as the financial engineers and the accountants agree on how to deal with a new financial instrument, it seems another, more complicated instrument is created, requiring another set of amendments to the standards for recognition and measurement. Adding another layer to the mix has been the worldwide economic crisis of the past two years and its impact on financial instruments especially insofar as fair values are concerned. The IASB has had to deal with pressure from regulators, investors, financial institutions, and investors over the impact of illiquid markets on fair value determination. To put it simply, right now, the recognition and measurement of financial instruments is akin to trying to hit a moving target. What follows is a summary of the requirements as of July 2009. Note that with the release of IFRS 9, an update to this article will follow in 2010. Overview of IAS 39 Objective Scope The objective of IAS 39 is to establish principles for recognizing and measuring financial assets, financial liabilities, and some contracts to buy or sell non-financial items. The principles in IAS 39 complement those of IFRS 7 Financial Instruments: Disclosures, and for presentation of information about them in IAS 32 Financial Instruments: Presentation. As with IAS 32 and IFRS 7, IAS 39 is different from most other Standards in its Appendixes the appendixes are an integral part of the Standard. IAS 39 applies to all entities and to all types of financial instruments, except where it specifically defers to another Standard and/or a different accounting treatment ( 2). Even at that, it often includes qualifiers that effectively scope the item back into IAS 39. For example, IAS 39 states that it does not apply to interests in subsidiaries, associates, or joint ventures IAS 39, Financial Instruments: Recognition and Measurement 2
that are accounted for in accordance with IAS 27 Consolidated and Separate Financial Statements, IAS 28 Investments in Associates, or IAS 31 Interests in Joint Ventures respectively. However, IAS 39 then adds, entities shall apply this Standard to an interest in a subsidiary, associate, or joint venture that according to IAS 27, IAS 28, or IAS 31 is accounted for under this Standard. In essence, it seems to say that even if it doesn t apply, it does! Similarly, paragraph 2 states that IAS 39 does not apply to rights and obligations under leases to which IAS 17 Leases applies. However, IAS 39 then recaptures at least part of what it just scoped out: lease receivables recognized by a lessor, and finance lease payables recognised by a lessee, are subject to the derecognition and impairment provisions in IAS 39, and derivatives embedded in leases are subject to the embedded derivatives provisions of IAS 39. IAS 39 does not apply to employers rights and obligations under employee benefit plans to which IAS 19 Employee Benefits applies, nor does it apply to financial instruments, contracts, and obligations under share-based payment transactions to which IFRS 2 Share-based Payment applies, except for limited exceptions that are deemed within the scope of IAS 39. IAS 39 does not apply to financial instruments issued by the entity that meet the definition of an equity instrument or to instruments that are required to be classified as equity instruments by the issuer in accordance with paragraphs 16A and 16B or paragraphs 16C and 16D of IAS 32. However, the holder of any such equity instruments must apply IAS 39 to those instruments, unless they are accounted for in accordance with IAS 27, IAS 28, or IAS 31 respectively. Likewise, IAS 39 does not apply to rights and obligations arising under an insurance contract as defined in IFRS 4 Insurance Contracts, other than an issuer s rights and obligations arising under an insurance contract that meet the definition of a financial guarantee contract 3 in IAS 39, or to a contract that is within the scope of IFRS 4 because it contains a discretionary participation feature. However, like leases, IAS 39 recaptures some aspects of insurance contracts: it does apply to any derivatives embedded in a contract within the scope of IFRS 4 if the derivative is not itself a contract within the scope of IFRS 4. IAS 39 does not apply to loan commitments other than those loan commitments 4 described in paragraph 4. Instead, IAS 37 Provisions, Contingent Liabilities and Contingent Assets is applied to loan commitments that are not within the scope of IAS 39. However, all loan commitments are subject to the derecognition provisions of IAS 39. Finally, IAS 39 applies to contracts to buy or sell a non-financial item that can be settled net in cash or another financial instrument, or by exchanging financial instruments, as if the contracts were financial instruments, with the exception of contracts that 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. Definitions Recognizing the linked nature of the three financial instruments standards, IAS 39 states that the terms defined in IAS 32 are used with the meanings specified in paragraph 11 of IAS 32 ( 8). 3 4 A financial guarantee contract is 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. Loan commitments within the scope of IAS 39 are loan commitments that the entity designates as financial liabilities at fair value through profit or loss; loan commitments that can be settled net in cash or by delivering or issuing another financial instrument; and commitments to provide a loan at a below-market interest rate. IAS 39, Financial Instruments: Recognition and Measurement 3
Paragraph 9 then provides the key definitions for applying IAS 39 (and Handbook section 3855) to financial instruments: A derivative is a financial instrument or other contract within the scope of IAS 39 with all three of the following characteristics: its value changes in response to the change in a specified interest rate, financial instrument price, commodity price, foreign exchange rate, index of prices or rates, credit rating or credit index, or other variable, provided in the case of a non-financial variable that the variable is not specific to a party to the contract (sometimes called the underlying ) it 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 it is settled at a future date A financial asset or financial liability at fair value through profit or loss is a financial asset or financial liability that meets either of the following conditions: it is classified as held for trading or upon initial recognition, it is designated by the entity as at fair value through profit or loss. IAS 39 stipulates that investments in equity instruments that do not have a quoted market price in an active market and whose fair value cannot be reliably measured are not to be designated as at fair value through profit or loss. Held-to-maturity investments are non-derivative financial assets with fixed or determinable payments and fixed maturity that an entity has the positive intention and ability to hold to maturity other than those that the entity upon initial recognition designates either as at fair value through profit or loss or available for sale, or those that meet the definition of loans and receivables. In order to prevent (or at least to limit) management manipulation, IAS 39 stipulates that an entity cannot classify any financial assets as held to maturity if the entity has, during the current financial year or during the two preceding financial years, sold or reclassified more than an insignificant amount of held-to-maturity investments before maturity (where more than insignificant is in relation to the total amount of held-to-maturity investments) other than sales or reclassifications that: are so close to maturity or the financial asset s call date that changes in the market rate of interest would not have a significant effect on the financial asset s fair value occur after the entity has collected substantially all of the financial asset s original principal through scheduled payments or prepayments, or are attributable to an isolated event that is beyond the entity s control, is non-recurring and could not have been reasonably anticipated by the entity Loans and receivables are non-derivative financial assets with fixed or determinable payments that are not quoted in an active market other than those: that the entity intends to sell immediately or in the near term, which must be classified as held for trading, and those that the entity upon initial recognition designates as at fair value through profit or loss that the entity upon initial recognition designates as available for sale, or for which the holder may not recover substantially all of its initial investment, other than because of credit deterioration, which are to be classified as available for sale Available-for-sale financial assets are those non-derivative financial assets that are designated as available for sale or are not classified as loans and receivables, held-to-maturity investments or financial assets at fair value through profit or loss in other words, anything left over! IAS 39, Financial Instruments: Recognition and Measurement 4
Definitions relating to recognition and measurement The amortized cost of a financial asset or financial liability is the amount at which the financial asset or financial liability is measured at initial recognition minus principal repayments, plus or minus the cumulative amortization using the effective interest method of any difference between that initial amount and the maturity amount, and minus any reduction (directly or through the use of an allowance account) for impairment or uncollectibility. The effective interest method is a method of calculating the amortized cost of a financial asset or a financial liability (or group of financial assets or financial liabilities) and of allocating the interest income or interest expense over the relevant period such that it exactly discounts estimated future cash payments or receipts through the expected life of the financial instrument or, when appropriate, a shorter period, to the net carrying amount of the financial asset or financial liability. Derecognition is the removal of a previously recognized financial asset or financial liability from an entity s statement of financial position. Fair value is the amount for which an asset could be exchanged, or a liability settled, between knowledgeable, willing parties in an arm s length transaction. A regular way purchase or sale is a purchase or sale of a financial asset under a contract whose terms require delivery of the asset within the time frame established generally by regulation or convention in the marketplace concerned. Transaction costs are incremental costs that are directly attributable to the acquisition, issue or disposal of a financial asset or financial liability. Definitions relating to hedge accounting 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. A hedging instrument is 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. A hedged item is an asset, liability, firm commitment, highly probable forecast transaction or net investment in a foreign operation that exposes the entity to risk of changes in fair value or future cash flows and is designated as being hedged. 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. Overview of the standard Recognition and derecognition All financial assets and financial liabilities, including derivative instruments, must be recognized on the balance sheet ( 14). In order to remove (i.e. derecognize) assets from its balance sheet, an entity must lose control over those financial assets. In addition, a substantive risk from the assets must be transferred. To derecognize liabilities, the debtor must be legally released from its primary obligation related to that liability ( 17 and 39). IAS 39, Financial Instruments: Recognition and Measurement 5
Measurement Financial assets must be classified into one of the four categories: fair value through profit or loss; loans and receivables; held to maturity; and available for sale ( 45). Financial liabilities are categorised as either fair value through profit or loss or amortized cost ( 47). The categorisation determines whether and where any remeasurement to fair value is recognized in an entity s financial statements. Financial assets are to be carried at fair value, with the exceptions being loans and receivables, held to maturity assets, and the rare circumstances where the fair value of an equity instrument cannot be reliably measured ( 46). Remeasurement to fair value must be performed at each financial reporting date. The effect of remeasurement to fair value must be recognized and consistently applied in one of two ways an entity can choose to recognize all changes in fair value in the income statement, or it can choose to recognize changes in fair value of instruments deemed fair value through profit or loss in the income statement, and available for sale instruments as other comprehensive income. These latter amounts hit the income statement when the instrument is sold or becomes impaired ( 55). Derivatives and hedge accounting Under IAS 39, all derivatives (including some embedded derivatives) must be measured at fair value in the balance sheet. This is regardless of whether they are categorized as fair value through profit or loss or as hedging instruments. Unless they qualify as hedging instruments, all fair value gains and losses are recognized immediately in the income statement. A non-derivative financial instrument can have certain characteristics that cause it to behave like a derivative. These characteristics need to be evaluated to determine whether they should be separated from the financial instrument and accounted for separately as a stand-alone derivative. Hedge accounting is a choice that each entity makes for each economic hedge that it has in place. The choice reflects a trade-off between the cost of achieving hedge accounting and the potential benefit achieved by reducing the income statement volatility that would otherwise arise. There are three hedge accounting models under IAS 39, which are the fair value hedge, the cash flow hedge, and the hedge of a net investment in a foreign entity ( 86). The appropriate accounting model for a hedge relationship depends on the nature of the item being hedged. In order to qualify for hedge accounting, an entity must designate its hedge relationships and document how it will measure effectiveness ( 88). Each individual relationship between a derivative and its hedged asset, liability, or future cash flow must be documented separately. An entity must demonstrate that each hedge has been highly effective in each reporting period. In order to continue hedge accounting, there must be an expectation that future gains and losses on the hedged item and hedging instrument will almost fully offset. Reclassifications In order to prevent (or limit) management manipulations (as with held to maturity investments), IAS 39 proscribes reclassification of financial instruments except in very specific circumstances. Paragraph 50 states that an entity cannot reclassify any financial instrument into the fair value through profit or loss category after initial recognition. It further states that an entity cannot reclassify a derivative out of the fair value through profit or loss category while it is held or issued nor can it reclassify any financial instrument out of the fair value through profit or loss category if upon initial recognition it was designated by the entity as at fair value through profit or loss. However, IAS 39 does allow that an entity may, if a financial asset is no longer held for the purpose of selling or repurchasing it in the near term (notwithstanding that the financial asset IAS 39, Financial Instruments: Recognition and Measurement 6
may have been acquired or incurred principally for the purpose of selling or repurchasing it in the near term), reclassify that financial asset out of the fair value through profit or loss category if the requirements in paragraph 50B or 50D are met. Paragraph 50B then says that a financial asset under review applies (except a financial asset of the type described in paragraph 50D) may be reclassified out of the fair value through profit or loss category only in rare circumstances. OK that s a big help. So what does paragraph 50D say? It states that a financial asset that would have met the definition of loans and receivables (if the financial asset had not been required to be classified as held for trading at initial recognition) may be reclassified out of the fair value through profit or loss category if the entity has the intention and ability to hold the financial asset for the foreseeable future or until maturity. What about other categories? Paragraph 50E states that a financial asset classified as available for sale that would have met the definition of loans and receivables (if it had not been designated as available for sale) may be reclassified out of the available-for-sale category to the loans and receivables category if the entity has the intention and ability to hold the financial asset for the foreseeable future or until maturity. Finally, if as a result of a change in intention or ability it is no longer appropriate to classify an investment as held to maturity, it must be reclassified as available for sale and remeasured at fair value ( 51). Gains and losses IAS 39 requires an entity to recognize a gain or loss arising from a change in the fair value of a financial asset or financial liability that is not part of a hedging relationship depending on the classification of the financial instrument ( 55). Obviously, a gain or loss on a financial asset or financial liability classified as at fair value through profit or loss is recognised in profit or loss. A gain or loss on an available for sale financial asset is recognised in other comprehensive income, except for impairment losses and foreign exchange gains and losses, until the financial asset is derecognised. Finally, for financial assets and financial liabilities carried at amortized cost, a gain or loss is recognised in profit or loss when the financial asset or financial liability is derecognised and through the amortisation process. Changes in fair value are not recognized, unless the financial asset or financial liability is impaired ( 56). Impairment IAS 39 requires an entity to test a financial instrument for impairment at the end of each reporting period. The challenge is to recognize whether there has been impairment since it may not be possible to identify a single, discrete event that caused the impairment. According to IAS 39, impairment exists if, and only if, there is objective evidence as a result of one or more events that occurred after the initial recognition of the asset (a loss event ) and that loss event (or events) has an impact on the estimated future cash flows of the financial asset or group of financial assets that can be reliably estimated ( 59). Impairment is not just a decline in value ( 60). The disappearance of an active market because an entity s financial instruments are no longer publicly traded is not evidence of impairment. A downgrade of an entity s credit rating is not, of itself, evidence of impairment (although it may be evidence of impairment when considered with other available information). A decline in the fair value of a financial asset below its cost or amortized cost is not necessarily evidence of impairment (it may result from an increase in the risk-free interest rate). Instead, an entity must refer to a shopping list provided by paragraph 59, recognizing that the loss events cited do not represent an exhaustive list. 1. If there is objective evidence that an impairment loss on loans and receivables or held-tomaturity investments carried at amortized cost has been incurred, the amount of the loss IAS 39, Financial Instruments: Recognition and Measurement 7
Hedging is measured as the difference between the asset s carrying amount and the present value of estimated future cash flows (excluding future credit losses that have not been incurred) discounted at the financial asset s original effective interest rate. The carrying amount of the asset is reduced either directly or through use of an allowance account. The amount of the loss is recognized in profit or loss ( 63). If, in a subsequent period, the amount of the impairment loss decreases and the decrease can be related objectively to an event occurring after the impairment was recognised (such as an improvement in the debtor s credit rating), the previously recognised impairment loss can be reversed either directly or by adjusting an allowance account ( 65). However, the reversal cannot result in a carrying amount of the financial asset that exceeds what the amortized cost would have been had the impairment not been recognized at the date the impairment is reversed (similar to IAS 16). The amount of the reversal is recognized in profit or loss (since the original loss was also recognized in profit or loss). 2. If there is objective evidence that an impairment loss has been incurred on an unquoted equity instrument that is not carried at fair value because its fair value cannot be reliably measured, or on a derivative asset that is linked to and must be settled by delivery of such an unquoted equity instrument, the amount of the impairment loss is measured as the difference between the carrying amount of the financial asset and the present value of estimated future cash flows discounted at the current market rate of return for a similar financial asset. Such impairment losses are not to be reversed ( 66). 3. When a decline in the fair value of an available for sale financial asset has been recognized in other comprehensive income and there is objective evidence that the asset is impaired, the cumulative loss that had been recognized in other comprehensive income should be reclassified from equity to profit or loss as a reclassification adjustment even though the financial asset has not been derecognized. Impairment losses arising from equity instruments are not to be reversed ( 69). However, if the fair value of a debt instrument classified as available for sale subsequently increases, the impairment loss is reversed, with the amount of the reversal recognized in profit or loss ( 70). In addition to the recognition and measurement of financial instruments, IAS 39 also provides the standards for hedge accounting. Hedge accounting recognizes the offsetting effects on profit or loss of changes in the fair values of the hedging instrument and the hedged item ( 85). Generally speaking, IAS 39 does not restrict the circumstances in which a derivative may be designated as a hedging instrument provided the conditions in paragraph 88 are met, except for some written options. However, a non-derivative financial asset or non-derivative financial liability may be designated as a hedging instrument only for a hedge of a foreign currency risk ( 72). Note that IAS 39 does not recognize what are called natural hedges. For example, a Canadian firm (SRL Limited) may deal with customers domiciled in the United States, and so it bills these clients in US dollars. It may also deal with suppliers in Germany, who choose to bill the Canadian firm in US dollars. Suppose SRL is owed one million US dollars by its US clients. Further, suppose SRL owes its German supplier $500,000 US. SRL has no currency risk with respective to its accounts payable since it is owed an amount equal to its debt in the same currency. The problem for SRL is that there is no legal right of offset, so it cannot hedge the payable with its receivable for the purposes of IAS 39. However, SRL has effectively hedged the payable its receivable will cover its payable. This is a natural hedge. Likewise, hedges between sub-units that are eventually consolidated are not recognized since the hedges will be eliminated on consolidation. Only instruments that involve a party IAS 39, Financial Instruments: Recognition and Measurement 8
external to the reporting entity (i.e., external to the group or individual entity that is being reported on) can be designated as hedging instruments ( 73). Hedged items A hedged item can be a recognized asset or liability, an unrecognised firm commitment, a highly probable forecast transaction or a net investment in a foreign operation. The hedged item can be a single asset, liability, firm commitment, highly probable forecast transaction or net investment in a foreign operation, a group of assets, liabilities, firm commitments, highly probable forecast transactions or net investments in foreign operations with similar risk characteristics or in a portfolio hedge of interest rate risk only, a portion of the portfolio of financial assets or financial liabilities that share the risk being hedged ( 78). Despite the general notion that an entity can protect itself from potential risks, not all financial instruments can be hedged. For example, a held-to-maturity investment cannot be a hedged item with respect to interest-rate risk or prepayment risk because designation of an investment as held to maturity requires an intention to hold the investment until maturity without regard to changes in the fair value or cash flows of such an investment attributable to changes in interest rates ( 79). However, a held-to-maturity investment can be a hedged item with respect to risks from changes in foreign currency exchange rates and credit risk. Also, as noted earlier, only assets, liabilities, firm commitments or highly probable forecast transactions that involve a party external to the entity can be designated as hedged items art least for hedge accounting purposes ( 80). Furthermore, it isn t necessary (although it would be hard to understand why) for an entity to hedge all of the risk associated with a financial instrument. That is, a financial asset or financial liability may be a hedged item with respect to the risks associated with only a portion of its cash flows or fair value (such as one or more selected contractual cash flows or portions of them or a percentage of the fair value) provided that effectiveness can be measured. IAS 39 permits an entity to hedge some of the risks associated with any non-financial items it may hold. However, If the hedged item is a non-financial asset or non-financial liability, it can only be designated as a hedged item either for foreign currency risks, or in its entirety for all risks, because of the difficulty of isolating and measuring the appropriate portion of the cash flows or fair value changes attributable to specific risks other than foreign currency risks ( 82). Finally, similar assets or similar liabilities can be aggregated and hedged as a group ( 83). However, such action is only permitted if the individual assets or individual liabilities in the group share the risk exposure that is designated as being hedged. Furthermore, the change in fair value attributable to the hedged risk for each individual item in the group needs to be approximately proportional to the overall change in fair value attributable to the hedged risk of the group of items. If this latter condition is not present or determinable, then the item cannot be part of the group. Note that because an entity assesses hedge effectiveness by comparing the change in the fair value or cash flow of a hedging instrument and a hedged item, comparing a hedging instrument with an overall net position (e.g., the net of all fixed rate assets and fixed rate liabilities with similar maturities), rather than with a specific hedged item, does not qualify for hedge accounting ( 84). Hedging relationships Hedging relationships are of three types ( 86). These types are: 1. 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 IAS 39, Financial Instruments: Recognition and Measurement 9
asset, liability or firm commitment, that is attributable to a particular risk and could affect profit or loss. 2. A cash flow hedge a hedge of the exposure to variability in cash flows that is either attributable to a particular risk associated with a recognized asset or liability (such as all or some future interest payments on variable rate debt) or to a highly probable forecast transaction and could affect profit or loss. 3. A hedge of a net investment in a foreign operation as defined in IAS 21 (which is accounted for the same way as a cash flow hedge). Hedged qualifications Paragraph 88 of IAS 39 stipulates that a hedging relationship qualifies for hedge accounting if, and only if, all of the following conditions are met: At the inception of the hedge there is formal designation and documentation of the hedging relationship and the entity s risk management objective and strategy for undertaking the hedge. The hedge is expected to be highly effective in achieving offsetting changes in fair value or cash flows attributable to the hedged risk, consistently with the originally documented risk management strategy for that particular hedging relationship. For cash flow hedges, a forecast transaction that is the subject of the hedge must be highly probable and must present an exposure to variations in cash flows that could ultimately affect profit or loss. The effectiveness of the hedge can be reliably measured, ie the fair value or cash flows of the hedged item that are attributable to the hedged risk and the fair value of the hedging instrument can be reliably measured. The hedge is assessed on an ongoing basis and determined actually to have been highly effective throughout the financial reporting periods for which the hedge was designated. Assuming the conditions are met, paragraphs 89 102 of the Standard describe the accounting treatment associated with the three types of hedges. Fair value hedges The gain or loss from remeasuring the hedging instrument at fair value (for a derivative hedging instrument) or the foreign currency component of its carrying amount measured in accordance with IAS 21 (for a non-derivative hedging instrument) is recognized in profit or loss. Likewise, the gain or loss on the hedged item attributable to the hedged risk is used to adjust the carrying amount of the hedged item and is recognized in profit or loss. The effect assuming a perfect hedge is no net impact on profit and loss. Recognition of the gain or loss attributable to the hedged risk in profit or loss applies if the hedged item is an availablefor-sale financial asset ( 89). An entity discontinues prospectively hedge accounting if the hedging instrument expires or is sold, terminated or exercised; the hedge no longer meets the criteria for hedge accounting; or the entity revokes the designation. Note that the replacement or rollover of a hedging instrument into another hedging instrument is not considered expiration or termination if the replacement or rollover is part of the entity s documented hedging strategy ( 91). Cash flow hedges The gain or loss from remeasuring the hedging instrument for a cash flow is treated differently than for a fair value hedge. Here, the portion of the gain or loss on the hedging instrument that is determined to be an effective hedge is recognized in other comprehensive IAS 39, Financial Instruments: Recognition and Measurement 10
income, while any ineffective portion of the gain or loss on the hedging instrument is recognized in profit or loss. ( 95) Basically, any gains and losses associated with cash flow hedges are deferred to other comprehensive income until the hedging relationship is ended (however that may happen). The underlying perspective is that by hedging, an entity locks its cash flows. Consequently, it makes no sense to recognize any gains or losses until the cash flows are actually realized or paid. Only when that event occurs would it be appropriate for the entity to recognize the benefits (or costs) of its decision to hedge its cash flows. Consider our earlier example of SRL Limited. It is November 3, 2009. The firm is worried about fluctuations in the US/Canadian dollar exchange rate, so it decides to hedge its receivable. Knowing that it will receive one million US dollars on March 1, 2010, SRL negotiates a rate of 0.925 with its bank. Doing so locks the amount of cash that SRL will receive on March 1, 2010 $1,081,108.10 Canadian. Now, suppose between November 4, 2009 and December 31, 2009, the US/Canadian exchange rate fluctuates between 0.93 and 0.97. Should SRL recognize a gain on its financial statements? It could be argued it should, since the amount of Canadian dollars it could receive on December 31, 2009 is different from the amount of dollars it will receive on March 1, 2010. However, this is an unrealized gain since no transaction has actually occurred all that has happened is that the US/Canadian exchange rate changed. Because the firm hedged its cash flows, it is insensitive to changes in the exchange rate. Furthermore the US/Canadian exchange rate will continue to change and it might go back to around 0.92 by the time March 1 rolls around. A loss will arise on settlement since the Canadian dollar has dropped since December 31, 2009. The net effect would be to recognize a loss that offsets the gain recognized in the previous fiscal period. Realistically, the firm has not suffered a loss, nor did it make a gain in the previous period. However, the change in valuation of the hedging item (the negotiated exchange with the bank) is a derivative, and the unrealized gain must be recognized at fiscal year end (December 31 in this case). Since, this scenario classifies as a cash flow hedge, the change in valuation qualifying as an effective hedge is reported in other comprehensive income. Any ineffective amounts are recorded in profit and loss. As with fair value hedges, an entity discontinues prospectively hedge accounting if the hedging instrument expires or is sold, terminated or exercised; the hedge no longer meets the criteria for hedge accounting; or the entity revokes the designation. In addition, if a forecast transaction is no longer expected to occur, hedge accounting is ended ( 101). Discontinuing the hedging relationship requires an entity to reclassify amounts that had been recognized in other comprehensive income from equity to profit or loss as a reclassification adjustment (see IAS 1) in the same period or periods during which the hedged forecast cash flows affect profit or loss ( 100). Hedges of a net investment in a foreign operation Hedges of a net investment in a foreign operation, including a hedge of a monetary item that is accounted for as part of the net investment (see IAS 21), are accounted for similarly to cash flow hedges. In other words, the portion of the gain or loss on the hedging instrument that is determined to be an effective hedge is recognized in other comprehensive income while any ineffective portion is recognized in profit or loss. Any gain or loss on the hedging instrument relating to the effective portion of the hedge that has been recognized in other comprehensive income is reclassified from equity to profit or loss as a reclassification adjustment (see IAS 1) in accordance with paragraphs 48 49 of IAS 21 on the disposal or partial disposal of the foreign operation ( 102). IAS 39, Financial Instruments: Recognition and Measurement 11
Differences from Canadian GAAP The move to International Financial Reporting Standards has been much more efficient that it might otherwise be mainly because the Accounting Standards Board began actively converging Canadian GAAP with International GAAP long before the formal adoption of IFRS. The Handbook sections dealing with financial instruments are perfect examples of this approach. Handbook section 3855 is, for all intents and purposes, identical to IAS 39, except that IAS 39: restricts the circumstances in which the option to measure a financial instrument at fair value through profit or loss is available requires quoted loans to be measured at fair value through profit or loss, whereas Section 3855 classifies these as loans and receivables and accounts for them at amortized cost (other than debt securities, which may be classified as held for trading, held to maturity or available for sale) requires all available-for-sale financial assets to be measured at fair value unless fair value is not reliably determinable, whereas Section 3855 requires non- quoted equity instruments classified as available for sale to be measured at cost requires foreign exchange gains and losses on available-for-sale financial assets to be recognized immediately in net income does not allow a choice of accounting policy for transaction costs does not address financial instruments exchanged or issued in related party transactions requires reversal of impairment losses in some circumstances, and has no scope exceptions for non-publicly accountable enterprises and not-for-profit organizations Section 3865 and IAS 39 are converged, except that IAS 39 permits fair value hedge accounting for a portfolio hedge of interest rate risk. Articles in this series will discuss: IFRS 1 First-time Adoption of IFRS IFRS 3 Business Combinations IFRS 7 Financial Instruments: Disclosures IAS 1 Presentation of Financial Statements IAS 16 Property, Plant and Equipment IAS 27 Consolidated and Separate Financial Statements IAS 32 Financial Instruments: Presentation IAS 36 Impairment of Assets IAS 37 Provisions, Contingent Liabilities and Contingent Assets IAS 38 Intangible Assets IAS 39 Financial Instruments: Recognition and Measurement For a more comprehensive introduction to the adoption of IFRSs, see the online course IAS 32, available on PD Net. You must be registered to access and purchase the course. If you are not registered on PD Net, register now it s fast, easy, and free. IAS 39, Financial Instruments: Recognition and Measurement 12
Brian and Laura Friedrich are the principals of friedrich & friedrich corporation, an accounting research, standards, and education firm. The firm provides policy, procedure, and governance guidance; develops courses, examinations, and other assessments; and supports the development of regional public accounting standards in Canada and internationally. Brian and Laura have served as authors, curriculum developers, lecturers, exam developers, and markers for numerous CGA and university courses in Canada, China, and the Caribbean. Their volunteer involvement has earned them CGA-BC s inaugural Ambassador of Distinction Award (2004) and the J.M. Macbeth Award for service at the chapter level (Brian in 2006 and Laura in 2007). Brian and Laura are also Fellows of the Association of Chartered Certified Accountants (ACCA). Stephen Spector is a Lecturer currently teaching Financial and Managerial Accounting at Simon Fraser University. He became a CGA in 1985 after obtaining his Master of Arts in Economics from SFU in 1982. In 1997, CGA-BC presented him with the Harold Clarke Award of Merit for recognition of his service to the By-Laws Committee for 1990-1996. In 1999, Stephen received the Fellow Certified General Accountant (FCGA) award for distinguished service to the Canadian accounting profession. He has been on SFU s Faculty of Business Administration s Teaching Honour Roll for May 2004 to April 2005 and May 2006 to April 2007. In August 2008, he was one of the two annual winners of the Business Faculty s TD Canada Trust Distinguished Teaching Award. Stephen has held a number of volunteer positions with CGA-BC; he currently sits on CGA-BC s board of governors where he is CGA-BC s President. IAS 39, Financial Instruments: Recognition and Measurement 13