for Accounting Professionals
IAS 32/39 Financial Instruments Part 4: Hedge Accounting + Disclosures
2011
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IAS 32/39 Financial Instruments Part 4: Hedge Accounting + Disclosures
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TACIS project partners included Rosexpertiza (Russia), ACCA (UK), Agriconsulting (Italy), FBK (Russia), and European Savings Bank Group (Brussels). The help of Philip W. Smith (editor of the third edition) and Allan Gamborg, project managers and Ekaterina Nekrasova, Director of PricewaterhouseCoopers, who managed the production of the Russian version (2008-9) is gratefully acknowledged. Glyn R. Phillips, manager of the first two projects conceived the idea, designed the workbooks and edited the first two versions. We are proud to realise his vision.
Robin Joyce
Professor of the Chair of
International Banking and Finance
Financial University
under the Government of the Russian Federation
Visiting Professor of the Siberian Academy of Finance and Banking Moscow, Russia 2011 Updated
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IAS 32/39 Financial Instruments Part 4: Hedge Accounting + Disclosures
CONTENTS
PREFACE 2
Introduction 4
1 Scope 6
2 Glossary 7
4. Work Book 4: Hedge Accounting and Disclosures 11
4.1 The Rationale Of Hedging 11
4.2 HEDGE ACCOUNTING and HEDGING 12
4.3 HEDGED ITEMS 12
4.4 Overview 14
4.5 Criteria for hedge accounting 14
4.6 Categories of hedges 15
4.7 Accounting for hedges 18
4.8 Hedge effectiveness / ineffectiveness 20
4.9 Discontinuing hedge accounting 23
4.10 Transition 25
5. Practical Experience - A survey of banks’ 2005 IFRS annual reports (PwC 2006) 25
5.1 Hedging and derivatives 25
5.2 Hedge accounting policies 26
5.3 Cash Flow hedging strategies 29
5.4 Hedge effectiveness 30
5.5 Deferred gains and losses in equity 31
5.6 Concluding remarks 31
5.7 Future developments – next generation of hedge strategies 32
6.Frequently Asked Questions (taken from the PwC publication: International Financial Reporting Standards IAS 39 – Achieving hedge accounting in practice - 2005) 32
7. Disclosures 56
8.Multiple choice questions 59
9. Answers to multiple choice questions 61
Note: Material from the following PricewaterhouseCoopers publications has been used in this workbook:
-Applying IFRS
-IFRS News
-Accounting Solutions
1 .Introduction
OVERVIEW
Aim
IFRS 9 will replace IAS 39. Until it does, we will support IAS 39 workbooks. There are separate IAS 32 and IFRS 9 workbooks.
The aim of this workbook is to facilitate an understanding of IAS 32 and IAS 39.
Book 3 has bookkeeping for each category of financial instruments.
IAS 32 deals with the presentation of financial instruments and especially their classification as debt or equity whilst IAS 39 deals with recognition, derecognition, measurement and hedge accounting. IFRS 7 Financial Instruments: Disclosures is the subject of a separate workbook.
These three standards provide comprehensive guidance on the accounting for financial instruments. The need for such guidance is crucial as financial instruments are a large part of the assets and liabilities of many companies, especially financial institutions.
The standards require companies to disclose their exposure to financial instruments and to account for their impacts - in most cases as they happen, rather than allowing problems to be hidden.
IAS 39 requires most derivatives to be reported at their ‘fair’ or market value, rather than at cost.
Reporting at market value overcomes the problem that the cost of a derivative is often nil or immaterial. If derivatives are measured at cost, they are often not included in the balance sheet at all and their success (or otherwise) in reducing risk is not visible.
In contrast, measuring derivatives at fair value ensures that their leveraged nature and their success in reducing risk are reported.
IAS 32 and IAS 39
IAS 32 deals with the presentation of financial instruments, (when instruments are presented as liability or equity, and the information is to be shown in the notes).
IAS 39 deals with the measurement of financial instruments and with their recognition (when they should be included in financial statements and how they should be valued).
Why do we need standards on financial instruments?
Financial instruments are a large part of the assets and liabilities of many undertakings, especially financial institutions. They also play a key role in the efficient operation of financial markets.
Financial instruments, including derivatives, can be useful tools for managing risk, but they can also present risk. In recent years there have been many ‘disasters’ associated with derivatives and other financial instruments.
The standards require companies to disclose their exposure to financial instruments and to account for the effectiveness - in most cases as they happen, rather than allowing problems to be hidden away.
To which companies do the standards apply ?
The standards apply to all companies reporting under IFRS.
To what financial instruments do the standards apply?
The standards apply to all financial instruments except:
· Those covered by another more specific standards - such a interests in subsidiaries, associates and joint ventures, post-employment benefits (pensions) and leases
· Insurance contracts, and certain similar contracts
· Most loan commitments
The standards also apply to contracts to buy or sell a non-financial item (such as commodity contracts) where these are for dealing purposes.
The main requirements of IAS 32
Presentation by the issuer - debt or equity
IAS 32 adopts definitions of liabilities and equity based on the IFRS Framework. It is similar to the frameworks used by many national standard-setters:
· A financial instrument is a liability if it is a contractual obligation to deliver cash or other financial assets. The finance cost of liabilities is accounted for as an expense.
· A financial instrument is equity if it evidences a residual interest in the assets of an undertaking after deducting all of its liabilities. Payments of equity are treated as distributions, not as expenses.
Convertible debt (that gives the holder a choice of repayment in cash or in shares) is separated into its debt and equity components. It is analysed into an issue of ordinary debt at a discount, and a credit to equity for the conversion right.
All relevant features need to be considered when classifying a financial instrument. For example:
• If the issuer can or will be forced to redeem the instrument, classification as a liability is appropriate;
• If the choice of settling a financial instrument in cash or otherwise is contingent on the outcome of circumstances beyond the control of both the issuer and the holder, the instrument is a liability as the issuer does not have an unconditional right to avoid settlement; and
• An instrument which includes an option for the holder to put the rights inherent in that instrument back to the issuer for cash or another financial instrument is a liability.
The treatment of interest, dividends, losses and gains in the income statement follows the classification of the related instrument.
Not all instruments are either debt or equity. Some, known as compound instruments, contain elements of both in a single contact.
Such instruments, such as bonds that are convertible into equity shares either mandatorily or at the option of the holder, must be split into liability and equity components.
Each component is then accounted for separately. The liability component is determined first by fair valuing the cash flows excluding any equity component, and the residual is assigned to equity.
In addition to ordinary debt, liabilities include mandatory redeemable shares, such as units of a mutual fund and some preferred shares, because they contain an obligation to pay cash.
Offsetting
A financial asset and a financial liability may only be offset and the net amount reported in the balance sheet when an undertaking both:
· has a current right to set off the recognised amounts; and
· intends either to settle on a net basis, or to realise the asset and settle the liability simultaneously.
Situations that generally do not qualify for offsetting include master netting agreements, where there is no intention to settle net, and where assets are set aside to meet a liability but the undertaking remains primarily liable.
The main requirements of IAS 39
Measurement
IAS 39 divides financial assets and financial liabilities into four classes (plus one option treatment) as follows:
· Fair value through profit and loss - trading assets and liabilities, including all derivatives that are not hedges, are measured at fair value through profit and loss
- all gains and losses are recognised in profit and loss as they arise.
· Loans and receivables are ordinarily accounted for at amortised cost, as are most liabilities.
· Held-to-maturity investments are accounted for at amortised cost.
· All other financial assets are classified as available-for-sale and measured at fair value, with all gains and loses taken to equity. On disposal, gains and losses previously taken to equity are recycled to profit or loss.
There is an option to account for any financial asset or liability at fair value through profit and loss.
There are special rules for hedge accounting as described in this workbook.
Another aspect of measurement is impairment - when and how losses should be recognised in profit and loss on those assets that are not accounted for at fair value through profit and loss.
Whenever there is objective evidence of impairment as a result of a past event, impairment should be recognised immediately and recorded in profit and loss.
Among other things, the IAS 39 clarifies that:
· Impairment should only take into account losses that have already been incurred, and not those that might happen in the future
· Impairment losses on available-for-sale assets are taken from equity and recognised in profit and loss. For equity investments, evidence of impairment may include significant adverse changes in the issuer’s market position, or a significant or prolonged decline in the fair value of the investment.
Fair value is the only measurement that can capture the risky nature of derivatives. The information is essential to communicate to investors the nature of the rights and obligations inherent in them. Fair value makes the derivatives visible, so that problems are not hidden away.
Hedge Accounting
Hedging techniques are used by banks and undertakings to reduce existing market, interest rate or foreign currency risks. These techniques include the use of futures, swaps and options. The success of a hedging strategy is measured not by the profit produced by the hedge itself, but by the extent to which that profit offsets the results of the item hedged.
IAS 39 describes three main kinds of hedging relationship and their accounting treatment:
· A cash flow hedge is a hedge of the exposure to variability in cash flows, often in foreign currencies. The hedge matches the cash inflows with cash outflows to minimise foreign exchange exposure.
· A fair value hedge - in which the fair value of the item being hedged changes as market prices change. Changes in the fair value of both the hedged item and the hedging instrument are initially reported in equity, and transferred to profit and loss to match the offsetting gains and losses on the hedged transaction.
· A hedge of a net investment in foreign operation should be accounted for in the same way as a cash flow hedge.
The following principles have been adopted in order to provide discipline over the use of hedge accounting:
· The hedging relationship has to be defined by designation and documentation, reliably measurable, and actually effective;
· To the extent that a hedging relationship is effective, the offsetting gains and losses on the hedging instrument and the hedged item are recognised in profit and loss at the same time;
· All hedge ineffectiveness is recorded immediately in profit and loss;
· Items must meet the definitions of assets and liabilities to be recognised in the balance sheet.
Hedge accounting for internal hedges is not permitted, as internal transactions are eliminated on consolidation - the undertaking is merely dealing with itself.
However, where internal hedges are used as a route to the market via an internal treasury centre, IAS 39 clarifies what needs to be done in order to achieve hedge accounting.
2Scope
The scope of the standards is very wide-ranging. Anything that meets the definition of a financial instrument is covered unless it falls within one of the specific exemptions.
Within scope of IAS 32 and IAS 39 / Within scope of IAS 32 only / Out of scopeDebt and equity investments / Investments in subsidiaries, associates and joint ventures
Loans and receivables / Lease receivables (Note 1)
Own debt / Own equity / Lease payables (Note 1)
Tax balances
Employee benefits
Cash and cash equivalents
Derivatives – e.g.:
Interest rate swaps
Currency forwards/swaps
Purchased/written options
Commodity contracts (Note 2)
Collars/caps
Credit derivatives
Cash or net share settleable derivatives on own shares / Derivatives on own shares settled only by delivery of a fixed number of shares for a fixed amount of cash / Own-use commodity contracts
Derivatives on subsidiaries, associates and joint ventures
Embedded derivatives
Loan commitments held for trading (Note 3) / Other loan commitments
Financial guarantees (Note 4) / Insurance contracts
Weather derivatives
Note 1 – Leases: Lease receivables are included in the scope of IAS 39 for derecognition and impairment purposes only. Finance lease payables are subject to the derecognition provisions. Any derivatives embedded in lease contracts are also within the scope of IAS 39.