IFRS REPORTING

Financial Instruments Accounting
March 2004

AUDIT

AUDIT

TAX

ADVISORY

Preface
IAS 39 Financial Instruments: Recognition and Measurement has been in effect for several years and most entities reporting under International Financial Reporting Standards (IFRSs) have issued two annual reports using IAS 39 to account for their investments, loans, receivables, borrowings and derivative and hedging activities. Many have found that experience in working with the standard does little to ease the pain. During 2000 and 2001, the IAS 39 Implementation Guidance Committee issued more than 200 Q&A interpretations of the standard based on questions and issues raised by entities and their auditors. The complexity and the volume of the guidance continues to provide a challenge for entities as their understanding of the basic requirements increases. “The more you know, the more you realise how much you don’t know” seems particularly relevant to IAS 39. Requirements for entities in the European Union (EU), Australia, Russia and elsewhere to report under IFRS by 2005 create the same challenges for a brand new group of IFRS users, of which there will be some 7,000 in Europe alone. In December 2003 the IASB issued revised versions of IAS 32 Financial Instruments: Disclosure and Presentation and IAS 39 incorporating significant and wide-ranging changes to both standards, effective for reporting periods beginning on or after 1 January 2005. With the exceptions of portfolio hedging for interest rate risk, the scope of the fair value option and one or two amendments that may flow from the IASB’s insurance project, the 2005 requirements are now set in stone. For European companies, the only remaining hurdle is EU endorsement during the course of 2004. Both existing IFRS reporters and first-time adopters will need to spend significant amounts of time in 2004 preparing to implement the standards. First-time adopters in particular will need to have a complete and thorough implementation process in place to enable a successful transition to IFRS. Our experience is that the implementation challenge is a tough one, but is achievable as long as sufficient time and the right resources are devoted to it. Implementing IAS 39 requires a structured process. This could well require a dedicated team to identify and address the entity’s major issues and potential changes to current business practices as well as to information systems. Preparers and users will have to develop a fundamental understanding of the concepts and principles of accounting for financial instruments. This will involve training personnel and developing expertise and understanding of the way in which IFRS collectively deal with financial instruments. This publication provides a comprehensive overview of the existing IAS 32 and IAS 39 to address accounting for financial instruments with an emphasis on practical application issues. It provides an update to the first edition issued in September 2000, taking into account guidance issued subsequently as well as examples based on practical experience from working with KPMG member firms’ clients. At the same time we have incorporated guidance

© 2004 KPMG International. KPMG International is a Swiss cooperative of which all KPMG firms are members. KPMG International provides no services to clients. Each member firm is a separate and independent legal entity and each describes itself as such. All rights reserved.

on the likely impact of the December 2003 amendments. KPMG member firms welcome the opportunity to help entities in understanding and implementing these standards. For information on how a KPMG member firm can assist you, please contact your regular KPMG business adviser or any of our offices worldwide (www.kpmg.co.uk/ias (to be updated shortly, at the date of this publication, to www.kpmg.co.uk/ifrs)).

KPMG March 2004

© 2004 KPMG International. KPMG International is a Swiss cooperative of which all KPMG firms are members. KPMG International provides no services to clients. Each member firm is a separate and independent legal entity and each describes itself as such. All rights reserved.

are by their nature based on narrowly defined facts and circumstances. In addition. a summarised comparison between IFRS and US GAAP is included as Appendix B and abbreviations used throughout the text are identified in Appendix C. Organisation of the text Throughout this publication we have made reference to current IFRS literature and interpretations of that literature. This publication considers standards and interpretative guidance that are in force at December 2003. A list of all case studies is included as Appendix D. circumstances © 2004 KPMG International. IAS 39 itself. Case studies and examples are included throughout the text to elaborate or clarify the more complex principles of the financial instruments standards. A glossary of frequently used terms is included as Appendix A to the publication. Earlier adoption is permitted. In most instances. Future updates to this publication will provide practical guidance and interpretation on the amendments. Further interpretations of the amended standards are likely to develop during the course of 2004 as companies work with their advisers to implement them.About this publication Content Information in this publication is current up to December 2003. Keep in contact and stay up-to-date IFRS literature on financial instruments is intended to cover all types of industries and transactions. but an entity must then adopt all the requirements of both amended standards. References are to the amended standards issued in December 2003. Each member firm is a separate and independent legal entity and each describes itself as such. and in some respects. Piecemeal early adoption is not permitted. All rights reserved. . Commentary on the December 2003 amendments to the standards is provided separately in red where applicable within each Section. and also provides a commentary on the likely impact of the amendments issued in December 2003 which are not required to be adopted until financial years commencing on or after 1 January 2005. Readers should be aware that the amended standards are applicable for periods beginning on or after 1 January 2005. further interpretation will be needed in order for an entity to apply these standards to its own facts. The interpretive guidance. KPMG International provides no services to clients. KPMG International is a Swiss cooperative of which all KPMG firms are members. A column noted as Reference is included in the left margin of Sections 2 to 11 to enable users to identify the relevant paragraphs of the standards or other interpretative literature. This publication has been updated for additional interpretations of IAS 39 based on guidance issued subsequent to September 2000 when the first edition of this publication was released. Direct quotations from IFRS are shaded in blue within the text.

Further.and individual transactions. .kpmg. This publication has been produced by KPMG’s IFR Group. KPMG International is a Swiss cooperative of which all KPMG firms are members. Each member firm is a separate and independent legal entity and each describes itself as such. © 2004 KPMG International. as at the date of this publication.uk/ifrs). Users are cautioned to read this publication in conjunction with the actual text of the standards and implementation guidance issued.kpmg.co. which may change as practice and implementation guidance continue to develop in these areas. some of the information contained in this publication is based on KPMG’s International Financial Reporting Group’s (IFR Group’s) interpretations of the current literature. KPMG International provides no services to clients. to www. where you will find up-to-date technical information and a briefing on KPMG’s IFRS conversion resources. For more information. please visit www.uk/ias (to be updated shortly. All rights reserved.co. and to consult their professional advisers before concluding on accounting treatments for their own transactions.

KPMG International is a Swiss cooperative of which all KPMG firms are members.2 Economic characteristics and risks 3.2 Initial measurement 4.3 Financial risks 3.1 Overview 4. Embedded derivatives 3.Contents Page 1. Classification 5.3 Highlights of the standards 4 4 4 5 9 9 13 19 20 20 22 23 29 29 29 31 34 46 51 51 52 63 2.2 Development of the standards 1. Scope and definitions 2.3 Classification of financial liabilities © 2004 KPMG International.1 Overview 5. All rights reserved. Introduction to the financial instruments standards 1.3 Recognition 4.3 Separation of the embedded derivative 4.2 Classification of financial assets 5.4 Derecognition 4. Recognition and derecognition 4.1 The need for financial instruments standards 1.1 Overview 3. .2 Definitions relating to financial instruments 2. Each member firm is a separate and independent legal entity and each describes itself as such.1 Scope of the standards 2. KPMG International provides no services to clients.5 Special purpose entities and derecognition 5.

1 Overview 9. Hedge accounting 8.4 Equity price risk 7.5 Reclassifications of financial assets 6. Subsequent measurement 6.8 Net position hedging and internal derivatives 8.2 Interest rate risk 7.5 Hedging instruments 8.2 Hedge accounting basic concepts 8.1 Overview 7.4 Impairment of financial assets 6.3 Foreign currency risk 9.4 Hedged items 8. KPMG International is a Swiss cooperative of which all KPMG firms are members.4 Hedging a net investment 9.6 Criteria for hedge accounting 8.3 Foreign currency risk 7.5 Credit risk 8. Hedge accounting for each type of financial risk 9. Subsequent measurement – examples 7.3 The hedge accounting models 8. All rights reserved. KPMG International provides no services to clients.2 Classification determines subsequent measurement 6.9 Other considerations 9.1 Overview 6. Each member firm is a separate and independent legal entity and each describes itself as such.5 Hedging commodity price risk 65 65 67 69 82 90 93 94 94 95 98 101 103 104 104 105 107 112 117 121 131 134 135 137 137 137 156 171 175 © 2004 KPMG International. .6 Deferred tax assets and liabilities 7 .2 Interest rate risk 9.1 Overview 8.Page 6.7 Termination of a hedge relationship 8.3 Valuation issues 6.

Abbreviations D. Presentation and disclosure 10. List of cases © 2004 KPMG International. Glossary B. Each member firm is a separate and independent legal entity and each describes itself as such. .1 Overview 11. All rights reserved. IFRS and US GAAP financial instruments comparison 184 184 184 186 194 195 206 206 206 211 212 214 221 228 229 C. KPMG International is a Swiss cooperative of which all KPMG firms are members.3 Liability versus equity 10.5 Required disclosures 11.4 Income statement presentation 10. KPMG International provides no services to clients.2 Balance sheet presentation 10.3 Transition requirements for existing users of IFRS 11.1 Overview 10.4 First time implementation: practical considerations A.Page 10. Transition and implementation of IAS 39 11.2 First-time adoption of IFRS 11.

This changing environment has been the impetus for a constant stream of innovative and often complex financial products. collectively referred to throughout this publication as the financial instruments standards. The accounting profession as a whole has made efforts during recent years to develop accounting literature to address financial instruments. IAS 30 will be withdrawn together with the financial risk disclosure requirements in IAS 32. There are other standards and interpretations that are relevant to a discussion of financial instruments accounting. this body adopted all of the then-current standards and interpretations of the IASC. and prohibiting certain industry practices such as catastrophe provisions and equalisation reserves. The second phase of the project addressed recognition and measurement. or whether public or non-public. . all entities reporting under IFRS. The first phase addressed disclosure and financial statement presentation. Insurance contracts. but was later expanded to cover all entities). would continue to be dealt with under an entity’s existing accounting framework. The use of derivative instruments has become a common practice for many entities of all sizes and throughout all industries. Both projects will affect the accounting for and disclosure of financial instruments in due course.1 Introduction to the financial instruments standards The need for financial instruments standards In the past two decades there has been a dramatic increase in the sophistication of financial markets. With these standards. KPMG International is a Swiss cooperative of which all KPMG firms are members. The International Accounting Standards Committee (IASC) issued two standards that specifically address accounting for financial instruments. With the globalisation of markets many entities face increasing challenges in controlling risks to which they are exposed. but neither will be effective before 2005. regardless of their size or industry. The IASB is currently addressing certain aspects of insurance accounting with a view to introducing interim requirements that would be effective in 2005. In 1994 the IASC divided this project into two phases.IFRS Financial Instruments Accounting March 2004 1. KPMG International provides no services to clients. 1. All rights reserved. The proposals are not dealt with further in this publication. 1. When the project is completed. must account for and make disclosures about financial instruments in a similar manner. 4 1. was formed in 2001. the successor organisation to the IASC. Each member firm is a separate and independent legal entity and each describes itself as such. The IASB is also undertaking a project to develop a new standard for disclosure of risks arising from financial instruments (this scope of this project was originally to update IAS 30 Disclosures in the Financial Statements of Banks and Similar Financial Institutions.2 Development of the standards © 2004 KPMG International. In the longer term the IASB expects to issue a comprehensive standard on insurance contracts. including IAS 32 and IAS 39. These interim requirements would be limited to defining insurance risk and distinguishing it from financial risks dealt with under the financial instruments standards. These are International Accounting Standard (IAS) 32 Financial Instruments: Disclosure and Presentation and IAS 39 Financial Instruments: Recognition and Measurement.2 Development of the standards The IASC began its project to develop a comprehensive set of standards addressing financial instruments in 1989. in the interim. When the International Accounting Standards Board (IASB). most notably IAS 21 The Effects of Changes in Foreign Exchange Rates and SIC–12 Consolidation – Special Purpose Entities. and resulted in the issuance of IAS 32 in 1995.

a substantive risk from the assets must be transferred.1 is a basic overview of the financial instruments standards dealt with in this publication. called the Joint Working Group (JWG). An Exposure Draft of proposed amendments to IAS 32 and IAS 39 was released in June 2002 for public comment. derecognition and measurement of an entity’s financial instruments and for hedge accounting. 1.3 Highlights of the standards © 2004 KPMG International. Such a new standard is not expected prior to 2005. 5 .1 Overview of the financial instruments standards The requirements of the financial instruments standards are summarised at a very high level below. KPMG International is a Swiss cooperative of which all KPMG firms are members. This group. derecognise) assets from its balance sheet.1 Recognition and derecognition ■ All financial assets and financial liabilities. released their Exposure Draft in December 2000 for public comment. In October 2003.e. the IASC was working with a collaboration of national standard setters from 13 countries to develop a completely new standard on financial instruments accounting. It also introduced some changes to the disclosure and presentation requirements of IAS 32. an entity must lose control over those financial assets. Their proposals and the results of comments received from the public were presented to the IASB in early 2002.3. The IASB released the revised versions of IAS 32 and IAS 39 in December 2003. Each member firm is a separate and independent legal entity and each describes itself as such.IFRS Financial Instruments Accounting March 2004 IAS 39 was originally intended to be an interim standard. It is now a long-term project of the IASB to develop a new standard for financial instruments. including derivative instruments.3 Highlights of the standards Prior to the issuance of IAS 32 and IAS 39 there was no comprehensive guidance in IFRS addressing financial instruments. At the same time that the standard became effective in 2001. All rights reserved. In issuing the proposed amendments to IAS 32 and IAS 39 the Board stated that it expected the amended standards to be in place for “a considerable period”. In order to remove (i. dealing with certain aspects of hedge accounting which are particularly relevant for financial institutions. IAS 39 introduced new requirements for the recognition. particularly so for derivatives. 1. In addition. the IASB issued an Exposure Draft Fair Value Hedge Accounting for a Portfolio Hedge of Interest Rate Risk. IAS 39 ■ 1. should be recognised in the balance sheet. Figure 1. Figure 1. KPMG International provides no services to clients.

The appropriate accounting model for a hedge relationship depends on the nature of the item being hedged. and available-for-sale instruments as a component of equity. In order to qualify for hedge accounting.IFRS Financial Instruments Accounting March 2004 is complex and restrictive in this area. In some circumstances. Financial liabilities are categorised as either trading or non-trading. and in the rare circumstances where the fair value of an unlisted equity instrument cannot be reliably measured.3 Derivatives and hedge accounting ■ Under IAS 39. Unless they qualify as hedging instruments. which are the fair value hedge. with the exceptions being originated loans and receivables. held-to-maturity. This is regardless of whether they are categorised as trading or as hedging instruments. 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.3 Highlights of the standards ■ ■ ■ ■ ■ 6 © 2004 KPMG International. it can choose to recognise changes in fair value of trading instruments in the income statement. ■ In order to derecognise a liability.3. An entity can choose to recognise all changes in fair value in the income statement. there must be an expectation that future gains and losses on the hedged item and hedging instrument will almost fully offset. Fair value changes deferred in equity are recycled to the income statement when the instrument is sold or becomes impaired. The effect of remeasurement to fair value must be recognised and consistently applied in one of two ways. . the cash flow hedge and the hedge of a net investment in a foreign entity.3. The categorisation determines whether and where any remeasurement to fair value is recognised in an entity’s financial statements. Alternatively. liability or future cash flow must be documented separately. Remeasurement to fair value must be performed at each financial reporting date. There are three hedge accounting models under IAS 39. originated loans and receivables. 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. A non-derivative financial instrument can have certain characteristics that cause it to behave like a derivative. KPMG International provides no services to clients. Many financial assets are carried at fair value. In order to continue hedge accounting. All rights reserved. an entity must designate its hedge relationships and document how it will measure effectiveness.2 Measurement ■ Financial assets must be classified into one of four categories: trading. KPMG International is a Swiss cooperative of which all KPMG firms are members. Each individual relationship between a derivative and its hedged asset. all derivatives (including some embedded derivatives) must be measured at fair value in the balance sheet. and available-for-sale. Entities converting to IFRS may find assets that were derecognised under previous GAAP may have to be included on balance sheet in their IFRS financial statements. 1. a debtor must be legally released from its primary obligation related to that liability. Hedge accounting is permitted provided that the entity can establish that each hedge has been highly effective in each reporting period. ■ ■ 1. 1. Each member firm is a separate and independent legal entity and each describes itself as such. the standard prohibits hedge accounting. held-to-maturity assets. all fair value gains and losses are recognised immediately in the income statement. Hedge accounting is a choice that each entity makes for each economic hedge that it has in place. It provides guidance for transactions such as factoring and securitisations.

to classify any non-derivative financial asset as available-for-sale. fair value information and other quantitative disclosures of income and expense. Significant qualitative and quantitative disclosures about financial instruments. The requirement to separate certain embedded foreign currency derivatives has been relaxed in certain cases.3. where the currency in which the sale is denominated is not the functional currency of either of the parties to the contract. on initial recognition or when the standards are first applied. KPMG International provides no services to clients. All rights reserved.4 Disclosure and presentation ■ Guidance is provided on the classification of financial instruments as equity or debt. financial risk management and hedging activities are required. and gains and losses from financial instruments are required. as well as methods and significant assumptions. resulting in partial derecognition. the amendments to the standards introduce the following changes: ■ The requirements on derecognition of financial assets are significantly reworded and to some extent revised (although for certain transactions the resulting changes to the accounting are substantial). Subsequent transfers in or out of the new category are prohibited. with fair value changes subsequently being recognised as a component of equity. In addition. Each member firm is a separate and independent legal entity and each describes itself as such. Similarly. emphasising that the standards follow an incurred loss model. Disclosures should note the significant terms and conditions of instruments as well as information about interest rate risk and credit risk of financial instruments.IFRS Financial Instruments Accounting March 2004 ■ Implementing these requirements can involve significant systems amendments. or on the date the amended standards are first applied. New guidance is provided on the application of the impairment requirements. and risk management objectives and policies for hedging. A new category of ‘financial assets measured at fair value through profit or loss’ is introduced.3 Highlights of the standards © 2004 KPMG International. KPMG International is a Swiss cooperative of which all KPMG firms are members. ■ ■ ■ ■ 1. ■ ■ ■ ■ December 2003 amendments At a very high level. retaining elements of both risks and rewards and control criteria. an entity may choose. Netting requires a legal right of set off as well as the intention to offset the assets and liabilities or settle simultaneously. Criteria are specified for the netting of financial assets and financial liabilities. Impairment losses recognised on equity instruments classified as ‘available-for-sale’ are prohibited from being reversed through profit or loss. except in limited numbers of transactions where a new ‘continuing involvement’ approach is adopted. The standard should now be simpler to apply under the decision tree approach. such as convertible bonds. and accounting for compound instruments with characteristics of both equity and debt instruments. 7 . 1. particularly when large numbers of derivatives are used as hedging instruments. The option to recognise fair value changes on available-for-sale financial assets in profit or loss is consequently removed. Any subsequent increase in fair value is instead recognised in equity. Required disclosures include how fair value is determined. An entity may choose to include any financial asset or financial liability in this category on the day the asset or liability is first recognised.

the item is a financial liability whose amount is contractually linked to the performance of assets that are measured at fair value. In practice.IFRS Financial Instruments Accounting March 2004 ■ Further guidance is also provided on how to calculate amortised cost using the effective yield method and on fair value measurement techniques. particularly on the use of internal transactions in hedging relationships. .3 Highlights of the standards © 2004 KPMG International. ■ ■ ■ IASB Board meeting February 2004 At this meeting the IASB tentatively concluded that it should make two further amendments to the standards. The first would be to limit the use of the fair value through profit or loss option. Additional restrictions are placed on the use of hedge accounting in some circumstances. This amendment is likely to be issued without further exposure in April 2004. The cash flow hedge accounting model has in some cases prohibited basis adjustments and in others made them optional. the degree of correlation required to achieve hedge accounting will be closer to the 80 to 125 per cent range required for retrospective testing. this change is likely to mean that as long as the entity is not deliberately under-hedging. or the exposure to fair value changes in the item is substantially offset by corresponding changes in the value of another financial asset or liability. in respect of the prospective effectiveness test for hedge accounting. Each member firm is a separate and independent legal entity and each describes itself as such. New disclosures are added. KPMG International provides no services to clients. KPMG International is a Swiss cooperative of which all KPMG firms are members. The requirements on classification of issued instruments such as preference shares and convertible bonds between liabilities and equity are amended slightly and new requirements are provided on how to account for derivatives on an entity’s own equity. 8 1. in particular on the sensitivity of fair value estimates to key inputs to a valuation model. All rights reserved. Some hedging relationships involving firm commitments that were previously accounted for as cash flow hedges will be accounted for as fair value hedges. The second amendment would be to remove the requirement. to four circumstances: ■ ■ ■ the item is an available-for-sale asset (but not a loan or receivable). described above. that changes in fair value or cash flows of the hedged item should be expected to ‘almost fully offset’. the item contains one or more embedded derivatives. including a derivative. ■ This proposal is expected to be exposed for public comment during the second quarter of 2004 and finalised in the third quarter.

1 shows summary balance sheets for a corporate and a financial institution. KPMG International provides no services to clients. net of allowances Financial investments Accrued income Property.IFRS Financial Instruments Accounting March 2004 2. including typical financial assets and liabilities of each. Scope and definitions Key topics covered in this Section: ■ ■ ■ Financial instruments included and excluded from the scope Financial instruments defined Financial risks defined 2. KPMG International is a Swiss cooperative of which all KPMG firms are members.1 Effect of financial instruments on a corporate / financial institution Corporate balance sheet Assets Property. Each member firm is a separate and independent legal entity and each describes itself as such.2. It is important first to understand what items are considered to be financial instruments under IFRS. plant and equipment Investments Deferred tax assets Total non-current assets Inventories Other receivables Cash and cash equivalents Total current assets Total assets Equity and liabilities Issued capital Reserves Retained earnings Total capital and reserves Interest-bearing loans and borrowings Pension obligations Provisions Total non-current liabilities Bank overdraft Other payables Total current liabilities Total equity and liabilities Reference Financial institution balance sheet Assets Cash and bank balances Cash collateral on securities Trading portfolio assets Loans. 9 . Table 2.1 Scope of the standards The standards on financial instruments apply to all financial instruments. All rights reserved.1 Scope of the standards © 2004 KPMG International. except for those specifically excluded from the scope of IAS 32 or IAS 39. plant and equipment Other assets Total assets Equity and liabilities Issued capital Reserves Retained earnings Total capital and reserves Money market paper Due to banks Repurchase agreements Trading portfolio liabilities Due to customers Long-term debt Other liabilities Total equity and liabilities 2. Table 2. The definitions of financial assets and financial liabilities are discussed later in Section 2.

2 Items excluded from the financial instruments standards IAS 32 Interests in subsidiaries Interests in associates Interests in joint ventures Employers’ assets and liabilities under employee benefit plans Employers’ assets and liabilities in respect of post-employment employee benefits Employers’ obligations in respect of employee stock option and stock purchase plans Disclosures of employee benefit plans’ obligations for post-employment benefits Rights and obligations under insurance contracts (except embedded derivatives) Rights and obligations under leases (other than securitised lease receivables and embedded derivatives) Equity instruments issued by the entity. For the financial assets and liabilities listed in Table 2. including letters of credit Contracts for contingent consideration in a business combination ‘Weather derivatives’: contracts that require a payment based on climatic. even though they may possess all of the required characteristics of a financial instrument. KPMG International provides no services to clients.2. geological or some other physical variables “✗ ” Indicates a specific exclusion from the standard. ✗ ✗ – – ✗ ✗ ✗ ✗ IAS 39 ✗ ✗ ✗ ✗ – – – ✗ Applicable standard IAS 27 IAS 28 IAS 31 IAS 19 IAS 19 IAS 19 IAS 26 IASB’s insurance project – ✗ IAS 17 – – – ✗ ✗ ✗ IFRS 2 * IAS 37 IAS 22 – ✗ IASB’s insurance project 10 2. . Table 2. entities should refer to other existing standards.2 Certain instruments and contracts are excluded from the scope of the financial instruments standards. classified as shareholders’ equity Financial guarantee contracts. including warrants and options. KPMG International is a Swiss cooperative of which all KPMG firms are members. All rights reserved. 39. * There are two current standards that address aspects of equity instruments issued by the entity (IAS 32 (revised December 2003) and IFRS 2 on share-based payment transactions).1 Scope of the standards © 2004 KPMG International.1 are those figures that may contain financial instruments that fall within the scope of the financial instruments standards. This table demonstrates that many of the accounts of a typical corporate or financial institution are subject to these standards.IFRS Financial Instruments Accounting March 2004 Reference The items in italics in Table 2. if applicable. Each member firm is a separate and independent legal entity and each describes itself as such.

Finance lease receivables are subject to the derecognition provisions of IAS 39. it is anticipated that the scope exclusion in IAS 39 for weather derivatives will be removed. KPMG International provides no services to clients. The financial instruments standards do not change the accounting with respect to investments in subsidiaries. Additionally. This requires changes in fair value to be recognised in the income statement. except those when the entity has a history of settling such commitments in cash or of trading the loan shortly after its issue. private equity funds) view the equity stake as a strategic investment that is intended to be disposed of in the future. venture capital funds. Certain types of investors or investment vehicles may hold a large equity interest in another entity so that consolidation or associate accounting is applicable.g. a number of items are excluded from the scope of IAS 39.1 Scope of the standards © 2004 KPMG International. IAS 31 Interests in Joint Ventures allows a similar approach to be taken for jointly controlled entities. Options to buy and sell interests in subsidiaries. an agreement by a bank to grant a loan at a fixed interest rate). IAS 28 Investments in Associates (revised 2003) allows these venture capitalists and similar entities to apply fair value accounting under IAS 39 rather than accounting for the holding as an associate. KPMG International is a Swiss cooperative of which all KPMG firms are members. Loan commitments were previously exempt from derivative accounting when they qualified as ‘regular way’ transactions. associates and joint ventures.IFRS Financial Instruments Accounting March 2004 Reference As noted in Table 2. Each member firm is a separate and independent legal entity and each describes itself as such.1. derivatives embedded within excluded instruments. However. December 2003 amendments 39.g. within leases or insurance contracts. associates or joint ventures may meet the definition of a derivative. These investors (e. While most financial instruments. These would also be accounted for as financial instruments. 11 .2). Contingent Liabilities and Contingent Assets. they are included where they are in relation to commodity contracts which fall within the scope of IAS 39 (see Section 2.3 2. contracts and obligations under share-based payment transactions to which IFRS 2 Share-based Payment applies are excluded from the scope of IAS 39. there is no similar amendment in respect of consolidation under IAS 27 Consolidated and Separate Financial Statements (revised 2003). for example. the intention of the investor is not the relevant consideration for determining whether the holding is within the scope of IAS 39. Such guarantees and commitments are initially measured at fair value and subsequently measured at the higher of the amount initially recognised (less amounts recognised as revenue under IAS 18 Revenue) and the provision that would be required under IAS 37 Provisions.2. still are within the scope of the financial instruments standards. Additional guidance is provided on the accounting for issued financial guarantee contracts and loan commitments that are excluded from the scope of the standard.2(i) The amendments will exclude from the scope of the standards loan commitments (e. All rights reserved. the investor’s preference is to account for this interest as a financial instrument rather than as a subsidiary or associate. The applicable standard for each of these investments is noted above. 39. many financial instruments excluded from the scope of IAS 39 still are subject to the disclosure and presentation requirements of IAS 32. On completion of the Phase I Insurance standard. However. However. expected in late March 2004. Generally. All other investments in equity securities are within the scope of the financial instruments standards.

the standard on insurance contracts. Derivative contracts based on gold could also fall within the financial 39. However. it may contain an embedded derivative that must be separated and accounted for as a derivative in accordance with IAS 39. Each member firm is a separate and independent legal entity and each describes itself as such. Commodities are viewed broadly under the financial instruments standards. in most respects. there may be difficulty in determining whether or not contracts that take the form of insurance also have financial risks. 2. All rights reserved.1. Likewise. if an entity has a pattern of settling commodity-based contracts on a net basis. In practice.1 Scope of the standards © 2004 KPMG International. KPMG International provides no services to clients.6 39. December 2003 amendments 39. If the terms of the contracts are such that they can only be settled by delivery and there is no practice of settling net. The new definition will need to be applied in determining whether a contract is an insurance contract or a financial instrument. Contracts that may be described as insurance contracts but that do not contain significant insurance risk will be accounted for under IAS 39. KPMG International is a Swiss cooperative of which all KPMG firms are members. will include a new definition of insurance contracts and will. expected in late March 2004. a forward or option to purchase or sell a commodity) may meet the definition of a derivative.IFRS Financial Instruments Accounting March 2004 Reference 2.1 12 2.2(d) The amendments do not change the guidance on how to distinguish between an insurance contract and a financial instrument. sale or usage requirements and fall within the scope of the financial instruments standards. .2 Commodities contracts and normal purchases and sales A contract that is based on a commodity (e. as will non-insurance derivatives embedded in insurance contracts.g. derivative contracts based on non-financial assets such as real estate could fall within the scope of IAS 39. entities that enter into offsetting contracts that effectively achieve net settlement would not qualify for this exemption. not net settled). Commodity-based contracts that give a right to either party to settle in cash or some other financial instrument are included in the scope of the financial instruments standards unless these are (a) entered into with the purpose of meeting the entity’s purchase or sales needs and (b) expected to be settled physically by delivery of the commodities (i. However.2(d) Insurance-like contracts Obligations arising under insurance contracts are excluded from the scope of both financial instruments standards. The intention to settle net may be evidenced by a historical pattern of entering into offsetting agreements. However.e. Intention and past practice of the entity are important considerations when evaluating a commodities contract that can be settled net.2 and B. Those contracts should be treated as executory contracts rather than as derivatives. The same principle applies to reinsurance contracts where the underlying risk is financial risk. but involves the transfer of financial risks. Regardless of whether an insurance or reinsurance contract is included within the scope of IAS 39. as opposed to insurance risks.AG4 32.1. If a financial instrument takes the form of an insurance contract. For example. the contracts are not accounted for as derivatives. the contracts are deemed to not be for the purpose of meeting the entity’s expected purchase.5-7 39. permit an entity to continue its existing accounting for insurance contracts. the other financial assets and liabilities of insurance entities are not.2(d) 39.6 IG A.1 39. meaning that they may be any type of goods on which derivative contracts may be based that give rights to one party to receive or deliver these types of goods to another party. the contract would fall within the scope of the financial instruments standards.

9 and 32. KPMG International is a Swiss cooperative of which all KPMG firms are members.2 Definitions relating to financial instruments © 2004 KPMG International. All rights reserved.11 A financial instrument is any contract that gives rise to both a financial asset of one enterprise and a financial liability or equity instrument of another enterprise.g. or (d) an equity instrument of another enterprise. even though gold itself is not a financial instrument and is therefore outside the scope of the standards.5 and 6 The amendments clarify the circumstances in which a commodities contract should be accounted for as a financial instrument.13 The terms contract and contractual in the above definitions refer to an agreement between two or more parties that has clear economic consequences and that the parties have little. introducing two further restrictions on an entity’s ability to use the scope exemptions for commodities contracts: ■ Although the standard still applies only to those contracts that may be settled in cash (or other financial assets) the amendments increase significantly the meaning of ‘may be settled in cash’.9 and 32. KPMG International provides no services to clients. A financial liability is any liability that is a contractual obligation: (a) to deliver cash or another financial asset to another enterprise. 2. a written option. receivables. even if the terms of the contract require settlement by physical delivery. can never qualify for the ‘normal purchases and sales’ exclusion. (c) a contractual right to exchange financial instruments with another enterprise under conditions that are potentially favourable.2. ■ 2. Each member firm is a separate and independent legal entity and each describes itself as such. as well as interest rate swaps and currency swaps). Therefore. Contracts defining financial instruments may take a variety of forms and do not need 13 2. Commodity and similar contracts will be accounted for as derivatives if the entity has a practice of trading the commodity shortly after delivery or if the product is readily convertible to cash. They include both primary financial instruments (e. (b) a contractual right to receive cash or another financial asset from another enterprise. usually because the agreement is enforceable by law. 39. under which an entity might be required to purchase or sell a commodity or other non-financial asset. or (b) to exchange financial instruments with another enterprise under conditions that are potentially unfavourable. because the entity cannot control whether or not the purchase or sale will take place. . Many commodity contracts are therefore likely to be included in the scope of the standards.g.IFRS Financial Instruments Accounting March 2004 Reference instruments standards. debt and shares in another entity) and derivative financial instruments (e. and Under the amendments. including futures. financial options and forwards.2 Definitions relating to financial instruments Financial instruments embrace a broad range of assets and liabilities. The normal purchases / sales exemption is retained for contracts other than written options that meet the requirement above. if any.11 32. discretion to avoid. 39. December 2003 amendments 39. it cannot be a ‘normal’ purchase or sale requirement.1 Financial assets and financial liabilities A financial asset is any asset that is: (a) cash.

KPMG International is a Swiss cooperative of which all KPMG firms are members. or similar variable (sometimes called the underlying). 39. and (c) that is settled at a future date. and they discuss when these derivatives are to be accounted for as an entity’s own equity and when they are to be accounted for as assets or liabilities. security price. 2. The requirements are covered in Section 10. The other reason for amending the definitions is to cover derivatives whose underlying is the entity’s own equity share price. commodity price.11 and 39. although not in the definitions. a credit rating or credit index.21-24 The amendments provide a comprehensive framework on the accounting for transactions in own equity.2 32. An example of an item not meeting the definitions would be a tax liability. All of the above must be met in order for a financial instrument to be a derivative.3 Derivatives A derivative is a financial instrument: (a) whose value changes in response to the change in a specified interest rate. foreign exchange rate.9 Equity instruments An equity instrument is any contract that evidences a residual interest in the assets of an enterprise after deducting all of its liabilities.2.IFRS Financial Instruments Accounting March 2004 Reference to be in writing.11 and 39. (b) that requires no initial net investment or little initial net investment relative to other types of contracts that have similar responses to changes in market conditions. The current versions of the financial instruments standards do not address accounting for transactions in own equity other than treasury shares.2 Definitions relating to financial instruments © 2004 KPMG International. KPMG International provides no services to clients. December 2003 amendments SIC-16 32.9 14 2. 2.2(e) The amendments expand the definitions of financial asset and financial liability to cover contracts that will or may be settled in an entity’s own equity instruments. including derivatives whose underlying is an entity’s own equity shares. This change is likely to have little impact in practice as similar requirements were already included in the existing standards. All rights reserved. index of prices or rates. . as it is not based on a contract between two or more parties. The topic of classification of instruments (by an issuer) as liabilities versus equity is covered in Section 10. December 2003 amendments 32. Each member firm is a separate and independent legal entity and each describes itself as such. The amended definition clarifies that a liability settled by delivering a variable number of the entity’s own equity instruments with a fixed or determinable value (in other words where shares are used as a settlement currency) is a financial liability.2.

000 if a specified index increases by a determined number of points in the next month. Each member firm is a separate and independent legal entity and each describes itself as such.2.2 Definitions relating to financial instruments © 2004 KPMG International.IFRS Financial Instruments Accounting March 2004 Reference December 2003 amendments 39. This is explained further in Section 2. fixed or floating) interest rates.8 39. may be either a gross or net exchange of cash or other financial instruments. An interest rate swap is a contract that results in the exchange of cash flows based on different (i. a derivative could require a fixed payment as a result of some future event that is unrelated to a notional amount. Another example of a derivative is a forward contract to acquire a bond at some future date at an agreed price. or changes in foreign exchange or interest rates. However. a rate (such as an interest rate). IG B. The amended definition requires only an initial net investment that is smaller than would be required for a similar non-derivative contract with similar responses to changes in market conditions. The amendment is not a substantive change to the definition. A key element of a derivative is that the transaction must allow for settlement in the form of cash or the right to another financial instrument. The settlement amount is not based on and does not need to change proportionally with an underlying. oil or wheat). The initial net investment should be less than the investment needed to acquire a primary financial instrument that has a similar response to changes in market IG B. KPMG International provides no services to clients. Settlement of a derivative. Alternatively.2 Little or no initial net investment There is no quantified guidance as to what constitutes little or no initial net investment.e.3.3.1 Change in value based on an underlying A derivative financial instrument is a financial instrument that provides the holder (or writer) with the right (or obligation) to receive (or pay) cash or another financial instrument in amounts determined by reference to price changes in an underlying price or index. An equity call option gives the holder the right to receive a financial instrument and will be exercised if the price of the equity security rises above the exercise price of the call option.2 and B. an index of prices (such as a stock exchange index) or some other indicator that has a measurable value. a number of shares. at a future date.2. KPMG International is a Swiss cooperative of which all KPMG firms are members. which can be an amount of currency. such as an interest rate swap. For example.AG9 A derivative usually has a notional amount. 15 . an entity may enter into a contract whereby it will receive a fixed payment of 1.2. Examples include interest rate swaps. A derivative may have more than one underlying variable.9 The revised standards include an amendment to part (b) of the definition. The underlying price change upon which a derivative financial instrument is based may be that of a primary financial instrument (such as a bond or equity security) or a commodity (such as gold.3. Common types of derivatives are options. A foreign currency forward contract is an agreement to exchange at some future date an amount of one currency for an amount of another currency at a set forward exchange rate. 2. a number of units of weight or volume or other units specified in the contract.3 39.2. swaps and forwards. the holder or writer is not required to invest in or receive the notional amount at the inception of the contract.AG11 2. The forward contract has a positive fair value if the price of the bond increases and a negative fair value if the price of the bond decreases compared to the agreed upon price. foreign currency forward contracts or equity call options. 2. All rights reserved.

All rights reserved. The entity prepays its fixed obligation by paying the counterparty the fixed obligation discounted using the current market rate. Rather. In this circumstance. such as when an entity can demonstrate an economic need or a substantive business purpose for structuring transactions separately that could not have been accomplished in a single transaction. for example. but prepays the contract based on the current market price. 16 2. Also. which in substance form an interest rate swap. In the latter case under IAS 39 the instrument would not be accounted for as a derivative. the amount prepaid by the entity) is still significantly less than investing in a similar primary financial instrument that responds equally to changes in the underlying interest rate.2 Definitions relating to financial instruments © 2004 KPMG International. but rather as an investment in the underlying itself. all of the criteria for being a derivative are still met.6 ■ 39. these loans are considered to be a derivative and should be accounted for as such if all of the defining characteristics of a derivative are met. However. The entity will continue to receive the variable rates over the life of the swap.AG11 IG B. the floating rate leg of the swap is still a derivative instrument. For example: IG B. IG B. Each member firm is a separate and independent legal entity and each describes itself as such. the exchange of one currency for another is a cross currency swap. If there is an exchange of amounts when entering into a contract. . margin accounts are funds required to be deposited as collateral with a broker in order to have transactions executed by that broker. except when the option is so deep in the money that the premium paid is equivalent to making an investment in the underlying. The premium paid for an option fulfils the requirement of little or no initial investment as it is less than the amount required to obtain the underlying instrument outright. This depends on whether all of the criteria of the definition are still met. The initial net investment (i.9 An example of a derivative instrument is an option that gives the holder the right to buy another financial instrument at a strike price on or before a specified date.e. Sometimes part of a derivative is prepaid.4 ■ If a party to an interest rate swap transaction prepays its pay-fixed obligation at inception. To illustrate. There are exceptions to this. when an entity enters into a forward contract to purchase an investment which will be settled in the future. this is considered to be a termination of the old swap and an origination of a new swap. the instrument’s fair value changes in response to changes in interest rates and the instrument is settled at a future date. If two offsetting loans are entered into that have equal terms and conditions except for their interest rates. less than does not necessarily mean insignificant in relation to the overall investment and needs to be interpreted on a relative basis.IFRS Financial Instruments Accounting March 2004 Reference conditions. Rather the entity would record the investment itself as a non-derivative financial asset. the entity does not have a derivative contract as this does not meet the criteria of little or no initial net investment. which is not seen as an initial net investment provided the amounts of cash are of equal fair value. Similarly. If the party prepays the pay-fixed obligation at a subsequent date.10 ■ A margin account is not considered to be an initial net investment. The question then arises as to whether the remaining part still constitutes a derivative. KPMG International is a Swiss cooperative of which all KPMG firms are members. KPMG International provides no services to clients. 39. an entity enters into an interest rate swap contract where it pays fixed and receives variable rates based on a notional amount.AG11 ■ IG B.

initially at their cost. such as a rating downgrade. payment on the contract should only be triggered if the holder of the contract experiences a financial loss from a debtor’s failure to make a payment when due. A related consideration when determining whether an instrument must be accounted for as a derivative is the exemption for so-called regular way transactions. Therefore. ■ ■ 2. All rights reserved. is considered a derivative that is within the scope of IAS 39.2. An option is considered to be settled upon exercise or at its maturity.3 2. 17 . an option has a future exercise date and interest rate swaps have several dates on which interest is settled. KPMG International provides no services to clients. Each member firm is a separate and independent legal entity and each describes itself as such. To be excluded from IAS 39. Some contracts that are labelled as financial guarantees provide for a payment to be made if events other than an actual financial loss occur. A contract triggered by a change in an underlying rate or index.IFRS Financial Instruments Accounting March 2004 Reference IG B. Derivatives are often used to hedge the risks related to other financial and non-financial assets and liabilities. 2.5 ■ In the reverse situation.) is not an important factor when determining whether IAS 39 is applicable.g.2(f) Financial guarantee contracts and credit derivatives Financial guarantee contracts where a payment is made if a debtor fails to make payment when due are outside the scope of IAS 39.2.3 Settlement at a future date Derivatives require settlement at a future date. letter of credit. For instance in some standard credit default agreements.4 39.3. 2. which is the fair value of the related consideration given or received (Section 4). the swap is no longer a derivative instrument because the prepaid amount now provides a return that is the same as that of an amortising fixed rate debt instrument of the amount of the prepayment.2 Definitions relating to financial instruments © 2004 KPMG International. A forward contract is settled on a specified future date. the initial net investment equals that of other financial instruments with fixed annuities. derivative etc. Therefore. KPMG International is a Swiss cooperative of which all KPMG firms are members.g. guarantee. a payment is triggered if the debtor’s credit rating is downgraded below a specified level. ■ Derivatives should be recognised on an entity’s balance sheet. The form of the contract (e.2.3. Any contract where there is a time period between the trade date and the settlement date would be a derivative if the other criteria are also met.2. if a party to an interest rate swap transaction prepays its payvariable obligation at inception using current market rates. the option still meets the criteria of settlement at a future date. If specific hedging criteria are met. not leveraged). This topic is covered in Section 4. 39. This should be a pre-condition for payment under the contract.3. the derivative and the related item being hedged qualify for hedge accounting treatment (Sections 8 and 9).4 Summary of key concepts concerning derivatives There are several key concepts relating to derivatives which are considered in detail in later Sections. even though the option may not be expected to be exercised when it is out-of-the-money. The amount of the payment should be proportional to that loss (e. Derivatives are thereafter measured at their fair value at each reporting date with changes recognised in the income statement (Section 6).

18 2. Entity B also enters into a guarantee contract issued by Bank A that is triggered by the default of designated payments of Entity C to Entity B.5 Embedded derivatives A non-derivative financial instrument can have certain characteristics that cause it to behave like a derivative. Such instruments are initially measured at fair value and subsequently measured at the higher of the amount initially recognised (less amounts recognised as revenue under IAS 18) and the provision that would be required under IAS 37. This contract would be accounted for as a financial guarantee. Each member firm is a separate and independent legal entity and each describes itself as such. All rights reserved. and accounted for as a stand-alone derivative. .IFRS Financial Instruments Accounting March 2004 Reference 39.2 Definitions relating to financial instruments © 2004 KPMG International. December 2003 amendments 39. This is the case for both the holder and the issuer of the guarantee contract.2(f) The distinction between financial guarantee contracts and credit derivatives remains as described above. An embedded derivative must be evaluated to determine whether it must be separated from the financial instrument.2. Section 3 is devoted to this topic.2(f) Entity B makes a loan to Entity C.2(f) To be excluded from IAS 39. both in the financial statements of Bank A (issuer) and Entity B (holder). Because Entity B is not exposed to a risk of financial loss (only Entity D has this risk) the contract is a derivative. KPMG International is a Swiss cooperative of which all KPMG firms are members.1 Guarantee contract versus credit derivative 39. However. the contract should be accounted for as a derivative in the financial statements of Bank A and Entity B. the holder of the financial guarantee contract must be the party that is exposed to the risk of loss from the debtor’s failure to make payment.3 39.2 Guarantee contract held by a third party A guarantee contract issued by Bank A to Entity B is triggered by the default of designated payments by Entity C to Entity D. not a derivative. The amendments provide additional guidance on the initial and subsequent measurement of issued financial guarantee contracts and loan commitments that are excluded from the scope of the standard. KPMG International provides no services to clients. Case 2. Case 2. in the financial statements of Bank A and Entity B. assume the same structure is in place except that Bank A will make payments to Entity B based on a change of the credit rating of Entity C. In such a case. 2. That is because the event of default merely acts as the underlying variable in a derivative contract. A guarantee must be treated as a derivative if the holder of the contract is not the party exposed to risk of loss.

3 Financial risks Risk can be viewed as uncertainty in cash flows. KPMG International is a Swiss cooperative of which all KPMG firms are members. Essentially hedging means matching the characteristics of incoming and outgoing cash flows in such a way that the effects of changes in market prices or rates are reduced or have no impact on the future net cash flows for the entity and therefore have no impact on the income or value of the entity. Sections 8 and 9 are devoted to hedge accounting topics. Each member firm is a separate and independent legal entity and each describes itself as such. 2.IFRS Financial Instruments Accounting March 2004 Reference 2. The following are financial risks that are related to financial instruments: 32. The distinction between economic financial risk management and hedge accounting is important to understand. The use of hedge accounting is restricted under IAS 39 and can be costly to achieve. Credit risk – the risk that one party to a financial instrument will fail to discharge an obligation and cause the other party to incur a financial loss. not all economic financial risk management practices will qualify for hedge accounting. The use of hedge accounting allows an entity to reflect the economics of a hedge relationship in the financial statements by matching offsetting gains and losses in the income statement in the same reporting period. or by general market conditions.52 Interest rate risk – the risk that future changes in prevailing interest rates will affect the fair value or cash flows of a financial right or obligation. KPMG International provides no services to clients. However. A common strategy in risk management is hedging. The uncertainty in cash flows influences the fair value of recognised assets and liabilities or the level of cash flows relating to future transactions. which may result in a loss being incurred because a position cannot be liquidated quickly at close to its fair value. Liquidity risk – the risk that an entity will encounter difficulty in raising funds to meet commitments.3 Financial risks © 2004 KPMG International. Market risk (also referred to as commodity or price risk) – the risk that the fair value or cash flows of an instrument will be affected by factors specific to the particular instrument or to the issuer of the instrument. Currency risk (also referred to as foreign exchange (FX) rate risk) – the risk that changes in foreign exchange rates will affect the fair value or cash flows of a recognised financial instrument. All rights reserved. where risks that an entity faces are reduced or eliminated by entering into transactions that give an offsetting risk profile. An example of this is the risk of price changes of an equity instrument. An entity may reduce its exposure to credit risk through policy measures such as imposing credit limitations or requiring collateral from counterparties. or the fair value of that right or obligation. firm commitment or forecasted transaction. or it may use credit derivatives. 19 . Changes in market interest rates may affect an entity’s right to receive or obligation to pay cash or another financial instrument at a future date.

KPMG International provides no services to clients.1 Overview © 2004 KPMG International. Reference 39. be a financial instrument.2 later in this Section. All rights reserved. Such derivatives could be attached at inception or at a later stage by a party to the contract or by a third party. a lease. If the combined instrument is carried at fair value with changes in fair value recognised in the income statement. An embedded derivative is one or more implicit or explicit terms in a contract that affect the cash flows of the contract in a manner similar to a stand-alone derivative instrument. whatever the form.10 39. a royalty agreement or a franchise agreement.IFRS Financial Instruments Accounting March 2004 3.11 20 3. Each member firm is a separate and independent legal entity and each describes itself as such. and to prevent entities from circumventing the requirement to measure derivatives at their fair value in the balance sheet. If a contract or set of contracts contains derivative features that may be transferred separately. 39.10 39. an insurance contract.1 and in Table 3. then it may not be separated. separate accounting is not necessary. a purchase agreement. a construction contract. nor is it permitted. The process of reviewing a range of contracts to identify those that might contain embedded derivatives is an important and time-consuming aspect of IAS 39. as shown in the decision tree in Figure 3. The standards include detailed examples of host contracts and derivatives that require separation and those that do not. these are not considered to be embedded derivatives. a service agreement. A host contract may. An embedded derivative that meets the definition must be separated from its host contract and measured as if it were a stand-alone derivative if its economic characteristics are not closely related to those of the host contract.1 Overview Derivatives are typically stand-alone instruments. Embedded derivatives Key topics covered in this Section: ■ ■ ■ What are embedded derivatives Distinguishing characteristics Separate accounting 3. The component that is a derivative instrument is referred to as an embedded derivative.10 and 11 If an embedded derivative is separated. but rather freestanding derivatives. KPMG International is a Swiss cooperative of which all KPMG firms are members. Determining whether an embedded derivative should be accounted for separately can be a complex process. the host contract is accounted for under IAS 39 if it is itself a financial instrument. or in accordance with other appropriate IFRS if it is not a financial instrument. but they may also be found as components embedded in a financial instrument or in a non-financial contract. This is intended to achieve consistent treatment of transactions of similar substance. If the economic characteristics of an embedded derivative are closely related to those of the host contract. . for example.

in respect of each purchase. 3. For example. avoid the complexity of separating and measuring embedded derivatives by measuring the entire instrument at fair value through profit or loss. It may be simpler for the entity to determine a fair value for the instrument as a whole than separately for the embedded derivative components. the equity call option embedded in an availablefor-sale investment in a convertible bond would be separated and measured at fair value (if changes in the value of available-for-sale assets were recognised in equity. Each member firm is a separate and independent legal entity and each describes itself as such. equity prices. If the convertible is listed. All rights reserved. to designate the instrument on initial recognition as ‘fair value through profit or loss’. Another example may be a complex investment product issued by a bank or insurer that contains a host deposit contract and a number of embedded derivatives based on interest rates. origination or issue of a financial instrument. thereby avoiding the need separately to value and account for the option.1 Overview © 2004 KPMG International. it will be simpler for the entity to designate the entire bond as fair value through profit or loss and measure it at its market price. as permitted by the previous standard as an accounting policy choice).IFRS Financial Instruments Accounting March 2004 Reference Figure 3. prior to the amendments. KPMG International is a Swiss cooperative of which all KPMG firms are members. 21 . etc. therefore. An entity may. KPMG International provides no services to clients.1 Decision tree for hybrid financial instruments December 2003 amendments 39.9 One of the amendments will be to introduce a choice.

■ expectations of future interest rates and inflation (forward rates). In certain circumstances the currency of cash flows generated by committed future sales and purchases of an entity may differ from the reporting or measurement currency of either the supplier or the customer. mortality). Table 3. Entity A should account for the supply contract as the host contract in Euro with an embedded foreign currency forward. and ■ actuarial assumptions (e. Changes in fair value of the foreign currency component of the contract should be included in the income statement (unless hedge accounting can be applied). either positively or negatively. 39. and ■ the currency in which payment is denominated. and ■ revenues generated from the leased asset (e.1 Key characteristics of common host contracts Host contract Debt contract Key characteristics The value of a debt contract is driven by the interest rates associated with the contract. ■ inflation rates. The table below outlines the key characteristics of common host contracts. ■ Contracts for goods and services 39. Leverage in this context (for contracts other than options) means that the value of the hybrid instrument changes in proportion to the underlying by more than 100 per cent. ■ inflation rates.g. ■ interest rates.g. The value of an insurance contract is dependent on: level of future premiums. KPMG International provides no services to clients. and sells goods or services to Asia priced in USD. ■ credit risk (specific and sector spread). ■ Equity contract Insurance contract Lease contract The value of a lease contract is dependent on: ■ inflation rates. . lease rentals). KPMG International is a Swiss cooperative of which all KPMG firms are members. expected claims.2 Economic characteristics and risks © 2004 KPMG International.2 39. For example.AG33 22 3. and ■ expected liquidity / maturity.AG33 Any feature that leverages the exposure of the host contract to more than an insignificant extent constitutes an embedded derivative that must be separated. Each member firm is a separate and independent legal entity and each describes itself as such.AG30 and 33 Economic characteristics and risks IAS 39 sets out examples of when the characteristics and risks are and when they are not closely related. Such contracts are likely to contain embedded derivatives which should be accounted for separately. which comprise the factors of: ■ risk-free interest rate. All rights reserved. Entity A has Euro as its measurement currency. The value of supply contracts is dependent on: the price of the goods or services sold.IFRS Financial Instruments Accounting March 2004 Reference 3. ■ interest rates. The value of an equity contract is associated with the underlying equity price or index.

IFRS Financial Instruments Accounting March 2004 Reference 39.12 are clearly present in the hybrid instrument as evidenced by the contractual terms and the economic substance of the hybrid instrument. at a minimum.3 Separation of the embedded derivative © 2004 KPMG International.2. embedded derivatives that are not presented separately in the balance sheet should be disclosed. December 2003 amendments As noted above and in Table 3. 3. Therefore.3 Separation of the embedded derivative An embedded derivative that meets all of the criteria needs to be accounted for separately from its host. ‘Routinely denominated’ is interpreted extremely narrowly.11 39. 39. an entity is required to disclose separately its financial instruments carried at cost and those carried at fair value. In the case of multiple embedded derivative components the embedded derivatives are only separated individually if they: ■ 39. the Asian country in which it is sold. KPMG International provides no services to clients. relate to different risk exposures. the entire combined contract (host and embedded derivative) is to be treated as a financial instrument held for trading.AG30 and 33 IAS 39 also provides examples of when the economic characteristics and risks of an embedded derivative are and are not considered to be closely related to the host contract. KPMG International is a Swiss cooperative of which all KPMG firms are members. and are readily separable and independent of each other. Under the existing standard. for example. Where no separation is required. If an embedded derivative cannot be measured reliably although the characteristics are such that separation would be required.2 presents examples of typical host contracts and embedded derivative components. Table 3. However. the embedded derivative would not be separated as long as Entity A can demonstrate that it is common for this type of product or service to be priced in USD in. a committed purchase or sales contract in a foreign currency contains an embedded derivative. All rights reserved. IAS 39 does not require separate presentation of embedded derivatives in the balance sheet.AG33(f) The amendments introduce a further exemption. ■ ■ 3. In the example above. that embedded derivative must be separated unless the currency of the contract is the functional currency of another party to the contract or is the currency in which the product is routinely denominated in international commerce. that the embedded derivative should not be separated if the contract requires payment in a currency that is commonly used in contracts in that economic environment. This is followed by a list of features of the derivative component that are considered to be closely related and those that are not. this assumes there is no leverage nor inverse leverage. so that an oil transaction denominated in USD is one of the few transactions that qualifies for this exemption. 23 . Each member firm is a separate and independent legal entity and each describes itself as such.

When interest or principal payments are dependent on principal payments Commodity-linked or Never closely related to a debt host contract. therefore. When interest or principal payments are dependent on commodity prices or other non-financial assets (indexed). Option or automatic When the option to extend the maturity is made at prevailing market provision to terms at the time of the extension.Debt 24 Features closely related (no separation) (separation required) Table 3. Equity kicker Never closely related to a debt host contract. or when the exercise price results in a significant gain or loss.3 Separation of the embedded derivative © 2004 KPMG International. When a subordinated loan entitles the grantor of the loan to receive shares of the borrowing entity for free or at a very low price. When exercisable for other than the accreted or amortised amount of the debt. such as when final maturity debt is issued or purchased at an insignificant discount or premium. the conversion option must be accounted for separately. Equity conversion feature Never closely related to a debt host contract. KPMG International provides no services to clients. IFRS Financial Instruments Accounting March 2004 1 Interest rates of a debt instrument and the changes in fair value of an equity instrument are not closely related. Never closely related to a debt host contract. 1 When the option or automatic provision to extend the maturity is on terms which differ from market terms at the time of extension. All rights reserved. Each member firm is a separate and independent legal entity and each describes itself as such. . other non-financial- indexed interest or principal payments When the debt instrument may be converted to equity shares of the issuer or another entity.2 Host contracts and embedded derivative components Features not closely related Type of host contract Type of embedded derivative component Instrument Instrument Equity-linked interest or equity prices (indexed). 3. KPMG International is a Swiss cooperative of which all KPMG firms are members. extend maturity Call or put option to When exercisable at the accreted or amortised amount or when the exercise repay before price of the option does not result in a significant gain or loss.

Each member firm is a separate and independent legal entity and each describes itself as such.e. or the issuer would pay more than twice the market rate at inception. Interest caps and floors When the embedded cap or floor is at or out-of-the money at the time of issue.2 Host contracts and embedded derivative components (continued) Features closely related (no separation) (separation required) Type of host contract Type of embedded derivative component Features not closely related Instrument Instrument Credit derivative item other than the debt instrument itself. When the embedded cap is below the market rate of interest (in-the-money cap) or the floor is above the market rate of interest (in-the-money floor) at the time of issue. or the issuer would not pay more than twice the market rate at inception. the exercise interest rate of the cap is at or above market rates 3. . Foreign currency currency. ■ When the indexing relates to future interest or inflation. Foreign currency gains and losses are accounted for under IAS 21. Determination of these limits involves the estimation of future movements in the relevant indices. interest payments economic environment in which the debt is denominated. When the indexing is not in a one-to-one proportion to the debt. As objective indications of future movements are generally not available it would IFRS Financial Instruments Accounting March 2004 25 be relevant to apply historic movements for this purpose. this also applies when the contract permits. Index-linked the holder of the instrument would recover substantially all of its recorded investment. There should be a high expectation at inception that these limits will not be exceeded.Table 3. significantly leveraged through a different notional reference or a significant inverse relation to the market rate.3 Separation of the embedded derivative and the floor is at or below market rates. KPMG International is a Swiss cooperative of which all KPMG firms are members. When a foreign currency option is included on debt repayment. Debt Inflation-indexed When the inflation index is one commonly used for this purpose in the When the inflation index relates to a different economic environment or the index is not one that is commonly used for this purpose. but does not require that not all of the recorded investment is recovered. resulting in a (floating) rates situation where: of interest ■ ■ the holder of the instrument would not recover substantially all of its recorded investment. All rights reserved. or When cash flows are denominated in a foreign currency and: either the principal and interest are denominated in the same foreign the principal and interest are denominated in different foreign currencies. resulting in a situation where: ■ When the payments depend on the credit risk of the issuer of the debt When the payments depend on the credit risk of a reference instrument itself. KPMG International provides no services to clients. for example. debt instruments ■ ■ © 2004 KPMG International. 2 The assessment of the effect of these features should be made when the contract is entered into.2 From the holder’s perspective. i.

or the index is unrelated to inflation in the lease payments provided that the indexing is not significantly leveraged and that the index relates to inflation in an economic environment that is relevant to the lease contract. that contract operates (measurement currency). Each member firm is a separate and independent legal entity and each describes itself as such. When lease payments are adjusted based on an inflation-related index. Always separated when held by an entity.3 Separation of the embedded derivative © 2004 KPMG International.Equity (held by an entity) Lease 26 Features closely related (no separation) (separation required) Table 3. or indices that are closely related to the lease. IFRS Financial Instruments Accounting March 2004 . ■ Foreign currency component When rentals are denominated in a foreign currency that is the currency When rentals are not denominated in a foreign currency that is the currency of the primary economic environment in which any substantial party to that contract operates (measurement currency). of the primary economic environment in which any substantial party to 3.2 Host contracts and embedded derivative components (continued) Features not closely related Type of host contract Type of embedded derivative component Instrument Instrument Equity call and Never closely related to a host contract. When contingent rentals are based on: ■ leveraged sales or variable interest rates. or indices that are not closely related to the lease. put options Inflation-indexed entity’s own economic environment. All rights reserved. When lease payments are adjusted according to a leveraged inflation index. When contingent rentals are based on: ■ ■ Contingent rentals related sales or variable interest rates. KPMG International provides no services to clients. KPMG International is a Swiss cooperative of which all KPMG firms are members.

All rights reserved.3 Separation of the embedded derivative © 2004 KPMG International. KPMG International provides no services to clients.g. unrelated to the price of the purchased or sold goods or services). range (a collar) put is at or below market rates at the time the contract is entered into. resulting in a price i. the exercise price of the call is at or above market rates and of the 3. IFRS Financial Instruments Accounting March 2004 27 3 Note that: ‘Routinely denominated’ is very narrowly defined.e. .g. related to the price of the purchased to indices or sold goods or services). KPMG International is a Swiss cooperative of which all KPMG firms are members. Commercial contracts (purchase. Price clauses When commercial contracts are based on prices or indices that are When commercial contracts are based on prices or indices unrelated to the contract (e.2 Host contracts and embedded derivative components (continued) Features closely related (no separation) (separation required) Type of host contract Type of embedded derivative component Features not closely related Instrument Instrument Foreign currency component When commercial contracts require payment denominated in a currency that is not: ■ When a commercial contract involves payment for goods or services that is the currency of the primary economic environment in which any substantial party to that contract operates (measurement currency). option. related closely related to the contract (e.Table 3. or (measurement currency). When the purchased call and written put are in-the-money at the time the contract is entered into. not just in one local area. sale) Combination of call and put When the purchased call and the written put are at or out-of-the money. Each member firm is a separate and independent legal entity and each describes itself as such. It is only a currency that is used for similar transactions all around the world.3 the currency in which the price of the related good or service that is acquired or delivered is routinely denominated in international commerce worldwide. and ■ denominated in a foreign currency: ■ the currency of the primary economic environment in which any substantial party to that contract operates ■ that is the currency in which the price of the related good or service that is acquired or delivered is routinely denominated in international commerce worldwide.

3.AG33 39.AG28 and 32. 39. through quoted market prices) than for the derivative component.2 Designating embedded derivatives as hedging instruments Embedded derivatives that are accounted for separately may be designated as hedging instruments. All rights reserved. However. if a debt instrument has a principal amount related to an equity index and that amount doubles if the equity index exceeds a certain level.g.2 28 3.3. For example. separation is not optional. the embedded derivative must be valued based on terms that are clearly present in the hybrid instrument. Each member firm is a separate and independent legal entity and each describes itself as such. multiple embedded derivatives should not be separated individually.1 How to split fair values at initial recognition As the derivative component is measured separately at fair value upon initial recognition. When separating an embedded feature that is an option. IAS 39 does not permit an entity to separate the hybrid instrument.IFRS Financial Instruments Accounting March 2004 Reference In many cases. the carrying amount of the host contract at initial recognition is the difference between the cost of the hybrid instrument and the fair value of the embedded derivative. 39. for example.3. the separation should be based on the stated terms of the option feature documented in the hybrid instrument. This means that the forward price should be at market rates. it may be acceptable to use those values to determine the fair value of the derivative upon initial recognition. If an embedded derivative is not required to be separated. . two options that give the holder a right to choose both the interest rate index on which interest payments are determined and the currency in which the principal is repaid. those two options may qualify for separation as two separate embedded derivatives as they relate to different risk exposures and are readily separable and independent of each other. it is not appropriate to separate both a forward and an option on the equity index because those derivative features relate to the same risk exposure.1 and C. Instead the forward and the option elements are treated as a single compound embedded derivative. When separating an instrument that is a forward. KPMG International provides no services to clients. the forward price is set such that the fair value of the embedded derivative is zero at the inception of the contract.AG29 On the other hand.31 IG C. KPMG International is a Swiss cooperative of which all KPMG firms are members. In other words.3 Separation of the embedded derivative © 2004 KPMG International. if a hybrid debt instrument contains. The normal hedge accounting criteria as outlined in Section 8 apply to embedded derivatives used as hedging instruments. 3. As a result the embedded derivative would not necessarily have a fair value or intrinsic value equal to zero at the initial recognition of the hybrid instrument. Where more reliable fair values exist for the hybrid instrument and the host contract (e.

43 and 39. then an estimate of future cash payments or receipts.e. parts of that instrument can be retained or new instruments may need to be recognised. a financial instrument is included in the balance sheet at cost.AG64 29 . the initial carrying amount of the loan is not the amount lent. KPMG International provides no services to clients.2 Initial measurement © 2004 KPMG International. its obligation. An instrument is recognised in the balance sheet when the entity becomes party to a contract that comprises a financial instrument. The consideration given or received is normally the transaction price or the market price.2 Initial measurement At initial measurement. For financial liabilities derecognition depends on whether an entity has settled. All rights reserved. discounted using the current market interest rate for a similar financial instrument. There are specific rules governing when an entity may remove financial assets and financial liabilities from its balance sheet. It can also be the fair value of financial instruments (other than cash) given or received in exchange for the financial instrument to be recognised. For financial assets these rules are based on whether an entity has given up control over the contractual rights of the financial asset. the cost amount given by the bank (which recognises an asset) and the amount received by the customer (which recognises a liability) is often interpreted to be the cash transferred. Reference 39. should be used to approximate the fair value. but 4. This same issue often arises in relation to low or no interest inter-company loans or inter-company current accounts. If a bank makes a low interest or interest-free loan to a customer. If the transaction is not based on market terms. which should equal its fair value. Recognition and derecognition Key topics covered in this Section: ■ ■ ■ ■ ■ Initial measurement Transaction costs Recognition Trade date versus settlement date accounting Derecognition of: – financial assets – financial liabilities ■ Issues relating to special purpose entities 4. or if a market price cannot be readily determined. i. 4.1 Overview An entity must consider both the amount to be recognised as well as the timing of recognition. KPMG International is a Swiss cooperative of which all KPMG firms are members.14 39. the consideration given or received. In both situations when derecognising a financial instrument.AG64 39. In both cases. Each member firm is a separate and independent legal entity and each describes itself as such.IFRS Financial Instruments Accounting March 2004 4. or has been legally relieved of.

advisers. 30 . Transaction costs do not include internal financing. The interest rate on the loan is four per cent.IFRS Financial Instruments Accounting March 2004 Reference rather the fair value of the consideration given to obtain the right to payment in the future. but both internal and external costs must be incremental. The difference is not a financial asset. A low interest or interest-free loan discounted at a market rate of interest results in a present value that is less than the amount lent. Transaction costs may include internal costs.AG13 Transaction costs Transaction costs are included in the initial measurement of financial assets and liabilities. but for equity instruments they are recognised only at the time of sale. The treatment of transaction costs after initial recognition depends on the subsequent measurement of the instrument of which they are a part: ■ IG E. for financial assets that are carried at fair value with changes in fair value recognised in the income statement.1 Low interest loan Bank Q grants a three-year loan of 50. if this difference qualifies for recognition under another applicable IFRS (e. Bank Q believes that the future business to be generated with this new customer will lead to a profitable lending relationship. for financial assets carried at cost. Case 4. nor do they include debt premiums or discounts.2 Initial measurement © 2004 KPMG International. the transaction costs are recognised in the income statement at the time of sale. such as fees and commissions paid to agents.672 is expensed immediately as the expectation about future lending relationships does not qualify for recognition as an intangible asset. holding and administrative costs. 4. the transaction costs are expensed upon subsequent measurement. ■ ■ ■ 39. and transfer taxes and duties.1 for financial assets and liabilities that are carried at amortised cost. All rights reserved.1. brokers and dealers.1 39. while the current market lending rates for similar loans to customers with a similar credit risk profile is six per cent. the transaction costs for debt instruments are amortised to the income statement as part of the recognition of the effective interest on such instruments.328. KPMG International provides no services to clients. and for financial assets that are carried at fair value with changes in fair value recognised directly in equity. If the difference does not qualify for recognition. On initial recognition Bank Q should recognise the carrying amount of the loan as the fair value of the payments that it will receive from the customer. The difference of 2. it must be expensed. Discounting the interest and principal repayments using the market rate of six per cent.g.2. a recognisable intangible benefit) then it is recognised as an asset.000 to an important new customer. incurred or expected to be incurred at a subsequent date related to the transfer or disposal of a financial instrument. KPMG International is a Swiss cooperative of which all KPMG firms are members. but with no set maturity.46 Transaction costs. as well as levies paid to regulatory agencies and securities exchanges. Each member firm is a separate and independent legal entity and each describes itself as such. Transaction costs that are included in the initial measurement are those costs paid to external parties. These may be incurred when an entity enters into a contractual arrangement. should not be considered in the subsequent 4. the transaction costs are amortised to the income statement as part of the recognition of the effective interest. However. Bank Q will recognise an originated loan of 47.

A regular way contract may be a purchase or a sale that requires delivery of assets within a period of time generally 4. . it becomes a party to the contractual provisions of the instrument. In practice. The requirement is also applied on an instrument-by-instrument basis.AG12 Because of the short duration between the trade date and the settlement date in these types of regulated market situations. KPMG International is a Swiss cooperative of which all KPMG firms are members.AG35 39. KPMG International provides no services to clients. Incremental costs are those that would not have been incurred if the instrument had not been acquired. All rights reserved. Disposal costs are only included in the income statement when a financial instrument is derecognised.43 The amended standards specify more clearly that the amount at which a financial asset or liability is recognised initially is its fair value plus.3. few internal costs are likely to meet this requirement. in the case of a financial asset or financial liability that is not at fair value through profit or loss. instead they are charged immediately to the income statement.2 Trade date versus settlement date accounting The trade date is the date an entity enters into a contract for the purchase or sale of an asset.AG55 and 56 39. transaction costs. an entity’s estimated but uncommitted sales do not qualify as financial assets or liabilities. However. Each member firm is a separate and independent legal entity and each describes itself as such. It will not. The amended standards confirm that transaction costs must be incremental and directly attributable to the acquisition. 4.3. planned but not committed future transactions.9 39. issue or disposal of an instrument.3 4. Transaction costs on financial instruments measured at fair value through profit or loss are not included in the amount at which the instrument is measured initially. no matter how likely. 39. Situations where an entity has become a party to contractual provisions include committing to a purchase of securities or committing to write a derivative option.1 Recognition When to recognise An enterprise should recognise a financial asset or liability in its balance sheet when. The recognition principle in IAS 39 would result in all transactions that occur in regulated markets to be accounted for on the trade date. In contrast. December 2003 amendments 39. 4. and only when. such regular way contracts are not recognised as derivative contracts under IAS 39.43 39. the standard recognises that practice by many financial institutions and corporates is to use settlement date accounting. are not financial assets or liabilities as they do not represent situations where the entity becomes a party to a contract requiring future receipt or delivery of assets.3 Recognition 31 © 2004 KPMG International. For example. and that it would be cumbersome to account for such transactions as derivatives between the trade and settlement date. be permitted to treat as transaction costs the internal costs associated with developing a new investment product. The settlement date is the date that the financial instrument is delivered to or transferred from the entity. issued or disposed of. for example.IFRS Financial Instruments Accounting March 2004 Reference measurement of the financial instrument.14 39.

3 Recognition © 2004 KPMG International. an entity may choose either trade date or settlement date accounting. However. All rights reserved. For example. Rather. where the constraints in the marketplace prevent immediate settlement at the trade or commitment date. IG B. What would be the impact on the balance sheet of the bond purchase at each of the dates of 28 June.30 recognised to be the market convention or established by regulation in the marketplace in which the transaction actually takes place. the term ‘marketplace’ means the environment in which the financial asset is customarily traded. organised over-the-counter market. The approach should be applied consistently for both purchases and sales of the different categories of financial assets. Under trade date accounting. In the case of a sale under settlement date accounting the opposite occurs: changes in the fair value after the trade date are not taken into account. a formal stock exchange. Therefore. therefore the general recognition and derecognition requirements apply. AG53 and IG B. The example illustrates initial measurement of the bond purchase under two scenarios: (1) a bond subsequently carried at fair value and (2) a bond subsequently carried at amortised cost. This exception is a practical approach taken in IAS 39 to prevent the recognition of derivatives in many situations.0 million and the fair value remains as 10.1 million. the asset is recognised on the actual date of settlement. it is not required that an organised market exists (e.38. The regular way exception requires that the transaction will be fulfilled through actual delivery of the financial instrument. the fair value of the bond is 10. There are no specific requirements about trade date and settlement date accounting in respect of financial liabilities.1 million. Each member firm is a separate and independent legal entity and each describes itself as such. the bond purchase is settled for 10. the asset to be received and related obligation to pay for it are recognised on the date the contract is entered into.AG54 39. If settlement date accounting is chosen. . a commitment for a three-month settlement (assuming that this is not the norm in the marketplace of these instruments) for the same security transaction would meet the definition of a derivative because it is not considered to be a regular way transaction. and for very short periods. KPMG International provides no services to clients. 30 June and 1 July? The balance sheet impact is shown below for both the settlement date approach and the trade date approach. making subsequent changes in fair value irrelevant from the seller’s perspective. In the case of a purchase under settlement date accounting. a commitment for a standard three-day settlement (assumed to be the norm for a particular marketplace) of a security purchase transaction would not be treated as a derivative as this is a regular way transaction. etc). On 30 June 20X1. i.g.e. When accounting for regular way purchases and sales of a financial asset. Entity X agrees to purchase a bond for settlement on 1 July 20X1.29 39.28 IG B.IFRS Financial Instruments Accounting March 2004 Reference IG B. KPMG International is a Swiss cooperative of which all KPMG firms are members.0 million.32 39. changes in the fair value of the financial instrument between the date of trade and settlement should be recognised if the financial instrument is carried at fair value. The purchase price of the bond is 10. On 1 July.57 32 4. the date that the instruments are exchanged. Case 4. comparing trade date and settlement date accounting On 28 June 20X1. if a contract allows for or requires net cash settlement it does not qualify as a regular way contract.2 Purchase of a bond. In order for a financial asset purchase to be regular way. as there is a set sale price agreed upon at the trade date.

1 – – (0. the use of trade date accounting versus settlement date accounting could have a significant temporary impact on the balance sheet of an entity. Each member firm is a separate and independent legal entity and each describes itself as such.1 (10. with a settlement date of 1 December 20X1.0) (0. However.0 (10. All rights reserved.3 Sale of a bond.IFRS Financial Instruments Accounting March 2004 Reference IG D.5 million. KPMG International provides no services to clients. Case 4. depending on the classification of the bond.0) 10. 33 . the effect on the income statement and on equity is the same under settlement date and trade date accounting for purchases.1) – 10. On 30 November 20X1.6 million. KPMG International is a Swiss cooperative of which all KPMG firms are members.0) (0.1 (10.2. the bond is worth 9.3 Recognition © 2004 KPMG International.0) – – 10.e. What would be the impact on the balance sheet of the bond sale at 28 November.6 million and the fair value of the bond is still 9.5 million. 30 November and 1 December? 4. retained earnings) or directly in equity. comparing trade date and settlement date accounting On 28 November 20X1.0 (10.0) 0. On 1 December 20X1.1 (10.0) – – 10.1) – – – – – 10.1) – 10.0) (0.0) – This is recognised either in the income statement (i. its fair value at that date.1) – 10.0 (10. As noted in the example.1 Settlement date accounting (amounts in millions) Fair value Amortised cost Trade date accounting Fair value Amortised cost 28 June 20X1 Financial asset-bond Financial liability 30 June 20X1 Financial asset-receivable (revaluation gain) Financial asset-bond Financial liability Equity 1 July 20X1 Financial asset-receivable (revaluation gain) Financial asset-bond Cash paid Equity a a – – – – 10. the bond is settled at a price of 9.0 (10. Entity X agrees to sell the bond for 9.0 (10.

IFRS Financial Instruments Accounting March 2004

Reference 39.AG56

Settlement date accounting (amounts in millions) Fair value Amortised cost

Trade date accounting Fair value Amortised cost

28 November 20X1 Financial asset-bond Financial asset-receivable Retained earnings b Equity c 30 November 20X1 Financial asset-bond Financial asset-receivable Retained earnings b Equity c 1 December 20X1 Cash Financial asset-bond Financial asset-receivable Retained earnings d
b

9.6 – – 0.4

10.0 – – –

– 9.6 0.4 –

– 9.6 0.4 –

9.6 – – 0.4

10.0 – – –

– 9.6 0.4 –

– 9.6 0.4 –

9.6 – – 0.4

9.6 – – 0.4

9.6 – – 0.4

9.6 – – 0.4

For trade date accounting the loss is recognised in the income statement (i.e. retained earnings) on the trade date.

c

For settlement date accounting the revaluation adjustment is recognised in equity until actual settlement, assuming fair value changes on this instrument are recognised in equity.

d

For both trade date and settlement date accounting the effect is ultimately the same (i.e. the loss is reflected in the income statement).

Despite the change in fair value of the bond between the trade date and settlement date, Entity X does not record the additional 0.1 million loss as it will receive 9.6 million on the settlement date from the purchaser. As can be seen above, when accounting for sales, the effect on equity, the presentation of the transaction in the income statement and in the balance sheet may be temporarily different under trade date versus settlement date accounting. 4.4 4.4.1
39.17 and AG36

Derecognition Derecognition of a financial asset Derecognition of a financial asset or a portion of a financial asset occurs under the current standards when, and only when, the entity loses control of the contractual rights that comprise the financial asset (or portion thereof). An entity loses control if it realises the rights to benefits specified in the contract, those rights expire or the entity surrenders those rights. The derecognition provisions in IAS 39 take a financial components approach. The financial components approach focuses on control of the financial assets or portions thereof that are transferred to another party. A transfer can be broken down into its various financial components, which are then recognised by the parties to the transfer that control those components. Examples of components of a financial asset are its cash flows from principal

34

4.4 Derecognition © 2004 KPMG International. KPMG International is a Swiss cooperative of which all KPMG firms are members. KPMG International provides no services to clients. Each member firm is a separate and independent legal entity and each describes itself as such. All rights reserved.

IFRS Financial Instruments Accounting March 2004

Reference

repayment and cash flows from interest coupons. These cash flows can be segregated and potentially transferred to other parties. Determining control over a financial asset under the current standards requires identifying the risks and benefits of the asset and evaluating which party has exposure to and / or benefits from these. Thus the principles in IAS 39 on derecognition are regarded as a mixed approach that on one hand uses a financial components approach and on the other hand employs a risks and rewards approach. Within IAS 39 there are several examples of situations where a transferor has not lost control of a transferred financial asset (or portion thereof) by retaining the risks and rewards related to such asset (or portion thereof). The examples are when:
39.AG51

The transferor has the right to reacquire the asset (or has a right of first refusal to purchase the asset) unless either (i) the reacquisition price is fair value; or (ii) the assets are readily obtainable in the market. The transferor is both entitled and obliged to repurchase or redeem the transferred asset on terms that effectively provide the transferee with a rate of return similar to that on a loan secured by the transferred asset. The transferor has retained substantially all of the risks and returns of ownership through a total return swap with the transferee (and the asset is not readily obtainable in the market). The transferor has retained substantially all of the risks of ownership through an unconditional put option on a transferred asset held by the transferee (and the asset is not readily obtainable).

39.AG51

39.20 and AG39-41

39.AG51

39.AG42-44

Both the position of the transferor and the position of the transferee must be considered. After transferring the assets, the transferor should not be able to sell or pledge the assets to another party and should not be able to use the cash flows generated by the assets for its own benefit. The transferor has generally not lost control unless the transferee has the ability to obtain the benefits of the transferred asset. Derecognition is not limited to the situations noted above. If, for example, neither the transferee nor the transferor has the right to sell or pledge a portfolio of loans (which often is the case when only a portion of the assets is transferred), the transferred portion of the loans may be derecognised if it is demonstrated that the transferee has the ability to obtain the benefits of its portion of the assets, that is to say, the transferee may sell or pledge its interests in its portion of the loans. December 2003 amendments

39.16 and 20

39.15-42

Derecognition requirements for assets have been significantly reworded and to an extent revised (although for certain transactions the resulting changes to the accounting are substantial). Elements of both the components / control, and risks and rewards, approaches are retained but a new ‘continuing involvement’ approach is introduced, resulting in partial derecognition in a number of more complex transactions where previously no derecognition would have been permitted. These are dealt with further in the Sections below.

4.4 Derecognition © 2004 KPMG International. KPMG International is a Swiss cooperative of which all KPMG firms are members. KPMG International provides no services to clients. Each member firm is a separate and independent legal entity and each describes itself as such. All rights reserved.

35

IFRS Financial Instruments Accounting March 2004

Reference

The amendments also clarify the requirements considerably by introducing a step-bystep approach to analysing transactions, thus placing the various steps to be taken in determining whether a transaction qualifies for derecognition in a mandatory hierarchy. In the existing standard it is often difficult to establish when one requirement takes precedence over another.
39.AG36

A decision tree outlining the new approach, with paragraph references to the revised IAS 39, is as follows:

36

4.4 Derecognition © 2004 KPMG International. KPMG International is a Swiss cooperative of which all KPMG firms are members. KPMG International provides no services to clients. Each member firm is a separate and independent legal entity and each describes itself as such. All rights reserved.

IFRS Financial Instruments Accounting March 2004

Reference

The steps involved in the analysis under the amended standard are, in summary: 1. What is the reporting entity? If the reporting entity is a group, the purpose of this step is to ensure, for example, that all controlled special purpose entities (SPEs) are consolidated before considering derecognition. Essentially there is no benefit in analysing whether an entity achieves derecognition when transferring financial assets to an SPE if the SPE is then consolidated under SIC–12 and only the group financial statements are prepared using IFRS. 2. Should the analysis be applied to a component of a financial asset or to the asset in its entirety? A component is permitted to be considered for derecognition separately only if it represents: (a) specifically identified contractual cash flows, such as a stream of interest-only or principal only cash flows; (b) a fully proportionate share of the cash flows from the asset, for example, 50 per cent of all the interest and principal payments received on a loan; or (c) a fully proportionate share of specifically identified contractual cash flows, for example, 30 per cent of the interest cash flows received on a bond. The analysis may be applied either to an individual asset or to a portfolio of similar assets. The remaining steps are then applied to the portfolio, asset or qualifying part or proportion identified in this step. This is referred to in the steps below as ‘the asset’. 3. Have the rights to the cash flows from the asset expired? This would be the case, for example, when a debt instrument has been repaid or a purchased option expires unexercised. If yes, the asset is derecognised. 4. Have the rights to the cash flows from the asset been transferred? This would apply in a legal sale of the asset, or a legal assignment of the rights to its cash flows. 5. If the entity has not transferred the rights to cash flows from the asset, has the entity assumed an obligation to ‘pass through’ the cash flows from the asset to another party? Does that pass-through meet all of the following conditions?

The entity has no obligation to pay amounts to the other party unless it collects equivalent amounts from the original asset; The entity is prohibited by the terms of the transfer contract from selling or pledging the original asset other than as security to the other party for the obligation to pay that party cash flows; and The entity has an obligation to remit any cash flows it collects on behalf of the other party without material delay. In addition, during any short period between collection by the entity and payment to the other party, the funds may not be reinvested other than in cash and cash equivalents (as defined by IAS 7 Cash Flow Statements) and any interest earned must be passed to the other party.

If there is neither a legal sale nor a qualifying pass-through arrangement, no derecognition is permitted. The transaction is treated as a secured borrowing.

4.4 Derecognition © 2004 KPMG International. KPMG International is a Swiss cooperative of which all KPMG firms are members. KPMG International provides no services to clients. Each member firm is a separate and independent legal entity and each describes itself as such. All rights reserved.

37

Alternatively.1. If the asset is measured at amortised cost. for example. In the examples given in the rest of this Section.5. 6. The asset remains on balance sheet to the extent of the maximum potential exposure and a corresponding liability is recognised. If the asset has been transferred. 7.1. The detailed requirements are complex. in a sale with a fixed price repurchase agreement or a sale with a total return swap. then control has been transferred and the asset is derecognised. to the variability in the amounts and timing of the net cash flows of the assets. or to a qualifying arrangement to pass through all cash flows with no further interest by the entity in any of the future economic outcomes from the asset.1 Evaluating the risks associated with a transferred asset For financial assets with relatively short maturities. If control has not been transferred.3 and in the securitisation example in Section 4. because the asset is listed and therefore the buyer could sell it and subsequently repurchase it if required. Have substantially all the risks and rewards been retained? This would be the case.4. under continuing involvement derecognition will be precluded to the extent of the amount which might become payable under the option or guarantee. 38 4. for example. 9. before and after the transfer. KPMG International provides no services to clients. have substantially all the risks and rewards been transferred? This would apply either to a clean sale with no ‘strings’ attached. Each member firm is a separate and independent legal entity and each describes itself as such. the only substantive risk to consider generally is credit risk. Control in this context means the practical ability to sell the asset. Essentially. If the asset has been transferred. KPMG International is a Swiss cooperative of which all KPMG firms are members. the outcomes under the amended standard are likely to be the same as under the existing standard unless otherwise stated. If the asset is measured at fair value.IFRS Financial Instruments Accounting March 2004 Reference The requirements for pass-through are considered further in Section 4. All rights reserved. In such cases. then the entity continues to recognise the asset to the extent of its continuing involvement. the asset is derecognised. but has retained control. If the buyer has an unfettered and practical ability to sell the asset. but substantially all its risks and rewards have been neither transferred nor retained (in other words. some risks and rewards are retained. either through a legal sale or a qualifying passthrough arrangement.4. has the entity transferred control of the asset? Examples would be a sale with a retained call option or a sale with a written put option. 4. the liability is measured at fair value. . The transfer of risks and rewards is evaluated by comparing the entity’s exposure. but the principle is that the net amount recognised for the asset and the liability reflects the entity’s remaining net potential maximum exposure to the asset. If the transferor retains the credit risk on short-term financial assets through a guarantee then derecognition would not be appropriate.4 Derecognition © 2004 KPMG International. 8. This concept has been introduced to deal with those circumstances where an entity has neither transferred nor retained substantially all the risks and rewards relating to the transferred asset. the corresponding liability is measured at amortised cost. no derecognition is permitted and the transaction is treated as a secured borrowing. and some are transferred). If yes. such as trade receivables. the asset is derecognised to the extent the entity has no continuing exposure to the asset. the continuing involvement may be in the form of an option or guarantee. If yes.

39 . In some repo transactions. the entity needs to transfer a significant exposure to loss from that substantive risk.AG49 39. Typically in a securities lending transaction. if the transferor cannot derecognise a financial asset then the transferee should not recognise the financial asset on its balance sheet. the transferee may substitute similar assets of equal fair value. if a transfer of credit risk (which is considered to be a substantive risk of the assets transferred) will only occur in a catastrophe or similar situation because historical losses are covered through a guarantee by the transferor. A securities lending transaction that requires the borrower to return the transferred financial asset at a later date and for a specified price would be accounted for in a similar way to that described above for repo transactions. Instead the transferee recognises a receivable from the transferor for the repayment of the cash proceeds or other consideration.4. the financial assets stay on the books of the transferor and a borrowing is recognised for the proceeds received from the transferee. In this situation. there is collateral given by the securities borrower / transferee to the securities lender / transferor. Each member firm is a separate and independent legal entity and each describes itself as such. The borrower recognises a receivable from the lender. In order for derecognition to be appropriate. 39. but not all. All rights reserved.1 39. Consequently. In such cases the sale and purchase are viewed as two separate transactions under IAS 39. For example.AG51(a-c) IG D. If cash is given as collateral and is not legally separated from the lender’s assets. 4. A risk of loss is considered to be significant when it is based on historical loss experience for an entity and considering the type of asset transferred. the seller should continue to recognise the financial assets and should not recognise the options. A wash sale may qualify for derecognition as long as there is not a contractual commitment to repurchase the assets sold. the lender recognises the cash and a payable to the borrower. of a risk that it considers to be a substantive risk of the transferred assets. Because only one entity can control a financial asset (or component thereof).2 39. If this occurs. The most common example of a collateralised borrowing is a standard repurchase (repo) transaction. The financial assets act as collateral for the transferee in the event of non-payment on the borrowing. where a seller transfers assets and agrees to repurchase the same assets at a later date and at a specified price. upon substitution the transferor derecognises the assets originally transferred and recognises the assets actually returned by the transferee.29 Transfer of a financial asset with no derecognition Transfers of financial assets that do not satisfy the conditions for derecognition are accounted for as collateralised borrowings. when returning transferred assets to the transferor. this is considered to be outside the range of likely loss outcomes. In other words.1. This would not be considered a transfer of a significant exposure to loss from credit risk.AG51(e) 4.1. in such cases. If derecognition is prevented due to the existence of a derivative (whether stand-alone or embedded in a contract).IFRS Financial Instruments Accounting March 2004 Reference An entity might transfer part. KPMG International provides no services to clients.4 Derecognition © 2004 KPMG International. derecognition would not be appropriate.AG50 39. KPMG International is a Swiss cooperative of which all KPMG firms are members. the derivative itself would not be recognised if recognising both the derivative and the borrowing result in double counting in the transferor’s balance sheet. A wash sale transaction is one where an entity purchases a financial asset either immediately before or after the sale of the same asset. Effectively the seller / transferor has a call option and the buyer / transferee has a put option on the transferred assets.

4. derecognition involves determining the legal contractual rights and obligations arising from a contract. then Step 7 in the new approach described on page 38 will result in the transaction being treated as a secured borrowing because substantially all the risks and rewards associated with the asset have been retained by the transferor. the liability is reduced and an impairment loss recognised if not previously recognised by the transferor.AG51(i) Entity A (the transferor) sells receivables to Entity B (the transferee). However. Using a financial components approach. Under the right of recourse. How should the transaction be accounted for? The transaction is accounted for by the transferor as a secured loan as it does not qualify for derecognition. the bank may be able to derecognise the loans. when market quotations do not exist. Each member firm is a separate and independent legal entity and each describes itself as such. KPMG International is a Swiss cooperative of which all KPMG firms are members. If uncollected receivables are returned to the transferor for cash.4 Derecognition © 2004 KPMG International. The liability is measured at amortised cost with an interest expense of 5. 28 and AG52 40 4. When determining fair value of the retained interest the best evidence is obtained by reference to a market quotation. the transferee is entitled to sell the receivables back to the transferor in the event of unfavourable changes in interest rates or the credit ratings of the underlying debtors.1. valuation models with inputs based on market information may generally be used. Consequently the transferor is regarded as having retained substantially all the risks of ownership of the receivables. In the rare 39. the transferor is obligated to compensate the transferee for the failure of the debtors to pay when due. For example. In addition to the recourse. The carrying amount of the asset sold is allocated between the part retained and the part sold. and recognising the retained components based on the fair values of the assets retained and the liabilities incurred.IFRS Financial Instruments Accounting March 2004 Reference Case 4. the transferor has granted the transferee a put option on the transferred assets allowing the transferee to sell the receivables back to the transferor in the event of actual credit losses and changes in underlying credit ratings or interest rates. which are due in six months and have a carrying value of 100.000 being recognised over the six-month period until maturity. The transferor continues to recognise the receivables as assets.16(a) 39. but retain the right to receive 50 per cent of the interest on the loans. This is because the transferor has retained substantially all of the risks associated with the assets. KPMG International provides no services to clients.4.4 Receivables sold with full recourse 39. but would recognise the value of the right to the 50 per cent of interest revenues as an asset. based on their relative fair values at the date of sale.27. All rights reserved.3 Derecognition of a part of a financial asset If an entity transfers less than all of the financial asset. The transferor recognises 95.000 as a liability.000 subject to full recourse. a bank may sell a portfolio of loans.000 are sold for a cash payment of 95. The receivables. December 2003 amendments Under the amended standards. Assuming the rights to all of the cash flows in the receivables are legally transferred. . Although the transferee has the ability to sell or pledge approximately the full value of the assets transferred. Cash received on the receivables by either the transferor or transferee reduces both the receivables and the liability. the result in this case remains unchanged.

KPMG International provides no services to clients. in doing so. Servicing generally involves activities such as collecting payments from debtors. This is done through a net present value calculation comparing the servicing fees to be received. and the entire carrying amount should be allocated to the part of the asset sold. Servicing contracts often are transferable.Fair value adjustment previously recorded in equity = Gain or loss on derecognition As shown in the formula. The latter would be only those cash flows that would not be lost upon termination or transfer of the servicing contract. remitting cash to the transferee. In this case. 39. If derecognition occurs. the asset should be measured at zero. the interest spread must be analysed to determine what portion should be allocated to a servicing asset (or liability) and what portion allocated to an interest-only strip receivable. the gain or loss is recognised based on the following formula: Proceeds received Carrying amount of the financial asset (or portion thereof) sold Fair value of any new financial liability (or portion thereof) assumed Service liability (if any) + Fair value of any new financial asset (or portion thereof) acquired +/. For example. KPMG International is a Swiss cooperative of which all KPMG firms are members. for which it receives a fee. if any.IFRS Financial Instruments Accounting March 2004 Reference circumstances where the fair value of the part of the asset that is retained cannot be reliably measured. For example. If the costs of servicing exceed the servicing fees to be received. If the servicing fees to be received will exceed the costs of servicing.4 Derecognition © 2004 KPMG International. Each member firm is a separate and independent legal entity and each describes itself as such. 39. creates a new financial asset or assumes a new financial liability. Servicing activity must be taken into account when an entity transfers financial assets to another party. which is removed from equity and recognised as part of the gain or loss in the income statement. All of these activities may occur without the debtor knowing that its receivable / loan has been transferred to a third party. a bank may sell a portfolio of loans but still act as the servicer of the portfolio. i). the transferee may find a new party to take over the servicing activity. 24 and AG45 The servicing fees to consider are only those cash flows that the servicer would lose upon termination or transfer of the servicing contract. 41 . by the transferor with the normal expected costs to perform these services. When the transferor has an obligation to perform servicing activities. the entity records a servicing asset. one component of the calculation of the gain or loss is any cumulative balance of revaluation gains and losses previously reported in equity.16(a. 4. the entity records a servicing liability. if a transferor retains an interest spread on transferred receivables and performs the servicing. All rights reserved. the entity should recognise the servicing rights as an asset or liability. the entity determines whether a servicing asset or a servicing liability should be recognised. providing reports to the transferee on the payment status of the transferred assets and performing collection activities for non-performing assets / debtors. meaning that if the entity does not adequately perform its servicing duties.24 and 25 There may also be instances when an entity transfers control of a financial asset and.

000 36. If the proceeds are less than the carrying amount sold. Each member firm is a separate and independent legal entity and each describes itself as such. Interest-only strip = 60.000 54.e. The sales proceeds received are 1.0% 3.000 60. and for a financial liability. the portfolio of loans) should be allocated between the part of the asset retained and the part sold.000.000 40. the initial carrying amounts: ■ ■ for a financial asset.0% 910. This calculation is based on the relative fair values of the assets.000.000.000.e. The loans in this portfolio yield a fixed 10 per cent rate of interest for their estimated lives of nine years.000. North Bank will be compensated for performing the servicing through a right to receive one half of the interest income not sold (i.000 1. should be such that no gain is recognised on the transaction. any excess proceeds over the carrying amount of the asset sold would be recognised as a liability in the balance sheet rather than recognised as a gain in the income statement.5 Transfer of a portfolio of loans North Bank originates mortgage loans in its normal course of business.e. All rights reserved. It then determines the fair value of the new assets to be as follows: Servicing asset = 40.6% 5. Case 4. The remaining 100 basis points (i.000. 100 of the 200 basis points).000 42 4. Percentage of total fair value Allocated carrying amount Fair value Loans sold Servicing asset Interest-only strip Total 1.000 91. one per cent) is considered to be an interest-only strip retained by North Bank. North Bank performs the following calculation to determine the allocated carrying amounts of each asset. KPMG International is a Swiss cooperative of which all KPMG firms are members. In this case. should be set at zero. The servicing asset’s fair value is calculated as the present value of expected future cash flows (i.4% 100. For this activity.000 plus the right to receive interest income of eight per cent. a loss should be recognised in the income statement immediately. North Bank will continue to service the loans. servicing fees less the cost of performing the servicing). KPMG International provides no services to clients. In order to preserve the relationships with bank customers.000. North Bank sells loans with principal of 1.IFRS Financial Instruments Accounting March 2004 Reference In the rare circumstance that a new financial asset is acquired or a new financial liability is assumed but cannot be measured reliably.4 Derecognition © 2004 KPMG International.100.000 1. North Bank enters into a transaction to sell a portfolio of loans to a third party. The carrying amount of the financial asset (in this case. .

being the principal element and 80 per cent of the interest cash flows. or both portions. Each member firm is a separate and independent legal entity and each describes itself as such. under the amended standard. 4. 43 . Those criteria are: ■ the entity has no obligation to pay cash flows to the buyer unless it collects equivalent cash flows on the transferred asset. the rights to cash flows from the assets have not expired as the mortgage loans still exist (Step 3) and so the next stage is to consider whether or not the legal rights to cash flows have been transferred (Step 4). the related proceeds will be treated as a secured borrowing.000.IFRS Financial Instruments Accounting March 2004 Reference North Bank records the sale transaction with the following journal entry: Debit 31 December 20X1 Proceeds on sale (cash or receivable) Interest-only strip Servicing asset Loans Gain on sale of loans Credit 1. In this case there is no SPE involved in the structure (Step 1). separately for the purposes of derecognition. The accounting would then be as described above under the previous IAS 39.000 1. there will be no derecognition of the respective portion. KPMG International provides no services to clients. then the transferred portion(s) will be derecognised as long as substantially all the risks and rewards of those components have been transferred (Step 6). the first test to be applied is whether the revised derecognition requirements should be applied to the transferred asset in its entirety or to separate portions (Step 2). The effect of the servicing arrangement is that the legal rights to cash flows have not been transferred and North Bank therefore needs to consider whether its obligation to collect cash on behalf of the third party and pass it on meets the criteria for a pass through arrangement (Step 5). However.000 90. If North Bank has structured the contract to meet the pass-through requirements.000 36. Clearly. Consequently. It is assumed that the 80 per cent of interest cash flows to be transferred to the third party represent a fully proportionate share of the interest cash flows received. and the entity is required to remit any cash flows received on the asset without material delay. ■ ■ Whether or not these requirements are met will depend on the details of the arrangement. All rights reserved. This means that North Bank will consider two portions. if North Bank has not achieved qualifying pass through with regard to the principal or interest portion.000 54. the entity is prohibited from selling or pledging the original assets other than as security to the buyer.4 Derecognition © 2004 KPMG International. Instead.AG36 The steps referred to below are set out on pages 37 and 38. KPMG International is a Swiss cooperative of which all KPMG firms are members.000.000 December 2003 amendments 39.

other financial assets. significant prepayment risk relating to the fixed rate loans).4. North Bank would recognise an asset of 100. All rights reserved.000) of the principal element.000 of the principal element with any defaults being shared on a pari passu basis with the transferee). 100. the entity is not legally released from the obligation. North Bank needs to consider Step 9. and only when. goods or services.IFRS Financial Instruments Accounting March 2004 Reference It is possible that North Bank will have retained some risks and rewards relating to the transferred portions. it is assumed that the third party does not unilaterally have the practical ability to sell the assets without needing to impose additional restrictions on that transfer. for example.g. ■ 39.) Where substantially all the risks and rewards in the transferred components are neither transferred nor retained and the buyer is not able to sell those components (Step 8). In this case. or the debtor is legally released from primary responsibility for the liability (or part thereof) either by process of law or by the creditor. it is extinguished. when the obligation specified in the contract is discharged. This is consistent with the treatment of treasury shares reacquired by an entity. derecognition by North Bank would be appropriate. if the modified terms set out above applied (the retention of an entitlement to 100. with any defaults being shared on a pari passu basis with the transferee. Each member firm is a separate and independent legal entity and each describes itself as such. However. meaning that Step 6 will not be met. It is not possible for an entity to extinguish a liability through an in-substance defeasance of its debt.AG57 and AG59 44 4. North Bank then needs to consider whether it has retained control over the transferred portions (Step 8). . it would be likely to be the case if. While this may not be entirely clear from the example. without having legally assumed the responsibility for the liability and without the lender being part of the contractual arrangements relating to the third party vehicle and having rights thereto. except that in the case of extinguishing a liability.4 Derecognition © 2004 KPMG International. This condition is met when: ■ the debtor discharges the liability by paying the creditor. KPMG International provides no services to clients. a gain or loss may be recognised.e. 39. the terms of the arrangement were such that North Bank retained the entitlement to a portion (e.g. However. KPMG International is a Swiss cooperative of which all KPMG firms are members.AG58 The conditions are also met and a liability is derecognised when an entity repurchases its own bonds issued previously. In consequence.2 39. in addition to recognising the balances set out in the case. In-substance defeasance occurs when an entity makes payments related to its obligations to a third party (typically a trust or similar vehicle). the continuing involvement rules apply (Step 9). North Bank might then determine that it has retained some significant risks and rewards of ownership (the retained interest). that then makes payments to the lender. cancelled or expired. i. normally with cash. (Note that if the third party was able to sell the transferred assets without restriction.39-42 Derecognition of a financial liability Derecognition of a financial liability occurs when. 4. but transferred others (e.000 (its retained interest) and a liability of the same amount (the maximum amount of cash flows it would not receive). it is assumed that North Bank has not retained substantially all of the risks and rewards of the portions that have been transferred and therefore will not be required to continue to recognise the asset sold to the third party in its entirety (Step 7). irrespective of whether the entity intends to resell the bonds to other parties. In such circumstances.

The issue of exchange and modification of debt terms is illustrated by the following: Case 4. with a maturity date of 31 December 20X5. The term of the loan is five years.617 by discounting the modified cash flows at the historical effective rate of eight per cent. Therefore.000. KPMG International provides no services to clients. including any fees paid (net of any fees received). a substantial modification of the terms of an existing debt instrument should be accounted for as an extinguishment of the old debt.AG60 and AG61 therefore derecognition of the liability would be inappropriate. If an extinguishment does occur. Each member firm is a separate and independent legal entity and each describes itself as such. Bank D grants a loan to Entity U of 200. Entity U must assess whether the terms of the modified loan are substantially different from the original loan. KPMG International is a Swiss cooperative of which all KPMG firms are members. All rights reserved. 45 .41 4.IFRS Financial Instruments Accounting March 2004 Reference 39.40 39. If the exchange or modification is not accounted for as an extinguishment. representing the current interest rate for Entity U. the creditor must also agree to accept the third party as the new primary obligor in order for the entity to derecognise its liability. which is the market interest rate at that time. Certain transactions or modifications between borrowers and lenders may give rise to derecognition issues.6 Modification of the terms of a loan On 1 January 20X1. Similarly. costs and fees incurred are recognised as an adjustment to the carrying value of the liability and amortised over the remaining term of the modified instrument. 39. Entity U calculates the present value of the modified loan of 220. with a contractual interest rate of eight per cent. The circumstances of these modifications (such as due to financial difficulties of the borrower) are not relevant in determining whether the modification is an extinguishment of debt. No fees are paid or received. The discount rate to use for both calculations is not specifically addressed in the standard. an extinguishment of debt has occurred and the original loan should be derecognised. The contractual interest rate is increased to 12 per cent for the remaining term to maturity. In addition. given the increase in market interest rates and the current credit standing of Entity U. Entity U negotiates with Bank D to extend the term of the loan by an additional two years so that the loan will mature on 31 December 20X7. If the borrower and lender exchange instruments with terms substantially different from the original transaction.AG62 39. The present value differs by more than 10 per cent from the present value of the original cash flows of the loan calculated on the same basis. On 31 December 20X4. therefore the entity may use either the effective interest rate under the old terms or under the new terms (applied consistently to both transactions). What accounting entries would Entity U record on 31 December 20X4? For accounting purposes. any costs or fees incurred are recognised as a gain or loss immediately. is at least 10 per cent different from the discounted present value of the remaining cash flows of the original debt instrument.4 Derecognition © 2004 KPMG International. An entity may arrange for a third party to assume the primary responsibility for the obligation for a fee while continuing to make the contractual payments on behalf of the third party. Terms are substantially different if the discounted present value of the cash flows under the new terms. derecognition of the old debt and recognition of a new debt instrument would result.

000 200. when transferring (part of) a financial liability. issuance of securities to investors and payment of proceeds to the transferor).5 4.4. KPMG International provides no services to clients. Entities commonly use securitisations to monetise financial assets such as homogeneous consumer loans.1 must be considered for both the transferred assets and the residual interests in the SPE. KPMG International is a Swiss cooperative of which all KPMG firms are members.4. as both loans were originally issued at market interest rates. Generally all of these steps occur simultaneously (i. and the carrying value of the original loan is derecognised. Similar to a financial asset. . set up with a specific intent. as discussed in Section 4. The accounting is similar to the accounting for derecognition of parts of financial assets with the creation of new instruments.1.e. credit card receivables. such as the securitisation of financial assets. The factors noted in Section 4. 46 4. the determination is not so straightforward. transfer of financial assets. 39.000 The modified loan is recognised at its fair value. All rights reserved. No loss is recognised since the carrying amount of the loan equals the fair value of the modified loan. for example. The only impact would be any fees incurred by Entity U. Each member firm is a separate and independent legal entity and each describes itself as such. In a securitisation the transferring entity sells financial assets to the SPE in return for cash proceeds.IFRS Financial Instruments Accounting March 2004 Reference The accounting entries for Entity U would be as follows: Debit 31 December 20X3 Original borrowing (at eight per cent) Modified borrowing (at 12 per cent) To record the extinguishment of the former liability and to record the new obligation Credit 200. when a transferor retains the residual gains associated with the transferred assets or residual interests in the SPE.AG51(f-h) Transfers to an SPE must meet the derecognition criteria described in this Section in order for the transferor to record a sale. calculated at the current market interest rate.5 Special purpose entities and derecognition © 2004 KPMG International. Securitisation of assets and sales to investors often occur through an SPE. An SPE generally will be a legal entity with limited activities. Such constraints would include options or forward agreements held by the transferor on the residual interests of the SPE. In situations where less than all of the benefits are transferred. trade receivables or mortgage loans by selling newly created securities collateralised by these assets to investors. 4. whose purpose is to hold the beneficial interests in securitised assets and to pass through monies earned on those assets to the investors in its securities.1 Special purpose entities and derecognition Typical transactions In some instances transactions involving the transfer of financial instruments are conducted with special purpose entities (SPEs). In situations where all of the benefits of the assets are transferred to such an SPE. parts of the financial liability could be retained and new financial instruments (either assets or liabilities) could be created.5. which would have to be expensed. derecognition by the transferor is appropriate if there are no additional constraints imposed by the transferor.

The general principles addressing consolidation are found in IAS 27.5. including the SPE. In many cases. this requires that any cash flows arising from the assets are not retained by the group. 4. That standard requires consolidation based on control over an entity. KPMG International provides no services to clients. All rights reserved. in the majority of cases it is unlikely that consolidation by the originator can be avoided. this last requirement does not preclude the group from making short-term advances. it is likely that the SPE will have retained control of the transferred assets. However. the pass-through requirements will not be met. therefore. 39. 39. 47 . then the transaction to be considered for derecognition at the group level is the possible transfer of assets by the group. instead being transferred either immediately or within a short period (no more than a matter of days) to the external beneficial interest holders. Each member firm is a separate and independent legal entity and each describes itself as such. the critical issue may be whether or not the cash flows from the assets. Even in those cases where the pass-through test is met.5 Special purpose entities and derecognition © 2004 KPMG International.AG36 Under the amended standards. are passed through without material delay in an arrangement that meets the new ‘pass-through’ requirements.g. KPMG International is a Swiss cooperative of which all KPMG firms are members. An SPE is unlikely to transfer legal rights to the cash flows from its assets to its investors. with the right of full recovery of the amount lent plus accrued interest at market rates. the transferor should not have substantive benefits from reinvestment of the cash flows from the interest and principal payments.19 In cases where cash flows are reinvested by the SPE in new assets under a ‘revolving’ structure.5. to its beneficial interest holders. those where the transferring entity has other than a fully proportionate share in the cash flows). If an SPE is consolidated. December 2003 amendments 39. whether or not an SPE should be consolidated under SIC–12 (see Section 4.IFRS Financial Instruments Accounting March 2004 Reference In order to qualify for derecognition of. loans where the transferor is also the servicer and has custody over the assets. The group also needs to have no obligation to pay any amounts to the external beneficial interest holders unless equivalent amounts are collected from the original assets. Essentially. given current structures.2 Consolidation of special purpose entities The issue of consolidation is an important consideration to entities that use SPEs. In many other cases meeting the pass-through requirements will also be difficult to achieve and some arrangements may need to be restructured (e.20 27. then the potential derecognition transaction is the transfer of assets by the originator into the SPE. However.2 below) is specifically required to be considered before analysing the transaction for derecognition under IAS 39. Partial derecognition may then be appropriate under the continuing involvement approach in the amended standards. for example. These should be transferred to the transferee or the SPE under the terms of the servicing agreement. If the SPE is not consolidated.4 and 13 4. and only the cash flows from the assets.

the benefits to be evaluated are not the gross cash flows of all of the assets in the SPE.10(b) ■ The entity has decision-making powers to obtain the majority of the benefits of the activities of the SPE.10(c) ■ The entity has rights to obtain the majority of benefits of the SPE (and therefore may be exposed to risks incident to the SPE’s activities). or through an autopilot mechanism achieves the same effect. SIC–12 takes a pure risks and rewards approach when making the determination of control over an SPE. SIC-12. Therefore. but have to consolidate the SPE into which the assets are transferred. Majority of should be interpreted as more than half. Commentary: This requires evaluating the SPE’s purpose. meaning that other factors not specifically stated in SIC–12 may also indicate control. Residual benefits are the positive variability in net cash flows within a reasonably likely range of outcomes. its activities and what entity benefits most from them. However. in substance: ■ SIC-12. This factor is often difficult to evaluate as there may be more than one party that derives some benefits from an SPE.5 Special purpose entities and derecognition © 2004 KPMG International.3 The particular problem with applying IAS 27 to an SPE is that the typical control features discussed above may not be evident due to the entity’s nature. therefore consolidation based on voting powers is not meaningful. Commentary: An SPE being on autopilot does not necessarily mean that the sponsor or another entity must be in control. directly addresses these types of entities by providing guidance for when an entity should consolidate an SPE. KPMG International provides no services to clients. if there are reserves or equity that 48 4. Commentary: This factor and the next (majority of risks) are often the most crucial to evaluate when determining if consolidation is necessary.10 SIC–12 notes several factors that may indicate that an entity has control over an SPE. KPMG International is a Swiss cooperative of which all KPMG firms are members. and in effect. Whereas IAS 39 takes a mixed approach of financial components and risks and rewards in addressing control over financial instruments or portions thereof. Often the creator or sponsor of an SPE retains significant beneficial interest in the SPE’s activities that would give it effective control of the SPE when applying SIC–12. an SPE being set up with limited ongoing decisions to be made does not automatically mean the entity has operational substance on its own. Typically there is no substantive equity holder in the SPE. SPEs often have limited activities so that day-to-day financial and operating policies may be predetermined. An example is when the SPE is engaged in an activity that supports one entity’s ongoing major or central operations. over the transferred assets as well. There must also be the objective of obtaining benefits from the SPE’s activities. In that case. These are examples. All rights reserved. The examples are when. SIC-12. IAS 39 effectively requires there to be some substantive risk transfer to achieve derecognition. As discussed earlier in this Section. SIC-12. it is not uncommon for a transferor to derecognise transferred assets. Each member firm is a separate and independent legal entity and each describes itself as such. an interpretation of IAS 27. Likewise. In this case the SPE is set up to run virtually on autopilot from its inception. For example. whereas SIC–12 indicates that a majority of risk should be transferred to avoid consolidation.10(a) The activities of the SPE are on behalf of the entity where the entity obtains benefits from the SPE’s operation.IFRS Financial Instruments Accounting March 2004 Reference SIC-12. . Rather it is the residual benefits that are important. an evaluation of majority of benefits is necessary. SIC–12.

residual risks are the negative variability in net cash flows within a reasonably likely range of outcomes.IFRS Financial Instruments Accounting March 2004 Reference would be distributed when the SPE is wound up. it is often the case under the existing standards that an entity could achieve derecognition for financial assets transferred into an SPE (by achieving some substantive transfer of risk). The factors noted above should be analysed independently meaning that if an entity has any one of the four indicators above. an entity entitled to the majority of this potential upside may be required to consolidate the SPE. whether derecognition criteria in IAS 39 are met when transferring instruments to the SPE. but that the SPE was then consolidated into the group financial statements under SIC–12. 4. and second. Securitisation transactions often have substantial guarantees or credit enhancements in order to receive a higher rating on the related securities issued by the SPE. It would be inappropriate to conclude that because a situation does not encompass all four of the above factors. December 2003 amendments As noted above. Therefore. an entity must consider carefully: ■ first. and therefore should consolidate the entity. ■ 39. if there are senior and subordinated cash flows in an SPE. this factor is often decisive when determining consolidation. SIC–12 is not a concern. An entity with the majority of this exposure may be required to consolidate the SPE. KPMG International provides no services to clients. the senior cash flows should be disregarded and the evaluation should focus on the subordinated cash flows and any equity (being real equity or some type of reserve). Again it is not gross cash flows but residual cash flow risks that are important. 49 . Similar to the above. Each member firm is a separate and independent legal entity and each describes itself as such. This may also occur through put options granted to the SPE to take back defaulted or non-performing assets.AG36 The IASB has addressed this apparent inconsistency in the amendments by requiring SIC–12 to be considered in the hierarchy of rules before the derecognition requirements of IAS 39. KPMG International is a Swiss cooperative of which all KPMG firms are members. the consolidation issue is dealt with first. For the stand-alone financial statements of the transferor entity. for the purposes of the group financial statements. whether there are indicators that the entity has control over the SPE under SIC–12. All rights reserved. Retention of benefits or risks by a transferor may occur if the transferor keeps a subordinated position on the transferred assets or by taking subordinated notes issued by the SPE. it should consolidate the SPE. For example. or through other forms of guarantees. Commentary: Along with analysing the majority of benefits. These must be included in an entity’s analysis of the risks and rewards that result from a transaction. The remainder of this discussion considers the position from the perspective of the consolidated financial statements.10(d) ■ The entity retains the majority of the residual or ownership risks related to the SPE or its assets in order to obtain benefits from its activities. the entity does not need to consolidate the SPE. SIC-12.5 Special purpose entities and derecognition © 2004 KPMG International. When entering into transactions with an SPE. derivatives or insurancelike agreements.

The discussion below sets out the evaluation procedure to be followed if the SPE is consolidated. is that the assets of the (consolidated) SPE will be partly derecognised under the continuing involvement rules in the amended standards. The asset considered for derecognition will be the entire portfolio of assets held by the SPE. it will be necessary to consider whether the SPE’s obligation to pass the cash flows to the external beneficial interest holders meet the pass-through criteria. The next consideration is whether there is a transfer that might qualify for derecognition. This is because. although partial derecognition under a continuing involvement approach may. be possible.17-19 50 4. a possible outcome. then the derecognition transaction to be considered under IAS 39 is the transfer of assets from the group to the SPE.4. the asset transferred (see Step 2 in the analysis under Section 4. 39. . Each member firm is a separate and independent legal entity and each describes itself as such. If so. KPMG International provides no services to clients. In most cases. the legal rights to cash flows will not be passed to beneficial interest holders in the SPE. Therefore. typically. the group will retain an interest in the residual cash flows. 39. In many cases it will be impossible to meet the pass-through requirements and no derecognition by the SPE will be possible. so that the first (say) 90 per cent of cash flows pass outside the group and the last (say) 10 per cent are retained within the group. Some transactions may be structured so that all of the cash flows due to external beneficial interest holders are passed through without material delay. Such arrangements will fail to meet the pass-through criteria because the guarantee creates an obligation on the part of the group to pay cash to the external beneficial interest holders under the guarantee if cash is not collected on the securitised assets.1 above) will be neither specifically identified components of the assets nor a fully proportionate share of any component of the asset. then the derecognition transaction to be analysed under IAS 39 is the transfer of rights from the group (including the SPE) to the external beneficial interestholders in the SPE. As under the existing standards.5 Special purpose entities and derecognition © 2004 KPMG International. but rather by providing credit risk guarantees to the external beneficial interest holders. In some cases the group will retain an interest in an SPE not by retaining beneficial interests. it is likely to be difficult to achieve off balance sheet treatment for securitisation transactions. In many common securitisation transactions. KPMG International is a Swiss cooperative of which all KPMG firms are members.IFRS Financial Instruments Accounting March 2004 Reference If the SPE is not consolidated.16 The first issue to consider is whether to perform the evaluation for assets in their entirety or for components of assets. If the SPE is consolidated. in a limited number of cases. All rights reserved. as long as substantive risks and rewards are also transferred.

The classification of financial instruments dictates how these assets and liabilities are subsequently measured in the financial statements of an entity. There are four categories of financial assets: trading. Figure 5. All rights reserved. 51 . Each member firm is a separate and independent legal entity and each describes itself as such. loans and receivables originated by the entity. Classification Key topics covered in this Section: ■ ■ Categories and classification of financial assets and financial liabilities Criteria for the held-to-maturity category 5. KPMG International is a Swiss cooperative of which all KPMG firms are members.1 Overview © 2004 KPMG International.1 Overview IAS 39 establishes specific categories into which all financial assets and liabilities must be classified.IFRS Financial Instruments Accounting March 2004 5. KPMG International provides no services to clients.1 Classification of financial assets and liabilities Reference 39.45 5. There are two categories of financial liabilities: trading liabilities and other financial liabilities. The assessment of which category financial assets and financial liabilities belong to should be performed in the same order as outlined in the discussion and figures below. held-to-maturity and available-for-sale.

IFRS Financial Instruments Accounting March 2004 Reference 5. For instance. 39. KPMG International is a Swiss cooperative of which all KPMG firms are members.9 and IG B. Furthermore. For example. based on movements in those entities’ share prices. When this is done on a frequent basis. it is part of a portfolio for which there is evidence of a recent actual pattern of short-term profit-taking. When the favourable movement in the interest rate occurs.2 Classification of financial assets © 2004 KPMG International.1 Classification of financial assets Trading assets IAS 39 defines financial instruments.12 39. the entity has established a pattern of trading for the purpose of generating profits from fluctuations in price. On the other hand. if an entity acquires a non-derivative financial asset with an intention to hold it for a long period irrespective of short-term fluctuations in price. This activity would not necessarily require the investments to be classified as trading because the activity may not be related to generating profits from short-term fluctuations in prices. A financial asset should be classified as held for trading if. both assets and liabilities. traders may actively trade an asset’s risks rather than the asset itself. 52 5. An entity should adopt a definition of short-term and apply a consistent approach to the definition used. Financial assets for which there is the intent to sell in the short-term or evidence that they are expected to be resold in the near term should be classified as trading at the date of purchase. the bank will issue an offsetting liability instrument. Other evidence may indicate that a financial asset is being held for trading purposes. It also does not limit the period for which an instrument that is designated as being held-for-trading can be held. Evidence of trading may be inferred based on the turnover and the average holding period of financial assets included in the portfolio. even if the asset is not subsequently sold within a short period of time.9 A financial asset or liability held for trading is one that was acquired or incurred principally for the purpose of generating a profit from short-term fluctuations in price or dealer’s margin. When there is the intention of generating a profit from short-term fluctuations in price or dealer’s margin the financial asset is appropriately classified as trading.AG15 To generate short-term profits. The standard does not define short-term. Each member firm is a separate and independent legal entity and each describes itself as such. All rights reserved.2. regardless of why it was acquired.11 IG B. a fund manager of an investment portfolio might buy and sell investments in order to rebalance the portfolio in line with a fund’s parameters. held for trading as follows: 39. The 30-day money market instrument should be classified as held for trading in spite of the fact that there is no intention to physically sell the instrument. a bank may invest in a 30-day money market instrument for the purpose of generating profit from short-term fluctuations in the interest rate. The intention to profit from short-term fluctuations in price or dealer’s margin need not be explicitly stated by the entity. Derivative financial assets and derivative financial liabilities are always deemed held for trading unless they are designated and effective hedging instruments. instead of selling the instrument. an entity may buy and sell shares for a specific portfolio. .2 5. Additional purchases of shares into this portfolio would also be designated as held for trading. such an instrument cannot be classified as held for trading. The offsetting liability instrument should be classified as trading as well because it was issued for trading purposes to earn arbitrage profits. KPMG International provides no services to clients.

financial assets that are part of a portfolio of similar assets for which there is a recent actual pattern of short-term profit-taking. all derivative financial assets that are not designated and effective hedging instruments. The trading assets category has therefore been redefined to include both trading assets as defined above. as described in Section 3. Since both the bond and the swap will be measured at fair value through profit or loss. an entity that purchases a fixed rate bond and immediately enters into an interest rate swap to ‘convert’ the interest to floating rate might. Each member firm is a separate and independent legal entity and each describes itself as such. instead of claiming hedge accounting. There is no requirement for consistency in the use of the fair value through income designation. IASB Board meeting February 2004 As explained more fully in Section 1. It might also be used to achieve consistent measurement of matching asset and liability positions. Another likely use of the new designation is to avoid the need to measure separately the fair value of a separable embedded derivative. there are some important consequences of using the new designation for this purpose. December 2003 amendments ■ ■ ■ 39. For example. the offsetting effects of changes in market interest rates on the fair value of each instrument will be recognised in profit or loss without the need for hedge accounting.IFRS Financial Instruments Accounting March 2004 Reference In summary. All rights reserved. designate the bond as ‘at fair value through profit or loss’. 53 . and those assets that an entity has chosen to measure at fair value through profit or loss. KPMG International provides no services to clients. However. In particular. the IASB is proposing to limit the use of the fair value through profit or loss option to four specific circumstances.9 Under the amended standards an entity will have a free choice.2 Classification of financial assets © 2004 KPMG International. KPMG International is a Swiss cooperative of which all KPMG firms are members. on initial recognition (and on adoption of the revised standard) to designate any financial asset or financial liability as ‘at fair value through profit or loss’. meaning that an entity can choose which (if any) of its financial assets and liabilities are to be included in this category. Separate disclosure is required of the amounts included in the two sub-categories. or if the entity’s strategy will involve subsequent de-designation of some or all of the economic hedge it puts in place initially. It may also result in excessive earnings volatility if the hedge is put in place for only part of the life of the instrument. One of the main benefits of the new category is that it may allow an entity. and hybrid instruments that include an embedded derivative that cannot be separately measured but that otherwise would have been separated based on the criteria of IAS 39. the designation of an instrument as fair value through profit or loss may only be used on day one and is not reversible.6). to avoid the cost and complexity of meeting the criteria for hedge accounting (see Section 8. although the amounts included in it must be disclosed. in some cases. This alternative to hedge accounting therefore cannot be used if an entity buys or issues an instrument and later wishes to put a hedge in place. financial assets held for trading include: ■ financial assets acquired for the purpose of generating a profit from short-term fluctuations in price or dealer’s margin. 5.

9 Loans and receivables IAS 39 defines loans and receivables originated by the entity as follows: Loans and receivables originated by the enterprise are financial assets that are created by the enterprise by providing money.1 Origination of a loan Entity M participates in a loan at the date of origination via an investment bank and plans to classify the loan as originated by the entity. Any loans or receivables purchased by an entity (such as a loan or receivable resulting from a transfer of an existing financial instrument from one holder to another) cannot be accounted for as being originated by the entity. rather.2 39. Loans and receivables originated by the entity. it is not necessary that the lender is involved in setting the terms of the contract. which should be classified as held for trading.IFRS Financial Instruments Accounting March 2004 Reference 5. equity instruments are excluded from this classification. The essential requirement of IAS 39 for loans and receivables originated by the entity is that the lender must contribute funds when the financial asset is first created. should not be included in this category. All rights reserved. .22 Since the definition uses the words loans and receivables and debtor. Loans and receivables originated by the enterprise are not included in held-to-maturity investments but. Loans and receivables originated by the entity thus are financial assets: ■ that have been directly provided by the lender to a respective borrower or that result from the sale of goods and services. and that are not trading instruments. or services directly to a debtor. Loans and receivables originated by the entity may not be classified as held-to-maturity or available-for-sale. but rather classified as financial assets held for trading. Each member firm is a separate and independent legal entity and each describes itself as such. but intended to be resold for purposes of short-term profit-taking. goods. KPMG International is a Swiss cooperative of which all KPMG firms are members. 54 5. but rather purchased from the investment bank. as Entity M would not be providing the funds directly to the debtor.2.2 Classification of financial assets © 2004 KPMG International. In that case classification as originated by the entity would not be appropriate. it would not be considered as originated. ■ IG B. pay a fixed or determinable return and are in substance debt instruments. Case 5. Had Entity M entered the participation even one day after its original issuance. are classified separately under this standard. The fact that there is an intermediary does not change the substance of the transaction. However. as may be the case in a syndication or participation. Exceptions to this are certain types of shares that must be redeemed at a specified date. other than those that are originated with the intent to be sold immediately or in the short-term. Is this classification appropriate? This classification is appropriate as Entity M participates in the loan at its origination. KPMG International provides no services to clients. The holder can potentially classify such instruments as originated loans.

2 Classification of financial assets © 2004 KPMG International. and the other purchased in the market. The second is that a bank might own two portfolios of bonds. Classification of instruments as held-to-maturity therefore depends on: ■ ■ the terms and characteristics of the financial asset. 55 . The first is that. a bank could own two identical portfolios of loans. This means that a listed debt security cannot be classified within ‘loans and receivables’. under the existing standards.IFRS Financial Instruments Accounting March 2004 Reference December 2003 amendments 39. each is required. Each member firm is a separate and independent legal entity and each describes itself as such. and therefore included in the originated loans category.3 Held-to-maturity investments Held-to-maturity investments are defined as follows: 39. The category is redefined simply as ‘loans and receivables’ and therefore includes both purchased and originated loans.9 Under the amendments the requirement for loans to be ‘originated by the entity’ is removed. one purchased from the issuer on the date of issue. one originated and one purchased. KPMG International is a Swiss cooperative of which all KPMG firms are members. 5.9 Held-to-maturity investments are financial assets with fixed or determinable payments and fixed maturity that an enterprise has the positive intent and ability to hold to maturity other than loans and receivables originated by the enterprise. The main requirements for a financial asset to be classified as a loan or receivable is that it has fixed or determinable payments and is not a derivative. under the existing standards. and be required to account for each in a different way. or on adoption of the revised standard. 5. an entity has a free choice to classify any loan or receivable as ‘availablefor-sale’ at initial recognition. In addition. All rights reserved. The amendments are designed to provide a solution to two issues raised by financial institutions. and the ability and actual intent of the entity to hold those instruments to maturity. the revised definition excludes any instrument that is quoted in an active market. to be accounted for differently. Again. However. KPMG International provides no services to clients. even if it is acquired at original issuance by providing funds directly to the issuer.2.

KPMG International is a Swiss cooperative of which all KPMG firms are members. The potential benefit of using the held-to-maturity category is that the assets are carried at amortised cost. 39. Nevertheless. such as interest and principal payments on debt. Typical equity contracts (e.IFRS Financial Instruments Accounting March 2004 Reference Figure 5. 5. share options or warrants) cannot be held-to-maturity investments because the amounts the holder receives may vary in a manner that cannot be determined at the purchase of the contract. KPMG International provides no services to clients.AG25 A prerequisite for the classification of a financial asset as held-to-maturity is the entity’s intent and ability to actually hold that asset until maturity. Other types of equity securities (e.g. pay a fixed or determinable return and are in substance debt instruments. perpetual bonds that provide for interest payments for an indefinite period would not qualify as held-to-maturity instruments. Generally this category would be used for fixed rate instruments whose fair values may change significantly in response to changes in interest rates. However. Exceptions to this are certain types of preference shares that must be redeemed at a specified date. For example. All rights reserved.3.AG17 39.1 Fixed maturity and determinable payments Instruments classified as held-to-maturity must have a fixed maturity and fixed or determinable payments. . common shares) usually have an unlimited maturity and therefore cannot be held-to-maturity financial assets.2 Classification of financial assets © 2004 KPMG International.g. it is mainly debt contracts that are classified as held-to-maturity. but sells the instrument before its maturity. Since held-to-maturity instruments should have a fixed maturity. even certain debt instruments may have an unlimited or unspecified maturity. An entity should assess its intent and ability to hold its held-to-maturity investments not only at initial acquisition but again at each balance sheet date.9 39.2 Decision tree for reviewing the classification of assets as held-to-maturity 39. meaning a contractual arrangement that defines both the amounts and dates of payments to the holder. Each member firm is a separate and independent legal entity and each describes itself as such.AG17 56 5. These so-called tainting rules are discussed later in this Section. significant penalties exist for an entity that classifies an instrument as held-to-maturity.2.

An embedded option that may shorten the stated maturity of a debt instrument casts doubt on an entity’s intent to hold a financial asset until maturity. 57 .10 and IG C. which could not be anticipated by the entity when deciding whether it has the positive intent (and ability) to hold an asset until maturity.2 Held-to-maturity classification IG B. A floating rate interest asset also could qualify as a held-to-maturity investment since its payments are either fixed (the principal) or specified by reference to a market rate or benchmark rate. 5. The interest on the bond is indexed to the price of oil. KPMG International is a Swiss cooperative of which all KPMG firms are members.AG16 39. and therefore is expected to exercise that right. there will be little advantage in using the held-to-maturity category for floating rate assets as their fair values will not change significantly in response to changes in market interest rates. the purchase of an instrument with a put feature is inconsistent with the positive intent to hold the asset until maturity. This is because payment for a right to convert would be inconsistent with an intention to hold to maturity.3 5.9 39.IFRS Financial Instruments Accounting March 2004 Reference A financial asset whose maturity is fixed still might not qualify as a held-to-maturity investment if its payments are not determinable. however.13 and B. if the issuer may call the instrument at or above its carrying amount. For example.2. KPMG International provides no services to clients. even though there may be an agreed term. Case 5. In the case of a call option held by the issuer. The demonstration of positive intent to hold an instrument to maturity would not be negated by a highly unusual and unlikely occurrence. it may categorise the bond as held-to-maturity. Each member firm is a separate and independent legal entity and each describes itself as such. Can Bank Q categorise this bond as held-to-maturity? The fact that the return is dependent on the price of oil means that this bond includes an embedded derivative that is not closely related to the host contract. unless the conversion option is exercisable only at maturity. The most obvious example of a financial instrument with determinable payments is a fixed rate bond. However.AG18.2 Intent to hold to maturity If an entity only has the intent to hold an instrument for some period. A debt instrument with an equity conversion option generally cannot be classified as heldto-maturity. such as a run on a bank or a similar situation. the positive intent to hold to maturity does not exist. The embedded derivative and host contract should be separated. 39. this does not affect the investor’s intent to hold the security until maturity.3. If Bank Q has the intent and ability to hold the host to maturity.AG21 39.14 Bank Q wants to categorise a bond issued by an oil company as held-to-maturity. resulting in an embedded commodity contract to be measured at fair value and a host debt instrument. the entity cannot demonstrate a positive intent to hold the asset until maturity. AG19 and 39. Likewise if the issuer has the right to settle the financial asset at an amount that is significantly below the carrying amount. the holder should demonstrate that substantially all of the carrying amount would be recovered if the instrument were called before maturity to be able to classify the asset as held-to-maturity. as both interest and principal payments are fixed. All rights reserved.2 Classification of financial assets © 2004 KPMG International. Thus. but has not actually defined that period to be to maturity. profit-sharing rights do not have determinable payments. In many cases.

AG23 financial resources are not available to the entity to finance the asset to maturity. . The fair value of the bonds has appreciated significantly over the carrying value and management decides that Entity T should realise the gains through a sale. An example is the expectation that a regulator will exercise its right in certain industries like the banking and insurance industry to force an entity to sell certain assets in the event of a credit risk change. the high risk and volatility of a mortgage-backed interest-only certificate makes active management of such strips more likely than holding these to maturity. the risk profile of a particular financial asset may raise similar questions on the intention. but rather this should be assessed by an entity any time a potential tainting situation arises.AG17 IG B.3. The same reasoning may apply to debt instruments with high credit risk. Case 5.9 Tainting of the held-to-maturity portfolio If an entity sells.3.000 of bonds from its held-to-maturity portfolio on 15 April 20X1. In these circumstances. the resources may not be available to continue to hold certain debt instruments. All rights reserved.2.IFRS Financial Instruments Accounting March 2004 Reference 39. Assuming that Entity T’s financial reporting year-end is 31 December.4 39.3 Tainting of held-to-maturity assets Entity T sells 1. the entity may not classify any financial assets as held-to-maturity for a period of two financial years after the occurrence of this event. or legal or other constraints could frustrate the intention of the entity to hold the investment to maturity. for example. A significant risk of non-payment of interest and principal on a bond is not in itself a consideration in qualifying for the heldto-maturity category as long as there is an intent and ability to hold the instrument until maturity. However. the action of selling investments from the held-to-maturity portfolio taints the entire portfolio and all remaining investments in that category must be reclassified.000.2 Classification of financial assets © 2004 KPMG International. KPMG International provides no services to clients. For example. Each member firm is a separate and independent legal entity and each describes itself as such. KPMG International is a Swiss cooperative of which all KPMG firms are members. Entity T will be prohibited from classifying any assets as held-to-maturity for two full financial years. It is important to also consider the reasons for an entity’s actions when determining if the portfolio has been tainted.2. the entity cannot use the held-to-maturity classification for its assets until at least 1 January 20X4. IAS 39 does not stipulate what is considered more than an insignificant amount. 58 5. an entity would taint its held-to-maturity portfolio if it subsequently sold such a bond as a result of a credit rating downgrade that could have been foreseen. transfers or exercises a put option on more than an insignificant amount of the portfolio of held-to-maturity financial assets. high yield (junk) bonds and subordinated bonds.15 Also. if it is expected or likely that an entity will acquire another business and will need all of its funding for this investment. The entity cannot demonstrate the ability if: ■ 39. For example. 5. ■ 5.3 Ability to hold to maturity An entity needs to demonstrate its ability to hold a financial asset to maturity to categorise it as such.

In cases where the sales are not isolated. If an entity periodically sells or transfers insignificant portions this may cast a doubt on the entity’s intent and ability with regard to its held-to-maturity portfolio. Any sale or reclassification should be a one-off event. 5. The tainting requirements apply group-wide. if an entity is expected to receive back other comparable securities. but not the securities lent. the tainting rules do not apply if only an insignificant amount of held-to-maturity investments is sold or reclassified.2 Classification of financial assets © 2004 KPMG International. entities are advised to consider carefully any plans for sales. The standard does not define what an insignificant amount means. If an entity has various portfolios of held-tomaturity instruments. 39.5 Exceptions from tainting There are a limited number of exceptions to the tainting rules. transfers or exercises of put options before classifying an asset as held-to-maturity to avoid a forced reclassification of the whole portfolio. because the fair value and the amortised cost are both equal to the face value of the financial asset. Firstly. so that a subsidiary that sells more than an insignificant amount from its held-to-maturity portfolio can preclude the entire group from using the held-to-maturity category. unless the entity does not expect to be able to maintain or recover access to those financial assets. Interest rate risk is substantially eliminated as a pricing factor at that point. Tainting requires a reclassification of the total remaining held-to-maturity portfolio in the (consolidated) financial statements into either the trading or available-for-sale categories.9 Sales of held-to-maturity investments close to maturity or call exercise date usually do not result in significant gains or losses. For example. Many entities adopting IAS 39 have decided either not to use the held-to-maturity category or to use it only at the parent company level where the intention and ability can be properly tested for each transaction at the onset and ongoing. classification as held-to-maturity is not appropriate. Reclassifications of financial instruments are discussed in Section 6. In practice.18 Selling securities classified as held-to-maturity under repurchase agreements does not constrain the entity’s intent and ability to hold those financial assets until maturity. after substantially all of the original principal is already collected.19-21 The tainting rules are intended to test an entity’s assertion that it intends and is able to hold an instrument until maturity. Therefore.3. KPMG International provides no services to clients. a judgement will be required in each particular situation. KPMG International is a Swiss cooperative of which all KPMG firms are members. 59 .5. All rights reserved. for example. Each member firm is a separate and independent legal entity and each describes itself as such. the amount sold or reclassified should be assessed on a cumulative basis in assessing whether the sales are insignificant.9 very close to maturity or call exercise date. 5. or due to an isolated non-recurring event beyond the entity’s control. IG B. by industry or by country of issuance.2. Sales or reclassifications do not result in tainting if they occur: ■ ■ ■ 39.IFRS Financial Instruments Accounting March 2004 Reference IG B. the sale or transfer of instruments from one of the portfolio taints all the other held-to-maturity portfolios of the entity.

for example. when 90 per cent or more of the principal investment has been collected through scheduled payments or prepayments. in such a situation. sales made after a change in senior management. In very rare instances. a sale of the remaining principal would generally qualify for this exception. IAS 39 does not define the phrase substantially all of the principal investment. . circumstances may arise that the entity could not have reasonably foreseen or anticipated. However. Changes in tax laws A significant change in tax laws.15 39. KPMG International provides no services to clients. If the event is not isolated or is potentially recurring. an example of this is a significant downgrade by a credit rating agency. Also. this will also call into question the entity’s intent to hold the remaining portfolio until maturity. an entity has to sell held-to-maturity investments. affecting specific investments in the portfolio. a sale triggered by such a downgrading would result in tainting. the initial quality of the asset must have been such that the deterioration could not have been reasonably foreseen.9 Similarly. If an entity has control over or initiated the isolated or non-recurring event. may not cast doubt on the intention or ability of the entity with respect to the held-to-maturity category. major business combinations or dispositions with consequences for the interest rate risk position and credit risk policies of an entity. when almost the entire principal has been collected through scheduled payments or through prepayments. from: ■ 39. the remaining portfolio is not tainted if the event leading to sales of investments is isolated and non-recurring. All rights reserved. KPMG International is a Swiss cooperative of which all KPMG firms are members. 60 5. such as the elimination or the significant reduction of the tax-exempt status of an investment that affects the investment specifically. A credit downgrade of a notch within a class or from one rating class to an immediately lower rating class often could be considered reasonably anticipated. the remaining part would not be materially affected by changes in the interest rate and therefore the sale would not result in a significant gain or loss. this inevitably casts doubt on its ability to hold the remaining portfolio until maturity. Given the scarceness of external credit ratings for debt for borrowers outside the United States. If. significant changes in tax laws. for example.2 Classification of financial assets © 2004 KPMG International.9 IG B. however. if the event could have been reasonably anticipated at the date the held-to-maturity classification was made the instrument should not have been classified as such. ■ ■ ■ Deterioration in creditworthiness IG B.AG22(a) Although IAS 39 does not provide a definition of a significant deterioration of an issuer’s creditworthiness. and the entity anticipates further sales of held-to-maturity investments. Therefore. or significant changes in statutory or regulatory requirements.IFRS Financial Instruments Accounting March 2004 Reference 39.15 a significant deterioration in the creditworthiness of the issuer of the instrument that could not have been anticipated when the instrument was acquired.AG22 IG B.16 39. downgrades as reflected in an entity’s proprietary internal credit rating system may support the demonstration of significant deterioration. Each member firm is a separate and independent legal entity and each describes itself as such. Situations that may not have been anticipated when instruments were included in the held-to-maturity category and would not question the entity’s intent and ability to hold investments to maturity may result.

4 Held-to-maturity portfolio acquired in a business combination 39. 61 . for example. Each member firm is a separate and independent legal entity and each describes itself as such. sales of held-to-maturity investments prior to a business combination or disposal. but Bank Y does not have an ability and intent to hold these securities until maturity. KPMG International provides no services to clients. 5. In this case it would not be acceptable to use the change in tax laws as an exception from tainting. Bank Y should not continue to treat these securities as held-to-maturity.AG22 and IG B. it may have a consequence on the entity’s interest rate risk and credit risk positions. Major business combination or disposition Although a major business combination or the sale of a significant segment of the entity is a controllable event. At the level of Bank X (which would be relevant if Bank X continues to prepare separate financial statements under IFRS) the transfers from the held-to-maturity portfolio would not be considered tainting if the transfers were necessitated by the business combination as a result of which the held-to-maturity portfolio of Bank X had to be brought in line with the policies of Bank Y. intends to relocate its treasury activities and in that process liquidate part of the held-to-maturity portfolio in order to restore the interest rate risk position. In such situations. will cast doubt on the entity’s intent to hold its remaining investments until maturity. due to changes in tax laws that affect the whole group. the classification as held-to-maturity would not be violated.16 Bank Y has acquired Bank X. Case 5. if Bank X classified certain securities as held-to-maturity. an entity may have a history of entering into schemes for tax related purposes then subsequently reversing or terminating the transaction due to changes in tax laws. Bank Y will have to classify the securities acquired as a result of the business combination applying corresponding rules in IAS 39 without regard to how these securities were classified by Bank X before the acquisition. However. a business combination cannot be regarded as a possibility for transferring securities from the held-to-maturity portfolio that Bank Y had before the acquisition. The exemption regarding changes in tax laws is not always applicable. At the date of the acquisition.19 Although sales subsequent to business combinations and segment disposals may not taint the held-to-maturity portfolio. since the entity could not have foreseen the change in tax laws. sales that are necessary to maintain the entity’s existing risk positions and that support proper risk management do not taint the held-tomaturity portfolio. since this change impacts all debt instruments held by the entity. The tainting rules would not be relevant in this case at the group level because there is no transfer on the group balance sheet. an entity has a captive finance company in a tax haven and.IFRS Financial Instruments Accounting March 2004 Reference If. A change in the applicable marginal tax rate for interest income is not sufficient justification for sales of held-to-maturity investments. or in response to an unsolicited tender offer. For example. All rights reserved. Thus. IG B.2 Classification of financial assets © 2004 KPMG International. KPMG International is a Swiss cooperative of which all KPMG firms are members. The new management wants to transfer some held-tomaturity securities of Bank X to available-for-sale securities because the management believes that the time to maturity of certain securities is too long and the held-tomaturity portfolio after the business combination is unreasonably large.

December 2003 amendments 39. Each member firm is a separate and independent legal entity and each describes itself as such.9 The amended standards introduce a free choice. When an entity originates a loan. These are actions applicable to the industry as a whole. therefore. 5. It would call into question the intent to hold the rest of the securities until maturity and would result in tainting. on initial recognition (and on adoption of the amendments). In that case it will be difficult to demonstrate that the regulator’s action could not have been reasonably anticipated by the entity. then under the amended standards it will have a free choice to classify that loan as either: ■ fair value through profit or loss. All rights reserved. and not to a specific entity. A change in business strategy is not a valid reason for transferring securities out of the held-to-maturity portfolio. to measure it at fair value with fair value changes recognised in a separate category of equity.4 Available-for-sale assets Available-for-sale financial assets are assets that are not trading. KPMG International provides no services to clients.17 The exceptions are intended to shield entities operating in regulated industries from potential tainting situations resulting from actions taken by the industry’s regulator. 62 5. As a result the entity would need to sell (part of) these investments. KPMG International is a Swiss cooperative of which all KPMG firms are members. This is essentially a residual category for all of those financial assets that do not fit the criteria of the other categories. ■ IG B.9 39. . However. for example.IFRS Financial Instruments Accounting March 2004 Reference For example.9 There are no significant changes in the amended standards with respect to the held-tomaturity classification. held-to-maturity investments or originated loans or receivables. Changes in statutory or regulatory requirements Examples of changes in statutory or regulatory requirements that do not have tainting implications for the held-to-maturity portfolio are: ■ changes either in the statutes or in regulations affecting the entity that modify what constitutes a permissible investment or the maximum level of certain types of investments. sales could occur in response to an entity-specific increase in capital requirements set by the industry’s regulator. and significant increases in capital requirements or in the risk weightings as a result of which the size of the held-to-maturity portfolio has to be decreased. if as a result of the acquisition the business strategy of the group changed and Bank Y transferred some of its existing securities out of the held-to-maturity portfolio. to classify any non-derivative financial asset as available-for-sale and. December 2003 amendments 39. such transfers would trigger tainting of the whole portfolio. unless the increase in entity-specific capital requirements represents a significant change in the regulator’s policy for setting entity-specific capital requirements.2 Classification of financial assets © 2004 KPMG International.2.

1 dealing with trading assets. as noted in Table 5. IASB Board meeting February 2004 As explained more fully in Section 1. A short seller is an entity that sells securities or another type of financial instruments that it does not yet hold. or loans (measured at amortised cost). KPMG International is a Swiss cooperative of which all KPMG firms are members. this category is generally more applicable to financial institutions than to corporates due to the nature of their respective operations.AG15 5.5 Categorising types of financial assets Certain types of financial assets may be eligible for inclusion in more than one category of financial assets. KPMG International provides no services to clients.2.3 5. 5.1 Types of financial assets Financial instrument Derivatives (not in a hedge relationship) Loans and receivables Bonds and notes (listed) Equity securities Held for trading ✔ ✔ ✔ ✔ Originated by the entity – ✔ – – Held-tomaturity – ✔ ✔ – Availablefor-sale – ✔ ✔ ✔ 5.IFRS Financial Instruments Accounting March 2004 Reference ■ ■ available-for-sale (fair value through equity). 63 . Each member firm is a separate and independent legal entity and each describes itself as such.1. A liability that is used to fund trading activities is not necessarily a trading instrument itself. the IASB is proposing to limit the use of the fair value through income option to exclude loans and receivables. this treatment is also appropriate for other non-derivative financial instruments sold short.9 Classification of financial liabilities Trading A financial liability is categorised as held for trading if it is a trading instrument as described in Section 5. funding activities for trading portfolios would not be automatically classified as liabilities held for trading. Liabilities held for trading include derivatives with a negative fair value. except those that are hedging instruments. creating an obligation to deliver securities. Table 5. Therefore. 39. Except in the case of derivatives.2. and obligations to deliver securities borrowed by a short seller. All rights reserved.3. Although only securities that are sold short are specifically mentioned as an example of liabilities that are classified as held for trading.AG15 39.3 Classification of financial liabilities © 2004 KPMG International.1 39. as the definition of trading assets and liabilities relates to all financial instruments.

In addition to those considerations relating to financial assets. However. to avoid the cost and complexity of meeting the criteria for hedge accounting (see Section 8. All liabilities other than trading liabilities and derivatives that are hedging instruments automatically fall into this category. For example.3.6). 64 5. on initial recognition and on first adopting the amendments. in some cases. borrowings and customer deposit accounts. the offsetting effects of changes in market interest rates on the fair value of each instrument will be recognised in profit or loss without the need for hedge accounting. The new designation may allow an entity. IASB Board meeting February 2004 As explained more fully in Section 1. KPMG International provides no services to clients. the IASB is proposing to limit the use of the fair value through income option to four specific circumstances. an entity that issues a fixed rate bond and immediately enters into an interest rate swap to ‘convert’ the interest to a floating rate might. designate the bond as ‘fair value through profit or loss’. All rights reserved. but also for changes in the entity’s own credit risk. there are some important consequences of using this designation (see Section 5.2.9 As with financial assets (see Section 5. separate disclosure is required of the amount of the change in fair value that is attributable to changes in the benchmark interest rate.3 Classification of financial liabilities © 2004 KPMG International.2 Other liabilities Other liabilities constitute the residual category similar to the available-for-sale category of financial assets.2. . KPMG International is a Swiss cooperative of which all KPMG firms are members. instead of claiming hedge accounting. in the example above the bond will be remeasured. to classify any financial liability (including own borrowings) as ‘fair value through profit or loss’.1). Each member firm is a separate and independent legal entity and each describes itself as such.1). not just for changes in market interest rates.IFRS Financial Instruments Accounting March 2004 Reference December 2003 amendments 39. an entity will have a free choice under the amended standards. Common examples are an entity’s trade payables. Since both the bond and the swap will be measured at fair value through profit or loss. 5. For liabilities designated as ‘fair value through profit or loss’. through profit or loss.

which are measured at fair value with changes in fair value included in the income statement.IFRS Financial Instruments Accounting March 2004 6. 6. including use of the effective interest method. FC = foreign currency Reference 6. the instrument is stated at cost. except for loans and receivables originated by the entity and held-to-maturity assets. When the fair value of an instrument cannot be reliably measured. except for those instruments that are held for trading. KPMG International is a Swiss cooperative of which all KPMG firms are members.1 Overview The measurement approach to be applied under IAS 39 depends upon the classification of an instrument into one of the four categories of financial assets or one of the two categories of financial liabilities discussed in Section 5. The concepts of fair value and amortised cost. Initially all financial instruments are recognised at cost. are discussed in Section 6. 65 . which are measured at amortised cost. for available-for-sale instruments. all other financial assets are measured at fair value. which is the fair value of the consideration given or received. with changes in the fair value included in either the income statement or as a separate component of equity. and financial liabilities are measured at amortised cost. All rights reserved. Subsequent measurement Key topics covered in this Section: ■ ■ ■ ■ ■ ■ ■ Subsequent measurement Fair value Amortised cost Foreign currency transactions Impairment issues Reclassifications and transfers between portfolios Deferred tax assets and liabilities Abbreviations used in this Section: MC = measurement currency. Subsequently: ■ ■ derivatives are always measured at fair value.3. ■ It is presumed that fair value can be reliably measured for most financial assets. KPMG International provides no services to clients. Financial assets held for trading and available-for-sale are measured at fair value in the balance sheet with changes in the fair value included in the income statement or. Each member firm is a separate and independent legal entity and each describes itself as such.1 Overview © 2004 KPMG International.

48. A mandatory hierarchy has been introduced. for example. KPMG International is a Swiss cooperative of which all KPMG firms are members. However. to classify the instrument either as ‘fair value through profit or loss’ or as ‘available-for-sale’. Additional guidance is provided on how fair value is to be determined. on initial recognition of a financial asset or financial liability. however. including the methods and significant assumptions applied. For a group of prepayable mortgage loans. as appropriate with mid prices being used only where there are matching asset and liability positions.9 As explained in Section 5. the value obtained through the use of valuation techniques should be tested and validated by comparing it to recent market transactions for similar items.55 39. bid and offer prices are to be used. KPMG International provides no services to clients. the extent to which market prices and valuation models have been applied in determining fair values and the total change in fair value recognised in profit or loss that is derived from the use of valuation models. The use of valuation techniques and models may not be used to ‘override’ an observable market price. is that an entity wishing to measure its available-forsale financial assets at fair value through profit or loss will need to put in place a system to ensure that each is designated as such on the date of purchase or origination.1 Overview © 2004 KPMG International. One consequence. This policy choice is considered unnecessary because of the fair value through profit or loss election that is now available on an instrument-by-instrument basis. IASB Board meeting February 2004 As explained more fully in Section 1. The exception is that the amendments remove the policy choice for an entity to measure available-for-sale financial assets at fair value with fair value changes recognised in profit or loss. although the classification of instruments between categories (and therefore the measurement basis applied) may change significantly under the amended standards. Generally. . discounts and premiums are generally amortised over the expected life of an instrument. with a quoted price in an active market being applied first. It is clarified that transaction costs. Historical prepayment patterns would be used to estimate expected lives. Revised prepayment estimates will give rise to gains and losses in the income statement. followed by the price obtained in a similar market transaction (where there is no direct market price). any discount. transaction costs are taken to profit or loss on initial recognition. will not change. the originated loans category is extended to cover also purchased loans. In addition. Where market prices are used. on initial recognition and subsequently.IFRS Financial Instruments Accounting March 2004 Reference December 2003 amendments 39. with valuation techniques being applied where there is no active market.AG69-AG82 66 6. where a market is inactive. All rights reserved. The amended standards also provide new guidance on how to measure amortised cost using the effective yield method. the IASB is proposing to limit the use of the fair value through income option to four specific circumstances. 39. Each member firm is a separate and independent legal entity and each describes itself as such. the amended standards will introduce a free choice. Where the classification of a financial asset or financial liability results in it being measured at fair value through profit or loss. and at the same time narrowed to exclude instruments that are quoted in an active market. transaction costs and related fees would be amortised over a period shorter than the contractual maturity. fees. Extensive disclosures are required about how fair values are determined. 39. the measurement of amounts in each category.

perpetual floating rate loans) should be measured at cost.24 6.1 39. Loans and receivables originated by the entity that do not have a fixed maturity (e. 39. The fair value of the loan at the date of acquisition is its cost. KPMG International provides no services to clients. are measured at fair value. KPMG International is a Swiss cooperative of which all KPMG firms are members. there is no amortisation of a difference between the initial amount IG B. if fair value is not considered to be reliably measurable. 67 .2. including derivatives. Each member firm is a separate and independent legal entity and each describes itself as such.IFRS Financial Instruments Accounting March 2004 Reference Figure 6.1 Measurement of financial instruments 6. Changes in the fair value of financial assets and liabilities held for trading (including derivatives) are recognised in the income statement.46 Loans and receivables originated by the entity that have a fixed maturity should be measured at amortised cost using the effective interest rate method.2 Classification determines subsequent measurement © 2004 KPMG International. Because there are no repayments of principal. A lack of a reliably measurable fair value could indicate that there is no possibility for trading with the intent of short-term profit-taking. All rights reserved.3.2. it is questionable whether such an instrument should be included in the trading portfolio.g. Fair value of these financial instruments should be reliably measurable.2 Loans and receivables originated by the entity Subsequent measurement of loans and receivables originated by the entity is at amortised cost. The amortised cost method of accounting is further discussed in Section 6. Any difference between cost and the amount repayable at maturity is recognised as interest income over the remaining period to maturity.2. Transaction costs that will be incurred upon sale or disposal of a financial asset are not deducted from the measurement.46 and 47 Classification determines subsequent measurement Trading assets and liabilities Financial assets and liabilities held for trading. 6.2 6. In respect of nonderivative financial instruments classified as held for trading.

the clean price of the instrument (i.g. For a partial disposal.55 included in income. the fair value of the debt instrument excluding accrued interest) should be compared with the amortised cost of the debt instrument at the measurement date. in high-inflation countries). or recognised directly in equity through the statement of changes in equity. disposal or impairment of the asset.2. KPMG International is a Swiss cooperative of which all KPMG firms are members.55 As noted above.55(b) 32. 6.IFRS Financial Instruments Accounting March 2004 Reference 39.46 39. a proportional share of the fair value gains and losses previously recognised in equity must be recycled to the income statement. like loans and receivables originated by the entity with a fixed maturity. The exemption would apply mainly to start-up entities.AG79 and AG84 and a maturity amount. December 2003 amendments 39. 68 6.2 Classification determines subsequent measurement © 2004 KPMG International. The basis for recording interest income is the historical effective interest rate. There is an exception from measurement at fair value of an available-for-sale asset if its fair value cannot be reliably measured. All rights reserved. short-duration receivables with no stated interest rate may be measured at original invoice amount unless the effect of imputing interest would be significant (e. Also. which is a similar treatment to the subsequent measurement of financial assets held for trading. also excluding accrued interest.4 Available-for-sale Available-for-sale financial assets are measured at fair value on the balance sheet. 39. Fair value changes may either be: ■ 39. For the correct measurement of the debt instrument.2.94(h) The subsequent measurement of available-for-sale debt instruments with fair value changes recognised directly in equity is complicated by the fact that interest income is recognised in the income statement each period.27 ■ 39.46 39. Each member firm is a separate and independent legal entity and each describes itself as such. even though the debt instrument is measured at fair value. . Such gains and losses must include all fair value changes up to the date of disposal. 6.e. such amounts are recycled to the income statement upon sale.3 Held-to-maturity Held-to-maturity assets. This exemption only applies to unlisted equity instruments or derivative contracts based on those instruments where there is insufficient history of profits or cash flows to support a reliable fair value measurement. Therefore. KPMG International provides no services to clients. the holder must apply the effective interest method and calculate the amortised cost of the instrument to determine interest income. When changes in fair value are recognised directly in equity. should be measured at amortised cost using the effective interest rate method. the fair value through income policy choice for available-for-sale financial assets is not available under the amended standards.

1.1. and does not have an intention or a need to liquidate instruments. 39. The fair value of a financial instrument should be reliably measurable.3. Underlying the concept of fair value is the presumption that the entity is a going concern.AG69 39. 32.9. If an entity cannot obtain an exact fair value. involuntary liquidation or distress sale.3 6. Each member firm is a separate and independent legal entity and each describes itself as such.3 Valuation issues © 2004 KPMG International.1 39.1 Classification of financial assets and liabilities determines the measurement 6. between knowledgeable and willing parties in an arm’s length transaction.1. Therefore. The variability within the range should not be significant and the probabilities of various estimates within the range should be estimable. KPMG International is a Swiss cooperative of which all KPMG firms are members. or a liability settled.3. it instead may determine a range of reasonable fair value estimates. KPMG International provides no services to clients.5 In summary Subsequent measurement of financial instruments is summarised in Figure 6.IFRS Financial Instruments Accounting March 2004 Reference 6. Figure 6. All rights reserved. Fair value does not take into consideration transaction costs expected to be incurred on transfer or disposal of a financial instrument.1 6.AG80 and AG81 6.2. nor undertake a transaction on adverse terms.1 Valuation issues Fair value General considerations Fair value is defined as the amount for which an asset could be exchanged.11 and IG E. fair value normally is not an amount that an entity would receive or pay in a forced transaction. 69 .

valuing an interest rate swap through discounting cash flows based on the contractual terms and rates obtained from published sources). Where an active.g. making reference to a debt instrument that is rated by an independent rating agency and whose cash flows can be reasonably estimated and discounted based on market rates for estimating the fair value of another bond). reliable evidence validating a higher or lower amount.AG74-76 ■ The methods used to determine fair value should be consistently applied during and between reporting periods for similar types of instruments. For example. AG79 and IG E. such as: ■ an active public market that makes available a published market price quotation (e. estimation methods and valuation models may be used to calculate fair value. All rights reserved.g. It is presumed that such matching positions would be settled within a similar time period. and option pricing models. An entity may not depart from using bid and ask / offer prices in order to comply with regulatory requirements. KPMG International is a Swiss cooperative of which all KPMG firms are members.3. well-established market does not exist for a particular financial instrument. it would be generally inappropriate to make adjustments when valuing large holdings.2. the appropriate quoted market price is usually the current bid price.g.AG72 and AG74 ■ 39. by reference to prices available from recent transactions or for similar instruments (e. . Quoted market prices may not be indicative of the fair value of an instrument if the activity in the market is infrequent.3 Valuation issues © 2004 KPMG International.2 Sources of fair value Fair values may be obtained from various sources. However. the appropriate quoted market price is usually the current offer or asking price.1 For a financial asset held or a financial liability to be issued.IFRS Financial Instruments Accounting March 2004 Reference 6. 39. if an entity entered into a contract with a third party to sell the shares at a fixed price in the immediate future. dealer. that might justify an adjustment to the quoted price. KPMG International provides no services to clients. broker. pricing service or regulatory agency). For a financial asset to be acquired or a financial liability held. liquid. When an entity has matching asset and liability positions. Adjustments to the quoted price may be possible only if an entity can present objective.1.2 methods based on the valuation of quoted instruments that are substantially the same as the instruments being valued.2. industry group. Each member firm is a separate and independent legal entity and each describes itself as such. providing that they are sufficiently reliable and the inputs are based on market data. and appropriate valuation models with data inputs that can be measured reliably because such data is available from active markets (e. an entity cannot depart from the quoted market price solely because independent estimates indicate that the entity would obtain a higher or lower price by selling the holding as a block. an equity security listed on a well-developed stock market where quoted prices are readily and regularly available from an exchange. the market is not well-established or only small volumes are traded relative to the number of units of the financial instrument outstanding. Estimation methods that may be used include: ■ 39. 39. discounted cash flows calculations.AG74. it may use mid-market prices as a basis for establishing fair values. For example. ■ ■ 70 6.AG71 and AG72 IG E.

000) (103. Each member firm is a separate and independent legal entity and each describes itself as such.000. The IRS has a maturity of five years and settlement of net cash flows is done semi-annually. In order to determine the fair value of the IRS at 30 June 20X1.822) (76. Fixed leg of the IRS Discounting of the fixed leg of cash flows is performed on the remaining nine fixed rate payments that will occur every six months from 31 December 20X1 to 31 December 20X5.808. The terms of the IRS are to pay a fixed rate of six per cent and receive a variable rate of six-month LIBOR. KPMG International provides no services to clients.537) (2. valuation models based on data inputs that are reliably measurable can be used as a method of valuation when published market prices for instruments are not available. performs a discounted cash flow calculation. the yield curve usually would not be flat.000) (3.832) (2.034) (2.902. All rights reserved.000) (3. These cash flows are three million every six months. XYZ Co. XYZ Co.567.000.223) (97.627) (2.000.318.304. At 30 June 20X1.717. Case 6.629.803) 6.000) (3.000.IFRS Financial Instruments Accounting March 2004 Reference As mentioned above. KPMG International is a Swiss cooperative of which all KPMG firms are members.1 Determining the fair value of an interest rate swap On 1 January 20X1.000.000.000) (3. however.7 per cent.000. The increase in interest rates changes the cash flows of the variable leg of the swap.000) (3.382.3 Valuation issues © 2004 KPMG International.000) (3. interest rates have increased. The future fixed rate cash flows and the related present value at 30 June 20X1 are as follows: Settlement date 31 December 20X1 30 June 20X2 31 December 20X2 30 June 20X3 31 December 20X3 30 June 20X4 31 December 20X4 30 June 20X5 31 December 20X5 Total discounted cash flows Cash flows (3. For the purpose of this example. the same effective rate is used throughout the term of the transaction for discounting cash flows. At inception the fair value of the IRS is zero.000) Present value of cash flows (2.461.000. In an actual situation.000. The following case demonstrates a basic fair value calculation for an IRS.758) (2.544. This would be the case for an interest rate swap (IRS).000) (3. The variable interest rate for the period from 1 July 20X1 to 31 December 20X1 is set at 6.667) (2.303) (2. based on the agreed fixed rate of six per cent (the annual fixed rate on the IRS). enters into an IRS with a notional value of 100 million. 71 . The discount rate to be used is the applicable LIBOR theoretical spot rate calculated from Euro futures or swap quotes.

All rights reserved. In other words. However.3 Valuation issues © 2004 KPMG International. The first step is to use a market value. The main features of the enhanced guidance are: ■ the objective is stated as being to establish what a transaction price would have been on the measurement date in an arm’s length exchange motivated by normal business considerations.318. a valuation model may not be used to recognise a profit or loss on initial recognition unless the model uses only market data.197 December 2003 amendments 39. . at the repricing date the present value of the variable leg will be par unless there is a change in the credit spread which is not factored into the repriced interest rate. ■ ■ ■ ■ 72 6.48.AG69-82 The amended standards provide much clearer guidance on how an entity might go about measuring fair value. Fair value of the IRS To determine the fair value of the IRS. particularly for an instrument that is not traded in an active market. the maximum possible use should be made of market inputs. Generally. KPMG International is a Swiss cooperative of which all KPMG firms are members. Any valuation technique must be developed with that aim in mind. to require that a valuation technique should incorporate all factors that market participants would consider and be consistent with accepted economic methodologies. to clarify that the fair value of a transaction on the date of the transaction is the market price unless fair value is evidenced by other observable market transactions or is based on a valuation technique based only on market data.000 (97.803 is netted against the present value of the variable rate receipts of 100 million: Cash flows Receipts – based on variable rates Payments – based on fixed rates Net Present value 100. the present value of the fixed rate payments obligation of 97.318. KPMG International provides no services to clients. if the valuation is made between repricing dates.IFRS Financial Instruments Accounting March 2004 Reference Variable leg of the IRS The variable rate receipts are calculated using the LIBOR forward rates. a hierarchy for the approach to apply in determining a fair value. 39. Each member firm is a separate and independent legal entity and each describes itself as such.000.803) 2. Thereafter market prices for similar instruments and valuation models are given equal prominence in the hierarchy of techniques. The discount rate is the same rate used to discount fixed rate payments.681. Market data can include historical data as long as the entity can demonstrate that the result from the model provides a more reliable estimate of fair value than the transaction price. the value of the variable leg may be different from its par value because its fair value will be subject to the short-term interest rates fluctuation until the next repricing date.

1. A previous gain or loss on that asset that has been recognised directly in equity should be left in equity until the financial asset has been sold or otherwise disposed of. 6. 39. the entire combined contract should be treated as a financial instrument held for trading.e. In that case. Each member firm is a separate and independent legal entity and each describes itself as such. and applies to both trading and available-for-sale instruments. or accounted for in accordance with the entity’s accounting policy for available-for-sale securities if the instrument is not held for trading (i. If a reliable fair value subsequently becomes available.3 Valuation issues © 2004 KPMG International. the difference between cost and the fair value at that time should be: ■ ■ 39. recognised in the income statement or directly in equity). it should use a supportable methodology rather than arbitrarily choose a fair value within a range of reasonable estimates. and that must be settled by. ■ The standards also clarify that the fair value of a liability that is repayable on demand is not less than the present value of the amount repayable on demand.46. it may be the case that fair value is no longer reliably measurable for a financial instrument that has been measured at fair value. If the fair value cannot be reliably measured. If an entity estimates the value of a financial instrument.AG81 This exception includes derivatives that are linked to. An exception to this is where an entity has assets and liabilities with offsetting market risks. If an embedded derivative that is required to be separated cannot be reliably measured. In rare circumstances. In that situation the last reliably estimated fair value becomes the new cost basis. delivery of such an unquoted equity instrument. KPMG International is a Swiss cooperative of which all KPMG firms are members. There is only one exception noted. 66 and AG81 39.3 When is fair value not reliably measurable? IAS 39 has a presumption that fair value can be reliably determined for most financial assets.54 IG C. These instruments are subject to normal impairment recognition requirements. the combined instrument is measured at cost less impairment. which is for an investment in an equity instrument that does not have a quoted market price in an active market and for which other methods of reasonably estimating fair value are clearly inappropriate or unworkable. bid and asking prices are applied to the net open position as appropriate. There may also be situations in which the fair value of such instruments can be estimated. discounted from the first date at which the investor could require repayment. at which time it should be recognised in the income statement. in which case the mid prices can be used for the offsetting risk positions. 6. 73 . KPMG International provides no services to clients. and it is clarified that the appropriate market price for an asset held or liability to be issued is normally the current bid price and for an asset to be acquired or liability held the asking price. The entity might conclude. however. that the equity component of the combined instrument may be sufficiently significant to preclude it from obtaining a reliable estimate of the entire instrument.3.11 39. the instruments should be stated at cost until a fair value can be reliably established.53 recognised in the income statement if the instrument is held for trading. All rights reserved.IFRS Financial Instruments Accounting March 2004 Reference ■ if an entity operates in more than one active market. the price at the balance sheet date for the instrument (without repackaging or modification) in the most advantageous market to which the entity has access should be used as fair value.

2. have accrued since the most recent interest payment date or market rates of interest have changed since the debt instrument was most recently repriced.3.9 Fixed rate instruments The effective interest method is a method of calculating amortisation or accretion using the effective interest rate of an interest-bearing financial asset or liability.2 6. IG B. plus or minus the cumulative amortisation of any difference between that initial amount and the maturity amount. Whether the discount. 74 © 2004 KPMG International. the entity should use the effective interest method to allocate interest income or expense over the term of the debt instrument to achieve a level yield to maturity. an investor purchases directly from the issuer a five-year floating rate note paying three-month LIBOR at a discount to reflect the difference between the variable rate set one month before at four per cent and the current yield of five per cent. In this case the amortisation period should be the period until the next repricing. .AG6-8 Floating rate financial instruments Calculating the effective interest rate and amortised cost is different for floating rate financial instruments that have been acquired or issued at a discount or premium. That computation should include all fees and points paid or received between parties to the contract.1 39.47 Amortised cost General considerations Amortised cost applies to both financial assets and financial liabilities. 39. that is a constant interest rate on the carrying amount of the instrument in each reporting period.3. premium or transaction costs are recognised in the income statement over the remaining term of the instrument or over the remaining term to the next repricing date depends on the reason for the existence of the premium or discount. For example. KPMG International provides no services to clients. Each member firm is a separate and independent legal entity and each describes itself as such. The effective interest rate method should be used for amortising premiums. In this case.IFRS Financial Instruments Accounting March 2004 Reference 6. and minus any write-down (directly or through the use of an allowance account) for impairment or uncollectability.9 6. KPMG International is a Swiss cooperative of which all KPMG firms are members.3 39.2 39. stepped interest) over the term of the debt instrument. The periodic re-estimation of determinable cash flows to reflect movements in market rates of interest will change the instrument’s effective yield.3. The effective interest rate (or internal rate of return) is the rate that exactly discounts the expected stream of future cash payments through maturity or the next market-based repricing date to the current net carrying amount of the financial asset or financial liability. The amortised cost of a financial asset or financial liability is the amount at which the financial asset or liability was measured at initial recognition minus principal repayments.3.2.2. ■ The period to next interest repricing date is used when a discount or premium results because interest payments are in arrears.e. Sometimes entities purchase or issue debt instruments with a predetermined rate of interest that increases or decreases progressively (i. All rights reserved.27 6. discounts and transaction costs for both financial assets and liabilities.

it would be reasonable to determine an amortisation schedule of the transaction costs based on the interest rate in effect at inception ignoring subsequent changes in the interest rate. IAS 39 does not prescribe any specific methodology about how transaction costs should be amortised for a floating rate loan. the calculations under the revised standard are likely to be the same as those illustrated. The revised carrying amount should equal the amount that would have been recognised if the change in estimate had been known from the outset (cumulative catch up approach). December 2003 amendments 39. Contractual cash flows would be used only in the rare cases where expected cash flows cannot be estimated reliably. 75 . KPMG International is a Swiss cooperative of which all KPMG firms are members. For example.IFRS Financial Instruments Accounting March 2004 Reference ■ The remaining term of the instrument is used in a situation when the discount or premium arises because the credit spread required by the market for the instrument is higher or lower than the credit spread that is implicit in the variable rate. For example. If there is a change in estimated future cash flows (other than due to impairment). KPMG International provides no services to clients. the amortisation period should be to the maturity of the instrument and not to the next repricing date because the repricing will not reflect the change in the credit spread. For example. Each member firm is a separate and independent legal entity and each describes itself as such. if a five-year floating rate note paying three-month LIBOR trades at a discount due to deterioration in the credit quality of the issuer subsequent to the issuance of the note. All rights reserved. 6.9 The amendments clarify that it is the expected and not the contractual cash flows that should be used to determine the effective yield on an instrument. the carrying amount of the instrument is adjusted in the period of change with a corresponding gain or loss being recognised in the income statement. for a portfolio of prepayable mortgage loans. Note that the use of expected cash flows specifically excludes the effect of expected future credit losses.3 Valuation issues © 2004 KPMG International. The remaining term of the instrument is also used for amortisation of transaction costs. In the examples below. The amortised cost calculation cannot therefore be used to remove credit spread from interest income to cover future losses. Any methodology that would establish a reasonable basis for amortisation of the transaction costs may be used. an entity would need to estimate prepayment patterns based on historical data and build the cash flows arising on early settlements into the effective yield calculations. The impact will be to amortise any initial discounts or transaction costs over the period to expected maturity rather than over the period to the contractual maturity of the loans (where the expected period to maturity is shorter than the contractual maturity).

07)2 (1.000 6.07)2 (1.07)3 (1.000 notional amount. Bank Y classifies the loan as originated by the entity.713 (being 6.07)4 (1.613 The interest income recorded in the income statement in year one is 6.3 Valuation issues © 2004 KPMG International.867 96.000 106.07)3 (1.000 6. Each member firm is a separate and independent legal entity and each describes itself as such.07) (1.898 80.000 106.577 95.241 4. the effective yield is 10.607 5.898 4. How should Bank Y account for the interest and the amortisation of the loan at 31 December assuming annual compounding? To calculate the amortised cost.e. 76 6.607 5. six per cent coupon rate. effective interest rate) is seven per cent.577 75.900 The effective interest rate of seven per cent is used to calculate the amortised cost of the treasury note at the beginning of year two as follows: Year 2 3 4 5 Amortised cost at beginning of year two Cash flows 6.000 6. KPMG International provides no services to clients. All rights reserved.07) (1.900. .000 6. The total interest income is seven per cent of the opening balance of 95.000 interest coupon plus 713 related to amortisation of the discount at the beginning of year).000 6.07)4 Present value of cash flows 5.3 Effective interest rate calculation On 1 January 20X1. Case 6. the fair value of the treasury note at the beginning of year one is calculated as follows: Year 1 2 3 4 5 Amortised cost at beginning of year one Cash flows 6.IFRS Financial Instruments Accounting March 2004 Reference Case 6.000 Discount factor (1.53 per cent herein).2 Calculation of (amortised) cost An entity purchases a government-issued treasury note with a 100.53482 per cent (rounded to 10. Bank Y grants a five-year loan of 50 million to Entity Z with an annual coupon of 10 per cent.000 Discount factor (1. The market rate at the time of issuance (i. Using the effective interest rate method. KPMG International is a Swiss cooperative of which all KPMG firms are members.900. The issue price of the loan is 98 per cent of the redemption value.241 4. and maturity in five years for a discounted purchase price of 95. Based on the cash flows of the loan.07)5 Present value of cash flows 5. the effective interest rate should be determined first.

207 49.e. the loan receivable is presented net of the discount amount (i. Interest income may be calculated on a daily.000 5. Figure 6.000 5.000 To calculate the effective interest income. which was used often in practice prior to IAS 39.000 5.000.000.008 218.000.000.341. KPMG International is a Swiss cooperative of which all KPMG firms are members.000. Each member firm is a separate and independent legal entity and each describes itself as such.000 divided by five years).53%) – 5.000.IFRS Financial Instruments Accounting March 2004 Reference The amortisation schedule is as follows: Date 1 January 20X1 31 December 20X1 31 December 20X2 31 December 20X3 31 December 20X4 31 December 20X5 Total Amortised cost 49. 49 million).063 At maturity the discount will be completely amortised and the carrying amount is equal to the face value of the loan.000 49.241.000 49.063 5.008 5.075 50.162. Debit 31 December 20X1 Accrued interest receivable Loan receivable (discount) Interest income To record the effective interest income on the loan at 31 December Credit 5.925 1. 6. The difference between the calculated effective interest for a given reporting period and the asset’s coupon is the amortisation of the discount during that reporting period.2 demonstrates the impact of amortising the discount using the straight-line method and using the effective interest method. KPMG International provides no services to clients.063 49.000 Amortisation – 162.162.162.868 241.000. the amortisation is not constant at 200.3 Valuation issues © 2004 KPMG International. depending on the reporting frequency of the entity. Contrary to straight-line amortisation.000.000.000.000 5.218.000 (1.925 26.000. The amortised amount increases each reporting period as the carrying amount of the loan increases.000. The journal entries for recording the loan and the interest income are as follows: Debit 1 January 20X1 Loan receivable (notional) Loan receivable (discount) Cash To record the loan Credit 50. monthly or quarterly basis.000.136 5.179. the effective interest rate is applied to the amortised cost of the loan at the end of the previous reporting period.539.136 198.000 On the balance sheet.000.000 Interest income (at 10.000 Coupon – 5.000 1.000 162. All rights reserved.063 179. Thus the amortised cost of the loan at the end of the previous reporting period plus amortisation in the current reporting period gives the amortised cost at the end of the current reporting period.063 5.199 49. 77 .758.868 5.198.000 25.000.

proportionate consolidation or use of the equity method.1 Foreign currency transactions General considerations Entities may have exposure to foreign currency risk. KPMG International provides no services to clients. most notably in the area of hedge accounting where IAS 21 has very limited provisions. This Section deals with interactions between IAS 39 and IAS 21 when measuring financial instruments denominated in a foreign currency. but merely refer to and supplement the requirements in IAS 21.3.3.3 6. Accounting for changes in foreign exchange rates is covered by IAS 21.3. Each member firm is a separate and independent legal entity and each describes itself as such. The measurement principles of IAS 39 generally do not affect these rules. 78 6.2 Straight-line versus effective interest method 6.3 Valuation issues © 2004 KPMG International.2 21.3. 6. which includes the accounting for: ■ ■ transactions in foreign currencies.IFRS Financial Instruments Accounting March 2004 Reference Figure 6. and translation of the financial statements of foreign operations that are included in the financial statements of the entity by consolidation. . Hedging of foreign currency exposures is covered in Sections 8 and 9. All rights reserved. KPMG International is a Swiss cooperative of which all KPMG firms are members. either from transactions in foreign currencies or from investments in foreign operations.21 Recording foreign currency transactions All transactions in currencies other than the functional currency of the entity must be initially recognised using the spot rate at the date of the transaction. The spot rate is determined as the price of a foreign currency purchased or sold with immediate delivery (for practical reasons immediate is often agreed to be two days after the transaction date).3.

23 6. when foreign exchange rates fluctuate significantly it may be necessary to translate foreign currency interest and amortisation amounts more frequently. contractual rights / obligations to receive / pay cash where the amount of money is not fixed nor determinable are nonmonetary financial instruments. KPMG International is a Swiss cooperative of which all KPMG firms are members. all monetary items in foreign currencies are translated at the closing spot rates with any gains or losses resulting from changes in the foreign exchange rates included in net income. Dividends should be recognised in income when the shareholder’s right to receive payment is established. The example below demonstrates the accounting for monetary financial instruments measured at amortised cost and fair value. Gains and losses recognised in the income statement include the effect of changes in foreign exchange rates. This value is then translated into the functional currency at the foreign exchange rate at the reporting rate. This is the case.28 and 39.8 Monetary items are money held and assets and liabilities to be received or paid in fixed or determinable amounts of money.3 Subsequent reporting of foreign currency trading instruments Non-derivative instruments that are held for trading purposes and all derivatives are measured at fair value in the foreign currency. for example. amortisation of premiums and discounts and impairment losses in foreign currency are recognised in the income statement as they accrue and are translated at the foreign exchange rate at the date of accrual.22 Interest amounts.3. All rights reserved. 79 . KPMG International provides no services to clients. This definition is narrower than the definition of a financial instrument. Impairment losses in a foreign currency are recognised in the income statement when they are incurred and are translated at the spot rate at that date.3. 21. 6.4 Subsequent reporting of other foreign currency financial instruments Monetary financial instruments 18.30(a) 21. with equity shares where the holder has no right to a determinable amount of money. Normally it would be acceptable to calculate amortisation and interest amounts on a monthly basis and translate those amounts at an average foreign exchange rate. Therefore.3 Valuation issues © 2004 KPMG International. All exchange differences on translation of monetary items should be recognised in the income statement in the period in which they arise. This is generally at the time of declaration. Consequently.AG83 Derivative contracts are settled at amounts which are determinable at the settlement date in accordance with the terms of the contract and the price of the underlying. 6. All derivatives that are settled in cash are monetary items.3. 21. Each member firm is a separate and independent legal entity and each describes itself as such. which implies that not all financial instruments are monetary. However.IFRS Financial Instruments Accounting March 2004 Reference 18. the foreign exchange rate used should be the foreign exchange rate at that date. even if the underlying is a nonmonetary item. At subsequent balance sheet dates.30(c) 21.3.

000. The cash flows are discounted at the original effective interest rate.5 and 1. The carrying values at 1 January and at 31 December 20X1. Each member firm is a separate and independent legal entity and each describes itself as such.4 Measurement of monetary financial instruments denominated in a foreign currency Foreign currency loan At 1 January 20X1. therefore.836 150. are presented below: Cash flows at 1 January 20X1 Present value of cash flows 11. the spot rate is 1.6. The security is purchased at par and matures on 31 December 20X4. At 1 January 20X1. All rights reserved.000 Carrying value in MC (at a spot rate of 1. an entity originates a loan of foreign currency (FC) 150 million with an eight per cent fixed rate of interest and measures the loan at amortised cost.5 1.074.000 100.000 12.111.000 Cash flows – 12. therefore. The entity records fair value changes on available-for-sale securities in equity.500 (6. respectively) The foreign exchange rate difference based on changes in the spot rate amounts to MC 6. The spot rate at 31 December 20X1 has increased to 1.6 Fair value (in FC) 150.000.100.000 93.5.000.000 Fair value (in MC) 100.750. the interest rates decreased so that the fair value of the security became FC 150.5.000.000.IFRS Financial Instruments Accounting March 2004 Reference Case 6. the entity records an asset of measurement currency (MC) 100 million.525.000 162. the spot rate is 1. KPMG International provides no services to clients. The total fair value change in the measurement currency is calculated as follows: Date 1 January 20X1 31 December 20X1 Fair value change Spot rate 1. when the spot rate has increased to 1.111.000. .000. in conformity with measurement at amortised cost.500) 80 6.000 and is recognised in the income statement. The loan is at par and matures on 31 December 20X4.000 31 December 20X1 Present value of cash flows – 11.187.823 150. KPMG International is a Swiss cooperative of which all KPMG firms are members.000.000 93.000 150.066 9.600.812.000 12.000.288.100.000.6.000 162. an entity purchases a debt security of foreign currency (FC) 150 million with an eight per cent fixed rate of interest. At 1 January 20X1.3 Valuation issues © 2004 KPMG International.000 (amounts in FC) 31 December 20X1 31 December 20X2 31 December 20X3 31 December 20X4 Carrying value in FC Cash flows 12.111 10.987 119.288. Foreign currency debt security At 1 January 20X1.000.111 10. The entity classifies the security as available-for-sale and measures the security at fair value.000.6.066 128. the entity records an asset of measurement currency (MC) 100 million.000 12.250. At 31 December 20X2.000.000 100.

such as equity securities. KPMG International provides no services to clients. Thus. KPMG International is a Swiss cooperative of which all KPMG firms are members. which is a MC 62.3 in Section 7 illustrates calculations of exchange gains and losses included in the income statement for monetary items issued or acquired at a premium or discount.000.500 gain. Dual currency loans A dual currency loan is an instrument where the principal and interest are denominated in different currencies. The amortised cost at 31 December 20X1 is FC 150.23 Non-monetary items generally are not translated subsequent to initial recognition. the embedded derivative is not separated because changes in the spot rate on the foreign currency denominated element (the interest or the principal) should be measured under IAS 21 at the closing rate with any resulting foreign exchange gains or losses recognised in the income statement. However.250. Case 7. which is then translated into the measurement currency. for available-for-sale equity instruments remeasured through equity the entire change in fair value is recognised in equity. are measured at fair value. All rights reserved. Changes due to impairment losses have been disregarded in this summary.000.750. the fair value is first determined in the foreign currency.000.IFRS Financial Instruments Accounting March 2004 Reference The entity has to distinguish between: ■ changes in fair value due to changes in interest rates (and credit spread. ■ IG E.1 below indicates whether fair value changes resulting from foreign currency and other risks should be included in the income statement or as a separate component of equity. 6. Such instruments should be reported using the foreign exchange rates that existed when the fair values were determined. and changes in fair value due to changes in the foreign exchange rate which must be recognised in the income statement. if applicable) which are to be included in equity. 81 . most non-monetary financial instruments. Thus. which is equal to MC 93.3. the foreign exchange loss to be included in the income statement is equal to MC 6.3 Valuation issues © 2004 KPMG International.2 In order to determine the fair value changes related to foreign exchange changes to be recognised in the income statement. the instrument is treated as an asset measured at amortised cost in the foreign currency. Foreign exchange gains and losses are not separated from the total fair value changes. Each member firm is a separate and independent legal entity and each describes itself as such. However. Non-monetary financial instruments 21. A dual currency loan with principal denominated in the measurement currency and interest payments denominated in a foreign currency contains an embedded foreign currency derivative. The cumulative gain or loss to be included directly in equity is the difference between the fair value and the amortised cost at the reporting date. Therefore. Table 6.000.

If there is no objective evidence of impairment no further action need be taken at that time for that instrument. the scope for judgement in determining whether a decline in fair value of available-for-sale investments represents an impairment is therefore reduced. 63 and 66 The amendments clarify that an impairment loss is recognised only when it is incurred. KPMG International is a Swiss cooperative of which all KPMG firms are members. This assessment should be done at least at each reporting period.58. The entity must first assess whether there is objective evidence that impairment exists for a financial asset. the recoverable amount is fair value. unemployment.1 Where to record changes in fair value Change in fair value from: Foreign currency ✔ ✔ ✔ ✔ To be included in: Income statement For all changes For all changes For all changes – Separate component of equity – – – Changes in fair value. December 2003 amendments 39. Each member firm is a separate and independent legal entity and each describes itself as such. including FX changes Other changes in fair value Financial instrument Trading instruments Originated loans and receivables Held-to-maturity Non-monetary available-for-sale instruments Other risks ✔ N/a N/a ✔ Monetary available-for-sale instruments ✔ ✔ FX changes 6. although the implementation guidance to IAS 39 continues to acknowledge that it is possible for the available-for-sale reserve in equity to become negative. in estimating cash flows for the purpose of estimating the recoverable amount of a portfolio of loans. of bankruptcy. the amendments clarify that in the case of available-for-sale financial assets.IFRS Financial Instruments Accounting March 2004 Reference Table 6. . Therefore. of borrowers that is estimated to have occurred at the balance sheet date. the contractual cash flows are adjusted only for the impact. Consequently. etc.4 Impairment of financial assets © 2004 KPMG International.4. However. Overall.4 Impairment of financial assets Addressing impairment of financial assets is a two-step process. death.10 82 6. IG E. Impairment losses are not recognised for losses expected to take place as a result of future events. In addition. Additional guidance is included for the recognition of impairment of available-for-sale equity investments. so that where it is assessed that an available-forsale asset has become impaired estimating a recoverable amount based on discounted future cash flows is unnecessary. based on historical data. KPMG International provides no services to clients. if there is objective evidence of impairment. All rights reserved. the entity should record an impairment loss during the reporting period so that the financial asset is recognised at its recoverable amount. no loss should be recognised on the day that a loan is granted.

as well as trends for similar financial assets. it may be evidence of impairment when considered with other available information.1 A change in the credit rating is not of itself evidence of impairment. An additional indicator is the magnitude of the difference between the original cost and the current value of the equity instrument. a declining relationship of market price per share to net asset value per share at the date of evaluation compared to the relationship at acquisition. as it can with debt instruments. The greater this difference.4 Impairment of financial assets © 2004 KPMG International. However. the greater also is the evidence of potential impairment. this may be an impairment indicator due to pure market and / or industry conditions. KPMG International is a Swiss cooperative of which all KPMG firms are members.4. the entity should take into account information about the debtor’s / issuer’s liquidity and solvency. high probability of bankruptcy. In practice there are a number of additional indicators and sources of evidence of impairment of equity securities that an entity may look to.4. impairment cannot be identified based on analysing cash flows. including: ■ 39. recent losses of the issuer.10 a decline in the fair value of the equity instrument that seems to be related to issuer conditions rather than general market or industry conditions. if the fair value at the acquisition date had been extremely high due to a market level which is unlikely to be recovered in the future. For equity instruments.4. or a decrease in the market value of an issuer’s debt securities significantly beyond factors explainable by changes in market interest rates. However. to the extent that they influence the recoverable amount of the financial asset.IFRS Financial Instruments Accounting March 2004 Reference 6. Each member firm is a separate and independent legal entity and each describes itself as such.61 and IG E. market and industry conditions. on its own the fact that the fair value of an equity security is below its cost does not necessarily indicate impairment. Instead impairment is based on the identification of indicators such as those characteristics described above. such as default or delinquency in interest or principal payments. In addition. financial conditions and near term prospects of the issuer.60 Objective evidence of impairment Indicators of objective evidence of impairment include: ■ ■ ■ financial difficulties of the issuer. such as one of the indicators noted above. ■ ■ ■ ■ ■ 6. a declining price / earnings ratio at time of evaluation compared to at the date of acquisition. disappearance of an active market for the financial asset due to financial difficulties of the issuer. 83 . KPMG International provides no services to clients. including any specific adverse events that may influence the issuer’s operations. ■ ■ ■ ■ 39. For example. breach of a contract. and local economic trends and conditions when evaluating for evidence of impairment. concessions granted from the lender to the borrower that the lender would not have considered normally.1 39. recognition of an impairment loss on that asset in a previous reporting period.60 IG E. All rights reserved.

For such instruments. December 2003 amendments ■ 39. This would not be appropriate as such assets are measured at amortised cost. might it be possible to demonstrate that a significant decline in value is not an impairment. the impairment loss to be recognised is the difference between cost and fair value of the instrument. However.68 In the case of an equity instrument included in the available-for-sale category.63 and AG84 ■ Financial assets carried at amortised cost: Impairment has occurred if it is probable that an entity will not be able to collect all amounts due (principal and interest) according to the contractual terms. similar to those described above. the loss is the difference between amortised cost and fair value. Specifically a significant or prolonged decline in value below cost is objective evidence of impairment under the amended standards. There is no quantified guidance on what is ‘significant’ or ‘prolonged’ and this evaluation will require judgement.IFRS Financial Instruments Accounting March 2004 Reference ■ ■ qualified independent auditor’s report on the issuer’s most recent financial statements. when market prices have subsequently recovered. . for example. Financial assets carried at fair value: Impairment is only an issue for availablefor-sale instruments in which changes in fair value are recognised as a component of equity rather than in the income statement. Although there remains some scope for judgement on whether a decline in the market value of an equity share represents an impairment.61 The amended standards include additional indicators of objective evidence of impairment for investments in equity instruments. and therefore measurement of the impairment loss. KPMG International provides no services to clients.4. All rights reserved. differs between assets carried at amortised cost and those carried at fair value. These differences are summarised as follows: 39. The recoverable amount is the present value of expected future cash flows discounted at the financial instrument’s original effective interest rate. or realisation of a loss on subsequent disposal of the investment.2 Measuring impairment For a financial asset that is impaired. Impairment is measured using the asset’s original effective interest rate because discounting at the current market rate of interest would. there is a strong presumption that a significant or prolonged decline in market value below cost is objective evidence of impairment. 39. such as a decision to suspend or decrease dividend payments. The loss recognised in the income statement is the difference between the carrying amount and the recoverable amount. 6. impose fair value measurement on the financial asset. KPMG International is a Swiss cooperative of which all KPMG firms are members. negative changes in the dividend policy of the issuer.67 ■ 39. The recoverable amount.4 Impairment of financial assets © 2004 KPMG International. The recoverable amount of a debt instrument is the present 84 6. if a charge for an impairment loss is required. the impairment loss as well as any net cumulative unrealised loss previously recognised in equity must be recycled to the income statement. only in rare cases. Each member firm is a separate and independent legal entity and each describes itself as such. the entity must determine its recoverable amount. In the case of impairment of a debt instrument included in the available-for-sale category. in effect.

the discount rate used is the current variable rate applicable to the next repricing date. in order to avoid double counting. it becomes clear Entity Z is experiencing severe financial difficulties and will not be able to meet its obligations of principal and interest according to the contractual terms. The effective yield at the date of origination is 10. interest paid) during the period of the delinquency. Assume that Bank Y grants a loan in the year 20X1 to Entity Z. decreased or postponed based on the current expectations for amount and timing of these cash flows as a result of losses incurred at the balance sheet date.AG84 If the holder expects that recovery on the instrument will come from the cash flows of the collateral. KPMG International is a Swiss cooperative of which all KPMG firms are members. However. adjusted for changes in the benchmark or risk-free interest rate for that financial asset. the original credit risk spread should be held constant and not adjusted to reflect the current credit risk spread. impairment must be recognised unless there is full compensation (i. Generally the current market rate for a similar financial asset should be interpreted as the original effective interest rate. KPMG International provides no services to clients. Case 6. If the fair value hedge was in respect of interest rate risk. which represents its inherent effective interest rate. Bank Y expects to recover only 25 million of the 50 million principal due and does not expect to receive the interest payment due at 31 December 20X5. In other words. The expected cash flows that are included in the calculation are the contractual cash flows of the instrument itself.207. the appropriate current market rate should consider adjustments for interest rates. The adjusted effective interest rate is used as the discount rate for measuring the impairment loss.3. even though all of the principal will be recovered. however. IG E. At 31 December 20X3. Even where cash flows are delayed for a period of time. Bank Y expects that it will receive the contractual interest payment of 10 per cent due at 31 December 20X4. The carrying amount of a fixed rate instrument measured at amortised cost may be adjusted for fair value changes in a fair value hedge (hedge accounting is discussed in Section 8). on maturity of the loan. At that date the carrying amount of the loan at amortised cost is 49. 39.4 For a variable rate loan measured at amortised cost.53482 per cent (rounded to 10. All rights reserved.4. The interest rate on the loan is 10 per cent and the loan is issued at 98 per cent of its face value. Each member firm is a separate and independent legal entity and each describes itself as such.e. The maturity date is 31 December 20X5.5 Impairment of a loan The following case is partially based on the earlier Case 6.IFRS Financial Instruments Accounting March 2004 Reference value of expected future cash flows discounted at the current market rate of interest for a similar financial asset. The adjusted carrying amount is the basis for the determination of impairment losses.4 Impairment of financial assets © 2004 KPMG International. then the fair value of the collateral is taken into account when calculating the impairment loss. What would be the calculated impairment loss if the loan is categorised as originated by the Bank Y? 6.53 per cent for the rest of this Case).539. 85 . the hedge adjustment also changes the effective interest rate.

000.165) should be recognised in the income statement.000.531 = 5. the credit risk premium for such a term and structure of a loan for Entity Z was 400 basis points. the recoverable amount is also the fair value of the loan because the current market interest rate is being applied to the expected cash flows. Thus. In this case.197.000. KPMG International is a Swiss cooperative of which all KPMG firms are members. How is the impairment loss then calculated? 86 6.000 25.985. Bank Y should reassess the impairment loss at each reporting date.5 per cent + 400 basis points) is used to discount the expected cash flows related to the Entity Z loan if it is included in the available-forsale category.165 = 5.125 (1.531).539.985. the present value based on this original effective interest rate is 24. How would Bank Y calculate the impairment loss if this instead is a purchased loan categorised as available-for-sale with changes in fair value recognised as a component of equity? The recoverable amount would be calculated based on discounting the expected cash flows using the current effective interest rate. any unrealised gains or losses relating to this loan are recycled out of equity and recognised in the income statement at the time the impairment loss is recognised.531 results in an impairment loss of 25. Each member firm is a separate and independent legal entity and each describes itself as such.042 (49.1053 (1.197.554.53 per cent for a debt instrument with the same terms as the Entity Z loan.197. Assume the same information as above. The discounted remaining cash flows are calculated as follows: 24. Assume that accrued interest is paid at 31 December 20X3 and thus is not included in the calculation. Therefore. In addition.53 per cent.000.5 per cent for a similar type of debt instrument. Given that only 25 million in principal and the 31 December 20X4 interest payment are expected to be received. At 31 December 20X3. Bank Y expects that it will only be able to recover the amount owed on the loan by taking legal possession of the securities.1053)2 As such.165. KPMG International provides no services to clients.207 – 24. All rights reserved.000 25.676 (49. an impairment loss of 24.000 + 1. the effective risk-free interest rate is 8.539.4 Impairment of financial assets © 2004 KPMG International. . This discounted cash flow is calculated as follows: 24.207 – 24.985. a rate of 12. Assume that the risk-free effective interest rate at the date of the loan acquisition by Bank Y was 6.000 + 1. The current effective interest rate is determined by reference to the change in the benchmark rate or the risk-free interest rate.125)2 The calculated recoverable amount of 24.53 per cent.341.5 per cent (8. The change in the credit spread from initial recognition of the loan is not taken into account.IFRS Financial Instruments Accounting March 2004 Reference The impairment loss is measured based on discounting the expected cash flows at the original effective interest rate of 10. except that the loan is collateralised by liquid securities. which is part of the effective interest rate of 10.

then the impairment of that particular asset should be recognised.59 and 61 6. For example. A new impairment analysis would then be prepared excluding the receivables of this client from the analysis. If no contractual interest payments will be collected. The loss is calculated as the difference between the carrying amount and this recoverable amount. either the original effective interest rate or the current effective interest rate). 39. An impairment loss may be recognised by writing down the asset or recording an allowance provision to be deducted from the carrying amount of the asset. Those receivables are normally considered to be similar in nature. However. 6.AG84 IG E.64 Now assume that within that portfolio. interest income is recognised based on the rate used to discount the future cash flows when measuring the recoverable amount (i. Future interest receipts should be taken into account when the entity estimates the future cash flows of the instrument. Each member firm is a separate and independent legal entity and each describes itself as such. KPMG International provides no services to clients. This could be an indicator that a write-down is required for a group of similar financial assets. the estimated recoverable amount of the loan equals the fair value of the securities less any costs expected to obtain the collateral.7 39.8 In this case. such as an originated loan or receivable. KPMG International is a Swiss cooperative of which all KPMG firms are members.4.4. then the only interest income recognised is the unwinding of the discount on those cash flows expected to be received. All rights reserved. One of the circumstances that provides objective evidence of impairment is the existence of a historical pattern of collections of accounts receivable that indicates that less than the entire amount will be collected. the entity estimates that an impairment loss of 20 million should be recognised based on the whole portfolio. the collateral itself should not be recognised on Bank Y’s balance sheet until the securities meet the recognition criteria for financial assets.AG93 39. Based on a statistical analysis.4 Impairment of financial assets © 2004 KPMG International.4. It is inappropriate to simply suspend interest recognition on a non-performing interest-bearing instrument.58 39. 6. However. assume that an entity performs an impairment analysis of its receivables portfolio of 500 million.4 Types of impairment measurement – individual or portfolio Impairment losses should be measured and recognised individually for financial assets that are individually significant.4. if an entity knows that an individual financial asset carried at amortised cost is impaired. 87 . one particular client is known to have financial difficulties and the impairment loss on the receivables due from that client is calculated at eight million.IFRS Financial Instruments Accounting March 2004 Reference 39. Impairment losses may be measured on a portfolio basis for a group of similar assets that are not individually significant. the deferred tax amount should also be recognised in the income statement. The impairment loss of eight million would be recognised separately as an impairment loss.3 Interest income recognition on impaired assets After an impairment loss has been recognised in the income statement.e. 12.64 IG E. If the impairment loss relates to an available-for-sale asset where a deferred tax liability or deferred tax asset was previously recognised for an unrealised gain or loss on the instrument.

it should not be included in a portfolio test for impairment. These cash flows should then be discounted at a rate that approximates the original effective interest rate. therefore. patterns of non-payment on a portfolio of homogeneous consumer loans or credit card receivables. KPMG International provides no services to clients. it nevertheless should be included in a portfolio of similar loans for the purpose of a portfolio-based impairment test. December 2003 amendments IG E. equity price risk). . for example. but which have not been reported or allocated to specific loan balances. It is only when that loan is included in a portfolio of similar loans that the bank determines inherent losses in the portfolio based on historical experience. judgement is necessary to determine a discounting methodology appropriate to that portfolio.64 As noted above. the amended standards clarify that the impairment model is an incurred loss model.2 39. Specifically: ■ If a loan is tested individually for impairment and found to be impaired. KPMG International is a Swiss cooperative of which all KPMG firms are members. This approach is different from applying a portfolio approach to a group of individual equity instruments. Even though the provision cannot yet be allocated to individual financial assets. an entity may be able accurately to determine the future expected cash flows of the portfolio of similar interest-bearing assets. In the case of shares in an investment fund. For portfolios of similar assets.IFRS Financial Instruments Accounting March 2004 Reference IG E. Each member firm is a separate and independent legal entity and each describes itself as such. Historical loss experience.5 A reasonable approach to impairment provisioning is to determine impairment losses that are probable based on the current environment combined with historical experience such as. it is likely that a decrease in the fair value of an investment fund is due to an impairment of at least some of the underlying assets held by the fund. A portfolio approach to impairment is not appropriate for individual equity instruments because equity instruments of different issuers are not considered to have similar risk characteristics (i. All rights reserved. However.e. However. if a loan is tested individually and is found not to be impaired. This is because there is no evidence of impairment of the loan upon origination. and The methodology used should ensure that an impairment loss is not recognised on the initial recognition of an asset.4 Impairment of financial assets © 2004 KPMG International. As discussed above it is allowable to calculate impairment losses and record a provision using a portfolio methodology for groups of similar assets. Further guidance is also provided on how to assess impairment for a group of loans or receivables. this does not mean that an entity is allowed to take an immediate write-down upon originating a new financial asset. ■ ■ 88 6. an investment fund should be evaluated based on the fair value of the investment fund itself rather than on the underlying investments held by the fund.4.4. such as an originated loan by a bank. is the basis for estimating losses that have been incurred within the portfolio. based on historical experience. Conversely. these assets will have a range of interest rates. adjusted for observable data reflecting economic conditions at the reporting date. An entity may employ various methodologies for determining impairment as long as they take into account the net present value of future expected cash flows based on losses incurred at the balance sheet date.

6. In some places. However. KPMG International provides no services to clients. in respect of available-for-sale equity investments. the write-down of the financial asset should be reversed either directly through the income statement or by adjusting a previously established allowance account through the income statement. Certain entities. for example. 69 and 70 Reversal of impairment losses Impairment should be assessed at each reporting date. IG E. The appropriation of retained earnings is an equity-only movement. December 2003 amendments 39. All rights reserved. the write-up in value of a financial asset through the income statement is limited to the amount previously recognised in the write-down. Consequently. Each member firm is a separate and independent legal entity and each describes itself as such. In the case of an impairment reversal. taking into account any repayments of principal. but rather is an unallocated reserve to be used for unplanned and unexpected losses. the amended standards state that an impairment loss may not be reversed through the income statement. for losses inherent in a group of assets and based on historical loss experiences.44 and 50 6. General provisions that are in excess of such portfolio-based amounts. or bad debt losses that are in addition to those necessary for individually significant financial assets or groups of similar financial assets are not allowed under IFRS.69 The amendments do not change the requirements on available-for-sale debt instruments. may set aside amounts for general banking risks through an appropriation of retained earnings.5 39. 89 . any subsequent increase in the carrying amount of an available-for-sale equity security is a fair value change that is recognised in equity. is recognised as an adjustment to equity in line with the accounting policy on the instrument.4. An illustration of such a situation would be an entity that has successfully improved its credit rating. through a reorganisation or after having received important sales orders. and any charges or reversals are not included in the entity’s income statement. any appreciation above (amortised) cost. KPMG International is a Swiss cooperative of which all KPMG firms are members. However.6 The term general provision is used differently in different parts of the world. For an available-for-sale instrument that is measured at fair value with changes in equity.IFRS Financial Instruments Accounting March 2004 Reference 6.4 Impairment of financial assets © 2004 KPMG International. general provisions are portfolio-based provisions.6 General provisions for credit risk Impairment provisions relate to situations where provisions are calculated for known risks of impairment. In other places. If in a subsequent reporting period the amount of an impairment or bad debt loss decreases and the decrease can be objectively related to an event occurring after the write-down. For a held-to-maturity asset and for originated loans and receivables.4. as described above. There should be objective evidence that the carrying amounts of individually significant financial assets or groups of comparable financial assets are greater than their recoverable amounts.4. 30.65. Any general provision that is an unallocated reserve established through a charge to the income statement should be reversed. a general provision refers to one that is not specifically related to expected losses in a group of assets. it is important to note that this is not a general provision. such as banks. any appreciation above (amortised) cost is not recognised.

KPMG International provides no services to clients.4. An impairment loss recognised on an available-for-sale debt instrument can be reversed. the accounting treatment applied should be disclosed along with the nature and the amount of any impairment loss or reversal.IFRS Financial Instruments Accounting March 2004 Reference 6. including an indication of whether such a transfer is permitted or why such transfers may take place.65 Foreign exchange gains and losses on an impaired monetary asset should continue to be recognised in the income statement. KPMG International is a Swiss cooperative of which all KPMG firms are members.2. Again in this case. should consider whether the decline should be treated as an impairment loss rather than as a normal foreign exchange translation loss. denominated in foreign currency. 39. In our view. All rights reserved.4.94(i) 90 6. This may occur if there is a sudden and severe devaluation of a foreign currency. no guidance is given regarding the treatment of exchange differences relating to the reversal.23 39. It is our view that until the previously recognised loss denominated in foreign currency is fully reversed. there is no specific guidance on how to measure impairment losses. Table 6. If by a subsequent improvement in circumstances an entity is able to reverse the impairment loss.7 Measuring impairment of financial assets denominated in a foreign currency For financial assets denominated in a foreign currency. The devaluation of the foreign currency may influence the credit risk and country risk associated with entities operating in that environment.1 Reclassifications of financial assets Transfers between categories An entity may wish to or need to transfer a financial asset from one category to another. At a minimum. The recoverable amount should be translated into the measurement currency using the foreign exchange rate at the date when the impairment is recognised. the situation is different. However. an entity that has foreign currency loans or receivables. Such limitations are imposed due to the concept in IAS 39 that asset classification should generally be clear as of the moment the asset is acquired or originated. the related foreign exchange differences should be recognised in the income statement.9 39. The amount of loss to be removed from equity and included in the income statement is the total net difference between the asset’s acquisition cost and current fair value in the measurement currency. it is advisable to record the impairment loss and any subsequent reversal at the spot rate in effect on the date when the reversal is recognised. such reversal should be recognised at the spot rate at the date when the reversal is recognised. Typically the recoverable amount of the asset is first determined in the foreign currency. 6.68 IG E. in part or in whole. For non-monetary assets held as available-for-sale with changes in fair value recognised in equity. Therefore. or holds debt securities denominated in a foreign currency that becomes devalued. There may be situations where the fair value of an asset in its currency of denomination is affected by foreign exchange rates. .5. Only in such instances should changes in foreign exchange rates be a factor for determining whether a further impairment loss or reversal of an impairment loss should be recognised in the income statement. Each member firm is a separate and independent legal entity and each describes itself as such. all possible transfers between categories are outlined.5 Reclassifications of financial assets © 2004 KPMG International. Any subsequent reversal should be limited to the amount of loss previously recognised.69 and 70 32. for certain categories transfers should be very rare or may not be allowed at all without tainting implications. 21.5 6. The difference between the recoverable amount and the carrying amount in the measurement currency is recognised in the income statement.

50 From trading IAS 39 is clear in regard to transfers from the trading portfolio – such transfers are not allowed. However. and not just because the entity has decided to sell the loans in the near future. or in the short-term. the assets are remeasured to fair value with differences between (amortised) cost and fair value recognised in the income statement.2 39. Unless a transfer meets one of the exceptions described in greater detail in Section 5. Entities should not reclassify to trading a tainted portfolio of held-to-maturity investments if after the tainting period (i.5 Reclassifications of financial assets 91 © 2004 KPMG International. two full financial years) the entity plans to reinstate the portfolio in held-to-maturity. . Each member firm is a separate and independent legal entity and each describes itself as such.9 and 50 From originated loans and receivables Originated loans and receivables should be classified as trading at the origination date if the intent is to sell such loans immediately. KPMG International is a Swiss cooperative of which all KPMG firms are members. The rationale is that the designation of a financial asset as held for trading is based on the objective for initially acquiring it (which is for trading purposes).1.3. If the held-to-maturity category is tainted. Reclassifications and sales of originated loans and receivables are possible without any of the tainting issues applicable to the held-to-maturity category.1.5. An example is when responsibility for a portfolio of loans is transferred from the banking division to the trading division and when the objective for holding the loans has clearly changed. All rights reserved.1. Differences between the amortised cost and fair value at the date of transfer are included either in equity or in the income statement depending upon the new classification of the assets.1 39. KPMG International provides no services to clients.5. or if they are part of a portfolio of loans for which there is an actual pattern of profit-taking. 6. such transfers should not be common.AG22 From held-to-maturity Transfers from the held-to-maturity category should be rare. Upon transfer to the trading portfolio.5. 6.3 39. A transfer from the originated loans and receivables portfolio to the trading portfolio at a later stage may happen only if there is evidence of a recent pattern of short-term profit-taking that justifies such a reclassification. it would be viewed in the same way as a sale and could thus taint the portfolio.e.2.2 Rules for transfers between financial assets categories Transfer to: Trading Transfer from: Trading Originated loans and receivables Held-to-maturity N/a If pattern of shortterm profit-taking Results in tainting Originated loans and receivables Not permitted N/a N/a N/a Held-tomaturity Not permitted N/a N/a In case of change in intent and if all criteria are met Available-forsale Not permitted N/a Results in tainting N/a Available-for-sale If pattern of shortterm profit-taking 6. as this objective would not be consistent with the intent of a 6. all assets in this category are remeasured at fair value and reclassified either to the available-for-sale or trading portfolios.IFRS Financial Instruments Accounting March 2004 Reference Table 6.

5. Any fair value component included in equity remains there and is amortised as an adjustment to the yield in a similar manner to a premium or discount. 39. December 2003 amendments 39. an entity is prohibited from transferring a financial asset or liability into or out of the fair value through profit or loss category. The fair value at the transfer date represents the new basis for recognising changes in fair value for the trading asset. Each member firm is a separate and independent legal entity and each describes itself as such. All rights reserved. Conversely.1. and to designate loans and held-to-maturity assets as available-for-sale. are not transactions that are recognised in the consolidated financial statements. the cumulative gain or loss included as a component of equity at the date of the reclassification is removed and recognised in the income statement. which involve transfers of financial instruments between group entities. 92 6. Furthermore. The amortisation of these two amounts should offset over the remaining life of the financial instrument. Upon derecognition of the asset. This may only be done if there is recent evidence of a pattern of short-term profit-taking that justifies such a reclassification. KPMG International provides no services to clients. A decision to sell a financial asset that is not classified as held for trading in the near future does not make that asset a financial asset held for trading.4 39. choice is only available when a financial asset or liability is first recognised (or when the amended standards are first applied). or available-for-sale. using the effective interest rate method.9 and 50 As noted above.IFRS Financial Instruments Accounting March 2004 Reference trading portfolio.50 From available-for-sale Instruments may be transferred from available-for-sale to trading. The effects of such transactions are eliminated upon consolidation.5. any cumulative gain or loss included as a fair value component of equity should remain there until derecognition of the reclassified asset. any difference between the new amortised cost amount and the maturity amount is also recognised as a yield adjustment in the income statement. Similar restrictions on reclassification do not apply to the available-for-sale category. Instead the entity should reclassify the tainted portfolio to available-forsale for the duration of the tainting period. the amended standards allow an entity much more flexibility to use a fair value through income measure for any financial asset or financial liability. the fair value through profit or loss. 6.2 Internal transfers of financial instruments Internal transactions. KPMG International is a Swiss cooperative of which all KPMG firms are members. and the entity decides to reclassify assets back to that category. 6.5 Reclassifications of financial assets © 2004 KPMG International. However. such transfers could be an indication that there has been a change in the group’s intent for holding the portfolios concerned.54 Transfers from available-for-sale to held-to-maturity can occur if there has been a change in the intent and ability of the entity. the fair value at the date of transfer becomes the new amortised cost basis for the held-to-maturity assets. such a transfer could occur if the tainting prohibition period on held-to-maturity assets has passed. In case of a transfer from available-for-sale to held-to-maturity. For instance. However. . If such a transfer occurs.

The accounting for the effects of deferred taxes of a transaction should be consistent with the accounting for the transaction itself. where there is a change in fair value of hedging instruments and the hedged items.4 in Section 7 illustrate the effect of deferred taxes when remeasuring a financial asset to fair value. 93 . for example. KPMG International is a Swiss cooperative of which all KPMG firms are members. In the majority of examples and cases in this publication. 12. deferred tax assets or liabilities may arise from instruments valued at fair value and from hedge accounting. Cases 7. Depending on the tax legislation in various countries. and also from other adjustments to the carrying amount. These same concepts may also be applicable to hedging transactions. 6.2 and 7. and a corresponding deferred tax asset or liability is established on the balance sheet.61 For changes in fair value that are recognised as a component of equity.6 Deferred tax assets and liabilities © 2004 KPMG International.IFRS Financial Instruments Accounting March 2004 Reference 6. With respect to financial instruments measurement. for a transaction whose effect is recognised in equity. All rights reserved. Each member firm is a separate and independent legal entity and each describes itself as such. measurement of financial instruments may give rise to deferred taxes. KPMG International provides no services to clients. the effects of deferred taxes have been disregarded. from the amortised cost method differing from the tax measurement basis or from differences in the treatment of transaction costs between IFRS and the applicable statutory tax regulations. In other words. deferred tax assets or liabilities are recognised for all temporary differences between the carrying amount of an asset or liability in the balance sheet and its tax base.6 12. if applicable. the related deferred tax effect should also be recognised in equity.57 Deferred tax assets and liabilities Under IAS 12 Income Taxes. the revaluation component in equity should be shown net of deferred taxes.

1 Overview © 2004 KPMG International. 94 7.1 Risk positions Foreign exchange (FX) risk ✔ ✔ Interest rate risk Trading Originated loans and receivables Held-to-maturity ✔ ✔ Price risk ✔ – Credit risk ✔ ✔ Measurement Fair value.IFRS Financial Instruments Accounting March 2004 7. The cases build upon the discussion of classification of financial assets and financial liabilities (Section 5) and of measurement and valuation issues (Section 6). Abbreviations used in this Section: MC = measurement currency. The cases are presented by type of financial risk. which are discussed in Section 8. with changes in income FX at fair value. interest rate risk at amortised cost ✔ ✔ – ✔ Available-for-sale ✔ ✔ ✔ ✔ Non-trading liabilities ✔ ✔ – – An entity may manage these risk positions by entering into hedging transactions. KPMG International provides no services to clients. FC = foreign currency Reference 7. KPMG International is a Swiss cooperative of which all KPMG firms are members. credit risk and interest rate risk at amortised cost Fair value. . Each member firm is a separate and independent legal entity and each describes itself as such. with changes in income or equity FX risk at fair value. credit risk and interest rate risk at amortised cost FX at fair value. All rights reserved.1 indicates the possible risk positions associated with each category of financial instrument and how they should be measured.1 Overview Table 7. Subsequent measurement – examples Key topics covered in this Section: This Section contains cases that demonstrate the measurement principles for various financial assets and financial liabilities. Table 7.

9 Because Entity T sells more than an insignificant amount of its held-to-maturity portfolio. The bonds have a remaining life of four years. two years after it acquired the bonds at par. However. The amortised cost and the fair value of the remaining held-to-maturity portfolio is 90. Each member firm is a separate and independent legal entity and each describes itself as such.500.000 Credit If the remainder of the portfolio is classified as available-for-sale with movements in fair value reflected as a component of equity until sold. and Entity T intends and is able to hold these bonds to maturity.5 million.000 Credit 39. The difference between the carrying amount and the fair value is recognised either in the income statement or in equity.000 4.000 10.000 Credit 7.000.000 500. KPMG International is a Swiss cooperative of which all KPMG firms are members. the tainting rules require the entity to reclassify the remaining held-to-maturity portfolio to either available-for-sale or trading. 39. respectively. For this example.IFRS Financial Instruments Accounting March 2004 Reference 7.1 Transfer and subsequent remeasurement of held-to-maturity investments Entity T buys 100 million in bonds issued by a triple A credit rated financial institution.500. Entity T would record: Debit Available-for-sale investments Loss on investments (income statement) Held-to-maturity investments To account for the transfer of the remainder of the portfolio 85.5 million.500.000 90.500.0 million and 85. Entity T would record: Debit Available-for-sale investments Loss on investments (equity) Held-to-maturity investments To account for the transfer of the remainder of the portfolio 85.000 4. 95 .000. The journal entries are as follows: Debit Cash Loss on sale of bonds Held-to-maturity investment To account for the sale of bonds 9.000.2 Interest rate risk Case 7. Entity T sells 10 per cent of the bond portfolio for 9.000 90.500.2 Interest rate risk © 2004 KPMG International. assume there is no related premium or discount. KPMG International provides no services to clients.51 If the remainder of the portfolio is classified as available-for-sale and movements in fair value are reflected in the income statement. All rights reserved. depending upon where the entity opts to record fair value changes (applies to available-for-sale only).

000.008 5. the measurement of the loan is at fair value. the accrued coupon interest of 2.442 = 5.000 25.000. The clean price amounts to 49.000 4. Amortised cost 49.000 (1. All rights reserved.440.000.53%) – 5.136 5. Given an interest rate on comparable loans with the same credit risk of 10 per cent at 30 June 20X1.218.500. the fair value of the loan at that date can then be calculated by discounting the cash flows: 52.925 26.000 Amortisation – 162. as amortisation should be on an effective yield basis.000.000 Date 1 January 20X1 31 December 20X1 31 December 20X2 31 December 20X3 31 December 20X4 31 December 20X5 Total Coupon – 5.000 The amortisation for the half year ended 30 June 20X1 is calculated (in this example) by taking half of the cost to be amortised in the year 20X1. Interest on the loan is recognised on the basis of the effective interest method.5 + 5.000.000. .063 5.000. the interest on comparable loans to borrowers with the same creditworthiness is 10 per cent. 96 7.000.10) 1.008 218.5 + 5.442 includes accrued interest. Each member firm is a separate and independent legal entity and each describes itself as such. This was to simplify this case.000 90.000.000 5.207 49.000.075 50.032.000.063 49.179. The amortised cost at 30 June 20X1 therefore amounts to 49.000 49.000. Entity T would record: Debit Trading assets Loss on investments (income statement) Held-to-maturity investments To account for the transfer of the remainder of the portfolio 85.000.868 241.081.000.440. Inter Bank acquires a loan to Entity Z with an annual coupon of 10 per cent and a face amount of 50.000 5.IFRS Financial Instruments Accounting March 2004 Reference If the remainder of the portfolio is classified as trading.198.000.341.000 5.5 million at 30 June is subtracted from the fair value. To calculate the applicable clean price of the loan. assume Inter Bank classifies the loan as available-for-sale with fair value changes recognised as a component of equity.940. In this case.5 + 5.2 Interest rate risk © 2004 KPMG International.758.925 1.162.10) 2.241.000 (1. KPMG International provides no services to clients.063 179. which is 81.032.5 The amount of 52. The purchase price of the loan is 98 per cent of the redemption value.000.10) 0.000.10)4.000 (1.868 5.000 (1.10) 3.5 + 55.539.199 49.162.000 5.136 198. At 30 June 20X1.000 Effective interest (10.000.442.500.000 (1. Since the loan is classified as available-for-sale. KPMG International is a Swiss cooperative of which all KPMG firms are members.2 Remeasurement of an available-for-sale asset On 1 January 20X1.00 Credit Case 7.

Debit 30 June 20X1 Available-for-sale assets Equity To record the fair value change during the reporting period Equity Deferred taxes (balance sheet) To record the related deferred tax liability Credit 859. Inter Bank sells the loan to another financial institution.442 49.410 Assume that the measurement for tax purposes is amortised cost and the applicable tax rate is 40 per cent.410 859.500.550 based on the current interest rate of 11 per cent on loans with similar maturity and credit risk.000.549. being the fair value at that time of the loan 30 June 20X1 Available-for-sale assets (accrued interest) Available-for-sale assets (discount) Interest income To recognise the effective interest income (coupon plus amortisation) Credit 50.000 49. A deferred tax liability of 343.581.000 81.2 Interest rate risk © 2004 KPMG International.764 343. Each member firm is a separate and independent legal entity and each describes itself as such.IFRS Financial Instruments Accounting March 2004 Reference A comparison of the clean price and amortised cost at 30 June 20X1 results in a positive change in fair value of: Fair value at 30 June Amortised cost at 30 June Change in value 49.764 related to the change in fair value should be recognised.000.032 859. since it is a component of the fair value.000 1. Assume that Inter Bank recognised its fair value adjustment and accrual of interest at 31 December 20X4 and this value has not changed. and amounts to 49. The journal entries recognised by Inter Bank are as follows: Debit 1 January 20X1 Available-for-sale assets (notional) Available-for-sale assets (discount) Cash To record the initial amortised cost. The fair value of the loan at 1 January 20X5 equals the fair value of the loan at 31 December 20X4.764 Continuation of the case (to 20X5): At 1 January 20X5. 7.000.032 2.081.940. All rights reserved.410 343.032 The accrued interest is presented as an increase in the fair value of the instrument in the balance sheet. 97 .000 2. KPMG International is a Swiss cooperative of which all KPMG firms are members. KPMG International provides no services to clients.

This difference between the fair value and amortised cost at 1 January 20X5 is a loss of 208. the effective interest rate is nine per cent. Bank A buys a foreign currency (FC) 100 million unlisted bond with a fixed annual interest coupon of six per cent. Debit 1 January 20X5 Realised loss on sale Deferred taxes (balance sheet) Equity To recycle the fair value changes from equity to the income statement Current taxes (balance sheet) Tax expense (income statement) To record the impact on tax expense of the realised loss Credit 208. monetary assets accounted for as held-to-maturity. and monetary liabilities that are not held for trading.210 83. maturing at 31 December 20X4.210 7.550 49. Each member firm is a separate and independent legal entity and each describes itself as such.840 for this bond. Assume there are no transaction costs.758. . The discount is due to the market yield for similar bonds at 1 January 20X1 being nine per cent. For purpose 98 7.025 83. KPMG International provides no services to clients.550 less the amortised cost of 49. the other aspects of this example are also applicable to: ■ ■ ■ monetary assets accounted for as originated loans and receivables.549.3 Foreign currency risk © 2004 KPMG International.IFRS Financial Instruments Accounting March 2004 Reference The journal entries to record this transaction are as follows: Debit 1 January 20X5 Cash Available-for-sale assets To record the proceeds on sale of the loan Credit 49. Case 7.3 Foreign currency risk The example below illustrates how changes in foreign exchange rates affect a debt security held as available-for-sale with changes in fair value recognised directly in equity. Bank A will classify the bond as available-for-sale with changes in fair value recognised directly in equity.3 Available-for-sale debt security in a foreign currency including amortisation On 1 January 20X1.210 124.075).550 Inter Bank must also recognise the change in fair value that was previously recognised in equity in the income statement. Bank A will record interest income at nine per cent of amortised cost using the effective interest rate method on a historical cost basis.025 (the fair value of 49. KPMG International is a Swiss cooperative of which all KPMG firms are members. Bank A pays the market price of FC 90.815 83.549. Therefore. All rights reserved. Except for the measurement at fair value in the underlying foreign currency.549.280.

550. The difference between the amortised 7.197.294 Effective interest (9%) (in FC) 8.000.840 92.316.780 155.421.614.572.650 11.922 138.450 1.2 and E. The amortisation schedules in foreign currency (FC) and in measurement currency (MC) are as follows: Amortised cost (in FC) 90.150.259 4.525. For this purpose.294 Exchange gain/(loss) in income on debt security a (in MC) – (9.000 1.706 100.000 6.000.000.040 8.220 4. the fair value in FC and MC (using spot rates) until the redemption of the bond is as follows: Date 1 January 20X1 31 December 20X1 31 December 20X2 31 December 20X3 31 December 20X4 21.040 2.193 Date 1 January 20X1 31 December 20X1 31 December 20X2 31 December 20X3 31 December 20X4 Date 1 January 20X1 31 December 20X1 31 December 20X2 31 December 20X3 31 December 20X4 Average exchange Amortised rate cost (in MC) – 1.525 135.000.260 131.695.347. Each member firm is a separate and independent legal entity and each describes itself as such.4 Spot rate Fair value (in FC) Fair value (in MC) 135. credit rating and maturity) is 8.700.574.000.406.248 a Calculated by comparing amortised cost at beginning of the period and amortised cost at end of the period.116 94.559 155.50 90.434 4.214 1. excluding accretion of the discount during the reporting period.000 Interest cash flow (6%) (in MC) 8.5 per cent.060.840 1.260 129.000 8.722.475 1.678.125.752.799.851.543.000.000 6.084 3.280.425 1.084 12.50 97.666 97.724.000 Discount accretion (in FC) 2.280.125.850.650 3.316.55 100.081.944 1. KPMG International is a Swiss cooperative of which all KPMG firms are members.871.000 6.000.000 Because the bond is a monetary item.276 2.421.40 93.347. IG E.710 146.434 13.752.781.348) 4.368.000. 99 .276 8.550 8.247.248 Effective interest (9%) (in MC) 11. foreign exchange differences must be recognised in the income statement. the security is treated as an asset measured at amortised cost in the foreign currency. All rights reserved.3. the market interest rate for similar bonds (in terms of currency.000 Discount accretion (in MC) 3.525. KPMG International provides no services to clients.23.000 Interest cash flow (6%) (in FC) 6.866 145.550 2.3 Foreign currency risk © 2004 KPMG International.45 95.000 9. it is assumed that the use of the average foreign exchange rate provides a reliable approximation of the spot rate applicable to the accrual of interest income during the reporting period.134.IFRS Financial Instruments Accounting March 2004 Reference of this illustrative example.301. Assuming no further changes in interest rates.853 1.562 137.931.3. At 31 December 20X1.579.000 8.

724. Fair value excluding at end FX of reporting (equity)b period (in MC) (in MC) 1.692.781.348 9.259 4.840 at the spot rate of 1.134.931.421.434 4.221) 131.650 3.623) (672.260 135.922 138. KPMG International is a Swiss cooperative of which all KPMG firms are members. ignoring tax effects): Debit 1 January 20X1 AFS debt security Cash To record the purchase of the bond: FC 90.248 (9. The required journal entries for the first two years are as follows (amounts are in MC.780 155.000 Date 20X1 20X2 20X3 20X4 b Calculated by comparing the change in fair value from the beginning of the reporting period to end of the reporting period.700. The exchange differences on the debt security to report in the income statement and the fair value changes to report in equity are calculated as follows: Fair value at beginning of reporting period (in MC) 135.301.678.543.081.360 (460.780 Exchange gain/(loss) on debt Discount security accretion (income) (in MC) (in MC) 3.197.IFRS Financial Instruments Accounting March 2004 Reference cost and fair value in the measurement currency is the cumulative gain or loss reported in equity.579. KPMG International provides no services to clients.134.45 31 December 20X1 AFS debt security AFS revaluation allowance (equity) To record the increase in fair value above the amortised cost in the measurement currency Exchange loss (income statement) AFS debt security Accrued interest receivable To record the FX adjustment of balance sheet items from opening and average FX rate to the closing spot rate Credit 135.348 300.3 Foreign currency risk © 2004 KPMG International. less the effect of foreign exchange differences (see a above).799.000.922 138. All rights reserved.421.084 3.650 1.360 1.360 9. Each member firm is a separate and independent legal entity and each describes itself as such.516) (559.220 4.000 100 7. .000.280.260 8.125.692.543. less the discount accretion.276.692.650 11.000) and amortisation of FC 2.50 During 20X1 Accrued interest receivable AFS debt security (accretion) Interest income (income statement) To record the receivable coupon interest at six per cent (FC 6.000 3.193 Change in fair value.710 146. These amounts are recognised at an average FX rate of 1.710 146.081.260 131.060.579.421.348) 4.060.434.

000 Credit 8.000.516 4.000 3. These amounts were recognised at an average FX rate of 1. Each member firm is a separate and independent legal entity and each describes itself as such.000 units.000 at the spot rate of 1. Entity M buys 100.678.425 31 December 20X2 AFS revaluation allowance (equity) AFS debt security To record the increase in fair value above the amortised cost in the measurement currency AFS debt security Accrued interest receivable Exchange gain (income statement) To record the FX adjustment of balance sheet items from opening and average FX rates to the closing spot rate Cash Accrued interest receivable To record the receipt of interest coupon FC 6.000. 7.000 8.400. KPMG International is a Swiss cooperative of which all KPMG firms are members. On 15 January.851.220 150.000 Similar journal entries will be made in 20X3 and 20X4. All rights reserved.4 Equity price risk © 2004 KPMG International.000 at the spot rate of 1. with changes in fair value recognised directly in equity. 7.40 During 20X2 Accrued interest receivable AFS debt security (accretion) Interest income (income statement) To record the receivable coupon interest at six per cent (FC 6.000 8.316.220 8. KPMG International provides no services to clients.700. Assuming that the measurement for tax purposes is cost and the applicable tax rate is 40 per cent.700.000.828.516 460.4 Equity price risk Case 7.IFRS Financial Instruments Accounting March 2004 Reference Debit Cash Accrued interest receivable To record the receipt of interest coupon FC 6. At that date the entity purchases another 50.400.000 4.550.301. 101 .084 11.550.000 units of an equity security for 10 million and classifies these securities as available-for-sale.084 460.45 8. the fair value of the securities increases from 100 to 115.4 Measurement of available-for-sale equity securities On 4 January.000) and amortisation of FC 2.

If Entity M applies the FIFO method. Therefore. All rights reserved. Each member firm is a separate and independent legal entity and each describes itself as such. the fair value of the securities increases from 115 to 125.000 600.000 600. the profit would be 125 – 100 = 25 per share.000 for the sale of 25.000 securities Credit 10.g.000 5.000 1. Entity M may opt for any one of these methods. 625.000.000. The method used should be applied consistently and disclosed as an accounting policy note.000 600.000 Entity M decides to sell 25.500.4 Equity price risk © 2004 KPMG International. The journal entry to record the change in fair value is: Debit 31 January Available-for-sale assets Equity For the increase in fair value from 115 to 125 on 150.000 10. e.000 of the units for 125 on 1 February.000 5. i.000 shares. KPMG International is a Swiss cooperative of which all KPMG firms are members.500.e.000 1.000 units Equity Deferred tax (balance sheet) To record the related deferred tax liability Credit 1.750.000 At 31 January.000 600. FIFO.500. KPMG International provides no services to clients. 102 7.IFRS Financial Instruments Accounting March 2004 Reference The journal entries for the above series of transactions are as follows: Debit 4 January Available-for-sale assets Cash To record the purchase of the securities 15 January Available-for-sale assets Equity To record the change in fair value from 100 to 115 on 100. .000 1. average purchase price or specific identification.000 units Equity Deferred taxes (balance sheet) To record the related deferred tax liability Available-for-sale assets Cash To record the purchase of 50. The financial instruments standards do not specify what method. should be used to calculate the gain (or loss) on the partial disposal.500.750.

000 375.000 250.000 625.000 3. Therefore. KPMG International is a Swiss cooperative of which all KPMG firms are members.125.000 7.2 may be used as reference when remeasuring a financial asset for changes in credit risk. recycled from equity Tax expense (income statement) Current taxes To record the impact on tax expense of the realised gain Credit 3.5 Credit risk © 2004 KPMG International.125.IFRS Financial Instruments Accounting March 2004 Reference The journal entries are as follows: Debit 1 February Cash Available-for-sale assets To record the proceeds from the sales Deferred taxes (balance sheet) Equity Gain on sale of securities (income statement) To record the realisation of the gain on the sale. KPMG International provides no services to clients.000 250.000 250. 7.5 Credit risk The calculation of the impact of credit risk on the measurement of financial assets that are measured at fair value is similar to the impact of interest rate risk. All rights reserved. Each member firm is a separate and independent legal entity and each describes itself as such. the cases included in Section 7. 103 .

For other entities. In determining whether and to what extent hedge accounting should be applied. The term hedging refers to a risk management strategy. but sets out the requirements related to the accounting for such activities. changes to systems and processes) and the potential volatility in reported earnings when hedge accounting is not applied. especially financial institutions. Specific issues relating to hedging of different types of risks (currency risk.e. Some entities may find it useful to apply hedge accounting only to a small number of significant transactions. KPMG International is a Swiss cooperative of which all KPMG firms are members. entities may need to consider the possible trade-off between the cost of implementing hedge accounting (i. Entities carry out hedging activities in order to limit their exposure to different financial risks such as currency risk.IFRS Financial Instruments Accounting March 2004 8. interest rate risk. while hedge accounting refers to the accounting method entities may choose to reflect hedging activities in their financial statements.1 Overview This Section provides an overview of the general principles for hedge accounting. Hedge accounting Key topics covered in this Section: ■ ■ Hedging versus hedge accounting The hedge accounting models: – Fair value hedge – Cash flow hedge – Hedge of a net investment in a foreign entity ■ ■ ■ ■ ■ ■ Hedged items and hedging instruments Hedge documentation Hedge effectiveness Highly probable transactions Termination of a hedge relationship Net position hedges Abbreviations used in this Section: MC = measurement currency. Each member firm is a separate and independent legal entity and each describes itself as such. FC = foreign currency Reference 8. KPMG International provides no services to clients. These activities often consist of entering into a derivative contract with a counterparty to eliminate or limit the risk.) as well as examples of hedge accounting are included in Section 9. price risk etc. the ability to apply hedge accounting may be a necessity. yet by doing so significantly reduce the volatility in earnings. 104 8. interest rate risk etc. IAS 39 does not change the principles that underpin entities’ hedging activities. All rights reserved. . Application of hedge accounting is not mandatory and in principle can be chosen on a transaction-by-transaction basis.1 Overview © 2004 KPMG International.

another financial instrument whose changes in fair value or cash flows are expected to offset changes in the fair value or cash flows of a designated hedged item. KPMG International provides no services to clients. KPMG International is a Swiss cooperative of which all KPMG firms are members.6 Section 8. are met: ■ 39. Each member firm is a separate and independent legal entity and each describes itself as such. can be hedging instruments.6 8.2 8.88 the hedge relationship is designated and documented at inception.6 Section 8. in limited circumstances.1 39. a measurable risk or an amount.6 Section 8. Table 8.IFRS Financial Instruments Accounting March 2004 Reference Regardless of the type of financial risk exposure.2 Hedge accounting basic concepts © 2004 KPMG International. 8.2 Section 8.72 and 78-80 Derivatives and certain foreign currency denominated non-derivative financial instruments. 105 . liability. hedge accounting usually involves a number of the same key steps in order to comply with IAS 39 requirements. Hedging instrument: A designated derivative or. Hedge accounting may only be applied if the following strict criteria. a portfolio or an entire position or part of a position. ■ ■ 39.1 Steps in the hedging process At inception of a hedge Step 1 – Determine the need for hedging Step 2 – Choose a hedge accounting model Step 3 – Determine whether hedge criteria are met Step 4 – Prepare hedge documentation Ongoing (at least each reporting date) Step 5 – Measure actual hedge effectiveness Step 6 – Reassess prospective hedge effectiveness Step 7 – Reassess hedge relationships and need for de-designation Step 8 – Prepare hedge accounting journal entries Section 8. A hedged item can be a single instrument.3 Section 8. These will each be described in detail in the Sections noted. All rights reserved. Hedge effectiveness: The degree to which changes in a hedged item’s fair value or cash flows attributable to a hedged risk are offset by changes in the fair value or cash flows of the hedging instrument.2. discussed in more detail later in this Section.9 Hedge accounting basic concepts Terminology IAS 32 and IAS 39 use a variety of terms to describe the components in a hedge relationship where hedge accounting is applied: ■ Hedged item: An asset. and that has been designated by an entity as being hedged. where the part is a proportion.7 Section 9 Section 8. or proportions thereof. firm commitment. or forecasted transaction that exposes the entity to risk of changes in fair value or future cash flows.

.2 The need for hedge accounting Hedge accounting is sometimes necessary due to accounting mismatches in: ■ Measurement – some financial instruments (non-derivative) are not measured at fair value with changes being recognised in the income statement whereas all derivatives (which are commonly used as hedging instruments) are measured at fair value. it is necessary to have matching in the recognition of gains and losses on the hedging instrument and the hedged item. For derivatives this means measurement at fair value with changes recognised in the income statement.2 Hedge accounting basic concepts © 2004 KPMG International. ■ ■ When a hedge does not meet the hedge accounting criteria. Both of these techniques are used under IAS 39.2. KPMG International provides no services to clients. to be applied when hedging the fair value of assets and liabilities already recognised in the balance sheet. the cash flow hedge accounting model. depending on the nature of the hedging relationship. and in the case of hedging of a future cash flow. 106 8. Each member firm is a separate and independent legal entity and each describes itself as such. ■ ■ 8. to be applied when hedging future contracted or expected cash flows. Matching can be achieved in principle by delaying the recording of certain gains and losses on the hedging instrument or by accelerating the recording of certain gains and losses on the hedged item in the income statement. ■ Examples of measurement mismatches include the hedge of interest rate risk on fixed rate debt instruments that are not held for trading and the hedge of foreign currency and other price risk on equity shares that are held as available-for-sale with fair value changes recognised directly in equity. hedge effectiveness can be reliably measured on an ongoing basis. KPMG International is a Swiss cooperative of which all KPMG firms are members. Recognition mismatches include the hedge of contracted or expected but not yet recognised sale.86 The hedge accounting models specified in IAS 39 are: ■ the fair value hedge accounting model. All rights reserved. purchase or financing transactions in foreign currencies and future (committed) variable interest payments. the hedging instrument and the hedged position must be accounted for in accordance with the normal requirements for each particular instrument. and Recognition – future transactions that may be hedged are not recognised in the balance sheet or are included in the income statement only in a future reporting period. 39. In order for the income statement to reflect the effect of the hedge. and the hedge of a net investment in a foreign entity.IFRS Financial Instruments Accounting March 2004 Reference ■ the hedge is expected to be highly effective at inception and throughout the life of the hedge relationship. cash flows are highly probable of occurring.

89 ■ 39.1 The hedge accounting models Fair value hedge accounting model A fair value hedge seeks to offset certain risks of changes in the fair value of an existing asset or liability that will give rise to a gain or loss being recognised in the income statement. The accounting for a fair value hedge essentially overrides the normal measurement principles for financial instruments discussed in earlier Sections.1 Fair value hedge accounting 39. the part of the fair value change that is attributable to the risk being hedged is recognised in the income statement rather than in equity. Another example is the hedge of the changes in value of inventory using commodity forwards.86 A hedge of the exposure to changes in the fair value of a recognised asset or liability.3 The hedge accounting models 39. IAS 39 defines a fair value hedge as: 39. All rights reserved. The applicable standards are IAS 39 for financial assets and IAS 36 Impairment of Assets for non-financial assets. 8. KPMG International is a Swiss cooperative of which all KPMG firms are members.3. However. Each member firm is a separate and independent legal entity and each describes itself as such. A hedged item otherwise carried at (amortised) cost is adjusted by the change in fair value that is attributable to the risk being hedged.3 8. An available-for-sale hedged item whose fair value changes are otherwise recognised in equity continues to be adjusted for fair value changes.AG102 The fair value hedge accounting method can be summarised as follows: 39.89 ■ 107 © 2004 KPMG International. with fair value changes recognised in the income statement. .IFRS Financial Instruments Accounting March 2004 Reference 8. Figure 8. An example of a fair value hedge is the hedge of a fixed rate bond with an interest rate swap. KPMG International provides no services to clients.89 ■ The hedging instrument is measured at fair value. changing the interest rate from fixed to floating. and that is attributable to a particular risk and that will affect reported net income. This adjustment is recognised in the income statement to offset the effect of the gain or loss on the hedging instrument. The adjusted carrying amounts of assets in a fair value hedging relationship are subject to impairment testing. or an identified portion of such an asset or liability.

This is intended to avoid volatility in the income statement in a period when the gains and losses on the hedged item are not (yet) recognised in the income statement.3.86 A hedge of the exposure to variability in cash flows that: (i) is attributable to a particular risk associated with a recognised asset or liability (such as all or some future interest payments on variable rate debt) or a forecasted transaction (such as an anticipated purchase or sale). 108 8. time value of options and forward points of foreign currency forward contracts). a hedge of the foreign currency risk on a firm commitment in a foreign currency may be accounted for as a cash flow hedge. a bond hedged for interest rate risk is not adjusted for fair value changes due to changes in credit risk). The net effect of the hedge in the income statement represents: – the ineffective portion of the fair value hedge. This means that changes in value of the (as yet unrecognised) contract will be recognised on balance sheet.87 39. and changes in fair value of the derivative that have been excluded by the entity’s choice from the hedge relationship (e.92 The adjustment of the carrying amount of the hedged item changes the effective interest rate of interest-bearing hedged items. but any gain or loss that is determined to be an effective hedge is recognised in equity.IFRS Financial Instruments Accounting March 2004 Reference IG E. .4 ■ 39. The definition of a fair value hedge in the amended standard is amended accordingly.g. 39. December 2003 amendments 39. All rights reserved.2 Cash flow hedge accounting model A cash flow hedge is defined as: 39. 8.95 The hedging instrument is measured under the normal IFRS principles. KPMG International provides no services to clients.4. As a result the income or expense relating to those hedged items includes the original amortisation of any discount or premium as well as the amortisation of the adjustment to the carrying amount resulting from the fair value hedge. Amortisation of the adjustment should begin no later than when the hedged item ceases to be adjusted for changes in the fair value attributable to the risk being hedged. but requires cash flow hedge accounting. KPMG International is a Swiss cooperative of which all KPMG firms are members.90 ■ The gains and losses attributable to risks other than the hedged risk follow the normal measurement principles (e. Each member firm is a separate and independent legal entity and each describes itself as such.86 The amended standard requires that a hedge of a firm commitment should be accounted for as a fair value hedge.74 – 39. An example of a cash flow hedge is the hedge of future expected sales in a foreign currency or of future floating interest payments on a recognised liability.g. under the amended standard. However. The existing standard recognises that a firm commitment gives rise to a fair value exposure.3 The hedge accounting models © 2004 KPMG International. Any ineffective part of the hedge is recognised in the income statement. ■ 39. and that (ii) will affect reported net profit or loss.

IFRS Financial Instruments Accounting March 2004

Reference 39.97

In order to match the gains and losses of the hedged item and the hedging instrument in the income statement, the changes in fair value of the hedging instrument recognised in equity must be removed from equity and recognised in the income statement at the same time that the cash flows from the hedged item are recognised in the income statement (sometimes referred to as recycling). However, when the hedged item is an expected future transaction that results in the recognition of an asset or a liability, the gain or loss on the hedging instrument will be recognised as an adjustment to the initial recognition amount of the asset or liability (often referred to as a basis adjustment). For example, an entity may hedge the foreign currency risk from an expected purchase of inventory in a foreign currency using a forward contract. When the inventory is recognised in the balance sheet the gain or loss on the forward contract is recognised as part of the carrying amount of the inventory. Once the expected future transaction occurs, assets arising from the hedge may be subject to other standards, for example, IAS 36 for impairment testing or IAS 2 Inventories for testing net realisable value.

39.97 and 98

39.97

The basis adjustment will affect the income statement either through amortisation, depreciation, impairment or on disposal / derecognition. For example, a basis adjustment included in the carrying amount of inventory would be recognised in the income statement as part of the cost of sales when the inventory is sold. Figure 8.2 Cash flow hedge accounting

The cash flow hedge accounting method can be summarised as follows:

No accounting entries are required in respect of the hedged future cash flow, whether this is the expected cash flow from a future purchase or sales transaction or from future interest cash flows related to an existing asset or liability. The hedging instrument is measured at fair value (for a foreign currency hedging instrument that is not a derivative, this applies only to changes in foreign exchange rates). The change in fair value that relates to the effective part of the hedge is recognised directly in equity. The ineffective part and the fair value changes of the derivative that have been excluded by the entity’s choice from the hedge relationship (e.g. time value of options and forward points of forward contracts) are recognised in the income statement.

21.23

39.95 and 96

8.3 The hedge accounting models © 2004 KPMG International. KPMG International is a Swiss cooperative of which all KPMG firms are members. KPMG International provides no services to clients. Each member firm is a separate and independent legal entity and each describes itself as such. All rights reserved.

109

IFRS Financial Instruments Accounting March 2004

Reference 39.100

Fair value changes remain in equity until the hedged cash flow is recognised. The gains and losses recognised in equity are included in the income statement in the same period(s) as the cash flows of the hedged item. December 2003 amendments

39.86

As noted above, the fair value hedging model will be required, under the amended standards, to be used for most hedges of firm commitments. The exception is a firm commitment in a foreign currency, which may be accounted for as a cash flow hedge. The amendments limit the use of ‘basis adjustment’. Under the existing standard, basis adjustment is required for a cash flow hedge in which the hedged cash flow results in a recognised asset or liability.

39.97

Under the amended standards, basis adjustment will be prohibited for cash flow hedges that result in a recognised financial asset or financial liability. An example would be a hedge of the interest rate risk in a forecast issuance of a bond, using an interest rate swap. Under the existing standards, fair value changes on the swap would be initially deferred in equity, to the extent the hedge is effective, until the date of issue of the bond. At that date, the accumulated amount deferred in equity would be adjusted against the initial carrying amount of the bond and would subsequently be amortised as part of the effective yield calculation. Under the amended standards, the amount deferred in equity would remain there, but would be amortised from equity into the income statement over the life of the bond, also on an effective yield basis. In respect of hedged purchases of non-financial assets such as inventory or property, plant and equipment, basis adjustment will be permitted under the amended standards, but not required. The approach adopted must be applied consistently as an accounting policy choice to all cash flow hedges that result in the acquisition of a non-financial asset or non-financial liability. In most cases, basis adjustment will be more straightforward as it does not require tracking of the amount deferred in equity over long periods. If a basis adjustment approach is not followed, such tracking would be required in order to calculate the amount to be released into profit or loss in each reporting period and for impairment testing purposes. On the other hand, US GAAP does not permit basis adjustment, and therefore an entity that also reports under US GAAP may avoid a reconciling item in this respect by choosing not to apply basis adjustment. 8.3.3 Net investment hedging An investor in a foreign entity is exposed to changes in value of the net assets of the foreign entity (i.e. the net investment) arising from the translation of the net assets into the group’s measurement currency. Such exposures are often hedged through borrowings denominated in the foreign entity’s measurement currency or (in more limited circumstances) derivative foreign currency contracts. Principles relating to hedging of net investments in a foreign entity are:
■ ■

39.98

39.102, 21.39 and SIC-19.4

21.39

gains and losses on a net investment in a foreign entity are recognised directly in equity; corresponding gains and losses on related foreign currency liabilities used as hedging instruments are also recognised directly in equity; and

110

8.3 The hedge accounting models © 2004 KPMG International. KPMG International is a Swiss cooperative of which all KPMG firms are members. KPMG International provides no services to clients. Each member firm is a separate and independent legal entity and each describes itself as such. All rights reserved.

IFRS Financial Instruments Accounting March 2004

Reference 21.48

any net deferred foreign currency gains and losses are recognised in the income statement at the time of disposal of the foreign entity.

39.88 and 102

IAS 39 does not override the principles of IAS 21. However, IAS 39 introduces the hedge accounting criteria to hedging of net investments. This means that all the criteria discussed in Section 8.6, such as documentation and effectiveness assessment, must be met for the hedge of a net investment in a foreign entity. An entity must still adhere to the criteria for designation and assessing effectiveness even when using non-derivative hedging instruments. 8.3.4 When is hedge accounting not required? When the hedging instrument and the hedged item are already accounted for in the same manner, the effects of the hedge relationship will automatically be reflected in the income statement or in equity, making hedge accounting unnecessary. However, the application of hedge accounting is not prohibited, provided that all hedge accounting criteria are met. Hedge accounting generally is not required for:

hedging of trading items when changes in fair value are recognised directly in the income statement. In this case both items are already recognised at fair value with gains and losses included in the income statement; and hedging of foreign currency risk of monetary items. For example, when a financial liability in a foreign currency is hedged with a deposit placement in the same currency, the liability as well as the deposit is required to be measured at the applicable closing spot rates with changes recognised in the income statement.

21.39

21.23

However, hedge accounting is not prohibited and may be advantageous in some circumstances. For example, an entity may wish to hedge the foreign currency risk on a long-term foreign currency trade payable due in one year’s time. To do this the entity takes out a forward with a maturity of one year. The trade payable is translated into the entity’s measurement currency at each reporting date at the closing spot rate while the forward is measured at its fair value based on the forward rate (not spot rate). In cases where the spot / forward differential is significant and volatile, this difference in rates may cause undesirable volatility in the income statement. Overall business risks cannot qualify for hedge accounting, as they cannot be separately and reliably measured. For instance, the risk of obsolescence in inventory or expropriation by a government cannot be hedged since those risks are not measurable. Also the risk of transactions not occurring falls into this category of overall business risks. December 2003 amendments

39.AG110 and IG F.2.8

39.9

The amended standard permits an entity, on initial recognition, to designate any financial asset or liability at ‘fair value through profit or loss’. As noted in Sections 5.2.1 and 5.3.1, this may allow an entity to avoid the cost and complexity of meeting the criteria for hedge accounting.

8.3 The hedge accounting models © 2004 KPMG International. KPMG International is a Swiss cooperative of which all KPMG firms are members. KPMG International provides no services to clients. Each member firm is a separate and independent legal entity and each describes itself as such. All rights reserved.

111

IFRS Financial Instruments Accounting March 2004

Reference

8.4
39.9

Hedged items The hedged item is the underlying item that is exposed to the specific financial risk that an entity has chosen to hedge.

8.4.1

What qualifies as a hedged item? In general the hedged item can be:

39.78

■ ■ ■

a recognised asset or liability; an unrecognised firm commitment; or an uncommitted but highly probable anticipated future transaction (forecasted transaction).

39.80, 86, AG110 and SIC-16

Hedge accounting may only be applied to hedges of exposures that can affect the income statement. Most transactions can affect the income statement. Exceptions are transactions with shareholders such as share issuances, dividend payments etc. as well as most intragroup transactions. A key requirement is that the hedged item exposes the entity to a risk that can be separately identified and reliably measured throughout the period of the hedge. Exposures to financial market risks such as interest rate risk and foreign currency risk in financial instruments can usually be separately identified and reliably measured. Also, exposure from items with commodity price risk or credit risk may be hedged. The forecasted purchase of an asset to be classified as held-to-maturity may be hedged for the period until the asset is recognised on the balance sheet. Although a held-tomaturity instrument may not be hedged for interest rate risk, the reinvestments of cash flows generated by a held-to-maturity instrument may be hedged. Additionally, a held-tomaturity investment can be hedged with respect to credit risk and foreign currency risk. Non-monetary items (such as equity shares) denominated in a foreign currency and held as available-for-sale with changes in fair value recognised in equity also may be the hedged item. Case 8.1 Hedge of a non-monetary item Entity A acquires equity shares in Entity B on a foreign stock exchange (shares are denominated in a foreign currency). Entity A classifies the shares as available-for-sale instruments with changes in the fair value recognised in equity. To hedge against foreign currency risk, Entity A enters into a forward currency contract. Entity A plans to rollover the contracts as they expire until the shares are later sold. In this situation the forward contract may be designated as a hedging instrument for the fair value changes relating to foreign currency risk of the shares provided that:

39.AG110

IG F.2.10 and F.2.11

IG F.2.19

the acquired shares are not traded on a stock exchange on which trades are denominated in the same currency as Entity A’s own measurement currency. This might be the case if Entity B’s shares are dual-listed and one of the listings is on an exchange where trades are denominated in Entity A’s measurement currency; and dividends to Entity A are not denominated in Entity A’s (but rather Entity B’s) measurement currency.

112

8.4 Hedged items © 2004 KPMG International. KPMG International is a Swiss cooperative of which all KPMG firms are members. KPMG International provides no services to clients. Each member firm is a separate and independent legal entity and each describes itself as such. All rights reserved.

as both the income from the investment in the subsidiary and the full fair value changes would be recognised in the consolidated income statement. 8. The prohibition against hedging interest rate risk on held-to-maturity investments relates to both hedging the risk of fair value changes of a fixed rate instrument and the risk of variability in the interest cash flows of variable rate instruments. An entity’s own equity instruments cannot be the hedged item since there is no risk exposure that affects the income statement because transactions in own shares are recognised directly in equity.7 ■ 113 © 2004 KPMG International. KPMG International provides no services to clients. Through consolidation the parent entity recognises its share of the subsidiary’s net income rather than the fair value changes in its investment in the subsidiary. In theory. Likewise forecasted transactions in an entity’s own equity cannot be a hedged item. for fixed rate held-to-maturity instruments. 39. cash flows generated from its operations are in its own measurement currency and hence do not give rise to a foreign currency risk exposure at the foreign entity reporting level.88 ■ 21. rather than its fair value changes. in the income statement. The reason is that the equity method of accounting recognises the investor’s share of the investee’s net income or loss. KPMG International is a Swiss cooperative of which all KPMG firms are members. When the hedged item is a non-financial asset or liability.2.2 Items that do not qualify as hedged items There are a number of items that for different reasons do not qualify for hedge accounting.78 and 79 ■ IAS 39 generally precludes derivatives from being the hedged item and as such derivatives can only serve as hedging instruments. a held-to-maturity investment cannot be a hedged item with respect to interest rate risk. liability or cash flow. the hedge must either be designated for the foreign currency risk only or for the entire risk of the asset.10 ■ 39. In these cases the normal recognition and measurement principles in IAS 39 must be applied. This is 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. Because prepayment risk on interest-bearing instruments is primarily a function of interest rate changes this risk is akin to interest rate risk and hence cannot be hedged when the hedged item is a held-to-maturity investment. The fair value at maturity is unaffected by changes in interest rates. which also cannot be a hedged item in a fair value hedge.39 ■ SIC-16 IG F. To allow the subsidiary to be a hedged item would result in double counting.2.82 and AG100 ■ 39. From a foreign entity’s own perspective. Groups with foreign entities may wish to hedge the foreign currency exposure from the expected profits from the foreign entities using derivatives or other financial instruments. an entity should be indifferent to changes in interest rates since the entity does not intend to dispose of the investment before its maturity.2. expected net profits from a foreign entity do not qualify as hedged items since they are not subject to a cash flow risk exposure. Unlike originated loans and receivables.4 Hedged items ■ ■ IG F.1 39.78.4. Each member firm is a separate and independent legal entity and each describes itself as such. An equity investment accounted for under the equity method (joint venture or associate) cannot be a hedged item in a fair value hedge. The same reasoning applies to an investment in a consolidated subsidiary.AG99 ■ ■ 39. However.IFRS Financial Instruments Accounting March 2004 Reference 8. All rights reserved. 79 and IG F. .

this will introduce a number of additional requirements for this form of hedge accounting. 8. It is not necessary that each item in the portfolio shares all of the same risks and is correlated with respect to all risks.2. when issued. Hedging a portfolio requires that: ■ the individual assets. Future amendments to IAS 39 At the date of this publication. in this scenario. . liability or expected transaction.5 Hedging exposure to interest rates or credit risk spread of a bond (rather than hedging the full market risk). 39.81 Financial assets or liabilities may be hedged with respect to a particular financial risk component. KPMG International provides no services to clients. it cannot be expected that the fair value changes of individual items in the portfolio would be approximately proportional to the fair value change of the entire group. To achieve the required correlation. Hedging exposure to the risk-free interest rate in a fixed or floating rate liability (rather than hedging the entire interest rate risk). KPMG International is a Swiss cooperative of which all KPMG firms are members. ■ IG F. All rights reserved.20 An example of a portfolio that would not qualify as a hedged item is a portfolio of different shares that replicates a particular stock index. Such correlation usually requires that the individual sales are denominated in the same foreign currency and are expected to take place in the same time period.3 Hedging a portfolio of items A hedge relationship may be established not only for a single asset.IFRS Financial Instruments Accounting March 2004 Reference 8. Examples of items that may be hedge accounted for on a portfolio basis include the following: ■ A portfolio of short-term corporate bonds may be hedged as one portfolio with respect to a shared risk-free interest rate. 8.3. liabilities or future transactions in the portfolio share the same characteristics with respect to the hedged risk. the bonds would need to have the same or very similar maturity or repricing date and exposure to the same underlying interest rate. A group of expected future sales may be hedged as one portfolio with respect to foreign currency risk. It is anticipated that.4.4 Hedged items ■ 114 © 2004 KPMG International.83 ■ This means that the portfolio of items must have shared risk characteristics with respect to the risk being hedged. provided that the exposure to the particular risk component is separable and can be reliably measured.4. and the change in fair value attributable to the hedged risk for each individual item in the portfolio is expected to be approximately proportional to the overall change in fair value attributable to the hedged risk of the group. An entity may hold such a portfolio and economically hedge this with a put option on the stock index. the IASB is finalising its deliberations in respect of Fair Value Hedge Accounting for a Portfolio Hedge of Interest Rate Risk. However. Each member firm is a separate and independent legal entity and each describes itself as such. as long as the hedged risk is a common risk characteristic. but also for a portfolio of items.4 Hedging risk components and proportions of items Hedging a risk component of a financial instrument 39. Examples of such risk components include: ■ 39.81 and IG F.

e. This can be done either by specifying the number of units expected to be purchased / sold (e. this hedge is only likely to be effective if the price fluctuations on sugar and chocolate bars have been highly correlated in the past and are expected to remain so in the future. For example. milk etc. It would not be permissible in this situation to designate as the hedged item the price risk relating only to the price of sugar.IFRS Financial Instruments Accounting March 2004 Reference IG F.10 ■ ■ 8.81 IAS 39 also allows a proportion of the fair value or cash flows of an item to be hedged.g. Each member firm is a separate and independent legal entity and each describes itself as such.17 Hedging the interest rate risk for the first five years of a 10-year fixed rate bond with a five-year pay-fixed receive-floating interest rate swap. A price risk relating to a non-financial component may not be hedged. the hedge is unlikely to be highly effective.2. It would not be permissible to designate the first 50 per cent of sales as the hedged item as this designation would not lead to an identifiable amount being hedged (i. cocoa. Hedging the interest rate risk of half of the notional amount of a bond.82 Non-financial items may not be hedged for separable risk components other than foreign currency risk. IG F.5 ■ Hedging a risk component of a non-financial item 39.2. KPMG International provides no services to clients. the first 500 units out of expected purchases / sales of 800 units) or by specifying the monetary value of the purchase or sale (e. KPMG International is a Swiss cooperative of which all KPMG firms are members.3.19 ■ Hedging foreign currency exposure only in a portfolio of foreign currency denominated equity instruments (rather than hedging the full market price risk). the first 25 million). Hedging the price or foreign currency risk of a proportion of a forecasted purchase or sale. 115 . which is not known until after the fact) and hedge effectiveness testing would not be possible. That is because only foreign currency risk is assumed to be a separately measurable risk component. the first 50 per cent of sales would depend on the total amount of sales in the period.4 Hedged items © 2004 KPMG International.). A floating rate debt instrument is normally considered not to have fair value exposure because of periodic resetting of its interest rate. All rights reserved. However. Examples of such designations would be: ■ IG F.g. As an alternative the producer may designate the sugar forward as a hedge of the entire fair value changes of the chocolate bar inventory.3.AG100 39. such an instrument could be hedged in a fair value hedge for credit spread or for interest rate risk exposure that can occur between interest reset dates. As chocolate bars consist of other ingredients than sugar (e. IG F. and in that case hedge accounting would not be permissible. a producer of chocolate bars may wish to hedge the fair value of its inventory in respect of changes in the sugar price (a major ingredient in chocolate bars) by taking out a sugar forward in the commodity market. However. Hedging a proportion of a hedged item 39. In this situation the bond is hedged for a period of time less than its full term.g.

KPMG International is a Swiss cooperative of which all KPMG firms are members. This approach will give rise to some ineffectiveness in practice. then a derivative with a notional amount of 1. If there is a valid statistical relationship between the two prices. Intragroup monetary items lead to a group exposure that affects the group income statement in instances when: ■ ■ ■ 39. even if that component can be proven to exist and can be measured reliably.02 tons of Columbian coffee would be designated as a hedge of the purchase of one ton of Brazilian coffee.AG100 Several comments on the proposed amendments had proposed that separate components of a non-financial item should qualify for hedge accounting as long as changes in the fair value of the hedged component could be measured reliably. however.5 Intragroup balances or transactions as the hedged item Although intragroup transactions are eliminated on consolidation. Each member firm is a separate and independent legal entity and each describes itself as such.IFRS Financial Instruments Accounting March 2004 Reference December 2003 amendments 39.4 Hedged items © 2004 KPMG International. and at least one of the group entities is a foreign entity. However. All rights reserved. For example. but has clarified in the amended standards that hedge accounting might be achieved by adjusting the hedge ratio to maximise effectiveness. if the slope of the ‘line of best fit’ is 1. For example. For example. 116 8. The Board rejected this suggestion. 8. the parent still has foreign exchange rate differences since the item is denominated in FC. a regression analysis might be performed to establish a statistical relationship between the price of a transaction in Brazilian coffee (the hedged item) and a hedging instrument whose underlying is the price of Columbian coffee.80 and 21. to prohibit the hedged item to be designated as the Columbian coffee component of the Brazilian coffee price. KPMG International provides no services to clients. The amended standards will continue. Such an intragroup monetary item could qualify as a hedged item for purposes of hedge accounting if all other criteria are met. the foreign exchange difference cannot be eliminated. The transaction itself is eliminated on consolidation. although it may be sufficient to ensure that hedge accounting can be achieved. intragroup monetary items can be designated as hedged items at the group level in situations where foreign exchange rate exposure cannot be eliminated on consolidation. the item is denominated in one of these measurement currencies.02. .45 items have been transacted between group entities with different measurement currencies.4. the slope of the regression line can be used to establish the hedge ratio that will maximise expected effectiveness. Therefore. an intragroup payable / receivable between a parent with measurement currency (MC) and its foreign subsidiary is denominated in foreign currency (FC).

a forecast external transaction by a foreign entity in its own functional currency cannot generally qualify as a hedged item because the group has no exposure to foreign currency cash flow risk.77 It is possible to use two or more derivatives. as long as the other criteria for hedge accounting are met. an interest rate swap and a currency forward could be designated together to hedge a loan in a foreign currency. and compound derivatives (such as cross currency interest rate swaps and collars). The reason for this amendment would seem to be that the foreign exchange risk in most forecasted intragroup transactions will affect group profit or loss only indirectly as a result of translating the income statement of a foreign entity for consolidation purposes into the reporting currency of the group. 8. Each member firm is a separate and independent legal entity and each describes itself as such. Non-derivative financial assets or liabilities may be designated as hedging instruments for hedges of foreign currency risk only. then the standard may not preclude a forecast external foreign currency cash flow from qualifying as a hedged item. and whose foreign currency component is reliably measurable. All rights reserved. swaps. The derivatives do not have to be entered into with the same counterparty. KPMG International is a Swiss cooperative of which all KPMG firms are members. KPMG International provides no services to clients. or proportions thereof. options. An exception is a non-derivative instrument that is denominated in a foreign currency. that is designated as a hedge of foreign currency risk.AG96 8. or an intragroup firm commitment. cannot qualify as a hedged item at the group level if there is no potential impact on the profit or loss of the group. 39.5. a borrowing denominated in a foreign currency can be designated to hedge a sales commitment in the same foreign currency. 117 . at the group level only. However. that cash flows from the forecast external transaction are passed directly to an entity with a different functional currency. Generally financial assets and liabilities whose fair value cannot be reliably measured also cannot be hedging instruments. For example. A forecast intragroup transaction. 39.IFRS Financial Instruments Accounting March 2004 Reference December 2003 amendments In amending the standards.72 Hedging instruments What qualifies as a hedging instrument? Derivatives are generally the only instruments that can be used as hedging instruments. the guidance permitting a forecasted intragroup transaction to qualify as a hedged item in a cash flow hedge has been withdrawn. For example.1 39.5 8.5 Hedging instruments © 2004 KPMG International. as the hedging instrument for the same hedged item. for example. where the group is able to demonstrate. Some of the derivatives that are commonly used in hedging transactions and may qualify for hedge accounting include: ■ ■ ■ ■ forward and futures contracts. such that the forecast external transaction does create a foreign currency cash flow exposure to the group. At the group level.

accordingly. The effect of the strategy is that the entity is protected against decreases in value below 90. In this case the option is more likely to be effective in matching the changes in the hedged item. . Options. by buying a put option to sell at 90 and writing a call option to sell at 100.5. but not an obligation. This is demonstrated in Figure 8. a forecasted transaction in a foreign currency may be hedged with an option. Some hedging strategies involve a written call option and a purchased put option with different strike prices. since the change in the time value element of the option is not offset by an equal and opposite change in the forecasted transaction. Changes in time value would not be included in the hedge relationship and as a result would be recognised directly in the income statement regardless of which hedging model is used.5 Hedging instruments © 2004 KPMG International. to use the derivative. In this situation the cash flows of the forecasted transaction do not include a time value component while the option does.e. The change in fair value of the option and the change in cash flows of the forecasted transaction will not be the same. that is closely related and for that reason not separated from the host contract. but has given up the upside potential of a price increase above 100. Each member firm is a separate and independent legal entity and each describes itself as such. KPMG International is a Swiss cooperative of which all KPMG firms are members. i.74 and AG94 39. the holder has a right.74 IAS 39 allows for the time value of an option to be excluded from the effectiveness assessment.2 Using options as hedging instruments Purchased options may be used as hedging instruments provided that the criteria in Section 8. For example.1. since both the separated purchased option and the written option would be measured at fair value in the income statement. in contrast to forward and futures contracts. For example. 39. All rights reserved. hedge accounting would not need to be applied. 39. Such a strategy may be used in situations where an entity wants to limit its hedging costs by reducing the hedge protection to a certain range of prices or rates. contain both an intrinsic value and a time value due to the nature of the instrument.AG97 An entity’s own equity securities cannot be hedging instruments since they are not financial assets or financial liabilities of the issuing entity. cannot be used as hedging instruments unless they are designated as an offsetting hedge of a purchased option.6 are met. such as callable debt. If the embedded purchased option were to be separated. 8. hedge accounting may be applied when a written option is related to a purchased option embedded in a contract.IFRS Financial Instruments Accounting March 2004 Reference 39. an entity may hedge a bond held as available-for-sale with fair value changes recognised directly in equity. For example.3. If the option is designated in its entirety (including time value) hedge effectiveness testing must be based on the full fair value change of the option and the change in cash flows of the forecasted transaction.3 Written options Written options generally increase risk exposure and.5. 8.AG94 IG F. in combination forming a collar.3 118 8. KPMG International provides no services to clients.

and the notional amount of the written option component is not greater than the notional amount of the purchased option component. ■ ■ 8.AG94 and IG F.75 8.75 Using a part of an instrument as the hedging instrument A proportion of a financial instrument may be designated as the hedging instrument (i. For instance. For example.5. risk components) that cause changes in fair value are co-dependent. an instrument with a maturity of 10 years cannot be designated as a hedging instrument for only its first eight years. should be designated in its entirety.e. For example.4 39.1. a risk component) generally is not allowed.2(i) 39. a cross 119 39. currency. 50 per cent of the fair value changes on a forward contract may be designated as the hedging instrument in a hedge of a forecasted sale.3 Hedge accounting may be applied to such a hedging strategy provided that: ■ no net premium is received either at inception or over the life of the combination of options (if a premium was received it would be evidence that the instrument was a net written option).75 and IG F. or a proportion thereof. since there is normally a single fair value measure for a hedging instrument and the factors (i.5 Hedging instruments © 2004 KPMG International.g.6. using only a portion (e. KPMG International provides no services to clients.IFRS Financial Instruments Accounting March 2004 Reference Figure 8. KPMG International is a Swiss cooperative of which all KPMG firms are members. Each member firm is a separate and independent legal entity and each describes itself as such.3 Using a collar as the hedging instrument 39. a percentage of the whole instrument). A hedging instrument. .e. the options have similar critical terms and conditions. All rights reserved. Derivatives as well as non-derivatives must be designated as hedging instruments for the entire remaining period in which they are outstanding. While using an entire instrument or a proportion of an instrument is acceptable for hedge accounting. denomination and maturity date). with the exception of strike prices (same underlying variable or variables.

12 IG F. . Entity A also has a fixed rate USD financial asset with the same maturity and payment dates. since in many instances these instruments are not measured at fair value.2. All rights reserved. In order to offset the currency and interest rate risk on the financial asset and liability Entity A enters into a swap to pay USD fixed and receive GBP floating. it could be designated as a cash flow hedge of the cash flow exposure from the variable cash outflows of the GBP bond and the foreign currency risk between USD and GBP.2. this type of hedge is appropriate only as long as an entity has both foreign currency exposures and is not creating a new foreign currency position but rather decreasing its risk exposure.74 ■ 39. In our view. Both currency exposures should be referred to in the hedge documentation. There are a few exceptions to consider: 39. Alternatively. Where possible a cross currency interest rate swap should be designated in its entirety as a fair value or cash flow hedge. A derivative hedging instrument may be designated for a particular risk providing that the other parts of the hedging instrument are designated as hedging other risks of the hedged item and all other hedge criteria are met. 120 8.18 The swap may be designated as a hedging instrument of the USD financial assets against the fair value exposure from changes in the US interest rates and the foreign currency risk between USD and GBP. Case 8.72 ■ A non-derivative instrument may be designated as a hedging instrument for foreign currency risk only.76 IG F. although the hedge does not convert the currency exposure to the entity’s measurement currency EUR. For example. KPMG International is a Swiss cooperative of which all KPMG firms are members.IFRS Financial Instruments Accounting March 2004 Reference currency interest rate swap must be designated both with respect to foreign currency risk and interest rate risk.2 Hedging with a cross currency interest rate swap (CCIRS) Entity A with EUR as its measurement currency issues a floating rate GBP denominated bond. this may create practical difficulties in separating fair values between risks that are interrelated. To allow non-derivatives to be used in situations other than hedging foreign currency risk would create difficulties. KPMG International provides no services to clients. The interest element of a foreign currency forward contract may be excluded from a hedge relationship when measuring hedge effectiveness. Both of these designations would be permissible under IAS 39. a cross currency interest rate swap may be designated as a cash flow hedge with respect to interest rate risk and fair value hedge with respect to foreign currency risk.18 ■ IG F.5 Hedging instruments © 2004 KPMG International. Each member firm is a separate and independent legal entity and each describes itself as such. The time value of an option likewise may be excluded from a hedge relationship. 39. However.1.

8. a forecasted transaction must be highly probable and must present an exposure to variations in cash flows that could ultimately affect reported net income. formal documentation of the hedge relationship must be established. technology used etc. Entities generally wish to base their hedge documentation on reports already prepared for risk management purposes and limit the amount of additional work required by IAS 39. The method and procedures should be described in sufficient detail to establish a firm basis for measurement at subsequent dates in order to be consistently applied for the particular hedge. The important thing is that the documentation includes the basic content noted above. All rights reserved. the nature of the risk being hedged. 121 . and determined to have been highly effective over the full period. liability or cash flows) and the hedging instrument. ■ The hedge relationship should be evidenced and driven by management’s approach to risk management and the decision to hedge the particular risk. however. the effectiveness of the hedge can be reliably measured.88 Criteria for hedge accounting The hedge relationship must meet the following criteria in order for the hedging instrument and the hedged item to qualify for hedge accounting: ■ ■ ■ ■ the hedge is formally documented at inception.88 Formal documentation at inception At the inception of the hedge.6 39. the hedge is expected to be highly effective. Note.1 39. and for cash flow hedges. The designation and effectiveness assessment should principally follow the methodologies that management has in place for risk identification and measurement. and how hedge effectiveness will be assessed prospectively and measured on an ongoing basis. KPMG International is a Swiss cooperative of which all KPMG firms are members.6 Criteria for hedge accounting © 2004 KPMG International. the hedge is assessed prospectively on an ongoing basis. clear identification of the hedged item (asset. KPMG International provides no services to clients.IFRS Financial Instruments Accounting March 2004 Reference 8. ■ IAS 39 does not mandate a specific format for the documentation and in practice hedge documentation may vary in terms of lay-out. since they are included by reference to other documentation. Each member firm is a separate and independent legal entity and each describes itself as such. What is important is that a system is established that links the details of the hedged item and hedging instrument with standardised information from other sources in such a way that full documentation is 8. The following examples of hedge documentation would meet the requirements of IAS 39. that in practical terms an entity may be able to standardise its documentation forms in such a way that narrative descriptions are minimised or not necessary.6. The hedge documentation prepared at inception of the hedge must include a description of the following: ■ ■ ■ the entity’s risk management objective and strategy for undertaking the hedge.

000 in 12 months.000 at the forward exchange rate of FC 1. GTC wants to hedge the foreign currency exposure of the firm commitment. the carrying amount of the machine at acquisition. To reduce this exposure so as to be in compliance with risk management requirements to limit exposures to foreign currency risk. When the forward contract is closed and the machine is purchased (31 December 20X1).000 in 12 months caused by fluctuations in the foreign exchange rate between the MC and FC. Hedged item Changes in the fair value of the future cash flows of the firm commitment [contract # 67890] to purchase a machine from a foreign manufacturer for FC 10. GTC enters into a 12month forward contract to exchange a fixed amount of measurement currency (MC) for a fixed amount of FC. Case 8. GTC is exposed to changes in the MC / FC exchange rate.IFRS Financial Instruments Accounting March 2004 Reference available to demonstrate the existence of a qualifying hedge relationship at any time during its life.6 Criteria for hedge accounting © 2004 KPMG International. All rights reserved. . 122 8. or subtraction from. 12-month forward contract to exchange a fixed amount of MC for the amount of FC.3 Documentation of an FX cash flow hedge Global Tech Company (GTC) has made a firm commitment to purchase a machine from a foreign manufacturer in foreign currency (FC) 10. The gain or loss on the firm commitment will be measured based on the present value of the changes in FC forward exchange rates. Notional amount FC 10. Derivative hedging instrument Identification: [Trade # 12345]. Method for recognising the forward contract Any changes in the fair value of the forward contract during the period in which the hedge is in effect will be reflected as a component of equity to the extent that the hedge is effective. the following documentation is prepared on 1 January 20X1: Risk management objective and strategy and nature of the hedged risk On 1 January 20X1. the effective part of the forward will be reclassified as an addition to. KPMG International is a Swiss cooperative of which all KPMG firms are members. KPMG International provides no services to clients. Changes in the expected value of the forward contract are expected to be highly effective in offsetting the exposure to changes in fair value of the firm commitment. As a result. on 1 January 20X1 GTC also entered into a 12-month forward contract to exchange a fixed amount of MC for a fixed amount of FC. Based on this background information.5 : MC 1 at inception of the contract. GTC entered into a commitment to purchase a machine from a foreign manufacturer for FC 10.000 in 12 months. Each member firm is a separate and independent legal entity and each describes itself as such.

and are expected to occur at the same time. 123 . Due to the bank’s overall interest rate risk position and funding structure. The interest rate on the bond is fixed at six per cent. No premium was paid for the IRS. Bank A purchases a bond with a maturity of five years. Bank A simultaneously enters into a five-year interest rate swap (IRS) with a notional amount of 100 million to receive interest at LIBOR and pay interest at a fixed rate of six per cent. The combination of the IRS and the purchased bond results in Bank A being hedged against changes in the fair value of the purchased bond due to changes in interest rates. Bank A is exposed to changes in the fair value of the purchased bond due to changes in market interest rates. amounts. As a result. The interest rate on the purchased bond is six per cent. Specific transaction documentation then could be limited to contract numbers. The bond is purchased at a par value of 100 million and is included in the bank’s available-forsale portfolio. On a quarterly basis. GTC will assess hedge effectiveness on a cumulative basis by comparing the changes in fair value of the forward contract that are due to changes in forward rates with changes in the present value of cash flows. The following documentation is prepared on 1 January 20X1: Risk management objective and strategy On 1 January 20X1. Case 8. KPMG International is a Swiss cooperative of which all KPMG firms are members. The hedge relationship results in the bank being hedged against changes in the fair value of the purchased bond due to changes in interest rate. effectiveness should be close to 100 per cent.IFRS Financial Instruments Accounting March 2004 Reference Hedge effectiveness Management expects the hedge relationship will continue to be highly effective during the next 12 months. most of hedge documentation could be provided in a standardised form as part of its risk management policy manual. 8. dates. Bank A purchased a five-year 100 million fixed rate bond [reference ABCDE] which is carried in the available-for-sale portfolio. As long as the timing of the cash flows does not change.4 Documentation of a fair value hedge relationship On 1 January 20X1. Bank A meets this objective by entering into a five-year IRS with a notional amount of 100 million to receive interest at a variable rate equal to LIBOR and to pay interest at a fixed rate of six per cent. which is the period of the hedge relationship. Each member firm is a separate and independent legal entity and each describes itself as such.6 Criteria for hedge accounting © 2004 KPMG International. with changes in fair value recognised in equity. rates and a reference to the appropriate policies in the manual. The swap reprices twice a year and requires payments to be made or received on 1 July and 1 January of each year. All rights reserved. Expected cash flows on the forward and firm commitment are for the same currency and amount. Bank A designates the IRS as a fair value hedge of the interest rate risk inherent in the fixed rate bond. KPMG International provides no services to clients. currencies. its risk management policies require that the bank should minimise its exposure to fair value changes in the price of the bond due to changes in market interest rates. Note that if an entity enters into similar types of hedge transactions regularly.

6 Criteria for hedge accounting © 2004 KPMG International. 124 8. Each member firm is a separate and independent legal entity and each describes itself as such. Hedge effectiveness The critical terms of the IRS and the purchased bond are identical. repricing 1 July and 1 January of each year Floating leg payer: Bank B Settlement: net cash due in arrears on 1 July and 1 January of each year The fair value changes of the IRS due to changes in interest rates will be recognised in the income statement. ■ ■ ■ ■ ■ Due to the above. it is unlikely that the purchased bond will be repaid prior to maturity. there is no floor or cap on the variable interest rate of the swap. both the interest received on the bond and paid on the IRS are fixed. . KPMG International provides no services to clients. purchased 1 January 20X1 and paying a fixed rate of interest of six per cent. the formula for computing net settlements under the IRS is the same for each net settlement. the fair value changes of the bond due to changes in market interest rates are designated as hedged. The fixed rate is the same throughout the term and the variable rate equals LIBOR throughout the term. and all other terms of the purchased bond and the IRS are typical of those instruments and do not invalidate the assumption of no ineffectiveness. Bank A concludes that at inception the hedge relationship is expected to be highly effective in achieving offsetting fair value changes of the IRS and the purchased bond due to changes in interest rates. KPMG International is a Swiss cooperative of which all KPMG firms are members. the maturity date of the IRS matches the maturity date of the purchased bond. as the hedged item. The following conditions have been met: ■ ■ ■ ■ the notional amount of the IRS equals the principal amount of the bond purchased. All rights reserved. The changes in the fair value of the bond relating to the hedged risk are also included in the income statement. the fair value of the swap at its inception is zero.IFRS Financial Instruments Accounting March 2004 Reference The derivative hedging instrument IRS [contract XYZ] will be used as the hedging instrument: ■ ■ ■ ■ ■ ■ ■ Notional amount: 100 million Premium paid: none Fixed leg: six per cent per annum Fixed leg payer: Bank A Floating leg: LIBOR. The hedged item Bank A designates the five-year bond.

IFRS Financial Instruments Accounting March 2004 Reference Ongoing effectiveness testing will be performed through comparison of the cumulative changes in the fair value of the bond to cumulative changes in the clean fair value of the IRS (i. Management believes this effectiveness can be reliably measured. at inception and throughout the life of the hedge. Each member firm is a separate and independent legal entity and each describes itself as such.1 39. Changes in the fair values of each instrument will be modelled by Bank A on a quarterly basis and assessed on a cumulative basis. This offsetting must be expected to occur in a manner consistent with the originally documented risk management strategy for that particular type of hedge relationship.6. 8. the hedge transaction must be expected to be highly effective in achieving offsetting changes in the fair value or cash flows attributable to the hedged item. All rights reserved. 125 . 39. For example.4 Different requirements for effectiveness assessment and measurement 8.e. A summary of the requirements for prospective assessment and measurement of hedge effectiveness can be illustrated as follows: Figure 8. KPMG International is a Swiss cooperative of which all KPMG firms are members. The method chosen will depend on the entity’s risk management strategy. an entity would generally use the same methods for prospectively assessing as well as for measuring actual hedge effectiveness for forecasted sales to the same export market in each period. accrued interest will be excluded from the fair value).4 Hedge effectiveness An entity must adopt a method for assessing hedge effectiveness that is consistently applied for similar types of hedges unless different methods are explicitly justified. KPMG International provides no services to clients.2 IG F.6.6 Criteria for hedge accounting © 2004 KPMG International.4.88 and AG105 8. This analysis will exclude changes in fair value of the bond due to risks and factors other than interest rates. the entity can expect changes in the fair value or cash flows of the hedged item to be almost fully offset by the changes in the fair value or cash flows of the hedging instrument.2. IAS 39 states that: A hedge is normally regarded as highly effective if.88 Prospective assessment of effectiveness In order for hedge accounting to be applied.

All rights reserved. the IASB has tentatively agreed to remove the requirement that. The actual results of hedge effectiveness must be within a range of 80 to 125 per cent offset for hedge accounting to be applied. currency and maturity.4 39. IAS 39 does not allow the use of a short-cut method and as a result effectiveness assessment and measurement must be performed at a minimum at each reporting date. KPMG International is a Swiss cooperative of which all KPMG firms are members. However.2. At a minimum. a formal measurement of the actual effectiveness results must be performed. Another example would be the hedge of a fixed rate borrowing with a receive-fixed pay-floating interest rate swap where the notional amount. interest basis and interest repricing terms are identical. such as a regression analysis that analyses the correlation between changes in value or cash flows of the hedged item and the hedging instrument for a given historic period. IASB Board meeting February 2004 As explained more fully in Section 1.6 Criteria for hedge accounting © 2004 KPMG International.2 Ongoing assessment and measurement Effectiveness must be measured on an ongoing basis and the hedge relationship proved actually to have been highly effective throughout the financial reporting period.4. ■ ■ 39. gains and losses should ‘almost fully offset’.AG107 and AG108 An example of the first bullet point above would be hedging a specific bond held by entering into a forward contract to sell an equivalent bond with the same notional amount. but rather emphasises that the method must follow the risk management methodologies of the entity. or using a statistical model. Hedge effectiveness measurement may be based on either a period by period or on a cumulative basis depending on what has been IG F. the hedge documentation must specify how the results of the analysis are to be interpreted. 8. When the critical terms are not exactly the same or only a portion of the asset. If confirmed.IFRS Financial Instruments Accounting March 2004 Reference Expectation of an almost perfect offset at inception is necessary to allow for unexpected imperfections in the hedge relationship during the hedge period that might otherwise require early termination of hedge accounting. the frequency of this should be whenever interim or annual financial statements are prepared. prospectively. such as: ■ matching critical terms of the hedging instrument and the entire hedged item may support a conclusion that changes in fair value or cash flows attributable to the risk being hedged are expected to completely offset at inception and on an ongoing basis. prospective hedge effectiveness must be assessed and documented.6. this amendment is likely to mean that some hedging relationships that previously failed to qualify for hedge accounting will qualify in the future.AG106-108 IAS 39 does not prescribe a single method for the assessment of effectiveness.7 39. When a statistical model is used. The prospective effectiveness assessment can be performed in several ways. maturity. Entities may be inclined to perform hedge effectiveness testing more frequently in order to minimise the time period where hedge accounting cannot be applied due to ineffectiveness and in order to better manage the risk exposure. 39.88 and AG105-108 IG F. .4. KPMG International provides no services to clients.AG105 126 8. liability or transaction is being hedged. currency. Each member firm is a separate and independent legal entity and each describes itself as such. using a scenario analysis of historical data. This direct approach to assessing hedge effectiveness can be applied for prospective assessment.

IG F. Both when assessing prospectively and when measuring actual effectiveness.4. The excluded portion of the option or forward is recognised immediately in the income statement. . The assessment of hedge effectiveness for interest rate risk can be performed using a maturity schedule. no effectiveness measurement is necessary. Further discussion of this methodology is included in Section 9. This means that some of the methods used for prospective hedge assessment (e. as the notional amount of the hedging instrument may be more than the remaining outstanding amount of the hedged item. it cannot just be assumed that the change in fair value or cash flows of the hedged item in respect of the hedged risk equals the fair value change of the hedging instrument). when the option is out-of-the-money.74.4. the creditworthiness of the counterparty to the hedging instrument and the likelihood of default should be considered. For the latter. The net exposure hedged must then be associated with an asset.6 Criteria for hedge accounting 39. the risk of prepayment or changes to timing of future cash flows should be considered when an entity designates its hedge relationships. though there is little elaboration in IAS 39 about what is acceptable.e. the measurement of hedge effectiveness is based only on the changes in the intrinsic value of the option or the spot rate of the forward. Therefore.AG106-108 and IG F.1. Each member firm is a separate and independent legal entity and each describes itself as such.2 established in the hedge documentation. In that case it is likely that the hedge relationship would no longer be effective. where the hedging instrument is constantly adjusted in order to maintain a desired hedge ratio. this will lead to a situation where the entity is over-hedged. KPMG International provides no services to clients. The same applies to expectations about changed timing of future cash flows.AG111 127 © 2004 KPMG International.3 39. KPMG International is a Swiss cooperative of which all KPMG firms are members. liability or cash inflow or outflow in order to apply hedge accounting.g. 39. A deltaneutral hedging strategy. statistical analysis) would not be used for measuring actual hedge effectiveness. If the hedged item is repaid before expected.4 A single method for the prospective assessment of effectiveness is not prescribed and the method applied may be different for different types of hedges.9 The time value of an option or the interest element of a forward may be excluded from the ongoing effectiveness assessment.AG106-108 and IG F. the periodic measurement of hedge effectiveness would usually involve a method that compares the actual change in fair value of the hedged asset or liability or in cash flows with respect to the hedged risk to the change in the fair value of the hedging instrument (an offset method). hedge accounting is not precluded if the effectiveness remains sufficient on a cumulative basis. even if a hedge is not highly effective in a particular period. Such a maturity schedule would show the net position for each strip of the maturity schedule resulting from the aggregation of the assets and liabilities maturing or repricing of cash flows at that time.2. may qualify for hedge accounting. For an option. Prepayment risk will impact the effectiveness of fair value hedges. provided that the correlation of the changes of the hedging instrument and the designated hedged item can be assessed. the hedge relationship would be designated only for the price range when the option is in-the-money. All rights reserved. Therefore. However. and is therefore the more common method in practice. 39. Measuring effectiveness on a cumulative basis may reduce the risk of a hedge becoming ineffective.4. The value of a swap could be affected by changes in the respective swap counterparty’s credit rating. The gain or loss on the hedged item must be measured independently from that of the hedging instrument (i. however prospective assessment is still required. 8.IFRS Financial Instruments Accounting March 2004 Reference IG F. The reason for this is that any ineffectiveness of the hedging instrument must be recognised in the income statement. A dynamic strategy including intrinsic value and time value may also be applied. When the time value of an option or the interest element of a forward is excluded from the hedge.

KPMG International provides no services to clients. In order to hedge the commodity price risk of the transaction. During the hedging period in 20X1. anticipates its sales at market rates of precious metals that will occur in early May 20X1.IFRS Financial Instruments Accounting March 2004 Reference IG F. All rights reserved.6 Criteria for hedge accounting © 2004 KPMG International.5 Effectiveness testing On 1 January 20X1. KPMG International is a Swiss cooperative of which all KPMG firms are members.4. Case 8. As part of monitoring the ongoing effectiveness of the hedge relationship. The fair value of the hedging instrument is zero at inception. each month ABCorp determines the change in the discounted cash flows expected from the anticipated sales and the change in the fair value of the forward. ABCorp enters into a forward (the hedging instrument) maturing on 1 May 20X1 to hedge the anticipated sales of precious metals (the hedged item). the fair values and the changes in discounted cash flows of the hedging instrument and the hedged item respectively are as follows: 31 January 28 February 31 March 30 April Section 1 – Periodic effectiveness Change in fair value for the month: Hedging instrument Hedged item Effectiveness for the month (100) 90 111% (50) 70 71% 110 (110) 100% 140 (140) 100% Section 2 – Cumulative effectiveness Cumulative change in fair value: Hedging instrument Hedged item Cumulative effectiveness (100) 90 111% (150) 160 94% (40) 50 80% 100 (90) 111% Section 3 – Determination of effectiveness Cumulative effective portion of the hedging instrument revaluation included as a component of equity Change in the effective portion of the hedging instrument revaluation for the month Change in the hedging instrument revaluation for the month Ineffective portion of hedging instrument revaluation for each month recognised in the income statement (90) (150) (40) 90 (90) (100) (60) (50) 110 110 130 140 (10) 10 – 10 128 8. Each member firm is a separate and independent legal entity and each describes itself as such. This should be noted in the hedge documentation. ABCorp determines and documents that the hedge is an effective cash flow hedge at inception. .1 Hedge effectiveness may be measured on either a pre-tax or post-tax basis. ABCorp a commodities dealer.

At 28 February 20X1. Thus. The hedge remains within the 80 to 125 per cent range. at 31 January 20X1 the effective portion of the hedging instrument revaluation is only that amount that offsets the revaluation of the hedged item. KPMG International is a Swiss cooperative of which all KPMG firms are members. therefore the relationship qualifies for hedge accounting until the month of February 20X1. The cumulative loss on the hedging instrument is now less than the cumulative gain on the hedged item.IFRS Financial Instruments Accounting March 2004 Reference Section 1 illustrates the effectiveness measured on a period-by-period basis while Section 2 illustrates a cumulative basis. Lastly. (Note: The numbers used in the above example are illustrative. the revaluation component in equity would be 90 and an ineffectiveness gain of 10 is recognised in the income statement. as the revaluation gain on the hedged item is only 90. and the portion that is ineffective. 129 . and include this choice in its documentation of the hedge relationship.) 8. there is an ineffective portion of -10 for the hedging instrument that must be recognised in the income statement and the remaining -90 is recognised as a component of equity. at 30 April 20X1. Section 3 details the analysis for determining the effective portion of the hedging instrument revaluation that should be included as a component of equity. the cumulative revaluation gain on the hedged item increases to 160. All rights reserved. no portion of the hedging instrument revaluation is ineffective. The example does not consider the ongoing assessment of prospective effectiveness that is also required at each reporting date. the cumulative revaluation loss on the hedging instrument increases to -150. During the hedging period. At 31 March 20X1. which supports the effectiveness of the hedge relationship for the period. KPMG International provides no services to clients. the cumulative revaluation on the hedging instrument increases to a gain of 100 which more than offsets the revaluation loss of -90 on the hedged item. The analysis consists of three main sections. the cumulative effectiveness remains within the range of 80 to 125 per cent. The hedge relationship continues to be maintained as IAS 39 allows hedge effectiveness to be measured on a cumulative basis when consistently applied. Each member firm is a separate and independent legal entity and each describes itself as such. The hedging instrument is revalued at a loss of -100. As such. As such. The change in value of the hedging instrument is divided into the portion that is effective. to which hedge accounting is applied. the full revaluation loss of the hedging instrument of -150 is included as a component of equity. However. However. which is immediately recognised in the income statement. the revaluation component in equity would be a loss of -40. This is for demonstration purposes only – an entity should choose only one of these two methods at the inception of the hedge. but no ineffective portion is recognised in the income statement as the cumulative revaluation gain on the hedged item is 50. on a cumulative basis. the cumulative change in fair value of the hedging instrument remains less than the change in fair value of the hedged item. Section 2 details the cumulative change in fair values of the hedging instrument and hedged item.6 Criteria for hedge accounting © 2004 KPMG International. Section 1 details the monthly effectiveness and fair value changes of the hedging instrument and changes in discounted cash flows of the hedged item. As such. when the monthly effectiveness is 71 per cent. For example.

6.3 39. ■ The impact of this change is unlikely to be significant in practice.96 In a cash flow hedge.96 In amending the standards.3 39.96 ■ 39.6.7 130 © 2004 KPMG International. For example. 8. For groups of similar transactions the probability criterion may be met by designating a lower and therefore more certain amount of risk exposure as being hedged. . It is now described more simply as the lesser of: ■ the cumulative gain or loss on the hedging instrument from the inception of the hedge. it is possible that the bank may estimate with high probability the amount of mortgages that will eventually be closed. Ineffectiveness of the hedging instrument must be recognised in the income statement. 8.3. To reduce the interest rate risk inherent in the anticipated mortgage transactions. KPMG International is a Swiss cooperative of which all KPMG firms are members. the Board has taken the opportunity to simplify its explanation of the effective portion of a cash flow hedge. When evaluating the probability of acceptance by only a single customer. the bank would apply cash flow hedge accounting for the hedge of interest rate risk on the amount of mortgages that are highly probable of closing. December 2003 amendments 39. which give the customer 90 days to lock in a mortgage at a specified rate.88 Forecasted transactions must be highly probable Forecasted transactions must be highly probable and must present an exposure to variations in cash flows that ultimately could affect the income statement. when evaluating the probability of a group of commitments. the difference must be recognised in the income statement as hedge ineffectiveness. a bank may enter into fixed rate mortgage loan commitments with potential customers. Each member firm is a separate and independent legal entity and each describes itself as such. 39. In practice. and the cumulative change in fair value (present value) of the expected future cash flows from the hedged item from inception of the hedge. the fair value change on the hedged item and the hedging instrument often will not offset completely. a high probability would be difficult to demonstrate. The effective portion of a cash flow hedge is the lesser of: ■ the cumulative gain or loss on the hedging instrument necessary to offset the cumulative change in expected future cash flows on the hedged item from inception of the hedge excluding the ineffective component.2. On the other hand. All rights reserved. except when a non-derivative instrument is used to hedge a foreign net investment. and the cumulative change in the fair value of the expected future cash flows on the hedged item from inception. the bank enters into forward starting interest rate swaps on the expected acceptances. forecasts and budgets as well as historical data may be used as the basis to assess the highly probable assumption.6 Criteria for hedge accounting IG F.89 and 95 Hedge ineffectiveness Even when a hedge relationship meets the effectiveness criteria. KPMG International provides no services to clients. an indicator of a transaction being highly probable is a likelihood of more than 90 per cent. Management’s intent. if the full cumulative gain or loss on the hedging instrument is more than the cumulative expected future cash flows on the hedged item.IFRS Financial Instruments Accounting March 2004 Reference 8. In this case.

it is clear whether the transaction is or is not the hedged transaction. Each member firm is a separate and independent legal entity and each describes itself as such. KPMG International provides no services to clients. Examples of situations that would cause a hedge relationship to be terminated include: ■ ■ ■ ■ ■ the hedging instrument expires. Hedging anticipated transactions with purchased options might raise questions about management’s assessment of whether the transaction will actually occur.11 Defining the time period in which the forecasted transaction is expected to occur IAS 39 requires that the forecasted transaction must be identified and documented with sufficient specificity so that when the transaction occurs. assessing the probability of interest cash flows for the portfolio rather than for a single instrument could result in an acceptable hedge of these instruments for a bottom layer of the interest cash flows.3. In order to determine the proper time periods for hedge accounting purposes an entity may look to: ■ Forecasts and budgets: The expectation is that entities generally would not identify longer time periods for hedge accounting purposes than those used for forecasting and budgeting. 8. For example. Generally one would expect the forecast periods for manufacturers of ships or aircraft to be longer than those of retail stores because retailers usually sell smaller items in large quantities and can usually more easily forecast the timing of sales over shorter periods of time. KPMG International is a Swiss cooperative of which all KPMG firms are members.7 39. or is sold. the forecasted transaction is no longer highly probable. as a basis for assessing hedge effectiveness.101 Termination of a hedge relationship There are several circumstances that could lead to the termination of a hedge relationship. But the documentation should identify a time period in which the forecasted transaction is expected to occur within a reasonably specific and generally narrow range of time. The entity wants to hedge the potential foreign currency income from that contract although the income is not yet certain. ■ Although the above factors provide an indication of what may be the appropriate time period in which the transaction is expected to occur.1 IG F. the effectiveness criteria are no longer met. 8. All rights reserved.IFRS Financial Instruments Accounting March 2004 Reference Similarly. The foreign currency cash flows in this case might not be highly probable as they depend on the entity first winning the bid for the contract. .3. The nature of the business / industry: The forecasting and budgeting periods used by an entity are influenced by the entity’s ability reliably to forecast the timing of its transactions. an entity purchases an option on a particular foreign currency because the entity has made a bid for a large contract in that foreign currency. or management chooses to de-designate the hedge relationship. An entity is not required to predict and document the exact date a forecasted transaction is expected to occur.6. terminated or exercised. when assessing the probability of hedging certain instruments with prepayment risk.3.10 and F.7 Termination of a hedge relationship 131 © 2004 KPMG International. the hedged item is derecognised. 8. the actual time period should always be determined on a case-by-case basis and will involve some degree of judgement.

KPMG International provides no services to clients. Each member firm is a separate and independent legal entity and each describes itself as such. and the hedge relationship should be terminated.91 If the hedge effectiveness criteria are no longer met.2. When an effective hedge relationship no longer exists. The effect of delays of forecasted transactions is considered in more detail in Section 9. the entity may continue to perform hedge effectiveness testing on a cumulative basis from the beginning of the period in which the first hedging instrument was rolled over. If the forecasted transaction that the instrument was originally intended to hedge is no longer expected to occur. Using a rollover hedge strategy. 92 and 101 A replacement of a hedging instrument or rollover is not deemed to be a termination if the new instrument has the same characteristics as the instrument being replaced.101(c) 39.91. If a forecasted transaction is not expected to occur in the initially forecasted period or within a relatively short period thereafter.7 Termination of a hedge relationship © 2004 KPMG International. It may not be replaced by another expected transaction. it continues to meet the hedge criteria and the rollover strategy is properly documented at inception. hedge accounting must be terminated. the net cumulative gain or loss that was recognised in equity during the effective period of the hedge remains in equity until the transaction actually occurs. . Figure 8.IFRS Financial Instruments Accounting March 2004 Reference 39. The notion of a highly probable forecasted transaction is a higher degree of probability than one that is merely expected to occur. any gains or losses on the hedging instrument that have been recognised in equity are recognised in the income statement immediately. which may be the previous interim or annual reporting date. prospectively the entity can no longer apply hedge accounting. Figure 8.3. However. If a forecasted transaction is no longer highly probable but is still expected to occur. All rights reserved. the accounting for the hedging instrument and the hedged item must revert to accounting under the normal principles. Hedge accounting for a forecasted transaction that is no longer expected to occur must be terminated.5 summarises the accounting treatment for a forecasted transaction where the probability of the transaction occurring changes. it is not considered to be the same hedge. 132 8. Termination of a hedge must have effect prospectively as of the date when the hedge was last proved effective. KPMG International is a Swiss cooperative of which all KPMG firms are members.5 Accounting impact of a change in expectation of a forecasted transaction 39.88 39. Also amortisation of any fair value adjustment made to the hedged item under a fair value hedge may continue to be deferred until the rollover hedge strategy is discontinued.

6.75 and IG F. Not applicable. 8.IFRS Financial Instruments Accounting March 2004 Reference For this reason testing hedge effectiveness more regularly is a way to reduce the impact of the unexpected termination of a hedge relationship. The gain or loss on the hedging instrument previously recorded in equity is recorded in the income statement immediately.7 Termination of a hedge relationship © 2004 KPMG International. 39. including the adjustments resulting from the hedge. the instrument may be re-designated to a new hedge relationship. Table 8. The hedging instrument continues to be measured at fair value with changes recorded in the income statement. For example. 133 . KPMG International provides no services to clients. Hedge accounting is terminated prospectively. The changes in fair value of the remaining unused portion of the forward (20) must be recognised in the income statement. All rights reserved. Expected transaction or firm commitment no longer expected to occur. 39.2(i) If a hedging instrument ceases to be part of a hedge relationship. A new relationship under which a proportion (80) of the forward is designated as a hedge of the new expected cash flow of 80 would be allowed. as long as this is for the entire remaining term of the instrument. The hedging instrument continues to be measured at fair value with changes recorded in the income statement. KPMG International is a Swiss cooperative of which all KPMG firms are members. Not applicable. In this situation. This would once again fulfil the requirement of being designated as a hedging instrument for the entire outstanding period. The gain or loss on the hedging instrument previously recorded in equity is recorded in the income statement immediately. Any gain or loss previously recognised in equity remains in equity until the transaction occurs or is no longer expected to occur.2 Accounting consequences of hedge termination Reason for termination Hedged item: Derecognition of the hedged item. the original hedge designation would be discontinued. Further changes in the fair value of the hedging instrument must be recorded in the income statement. a forward contract of 100 designated to hedge a forecasted transaction of 100 may no longer be expected to be effective if new forecasts indicate the forecasted transaction may now only involve expected cash flows of 80.101 A gain or loss on the derecognised item is recorded in the income statement based on the carrying amount. Each member firm is a separate and independent legal entity and each describes itself as such. Fair value hedge Cash flow hedge 39.101 Expected transaction or firm commitment no longer highly probable but still expected to occur.

i. cease to be adjusted for changes resulting from the hedged risk.91. Each member firm is a separate and independent legal entity and each describes itself as such.IFRS Financial Instruments Accounting March 2004 Reference Reason for termination Hedging instrument: Derecognition of the hedging instrument other than replacements and rollovers.1 Net position hedging and internal derivatives Net positions Many financial institutions and corporates use net position hedging strategies under which a centralised treasury function accumulates risk originated in the operational subsidiaries or divisions.8 Net position hedging and internal derivatives © 2004 KPMG International. The treasury function hedges the net exposure in accordance with the group’s risk policies by entering into a hedge transaction with a party external to the group. 8. the adjustment recorded as part of the carrying amount of the hedged item should be amortised to the income statement from that date onwards using the effective interest method. If the hedged item is a debt instrument and the maturity is determinable. KPMG International provides no services to clients. A gain or loss on the hedging instrument previously recorded in equity remains in equity until the forecasted transaction occurs.8. KPMG International is a Swiss cooperative of which all KPMG firms are members. 39.8 8. 134 8. Same accounting as in derecognition of the hedging instrument except that instead of derecognising the hedging instrument it should be prospectively remeasured through the income statement. unless the hedging instrument is redesignated as a hedge of another hedged item. 92 and 101 The hedge no longer meets the hedge criteria (effectiveness) or management decides to dedesignate the hedge. The hedged item must revert to the applicable accounting requirements from the date of derecognition of the hedging instrument. Same accounting as in derecognition of the hedging instrument except that instead of derecognising the hedging instrument it should be prospectively remeasured through the income statement.91. . Fair value hedge Cash flow hedge 39. All rights reserved.e. 92 and 101 The gain or loss on derecognition of the hedging instrument is recorded in the income statement. unless the hedging instrument is redesignated as a hedge of another hedged item.

unless this oneto-one relationship can be established. an entity may have fixed rate assets and liabilities that provide a natural economic hedge that leaves the entity with no exposure to interest rate risk. However. an entity is not necessarily precluded from hedge accounting by hedging net positions. when issued. Therefore. the effects of the internal transactions must be eliminated on consolidation. the IASB is finalising its deliberations in respect of Fair Value Hedge Accounting for a Portfolio Hedge of Interest Rate Risk.IFRS Financial Instruments Accounting March 2004 Reference Net position hedging does not by itself qualify for hedge accounting treatment because of the inability to: ■ associate hedging gains and losses with a specific item being hedged when measuring effectiveness. 39.9. It is anticipated that.1. as well as potentially to benefit from pricing advantages of being able to group smaller individual transactions for offsetting by larger transactions done with external third parties. This Section gives a brief overview of some of these issues. or for netting of opposite exposures. Hedging interest rate net positions is discussed in Section 9. In general.6 8.2. Each member firm is a separate and independent legal entity and each describes itself as such. This requires the elimination of all transactions and balances between group entities. For example. this will introduce a number of additional requirements for this form of hedge accounting. 39.2 Internal derivatives Derivatives between entities within the same reporting group may be used to control and monitor risks through a central treasury function. an entity may choose to manage and (economically) hedge risk on a net basis. ■ 39. hedge accounting can be achieved in such cases if a one-to-one relationship of the internal transactions to related external transactions is documented. hedge accounting may be applied to this transaction provided that the relevant hedge accounting criteria are met.6 Accounting for internal derivative transactions should be viewed in light of IFRS consolidation requirements.2. Although this would increase the entity’s overall interest rate risk exposure. 8.1 Risk reduction and hedge accounting IAS 39 does not require an overall risk reduction in order to apply hedge accounting.9 Other considerations There are a variety of issues directly or indirectly related to or impacted by the hedge accounting principles.72 and IG F. This entity may decide to enter into a pay-fixed receive-floating swap and designate this as a hedge of either the assets or liabilities. KPMG International provides no services to clients. That is.5 and F. but for hedge accounting purposes designate a specific item within the net position as the hedged item. 8. 135 . only derivatives involving external third parties can be designated as hedging instruments in the consolidated financial statements. KPMG International is a Swiss cooperative of which all KPMG firms are members. 8. and determine the reporting period in which such gains and losses should be recognised in the income statement. All rights reserved. Future amendments to IAS 39 At the date of this publication.84 and AG101 However.3.1. Hedging foreign currency net positions is discussed in Section 9.8.73 IG F.9 Other considerations © 2004 KPMG International.

In such cases. since at this point the impairment on the hedged item affects the income statement. However.97 and 98 The restrictions introduced in respect of basis adjustments mean that amounts relating to a cash flow hedge of an asset that has been acquired may be retained in equity. This impairment must be recognised in the income statement. it will be necessary to ensure that if the related asset becomes impaired.9 Other considerations © 2004 KPMG International. 8. This means that a gain of 70 (250 – 180) ignoring time value. The amount of impairment to record would be the difference between the original cost of the securities (300) and the new fair value (180). 136 8.9.9. KPMG International provides no services to clients.18 IAS 39 does not specifically require that a hedge of foreign currency risk is designated so as to convert a foreign currency into the entity’s measurement currency. Therefore.5.58 and 39. will be recognised in the income statement and will partly offset the loss on the securities.97 and 98 39. an entity may hold a portfolio of securities that are classified as availablefor-sale with fair value adjustments recognised in equity. This is permissible under IFRS. an appropriate amount is also recycled from equity to profit or loss. the hedge accounting principles may require that a gain on a hedging instrument used to hedge the risk that gave rise to the impairment will be recognised simultaneously in the income statement and may (partly) offset the recognised impairment. Each member firm is a separate and independent legal entity and each describes itself as such. the related gain on the put option would also be recognised in the income statement.IFRS Financial Instruments Accounting March 2004 Reference IG F. this impairment should be recognised even if the risk that causes the impairment is being hedged and hedge accounting is applied. KPMG International is a Swiss cooperative of which all KPMG firms are members.58-70 39. provided that the entity has corresponding asset and liability positions denominated in the foreign currencies that are hedged by the cross currency interest rate swap. Assume that the fair value of the portfolio subsequently decreases by 120 and there is objective evidence of impairment. December 2003 amendments 12. The entity has a put option to put the securities to a third party at 250.2 Deferred tax issues In accordance with IAS 12 for transactions recognised directly in equity.4. The fair value at a given point is 300.3 Impairment of an asset that is hedged The principles for hedge accounting do not override the accounting treatment under IAS 36 or IAS 39 if there is impairment of the hedged item. if a hedged item is impaired. However. For example. when designating the hedge. In respect of hedge accounting this means that current and deferred taxes on gains or losses on hedging instruments deferred in equity also should be recognised in equity until such time when the gain or loss is recycled to the income statement.61 36. As described earlier is Section 8. . it is important to clearly specify in the hedge documentation the risks that are being hedged. All rights reserved. all current and deferred tax should also be recognised in equity.2.59 and 61 39. Therefore. The entity designates the option as a hedge of the cash flows from an expected future sale of the securities. an entity may wish to use a cross currency interest rate swap to eliminate the currency and interest exposure of an asset and a liability in two different foreign currencies. not taking into account the existence of the put option. 8. The entity may apply hedge accounting to this transaction provided that the hedge relationship meets the relevant criteria.

LIBOR) and hence the interest rate risk relates to variations in future cash flows. 9.AG102 IG F.2.1 Overview Section 8 explained the basic requirements. ■ 9. Interest-bearing instruments bear either: ■ Fixed interest: Since the interest rate is fixed. FC = foreign currency Reference 9.2. ■ 39. the accounting models and criteria for hedge accounting under IAS 39. KPMG International is a Swiss cooperative of which all KPMG firms are members.2 Interest rate risk © 2004 KPMG International. This Section focuses on some of the most common financial risks that an entity may hedge and how applying hedge accounting to these risks will affect the income statement and balance sheet. It also provides examples of the journal entries needed to record the hedge accounting transactions.13 Possible hedged items in fair value hedges include: ■ ■ fixed rate loans and receivables originated by the entity.1 Interest rate risk Identifying the hedged risk and the hedging models Interest rate risk arises from entities holding interest-bearing financial assets and / or liabilities or from forecasted or committed future transactions with an interest-bearing element in them.IFRS Financial Instruments Accounting March 2004 9. and fixed rate financial liabilities not held for trading. Each member firm is a separate and independent legal entity and each describes itself as such. future interest payments are also fixed.g. fixed rate assets categorised as available-for-sale with fair value changes recognised directly in equity. or Floating interest: In this case the future interest payments will depend on an underlying interest index (e. Hedge accounting for each type of financial risk Key topics covered in this Section: ■ ■ ■ ■ Interest rate risk hedging Foreign currency risk hedging Hedges of net investments in foreign entities Commodity and equity price risk hedging Abbreviations used in this Section: MC = measurement currency.2 9. In this case the interest rate risk relates to the fair value change of the financial asset or liability in response to changing market interest rates. 137 . KPMG International provides no services to clients. All rights reserved.

2.6. firm commitments that have an interest rate exposure. Entities can make their own assessment as to which of these two hedge models can be best applied in their circumstances. floating rate assets categorised as available-for-sale with fair value changes recognised directly in equity. assets and liabilities designated as the hedged item must be remeasured for fair value changes attributable to the hedged risk. This requires a system that enables the entity to track the timing of the cash flows. IG F.95-100 138 9. ■ ■ ■ In some cases the same interest rate risk exposure may be hedged with either a fair value hedge or a cash flow hedge. Under a cash flow model the fair value changes of the hedging instruments are recognised in equity and are later released to the income statement when the cash flows from the hedged items are recognised in the income statement. This swap may be designated as the hedging instrument of either: ■ ■ a fixed rate asset in a fair value hedge. floating rate financial liabilities not held for trading. and that can associate these changes with the hedged items. for many entities such information can be based on the cash flow information already captured in risk management systems of the entity.2 Interest rate risk © 2004 KPMG International. or a floating rate liability in a cash flow hedge. IG F. KPMG International is a Swiss cooperative of which all KPMG firms are members.6. KPMG International provides no services to clients. The decision about which hedge accounting model to use may depend upon the information systems and reporting that the entity has available. For example. The entity must assess whether existing information systems are best set up to manage and track the information required under a fair value model or a cash flow model. as well as the timing of the reversal of the hedging gains and losses from equity. This is especially important to entities such as banks and corporate treasuries that need to account for multiple hedge transactions. e.g.2 The derivative has the same economic effect of reducing the interest rate exposure. Each member firm is a separate and independent legal entity and each describes itself as such.3 on effectiveness testing of interest rate hedges. prepayment risk in mortgage loans may be an issue. an entity with an overall (net) interest rate risk exposure to floating rate liabilities may choose to hedge this exposure with a pay-fixed receive-floating swap. but the accounting differs depending on whether the hedge relationship is designated as either a fair value or cash flow hedge. and normally result in an adjustment of the effective interest yield. and highly probable anticipated transactions that have an interest rate exposure. as discussed in Section 9. Also the system should be able to recompute the effective yield of the hedged item and amortise the changes to the income statement over the remaining life of the hedged item.IFRS Financial Instruments Accounting March 2004 Reference 39. .1 and F. All rights reserved. Although this may impose a challenge. This usually requires a system that is able to track changes in fair value of the hedged risk. 39. This decision also may depend upon the characteristics of the hedged items and whether hedge accounting criteria can be met.6.2 Under a fair value model.AG103 Possible hedged items in cash flow hedges include cash flows from: ■ ■ floating rate loans and receivables originated by the entity.

2 Hedging expected interest cash flows An entity may choose to hedge the interest cash flows from interest-bearing assets and liabilities including: ■ ■ floating rate assets (e. and then would adjust the initial carrying amount of the debt.2 and F.88 To meet the hedge accounting criteria a forecasted debt issuance must be highly probable. and that the re-issue after three years is highly probable. This would be the case once the entity enters into an agreement to issue the bond. At inception of the hedge the criteria for hedge accounting must be met. debt securities. The gain or loss is recognised in the income statement as interest payments are made and effectively adjusts the interest expense recognised on the debt. expected rollovers of existing loans.g.2. The gains or losses resulting from the hedging instrument until the debt is issued would be deferred in equity. The entity intends to issue similar notes immediately after the maturity of the initial notes.2 Interest rate risk © 2004 KPMG International. KPMG International is a Swiss cooperative of which all KPMG firms are members. and floating rate liabilities (e. All rights reserved.IFRS Financial Instruments Accounting March 2004 Reference 9. The appropriate hedge accounting model in this case would be a cash flow hedge.6. at which point the deferred gain or loss would adjust the initial carrying amount of the bond (as a basis adjustment). For example. In this situation the entity may enter into a six-year swap to hedge the variability in expected interest cash flows on both notes. bonds issued by a corporate). customer deposits at a bank. originated loans). or expected draw-downs under revolving credit facilities. 9. an entity in the process of issuing a bond may wish to hedge the risk of changes in interest rates from the time the entity decides to issue the bond until it is issued. an expected purchase of financial assets. including the criteria that the hedge would be highly effective. This could be done using an interest future or another derivative instrument. To the extent it is effective. The subsequent amortisation of the basis adjustment would be recognised by adjusting the instrument’s future interest expense.g. 39. 139 .2. but may already be evidenced at an earlier stage when management decides upon a debt issuance as part of the entity’s funding strategy. KPMG International provides no services to clients. each with a maturity of three years. For hedge accounting purposes the hedge could be designated as a hedge of the expected interest payments in different periods including interest payments arising from the forecasted refinancing of the debt. Each member firm is a separate and independent legal entity and each describes itself as such.2 An entity may apply hedge accounting to an anticipated debt issuance. Another example of a hedge of forecasted interest payments is that of an entity which plans to issue a series of floating rate notes. An entity also may hedge its interest rate risk exposure from forecasted interest payments such as: ■ ■ ■ ■ an expected debt issuance. IG F. the gain or loss on the derivative would be deferred in equity until the bond is issued.

Each member firm is a separate and independent legal entity and each describes itself as such.97 As noted above.3 Effectiveness testing of interest rate risk hedges The effectiveness requirements discussed in Section 8 are applicable for hedges of interest rate risk. The effect of the hedge is achieved. However. but the separate tracking of the amount deferred in equity may be more complex. as well as the requirement of high probability for forecasted cash flows. Moreover.5 140 9. Hence the likelihood of ineffectiveness due to prepayment is larger since the effect on the fair value is not absorbed by a portfolio. Forecasted transactions create a cash flow exposure to interest rate changes because related interest payments will be based on the actual market rate when the transaction occurs. it may be difficult to group a portfolio of fixed rate assets subject to prepayment risk since it may be difficult to prove that the changes in fair value of the individual assets are approximately proportional to the overall change in fair value of the portfolio. An added complication will be the need to take into account separately any debit deferred in equity when assessing impairment of an asset whose cash flows have previously been hedged. IG F. All rights reserved. by amortising the amount deferred in equity under the cash flow hedge into income over the life of the hedged item. For interest-bearing assets that are on balance sheet. prepayment options could have a significant impact on whether a hedge relationship is effective. Examples of prepayable assets include originated loans that may be prepaid by the borrower and debt securities that may be repaid early by the issuer. In a fair value hedge it may be difficult to achieve a highly effective offset of fair values of the hedged item and the hedging instrument when the hedged item terminates early due to prepayment. This could be demonstrated by the entity preparing a cash flow maturity schedule that shows sufficient gross levels of expected cash flows in each period to support a highly probable assertion.2 Interest rate risk © 2004 KPMG International. .2 Prepayment risk affects the timing as well as the amount of cash flows. a bank may be able to accurately determine what levels of prepayments are expected for a particular class of its originated loans. The income statement effect should be the same as using basis adjustment. when the hedged item is designated as a portion of gross cash flows of a portfolio in a given period. In these situations the hedge effectiveness assessment would be based on the 39. Prepayment risk may also affect whether a cash flow hedge is considered to be highly probable of occurring.IFRS Financial Instruments Accounting March 2004 Reference December 2003 amendments 39.2.5. Effectiveness is likely to be more difficult to demonstrate for a fair value hedge than for a cash flow hedge when hedging a portfolio. therefore this risk may impact effectiveness results for fair value hedges. the amendments will prohibit the use of basis adjustment in a hedge of a forecast purchase or issuance of a financial asset or liability. KPMG International provides no services to clients. KPMG International is a Swiss cooperative of which all KPMG firms are members. 9. A prepayable hedged item will generally experience smaller fair value changes than a hedged item that is not prepayable. As a result fixed rate assets subject to prepayment risk may have to be hedged on a one-to-one basis. the effect of a prepayment is less likely to cause the hedge not to be highly probable as long as there are sufficient cash flows in the period. instead. For example.6. The bank might hedge only a portion of the contractual cash flows from that portfolio of loans. as the bank expects a number of the borrowers to pay off their loans early.88 IG F.

17 When only a portion of an interest-bearing instrument is hedged. an entity may choose to hedge the interest rate risk of an acquired 10-year fixed rate bond only for the first five years.2 Interest rate risk © 2004 KPMG International.2 about hedging interest rate risk. KPMG International is a Swiss cooperative of which all KPMG firms are members. The bonds are issued at par.2. For forecasted transactions such as anticipated debt issuances. GTC’s overall risk management strategy and current position is to have variable rate funding. For effectiveness testing purposes the loan is treated as if it had a synthetic principal repayment in year five. Therefore.5 has a detailed example about how hedge effectiveness may be measured for a forecasted transaction in a debt instrument. The interest rate on the bonds is fixed at six per cent and is payable semi-annually. The hedge relationship is determined to be effective based on the offsetting effect of the fair value changes of the IRS to the fair value changes of the bond.7 per cent. The fair value of the IRS at inception is zero. The entity may designate a pay-fixed and receive-floating interest rate swap with five years to maturity as the hedging instrument. All rights reserved. In these situations hedge effectiveness may be measured based on the changes in the interest rates that have occurred between the designation of the hedge and the date that effectiveness testing is performed. effectiveness testing usually becomes more difficult. Management designates and documents the IRS as a fair value hedge of interest rate risk for the issued bonds. The forward interest rates that should be used are those that correspond with the term of the expected transaction at inception and at the date of the effectiveness testing. For example. The timing of the IRS cash flows equals those of the bond’s interest expense. calculated using the forward interest rate on the applicable yield curve. which should be highly probable in order to qualify for hedge accounting. Any fair value difference resulting from changes between the five-year and 10-year yield curve would not be considered part of the hedge relationship and the carrying amount of the loan would not be adjusted by this amount. The IRS pays a floating interest rate based on LIBOR and receives a six per cent fixed interest rate.1 Fair value hedge of a fixed interest rate liability Global Tech Company (GTC) requires financing of 100 million for five years. KPMG International provides no services to clients. IG F.5. but only to the extent affected by changes in the yield curve relating to the five years of the swap. The floating rate of interest for the first six months is 5. The following cases demonstrate a number of the issues that have been discussed in Section 9. Each member firm is a separate and independent legal entity and each describes itself as such. The same is true for fair value changes of the interest payments after year five. GTC enters into a five-year interest rate swap (IRS) with a notional amount of 100 million. Case 9. GTC issues non-callable five-year 100 million of bonds.IFRS Financial Instruments Accounting March 2004 Reference expected interest payments. 141 . On 1 January 20X1. IG F. This swap could be designated as a hedge of the fair value of the first five years of interest payments and the change in fair value of the principal payments in year 10. 9. it is not possible to determine what the actual market interest rate will be for the debt issuance.

management determines that the hedge is still effective.000 100. which represents the floating interest of 5.000 150.000 to 96.850. .850.000 3.000. KPMG International provides no services to clients.804.000 3.7 per cent. All rights reserved.7 per cent to 6.000 3. interest rates have increased.804.IFRS Financial Instruments Accounting March 2004 Reference The following entries are made to record the transactions: Debit 1 January 20X1 No entry is necessary related to the IRS.196. The interest rates for the next six months of the variable leg of the swap have repriced from 5.000.000. Each member firm is a separate and independent legal entity and each describes itself as such.804. pay 5. The following accounting entries are recorded at 30 June 20X1: Debit 30 June 20X1 Interest expense Cash To record the payment of six per cent fixed interest on the bonds Bonds payable Hedging revaluation gain (income statement) To record the change in the fair value of the bonds attributable to the hedged risk Cash Interest income To record the settlement of net interest accruals on the IRS for the period 1 January 20X1 to 30 June 20X1 (Receive six per cent fixed 3.7 per cent.000.000. GTC separately revalues the IRS and has determined that its fair value is 3. The fair value of the bond (after settlement of interest) has changed from 100.000.000 At 30 June 20X1. Due to this general increase in market interest rates.804.7 per cent floating 2.000.000) Hedging revaluation loss (income statement) IRS liability To record the change in the fair value of the IRS after settlement of interest Credit 3. the net interest expense shown in the income statement is 2.000 3. Based on the offsetting effect of the fair value changes of the IRS and the fair value changes of the bond.000 3. as the cost is zero at inception Cash Bonds payable To record the proceeds from the bond issuance Credit 100.000 As can be seen from the above entries.000. 142 9. a fair value gain on the bonds payable and a loss on the IRS have resulted.804.000.2 Interest rate risk © 2004 KPMG International. KPMG International is a Swiss cooperative of which all KPMG firms are members.000.000 150.

000 350.563. therefore.000 367.200.2 Interest rate risk © 2004 KPMG International.000 93.000. GTC separately revalues the IRS and has determined that its fair value is 3. Based on the offsetting effect of the fair value changes of the IRS to the fair value changes of the bond.7 per cent.000 3.000 367.000 93.563. The following accounting entries are recorded at 31 December 20X1: Debit 31 December 20X1 Interest expense Cash To record the payment of six per cent fixed interest on the bonds Hedging revaluation loss (income statement) Bonds payable To record the change in the fair value of the bonds attributable to the hedged risk Interest expense Cash To record the settlement of the IRS for the period 30 June 20X1 to 31 December 20X1 (Receive six per cent fixed 3. which represents the floating interest of 6.000 9.000. management determines that the hedge is still effective. 143 .000 3.437. The balance sheet at 31 December 20X1 will be as follows: Assets Cash 93.800.350.000 The interest expense shown in the income statement is 3.000 367.000.IFRS Financial Instruments Accounting March 2004 Reference At 31 December 20X1.000.7 per cent for this six-month period. KPMG International is a Swiss cooperative of which all KPMG firms are members.7 per cent floating 3.000 350.000) IRS liability Hedging revaluation gain (income statement) To record the change in the fair value of the interest rate swap Credit 3.800. interest rates have not changed.000 367.800.000.000. The fair value (after settlement of interest) of the bond is 96. pay 6. Each member firm is a separate and independent legal entity and each describes itself as such.000. All rights reserved.437. the interest rate on the variable leg of the swap remains at 6. KPMG International provides no services to clients.350.000 Liabilities and equity Retained earnings Bonds payable IRS liability (6.000) 96.

350. This results in a discount of 3. The fair value of the IRS at inception is zero. Fair value changes due to other factors such as credit risk are excluded from the hedge relationship and therefore do not give rise to any ineffectiveness.437. GTC terminates the IRS and pays 3.000 Credit As can be seen from the balance sheet at 31 December 20X1. As a result the only possible ineffectiveness would be due to changes in credit risk from the counterparty to the swap since this would affect the fair value of the swap (remember that derivatives have to be designated in their entirety).000 3.437. The IRS is designated and documented as a cash flow hedge of the future interest payments on the bond. GTC issues non-callable five-year 100 million floating rate bonds. This discount would be amortised over the remaining life of the bonds as a yield adjustment to the interest expense on the bonds payable.850. This is due to the designation of the hedge. The bonds are issued at par. The following entry is made: Debit IRS liability Cash To record the settlement of the IRS for fair value at 31 December 20X1 3.437. . The hedge is designated such that the bond is hedged only with respect to changes in six-month LIBOR. On 1 January 20X1.7 per cent Second half year at 6. 144 9.000 from the par value of 100 million.000 3. it determines that it does not wish to expose itself to fluctuations in market interest rates. Case 9.000 to the counterparty for settlement. The hedge relationship is determined to be effective.2 Cash flow hedge of a variable rate liability GTC requires financing for its operations of 100 million for five years.2 Interest rate risk © 2004 KPMG International. KPMG International is a Swiss cooperative of which all KPMG firms are members.000.5 per cent) is payable semi-annually. This is determined based on the offsetting effect of the cash flows of the IRS and the interest expense cash flows of the bond. Each member firm is a separate and independent legal entity and each describes itself as such.IFRS Financial Instruments Accounting March 2004 Reference The income statement shows interest expense related to the transactions as follows: First half year at 5.7 per cent for the period from 1 January to 30 June 20X1).000 6.563. The timing of the IRS cash flows equals those of the bond interest expense. As part of GTC’s risk management policy. The IRS pays six per cent fixed and receives floating cash flows based on LIBOR (set at 5. In this example the hedge is found to be 100 per cent effective. All rights reserved.000 Termination of the hedge Assume that on 31 December 20X1. GTC determines that it should end the IRS hedge due to a change in its risk position. After the issue of the bonds. The floating interest of LIBOR plus 50 basis points (0.437. the bonds payable are carried at 96. GTC immediately enters into a five-year interest rate swap (IRS) with a notional amount of 100 million. KPMG International provides no services to clients.7 per cent Total 20X1 2.200.

442. as the cost is zero at inception Cash Bonds payable To record the proceeds from the bond issuance 100. Since the interest on the bond is variable and the interest rate for the next period has been set at the same date the hedge effectiveness is assessed. The fair value changes of the IRS during the period from 1 January 20X1 to 30 June 20X1 are summarised below: 1 January 20X1 Fixed leg Floating leg IRS (100. the change in the fair value of the floating leg of the IRS is compared with the change in the fair value of the bond. Due to this general increase in market interest rates. a fair value gain on the IRS results.2 Interest rate risk © 2004 KPMG International.000 To assess the effectiveness of the hedge. The increased credit risk of the counterparty results in a specific credit spread of 0. The swap rate for the remaining term has increased from six per cent to seven per cent. Each member firm is a separate and independent legal entity and each describes itself as such. resulting in a hedge ineffectiveness of 362. This adjustment is limited to the lesser of the cumulative gain or loss on the hedging instrument (3.000.000 (362. As such the fair value of the IRS is determined to be 3. However.804.000 – 30 June 20X1 (96.442. GTC records the following entries: Debit 1 January 20X1 No entry is necessary related to the IRS.196. interest rates have increased compared to 1 January 20X1.000 Credit At 30 June 20X1.IFRS Financial Instruments Accounting March 2004 Reference The effective interest payable is fixed at 6.000.000 100.000 after the settlement of interest due on 30 June 20X1.804.442. The discount rate to be used for discounting the receivable (floating) leg of the swap is therefore 7.5 per cent (6 per cent fixed from the IRS plus the additional 0. Therefore.000.75 per cent.5 per cent on the bond).000. the full change in the fair value of the IRS is recognised in the hedge revaluation reserve as a component of equity. However. based on the expected cash flows from the IRS. as the hedged risk is the variability of interest cash flows from the bond.45 per cent at 30 June 20X1.000 3. the change in the fair value of the bond is zero. KPMG International is a Swiss cooperative of which all KPMG firms are members.000) 3.000) 99.638. 145 .7 per cent for the next six months of the variable leg. GTC determines that the relationship is still an effective hedge of the interest expense cash flows on the bond.442. All rights reserved.000. KPMG International provides no services to clients.000 Change 3. LIBOR increases to 6. during this time the credit risk of the swap counterparty worsens and the applicable interest rate associated with the counterparty has increased beyond the general increase in market interest rates.000) and 9.000. The change in expected future cash flows on the bonds is 3.000) 100.

the interest expense shown in the income statement is 3.2 Interest rate risk © 2004 KPMG International. The counterparty specific credit spread has decreased from 0. At 31 December 20X1.442.5 per cent) Credit 3.000.100. receive 5.2 per cent floating interest on the notes (LIBOR of 6. the credit risk associated with the counterparty to the IRS has changed since that date.000.IFRS Financial Instruments Accounting March 2004 Reference the fair value of the cumulative change in expected future cash flows on the hedged item (3. The following accounting entries are made at 30 June 20X1: Debit 30 June 20X1 Interest expense Cash To record the payment of 6.5 per cent.000 3. Based on the offsetting of the change in expected cash flows on the IRS and the change in interest expense cash flows on the bond.7 per cent plus a premium of 0.5 per cent.000 3. The expected future cash flows of the bond are now 3. the hedge is still deemed to be effective.000).437.600.850.000 146 9.196.7 per cent plus premium of 0. The fair value (after settlement of interest) of the IRS is now 3. Each member firm is a separate and independent legal entity and each describes itself as such.000.000 3.75 per cent to 0. The following accounting entries are recorded: Debit 31 December 20X1 Interest expense Cash To record the payment of 7. interest rates have not changed since 30 June 20X1.2 per cent floating interest on the bonds payable (LIBOR 5.600.442.000.000 150.5 per cent) Interest expense Cash To record the net settlement of the IRS for the period from 1 January 20X1 to 30 June 20X1 (Pay six per cent fixed 3. which represents the fixed interest of 6.000 150.7 per cent floating 2.804. .250.000. KPMG International is a Swiss cooperative of which all KPMG firms are members.000) IRS Hedge revaluation reserve (equity) To record the change in the fair value of the IRS after settlement of interest Credit 3.100. All rights reserved. KPMG International provides no services to clients.000 As can be seen from the above entries.000 3. however.

000 246. but wants to retain the ability to benefit from LIBOR rates below eight per cent. The combination of the cap and the loan results in DEBTCO paying interest at a variable rate (LIBOR plus two per cent) not exceeding 10 per cent.000 Liabilities Retained earnings Equity (hedge revaluation reserve) Bonds payable (6. which represents the fixed interest of 6.000.000) 3.5 per cent.000 Credit 350. The interest rate on the loan is variable at LIBOR plus two per cent.000 100.000 246. the hedge relationship is expected to be highly effective in achieving offsetting cash flows attributable to changes 9.500.000 an out-of-the-money interest rate cap from a bank. DEBTCO obtains a three-year loan of 10.000 Case 9.000 * (LIBOR – eight per cent). The critical terms of the cap are identical to those of the loan and DEBTCO concludes that. rates are reset at 1 January and interest amounts are settled at 31 December. KPMG International provides no services to clients. time value changes are recognised in the income statement as they arise.000 As can be seen from the above entries.2 Interest rate risk © 2004 KPMG International.196.000.196.000. receive 6. KPMG International is a Swiss cooperative of which all KPMG firms are members.350. DEBTCO purchases for 300.696.000) Hedge revaluation reserve (equity) IRS To adjust the fair value of the cash flow hedge 350. When LIBOR exceeds eight per cent for a particular year DEBTCO receives from the bank under the cap an amount calculated as 10.IFRS Financial Instruments Accounting March 2004 Reference Debit Cash Interest income To record the settlement of the IRS for the period from 1 July 20X1 to 31 December 20X1 (Pay six per cent fixed 3.000 96.000.000 96. 147 .500. In order to protect itself from this exposure.696. DEBTCO is concerned that interest rates may rise during the next three years. On both the variable-rate loan and the interest rate cap. The balance sheet at 31 December 20X1 will be as follows: Assets Cash IRS asset 93.000 3.000.3 Cash flow hedge using an interest rate cap At 1 January 20X1. Changes in the time value of the option will be excluded from the assessment of hedge effectiveness. Therefore. the interest expense shown in the income statement is again 3. DEBTCO designates and documents the intrinsic value of the purchased interest rate cap as a cash flow hedge of the interest rate risk attributable to the future interest payments on the loan for changes in LIBOR above eight per cent.000. Each member firm is a separate and independent legal entity and each describes itself as such. both at inception of the hedge and on an ongoing basis.7 per cent floating 3.250.000. All rights reserved.

000) 70.000 148 9. KPMG International is a Swiss cooperative of which all KPMG firms are members. intrinsic value and time value of the interest rate cap and changes therein at the end of each reporting period.000) Change in time value gain/(loss) – (20.000) (150.100. Alternatively. Each member firm is a separate and independent legal entity and each describes itself as such. can reasonably be expected to equal the present value of the cumulative change in expected future cash flows on the debt obligation when LIBOR is greater than eight per cent.IFRS Financial Instruments Accounting March 2004 Reference in LIBOR when LIBOR is greater than eight per cent.000 280.2 Interest rate risk © 2004 KPMG International.000) Interest payable on Net interest Net interest loan payable payable 900. All rights reserved.000 Time value 300.000) Date 1 January 20X1 31 December 20X1 31 December 20X2 31 December 20X3 Fair value 300. During the three-year period LIBOR rates and related amounts are as follows: Receivable under cap – (100.000 280.000 – IAS 39 does not specify how to compute the intrinsic value of a cap option where the option involves a series of payments. Assuming that all criteria for hedge accounting have been met. .000. 20X2.000 350.000 200.000 200. This should be reassessed each reporting period.000) (130.000 150.000.000 300. KPMG International provides no services to clients. the following journal entries must be made on 1 January 20X1 and 31 December 20X1.000.000 1. DEBTCO does not need to assess effectiveness in instances where LIBOR is less than eight per cent.000) (200.000 1. The cumulative gains or losses on the interest rate cap.000 10.000 1.000. In this example.000 300. and 20X3: Debit 1 January 20X1 Cash Loan payable To record the initial borrowing Interest rate cap (asset) Cash To record the purchase of interest rate cap Credit 10.000 Change in fair value gain/(loss) – (20.200.000 9% 10% 10% Date 20X1 20X2 20X3 Rate 7% 9% 10% The fair value.000 900.000 1.000 (150. As the cap is being used to purchase one-way protection against any increase in LIBOR. the intrinsic value of the cap might be calculated for each reporting period by comparing the cap rate with the market’s expectations of movements in LIBOR using the LIBOR forward yield curve. adjusted to remove time value gains and losses. the intrinsic value of the cap is assumed to equal the expected future cash flows holding constant the cap’s current reporting period cash flow of one per cent (nine per cent – eight per cent) for the remaining term of the cap and excluding the time value of money. but before cash settlement of interest are as follows: Intrinsic value – – 200.

000 represents the change in time value.2 Interest rate risk © 2004 KPMG International.000 20.000 1.000 100.000 70.000 1.000 130.100.000 represents the increase in the interest rate cap’s intrinsic value Hedging reserve (equity) Hedge income (or interest income) (income statement) Represents the release to the income statement of the proportion of the increase in intrinsic value of the cap which relates to the realised cash flow through interest expense incurred in 20X2 Cash Interest rate cap (asset) To record the cash received upon settlement of the interest rate cap 31 December 20X3 Interest expense (income statement) Cash To record interest expense on the loan (LIBOR + two per cent) Hedge expense (income statement) Interest rate cap (asset) Hedging reserve (equity) To record the change in the fair value of the interest rate cap – 150.IFRS Financial Instruments Accounting March 2004 Reference Debit 31 December 20X1 Interest expense (income statement) Cash To record interest expense on the loan (LIBOR + two per cent) Hedge expense (income statement) Interest rate cap (asset) To record the change in the fair value of the interest rate cap – time value change 31 December 20X2 Interest expense (income statement) Cash To record interest expense on the loan (LIBOR + two per cent) Hedge expense (income statement) Interest rate cap (asset) Hedging reserve (equity) To record the change in the fair value of the interest rate cap.000 100.000 20. All rights reserved. 100.000 1. and 200. 130.000 50.000 200. KPMG International is a Swiss cooperative of which all KPMG firms are members. which is excluded from the assessment of hedge effectiveness.000 100.000 1. Each member firm is a separate and independent legal entity and each describes itself as such.100. KPMG International provides no services to clients.000 100.000 gain represents the intrinsic value change 900.000 Credit 900.000 loss represents the time value change.000 100.000 150. 149 .200.000 9.200.

However.2. Generally the entity needs to select (one or a group of) specified assets or liabilities.000 Credit 200.150.2. All rights reserved. cash flows or forecasted transactions that are part of the net position.000 (i. particularly so for banks and other financial institutions.000 200. Each member firm is a separate and independent legal entity and each describes itself as such.2 Interest rate risk © 2004 KPMG International. recognition in earnings of changes in the fair value of the cap due to changes in time value results in variability of total interest expense during each year: 20X1 Interest on LIBOR + two per cent debt Reclassified from equity (effect of cap) Interest expense adjusted by effect of hedge Change in time value of cap Total expense 900.000 As a result of the hedge.e.4 gives a basic example of this approach. 39. KPMG International provides no services to clients. a net position may not be designated as the hedged item. KPMG International is a Swiss cooperative of which all KPMG firms are members.000.000 (100. an entity still may be able to apply hedge accounting if the hedge relationship is designated in a way that meets the criteria set forth in IAS 39.4 Net position hedging of interest rate risk Banks and similar financial institutions often manage this risk on a net basis. .100.e. AG101 and IG F.200.130. This is because there may be some natural offsets within an entity’s balance sheet already. The above approach may be useful in some cases.000) 1. Case 9.000 150.000 – 900.000 (200. in instances where LIBOR exceeded eight per cent).000 20. usually in time buckets which group assets and liabilities by the earlier of expected maturity or repricing date.000 200.000.000 1.000 20X3 1. However. Such entities assess the interest rate risk in all interest-bearing financial assets and liabilities and determine the net exposures.21 For hedge accounting purposes. Therefore.000 130. the payments received from the interest rate cap effectively reduce interest expense to 10 per cent as illustrated below. the real economic risk) 150 9.IFRS Financial Instruments Accounting March 2004 Reference Debit Hedging reserve (equity) Hedge income (or interest income) (income statement) To record the release to the income statement of the proportion of the increase in intrinsic value of the cap which relates to the realised cash flow through interest expense incurred in 20X3 Cash Interest rate cap (asset) To record the cash received upon final settlement of the interest rate cap 200.000. during those periods where the contractual terms of this loan would result in an interest expense greater than 10 per cent or 1. DEBTCO has effectively capped its interest expense on the three-year loan at 10 per cent.000) 1. and designate these as the hedged item.000 920. it is only for the net risk positions that the entity may decide to obtain derivatives or other instruments to provide an economic hedge.000 20X2 1.000 9.84. Specifically. although it is arbitrary in that the hedged item (for accounting purposes) is not the net position (i.000 1.

Note: Similar to variable rate instruments. The notional amounts of existing interest rate swap contracts are compared to the net exposures determined in Step 1. explained in the note below. The method involves scheduling out all of the entity’s interest rate cash flow exposures (hedged items) and all of its interest rate swaps (hedging instruments) over a period of time. A typical schedule / gap analysis might use one-month time periods for up to several years in the future. The cash inflows and outflows and the repricing of variable rate assets and liabilities create a net exposure in each period – either a net cash inflow that needs to be reinvested.6. Step 2: If the entity already has pre-existing interest rate swaps that would meet hedge accounting criteria. The net exposure identified for each period may be used as the starting point for assessing the entity’s overall cash flow exposure to interest rates.2 Hedge accounting considerations when interest rate risk is managed on a net basis. An entity may tailor its own method to satisfy the basic criteria in IAS 39 while utilising existing risk management systems. the fixed interest to be received or paid and the principal are included in the analysis in each period in which they are expected to be received or paid. The schedule should reflect estimates about prepayments and defaults. the schedule might use one-year or even longer time periods. this approach may not be practical for entities that have an ongoing interest rate risk management program and have large volumes of netted interest rate positions. which is a further extension of the basic approach above.IFRS Financial Instruments Accounting March 2004 Reference that the entity wants to manage. KPMG International is a Swiss cooperative of which all KPMG firms are members. refinancing or repricing of the instruments’ cash flows. KPMG International provides no services to clients. and the interest repricing exposures (from variable rate assets and liabilities). For variable rate instruments.2 Interest rate risk © 2004 KPMG International. Further. A summary of this method is described in the following steps. the notional amounts of the interest rate swaps are included in each period that they remain outstanding. Interest amounts for variable rate instruments can be estimated using forward rates. Each member firm is a separate and independent legal entity and each describes itself as such. Note: For fixed rate instruments. For both the fixed rate and variable rate instruments. and should be read in conjunction with the IGC’s illustrative example. This example illustrates a method for hedging interest rate risk in a portfolio of interest-bearing assets and liabilities using interest rate swaps. Any difference between the two is the amount of remaining exposure that the entity may want to hedge.6. is provided in IG F. the entire notional amount and estimated interest amounts are included in each period that the instruments are expected to reprice. The swaps’ notional amounts 9. All rights reserved. There is presumed to be an exposure to interest rates in that period because the cash flows will need to be reinvested or refinanced during that period. One such method. or a net cash outflow that needs to be paid.3. these should be included in the analysis in each period that they are outstanding to determine the entity’s actual net exposure. This is typically the case for financial institutions. which is an illustrative example of applying Question IG F. 151 . For longer-term assets and liabilities. ■ All of the identified cash flows are scheduled out in a maturity schedule. there is a common exposure to interest rate changes created by the reinvestment. Step 1: The entity should identify for each reporting period: ■ the forecasted principal and interest cash inflows and outflows (from both fixed and variable rate assets and liabilities).

All rights reserved. There is interest rate exposure in subsequent periods as well. it does not matter that the cash flows from that period are from both fixed and from variable instruments or from rollovers of short-term debt. The key feature is that all of these instruments share the same exposure to changes in the forward interest rate during that one period.IFRS Financial Instruments Accounting March 2004 Reference create an interest rate exposure because interest is computed based on the notional amount each period. If the actual net exposure is an outflow. the entity determines the expected interest based on refinancing of cash outflows and repricing of liabilities. and the variable component of the swap is repriced each period. Therefore. This may even be how the entity addresses interest rate risk already. Each member firm is a separate and independent legal entity and each describes itself as such. to the extent that total expected interest cash inflows exceed the hedged interest cash inflows in each of the periods being hedged by the swaps. nor for what period of time the cash flows will be reinvested. To the extent that the net exposure exceeds risk management limits. Step 4: In order to apply hedge accounting. Step 3: At this point the entity has identified its actual net exposure to interest rate risk. . This percentage is applied to the gross interest calculated in Step 4(b) above to determine the hedged expected interest. However. the entity may hedge the balance by entering into additional interest rate swaps (or other interest rate derivatives) to reduce that part of the exposure. further steps are needed to qualify for hedge accounting. Note: Steps 1 to 3 above are procedures an entity may follow in doing economic hedging. Step 5: Hedge effectiveness of the net position needs to be tested at least each reporting period. Steps 1 to 3 identified the net exposures that the entity wants to hedge. Because of this designation. The entity’s risk management policies usually will identify what is a tolerable interest exposure to leave unhedged. 152 9. This is simply the notional amount of the interest rate swaps designated as hedging instruments in each period divided by the gross amounts of exposure for each period.2 Interest rate risk © 2004 KPMG International. for both effectiveness testing and for accounting purposes.) (b) The designated hedged item is the expected interest from the reinvestment of the cash inflows or repricing of the gross amount for the first period after the forecasted transaction occurs. the hedging instruments in each period now need to be associated with a gross cash flow position. (This assumes that the actual net exposure determined in Step 3 is an inflow exposure. that is not designated as being hedged as that would require knowing the number of periods of reinvestment. (a) The entity determines the expected interest from the reinvestment of the cash inflows and repricing of assets by multiplying the gross amounts of exposure for each period by the forward rate for each period. However. the entity only need compare the cumulative changes in the present value of the hedged interest cash inflows with the cumulative change in the fair value of the interest rate swaps. However. the interest rate swaps now need to be specifically related to cash flow interest risks. KPMG International is a Swiss cooperative of which all KPMG firms are members. this process is simplified due to the designation of the hedged item as a portion (expressed as a percentage) of expected interest for the first period only after the forecasted transaction. however. KPMG International provides no services to clients. refinance or repricing for all items. (c) The entity determines the portion of its gross cash flows that are being hedged (expressed in terms of a percentage).

2 Step 4 illustrated: Identify gross cash flows as the hedged positions By following the approach suggested in the illustrative example set out in IG F. All rights reserved.3.6. In this example that portion is the cash flows occurring in the first period after the reinvestment / repricing date. Namely: 39. In that case the effectiveness test results would be very highly effective. 39. the requirements in IAS 39 are met in respect of what qualifies as a hedging instrument and hedged item.75 ■ 9. Figure 9.81 ■ Hedged item: The hedged expected interest is a portion of the total cash flows. For financial assets and liabilities. KPMG International is a Swiss cooperative of which all KPMG firms are members. an entity may designate a portion of a cash flow as the hedged item.1 Steps 1 to 3 illustrated: Identify the interest rate exposure and swaps used for hedging Figure 9. Each member firm is a separate and independent legal entity and each describes itself as such.IFRS Financial Instruments Accounting March 2004 Reference Note: The interest rate hedged should be defined as the benchmark interest rate. KPMG International provides no services to clients.2 Interest rate risk © 2004 KPMG International. 153 . Hedging instrument: The interest rate swaps are designated as hedging the expected interest cash inflows for each remaining period in which the swaps are outstanding.

and hedge accounting could be applied. All rights reserved. and supported by the history of actual repricing cash flows. rather than documenting the net position as the hedged item. the bank could designate 700 of customer deposits in the less than one-month band. KPMG International provides no services to clients. In order to illustrate this.000 2.200 100 5. Forecasting of cash flows should be part of the asset and liability management process of forecasting the repricing cash flows of the bank.g.) Less than 1 month Assets Treasury bills Placements with banks Loans Bonds Assets in the repricing band Liabilities Customer deposits Deposits from banks Bills. for example.IFRS Financial Instruments Accounting March 2004 Reference Case 9. with a detailed breakdown in the first year and wider bands in subsequent years.500 300 7. For illustration purposes. if the bank wishes to hedge the entire 700 net liability exposure in the first time band. However. (Normally the maturity breakdown would include periods up to. Each member firm is a separate and independent legal entity and each describes itself as such. KPMG International is a Swiss cooperative of which all KPMG firms are members. .100 2.000 400 Under a net position-hedging scenario.400 3. High probability of the expected cash flows could be supported if customer deposits of far more than 700 are available. suppose that the bank designates a swap (pay-fixed.800 300 2 to 3 months 200 400 6.300 (700) 1 to 2 months 300 500 5. e. such as the bottom layer of the customer deposits. commercial paper issued Liabilities in the repricing band Net position for the currency 100 300 5.600 4. The customer deposits designated should share the same exposure to the risk that is being hedged.200 100 6. The bank must establish that it is highly probable that greater than 700 of customer deposits with similar characteristics will be available each month the swap is outstanding.000 500 7.000 200 5.4 Net position hedging – interest rate risk A bank monitors its interest rate risk exposures through reviewing gaps within repricing bands of net asset or liability positions of a single currency.000 300 6. it could do so through a derivative instrument for the repricing band of less than one month. only the first three months are illustrated. the exposure to a benchmark interest rate risk. The bank could perform statistical analysis to document this shared risk basis.2 Interest rate risk © 2004 KPMG International.500 3. 154 9. receivevariable) as a cash flow hedge of the interest payable on 700 of liabilities that reprice each month. 10 years. The same approach described here may be used for the other repricing bands noted above.500 3.

2 Interest rate risk © 2004 KPMG International. Trading desk – internal swap ■ ■ Receive-fixed at eight per cent – notional 100 million. liquidity and other risk exposures from the bank’s lending and funding operations. by setting up a separate book for the transactions of the trading desk with the banking desk and the related external party transactions. Trading desk – external swap ■ ■ ■ Receive variable at the six-month inter-bank rate – notional 100 million. the banking desk enters into interest rate swap agreements with the trading desk to swap a floating rate of interest for a fixed rate (cash flow hedge). with the rate based on the six-month inter-bank rate: Banking desk – internal swap ■ ■ Receive variable at the six-month inter-bank rate – notional 100 million. in addition to the transactions with the banking desk. Financial assets and liabilities of these operations are generally carried at amortised cost. In such a case. KPMG International provides no services to clients. Each member firm is a separate and independent legal entity and each describes itself as such. Term and payment dates of external swap mirror those of the banking desk’s internal swap. The trading desk enters into various other derivative agreements with external parties as part of its trading activities. Pay-variable at the six-month inter-bank rate – notional 100 million.5 Hedging on a group basis – interest rate risk Assume that a bank has both a trading desk and a banking desk. no more than 75 million could be designated as a hedge and would qualify for hedge accounting. 155 . if instead an interest rate swap with a notional 75 million was outstanding with a third party. in the above case. The example assumes an exposure to a floating rate liability. The banking desk manages the interest. Pay-fixed at eight per cent – notional 100 million. Therefore. provided the other hedge criteria are met. The transactions that would be entered into by the bank in order to apply hedge accounting are noted below. The swap with the external party is effective in offsetting the exposure of the banking desk. These transactions with the trading desk are documented as hedging transactions and the banking desk would like to apply hedge accounting. there is an equivalent contract that the trading desk entered into with an external party. Pay-fixed at eight per cent – notional 100 million. KPMG International is a Swiss cooperative of which all KPMG firms are members. 9.5-7 Hedge accounting is not appropriate for internal transactions unless it can be demonstrated that for each instrument that the banking desk has entered into with the trading desk. All rights reserved. However. for example. the accounting treatment would be different. hedge accounting is appropriate.IFRS Financial Instruments Accounting March 2004 Reference Case 9. all such instruments are trading instruments and are carried at fair value with changes recognised in the income statement. this can be achieved. In the accounting records of the trading desk.1. IG F. In order to manage its interest rate risk exposures. In practice.

Fair value hedging accounting for interest rate risk on a portfolio basis The IASB is in the process of considering amendments that might allow financial institutions in particular more easily to apply fair value hedge accounting for hedges of interest rate risk when its risk management approach is to hedge a net balance sheet position.6. The IASB expects to issue limited amendments to the standards in this respect in March 2004. All rights reserved. KPMG International provides no services to clients. or portions thereof.e. Application of hedge accounting principles to this currency exposure will not change the measurement of the hedged item or the hedging instrument as gains or losses resulting from changes in foreign exchange rates would be recognised in the income statement. 9. it must have a separately measurable foreign currency component in its pricing.IFRS Financial Instruments Accounting March 2004 Reference It is possible to achieve hedge accounting when the trading desk aggregates several internal swaps.1 Foreign currency risk Identifying the hedged risk and the hedging models Hedge accounting for hedges of foreign currency risk is commonly used for: ■ hedging the future cash flows or value (foreign currency component) of non-monetary financial assets or liabilities when fair value changes are not recognised in the income statement (fair value or cash flow hedge). An example of this is an investment property located in a country with a different currency and that is measured at fair value at each balance sheet date. That is. .5 Property. the expected cash flows from this sale could be a hedged item under a cash flow hedge provided that the transaction is highly probable and the other criteria for hedge accounting are met.3 9.3. and hedging forecasted future transactions in foreign currency (cash flow hedge) whether a firm / contractual commitment or a highly probable anticipated transaction. IG F. they should not be used to offset each other. i. Each member firm is a separate and independent legal entity and each describes itself as such. 156 9. as opposed to an asset that is expected to be sold in a foreign currency. certain issues such as the measurement of ineffectiveness. if these assets are expected to be sold. The fair value of this property will include a currency component equal to the changes in the spot rate between the foreign currency and the owner’s measurement currency. the amortisation of the fair value hedge adjustments to the portfolio and the treatment of demand deposits in such a model remain under discussion. and enters into one offsetting external contract. KPMG International is a Swiss cooperative of which all KPMG firms are members. However. The aggregated internal swaps must be a gross amount. This approach can be done provided that the external swap is identified and is effective in hedging the aggregate exposure of the banking desk. plant and equipment carried at historical cost cannot be hedged for foreign currency risk since the assets are not remeasured for changes in foreign exchange rates.3 Foreign currency risk © 2004 KPMG International. At the date of this publication. ■ Accounting for the hedge of foreign currency risk on a non-financial asset as a fair value hedge requires that the hedged item itself is denominated in a foreign currency.

KPMG International is a Swiss cooperative of which all KPMG firms are members.101 Firm commitments and forecasted transactions with identified counterparties Whenever the timing of delivery. Alternatively. Each member firm is a separate and independent legal entity and each describes itself as such. but will still occur. In determining the appropriate accounting treatment for delayed transactions it is useful initially to distinguish between hedged cash flows related to: ■ ■ ■ a firm commitment. If the firm commitment is delayed. whether the entity can demonstrate that the delayed transaction is the same transaction as the one that was originally hedged. KPMG International provides no services to clients. delayed delivery or complaints about delivery. payments or other terms under a firm commitment are changed. there may be a little more flexibility in what is regarded as a relatively short period of time because there is no firm commitment that establishes a delivery date. 9. it is our view that hedge accounting may be continued under certain circumstances.4 When delays of cash flows occur. 9. These circumstances are that the firm commitment can still be uniquely identified.3. If a date (e.1 39. when taking into account all the facts and circumstances surrounding the delay. and forecasted transactions with unidentified counterparties. liquidity problems on the part of the counterparty. Sometimes cash flows do not occur when they are expected. a forecasted transaction with an identified counterparty.4 When the timing of a firm commitment or a highly probable forecasted transaction is delayed. or whether a new firm commitment with new terms has been created. some degree of ineffectiveness is likely to occur. IG F. However.3.2 The effect of delays or prepayments of hedged cash flows Delays or prepayments of hedged cash flows frequently occur when hedging foreign currency risk in a cash flow hedge. an entity must evaluate whether the original firm commitment still exists.5.g.11 IG F. 157 .3. it may be due to customers’ changing specifications for the ordered product or a change in a customer’s production schedule. delivery date.IFRS Financial Instruments Accounting March 2004 Reference 9. completion date) is not specified. Determining the timing of forecasted cash flows involves making estimates. The latter situation would result in the original hedge relationship being terminated and the gains or losses on the hedging instrument previously recognised in equity would be recognised in the income statement. rather it should be hedged as a forecasted transaction with an identified counterparty. these issues are also applicable any time an entity is hedging other types of financial risks in forecasted transactions. The key issue is. since the timing of the hedged item and the hedging instrument will no longer be the same.5. IG F. it is important to determine the cause and duration of the delay. this last item should be interpreted rather narrowly because the contract supporting a firm commitment generally will specify a date or range of dates. a binding agreement still exists and the cash flows are still expected to occur within a relatively short period of time after the original transaction date. For a firm commitment.3 Foreign currency risk © 2004 KPMG International. the transaction is unlikely to meet the definition of a firm commitment.2. For a forecasted (highly probable) transaction with an identified counterparty. A firm commitment could be delayed for a number of reasons such as a breach of the contract. All rights reserved.

it would be very unlikely that an entity would be able to demonstrate that sales in later periods are due to a shortfall in an earlier period. forecasted sales) with unidentified counterparties within a certain time period. a shorter time period) than for forecasted transactions with identified counterparties.3 Foreign currency risk © 2004 KPMG International. The method used must be included in the hedge documentation. For example. the hedging instrument may not be re-designated for a shorter period (i.IFRS Financial Instruments Accounting March 2004 Reference IG F. this narrow range of time should be more strictly interpreted (i. a history of designating hedges of forecasted transactions and then determining they are no longer expected to occur may call into question the entity’s ability to accurately predict forecasted transactions. The transactions must take place within a narrow range of time from a most probable date. 39. 9. an entity may be able to demonstrate that such a shortfall will be offset by increased cash flows in a later period. In addition. In that case hedge accounting should be discontinued. Both approaches have potential benefits and drawbacks. regardless of whether 9. Entities often hedge foreign currency risk from forecasted transactions using forward contracts. Our view is that for forecasted transactions with unidentified counterparties. as well as the propriety of using hedge accounting in the future for similar transactions. 39. If effectiveness is measured based on forward rates. until the cash flow is now expected to occur). the changes in the fair value of the forward and the change in expected cash flows from the forecasted transactions must be measured. KPMG International is a Swiss cooperative of which all KPMG firms are members.11 IG F. Each member firm is a separate and independent legal entity and each describes itself as such. KPMG International provides no services to clients.5. the industry and environment that the entity operates in should be considered. However.3.5.g. When forecasted cash flows in one period do not occur. Since the hedging instrument would expire later than the hedged cash flows.75 In other cases the timing of a hedged cash flow may change to be earlier than originally expected.101 and IG F.e.2 Cash flows from forecasted transactions with unidentified counterparties Cash flows from forecasted transactions with unidentified counterparties are designated with reference to the time period in which the transactions are expected to occur. When the hedged item is designated as cash flows from forecasted transactions (e.4 and 39.6 A hedge relationship between a forecasted transaction and a forward contract used to hedge the foreign currency risk may be measured based on either spot rates or forward rates. some ineffectiveness is likely to occur in this situation as well.2. At a later point the entity revises its forecast to expected sales of FC 75 in the first quarter and FC 125 in the second quarter.6. as there is still the requirement that a hedging instrument must be designated for its entire remaining time outstanding. All rights reserved. IG F. 158 .3. In determining the length of such a period.88. an entity initially forecasts sales of FC 100 in each of the first two quarters of the next year.2 also are applicable when hedging foreign currency risk.e.3 Effectiveness testing of foreign currency hedging transactions The principles described in Section 8.3. This is because these forecasted transactions do not yet have any identified counterparties that would otherwise allow them to be identified with respect to a specific expected transaction. 9. In performing hedge effectiveness testing.3. However. the forward points on the forward contract will not be recognised in the income statement to the extent the forward is fully effective. The total amount of sales in the two quarters remains unchanged at FC 200.7 For hedge accounting to be continued the original forecasted transaction must still exist and be highly probable of occurring.

committed transactions are hedged 100 per cent. in order to hedge the currency inflow from the remaining 50 per cent of the sales.6 Cash flow hedge of foreign currency sales transactions Components Manufacturer produces components that are sold to domestic and foreign customers. The hedge is expected to be highly effective. Components Manufacturer includes the time value of foreign currency forward contracts when measuring hedge effectiveness. Components Manufacturer projects sales to its foreign customers during April 20X1 will be 100. cash payment falls due one month after the invoice date. quantity and timing are fixed.000 for MC at 0. and recognised in the income statement. amounting to sales revenue of foreign currency (FC) 10. Hedge effectiveness will be assessed by comparing the changes in the discounted cash flows of the incoming amounts of FC to the changes in fair value of the forward contract.6829 at 15 May 20X1 and is documented as a cash flow hedge. The hedge is transacted by entering into a foreign currency forward contract (forward 1) to sell FC 5. timing differences between the settlement of the forecasted transaction and the derivative will cause some ineffectiveness. For export sales. only 50 per cent of the total anticipated sales are hedged. a further foreign currency forward contract (forward 2) is entered to sell FC 5. KPMG International is a Swiss cooperative of which all KPMG firms are members.000. Export sales are denominated in the customers’ measurement currency.7100 at 15 May 20X1.000 of sales in April 20X1 are still anticipated but uncommitted. 9. anticipated transactions that are highly probable are hedged 50 per cent. KPMG International provides no services to clients. The following cases demonstrate a number of the issues that have been discussed in Section 9. and only transactions anticipated to occur within six months are hedged. This ineffectiveness must be measured whenever the entity performs its effectiveness testing. All rights reserved.000 for measurement currency (MC) at 0. A review of the sales order book at 31 March 20X1 shows that all of the anticipated sale contracts for invoicing in April are now signed. In accordance with the hedging policy.000 units.000. In order to reduce the currency risk from the export sales.000.000.3 Foreign currency risk © 2004 KPMG International. Components Manufacturer has the following hedging policy: ■ ■ ■ ■ a transaction is committed when the pricing. Each member firm is a separate and independent legal entity and each describes itself as such.000. This is expected to give a nearly 100 per cent effective cash flow hedge as the fair value of the sales transactions during the period of the hedge will be affected by FC interest rates as well as the spot rates.3 about hedging foreign currency risk. Case 9. 159 . all of the FC 10. At 28 February 20X1. Therefore.IFRS Financial Instruments Accounting March 2004 Reference forward rates or spots rates are applied.

7117 – 0.000 (forward 1) (in MC) – (134. The cash flows being hedged are now recognised in the balance sheet as receivables of FC 10.152) (189. which is the difference between the contract rate and the forward rate multiplied by the notional foreign currency amount.990) (54. The deferred gain or loss is released from equity and recognised in the income statement. KPMG International provides no services to clients.000.000 2.115.491 Credit 7.000.000 160 9. Assuming that all criteria for hedge accounting have been met.7208 Forward rate (1 FC = MC) 0.000. Each member firm is a separate and independent legal entity and each describes itself as such.7115) 134.491) (139.000 7.7117 0.6860 0.7108 N/a The fair value of the forward is the present value of the expected settlement amount. The discount rate used is six per cent.IFRS Financial Instruments Accounting March 2004 Reference The spot and forward exchange rates and the fair value of the forward contracts are as follows: Fair value of forward sale of FC 5.000 2.115.000. FC 10.000*(0.6829 0.3 Foreign currency risk © 2004 KPMG International.491 134. .000 (forward 2) (in MC) N/a – (3. KPMG International is a Swiss cooperative of which all KPMG firms are members.500) Fair value of forward sale of FC 5.000) Date 28 February 31 March 30 April 15 May Spot rate (1 FC = MC) 0. The fair value of the forward contract is zero 31 March 20X1 Hedging reserve (equity) Derivatives (liabilities) To record the change in fair value of forward 1 1 to 30 April 20X1 Trade receivables Export sales To record the sales transactions at the prevailing rate on the date the sales are recognised (on average assumed to be 0.000.000.7100 0. All rights reserved.7120 0. the required journal entries are as follows (amounts in MC): Debit 28 February 20X1 No entries in income statement or balance sheet are required. As a result hedge accounting is no longer necessary because foreign currency gains and losses on the amounts receivable are recognised in the income statement and will be offset by the revaluation gains and losses on the forwards. During April export sales of FC 10.7115) 30 April 20X1 Trade receivables FX gain on trade receivables (income statement) To record the trade receivables at the closing spot rate.000 are invoiced and recognised in the income statement.

000 45.000. FC 5.7208 – 0.010 50.000*(0.IFRS Financial Instruments Accounting March 2004 Reference Debit Hedging reserve (equity) Derivatives (liabilities) To record the change in fair value of forward 1 Hedging reserve (equity) Derivatives (liabilities) To record the change in fair value of forward 2 Export sales (income statement) Hedging reserve (equity) To record the release of the deferred hedge results upon recording the sales (MC 139.152 + MC 3.000 16.990) 1 to 15 May 20X1 Cash Trade receivables To record the payments from receivables at the spot rate at the day of payment (on average 0.575. All rights reserved.348 50.7150) Trade receivables FX gain on trade receivables (income statement) To record the FX gain on trade receivables.500 54. FC 5.500 189.500 45.661 Credit 4.142 143.000 29. KPMG International is a Swiss cooperative of which all KPMG firms are members.7208 – 0.500 50. 161 .661 3.000 9.990 143. Each member firm is a separate and independent legal entity and each describes itself as such.000 3.000.7117) FX loss on forward (income statement) Derivatives (liabilities) To record the change in fair value of forward 1 for the period from 1 to 15 May FX loss on forward (income statement) Derivatives (liabilities) To record the change in fair value of forward 2 for the period from 1 to 15 May Derivatives (liabilities) Cash To record the settlement of forward 1 Derivatives (liabilities) Cash To record the settlement of forward 2 4.010 189.000 54.000*(0.142 3.500 29.000*(0. FC 5. KPMG International provides no services to clients.7117) 15 May 20X1 Cash FX gain on cash (income statement) To record the revaluation of the bank balance to 15 May spot rate.500 16.990 3.575.3 Foreign currency risk © 2004 KPMG International.348 50.000.7150 – 0.7150) Trade receivables FX gain on trade receivables (income statement) To record the FX gain on trade receivables.

7208) Credit 3. whereas the forward contracts are settled on 15 May.000*(0.000 51.000 6.655.000 51. the balance sheet.964.7310 – 0. whereas the release from the hedge revaluation reserve is recognised at the end of April (for practical reasons) when the rate was 0. The FC bank account was overdrawn for a period.000 Summary At 31 May 20X1. Interest element on the forward contracts for the period where hedge accounting is not applied (1 to 15 May): From 30 April the cash flow hedge is de-designated.000 at 0.500 The FX loss in this example is caused by: ■ Timing mismatches: Receivables and sales are recognised at the spot rate at the date of the transaction (on average 0.964.7310) FX loss on cash (income statement) Cash To record the FX loss on forwards settled before all receivables were paid.500 Equity Export sales (retained earnings) 6.550.964. KPMG International is a Swiss cooperative of which all KPMG firms are members.000*(0.000 at 0.000. receivables are collected during the month of May and recognised at the relevant spot rates. .3 Foreign currency risk © 2004 KPMG International.000.7208) Trade receivables FX gain on trade receivables (income statement) To record the FX gain on payments of receivables.414. ■ 162 9. including the income statement impact.6829 Forward 2: FC 5.000 51. FC 5.500 6.500 The bank balance reflects the settlement of the two forward contracts (amounts in MC): Forward 1: FC 5.000 51.000.7115) during April.000.7310 – 0.7100 Total 3.964.655. FC 5. KPMG International provides no services to clients. A perfect offset is not achieved due to the interest element included in the changes in fair value of the forward contracts.500 3. All rights reserved. The FX results on the receivables are recognised in the income statement. Each member firm is a separate and independent legal entity and each describes itself as such.000 3. but the forward contracts remain as an economic hedge of the receivables to be collected during May. after all these transactions have settled.858 FX loss (retained earnings) (7.7117. is as follows (amounts in MC): Assets Cash Total assets 6.971. Furthermore.358) Total equity 6. as are the results on the forward contracts.IFRS Financial Instruments Accounting March 2004 Reference Debit 15 to 31 May 20X1 Cash Trade receivables To record the payments from receivables at the spot rate at the day of payment (on average 0.

Forward rate for 30 April Spot rate settlement (1 MC = FC) (1 MC = FC) 102.7 Cash flow hedge of foreign currency purchase transactions Components Manufacturer purchases certain subcomponents in the Far East. All rights reserved.491*2/5) Credit 53. KPMG International provides no services to clients.000.000.000 and there are no more anticipated transactions for April 20X1.000.000. and hedge accounting for FC 2. In such a case it is now unlikely that the anticipated sales transactions will occur.796 53.75 105. At 28 February 20X1. 163 . The hedge is documented and accounted for as a cash flow hedge. Components Manufacturer may continue to have a hedge relationship for FC 3.17 102.000 that is still expected remains in equity.51 N/a Fair value of forward contract (in MC) – (211.000.796 Case 9. The following journal entries are required (amounts in MC): Debit 31 March 20X1 FX losses (income statement) Hedging reserve (equity) To record in the income statement the portion of deferred losses that reflects the cash flows that are no longer expected to occur (134.070) (120. The price is foreign currency (FC) 750 million which falls due at 30 April 20X1.000.46.5 million.160) Date 28 February 31 March 30 April 9.IFRS Financial Instruments Accounting March 2004 Reference Termination of hedge accounting Assume the same scenario as above except that on 31 March 20X1 the committed transactions are actually only FC 3. Effectiveness testing is based on changes in forward rates. Each member firm is a separate and independent legal entity and each describes itself as such. Components Manufacturer hedges the foreign currency risk by entering into a forward contract to purchase FC 750 million for MC on 30 April 20X1 at 102.3 Foreign currency risk © 2004 KPMG International. However.000 must be discontinued.000 of the originally anticipated sales of FC 5. KPMG International is a Swiss cooperative of which all KPMG firms are members. Fair value changes on the foreign currency forward contract must be recognised in the income statement to the extent the anticipated sales will not occur.78 104.000.46 105.000 should be recognised immediately in the income statement as the cash flow is no longer expected to occur. The unrealised FX loss relating to the FC 3. Components Manufacturer signs a contract to purchase one million units of subcomponents from a foreign supplier for delivery at 31 March. The entity’s risk management policy is to hedge foreign currency transactions of more than measurement currency (MC) 2. The unrealised FX loss on the FC 2.

KPMG International is a Swiss cooperative of which all KPMG firms are members.3 Foreign currency risk © 2004 KPMG International.IFRS Financial Instruments Accounting March 2004 Reference Assuming that all criteria for hedge accounting have been met.160 120.199.910 90.000/105.770 7.187 Credit 211.090.000.070 211.070 109. 164 9.160 The effect of the hedge is recognised as a basis adjustment to the cost of inventory.187 7. KPMG International provides no services to clients. the required journal entries are as follows (amounts in MC): Debit 28 February 20X1 No entries in the income statement or balance sheet are required.070 7.910 7.770 120.583 90. Each member firm is a separate and independent legal entity and each describes itself as such.199.070 211. The fair value of the forward contract is zero at that date 31 March 20X1 Hedging reserve (equity) Derivatives (liabilities) To record the change in fair value of the forward Inventories Trade liabilities To record the purchase transaction at the spot rate on the delivery date (FC 750.583 109. All rights reserved.78 spot rate) Inventories Hedging reserve (equity) To record the release of the deferred hedge results upon de-designation of the hedge 30 April 20X1 FX loss on trade liabilities (income statement) Trade liabilities To record the FX loss on the liability Derivatives (liabilities) FX gain (income statement) To record the change in fair value of the forward Trade liabilities Cash To record payment of the liability at the spot rate on the payment date Derivatives (liabilities) Cash To record the settlement of the forward 211. . The adjustment to inventory is recognised in the income statement in cost of sales when the inventory is sold.090.

8 Fair value hedge of foreign currency risk on available-for-sale equities Safeinvestor is a large pension fund set up for the employees of a brewery. Safeinvestor decides to hedge only 85 per cent of the market value of the portfolio. Safeinvestor enters into a foreign currency forward contract to sell FC 25. Also. However. the time value is excluded from the hedge relationship. This is because of the uncertainty about the short-term development in the market value (and therefore the exposure).e. management believes that it is possible to earn a higher return on equity shares in certain foreign markets. Safeinvestor buys a portfolio of foreign currency denominated equity shares for foreign currency (FC) 30 million. The terms of the forward contract are as follows: ■ ■ ■ sell FC 25. and as part of the investment strategy Safeinvestor seeks to hedge all significant exposure to foreign currency risk beyond certain limits. The hedge is expected to be highly effective and hedge effectiveness will be assessed by comparing the changes in the fair value of the first FC 25. In recent years the pension fund assets have grown and management is finding it increasingly difficult to achieve a sufficient diversification in the domestic equity market. 165 . and accordingly an increased foreign currency exposure. This contract will then be rolled for as long as the position is outstanding.5 million of equity shares due to changes in spot rates to the changes in the value of the forward contract also due to changes in spot rates. 9. Each member firm is a separate and independent legal entity and each describes itself as such. KPMG International is a Swiss cooperative of which all KPMG firms are members. Consequently.IFRS Financial Instruments Accounting March 2004 Reference Case 9.359. management decides to invest in a large foreign equity market. Although a steady growth in the value of the portfolio is expected in the medium to long-term. At 1 April 20X1. KPMG International provides no services to clients. All rights reserved. Safeinvestor’s policy is to adjust the hedge by entering into additional foreign currency forward contracts so that at least 75 per cent of the foreign currency risk is hedged. all of Safeinvestor’s pension obligations are denominated in its measurement currency (MC).5 million for MC at 15 October 20X1.000 buy MC 64.500. The shares are treated as available-forsale securities with changes in the fair value being recognised directly in equity.5 million of shares. The forward contract is designated as a fair value hedge of the currency risk associated with the first FC 25.3 Foreign currency risk © 2004 KPMG International. The time value of the forward contract is excluded from the assessment of hedge effectiveness. i.915 maturity 15 October 20X1 (This implies a forward rate of 2.52). If the value of the portfolio increases significantly.

FC 25. MC 30 million at 2. KPMG International provides no services to clients.000 166 9.570.430.769 3.884. Each member firm is a separate and independent legal entity and each describes itself as such.5 million * (2.41 2.000 (1.570. No entries are required for the forward contract 30 June 20X1 Securities available-for-sale AFS revaluation reserve (equity) To record the change in fair value of securities Derivatives (assets) Derivative revaluation gain (income statement) To record the change in fair value of forward Hedge revaluation loss (income statement) AFS revaluation reserve (equity) To transfer the fair value change of securities in respect of the hedged risk to the income statement.550.IFRS Financial Instruments Accounting March 2004 Reference During the period of the hedge value of the forward is as follows (amounts in MC): Spot rate (1 FC = MC) 2.884.850.480.000 Value change (in MC) – 7. KPMG International is a Swiss cooperative of which all KPMG firms are members.915 Spot element – 3.39 2.530.833) 1.920.000.031.000) 11.400.500.500.769 374.769 3.000 78. All rights reserved. .000 3.45 Value of forward contract – 3.55) Credit 76.000 Forward element – (538.979 (1.500.000 66.41 – 2.55.000 510.167 (665.000 Date 1 April 30 June 30 September 15 October Assuming that all criteria for hedge accounting have been met.000 7.000 3.000) 2.000 35.000 Value (in MC) 76. the required journal entries are as follows (amounts in MC): Debit 1 April 20X1 Securities available-for-sale Cash To record the purchase of securities.000 76.031.000.850.000 7.231) (135.406.031.085) Date 1 April 30 June 30 September 15 October The value of the foreign equity portfolio changes as follows.350.031.000 84.570.748 1.769 3.000.000 32.000 28.000.850.000 (17.55 2.021) 8. as a result of changes in equity prices and changes in the spot rate: Value (in FC) 30.521.915 Value change – 3.3 Foreign currency risk © 2004 KPMG International.

3 Foreign currency risk © 2004 KPMG International.5 million * (2.521. KPMG International is a Swiss cooperative of which all KPMG firms are members. in accordance with the hedging policy.530. FC 25. 9.39 – 2.41) 15 October 20X1 Securities available-for-sale AFS revaluation reserve (equity) To record the change in fair value of securities Derivative revaluation loss (income statement) Derivatives (assets) To record the change in fair value of forward AFS revaluation reserve (equity) Hedge revaluation gain (income statement) To transfer the fair value change of securities in respect of the hedged risk to the income statement.000 1. FC 25.000 11.430. the portfolio of shares that was designated as the hedged item at 1 April 20X1 must continue to be the hedged item for the entire period of the hedge.530. This means that active management of the portfolio may preclude fair value hedge accounting.521.480.000 510.45 – 2.000 17.979 510. However.5 million of the equity portfolio due to the same spot rates. KPMG International provides no services to clients. In order for fair value hedge accounting to be applied. The increase in the value of the equity shares at 30 June 20X1 would.000 1.884.833 1.915 The hedge stays effective for the full period as the changes in fair value of the forward contract. perfectly offset changes in the value of FC 25.5 million * (2. result in an additional hedge transaction being entered into.884.979 374. due to changes in spot rates. All rights reserved.480.39) Cash Derivatives (assets) To record the settlement of forward contract Credit 17.430.915 1.000 1.000 11. 167 .IFRS Financial Instruments Accounting March 2004 Reference Debit 30 September 20X1 AFS revaluation reserve (equity) Securities available-for-sale To record the change in fair value of securities Derivatives (assets) Derivative revaluation gain (income statement) To record the change in fair value of forward Hedge revaluation loss (income statement) AFS revaluation reserve (equity) To transfer the fair value change of securities in respect of the hedged risk to the income statement. due to the market movements through 30 September 20X1 this hedge would need to be unwound as the value of the portfolio (and therefore the foreign currency risk) decreased.833 1.000 374. Each member firm is a separate and independent legal entity and each describes itself as such.

IG F.4 Net position hedging of foreign currency risk Net position hedging strategies for foreign currency risk often include the use of a central treasury that accumulates foreign currency risk exposures from group entities and then hedges the net risk exposure with a third party such as a bank. an entity may choose to manage risk on a net basis while for hedge accounting purposes designate the hedge in such a way so as to comply with the requirements in IAS 39. depending on whether cash flow hedging or fair value hedging is applied. or in some circumstances designate offsetting exposures as the hedging instruments in cash flow hedges using internal derivatives to build a documentation trail. and in equity or in the income statement by the individual subsidiaries. KPMG International provides no services to clients.1. To achieve hedge accounting. in some cases it will be possible to apply hedge accounting in the group financial statements. management may designate the hedge as a hedge of the anticipated disposal of the shares providing that the timing of such disposal is highly probable. Hedge accounting at the subsidiary’s financial reporting level is possible if the hedge with the parent is properly documented at that reporting level. and apply cash flow hedge accounting. However.7 168 9. 9. 39. and that the central treasury department can demonstrate that each bundle of risk by currency and time period is netted and fully offset externally. KPMG International is a Swiss cooperative of which all KPMG firms are members.3 Foreign currency risk © 2004 KPMG International. This process may be more in line with the risk management procedures already used by the treasury department. it is crucial that the individual subsidiaries properly document their internal hedge transactions. However.6 and F. Although the effects of internal derivatives would have to be eliminated in consolidation.73 The internal derivatives between a central treasury and the individual entities must be eliminated on consolidation and cannot be designated as hedging instruments in the consolidated financial statements.6 ■ 39. Based on overall risk management objectives and policies the central treasury will determine how best to manage the risk exposure. if all other hedge accounting criteria are met. a net position generally does not qualify as a hedged item for hedge accounting purposes.3. thus ensuring that each qualifying hedging instrument is linked to a qualifying hedged position. due to the ability to designate a non-derivative financial asset or liability as a hedging instrument for foreign currency risk. All rights reserved. Each member firm is a separate and independent legal entity and each describes itself as such. IG F.1.AG101 As mentioned in Section 8. and all other hedge criteria are met. Gains and losses from the internal hedging instrument are recognised in the income statement by the central treasury department.IFRS Financial Instruments Accounting March 2004 Reference As an alternative approach. In this situation the individual foreign currency positions hedged still must be linked using internal contracts. Depending on the entity’s risk management policies and internal procedures the entity may: 39AG101 ■ document and designate a hedge between the external derivatives and a gross position in a group entity that matches the net position. The model that is more appropriate may depend also on the entity’s ability to collect the relevant information required under each model. . hedge accounting may still be used for cash flow hedges as well as for fair value hedges.1. The central treasury often will enter into internal derivatives with other group entities or divisions to effectively transfer the foreign currency risk to the central treasury. Cash flow hedge accounting requires specification of the size and timing of the cash flow being hedged.

000 3.300 900 1 to 2 months 2. for the cash flows expected in the period of two to three months.100 2. The cash flow bands used should be based on the business cycle of the corporate and the period over which it chooses to hedge the cash flows (which would generally cover a longer period than those used in the example below). 9. the exposure of FC 500 could be hedged with a forward.600 500 2 to 3 months 3. Less than 1 month FC inflows Sales Cash inflows FC outflows Purchases of goods Purchases of services Cash outflows Net cash flows in FC 2.IFRS Financial Instruments Accounting March 2004 Reference IG F. For example. KPMG International provides no services to clients. hedging a net exposure is possible.3.200 1. All rights reserved. It is important that the hedged item is the first FC 500 of sales in that time band so that it is clear when the hedged item affects the income statement.200 2. Case 9. provided that an entity documents the hedge relationship as a hedge of part of a gross position that itself forms part of the net position.2.500 100 1.14 The group treasury may hedge the exposure of another operating unit without entering into an internal transaction with that unit as long as the hedge relationship is properly documented at the group level.3 Foreign currency risk © 2004 KPMG International.10 As demonstrated in the example.100 1. IG F. and could designate a derivative or a non-derivative foreign currency instrument as the hedging instrument. To achieve hedge accounting treatment under IFRS.9 Net position hedging – foreign currency risk Assume a corporate has foreign currency cash outflows for payments of goods and services and the same foreign currency cash inflows from sales of its products.300 200 2. KPMG International is a Swiss cooperative of which all KPMG firms are members. the corporate could designate the first FC 500 of highly probable anticipated and committed sales in that month as the hedged item. Each member firm is a separate and independent legal entity and each describes itself as such. The corporate monitors this foreign currency risk by analysing the net foreign currency outflows and inflows expected within each cash flow time band.000 2. 169 .500 500 Under net position hedging the net expected cash flow in each time band could be hedged. Assume that the cash inflows and outflows are all highly probable or committed transactions.000 300 1.

Subsidiary B has highly probable forecasted purchases of FC 500 that it expects to pay in 60 days. All rights reserved.10 Hedging on a group basis – foreign currency risk 39. Subsidiary B hedges this exposure by entering into a forward contract with the corporate treasury to receive FC 500 in 60 days. To hedge this exposure. The parent entity itself has no expected exposure to that foreign currency during this period.84 and AG101 A group consists of a parent entity (including corporate treasury) and its subsidiaries A and B. In order to apply hedge accounting to this transaction the group will designate the external forward contract as a hedge of a gross exposure in one of the subsidiaries rather than the net exposure. Subsidiary A has highly probable cash inflows from future revenues of FC 200 that it expects to receive in 60 days. KPMG International provides no services to clients. Each member firm is a separate and independent legal entity and each describes itself as such.IFRS Financial Instruments Accounting March 2004 Reference Case 9.3 Group hedging of foreign currency risk The effect of the internal derivatives with the subsidiaries is to transfer the foreign currency risk to the corporate treasury. The corporate treasury will hedge this exposure by entering into a forward contract with an external third party. This in effect means that the group has hedged its net exposure of FC 300 in accordance with its risk policies and that hedge accounting can be applied to this hedging strategy provided that the other hedge accounting criteria are met. KPMG International is a Swiss cooperative of which all KPMG firms are members. 170 9. Subsidiary A enters into a forward contract with the corporate treasury to pay FC 200 in 60 days. Figure 9. . The net currency exposure from FC in the next time period is a FC 300 outflow. The group does this by designating the first FC 300 of cash outflows from purchases in Subsidiary B as the hedged item and the external forward contract as the hedging instrument.3 Foreign currency risk © 2004 KPMG International.

Each member firm is a separate and independent legal entity and each describes itself as such.4 9.6 In finalising the amendments. might be recognised in the income statement in June 20X5. it is clear from the amendments that a portfolio of cash flows in a particular currency and within a narrow time-band must also affect profit or loss in the same period. that is a subsidiary whose functional currency is different from the reporting currency of the group. and so these two transactions would be netted using internal derivatives. 171 . it will not be appropriate. the internal derivatives are hedging instruments for each of the subsidiary entities’ stand-alone financial statements.1. The changes are likely to make it more difficult to apply the approach described.4 Hedging a net investment © 2004 KPMG International. and at the group level provide part of the linkage of documentation to the external derivative transaction. then (b) designate the external derivatives as hedging instruments at the group level. it would need to reflect in the financial statements that. between each hedged cash flow within the group and a portion of the related external derivative.4. at the group level. For example. KPMG International is a Swiss cooperative of which all KPMG firms are members. The forecast purchase of FC 500 by Subsidiary B. the foreign currency exposure is hedged like any other foreign currency transaction 9. 9. In other cases. but not netting internal derivatives in the treasury centre). under the amended standards. consider Case 9. via the internal contracts. In particular. KPMG International provides no services to clients. Under this approach. If it continued to use the same netting process. The hedge accounting claimed by Subsidiaries A and B in their individual financial statements would not be reversed or adjusted at the group level. to defer in equity at the end of June 20X5 an amount related to the expected revenue transaction in Subsidiary A in July 20X5. If this transaction affects profit or loss as expected in June. Under the amended standards. The alternative approach under the amended standards would be to: (a) enter into external derivatives to hedge aggregate long positions and short positions in each FC and each time period separately (in other words. and (c) put in place additional documentation at the group level to link each external derivative to its associated group of internal derivatives. only the cash flows need occur within the same reporting period. the hedged item is FC 300 of the expected payments by Subsidiary B. An adjustment will need to be made on consolidation.10 above. All rights reserved. by aggregating. the Board has made changes to the existing guidance (IGC 134-1-b) for entities using internal derivatives that are netted through a treasury centre. through the group corporate treasury to an external derivative covering the net position of FC 300. The forecast sale by Subsidiary A of FC 200 in July 20X5 might be expected to generate cash in August 20X5. the group would need to make adjustments to the hedge accounting entries made by Subsidiaries A and B. so that the chain of hedge documentation is completed.IFRS Financial Instruments Accounting March 2004 Reference December 2003 amendments IG F. also expected to be paid for in August 20X5. Under the existing standards.1 Hedging a net investment Identifying the hedged risk and the hedging model Net investment hedge accounting is available only for a foreign entity.

1 Components of a net investment in a foreign entity Carrying amount of net assets of the foreign entity +/. It is the carrying amount of the total net assets (assets less liabilities) that is designated as the hedged item in a net investment hedge regardless of whether individual assets or liabilities in that foreign entity are denominated in a currency different from the foreign entity’s measurement currency. These additional cash flows from the net investment could be designated. The carrying amount of Entity B’s net assets was MC 60 and Entity A recognised fair value adjustments to specific assets and liabilities of MC 30 and goodwill of MC 10. Such fair value adjustments resulting from internally generated goodwill do not qualify for hedge accounting under the net investment hedge model. 21. Subsidiary B may separately decide to hedge the foreign currency risk of the GBP loans. 172 9. This means that the future cash flows would have to be highly probable..Loans to or from a foreign entity not planned or intended to be settled in the foreseeable future Amount that can be the hedged item in a net investment hedge Case 9. with EUR as its measurement currency. this still must meet the general criteria for cash flow hedges. The carrying amount of Subsidiary B’s net assets is USD 100.4 Hedging a net investment © 2004 KPMG International. the subsidiary. i. includes in its consolidated financial statements the foreign Subsidiary B with USD as its measurement currency. Table 9.11 Hedged item in a net investment hedge Entity A. In some instances the future cash flows from the investment may be expected to exceed the net asset value. However. KPMG International is a Swiss cooperative of which all KPMG firms are members. During 20X2 Entity A extended a loan to Entity B of MC 20. KPMG International provides no services to clients. and neither can the parent entity.Other consolidation adjustments to carrying amounts + Carrying amount of goodwill paid in an acquisition +/.15 Loans to or from a foreign entity that are neither planned nor intended to be settled in the foreseeable future should be treated as part of the investment in the foreign entity. Part of Subsidiary B’s net assets consists of loans denominated in GBP. Case 9. that is itself the foreign net investment cannot apply net investment hedge accounting in its own books.IFRS Financial Instruments Accounting March 2004 Reference exposures. for example. associate etc. Each member firm is a separate and independent legal entity and each describes itself as such. . such as when there is significant unrecognised goodwill or unrecognised value changes in assets or liabilities. as a cash flow hedge of the proceeds from sale of the foreign entity. The net investment hedging model can only be applied at the group level. This is only likely to be the case if sale negotiations for the entity have been completed. All rights reserved.e. Nevertheless Entity A will identify the net assets of Subsidiary B of USD 100 as the hedged item in a net investment hedge. This is because the loans denominated in GBP will be translated into USD in Subsidiary B’s own financial statements before Subsidiary B is consolidated into Entity A. and the timing and amount must be known.12 Hedgeable components of a net investment in a foreign entity In 20X0 Entity A bought Entity B for MC 100.

9. The remaining fair value adjustments are MC 25 and goodwill is MC 7. if a group expects its foreign entity could make losses the group may decide to hedge less than the full carrying amount of the net assets. liabilities or forecasted transactions that lead to actual cash flows and that will ultimately affect the income statement at the consolidated level.2 39. Although the accounting is similar. the changes in value relating to the spot-forward differential would be excluded from the hedge relationship and recognised in the income statement. It is only once dividends are declared and become a receivable that hedge accounting may be applied.4 Hedging a net investment 173 © 2004 KPMG International.4. they cannot be accounted for under either a fair value hedge or a cash flow hedge model.81 Expected net profit or loss of a net investment in a foreign entity The hedged item may be all or a portion of the carrying amount of the foreign entity at the beginning of a given reporting period. The loan has not been repaid and is not intended to be repaid. it would be reasonable to determine hedge effectiveness using changes in spot rates. All rights reserved. Therefore. although in practice most groups would revisit their net investment hedges only quarterly or semi-annually. The additional net assets could be designated as a hedged item in a net investment hedge as they arise. which could result in an over-hedged position. since expected net profits in future reporting periods do not constitute recognised assets. these cannot be hedged in a cash flow hedge or a net investment hedge. the nature of this type of hedge is different from a normal cash flow hedge. 9. Expected net losses in a foreign entity would reduce the year-end net investment balance. 21. expected dividends do not give rise to an exposure that will be recognised in the income statement. . the same hedge effectiveness criteria described earlier in this Section and in Section 8 is also applicable for hedges of net investments in foreign entities. This amount would be MC 122 (70 + 25 + 7 + 20). However. Therefore. Translation risk arises once the net profit is recognised as an increase in net assets of the foreign entity. Each member firm is a separate and independent legal entity and each describes itself as such. Entities also might wish to hedge anticipated dividends from foreign entities. This means that expected profits from the foreign entity in that period cannot be the hedged item under a net investment hedge model. Therefore. Where the hedging instrument is a derivative.4. The carrying amount of the net investment that Entity A may designate as the hedged item is equal to the amount of Entity A’s net investment in Entity B including goodwill. Expected net profits from a foreign entity expose a reporting group to potential volatility in the consolidated income statement as transactions in the foreign entity are translated into the group’s measurement currency at spot rates at the date of the transactions or average rates. Entities may want to hedge this translation risk exposure.3 39.88 Hedge effectiveness IAS 21 does not set any criteria for when hedge accounting can be applied.86 9. The exposure being hedged is the closing spot rate translation exposure under IAS 21. as an approximation of spot rates. KPMG International provides no services to clients. Therefore.IFRS Financial Instruments Accounting March 2004 Reference In 20X3 the carrying amount (not including fair value adjustment from the acquisition) of Entity B’s assets and liabilities is MC 70. as otherwise it would not be able to satisfy the hedge accounting criteria that the hedge relationship is expected to be highly effective on an ongoing basis. However. KPMG International is a Swiss cooperative of which all KPMG firms are members.39 and 40 39.

The foreign exchange rate and fair value of the forward contract move as follows: Spot rate (1 FC = MC) 1.000 3.570.000.000 430.4 Hedging a net investment © 2004 KPMG International.430.000 70. At 1 October 20X1. the required journal entries are as follows (amounts in MC): Debit 1 October 20X1 No entries in the income statement nor the balance sheet are required. . The fair value of the forward contract is zero 31 December 20X1 Derivatives (asset) Foreign exchange losses (income statement) Foreign currency translation reserve (equity) To record the change in fair value of the forward Foreign currency translation reserve (equity) Net investment in subsidiary (asset) To record the foreign exchange losses of the subsidiary (The adjustment to the net investment would be derived by translating the subsidiary’s balance sheet at the spot rate at the balance sheet date) 31 March 20X2 Derivatives (asset) Foreign exchange losses (income statement) Foreign currency translation reserve (equity) To record the change in fair value of the forward Foreign currency translation reserve (equity) Net investment in subsidiary (asset) To record the change in foreign exchange losses of the subsidiary 3. The time value of the forward contract is excluded from the assessment of hedge effectiveness.000 3.000 2.000 2. Each member firm is a separate and independent legal entity and each describes itself as such.000 2.64 1.500.500. All rights reserved.000.IFRS Financial Instruments Accounting March 2004 Reference Case 9. KPMG International is a Swiss cooperative of which all KPMG firms are members.430.500.60 Forward exchange rate (1 FC = MC) 1.13 Hedge of a net investment in a foreign entity GlobalTechCo has a net investment in a foreign subsidiary of foreign currency (FC) 50 million.000.000. GlobalTechCo enters into a foreign currency forward contract to sell FC 50 million for measurement currency (MC) at 1 April 20X2.000 5.000 3.70 1. GlobalTechCo will review the net investment balance on a quarterly basis and adjust the hedge to the value of the net investment.000 Credit 1.000 Date 1 October 20X1 31 December 20X1 31 March 20X2 Assuming that all criteria for hedge accounting have been met.63 N/a Fair value of forward contract – 3.000 174 9.71 1. KPMG International provides no services to clients.

KPMG International provides no services to clients.4. 9. harvest yield. The situation is illustrated in Figure 9. Each member firm is a separate and independent legal entity and each describes itself as such. 175 . as well as coffee beans and metals.1 Hedging commodity price risk Identifying the hedged risk and the hedging models This and the following Sections discuss the hedge accounting principles for a situation where an entity purchases a commodity contract that is accounted for under IAS 39 as a derivative used to hedge an expected purchase or sale of the underlying commodity. purity of the actual product.000 The gain on the hedging transaction will remain in equity until the subsidiary is disposed.4 Hedging with commodity contracts In practice a number of issues arise regarding commodity hedging where derivatives such as futures on that commodity are traded in a standardised form on a commodity exchange or where only an ingredient or component is hedged. The commodity contract is to be used to lock into a price for the commodity that the entity expects to purchase.000. exchange-traded derivatives are based on a standard quality or grade of these commodities. 39.5 Hedging commodity price risk © 2004 KPMG International. KPMG International is a Swiss cooperative of which all KPMG firms are members. This is because the actual product that will be obtained depends on specific circumstances in the future.5 An entity may enter into commodity contracts through a broker on a commodity exchange. 9. For certain commodities. or even consumer demand. Entities often enter into derivatives for a standard commodity prior to determining the actual quality of product they require for production. All rights reserved. Figure 9.5.000 Credit 5. Examples of commodities that are traded in a standardised form are wheat. such as where the commodity comes from.000. corn and other agricultural products.5 9.IFRS Financial Instruments Accounting March 2004 Reference Debit Cash Derivatives (asset) To record the settlement of the forward 5.

The quantity of each of the components in a metric ton of jet fuel is always fixed. In these cases only a standard commodity can be identified at the time the futures contract is entered into. Various strategies are possible when hedging a transaction such as jet fuel purchases. or only a component of the price exposure. brent or gas oil) and to retain an exposure to the price of the other components. IAS 39 does not allow entities to designate only a component of price risk of a commodity as the hedged item. in order for this hedging strategy to qualify for hedge accounting. This may be due to the costs of hedging. it may be difficult to demonstrate on a prospective basis that the hedge relationship is expected to be highly effective throughout the hedging period. However. This may result in perfect effectiveness of those components. Because of the differences in the hedging instrument (futures contract based on the standard commodity) and hedged item (actual product to be purchased / sold). The price of the standard commodity is a surrogate for the price of the actual commodity. However. as the critical terms of the derivative and the critical terms of the component match. or the independent nature of the pricing of the various components. Therefore. However. the entire price risk of the jet fuel purchase must be designated as the hedged item. 176 9.IFRS Financial Instruments Accounting March 2004 Reference 39. All rights reserved. The price risk of a standard commodity can often be isolated and measured because commodity derivative markets are well developed in many places. entities cannot designate a standardised commodity component as the hedged item. Additionally. Each member firm is a separate and independent legal entity and each describes itself as such.5 Hedging commodity price risk © 2004 KPMG International. the relatively more liquid nature of these components. KPMG International is a Swiss cooperative of which all KPMG firms are members. A similar issue arises when an entity hedges an ingredient of a non-financial item. Even if an effective relationship is demonstrated initially. not all would qualify for hedge accounting. The brent and gas oil swaps respectively will be economic hedges of the corresponding brent or gas oil component of the jet fuel purchases.g. as noted above. hedge ineffectiveness may arise. ■ Hedging components of the jet fuel price: An entity may choose to hedge only its exposure to certain of the jet fuel components (e. For example. The actual item to be purchased must be designated as the hedged item. the relative value of each of the components differs as the prices of the components move more or less independently. IAS 39 prohibits hedge accounting for components of risk for non-financial items such as jet fuel purchases. When hedging with a standardised derivative. the prices change in parallel and the notional amount of the derivative equates to the quantity of the component in the jet fuel that will be purchased. But because the prices of the individual components move more or less independently it may not be possible to demonstrate on a prospective basis that the hedge relationship is expected to be highly effective throughout the hedging period. the extent of ineffectiveness later may result in the hedge no longer qualifying as highly effective. . However. although the purchase or sale of the underlying commodity may be highly probable.82 IAS 39 requires that the item that is being hedged can be identified. when hedging the purchase of jet fuel an entity may want to hedge its entire jet fuel price exposure. Each of the components is traded and market prices are available for each of the components. A high degree of correlation must be demonstrated between the price of the hedged ingredient and the jet fuel price. The price of jet fuel is derived from the prices of the various components that make up jet fuel. KPMG International provides no services to clients. the fact these components are the most significant components of jet fuel prices. As a result of the requirement to only hedge commodities in their entirety. the quality of the actual commodity to be purchased generally will differ from the standard quality.

177 . December 2003 amendments 39. The amended standards will continue. an entity may use a jet fuel derivative to hedge the entire price risk exposure from the purchase of jet fuel.000.150 Fair value of the Non-deliverable non-deliverable forward price forward 1. primarily to industrial manufacturers. The cost of this hedged inventory under the FIFO method is 900 per ton for a recognised cost of 1. This approach will give rise to some ineffectiveness in practice.000) Date 1 July 31 July 31 August 9. The forward is designated as a hedging instrument in a fair value hedge of the inventory. For example.AG100 Several comments on the proposed amendments had proposed that separate components of a non-financial item should qualify for hedge accounting as long as changes in the fair value of the hedged component could be measured reliably. If there is a valid statistical relationship between the two prices.000 tons of zinc at a price of 1.000) (100. KPMG International provides no services to clients. although it may be sufficient to ensure that hedge accounting can be achieved. refines and then sells to end-users.02 tons of Columbian coffee would be designated as a hedge of the purchase of one ton of Brazilian coffee. the slope of the regression line can be used to establish the hedge ratio that will maximise expected effectiveness.100 per ton with a maturity of 31 August 20X1. Big Metal wishes to hedge a portion of its zinc inventory.5 Hedging commodity price risk © 2004 KPMG International. The Board rejected this suggestion. Each member firm is a separate and independent legal entity and each describes itself as such. One of these metals is zinc.14 Fair value hedge of commodity price risk Big Metal is a refiner and wholesaler of metals. The zinc spot and forward prices are as follows: Spot rates per ton 1. a regression analysis might be performed to establish a statistical relationship between the price of a transaction in Brazilian coffee (the hedged item) and a hedging instrument whose underlying is the price of Columbian coffee.050 1. but has clarified in the amended standards that hedge accounting might be achieved by adjusting the hedge ratio to maximise effectiveness. however. All rights reserved. Case 9. if the slope of the ‘line of best fit’ is 1. then a derivative with a notional amount of 1.100 1.150 – (48.02. to prohibit the hedged item to be designated as the Columbian coffee component of the Brazilian coffee price.125 1. On 1 July 20X1. For example.800. Management determines and documents that the forward will be highly effective in offsetting the fair value change in the inventory of zinc.100 1. The entity maintains an inventory of metals that it obtains directly from various mining companies. KPMG International is a Swiss cooperative of which all KPMG firms are members. This hedging strategy would qualify for hedge accounting assuming all other criteria have been met. which it refines to a high-grade quality and then sells wholesale. Big Metal enters into a non-deliverable forward with a metals broker to sell 2. even if that component can be proven to exist and can be measured reliably.IFRS Financial Instruments Accounting March 2004 Reference ■ Hedging the entire price of jet fuel: In order to meet the requirements of IAS 39 regarding hedging of commodity price risk.

KPMG International provides no services to clients. KPMG International is a Swiss cooperative of which all KPMG firms are members.000 46.000 since the date of hedge inception.000 Credit 45. The accounting entries are as follows: Debit 31 August 20X1 Hedging revaluation loss (income statement) Forward liability To record the revaluation of the forward for the period from 31 July to 31 August 20X1 Inventory Hedging revaluation gain (income statement) To record the change in the fair value of the zinc inventory for the period from 31 July to 31 August 20X1 Forward liability Cash To record the settlement of the forward Credit 52.000 45.000 Based on the change in the fair value of the forward and the change in the fair value of the inventory. On 31 August 20X1.000).000). The value of the zinc inventory is affected by other factors in addition to zinc spot prices. the fair value of the forward is (100.000 46.000 from 31 July 20X1 resulting in a total fair value increase in the inventory for the hedging period of 91.000.000 100. The value of the inventory increased by 46. The value of the 2. The accounting entries on these dates are as follows: Debit 1 July 20X1 No entries are made related to the forward as the cost is zero 31 July 20X1 Hedging revaluation loss (income statement) Forward liability To record the revaluation of the forward for the period from 1 to 31 July 20X1 Inventory Hedging revaluation gain (income statement) To record the change in the fair value of the zinc inventory for the period from 1 to 31 July 20X1 48.000 178 9.000. .000 100.IFRS Financial Instruments Accounting March 2004 Reference On 31 July 20X1.5 Hedging commodity price risk © 2004 KPMG International. it is determined that the hedge remains highly effective.000 48.000 tons of the hedged zinc inventory has increased by 45. the fair value of the forward is (48. The forward has also matured at that time and is settled through net cash payment to the broker of 100.000 52. Each member firm is a separate and independent legal entity and each describes itself as such. All rights reserved.

891. However.5 Hedging commodity price risk © 2004 KPMG International.300.000 Case 9.300.000.000 1.891. Big Metal documents that the hedge relationship is between the changes in fair value of the forward and the changes in expected future cash flows from expected sales of 2. It is highly probable that the sale will occur based on the historical and expected sales.800. 179 . Management determines and documents 9. KPMG International provides no services to clients.845.300.000 + 45. KPMG International is a Swiss cooperative of which all KPMG firms are members.000) 409.000 The following table summarises the change in the inventory value during the hedged period prior to the eventual sale: Date 1 July 31 July 31 August Recorded carrying amount of hedged inventory.150 per ton Cost of sales Inventory To record the cost of the sale of the inventory (1.300.000 tons of zinc inventory in August 20X1.000 tons of zinc at a sale price of 1. Big Metal designates a cash flow hedge of future anticipated sales of 2. All rights reserved.000 1.891.15 Cash flow hedge of commodity price risk This case is intended to demonstrate the different journal entries required when using a cash flow hedge.000 2. net of adjustments: 1. Based on the adjusted inventory value.000 + 46. Debit 31 August 20X1 Accounts receivable Sales To record the sale of 2.000 tons of zinc is calculated as follows: Financial statement item Sales Cost of sales Gross margin Amount 2.000 1. the carrying value does not exceed the net realisable value. the gross margin for the sale of the hedged 2.000 (1.000) Credit 2.000 1. Big Metal enters into a non-deliverable forward with a metals broker for 2.100 per ton with a maturity of 31 August 20X1.IFRS Financial Instruments Accounting March 2004 Reference On 31 August 20X1.800. instead of designating a fair value hedge for the inventory.000 tons of zinc at 1.000 tons of zinc to a steel producer at a price of 1.150 per ton for a total value of 2.000 tons of zinc expected to occur in August 20X1. Each member firm is a separate and independent legal entity and each describes itself as such.000 The adjusted inventory value should be tested for the lower of cost or net realisable value under IAS 2. In this example. On 1 July 20X1. Assume the same fact pattern as above regarding Big Metal.891. Big Metal sells 2.

000.000 6. .125 1.000 52.100 1. KPMG International is a Swiss cooperative of which all KPMG firms are members.000 100. the fair value of the forward is (100. Each member firm is a separate and independent legal entity and each describes itself as such.IFRS Financial Instruments Accounting March 2004 Reference that the forward is expected to be highly effective in offsetting the cash flow changes from the expected sales.100 1. The forward has also matured at that time and is settled through net cash payment to the broker of 100.000) (100.000).000 3.000 since the date of hedge inception.000 tons of zinc inventory have increased by 45.150 – (48. All rights reserved. the fair value of the forward is (48.000) Date 1 July 31 July 31 August On 31 July 20X1.000 Credit Management determines that the hedge relationship remains effective. The accounting entries on these dates are as follows: Debit 1 July 20X1 No entries are made related to the forward as the cost is zero 31 July 20X1 Hedge reserve (equity) Hedge ineffectiveness (income statement) Forward liability To record the revaluation of the forward for the period from 1 to 31 July 20X1 including the ineffective portion of the forward 45. The accounting entries are as follows: Debit 31 August 20X1 Hedge reserve (equity) Hedge ineffectiveness (income statement) Forward liability To record the revaluation of the forward for the period from 31 July 20X1 to 31 August 20X1 including the ineffective portion of the forward Forward liability Cash To record the settlement of the forward Credit 46. The zinc spot and forward prices are as follows: Fair value of the Spot rates Non-deliverable non-deliverable per ton forward price forward 1. On 31 August 20X1.050 1. The expected cash flows from forecasted sales of zinc change by a further 46.000 48.000 100.000 180 9.000).000.5 Hedging commodity price risk © 2004 KPMG International.150 1. KPMG International provides no services to clients. Assume that the expected cash flows from the highly probable sale of 2.

000 tons of zinc at 1.IFRS Financial Instruments Accounting March 2004 Reference On 31 August 20X1. the value of the securities has increased from 120 million to 130 million. the fair value of the securities is 120 million. Case 9.000 91.2 Other market price risks Entities that hold equity securities as investments are exposed to market price risk.300.300.800. Big Metal sells 2. KPMG International is a Swiss cooperative of which all KPMG firms are members. The actual mechanics of hedge accounting of equity price risk are similar to those demonstrated above for commodity price risk. 181 .5 Hedging commodity price risk © 2004 KPMG International.000) (1.300.000 tons of zinc to a steel producer at a price of 1.000 1.000 The gross margin on the sale of the zinc is calculated as follows: Financial statement item Sales Hedge adjustment Cost of sales Gross margin Amount 2. Debit 31 August 20X1 Accounts receivable Cost of sales Sales Inventory To record the sale of 2. with a total cost basis 115 million. KPMG International provides no services to clients.000 2.000 (91.300.5.000 1.000 91. The securities are remeasured at fair value with the cumulative change of 15 million recognised as a component of equity.16 Fair value hedge of equity securities The following is an example of hedging with a purchased put option to hedge price risk on equity securities classified as available-for-sale.800.150 per ton Sales Hedge reserve (equity) To recognise the hedge reserve in the income statement due to the recognition of the hedged cash flows Credit 2.000 9. The revaluation gain of five million is recognised as a component of equity. At 1 January 20X1. The securities are classified as available-for-sale with changes in fair value recognised in equity.800. 9. Hedge accounting for the price risk of securities is relevant only for securities held as available-for-sale with changes in fair value recognised in equity.000.150 per ton for a total value of 2. All rights reserved.000) 409. At 30 June 20X1. Each member firm is a separate and independent legal entity and each describes itself as such. Entity X owns equity shares of an entity listed on a domestic stock exchange.

and to record the decrease in the value of the option.000 12.000 Time value – 12. 182 9. the option is out-of-the-money (i. Management has documented and assessed the purchased put option as an effective hedge in offsetting decreases in the fair value of the equity securities below 130 million.000.000.000 9. The fair value of the securities and the put option during the period are as follows: Date 1 January 20X1 30 June 20X1 30 September 20X1 31 December 20X1 Value of the securities 120.000.000.5 Hedging commodity price risk © 2004 KPMG International. All rights reserved.000.000. the option has no intrinsic value).000 At 30 September 20X1.000.000 5. due to volatility in the price risk of the securities and to comply with internal risk management policies.000.000. KPMG International is a Swiss cooperative of which all KPMG firms are members. The following entries are made to record the change in fair value of the availablefor-sale securities.000 126.000.000 136. .IFRS Financial Instruments Accounting March 2004 Reference At 30 June 20X1.000. Therefore.000 10.000 The following journal entries are made to record the remeasurement of the securities and the payment of the option premium: Debit 30 June 20X1 Available-for-sale securities AFS revaluation reserve (equity) To remeasure the available-for-sale securities to fair value of 130 million Hedging derivatives (assets) Cash To record the option at its fair value Credit 10. Each member firm is a separate and independent legal entity and each describes itself as such. as the risk being hedged was designated as being declines in fair value of the securities below 130 million. The time value component will not be included in determining the effectiveness of the hedge.000.e.000 12. The option premium paid is 12 million. management decides to purchase a European put option on the securities with a strike price equal to the current market price of 130 million and a maturity date of 30 June 20X2. The value of the option decreases to seven million all due to the decrease in its time value.000 7.000.000. the fair value of the securities increases to 136 million. KPMG International provides no services to clients.000 130. There are no hedge accounting entries to be made for this period.000.000 Intrinsic value – – – 4.000 Total option value – 12.000 7.

000.000 5. these entries have been separated into two parts to demonstrate the accounting for the changes in value of the securities that are not being hedged (i.000. four million represents intrinsic value and five million represents time value). the effective part of the hedge Credit 6. KPMG International is a Swiss cooperative of which all KPMG firms are members. Each member firm is a separate and independent legal entity and each describes itself as such.e. Likewise the changes in value of the option are separated to demonstrate changes in the time value.IFRS Financial Instruments Accounting March 2004 Reference Debit 30 September 20X1 Available-for-sale securities AFS revaluation reserve (equity) To record the remeasurement gain on the available-for-sale securities Hedging costs (income statement) Hedging derivatives (assets) To record the remeasurement loss on the option due to change in time value (which is not part of the hedge relationship) Credit 6.000.000 4. 183 . KPMG International provides no services to clients. the following entries are made to recognise the change in the fair value of the available-for-sale securities and the changes in the fair value of the option.000 2.5 Hedging commodity price risk © 2004 KPMG International.000.000. the value of the hedged securities decreases to 126 million. and changes in the option’s intrinsic value. All rights reserved.000 The option is still expected to be effective as a hedge of decreases in the fair value of the available-for-sale securities below the strike price of the option. For illustrative purposes.000 6. which is excluded from the hedge relationship Hedging derivatives (assets) Hedge results (income statement) To record the change in the intrinsic value of the option – i.000 4. decrease below 130 million). At 31 December 20X1.000 5.000.000.e. As such. Debit 31 December 20X1 AFS revaluation reserve (equity) Available-for-sale securities To record the unhedged decrease in fair value of the available-for-sale securities (from 136 million to 130 million) Hedge results (income statement) Available-for-sale securities To record the hedged decrease in fair value of the available-for-sale securities (from 130 million to 126 million) Hedging costs (income statement) Hedging derivatives (assets) To record the changes in time value of the option.000 4.000.000. decrease down to 130 million) and the changes in value that are being hedged (i.000 6.000 9.e.000 2.000 4. The value of the put option increases to nine million (of that amount.000. which have been excluded from the hedge relationship.000.000.

This will eventually replace IAS 30. not just to financial institutions. with separate presentation of cash and cash equivalents. Each member firm is a separate and independent legal entity and each describes itself as such. however the requirements of that standard remain in effect until a new standard is issued. KPMG International is a Swiss cooperative of which all KPMG firms are members. Given the present status of IAS 30.68 IAS 1 requires that financial assets be presented on the face of the balance sheet. use of derivatives and risk management strategies. trade and other receivables 184 10. . There is a current IASB project that addresses disclosures about financial activities and financial instruments. KPMG International provides no services to clients.IFRS Financial Instruments Accounting March 2004 10.1. Since the time IAS 30 was issued. Although some disclosures of IAS 32 were eliminated upon implementation of IAS 39. Presentation and disclosure Key topics covered in this Section: ■ ■ ■ ■ Balance sheet presentation Liability versus equity Income statement presentation Required disclosures Abbreviations used in this Section: MC = measurement currency. The objective of the disclosures is to enhance financial statement users’ understanding of the significance of on and off balance sheet financial instruments to an entity’s overall financial position and performance.1 Presentation and disclosures for financial institutions Banks and similar financial institutions have to comply with IAS 30 in addition to IAS 32 and IAS 39. FC = foreign currency Reference 10. this Section does not cover in detail the requirements of IAS 30. the latter contains significant additional disclosure requirements relating to hedge accounting.2 10. there have been significant developments in the financial services environment and IAS 32 and IAS 39 subsequently came into effect. 1.1 Overview © 2004 KPMG International.1 Balance sheet presentation Presentation of classes of financial instruments IAS 32 and IAS 39 do not address the balance sheet presentation of financial instruments. All rights reserved.1 Overview IAS 32 and IAS 39 set out the required disclosures and presentation of financial instruments. The revisions are expected to be extensive and the new standard is expected to apply to all entities that have financial instruments. As a result IAS 30 is not up-to-date and IAS 32 and IAS 39 have made some of its requirements redundant. 10. 10.2.

IFRS Financial Instruments Accounting March 2004 Reference and investments accounted for under the equity method.2.51 1. even if there are master netting agreements in place.42 there is a legally enforceable right to set off the recognised amounts. The offset conditions are not met for derivative instruments simply because they are issued by the same counterparty. Each member firm is a separate and independent legal entity and each describes itself as such.2. 10. with additional details disclosed in the notes to the financial statements. instruments within the four financial asset categories of trading. respectively. 1.59 32. Therefore.2 Remeasurement gains and losses as a component of equity Fair value adjustments on available-for-sale securities that are reported in equity and remeasurement gains and losses on cash flow hedging instruments and net investment hedges are each included as separate components of equity.52 If an entity makes a distinction between current and non-current assets and liabilities on the face of the balance sheet. it is not required to present such balances as separate components of equity on the face of the balance sheet itself. with trading assets and liabilities classified as current. Additional lines items may be used.3 Netting Financial assets and liabilities should be offset and the net amount reported in the balance sheet only if both of the following conditions are met: ■ ■ 32. and there is the intention to settle on a net basis or to realise the asset and settle the liability simultaneously. either on the face of the balance sheet or in the notes to the financial statements. No guidance has been included in the amended standards on how to present these instruments. originated loans and receivables. KPMG International provides no services to clients. If derivative instruments are not significant these instruments may be included (gross) within other financial assets and other financial liabilities. However. Derivative assets and liabilities should be presented separately if they are significant. 10.2 Balance sheet presentation © 2004 KPMG International. Non-current interest-bearing liabilities should also be presented on the balance sheet. We consider that they should be shown as a separate category. held-to-maturity. It would not be appropriate to offset assets and liabilities that the entity has with unrelated counterparties.94 32. an entity should disclose the balance of the financial assets in each of these four financial asset categories. Further. Neither of the conditions noted above is likely to be met in these circumstances. KPMG International is a Swiss cooperative of which all KPMG firms are members. All rights reserved. and available-for-sale should be classified as current or non-current. December 2003 amendments The ability to designate any financial asset or financial liability at fair value through profit or loss means that not all financial instruments in this category will be current. 185 . These requirements may apply to instruments such as receivables and payables with the same counterparty if a legal right of offset is agreed between the parties. derivatives with positive and negative fair values are generally reported gross 10.

If an instrument is classified as equity. Therefore. . KPMG International is a Swiss cooperative of which all KPMG firms are members. Master netting agreements are discussed later in Section 10. This differs from accounting practice in many countries and can have a significant impact on the financial statements.2. 10. There could be situations where instruments that qualify as equity for legal or regulatory purposes (such as certain preferred shares) are recognised as liabilities for financial reporting purposes. convertible instruments and perpetual instruments.18 Liability versus equity Classifying instruments as either liabilities or equity in the financial statements of the issuer often presents difficulties. All rights reserved. 32.4. or both). subordinated instruments. the substance of the instrument rather than its legal form takes precedence. the financial ability of the issuer or the probability of settlement being required. If an instrument is classified as a liability under IFRS.1 provides guidance on classifying an instrument as equity or as a liability. options. In determining the classification. Figure 10. its coupon payments and any amortisation of discounts or premiums are recognised as finance costs in the income statement.5. KPMG International provides no services to clients.3 32. Instruments commonly affected by this requirement include preference shares. other classes of shares that have special terms and conditions. Hedging instruments and the related items being hedged generally do not meet the conditions for offset. Each member firm is a separate and independent legal entity and each describes itself as such. An obligation may arise from a liability to repay principal or to pay interest or dividends. 186 10. Only when an instrument does not give rise to a contractual obligation on the part of the issuer is it equity. Equity instruments include shares. the fair values of hedging derivative instruments should be shown as separate assets or liabilities in the balance sheet and not presented in the same balance sheet line item as the hedged item. the dividends declared and paid are accounted for in equity and do not flow through the income statement.IFRS Financial Instruments Accounting March 2004 Reference as assets and liabilities.17 and 19(a) The primary factor in distinguishing a financial liability and an equity instrument is whether there exists a contractual obligation for the issuer to make payments (either principal. The balance sheet classification determines the treatment of distributions as interest or as dividends. Any instrument that an issuer may be obliged to settle in cash or another financial instrument is a liability regardless of the manner in which it otherwise could be settled. respectively. 32.15 The equity or liability classification is made at initial recognition and is not revised as a result of subsequent changes in circumstances.3 Liability versus equity © 2004 KPMG International. warrants and any other instruments that evidence a residual interest in an entity and that do not incorporate contractual obligations for the issuer to deliver cash or another financial asset or to exchange financial instruments under potentially unfavourable conditions. interest or dividends.

IFRS Financial Instruments Accounting March 2004

Reference

Figure 10.1 Decision tree for classification as a liability or equity

10.3.1

Discretionary payments Dividends or other payments are discretionary only when the entity has no obligation to declare and pay the dividends or similar payments. For example, dividends paid on ordinary shares vary depending on the level of profitability. However, there is no requirement by an entity’s board to declare a dividend on ordinary shares. Although there may be a shareholder expectation that dividends will be declared and paid if a certain level of profitability is achieved, this does not give rise to a contractual obligation. On the other hand, dividends that are obliged to be paid at an agreed rate (e.g. annual six per cent mandatorily payable dividend) give rise to a contractual obligation. The fact that the issuer may be unable to pay the dividends does not take away the obligation. Examples of the application of the principles of IAS 32 to some common types of instruments are illustrated listed in Table 10.1.

10.3 Liability versus equity © 2004 KPMG International. KPMG International is a Swiss cooperative of which all KPMG firms are members. KPMG International provides no services to clients. Each member firm is a separate and independent legal entity and each describes itself as such. All rights reserved.

187

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Table 10.1 Classification of issued instruments Liability Perpetual debt instruments Redeemable preference shares Non-redeemable preference shares with mandatory dividends Puttable instruments Bond or share with a contingent settlement provision that may require the issuer to settle in cash or other financial assets Subordinated liabilities Contractual obligations that will be settled in cash or by issuing a variable number of shares Equity Non-redeemable preference shares with discretionary dividends Ordinary share capital Compound instrument Convertible bonds Convertible preference shares An instrument that does not establish an explicit contractual obligation to repay may establish it indirectly through its terms and conditions. The idea of economic compulsion is that by the terms and conditions set out in the instrument, the issuer and the holder have tacitly agreed that the instrument will be repaid. For example, Entity A issues an instrument that may be settled for (a) cash of 100 or (b) delivery of 50 of Entity A’s own shares (which have a current price of 10 per share). At inception of the instrument there is a high expectation that Entity A is economically compelled to settle for cash. In this case, the instrument is classified as a financial liability. December 2003 amendments
32.17-20

The amended standards place more emphasis than the existing standards on the notion of discretion to avoid payment. If an entity does not have an unconditional right to avoid a contractual obligation, that obligation meets the definition of a financial liability under the amendments. This extends to instruments that contain a contractual obligation to deliver cash (or another financial asset) depending on the outcome of an event which is beyond the control of the issuer. Such an event would include the issuer’s revenue, profit or reserves reaching, or failing to reach, a certain level. If the issuer does not have an unconditional right to avoid payment, the instrument is classified as a liability. The only exceptions are circumstances when the cash settlement clause is not ‘genuine’ or when cash settlement is required only in the event of the issuer’s liquidation.

32.25

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Reference

10.3.2
32.28

Compound instruments A financial instrument may include both liability and equity components. In such cases, the instrument should be classified into its component parts. These must be presented separately in the balance sheet. As noted previously, the classification of the equity and the liability components of an instrument is based on the substance rather than the form of the components. The allocation of the instrument into its component parts should be performed on initial recognition of the compound instrument such that no gain or loss is recognised. The recommended approach to perform the allocation is as follows:

32.31

Determine the amount to allocate to the liability element. This is the future interest and principal cash flows on the liability component, discounted at a rate applicable to a similar liability without an equity component. The value of any embedded derivatives, other than the equity feature, are included in the amount allocated to the liability. Allocate the remaining amount of the issue proceeds to the equity element. December 2003 amendments

32.31

The amendments require that, because equity is a residual amount, the approach to allocating the instrument into its component parts should be first to measure the liability, including any non-equity derivatives such as issuer call options or prepayment options, and then to allocate the remaining proceeds to the equity component. The amended standards clarify that no gain or loss arises on initial recognition of a compound instrument, nor on conversion at maturity. When an instrument is settled before maturity, the proceeds are allocated between the liability and equity components, using a methodology consistent with that required on initial recognition to determine the liability component.

32.27

Some convertible bonds may contain an option allowing the issuer, if the conversion option is exercised, to settle the instrument in cash. Even though such a clause would not appear to create an obligation for the issuer, the standards are clear that any settlement possibility other than delivery of a fixed number of shares for a fixed amount of cash will result in the conversion feature (an equity call option) being classified as a derivative liability. The only solution would appear to be for an issuer to notify all its bond-holders that it has waived its right to cash settle and therefore to render the cash settlement alternative invalid. 10.3.2.1 Convertible bonds

32.29

A common example of a compound instrument is convertible debt issued by an entity. The instrument consists of a financial liability plus an option issued to the holder to convert the instrument into equity shares of the issuer. The economic effect of this instrument (insubstance) is the same as simultaneously issuing a debt instrument with an early settlement provision and issuing warrants to purchase shares of the issuer. Convertible bonds typically are issued with a low interest coupon because investors view the ability to convert the instrument to the issuer’s shares as an opportunity to participate in the potential upside from an increase in share price. By separating the
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IFRS Financial Instruments Accounting March 2004

Reference

convertible bond into its equity component (i.e. the conversion feature) and liability component, this creates an additional discount on the liability that is amortised and recognised in the income statement as interest expense until the date of redemption (or conversion if that occurs earlier). Case 10.1 Income statement impact of a convertible bond Co X issues a bond convertible into the entity’s own shares in five years. The convertible bond has a face amount of 100 and bears a stated coupon rate of three per cent, which is below the current market rate for non-convertible debt instruments of similar entities. Co X must determine the liability and equity components of the instrument. The liability component is determined to be 85. The equity component is assigned the remaining amount of 15. In addition to the three per cent interest expense recognised, Co X must also amortise the discount of 15 over the term of the bond. This amortisation also is included in interest expense. The coupon interest plus the amortisation amount should result in Co X recognising interest expense on the liability at or around the market rate of interest for bonds with similar terms, but without the conversion feature, when the bond was issued. 10.3.3
32.AG6

Perpetual instruments Perpetual debt instruments normally provide the holder with a contractual right to receive interest payments extending into the indefinite future, with no right to a return of principal. Even though the holder may not receive a return of principal, such instruments are a liability of the issuer as there is a contractual obligation to make a stream of future interest payments to the holder. The face value or the carrying amount of the instrument reflects the present value of the holder’s right to receive a stream of interest in perpetuity.

10.3.4
32.19, AG25 and AG26

Preference shares Preference shares provide the holder with certain rights. Preference shares could have rights or characteristics that meet the definition of a liability rather than equity; therefore, these must be considered when determining the appropriate classification. Preference shares that provide for redemption at the option of the holder give rise to a contractual obligation and should be classified as a liability. Where preference shares are not redeemable at the option of the holder the appropriate classification depends on the other terms of the preference shares, in particular the dividend rights attaching to the shares. If the dividends are not discretionary, then the obligation to pay dividends gives rise to a contractual obligation. Preference dividends that are payable at a specified rate require special attention, and in many cases are not discretionary. A typical example is a cumulative perpetual preference share where the issuer: (a) must pay a dividend on the preference shares if it pays a dividend on its ordinary shares; and (b) if it does not pay a dividend on its ordinary shares, the preference dividend may be deferred (i.e. it is cumulative). This so-called dividend stopper feature does not by itself create an obligation. However, the deferral feature will allow the instrument to be classified as equity only if: (a) the accumulated dividends can be deferred indefinitely, even until the entity is liquidated; and (b) there is no other feature of the instrument that would indicate

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the shares have a value of 0. but rather as a derivative instrument.3. For example. or the transaction must be settled in cash.5.2 Share warrants or options An option or warrant on an entity’s own equity is not accounted for as an obligation when issued if there is no requirement for repayment in cash or other financial assets and the contract will be settled by the entity issuing a fixed number of its own shares. Entity A enters into a forward contract with a bank that it intends to settle in its own shares in six months.5 Instruments to be settled in own equity 10.8 per share by the settlement date. but that the entity can choose to settle in its own shares. The holder of the instrument in this situation is not exposed to the market risk of the equity securities. the instrument is a liability. Each member firm is a separate and independent legal entity and each describes itself as such. if the deferred accumulated dividends accrue interest to compensate the holder for the deferral period. In such cases the entity does not have a contractual obligation to settle in a financial asset or to exchange financial instruments under conditions that are potentially unfavourable. If an entity issues a warrant or option on its own shares and the holder has a right to request cash settlement.3. it is obligated to settle by delivering 125 shares to the holder (rather than the 100 shares owed at the time the obligation was entered). If the entity settles in shares. 10. KPMG International provides no services to clients.11 and 21 If an entity has an obligation that it can settle either by payment of financial assets or by payment in the form of its own equity shares. This would not be accounted for as an equity instrument. Therefore. Similarly. then the substance of the instrument still is a liability. such an obligation should be accounted for as a liability of the issuer. the entity has an obligation to deliver cash or exchange financial instruments (i. there may be an issue as to whether the obligation is a liability or equity. as the value of the instrument is unrelated to the changes in fair value of the entity’s own shares.1 Obligation to settle in cash or a variable number of own equity shares 32. As a result. Entity A will deliver fewer of its own shares to the bank. KPMG International is a Swiss cooperative of which all KPMG firms are members. 10.3.0 per share. If the number of equity shares required to settle the obligation varies with changes in fair value such that the total fair value of the equity shares transferred always equals the amount of the contractual obligation. For example. Due to changes in value of the entity over the six-month holding period.IFRS Financial Instruments Accounting March 2004 Reference its substance is a liability.3 Liability versus equity © 2004 KPMG International. or can be compelled by the holder to settle in cash. then the holder of the obligation is not exposed to a gain or loss from the price of the equity shares. or other derivative instrument whose value changes in response to something other than the market price of the entity’s own equity securities. As a result the instrument is classified as a derivative. 191 . In this case. option. If Entity B’s share price is lower at the end of six months. the number of Entity A shares to be delivered always equals the value of the derivative based on Entity B’s share price. All rights reserved. At issuance the entity’s shares have a value of 1. The number of shares to be delivered at that time is based on the change in share price of Entity B during the same period. receive shares and deliver cash in this case) under conditions 10.e. The entity is either required to settle in cash. For example. an entity may hold a forward.5. an entity issues an obligation for 100 to be paid in cash or own equity shares to the holder in six months. The instrument would be classified as a liability in this case.

to 100 ounces of gold. Examples are: (a) a contract to deliver as many of an entity’s own equity instruments as are equal in value. Some instruments. 10. will result in the instrument being classified as a financial asset or financial liability. and an instrument that is redeemable if an anticipated initial public offering does not occur. However. In our view. the instrument should be classified as a liability (as a default treatment) unless the probability of settlement in cash or another financial asset is remote. the instrument is a liability. such as a forward purchase of own shares or a written put option on own shares. KPMG International is a Swiss cooperative of which all KPMG firms are members. KPMG International provides no services to clients. depending on the outcome of uncertain events 32.25 If an instrument will be settled by an entity issuing its own shares or in cash depending on the outcome of uncertain future events that are beyond the control of the holder or the issuer. despite its classification as a derivative liability. December 2003 amendments The amended standards clarify certain existing guidance and at the same time bring tighter requirements that must be met before an instrument can be classified as equity. whose underlying is the entity’s own equity are classified as equity only if they will and can only be settled by the entity exchanging a fixed number of its own equity instruments for a fixed amount of cash. For example. at the date of settlement. It is accounted for as a derivative liability. often as a derivative instrument. Any instrument that creates a potential obligation for an entity to settle in cash (or other financial assets) is required to be treated as a financial liability measured at the present value of the gross obligation. It is only in cases where settlement in cash or another financial asset is extremely unlikely that such an instrument is not treated as a liability. to 100.5. even though the derivative itself may be an equity instrument (if it is fixed cash for fixed shares 192 10. The entity’s equity instruments are then used only as a currency in which the transaction is settled. Derivative instruments. Each member firm is a separate and independent legal entity and each describes itself as such.3. Any other settlement possibility. an instrument that is redeemable if the share price reaches a certain level. therefore. such as share options. at the date of settlement.AG27 The amended standards confirm that an instrument that is settled for a fixed or determinable value. even at the discretion of the entity itself. All rights reserved.IFRS Financial Instruments Accounting March 2004 Reference that are potentially unfavourable. at the present value of the gross future cash flow).e.3 Obligation to settle in cash or shares. or (b) a contract to deliver as many of an entity’s own equity instruments as are equal in value. . may or will require the entity to deliver cash (or another financial asset) to repurchase its own shares.3 Liability versus equity © 2004 KPMG International. in each of the following situations it would not be reasonable to conclude that the possibility of cash settlement is remote. but in the form of a variable number of the entity’s own shares is a liability. this will be measured as if it were a financial liability (i. the instrument should be classified as a liability: ■ ■ ■ an instrument that is convertible or redeemable at the option of the holder. 32. Therefore.

any instrument that creates a potential obligation for an entity to settle in cash (or other financial assets) is classified as a liability. Although the legal form of such financial instruments often includes the right to a residual interest in the assets of an entity. the inclusion of an option for the holder to put the instrument back for cash or another financial asset means that the instrument meets the definition of a financial liability. even if the obligation is contingent on uncertain future events. under the amended standards. Therefore. The amended standards require that such instruments are presented as liabilities. with a corresponding debit to equity. including those relating to equity compensation plans. then the carrying amount of the liability at that time is reclassified to equity. unless the cash settlement provision is not genuine.18 The amended standards also deal specifically with puttable instruments. 193 . the amended standards confirm a requirement previously in SIC–16 Share Capital – Reacquired Own Equity Instruments (Treasury Shares) that treasury shares held by an entity are treated as equity instruments. Typically these are instruments issued by investment funds. They are measured at the amount that would be payable if the instrument was redeemed at the balance sheet date. but do not preclude such items. Finally. for example. The approach to be taken in determining whether a transaction in an entity’s own equity gives rise to a liability. if a put option is not exercised.3 Liability versus equity © 2004 KPMG International. an entity is required to recognise a liability for the present value of the redemption amount. KPMG International provides no services to clients. All rights reserved. The requirements have been extended to apply to all treasury shares. SIC–5 Classification of Financial Instruments – Contingent Settlement Provisions has been withdrawn. If the contract expires without the obligation being settled. 32. The classification as a financial liability is independent of considerations such as when the right is exercisable. derivative or transaction in equity is as follows: 32.33 32.IFRS Financial Instruments Accounting March 2004 Reference only). Each member firm is a separate and independent legal entity and each describes itself as such. a reclassification is made from equity to reflect the obligation to repurchase the shares in the future. In effect. from being included within a ‘total members’ interests’ sub-total. and that no gain or loss arises on the acquisition or disposal of treasury shares. on the balance sheet. how the amount payable on exercise is determined and whether the instrument has a fixed maturity.26 and 27 10. cooperatives and similar entities. that are redeemable by the holder at net asset value. KPMG International is a Swiss cooperative of which all KPMG firms are members.

and (c) the portion excluded from the assessment of effectiveness.4 Income statement presentation There is currently no specific guidance on the income statement presentation of gains or losses on financial instruments.4 Income statement presentation © 2004 KPMG International. cost of sales or other line items related the hedged item. 10. As the financial instruments standards are silent as to the presentation of these items in the income statement. even if the derivative instrument is intended to be an economic hedge of these items. In the meantime we recommend that gains and losses on financial instruments be reported in the most appropriate line item according to their nature. there are several alternatives to consider when recording such gains and losses. For example. KPMG International is a Swiss cooperative of which all KPMG firms are members.94(h) Presentation of gains and losses on trading activities Gains and losses arising from disposals of trading instruments and changes in the carrying amount of trading instruments. The same possibilities exist for a cash flow hedge (although the timing of recognition of the effective portion of the hedging instrument would be different): ■ present the entire change in fair value of the derivative hedging instrument in the same line item as gains and losses from the hedged item. Present the ineffective portion and the excluded portion in the same line item as gains or losses on non-hedging derivative instruments. . present the effective and ineffective portions of the derivative hedging instrument in the same line item as gains and losses from the hedged item. We expect this issue to be addressed during the IASB’s project on performance reporting. or present only the effective portion of the derivative hedging instrument in the same line item as the hedged item.IFRS Financial Instruments Accounting March 2004 Reference 10. which are: (a) the effective portion.2 1. (b) the ineffective portion.4. 10. All rights reserved. Each member firm is a separate and independent legal entity and each describes itself as such. ■ ■ If hedge accounting is not applied to a derivative instrument. including foreign currency gains and losses and investment income from trading instruments are normally reported on a net basis.4. Present the portion excluded from the assessment of hedge effectiveness in the same line item as gains or losses on non-hedging derivative instruments. it is common practice for foreign currency gains and losses that arise from operating activities to be presented as part of operating income or expenditure and exchange gains and losses related to financing activities to be presented as part of financial income or expenditure. it is preferable that the gains or losses on the derivative instrument are not presented as an adjustment to revenues. KPMG International provides no services to clients. this is the preferred alternative.35 and 32.1 Presentation of gains and losses on hedging activities Gains and losses on derivative hedging instruments have three possible elements. The following alternatives relate to a fair value hedge. 194 10. However. there are no specific requirements in IFRS addressing the presentation of derivatives. In our view. A split of realised and unrealised gains and losses on instruments held for trading is not required.

example disclosures on financial instruments are not given in this publication. a reconciliation of the movements in each of these components of equity should be shown in the notes to the financial statements. entities are required to provide a discussion of financial risk management objectives and policies.5 Required disclosures ■ 195 © 2004 KPMG International. KPMG International is a Swiss cooperative of which all KPMG firms are members. 10. 10. Full details of disclosure requirements are documented in the standards and in KPMG’s IFRS Disclosure Checklist. The discussion below focuses on the most common disclosures. All rights reserved.94 The amendments clarify that there is no requirement separately to disclose interest income or expense arising from other fair value changes on instruments carried at fair value through profit or loss. Disclosure requirements also focus on providing fair value information for instruments not carried at fair value. cash flow hedge reserve. and foreign currency translation reserve should each be presented separately in the statement.5.53 and 55 32. the basis of measurement applied to financial assets and financial liabilities both on initial recognition and subsequently.4. it is not necessary to repeat such information in the notes to the financial statements. including hedging policies.51 32. To the extent that required information for financial instruments is presented on the face of the balance sheet or income statement.5. If instead an entity presents a statement of total recognised gains and losses. Each member firm is a separate and independent legal entity and each describes itself as such. When amounts stated in note disclosures relate to line items in the balance sheet and income statement. In addition.IFRS Financial Instruments Accounting March 2004 Reference December 2003 amendments 32.3 Presentation of changes in equity If a statement of changes in equity is presented as a primary financial statement.60 and 66 the criteria applied in determining when to recognise a financial asset or financial liability on the balance sheet and when to cease to recognise it. 10.5 10. then the amounts recognised in equity and the amounts removed from equity should be disclosed as components of the total recognised gains and losses.56 and 57 32. These accounting policy notes should address the following: ■ 32. performance and cash flows. with the exception of example hedging disclosures. KPMG’s IFRS Illustrative Financial Statements series contains example IFRS disclosures.2 Accounting policy notes Significant accounting policies must be disclosed for each class of financial instrument.1 Required disclosures General The disclosure requirements are focused on providing information that enhances a user’s understanding of the impact of financial instruments on the entity’s financial position. KPMG International provides no services to clients. sufficient information should be provided to permit a reconciliation to these relevant line items. As such. 10. .90 and 93 32. In addition to specific disclosures regarding particular instruments. the available-for-sale revaluation reserve.

For example.e. 32. create a potentially significant exposure to risks. the fair values i. the amount on which future payments are based. .62 32.5 Required disclosures © 2004 KPMG International. Examples of the type of information that should be disclosed for derivative instruments include: ■ ■ the principal / notional amount i. All rights reserved. the amounts included in the balance sheet in assets or liabilities. the foreign currency in which instruments are denominated should be disclosed as well as maturities of instruments. KPMG International provides no services to clients. Disclosures may include a combination of narrative descriptions and specific quantified data.61 ■ ■ 10. 32. Determining the level of detail to be disclosed in each circumstance is an issue of judgement taking into account the significance of each type of financial instrument. timing and certainty of future cash flows. the general disclosure requirements of the standard are sufficiently broad to encompass all financial risks. KPMG International is a Swiss cooperative of which all KPMG firms are members. 32. Each member firm is a separate and independent legal entity and each describes itself as such. and whether gains and losses arising from changes in the fair value of available-forsale financial assets are recognised in the income statement or as a separate component of equity.3 32. That standard does not prescribe either the format in which the information must be disclosed or its location in the financial statements. including significant terms and conditions that may affect the amount. When derivative financial instruments. Although the specific requirements of IAS 32 only refer directly to interest rate risk and credit risk disclosures. the disclosures should be given for appropriate groupings of like instruments.60 196 10.56 and 57 Disclosures of risk management policies The risk management disclosure requirements in IAS 32 are expressed in general terms.4 32. whether regular way transactions are accounted for at trade date or settlement date for each category of financial asset. whether they are carried at fair value or cost and their classification according to IAS 39. If no single instrument is individually significant. including foreign currency risk and liquidity risk.5. 32.55 Financial instruments are grouped into classes based on such information as the characteristics of the instruments. and maturities based on the remaining period at the balance sheet date to the contractual maturity date. specific information to illustrate the terms and conditions should be disclosed.5. IAS 39 requires specific disclosures about hedge accounting activities and specific quantitative information.IFRS Financial Instruments Accounting March 2004 Reference ■ the basis on which income and expense arising from financial assets and financial liabilities is recognised and measured.e. In addition. financial liability and equity instrument an entity should disclose information about the extent and nature of the instruments.60 Terms and conditions of financial instruments For each class of financial asset. either individually or as a class.60 ■ 10. respectively. as appropriate to the nature of the financial instruments.

10. e. The disclosures should include an indication of which financial assets and financial liabilities are: ■ ■ 32. management generally provides additional commentary on the risk management activities in a financial review. Financial instruments that do not have a contractual maturity date are usually allocated to maturity groupings based on the expected maturity date or repricing date. whichever dates are earlier. In addition.5 Required disclosures © 2004 KPMG International. 197 . ■ 32. 32. All rights reserved.70 To supplement information about contractual repricing and maturity dates.71 exposed to interest rate price risk – such as fixed interest rate financial assets and liabilities. and effective interest rates. an entity may elect also to disclose information about expected repricing or maturity dates when those dates differ significantly from the contractual dates. exposed to interest rate cash flow risk – such as floating rate financial assets and liabilities. The requirement does not apply to financial instruments such as non-monetary instruments and derivatives that do not bear a determinable effective interest rate. Appropriate maturity groupings should be determined based on the characteristics of outstanding contracts. operational risks) if these risks are significant. including: ■ ■ contractual repricing or contractual maturity dates.5. KPMG International provides no services to clients. structure and financing that considers the financial risk profile of the entity as a whole.72 Effective interest rates only need to be disclosed for interest-bearing instruments or those where interest can be imputed.1 Interest rate risk 32. the requirement applies to debentures. The risk management disclosures usually will be preceded by a general discussion of the entity’s activities. Information normally would be provided about the existence and roles of risk management committees and the process used by the entity to manage risk. when applicable. The effective interest rates to be disclosed for floating rate instruments are the rates at the balance sheet date. such as zero-coupon bonds.g. KPMG International is a Swiss cooperative of which all KPMG firms are members. Entities may also wish to disclose details of management of non-financial risk (e.g.IFRS Financial Instruments Accounting March 2004 Reference Therefore. 10. Each member firm is a separate and independent legal entity and each describes itself as such. and not exposed to interest rate risk – such as certain equity investments. notes and similar monetary financial instruments involving future payments that create a return to the holder and a cost to the issuer that reflects the time value of money.67 For each class of financial asset and financial liability an entity should disclose information about its exposure to interest rate risk.5 per cent. three-month LIBOR plus 0.4. appropriate disclosures regarding all financial risks should be provided. These are normally expressed in terms of the underlying index and the margin. Therefore.

Concentrations of credit risk may arise from exposure to a single debtor or groups of debtors having a similar characteristic. KPMG International is a Swiss cooperative of which all KPMG firms are members.5 32. including its approach towards managing financial risks.5. 32. the entity should disclose its risk management policies. additional disclosure should be provided. KPMG International provides no services to clients.5. A description of the shared characteristic that distinguishes each concentration and the maximum credit risk exposure associated with all recognised and unrecognised financial instruments sharing that characteristic should be disclosed.2 Credit risk 32. including: ■ the amount that best represents its maximum credit risk exposure at the balance sheet date. An entity would satisfy the broader disclosure requirements by describing its overall financial risk management objectives. both recognised and unrecognised. This disclosure should indicate: ■ 32. Disclosures should explain what are the financial risks. 58 and 59 Hedging The disclosures relating to hedging and hedge accounting activities can be viewed as a top-down approach to disclosure through the combination of the risk and the more specific transactional disclosures in IAS 32. an entity should disclose information about its exposure to credit risk. and significant concentrations of credit risk.56.83 Concentrations of credit risk should be disclosed when they are not apparent from other disclosures about the nature and financial position of the business and they result in significant exposure to loss in the event of default by other parties. At the next level of detail. how the entity manages the risk and why the entity enters into various hedging instruments. and the extent to which the overall credit risk exposure is reduced through a master netting agreement may change substantially within a short period following the balance sheet date because the exposure is affected by each transaction subject to the agreement.5 Required disclosures © 2004 KPMG International.IFRS Financial Instruments Accounting March 2004 Reference 10. . without taking account of the fair value of any collateral. Entities may be involved in one or more master netting agreements that serve to mitigate exposures to credit losses but do not meet the criteria for offsetting.81 that the credit risk of the financial assets subject to the master netting arrangement is eliminated only to the extent that financial liabilities due to the same counterparty will be settled after the assets are realised. This approach can be further described as follows. ■ 10.76 For each class of financial asset. All rights reserved. in the event that other parties fail to perform their obligations under financial instruments. This would include more specifically the hedging strategies used to mitigate financial risks. ■ Such information is intended to enable users of the financial statements to assess the extent to which failures by counterparties could reduce the amount of future cash flows from financial assets on hand at the balance sheet date. When these master netting agreements significantly reduce credit risk associated with financial assets that are not offset in the financial statements with financial liabilities related to the same counterparty. 198 10.4. Each member firm is a separate and independent legal entity and each describes itself as such.

2 Example disclosure of risk management objectives and policies 32. the nature of the risks being hedged. and ■ ■ ■ 32. entities should not view the examples below to be boilerplate disclosures. and a description of any forecasted transactions that were originally hedged. and the amount removed from equity and added to the initial measurement of the balance sheet amount for a hedged forecasted transaction.IFRS Financial Instruments Accounting March 2004 Reference This may include a discussion of: ■ ■ how specific financial risks are identified. The following disclosures are made separately for fair value hedges. and details of the extent of transactions that are hedged. including members of senior management. IAS 32 does not specify the future time bands for which the disclosures should be made. 10.5 Required disclosures © 2004 KPMG International. and how these instruments modify or eliminate risk. cash flow hedges and hedges of net investments in foreign entities: ■ ■ a description of the hedge. when they are expected to affect net income. ABC has a risk management committee. The level of detail of disclosures will vary depending on an entity’s use of hedges and derivative financial instruments. but rather illustrative guidance of the above disclosure requirements. monitored and measured. KPMG International is a Swiss cooperative of which all KPMG firms are members. the following should be disclosed: – – – the amount recognised in equity during the reporting period. an entity is required to make specific disclosures about its outstanding hedge accounting relationships.12 ■ if an instrument is used to hedge one risk in a cash flow hedge and another risk under a fair value hedge. the periods in which the transactions are expected to occur. All rights reserved.56 AB Corp (ABC) uses derivative financial instruments to reduce exposure to fluctuations in interest rates and foreign exchange rates. that continually monitors the entity’s exposures to interest rate risk and foreign currency risk as well as its use of derivative instruments. a description of the financial instruments designated as hedging instruments for the hedge and their fair values. The cases below are intended to provide examples of typical disclosures of hedging activities. Management should decide on appropriate groupings based on the characteristics of the forecasted transactions. but are now no longer expected to occur. KPMG International provides no services to clients. Each member firm is a separate and independent legal entity and each describes itself as such. The entity does not enter into derivative financial instruments for any purpose other than hedging.1. ■ Lastly. 199 . Therefore. separate disclosures for the two hedges should be provided. if a gain or loss on derivative or non-derivative financial assets and liabilities designated as hedging instruments in cash flow hedges has been directly recognised in equity. what specific types of hedging instrument are entered into. for hedges of forecasted transactions.58 and IG F. Case 10. the amount removed from equity and reported in the income statement.

The entity is exposed to variability in interest payments due to changes in interest rates. However. Case 10. At 31 December 20X1. Each member firm is a separate and independent legal entity and each describes itself as such. ABC issues variable rate mediumterm notes and commercial paper depending on the entity’s financing needs. All rights reserved. ABC has several subsidiaries in foreign countries that operate using the local currencies of those countries.5 Required disclosures © 2004 KPMG International. Manufacturer B has entered into foreign currency forward contracts to hedge its exposure to foreign currency fluctuations. .000. The interest rate swaps change the variable rate cash flow exposure from the mediumterm notes so that ABC is in a pay-fixed. ABC has net investments in foreign subsidiaries in Country A and Country J for which ABC enters into foreign currency forward contracts to sell foreign currency of those countries.000). The interest rate caps limit the entity’s exposure to increases in interest rates above a certain amount on its commercial paper liabilities. Manufacturer B hedges at least 70 per cent of anticipated export 200 10. which are settled on a net basis.3 Example disclosures of types of hedges Fair value hedge 32.000. KPMG International is a Swiss cooperative of which all KPMG firms are members. Management has established the policy of limiting the entity’s exposure to variability in interest rates to 60 to 70 per cent of its anticipated interest payments in each period. It is Corporate A’s policy to limit overall exposure to interest rate risk by entering into interest rate swaps to enable it to match its funding with its variable rate interest-bearing assets.58 Corporate A has designated a fair value hedge of its fixed rate liabilities of 5. ABC is exposed to foreign currency risk arising from foreigncurrency denominated forecasted transactions and net investments in foreign operations. The risk management policy requires at least 50 per cent of sales anticipated for a period of six months in advance to be hedged. this percentage may be higher in certain countries where management perceives there is greater exposure to foreign currency fluctuations.000. Management uses certain derivative instruments with the specific intention of minimising the impact of foreign currency fluctuations on income. ABC achieves this through the use of interest rate swaps and caps. In all cases the level of anticipated sales hedged is considered highly probable of occurring based on historic sales levels and current budgets and forecasts. Cash flow hedge Manufacturer B has designated cash flow hedges of its export sales since export sales generally are denominated in the customers’ measurement currency. receive-variable position. the fair value of interest rate swaps is (47. KPMG International provides no services to clients. ABC makes fixed interest payments to the counterparty and receives variable interest payments. ABC reviews the net investment balances in the subsidiaries and adjusts the hedge on a quarterly basis to the respective values of the net investments in the subsidiaries.000 whereby it receives a fixed rate of eight per cent and pays a variable rate based on LIBOR. ABC enters into foreign currency forward contracts on its forecasted sales transactions in foreign countries. Corporate A has entered into an interest rate swap with a notional amount of 5.IFRS Financial Instruments Accounting March 2004 Reference ABC uses variable rate debt to finance its operations.

IFRS Financial Instruments Accounting March 2004

Reference

sales for a period of three months in advance. Manufacturer B considers these anticipated sales to be highly probable based on past experience and considering budgets and forecasts. At 31 December 20X1, all hedged export sales are still expected to occur. At this date, Manufacturer B has several foreign currency forwards to sell foreign currency, which are summarised as follows:
Fair value at 31 December 20X1 (in MC) (215,000) (132,000) (45,000)

Contract FC-1 FC-2 FC-3

Notional amount 4,000,000 2,000,000 1,000,000

Transaction date 15 January 20X2 15 February 20X2 15 March 20X2

Case 10.4 Example disclosure of gains or losses on hedging instruments recognised in equity
32.59

The table below shows changes in the cash flow hedging reserve (a component of equity) during the year ended 31 December 20X1.
Balance of cash flow hedging reserve at 1 January 20X1 Effective portion of gains or losses on hedging instruments used in cash flow hedges Gains or losses on hedging instruments transferred to the income statement Gains or losses transferred to adjust the initial measurement of the hedged asset Balance of cash flow hedging reserve at 31 December 20X1 X X (X) (X) X

32.58 and 59

The following table shows when the gains and losses reported directly in equity are expected to enter into the determination of net profit or loss. Where the derivatives hedge anticipated acquisitions of assets, the amounts will adjust the initial measurement of the underlying asset, and will affect net profit or loss only when the underlying asset does so. Otherwise the gains and losses will be reported in net profit or loss when the forecasted transaction occurs and is recognised in the income statement.
Gains 20X1 Adjustments reported in income when the forecasted transaction occurs: Less than three months Between three months and one year More than one year Adjustments to initial measurement of an asset: Less than one year Between one and two years Between two and five years More than five years Losses 20X1

10.5 Required disclosures © 2004 KPMG International. KPMG International is a Swiss cooperative of which all KPMG firms are members. KPMG International provides no services to clients. Each member firm is a separate and independent legal entity and each describes itself as such. All rights reserved.

201

IFRS Financial Instruments Accounting March 2004

Reference

The expected timing of recognition of those gains and losses that will adjust the initial measurement of assets and liabilities is as follows: Less than one year Between two and three years More than three years

10.5.6
32.94

Income statement disclosures Disclosure of significant items of income, expense, gains and losses resulting from financial assets and liabilities should be made. These disclosures should be made regardless of whether such items are recognised in the income statement or included as a separate component of equity, such as for certain available-for-sale assets and cash flow hedges. To comply with this requirement, details of significant fair value changes should be provided for each of the following categories of instruments, distinguishing between changes that are reported in net profit or loss and changes that are included in equity:
■ ■ ■

IG G.1

available-for-sale assets; trading assets and liabilities; and hedging instruments.

In addition, details of the components of changes in fair value may be disclosed based on managements’ classification for internal purposes. For example, an entity may choose to disclose separately the change in the fair value of derivatives that do not qualify as hedging instruments under IAS 39, but which are used by an entity as economic hedges. Total interest income and expense must be disclosed separately on an historical cost basis. Thus, if interest income from trading financial assets is included in a trading gain or loss line on the face of the income statement, then the interest income should be disclosed separately. If the interest income on such assets is accounted for as interest income on the face of the income statement, then there is no need for separate disclosure. The requirement to disclose interest income on a historical cost basis applies equally to interest-bearing available-forsale assets. Therefore, even if available-for-sale assets are remeasured to fair value through equity, interest income on these instruments must be calculated using the original effective interest rates of the instruments. This interest income should be recognised in the income statement and disclosed as part of the total interest income. December 2003 amendments
32.94

The amendments do not require separate disclosure of interest income for instruments that are measured at fair value through profit or loss. We recommend that gains and losses on trading instruments, and gains and losses on instruments classified as fair value through profit or loss are disclosed separately.

202

10.5 Required disclosures © 2004 KPMG International. KPMG International is a Swiss cooperative of which all KPMG firms are members. KPMG International provides no services to clients. Each member firm is a separate and independent legal entity and each describes itself as such. All rights reserved.

IFRS Financial Instruments Accounting March 2004

Reference

10.5.7

Fair value disclosures Methods and significant assumptions applied in estimating fair values of financial assets and liabilities must be disclosed. This should be done for each significant class of financial asset and liability. As part of this disclosure it is necessary to disclose

32.92 and 93

how fair value is determined, e.g. quoted market prices, discounted cash flows and other valuation techniques; and significant assumptions used in the calculation, e.g. prepayment rates, rates of estimated credit losses and interest or discount rates.

32.86

For each class of financial asset and financial liability an entity should disclose information about fair value. This fair value need not be separately disclosed if the financial instruments are carried at fair value. For example, a separate disclosure of the fair value of availablefor-sale securities generally would not be considered necessary as these instruments are carried at fair value. When it is not practicable within constraints of timeliness or cost to determine the fair value of a financial asset or financial liability with sufficient reliability, that fact should be disclosed together with information about the principal characteristics of the underlying financial instrument that are pertinent to its fair value. As described in Section 6 on subsequent measurement, IAS 39 presumes that a reliable fair value can be determined for almost all financial assets. The only exception to this is certain unquoted equity instruments or derivatives linked to such equity instruments for which a reliable fair value cannot be obtained. If any trading or available-for-sale financial assets are not stated at fair value because their fair value cannot be measured reliably, the entity must instead disclose:
■ ■ ■ ■ ■

32.90

32.90

the fact that these assets cannot be reliably measured; a description of the financial assets; the carrying amount; an explanation of why fair value cannot be measured reliably; and if possible, the range of estimates within which fair value is likely to lie.

32.90

If any financial assets that were not stated at fair value because their fair value could not be measured reliably are sold, disclose:
■ ■ ■

the fact that they have been sold; their carrying amount at the time of sale; and the gain or loss recognised.

If financial assets are carried in the balance sheet at an amount in excess of fair value, the entity should disclose the carrying amount of the financial assets and the reasons for not reducing the carrying amount, including the nature of the evidence that provides the basis for management’s belief that the carrying amount will be recovered. Generally this will only be the case for either originated loans and receivables and held-to-maturity assets that management has determined to be not impaired under IAS 39’s impairment principles.

10.5 Required disclosures © 2004 KPMG International. KPMG International is a Swiss cooperative of which all KPMG firms are members. KPMG International provides no services to clients. Each member firm is a separate and independent legal entity and each describes itself as such. All rights reserved.

203

IFRS Financial Instruments Accounting March 2004

Reference

10.5.8
32.94(h)

Other disclosures If the change in fair values of available-for-sale financial assets is recognised as a component of equity, a reconciliation of the movements in this component of equity during the reporting period should be disclosed. Revaluations of financial instruments often give rise to deferred tax temporary differences. The amount of deferred tax relating to each category of temporary difference must be disclosed. Therefore, deferred tax relating to each category of financial instruments should be separately disclosed. Current and deferred tax that arises on available-for-sale financial assets that are revalued through equity, as well as derivatives used in cash flow hedges, will be reported directly in equity. This deferred tax should be included in the disclosure of the total amount of current and deferred tax reported directly in equity. The reason for reclassifications into the held-to-maturity category should be disclosed, if any have occurred. If securitisations or repurchase agreements have occurred in the current reporting period or there are remaining interests from such transactions in previous reporting periods, the following should be disclosed:
■ ■

12.81

32.94(g)

32.94(a)

the nature and extent of such transactions; and whether the financial assets have been derecognised.

32.94(i)

For each significant financial asset, the nature and amount of any impairment loss or reversal of impairment provision balance should be disclosed – effectively a roll forward of the impairment loss. The amount of interest income that has been accrued on impaired loans, but has not yet been received, should also be disclosed. The aggregate carrying amount of secured liabilities and the nature and carrying amount of the assets pledged as security as well as any significant terms and conditions relating to the pledged assets should be disclosed. A lender should disclose:

32.94(b)

32.94(c)

■ ■ ■

the fair value of collateral that it has accepted and is permitted to sell or repledge; the fair value of collateral that it has sold or repledged; and any significant terms and conditions associated with its use of the collateral.

32.94(e)

The following disclosures are encouraged when they are likely to enhance the financial statement user’s understanding:

the total amount of the change in the fair value of financial assets and financial liabilities that has been recognised as income or expense for the reporting period; and the average aggregate fair value during the reporting period of all financial assets and financial liabilities, particularly when the amounts on hand at the balance sheet date are unrepresentative of amounts on hand during the reporting period.

204

10.5 Required disclosures © 2004 KPMG International. KPMG International is a Swiss cooperative of which all KPMG firms are members. KPMG International provides no services to clients. Each member firm is a separate and independent legal entity and each describes itself as such. All rights reserved.

including the sensitivities of fair value estimates to changes in key assumptions. KPMG International is a Swiss cooperative of which all KPMG firms are members. All rights reserved. information about assets retained in transactions that do not qualify for derecognition in their entirety. the carrying amounts of trading assets and liabilities and. 205 . information about compound instruments that have multiple embedded derivative features. the amount of the fair value change of a financial liability designated as fair value through profit or loss that arises from factors other than changes in market interest rates (e. ■ ■ ■ ■ ■ 10. those designated on initial recognition as fair value through profit or loss. and information about defaults by the entity on loans payable and other breaches of loan agreements. changes in the entity’s own credit risk).5 Required disclosures © 2004 KPMG International. Each member firm is a separate and independent legal entity and each describes itself as such. separately.g.IFRS Financial Instruments Accounting March 2004 Reference December 2003 amendments The amended standards will introduce the following additional disclosure requirements: ■ information about the use of valuation techniques. KPMG International provides no services to clients.

although partial or fully retrospective application is available. Reference 206 11. 11. KPMG International provides no services to clients. For entities that will be adopting IFRS for the first time. Early application is permitted. All rights reserved. There are certain limited exemptions to this principle. in respect of these two standards only. Another exemption is that an entity that has issued instruments with liability and equity components.IFRS Financial Instruments Accounting March 2004 11. At that date. A significant exemption is available for transactions that took place before 1 January 2004 and resulted in the derecognition of one or more financial instruments under previous GAAP. These are not required to be re-evaluated under the principles of IAS 39. becomes the first day of the entity’s first IFRS reporting period.2 First-time adoption of IFRS IFRS 1 generally requires full retrospective application of all IFRS effective at the reporting date for an entity’s first IFRS financial statements.1 Overview The amended IAS 32 and IAS 39 become operative for financial years beginning on or after 1 January 2005. not the first day of the comparative period. Some of the possibilities are considered in Steps 1 to 9 below. Each member firm is a separate and independent legal entity and each describes itself as such. but comparatives are not required to be restated. Piecemeal application of the amendments is not permitted. For first-time adopters of IFRS an opening balance sheet adjustment is made. The most significant exception to the principles in IFRS 1 for financial instruments is that an entity applying IFRS for the first time before 1 January 2006 need not restate its comparative information with respect to IAS 32 and IAS 39. such as convertible bonds. the IASB has clarified the required transition adjustments for all existing IFRS and SIC interpretations in its standard IFRS 1 First-time Adoption of IFRSs. . the transitional requirements are broadly retrospective.2 First-time adoption of IFRS © 2004 KPMG International. possibly between retained earnings and paidin capital. For entities currently using the existing IAS 39. depending on its previous accounting for financial instruments. KPMG International is a Swiss cooperative of which all KPMG firms are members. the entity will be required to make a number of adjustments. Transition and implementation of IAS 39 Key topics covered in this Section: ■ ■ Transition rules for first-time adopters and for existing IFRS users Practical considerations when adopting IAS 39 11. The date of transition. In such cases. a fully retrospective application of IAS 32 would require no more than a reclassification of amounts within equity. with one or two exceptions. including in the area of financial instruments. but an entity must then apply all the requirements of both standards. need not apply the ‘split accounting’ requirements in IAS 32 if the instrument has been settled or converted before the date of transition.

KPMG International is a Swiss cooperative of which all KPMG firms are members. Each member firm is a separate and independent legal entity and each describes itself as such. again taking advantage of the free choice to classify liabilities as fair value through profit or loss. the allocation between liabilities and equity should be based on the circumstances at the date of issue of the instrument. 11. the entity must separately identify the liability and equity components. Note that this last designation cannot be reversed. IAS 32 requires that the entity considers the facts and circumstances at the time the instrument was issued when determining classification as a financial liability or equity. cumulative interest on the liability portion) and the true equity component. upon initial adoption an entity should classify financial assets in accordance with one of the four categories specified in IAS 39 (see Section 5). The equity component must be split between the retained earnings component (i. and also taking advantage of the free choice at the date of transition to designate any non-derivative financial asset as available-forsale and any financial asset or financial liability as fair value through profit or loss.e.2 First-time adoption of IFRS © 2004 KPMG International.15 Financial liabilities should be classified as either trading or non-trading liabilities. not the facts and circumstances at the date of transition. 39. where appropriate. The process of classification will include designating financial assets as held-to-maturity where appropriate. Derecognition transactions taking place before 1 January 2004 are not required to be re-evaluated. Step 3 For a compound instrument where the liability component is still outstanding at the transition date. they must be included in the opening IFRS balance sheet. Further adjustments may be necessary following a more detailed analysis of the facts and circumstances of each particular entity and the differences between its existing accounting policies and the requirements of IFRS: Step 1 An entity should consider whether it should recognise financial assets that were derecognised under previous GAAP. Transactions taking place on or after 1 January 2004 that resulted in derecognition of one or more financial instruments must be re-evaluated under IAS 39. Step 2 Instruments issued by an entity should be classified as either equity or as liabilities in accordance with the criteria of the financial instruments standards (see Section 10). Note.105 Having recognised all financial instruments as appropriate. however. 207 . KPMG International provides no services to clients. 32.IFRS Financial Instruments Accounting March 2004 Reference 39. If the instrument(s) would not have been derecognised under IAS 39. that there is no exemption for first-time adopters from the requirement to consolidate any special purpose entity into which financial assets may have been transferred. and the subsequent interest expense on the liability component should be calculated using the effective yield method required by the standards. All rights reserved.105 Set out below is a step-by-step approach to transitional accounting adjustments that might be followed by entities adopting the revised financial instruments standards as part of a wider IFRS conversion project. Again.

provisions or general reserves under existing requirements need to be reversed and / or whether new impairment write-downs should be provided under the incurred losses model in the standards. Step 5 IFRS 1. In many cases. . Any adjustments should be recognised against retained earnings. the separation of embedded derivatives from a host contract should be based on the circumstances in place when the combined instrument was purchased or issued. For example. As an exception. As a result. the difference between the amortised cost and the fair value of an available-for-sale financial asset is recognised in an available-for-sale fair value reserve rather than in retained earnings. However. the amounts recognised in the reserve are released to the income statement. Step 6 39.IFRS Financial Instruments Accounting March 2004 Reference Step 4 An entity identifies those financial assets and liabilities that should be measured at fair value and those that should be measured at amortised cost. Step 7 This stage will first involve determining whether hedge accounting has been applied under the entity’s previous GAAP and. Upon subsequent disposal or impairment of the asset. Any adjustment to the previous carrying amounts should be recognised as an adjustment to the opening balance of retained earnings. formal (or even informal) guidance for hedge accounting. based on their classification (determined in Steps 1 and 2 above). under certain 208 11. including embedded derivatives. particularly in respect of the hedging instrument. Any gains and losses on derivatives that are deferred amongst assets and liabilities should be eliminated against retained earnings. and therefore to identify a hedged item under previous GAAP. if any. KPMG International provides no services to clients. The difference between the previous carrying amount (which may have been zero) and the fair value of derivatives should be recognised as an adjustment to the opening balance of retained earnings at this time. that hedge accounting has previously been applied. it may be clear from the accounting. how hedge accounting has been applied. KPMG International is a Swiss cooperative of which all KPMG firms are members.2 First-time adoption of IFRS © 2004 KPMG International. in its balance sheet as either assets or liabilities and should measure them at fair value.105 The entity should recognise all derivatives. In measuring financial assets and financial liabilities. This will have a corresponding impact on the transitional adjustments. hedging relationships may not be documented. in some cases it may be impossible to determine the precise purpose for which derivatives were acquired under previous GAAP. In such cases. and it should remeasure these as appropriate. Further adjustments to establish transitional balances related to hedge accounting are dealt with separately below. fair value must be estimated using the guidance in the standards and amortised cost must be measured using the guidance on the effective yield method based on the estimated maturities of assets and liabilities. Each member firm is a separate and independent legal entity and each describes itself as such. the entity’s previous GAAP may have little. All rights reserved.IG59 The entity should assess whether any impairment write-downs. As with other adjustments. no transitional hedge accounting adjustments will be made. if so.

regardless of whether hedge accounting is to be claimed going forward under IAS 39: Fair value hedging relationships The entity will adjust the carrying amount of the hedged asset or liability by the lower of: IFRS 1. Where hedge accounting has been applied under previous GAAP. Where the hedge does fall within one of these definitions. a hedge of a net position could be re-designated as a hedge of an underlying gross position before the transition date). and (b) the cumulative change in fair value of the hedging instrument that is in respect of the designated hedged risk and. All rights reserved.2 First-time adoption of IFRS © 2004 KPMG International. the hedge of a net position). and does fall within the fair value or cash flow categories permitted by IAS 39. KPMG International provides no services to clients. where a derivative is used to hedge forecast transactions all changes in value of that derivative. Each member firm is a separate and independent legal entity and each describes itself as such. was either not recognised or was deferred in the balance sheet as an asset or liability.IG60A (a) the cumulative change in the fair value of the hedged item since inception of the hedge that is due to the hedged risk and was not recognised under the entity’s previous GAAP. In other cases the entity may have documented the purpose for which a derivative was acquired so that a hedged item can be identified under previous GAAP. Where a hedge can be identified under previous GAAP. re-designate the hedge in order that it will comply with IAS 39 going forward (see Step 9 below). the next step is to consider whether the type of hedge accounting that has been applied is permitted by IAS 39. to re-designate hedging relationships to those which are permitted under IAS 39 (e. 209 . irrespective of the precise accounting. before transition date. the entity may then wish to consider whether it can document and. It is not necessary to determine at this stage whether the hedge would or would not have met the hedge accounting requirements of IAS 39 as this will apply only from the date of transition onwards (see Step 9 below). KPMG International is a Swiss cooperative of which all KPMG firms are members. which are to be applied to the forecast transactions when they occur. where a derivative is not being used as a hedging instrument. perhaps more commonly found. However. it might be possible. the transitional rules set out below will apply. the derivative will be treated as a standalone financial instrument on transition date. 11. it is held on balance sheet at fair value with changes in value being included in profit or loss. if necessary. are kept off balance sheet with accrual accounting being applied to the derivative. or being taken to equity. This will be the case where the hedge falls within the IAS 39 definitions of fair value or cash flow.IG60 IFRS 1. the following adjustments are required on the date of transition.IFRS Financial Instruments Accounting March 2004 Reference GAAPs. under previous GAAP. IFRS 1. In contrast. meaning that advantage could then be taken of the transitional rules.g. the use of a written option as the hedging instrument or.g. However. Where a hedge does not meet the requirements of IAS 39 at the transition date.29 Where the type of hedge accounting applied under previous GAAP is not permitted by IAS 39 (e. in each jurisdiction a review will be required to determine whether or not hedge accounting has previously been applied.

some hedging relationships that existed under the entity’s previous GAAP may not qualify for hedge accounting at all under IAS 39. as noted above. in respect of these two standards only. However. take the opportunity to review one or more of its risk management policies or processes. IFRS 1. the full amount of any change in value having been taken to retained earnings). meaning that a change in hedging strategy may be required. an entity applying IFRS for the first time before 1 January 2006 need not restate its comparative information with respect to IAS 32 and IAS 39. at the transition date. on transition to IFRS.IG60B The entity will reflect the entire cumulative gain or loss on the hedging derivative since the inception of the hedging relationship in equity (under Step 4 this will already have been dealt with.27 As noted above.36A IFRS 1. As noted in Step 7 above. or to change the types of hedging instrument in order to be able to apply hedge accounting in the most cost-effective way under IFRS.IFRS Financial Instruments Accounting March 2004 Reference Cash flow hedging relationships IFRS 1.22 These are not dealt with specifically by the transitional guidance. with associated disclosure being made.101 IFRS 1. becomes the first day of the entity’s first IFRS reporting period. an amount will be transferred out of retained earnings and recognised in a separate cash flow hedging reserve.IG53 and IFRS 1. represents transactions which are not expected to take place. Step 8 An entity may. Net investment hedging relationships IFRS 1. However. All rights reserved. KPMG International is a Swiss cooperative of which all KPMG firms are members. but hedge accounting is not claimed going forward under IAS 39.2 First-time adoption of IFRS © 2004 KPMG International. 210 11. whether these meet the strict criteria for hedge accounting. Where adjustments were made in respect of existing hedging relationship on the date of transition under Step 7. derecognition transactions entered into on or after 1 January 2004 may need to be restated.IG60B and 39. it is noted in IAS 39 that net investment hedges are accounted for in a similar manner to cash flow hedges. Any excess amount which. However. Step 9 IFRS 1. hedge accounting will be discontinued prospectively with the normal IAS 39 rules applying to the related balances that arose on transition. where advantage is taken of the transitional relief included in IFRS 1 to set the translation reserve to nil on transition date. not the first day of the comparative period. To the extent that the related forecast transaction is either highly probable or expected to occur at the transition date. will remain in retained earnings. The date of transition. Retrospective designation is not permitted. the related hedge reserve will also be set at nil with any adjustment arising from the recognition of the derivative or non-derivative hedging instrument being taken to retained earnings. .IG60 An entity will then consider which of its hedging relationships it wishes to designate as hedges under IAS 39 from the date of transition and. Each member firm is a separate and independent legal entity and each describes itself as such. if so.IG60. Comparative information and disclosure IFRS 1. KPMG International provides no services to clients. meaning that on the date of transition those relationships will need to be formally documented and meet the prospective effectiveness test. In our view the same basic process as set out above should be followed.

29 ■ 11. A reconciliation is required between the balance sheet at the date of transition (for the purposes of IAS 32 and IAS 39) and the comparative period’s reporting date with disclosures required by IAS 8 Accounting Policies.28 IFRS 1. Changes in Accounting Estimates and Errors on a change in accounting policy. an entity may choose to designate a previously recognised financial asset or liability as a financial asset or liability at fair value through profit or loss. This disclosure includes the nature of the change in policy. The standards should be applied retrospectively by adjusting the opening balance of retained earnings in the earliest period presented.IFRS Financial Instruments Accounting March 2004 Reference IFRS 1. disclosure is required of the nature (but not the amount) of the main adjustments that would be required to make the information comply with IAS 32 and IAS 39. even if the entity does not intend to use that method in the future.25A if an entity derecognised a financial asset under the existing standards before 1 January 2004. if any. and other comparative amounts as necessary.36A(c) IAS 8.36A An entity that chooses to present comparative information that does not comply with IAS 32 and IAS 39 in its first year of transition is required to apply its previous GAAP to financial instruments within the scope of IAS 32 and IAS 39 in its comparative information and disclose that fact. In addition. Each member firm is a separate and independent legal entity and each describes itself as such. KPMG International provides no services to clients. All rights reserved. financial instruments an entity will designate. disclosure is required of the fair value of the assets and liabilities classified into each category and the classification and carrying amount in the previous financial statements. and any ‘basis adjustment’ made to a non-financial asset or liability should not be reversed. In addition. IFRS 1. 211 . a description of transitional provisions and the amount of the adjustment required to each financial statement line item. any basis adjustment recognised to a financial asset or liability should be restated. KPMG International is a Swiss cooperative of which all KPMG firms are members. 11. it need not consider whether that asset should be reinstated under the amended standards. Reclassification of transactions in own equity may also have a significant impact. The choice of which. or as availablefor-sale.IG59 and IFRS 1.3 Transition requirements for existing users of IFRS The amendments described throughout this publication highlight the areas where adjustments may be required. It may. and any amounts deferred in a cash flow hedge reserve for hedges of firm commitments (except those in a foreign currency) should be adjusted against the related assets following the fair value hedging model.3 Transition requirements for existing users of IFRS © 2004 KPMG International. by choice. choose a date earlier than 1 January 2004 and restate for derecognition transactions that took place after that earlier date. The exceptions are: ■ IFRS 1. In such cases. as either fair value through profit or loss or available-for-sale as permitted under the amended standards may be one of the most significant changes. However. however.

11. repurchase agreements. There may be instances where either hedging model can be used. especially with respect to securitisations. The entity must also identify all contracts that meet the definition of a derivative under IAS 39 and identify all embedded derivatives. and information technology.4. An entity that operates in distinct business units must ensure that all of these units are included in the implementation effort to foster consistent adoption across the entity. Each member firm is a separate and independent legal entity and each describes itself as such.1 First time implementation: practical considerations Organising the implementation effort Due to the far-reaching impact of IAS 39 on an entity’s day-to-day operations.2 Analysing the entity’s exposure to financial instruments The entity must first identify all of its financial assets and liabilities and classify these based on their purpose and term prior to determining which should be carried at fair value and which at amortised cost. systems capabilities and legal contracts. treatment under IFRS requirements.IFRS Financial Instruments Accounting March 2004 Reference 11. . All rights reserved. compliance department. The implementation effort should include those knowledgeable about the entity’s current strategies and usage of financial instruments and hedging. the implementation effort must reach across functions and involve a multi-disciplinary group. An entity with centralised functions might require only a smaller implementation team. KPMG International provides no services to clients. Consideration must be given to potential changes in policies resulting from recognition and derecognition criteria. the entity should determine whether the ongoing relationship represents a fair value hedge or a cash flow hedge. 212 11.4. legal and tax departments. current accounting practices. Instruments classified as liabilities or as equity under the previous GAAP may need to be reclassified under IAS 32. The entity should determine which model to use.4 11. transfers relating to components of assets or liabilities and where new assets or liabilities arise. KPMG International is a Swiss cooperative of which all KPMG firms are members. internal and external audit. An effective implementation team would generally include the following functions: ■ ■ ■ ■ ■ ■ ■ treasury. securities lending. as this will drive the ongoing accounting for that relationship. financial risk management department. The level of resources required for the implementation effort is dependent on the structure and size of the entity.4 First time implementation: practical considerations © 2004 KPMG International. financial controllers. and external financial reporting. For existing hedge relationships that qualify for hedge accounting under IAS 39. internal accounting policy makers.

4 Systems considerations An assessment of current systems capabilities should be performed well in advance of the transition date. including its income statement.3 Amend internal policies and procedures The entity should ensure that its documented policies and procedures on financial instruments meet the requirements of IAS 39 in relation to recognition. measurement. Certain hedging practices under the entity’s current strategies may no longer receive hedge accounting treatment. discounted cash flow calculations.4 First time implementation: practical considerations © 2004 KPMG International. it is important to understand the impact that adoption of IAS 39 will have on the entity’s financial statements. derecognition. impairment calculations. changes in equity and balance sheet. All rights reserved. ■ ■ 11. 11. and providing the necessary internal and external reporting information. The entity should determine and document how it expects to measure effectiveness in its hedge relationships.4. and recycling amounts out of equity when appropriate. identification of hedge relationships. The adoption of IAS 39 may create the need for enhancements to the treasury systems as well as to accounting systems. measurable and effective. cash flow hedge adjustments. including derivative instruments. including hedging model used. and hedge accounting. accounting for basis adjustments to hedged transactions that result in assets and liabilities. classification and reporting of financial instruments. A hedge relationship must be documented from its inception. Also. and meet the minimum requirements that the relationship is clearly defined.IFRS Financial Instruments Accounting March 2004 Reference Lastly. tracking amounts in equity in respect of fair value adjustments of available-for-sale instruments. KPMG International is a Swiss cooperative of which all KPMG firms are members. 11. hedge effectiveness calculations. 213 . Each member firm is a separate and independent legal entity and each describes itself as such. Systems should be capable of: ■ ■ ■ ■ ■ ■ ■ ■ interest and amortisation calculations using the effective interest method. fair value calculations for all financial instruments. KPMG International provides no services to clients.4. As a result the entity must determine whether certain hedging strategies should be modified. changes to current practice may be required in order to avoid forced reclassifications under the tainting rules for held-to-maturity assets.

A financial instrument that. or are designated as available-for-sale on initial recognition. from the issuer’s perspective. includes both a liability and an equity element. and minus any writedown for impairment. A combination of a purchased cap and a written floor that protects against a movement outside a range of interest rates or some other underlying. that is attributable to changes in variable rates or prices. See forecasted transaction below. Financial assets that are not held for trading. plus or minus the cumulative amortisation / accretion of any premium / discount. KPMG International is a Swiss cooperative of which all KPMG firms are members. A risk management strategy whereby one central unit of an entity transacts hedging activities on behalf of some or all entities within the group. The extent to which an entity remains exposed to changes in the value of a transferred asset where the entity has neither transferred nor retained substantially all of the risks and rewards of the transferred asset. All rights reserved. A principal party to a transaction. Anticipated future transaction Available-for-sale Call option Cap Cash flow hedge Central treasury hedging Collar Continuing involvement Commodity-based contract Compound instrument Counterparty Credit risk Default risk 214 Appendix A Glossary © 2004 KPMG International. Each member firm is a separate and independent legal entity and each describes itself as such. See credit risk above. or forecasted transaction. A contract for delivery of a commodity that also allows for settlement in cash or some other financial instrument.IFRS Financial Instruments Accounting March 2004 A. or held-to-maturity investments. KPMG International provides no services to clients. A hedge of the exposure to variability in the cash flows of a recognised asset or liability. An option contract that protects the holder from a rise in interest rates or some other underlying index beyond a certain point. An option contract giving the holder the right. to buy a specific quantity of an asset for a fixed price during a specific time period (or on a specified date). . Glossary Amortised cost The amount at which a financial asset or liability is measured at initial recognition minus principal repayments. The risk that one party to a financial instrument will fail to discharge an obligation and cause the other party to incur a financial loss. loans and receivables originated by the entity. but not the obligation.

A financial instrument (usually a bond) where the principal and interest payments are made in different currencies. or a firm commitment. or settled upon exercise of an option. 215 . A financial instrument whose value changes in response to a change in a specified underlying. The effective interest rate is the rate that discounts the expected stream of future cash payments to the instrument’s carrying amount. The amount at which an asset (liability) could be bought (incurred) or sold (settled) in an arm’s length transaction between knowledgeable. that is attributable to a particular risk. An asset that is cash. Implicit or explicit terms in a contract that affect some or all of the cash flows of a contract in a manner similar to a freestanding derivative instrument. a contractual right to receive cash or another financial asset from another entity. Each member firm is a separate and independent legal entity and each describes itself as such. a contractual right to exchange financial instruments with another entity under potentially favourable conditions. and interest payments are made in a foreign currency. willing parties. A method of calculating amortisation using the effective interest rate of a financial instrument. Derivative Dual currency instrument Effective interest method Embedded derivative Equity Exercise price Fair value Fair value hedge Financial asset Appendix A Glossary © 2004 KPMG International. an equity instrument of another entity.IFRS Financial Instruments Accounting March 2004 Derecognition The act of removing a recognised financial asset or liability from the entity’s balance sheet. This may be accomplished through the sale. KPMG International provides no services to clients. All rights reserved. and that is settled at a future date. A hedge of the exposure to changes in the fair value of a recognised asset or liability or a portion thereof. or a contract that will or may be settled in the entity’s own equity instruments and is either a non-derivative for which the entity is or may be obliged to receive a variable number of the entity’s own equity instruments or a derivative that will or may be settled other than by the exchange of a fixed amount of cash or another financial asset for a fixed number of the entity’s own equity instruments (for this latter purpose the entity’s own equity instruments do not include contracts that are themselves contracts for the future receipt or delivery of the entity’s own equity instruments). for which there is little or no initial net investment. A contract evidencing a residual interest in the assets of an entity after deducting all of its liabilities. The price at which an underlying instrument may be bought. A typical example is a bond where principal payments are made in the measurement currency of the holder. KPMG International is a Swiss cooperative of which all KPMG firms are members. transfer or expiration of a financial asset or through the legal settlement of or release from a financial liability. sold. and that will affect reported net income.

and timing of settlement are specified. or to exchange financial instruments with another entity under conditions that are potentially unfavourable to the entity. An option contract that protects the holder against a decline in interest rates or some other underlying below a certain point. or Upon initial recognition it is designated by the entity at fair value through profit or loss. Financial instrument Financial liability Firm commitment Floor Forecasted transaction Foreign currency 216 Appendix A Glossary © 2004 KPMG International. price. or are part of a portfolio of identified financial instruments that are managed together and for which there is evidence of a recent actual pattern of short-term profit-taking. Any contract that gives rise to both a financial asset of one entity and a financial liability or equity instrument of another entity. Such assets or liabilities are acquired or incurred principally for the purpose of generating a profit from short-term fluctuations in price or dealer’s margin. This approach requires that the party that controls the individual financial components should record those assets or liabilities. All rights reserved. .IFRS Financial Instruments Accounting March 2004 Financial asset or financial liability at fair value through profit or loss A financial asset or liability that meets either of the following conditions: A financial asset or financial liability that is classified as held for trading. Any financial asset or liability within the scope of IAS 39 (revised) may be designated when initially recognised as a financial asset or financial liability through profit or loss except for investments in equity investments that do not have a quoted market price in an active market and whose fair value cannot be reliably measured. or a contract that will or may be settled in the entity’s own equity instruments and is either a non-derivative for which the entity is or may be obliged to deliver a variable number of the entity’s own equity instruments or a derivative that will or may be settled other than by the exchange of a fixed amount of cash or another financial asset for a fixed number of the entity’s own equity instruments (for this latter purpose the entity’s own equity instruments do not include instruments that are themselves contracts for the future receipt or delivery of the entity’s own equity instruments). A transaction that is expected to occur for which there is no firm commitment. All derivatives are deemed to be trading instruments unless they qualify for hedge accounting. KPMG International provides no services to clients. Financial components approach An approach whereby the recognition or derecognition of a financial asset or liability is viewed in terms of its financial components that comprise that asset or liability. An agreement with another party that binds both parties and is usually legally enforceable. whereby the significant terms of the transaction. Each member firm is a separate and independent legal entity and each describes itself as such. A currency other than the measurement currency of an entity. including quantity. Also referred to as an anticipated future transaction. KPMG International is a Swiss cooperative of which all KPMG firms are members. A liability that is a contractual obligation to deliver cash or another financial asset to another entity.

and the other party to sell a specific asset for a fixed price at a future date. another financial instrument whose changes in fair value or cash flows are expected to offset changes in the fair value or cash flows of a designated hedged item. A forward contract that is standardised and exchange-traded. A hedged item may be a group of similar assets or liabilities. KPMG International is a Swiss cooperative of which all KPMG firms are members. Each member firm is a separate and independent legal entity and each describes itself as such. Foreign operation Forward contract Forward rate Functional currency Futures contract Guidance on Implementing IAS 39: Financial Instruments: Recognition and Measurement Hedge effectiveness Hedged item Hedging Hedging instrument Held-to-maturity asset Host contract Hybrid instrument Appendix A Glossary © 2004 KPMG International. currency or other asset. KPMG International provides no services to clients. Also referred to as currency risk. liability. firm commitment. Financial assets that have fixed or determinable payments and a fixed maturity and that an entity has the positive intent and ability to hold until maturity. An entity that is a subsidiary. A strategy used in risk management whereby an entity seeks to reduce or eliminate financial risks by entering into transactions that give an offsetting risk profile. but is not necessarily. and that has been designated by an entity as being hedged. The degree to which changes in fair value or cash flows attributable to a hedged risk are offset by changes in the fair value or cash flows of the hedging instrument. joint venture or branch of a reporting entity. The foreign exchange rate used in an agreement to exchange at a specified future date a specified amount of a commodity. and has superseded in the revised IAS 39. A non-exchange-traded contract that obligates one party to buy. or forecasted transaction that exposes the entity to a risk of changes in fair value or future cash flows. Implementation Guidance issued by the Implementation Guidance Committee (IGC Q&A – see below) in respect of the previous IAS 39. All rights reserved. An asset. The host contract may be. the activities of which are based or conducted in a country or currency other than those of the reporting entity. whereby special accounting rules may be used if specific hedge effectiveness and other criteria are met. or a portion thereof. A contract that comprises an embedded derivative component and a host contract. The currency of the primary economic environment in which an entity operates. firm commitment or forecasted transaction.IFRS Financial Instruments Accounting March 2004 Foreign exchange risk The risk that changes in foreign exchange rates will affect the fair value or cash flows of a recognised financial instrument. 217 . A designated derivative or. The portion of a hybrid instrument that is the host to an embedded derivative. associate. in limited circumstances. This may or may not allow an entity to use hedge accounting. Guidance which has been developed from. a financial instrument.

International Financial Reporting Interpretations Committee. From 2002. An option that is not in-the-money has no intrinsic value. or by general market conditions. IFRS is an acceptable GAAP (generally accepted accounting principles) in many countries and on many stock exchanges around the world. In 2002. these are the successor organisations to the IASC and SIC respectively.) Money held and assets to be received or liabilities to be paid in fixed or determinable amounts of money. This is the currency of the primary economic exposure of the entity. All rights reserved. In this publication. The risk that fair values or cash flows will be affected by factors specific to a particular instrument or to the issuer of an instrument. IASB and IFRIC IFRS IGC Q&A Impairment Interest rate risk In-the-money option Intrinsic value Lease contract Market risk Measurement currency Monetary item Net investment hedge 218 Appendix A Glossary © 2004 KPMG International. International Accounting Standards Board. or a put option whose exercise price is greater than the spot price of the underlying instrument. KPMG International is a Swiss cooperative of which all KPMG firms are members. the body of accounting standards and interpretations issued or endorsed by the IASB. Note that in the revised financial instrument standards. A hedge of the exposure to changes in value of a net investment in a foreign entity arising from changes in foreign exchange rates. Each member firm is a separate and independent legal entity and each describes itself as such. International Financial Reporting Standards. The positive difference between the current price of the underlying and the exercise price in those situations when an option is in-the-money.IFRS Financial Instruments Accounting March 2004 IAS International Accounting Standards. A call option whose exercise price is lower than the spot price of the underlying instrument. . this guidance has in some cases been deleted or amended. An agreement whereby the lessor conveys to the lessee in return for a payment or series of payments the right to use an asset for an agreed period of time. a body of accounting standards and interpretations issued by the International Accounting Standards Committee (IASC). this became known as IFRS (see below). with this guidance then either having been incorporated into the standards themselves or published separately as ‘Guidance on Implementing IAS 39 Financial Instruments: Recognition and Measurement’. The risk that changes in market interest rates may affect the fair value or cash flows of a financial instrument. Implementation guidance developed by the Implementation Guidance Committee of the IASC in the form of questions and answers. (This definition was included in the original IAS 21 and was deleted on that standard’s revision in 2003. implementation guidance that is relevant to specific topic areas is referenced in the margin. KPMG International provides no services to clients. A situation where the estimated recoverable amount of a financial asset has declined below its carrying amount. The currency used by an entity in preparing its financial statements.

Note that this category has been subsumed within ‘Financial asset or financial liability at fair value through profit or loss’. A call option whose exercise price is greater than the spot price of the underlying instrument. The party receiving the return based on the interest index is considered to receive a lender’s return. 219 . or a put option whose exercise price is lower than the spot price of the underlying instrument.e. to buy or sell an asset. KPMG International is a Swiss cooperative of which all KPMG firms are members. A financial instrument that is acquired or incurred principally for the purpose of generating a profit from short-term fluctuations in price or dealer’s margin. All rights reserved. The date that a financial instrument is delivered to or transferred from an entity. KPMG International provides no services to clients. A contract that provides the actual returns and credit risks of a transaction to one party in return for a specified interest index to the other party. but not the obligation. A contract between two parties. a number of units of weight or volume or other units specified in a derivative contract. An option contract giving the holder the right. Put option Regular way transaction Risks and rewards approach Settlement date Spot rate Swap Time value Total return swap Trade date Trading assets and liabilities Appendix A Glossary © 2004 KPMG International. All derivatives are deemed to be trading instruments unless they qualify for hedge accounting. The difference between the total value (i. to sell a specific quantity of an asset for a fixed price during a specific period of time or at a set date. The foreign exchange rate between two currencies on a given date. but not the obligation. A contract for a purchase or sale of financial assets that requires delivery of the assets within a period of time that is generally established either by regulation or convention in that marketplace. or rate for a specific price. Each member firm is a separate and independent legal entity and each describes itself as such. Net position hedging Notional amount Option Out-of-the-money option A risk management strategy whereby an entity hedges its net risk positions / exposures. currency. An approach whereby the recognition or derecognition of a financial asset or liability depends upon whether the party to a transfer of financial instruments is deemed to have retained the risks in order to obtain the related benefits.IFRS Financial Instruments Accounting March 2004 Net investment in a foreign entity A reporting entity’s share in the net assets of a foreign entity. An amount of currency. which gives one party the right. number of shares. An agreement by two parties to exchange a series of cash flows in the future. fair value) of an option and the option’s intrinsic value. The date that an entity enters into a contract for the purchase or sale of a financial instrument.

the Financial Accounting Standards Board.IFRS Financial Instruments Accounting March 2004 Transaction costs Underlying Incremental costs that are directly attributable to the acquisition or disposal of a financial asset or liability. or other variables. index of prices or rates. or index. A figure demonstrating the relationship between interest rates and time to maturity. The degree of price fluctuation for a given asset. These principles are primarily set by a national accounting body. foreign exchange rate. These are insurance-type policies used by entities. but may or may not be directly related to an amount of loss incurred by the entity. An option contract for which a net premium is received. Each member firm is a separate and independent legal entity and each describes itself as such. commodity price. A specified interest rate. KPMG International is a Swiss cooperative of which all KPMG firms are members. geological. KPMG International provides no services to clients. or FASB. . An underlying may be a price or rate of an asset or liability. All rights reserved. or other physical variables. A contract that requires payment based on climatic. Generally accepted accounting principles of the United States. security price. rate. but is not the asset or liability itself. US GAAP Volatility Weather derivative Written option Yield curve 220 Appendix A Glossary © 2004 KPMG International.

Scope IAS 39 is a comprehensive standard that deals with all aspects of recognition and measurement of financial instruments. In addition. SFAS 133 (and amendments SFAS 138 and SFAS 149) deal specifically with recognition and measurement of derivatives and hedge accounting. There are more differences (especially as to the finer points) than those indicated below. US GAAP Derivatives All derivative instruments are deemed to be trading. KPMG International provides no services to clients. All types of financial instruments are within its scope. The IGC Q&A are guidance. Guidance has developed over a much longer period of time. KPMG International is a Swiss cooperative of which all KPMG firms are members. 115. Questions and Answers (Q&A) on IAS 39 have been issued by the Implementation Guidance Committee (IGC). 138 and 140. IFRS General The literature addressing financial instruments is mostly contained in IAS 32. Derivatives are either hedging or non-hedging instruments under SFAS 133. often in response to new financial products introduced in the markets. derecognition. Recognition and measurement and derecognition issues for other financial instruments are dealt with in different standards (primarily SFAS 115 and 140). 221 . IAS 39 and IAS 21 (for foreign currency accounting). 133. There are over a dozen FASB standards that address various aspects of financial instruments. The standards do not aim to provide industry-specific requirements. impairment and hedge accounting. unless they are part of an effective hedge relationship. DIG Issues are interpretative guidance based on issues raised in practice. The FASB has issued Q&A for SFAS 115 and 140. This includes fair value considerations. The standards form a comprehensive set of principles for financial instruments accounting. Appendix B IFRS and US GAAP financial instruments comparison © 2004 KPMG International.IFRS Financial Instruments Accounting March 2004 B. IFRS and US GAAP financial instruments comparison The following summary highlights the major principles related to accounting for financial instruments under IAS and under US GAAP. The US GAAP body of literature is far more detailed and complex in terms of its hierarchy. Each member firm is a separate and independent legal entity and each describes itself as such. but do not have the standing of an IASB standard or interpretation. All derivatives are measured on the balance sheet at fair value. All rights reserved. interpretations made under IFRS could differ from those that would be made under US GAAP. The main sources for comparison are IAS 32 and IAS 39 and FASB (Financial Accounting Standards Board) Statements No. All derivatives are measured on the balance sheet at fair value. Implementation Issues on SFAS 133 have been issued by the Derivatives Implementation Group (DIG). as well as certain similarities and differences.

The FASB has a current project that is expected to address classification of compound instruments. The embedded derivative is then accounted for as a freestanding derivative. . There are some instruments classified as equity under US GAAP that would be classified as liabilities under IFRS. Instruments that can readily be settled net outside the contract or that require the delivery of an asset that is convertible to cash also meet this criterion. which is defined in terms of the fair value of the consideration exchanged. Similar approach under US GAAP. The approach under US GAAP is a financial components model that focuses on control. KPMG International provides no services to clients. the terms of a derivative instrument should either require or permit net settlement. Similar approach under US GAAP. All rights reserved. Derivatives may have either net or gross settlement provisions. Similar principle under US GAAP. Transaction costs incurred to acquire a financial asset are capitalised as part of the initial recognition. KPMG International is a Swiss cooperative of which all KPMG firms are members. Derecognition IAS 39 follows a financial components model for derecognition. Surrender of control over the transferred financial asset is the key criterion for derecognition of assets. This is exhibited by the transfer of a substantive risk of the assets to the transferee. with the liability and equity components separately recognised. Each member firm is a separate and independent legal entity and each describes itself as such. Regular way purchases and sales of financial assets may be recognised on either the trade date or the settlement date.IFRS Financial Instruments Accounting March 2004 IFRS A contract with an embedded derivative not closely related should generally be separated into its host and derivative components. but also contains certain risks and rewards aspects. A compound instrument that has both liability and equity characteristics must be separated. Classification as equity or as a liability is based on the substance of the contractual arrangement rather than its legal form. US GAAP has specific criteria that must be met to demonstrate the surrender of control. US GAAP Similar approach under US GAAP. One such criterion not in IAS 39 is that the transferred assets must be legally isolated from the transferor. 222 Appendix B IFRS and US GAAP financial instruments comparison © 2004 KPMG International. Recognition Financial assets and liabilities are initially measured at cost. Generally.

For changes in fair value of available-for-sale financial assets. All other financial instruments fall under other rules of US GAAP. KPMG International is a Swiss cooperative of which all KPMG firms are members. a similar recycling system is used: adjustments are reported in other comprehensive income (a component of equity). amortised cost is used for held-to-maturity debt securities. a securitisation may be off balance sheet altogether. originated loans and receivables and non-trading liabilities. ■ ■ Mortgage loans held for sale are carried at the lower of cost or fair value. either immediate income statement recognition or a recycling system is used: in the latter adjustments are reported in equity and are subsequently recycled out of equity and recognised in the income statement when realised. Fair value adjustments on trading items are recognised in the income statement. Similar approach under US GAAP. assets subject to a securitisation may be derecognised from the transferor’s balance sheet. US GAAP If the transfer involves: ■ a qualifying special purpose entity (QSPE). an entity must have legal release from being the primary obligor. The following categories are used only for debt securities and marketable equity securities and derivatives: ■ amortised cost is used for held-to-maturity assets. Appendix B IFRS and US GAAP financial instruments comparison © 2004 KPMG International. 223 . and fair value is used for available-for-sale assets and trading assets and liabilities. Measurement The following categories cover all financial assets and liabilities other than hedging instruments: ■ Similar approach under US GAAP. In-substance defeasance alone will not lead to derecognition. All rights reserved. Each member firm is a separate and independent legal entity and each describes itself as such. or a variable interest entity (VIE) that is not a QSPE. For changes in fair value of available-for-sale securities. a non-QSPE that is adequately capitalised. KPMG International provides no services to clients. and fair value is used for available-for-sale and trading securities. An entity’s own debt is stated at amortised cost. basic consolidation criteria should be considered. they are subsequently recycled from other comprehensive income and recognised in the income statement when realised. parties should evaluate whether they have the majority of variable interests in the entity for determining consolidation of the VIE. ■ ■ For derecognition of a financial liability to occur.IFRS Financial Instruments Accounting March 2004 IFRS If the transfer involves a special purpose entity (SPE). and are generally carried at amortised cost. however as a result of SIC–12 the assets of an SPE could be consolidated and separately recognised in the consolidated balance sheet.

KPMG International provides no services to clients. A cash flow hedge may be used to hedge the exposure to variability in cash flows of a hedged item attributable to changes in variable rates or prices. except that a short-cut method is allowed for certain hedges of interest rate risk where 100 per cent effectiveness can be assumed if certain criteria are met. A fair value hedge may be used to hedge the exposure to changes in the fair value of a hedged item attributable to its fixed terms. For non-monetary available-for-sale assets.IFRS Financial Instruments Accounting March 2004 IFRS For available-for-sale monetary financial assets. This is normally the currency of the environment in which the entity generates and expends cash. both at inception and throughout the life of the hedge. Similar approach under US GAAP. Practice has developed where both future expectation and actual results should be in a range of 80 to 125 per cent offset. Each member firm is a separate and independent legal entity and each describes itself as such. Any remaining change is in equity. change in fair value attributable to foreign exchange differences is always recognised in the income statement. Impairment losses may be reversed subsequently. Subsequent changes (that are not other than temporary impairment) are included in other comprehensive income (OCI). . If impairment is other than temporary. No subsequent reversals are permitted. and required write-downs in the financial asset’s carrying amount are recognised in the income statement. Impairment should be assessed at each balance sheet date. a component of equity. subsequent increases or decreases in fair value that are not deemed to be impairment are included as a separate component of equity (if that is the option chosen by the entity to recognise fair value changes). US GAAP For available-for-sale securities the entire change in fair value including foreign exchange differences is recognised in other comprehensive income. Similar approach under US GAAP. Hedging A highly effective hedge is one where changes in fair value or cash flows of the hedged item are expected to be almost fully offset by the changes in fair value or cash flows of the hedging instrument. Actual results should be in a range of 80 to 125 per cent offset. a writedown in the financial asset’s carrying basis is recognised in the income statement. the entire change is recognised in equity. Similar approach under US GAAP. KPMG International is a Swiss cooperative of which all KPMG firms are members. also through the income statement. 224 Appendix B IFRS and US GAAP financial instruments comparison © 2004 KPMG International. Functional currency is used to describe the currency of the primary economic environment in which an entity operates. and should be the currency that reflects the economic substance of the underlying events and circumstances relevant to the entity. if the entity has chosen to present fair value changes there (see above). For available-for-sale instruments. All rights reserved. Measurement currency is the currency in which the financial statements are measured. A hedge effectiveness test must be performed at inception and on an ongoing basis at each reporting period. if circumstances warrant this.

and is recycled as and when the hedged transaction affects the income statement. KPMG International provides no services to clients. basis adjustment). Internal derivatives may be used as hedging instruments in a hedge of foreign currency risk for purposes of hedge accounting. A basis adjustment to the asset or liability is not allowed. other hedges of firm commitments are fair value hedges. the change in fair value of the hedging instrument is recognised in the income statement. only certain cash flow hedges of foreign currency risk qualify for a netting approach. The hedge of a net investment in a foreign entity is accounted for in a manner similar to a cash flow hedge. Similar approach under US GAAP. hedge results are included in the cost basis of the asset or liability (i. A derivative or non-derivative may be used to hedge foreign currency risk in a fair value hedge or a cash flow hedge of a recognised asset or liability. is a cash flow hedge. if such derivatives are offset by third party contracts on a net basis. When the hedging instrument is a derivative. For cash flow hedges. They may not be used as hedging instruments for purposes of hedging other than foreign currency risks. and is recycled as and when the hedged transaction affects the income statement. If an asset or liability results from the hedged transaction. a group treasury department that holds a hedge must write an offsetting instrument with the group member holding the exposure.e. For cash flow hedges. but not to hedge any other exposures. committed or otherwise. A foreign currency hedge of a firm commitment may be a fair value or a cash flow hedge. Appendix B IFRS and US GAAP financial instruments comparison © 2004 KPMG International. Therefore. Recognised foreign currency denominated assets and liabilities may be the hedged item in a fair value or cash flow hedge. The ineffective portion of a net investment hedge is recognised in equity when the hedging instrument is a non-derivative. KPMG International is a Swiss cooperative of which all KPMG firms are members. A hedge of any future transaction. hedges of forecasted transactions are cash flow hedges. as is the hedged item in respect of the hedged risk. However.IFRS Financial Instruments Accounting March 2004 IFRS For fair value hedges. the effective part of the change in fair value of the hedging instrument is recognised in equity. Similar approach under US GAAP. unless there is an offset with a third party contract. 225 . Foreign currency hedges are not permitted in consolidated accounts unless the subsidiary holding the exposure is also a party to the hedge. A non-derivative may be used to hedge foreign currency risk in an unrecognised firm commitment or the hedge of a net investment. the ineffective portion is recognised in the income statement. There is no requirement that a subsidiary within a group of consolidated accounts that holds a foreign currency exposure must be a party to the hedge of that exposure. The ineffective portion of a net investment hedge is recognised in the income statement. the effective part of the change in fair value of the hedging instrument is recognised in other comprehensive income or equity. Similar approach under US GAAP. Each member firm is a separate and independent legal entity and each describes itself as such. All rights reserved. US GAAP Similar approach under US GAAP.

Disclosure of management’s objectives and policies is required for derivatives held or issued. Disclosure of management’s objectives and policies is required for those instruments held for risk management purposes. Information about interest rate risk exposures should be disclosed for each type of financial asset and liability. 226 Appendix B IFRS and US GAAP financial instruments comparison © 2004 KPMG International. Similar disclosures under US GAAP. These include changes in fair value of available-for-sale assets (when an entity records these changes in equity rather than in the income statement) and the effective portion of the change in value of a hedging instrument in a cash flow hedge. including the hedging instrument. Similar disclosures under US GAAP for derivative instruments and retained interests. Each member firm is a separate and independent legal entity and each describes itself as such. Maximum credit risk exposures as well as concentrations of credit risk should be disclosed. KPMG International is a Swiss cooperative of which all KPMG firms are members. Disclosures of the nature and amount of an impairment loss or reversal of an impairment loss should be made. Similar disclosures under US GAAP. Hedging relationships should be disclosed by type of hedge. Similar disclosures under US GAAP. and in the case of forecasted transactions when the transactions are expected to occur. Gains and losses that are recognised directly in equity are disclosed. Similar disclosures under US GAAP. Fair value of all financial instruments should be disclosed either in the notes or on the face of the balance sheet. . as well as the intent to do so. the risk being hedged. Similar disclosures under US GAAP. Disclosure includes a description of the relationship. Similar disclosures under US GAAP.IFRS Financial Instruments Accounting March 2004 IFRS Presentation and disclosure Financial assets and liabilities should be offset and reported net only when an entity has both the legal right to set off the amounts. Similar disclosures under US GAAP. US GAAP Similar approach under US GAAP. Similar disclosures under US GAAP. Amounts recycled from equity to the income statement must be disclosed. including the maximum credit exposure of each concentration and their shared characteristics. All rights reserved. Accounting principles applied as well as significant terms and conditions of financial instruments should be disclosed. KPMG International provides no services to clients. The methods and significant assumptions applied to estimate fair values are required to be disclosed.

in certain respects. with the transfer of risks and rewards generally being considered first. Each member firm is a separate and independent legal entity and each describes itself as such.IFRS Financial Instruments Accounting March 2004 December 2003 amendments In the area of derecognition. With respect to the consolidation of SPEs. the prohibition on reversals of impairment losses on available-for-sale equity instruments. similar to new rules for those instruments under US GAAP. the prohibition on basis adjustment for a cash flow hedge of the purchase or issuance of a financial asset or liability. few of which converge towards IFRS. the amendments to IFRS first require consideration of whether an SPE should be consolidated into the reporting entity before consideration of derecognition. In addition. KPMG International provides no services to clients. the option in the amendments to designate any financial asset or financial liability as fair value through profit or loss or as available-for-sale. For example: ■ the widening of the scope of the amended standards to include commodity contracts where the underlying is readily convertible to cash. the new exemption for embedded derivatives denominated in a currency which is ‘commonly used in that economic environment’ and the new restrictions on the use of internal transactions as hedged items and hedging instruments create new differences with US GAAP. The new rules for derivatives on own equity are. All rights reserved. and the option not to include a basis adjustment for a cash flow hedge of the purchase of a non-financial asset. ■ ■ ■ ■ ■ ■ ■ Appendix B IFRS and US GAAP financial instruments comparison © 2004 KPMG International. the requirement to account for most firm commitment hedges as fair value hedges. and that the transaction price is the best evidence of fair value when the instrument is not traded in an active market. the amendments have added to the differences between IFRS and US GAAP. and the assessment of control being considered only when substantially all the risks and rewards related to transferred assets have been neither transferred nor retained. the clarification that a market price in an active market is the best evidence of fair value. and then place the previous requirements in a hierarchy. However. As noted in Section 4. None of the amendments bring IFRS closer to US GAAP. In other respects the amendments have moved IFRS closer to US GAAP. eliminating the previous policy choice to measure available-for-sale financial assets at fair value through profit or loss. 227 . US GAAP has been subject to further developments. the scope exclusion for certain loan commitments. If control has not been transferred in these circumstances. SIC–12 remains in place. some significant differences remain. IFRS switches to a continuing involvement model which results in partial derecognition. Furthermore. KPMG International is a Swiss cooperative of which all KPMG firms are members.

IFRS Financial Instruments Accounting March 2004 C. Each member firm is a separate and independent legal entity and each describes itself as such. Abbreviations AFS CCIRS FC FIFO FX GAAP HTM IASB IFRIC IFRS IGC IRS LIBOR MC SIC SPE Available-for-sale Cross currency interest rate swap Foreign currency First-in first-out method (for inventory) Foreign exchange (risk) Generally accepted accounting principles Held-to-maturity International Accounting Standards Board International Financial Reporting Interpretations Committee International Financial Reporting Standard Implementation Guidance Committee Interest rate swap London inter bank offered rate Measurement currency Standing Interpretations Committee Special purpose entity 228 Appendix C Abbreviations © 2004 KPMG International. KPMG International is a Swiss cooperative of which all KPMG firms are members. KPMG International provides no services to clients. All rights reserved. .

2 Case 6.1 Case 6.1 Case 2.2 Guarantee contract versus credit derivative Guarantee contract held by a third party 18 18 Section 4 Case 4. KPMG International provides no services to clients.3 Case 4. comparing trade date and settlement date accounting Receivables sold with full recourse Transfer of a portfolio of loans Modification of the terms of a loan 30 32 33 40 42 45 Section 5 Case 5. All rights reserved.4 Case 6.3 Case 5. Each member firm is a separate and independent legal entity and each describes itself as such.4 Case 4.IFRS Financial Instruments Accounting March 2004 D.4 Origination of a loan Held-to-maturity classification Tainting of held-to-maturity assets Held-to-maturity portfolio acquired in a business combination 54 57 58 61 Section 6 Case 6.2 Case 4. List of cases Page Section 2 Case 2. 229 . comparing trade date and settlement date accounting Sale of a bond. KPMG International is a Swiss cooperative of which all KPMG firms are members.6 Low interest loan Purchase of a bond.1 Case 4.3 Case 6.5 Case 4.5 Determining the fair value of an interest rate swap Calculation of (amortised) cost Effective interest rate calculation Measurement of monetary financial instruments denominated in a foreign currency Impairment of a loan 71 76 76 80 85 Appendix D List of cases © 2004 KPMG International.1 Case 5.2 Case 5.

4 Transfer and subsequent remeasurement of held-to-maturity investments Remeasurement of an available-for-sale asset Available-for-sale debt security in a foreign currency including amortisation Measurement of available-for-sale equity securities 95 96 98 101 Section 8 Case 8. Each member firm is a separate and independent legal entity and each describes itself as such. All rights reserved.6 Case 9.7 Case 9.1 Case 7.13 Case 9.14 Case 9.8 Case 9.2 Case 9.5 Case 9.IFRS Financial Instruments Accounting March 2004 Page Section 7 Case 7.5 Hedge of a non-monetary item Hedging with a cross currency interest rate swap (CCIRS) Documentation of an FX cash flow hedge Documentation of a fair value hedge relationship Effectiveness testing 112 120 122 123 128 Section 9 Case 9. KPMG International provides no services to clients.3 Case 7.10 Case 9.3 Case 8.2 Case 7. .12 Case 9.1 Case 8.15 Case 9.4 Case 8.2 Case 8.4 Case 9.16 Fair value hedge of a fixed interest rate liability Cash flow hedge of a variable rate liability Cash flow hedge using an interest rate cap Net position hedging – interest rate risk Hedging on a group basis – interest rate risk Cash flow hedge of foreign currency sales transactions Cash flow hedge of foreign currency purchase transactions Fair value hedge of foreign currency risk on available-for-sale equities Net position hedging – foreign currency risk Hedging on a group basis – foreign currency risk Hedged item in a net investment hedge Hedgeable components of a net investment in a foreign entity Hedge of a net investment in a foreign entity Fair value hedge of commodity price risk Cash flow hedge of commodity price risk Fair value hedge of equity securities 141 144 147 154 155 159 163 165 169 170 172 172 174 177 179 181 230 Appendix D List of cases © 2004 KPMG International.11 Case 9.9 Case 9. KPMG International is a Swiss cooperative of which all KPMG firms are members.1 Case 9.3 Case 9.

Each member firm is a separate and independent legal entity and each describes itself as such. 231 .1 Case 10. KPMG International provides no services to clients.2 Case 10. All rights reserved.4 Income statement impact of a convertible bond Example disclosure of risk management objectives and policies Example disclosures of types of hedges Example disclosure of gains or losses on hedging instruments recognised in equity 190 199 200 201 Appendix D List of cases © 2004 KPMG International. KPMG International is a Swiss cooperative of which all KPMG firms are members.3 Case 10.IFRS Financial Instruments Accounting March 2004 Page Section 10 Case 10.

London EC4M 6XH. All rights reserved. No one should act upon such information without appropriate professional advice after a thorough examination of the particular situation. © 2003 International Accounting Standards Committee Foundation (IASCF). is a network of independent member firms. agents. or joint venturers. subsidiaries. 208149 March 2004 . there can be no guarantee that such information is accurate as of the date it is received or that it will continue to be accurate in the future.com The information contained herein is of a general nature and is not intended to address the circumstances of any particular individual or entity. KPMG International is a Swiss cooperative of which all KPMG firms are members. Portions of various IASB documents. KPMG International and its member firms are legally distinct and separate entities. United Kingdom. 30 Cannon Street.kpmg. They are not and nothing contained herein shall be construed to place these entities in the relationship of parents. KPMG International provides no services to clients. © 2004 KPMG International. Printed in the United Kingdom. Each member firm is a separate and independent legal entity and each describes itself as such. Complete copies of these documents are available from the IASB. No member firm has any authority (actual. Although we endeavour to provide accurate and timely information. are reprinted with permission. partners. KPMG International provides no audit or other client services. KPMG International. implied or otherwise) to obligate or bind KPMG International or any member firm in any manner whatsoever. Such services are provided solely by member firms in their respective geographic areas. a Swiss cooperative. apparent.

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