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IAS 32 and IAS 39IAS 32 and IAS 39
Accounting for Financial InstrumentsAccounting for Financial Instruments
Advanced – IBR – 3 december 2010Advanced – IBR – 3 december 2010
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DisclaimerDisclaimer
Th i f ti t i d h i i f l t d i tThe information contained herein is of a general nature and is not intended to address the circumstances of any particular individual or
entity. Although we endeavor to provide accurate and timely information, 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. No one should act on such information without appropriate professional advice after a thorough examination of the
particular situation.
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AgendaAgenda
Definitions categories recognitionDefinitions categories recognitionDefinitions, categories, recognition and measurement
Hedge accounting
Presentation
Definitions, categories, recognition and measurement
Hedge accounting
Presentation
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Definition of financial instrumentsDefinition of financial instruments
A financial instrument is a contract that gives rise to:• a financial asset of one entity and • a financial liability or equity instrument of another entity
Financialasset
CashEquity instrument of another entityContractual right to receive cash or another
Financialliability
Equity instrument
Contractual obligation to deliver cash or another financial asset or to ex-change financial asset or liabilities under potentially unfavourable conditions
Contract evidencing a residual interest in the assets of an entity after deducting all of its liabilities
a financial liability or equity instrument of another entity
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financial asset or to exchange financial assets or liabilities under potentially favourable conditionsCertain contracts settled in the entity’s own equity
unfavourable conditionsCertain contracts settled in the entity’s own equity
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Categories of financial instrumentsCategories of financial instruments
4 categories of financial assets:
A financial asset at fair value through profit or loss
Held-to-maturity investments
Loans and receivables
Available-for-sale financial assets
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Categories of financial instrumentsCategories of financial instruments
2 categories of financial liabilities:
A financial liability at fair value through profit or loss
Other financial liabilities
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Definition - DerivativeDefinition - Derivative
Three characteristics
No or little initial net investment
Settled at a future date
Fair value changes in response to the change in underlying
Interest rate,Security price, Commodity price
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Commodity price, Foreign exchange rate, Credit rating, orOther index
RecognitionRecognition
All financial assets and financial liabilities, including derivatives,
should be recognised on the balance sheet when the entityshould be recognised on the balance sheet when the entity
becomes party to the contractual provisions of the instrument
Financial assets
@
Financial liabilities
@
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“fair value of consideration
given”
“fair value of consideration
received”
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Subsequent measurement of financial instrumentsSubsequent measurement of financial instruments
Instrument Measurement Value changes
P&LFinancial assets at fair value through profit or loss Fair value
Not relevant(unless impaired)
P&L
Held-to-maturity investments
Amortised cost(effective interest rate)
Not relevant(unless impaired)
Amortised cost(effective interest rate)
Loans and receivables
Available-for-sale Fair value
g p
Financial liabilities at fair
Equity(unless impaired)
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P&L
P&L
Derivatives Fair value
Financial liabilities at fair value through profit or loss Fair value
Other liabilities Not relevantAmortised cost
AgendaAgenda
Definitions categories recognitionDefinitions categories recognitionDefinitions, categories, recognition and measurement
Hedge accounting
Presentation
Definitions, categories, recognition and measurement
Hedge accounting
Presentation
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Introduction to hedge accountingIntroduction to hedge accounting
To hedge or not to hedge
i t th tiis not the question
Whether to apply hedge accounting
that is the issue
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How are financial risk management and hedge accounting related?How are financial risk management and hedge accounting related?
Financial Risk Management
Accept risks Mitigate risks
Hedging
Typesof Financial
Risks
Risk objectsand
exposure
RM tacticsRM
Instruments
Risk identification Risk Management Strategy
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Other
Hedge accounting
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Reasons for Special Hedge AccountingReasons for Special Hedge Accounting
Recognition mismatchesbetween hedged item
and hedging instruments
i.e.because the hedged item is not
yet recognised in the balance sheet
Measurement mismatchesbetween hedged item
and hedging instruments
i.e.because the hedged item is not
measured at fair value
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recognised in the balance sheetor in the income statement
measured at fair value
Hedgeable risksHedgeable risks
Hedgeable risks on financial asset/liability:
Interest rate risk
Foreign currency risk
Credit risk
Equity price risk
Hedgeable risks on non-financial asset/non-
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financial liability:
Entire risk
Foreign currency risk component
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Hedged itemHedged item
To qualify for designation the hedged item should create an exposure to risk that ultimately affects profit or loss
The following can be designated as hedged items:
A single or group of assets/liabilities
Firm commitments or highly probable forecast transactions
Non-financial assets/liabilities for foreign currency risk or the entire risk
A portion of the cash flows on any financial asset/liability
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A portion of the cash flows on any financial asset/liability
Net investments in foreign operations
Net positions cannot be designated as hedged items
Hedging instrumentHedging instrument
The following can be designated as hedging instruments:
All derivatives with third parties
Non-derivatives for a hedge of foreign currency risk
Combination of two or more derivatives or non-derivatives, except for net written options
Portion of hedging instrument can be used as well (say 50% of the notional)
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Hedging instrument cannot be designated for a portion of its life
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Types of hedgesTypes of hedges
Fair value hedges
Hedge of exposure to changes in fair value of:
Cash flow hedges
Hedge of exposure to variability in cash flows that is:attributable to a particular risk associated with a recognised asset or liability or a
a recognised asset or liability; an unrecognised firm commitment; or an identified portion of any of the above two;
that is attributable to a particular risk; and
could affect P&L
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attributable to a particular risk associated with a recognised asset or liability or a highly probable forecast transaction (also an inter-company one); and
could affect P&L
Hedges of a net investment in a foreign operation
Fair value hedge accounting modelFair value hedge accounting model
Measurement of hedging instrument
Changes in fair value
Fair value
Measurement of hedged item
Fair value with
Profitor
loss
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Fair value with respect to risk
being hedged (*)
(*) This applies even if a hedged item is otherwise measured at cost
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Cash flow hedge accounting modelCash flow hedge accounting model
Changesin fair valueMeasurement of
EffectiveEquity
(*)
hedging instrument
Fair value
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Profitor loss
(*) Based on timing of earnings impact of hedged item (e.g. cost of sales, depreciation, interest)
Hedge accounting criteriaHedge accounting criteria
Exposure must be due to specific hedgeable risk that ultimately affects earnings
At inception, the hedge must be expected to be highly effective and effectiveness must be reliably measurable
The hedge must remain highly effective during the whole period of the hedge
The hedging relationship should be formally
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The hedging relationship should be formally designated
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Hedge accounting criteria (continued)Hedge accounting criteria (continued)
Formal documentation is required at the inception of the hedge and must include:
Identification of the hedging instrument and the hedged item or transaction
The nature of the risk being hedged
The risk management objective and strategy for undertaking the hedge
How effectiveness will be assessed
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How effectiveness will be assessed
The rules are strict, thus costs/benefits of hedge accounting should be considered
Assessment of hedge effectivenessAssessment of hedge effectiveness
Prospective assessmentAt inception and throughout the life of the hedge
Retrospective assessment At each reporting date and throughout the life of the hedgeg
Be highly effective in offsetting changesTesting methods (e.g. regression analysis, risk-reduction test, etc.) Hedging results within the range of 80-125%
g gTesting methods (e.g. dollar-offset, regression analysis, etc.)Hedging results within the range of 80-125%
Discontinue hedge accounting
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Hedge accounting; ineffectiveness to profit or loss125%
100%
80%
Hedge accounting; ineffectiveness to profit or loss
Discontinue hedge accounting
Discontinue hedge accounting
Hedge accounting; ineffectiveness to profit or loss
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Hedge accounting - General guidelines Effectiveness – Assessment versus MeasurementHedge accounting - General guidelines Effectiveness – Assessment versus Measurement
Purpose
When
Assessment Measurement
At inception of the hedge
To provide a basis for the application of hedge accounting
N/A
At each reporting date
Ongoing assessment of the expected hedge effectiveness to provide a basis going forward
Measurement of the actual effectiveness for:
Decision on continued application of hedge accounting
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Recording of ineffective part of the hedge to be included in the income statement
Cash flow hedge Effectiveness TestCash flow hedge Effectiveness Test
On 1 January 2008 Dotcom enters into a qualifying cash flow hedgef ti i t d t ti t d t b t 1 Mof an anticipated transaction expected to occur on or about 1 May
2008. Every month Dotcom calculates the present value of theexpected cash flows of this anticipated transaction. CorporateTreasury of Dotcom reports the fair value of the forward used to
hedge the FX exposure.
31/1 28/2 31/3 30/4
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Fair value derivative
-100 -150 -40 100
Fair Value forecasted Cash Flow
90 160 50 -90
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Cash flow hedge Effectiveness TestCash flow hedge Effectiveness Test
Question:Determine on a monthly basis whether the hedge is considered highly effective?
31/01 28/02 31/03 30/04
Cumulative result on forward contract
-100 -150 -40 100
Cumulative result on expected future cash flows
90 160 50 -90
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expected future cash flows
Cumulative dollar offset 111% 94% 80% 111%
Cash flow hedge Effectiveness TestCash flow hedge Effectiveness Test
Question:Determine the ineffective portion of the hedge by month.
31/01 28/02 31/03 30/04
Cumulative effective portion -90 -150 -40 90
Actual change in value of forward
-100 -50 110 140
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Change in effective portion -90 -60 110 130
Ineffective portion -10 10 0 10
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Cash Flow Hedge Accounting of Forecast Intragroup TransactionCash Flow Hedge Accounting of Forecast Intragroup Transaction
A highly probable forecasted internal transaction can be designated as the hedged item in consolidated financial statements if:
The transaction is denominated in a currency other than the functional currency of the entity entering into the transaction; and
It will affect the group P&L
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Hedges of a net investmentHedges of a net investment
Must meet requirements for hedge accounting
Accounting treatment similar to that of a cash flow ghedge
Effective portion of gain or loss on hedging instrument recorded in the same manner as the foreign currency translation gain or loss i.e., in equity
Ineffective portion of gain or loss on hedging
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Ineffective portion of gain or loss on hedging instrument recorded in P&L
Release to P&L when the net investment is sold
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IFRIC 16 Hedges of Net Investment in a Foreign OperationIFRIC 16 Hedges of Net Investment in a Foreign Operation
Scope
addresses hedge accounting for net investments in foreign operations
guidance in IFRIC 16 does not apply to other forms of hedge accounting
Effective for annual periods beginning on or after 1 October 2008
Where existing hedge of net investment does not
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Where existing hedge of net investment does not meet the conditions in IFRIC 16, entity applies IAS 39 to discontinue the hedge prospectively
IFRIC 16 Hedges of Net Investment in a Foreign Operation (continued)IFRIC 16 Hedges of Net Investment in a Foreign Operation (continued)
IssuesIs the hedged risk the difference between the functional currency of the foreign operation andcurrency of the foreign operation and
the presentation currency of the group? the functional currency of the parent entity?
Amount of the hedged item
ConsensusApply hedge accounting to FX difference between functional currency (FC) of the foreign operation and FC of any parent
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currency (FC) of the foreign operation and FC of any parent entity (immediate, intermediate or ultimate) of that foreign operationPresentation currency risk cannot be hedgedHedged item = net assets equal to or less than the carrying amount of net assets in the consolidated financial statements of the parent
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IFRIC 16 Hedges of Net Investment in a Foreign Operation (continued)IFRIC 16 Hedges of Net Investment in a Foreign Operation (continued)
IssuesWhere within a group can the hedging instrument be held:
Can it only be held by the entity hedging the net investment?Can it only be held by the entity hedging the net investment?Can it be held by any entity within the group?
Does the nature of the hedging instrument or the method of consolidation affect effectiveness
ConsensusHedging instrument can be held by any entity within the group including the foreign operation being hedged*
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group, including the foreign operation being hedged . Hedging instrument may be a derivative or non-derivative Assessment of effectiveness is not affected by the nature of the hedging instrument or by the method of consolidation
IFRIC 16 Hedges of Net Investment in a Foreign Operation (continued)IFRIC 16 Hedges of Net Investment in a Foreign Operation (continued)
IssuesWhat amounts which should be reclassified from equity to profit or loss on disposal of the foreign operation.Whether the method of consolidation affects the amount which isWhether the method of consolidation affects the amount which is reclassified from equity to profit or loss.
ConsensusWhen the hedged foreign operation is disposed of, the cumulative gain or loss that was determined to be an effective hedge, is reclassified from the foreign currency translation reserve in the consolidated financial statements of the parent to profit or lossThe method of consolidation, i.e., step-by-step or direct, may affect the amount included in the group’s foreign currency translation
i t f th h d d t i t t
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reserve in respect of the hedged net investmentUpon disposal of the net investment, the step-by-step method may result in reclassification to profit or loss of an amount different to that used to determine hedge effectivenessDifference may be eliminated by using instead the amount based on the direct method – accounting policy choice, which should be followed consistently for all net investments (hedged and unhedged)
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Illustrative Example Illustrative Example
Step by step
FCTR for B 77M euro loss
ParentEUR
Subsidiary BGBP
Subsidiary AJPY
100%
JPY 400B100%
GBP 500M
FCTR for C 69M euro gain
Net loss 8M euro
Direct method
FCTR for B 54M euro loss
FCTR for C 46M euro gain
Net loss 8M euro
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Subsidiary CFunctional currency $
100%
USD 300M (GBP 151M)
1/1/09 31/12/09
EUR/USD 1:1.58 1:1.27
EUR/GBP 1:0.79 1:0.90
GBP/USD 1:1.99 1:1.41
Portfolio hedgingPortfolio hedging
To hedge a group of similar assets/liabilities:
Each individual item must share the hedged riskEach individual item must share the hedged risk exposure (e.g. interest, FX, price, credit rating etc.)
Changes in value due to the hedged risk must affect each item in a manner generally proportionate to the aggregate portfolio
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ExampleHedging a net positionExampleHedging a net position
Is it possible to apply ForwardIs it possible to apply hedge accounting?
Forecastpurchases
Forward contract
$20
Forecast sales
$100
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$80
Forward
SolutionHedging a net positionSolutionHedging a net position
IAS 39 i h d d
Forecast sales
$100Forecast
purchases
Forward contract
$20
IAS 39 requires hedged item to be identified
Therefore cannot hedge a net position
BUT - can designate $20 of the forecast sales as the hedged item and achieve hedge accounting
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$80Hedged sales
$20
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Discontinuation of hedge accountingDiscontinuation of hedge accounting
Fair value hedges Cash flow hedges
Future changes in fair value of hedging instr ment
Continue to be taken to profit or loss
Recognized immediately in profit or losshedging instrument profit or loss in profit or loss
Changes in fair value of hedged item
Treat as if not hedged
For hedges of interest bearing assets, adjustments to date is amortized to profit or loss over the period to maturity
N/A
Amounts recorded to date in a) Transferred to profit
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equity:
a) hedged item still exist or still expected to occur
b) hedged item or transaction no longer expected to occur
N/A
or loss at the same time as the change in the hedged cash flows is recognized in profit or loss
b) Transferred to profit or loss immediately
AgendaAgenda
Definitions categories recognitionDefinitions categories recognitionDefinitions, categories, recognition and measurement
Hedge accounting
Presentation
Definitions, categories, recognition and measurement
Hedge accounting
Presentation
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Liability or equity? Liability or equity?
Is there a contractual obligation (for what?) that the issuer cannot avoid?
Assess at initial recognition Determine liability component
Yes
Liability
No
Equity
Part
Compound instrument
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ssess at t a ecog t o
Classification continues until disposal
Determine liability component
fair value
include embedded derivatives
Equity is residual
No gain or loss on separation
IFRIC 2 Members’ Shares in Co-operative Entities and Similar InstrumentsIFRIC 2 Members’ Shares in Co-operative Entities and Similar Instruments
Members’ shares that would be classified as equity if members did not have the right to request redemption are equity if:
The entity has the unconditional right to refuse redemption of the members’ shares; or
Redemption is unconditionally prohibited by local law, regulation or the entity’s governing charter
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regulation or the entity s governing charter
21
Offsetting a financial asset and a financial liabilityOffsetting a financial asset and a financial liability
&A legally enforceable right to set off
An intention to settle net or to realise the asset and settle the liability
simultaneously
&Master netting agreements
Several instruments used to emulate a single instrument (synthetic instrument)
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Items with the same risk, but different counterparties
Financial assets pledged as collateral for non-recourse liabilities
Assets set aside in a trust to discharge a liability that have not been accepted by the creditor (sinking fund arrangements)
Obligations as a result of losses recoverable via insurance
DisclosuresSignificance of Financial Instruments for Financial Position and Performance
DisclosuresSignificance of Financial Instruments for Financial Position and Performance
Hedge accountingDescription of each type of hedge, financial instruments designated as hedging instruments and nature of risks being hedgedF h fl h dFor cash flow hedges:
when cash flows are expected to occur and when they are expected to affect profit or loss;description of forecast transactions no longer expected to occur;amount recognised in other comprehensive income (‘OCI’);amount reclassified from OCI to profit or loss; andamount removed from OCI and included in initial cost of non-financial asset or non-financial liability
For fair value hedges:gains/losses on hedging instrument; and
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gains/losses on hedging instrument; andgains/losses on hedged item attributable to hedged risk
Ineffectiveness recognised in profit or loss that arises from cash flow hedges and net investment hedges