Concepts, Rules, And Examples


Concepts, Rules, And Examples

Accounting for Debt and Equity Investments

IAS 39, which was effective in 2001, provides an entirely different strategy for the recognition and measurement of financial instruments such as debt and equity securities held as investment assets. IAS 39 also addresses accounting for financial liabilities (see Chapter 12) and the matter of hedging using financial derivatives and other instruments, which was introduced in Chapter 5 and which will be further explored later in the present chapter.

Under the provisions of IAS 39, the formerly important distinction between current and noncurrent investments is eliminated completely. Instead, the issue of "management intent" is manifested in the tripartite distinction of investments into those held for trading, those available for sale albeit not held for trading purposes, and those intended to be held to maturity. The accounting for debt and equity securities held as investments is dependent upon which of these categories they are placed in, as described in detail in Chapter 5. In the following sections of this chapter, illustrations of the accounting for such investments will be presented.

For convenience, some of the key provisions of IAS 39 are repeated in the following discussion, but these are less extensive than the presentation in Chapter 5, which should be referred to by the reader.

Determining the cost of debt and equity investments.

Debt and equity securities held as investment assets are recorded at cost, including transactions costs, as of the date when the investor entity becomes a party to the contractual provisions of the instrument. In general this date is readily determinable and unambiguous. For securities purchased "regular way" (when settlement date follows the trade date by several days), however, recognition may be on either the trade or the settlement date. Any change in fair value between these dates must be recognized (strictly speaking, regular-way trades involve a forward contract, which is a derivative financial instrument, but IAS 39 does not require that these be actually accounted for as derivatives).

Carrying amount for investments—general considerations.

Debt and equity securities held as investments are to be accounted for at fair value, if held for trading or if otherwise available for sale. Transaction costs are excluded from the fair value determinations, and thus, unless there has been an increase in value since acquisition date, there will often be a loss recognized in the first holding period, due to the fact that when originally recorded, transaction costs were included.

In the case of investments held for trading purposes, changes in fair value from period to period are included in operating results. On the other hand, in the case of investments classified as available-for-sale, the changes in fair value may either be included in current operating results, or recognized directly in equity through the statement of changes in equity, but each reporting entity must make a onetime election of which of these alternatives it will conform to thereafter. While apparently a change from reporting in equity to inclusion in current operating results would be tolerated, IAS 39 makes it quite clear that the converse could not be justified under the terms of IAS 8. In other words, it is implicit that inclusion of these gains and losses in earnings is deemed a preferable method of financial reporting.

Debt securities to be held to maturity (assuming that the conditions for this as set forth by IAS 39 are met; namely, that management has demonstrated both the intent and the ability to hold the securities until the maturity date) are maintained at amortized historical cost, unless objective evidence of impairment exists. The transaction costs included in the originally recorded basis are not eliminated, but are typically amortized as part of any premium or discount.

Constraints on use of held-to-maturity classification.

It is clear that an enterprise cannot have a demonstrated ability to hold to maturity an investment if it is subject to a constraint that could frustrate its intention to hold the financial asset to maturity. The question arises as to whether this means that a debt security that has been pledged as collateral or transferred to another party under a "repo" or securities lending transaction and continues to be recognized, cannot be classified as a held-to-maturity investment. The IGC has expressed the opinion that an enterprise's intent and ability to hold debt securities to maturity is not necessarily constrained if those securities have been pledged as collateral or are subject to a repurchase agreement or securities lending agreement. However, according to the IGC, an enterprise does not have the positive intent and ability to hold the debt securities until maturity if it does not expect to be able to maintain or recover access to the securities.

The strictures against early sales of securities that had been classified as held-to-maturity are quite severe. The IASC's IGC has observed that if an investor sells a significant amount of financial assets classified as held-to-maturity, does not classify any financial assets acquired after that date as held-to-maturity, but maintains that it still intends to hold the remaining held-to-maturity investments to maturity and accordingly does not reclassify them, the investor will be deemed not in compliance with IAS 39. According to the this interpretation, whenever a sale or transfer of more than an insignificant amount of financial assets classified as held-to-maturity results in the conditions in IAS 39 not being satisfied, no instruments should continue to be classified in that category. Thus, any remaining held-to-maturity assets are to be reclassified as either available-for-sale (most likely) or held-for-trading (very unlikely). The reclassification is recorded in the reporting period in which the sales or transfers occurred and is accounted for as a change in classification as prescribed by the standard. Once this violation has occurred, at least two full financial years must pass before an enterprise can again classify financial assets as held-to-maturity.

Another question concerning the ability to continue classification of investments as held-to-maturity relates to sales that are triggered by a change in the management of the investor entity. According to the IGC, such sales would definitely compromise the classification of other financial assets as held-to-maturity. A change in management is not identified under IAS 39 as an instance where sales or transfers from held-to-maturity do not compromise the classification as held-to-maturity. Sales that are made in response to such a change in management would, therefore, call into question the enterprise's intent to hold any of its investments to maturity.

The IGC cites an example similar to the following, of a company that held a portfolio of financial assets that was classified as held-to-maturity. In the current period, at the direction of the board of directors, the entire senior management team has been replaced. The new management wishes to sell a portion of the held-to-maturity financial assets in order to carry out an expansion strategy designated and approved by the board, as part of its recovery strategy. Although the previous management team had been in place since the enterprise's inception and the company had never before undergone a major restructuring, the sale will nevertheless call into question this entity's intent to hold remaining held-to-maturity financial assets to maturity. If the sale goes forward, all held-to-maturity securities would have to be reclassified.

Another example of the stringency of the requirements for classifying securities as held-to-maturity is suggested by an IGC position on sales made to satisfy regulatory authorities. In some countries, regulators of banks or other industries may set capital requirements on an entity-specific basis based on an assessment of the risk in that particular entity. IAS 39 indicates that an enterprise that sells held-to-maturity investments in response to an unanticipated significant increase by the regulator in the industry's capital requirements may do so under that standard without necessarily raising a question about its intention to hold other investments to maturity. The IGC has ruled, however, that sales of held-to-maturity investments that are due to a significant increase in entity-specific capital requirements imposed by regulators (contrasted to industry-wide requirements) will indeed "taint" the enterprise's intent to hold other financial assets as held-to-maturity unless it can be demonstrated that the sales fulfill the condition in IAS 39 in that they result from an increase in capital requirements which is an isolated event that is beyond the enterprise's control and that is nonrecurring and could not have been reasonably anticipated by the enterprise.

Held-to-maturity investments can be disposed of before maturity under certain conditions.

As noted above, an enterprise may not classify any financial asset as held-to-maturity unless it has both the positive intent and ability to hold it to maturity. To put teeth into this threshold criterion, IAS 39 stipulates that, if a sale of a held-to-maturity financial asset occurs, it calls into question the enterprise's intent to hold all other held-to-maturity financial assets to maturity. Exceptions are allowed for sales "close enough to maturity," and after collection of "substantially all" of the original principal.

Questions have arisen in practice on how these conditions be interpreted. In response, the IASC's IAS 39 Implementation Guidance Committee (IGC) has offered certain insights into the application of these exception criteria. According to the IGC, these conditions relate to situations in which an enterprise can be expected to be indifferent whether to hold or sell a financial asset because movements in interest rates after substantially all of the original principal has been collected or when the instrument is close to maturity will not have a significant impact on its fair value. Thus, in such situations, a sale would not affect reported net profit or loss and no price volatility would be expected during the remaining period to maturity.

More specifically, the condition "close enough to maturity" addresses the extent to which interest rate risk is substantially eliminated as a pricing factor. According to the IGC, if an enterprise sells a financial asset less than three months before its scheduled maturity, which would generally qualify for use of this exception. The impact on the fair value of the instrument for a difference between the stated interest rate and the market rate generally would be small for an instrument that matures in three months, relative to an instrument that matures in several years, for example.

The condition of having collected "substantially all" of the original principal provides guidance as to when a sale is for not more than an insignificant amount. Thus, if an enterprise sells a financial asset after it has collected 90% or more of the financial asset's original principal through scheduled payments or prepayments, the requirements of IAS 39 would probably not be deemed to have been violated. However, if the enterprise has collected only 10% of the original principal, then that condition clearly is not met. The 90% threshold is apparently not meant to be absolute, so that some judgement is still needed to operationalize this exception.

In some cases a debt instrument will have a put option associated with it; this gives the holder (the investor) the right, but not the obligation, to require that the issuer redeem the debt, under defined conditions. IAS 39 permits an enterprise to classify a puttable debt instrument as held-to-maturity, provided that the investor has the positive intent and ability to hold the investment until maturity and does not intend to exercise the put option. However, if an enterprise has sold, transferred, or exercised a put option on more than an insignificant amount of other held-to-maturity investments, the standard prohibits continued use of the held-to-maturity classification, subject to exceptions for certain sales (very close to maturity, after substantially all principal has been recovered, and due to certain isolated events). The IGC has stated that these same exceptions apply to transfers and exercises (rather than outright sales) of put options in similar circumstances. The IGC cautions, however, that classification of puttable debt as held-to-maturity requires great care, as it seems inconsistent with the likely intent of purchasing a puttable debt instrument. Given that the investor presumably would have paid extra for the put option, it would seem counter intuitive that the investor would be willing to represent that it does not intend to exercise that option.

In addition to debt securities being held to maturity, any financial asset that does not have a quoted market price in an active market, and the fair value of which cannot be reliably measured, will of necessity also be maintained at historical cost, again absent any evidence of impairment in value. Furthermore, loans or receivables which are originated by the reporting entity, and which are not held for trading purposes, are also to be maintained at historical cost, per IAS 39. Loans or receivables that are acquired from others, however, are accounted for in the same manner as other debt securities (i.e., they must be classified as held-for-trading, available-for-sale, or held-to-maturity, and accounted for accordingly).

Under IAS 39, held-to-maturity financial assets (i.e., debt instruments held for long-term investment) and originated loans are measured at amortized cost, using the effective interest method. This requires that any premium or discount be amortized not on the straight-line basis, but rather by the effective interest method to achieve a constant yield. A question arises as to how discount or premium arising in connection with the purchase of a variable-rate debt instrument should be amortized (i.e., whether it should be amortized to maturity or to the next repricing date.)

The IGC has ruled that this depends generally on whether, at the next repricing date, the fair value of the financial asset will be its par value. In theory, of course, a constantly re-pricing variable-rate instrument will sell at par value, since it offers a current yield fully reflective of market rates and the issuer's credit risk. Accordingly, the IGC notes that there are two potential reasons for the discount or premium: it either (1) could reflect the timing of interest payments—for instance, because interest payments are in arrears or have otherwise accrued since the most recent interest payment date or market rates of interest have changed since the debt instrument was most recently repriced to par—or (2) the market's required yield differs from the stated variable rate, for instance, because the credit spread required by the market for the specific instrument is higher or lower than the credit spread that is implicit in the variable rate.

Thus, a discount or premium that reflects interest that has accrued on the instrument since interest was last paid or changes in market rates of interest since the debt instrument was most recently repriced to par is to be amortized to the date that the accrued interest will be paid and the variable interest rate is reset to market. On the other hand, to the extent the discount or premium results from a change in the credit spread over the variable rate specified in the instrument, it is to be amortized over the remaining term to maturity of the instrument. In this case, the date the interest rate is next reset is not a market-based repricing date of the entire instrument, since the variable rate is not adjusted for changes in the credit spread for the specific issue.

To illustrate, a twenty-year bond is issued at $10,000,000, which is the principal (i.e., par) amount. The debt requires quarterly interest payments equal to current three-month LIBOR plus 1% over the life of the instrument. The interest rate reflects the market-based required rate of return associated with the bond issue at issuance. Subsequent to issuance, the credit quality of the issuer deteriorates, resulting in a bond rating downgrade. Thereafter, the bond trades at a significant discount. Columbia Co. purchases the bond for $9,500,000 and classifies it as held-to-maturity. In this case, the discount of $500,000 is amortized to net profit or loss over the period to the maturity of the bond. The discount is not amortized to the next date interest rate payments are reset. At each reporting date, Columbia assesses the likelihood that it will not be able to collect all amounts due (principal and interest) according to the contractual terms of the instrument, to determine the need for recognizing an impairment loss as a charge against earnings.

Example of accounting for investments in equity securities

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Assume that Raphael Corporation purchases the following equity securities for investment purposes during 2003:

Security description

Acquisition cost

Fair value at year-end

1,000 shares Belarus Steel common stock

$ 34,500

$ 37,000

2,000 shares Wimbledon pfd. "A" stock

125,000

109,500

1,000 shares Hillcrest common stock

74,250

88,750

Assume that, at the respective dates of acquisition, management of Raphael Corporation designated the Belarus Steel and Hillcrest common stock investments as being for trading purposes, while the Wimbledon preferred shares were designated as having been purchased for long term-investment purposes (and will thus be categorized as available-for-sale rather than trading). Accordingly, the entries to record the purchases were as follows:

Investment in equity securities—held-for-trading

108,750

 
  • Cash

 

108,750

Investment in equity securities—available-for-sale

125,000

 
  • Cash

 

125,000

At year-end, both portfolios are adjusted to fair market value; the decline in Wimbledon preferred stock, series A, is judged to be a temporary market fluctuation because there is no objective evidence of impairment. Raphael Corporation makes a onetime election to report these changes in fair value in equity, rather than in earnings. The entries to adjust the investment accounts at December 31, 2003, are

Investment in equity securities—held-for-trading

17,000

 
  • Gain on holding equity securities

 

17,000

Unrealized loss on securities—available-for-sale (an equity account)

15,500

 
  • Investment in equity securities—available-for-sale

 

15,500

Thus, the change in value of the portfolio of trading securities is recognized in earnings, whereas the change in the value of the available-for-sale securities is reflected directly in stockholders' equity, after being reported in equity, via the statement of changes in equity

end example

Accounting for changes in value.

Changes in the value of held-for-trading securities are taken into income currently. Changes in the value of available-for-sale securities are reflected either in earnings or directly in equity, depending on which method had been initially elected by the reporting entity. Changes in value of held-to-maturity securities, unless deemed to be impairments, are ignored. Values are normally determined with reference to market prices, but in some circumstances other approaches will need to be used, such as discounted cash flow analysis, using the discount rate apropos to the instrument's risk characteristics, term to maturity, and so forth.

When an investment in bonds is classified as available-for-sale, and the enterprise has adopted the policy of reporting fair value changes in equity until the investment is sold, the amortization of premium or discount on such an investment should be reported in net profit or loss as part of interest income or expense. The IGC has rejected the conceptual alternative mode of presentation in equity as part of the recognized fair value change. The IGC notes that, under other provisions of this standard, as well as under provisions of IAS 18 and IAS 32, these amounts are measured using the effective interest method, which means that the amortization of premium or discount is part of interest income or interest expense and, therefore, included in determining net profit or loss.

Accounting for changes in classification.

There is a limited ability to revise the classification of certain investments in financial instruments under IAS 39. Those which are first denoted as held-for-trading, however, can almost never be later defined as held-to-maturity or as available-for-sale, since it has been held by the IASC that an initial categorization as held-for-trading must be based on the original objective for the investment's acquisition. Investments denoted as available-for-sale may be reclassified to trading only if there is sufficient evidence of a recent actual pattern of short-term profit-taking to warrant this change.

Investments are also very unlikely to be reclassified to held-to-maturity after acquisition, since here, too, the original intent will be of great importance. Furthermore, investments classified as held-to-maturity may be mandatorily reclassified to available-for-sale if the entity, during the current year or the two prior years, has sold, transferred, or exercised a put option on more than an insignificant amount of similarly classified securities before maturity date. However, sales very close to the maturity dates (or exercised call dates) will not "taint" the classification of other held-to-maturity securities, nor will sales occurring after substantially all of the asset's principal has been collected (e.g., in the case of serial bonds or mortgage securities), or when made in response to isolated events beyond the entity's control (e.g., the debtor's impending financial collapse) when nonrecurring in nature and not subject to having been forecast by the entity.

Transfers out of the held-to-maturity category jeopardizes all other similar classifications.

IAS 39 requires that a held-to-maturity investment must be reclassified (to either available-for-sale or trading) and remeasured at fair value if there is a change of intent or ability. The IGC has addressed the issue of whether such a reclassification might call into question the classification of other held-to-maturity investments. It finds that such reclassifications could well raise the specter of having to reclassify all similarly categorized investments. IAS 39's requirements concerning early sales of some held-to-maturity investments applies not only to sales, but also to transfers of such investments. The term "transfer" comprises any reclassification out of the held-to-maturity category. Thus, the transfer of more than an insignificant portion of held-to-maturity investments into the available-for-sale or trading category would not be consistent with an intent to hold other held-to-maturity investments to maturity.

Transfers to held-to-maturity category.

Under IAS 39's provisions, intent and ability to hold to maturity should be assessed at each balance sheet date. While normally investments to be held to maturity are acquired with that intention specifically in mind, it is not inconceivable that investments first classified as available-for-sale would later be reclassified as held-to-maturity. If so, the then fair value becomes the cost basis of the investment, which thereafter is reported at amortized cost. For example, if bonds with a face value of $100,000 were acquired as an available-for-sale investment at a cost of $82,000 and have since risen in value to $87,500 are recategorized as held-to-maturity, the $87,500 will be the new cost basis. The $12,500 "discount" from face value will be amortized, using the effective interest method, to the projected maturity date.

The accounting for the $5,500 difference between the original acquisition cost and the fair value at the date of transfer to the held-to-maturity portfolio depends upon whether the entity had elected to report fair value changes on available-for-sale securities in earnings or in equity. If the former, the $5,500 gain had already been recognized in results of operations, and this will not be revised on a retrospective basis. However, if the gain had been reported in shareholders' equity (after being included in a statement of changes in equity), it will be accounted for by amortizing it to earnings over the remaining holding period. In the present case, assuming recognition in equity had been chosen, the effective discount on the bonds will be $18,000, all of which will be amortized to earnings over the term to maturity, so as to produce a constant return on the increasing book value of the investment.

Transfers between available-for-sale and trading investment categories.

Under the provisions of IAS 39, investments held first for trading purposes cannot later be reclassified to available-for-sale; conversely, transfers to the trading portfolio are expected to be infrequent, occurring only when there is evidence of trading behavior by the enterprise which strongly suggests that the investment in question will indeed be traded in the short term.

Under IAS 39, if there is evidence of a recent actual pattern of short-term profit-taking, the reporting entity is to reclassify a financial asset into the trading category. However, the method by which gains and losses on an equity investment that have been deferred in equity are be recognized was not specified in that standard. The IGC has resolved this issue, reasoning by analogy from another provision in IAS 39, which deals with a different reclassification situation (whereby a financial asset formerly carried at fair value is to be reported henceforth at amortized cost).

The IGC holds that where the changes in fair value subsequent to initial recognition have been recognized directly in equity for the available-for-sale equity investment, it is inappropriate to recognize a gain or loss on the transfer since this would allow too much flexibility in the timing of revenue recognition in net profit or loss. Instead, the gain or loss upon the transfer is recognized as follows: the cumulative prior fair value change on that asset that had been recognized directly in equity is left in equity until the financial asset is sold or otherwise disposed of, at which time it enters into the determination of net profit or loss.

The IGC derived comfort from the fact that this prescription is consistent with a provision of IAS 39 that addresses discontinuance of hedge accounting. That provision requires that the cumulative prior fair value change that was reported in equity remains in equity until the forecasted transaction occurs for cash flow hedging relationships. In any event, if there is evidence of a recent actual pattern of short-term profit-taking that justifies reclassification, the turnover in the portfolio would often result in the gains or losses being recognized in net profit or loss within a reasonably short period after reclassification.

To illustrate, consider Raphael Corporation's investment in Hillcrest common stock, which was assigned to the trading portfolio and at December 31, 2003, was marked to fair value of $88,750. If in April 2004 management were to determine that this investment will not be traded, but rather will continue to be held indefinitely, it would be constrained by IAS 39 from altering the accounting for the investment. Thus, it would have to be maintained as a trading investment, continually marked to fair value, with value changes reflected in current operating results, notwithstanding the intent to not trade it.

To illustrate, consider the investment in Wimbledon preferred stock, which was held as an available-for-sale asset, and which in March 2004 was adjusted to a fair value of $112,000 (as illustrated above). The increase from adjusted cost ($109,500) was reflected in changes in equity rather than in earnings, consistent with the entity's elected accounting method, and given that the security was not at the time being held for trading. Now assume that, in June 2004, there is evidence of a recent actual pattern of short-term profit-taking in the portfolio in which the investment was held which justifies its reclassification into the trading category. Further, the value of the shares held, at the date of this decision, is $114,700. The entry to record the transfer from available-for-sale to trading is as follows:

Investment in equity securities—held-for-trading

114,700

 
  • Investment in equity securities—available-for-sale

 

112,000

  • Unrealized gain on securities—available-for-sale (an equity account)

 

2,700

There is no recognized gain or loss at the time of transfer because where changes in fair value subsequent to initial recognition have been recognized directly in equity for an available-for-sale equity investment, it is inappropriate to recognize a gain or loss on the transfer to trading. The gain or loss recorded in an equity account remains there until such time as the security is ultimately sold. While this rule was not explicit in IAS 39, it was subsequently set forth by the IGC, which analogized from another requirement of the standard.

Any further gains or losses after the transfer to the trading portfolio will be handled as earlier described (i.e., recognized in income currently). When the asset is sold or otherwise derecognized, the cumulative gain or loss in equity is removed from equity and included in net profit or loss.

Transfers among portfolios, to the extent permitted, are to be made at fair value as of the date of transfer.

Example of accounting for debt securities

start example

Marseilles Corporation purchases the following debt securities as investments in 2002:

Issue

Face value

Price paid[a]

DeLacroix Chemical 8% due 2007

$200,000

$190,000

Forsythe Pharmaceutical 9.90% due 2019

500,000

575,000

Luckystrike Mining 6% due 2004

100,000

65,000

[a]Accrued interest is ignored in these amounts; the normal entries for interest accrual and receipt are assumed.

Management has stated that Marseilles's objectives differed among the various investments. Thus, the DeLacroix bonds are considered to be suitable as a long-term investment, with the intention that they will be held until maturity. The Luckystrike bonds are a speculation; the significant discount from par value was seen as very attractive, despite the low coupon rate. Management believes the bonds were depressed because mining stocks and bonds have been out of favor, but believes the economic recovery will lead to a surge in market value, at which point the bonds will be sold for a quick profit. The Forsythe Pharmaceutical bonds are deemed a good investment, but with a maturity date sixteen years in the future, management is unable to commit to holding these to maturity.

Based on the foregoing, the appropriate accounting for the three investments in bonds would be as follows:

  • DeLacroix Chemical 8% due 2007

    These should be accounted for as held-to-maturity; maintain at historical cost, with the discount ($10,000) to be amortized over term to maturity using the effective interest method.

  • Forsythe Pharmaceutical 9.90% due 2019

    Account for these as available-for-sale, since neither the held-for-trading nor held-to-maturity criteria apply. These should be reported at fair market value at each balance sheet date, with any unrealized gain or loss included in the equity account (consistent with the entity's normal accounting practice), unless an impairment occurs.

  • Luckystrike Mining 6% due 2004

    As an admitted speculation, these should be accounted for as part of the trading portfolio, and also reported at fair market value on the balance sheet. All adjustments to carrying value will be included in earnings each year, whether the fair value fluctuations are temporary or permanent in nature.

end example

Accounting for Transfers between Portfolios

Transfers between portfolio categories are to be accounted for at fair market value at the date of the transfer, as described above. However, only certain types of transfers are permitted under IAS 39, as the standard has been interpreted by the IGC. For example, transfers to or from the trading category are almost never permitted, since there is a strong presumption that trading securities are properly defined at the date of their acquisition. (In rare cases, securities available-for-sale will be recategorized as trading when other, very similar securities have in fact been actively traded by the reporting entity.)

To better understand the limited opportunity for reclassification of securities held as trading, available-for-sale or held-to maturity investments by the entity, and the accounting for such transfers as are permitted, consider the following events:

  1. Marseilles management decides in 2003, when the Forsythe bonds have a market (fair) value of $604,500, that the bonds will be disposed of in the short term, hopefully when the price hits $605,000. While it might previously have been acceptable to reclassify these to the trading account based on management's current intentions, the IGC has held that a decision to sell a financial asset does not make it a financial asset held for trading. The rare exception to this general principle, according to the IGC, would occur when there is a portfolio of very similar assets for which there is a recent pattern of trading; in such case, reclassification of the remaining items to trading would be justified. In this present example, there are no other holdings that are virtually the same as the Forsythe bonds; accordingly, no reclassification can be permitted.

  2. In 2003, Marseilles management also made a decision about its investment in DeLacroix Chemical bonds. These bonds, which were originally designated as held-to-maturity, were accounted for at amortized historical cost. Assume the amortization in 2002 was $2,000 (because the bonds were not held for a full year), so that the book value of the investment at year-end 2002 was $192,000. In 2003, at a time when the value of these bonds was $198,000, management concluded that it was no longer certain that they would be held to maturity. While the change in management's intention could be seen as providing support for a reclassification of this investment to the available-for-sale portfolio, to do so would raise a tainting concern which would jeopardize any classification of further investments as held-to-maturity.

According to IAS 39, investments in debt instruments may be categorized as held-to-maturity only when there is a positive intent to do so. The intent is absent when the reporting entity stands ready to sell that asset in response to changes in market conditions or the entity's liquidity needs, among other considerations. As described here, Marseilles management seemingly has reacted to either market conditions or its own liquidity needs in effectively retracting its commitment to hold the DeLacroix bonds to maturity. If reclassification were effected, there would be a presumption that no other fixed maturity investment could thereafter be classified as held-to-maturity—there would be tainting which would preclude usage of that classification. This would apply even to other investments being held currently, where no intent to dispose before maturity was manifested. Thus (as interpreted by the IGC), the tainting issue must be taken extremely seriously.

It should also be understood that transfers into the held-to-maturity category would not be feasible, since essentially the characteristics of intent and ability as of the date of acquisition would not have been satisfied. Thus, the guidance under IAS 39 is substantially more rigid than the superficially identical set of criteria under US GAAP.

Accounting for impairments in value.

A financial asset will be deemed to have become impaired whenever the carrying amount exceeds the recoverable amount. This is to be assessed at each balance sheet date, making reference, for example, to any significant financial difficulties of the issuer, a contractual breach by the issuer, the probability of a bankruptcy or financial reorganization, or the disappearance of an active market for the issuer's securities (although an enterprise which has "gone private" does not create the presumption of impairment).

In general, trading securities will be carried at fair value and any impairment will have been recognized as it was developing, with immediate recognition in the operating results of the investor. Available-for-sale securities will similarly have been adjusted to fair value, with any loss given recognition in earnings, even if the reporting enterprise had elected to report normal value changes (i.e., those not due to permanent impairments) in equity. In this latter instance, the amount of value decline previously reported in equity must also be removed from equity and reported in current operations.

For securities being reported at amortized historical cost (those held to maturity, plus loans or receivables originated by the enterprise), the amount of the impairment to be recognized will be the difference between the carrying amount and the present value of expected future cash flows, discounted using the instrument's original discount rate. The current market discount rate is not to be used, since to do so would introduce an element of fair value accounting, which is not pertinent to such investments. Any write-down for impairment, which may be made directly or via an allowance account, must be reported in current operating results. If later events, such as a revision in the obligor's credit rating, result in a lessened measure of impairment, the previously recognized impairment may be partially or fully reversed, also through reported earnings.

Securities that are not carried at fair value because of the absence of fair value information are nonetheless subject to review for possible impairments. These are measured as the difference between carrying amount and the present value of expected future cash flows, discounted using the current market interest rate for similar instruments. Note that current rates, not the original effective rate, are the relevant reference, since these investments were being maintained at cost by default (i.e., due to the absence of reliable fair value data), not because they qualified for amortized historical cost due to being held to maturity. Accordingly, the application of fair value accounting, or a reasonable surrogate for it, is valid in such instances.

Once an asset is deemed impaired and written down to its estimated recoverable amount, future interest is accreted using the same discount rate used to compute the impaired value. Thus, for held-to-maturity investments, after being adjusted to recoverable amount, the interest accruals will continue to be consistent with the original effective rate. For securities not carried at fair value due to lack of sufficient information, however, future interest income, if any, will be accrued using the current rate employed to determine the recoverable amount to which the asset's carrying value was adjusted.

Market value decline is not necessarily evidence of impairment.

The fair (i.e., market) value of an equity security that is classified as available-for-sale may fall below its cost. As interpreted by the IGC, this is not necessarily evidence of impairment. When an entity reports fair value changes on available-for-sale financial assets in equity in accordance with IAS 39, it continues to do so until there is objective evidence of impairment, such as the circumstances identified in the standard. If objective evidence of impairment exists, any cumulative net loss that has been recognized directly in equity is removed and recognized in net profit or loss for the period.

Value increases in some portfolio assets cannot be used to offset impairment losses from other assets.

IAS 39 requires that impairment be recognized for financial assets carried at amortized cost. IAS 39 states that impairment may be measured and recognized individually or, for a group of similar financial assets, on a portfolio basis. The IGC has ruled that if one asset in the group is impaired but the fair value of another asset in the group is above its amortized cost, nonrecognition of the impairment of the first asset is not permitted. If an enterprise knows that an individual financial asset carried at amortized cost is impaired, IAS 39 requires that the impairment of that asset be recognized. Measurement of impairment on a portfolio basis under IAS 39 is applicable only when there is indication of impairment in a group of similar assets, and impairment cannot be identified with an individual asset in that group.

Assessment of loan impairment must take into consideration related interest rate swap.

An originated loan with fixed interest rate payments is hedged against the exposure to interest rate risk by a "receive-variable pay-fixed" interest rate swap. The hedge relationship qualifies for fair value hedge accounting and is reported as a fair value hedge. Thus, the carrying amount of the loan includes an adjustment for fair value changes attributable to movements in interest rates. According to an interpretive finding by the IGC, an assessment of impairment in the loan should take into account the fair value adjustment for interest rate risk. The IGC has stated that, since the loan's original effective interest rate prior to the hedge is made irrelevant once the carrying amount of the loan is adjusted for any changes in its fair value attributable to interest rate movements, the original effective interest rate and amortized cost of the loan are adjusted to take into account recognized fair value changes. The adjusted effective interest rate is calculated using the adjusted carrying amount of the loan. An impairment loss on the hedged loan should therefore be calculated as the difference between its carrying amount after adjustment for fair value changes attributable to the risk being hedged and the expected future cash flows of the loan discounted at the adjusted effective interest rate.

Recognition of impairment of loans.

Assume that, due to financial difficulties of Knapsack Co., one of its customers, the Galactic Bank, becomes concerned that Knapsack will not be able to make all principal and interest payments due on an originated loan when they become due. Galactic negotiates a restructuring of the loan, and it now expects that Knapsack will be able to meet its obligations under the restructured terms. Whether Galactic Bank will recognize an impairment loss—and in what magnitude—will depend, according to the IGC, on the specifics of the restructured terms. The IGC offers the following guidelines:

If, under the terms of the restructuring, Knapsack Co. will pay the full principal amount of the original loan five years after the original due date, but none of the interest due under the original terms, an impairment must be recognized, since the present value of the future principal and interest payments discounted at the loan's original effective interest rate (i.e., the recoverable amount) will be lower than the carrying amount of the loan.

If, on the other hand, Knapsack Co.'s restructuring agreement calls for it to pay the full principal amount of the original loan on the original due date, but none of the interest due under the original terms, the same result as the foregoing will again hold. The impairment will be measured as the difference between the former carrying amount and the present value of the future principal and interest payments discounted at the loan's original effective interest rate.

As yet another variation on the restructuring theme, if Knapsack will pay the full principal amount on the original due date with interest, only at a lower interest rate than the interest rate inherent in the original loan, again the same guidance is offered by the IGC, so that an impairment must be recognized.

This same outcome prevails if Knapsack agrees to pay the full principal amount five years after the original due date and all interest accrued during the original loan term, but no interest for the extended term. Since the present value of future cash flows is lower than the loan's carrying amount, impairment is to be recognized.

As a final option, the IGC offers the loan restructuring situation whereby Knapsack is to pay the full principal amount five years after the original due date and all interest, including interest for both the original term of the loan and the extended term. In this scenario, even though the amount and timing of payments has changed, Galactic Bank will nonetheless receive interest on interest, so that the present value of the future principal and interest payments discounted at the loan's original effective interest rate will equal the carrying amount of the loan. Therefore, there is no impairment loss.

Example of impairment of investments

start example

Given the foregoing, assume now, with reference again to the Raphael Corporation example first presented earlier in this chapter, that in January 2004 new information comes to Raphael Corporation management regarding the viability of Wimbledon Corp. Based on this information, it is determined that the decline in Wimbledon preferred stock is probably not a temporary one, but rather is an impairment of the asset as that term is used in IAS 39. The standard prescribes that such a decline be reflected in earnings. The stock's fair value has remained at the amount last reported, $109,500, but this value is no longer viewed as being only a market fluctuation. Accordingly, the entry to recognize the fact of the investment's permanent impairment is as follows:

Impairment loss on holding equity securities

15,500

 
  • Unrealized loss on securities—available-for-sale (an equity account)

 

15,500

Any recovery in this value would be recognized in earnings if it can be objectively demonstrated that the recovery was based on subsequent developments. Otherwise, later market fluctuations will be reported in either equity or earnings, based on the accounting method the entity elected for reporting normal changes in the fair value of available-for-sale investments.

To illustrate this point, assume that in March 2004 further information comes to management's attention, which now suggests that the decline in Wimbledon preferred had indeed been only a temporary decline; in fact, the value of Wimbledon now rises to $112,000. There is no evidence of any specific event after the date of the impairment that is responsible for this recovery in value. Since the carrying value after the recognition of the impairment was $109,500, the increase to $112,000 will be accounted for as an increase to be reflected in earnings. Accordingly, the entry now required is

Investment in equity securities—available-for-sale

2,500

 
  • Reversal of impairment loss—available-for-sale

 

2,500

Note that increases in value above the original cost basis are not taken into earnings, since the investment is still considered to be available-for-sale, rather than a part of the trading portfolio. Increases in value up to the original cost basis are recognized in current earnings.

end example

Structured notes as held-to-maturity investments.

Among the more complex of what are commonly referred to as "engineered" financial products, which have become commonplace over the last decade, are "structured notes." Structured notes and related products are privately negotiated and not easily marketable once acquired. These instruments often appear to be straightforward debt investments, but in fact contain provisions which have the potential to greatly increase or decrease the return to the investor, based on (typically) the movement of some index related to currency exchange rates, interest rates, or, in some cases, stock price indices. The IGC has addressed the question of whether these assets can be considered as held-to-maturity investments. The IGC offers as an example a structured note tied to an equity price index, upon which the following illustration is based.

Cartegena Co. purchases a five-year "equity-index-linked note" with an original issue price of $1,000,000 at a market price of $1,200,000 at the time of purchase. The note requires no interest payments prior to maturity. At maturity, the note requires payment of the original issue price of $1,000,000 plus a supplemental redemption amount that depends on whether a specified stock price index (e.g. the Dow Jones Industrial Average) exceeds a predetermined level at the maturity date. If the stock index does not exceed or is equal to the predetermined level, no supplemental redemption amount is paid. If the stock index exceeds the predetermined level, the supplemental redemption amount will equal 1.15 times the difference between the level of the stock index at maturity and the level of the stock index at original issuance of the note divided by the level of the stock index at original issuance.

Obviously, the investment is largely a gamble on an increase in the Dow Jones average over the five-year term, since Cartegena is paying a substantial premium and, as a worst case scenario, could lose its entire premium plus the opportunity cost of lost interest over the five years. Structured notes such as this are very difficult to dispose of on the secondary (i.e., resale) market, having been created (structured) to fit the unique needs or desires of the issuer and investor. Determining a fair value at any intermediate point in the five-year holding period would be difficult or impossible, absent arm's-length bids, particularly if the underlying index has yet to advance to a level at which a gain will be reaped by the investor.

In the present example, assume that Cartegena has the positive intent and ability to hold the note to maturity. According to guidance issued by the IGC, it can indeed classify this note as a held-to-maturity investment, because it has a fixed payment of $1,000,000 and a fixed maturity, and because Cartegena Co. has the positive intent and ability to hold it to maturity. However, the equity index feature is a call option not closely related to the debt host, and accordingly, it must be separated as an embedded derivative under IAS 39. The purchase price of $1,200,000 must be allocated between the host debt instrument and the embedded derivative. For instance, if the fair value of the embedded option at acquisition is $400,000, the host debt instrument is measured at $800,000 on initial recognition. In this case, the discount of $200,000 that is implicit in the host bond is amortized to net profit or loss over the term to maturity of the note using the effective interest method.

A similar situation arises if the investment is a bond with a fixed payment at maturity and a fixed maturity date, but with variable interest payments indexed to the price of a commodity or equity (commodity-indexed or equity-indexed bonds). If the enterprise has the positive intent and ability to hold the bond to maturity, it can be classified as held-to-maturity. However, as confirmed in an interpretation offered by the IGC, the commodity-indexed or equity-indexed interest payments result in an embedded derivative that is separated and accounted for as a derivative at fair value. The special exception in IAS 39, under which, if the two components cannot be reasonably separated the entire financial asset is classified as held for trading purposes, is found not to be applicable. According to the IGC, it should be straightforward to separate the host debt investment (the fixed payment at maturity) from the embedded derivative (the index-linked interest payments).

Accounting for sales of investments in financial instruments.

In general, sales of investments are accounted for by eliminating the carrying value and recognizing a gain or loss for the difference between carrying amount and sales proceeds. Derecognition will occur only when the entity loses control over the contractual rights which comprise the financial asset, or a portion thereof. IAS 39 sets forth certain conditions to define loss of control. Thus, for example, in most cases if the transferor has the right to reacquire the transferred asset, derecognition will not be warranted, unless the asset is readily obtainable in the market or reacquisition is to be at then-fair value. Arrangements which are essentially repurchase (repo) arrangements are similarly not sales and do not result in derecognition. In general, the transferee must obtain the benefits of the transferred asset in order to warrant derecognition by the transferor.

In some instances, the asset will be sold as part of a compound transaction in which the transferor either retains part of the asset, obtains another financial instrument, or incurs a financial liability. If the fair values of all components of the transaction (asset retained, new asset acquired, etc.) are known, computing the gain or loss will be no problem. However, if one or more elements are not subject to an objective assessment, special requirement apply. In the unlikely event that the fair value of the component retained cannot be determined, it should be recorded at zero, thereby conservatively measuring the gain (or loss) on the transaction. Similarly, if a new financial asset is obtained and it cannot be objectively valued, it must be recorded at zero value.

On the other hand, if a financial liability is assumed (e.g., a guarantee) and it cannot be measured at fair value, then the initial carrying amount should be such (i.e., large enough) that no gain is recognized on the transaction. If necessitated by IAS 39's provisions, a loss should be recognized on the transaction. For example, if an asset carried at $4,000 is sold for $4,200 in cash, with the transferor assuming a guarantee obligation which cannot be valued (admittedly, this is unlikely to occur in the context of a truly "arm's-length" transaction), no gain would be recognized and the financial liability would accordingly be initially recorded at $200. On the other hand, if the selling price were instead only $3,800, a loss of $200 would be immediately recognized, and the guarantee obligation would be given no value (but would be disclosed).

Presentation and Disclosure Issues

Income statement presentation.

Under IAS 39, significant items of income, expense, gain and loss deriving from financial assets and financial liabilities are to be given sufficient disclosure. This applies equally to those items included in the income statement, and those reflected directly in equity. Interest income and interest expense are to be disclosed on a "gross" basis (i.e., interest income is not to be netted against interest expense). Additional disclosure is required of interest accrued on impaired loans.

With regard to available-for-sale financial assets which have been adjusted to fair value, a distinction is to be maintained between the total gain or loss associated with derecognition (typically, from disposition) which is included in net income or loss for the period, and gains and losses which are value adjustments being made for the period. The most common terminology is to denote the former as realized and the latter as unrealized gains and losses.

Other disclosures required.

In addition to the distinctions to be made in the income statement or the notes thereto, IAS 39 also specifies a number of other mandatory disclosures. These include

  • The methods and key assumptions used in determining fair values of financial assets and liabilities, separately by major class as suggested in IAS 32

  • A statement as to whether reporting value changes in earnings or directly in equity was elected for available-for-sale securities

  • A statement as to whether trade date or settlement date accounting is used for "regular way" trades, for each of the four categories of financial assets

  • Disclosures pertaining to hedging, including describing the entity's risk management objectives and policies and policy for hedging each major type of forecasted transaction

  • For designated fair value hedges, cash flow hedges, and hedges of net investments in a foreign entity (separately), descriptions of the hedges and of the hedging instruments used, and the fair values thereof, the nature of the risks being hedged, and for forecasted transactions that are expected to occur, when the forecasted transactions are expected to enter into the determination of net income as well as descriptions of hedges of forecasted transactions that are no longer anticipated

  • For gains and losses on financial assets and liabilities designated as hedges that have been taken directly to equity, the amount so recognized in the current reporting period, the amount removed from equity and reported in earnings, and the amount removed from equity and added to the carrying value of an acquired asset or incurred liability during the reporting period

  • The amounts of fair value adjustments pertaining to available-for-sale financial assets recognized in or removed from equity during the period

  • The carrying amount and description of any trading or available-for-sale securities for which fair values could not be determined, with an explanation of why such assessments could not be made, including (where possible) ranges of likely fair values, as well as the amount of any gain or loss incurred on sales of assets for which previously fair values could not be determined

  • For each securitization or repo agreement occurring during the period, and for remaining retained interests in earlier such transactions, the nature and extent of those transactions, including descriptions of collateral and quantitative information about key assumptions used in calculating fair values therefor, and a statement as to whether the financial assets had been derecognized

  • Information about reclassifications of securities previously carried at fair value to the amortized cost basis

  • The nature and amount of any impairment loss or reversals thereof, separately for each significant class of financial asset

Accounting for Hedging Activities

The topic of hedging is almost inextricably intertwined with the subject of financial derivatives, since most (but not all) hedging is accomplished using derivatives. IAS 39 addresses both of these matters extensively, and the IGC has provided yet more instructional materials on these issues. In the following sections, a basic review of, first, derivative financial instruments, and second, hedging activities, will he presented.

Derivatives.

As defined by IAS 39, a derivative is a financial instrument with all the following characteristics:

  1. Its value changes in response to the change in a specified interest rate, security price, commodity price, foreign exchange rate, index of prices or rates, a credit rating or credit index, or similar variable (sometimes called the underlying);

  2. It requires no initial net investment or little initial net investment relative to other types of contracts that have a similar response to changes in market conditions; and

  3. It is settled at a future date.

Examples of financial instruments that meet the foregoing definition include the following, along with the underlying variable which affects the derivative's value.

Type of contract

Main pricing—settlement variable (underline variable)

Interest rate swap

Interest rates

Currency swap (foreign exchange swap)

Currency rates

Commodity swap

Commodity prices

Equity swap (equity of another enterprise)

Equity prices

Credit swap

Credit rating, credit index, or credit price

Total return swap

Total fair value of the reference asset and interest rates

Purchased or written treasury bond option (call or put)

Interest rates

Purchased or written currency option (call or put)

Currency rates

Purchased or written commodity option (call or put)

Commodity prices

Purchased or written stock option (call or put)

Equity prices (equity of another enterprise)

Interest rate futures linked to government debt (treasury futures)

Interest rates

Currency futures

Currency rates

Commodity futures

Commodity prices

Interest rate forward linked to government debt (treasury forward)

Interest rates

Currency forward

Currency rates

Commodity forward

Commodity prices

Equity forward

Equity prices (equity of another enterprise)

The issue of what is meant by "little or no net investment" has been explored by the IGC. According to the IGC, professional judgement will be required in determining what constitutes little or no initial net investment, and is to be interpreted on a relative basis—the initial net investment is less than that needed to acquire a primary financial instrument with a similar response to changes in market conditions. This reflects the inherent leverage features typical of derivative agreements compared to the underlying instruments. If, for example, a "deep in the money" call option is purchased (that is, the option's value consists mostly of intrinsic value), a significant premium is paid. If the premium is equal or close to the amount required to invest in the underlying instrument, this would fail the "little initial net investment" criterion.

A margin account is not part of the initial net investment in a derivative instrument. Margin accounts are a form of collateral for the counterparty or clearinghouse and may take the form of cash, securities, or other specified assets, typically liquid ones. Margin accounts are separate assets that are to be accounted for separately. Accordingly, in determining whether an arrangement qualifies as a derivative, the margin deposit is not a factor in assessing whether the "little or no net investment" criterion has been met.

A financial instrument can qualify as a derivative even if the settlement amount does not vary proportionately. The IAS 39 Implementation Guidance Committee offers an example of this phenomenon, similar to the following: Accurate Corp. enters into a contract that requires it to pay Aimless Co. $2 million if the stock of Reference Corp. rises by $5 per share or more during a six-month period. Conversely, Accurate Corp. will receive from Aimless Co. a payment of $2 million if the stock of Reference Corp. declines by $5 or more during that same six-month period. If price changes are within the ±$5 collar range, no payments will be made or received by the parties. This arrangement would qualify as a derivative instrument, the underlying being the price of Reference Corp. common stock. IAS 39 provides that "a derivative could require a fixed payment as a result of some future event that is unrelated to a notional amount."

In some instances what might first appear to be normal financial instruments are actually derivative transactions. The IGC offers the example of offsetting loans, which serve the same purpose and should be accounted for as an interest rate swap. The example is as follows:

Aguilar S.A. makes a five-year fixed-rate loan to Battapaglia Spa, while Battapaglia at the same time makes a five-year variable-rate loan for the same amount to Aguilar. There are no transfers of principal at inception of the two loans, since Aguilar and Battapaglia have a netting agreement. Since this meets the definition of a derivative (that is, there is an underlying variable, no or little initial net investment, and future settlement), the contractual effect of the loans is the equivalent of an interest rate swap arrangement with no initial net investment. Nonderivative transactions are aggregated and treated as a derivative when the transactions result, in substance, in a derivative.

Indicators of this would include: (1) they are entered into at the same time and in contemplation of one another, (2) they have the same counterparty, (3) they relate to the same risk, and (4) there is no apparent economic need or substantive business purpose for structuring the transactions separately that could not also have been accomplished in a single transaction. Note that even in the absence of a netting agreement, the foregoing arrangement would be deemed to be a derivative.

Difficulty of identifying whether certain transactions involve derivatives.

The definition of derivatives has already been addressed. While seemingly straightforward, the almost limitless and still expanding variety of "engineered" financial products often makes definitive categorization more difficult than this at first would appear to be. The IGC illustrates this with examples of two variants on interest rate swaps, both of which involve prepayments. The first of these, a prepaid interest rate swap (fixed-rate payment obligation prepaid at inception or subsequently) qualifies as a derivative; the second, a variable-rate payment obligation prepaid at inception or subsequently) would not be a derivative. The reasoning is set forth in the next paragraphs, which are adapted from the IGC guidance.

First consider the "pay-fixed, receive-variable" interest rate swap that the party prepays at inception. Assume Agememnon Corp. enters into a $100 million notional amount five-year pay-fixed, receive-variable interest rate swap with Baltic Metals, Inc. The interest rate of the variable part of the swap resets on a quarterly basis to the three-month LIBOR. The interest rate of the fixed part of the swap is 10% per year. Agememnon Corp. prepays its fixed obligation under the swap of $50 million (= $100 million x 10% x five years) at inception, discounted using market interest rates, while retaining the right to receive interest payments on the $100 million reset quarterly based on three-month LIBOR over the life of the swap.

The initial net investment in the interest rate swap is significantly less than the notional amount on which the variable payments under the variable leg will be calculated. The contract requires little initial net investment relative to other types of contracts that have a similar response to changes in market conditions, such as a variable-rate bond. Therefore, the contract fulfills the "no or little initial net investment" provision of IAS 39. Even though Agememnon Corp. has no future performance obligation, the ultimate settlement of the contract is at a future date and the value of the contract changes in response to changes in the LIBOR index. Accordingly, the contract is considered to be a derivative contract. The IGC further notes that if the fixed-rate payment obligation is prepaid subsequent to initial recognition, which would be considered a termination of the old swap and an origination of a new instrument, which would have to be evaluated under IAS 39.

Now consider the opposite situation, a prepaid pay-variable, receive-fixed interest rate swap, which the IGC concludes is not a derivative. This result obtains because it provides a return on the prepaid (invested) amount comparable to the return on a debt instrument with fixed cash flows. For example, assume now that Synchronous Ltd. enters into a $100 million notional amount five-year "pay-variable, receive-fixed" interest rate swap with counterparty Cabot Corp. The variable leg of the swap resets on a quarterly basis to the three-month LIBOR. The fixed interest payments under the swap are calculated as 10% times the swap's notional amount, or $10 million per year. Synchronous Ltd. prepays its obligation under the variable leg of the swap at inception at current market rates, while retaining the right to receive fixed interest payments of 10% on $100 million per year. The cash inflows under the contract are equivalent to those of a financial instrument with a fixed annuity stream, since Synchronous Ltd. knows it will receive $10 million per year over the life of the swap. Therefore, all else being equal, the initial investment in the contract should equal that of other financial instruments that consist of fixed annuities. Thus, the initial net investment in the pay-variable, receive-fixed interest rate swap is equal to the investment required in a nonderivative contract that has a similar response to changes in market conditions. For this reason, the instrument fails the "no or little net investment" criterion of IAS 39. Therefore, the contract is not accounted for as a derivative under IAS 39. By discharging the obligation to pay variable interest rate payments, Synchronous Ltd. effectively extends an annuity loan to Cabot Corp. In this situation, the instrument is accounted for as a loan originated by the enterprise unless Synchronous Ltd. has the intent to sell it immediately or in the short term.

In yet other instances, according to the IAS 39 Implementation Guidance Committee, arrangements that technically meet the definition of derivatives are not to be accounted for as such. For example, assume National Wire Products Corp. enters into a fixed-price forward contract to purchase two million kilograms of copper. The contract permits National Wire to take physical delivery of the copper at the end of twelve months or to pay or receive a net settlement in cash, based on the change in fair value of copper. While such a contract meets the definition of a derivative, it is not necessarily accounted for as a derivative. The contract is a derivative instrument because there is no initial net investment, the contract is based on the price of an underlying, copper, and it is to be settled at a future date. However, if National Wire intends to settle the contract by taking delivery and has no history of settling in cash, the contract is not accounted for as a derivative under IAS 39. Instead, it is accounted for as an executory contract for the purchase of inventory.

Just as some seemingly derivative transactions may be accounted for as not involving a derivative instrument, the opposite situation can also occur, where some seemingly nonderivative transactions would be accounted for as being derivatives. For example, Argyle Corp. enters into a forward contract to purchase a commodity or other nonfinancial asset that contractually is to be settled by taking delivery. Argyle has an established pattern of settling such contracts prior to delivery by contracting with a third party. Argyle settles any market value difference for the contract price directly with the third party. Per the IGC, this pattern of settlement prohibits Argyle Corp. from qualifying for the exemption based on normal delivery; the contract is accounted for as a derivative. IAS 39 applies to a contract to purchase a nonfinancial asset if the contract meets the definition of a derivative and the contract does not qualify for the exemption for delivery in the normal course of business. In this case, Argyle does not expect to take delivery. Under the standard, a pattern of entering into offsetting contracts that effectively accomplishes settlement on a net basis does not qualify for the exemption for delivery in the normal course of business.

Forward contracts to purchase fixed-rate debt instruments (such as mortgages) at fixed prices are to be accounted for as derivatives. They meet the definition of a derivative because there is no or little initial net investment, there is an underlying variable (interest rates), and they will be settled in the future. (Such transactions are to be accounted for as a regular way transaction, however, if regular way delivery is required. Regular way delivery is defined by IAS 39 to include contracts for purchases or sales of financial instruments that require delivery in the time frame generally established by regulation or convention in the marketplace concerned. Regular way contracts are explicitly defined as not being derivatives.)

Interest rate (and currency) swaps have become widely used financial arrangements. The IGC has noted that whether an interest rate swap settles gross or net does not impact defining a swap as a derivative. Some had expressed the concern that gross settlement, with each party paying the gross amount due based on the defined notional amounts and interest rates, would cause the arrangement to not qualify under the definition for derivatives. However, the IGC has clarified that, regardless of how the arrangement is to be settled, the three key defining characteristics are present in all interest rate swaps—namely, that value changes are in response to changes in an underlying variable (interest rates or an index of rates), that there is little or no initial net investment, and that settlements will occur at future dates. Thus, swaps are always derivatives.

Not all derivatives involve financial instruments. Consider Corboy Co., which owns an office building and enters into a put option, with a term of five years, with an investor that permits it to put the building to the investor for $15 million. The current value of the building is $17.5 million. The option, if exercised, may be settled through physical delivery or net cash, at Corboy's option. Corboy's accounting depends on Corboy's intent and past practice for settlement. Although the contract meets the definition of a derivative, Corboy does not account for it as a derivative if it intends to settle the contract by delivering the building if it exercises its option, and there is no past practice of settling net.

The investor, however, cannot conclude that the option was entered into to meet the investor's expected purchase, sale, or usage requirements because the investor does not have the ability to require delivery. Therefore, the investor has to account for the contract as a derivative. Regardless of past practices, the investor's intention does not affect whether settlement is by delivery or in cash. The investor has written an option, and a written option in which the holder has the choice of physical delivery or net cash settlement can never satisfy the normal delivery requirement for the exemption from IAS 39 for the investor. However, if the contract required physical delivery and the reporting enterprise had no past practice of settling net in cash, the contract would not be accounted for as a derivative.

Embedded derivatives.

In certain cases, IAS 39 requires that an embedded derivative be separated from a host contract. The embedded derivative must then be accounted for separately as a derivative, at fair value. That does not, however, require separating them in the balance sheet; IAS 39 does not address the presentation in the balance sheet of embedded derivatives. However, IAS 32 requires separate disclosure of financial assets carried at cost and financial assets carried at fair value, although this could be in the notes rather than on the face of the balance sheet.

The concept of embedded derivatives embraces such elements as conversion features, such as found in convertible debts. For example, an investment in a bond (a financial asset) may be convertible into shares of the issuing enterprise or another enterprise at any time prior to the bond's maturity, at the option of the holder. The existence of the conversion feature in such a situation generally precludes classification as a held-to-maturity investment because that would be inconsistent with paying for the conversion feature—the right to convert into equity shares before maturity.

An investment in a convertible bond can be classified as an available-for-sale financial asset provided it is not purchased for trading purposes. The equity conversion option is an embedded derivative. If the bond is classified as available-for-sale with fair value changes recognized directly in equity until the bond is sold, the equity conversion option (the embedded derivative) is generally separated. The amount paid for the bond is split between the debt security without the conversion option and the equity conversion option itself. Changes in the fair value of the equity conversion option are recognized in the income statement unless the option is part of a cash flow hedging relationship. If the convertible bond is carried at fair value with changes in fair value reported in net profit or loss, separating the embedded derivative from the host bond is not permitted.

When an evaluation is made, using the criteria in IAS 39, which leads to the conclusion that the embedded derivative must be separately accounted for, the initial carrying amounts of a host and the embedded derivative must be determined. Since the embedded derivative must be recorded at fair value with changes in fair value reported in net profit or loss, the initial carrying amount assigned to the host contract on separation is determined as the difference between the cost (fair value of the consideration given) for the hybrid (combined) instrument and the fair value of the embedded derivative.

IAS 32 suggests, as one method of separating the liability and equity components contained in a compound financial instrument, allocating the aggregate carrying amount based on the relative fair values of the liability and equity components. However, IAS 32 is not applicable to the separation of a derivative from a hybrid instrument under IAS 39. It would be inappropriate to allocate the basis in the hybrid instrument under IAS 39 to the derivative and nonderivative components based on their relative fair values, since that might result in an immediate gain or loss being recognized in net profit or loss on the subsequent measurement of the derivative at fair value.

For example, Erewohn AG acquires a five-year floating-rate debt instrument issued by Spacemaker Co. At the same time, it enters into a five-year "pay-variable, receive-fixed" interest rate swap with the St. Helena Bank. Erewohn considers the combination of the debt instrument and swap to be a "synthetic fixed-rate instrument" and classifies the instrument as a held-to-maturity investment, since it has the positive intent and ability to hold it to maturity. Erewohn contends that separate accounting for the swap is inappropriate, since IAS 39 requires an embedded derivative to be classified together with its host instrument if the derivative is linked to an interest rate that can change the amount of interest that would otherwise be paid or received on the host debt contract.

According to the IGC, however, the company's analysis is not correct. Embedded derivative instruments are terms and conditions that are included in nonderivative host contracts. It is generally inappropriate to treat two or more separate financial instruments as a single combined instrument (synthetic instrument accounting) for the purposes of applying IAS 39. Each of the financial instruments has its own terms and conditions and each may be transferred or settled separately. Therefore, the debt instrument and the swap are classified separately.

Hedging accounting under IAS 39.

When there is a hedging relationship between a hedging instrument and another item (the underlying), and certain conditions are met, then special "hedging accounting" will be applied. The purpose is to relate the value changes in the hedging instrument and the underlying so that these affect earnings in the same period. Hedging instruments are often financial derivatives, such as options or futures, but this is not a necessary condition. Hedging may be engaged in to protect against changes in fair values, changes in expected cash flows, or changes in the value of an investment in a foreign operation, such as a subsidiary, due to currency rate movements. There is no requirement that enterprises engage in hedging, but the principles of good management will often dictate that this be done.

For a simplistic example of the need for, and means of, hedging, consider an entity that holds US Treasury bonds as an investment. The bonds have a maturity some ten years in the future, but the entity actually intends to dispose of these in the intermediate term, for example, within four years to partially finance a plant expansion currently being planned. Obviously, an unexpected increase in general interest rates during the projected four-year holding period would be an unwelcome development, since it would cause a decline in the market value of the bonds and could accordingly result in an unanticipated loss of principal. One means of guarding against this would be to purchase a put option on these bonds, permitting the enterprise to sell them at an agreed-upon price, which would be most valuable should there be a price decline. If interest rates do indeed rise, the increasing value of the "put" will (if properly structured) offset the declining value of the bonds themselves, thus providing an effective fair value hedge. (Other hedging strategies are also available, including selling short Treasury bond futures, and the entity of course could have reduced or eliminated the need to hedge entirely by having invested in Treasury bonds having a maturity more closely matched to its anticipated cash need.)

Special hedge accounting is necessitated by the fact that fair value changes in not all financial instruments are reported in current earnings. Thus, if the entity in the foregoing example holding the Treasuries has elected to report changes in available-for-sale investments (which would include the Treasury bonds in this instance) directly in equity, but the changes in the hedging instrument's fair value were to be reported in current operations, there would be a fundamental mismatching which would distort the real hedging relationship that had been established. To avoid this result, the entity may elect to apply special hedge accounting as prescribed by IAS 39, as was discussed in some detail in Chapter 5. It should be noted, though, that hedge accounting is optional. An entity that carries out hedging activities for risk management purposes may well decide not to apply hedge accounting for some hedging transactions if it wishes to reduce the cost and burden of complying with the hedge accounting requirements in IAS 39.

Accounting for gains and losses from fair value hedges.

The accounting for qualifying gains and losses on fair value hedges is as follows:

  1. On the hedging instrument, they are recognized in earnings.

  2. On the hedged item, they are recognized in earnings even if the gains or losses would normally have been recognized directly in equity if not hedged.

The foregoing rule applies even in the case of investments (classified as available-for-sale) for which unrealized gains and losses are being accumulated directly in equity, if that method was appropriately elected by the reporting enterprise, as permitted by IAS 39. In all instances, to the extent that there are differences between the amounts of gain or loss on hedging and hedged items, these will be due either to amounts excluded from assessment effectiveness, or to hedge ineffectiveness; in either event, these are recognized currently in earnings.

As an example, consider an available-for-sale security, the carrying amount of which is adjusted by the amount of gain or loss resulting from the hedged risk, a fair value hedge. It is assumed that the entire investment was hedged, but it is also possible to hedge merely a portion of the investment. The facts are as follows:

Hedged item:

Available-for-sale security

Hedging instrument:

Put option

Underlying:

Price of the security

Notional amount:

100 shares of the security

Example 1

start example

On July 1, 2003, Gardiner Company purchased 100 shares of Disney Co. common stock at a cost of $15 per share and classified it as an available-for-sale security. On October 1, Gardiner Company purchased an at-the-money put on Disney with an exercise price of $25 and an expiration date of April 2004. This put purchase locks in a profit of $650, as long as the price is equal to $25 or lower, but allows continued profitability if the price of the Disney stock goes above $25. (In other words, the put cost a premium of $350, which if deducted from the locked-in gain [$2,500 market value less $1,500 cost] leaves a net gain of $650 to be realized.)

The premium paid for an at-the-money option (i.e., where the exercise price is current market value of the underlying) is the price paid for the right to have the entire remaining option period in which to exercise the option. In the present example, Gardiner Company specifies that only the intrinsic value of the option is to be used to measure effectiveness. Thus, the time value decreases of the put will be charged against the income of the period, and not offset against the change in value of the underlying, hedged item. Gardiner Company then documents the hedge's strategy, objectives, hedging relationships, and method of measuring effectiveness. The following table shows the fair value of the hedged item and the hedging instrument.

Case One
 

10/1/03

12/31/03

3/31/04

4/17/04

Hedged item:

    

Disney share price

$ 25

$ 22

$ 20

$ 20

Number of shares

100

100

100

100

Total value of shares

$2,500

$2,200

$2,000

$2,000

Hedging instrument:

    

Put option (100 shares)

    

Intrinsic value

$ 0

$ 300

$ 500

$ 500

Time value

350

215

53

0

Total

$ 350

$ 515

$ 553

$ 500

Intrinsic value

    

Gain (loss) on put from last measurement date

$ 0

$ 300

$ 200

$ 0

Entries to record the foregoing changes in value, ignoring tax effects and transaction costs, are as follows:

7/1/03

Purchase:

Available-for-sale securities

1,500

 
  
  • Cash

 

1,500

9/30/03

End of quarter:

Valuation allowance—available-for-sale securities

1,000

 
  
  • Shareholders' equity

 

1,000

10/1/03

Put purchase:

Put option

350

 
  
  • Cash

 

350

12/31/03

End of year:

Put option

300

 
  
  • Hedge gain/loss (intrinsic value gain)

 

300

  

Gain/loss

135

 
  
  • Put option (time value loss)

 

135

  

Hedge gain/loss

300

 
  
  • Available-for-sale securities (market value loss)

 

300

3/31/04

End of quarter:

Put option

200

 
  
  • Hedge gain/loss (intrinsic value changes)

 

200

  

Gain/loss

162

 
  
  • Put option (time value loss)

 

162

  

Hedge gain/loss

200

 
  
  • Available-for-sale securities (market value loss)

 

200

4/17/04

Put expires:

Put option

0

 
  
  • Hedge gain/loss (intrinsic value changes)

 

0

  

Gain/loss

53

 
  
  • Put option (time value changes)

 

53

  

Hedge gain/loss

0

 
  
  • Available-for-sale securities (market value changes)

 

0

An option is said to be "in-the-money" if the exercise price is above the market value (for a put option) or below the market value (for a call option). At or before expiration, an in-the-money put should be sold or exercised (to let it simply expire would be to effectively discard a valuable asset). It should be stressed that this applies to so-called "American options," which may be exercised at any time prior to expiration; so-called "European options" can only be exercised at the expiration date. Assuming that the put option is sold immediately before its expiration date, the entry would be

4/17/04

Put sold:

Cash

500

 
  
  • Put option

 

500

On the other hand, if the put is exercised (i.e., the underlying security is delivered to the counterparty, which is obligated to pay $25 per share for the stock), the entry would be

4/17/04

Cash

2,500

 
 

Shareholders' equity

1,000

 
 
  • Valuation allowance—available-for-sale securities

 

1,000

 
  • Available-for-sale securities

 

1,000

 
  • Put option

 

500

 
  • Gain on sale of securities

 

1,000

The cumulative effect on retained earnings of the hedge and sale is a net gain of $650 ($1,000-$350).

end example

Example 2

start example

To further illustrate fair value hedge accounting, the facts in the preceding example will now be slightly modified. Now, the share price increases after the put option is purchased, thus making the put worthless, since the shares could be sold for a more advantageous price on the open market.

Case Two
 

10/1/03

12/31/03

3/31/04

4/17/04

Hedged item:

    

Disney share price

$ 25

$ 28

$ 30

$ 31

Number of shares

100

100

100

100

Total value of shares

$2,500

$2,800

$3,000

$3,100

Hedging instrument:

    

Put option (100 shares)

    

Intrinsic value

$ 0

$ 0

$ 0

$ 0

Time value

350

100

25

0

Total

$ 350

$ 100

$ 25

$ 0

Intrinsic value

    

Gain (loss) on put from last measurement date

$ 0

$ 0

$ 0

$ 0

Entries to record the foregoing changes in value, ignoring tax effects and transaction costs, are as follows:

7/1/03

Purchase:

Available-for-sale securities

1,500

 
  
  • Cash

 

1,500

9/30/03

End of quarter:

Valuation allowance—available-for-sale security

1,000

 
  
  • Shareholders' equity

 

1,000

10/1/03

Put purchase:

Put option

350

 
  
  • Cash

 

350

12/31/03

End of year:

Put option

0

 
  
  • Hedge gain/loss (intrinsic value gain)

 

0

  

Hedge gain/loss

250

 
  
  • Put option (time value loss)

 

250

  

Available-for-sale security

300

 
  
  • Shareholders' equity

 

300

3/31/04

End of quarter:

Put option

0

 
  
  • Hedge gain/loss (intrinsic value change)

 

0

  

Hedge gain/loss

75

 
  
  • Put option (time value loss)

 

75

  

Available-for-sale securities

200

 
  
  • Shareholders' equity

 

200

4/17/04

Put expires:

Put option

0

 
  
  • Hedge gain/loss (intrinsic value change)

 

0

  

Hedge gain/loss

25

 
  
  • Put option (time value change)

 

25

  

Available-for-sale securities

100

 
  
  • Shareholders' equity

 

100

The put expired unexercised and Gardiner Company must decide whether to sell the security. If it continues to hold, normal IAS 39 accounting would apply. In this example, since it was hypothesized that Gardiner had elected to record the effects of value changes (apart from those which were hedging related) directly in shareholders' equity, it would continue to apply this accounting after the expiration of the put option. Assuming, however, that the security is instead sold, the entry would be

4/17/04

Cash

3,100

 
 

Shareholders' equity

1,600

 
 
  • Available-for-sale securities

 

1,500

 
  • Valuation allowance—available-for-sale securities

 

1,600

 
  • Gain on sale of securities

 

1,600

end example

Accounting for gains and losses from cash flow hedges.

Cash flow hedges generally involve forecasted transactions or events. The intention is to defer the recognition of gains or losses arising from the hedging activity itself until the forecasted transaction takes place, and then to have the formerly deferred gain or loss affect earnings when the forecasted transaction affects earnings. While overwhelmingly it will be derivative financial instruments that are used to hedge cash flows relating to forecasted transactions, IAS 39 contemplates the use of non-derivatives for this purpose as well in the case of hedges of foreign currency risk. Forecasted transactions may include future cash flows arising from presently existing, recognized assets or liabilities—for example, future interest rate payments to be made on debt carrying floating interest rates are subject to cash flow hedging.

The accounting for qualifying gains and losses on cash flow hedges is as follows:

  1. On the hedging instrument, the portion of the gain or loss that is determined to be an effective hedge will he recognized directly in equity.

  2. Also on the hedging instrument, the ineffective portion should be reported in earnings, if the instrument is a derivative; otherwise, it should be reported in a manner consistent with the accounting for other financial assets or liabilities as set forth in IAS 39. Thus, if an available-for-sale security has been used as the hedging instrument in a particular cash flow hedging situation, and the enterprise has elected to report value changes in equity, then any ineffective portion of the hedge should continue to be recorded in equity.

According to IAS 39, the separate component of equity associated with the hedged item should be adjusted to the lesser (in absolute terms) of either 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 hedge inception, excluding the ineffective portion, or the fair value of the cumulative change in expected future cash flows on the hedged item from inception of the hedge. Furthermore, any remaining gain or loss on the hedging instrument (i.e., the ineffective portion) must be recognized currently in earnings or directly in equity, as dictated by the nature of the instrument and entity's accounting policy (for available-for-sale instruments, where there is a choice of reporting directly in equity or in earnings). If the entity's policy regarding the hedge is to exclude a portion from the measure of hedge effectiveness (e.g., time value of options in the preceding example in this section of Chapter 10), then any related gain or loss must be incorporated into either earnings or equity based on the nature of the item and the elected policy.

Example of "plain vanilla" interest rate swap

start example

On July 1, 2003, Abbott Corp. borrows $5 million with a fixed maturity (no prepayment option) of June 30, 2007, carrying interest at the US prime interest rate + 1/2%. Interest payments are due semiannually; the entire principal is due at maturity. At the same date, Abbott Corp. enters into a "plain-vanilla-type" swap arrangement, calling for fixed payments at 8% and the receipt of prime + 1/2%, on a notional amount of $5 million. At that date prime is 7.5%, and there is no premium due on the swap arrangement since the fixed and variable payments are equal. (Note that swaps are privately negotiated and, accordingly, a wide range of terms will be encountered in practice; this is simply intended as an example, albeit a very typical one.)

The foregoing swap qualifies as a cash flow hedge under IAS 39. Given the nature of this swap, it is reasonable to assume no ineffectiveness, but in real world situations this must be carefully evaluated with reference to the specific circumstances of each case; IAS 39 does not provide a short-cut method (which contrasts with the corresponding US GAAP standard). IAS 39 defines effectiveness in terms of results: if at inception and throughout the life of the hedge, the enterprise can expect an almost complete offset of cash flow variations, and in fact (retrospectively) actual results are within a range of 80 to 125%, the hedge will be judged highly effective.

In the present example, assume that in fact the hedge proves to be highly effective. Also, assume that the prime rate over the four-year term of the loan, as of each interest payment date, is as follows, along with the fair value of the remaining term of the interest swap at those dates:

Date

Prime rate (%)

Fair value of swap [a]

December 31, 2003

6.5

$(150,051)

June 30, 2004

6.0

(196,580)

December 31, 2004

6.5

(111,296)

June 30, 2005

7.0

(45,374)

December 31, 2005

7.5

0

June 30, 2006

8.0

23,576

December 31, 2006

8.5

24,038

June 30, 2007

8.0

0

[a]Fair values are determined as the present values of future cash flows resulting from expected interest rule differentials, based on current prime rate, discounted at 8%.

end example

Regarding the fair values presented in the foregoing table, it should be assumed that the market (fair) values of the swap contract are precisely equal to the present value, at each valuation date (assumed to be the interest payment dates), of the differential future cash flows resulting from utilization of the swap. Future variable interest rates (prime + 1/2%) are assumed to be the same as the existing rates at each valuation date (i.e., the yield curve is flat and there is no basis for any expectation of rate changes, and therefore, the best estimate at any given moment is that the current rate will persist over time). The discount rate, 8%, is assumed to be constant over time.

Thus, for example, the fair value of the swap at December 31, 2003, would be the present value of an annuity of seven payments (the number of remaining semiannual interest payments due) of $25,000 each (pay 8%, receive 7%, based on then-existing prime rate of 6.5%) to be made to the swap counterparty, discounted at an annual rate of 8%. (Consistent with the convention for quoting interest rates as bond-equivalent yields, 4% is used for the semiannual discounting, rather than the rate that would compound to 8% annually.) The present value of a stream of seven $25,000 payments to the swap counterparty amounts to $150,051 at December 31, 2003, which is the swap liability to be reported by Abbott Corp. at that date. The offset is a debit to equity, since the hedge is continually judged to be 100% effective in this case.

The semiannual accounting entries will be as follows:

December 31, 2003

  • Interest expense

175,000

 
    • Accrued interest (or cash)

 

175,000

  • To accrue or pay interest on the debt at the variable rate of prime + 1/2% (7.0%)

  • Interest expense

25,000

 
    • Accrued interest (or cash)

 

25,000

  • To record net settle-up on swap arrangement [8.0 - 7.0%]

  • Shareholders' equity

150,051

 
    • Obligation under swap contract

 

150,051

  • To record the fair value of the swap contract as of this date (a net liability because fixed rate payable is below expected variable rate based on current prime rate)

June 30, 2004

  • Interest expense

162,500

 
    • Accrued interest (or cash)

 

162,500

  • To accrue or pay interest on the debt at the variable rate of prime + 1/2% (6.5%)

  • Interest expense

37,500

 
    • Accrued interest (or cash)

 

37,500

  • To record net settle-up on swap arrangement [8.0 - 6.5%]

  • Shareholders' equity

46,529

 
    • Obligation under swap contract

 

46,529

  • To record the fair value of the swap contract as of this date (increase in obligation because of further decline in prime rate)

December 31, 2004

  • Interest expense

175,000

 
    • Accrued interest (or cash)

 

175,000

  • To accrue or pay interest on the debt at the variable rate of prime + 1/2% (7.0%)

  • Interest expense

25,000

 
    • Accrued interest (or cash)

 

25,000

  • To record net settle-up on swap arrangement [8.0 - 7.0%]

  • Obligation under swap contract

85,284

 
    • Shareholders' equity

 

85,284

  • To record the fair value of the swap contract as of this date (decrease in obligation due to increase in prime rate)

June 30, 2005

  • Interest expense

187,500

 
    • Accrued interest (or cash)

 

187,500

  • To accrue or pay interest on the debt at the variable rate of prime + 1/2% (7.5%)

  • Interest expense

12,500

 
    • Accrued interest (or cash)

 

12,500

  • To record net settle-up on swap arrangement [8.0 - 7.5%]

  • Obligation under swap contract

65,922

 
    • Shareholders' equity

 

65,922

  • To record the fair value of the swap contract as of this date (further increase in prime rate reduces fair value of derivative)

December 31, 2005

  • Interest expense

200,000

 
    • Accrued interest (or cash)

 

200,000

  • To accrue or pay interest on the debt at the variable rate of prime + 1/2% (8.0%)

  • Interest expense

0

 
    • Accrued interest (or cash)

 

0

  • To record net settle-up on swap arrangement [8.0 - 8.0%]

  • Obligation under swap contract

45,374

 
    • Shareholders' equity

 

45,374

  • To record the fair value of the swap contract as of this date (further increase in prime rate eliminates fair value of the derivative)

June 30, 2006

  • Interest expense

212,500

 
    • Accrued interest (or cash)

 

212,500

  • To accrue or pay interest on the debt at the variable rate of prime + 1/2% (8.5%)

  • Accrued interest (or cash)

12,500

 
    • Interest expense

 

12,500

  • To record net settle-up on swap arrangement [8.0 - 8.5%]

  • Receivable under swap contract

23,576

 
    • Shareholders' equity

 

23,576

  • To record the fair value of the swap contract as of this date (increase in prime rate creates net asset position for derivative)

December 31, 2006

  • Interest expense

225,000

 
    • Accrued interest (or cash)

 

225,000

  • To accrue or pay interest on the debt at the variable rate of prime + 1/2% (9.0%)

  • Accrued interest (or cash)

25,000

 
    • Interest expense

 

25,000

  • To record net settle-up on swap arrangement [8.0 - 9.0%]

  • Receivable under swap contract

462

 
    • Shareholders' equity

 

462

  • To record the fair value of the swap contract as of this date (increase in asset value due to further rise in prime rate)

June 30, 2007

  • Interest expense

212,500

 
    • Accrued interest (or cash)

 

212,500

  • To accrue or pay interest on the debt at the variable rate of prime + 1/2% (8.5%)

  • Accrued interest (or cash)

12,500

 
    • Interest expense

 

12,500

  • To record net settle-up on swap arrangement [8.0 - 8.5%]

  • Shareholders' equity

24,038

 
    • Receivable under swap contract

 

24,038

  • To record the fair value of the swap contract as of this date (value declines to zero as expiration date approaches)

Example of option on an interest rate swap

start example

The facts of this example are a further variation on the previous one (the "plain vanilla" swap). Abbott Corp. anticipates, as of June 30, 2003, that as of June 30, 2005, it will become a borrower of $5 million with a fixed maturity four years hence (i.e., at June 30, 2009). Based on its current credit rating, it will be able to borrow at the US prime interest rate + 1/2%. As of June 30, 2003, it is able to purchase a "swaption" (an option on an interest rate swap, calling for fixed pay at 8% and variable receipt at prime + 1/2%, on a notional amount of $5 million, for a term of four years) for a single payment of $25,000. The option will expire in two years. At June 30, 2003, the prime is 7.5%.

Note 

The interest rate behavior in this example differs somewhat from the prior example, to better illustrate the "one-sideness" of options, versus the obligation under a plain vanilla swap arrangement or of other nonoption contracts, such as futures and forwards.

It will be assumed that the time value of the swaption expires ratably over the two years.

This swaption qualifies as a cash flow hedge under IAS 39. However, while the change in fair value of the contract is an effective hedge of the cash flow variability of the prospective debt issuance, the premium paid is a reflection of the time value of money and would not be an effective part of the hedge. Accordingly, it is to be expensed as incurred, rather than being deferred.

The table below gives the prime rate at semiannual intervals including the two-year period prior to the debt issuance, plus the four years during which the debt (and the swap, if the option is exercised) will be outstanding, as well as the fair value of the swaption (and later, the swap itself) at these points in time.

Date

Prime rate (%)

Fair value of swaption/swap [a]

December 31, 2003

7.5

$ 0

June 30, 2004

8.0

77,925

December 31, 2004

6.5

0

June 30, 2005

7.0

(84,159)

December 31, 2005

7.5

0

June 30, 2006

8.0

65,527

December 31, 2006

8.5

111,296

June 30, 2007

8.0

45,374

December 31, 2007

8.0

34,689

June 30, 2008

7.5

0

December 31, 2008

7.5

0

June 30, 2009

7.0

0

[a]Fair value is determined as the present value of future expected interest rate differentials, based on current prime rate, discounted at 8%. An "out-of-the-money" swaption is valued at zero, since the option does not have to be exercised. Since the option is exercised on June 30, 2005, the value at that date is recorded, although negative.

The value of the swaption contract is only recorded (unless and until exercised, of course, at which point it becomes a contractually binding swap) if it is positive, since if "out-of-the-money," the holder would forego exercise in most instances and thus there is no liability by the holder to be reported. This illustrates the asymmetrical nature of options, where the most that can be lost by the option holder is the premium paid, since exercise by the holder is never required, unlike the case with futures and forwards, in which both parties are obligated to perform.

The present example is an illustration of counterintuitive (but not really illogical) behavior by the holder of an out-of-the-money option. Despite having a negative value, the option holder determines that exercise is advisable, presumably because it expects that over the term of the debt unfavorable movements in interest rates will occur.

At June 30, 2004, the swaption is an asset, since the reference variable rate (prime + 1/2%) is greater than the fixed swap rate, and thus the expectation is that the option will be exercised at expiration. This would (if present rates hold steady, which is the naļve assumption) result in a series of eight semiannual payments from the swap counterparty in the amount of $12,500. Discounting this at a nominal 8%, the present value as of the debt origination date (to be June 30, 2005) would be $84,159, which, when further discounted to June 30, 2004, yields a fair value of $74,925.

Note that the following period (at December 31, 2004) prime drops to such an extent that the value of the swaption evaporates entirely. Actually, the value becomes negative, which will not be reported since the holder is under no obligation to exercise the option under unfavorable conditions; the carrying value is therefore eliminated as of that date.

At the expiration of the swaption contract, the holder does (for this example) exercise, notwithstanding a negative fair value, and from that point forward the fair value of the swap will be reported, whether positive (an asset) or negative (a liability). Once exercised, the swap represents a series of forward contracts, the fair value of which must be fully recognized under IAS 39. (Note that, in the real world, the holder would have likely had another choice: to let the unfavorable swaption expire unexercised, but to negotiate a new interest rate swap, presumably at more favorable terms given that prime is only 7% at that date; for example, a swap of 7.5% fixed versus prime + 1/2% would likely be available at little or no cost.)

As noted above, assume that, at the option expiration date, despite the fact that prime + 1/2% is below the fixed pay rate on the swap, the management is convinced that rates will climb over the four-year term of the loan, and thus it does exercise the swaption at that date. Given this, the accounting journal entries over the entire six years are as follows:

June 30, 2003

  • Swaption contract

25,000

 
    • Cash

 

25,000

  • To record purchase premium on swaption contract

December 31, 2003

  • Gain/loss on hedging arrangement

6,250

 
    • Swaption contract

 

6,250

  • To record change in time value of swaption contract—charge premium to income since this represents payment for time value of money, which expires ratably over two-year term

June 30, 2004

  • Swaption contract

77,925

 
    • Shareholders' equity

 

77,925

  • To record the fair value of the swaption contract as of this date

  • Gain/loss on hedging arrangement

6,250

 
    • Swaption contract

 

6,250

  • To record change in time value of swaption contract—charge premium to income since this represents payment for time value of money, which expires ratably over two-year term

December 31, 2004

  • Shareholders' equity

77,925

 
    • Swaption contract

 

77,925

  • To record the change in fair value of the swaption contract as of this date; since contract is out-of-the-money, it is not written down below zero (i.e., a net liability is not reported)

  • Gain/loss on hedging arrangement

6,250

 
    • Swaption contract

 

6.250

  • To record change in time value of swaption contractcharge premium to income since this represents payment for time value of money, which expires ratably over two-year term

June 30, 2005

  • Shareholders' equity

84,159

 
    • Swaption contract

 

84,159

  • To record the fair value of the swaption contract as of this date—a net liability is reported since swap option was exercised

  • Gain/loss on hedging arrangement

6,250

 
    • Swaption contract

 

6,250

  • To record change in time value of swaption contract—charge premium to income since this represents payment for time value of money, which expires ratably over two-year term

December 31, 2005

  • Interest expense

200,000

 
    • Accrued interest (or cash)

 

200,000

  • To accrue or pay interest on the debt at the variable rate of prime + 1/2% (8.0%)

  • Interest expense

0

 
    • Accrued interest (or cash)

 

0

  • To record net settle-up on swap arrangement [8.0 - 8.0%]

  • Swap contract

84,159

 
    • Shareholders' equity

 

84,159

  • To record the change in the fair value of the swap contract as of this date

June 30, 2006

  • Interest expense

212,500

 
    • Accrued interest (or cash)

 

212,500

  • To accrue or pay interest on the debt at the variable rate of prime + 1/2% (8.5%)

  • Accrued interest (or cash)

12,500

 
    • Interest expense

 

12,500

  • To record net settle-up on swap arrangement [8.0 - 8.5%]

  • Swap contract

65,527

 
    • Shareholders' equity

 

65,527

  • To record the fair value of the swap contract as of this date

December 31, 2006

  • Interest expense

225,000

 
    • Accrued interest (or cash)

 

225,000

  • To accrue or pay interest on the debt at the variable rate of prime + 1/2% (9.0%)

  • Accrued interest (or cash)

25,000

 
    • Interest expense

 

25,000

  • To record net settle-up on swap arrangement [8.0 - 9.0%]

  • Swap contract

45,769

 
    • Shareholders' equity

 

45,769

  • To record the fair value of the swap contract as of this date

June 30, 2007

  • Interest expense

212,500

 
    • Accrued interest (or cash)

 

212,500

  • To accrue or pay interest on the debt at the variable rate of prime + 1/2% (8.5%)

  • Accrued interest (cash)

12,500

 
    • Interest expense

 

12,500

  • To record net settle-up on swap arrangement [8.0 - 8.5%]

  • Shareholders' equity

65,922

 
    • Swap contract

 

65,922

  • To record the change in the fair value of the swap contract as of this date (declining prime rate causes swap to lose value)

December 31, 2007

  • Interest expense

212,500

 
    • Accrued interest (or cash)

 

212,000

  • To accrue or pay interest on the debt at the variable rate of prime + 1/2% (8.5%)

  • Accrued interest (or cash)

12,500

 
    • Interest expense

 

12,500

  • To record net settle-up on swap arrangement [8.0 - 8.5%]

  • Shareholders' equity

10,685

 
    • Swap contract

 

10,685

  • To record the fair value of the swap contract as of this date (decline is due to passage of time, as the prime rate expectations have not changed from the earlier period)

June 30, 2008

  • Interest expense

200,000

 
    • Accrued interest (or cash)

 

200,000

  • To accrue or pay interest on the debt at the variable rate of prime + 1/2% (8.0%)

  • Accrued interest (or cash)

0

 
    • Interest expense

 

0

  • To record net settle-up on swap arrangement [8.0- 8.5%]

  • Shareholders' equity

34,689

 
    • Swap contract

 

34,689

  • To record the fair value of the swap contract as of this date

December 31, 2008

  • Interest expense

200,000

 
    • Accrued interest (or cash)

 

200,000

  • To accrue or pay interest on the debt at the variable rate of prime + 1/2% (8.0%)

  • Accrued interest (or cash)

0

 
    • Interest expense

 

0

  • To record net settle-up on swap arrangement [8.0 - 8.0%]

  • Swap contract

0

 
    • Shareholders' equity

 

0

  • No change to the fair value of the swap contract as of this date

June 30, 2009

  • Interest expense

187,500

 
    • Accrued interest (or cash)

 

187,500

  • To accrue or pay interest on the debt at the variable rate of prime + 1/2% (7.5%)

  • Interest expense

12,500

 
    • Accrued interest (or cash)

 

12,500

  • To record net settle-up on swap arrangement [8.0 - 7.5%]

  • Shareholders' equity

0

 
    • Swap contract

 

0

  • No change to the fair value of the swap contract, which expires as of this date

end example

Example of using options to hedge a future purchase of inventory

start example

Friendly Chemicals Corp. uses petroleum as a feedstock from which it produces a range of chemicals for sale to producers of synthetic fabrics and other consumer goods. It is concerned about the rising price of oil and decides to hedge a major purchase it plans to make in mid-2004. Oil futures and options are traded on the New York Mercantile Exchange and in other markets; Friendly decides to use options rather than futures because it is only interested in protecting itself from a price increase; if prices decline, it wishes to reap that benefit rather than suffer the loss which would result from holding a futures contract in a declining market environment.

At December 31, 2003, Friendly projects a need for 10 million barrels of crude oil of a defined grade to be purchased by mid-2004; this will suffice for production through mid-2005. The current world price for this grade of crude is $14.50 per barrel, but prices have been rising recently. Management desires to limit its crude oil costs to no higher than $15.75 per barrel, and accordingly purchases, at a cost of $2 million, an option to purchase up to 10 million barrels at a cost of $15.55 per barrel, at any time through December 2004. When the option premium is added to this $15.55 per barrel cost, it would make the total cost $15.75 per barrel if the full 10 million barrels are acquired.

Management has studied the behavior of option prices and has concluded that changes in option prices that relate to time value are not correlated to price changes and hence are ineffective in hedging price changes. On the other hand, changes in option prices that pertain to pricing changes (intrinsic value changes) are highly effective as hedging vehicles. The table below reports the value of these options, analyzed in terms of time value and intrinsic value, over the period from December 2003 through December 2004.

Date

Price of oil/barrel

Fair value of option relating to

Time value[a]

Intrinsic value

December 31, 2003

$14.50

$2,000,000

$ 0

January 31, 2004

14.90

1,900,000

0

February 28, 2004

15.30

1,800,000

0

March 31, 2004

15.80

1,700,000

2,500,000

April 30, 2004

16.00

1,600,000

4,500,000

May 31, 2004

15.85

1,500,000

3,000,000

June 30, 2004[b]

16.00

700,000

2,250,000

July 31, 2004

15.60

650,000

250,000

August 31, 2004

15.50

600,000

0

September 30, 2004

15.75

550,000

1,000,000

October 31, 2004

15.80

500,000

1,250,000

November 30, 2004

15.85

450,000

1,500,000

December 31, 2004[c]

15,90

400,000

1,750,000

[a]This example does not address how the time value of options would be computed in practice.

[b]Options for five million barrels exercised: remainder held until end of December, then sold.

[c]Values cited are immediately prior to sale of remaining options.

At the end of June 2004, Friendly Chemicals exercises options for five million barrels, paying $15.55 per barrel for oil that is then selling on world markets for $16.00 each. It holds the remaining options until December, when it sells these for an aggregate price of $2.1 million, a slight discount to the nominal fair value at that date.

The inventory acquired in mid-2004 is processed and included in goods available for sale. Sales of these goods, in terms of the five million barrels of crude oil which were consumed in their production, are as follows:

Date

Equivalent barrels sold in month

Equivalent barrels on hand at month end

June 30, 2004

300,000

4,700,000

July 31, 2004

250,000

4,450,000

August 31, 2004

400,000

4,050,000

September 30, 2004

350,000

3,700,000

October 31, 2004

550,000

3,150,000

November 30, 2004

500,000

2,650,000

December 31, 2004

650,000

2,000,000

Based on the foregoing facts, the journal entries prepared on a monthly basis (for illustrative purposes) for the period December 2003 through December 2004 are as follows:

December 31, 2003

  • Option contract

2,000,000

 
    • Cash

 

2,000,000

  • To record purchase premium on option contract for up to 10 million barrels of oil at price of $15.55 per barrel

January 31, 2004

  • Gain/loss on hedging transaction

100,000

 
    • Option contract

 

100,000

  • To record change in time value of option contract—charge premium to income since this represents payment for time value of money, which expires ratably over two-year term and does not qualify for hedge accounting treatment

  • Option contract

0

 
    • Shareholders' equity

 

0

  • To reflect change in intrinsic value of option contracts (no value at this date)

February 28, 2004

  • Gain/loss on hedging transaction

100,000

 
    • Option contract

 

100,000

  • To record change in time value of option contract—charge premium to income since this represents payment for time value of money, which expires ratably over two-year term and does not qualify for hedge accounting treatment

  • Option contract

0

 
    • Shareholders' equity

 

0

  • To reflect change in intrinsic value of option contracts (no value at this date)

March 31, 2004

  • Gain/loss on hedging transaction

100,000

 
    • Option contract

 

100,000

  • To record change in time value of option contractcharge premium to income since this represents payment for time value of money, which expires ratably over two-year term and does not qualify for hedge accounting treatment

  • Option contract

2,500,000

 
    • Shareholders' equity

 

2,500,000

  • To reflect change in intrinsic value of option contracts

April 30, 2004

  • Gain/loss on hedging transaction

100,000

 
    • Option contract

 

100,000

  • To record change in time value of option contractcharge premium to income since this represents payment for time value of money, which expires ratably over two-year term and does not qualify for hedge accounting treatment

  • Option contract

2,000,000

 
    • Shareholders' equity

 

2,000,000

  • To reflect change in intrinsic value of option contracts (further increase in value)

May 31, 2004

  • Gain/loss on hedging transaction

100,000

 
    • Option contract

 

100,000

  • To record change in time value of option contract—charge premium to income since this represents payment for time value of money, which expires ratably over two-year term and does not qualify for hedge accounting treatment

  • Shareholders' equity

1,500,000

 
    • Option contract

 

1,500,000

  • To reflect change in intrinsic value of option contracts (decline in value)

June 30, 2004

  • Gain/loss on hedging transaction

800,000

 
    • Option contract

 

800,000

  • To record change in time value of option contract—charge premium to income since this represents payment for time value of money, which expires ratably over two-year term and does not qualify for hedge accounting treatment; since one-half the options were exercised in June, the remaining unexpensed time value of that portion is also entirely written off at this time

  • Option contracts

1,500,000

 
    • Shareholders' equity

 

1,500,000

  • To reflect change in intrinsic value of option contracts (further increase in value) before accounting for exercise of options on five million barrels

  • June 30 value of options before exercise

 

4,500,000

  • Allocation to oil purchased at $15.55

 

2,250,000

  • Remaining option valuation adjustment

 

2,250,000

  • The allocation of exercised options will be used to adjust the carrying value of the inventory, and ultimately will be transferred to cost of goods sold as a contra cost, as the five million barrels are sold, at the rate of 45¢ per equivalent barrel.

  • Inventory

77,750,000

 
    • Cash

 

77,750,000

  • To record purchase of five million barrels of oil at option price of $15.55/barrel

  • Inventory

2,250,000

 
    • Option contract

 

2,250,000

  • To increase the recorded value of the inventory to include the fair value of options given up in acquiring the oil (taken together, the cash purchase price and the fair value of options surrendered add to $16 per barrel, the world market price at date of purchase)

  • Shareholders' equity

2,250,000

 
    • Inventory

 

2,250,000

  • To remove deferred gain from equity and include in initial measurement of inventory

  • Cost of goods sold

4,935,000

 
    • Inventory

 

4,935,000

  • To record cost of goods sold

July 31, 2004

  • Gain/loss on hedging transaction

50,000

 
    • Option contract

 

50,000

  • To record change in time value of option contract—charge premium to income since this represents payment for time value of money, which expires ratably over two-year term, and does not qualify for hedge accounting treatment

  • Shareholders' equity

2,000,000

 
    • Option contract

 

2,000,000

  • To reflect change in intrinsic value of remaining option contracts (decline in value)

  • Cost of goods sold

3,887,500

 
    • Inventory

 

3,887,500

  • To record cost of goods sold

August 31, 2004

  • Loss on hedging transaction

50,000

 
    • Option contract

 

50,000

  • To record change in time value of option contract—charge premium to income since this represents payment for time value of money, which expires ratably over two-year term, and does not qualify for hedge accounting treatment

  • Shareholders' equity

250,000

 
    • Option contract

 

250,000

  • To reflect change in intrinsic value of remaining option contracts (decline in value)

  • Cost of goods sold

6,220,000

 
    • Inventory

 

6,220,000

  • To record cost of goods sold

September 30, 2004

  • Gain/loss on hedging transaction

50,000

 
    • Option contract

 

50,000

  • To record change in time value of option contractcharge premium to income since this represents payment for time value of money, which expires ratably over two-year term, and does not qualify for hedge accounting treatment

  • Option contract

1,000,000

 
    • Shareholders' equity

 

1,000,000

  • To reflect change in intrinsic value of remaining option contracts (increase in value)

  • Cost of goods sold

5,442,500

 
    • Inventory

 

5,442,500

  • To record cost of goods sold

October 31, 2004

  • Gain/loss on hedging transaction

50,000

 
    • Option contract

 

50,000

  • To record change in time value of option contract—charge premium to income since this represents payment for time value of money, which expires ratably over two-year term, and does not qualify for hedge accounting treatment

  • Option contract

250,000

 
    • Shareholders' equity

 

250,000

  • To reflect change in intrinsic value of remaining option contracts (further increase in value)

  • Cost of goods sold

8,552,500

 
    • Inventory

 

8,552,500

  • To record cost of goods sold

November 30, 2004

  • Gain/loss on hedging transaction

50,000

 
    • Option contract

 

50,000

  • To record change in time value of option contract—charge premium to income since this represents payment for time value of money, which expires ratably over two-year term, and does not qualify for hedge accounting treatment

  • Option contract

250,000

 
    • Shareholders' equity

 

250,000

  • To reflect change in intrinsic value of remaining option contracts (further increase in value)

  • Cost of goods sold

7,775,000

 
    • Inventory

 

7,775,000

  • To record cost of goods sold

December 31, 2004

  • Gain/loss on hedging transaction

50,000

 
    • Option contract

 

50,000

  • To record change in time value of option contractcharge premium to income since this represents payment for time value of money, which expires ratably over two-year term, and does not qualify for hedge accounting treatment

  • Option contract

250,000

 
    • Shareholders' equity

 

250,000

  • To reflect change in intrinsic value of remaining option contracts (further increase in value) before sale of options

  • Cost of goods sold

10,107,500

 
    • Inventory

 

10,107,500

  • To record cost of goods sold

  • Cash

2,100,000

 
  • Loss on sale of options

50,000

 
    • Option contract

 

2,150.000

  • Shareholders' equity

1,750,000

 
    • Gain on sale of options

 

1,750,000

  • To record sale of remaining option contracts; the cash price was $50,000 lower than carrying value of asset sold (options having unexpired time value of $400,000 plus intrinsic value of $1,750,000), but transfer of shareholders' equity to income recognizes formerly deferred gain; since no further inventory purchases are planned in connection with this hedging activity, the unrealized gain is taken into income

end example

Hedging on a "net" basis.

The IGC has addressed the issue of whether an enterprise can group financial assets together with financial liabilities for the purpose of determining the net cash flow exposure to be hedged for hedge accounting purposes. It finds that while an enterprise's hedging strategy and risk management practices may assess cash flow risk on a net basis, IAS 39 does not permit designating a net cash flow exposure as a hedged item for hedge accounting purposes. IAS 39 provides an example of how a bank might assess its risk on a net basis (with similar assets and liabilities grouped together) and then qualify for hedge accounting by hedging on a gross basis.

Partial term hedging.

IAS 39 indicates that a hedging relationship may not be designated for only a portion of the time period in which a hedging instrument is outstanding. On the other hand, it is permitted to designate a derivative as hedging only a portion of the time period to maturity of a hedged item. For example, if Aquarian Corp. acquires a 10% fixedrate government bond with a remaining term to maturity of ten years, and classifies the bond as available-for-sale, it may hedge itself against fair value exposure on the bond associated with the present value of the interest rate payments until year five by acquiring a five-year "pay-fixed, receive-floating" swap. The swap may be designated as hedging the fair value exposure of the interest rate payments on the government bond until year five and the change in value of the principal payment due at maturity to the extent affected by changes in the yield curve relating to the five years of the swap.

Interest rate risk managed on a net basis should be designated as hedge of gross exposure.

If an enterprise manages its exposure to interest rate risk on a net basis, a number of complex financial reporting issues must be addressed, regarding the ability to use hedge accounting. The IGC has offered substantial guidance on a number of matters, the more generally applicable of which are summarized in the following paragraphs.

The IGC has concluded that a derivative that is used to manage interest rate risk on a net basis be designated as a hedging instrument in a fair value hedge or a cash flow hedge of a gross exposure under IAS 39. An enterprise may designate the derivative used in interest rate risk management activities either as a fair value hedge of assets or liabilities or as a cash flow hedge of forecasted transactions, such as the anticipated reinvestment of cash inflows, the anticipated refinancing or rollover of a financial liability, and the cash flow consequences of the resetting of interest rates for an asset or a liability.

The IGC also notes that firm commitments to purchase or sell assets at fixed prices create fair value exposures, but are accounted for as cash flow hedges. In economic terms, it does not matter whether the derivative instrument is considered a fair value hedge or a cash flow hedge. Under either perspective of the exposure, the derivative has the same economic effect of reducing the net exposure. For example, a receive-fixed, pay-variable interest rate swap can be considered to be a cash flow hedge of a variable-rate asset or a fair value hedge of a fixed-rate liability. Under either perspective, the fair value or cash flows of the interest rate swap offsets the exposure to interest rate changes. However, accounting consequences differ depending on whether the derivative is designated as a fair value hedge or a cash flow hedge, as discussed below.

Consider the following illustration. Among its financial resources and obligations, a bank has the following assets and liabilities having maturities of two years:

 

Variable interest

Fixed interest

Assets

60,000

100,000

Liabilities

(100,000)

(60,000)

Net

(40,000)

40,000

  • The bank enters into a two-year interest rate swap with a notional principal of $40,000 to receive a variable interest rate and pay a fixed interest rate, in order to hedge the net exposure of the two-year maturity financial assets and liabilities. According to the IGC, this may be designated either as a fair value hedge of $40,000 of the fixed-rate assets or as a cash flow hedge of $40,000 of the variable-rate liabilities. It cannot be designated as a hedge of the net exposure, however.

Determining whether a derivative that is used to manage interest rate risk on a net basis should be designated as a hedging instrument in a fair value hedge or a cash flow hedge of a gross exposure is based on a number of critical considerations. These include the assessment of hedge effectiveness in the presence of prepayment risk, and the ability of the information systems to attribute fair value or cash flow changes of hedging instruments to fair value or cash flow changes, respectively, of hedged items. For accounting purposes, the designation of the derivative as hedging a fair value exposure or a cash flow exposure is important because both the qualification requirements for hedge accounting and the recognition of hedging gains and losses differ for each of these categories. The IGC has observed that it will often be easier to demonstrate high effectiveness for a cash flow hedge than for a fair value hedge.

Another important issue involves the effects of prepayments on the fair value of an instrument and the timing of its cash flows, as well as the impacts on the effectiveness test for fair value hedges and the probability test for cash flow hedges, respectively. Effectiveness is often more difficult to achieve for fair value hedges than for cash flow hedges when the instrument being hedged is subject to prepayment risk. For a fair value hedge to qualify for hedge accounting, the changes in the fair value of the derivative hedging instrument must be expected to be highly effective in offsetting the changes in the fair value of the hedged item. This test may be difficult to meet if, for example, the derivative hedging instrument is a forward contract having a fixed term, and the financial assets being hedged are subject to prepayment by the borrower.

Also, it may be difficult to conclude that, for a portfolio of fixed-rate assets that are subject to prepayment, the changes in the fair value for each individual item in the group will be expected to be approximately proportional to the overall changes in fair value attributable to the hedged risk of the group. Even if the risk being hedged is a benchmark interest rate, to be able to conclude that fair value changes will be proportional for each item in the portfolio, it may be necessary to disaggregate the asset portfolio into categories based on term, coupon, credit, type of loan, and other characteristics.

In economic terms, a forward derivative instrument could be used to hedge assets that are subject to prepayment, but it would be effective only for small movements in interest rates. A reasonable estimate of prepayments can be made for a given interest rate environment and the derivative position can be adjusted as the interest rate environment changes. However, for accounting purposes, the expectation of effectiveness has to be based on existing fair value exposures and the potential for interest rate movements, without consideration of future adjustments to those positions. The fair value exposure attributable to prepayment risk can generally be hedged with options.

For a cash flow hedge to qualify for hedge accounting, the forecasted cash flows, including the reinvestment of cash inflows or the refinancing of cash outflows, must be highly probable, and the hedge expected to be highly effective in achieving offsetting changes in the cash flows of the hedged item and hedging instrument. Prepayments affect the timing of cash flows and, therefore, the probability of occurrence of the forecasted transaction. If the hedge is established for risk management purposes on a net basis, an enterprise may have sufficient levels of highly probable cash flows on a gross basis to support the designation for accounting purposes of forecasted transactions associated with a portion of the gross cash flows as the hedged item. In this case, the portion of the gross cash flows designated as being hedged may be chosen to be equal to the amount of net cash flows being hedged for risk management purposes.

The IAS 39 Implementation Guidance Committee has also emphasized that there are important systems considerations relating to the use of hedge accounting. It notes that the accounting differs for fair value hedges and cash flow hedges. It is usually easier to use existing information systems to manage and track cash flow hedges than it is for fair value hedges.

Under fair value hedge accounting, the assets or liabilities that are designated as being hedged are remeasured for those changes in fair values during the hedge period that are attributable to the risk being hedged. Such changes adjust the carrying amount of the hedged items and, for interest-sensitive assets and liabilities, may result in an adjustment of the effective yield of the hedged item. As a consequence of fair value hedging activities, the changes in fair value have to be allocated to the hedged assets or liabilities being hedged in order to be able to recompute their effective yield, determine the subsequent amortization of the fair value adjustment to net profit or loss, and determine the amount that should be recognized in net profit or loss when assets are sold or liabilities extinguished. To comply with the requirements for fair value hedge accounting, it generally will be necessary to establish a system to track the changes in the fair value attributable to the hedged risk, associate those changes with individual hedged items, recompute the effective yield of the hedged items, and amortize the changes to net profit or loss over the life of the respective hedged item.

Under cash flow hedge accounting, the cash flows relating to the forecasted transactions that are designated as being hedged reflect changes in interest rates. The adjustment for changes in the fair value of a hedging derivative instrument is initially recognized in equity. To comply with the requirements for cash flow hedge accounting, it is necessary to determine when the adjustments to equity from changes in the fair value of a hedging instrument should be recognized in net profit or loss. For cash flow hedges, it is not necessary to create a separate system to make this determination. The system used to determine the extent of the net exposure provides the basis for scheduling out the changes in the cash flows of the derivative and the recognition of such changes in net profit or loss. The timing of the recognition in earnings can be predetermined when the hedge is associated with the exposure to changes in cash flows.

The forecasted transactions that are being hedged can be associated with a specific principal amount in specific future periods, composed of variable-rate assets and cash inflows being reinvested or variable-rate liabilities and cash outflows being refinanced, each of which create a cash flow exposure to changes in interest rates. The specific principal amounts in specific future periods are equal to the notional amount of the derivative hedging instruments and are hedged only for the period that corresponds to the repricing or maturity of the derivative hedging instruments so that the cash flow changes resulting from changes in interest rate are matched with the derivative hedging instrument. IAS 39 specifies that the amounts recognized in equity should be included in net profit or loss in the same period or periods during which the hedged item affects net profit or loss.

If a hedging relationship is designated as a cash flow hedge relating to changes in cash flows resulting from interest rate changes, the documentation required by IAS 39 would include information about the hedging relationship; the enterprise's risk management objective and strategy for undertaking the hedge; the type of hedge; the hedged item; the hedged risk; the hedging instrument; and the method of assessing effectiveness.

Information about the hedging relationship would include the maturity schedule of cash flows used for risk management purposes, to determine exposures to cash flow mismatches on a net basis would provide part of the documentation of the hedging relationship. The enterprise's risk management objective and strategy for undertaking the hedge would be addressed in terms of the enterprise's overall risk management objective and strategy for hedging exposures to interest rate risk would provide part of the documentation of the hedging objective and strategy. The fact that the hedge is a cash flow hedge would also be noted.

The hedged item will be documented as a group of forecasted transactions (interest cash flows) that are expected to occur with a high degree of probability in specified future periods, for instance, scheduled on a monthly basis. The hedged item may include interest cash flows resulting from the reinvestment of cash inflows, including the resetting of interest rates on assets, or from the refinancing of cash outflows, including the resetting of interest rates on liabilities and rollovers of financial liabilities. The forecasted transactions meet the probability test if there are sufficient levels of highly probable cash flows in the specified future periods to encompass the amounts designated as being hedged on a gross basis.

The risk designated as being hedged is documented as a portion of the overall exposure to changes in a specified market interest rate, often the risk-free interest rate or an interbank offered rate, common to all items in the group. To help ensure that the hedge effectiveness test is met at inception of the hedge and subsequently, the designated hedged portion of the interest rate risk could be documented as being based off the same yield curve as the derivative hedging instrument

Each derivative hedging instrument is documented as a hedge of specified amounts in specified future time periods corresponding with the forecasted transactions occurring in the specified future periods designated as being hedged.

The method of assessing effectiveness is documented by comparing the changes in the cash flows of the derivatives allocated to the applicable periods in which they are designated as a hedge to the changes in the cash flows of the forecasted transactions being hedged. Measurement of the cash flow changes is based on the applicable yield curves of the derivatives and hedged items.

When a hedging relationship is designated as a cash flow hedge, the entity might satisfy the requirement for an expectation of high effectiveness in achieving offsetting changes by preparing an analysis demonstrating high historical and expected future correlation between the interest rate risk designated as being hedged and the interest rate risk of the hedging instrument. Existing documentation of the hedge ratio used in establishing the derivative contracts may also serve to demonstrate an expectation of effectiveness.

If the hedging relationship is designated as a cash flow hedge, an enterprise may demonstrate a high probability of the forecasted transactions occurring by preparing a cash flow maturity schedule showing that there exist sufficient aggregate gross levels of expected cash flows, including the effects of the resetting of interest rates for assets or liabilities, to establish that the forecasted transactions that are designated as being hedged are highly probable of occurring. Such a schedule should be supported by management's stated intent and past practice of reinvesting cash inflows and refinancing cash outflows.

For instance, an enterprise may forecast aggregate gross cash inflows of $10,000 and aggregate gross cash outflows of $9,000 in a particular time period in the near future. In this case, it may wish to designate the forecasted reinvestment of gross cash inflows of $1,000 as the hedged item in the future time period. If more than $1,000 of the forecasted cash inflows are contractually specified and have low credit risk, the enterprise has very strong evidence to support an assertion that gross cash inflows of $1,000 are highly probable of occurring and support the designation of the forecasted reinvestment of those cash flows as being hedged for a particular portion of the reinvestment period. A high probability of the forecasted transactions occurring may also be demonstrated under other circumstances.

If the hedging relationship is designated as a cash flow hedge, an enterprise will assess and measure effectiveness under IAS 39, at a minimum, at the time an enterprise prepares its annual or interim financial reports. However, an enterprise may wish to measure it more frequently on a specified periodic basis, at the end of each month or other applicable reporting period. It is also measured whenever derivative positions designated as hedging instruments are changed or hedges are terminated to ensure that the recognition in net profit or loss of the changes in the fair value amounts on assets and liabilities and the recognition of changes in the fair value of derivative instruments designated as cash flow hedges are appropriate.

Changes in the cash flows of the derivative are computed and allocated to the applicable periods in which the derivative is designated as a hedge and are compared with computations of changes in the cash flows of the forecasted transactions. Computations are based on yield curves applicable to the hedged items and the derivative hedging instruments and applicable interest rates for the specified periods being hedged. The schedule used to determine effectiveness could be maintained and used as the basis for determining the period in which the hedging gains and losses recognized initially in equity are reclassified out of equity and recognized in net profit or loss.

If the hedging relationship is designated as a cash flow hedge, an enterprise will account for the hedge as follows: (1) the portion of gains and losses on hedging derivatives determined to result from effective hedges is recognized in equity whenever effectiveness is measured and (2) the ineffective portion of gains and losses resulting from hedging derivatives is recognized in net profit or loss.

The amounts recognized in equity should be included in net profit or loss in the same period or periods during which the hedged item affects net profit or loss. Accordingly, when the forecasted transactions occur, the amounts previously recognized in equity are recognized in net profit or loss. For instance, if an interest rate swap is designated as a hedging instrument of a series of forecasted cash flows, the changes in the cash flows of the swap are recognized in net profit or loss in the periods when the forecasted cash flows and the cash flows of the swap offset each other.

If the hedging relationship is designated as a cash flow hedge, the treatment of any net cumulative gains and losses recognized in equity if the hedging instrument is terminated prematurely, the hedge accounting criteria are no longer met, or the hedged forecasted transactions are no longer expected to take place, will be as described in the following. If the hedging instrument is terminated prematurely or the hedge no longer meets the criteria for qualification for hedge accounting (for instance, the forecasted transactions are no longer highly probable), the net cumulative gain or loss reported in equity remains in equity until the forecasted transaction occurs. If the hedged forecasted transactions are no longer expected to occur, the net cumulative gain or loss is reported in net profit or loss for the period.

IAS 39 states that a hedging relationship may not be designated for only a portion of the time period in which a hedging instrument is outstanding. If the hedging relationship is designated as a cash flow hedge, and the hedge subsequently fails the test for being highly effective, IAS 39 does not preclude redesignating the hedging instrument. The standard indicates that a derivative instrument may not be designated as a hedging instrument for only a portion of its remaining period to maturity but does not refer to the derivative instrument's original period to maturity. If there is a hedge effectiveness failure, the ineffective portion of the gain or loss on the derivative instrument is recognized immediately in net profit or loss and hedge accounting based on the previous designation of the hedge relationship cannot be continued. In this case, the derivative instrument may be redesignated prospectively as a hedging instrument in a new hedging relationship, provided this hedging relationship satisfies the necessary conditions. The derivative instrument must be redesignated as a hedge for the entire time period it remains outstanding.

For cash flow hedges, IAS 39 states that "if the hedged firm commitment or forecasted transaction results in the recognition of an asset or liability, then at the time the asset or liability is recognized the associated gains or losses that were recognized directly in equity, should enter into the initial measurement of the carrying amount of the asset or liability" (basis adjustment). If a derivative is used to manage a net exposure to interest rate risk and the derivative is designated as a cash flow hedge of forecasted interest cash flows or portions thereof on a gross basis, there will be no basis adjustment when the forecasted cash flow occurs. There is no basis adjustment because the hedged forecasted transactions do not result in the recognition of assets or liabilities and the effect of interest rate changes that are designated as being hedged is recognized in net profit or loss in the period in which the forecasted transactions occur. Although the types of hedges described herein would not result in basis adjustment if instead the derivative is designated as a hedge of a forecasted purchase of a financial asset or issuance of a liability, the derivative gain or loss would be an adjustment to the basis of the asset or liability upon the occurrence of the transaction.

IAS 39 permits a portion of a cash flow exposure to be designated as a hedged item. While IAS 39 does not specifically address a hedge of a portion of a cash flow exposure for a forecasted transaction, it specifies that a financial asset or liability may be a hedged item with respect to the risks associated with only a portion of its cash flows or fair value, if effectiveness can be measured. The ability to hedge a portion of a cash flow exposure resulting from the resetting of interest rates for assets and liabilities suggests that a portion of a cash flow exposure resulting from the forecasted reinvestment of cash inflows or the refinancing or rollover of financial liabilities can also be hedged. The basis for qualification as a hedged item of a portion of an exposure is the ability to measure effectiveness.

Furthermore, IAS 39 specifies that a nonfinancial asset or liability can be hedged only in its entirety or for foreign currency risk but not for a portion of other risks because of the difficulty of isolating and measuring the risks attributable to a specific risk. Accordingly, assuming effectiveness can be measured, a portion of a cash flow exposure of forecasted transactions associated with, for example, the resetting of interest rates for a variable-rate asset or liability can be designated as a hedged item.

Since forecasted transactions will have different terms when they occur, including credit exposures, maturities, and option features, there may be an issue over how an enterprise can satisfy the tests in IAS 39 requiring that the hedged group have similar risk characteristics. According to the IGC, the standard provides for hedging a group of assets, liabilities, firm commitments, or forecasted transactions with similar risk characteristics. IAS 39 provides additional guidance and specifies that portfolio hedging is permitted if two conditions are met, namely: the individual items in the portfolio share the same risk for which they are designated and the change in the fair value attributable to the hedged risk for each individual item in the group will be expected to be approximately proportional to the overall change in fair value.

When an enterprise associates a derivative hedging instrument with a gross exposure, the hedged item typically is a group of forecasted transactions. For hedges of cash flow exposures relating to a group of forecasted transactions, the overall exposure of the forecasted transactions and the assets or liabilities that are repricing may have very different risks. The exposure from forecasted transactions may differ based on the terms that are expected as they relate to credit exposures, maturities, option, and other features. Although the overall risk exposures may be different for the individual items in the group, a specific risk inherent in each of the items in the group can be designated as being hedged.

The items in the portfolio do not necessarily have to have the same overall exposure to risk, providing they share the same risk for which they are designated as being hedged. A common risk typically shared by a portfolio of financial instruments is exposure to changes in the risk-free interest rate or to changes in a specified rate that has a credit exposure equal to the highest credit-rated instrument in the portfolio (that is, the instrument with the lowest credit risk). If the instruments that are grouped into a portfolio have different credit exposures, they may be hedged as a group for a portion of the exposure. The risk they have in common that is designated as being hedged is the exposure to interest rate changes from the highest credit-rated instrument in the portfolio. This ensures that the change in fair value attributable to the hedged risk for each individual item in the group is expected to be approximately proportional to the overall change in fair value attributable to the hedged risk of the group. It is likely there will be some ineffectiveness if the hedging instrument has a credit quality that is inferior to the credit quality of the highest credit-rated instrument being hedged, since a hedging relationship is designated for a hedging instrument in its entirety.

For example, if a portfolio of assets consists of assets rated A, BB, and B, and the current market interest rates for these assets are LIBOR+ 20 basis points, LIBOR+ 40 basis points, and LIBOR+ 60 basis points, respectively, an enterprise may use a swap that pays fixed interest rate and for which variable interest payments are made based on LIBOR to hedge the exposure to variable interest rates. If LIBOR is designated as the risk being hedged, credit spreads above LIBOR on the hedged items are excluded from the designated hedge relationship and the assessment of hedge effectiveness.

Proposed Changes to Accounting for Financial Instruments Held for Investment

IAS 32 and IAS 39 are the major pronouncements that deal with accounting for financial instruments—with the former standard addressing matters of reporting and disclosure, and the latter being directed to issues of recognition, derecognition, and measurement. When IAS 39 was issued, as the former IASC was hastening to complete the "core set of standards" as it had agreed to do in order to gain IOSCO's consideration (see Chapter 1 for complete discussion), it was viewed as a mere way station in the journey toward a comprehensive fair value measurement standard to be applicable to all financial assets and liabilities. The new IASB, however, has discovered that fundamental issues, not to mention substantial opposition from certain important constituencies, remain to be solved, and that this process will perhaps take several more years. In the interim, the need for certain improvements to existing IAS 32 and IAS 39 has become evident. Hence, the short-term product of making these standards more workable has been undertaken.

The IASB has exposed for comment a substantial revision to IAS 32 and 39, which, if adopted, would be issued as early as Spring 2003, for possible application by year-end. The revised standards would be more coherent (e.g., all disclosure requirements, including those currently found in IAS 39, would be relocated to IAS 32) and would incorporate some guidance currently found in SIC pronouncements (which would be withdrawn) and in interpretive matter offered by the IAS 39 Implementation Guidance Committee (which would continue to offer nonauthoritative assistance; to date, over 200 suggestions in question-and-answer format have been published). The following paragraphs will survey the more significant changes that may be wrought by these revisions which might affect the accounting by an investor. (Matters pertaining to accounting by the issuer of the instrument are addressed in Chapter 17.)

One very important proposed change pertains to compound financial instruments (i.e., those having characteristics of both liabilities and equity). When an instrument is compound, the liability and equity components must be separately accounted for under IAS 32. Currently, the allocation to the liability component may be accomplished either as a residual amount after separating the equity element, or by measuring the elements based on a relative-fair-value method. The proposal is to eliminate this choice and substitute a method which would require that any asset and liability elements be separated first, with the residual allocated to the equity element. This will conform to the definition of an equity instrument as a residual, as set forth in IAS 39.

The proposed revised IAS 32 would clarify certain disclosure requirements for investments in financial assets. Disclosure will be required of the extent to which fair values are estimated using a valuation technique and the extent to which valuations using valuation techniques are based on assumptions that are not supported by observable market prices. Also to be set forth would be the sensitivity of the estimated fair value to changes in those assumptions, based on a range of reasonably possible alternative assumptions, and the change in fair values estimated using valuation techniques and recognized in profit or loss during the reporting period.

Furthermore, the nature and extent of transfers of financial assets that do not qualify for derecognition will be subject to disclosure, along with an explanation of the risks inherent in any component that continues to be recognized after a transfer of financial assets that does not qualify for derecognition.

Conditions for derecognition of a financial asset would be elucidated by the proposed changes to IAS 39. A guiding principle would become a "continuing involvement approach" that disallows derecognition to the extent to which the transferor has continuing involvement in an asset or a portion of an asset it has transferred. The transferor would be deemed to have a continuing involvement when: (1) it could, or could be required to. reacquire control of the transferred asset (e.g., it has a call option); or (2) compensation based on the performance of the transferred asset will be paid (e.g., a guarantee is provided to the transferee). IASB states that there will be no exceptions to this general principle.

Several existing provisions in IAS 39 are to be eliminated, consistent with the proposed move to a "continuing involvement approach" as a derecognition threshold. First, the idea that the transferor must not retain substantially all of the risk and returns of particular assets for any portion of those assets to qualify for derecognition will be dispensed with. And, second, the transferee "right to sell or repledge" condition for derecognition will be dropped.

Guidance will also be provided on pass-through arrangements. When the transferor continues to collect cash flows from the transferred asset, additional conditions must be met for a transfer to qualify for derecognition. These new conditions are that the transferor have no obligation to pay cash flows to the transferee unless it collects equivalent cash flows from the transferred asset; that the transferor not be permitted to use the transferred asset for its benefit; and that the transferor be obligated to remit on a timely basis to the transferee any cash flows it collects on behalf of the transferee.

At present, disclosures are required when financial assets are pledged as collateral for borrowings. Under the revised IAS 39, this will be expanded somewhat. If the transferee has the ability to sell or repledge collateral received, the transferor will be required to reclassify the collateral in its balance sheet (e.g., as securities pledged). If the transferor defaults on the related obligation and is no longer entitled to the transferred asset, the transferor will derecognize the asset.

Under IAS 39, changes in the fair value of financial assets held for trading are reflected currently in earnings. The proposed amendment to the standard would preclude transfers into or out of the trading category, to eliminate the opportunity for manipulation of reported results of operations (e.g., by removing securities from the trading account when unrealized losses are being experienced). There would be no change, however in the criteria used to classify the securities as either trading or available-for-sale, and designation as held-for-trading would be freely selectable. For that reason, the current option to recognize gains and losses on available-for-sale financial assets in earnings (a choice made only at inception) is to be eliminated. More guidance would be added regarding the means of determination of fair values.

New guidance would be provided relative to identification of impairment of available-for-sale investments. An important change being proposed is the elimination of the option to reverse previously recognized impairments; under revised IAS 39, any impairment to available-for-sale investments would be permanent.

Equity Method of Accounting for Investments

The preceding discussion addressed investments in which the investor has essentially a passive position, due to holding only a small minority ownership interest (or, in the case of debt, no actual ownership interest at all). In such situations, the investor is unable to control or materially influence decisions to be made by management of the investee. The use of fair value accounting has been deemed most appropriate in such circumstances.

In other situations an investor will have active control over the decisions taken by the management of the investee, or have joint control over those decisions, to be made in conjunction with its co-investors. A third logical possibility is that the investor will have something less than control (or joint control), but will clearly also not be a mere passive investor. This last named circumstance is that where there is significant influence over an investee.

The notion of applying what is now known as equity-method accounting to investment situations where the investor is able to exercise significant influence developed in the early 1950s, as an application of the "substance over form" philosophy of financial reporting. It was not actually made mandatory, however, until the late 1960s, in the US. Because the actual determination of the existence of significant influence was anticipated to be difficult, a somewhat arbitrary, refutable presumption of such influence was set at a 20% voting interest in the investee. This became the de facto standard for all later accounting requirements seeking to emulate the pioneering one set forth under US GAAP.

The necessity of applying a method of accounting such as the equity method, when significant influence over the investee is held by the investor, can easily be understood when one considers how readily manipulation of the investor's financial position and results of operations could be achieved in its absence. If an investee has substantial income, but the investor, employing the cost method of accounting for the investment, uses its influence to defer the investee's declaration of dividends, the result would be that the investor would not be reporting its share of the investee's economic operating results, even though it had been in a position to cause a distribution of dividends, had it chosen to do so. This might be motivated, for example, by a desire to put aside future earnings to compensate for an expected, or feared, decline in the investor's own operations.

Conversely, the investor could effect or encourage a dividend distribution even in the absence of earnings by the investee. This could be motivated by a need for reportable earnings, perhaps to offset disappointing performance in the investor's own operations. In either case, the opportunity to manipulate reported results of operations would be of great concern.

More importantly, however, the use of the cost method would simply not reflect the economic reality of the investor's interest in an entity whose operations were indicative, in part at least, of the reporting entity's (i.e., the investor's) management decisions and operational skills. Thus, the clearly demonstrable need to reflect substance, rather than mere form, made the development of the equity method highly desirable.

The pure equity method is not the only possible means of accomplishing the goal of reporting the economic performance of the investor. Other suggested solutions include the expanded equity method and proportionate consolidation. International accounting standards and the various national standard-setting bodies have directed differing levels of attention to these alternatives over the years; the simple equity method has received the most universal support.

The equity method permits an entity (the investor) controlling a certain share of the voting interest in another entity (the investee) to incorporate its pro rata share of the investee's operating results into its earnings. However, rather than include its share of each component of the investee's revenues, expenses, assets and liabilities into its financial statements, the investor will only include its share of the investee's net income as a separate line item in its income. Similarly, only a single line in the investor's balance is presented, but this reflects, to a degree, the investor's share in each of the investee's assets and liabilities. For this reason, the equity method has been referred to as "one-line consolidation."

It is important to recognize that the bottom-line impact on the investor's financial statements is identical whether the equity method or full consolidation is employed; only the amount of detail presented within the statements will differ. An understanding of this principle will be useful as the need to identify the "goodwill" component of the cost of the investment is explained, below.

Expanded equity method.

Less commonly presented than the pure equity method of accounting are the expanded equity method and the proportionate consolidation method. These alternative approaches effectively are successive points along a continuum ranging from a pure historical cost basis to full consolidation. In contrast to the one-line consolidation approach of the simple equity method, the expanded equity method is an attempt to provide more meaningful detail about the various assets and liabilities, and revenues and expenses, in which the investor has an economic interest. Thus, if using the expanded equity method, the investor's interest in the investee's aggregate current assets would be presented, as a single number, in the current asset section of the investor's balance sheet. Similarly, the investor's share of the investee's noncurrent assets, current liabilities, and noncurrent liabilities would be captioned separately in the corresponding section of the investor's balance sheet.

On the income statement, using this expanded equity method, the investor's share of significant items of revenue, expense, gains, and losses would be set forth separately. This would not extend to every item of the income statement, but would highlight the major ones. Greater or lesser degrees of detail would be possible, depending on the investor's preferences, since there are no definitive standards governing this method.

A major advantage of this method of reporting an investor's interest in the investee is that the investor's financial statements will provide a more meaningful insight into the true economic scope of its operations, including indications of the gross volume of business being transacted. Furthermore, financial position will not be distorted by, for example, effectively merging the investee's current assets with the investor's noncurrent assets, which would be the result of placing equity in investee in the noncurrent asset section, as is required under common practice. As the amount of detail expands, the expanded equity method edges into proportionate consolidation, however.

The expanded equity method has not been endorsed, as such, although the equity method as defined by US GAAP (in APB Opinion 18) does incorporate elements of this approach. Specifically, APB 18 mandates one-line consolidation for the balance sheet, but requires that certain components of the investee's income statement (such as extraordinary items) retain their character when incorporated into the investor's income statement. Thus APB 18's requirements do go beyond a strict application of the equity method.

Proportionate consolidation.

This is a more fully developed variant of the expanded equity method, whereby the investor's share of each element of the investee's balance sheet and income statement is reported in the investor's statements. Although there is nonauthoritative GAAP in the United States supporting this method of accounting for investments in joint ventures, and under international accounting standards (as discussed later in the chapter) this method is prescribed optionally for joint ventures, it has not been widely advocated for investments in which the investor does not exercise, at a minimum, joint control. Nonetheless, from a conceptual perspective, it does have appeal since it would convey the full scope of economic activities over which the reporting entity could be said to have either direct control or indirect yet significant impact.

Equity method as prescribed by IAS 28.

The equity method is generally not available to be used as a substitute for consolidation. Consolidation is required when a majority voting interest is held by the reporting entity (the parent) in another entity (the subsidiary). The equity method is intended for use where the reporting entity (the investor) has significant influence over the operations of the other entity (the investee), but lacks control.

In general, significant influence is inferred when the investor owns between 20% and 50% of the investee's voting common stock. However, the 20% threshold stipulated in IAS 28 is not an absolute one. Specific circumstances may suggest that significant influence exists even though the investor's level of ownership is under 20%, in which case the equity method should be applied. In other instances, significant influence may he absent despite a level of ownership above 20%. Therefore, the existence of significant influence in the 20% to 50% ownership range should be treated as a refutable presumption. This 20% lower threshold is identical to that prescribed under US GAAP.

In considering whether significant influence exists, IAS 28 identifies the following factors as evidence that such influence is present: (1) investor representation on the board of directors or its equivalent, (2) participation in policy-making processes, (3) material transactions between the investor and investee, (4) interchange of managerial personnel, and (5) provision of essential technical information. There may be other factors present that suggest a lack of significant influence, such as organized opposition by the other shareholders, majority ownership by a small group of shareholders not inclusive of the investor, and inability to achieve representation on the board or to obtain information on the operations of the investee. Whether sufficient contrary evidence exists to negate the presumption of significant influence is a matter of judgment and requires a careful evaluation of all pertinent facts and circumstances, over an extended period of time in some cases.

When equity method is required.

IAS 28 stipulates that the equity method should be employed by the investor for all investments in associates, unless the investment is acquired and held exclusively with a view to its disposal in the near term, or if it operates under severe long-term restrictions that would preclude making distributions to investors. In the latter cases, the use of the equity method of accounting would not be deemed appropriate; rather, the investment would be carried at its historical cost.

The standard does make something of a distinction between the accounting for investments in associates in consolidated financials versus that in separate financials of the investor. As amended by IAS 39, IAS 28 provides that in the separate financials of the investor the investment in the associate may be carried at either cost, by the equity method, or as an available-for-sale financial asset consistent with IAS 39's provisions, if the investor also prepares consolidated financial statements. If the investor does not issue consolidated financial statements, the choices are expanded to include, if warranted by the facts, treating the investment as a trading security as well.

In practice, many parent-only financial statements apply equity method accounting to subsidiaries and significant influence investees alike. This probably does provide the most meaningful reporting, avoiding detailed inclusion of any assets, liabilities, revenues, or expenses other than the parent company's own in its financial statements, while not distorting the bottom line measure of economic performance.

Complications in applying equity method accounting.

Complexities in the use of the equity method arise in two areas. First, the cost of the investment to the investor might not be equal to the fair value of the investor's share of investee net assets; this is analogous to the existence of goodwill in a purchase business combination. Or the fair value of the investor's share of the investee's net assets may not be equal to the book value thereof; this situation is analogous to the purchase cost allocation problem in consolidations. Since the ultimate income statement result from the use of equity method accounting must generally be the same as full consolidation, an adjustment must be made for each of these differentials.

The second major complexity relates to interperiod income tax allocation. The equity method causes the investor to reflect current earnings based on the investee's operating results; however, for income tax purposes the investor reports only dividends received and gains or losses on disposal of the investment. Thus, temporary differences result, and IAS 12 provides guidance as to the appropriate method of computing the deferred tax effects of these differences.

In the absence of these complicating factors, use of the equity method by the investor is straightforward: The original cost of the investment is increased by the investor's share of the investee's earnings and is decreased by its share of investee losses and by dividends received. The basic procedure is illustrated below.

Example of a simple case ignoring deferred taxes

start example

Assume the following information:

On January 2, 2003, Regency Corporation (the investor) acquired 40% of Elixir Company's (the investee) voting common stock on the open market for $100,000. Unless demonstrated otherwise, it is assumed that Regency Corporation can exercise significant influence over Elixir Company's operating and financing policies. On January 2, Elixir's stockholders' equity is comprised of the following accounts:

Common stock, par $1, 100,000 shares authorized, 50,000 shares issued and outstanding

$ 50,000

Additional paid-in capital

150,000

Retained earnings

50.000

  • Total stockholders' equity

$250,000

Note that the cost of Elixir Company common stock was equal to 40% of the book value of Elixir's net assets. Assume also that there is no difference between the book value and the fair value of Elixir Company's assets and liabilities. Accordingly, the balance in the investment account in Regency's records represents exactly 40% of Elixir's stockholders' equity (net assets). Assume further that Elixir Company reported a 2003 net income of $30,000 and paid cash dividends of $10,000. Its stockholders' equity at year-end would be as follows:

Common stock, par $ 1,100,000 shares authorized, 50,000 shares issued and outstanding

$ 50,000

Additional paid-in capital

150,000

Retained earnings

70,000

  • Total stockholders' equity

$270,000

Regency Corporation would record its share of the increase in Elixir Company's net assets during 2003 as follows:

Investment in Elixir Company

12,000

 
  • Equity in Elixir income ($30,000 x 40%)

 

12,000

Cash

4,000

 
  • Investment in Elixir Company ($10,000 x 40%)

 

4,000

When Regency's balance sheet is prepared at December 31, 2003, the balance reported in the investment account would be $108,000 ($100,000 + $12,000 - $4,000). This amount represents 40% of the book value of Elixir's net assets at the end of the year (40% x $270,000). Note also that the equity in Elixir income is reported as one amount on Regency's income statement under the caption "Other income and expense."

end example

IAS 12 (which was revised substantially after first being promulgated) established the requirement that deferred income taxes be provided for the tax effects of timing differences. Under this standard, discussed in detail in Chapter 15, the liability method must be employed, under which the provision of a net deferred tax asset or liability is adjusted at each balance sheet date to reflect the current expectations regarding the amount that ultimately is to be received or paid.

In order to compute the deferred tax effects of income recognized by an investor employing the equity method of accounting for its investment, it must make an assumption regarding the means by which undistributed earnings of its investee will be realized. Earnings can generally be realized either through subsequent receipt of dividends, or by disposition of the investment at a gain, which presumably would reflect the investee's undistributed earnings as of that date. In many jurisdictions, these alternative modes of income realization will have differing tax implications. For example, in many jurisdictions the assumption of future dividends would result in taxes at the investor's marginal tax rate on ordinary income (net of any dividends received deduction or exclusion permitted by the local taxing authorities). If the sale of the investment is expected to be the route by which earnings are realized, this would commonly result in a capital gain, which in some jurisdictions is taxed at a different rate, or not taxed at all.

Example of a simple case including deferred taxes

start example

Assume the same information as in the example above. In addition, assume that Regency Corporation has a combined (federal, state, and local) marginal tax rate of 34% on ordinary income and that it anticipates realization of Elixir Company earnings through future dividend receipts. In Regency's tax jurisdiction, there is an 80% deduction for dividends received from non-subsidiary investees, meaning that only 20% of the income is subject to ordinary tax. Regency Corporation's entries at year-end 2003 will be as follows:

  1. Investment in Elixir Company

12,000

 
  • Equity in Elixir income

 

12,000

  1. Income tax expense

816

 
  • Deferred taxes

 

816

(Taxable portion of investee earnings to be received in the future as dividends times marginal tax rate: $12,000 x 20% x 34% = $816)

  1. Cash

4.000

 
  • Investment in Elixir Company

 

4,000

  1. Deferred taxes

272

 
  • Taxes payable—current

 

272

[Fraction of investee earnings currently taxed ($4,000/12,000) × 816 = $272]

Under the liability method of interperiod income tax allocation, as required by IAS 12, the tax provision should be based on the projected tax effect of the temporary difference reversal, and this may be subsequently adjusted for a variety of reasons, including alterations in tax rates and revision to management expectations (see Chapter 15 for a complete discussion).

Furthermore, when the taxable income (from dividends or the sale of the investment) is ultimately realized, the actual incidence of tax may still differ from the amount of deferred tax provided, as adjusted. This may occur because, assuming graduated rates and other complexities apply, the actual tax effect is a function of the entity's other current items of income and expense in the year of realization. Also, notwithstanding good-faith expectations, the realization of the investee's earnings may come in a manner other than anticipated (e.g., a sudden decision to sell rather than hold the investment could precipitate capital gains when future dividend income was planned for).

To illustrate this last point, assume that in 2004, before any further earnings or dividends are reported by the investee, the investor sells the entire investment for $115,000. The tax impact is

Selling price

$115,000

Less cost

100,000

Gain

$ 15,000

Capital gain rate (marginal corporate rate)

x 34%

Tax liability

$ 5,100

The entries to record the sale, the tax thereon, and the amortization of deferred taxes provided previously on the undistributed 2003 earnings are as follows:

  1. Cash

115,000

 
  • Investment in Elixir Company

 

108,000

  • Gain on sale of investment

 

7,000

  1. Income tax expense

4,556

 

Deferred tax liability

544

 
  • Taxes payable—current

 

5,100

In the above, income tax expense of $4,556 is the sum of two factors: (1) the capital gains rate of 34% applied to the actual book gain realized ($115,000 selling price less $108,000 carrying value), for a tax of $2,380, and (2) the difference between the capital gains tax rate (34%) and the effective rate on dividend income (20% x 34% = 6.8%) on the undistributed 2003 earnings of Elixir Company previously recognized as ordinary income by Regency Corporation [$8,000 x (34% - 6.8%) = $2,176].

Note that if the realization through a sale of the investment had been anticipated at the time the 2003 balance sheet was being prepared, the deferred tax liability account would have been adjusted (possibly to the entire $5,100 amount of the ultimate obligation), with the offsetting entry applied to 2003 ordinary tax expense. The example above explicitly assumes that sale of the investment was not anticipated prior to 2004.

end example

Accounting for a differential between cost and book value.

The simple examples presented thus far avoided the major complexity of equity method accounting, the allocation of the differential between the cost to the investor and the investor's share in the net equity (net assets at book value) of the investee. Since the net impact of equity method accounting must equal that of full consolidation accounting, this differential must be analyzed into the following components and accounted for accordingly:

  1. The difference between the book and fair values of the investee's net assets at the date the investment is made.

  2. The remaining difference between the fair value of the net assets and the cost of the investment, that is generally attributable to goodwill.

According to IAS 28, any difference between the cost of the investment and the investor's share of the fair values of the net identifiable assets of the associate should be identified and accounted for in accordance with IAS 22 (as detailed in Chapter 11). Thus, the differential should be allocated to specific asset categories, and these differences will then be amortized to the income from investee account as appropriate, for example, over the economic lives of fixed assets whose fair values exceeded book values. The difference between fair value and cost will be treated like goodwill and, in accordance with the provisions of IAS 22, amortized over a period generally not to exceed five years, but potentially as long as twenty years.

Example of a complex case ignoring deferred taxes

start example

Assume again that Regency Corporation acquired 40% of Elixir Company's shares on January 2, 2003, but that the price paid was $140,000. Elixir Company's assets and liabilities at that date had the following book and fair values:

 

Book value

Fair value

Cash

$ 10,000

$ 10,000

Accounts receivable (net)

40,000

40,000

Inventories (FIFO cost)

80,000

90,000

Land

50,000

40,000

Plant and equipment (net of accumulated depreciation)

140,000

220,000

  • Total assets

$320,000

$400,000

Liabilities

(70,000)

(70,000)

Net assets (stockholders' equity)

$250,000

$330,000

The first order of business is the calculation of the differential, as follows:

Regency's cost for 40% of Elixir's common stock

$140,000

Book value of 40% of Elixir's net assets ($250,000 × 40%)

(100,000)

Total differential

$ 40,000

Next, the $40,000 is allocated to those individual assets and liabilities for which fair value differs from book value. In the example, the differential is allocated to inventories, land, and plant and equipment, as follows:

Item

Book value

Fair value

Difference debit (credit)

40% of difference debit (credit)

Inventories

$ 80,000

$ 90,000

$ 10,000

$ 4,000

Land

50,000

40,000

(10,000)

(4,000)

Plant and equipment

140,000

220,000

80,000

32,000

Differential allocated

   

$32,000

The difference between the allocated differential of $32,000 and the total differential of $40,000 is goodwill of $8,000. As shown by the following computation, goodwill represents the excess of the cost of the investment over the fair value of the net assets acquired.

Regency's cost for 40% of Elixir's common stock

$140,000

40% of Elixir's net assets ($330,000 × 40%)

(132,000)

Excess of cost over fair value (goodwill)

$ 8,000

At this point it is important to note that the allocation of the differential is not recorded formally by either Regency Corporation or Elixir Company. Furthermore, Regency does not remove the differential from the investment account and allocate it to the respective assets, since the use of the equity method (one-line consolidation) does not involve the recording of individual assets and liabilities. Regency leaves the differential of $40,000 in the investment account, as part of the balance of $140,000 at January 2, 2003. Accordingly, information pertaining to the allocation of the differential is maintained by the investor, but this information is outside the formal accounting system, which is comprised of journal entries and account balances.

After the differential has been allocated, the amortization pattern is developed. To develop the pattern in this example, assume that Elixir's plant and equipment have 10 years of useful life remaining and that Elixir depreciates its fixed assets on a straight-line basis. Furthermore, assume that Regency amortizes goodwill over a 20-year period. Regency would prepare the following amortization schedule:

Item

Differential debit (credit)

Useful life

Amortization

2003

2004

2005

Inventories (FIFO)

$ 4,000

Sold in 2002

$4,000

$ --

$ --

Land

(4,000)

Indefinite

--

--

--

Plant and equipment (net)

32,000

10 years

3.200

3,200

3,200

Goodwill

8.000

20 years

400

400

400

Totals

$40,000

 

$7,600

$3,600

$3,600

Note that the entire differential allocated to inventories is amortized in 2003 because the cost flow assumption used by Elixir is FIFO. If Elixir had been using LIFO instead of FIFO, no amortization would take place until Elixir sold some of the inventory that existed at January 2, 2003. Since this sale could be delayed for many years under LIFO, the differential allocated to LIFO inventories would not be amortized until Elixir sold more inventory than it manufactured/purchased. Note also that the differential allocated to Elixir's land is not amortized, because land is not a depreciable asset.

The amortization of the differential is recorded formally in the accounting system of Regency Corporation. Recording the amortization adjusts the equity in Elixir's income that Regency recorded based on Elixir's income statement. Elixir's income must be adjusted because it is based on Elixir's book values, not on the cost that Regency incurred to acquire Elixir. Regency would make the following entries in 2003, assuming that Elixir reported net income of $30,000 and paid cash dividends of $10,000:

  1. Investment in Elixir

12,000

 
  • Equity in Elixir income ($30,000 x 40%)

 

12,000

  1. Equity in Elixir income (amortization of differential)

7,600

 
  • Investment in Elixir

 

7,600

  1. Cash

4,000

 
  • Investment in Elixir ($10,000 x 40%)

 

4,000

The balance in the investment account on Regency's records at the end of 2003 is $140,400 [$140,000 + $12,000 - ($7,600 + $4,000)], and Elixir's stockholders' equity, as shown previously, is $270,000. The investment account balance of $140,000 is not equal to 40% of $270,000. However, this difference can easily be explained, as follows:

Balance in investment account at December 31, 2003

 

$140,400

40% of Elixir's net assets at December 31, 2003

 

108,000

  • Difference at December 31, 2003

 

$ 32,400

Differential at January 2, 2003

$40,000

 

Differential amortized during 2003

(7,600)

 
  • Unamortized differential at December 31, 2003

 

$ 32,400

As the years go by, the balance in the investment account will come closer and closer to representing 40% of the book value of Elixir's net assets. After twenty years, the remaining difference between these two amounts would be attributed solely to the original differential allocated to land (a $4,000 credit). This $4,000 difference would remain until Elixir sold the property.

To illustrate how the sale of land would affect equity method procedures, assume that Elixir sold the land in the year 2023 for $80,000. Since Elixir's cost for the land was $50,000, it would report a gain of $30,000, of which $12,000 ($30,000 x 40%) would be recorded by Regency. when it records its 40% share of Elixir's reported net income, ignoring income taxes. However, from Regency's viewpoint, the gain on sale of land should have been $40,000 ($80,000 - $40,000) because the cost of the land from Regency's perspective was $40,000 at January 2, 2003. Therefore, besides the $12,000 share of the gain recorded above, Regency should record an additional $4,000 gain [($40,000 - $30,000) x 40%] by debiting the investment account and crediting the equity in Elixir income account. This $4,000 debit to the investment account will negate the $4,000 differential allocated to land on January 2, 2003, since the original differential was a credit (the fair market value of the land was $10,000 less than its book value).

end example

Example of a complex case including deferred taxes

start example

The impact of interperiod income tax allocation in the foregoing example is similar to that demonstrated earlier in the simplified example. However, a complication arises with regard to the portion of the differential allocated to goodwill, since in some jurisdictions amounts representing goodwill are not amortizable for tax purposes and, therefore, will be a permanent (not a timing) difference that does not give rise to deferred taxes. The other components of the differential in this example are all generally defined as being timing differences.

The entries recorded by Regency Corporation in 2003 would be

  1. Investment in Elixir

12,000

 
  • Equity in Elixir income

 

12,000

  1. Income tax expense

816

 
  • Deferred tax liability ($12,000 × 20% × 34%)

 

816

  1. Cash

4,000

 
  • Investment in Elixir

 

4,000

  1. Deferred tax liability

272

 
  • Taxes payable—current ($4,000/12,000 × 816)

 

272

  1. Equity in Elixir income

7,600

 
  • Investment in Elixir

 

7,600

  1. Deferred tax liability

490

 
  • Income tax expense ($7,200 × 20% × 34%)

 

490

Note that the tax effect of the amortization of the differential is based on $7,200, not $7,600, since the $400 goodwill amortization would not have been tax deductible.

end example

Reporting disparate elements of the investee's income statement.

As suggested earlier in this section, the expanded equity method would require that the major captions in the investee's income statement maintain their character when reported, pro rata, by the investor. IAS 28 does not mandate use of the expanded equity method, although it notes in its disclosure requirements that the investor's share of extraordinary and prior period items should be noted. Although the standard is silent on separate reporting on the face of the financial statements themselves, the authors are of the opinion that, to the extent that certain items would be a material part of the investor's income statement and thus have the potential to mislead users of those financial statements, it would be prudent and fully consistent with the spirit of IAS 28 to report these separately. For example, if the investee reports a correction of a fundamental error according to IAS 8, or an extraordinary gain or loss, it would be distortive to include the investor's share of these in equity in earnings of investee without signaling that these are not normal, recurring items of income or loss.

The solution, of course, is to include the investor's share of these items with similar items in the investor's financial statements. That is, the expanded equity method concept should be applied, judiciously, to the investor's income statement. This would not extend, however, to separate reporting of any items of operating income or expense (gross sales, salaries, depreciation, etc.).

Example of accounting for separately reportable items

start example

Assume that both an extraordinary item and a prior period adjustment reported in an investee's income and retained earnings statements are individually considered material from the investor's viewpoint.

Investee's income statement:

  • Income before extraordinary item

$ 80,000

  • Extraordinary loss from earthquake (net of taxes of $ 12,000)

(18,000)

  • Net income

$ 62,000

Investee's retained earnings statement:

  • Retained earnings at January 1, 2003, as originally reported

$250,000

  • Add prior period adjustment—correction of an error made in 2002 (net of taxes of $10,000)

20,000

  • Retained earnings at January 1, 2003, as restated

$270,000

If an investor owned 30% of the voting common stock of this investee, the investor would make the following journal entries in 2003:

  1. Investment in investee company

24,000

 
  • Equity in investee income before extraordinary item ($80,000 × 30%)

 

24,000

  1. Equity in investee extraordinary loss

5,400

 
  • Investment in investee company ($180,000 × 30%)

 

5,400

  1. Investment in investee company

6,000

 
  • Equity in investee prior period adjustment ($20,000 × 30%)

 

6,000

The equity in the investee's prior period adjustment should be reported on the investor's retained earnings statement, and the equity in the extraordinary loss should be reported separately in the appropriate section on the investor's income statement.

end example

Intercompany transactions between investor and investee.

Transactions between the investor and the investee may require that the investor make certain adjustments when it records its share of the investee earnings. According to the realization concept, profits can be recognized by an entity only when realized through a sale to outside (unrelated) parties in arm's-length transactions (sales and purchases) between the investor and investee. Similar problems can arise when sales of fixed assets between the parties occur. In all cases, there is no need for any adjustment when the transfers are made at book value (i.e., without either party recognizing a profit or loss in its separate accounting records).

In preparing consolidated financial statements, all intercompany (parent-subsidiary) transactions are eliminated. However, when the equity method is used to account for investments, only the profit component of intercompany (investor-investee) transactions is eliminated. This is because the equity method does not result in the combining of all income statement accounts (such as sales and cost of sales) and therefore will not cause the financial statements to contain redundancies. In contrast, consolidated statements would include redundancies if the gross amounts of all intercompany transactions were not eliminated.

IAS 28 was not explicit regarding the percentage of unrealized profits on investor-investee transactions that were to be eliminated. Logical arguments can be made either to eliminate 100% of intercompany profits not realized through a subsequent transaction with unrelated third parties, that would follow the model of consolidated financial statements, or to eliminate only the percentage held by the investor. In SIC 3, the Standing Interpretations Committee has held that when applying the equity method, unrealized profits should be eliminated for both "upstream" and "downstream" transactions (i.e., sales from investee to investor, and from investor to investee) to the extent of the investor's interest in the investee. This proportional method is set forth in IAS 31, dealing with joint ventures, which does address this issue. The logic is that in an investor-investee situation, the investor does not have control (as would be the case with a subsidiary), and thus the nonowned percentage is effectively realized through an arm's-length transaction. For joint ventures, IAS 31 prescribes proportionate consolidation, which implies likewise that profits on intercompany transactions be eliminated only to the extent of the investor's interest in the venture. However, to the extent that losses are indicative of impairment in the value of the investment, the rule that profit elimination be limited to the investor's ownership percentage would not apply.

Example of accounting for intercompany transactions

start example

Continue with the same information from the previous example and also assume that Elixir Company sold inventory to Regency Corporation in 2004 for $2,000 above Elixir's cost. Thirty percent of this inventory remains unsold by Regency at the end of 2004. Elixir's net income for 2004, including the gross profit on the inventory sold to Regency, is $20,000; Elixir's income tax rate is 34%. Regency should make the following journal entries for 2004 (ignoring deferred taxes):

  1. Investment in Elixir

8,000

 
  • Equity in Elixir income ($20,000 x 40%)

 

8,000

  1. Equity in Elixir income (amortization of differential)

3,600

 
  • Investment in Elixir

 

3,600

  1. Equity in Elixir income

158

 
  • Investment in Elixir ($2,000 x 30% x 66% x 40%)

 

158

The amount in the last entry needs further elaboration. Since 30% of the inventory remains unsold, only $600 of the intercompany profit is unrealized at year-end. This profit, net of income taxes, is $396. Regency's share of this profit ($158) is included in the first ($8,000) entry recorded. Accordingly, the third entry is needed to adjust or correct the equity in the reported net income of the investee.

Eliminating entries for intercompany profits in fixed assets are similar to those in the examples above. However, intercompany profit is realized only as the assets are depreciated by the purchasing entity. In other words, if an investor buys or sells fixed assets from or to an investee at a price above book value, the gain would only be realized piecemeal over the asset's remaining depreciable life. Accordingly, in the year of sale the pro rata share (based on the investor's percentage ownership interest in the investee, regardless of whether the sale is upstream or downstream) of the unrealized portion of the intercompany profit would have to be eliminated. In each subsequent year during the asset's life, the pro rata share of the gain realized in the period would be added to income from the investee.

end example

Example of eliminating intercompany profit on fixed assets

start example

Assume that Radnor Co., that owns 25% of Empanada Co., sold to Empanada a fixed asset having a five-year remaining life, at a gain of $100,000. Radnor Co. expects to remain in the 34% marginal tax bracket. The sale occurred at the end of 2002; Empanada Co. will use straight-line depreciation to amortize the asset over the years 2003 through 2007.

The entries related to the foregoing are

2002:

  
  1. Gain on sale of fixed asset

25,000

 
  • Deferred gain

 

25,000

To defer the unrealized portion of the gain

  1. Deferred tax benefit

8,500

 
  • Income tax expense

 

8,500

Tax effect of gain deferral

Alternatively, the 2002 events could have been reported by this single entry.

Equity in Empanada income

16,500

 
  • Investment in Empanada Co.

 

16,500

2003 through 2007 (each year):

  1. Deferred gain

5,000

 
  • Gain on sale of fixed assets

 

5,000

To amortize deferred gain

  1. Income tax expense

1,700

 
  • Deferred tax benefit

 

1,700

Tax effect of gain realization

The alternative treatment would be

Investment in Empanada Co.

3,300

 
  • Equity in Empanada income

 

3,300

In the example above, the tax currently paid by Radnor Co. (34% x $25,000 taxable gain on the transaction) is recorded as a deferred tax benefit in 2002 since taxes will not be due on the book gain recognized in the years 2003 through 2007. Under provisions of IAS 12, deferred tax benefits should be recorded to reflect the tax effects of all deductible timing differences. Unless Radnor Co. could demonstrate that future taxable amounts arising from existing temporary differences exist, this deferred tax benefit might be offset by an equivalent valuation allowance in Radnor Co.'s balance sheet at year-end 2002, because of the doubt that it will ever be realized. Thus, the deferred tax benefit might not be recognizable, net of the valuation allowance, for financial reporting purposes unless other temporary differences not specified in the example provided future taxable amounts to offset the net deductible effect of the deferred gain.

Note 

The deferred tax impact of an item of income for book purposes in excess of tax is the same as a deduction for tax purposes in excess of book.

This is discussed more fully in Chapter 15.

end example

Accounting for a partial sale or additional purchase of the equity investment.

This section covers the accounting issues that arise when the investor either sells some or all of its equity or acquires additional equity in the investee. The consequence of these actions could involve discontinuation of the equity method of accounting, or resumption of the use of that method.

Example of accounting for a discontinuance of the equity method

start example

Assume that Plato Corp. owns 10,000 shares (30%) of Xenia Co. common stock for which it paid $250,000 ten years ago. On July 1, 2003, Plato sells 5,000 Xenia shares for $375,000. The balance in the Investment in Xenia Co. account at January 1, 2003, was $600,000. Assume that all the original differential between cost and book value has been amortized. To calculate the gain (loss) on this sale of 5,000 shares, it is necessary first to adjust the investment account so that it is current as of the date of sale. Assuming that the investee had net income of $100,000 for the six months ended June 30, 2003, the investor should record the following entries:

  1. Investment in Xenia Co.

30,000

 
  • Equity in Xenia income ($100,000 x 30%)

 

30,000

  1. Income tax expense

2,040

 
  • Deferred tax liability ($30,000 x 20% x 34%)

 

2,040

The gain on sale can now be computed, as follows:

Proceeds on sale of 5,000 shares

$375,000

Book value of the 5,000 shares ($630,000 x 50%)

315,000

Gain from sale of Xenia common

$ 60,000

Two entries will be needed to reflect the sale: one to record the proceeds, the reduction in the investment account, and the gain (or loss); the other to record the tax effects thereof. Recall that the investor must have computed the deferred tax effect of the undistributed earnings of the investee that it had recorded each year, on the basis that those earnings either would eventually be paid as dividends or would be realized as capital gains. When those dividends are ultimately received or when the investment is disposed of, the deferred tax liability recorded previously must be amortized.

To illustrate, assume that the investor in this example, Plato Corp., provided deferred taxes at an effective rate for dividends (considering the assumed 80% exclusion of intercorporate dividends) of 6.8%. The realized capital gain will be taxed at an assumed 34%. For tax purposes, this gain is computed as $375,000 - $125,000 = $250,000, giving a tax effect of $85,000. For accounting purposes, the deferred taxes already provided are 6.8% x ($315,000 - $125,000), or $12,920. Accordingly, an additional tax expense of $72,080 is incurred on the sale, due to the fact that an additional gain was realized for book purposes ($375,000 - $315,000 = $60,000; tax at 34% = $20,400) and that the tax previously provided for at dividend income rates was lower than the real capital gains rate [$190,000 x (34% - 6.8%) = $51,680 extra tax due]. The entries are as follows:

  1. Cash

375,000

 
  • Investment in Xenia Co.

 

315,000

  • Gain on sale of Xenia Co. stock

 

60,000

  1. Deferred tax liability

12,920

 

Income tax expense

72,080

 
  • Taxes payable—current

 

85,000

end example

The gains (losses) from sales of investee stock are reported on the investor's income statement in the other income and expense section, assuming that a multistep income statement is presented.

According to IAS 28, an investor should discontinue use of the equity method when (1) it ceases to have significant influence in an associate while retaining some or all of its investment, or (2) the use of the equity method is no longer deemed to be appropriate because the associate is operating under severe and long-lasting restrictions that will limit its ability to transfer funds to the investor entity.

In the foregoing example, the sale of stock reduced the percentage of the investee owned by the investor to 15%. In a situation such as this, discontinuation of the equity method is generally prescribed, although it is not inconceivable that significant influence can still be demonstrated at that ownership level, which would require continued application of equity method accounting.

The balance in the investment account on the date the equity method is suspended ($315,000 in the example) continues as an asset, but it then becomes subject to the IAS 39 requirement that it be accounted for at fair value. Passive equity investments are classified as either held-for-trading or available-for-sale; in this fact situation, categorization as available-for-sale is most likely. Under IAS 39, changes in fair value of available-for-sale investments are reported either in earnings or directly in equity, depending on the election made by the reporting entity upon first adoption. For purposes of this example, assume election of reporting changes in the fair value of available-for-sale investments will be shown in equity.

The change in ownership precipitates a change in accounting principle from equity method to fair value. This change does not require computation of a cumulative effect or any retroactive disclosures in the investor's financial statements. In periods subsequent to this change, the investor records cash dividends received from the investment as dividend revenue. Any dividends received in excess of the investor's share of post-disposal-date earnings of the investee (which are unlikely) should be credited to the investment account rather than to income, as they would represent a return of capital, rather than income.

An entity may hold an investment in another enterprise's common stock that is below the level that would create a presumption of significant influence, which it later increases so that the threshold for application of the equity method is exceeded. The guidance of IAS 28 would suggest that when the equity method is first applied, the difference between the carrying value of the investment and the fair value of the underlying net identifiable assets must be computed (as described earlier in the chapter). Even though IAS 39's fair value provisions were being applied, there will likely be a difference between the fair value of the passive investment (gauged by market prices for publicly-traded securities) and the fair value of the investee's underlying net assets (which are driven by the ability to generate cash flows, etc.). Thus, when the equity method accounting threshold is first exceeded for a formerly passively held investment, determination of the "goodwill-like" component of the investment will typically be necessary.

Example of accounting for a return to the equity method of accounting

start example

Continuing the same example, Xenia Co. reported earnings for the second half of 2003 and all of 2004, respectively, of $150,000 and $350,000; Xenia paid dividends of $100,000 and $150,000 in December of those years. During the period from July 2003 through December 2004, Plato Corp. accounted for its investment in Xenia Co. as an investment in marketable securities, at fair value, with changes in carrying value being reflected directly in equity. At December 31, 2003, the fair value of Plato's holding of Xenia's stock is assessed at $335,000; at December 31, 2004, the fair value is $365,000.

In January 2005. the Plato Corp. purchased 10,000 Xenia shares in the open market for $700,000, thereby increasing its ownership share to 45% and necessitating a return to equity method accounting. The fair value of Plato's interest in the underlying identifiable net assets of Xenia at this date is $1,000,000. The relevant entries are as follows:

  1. Cash

15,000

 
  • Income from Xenia dividends

 

15,000

To report dividends paid in 2003

  1. Investment in Xenia Corp.

20,000

 
  • Unrealized gain on available-for-sale investment

 

20,000

To reflect increased value of investment

  1. Income tax expense

1,020

 

Unrealized gain on available-for-sale investment

6,800

 
  • Taxes payable—current

 

1,020

  • Taxes payable—deferred

 

6,800

To record taxed on dividends at current effective tax rate [$15,000 × .068] and deferred taxes on value increase [$20,000 × .34] in 2003

  1. Cash

22,500

 
  • Income from Xenia dividends

 

22,500

To report dividends paid in 2004

  1. Investment in Xenia Corp.

30,000

 
  • Unrealized gain on available-for-sale investment

 

30,000

To reflect increased value of investment

  1. Income tax expense

1,530

 

Unrealized gain on available-for-sale investment

10,200

 
  • Taxes payable—current

 

1,530

  • Taxes payable—deferred

 

10,200

To record taxes on dividends at current effective tax rate [$22,500 × .068] and deferred taxes on value increase [$30,000 × .34] in 2004

  1. Investment in Xeniu Co.

700,000

 
  • Cash

 

700,000

To record additional investment in Xenia

  1. Unrealized gain on available-for-sale investment

33,000

 
  • Income from investment

 

33,000

See explanation for this entry below

The explanation for the last entry above is as follows. IAS 28 does not suggest that a return to the previously discontinued equity method would result in a restatement of the investment account and the additional equity and retained earnings accounts to "catch up" to what the balances would have been had that not taken place. Accordingly, the authors believe that the new cost basis of the investment at the time the equity method is reestablished should be the adjusted carrying amount immediately prior thereto. In the present example, the carrying amount was as follows:

Balance 6/30/03

$ 315,000

Adjust to fair value 12/03

20,000

Adjust to fair value 12/04

30,000

Balance, 12/04

$ 365,000

Additional investment, 1/05

700,000

Carrying value, 1/05

$1,065,000

The difference between the new cost basis, $1,065,000, and Plato's equity in Xenia's net identifiable assets, ($1,065,000 - $1,000,000 =) $65,000, would be treated similar to goodwill and amortized (generally over a maximum of twenty years), as illustrated earlier in this chapter.

It would not be appropriate to carry forward the amount reflected in the additional equity account, $33,000, since the investment is no longer to be accounted for under IAS 39. Accordingly, in the authors' opinion, this should be reported as current period earnings, analogous to how the disposition of any other available-for-sale investment would be accounted for (where the unrealized gain or loss had been reported in equity, not in earnings during the holding period). The income will have been realized by adoption or readoption of the equity method. Note that the $33,000 balance is the net of the cumulative $50,000 upward revaluation recognized in 2003 and 2004, and the $17,000 tax provision, at capital gain rates (assumed in this example to be 34%), which was expected to pertain to the ultimate realization of this value increase. If, at the time the equity method is resumed, the effective tax rate is expected to differ from that used to compute deferred taxes earlier (e.g., due to the effect of the significant influence over the investee's dividend decisions), then there would be a need for an adjustment to the deferred tax provision.

To illustrate the latter point, assume that Plato now expects to realize all its income from Xenia in the form of dividends, to be taxed at an effective rate of 6.8%. The entry to adjust the deferred tax liability would be

Taxes payable—deferred

13,600

 
  • Tax expense

 

13,600

To record adjustment to deferred taxes

Note that the offset to the deferred tax adjustment is to current period (i.e., 2005) tax expense, under the rules of IAS 12, as described more fully in Chapter 15.

The foregoing illustration adjusts the additional equity account to earnings, since the resumption of equity method accounting is seen as an economic event of that period, similar to an outright sale of the investment. However, IAS 28 is silent on this matter and an argument could perhaps be made that this adjustment should be made to retained earnings directly, in effect as an adjustment to prior periods' earnings. This is the accounting prescribed under US GAAP.

end example

Investor accounting for investee capital transactions.

Investor accounting for investee capital transactions that affect the worth of the investor's investment is not addressed by IAS 28. However, given that ultimately the effect of using equity method accounting is intended to mirror full consolidation, it is logical that investee transactions of a capital nature, which affect the investor's share of the investee's stockholders' equity, should be accounted for as if the investee were a consolidated subsidiary. These transactions principally include situations where the investee purchases treasury stock from, or sells unissued shares or shares held in the treasury to, outside shareholders (i.e., owners other than the reporting entity). (Note that, if the investor participates in these transactions on a pro rata basis, its percentage ownership will not change and no special accounting would be necessary.) Similar results will be obtained when holders of outstanding options or convertible securities acquire additional investee common shares via exercise or conversion.

When the investee engages in one of the foregoing capital transactions, the investor's ownership percentage will be altered. This gives rise to a gain or loss, depending on whether the price paid (for treasury shares acquired) or received (for shares issued) is greater or lesser than the per share carrying value of the investor's interest in the investee. However, since no gain or loss can be recognized on capital transactions, these purchases or sales will be reflected in paid-in capital and/or retained earnings directly, without being reported through the investor's income statement. This method is consistent with the treatment that would be accorded to a consolidated subsidiary's capital transactions.

Example of accounting for an investee capital transaction

start example

Assume that Roger Corp. purchases, on 1/2/03, 25% (2,000 shares) of Energetic Corp.'s outstanding shares for $80,000. The cost is equal to both the book and fair values of Roger's interest in Energetic's underlying net assets (i.e., there is no differential to be accounted for as goodwill). One week later, Energetic Corp. acquires 1,000 shares of its stock from other shareholders, in a treasury stock transaction, for $50,000. Since the price paid ($50/share) exceeded Roger Corp.'s per share carrying value of its interest, ($80,000 ÷ 2,000 shares =) $40, Roger Corp. has in fact suffered economic harm by this transaction. Also, Roger's percentage ownership of Energetic Corp. has increased, because the number of shares held by third parties, and total shares outstanding, have been reduced.

Roger Corp.'s new interest in Energetic's net assets is

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The interest held by Roger Corp. has thus been diminished by $80,000 - $77,143 = $2,857. Therefore, Roger Corp. should make the following entry:

Paid-in capital (or retained earnings)

2,857

 
  • Investment in Energetic Corp.

 

2,857

Roger Corp. should charge the loss against paid-in capital only if paid-in capital from past transactions of a similar nature exists; otherwise, the debit must be made to retained earnings. Had the transaction given rise to a gain, it would have been credited to paid-in capital only (never to retained earnings) following the accounting principle that transactions in one's own shares cannot produce reportable earnings.

Note that the amount of the charge to paid-in capital (or retained earnings) in the entry above can be verified as follows: Roger Corp.'s share of the posttransaction net equity (2/7) times the excess price paid to outside interests ($50 - $40 = $10) times the number of shares purchased = 2/7 x $10 x 1,000 = $2,857.

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Other than temporary impairment in value of equity method investments.

IAS 28 provides that if there is a decline in value of an investment accounted for by the equity method which is determined to be "other than temporary" in nature, the carrying value of the investment should be adjusted downward. This criterion must be applied on an individual investment basis.

Other requirements of IAS 28.

The standard requires that there be disclosure of the percentage of ownership that is held by the investor in each investment and, if it differs, the percentage of voting rights that are controlled. The method of accounting that is being applied to each significant investment should also be identified.

In addition, there may have been certain assumptions or adjustments made in developing information so that the equity method was applied. For example, the investee may have used different accounting principles than the investor, for which the investor made allowances in determining its share of the investee's operating results. The reported results of an investee that used LIFO inventory accounting, for instance, may have been adjusted by the investor to conform to its FIFO costing method. Also, the investee's fiscal year may have differed from the investor's, and the investor may have converted this to its fiscal year by adding and subtracting stub period data. In any such case, if the impact is material, the fact of having made these adjustments should be disclosed, although it would be unusual to report the actual amount of such adjustments to users of the investor's financial statements.

If an associate has outstanding cumulative preferred stock, held by interests other than the investor, the investor should compute its equity interest in the investee's earnings after deducting dividends due to the preferred shareholders, whether or not declared. If material, this should be explained in the investor's financial statements.

When, due to the investor's recognition of recurring investee losses, the carrying value of the equity method investment has been reduced to zero, normally the investor will not recognize any share of further investee losses. If an investor ceases recognition of its share of losses of an investee, SIC 20 requires that disclosure be made in the notes to the financial statements of the unrecognized share of losses, both incurred during the current reporting period and cumulatively to date. The reason for the disclosure of cumulative unrecognized losses is that this is a measure of the amount of future investee earnings that will have to be realized before any further income will be reported in earnings by the investor.

There are certain exceptions to this rule. If the investor has incurred obligations or made payments on behalf of the associate to satisfy obligations of the associate that the investor has guaranteed or to which it is otherwise committed, whether funded or not, it should record further losses up to the amount of the guarantee or other commitment.

There are many common situations in which this occurs. For example, in the case of some closely held companies the investor negotiates banking facilities (both funded and unfunded) on the basis of the financial strength of the entire controlled group, not solely on the basis of the financial condition of the investee utilizing the borrowed funds. Where the investor has participated in the lending arrangements, even if its commitment is only moral, rather than contractual, it should be assumed that it will suffer losses beyond the nominal limit of its actual investment in the investee's shares, should that be necessary.

Impact of Potential Voting Interests on Application of Equity Method Accounting for Investments in Associates

Historically, actual voting interests in equity method investees has been the criterion used to determine (1) if equity method accounting for investees is to be employed; and (2) what percentage to apply in determining the allocation of the equity method investee's earnings to be included in the earnings of the equity method investor. However, the SIC has now addressed the situation in which the equity method investor has, in addition to its actual voting shareholder interest, a further potential voting interest in the investee.

The potential interest may exist in the form of options, warrants, convertible shares, or a contractual arrangement to acquire additional shares, including shares that it may have sold to another shareholder in the investee or to another party, with a right or contractual arrangement to reacquire the shares transferred.

As to whether the potential shares should be considered in reaching a decision as to whether significant influence is present, and thus whether reporting entity is to be regarded as the equity method investor and should therefore apply equity method accounting, SIC 33 holds that this is indeed a factor to weigh. It has concluded that the existence and effect of potential voting rights that are presently exercisable or presently convertible should be considered, in addition to the other factors set forth in IAS 28, when assessing whether an enterprise significantly influences another enterprise. All potential voting rights should be considered, including potential voting rights held by other enterprises (which would counter the impact of the reporting entity's potential voting interest).

For example, an entity holding a 15% voting interest in another entity, but having options, not counterbalanced by options held by another party, to acquire another 15% voting interest, would thus effectively have a 30% current and potential voting interest, making use of the equity method of accounting for the investment required, under the provisions of SIC 33.

Regarding whether the potential share interest should be considered when determining what fraction of the investee's income should be allocated to the investor, the general answer is no. SIC 33 states that the proportion allocated to an investor that accounts for its investment using the equity method under IAS 28 should be determined based solely on present ownership interests.

However, the enterprise may, in substance, have a present ownership interest when it sells and simultaneously agrees to repurchase some of the voting shares it had held in the investee, but does not lose control of access to economic benefits associated with an ownership interest. In this circumstance, the proportion allocated should be determined taking into account the eventual exercise of potential voting rights and other derivatives that, in substance, presently give access to the economic benefits associated with an ownership interest. Note that the right to reacquire shares alone is not enough to have those shares included for purposes of determining the percentage of the investee's income to be reported by the investor. Rather, the investor must have ongoing access to the economic benefits of ownership of those shares.

Accounting for Investments in Joint Ventures

International accounting standards address accounting for interests in joint ventures as a topic separate from accounting for other investments. Joint ventures share many characteristics with investments that are accounted for by the equity method: The investor clearly has significant influence over the investee but does not have absolute control, and hence full consolidation is typically unwarranted. According to the provisions of IAS 31, two different methods of accounting are possible, although not as true alternatives for the same fact situations: the proportional consolidation method and the equity method.

Joint ventures can take many forms and structures. Joint ventures may be created as partnerships, as corporations, or as unincorporated associations. The standard identifies three distinct types, referred to as jointly controlled operations, jointly controlled assets, and jointly controlled entities. Notwithstanding the formal structure, all joint ventures are characterized by certain features: having two or more venturers that are bound by a contractual arrangement, and by the fact that the contractual agreement establishes joint control of the enterprise.

The contractual provision(s) establishing joint control most clearly differentiates joint ventures from other investment scenarios in which the investor has significant influence over the investee. In fact, in the absence of such a contractual provision, joint venture accounting would not be appropriate, even in a situation in which two parties each have 50% ownership interests in an investee. The actual existence of such a contractual provision can be evidenced in a number of ways, although most typically it is in writing and often addresses such matters as the nature, term of existence, and reporting obligations of the joint venture; the governing mechanisms for the venture; the capital contributions by the respective venturers; and the intended division of output, income, expenses, or net results of the venture.

The contractual arrangement also establishes joint control over the venture. The thrust of such a provision is to ensure that no venturer can control the venture unilaterally. Certain decision areas will be stipulated as requiring consent by all the venturers, while other decision areas may be defined as needing the consent of only a majority of the venturers. There is no specific set of decisions that must fall into either grouping, however.

Typically, one venturer will be designated as the manager or operator of the venture. This does not imply the absolute power to govern; however, if such power exists, the venture would be a subsidiary, subject to the requirements of IAS 27 and not accounted for properly under IAS 31.

Specific accounting guidance is dependent on whether the enterprise represents jointly controlled operations, jointly controlled assets, or a jointly controlled entity.

Jointly controlled operations.

The first of three types of joint ventures, this is characterized by the assigned use of certain assets or other resources, in contrast to an establishment of a new entity, be it a corporation or partnership. Thus, from a formal or legal perspective, this variety of joint venture may not have an existence separate from its sponsors; from an economic point of view, however, the joint venture can still be said to exist, which means that it may exist as an accounting entity. Typically, this form of operation will utilize assets owned by the venture partners, often including plant and equipment as well as inventories, and the partners will sometimes incur debt on behalf of the operation. Actual operations may be conducted on an integrated basis with the partners' own, separate operations, with certain employees, for example, devoting a part of their efforts to the jointly controlled operation. The European Consortium Airbus may be a prototype of this type of enterprise.

IAS 31 is concerned not with the accounting by the entity conducting the jointly controlled operations, but by the venturers having an interest in the enterprise. Each venturer should recognize in its separate financial statements all assets of the venture that it controls, all liabilities that it incurs, all expenses that it incurs, and its share of any revenues produced by the venture. Often, since the assets are already owned by the venturers, they would be included in their respective financial statements in any event; similarly, any debt incurred will be reported by the partner even absent this special rule. Perhaps the only real challenge, from a measurement and disclosure perspective, would be the revenues attributable to each venturer's efforts, which will be determined by reference to the joint venture agreement and other documents.

Jointly controlled assets.

In certain industries, such as oil and gas exploration and transmission and mineral extraction, jointly controlled assets are frequently employed. For example, oil pipelines may be controlled jointly by a number of oil producers, each of which uses the facilities and shares in its costs of operation. Certain informal real estate partnerships may also function in this fashion.

IAS 31 stipulates that in the case of jointly controlled assets, each venturer must report in its own financial statements its share of all jointly controlled assets, appropriately classified according to their natures. It must also report any liabilities that it has incurred on behalf of these jointly controlled assets, as well as its share of any jointly incurred liabilities. Each venturer will report any income earned from the use its share of the jointly controlled assets, along with the pro rata expenses and any other expenses it has incurred directly.

Jointly controlled entities.

The major type of joint venture is the jointly controlled enterprise, which is really a form of partnership (although it may well be structured legally as a corporation) in which each partner has a form of control, rather than only significant influence. The classic example is an equal partnership of two partners; obviously, neither has a majority and either can block any important action, so the two partners must effectively agree on each key decision. Although this may be the model for a jointly controlled entity, it may in practice have more than two venturers and, depending on the partnership or shareholders' agreement, even minority owners may have joint control. For example, a partnership whose partners have 30%, 30%, 30%, and 10% interests, respectively, may have entered into a contractual agreement that stipulates that investment or financing actions may be taken only if there is unanimity among the partners.

Jointly controlled entities control the assets of the joint venture and may incur liabilities and expenses on its behalf. As a legal entity, it may enter into contracts and borrow funds, among other activities. In general, each venturer will share the net results in proportion to its ownership interest. As an entity with a distinct and separate legal and economic identity, the jointly controlled entity will normally produce its own financial statements and other tax and legal reports.

IAS 31 provides alternative accounting treatments that may be applied by the venture partners to reflect the operations and financial position of the venture. The objective is to report economic substance, rather than mere form, but there is not universal agreement on how this may best be achieved.

The benchmark treatment under the standard is the use of proportionate consolidation, which requires that the venture partner reflect its share of all assets, liabilities, revenues, and expenses on its financial statements as if these were incurred or held directly. In fact, this technique is very effective at conveying the true scope of an entity's operations, when those operations include interests in one or more jointly controlled entities. In this regard, the international accounting standards are more advanced than US, UK, or other national standards, which at best permit proportionate consolidation but do not mandate this accounting treatment.

If the venturer employs the proportionate consolidation method, it will have a choice between two presentation formats that are equally acceptable. First, the venture partner may include its share of the assets, liabilities, revenues, and expenses of the jointly controlled entity with similar items under its sole control. Thus, under this method, its share of the venture's receivables would be added to its own accounts receivable and presented as a single total on its balance sheet. Alternatively, the items that are undivided interests in the venture's assets, and so on, may be shown on separate lines of the venturer's financial statements, although still placed within the correct grouping. For example, the venture's receivables might be shown immediately below the partner's individually owned accounts receivable. In either case, the same category totals (aggregate current assets, etc.) will be presented; the only distinction is whether the venture-owned items are given separate recognition. Even if presented on a combined basis, however, the appropriate detail can still be shown in the financial statement footnotes, and indeed to achieve a fair presentation, this might be needed.

The proportionate consolidation method should be discontinued when the partner no longer has the ability to control the entity jointly. This may occur when the interest formerly held is disposed of, or when external restrictions are placed on the ability to exercise control. In some cases a partner will waive its right to control the entity, possibly in exchange for other economic advantages, such as a larger interest in the operating results.

Under the provisions of IAS 31, a second accounting method, the equity method, is also considered to be acceptable. The equity method in this context is as described in IAS 28 and as explained in the preceding section. As with the proportionate consolidation method, use of the equity method must be discontinued when the venturer no longer has joint control or significant influence over the jointly controlled entity.

Accounting for jointly controlled entities as passive investments.

Although the expectation is that investments in jointly controlled entities will be accounted for by the proportionate consolidation or equity method (the benchmark and allowed alternative treatments, respectively), in certain circumstances the venturer should account for its interest following the guidelines of IAS 39, that is, as a passive investment. This would be the prescription when the investment has been acquired and is being held with a view toward disposition in the short term, or when the investee is operating under severe long-term restrictions that severely impair its ability to transfer funds to its venturer owners. (Note, however, that a current proposal made as part of the IASB's Improvements Project will restrict the application of IAS 39 measurement [i.e., fair value, with changes therein taken to earnings currently] to joint venture interests which have been acquired and held exclusively with the intent that they be disposed of within twelve months from acquisition.)

If the investment is seen as being strictly temporary, effectively it is being held for trading purposes in the same manner as a temporary investment in marketable securities would be. In such a situation it would not be logical to apply either the proportionate consolidation or equity method, since it would not be the venturer's share of the operating results of the venture that provided value to the venturer, but rather, the change in fair value.

Similarly, if the venture were operating under such severe restrictions, expected to persist beyond a short time horizon, that transfers of funds from the jointly controlled entity to its venture parents were precluded, it would be misleading and conceptually invalid to treat the venture's operating results as bearing directly on the venture parents' earnings results. In such a case, an inability to transfer funds would mean that the venture partners would be unable to obtain any benefit, in the short run at least, from their investment in the jointly controlled entity.

As amended by IAS 39, IAS 31 provides that in the separate financial statements of an investor that issues consolidated financial statements as well, the cost method may alternatively be employed to present the investment in the joint venture.

Change from joint control to full control status.

If one of the venturers' interest in the jointly controlled entity is increased, whether by an acquisition of some or all of another of the venturers' interest, or by action of a contractual provision of the venture agreement (resulting from a failure to perform by another venturer, etc.), the proportionate consolidation method of accounting ceases to be appropriate and full consolidation will become necessary. Guidance on preparation of consolidated financial statements is provided by IAS 27 and is discussed fully in Chapter 11.

Accounting for Transactions between Venture Partner and Jointly Controlled Entity

Transfers at a gain to the transferor.

A general, underlying principle of financial reporting is that earnings are to be realized only by engaging in transactions with outside parties. Thus, gains cannot be recognized by transferring assets (be they productive assets or goods held for sale in the normal course of the business) to a subsidiary, affiliate, or joint venture, to the extent this really would represent a transaction by an entity with itself. Were this not the rule, enterprises would establish a range of related entities to sell goods to, thereby permitting the reporting of profits well before any sale to real, unrelated customers ever took place. The potential for abuse of the financial reporting process in such a scenario is too obvious to need elaboration.

IAS 31 stipulates that when a venturer sells or transfers assets to a jointly controlled entity, it may recognize profit only to the extent that the venture is owned by the other venture partners, and then only to the extent that the risks and rewards of ownership have indeed been transferred to the jointly controlled entity. The logic is that a portion of the profit has in fact been realized, to the extent that the purchase was agreed on by unrelated parties that jointly control the entity making the acquisition. For example, if venturers A, B, and C jointly control venture D (each having a 1/3 interest), and A sells equipment having a book value of $40,000 to the venture for $100,000, only 2/3 of the apparent gain of $60,000, or $40,000, may be realized. In its balance sheet immediately after this transaction, A would report its share of the asset reflected in the balance sheet of D, 1/3 x $100,000 = $33,333, minus the unrealized gain of $20,000, for a net of $13,333. This is identical to A's remaining 1/3 interest in the pretransaction basis of the asset (1/3 x $40,000 = $13,333). Thus, there is no step up in the carrying value of the proportionate share of the asset reflected in the transferor's balance sheet.

If the asset is subject to depreciation, the deferred gain on the transfer (1/3 x $60,000 = $20,000) would be amortized in proportion to the depreciation reflected by the venture, such that the depreciated balance of the asset reported by A is the same as would have been reported had the transfer not taken place. For example, assume that the asset has a useful economic life of five years after the date of transfer to D. The deferred gain ($20,000) would be amortized to income at a rate of $4,000 per year. At the end of the first posttransfer year, D would report a net carrying value of $100,000 - $20,000 = $80,000; A's proportionate interest is 1/3 x $80,000 = $26,667. The unamortized balance of the deferred gain is $20,000 - $4,000 = $16,000. Thus the net reported amount of A's share of the jointly controlled entity's asset is $26,667 - $16,000 = $10,667. This amount is precisely what A would have reported the remaining share of its asset at on this date: 1/3 x ($40,000 - $8,000) = $10,667.

Of course, A has also reported a gain of $40,000 as of the date of the transfer of its asset to joint venture D, but this represents the gain that has been realized by the sale of 2/3 of the asset to unrelated parties B and C, the coventurers in D. In short, two-thirds of the asset has been sold at a gain, while one-third has been retained and is continuing to be used and depreciated over its remaining economic life and is reported on the cost basis in A's financial statements.

The matters described above have been further emphasized by the Standing Interpretation Committee's interpretation, SIC 13, which holds that gains or losses will result from contributions of nonmonetary assets to a jointly controlled enterprise only when significant risks and rewards of ownership have been transferred, and the gain or loss can be reliably measured. However, no gain or loss would be recognized when the asset is contributed in exchange for an equity interest in the jointly controlled enterprise when the asset is similar to assets contributed by the other venturers. Any unrealized gain or loss should be netted against the related assets, and not presented as deferred gain or loss in the venturer's consolidated financial statements.ized for financial reporting purposes. The situation when a transfer is at an amount below the transferor's carrying value is not analogous; rather, such a transfer is deemed to be confirmation of a permanent decline in value, which must be recognized by the transferor immediately rather than being deferred. This reflects the conservative bias in accounting: Unrealized losses are often recognized, while unrealized gains are deferred.

Transfers of assets at a loss.

The foregoing illustration was predicated on a transfer to the jointly controlled entity at a nominal gain to the transferor, of which a portion was real-

Assume that venturer C (a 1/3 owner of D, as described above) transfers an asset it had been carrying at $150,000 to jointly controlled entity D at a price of $120,000. If the decline is deemed to be other than temporary in nature (that presumptively it is, since C would not normally have been willing to engage in this transaction if the decline were expected to be reversed in the near term), C must recognize the full $30,000 at the time of the transfer. Subsequently, C will pick up its 1/3 interest in the asset held by D (1/3 x $120,000 = $40,000) as its own asset in its balance sheet, before considering any depreciation, and so on.

Accounting for Assets Purchased from a Jointly Controlled Entity

Transfers at a gain to the transferor.

A similar situation arises when a venture partner acquires an asset from a jointly controlled entity: The venturer cannot reflect the gain recognized by the joint venture, to the extent that this represents its share in the results of the venture's operations. For example, again assuming that A, B, and C jointly own D, an asset having a book value of $200,000 is transferred by D to B for a price of $275,000. Since B has a 1/3 interest in D, it would (unless an adjustment were made to its accounting) report $25,000 of D's gain as its own, which would violate the realization concept under GAAP.

To avoid this result, B will record the asset at its cost, $275,000, less the deferred gain, $25,000, for a net carrying value of $250,000, which represents the transferor's basis, $200,000, plus the increase in value realized by unrelated parties (A and C) in the amount of $50,000.

As the asset is depreciated, the deferred gain will be amortized apace. For example, assume that the useful life of the asset in B's hands is ten years. At the end of the first year, the carrying value of the asset is $275,000 - $27,500 = $247,500; the unamortized balance of the deferred gain is $25,000 - $2,500 = $22,500. Thus the net carrying value, after offsetting the remaining deferred gain, will be $247,500 - $22,500 = $225,000. This corresponds to the remaining life of the asset (9/10 of its estimated life) times its original net carrying amount, $250,000. The amortization of the deferred gain should be credited to depreciation expense to offset the depreciation charged on the nominal acquisition price and thereby to reduce it to a cost basis as required by GAAP.

Transfers at a loss to the transferor.

If the asset was acquired by B at a loss to D, on the other hand, and the decline was deemed to be indicative of an other than temporary diminution in value, B should recognize its share of this decline. This contrasts with the gain scenario discussed immediately above, and as such is entirely consistent with the accounting treatment for transfers from the venture partner to the jointly controlled venture.

For example, if D sells an asset carried at $50,000 to B for $44,000, and the reason for this discount is an other than temporary decline in the value of said asset, the venture, D, records a loss of $6,000 and each venture partner will in turn recognize a $2,000 loss. B would report the asset at its acquisition cost of $44,000 and will also report its share of the loss, $2,000. This loss will not be deferred and will not be added to the carrying value of the asset in B's hands (as would have been the case if B treated only the $4,000 loss realized by unrelated parties A and C as being recognizable).

Disclosure Requirements

A venture partner is required to disclose in the notes to the financial statements its ownership interests in all significant joint ventures, including its ownership percentage and other relevant data. If the venturer uses proportionate consolidation and merges its share of the assets, liabilities, revenues, and expenses of the jointly controlled entity with its own assets, liabilities, revenues, and expenses, or if the venturer uses the equity method, the notes should disclose the amounts of the current and long-term assets, current and long-term liabilities, revenues, and expenses related to its interests in jointly controlled ventures.

Furthermore, the joint venture partner should disclose any contingencies that the venturer has incurred in relation to its interests in any joint ventures, noting any share of contingencies jointly incurred with other joint venturers. In addition, the venturer's share of any contingencies of the joint venture (as distinct from contingencies incurred in connection with its investment in the venture) for which it may be contingently liable must be reported. Finally, those contingencies that arise because the venturer is contingently liable for the liabilities of the other partners in the jointly controlled entity must be set forth. These disclosures are a logical application of the rules set forth in IAS 37, which is discussed in Chapter 12 of this book.

A venture partner should also disclose in the notes to her/his financial statements information about any commitments s/he has outstanding in respect to interests s/he has in joint ventures. These include any capital commitments s/he has and her/his share of any joint commitments s/he may have incurred with other venture partners, as well as her/his share of the capital commitments of the joint ventures themselves, if any.

Proposed changes to accounting for investments in both associates and joint ventures.

Investments in subsidiaries, associates, and joint ventures are obviously very similar in many regards, and this would suggest that the accounting for these categories of investments should be, by and large, parallel. The goal should be to reflect the economic substance of the investor's interest in the subsidiary, equity investment, or joint venture. The issuance of IAS 39 introduced certain disparities in financial reporting for the different varieties of intercorporate investments.

Specifically, IAS 39 amended IAS 27 by introducing a requirement for subsidiaries that are held temporarily or which operate under severe long-term restrictions to be accounted for in accordance with IAS 39 in consolidated financial statements. In other words, these investments (which are, under IAS 27, not consolidated when either of these named conditions exist) are to be accounted for at fair value, rather than at cost.

IAS 39 did not, however, address the accounting for associates (equity method investments) or joint ventures under similar circumstances. Amendments were later proposed to the relevant standards (IAS 28 and 31), to conform the accounting for these investments in separate financial statements of the investor to that for subsidiaries.

At present, under the IASB's Improvements Project, proposals are outstanding that would change and unify the available accounting options for the presentation of investments in subsidiaries, associates, and joint ventures in the parent entity's nonconsolidated (i.e., separate) financial statements. Under these proposals (as amendments to IAS 27, 28, and 31), the investor would be free to elect the cost method or the IAS 39 (fair value) method of accounting for these unconsolidated, nonequity method investments. The reporting entity would be required to apply the same method of accounting (i.e., either cost or fair value) to all investments in a given category.

Under the cost method, the investor recognizes its investment in the investee at cost. The investor recognizes income only to the extent that it receives distributions from the accumulated net profits of the investee arising after the date of acquisition by the investor. Distributions received in excess of such profits are regarded as a recovery of investments and are recognized as a reduction of the cost of the investment.

The revised standards will indicate that users of the financial statements of a parent, joint venturer, or investor in an associate are usually concerned with, and need to be informed about, the financial position, results of operations and changes in financial position of the group as a whole. This need is served by consolidated financial statements or financial statements in which the associate is accounted for under the equity method, that present financial information about the group as a single economic entity without regard for the legal boundaries of the separate legal entities. In contrast, separate financial statements present financial information about the entity's position viewed as an investor. Thus, such separate (nonconsolidated) financial statements are not to be viewed as substitutes for the primary financial statements of the parent entity, which would be required to consolidate subsidiaries, apply equity method accounting to associates, and apply either proportionate consolidation or equity method accounting to joint ventures.

Accounting for Other Investment Property

Investment property.

An investment in land or a building, part of a building, or both, if held by the owner (or a lessee under a finance lease) with the intention of earning rentals or for capital appreciation or both, is defined by IAS 40 as an investment property. An investment property is capable of generating cash flows independently of other assets held by the enterprise. Investment property is sometimes referred to as being "passive" investments, to distinguish it from actively managed property such as plant assets, the use of which is integrated with the rest of the enterprise's operations. This characteristic is what distinguishes investment property from owner-occupied property, which is property held by the enterprise or a lessee under a finance lease, for use in its business (i.e., for use in production or supply of goods or services or for administrative purposes).

The best way to understand what investment property constitutes is to look at examples of investments that are considered by the standard as investment properties, and contrast these with those investments that do not qualify for this categorization.

According to the standard, examples of investment property are

  • Land held for long-term capital appreciation as opposed to short-term purposes like land held for sale in the ordinary course of business;

  • Land held for an undetermined future use;

  • Building owned by the reporting enterprise (or held by the reporting enterprise under a finance lease) and leased out under one or more operating leases; and

  • Vacant building held by an enterprise to be leased out under one or more operating leases.

According to IAS 40, investment property does not include

  • Property employed in the business, (i.e., held for use in production or supply of goods or services or for administrative purposes, the accounting for which is governed by IAS 16);

  • Property being constructed or developed on behalf of others, the accounting of which is outlined in IAS 11;

  • Property held for sale in the ordinary course of the business, the accounting for which is specified by IAS 2; and

  • Property under construction or being developed for future use as investment property. IAS 16 is applied to such property until the construction or development is completed, at which time, IAS 40 governs. However, existing investment property that is being redeveloped for continued future use would qualify as investment property.

Apportioning property between investment property and owner-occupied property.

In many cases it will be clear what constitutes investment property as opposed to owner-occupied property, but in other instances making this distinction might be less obvious. Certain properties are not held entirely for rental purposes or for capital appreciation purposes. For example, portions of these properties might be used by the enterprise for manufacturing or for administrative purposes. If these portions, earmarked for different purposes, could be sold separately, then the enterprise is required to account for them separately. However, if the portions cannot be sold separately, the property would be deemed as investment property if an insignificant portion is held by the enterprise for business use.

When ancillary services are provided by the enterprise and these ancillary services are a relatively insignificant component of the arrangement, as when the owner of a residential building provides maintenance and security services to the tenants, the enterprise treats such an investment as investment property. On the other hand, if the service provided is a comparatively significant component of the arrangement, then the investment would be considered as an owner-occupied property.

For instance, an enterprise that owns and operates a motel and also provides services to the guests of the motel would be unable to argue that it is an investment property as that term is used by IAS 40. Rather, such an investment would be classified as an owner-occupied property. Judgement is therefore required in determining whether a property qualifies as investment property. It is so important a factor that if an enterprise develops criteria for determining when to classify a property as an investment property, it is required by this standard to disclose these criteria in the context of difficult or controversial classifications.

Property leased to a subsidiary or a parent company.

Property leased to a subsidiary or its parent company is considered an investment property from the perspective of the enterprise. However, for the purposes of consolidated financial statements, from the perspective of the group as a whole, it will not qualify as an investment property, since it is an owner-occupied property when viewed from the parent company level.

Recognition and measurement.

Investment property will be recognized when it becomes probable that the enterprise will enjoy the future economic benefits which are attributable to it, and when the cost or fair value can be reliably measured. In general, this will occur when the property is first acquired or constructed by the reporting enterprise. In only unusual circumstances would it be concluded that the owner's likelihood of receipt of the economic benefits would be less than probable, necessitating deferral of initial recognition of the asset.

Initial measurement will be at cost, which is equivalent to fair value, assuming that the acquisition was the result of an arm's-length exchange transaction. Included in the purchase cost will be such directly attributable expenditure as legal fees and property transfer taxes, if incurred in the transaction. If the asset is self-constructed, cost will include not only direct expenditures on product or services consumed, but also overhead charges which can be allocated on a reasonable and consistent basis, in the same manner as these are allocated to inventories under the guidelines of IAS 2. To the extent that the acquisition cost includes an interest charge, if the payment is deferred, the amount to be recognized as an investment asset should not include the interest charges. Furthermore, start-up costs (unless they are essential in bringing the property to its working condition), initial operating losses (incurred prior to the investment property achieving planned level of occupancy) or abnormal waste (in construction or development) do not constitute part of the capitalized cost of an investment property.

Subsequent expenditures.

In some instances there may be further expenditure incurred on the investment property after the date of initial recognition. Consistent with similar situations arising in connection with plant, property and equipment (dealt with under IAS 16), if it can be demonstrated that the subsequent expenditure will enhance the generation of future economic benefits to the enterprise, then those costs may be added to the carrying value of the investment property. In other words, if as a result of incurring subsequent expenditure it is probable that future economic benefits in excess of the originally assessed level of performance of the existing investment property will flow to the enterprise, such expenditure should be added to the carrying amount of the investment property. By implication, all other subsequent expenditure should be expensed in the periods they are incurred.

Sometimes, the appropriate accounting treatment for subsequent expenditure would depend upon the circumstances that were considered in the initial measurement and recognition of the investment property. For example, if a property (say, an office building) is acquired for investment purposes in a condition that makes it incumbent upon the enterprise to perform significant renovations thereafter, then such renovation costs (which would constitute subsequent expenditures) will be added to the carrying value of the investment property when incurred later.

Fair value model vs. historical cost.

Analogous to the financial reporting of plant and equipment under IAS 16, IAS 40 provides that investment property may be reported at either fair value or at depreciated (historical) cost less accumulated impairment. The cost model is the benchmark treatment prescribed by IAS 16 for plant assets. The fair value approach under IAS 40 more closely resembles that used for financial instruments than it does the allowed alternative (revaluation) method for plant assets, however. Also, under IAS 40 if the cost method is used, fair value information must nonetheless be disclosed.

Fair value.

When investment property is carried at fair value, at each subsequent financial reporting date the carrying amount must be adjusted to the then-current fair value, with the adjustment being reported in the net profit or loss for the period in which it arises. The inclusion of the value adjustments in earnings—in contrast to the revaluation approach under IAS 16, whereby adjustments are generally reported in equity—is a reflection of the different roles played by plant assets and by other investment property. The former are used, or consumed, in the operation of the business, which is often centered upon the production of goods and services for sale to customers. The latter are held for possible appreciation in value, and hence those value changes are highly germane to the assessment of periodic operating performance. With this distinction in mind, the decision was made to not only permit fair value reporting, but to require value changes to be included in earnings.

IAS 40 represents the first time that fair value accounting is being embraced as an accounting model for nonfinancial assets. This has been a matter of great controversy, and to address the many concerns voiced during the exposure draft stage, the IASC added more guidance on the subject to the final standard. This standard is quite comprehensive, and it includes some very insightful and practical hints on applying the standard.

Fair value is defined by the standard as the most probable price reasonably obtainable in the marketplace at the balance sheet date. Fair value would not be appropriately measured with reference to either a past or a future date. Further, the definition envisions "knowledgeable, willing parties" as being the arbiters of fair value. This presupposes that both the buyer and seller are willing to enter into the transaction, and that they each have reasonable knowledge about the nature and characteristics of the investment property, its potential uses, and the state of the market as of the valuation date. Put another way, fair value presumes that neither the buyer nor the seller is acting under coercion; and fair value is not a price that is based on a "distress sale."

The standard goes into great detail to explain the concept of a "willing buyer" (i.e., one who is motivated but not compelled to buy) and a "willing seller" (i.e., one who is neither overeager nor a forced seller). For instance, in explaining the concept of a "willing seller," the standard clarifies that the motivation to sell at market terms for the best price obtainable in the open market is derived "after proper marketing." This expression has been explained very eloquently by the standard to mean that in order to be considered as "after proper marketing," the investment property would need to be "exposed to the market" in the most appropriate manner to effect its disposal at the best price obtainable. The length of exposure time, according to the standard, must be "sufficient" to allow the investment property to be brought to the attention of an "adequate number" of potential purchasers.

As if there were not enough unknowns in the equation, the standard further qualifies this by stating that the "exposure period" is assumed to occur "prior to the balance sheet date." With respect to the length of the exposure period, the standard opines that "it may vary with market conditions." Some may find this an example of "overkill" which confuses, rather than clarifies the standard and impedes attempts to apply it. However, given that this is the maiden attempt by the IASC to mandate fair value accounting for nonfinancial assets, it may in hindsight be warranted.

The standard encourages an enterprise to determine the fair value based on a valuation by an independent valuer who holds a recognized and relevant professional qualification and who has had recent experience in the location and category of the investment property being valued. While terms such as "relevant" are not defined, IAS 40 does offer a significant amount of practical guidance on issues relating to the determination of fair values. These practical hints will likely greatly facilitate the correct application of the principles enshrined in the standard. They are summarized as follows:

  • Factors that could distort the value, such as the incorporation of particularly favorable or unfavorable financing terms, the inclusion of sale and leaseback arrangements, or any other concession by either buyer or seller, are not to be given any consideration in the valuation process;

  • On the other hand, the actual conditions in the marketplace at the valuation date, even if these represent somewhat atypical climatic factors, will govern the valuation process. For example, if the economy is in the midst of a recession and rental properties' prices are depressed, no attempt should be made to normalize fair value, since that would add a subjective element and depart from the concept of fair value as of the balance sheet date;

  • Fair values should be determined without any deduction for transaction costs that the enterprise may incur on the sale or other disposal of the investment property;

  • Fair value should reflect the actual state of the market and circumstances as of the balance sheet date, not as of either a past or a future date;

  • In the absence of current prices on an active market, an enterprise should use information from a variety of sources, including: current prices on an active market of dissimilar properties with suitable adjustments for the differences, recent prices on less active markets, with necessary adjustments, and discounted cash flow projections based on reliable estimates of future cash flows using an appropriate discount rate;

  • Fair value differs from "value in use" as defined in IAS 36. Whereas fair value is reflective of market knowledge and estimates of participants in the market in general, value in use reflects the enterprise's knowledge and estimates that are entity-specific and are thus not applicable to enterprises in general. In other words, value in use is an estimate at the enterprise level or at a "microlevel," while fair value is a "macrolevel" concept that is reflective of the perceptions of the market participants in general;

  • Enterprises are alerted to the possibility of double counting in determining the fair value of certain types of investment property. For instance, when an office building is leased on a furnished basis, the fair value of office furniture and fixtures is generally included in the fair value of the investment property (in this case the office building). The IASC's apparent rationale is that the rental income relates to the furnished office building; when fair values of furniture and fixtures are included along with the fair value of the investment property, the enterprise does not recognize them as separate assets; and

  • Lastly, the fair value of investment property should neither reflect the future capital expenditure (that would improve or enhance the property), nor the related future benefits from this future expenditure.

Inability to measure fair value reliably.

There is a rebuttable presumption that, if an entity acquires or constructs property that will qualify as investment property under this standard, it will be able to assess fair value reliably on an ongoing basis. In rare circumstances, however, when an enterprise acquires for the first time an investment property (or when an existing property first qualifies to be classified as investment property following the completion of development or construction, or when there has been change of use), there may be clear evidence that the fair value of the investment property cannot reliably be determined, on a continuous basis.

Under such exceptional circumstances, the standard stipulates that the enterprise should measure that investment property using the benchmark treatment in IAS 16 until the disposal of the investment property. According to IAS 40, the residual value of such investment property measured under the benchmark treatment in IAS 16 should be presumed to be zero. The standard further states that under the exceptional circumstances explained above, in the case of an enterprise that uses the fair value model, the enterprise should measure the other investment properties held by it at fair values. In other words, notwithstanding the fact that one of the investment properties, due to exceptional circumstances, is being carried under the benchmark (cost) treatment in IAS 16, an enterprise that uses the fair value model should continue carrying the other investment properties at fair values. While this results in a mixed measure of the aggregate investment property, it underlines the perceived importance of the fair value method.

Transfers to or from investment property.

Transfers to or from investment property should be made only when there is demonstrated "change in use" as contemplated by the standard. A change in use takes place when there is a transfer

  • From investment property to owner-occupied property, when owner-occupation commences;

  • From investment property to inventories, on commencement of development with a view to sale;

  • From an owner-occupied property to investment property, when owner-occupation ends;

  • Of inventories to investment property, when an operating lease to a third party commences; or

  • Of property in the course of development or construction to investment property, at end of the construction or development.

In the case of an enterprise that employs the cost model, transfers between investment property, owner-occupied property and inventories do not change the carrying amount of the property transferred and thus do not change the cost of that property for measurement or disclosure purposes. When the investment property is carried under the fair value model, vastly different results follow as far as recognition and measurement is concerned. These are explained below.

  1. Transfers from (or to) investment property to (or from) plant and equipment (in the case of investment property carried under the fair value model). In some instances, property that at first is appropriately classified as investment property under IAS 40 may later become plant, property, and equipment as defined under IAS 16. For example, a building is obtained and leased to unrelated parties, but at a later date the entity expands its own operations to the extent that it now chooses to utilize the building formerly held as a passive investment for its own purposes, such as for the corporate executive offices. The amount reflected in the accounting records as the fair value of the property as of the date of change in status would become the cost basis for subsequent accounting purposes. Previously recognized changes in value, if any, would not be reversed.

    Similarly, if property first classified as owner-occupied property and treated as plant and equipment under the benchmark treatment of IAS 16 is later redeployed as investment property, it is to be measured at fair value at the date of the change in its usage. If the value is lower than the carrying amount (i.e., if there is a previously unrecognized decline in its fair value) then this will be reflected in earnings in the period of redeployment as an investment property. On the other hand, if there has been an unrecognized increase in value, the accounting will depend on whether this is a reversal of a previously recognized value impairment. If the increase is a reversal of a decline in value, the increase should be recognized currently in earnings; the amount so reported, however, should not exceed the amount needed to restore the carrying amount to what it would have been, net of depreciation, had the earlier impairment loss not occurred.

    If, on the other hand, there was no previously recognized impairment which the current value increase is effectively reversing (or, to the extent that the current increase exceeds the earlier decline), then the increase should be reported directly in equity, by means of the statement of changes in equity. If the investment property is later disposed of, any resultant gain or loss computation should not include the effect of the amount reported directly in equity.

  2. Transfers from inventory to investment property (in the case of investment property carried under the fair value model). It may also happen that property originally classified as inventory, originally held for sale in the normal course of the business, is later redeployed as investment property. When reclassified, the initial carrying amount should be fair value as of that date. Any gain or loss resulting from this reclassification would be reported in current period's earnings. IAS 40 does not contemplate reclassification from investment property to inventory, however. When the enterprise determines that property held as investment property is to be disposed of, that property should be retained as investment property until actually sold. It should not be derecognized (eliminated from the balance sheet) or transferred to an inventory classification.

  3. Transfer on completion of construction or development of self-constructed investment property (to be carried at fair value). On completion of construction or development of self-constructed investment property that will be carried at fair value, any difference between the fair value of the property at that date and its previous carrying amount should be recognized in the net income or loss for the period.

Disposal and retirement of investment property.

An investment property should be derecognized (i.e., eliminated from the balance sheet of the enterprise) on disposal or when it is permanently withdrawn from use and no future economic benefits are expected from its disposal. The word "disposal" has been used in the standard to mean not only a sale but also the entering into of a finance lease by the enterprise. Any gains or losses on disposal or retirement of an investment property should be determined as the difference between the net disposal proceeds and the carrying amount of the asset and should be recognized in the net income or loss for the period.

Disclosure requirements.

It is anticipated that in certain cases investment property will be property that is owned by the reporting entity and leased to others under operating-type lease arrangements. The disclosure requirements set forth in IAS 17 (and discussed in Chapter 14) continue unaltered by IAS 40. In addition, IAS 40 stipulates a number of new disclosure requirements set out below.

  1. Disclosures applicable to all investment properties

    • When classification is difficult, an enterprise that holds an investment property will need to disclose the criteria used to distinguish investment property from owner-occupied property and from property held for sale in the ordinary course of business.

    • The methods and any significant assumptions that were used in ascertaining the fair values of the investment properties are to be disclosed as well. Such disclosure also includes a statement about whether the determination of fair value was supported by market evidence or relied heavily on other factors (which the enterprise needs to disclose as well) due to the nature of the property and the absence of comparable market data.

    • If investment property has been revalued by an independent appraiser, having recognized and relevant qualifications, and who has recent experience with properties having similar characteristics of location and type, the extent to which the fair value of investment property (either used in case the fair value model is used or disclosed in case the cost model is used) is based on valuation by such an independent valuer. If there is no such valuation, that fact should be disclosed as well.

    • The following should be disclosed in the income statement:

      • The amount of rental income derived from investment property;

      • Direct operating expenses (including repairs and maintenance) arising from investment property that generated rental income; and

      • Direct operating expenses (including repairs and maintenance) arising from investment property that did not generate rental income.

      • The existence and the amount of any restrictions which may potentially affect the realizability of investment property or the remittance of income and proceeds from disposal to be received; and

      • Material contractual obligations to purchase or build investment property or for repairs, maintenance or improvements thereto.

  2. Disclosures applicable to investment property measured using the fair value model

    • In addition to the disclosures outlined above, the standard requires that an enterprise that uses the fair value model should also present a reconciliation of the carrying amounts of the investment property, from the beginning to the end of the reporting period. The reconciliation will separately identify additions resulting from acquisitions, those resulting from business combinations, and those deriving from capitalized expenditures subsequent to the property's initial recognition. It will also identify disposals, gains or losses from fair value adjustments, the net exchange differences, if any, arising from the translation of the financial statements of a foreign entity, transfers to and from inventories and owner-occupied properties, and any other movements. (Comparative reconciliation data for prior periods need not be presented).

    • Under exceptional circumstances, due to lack of reliable fair value, when an enterprise measures investment property using the benchmark treatment under IAS 16, the above reconciliation should disclose amounts separately for that investment property from amounts relating to other investment property. In addition, an enterprise should also disclose

      • A description of such a property,

      • An explanation of why fair value cannot be reliably measured,

      • If possible, the range of estimates within which fair value is highly likely to lie, and

      • On disposal of such an investment property, the fact that the enterprise has disposed of investment property not carried at fair value along with its carrying amount at the time of disposal and the amount of gain or loss recognized.

  3. Disclosures applicable to investment property measured using the cost model

    • In addition to the disclosure requirements outlined in 1. above, the standard requires that an enterprise that applies the cost model should also disclose: the depreciation methods used, the useful lives or the depreciation rates used, and the gross carrying amount and the accumulated depreciation (aggregated with accumulated impairment losses) at the beginning and end of the period. It should also disclose a reconciliation of the carrying amount of investment property at the beginning and the end of the period showing the following details: additions resulting from acquisitions, those resulting from business combinations, and those deriving from capitalized expenditures subsequent to the property's initial recognition. It should also disclose disposals, depreciation, impairment losses recognized and reversed, the net exchange differences, if any, arising from the translation of the financial statements of a foreign entity, transfers to and from inventories and owner-occupied properties, and any other movements. (Comparative reconciliation data for prior periods need not be presented.)

    • The fair value of investment property carried under the cost model should also be disclosed. In exceptional cases, when the fair value of the investment property cannot be reliably estimated, the enterprise should instead disclose

      • A description of such property,

      • An explanation of why fair value cannot be reliably measured, and

      • If possible, the range of estimates within which fair value is highly likely to lie.

Transitional Provisions

Fair value model.

Under the fair value model, an enterprise should report the effect of adopting this standard on its effective date (or earlier) as an adjustment to the opening balance of retained earnings for the period in which the standard is first adopted. In addition

  • If the enterprise has previously disclosed publicly (in financial statements or otherwise) the fair value of its investment property in earlier periods (determined on a basis that satisfies the definition of fair value given in the standard), the enterprise is encouraged, but not required, to

    • Adjust the opening balance of retained earnings for the earliest period presented for which such fair value was disclosed publicly; and

    • Restate comparative information for those periods.

  • If the enterprise has not previously disclosed publicly the information described in 1., the enterprise should not restate comparative information and should disclose that fact.

Cost model.

IAS 8 applies to any change in accounting policies that occurs when an enterprise first adopts this standard and chooses to use the cost model. The effect of the change in accounting policies includes the reclassification of any amount held in revaluation surplus for investment property.

Effective date.

This International Accounting Standard became operative for annual financial statements covering periods beginning on or after January 1, 2001. Earlier application was encouraged. If an enterprise applied this Standard for periods beginning before January 1, 2001, it was required to disclose that fact.