Financial instruments, as they have grown in complexity and variation, have provided accounting standard-setting bodies worldwide with some of their greatest challenges. While even nonderivative instruments have become bewilderingly convoluted, the most formidable hurdles have been the need to comprehend and set reporting and disclosure rules for derivatives. The fact that many derivative-based transactions do not involve initial cash outlays, or involve outlays which are trivial in comparison to the amounts which are placed at risk, has caused accountants to first question and ultimately largely abandon the venerable historical cost concept, which has been the basis for most transaction reporting.
Standard setters have long since dealt with such mundane instruments as corporate stocks and bonds, although even in this context the financial reporting standards (such as that provided by now-superseded IAS 25) have exhibited evolutionary development and, until IAS 39, offered perhaps excessive flexibility, which has impeded comparability among different entities' financial statements.
The more intractable problems, however, have arisen as a result of the explosive expansion in the use of financial derivatives. While some accounting guidance has previously been available pertaining to the more prosaic of these derivatives, such as warrants and futures contracts, this has been minimal and has not been sufficiently robust to address recognition, measurement, and disclosure issues, matters involving such exotic, yet now commonplace, instruments as interest rate swaps, options, and complex hedges of interest rates or foreign currencies. Derivatives found commonly in today's business environment include option contracts, interest rate caps, interest rate floors, fixed-rate loan commitments, note issuance facilities, letters of credit, forward contracts, forward interest rate agreements, interest rate collars, futures, swaps, mortgage-backed securities, interest-only obligations, principal-only obligations, indexed debt. and other optional characteristics which are directly incorporated within receivables and payables such as convertible bond conversion or call terms (embedded derivatives).
The basic business purpose of derivative financial instruments is to manage some category of risk, such as stock price movements, interest rate variations, currency fluctuations and commodity price volatility. The parties involved tend to be brokerage firms, financial institutions, insurance companies, and large corporations, although any two or more entities of any size can hold or issue derivatives. The derivatives are contracts that may be used for speculation, arbitrage, or to protect or hedge one or more of the parties from adverse movement in the underlying base. Previous accounting rules (both the various national standards and IAS) had not coped well with these innovative instruments, but with the recent promulgation of IAS 39 (and the similar but not identical US standard, SFAS 133), there are now clear-cut requirements that should prove to be universally suitable, whatever the future developments from the "financial engineers."
Beginning in 1989, the IASC attempted to develop a comprehensive standard that would address recognition, derecognition, measurement, presentation and disclosure issues pertaining to financial instruments. One intention was to establish uniform standards which would be applicable to both financial assets and financial liabilities—a goal which has not to date been achieved. Two successive Exposure Drafts—E40, issued in 1991, and E48, issued in 1994—were widely debated and ultimately shown to be perhaps too ambitious, given the level of concern and opposition by certain constituent groups, and the limited progress made by other national standard-setting bodies in their similar efforts. Thus the IASC concluded, as did the US's FASB, that it would not be feasible to promulgate a single standard which would definitively resolve all the issues; nor could a new standard impose uniform requirements on both assets and liabilities, regardless of the logic of doing so.
Accordingly, the IASC's efforts were bifurcated, with IAS 32 (issued in 1995) setting presentation and disclosure requirements, while the more troublesome matters of recognition, derecognition and measurement were subjected to further deliberation. The result of those extended efforts was the issuance of IAS 39 in 1998, which represented the final component of the IASC's "core set of standards" program. However, the necessary compromises made to meet the IOSCO-IASC deadline have necessitated labeling this standard as only an "interim" one. Further work has been promised, intended to yield, within another few years, a successor to this standard—this time a truly comprehensive one. The objective remains to ultimately have a universal standard that would govern accounting and reporting for all financial assets and liabilities, but this will remain a difficult goal to achieve.
While IAS 32 sets requirements for the classification by issuers of financial instruments as either liabilities or equity, and for offsetting of financial assets and liabilities, as well as for the disclosure of related information in the financial statements, the recent IAS 39 has tackled the somewhat more substantive questions of recognition, derecognition, measurement, and hedge accounting. Fair value reporting has been embraced, with a few important exceptions, for financial assets, while historical cost-based reporting has been largely preserved for financial liabilities. Special hedge accounting has been endorsed for those situations in which a strict set of criteria are met, with the objectives of achieving good "matching" and of ensuring that all derivative financial instruments receive formal financial statement recognition. Of course, had the IASC fully endorsed fair value accounting for all financial assets and liabilities, special hedge accounting rules would have been unnecessary to address measurement mismatches. Thus, if the IASC is successful in completing the next phase of the financial instruments project, the final rules could well be significantly less cumbersome and convoluted than are those embodied in IAS 32 and 39.
In the remainder of this chapter, the general requirements of IAS 32 and 39 will be addressed, and illustrations will be provided of the basic concepts of these standards. IAS 39 became effective in 2001, and its disclosure requirements superseded those in IAS 32. More detailed discussions of hedging and of derivative financial instruments are incorporated in Chapter 10.
While some were disappointed that the standard issued in 1995 failed to comprehensively address the range of issues posed by financial assets and liabilities, IAS 32 was an important achievement for several reasons. IAS 32 represented a commitment to a strict "substance over form" approach. The most signal accomplishment, however, was the requirement for separate presentation of disparate elements of compound financial instruments.
Under IAS 32, financial assets and liabilities are defined as follows:
Financial asset: Any asset that is
A contractual right to receive cash or another financial asset from another enterprise
A contractual right to exchange financial instruments with another enterprise under conditions that are potentially favorable
An equity instrument of another enterprise
Financial liability: Any liability that is a contractual obligation
To deliver cash or another financial asset to another enterprise; or
To exchange financial instruments with another enterprise under conditions which are potentially unfavorable.
According to the foregoing definition, financial instruments encompass a broad domain within the balance sheet. Included are both primary instruments, such as stocks and bonds, and derivative instruments, such as options, forwards, and swaps. Physical assets, such as inventories or plant assets, and such long-lived intangible assets as patents and goodwill, are excluded from the definition; although control of such assets may create opportunities to generate future cash inflows, it does not grant to the holder a present right to receive cash or other financial assets. Similarly, liabilities that are not contractual in nature, such as income taxes payable (which are statutory, but not contractual, obligations), are not financial instruments either.
Some contractual rights and obligations do not involve the transfer of financial assets. For example, a commitment to deliver commodities such as agricultural products or precious metals is not a financial instrument, although in practice these contracts are often used for hedging purposes by enterprises and are often settled in cash (technically, the contracts are closed out by entering into offsetting transactions before their mandatory settlement dates). The fact that the contracts call for delivery of physical product, unless canceled by a closing market transaction prior to the maturity date, prevents these from being included within the definition of financial instruments.
It sometimes happens that financial instruments of a given issuer may have attributes of both liabilities and equity. From a financial reporting perspective, the central issue is whether to account for these "compound" instruments in total as either liabilities or equity, or to disaggregate them into both liabilities and equity instruments. While the notion of disaggregation has long been discussed (conceptually, of course, this issue should not have been difficult to resolve, since the time-honored accounting tradition of substance over form should have provided clear guidance on this matter) it had not been effectively dealt with prior to IAS 32. The reluctance to resolve this derived from a variety of causes, including the concern that a strict doctrine of substance over form could trigger serious legal complications.
One example of the foregoing problem pertains to mandatorily redeemable preferred stock, which has historically been considered part of an entity's equity base despite having important characteristics of debt. Requiring that such quasi equity issuances be recategorized as debt might have resulted in many entities being deemed to be in violation of existing debt covenants and other contractual commitments. At a minimum, their balance sheets would imply a greater amount of leverage than previously, with possibly negative implications for lenders. Concerns such as this caused the FASB to demur from adopting a strict "substance over form" approach in its financial instruments standards, despite having stated in its 1991 discussion memorandum that all debt-like instruments should be classified as debt, not equity. The IASC, however, has resolutely dealt with this matter, to its great credit.
Under the provisions of IAS 32, the issuer of a financial instrument must classify it, or its component parts, if a compound instrument (defined and discussed below), in accordance with the substance of the respective contractual arrangement. Thus it is quite clear that under international accounting standards, when the instrument gives rise to an obligation on the part of the issuer to deliver cash or another financial asset or to exchange financial instruments on potentially unfavorable terms, it is to be classified as a liability, not as equity. Mandatorily redeemable preferred stock and preferred stock issued with put options (options that can be exercised by the holder, potentially requiring the issuer to redeem the shares at agreed-upon prices) must, under this definition, be presented as liabilities.
The presentation of common stock subject to a buyout agreement with the entity's shareholders is less clear. Closely held enterprises frequently structure buy-sell agreements with each shareholder, which require that upon the occurrence of defined events, such as a shareholder's retirement or death, the entity will be required to redeem the former shareholder's ownership interest at a defined or determinable price, such as fair or book value. The practical effect of buy-sell agreements is that all but the final shareholder will eventually become creditors; the last to retire or die will be, by default, the residual owner of the business, since the entity will be unable to redeem that holder's shares unless a new investor enters the picture. IAS 32 does not address this type of situation explicitly, although circumstances of this sort are clearly alluded to by the standard, which notes that "if a financial instrument labeled as a share gives the holder an option to require redemption upon the occurrence of a future event that is highly likely to occur, classification as a financial liability on initial recognition reflects the substance of the instrument." Notwithstanding this guidance, enterprises can be expected to be quite reluctant to reclassify the majority of stockholders' equity as debt in cases such as that described above.
IAS 32 goes beyond the formal terms of a financial instrument in seeking to determine whether it might be a liability. It also looks to the implied establishment of an obligation to redeem. For example, when preferred stock is issued that has a contractually increasing dividend requirement coupled with a call provision (giving the issuer the right, but not the obligation, to redeem the shares), the practical effect is that the issuer will be compelled, at some point, to call the shares for redemption. For this reason, the instrument is to be classified and accounted for as a liability upon its original issuance.
IAS 32 also addresses the difficult question of how compound instruments are to be categorized. Consistent with the substance over form stance taken regarding simple debt or equity instruments, the IASC has mandated that at inception compound instruments be analyzed into their constituent elements and accounted for accordingly.
Compound instruments may be comprised of one or more liabilities and/or equities, which need to be evaluated as separate instruments. Since IAS 32 does not address recognition or measurement matters, no single method of valuation is prescribed. However, the standard does suggest two possible approaches.
Assign to the least easily measured components the residual amounts, after assigning values to the more easily measured components of the compound instrument.
Measure the values of each component directly, and then, if necessary, adjust each on a pro rata basis if the total amounts exceed the proceeds from the issuance of the compound instrument.
Example of value allocation using the suggested value allocation approaches
To illustrate the allocation of proceeds in a compound instrument situation, assume these facts.
5,000 convertible bonds are sold January 1, 2003, due December 31, 2006.
Issuance price is par ($1,000 per bond); total issuance proceeds are $5,000,000.
Interest is due in arrears, semiannually, at a nominal rate of 5%.
Each bond is convertible into 150 shares of common stock of the issuer.
At issuance date, similar, nonconvertible, debt must yield 8%.
At issuance date, common shares are trading at $5, and expected dividends over the next 4 years are $.20 per share per year.
The relevant risk-free rate on 4-year obligations is 4%.
The historical variability of the stock price is indicated by a standard deviation of annual returns of 25%.
Residual value method. The residual value of the equity component of the compound instrument is computed as follows:
Use the reference discount rate, 8%, to compute the market value of straight debt carrying a 5% yield:
PV of $5,000,000 due in 4 years
PV of semiannual payments of $ 125,000 for 8 periods
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Compute the amount allocable to the conversion feature
Total proceeds from issuance of compound instrument
Value allocable to debt
Residual value allocable to equity component
Alternative approach using options pricing model. This approach values the conversion feature directly, using the Black-Scholes option pricing model (or an equivalent technique).
Compute the standard deviation of proportionate changes in the fair value of the asset underlying the option multiplied by the square root of the time to expiration of the option
Compute the ratio of the fair value of the asset underlying the option to the present value of the option exercise price
Since expected dividend per share is $.20 per year, the present value of this stream over 4 years would (at the risk-free rate) be $.726.
The shares are trading at $5.00.
Therefore, the value of the underlying optioned asset, stripped of the stream of dividends that a holder of an unexercised option would forfeit, is
$5.00 - .726 = $4.274 per share.
The implicit exercise price is $1,000 150 shares = $6.667 per share. This must be discounted at the risk-free rate, 5%, over 4 years, assuming that conversion takes place at the expiration of the conversion period, as follows:
$6.667 1.054 = 6.667 1.2155 = $5.485
Therefore, the ratio of the underlying asset, $4.274, to the exercise price, $5.485, is .7792.
Reference must now be made to a call option valuation table to assign a fair value to these two computed amounts (the standard deviation of proportionate changes in the fair value of the asset underlying the option multiplied by the square root of the time to expiration of the option, .50, and the ratio of the fair value of the asset underlying the option to the present value of the option exercise price, .7792). For this example, assume that the table value is 13.44% (meaning that the fair value of the option is 13.44%) of the fair value of the underlying asset.
The dollar valuation of the conversion option, then, is given as
.1344 x $4.274 per share x 150 shares/bond x 5,000 bonds = $430,819
Since the fair value of the straight debt (computed above, $4,495,044) plus the fair value of the options ($430,819) does not equal the proceeds, $5,000,000, both amounts should be adjusted pro rata (resulting in recording the debt at $4,562,697 and the options at $437,303).
IAS 32 establishes that income earned while holding financial instruments, and gains or losses from disposing of financial instruments should be reported in the income statement. Dividends paid on equity instruments issued should be charged directly to equity. (These will be reported in the statement of changes in equity.) The balance sheet classification of the instrument drives the income statement classification of the related interest or dividends. For example, if mandatorily redeemable preferred shares have been categorized as debt on the issuer's balance sheet, dividend payments on those shares must be reported in the income statement in the same manner as interest expense. Gains or losses on redemptions or refinancings of financial instruments classed as liabilities would be reported similarly in the income statement, while gains or losses on equity are credited or charged to equity directly.
Under the provisions of IAS 32, offsetting financial assets and liabilities is permitted only when the enterprise both (1) has the legally enforceable right to set off the recognized amounts, and (2) intends to settle the asset and liability on a net basis, or to realize the asset and settle the liability simultaneously. Of great significance is the fact that offsetting does not give rise to gain or loss recognition, which distinguishes it from the derecognition of an instrument (which was not addressed by IAS 32, but was later dealt with by IAS 39).
Simultaneous settlement of a financial asset and a financial liability can be presumed only under defined circumstances. The most typical of such cases is when both instruments will be settled through a clearinghouse functioning for an organized exchange. Other situations may superficially appear to warrant the same ac-counting treatment but in fact do not give rise to legitimate offsetting. For example, if the entity will exchange checks with a single counterparty for the settlement of both instruments, it becomes exposed to credit risk for a time, however brief, when it has paid the other party for the amount of the obligation owed to it but has yet to receive the counterparty's funds to settle the amount it is owed by the counterparty. Offsetting would not be warranted in such a context.
The standard sets forth a number of other circumstances in which offsetting would not be justified. These include
When several different instruments are used to synthesize the features of another type of instrument (which typically would involve a number of different counterparties, thus violating a basic principle of offsetting).
When financial assets and financial liabilities arise from instruments having the same primary risk exposure (such as when both are forward contracts) but with different counterparties.
When financial assets are pledged as collateral for nonrecourse financial liabilities (as the intention is not typically to effect offsetting, but rather, to settle the obligation and gain release of the collateral).
When financial assets are set aside in a trust for the purpose of discharging a financial obligation but the assets have not been formally accepted by the creditor (as when a sinking fund is established, or when in-substance defeasance of debt is arranged).
When obligations incurred as a consequence of events giving rise to losses are expected to be recovered from a third party by virtue of an insurance claim (again, different counterparties means that the entity is exposed to credit risk, however slight).
Even the existence of a master netting agreement does not automatically justify the offsetting of financial assets and financial liabilities. Only if both the stipulated conditions (both the right to offset and the intention to do so) are met can this accounting treatment be employed.
The disclosure requirements established by IAS 32 have now been largely subsumed under those established by IAS 39. These are discussed later in this chapter.
Since the IASC's original efforts to develop a comprehensive standard on accounting and reporting for financial instruments failed to bear fruit and the program had to be bifurcated (leading to the issuance of IAS 32 in 1995), substantial attention has been directed to the development of a standard on recognition and measurement. The two major challenges were (1) to decide whether to impose uniform measurement and reporting standards on financial assets and financial liabilities and (2) to determine whether special hedge accounting would be necessary and acceptable. The IASC's experience was similar to that of national standard-setting bodies regarding both of these; strong opposition, coupled with some perceived practical difficulties, precluded the imposition of uniform asset and liability requirements, and special hedge accounting was therefore made a necessity.
The IASC's failure to develop, at that time, a comprehensive and uniform set of standards for all financial assets and liabilities must not be judged too harshly, since it mirrors the difficulties of the major national standard-setting bodies, none of which have been able to traverse this complex issue. In addition, IASC's focus has necessarily been on meeting the minimum threshold for completion of the "core set of standards" so that IOSCO consideration of endorsing the IAS for cross-border securities registrations could go forward. (As discussed in Chapter 1, this was successfully accomplished and IOSCO endorsement, albeit with some qualifications, was given.) The IASC's attention will now turn to other matters, including the application of fair value accounting to all financial assets and liabilities.
The major changes wrought by IAS 39 are to greatly expand the use of fair values for measuring and reporting financial instruments (replacing most of the provisions of IAS 25, which permitted a wide range of measurement options for various categories of investments), and to address the important issue of financial derivatives, requiring that these be formally recognized and measured at fair value in most cases. IAS 39 is very similar to the US standard, SFAS 133, although without the vast and detailed guidance offered by that standard, as is typical of US financial reporting rules.
With the issuance of IAS 39, the IASC produced the final and, some would argue, most important element in the core set of standards project, making possible endorsement of the international standards for use in cross-border securities registrations. IAS 39 is not a perfect document and was agreed to only after the IASC staff had first proposed the incorporation of (for interim purposes only, in order to complete the core set of standards project within the self-imposed time deadline) the full body of US GAAP on financial instruments into IAS. That effort apparently offended the political sensibilities of non-US standard setters and was quickly abandoned, leaving it to the IASC to produce IAS 39 late in 1998, a few months after the nominal deadline for the core set of standards had passed.
Both the US and international standard setters are clearly gravitating toward a pure fair value model for all financial instruments, perhaps with changes in value included in current period earnings in all cases. For various reasons, this solution has not been universally greeted with enthusiasm, and as a consequence both the US standard, SFAS 133, and the international standard, IAS 39, have endorsed mixed attribute models. This has necessitated the endorsement of accounting for hedging situations, which among other things requires that hedging be defined and that measures be established to evaluate the effectiveness of those hedges, in order to determine whether the special accounting is warranted in any given circumstance. A pure fair value reporting model for financial assets and liabilities would have obviated the need for these specially designed treatments.
It now appears likely that IASB's development of a pure fair value model for financial assets and liabilities will be a protracted exercise. It is not expected that there will be substantive attention given to this until 2004, at the earliest.
IAS 39 is applicable to all financial instruments except interests in subsidiaries, associates and joint ventures that are accounted for in accordance with IAS 27, 28, and 31, respectively; rights and obligations under operating leases, to which IAS 17 applies; most rights and obligations under insurance contracts; employers' assets and liabilities under employee benefit plans and employee equity compensation plans, to which IAS 19 applies; and equity instruments issued by the reporting enterprise.
IAS 39 is not applicable to financial guarantee contracts, such as letters of credit, when these call for payments that would have to be made only if the primary debtor fails to perform. Accounting for these types of arrangements is specified by IAS 37. On the other hand, if the guarantor will have to make payments when a defined change in credit rating, commodity prices, interest rates, security price, foreign exchange rate, an index of rates or prices, or other underlying indicator occurs, then the provisions of IAS 39 do apply. Also, if a guarantee arises from an event leading to the derecognition of a financial instrument, the guarantee must be recognized as set forth in this standard.
IAS 39 does not apply to contingent consideration arrangements pursuant to a business combination. Also, the standard does not apply to contracts that require payments dependent upon climatic, geological, or other physical factors or events, although if other types of derivatives are embedded therein, IAS 39 would set the requirements for recognition, measurement, disclosure, and derecognition.
IAS 39 must be applied to commodity-based contracts that give either party the right to settle by cash or some other financial instrument, with the exception of commodity contracts that were entered into and continue to meet the enterprise's expected purchase, sale, or usage requirements and were designated for that purpose at their inception. With regard to embedded derivatives, if their economic characteristics and risks are not closely related to the economic characteristics and risks of the host contract, and if a separate instrument with the same terms as the embedded derivative would meet the definition of a derivative, they are to be separated from the host contract and accounted for as a derivative in accordance with the standard.
Criteria for both recognition and derecognition are set forth in IAS 39. An entity is now required to recognize a financial asset or financial liability on its balance sheet when it becomes a party to the contractual provisions of the instrument. It will derecognize the financial asset or a portion of the financial asset when it realizes the rights to benefits specified in the contract, the rights expire, or the enterprise surrenders or otherwise loses control of the contractual rights that comprise the financial asset (or a portion of the financial asset).
The question of when derecognition is warranted is more complex than it first appears, which is one reason why a significant portion of the IASC's IAS 39 Implementation Guidance Committee's (IGC) output to date has dealt with these matters. The IGC has stated that the factors and examples set forth in IAS 39 should not be viewed in isolation, and the transfer of control can potentially be demonstrated in other ways, as well. It cites the following factors that suggest that an enterprise loses control of the contractual rights that comprise financial assets when a portion of those assets are sold and the parties to the transaction have rights to the cash flows of the underlying loans and/or obligations relating to the portion of the financial assets sold:
The transaction can be distinguished from a collateralized borrowing because the transferor has no legal right to reacquire the rights to and benefits from the asset or the portion of the asset that is the subject of the transfer. This inability is often evidenced by legally documenting the transfer as a sale. Although IAS 39 does not require that a transfer must be documented in any given manner, legal documentation supporting a transfer provides the basis for determining that the transferor has no legal right to re-acquire the rights to and benefits from the transferred asset. To the contrary, an explicit contract or agreement to repurchase the transferred assets would often preclude derecognition under IAS 39.
The transferor is prohibited by the terms of the transfer contract or documents from selling or pledging the underlying financial assets that are the subject of the transfer; thus, the transferor relinquishes control of such assets. This is of particular importance in the situation in which there is a transfer of a portion of financial assets, where neither the transferor nor the transferee generally would have the right to sell the underlying assets because they are jointly owned. On the other hand, it would be difficult to conclude that the transferor surrendered the rights that comprise the financial asset if it retained the right to sell or pledge assets that are purported to be the subject of the transfer.
Although the transferee is unable to sell or pledge the underlying financial assets that are the subject of the transfer, it has the ability to sell or pledge its interest in the transferred financial assets. This is most pertinent in the situation in which the rights to and benefits from a portion of financial assets are sold.
If a transferor retains custody of loans (or similar financial assets) that are the subject of a partial sale and it provides ongoing servicing, the transferor is obligated to remit the cash flows it collects on behalf of the investors on a timely basis. Thus, the transferor is not entitled to reinvest such cash flows for its benefit, except (typically) to provide a return from short-term, high-quality investments made from the collection date to the date of remittance to the investors. To some, this ability to service financial assets that are the subject of a partial sale may suggest that the transferor has not surrendered control over the contractual rights that comprise the financial assets as required by IAS 39. However, a transferor that provides servicing acts only as an agent for the investors in the beneficial interests that have been transferred if, under the servicing agreement, the transferor does not have use of or benefit from the cash it collects on behalf of the investors and is required to remit to them on a timely basis, as specified in the servicing agreement, the cash it collects representing their beneficial interests in the financial assets.
The Implementation Guidance Committee has also noted the following factors limit the extent to which the transferred portion of the financial assets qualify for derecognition:
If the transferor has retained a call option on all or a portion of the transferred assets, and if the assets are not readily obtainable in the market, or the stated reacquisition price is not the fair value at the time of reacquisition, then derecognition to the full extent of the repurchase provision is prohibited. Derecognition is also prohibited if the assets are not readily obtainable in the market and the transferee holds an unconditional put option or has entered into a "total return swap" with the transferor on all or a portion of the transferred assets. Similarly, derecognition is prohibited to the extent the transferor and transferee have entered into a forward repurchase agreement on terms that provide the transferee with a lender's return on the assets received in exchange for the transferred assets.
If the transferor provides a guarantee to the transferees for both credit risk and interest rate risk, and there are no other substantive risks, the portion of the transferred financial assets that would otherwise qualify for derecognition is reduced to the extent that both of these risks are not transferred. The reduction is the lower of (1) the maximum amount of the credit guarantee or (2) the percentage of the transferred financial asset that is guaranteed by the transferor against interest rate risk. IASC's IAS 39 Implementation Guidance Committee (IGC) offers the example of a transfer of $800,000 (value) and retention of $200,000 (value) of an asset of $1,000,000 total value, and a pledge and subordination of the $200,000 retained in a credit guarantee to the transferee. In such a case, the transferred $800,000 is derecognized. On the other hand, if the transferor pledges and subordinates the $200,000 retained as a guarantee for both credit risk and interest rate risk and there are no other substantive risks, only $600,000 ($800,000 - $200,000) is to be derecognized. This is referred to as a "total return swap."
The IGC further notes that if the underlying financial assets cannot be sold by either party, then the beneficial interests are not considered readily obtainable for the purposes of applying IAS 39. Even though both the transferor and transferee have the right to sell or pledge their respective beneficial interests in the underlying financial assets, if such beneficial interests are not readily obtainable in the market, they would also be considered not readily obtainable for purposes of the guidance in IAS 39. In these circumstances, a transferee would not be able to sell its beneficial interest if it were subject to a repurchase arrangement because the beneficial interest would not necessarily be available to be repurchased to satisfy the repurchase arrangement.
If an entity transfers a part of a financial asset to others while retaining a portion of the asset or assumes a related liability, the carrying amount of the financial asset should be allocated between the part retained and the part sold or amount of liability retained, based on their relative fair values on the date of sale. Gain or loss should be recognized based only on the proceeds for the portion sold. If the fair value of the part of the asset retained cannot be measured reliably, then a "cost recovery" approach should be used to measure profit (that is, allocate all the cost to the portion sold). If a related liability is retained and cannot be valued, no gain should be recognized on the transfer, and the liability should be measured at the difference between the proceeds and the carrying amount of the part of the financial asset that was sold, with a loss recognized equal to the difference between the proceeds and the sum of the amount recognized for the liability and the previous carrying amount of the financial asset transferred.
The IGC has, in addition to the foregoing broad observations, offered a number of highly specific responses to factual situations posed to it, regarding derecognition of financial instruments held as assets. The more generally applicable of these are summarized in the following paragraphs.
Transfers to special purpose entities (SPE). In some cases, a transferor will transfer financial assets in a securitization transaction to a special purpose entity that it will be required to consolidate and the SPE later transfers a portion of those financial assets to third-party investors. The IGC states that the evaluation of whether a transfer of a portion of financial assets meets the derecognition criteria under IAS 39 generally will not differ if the transfer is directly to investors or through an SPE that obtains the financial assets and then transfers a portion of those financial assets to third-party investors. If a transfer by a special purpose entity to a third-party investor meets the conditions specified for derecognition in IAS 39, the transfer would be accounted for as a sale by the special purpose entity and those derecognized assets or portions thereof would not be brought back on the balance sheet in the consolidated financial statements of the enterprise.
Dispositions with full recourse for transferee. If an entity sells receivables and provides a guarantee to the buyer to pay for any credit losses that may be incurred on the receivables as a result of the failure of the debtor to pay when due, while all other substantive benefits and risks (e.g., interest rate risk) of the receivables have been transferred to the buyer, the transaction qualifies as a transfer under IAS 39. In this scenario, the transferor has lost control over the receivables because the transferee has the ability to obtain the benefits of the transferred assets, and the risk retained by the transferor is limited to credit risk in the case of default. Under IAS 39, the guarantee is treated as a separate financial instrument to be recognized as a financial liability by the transferor.
Right of first refusal. The IGC has endorsed derecognition if the transferor retains a right of first refusal that permits the transferor to purchase the transferred assets at their fair value at the date of reacquisition should the transferee decide to sell them. It is deemed appropriate since the reacquisition price is the fair value at the time of the reacquisition.
Put option given to transferee. As noted earlier in this chapter, "factoring with recourse" is a popular form of receivables financing. Under the right of recourse, the transferor is obligated to compensate the transferee for the failure of the underlying debtors to pay when due. In addition, the recourse provision often entitles the transferee to sell the receivables back to the transferor at a fixed price in the event of unfavorable changes in interest rates or credit ratings of the underlying debtors. In many cases, such financing is promoted as being a sale of the customers' accounts; however, the IGC has held that in such cases derecognition will not generally be warranted.
Instead, this transaction should be accounted for as a collateralized borrowing by the transferor, since it does not qualify for derecognition. While the transferor has lost control, since the transferee has the ability to obtain the benefits of the transferred asset and is free to sell or pledge approximately the full fair value of the transferred asset, the transferor has granted the transferee a put option on the transferred asset since the transferee may sell the receivables back to the transferor in the event of both actual credit losses and changes in underlying credit ratings or interest rates. This is similar to other situations described in IAS 39, in which a transferor has not lost control and therefore a financial asset is not derecognized if the transferor retains substantially all the risks of ownership through an unconditional put option on the transferred assets held by the transferee.
Estimating fair values when a portion of a financial asset is sold. If an entity transfers a portion of a financial asset to others while retaining a part of the asset or assumes a related liability, the carrying amount of the financial asset should be allocated between the portion retained and the part sold or amount of liability retained, based on their relative fair values on the date of sale. The best evidence of the fair value of the retained interest in the bonds is obtained by reference to market quotations. Valuation models are generally used when market quotations do not exist. Gain or loss should be recognized based only on the proceeds for the portion sold.
If the fair value of the part of the asset retained cannot be measured reliably, then a "cost recovery" approach should be used to measure profit (that is, allocate all the cost to the portion sold). If a related liability is retained and cannot be valued, no gain should be recognized on the transfer, and the liability should be measured at the difference between the proceeds and the carrying amount of the part of the financial asset that was sold, with a loss recognized equal to the difference between the proceeds and the sum of the amount recognized for the liability and the previous carrying amount of the financial asset transferred.
The IGC cites an example in which a portfolio of bonds is partially transferred to an unrelated party, with the balance retained by the reporting entity, with the yield to the transferee being different than that on the underlying bonds (i.e., market rates had diverged from the coupon rates). It notes two alternative methods for estimating the fair value of the retained interests in the bonds for purposes of allocating the basis in the bonds between the portion sold and the portion retained. The first method, deemed most suitable when there is no market evidence of the fair value of the bonds as a whole, requires making an estimate of the future cash flows of the underlying bonds based on their contractual payments, reduced by estimates of prepayments and credit losses. The cash flows are then discounted by an estimate of the appropriate risk-adjusted interest rate. This method produces a fair value of the retained interests in the bonds; the transferor would recognize a gain on sale computed by subtracting from the proceeds the amount allocated to the basis sold.
The alternative method is to obtain a market quotation on bonds that are similar to the bonds it acquired previously and are the subject of the current sale. This is prorated to the portion being sold, with a gain on sale being recognized as the difference between the prorated amount and the proceeds of the sale.
The IGC further notes that when the asset being partially transferred is one which has been originated by the transferor, some modifications in methodology might be necessary, due to a lack of an active market. However, reference to actual lending transactions of the transferor as a means of estimating the fair value of the retained beneficial interests in the loans might provide a more objective and reliable estimate of fair value than the discounted cash flow model described above, because it is based on actual market transactions. While the market interest rates may have changed between the origination dates of the loans and the subsequent sales date of a portion of the loans, the corresponding change in the value of the loans might be determined by reference to current market interest rates being charged by the transferor, or perhaps its competitors for similar loans (e.g., with similar remaining maturity, cash flow pattern, currency, credit risk, collateral, and interest basis). Alternatively, if there is no change in the credit risk of the borrowers subsequent to the origination of the loans, an estimate of the current market interest rate might be derived by using a benchmark interest rate of a higher quality than the loans, holding the credit spread constant, and adjusting for the change in the benchmark interest rate from the origination dates to the subsequent sales date.
A detailed example of accounting for partial transfers of financial assets is presented below.
Examples of allocation between asset sold and asset or liability retained
Assume that an investment in mortgages, carried at $14.5 million, is being sold, but the enterprise is retaining the "servicing rights" to these mortgages. Servicing rights entail making monthly collections of principal and interest and forwarding these to the holders of the mortgages; it also involves other activities such as taking legal action to compel payment by delinquent debtors, and so forth. For such efforts, the servicing party is compensated; in this example, the present value of future servicing income can be estimated at $1.2 million, while the mortgage portfolio, without servicing, is sold for $13.6 million. Since values of both components (the portion sold and the portion retained) can be reliably valued, gain or loss is determined by first allocating the carrying value pro rata to the two portions, as follows:
Selling price or fair value
Percentage of total
Mortgages without servicing rights
The sale of the portfolio, sans servicing rights, will result in a gain of $13.6 M - 13.32 M = $280,000. The servicing rights will be recorded as an asset in the amount $1.18 million.
Under other circumstances, transactions such as the foregoing will necessitate loss recognition. Assume the same facts as above, except that the selling price of the mortgage portfolio with servicing is only $13.1 million. In this case, the allocation of fair values and loss recognition will be as follows:
Selling price or fair value
Percentage of total
Mortgages without servicing rights
A loss on the sale of the mortgages amounting to $13.28 M - 13.1 M = $180,000 will be recognized. The servicing rights will be recorded as an asset in the amount $1.22 million.
Finally, consider a sale as above, but the obligation to continue servicing the portfolio, rather than representing an asset to the seller, is a liability, since the estimate of future costs to be incurred in carrying out these duties exceeds the future revenues to be derived therefrom. Assume this net liability has a present fair value of $ 1.1 million and that the selling price of the mortgages is $14.6 million. The allocation process and resulting gain or loss recognition is as follows:
Selling price or fair value
Percentage of total
Mortgages without servicing rights
A loss on the sale of the mortgages amounting to $15.68 M - 14.6 M = $1,080,000 will be recognized. The servicing rights will be recorded as a liability in the amount $1.1 million.
It should be added that, for the foregoing examples in which a net asset is retained, the servicing asset is deemed to be an intangible and accordingly will be accounted for under the provisions of IAS 38. Normally, this asset would be reported at amortized cost, unless impairment occurs which would necessitate a downward adjustment in carrying value. The net servicing liability would be considered similar to other liabilities and accounted for at its amortized amount.
Transfers of financial liabilities, with part of the obligation retained or with a new obligation created pursuant to the transfer, should be accounted for in a manner analogous to the foregoing examples. Using fair values and transaction prices, the carrying amount of the obligation should be allocated so that gain or loss can be computed and the liability retained or created can be appropriately recorded.
According to IAS 39, in those circumstances in which the asset retained cannot be valued, it should be recorded at zero (i.e., no portion of the carrying amount of the asset sold should be allocated to the asset retained). When the retained asset is valued at zero, the gain to be recognized from the transaction will be less than would have otherwise been the case, and any loss recognized will be greater than otherwise would have been true. Thus, this is a conservative procedure to follow under these circumstances.
On the other hand, if a new financial liability is assumed but cannot be measured reliably, assigning a zero carrying amount would obviously not achieve the same conservative financial reporting objective that assigning zero value to a retained asset would. Therefore, in such a situation the initial carrying amount of the retained liability should be a large enough amount such that no gain is recognized on the transaction. Furthermore, if application of IAS 37, Provisions, Contingent Liabilities, and Contingent Assets, requires recognition of a larger provision, a loss should be recognized on the transaction.
IAS 39 holds that a financial liability (or a part of a financial liability) should be removed from the balance sheet only when it is extinguished, that is, when the obligation specified in the contract is discharged, canceled, or expires, or when the primary responsibility for the liability (or a part thereof) is transferred to another party. Among other implications, this means that in-substance defeasance (which involves segregation of assets to be used for the future retirement of specific obligations of the enterprise) may no longer be given accounting recognition, since this does not entail actual discharge of the liability.
Initial recognition of financial assets is to be at cost, which is assumed to be equal to fair value for assets acquired in arm's-length transactions. Transaction costs such as fees and commissions are to be included in the recognized amount of all financial assets and liabilities.
For financial instruments that are carried at amortized cost (held-to-maturity investments, originated loans, and most financial liabilities) the transaction costs are included in the calculation of amortized cost using the effective interest method. In effect, transaction costs are amortized through the income statement over the life of the instrument. On the other hand, for financial instruments that are carried at fair value, such as available-for-sale investments and instruments held for trading, transaction costs are not included in the fair value measurement subsequent to acquisition. In many instances, this will cause loss recognition for the transaction costs at that time, particularly if the first reporting date is shortly after the assets were acquired. If the values have increased since acquisition, however, some or all of this loss recognition will be averted.
For available-for-sale financial assets, the timing of recognizing transaction costs in net income depends on the reporting entity's policy for reporting fair value changes. As discussed in Chapter 10, each entity had a onetime election to either report changes in value of the available-for-sale securities in earnings currently or to accumulate them in an equity account. If the former were elected, the transaction costs are included in net profit or loss at initial remeasurement to fair value. If the enterprise elected the latter alternative, and the financial asset has fixed or determinable payments and a fixed maturity (i.e., it is a debt investment), the transaction costs are amortized to net profit or loss using the effective interest method (this has been recently confirmed by the IGC). If the enterprise has elected to follow the latter alternative and the financial asset does not have fixed or determinable payments and a fixed maturity (i.e., it is an equity investment), the transaction costs are recognized in income at the time of eventual sale. For trading assets, the transaction costs are included in net profit or loss at initial remeasurement to fair value.
When applying the fair value measure, the transaction costs which would have to be incurred if there were to be a sale of the asset are not recognized (i.e., fair value is not net of selling costs) and thus fair value for reporting purposes is without the impact of transaction costs on either acquisition or assumed disposition.
Consider the following example of the acquisition of a financial asset. Assume an investment security is acquired as follows: 2,000 shares of Ravinia Corp. common stock, par value $5 per share, are purchased on the open market on October 15 for $76 per share, plus total commissions and fees of $1,775. At December 31, the shares are quoted at $761/2, and a sale at that date would entail the payment of commissions and fees of $1,550. The investment is recorded on October 15 at a total of [($76 x 2,000 shares) + $1,775 = ] $153,775. When the time comes to prepare the year-end balance sheet, this investment will be presented at $76 1/2 x 2,000 shares = $153,000, which will necessitate a write-down of $775. Thus, part but not all of the original commissions and fees will be reclassified to a loss account at that time. On the other hand, the potential cost of a sale, which would make the net realizable amount [$153,000 - 1,550 = $151,450] lower than fair value, as defined by IAS 39, is to be ignored in all such remeasurements.
In rare instances, when the value of consideration given or received cannot be observed directly or indirectly by means of other market values, then IAS 39 directs that value be ascribed by means of computing the present value of all future cash payments or receipts, using the prevailing market rate of similar types of instruments as the discount rate.
Normal securities trades clear or settle several days after the trade date. In practice, historically, some have recorded such transaction son the trade date, while others have waited until the settlement date to give formal recognition to the purchase or sale transaction. Under the provisions of IAS 39, as amended, an entity may elect to use either trade date accounting or settlement date accounting for purchases and sales of financial assets. However, it is required that the reporting entity apply the selected accounting policy in a consistent manner for both purchases and sales of financial assets that belong to the same balance sheet category (i.e., financial assets held for trading, those available for sale, those to be held to maturity, and loans and receivables originated by the entity).
When trade date accounting is used, the asset is recognized at the trade date and all subsequent changes in value will be reflected as required under IAS 39. On the other hand, if settlement date accounting is used to record purchases, there would be a failure to recognize changes in value from trade to settlement date, before formally recording the asset. For that reason, IAS 39 requires that changes in the fair value of the underlying security during the interval from trade date to settlement date must be given accounting 3recognition, to the extent that changes in fair value would otherwise have been accounted for, consistent with the nature of the investment. Thus, for held-to-maturity investments, fair value changes between trade and settlement dates are not reported, since these investments are accounted for at amortized historical cost, not at fair values (unless a permanent impairment occurs, which is unlikely in the brief span from trade to settlement dates). In the case of trading securities, changes in fair value between the trade and settlement dates would be taken into income. For available-for-sale investments, the changes in fair value during the time interval from trade date to settlement date would be reported in stockholders' equity or in earnings, depending on which of these options had been elected by the enterprise.
Before the issuance of IAS 39, the carrying values of financial instruments qualifying as investments were determined by a range of methods, varying by type of instrument, with many options available for the reporting entity to select from for any given category of investment asset. This situation has been changed significantly by IAS 39, which requires that subsequent remeasurement of financial assets be at fair value excluding transaction costs, except for (1) loans and receivables originated by the entity and not held for trading purposes, (2) held-to-maturity investments, and (3) any financial asset whose fair value cannot be reliably measured. Held-to-maturity investments and loans and receivables originated by the entity are to be reported at amortized cost; other financial assets which have indeterminate fair values but fixed maturities will be measured at amortized cost using the effective interest rate method, while those that do not have fixed maturities are to be measured at cost. In all cases, periodic review for possible impairment is needed, and if impairment exists, a loss is to be recognized in current period earnings. Derivative financial instruments that are assets must be valued at fair value.
One issue frequently raised pertains to how fair value should be gauged when the reporting entity owns a large enough fraction of the total class outstanding (or of the portion actively trading on a given day) such that a disposition would be expected to "move the market." The market could be affected in one of two ways: either the large block would fetch a premium price (in the nature of a "control premium" although the transferor's shares could not truly represent a controlling interest—if it did, the investment would have been accounted for under IAS 28 or 27, not under IAS 39), or it would cause a decline due to the imbalance of supply and demand. The IGC has stated that there is a presumption that a published price quotation in an active market is the best estimate of fair value. This should be used, without adjustment for possible premiums or discounts that might result from the (hypothetical) sale of the entity's holdings, unless it could present objective, reliable evidence validating a higher (or lower) amount. In practice, this exception is expected to rarely be appropriate.
In many situations a lender will hold collateral, often in the form of marketable securities, as additional assurance that the obligation will be repaid when due. IAS 39 required that a creditor (lender) should recognize in its balance sheet collateral it received from a debtor (borrower) when the creditor was permitted to sell or repledge the collateral without constraints. This gave rise to the circumstance, which some found both odd and incorrect, that both parties to a secured lending transaction could be reporting the same asset on their respective balance sheets simultaneously. Indeed, there was a substantial question as to whether, under the IASC Framework, the collateral and the related obligation to return the collateral would even meet the definition of an asset or a liability from the perspective of the creditor.
Because this requirement drew a great deal of criticism, and because such a practice was found to be rare under national accounting standards (a similar requirement under US GAAP was established by SFAS 125 and was later withdrawn), the IASC has deleted this requirement. However, there is a general requirement for borrowers to disclose financial assets that are pledged as collateral, much as now exists for inventories; property, plant, and equipment; and intangible assets. Also, lenders must disclose the fair value of any collateral that they have received and are permitted to sell or repledge in the absence of default. If the lender sells or repledges collateral it has received, it will disclose the fair value of that collateral separately.
Financial assets that are hedged against exposure in changes in fair value must be accounted for at an adjusted carrying amount that reflects changes in fair value attributable to the risk designated as being hedged, with a derivative the hedging instrument likewise accounted for at fair value, as discussed later in this chapter. Financial assets which have values less than zero are to be accounted for as financial liabilities; that is, at fair value if held for trading or if a derivative instrument, otherwise at amortized cost in most cases.
Changes in the value of held-to-maturity investments are generally not recognized. However, the use of the held-to-maturity classification is strictly limited to situations in which both intent and ability to hold are present, and past behavior is to be used to evaluate whether the expression of intent is indeed sincere. Intent to hold for an indefinite period would not be a basis for classification as held-to-maturity, nor would a willingness to dispose of the investment if certain changes in interest rates or market risks were to occur, or if improved yields on alternative investments or other factors were to develop.
If the issuer of the instrument that the enterprise holds as a financial asset has the right to settle it at an amount materially below amortized cost, the use of the held-to-maturity classification is not permitted. For instance, a normal call feature will not preclude held-to-maturity classification if the holder would recover substantially all of the carrying amount if the call feature is exercised by the issuer. If the entity holding the investment has a put option (giving it the right to demand early redemption, but not the obligation to do so), classification as held-to-maturity remains possible, if the enterprise has the intent and ability to hold to maturity, coupled with a positive intent not to exercise the option.
As a practical matter, the held-to-maturity category will be reserved to debt securities held as investments, since equity securities have indefinite life (thus rendering untestable the holder's representation of its intent to hold to maturity) or else have indeterminable returns to the holder (as with warrants and options). Notwithstanding the nature of the investment, use of the held-to-maturity classification is prohibited if the reporting entity has, during the current reporting year or two prior years, sold, transferred, or exercised the put option on a significant amount of held-to-maturity investments before maturity. However, IAS 39 provides certain exceptions to the foregoing rule: sales close to maturity or an exercised call date such that market rate changes would not affect the asset's fair value; a sale after substantially all of the original principal had been recovered; and sales due to isolated events beyond the enterprise's control, which are nonrecurring and which could not have been reasonably anticipated by it (e.g., a significant decline in the issuer's creditworthiness, changes in tax laws, or other changes in the legal or regulatory environment). To the extent that any of these conditions exist, sales from the held-to-maturity portfolio will not taint the remaining assets.
Under the provisions of IAS 39, the determination that there is both intent and ability to hold financial assets to maturity must be made not merely at acquisition, but also at each subsequent balance sheet date. If at one of these later determination dates it is concluded that the criteria are no longer met, then the investment should be remeasured at fair value at that time. In general, the investment would be reclassified to the available-for-sale category under such circumstances, and accordingly the adjustment to fair value would be recognized in stockholders' equity directly or else in earnings, depending on which method was elected by the reporting enterprise (see discussion below regarding this onetime election). It is also possible, if not likely, that formerly held-to-maturity securities would be reclassified to the trading category, in which case the adjustment to fair value would be taken to current earnings.
It is far less conceivable that securities could be reclassified to the held-to-maturity category after being first held in another portfolio. However, IAS 39 notes that a change in intent may occur under some circumstances. Furthermore, securities acquired for the held-to-maturity portfolio may have been recently valued at fair value because the entity violated the conditions with regard to other held-to-maturity investments (i.e., selling before maturity, etc., without having any of the exception conditions satisfied). When the two-year period during which fair value accounting was mandatorily applied expires, the enterprise would be free to resume amortized cost accounting with regard to the other remaining held-to-maturity securities. In such instances, the then-current fair value would become the new amortized cost basis. Any earlier gain or loss from fair value adjustments, if recognized in stockholders' equity, would be amortized over the remaining term to maturity, in the manner of premium and discount.
Changes in the value of trading securities are reported currently in earnings. IAS 39 defines derivative financial instruments as being, ipso facto, financial instruments held for trading, unless held for designated hedging purposes. Regarding other investments which are neither held-to-maturity nor trading (i.e., which are available for sale), IAS 39 offers reporting entities a choice of reporting methods, election of which is limited to initial application of the standard. An entity may elect to report these gains and losses either in income, or directly in stockholders' equity—being reported in the statement of changes in equity as set forth in IAS 1 (and discussed in Chapter 3).
This position is in contrast, for example, with the requirement under the corresponding US standard (SFAS 115), which does not provide the option of reporting gains or losses from fair value changes on available-for-sale securities in current earnings. It is likely that a preponderance of entities reporting under IAS 39 will similarly choose to avoid impacting the current year's operating results and will instead logically conclude that since over time many of these market-based value fluctuations will reverse and offset, recordation within equity would be preferable.
As noted, the selection of the method to be used to account for changes in the fair value of available-for-sale investments is to be made when IAS 39 is first applied. A subsequent change in method would have to be justified under the provisions of IAS 8; the IASC has stated that it is deemed to be highly unlikely that a change from current earnings recognition to accumulation directly in equity could be supported.
Notwithstanding the option to accumulate the effects of changes in the fair values of available-for-sale financial assets in equity, IAS 39 does mandate that impairment losses have to be recognized in earnings. This is described below.
An impairment in value of equity securities classified as available-for-sale must be reflected in earnings. A financial asset is impaired if its carrying amount is greater than its estimated recoverable amount. Specifically, this is meant to be the result of other than the normal fluctuations in value characteristic of all investments, due to general movements in the underlying markets, etc. In the absence of an ability to demonstrate that a decline is temporary, the conclusion must be that there is an impairment which must be recognized in income. Declines are measured at the individual security level, and thus, losses in one security's value cannot be offset by gains in another's value.
While temporary declines in value of available-for-sale investments are reported either in earnings or directly in stockholders' equity (as discussed, this was an election to be made by the reporting entity only upon adoption of IAS 39), impairment losses must be included in earnings. Similarly, reversals of impairment losses (if recovery can be objectively attributed to events occurring after the impairment recognition) should always be reported in earnings.
Under provisions of the now-superseded IAS 25, the accounting for debt securities held as investments was driven by the classification as a current or a noncurrent asset, and within each of these categories, diverse accounting methods were acceptable. Thus, for noncurrent investments, either the amortized historical cost method or revaluation was allowed.
Under IAS 39, however, no optional methods are offered, and fair value is required for debt securities held for trading or available for sale, while amortized cost is prescribed for those in the held-to-maturity portfolio, as that is narrowly defined by the standard. The held-to-maturity category is the most restrictive of the three; debt instruments can be so classified only if the reporting entity has the positive intent and the ability to hold the securities for that length of time. A mere intent to hold an investment for an indefinite period is not adequate to permit such a classification. On the other hand, a variety of isolated causes may necessitate transferring an investment in a debt security from the held-for-investment category without calling into question the investor's general intention to hold other similarly classified investments to maturity. Among these are declines in the creditworthiness of a particular investment's issuer or a change in tax law or regulatory rules. On the other hand, sales of investments which were classified as held-to-maturity for other reasons will call into question the entity's assertions, both in the past and in the future, about its intentions regarding these and other similarly categorized securities. For this reason, transfers from or sales of held-to-maturity securities will be very rare, indeed.
If it cannot be established that a particular debt security held as an investment will be held for trading or held to maturity, it must be classed as available-for-sale. Whatever the original classification of the investment, however, transfers among the three portfolios will be made as intentions change.
Accounting for debt securities that are held for trading and those that are available for sale is based on fair value. For balance sheet purposes, increases or decreases in value are reflected by adjustments to the asset account; such adjustments are to be determined on an individual security basis. Changes in the values of debt securities in the trading portfolio are recognized in earnings immediately, while changes in the values of debt securities in the available-for-sale category are reported either in earnings or in stockholders' equity, based on the election made when IAS 39 was first adopted.
IAS 39 says very little regarding the reclassifications of investments. Nonetheless, from the basic principles espoused by the standard, it is clear that transfers of any given security between classifications should be accounted for at fair market value. IAS 39 states that transfers from the trading category should not take place, because classification as a trading security is based on the original intent in acquiring it. The standard also says that transfers to the trading category would be unusual but not prohibited. In the case of a transfer to the trading portfolio, any previously unrecognized unrealized gain or loss is retained in equity until the asset is derecognized, if unrealized gains or losses have been included in equity.
If a debt security is being transferred from held-to-maturity to the available-for-sale portfolio, and if fair value adjustments to items in the available-for-sale portfolio are being accounted for as changes in stockholders' equity without being reported in earnings, then the unrealized gain or loss, not previously reflected in the investment account, must be added to the appropriate equity account at the date of transfer and reported in the statement of changes in equity at that time. On the other hand, if fair value adjustments are reported in earnings, then transfers from the held-to-maturity portfolio to the available-for-sale portfolio will trigger income or loss recognition in most cases.
If a security is being transferred from available-for-sale to held-to-maturity, there will similarly be alternative accounting ramifications depending on how the fair value adjustments had been dealt with when the security was considered to be available-for-sale. If those adjustments were taken to income, as permitted by IAS 39, then no further adjustment is necessary (assuming the records are up-to-date as of the date of the transfer). However, if the fair value adjustments were made directly to equity, then logic suggests that the unrealized holding gain or loss previously accumulated in equity should be maintained in the equity account, and should prospectively be amortized to income over the remaining term to maturity as an adjustment of yield, using the effective interest method.
IAS 39 establishes a need for earnings recognition when impairment losses occur which affect investments included in the held-to-maturity portfolio. Evaluation of whether there is objective evidence of impairment is to be made at each balance sheet date; if this exists, the recoverable amount of the financial asset should be ascertained. Evidence of impairment could be provided by information about the financial difficulties of the issuer, an actual breach or default by the obligor, a debt restructuring by the issuer, a delisting of the issuer's securities or a high probability that this will occur in the near term, and similar developments. On the other hand, IAS 39 cautions that a change in status to not being publicly traded does not constitute evidence of a security's impairment, nor does a downward credit rating revision, taken alone, although in combination with other factors these could have significance.
For held-to-maturity securities, the standard provides that when it becomes probable that the holder will not be able to collect all amounts that are due contractually (including both interest and principal), an impairment loss is to be recognized. Similarly, when loans or receivables originated by the entity and not held for trading have such an impairment, a bad debt loss is to be recognized currently. In determining the amount of such loss, the carrying amount (amortized cost) is compared to its recoverable amount, defined as the present value of projected future cash flows, discounted using the instrument's original effective interest rate (not the current market interest rate). A write-down to this recoverable amount is indicated when impairment has been found to have occurred. Use of the current market rate of interest is prohibited because to use this rate would be to indirectly impose a fair value measure, which of course is contrary to the concept of accounting for held-to-maturity financial assets, and loans and receivables originated by the entity, at amortized historical cost.
When in a later period there is a reversal of the impairment recognized earlier with regard to held-to-maturity financial assets or loans and receivables originated by the entity, this recovery should be appropriately reported in earnings. However, the reversal cannot result in carrying the asset at an amount in excess of that which it would have been reported at on that date, considering intervening periods' amortization if pertinent.
When the carrying value of a held-to-maturity financial asset is reduced due to findings of impairment, future interest income must be computed on the basis used to reduce the asset to its recoverable amount. That is, the effective rate of the original investment (including the impact of any premium or discount amortization) will be used, not its contractual rate.
Having once been reduced in carrying value due to a finding of impairment, there often will be a heightened need to monitor further impairments in later periods. If such evidence is objectively determinable, yet another computation of recoverable amount (and possibly a further adjustment to the financial asset's carrying amount) will be required.
In the case of available-for-sale securities for which adjustments due to changes in fair value have been accumulated in stockholders' equity (for enterprises which had elected that optional reporting methodology), the discovery that there has been a permanent impairment in value will also necessitate accounting recognition. The appropriate amount of the accumulated fair value adjustment must be removed from equity and reported in earnings at the time objective evidence of impairment is determined to exist. The difference between acquisition cost and either current fair value (for equity-type instruments) or recoverable amount (for debt instruments) is the usual measure of impairment.
Recoverable amount, as used in the context of available-for-sale financial assets, differs from the identically named concept applied to held-to-maturity assets. In the latter case, as noted above, projected future cash flows are to be discounted at the instrument's original effective rate, to avoid confounding the impairment mea-sure by reference to current fair values, which would be inappropriate if applied to this class of investment. In the setting of available-for-sale instruments, however, fair value is both quite appropriate and required. Thus, if debt instruments are in the available-for-sale category and are being evaluated for impairment, future cash flows must be discounted at the current market rate of interest applicable to such instruments.
The remeasurement of financial liabilities is discussed and illustrated in Chapter 12.
As under the similar US standard, IAS 39 provides for special hedge accounting under defined circumstances. The standard defines three types of hedging relationships: fair value hedges, cash flow hedges, and hedges of net investment in a foreign entity. These are described in IAS 39 as follows:
Fair value hedges. A hedge, using a derivative or other financial instrument, of the exposure to changes in the fair value of a recognized asset or liability, or an identified portion of such an asset or liability, that is attributable to a particular risk and will affect reported net income.
Cash flow hedges. A hedge, using a derivative or other financial instrument, of the exposure to variability in cash flows that is attributable to a particular risk associated with a recognized asset or liability (such as all or a portion of future interest payments on variable-rate debt) or forecasted transaction (such as an anticipated purchase or sale) that will affect reported income or loss. A hedge of an unrecognized firm commitment to buy an asset at a fixed price is treated as a cash flow hedge, although actually a fair value hedge.
Hedges of a net investment in a foreign entity (as defined in IAS 21) using a derivative or other financial instrument.
The most contentious issue regarding hedging has been the decision to apply special hedge accounting to such transactions. If all financial instruments were marked to market (fair) values, there would be no need for special accounting except, perhaps, for hedges of unrecognized firm commitments and forecasted transactions. However, given that fair value accounting has yet to be fully accepted for financial instruments held as assets, and is even less widely accepted for financial instruments classed as liabilities, the topic of hedge accounting must be addressed. Under the provisions of IAS 39, a hedging relationship will qualify for special hedge accounting presentation if all of the following conditions are met:
At the inception of the hedge there is formal documentation of the hedging relationship and the enterprise's risk management objective and strategy for undertaking the hedge. That documentation should include identification of the hedging instrument, the related hedged item or transaction, the nature of the risk being hedged, and how the enterprise will assess the hedging instrument's effectiveness if offsetting the exposure to changes in the hedged item's fair value or the hedged transaction's cash flows that is attributable to the hedged risk.
The hedge is expected to be highly effective in achieving offsetting changes in fair value or cash flows attributable to the hedged risk, consistent with the originally documented risk management strategy for that particular hedging relationship.
For cash flow hedges, a forecasted transaction that is the subject of the hedge must be probable and present an exposure to price risk that could produce variation in cash flows that will affect reported income.
The effectiveness of the hedge can be reliably measured, that is, the fair value or cash flows of the hedged item and the fair value of the hedging instrument can be reliably measured.
The hedge was assessed and determined actually to have been effective throughout the financial reporting period.
Under IAS 39, a hedging relationship could be designated for a hedging instrument taken as a whole, or for a component of a hedging instrument, provided that the fair value of each component can be measured reliably over its life. Thus, an enterprise could designate the change in the intrinsic value of an option as the hedge, while the remaining component of the option (its time value) is excluded.
As noted, to qualify for hedge accounting, the effectiveness of a hedge would have to be subject to effectiveness testing. The method an enterprise adopts for this would depend on its risk management strategy, and this could vary for different types of hedges. If the principal terms of the hedging instrument and of the entire hedged asset or liability or hedged forecasted transaction are the same, the changes in fair value and cash flows attributable to the risk being hedged offset fully, both when the hedge is entered into and thereafter until completion. An interest rate swap is likely to be an effective hedge if the notional and principal amounts, term, repricing dates, dates of interest or principal receipts and payments, and basis for measuring interest rates are the same for the hedging instrument and the hedged item.
Also, to qualify for special hedge accounting under IAS 39's provisions, the hedge would have to relate to a specific identified and designated risk, and not merely to overall enterprise business risks, and must ultimately affect the enterprise's net profit or loss, not just its equity.
The standard provides that a hedge can be judged to be highly effective if, both at inception and throughout its life, the reporting entity can expect that changes in the fair value or cash flows (depending on the type of hedge) of the hedged item will be virtually fully offset by changes in the fair value or cash flows of the underlying or hedged item, and that actual results are within a range of 80% to 125% of full offset. While there is flexibility in terms of how an entity measures and monitors effectiveness (and this may even vary within an entity regarding different types of hedges), the fact that IAS 39 provides quantified upper and lower effectiveness thresholds underlines the importance of making such a determination. The documentation of the enterprise's hedging strategy must stipulate how this will be achieved, and hedging effectiveness must be assessed at least as often as financial reports are prepared.
With specific regard to fair value hedges, IAS 39 prescribes the following special hedge accounting:
The gain or loss from remeasuring the hedging instrument at fair value is to be recognized currently in net profit or loss; and
The gain or loss on the hedged item attributable to the hedged risk should adjust the carrying amount of the hedged item and be recognized currently in net profit or loss.
These requirements apply even if a hedged item is otherwise measured at fair value with changes in fair value recognized directly in equity (i.e., financial instruments not held for trading purposes, for which recordation in equity had been elected by the reporting entity). Hedge accounting must be discontinued, however, when the hedging instrument expires or is sold, terminated, or exercised, or when the hedge no longer meets the criteria for qualification for hedge accounting.
When there has been an adjustment made to the carrying amount of a hedged, interest-bearing instrument, it should be amortized to earnings, beginning no later than when it ceases to be adjusted for changes in fair value attributable to the risk being hedged.
Gain or loss relating to the portion of a cash flow hedge that is determined to be effective is to be recognized directly in stockholders' equity, through the statement of changes in equity. The ineffective portion, if any, must be recognized currently in earnings if the hedging instrument is a derivative or if it pertains to a trading instrument. If it relates to an available-for-sale instrument and in the (highly unusual) event the hedging instrument is not a derivative, then the ineffective portion may be either included in income or in equity, depending on which method the entity has elected for reporting fair value changes for such instruments.
Per IAS 39, the separate component of equity associated with the hedged item is to be adjusted to the lesser of two amounts: (1) the cumulative gain or loss on the hedging instrument needed to offset the cumulative change in expected future cash flows on the hedged item from inception of the hedge, less the portion associated with the ineffective component, or (2) the fair value of the cumulative change in expected future cash flows on the hedged item from inception of the hedge. Any remaining gain or loss (the ineffective portion) is either taken to earnings or equity as described above.
If the hedge relates to a firm commitment or forecasted transaction, and this in turn results in the recognition of an asset or liability, then when the asset or liability is first recognized the related gains or losses previously taken directly to equity should be removed from equity and added to or deducted from the basis of the asset or liability. When the asset or liability later affects earnings (e.g., when the asset is amortized or depreciated), the gain or loss will likewise impact operating results. However, the standard on impairment (and other IAS) are fully applicable, so that, for example, if deferred hedging losses are added to the cost of an asset, and it later fails an impairment test, some or all of that deferred loss will have to be immediately recognized.
In the case of other cash flow hedges (i.e., those not resulting in recognition of assets or liabilities), amounts reflected in equity will be recognized in earnings in the period or periods when the hedged firm commitment or forecasted transaction also affects earnings.
Hedge accounting is to be discontinued when the hedging instrument is sold, expires, is terminated or exercised. If the gain or loss was accumulated in equity, it should remain there until such time as the forecasted transaction occurs, when it is added to the asset or liability recorded or is taken into earnings when the transaction impacts earnings. Hedge accounting is also discontinued prospectively when the hedge ceases meeting the criteria for qualification of hedge accounting. The accumulated gain or loss remains in equity until the committed or forecasted transaction occurs, whereupon it will be handled as discussed above.
Finally, if the forecasted or committed transaction is no longer expected to occur, hedge accounting is prospectively discontinued. In this case, the accumulated gain or loss included in equity must be immediately taken into earnings.
Hedges of a net investment in a foreign entity are accounted for similarly to those of cash flows. To the extent it is determined to be effective, accumulated gains or losses are reflected in equity via the statement of changes in equity. The ineffective portion is generally reported in earnings, but to the limited extent the hedging instrument is not a derivative, the gain or loss is accounted for consistent with IAS 21, which states that exchange differences arising on a foreign currency liability accounted for as a hedge of a net investment in a foreign entity should be classified as equity until the investment is disposed of, at which time it should be recognized in earnings.
In terms of financial reporting, the gain or loss on the effective portion of these hedges should be classified in the same manner as the foreign currency translation gain or loss. According to IAS 21, translation gains and losses are not reported in earnings but instead are reported directly in equity, with allocation being made to minority interest when the foreign entity is not wholly owned by the reporting entity. Likewise, any hedging gain or loss would be reported in equity. When the foreign entity is disposed of, the accumulated translation gain or loss would be reported in earnings, as would any related deferred hedging gain or loss.
When a hedge does not qualify for special hedge accounting (due to failure to properly document, ineffectiveness, etc.), any gains or losses are to be accounted for based on the nature of the hedging instrument. If a derivative financial instrument, the gains or losses must be reported in earnings. Similarly, if the item is held for trading, immediate recognition in earnings is mandatory. If it is not a derivative, and is an available-for-sale instrument, then the provision of IAS 39 that offers a choice of reporting methods comes into play. Thus, either immediate earnings recognition or recognition in equity can be elected when IAS 39 is first applied. Consistent application of the chosen methodology will be required thereafter.
Under the provisions of IAS 39, assuming other conditions are also met, hedge accounting may be applied as long as, and to the extent that, the hedge is effective. By effective, the standard is alluding to the degree to which offsetting changes in fair values or cash flows attributable to the hedged risk are achieved by the hedging instrument. A hedge is generally deemed effective if, at inception and throughout the period of the hedge, the ratio of changes in value of the underlying to changes in value of the hedging instrument are in a range of 80 to 125%.
Hedge effectiveness will be heavily impacted by the nature of the instruments used for hedging. For example, interest rate swaps will be almost completely effective if the notional and principal amounts match, and the terms, repricing dates, interest and principal payment dates, and basis for measurement are the same. On the other hand, if the hedged and hedging instruments are denominated in different currencies, effectiveness will not be 100% in most instances. Also, if the rate change is partially due to changes in perceived credit risk, there will be a lack of perfect correlation as well.
Hedges must be defined in terms of specific identified and designated risks. Overall (enterprise) risk cannot be the basis for hedging. Also, it must be possible to precisely measure the risk being hedged; thus, threat of expropriation (which may be an insurable risk) is not a risk that can be hedged, as that term is used in IAS 39. Similarly, investments accounted for by the equity method cannot be hedged, since that would be inconsistent with the equity method of accounting. In contrast, a net investment in a foreign subsidiary can be hedged, since this is a function of currency exchange rates alone.
If a hedge does not qualify for special hedge accounting because it is not effective, any gains or losses arising from changes in the fair value of a hedged item measured at fair value, subsequent to initial recognition, are reported as otherwise prescribed by IAS 39. That is, if an item is held for trading, changes in value are reported in earnings; if available for sale, the changes are reported in earnings or in equity, consistent with the onetime election made by the reporting entity.
IAS 32 was effective in 1996 and established an expansive set of disclosure requirements. IAS 39, which became effective in 2001, carried forward these requirements with only minor changes and added further informational disclosure requirements. Following are the disclosures to be made, as relevant to the reporting entity's situation, following implementation of IAS 39. These are heavily oriented toward providing the users of the financial statements with clear understanding of the reporting entity's various risks, as explained in the following paragraphs.
The major objective of the disclosure requirements established by IAS 32 is to give financial statement users the ability to assess on- and off-balance-sheet risks, which prominently includes risks relating to future cash flows associated with the financial instruments. The standard presents the following typology of risk:
Price risk, which implies not merely the risk of loss but also the potential for gain, and which is in turn comprised of
Currency risk— The risk that the value of an instrument will vary due to changes in currency exchange rates.
Interest-rate risk— The risk that the value of the instrument will fluctuate due to changes in market interest rates.
Market risk— A broader concept that subsumes interest rate risk, this is, the risk that prices will fluctuate due to factors specific to the financial instrument or due to factors that are generally affecting other securities trading in the same markets.
Credit risk is related to the failure of one party to perform as it is required to contractually.
Liquidity risk (also known as funding risk) is a function of the possible difficulty to be encountered in raising funds to meet commitments; it may result from an inability to sell a financial asset at its fair value.
Cash flow risk is the risk that the future cash flows associated with a monetary financial instrument will fluctuate in amount, as when a debt instrument carries a floating interest rate, potentially causing a change in cash flows while fair values will remain constant (absent a coincidentally occurring change in creditworthiness).
The standard does address the means by which interest rate and credit risk factors are to be addressed in the financial statements, while cash flow and liquidity risk are discussed in general terms only. These matters are elaborated upon in the following paragraphs.
Interest-rate risk is the risk associated with holding fixed-rate instruments in a changing interest-rate environment. As market rates rise, the price of fixed-interest-rate instruments will decline, and vice versa. This relationship holds in all cases, irrespective of other specific factors, such as changes in perceived creditworthiness of the borrower. However, with certain complex instruments such as mortgage-backed bonds (a popular form of derivative instrument), where the behavior of the underlying debtors can be expected to be altered by changes in the interest-rate environment (i.e., as market interest rates decline, prepayments by mortgagors increase in frequency, raising reinvestment rate risk to the bondholders and accordingly tempering the otherwise expected upward movement of the bond prices), the inverse relationship will become distorted.
IAS 32 requires that for each class of financial asset and financial liability, both those that are recognized (i.e., on-balance-sheet) and those that are not recognized (off-balance-sheet), the reporting entity should disclose information which will illuminate its exposure to interest-rate risk. This includes disclosure of contractual repricing dates or maturity dates, whichever are earlier, as well as effective interest rates, if applicable.
These data provide the user of the financial statements with an ability to predict cash flows, since fixed-rate instruments will generate cash inflows (if assets) or outflows (if liabilities) at a given rate until the maturity date or the earlier repricing date, although other features, such as optional call dates or serial retirements, can complicate this further. The combination of information on contractual (or coupon) rates, maturity dates, and changing market conditions (not provided by the financial statements, but presumably available to anyone with access to the financial press) also provides insight into the price risk of the underlying debt instruments, while for debt having floating rates of interest, knowledge of market conditions provides insight into cash flow risk.
The standard also suggests, but does not require, that when expected repricings are to occur at dates that differ significantly from contractual dates, such information be provided as well. An example is when the enterprise is an investor in fixed-rate mortgage loans and when prepayments can be reliably estimated; as the funds thereby generated will need to be reinvested at then-current market rates, altering the patterns and amounts of future cash flows from what a simple reading of the balance sheet might otherwise suggest. Information based on management expectations should be clearly distinguished from that which is based on contractual provisions.
IAS 32 suggests that a meaningful way to present this information is to group financial assets and financial liabilities into categories as follows:
Those debt instruments that have fixed rates and thus expose the reporting entity to interest-rate (price) risk
Those debt instruments that have floating rates and thus expose the entity to cashflow risk
Those instruments, typically equity, which are not interest-rate sensitive
Effective interest rates, as used in this standard, means the internal rate of return, which is the discount rate that equates the present value of all future cash flows associated with the instrument with its current market price. Put another way, this is the measure of the time value of money as it relates to the financial instrument in question. Effective interest rates cannot be determined for derivative financial instruments such as swaps, forwards and options, although these are often affected by changes in interest rates, and the effective rate disclosures prescribed by IAS 32 do not apply in such cases. In any event, the risk characteristics of such instruments must be discussed in the footnote disclosures.
The nature of the reporting enterprise's business and the extent to which it holds financial assets or is obligated by financial liabilities will affect the manner in which such disclosures are presented, and no single method of making such disclosures will be suitable for every entity. The standard suggests that in many cases a tabular disclosure of amounts of financial instruments exposed to interest-rate risk will be useful, with the instruments grouped according to repricing or maturity dates (e.g., within one year, from one to five years, and over five years from the balance sheet date). In other cases (for financial institutions, for example), finer distinctions of maturities might be warranted. Similar tabular presentations of data on floating-rate instruments (which create cash-flow risk rather than interest-rate |price| risk) should also be presented, when pertinent. When other risk factors are also present, such as credit risk (discussed in the following section), a series of tabular presentations, segregating instruments into risk classes and then categorizing each in terms of maturities and so on, may be necessary to convey the risk dimensions adequately to readers.
Sensitivity analysis has been alluded to in a number of accounting standards over the years. Since it has always been presented as an optional feature, it has rarely been employed in actual disclosures, despite having great potential for being useful to readers. In the context of financial instruments, sensitivity analysis would imply a discussion of the effect on portfolio value of a hypothetical change (say, a 1% change, plus or minus) in interest rates. There are at least two reasons why such information, unless accompanied by an adequate discussion of the particular characteristics of the financial instruments in question, might be misleading to financial statement readers.
First, because of the phenomenon known as convexity, the value change of each successive 1% interest change in rates is not a constant, but rather, a function of current market rates. For example, if the market rate at the balance sheet date is 8%, a move to 9% might cause a $20,000 decline in value in a given bond portfolio, but a further 1% change in the market rate, from 9% to 10%, would not have a further $20,000 effect. Instead, the effect would be an amount greater or lesser depending on the coupon (contractual) rate of interest of the underlying financial instruments. A reader, however, would rarely appreciate this fact and would probably extrapolate the sensitivity data in a linear manner, which could be materially misleading in the absence of further narrative information.
Second, sensitivity data most often are presented in a manner that suggests that they apply symmetrically. Thus, in the foregoing example, the presumption is that a 1% market rate decline would boost the portfolio value by $20,000 and that a 1% rate increase would depress it by a similar amount. However, some instruments, most notably those with embedded options (mortgage-backed bonds, having prepayment options, are the most common example cited, although exotic derivatives can be far more difficult to analyze) will not exhibit symmetrical price behavior, and the asymmetries will become exaggerated as hypothetical market rates stray further from the current rates. As a practical matter, the only way to convey these subtleties in a meaningful fashion would be to incorporate extensive tables of information into the footnotes, which many users would find to be impossibly confusing.
For these and possibly other reasons, although recommended by IAS 32, it is not anticipated that sensitivity data will be provided widely in the near term. If provided, however, any assumptions and the methodologies employed should be explained adequately, along with any needed caveats concerning the validity of extrapolation over greater ranges of market rate changes and over time.
IAS 32 also demands that for each class of financial asset, both recognized (i.e., on-balance-sheet) and unrecognized (off-balance-sheet), information be provided as to exposure to credit risk. Specifically, the maximum amount of credit risk exposure as of the balance sheet date, without considering possible recoveries from any collateral that may have been provided, should be stated and any significant concentrations of credit risk should be discussed.
Disclosure is required of the amount that best represents the maximum credit risk exposure at the balance sheet date. In many cases, this is simply the carrying value of such instruments; for example, accounts receivable net of any allowance for uncollectibles already provided would be the measure of credit risk associated with trade receivables. In other cases, the maximum loss would be an amount less than that which is revealed on the balance sheet, as when a legal right of offset exists but the financial asset was not presented on a net basis on the balance sheet because one of the required conditions set forth in IAS 32 (intention to settle on a net basis) was not met. In yet other circumstances, the maximum accounting loss that could be incurred would be greater, as when the asset is unrecognized in the balance sheet although otherwise disclosed in the footnotes as, for example, when the entity has guaranteed collection of receivables that have been sold to another party (often called factoring with recourse, discussed earlier).
There are a large number of potential combinations of factors that could affect maximum credit risk exposure, and in other than the most basic circumstances it is likely that extended narratives will be needed to convey the risks fully in the most meaningful way to users of the financial statements. For example, when an entity has financial assets owed from and financial liabilities owed to the same counter-party, with the right of offset but without having an intent to settle on a net basis, the maximum amount subject to credit risk may be lower than the carrying value of the asset. However, if past behavior suggests that the enterprise would probably respond to the debtor's difficulties by extending the maturity of the financial asset beyond the maturity of the related liability, it will voluntarily expose itself to greater risk since it will presumably settle its obligation and thus forfeit the opportunity to offset these related instruments.
When the maximum credit risk exposure associated with a particular financial asset or group of assets is the same as the amount presented on the face of the balance sheet, it is not necessary to reiterate this fact in the footnotes. The presumption is that there will be disclosures made for all material items for which this fact does not hold, however.
In addition to disclosure of maximum credit risk, IAS 32 requires disclosure of concentrations of credit risk when these are not otherwise apparent from the financial statements. Common examples of this involve trade accounts receivable that are due from debtors within one geographic region or operating within one industry segment, as when a large fraction of receivables are due from, say, housing construction contractors in the Netherlands, many of whom might find themselves in financial difficulty if economic conditions deteriorated in that narrowly defined market. In addition to geographic locale and industry, other factors to consider would include the creditworthiness of the debtors (e.g., if the reporting entity targets a market such as college students not having steady employment, or third-world governments) and the nature of the activities undertaken by the counterparties. The disclosures should provide a clear indication of the characteristics shared by the debtors.
Examples of disclosures of credit risk
Note 5: Interest Rate Swap Agreements
The differential to be paid or received is accrued as interest rates change and is recognized over the life of the agreements.
Note 8: Foreign Exchange Contracts
The corporation enters into foreign exchange contracts as a hedge against accounts payable denominated in foreign currencies. Market value gains and losses are recognized, and the resulting credit or debit offsets foreign exchange losses or gains on those payables.
Note 13: Financial Instruments with Off-Balance-Sheet Risk
In the normal course of business, the corporation enters into or is a party to various financial instruments and contractual obligations that, under certain conditions, could give rise to or involve elements of, market or credit risk in excess of that shown in the statement of financial condition. These financial instruments and contractual obligations include interest rate swaps, forward foreign exchange contracts, financial guarantees, and commitments to extend credit. The corporation monitors and limits its exposure to market risk through management policies designed to identify and reduce excess risk. The corporation limits its credit risk through monitoring of client credit exposure, reviews, and conservative estimates of allowances for bad debt and through the prudent use of collateral for large amounts of credit. The corporation monitors collateral values on a daily basis and requires additional collateral when deemed necessary.
Note 6: Interest Rate Swaps and Forward Exchange Contracts
The corporation enters into a variety of interest rate swaps and forward foreign exchange contracts. The primary use of these financial instruments is to reduce interest rate fluctuations and to stabilize costs or to hedge foreign currency liabilities or assets. Interest rate swap transactions involve the exchange of floating-rate and fixed-rate interest payment of obligations without the exchange of underlying notional amounts. The company is exposed to credit risk in the unlikely event of nonperformance by the counterparty. The differential to be received or paid is accrued as interest rates change and is recognized over the life of the agreement. Forward foreign exchange contracts represent commitments to exchange currencies at a specified future date. Gains (losses) on these contracts serve primarily to stabilize costs. Foreign currency exposure for the corporation will result in the unlikely event that the other party fails to perform under the contract.
Note 3: Financial Guarantees
Financial guarantees are conditional commitments to guarantee performance to third parties. These guarantees are primarily issued to guarantee borrowing arrangements. The corporation's credit risk exposure on these guarantees is not material.
Note 8: Commitment to Extend Credit
Loan commitments are agreements to extend credit under agreed-upon terms. The corporation's commitment to extend credit assists customers to meet their liquidity needs. These commitments generally have fixed expiration or other termination clauses. The corporation anticipates that not all of these commitments will be utilized. The amount of unused commitment does not necessarily represent future funding requirements.
Note 9: Summary of Off-Balance-Sheet Financial Instruments
The off-balance-sheet financial instruments are summarized as follows (in thousands):
Financial instruments whose notional or contract amounts exceed the amount of credit risk:
Contract or notional amount
Interest rate swap agreements
Forward foreign exchange contracts
Financial instruments whose contract amount represents credit risk:
Contract or notional amount
Commitments to extend credit
For certain corporations, industry or regional concentrations of credit risk may be disclosed adequately by a description of the business. Some examples of such disclosure language are
Credit risk for these off-balance-sheet financial instruments is concentrated in Asia and in the trucking industry.
All financial instruments entered into by the corporation relate to Japanese government, international, and domestic commercial airline customers.
Example of disclosure of concentration of credit risk
Note 5: Significant Group Concentrations of Credit Risk
The corporation grants credit to customers throughout Europe and the Middle East. As of December 31, 2002, the five areas where the corporation had the greatest amount of credit risk were as follows:
United Arab Emirates
IAS 32 further requires that for each class of financial asset and financial liability, the reporting enterprise should disclose information about fair value. This requirement is not operative, however, in the case of financial assets or liabilities that are already to be carried at fair value, per IAS 39. An exception is provided in the case when it is not deemed practicable within the constraints of timeliness or cost to determine fair value with sufficient reliability. However, when an entity avails itself of this option, it must disclose that fact, coupled with a summary of pertinent characteristics of the instrument, such that readers can make their own assessments of fair value should they so choose.
Stockholders and others have every reason to expect that management understands the values of the assets it acquires for the business or of the obligations it incurs. Therefore, a confession in the financial statements to the effect that fair values could not be determined, if made more than infrequently, would appear either disingenuous or an admission of managerial malfeasance. For this reason, a good-faith attempt to determine the fair value data requested by IAS 32, coupled with disclosures that set forth whatever caveats are deemed necessary to make the information not misleading, is probably the best course to follow.
Beyond the basic concern of computing fair values, there is the further issue of what this information is intended to imply. This question arises most commonly in the context of financial obligations, which represent contractual commitments to repay fixed sums at fixed points in time, that are not subject to adjustment for market-driven changes in value.
For example, assume that an entity owes a bank loan carrying fixed 9.5% interest, with the principal due as a $300,000 balloon payment three years hence. If current rates are 7%, the fair value of this obligation is something greater than its face value (in fact, the computed present value of future cash flows, discounted at 7%, is 5342,060, which will be the surrogate for fair value), yet the contractual obligation is unchanged at the original $300,000. What, then, is the purpose of communicating to financial statement users that the fair value is the higher, $342,060, amount?
The explanation of this disclosure is that the economic burden being borne by the entity is heavier than would have been the case had a floating market rate of interest been attached to the debt. The spread between the disclosed fair value, $342,060, and the face amount of the debt, $300,000, is the present value of the additional interest to be paid in the future under the fixed-rate agreement over the amount that would be payable at the current market rate. Thus, fair value disclosure does not measure future cash flows, per se, but rather is an indication of economic burden or benefit in the assumed absence of any restructuring or other alteration of the debt.
Fair value is the exchange price in a current transaction (other than in a forced or liquidation sale) between willing parties. If a quoted market price is available, it should be used, after adjustment for transaction costs that would normally be incurred in a real transaction of this type. If there is more than one market price, the one used should be the one from the most active market. The possible effects on market price from the sale of large holdings and/or from thinly traded issues should generally be disregarded for purposes of this determination, since it would tend to introduce too much subjectivity into this measurement process.
If quoted market prices are unavailable, management's best estimate of fair value can be used. A number of standardized techniques, which attempt to tie the prices of various financial instruments to those having readily determinable fair values, are widely employed for this purpose. Some bases from which an estimate may be made include
Matrix pricing models
Option pricing models
Financial instruments with similar characteristics adjusted for risks involved
Financial instruments with similar valuation techniques (i.e. present value) adjusted for risks involved
IAS 32 notes that in some instances when the instruments are not traded in active markets (or perhaps when bid-ask prices are widely spread, as with thinly traded or unlisted securities), rather than presenting a single fair value estimate, which might convey a sense of precision that is not warranted under the circumstances, a range of fair values should be displayed. Actually, in a number of earlier proposals and discussions among academics, standards setters, users, and others, the idea of matrix reporting, showing alternative valuations relating to defined conditions, this approach has been proposed, but it has rarely been seen as an attractive option. The opposition generally derives from the fear that offering readers alternative valuations will serve to cause confusion. Furthermore, it could devalue the financial reporting process by alluding to an inability to ascertain a single correct answer. It is the authors' expectation that few preparers will avail themselves of this suggestion and more likely will present a single fair value amount to be associated with each class of financial asset and financial liability, with appropriate caveats expressed, as needed, in the accompanying narrative disclosures.
Note X: Financial Instruments Disclosures of Fair Value
The estimates of fair value of financial instruments are summarized as follows (in thousands):
Instruments for which carrying amounts approximate fair values:
Fair values approximate carrying values because of the short time until realization or liquidation.
Instruments for which fair values exceed carrying amounts:
Estimated fair values are based on available quoted market prices, present value calculations, and option pricing models.
Instruments for which carrying amounts exceed fair values:
Estimated fair values are based on quoted market prices, present value calculations, and the prices of the same or similar instruments after considering risk, current interest rates, and remaining maturities.
Unrecognized financial instruments:
Estimated fair values after considering risk, current interest rates and remaining maturities were based on the following:
Credit commitments— Value of the same or similar instruments after considering credit ratings of counterparties.
Financial guarantees— Cost to settle or terminate obligations with counterparties at reporting date.
Fair value not estimated:
Fair value could not be estimated without incurring excessive costs. Investment is carried at original cost and represents an 8% investment in the common stock of a privately held untraded company that supplies the corporation. Management considers the risk of loss to be negligible.
Prior to the implementation of IAS 39, there were certain circumstances in which an entity might have carried one or several financial assets at amounts that exceeded fair value, notwithstanding the general rule under accounting theory that such declines should be formally recognized in most instances. Normally, failure to recognize such declines would have been justified only when there is no objective evidence of impairment.
IAS 32 requires that when one or more financial assets are reported at amounts that exceed fair value, disclosure should be made of both carrying amount and fair value, either individually or grouped in an appropriate manner, and the reasons for not reducing the carrying value to fair value should be set forth, including the nature of the evidence that provides the basis for management's belief that the carrying value will be recovered. The purpose is to alert the financial statement readers to the risk that carrying amounts might later be reduced if a change in circumstances causes management to reassess the likelihood of recovery.
With the implementation of IAS 39, the issue of reporting investments or other financial assets at amounts in excess of fair value became virtually moot. Essentially, only held-to-maturity investments in debt instruments, and holding of loans and receivables originated by the enterprise, might be presented at amounts in excess of fair value, for instance, when they carry a fixed interest rate that is lower than the prevailing market interest rates for similar instruments and there is no objective evidence of impairment.
IAS 32 encourages financial statement preparers to make other disclosures as warranted to enhance the readers' understanding of the financial statements and hence, of the operations of the enterprise being reported on. It suggests that these further disclosures could include such matters as
The total amount of change in the fair value of financial assets and financial liabilities that has been recognized in income for the period
The average aggregate carrying amount during the year being reported on of recognized financial assets and financial liabilities; the average aggregate principal, stated, notional, or similar amounts of unrecognized financial assets and financial liabilities; and the average aggregate fair value of all financial assets and financial liabilities, all of which information is particularly useful when the amounts on hand at the balance sheet dates are not representative of the levels of activity during the period
IAS 39 establishes four categories of financial assets and liabilities, as follows:
Loans and receivables originated by the entity and not held for trading.
When relevant, the financial statements must disclose, for each of these four categories of instruments, whether regular way purchases of securities are accounted for at trade date or settlement date.
Also to be disclosed are a description of the reporting entity's financial risk management objectives and policies, including its policy for each major type of forecasted transaction (for example, in the case of hedges of risks relating to future sales, that description should indicate the nature of the risks being hedged, approximately how many months or years of future sales have been hedged, and the approximate percentage of sales in those future months or years); whether gain or loss on financial assets and liabilities measured at fair value subsequent to initial recognition, other than those relating to hedges, has been recognized directly in equity, and if so, the cumulative amount recognized as of the balance sheet date; and, when fair value cannot be reliably measured for a group of financial assets or financial liabilities that would otherwise have to be carried at fair value, that fact should be disclosed together with a description of the financial instruments, their carrying amount, and an explanation of why fair value cannot be reliably measured.
For designated fair value hedges, cash flow hedges, and hedges of net investment in a foreign entity, there are to be separate descriptions of the hedges, the financial instruments designated as hedging instruments together with fair values at the balance sheet date, the nature of the risks being hedged, and for forecasted transactions, the periods in which the forecasted transactions are expected to occur, when they are expected to enter into the determination of net profit or loss (e.g., a forecasted acquisition of property may affect earnings over the asset's depreciable lifetime), plus a description of any forecasted transaction for which hedge accounting was previously employed but which is no longer expected to occur.
When there has been a gain or loss on derivative and nonderivative financial assets or liabilities designated as hedging instruments in cash flow hedges which has been recognized directly in equity, disclosure is to be made of the amount so recognized during the current reporting period, the amount removed from equity and included in earnings for the period, and the amount removed from equity and included in the initial measurement of acquisition cost or carrying amount of the asset or liability in a hedged forecasted transaction during the current period.
The financial statements must also disclose the following with regard to financial instruments: the amount of any gains or losses resulting from remeasuring available-for-sale instruments at fair value, included directly in equity in the current period, and the amount removed from equity and reported in current operating results; a description of any held-for-trading or available-for-sale financial assets for which fair value cannot be determined, together with (when possible) the range of possible fair values thereof; the carrying amount and gain or loss on sale of any financial assets whose fair value was not previously determinable; significant items of income, expense, gain and loss resulting from financial assets or liabilities, whether included in earnings or in equity, with separate (gross) reporting of interest income and interest expense, and with separate reporting of realized and unrealized gains and losses resulting from available-for-sale financial assets. It is not necessary to distinguish realized and unrealized gains and losses resulting from held-for-trading financial assets, however.
If there are impaired loans, the amount of interest accrued but not received in cash must be disclosed.
If the entity has participated in securitizations or repurchase agreements, these must be described, and the nature of any collateral and key assumptions made in computing retained or new interests are to be discussed. There must be disclosure of whether the financial assets have been derecognized.
Any reclassifications of financial assets from categories reported at fair value to those reported at amortized historical cost (either because now deemed held-to-maturity, or because fair values are no longer obtainable) are to be explained.
Finally, any impairments or reversals of impairments are to be disclosed, separately for each class (held-to-maturity, etc.) of investment.
The IASB has undertaken a project, Improvements to IAS 39: Recognition and Measurement, which promises to result, in the early part of 2003, in significant changes to both IAS 32 and IAS 39. Many of these changes will simplify application of these standards.
The more important of these changes proposed for IAS 32 are as follows:
Regarding the classification of compound instruments by the issuer, the amendments will eliminate the present options in IAS 32 to measure the liability element of a compound financial instrument initially either as a residual amount, after separating the equity element, or by measuring the elements based on a relative fair value method. Instead, any asset and liability elements are separated first, and the residual is then to be accounted for as the equity element. This will conform the requirements in IAS 32 relating to the separation of liability and equity elements with the definition in IAS 39 of an equity instrument as a residual.
Concerning the classification of derivatives based on an entity's own shares, the amendment will provide guidance as follows:
A derivative that is indexed to the price of an entity's own shares and requires net cash or net share settlement, or that gives the counterparty a choice of net cash or net share settlement, is to be treated as a derivative asset or derivative liability (i.e., not as an equity instrument) and is to be accounted for as such under IAS 39.
A derivative that is indexed to the price of an entity's own shares and gives the entity a right to require net cash or net share settlement instead of gross physical settlement is to be treated as a derivative asset or derivative liability (i.e., not as an equity instrument), unless the entity has an established history of settling such contracts through a gross exchange of a fixed number of the entity's own shares for a fixed amount of cash or other financial assets.
Changes in the fair value of a derivative that is fully indexed to the price of an entity's own shares and that will result in the receipt or delivery of a fixed number of an entity's own shares in exchange for a fixed amount of cash or other financial assets are not recognized in the financial statements, since to do otherwise would be to allow changes in the value of the reporting entity's equity shares to be reflected in its earnings.
When a derivative involves an obligation to pay cash in exchange for receiving an entity's own shares, there is a liability for the share redemption amount. The objective of this proposed amendment is to clarify the requirements affecting the classification of derivatives based on an entity's own shares to promote the consistent application of those requirements.
The changes to IAS 32 affecting disclosures to be made in the financial statements are as follows:
The exemption in IAS 32 from the requirement to disclose fair value of certain financial assets and financial liabilities would be conformed to the exemption in IAS 39 from the requirement to measure at fair value certain unquoted financial assets and financial liabilities.
Disclosure would be required of:
The extent to which fair values are estimated using a valuation technique.
The extent to which valuations using valuation techniques are based on assumptions that are not supported by observable market prices.
The sensitivity of the estimated fair value to changes in those assumptions based on a range of reasonably possible alternative assumptions.
The change in fair values estimated using valuation techniques recognized in profit or loss during the reporting period.
The nature and extent of transfers of financial assets that do not qualify for derecognition.
The risks inherent in any component that continues to be recognized after a transfer of financial assets that does not qualify for derecognition.
The difference between the carrying amount and settlement amount of nonderivative financial liabilities that are carried at fair value.
Any defaults in the payment of principal or interest and breaches of sinking fund or redemption provisions on loans payable, and any other breaches of loan agreements when those breaches can permit the lender to demand repayment.
An issuer of a compound instrument with multiple embedded derivative features (such as an issued callable convertible bond) is required to disclose information about the existence of those features and the effective yield of that instrument.
The existing disclosure requirements in IAS 39 will be moved to IAS 32.
Existing elements from certain SIC Interpretations would be incorporated into IAS 32, as follows:
SIC 5, but no exception would be made to the principle that a financial instrument that an entity could potentially be required to settle by delivering cash or other financial assets, depending on the occurrence or nonoccurence of uncertain future events or on the outcome of uncertain circumstances that are beyond the control of both the issuer and the holder, should be classified as a financial liability.
SIC 16 and SIC 17, in their entireties.
Also, the key elements of proposed SIC 34, addressing the matter of financial instruments or rights that are redeemable by the holder, would be incorporated into IAS 32. This draft interpretation states that
An issued instrument that involves a right for the holder to put the instrument back to the issuer for cash or another financial asset, the amount of which is determined based on an index or other item that has the potential to increase and decrease, is a liability; and
An entity (such as an open-ended mutual fund or unit trust) may present a liability to repay a proportionate share of the net asset value of the entity as "net asset value available to unit holders" on the face of the balance sheet and the change in the value of the liability as "change in net asset value available to unit holders" on the face of the income statement.
Turning now to the changes proposed for IAS 39, the various amendments would affect the following provisions:
A specific scope exclusion would be added for loan commitments that are not designated as held for trading and cannot be settled net. The objective would be to simplify the accounting for entities that grant or hold loan commitments that will result in the origination of a loan asset and, in the absence of a specific scope exclusion, would be accounted for as derivatives under IAS 39.
Financial guarantee contracts are to be initially recognized and measured in accordance with IAS 39. Subsequently, the issuer of such a contract would measure it at the amount the entity would rationally pay to settle the obligation at the balance sheet date or transfer it to a third party, consistent with the provisions of IAS 37. The objective of the proposed amendment would be to ensure that issued financial guarantee contracts that provide for specified payments to be made to reimburse the holder for a loss it incurs because a specified debtor fails to make payment when due are recognized as liabilities.
Contracts to buy or sell nonfinancial items would have to be accounted for as derivatives if the entity has a practice of taking delivery of the underlying and selling it within a short period after delivery for the purpose of generating profit from short-term fluctuations in price or dealer's margin. The objective would be to ensure that derivative-type contracts on nonfinancial items are accounted for as derivatives when they are used for trading purposes. It is not the intent to change the accounting for entities that profit from delivery of goods rather than speculating on price changes.
There would also be changes to the provisions affecting the derecognition of a financial asset, as follows:
The derecognition provisions in IAS 39 would be clarified by establishing as the guiding principle 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. A transferor would be deemed to have a continuing involvement when
It could, or could be required to, reacquire control of the transferred asset (for example, if the financial asset can be called back by the transferor, the transfer does not qualify for derecognition to the extent of the asset that is subject to the call option); or
Compensation based on the performance of the transferred asset will be paid (for example, if the transferor provides a guarantee, derecognition is precluded up to the amount of the guarantee).
No exceptions would be permitted to the general principle. The following existing provisions in IAS 39 accordingly would have to be eliminated:
The notion 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; and
The transferee "right to sell or repledge" condition for derecognition.
Guidance would be provided on pass-through arrangements. When the transferor continues to collect cash flows from the transferred asset, additional conditions would have to be met for a transfer to qualify for derecognition, including
The transferor could have no obligation to pay cash flows to the transferee unless it collects equivalent cash flows from the transferred asset;
The transferor could not use the transferred asset for its benefit; and
The transferor would be obligated to remit on a timely basis to the transferee, any cash flows it collects on behalf of the transferee.
Guidance would also be provided on the accounting for collateral, including
If the transferee has the ability to sell or repledge collateral received, the transferor would have to reclassify the collateral in its balance sheet (for example, as securities pledged);
If the transferee were to sell the collateral received, the transferee would record a liability for the obligation to return the collateral; and
If the transferor were to default and no longer be entitled to the transferred net asset, the transferor would derecognize the asset and the transferee would recognize the asset.
The objective of these proposed amendments is to facilitate the implementation and application of IAS 39 by clarifying the guidance and eliminating internal inconsistencies. The results of applying the proposed amendments are generally consistent with the guidance that already exists in IAS 39 and the guidance that has been provided by the IAS 39 IGC regarding the matter of derecognition. However, under the proposed amendments, the assessment of derecognition is based on the continuing involvement of the transferor with the financial asset being transferred. It would not be necessary to consider risk retained and to use that as the basis for assessing whether derecognition is appropriate.
Concerning the matter of measurement, a number of changes have been proposed.
An entity would be permitted to measure any financial asset or financial liability at fair value, with changes in fair value recognized in profit or loss, by designating it at initial recognition as held for trading. In presenting and disclosing information, an entity could use an appropriate label for such instruments other than trading (such as "financial instruments at fair value [through net income]"). To impose discipline on this approach, an entity would be precluded from reclassifying financial instruments into (or out of) the category during the holding period. The objective would be to simplify the application of IAS 39 (for example, for hybrid instruments and for entities with matched asset/liability positions) and to enable consistent measurement of financial assets and financial liabilities. The proposed designation would be at the entity's option and would not require greater use of fair values than at present under IAS 39.
The option to recognize gains and losses on available-for-sale financial assets in profit or loss would be eliminated (because it is no longer necessary in light of the proposed amendment just noted). Under that proposed amendment, an entity is permitted by designation to measure any financial instrument at fair value with gains and losses reported in net income.
An entity would be permitted to designate an asset that would otherwise be classified as a loan or receivable originated by the entity as an available-for-sale financial asset.
Additional guidance would be provided about how to determine fair values using valuation techniques. The object would be to establish what the transaction price would have been on the measurement date in an arm's-length exchange motivated by normal business considerations. A valuation technique (1) incorporates all factors that market participants would consider in setting a price, and (2) is consistent with accepted economic methodologies for pricing financial instruments. In applying valuation techniques, an entity would use estimates and assumptions that are consistent with available information about the estimates and assumptions market participants would use in setting a price for the financial instrument.
The amendments would also address accounting for the impairment of financial assets with the following directives:
Guidance would be provided about how to evaluate impairment that is inherent in a group of loans, receivables, or held-to-maturity investments, but cannot yet be identified with any individual financial asset in the group as follows:
An asset that is individually identified as impaired should not be included in a group of assts that are collectively assessed for impairment.
An asset that has been individually assessed for impairment and found not to be individually impaired should be included in a collective assessment of impairment. The occurrence of an event or a combination of events should not be a precondition for including an asset in a group of assets that are collectively evaluated for impairment.
Assets should be grouped by similar credit risk characteristics that are indicative of the debtors' ability to pay all amounts due according to the contractual terms.
Contractual cash flows and historical loss experience should provide the basis for estimating expected cash flow. Historical loss rates should be adjusted on the basis of relevant observable data that reflect current economic conditions.
The methodology for measuring impairment should ensure that an impairment loss is not recognized immediately on initial recognition. Therefore, for the purposes of measuring impairment in groups of assets, estimated cash flows (contractual principal and interest payments adjusted for estimated credit losses) should be discounted using an original effective interest rate that equates the present value of the originally estimated cash flows with the initial net carrying amount of those assets.
The objective of the proposed amendment is to ensure that impairment losses that exist in a group of assets are recognized in the financial statements even though they cannot yet be identified with any individual assets.
Guidance would also be provided on what constitutes objective evidence of impairment for investments in equity instruments.
Impairment losses recognized on investments in debt or equity instruments that are classified as available for sale could not be reversed.
Concerning the matter of hedge accounting, the amendments proposed to IAS 39 would do the following:
Hedges of firm commitments would be treated as fair value hedges rather than cash flow hedges.
When a hedged forecast transaction actually occurs and results in an asset or liability, the gain or loss deferred in equity would not adjust the initial carrying amount of the asset or liability (basis adjustment), but remains in equity and is reported in profit or loss in a manner that is consistent with the reporting of gains and losses on the asset or liability.