IAS 39 - Accounting for Financial Instruments

Table of Contents

Executive Summary

1. Scope

2. Financial Instruments - General Definitions and Regulations
2.1. Overview
2.2. Financial Assets
2.3. Financial Liabilities
2.4. Five Categories of Financial Instruments
2.4.1. Financial Assets and Liabilities at Fair Value through Profit or Loss
2.4.2. Held-to-Maturity Investment Assets
2.4.3. Loans and Receivables
2.4.4. Available-for-Sale Financial Assets
2.5. Offsetting of Financial Assets and Liabilities
2.6. Equity Instruments
2.7. Differentiation between Equity and Liabilities
2.7.1. Compound Equity and Liability Instruments
2.8. Derivatives
2.8.1. Overview
2.8.2. Derivatives under IAS 39
2.8.3. Embedded Derivatives

3. Initial Recognition and Measurement
3.1. Initial Recognition
3.1.1. Trade Date versus Settlement Date
3.2. Initial Measurement
3.2.1. Fair Value
3.2.2. Transaction costs

4. Subsequent Measurement
4.1. Fair Value versus Amortized Cost
4.2. Financial assets at Fair Value
4.3. Financial Assets excluded from Fair Valuation
4.3.1. Amortized Cost and Effective Interest Method
4.4. Impairment
4.4.1. Impairment of Financial Assets Carried at Amortized Cost or Cost
4.4.2. Impairment of Available-for-Sale Asset
4.5. Financial Liabilities

5. Derecognition
5.1. Derecognition of Financial Assets
5.1.1. Gains and Losses on Derecognition Date
5.1.2. Recording based on Continuing Involvement
5.2. Derecognition of Financial Liabilities

6. Hedge Accounting
6.1. Overview
6.2. Requirements and Definitions
6.2.1. Hedged Item
6.2.2. Hedging Instruments
6.2.3. Formal Designation and Documentation
6.2.4. Hedge Effectiveness
6.3. Types of Hedges
6.3.1. Fair Value Hedge
6.3.2. Cash Flow Hedge
6.3.3. Net Investment in a Foreign Entity
6.4. Discontinuing Hedge Accounting
6.5. Portfolio Hedging
6.5.1. Current Regulations under Revised IAS 39
6.5.2. Portfolio-Hedge under ED 2003

7. Summary & Conclusion

Appendix

Glossary

Bibliography

Table of Figures:

Figure 2.4-1: Five Categories of Financial Instruments

Figure 2.8-1: Derivative Overview (source Achleitner, p.139)

Figure 2.8-2: Host Contracts with Closely and Not-Closely related Embedded Derivatives

Figure 4.3-1: Subsequent Measurement of Financial Assets

Figure 5.1-1: Decision Tree – Testing for Derecognition A-V

Table of Examples:

Example 2.4-1: Tainting Period of Held-to-Maturity Instruments

Example 2.7-1: Equity vs. Liability

Example 2.7-2: Separation of a Compound Instrument

Example 6.2-1: Equity Portfolio as Hedged Item

Example 6.2-2: Non-Financial Hedged Item

Example 6.2-3: Covered Call Hedge

Example 6.2-4: One Hedging Instrument hedges two different Risk Exposures

Example 6.2-5: Hedging only part of the Hedged Items time to maturity

Example 6.2-6: Hedges with different Underlying Assets

Example 6.2-7: Dollar-Offset Ratio

Example 6.3-1: Fair Value Hedge of Available-for-Sale Securities

Example 6.3-2: Deferred Amortization until the End of a Fair Value Hedge

Example 6.3-3: Cash Flow Hedge with a Swaption

Example 6.3-4: Hedge Net Investment in a Foreign Entity

Example 6.5-1: Banks’ Modern Risk Management

Example 6.5-2: Macro-Hedging under current IAS 39

Executive Summary

Financial markets have developed extremely in volume and complexity in the last 20 years. International investments are booming, due to the general relaxation of capital controls and the increasing demand of international diversification by investors.

Driven by these developments the use and variety of financial instruments has grown enormously. Risk management strategies that are crucial to business success can no longer be executed without the use of derivative instruments.

Accounting standards have not kept pace with the dynamic development of financial markets and instruments. Concerns about proper accounting regulations for financial instruments, especially derivatives, have been sharpened by the publicity surrounding large derivative-instrument losses at several companies. Incidences like the breakdown of the Barings Bank and huge losses by the German Metallgesellschaft have captured the public‘s attention. One of the standard setters’ greatest challenges is to develop principles applicable to the full range of financial instruments and implement structures that will adapt to new products that will continue to develop.

Considering these aspects, the focus of this paper is to illustrate how financial instruments are accounted for under the regulations of the International Accounting Standard (IAS) 39. It refers to the latest version, “Revised IAS 39”, which was issued in December 2003 and has to be applied for the annual reporting period beginning on or after January 1. 2005. First, the general regulations of this standard are demonstrated followed by special hedge accounting regulations. An overall conclusion that points out critical issues of IAS 39 is provided at the end of the paper.

IAS 39 is highly complex and one of the most criticized International Financial Reporting Standards (IFRS). In many cases, the adoption of IAS 39 will lead to significant changes compared to former accounting regulations applied. Therefore the paper is designed to provide a broad understanding of the standard and to facilitate its implementation.

1. Scope

The application of IAS 39 is not limited to certain entities.^[1] It has to be applied by all entities and there are no exceptions as to size, industry or the legal structure of a company.^[2] Thus, the International Accounting Standard Board (IASB) retains its general philosophy that there should be no facilitations for small and medium-sized entities.^[3]

IAS 39 covers all financial instruments except those that are specifically addressed by another standard, such as:^[4]

- interests in subsidiaries, associates, and joint ventures;^[5]
- rights and obligations under leases;^[6]
- employers’ assets and liabilities under employee benefit plans;
- rights and obligations under insurance contracts;^[7]
- equity instruments issued by the reporting entity including options, warrants, and other financial instruments that are classified as shareholders’ equity of the reporting entity;^[8]
- financial guarantee contracts, including letters of credits, that provide for payments to be made if the debtor fails to make payment when due;^[9]
- contracts for contingent consideration in a business combination;
- contracts that require a payment based on climatic, geological, or other physical variables,^[10]
- loan commitments that cannot be settled net in cash or another financial instrument.

Financial guarantee contracts are subject to this Standard if they provide for payments to be made in response to changes in a specified interest rate, security price, commodity price, credit rating, foreign exchange rate, index of prices or rates, or other underlying variables.

In general commodity based contracts are not within the scope of IAS 39. Yet, commodity-based contracts that give either party the right to settle in cash or some other financial instrument or that are readily convertible into cash are treated as financial instrument. Note that the term “readily convertible into cash” covers all marketable assets. Furthermore, if an entity enters into offsetting contracts that effectively accomplish settlement on a net basis or by exchanging financial instruments it has to apply IAS 39. This is also true, if the entity has a practice of shot-term profit taking in these kinds of contracts.^[11] Such transactions are, for instance, taking delivery of a forward contract and simultaneously selling the underlying asset in the spot market in order to profit from price differences in forward and spot prices.

In contrast, a forward contract to buy or sell expected input or output items for productions purposes, is accounted for as an executory contract, even if the contract permits the entity to pay or receive a net settlement in cash.^[12] So-called “regular way contracts” are contracts which part of the general business operations of a company and were entered into for the purpose of receiving or delivering non-financial items in accordance with the entities expected purchase, sale or usage requirements.^[13]

Loan commitments which are designated as financial liabilities at fair value through profit and loss are included in the scope. Additionally, entities that have a past practice of selling the asset which was financed by the loan shortly after origination have to apply IAS 39 to all their loan commitments of this kind.^[14]

2. Financial Instruments - General Definitions and Regulations

2.1. Overview

A financial instrument is widely defined as any contract that result in a financial asset of one entity and a financial liability or equity instrument of another entity.^[15]

The term entity is very broadly defined. It includes all individuals, partnerships, incorporated bodies and government agencies.

In general, such a contract can be enforced by law and it has to have clear economic consequences.^[16] This means that all non-contractual assets or liabilities, such as income taxes, do not meet this definition.^[17] The contract can have any from; it can be a written, verbal or online agreement.^[18]

The term financial instruments include both primary instruments and derivative instruments.^[19] However, physical assets and assets, such as prepaid expenses which will result in the delivery of goods or services are not financial instruments.^[20]

2.2. Financial Assets

A financial asset is any asset that is:^[21]

- cash;
- an equity instrument of another entity;
- a contractual right to receive cash or another financial asset from another entity or; to exchange financial instruments with another entity under conditions that are potentially favourable; or
- a contract that will or may be settled in the entity’s own equity instruments and is either
- a non-derivative for which the entity is or may be obligated to receive a variable number of the entity’s own equity instruments; or
- a derivative that will or may be settled other than by the exchange of a fixed amount of cash or another financial asset for a fixed number of the entity’s own equity instruments.

Common examples are trade accounts receivable; bonds, notes, deposits or loans.^[22]

2.3. Financial Liabilities

A financial liability is defined as any liability that is:^[23]

- a contractual obligation to deliver cash or another financial asset to another entity; or to exchange financial instruments with another entity under conditions that are potentially unfavorable; or
- a contract that will or may be settled in the entity’s own equity instruments and is:
- a non-derivative for which the entity is or may be obliged to deliver a variable number of the entity’s own equity instruments; or
- a derivative that will or may be settled other than by the exchange of a fixed amount of cash of another financial asset for a fixed number of the entity’s own equity instruments.

Common examples for financial liabilities are trade accounts payables, or notes, bonds, and loans payables, since all of them represent contractual obligations to deliver cash in the future.^[24] Therefore, liabilities which can be settled by the delivery of goods or services, advance payments on orders for instance, are not financial liabilities.^[25]

2.4. Five Categories of Financial Instruments

IAS 39 divides financial instruments into five different categories, which are handled differently in terms of measurement methods and the treatment of arising gains and losses.

The categories have to be clearly distinguishable at all times. Even if it is not explicitly required by the standard, it is advisable that entities define them properly, set objectives and comprehensive criteria to ensure a group wide consistent treatment. The criteria should be in line with the organizational structure and other relevant issues of the entity.^[26]

Since the requirements must be applied retrospectively, prior classification of financial instruments, including derivatives on own shares have to be reviewed.^[27]

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Figure 2.4-1: Five Categories of Financial Instruments

2.4.1. Financial Assets and Liabilities at Fair Value through Profit or Loss

This category has two sub-categories. First any financial asset or liability can currently be designated “at fair value through profit or loss” when initially recognized. Second, all financial instruments held-for-trading have to be taken into this category.

A financial asset or liability held for trading is either^[28]

- acquired or incurred principally for the purpose of selling or repurchasing it in the near term; or
- part of a portfolio for which there is evidence of recent short-term profit-taking; or
- a derivative, except it is designated and effective hedging instrument.

IAS 39 does not define the period, considered as near term. Classifying this term has to be decided on the company’s own discretion.^[29] However, a period of hours or days seems more appropriate than month or years. Nevertheless, financial instruments in trading portfolios can be held for much longer than this time.^[30] The defined period will probably vary between different branches and products.^[31] Trading generally reflects active and frequent buying and selling, and financial instruments held-for-trading are usually used with the aim of generating short-term profit from price or dealer’s margin.

Only the fact that a liability is used to fund trading activities does not make it automatically a trading liability, but they can be if all the criteria are met.^[32]

All liabilities that are neither trading liabilities nor designated at fair value through profit and loss form a separate category - “non-trading liabilities”.

The sub-category “at fair value through profit and loss” was not part of the previous standard. It is a further step towards full fair value accounting of financial instruments, which many International Accounting Standard Board (IASB) members favor. There are currently no restrictions on the voluntary designation but it is irrevocable. Thus, the asset or liability cannot be moved to another category during its life.

Yet some important decisions concerning the new category have been made during the Board meeting at the end of February 2004. Based on concerns raised by the European Central Bank, the IASB will probably restrict the use of the fair value option. The Board plans to limit the designation to:

- financial asset or financial liability that contain one or more embedded derivatives;

- financial liabilities whose amount is contractually linked to the performance of assets that are measured at fair value; or

- a financial asset or liability whose exposure to changes in its fair value is substantially offset by the exposure to the change in fair value of another financial asset or financial liability, including a derivative.

These regulations are not adopted yet. The discussion of these issues will be continued in a future meeting. As there will probably be new questions arising from these decisions, a new Exposure Draft is expected. The question of how to ensure the substantially offsetting of fair value changes between financial instruments is likely to lead to new discussions.

2.4.2. Held-to-Maturity Investment Assets

Investments which qualify for this category have to be non-derivative financial assets with fixed or determinable payments and a fixed maturity. In addition, the reporting entity has to have the positive intent and ability to hold them until maturity.^[33] This must be proven at each balance sheet date.^[34]

Therefore, it is not possible to designate an asset into this category if:^[35]

- the entity has the intent to hold the asset for only an undefined period;
- the entity stands ready to sell the asset in response to changes in interest rates or other variables effecting its value; or
- the issuer has a right to settle the asset at an amount significantly below its amortized cost.

The fixed maturity and fixed or determinable payments have to be ensured by a contractual arrangement that defines the amounts and dates of payments to the holder, such as interest and principal payments on debt. Therefore, almost all equity securities cannot be classified as held-to-maturity investments, since they have either an indefinite life (e.g. ordinary shares) or the amount the holder may receive cannot be exactly predetermined (e.g. share options or warrants).^[36]

Callable financial assets may qualify for this category. A call option simply accelerates the asset’s maturity, if exercised.^[37] However, if the holder does not recover substantially all of the investments carrying amount, the criteria are not met. Puttable assets cannot be classified in this category since the additional payment for the put feature is not consisting with the intention to hold the asset until maturity.^[38]

In addition, instruments that have been pledged as collateral or transferred under a repurchase agreement do not frustrate the entity’s intention to hold these instruments until maturity, as long as it expects to maintain access to them.^[39]

If an entity does not have the financial resources to continue to finance the investment until maturity or if it is subject to an existing legal or other constraint then it does not meet the requirements.^[40] Both the intention and ability criteria have to be met without any doubt at all times.^[41]

If an entity has sold, transferred, or reclassified more than an insignificant amount of these investments before maturity, all financial instruments are banned from this category and have to be reclassified. The entity is then prohibited from classifying any financial assets as held-to-maturity until the end of the second financial year following the premature sales. The so-called “tainting rule” has to be considered for the period of the current and the two preceding financial years (see the following example).^[42]

Abbildung in dieser Leseprobe nicht enthalten

Example 2.4-1^[43]: Tainting Period of Held-to-Maturity Instruments

IAS 39 does not define “more than an insignificant amount”, but an appropriate range should be not more than 10 to 15 % of all held-to-maturity assets.^[44] Since the term refers to the current and the two preceding years, sales during that time should be considered on a cumulative basis.^[45]

Exceptions are sales close enough to maturity, so that changes in the market interest rate would not significantly affect the fair value of the investment; or sales made after the entity has already collected substantially the entire original principal. Furthermore, sales which are attributable to an isolated event that is beyond the entity’s control and that could not have been anticipated will not require reclassification (e.g. changes in: the issuer’s creditworthiness, tax laws, or regulatory).^[46]

This restriction limits the management to make future strategic decisions such as restructuring portfolios due to a change in risk management policies.^[47] In a sense, a penalty is imposed for a change in management’s intention.^[48] Consequently, many entities, the Commerzbank AG for instance, have already declared that they will not use the held-for-maturity class at all. Instead they will designate securities that are held until maturity as available-for-sale assets.^[49]

2.4.3. Loans and Receivables

All non-derivative financial assets with fixed or determinable payments that are not quoted in an active market qualify for this category.^[50]

Revised IAS 39 no longer restricts this category to originated loans and receivables and thus includes those loans that were purchased by the entity. This rule eliminates the previous problems of entities that managed purchased and originated loans together but separated them for accounting purposes.

Common examples are trade receivables, loan assets, deposits held in banks, and investments in debt instruments which are not quoted in an active market. Financial assets for which the holder may not recover substantially all of its initial investment, other than because of credit deterioration, are excluded. Furthermore, an interest acquired in a pool of assets (e.g. an interest in a mutual fund) does not meet the definition of this category.

2.4.4. Available-for-Sale Financial Assets

All financial assets that are not designated in one of the above categories are classified as available-for-sale financial assets.^[51] In addition, an entity can designate any asset, other than trading assets, into this category at inception.

It is likely that a substantial portion of the entities’ financial assets will be included in this category. In general, all equity instruments (other than those classified as at fair value through profit and loss) will be categorized as available-for-sale.

2.5. Offsetting of Financial Assets and Liabilities

In general, assets and liabilities have to be presented separately from each other.^[52]

However, IAS 32 requires offsetting, when an entity

- has a legally enforceable right to set off the recognized amounts; and
- intends to settle on a net basis, or to settle the asset and the liability simultaneously.^[53]

This regulation includes two or more separate financial instruments.^[54] The right to offset has to be a legal enforceable right. Only the intention of one or both parties to settle on a net basis does not justify offsetting.^[55] If the entity has a legal right but does not intend to settle net, it has to present the items separately and disclose the effect on the entity’s exposure to credit risk in its notes.^[56]

IAS 32 gives several examples for situations, in which offsetting is inappropriate. Offsetting is not permitted if:^[57]

- several different financial instruments are used to imitate the features of a single instrument (synthetic instrument);
- financial assets and liabilities have the same primary risk exposure, but different counterparties;
- assets are pledged as collateral;
- financial assets are set aside in trust (e.g. sinking fund arrangement); and
- obligations expected to be recovered from a third party under an insurance policy.

Valuation allowances, like allowances for doubtful debts are not considered as offsetting, and are therefore reported on a net basis.^[58]

In cases, where settlement of two financial instruments is done simultaneously through a clearing house or other organized financial markets a single net amount has to be presented.^[59] A netting master agreement, however, does not provide the right to offset unless the general criteria are met.^[60]

Offsetting can have a significant affect on an entities credit and liquidity risk. Especially banks feel that the prohibition of netting is out of line with existing practice and that it does overstate the real risk exposure. Commercial benefits of master netting agreements and similar arrangements are ignored. Moreover, it leads to the presentation of transactions which are not relevant and of economic substance.^[61] The tight restrictions will cause a significant increase in net positions in many entity’s balance sheets under IFRS.^[62]

2.6. Equity Instruments

An equity instrument is any contract that testifies ownership rights on the net assets of an entity, which is the residual interest in the assets of an entity after deducting all of its liabilities.^[63]

Although equity instruments are financial instruments, they are particularly excluded from the scope of IAS 39, if issued by the reporting company. However, the holder of such instruments is requited to apply the standard to those instruments. Examples are non-puttable common shares and warrants or call-options to purchase a fixed number of common shares in the issuing entity. In addition, some types of preferred shares are equity instruments.

2.7. Differentiation between Equity and Liabilities

The critical feature in differentiating equity and liabilities is the existence of a contractual obligation to deliver cash or another financial asset, or to exchange financial instruments under conditions that are potentially unfavorable to the issuer. For instance, although the holder of an equity instrument may be entitled to receive dividends payments, he has no contractual right to receive such payments.^[64]

The classification of an instrument has to be made by assessing its economic substance, rather than its legal from, when it is first recognized. In general, substance and legal from are equivalent. However, a preferred share with a mandatory redemption feature, which forces the issuer to redeem the share on a certain date, is a financial liability rather than an equity instrument. This also applies if the holder has an option to require redemption upon the occurrence of a future event that is likely to occur. Other examples include shares in mutual funds and co-operatives, as they can be redeemed. In addition, puttable instruments which give the holder the right to put them back to the issuer in exchange for cash or other financial assets are classified as liabilities.^[65]

An entity may be able to settle its contractual obligation by delivering its own equity securities. If the number of securities required for payment is a fixed amount the securities are still treated as equity since the entity’s risk exposure does not increase by changes in the fair value of the securities. Conversely, if the number of securities required for payment varies with changes in the fair value of the securities, the obligation should be recognized as a liability (see the following example).^[66]

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Example 2.7-1: Equity vs. Liability

Furthermore, a company may be obliged to purchase its own equity instruments for cash or another financial asset. Such a contract gives rise to a financial liability as well.^[67] Contrary, an entity’s obligation to issue its own equity securities in exchange for financial assets of another party is not potentially unfavorable since it results in an increase in equity and cannot result in a loss. Share options or warrants that require an entity to issue or deliver its own equity instruments are equity instruments since the entity does not have to deliver cash or another financial instrument. Costs incurred by the purchase of an option that gives an entity the right to reacquire a fixed number of its own equity instruments are not considered as financial assets, since it will not receive cash or other financial asset through exercising the option; they have to be deducted directly from equity.^[68]

[...]

^[1] See Förschel, Holland, Kroner, 2001, p. 226

^[2] See Scharpf 2001, p. 4

^[3] See Barckow, Bellavite-Hövermann, 2000, p. 8

^[4] See IAS 39.2

^[5] However, an enterprise applies this Standard in its consolidated financial statements to account for an interest in a subsidiary, associate, or joint venture that (a) is acquired and held for disposal in the near future; or (b) operates under severe long-term restrictions that significantly impair its ability to transfer funds to the enterprise. In these cases, the disclosure requirements in IAS 27, 28, and 31 apply in addition to those in this standard.

^[6] However, lease receivables recognized on a lessor’s balance sheet are subjects to the recognition provisions of IAS 39 and this Standard does apply to derivatives that are embedded in leases.

^[7] As in lease contracts, embedded derivates have to be accounted for in accordance with IAS 39.

^[8] However, the holder of such instruments is requited to apply this Standard to those instruments.

^[9] Issued financial guarantee contracts meet the definition of a liability and should be recognized as such (IAS 39 BC21). An issuer of such a financial guarantee contract shall initially recognize it at fair value, and subsequently at the higher of (i) the amount recognized under IAS 27, and (ii) the amount initially recognized less appropriate amortization (IAS 39.3).

^[10] Weather derivatives are commonly used as insurance policies, payments are based on the amount of loss to the insured entity, and do not involve the transfer of financial risks (IAS 39 AG1) However, the Standard does apply to other types of derivatives that are embedded in such contracts such as embedded interest rate swaps 39.2(d).

^[11] See IAS 39.6

^[12] See GoI A.1

^[13] See IAS 39.5

^[14] See IAS 39.4

^[15] See IAS 32.14

^[16] See IAS 32.13

^[17] See IAS 32 AG12

^[18] See IAS 32.13

^[19] See IAS 32.15

^[20] See IAS 32 AG10 and AG11

^[21] IAS 32.11

^[22] See IAS 32 AG4

^[23] IAS 32.11

^[24] See IAS 32 AG4

^[25] See Barckow and Bellavite-Hövermann, 2000, p. 17

^[26] See Scharpf, 2001 p.21

^[27] See PWC, 2004, A, p. 9

^[28] See IAS 39.9

^[29] See E &Y, 2000, A, p. 10

^[30] See E &Y, 2000, C, p.18

^[31] See Scharpf 2001, p.23

^[32] See IAS 39 AG15

^[33] IAS 39.9

^[34] See IAS 39 AG25

^[35] See IAS 39 AG16

^[36] See IAS 39 AG17

^[37] See IAS 39 AG18

^[38] See IAS 39 AG19

^[39] See GoI B.18

^[40] See IAS 39 AG23

^[41] See Gebhardt, Naumann, 1999, p. 1466

^[42] See IAS 39.9

^[43] See PWC, 2000, p.27

^[44] See Baily, Wild, 2000, p. 411

^[45] See Scharpf, 2001, p.29

^[46] See IAS 39.9

^[47] See Kemmer, Naumann, 2003, p.572

^[48] See Scharpenberg, Brackow, 2001, 65

^[49] See Kemmer, Naumann, 2003, p. 570

^[50] IAS 39.9

^[51] See IAS 39.9

^[52] See IAS 1.33

^[53] IAS 32.42

^[54] See IAS 32.43

^[55] See IAS 32.46

^[56] See IAS 32.47

^[57] IAS 32.49

^[58] See IAS 1.35

^[59] See IAS 32.48

^[60] See IAS 32.50

^[61] See FBE, 2003, B, p.2

^[62] See E&Y, 2004, p.20

^[63] IAS 32.11

^[64] See IAS 32.18

^[65] IAS 32.18

^[66] See IAS 32.21

^[67] See IAS 32.23

^[68] See IAS 32 AG14