Financial Instruments - Part I - For Website 08 EXCELLENT SUMMARY

This Project is funded by EU
for Bank Accounting Professionals
IAS 32/39 Financial Instruments Part 1 Recognition
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Financial instruments under IFRS
PREFACE
These workbooks are an update of those originally written by the project team of the European Union funded project Accounting Reform II in the Russian Federation and revised by the project team of the European Union funded project, Implementation of Accounting Reform in the Russian Federation. This version has been produced by the European Union funded project Transition to IFRS in the Banking Sector. The workbooks cover various concepts of IFRS based accounting. They are intended to be practical self-instruction aids that professional accountants can use to upgrade their knowledge, understanding and skills. The purpose of this version is to help bank accountants in the use of IFRS. Each workbook is a self-standing short course designed for approximately of three hours of study. The members of the project team were contributed by PwC Moscow, FBK Moscow, and European Savings Bank Group Brussels. Although the workbooks are part of a series, each one is independent of the others. A basic knowledge of accounting is assumed but if any additional knowledge is required this is mentioned at the beginning of the section. Each workbook is a combination of Information, Examples, Self-Test Questions and Answers. The volumes within each series are described in detail and available for download from the project web site. The copyright of the material contained in each workbook belongs to the European Union and according to its policy may be used free of charge for any non-commercial purpose. -IFRS News -Accounting Solutions -Financial instruments under IFRS 2006 -Illustrative consolidated financial statements 2006 Banks The project team would like to express thanks to those who have contributed their time and thoughts to the content of the workbooks. In particular: The European Union Delegation, Moscow The Bank of Russia, Moscow
Note: Material from the following PricewaterhouseCoopers publications has been used in this workbook: -Applying IFRS
Contact: e-mail anna.voevoda@ru.pwc.com Tel. + 7 495 772-7091 website www.banks2ifrs.ru Fax. + 7 495 772-7094
Moscow, Russia, June 2008 (Updated)
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CONTENTS
IAS 32 and IAS 39

IAS 32 deals with the presentation of financial instruments (when instruments are presented as liability or equity, and the information is to be shown in the notes). IAS 39 deals with the measurement of financial instruments and with their recognition (when they should be included in financial statements and how they should be valued).
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Aim
Introduction
OVERVIEW
The aim of this workbook is to facilitate an understanding of IAS 32 and IAS 39. IAS 32 deals with the presentation of financial instruments and especially their classification as debt or equity, whilst IAS 39 deals with recognition, derecognition, measurement and hedge accounting. IFRS 7 Financial Instruments: Disclosures is the subject of a separate workbook. These three standards provide comprehensive guidance on the accounting for financial instruments. The need for such guidance is crucial as financial instruments are a large part of the assets and liabilities of many companies, especially financial institutions. The standards require companies to disclose their exposure to financial instruments and to account for their impacts-in most cases as they happen, rather than allowing problems to be hidden. IAS 39 requires most derivatives to be reported at their fair or market value, rather than at cost. This overcomes the problem that the cost of a derivative is often nil or immaterial. If derivatives are measured at cost, they are often not included in the balance sheet at all and their success (or otherwise) in reducing risk is not visible. In contrast, measuring derivatives at fair value ensures that their leveraged nature and their success in reducing risk are reported.
Why do we need standards on financial instruments?

Financial instruments are a large part of the assets and liabilities of many undertakings, especially financial institutions. They also play a key role in the efficient operation of financial markets. Financial instruments, including derivatives, can be useful tools for managing risk, but they can also be very risky themselves. In recent years there have been many disasters associated with derivatives and other financial instruments. The standards require companies to disclose their exposure to financial instruments and to account for their effects-in most cases as they happen, rather than allowing problems to be hidden away.
To which companies do the standards apply?

The standards apply to all companies reporting under IFRS.
To what financial instruments do the standards apply?

The standards apply to all financial instruments except: Those covered by another more specific standards-such a interests in subsidiaries, associates and joint ventures, and post-employment benefits (pensions) Insurance contracts, and certain similar contracts Most loan commitments 3
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The standards also apply to contracts to buy or sell a non-financial item (such as commodity contracts) where these are for dealing purposes.
The treatment of interest, dividends, losses and gains in the income statement follows the classification of the related instrument. Not all instruments are either debt or equity. Some, known as compound instruments, contain elements of both in a single contact. Such instruments, such as bonds that are convertible into equity shares either mandatorily or at the option of the holder, must be split into liability and equity components. Each is then accounted for separately. The liability element is determined first by fair valuing the cash flows excluding any equity component, and the residual is assigned to equity. As well as ordinary debt, liabilities include mandatory redeemable shares, such as units of a mutual fund and some preferred shares, because they contain an obligation to pay cash.
The main requirements of IAS 32 Presentation by the issuer - debt or equity

IAS 32 adopts definitions of liabilities and equity based on the IFRS Framework. It is similar to the frameworks used by many national standardsetters, A financial instrument is a liability if it is a contractual obligation to deliver cash or other financial assets. The finance cost of liabilities is accounted for as an expense. A financial instrument is equity if it evidences a residual interest in the assets of an undertaking after deducting all of its liabilities. Payments of equity are treated as distributions, not as expenses.
Offsetting
Convertible debt (that gives the holder choice of repayment in cash, or in shares) is separated into its debt and equity components. It is analysed into an issue of ordinary debt at a discount, and a credit to equity for the conversion right. All relevant features need to be considered when classifying a financial instrument. For example: If the issuer can or will be forced to redeem the instrument, classification as a liability is appropriate; If the choice of settling a financial instrument in cash or otherwise is contingent on the outcome of circumstances beyond the control of both the issuer and the holder, the instrument is a liability as the issuer does not have an unconditional right to avoid settlement; and An instrument which includes an option for the holder to put the rights inherent in that instrument back to the issuer for cash or another financial instrument is a liability. A financial asset and a financial liability may only be offset and the net amount reported in the balance sheet when an undertaking both: Has a current right to set off the recognised amounts; and Intends either to settle on a net basis, or to realise the asset and settle the liability simultaneously. Situations that generally do not qualify for offsetting include master netting agreements, where there is no intention to settle net, and where assets are set aside to meet a liability but the undertaking remains primarily liable.
The main requirements of IAS 39 Measurement

IAS 39 divides financial assets and financial liabilities into four classes (plus one option treatment) as follows: Trading assets and liabilities, including all derivatives that are not hedges, are measured at fair value through profit and loss -all gains and losses are recognised in profit and loss as they arise. 4
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Loans and receivables are ordinarily accounted for at amortised cost, as are most liabilities. Held-to-maturity investments are also accounted for at amortised cost.
market, interest rate or foreign currency risks. These include the use of futures, swaps and options. The success of a hedging strategy is measured not by the profit produced by the hedge itself, but by the extent to which that profit offsets the results of the item hedged. IAS 39 describes three main kinds of hedging relationship and their accounting treatment: A cash flow hedge is a hedge of the exposure to variability in cash flows,
often in foreign currencies. The hedge matches the cash inflows with cash outflows to minimise foreign exchange exposure.
All other financial assets are classified as available-for-sale and measured at fair value, with all gains and loses taken to equity. On disposal, gains and losses previously taken to equity are recycled to profit or loss.
There is an option to account for any financial asset or liability at fair value through profit and loss. There are special rules for hedge accounting as described in a separate workbook. Another aspect of measurement is impairment - when and how losses should be recognised in profit and loss on those assets that are not accounted for at fair value through profit and loss. Whenever there is objective evidence of impairment as a result of a past event, impairment should be recognised. Among other things, IAS 39 clarifies that: Impairment should only take into account losses that have already been incurred, and not those that might happen in the future Impairment losses on available-for-sale assets are taken from equity and recognised in profit and loss. For equity investments, evidence of impairment may include significant adverse changes in the issuers market position, or a significant or prolonged decline in the fair value of the investment.
A fair value hedge - in which the fair value of the item being hedged, changes as market prices change. Changes in the fair value of both the hedging instrument are initially reported in equity, and transferred to profit and loss to match the offsetting gains and losses on the hedged transaction. A hedge of a net investment in foreign operation should be accounted for in the same way as a cash flow hedge. Hedge accounting allows undertakings to depart selectively from the normal accounting treatment and allows losses to be held back or gains to be accelerated.
The following principles have been adopted in order to provide discipline over the use of hedge accounting: The hedging relationship has to be defined by designation and documentation, reliably measurable, and actually effective To the extent that a hedging relationship is effective, the offsetting gains and losses on the hedging instrument and the hedged item are recognised in profit and loss at the same time All hedge ineffectiveness is recorded immediately in profit and loss Items must meet the definitions of assets and liabilities to be recognised in the balance sheet.
Fair value is the only measurement that can capture the risky nature of derivatives. The information is essential to communicate to investors the nature of the rights and obligations inherent in them. Fair value makes the derivatives visible, so that problems are not hidden away.
Hedge Accounting
Hedging techniques are used by banks and undertakings to reduce existing Hedge accounting for internal hedges is not permitted, as internal transactions are eliminated on consolidation - the undertaking is merely dealing with itself. 5
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However, where internal hedges are used as a route to the market, via an internal treasury centre, IAS 39 clarifies what needs to be done in order to achieve hedge accounting. Part 4 of our workbooks on Financial Instruments covers hedge accounting.
subsidiaries, associates and joint ventures Embedded derivatives Loan commitments held Other loan for trading (Note 3) commitments Financial guarantees (Note Insurance contracts 4) Weather derivatives Note 1 Leases: Lease receivables are included in the scope of IAS 39 for derecognition and impairment purposes only. Finance lease payables are subject to the derecognition provisions. Any derivatives embedded in lease contracts are also within the scope of IAS 39.
Scope
The scope of the standards is very wide-ranging. Anything that meets the definition of a financial instrument is covered unless it falls within one of the specific exemptions.
Within scope of IAS 32 and IAS 39

Debt and equity investments Loans and receivables Own debt
Within scope of IAS 32 only
Out of scope
Investments in subsidiaries, associates and joint ventures Lease receivables (Note 1) Lease payables (Note 1) Tax balances Employee benefits
Note 2 Commodity contracts: Contracts to buy or sell non-financial

items are within the scope of IAS 32 and IAS 39 if they can be settled net in cash, or another financial asset, and they are not own-use commodity contracts. Settling net includes taking delivery of the underlying asset and selling it within a short period to generate a profit from short-term fluctuations in price.
Own equity
Note 3 Loan commitments: Loan commitments are outside the scope of

IAS 39 if they cannot be settled net in cash or by some other financial instrument, unless - they are held for trading or to generate assets of a class which the undertaking has a past practice of selling; or -the undertaking chooses to include them with other derivatives under IAS 39.
Cash and cash equivalents Derivatives e.g.: Interest rate swaps Currency forwards/swaps Purchased/written options Commodity contracts (Note 2) Collars/caps Credit derivatives Cash or net share settleable derivatives on own shares Derivatives on Derivatives on own shares settled only by delivery of a fixed number of shares for a fixed amount of cash Own-use commodity contracts
Note 4 Financial guarantees: A financial guarantee is a contract that

requires the issuer to make specified payments to reimburse the holder for a loss that it incurs because a specified debtor fails to make a payment when due in accordance with the original or modified terms of a debt instrument.
The issuer of such a financial guarantee would account for it initially at fair value under IAS 39, and subsequently at the higher of that amount initially recognised less cumulative amortisation recognised in accordance with IAS 18 or the amount determined in accordance with IAS 37. Guarantees based on an underlying price or index are derivatives within the scope of IAS 39. 6
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Effective interest rate: the rate that exactly discounts future cash payments
Glossary
Amortised cost: the amount at which the financial asset or financial liability
is measured at initial recognition minus principal repayments, plus or minus the cumulative amortisation using the effective interest method of any difference between that initial amount and the maturity amount, and minus any reduction (directly or through the use of an allowance account) for impairment or uncollectability. Available-for-sale financial assets: those financial assets that are designated as available-for-sale or are not classified as (i) loans and receivables, (ii) held-to-maturity investments, or (iii) financial assets at fair value through profit or loss.
or receipts through the expected life of the financial instrument or, when appropriate a shorter period, to the net carrying amount of the financial asset or financial liability. When calculating the effective interest rate, an undertaking shall consider all terms of the instrument (for example, prepayment, call and similar options) but shall not consider future credit losses. The calculation includes all fees paid or received, transaction costs, and all other premiums or discounts. Normally the cash flows and the expected life of a group of similar financial instruments can be estimated reliably. If not, the undertaking shall use the contractual cash flows over the full contractual term of the financial instrument (or group of financial instruments).
Cash flow hedge: a hedge of the exposure to variability in cash flows that:
is attributable to a particular risk associated with an asset or liability or a highly probable forecast transaction and could affect profit.
Embedded derivative: a component of a combined instrument where some

of the cash flows of the combined instrument vary in a way similar to a standalone derivative. An embedded derivative causes some or all of the cash flows that the contract would otherwise require to be modified based on a specified interest rate, security price, commodity price, foreign exchange rate, index of prices or rates, or other variable A derivative that is attached to a financial instrument but is transferable independently of that instrument, or has a different counterparty from that instrument, is not an embedded derivative but a separate financial instrument.
Derecognition: removal of a financial asset or financial liability from the

balance sheet.
Derivative : a financial instrument with all three of the following

characteristics: (i)Its value changes in response to the change in a specified interest rate, security price, commodity price, foreign exchange rate, index of prices or rates, a credit rating or credit index, or other variable (sometimes called the underlying); (ii)It requires no initial net investment or an initial net investment that is smaller than would be required for other types of contracts that would be expected to have a similar response to changes in market factors; and (iii)It is settled at a future date.
Equity: any contract that gives a residual interest in the assets of an

undertaking after deducting all of its liabilities.
Fair value: the amount for which an asset could be exchanged, or a liability
settled between knowledgeable, independent parties. In an active market, for assets it is the market bid price and for liabilities it is the market offer price.
Effective interest method: a method of calculating the amortised cost of a

financial asset or financial liability and of allocating the interest income or interest expense over the relevant period.
Fair value hedge: a hedge of the exposure to changes in fair value of a

recognised asset or liability or an unrecognised firm commitment, or an 7
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identified portion of such an asset, liability or firm commitment, that is attributable to a particular risk and could affect profit.
A financial asset or financial liability is classified as held for trading if it is: (i) acquired or incurred principally for the purpose of selling or repurchasing it in the near term; (ii) part of a portfolio of identified financial instruments that are managed together and for which there is evidence of a recent actual pattern of short-term profit-taking; or (iii) a derivative (except for a derivative that is a financial guarantee contract or a designated and effective hedging instrument).
Financial instrument: any contract that gives rise to a financial asset of one
undertaking and a financial liability or equity instrument of another undertaking.
Financial asset: any asset that is:

(1) Cash; (2) An equity instrument of another undertaking; (3) A contractual right: (i) To receive cash or another financial asset from another undertaking; or (ii)To exchange financial assets or financial liabilities with another undertaking under conditions that are potentially favourable to the undertaking; or (4)A contract that will or may be settled in the undertakings own equity instruments and is: (i)A non-derivative for which the undertaking is or may be obliged to receive a variable number of the undertakings own equity instruments; or (ii)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 undertakings own equity instruments. The undertakings own equity instruments do not include instruments that are themselves contracts for the future receipt or delivery of the undertakings own equity instruments.
(2)Upon initial recognition, it is designated as at fair value through profit or loss. An undertaking may use this designation only when doing so results in more relevant information, because either: (i) it eliminates or significantly reduces a measurement or recognition inconsistency (sometimes referred to as an accounting mismatch) that would otherwise arise from measuring assets or liabilities or recognising the gains and losses on them on different bases; or (ii) a group of financial assets, financial liabilities or both is managed and its performance is evaluated on a fair value basis, in accordance with a documented risk management or investment strategy, and information about the group is provided internally on that basis to the undertakings key management personnel (IAS 24, Related Party Disclosures), for example the undertakings board of directors and chief executive officer. An undertaking may also designate an entire hybrid (combined) contract as a financial asset or financial liability at fair value through profit or loss if the contract contains one or more embedded derivatives, unless: (1) the embedded derivative(s) does not significantly modify the cash flows that otherwise would be required by the contract; or (2) it is clear with little or no analysis when a similar hybrid (combined) instrument is first considered, that separation of the embedded derivative(s) is prohibited, such as a prepayment option embedded in a loan that permits the holder to prepay the loan for approximately its amortised cost. 8
Financial asset or financial liability at fair value through profit or loss: a financial asset or financial liability that meets either of the following
conditions: (1)It is classified as held for trading (see trading financial assets and financial liabilities below)
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Financial liability: any liability that is:

(1)A contractual obligation:
exposes the undertaking to risk of changes in fair value or future cash flows and is designated as being hedged.
Hedging instrument: a designated derivative, or non-derivative financial

(i)To deliver cash or another financial asset to another undertaking; or (ii)To exchange financial assets or financial liabilities with another undertaking under conditions that are potentially unfavourable to the undertaking; or (2)A contract that will or may be settled in the undertakings own equity instruments and is: (i)A non-derivative for which the undertaking is, or may be, obliged to deliver a variable number of the undertakings own equity instruments; or (ii)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 undertakings own equity instruments. For this purpose the undertakings own equity instruments do not include instruments that are themselves contracts for the future receipt or delivery of the undertakings own equity instruments. asset or non-derivative financial liability, whose fair value or cash flows are expected to offset changes in the fair value or cash flows of a designated hedged item. A non-derivative financial asset or non-derivative financial liability may be designated as a hedging instrument for hedge accounting purposes only if it hedges the risk of changes in foreign currency exchange rates.
Held-to-maturity investments: a financial asset with fixed or determinable

payments and fixed maturity that an undertaking has the positive intent and ability to hold to maturity, unless designated as held for trading or available-forsale, or that meet the definition of loans and receivables. Loans and receivables: non-derivative financial assets with fixed or determinable payments that are not quoted in an active market, other than: (i)Those that the undertaking intends to sell in the near term, which shall be classified as held for trading, and those that the undertaking upon initial recognition designates as at fair value through profit or loss; (ii)Those that the undertaking upon initial recognition designates as availablefor-sale; or (iii)Those for which the holder may not recover substantially all of its initial investment (other than because of credit deterioration) which shall be classified as available-for-sale. An interest acquired in a pool of assets that are not loans or receivables (for example, an interest in a mutual fund or a similar fund) is not a loan or receivable.
Financial guarantee:a contract that requires the issuer to make specified

payments to reimburse the holder for a loss it incurs because a specified debtor fails to make payment when due in accordance with the original or modified terms of a debt instrument.
Firm commitment: a binding agreement for the exchange of a specified

quantity of resources at a specified price on a specified future date or dates.
Forecast transaction: an uncommitted but anticipated future transaction. Hedge effectiveness: the degree to which offsetting changes in the fair
value or cash flows of the hedged item are offset by changes in the fair value or cash flows of the hedging instrument.
Net investment in a foreign operation : the amount of the undertaking's

interest in the net assets of that operation.
Hedged item: an asset, liability, firm commitment, highly-probable forecast

future transaction, or net investment in a foreign operation that
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Regular way purchase or sale: a contract for the purchase or sale of a

financial asset that requires delivery of the asset within the time frame established by regulation or convention in the marketplace concerned.
OVERVIEW
Key issues
Tainting: where an undertaking sells or transfers more than an insignificant

amount of its held-to-maturity investments, it must reclassify all of them as available-for-sale. It is then prohibited from classifying any assets as held-tomaturity for the next two full annual financial periods, until confidence in its intentions is restored.
Financial assets and liabilities are initially measured at fair value.

An undertaking may designate a financial instrument irrevo cably on initial recognition as held at fair value through profit or loss, provided certain criteria are met. Loans purchased by the undertaking that would otherwise meet the definition of loans and receivables are classified as such. Failure to comply with the rules for held-to-maturity assets taints the whole category. Transfers into and out of the held for trading category after initial recognition are prohibited. Embedded derivatives should be accounted for separately if their economics are not closely related to those of the host contract.
Trading financial assets and liabilities: a financial asset or financial

liability is classified as held for trading if it is (i) acquired or incurred for the purpose of selling or repurchasing it in the near term; (ii) part of a portfolio of financial instruments that are managed together and for which there is evidence of a recent actual pattern of short-term profit-taking; or (iii) a derivative (except for a derivative that is a designated and effective hedging instrument).
Transaction costs: incremental costs that are directly attributable to the

acquisition or disposal of a financial asset or financial liability. An incremental cost is one that would not have been incurred if the undertaking had not acquired, issued or disposed of the financial instrument. Transaction costs include fees and commissions paid to agents, advisers, brokers and dealers, levies by regulatory agencies and securities exchanges, and transfer taxes and duties. Transaction costs do not include debt premiums or discounts, financing costs or internal administrative or holding costs.
Initial recognition
An undertaking shall recognise a financial asset or a financial liability on its balance sheet when the undertaking becomes a party to the contractual provisions of the instrument. An undertaking records all of its contractual rights and obligations under derivatives in its balance sheet as assets and liabilities, respectively, except for derivatives that prevent a transfer of financial assets from being accounted for as a sale. If a transfer of a financial asset does not qualify for derecognition, the transferee does not record the transferred asset as its asset. This would apply to the lender who receives securities as collateral, including REPO agreements. Examples : recording contractual rights and obligations under derivatives in its balance sheet as assets and liabilities
Work Book 1. - Initial Recognition and Classification Including Debt/Equity Classification
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1. unconditional receivables and payables are recorded as assets or liabilities when the undertaking becomes a party to the contract and, as a consequence, has a legal right to receive or a legal obligation to pay cash. 2. assets to be acquired and liabilities to be incurred as a result of a firm commitment to purchase or sell goods or services are generally not recognised until at least one of the parties has performed under the agreement. For example, an undertaking that receives a firm order does not generally recognise an asset (and the entity that places the order does not recognise a liability) at the time of the commitment but delays recognition until the ordered goods or services have been shipped, delivered or rendered. If a firm commitment to buy or sell non-financial items is within the scope of IAS 39, its net fair value is recognised as an asset or liability on the commitment date. If a previously-unrecognised firm commitment is designated as a hedged item in a fair value hedge, any change in the net fair value attributable to the hedged risk is recognised as an asset or liability after the inception of the hedge. 3. a forward contract that is within the scope of IAS 39 is recognised as an asset or a liability on the commitment date, rather than on the date on which settlement takes place. When an undertaking becomes a party to a forward contract, the fair values of the right and obligation are often equal, so that the net fair value of the forward is zero. If the net fair value of the right and obligation is not zero, the contract is recognised as an asset or liability. 4. option contracts that are within the scope of IAS 39 are recognised as assets or liabilities when the holder or writer becomes a party to the contract. Planned future transactions, no matter how likely, are not assets and liabilities because the entity has not become a party to a contract.
Example: Does possession of an asset indicate control? Issue The recognition of an asset in the balance sheet occurs when it is probable that the future economic benefits will flow to the entity and the asset has a cost or value that can be measured reliably. The entity must have control over the assets future economic benefits. Control of an asset is defined as the power to obtain the future economic benefits that flow from it. Does possession of an asset automatically indicate control? Background Entity A enters into a legal arrangement to act as trustee for entity B by holding listed shares on Bs behalf. B makes all investment decisions and A will act according to Bs instructions. A will earn a trustee fee for holding the shares. Any dividends or profit/(loss) from the investments belong to B. Solution A should not recognise the listed shares as its asset even though it is in possession of the shares. A does not control the investments future economic benefits. Benefits from the investments flow to B, and A earns a trustee fee for holding the shares regardless of how the shares perform. The listed shares therefore do not meet the criteria of an asset in As balance sheet. Banks commonly act as trustees and in other fiduciary capacities that result in the holding or placing of assets on behalf of individuals, trusts, retirement benefit plans and other institutions. Provided the trustee or similar relationship is legally supported, these assets are not the banks and, therefore, are not included in its balance sheet. The same principle applies to all other entities.
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Example: REPOs - Recognition of inventory sold to a bank with an agreement to repurchase similar inventory Issue A sale and repurchase agreement is in substance a financing arrangement and does not give rise to revenue when the seller has retained the risks and rewards of ownership, even though legal title has been transferred [IAS18]. Should an entity recognise revenue on the sale of goods when repurchase rights exist? Background The management of entity A is considering the following two alternative transactions: a) sale of inventory to a bank for 500,000 with an obligation to repurchase the inventory at a later stage; or b) sale of inventory to a bank for 500,000 with an option to repurchase the inventory any time up to 12 months from the date of sale. The repurchase price in both alternatives is 500,000 plus an imputed financing cost. The bank is required to provide substantially the same quality and quantity of inventory as was sold to it (that is, the bank is not required to return precisely the same physical inventory as was originally sold to it). The fair value of the inventory sold to the bank is 1,000,000. Solution Management should recognise the transactions as follows: a) Sale with repurchase obligation: management should not recognise revenue on the transfer of the inventory to the bank. The inventory should remain on entity As balance sheet and the proceeds from the bank should be recognised as a collateralised borrowing. Even though the inventory repurchased from the bank is not the inventory sold, it is in substance the same asset. The substance of the transaction is that the sale and repurchase are linked transactions, and entity A does not
transfer the risks and rewards associated with the inventory to the bank. b) Sale with repurchase option: management should not recognise revenue unless and until the option is allowed to lapse. The inventory should remain on entity As balance sheet and the proceeds recognised as a collateralised borrowing until As right to repurchase the inventory lapses. Although the entity does not have title to the inventory during the period between sale and repurchase, the substance of the transaction as a whole is still that of a financing rather than a sale of the inventory.
Example: Sale subject to share of future benefits - a financing arrangement Issue An entity should recognise revenue when [IAS18]: a) it has transferred significant risks and rewards of ownership of the goods to the buyer; b) it does not retain continuing managerial involvement or control over the goods sold; c) the amount of revenue can be measured reliably; d) it is probable that the economic benefits associated with the transaction will flow to the entity; and e) the costs incurred or to be incurred in respect of the transaction can be measured reliably. What are the circumstances under which an entity retains a continuing involvement in an asset? Background Entity A owns a hotel resort located in the Bahamas. The resort includes a casino that is housed in a separate building that is part of the premises of the entire hotel resort. The casinos patrons are largely tourists and non-resident visitors. Entity A operates the hotel and other facilities on the hotel resort, including the casino. During the year, the casino was sold to entity B. 12
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A and B agree that A will operate the casino for its remaining useful life. Entity A will receive 85% of the net profit of the casino as operator fees, and the remaining 15% will be paid to entity B. A has also provided a guarantee to B that the casino will have net profits of at least 10 million. Solution Entity A should not recognise the arrangement as a sale of the casino, as it continues to enjoy substantially all of its risks and rewards and has a continuing involvement in its management. The transaction is in substance a financing arrangement and the proceeds should be recognised as a borrowing. Under IAS 39 an undertaking is required to record a financial asset or liability on its balance sheet only when it becomes a party to the contractual provisions of the instrument. Initial measurement: financial assets and liabilities are initially measured at fair value (discussed in the measurement chapter). Usually this will be the same as the fair value of the consideration given (in the case of an asset) or received (in the case of a liability). However, if this is not the case, any difference is accounted for in accordance with the substance of the transaction. For example, if the instrument is valued by reference to a more favourable market than the one in which the transaction took place, an initial profit is recognised. Alternatively, a loan given to a related party at below-market rates will need to be remeasured at fair value by discounting it at the market rate. Example: Loans with a below-market rate of interest Issue The fair value of a financial instrument on initial recognition is normally the transaction price (that is, the fair value of the consideration given or received). However, if part of the consideration given or received is for something other than the financial instrument, the fair value of the financial instrument is
estimated, using a valuation technique [IAS39]. How should management account for a low-interest loan given to an essential supplier? Background Entity A manufactures rocket engines. A third party, entity B, produces one of the components used in the engines. The component manufactured by B is relatively small compared with the rocket engines, but is critical to As operations. Entity B owns the patents over the technology used in its components. B has been struggling to expand its production facilities to keep pace with As demand for its components. Consequently, on 1 January 20X1, A lends 10,000 to B to finance the expansion required. The loan is for a period of 5 years, and A classifies the asset as an originated loan. The loan carries interest at a rate of 5% (payable annually), whereas the interest rate that B would be able to obtain on similar loans from the market is 10%. Thus, the loans fair value, calculated as a net present value of interest payments and principal repayments, discounted at 10%, is 8,105. Solution As management should initially recognise the loan at its fair value of 8,105. The loan receivable bears interest at an effective rate of 10%, and should be amortised to its face value by the end of year 5. The table below provides information about the amortised cost, interest income and cash flows in each reporting period. Year (a) Amortised cost at the beginning of the year (b = a x 10%) Interest income (c) (d = a + b c)
Cash Amortised flows cost at the end of the year 13
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20x1 20x2 20x3 20x4 20x5
8,105.0 8,415.5 8,757.0 9,132.7 9,546.0
810.5 841.5 875.7 913.3 954.6
500 500 500 500 10,000 + 500
8,415.5 8,757.0 9,132.7 9,546.0 10,000.0
Entity A should account for the loan in accordance with the guidance in IAS 39, even though it is considered part of the net investment in the associate. The loan should be initially recognised at fair value in accordance with IAS 39. A loan that is repayable on demand cannot have a fair value that is less than the amount repayable (IAS 39.49). Consequently the loan should be recognised at the amount leant to entity B. Subsequent measurement of the loan should be at amortised cost, however, the loan will continue to be carried at cost under IAS 39.This is because there is no effective interest rate and so no amortisation to record under the amortised cost method. The loan may be classified on the balance sheet either as part of other receivables or as part of the investment in associates. The notes to the financial statements should provide an adequate description of the loan balance so that its nature is clear to a reader of the financial statements. Transaction costs: These are included in the initial carrying value of financial assets and liabilities, unless they are carried at fair value through profit or loss when the transaction costs are recognised in the income statement. Transaction costs include fees and commissions paid to agents (including staff acting as selling agents), advisers, brokers and dealers, levies by regulatory agencies and securities exchanges, and transfer taxes and duties. Transaction costs do not include debt premiums or discounts, financing costs or internal administrative or holding costs. Financial guarantee contracts How does the holder of a financial guarantee account for any costs relating to it, and how does a financial guarantee impact impairment calculation? IAS 39 only applies to the issuer of financial guarantee contracts. The accounting by the holder of such a contract is therefore outside the standards scope. The holders accounting treatment depends on whether the guarantee is 14
In the following examples, I/B refers to Income Statement and Balance Sheet. Example: more favourable market You buy a financial instrument for $20.000. The value in a more favourable market is $21.000. You recognise the profit of $1.000.
I/B
Financial instrument Cash Purchase of Financial instrument Financial instrument Gain on Financial instrument Recognition of profit B B B I
DR
20.000
CR
20.000
1.000 1.000
Example: Accounting for long-term loan to associate Entity A has an associate, entity B. Entity A has made a loan to entity B. The loan is non-interest bearing and repayable on demand but entity A does not plan or expect to require settlement of the loan for the foreseeable future. The loan is not collateralised. Entity A views the loan to the associate as part of its net investment in the associate in accordance with IAS 28.29. How should entity A account for and classify the loan to entity B?
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purchased at origination of a debt instrument or to guarantee pre-existing debt instruments. In the first case, the purchaser of the financial guarantee contract treats the cost of the guarantee as a transaction cost under IAS 39. Thus the cost is amortised using the effective interest rate method, unless the debt instrument is measured at fair value through profit and loss. In the second case, the cost is recognised as a prepayment asset and amortised over the shorter of the life of the guarantee and the expected life of the guaranteed debt instruments. The asset is tested for impairment under IAS 36, Impairment of Assets. Lenders classify the amortisation and impairment charges as a reduction of interest income. When estimating the expected future cash flows of a loan, an entity reflects the cash flows from any collateral. Collateral includes financial guarantees that are entered into as part of the contractual terms of the loan. A guarantee of an individual loan entered into at the same time as the loan contract effectively forms part of the contractual terms of the loan. Therefore, the impairment charge is shown net of any financial guarantee reimbursement. In the situation where a guarantee of a portfolio of loans has been entered into separately from the loans, the guarantee is separate from the loan and the reimbursement does not constitute cash from the loan. Therefore, the reimbursement is treated as a separate asset in accordance with IAS 37, Provisions, Contingent Liabilities and Contingent Assets,and not netted against the impairment charge. Accounting for financial guarantees IAS 39 or IFRS 4? IFRS News November 2005 All guarantee contracts are accounted for under IAS 39 unless the issuer has previously asserted explicitly (eg, in its financial statements or submissions to
regulators) that it regards the contracts in question as insurance contracts and has applied the accounting treatment specifically applicable to insurance contracts. The issuer has a choice of applying IFRS 4 or IAS 39 for guarantee contracts that meet these two tests. The accounting for financial guarantees will reflect the entitys business model. In particular, credit insurers will retain most aspects of their existing accounting, and non-insurers are not required to apply the requirements and disclosures of an insurance standard. The accounting treatment of a financial guarantee contract by the holder remains outside the scope of IAS 39 and IFRS 4. Definition of a financial guarantee contract The following definition of a financial guarantee contact, which is currently included in IFRS 4, has been added to IAS 39: A contract that requires the issuer to make specified payments to reimburse the holder for a loss it incurs because a specified debtor fails to make payment when due in accordance with the original or modified terms of a debt instrument. Financial guarantee contracts comprise three parties: the issuer of the financial guarantee, the holder of the financial guarantee, and a specified debtor. Instruments with various legal forms will meet this definition, including credit guarantees, some types of letters of credit, credit default contracts and credit insurance contracts. Not all types of guarantee contract will meet this definition. The key question is whether the contract requires payments even if the holder has not incurred a loss on the failure of the debtor to make payments when due. A contract that requires payments in response to changes in a specified credit rating, for example, is a derivative contract that must be recognised and measured at fair value under IAS 39. 15
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Accounting treatment The accounting treatment and disclosure requirements differ depending on whether IAS 39 or IFRS 4 is applied. An issuer could apply the fair value option to those financial guarantee contracts to which IAS 39 is applied, provided the IAS 39 conditions are met. Intra-group guarantees The amendment does not provide an exemption for intra-group financial guarantees; for example, a guarantee issued by a parent to one if its subsidiaries. The accounting treatment described above is applicable for the issuers standalone financial statements. Practical difficulties may arise in measuring the fair value of such intragroup financial guarantees. It is common either for no fee to be charged, or for the fee not to be on arms length terms and hence not to reflect the fair value of the financial guarantee. The issuer is required to determine the fee that would be charged for the guarantee in an arms length, market transaction. When a parent company gives a financial guarantee for less than its fair value (including where it charges no fee), the difference between the amount charged and fair value is a capital contribution. This treatment of intra-group guarantees under IFRS is different from US GAAP, which excludes intra-group guarantees from the scope of FIN 45. Accounting treatment for the holder of a financial guarantee The accounting treatment for the holder of a financial guarantee contract is outside the scope of IAS 39 and IFRS 4. The holder of a financial guarantee has two elements to account for: the premium paid and payments received under the contract. The premium paid is recognised as an asset in the balance sheet and amortised over the life of the guarantee contract. Payments (and potential payments) that become due because the specified debtor fails to make payment when due are taken into account when determining the amount of any impairment of the holders receivable from the debtor.
* IAS 37 is based on the best estimate of the expenditure required to settle the
present obligation. Discounting is required. ** Discounting is not mandatory under IFRS 4.
Classification Debt versus Equity
IAS 32 establishes principles for distinguishing between liabilities and equity. The economic substance of a financial instrument, rather than its legal form, governs its classification. An instrument is a liability when the issuer is, or can be required, to deliver either cash or another financial asset to the holder. This distinguishes a liability from equity. An instrument is classified as equity when it represents a residual interest in the net assets of the issuer. All relevant features need to be considered when classifying a financial instrument. For example:
If the issuer can, or will be forced to, redeem the instrument, it is a liability. If the choice of settling a financial instrument in cash (or otherwise) is
contingent on the outcome of circumstances beyond the control of both the 16
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issuer and the holder, the instrument is a liability as the issuer does not have an unconditional right to avoid settlement.
An instrument which has an option for the holder to sell the rights in that
non-cumulative, are at the discretion of the issuer, the shares are equity instruments. The classification of a preference share as an equity instrument or a financial liability is not affected by, for example: i. a history of making distributions; ii. an intention to make distributions in the future; iii. a possible negative impact on the price of ordinary shares of the issuer if distributions are not made (because of restrictions on paying dividends on the ordinary shares if dividends are not paid on the preference shares); iv. the amount of the issuers reserves; v. an issuers expectation of a profit or loss for a period; or vi. an ability or inability of the issuer to influence the amount of its profit or loss for the period. Not all instruments are either only debt or only equity.
instrument back to the issuer for cash (or another financial instrument) is a liability. The treatment of interest, dividends, losses and gains in the income statement follows the classification of the related instrument.
Preference shares Equity or Liability?

Traditionally, preference shares have been considered to be equity, as they reward the holders with dividends, and have been shown within the capital structure of companies. IFRS determines whether or not preference (or preferred) shares are equity or liabilities by assessing the particular rights attaching to the share. For example, a preference share that provides for redemption on a specific date or at the option of the holder contains a financial liability, as the issuer has an obligation to pay cash to the holder of the share. The potential inability of an issuer to satisfy an obligation to redeem a preference share when contractually required to do so, whether because of a lack of funds, a statutory restriction or insufficient profits or reserves, does not negate the obligation or classification. An option of the issuer to redeem the shares for cash does not satisfy the definition of a financial liability because the issuer does not have a present obligation to transfer financial assets to the shareholders. Redemption of the shares is solely at the discretion of the issuer. An obligation to pay cash (and therefore a liability) may arise, however, when the issuer exercises its option, usually by formally notifying the shareholders of an intention to redeem the shares. When preference shares are non-redeemable, classification is based on an assessment of the substance of the contractual arrangements. When distributions to holders of the preference shares, whether cumulative or
Compound instruments
Compound instruments contain elements of both in a single contact. Instruments, such as bonds that are convertible into equity shares, either mandatorily or at the option of the holder, must be split into liability and equity components. Each is then accounted for separately. The liability element is determined first by fair valuing the cash flows excluding any equity component, and the residual is assigned to equity.
Examples - non-cumulative preference share 1. A non-cumulative preference share is mandatorily redeemable for cash in ten years, but that dividends are payable at the discretion of the entity before the redemption date. Such an instrument is a compound financial instrument, with the liability component being the present value of the redemption amount. 17
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The unwinding of the discount on this liability component is recognised in profit or loss and classified as interest expense. Any dividends paid relate to the equity component and are recognised as a distribution of profit or loss. Similarly, bonds with warrants attached must be split into liability and equity components. Application of the fixed for fixed principle A contract to exchange a financial asset for an entitys own equity instruments is classified as equity only if both the amount of financial assets and the number of equity instruments are fixed. If either the amount of financial assets or the number of equity instruments is not fixed, a financial liability exists. This raises the question of what fixed means. For example, if the amount is fixed but in a currency other than the functional currency of the issuing entity, then the amount is not fixed for the purpose of classifying the financial instrument. (See also Annex 1 IAS 32 - Frequently Asked Questions)
The Decision Tree below illustrates whether an instrument is a financial liability or equity instrument:
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Debt vs Equity Decision Tree

Is settlement in cash either: -mandatory -at the option of the holder
Yes
No Yes
In substance, does the issuing undertaking have full discretion to avoid cash settlement?
No No
Is settlement in a variable number of the issuing undertakings equity securities? Does the settlement depend on the outcome of uncertain future events or circumstances beyond the issuing undertakings control?
No
Yes
Is the holder exposed to the risk of fluctuations in (a)price or (b)(b)residual price or (b) residual interest in the issuing undertaking's own equity securities?
Yes No
Yes
EQUITY www.banks2ifrs.ru
Yes
Is the possibility that the issuing undertaking will be required to settle in cash/other financial asset remote?
No
LIABILITY
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The table illustrates whether an instrument is a financial liability or equity instrument.
Debt versus equity: update on IFRIC position - IFRS News May 2006 The classification of financial instruments as debt or equity instruments can be complex.
Instrument
Cash obligation for principal

No Yes
Cash obligation for coupon/ dividends

No Yes
Settleme nt in fixed number of shares

n/a Yes
Classification
The classifications resulting from IAS 32 can also be counter-intuitive and differ from those under tax laws or other regulatory frameworks. It is therefore not surprising that IFRIC has received a number of requests for interpretations of debt versus equity classification.
Ordinary shares Redeemable preference shares with 5% fixed dividend each year subject to availability of distributable profits Redeemable preference shares with discretionary dividends Convertible bond which converts into fixed number of shares Convertible bond which converts into shares to the value of the liability
Equity Liability
IFRIC rejected a request in March 2006 for an interpretation on the classification of two common structures step-up instruments and linked instruments on the grounds that IAS 32 is clear.
This text looks at the IAS 32 principles that are relevant to these instruments and IFRICs decisions on them. It only considers instruments that are settled in cash and does not cover instruments that may or will be settled in the issuers own equity. Debt / equity classification principles in IAS 32 A key feature of a financial liability under IAS 32 is a contractual obligation to deliver cash or another financial asset, or to exchange financial assets or liabilities under conditions that are potentially unfavourable.
Yes
No
No
Liability for principal and equity for dividends
Yes
Yes
Yes
Liability for bond and equity for conversion option Liability
Yes
Yes
No
An instrument that contains no such contractual obligation is classified as equity. This will be the case when the entity has discretion over whether to make any cash payments.
A significant issue is therefore what is meant by discretion?
IAS 32 is clear that whether discretion exists is not affected by the entitys
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intention or ability to make distributions in the future, the amount of the issuer's reserves, any economic compulsion to make distribution or the ranking of the instrument on the liquidation of the entity. IAS 32 also requires an instrument to be classified in accordance with its substance rather than its legal form; for example, a share can be classified as a liability under IAS 32 if it obliges the entity to make payments. A note or bond can be classified as equity if it contains no such obligation. However, anything outside the contractual terms is not considered when classifying an instrument under IAS 32. It is only the substance of the contractual terms of a financial instrument and whether these give rise to a contractual obligation that should be taken into consideration. Applying principles to step-up instruments and linked instruments Example: Step-up instruments Example In 2X06, an entity issues perpetual callable preference shares with a 5% dividend whose payment is mandatory if dividends are paid on ordinary shares. Dividends on ordinary shares are payable at the discretion of the issuer. The instrument includes a step-up dividend clause that increases the dividend to a pre-determined rate in 2X10 (for example, to 10% which is expected to be significantly above market rates), and a call option for the issuer to redeem the instrument in 2X10. The entity is expected to call the instrument in 2X10 so as to avoid the above market payments (this is commonly referred to as economic compulsion). IFRIC conclusion The instrument should be classified as equity under IAS 32. An economic incentive to make distributions or redeem an instrument is not a contractual obligation. The entity could choose not to redeem the instrument and to pay no distributions on it in perpetuity. Whilst a consequence of this would be that the
entity could not pay an ordinary dividend, this does not amount to a contractual obligation. Example: Linked instruments Example An entity issues perpetual callable preference shares (the base instrument) that must pay dividends if interest is paid on another instrument (the linked instrument) issued by the entity. The linked instrument is a liability, as its terms oblige the entity to make interest payments. IFRIC conclusion The base instrument is a liability, as the linkage to the linked instrument creates a contractual obligation for the entity to pay dividends on the base instrument. The linked instrument (sometimes called a baby preference share) frequently has a small face amount compared to the base instrument. IFRIC stated that the insignificant value does not impact the liability classification. It does not eliminate the fact that the issuer has no discretion over the payment of the dividend on the base instrument (ie, the linking has created a contractual obligation in this fact pattern). Comment The addition of a linked instrument is one of the most commonly used practices to achieve liability classification for a base instrument that would otherwise be classified as equity. Management may wish to obtain liability classification when it has hedged some of the future payments on the base instrument, as hedge accounting cannot be used if the hedged base instrument is classified as equity. Conclusion The IFRIC decisions outlined above show that it is critical to understand all the features, terms and conditions of an instrument in order to ensure its appropriate classification as debt or equity. An economic incentive to make payments no matter how great does not amount to a contractual obligation and is therefore not sufficient for liability classification. 21
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DERIVATIVES ON OWN SHARES (INCLUDING SHARE OPTIONS)

Derivative contracts that result in the delivery of a fixed amount of cash or other financial assets for a fixed number of an undertakings own equity instruments are classified as equity instruments. All other derivatives on own equity are treated as derivatives and accounted for as such under IAS 39. This includes any that: can, or must, be settled on a net basis in cash (or other financial assets) or in shares; may be settled gross by delivery of a variable number of own shares; or may be settled by delivery of a fixed number of own shares for a variable amount of cash (or other financial assets). Any derivative on own equity, which gives either party a choice over how it is settled (in cash or otherwise), is a financial asset or liability unless all of the settlement alternatives would result in equity classification. The table below illustrates this.
amount of cash that will be received (or delivered) is based on changes in the market price of the undertakings own equity A contract that will be settled in a variable number of own shares, determined so as to equal a fixed value or a value based on changes in an underlying variable (e.g., a commodity price) A contract containing multiple settlement alternatives (e.g., net in cash, net in own shares, or by exchanging own shares for cash or other financial assets) Derivative asset or liability Forward contract on the price of gold that is settled in own shares
Derivative asset or liability
Instrument
A contract that is settled by the issuer delivering a fixed number of the issuers own shares in exchange for a fixed monetary amount of cash or other assets A contract that requires an undertaking to repurchase (redeem) its own shares for cash or other financial assets at a fixed (or determinable) date, or on demand An obligation to redeem own shares for cash that is conditional on the counterparty exercising a right to redeem A contract that will be settled in cash or other assets where the
Classification
Equity
Example
A warrant giving the counterparty a right to subscribe for a fixed number of the undertakings shares for a fixed amount of cash Forward contract to repurchase own shares for cash
Derivative asset or liability Share option that the issuer can decide to settle either in cash or by delivering own shares for cash
Examples: Classification of financial instruments debt versus equity a) A company issues 300m of dated preference shares. The company can defer coupon payments on the preference shares. Would this instrument be classified as a financial liability or an equity instrument under IAS 32? The instrument has both financial liability and equity components. IAS 32 states that an instrument is a financial liability when the issuer has a contractual obligation to deliver cash or another financial asset to another entity. There is an obligation for the company to repay the principal in cash given the fact that the preference shares are dated and, as such, this component is a financial liability. However, with respect to coupon payments, this component is equity as the issuer has no contractual obligation to deliver cash to the holder of the instrument given that it has discretion to defer coupon payments. Therefore, 22
Liability (redemption amount)
Liability (redemption amount)
Written option to repurchase own shares for cash
Derivative asset or liability
Net cash settled share option
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the instrument is a compound financial instrument. In accordance with IAS 32, the initial carrying amount of a compound financial instrument is allocated between its equity and liability components. The equity component is assigned the residual amount after deducting from the fair value of the instrument as a whole, the amount separately determined for the liability component. b) A company issues 250m of 6.625% perpetual capital step-up securities. Interest is payable on this instrument on 1 June each year. The company can defer interest payments. These deferred payments will accumulate as deferred interest. and be payable only upon redemption of the instrument. In 2007, the interest rate will be reset to 7.25%.At the reset date the instrument can be redeemed at the option of the issuer. Would this instrument be classified as debt or equity under IAS 32? This instrument would be classified as an equity instrument. IAS 32 states that if an entity does not have an unconditional right to avoid delivering cash or another financial asset to settle a contractual obligation, the obligation meets the definition of a financial liability. In this case, the company is able to avoid redemption as this event is wholly under the companys control. As such, the principal is not a financial liability. Similarly, with respect to the interest payments, these are payable only on redemption. As a result, the company has the ability to avoid payment of interest by not redeeming the instrument. c) A company issues 100m of irredeemable bonds at a market rate of interest (instrument 1). Coupon payments are payable on 1 June each year, however the company can defer these coupon payments. The deferred coupon payments will accumulate as deferred interest. and are payable in the event that the company makes a coupon payment on any other pari passu or subordinated bonds in issue. The company has in issue a 50m pari passu 5.5% bond (instrument 2) on
which the coupon payments are mandatory on 1 June each year. Would instrument 1 be classified as a financial liability or an equity instrument under IAS 32? Instrument 1 is a financial liability. The terms establish an indirect obligation to pay the coupon on instrument 1 if, and when, a coupon is paid on any other pari passu or subordinated bonds. As the company has such a bond in issue (instrument 2) and there is a contractual obligation to pay the coupon on instrument 2 each year, this creates an indirect contractual obligation for the company to also pay the coupon on instrument 1 each year. As a result, instrument 1 is a financial liability. A contract that contains an obligation for an entity to purchase its own equity instruments for cash or another financial asset gives rise to a financial liability for the present value of the redemption amount (for example, for the present value of the forward repurchase price, option exercise price or other redemption amount). This is the case even if the contract itself is an equity instrument. One example is an entitys obligation under a forward contract to purchase its own equity instruments for cash. When the financial liability is recognised initially under IAS 39, its fair value (the present value of the redemption amount) is reclassified from equity. Subsequently, the financial liability is measured in accordance with IAS 39. If the contract expires without delivery, the carrying amount of the financial liability is reclassified to equity. An entitys contractual obligation to purchase its own equity instruments gives rise to a financial liability for the present value of the redemption amount even if the obligation to purchase is conditional on the counterparty exercising a right to redeem (eg a written put option that gives the counterparty the right to sell an entitys own equity instruments to the entity for a fixed price).
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Questions On Debt/Equity Classification
shareholder will also participate in the dividends paid to the series A shareholders. The series B shareholder is entitled to the residual value of the property division in the event of a liquidation of Tomsk. Should management classify series B shares (a special class of shares) as i) financial liabilities or ii) equity instruments? Answer The series B shares should be classified as equity instruments. The management of Tomsk has an obligation to distribute the property divisions profits to the B shareholders. The distribution occurs only as a result of the declaration of a dividend by Tomsks management. The obligation to make a distribution to the B shareholder is therefore at the discretion of Tomsks management, and can be avoided if it chooses not to declare a dividend. Question 4 Orel has issued perpetual preference shares that give the holder the right to receive annual dividends at a rate of 8%. The holder has no right to a return of the principal. What is the appropriate classification for perpetual preference shares? Answer The shares should be classified as financial liabilities. IAS 32 confirms that perpetual preference shares are financial liabilities. Perpetual instruments normally provide the issuer with a contractual obligation to make fixed dividend payments extending into the indefinite future. The payments are similar to interest payments, and give the holder a lenders rate of return.
Question 1 Alfa has issued a perpetual preference share, which is redeemable at the option of the undertaking but not at the option of the holders. Dividends of 10% must be paid annually, provided that there are sufficient distributable profits. Should the issue proceeds be classified as debt or equity in the accounts of the issuer? Answer Settlement is not mandatory and is at the option of the issuer The undertaking has no discretion to avoid interest payments The settlement does not depend on the outcome of uncertain future events beyond the issuing undertakings control. The dividend payments of 10% include an element of capital repayment and which will always be cash. Therefore the instrument is a liability. Question 2 Beta has issued cumulative, non-redeemable 5% fixed preference shares where the payment of the dividend is solely at the discretion of the board of directors. How should Beta classify the instrument? Answer As equity. When preferred shares are non-redeemable, and when distributions to holders of the preferred shares whether cumulative or non-cumulative are at the discretion of the issuer, the shares are equity. Question 3 Tomsk issued series A and series B shares. Series A shares are considered ordinary shares and issued to all shareholders while series B shares are issued to only one shareholder. Series B shares have the same voting and dividend entitlements as series A shares. Also the holder of the series B shares is entitled to a discretionary dividend based on the profit of the Tomsks property division. The series A shareholders are not entitled to this dividend. The B
Classification liabilities
financial
assets
and
Financial assets four categories

24
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Financial assets at fair value through profit and loss Loans and receivables
Available-for-sale financial assets
Held-to-maturity investments
It is essential for a bank to have a documented policy on the classification of financial instruments and for this policy to be rigorously enforced. This is because the different accounting policies for different categories would otherwise provide opportunities for profit manipulation. Reclassification of financial instruments may be viewed by readers of financial statements (and possibly bank supervisors) as either that the bank is in financial trouble, or that its management is unable to manage its financial instruments successfully. Either conclusion would be a serious blow to a banks reputation. A bank (or other user) uses as many of the categories as it needs, not necessarily all four. For example, Held-to-maturity investments may not be of interest to the bank, or it may not have the financial capacity to finance such investments. The policy should identify that this category should not be used, if this is the case.
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Financial Instruments - Decision Tree for Categories

Asset is acquired/held to generate profit? Or originated to be sold in the short-term?
YES
NO
Part of portfolio with a pattern of profit taking?
YES
NO
Is it a derivative?
NO
Is its designated & effective hedge
YES
NO
YES
Apply hedge accounting Are there: -fixed and determinable payments -fixed maturity - intent & ability to hold maturity?
NO
Is there intention to sell in the short term?
Is it created by giving money, goods or services directly to debtor?
YES
Financial assets at fair value through profit and loss
NO
Loans and receivables
YES
NO
Available for sale
YES
Held to maturity
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Financial Assets by class under IFRS 7 - examples

Category
Trading assets Financial assets at fair value through profit or loss Derivative financial instruments Designated at fair value through profit and loss Debt securities Equity securities Loans and advances to banks Loans and advances to clients
Class
Examples
Debt securities Equity securities
Loans and advances to banks Loans and receivables Loans to individuals (retail) Overdrafts Credit cards Term loans Mortgages Large corporate SMEs Others
Loans and advances to clients Loans to corporate entities Investment securities debt securities Held-to-maturity investments Investment securities debt securities Available-for-sale financial assets Investment securities equity securities Listed Unlisted Listed Listed Unlisted
Financial Liabilities by class under IFRS 7 - examples

Category
Trading liabilities Financial liabilities at fair value through profit or loss Derivative financial instruments Designated at fair value through profit and loss Financial liabilities at amortised cost Deposits from banks Due to clients Debt securities in issue Retail customers Large corporate SMEs Debt securities in issue
Class
Examples
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Other deposits
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Classes of financial instruments IFRS 7, Financial Instruments: Disclosures, requires certain disclosures to be given by class of financial instrument, for example, the reconciliation of an allowance account. IFRS 7 does not provide a prescriptive list of classes of financial instruments. It states that a class should contain financial instruments of the same nature and characteristics and that the classes should be reconciled to the line items presented in the balance sheet. What considerations should an entity apply in identifying different classes of financial instruments since a prescriptive list of classes is not provided? For example, should a bank disclose loans and advances as a single class, or should it be split further into separate classes? A .class of financial instruments is not the same as a category of financial instruments. Categories are defined in IAS 39 as financial assets at fair value through profit or loss, held-to-maturity investments, loans and receivables, available-for-sale financial assets, financial liabilities at fair value through profit or loss and financial liabilities measured at amortised cost. Classes are expected to be determined at a lower level than the measurement categories in IAS 39 and reconciled back to the balance sheet, as required by IFRS 7. However, the level of detail for a class should be determined on an entity-specific basis. In the case of banks, the category .loans and advances is expected to comprise more than one class unless the loans have similar characteristics. It may be appropriate to provide separate classes by: -types of customers . for example,commercial loans and loans to individuals; or - types of loans . for example, mortgages, credit cards, unsecured loans and overdrafts. In some cases,.loans to clients. can be one class if all the loans have similar characteristics (eg, a saving bank providing only one type of loan to individuals).
Financial assets at fair value through profit and loss
This category has two sub-categories: -financial assets held for trading and -those designated to the category at inception. A financial asset is held for trading either: if acquired (or originated) for the purpose of generating a profit from shortterm fluctuations in price (or dealers margin) or if, on initial recognition, it is part of a portfolio of identified instruments that are managed together and for which there is evidence of a recent actual pattern of short-term profit-taking. Trading assets include debt and equity securities and loans and receivables acquired with the intention of making a short-term profit from price or dealers margin. Derivatives are always categorised as held for trading unless they are accounted for as hedges or a a financial guarantee contract. Example: Forward contract to purchase a commodity: pattern of net settlement Issue IAS 39 applies to those contracts to buy or sell a non-financial item that can be settled net in cash or another financial instrument, or by exchanging financial instruments, as if the contracts were financial instruments. Contracts that were entered into and continue to be held for the purpose of the receipt or delivery of a non-financial item in accordance with the entitys expected purchase, sale or usage requirements are out of the scope of IAS 39. Does an entitys historical pattern of settlement impact on whether an entity qualifies for the exemption under IAS39? 28
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Background An entity enters into a forward contract to purchase oil. The entity has an established pattern of settling such contracts before delivery by contracting with a third party. The entity settles any market value difference for the contract price directly with the third party. Solution The forward contract to purchase oil is recognised as a derivative. IAS 39 applies to a contract to purchase a non-financial asset if the contract meets the definition of a derivative and the contract does not qualify for the exemption for delivery in the normal course of business. The entity does not expect to take delivery. A pattern of entering into offsetting contracts that effectively accomplishes settlement on a net basis does not qualify for the exemption for delivery in the normal course of business. The contract would not be recognised as a derivative if the entity intended to take delivery and had consistently taken delivery in the past.
should compensate the policyholder for incurring a loss as a result of changes in a non-financial variable specific to a party of the contract. Although there may be a loss incurred with increased rainfall, E may receive a payment even if it incurs no loss. (Refer to IFRS 4, BC55-BC60.)
The second sub-category (see Amendment to IAS 39: the fair value option below) includes any financial assets that an undertaking has decided to designate to the category on initial recognition, provided such a designation results in more relevant information either: because it eliminates or significantly reduces a measurement or recognition inconsistency (ie, accounting mismatch); or because it is part of a group of financial assets, financial liabilities or both that is managed, and its performance is evaluated on a fair value basis in accordance with a documented risk management or investment strategy, and information about this group is provided internally on that basis to the undertakings key management personnel (as defined in IAS 24). Amendment to IAS 39: the fair value option - IFRS News July 2005
Example: Weather derivatives Entity E is a farmer who operates in the wheat industry. Due to recent flooding, the entity enters into a contract in an attempt to reduce its exposure to the risk of flooding. The contract requires the counterparty to pay entity E 100,000 for every millimetre of rain in excess of 10mm in the region in which entity E operates. How should entity E account for the contract? The contract is within the scope of IAS 39 and should be accounted for as a derivative. Insurance contracts are scoped out of IAS 39 and are within the scope of IFRS 4, Insurance Contracts. However, the above contract would not meet the definition of an insurance contract. In order for a contract to be considered an insurance contract, the payment
IAS 39 previously allowed an entity to designate any financial asset or financial liability to be measured at fair value with changes in value recognised in profit or loss. Some constituents primarily prudential supervisors of banks, securities companies and insurers were concerned that this unrestricted option might be used inappropriately. The EUs decision to include the fair value option in its carve out of IAS 39 reflected these concerns: the fair value option cannot currently be applied to the liabilities of EU companies. Following consultation, the IASB has revised the fair value option. The requirements The amendments permit the fair value option to be used only when doing so results in more relevant information because either: 29
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it eliminates or significantly reduces a measurement or recognition inconsistency (accounting mismatch) that would otherwise arise from measuring assets or liabilities, or recognising the gains and losses on them on different bases; or a group of financial assets and/or financial liabilities or both is managed and its performance is evaluated on a fair value basis, in accordance with a documented risk management or investment strategy and information about the assets and or liabilities is provided internally to the entitys key management (as defined in IAS 24). If a contract contains one or more embedded derivatives, an entity may apply the fair value option to the entire combined contract unless: that embedded derivative does not significantly modify the cash flows that otherwise would be required by the contract; or it is clear with little or no analysis that separation of the embedded derivative is prohibited. The amendments still require items that use the fair value option to be designated on initial recognition. The use of the option is an accounting policy choice and therefore entities must disclose the criteria for using it. This disclosure includes a narrative description of how using the option is consistent with the entitys documented risk management or investment strategy when criterion (ii) below is used. Implications The fair value option is likely to simplify the application of IAS 39 for some entities. Criterion (i) accounting mismatch The option can be used in place of fair value hedge accounting to deal with a measurement mismatch. It can also eliminate the problems that arise from a mixed measurement model where financial assets are measured at fair value and related financial liabilities are measured at amortised cost.
An entity may have liabilities whose cash flows are contractually based on the performance of assets that are otherwise classified as available-for-sale. The option, in this case, will reduce the mismatch which arises from taking changes in the expected cash flows of the liabilities to profit or loss while the fair value movement on the related assets are taken to equity. Criterion (ii) managed on a fair value basis The option may avoid any inconsistency between management and statutory reporting for a group of financial assets and liabilities that are managed and evaluated on a fair value basis. Some profit and loss reporting on a fair value basis must be prepared and provided internally to the entitys key management to qualify under this criterion. It is not sufficient for assets to be managed using a Value at Risk (VaR) methodology. Criterion (iii) embedded derivatives The option will eliminate the burden of identifying all of the embedded derivatives, determining which are required to be separated under IAS 39 and valuing those that are required to be separated. It may be simpler to use the option to value the entire instrument; this could result in more reliable measures. This should be helpful for the structured products issued by banks and similar entities that may contain several embedded derivatives. Conclusion The amended fair value option will enable many entities to simplify the application of IAS 39 and avoid anomalies. See also Annex 2 - Fair value option - frequently asked questions If a financial asset contains one or more embedded derivatives, the undertaking may designate the entire contract as fair value through profit or loss, unless the embedded derivative does not significantly modify the cash flows that otherwise would be required by the contract, or it is clear with little 30
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or no analysis that separation of such an embedded derivative is prohibited by IAS 39. The asset cannot be moved to another category during its life.
Entity A may choose to account for its subsidiaries including its interest in its SPEs as available-for-sale financial assets, or it may elect to classify them at fair value through profit and loss in its separate financial statements, provided it meets the conditions in IAS 39 for that classification. Entity A should apply its accounting policy choice consistently to all of its subsidiaries including SPEs.
Available-for-sale financial assets
All financial assets that are not classified in another category are classified as available-for-sale. This should not be an issue for banks, as they will have a clearly-defined categorisation policy, but will apply to companies without such a policy which acquire financial assets. The available-for-sale category includes all equity securities other than those classified as at fair value through profit or loss. An undertaking also has the right to designate any asset, other than a trading one, to this category at inception. Example: Loans to customers Entity A is a parent company that prepares consolidated financial statements. Some of As subsidiaries are in the business of providing loans to customers. These loans are sold to trusts set up as special purpose entities (SPEs) under a securitisation arrangement to achieve lower financing costs. Entity A holds a beneficial residual interest in the SPE trusts and consolidates the SPEs under SIC-12, Consolidation . Special Purpose Entities, in its consolidated financial statements. A is preparing its separate financial statements in accordance with IAS 27, Consolidated and Separate Financial Statements, and would like to account for its investments in its subsidiaries at fair value in accordance with IAS 39, as permitted by IAS 27. Should entity As beneficial interest in its SPEs be accounted for in the same way as its conventional subsidiaries in its separate financial statements? Yes. The SPEs that qualify for consolidation under SIC-12 in consolidated financial statements are subsidiaries in the context of IAS 27.Consequently if A elects to account for its subsidiaries in accordance with IAS 39 in its separate financial statements, this election applies equally to its SPEs.
10 Loans and receivables

Loans and receivables are non-derivative financial assets with fixed or determinable payments that are not quoted in an active market. They typically arise when an undertaking provides money, goods or services directly to a debtor with no intention of trading the receivable. A loan acquired from another lender (for example, as a partner in a syndicated loan) is also included in this category, as are loans purchased. Other loans and receivables acquired (but not classified as loans and receivables) include: i. those that the entity intends to sell immediately or in the near term, which shall be classified as held for trading, and those that the entity upon initial recognition designates as at fair value through profit or loss; ii. those that the entity upon initial recognition designates as available for sale; or iii. those for which the holder may not recover substantially all of its initial investment, other than because of credit deterioration, which shall be classified as available for sale (for example a fixed rate interest-only strip created in a securitisation and subject to prepayment risk). An interest acquired in a pool of assets that are not loans or receivables (for example, an interest in a mutual fund or a similar fund) is not a loan or receivable.
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Any non-derivative financial asset with fixed or determinable payments (including loan assets, trade receivables, investments in debt instruments and deposits held in banks) could potentially meet the definition of loans and receivables. However, a financial asset that is quoted in an active market (such as a quoted debt instrument) does not qualify for classification as a loan or receivable. Financial assets that do not meet the definition of loans and receivables may be classified as held-to-maturity investments if they meet the conditions for that classification. On initial recognition of a financial asset that would otherwise be classified as a loan or receivable, an entity may designate it as a financial asset at fair value through profit or loss, or available for sale.
If an undertaking sells more than an insignificant amount of held-to-maturity securities, other than in exceptional circumstances, this casts doubt on its intent or ability to hold investments to maturity. The consequences are harsh: the undertaking is prohibited from using the held-to-maturity classification for any financial assets for two financial years. All its held-to-maturity investments are reclassified as available-for-sale and measured at fair value. When the prohibition ends (at the end of the second financial year following the tainting), the portfolio becomes cleansed and the undertaking is once more able to classify the securities as held-to-maturity. Sales before maturity could be made, and not raise a question about the entity's intention to hold other investments to maturity, if they are attributable to any of the following: i. ii. a significant deterioration in the issuer's creditworthiness. a change in tax law that eliminates or significantly reduces the tax-exempt status of interest on the held-to-maturity investment (but not a change in tax law that revises the marginal tax rates applicable to interest income). a major business combination or major disposition (such as a sale of a segment) that necessitates the sale or transfer of held-to-maturity investments to maintain the entity's existing interest rate risk position or credit risk policy (although the business combination is an event within the entity's control, the changes to its investment portfolio to maintain an interest rate risk position or credit risk policy may be consequential rather than anticipated). a change in statutory or regulatory requirements significantly modifying either what constitutes a permissible investment or the maximum level of particular types of investments, thereby causing an entity to dispose of a held-to-maturity investment. a significant increase in the industry's regulatory capital requirements that causes the entity to downsize by selling held-to-maturity investments.
11 Held-to-maturity investments
Held-to-maturity investments are financial assets with fixed or determinable payments and fixed maturity (e.g., debt securities and redeemable preference shares) that an undertaking has the positive intent and ability to hold to maturity. This category excludes loans originated by the undertaking. Equity securities cannot be classified as held-to-maturity because they do not have a fixed maturity date. If the terms of a perpetual debt instrument provide for interest payments for an indefinite period, the instrument cannot be classified as held to maturity because there is no maturity date. A financial asset that is puttable (ie the holder has the right to require that the issuer repay or redeem the financial asset before maturity) cannot be classified as a held-to-maturity investment because paying for a put feature in a financial asset is inconsistent with expressing an intention to hold the financial asset until maturity. The intent and ability must be assessed not only when the assets are initially acquired but also at each subsequent balance sheet date. A positive intent to hold assets to maturity is a much higher hurdle than simply having no present intention to sell.
iii.
iv.
v.
vi. a significant increase in the risk weights of held-to-maturity investments used for regulatory risk-based capital purposes.
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Financial liabilities two categories

Financial liabilities at fair value through profit and loss Other financial liabilities
inducement to those who respond favourably within 30 days. The new instrument will have different terms and conditions from the previous notes because of its convertible nature. The payment of the inducement is conditional on the exchange into convertible debt taking place. Can the inducement be included in the initial recognition of the new convertible debt and therefore deferred and amortised as part of the effective interest method under IAS 39? The treatment of the inducement will depend on various factors. IAS 39 states that an exchange of debt instruments between issuer and holder on substantially different terms should be treated as an extinguishment of the old debt and recognition of a new debt; it is likely a gain or loss will arise on the extinguishment of the old debt. If the terms are not substantially different, then the exchange is not treated as an extinguishment and reissue and any costs meeting the capitalisation criteria in IAS 39 adjust the carrying amount of the debt and are amortised over the remaining term of the modified liability. The new debt is hybrid in nature due to the convertible feature whereas the old debt is plain vanilla term debt. On that basis, the terms of the old and new instruments would be substantially different and the old debt is extinguished. Entity G then needs to consider whether the inducement is a transaction cost that falls to be included in the calculation of the effective interest rate of the new instrument. Although the cost would not have been incurred if entity G had not issued the new convertible debt, it is not directly attributable to the new debt. The new debt could still have been issued had the inducement not been paid. The inducement merely encouraged the note holders to respond quickly but was not directly related to the issue of the new debt. Entity G should include the cost of the inducements into the calculation of the gain or loss on redemption of the old notes and take the cost directly to the profit and loss account. 33
12 Financial liabilities at fair value through profit and loss

The category of financial liabilities at fair value through profit and loss also has two sub-categories: -liabilities held for trading and -those designated to the category at inception. Financial liabilities held for trading include:
Derivative liabilities that are not accounted for as hedging instruments Obligations to deliver securities or other financial assets borrowed by a short
seller
Financial liabilities that are incurred with the intention to repurchase them in the
near term and

Financial liabilities that form part of a portfolio of identified financial instruments
that are managed together and for which there is evidence of a recent actual pattern of short-term profit taking. As with financial assets, an undertaking has the right to designate any financial liability to this category on initial recognition, provided it meets one of the criteria detailed above for assets, but it is irrevocable. The liability cannot subsequently be transferred to another category. Example: Exchange of debt instruments Entity G has debt (long-term notes) in issue. It intends to exchange the notes into convertible debt but requires the consent of a majority of the note holders to do so. To encourage a quick response from the note holders, entity G is offering a cash
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13 Reclassification categories
of
assets
between
Reclassifications between categories are rare under IAS 39 and are prohibited into and out of the fair value through profit and loss category. Reclassifications from the held-to-maturity category as a result of a change of intent or ability are treated as sales and normally result in the whole category being tainted. The most common reason for a reclassification is when the whole category is tainted and has to be reclassified as available-for-sale for two years. In such circumstances, the assets are re-measured to fair value, with any difference recognised in equity.
Reclassification rules between financial assets are as follows: Fair value through profit or loss Not permitted, except as stated below. An entity should not reclassify a financial instrument into or out of the fair value through profit or loss category while it is held or issued. The 2007 Annual Improvements Project allows movements into and out of the fair value through profit or loss category where: A derivative commences or ceases to qualify as a hedging instrument in cash flow or net investment hedge. Financial assets are reclassified following a change in policy by an insurance company in accordance with IFRS 4. Transfer from held-to-maturity to available for sale Permitted. If, as a result of a change in intention or ability, it is no longer appropriate to classify an investment as held to maturity, it should be reclassified as available for sale and remeasured at fair value. Transfer from available for sale to held to maturity Permitted. If, as a result of a change in intention or ability, or rare circumstance that a reliable measure of fair value is no longer available or because the two preceding financial years have passed (ie tainting rules), it becomes appropriate to carry a financial instrument at amortised cost. Transfer from loans and receivable to available for sale Not permitted. The category of loans and receivables refers to the circumstances in which the financial asset first satisfied the recognition criteria in IAS 39. Transfer from available for sale to loans and receivables Not permitted. The definition of loans and receivables implies that an instrument classified as available for sale at initial recognition could not be classified as loans and receivables in the future.
EXAMPLE - tainted category

You buy $2m of bonds that you classify as held-to-maturity. Interest rates fall and you decide to benefit from this by selling the bonds now, rather than wait until their maturity. All remaining instruments in this category must be reclassified as available-for sale, and you may not use the held-to-maturity classification for a further two years. An instrument may be reclassified into the category where the tainted held-tomaturity portfolio has been cleansed. In this case the financial assets carrying value at the date of reclassification is remeasured as amortised cost. Any unrealised gains and losses already recognised remain in equity until the asset is impaired or derecognised.
14 TREASURY SHARES
An entitys own equity instruments are not recognised as a financial asset, regardless of the reason for which they are reacquired. If an entity reacquires its own equity instruments, those instruments (treasury shares) shall be deducted from equity. No gain or loss shall be recognised in profit or loss on the purchase, sale, issue or cancellation of an entitys own equity instruments.
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Such treasury shares may be acquired and held by the entity or by other members of the consolidated group. Consideration paid or received shall be recognised directly in equity. The transaction represents a transfer between those holders of equity instruments who have given up their equity interest and those who continue to hold an equity instrument. The amount of treasury shares held is disclosed separately either on the face of the balance sheet or in the notes. An entity provides disclosure in accordance with IAS 24 Related Party Disclosures if the entity reacquires its own equity instruments from related parties. An example of this is when key management personnel buy shares to profit from exercising their share options and the entity repurchases them from the key management personnel. However, when an entity holds its own equity on behalf of others, eg a financial institution holding its own equity on behalf of a client, there is an agency relationship and those holdings are not included in the entitys balance sheet.
It requires no initial net investment or an initial net investment that is smaller
than would be required to purchase the underlying instrument, and

It is settled at a future date.
Usually, a derivative is characterised by a notional amount, which is for instance an amount of currency, a number of shares or a number of units of weight or volume. Typical derivatives are: 1) Futures contracts that provide for the future delivery of financial instruments or commodities under terms established at the outset. 2) Forward contracts that commit two parties to an exchange at a specific future date under terms set at the contract date. 3) Swap contracts whereby there is an agreement between two counterparties to exchange cash flows. 4) Option contracts whereby a transaction is set up giving one of the parties the right to buy or sell something to the other at a specified price for a specified period of time.
15 Embedded derivatives derivatives combined with non-derivatives in a contract

IAS 39 defines a derivative as a financial instrument with all these characteristics:
Its value changes in response to changes in an underlying price or index
A derivative instrument may not require the holder or writer to invest (or receive) the notional amount at the start of the contract. Alternatively, a derivative could require a fixed payment or payment of an amount that can change (but not proportionately with a change in the underlying) as a result of some future event that is unrelated to a notional amount. For example, a contract may require a fixed payment of $1,000,000 if six-month LIBOR increases by 100 basis points. Such a contract is a derivative even though a notional amount is not specified.
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EXAMPLES - contracts that normally qualify as derivatives under IAS 39 Type of contract Interest rate swap Currency swap (foreign exchange swap) Commodity swap Equity swap Credit swap Total return swap Purchased or written treasury bond option (call or put) Purchased or written currency option (call or put) Purchased or written commodity option (call or put) Purchased or written stock option (call or put) Interest rate futures linked to government debt (treasury futures) Currency futures Commodity futures Interest rate forward linked to government debt (treasury forward) Currency forward Commodity forward Equity forward
Main pricing-settlement variable (underlying variable) Interest rates Currency rates Commodity prices Equity prices (equity of another entity) Credit rating, credit index or credit price Total fair value of the reference asset and interest rates Interest rates Currency rates Commodity prices Equity prices (equity of another entity) Interest rates Currency rates Commodity prices Interest rates Currency rates Commodity prices Equity prices (equity of another entity)
An embedded derivative is a derivative instrument that is combined with a nonderivative host contract to form a single hybrid instrument (two financial instruments in one). The host contract may be a debt or equity instrument, a lease, an insurance contract or a sale or purchase contract. All separated embedded derivatives are accounted for as "Financial assets or financial liabilities at fair value through profit or loss", unless they are hedging instruments. When separating an embedded derivative from its host contract, the derivative element is valued first and the residual is assigned to the host contract. (A derivative contained in a financial asset or liability that is carried at fair value through profit or loss is not separated, as changes in its value are included in
changes in the value of the combined instrument and hence are already reported in profit or loss.) Identification of embedded derivatives requires a review of all financial assets and liabilities that are carried at amortised cost or classified as available for sale and contracts such as operating leases, purchase and sale contracts and commitments. An embedded derivative is a component of a hybrid (combined) instrument that also includes a non-derivative host contractwith the effect that some of the cash flows of the combined instrument vary in a way similar to a stand-alone derivative. An embedded derivative causes some or all of the cash flows of the contract to be modified according to: 36
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- a specified interest rate, -financial instrument price, -commodity price, -foreign exchange rate, -index of prices or rates, -credit rating or -credit index, or -other variable, provided in the case of a non-financial variable that the variable is not specific to a party to the contract. A derivative that is attached to a financial instrument, but is contractually transferable independently of that instrument, or has a different counterparty from that instrument, is not an embedded derivative, but a separate financial instrument. If an embedded derivative is separated, the host contract shall be accounted for if it is a financial instrument, and in accordance with other appropriate Standards if it is not a financial instrument. If a contract contains one or more embedded derivatives, an undertaking may designate the entire hybrid (combined) contract as a financial asset or financial liability at fair value through profit or loss unless: 1. the embedded derivative(s) does not significantly modify the cash flows that otherwise would be required by the contract; or 2. it is clear that separation of the embedded derivative(s) is prohibited, such as a prepayment option embedded in a loan that permits the holder to prepay the loan for approximately its amortised cost.
If an undertaking is required to separate an embedded derivative from its host contract, but is unable to measure the embedded derivative separately, either at acquisition or at a subsequent financial reporting date, it shall designate the entire hybrid (combined) contract as at fair value through profit or loss. If an undertaking is unable to determine reliably the fair value of an embedded derivative on the basis of its terms and conditions (for example, because the embedded derivative is based on an unquoted equity instrument), the fair value of the embedded derivative is the difference between the fair value of the hybrid (combined) instrument and the fair value of the host contract. If the undertaking is unable to determine the fair value of the embedded derivative using this method, the hybrid (combined) instrument is designated as at fair value through profit or loss. IAS 39 prevents abuse of the requirements for carrying derivatives at fair value through profit and loss by requiring separate recognition of derivatives embedded in a host contract that is accounted for differently. An embedded derivative should be split from the host contract and accounted for separately if:
Its economics are not closely related to those of the host contract (see
examples below)
A separate instrument with the same terms as the embedded derivative would
meet the definition of a derivative, and

The entire contract is not carried at fair value through profit and loss.
Instruments containing embedded derivatives When an undertaking becomes a party to a hybrid (combined) instrument that contains one or more embedded derivatives, the undertaking must identify any embedded derivative, assess whether it is required to be separated from the host contract and, for those to be separated, measure the derivatives at fair value at initial recognition and subsequently. These requirements can be more complex, or result in less reliable measures, than measuring the entire instrument at fair value through profit or loss. For that reason, IAS 39 permits the entire instrument to be designated as at fair value through profit or loss, 37
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unless: 1. the embedded derivative(s) does not significantly modify the cash flows that otherwise would be required by the contract; or 2. it is clear with little or no analysis when a similar hybrid (combined) instrument is first considered that separation of the embedded derivative(s) is prohibited, such as a prepayment option embedded in a loan that permits the holder to prepay the loan for approximately its amortised cost. Embedded foreign currency derivatives
An entity should not be able to circumvent the recognition and measurement requirements for derivatives merely by embedding a derivative in a non-derivative financial instrument or other contract, for example, a commodity forward in a debt instrument. To achieve consistency in accounting for such embedded derivatives, all derivatives embedded in financial instruments that are not measured at fair value with gains and losses recognised in the income statement ought to be accounted for separately as derivatives. However, as a practical expedient an embedded derivative need not be separated if it is regarded as closely related to its host contract. When the embedded derivative bears a close economic relationship to the host contract, such as a cap or a floor on the interest rate on a loan, it is less likely that the derivative was embedded to achieve a desired accounting result. A foreign currency derivative in a contract should not be required to be separated if it is denominated in a currency that is commonly used in business transactions (that are not financial instruments) in the environment in which the transaction takes place. A foreign currency derivative would be viewed as closely related to the host contract if the currency is commonly used in local business transactions, for example, when monetary amounts are viewed by the general population not in terms of the local currency but in terms of a relatively stable foreign currency, and prices may be quoted in that foreign currency.
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Questions need to be asked

Split and separately account Is the contract carried at fair value through profit or loss? YES NO Would it be a derivative if it was freestanding? YES Is it closely related to the host contract? NO
NO
YES
Do not split out the embedded derivative
The following table contrasts contracts containing embedded derivatives to identify those which are not closely related (and should be accounted for separately): Not closely Closely related related Equity conversion or put option in Interest rate swap embedded in a debt debt instrument instrument
Fixed rate debt extension option Debt security with interest or Inflation indexed lease contracts Cap and floor in a sale and purchase
principal linked to commodity or equity prices

Credit derivatives embedded in a
contract
Prepayment option in a mortgage
host debt instrument

Sales or purchases not in (1)
where the options exercise price is approximately equal to the mortgages amortised cost on each exercise date
A forward foreign exchange contract
measurement currency of either party (2) currency in which products are routinely denominated in international commerce or (3) currency commonly used in the economic environment in which transaction takes place
that results in payments in either partys reporting currency

Dual currency bonds Foreign currency denominated debt
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Examples: - embedded derivatives not closely related to the host contract In these examples, an undertaking accounts for the embedded derivative separately from the host contract. 1. A put option embedded in an instrument that enables the holder to require the issuer to reacquire the instrument for an amount of cash (or other assets) that varies on the basis of the change in: - an equity price, or - commodity price or -index is not closely related to a host debt instrument. 2. A call option embedded in an equity instrument that enables the issuer to reacquire that equity instrument at a specified price is not closely related to the host equity instrument from the perspective of the holder. From the issuer's perspective, the call option is an equity instrument provided it meets the conditions for that classification under IAS 32, in which case it is excluded from the scope of IAS 39. 3. An option or automatic provision to extend the remaining term to maturity of a debt instrument is not closely related to the host debt instrument, unless there is a concurrent adjustment to the approximate current market rate of interest at the time of the extension. If an undertaking issues a debt instrument and the holder of that debt instrument writes a call (buy) option on the debt instrument to a third party, the issuer regards the call option as extending the term to maturity of the debt instrument, provided the issuer can be required to participate in (or facilitate) the remarketing of the debt instrument as a result of the call option being exercised. 4. Equity-indexed interest or principal payments embedded in a host debt instrument or insurance contractby which the amount of interest, or principal, is indexed to the value of equity instrumentsare not closely related to the host instrument because the risks inherent in the host and the embedded derivative are dissimilar. 5. Commodity-indexed interest or principal payments embedded in a host debt
instrument, or insurance contractby which the amount of interest, or principal, is indexed to the price of a commodity (such as gold)are not closely related to the host instrument as the risks inherent in the host and the embedded derivative are dissimilar. 6. An equity conversion feature embedded in a convertible debt instrument is not closely related to the host debt instrument from the perspective of the holder of the instrument. From the issuer's perspective, the equity conversion option is an equity instrument and excluded from the scope of IAS 39 provided it meets the conditions for that classification under IAS 32. 7. A call (buy), put (sell), or prepayment option embedded in a host debt contract, or host insurance contract, is not closely related to the host contract unless the option's exercise price is approximately equal on each exercise date to the amortised cost of the host debt instrument, or the carrying amount of the host insurance contract. From the perspective of the issuer of a convertible debt instrument with an embedded call or put option feature, the assessment of whether the call or put option is closely related to the host debt contract is made before separating the equity element under IAS 32. 8. Credit derivatives that are embedded in a host debt instrument and allow one party (the 'beneficiary') to transfer the credit risk of a particular reference asset, which it may not own, to another party (the 'guarantor') are not closely related to the host debt instrument. Such credit derivatives allow the guarantor to assume the credit risk associated with the reference asset without directly owning it. Examples: - embedded derivatives closely related to the host contract In these examples, an undertaking does not account for the embedded derivative separately from the host contract. 1.An embedded derivative in which the underlying is an: - interest rate or - interest rate index
that can change the amount of interest that would otherwise be paid (or received) on an interest-bearing host debt contract or insurance contract is closely related to the host contract unless the combined instrument can be settled so that the holder would not recover substantially all of its recognised investment, or the embedded derivative could at least double the holder's initial rate of return on the host contract and could result in a rate of return that is at least twice what the market return would be for a contract with the same terms as the host contract. 2. An embedded floor or cap on the interest rate on a debt contract, or insurance contract, is closely related to the host contract, provided the cap is at, or above, the market rate of interest and the floor is at, or below, the market rate of interest when the contract is issued, and the cap or floor is not leveraged in relation to the host contract. Similarly, provisions included in a contract to purchase, or sell, an asset (eg a commodity) that establish a cap and a floor on the price to be paid (or received) for the asset are closely related to the host contract if both the cap and floor were out of the money (unlikely to be exercised) at inception and are not leveraged. 3. An embedded foreign currency derivative that provides a stream of principal, or interest, payments that are denominated in a foreign currency, and is embedded in a host debt instrument (eg a dual currency bond) is closely related to the host debt instrument. Such a derivative is not separated from the host instrument because IAS 21 requires foreign currency gains and losses on monetary items to be recorded in the income statement. 4. An embedded foreign currency derivative in a host contract that is an insurance contract or not a financial instrument (such as a contract for the purchase, or sale, of a non-financial item where the price is denominated in a foreign currency) is closely related to the host contract provided it is not leveraged, does not contain an option feature, and requires payments denominated in one of the following currencies: i. the functional currency of any substantial party to that contract; ii. the currency in which the price of the related good or service is routinely
denominated in commercial transactions around the world (such as the US dollar for crude oil transactions); or iii. a currency that is commonly used in contracts to purchase, or sell, nonfinancial items in the economic environment in which the transaction takes place (eg a relatively stable and liquid currency that is commonly used in local business transactions or external trade). 5. An embedded prepayment option in an interest-only, or principal-only, strip is closely related to the host contract provided the host contract (i) initially resulted from separating the right to receive contractual cash flows of a financial instrument that, in and of itself, did not contain an embedded derivative, and (ii) does not contain any terms not present in the original host debt contract. 6. An embedded derivative in a host lease contract is closely related to the host contract if the embedded derivative is (i) an inflation-related index such as an index of lease payments to a consumer price index (provided that the lease is not leveraged and the index relates to inflation in the undertaking's own economic environment), (ii) contingent rentals based on related sales or (iii) contingent rentals based on variable interest rates. 7. A unit-linking feature embedded in a host financial instrument, or host insurance contract, is closely related to the host instrument, or host contract, if the unit-denominated payments are measured at current unit values that reflect the fair values of the assets of the fund. A unit-linking feature is a contractual term that requires payments denominated in units of an internal or external investment fund. 8. A derivative embedded in an insurance contract is closely related to the host insurance contract if the embedded derivative and host insurance contract are so interdependent that an undertaking cannot measure the embedded derivative separately (ie without considering the host contract).
Example: Preference shares convertible to ordinary shares Company G holds preference shares that are convertible into ordinary shares. These shares are treated as available for sale under IAS 39. Conversion is to a fixed number of shares and can occur at particular times in the future. Is there an embedded derivative in the contract that needs to be separately fair valued through the income statement? In general, investments in preference shares convertible into ordinary shares could be presented as .loans and receivables. (if classified as a liability by the issuer) at fair value through profit or loss or available for sale, depending on the terms attached to the shares. The conversion feature in the contract is an embedded derivative in this case, as some of the cash flows in the contract will vary in a way similar to a stand-alone derivative and are different from those that we would normally expect to see from an investment in preference shares. In addition, a separate instrument with the same terms would meet the definition of a derivative. In this case, the asset is being presented as .available for sale. And although it is carried at fair value, since any movements in fair values are recorded directly in equity, the embedded derivative will need to be accounted for separately. This means that the changes in the fair value of the embedded derivative will be recorded in the income statement. If the shares were designated as .at fair value through profit or loss. the embedded derivative would not need to be accounted for separately. This is because all changes in fair value are recognised in profit or loss so there is no need to measure and present separately the embedded derivative. Had the terms attached to the preference shares meant that the shares could be presented as loans and receivables, the embedded derivative would need to be accounted for separately with changes in the fair value being recorded in the income statement. Example: Embedded derivatives: accounting for a convertible bond The accounting treatment of an investment in a bond (financial asset) that is convertible into shares of the issuing entity or another entity before maturity? An investment in a convertible bond that is convertible before maturity generally cannot be classified as a held-to-maturity investment as that would be inconsistent with paying for the conversion featurethe right to convert into equity shares before maturity. An investment in a convertible bond can be classified as an available-for-sale financial asset if it is not purchased for trading purposes. The equity conversion option is an embedded derivative. If the bond is classified as available for sale (ie fair value changes recognised directly in equity until the bond is sold), the equity conversion option (the embedded derivative) is separated. The amount paid for the bond is split between the debt instrument without the conversion option and the equity conversion option. Changes in the fair value of the equity conversion option are recognised in profit or loss unless the option is part of a cash flow hedging relationship. If the convertible bond is measured at fair value with changes in fair value recognised in the income statement, separating the embedded derivative from the host bond is not permitted.
Example: Financial instruments and contingent settlement provisions Entity G has issued a bond that is convertible into ordinary shares at the option of the holder. Interest payments are at the discretion of the entity absent an initial public offering (IPO). However, if an IPO does not take place by 2010, the entity must redeem both the principal and all unpaid cumulative interest. Should the instrument be classified as debt or equity in the financial statements? The discretionary interest payments and the option to convert the bond into ordinary shares are indicators of an equity instrument. However, the fact that the entity may be obliged to settle both the principal and the interest in cash if no IPO takes place means that it should recognise a financial liability for the whole amount. IAS 32 states that where an entity is required to settle an instrument in such a
way that it would be a financial liability in the event of an uncertain future event beyond the control of both the issuer and the holder of the instrument, the issuer does not have the unconditional right to avoid delivering cash or another financial asset. In this case, while it may be within the entitys control to determine whether to attempt an IPO, the success of the transaction will depend on whether the market will accept an IPO and whether all regulatory approvals will be obtained. These factors are beyond the control of the entity; therefore the criteria in IAS 32 are met. As the entity does not have the unconditional right to avoid delivering cash, the bond should be classified as a financial liability.
US$10 bond is convertible into 10 ordinary shares of entity D. Entity Ds management is considering how this bond should be accounted for under IFRS. The convertible bond is a foreign currency bond and is accounted for as a financial liability with an embedded derivative that is not closely related to the underlying (IAS 39). A convertible bond that is denominated in the functional currency of the issuer is treated as a compound financial instrument: the debt element is treated as a liability and the equity conversion element as equity (IAS 32). However, the instrument described here is not accounted for in this way because an exchange of a fixed amount of shares for a fixed amount of foreign currency represents a variable amount of cash measured in the functional currency of entity D. The financial liability host contract of the convertible bond is a monetary item, accounted for at amortised cost and translated into Thai baht at the closing rate. The embedded derivative is a financial instrument at fair value through profit and loss in Thai baht. If Ds management is not able to determine reliably the fair value of the embedded derivative, it should treat the whole instrument as a financial liability at fair value through profit and loss. Example: Dual currency bond Maypole plc has a sterling functional currency. Maypole issues a bond with a principal denominated in euros repayable at the end of the bond term and interest payable each year denominated in US dollars, calculated as a fixed percentage of a notional US dollar amount. How should this instrument be accounted for by Maypole? A bond issued in a currency that is not the functional currency of the entity is a foreign currency monetary item. Such a monetary item is accounted for under IAS 21, The Effects of Changes in Foreign Exchange Rates, which requires foreign currency gains and losses to be recognised in the income statement. Therefore, a foreign currency derivative that may be embedded in such a host
Example: Fair value disclosures for convertible bond Entity B has issued a convertible bond that under IAS 32 is accounted for as a compound instrument. The liability component is measured at amortised cost. According IFRS 7, Financial Instruments: Disclosure, the entity is required to disclose the fair value of the financial instrument in a way that permits it to be compared with its carrying amount. Is the fair value disclosure required: a) only for the liability component? b) separately for the liability and the equity components? Or; c) for the convertible bond in its entirety? IFRS 7 requires fair value disclosures only for financial assets and liabilities. The equity component does not meet the definition of a financial asset or financial liability, so only the fair value of the liability component needs to be disclosed (answer a).
Example: Foreign currency bond Entity D has a Thai baht functional currency. It has issued a convertible bond denominated in US dollars in order to raise capital from foreign investors. Each
debt instrument is considered closely related and is not separated. This also applies to dual currency bonds. For measurement purposes, therefore, the fixed rate dual currency bond should be analysed into its two components: a zero coupon bond denominated in euros; and an instalment bond with annual payments denominated in US dollars. Each component is recognised initially at fair value, being the present value of the future payments to be made. Subsequently, each component is measured separately at amortised cost (unless the entire bond is classified as at fair value though profit and loss) using the effective interest rate method in accordance with IAS 39. The interest cost of each component is calculated separately in the relevant foreign currency (that is, in euros for the zero coupon bond and in US dollars for the instalment bond) and translated into sterling at the relevant average rate under IAS 21. The resulting carrying amount of each component is translated to sterling at each period end using the closing rate, with exchange movements recognised in the income statement in accordance with IAS 21.
An embedded non-option derivative (such as an embedded forward or swap) is separated from its host contract on the basis of its stated or implied substantive terms, so as to result in it having a fair value of zero at initial recognition. An embedded option-based derivative such as an: -embedded put, -call, -cap, -floor or -swaption is separated from its host contract on the basis of the stated terms of the option feature. The initial carrying amount of the host instrument is the residual amount after separating the embedded derivative. Generally, multiple embedded derivatives in a single instrument are treated as a single compound embedded derivative. However, embedded derivatives that are classified as equity are accounted for separately from those classified as assets or liabilities. In addition, if an instrument has more than one embedded derivative and those derivatives relate to different risk exposures and are readily separable and independent of each other, they are accounted for separately from each other. Puttable Financial Instruments and Obligations Arising on Liquidation A puttable instrument is a financial instrument that gives the holder the right to put the instrument back to the issuer for cash (or another financial asset) or is automatically put back to the issuer on the occurrence of an uncertain future event or the death or retirement of the instrument holder. The amount of cash varies on the basis of the change in an equity or commodity index that may increase or decrease (a 'puttable (sell) instrument'). Unless the issuer on initial recognition designates the puttable instrument as a financial liability at fair value through profit or loss, it is required to separate an embedded derivative (ie the indexed principal payment) because the host contract is a debt instrument and the indexed principal payment is not closely related to a host debt instrument.
16 Embedded derivatives equity instruments, non-option derivatives, multiple embedded derivatives, puttable instruments
If a host contract has no stated, nor predetermined, maturity and represents a residual interest in the net assets of an undertaking, then its economic characteristics and risks are those of an equity instrument, and an embedded derivative would need to possess equity characteristics related to the same undertaking to be regarded as closely related. If the host contract is not an equity instrument and meets the definition of a financial instrument, then its economic characteristics and risks are those of a debt instrument.
Because the principal payment can increase and decrease, the embedded derivative is a non-option derivative whose value is indexed to the underlying variable. In the case of a puttable instrument that can be put back at any time for cash equal to a proportionate share of the net asset value of an undertaking (such as units of an open-ended mutual fund or some unit-linked investment products), the effect of separating an embedded derivative and accounting for each component is to measure the combined instrument at the redemption amount that is payable at the balance sheet date if the holder exercised its right to put the instrument back to the issuer. In February 2008, the IASB amended IAS 32 by requiring some puttable financial instruments and some financial instruments that impose on the entity an obligation to deliver to another party a pro-rata share of the net assets of the entity only on liquidation to be classified as equity. The amendment addresses the classification of some: (a) puttable financial instruments, and (b) instruments, or components of instruments, that impose on the entity an obligation to deliver to another party a pro rata share of the net assets of the entity only on liquidation. The objective was a short-term, limited scope amendment to improve the financial reporting of particular types of financial instruments that meet the definition of a financial liability but represent the residual interest in the net assets of the entity. See also Annex 3 Puttable Instruments Detailed rules Example: Puttable instruments Spring Open-ended Investment Fund has two classes of shares: founder shares and investor shares. The fund has issued 1,000 founder shares with a par value of 1 each, which are held by the investment manager for regulatory purposes. The founder shares are not redeemable, carry voting rights but are not entitled to dividends. The fund has also issued 900,000 investor shares with a par value of 0.01 each.
These shares are redeemable at fair value at the option of the holder, carry no voting rights, but are entitled to dividends. In the event of a winding up or on dissolution of the fund, the founder shares share rank equally with the investor shares, with each share entitled to an amount equal to its par value. The investor shares are entitled to all of the surplus assets of the fund that remain after the par value amounts have been paid. If Spring early adopts the amendment to IAS 32 and IAS 1, Presentation of Financial Statements, for puttable financial instruments and obligations arising on a liquidation, would both classes of shares be reflected as equity? No, the investor shares would not be classified as equity. In order for the investor shares to be classified as equity, a number of tests would need to be met. One of these tests is that the shares form part of the most subordinate class of instruments. This means primarily that the instrument has no priority over other claims to the assets of the entity on liquidation. Furthermore, the instruments in the most subordinate class of instruments must have identical features. As this latter requirement is not met, the investor shares will remain classified as financial liabilities. If the founder shares were repurchased by Spring the investor shares may, depending on their precise terms, meet the tests in the amended IAS 32 in which case the investor shares would fall to be classified as equity. The founder shares are classified as equity as they are not puttable and there is no other obligation on the entity to deliver cash or other financial assets to the holder. Example: Puts and calls over minority interests Entity D purchases 90% of F from entity E on 31 December 2006. E has a put option to sell its remaining 10% stake in F to D in two years time at a fixed price. D has a call option to purchase the stake under the same terms and conditions. How should D account for the options? Entity D should consider where the risks and rewards of ownership of the minority interest lie. In this situation, it is likely that the option will be exercised.
If the exercise price of the option is higher than the market value of the minority stake, it is likely that E will exercise its put option to sell the stake to D. Conversely, if the market price rises above the exercise price, D will exercise its call option to buy the stake from E. In substance, D is exposed to the risks and rewards of ownership of the minority stake from the date of acquisition of the majority stake. Therefore, it should consolidate 100% of F from 31 December 2006. No minority interest should be recognised and the goodwill calculated on the business combination should include that associated with the 10% stake subject to the option. D should also record a liability for the purchase price of the minority stake under IAS 32, This should be discounted to the expected redemption date. The accretion of the discount should be recognised as a finance charge in the income statement. The answer could differ depending on the terms of the put and call option and also whether or not the option is written as part of a business combination. Embedded derivatives _ IFRS News July 2007 Question 8 Instruments whose payments are linked to EBITDA or sales revenue Company A issues a mandatorily redeemable bond whose coupon payments are based on a multiple of EBITDA. These payments meet the definition of a financial liability under IAS 32.25. Does the linkage to EBITDA mean that there is an embedded derivative in the host debt contract? Answer 8 No. Both sales revenue and EBITDA are non-financial variables that are specific to a party of the contract on the grounds that they are primarily a function of business risk. The definition of a derivative in IAS 39.9(a) is not therefore met. Management applies IAS 39.9 for the calculation of the effective interest rate. Note: this view may change. The IASB at its February 2007 meeting tentatively agreed to delete the exclusion in the definition of a derivative for contracts that are linked to a non-financial variable that is specific to a party to the contract, with the effect that only those contracts that meet the definition of insurance contracts would fail to be treated as derivatives.
Question 9 What are the components of a foreign currency denominated convertible instrument? What are the components of a foreign currency denominated convertible instrument? For example, a UK company (functional currency GBP) issues a convertible bond denominated in US dollars and convertible on a number of dates into a fixed number of shares of the parent. Answer 9 The whole contract is a liability. The host contract is a US dollar bond (whose FX risk is accounted for under IAS 21). The embedded derivative is a written option for the holder to exchange the US dollar bond for a fixed number of GBPdenominated shares. Question 10 Conversion into warrants A convertible bond is convertible into a fixed number of warrants on shares in the borrower. Is the conversion option an equity component? Answer 10 No. The issuers own equity instruments do not include instruments that are themselves contracts for the future receipt or delivery of the issuers own equity instruments, in accordance with IAS 32.16(b)(ii). The warrant is a contract for the future receipt of the issuers own equity instruments; the conversion option is not therefore an equity component to purchase own shares. Question 11 Contingent settlement options A company has issued convertible bonds whose terms include a clause giving the issuer the option to redeem in cash the bonds at their fair market value in the event of the occurrence of an uncertain future event. Does this contingent settlement option prevent the conversion option from being an equity component? Answer 11 Yes. The conversion option is a derivative. The terms of the convertible bond give the issuer the option to redeem the bonds for cash at their fair market value. There is a settlement alternative for the equity conversion option, as it can be settled at fair value either in shares or in cash that is, there is a net cash settlement option.
An equity conversion option for which either party has a choice of settlement in cash or shares is a financial liability under IAS 32.26. IAS 32.26 overturns the usual principle that something that is in the control of an issuer is not an obligation. This right of choice of settlement is contingent upon a future event in the example above, but the equity conversion option is still accounted for as an embedded derivative in accordance with IAS 32.26. Question 12 Provisional issuer call option to redeem at par Company A issues a convertible bond that, if converted, converts into a fixed number of equity shares. The bond also contains a provisional call option that gives the issuer the option to redeem the bonds at par if the shares price is 130% of the conversion price for at least 20 days. How should Company A account for the provisional call option? Answer 12 The convertible bond is a compound financial instrument with a debt host and equity conversion option. As the issuer call option is to redeem the bonds at par, it does not result in the conversion option having a cash settlement alternative. The conversion option is not therefore accounted for as an embedded derivative in accordance with IAS 32.26. In respect of the issuer call option, the value of any derivative feature (such as a call option) embedded in a compound financial instrument, other than the equity component, is included in the liability component (IAS 32). The call option is therefore considered part of the liability and not the equity component. When determining whether the embedded option is closely related, the assessment of whether the call or put option is closely related to the host debt contract from the issuers perspective is made before separating the equity element under IAS 32. Example: Definition of a derivative Entity A is assessing three new contracts to identify any embedded derivatives that may require separate valuation in accordance with IAS 39.
The definition of a derivative excludes contracts where the underlying is a nonfinancial variable that is specific to a party to the contract. Are there derivatives within the following contracts for entity A? a) Entity A has issued a mandatory redeemable bond whose coupon payments are based on a multiple of earnings before interest, tax, depreciation and amortisation (EBITDA). b) Entity A has entered into an agreement pre-year- end to purchase 100 newlyissued shares of entity B for 2.80 each. The terms of the agreement are that the shares will be issued and payment will be made post-year-end. The quoted share price of entity B was 2.80 at the date of the agreement. c) Entity A has entered into a contract to sell a fixed number of its own equity shares, with an exercise price that varies with entity As sales revenue. a) An entitys EBITDA depends on a combination of financial and non-financial factors. However, a key factor is general business risks specific to the entity, such as the management talent of the company, the success of its products and its marketing efforts. Thus the EBITDA of a party to a contract is considered to be a non-financial variable specific to a p arty to a contract. There is not therefore an embedded derivative within this host debt contract. b) The share price is a financial variable, as it is a financial instrument price. The commitment to buy shares at 2.80 is a derivative between the commitment date and the date the shares are issued and payment made. c) This contract has two underlyings. The first is sales revenue that affects the cash to be received. The second is the price of the entitys shares that affects the value of the shares to be delivered. Sales revenue, like EBITDA, is a non-financial variable specific to a party to the contract. However, the price of entity As shares is a financial variable. The inclusion of one relevant underlying is sufficient for the contract to be a derivative. Note: The conclusion in (a) above may change in the future, as the International
Accounting Standards Board at its February 2007 meeting tentatively agreed to delete the exclusion in the definition of a derivative for contracts that are linked to a non-financial variable that is specific to a party to the contract.
held for trading.

Any financial asset can be classified as available-for-sale at the date of
17 Points for preparers to consider

For existing IFRS preparers - points to consider:
When IAS 39 is first applied, an undertaking is allowed to classify any of its
transition and any financial asset or liability can be designated as at fair value through profit and loss.
18 Questions and Answers on Recognition and Classification

1 Unconditional receivables/(payables)
Initial
How are the following assets and financial liabilities recorded?

financial assets as at fair value through profit or loss or as available-for-sale and any of its financial liabilities as at fair value through profit and loss provided that the assets and liabilities meet the criteria for such designation. There are detailed requirements concerning the transition to the use of the fair value option in IAS 39.
The definition of loans and receivables has been expanded to include loans
Recorded as assets (or liabilities) when the undertaking becomes a party to the contract and has a right to receive (or obligation to pay) cash. 2 Assets to be acquired/(liabilities to be incurred) as a result of a firm commitment to purchase (or sell) goods or services. These are not recorded until at least one of the parties has performed under the agreement such that it is entitled to receive (or obligated to give) an asset. For example, an undertaking that receives a firm order does not record an asset (and the undertaking that places the order does not record a liability) at the time of the commitment but delays recognition until the goods or services have been shipped, delivered or rendered. 3 Planned future transactions The undertaking has not become a party to a contract requiring future receipt (or delivery) of assets arising out of future transactions, as at the financial reporting date. No matter how likely this is to happen these are not assets and liabilities of an undertaking. 4 Derivatives An undertaking must record all of its contractual rights (or obligations) under derivatives in its balance sheet as assets (or liabilities). Examples:
purchased by the undertaking, but debt instruments are excluded if they are quoted in an active market.
For first-time adopters - points to consider:

On first-time adoption, an undertaking will classify all its financial assets in
accordance with IAS 39, irrespective of their classification under local GAAP.
A financial asset can be classified as a held-to-maturity investment if (1)
there is, at the date of transition, a positive intent and ability to hold it to maturity and (2) the asset does not meet the criteria for classification as loans and receivables.
A financial asset can be classified as loans and receivables if it meets the
definition when the undertaking first applies IAS 39.

A non-derivative financial asset (or liability) must be classified as trading if
the asset (or liability) was acquired or incurred principally for the purpose of selling or repurchasing it in the near term or is, at the date of transition, part of a portfolio of identified financial instruments which are managed together, and for which there is evidence of a recent actual pattern of short-term profittaking.
Derivatives not designated as hedging instruments must be classified as
- forward contracts-recorded as assets (or liabilities) on the date that the contract is written or is effective, rather than the closing date on which the exchange actually takes place. - financial options-recognised as assets (or liabilities) when the holder or writer becomes a party to the contract.
19 Annex 1 - IAS 32 - Frequently Asked Questions

- What is meant by contractual obligation? _ IFRS News July 2007 Question 1 Legal/statutory obligation to pay dividends Does a legal/statutory obligation (an obligation as result of the operation of law) to pay dividends meet the definition of a contractual obligation in IAS 32? Answer 1 No. A financial liability arises from the existence of a contractual obligation of one party to the financial instrument (the issuer) to deliver cash or another financial asset to the other party (the holder) (IAS 32). An obligation established from local law or statute is not contractual; it does not therefore create a contractual obligation as required by the definition of a financial liability. Question 2 Preference share linkers that link to an ordinary share with a legal/statutory right to pay dividends An entity has issued ordinary shares that have a legal/statutory requirement to pay dividends. The entity has also issued a second class of shares (for example, preference shares) with a fixed dividend that is required to be paid in the event a dividend is paid on the entitys ordinary shares (a dividend pusher). Does the legal/statutory obligation to pay a dividend on the ordinary share create an indirect contractual obligation to pay the dividend on the preference shares? Answer 2 Yes. The preference share is classified as a liability. This is based on the fact that the entity has no ability to avoid paying a dividend of the preference shares, as it has a contractual obligation to do so when it is legally/statutorily obliged to make a dividend payment on its ordinary shares. Question 3 In IAS 32.25 what is meant by liquidation? What does the term liquidation mean in IAS 32.25? Should liquidation be interpreted more broadly to include all kinds of insolvency proceedings (such as receivership, administration etc) that might (or might not) result when the entity is no longer a going concern?
Answer 3 No. The term liquidation means only the winding up of the entity. If the terms of an instrument state that it is mandatorily redeemable upon the event of insolvency proceedings, such that the entity became obliged to repay it irrespective of whether the insolvency leads to liquidation, these terms do not meet the exception in IAS 32.25(b); the instrument is therefore classified as a financial liability. Question 4 Is a change in control event within the control of either party to the contract? A contract between Company A and a third party contains a requirement for Company A to make payments to the third party on a change of control of Company A for example, Company A being taken over by Company B (where Company B is not connected to Company A). Is such a change of control outside the control of either party to the contract for the purposes of IAS 32.25, such that the contract is a liability (given a change of control is both uncertain and genuine)? Answer 4 Yes. A change in control is outside the control of both the entity and the counterparty provided that it need not be agreed by the entity in a general meeting. This will be the case if a purchaser could approach individual shareholders and buy their shares. Payments that are contingent on a change of control are therefore liabilities when no agreement by a general meeting is required. Question 5 Is an IPO event within the control of either party to the contract? An undated cumulative convertible bond, whose interest payments are at the discretion of the entity absent an Initial Public Offering (IPO), contains a clause that states that the instrument (including all unpaid cumulative interest) will become mandatorily payable if there is not an IPO. Given the IPO event is both uncertain and genuine, does it also meet the criterion of being outside the control of both issuer and holder, thus making it a contingent settlement event in accordance with IAS 32.25? Answer 5 Yes. It may be within the entitys control to determine whether the IPO is
attempted, but market and regulatory forces determine whether any attempt is successful (ie, whether the market will accept an IPO and whether all regulatory approvals will be obtained). These forces are beyond the control of the entity. Redemption upon an IPO event not occurring therefore meets the definition of a contingent settlement event and results in the bond being classified as a financial liability. Question 6 Shares with an obligation to pay out a percentage of profits Is a financial instrument that includes an obligation to pay out a fixed percentage of profits (10% of profits) and is mandatorily redeemable at par after 20 years a financial liability of the issuer? If so, how is it measured? Answer 6 Yes. The instrument has two liability components, a contractual obligation to redeem the instrument at par after 20 years and a contractual obligation to pay 10% of profits until redemption. The latter is a financial liability because, although the payment depends on the entity making profits, future profits are outside the control of both the issuer and holder, and if profits are made, the issuer cannot avoid making the payment (IAS 32.25). The 10% obligation does not meet the definition of an embedded derivative, as the entitys profit is a non-financial variable that is specific to a party to the contract. See Question 8. Note: this view may change. The IASB at its February 2007 meeting tentatively agreed to delete the exclusion in the definition of a derivative for contracts that are linked to a nonfinancial variable that is specific to a party to the contract, with the effect that only those contracts that meet the definition of insurance contracts would fail to be treated as derivatives. The instrument is initially measured at fair value and subsequently at amortised cost in accordance with IAS 39.47, unless it can be and is designated as at FVTPL. Question 7 Legal obligation to launch a takeover bid An entity acquires a significant stake in a listed company. The entity is obliged by local law to launch a takeover bid for the remaining shares.
Does this obligation result in a liability for the present value of the exercise price under IAS 32.23 (in the same way as a put option written to a minority interest)? Answer 7 No. A financial liability arises from the existence of a contractual obligation of one party to the financial instrument (the issuer) to deliver cash to the other party (the holder) (IAS 32.17). A statutory requirement to launch a takeover bid is a legal obligation not a contractual obligation; no liability is therefore recognised. Linkage of two or more contracts - IFRS News September 2007 Question 1 Linked transactions Where an entity issues two or more instruments at (or nearly at) the same time to the same counterparty, are these instruments considered as linked and viewed as a single instrument, or as two separate contracts? Answer 1 The indicators outlined in IAS 39.AG51(e) and IAS 39.IGB.6 must be considered when determining whether the contracts are linked and viewed as a single arrangement or as two separate contracts. Indicators that the contracts are linked include: they are entered into at the same time and in contemplation to one another; they have the same counterparty; they relate to the same risk; there is no apparent economic need or substantive business purpose for structuring the transaction separately that would not also have been accomplished in a single transaction; and they cannot be transferred or redeemed separately (IAS 39.10) Reclassification between debt and equity Question 2 Settlement of a financial liability with a new equity instrument A company exchanges its existing debt instruments for equity shares through renegotiations with their holders to reduce an excessive interest burden. How is the exchange accounted for?
Option 1: the accounting treatment is the same as where an existing convertible debt is converted into shares that is, the carrying amount of the existing debt instrument is transferred to equity and no gain or loss arises on the conversion (IAS32.AG32); or Option 2: the exchange of an existing debt instrument of the issuer with new equity instruments is, in substance, an extinguishment of the existing financial liability. The original debt instrument is therefore derecognised in accordance with IAS 39.39; the new equity instruments issued are recognised at fair value, with the difference between this amount and the carrying amount of the derecognised financial liability recognised as a gain or loss in profit or loss in accordance with IAS 39.41. Answer 2 Either treatment is acceptable. IAS 32 does not specifically deal with a transfer from debt to equity; the issuer can therefore choose either Option 1 or Option 2. This is an accounting policy choice. The chosen treatment is therefore applied on a consistent basis. Question 3 How should a transfer from equity to debt be accounted for when the transfer is a result of a change in contractual terms? A company has in issue a perpetual debt instrument that is classified as equity, as the company has the discretion not to make any payments. The company changes the contractual terms of the instrument subsequent to its issue in such a way that the instrument is now classified as debt. This might be achieved, for example, through changing the terms to require the coupon to be paid on the occurrence of a genuine contingent settlement event. Can the transfer from equity to debt be accounted for as a continuation of an existing instrument that is, the carrying amount of the instrument is transferred to liabilities with no gain or loss being recognised? Answer 3 No. The IFRIC issued rejection wording in November 2006 that clarified that a financial liability is initially recognised at the time when the contractual terms
are changed, irrespective of whether the change affects cash flows under the contract. The new liability is measured at its fair value in accordance with IAS 39.43. The IFRIC also observed that the change in the terms of the instrument gave rise to derecognition of the original equity instrument. IAS 32.33 states that no gain or loss is recognised in profit or loss on the purchase, sale, issue or cancellation of an entitys own equity instrument. The difference between the carrying amount of the equity instrument and the fair value of the newly recognised financial liability is recognised in equity at the time when the terms are changed. This applies even if the change has no impact on the expected cash flows of the instrument. Separation of a compound instrument into its components Question 4 Convertible debt with embedded puts and calls A company issues a convertible debt instrument that contains both an equity conversion option and embedded written puts and purchased calls. The debt component is initially measured at the fair value of a vanilla debt with the same contractual maturity, plus the value of the written puts less value of the purchased calls, in accordance with IAS 32.31 and as illustrated in IAS 32. IE37 and IE38 (example 10). If the puts and calls are not required to be separated from the debt host, are they taken into account when determining the expected life of the debt component and hence its effective interest rate? Answer 4 Yes. The debt component is measured at amortised cost using the effective interest rate method as defined in IAS 39.9. The puts and calls are considered in determining the expected future life of the instrument and therefore the expected interest rate. Other issues Question 5 Issue costs Company A incurs IPO costs that relate to both newly issued shares and the listing of existing shares. Can all the costs be recognised in equity?
Answer 5 No. Transaction costs that relate jointly to more than one transaction (for example, costs of a concurrent offering of some shares and a stock exchange listing of other shares) are allocated to those transactions using a basis of allocation that is rational and consistent with similar transactions (IAS 32.38). Only the costs associated with the listing of the new shares and not those attributed to the existing shares are recognised in equity. Company A allocates the IPO costs between the new shares and the existing shares. Where a cost relates to both the newly issued shares and the listing of existing shares, the allocation is made using a rational and consistent method. If costs (such as an underwriting fee) relate solely to the issue of new shares, they are accounted for as a deduction in equity if they are incremental and directly attributable to the issue of new shares. The costs allocated to the listing of existing shares are expensed in profit or loss. Question 6 Do marketing costs meet the definition of equity issue costs? Company A undergoes an IPO that includes the issue of new shares. The costs include costs for marketing the IPO, including the road show. Are all these costs incremental and directly attributable to the issue of new shares? Answer 6 Generally, no. These costs must be directly attributable to the shares being issued in order to meet the definition of transaction costs (IAS 39.9 and IAS 39.AG13). Marketing costs relate to the marketing of the entity itself. Therefore, in most situations, these costs do not meet the definition of directly attributable and are expensed through profit or loss. Question 7 Partly paid instruments discretionary call dates A company that is currently in an expansion phase issues some partly paid shares in November 20X5. A call to further pay up the partly paid shares may be made by the issuer on or after 1 January 20X6. Is the element of share capital not yet called recognised in the balance sheet
at the date the partly paid shares are initially issued together with a receivable? Answer 7 No. If the call for further monies may be made by the issuer at a future point in time at its discretion, this element of share capital is not recognised in the balance sheet and no receivable is recognised until the call is made. A receivable is only recognised when it meets the definition of a financial asset that is, the issuer has a contractual right to receive cash from the shareholder. The past event of issuing the partly paid shares gives the company the right to make future calls, but there is no contractual right to force the issuer to make the calls and there is no contractual obligation on the shareholder to deliver cash until the call is made; it cannot therefore be a financial asset of the issuer, as it is not a financial liability of the other party. The issue of partly paid shares and calls for further payment may be subject to legislation; due regard must also be paid to the requirements of the law under which the company is incorporated. Question 8 Partly paid instruments fixed call dates A company that is currently in an expansion phase issues some partly paid shares. The share agreement contains a fixed schedule of definite call dates that the company and the shareholders have no ability to avoid. Is the element of share capital not yet called recognised in the balance sheet at the date the partly paid shares are initially issued together with a receivable? Answer 8 It depends. It will be a matter of law of the territory in which the company is incorporated as to whether such a schedule of calls has the effect that the calls are legally obliged to be made. If the shares are deemed to be called and paid up that is, where the effect is that the shareholder is legally obliged to make payments as a result of the agreement and the fixed schedule of payments a receivable is recognised for the outstanding proceeds of issue. This receivable is measured at fair value on initial recognition and subsequently at amortised cost in accordance with IAS 39 (unless designated
as at FVTPL). The amortised cost will be calculated using an effective interest rate such that the receivable is measured at the net present value of the future receipts. The guidance in Question 8 applies if the instrument is not deemed to be called and paid up. Question 9 Short sales of own equity Bank A trades in its own equity securities. This includes short sales where the bank borrows its own equity securities from others and therefore has an obligation to buy back shares from the market to deliver to third parties. The bank operates in a jurisdiction where short sales in its own equity securities are legal. Are these trades recognised in equity or as trading liabilities under IAS 39 and measured at fair value through profit or loss?
Answer 9 The requirement for own equity transactions in IAS 32.16 is no different for short sales. The trades and any gains and losses on them are recognised in equity in accordance with IAS 32.23. Question 10 Before maturity conversion of a convertible bond with a US conversion option Convertible bonds with a US conversion option are regularly converted before the original maturity date of the loan. 1. To the extent the carrying amount at the date of conversion is not equal to the principal amount converted, is the difference recognised as a gain or loss on conversion? 2. Does the expected life of the host liability that is used to determine its effective interest rate include any expectations of early conversion? Answer 10 1. No. The meaning of maturity in IAS 32.AG32 is any date when a holder converts the bond according to its contractual terms. 2. No. IAS 32.IE9 illustrates the accounting for such a convertible on initial recognition. It illustrates that the early conversion option is a characteristic of
the equity component and not of the host liability, and that the expected life of the liability is determined without considering possible early conversion. The estimated cash flows used to apply the effective interest rate method are therefore the contractual cash flows based on the contractual maturity. Question 11 Own share buy-back programme During certain times of the year (for example, before an entity releases its results), a listed company is prohibited by local listing rules from buying its own shares in the market. The local listing rules may permit other arrangements to be entered into with independent third parties that result in the listed entitys shares being purchased on behalf of the listed company. For example, a listed company has entered into a contract with a bank that mandates the bank to buy the companys shares from the market during the prohibition period. The contract requires the company to buy the shares the bank has purchased immediately after the prohibition period. The number of shares to be bought is not fixed (but depends on the daily turnover of the shares in the market) but is subject to a cap set by the entity so as to meet the companys objective and avoid breaching the listing rules. The shares will be bought by the bank at their market price, and the price that the company will pay the bank is that same market price plus a fee or spread. The contract is structured so that the bank is not acting as an agent for the company, and the bank acts independently in deciding how many shares to buy and on what dates. Does the company have an obligation to acquire its own equity instruments under IAS 32.23? If so, how is this financial liability measured under IAS 39? Answer 11 Yes. The company is contractually obliged to buy the shares the bank has purchased. IAS 32.23 requires the company to recognise a financial liability at the present value of the redemption/repurchase amount. The corresponding debit is to equity under IAS 32.23, as the underlying is the companys own shares. The financial liability is measured on initial recognition based on the maximum number of shares that may be purchased (ie, the cap)
and a best estimate of share price. Subsequent changes in the estimated repurchase amount arising from changes in share price are accounted for in accordance with IAS 39.AG8. However, if the total number of shares actually bought is less than the cap, the difference is accounted for in the same way as an option that expires unexercised by a corresponding reclassification from liabilities to equity. The company must ensure it meets any local listing requirements for notification of such transactions to the relevant regulators. IAS 32 from the issuers perspective - IFRS News June 2007 What is meant by fixed for fixed in the determination of an equity instrument? IAS 32.16. (Extract) When an issuer determines whether a financial instrument is an equity instrument rather than a financial liability, the instrument is an equity instrument only if both conditions (a) and (b) below are met. a. i. ii. The instrument includes no contractual obligation: to deliver cash or another financial asset to another entity; or to exchange financial assets or financial liabilities with another entity under conditions that are potentially unfavourable to the issuer. If the instrument will or may be settled in the issuers own equity instruments, it is: a non-derivative that includes no contractual obligation for the issuer to deliver a variable number of its own equity instruments; or
b.
i.
ii. a derivative that will be settled only by the issuer exchanging a fixed amount of cash or another financial asset for a fixed number of its own equity instruments (fixed for fixed). For this purpose the issuers own equity instruments do not include instruments that are themselves contracts for the future receipt or delivery of the issuers own equity instruments.
A contractual obligation, including one arising from a derivative financial instrument, that will or may result in the future receipt or delivery of the issuers own equity instruments, but does not meet conditions (a) and (b) above, is not an equity instrument.
It depends. For the purposes of the groups consolidated accounts, a group must look to either the functional currency of the parent (whose shares the bond is convertible into), or that of the subsidiary (whose liability will be extinguished if the bond is converted). The choice to look to the functional currency of the subsidiary or the parent is a policy choice and must be applied on a consistent basis for all similar instruments. IFRIC considered this issue (November 2006) and decided to give no guidance. In the individual financial statements of the subsidiary, the convertible is classified completely as a financial liability, as the conversion option relates to the shares of the parent and not the equity of the subsidiary. In the individual financial statements of the subsidiary, under IAS 39 the conversion option is an embedded derivative that must be separated, as it is not closely related to the debt host. Question 3 Bermudian options with fixed but different strike prices An entity issues an option to buy or sell a fixed number of shares at a specified exercise price. The terms of the option state that the specified exercise price varies with the share price of the entity such that: Share price Conversion ratio 0-10 CU 10 shares at 1 CU per share 11-20 CU 10 shares at 1.50 CU per share Does this breach the fixed for fixed settlement requirements in IAS 32.16b(ii)? Answer 3
Question 1 - Foreign currency convertible bonds If a convertible bond is issued in a currency that is not the functional currency of the issuer, does this violate the fixed for fixed requirement in IAS 32. 16b(ii)? Answer 1 Yes. The IFRIC clarified that a convertible bond issued out of a single entity that is denominated in a foreign currency has no equity component (that is, it is a liability with an embedded derivative). This is because the fixed amount of the foreign currency bond that will be extinguished if the holder converts represents a variable amount of cash in the functional currency of the issuer. It therefore fails the fixed for fixed requirement and precludes the conversion option being classified as equity. The whole of the convertible bond is classified as a financial liability under IAS 32 and is subject to IAS 39 for recognition and measurement. Under IAS 39, the convertible bond is assessed as having a host debt instrument and an embedded foreign exchange equity derivative. The latter is not closely related to the debt host so will need to be separated if the debt host is carried at amortised cost. Question 2 Foreign currency convertible bonds issued by the subsidiary convertible into the shares of the parent A subsidiary issues a convertible bond that (if converted) converts into shares of the parent, where the subsidiary and parent have different functional currencies. Which currency must be looked to in the groups consolidated financial statements when determining whether the fixed for fixed requirement in IAS 32 is met? Answer 2
Yes. The variability in the exercise price, as a function of the share price of the entity, results in a variable amount of cash for a fixed number of shares. The fixed for fixed requirement is therefore violated. The option is therefore a derivative and not an equity instrument. Question 4 Change in conversion ratio upon a bonus issue A convertible bonds provides for a change to the conversion ratio upon a bonus issue of the issuers ordinary shares for nil consideration.
Does this bonus issue adjustment violate the fixed for fixed requirement in IAS 32.16b(ii)? Answer 4 No. Where the adjustment to the conversion ratio merely preserves the rights of the convertible bondholders relative to ordinary shareholders ie, it maintains their relative ownership interests the adjustment would not violate the fixed for fixed requirement. Question 5 Change in conversion ratio upon a rights issue A convertible bond provides for a change to the conversion ratio upon a rights issue. Does an adjustment for a rights issue violate the fixed for fixed requirement in IAS 32.16b(ii)? Answer 5 It depends. A rights issue is typically made up of two components: a bonus issue of nil paid ordinary shares, and the issue of new ordinary shares at market price. An adjustment for the bonus issue component of a rights issue preserves the relative rights of the convertible bondholders relative to the ordinary shareholders (see Question 4). An adjustment for this bonus issue component does not therefore violate the fixed for fixed requirement. However, an adjustment for the second component the issue of new ordinary shares at market price does not preserve the economic position of the convertible bondholders and the ordinary shareholders relative to each other. An adjustment for this new share issue component does not therefore meet the fixed for fixed requirement. Question 6 Change in conversion ratio upon a dividend payment A convertible bond contains a clause that adjusts the conversion price for dividends paid. Does this violate the fixed for fixed requirement in IAS 32.16b(ii)? Answer 6 It depends. Generally the conversion price of a convertible bond is initially set with the presumption that an anticipated level of dividend will be paid each year. An adjustment to the conversion price based upon payment of that dividend
would violate the fixed for fixed requirement as the relative economic rights of the convertible bondholders and the ordinary shareholders would not be preserved ie, it would change the capital structure. However an adjustment to the conversion ratio for a dividend in excess of the anticipated level for example a special dividend that is effectively a return of capital that is a proportional reduction of all ordinary shares is unlikely to violate the fixed for fixed requirement. Such an adjustment would be viewed as preserving the relative economic rights of the convertible bondholders and the ordinary shareholders. Question 7 Contracts to exchange a fixed number of equity instruments for a specified minority interest An entity issues an option that allows the holders to exchange a fixed number of one kind of the entitys own equity for a fixed number of a different kind of equity. An example is an option for a minority shareholder to exchange its holding of shares in a subsidiary for a fixed number of equity shares in the parent. Is a contract to exchange one type of equity for another type of equity classified as equity under IAS 32? Answer 7 Yes. From the perspective of the group in preparing its consolidated accounts, the option is to exchange a fixed amount of one type of equity for a fixed amount of another type of equity. The fixed for fixed requirement in IAS 32.16(b)(ii) does not cover this; it only deals with contracts to exchange equity for financial assets. Both legs of the contract are a fixed number of shares, and in both cases the shares are a residual interest in some or all of the entity (ie, are equity). The contract does not violate the part of the definition of a financial liability in IAS 32.11(b)(i) because, although it is a non-derivative contract, it does not oblige the entity to deliver a variable number of its own equity instruments. The entity is not therefore using its own equity instruments as currency. From the perspective of the parent in preparing its separate financial statements, the contract is a derivative (as it is over an asset investment in subsidiary) rather than an equity instrument.
Company A? Question 8 Contingent conversion bond Company A issues a contingently convertible bond; the debt host becomes convertible into common shares of A at a fixed ratio of 1:1.25 only if the contingent event occurs. The contingent event meets the definition of a contingent settlement event in accordance with IAS 32.25 and is genuine for example, a change in control event (see Question B.4). There are no adjustments to the conversion ratio upon the contingent event occurring, and there are no other put or call options. Is the conversion option an equity component, as it meets the fixed for fixed criteria, even though it can only be exercised based on the occurrence of a contingent event? Answer 8 Yes. The instrument is first separated into its component parts, namely a debt host and equity conversion option. The fact that the option is only contingently convertible will not cause liability classification of the conversion option under IAS 32.25 provided that, upon occurrence of the contingent event, it would be settled in such a way as to require classification as equity. If the contingent event were to occur in the example above, the conversion to own shares would still satisfy the fixed for fixed requirement in IAS 32.16(b)(ii). The conversion option would be classified as an equity component, and the entire instrument would be a compound financial instrument. Question 9 Call options where the underlying is an exchange ratio Companies A, B and X are listed companies. Company A purchases an option to buy 5% of the share capital of Company X from Company B, in return for Company A delivering its own equity shares to Company B. The exchange ratio is fixed when the option is written (for example, Company A pays B 0.8 of As own shares for the purchase of 1 share of Company X). Does the option violate the fixed for fixed requirement in IAS 32.16(b)(ii) for Answer 9 Yes. The exchange ratio is not fixed for fixed. The fixed number of Company As shares that Company A may issue is not equal to a fixed amount of cash, as the value of each share acquired in exchange can vary. Company A must treat its purchased option as a derivative instrument under IAS 39. Question 10 Written warrant to buy a fixed percentage of fully diluted share capital at a fixed price per share Company A writes a call option over its own ordinary shares to Bank B. The option grants Bank B the right to subscribe for 2.5% of the fully diluted ordinary share capital of Company A at a fixed price per share. The amount of the fully diluted ordinary share capital is unknown. Is the written call option over Company As own shares considered an equity instrument in the hands of Company A? Answer 10 Yes, as long as the price for one share is fixed and any variation in the number of shares preserves the relative economic rights of the various shareholders. It makes no difference if the contract grants the right to an absolute number of ordinary shares or a percentage of the diluted ordinary share capital, as long as the price for one share is fixed. The above contract does represent an exchange of a fixed amount of cash for a fixed number of shares (as per share the price is fixed). The fixed for fixed requirement is met and the option is an equity instrument of Company A provided that the cash to be paid by Bank B is always the result of multiplying the number of ordinary shares issued by Company A by the fixed price per share stipulated in the contract and the option holders proportionate interest in the company is preserved. If the cash amount to be paid by Bank B is constant in absolute terms and does not change proportionately with changes in the number of shares to be issued, the contract fails the fixed for fixed requirement. The option is not an equity instrument of Company A. This is because the price per share is not fixed. Other adjustments to the price per share fail the fixed for fixed requirement unless they preserve the relative economic rights of the various shareholders.
For example, an adjustment to the amount of cash that Bank B has to pay to reflect an issue of new ordinary shares by Company A for cash fail the fixed for fixed requirement. Question 11 Instruments that are settled in a variable number of shares but subject to a cap An entity issues an instrument that is settled in a variable number of shares but is subject to a cap to prevent excessive dilution of the existing shareholders through the issue of new shares. The cap is out of the money on issuance. Given that the host instrument is a liability (as it is settled in a variable number of shares), is the cap an equity instrument, on the grounds that a similar stand-alone cap would be classified as equity? Answer 11 No. The entire instrument is a liability on the grounds that the fixed for fixed requirement in IAS 32.16(b)(ii) is not met for the instrument as a whole (ie, the instrument is settled in a variable number of shares). Question 12 Instruments that are settled in a fixed number of shares except where the share price is in a specific range An entity issues an instrument that is settled in a fixed number of shares except where the share price is in a specified range. Within that range, settlement could be in a variable number of shares to the value of a specified amount, or an adjusted number of shares determined at inception based on a sliding scale. It is unknown at inception whether the share price will be within this range and hence how many shares will be delivered in settlement. Is this instrument a financial liability on the grounds that the fixed for fixed requirement in IAS 32.16(b)(ii) is not met? Answer 12 Yes. The fact that the number of shares varies when the share price is in a specific range means that the fixed for fixed requirement is violated.
20 Annex 2 - Fair value option - frequently asked questions

IFRS News - December 2005 The fair value option, in IAS 39 does not contain detailed prescriptive guidance about when the fair value option can be applied. It uses a principles-based approach, supported by examples. This annex addresses some commonly-asked questions that have arisen from the practical application of these principles. IAS 39 permits the irrevocable designation on initial recognition of a financial asset or financial liability as at fair value through profit or loss (FVTPL) only when the entity demonstrates that it falls within one (or more) of the following three criteria: -designation at FVTPL eliminates or significantly reduces a measurement or recognition inconsistency (sometimes referred to as an accounting mismatch) that would otherwise arise from measuring assets or liabilities or recognising the gains and losses on them on different bases (IAS 39.9(b)(i)); -a group of financial assets, financial liabilities or both is managed and its performance is evaluated on a fair value basis, in accordance with a documented risk management or investment strategy, and information about the group is provided internally on that basis to the entitys key management personnel (as defined in IAS 24 Related Party Disclosures (as revised in 2003)), for example the entitys board of directors and chief executive officer (IAS 39.9(b)(ii)); or -the item proposed to be designated at FVTPL is a hybrid (combined) contract that contains one or more embedded derivatives unless: the embedded derivative(s) does not significantly modify the cash flows that otherwise would be required by the contract; or it is clear with little or no analysis when a similar hybrid (combined) instrument is first considered that separation of the embedded derivative(s) is prohibited (IAS 39.11A). This annex addresses commonly asked questions about each of the above three
criteria in turn. Criterion 1: accounting mismatch (IAS 39.9(b)(i)) Question 1 What is the meaning of significant in the context of eliminates or significantly reduces a measurement or recognition inconsistency? Solution The IASB has not established a percentage, or a bright line, for the interpretation of significant. Management should look at the objective of the proposed designation as at FVTPL. Comparing the accounting impact ie, the measurement basis and the recognition of gains and losses of all relevant items (including, for example, any funding that it is not proposed to be designated at fair value through profit or loss) before and after the designation will give an indication of whether an accounting mismatch has been eliminated or significantly reduced. It is clear from the IAS 39.BC 75B that an effectiveness test similar to that used for hedge accounting is not required to demonstrate that a reduction in an accounting mismatch is significant. Further guidance is given in questions 2 and 3 below. Question 2 An entity is about to originate 100 of fixed rate assets that, if not designated as at FVTPL, will be classified as available-for-sale, and 50 of fixed rate liabilities that, if not designated as at FVTPL, will be measured at amortised cost. The assets and liabilities share the same interest rate risk, as they are at fixed rates. Can the entity designate the entire 100 of assets and 50 of liabilities at FVTPL to significantly reduce the accounting mismatch between them? Solution No. Designating the entire 100 of assets at FVTPL eliminates a mismatch with the 50 of liabilities, but it opens up a new mismatch for the other 50 of assets that
do not have matching liabilities. However, we should ask why the entity wishes to use the fair value option in such a case. For example, is there a pre-existing derivative that offsets the other 50 of assets? Does the entity expect to issue a further 50 of liabilities with no more than a reasonable delay (and designate them at FVTPL) so as to eliminate the mismatch completely? Designation of the entire 100 of assets would be acceptable in such cases. Question 3 An entity is about to issue a 10-year liability that, if not designated as at FVTPL, will be measured at amortised cost, and a nine-year derivative that it regards as related to the liability and whose risks offset those of the asset. The entity wishes to designate the liability as at FVTPL to eliminate the measurement and recognition inconsistency with the derivative. Although the relationship does not completely eliminate the economic exposure, can the entity still designate the liability as at FVTPL? Solution Yes. The difference in maturities does not prevent the entity from designating the liability as at FVTPL, provided there is a perceived economic relationship between the derivative and the liability. The fair value option does not require the elimination of economic volatility; it requires the elimination or significant reduction of an accounting mismatch. The notion of an accounting mismatch between an asset and a liability involves two propositions, as described in IAS 39.BC 75. Firstly, the asset and liability are measured, or the gains and losses are recognised, inconsistently. In the above example, the liability is measured at amortised cost and the derivative is measured at fair value, hence the accounting mismatch. Secondly, there is a perceived economic relationship between the asset and
liability for example, they share a risk that gives rise to opposite changes in fair value that tend to offset. Question 4 An entity is about to issue a nine-year liability that, if not designated as at FVTPL, will be measured at amortised cost, and a 10-year derivative that it regards as related to the liability and whose risks offset those of the asset. The entity designates the liability as at FVTPL to eliminate the measurement and recognition inconsistency that exists for the first nine years. At the start of year 10 (after the liability has been repaid), can the entity designate the derivative as a hedging instrument in a new hedge relationship? Solution Yes, provided the new hedge relationship meets all of the conditions for hedge accounting, including the expectation that it will be highly effective. IAS 39 permits the designation of pre-existing derivatives as hedging instruments. Question 5 A subsidiary is about to issue a liability to a third party and enter into a related interest rate swap with its parent. An accounting mismatch exists in the stand alone accounts of the subsidiary, and it intends to designate the liability as at FVTPL. Can the group similarly designate the liability as at FVTPL in the consolidated accounts? Solution No. The swap cannot be used to designate the liability as at FVTPL in the consolidated accounts. The swap will be eliminated, and the mismatch will not exist in the consolidated financial statements. However, if the entity can identify an external swap or other instrument that gives rise to an accounting mismatch on a consolidated basis, this may justify
designating the liability as at FVTPL in the consolidated accounts. Question 6 It is necessary to demonstrate that there is an accounting mismatch in order to use the fair value option under IAS 39.9(b)(i). What is the extent of evidence that is required? Solution The evidence needs to identify clearly the accounting mismatch for which the fair value option is to be used but, provided it meets this criterion, need not be extensive. It may be possible to use the same evidence for a number of similar transactions, depending on the circumstances for example, by identifying a particular kind of accounting mismatch that arises from one of the entitys chosen risk management strategies. It is not necessary to have the extensive documentation required for hedge accounting, but the entity does need to provide evidence that the fair value option was designated at inception. Also, IAS 32/IFRS 7 require disclosure of the carrying amounts of assets and, separately, liabilities designated as at FVTPL. The evidence must therefore include precise identification of the assets and liabilities to which the fair value option has been applied. Question 7 An accounting mismatch exists on initial recognitio n and the entity applies the fair value option. If subsequently the accounting mismatch ceases to exist, can the entity de-designate the fair value classification and change the measurement to amortised cost? Solution No. The designation is irrevocable. Once designated, the entity cannot change from fair value measurement to amortised cost. Even if one part of the position that gave rise to the accounting mismatch is derecognised (for example, because
it is sold), the remainder of the position must continue to be measured at FVTPL. Question 8 An entity originates a financial asset that is measured at fair value; it simultaneously issues a liability, which the entity considers related, that is measured at amortised cost. Six months later the entity decides it wants to use the fair value option and designate the liability as at FVTPL to reduce the measurement inconsistency. Is the entity permitted to use the fair value option in this case? Solution No. Designation as at FVTPL may be made only on initial recognition. Question 9 The fair value option does not require the entity to enter into all of the assets and liabilities at exactly the same time. A reasonable delay is permitted as long as the remaining transactions are expected to occur (AG 4F). What is meant by reasonable delay? Solution Reasonable delay is assessed on a case-by-case basis, based on what is reasonable in the circumstances of a particular case. For example, a reasonable delay could be a fairly short period in the case of entering into a derivative to offset some of the risks of an asset. A longer period could be justified if the delay arises from the need to assemble a portfolio of similar assets and arrange their funding. However, all financial assets and liabilities designated as at FVTPL must be accounted for on this basis from their initial recognition (and not only from the time any offsetting position is entered into). Question 10
Some entities may consider using the fair value option in place of fair value hedge accounting to overcome measurement or recognition inconsistencies. If the entity were to use fair value hedge accounting (for example, for a hedge of the interest rate risk on a fixed rate loan), it would adjust the carrying amount of the hedged item (the loan) for only changes in its fair value that are attributable to the hedged risk (interest rate risk). If the entity chooses the fair value option, can it similarly adjust the carrying amount of the designated item (the loan) only for changes in its fair value that are attributable to one risk (for example, interest rate risk)? Solution No. When the fair value option is used, the designated financial asset or financial liability is measured at full fair value, and the entire change in its fair value is recognised in the income statement. The instrument cannot be split into different portions or components of risk only some of which are measured at fair value. Using the fair value option may not therefore have the same effect as using fair value hedge accounting. The two accounting treatments will have the same effect only when: the hedge relationship covers the entire change in fair value and is not limited to selected risks; hedge accounting is applied from the initial recognition of the hedged item; and hedge accounting continues until the hedged item is derecognised.
Question 11 Should all financial assets and financial liabilities in a portfolio giving rise to the measurement or recognition inconsistency be designated as at FVTPL, or can only some of the financial assets and liabilities in the portfolio be so designated? For example, an entity is about to originate 50 of assets and issue 100 of liabilities, all of approximately equal amount. Can it designate 25 of the assets
and all 100 of the liabilities, assuming that a measurement inconsistency exists? Solution The entity can choose some assets or liabilities, provided doing so reduces the measurement or recognition inconsistency, as explained in IAS 39.AG 4G: It would not be acceptable to designate only some of the financial assets and liabilities giving rise to the inconsistency as at FVTPL if to do so would not eliminate or significantly reduce the inconsistency... The fair value option would not be permitted, as the designation of 25 of the assets and all 100 of the liabilities creates an additional accounting mismatch. However, if the entity wanted to designate, say, 25 of the assets and 25 of the liabilities, this would be acceptable. An entity may wish to designate some but not all of the financial assets and financial liabilities as at FVTPL for a number of reasons. For example, it might want to designate only those items that do not have significant credit risk. Or it might want to take into account future funding plans for a portfolio of assets that will affect the extent of the accounting mismatch. Criterion 2: managed on a fair value basis (IAS 39.9(b)(ii)) The criterion in IAS 39.9(b)(ii) can be analysed in three parts: a group of financial assets, financial liabilities or both is managed and its performance is evaluated on a fair value basis; in accordance with a documented risk management or investment strategy; and information about the group is provided internally on that basis to the entitys key management personnel.
Question 12 If entities are managing a portfolio using value at risk (VaR), is this sufficient to meet the requirement that it is managed and its performance is evaluated on a fair value basis? Similarly, if a mutual fund or similar entity regularly publishes the fair value of the net assets in the fund, is this sufficient to meet the requirement? Solution No. VaR is a risk management technique. The portfolios performance, however, is not evaluated on a fair value basis. Managing a portfolio using VaR is not therefore sufficient to meet the criterion in IAS 39.9(b)(ii). Similarly, merely publishing fair value information is not sufficient; the assets should be evaluated and managed on a fair value basis. Question 13 Does management need to be evaluating a portfolio on a full fair value basis or can it evaluate on a risk-by-risk basis? For example, an entity originates fixed interest rate loans and manages the interest rate risk of this portfolio based on the fair value attributable only to interest rate changes. Solution Management should evaluate the portfolio on a full fair value basis. The fair value concept is a broader notion than hedge accounting, such that evaluating the performance of the portfolio for only some risks is not sufficient. If an entitys risk management policy and the resulting management information looks at changes in fair value for only some risks rather than the entire change in fair value, this will not be sufficient to justify use of the fair value option. Question 14
(1) A group of financial assets, financial liabilities or both is managed and its performance is evaluated on a fair value basis
IAS 39.AG4I gives examples of the application of IAS 39.9(b)(ii). AG4I(a) deals with venture capital organisations, as follows:
The entity is a venture capital organisation, mutual fund, unit trust or similar entity whose business is investing in financial assets with a view to profiting from their total return in the form of interest or dividends and changes in fair value. IAS 28 Investments in Associates and IAS 31 Interests in Joint Ventures allow such investments to be excluded from their scope provided they are measured at fair value through profit or loss. An entity may apply the same accounting policy to other investments managed on a total return basis but over which its influence is insufficient for them to be within the scope of IAS 28 or IAS 31. IAS 39.AG4J states that: an entity that designates financial instruments as at fair value through profit or loss on the basis of this condition shall so designate all eligible financial instruments that are managed and evaluated together [emphasis added] If a venture capital organisation chooses the IAS 28 exemption by designating its investment in associates as at FVTPL, should the venture capital organisation also designate at FVTPL its other investments (over which it has insufficient influence for them to qualify as associates) that are managed on a total return basis as part of the same portfolio? Solution Yes, if an entity chooses the fair value option, it must be applied to all the financial instruments that are managed and evaluated together. However, the entity need not apply the fair value option to other portfolios if it manages and evaluates investments in associates to which the IAS 28 exemption is applied as a separate portfolio. (2) In accordance with a documented risk management or investment strategy Question 15 What extent of documentation is required to qualify as a documented risk management or investment strategy? Is reference to a documented risk
management strategy relating to other issues permitted? Solution The documentation does not need to be as extensive as is required for hedge accounting and may be on a portfolio basis rather than item by item. However, the documentation needs to identify clearly the items for which the fair value option is to be used. If the documentation relies on several other pre-existing documents, there needs to be an overall document that references these other documents and clearly demonstrates that the entity manages and evaluates the relevant financial assets or financial liabilities on a fair value basis. The documentation also needs to be sufficient for the entity to meet the requirement in IAS 32.66(d)(ii) to disclose how the designation as at FVTPL is consistent with the entitys documented risk management strategy. (3) Information about the group is provided internally on that basis to the entitys key management personnel Question 16 What is meant by key management personnel? Does it imply that all of the entitys key management personnel should be provided with the information? Solution The term key management personnel in IAS 39 has the same meaning as in the definition in IAS 24, Related Party Disclosures. That is: Key management personnel are those persons having authority and responsibility for planning, directing and controlling the activities of the entity, directly or indirectly, including any director (whether executive or otherwise) of the entity (IAS 24.9). It is acceptable for some and not all of key management to be provided with the required information about a group of financial assets/liabilities that is managed on a fair value basis.
Question 17 Can information provided to a subsidiarys key management personnel enable the fair value option to be used at the group level if the other requirements in IAS 39.9(b)(ii) are met? Solution It depends. Information provided to a subsidiarys key management personnel alone is not enough to enable the fair value option to be used at the group level. However, if those management personnel also include key management of the group such as a main board director who is included in the IAS 24 disclosures given in consolidated financial statements the fair value option could be used. The information could alternatively be reported separately (for example, in a summary report) to key management personnel of the group and therefore meet the IAS 39criteria. Even if these conditions are not met, information provided to a subsidiarys key management personnel can enable the fair value option to be used at the subsidiary level provided the other requirements in IAS 39.9(b)(ii) are met. Criterion 3: embedded derivatives (IAS 39.11A) Question 18 Is there an established percentage for the interpretation of significantly modify? Solution No. There is no bright-line test. Management needs to look at the substance and objective of the transaction. Question 19 For which of the following hybrid products that contain embedded derivatives is the use of the fair value option not permitted? -Prepayment options in mortgages;
-Interest rate caps and floors in floating rate loans; -Extension options; -Embedded foreign currency derivatives; -An embedded derivative whose underlying might be a non-financial variable that is specific to a party to the contract. Solution This question should be answered on a case-by-case assessment. If management and auditors with a reasonable knowledge and understanding of the requirements of IAS 39 are not sure whether an embedded derivative is required to be separated from the host contract, it is not apparent with little or no analysis whether separation is required, and the fair value option is permitted. The subject of this annex is the accounting requirements of the fair value option set out in IAS 39. Banks and their auditors should also be aware of the regulatory guidance that is being developed by the regulators on the use of the fair value option by banks. For further information, refer to the draft guidance prepared by the Basel Committee: Supervisory guidance on the use of the fair value option by banks under International Financial Reporting Standards, issued in July 2005.
21 Annex 3 Puttable Instruments Detailed rules

Scope The amendment addresses the classification of certain: (a) puttable financial instruments (for example, some shares issued by cooperatives); and (b) instruments, or components of instruments, that impose on the entity an obligation to deliver to another party a pro rata shares of the net assets of the entity only on liquidation (for example, some shares issued by limited life entities).
The amendment is very restrictive in scope as the puttable instruments and finite life entities need to meet very precise criteria to be within the scope. The amendment should not be used by analogy and furthermore, the classification of instruments under this exception should be restricted to the accounting for such an instrument under IAS 32, IAS 39, IFRS 7 and IAS 1, The instruments should not be considered an equity instrument under other guidance, for example, IFRS 2, 'Share-based payments'.
3 All instruments in the class of instruments that is subordinate to all other classes of instruments must have identical features. Examples are that they must all be puttable, and the formula or other method used to calculate the redemption price must be the same. (IAS 32 para 16A9c)). 4 The instrument must not include other features that would make it a financial liability. For example, there must be no other contractual obligation to deliver cash or settle in the entity's own equity instruments for a variable amount of cash and/or own equity. (IAS 32 para 16A(d)). 5 The total expected cash flows attributable to the instrument over the life of the instrument are based substantially on the profit or loss, the change in the recognised net assets or the change in the fair value of the recognised and unrecognised net assets of the entity over the life of the instrument. (IAS 32 para 16A (e)). Profit or loss and the change in the recognised net assets should be measured in accordance with the relevant IFRSs. In certain situations the holder of a puttable instrument may enter into transactions with the entity in a role other than that of an owner, for example, when a general partner is remunerated for providing a guarantee to the entity. Another example is where rebates are provided to instrument holders and the amounts of these are based on their services rendered or business generated during the current and previous years. It is important to note that the cash flows and contractual terms and conditions of a transaction between the instrument holder in the role as a non-owner and the issuing entity must be similar to an equivalent transaction that might occur between a non-instrument holder and the issuing entity ie at arms length. 6 The issuer must have no other financial instrument or contract that substantially restricts or fixes the residual return to the puttable instrument holder (IAS 32 para 16B). Instruments or components of instruments, that imposes on the entity an obligation to deliver to another party a pro rata share of net assets of the entity only on liquidation.
Puttable instruments A puttable financial instrument will be within the scope of the amendment and, therefore, be classified as an equity instrument if it has all of the following features: 1 Entitles holder to a pro rata share of the entities net assets in the event of the entity's liquidation. A pro rata share is determined by dividing the entity's net assets on liquidation into units of equal amounts and multiplying that amount by the number of the units held by the financial instrument holder (IAS 32 para 16A(a)). 2 The instrument is in the class of instrument that is subordinate to other classes of instruments. To be within this class the instrument must have no priority over other claims to the assets of the entity on liquation and does not need to be converted into another instrument before it is in the class of instruments that is the most subordinated (IAS 32 paragraph 16A(b)). For example, this is a common feature of investment funds where there is often a small class of management shares that are subordinated to the external financing that is in the form of puttable instruments. Because of the requirement to be the most subordinated, the bulk of the shares of these funds (the external financing) are not in the scope of the amendment. There is no materiality concept associated with the most subordinated class.
Some financial instruments include a contractual obligation for the issuing entity to deliver to the holder a pro rata share of its net assets on liquidation. In certain circumstances liquidation of an entity is certain to occur and outside the control of the entity (such as finitie life entities) or is uncertain to occur but at the option of the instrument holder. As an exception to the definition of a financial liability in IAS 32, an instrument that includes such an obligation is classified as equity if it meets criteria 1, 2, 3 and 6 above. Impact on consolidation Instruments issued by a subsidiary that meet the criteria outlined above and therefore are within the scope of the amendment at a separate or individual financial statement level, are not considered to be the most subordinated class from the group perspective (IAS 32). Consequently, instruments classified as equity instruments in accordance with the amendment in the separate or individual financial statements that are noncontrolling interests are classified as liabilities in the consolidated financial statements of the group. Reclassification Instruments will be in the scope of the amendment from the date when the instrument has all the features and meets the criteria set out above (criteria 1 to 7 for puttable instruments and criteria 1, 2, 3 and 6 for finite life entities). An entity should reclassify a financial instrument when appropriate as follows: Reclassify an equity instrument to a financial liability from the date the instrument ceases to have all the features required by the amendment. The financial liability is measured at the instrument's fair value at the date of reclassification. Any difference between the carrying value of the equity instrument and fair value of the liability on the date of reclassification should be recognised in equity. Reclassify a financial liability as equity from the date the instrument has all the features required by the amendment. The equity instrument should be measured at the carrying value of the financial liability at the date of reclassification.
Disclosures on puttables classified as equity instruments For puttable instrument classified as equity instruments as a result of applying the amendment, an entity should disclose: summary quantitative date about the amount classified as equity; its objective, policies and processes for managing its obligation to repurchase or redeem the instruments when required to do so by the instruments holders, including changes from previous period; the expected cash outflow on redemption or repurchase of that class of financial instruments; and information about how the expected cash outflow on redemption or repurchase was determined. An entity shall disclose if it is a limited life entity, including information regarding the length of its life. Where an entity has reclassified a puttable instrument or finite life entity between financial liabilities and equity, it should disclose the amount reclassified into and out of each category and the timing and reason for the reclassification.
22
Multiple choice questions
1. When the cost of a derivative is often nil or immaterial, the solution is to value it at:
1. Historic cost. 2. Discounted replacement cost. 3. Fair value.
2. To which companies do the standards apply?

1. Listed companies. 2. All companies reporting under IFRS. 3. Banks.
3. The standards apply to all financial instruments including:

1. Interests in subsidiaries, associates and joint ventures, and postemployment benefits (pensions) 2. Insurance contracts, and certain similar contracts
3. Most loan commitments 4. Commodity contracts used for dealing.
2. Equity instrument. 3. Liability.
4. IFRS 7 requires information on:

(i) (ii) (iii) (iv) (v) (vi) 1. 2. 3. 4. 5. 6. (i) (i)-(ii) (i)-(iii) (i)-(iv) (i)-(v) (i)-(vi) The risks associated with the undertakings financial instruments Managements policies for controlling these risks The accounting policies applied to the instruments The nature and extent of an undertakings use of financial instruments The business purposes they serve The markets in which the financial instruments are traded.
8. When it represents a residual interest in the net assets of the issuer, an instrument is classified as:
1. A compound instrument. 2. Equity. 3. A liability.
9. Instruments, such as bonds that are convertible into equity shares are:
1. A compound instrument. 2. Equity. 3. A liability.
10. Derivative contracts that result in the delivery of a fixed amount of cash or other financial assets for a fixed number of an undertakings own equity instruments are classified as:
1. Compound instruments. 2. Equity. 3. Liabilities.
5. A financial asset and a financial liability may only be offset and the net amount reported in the balance sheet when an undertaking:
(i) Has a current right to set off the recognised amounts. (ii) Intends either to settle on a net basis, or to realise the asset and settle the liability simultaneously. (iii) Has the asset and liability denominated in the same currency. 1. (i) 2. (i)-(ii) 3. (i)-(iii)
11. Financial assets and liabilities are initially measured at:

1. Cost. 2. Fair value. 3. Amortised cost.
12. Transfers into and out of the held for trading category after initial recognition are:
1. Prohibited. 2. Encouraged. 3. Delayed until the following accounting period.
6. Liability and equity components of compound instruments are accounted for:

1.Separately. 2. In equity. 3. In profit and loss.
13. Unless they are accounted for as hedges, derivatives are always categorised as
1. Held for trading. 2. Available-for-sale. 3. Loans and receivables.
7. When the issuer is, or can be required, to deliver either cash or another financial asset to the holder. This is a:
1. Compound instrument.
14. All equity securities other than those classified as at fair value through profit or loss are:
2. Held for trading. 3. A derivative.

15. A loan acquired from another lender is classified as:
18.
- Futures contracts which provide for the future delivery of financial instruments or commodities under terms established at the outset - Forward contracts which commit two parties to an exchange at a specific future date under terms set at the contract date - Swap contracts whereby there is an agreement between two counterparties to exchange cash flows -Option contracts whereby a transaction is set up giving one of the parties the right to buy or sell something to the other at a specified price for a specified period of time. are all: 1. Liabilities. 2. Held for trading. 3. Derivatives.

16.
Obligations to deliver securities or other financial
assets borrowed by a short seller
Derivative liabilities that are not accounted for as hedging instruments to repurchase them in the near term and
Financial liabilities that are incurred with the intention Financial liabilities that form part of a portfolio of
identified financial instruments that are managed together and for which there is evidence of a recent actual pattern of short-term profit taking. are all: 1. Available-for-sale. 2. Loans and receivables. 3. Financial liabilities held for trading
19. Relating to an embedded derivative, when:

Its economics are not closely related to those of the
host contract
A separate instrument with the same terms as the
embedded derivative would meet the definition of a derivative, and

The entire contract is not carried at fair value through
17. A financial instrument with all these characteristics:

Its value changes in response to changes in an
underlying price or index

It requires no initial net investment or an initial net
profit and loss. 1. It should be split from the host contract and accounted for separately. 2. It should not be split from the host contract. 3. Either treatment is allowed.
investment that is smaller than would be required to purchase the underlying instrument, and
It is settled at a future date is
1. A Liability.
23
1. 2. 3. 4. 5. 6. 7. 8. 9. 10. 11. 12. 13. 14. 15. 16. 17. 18. 19.
Answers to multiple choice questions

Answer
3
Question
2 4 5 2 1 3 2 1 2 2 1 1 2 3 3 3 3 1
This publication has been produced with the assistance of the European Union. The contents of this publication are the sole responsibility of ZAO PricewaterhouseCoopers, FBK and European Savings Bank Group and can in no way be taken to reflect the views of the European Union.

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IAS 32/39 Financial Instruments Part 1 Recognition

Financial instruments under IFRS

Moscow, Russia, June 2008 (Updated)

Financial instruments under IFRS

IAS 32 and IAS 39

Why do we need standards on financial instruments?

To which companies do the standards apply?

To what financial instruments do the standards apply?

Financial instruments under IFRS

The main requirements of IAS 32 Presentation by the issuer - debt or equity

The main requirements of IAS 39 Measurement

Financial instruments under IFRS

Financial instruments under IFRS

Within scope of IAS 32 and IAS 39

Within scope of IAS 32 only

Note 2 Commodity contracts: Contracts to buy or sell non-financial

Note 3 Loan commitments: Loan commitments are outside the scope of

Note 4 Financial guarantees: A financial guarantee is a contract that

Financial instruments under IFRS

Embedded derivative: a component of a combined instrument where some

Derecognition: removal of a financial asset or financial liability from the

Derivative : a financial instrument with all three of the following

Equity: any contract that gives a residual interest in the assets of an

Effective interest method: a method of calculating the amortised cost of a

Fair value hedge: a hedge of the exposure to changes in fair value of a

Financial instruments under IFRS

Financial asset: any asset that is:

Financial instruments under IFRS

Financial liability: any liability that is:

Hedging instrument: a designated derivative, or non-derivative financial

Held-to-maturity investments: a financial asset with fixed or determinable

Financial guarantee:a contract that requires the issuer to make specified

Firm commitment: a binding agreement for the exchange of a specified

Net investment in a foreign operation : the amount of the undertaking's

Hedged item: an asset, liability, firm commitment, highly-probable forecast

Financial instruments under IFRS

Regular way purchase or sale: a contract for the purchase or sale of a

Tainting: where an undertaking sells or transfers more than an insignificant

Financial assets and liabilities are initially measured at fair value.

Trading financial assets and liabilities: a financial asset or financial

Transaction costs: incremental costs that are directly attributable to the

Work Book 1. - Initial Recognition and Classification Including Debt/Equity Classification

Financial instruments under IFRS

Financial instruments under IFRS

Financial instruments under IFRS

Cash Amortised flows cost at the end of the year 13

Financial instruments under IFRS

20x1 20x2 20x3 20x4 20x5

8,105.0 8,415.5 8,757.0 9,132.7 9,546.0

810.5 841.5 875.7 913.3 954.6

500 500 500 500 10,000 + 500

8,415.5 8,757.0 9,132.7 9,546.0 10,000.0

Financial instruments under IFRS

Financial instruments under IFRS

present obligation. Discounting is required. ** Discounting is not mandatory under IFRS 4.

Classification Debt versus Equity

contingent on the outcome of circumstances beyond the control of both the 16

Financial instruments under IFRS

Preference shares Equity or Liability?

Financial instruments under IFRS