Financial Instruments

Comprehensive Scope
• IAS 39 Financial Instruments: Recognition and Measurement
– Deals with topics addressed in FAS133, FAS115, FAS140, FAS114,
FAS155, FAS156, FAS159

• IAS 32 Financial Instruments: Presentation

– Deals with topics addressed in FAS150, APB14, EITF00-19,
FIN39/FIN41, EITF D-98

• IFRS 7 Financial Instruments: Disclosures

– Deals with topics addressed in FAS107, FAS157, SEC rules
 Key Concepts
• Financial instrument
– Any contract that gives rise to a financial asset of one entity and
a financial liability or equity instrument of another entity

• Financial asset
– Any asset that is:
• Cash
• An equity instrument of another entity
• –Contractual right to receive cash or another financial asset from
another entity
• –Contractual right to exchange financial asset or financial liability
with another entity under conditions that are potentially favorable to
the entity
• –Contract that will or may be settled in the entity’s own equity
instrument*

*Subject to certain conditions

 Key Concepts
• Financial liability
– Any liability that is:

• Contractual obligation to deliver cash or another financial

asset to another entity

• Contractual obligation to exchange financial asset or financial

liability with another entity under conditions that are
potentially unfavorable to the entity

• Contract that will or may be settled in the entity’s own equity

instrument*

*Subject to certain conditions

 Financial Asset Categories
• Fair value through profit and loss (FVTPL)
– Held for Trading (HFT); or
– Designated on initial recognition
• Designation irrevocable
• Excludes equity investments with no active market price
– Includes all derivatives

• Held to maturity (HTM)

– Fixed / determinable payments and fixed maturity; and
– Positive intention to hold
– Measure at amortized cost
 Financial Asset Categories
• Loan and receivable
– Fixed or determinable payments
– Not quoted in an active market
– Measure at amortized cost

• Available for sale (AFS)

– Residual category
– Measure at fair value through equity (except for
impairment losses, foreign exchange, interest)
– Cumulative gain or loss recycled
 IAS 39 Recognition and
Measurement
• IAS 39 initially drafted based on US GAAP
– FAS 114
– FAS 115
– FAS 133
– FAS 140
– FAS 155
– FAS 156
– FAS 157 and
– FAS 159
 IAS 39 Recognition and
Measurement
• Similarities
– Debt and equity investments
– Impairment
– Extinguishments
– Derivatives & Hedging
– Fair Value Option
 IAS 39 Recognition and
Measurement
• Differences
– Financial asset transfers
– NO QSPEs
 Debt and Equity Investments
• Basic approach to classifying asset similar
to FAS 115
– Held-to-Maturity,
– Available-for-Sale, and
– Held-for-Trading investments
 Debt and Equity Investments
• Differences
US GAAP IFRS
FX gains/losses on AFS debt OCI Earnings

Classifying puttable debt as HTM OK Not OK

Reclassifications in or out of trading Should be rare Not OK

Category for “fair value thru P&L” NO YES

Category for “loans/ receivables” NO YES

Classifying loans/receivables as AFS Out of scope OK

 Impairment
• Basic approach similar to FAS 114 &115
• Differences

FAS 115 IAS 39

Basis for measuring impairment of HTM Fair Value FAS 114

investment approach

Reversal of impairment losses on debt Not OK OK

securities thru earnings

Decline in FV of AFS security due to YES NO

changes in risk free interest rates potential
evidence of impairment
 Liability Extinguishments
• Conditions for recognizing extinguishments of liabilities are the
same under IAS39 and FAS140
– Payment or legal release

• Remove a financial liability when it is extinguished, i.e. when

the obligation is discharged, cancelled or expires.

• Extinguishment occurs through:

– The debtor repaying the creditor;
– The debtor being legally released from primary responsibility for the
liability
 Fair Value Option
• Fair value option in IAS 39 “looks” more restrictive than FAS
159
• Conditions:
1.Designation upon initial recognition
2.Justification:
–To significantly reduce an accounting mismatch OR
–Based on a documented risk management or investment strategy OR
–Hybrid instrument
3.Reliably measurable
 Financial Asset Transfers
• Fundamentally different model in IAS 39 compared
with FAS140
– No legal isolation test
• Risks & rewards test takes precedence over “control”
– Illustrations: sale with total return swap or credit
guarantee
• Only if evaluation of risks & rewards is inconclusive
does “control” come into play
 IAS 39 Derecognition Matrix
Situation Accounting Treatment
Substantially all risks/rewards Dereognize old asset
transferred
Transferred & retained significant Dereognize old asset
risks/rewards Control transferred

Transferred & retained significant Continuing involvement

risks/rewards Control retained approach

Substantially all risks/rewards Continue to recognize old

retained asset
 No QSPEs
• Unlike FAS140, there is no exception from consolidation
for QSPEs under IFRS
• Under SIC-12 consolidation of SPEs based on whether
the substance of the relationship indicates “control”
– Activities (e.g., specific business needs)
– Decision-making (including by ‘auto-pilot’)
– Benefits
– Risks
 Definition of a Derivative
IFRS
Derivative is a contract:
• whose value changes in
response to an underlying;
• which requires little or no
initial net investment; and
• which settles at a future
date
IAS 39 scopes out lease contracts and contracts for “own use” but these contracts
may contain embedded derivatives
US GAAP
Derivative is a contract that:
• contains a notional and
underlying;
• requires little or no initial net
investment; and
• requires or provides for net
settlement
Derivatives–Common Principles
• Derivatives must meet the definition of an asset or
liability
• Fair value is the only relevant measure
• Embedded derivatives must be bifurcated if:
– Not closely related
– Hybrid not Mark-To-Market through income statement
– Meets definition of a derivative
• Hedge accounting in limited circumstances
 Similarity - Derivatives
• Basic approach to accounting for derivatives
(including embedded derivatives) similar to
FAS133
– Measured at fair value with changes in fair value recognized in
earnings (except cash flow hedges)
– Embedded derivatives that are not “closely related” are required to
be bifurcated

• Differences:

Definition of a derivative FAS133 IAS39

Net settlement characteristic Required Not required
Notional amount and/or payment
provision Required Not required
 Derivative example
Company X enters into a contract with
Company B that permits it to acquire the
1,000,000 shares of Company C (a non-
listed company) for Euro 10 million at
December 31, 2010.
Company X does not expect that it will
acquire the shares in the future.
 Derivative example
• Underlying –Security price of Company C

• Notional–Euro 10 million

• Initial net investment–none

• Future settlement–Explicit through the payment provision in

exchange for the shares

• Derivative under IAS 39?

• Derivative under SFAS 133?
 Derivative Example
• Derivative under IAS 39?

• Derivative under SFAS 133?

Hedge Accounting
 Hedge accounting
• Hedge accounting is elective and strict qualification criteria
– Documentation
– Hedge effectiveness assessment and measurement

Cash Flow Fair Value

Hedges Hedges
Foreign Currency
Hedges
 Hedging
• Basic approach to hedge accounting similar to FAS133:
– Hedge Designation and Documentation
• Type of hedge–fair value hedging
– cash flow hedging,
– Foreign currency net investment
• Management objective
• Nature of risk being hedge
• Identification of hedging instrument and hedge item
• Both prospective and retrospective assessment of effectiveness
 The Hedger’s Dilemma
Period 1 Period 2 Total
Exposure 30 30

Derivative (30) (30)

P&L (30) 30 0
 Hedge Basics - Objectives
Period 1 Period 2 Total
Exposure 30 30

Derivative (30) (30)

P&L (30) 30 0
 Hedge Basics - Objectives
Period 1 Period 2 Total
Exposure 30 30

Derivative (30) (30)

P&L (30) 30 0
 Hedge Basics - Objectives
FV Hedge

Period 1 Period 2 Total

Exposure 30 30

Derivative (30) (30)

P&L (30) 30 0

Cash Flow
Hedge
 Hedge Basics - Ineffectiveness
Period 1 Period 2 Total
Exposure 30 30

Derivative (2) (30) (32)

P&L (2) 0 (2)
 Steps to Hedge Accounting
• Formulate policy
• Identify exposure
• Design strategy
• Document
• Execute
• Monitor
 Documentation
• Formal documentation is required at the inception of the
hedge and must include:
– Identification of the hedging instrument and the hedged item or
transaction
– The nature of the risk being hedged
– The risk management objective/strategy
– How effectiveness will be assessed
– How ineffectiveness will be measured
Liability vs Equity Classification
Liability vs Equity Classification
• IAS 32 initially drafted jointly with Canada
• US GAAP that applies
– FAS 150
– FIN 39 and 41
– EITF D-98
– EITF 00-19
– EITF 00-27
– APB 14
 Liability vs Equity Classification
• Similarities • Differences
– Liability treatment for: – Split accounting for
• Mandatorily convertibles
redeemable shares – No special BCF rules
• Obligations to
repurchase shares – No mezzanine equity
• Stock Settled debt – Criteria for offsetting of
– Treasury Share financial
transactions assets/liabilities
– Derivatives on own
shares
 Liability Classification
• Similar to FAS150, the following types of
instruments are classified as liabilities under
IAS32:
– Mandatorily redeemable financial instruments
– Forward contracts to repurchase outstanding shares
– Written put contracts on outstanding shares
– Share-settled debt
 Liability Classification
• Differences:
FAS150 IAS32
Puttable (redeemable) shares Out of scope Liabilities
Contingently redeemable shares Out of scope Liabilities
Measurement of written puts on
own equity Fair value Present value of
redemption amount
 Treasury Shares

• Similar to U.S. GAAP, no gain or loss is

recognized on the purchase, sale, issue, or
cancellation of treasury shares

• Similar to U.S. GAAP, treasury shares are not

treated as assets, but deducted from equity
 Split Accounting
• Unlike APB14, issued convertible debt is bifurcated
into liability and equity components under IAS32
– Initial present value of principal and interest cash flows
discounted using market rates presented as a liability
– Residual (initial fair value of equity conversion option)
presented as equity
– Results in more representative interest expense

• Accordingly, there are no Beneficial Conversion

Feature (BCF) requirements like those in EITF98-5
and EITF00-27 under IFRS
 Split Accounting –IAS 32
• Method of separation
– Use initial carrying amount of compound instrument as your starting point
– Determine fair value of the liability element
– Allocate the residual amount to the equity element (‘with-and-without’
method)
 Split Accounting –IAS 32
• Example–You issue convertible debt for
proceeds of 100
– You estimate fair value of conversion option
to be 12
– You estimate present value of contractual
cash flows to be 90

– How would you allocate the proceeds of 100?

 Split Accounting –IAS 32
• Allocate 90 to liabilities

• The residual (10) is allocated to equity

 Mezzanine Equity
• Unlike EITF D-98, there is no mezzanine equity section under
IFRS
• Under IAS 32, redeemable shares are liabilities –including
contingently redeemable shares
• Exceptions
– redeemable only at liquidation
– redemption option not genuine
– Puttable Instruments that represents the most residual interest in the
entity (New Amendment)
 Offsetting
• Offsetting of recognized amounts for financial assets and financial
liabilities

• IAS 32 requires net presentation (offsetting) when, and only when:

(1)Legally enforceable right to set off
(2)Intention to settle net or simultaneously

• Unlike FIN 39/FIN 41:

– offsetting is not elective under IAS 32
– there is no exception from the intent requirement for derivatives or repos
subject to master netting agreements
 Derivatives on Own Shares
• Unlike EITF 00-19, net share settled derivatives on own
equity are always accounted for as derivatives at fair
value under IAS 32/IAS 39

• Unlike EITF 00-19, derivatives on own equity for which

the entity has the option to settle gross in own shares
are accounted for as derivatives at fair value if either the
issuer or the counterparty can elect net settlement