Financial Instruments Accounting: March 2004

IFRS REPORTING
Financial
Instruments
Accounting
March 2004
AUDIT
AUDIT ■ TAX ■ ADVISORY

Preface
IAS 39 Financial Instruments: Recognition and Measurement has been in effect for several
years and most entities reporting under International Financial Reporting Standards (IFRSs)
have issued two annual reports using IAS 39 to account for their investments, loans,
receivables, borrowings and derivative and hedging activities. Many have found that
experience in working with the standard does little to ease the pain. During 2000 and 2001,
the IAS 39 Implementation Guidance Committee issued more than 200 Q&A interpretations
of the standard based on questions and issues raised by entities and their auditors.
The complexity and the volume of the guidance continues to provide a challenge for entities
as their understanding of the basic requirements increases. “The more you know, the more
you realise how much you don’t know” seems particularly relevant to IAS 39.
Requirements for entities in the European Union (EU), Australia, Russia and elsewhere to
report under IFRS by 2005 create the same challenges for a brand new group of IFRS users,
of which there will be some 7,000 in Europe alone.
In December 2003 the IASB issued revised versions of IAS 32 Financial Instruments:
Disclosure and Presentation and IAS 39 incorporating significant and wide-ranging changes
to both standards, effective for reporting periods beginning on or after 1 January 2005. With
the exceptions of portfolio hedging for interest rate risk, the scope of the fair value option
and one or two amendments that may flow from the IASB’s insurance project, the 2005
requirements are now set in stone. For European companies, the only remaining hurdle is
EU endorsement during the course of 2004.
Both existing IFRS reporters and first-time adopters will need to spend significant amounts
of time in 2004 preparing to implement the standards. First-time adopters in particular will
need to have a complete and thorough implementation process in place to enable a
successful transition to IFRS. Our experience is that the implementation challenge is a tough
one, but is achievable as long as sufficient time and the right resources are devoted to it.
Implementing IAS 39 requires a structured process. This could well require a dedicated team
to identify and address the entity’s major issues and potential changes to current business
practices as well as to information systems. Preparers and users will have to develop a
fundamental understanding of the concepts and principles of accounting for financial
instruments. This will involve training personnel and developing expertise and understanding
of the way in which IFRS collectively deal with financial instruments.
This publication provides a comprehensive overview of the existing IAS 32 and IAS 39 to
address accounting for financial instruments with an emphasis on practical application
issues. It provides an update to the first edition issued in September 2000, taking into account
guidance issued subsequently as well as examples based on practical experience from
working with KPMG member firms’ clients. At the same time we have incorporated guidance
© 2004 KPMG International. KPMG International is a Swiss cooperative of which all KPMG firms are members. KPMG International provides
no services to clients. Each member firm is a separate and independent legal entity and each describes itself as such. All rights reserved.
on the likely impact of the December 2003 amendments. KPMG member firms welcome the
opportunity to help entities in understanding and implementing these standards. For
information on how a KPMG member firm can assist you, please contact your regular KPMG
business adviser or any of our offices worldwide (www.kpmg.co.uk/ias (to be updated shortly,
at the date of this publication, to www.kpmg.co.uk/ifrs)).
KPMG
March 2004
About this publication
Content
Information in this publication is current up to December 2003. This publication has been
updated for additional interpretations of IAS 39 based on guidance issued subsequent to
September 2000 when the first edition of this publication was released. This publication
considers standards and interpretative guidance that are in force at December 2003, and also
provides a commentary on the likely impact of the amendments issued in December 2003
which are not required to be adopted until financial years commencing on or after 1 January
2005. Further interpretations of the amended standards are likely to develop during the course
of 2004 as companies work with their advisers to implement them. Readers should be aware
that the amended standards are applicable for periods beginning on or after 1 January 2005.
Earlier adoption is permitted, but an entity must then adopt all the requirements of both
amended standards. Piecemeal early adoption is not permitted. Future updates to this
publication will provide practical guidance and interpretation on the amendments.
Organisation of the text

Throughout this publication we have made reference to current IFRS literature and interpretations
of that literature. Direct quotations from IFRS are shaded in blue within the text.
A column noted as Reference is included in the left margin of Sections 2 to 11 to enable users
to identify the relevant paragraphs of the standards or other interpretative literature. References
are to the amended standards issued in December 2003.
A glossary of frequently used terms is included as Appendix A to the publication. In addition,

a summarised comparison between IFRS and US GAAP is included as Appendix B and
abbreviations used throughout the text are identified in Appendix C.
Case studies and examples are included throughout the text to elaborate or clarify the more
complex principles of the financial instruments standards. A list of all case studies is included
as Appendix D.
Commentary on the December 2003 amendments to the standards is provided separately in

red where applicable within each Section.
Keep in contact and stay up-to-date

IFRS literature on financial instruments is intended to cover all types of industries and
transactions. The interpretive guidance, and in some respects, IAS 39 itself, are by their nature
based on narrowly defined facts and circumstances. In most instances, further interpretation
will be needed in order for an entity to apply these standards to its own facts, circumstances
and individual transactions. Further, some of the information contained in this publication is
based on KPMG’s International Financial Reporting Group’s (IFR Group’s) interpretations of
the current literature, which may change as practice and implementation guidance continue
to develop in these areas. Users are cautioned to read this publication in conjunction with the
actual text of the standards and implementation guidance issued, and to consult their
professional advisers before concluding on accounting treatments for their own transactions.
This publication has been produced by KPMG’s IFR Group. For more information, please visit
www.kpmg.co.uk/ias (to be updated shortly, as at the date of this publication, to
www.kpmg.co.uk/ifrs), where you will find up-to-date technical information and a briefing on
KPMG’s IFRS conversion resources.
Contents
Page
1. Introduction to the financial instruments standards 4

1.1 The need for financial instruments standards 4
1.2 Development of the standards 4
1.3 Highlights of the standards 5
2. Scope and definitions 9

2.1 Scope of the standards 9
2.2 Definitions relating to financial instruments 13
2.3 Financial risks 19
3. Embedded derivatives 20
3.1 Overview 20
3.2 Economic characteristics and risks 22
3.3 Separation of the embedded derivative 23
4. Recognition and derecognition 29

4.1 Overview 29
4.2 Initial measurement 29
4.3 Recognition 31
4.4 Derecognition 34
4.5 Special purpose entities and derecognition 46
5. Classification 51
5.1 Overview 51
5.2 Classification of financial assets 52
5.3 Classification of financial liabilities 63
Page
6. Subsequent measurement 65
6.1 Overview 65
6.2 Classification determines subsequent measurement 67
6.3 Valuation issues 69
6.4 Impairment of financial assets 82
6.5 Reclassifications of financial assets 90
6.6 Deferred tax assets and liabilities 93
7. Subsequent measurement – examples 94

7.1 Overview 94
7.2 Interest rate risk 95
7.3 Foreign currency risk 98
7.4 Equity price risk 101
7.5 Credit risk 103
8. Hedge accounting 104

8.1 Overview 104
8.2 Hedge accounting basic concepts 105
8.3 The hedge accounting models 107
8.4 Hedged items 112
8.5 Hedging instruments 117
8.6 Criteria for hedge accounting 121
8.7 Termination of a hedge relationship 131
8.8 Net position hedging and internal derivatives 134
8.9 Other considerations 135
9. Hedge accounting for each type of financial risk 137

9.1 Overview 137
9.4 Hedging a net investment 171
9.5 Hedging commodity price risk 175
Page
10. Presentation and disclosure 184

10.1 Overview 184
10.2 Balance sheet presentation 184
10.3 Liability versus equity 186
10.4 Income statement presentation 194
10.5 Required disclosures 195
11. Transition and implementation of IAS 39 206

11.1 Overview 206
11.2 First-time adoption of IFRS 206
11.3 Transition requirements for existing users of IFRS 211
11.4 First time implementation: practical considerations 212
A. Glossary 214
B. IFRS and US GAAP financial instruments comparison 221
C. Abbreviations 228
D. List of cases 229
IFRS Financial Instruments Accounting
March 2004
1. Introduction to the financial instruments standards
1.1 The need for financial instruments standards

In the past two decades there has been a dramatic increase in the sophistication of financial markets.
With the globalisation of markets many entities face increasing challenges in controlling risks to which
they are exposed. This changing environment has been the impetus for a constant stream of innovative
and often complex financial products. The use of derivative instruments has become a common practice
for many entities of all sizes and throughout all industries. The accounting profession as a whole has
made efforts during recent years to develop accounting literature to address financial instruments.
The International Accounting Standards Committee (IASC) issued two standards that specifically
address accounting for financial instruments. These are International Accounting Standard (IAS) 32
Financial Instruments: Disclosure and Presentation and IAS 39 Financial Instruments: Recognition
and Measurement, collectively referred to throughout this publication as the financial instruments
standards. When the International Accounting Standards Board (IASB), the successor organisation to
the IASC, was formed in 2001, this body adopted all of the then-current standards and interpretations
of the IASC, including IAS 32 and IAS 39. With these standards, all entities reporting under IFRS,
regardless of their size or industry, or whether public or non-public, must account for and make disclosures
about financial instruments in a similar manner.
There are other standards and interpretations that are relevant to a discussion of financial instruments
accounting, most notably IAS 21 The Effects of Changes in Foreign Exchange Rates and SIC–12
Consolidation – Special Purpose Entities.
The IASB is currently addressing certain aspects of insurance accounting with a view to introducing
interim requirements that would be effective in 2005. These interim requirements would be limited to
defining insurance risk and distinguishing it from financial risks dealt with under the financial instruments
standards, and prohibiting certain industry practices such as catastrophe provisions and equalisation
reserves. Insurance contracts, in the interim, would continue to be dealt with under an entity’s existing
accounting framework. The proposals are not dealt with further in this publication.
In the longer term the IASB expects to issue a comprehensive standard on insurance contracts.
The IASB is also undertaking a project to develop a new standard for disclosure of risks arising from
financial instruments (this scope of this project was originally to update IAS 30 Disclosures in the
Financial Statements of Banks and Similar Financial Institutions, but was later expanded to cover
all entities). When the project is completed, IAS 30 will be withdrawn together with the financial risk
disclosure requirements in IAS 32. Both projects will affect the accounting for and disclosure of
financial instruments in due course, but neither will be effective before 2005.
1.2 Development of the standards

The IASC began its project to develop a comprehensive set of standards addressing financial instruments
in 1989. In 1994 the IASC divided this project into two phases. The first phase addressed disclosure
and financial statement presentation, and resulted in the issuance of IAS 32 in 1995. The second phase
of the project addressed recognition and measurement.
4 1.2 Development of the standards
March 2004
IAS 39 was originally intended to be an interim standard. At the same time that the standard became
effective in 2001, the IASC was working with a collaboration of national standard setters from
13 countries to develop a completely new standard on financial instruments accounting. This group,
called the Joint Working Group (JWG), released their Exposure Draft in December 2000 for public
comment. Their proposals and the results of comments received from the public were presented to the
IASB in early 2002. It is now a long-term project of the IASB to develop a new standard for financial
instruments. Such a new standard is not expected prior to 2005.
An Exposure Draft of proposed amendments to IAS 32 and IAS 39 was released in June 2002 for
public comment. In issuing the proposed amendments to IAS 32 and IAS 39 the Board stated that it
expected the amended standards to be in place for “a considerable period”. The IASB released the
revised versions of IAS 32 and IAS 39 in December 2003.
In October 2003, the IASB issued an Exposure Draft Fair Value Hedge Accounting for a Portfolio
Hedge of Interest Rate Risk, dealing with certain aspects of hedge accounting which are particularly
relevant for financial institutions.
1.3 Highlights of the standards

Prior to the issuance of IAS 32 and IAS 39 there was no comprehensive guidance in IFRS addressing
financial instruments, particularly so for derivatives. IAS 39 introduced new requirements for the
recognition, derecognition and measurement of an entity’s financial instruments and for hedge
accounting. It also introduced some changes to the disclosure and presentation requirements of IAS 32.
Figure 1.1 is a basic overview of the financial instruments standards dealt with in this publication.
Figure 1.1 Overview of the financial instruments standards
The requirements of the financial instruments standards are summarised at a very high level below.
1.3.1 Recognition and derecognition

■ All financial assets and financial liabilities, including derivative instruments, should be recognised in
the balance sheet.
■ In order to remove (i.e. derecognise) assets from its balance sheet, an entity must lose control over
those financial assets. In addition, a substantive risk from the assets must be transferred. IAS 39

March 2004
is complex and restrictive in this area. It provides guidance for transactions such as factoring and
securitisations. Entities converting to IFRS may find assets that were derecognised under previous
GAAP may have to be included on balance sheet in their IFRS financial statements.
■ In order to derecognise a liability, a debtor must be legally released from its primary obligation
related to that liability.
1.3.2 Measurement
■ Financial assets must be classified into one of four categories: trading; originated loans and
receivables; held-to-maturity; and available-for-sale. Financial liabilities are categorised as either
trading or non-trading. The categorisation determines whether and where any remeasurement to
fair value is recognised in an entity’s financial statements.
■ Many financial assets are carried at fair value, with the exceptions being originated loans and
receivables, held-to-maturity assets, and in the rare circumstances where the fair value of an
unlisted equity instrument cannot be reliably measured. Remeasurement to fair value must be
performed at each financial reporting date.
■ The effect of remeasurement to fair value must be recognised and consistently applied in one of
two ways. An entity can choose to recognise all changes in fair value in the income statement.
Alternatively, it can choose to recognise changes in fair value of trading instruments in the income
statement, and available-for-sale instruments as a component of equity. Fair value changes deferred
in equity are recycled to the income statement when the instrument is sold or becomes impaired.
1.3.3 Derivatives and hedge accounting

■ Under IAS 39, all derivatives (including some embedded derivatives) must be measured at fair
value in the balance sheet. This is regardless of whether they are categorised as trading or as
hedging instruments. Unless they qualify as hedging instruments, all fair value gains and losses are
recognised immediately in the income statement.
■ A non-derivative financial instrument can have certain characteristics that cause it to behave like
a derivative. These characteristics need to be evaluated to determine whether they should be
separated from the financial instrument and accounted for separately as a stand-alone derivative.
■ Hedge accounting is a choice that each entity makes for each economic hedge that it has in place.
The choice reflects a trade-off between the cost of achieving hedge accounting and the potential
benefit achieved by reducing the income statement volatility that would otherwise arise. In some
circumstances, the standard prohibits hedge accounting.
■ In order to qualify for hedge accounting, an entity must designate its hedge relationships and
document how it will measure effectiveness. Each individual relationship between a derivative and
its hedged asset, liability or future cash flow must be documented separately.
■ Hedge accounting is permitted provided that the entity can establish that each hedge has been
highly effective in each reporting period. In order to continue hedge accounting, there must be an
expectation that future gains and losses on the hedged item and hedging instrument will almost
fully offset.
■ There are three hedge accounting models under IAS 39, which are the fair value hedge, the cash
flow hedge and the hedge of a net investment in a foreign entity. The appropriate accounting model
for a hedge relationship depends on the nature of the item being hedged.
6 1.3 Highlights of the standards
March 2004
■ Implementing these requirements can involve significant systems amendments, particularly when
large numbers of derivatives are used as hedging instruments.
1.3.4 Disclosure and presentation

■ Guidance is provided on the classification of financial instruments as equity or debt, and accounting
for compound instruments with characteristics of both equity and debt instruments, such as
convertible bonds.
■ Criteria are specified for the netting of financial assets and financial liabilities. Netting requires a
legal right of set off as well as the intention to offset the assets and liabilities or settle simultaneously.
■ Significant qualitative and quantitative disclosures about financial instruments, financial risk
management and hedging activities are required.
■ Required disclosures include how fair value is determined, as well as methods and significant
assumptions, and risk management objectives and policies for hedging. Disclosures should note the
significant terms and conditions of instruments as well as information about interest rate risk and
credit risk of financial instruments.
■ In addition, fair value information and other quantitative disclosures of income and expense, and
gains and losses from financial instruments are required.
December 2003 amendments

At a very high level, the amendments to the standards introduce the following changes:
■ The requirements on derecognition of financial assets are significantly reworded and to some extent
revised (although for certain transactions the resulting changes to the accounting are substantial),
retaining elements of both risks and rewards and control criteria. The standard should now be
simpler to apply under the decision tree approach, except in limited numbers of transactions where
a new ‘continuing involvement’ approach is adopted, resulting in partial derecognition.
■ A new category of ‘financial assets measured at fair value through profit or loss’ is introduced.
An entity may choose to include any financial asset or financial liability in this category on the day
the asset or liability is first recognised, or on the date the amended standards are first applied.
Subsequent transfers in or out of the new category are prohibited. The option to recognise fair
value changes on available-for-sale financial assets in profit or loss is consequently removed.
■ Similarly, an entity may choose, on initial recognition or when the standards are first applied, to
classify any non-derivative financial asset as available-for-sale, with fair value changes
subsequently being recognised as a component of equity.
■ The requirement to separate certain embedded foreign currency derivatives has been relaxed in
certain cases, where the currency in which the sale is denominated is not the functional currency
of either of the parties to the contract.
■ New guidance is provided on the application of the impairment requirements, emphasising that
the standards follow an incurred loss model. Impairment losses recognised on equity instruments
classified as ‘available-for-sale’ are prohibited from being reversed through profit or loss.
Any subsequent increase in fair value is instead recognised in equity.

March 2004
■ Further guidance is also provided on how to calculate amortised cost using the effective yield
method and on fair value measurement techniques.
■ Additional restrictions are placed on the use of hedge accounting in some circumstances, particularly
on the use of internal transactions in hedging relationships. Some hedging relationships involving
firm commitments that were previously accounted for as cash flow hedges will be accounted for
as fair value hedges. The cash flow hedge accounting model has in some cases prohibited basis
adjustments and in others made them optional.
■ The requirements on classification of issued instruments such as preference shares and convertible
bonds between liabilities and equity are amended slightly and new requirements are provided on
how to account for derivatives on an entity’s own equity.
■ New disclosures are added, in particular on the sensitivity of fair value estimates to key inputs to
a valuation model.
IASB Board meeting February 2004

At this meeting the IASB tentatively concluded that it should make two further amendments to the
standards. The first would be to limit the use of the fair value through profit or loss option, described
above, to four circumstances:
■ the item is an available-for-sale asset (but not a loan or receivable);
■ the item contains one or more embedded derivatives;
■ the item is a financial liability whose amount is contractually linked to the performance of assets
that are measured at fair value; or
■ the exposure to fair value changes in the item is substantially offset by corresponding changes in
the value of another financial asset or liability, including a derivative.
This proposal is expected to be exposed for public comment during the second quarter of 2004 and
finalised in the third quarter.
The second amendment would be to remove the requirement, in respect of the prospective effectiveness
test for hedge accounting, that changes in fair value or cash flows of the hedged item should be
expected to ‘almost fully offset’. In practice, this change is likely to mean that as long as the entity is
not deliberately under-hedging, the degree of correlation required to achieve hedge accounting will be
closer to the 80 to 125 per cent range required for retrospective testing. This amendment is likely to
be issued without further exposure in April 2004.
8 1.3 Highlights of the standards
March 2004
2. Scope and definitions
Key topics covered in this Section:

■ Financial instruments included and excluded from the scope
■ Financial instruments defined
■ Financial risks defined
Reference 2.1 Scope of the standards

The standards on financial instruments apply to all financial instruments, except for those
specifically excluded from the scope of IAS 32 or IAS 39. It is important first to understand
what items are considered to be financial instruments under IFRS. Table 2.1 shows
summary balance sheets for a corporate and a financial institution, including typical financial
assets and liabilities of each. The definitions of financial assets and financial liabilities are
discussed later in Section 2.2.
Table 2.1 Effect of financial instruments on a corporate / financial institution

Corporate balance sheet Financial institution balance sheet
Assets Assets
Property, plant and equipment Cash and bank balances
Investments Cash collateral on securities
Deferred tax assets Trading portfolio assets
Total non-current assets Loans, net of allowances
Inventories Financial investments
Other receivables Accrued income
Cash and cash equivalents Property, plant and equipment
Total current assets Other assets
Total assets Total assets
Equity and liabilities Equity and liabilities
Issued capital Issued capital
Reserves Reserves
Retained earnings Retained earnings
Total capital and reserves Total capital and reserves
Interest-bearing loans and borrowings Money market paper
Pension obligations Due to banks
Provisions Repurchase agreements
Total non-current liabilities Trading portfolio liabilities
Bank overdraft Due to customers
Other payables Long-term debt
Total current liabilities Other liabilities
Total equity and liabilities Total equity and liabilities

March 2004
Reference
The items in italics in Table 2.1 are those figures that may contain financial instruments
that fall within the scope of the financial instruments standards. This table demonstrates
that many of the accounts of a typical corporate or financial institution are subject to
these standards.
39.2 Certain instruments and contracts are excluded from the scope of the financial instruments
standards, even though they may possess all of the required characteristics of a financial
instrument. For the financial assets and liabilities listed in Table 2.2, entities should refer
to other existing standards, if applicable.
Table 2.2 Items excluded from the financial instruments standards

Applicable
IAS 32 IAS 39 standard
Interests in subsidiaries ✗ ✗ IAS 27

Interests in associates ✗ ✗ IAS 28
Interests in joint ventures – ✗ IAS 31
Employers’ assets and liabilities under
employee benefit plans – ✗ IAS 19
Employers’ assets and liabilities in respect of
post-employment employee benefits ✗ – IAS 19
Employers’ obligations in respect of employee
stock option and stock purchase plans ✗ – IAS 19
Disclosures of employee benefit plans’
obligations for post-employment benefits ✗ – IAS 26
Rights and obligations under insurance contracts
(except embedded derivatives) ✗ ✗ IASB’s insurance
project
Rights and obligations under leases (other
than securitised lease receivables and
embedded derivatives) – ✗ IAS 17
Equity instruments issued by the entity,
including warrants and options, classified as
shareholders’ equity – ✗ IFRS 2 *
Financial guarantee contracts, including
letters of credit – ✗ IAS 37
Contracts for contingent consideration in a
business combination – ✗ IAS 22
‘Weather derivatives’: contracts that require a
payment based on climatic, geological or some
other physical variables – ✗ IASB’s insurance
project
“✗ ” Indicates a specific exclusion from the standard.

* There are two current standards that address aspects of equity instruments issued by the
entity (IAS 32 (revised December 2003) and IFRS 2 on share-based payment transactions).
10 2.1 Scope of the standards
March 2004
Reference
As noted in Table 2.2, a number of items are excluded from the scope of IAS 39.
However, derivatives embedded within excluded instruments, for example, within leases
or insurance contracts, still are within the scope of the financial instruments standards.
Finance lease receivables are subject to the derecognition provisions of IAS 39.
While most financial instruments, contracts and obligations under share-based payment
transactions to which IFRS 2 Share-based Payment applies are excluded from the
scope of IAS 39, they are included where they are in relation to commodity contracts
which fall within the scope of IAS 39 (see Section 2.1.2). Additionally, many financial
instruments excluded from the scope of IAS 39 still are subject to the disclosure and
presentation requirements of IAS 32.
The financial instruments standards do not change the accounting with respect to
investments in subsidiaries, associates and joint ventures. The applicable standard for
each of these investments is noted above. All other investments in equity securities are
within the scope of the financial instruments standards. Options to buy and sell interests
in subsidiaries, associates or joint ventures may meet the definition of a derivative.
These would also be accounted for as financial instruments.
Certain types of investors or investment vehicles may hold a large equity interest in
another entity so that consolidation or associate accounting is applicable. These investors
(e.g. venture capital funds, private equity funds) view the equity stake as a strategic
investment that is intended to be disposed of in the future. Generally, the investor’s
preference is to account for this interest as a financial instrument rather than as a subsidiary
or associate. However, the intention of the investor is not the relevant consideration for
determining whether the holding is within the scope of IAS 39. IAS 28 Investments in
Associates (revised 2003) allows these venture capitalists and similar entities to apply
fair value accounting under IAS 39 rather than accounting for the holding as an associate.
This requires changes in fair value to be recognised in the income statement. IAS 31
Interests in Joint Ventures allows a similar approach to be taken for jointly controlled
entities. However, there is no similar amendment in respect of consolidation under IAS 27
Consolidated and Separate Financial Statements (revised 2003).

39.2(i) The amendments will exclude from the scope of the standards loan commitments
(e.g. an agreement by a bank to grant a loan at a fixed interest rate), except those
when the entity has a history of settling such commitments in cash or of trading the
loan shortly after its issue. Loan commitments were previously exempt from derivative
accounting when they qualified as ‘regular way’ transactions.
39.3 Additional guidance is provided on the accounting for issued financial guarantee contracts
and loan commitments that are excluded from the scope of the standard. Such guarantees
and commitments are initially measured at fair value and subsequently measured at the
higher of the amount initially recognised (less amounts recognised as revenue under
IAS 18 Revenue) and the provision that would be required under IAS 37 Provisions,
Contingent Liabilities and Contingent Assets.
On completion of the Phase I Insurance standard, expected in late March 2004, it is
anticipated that the scope exclusion in IAS 39 for weather derivatives will be removed.

March 2004
Reference
2.1.1 Insurance-like contracts
39.AG4 Obligations arising under insurance contracts are excluded from the scope of both financial
instruments standards. However, the other financial assets and liabilities of insurance
32.6 entities are not. If a financial instrument takes the form of an insurance contract, but
involves the transfer of financial risks, as opposed to insurance risks, the contract would
39.2(d) fall within the scope of the financial instruments standards. The same principle applies to
reinsurance contracts where the underlying risk is financial risk. In practice, there may
be difficulty in determining whether or not contracts that take the form of insurance also
39.2(d) have financial risks. Regardless of whether an insurance or reinsurance contract is included
within the scope of IAS 39, it may contain an embedded derivative that must be separated
and accounted for as a derivative in accordance with IAS 39.

39.2(d) The amendments do not change the guidance on how to distinguish between an insurance
contract and a financial instrument. However, the standard on insurance contracts,
expected in late March 2004, will include a new definition of insurance contracts and
will, in most respects, permit an entity to continue its existing accounting for insurance
contracts. The new definition will need to be applied in determining whether a contract
is an insurance contract or a financial instrument. Contracts that may be described as
insurance contracts but that do not contain significant insurance risk will be accounted
for under IAS 39, as will non-insurance derivatives embedded in insurance contracts.
2.1.2 Commodities contracts and normal purchases and sales

39.5-7 A contract that is based on a commodity (e.g. a forward or option to purchase or sell a
commodity) may meet the definition of a derivative. Commodity-based contracts that
give a right to either party to settle in cash or some other financial instrument are included
in the scope of the financial instruments standards unless these are (a) entered into with
the purpose of meeting the entity’s purchase or sales needs and (b) expected to be settled
physically by delivery of the commodities (i.e. not net settled). Those contracts should be
treated as executory contracts rather than as derivatives.
39.6 Intention and past practice of the entity are important considerations when evaluating a
commodities contract that can be settled net. If the terms of the contracts are such that
they can only be settled by delivery and there is no practice of settling net, the contracts
are not accounted for as derivatives. However, if an entity has a pattern of settling
commodity-based contracts on a net basis, the contracts are deemed to not be for the
purpose of meeting the entity’s expected purchase, sale or usage requirements and fall
within the scope of the financial instruments standards. The intention to settle net may be
evidenced by a historical pattern of entering into offsetting agreements. Likewise, entities
that enter into offsetting contracts that effectively achieve net settlement would not qualify
for this exemption.
IG A.2 and B.1 Commodities are viewed broadly under the financial instruments standards, meaning that
they may be any type of goods on which derivative contracts may be based that give
rights to one party to receive or deliver these types of goods to another party. For example,
derivative contracts based on non-financial assets such as real estate could fall within the
scope of IAS 39. Derivative contracts based on gold could also fall within the financial
12 2.1 Scope of the standards
March 2004
Reference
instruments standards, even though gold itself is not a financial instrument and is therefore
outside the scope of the standards.

39.5 and 6 The amendments clarify the circumstances in which a commodities contract should be
accounted for as a financial instrument, introducing two further restrictions on an entity’s
ability to use the scope exemptions for commodities contracts:
■ Although the standard still applies only to those contracts that may be settled in
cash (or other financial assets) the amendments increase significantly the meaning
of ‘may be settled in cash’. Commodity and similar contracts will be accounted for
as derivatives if the entity has a practice of trading the commodity shortly after
delivery or if the product is readily convertible to cash. Many commodity contracts
are therefore likely to be included in the scope of the standards, even if the terms
of the contract require settlement by physical delivery; and
■ Under the amendments, a written option, under which an entity might be required
to purchase or sell a commodity or other non-financial asset, can never qualify for
the ‘normal purchases and sales’ exclusion, because the entity cannot control
whether or not the purchase or sale will take place. Therefore, it cannot be a
‘normal’ purchase or sale requirement. The normal purchases / sales exemption is
retained for contracts other than written options that meet the requirement above.
2.2 Definitions relating to financial instruments

Financial instruments embrace a broad range of assets and liabilities. They include both
primary financial instruments (e.g. receivables, debt and shares in another entity) and
derivative financial instruments (e.g. financial options and forwards, including futures, as
well as interest rate swaps and currency swaps).
39.9 and 32.11 A financial instrument is any contract that gives rise to both a financial asset of one
enterprise and a financial liability or equity instrument of another enterprise.
2.2.1 Financial assets and financial liabilities
39.9 and 32.11 A financial asset is any asset that is: (a) cash; (b) a contractual right to receive cash
or another financial asset from another enterprise; (c) a contractual right to exchange
financial instruments with another enterprise under conditions that are potentially
favourable; or (d) an equity instrument of another enterprise.
A financial liability is any liability that is a contractual obligation: (a) to deliver cash or
another financial asset to another enterprise; or (b) to exchange financial instruments
with another enterprise under conditions that are potentially unfavourable.
32.13 The terms contract and contractual in the above definitions refer to an agreement
between two or more parties that has clear economic consequences and that the parties
have little, if any, discretion to avoid, usually because the agreement is enforceable by
law. Contracts defining financial instruments may take a variety of forms and do not need

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to be in writing. An example of an item not meeting the definitions would be a tax liability,
as it is not based on a contract between two or more parties.

32.11 and 39.2(e) The amendments expand the definitions of financial asset and financial liability to cover
contracts that will or may be settled in an entity’s own equity instruments. The amended
definition clarifies that a liability settled by delivering a variable number of the entity’s
own equity instruments with a fixed or determinable value (in other words where
shares are used as a settlement currency) is a financial liability. This change is likely to
have little impact in practice as similar requirements were already included in the
existing standards, although not in the definitions.
The other reason for amending the definitions is to cover derivatives whose underlying
is the entity’s own equity share price.
2.2.2 Equity instruments
32.11 and 39.9 An equity instrument is any contract that evidences a residual interest in the assets
of an enterprise after deducting all of its liabilities.
SIC-16 The current versions of the financial instruments standards do not address accounting for
transactions in own equity other than treasury shares. The topic of classification of
instruments (by an issuer) as liabilities versus equity is covered in Section 10.

32.21-24 The amendments provide a comprehensive framework on the accounting for transactions
in own equity, including derivatives whose underlying is an entity’s own equity shares,
and they discuss when these derivatives are to be accounted for as an entity’s own
equity and when they are to be accounted for as assets or liabilities. The requirements
are covered in Section 10.
2.2.3 Derivatives
39.9 A derivative is a financial instrument:

(a) whose value changes in response to the change in a specified interest rate, security
price, commodity price, foreign exchange rate, index of prices or rates, a credit
rating or credit index, or similar variable (sometimes called the underlying);
(b) that requires no initial net investment or little initial net investment relative to other
types of contracts that have similar responses to changes in market conditions; and
(c) that is settled at a future date.
All of the above must be met in order for a financial instrument to be a derivative.
14 2.2 Definitions relating to financial instruments
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39.9 The revised standards include an amendment to part (b) of the definition. The amended
definition requires only an initial net investment that is smaller than would be required
for a similar non-derivative contract with similar responses to changes in market
conditions. This is explained further in Section 2.2.3.2. The amendment is not a
substantive change to the definition.
2.2.3.1 Change in value based on an underlying

IG B.8 A derivative financial instrument is a financial instrument that provides the holder (or
writer) with the right (or obligation) to receive (or pay) cash or another financial instrument
in amounts determined by reference to price changes in an underlying price or index, or
changes in foreign exchange or interest rates, at a future date. A derivative may have
more than one underlying variable.
Common types of derivatives are options, swaps and forwards. Examples include interest
rate swaps, foreign currency forward contracts or equity call options. An interest rate
swap is a contract that results in the exchange of cash flows based on different (i.e. fixed
or floating) interest rates. A foreign currency forward contract is an agreement to exchange
at some future date an amount of one currency for an amount of another currency at a
set forward exchange rate. An equity call option gives the holder the right to receive a
financial instrument and will be exercised if the price of the equity security rises above
the exercise price of the call option. Another example of a derivative is a forward contract
to acquire a bond at some future date at an agreed price. The forward contract has a
positive fair value if the price of the bond increases and a negative fair value if the price
of the bond decreases compared to the agreed upon price.
39.AG9 A derivative usually has a notional amount, which can be an amount of currency, a number
of shares, a number of units of weight or volume or other units specified in the contract.
However, the holder or writer is not required to invest in or receive the notional amount at
the inception of the contract. Alternatively, a derivative could require a fixed payment as
a result of some future event that is unrelated to a notional amount. For example, an entity
may enter into a contract whereby it will receive a fixed payment of 1,000 if a specified
index increases by a determined number of points in the next month. The settlement
amount is not based on and does not need to change proportionally with an underlying.
IG B.2 and B.3 The underlying price change upon which a derivative financial instrument is based may be
that of a primary financial instrument (such as a bond or equity security) or a commodity
(such as gold, oil or wheat), a rate (such as an interest rate), an index of prices (such as a
stock exchange index) or some other indicator that has a measurable value. A key element
of a derivative is that the transaction must allow for settlement in the form of cash or the
right to another financial instrument. Settlement of a derivative, such as an interest rate
swap, may be either a gross or net exchange of cash or other financial instruments.
2.2.3.2 Little or no initial net investment

39.AG11 There is no quantified guidance as to what constitutes little or no initial net
investment. The initial net investment should be less than the investment needed to
acquire a primary financial instrument that has a similar response to changes in market

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conditions. However, less than does not necessarily mean insignificant in relation
to the overall investment and needs to be interpreted on a relative basis.
For example:
IG B.10 ■ A margin account is not considered to be an initial net investment. Rather, margin
accounts are funds required to be deposited as collateral with a broker in order to
have transactions executed by that broker.
39.AG11 ■ If there is an exchange of amounts when entering into a contract, for example, the
exchange of one currency for another is a cross currency swap, which is not seen as
an initial net investment provided the amounts of cash are of equal fair value.
IG B.6 ■ If two offsetting loans are entered into that have equal terms and conditions except for
their interest rates, which in substance form an interest rate swap, these loans are considered
to be a derivative and should be accounted for as such if all of the defining characteristics
of a derivative are met. There are exceptions to this, such as when an entity can demonstrate
an economic need or a substantive business purpose for structuring transactions separately
that could not have been accomplished in a single transaction.
39.AG11 An example of a derivative instrument is an option that gives the holder the right to buy
another financial instrument at a strike price on or before a specified date. The premium
paid for an option fulfils the requirement of little or no initial investment as it is less than
the amount required to obtain the underlying instrument outright, except when the option
is so deep in the money that the premium paid is equivalent to making an investment in the
IG B.9 underlying. In the latter case under IAS 39 the instrument would not be accounted for as
a derivative, but rather as an investment in the underlying itself. Similarly, when an entity
enters into a forward contract to purchase an investment which will be settled in the
future, but prepays the contract based on the current market price, the entity does not
have a derivative contract as this does not meet the criteria of little or no initial net
investment. Rather the entity would record the investment itself as a non-derivative
financial asset.
Sometimes part of a derivative is prepaid. The question then arises as to whether the
remaining part still constitutes a derivative. This depends on whether all of the criteria of
the definition are still met.
IG B.4 ■ If a party to an interest rate swap transaction prepays its pay-fixed obligation at
inception, the floating rate leg of the swap is still a derivative instrument. To illustrate,
an entity enters into an interest rate swap contract where it pays fixed and receives
variable rates based on a notional amount. The entity prepays its fixed obligation by
paying the counterparty the fixed obligation discounted using the current market rate.
The entity will continue to receive the variable rates over the life of the swap. In this
circumstance, all of the criteria for being a derivative are still met. The initial net
investment (i.e. the amount prepaid by the entity) is still significantly less than investing
in a similar primary financial instrument that responds equally to changes in the
underlying interest rate. Also, the instrument’s fair value changes in response to
changes in interest rates and the instrument is settled at a future date. If the party
prepays the pay-fixed obligation at a subsequent date, this is considered to be a
termination of the old swap and an origination of a new swap.
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IG B.5 ■ In the reverse situation, if a party to an interest rate swap transaction prepays its pay-
variable obligation at inception using current market rates, the swap is no longer a
derivative instrument because the prepaid amount now provides a return that is the
same as that of an amortising fixed rate debt instrument of the amount of the
prepayment. Therefore, the initial net investment equals that of other financial
instruments with fixed annuities.
2.2.3.3 Settlement at a future date

Derivatives require settlement at a future date. A forward contract is settled on a specified
future date, an option has a future exercise date and interest rate swaps have several
dates on which interest is settled. An option is considered to be settled upon exercise or at
its maturity. Therefore, even though the option may not be expected to be exercised
when it is out-of-the-money, the option still meets the criteria of settlement at a future
date. Any contract where there is a time period between the trade date and the settlement
date would be a derivative if the other criteria are also met.
A related consideration when determining whether an instrument must be accounted for
as a derivative is the exemption for so-called regular way transactions. This topic is
covered in Section 4.3.2.
2.2.3.4 Summary of key concepts concerning derivatives

There are several key concepts relating to derivatives which are considered in detail in
later Sections.
■ Derivatives should be recognised on an entity’s balance sheet, initially at their cost,
which is the fair value of the related consideration given or received (Section 4).
■ Derivatives are thereafter measured at their fair value at each reporting date with
changes recognised in the income statement (Section 6).
■ Derivatives are often used to hedge the risks related to other financial and non-financial
assets and liabilities. If specific hedging criteria are met, the derivative and the related
item being hedged qualify for hedge accounting treatment (Sections 8 and 9).
2.2.4 Financial guarantee contracts and credit derivatives

39.2(f) Financial guarantee contracts where a payment is made if a debtor fails to make payment
when due are outside the scope of IAS 39. The form of the contract (e.g. guarantee, letter
of credit, derivative etc.) is not an important factor when determining whether IAS 39 is
applicable. To be excluded from IAS 39, payment on the contract should only be triggered
if the holder of the contract experiences a financial loss from a debtor’s failure to make a
payment when due. This should be a pre-condition for payment under the contract.
The amount of the payment should be proportional to that loss (e.g. not leveraged).
39.3 Some contracts that are labelled as financial guarantees provide for a payment to be
made if events other than an actual financial loss occur. For instance in some standard
credit default agreements, a payment is triggered if the debtor’s credit rating is downgraded
below a specified level. A contract triggered by a change in an underlying rate or index,
such as a rating downgrade, is considered a derivative that is within the scope of IAS 39.

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39.2(f) To be excluded from IAS 39, the holder of the financial guarantee contract must be the
party that is exposed to the risk of loss from the debtor’s failure to make payment.
A guarantee must be treated as a derivative if the holder of the contract is not the party
exposed to risk of loss. That is because the event of default merely acts as the underlying
variable in a derivative contract. This is the case for both the holder and the issuer of the
guarantee contract.
Case 2.1 Guarantee contract versus credit derivative

39.2(f) Entity B makes a loan to Entity C. Entity B also enters into a guarantee contract issued
by Bank A that is triggered by the default of designated payments of Entity C to
Entity B. This contract would be accounted for as a financial guarantee, not a derivative,
in the financial statements of Bank A and Entity B.
39.3 However, assume the same structure is in place except that Bank A will make
payments to Entity B based on a change of the credit rating of Entity C. In such a
case, the contract should be accounted for as a derivative in the financial statements
of Bank A and Entity B.
Case 2.2 Guarantee contract held by a third party

A guarantee contract issued by Bank A to Entity B is triggered by the default of
designated payments by Entity C to Entity D. Because Entity B is not exposed to a risk
of financial loss (only Entity D has this risk) the contract is a derivative, both in the
financial statements of Bank A (issuer) and Entity B (holder).

39.2(f) The distinction between financial guarantee contracts and credit derivatives remains
as described above. The amendments provide additional guidance on the initial and
subsequent measurement of issued financial guarantee contracts and loan commitments
that are excluded from the scope of the standard. Such instruments are initially measured
at fair value and subsequently measured at the higher of the amount initially recognised
(less amounts recognised as revenue under IAS 18) and the provision that would be
required under IAS 37.
2.2.5 Embedded derivatives

A non-derivative financial instrument can have certain characteristics that cause it to
behave like a derivative. An embedded derivative must be evaluated to determine whether
it must be separated from the financial instrument, and accounted for as a stand-alone
derivative. Section 3 is devoted to this topic.
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2.3 Financial risks
Risk can be viewed as uncertainty in cash flows. The uncertainty in cash flows influences
the fair value of recognised assets and liabilities or the level of cash flows relating to
future transactions. The following are financial risks that are related to financial instruments:
32.52 Interest rate risk – the risk that future changes in prevailing interest rates will affect the
fair value or cash flows of a financial right or obligation. Changes in market interest rates
may affect an entity’s right to receive or obligation to pay cash or another financial
instrument at a future date, or the fair value of that right or obligation.
Currency risk (also referred to as foreign exchange (FX) rate risk) – the risk that
changes in foreign exchange rates will affect the fair value or cash flows of a recognised
financial instrument, firm commitment or forecasted transaction.
Market risk (also referred to as commodity or price risk) – the risk that the fair value
or cash flows of an instrument will be affected by factors specific to the particular
instrument or to the issuer of the instrument, or by general market conditions. An example
of this is the risk of price changes of an equity instrument.
Credit risk – the risk that one party to a financial instrument will fail to discharge an
obligation and cause the other party to incur a financial loss. An entity may reduce its
exposure to credit risk through policy measures such as imposing credit limitations or
requiring collateral from counterparties, or it may use credit derivatives.
Liquidity risk – the risk that an entity will encounter difficulty in raising funds to meet
commitments, which may result in a loss being incurred because a position cannot be
liquidated quickly at close to its fair value.
A common strategy in risk management is hedging, where risks that an entity faces are
reduced or eliminated by entering into transactions that give an offsetting risk profile.
Essentially hedging means matching the characteristics of incoming and outgoing cash
flows in such a way that the effects of changes in market prices or rates are reduced or
have no impact on the future net cash flows for the entity and therefore have no impact
on the income or value of the entity.
The distinction between economic financial risk management and hedge accounting is
important to understand. The use of hedge accounting allows an entity to reflect the
economics of a hedge relationship in the financial statements by matching offsetting gains
and losses in the income statement in the same reporting period. However, not all economic
financial risk management practices will qualify for hedge accounting. The use of hedge
accounting is restricted under IAS 39 and can be costly to achieve. Sections 8 and 9 are
devoted to hedge accounting topics.
2.3 Financial risks 19

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3. Embedded derivatives

■ What are embedded derivatives
■ Distinguishing characteristics
■ Separate accounting
Reference 3.1 Overview

39.10 Derivatives are typically stand-alone instruments, but they may also be found as
components embedded in a financial instrument or in a non-financial contract. A host
contract may, for example, be a financial instrument, an insurance contract, a lease, a
purchase agreement, a service agreement, a construction contract, a royalty agreement
or a franchise agreement.
39.10 The component that is a derivative instrument is referred to as an embedded derivative.
An embedded derivative is one or more implicit or explicit terms in a contract that affect
the cash flows of the contract in a manner similar to a stand-alone derivative instrument.
If a contract or set of contracts contains derivative features that may be transferred
separately, these are not considered to be embedded derivatives, but rather freestanding
derivatives. Such derivatives could be attached at inception or at a later stage by a party
to the contract or by a third party.
An embedded derivative that meets the definition must be separated from its host contract
and measured as if it were a stand-alone derivative if its economic characteristics are not
closely related to those of the host contract. If the economic characteristics of an embedded
derivative are closely related to those of the host contract, then it may not be separated.
The standards include detailed examples of host contracts and derivatives that require
separation and those that do not.
39.10 and 11 If an embedded derivative is separated, the host contract is accounted for under IAS 39
if it is itself a financial instrument, or in accordance with other appropriate IFRS if it is not
a financial instrument. This is intended to achieve consistent treatment of transactions of
similar substance, whatever the form, and to prevent entities from circumventing the
requirement to measure derivatives at their fair value in the balance sheet.
39.11 If the combined instrument is carried at fair value with changes in fair value recognised in
the income statement, separate accounting is not necessary, nor is it permitted.
Determining whether an embedded derivative should be accounted for separately can be
a complex process, as shown in the decision tree in Figure 3.1 and in Table 3.2 later in this
Section. The process of reviewing a range of contracts to identify those that might contain
embedded derivatives is an important and time-consuming aspect of IAS 39.
20 3.1 Overview
March 2004
Reference
Figure 3.1 Decision tree for hybrid financial instruments

39.9 One of the amendments will be to introduce a choice, in respect of each purchase,
origination or issue of a financial instrument, to designate the instrument on initial
recognition as ‘fair value through profit or loss’. An entity may, therefore, avoid the
complexity of separating and measuring embedded derivatives by measuring the entire
instrument at fair value through profit or loss.
For example, prior to the amendments, the equity call option embedded in an available-
for-sale investment in a convertible bond would be separated and measured at fair
value (if changes in the value of available-for-sale assets were recognised in equity, as
permitted by the previous standard as an accounting policy choice). If the convertible
is listed, it will be simpler for the entity to designate the entire bond as fair value
through profit or loss and measure it at its market price, thereby avoiding the need
separately to value and account for the option.
Another example may be a complex investment product issued by a bank or insurer that
contains a host deposit contract and a number of embedded derivatives based on interest
rates, equity prices, etc. It may be simpler for the entity to determine a fair value for the
instrument as a whole than separately for the embedded derivative components.
3.1 Overview 21
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3.2 Economic characteristics and risks
39.AG30 and 33 IAS 39 sets out examples of when the characteristics and risks are and when they are
not closely related.
The table below outlines the key characteristics of common host contracts.
Table 3.1 Key characteristics of common host contracts

Host contract Key characteristics
Debt contract The value of a debt contract is driven by the interest rates associated
with the contract, which comprise the factors of:
■ risk-free interest rate;
■ expectations of future interest rates and inflation (forward rates);
■ credit risk (specific and sector spread); and
■ expected liquidity / maturity.
Equity contract The value of an equity contract is associated with the underlying
equity price or index.
Insurance contract The value of an insurance contract is dependent on:

■ level of future premiums;
■ interest rates;
■ inflation rates; and
■ actuarial assumptions (e.g. expected claims, mortality).
Lease contract The value of a lease contract is dependent on:

■ inflation rates;
■ interest rates; and
■ revenues generated from the leased asset (e.g. lease rentals).
Contracts for The value of supply contracts is dependent on:

goods and services ■ the price of the goods or services sold;
■ inflation rates; and
■ the currency in which payment is denominated.
39.AG33 Any feature that leverages the exposure of the host contract to more than an insignificant
extent constitutes an embedded derivative that must be separated. Leverage in this context
(for contracts other than options) means that the value of the hybrid instrument changes
in proportion to the underlying by more than 100 per cent, either positively or negatively.
39.AG33 In certain circumstances the currency of cash flows generated by committed future sales
and purchases of an entity may differ from the reporting or measurement currency of either
the supplier or the customer. Such contracts are likely to contain embedded derivatives
which should be accounted for separately. For example, Entity A has Euro as its measurement
currency, and sells goods or services to Asia priced in USD. Entity A should account for the
supply contract as the host contract in Euro with an embedded foreign currency forward.
Changes in fair value of the foreign currency component of the contract should be included
in the income statement (unless hedge accounting can be applied).
22 3.2 Economic characteristics and risks
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39.AG30 and 33 IAS 39 also provides examples of when the economic characteristics and risks of an
embedded derivative are and are not considered to be closely related to the host contract.
Table 3.2 presents examples of typical host contracts and embedded derivative components.
This is followed by a list of features of the derivative component that are considered to be
closely related and those that are not. Where no separation is required, this assumes
there is no leverage nor inverse leverage.

As noted above and in Table 3.2, a committed purchase or sales contract in a foreign
currency contains an embedded derivative. Under the existing standard, that embedded
derivative must be separated unless the currency of the contract is the functional
currency of another party to the contract or is the currency in which the product is
routinely denominated in international commerce. ‘Routinely denominated’ is interpreted
extremely narrowly, so that an oil transaction denominated in USD is one of the few
transactions that qualifies for this exemption.
39.AG33(f) The amendments introduce a further exemption, that the embedded derivative should
not be separated if the contract requires payment in a currency that is commonly used
in contracts in that economic environment. In the example above, the embedded
derivative would not be separated as long as Entity A can demonstrate that it is common
for this type of product or service to be priced in USD in, for example, the Asian
country in which it is sold.
3.3 Separation of the embedded derivative

39.11 An embedded derivative that meets all of the criteria needs to be accounted for separately
from its host. IAS 39 does not require separate presentation of embedded derivatives in the
balance sheet. However, an entity is required to disclose separately its financial instruments
carried at cost and those carried at fair value. Therefore, at a minimum, embedded derivatives
that are not presented separately in the balance sheet should be disclosed.
39.12 If an embedded derivative cannot be measured reliably although the characteristics are
such that separation would be required, the entire combined contract (host and embedded
derivative) is to be treated as a financial instrument held for trading.
In the case of multiple embedded derivative components the embedded derivatives are
only separated individually if they:
■ are clearly present in the hybrid instrument as evidenced by the contractual terms
and the economic substance of the hybrid instrument;
■ relate to different risk exposures; and
■ are readily separable and independent of each other.
3.3 Separation of the embedded derivative 23

Table 3.2 Host contracts and embedded derivative components
24
Type of Type of embedded Features closely related Features not closely related
host contract derivative component (no separation) (separation required)
Instrument Instrument
Equity-linked interest or Never closely related to a debt host contract. When interest or principal payments are dependent on
principal payments equity prices (indexed).
Commodity-linked or Never closely related to a debt host contract. When interest or principal payments are dependent on
other non-financial- commodity prices or other non-financial assets (indexed).
indexed interest or
principal payments
Equity conversion feature Never closely related to a debt host contract. When the debt instrument may be converted to equity shares
of the issuer or another entity. 1
Option or automatic When the option to extend the maturity is made at prevailing market When the option or automatic provision to extend the
Debt
provision to terms at the time of the extension. maturity is on terms which differ from market terms at the
extend maturity time of extension.
Call or put option to When exercisable at the accreted or amortised amount or when the exercise When exercisable for other than the accreted or amortised
repay before price of the option does not result in a significant gain or loss, such as when amount of the debt, or when the exercise price results in a
final maturity debt is issued or purchased at an insignificant discount or premium. significant gain or loss.
Equity kicker Never closely related to a debt host contract. When a subordinated loan entitles the grantor of the loan

to receive shares of the borrowing entity for free or at a
very low price.
1
Interest rates of a debt instrument and the changes in fair value of an equity instrument are not closely related, therefore, the conversion option must be accounted for separately.
March 2004
Table 3.2 Host contracts and embedded derivative components (continued)
Credit derivative When the payments depend on the credit risk of the issuer of the debt When the payments depend on the credit risk of a reference
instrument itself. item other than the debt instrument itself.
Index-linked When the indexing relates to future interest or inflation, resulting in a When the indexing is not in a one-to-one proportion to
(floating) rates situation where: the debt, for example, significantly leveraged through a
of interest ■ the holder of the instrument would recover substantially all of its different notional reference or a significant inverse
recorded investment; or relation to the market rate, resulting in a situation where:
■ the issuer would not pay more than twice the market rate at inception. ■ the holder of the instrument would not recover
From the holder’s perspective, this also applies when the contract permits, substantially all of its recorded investment; or
but does not require that not all of the recorded investment is recovered. ■ the issuer would pay more than twice the market rate
at inception.2
Inflation-indexed When the inflation index is one commonly used for this purpose in the When the inflation index relates to a different economic
Debt
interest payments economic environment in which the debt is denominated. environment or the index is not one that is commonly
used for this purpose.
Interest caps and floors When the embedded cap or floor is at or out-of-the money at the time of When the embedded cap is below the market rate of interest
issue, i.e. the exercise interest rate of the cap is at or above market rates (in-the-money cap) or the floor is above the market rate
and the floor is at or below market rates. of interest (in-the-money floor) at the time of issue.

Foreign currency When cash flows are denominated in a foreign currency and: When a foreign currency option is included on debt repayment.
debt instruments ■ either the principal and interest are denominated in the same foreign
currency; or
■ the principal and interest are denominated in different foreign
currencies. Foreign currency gains and losses are accounted for under
IAS 21.
2
The assessment of the effect of these features should be made when the contract is entered into. There should be a high expectation at inception that these limits will not be exceeded.
Determination of these limits involves the estimation of future movements in the relevant indices. As objective indications of future movements are generally not available it would
be relevant to apply historic movements for this purpose.
25
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26
Equity call and Never closely related to a host contract. Always separated when held by an entity.
put options
an entity)
Equity (held by
Inflation-indexed When lease payments are adjusted based on an inflation-related index, When lease payments are adjusted according to a leveraged
lease payments provided that the indexing is not significantly leveraged and that the inflation index, or the index is unrelated to inflation in the
index relates to inflation in an economic environment that is relevant entity’s own economic environment.
to the lease contract.
Contingent rentals When contingent rentals are based on: When contingent rentals are based on:
■ related sales or variable interest rates; or ■ leveraged sales or variable interest rates; or
Lease
■ indices that are closely related to the lease. ■ indices that are not closely related to the lease.
Foreign currency component When rentals are denominated in a foreign currency that is the currency When rentals are not denominated in a foreign currency
of the primary economic environment in which any substantial party to that is the currency of the primary economic environment
that contract operates (measurement currency). in which any substantial party to that contract operates
(measurement currency).
March 2004
Foreign currency component When a commercial contract involves payment for goods or services When commercial contracts require payment denominated
denominated in a foreign currency: in a currency that is not:
■ that is the currency of the primary economic environment in which ■ the currency of the primary economic environment in
any substantial party to that contract operates (measurement which any substantial party to that contract operates
currency); or (measurement currency); and
■ that is the currency in which the price of the related good or service ■ the currency in which the price of the related good or
that is acquired or delivered is routinely denominated in international service that is acquired or delivered is routinely
commerce worldwide.3 denominated in international commerce worldwide.
Price clauses When commercial contracts are based on prices or indices that are When commercial contracts are based on prices or indices
related closely related to the contract (e.g. related to the price of the purchased unrelated to the contract (e.g. unrelated to the price of the
to indices or sold goods or services). purchased or sold goods or services).
Combination of call and put When the purchased call and written put are in-the-money
Commercial contracts (purchase, sale)

When the purchased call and the written put are at or out-of-the money,
option, resulting in a price i.e. the exercise price of the call is at or above market rates and of the at the time the contract is entered into.
range (a collar) put is at or below market rates at the time the contract is entered into.
3
27
Note that: ‘Routinely denominated’ is very narrowly defined. It is only a currency that is used for similar transactions all around the world, not just in one local area.
March 2004
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In many cases, multiple embedded derivatives should not be separated individually.
For example, if a debt instrument has a principal amount related to an equity index and
that amount doubles if the equity index exceeds a certain level, it is not appropriate to
separate both a forward and an option on the equity index because those derivative
features relate to the same risk exposure. Instead the forward and the option elements
are treated as a single compound embedded derivative.
39.AG29 On the other hand, if a hybrid debt instrument contains, for example, two options that give
the holder a right to choose both the interest rate index on which interest payments are
determined and the currency in which the principal is repaid, those two options may
qualify for separation as two separate embedded derivatives as they relate to different
risk exposures and are readily separable and independent of each other.
39.AG33 If an embedded derivative is not required to be separated, IAS 39 does not permit an
entity to separate the hybrid instrument. In other words, separation is not optional.
3.3.1 How to split fair values at initial recognition

39.AG28 and As the derivative component is measured separately at fair value upon initial recognition,
32.31 the carrying amount of the host contract at initial recognition is the difference between
the cost of the hybrid instrument and the fair value of the embedded derivative. Where more
reliable fair values exist for the hybrid instrument and the host contract (e.g. through
quoted market prices) than for the derivative component, it may be acceptable to use
those values to determine the fair value of the derivative upon initial recognition.
IG C.1 and C.2 When separating an instrument that is a forward, the forward price is set such that the
fair value of the embedded derivative is zero at the inception of the contract. This means
that the forward price should be at market rates. When separating an embedded feature
that is an option, the separation should be based on the stated terms of the option feature
documented in the hybrid instrument. As a result the embedded derivative would not
necessarily have a fair value or intrinsic value equal to zero at the initial recognition of the
hybrid instrument. However, the embedded derivative must be valued based on terms
that are clearly present in the hybrid instrument.
3.3.2 Designating embedded derivatives as hedging instruments

Embedded derivatives that are accounted for separately may be designated as hedging
instruments. The normal hedge accounting criteria as outlined in Section 8 apply to
embedded derivatives used as hedging instruments.
28 3.3 Separation of the embedded derivative
March 2004
4. Recognition and derecognition

■ Initial measurement
■ Transaction costs
■ Recognition
■ Trade date versus settlement date accounting
■ Derecognition of:
– financial assets
– financial liabilities
■ Issues relating to special purpose entities

39.14 An entity must consider both the amount to be recognised as well as the timing of
recognition. An instrument is recognised in the balance sheet when the entity becomes
party to a contract that comprises a financial instrument.
There are specific rules governing when an entity may remove financial assets and financial
liabilities from its balance sheet. For financial assets these rules are based on whether an
entity has given up control over the contractual rights of the financial asset. For financial
liabilities derecognition depends on whether an entity has settled, or has been legally
relieved of, its obligation. In both situations when derecognising a financial instrument,
parts of that instrument can be retained or new instruments may need to be recognised.
4.2 Initial measurement

39.43 and At initial measurement, a financial instrument is included in the balance sheet at cost,
39.AG64 which should equal its fair value, i.e. the consideration given or received. The consideration
given or received is normally the transaction price or the market price. It can also be the
fair value of financial instruments (other than cash) given or received in exchange for the
financial instrument to be recognised. If the transaction is not based on market terms, or
if a market price cannot be readily determined, then an estimate of future cash payments
or receipts, discounted using the current market interest rate for a similar financial
instrument, should be used to approximate the fair value.
39.AG64 If a bank makes a low interest or interest-free loan to a customer, the cost amount given
by the bank (which recognises an asset) and the amount received by the customer (which
recognises a liability) is often interpreted to be the cash transferred. This same issue
often arises in relation to low or no interest inter-company loans or inter-company current
accounts. In both cases, the initial carrying amount of the loan is not the amount lent, but
4.2 Initial measurement 29

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Reference
rather the fair value of the consideration given to obtain the right to payment in the future.
A low interest or interest-free loan discounted at a market rate of interest results in a
present value that is less than the amount lent. The difference is not a financial asset.
However, if this difference qualifies for recognition under another applicable IFRS (e.g. a
recognisable intangible benefit) then it is recognised as an asset. If the difference does
not qualify for recognition, it must be expensed.
Case 4.1 Low interest loan

Bank Q grants a three-year loan of 50,000 to an important new customer. The interest rate
on the loan is four per cent, while the current market lending rates for similar loans to
customers with a similar credit risk profile is six per cent. Bank Q believes that the future
business to be generated with this new customer will lead to a profitable lending relationship.
On initial recognition Bank Q should recognise the carrying amount of the loan as the
fair value of the payments that it will receive from the customer. Discounting the
interest and principal repayments using the market rate of six per cent, Bank Q will
recognise an originated loan of 47,328. The difference of 2,672 is expensed immediately
as the expectation about future lending relationships does not qualify for recognition as
an intangible asset.
4.2.1 Transaction costs
39.AG13 Transaction costs are included in the initial measurement of financial assets and liabilities.
These may be incurred when an entity enters into a contractual arrangement.
Transaction costs that are included in the initial measurement are those costs paid to
external parties, such as fees and commissions paid to agents, advisers, brokers and
dealers, as well as levies paid to regulatory agencies and securities exchanges, and transfer
taxes and duties. Transaction costs may include internal costs, but both internal and external
costs must be incremental. Transaction costs do not include internal financing, holding
and administrative costs, nor do they include debt premiums or discounts.
IG E.1.1 The treatment of transaction costs after initial recognition depends on the subsequent
measurement of the instrument of which they are a part:
■ for financial assets and liabilities that are carried at amortised cost, the transaction costs
are amortised to the income statement as part of the recognition of the effective interest;
■ for financial assets carried at cost, but with no set maturity, the transaction costs are
recognised in the income statement at the time of sale;
■ for financial assets that are carried at fair value with changes in fair value recognised
in the income statement, the transaction costs are expensed upon subsequent
measurement; and
■ for financial assets that are carried at fair value with changes in fair value recognised
directly in equity, the transaction costs for debt instruments are amortised to the
income statement as part of the recognition of the effective interest on such
instruments, but for equity instruments they are recognised only at the time of sale.
39.46 Transaction costs, incurred or expected to be incurred at a subsequent date related to the
transfer or disposal of a financial instrument, should not be considered in the subsequent
30 4.2 Initial measurement
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Reference
measurement of the financial instrument. Disposal costs are only included in the income
statement when a financial instrument is derecognised.

39.43 The amended standards specify more clearly that the amount at which a financial asset
or liability is recognised initially is its fair value plus, in the case of a financial asset or
financial liability that is not at fair value through profit or loss, transaction costs.
39.9 The amended standards confirm that transaction costs must be incremental and directly
attributable to the acquisition, issue or disposal of an instrument. Incremental costs are
those that would not have been incurred if the instrument had not been acquired, issued
or disposed of. In practice, few internal costs are likely to meet this requirement.
The requirement is also applied on an instrument-by-instrument basis. It will not, for
example, be permitted to treat as transaction costs the internal costs associated with
developing a new investment product.
39.43 Transaction costs on financial instruments measured at fair value through profit or loss
are not included in the amount at which the instrument is measured initially, instead
they are charged immediately to the income statement.
4.3 Recognition
4.3.1 When to recognise

39.14 An enterprise should recognise a financial asset or liability in its balance sheet when,
and only when, it becomes a party to the contractual provisions of the instrument.
39.AG35 Situations where an entity has become a party to contractual provisions include committing
to a purchase of securities or committing to write a derivative option. In contrast, planned
but not committed future transactions, no matter how likely, are not financial assets or
liabilities as they do not represent situations where the entity becomes a party to a contract
requiring future receipt or delivery of assets. For example, an entity’s estimated but
uncommitted sales do not qualify as financial assets or liabilities.
4.3.2 Trade date versus settlement date accounting

39.AG55 and 56 The trade date is the date an entity enters into a contract for the purchase or sale of an
asset. The settlement date is the date that the financial instrument is delivered to or
transferred from the entity.
The recognition principle in IAS 39 would result in all transactions that occur in regulated
markets to be accounted for on the trade date. However, the standard recognises that
practice by many financial institutions and corporates is to use settlement date accounting,
and that it would be cumbersome to account for such transactions as derivatives between
the trade and settlement date.
39.AG12 Because of the short duration between the trade date and the settlement date in
these types of regulated market situations, such regular way contracts are not
recognised as derivative contracts under IAS 39. A regular way contract may be a
purchase or a sale that requires delivery of assets within a period of time generally
4.3 Recognition 31
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Reference
recognised to be the market convention or established by regulation in the marketplace
IG B.30 in which the transaction actually takes place. This exception is a practical approach
taken in IAS 39 to prevent the recognition of derivatives in many situations, and for
very short periods, where the constraints in the marketplace prevent immediate
settlement at the trade or commitment date.
IG B.28 In order for a financial asset purchase to be regular way, it is not required that an organised
market exists (e.g. a formal stock exchange, organised over-the-counter market, etc).
Rather, the term ‘marketplace’ means the environment in which the financial asset is
customarily traded. For example, a commitment for a standard three-day settlement
(assumed to be the norm for a particular marketplace) of a security purchase transaction
would not be treated as a derivative as this is a regular way transaction. However, a
commitment for a three-month settlement (assuming that this is not the norm in the
IG B.29 marketplace of these instruments) for the same security transaction would meet the
definition of a derivative because it is not considered to be a regular way transaction.
39.AG54 The regular way exception requires that the transaction will be fulfilled through actual
delivery of the financial instrument. Therefore, if a contract allows for or requires net
cash settlement it does not qualify as a regular way contract.
39.38, AG53 When accounting for regular way purchases and sales of a financial asset, an entity may
and IG B.32 choose either trade date or settlement date accounting. The approach should be applied
consistently for both purchases and sales of the different categories of financial assets.
There are no specific requirements about trade date and settlement date accounting in
respect of financial liabilities, therefore the general recognition and derecognition
requirements apply. Under trade date accounting, the asset to be received and related
obligation to pay for it are recognised on the date the contract is entered into. If settlement
date accounting is chosen, the asset is recognised on the actual date of settlement, i.e. the
date that the instruments are exchanged. In the case of a purchase under settlement date
accounting, changes in the fair value of the financial instrument between the date of trade
and settlement should be recognised if the financial instrument is carried at fair
39.57 value. In the case of a sale under settlement date accounting the opposite occurs: changes
in the fair value after the trade date are not taken into account, as there is a set sale price
agreed upon at the trade date, making subsequent changes in fair value irrelevant from
the seller’s perspective.
Case 4.2 Purchase of a bond, comparing trade date and settlement date accounting
On 28 June 20X1, Entity X agrees to purchase a bond for settlement on 1 July 20X1.
The purchase price of the bond is 10.0 million. On 30 June 20X1, the fair value of the
bond is 10.1 million. On 1 July, the bond purchase is settled for 10.0 million and the fair
value remains as 10.1 million.
What would be the impact on the balance sheet of the bond purchase at each of the
dates of 28 June, 30 June and 1 July?
The balance sheet impact is shown below for both the settlement date approach and
the trade date approach. The example illustrates initial measurement of the bond purchase
under two scenarios: (1) a bond subsequently carried at fair value and (2) a bond
subsequently carried at amortised cost.
32 4.3 Recognition
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Reference
IG D.2.1 Settlement date accounting Trade date accounting
(amounts in millions) Fair value Amortised cost Fair value Amortised cost
28 June 20X1
Financial asset-bond – – 10.0 10.0
Financial liability – – (10.0) (10.0)
30 June 20X1
Financial asset-receivable
(revaluation gain) 0.1 – – –
Financial asset-bond – – 10.1 10.0
Financial liability – – (10.0) (10.0)
Equity (0.1) – (0.1) –
1 July 20X1
Financial asset-receivable
(revaluation gain) – – – –
Financial asset-bond 10.1 10.0 10.1 10.0
Cash paid (10.0) (10.0) (10.0) (10.0)
Equity a (0.1) – (0.1) –
a
This is recognised either in the income statement (i.e. retained earnings) or directly in equity, depending
on the classification of the bond.
As noted in the example, the effect on the income statement and on equity is the same
under settlement date and trade date accounting for purchases. However, the use of
trade date accounting versus settlement date accounting could have a significant temporary
impact on the balance sheet of an entity.
Case 4.3 Sale of a bond, comparing trade date and settlement date accounting
On 28 November 20X1, Entity X agrees to sell the bond for 9.6 million, its fair value at
that date, with a settlement date of 1 December 20X1. On 30 November 20X1, the
bond is worth 9.5 million. On 1 December 20X1, the bond is settled at a price of
9.6 million and the fair value of the bond is still 9.5 million.
What would be the impact on the balance sheet of the bond sale at 28 November,
30 November and 1 December?
4.3 Recognition 33
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39.AG56 Settlement date accounting Trade date accounting
(amounts in millions) Fair value Amortised cost Fair value Amortised cost
28 November 20X1
Financial asset-bond 9.6 10.0 – –
Financial asset-receivable – – 9.6 9.6
Retained earnings b – – 0.4 0.4
Equity c 0.4 – – –
30 November 20X1
Financial asset-bond 9.6 10.0 – –
Financial asset-receivable – – 9.6 9.6
Retained earnings b – – 0.4 0.4
Equity c 0.4 – – –
1 December 20X1
Cash 9.6 9.6 9.6 9.6
Financial asset-bond – – – –
Financial asset-receivable – – – –
Retained earnings d 0.4 0.4 0.4 0.4
b
For trade date accounting the loss is recognised in the income statement (i.e. retained earnings) on the
trade date.
c
For settlement date accounting the revaluation adjustment is recognised in equity until actual settlement,
assuming fair value changes on this instrument are recognised in equity.
d
For both trade date and settlement date accounting the effect is ultimately the same (i.e. the loss is reflected
in the income statement).
Despite the change in fair value of the bond between the trade date and settlement
date, Entity X does not record the additional 0.1 million loss as it will receive 9.6 million
on the settlement date from the purchaser.
As can be seen above, when accounting for sales, the effect on equity, the presentation
of the transaction in the income statement and in the balance sheet may be temporarily
different under trade date versus settlement date accounting.
4.4 Derecognition
4.4.1 Derecognition of a financial asset

39.17 and AG36 Derecognition of a financial asset or a portion of a financial asset occurs under the
current standards when, and only when, the entity loses control of the contractual rights
that comprise the financial asset (or portion thereof). An entity loses control if it realises
the rights to benefits specified in the contract, those rights expire or the entity surrenders
those rights.
The derecognition provisions in IAS 39 take a financial components approach. The financial
components approach focuses on control of the financial assets or portions thereof that
are transferred to another party. A transfer can be broken down into its various financial
components, which are then recognised by the parties to the transfer that control those
components. Examples of components of a financial asset are its cash flows from principal
34 4.4 Derecognition
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Reference
repayment and cash flows from interest coupons. These cash flows can be segregated
and potentially transferred to other parties.
Determining control over a financial asset under the current standards requires identifying
the risks and benefits of the asset and evaluating which party has exposure to and / or
benefits from these. Thus the principles in IAS 39 on derecognition are regarded as a
mixed approach that on one hand uses a financial components approach and on the other
hand employs a risks and rewards approach.
Within IAS 39 there are several examples of situations where a transferor has not lost
control of a transferred financial asset (or portion thereof) by retaining the risks and
rewards related to such asset (or portion thereof). The examples are when:
39.AG51 ■ The transferor has the right to reacquire the asset (or has a right of first refusal to
purchase the asset) unless either (i) the reacquisition price is fair value; or (ii) the
assets are readily obtainable in the market.
39.AG51 ■ The transferor is both entitled and obliged to repurchase or redeem the transferred
asset on terms that effectively provide the transferee with a rate of return similar to
that on a loan secured by the transferred asset.
39.20 and ■ The transferor has retained substantially all of the risks and returns of ownership
AG39-41 through a total return swap with the transferee (and the asset is not readily obtainable
in the market).
39.AG51 ■ The transferor has retained substantially all of the risks of ownership through an
unconditional put option on a transferred asset held by the transferee (and the asset is
not readily obtainable).
39.AG42-44 Both the position of the transferor and the position of the transferee must be considered.
After transferring the assets, the transferor should not be able to sell or pledge the assets
to another party and should not be able to use the cash flows generated by the assets for
its own benefit. The transferor has generally not lost control unless the transferee has the
ability to obtain the benefits of the transferred asset.
39.16 and 20 Derecognition is not limited to the situations noted above. If, for example, neither the
transferee nor the transferor has the right to sell or pledge a portfolio of loans (which
often is the case when only a portion of the assets is transferred), the transferred portion
of the loans may be derecognised if it is demonstrated that the transferee has the ability
to obtain the benefits of its portion of the assets, that is to say, the transferee may sell or
pledge its interests in its portion of the loans.

39.15-42 Derecognition requirements for assets have been significantly reworded and to an
extent revised (although for certain transactions the resulting changes to the accounting
are substantial). Elements of both the components / control, and risks and rewards,
approaches are retained but a new ‘continuing involvement’ approach is introduced,
resulting in partial derecognition in a number of more complex transactions where
previously no derecognition would have been permitted. These are dealt with further in
the Sections below.
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The amendments also clarify the requirements considerably by introducing a step-by-

step approach to analysing transactions, thus placing the various steps to be taken in
determining whether a transaction qualifies for derecognition in a mandatory hierarchy.
In the existing standard it is often difficult to establish when one requirement takes
precedence over another.
39.AG36 A decision tree outlining the new approach, with paragraph references to the revised
IAS 39, is as follows:
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The steps involved in the analysis under the amended standard are, in summary:
1. What is the reporting entity? If the reporting entity is a group, the purpose of this
step is to ensure, for example, that all controlled special purpose entities (SPEs)
are consolidated before considering derecognition. Essentially there is no benefit in
analysing whether an entity achieves derecognition when transferring financial
assets to an SPE if the SPE is then consolidated under SIC–12 and only the group
financial statements are prepared using IFRS.
2. Should the analysis be applied to a component of a financial asset or to the asset in
its entirety? A component is permitted to be considered for derecognition separately
only if it represents:
(a) specifically identified contractual cash flows, such as a stream of interest-only
or principal only cash flows;
(b) a fully proportionate share of the cash flows from the asset, for example, 50 per
cent of all the interest and principal payments received on a loan; or
(c) a fully proportionate share of specifically identified contractual cash flows, for
example, 30 per cent of the interest cash flows received on a bond.
The analysis may be applied either to an individual asset or to a portfolio of similar
assets. The remaining steps are then applied to the portfolio, asset or qualifying
part or proportion identified in this step. This is referred to in the steps below as
‘the asset’.
3. Have the rights to the cash flows from the asset expired? This would be the case,
for example, when a debt instrument has been repaid or a purchased option expires
unexercised. If yes, the asset is derecognised.
4. Have the rights to the cash flows from the asset been transferred? This would apply
in a legal sale of the asset, or a legal assignment of the rights to its cash flows.
5. If the entity has not transferred the rights to cash flows from the asset, has the
entity assumed an obligation to ‘pass through’ the cash flows from the asset to
another party? Does that pass-through meet all of the following conditions?
■ The entity has no obligation to pay amounts to the other party unless it collects
equivalent amounts from the original asset;
■ The entity is prohibited by the terms of the transfer contract from selling or
pledging the original asset other than as security to the other party for the
obligation to pay that party cash flows; and
■ The entity has an obligation to remit any cash flows it collects on behalf of the
other party without material delay. In addition, during any short period between
collection by the entity and payment to the other party, the funds may not be
reinvested other than in cash and cash equivalents (as defined by IAS 7 Cash
Flow Statements) and any interest earned must be passed to the other party.
If there is neither a legal sale nor a qualifying pass-through arrangement, no
derecognition is permitted. The transaction is treated as a secured borrowing.
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The requirements for pass-through are considered further in Section 4.4.1.3 and in
the securitisation example in Section 4.5.
6. If the asset has been transferred, either through a legal sale or a qualifying pass-
through arrangement, have substantially all the risks and rewards been transferred?
This would apply either to a clean sale with no ‘strings’ attached, or to a qualifying
arrangement to pass through all cash flows with no further interest by the entity in
any of the future economic outcomes from the asset. If yes, the asset is
derecognised. The transfer of risks and rewards is evaluated by comparing the
entity’s exposure, before and after the transfer, to the variability in the amounts
and timing of the net cash flows of the assets.
7. Have substantially all the risks and rewards been retained? This would be the
case, for example, in a sale with a fixed price repurchase agreement or a sale with
a total return swap. If yes, no derecognition is permitted and the transaction is
treated as a secured borrowing.
8. If the asset has been transferred, but substantially all its risks and rewards have
been neither transferred nor retained (in other words, some risks and rewards are
retained, and some are transferred), has the entity transferred control of the asset?
Examples would be a sale with a retained call option or a sale with a written put
option. Control in this context means the practical ability to sell the asset. If the
buyer has an unfettered and practical ability to sell the asset, for example, because
the asset is listed and therefore the buyer could sell it and subsequently repurchase
it if required, then control has been transferred and the asset is derecognised.
9. If control has not been transferred, then the entity continues to recognise the asset
to the extent of its continuing involvement. This concept has been introduced to
deal with those circumstances where an entity has neither transferred nor retained
substantially all the risks and rewards relating to the transferred asset, but has
retained control. Essentially, the asset is derecognised to the extent the entity has
no continuing exposure to the asset. The asset remains on balance sheet to the
extent of the maximum potential exposure and a corresponding liability is recognised.
The detailed requirements are complex, but the principle is that the net amount
recognised for the asset and the liability reflects the entity’s remaining net potential
maximum exposure to the asset. If the asset is measured at amortised cost, the
corresponding liability is measured at amortised cost. If the asset is measured at
fair value, the liability is measured at fair value. Alternatively, the continuing
involvement may be in the form of an option or guarantee. In such cases, under
continuing involvement derecognition will be precluded to the extent of the amount
which might become payable under the option or guarantee.
In the examples given in the rest of this Section, the outcomes under the amended
standard are likely to be the same as under the existing standard unless
otherwise stated.
4.4.1.1 Evaluating the risks associated with a transferred asset

For financial assets with relatively short maturities, such as trade receivables, the
only substantive risk to consider generally is credit risk. If the transferor retains the
credit risk on short-term financial assets through a guarantee then derecognition would
not be appropriate.
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An entity might transfer part, but not all, of a risk that it considers to be a substantive risk
of the transferred assets. In order for derecognition to be appropriate, the entity needs to
transfer a significant exposure to loss from that substantive risk. A risk of loss is
considered to be significant when it is based on historical loss experience for an entity and
considering the type of asset transferred. For example, if a transfer of credit risk (which
is considered to be a substantive risk of the assets transferred) will only occur in a
catastrophe or similar situation because historical losses are covered through a guarantee
by the transferor, this is considered to be outside the range of likely loss outcomes. This
would not be considered a transfer of a significant exposure to loss from credit risk.
Consequently, in such cases, derecognition would not be appropriate.
4.4.1.2 Transfer of a financial asset with no derecognition

39.29 Transfers of financial assets that do not satisfy the conditions for derecognition are
accounted for as collateralised borrowings. In other words, the financial assets stay on
the books of the transferor and a borrowing is recognised for the proceeds received from
the transferee. The financial assets act as collateral for the transferee in the event of
39.AG49 non-payment on the borrowing. If derecognition is prevented due to the existence of a
derivative (whether stand-alone or embedded in a contract), the derivative itself would
not be recognised if recognising both the derivative and the borrowing result in double
counting in the transferor’s balance sheet.
39.AG50 The most common example of a collateralised borrowing is a standard repurchase (repo)
transaction, where a seller transfers assets and agrees to repurchase the same assets at
a later date and at a specified price. Effectively the seller / transferor has a call option
and the buyer / transferee has a put option on the transferred assets. In this situation, the
seller should continue to recognise the financial assets and should not recognise the options.
Because only one entity can control a financial asset (or component thereof), if the
transferor cannot derecognise a financial asset then the transferee should not recognise
the financial asset on its balance sheet. Instead the transferee recognises a receivable
from the transferor for the repayment of the cash proceeds or other consideration.
39.AG51(a-c) In some repo transactions, when returning transferred assets to the transferor, the
transferee may substitute similar assets of equal fair value. If this occurs, upon substitution
the transferor derecognises the assets originally transferred and recognises the assets
actually returned by the transferee.
IG D.1.1 A securities lending transaction that requires the borrower to return the transferred financial
asset at a later date and for a specified price would be accounted for in a similar way to
that described above for repo transactions. Typically in a securities lending transaction,
there is collateral given by the securities borrower / transferee to the securities lender /
transferor. If cash is given as collateral and is not legally separated from the lender’s
assets, the lender recognises the cash and a payable to the borrower. The borrower
recognises a receivable from the lender.
39.AG51(e) A wash sale transaction is one where an entity purchases a financial asset either immediately
before or after the sale of the same asset. A wash sale may qualify for derecognition as
long as there is not a contractual commitment to repurchase the assets sold. In such
cases the sale and purchase are viewed as two separate transactions under IAS 39.
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Case 4.4 Receivables sold with full recourse

39.AG51(i) Entity A (the transferor) sells receivables to Entity B (the transferee). The receivables,
which are due in six months and have a carrying value of 100,000 are sold for a cash
payment of 95,000 subject to full recourse. Under the right of recourse, the transferor
is obligated to compensate the transferee for the failure of the debtors to pay when
due. In addition to the recourse, the transferee is entitled to sell the receivables back to
the transferor in the event of unfavourable changes in interest rates or the credit ratings
of the underlying debtors.
How should the transaction be accounted for? The transaction is accounted for by the
transferor as a secured loan as it does not qualify for derecognition. This is because
the transferor has retained substantially all of the risks associated with the assets.
Although the transferee has the ability to sell or pledge approximately the full value of
the assets transferred, the transferor has granted the transferee a put option on the
transferred assets allowing the transferee to sell the receivables back to the transferor
in the event of actual credit losses and changes in underlying credit ratings or interest
rates. Consequently the transferor is regarded as having retained substantially all the
risks of ownership of the receivables.
The transferor recognises 95,000 as a liability. The liability is measured at amortised cost
with an interest expense of 5,000 being recognised over the six-month period until maturity.
The transferor continues to recognise the receivables as assets. Cash received on the
receivables by either the transferor or transferee reduces both the receivables and the
liability. If uncollected receivables are returned to the transferor for cash, the liability is
reduced and an impairment loss recognised if not previously recognised by the transferor.

Under the amended standards, the result in this case remains unchanged. Assuming
the rights to all of the cash flows in the receivables are legally transferred, then Step 7
in the new approach described on page 38 will result in the transaction being treated as
a secured borrowing because substantially all the risks and rewards associated with
the asset have been retained by the transferor.
4.4.1.3 Derecognition of a part of a financial asset

39.16(a) If an entity transfers less than all of the financial asset, derecognition involves determining
the legal contractual rights and obligations arising from a contract, and recognising the
retained components based on the fair values of the assets retained and the liabilities
incurred. For example, a bank may sell a portfolio of loans, but retain the right to receive
50 per cent of the interest on the loans. Using a financial components approach, the bank
may be able to derecognise the loans, but would recognise the value of the right to the
50 per cent of interest revenues as an asset. The carrying amount of the asset sold is
allocated between the part retained and the part sold, based on their relative fair values at
the date of sale.
39.27, 28 and When determining fair value of the retained interest the best evidence is obtained by
AG52 reference to a market quotation. However, when market quotations do not exist, valuation
models with inputs based on market information may generally be used. In the rare
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circumstances where the fair value of the part of the asset that is retained cannot be
reliably measured, the asset should be measured at zero, and the entire carrying amount
should be allocated to the part of the asset sold.
39.24 and 25 There may also be instances when an entity transfers control of a financial asset and, in
doing so, creates a new financial asset or assumes a new financial liability. For example,
a bank may sell a portfolio of loans but still act as the servicer of the portfolio, for which
it receives a fee. In this case, the entity should recognise the servicing rights as an asset
or liability.
Servicing activity must be taken into account when an entity transfers financial assets to
another party. Servicing generally involves activities such as collecting payments from
debtors, remitting cash to the transferee, providing reports to the transferee on the payment
status of the transferred assets and performing collection activities for non-performing
assets / debtors. All of these activities may occur without the debtor knowing that its
receivable / loan has been transferred to a third party. When the transferor has an obligation
to perform servicing activities, the entity determines whether a servicing asset or a servicing
liability should be recognised. This is done through a net present value calculation comparing
the servicing fees to be received, if any, by the transferor with the normal expected costs
to perform these services. If the servicing fees to be received will exceed the costs of
servicing, the entity records a servicing asset. If the costs of servicing exceed the servicing
fees to be received, the entity records a servicing liability. Servicing contracts often are
transferable, meaning that if the entity does not adequately perform its servicing duties,
the transferee may find a new party to take over the servicing activity.
39.16(a, i), 24 The servicing fees to consider are only those cash flows that the servicer would lose
and AG45 upon termination or transfer of the servicing contract. For example, if a transferor retains
an interest spread on transferred receivables and performs the servicing, the interest
spread must be analysed to determine what portion should be allocated to a servicing
asset (or liability) and what portion allocated to an interest-only strip receivable. The latter
would be only those cash flows that would not be lost upon termination or transfer of the
servicing contract.
If derecognition occurs, the gain or loss is recognised based on the following formula:
Proceeds received
- Carrying amount of the financial asset (or portion thereof) sold
- Fair value of any new financial liability (or portion thereof) assumed
+ Fair value of any new financial asset (or portion thereof) acquired
- Service liability (if any)
+/- Fair value adjustment previously recorded in equity
= Gain or loss on derecognition
As shown in the formula, one component of the calculation of the gain or loss is any
cumulative balance of revaluation gains and losses previously reported in equity, which is
removed from equity and recognised as part of the gain or loss in the income statement.
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In the rare circumstance that a new financial asset is acquired or a new financial liability
is assumed but cannot be measured reliably, the initial carrying amounts:
■ for a financial asset, should be set at zero; and
■ for a financial liability, should be such that no gain is recognised on the transaction.
In this case, any excess proceeds over the carrying amount of the asset sold would
be recognised as a liability in the balance sheet rather than recognised as a gain in the
income statement. If the proceeds are less than the carrying amount sold, a loss
should be recognised in the income statement immediately.
Case 4.5 Transfer of a portfolio of loans

North Bank originates mortgage loans in its normal course of business. North Bank
enters into a transaction to sell a portfolio of loans to a third party. The loans in this
portfolio yield a fixed 10 per cent rate of interest for their estimated lives of nine years.
North Bank sells loans with principal of 1,000,000 plus the right to receive interest
income of eight per cent. The sales proceeds received are 1,000,000.
In order to preserve the relationships with bank customers, North Bank will continue to
service the loans. For this activity, North Bank will be compensated for performing the
servicing through a right to receive one half of the interest income not sold (i.e. 100 of
the 200 basis points).
The remaining 100 basis points (i.e. one per cent) is considered to be an interest-only
strip retained by North Bank. It then determines the fair value of the new assets to
be as follows: Servicing asset = 40,000; Interest-only strip = 60,000. The servicing
asset’s fair value is calculated as the present value of expected future cash flows
(i.e. servicing fees less the cost of performing the servicing).
The carrying amount of the financial asset (in this case, the portfolio of loans) should
be allocated between the part of the asset retained and the part sold. This calculation
is based on the relative fair values of the assets. North Bank performs the following
calculation to determine the allocated carrying amounts of each asset.
Percentage Allocated
of total carrying
Fair value fair value amount
Loans sold 1,000,000 91.0% 910,000

Servicing asset 40,000 3.6% 36,000
Interest-only strip 60,000 5.4% 54,000
Total 1,100,000 100.0% 1,000,000
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North Bank records the sale transaction with the following journal entry:
Debit Credit
31 December 20X1
Proceeds on sale (cash or receivable) 1,000,000
Interest-only strip 54,000
Servicing asset 36,000
Loans 1,000,000
Gain on sale of loans 90,000

39.AG36 The steps referred to below are set out on pages 37 and 38.
In this case there is no SPE involved in the structure (Step 1). Consequently, under the
amended standard, the first test to be applied is whether the revised derecognition
requirements should be applied to the transferred asset in its entirety or to separate
portions (Step 2).
It is assumed that the 80 per cent of interest cash flows to be transferred to the third
party represent a fully proportionate share of the interest cash flows received.
This means that North Bank will consider two portions, being the principal element and
80 per cent of the interest cash flows, separately for the purposes of derecognition.
Clearly, the rights to cash flows from the assets have not expired as the mortgage
loans still exist (Step 3) and so the next stage is to consider whether or not the legal
rights to cash flows have been transferred (Step 4).
The effect of the servicing arrangement is that the legal rights to cash flows have not
been transferred and North Bank therefore needs to consider whether its obligation to
collect cash on behalf of the third party and pass it on meets the criteria for a pass
through arrangement (Step 5). Those criteria are:
■ the entity has no obligation to pay cash flows to the buyer unless it collects equivalent
cash flows on the transferred asset;
■ the entity is prohibited from selling or pledging the original assets other than as
security to the buyer; and
■ the entity is required to remit any cash flows received on the asset without
material delay.
Whether or not these requirements are met will depend on the details of the arrangement.
However, if North Bank has not achieved qualifying pass through with regard to the
principal or interest portion, or both portions, there will be no derecognition of the
respective portion. Instead, the related proceeds will be treated as a secured borrowing.
If North Bank has structured the contract to meet the pass-through requirements, then
the transferred portion(s) will be derecognised as long as substantially all the risks and
rewards of those components have been transferred (Step 6). The accounting would
then be as described above under the previous IAS 39.
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It is possible that North Bank will have retained some risks and rewards relating to the
transferred portions, meaning that Step 6 will not be met. However, it is assumed that
North Bank has not retained substantially all of the risks and rewards of the portions
that have been transferred and therefore will not be required to continue to recognise
the asset sold to the third party in its entirety (Step 7). While this may not be entirely
clear from the example, it would be likely to be the case if, for example, the terms of
the arrangement were such that North Bank retained the entitlement to a portion
(e.g. 100,000) of the principal element, with any defaults being shared on a pari passu
basis with the transferee. North Bank might then determine that it has retained some
significant risks and rewards of ownership (the retained interest), but transferred others
(e.g. significant prepayment risk relating to the fixed rate loans).
North Bank then needs to consider whether it has retained control over the transferred
portions (Step 8). In this case, it is assumed that the third party does not unilaterally
have the practical ability to sell the assets without needing to impose additional restrictions
on that transfer. In consequence, North Bank needs to consider Step 9. (Note that if
the third party was able to sell the transferred assets without restriction, derecognition
by North Bank would be appropriate.)
Where substantially all the risks and rewards in the transferred components are neither
transferred nor retained and the buyer is not able to sell those components (Step 8), the
continuing involvement rules apply (Step 9). In such circumstances, if the modified
terms set out above applied (the retention of an entitlement to 100,000 of the principal
element with any defaults being shared on a pari passu basis with the transferee), in
addition to recognising the balances set out in the case, North Bank would recognise
an asset of 100,000 (its retained interest) and a liability of the same amount (the maximum
amount of cash flows it would not receive).
4.4.2 Derecognition of a financial liability

39.39-42 Derecognition of a financial liability occurs when, and only when, it is extinguished, i.e. when
the obligation specified in the contract is discharged, cancelled or expired. This condition
is met when:
■ the debtor discharges the liability by paying the creditor, normally with cash, other
financial assets, goods or services; or
■ the debtor is legally released from primary responsibility for the liability (or part thereof)
either by process of law or by the creditor.
39.AG58 The conditions are also met and a liability is derecognised when an entity repurchases its
own bonds issued previously, irrespective of whether the entity intends to resell the bonds
to other parties. This is consistent with the treatment of treasury shares reacquired by an
entity, except that in the case of extinguishing a liability, a gain or loss may be recognised.
39.AG57 and It is not possible for an entity to extinguish a liability through an in-substance defeasance
AG59 of its debt. In-substance defeasance occurs when an entity makes payments related to its
obligations to a third party (typically a trust or similar vehicle), that then makes payments
to the lender, without having legally assumed the responsibility for the liability and without
the lender being part of the contractual arrangements relating to the third party vehicle
and having rights thereto. However, the entity is not legally released from the obligation,
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therefore derecognition of the liability would be inappropriate. An entity may arrange for
a third party to assume the primary responsibility for the obligation for a fee while continuing
39.AG60 and to make the contractual payments on behalf of the third party. In addition, the creditor
AG61 must also agree to accept the third party as the new primary obligor in order for the entity
to derecognise its liability.
39.40 Certain transactions or modifications between borrowers and lenders may give rise to
derecognition issues. If the borrower and lender exchange instruments with terms
substantially different from the original transaction, derecognition of the old debt and
recognition of a new debt instrument would result. Similarly, a substantial modification of
the terms of an existing debt instrument should be accounted for as an extinguishment of
the old debt. The circumstances of these modifications (such as due to financial difficulties
of the borrower) are not relevant in determining whether the modification is an
extinguishment of debt.
39.AG62 Terms are substantially different if the discounted present value of the cash flows under
the new terms, including any fees paid (net of any fees received), is at least 10 per cent
different from the discounted present value of the remaining cash flows of the original
debt instrument. The discount rate to use for both calculations is not specifically addressed
in the standard, therefore the entity may use either the effective interest rate under the
39.41 old terms or under the new terms (applied consistently to both transactions). If an
extinguishment does occur, any costs or fees incurred are recognised as a gain or loss
immediately. If the exchange or modification is not accounted for as an extinguishment,
costs and fees incurred are recognised as an adjustment to the carrying value of the
liability and amortised over the remaining term of the modified instrument.
The issue of exchange and modification of debt terms is illustrated by the following:
Case 4.6 Modification of the terms of a loan

On 1 January 20X1, Bank D grants a loan to Entity U of 200,000, with a contractual
interest rate of eight per cent, which is the market interest rate at that time. The term
of the loan is five years, with a maturity date of 31 December 20X5.
On 31 December 20X4, Entity U negotiates with Bank D to extend the term of the
loan by an additional two years so that the loan will mature on 31 December 20X7.
The contractual interest rate is increased to 12 per cent for the remaining term to
maturity, representing the current interest rate for Entity U, given the increase in market
interest rates and the current credit standing of Entity U. No fees are paid or received.
What accounting entries would Entity U record on 31 December 20X4?
For accounting purposes, Entity U must assess whether the terms of the modified
loan are substantially different from the original loan. Entity U calculates the present
value of the modified loan of 220,617 by discounting the modified cash flows at the
historical effective rate of eight per cent. The present value differs by more than
10 per cent from the present value of the original cash flows of the loan calculated
on the same basis. Therefore, an extinguishment of debt has occurred and the original
loan should be derecognised.
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The accounting entries for Entity U would be as follows:

Debit Credit
31 December 20X3
Original borrowing (at eight per cent) 200,000
Modified borrowing (at 12 per cent) 200,000
To record the extinguishment of the former liability
and to record the new obligation
The modified loan is recognised at its fair value, calculated at the current market
interest rate, and the carrying value of the original loan is derecognised. No loss is
recognised since the carrying amount of the loan equals the fair value of the modified
loan, as both loans were originally issued at market interest rates. The only impact
would be any fees incurred by Entity U, which would have to be expensed.
Similar to a financial asset, when transferring (part of) a financial liability, parts of the
financial liability could be retained and new financial instruments (either assets or liabilities)
could be created. The accounting is similar to the accounting for derecognition of parts of
financial assets with the creation of new instruments, as discussed in Section 4.4.1.
4.5 Special purpose entities and derecognition
4.5.1 Typical transactions

In some instances transactions involving the transfer of financial instruments are conducted
with special purpose entities (SPEs), set up with a specific intent, such as the securitisation
of financial assets.
Entities commonly use securitisations to monetise financial assets such as homogeneous
consumer loans, credit card receivables, trade receivables or mortgage loans by selling
newly created securities collateralised by these assets to investors. Securitisation of assets
and sales to investors often occur through an SPE. An SPE generally will be a legal entity
with limited activities, whose purpose is to hold the beneficial interests in securitised
assets and to pass through monies earned on those assets to the investors in its securities.
In a securitisation the transferring entity sells financial assets to the SPE in return for
cash proceeds. Generally all of these steps occur simultaneously (i.e. transfer of financial
assets, issuance of securities to investors and payment of proceeds to the transferor).
39.AG51(f-h) Transfers to an SPE must meet the derecognition criteria described in this Section in
order for the transferor to record a sale. In situations where all of the benefits of the
assets are transferred to such an SPE, derecognition by the transferor is appropriate if
there are no additional constraints imposed by the transferor. Such constraints would
include options or forward agreements held by the transferor on the residual interests of
the SPE. In situations where less than all of the benefits are transferred, for example,
when a transferor retains the residual gains associated with the transferred assets or
residual interests in the SPE, the determination is not so straightforward. The factors
noted in Section 4.4.1 must be considered for both the transferred assets and the residual
interests in the SPE.
46 4.5 Special purpose entities and derecognition
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In order to qualify for derecognition of, for example, loans where the transferor is
also the servicer and has custody over the assets, the transferor should not have
substantive benefits from reinvestment of the cash flows from the interest and principal
payments. These should be transferred to the transferee or the SPE under the terms
of the servicing agreement.

39.AG36 Under the amended standards, whether or not an SPE should be consolidated under
SIC–12 (see Section 4.5.2 below) is specifically required to be considered before
analysing the transaction for derecognition under IAS 39. If an SPE is consolidated,
then the transaction to be considered for derecognition at the group level is the possible
transfer of assets by the group, including the SPE, to its beneficial interest holders.
An SPE is unlikely to transfer legal rights to the cash flows from its assets to its
investors. In many cases, therefore, the critical issue may be whether or not the cash
flows from the assets, and only the cash flows from the assets, are passed through
without material delay in an arrangement that meets the new ‘pass-through’
requirements. Essentially, this requires that any cash flows arising from the assets are
not retained by the group, instead being transferred either immediately or within a short
period (no more than a matter of days) to the external beneficial interest holders.
The group also needs to have no obligation to pay any amounts to the external beneficial
interest holders unless equivalent amounts are collected from the original assets.
However, this last requirement does not preclude the group from making short-term
advances, with the right of full recovery of the amount lent plus accrued interest at
market rates.
39.19 In cases where cash flows are reinvested by the SPE in new assets under a ‘revolving’
structure, the pass-through requirements will not be met. In many other cases meeting
the pass-through requirements will also be difficult to achieve and some arrangements
may need to be restructured (e.g. those where the transferring entity has other than a
fully proportionate share in the cash flows).
39.20 Even in those cases where the pass-through test is met, it is likely that the SPE will
have retained control of the transferred assets. Partial derecognition may then be
appropriate under the continuing involvement approach in the amended standards.
If the SPE is not consolidated, then the potential derecognition transaction is the transfer
of assets by the originator into the SPE. However, given current structures, in the
majority of cases it is unlikely that consolidation by the originator can be avoided.
4.5.2 Consolidation of special purpose entities

27.4 and 13 The issue of consolidation is an important consideration to entities that use SPEs.
The general principles addressing consolidation are found in IAS 27. That standard requires
consolidation based on control over an entity.

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SIC-12.3 The particular problem with applying IAS 27 to an SPE is that the typical control
features discussed above may not be evident due to the entity’s nature. Typically there
is no substantive equity holder in the SPE, therefore consolidation based on voting
powers is not meaningful. SPEs often have limited activities so that day-to-day financial
and operating policies may be predetermined. In this case the SPE is set up to run
virtually on autopilot from its inception. SIC–12, an interpretation of IAS 27, directly
addresses these types of entities by providing guidance for when an entity should
consolidate an SPE. Often the creator or sponsor of an SPE retains significant
beneficial interest in the SPE’s activities that would give it effective control of the
SPE when applying SIC–12.
Whereas IAS 39 takes a mixed approach of financial components and risks and rewards
in addressing control over financial instruments or portions thereof, SIC–12 takes a pure
risks and rewards approach when making the determination of control over an SPE.
As discussed earlier in this Section, IAS 39 effectively requires there to be some
substantive risk transfer to achieve derecognition, whereas SIC–12 indicates that a
majority of risk should be transferred to avoid consolidation. Therefore, it is not uncommon
for a transferor to derecognise transferred assets, but have to consolidate the SPE into
which the assets are transferred.
SIC-12.10 SIC–12 notes several factors that may indicate that an entity has control over an SPE,
and in effect, over the transferred assets as well. These are examples, meaning that
other factors not specifically stated in SIC–12 may also indicate control. The examples
are when, in substance:
SIC-12.10(a) ■ The activities of the SPE are on behalf of the entity where the entity obtains benefits
from the SPE’s operation.
Commentary: This requires evaluating the SPE’s purpose, its activities and what
entity benefits most from them. An example is when the SPE is engaged in an activity
that supports one entity’s ongoing major or central operations. This factor is often
difficult to evaluate as there may be more than one party that derives some benefits
from an SPE. In that case, an evaluation of majority of benefits is necessary.
SIC-12.10(b) ■ The entity has decision-making powers to obtain the majority of the benefits of the
activities of the SPE, or through an autopilot mechanism achieves the same effect.
Commentary: An SPE being on autopilot does not necessarily mean that the sponsor
or another entity must be in control. There must also be the objective of obtaining
benefits from the SPE’s activities. Likewise, an SPE being set up with limited ongoing
decisions to be made does not automatically mean the entity has operational substance
on its own.
SIC-12.10(c) ■ The entity has rights to obtain the majority of benefits of the SPE (and therefore may
be exposed to risks incident to the SPE’s activities).
Commentary: This factor and the next (majority of risks) are often the most crucial
to evaluate when determining if consolidation is necessary. Majority of should be
interpreted as more than half. However, the benefits to be evaluated are not the gross
cash flows of all of the assets in the SPE. Rather it is the residual benefits that are
important. Residual benefits are the positive variability in net cash flows within a
reasonably likely range of outcomes. For example, if there are reserves or equity that
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would be distributed when the SPE is wound up, an entity entitled to the majority of
this potential upside may be required to consolidate the SPE.
SIC-12.10(d) ■ The entity retains the majority of the residual or ownership risks related to the SPE or
its assets in order to obtain benefits from its activities.
Commentary: Along with analysing the majority of benefits, this factor is often decisive
when determining consolidation. Again it is not gross cash flows but residual cash
flow risks that are important. Similar to the above, residual risks are the negative
variability in net cash flows within a reasonably likely range of outcomes. For example,
if there are senior and subordinated cash flows in an SPE, the senior cash flows
should be disregarded and the evaluation should focus on the subordinated cash flows
and any equity (being real equity or some type of reserve). An entity with the majority
of this exposure may be required to consolidate the SPE.
The factors noted above should be analysed independently meaning that if an entity has
any one of the four indicators above, it should consolidate the SPE. It would be inappropriate
to conclude that because a situation does not encompass all four of the above factors, the
entity does not need to consolidate the SPE.
Retention of benefits or risks by a transferor may occur if the transferor keeps a
subordinated position on the transferred assets or by taking subordinated notes issued by
the SPE. This may also occur through put options granted to the SPE to take back defaulted
or non-performing assets, or through other forms of guarantees, derivatives or insurance-
like agreements. Securitisation transactions often have substantial guarantees or credit
enhancements in order to receive a higher rating on the related securities issued by the
SPE. These must be included in an entity’s analysis of the risks and rewards that result
from a transaction.
When entering into transactions with an SPE, an entity must consider carefully:
■ first, whether derecognition criteria in IAS 39 are met when transferring instruments
to the SPE; and
■ second, whether there are indicators that the entity has control over the SPE under
SIC–12, and therefore should consolidate the entity.

As noted above, it is often the case under the existing standards that an entity could
achieve derecognition for financial assets transferred into an SPE (by achieving some
substantive transfer of risk), but that the SPE was then consolidated into the group
financial statements under SIC–12.
39.AG36 The IASB has addressed this apparent inconsistency in the amendments by requiring
SIC–12 to be considered in the hierarchy of rules before the derecognition requirements
of IAS 39. Therefore, for the purposes of the group financial statements, the consolidation
issue is dealt with first. For the stand-alone financial statements of the transferor entity,
SIC–12 is not a concern. The remainder of this discussion considers the position from
the perspective of the consolidated financial statements.

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If the SPE is not consolidated, then the derecognition transaction to be considered

under IAS 39 is the transfer of assets from the group to the SPE. If the SPE is
consolidated, then the derecognition transaction to be analysed under IAS 39 is the
transfer of rights from the group (including the SPE) to the external beneficial interest-
holders in the SPE. The discussion below sets out the evaluation procedure to be
followed if the SPE is consolidated.
39.16 The first issue to consider is whether to perform the evaluation for assets in their
entirety or for components of assets. In many common securitisation transactions, the
asset transferred (see Step 2 in the analysis under Section 4.4.1 above) will be neither
specifically identified components of the assets nor a fully proportionate share of any
component of the asset. This is because, typically, the group will retain an interest in
the residual cash flows, so that the first (say) 90 per cent of cash flows pass outside
the group and the last (say) 10 per cent are retained within the group. The asset
considered for derecognition will be the entire portfolio of assets held by the SPE.
39.17-19 The next consideration is whether there is a transfer that might qualify for derecognition.
In most cases, the legal rights to cash flows will not be passed to beneficial interest
holders in the SPE. Therefore, it will be necessary to consider whether the SPE’s
obligation to pass the cash flows to the external beneficial interest holders meet the
pass-through criteria. Some transactions may be structured so that all of the cash
flows due to external beneficial interest holders are passed through without material
delay. If so, a possible outcome, as long as substantive risks and rewards are also
transferred, is that the assets of the (consolidated) SPE will be partly derecognised
under the continuing involvement rules in the amended standards. In many cases it will
be impossible to meet the pass-through requirements and no derecognition by the SPE
will be possible.
In some cases the group will retain an interest in an SPE not by retaining beneficial
interests, but rather by providing credit risk guarantees to the external beneficial interest
holders. Such arrangements will fail to meet the pass-through criteria because the guarantee
creates an obligation on the part of the group to pay cash to the external beneficial
interest holders under the guarantee if cash is not collected on the securitised assets.
As under the existing standards, it is likely to be difficult to achieve off balance sheet
treatment for securitisation transactions, although partial derecognition under a continuing
involvement approach may, in a limited number of cases, be possible.
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5. Classification

■ Categories and classification of financial assets and financial liabilities
■ Criteria for the held-to-maturity category

39.45 IAS 39 establishes specific categories into which all financial assets and liabilities must
be classified. The classification of financial instruments dictates how these assets and
liabilities are subsequently measured in the financial statements of an entity. There are
four categories of financial assets: trading, loans and receivables originated by the entity,
held-to-maturity and available-for-sale. There are two categories of financial liabilities:
trading liabilities and other financial liabilities.
The assessment of which category financial assets and financial liabilities belong to should
be performed in the same order as outlined in the discussion and figures below.
Figure 5.1 Classification of financial assets and liabilities
5.1 Overview 51
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5.2 Classification of financial assets
5.2.1 Trading assets

IAS 39 defines financial instruments, both assets and liabilities, held for trading as follows:
39.9 A financial asset or liability held for trading is one that was acquired or incurred principally
for the purpose of generating a profit from short-term fluctuations in price or dealer’s
margin. A financial asset should be classified as held for trading if, regardless of why it
was acquired, it is part of a portfolio for which there is evidence of a recent actual
pattern of short-term profit-taking. Derivative financial assets and derivative financial
liabilities are always deemed held for trading unless they are designated and effective
hedging instruments.
39.9 and The intention to profit from short-term fluctuations in price or dealer’s margin need not be
IG B.11 explicitly stated by the entity. Other evidence may indicate that a financial asset is being
held for trading purposes. Evidence of trading may be inferred based on the turnover and
the average holding period of financial assets included in the portfolio. For instance, an
entity may buy and sell shares for a specific portfolio, based on movements in those entities’
share prices. When this is done on a frequent basis, the entity has established a pattern of
trading for the purpose of generating profits from fluctuations in price. Additional purchases
of shares into this portfolio would also be designated as held for trading.
IG B.12 On the other hand, a fund manager of an investment portfolio might buy and sell investments
in order to rebalance the portfolio in line with a fund’s parameters. This activity would not
necessarily require the investments to be classified as trading because the activity may
not be related to generating profits from short-term fluctuations in prices. Furthermore, if
an entity acquires a non-derivative financial asset with an intention to hold it for a long
period irrespective of short-term fluctuations in price, such an instrument cannot be
classified as held for trading.
Financial assets for which there is the intent to sell in the short-term or evidence that they
are expected to be resold in the near term should be classified as trading at the date of
purchase. The standard does not define short-term. It also does not limit the period for
which an instrument that is designated as being held-for-trading can be held. An entity
should adopt a definition of short-term and apply a consistent approach to the definition
used. When there is the intention of generating a profit from short-term fluctuations in
price or dealer’s margin the financial asset is appropriately classified as trading, even if
the asset is not subsequently sold within a short period of time.
39.AG15 To generate short-term profits, traders may actively trade an asset’s risks rather than the
asset itself. For example, a bank may invest in a 30-day money market instrument for the
purpose of generating profit from short-term fluctuations in the interest rate. When the
favourable movement in the interest rate occurs, instead of selling the instrument, the
bank will issue an offsetting liability instrument. The 30-day money market instrument
should be classified as held for trading in spite of the fact that there is no intention to
physically sell the instrument. The offsetting liability instrument should be classified as
trading as well because it was issued for trading purposes to earn arbitrage profits.
52 5.2 Classification of financial assets
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In summary, financial assets held for trading include:
■ financial assets acquired for the purpose of generating a profit from short-term
fluctuations in price or dealer’s margin;
■ financial assets that are part of a portfolio of similar assets for which there is a recent
actual pattern of short-term profit-taking;
■ all derivative financial assets that are not designated and effective hedging
instruments; and
■ hybrid instruments that include an embedded derivative that cannot be separately
measured but that otherwise would have been separated based on the criteria of IAS 39.

39.9 Under the amended standards an entity will have a free choice, on initial recognition
(and on adoption of the revised standard) to designate any financial asset or financial
liability as ‘at fair value through profit or loss’. The trading assets category has therefore
been redefined to include both trading assets as defined above, and those assets that
an entity has chosen to measure at fair value through profit or loss. Separate disclosure
is required of the amounts included in the two sub-categories.
One of the main benefits of the new category is that it may allow an entity, in some
cases, to avoid the cost and complexity of meeting the criteria for hedge accounting
(see Section 8.6). For example, an entity that purchases a fixed rate bond and immediately
enters into an interest rate swap to ‘convert’ the interest to floating rate might, instead
of claiming hedge accounting, designate the bond as ‘at fair value through profit or
loss’. Since both the bond and the swap will be measured at fair value through profit or
loss, the offsetting effects of changes in market interest rates on the fair value of each
instrument will be recognised in profit or loss without the need for hedge accounting.
However, there are some important consequences of using the new designation for this
purpose. In particular, the designation of an instrument as fair value through profit or loss
may only be used on day one and is not reversible. This alternative to hedge accounting
therefore cannot be used if an entity buys or issues an instrument and later wishes to put
a hedge in place. It may also result in excessive earnings volatility if the hedge is put in
place for only part of the life of the instrument, or if the entity’s strategy will involve
subsequent de-designation of some or all of the economic hedge it puts in place initially.
Another likely use of the new designation is to avoid the need to measure separately
the fair value of a separable embedded derivative, as described in Section 3. It might
also be used to achieve consistent measurement of matching asset and liability positions.
There is no requirement for consistency in the use of the fair value through income designation,
meaning that an entity can choose which (if any) of its financial assets and liabilities
are to be included in this category, although the amounts included in it must be disclosed.

As explained more fully in Section 1, the IASB is proposing to limit the use of the fair
value through profit or loss option to four specific circumstances.

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5.2.2 Loans and receivables
39.9 IAS 39 defines loans and receivables originated by the entity as follows:
Loans and receivables originated by the enterprise are financial assets that are created
by the enterprise by providing money, goods, or services directly to a debtor, other than
those that are originated with the intent to be sold immediately or in the short-term,
which should be classified as held for trading. Loans and receivables originated by the
enterprise are not included in held-to-maturity investments but, rather, are classified
separately under this standard.
Loans and receivables originated by the entity thus are financial assets:
■ that have been directly provided by the lender to a respective borrower or that result
from the sale of goods and services; and
■ that are not trading instruments.
IG B.22 Since the definition uses the words loans and receivables and debtor, equity instruments
are excluded from this classification. Exceptions to this are certain types of shares that
must be redeemed at a specified date, pay a fixed or determinable return and are in
substance debt instruments. The holder can potentially classify such instruments as
originated loans.
The essential requirement of IAS 39 for loans and receivables originated by the entity is
that the lender must contribute funds when the financial asset is first created. However,
it is not necessary that the lender is involved in setting the terms of the contract, as may
be the case in a syndication or participation.
Loans and receivables originated by the entity, but intended to be resold for purposes of
short-term profit-taking, should not be included in this category, but rather classified as
financial assets held for trading. Loans and receivables originated by the entity may not
be classified as held-to-maturity or available-for-sale.
Any loans or receivables purchased by an entity (such as a loan or receivable resulting
from a transfer of an existing financial instrument from one holder to another) cannot be
accounted for as being originated by the entity.
Case 5.1 Origination of a loan

Entity M participates in a loan at the date of origination via an investment bank and
plans to classify the loan as originated by the entity. Is this classification appropriate?
This classification is appropriate as Entity M participates in the loan at its origination.
The fact that there is an intermediary does not change the substance of the transaction.
Had Entity M entered the participation even one day after its original issuance, it would
not be considered as originated, but rather purchased from the investment bank. In that
case classification as originated by the entity would not be appropriate, as Entity M
would not be providing the funds directly to the debtor.
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39.9 Under the amendments the requirement for loans to be ‘originated by the entity’ is
removed. The category is redefined simply as ‘loans and receivables’ and therefore
includes both purchased and originated loans. The main requirements for a financial
asset to be classified as a loan or receivable is that it has fixed or determinable payments
and is not a derivative. However, the revised definition excludes any instrument that is
quoted in an active market. This means that a listed debt security cannot be classified
within ‘loans and receivables’, even if it is acquired at original issuance by providing
funds directly to the issuer.
The amendments are designed to provide a solution to two issues raised by financial
institutions. The first is that, under the existing standards, a bank could own two identical
portfolios of loans, one originated and one purchased, and be required to account for
each in a different way. The second is that a bank might own two portfolios of bonds,
one purchased from the issuer on the date of issue, and therefore included in the
originated loans category, and the other purchased in the market. Again, each is required,
under the existing standards, to be accounted for differently.
In addition, an entity has a free choice to classify any loan or receivable as ‘available-
for-sale’ at initial recognition, or on adoption of the revised standard.
5.2.3 Held-to-maturity investments

Held-to-maturity investments are defined as follows:
39.9 Held-to-maturity investments are financial assets with fixed or determinable payments
and fixed maturity that an enterprise has the positive intent and ability to hold to maturity
other than loans and receivables originated by the enterprise.
Classification of instruments as held-to-maturity therefore depends on:

■ the terms and characteristics of the financial asset; and
■ the ability and actual intent of the entity to hold those instruments to maturity.

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Figure 5.2 Decision tree for reviewing the classification of assets as held-to-maturity
39.AG25 A prerequisite for the classification of a financial asset as held-to-maturity is the entity’s
intent and ability to actually hold that asset until maturity. An entity should assess its intent
and ability to hold its held-to-maturity investments not only at initial acquisition but again
at each balance sheet date.
The potential benefit of using the held-to-maturity category is that the assets are carried at
amortised cost. Generally this category would be used for fixed rate instruments whose fair
values may change significantly in response to changes in interest rates. However, significant
penalties exist for an entity that classifies an instrument as held-to-maturity, but sells the
instrument before its maturity. These so-called tainting rules are discussed later in this Section.
5.2.3.1 Fixed maturity and determinable payments

39.9 Instruments classified as held-to-maturity must have a fixed maturity and fixed or
determinable payments, meaning a contractual arrangement that defines both the amounts
and dates of payments to the holder, such as interest and principal payments on debt.
39.AG17 Typical equity contracts (e.g. common shares) usually have an unlimited maturity and
therefore cannot be held-to-maturity financial assets. Other types of equity securities
(e.g. share options or warrants) cannot be held-to-maturity investments because the
amounts the holder receives may vary in a manner that cannot be determined at the
purchase of the contract. Exceptions to this are certain types of preference shares that
must be redeemed at a specified date, pay a fixed or determinable return and are in
substance debt instruments.
39.AG17 Since held-to-maturity instruments should have a fixed maturity, it is mainly debt contracts
that are classified as held-to-maturity. Nevertheless, even certain debt instruments may
have an unlimited or unspecified maturity. For example, perpetual bonds that provide for
interest payments for an indefinite period would not qualify as held-to-maturity instruments.
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A financial asset whose maturity is fixed still might not qualify as a held-to-maturity
investment if its payments are not determinable. For example, profit-sharing rights do not
have determinable payments, even though there may be an agreed term.
The most obvious example of a financial instrument with determinable payments is a
fixed rate bond, as both interest and principal payments are fixed. A floating rate interest
asset also could qualify as a held-to-maturity investment since its payments are either
fixed (the principal) or specified by reference to a market rate or benchmark rate. In many
cases, however, there will be little advantage in using the held-to-maturity category for
floating rate assets as their fair values will not change significantly in response to changes
in market interest rates.
Case 5.2 Held-to-maturity classification

IG B.13 and Bank Q wants to categorise a bond issued by an oil company as held-to-maturity.
B.14 The interest on the bond is indexed to the price of oil. Can Bank Q categorise this bond
as held-to-maturity?
The fact that the return is dependent on the price of oil means that this bond includes an
embedded derivative that is not closely related to the host contract. The embedded
derivative and host contract should be separated, resulting in an embedded commodity
contract to be measured at fair value and a host debt instrument. If Bank Q has the intent
and ability to hold the host to maturity, it may categorise the bond as held-to-maturity.
5.2.3.2 Intent to hold to maturity

39.AG16 If an entity only has the intent to hold an instrument for some period, but has not actually
defined that period to be to maturity, the positive intent to hold to maturity does not exist.
Likewise if the issuer has the right to settle the financial asset at an amount that is
significantly below the carrying amount, and therefore is expected to exercise that right,
the entity cannot demonstrate a positive intent to hold the asset until maturity. However, if
the issuer may call the instrument at or above its carrying amount, this does not affect the
investor’s intent to hold the security until maturity.
39.AG21 The demonstration of positive intent to hold an instrument to maturity would not be negated
by a highly unusual and unlikely occurrence, such as a run on a bank or a similar situation,
which could not be anticipated by the entity when deciding whether it has the positive
intent (and ability) to hold an asset until maturity.
39.AG18, AG19 An embedded option that may shorten the stated maturity of a debt instrument casts
and 39.9 doubt on an entity’s intent to hold a financial asset until maturity. Thus, the purchase of an
instrument with a put feature is inconsistent with the positive intent to hold the asset until
maturity. In the case of a call option held by the issuer, the holder should demonstrate that
substantially all of the carrying amount would be recovered if the instrument were called
before maturity to be able to classify the asset as held-to-maturity.
39.10 and A debt instrument with an equity conversion option generally cannot be classified as held-
IG C.3 to-maturity. This is because payment for a right to convert would be inconsistent with an
intention to hold to maturity, unless the conversion option is exercisable only at maturity.

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39.AG17 Also, the risk profile of a particular financial asset may raise similar questions on the
intention. For example, the high risk and volatility of a mortgage-backed interest-only
certificate makes active management of such strips more likely than holding these to
IG B.15 maturity. The same reasoning may apply to debt instruments with high credit risk, for
example, high yield (junk) bonds and subordinated bonds. A significant risk of non-payment
of interest and principal on a bond is not in itself a consideration in qualifying for the held-
to-maturity category as long as there is an intent and ability to hold the instrument until
maturity. However, an entity would taint its held-to-maturity portfolio if it subsequently
sold such a bond as a result of a credit rating downgrade that could have been foreseen.
5.2.3.3 Ability to hold to maturity

39.AG23 An entity needs to demonstrate its ability to hold a financial asset to maturity to categorise
it as such. The entity cannot demonstrate the ability if:
■ financial resources are not available to the entity to finance the asset to maturity.
For example, if it is expected or likely that an entity will acquire another business and
will need all of its funding for this investment, the resources may not be available to
continue to hold certain debt instruments; or
■ legal or other constraints could frustrate the intention of the entity to hold the investment
to maturity. An example is the expectation that a regulator will exercise its right in
certain industries like the banking and insurance industry to force an entity to sell
certain assets in the event of a credit risk change.
5.2.3.4 Tainting of the held-to-maturity portfolio

39.9 If an entity sells, transfers or exercises a put option on more than an insignificant amount
of the portfolio of held-to-maturity financial assets, the entity may not classify any financial
assets as held-to-maturity for a period of two financial years after the occurrence of this
event. IAS 39 does not stipulate what is considered more than an insignificant amount,
but rather this should be assessed by an entity any time a potential tainting situation
arises. It is important to also consider the reasons for an entity’s actions when determining
if the portfolio has been tainted.
Case 5.3 Tainting of held-to-maturity assets

Entity T sells 1,000,000 of bonds from its held-to-maturity portfolio on 15 April 20X1.
The fair value of the bonds has appreciated significantly over the carrying value and
management decides that Entity T should realise the gains through a sale. In these
circumstances, the action of selling investments from the held-to-maturity portfolio
taints the entire portfolio and all remaining investments in that category must be
reclassified. Entity T will be prohibited from classifying any assets as held-to-maturity
for two full financial years. Assuming that Entity T’s financial reporting year-end is
31 December, the entity cannot use the held-to-maturity classification for its assets
until at least 1 January 20X4.
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IG B.19-21 The tainting rules are intended to test an entity’s assertion that it intends and is able to
hold an instrument until maturity. Tainting requires a reclassification of the total remaining
held-to-maturity portfolio in the (consolidated) financial statements into either the trading
or available-for-sale categories. Reclassifications of financial instruments are discussed
in Section 6.5.
The tainting requirements apply group-wide, so that a subsidiary that sells more than an
insignificant amount from its held-to-maturity portfolio can preclude the entire group
from using the held-to-maturity category. If an entity has various portfolios of held-to-
maturity instruments, for example, by industry or by country of issuance, the sale or
transfer of instruments from one of the portfolio taints all the other held-to-maturity
portfolios of the entity.
IG B.18 Selling securities classified as held-to-maturity under repurchase agreements does not
constrain the entity’s intent and ability to hold those financial assets until maturity, unless
the entity does not expect to be able to maintain or recover access to those financial
assets. For example, if an entity is expected to receive back other comparable securities,
but not the securities lent, classification as held-to-maturity is not appropriate.
In practice, entities are advised to consider carefully any plans for sales, transfers or
exercises of put options before classifying an asset as held-to-maturity to avoid a forced
reclassification of the whole portfolio. Many entities adopting IAS 39 have decided either
not to use the held-to-maturity category or to use it only at the parent company level
where the intention and ability can be properly tested for each transaction at the onset
and ongoing.
5.2.3.5 Exceptions from tainting

39.9 There are a limited number of exceptions to the tainting rules. Firstly, the tainting rules do
not apply if only an insignificant amount of held-to-maturity investments is sold or
reclassified. The standard does not define what an insignificant amount means. Therefore, a
judgement will be required in each particular situation. Any sale or reclassification should
be a one-off event. If an entity periodically sells or transfers insignificant portions this
may cast a doubt on the entity’s intent and ability with regard to its held-to-maturity
portfolio. In cases where the sales are not isolated, the amount sold or reclassified should
be assessed on a cumulative basis in assessing whether the sales are insignificant.
Sales or reclassifications do not result in tainting if they occur:
■ very close to maturity or call exercise date;
■ after substantially all of the original principal is already collected; or
■ due to an isolated non-recurring event beyond the entity’s control.
39.9 Sales of held-to-maturity investments close to maturity or call exercise date usually do
not result in significant gains or losses, because the fair value and the amortised cost are
both equal to the face value of the financial asset. Interest rate risk is substantially eliminated
as a pricing factor at that point.

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39.9 Similarly, when almost the entire principal has been collected through scheduled payments
or through prepayments, the remaining part would not be materially affected by changes
in the interest rate and therefore the sale would not result in a significant gain or loss.
IAS 39 does not define the phrase substantially all of the principal investment, however,
when 90 per cent or more of the principal investment has been collected through scheduled
payments or prepayments, a sale of the remaining principal would generally qualify for
this exception.
39.9 In very rare instances, circumstances may arise that the entity could not have reasonably
foreseen or anticipated. If, in such a situation, an entity has to sell held-to-maturity
investments, the remaining portfolio is not tainted if the event leading to sales of investments
is isolated and non-recurring. If the event is not isolated or is potentially recurring, and the
entity anticipates further sales of held-to-maturity investments, this inevitably casts doubt
IG B.16 on its ability to hold the remaining portfolio until maturity. Also, if the event could have
been reasonably anticipated at the date the held-to-maturity classification was made the
instrument should not have been classified as such. If an entity has control over or initiated
the isolated or non-recurring event, for example, sales made after a change in senior
management, this will also call into question the entity’s intent to hold the remaining portfolio
until maturity.
39.AG22 Situations that may not have been anticipated when instruments were included in the
held-to-maturity category and would not question the entity’s intent and ability to hold
investments to maturity may result, for example, from:
IG B.15 ■ a significant deterioration in the creditworthiness of the issuer of the instrument that
could not have been anticipated when the instrument was acquired;
■ significant changes in tax laws, affecting specific investments in the portfolio;
■ major business combinations or dispositions with consequences for the interest rate
risk position and credit risk policies of an entity; or
■ significant changes in statutory or regulatory requirements.
Deterioration in creditworthiness
IG B.15 Although IAS 39 does not provide a definition of a significant deterioration of an issuer’s
creditworthiness, an example of this is a significant downgrade by a credit rating agency.
39.AG22(a) Given the scarceness of external credit ratings for debt for borrowers outside the United
States, downgrades as reflected in an entity’s proprietary internal credit rating system
may support the demonstration of significant deterioration. However, the initial quality of
the asset must have been such that the deterioration could not have been reasonably
foreseen. A credit downgrade of a notch within a class or from one rating class to an
immediately lower rating class often could be considered reasonably anticipated. Therefore,
a sale triggered by such a downgrading would result in tainting.
Changes in tax laws

A significant change in tax laws, such as the elimination or the significant reduction of the
tax-exempt status of an investment that affects the investment specifically, may not cast
doubt on the intention or ability of the entity with respect to the held-to-maturity category.
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If, for example, an entity has a captive finance company in a tax haven and, due to
changes in tax laws that affect the whole group, intends to relocate its treasury activities
and in that process liquidate part of the held-to-maturity portfolio in order to restore the
interest rate risk position, the classification as held-to-maturity would not be violated,
since the entity could not have foreseen the change in tax laws.
The exemption regarding changes in tax laws is not always applicable. For example, an
entity may have a history of entering into schemes for tax related purposes then subsequently
reversing or terminating the transaction due to changes in tax laws. In this case it would not
be acceptable to use the change in tax laws as an exception from tainting.
A change in the applicable marginal tax rate for interest income is not sufficient justification
for sales of held-to-maturity investments, since this change impacts all debt instruments
held by the entity.
Major business combination or disposition

Although a major business combination or the sale of a significant segment of the entity is
a controllable event, it may have a consequence on the entity’s interest rate risk and
credit risk positions. In such situations, sales that are necessary to maintain the entity’s
existing risk positions and that support proper risk management do not taint the held-to-
maturity portfolio.
IG B.19 Although sales subsequent to business combinations and segment disposals may not taint
the held-to-maturity portfolio, sales of held-to-maturity investments prior to a business
combination or disposal, or in response to an unsolicited tender offer, will cast doubt on
the entity’s intent to hold its remaining investments until maturity.
Case 5.4 Held-to-maturity portfolio acquired in a business combination

39.AG22 and Bank Y has acquired Bank X. The new management wants to transfer some held-to-
IG B.16 maturity securities of Bank X to available-for-sale securities because the management
believes that the time to maturity of certain securities is too long and the held-to-
maturity portfolio after the business combination is unreasonably large.
At the date of the acquisition, Bank Y will have to classify the securities acquired as a
result of the business combination applying corresponding rules in IAS 39 without
regard to how these securities were classified by Bank X before the acquisition. Thus, if
Bank X classified certain securities as held-to-maturity, but Bank Y does not have an
ability and intent to hold these securities until maturity, Bank Y should not continue to
treat these securities as held-to-maturity. The tainting rules would not be relevant in
this case at the group level because there is no transfer on the group balance sheet.
At the level of Bank X (which would be relevant if Bank X continues to prepare
separate financial statements under IFRS) the transfers from the held-to-maturity
portfolio would not be considered tainting if the transfers were necessitated by the
business combination as a result of which the held-to-maturity portfolio of Bank X had
to be brought in line with the policies of Bank Y.
However, a business combination cannot be regarded as a possibility for transferring
securities from the held-to-maturity portfolio that Bank Y had before the acquisition.

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For example, if as a result of the acquisition the business strategy of the group changed
and Bank Y transferred some of its existing securities out of the held-to-maturity portfolio,
such transfers would trigger tainting of the whole portfolio. A change in business strategy
is not a valid reason for transferring securities out of the held-to-maturity portfolio.
It would call into question the intent to hold the rest of the securities until maturity and
would result in tainting.
Changes in statutory or regulatory requirements

Examples of changes in statutory or regulatory requirements that do not have tainting
implications for the held-to-maturity portfolio are:
■ changes either in the statutes or in regulations affecting the entity that modify what
constitutes a permissible investment or the maximum level of certain types of
investments. As a result the entity would need to sell (part of) these investments; and
■ significant increases in capital requirements or in the risk weightings as a result of
which the size of the held-to-maturity portfolio has to be decreased.
IG B.17 The exceptions are intended to shield entities operating in regulated industries from potential
tainting situations resulting from actions taken by the industry’s regulator. These are actions
applicable to the industry as a whole, and not to a specific entity. However, sales could
occur in response to an entity-specific increase in capital requirements set by the industry’s
regulator. In that case it will be difficult to demonstrate that the regulator’s action could
not have been reasonably anticipated by the entity, unless the increase in entity-specific
capital requirements represents a significant change in the regulator’s policy for setting
entity-specific capital requirements.

39.9 There are no significant changes in the amended standards with respect to the held-to-
maturity classification.
5.2.4 Available-for-sale assets

39.9 Available-for-sale financial assets are assets that are not trading, held-to-maturity
investments or originated loans or receivables. This is essentially a residual category for
all of those financial assets that do not fit the criteria of the other categories.

39.9 The amended standards introduce a free choice, on initial recognition (and on adoption
of the amendments), to classify any non-derivative financial asset as available-for-sale
and, therefore, to measure it at fair value with fair value changes recognised in a
separate category of equity.
When an entity originates a loan, for example, then under the amended standards it will
have a free choice to classify that loan as either:
■ fair value through profit or loss;
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■ available-for-sale (fair value through equity); or

■ loans (measured at amortised cost).

value through income option to exclude loans and receivables.
5.2.5 Categorising types of financial assets

Certain types of financial assets may be eligible for inclusion in more than one category
of financial assets, as noted in Table 5.1.
Table 5.1 Types of financial assets
Financial instrument Held for Originated by Held-to- Available-

trading the entity maturity for-sale
Derivatives (not in a
hedge relationship) ✔ – – –
Loans and receivables ✔ ✔ ✔ ✔
Bonds and notes (listed) ✔ – ✔ ✔
Equity securities ✔ – – ✔
5.3 Classification of financial liabilities
5.3.1 Trading
39.9 A financial liability is categorised as held for trading if it is a trading instrument as described
in Section 5.2.1 dealing with trading assets. Except in the case of derivatives, this category
is generally more applicable to financial institutions than to corporates due to the nature of
their respective operations.
39.AG15 Liabilities held for trading include derivatives with a negative fair value, except those
that are hedging instruments, and obligations to deliver securities borrowed by a short
seller. A short seller is an entity that sells securities or another type of financial instruments
that it does not yet hold, creating an obligation to deliver securities. Although only
securities that are sold short are specifically mentioned as an example of liabilities that
are classified as held for trading, this treatment is also appropriate for other non-derivative
financial instruments sold short, as the definition of trading assets and liabilities relates
to all financial instruments.
39.AG15 A liability that is used to fund trading activities is not necessarily a trading instrument
itself. Therefore, funding activities for trading portfolios would not be automatically
classified as liabilities held for trading.
5.3 Classification of financial liabilities 63

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39.9 As with financial assets (see Section 5.2.1), an entity will have a free choice under the
amended standards, on initial recognition and on first adopting the amendments, to
classify any financial liability (including own borrowings) as ‘fair value through profit
or loss’.
The new designation may allow an entity, in some cases, to avoid the cost and complexity
of meeting the criteria for hedge accounting (see Section 8.6). For example, an entity
that issues a fixed rate bond and immediately enters into an interest rate swap to
‘convert’ the interest to a floating rate might, instead of claiming hedge accounting,
designate the bond as ‘fair value through profit or loss’. Since both the bond and the
swap will be measured at fair value through profit or loss, the offsetting effects of
changes in market interest rates on the fair value of each instrument will be recognised
in profit or loss without the need for hedge accounting.
However, there are some important consequences of using this designation (see
Section 5.2.1). In addition to those considerations relating to financial assets, in the
example above the bond will be remeasured, through profit or loss, not just for changes
in market interest rates, but also for changes in the entity’s own credit risk.
For liabilities designated as ‘fair value through profit or loss’, separate disclosure is
required of the amount of the change in fair value that is attributable to changes in the
benchmark interest rate.

value through income option to four specific circumstances.
5.3.2 Other liabilities

Other liabilities constitute the residual category similar to the available-for-sale category
of financial assets. All liabilities other than trading liabilities and derivatives that are hedging
instruments automatically fall into this category. Common examples are an entity’s trade
payables, borrowings and customer deposit accounts.
64 5.3 Classification of financial liabilities
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6. Subsequent measurement

■ Subsequent measurement
■ Fair value
■ Amortised cost
■ Foreign currency transactions
■ Impairment issues
■ Reclassifications and transfers between portfolios
■ Deferred tax assets and liabilities
Abbreviations used in this Section: MC = measurement currency; FC = foreign currency

The measurement approach to be applied under IAS 39 depends upon the classification
of an instrument into one of the four categories of financial assets or one of the two
categories of financial liabilities discussed in Section 5.
Initially all financial instruments are recognised at cost, which is the fair value of the
consideration given or received. Subsequently:
■ derivatives are always measured at fair value;
■ all other financial assets are measured at fair value, except for loans and receivables
originated by the entity and held-to-maturity assets, which are measured at amortised
cost. Financial assets held for trading and available-for-sale are measured at fair
value in the balance sheet with changes in the fair value included in the income
statement or, for available-for-sale instruments, with changes in the fair value included
in either the income statement or as a separate component of equity; and
■ financial liabilities are measured at amortised cost, except for those instruments that
are held for trading, which are measured at fair value with changes in fair value
included in the income statement.
It is presumed that fair value can be reliably measured for most financial assets.
When the fair value of an instrument cannot be reliably measured, the instrument is
stated at cost.
The concepts of fair value and amortised cost, including use of the effective interest
method, are discussed in Section 6.3.
6.1 Overview 65
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39.9 As explained in Section 5, the amended standards will introduce a free choice, on initial
recognition of a financial asset or financial liability, to classify the instrument either as
‘fair value through profit or loss’ or as ‘available-for-sale’. In addition, the originated
loans category is extended to cover also purchased loans, and at the same time narrowed
to exclude instruments that are quoted in an active market.
39.55 Generally, although the classification of instruments between categories (and therefore
the measurement basis applied) may change significantly under the amended standards,
the measurement of amounts in each category, on initial recognition and subsequently,
will not change. The exception is that the amendments remove the policy choice for an
entity to measure available-for-sale financial assets at fair value with fair value changes
recognised in profit or loss. This policy choice is considered unnecessary because of the
fair value through profit or loss election that is now available on an instrument-by-instrument
basis. One consequence, however, is that an entity wishing to measure its available-for-
sale financial assets at fair value through profit or loss will need to put in place a system
to ensure that each is designated as such on the date of purchase or origination.
39.48, Additional guidance is provided on how fair value is to be determined. A mandatory
39.AG69-AG82 hierarchy has been introduced, with a quoted price in an active market being applied
first, followed by the price obtained in a similar market transaction (where there is no
direct market price), with valuation techniques being applied where there is no active
market. However, where a market is inactive, the value obtained through the use of
valuation techniques should be tested and validated by comparing it to recent market
transactions for similar items. The use of valuation techniques and models may not be
used to ‘override’ an observable market price. Where market prices are used, bid and
offer prices are to be used, as appropriate with mid prices being used only where there
are matching asset and liability positions. Extensive disclosures are required about how
fair values are determined, including the methods and significant assumptions applied,
the extent to which market prices and valuation models have been applied in determining
fair values and the total change in fair value recognised in profit or loss that is derived
from the use of valuation models.
The amended standards also provide new guidance on how to measure amortised cost
using the effective yield method. It is clarified that transaction costs, fees, discounts
and premiums are generally amortised over the expected life of an instrument. For a
group of prepayable mortgage loans, for example, any discount, transaction costs and
related fees would be amortised over a period shorter than the contractual maturity.
Historical prepayment patterns would be used to estimate expected lives.
Revised prepayment estimates will give rise to gains and losses in the income statement.
Where the classification of a financial asset or financial liability results in it being
measured at fair value through profit or loss, transaction costs are taken to profit or
loss on initial recognition.

value through income option to four specific circumstances.
66 6.1 Overview
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Figure 6.1 Measurement of financial instruments
6.2 Classification determines subsequent measurement
6.2.1 Trading assets and liabilities

39.46 and 47 Financial assets and liabilities held for trading, including derivatives, are measured at fair
value. Transaction costs that will be incurred upon sale or disposal of a financial asset are
not deducted from the measurement. Changes in the fair value of financial assets and
liabilities held for trading (including derivatives) are recognised in the income statement.
Fair value of these financial instruments should be reliably measurable. In respect of non-
derivative financial instruments classified as held for trading, if fair value is not considered
to be reliably measurable, it is questionable whether such an instrument should be included
in the trading portfolio. A lack of a reliably measurable fair value could indicate that there
is no possibility for trading with the intent of short-term profit-taking.
6.2.2 Loans and receivables originated by the entity

Subsequent measurement of loans and receivables originated by the entity is at
amortised cost.
39.46 Loans and receivables originated by the entity that have a fixed maturity should be measured
at amortised cost using the effective interest rate method. The fair value of the loan at the
date of acquisition is its cost. Any difference between cost and the amount repayable at
maturity is recognised as interest income over the remaining period to maturity.
The amortised cost method of accounting is further discussed in Section 6.3.2.
IG B.24 Loans and receivables originated by the entity that do not have a fixed maturity
(e.g. perpetual floating rate loans) should be measured at cost. Because there are no
repayments of principal, there is no amortisation of a difference between the initial amount
6.2 Classification determines subsequent measurement 67

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39.AG79 and and a maturity amount. Also, short-duration receivables with no stated interest rate may
AG84 be measured at original invoice amount unless the effect of imputing interest would be
significant (e.g. in high-inflation countries).
6.2.3 Held-to-maturity
39.46 Held-to-maturity assets, like loans and receivables originated by the entity with a fixed
maturity, should be measured at amortised cost using the effective interest rate method.
6.2.4 Available-for-sale
39.46 Available-for-sale financial assets are measured at fair value on the balance sheet. There is
an exception from measurement at fair value of an available-for-sale asset if its fair value
cannot be reliably measured. This exemption only applies to unlisted equity instruments or
derivative contracts based on those instruments where there is insufficient history of
profits or cash flows to support a reliable fair value measurement. The exemption would
apply mainly to start-up entities.
39.55 Fair value changes may either be:
■ included in income, which is a similar treatment to the subsequent measurement of
financial assets held for trading; or
39.27 ■ recognised directly in equity through the statement of changes in equity. When changes
in fair value are recognised directly in equity, such amounts are recycled to the income
statement upon sale, disposal or impairment of the asset. For a partial disposal, a
proportional share of the fair value gains and losses previously recognised in equity
must be recycled to the income statement. Such gains and losses must include all fair
value changes up to the date of disposal.
39.55(b) The subsequent measurement of available-for-sale debt instruments with fair value changes
recognised directly in equity is complicated by the fact that interest income is recognised
in the income statement each period. The basis for recording interest income is the historical
32.94(h) effective interest rate. For the correct measurement of the debt instrument, the clean
price of the instrument (i.e. the fair value of the debt instrument excluding accrued interest)
should be compared with the amortised cost of the debt instrument at the measurement
date, also excluding accrued interest. Therefore, even though the debt instrument is
measured at fair value, the holder must apply the effective interest method and calculate
the amortised cost of the instrument to determine interest income.

39.55 As noted above, the fair value through income policy choice for available-for-sale
financial assets is not available under the amended standards.
68 6.2 Classification determines subsequent measurement
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6.2.5 In summary
Subsequent measurement of financial instruments is summarised in Figure 6.1.
Figure 6.1 Classification of financial assets and liabilities determines the measurement
6.3 Valuation issues
6.3.1 Fair value
6.3.1.1 General considerations

39.9, 32.11 and Fair value is defined as the amount for which an asset could be exchanged, or a liability
IG E.1.1 settled, between knowledgeable and willing parties in an arm’s length transaction. Fair value
does not take into consideration transaction costs expected to be incurred on transfer or
disposal of a financial instrument.
39.AG69 Underlying the concept of fair value is the presumption that the entity is a going concern,
and does not have an intention or a need to liquidate instruments, nor undertake a transaction
on adverse terms. Therefore, fair value normally is not an amount that an entity would
receive or pay in a forced transaction, involuntary liquidation or distress sale.
39.AG80 and The fair value of a financial instrument should be reliably measurable. If an entity cannot
AG81 obtain an exact fair value, it instead may determine a range of reasonable fair value
estimates. The variability within the range should not be significant and the probabilities
of various estimates within the range should be estimable.

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6.3.1.2 Sources of fair value
Fair values may be obtained from various sources, such as:
■ an active public market that makes available a published market price quotation (e.g. an
equity security listed on a well-developed stock market where quoted prices are
readily and regularly available from an exchange, dealer, broker, industry group, pricing
service or regulatory agency);
39.AG72 and ■ by reference to prices available from recent transactions or for similar instruments
AG74 (e.g. making reference to a debt instrument that is rated by an independent rating
agency and whose cash flows can be reasonably estimated and discounted based on
market rates for estimating the fair value of another bond); and
39.AG74-76 ■ appropriate valuation models with data inputs that can be measured reliably because
such data is available from active markets (e.g. valuing an interest rate swap through
discounting cash flows based on the contractual terms and rates obtained from
published sources).
The methods used to determine fair value should be consistently applied during and between
reporting periods for similar types of instruments.
39.AG71 and For a financial asset held or a financial liability to be issued, the appropriate quoted market
AG72 price is usually the current bid price. For a financial asset to be acquired or a financial
liability held, the appropriate quoted market price is usually the current offer or asking
price. When an entity has matching asset and liability positions, it may use mid-market
prices as a basis for establishing fair values. It is presumed that such matching positions
IG E.2.1 would be settled within a similar time period. An entity may not depart from using bid and
ask / offer prices in order to comply with regulatory requirements.
39.AG74, AG79 Quoted market prices may not be indicative of the fair value of an instrument if the
and IG E.2.2 activity in the market is infrequent, the market is not well-established or only small volumes
are traded relative to the number of units of the financial instrument outstanding.
Adjustments to the quoted price may be possible only if an entity can present objective,
reliable evidence validating a higher or lower amount. For example, if an entity entered
into a contract with a third party to sell the shares at a fixed price in the immediate future,
that might justify an adjustment to the quoted price. However, it would be generally
inappropriate to make adjustments when valuing large holdings. For example, an entity
cannot depart from the quoted market price solely because independent estimates indicate
that the entity would obtain a higher or lower price by selling the holding as a block.
Where an active, liquid, well-established market does not exist for a particular financial
instrument, estimation methods and valuation models may be used to calculate fair value,
providing that they are sufficiently reliable and the inputs are based on market data.
Estimation methods that may be used include:
■ methods based on the valuation of quoted instruments that are substantially the same
as the instruments being valued;
■ discounted cash flows calculations; and
■ option pricing models.
70 6.3 Valuation issues
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As mentioned above, valuation models based on data inputs that are reliably measurable
can be used as a method of valuation when published market prices for instruments are
not available. This would be the case for an interest rate swap (IRS). The following case
demonstrates a basic fair value calculation for an IRS.
Case 6.1 Determining the fair value of an interest rate swap

On 1 January 20X1, XYZ Co. enters into an IRS with a notional value of 100 million.
The terms of the IRS are to pay a fixed rate of six per cent and receive a variable rate
of six-month LIBOR. The IRS has a maturity of five years and settlement of net cash
flows is done semi-annually. At inception the fair value of the IRS is zero.
At 30 June 20X1, interest rates have increased. The increase in interest rates changes
the cash flows of the variable leg of the swap. The variable interest rate for the period
from 1 July 20X1 to 31 December 20X1 is set at 6.7 per cent.
In order to determine the fair value of the IRS at 30 June 20X1, XYZ Co. performs a
discounted cash flow calculation.
Fixed leg of the IRS

Discounting of the fixed leg of cash flows is performed on the remaining nine fixed
rate payments that will occur every six months from 31 December 20X1 to 31 December
20X5. These cash flows are three million every six months, based on the agreed fixed
rate of six per cent (the annual fixed rate on the IRS). The discount rate to be used is
the applicable LIBOR theoretical spot rate calculated from Euro futures or swap quotes.
For the purpose of this example, the same effective rate is used throughout the term of
the transaction for discounting cash flows. In an actual situation, however, the yield
curve usually would not be flat.
The future fixed rate cash flows and the related present value at 30 June 20X1 are
as follows:
Present value
Settlement date Cash flows of cash flows
31 December 20X1 (3,000,000) (2,902,758)
30 June 20X2 (3,000,000) (2,808,667)
31 December 20X2 (3,000,000) (2,717,627)
30 June 20X3 (3,000,000) (2,629,537)
31 December 20X3 (3,000,000) (2,544,303)
30 June 20X4 (3,000,000) (2,461,832)
31 December 20X4 (3,000,000) (2,382,034)
30 June 20X5 (3,000,000) (2,304,822)
31 December 20X5 (103,000,000) (76,567,223)
Total discounted cash flows (97,318,803)

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Variable leg of the IRS

The variable rate receipts are calculated using the LIBOR forward rates. The discount
rate is the same rate used to discount fixed rate payments. Generally, at the repricing
date the present value of the variable leg will be par unless there is a change in the
credit spread which is not factored into the repriced interest rate. However, if the
valuation is made between repricing dates, the value of the variable leg may be different
from its par value because its fair value will be subject to the short-term interest rates
fluctuation until the next repricing date.
Fair value of the IRS

To determine the fair value of the IRS, the present value of the fixed rate payments
obligation of 97,318,803 is netted against the present value of the variable rate receipts
of 100 million:
Cash flows Present value
Receipts – based on variable rates 100,000,000
Payments – based on fixed rates (97,318,803)
Net 2,681,197

39.48, The amended standards provide much clearer guidance on how an entity might go
39.AG69-82 about measuring fair value, particularly for an instrument that is not traded in an active
market. The main features of the enhanced guidance are:
■ the objective is stated as being to establish what a transaction price would have
been on the measurement date in an arm’s length exchange motivated by normal
business considerations. Any valuation technique must be developed with that aim
in mind;
■ to require that a valuation technique should incorporate all factors that market
participants would consider and be consistent with accepted economic methodologies;
■ a hierarchy for the approach to apply in determining a fair value. The first step is to
use a market value. Thereafter market prices for similar instruments and valuation
models are given equal prominence in the hierarchy of techniques;
■ to clarify that the fair value of a transaction on the date of the transaction is the
market price unless fair value is evidenced by other observable market transactions
or is based on a valuation technique based only on market data. In other words, a
valuation model may not be used to recognise a profit or loss on initial recognition
unless the model uses only market data. Market data can include historical data as
long as the entity can demonstrate that the result from the model provides a more
reliable estimate of fair value than the transaction price;
■ the maximum possible use should be made of market inputs;
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■ if an entity operates in more than one active market, the price at the balance sheet
date for the instrument (without repackaging or modification) in the most advantageous
market to which the entity has access should be used as fair value; and
■ it is clarified that the appropriate market price for an asset held or liability to be issued
is normally the current bid price and for an asset to be acquired or liability held the
asking price. An exception to this is where an entity has assets and liabilities with
offsetting market risks, in which case the mid prices can be used for the offsetting
risk positions; bid and asking prices are applied to the net open position as appropriate.
The standards also clarify that the fair value of a liability that is repayable on demand
is not less than the present value of the amount repayable on demand, discounted from
the first date at which the investor could require repayment.
6.3.1.3 When is fair value not reliably measurable?

IAS 39 has a presumption that fair value can be reliably determined for most financial
assets. There is only one exception noted, which is for an investment in an equity instrument
that does not have a quoted market price in an active market and for which other methods
of reasonably estimating fair value are clearly inappropriate or unworkable.
39.AG81 This exception includes derivatives that are linked to, and that must be settled by, delivery of
such an unquoted equity instrument, and applies to both trading and available-for-sale
instruments. There may also be situations in which the fair value of such instruments can be
estimated. If an entity estimates the value of a financial instrument, it should use a supportable
methodology rather than arbitrarily choose a fair value within a range of reasonable estimates.
39.46, 66 and If the fair value cannot be reliably measured, the instruments should be stated at cost until
AG81 a fair value can be reliably established. These instruments are subject to normal impairment
recognition requirements.
39.54 In rare circumstances, it may be the case that fair value is no longer reliably measurable
for a financial instrument that has been measured at fair value. In that situation the last
reliably estimated fair value becomes the new cost basis. A previous gain or loss on that
asset that has been recognised directly in equity should be left in equity until the financial
asset has been sold or otherwise disposed of, at which time it should be recognised in the
income statement.
IG C.11 If an embedded derivative that is required to be separated cannot be reliably measured,
the entire combined contract should be treated as a financial instrument held for trading.
The entity might conclude, however, that the equity component of the combined instrument
may be sufficiently significant to preclude it from obtaining a reliable estimate of the
entire instrument. In that case, the combined instrument is measured at cost less impairment.
39.53 If a reliable fair value subsequently becomes available, the difference between cost and
the fair value at that time should be:
■ recognised in the income statement if the instrument is held for trading; or
■ accounted for in accordance with the entity’s accounting policy for available-for-sale
securities if the instrument is not held for trading (i.e. recognised in the income statement
or directly in equity).

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6.3.2 Amortised cost

39.47 Amortised cost applies to both financial assets and financial liabilities. The effective interest
rate method should be used for amortising premiums, discounts and transaction costs for
both financial assets and liabilities.
39.9 The amortised cost of a financial asset or financial liability is the amount at which the
financial asset or liability was measured at initial recognition minus principal repayments,
plus or minus the cumulative amortisation of any difference between that initial amount
and the maturity amount, and minus any write-down (directly or through the use of an
allowance account) for impairment or uncollectability.
6.3.2.2 Fixed rate instruments

39.9 The effective interest method is a method of calculating amortisation or accretion using the
effective interest rate of an interest-bearing financial asset or liability. The effective interest
rate (or internal rate of return) is the rate that exactly discounts the expected stream of
future cash payments through maturity or the next market-based repricing date to the current
net carrying amount of the financial asset or financial liability. That computation should
include all fees and points paid or received between parties to the contract.
IG B.27 Sometimes entities purchase or issue debt instruments with a predetermined rate of
interest that increases or decreases progressively (i.e. stepped interest) over the term
of the debt instrument. In this case, the entity should use the effective interest method
to allocate interest income or expense over the term of the debt instrument to achieve
a level yield to maturity, that is a constant interest rate on the carrying amount of the
instrument in each reporting period.
6.3.2.3 Floating rate financial instruments

39.AG6-8 Calculating the effective interest rate and amortised cost is different for floating rate
financial instruments that have been acquired or issued at a discount or premium.
The periodic re-estimation of determinable cash flows to reflect movements in market
rates of interest will change the instrument’s effective yield. Whether the discount, premium
or transaction costs are recognised in the income statement over the remaining term of
the instrument or over the remaining term to the next repricing date depends on the
reason for the existence of the premium or discount.
■ The period to next interest repricing date is used when a discount or premium results
because interest payments are in arrears, have accrued since the most recent interest
payment date or market rates of interest have changed since the debt instrument was
most recently repriced. For example, an investor purchases directly from the issuer a
five-year floating rate note paying three-month LIBOR at a discount to reflect the
difference between the variable rate set one month before at four per cent and the
current yield of five per cent. In this case the amortisation period should be the period
until the next repricing.
74
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■ The remaining term of the instrument is used in a situation when the discount or
premium arises because the credit spread required by the market for the instrument
is higher or lower than the credit spread that is implicit in the variable rate. For example,
if a five-year floating rate note paying three-month LIBOR trades at a discount due
to deterioration in the credit quality of the issuer subsequent to the issuance of the
note, the amortisation period should be to the maturity of the instrument and not to the
next repricing date because the repricing will not reflect the change in the credit
spread. The remaining term of the instrument is also used for amortisation of
transaction costs.
IAS 39 does not prescribe any specific methodology about how transaction costs should
be amortised for a floating rate loan. Any methodology that would establish a reasonable
basis for amortisation of the transaction costs may be used. For example, it would be
reasonable to determine an amortisation schedule of the transaction costs based on the
interest rate in effect at inception ignoring subsequent changes in the interest rate.

39.9 The amendments clarify that it is the expected and not the contractual cash flows that
should be used to determine the effective yield on an instrument. For example, for a
portfolio of prepayable mortgage loans, an entity would need to estimate prepayment
patterns based on historical data and build the cash flows arising on early settlements
into the effective yield calculations. The impact will be to amortise any initial discounts
or transaction costs over the period to expected maturity rather than over the period to
the contractual maturity of the loans (where the expected period to maturity is shorter
than the contractual maturity). Contractual cash flows would be used only in the rare
cases where expected cash flows cannot be estimated reliably.
If there is a change in estimated future cash flows (other than due to impairment), the
carrying amount of the instrument is adjusted in the period of change with a corresponding
gain or loss being recognised in the income statement. The revised carrying amount
should equal the amount that would have been recognised if the change in estimate had
been known from the outset (cumulative catch up approach).
Note that the use of expected cash flows specifically excludes the effect of expected
future credit losses. The amortised cost calculation cannot therefore be used to remove
credit spread from interest income to cover future losses.
In the examples below, the calculations under the revised standard are likely to be the
same as those illustrated.

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Case 6.2 Calculation of (amortised) cost

An entity purchases a government-issued treasury note with a 100,000 notional amount,
six per cent coupon rate, and maturity in five years for a discounted purchase price of
95,900. The market rate at the time of issuance (i.e. effective interest rate) is
seven per cent. Using the effective interest rate method, the fair value of the treasury
note at the beginning of year one is calculated as follows:
Discount Present value
Year Cash flows factor of cash flows
1 6,000 (1.07) 5,607
2 6,000 (1.07)2 5,241
3 6,000 (1.07)3 4,898
4 6,000 (1.07)4 4,577
5 106,000 (1.07)5 75,577
Amortised cost at beginning of year one 95,900
The effective interest rate of seven per cent is used to calculate the amortised cost of
the treasury note at the beginning of year two as follows:
Discount Present value
Year Cash flows factor of cash flows
2 6,000 (1.07) 5,607
3 6,000 (1.07)2 5,241
4 6,000 (1.07)3 4,898
5 106,000 (1.07)4 80,867
Amortised cost at beginning of year two 96,613
The interest income recorded in the income statement in year one is 6,713 (being 6,000
interest coupon plus 713 related to amortisation of the discount at the beginning of
year). The total interest income is seven per cent of the opening balance of 95,900.
Case 6.3 Effective interest rate calculation

On 1 January 20X1, Bank Y grants a five-year loan of 50 million to Entity Z with an
annual coupon of 10 per cent. The issue price of the loan is 98 per cent of the redemption
value. Bank Y classifies the loan as originated by the entity.
How should Bank Y account for the interest and the amortisation of the loan at
31 December assuming annual compounding?
To calculate the amortised cost, the effective interest rate should be determined first.
Based on the cash flows of the loan, the effective yield is 10.53482 per cent (rounded
to 10.53 per cent herein).
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The amortisation schedule is as follows:

Amortised Interest income
Date cost Coupon Amortisation (at 10.53%)
1 January 20X1 49,000,000 – – –
31 December 20X1 49,162,063 5,000,000 162,063 5,162,063
31 December 20X2 49,341,199 5,000,000 179,136 5,179,136
31 December 20X3 49,539,207 5,000,000 198,008 5,198,008
31 December 20X4 49,758,075 5,000,000 218,868 5,218,868
31 December 20X5 50,000,000 5,000,000 241,925 5,241,925
Total 25,000,000 1,000,000 26,000,000
To calculate the effective interest income, the effective interest rate is applied to the
amortised cost of the loan at the end of the previous reporting period. The difference
between the calculated effective interest for a given reporting period and the asset’s
coupon is the amortisation of the discount during that reporting period. Thus the amortised
cost of the loan at the end of the previous reporting period plus amortisation in the
current reporting period gives the amortised cost at the end of the current reporting
period. The journal entries for recording the loan and the interest income are as follows:
Debit Credit
1 January 20X1
Loan receivable (notional) 50,000,000
Loan receivable (discount) 1,000,000
Cash 49,000,000
To record the loan
On the balance sheet, the loan receivable is presented net of the discount amount
(i.e. 49 million).
Debit Credit
31 December 20X1
Accrued interest receivable 5,000,000
Loan receivable (discount) 162,063
Interest income 5,162,063
To record the effective interest income on the loan
at 31 December
At maturity the discount will be completely amortised and the carrying amount is equal
to the face value of the loan. Contrary to straight-line amortisation, which was used
often in practice prior to IAS 39, the amortisation is not constant at 200,000 (1,000,000
divided by five years). The amortised amount increases each reporting period as the
carrying amount of the loan increases. Interest income may be calculated on a daily,
monthly or quarterly basis, depending on the reporting frequency of the entity. Figure 6.2
demonstrates the impact of amortising the discount using the straight-line method and
using the effective interest method.

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Figure 6.2 Straight-line versus effective interest method
6.3.3 Foreign currency transactions

Entities may have exposure to foreign currency risk, either from transactions in foreign
currencies or from investments in foreign operations. Accounting for changes in foreign
exchange rates is covered by IAS 21, which includes the accounting for:
■ transactions in foreign currencies; and
■ translation of the financial statements of foreign operations that are included in the
financial statements of the entity by consolidation, proportionate consolidation or use
of the equity method.
The measurement principles of IAS 39 generally do not affect these rules, but merely
refer to and supplement the requirements in IAS 21, most notably in the area of hedge
accounting where IAS 21 has very limited provisions. This Section deals with interactions
between IAS 39 and IAS 21 when measuring financial instruments denominated in a
foreign currency. Hedging of foreign currency exposures is covered in Sections 8 and 9.
6.3.3.2 Recording foreign currency transactions

21.21 All transactions in currencies other than the functional currency of the entity must be
initially recognised using the spot rate at the date of the transaction. The spot rate is
determined as the price of a foreign currency purchased or sold with immediate
delivery (for practical reasons immediate is often agreed to be two days after the
transaction date).
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18.30(a) Interest amounts, amortisation of premiums and discounts and impairment losses in foreign
currency are recognised in the income statement as they accrue and are translated at the
foreign exchange rate at the date of accrual. Impairment losses in a foreign currency are
recognised in the income statement when they are incurred and are translated at the spot
21.22 rate at that date. Normally it would be acceptable to calculate amortisation and interest
amounts on a monthly basis and translate those amounts at an average foreign exchange
rate. However, when foreign exchange rates fluctuate significantly it may be necessary
to translate foreign currency interest and amortisation amounts more frequently.
18.30(c) Dividends should be recognised in income when the shareholder’s right to receive payment
is established. This is generally at the time of declaration. Therefore, the foreign exchange
rate used should be the foreign exchange rate at that date.
6.3.3.3 Subsequent reporting of foreign currency trading instruments

Non-derivative instruments that are held for trading purposes and all derivatives are measured
at fair value in the foreign currency. This value is then translated into the functional
currency at the foreign exchange rate at the reporting rate. Gains and losses recognised
in the income statement include the effect of changes in foreign exchange rates.
6.3.3.4 Subsequent reporting of other foreign currency financial instruments
Monetary financial instruments
21.8 Monetary items are money held and assets and liabilities to be received or paid in fixed
or determinable amounts of money.
This definition is narrower than the definition of a financial instrument, which implies that
not all financial instruments are monetary. Consequently, contractual rights / obligations
to receive / pay cash where the amount of money is not fixed nor determinable are non-
monetary financial instruments. This is the case, for example, with equity shares where
the holder has no right to a determinable amount of money.
21.28 and Derivative contracts are settled at amounts which are determinable at the settlement
39.AG83 date in accordance with the terms of the contract and the price of the underlying.
All derivatives that are settled in cash are monetary items, even if the underlying is a non-
monetary item.
21.23 At subsequent balance sheet dates, all monetary items in foreign currencies are translated
at the closing spot rates with any gains or losses resulting from changes in the foreign
exchange rates included in net income. All exchange differences on translation of monetary
items should be recognised in the income statement in the period in which they arise.
The example below demonstrates the accounting for monetary financial instruments
measured at amortised cost and fair value.

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Case 6.4 Measurement of monetary financial instruments denominated in a

foreign currency
Foreign currency loan

At 1 January 20X1, an entity originates a loan of foreign currency (FC) 150 million with
an eight per cent fixed rate of interest and measures the loan at amortised cost. The loan
is at par and matures on 31 December 20X4. At 1 January 20X1, the spot rate is 1.5,
therefore, the entity records an asset of measurement currency (MC) 100 million. The
cash flows are discounted at the original effective interest rate, in conformity with
measurement at amortised cost. The carrying values at 1 January and at 31 December
20X1, when the spot rate has increased to 1.6, are presented below:
Cash flows at 1 January 31 December
20X1 20X1
Present value Present value
(amounts in FC) Cash flows of cash flows Cash flows of cash flows
31 December 20X1 12,000,000 11,111,111 – –
31 December 20X2 12,000,000 10,288,066 12,000,000 11,111,111
31 December 20X3 12,000,000 9,525,987 12,000,000 10,288,066
31 December 20X4 162,000,000 119,074,836 162,000,000 128,600,823
Carrying value in FC 150,000,000 150,000,000
Carrying value in MC (at a spot

rate of 1.5 and 1.6, respectively) 100,000,000 93,750,000
The foreign exchange rate difference based on changes in the spot rate amounts to
MC 6,250,000 and is recognised in the income statement.
Foreign currency debt security

At 1 January 20X1, an entity purchases a debt security of foreign currency (FC)
150 million with an eight per cent fixed rate of interest. The entity classifies the security
as available-for-sale and measures the security at fair value. The entity records fair
value changes on available-for-sale securities in equity.
The security is purchased at par and matures on 31 December 20X4. At 1 January
20X1, the spot rate is 1.5, therefore, the entity records an asset of measurement currency
(MC) 100 million. At 31 December 20X2, the interest rates decreased so that the fair
value of the security became FC 150,100,000. The spot rate at 31 December 20X1 has
increased to 1.6.
The total fair value change in the measurement currency is calculated as follows:
Date Spot rate Fair value Fair value
(in FC) (in MC)
1 January 20X1 1.5 150,000,000 100,000,000
31 December 20X1 1.6 150,100,000 93,812,500
Fair value change 100,000 (6,187,500)
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The entity has to distinguish between:

■ changes in fair value due to changes in interest rates (and credit spread, if applicable)
which are to be included in equity; and
■ changes in fair value due to changes in the foreign exchange rate which must be
recognised in the income statement.
IG E.3.2 In order to determine the fair value changes related to foreign exchange changes to be
recognised in the income statement, the instrument is treated as an asset measured at
amortised cost in the foreign currency. The amortised cost at 31 December 20X1 is
FC 150,000,000, which is equal to MC 93,750,000. Thus, the foreign exchange loss to
be included in the income statement is equal to MC 6,250,000. The cumulative gain or
loss to be included directly in equity is the difference between the fair value and the
amortised cost at the reporting date, which is a MC 62,500 gain.
Case 7.3 in Section 7 illustrates calculations of exchange gains and losses included in the
income statement for monetary items issued or acquired at a premium or discount.
Dual currency loans

A dual currency loan is an instrument where the principal and interest are denominated in
different currencies. A dual currency loan with principal denominated in the measurement
currency and interest payments denominated in a foreign currency contains an embedded
foreign currency derivative. However, the embedded derivative is not separated because
changes in the spot rate on the foreign currency denominated element (the interest or the
principal) should be measured under IAS 21 at the closing rate with any resulting foreign
exchange gains or losses recognised in the income statement.
Non-monetary financial instruments

21.23 Non-monetary items generally are not translated subsequent to initial recognition.
However, most non-monetary financial instruments, such as equity securities, are measured
at fair value. Such instruments should be reported using the foreign exchange rates that
existed when the fair values were determined. Thus, the fair value is first determined in
the foreign currency, which is then translated into the measurement currency. Foreign
exchange gains and losses are not separated from the total fair value changes. Therefore,
for available-for-sale equity instruments remeasured through equity the entire change in
fair value is recognised in equity.
Table 6.1 below indicates whether fair value changes resulting from foreign currency and
other risks should be included in the income statement or as a separate component of
equity. Changes due to impairment losses have been disregarded in this summary.

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Table 6.1 Where to record changes in fair value
Change in fair value from: To be included in:
Separate
Foreign Income component
Financial instrument currency Other risks statement of equity
Trading instruments ✔ ✔ For all changes –

Originated loans and receivables ✔ N/a For all changes –
Held-to-maturity ✔ N/a For all changes –
Non-monetary available-for-sale ✔ ✔ – Changes in
instruments fair value,
including
FX changes
Monetary available-for-sale ✔ ✔ FX changes Other
instruments changes in
fair value
6.4 Impairment of financial assets

Addressing impairment of financial assets is a two-step process. The entity must first
assess whether there is objective evidence that impairment exists for a financial asset.
This assessment should be done at least at each reporting period. If there is no objective
evidence of impairment no further action need be taken at that time for that instrument.
However, if there is objective evidence of impairment, the entity should record an
impairment loss during the reporting period so that the financial asset is recognised at its
recoverable amount.

39.58, 63 and 66 The amendments clarify that an impairment loss is recognised only when it is incurred.
Impairment losses are not recognised for losses expected to take place as a result of
future events. Therefore, in estimating cash flows for the purpose of estimating the
recoverable amount of a portfolio of loans, the contractual cash flows are adjusted
only for the impact, based on historical data, of bankruptcy, death, unemployment, etc.
of borrowers that is estimated to have occurred at the balance sheet date.
Consequently, no loss should be recognised on the day that a loan is granted.
IG E.4.10 In addition, the amendments clarify that in the case of available-for-sale financial assets,
the recoverable amount is fair value, so that where it is assessed that an available-for-
sale asset has become impaired estimating a recoverable amount based on discounted
future cash flows is unnecessary. Additional guidance is included for the recognition of
impairment of available-for-sale equity investments.
Overall, although the implementation guidance to IAS 39 continues to acknowledge
that it is possible for the available-for-sale reserve in equity to become negative, the
scope for judgement in determining whether a decline in fair value of available-for-sale
investments represents an impairment is therefore reduced.
82 6.4 Impairment of financial assets
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6.4.1 Objective evidence of impairment
39.60 Indicators of objective evidence of impairment include:
■ financial difficulties of the issuer;
■ breach of a contract, such as default or delinquency in interest or principal payments;
■ concessions granted from the lender to the borrower that the lender would not have
considered normally;
■ high probability of bankruptcy;
■ recognition of an impairment loss on that asset in a previous reporting period;
■ disappearance of an active market for the financial asset due to financial difficulties
of the issuer; or
■ a decrease in the market value of an issuer’s debt securities significantly beyond
factors explainable by changes in market interest rates.
39.60 A change in the credit rating is not of itself evidence of impairment. However, it may be
evidence of impairment when considered with other available information, such as one of
IG E.4.1 the indicators noted above. In addition, the entity should take into account information about
the debtor’s / issuer’s liquidity and solvency, as well as trends for similar financial assets,
and local economic trends and conditions when evaluating for evidence of impairment.
39.61 and For equity instruments, impairment cannot be identified based on analysing cash flows, as
IG E.4.10 it can with debt instruments. Instead impairment is based on the identification of indicators
such as those characteristics described above. An additional indicator is the magnitude of
the difference between the original cost and the current value of the equity instrument.
The greater this difference, the greater also is the evidence of potential impairment.
However, on its own the fact that the fair value of an equity security is below its cost does
not necessarily indicate impairment.
In practice there are a number of additional indicators and sources of evidence of
impairment of equity securities that an entity may look to, including:
■ a decline in the fair value of the equity instrument that seems to be related to issuer
conditions rather than general market or industry conditions;
■ market and industry conditions, to the extent that they influence the recoverable amount
of the financial asset. For example, if the fair value at the acquisition date had been
extremely high due to a market level which is unlikely to be recovered in the future,
this may be an impairment indicator due to pure market and / or industry conditions;
■ a declining relationship of market price per share to net asset value per share at the
date of evaluation compared to the relationship at acquisition;
■ a declining price / earnings ratio at time of evaluation compared to at the date of acquisition;
■ financial conditions and near term prospects of the issuer, including any specific adverse
events that may influence the issuer’s operations;
■ recent losses of the issuer;

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Reference
■ qualified independent auditor’s report on the issuer’s most recent financial statements;
■ negative changes in the dividend policy of the issuer, such as a decision to suspend or
decrease dividend payments; or
■ realisation of a loss on subsequent disposal of the investment.

39.61 The amended standards include additional indicators of objective evidence of impairment
for investments in equity instruments, similar to those described above. Specifically a
significant or prolonged decline in value below cost is objective evidence of impairment
under the amended standards.
Although there remains some scope for judgement on whether a decline in the market
value of an equity share represents an impairment, there is a strong presumption that a
significant or prolonged decline in market value below cost is objective evidence of
impairment. There is no quantified guidance on what is ‘significant’ or ‘prolonged’ and
this evaluation will require judgement. However, only in rare cases, for example, when
market prices have subsequently recovered, might it be possible to demonstrate that a
significant decline in value is not an impairment.
6.4.2 Measuring impairment

For a financial asset that is impaired, the entity must determine its recoverable amount.
The recoverable amount, and therefore measurement of the impairment loss, differs
between assets carried at amortised cost and those carried at fair value. These differences
are summarised as follows:
39.63 and AG84 ■ Financial assets carried at amortised cost: Impairment has occurred if it is probable
that an entity will not be able to collect all amounts due (principal and interest) according
to the contractual terms. The loss recognised in the income statement is the difference
between the carrying amount and the recoverable amount. The recoverable amount
is the present value of expected future cash flows discounted at the financial
instrument’s original effective interest rate. Impairment is measured using the asset’s
original effective interest rate because discounting at the current market rate of
interest would, in effect, impose fair value measurement on the financial asset.
This would not be appropriate as such assets are measured at amortised cost.
39.67 ■ Financial assets carried at fair value: Impairment is only an issue for available-
for-sale instruments in which changes in fair value are recognised as a component of
equity rather than in the income statement. For such instruments, the impairment loss
as well as any net cumulative unrealised loss previously recognised in equity must be
recycled to the income statement.
39.68 In the case of an equity instrument included in the available-for-sale category, if a charge
for an impairment loss is required, the impairment loss to be recognised is the difference
between cost and fair value of the instrument. In the case of impairment of a debt
instrument included in the available-for-sale category, the loss is the difference between
amortised cost and fair value. The recoverable amount of a debt instrument is the present
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value of expected future cash flows discounted at the current market rate of interest for
a similar financial asset.
IG E.4.4 For a variable rate loan measured at amortised cost, the discount rate used is the current
variable rate applicable to the next repricing date, which represents its inherent effective
interest rate. The carrying amount of a fixed rate instrument measured at amortised cost
may be adjusted for fair value changes in a fair value hedge (hedge accounting is discussed
in Section 8). The adjusted carrying amount is the basis for the determination of impairment
losses. If the fair value hedge was in respect of interest rate risk, the hedge adjustment
also changes the effective interest rate. The adjusted effective interest rate is used as the
discount rate for measuring the impairment loss.
Generally the current market rate for a similar financial asset should be interpreted as the
original effective interest rate, adjusted for changes in the benchmark or risk-free interest
rate for that financial asset. In other words, in order to avoid double counting, the appropriate
current market rate should consider adjustments for interest rates, however, the original
credit risk spread should be held constant and not adjusted to reflect the current credit
risk spread.
The expected cash flows that are included in the calculation are the contractual cash
flows of the instrument itself, decreased or postponed based on the current expectations
for amount and timing of these cash flows as a result of losses incurred at the balance
sheet date. Even where cash flows are delayed for a period of time, even though all of
the principal will be recovered, impairment must be recognised unless there is full
compensation (i.e. interest paid) during the period of the delinquency.
39.AG84 If the holder expects that recovery on the instrument will come from the cash flows of
the collateral, then the fair value of the collateral is taken into account when calculating
the impairment loss.
Case 6.5 Impairment of a loan

The following case is partially based on the earlier Case 6.3. Assume that Bank Y
grants a loan in the year 20X1 to Entity Z. The interest rate on the loan is 10 per cent
and the loan is issued at 98 per cent of its face value. The maturity date is 31 December
20X5. The effective yield at the date of origination is 10.53482 per cent (rounded to
10.53 per cent for the rest of this Case).
At 31 December 20X3, it becomes clear Entity Z is experiencing severe financial
difficulties and will not be able to meet its obligations of principal and interest according
to the contractual terms. At that date the carrying amount of the loan at amortised cost
is 49,539,207.
Bank Y expects that it will receive the contractual interest payment of 10 per cent due
at 31 December 20X4. However, on maturity of the loan, Bank Y expects to recover
only 25 million of the 50 million principal due and does not expect to receive the interest
payment due at 31 December 20X5.
What would be the calculated impairment loss if the loan is categorised as originated
by the Bank Y?

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Reference
The impairment loss is measured based on discounting the expected cash flows at the
original effective interest rate of 10.53 per cent. Given that only 25 million in principal
and the 31 December 20X4 interest payment are expected to be received, the present
value based on this original effective interest rate is 24,985,165. Assume that accrued
interest is paid at 31 December 20X3 and thus is not included in the calculation.
The discounted remaining cash flows are calculated as follows:
5,000,000 25,000,000
24,985,165 = +
1.1053 (1.1053)2
As such, an impairment loss of 24,554,042 (49,539,207 – 24,985,165) should be
recognised in the income statement. Bank Y should reassess the impairment loss at
each reporting date.
How would Bank Y calculate the impairment loss if this instead is a purchased loan
categorised as available-for-sale with changes in fair value recognised as a component
of equity?
The recoverable amount would be calculated based on discounting the expected cash
flows using the current effective interest rate.
The current effective interest rate is determined by reference to the change in the
benchmark rate or the risk-free interest rate, which is part of the effective interest rate
of 10.53 per cent. The change in the credit spread from initial recognition of the loan is
not taken into account.
Assume that the risk-free effective interest rate at the date of the loan acquisition by
Bank Y was 6.53 per cent for a debt instrument with the same terms as the Entity Z
loan. Thus, the credit risk premium for such a term and structure of a loan for Entity Z
was 400 basis points. At 31 December 20X3, the effective risk-free interest rate is
8.5 per cent for a similar type of debt instrument.
Therefore, a rate of 12.5 per cent (8.5 per cent + 400 basis points) is used to discount
the expected cash flows related to the Entity Z loan if it is included in the available-for-
sale category. This discounted cash flow is calculated as follows:
5,000,000 25,000,000
24,197,531 = +
1.125 (1.125)2
The calculated recoverable amount of 24,197,531 results in an impairment loss of
25,341,676 (49,539,207 – 24,197,531). In this case, the recoverable amount is also the
fair value of the loan because the current market interest rate is being applied to the
expected cash flows. In addition, any unrealised gains or losses relating to this loan are
recycled out of equity and recognised in the income statement at the time the impairment
loss is recognised.
Assume the same information as above, except that the loan is collateralised by
liquid securities. Bank Y expects that it will only be able to recover the amount owed
on the loan by taking legal possession of the securities. How is the impairment loss
then calculated?
March 2004
Reference
39.AG84 In this case, the estimated recoverable amount of the loan equals the fair value of the
securities less any costs expected to obtain the collateral. The loss is calculated as the
IG E.4.8 difference between the carrying amount and this recoverable amount. However, the
collateral itself should not be recognised on Bank Y’s balance sheet until the securities
meet the recognition criteria for financial assets.
12.58 An impairment loss may be recognised by writing down the asset or recording an allowance
provision to be deducted from the carrying amount of the asset. If the impairment loss
relates to an available-for-sale asset where a deferred tax liability or deferred tax asset
was previously recognised for an unrealised gain or loss on the instrument, the deferred
tax amount should also be recognised in the income statement.
6.4.3 Interest income recognition on impaired assets

39.AG93 After an impairment loss has been recognised in the income statement, interest income is
recognised based on the rate used to discount the future cash flows when measuring the
recoverable amount (i.e. either the original effective interest rate or the current effective
interest rate).
It is inappropriate to simply suspend interest recognition on a non-performing interest-bearing
instrument, such as an originated loan or receivable. Future interest receipts should be taken
into account when the entity estimates the future cash flows of the instrument. If no
contractual interest payments will be collected, then the only interest income recognised is
the unwinding of the discount on those cash flows expected to be received.
6.4.4 Types of impairment measurement – individual or portfolio

39.64 Impairment losses should be measured and recognised individually for financial assets
that are individually significant. Impairment losses may be measured on a portfolio basis
IG E.4.7 for a group of similar assets that are not individually significant. However, if an entity
knows that an individual financial asset carried at amortised cost is impaired, then the
impairment of that particular asset should be recognised.
For example, assume that an entity performs an impairment analysis of its receivables
portfolio of 500 million. Those receivables are normally considered to be similar in nature.
Based on a statistical analysis, the entity estimates that an impairment loss of 20 million
should be recognised based on the whole portfolio.
39.64 Now assume that within that portfolio, one particular client is known to have financial
difficulties and the impairment loss on the receivables due from that client is calculated at
eight million. The impairment loss of eight million would be recognised separately as an
impairment loss. A new impairment analysis would then be prepared excluding the
receivables of this client from the analysis.
39.59 and 61 One of the circumstances that provides objective evidence of impairment is the existence
of a historical pattern of collections of accounts receivable that indicates that less than
the entire amount will be collected. This could be an indicator that a write-down is required
for a group of similar financial assets.

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IG E.4.5 A reasonable approach to impairment provisioning is to determine impairment losses that
are probable based on the current environment combined with historical experience such
as, for example, patterns of non-payment on a portfolio of homogeneous consumer loans
or credit card receivables. Even though the provision cannot yet be allocated to individual
financial assets, an entity may be able accurately to determine the future expected cash
flows of the portfolio of similar interest-bearing assets. These cash flows should then be
discounted at a rate that approximates the original effective interest rate. For portfolios of
similar assets, these assets will have a range of interest rates, therefore, judgement is
necessary to determine a discounting methodology appropriate to that portfolio. An entity
may employ various methodologies for determining impairment as long as they take into
account the net present value of future expected cash flows based on losses incurred at
the balance sheet date.
IG E.4.2 As discussed above it is allowable to calculate impairment losses and record a provision
using a portfolio methodology for groups of similar assets. However, this does not mean
that an entity is allowed to take an immediate write-down upon originating a new financial
asset, such as an originated loan by a bank, based on historical experience. This is because
there is no evidence of impairment of the loan upon origination. It is only when that loan
is included in a portfolio of similar loans that the bank determines inherent losses in the
portfolio based on historical experience.
A portfolio approach to impairment is not appropriate for individual equity instruments
because equity instruments of different issuers are not considered to have similar risk
characteristics (i.e. equity price risk). In the case of shares in an investment fund, it is
likely that a decrease in the fair value of an investment fund is due to an impairment of at
least some of the underlying assets held by the fund. However, an investment fund should
be evaluated based on the fair value of the investment fund itself rather than on the
underlying investments held by the fund. This approach is different from applying a portfolio
approach to a group of individual equity instruments.

39.64 As noted above, the amended standards clarify that the impairment model is an incurred
loss model. Further guidance is also provided on how to assess impairment for a group
of loans or receivables. Specifically:
■ If a loan is tested individually for impairment and found to be impaired, it should not
be included in a portfolio test for impairment. Conversely, if a loan is tested
individually and is found not to be impaired, it nevertheless should be included in a
portfolio of similar loans for the purpose of a portfolio-based impairment test;
■ Historical loss experience, adjusted for observable data reflecting economic
conditions at the reporting date, is the basis for estimating losses that have been
incurred within the portfolio, but which have not been reported or allocated to
specific loan balances; and
■ The methodology used should ensure that an impairment loss is not recognised on
the initial recognition of an asset.
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6.4.5 Reversal of impairment losses
39.65, 69 and 70 Impairment should be assessed at each reporting date. If in a subsequent reporting period
the amount of an impairment or bad debt loss decreases and the decrease can be objectively
related to an event occurring after the write-down, the write-down of the financial asset
should be reversed either directly through the income statement or by adjusting a previously
established allowance account through the income statement. An illustration of such a
situation would be an entity that has successfully improved its credit rating, for example,
through a reorganisation or after having received important sales orders.
In the case of an impairment reversal, the write-up in value of a financial asset through
the income statement is limited to the amount previously recognised in the write-down.
For an available-for-sale instrument that is measured at fair value with changes in equity,
any appreciation above (amortised) cost, taking into account any repayments of principal,
is recognised as an adjustment to equity in line with the accounting policy on the instrument.
For a held-to-maturity asset and for originated loans and receivables, any appreciation
above (amortised) cost is not recognised.

39.69 The amendments do not change the requirements on available-for-sale debt instruments.
However, in respect of available-for-sale equity investments, the amended standards
state that an impairment loss may not be reversed through the income statement.
Consequently, any subsequent increase in the carrying amount of an available-for-sale
equity security is a fair value change that is recognised in equity.
6.4.6 General provisions for credit risk

Impairment provisions relate to situations where provisions are calculated for known
risks of impairment. There should be objective evidence that the carrying amounts of
individually significant financial assets or groups of comparable financial assets are greater
than their recoverable amounts.
IG E.4.6 The term general provision is used differently in different parts of the world. In some
places, general provisions are portfolio-based provisions, as described above, for losses
inherent in a group of assets and based on historical loss experiences. In other places,
a general provision refers to one that is not specifically related to expected losses in a
group of assets, but rather is an unallocated reserve to be used for unplanned and
unexpected losses. General provisions that are in excess of such portfolio-based amounts,
or bad debt losses that are in addition to those necessary for individually significant
financial assets or groups of similar financial assets are not allowed under IFRS.
Any general provision that is an unallocated reserve established through a charge to
the income statement should be reversed.
30.44 and 50 Certain entities, such as banks, may set aside amounts for general banking risks through
an appropriation of retained earnings. However, it is important to note that this is not a
general provision. The appropriation of retained earnings is an equity-only movement,
and any charges or reversals are not included in the entity’s income statement.

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6.4.7 Measuring impairment of financial assets denominated in a foreign currency
For financial assets denominated in a foreign currency, there is no specific guidance on
how to measure impairment losses. Typically the recoverable amount of the asset is first
determined in the foreign currency. The recoverable amount should be translated into the
measurement currency using the foreign exchange rate at the date when the impairment
is recognised. The difference between the recoverable amount and the carrying amount
in the measurement currency is recognised in the income statement.
39.65 Foreign exchange gains and losses on an impaired monetary asset should continue to be
recognised in the income statement. If by a subsequent improvement in circumstances an
entity is able to reverse the impairment loss, in part or in whole, such reversal should be
recognised at the spot rate at the date when the reversal is recognised.
21.23 For non-monetary assets held as available-for-sale with changes in fair value recognised
39.68 in equity, the situation is different. The amount of loss to be removed from equity and
IG E.4.9 included in the income statement is the total net difference between the asset’s acquisition
cost and current fair value in the measurement currency.
39.69 and 70 An impairment loss recognised on an available-for-sale debt instrument can be reversed.
Again in this case, no guidance is given regarding the treatment of exchange differences
relating to the reversal. In our view, it is advisable to record the impairment loss and any
subsequent reversal at the spot rate in effect on the date when the reversal is recognised.
Any subsequent reversal should be limited to the amount of loss previously recognised,
denominated in foreign currency. It is our view that until the previously recognised loss
denominated in foreign currency is fully reversed, the related foreign exchange differences
32.94(i) should be recognised in the income statement. At a minimum, the accounting treatment applied
should be disclosed along with the nature and the amount of any impairment loss or reversal.
There may be situations where the fair value of an asset in its currency of denomination
is affected by foreign exchange rates. This may occur if there is a sudden and severe
devaluation of a foreign currency. The devaluation of the foreign currency may influence
the credit risk and country risk associated with entities operating in that environment.
Therefore, an entity that has foreign currency loans or receivables, or holds debt securities
denominated in a foreign currency that becomes devalued, should consider whether the
decline should be treated as an impairment loss rather than as a normal foreign exchange
translation loss. Only in such instances should changes in foreign exchange rates be a
factor for determining whether a further impairment loss or reversal of an impairment
loss should be recognised in the income statement.
6.5 Reclassifications of financial assets
6.5.1 Transfers between categories

An entity may wish to or need to transfer a financial asset from one category to another.
However, for certain categories transfers should be very rare or may not be allowed at all
without tainting implications. Such limitations are imposed due to the concept in IAS 39
that asset classification should generally be clear as of the moment the asset is acquired
or originated.
Table 6.2, all possible transfers between categories are outlined, including an indication of
whether such a transfer is permitted or why such transfers may take place.
90 6.5 Reclassifications of financial assets
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Table 6.2 Rules for transfers between financial assets categories
Transfer to: Originated loans Held-to- Available-for-
Trading and receivables maturity sale
Transfer from:
Trading N/a Not permitted Not permitted Not permitted
Originated loans If pattern of short- N/a N/a N/a

and receivables term profit-taking
Held-to-maturity Results in tainting N/a N/a Results in tainting
Available-for-sale If pattern of short- N/a In case of change N/a

term profit-taking in intent and if all
criteria are met
6.5.1.1 From trading

39.50 IAS 39 is clear in regard to transfers from the trading portfolio – such transfers are not
allowed. The rationale is that the designation of a financial asset as held for trading is
based on the objective for initially acquiring it (which is for trading purposes).
6.5.1.2 From originated loans and receivables

39.9 and 50 Originated loans and receivables should be classified as trading at the origination date if the
intent is to sell such loans immediately, or in the short-term, or if they are part of a portfolio
of loans for which there is an actual pattern of profit-taking. A transfer from the originated
loans and receivables portfolio to the trading portfolio at a later stage may happen only if
there is evidence of a recent pattern of short-term profit-taking that justifies such a
reclassification. An example is when responsibility for a portfolio of loans is transferred
from the banking division to the trading division and when the objective for holding the loans
has clearly changed, and not just because the entity has decided to sell the loans in the near
future. Upon transfer to the trading portfolio, the assets are remeasured to fair value with
differences between (amortised) cost and fair value recognised in the income statement.
Reclassifications and sales of originated loans and receivables are possible without any
of the tainting issues applicable to the held-to-maturity category. However, such transfers
should not be common.
6.5.1.3 From held-to-maturity

39.AG22 Transfers from the held-to-maturity category should be rare. Unless a transfer meets one
of the exceptions described in greater detail in Section 5.2.3, it would be viewed in the
same way as a sale and could thus taint the portfolio. If the held-to-maturity category is
tainted, all assets in this category are remeasured at fair value and reclassified either to
the available-for-sale or trading portfolios. Differences between the amortised cost and
fair value at the date of transfer are included either in equity or in the income statement
depending upon the new classification of the assets.
Entities should not reclassify to trading a tainted portfolio of held-to-maturity investments
if after the tainting period (i.e. two full financial years) the entity plans to reinstate the
portfolio in held-to-maturity, as this objective would not be consistent with the intent of a
6.5 Reclassifications of financial assets 91

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trading portfolio. Instead the entity should reclassify the tainted portfolio to available-for-
sale for the duration of the tainting period.
6.5.1.4 From available-for-sale

39.50 Instruments may be transferred from available-for-sale to trading. This may only be done
if there is recent evidence of a pattern of short-term profit-taking that justifies such a
reclassification. If such a transfer occurs, any cumulative gain or loss included as a fair
value component of equity should remain there until derecognition of the reclassified
asset. The fair value at the transfer date represents the new basis for recognising changes
in fair value for the trading asset. Upon derecognition of the asset, the cumulative gain or
loss included as a component of equity at the date of the reclassification is removed and
A decision to sell a financial asset that is not classified as held for trading in the near
future does not make that asset a financial asset held for trading.
39.54 Transfers from available-for-sale to held-to-maturity can occur if there has been a change
in the intent and ability of the entity. For instance, such a transfer could occur if the
tainting prohibition period on held-to-maturity assets has passed, and the entity decides to
reclassify assets back to that category. In case of a transfer from available-for-sale to
held-to-maturity, the fair value at the date of transfer becomes the new amortised cost
basis for the held-to-maturity assets. Any fair value component included in equity remains
there and is amortised as an adjustment to the yield in a similar manner to a premium or
discount, using the effective interest rate method. Conversely, any difference between
the new amortised cost amount and the maturity amount is also recognised as a yield
adjustment in the income statement. The amortisation of these two amounts should offset
over the remaining life of the financial instrument.
6.5.2 Internal transfers of financial instruments

Internal transactions, which involve transfers of financial instruments between group
entities, are not transactions that are recognised in the consolidated financial statements.
The effects of such transactions are eliminated upon consolidation. However, such
transfers could be an indication that there has been a change in the group’s intent for
holding the portfolios concerned.

39.9 and 50 As noted above, the amended standards allow an entity much more flexibility to use a
fair value through income measure for any financial asset or financial liability, and to
designate loans and held-to-maturity assets as available-for-sale. However, the fair
value through profit or loss, or available-for-sale, choice is only available when a financial
asset or liability is first recognised (or when the amended standards are first applied).
Furthermore, an entity is prohibited from transferring a financial asset or liability into or
out of the fair value through profit or loss category. Similar restrictions on reclassification
do not apply to the available-for-sale category.
92 6.5 Reclassifications of financial assets
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6.6 Deferred tax assets and liabilities
12.57 Under IAS 12 Income Taxes, deferred tax assets or liabilities are recognised for all
temporary differences between the carrying amount of an asset or liability in the balance
sheet and its tax base. Depending on the tax legislation in various countries, measurement
of financial instruments may give rise to deferred taxes. The accounting for the effects of
deferred taxes of a transaction should be consistent with the accounting for the transaction
itself. In other words, for a transaction whose effect is recognised in equity, the related
deferred tax effect should also be recognised in equity.
With respect to financial instruments measurement, deferred tax assets or liabilities may
arise from instruments valued at fair value and from hedge accounting, and also from
other adjustments to the carrying amount, for example, from the amortised cost method
differing from the tax measurement basis or from differences in the treatment of transaction
costs between IFRS and the applicable statutory tax regulations.
12.61 For changes in fair value that are recognised as a component of equity, the revaluation
component in equity should be shown net of deferred taxes, if applicable, and a
corresponding deferred tax asset or liability is established on the balance sheet. These
same concepts may also be applicable to hedging transactions, where there is a change in
fair value of hedging instruments and the hedged items.
In the majority of examples and cases in this publication, the effects of deferred taxes
have been disregarded. Cases 7.2 and 7.4 in Section 7 illustrate the effect of deferred
taxes when remeasuring a financial asset to fair value.
6.6 Deferred tax assets and liabilities 93

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7. Subsequent measurement – examples

This Section contains cases that demonstrate the measurement principles for various financial assets
and financial liabilities. The cases are presented by type of financial risk. The cases build upon the
discussion of classification of financial assets and financial liabilities (Section 5) and of measurement
and valuation issues (Section 6).

Table 7.1 indicates the possible risk positions associated with each category of financial
instrument and how they should be measured.
Table 7.1 Risk positions
Foreign
Interest exchange Price Credit
rate risk (FX) risk risk risk Measurement
Trading ✔ ✔ ✔ ✔ Fair value, with

changes in income
Originated loans ✔ ✔ – ✔ FX at fair value, credit
and receivables risk and interest rate
risk at amortised cost
Held-to-maturity ✔ ✔ – ✔ FX at fair value, credit
risk and interest rate
risk at amortised cost
Available-for-sale ✔ ✔ ✔ ✔ Fair value, with
changes in income
or equity
Non-trading ✔ ✔ – – FX risk at fair value,
liabilities interest rate risk at
amortised cost
An entity may manage these risk positions by entering into hedging transactions, which
are discussed in Section 8.
94 7.1 Overview
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7.2 Interest rate risk
Case 7.1 Transfer and subsequent remeasurement of held-to-maturity investments

Entity T buys 100 million in bonds issued by a triple A credit rated financial institution.
The bonds have a remaining life of four years, and Entity T intends and is able to hold
these bonds to maturity. For this example, assume there is no related premium or discount.
However, two years after it acquired the bonds at par, Entity T sells 10 per cent of the
bond portfolio for 9.5 million. The amortised cost and the fair value of the remaining
held-to-maturity portfolio is 90.0 million and 85.5 million, respectively.
39.9 Because Entity T sells more than an insignificant amount of its held-to-maturity portfolio,
the tainting rules require the entity to reclassify the remaining held-to-maturity portfolio
to either available-for-sale or trading. The difference between the carrying amount
and the fair value is recognised either in the income statement or in equity, depending
upon where the entity opts to record fair value changes (applies to available-for-sale
only). The journal entries are as follows:
Debit Credit
Cash 9,500,000
Loss on sale of bonds 500,000
Held-to-maturity investment 10,000,000
To account for the sale of bonds
39.51 If the remainder of the portfolio is classified as available-for-sale and movements in

fair value are reflected in the income statement, Entity T would record:
Debit Credit
Available-for-sale investments 85,500,000

Loss on investments (income statement) 4,500,000
Held-to-maturity investments 90,000,000
To account for the transfer of the remainder of
the portfolio
If the remainder of the portfolio is classified as available-for-sale with movements in

fair value reflected as a component of equity until sold, Entity T would record:
Debit Credit
Available-for-sale investments 85,500,000

Loss on investments (equity) 4,500,000
the portfolio

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If the remainder of the portfolio is classified as trading, Entity T would record:

Debit Credit
Trading assets 85,500,000

Loss on investments (income statement) 4,500,000
the portfolio
Case 7.2 Remeasurement of an available-for-sale asset

On 1 January 20X1, Inter Bank acquires a loan to Entity Z with an annual coupon of
10 per cent and a face amount of 50,000,000. The purchase price of the loan is
98 per cent of the redemption value. In this case, assume Inter Bank classifies the
loan as available-for-sale with fair value changes recognised as a component of
equity. At 30 June 20X1, the interest on comparable loans to borrowers with the
same creditworthiness is 10 per cent.
Since the loan is classified as available-for-sale, the measurement of the loan is at fair
value. Interest on the loan is recognised on the basis of the effective interest method.
Effective
Amortised interest
Date cost Coupon Amortisation (10.53%)
1 January 20X1 49,000,000 – – –
31 December 20X1 49,162,063 5,000,000 162,063 5,162,063
31 December 20X2 49,341,199 5,000,000 179,136 5,179,136
31 December 20X3 49,539,207 5,000,000 198,008 5,198,008
31 December 20X4 49,758,075 5,000,000 218,868 5,218,868
31 December 20X5 50,000,000 5,000,000 241,925 5,241,925
Total 25,000,000 1,000,000 26,000,000
The amortisation for the half year ended 30 June 20X1 is calculated (in this example)
by taking half of the cost to be amortised in the year 20X1, which is 81,032. This was
to simplify this case, as amortisation should be on an effective yield basis. The amortised
cost at 30 June 20X1 therefore amounts to 49,081,032.
Given an interest rate on comparable loans with the same credit risk of 10 per cent at
30 June 20X1, the fair value of the loan at that date can then be calculated by discounting
the cash flows:
5,000,000 5,000,000 5,000,000 5,000,000 55,000,000
52,440,442 = + + + +
0.5 1.5 2.5 3.5
(1.10) (1.10) (1.10) (1.10) (1.10)4.5
The amount of 52,440,442 includes accrued interest. To calculate the applicable clean
price of the loan, the accrued coupon interest of 2.5 million at 30 June is subtracted
from the fair value. The clean price amounts to 49,940,442.
96 7.2 Interest rate risk
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A comparison of the clean price and amortised cost at 30 June 20X1 results in a
positive change in fair value of:
Fair value at 30 June 49,940,442
Amortised cost at 30 June 49,081,032
Change in value 859,410
Assume that the measurement for tax purposes is amortised cost and the applicable
tax rate is 40 per cent. A deferred tax liability of 343,764 related to the change in fair
value should be recognised.
The journal entries recognised by Inter Bank are as follows:
Debit Credit
1 January 20X1
Available-for-sale assets (notional) 50,000,000
Available-for-sale assets (discount) 1,000,000
Cash 49,000,000
To record the initial amortised cost, being the fair value
at that time of the loan 30 June 20X1
Available-for-sale assets (accrued interest) 2,500,000
Available-for-sale assets (discount) 81,032
Interest income 2,581,032
To recognise the effective interest income (coupon
plus amortisation)
The accrued interest is presented as an increase in the fair value of the instrument in
the balance sheet, since it is a component of the fair value.
Debit Credit
30 June 20X1
Available-for-sale assets 859,410
Equity 859,410
To record the fair value change during the reporting period
Equity 343,764
Deferred taxes (balance sheet) 343,764
To record the related deferred tax liability
Continuation of the case (to 20X5):

At 1 January 20X5, Inter Bank sells the loan to another financial institution. The fair
value of the loan at 1 January 20X5 equals the fair value of the loan at 31 December
20X4, and amounts to 49,549,550 based on the current interest rate of 11 per cent on
loans with similar maturity and credit risk. Assume that Inter Bank recognised its
fair value adjustment and accrual of interest at 31 December 20X4 and this value
has not changed.

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The journal entries to record this transaction are as follows:

Debit Credit
1 January 20X5
Cash 49,549,550
Available-for-sale assets 49,549,550
To record the proceeds on sale of the loan
Inter Bank must also recognise the change in fair value that was previously recognised
in equity in the income statement. This difference between the fair value and amortised
cost at 1 January 20X5 is a loss of 208,025 (the fair value of 49,549,550 less the
amortised cost of 49,758,075).
Debit Credit
1 January 20X5
Realised loss on sale 208,025
Equity 124,815
To recycle the fair value changes from equity to the
income statement
Current taxes (balance sheet) 83,210
Tax expense (income statement) 83,210
To record the impact on tax expense of the realised loss
7.3 Foreign currency risk

The example below illustrates how changes in foreign exchange rates affect a debt security
held as available-for-sale with changes in fair value recognised directly in equity. Except
for the measurement at fair value in the underlying foreign currency, the other aspects of
this example are also applicable to:
■ monetary assets accounted for as originated loans and receivables;
■ monetary assets accounted for as held-to-maturity; and
■ monetary liabilities that are not held for trading.
Case 7.3 Available-for-sale debt security in a foreign currency including amortisation

On 1 January 20X1, Bank A buys a foreign currency (FC) 100 million unlisted bond
with a fixed annual interest coupon of six per cent, maturing at 31 December 20X4.
Bank A pays the market price of FC 90,280,840 for this bond. The discount is due to
the market yield for similar bonds at 1 January 20X1 being nine per cent. Bank A will
classify the bond as available-for-sale with changes in fair value recognised directly
in equity. Assume there are no transaction costs. Therefore, the effective interest
rate is nine per cent. Bank A will record interest income at nine per cent of amortised
cost using the effective interest rate method on a historical cost basis. For purpose
98 7.3 Foreign currency risk
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Reference
of this illustrative example, it is assumed that the use of the average foreign exchange
rate provides a reliable approximation of the spot rate applicable to the accrual of
interest income during the reporting period.
The amortisation schedules in foreign currency (FC) and in measurement currency
(MC) are as follows:
Interest Effective
Amortised cash flow Discount interest
cost (6%) accretion (9%)
Date (in FC) (in FC) (in FC) (in FC)
1 January 20X1 90,280,840
31 December 20X1 92,406,116 6,000,000 2,125,276 8,125,276
31 December 20X2 94,722,666 6,000,000 2,316,550 8,316,550
31 December 20X3 97,247,706 6,000,000 2,525,040 8,525,040
31 December 20X4 100,000,000 6,000,000 2,752,294 8,752,294
Exchange
gain/(loss)
Average Interest Effective in income
exchange Amortised cash flow Discount interest on debt
rate cost (6%) accretion (9%) security a
Date (in MC) (in MC) (in MC) (in MC) (in MC)
1 January 20X1 – 135,421,260 –
31 December 20X1 1.450 129,368,562 8,700,000 3,081,650 11,781,650 (9,134,348)
31 December 20X2 1.425 137,347,866 8,550,000 3,301,084 11,851,084 4,678,220
31 December 20X3 1.475 145,871,559 8,850,000 3,724,434 12,574,434 4,799,259
31 December 20X4 1.525 155,000,000 9,150,000 4,197,248 13,347,248 4,931,193
a Calculated by comparing amortised cost at beginning of the period and amortised cost at end of the period,
excluding accretion of the discount during the reporting period.
At 31 December 20X1, the market interest rate for similar bonds (in terms of currency,
credit rating and maturity) is 8.5 per cent. Assuming no further changes in interest
rates, the fair value in FC and MC (using spot rates) until the redemption of the bond is
as follows:
Fair value Fair value
Date Spot rate (in FC) (in MC)
1 January 20X1 1.50 90,280,840 135,421,260
31 December 20X1 1.40 93,614,944 131,060,922
31 December 20X2 1.45 95,572,214 138,579,710
31 December 20X3 1.50 97,695,853 146,543,780
31 December 20X4 1.55 100,000,000 155,000,000
21.23, IG E.3.2 Because the bond is a monetary item, foreign exchange differences must be recognised
and E.3.4 in the income statement. For this purpose, the security is treated as an asset measured
at amortised cost in the foreign currency. The difference between the amortised

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cost and fair value in the measurement currency is the cumulative gain or loss reported
in equity.
The exchange differences on the debt security to report in the income statement and
the fair value changes to report in equity are calculated as follows:
Exchange Change in
Fair value gain/(loss) fair value, Fair value
at beginning on debt excluding at end
of reporting Discount security FX of reporting
period accretion (income) (equity)b period
Date (in MC) (in MC) (in MC) (in MC) (in MC)
20X1 135,421,260 3,081,650 (9,134,348) 1,692,360 131,060,922
20X2 131,060,922 3,301,084 4,678,220 (460,516) 138,579,710
20X3 138,579,710 3,724,434 4,799,259 (559,623) 146,543,780
20X4 146,543,780 4,197,248 4,931,193 (672,221) 155,000,000
b
Calculated by comparing the change in fair value from the beginning of the reporting period to end of the
reporting period, less the discount accretion, less the effect of foreign exchange differences (see a above).
The required journal entries for the first two years are as follows (amounts are in MC,
ignoring tax effects):
Debit Credit
1 January 20X1
AFS debt security 135,421,260
Cash 135,421,260
To record the purchase of the bond: FC 90,280,840 at
the spot rate of 1.50
During 20X1
AFS debt security (accretion) 3,081,650
Interest income (income statement) 11,781,650
To record the receivable coupon interest at six per cent
(FC 6,000,000) and amortisation of FC 2,125,276.
These amounts are recognised at an average FX rate
of 1.45
31 December 20X1
AFS revaluation allowance (equity) 1,692,360
To record the increase in fair value above the
amortised cost in the measurement currency
Exchange loss (income statement) 9,434,348
Accrued interest receivable 300,000
To record the FX adjustment of balance sheet items from
opening and average FX rate to the closing spot rate
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Debit Credit
Cash 8,400,000
To record the receipt of interest coupon FC 6,000,000 at
the spot rate of 1.40
During 20X2
AFS debt security (accretion) 3,301,084
Interest income (income statement) 11,851,084
To record the receivable coupon interest at six per cent
(FC 6,000,000) and amortisation of FC 2,316,550. These
amounts were recognised at an average FX rate of 1.425
31 December 20X2
AFS revaluation allowance (equity) 460,516
AFS debt security 460,516
To record the increase in fair value above the amortised
cost in the measurement currency
Accrued interest receivable 150,000
Exchange gain (income statement) 4,828,220
To record the FX adjustment of balance sheet items from
opening and average FX rates to the closing spot rate
Cash 8,700,000
To record the receipt of interest coupon FC 6,000,000
at the spot rate of 1.45
Similar journal entries will be made in 20X3 and 20X4.
7.4 Equity price risk
Case 7.4 Measurement of available-for-sale equity securities

On 4 January, Entity M buys 100,000 units of an equity security for 10 million and
classifies these securities as available-for-sale, with changes in fair value recognised
directly in equity.
On 15 January, the fair value of the securities increases from 100 to 115. At that date
the entity purchases another 50,000 units. Assuming that the measurement for tax
purposes is cost and the applicable tax rate is 40 per cent.
7.4 Equity price risk 101

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The journal entries for the above series of transactions are as follows:
Debit Credit
4 January
Cash 10,000,000
To record the purchase of the securities
15 January
Equity 1,500,000
To record the change in fair value from 100 to 115 on
100,000 units
Equity 600,000
Cash 5,750,000
To record the purchase of 50,000 securities
At 31 January, the fair value of the securities increases from 115 to 125. The journal
entry to record the change in fair value is:
Debit Credit
31 January
Equity 1,500,000
For the increase in fair value from 115 to 125 on
150,000 units
Equity 600,000
Deferred tax (balance sheet) 600,000
Entity M decides to sell 25,000 of the units for 125 on 1 February. The financial
instruments standards do not specify what method, e.g. FIFO, average purchase price
or specific identification, should be used to calculate the gain (or loss) on the partial
disposal. Therefore, Entity M may opt for any one of these methods. The method used
should be applied consistently and disclosed as an accounting policy note.
If Entity M applies the FIFO method, the profit would be 125 – 100 = 25 per share, i.e.
625,000 for the sale of 25,000 shares.
102 7.4 Equity price risk
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The journal entries are as follows:

Debit Credit
1 February
Cash 3,125,000
To record the proceeds from the sales
Equity 375,000
Gain on sale of securities (income statement) 625,000
To record the realisation of the gain on the sale, recycled
from equity
Tax expense (income statement) 250,000
Current taxes 250,000
To record the impact on tax expense of the realised gain
7.5 Credit risk

The calculation of the impact of credit risk on the measurement of financial assets that
are measured at fair value is similar to the impact of interest rate risk. Therefore, the
cases included in Section 7.2 may be used as reference when remeasuring a financial
asset for changes in credit risk.
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8. Hedge accounting

■ Hedging versus hedge accounting
■ The hedge accounting models:
– Fair value hedge
– Cash flow hedge
– Hedge of a net investment in a foreign entity
■ Hedged items and hedging instruments
■ Hedge documentation
■ Hedge effectiveness
■ Highly probable transactions
■ Termination of a hedge relationship
■ Net position hedges

This Section provides an overview of the general principles for hedge accounting. Specific
issues relating to hedging of different types of risks (currency risk, interest rate risk etc.)
as well as examples of hedge accounting are included in Section 9.
Entities carry out hedging activities in order to limit their exposure to different financial
risks such as currency risk, interest rate risk, price risk etc. These activities often consist
of entering into a derivative contract with a counterparty to eliminate or limit the risk.
IAS 39 does not change the principles that underpin entities’ hedging activities, but sets
out the requirements related to the accounting for such activities. The term hedging
refers to a risk management strategy, while hedge accounting refers to the accounting
method entities may choose to reflect hedging activities in their financial statements.
Application of hedge accounting is not mandatory and in principle can be chosen on a
transaction-by-transaction basis. In determining whether and to what extent hedge
accounting should be applied, entities may need to consider the possible trade-off between
the cost of implementing hedge accounting (i.e. changes to systems and processes) and
the potential volatility in reported earnings when hedge accounting is not applied. Some
entities may find it useful to apply hedge accounting only to a small number of significant
transactions, yet by doing so significantly reduce the volatility in earnings. For other entities,
especially financial institutions, the ability to apply hedge accounting may be a necessity.
104 8.1 Overview
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Regardless of the type of financial risk exposure, hedge accounting usually involves a
number of the same key steps in order to comply with IAS 39 requirements. These will
each be described in detail in the Sections noted.
Table 8.1 Steps in the hedging process

At inception of a hedge
Step 1 – Determine the need for hedging Section 8.2
Step 2 – Choose a hedge accounting model Section 8.3
Step 3 – Determine whether hedge criteria are met Section 8.6
Step 4 – Prepare hedge documentation Section 8.6
Ongoing (at least each reporting date)
Step 5 – Measure actual hedge effectiveness Section 8.6
Step 6 – Reassess prospective hedge effectiveness Section 8.6
Step 7 – Reassess hedge relationships and need for de-designation Section 8.7
Step 8 – Prepare hedge accounting journal entries Section 9
8.2 Hedge accounting basic concepts
8.2.1 Terminology
39.9 IAS 32 and IAS 39 use a variety of terms to describe the components in a hedge relationship
where hedge accounting is applied:
■ Hedged item: An asset, liability, firm commitment, or forecasted transaction that
exposes the entity to risk of changes in fair value or future cash flows, and that has
been designated by an entity as being hedged.
■ Hedging instrument: A designated derivative or, in limited circumstances, another
financial instrument whose changes in fair value or cash flows are expected to offset
changes in the fair value or cash flows of a designated hedged item.
■ Hedge effectiveness: The degree to which changes in a hedged item’s fair value or
cash flows attributable to a hedged risk are offset by changes in the fair value or cash
flows of the hedging instrument.
39.72 and 78-80 Derivatives and certain foreign currency denominated non-derivative financial instruments,
or proportions thereof, can be hedging instruments. A hedged item can be a single
instrument, a portfolio or an entire position or part of a position, where the part is a
proportion, a measurable risk or an amount.
39.88 Hedge accounting may only be applied if the following strict criteria, discussed in more
detail later in this Section, are met:
■ the hedge relationship is designated and documented at inception;
8.2 Hedge accounting basic concepts 105

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■ the hedge is expected to be highly effective at inception and throughout the life of the
hedge relationship;
■ hedge effectiveness can be reliably measured on an ongoing basis; and
■ in the case of hedging of a future cash flow, cash flows are highly probable of occurring.
When a hedge does not meet the hedge accounting criteria, the hedging instrument and
the hedged position must be accounted for in accordance with the normal requirements
for each particular instrument. For derivatives this means measurement at fair value with
changes recognised in the income statement.
39.86 The hedge accounting models specified in IAS 39 are:
■ the fair value hedge accounting model, to be applied when hedging the fair value of
assets and liabilities already recognised in the balance sheet;
■ the cash flow hedge accounting model, to be applied when hedging future contracted
or expected cash flows; and
■ the hedge of a net investment in a foreign entity.
8.2.2 The need for hedge accounting

Hedge accounting is sometimes necessary due to accounting mismatches in:
■ Measurement – some financial instruments (non-derivative) are not measured at fair
value with changes being recognised in the income statement whereas all derivatives
(which are commonly used as hedging instruments) are measured at fair value; and
■ Recognition – future transactions that may be hedged are not recognised in the balance
sheet or are included in the income statement only in a future reporting period.
Examples of measurement mismatches include the hedge of interest rate risk on fixed
rate debt instruments that are not held for trading and the hedge of foreign currency and
other price risk on equity shares that are held as available-for-sale with fair value changes
recognised directly in equity. Recognition mismatches include the hedge of contracted or
expected but not yet recognised sale, purchase or financing transactions in foreign
currencies and future (committed) variable interest payments.
In order for the income statement to reflect the effect of the hedge, it is necessary to
have matching in the recognition of gains and losses on the hedging instrument and the
hedged item. Matching can be achieved in principle by delaying the recording of certain
gains and losses on the hedging instrument or by accelerating the recording of certain
gains and losses on the hedged item in the income statement. Both of these techniques
are used under IAS 39, depending on the nature of the hedging relationship.
106 8.2 Hedge accounting basic concepts
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8.3 The hedge accounting models
8.3.1 Fair value hedge accounting model

A fair value hedge seeks to offset certain risks of changes in the fair value of an existing
asset or liability that will give rise to a gain or loss being recognised in the income statement.
IAS 39 defines a fair value hedge as:
39.86 A hedge of the exposure to changes in the fair value of a recognised asset or liability,
or an identified portion of such an asset or liability; and that is attributable to a particular
risk and that will affect reported net income.
39.AG102 An example of a fair value hedge is the hedge of a fixed rate bond with an interest rate
swap, changing the interest rate from fixed to floating. Another example is the hedge of
the changes in value of inventory using commodity forwards.
The accounting for a fair value hedge essentially overrides the normal measurement
principles for financial instruments discussed in earlier Sections. The adjusted carrying
amounts of assets in a fair value hedging relationship are subject to impairment testing.
The applicable standards are IAS 39 for financial assets and IAS 36 Impairment of
Assets for non-financial assets.
Figure 8.1 Fair value hedge accounting
The fair value hedge accounting method can be summarised as follows:

39.89 ■ The hedging instrument is measured at fair value, with fair value changes recognised
in the income statement.
39.89 ■ A hedged item otherwise carried at (amortised) cost is adjusted by the change in fair
value that is attributable to the risk being hedged. This adjustment is recognised in the
income statement to offset the effect of the gain or loss on the hedging instrument.
39.89 ■ An available-for-sale hedged item whose fair value changes are otherwise recognised
in equity continues to be adjusted for fair value changes. However, the part of the fair
value change that is attributable to the risk being hedged is recognised in the income
statement rather than in equity.

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IG E.4.4 ■ The adjustment of the carrying amount of the hedged item changes the effective
interest rate of interest-bearing hedged items. As a result the income or expense
relating to those hedged items includes the original amortisation of any discount or
premium as well as the amortisation of the adjustment to the carrying amount resulting
39.92 from the fair value hedge. Amortisation of the adjustment should begin no later than
when the hedged item ceases to be adjusted for changes in the fair value attributable
to the risk being hedged.
■ The net effect of the hedge in the income statement represents:
– the ineffective portion of the fair value hedge; and
39.74 – changes in fair value of the derivative that have been excluded by the entity’s
choice from the hedge relationship (e.g. time value of options and forward points
of foreign currency forward contracts).
39.90 ■ The gains and losses attributable to risks other than the hedged risk follow the normal
measurement principles (e.g. a bond hedged for interest rate risk is not adjusted for
fair value changes due to changes in credit risk).

39.86 The amended standard requires that a hedge of a firm commitment should be
accounted for as a fair value hedge. This means that changes in value of the (as yet
unrecognised) contract will be recognised on balance sheet. The existing standard
recognises that a firm commitment gives rise to a fair value exposure, but requires
cash flow hedge accounting. The definition of a fair value hedge in the amended
standard is amended accordingly.
39.87 However, under the amended standard, a hedge of the foreign currency risk on a firm
commitment in a foreign currency may be accounted for as a cash flow hedge.
8.3.2 Cash flow hedge accounting model

A cash flow hedge is defined as:
39.86 A hedge of the exposure to variability in cash flows that: (i) is attributable to a particular
risk associated with a recognised asset or liability (such as all or some future interest
payments on variable rate debt) or a forecasted transaction (such as an anticipated
purchase or sale); and that (ii) will affect reported net profit or loss.
An example of a cash flow hedge is the hedge of future expected sales in a foreign
currency or of future floating interest payments on a recognised liability.
39.95 The hedging instrument is measured under the normal IFRS principles, but any gain or
loss that is determined to be an effective hedge is recognised in equity. This is intended to
avoid volatility in the income statement in a period when the gains and losses on the
hedged item are not (yet) recognised in the income statement. Any ineffective part of the
hedge is recognised in the income statement.
108 8.3 The hedge accounting models
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39.97 In order to match the gains and losses of the hedged item and the hedging instrument in
the income statement, the changes in fair value of the hedging instrument recognised in
equity must be removed from equity and recognised in the income statement at the same
time that the cash flows from the hedged item are recognised in the income statement
(sometimes referred to as recycling).
39.97 and 98 However, when the hedged item is an expected future transaction that results in the
recognition of an asset or a liability, the gain or loss on the hedging instrument will be
recognised as an adjustment to the initial recognition amount of the asset or liability (often
referred to as a basis adjustment). For example, an entity may hedge the foreign currency
risk from an expected purchase of inventory in a foreign currency using a forward contract.
When the inventory is recognised in the balance sheet the gain or loss on the forward
contract is recognised as part of the carrying amount of the inventory.
Once the expected future transaction occurs, assets arising from the hedge may be subject
to other standards, for example, IAS 36 for impairment testing or IAS 2 Inventories for
testing net realisable value.
39.97 The basis adjustment will affect the income statement either through amortisation,
depreciation, impairment or on disposal / derecognition. For example, a basis adjustment
included in the carrying amount of inventory would be recognised in the income statement
as part of the cost of sales when the inventory is sold.
Figure 8.2 Cash flow hedge accounting
The cash flow hedge accounting method can be summarised as follows:

■ No accounting entries are required in respect of the hedged future cash flow, whether
this is the expected cash flow from a future purchase or sales transaction or from
future interest cash flows related to an existing asset or liability.
21.23 ■ The hedging instrument is measured at fair value (for a foreign currency hedging instrument
that is not a derivative, this applies only to changes in foreign exchange rates).
39.95 and 96 ■ The change in fair value that relates to the effective part of the hedge is recognised
directly in equity. The ineffective part and the fair value changes of the derivative
that have been excluded by the entity’s choice from the hedge relationship (e.g. time
value of options and forward points of forward contracts) are recognised in the
income statement.

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39.100 ■ Fair value changes remain in equity until the hedged cash flow is recognised. The gains
and losses recognised in equity are included in the income statement in the same
period(s) as the cash flows of the hedged item.

39.86 As noted above, the fair value hedging model will be required, under the amended
standards, to be used for most hedges of firm commitments. The exception is a firm
commitment in a foreign currency, which may be accounted for as a cash flow hedge.
The amendments limit the use of ‘basis adjustment’. Under the existing standard, basis
adjustment is required for a cash flow hedge in which the hedged cash flow results in
a recognised asset or liability.
39.97 Under the amended standards, basis adjustment will be prohibited for cash flow hedges
that result in a recognised financial asset or financial liability. An example would be a
hedge of the interest rate risk in a forecast issuance of a bond, using an interest rate
swap. Under the existing standards, fair value changes on the swap would be initially
deferred in equity, to the extent the hedge is effective, until the date of issue of the
bond. At that date, the accumulated amount deferred in equity would be adjusted against
the initial carrying amount of the bond and would subsequently be amortised as part of
the effective yield calculation. Under the amended standards, the amount deferred in
equity would remain there, but would be amortised from equity into the income statement
over the life of the bond, also on an effective yield basis.
39.98 In respect of hedged purchases of non-financial assets such as inventory or property,
plant and equipment, basis adjustment will be permitted under the amended standards,
but not required. The approach adopted must be applied consistently as an accounting
policy choice to all cash flow hedges that result in the acquisition of a non-financial
asset or non-financial liability. In most cases, basis adjustment will be more straightforward
as it does not require tracking of the amount deferred in equity over long periods. If a
basis adjustment approach is not followed, such tracking would be required in order to
calculate the amount to be released into profit or loss in each reporting period and for
impairment testing purposes. On the other hand, US GAAP does not permit basis
adjustment, and therefore an entity that also reports under US GAAP may avoid a
reconciling item in this respect by choosing not to apply basis adjustment.
8.3.3 Net investment hedging

39.102, 21.39 An investor in a foreign entity is exposed to changes in value of the net assets of the
and SIC-19.4 foreign entity (i.e. the net investment) arising from the translation of the net assets into
the group’s measurement currency. Such exposures are often hedged through borrowings
denominated in the foreign entity’s measurement currency or (in more limited
circumstances) derivative foreign currency contracts. Principles relating to hedging of
net investments in a foreign entity are:
21.39 ■ gains and losses on a net investment in a foreign entity are recognised directly in equity;
■ corresponding gains and losses on related foreign currency liabilities used as hedging
instruments are also recognised directly in equity; and
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21.48 ■ any net deferred foreign currency gains and losses are recognised in the income
statement at the time of disposal of the foreign entity.
39.88 and 102 IAS 39 does not override the principles of IAS 21. However, IAS 39 introduces the hedge
accounting criteria to hedging of net investments. This means that all the criteria discussed
in Section 8.6, such as documentation and effectiveness assessment, must be met for the
hedge of a net investment in a foreign entity. An entity must still adhere to the criteria for
designation and assessing effectiveness even when using non-derivative hedging instruments.
8.3.4 When is hedge accounting not required?

When the hedging instrument and the hedged item are already accounted for in the same
manner, the effects of the hedge relationship will automatically be reflected in the income
statement or in equity, making hedge accounting unnecessary. However, the application
of hedge accounting is not prohibited, provided that all hedge accounting criteria are met.
Hedge accounting generally is not required for:
■ hedging of trading items when changes in fair value are recognised directly in the
income statement. In this case both items are already recognised at fair value with
gains and losses included in the income statement; and
21.39 ■ hedging of foreign currency risk of monetary items. For example, when a financial
liability in a foreign currency is hedged with a deposit placement in the same currency,
the liability as well as the deposit is required to be measured at the applicable closing
spot rates with changes recognised in the income statement.
21.23 However, hedge accounting is not prohibited and may be advantageous in some
circumstances. For example, an entity may wish to hedge the foreign currency risk on a
long-term foreign currency trade payable due in one year’s time. To do this the entity
takes out a forward with a maturity of one year. The trade payable is translated into the
entity’s measurement currency at each reporting date at the closing spot rate while the
forward is measured at its fair value based on the forward rate (not spot rate). In cases
where the spot / forward differential is significant and volatile, this difference in rates
may cause undesirable volatility in the income statement.
39.AG110 and Overall business risks cannot qualify for hedge accounting, as they cannot be separately
IG F.2.8 and reliably measured. For instance, the risk of obsolescence in inventory or expropriation
by a government cannot be hedged since those risks are not measurable. Also the risk of
transactions not occurring falls into this category of overall business risks.

39.9 The amended standard permits an entity, on initial recognition, to designate any financial
asset or liability at ‘fair value through profit or loss’. As noted in Sections 5.2.1 and
5.3.1, this may allow an entity to avoid the cost and complexity of meeting the criteria
for hedge accounting.

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8.4 Hedged items
39.9 The hedged item is the underlying item that is exposed to the specific financial risk that an
entity has chosen to hedge.
8.4.1 What qualifies as a hedged item?

In general the hedged item can be:
39.78 ■ a recognised asset or liability;
■ an unrecognised firm commitment; or
■ an uncommitted but highly probable anticipated future transaction (forecasted transaction).
39.80, 86, AG110 Hedge accounting may only be applied to hedges of exposures that can affect the income
and SIC-16 statement. Most transactions can affect the income statement. Exceptions are transactions
with shareholders such as share issuances, dividend payments etc. as well as most
intragroup transactions.
39.AG110 A key requirement is that the hedged item exposes the entity to a risk that can be separately
identified and reliably measured throughout the period of the hedge. Exposures to financial
market risks such as interest rate risk and foreign currency risk in financial instruments
can usually be separately identified and reliably measured. Also, exposure from items
with commodity price risk or credit risk may be hedged.
IG F.2.10 and The forecasted purchase of an asset to be classified as held-to-maturity may be hedged
F.2.11 for the period until the asset is recognised on the balance sheet. Although a held-to-
maturity instrument may not be hedged for interest rate risk, the reinvestments of cash
flows generated by a held-to-maturity instrument may be hedged. Additionally, a held-to-
maturity investment can be hedged with respect to credit risk and foreign currency risk.
IG F.2.19 Non-monetary items (such as equity shares) denominated in a foreign currency and held
as available-for-sale with changes in fair value recognised in equity also may be the
hedged item.
Case 8.1 Hedge of a non-monetary item

Entity A acquires equity shares in Entity B on a foreign stock exchange (shares are
denominated in a foreign currency). Entity A classifies the shares as available-for-sale
instruments with changes in the fair value recognised in equity. To hedge against foreign
currency risk, Entity A enters into a forward currency contract. Entity A plans to
rollover the contracts as they expire until the shares are later sold. In this situation the
forward contract may be designated as a hedging instrument for the fair value changes
relating to foreign currency risk of the shares provided that:
■ the acquired shares are not traded on a stock exchange on which trades are
denominated in the same currency as Entity A’s own measurement currency. This
might be the case if Entity B’s shares are dual-listed and one of the listings is on an
exchange where trades are denominated in Entity A’s measurement currency; and
■ dividends to Entity A are not denominated in Entity A’s (but rather Entity B’s)
measurement currency.
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8.4.2 Items that do not qualify as hedged items
There are a number of items that for different reasons do not qualify for hedge
accounting. In these cases the normal recognition and measurement principles in IAS 39
must be applied.
39.78, 79 and ■ IAS 39 generally precludes derivatives from being the hedged item and as such
IG F.2.1 derivatives can only serve as hedging instruments.
39.78 and 79 ■ Unlike originated loans and receivables, a held-to-maturity investment cannot be a
hedged item with respect to interest rate risk. In theory, for fixed rate held-to-maturity
instruments, an entity should be indifferent to changes in interest rates since the entity
does not intend to dispose of the investment before its maturity. The fair value at
maturity is unaffected by changes in interest rates.
■ Because prepayment risk on interest-bearing instruments is primarily a function of
interest rate changes this risk is akin to interest rate risk and hence cannot be hedged
when the hedged item is a held-to-maturity investment.
IG F.2.10 ■ The prohibition against hedging interest rate risk on held-to-maturity investments relates
to both hedging the risk of fair value changes of a fixed rate instrument and the risk of
variability in the interest cash flows of variable rate instruments.
39.82 and AG100 ■ When the hedged item is a non-financial asset or liability, the hedge must either be
designated for the foreign currency risk only or for the entire risk of the asset, liability
or cash flow. This is because of the difficulty of isolating and measuring the appropriate
portion of the cash flows or fair value changes attributable to specific risks other than
foreign currency risks.
39.AG99 ■ An equity investment accounted for under the equity method (joint venture or associate)
cannot be a hedged item in a fair value hedge. The reason is that the equity method of
accounting recognises the investor’s share of the investee’s net income or loss, rather
than its fair value changes, in the income statement.
■ The same reasoning applies to an investment in a consolidated subsidiary, which also
cannot be a hedged item in a fair value hedge. Through consolidation the parent entity
recognises its share of the subsidiary’s net income rather than the fair value changes in
its investment in the subsidiary. To allow the subsidiary to be a hedged item would result
in double counting, as both the income from the investment in the subsidiary and the full
fair value changes would be recognised in the consolidated income statement.
39.88 ■ Groups with foreign entities may wish to hedge the foreign currency exposure from
the expected profits from the foreign entities using derivatives or other financial
instruments. However, expected net profits from a foreign entity do not qualify as
hedged items since they are not subject to a cash flow risk exposure.
21.39 ■ From a foreign entity’s own perspective, cash flows generated from its operations
are in its own measurement currency and hence do not give rise to a foreign currency
risk exposure at the foreign entity reporting level.
SIC-16 ■ An entity’s own equity instruments cannot be the hedged item since there is no risk
exposure that affects the income statement because transactions in own shares are
IG F.2.7 recognised directly in equity. Likewise forecasted transactions in an entity’s own
equity cannot be a hedged item.

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8.4.3 Hedging a portfolio of items
A hedge relationship may be established not only for a single asset, liability or expected
transaction, but also for a portfolio of items. Hedging a portfolio requires that:
■ the individual assets, liabilities or future transactions in the portfolio share the same
characteristics with respect to the hedged risk; and
39.83 ■ the change in fair value attributable to the hedged risk for each individual item in the
portfolio is expected to be approximately proportional to the overall change in fair
value attributable to the hedged risk of the group.
This means that the portfolio of items must have shared risk characteristics with respect
to the risk being hedged. It is not necessary that each item in the portfolio shares all of the
same risks and is correlated with respect to all risks, as long as the hedged risk is a
common risk characteristic.
Examples of items that may be hedge accounted for on a portfolio basis include the following:
■ A portfolio of short-term corporate bonds may be hedged as one portfolio with respect
to a shared risk-free interest rate. To achieve the required correlation, the bonds
would need to have the same or very similar maturity or repricing date and exposure
to the same underlying interest rate.
■ A group of expected future sales may be hedged as one portfolio with respect to foreign
currency risk. Such correlation usually requires that the individual sales are denominated
in the same foreign currency and are expected to take place in the same time period.
IG F.2.20 An example of a portfolio that would not qualify as a hedged item is a portfolio of different
shares that replicates a particular stock index. An entity may hold such a portfolio and
economically hedge this with a put option on the stock index. However, in this scenario, it
cannot be expected that the fair value changes of individual items in the portfolio would
be approximately proportional to the fair value change of the entire group.
Future amendments to IAS 39

At the date of this publication, the IASB is finalising its deliberations in respect of Fair
Value Hedge Accounting for a Portfolio Hedge of Interest Rate Risk. It is anticipated
that, when issued, this will introduce a number of additional requirements for this form
of hedge accounting.
8.4.4 Hedging risk components and proportions of items
Hedging a risk component of a financial instrument

39.81 Financial assets or liabilities may be hedged with respect to a particular financial risk
component, provided that the exposure to the particular risk component is separable and
can be reliably measured. Examples of such risk components include:
39.81 and ■ Hedging exposure to interest rates or credit risk spread of a bond (rather than hedging
IG F.3.5 the full market risk).
■ Hedging exposure to the risk-free interest rate in a fixed or floating rate liability
(rather than hedging the entire interest rate risk).
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IG F.2.19 ■ Hedging foreign currency exposure only in a portfolio of foreign currency denominated
equity instruments (rather than hedging the full market price risk).
IG F.3.5 ■ A floating rate debt instrument is normally considered not to have fair value exposure
because of periodic resetting of its interest rate. However, such an instrument could
be hedged in a fair value hedge for credit spread or for interest rate risk exposure that
can occur between interest reset dates.
Hedging a risk component of a non-financial item

39.82 Non-financial items may not be hedged for separable risk components other than foreign
currency risk. That is because only foreign currency risk is assumed to be a separately
measurable risk component.
39.AG100 A price risk relating to a non-financial component may not be hedged. For example, a
producer of chocolate bars may wish to hedge the fair value of its inventory in respect of
changes in the sugar price (a major ingredient in chocolate bars) by taking out a sugar
forward in the commodity market. It would not be permissible in this situation to designate
as the hedged item the price risk relating only to the price of sugar. As an alternative the
producer may designate the sugar forward as a hedge of the entire fair value changes of
the chocolate bar inventory. However, this hedge is only likely to be effective if the price
fluctuations on sugar and chocolate bars have been highly correlated in the past and are
expected to remain so in the future. As chocolate bars consist of other ingredients than
sugar (e.g. cocoa, milk etc.), the hedge is unlikely to be highly effective, and in that case
hedge accounting would not be permissible.
Hedging a proportion of a hedged item

39.81 IAS 39 also allows a proportion of the fair value or cash flows of an item to be hedged.
Examples of such designations would be:
IG F.2.17 ■ Hedging the interest rate risk for the first five years of a 10-year fixed rate bond with
a five-year pay-fixed receive-floating interest rate swap. In this situation the bond is
hedged for a period of time less than its full term.
IG F.3.10 ■ Hedging the price or foreign currency risk of a proportion of a forecasted purchase
or sale. This can be done either by specifying the number of units expected to be
purchased / sold (e.g. the first 500 units out of expected purchases / sales of
800 units) or by specifying the monetary value of the purchase or sale (e.g. the first
25 million). It would not be permissible to designate the first 50 per cent of sales as
the hedged item as this designation would not lead to an identifiable amount being
hedged (i.e. the first 50 per cent of sales would depend on the total amount of sales
in the period, which is not known until after the fact) and hedge effectiveness
testing would not be possible.
■ Hedging the interest rate risk of half of the notional amount of a bond.

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39.AG100 Several comments on the proposed amendments had proposed that separate components
of a non-financial item should qualify for hedge accounting as long as changes in the
fair value of the hedged component could be measured reliably. The Board rejected
this suggestion, but has clarified in the amended standards that hedge accounting might
be achieved by adjusting the hedge ratio to maximise effectiveness.
For example, a regression analysis might be performed to establish a statistical relationship
between the price of a transaction in Brazilian coffee (the hedged item) and a hedging
instrument whose underlying is the price of Columbian coffee. If there is a valid statistical
relationship between the two prices, the slope of the regression line can be used to
establish the hedge ratio that will maximise expected effectiveness. For example, if the
slope of the ‘line of best fit’ is 1.02, then a derivative with a notional amount of 1.02
tons of Columbian coffee would be designated as a hedge of the purchase of one ton
of Brazilian coffee.
This approach will give rise to some ineffectiveness in practice, although it may be
sufficient to ensure that hedge accounting can be achieved. The amended standards
will continue, however, to prohibit the hedged item to be designated as the Columbian
coffee component of the Brazilian coffee price, even if that component can be proven
to exist and can be measured reliably.
8.4.5 Intragroup balances or transactions as the hedged item

39.80 and 21.45 Although intragroup transactions are eliminated on consolidation, intragroup monetary
items can be designated as hedged items at the group level in situations where foreign
exchange rate exposure cannot be eliminated on consolidation. Intragroup monetary items
lead to a group exposure that affects the group income statement in instances when:
■ items have been transacted between group entities with different measurement currencies;
■ the item is denominated in one of these measurement currencies; and
■ at least one of the group entities is a foreign entity.
For example, an intragroup payable / receivable between a parent with measurement
currency (MC) and its foreign subsidiary is denominated in foreign currency (FC).
The transaction itself is eliminated on consolidation. However, the parent still has foreign
exchange rate differences since the item is denominated in FC. Therefore, the foreign
exchange difference cannot be eliminated. Such an intragroup monetary item could qualify
as a hedged item for purposes of hedge accounting if all other criteria are met.
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In amending the standards, the guidance permitting a forecasted intragroup transaction
to qualify as a hedged item in a cash flow hedge has been withdrawn. The reason for
this amendment would seem to be that the foreign exchange risk in most forecasted
intragroup transactions will affect group profit or loss only indirectly as a result of
translating the income statement of a foreign entity for consolidation purposes into the
reporting currency of the group.
A forecast intragroup transaction, or an intragroup firm commitment, cannot qualify as
a hedged item at the group level if there is no potential impact on the profit or loss of
the group. At the group level, a forecast external transaction by a foreign entity in its
own functional currency cannot generally qualify as a hedged item because the group
has no exposure to foreign currency cash flow risk. However, where the group is able
to demonstrate, for example, that cash flows from the forecast external transaction
are passed directly to an entity with a different functional currency, such that the
forecast external transaction does create a foreign currency cash flow exposure to the
group, then the standard may not preclude a forecast external foreign currency cash
flow from qualifying as a hedged item, at the group level only, as long as the other
criteria for hedge accounting are met.
8.5 Hedging instruments
8.5.1 What qualifies as a hedging instrument?

39.72 Derivatives are generally the only instruments that can be used as hedging instruments.
Some of the derivatives that are commonly used in hedging transactions and may qualify
for hedge accounting include:
■ forward and futures contracts;
■ swaps;
■ options; and
■ compound derivatives (such as cross currency interest rate swaps and collars).
Non-derivative financial assets or liabilities may be designated as hedging instruments for
hedges of foreign currency risk only. For example, a borrowing denominated in a foreign
currency can be designated to hedge a sales commitment in the same foreign currency.
39.77 It is possible to use two or more derivatives, or proportions thereof, as the hedging instrument
for the same hedged item. The derivatives do not have to be entered into with the same
counterparty. For example, an interest rate swap and a currency forward could be
designated together to hedge a loan in a foreign currency.
39.AG96 Generally financial assets and liabilities whose fair value cannot be reliably measured
also cannot be hedging instruments. An exception is a non-derivative instrument that is
denominated in a foreign currency, that is designated as a hedge of foreign currency risk,
and whose foreign currency component is reliably measurable.

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39.AG97 An entity’s own equity securities cannot be hedging instruments since they are not financial
assets or financial liabilities of the issuing entity.
8.5.2 Using options as hedging instruments

39.74 and AG94 Purchased options may be used as hedging instruments provided that the criteria in
Section 8.6 are met. Options, in contrast to forward and futures contracts, contain both
an intrinsic value and a time value due to the nature of the instrument, i.e. the holder has
a right, but not an obligation, to use the derivative.
For example, a forecasted transaction in a foreign currency may be hedged with an
option. In this situation the cash flows of the forecasted transaction do not include a time
value component while the option does. If the option is designated in its entirety (including
time value) hedge effectiveness testing must be based on the full fair value change of the
option and the change in cash flows of the forecasted transaction. The change in fair
value of the option and the change in cash flows of the forecasted transaction will not be
the same, since the change in the time value element of the option is not offset by an
equal and opposite change in the forecasted transaction.
39.74 IAS 39 allows for the time value of an option to be excluded from the effectiveness
assessment. In this case the option is more likely to be effective in matching the changes
in the hedged item. Changes in time value would not be included in the hedge relationship
and as a result would be recognised directly in the income statement regardless of which
hedging model is used.
8.5.3 Written options

39.AG94 Written options generally increase risk exposure and, accordingly, cannot be used as
hedging instruments unless they are designated as an offsetting hedge of a purchased
IG F.1.3 option. For example, hedge accounting may be applied when a written option is related to
a purchased option embedded in a contract, such as callable debt, that is closely related
and for that reason not separated from the host contract. If the embedded purchased
option were to be separated, hedge accounting would not need to be applied, since both
the separated purchased option and the written option would be measured at fair value in
the income statement.
Some hedging strategies involve a written call option and a purchased put option with
different strike prices, in combination forming a collar. Such a strategy may be used in
situations where an entity wants to limit its hedging costs by reducing the hedge protection
to a certain range of prices or rates. For example, an entity may hedge a bond held as
available-for-sale with fair value changes recognised directly in equity, by buying a put
option to sell at 90 and writing a call option to sell at 100. The effect of the strategy is that
the entity is protected against decreases in value below 90, but has given up the upside
potential of a price increase above 100. This is demonstrated in Figure 8.3.
118 8.5 Hedging instruments
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Figure 8.3 Using a collar as the hedging instrument
39.AG94 and Hedge accounting may be applied to such a hedging strategy provided that:
IG F.1.3
■ no net premium is received either at inception or over the life of the combination of
options (if a premium was received it would be evidence that the instrument was a
net written option);
■ the options have similar critical terms and conditions, with the exception of strike
prices (same underlying variable or variables, currency, denomination and maturity
date); and
■ the notional amount of the written option component is not greater than the notional
amount of the purchased option component.
8.5.4 Using a part of an instrument as the hedging instrument

39.75 A proportion of a financial instrument may be designated as the hedging instrument
(i.e. a percentage of the whole instrument). For example, 50 per cent of the fair value
changes on a forward contract may be designated as the hedging instrument in a hedge
of a forecasted sale.
39.75 and Derivatives as well as non-derivatives must be designated as hedging instruments for the
IG F.6.2(i) entire remaining period in which they are outstanding. For instance, an instrument
with a maturity of 10 years cannot be designated as a hedging instrument for only its
first eight years.
39.75 A hedging instrument, or a proportion thereof, should be designated in its entirety, since
there is normally a single fair value measure for a hedging instrument and the factors
(i.e. risk components) that cause changes in fair value are co-dependent. While using an
entire instrument or a proportion of an instrument is acceptable for hedge accounting,
using only a portion (e.g. a risk component) generally is not allowed. For example, a cross

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currency interest rate swap must be designated both with respect to foreign currency risk
and interest rate risk.
There are a few exceptions to consider:
39.72 ■ A non-derivative instrument may be designated as a hedging instrument for foreign
currency risk only. To allow non-derivatives to be used in situations other than hedging
foreign currency risk would create difficulties, since in many instances these
instruments are not measured at fair value.
39.74 ■ The interest element of a foreign currency forward contract may be excluded from a
hedge relationship when measuring hedge effectiveness. The time value of an option
likewise may be excluded from a hedge relationship.
39.76 ■ A derivative hedging instrument may be designated for a particular risk providing that
the other parts of the hedging instrument are designated as hedging other risks of the
IG F.1.12 hedged item and all other hedge criteria are met. For example, a cross currency
interest rate swap may be designated as a cash flow hedge with respect to interest
IG F.2.18 rate risk and fair value hedge with respect to foreign currency risk. However, this
may create practical difficulties in separating fair values between risks that are inter-
related. Where possible a cross currency interest rate swap should be designated in
its entirety as a fair value or cash flow hedge.
Case 8.2 Hedging with a cross currency interest rate swap (CCIRS)
Entity A with EUR as its measurement currency issues a floating rate GBP
denominated bond. Entity A also has a fixed rate USD financial asset with the same
maturity and payment dates. In order to offset the currency and interest rate risk on
the financial asset and liability Entity A enters into a swap to pay USD fixed and
receive GBP floating.
IG F.2.18 The swap may be designated as a hedging instrument of the USD financial assets
against the fair value exposure from changes in the US interest rates and the foreign
currency risk between USD and GBP. Alternatively, it could be designated as a cash
flow hedge of the cash flow exposure from the variable cash outflows of the GBP
bond and the foreign currency risk between USD and GBP. Both of these designations
would be permissible under IAS 39, although the hedge does not convert the currency
exposure to the entity’s measurement currency EUR. In our view, this type of hedge is
appropriate only as long as an entity has both foreign currency exposures and is not
creating a new foreign currency position but rather decreasing its risk exposure.
Both currency exposures should be referred to in the hedge documentation.
120 8.5 Hedging instruments
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8.6 Criteria for hedge accounting
39.88 The hedge relationship must meet the following criteria in order for the hedging instrument
and the hedged item to qualify for hedge accounting:
■ the hedge is formally documented at inception;
■ the hedge is expected to be highly effective;
■ the effectiveness of the hedge can be reliably measured;
■ the hedge is assessed prospectively on an ongoing basis, and determined to have
been highly effective over the full period; and
■ for cash flow hedges, a forecasted transaction must be highly probable and must
present an exposure to variations in cash flows that could ultimately affect reported
net income.
The hedge relationship should be evidenced and driven by management’s approach to
risk management and the decision to hedge the particular risk. The designation and
effectiveness assessment should principally follow the methodologies that management
has in place for risk identification and measurement.
8.6.1 Formal documentation at inception

39.88 At the inception of the hedge, formal documentation of the hedge relationship must
be established.
The hedge documentation prepared at inception of the hedge must include a description
of the following:
■ the entity’s risk management objective and strategy for undertaking the hedge;
■ the nature of the risk being hedged;
■ clear identification of the hedged item (asset, liability or cash flows) and the hedging
instrument; and
■ how hedge effectiveness will be assessed prospectively and measured on an ongoing
basis. The method and procedures should be described in sufficient detail to establish
a firm basis for measurement at subsequent dates in order to be consistently applied
for the particular hedge.
IAS 39 does not mandate a specific format for the documentation and in practice hedge
documentation may vary in terms of lay-out, technology used etc. The important thing is
that the documentation includes the basic content noted above.
The following examples of hedge documentation would meet the requirements of IAS 39.
Note, however, that in practical terms an entity may be able to standardise its documentation
forms in such a way that narrative descriptions are minimised or not necessary, since
they are included by reference to other documentation. Entities generally wish to base
their hedge documentation on reports already prepared for risk management purposes
and limit the amount of additional work required by IAS 39. What is important is that a
system is established that links the details of the hedged item and hedging instrument with
standardised information from other sources in such a way that full documentation is

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available to demonstrate the existence of a qualifying hedge relationship at any time
during its life.
Case 8.3 Documentation of an FX cash flow hedge

Global Tech Company (GTC) has made a firm commitment to purchase a machine
from a foreign manufacturer in foreign currency (FC) 10,000 in 12 months. GTC wants
to hedge the foreign currency exposure of the firm commitment. GTC enters into a 12-
month forward contract to exchange a fixed amount of measurement currency (MC)
for a fixed amount of FC. Based on this background information, the following
documentation is prepared on 1 January 20X1:
Risk management objective and strategy and nature of the hedged risk
On 1 January 20X1, GTC entered into a commitment to purchase a machine from a
foreign manufacturer for FC 10,000 in 12 months. As a result, GTC is exposed to
changes in the MC / FC exchange rate. To reduce this exposure so as to be in
compliance with risk management requirements to limit exposures to foreign currency
risk, on 1 January 20X1 GTC also entered into a 12-month forward contract to exchange
a fixed amount of MC for a fixed amount of FC. Changes in the expected value of the
forward contract are expected to be highly effective in offsetting the exposure to
changes in fair value of the firm commitment.
Derivative hedging instrument

Identification: [Trade # 12345]; 12-month forward contract to exchange a fixed amount
of MC for the amount of FC.
Notional amount FC 10,000 at the forward exchange rate of FC 1.5 : MC 1 at inception
of the contract.
Hedged item
Changes in the fair value of the future cash flows of the firm commitment [contract
# 67890] to purchase a machine from a foreign manufacturer for FC 10,000 in 12 months
caused by fluctuations in the foreign exchange rate between the MC and FC. The gain
or loss on the firm commitment will be measured based on the present value of the
changes in FC forward exchange rates.
Method for recognising the forward contract

Any changes in the fair value of the forward contract during the period in which the
hedge is in effect will be reflected as a component of equity to the extent that the
hedge is effective. When the forward contract is closed and the machine is purchased
(31 December 20X1), the effective part of the forward will be reclassified as an addition
to, or subtraction from, the carrying amount of the machine at acquisition.
122 8.6 Criteria for hedge accounting
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Hedge effectiveness
Management expects the hedge relationship will continue to be highly effective during
the next 12 months, which is the period of the hedge relationship. Expected cash flows
on the forward and firm commitment are for the same currency and amount, and are
expected to occur at the same time.
On a quarterly basis, GTC will assess hedge effectiveness on a cumulative basis by
comparing the changes in fair value of the forward contract that are due to changes in
forward rates with changes in the present value of cash flows. As long as the timing of
the cash flows does not change, effectiveness should be close to 100 per cent.
Note that if an entity enters into similar types of hedge transactions regularly, most of
hedge documentation could be provided in a standardised form as part of its risk
management policy manual. Specific transaction documentation then could be limited to
contract numbers, amounts, currencies, dates, rates and a reference to the appropriate
policies in the manual.
Case 8.4 Documentation of a fair value hedge relationship

On 1 January 20X1, Bank A purchases a bond with a maturity of five years. The bond
is purchased at a par value of 100 million and is included in the bank’s available-for-
sale portfolio, with changes in fair value recognised in equity. The interest rate on the
bond is fixed at six per cent. Bank A simultaneously enters into a five-year interest
rate swap (IRS) with a notional amount of 100 million to receive interest at LIBOR
and pay interest at a fixed rate of six per cent. The combination of the IRS and the
purchased bond results in Bank A being hedged against changes in the fair value of
the purchased bond due to changes in interest rates. The swap reprices twice a year
and requires payments to be made or received on 1 July and 1 January of each year.
No premium was paid for the IRS. Bank A designates the IRS as a fair value hedge
of the interest rate risk inherent in the fixed rate bond. The following documentation
is prepared on 1 January 20X1:
Risk management objective and strategy

On 1 January 20X1, Bank A purchased a five-year 100 million fixed rate bond [reference
ABCDE] which is carried in the available-for-sale portfolio. The interest rate on the
purchased bond is six per cent. As a result, Bank A is exposed to changes in the fair
value of the purchased bond due to changes in market interest rates.
Due to the bank’s overall interest rate risk position and funding structure, its risk
management policies require that the bank should minimise its exposure to fair value
changes in the price of the bond due to changes in market interest rates. Bank A meets
this objective by entering into a five-year IRS with a notional amount of 100 million to
receive interest at a variable rate equal to LIBOR and to pay interest at a fixed rate of
six per cent. The hedge relationship results in the bank being hedged against changes
in the fair value of the purchased bond due to changes in interest rate.

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The derivative hedging instrument

IRS [contract XYZ] will be used as the hedging instrument:
■ Notional amount: 100 million
■ Premium paid: none
■ Fixed leg: six per cent per annum
■ Fixed leg payer: Bank A
■ Floating leg: LIBOR, repricing 1 July and 1 January of each year
■ Floating leg payer: Bank B
■ Settlement: net cash due in arrears on 1 July and 1 January of each year
The fair value changes of the IRS due to changes in interest rates will be recognised in
The hedged item

Bank A designates the five-year bond, purchased 1 January 20X1 and paying a fixed
rate of interest of six per cent, as the hedged item. The changes in the fair value of the
bond relating to the hedged risk are also included in the income statement.
Hedge effectiveness
The critical terms of the IRS and the purchased bond are identical. The following
conditions have been met:
■ the notional amount of the IRS equals the principal amount of the bond purchased;
■ both the interest received on the bond and paid on the IRS are fixed;
■ the maturity date of the IRS matches the maturity date of the purchased bond;
■ the formula for computing net settlements under the IRS is the same for each net
settlement. The fixed rate is the same throughout the term and the variable rate
equals LIBOR throughout the term;
■ there is no floor or cap on the variable interest rate of the swap;
■ the fair value of the swap at its inception is zero;
■ it is unlikely that the purchased bond will be repaid prior to maturity;
■ the fair value changes of the bond due to changes in market interest rates are
designated as hedged; and
■ all other terms of the purchased bond and the IRS are typical of those instruments
and do not invalidate the assumption of no ineffectiveness.
Due to the above, Bank A concludes that at inception the hedge relationship is expected
to be highly effective in achieving offsetting fair value changes of the IRS and the
purchased bond due to changes in interest rates.
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Ongoing effectiveness testing will be performed through comparison of the cumulative

changes in the fair value of the bond to cumulative changes in the clean fair value of
the IRS (i.e. accrued interest will be excluded from the fair value). This analysis will
exclude changes in fair value of the bond due to risks and factors other than interest
rates. Changes in the fair values of each instrument will be modelled by Bank A on a
quarterly basis and assessed on a cumulative basis. Management believes this
effectiveness can be reliably measured.
8.6.2 Hedge effectiveness

IG F.4.4 An entity must adopt a method for assessing hedge effectiveness that is consistently
applied for similar types of hedges unless different methods are explicitly justified.
For example, an entity would generally use the same methods for prospectively assessing
as well as for measuring actual hedge effectiveness for forecasted sales to the same
export market in each period. The method chosen will depend on the entity’s risk
management strategy.
A summary of the requirements for prospective assessment and measurement of hedge
effectiveness can be illustrated as follows:
Figure 8.4 Different requirements for effectiveness assessment and measurement
8.6.2.1 Prospective assessment of effectiveness

39.88 In order for hedge accounting to be applied, the hedge transaction must be expected to be
highly effective in achieving offsetting changes in the fair value or cash flows attributable
to the hedged item. This offsetting must be expected to occur in a manner consistent with
the originally documented risk management strategy for that particular type of hedge
relationship. IAS 39 states that:
39.88 and AG105 A hedge is normally regarded as highly effective if, at inception and throughout the life
of the hedge, the entity can expect changes in the fair value or cash flows of the
hedged item to be almost fully offset by the changes in the fair value or cash flows of
the hedging instrument.

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Expectation of an almost perfect offset at inception is necessary to allow for unexpected
imperfections in the hedge relationship during the hedge period that might otherwise require
early termination of hedge accounting.
39.AG106-108 IAS 39 does not prescribe a single method for the assessment of effectiveness, but rather
emphasises that the method must follow the risk management methodologies of the entity.
The prospective effectiveness assessment can be performed in several ways, such as:
■ matching critical terms of the hedging instrument and the entire hedged item may
support a conclusion that changes in fair value or cash flows attributable to the risk
being hedged are expected to completely offset at inception and on an ongoing basis;
■ using a scenario analysis of historical data; or
■ using a statistical model, such as a regression analysis that analyses the correlation
between changes in value or cash flows of the hedged item and the hedging instrument
for a given historic period.
39.AG107 and An example of the first bullet point above would be hedging a specific bond held by
AG108 entering into a forward contract to sell an equivalent bond with the same notional amount,
currency and maturity. Another example would be the hedge of a fixed rate borrowing
with a receive-fixed pay-floating interest rate swap where the notional amount, currency,
maturity, interest basis and interest repricing terms are identical. This direct approach to
assessing hedge effectiveness can be applied for prospective assessment. However, a
formal measurement of the actual effectiveness results must be performed.
IG F.4.4 When the critical terms are not exactly the same or only a portion of the asset, liability or
transaction is being hedged, prospective hedge effectiveness must be assessed and
documented. When a statistical model is used, the hedge documentation must specify
how the results of the analysis are to be interpreted.

As explained more fully in Section 1, the IASB has tentatively agreed to remove the
requirement that, prospectively, gains and losses should ‘almost fully offset’.
If confirmed, this amendment is likely to mean that some hedging relationships that
previously failed to qualify for hedge accounting will qualify in the future.
8.6.2.2 Ongoing assessment and measurement

39.88 and Effectiveness must be measured on an ongoing basis and the hedge relationship proved
AG105-108 actually to have been highly effective throughout the financial reporting period. At a
minimum, the frequency of this should be whenever interim or annual financial statements
are prepared. Entities may be inclined to perform hedge effectiveness testing more
frequently in order to minimise the time period where hedge accounting cannot be applied
IG F.4.7 due to ineffectiveness and in order to better manage the risk exposure. IAS 39 does not
allow the use of a short-cut method and as a result effectiveness assessment and
measurement must be performed at a minimum at each reporting date.
39.AG105 The actual results of hedge effectiveness must be within a range of 80 to 125 per cent
offset for hedge accounting to be applied. Hedge effectiveness measurement may be
based on either a period by period or on a cumulative basis depending on what has been
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established in the hedge documentation. For the latter, even if a hedge is not highly effective
in a particular period, hedge accounting is not precluded if the effectiveness remains
IG F.4.2 sufficient on a cumulative basis. Measuring effectiveness on a cumulative basis may reduce
the risk of a hedge becoming ineffective, and is therefore the more common method in practice.
The gain or loss on the hedged item must be measured independently from that of the
hedging instrument (i.e. it cannot just be assumed that the change in fair value or cash
flows of the hedged item in respect of the hedged risk equals the fair value change of the
hedging instrument). The reason for this is that any ineffectiveness of the hedging
instrument must be recognised in the income statement.
39.AG106-108 A single method for the prospective assessment of effectiveness is not prescribed and
and IG F.4.4 the method applied may be different for different types of hedges. However, the periodic
measurement of hedge effectiveness would usually involve a method that compares the
actual change in fair value of the hedged asset or liability or in cash flows with respect to
the hedged risk to the change in the fair value of the hedging instrument (an offset method).
This means that some of the methods used for prospective hedge assessment (e.g. statistical
analysis) would not be used for measuring actual hedge effectiveness.
IG F.4.3 Both when assessing prospectively and when measuring actual effectiveness, the
creditworthiness of the counterparty to the hedging instrument and the likelihood of default
should be considered. The value of a swap could be affected by changes in the respective
swap counterparty’s credit rating.
Prepayment risk will impact the effectiveness of fair value hedges. If the hedged item is
repaid before expected, this will lead to a situation where the entity is over-hedged, as the
notional amount of the hedging instrument may be more than the remaining outstanding
amount of the hedged item. In that case it is likely that the hedge relationship would no
longer be effective. The same applies to expectations about changed timing of future
cash flows. Therefore, the risk of prepayment or changes to timing of future cash flows
should be considered when an entity designates its hedge relationships.
39.74, The time value of an option or the interest element of a forward may be excluded from
39.AG106-108 the ongoing effectiveness assessment. For an option, the hedge relationship would be
and IG F.1.9 designated only for the price range when the option is in-the-money. Therefore, when the
option is out-of-the-money, no effectiveness measurement is necessary, however
prospective assessment is still required. The excluded portion of the option or forward is
recognised immediately in the income statement. When the time value of an option or the
interest element of a forward is excluded from the hedge, the measurement of hedge
effectiveness is based only on the changes in the intrinsic value of the option or the spot
rate of the forward. A dynamic strategy including intrinsic value and time value may also
be applied, though there is little elaboration in IAS 39 about what is acceptable. A delta-
neutral hedging strategy, where the hedging instrument is constantly adjusted in order to
maintain a desired hedge ratio, may qualify for hedge accounting.
39.AG111 The assessment of hedge effectiveness for interest rate risk can be performed using a
maturity schedule. Such a maturity schedule would show the net position for each strip of
the maturity schedule resulting from the aggregation of the assets and liabilities maturing or
repricing of cash flows at that time. The net exposure hedged must then be associated with
an asset, liability or cash inflow or outflow in order to apply hedge accounting, provided that
the correlation of the changes of the hedging instrument and the designated hedged item
can be assessed. Further discussion of this methodology is included in Section 9.2.

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IG F.4.1 Hedge effectiveness may be measured on either a pre-tax or post-tax basis. This should
be noted in the hedge documentation.
Case 8.5 Effectiveness testing

On 1 January 20X1, ABCorp a commodities dealer, anticipates its sales at market
rates of precious metals that will occur in early May 20X1. In order to hedge the
commodity price risk of the transaction, ABCorp enters into a forward (the hedging
instrument) maturing on 1 May 20X1 to hedge the anticipated sales of precious metals
(the hedged item). The fair value of the hedging instrument is zero at inception. ABCorp
determines and documents that the hedge is an effective cash flow hedge at inception.
As part of monitoring the ongoing effectiveness of the hedge relationship, each month
ABCorp determines the change in the discounted cash flows expected from the
anticipated sales and the change in the fair value of the forward.
During the hedging period in 20X1, the fair values and the changes in discounted cash
flows of the hedging instrument and the hedged item respectively are as follows:
31 January 28 February 31 March 30 April
Section 1 – Periodic effectiveness

Change in fair value for the month:
Hedging instrument (100) (50) 110 140
Hedged item 90 70 (110) (140)
Effectiveness for the month 111% 71% 100% 100%
Section 2 – Cumulative effectiveness

Cumulative change in fair value:
Hedging instrument (100) (150) (40) 100
Hedged item 90 160 50 (90)
Cumulative effectiveness 111% 94% 80% 111%
Section 3 – Determination of effectiveness

Cumulative effective portion of the
hedging instrument revaluation
included as a component of equity (90) (150) (40) 90
Change in the effective portion of the

hedging instrument revaluation
for the month (90) (60) 110 130
Change in the hedging instrument
revaluation for the month (100) (50) 110 140
Ineffective portion of hedging
instrument revaluation for each
month recognised in the
income statement (10) 10 – 10
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Section 1 illustrates the effectiveness measured on a period-by-period basis while

Section 2 illustrates a cumulative basis. This is for demonstration purposes only – an
entity should choose only one of these two methods at the inception of the hedge, and
include this choice in its documentation of the hedge relationship.
The analysis consists of three main sections. Section 1 details the monthly effectiveness
and fair value changes of the hedging instrument and changes in discounted cash flows
of the hedged item. The hedge remains within the 80 to 125 per cent range, therefore
the relationship qualifies for hedge accounting until the month of February 20X1, when
the monthly effectiveness is 71 per cent.
Section 2 details the cumulative change in fair values of the hedging instrument and
hedged item. The hedge relationship continues to be maintained as IAS 39 allows hedge
effectiveness to be measured on a cumulative basis when consistently applied. During
the hedging period, the cumulative effectiveness remains within the range of 80 to 125 per
cent, which supports the effectiveness of the hedge relationship for the period.
Section 3 details the analysis for determining the effective portion of the hedging
instrument revaluation that should be included as a component of equity.
The change in value of the hedging instrument is divided into the portion that is effective,
to which hedge accounting is applied, and the portion that is ineffective, which is
immediately recognised in the income statement.
For example, at 31 January 20X1 the effective portion of the hedging instrument
revaluation is only that amount that offsets the revaluation of the hedged item. The
hedging instrument is revalued at a loss of -100. However, as the revaluation gain on
the hedged item is only 90, there is an ineffective portion of -10 for the hedging instrument
that must be recognised in the income statement and the remaining -90 is recognised
as a component of equity.
At 28 February 20X1, the cumulative revaluation loss on the hedging instrument increases
to -150. However, the cumulative revaluation gain on the hedged item increases to
160. The cumulative loss on the hedging instrument is now less than the cumulative
gain on the hedged item. As such, on a cumulative basis, no portion of the hedging
instrument revaluation is ineffective. Thus, the full revaluation loss of the hedging
instrument of -150 is included as a component of equity.
At 31 March 20X1, the cumulative change in fair value of the hedging instrument
remains less than the change in fair value of the hedged item. As such, the revaluation
component in equity would be a loss of -40, but no ineffective portion is recognised in
the income statement as the cumulative revaluation gain on the hedged item is 50.
Lastly, at 30 April 20X1, the cumulative revaluation on the hedging instrument increases
to a gain of 100 which more than offsets the revaluation loss of -90 on the hedged item.
As such, the revaluation component in equity would be 90 and an ineffectiveness gain
of 10 is recognised in the income statement.
(Note: The numbers used in the above example are illustrative. The example does not
consider the ongoing assessment of prospective effectiveness that is also required at
each reporting date.)

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8.6.2.3 Hedge ineffectiveness
39.89 and 95 Even when a hedge relationship meets the effectiveness criteria, the fair value change on
the hedged item and the hedging instrument often will not offset completely. Ineffectiveness
of the hedging instrument must be recognised in the income statement, except when a
non-derivative instrument is used to hedge a foreign net investment.
The effective portion of a cash flow hedge is the lesser of:
■ the cumulative gain or loss on the hedging instrument necessary to offset the cumulative
change in expected future cash flows on the hedged item from inception of the hedge
excluding the ineffective component; and
39.96 ■ the cumulative change in the fair value of the expected future cash flows on the
hedged item from inception.
39.96 In a cash flow hedge, if the full cumulative gain or loss on the hedging instrument is more
than the cumulative expected future cash flows on the hedged item, the difference must
be recognised in the income statement as hedge ineffectiveness.

39.96 In amending the standards, the Board has taken the opportunity to simplify its explanation
of the effective portion of a cash flow hedge. It is now described more simply as the
lesser of:
■ the cumulative gain or loss on the hedging instrument from the inception of the
hedge; and
■ the cumulative change in fair value (present value) of the expected future cash
flows from the hedged item from inception of the hedge.
The impact of this change is unlikely to be significant in practice.
8.6.3 Forecasted transactions must be highly probable

39.88 Forecasted transactions must be highly probable and must present an exposure to
variations in cash flows that ultimately could affect the income statement. In practice, an
indicator of a transaction being highly probable is a likelihood of more than 90 per cent.
Management’s intent, forecasts and budgets as well as historical data may be used as the
basis to assess the highly probable assumption.
IG F.3.7 For groups of similar transactions the probability criterion may be met by designating a
lower and therefore more certain amount of risk exposure as being hedged. For example, a
bank may enter into fixed rate mortgage loan commitments with potential customers, which
give the customer 90 days to lock in a mortgage at a specified rate. To reduce the interest
rate risk inherent in the anticipated mortgage transactions, the bank enters into forward
starting interest rate swaps on the expected acceptances. When evaluating the probability
of acceptance by only a single customer, a high probability would be difficult to demonstrate.
On the other hand, when evaluating the probability of a group of commitments, it is possible
that the bank may estimate with high probability the amount of mortgages that will eventually
be closed. In this case, the bank would apply cash flow hedge accounting for the hedge of
interest rate risk on the amount of mortgages that are highly probable of closing.
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Similarly, when assessing the probability of hedging certain instruments with prepayment
risk, assessing the probability of interest cash flows for the portfolio rather than for a
single instrument could result in an acceptable hedge of these instruments for a bottom
layer of the interest cash flows.
Hedging anticipated transactions with purchased options might raise questions about
management’s assessment of whether the transaction will actually occur. For example,
an entity purchases an option on a particular foreign currency because the entity has
made a bid for a large contract in that foreign currency. The entity wants to hedge the
potential foreign currency income from that contract although the income is not yet certain.
The foreign currency cash flows in this case might not be highly probable as they depend
on the entity first winning the bid for the contract.
8.6.3.1 Defining the time period in which the forecasted transaction is expected to occur
IG F.3.10 and IAS 39 requires that the forecasted transaction must be identified and documented
F.3.11 with sufficient specificity so that when the transaction occurs, it is clear whether the
transaction is or is not the hedged transaction. An entity is not required to predict and
document the exact date a forecasted transaction is expected to occur. But the
documentation should identify a time period in which the forecasted transaction is
expected to occur within a reasonably specific and generally narrow range of time, as
a basis for assessing hedge effectiveness.
In order to determine the proper time periods for hedge accounting purposes an entity
may look to:
■ Forecasts and budgets: The expectation is that entities generally would not identify
longer time periods for hedge accounting purposes than those used for forecasting
and budgeting.
■ The nature of the business / industry: The forecasting and budgeting periods used
by an entity are influenced by the entity’s ability reliably to forecast the timing of its
transactions. Generally one would expect the forecast periods for manufacturers of
ships or aircraft to be longer than those of retail stores because retailers usually sell
smaller items in large quantities and can usually more easily forecast the timing of
sales over shorter periods of time.
Although the above factors provide an indication of what may be the appropriate time
period in which the transaction is expected to occur, the actual time period should always
be determined on a case-by-case basis and will involve some degree of judgement.
8.7 Termination of a hedge relationship

39.101 There are several circumstances that could lead to the termination of a hedge relationship.
Examples of situations that would cause a hedge relationship to be terminated include:
■ the hedging instrument expires, or is sold, terminated or exercised;
■ the hedged item is derecognised;
■ the forecasted transaction is no longer highly probable;
■ the effectiveness criteria are no longer met; or
■ management chooses to de-designate the hedge relationship.

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39.91, 92 and 101 A replacement of a hedging instrument or rollover is not deemed to be a termination if the
new instrument has the same characteristics as the instrument being replaced, it continues
to meet the hedge criteria and the rollover strategy is properly documented at inception.
Using a rollover hedge strategy, the entity may continue to perform hedge effectiveness
testing on a cumulative basis from the beginning of the period in which the first hedging
instrument was rolled over. Also amortisation of any fair value adjustment made to the
hedged item under a fair value hedge may continue to be deferred until the rollover hedge
strategy is discontinued.
39.101(c) The notion of a highly probable forecasted transaction is a higher degree of probability
than one that is merely expected to occur. If a forecasted transaction is no longer highly
probable but is still expected to occur, the net cumulative gain or loss that was recognised
in equity during the effective period of the hedge remains in equity until the transaction
actually occurs. However, prospectively the entity can no longer apply hedge accounting.
39.88 Hedge accounting for a forecasted transaction that is no longer expected to occur must
be terminated. It may not be replaced by another expected transaction. If a forecasted
transaction is not expected to occur in the initially forecasted period or within a relatively
short period thereafter, it is not considered to be the same hedge, and the hedge relationship
should be terminated. The effect of delays of forecasted transactions is considered in
more detail in Section 9.3.2.
When an effective hedge relationship no longer exists, the accounting for the hedging
instrument and the hedged item must revert to accounting under the normal principles.
If the forecasted transaction that the instrument was originally intended to hedge is no
longer expected to occur, any gains or losses on the hedging instrument that have been
recognised in equity are recognised in the income statement immediately.
Figure 8.5 summarises the accounting treatment for a forecasted transaction where the
probability of the transaction occurring changes.
Figure 8.5 Accounting impact of a change in expectation of a forecasted transaction
39.91 If the hedge effectiveness criteria are no longer met, hedge accounting must be terminated.
Termination of a hedge must have effect prospectively as of the date when the hedge
was last proved effective, which may be the previous interim or annual reporting date.
132 8.7 Termination of a hedge relationship
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For this reason testing hedge effectiveness more regularly is a way to reduce the impact
of the unexpected termination of a hedge relationship.
39.75 and If a hedging instrument ceases to be part of a hedge relationship, the instrument may be
IG F.6.2(i) re-designated to a new hedge relationship, as long as this is for the entire remaining term
of the instrument. This would once again fulfil the requirement of being designated as a
hedging instrument for the entire outstanding period. For example, a forward contract of
100 designated to hedge a forecasted transaction of 100 may no longer be expected to be
effective if new forecasts indicate the forecasted transaction may now only involve
expected cash flows of 80. In this situation, the original hedge designation would be
discontinued. A new relationship under which a proportion (80) of the forward is designated
as a hedge of the new expected cash flow of 80 would be allowed. The changes in fair
value of the remaining unused portion of the forward (20) must be recognised in the
income statement.
Table 8.2 Accounting consequences of hedge termination
Reason for termination Fair value hedge Cash flow hedge
Hedged item:
39.101 Derecognition of the A gain or loss on the The gain or loss on the
hedged item. derecognised item is hedging instrument
recorded in the income previously recorded in
statement based on the equity is recorded in the
carrying amount, including income statement
the adjustments resulting immediately. The hedging
from the hedge. The hedging instrument continues to be
instrument continues to be measured at fair value with
measured at fair value with changes recorded in the
changes recorded in the income statement.
income statement.
Expected transaction or firm Not applicable. The gain or loss on the

commitment no longer hedging instrument
expected to occur. previously recorded in equity
is recorded in the income
statement immediately.
39.101 Expected transaction or firm Not applicable. Hedge accounting is

commitment no longer terminated prospectively.
highly probable but still Further changes in the fair
expected to occur. value of the hedging
instrument must be recorded
Any gain or loss previously
recognised in equity remains
in equity until the
transaction occurs or is no
longer expected to occur.

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Reason for termination Fair value hedge Cash flow hedge
Hedging instrument:
39.91, 92 and 101 Derecognition of the hedging The gain or loss on A gain or loss on the
instrument other than derecognition of the hedging hedging instrument
replacements and rollovers. instrument is recorded in the previously recorded in
income statement. equity remains in equity
until the forecasted
The hedged item must revert transaction occurs.
to the applicable accounting
requirements from the date of
derecognition of the hedging
instrument, i.e. cease to be
adjusted for changes
resulting from the hedged
risk. If the hedged item is a
debt instrument and the
maturity is determinable, the
adjustment recorded as part
of the carrying amount of the
hedged item should be
amortised to the income
statement from that date
onwards using the effective
interest method.
39.91, 92 and 101 The hedge no longer meets Same accounting as in Same accounting as in
the hedge criteria derecognition of the hedging derecognition of the
(effectiveness) or instrument except that hedging instrument except
management decides to de- instead of derecognising the that instead of
designate the hedge. hedging instrument it should derecognising the hedging
be prospectively remeasured instrument it should be
through the income prospectively remeasured
statement, unless the through the income
hedging instrument is re- statement, unless the
designated as a hedge of hedging instrument is re-
another hedged item. designated as a hedge of
another hedged item.
8.8 Net position hedging and internal derivatives
8.8.1 Net positions

Many financial institutions and corporates use net position hedging strategies under
which a centralised treasury function accumulates risk originated in the operational
subsidiaries or divisions. The treasury function hedges the net exposure in accordance
with the group’s risk policies by entering into a hedge transaction with a party external
to the group.
134 8.8 Net position hedging and internal derivatives
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Net position hedging does not by itself qualify for hedge accounting treatment because of
the inability to:
■ associate hedging gains and losses with a specific item being hedged when measuring
effectiveness; and
■ determine the reporting period in which such gains and losses should be recognised in
39.84 and AG101 However, an entity is not necessarily precluded from hedge accounting by hedging net
positions. That is, an entity may choose to manage and (economically) hedge risk on a net
basis, but for hedge accounting purposes designate a specific item within the net position
as the hedged item. Hedging interest rate net positions is discussed in Section 9.2.
Hedging foreign currency net positions is discussed in Section 9.3.
Future amendments to IAS 39

At the date of this publication, the IASB is finalising its deliberations in respect of Fair
Value Hedge Accounting for a Portfolio Hedge of Interest Rate Risk. It is anticipated
that, when issued, this will introduce a number of additional requirements for this form
of hedge accounting.
8.8.2 Internal derivatives

Derivatives between entities within the same reporting group may be used to control and
monitor risks through a central treasury function, as well as potentially to benefit from
pricing advantages of being able to group smaller individual transactions for offsetting by
larger transactions done with external third parties, or for netting of opposite exposures.
39.73 Accounting for internal derivative transactions should be viewed in light of IFRS
consolidation requirements. This requires the elimination of all transactions and balances
between group entities. Therefore, only derivatives involving external third parties can be
designated as hedging instruments in the consolidated financial statements. However, hedge
accounting can be achieved in such cases if a one-to-one relationship of the internal
IG F.1.5 and transactions to related external transactions is documented. In general, unless this one-
F.1.6 to-one relationship can be established, the effects of the internal transactions must be
eliminated on consolidation.
8.9 Other considerations

There are a variety of issues directly or indirectly related to or impacted by the hedge
accounting principles. This Section gives a brief overview of some of these issues.
8.9.1 Risk reduction and hedge accounting

39.72 and IAS 39 does not require an overall risk reduction in order to apply hedge accounting.
IG F.2.6 For example, an entity may have fixed rate assets and liabilities that provide a natural
economic hedge that leaves the entity with no exposure to interest rate risk. This entity
may decide to enter into a pay-fixed receive-floating swap and designate this as a hedge
of either the assets or liabilities. Although this would increase the entity’s overall interest
rate risk exposure, hedge accounting may be applied to this transaction provided that the
relevant hedge accounting criteria are met.
8.9 Other considerations 135

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IG F.2.18 IAS 39 does not specifically require that a hedge of foreign currency risk is designated so as
to convert a foreign currency into the entity’s measurement currency. As described earlier
is Section 8.5.4, an entity may wish to use a cross currency interest rate swap to eliminate
the currency and interest exposure of an asset and a liability in two different foreign
currencies. This is permissible under IFRS, provided that the entity has corresponding asset
and liability positions denominated in the foreign currencies that are hedged by the cross
currency interest rate swap. Therefore, when designating the hedge, it is important to clearly
specify in the hedge documentation the risks that are being hedged.
8.9.2 Deferred tax issues

12.61 In accordance with IAS 12 for transactions recognised directly in equity, all current and
deferred tax should also be recognised in equity. In respect of hedge accounting this
means that current and deferred taxes on gains or losses on hedging instruments deferred
in equity also should be recognised in equity until such time when the gain or loss is
recycled to the income statement.
8.9.3 Impairment of an asset that is hedged

36.58 and The principles for hedge accounting do not override the accounting treatment under IAS 36
39.58-70 or IAS 39 if there is impairment of the hedged item. Therefore, if a hedged item is
impaired, this impairment should be recognised even if the risk that causes the impairment
is being hedged and hedge accounting is applied. However, the hedge accounting principles
may require that a gain on a hedging instrument used to hedge the risk that gave rise to
the impairment will be recognised simultaneously in the income statement and may (partly)
offset the recognised impairment.
39.59 and 61 For example, an entity may hold a portfolio of securities that are classified as available-
for-sale with fair value adjustments recognised in equity. The fair value at a given point is
300. The entity has a put option to put the securities to a third party at 250. The entity may
apply hedge accounting to this transaction provided that the hedge relationship meets the
relevant criteria. The entity designates the option as a hedge of the cash flows from an
expected future sale of the securities. Assume that the fair value of the portfolio
subsequently decreases by 120 and there is objective evidence of impairment.
This impairment must be recognised in the income statement. The amount of impairment
to record would be the difference between the original cost of the securities (300) and the
new fair value (180), not taking into account the existence of the put option. However, since
at this point the impairment on the hedged item affects the income statement, the related
39.97 and 98 gain on the put option would also be recognised in the income statement. This means that
a gain of 70 (250 – 180) ignoring time value, will be recognised in the income statement
and will partly offset the loss on the securities.

39.97 and 98 The restrictions introduced in respect of basis adjustments mean that amounts relating
to a cash flow hedge of an asset that has been acquired may be retained in equity.
In such cases, it will be necessary to ensure that if the related asset becomes impaired,
an appropriate amount is also recycled from equity to profit or loss.
136 8.9 Other considerations
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9. Hedge accounting for each type of financial risk

■ Interest rate risk hedging
■ Foreign currency risk hedging
■ Hedges of net investments in foreign entities
■ Commodity and equity price risk hedging

Section 8 explained the basic requirements, the accounting models and criteria for hedge
accounting under IAS 39. This Section focuses on some of the most common financial
risks that an entity may hedge and how applying hedge accounting to these risks will
affect the income statement and balance sheet. It also provides examples of the journal
entries needed to record the hedge accounting transactions.
9.2 Interest rate risk
9.2.1 Identifying the hedged risk and the hedging models

Interest rate risk arises from entities holding interest-bearing financial assets and / or
liabilities or from forecasted or committed future transactions with an interest-bearing
element in them. Interest-bearing instruments bear either:
■ Fixed interest: Since the interest rate is fixed, future interest payments are also
fixed. In this case the interest rate risk relates to the fair value change of the financial
asset or liability in response to changing market interest rates; or
■ Floating interest: In this case the future interest payments will depend on an underlying
interest index (e.g. LIBOR) and hence the interest rate risk relates to variations in
future cash flows.
39.AG102 Possible hedged items in fair value hedges include:
IG F.2.13 ■ fixed rate loans and receivables originated by the entity;
■ fixed rate assets categorised as available-for-sale with fair value changes recognised
directly in equity; and
■ fixed rate financial liabilities not held for trading.

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39.AG103 Possible hedged items in cash flow hedges include cash flows from:
■ floating rate loans and receivables originated by the entity;
■ floating rate assets categorised as available-for-sale with fair value changes recognised
directly in equity;
■ floating rate financial liabilities not held for trading;
■ firm commitments that have an interest rate exposure; and
■ highly probable anticipated transactions that have an interest rate exposure.
In some cases the same interest rate risk exposure may be hedged with either a fair value
hedge or a cash flow hedge. For example, an entity with an overall (net) interest rate risk
exposure to floating rate liabilities may choose to hedge this exposure with a pay-fixed
receive-floating swap. This swap may be designated as the hedging instrument of either:
■ a fixed rate asset in a fair value hedge; or
■ a floating rate liability in a cash flow hedge.
IG F.6.1 and F.6.2 The derivative has the same economic effect of reducing the interest rate exposure, but
the accounting differs depending on whether the hedge relationship is designated as either
a fair value or cash flow hedge. Entities can make their own assessment as to which of
these two hedge models can be best applied in their circumstances. This is especially
important to entities such as banks and corporate treasuries that need to account for
multiple hedge transactions.
The decision about which hedge accounting model to use may depend upon the information
systems and reporting that the entity has available. The entity must assess whether existing
information systems are best set up to manage and track the information required under
a fair value model or a cash flow model. This decision also may depend upon the
characteristics of the hedged items and whether hedge accounting criteria can be met,
e.g. prepayment risk in mortgage loans may be an issue, as discussed in Section 9.2.3 on
effectiveness testing of interest rate hedges.
IG F.6.2 Under a fair value model, assets and liabilities designated as the hedged item must be
remeasured for fair value changes attributable to the hedged risk, and normally result in
an adjustment of the effective interest yield. This usually requires a system that is able to
track changes in fair value of the hedged risk, and that can associate these changes with
the hedged items. Also the system should be able to recompute the effective yield of the
hedged item and amortise the changes to the income statement over the remaining life of
the hedged item.
39.95-100 Under a cash flow model the fair value changes of the hedging instruments are recognised
in equity and are later released to the income statement when the cash flows from the
hedged items are recognised in the income statement. This requires a system that enables
the entity to track the timing of the cash flows, as well as the timing of the reversal of the
hedging gains and losses from equity. Although this may impose a challenge, for many
entities such information can be based on the cash flow information already captured in
risk management systems of the entity.
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9.2.2 Hedging expected interest cash flows
An entity may choose to hedge the interest cash flows from interest-bearing assets and
liabilities including:
■ floating rate assets (e.g. debt securities, originated loans); and
■ floating rate liabilities (e.g. customer deposits at a bank, bonds issued by a corporate).
An entity also may hedge its interest rate risk exposure from forecasted interest payments
such as:
■ an expected debt issuance;
■ an expected purchase of financial assets;
■ expected rollovers of existing loans; or
■ expected draw-downs under revolving credit facilities.
IG F.2.2 and F.6.2 An entity may apply hedge accounting to an anticipated debt issuance. The appropriate
hedge accounting model in this case would be a cash flow hedge. The gains or losses
resulting from the hedging instrument until the debt is issued would be deferred in
equity, and then would adjust the initial carrying amount of the debt. The subsequent
amortisation of the basis adjustment would be recognised by adjusting the instrument’s
future interest expense.
For example, an entity in the process of issuing a bond may wish to hedge the risk of
changes in interest rates from the time the entity decides to issue the bond until it is
issued. This could be done using an interest future or another derivative instrument. To the
extent it is effective, the gain or loss on the derivative would be deferred in equity until the
bond is issued, at which point the deferred gain or loss would adjust the initial carrying
amount of the bond (as a basis adjustment). The gain or loss is recognised in the income
statement as interest payments are made and effectively adjusts the interest expense
recognised on the debt.
39.88 To meet the hedge accounting criteria a forecasted debt issuance must be highly probable.
This would be the case once the entity enters into an agreement to issue the bond, but
may already be evidenced at an earlier stage when management decides upon a debt
issuance as part of the entity’s funding strategy.
Another example of a hedge of forecasted interest payments is that of an entity which
plans to issue a series of floating rate notes, each with a maturity of three years. The entity
intends to issue similar notes immediately after the maturity of the initial notes. In this
situation the entity may enter into a six-year swap to hedge the variability in expected
interest cash flows on both notes. For hedge accounting purposes the hedge could be
designated as a hedge of the expected interest payments in different periods including
interest payments arising from the forecasted refinancing of the debt. At inception of the
hedge the criteria for hedge accounting must be met, including the criteria that the hedge
would be highly effective, and that the re-issue after three years is highly probable.

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39.97 As noted above, the amendments will prohibit the use of basis adjustment in a hedge of
a forecast purchase or issuance of a financial asset or liability. The effect of the hedge
is achieved, instead, by amortising the amount deferred in equity under the cash flow
hedge into income over the life of the hedged item. The income statement effect
should be the same as using basis adjustment, but the separate tracking of the amount
deferred in equity may be more complex. An added complication will be the need to
take into account separately any debit deferred in equity when assessing impairment
of an asset whose cash flows have previously been hedged.
9.2.3 Effectiveness testing of interest rate risk hedges

The effectiveness requirements discussed in Section 8 are applicable for hedges of interest
rate risk.
For interest-bearing assets that are on balance sheet, prepayment options could have a
significant impact on whether a hedge relationship is effective. Examples of prepayable
assets include originated loans that may be prepaid by the borrower and debt securities
that may be repaid early by the issuer.
IG F.6.2 Prepayment risk affects the timing as well as the amount of cash flows, therefore this
risk may impact effectiveness results for fair value hedges, as well as the requirement of
high probability for forecasted cash flows. A prepayable hedged item will generally
experience smaller fair value changes than a hedged item that is not prepayable.
Effectiveness is likely to be more difficult to demonstrate for a fair value hedge than for
a cash flow hedge when hedging a portfolio. In a fair value hedge it may be difficult to
achieve a highly effective offset of fair values of the hedged item and the hedging instrument
when the hedged item terminates early due to prepayment. Moreover, it may be difficult
to group a portfolio of fixed rate assets subject to prepayment risk since it may be difficult
to prove that the changes in fair value of the individual assets are approximately proportional
to the overall change in fair value of the portfolio. As a result fixed rate assets subject to
prepayment risk may have to be hedged on a one-to-one basis. Hence the likelihood of
ineffectiveness due to prepayment is larger since the effect on the fair value is not absorbed
by a portfolio.
39.88 Prepayment risk may also affect whether a cash flow hedge is considered to be highly
probable of occurring. However, when the hedged item is designated as a portion of gross
cash flows of a portfolio in a given period, the effect of a prepayment is less likely to cause
the hedge not to be highly probable as long as there are sufficient cash flows in the period.
This could be demonstrated by the entity preparing a cash flow maturity schedule that
shows sufficient gross levels of expected cash flows in each period to support a highly
probable assertion. For example, a bank may be able to accurately determine what levels of
prepayments are expected for a particular class of its originated loans. The bank might
hedge only a portion of the contractual cash flows from that portfolio of loans, as the bank
expects a number of the borrowers to pay off their loans early.
IG F.5.5 Forecasted transactions create a cash flow exposure to interest rate changes because
related interest payments will be based on the actual market rate when the transaction
occurs. In these situations the hedge effectiveness assessment would be based on the
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expected interest payments, calculated using the forward interest rate on the applicable
yield curve, which should be highly probable in order to qualify for hedge accounting.
For forecasted transactions such as anticipated debt issuances, it is not possible to
determine what the actual market interest rate will be for the debt issuance. In these
situations hedge effectiveness may be measured based on the changes in the interest
rates that have occurred between the designation of the hedge and the date that
effectiveness testing is performed. The forward interest rates that should be used are
those that correspond with the term of the expected transaction at inception and at the
date of the effectiveness testing. IG F.5.5 has a detailed example about how hedge
effectiveness may be measured for a forecasted transaction in a debt instrument.
IG F.2.17 When only a portion of an interest-bearing instrument is hedged, effectiveness testing
usually becomes more difficult. For example, an entity may choose to hedge the interest
rate risk of an acquired 10-year fixed rate bond only for the first five years. The entity
may designate a pay-fixed and receive-floating interest rate swap with five years to
maturity as the hedging instrument. This swap could be designated as a hedge of the fair
value of the first five years of interest payments and the change in fair value of the
principal payments in year 10, but only to the extent affected by changes in the yield
curve relating to the five years of the swap. For effectiveness testing purposes the loan is
treated as if it had a synthetic principal repayment in year five. Any fair value difference
resulting from changes between the five-year and 10-year yield curve would not be
considered part of the hedge relationship and the carrying amount of the loan would not
be adjusted by this amount. The same is true for fair value changes of the interest payments
after year five.
The following cases demonstrate a number of the issues that have been discussed in
Section 9.2 about hedging interest rate risk.
Case 9.1 Fair value hedge of a fixed interest rate liability

Global Tech Company (GTC) requires financing of 100 million for five years. On 1 January
20X1, GTC issues non-callable five-year 100 million of bonds. The interest rate on the
bonds is fixed at six per cent and is payable semi-annually. The bonds are issued at par.
GTC’s overall risk management strategy and current position is to have variable rate
funding. Therefore, GTC enters into a five-year interest rate swap (IRS) with a notional
amount of 100 million. The IRS pays a floating interest rate based on LIBOR and
receives a six per cent fixed interest rate. The floating rate of interest for the first six
months is 5.7 per cent. The timing of the IRS cash flows equals those of the bond’s
interest expense. The fair value of the IRS at inception is zero.
Management designates and documents the IRS as a fair value hedge of interest rate
risk for the issued bonds. The hedge relationship is determined to be effective based on
the offsetting effect of the fair value changes of the IRS to the fair value changes of
the bond.

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The following entries are made to record the transactions:

Debit Credit
1 January 20X1
No entry is necessary related to the IRS, as the cost
is zero at inception
Cash 100,000,000
Bonds payable 100,000,000
To record the proceeds from the bond issuance
At 30 June 20X1, interest rates have increased. The interest rates for the next six
months of the variable leg of the swap have repriced from 5.7 per cent to 6.7 per cent.
Due to this general increase in market interest rates, a fair value gain on the bonds
payable and a loss on the IRS have resulted. The fair value of the bond (after settlement
of interest) has changed from 100,000,000 to 96,196,000.
GTC separately revalues the IRS and has determined that its fair value is 3,804,000.
Based on the offsetting effect of the fair value changes of the IRS and the fair value
changes of the bond, management determines that the hedge is still effective.
The following accounting entries are recorded at 30 June 20X1:
Debit Credit
30 June 20X1
Interest expense 3,000,000
Cash 3,000,000
To record the payment of six per cent fixed interest
on the bonds
Hedging revaluation gain (income statement) 3,804,000
To record the change in the fair value of the bonds
attributable to the hedged risk
Cash 150,000
Interest income 150,000
To record the settlement of net interest accruals on the
IRS for the period 1 January 20X1 to 30 June 20X1
(Receive six per cent fixed 3,000,000; pay 5.7 per cent
floating 2,850,000)
Hedging revaluation loss (income statement) 3,804,000
IRS liability 3,804,000
To record the change in the fair value of the IRS after
settlement of interest
As can be seen from the above entries, the net interest expense shown in the income
statement is 2,850,000, which represents the floating interest of 5.7 per cent.
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At 31 December 20X1, interest rates have not changed, therefore, the interest rate on
the variable leg of the swap remains at 6.7 per cent. The fair value (after settlement of
interest) of the bond is 96,563,000.
GTC separately revalues the IRS and has determined that its fair value is 3,437,000.
Based on the offsetting effect of the fair value changes of the IRS to the fair value
changes of the bond, management determines that the hedge is still effective.
The following accounting entries are recorded at 31 December 20X1:
Debit Credit
31 December 20X1
Cash 3,000,000
To record the payment of six per cent fixed interest
on the bonds
Hedging revaluation loss (income statement) 367,000
Bonds payable 367,000
To record the change in the fair value of the bonds
attributable to the hedged risk
Interest expense 350,000
Cash 350,000
To record the settlement of the IRS for the period
30 June 20X1 to 31 December 20X1
(Receive six per cent fixed 3,000,000;
pay 6.7 per cent floating 3,350,000)
IRS liability 367,000
Hedging revaluation gain (income statement) 367,000
To record the change in the fair value of the interest
rate swap
The interest expense shown in the income statement is 3,350,000, which represents
the floating interest of 6.7 per cent for this six-month period.
The balance sheet at 31 December 20X1 will be as follows:
Assets Liabilities and equity
Cash 93,800,000 Retained earnings (6,200,000)

93,800,000 93,800,000

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The income statement shows interest expense related to the transactions as follows:
First half year at 5.7 per cent 2,850,000
Second half year at 6.7 per cent 3,350,000
Total 20X1 6,200,000
Termination of the hedge

Assume that on 31 December 20X1, GTC determines that it should end the IRS hedge
due to a change in its risk position. GTC terminates the IRS and pays 3,437,000 to the
counterparty for settlement. The following entry is made:
Debit Credit

Cash 3,437,000
To record the settlement of the IRS for fair value at
31 December 20X1
As can be seen from the balance sheet at 31 December 20X1, the bonds payable are
carried at 96,563,000. This results in a discount of 3,437,000 from the par value of
100 million. This discount would be amortised over the remaining life of the bonds as a
yield adjustment to the interest expense on the bonds payable.
In this example the hedge is found to be 100 per cent effective. This is due to the
designation of the hedge. The hedge is designated such that the bond is hedged only
with respect to changes in six-month LIBOR. Fair value changes due to other factors
such as credit risk are excluded from the hedge relationship and therefore do not give
rise to any ineffectiveness. As a result the only possible ineffectiveness would be due
to changes in credit risk from the counterparty to the swap since this would affect the
fair value of the swap (remember that derivatives have to be designated in their entirety).
Case 9.2 Cash flow hedge of a variable rate liability

GTC requires financing for its operations of 100 million for five years. On 1 January
20X1, GTC issues non-callable five-year 100 million floating rate bonds. The floating
interest of LIBOR plus 50 basis points (0.5 per cent) is payable semi-annually. The bonds
are issued at par.
As part of GTC’s risk management policy, it determines that it does not wish to expose
itself to fluctuations in market interest rates. After the issue of the bonds, GTC
immediately enters into a five-year interest rate swap (IRS) with a notional amount of
100 million. The IRS pays six per cent fixed and receives floating cash flows based on
LIBOR (set at 5.7 per cent for the period from 1 January to 30 June 20X1). The timing
of the IRS cash flows equals those of the bond interest expense. The fair value of the
IRS at inception is zero.
The IRS is designated and documented as a cash flow hedge of the future interest
payments on the bond. This is determined based on the offsetting effect of the cash
flows of the IRS and the interest expense cash flows of the bond. The hedge relationship
is determined to be effective.
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The effective interest payable is fixed at 6.5 per cent (6 per cent fixed from the IRS
plus the additional 0.5 per cent on the bond).
GTC records the following entries:
Debit Credit
1 January 20X1
No entry is necessary related to the IRS, as the cost
is zero at inception
Cash 100,000,000
To record the proceeds from the bond issuance
At 30 June 20X1, interest rates have increased compared to 1 January 20X1. The swap
rate for the remaining term has increased from six per cent to seven per cent. Due to
this general increase in market interest rates, a fair value gain on the IRS results.
LIBOR increases to 6.7 per cent for the next six months of the variable leg. However,
during this time the credit risk of the swap counterparty worsens and the applicable
interest rate associated with the counterparty has increased beyond the general
increase in market interest rates. The increased credit risk of the counterparty results
in a specific credit spread of 0.75 per cent. The discount rate to be used for discounting
the receivable (floating) leg of the swap is therefore 7.45 per cent at 30 June 20X1.
As such the fair value of the IRS is determined to be 3,442,000 after the settlement
of interest due on 30 June 20X1. The change in expected future cash flows on the
bonds is 3,804,000.
The fair value changes of the IRS during the period from 1 January 20X1 to 30 June
20X1 are summarised below:
1 January 20X1 30 June 20X1 Change
Fixed leg (100,000,000) (96,196,000) 3,804,000

Floating leg 100,000,000 99,638,000 (362,000)
IRS – 3,442,000 3,442,000
To assess the effectiveness of the hedge, the change in the fair value of the floating leg
of the IRS is compared with the change in the fair value of the bond, as the hedged risk
is the variability of interest cash flows from the bond. Since the interest on the bond is
variable and the interest rate for the next period has been set at the same date the
hedge effectiveness is assessed, the change in the fair value of the bond is zero, resulting
in a hedge ineffectiveness of 362,000.
However, based on the expected cash flows from the IRS, GTC determines that
the relationship is still an effective hedge of the interest expense cash flows on the
bond. Therefore, the full change in the fair value of the IRS is recognised in the
hedge revaluation reserve as a component of equity. This adjustment is limited to
the lesser of the cumulative gain or loss on the hedging instrument (3,442,000) and

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the fair value of the cumulative change in expected future cash flows on the hedged
item (3,804,000).
The following accounting entries are made at 30 June 20X1:
Debit Credit
30 June 20X1
Cash 3,100,000
To record the payment of 6.2 per cent floating interest
on the bonds payable (LIBOR 5.7 per cent plus
premium of 0.5 per cent)
Interest expense 150,000
Cash 150,000
To record the net settlement of the IRS for the period from
1 January 20X1 to 30 June 20X1 (Pay six per cent fixed
3,000,000; receive 5.7 per cent floating 2,850,000)
IRS 3,442,000
Hedge revaluation reserve (equity) 3,442,000
To record the change in the fair value of the IRS after
settlement of interest
As can be seen from the above entries, the interest expense shown in the income
statement is 3,250,000, which represents the fixed interest of 6.5 per cent.
At 31 December 20X1, interest rates have not changed since 30 June 20X1, however,
the credit risk associated with the counterparty to the IRS has changed since that date.
The counterparty specific credit spread has decreased from 0.75 per cent to 0.5 per
cent. The fair value (after settlement of interest) of the IRS is now 3,196,000.
The expected future cash flows of the bond are now 3,437,000. Based on the offsetting
of the change in expected cash flows on the IRS and the change in interest expense
cash flows on the bond, the hedge is still deemed to be effective.
The following accounting entries are recorded:
Debit Credit
31 December 20X1
Cash 3,600,000
To record the payment of 7.2 per cent floating
interest on the notes (LIBOR of 6.7 per cent plus
a premium of 0.5 per cent)
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Debit Credit
Cash 350,000
Interest income 350,000
To record the settlement of the IRS for the period from
1 July 20X1 to 31 December 20X1
(Pay six per cent fixed 3,000,000;
receive 6.7 per cent floating 3,350,000)
Hedge revaluation reserve (equity) 246,000
IRS 246,000
To adjust the fair value of the cash flow hedge
As can be seen from the above entries, the interest expense shown in the income
statement is again 3,250,000, which represents the fixed interest of 6.5 per cent.
The balance sheet at 31 December 20X1 will be as follows:
Assets Liabilities
Cash 93,500,000 Retained earnings (6,500,000)

IRS asset 3,196,000 Equity (hedge revaluation
reserve) 3,196,000
96,696,000 96,696,000
Case 9.3 Cash flow hedge using an interest rate cap

At 1 January 20X1, DEBTCO obtains a three-year loan of 10,000,000. The interest rate
on the loan is variable at LIBOR plus two per cent. DEBTCO is concerned that interest
rates may rise during the next three years, but wants to retain the ability to benefit from
LIBOR rates below eight per cent. In order to protect itself from this exposure, DEBTCO
purchases for 300,000 an out-of-the-money interest rate cap from a bank. When LIBOR
exceeds eight per cent for a particular year DEBTCO receives from the bank under the
cap an amount calculated as 10,000,000 * (LIBOR – eight per cent).
The combination of the cap and the loan results in DEBTCO paying interest at a
variable rate (LIBOR plus two per cent) not exceeding 10 per cent. On both the
variable-rate loan and the interest rate cap, rates are reset at 1 January and interest
amounts are settled at 31 December.
DEBTCO designates and documents the intrinsic value of the purchased interest rate
cap as a cash flow hedge of the interest rate risk attributable to the future interest
payments on the loan for changes in LIBOR above eight per cent. Changes in the time
value of the option will be excluded from the assessment of hedge effectiveness.
Therefore, time value changes are recognised in the income statement as they arise.
The critical terms of the cap are identical to those of the loan and DEBTCO concludes
that, both at inception of the hedge and on an ongoing basis, the hedge relationship is
expected to be highly effective in achieving offsetting cash flows attributable to changes

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in LIBOR when LIBOR is greater than eight per cent. As the cap is being used to
purchase one-way protection against any increase in LIBOR, DEBTCO does not
need to assess effectiveness in instances where LIBOR is less than eight per cent.
The cumulative gains or losses on the interest rate cap, adjusted to remove time value
gains and losses, can reasonably be expected to equal the present value of the cumulative
change in expected future cash flows on the debt obligation when LIBOR is greater
than eight per cent. This should be reassessed each reporting period.
During the three-year period LIBOR rates and related amounts are as follows:
Receivable Interest
under payable on Net interest Net interest
Date Rate cap loan payable payable
20X1 7% – 900,000 900,000 9%
20X2 9% (100,000) 1,100,000 1,000,000 10%
20X3 10% (200,000) 1,200,000 1,000,000 10%
The fair value, intrinsic value and time value of the interest rate cap and changes therein
at the end of each reporting period, but before cash settlement of interest are as follows:
Change in Change in
Intrinsic fair value time value
Date Fair value value Time value gain/(loss) gain/(loss)
1 January 20X1 300,000 – 300,000 – –
31 December 20X1 280,000 – 280,000 (20,000) (20,000)
31 December 20X2 350,000 200,000 150,000 70,000 (130,000)
31 December 20X3 200,000 200,000 – (150,000) (150,000)
IAS 39 does not specify how to compute the intrinsic value of a cap option where the
option involves a series of payments. In this example, the intrinsic value of the cap is
assumed to equal the expected future cash flows holding constant the cap’s current
reporting period cash flow of one per cent (nine per cent – eight per cent) for the
remaining term of the cap and excluding the time value of money. Alternatively, the
intrinsic value of the cap might be calculated for each reporting period by comparing
the cap rate with the market’s expectations of movements in LIBOR using the LIBOR
forward yield curve.
Assuming that all criteria for hedge accounting have been met, the following journal
entries must be made on 1 January 20X1 and 31 December 20X1, 20X2, and 20X3:
Debit Credit
1 January 20X1
Cash 10,000,000
Loan payable 10,000,000
To record the initial borrowing
Interest rate cap (asset) 300,000
Cash 300,000
To record the purchase of interest rate cap
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Debit Credit
31 December 20X1
Interest expense (income statement) 900,000
Cash 900,000
To record interest expense on the loan
(LIBOR + two per cent)
Hedge expense (income statement) 20,000
To record the change in the fair value of the interest
rate cap – time value change
31 December 20X2
Interest expense (income statement) 1,100,000
Cash 1,100,000
Hedging reserve (equity) 200,000
To record the change in the fair value of the interest rate
cap. 130,000 represents the change in time value,
which is excluded from the assessment of hedge
effectiveness, and 200,000 represents the increase
in the interest rate cap’s intrinsic value
Hedge income (or interest income) (income statement) 100,000
Represents the release to the income statement of the
proportion of the increase in intrinsic value of the cap
which relates to the realised cash flow through interest
expense incurred in 20X2
Cash 100,000
To record the cash received upon settlement of the
interest rate cap
31 December 20X3
Interest expense (income statement) 1,200,000
Cash 1,200,000
To record the change in the fair value of the interest rate
cap – 150,000 loss represents the time value change;
100,000 gain represents the intrinsic value change

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Debit Credit
Hedge income (or interest income) (income statement) 200,000
To record the release to the income statement of the
proportion of the increase in intrinsic value of the cap
which relates to the realised cash flow through interest
expense incurred in 20X3
Cash 200,000
To record the cash received upon final settlement of the
interest rate cap
As a result of the hedge, DEBTCO has effectively capped its interest expense on the
three-year loan at 10 per cent. Specifically, during those periods where the contractual
terms of this loan would result in an interest expense greater than 10 per cent or 1,000,000
(i.e. in instances where LIBOR exceeded eight per cent), the payments received from
the interest rate cap effectively reduce interest expense to 10 per cent as illustrated
below. However, recognition in earnings of changes in the fair value of the cap due to
changes in time value results in variability of total interest expense during each year:
20X1 20X2 20X3
Interest on LIBOR + two per cent debt 900,000 1,100,000 1,200,000
Reclassified from equity (effect of cap) – (100,000) (200,000)
Interest expense adjusted by effect
of hedge 900,000 1,000,000 1,000,000
Change in time value of cap 20,000 130,000 150,000
Total expense 920,000 1,130,000 1,150,000
9.2.4 Net position hedging of interest rate risk

Banks and similar financial institutions often manage this risk on a net basis, usually in
time buckets which group assets and liabilities by the earlier of expected maturity or
repricing date. Such entities assess the interest rate risk in all interest-bearing financial
assets and liabilities and determine the net exposures. This is because there may be some
natural offsets within an entity’s balance sheet already, particularly so for banks and
other financial institutions. Therefore, it is only for the net risk positions that the entity
may decide to obtain derivatives or other instruments to provide an economic hedge.
39.84, AG101 For hedge accounting purposes, a net position may not be designated as the hedged item.
and IG F.2.21 However, an entity still may be able to apply hedge accounting if the hedge relationship is
designated in a way that meets the criteria set forth in IAS 39. Generally the entity needs
to select (one or a group of) specified assets or liabilities, cash flows or forecasted
transactions that are part of the net position, and designate these as the hedged item.
Case 9.4 gives a basic example of this approach.
The above approach may be useful in some cases, although it is arbitrary in that the
hedged item (for accounting purposes) is not the net position (i.e. the real economic risk)
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that the entity wants to manage. Further, this approach may not be practical for entities
that have an ongoing interest rate risk management program and have large volumes of
netted interest rate positions. This is typically the case for financial institutions.
An entity may tailor its own method to satisfy the basic criteria in IAS 39 while utilising
existing risk management systems. One such method, which is a further extension of the
basic approach above, is provided in IG F.6.3, which is an illustrative example of applying
Question IG F.6.2 Hedge accounting considerations when interest rate risk is managed
on a net basis. This example illustrates a method for hedging interest rate risk in a
portfolio of interest-bearing assets and liabilities using interest rate swaps. The method
involves scheduling out all of the entity’s interest rate cash flow exposures (hedged items)
and all of its interest rate swaps (hedging instruments) over a period of time. A typical
schedule / gap analysis might use one-month time periods for up to several years in the
future. For longer-term assets and liabilities, the schedule might use one-year or even
longer time periods. A summary of this method is described in the following steps, and
should be read in conjunction with the IGC’s illustrative example.
Step 1: The entity should identify for each reporting period:

■ the forecasted principal and interest cash inflows and outflows (from both fixed
and variable rate assets and liabilities); and
■ the interest repricing exposures (from variable rate assets and liabilities), explained
in the note below.
All of the identified cash flows are scheduled out in a maturity schedule. The schedule
should reflect estimates about prepayments and defaults. The cash inflows and outflows
and the repricing of variable rate assets and liabilities create a net exposure in each
period – either a net cash inflow that needs to be reinvested, or a net cash outflow that
needs to be paid. The net exposure identified for each period may be used as the
starting point for assessing the entity’s overall cash flow exposure to interest rates.
Note: For fixed rate instruments, the fixed interest to be received or paid and the
principal are included in the analysis in each period in which they are expected to be
received or paid. There is presumed to be an exposure to interest rates in that period
because the cash flows will need to be reinvested or refinanced during that period.
For variable rate instruments, the entire notional amount and estimated interest amounts
are included in each period that the instruments are expected to reprice. Interest amounts
for variable rate instruments can be estimated using forward rates. For both the fixed
rate and variable rate instruments, there is a common exposure to interest rate changes
created by the reinvestment, refinancing or repricing of the instruments’ cash flows.
Step 2: If the entity already has pre-existing interest rate swaps that would meet
hedge accounting criteria, these should be included in the analysis in each period that
they are outstanding to determine the entity’s actual net exposure. The notional amounts
of existing interest rate swap contracts are compared to the net exposures determined
in Step 1. Any difference between the two is the amount of remaining exposure that
the entity may want to hedge.
Note: Similar to variable rate instruments, the notional amounts of the interest rate swaps
are included in each period that they remain outstanding. The swaps’ notional amounts

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create an interest rate exposure because interest is computed based on the notional
amount each period, and the variable component of the swap is repriced each period.
Step 3: At this point the entity has identified its actual net exposure to interest rate risk.
The entity’s risk management policies usually will identify what is a tolerable interest
exposure to leave unhedged. To the extent that the net exposure exceeds risk
management limits, the entity may hedge the balance by entering into additional interest
rate swaps (or other interest rate derivatives) to reduce that part of the exposure.
Note: Steps 1 to 3 above are procedures an entity may follow in doing economic
hedging. This may even be how the entity addresses interest rate risk already. However,
further steps are needed to qualify for hedge accounting.
Step 4: In order to apply hedge accounting, the hedging instruments in each period
now need to be associated with a gross cash flow position. Steps 1 to 3 identified the
net exposures that the entity wants to hedge. However, the interest rate swaps now
need to be specifically related to cash flow interest risks, for both effectiveness testing
and for accounting purposes.
(a) The entity determines the expected interest from the reinvestment of the cash
inflows and repricing of assets by multiplying the gross amounts of exposure for
each period by the forward rate for each period. (This assumes that the actual net
exposure determined in Step 3 is an inflow exposure. If the actual net exposure is
an outflow, the entity determines the expected interest based on refinancing of
cash outflows and repricing of liabilities.)
(b) The designated hedged item is the expected interest from the reinvestment of the
cash inflows or repricing of the gross amount for the first period after the
forecasted transaction occurs. Because of this designation, it does not matter
that the cash flows from that period are from both fixed and from variable instruments
or from rollovers of short-term debt, nor for what period of time the cash flows will
be reinvested. The key feature is that all of these instruments share the same
exposure to changes in the forward interest rate during that one period. There is
interest rate exposure in subsequent periods as well, however, that is not designated
as being hedged as that would require knowing the number of periods of
reinvestment, refinance or repricing for all items.
(c) The entity determines the portion of its gross cash flows that are being hedged
(expressed in terms of a percentage). This is simply the notional amount of the
interest rate swaps designated as hedging instruments in each period divided by the
gross amounts of exposure for each period. This percentage is applied to the gross
interest calculated in Step 4(b) above to determine the hedged expected interest.
Step 5: Hedge effectiveness of the net position needs to be tested at least each reporting
period. However, this process is simplified due to the designation of the hedged item as
a portion (expressed as a percentage) of expected interest for the first period only
after the forecasted transaction. Therefore, to the extent that total expected interest
cash inflows exceed the hedged interest cash inflows in each of the periods being
hedged by the swaps, the entity only need compare the cumulative changes in the
present value of the hedged interest cash inflows with the cumulative change in the
fair value of the interest rate swaps.
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Note: The interest rate hedged should be defined as the benchmark interest rate.
In that case the effectiveness test results would be very highly effective.
Figure 9.1 Steps 1 to 3 illustrated: Identify the interest rate exposure and swaps
used for hedging
Figure 9.2 Step 4 illustrated: Identify gross cash flows as the hedged positions
By following the approach suggested in the illustrative example set out in IG F.6.3, the
requirements in IAS 39 are met in respect of what qualifies as a hedging instrument
and hedged item. Namely:
39.81 ■ Hedged item: The hedged expected interest is a portion of the total cash flows.
For financial assets and liabilities, an entity may designate a portion of a cash flow
as the hedged item. In this example that portion is the cash flows occurring in the
first period after the reinvestment / repricing date.
39.75 ■ Hedging instrument: The interest rate swaps are designated as hedging the expected
interest cash inflows for each remaining period in which the swaps are outstanding.

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Case 9.4 Net position hedging – interest rate risk

A bank monitors its interest rate risk exposures through reviewing gaps within repricing
bands of net asset or liability positions of a single currency. For illustration purposes,
only the first three months are illustrated. (Normally the maturity breakdown would
include periods up to, for example, 10 years, with a detailed breakdown in the first year
and wider bands in subsequent years.)
Less than
1 month 1 to 2 months 2 to 3 months
Assets
Treasury bills 100 300 200
Placements with banks 300 500 400
Loans 5,000 5,200 6,500
Bonds 200 100 300
Assets in the repricing band 5,600 6,100 7,400
Liabilities
Customer deposits 4,000 2,500 3,500
Deposits from banks 2,000 3,200 3,000
Bills, commercial paper issued 300 100 500
Liabilities in the repricing band 6,300 5,800 7,000
Net position for the currency (700) 300 400
Under a net position-hedging scenario, if the bank wishes to hedge the entire 700 net
liability exposure in the first time band, it could do so through a derivative instrument
for the repricing band of less than one month. However, rather than documenting the
net position as the hedged item, the bank could designate 700 of customer deposits in
the less than one-month band, and hedge accounting could be applied.
In order to illustrate this, suppose that the bank designates a swap (pay-fixed, receive-
variable) as a cash flow hedge of the interest payable on 700 of liabilities that reprice
each month, such as the bottom layer of the customer deposits. The bank must establish
that it is highly probable that greater than 700 of customer deposits with similar
characteristics will be available each month the swap is outstanding. The customer
deposits designated should share the same exposure to the risk that is being hedged,
e.g. the exposure to a benchmark interest rate risk. The bank could perform statistical
analysis to document this shared risk basis. Forecasting of cash flows should be part of
the asset and liability management process of forecasting the repricing cash flows of
the bank, and supported by the history of actual repricing cash flows. High probability
of the expected cash flows could be supported if customer deposits of far more than
700 are available. The same approach described here may be used for the other repricing
bands noted above.
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Case 9.5 Hedging on a group basis – interest rate risk

Assume that a bank has both a trading desk and a banking desk. The banking desk
manages the interest, liquidity and other risk exposures from the bank’s lending and
funding operations. Financial assets and liabilities of these operations are generally
carried at amortised cost. In order to manage its interest rate risk exposures, the banking
desk enters into interest rate swap agreements with the trading desk to swap a floating
rate of interest for a fixed rate (cash flow hedge). These transactions with the trading
desk are documented as hedging transactions and the banking desk would like to apply
hedge accounting.
The trading desk enters into various other derivative agreements with external parties
as part of its trading activities, in addition to the transactions with the banking desk. In
the accounting records of the trading desk, all such instruments are trading instruments
and are carried at fair value with changes recognised in the income statement.
IG F.1.5-7 Hedge accounting is not appropriate for internal transactions unless it can be
demonstrated that for each instrument that the banking desk has entered into with the
trading desk, there is an equivalent contract that the trading desk entered into with an
external party. In practice, this can be achieved, for example, by setting up a separate
book for the transactions of the trading desk with the banking desk and the related
external party transactions.
The transactions that would be entered into by the bank in order to apply hedge accounting
are noted below. The example assumes an exposure to a floating rate liability, with the
rate based on the six-month inter-bank rate:
Banking desk – internal swap
■ Receive variable at the six-month inter-bank rate – notional 100 million.
■ Pay-fixed at eight per cent – notional 100 million.
Trading desk – internal swap
■ Receive-fixed at eight per cent – notional 100 million.
■ Pay-variable at the six-month inter-bank rate – notional 100 million.
Trading desk – external swap
■ Receive variable at the six-month inter-bank rate – notional 100 million.
■ Pay-fixed at eight per cent – notional 100 million.
■ Term and payment dates of external swap mirror those of the banking desk’s
internal swap.
The swap with the external party is effective in offsetting the exposure of the banking
desk. Therefore, in the above case, hedge accounting is appropriate, provided the
other hedge criteria are met. However, if instead an interest rate swap with a notional
75 million was outstanding with a third party, the accounting treatment would be different.
In such a case, no more than 75 million could be designated as a hedge and would
qualify for hedge accounting.

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It is possible to achieve hedge accounting when the trading desk aggregates several
internal swaps, or portions thereof, and enters into one offsetting external contract.
The aggregated internal swaps must be a gross amount, i.e. they should not be used to
offset each other. This approach can be done provided that the external swap is identified
and is effective in hedging the aggregate exposure of the banking desk.
Fair value hedging accounting for interest rate risk on a portfolio basis
The IASB is in the process of considering amendments that might allow financial institutions
in particular more easily to apply fair value hedge accounting for hedges of interest rate
risk when its risk management approach is to hedge a net balance sheet position. At the
date of this publication, certain issues such as the measurement of ineffectiveness, the
amortisation of the fair value hedge adjustments to the portfolio and the treatment of
demand deposits in such a model remain under discussion. The IASB expects to issue
limited amendments to the standards in this respect in March 2004.
9.3 Foreign currency risk

Hedge accounting for hedges of foreign currency risk is commonly used for:
■ hedging the future cash flows or value (foreign currency component) of non-monetary
financial assets or liabilities when fair value changes are not recognised in the income
statement (fair value or cash flow hedge); and
■ hedging forecasted future transactions in foreign currency (cash flow hedge) whether
a firm / contractual commitment or a highly probable anticipated transaction.
Accounting for the hedge of foreign currency risk on a non-financial asset as a fair value
hedge requires that the hedged item itself is denominated in a foreign currency, as opposed
to an asset that is expected to be sold in a foreign currency. That is, it must have a
separately measurable foreign currency component in its pricing. An example of this is an
investment property located in a country with a different currency and that is measured
at fair value at each balance sheet date. The fair value of this property will include a
currency component equal to the changes in the spot rate between the foreign currency
and the owner’s measurement currency. Application of hedge accounting principles to
this currency exposure will not change the measurement of the hedged item or the hedging
instrument as gains or losses resulting from changes in foreign exchange rates would be
IG F.6.5 Property, plant and equipment carried at historical cost cannot be hedged for foreign
currency risk since the assets are not remeasured for changes in foreign exchange rates.
However, if these assets are expected to be sold, the expected cash flows from this sale
could be a hedged item under a cash flow hedge provided that the transaction is highly
probable and the other criteria for hedge accounting are met.
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9.3.2 The effect of delays or prepayments of hedged cash flows
Delays or prepayments of hedged cash flows frequently occur when hedging foreign
currency risk in a cash flow hedge. However, these issues are also applicable any time an
entity is hedging other types of financial risks in forecasted transactions.
Determining the timing of forecasted cash flows involves making estimates.
Sometimes cash flows do not occur when they are expected. In determining the appropriate
accounting treatment for delayed transactions it is useful initially to distinguish between
hedged cash flows related to:
■ a firm commitment;
■ a forecasted transaction with an identified counterparty; and
■ forecasted transactions with unidentified counterparties.
9.3.2.1 Firm commitments and forecasted transactions with identified counterparties

39.101 Whenever the timing of delivery, payments or other terms under a firm commitment are
changed, an entity must evaluate whether the original firm commitment still exists, or whether
a new firm commitment with new terms has been created. The latter situation would result
in the original hedge relationship being terminated and the gains or losses on the hedging
instrument previously recognised in equity would be recognised in the income statement.
A firm commitment could be delayed for a number of reasons such as a breach of the
contract, liquidity problems on the part of the counterparty, delayed delivery or complaints
about delivery. Alternatively, it may be due to customers’ changing specifications for the
ordered product or a change in a customer’s production schedule. If the firm commitment
is delayed, but will still occur, it is important to determine the cause and duration of the delay.
IG F.5.4 When delays of cash flows occur, it is our view that hedge accounting may be continued
under certain circumstances. These circumstances are that the firm commitment can still
be uniquely identified, a binding agreement still exists and the cash flows are still expected
to occur within a relatively short period of time after the original transaction date. For a
firm commitment, this last item should be interpreted rather narrowly because the contract
supporting a firm commitment generally will specify a date or range of dates. If a date
(e.g. delivery date, completion date) is not specified, the transaction is unlikely to meet
the definition of a firm commitment; rather it should be hedged as a forecasted transaction
with an identified counterparty.
IG F.3.11 For a forecasted (highly probable) transaction with an identified counterparty, there may
be a little more flexibility in what is regarded as a relatively short period of time because
there is no firm commitment that establishes a delivery date.
The key issue is, when taking into account all the facts and circumstances surrounding
the delay, whether the entity can demonstrate that the delayed transaction is the same
transaction as the one that was originally hedged.
IG F.5.4 When the timing of a firm commitment or a highly probable forecasted transaction is
delayed, some degree of ineffectiveness is likely to occur, since the timing of the hedged
item and the hedging instrument will no longer be the same.

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IG F.5.4 and In other cases the timing of a hedged cash flow may change to be earlier than originally
39.75 expected. Since the hedging instrument would expire later than the hedged cash flows,
some ineffectiveness is likely to occur in this situation as well. However, the hedging
instrument may not be re-designated for a shorter period (i.e. until the cash flow is now
expected to occur), as there is still the requirement that a hedging instrument must be
designated for its entire remaining time outstanding.
9.3.2.2 Cash flows from forecasted transactions with unidentified counterparties

Cash flows from forecasted transactions with unidentified counterparties are designated
with reference to the time period in which the transactions are expected to occur. This is
because these forecasted transactions do not yet have any identified counterparties that
would otherwise allow them to be identified with respect to a specific expected transaction.
When forecasted cash flows in one period do not occur, an entity may be able to
demonstrate that such a shortfall will be offset by increased cash flows in a later period.
For example, an entity initially forecasts sales of FC 100 in each of the first two quarters
of the next year. At a later point the entity revises its forecast to expected sales of FC 75
in the first quarter and FC 125 in the second quarter. The total amount of sales in the two
quarters remains unchanged at FC 200.
39.88, 39.101 For hedge accounting to be continued the original forecasted transaction must still exist
and IG F.3.7 and be highly probable of occurring. When the hedged item is designated as cash flows
from forecasted transactions (e.g. forecasted sales) with unidentified counterparties within
a certain time period, it would be very unlikely that an entity would be able to demonstrate
that sales in later periods are due to a shortfall in an earlier period. In that case hedge
accounting should be discontinued. In addition, a history of designating hedges of
forecasted transactions and then determining they are no longer expected to occur may
call into question the entity’s ability to accurately predict forecasted transactions, as well
as the propriety of using hedge accounting in the future for similar transactions.
IG F.3.11 The transactions must take place within a narrow range of time from a most probable
date. In determining the length of such a period, the industry and environment that the
entity operates in should be considered. Our view is that for forecasted transactions with
unidentified counterparties, this narrow range of time should be more strictly interpreted
(i.e. a shorter time period) than for forecasted transactions with identified counterparties.
9.3.3 Effectiveness testing of foreign currency hedging transactions

The principles described in Section 8.6.2 also are applicable when hedging foreign
currency risk. Entities often hedge foreign currency risk from forecasted transactions
using forward contracts. In performing hedge effectiveness testing, the changes in the
fair value of the forward and the change in expected cash flows from the forecasted
transactions must be measured.
IG F.5.6 A hedge relationship between a forecasted transaction and a forward contract used to
hedge the foreign currency risk may be measured based on either spot rates or forward
rates. The method used must be included in the hedge documentation. Both approaches
have potential benefits and drawbacks. If effectiveness is measured based on forward
rates, the forward points on the forward contract will not be recognised in the income
statement to the extent the forward is fully effective. However, regardless of whether
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forward rates or spots rates are applied, timing differences between the settlement of the
forecasted transaction and the derivative will cause some ineffectiveness.
This ineffectiveness must be measured whenever the entity performs its effectiveness
testing, and recognised in the income statement.
The following cases demonstrate a number of the issues that have been discussed in
Section 9.3 about hedging foreign currency risk.
Case 9.6 Cash flow hedge of foreign currency sales transactions

Components Manufacturer produces components that are sold to domestic and foreign
customers. Export sales are denominated in the customers’ measurement currency.
In order to reduce the currency risk from the export sales, Components Manufacturer
has the following hedging policy:
■ a transaction is committed when the pricing, quantity and timing are fixed;
■ committed transactions are hedged 100 per cent;
■ anticipated transactions that are highly probable are hedged 50 per cent; and
■ only transactions anticipated to occur within six months are hedged.
For export sales, cash payment falls due one month after the invoice date. Components
Manufacturer projects sales to its foreign customers during April 20X1 will be 100,000
units, amounting to sales revenue of foreign currency (FC) 10,000,000.
At 28 February 20X1, all of the FC 10,000,000 of sales in April 20X1 are still anticipated
but uncommitted. Therefore, only 50 per cent of the total anticipated sales are hedged.
The hedge is transacted by entering into a foreign currency forward contract (forward 1)
to sell FC 5,000,000 for measurement currency (MC) at 0.6829 at 15 May 20X1 and is
documented as a cash flow hedge. The hedge is expected to be highly effective.
Hedge effectiveness will be assessed by comparing the changes in the discounted cash
flows of the incoming amounts of FC to the changes in fair value of the forward contract.
Components Manufacturer includes the time value of foreign currency forward contracts
when measuring hedge effectiveness. This is expected to give a nearly 100 per cent
effective cash flow hedge as the fair value of the sales transactions during the period of
the hedge will be affected by FC interest rates as well as the spot rates.
A review of the sales order book at 31 March 20X1 shows that all of the anticipated
sale contracts for invoicing in April are now signed. In accordance with the hedging
policy, a further foreign currency forward contract (forward 2) is entered to sell
FC 5,000,000 for MC at 0.7100 at 15 May 20X1, in order to hedge the currency inflow
from the remaining 50 per cent of the sales.

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The spot and forward exchange rates and the fair value of the forward contracts are
as follows:
Fair value Fair value
of forward of forward
sale of sale of
Forward FC 5,000,000 FC 5,000,000
Spot rate rate (forward 1) (forward 2)
Date (1 FC = MC) (1 FC = MC) (in MC) (in MC)
28 February 0.6860 0.6829 – N/a
31 March 0.7120 0.7100 (134,491) –
30 April 0.7117 0.7108 (139,152) (3,990)
15 May 0.7208 N/a (189,500) (54,000)
The fair value of the forward is the present value of the expected settlement amount,
which is the difference between the contract rate and the forward rate multiplied by
the notional foreign currency amount. The discount rate used is six per cent.
During April export sales of FC 10,000,000 are invoiced and recognised in the income
statement. The deferred gain or loss is released from equity and recognised in the income
statement. The cash flows being hedged are now recognised in the balance sheet as
receivables of FC 10,000,000. As a result hedge accounting is no longer necessary because
foreign currency gains and losses on the amounts receivable are recognised in the income
statement and will be offset by the revaluation gains and losses on the forwards.
Assuming that all criteria for hedge accounting have been met, the required journal
entries are as follows (amounts in MC):
Debit Credit
28 February 20X1
No entries in income statement or balance sheet are
required. The fair value of the forward contract is zero
31 March 20X1
Derivatives (liabilities) 134,491
To record the change in fair value of forward 1
1 to 30 April 20X1
Trade receivables 7,115,000
Export sales 7,115,000
To record the sales transactions at the prevailing rate on
the date the sales are recognised (on average assumed
to be 0.7115)
30 April 20X1
Trade receivables 2,000
FX gain on trade receivables (income statement) 2,000
To record the trade receivables at the closing spot rate;
FC 10,000,000*(0.7117 – 0.7115)
March 2004
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Debit Credit

Export sales (income statement) 143,142
To record the release of the deferred hedge results
upon recording the sales (MC 139,152 + MC 3,990)
1 to 15 May 20X1
Cash 3,575,000
To record the payments from receivables at the spot rate
at the day of payment (on average 0.7150)
To record the FX gain on trade receivables;
FC 5,000,000*(0.7150 – 0.7117)
15 May 20X1
Cash 29,000
FX gain on cash (income statement) 29,000
To record the revaluation of the bank balance to
15 May spot rate; FC 5,000,000*(0.7208 – 0.7150)
To record the FX gain on trade receivables;
FC 5,000,000*(0.7208 – 0.7117)
FX loss on forward (income statement) 50,348
To record the change in fair value of forward 1 for the
period from 1 to 15 May
FX loss on forward (income statement) 50,010
To record the change in fair value of forward 2 for
the period from 1 to 15 May
Cash 189,500
To record the settlement of forward 1
Cash 54,000
To record the settlement of forward 2

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Debit Credit
15 to 31 May 20X1
Cash 3,655,000
To record the payments from receivables at the spot rate
at the day of payment (on average 0.7310)
FX loss on cash (income statement) 51,000
Cash 51,000
To record the FX loss on forwards settled before all
receivables were paid. The FC bank account was over-
drawn for a period; FC 5,000,000*(0.7310 – 0.7208)
To record the FX gain on payments of receivables;
FC 5,000,000*(0.7310 – 0.7208)
Summary
At 31 May 20X1, after all these transactions have settled, the balance sheet, including
the income statement impact, is as follows (amounts in MC):
Assets Equity
Cash 6,964,500 Export sales (retained earnings) 6,971,858

FX loss (retained earnings) (7,358)
Total assets 6,964,500 Total equity 6,964,500
The bank balance reflects the settlement of the two forward contracts (amounts in MC):
Forward 1: FC 5,000,000 at 0.6829 3,414,500
Forward 2: FC 5,000,000 at 0.7100 3,550,000
Total 6,964,500
The FX loss in this example is caused by:

■ Timing mismatches: Receivables and sales are recognised at the spot rate at the
date of the transaction (on average 0.7115) during April; whereas the release from
the hedge revaluation reserve is recognised at the end of April (for practical reasons)
when the rate was 0.7117. Furthermore, receivables are collected during the month
of May and recognised at the relevant spot rates, whereas the forward contracts
are settled on 15 May.
■ Interest element on the forward contracts for the period where hedge accounting is
not applied (1 to 15 May): From 30 April the cash flow hedge is de-designated, but
the forward contracts remain as an economic hedge of the receivables to be collected
during May. The FX results on the receivables are recognised in the income statement,
as are the results on the forward contracts. A perfect offset is not achieved due to
the interest element included in the changes in fair value of the forward contracts.
March 2004
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Termination of hedge accounting

Assume the same scenario as above except that on 31 March 20X1 the committed
transactions are actually only FC 3,000,000 and there are no more anticipated
transactions for April 20X1. In such a case it is now unlikely that the anticipated sales
transactions will occur, and hedge accounting for FC 2,000,000 of the originally
anticipated sales of FC 5,000,000 must be discontinued. However, Components
Manufacturer may continue to have a hedge relationship for FC 3,000,000.
The unrealised FX loss on the FC 2,000,000 should be recognised immediately in the
income statement as the cash flow is no longer expected to occur. The unrealised FX
loss relating to the FC 3,000,000 that is still expected remains in equity. Fair value
changes on the foreign currency forward contract must be recognised in the income
statement to the extent the anticipated sales will not occur.
The following journal entries are required (amounts in MC):
Debit Credit
31 March 20X1
FX losses (income statement) 53,796
To record in the income statement the portion of
deferred losses that reflects the cash flows that are
no longer expected to occur (134,491*2/5)
Case 9.7 Cash flow hedge of foreign currency purchase transactions

Components Manufacturer purchases certain subcomponents in the Far East.
At 28 February 20X1, Components Manufacturer signs a contract to purchase one
million units of subcomponents from a foreign supplier for delivery at 31 March. The
price is foreign currency (FC) 750 million which falls due at 30 April 20X1. The entity’s
risk management policy is to hedge foreign currency transactions of more than
measurement currency (MC) 2.5 million. Components Manufacturer hedges the foreign
currency risk by entering into a forward contract to purchase FC 750 million for MC
on 30 April 20X1 at 102.46. The hedge is documented and accounted for as a cash
flow hedge. Effectiveness testing is based on changes in forward rates.
Forward rate for Fair value of
30 April forward
Spot rate settlement contract
Date (1 MC = FC) (1 MC = FC) (in MC)
28 February 102.75 102.46 –
31 March 105.78 105.51 (211,070)
30 April 104.17 N/a (120,160)

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Debit Credit
28 February 20X1
No entries in the income statement or balance sheet are
required. The fair value of the forward contract is zero
at that date
31 March 20X1
To record the change in fair value of the forward
Inventories 7,090,187
Trade liabilities 7,090,187
To record the purchase transaction at the spot rate on
the delivery date (FC 750,000,000/105.78 spot rate)
Inventories 211,070
To record the release of the deferred hedge results upon
de-designation of the hedge
30 April 20X1
FX loss on trade liabilities (income statement) 109,583
Trade liabilities 109,583
To record the FX loss on the liability
FX gain (income statement) 90,910
Trade liabilities 7,199,770
Cash 7,199,770
To record payment of the liability at the spot rate
on the payment date
Cash 120,160
To record the settlement of the forward
The effect of the hedge is recognised as a basis adjustment to the cost of inventory.
The adjustment to inventory is recognised in the income statement in cost of sales
when the inventory is sold.
March 2004
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Case 9.8 Fair value hedge of foreign currency risk on available-for-sale equities
Safeinvestor is a large pension fund set up for the employees of a brewery. In recent
years the pension fund assets have grown and management is finding it increasingly
difficult to achieve a sufficient diversification in the domestic equity market. Also,
management believes that it is possible to earn a higher return on equity shares in
certain foreign markets. Consequently, management decides to invest in a large foreign
equity market. However, all of Safeinvestor’s pension obligations are denominated in
its measurement currency (MC), and as part of the investment strategy Safeinvestor
seeks to hedge all significant exposure to foreign currency risk beyond certain limits.
At 1 April 20X1, Safeinvestor buys a portfolio of foreign currency denominated equity
shares for foreign currency (FC) 30 million. The shares are treated as available-for-
sale securities with changes in the fair value being recognised directly in equity.
Although a steady growth in the value of the portfolio is expected in the medium to
long-term, and accordingly an increased foreign currency exposure, Safeinvestor decides
to hedge only 85 per cent of the market value of the portfolio. This is because of the
uncertainty about the short-term development in the market value (and therefore the
exposure). Safeinvestor enters into a foreign currency forward contract to sell
FC 25.5 million for MC at 15 October 20X1. This contract will then be rolled for as
long as the position is outstanding. If the value of the portfolio increases significantly,
Safeinvestor’s policy is to adjust the hedge by entering into additional foreign currency
forward contracts so that at least 75 per cent of the foreign currency risk is hedged.
The forward contract is designated as a fair value hedge of the currency risk associated
with the first FC 25.5 million of shares. The time value of the forward contract is
excluded from the assessment of hedge effectiveness. The hedge is expected to be
highly effective and hedge effectiveness will be assessed by comparing the changes in
the fair value of the first FC 25.5 million of equity shares due to changes in spot rates
to the changes in the value of the forward contract also due to changes in spot rates,
i.e. the time value is excluded from the hedge relationship.
The terms of the forward contract are as follows:
■ sell FC 25,500,000
■ buy MC 64,359,915
■ maturity 15 October 20X1
(This implies a forward rate of 2.52).

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During the period of the hedge value of the forward is as follows (amounts in MC):
Value
Spot rate of forward Value Spot Forward
Date (1 FC = MC) contract change element element
1 April 2.55 – – – –
30 June 2.41 3,031,769 3,031,769 3,570,000 (538,231)
30 September 2.39 3,406,748 374,979 510,000 (135,021)
15 October 2.45 1,884,915 (1,521,833) (1,530,000) 8,167
1,884,915 2,550,000 (665,085)
The value of the foreign equity portfolio changes as follows, as a result of changes in
equity prices and changes in the spot rate:
Value
Value Value change
Date (in FC) (in MC) (in MC)
1 April 30,000,000 76,500,000 –
30 June 35,000,000 84,350,000 7,850,000
30 September 28,000,000 66,920,000 (17,430,000)
15 October 32,000,000 78,400,000 11,480,000
Debit Credit
1 April 20X1
Securities available-for-sale 76,500,000
Cash 76,500,000
To record the purchase of securities; MC 30 million
at 2.55. No entries are required for the forward contract
30 June 20X1
AFS revaluation reserve (equity) 7,850,000
To record the change in fair value of securities
Derivatives (assets) 3,031,769
Derivative revaluation gain (income statement) 3,031,769
To record the change in fair value of forward
Hedge revaluation loss (income statement) 3,570,000
To transfer the fair value change of securities in
respect of the hedged risk to the income statement;
FC 25.5 million * (2.41 – 2.55)
March 2004
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Debit Credit
30 September 20X1
Derivatives (assets) 374,979
Derivative revaluation gain (income statement) 374,979
Hedge revaluation loss (income statement) 510,000
AFS revaluation reserve (equity) 510,000
FC 25.5 million * (2.39 – 2.41)
15 October 20X1
Derivative revaluation loss (income statement) 1,521,833
Hedge revaluation gain (income statement) 1,530,000
FC 25.5 million * (2.45 – 2.39)
Cash 1,884,915
To record the settlement of forward contract
The hedge stays effective for the full period as the changes in fair value of the forward
contract, due to changes in spot rates, perfectly offset changes in the value of
FC 25.5 million of the equity portfolio due to the same spot rates.
The increase in the value of the equity shares at 30 June 20X1 would, in accordance
with the hedging policy, result in an additional hedge transaction being entered into.
However, due to the market movements through 30 September 20X1 this hedge would
need to be unwound as the value of the portfolio (and therefore the foreign currency
risk) decreased.
In order for fair value hedge accounting to be applied, the portfolio of shares that was
designated as the hedged item at 1 April 20X1 must continue to be the hedged item for
the entire period of the hedge. This means that active management of the portfolio
may preclude fair value hedge accounting.

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As an alternative approach, management may designate the hedge as a hedge of the

anticipated disposal of the shares providing that the timing of such disposal is highly
probable, and apply cash flow hedge accounting. Cash flow hedge accounting requires
specification of the size and timing of the cash flow being hedged. The model that is
more appropriate may depend also on the entity’s ability to collect the relevant
information required under each model.
9.3.4 Net position hedging of foreign currency risk

Net position hedging strategies for foreign currency risk often include the use of a central
treasury that accumulates foreign currency risk exposures from group entities and then
hedges the net risk exposure with a third party such as a bank. The central treasury often
will enter into internal derivatives with other group entities or divisions to effectively transfer
the foreign currency risk to the central treasury. Based on overall risk management objectives
and policies the central treasury will determine how best to manage the risk exposure.
39.AG101 As mentioned in Section 8, a net position generally does not qualify as a hedged item for
hedge accounting purposes. However, an entity may choose to manage risk on a net
basis while for hedge accounting purposes designate the hedge in such a way so as to
comply with the requirements in IAS 39.
Depending on the entity’s risk management policies and internal procedures the entity may:
39AG101 ■ document and designate a hedge between the external derivatives and a gross position
in a group entity that matches the net position; or
IG F.1.6 ■ in some circumstances designate offsetting exposures as the hedging instruments in
cash flow hedges using internal derivatives to build a documentation trail.
39.73 The internal derivatives between a central treasury and the individual entities must be
eliminated on consolidation and cannot be designated as hedging instruments in the
consolidated financial statements.
IG F.1.6 and F.1.7 However, if all other hedge accounting criteria are met, hedge accounting may still be
used for cash flow hedges as well as for fair value hedges. Although the effects of
internal derivatives would have to be eliminated in consolidation, in some cases it will be
possible to apply hedge accounting in the group financial statements, due to the ability to
designate a non-derivative financial asset or liability as a hedging instrument for foreign
currency risk. This process may be more in line with the risk management procedures
already used by the treasury department. In this situation the individual foreign currency
positions hedged still must be linked using internal contracts, thus ensuring that each
qualifying hedging instrument is linked to a qualifying hedged position.
To achieve hedge accounting, it is crucial that the individual subsidiaries properly document
their internal hedge transactions, and that the central treasury department can demonstrate
that each bundle of risk by currency and time period is netted and fully offset externally.
Gains and losses from the internal hedging instrument are recognised in the income statement
by the central treasury department, and in equity or in the income statement by the individual
subsidiaries, depending on whether cash flow hedging or fair value hedging is applied.
Hedge accounting at the subsidiary’s financial reporting level is possible if the hedge with the
parent is properly documented at that reporting level, and all other hedge criteria are met.
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IG F.2.14 The group treasury may hedge the exposure of another operating unit without entering
into an internal transaction with that unit as long as the hedge relationship is properly
documented at the group level.
Case 9.9 Net position hedging – foreign currency risk

Assume a corporate has foreign currency cash outflows for payments of goods and
services and the same foreign currency cash inflows from sales of its products.
The corporate monitors this foreign currency risk by analysing the net foreign currency
outflows and inflows expected within each cash flow time band. Assume that the cash
inflows and outflows are all highly probable or committed transactions. The cash flow
bands used should be based on the business cycle of the corporate and the period over
which it chooses to hedge the cash flows (which would generally cover a longer period
than those used in the example below).
Less than
1 month 1 to 2 months 2 to 3 months
FC inflows
Sales 2,200 2,100 3,000
Cash inflows 2,200 2,100 3,000
FC outflows
Purchases of goods 1,000 1,500 2,300
Purchases of services 300 100 200
Cash outflows 1,300 1,600 2,500
Net cash flows in FC 900 500 500
Under net position hedging the net expected cash flow in each time band could be
hedged. For example, for the cash flows expected in the period of two to three months,
the exposure of FC 500 could be hedged with a forward. To achieve hedge accounting
treatment under IFRS, the corporate could designate the first FC 500 of highly probable
anticipated and committed sales in that month as the hedged item, and could designate
a derivative or a non-derivative foreign currency instrument as the hedging instrument.
IG F.3.10 As demonstrated in the example, hedging a net exposure is possible, provided that an
entity documents the hedge relationship as a hedge of part of a gross position that
itself forms part of the net position. It is important that the hedged item is the first
FC 500 of sales in that time band so that it is clear when the hedged item affects the
income statement.

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Case 9.10 Hedging on a group basis – foreign currency risk

39.84 and AG101 A group consists of a parent entity (including corporate treasury) and its subsidiaries A
and B. Subsidiary A has highly probable cash inflows from future revenues of FC 200
that it expects to receive in 60 days. To hedge this exposure, Subsidiary A enters into a
forward contract with the corporate treasury to pay FC 200 in 60 days.
Subsidiary B has highly probable forecasted purchases of FC 500 that it expects to pay
in 60 days. Subsidiary B hedges this exposure by entering into a forward contract with
the corporate treasury to receive FC 500 in 60 days.
The parent entity itself has no expected exposure to that foreign currency during
this period.
Figure 9.3 Group hedging of foreign currency risk
The effect of the internal derivatives with the subsidiaries is to transfer the foreign
currency risk to the corporate treasury. The net currency exposure from FC in the
next time period is a FC 300 outflow. The corporate treasury will hedge this exposure
by entering into a forward contract with an external third party.
In order to apply hedge accounting to this transaction the group will designate the
external forward contract as a hedge of a gross exposure in one of the subsidiaries
rather than the net exposure. The group does this by designating the first FC 300 of
cash outflows from purchases in Subsidiary B as the hedged item and the external
forward contract as the hedging instrument. This in effect means that the group has
hedged its net exposure of FC 300 in accordance with its risk policies and that hedge
accounting can be applied to this hedging strategy provided that the other hedge
accounting criteria are met.
March 2004
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IG F.1.6 In finalising the amendments, the Board has made changes to the existing guidance
(IGC 134-1-b) for entities using internal derivatives that are netted through a treasury
centre. The changes are likely to make it more difficult to apply the approach described.
In particular, it is clear from the amendments that a portfolio of cash flows in a
particular currency and within a narrow time-band must also affect profit or loss in
the same period.
For example, consider Case 9.10 above. The forecast sale by Subsidiary A of FC 200 in
July 20X5 might be expected to generate cash in August 20X5. The forecast purchase of
FC 500 by Subsidiary B, also expected to be paid for in August 20X5, might be recognised
in the income statement in June 20X5. Under the existing standards, only the cash flows
need occur within the same reporting period, and so these two transactions would be
netted using internal derivatives, through the group corporate treasury to an external
derivative covering the net position of FC 300. The hedge accounting claimed by
Subsidiaries A and B in their individual financial statements would not be reversed or
adjusted at the group level.
Under the amended standards, the group would need to make adjustments to the hedge
accounting entries made by Subsidiaries A and B. If it continued to use the same
netting process, it would need to reflect in the financial statements that, at the group
level, the hedged item is FC 300 of the expected payments by Subsidiary B. If this
transaction affects profit or loss as expected in June, it will not be appropriate, under
the amended standards, to defer in equity at the end of June 20X5 an amount related to
the expected revenue transaction in Subsidiary A in July 20X5. An adjustment will
need to be made on consolidation.
The alternative approach under the amended standards would be to:
(a) enter into external derivatives to hedge aggregate long positions and short positions
in each FC and each time period separately (in other words, by aggregating, but
not netting internal derivatives in the treasury centre); then
(b) designate the external derivatives as hedging instruments at the group level; and
(c) put in place additional documentation at the group level to link each external derivative
to its associated group of internal derivatives, so that the chain of hedge
documentation is completed, via the internal contracts, between each hedged cash
flow within the group and a portion of the related external derivative.
Under this approach, the internal derivatives are hedging instruments for each of the
subsidiary entities’ stand-alone financial statements, and at the group level provide part
of the linkage of documentation to the external derivative transaction.
9.4 Hedging a net investment
9.4.1 Identifying the hedged risk and the hedging model

Net investment hedge accounting is available only for a foreign entity, that is a subsidiary
whose functional currency is different from the reporting currency of the group. In other
cases, the foreign currency exposure is hedged like any other foreign currency transaction

March 2004
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exposures. The net investment hedging model can only be applied at the group level,
i.e. the subsidiary, associate etc., that is itself the foreign net investment cannot apply
net investment hedge accounting in its own books, and neither can the parent entity.
It is the carrying amount of the total net assets (assets less liabilities) that is designated as
the hedged item in a net investment hedge regardless of whether individual assets or
liabilities in that foreign entity are denominated in a currency different from the foreign
entity’s measurement currency.
Case 9.11 Hedged item in a net investment hedge

Entity A, with EUR as its measurement currency, includes in its consolidated financial
statements the foreign Subsidiary B with USD as its measurement currency.
The carrying amount of Subsidiary B’s net assets is USD 100.
Part of Subsidiary B’s net assets consists of loans denominated in GBP. Nevertheless
Entity A will identify the net assets of Subsidiary B of USD 100 as the hedged item in
a net investment hedge. This is because the loans denominated in GBP will be translated
into USD in Subsidiary B’s own financial statements before Subsidiary B is consolidated
into Entity A. Subsidiary B may separately decide to hedge the foreign currency risk of
the GBP loans.
In some instances the future cash flows from the investment may be expected to exceed
the net asset value, such as when there is significant unrecognised goodwill or unrecognised
value changes in assets or liabilities. Such fair value adjustments resulting from internally
generated goodwill do not qualify for hedge accounting under the net investment hedge
model. These additional cash flows from the net investment could be designated, for
example, as a cash flow hedge of the proceeds from sale of the foreign entity. However, this
still must meet the general criteria for cash flow hedges. This means that the future cash
flows would have to be highly probable, and the timing and amount must be known.
This is only likely to be the case if sale negotiations for the entity have been completed.
21.15 Loans to or from a foreign entity that are neither planned nor intended to be settled in the
foreseeable future should be treated as part of the investment in the foreign entity.
Table 9.1 Components of a net investment in a foreign entity

Carrying amount of net assets of the foreign entity
+/- Other consolidation adjustments to carrying amounts
+ Carrying amount of goodwill paid in an acquisition
+/- Loans to or from a foreign entity not planned or intended to be settled in the foreseeable future
Amount that can be the hedged item in a net investment hedge
Case 9.12 Hedgeable components of a net investment in a foreign entity

In 20X0 Entity A bought Entity B for MC 100. The carrying amount of Entity B’s net
assets was MC 60 and Entity A recognised fair value adjustments to specific assets
and liabilities of MC 30 and goodwill of MC 10. During 20X2 Entity A extended a loan
to Entity B of MC 20.
172 9.4 Hedging a net investment
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In 20X3 the carrying amount (not including fair value adjustment from the acquisition)
of Entity B’s assets and liabilities is MC 70. The remaining fair value adjustments are
MC 25 and goodwill is MC 7. The loan has not been repaid and is not intended to be
repaid. The carrying amount of the net investment that Entity A may designate as the
hedged item is equal to the amount of Entity A’s net investment in Entity B including
goodwill. This amount would be MC 122 (70 + 25 + 7 + 20).
9.4.2 Expected net profit or loss of a net investment in a foreign entity

39.81 The hedged item may be all or a portion of the carrying amount of the foreign entity at the
beginning of a given reporting period. This means that expected profits from the foreign
entity in that period cannot be the hedged item under a net investment hedge model.
Translation risk arises once the net profit is recognised as an increase in net assets of the
foreign entity. The additional net assets could be designated as a hedged item in a net
investment hedge as they arise, although in practice most groups would revisit their net
investment hedges only quarterly or semi-annually.
21.39 and 40 Expected net profits from a foreign entity expose a reporting group to potential volatility
in the consolidated income statement as transactions in the foreign entity are translated
into the group’s measurement currency at spot rates at the date of the transactions or
average rates, as an approximation of spot rates. Entities may want to hedge this translation
39.86 risk exposure. However, since expected net profits in future reporting periods do not
constitute recognised assets, liabilities or forecasted transactions that lead to actual cash
flows and that will ultimately affect the income statement at the consolidated level, they
cannot be accounted for under either a fair value hedge or a cash flow hedge model.
Expected net losses in a foreign entity would reduce the year-end net investment balance,
which could result in an over-hedged position. Therefore, if a group expects its foreign
entity could make losses the group may decide to hedge less than the full carrying amount
of the net assets, as otherwise it would not be able to satisfy the hedge accounting criteria
that the hedge relationship is expected to be highly effective on an ongoing basis.
Entities also might wish to hedge anticipated dividends from foreign entities.
However, expected dividends do not give rise to an exposure that will be recognised in
the income statement. Therefore, these cannot be hedged in a cash flow hedge or a net
investment hedge. It is only once dividends are declared and become a receivable that
hedge accounting may be applied.
9.4.3 Hedge effectiveness

39.88 IAS 21 does not set any criteria for when hedge accounting can be applied. Therefore, the
same hedge effectiveness criteria described earlier in this Section and in Section 8 is also
applicable for hedges of net investments in foreign entities.
Although the accounting is similar, the nature of this type of hedge is different from a
normal cash flow hedge. The exposure being hedged is the closing spot rate translation
exposure under IAS 21. Therefore, it would be reasonable to determine hedge effectiveness
using changes in spot rates. Where the hedging instrument is a derivative, the changes in
value relating to the spot-forward differential would be excluded from the hedge relationship
and recognised in the income statement.

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Case 9.13 Hedge of a net investment in a foreign entity

GlobalTechCo has a net investment in a foreign subsidiary of foreign currency (FC)
50 million. At 1 October 20X1, GlobalTechCo enters into a foreign currency forward
contract to sell FC 50 million for measurement currency (MC) at 1 April 20X2.
GlobalTechCo will review the net investment balance on a quarterly basis and adjust
the hedge to the value of the net investment. The time value of the forward contract is
excluded from the assessment of hedge effectiveness.
The foreign exchange rate and fair value of the forward contract move as follows:
Forward Fair value
Spot rate exchange rate of forward
Date (1 FC = MC) (1 FC = MC) contract
1 October 20X1 1.71 1.70 –
31 December 20X1 1.64 1.63 3,430,000
31 March 20X2 1.60 N/a 5,000,000
Debit Credit
1 October 20X1
No entries in the income statement nor the balance sheet
are required. The fair value of the forward contract is zero
31 December 20X1
Derivatives (asset) 3,430,000
Foreign exchange losses (income statement) 70,000
Foreign currency translation reserve (equity) 3,500,000
Net investment in subsidiary (asset) 3,500,000
To record the foreign exchange losses of the subsidiary
(The adjustment to the net investment would be derived
by translating the subsidiary’s balance sheet at the spot
rate at the balance sheet date)
31 March 20X2
Foreign exchange losses (income statement) 430,000
Net investment in subsidiary (asset) 2,000,000
To record the change in foreign exchange losses
of the subsidiary
174 9.4 Hedging a net investment
March 2004
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Debit Credit
Cash 5,000,000
The gain on the hedging transaction will remain in equity until the subsidiary is disposed.
9.5 Hedging commodity price risk

This and the following Sections discuss the hedge accounting principles for a situation
where an entity purchases a commodity contract that is accounted for under IAS 39 as a
derivative used to hedge an expected purchase or sale of the underlying commodity.
39.5 An entity may enter into commodity contracts through a broker on a commodity exchange.
The commodity contract is to be used to lock into a price for the commodity that the entity
expects to purchase. The situation is illustrated in Figure 9.4.
Figure 9.4 Hedging with commodity contracts
In practice a number of issues arise regarding commodity hedging where derivatives

such as futures on that commodity are traded in a standardised form on a commodity
exchange or where only an ingredient or component is hedged.
For certain commodities, exchange-traded derivatives are based on a standard quality or
grade of these commodities. This is because the actual product that will be obtained
depends on specific circumstances in the future, such as where the commodity comes
from, purity of the actual product, harvest yield, or even consumer demand. Entities often
enter into derivatives for a standard commodity prior to determining the actual quality of
product they require for production. Examples of commodities that are traded in a
standardised form are wheat, corn and other agricultural products, as well as coffee
beans and metals.

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39.82 IAS 39 requires that the item that is being hedged can be identified. In these cases only a
standard commodity can be identified at the time the futures contract is entered into.
The price of the standard commodity is a surrogate for the price of the actual commodity.
The price risk of a standard commodity can often be isolated and measured because
commodity derivative markets are well developed in many places. However, IAS 39
does not allow entities to designate only a component of price risk of a commodity as the
hedged item. When hedging with a standardised derivative, although the purchase or sale
of the underlying commodity may be highly probable, the quality of the actual commodity
to be purchased generally will differ from the standard quality. As a result of the
requirement to only hedge commodities in their entirety, entities cannot designate a
standardised commodity component as the hedged item. The actual item to be purchased
must be designated as the hedged item. Because of the differences in the hedging instrument
(futures contract based on the standard commodity) and hedged item (actual product to
be purchased / sold), hedge ineffectiveness may arise. Additionally, it may be difficult to
demonstrate on a prospective basis that the hedge relationship is expected to be highly
effective throughout the hedging period.
A similar issue arises when an entity hedges an ingredient of a non-financial item.
For example, when hedging the purchase of jet fuel an entity may want to hedge its
entire jet fuel price exposure, or only a component of the price exposure. The price of
jet fuel is derived from the prices of the various components that make up jet fuel.
Each of the components is traded and market prices are available for each of the
components. The quantity of each of the components in a metric ton of jet fuel is
always fixed. However, the relative value of each of the components differs as the
prices of the components move more or less independently. Various strategies are
possible when hedging a transaction such as jet fuel purchases. However, not all would
qualify for hedge accounting.
■ Hedging components of the jet fuel price: An entity may choose to hedge only its
exposure to certain of the jet fuel components (e.g. brent or gas oil) and to retain an
exposure to the price of the other components. This may be due to the costs of
hedging, the relatively more liquid nature of these components, the fact these
components are the most significant components of jet fuel prices, or the independent
nature of the pricing of the various components. The brent and gas oil swaps
respectively will be economic hedges of the corresponding brent or gas oil component
of the jet fuel purchases. This may result in perfect effectiveness of those components,
as the critical terms of the derivative and the critical terms of the component match,
the prices change in parallel and the notional amount of the derivative equates to the
quantity of the component in the jet fuel that will be purchased. However, as noted
above, IAS 39 prohibits hedge accounting for components of risk for non-financial
items such as jet fuel purchases. Therefore, in order for this hedging strategy to
qualify for hedge accounting, the entire price risk of the jet fuel purchase must be
designated as the hedged item. A high degree of correlation must be demonstrated
between the price of the hedged ingredient and the jet fuel price. But because the
prices of the individual components move more or less independently it may not be
possible to demonstrate on a prospective basis that the hedge relationship is expected
to be highly effective throughout the hedging period. Even if an effective relationship
is demonstrated initially, the extent of ineffectiveness later may result in the hedge no
longer qualifying as highly effective.
176 9.5 Hedging commodity price risk
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■ Hedging the entire price of jet fuel: In order to meet the requirements of IAS 39
regarding hedging of commodity price risk, an entity may use a jet fuel derivative to
hedge the entire price risk exposure from the purchase of jet fuel. This hedging strategy
would qualify for hedge accounting assuming all other criteria have been met.

39.AG100 Several comments on the proposed amendments had proposed that separate components
of a non-financial item should qualify for hedge accounting as long as changes in the
fair value of the hedged component could be measured reliably. The Board rejected
this suggestion, but has clarified in the amended standards that hedge accounting might
be achieved by adjusting the hedge ratio to maximise effectiveness.
For example, a regression analysis might be performed to establish a statistical relationship
between the price of a transaction in Brazilian coffee (the hedged item) and a hedging
instrument whose underlying is the price of Columbian coffee. If there is a valid statistical
relationship between the two prices, the slope of the regression line can be used to establish
the hedge ratio that will maximise expected effectiveness. For example, if the slope of the
‘line of best fit’ is 1.02, then a derivative with a notional amount of 1.02 tons of Columbian
coffee would be designated as a hedge of the purchase of one ton of Brazilian coffee.
This approach will give rise to some ineffectiveness in practice, although it may be
sufficient to ensure that hedge accounting can be achieved. The amended standards
will continue, however, to prohibit the hedged item to be designated as the Columbian
coffee component of the Brazilian coffee price, even if that component can be proven
to exist and can be measured reliably.
Case 9.14 Fair value hedge of commodity price risk

Big Metal is a refiner and wholesaler of metals. The entity maintains an inventory of
metals that it obtains directly from various mining companies, refines and then sells to
end-users. One of these metals is zinc, which it refines to a high-grade quality and then
sells wholesale, primarily to industrial manufacturers.
Big Metal wishes to hedge a portion of its zinc inventory. On 1 July 20X1, Big Metal
enters into a non-deliverable forward with a metals broker to sell 2,000 tons of zinc at
a price of 1,100 per ton with a maturity of 31 August 20X1. The cost of this hedged
inventory under the FIFO method is 900 per ton for a recognised cost of 1,800,000.
The forward is designated as a hedging instrument in a fair value hedge of the inventory.
Management determines and documents that the forward will be highly effective in
offsetting the fair value change in the inventory of zinc. The zinc spot and forward
prices are as follows:
Fair value of the
Spot rates Non-deliverable non-deliverable
Date per ton forward price forward
1 July 1,050 1,100 –
31 July 1,100 1,125 (48,000)
31 August 1,150 1,150 (100,000)

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On 31 July 20X1, the fair value of the forward is (48,000). The value of the 2,000
tons of the hedged zinc inventory has increased by 45,000 since the date of hedge
inception. The value of the zinc inventory is affected by other factors in addition to
zinc spot prices.
The accounting entries on these dates are as follows:
Debit Credit
1 July 20X1
No entries are made related to the forward
as the cost is zero
31 July 20X1
Forward liability 48,000
To record the revaluation of the forward
for the period from 1 to 31 July 20X1
Inventory 45,000
To record the change in the fair value of the zinc
inventory for the period from 1 to 31 July 20X1
Based on the change in the fair value of the forward and the change in the fair value of
the inventory, it is determined that the hedge remains highly effective.
On 31 August 20X1, the fair value of the forward is (100,000). The forward has also
matured at that time and is settled through net cash payment to the broker of 100,000.
The value of the inventory increased by 46,000 from 31 July 20X1 resulting in a total
fair value increase in the inventory for the hedging period of 91,000. The accounting
entries are as follows:
Debit Credit
31 August 20X1
To record the revaluation of the forward for
the period from 31 July to 31 August 20X1
Inventory 46,000
To record the change in the fair value of the zinc
inventory for the period from 31 July to 31 August 20X1
Cash 100,000
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On 31 August 20X1, Big Metal sells 2,000 tons of zinc to a steel producer at a price of
1,150 per ton for a total value of 2,300,000.
Debit Credit
31 August 20X1
Accounts receivable 2,300,000
Sales 2,300,000
To record the sale of 2,000 tons of zinc at 1,150 per ton
Cost of sales 1,891,000
Inventory 1,891,000
To record the cost of the sale of the inventory
(1,800,000 + 45,000 + 46,000)
The following table summarises the change in the inventory value during the hedged
period prior to the eventual sale:
Recorded carrying amount of hedged
Date inventory, net of adjustments:
1 July 1,800,000
31 July 1,845,000
31 August 1,891,000
The adjusted inventory value should be tested for the lower of cost or net realisable
value under IAS 2. In this example, the carrying value does not exceed the net realisable
value. Based on the adjusted inventory value, the gross margin for the sale of the
hedged 2,000 tons of zinc is calculated as follows:
Financial statement item Amount
Sales 2,300,000
Cost of sales (1,891,000)
Gross margin 409,000
Case 9.15 Cash flow hedge of commodity price risk

This case is intended to demonstrate the different journal entries required when
using a cash flow hedge. Assume the same fact pattern as above regarding Big
Metal. However, instead of designating a fair value hedge for the inventory, Big Metal
designates a cash flow hedge of future anticipated sales of 2,000 tons of zinc expected
to occur in August 20X1. It is highly probable that the sale will occur based on the
historical and expected sales. On 1 July 20X1, Big Metal enters into a non-deliverable
forward with a metals broker for 2,000 tons of zinc at a sale price of 1,100 per ton with
a maturity of 31 August 20X1.
Big Metal documents that the hedge relationship is between the changes in fair value
of the forward and the changes in expected future cash flows from expected sales of
2,000 tons of zinc inventory in August 20X1. Management determines and documents

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that the forward is expected to be highly effective in offsetting the cash flow changes
from the expected sales.
The zinc spot and forward prices are as follows:
Fair value of the
Spot rates Non-deliverable non-deliverable
Date per ton forward price forward
1 July 1,050 1,100 –
31 July 1,100 1,125 (48,000)
31 August 1,150 1,150 (100,000)
On 31 July 20X1, the fair value of the forward is (48,000). Assume that the expected
cash flows from the highly probable sale of 2,000 tons of zinc inventory have increased
by 45,000 since the date of hedge inception.
The accounting entries on these dates are as follows:
Debit Credit
1 July 20X1
No entries are made related to the forward as
the cost is zero
31 July 20X1
Hedge reserve (equity) 45,000
Hedge ineffectiveness (income statement) 3,000
To record the revaluation of the forward for the period
from 1 to 31 July 20X1 including the ineffective portion
of the forward
Management determines that the hedge relationship remains effective.

On 31 August 20X1, the fair value of the forward is (100,000). The forward has also
matured at that time and is settled through net cash payment to the broker of 100,000.
The expected cash flows from forecasted sales of zinc change by a further 46,000.
The accounting entries are as follows:
Debit Credit
31 August 20X1
Hedge ineffectiveness (income statement) 6,000
To record the revaluation of the forward for the period
from 31 July 20X1 to 31 August 20X1 including the
ineffective portion of the forward
Cash 100,000
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On 31 August 20X1, Big Metal sells 2,000 tons of zinc to a steel producer at a price of
1,150 per ton for a total value of 2,300,000.
Debit Credit
31 August 20X1
Accounts receivable 2,300,000
Cost of sales 1,800,000
Sales 2,300,000
Inventory 1,800,000
To record the sale of 2,000 tons of zinc at 1,150 per ton
Sales 91,000
To recognise the hedge reserve in the income statement
due to the recognition of the hedged cash flows
The gross margin on the sale of the zinc is calculated as follows:

Financial statement item Amount
Sales 2,300,000
Hedge adjustment (91,000)
Cost of sales (1,800,000)
Gross margin 409,000
9.5.2 Other market price risks

Entities that hold equity securities as investments are exposed to market price risk.
Hedge accounting for the price risk of securities is relevant only for securities held as
available-for-sale with changes in fair value recognised in equity. The actual mechanics
of hedge accounting of equity price risk are similar to those demonstrated above for
commodity price risk.
Case 9.16 Fair value hedge of equity securities

The following is an example of hedging with a purchased put option to hedge price risk
on equity securities classified as available-for-sale.
Entity X owns equity shares of an entity listed on a domestic stock exchange.
The securities are classified as available-for-sale with changes in fair value recognised
in equity. At 1 January 20X1, the fair value of the securities is 120 million, with a
total cost basis 115 million. The revaluation gain of five million is recognised as a
component of equity.
At 30 June 20X1, the value of the securities has increased from 120 million to 130 million.
The securities are remeasured at fair value with the cumulative change of 15 million
recognised as a component of equity.

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At 30 June 20X1, due to volatility in the price risk of the securities and to comply with
internal risk management policies, management decides to purchase a European put
option on the securities with a strike price equal to the current market price of 130 million
and a maturity date of 30 June 20X2. The option premium paid is 12 million.
Management has documented and assessed the purchased put option as an effective
hedge in offsetting decreases in the fair value of the equity securities below 130 million.
The time value component will not be included in determining the effectiveness of
the hedge.
The fair value of the securities and the put option during the period are as follows:
Value of the Total option
Date securities value Intrinsic value Time value
1 January 20X1 120,000,000 – – –
30 June 20X1 130,000,000 12,000,000 – 12,000,000
30 September 20X1 136,000,000 7,000,000 – 7,000,000
31 December 20X1 126,000,000 9,000,000 4,000,000 5,000,000
The following journal entries are made to record the remeasurement of the securities
and the payment of the option premium:
Debit Credit
30 June 20X1
Available-for-sale securities 10,000,000
To remeasure the available-for-sale securities to
fair value of 130 million
Hedging derivatives (assets) 12,000,000
Cash 12,000,000
To record the option at its fair value
At 30 September 20X1, the fair value of the securities increases to 136 million.
Therefore, the option is out-of-the-money (i.e. the option has no intrinsic value).
There are no hedge accounting entries to be made for this period, as the risk being
hedged was designated as being declines in fair value of the securities below 130 million.
The value of the option decreases to seven million all due to the decrease in its time
value. The following entries are made to record the change in fair value of the available-
for-sale securities, and to record the decrease in the value of the option.
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Debit Credit
30 September 20X1
To record the remeasurement gain on the
available-for-sale securities
Hedging costs (income statement) 5,000,000
To record the remeasurement loss on the option
due to change in time value (which is not part of
the hedge relationship)
The option is still expected to be effective as a hedge of decreases in the fair value of
the available-for-sale securities below the strike price of the option.
At 31 December 20X1, the value of the hedged securities decreases to 126 million.
The value of the put option increases to nine million (of that amount, four million
represents intrinsic value and five million represents time value). As such, the following
entries are made to recognise the change in the fair value of the available-for-sale
securities and the changes in the fair value of the option.
For illustrative purposes, these entries have been separated into two parts to
demonstrate the accounting for the changes in value of the securities that are not
being hedged (i.e. decrease down to 130 million) and the changes in value that are
being hedged (i.e. decrease below 130 million). Likewise the changes in value of the
option are separated to demonstrate changes in the time value, which have been
excluded from the hedge relationship, and changes in the option’s intrinsic value.
Debit Credit
31 December 20X1
To record the unhedged decrease in fair value of the
(from 136 million to 130 million)
Hedge results (income statement) 4,000,000
To record the hedged decrease in fair value of the
(from 130 million to 126 million)
Hedging costs (income statement) 2,000,000
To record the changes in time value of the option,
which is excluded from the hedge relationship
Hedge results (income statement) 4,000,000
To record the change in the intrinsic value of
the option – i.e. the effective part of the hedge

March 2004
10. Presentation and disclosure

■ Balance sheet presentation
■ Liability versus equity
■ Income statement presentation
■ Required disclosures

IAS 32 and IAS 39 set out the required disclosures and presentation of financial instruments.
The objective of the disclosures is to enhance financial statement users’ understanding of
the significance of on and off balance sheet financial instruments to an entity’s overall
financial position and performance.
Although some disclosures of IAS 32 were eliminated upon implementation of IAS 39,
the latter contains significant additional disclosure requirements relating to hedge accounting,
use of derivatives and risk management strategies.
10.1.1 Presentation and disclosures for financial institutions

Banks and similar financial institutions have to comply with IAS 30 in addition to IAS 32
and IAS 39. Since the time IAS 30 was issued, there have been significant developments
in the financial services environment and IAS 32 and IAS 39 subsequently came into
effect. As a result IAS 30 is not up-to-date and IAS 32 and IAS 39 have made some of
its requirements redundant. There is a current IASB project that addresses disclosures
about financial activities and financial instruments. This will eventually replace IAS 30,
however the requirements of that standard remain in effect until a new standard is
issued. The revisions are expected to be extensive and the new standard is expected to
apply to all entities that have financial instruments, not just to financial institutions.
Given the present status of IAS 30, this Section does not cover in detail the requirements
of IAS 30.
10.2 Balance sheet presentation
10.2.1 Presentation of classes of financial instruments

IAS 32 and IAS 39 do not address the balance sheet presentation of financial instruments.
1.68 IAS 1 requires that financial assets be presented on the face of the balance sheet,
with separate presentation of cash and cash equivalents, trade and other receivables
184 10.1 Overview
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and investments accounted for under the equity method. Non-current interest-bearing
liabilities should also be presented on the balance sheet. Additional lines items may
be used.
1.51 If an entity makes a distinction between current and non-current assets and liabilities on
the face of the balance sheet, instruments within the four financial asset categories of
trading, held-to-maturity, originated loans and receivables, and available-for-sale should
be classified as current or non-current, with trading assets and liabilities classified as
1.52 current. Further, an entity should disclose the balance of the financial assets in each of
these four financial asset categories, either on the face of the balance sheet or in the
notes to the financial statements.
Derivative assets and liabilities should be presented separately if they are significant.
If derivative instruments are not significant these instruments may be included (gross)
within other financial assets and other financial liabilities, respectively, with additional
details disclosed in the notes to the financial statements.

The ability to designate any financial asset or financial liability at fair value through
profit or loss means that not all financial instruments in this category will be current.
No guidance has been included in the amended standards on how to present these
instruments. We consider that they should be shown as a separate category.
10.2.2 Remeasurement gains and losses as a component of equity

32.59 Fair value adjustments on available-for-sale securities that are reported in equity and
remeasurement gains and losses on cash flow hedging instruments and net investment
32.94 hedges are each included as separate components of equity. However, it is not required
to present such balances as separate components of equity on the face of the balance
sheet itself.
10.2.3 Netting
32.42 Financial assets and liabilities should be offset and the net amount reported in the balance
sheet only if both of the following conditions are met:
■ there is a legally enforceable right to set off the recognised amounts; and
■ there is the intention to settle on a net basis or to realise the asset and settle the
liability simultaneously.
These requirements may apply to instruments such as receivables and payables
with the same counterparty if a legal right of offset is agreed between the parties.
It would not be appropriate to offset assets and liabilities that the entity has with
unrelated counterparties. Neither of the conditions noted above is likely to be met
in these circumstances.
The offset conditions are not met for derivative instruments simply because they are
issued by the same counterparty, even if there are master netting agreements in place.
Therefore, derivatives with positive and negative fair values are generally reported gross
10.2 Balance sheet presentation 185

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as assets and liabilities, respectively. Master netting agreements are discussed later in
Section 10.5.4.2.
Hedging instruments and the related items being hedged generally do not meet the
conditions for offset. Therefore, the fair values of hedging derivative instruments should
be shown as separate assets or liabilities in the balance sheet and not presented in the
same balance sheet line item as the hedged item.
10.3 Liability versus equity

32.18 Classifying instruments as either liabilities or equity in the financial statements of the
issuer often presents difficulties. In determining the classification, the substance of the
instrument rather than its legal form takes precedence. There could be situations where
instruments that qualify as equity for legal or regulatory purposes (such as certain preferred
shares) are recognised as liabilities for financial reporting purposes. This differs from
accounting practice in many countries and can have a significant impact on the financial
statements. Instruments commonly affected by this requirement include preference shares,
other classes of shares that have special terms and conditions, subordinated instruments,
convertible instruments and perpetual instruments.
The balance sheet classification determines the treatment of distributions as interest or as
dividends. If an instrument is classified as a liability under IFRS, its coupon payments and
any amortisation of discounts or premiums are recognised as finance costs in the income
statement. If an instrument is classified as equity, the dividends declared and paid are
accounted for in equity and do not flow through the income statement.
32.17 and 19(a) The primary factor in distinguishing a financial liability and an equity instrument is whether
there exists a contractual obligation for the issuer to make payments (either principal,
interest or dividends, or both).
Any instrument that an issuer may be obliged to settle in cash or another financial instrument
is a liability regardless of the manner in which it otherwise could be settled, the financial
ability of the issuer or the probability of settlement being required. An obligation may arise
from a liability to repay principal or to pay interest or dividends. Only when an instrument
does not give rise to a contractual obligation on the part of the issuer is it equity.
Equity instruments include shares, options, warrants and any other instruments that evidence
a residual interest in an entity and that do not incorporate contractual obligations for the
issuer to deliver cash or another financial asset or to exchange financial instruments
under potentially unfavourable conditions.
32.15 The equity or liability classification is made at initial recognition and is not revised as a
result of subsequent changes in circumstances.
Figure 10.1 provides guidance on classifying an instrument as equity or as a liability.
186 10.3 Liability versus equity
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Figure 10.1 Decision tree for classification as a liability or equity
10.3.1 Discretionary payments

Dividends or other payments are discretionary only when the entity has no obligation to
declare and pay the dividends or similar payments. For example, dividends paid on ordinary
shares vary depending on the level of profitability. However, there is no requirement by
an entity’s board to declare a dividend on ordinary shares. Although there may be a
shareholder expectation that dividends will be declared and paid if a certain level of
profitability is achieved, this does not give rise to a contractual obligation.
On the other hand, dividends that are obliged to be paid at an agreed rate (e.g. annual
six per cent mandatorily payable dividend) give rise to a contractual obligation. The fact
that the issuer may be unable to pay the dividends does not take away the obligation.
Examples of the application of the principles of IAS 32 to some common types of
instruments are illustrated listed in Table 10.1.

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Table 10.1 Classification of issued instruments
Liability
Perpetual debt instruments
Redeemable preference shares
Non-redeemable preference shares with mandatory dividends
Puttable instruments
Bond or share with a contingent settlement provision that may require the issuer to
settle in cash or other financial assets
Subordinated liabilities
Contractual obligations that will be settled in cash or by issuing a variable number
of shares
Equity
Non-redeemable preference shares with discretionary dividends
Ordinary share capital
Compound instrument
Convertible bonds
Convertible preference shares
An instrument that does not establish an explicit contractual obligation to repay may
establish it indirectly through its terms and conditions. The idea of economic compulsion
is that by the terms and conditions set out in the instrument, the issuer and the holder have
tacitly agreed that the instrument will be repaid. For example, Entity A issues an instrument
that may be settled for (a) cash of 100 or (b) delivery of 50 of Entity A’s own shares
(which have a current price of 10 per share). At inception of the instrument there is a high
expectation that Entity A is economically compelled to settle for cash. In this case, the
instrument is classified as a financial liability.

32.17-20 The amended standards place more emphasis than the existing standards on the notion
of discretion to avoid payment. If an entity does not have an unconditional right to
avoid a contractual obligation, that obligation meets the definition of a financial liability
under the amendments.
32.25 This extends to instruments that contain a contractual obligation to deliver cash (or
another financial asset) depending on the outcome of an event which is beyond the
control of the issuer. Such an event would include the issuer’s revenue, profit or reserves
reaching, or failing to reach, a certain level. If the issuer does not have an unconditional
right to avoid payment, the instrument is classified as a liability. The only exceptions
are circumstances when the cash settlement clause is not ‘genuine’ or when cash
settlement is required only in the event of the issuer’s liquidation.
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10.3.2 Compound instruments
32.28 A financial instrument may include both liability and equity components. In such cases,
the instrument should be classified into its component parts. These must be presented
separately in the balance sheet. As noted previously, the classification of the equity and
the liability components of an instrument is based on the substance rather than the form
of the components.
The allocation of the instrument into its component parts should be performed on initial
recognition of the compound instrument such that no gain or loss is recognised.
The recommended approach to perform the allocation is as follows:
32.31 ■ Determine the amount to allocate to the liability element. This is the future interest
and principal cash flows on the liability component, discounted at a rate applicable to
a similar liability without an equity component. The value of any embedded derivatives,
other than the equity feature, are included in the amount allocated to the liability.
■ Allocate the remaining amount of the issue proceeds to the equity element.

32.31 The amendments require that, because equity is a residual amount, the approach to
allocating the instrument into its component parts should be first to measure the liability,
including any non-equity derivatives such as issuer call options or prepayment options,
and then to allocate the remaining proceeds to the equity component.
The amended standards clarify that no gain or loss arises on initial recognition of a
compound instrument, nor on conversion at maturity. When an instrument is settled
before maturity, the proceeds are allocated between the liability and equity components,
using a methodology consistent with that required on initial recognition to determine the
liability component.
32.27 Some convertible bonds may contain an option allowing the issuer, if the conversion
option is exercised, to settle the instrument in cash. Even though such a clause would
not appear to create an obligation for the issuer, the standards are clear that any
settlement possibility other than delivery of a fixed number of shares for a fixed
amount of cash will result in the conversion feature (an equity call option) being
classified as a derivative liability. The only solution would appear to be for an issuer
to notify all its bond-holders that it has waived its right to cash settle and therefore to
render the cash settlement alternative invalid.
10.3.2.1 Convertible bonds

32.29 A common example of a compound instrument is convertible debt issued by an entity.
The instrument consists of a financial liability plus an option issued to the holder to convert
the instrument into equity shares of the issuer. The economic effect of this instrument (in-
substance) is the same as simultaneously issuing a debt instrument with an early settlement
provision and issuing warrants to purchase shares of the issuer.
Convertible bonds typically are issued with a low interest coupon because investors
view the ability to convert the instrument to the issuer’s shares as an opportunity to
participate in the potential upside from an increase in share price. By separating the

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convertible bond into its equity component (i.e. the conversion feature) and liability
component, this creates an additional discount on the liability that is amortised and
recognised in the income statement as interest expense until the date of redemption (or
conversion if that occurs earlier).
Case 10.1 Income statement impact of a convertible bond

Co X issues a bond convertible into the entity’s own shares in five years. The convertible
bond has a face amount of 100 and bears a stated coupon rate of three per cent, which
is below the current market rate for non-convertible debt instruments of similar entities.
Co X must determine the liability and equity components of the instrument. The liability
component is determined to be 85. The equity component is assigned the remaining
amount of 15. In addition to the three per cent interest expense recognised, Co X must
also amortise the discount of 15 over the term of the bond. This amortisation also is
included in interest expense. The coupon interest plus the amortisation amount should
result in Co X recognising interest expense on the liability at or around the market rate
of interest for bonds with similar terms, but without the conversion feature, when the
bond was issued.
10.3.3 Perpetual instruments

32.AG6 Perpetual debt instruments normally provide the holder with a contractual right to receive
interest payments extending into the indefinite future, with no right to a return of principal.
Even though the holder may not receive a return of principal, such instruments are a
liability of the issuer as there is a contractual obligation to make a stream of future interest
payments to the holder. The face value or the carrying amount of the instrument reflects
the present value of the holder’s right to receive a stream of interest in perpetuity.
10.3.4 Preference shares

32.19, AG25 Preference shares provide the holder with certain rights. Preference shares could have
and AG26 rights or characteristics that meet the definition of a liability rather than equity; therefore,
these must be considered when determining the appropriate classification.
Preference shares that provide for redemption at the option of the holder give rise to a
contractual obligation and should be classified as a liability. Where preference shares are
not redeemable at the option of the holder the appropriate classification depends on the
other terms of the preference shares, in particular the dividend rights attaching to the
shares. If the dividends are not discretionary, then the obligation to pay dividends gives
rise to a contractual obligation. Preference dividends that are payable at a specified rate
require special attention, and in many cases are not discretionary.
A typical example is a cumulative perpetual preference share where the issuer: (a) must
pay a dividend on the preference shares if it pays a dividend on its ordinary shares; and
(b) if it does not pay a dividend on its ordinary shares, the preference dividend may be
deferred (i.e. it is cumulative). This so-called dividend stopper feature does not by itself
create an obligation. However, the deferral feature will allow the instrument to be classified
as equity only if: (a) the accumulated dividends can be deferred indefinitely, even until the
entity is liquidated; and (b) there is no other feature of the instrument that would indicate
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its substance is a liability. For example, if the deferred accumulated dividends accrue
interest to compensate the holder for the deferral period, then the substance of the
instrument still is a liability.
10.3.5 Instruments to be settled in own equity
10.3.5.1 Obligation to settle in cash or a variable number of own equity shares

32.11 and 21 If an entity has an obligation that it can settle either by payment of financial assets or by
payment in the form of its own equity shares, there may be an issue as to whether the
obligation is a liability or equity. If the number of equity shares required to settle the
obligation varies with changes in fair value such that the total fair value of the equity
shares transferred always equals the amount of the contractual obligation, then the holder
of the obligation is not exposed to a gain or loss from the price of the equity shares.
Therefore, such an obligation should be accounted for as a liability of the issuer.
For example, an entity issues an obligation for 100 to be paid in cash or own equity shares
to the holder in six months. At issuance the entity’s shares have a value of 1.0 per share.
Due to changes in value of the entity over the six-month holding period, the shares have
a value of 0.8 per share by the settlement date. If the entity settles in shares, it is obligated
to settle by delivering 125 shares to the holder (rather than the 100 shares owed at the
time the obligation was entered). The holder of the instrument in this situation is not
exposed to the market risk of the equity securities. The instrument would be classified as
a liability in this case.
Similarly, an entity may hold a forward, option, or other derivative instrument whose value
changes in response to something other than the market price of the entity’s own equity
securities, but that the entity can choose to settle in its own shares. This would not be
accounted for as an equity instrument, but rather as a derivative instrument, as the value of
the instrument is unrelated to the changes in fair value of the entity’s own shares. For example,
Entity A enters into a forward contract with a bank that it intends to settle in its own shares
in six months. The number of shares to be delivered at that time is based on the change in
share price of Entity B during the same period. If Entity B’s share price is lower at the end
of six months, Entity A will deliver fewer of its own shares to the bank. In this case, the
number of Entity A shares to be delivered always equals the value of the derivative based
on Entity B’s share price. As a result the instrument is classified as a derivative.
10.3.5.2 Share warrants or options

An option or warrant on an entity’s own equity is not accounted for as an obligation when
issued if there is no requirement for repayment in cash or other financial assets and the
contract will be settled by the entity issuing a fixed number of its own shares. In such
cases the entity does not have a contractual obligation to settle in a financial asset or to
exchange financial instruments under conditions that are potentially unfavourable.
If an entity issues a warrant or option on its own shares and the holder has a right to
request cash settlement, or the transaction must be settled in cash, the instrument is a
liability. The entity is either required to settle in cash, or can be compelled by the holder
to settle in cash. As a result, the entity has an obligation to deliver cash or exchange
financial instruments (i.e. receive shares and deliver cash in this case) under conditions

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that are potentially unfavourable. Therefore, the instrument is a liability. It is accounted
for as a derivative liability.
10.3.5.3 Obligation to settle in cash or shares, depending on the outcome of uncertain events
32.25 If an instrument will be settled by an entity issuing its own shares or in cash depending on
the outcome of uncertain future events that are beyond the control of the holder or the
issuer, the instrument should be classified as a liability (as a default treatment) unless the
probability of settlement in cash or another financial asset is remote. It is only in cases
where settlement in cash or another financial asset is extremely unlikely that such an
instrument is not treated as a liability.
In our view, in each of the following situations it would not be reasonable to conclude that
the possibility of cash settlement is remote; therefore, the instrument should be classified
as a liability:
■ an instrument that is convertible or redeemable at the option of the holder;
■ an instrument that is redeemable if the share price reaches a certain level; and
■ an instrument that is redeemable if an anticipated initial public offering does not occur.

The amended standards clarify certain existing guidance and at the same time bring
tighter requirements that must be met before an instrument can be classified as equity.
32.AG27 The amended standards confirm that an instrument that is settled for a fixed or
determinable value, but in the form of a variable number of the entity’s own shares is
a liability. The entity’s equity instruments are then used only as a currency in which the
transaction is settled. Examples are:
(a) a contract to deliver as many of an entity’s own equity instruments as are equal in
value, at the date of settlement, to 100; or
(b) a contract to deliver as many of an entity’s own equity instruments as are equal in
value, at the date of settlement, to 100 ounces of gold.
Derivative instruments, such as share options, whose underlying is the entity’s own equity
are classified as equity only if they will and can only be settled by the entity exchanging
a fixed number of its own equity instruments for a fixed amount of cash. Any other
settlement possibility, even at the discretion of the entity itself, will result in the instrument
being classified as a financial asset or financial liability, often as a derivative instrument.
However, despite its classification as a derivative liability, this will be measured as if it
were a financial liability (i.e. at the present value of the gross future cash flow).
Some instruments, such as a forward purchase of own shares or a written put option
on own shares, may or will require the entity to deliver cash (or another financial asset)
to repurchase its own shares. Any instrument that creates a potential obligation for an
entity to settle in cash (or other financial assets) is required to be treated as a financial
liability measured at the present value of the gross obligation. For example, even though
the derivative itself may be an equity instrument (if it is fixed cash for fixed shares
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only), an entity is required to recognise a liability for the present value of the redemption
amount, with a corresponding debit to equity. In effect, a reclassification is made from
equity to reflect the obligation to repurchase the shares in the future. If the contract
expires without the obligation being settled, for example, if a put option is not exercised,
then the carrying amount of the liability at that time is reclassified to equity.
32.18 The amended standards also deal specifically with puttable instruments. Typically these
are instruments issued by investment funds, cooperatives and similar entities, that are
redeemable by the holder at net asset value. Although the legal form of such financial
instruments often includes the right to a residual interest in the assets of an entity, the
inclusion of an option for the holder to put the instrument back for cash or another
financial asset means that the instrument meets the definition of a financial liability.
The classification as a financial liability is independent of considerations such as when
the right is exercisable, how the amount payable on exercise is determined and whether
the instrument has a fixed maturity. They are measured at the amount that would be
payable if the instrument was redeemed at the balance sheet date. The amended standards
require that such instruments are presented as liabilities, but do not preclude such items,
on the balance sheet, from being included within a ‘total members’ interests’ sub-total.
32.33 Finally, the amended standards confirm a requirement previously in SIC–16 Share Capital
– Reacquired Own Equity Instruments (Treasury Shares) that treasury shares held
by an entity are treated as equity instruments, and that no gain or loss arises on the
acquisition or disposal of treasury shares. The requirements have been extended to apply
to all treasury shares, including those relating to equity compensation plans.
32.26 and 27 SIC–5 Classification of Financial Instruments – Contingent Settlement Provisions
has been withdrawn. Therefore, under the amended standards, any instrument that
creates a potential obligation for an entity to settle in cash (or other financial assets) is
classified as a liability, even if the obligation is contingent on uncertain future events,
unless the cash settlement provision is not genuine.
The approach to be taken in determining whether a transaction in an entity’s own
equity gives rise to a liability, derivative or transaction in equity is as follows:

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10.4 Income statement presentation
There is currently no specific guidance on the income statement presentation of gains or
losses on financial instruments. We expect this issue to be addressed during the IASB’s
project on performance reporting. In the meantime we recommend that gains and losses
on financial instruments be reported in the most appropriate line item according to their
nature. For example, it is common practice for foreign currency gains and losses that
arise from operating activities to be presented as part of operating income or expenditure
and exchange gains and losses related to financing activities to be presented as part of
financial income or expenditure.
10.4.1 Presentation of gains and losses on hedging activities

Gains and losses on derivative hedging instruments have three possible elements, which
are: (a) the effective portion; (b) the ineffective portion; and (c) the portion excluded
from the assessment of effectiveness.
As the financial instruments standards are silent as to the presentation of these items in
the income statement, there are several alternatives to consider when recording such
gains and losses. The following alternatives relate to a fair value hedge. The same
possibilities exist for a cash flow hedge (although the timing of recognition of the effective
portion of the hedging instrument would be different):
■ present the entire change in fair value of the derivative hedging instrument in the
same line item as gains and losses from the hedged item;
■ present the effective and ineffective portions of the derivative hedging instrument in
the same line item as gains and losses from the hedged item. Present the portion
excluded from the assessment of hedge effectiveness in the same line item as gains
or losses on non-hedging derivative instruments; or
■ present only the effective portion of the derivative hedging instrument in the same
line item as the hedged item. Present the ineffective portion and the excluded portion
in the same line item as gains or losses on non-hedging derivative instruments. In our
view, this is the preferred alternative.
If hedge accounting is not applied to a derivative instrument, it is preferable that the gains
or losses on the derivative instrument are not presented as an adjustment to revenues,
cost of sales or other line items related the hedged item, even if the derivative instrument
is intended to be an economic hedge of these items. However, there are no specific
requirements in IFRS addressing the presentation of derivatives.
10.4.2 Presentation of gains and losses on trading activities

1.35 and 32.94(h) Gains and losses arising from disposals of trading instruments and changes in the carrying
amount of trading instruments, including foreign currency gains and losses and investment
income from trading instruments are normally reported on a net basis. A split of realised
and unrealised gains and losses on instruments held for trading is not required.
194 10.4 Income statement presentation
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32.94 The amendments clarify that there is no requirement separately to disclose interest
income or expense arising from other fair value changes on instruments carried at fair
value through profit or loss.
10.4.3 Presentation of changes in equity

If a statement of changes in equity is presented as a primary financial statement, the
available-for-sale revaluation reserve, cash flow hedge reserve, and foreign currency
translation reserve should each be presented separately in the statement. If instead an
entity presents a statement of total recognised gains and losses, then the amounts
recognised in equity and the amounts removed from equity should be disclosed as
components of the total recognised gains and losses. In addition, a reconciliation of the
movements in each of these components of equity should be shown in the notes to the
financial statements.
10.5 Required disclosures
10.5.1 General
32.51 The disclosure requirements are focused on providing information that enhances a user’s
understanding of the impact of financial instruments on the entity’s financial position,
32.56 and 57 performance and cash flows. In addition to specific disclosures regarding particular
instruments, entities are required to provide a discussion of financial risk management
objectives and policies, including hedging policies.
32.53 and 55 To the extent that required information for financial instruments is presented on the face
of the balance sheet or income statement, it is not necessary to repeat such information in
the notes to the financial statements. When amounts stated in note disclosures relate to
line items in the balance sheet and income statement, sufficient information should be
provided to permit a reconciliation to these relevant line items.
32.90 and 93 Disclosure requirements also focus on providing fair value information for instruments
not carried at fair value.
KPMG’s IFRS Illustrative Financial Statements series contains example IFRS
disclosures. As such, example disclosures on financial instruments are not given in this
publication, with the exception of example hedging disclosures. The discussion below
focuses on the most common disclosures. Full details of disclosure requirements are
documented in the standards and in KPMG’s IFRS Disclosure Checklist.
10.5.2 Accounting policy notes

32.60 and 66 Significant accounting policies must be disclosed for each class of financial instrument.
These accounting policy notes should address the following:
■ the criteria applied in determining when to recognise a financial asset or financial
liability on the balance sheet and when to cease to recognise it;
■ the basis of measurement applied to financial assets and financial liabilities both on
initial recognition and subsequently;

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■ the basis on which income and expense arising from financial assets and financial
liabilities is recognised and measured;
32.61 ■ whether regular way transactions are accounted for at trade date or settlement date
for each category of financial asset; and
■ whether gains and losses arising from changes in the fair value of available-for-
sale financial assets are recognised in the income statement or as a separate
component of equity.
10.5.3 Terms and conditions of financial instruments

32.60 For each class of financial asset, financial liability and equity instrument an entity should
disclose information about the extent and nature of the instruments, including significant
terms and conditions that may affect the amount, timing and certainty of future cash flows.
32.62 For example, the foreign currency in which instruments are denominated should be disclosed
as well as maturities of instruments.
If no single instrument is individually significant, the disclosures should be given for
appropriate groupings of like instruments.
32.55 Financial instruments are grouped into classes based on such information as the
characteristics of the instruments, whether they are carried at fair value or cost and their
classification according to IAS 39.
When derivative financial instruments, either individually or as a class, create a potentially
significant exposure to risks, specific information to illustrate the terms and conditions
should be disclosed. Examples of the type of information that should be disclosed for
derivative instruments include:
■ the principal / notional amount i.e. the amount on which future payments are based;
■ the fair values i.e. the amounts included in the balance sheet in assets or liabilities,
respectively; and
32.60 ■ maturities based on the remaining period at the balance sheet date to the contractual
maturity date.
10.5.4 Disclosures of risk management policies

32.56 and 57 The risk management disclosure requirements in IAS 32 are expressed in general terms.
That standard does not prescribe either the format in which the information must be
disclosed or its location in the financial statements. Disclosures may include a combination
of narrative descriptions and specific quantified data, as appropriate to the nature of the
financial instruments. In addition, IAS 39 requires specific disclosures about hedge
accounting activities and specific quantitative information. Determining the level of detail
to be disclosed in each circumstance is an issue of judgement taking into account the
significance of each type of financial instrument.
32.60 Although the specific requirements of IAS 32 only refer directly to interest rate risk and
credit risk disclosures, the general disclosure requirements of the standard are sufficiently
broad to encompass all financial risks, including foreign currency risk and liquidity risk.
196 10.5 Required disclosures
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Therefore, appropriate disclosures regarding all financial risks should be provided.
Information normally would be provided about the existence and roles of risk management
committees and the process used by the entity to manage risk. Entities may also wish to
disclose details of management of non-financial risk (e.g. operational risks) if these risks
are significant.
The risk management disclosures usually will be preceded by a general discussion of the
entity’s activities, structure and financing that considers the financial risk profile of the
entity as a whole. In addition, management generally provides additional commentary on
the risk management activities in a financial review.
10.5.4.1 Interest rate risk

32.67 For each class of financial asset and financial liability an entity should disclose information
about its exposure to interest rate risk, including:
■ contractual repricing or contractual maturity dates, whichever dates are earlier; and
■ effective interest rates, when applicable.
Appropriate maturity groupings should be determined based on the characteristics of
outstanding contracts. Financial instruments that do not have a contractual maturity
date are usually allocated to maturity groupings based on the expected maturity date or
repricing date.
32.70 To supplement information about contractual repricing and maturity dates, an entity may
elect also to disclose information about expected repricing or maturity dates when those
dates differ significantly from the contractual dates.
32.71 The disclosures should include an indication of which financial assets and financial
liabilities are:
■ exposed to interest rate price risk – such as fixed interest rate financial assets and liabilities;
■ exposed to interest rate cash flow risk – such as floating rate financial assets and
liabilities; and
■ not exposed to interest rate risk – such as certain equity investments.
32.72 Effective interest rates only need to be disclosed for interest-bearing instruments or
those where interest can be imputed, such as zero-coupon bonds. Therefore, the
requirement applies to debentures, notes and similar monetary financial instruments
involving future payments that create a return to the holder and a cost to the issuer that
reflects the time value of money. The requirement does not apply to financial instruments
such as non-monetary instruments and derivatives that do not bear a determinable
effective interest rate.
The effective interest rates to be disclosed for floating rate instruments are the rates at
the balance sheet date. These are normally expressed in terms of the underlying index
and the margin, e.g. three-month LIBOR plus 0.5 per cent.

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10.5.4.2 Credit risk
32.76 For each class of financial asset, both recognised and unrecognised, an entity should
disclose information about its exposure to credit risk, including:
■ the amount that best represents its maximum credit risk exposure at the balance
sheet date, without taking account of the fair value of any collateral, in the event that
other parties fail to perform their obligations under financial instruments; and
■ significant concentrations of credit risk.
Such information is intended to enable users of the financial statements to assess the
extent to which failures by counterparties could reduce the amount of future cash flows
from financial assets on hand at the balance sheet date.
32.83 Concentrations of credit risk should be disclosed when they are not apparent from other
disclosures about the nature and financial position of the business and they result in
significant exposure to loss in the event of default by other parties. Concentrations of
credit risk may arise from exposure to a single debtor or groups of debtors having a
similar characteristic. A description of the shared characteristic that distinguishes each
concentration and the maximum credit risk exposure associated with all recognised and
unrecognised financial instruments sharing that characteristic should be disclosed.
32.81 Entities may be involved in one or more master netting agreements that serve to mitigate
exposures to credit losses but do not meet the criteria for offsetting. When these master
netting agreements significantly reduce credit risk associated with financial assets that
are not offset in the financial statements with financial liabilities related to the same
counterparty, additional disclosure should be provided. This disclosure should indicate:
■ that the credit risk of the financial assets subject to the master netting arrangement is
eliminated only to the extent that financial liabilities due to the same counterparty will
be settled after the assets are realised; and
■ the extent to which the overall credit risk exposure is reduced through a master
netting agreement may change substantially within a short period following the
balance sheet date because the exposure is affected by each transaction subject to
the agreement.
10.5.5 Hedging
32.56, 58 and 59 The disclosures relating to hedging and hedge accounting activities can be viewed as a
top-down approach to disclosure through the combination of the risk and the more specific
transactional disclosures in IAS 32. This approach can be further described as follows.
An entity would satisfy the broader disclosure requirements by describing its overall
financial risk management objectives, including its approach towards managing financial
risks. Disclosures should explain what are the financial risks, how the entity manages the
risk and why the entity enters into various hedging instruments.
At the next level of detail, the entity should disclose its risk management policies. This would
include more specifically the hedging strategies used to mitigate financial risks.
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This may include a discussion of:
■ how specific financial risks are identified, monitored and measured;
■ what specific types of hedging instrument are entered into, and how these instruments
modify or eliminate risk; and
■ details of the extent of transactions that are hedged.
Lastly, an entity is required to make specific disclosures about its outstanding hedge
accounting relationships. The following disclosures are made separately for fair value
hedges, cash flow hedges and hedges of net investments in foreign entities:
■ a description of the hedge;
■ a description of the financial instruments designated as hedging instruments for the
hedge and their fair values;
■ the nature of the risks being hedged;
■ for hedges of forecasted transactions, the periods in which the transactions are expected
to occur, when they are expected to affect net income, and a description of any
forecasted transactions that were originally hedged, but are now no longer expected
to occur. IAS 32 does not specify the future time bands for which the disclosures
should be made. Management should decide on appropriate groupings based on the
characteristics of the forecasted transactions;
■ if a gain or loss on derivative or non-derivative financial assets and liabilities designated
as hedging instruments in cash flow hedges has been directly recognised in equity, the
following should be disclosed:
– the amount recognised in equity during the reporting period;
– the amount removed from equity and reported in the income statement; and
– the amount removed from equity and added to the initial measurement of the
balance sheet amount for a hedged forecasted transaction; and
32.58 and ■ if an instrument is used to hedge one risk in a cash flow hedge and another risk under
IG F.1.12 a fair value hedge, separate disclosures for the two hedges should be provided.
The cases below are intended to provide examples of typical disclosures of hedging
activities. The level of detail of disclosures will vary depending on an entity’s use of
hedges and derivative financial instruments. Therefore, entities should not view the
examples below to be boilerplate disclosures, but rather illustrative guidance of the
above disclosure requirements.
Case 10.2 Example disclosure of risk management objectives and policies

32.56 AB Corp (ABC) uses derivative financial instruments to reduce exposure to fluctuations in
interest rates and foreign exchange rates. The entity does not enter into derivative financial
instruments for any purpose other than hedging. ABC has a risk management committee,
including members of senior management, that continually monitors the entity’s exposures
to interest rate risk and foreign currency risk as well as its use of derivative instruments.

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ABC uses variable rate debt to finance its operations. ABC issues variable rate medium-
term notes and commercial paper depending on the entity’s financing needs. The entity
is exposed to variability in interest payments due to changes in interest rates.
Management has established the policy of limiting the entity’s exposure to variability in
interest rates to 60 to 70 per cent of its anticipated interest payments in each period.
ABC achieves this through the use of interest rate swaps and caps.
The interest rate swaps change the variable rate cash flow exposure from the medium-
term notes so that ABC is in a pay-fixed, receive-variable position. ABC makes fixed
interest payments to the counterparty and receives variable interest payments, which
are settled on a net basis. The interest rate caps limit the entity’s exposure to increases
in interest rates above a certain amount on its commercial paper liabilities.
ABC has several subsidiaries in foreign countries that operate using the local currencies
of those countries. ABC is exposed to foreign currency risk arising from foreign-
currency denominated forecasted transactions and net investments in foreign operations.
Management uses certain derivative instruments with the specific intention of minimising
the impact of foreign currency fluctuations on income. ABC enters into foreign currency
forward contracts on its forecasted sales transactions in foreign countries. The risk
management policy requires at least 50 per cent of sales anticipated for a period of
six months in advance to be hedged. However, this percentage may be higher in certain
countries where management perceives there is greater exposure to foreign currency
fluctuations. In all cases the level of anticipated sales hedged is considered highly
probable of occurring based on historic sales levels and current budgets and forecasts.
ABC has net investments in foreign subsidiaries in Country A and Country J for
which ABC enters into foreign currency forward contracts to sell foreign currency
of those countries. ABC reviews the net investment balances in the subsidiaries and
adjusts the hedge on a quarterly basis to the respective values of the net investments
in the subsidiaries.
Case 10.3 Example disclosures of types of hedges
Fair value hedge

32.58 Corporate A has designated a fair value hedge of its fixed rate liabilities of 5,000,000.
Corporate A has entered into an interest rate swap with a notional amount of 5,000,000
whereby it receives a fixed rate of eight per cent and pays a variable rate based on
LIBOR. It is Corporate A’s policy to limit overall exposure to interest rate risk by
entering into interest rate swaps to enable it to match its funding with its variable rate
interest-bearing assets. At 31 December 20X1, the fair value of interest rate swaps
is (47,000).
Cash flow hedge

Manufacturer B has designated cash flow hedges of its export sales since export sales
generally are denominated in the customers’ measurement currency. Manufacturer B
has entered into foreign currency forward contracts to hedge its exposure to foreign
currency fluctuations. Manufacturer B hedges at least 70 per cent of anticipated export
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sales for a period of three months in advance. Manufacturer B considers these

anticipated sales to be highly probable based on past experience and considering budgets
and forecasts. At 31 December 20X1, all hedged export sales are still expected to
occur. At this date, Manufacturer B has several foreign currency forwards to sell
foreign currency, which are summarised as follows:
Fair value at
31 December
Notional Transaction 20X1
Contract amount date (in MC)
FC-1 4,000,000 15 January 20X2 (215,000)
FC-2 2,000,000 15 February 20X2 (132,000)
FC-3 1,000,000 15 March 20X2 (45,000)
Case 10.4 Example disclosure of gains or losses on hedging instruments

recognised in equity
32.59 The table below shows changes in the cash flow hedging reserve (a component of
equity) during the year ended 31 December 20X1.
Balance of cash flow hedging reserve at 1 January 20X1 X
Effective portion of gains or losses on hedging instruments used in cash flow hedges X
Gains or losses on hedging instruments transferred to the income statement (X)
Gains or losses transferred to adjust the initial measurement of the hedged asset (X)
Balance of cash flow hedging reserve at 31 December 20X1 X
32.58 and 59 The following table shows when the gains and losses reported directly in equity are
expected to enter into the determination of net profit or loss. Where the derivatives
hedge anticipated acquisitions of assets, the amounts will adjust the initial measurement
of the underlying asset, and will affect net profit or loss only when the underlying asset
does so. Otherwise the gains and losses will be reported in net profit or loss when the
forecasted transaction occurs and is recognised in the income statement.
Gains 20X1 Losses 20X1
Adjustments reported in income when the forecasted
transaction occurs:
Less than three months
Between three months and one year
More than one year
Adjustments to initial measurement of an asset:
Less than one year
Between one and two years
Between two and five years
More than five years

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The expected timing of recognition of those gains and

losses that will adjust the initial measurement of assets
and liabilities is as follows:
Less than one year
Between two and three years
More than three years
10.5.6 Income statement disclosures

32.94 Disclosure of significant items of income, expense, gains and losses resulting from financial
assets and liabilities should be made. These disclosures should be made regardless of
whether such items are recognised in the income statement or included as a separate
component of equity, such as for certain available-for-sale assets and cash flow hedges.
IG G.1 To comply with this requirement, details of significant fair value changes should be provided
for each of the following categories of instruments, distinguishing between changes that
are reported in net profit or loss and changes that are included in equity:
■ available-for-sale assets;
■ trading assets and liabilities; and
■ hedging instruments.
In addition, details of the components of changes in fair value may be disclosed based on
managements’ classification for internal purposes. For example, an entity may choose to
disclose separately the change in the fair value of derivatives that do not qualify as hedging
instruments under IAS 39, but which are used by an entity as economic hedges.
Total interest income and expense must be disclosed separately on an historical cost basis.
Thus, if interest income from trading financial assets is included in a trading gain or loss line
on the face of the income statement, then the interest income should be disclosed separately.
If the interest income on such assets is accounted for as interest income on the face of the
income statement, then there is no need for separate disclosure. The requirement to disclose
interest income on a historical cost basis applies equally to interest-bearing available-for-
sale assets. Therefore, even if available-for-sale assets are remeasured to fair value through
equity, interest income on these instruments must be calculated using the original effective
interest rates of the instruments. This interest income should be recognised in the income
statement and disclosed as part of the total interest income.

32.94 The amendments do not require separate disclosure of interest income for instruments
that are measured at fair value through profit or loss. We recommend that gains and
losses on trading instruments, and gains and losses on instruments classified as fair
value through profit or loss are disclosed separately.
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10.5.7 Fair value disclosures
Methods and significant assumptions applied in estimating fair values of financial assets
and liabilities must be disclosed. This should be done for each significant class of financial
asset and liability. As part of this disclosure it is necessary to disclose
32.92 and 93 ■ how fair value is determined, e.g. quoted market prices, discounted cash flows and
other valuation techniques; and
■ significant assumptions used in the calculation, e.g. prepayment rates, rates of estimated
credit losses and interest or discount rates.
32.86 For each class of financial asset and financial liability an entity should disclose information
about fair value. This fair value need not be separately disclosed if the financial instruments
are carried at fair value. For example, a separate disclosure of the fair value of available-
for-sale securities generally would not be considered necessary as these instruments are
carried at fair value.
32.90 When it is not practicable within constraints of timeliness or cost to determine the fair
value of a financial asset or financial liability with sufficient reliability, that fact should be
disclosed together with information about the principal characteristics of the underlying
financial instrument that are pertinent to its fair value.
32.90 As described in Section 6 on subsequent measurement, IAS 39 presumes that a reliable
fair value can be determined for almost all financial assets. The only exception to this is
certain unquoted equity instruments or derivatives linked to such equity instruments for
which a reliable fair value cannot be obtained. If any trading or available-for-sale financial
assets are not stated at fair value because their fair value cannot be measured reliably,
the entity must instead disclose:
■ the fact that these assets cannot be reliably measured;
■ a description of the financial assets;
■ the carrying amount;
■ an explanation of why fair value cannot be measured reliably; and
■ if possible, the range of estimates within which fair value is likely to lie.
32.90 If any financial assets that were not stated at fair value because their fair value could not
be measured reliably are sold, disclose:
■ the fact that they have been sold;
■ their carrying amount at the time of sale; and
■ the gain or loss recognised.
If financial assets are carried in the balance sheet at an amount in excess of fair value, the
entity should disclose the carrying amount of the financial assets and the reasons for not
reducing the carrying amount, including the nature of the evidence that provides the basis
for management’s belief that the carrying amount will be recovered. Generally this will only
be the case for either originated loans and receivables and held-to-maturity assets that
management has determined to be not impaired under IAS 39’s impairment principles.

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10.5.8 Other disclosures
32.94(h) If the change in fair values of available-for-sale financial assets is recognised as a
component of equity, a reconciliation of the movements in this component of equity during
the reporting period should be disclosed.
12.81 Revaluations of financial instruments often give rise to deferred tax temporary differences.
The amount of deferred tax relating to each category of temporary difference must be
disclosed. Therefore, deferred tax relating to each category of financial instruments should
be separately disclosed. Current and deferred tax that arises on available-for-sale financial
assets that are revalued through equity, as well as derivatives used in cash flow hedges,
will be reported directly in equity. This deferred tax should be included in the disclosure of
the total amount of current and deferred tax reported directly in equity.
32.94(g) The reason for reclassifications into the held-to-maturity category should be disclosed, if
any have occurred.
32.94(a) If securitisations or repurchase agreements have occurred in the current reporting period
or there are remaining interests from such transactions in previous reporting periods, the
following should be disclosed:
■ the nature and extent of such transactions; and
■ whether the financial assets have been derecognised.
32.94(i) For each significant financial asset, the nature and amount of any impairment loss or
reversal of impairment provision balance should be disclosed – effectively a roll forward
of the impairment loss. The amount of interest income that has been accrued on impaired
loans, but has not yet been received, should also be disclosed.
32.94(b) The aggregate carrying amount of secured liabilities and the nature and carrying amount
of the assets pledged as security as well as any significant terms and conditions relating
to the pledged assets should be disclosed.
A lender should disclose:
32.94(c) ■ the fair value of collateral that it has accepted and is permitted to sell or repledge;
■ the fair value of collateral that it has sold or repledged; and
■ any significant terms and conditions associated with its use of the collateral.
32.94(e) The following disclosures are encouraged when they are likely to enhance the financial
statement user’s understanding:
■ the total amount of the change in the fair value of financial assets and financial
liabilities that has been recognised as income or expense for the reporting period; and
■ the average aggregate fair value during the reporting period of all financial assets and
financial liabilities, particularly when the amounts on hand at the balance sheet date
are unrepresentative of amounts on hand during the reporting period.
March 2004
Reference

The amended standards will introduce the following additional disclosure requirements:
■ information about the use of valuation techniques, including the sensitivities of fair
value estimates to changes in key assumptions;
■ information about assets retained in transactions that do not qualify for derecognition
in their entirety;
■ the carrying amounts of trading assets and liabilities and, separately, those designated
on initial recognition as fair value through profit or loss;
■ the amount of the fair value change of a financial liability designated as fair value
through profit or loss that arises from factors other than changes in market interest
rates (e.g. changes in the entity’s own credit risk);
■ information about compound instruments that have multiple embedded derivative
features; and
■ information about defaults by the entity on loans payable and other breaches of
loan agreements.

March 2004
11. Transition and implementation of IAS 39

■ Transition rules for first-time adopters and for existing IFRS users
■ Practical considerations when adopting IAS 39

The amended IAS 32 and IAS 39 become operative for financial years beginning on or
after 1 January 2005. Early application is permitted, but an entity must then apply all the
requirements of both standards. Piecemeal application of the amendments is not permitted.
For entities that will be adopting IFRS for the first time, the IASB has clarified the required
transition adjustments for all existing IFRS and SIC interpretations in its standard IFRS 1
First-time Adoption of IFRSs.
For entities currently using the existing IAS 39, the transitional requirements are broadly
retrospective, with one or two exceptions. For first-time adopters of IFRS an opening
balance sheet adjustment is made, but comparatives are not required to be restated.
11.2 First-time adoption of IFRS

IFRS 1 generally requires full retrospective application of all IFRS effective at the reporting
date for an entity’s first IFRS financial statements. There are certain limited exemptions
to this principle, including in the area of financial instruments.
The most significant exception to the principles in IFRS 1 for financial instruments is that
an entity applying IFRS for the first time before 1 January 2006 need not restate its
comparative information with respect to IAS 32 and IAS 39. The date of transition, in
respect of these two standards only, becomes the first day of the entity’s first IFRS
reporting period, not the first day of the comparative period. At that date, the entity will be
required to make a number of adjustments, depending on its previous accounting for
financial instruments. Some of the possibilities are considered in Steps 1 to 9 below.
A significant exemption is available for transactions that took place before 1 January
2004 and resulted in the derecognition of one or more financial instruments under previous
GAAP. These are not required to be re-evaluated under the principles of IAS 39, although
partial or fully retrospective application is available.
Another exemption is that an entity that has issued instruments with liability and equity
components, such as convertible bonds, need not apply the ‘split accounting’ requirements
in IAS 32 if the instrument has been settled or converted before the date of transition.
In such cases, a fully retrospective application of IAS 32 would require no more than a
reclassification of amounts within equity, possibly between retained earnings and paid-
in capital.
206 11.2 First-time adoption of IFRS
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Reference
39.105 Set out below is a step-by-step approach to transitional accounting adjustments that might
be followed by entities adopting the revised financial instruments standards as part of a
wider IFRS conversion project. Further adjustments may be necessary following a more
detailed analysis of the facts and circumstances of each particular entity and the differences
between its existing accounting policies and the requirements of IFRS:
Step 1
An entity should consider whether it should recognise financial assets that were
derecognised under previous GAAP. Derecognition transactions taking place before
1 January 2004 are not required to be re-evaluated. Transactions taking place on or after
1 January 2004 that resulted in derecognition of one or more financial instruments must
be re-evaluated under IAS 39. If the instrument(s) would not have been derecognised
under IAS 39, they must be included in the opening IFRS balance sheet. Note, however,
that there is no exemption for first-time adopters from the requirement to consolidate any
special purpose entity into which financial assets may have been transferred.
39.105 Having recognised all financial instruments as appropriate, upon initial adoption an entity
should classify financial assets in accordance with one of the four categories specified in
IAS 39 (see Section 5). The process of classification will include designating financial
assets as held-to-maturity where appropriate, and also taking advantage of the free choice
at the date of transition to designate any non-derivative financial asset as available-for-
sale and any financial asset or financial liability as fair value through profit or loss. Note that
this last designation cannot be reversed.
Step 2
Instruments issued by an entity should be classified as either equity or as liabilities in
accordance with the criteria of the financial instruments standards (see Section 10).
IAS 32 requires that the entity considers the facts and circumstances at the time the
instrument was issued when determining classification as a financial liability or equity, not
the facts and circumstances at the date of transition.
32.15 Financial liabilities should be classified as either trading or non-trading liabilities, again
taking advantage of the free choice to classify liabilities as fair value through profit or
loss, where appropriate.
Step 3
For a compound instrument where the liability component is still outstanding at the transition
date, the entity must separately identify the liability and equity components. The equity
component must be split between the retained earnings component (i.e. cumulative interest
on the liability portion) and the true equity component. Again, the allocation between
liabilities and equity should be based on the circumstances at the date of issue of the
instrument, and the subsequent interest expense on the liability component should be
calculated using the effective yield method required by the standards.

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Step 4
An entity identifies those financial assets and liabilities that should be measured at fair
value and those that should be measured at amortised cost, based on their classification
(determined in Steps 1 and 2 above), and it should remeasure these as appropriate.
Any adjustment to the previous carrying amounts should be recognised as an adjustment
to the opening balance of retained earnings.
As an exception, the difference between the amortised cost and the fair value of an
available-for-sale financial asset is recognised in an available-for-sale fair value reserve
rather than in retained earnings. Upon subsequent disposal or impairment of the asset, the
amounts recognised in the reserve are released to the income statement.
In measuring financial assets and financial liabilities, fair value must be estimated using
the guidance in the standards and amortised cost must be measured using the guidance
on the effective yield method based on the estimated maturities of assets and liabilities.
Step 5
IFRS 1.IG59 The entity should assess whether any impairment write-downs, provisions or general
reserves under existing requirements need to be reversed and / or whether new impairment
write-downs should be provided under the incurred losses model in the standards.
Any adjustments should be recognised against retained earnings.
Step 6
39.105 The entity should recognise all derivatives, including embedded derivatives, in its balance
sheet as either assets or liabilities and should measure them at fair value. The difference
between the previous carrying amount (which may have been zero) and the fair value of
derivatives should be recognised as an adjustment to the opening balance of retained
earnings at this time. Any gains and losses on derivatives that are deferred amongst
assets and liabilities should be eliminated against retained earnings. As with other
adjustments, the separation of embedded derivatives from a host contract should be based
on the circumstances in place when the combined instrument was purchased or issued.
Further adjustments to establish transitional balances related to hedge accounting are
dealt with separately below.
Step 7
This stage will first involve determining whether hedge accounting has been applied under
the entity’s previous GAAP and, if so, how hedge accounting has been applied. This will
have a corresponding impact on the transitional adjustments.
In many cases, the entity’s previous GAAP may have little, if any, formal (or even informal)
guidance for hedge accounting. As a result, hedging relationships may not be documented;
in some cases it may be impossible to determine the precise purpose for which derivatives
were acquired under previous GAAP, and therefore to identify a hedged item under
previous GAAP. In such cases, no transitional hedge accounting adjustments will be
made. However, it may be clear from the accounting, particularly in respect of the hedging
instrument, that hedge accounting has previously been applied. For example, under certain
March 2004
Reference
GAAPs, where a derivative is used to hedge forecast transactions all changes in value of
that derivative, which are to be applied to the forecast transactions when they occur, are
kept off balance sheet with accrual accounting being applied to the derivative. In contrast,
where a derivative is not being used as a hedging instrument, it is held on balance sheet at
fair value with changes in value being included in profit or loss, or being taken to equity. In
other cases the entity may have documented the purpose for which a derivative was
acquired so that a hedged item can be identified under previous GAAP. However,
irrespective of the precise accounting, in each jurisdiction a review will be required to
determine whether or not hedge accounting has previously been applied.
Where hedge accounting has been applied under previous GAAP, the next step is to
consider whether the type of hedge accounting that has been applied is permitted by
IAS 39. This will be the case where the hedge falls within the IAS 39 definitions of fair
value or cash flow. Where the hedge does fall within one of these definitions, the transitional
rules set out below will apply. It is not necessary to determine at this stage whether the
hedge would or would not have met the hedge accounting requirements of IAS 39 as this
will apply only from the date of transition onwards (see Step 9 below).
IFRS 1.29 Where the type of hedge accounting applied under previous GAAP is not permitted by
IAS 39 (e.g. the use of a written option as the hedging instrument or, perhaps more
commonly found, the hedge of a net position), the derivative will be treated as a stand-
alone financial instrument on transition date. However, it might be possible, before transition
date, to re-designate hedging relationships to those which are permitted under IAS 39
(e.g. a hedge of a net position could be re-designated as a hedge of an underlying gross
position before the transition date), meaning that advantage could then be taken of the
transitional rules.
IFRS 1.IG60 Where a hedge does not meet the requirements of IAS 39 at the transition date, the entity
may then wish to consider whether it can document and, if necessary, re-designate the
hedge in order that it will comply with IAS 39 going forward (see Step 9 below).
Where a hedge can be identified under previous GAAP, and does fall within the fair value
or cash flow categories permitted by IAS 39, the following adjustments are required on
the date of transition, regardless of whether hedge accounting is to be claimed going
forward under IAS 39:
Fair value hedging relationships

The entity will adjust the carrying amount of the hedged asset or liability by the lower of:
IFRS 1.IG60A (a) the cumulative change in the fair value of the hedged item since inception of the
hedge that is due to the hedged risk and was not recognised under the entity’s previous
GAAP; and
(b) the cumulative change in fair value of the hedging instrument that is in respect of the
designated hedged risk and, under previous GAAP, was either not recognised or was
deferred in the balance sheet as an asset or liability.

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Reference
Cash flow hedging relationships
IFRS 1.IG60B The entity will reflect the entire cumulative gain or loss on the hedging derivative since
the inception of the hedging relationship in equity (under Step 4 this will already have
been dealt with, the full amount of any change in value having been taken to retained
earnings). To the extent that the related forecast transaction is either highly probable or
expected to occur at the transition date, an amount will be transferred out of retained
earnings and recognised in a separate cash flow hedging reserve. Any excess amount
which, at the transition date, represents transactions which are not expected to take
place, will remain in retained earnings.
Net investment hedging relationships

IFRS 1.22 These are not dealt with specifically by the transitional guidance. However, it is noted in
IAS 39 that net investment hedges are accounted for in a similar manner to cash flow
hedges. In our view the same basic process as set out above should be followed.
However, where advantage is taken of the transitional relief included in IFRS 1 to set the
translation reserve to nil on transition date, the related hedge reserve will also be set at nil
with any adjustment arising from the recognition of the derivative or non-derivative hedging
instrument being taken to retained earnings.
Step 8
An entity may, on transition to IFRS, take the opportunity to review one or more of its risk
management policies or processes, or to change the types of hedging instrument in order
to be able to apply hedge accounting in the most cost-effective way under IFRS.
Step 9
IFRS 1.IG60 An entity will then consider which of its hedging relationships it wishes to designate as
hedges under IAS 39 from the date of transition and, if so, whether these meet the strict
criteria for hedge accounting. Retrospective designation is not permitted, meaning that on
the date of transition those relationships will need to be formally documented and meet
the prospective effectiveness test. As noted in Step 7 above, some hedging relationships
that existed under the entity’s previous GAAP may not qualify for hedge accounting at all
under IAS 39, meaning that a change in hedging strategy may be required.
IFRS 1.IG60, Where adjustments were made in respect of existing hedging relationship on the date of
IFRS 1.IG60B transition under Step 7, but hedge accounting is not claimed going forward under IAS 39,
and 39.101 hedge accounting will be discontinued prospectively with the normal IAS 39 rules applying
to the related balances that arose on transition.
Comparative information and disclosure

IFRS 1.36A As noted above, an entity applying IFRS for the first time before 1 January 2006 need not
restate its comparative information with respect to IAS 32 and IAS 39. The date of
transition, in respect of these two standards only, becomes the first day of the entity’s first
IFRS 1.IG53 and IFRS reporting period, not the first day of the comparative period. However, as noted
IFRS 1.27 above, derecognition transactions entered into on or after 1 January 2004 may need to be
restated, with associated disclosure being made.
March 2004
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IFRS 1.36A An entity that chooses to present comparative information that does not comply with
IAS 32 and IAS 39 in its first year of transition is required to apply its previous GAAP to
financial instruments within the scope of IAS 32 and IAS 39 in its comparative information
and disclose that fact. In addition, disclosure is required of the nature (but not the amount)
of the main adjustments that would be required to make the information comply with
IAS 32 and IAS 39.
IFRS 1.36A(c) A reconciliation is required between the balance sheet at the date of transition (for the
IAS 8.28 purposes of IAS 32 and IAS 39) and the comparative period’s reporting date with
disclosures required by IAS 8 Accounting Policies, Changes in Accounting Estimates
and Errors on a change in accounting policy. This disclosure includes the nature of the
change in policy, a description of transitional provisions and the amount of the adjustment
required to each financial statement line item.
IFRS 1.25A In addition, an entity may choose to designate a previously recognised financial asset or
liability as a financial asset or liability at fair value through profit or loss, or as available-
for-sale. In such cases, disclosure is required of the fair value of the assets and liabilities
classified into each category and the classification and carrying amount in the previous
financial statements.
11.3 Transition requirements for existing users of IFRS

The amendments described throughout this publication highlight the areas where
adjustments may be required. The choice of which, if any, financial instruments an entity
will designate, by choice, as either fair value through profit or loss or available-for-sale as
permitted under the amended standards may be one of the most significant changes.
Reclassification of transactions in own equity may also have a significant impact.
The standards should be applied retrospectively by adjusting the opening balance of retained
earnings in the earliest period presented, and other comparative amounts as necessary.
The exceptions are:
■ if an entity derecognised a financial asset under the existing standards before 1 January
2004, it need not consider whether that asset should be reinstated under the amended
standards. It may, however, choose a date earlier than 1 January 2004 and restate for
derecognition transactions that took place after that earlier date; and
IFRS 1.IG59 and ■ any ‘basis adjustment’ made to a non-financial asset or liability should not be reversed,
IFRS 1.29 even if the entity does not intend to use that method in the future. However, any basis
adjustment recognised to a financial asset or liability should be restated, and any
amounts deferred in a cash flow hedge reserve for hedges of firm commitments
(except those in a foreign currency) should be adjusted against the related assets
following the fair value hedging model.
11.3 Transition requirements for existing users of IFRS 211

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11.4 First time implementation: practical considerations
11.4.1 Organising the implementation effort

Due to the far-reaching impact of IAS 39 on an entity’s day-to-day operations, the
implementation effort must reach across functions and involve a multi-disciplinary group.
An effective implementation team would generally include the following functions:
■ treasury;
■ financial controllers, internal accounting policy makers, and external financial reporting;
■ internal and external audit;
■ financial risk management department;
■ legal and tax departments;
■ compliance department; and
■ information technology.
The implementation effort should include those knowledgeable about the entity’s current
strategies and usage of financial instruments and hedging; current accounting practices;
treatment under IFRS requirements; systems capabilities and legal contracts.
The level of resources required for the implementation effort is dependent on the
structure and size of the entity. An entity that operates in distinct business units must
ensure that all of these units are included in the implementation effort to foster consistent
adoption across the entity. An entity with centralised functions might require only a
smaller implementation team.
11.4.2 Analysing the entity’s exposure to financial instruments

The entity must first identify all of its financial assets and liabilities and classify these
based on their purpose and term prior to determining which should be carried at fair
value and which at amortised cost. Instruments classified as liabilities or as equity
under the previous GAAP may need to be reclassified under IAS 32. The entity must
also identify all contracts that meet the definition of a derivative under IAS 39 and
identify all embedded derivatives.
Consideration must be given to potential changes in policies resulting from recognition
and derecognition criteria, especially with respect to securitisations, securities lending,
repurchase agreements, transfers relating to components of assets or liabilities and where
new assets or liabilities arise.
For existing hedge relationships that qualify for hedge accounting under IAS 39, the entity
should determine whether the ongoing relationship represents a fair value hedge or a
cash flow hedge. There may be instances where either hedging model can be used.
The entity should determine which model to use, as this will drive the ongoing accounting
for that relationship.
212 11.4 First time implementation: practical considerations
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Reference
Lastly, it is important to understand the impact that adoption of IAS 39 will have on
the entity’s financial statements, including its income statement, changes in equity
and balance sheet.
11.4.3 Amend internal policies and procedures

The entity should ensure that its documented policies and procedures on financial
instruments meet the requirements of IAS 39 in relation to recognition, derecognition,
measurement, and hedge accounting.
A hedge relationship must be documented from its inception, and meet the minimum
requirements that the relationship is clearly defined, measurable and effective.
The entity should determine and document how it expects to measure effectiveness
in its hedge relationships.
Certain hedging practices under the entity’s current strategies may no longer receive
hedge accounting treatment. As a result the entity must determine whether certain hedging
strategies should be modified. Also, changes to current practice may be required in order
to avoid forced reclassifications under the tainting rules for held-to-maturity assets.
11.4.4 Systems considerations

An assessment of current systems capabilities should be performed well in advance of
the transition date. The adoption of IAS 39 may create the need for enhancements to the
treasury systems as well as to accounting systems. Systems should be capable of:
■ interest and amortisation calculations using the effective interest method;
■ discounted cash flow calculations;
■ impairment calculations;
■ classification and reporting of financial instruments;
■ fair value calculations for all financial instruments, including derivative instruments;
■ identification of hedge relationships, including hedging model used;
■ hedge effectiveness calculations;
■ tracking amounts in equity in respect of fair value adjustments of available-for-sale
instruments, cash flow hedge adjustments, and recycling amounts out of equity
when appropriate;
■ accounting for basis adjustments to hedged transactions that result in assets and
liabilities; and
■ providing the necessary internal and external reporting information.
11.4 First time implementation: practical considerations 213

March 2004
A. Glossary
Amortised cost The amount at which a financial asset or liability is measured at initial
recognition minus principal repayments, plus or minus the cumulative
amortisation / accretion of any premium / discount, and minus any write-
down for impairment.
Anticipated future transaction See forecasted transaction below.
Available-for-sale Financial assets that are not held for trading, loans and receivables
originated by the entity, or held-to-maturity investments, or are designated
as available-for-sale on initial recognition.
Call option An option contract giving the holder the right, but not the obligation, to
buy a specific quantity of an asset for a fixed price during a specific time
period (or on a specified date).
Cap An option contract that protects the holder from a rise in interest rates or
some other underlying index beyond a certain point.
Cash flow hedge A hedge of the exposure to variability in the cash flows of a recognised
asset or liability, or forecasted transaction, that is attributable to changes
in variable rates or prices.
Central treasury hedging A risk management strategy whereby one central unit of an entity transacts
hedging activities on behalf of some or all entities within the group.
Collar A combination of a purchased cap and a written floor that protects against
a movement outside a range of interest rates or some other underlying.
Continuing involvement The extent to which an entity remains exposed to changes in the value of
a transferred asset where the entity has neither transferred nor retained
substantially all of the risks and rewards of the transferred asset.
Commodity-based contract A contract for delivery of a commodity that also allows for settlement in
cash or some other financial instrument.
Compound instrument A financial instrument that, from the issuer’s perspective, includes both a
liability and an equity element.
Counterparty A principal party to a transaction.
Credit risk The risk that one party to a financial instrument will fail to discharge an
obligation and cause the other party to incur a financial loss.
Default risk See credit risk above.
214 Appendix A Glossary
March 2004
Derecognition The act of removing a recognised financial asset or liability from the
entity’s balance sheet. This may be accomplished through the sale, transfer
or expiration of a financial asset or through the legal settlement of or
release from a financial liability.
Derivative A financial instrument whose value changes in response to a change in a
specified underlying, for which there is little or no initial net investment,
and that is settled at a future date.
Dual currency instrument A financial instrument (usually a bond) where the principal and interest
payments are made in different currencies. A typical example is a bond
where principal payments are made in the measurement currency of the
holder, and interest payments are made in a foreign currency.
Effective interest method A method of calculating amortisation using the effective interest rate
of a financial instrument. The effective interest rate is the rate that
discounts the expected stream of future cash payments to the
instrument’s carrying amount.
Embedded derivative Implicit or explicit terms in a contract that affect some or all of the cash
flows of a contract in a manner similar to a freestanding derivative instrument.
Equity A contract evidencing a residual interest in the assets of an entity after
deducting all of its liabilities.
Exercise price The price at which an underlying instrument may be bought, sold, or
settled upon exercise of an option.
Fair value The amount at which an asset (liability) could be bought (incurred) or
sold (settled) in an arm’s length transaction between knowledgeable,
willing parties.
Fair value hedge A hedge of the exposure to changes in the fair value of a recognised
asset or liability or a portion thereof, or a firm commitment, that is
attributable to a particular risk, and that will affect reported net income.
Financial asset An asset that is cash, a contractual right to receive cash or another
financial asset from another entity, a contractual right to exchange financial
instruments with another entity under potentially favourable conditions,
an equity instrument of another entity, or a contract that will or may be
settled in the entity’s own equity instruments and is either a non-derivative
for which the entity is or may be obliged to receive a variable number of
the entity’s own equity instruments or a derivative that will or may be
settled other than by the exchange of a fixed amount of cash or another
financial asset for a fixed number of the entity’s own equity instruments
(for this latter purpose the entity’s own equity instruments do not include
contracts that are themselves contracts for the future receipt or delivery
of the entity’s own equity instruments).
Appendix A Glossary 215

March 2004
Financial asset or financial A financial asset or liability that meets either of the following conditions:
liability at fair value through
profit or loss A financial asset or financial liability that is classified as held for trading.
Such assets or liabilities are acquired or incurred principally for the purpose
of generating a profit from short-term fluctuations in price or dealer’s
margin, or are 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. All derivatives are deemed to be trading
instruments unless they qualify for hedge accounting.
or
Upon initial recognition it is designated by the entity at fair value through
profit or loss. Any financial asset or liability within the scope of IAS 39
(revised) may be designated when initially recognised as a financial asset
or financial liability through profit or loss except for investments in equity
investments that do not have a quoted market price in an active market
and whose fair value cannot be reliably measured.
Financial components approach An approach whereby the recognition or derecognition of a financial
asset or liability is viewed in terms of its financial components that comprise
that asset or liability. This approach requires that the party that controls
the individual financial components should record those assets or liabilities.
Financial instrument Any contract that gives rise to both a financial asset of one entity and a
financial liability or equity instrument of another entity.
Financial liability A liability that is a contractual obligation to deliver cash or another financial
asset to another entity, or to exchange financial instruments with another
entity under conditions that are potentially unfavourable to the entity, or a
contract that will or may be settled in the entity’s own equity instruments
and is either a non-derivative for which the entity is or may be obliged to
deliver a variable number of the entity’s own equity instruments or a
derivative that will or may be settled other than by the exchange of a
fixed amount of cash or another financial asset for a fixed number of the
entity’s own equity instruments (for this latter purpose the entity’s own
equity instruments do not include instruments that are themselves contracts
for the future receipt or delivery of the entity’s own equity instruments).
Firm commitment An agreement with another party that binds both parties and is usually
legally enforceable, whereby the significant terms of the transaction,
including quantity, price, and timing of settlement are specified.
Floor An option contract that protects the holder against a decline in interest
rates or some other underlying below a certain point.
Forecasted transaction A transaction that is expected to occur for which there is no firm
commitment. Also referred to as an anticipated future transaction.
Foreign currency A currency other than the measurement currency of an entity.
March 2004
Foreign exchange risk The risk that changes in foreign exchange rates will affect the fair value
or cash flows of a recognised financial instrument, firm commitment or
forecasted transaction. Also referred to as currency risk.
Foreign operation An entity that is a subsidiary, associate, joint venture or branch of a
reporting entity, the activities of which are based or conducted in a country
or currency other than those of the reporting entity.
Forward contract A non-exchange-traded contract that obligates one party to buy, and the
other party to sell a specific asset for a fixed price at a future date.
Forward rate The foreign exchange rate used in an agreement to exchange at a specified
future date a specified amount of a commodity, currency or other asset.
Functional currency The currency of the primary economic environment in which an
entity operates.
Futures contract A forward contract that is standardised and exchange-traded.
Guidance on Implementing Guidance which has been developed from, and has superseded in the
IAS 39: Financial Instruments: revised IAS 39, Implementation Guidance issued by the Implementation
Recognition and Measurement Guidance Committee (IGC Q&A – see below) in respect of the
previous IAS 39.
Hedge effectiveness The degree to which changes in fair value or cash flows attributable to a
hedged risk are offset by changes in the fair value or cash flows of the
hedging instrument.
Hedged item An asset, liability, firm commitment, or forecasted transaction that exposes
the entity to a risk of changes in fair value or future cash flows, and that
has been designated by an entity as being hedged. A hedged item may be
a group of similar assets or liabilities, or a portion thereof.
Hedging A strategy used in risk management whereby an entity seeks to reduce
or eliminate financial risks by entering into transactions that give an
offsetting risk profile. This may or may not allow an entity to use hedge
accounting, whereby special accounting rules may be used if specific
hedge effectiveness and other criteria are met.
Hedging instrument A designated derivative or, in limited circumstances, another financial
instrument whose changes in fair value or cash flows are expected to
offset changes in the fair value or cash flows of a designated hedged item.
Held-to-maturity asset Financial assets that have fixed or determinable payments and a fixed
maturity and that an entity has the positive intent and ability to hold
until maturity.
Host contract The portion of a hybrid instrument that is the host to an embedded derivative.
The host contract may be, but is not necessarily, a financial instrument.
Hybrid instrument A contract that comprises an embedded derivative component and a
host contract.

March 2004
IAS International Accounting Standards, a body of accounting standards and

interpretations issued by the International Accounting Standards
Committee (IASC). In 2002, this became known as IFRS (see below).
IASB and IFRIC International Accounting Standards Board; International Financial
Reporting Interpretations Committee. From 2002, these are the successor
organisations to the IASC and SIC respectively.
IFRS International Financial Reporting Standards, the body of accounting
standards and interpretations issued or endorsed by the IASB. IFRS is
an acceptable GAAP (generally accepted accounting principles) in many
countries and on many stock exchanges around the world.
IGC Q&A Implementation guidance developed by the Implementation Guidance
Committee of the IASC in the form of questions and answers. In this
publication, implementation guidance that is relevant to specific topic areas
is referenced in the margin. Note that in the revised financial instrument
standards, this guidance has in some cases been deleted or amended,
with this guidance then either having been incorporated into the standards
themselves or published separately as ‘Guidance on Implementing IAS 39
Financial Instruments: Recognition and Measurement’.
Impairment A situation where the estimated recoverable amount of a financial asset
has declined below its carrying amount.
Interest rate risk The risk that changes in market interest rates may affect the fair value
or cash flows of a financial instrument.
In-the-money option A call option whose exercise price is lower than the spot price of the
underlying instrument, or a put option whose exercise price is greater
than the spot price of the underlying instrument.
Intrinsic value The positive difference between the current price of the underlying and
the exercise price in those situations when an option is in-the-money. An
option that is not in-the-money has no intrinsic value.
Lease contract An agreement whereby the lessor conveys to the lessee in return for a
payment or series of payments the right to use an asset for an agreed
period of time.
Market risk The risk that fair values or cash flows will be affected by factors specific
to a particular instrument or to the issuer of an instrument, or by general
market conditions.
Measurement currency The currency used by an entity in preparing its financial statements.
This is the currency of the primary economic exposure of the entity.
(This definition was included in the original IAS 21 and was deleted on
that standard’s revision in 2003.)
Monetary item Money held and assets to be received or liabilities to be paid in fixed or
determinable amounts of money.
Net investment hedge A hedge of the exposure to changes in value of a net investment in a
foreign entity arising from changes in foreign exchange rates.
March 2004
Net investment in a foreign entity A reporting entity’s share in the net assets of a foreign entity.
Net position hedging A risk management strategy whereby an entity hedges its net risk
positions / exposures.
Notional amount An amount of currency, number of shares, a number of units of weight
or volume or other units specified in a derivative contract.
Option A contract between two parties, which gives one party the right, but not
the obligation, to buy or sell an asset, currency, or rate for a specific price.
Out-of-the-money option A call option whose exercise price is greater than the spot price of the
underlying instrument, or a put option whose exercise price is lower than
the spot price of the underlying instrument.
Put option An option contract giving the holder the right, but not the obligation, to
sell a specific quantity of an asset for a fixed price during a specific
period of time or at a set date.
Regular way transaction A contract for a purchase or sale of financial assets that requires delivery
of the assets within a period of time that is generally established either by
regulation or convention in that marketplace.
Risks and rewards approach An approach whereby the recognition or derecognition of a financial
asset or liability depends upon whether the party to a transfer of financial
instruments is deemed to have retained the risks in order to obtain the
related benefits.
Settlement date The date that a financial instrument is delivered to or transferred from
an entity.
Spot rate The foreign exchange rate between two currencies on a given date.
Swap An agreement by two parties to exchange a series of cash flows in
the future.
Time value The difference between the total value (i.e. fair value) of an option and
the option’s intrinsic value.
Total return swap A contract that provides the actual returns and credit risks of a transaction
to one party in return for a specified interest index to the other party. The
party receiving the return based on the interest index is considered to
receive a lender’s return.
Trade date The date that an entity enters into a contract for the purchase or sale of
a financial instrument.
Trading assets and liabilities A financial instrument that is acquired or incurred principally for the
purpose of generating a profit from short-term fluctuations in price or
dealer’s margin. All derivatives are deemed to be trading instruments
unless they qualify for hedge accounting.
Note that this category has been subsumed within ‘Financial asset or
financial liability at fair value through profit or loss’.

March 2004
Transaction costs Incremental costs that are directly attributable to the acquisition or disposal
of a financial asset or liability.
Underlying A specified interest rate, security price, commodity price, foreign
exchange rate, index of prices or rates, or other variables. An underlying
may be a price or rate of an asset or liability, but is not the asset or
liability itself.
US GAAP Generally accepted accounting principles of the United States. These
principles are primarily set by a national accounting body, the Financial
Accounting Standards Board, or FASB.
Volatility The degree of price fluctuation for a given asset, rate, or index.
Weather derivative A contract that requires payment based on climatic, geological, or other
physical variables. These are insurance-type policies used by entities,
but may or may not be directly related to an amount of loss incurred by
the entity.
Written option An option contract for which a net premium is received.
Yield curve A figure demonstrating the relationship between interest rates and time
to maturity.
March 2004
B. IFRS and US GAAP financial instruments comparison
The following summary highlights the major principles related to accounting for financial instruments under IAS
and under US GAAP, as well as certain similarities and differences. The main sources for comparison are
IAS 32 and IAS 39 and FASB (Financial Accounting Standards Board) Statements No. 115, 133, 138 and 140.
There are more differences (especially as to the finer points) than those indicated below. In addition, interpretations
made under IFRS could differ from those that would be made under US GAAP.
IFRS US GAAP
General
The literature addressing financial instruments is The US GAAP body of literature is far more detailed
mostly contained in IAS 32, IAS 39 and IAS 21 (for and complex in terms of its hierarchy. Guidance has
foreign currency accounting). The standards do not developed over a much longer period of time, often
aim to provide industry-specific requirements. in response to new financial products introduced in
The standards form a comprehensive set of principles the markets. There are over a dozen FASB standards
for financial instruments accounting. that address various aspects of financial instruments.
Scope
IAS 39 is a comprehensive standard that deals with SFAS 133 (and amendments SFAS 138 and
all aspects of recognition and measurement of SFAS 149) deal specifically with recognition and
financial instruments. This includes fair value measurement of derivatives and hedge accounting.
considerations, derecognition, impairment and hedge Recognition and measurement and derecognition
accounting. All types of financial instruments are issues for other financial instruments are dealt with
within its scope. in different standards (primarily SFAS 115 and 140).
Questions and Answers (Q&A) on IAS 39 have been Implementation Issues on SFAS 133 have been issued
issued by the Implementation Guidance Committee by the Derivatives Implementation Group (DIG). DIG
(IGC). The IGC Q&A are guidance, but do not have Issues are interpretative guidance based on issues
the standing of an IASB standard or interpretation. raised in practice. The FASB has issued Q&A for
SFAS 115 and 140.
Derivatives
All derivative instruments are deemed to be trading, Derivatives are either hedging or non-hedging
unless they are part of an effective hedge relationship. instruments under SFAS 133. All derivatives are
All derivatives are measured on the balance sheet at measured on the balance sheet at fair value.
fair value.
Appendix B IFRS and US GAAP financial instruments comparison 221

March 2004
IFRS US GAAP
A contract with an embedded derivative not closely Similar approach under US GAAP.
related should generally be separated into its host and
derivative components. The embedded derivative is
then accounted for as a freestanding derivative.
Derivatives may have either net or gross Generally, the terms of a derivative instrument should
settlement provisions. either require or permit net settlement. Instruments
that can readily be settled net outside the contract or
that require the delivery of an asset that is convertible
to cash also meet this criterion.
Recognition
Financial assets and liabilities are initially measured Similar approach under US GAAP.
at cost, which is defined in terms of the fair value of
the consideration exchanged. Transaction costs
incurred to acquire a financial asset are capitalised
as part of the initial recognition.
Classification as equity or as a liability is based on There are some instruments classified as equity
the substance of the contractual arrangement rather under US GAAP that would be classified as liabilities
than its legal form. under IFRS.
A compound instrument that has both liability and The FASB has a current project that is expected to
equity characteristics must be separated, with the address classification of compound instruments.
liability and equity components separately recognised.
Regular way purchases and sales of financial assets Similar approach under US GAAP.
may be recognised on either the trade date or the
settlement date.
Derecognition
IAS 39 follows a financial components model for The approach under US GAAP is a financial
derecognition, but also contains certain risks and components model that focuses on control.
rewards aspects.
Surrender of control over the transferred financial Similar principle under US GAAP. US GAAP has
asset is the key criterion for derecognition of assets. specific criteria that must be met to demonstrate the
This is exhibited by the transfer of a substantive risk surrender of control. One such criterion not in IAS 39
of the assets to the transferee. is that the transferred assets must be legally isolated
from the transferor.
222 Appendix B IFRS and US GAAP financial instruments comparison
March 2004
IFRS US GAAP
If the transfer involves a special purpose entity If the transfer involves:

(SPE), assets subject to a securitisation may be
derecognised from the transferor’s balance sheet,
■ a qualifying special purpose entity (QSPE), a
however as a result of SIC–12 the assets of an SPE securitisation may be off balance sheet altogether;
could be consolidated and separately recognised in ■ a non-QSPE that is adequately capitalised, basic
the consolidated balance sheet. consolidation criteria should be considered; or
■ a variable interest entity (VIE) that is not a QSPE,
parties should evaluate whether they have the
majority of variable interests in the entity for
determining consolidation of the VIE.
For derecognition of a financial liability to occur, an Similar approach under US GAAP.
entity must have legal release from being the primary
obligor. In-substance defeasance alone will not lead
to derecognition.
Measurement
The following categories cover all financial assets The following categories are used only for debt securities
and liabilities other than hedging instruments: and marketable equity securities and derivatives:
■ amortised cost is used for held-to-maturity assets, ■ amortised cost is used for held-to-maturity debt
originated loans and receivables and non-trading securities; and
liabilities; and
■ fair value is used for available-for-sale and
■ fair value is used for available-for-sale assets and trading securities.
trading assets and liabilities.
Mortgage loans held for sale are carried at the lower
of cost or fair value. An entity’s own debt is stated at
amortised cost. All other financial instruments fall
under other rules of US GAAP, and are generally
carried at amortised cost.
Fair value adjustments on trading items are recognised Similar approach under US GAAP.
For changes in fair value of available-for-sale financial For changes in fair value of available-for-sale securities,
assets, either immediate income statement a similar recycling system is used: adjustments are
recognition or a recycling system is used: in the latter reported in other comprehensive income (a component
adjustments are reported in equity and are of equity); they are subsequently recycled from other
subsequently recycled out of equity and recognised comprehensive income and recognised in the income
in the income statement when realised. statement when realised.

March 2004
IFRS US GAAP
For available-for-sale monetary financial assets, For available-for-sale securities the entire change in
change in fair value attributable to foreign exchange fair value including foreign exchange differences is
differences is always recognised in the income recognised in other comprehensive income, a
statement. Any remaining change is in equity, if the component of equity.
entity has chosen to present fair value changes there
(see above). For non-monetary available-for-sale
assets, the entire change is recognised in equity.
Impairment should be assessed at each balance sheet If impairment is other than temporary, a write-
date, and required write-downs in the financial asset’s down in the financial asset’s carrying basis is
carrying amount are recognised in the income recognised in the income statement. No subsequent
statement. Impairment losses may be reversed reversals are permitted.
subsequently, also through the income statement, if
circumstances warrant this.
For available-for-sale instruments, subsequent Similar approach under US GAAP. Subsequent
increases or decreases in fair value that are not changes (that are not other than temporary
deemed to be impairment are included as a separate impairment) are included in other comprehensive
component of equity (if that is the option chosen by income (OCI).
the entity to recognise fair value changes).
Measurement currency is the currency in which the Functional currency is used to describe the currency
financial statements are measured, and should be of the primary economic environment in which an
the currency that reflects the economic substance entity operates. This is normally the currency of the
of the underlying events and circumstances relevant environment in which the entity generates and
to the entity. expends cash.
Hedging
A highly effective hedge is one where changes in Practice has developed where both future expectation
fair value or cash flows of the hedged item are and actual results should be in a range of 80 to 125 per
expected to be almost fully offset by the changes in cent offset.
fair value or cash flows of the hedging instrument,
both at inception and throughout the life of the hedge.
Actual results should be in a range of 80 to 125 per
cent offset.
A hedge effectiveness test must be performed Similar approach under US GAAP, except that a
at inception and on an ongoing basis at each short-cut method is allowed for certain hedges of
reporting period. interest rate risk where 100 per cent effectiveness
can be assumed if certain criteria are met.
A fair value hedge may be used to hedge the exposure Similar approach under US GAAP.
to changes in the fair value of a hedged item
attributable to its fixed terms. A cash flow hedge may
be used to hedge the exposure to variability in cash
flows of a hedged item attributable to changes in
variable rates or prices.
March 2004
IFRS US GAAP
For fair value hedges, the change in fair value of the Similar approach under US GAAP.
hedging instrument is recognised in the income statement,
as is the hedged item in respect of the hedged risk.
For cash flow hedges, the effective part of the change For cash flow hedges, the effective part of the change
in fair value of the hedging instrument is recognised in fair value of the hedging instrument is recognised
in equity, and is recycled as and when the hedged in other comprehensive income or equity, and is
transaction affects the income statement. If an asset recycled as and when the hedged transaction affects
or liability results from the hedged transaction, hedge the income statement. A basis adjustment to the asset
results are included in the cost basis of the asset or or liability is not allowed.
liability (i.e. basis adjustment).
A hedge of any future transaction, committed or A foreign currency hedge of a firm commitment may
otherwise, is a cash flow hedge. be a fair value or a cash flow hedge; other hedges of
firm commitments are fair value hedges; hedges of
forecasted transactions are cash flow hedges.
Recognised foreign currency denominated assets and Similar approach under US GAAP.
liabilities may be the hedged item in a fair value or
cash flow hedge.
A derivative or non-derivative may be used to hedge A non-derivative may be used to hedge foreign
foreign currency risk in a fair value hedge or a cash currency risk in an unrecognised firm commitment
flow hedge of a recognised asset or liability. or the hedge of a net investment, but not to hedge
any other exposures.
The hedge of a net investment in a foreign entity is Similar approach under US GAAP.
accounted for in a manner similar to a cash flow hedge.
The ineffective portion of a net investment hedge is The ineffective portion of a net investment hedge is
recognised in equity when the hedging instrument is recognised in the income statement.
a non-derivative. When the hedging instrument is a
derivative, the ineffective portion is recognised in the
income statement.
There is no requirement that a subsidiary within a Foreign currency hedges are not permitted in
group of consolidated accounts that holds a foreign consolidated accounts unless the subsidiary holding
currency exposure must be a party to the hedge of the exposure is also a party to the hedge. Therefore,
that exposure. a group treasury department that holds a hedge must
write an offsetting instrument with the group member
holding the exposure.
Internal derivatives may be used as hedging Similar approach under US GAAP. However, only
instruments in a hedge of foreign currency risk for certain cash flow hedges of foreign currency risk
purposes of hedge accounting, if such derivatives are qualify for a netting approach.
offset by third party contracts on a net basis. They
may not be used as hedging instruments for purposes
of hedging other than foreign currency risks, unless
there is an offset with a third party contract.

March 2004
IFRS US GAAP
Presentation and disclosure

Financial assets and liabilities should be offset and Similar approach under US GAAP.
reported net only when an entity has both the legal
right to set off the amounts, as well as the intent to
do so.
Accounting principles applied as well as significant Similar disclosures under US GAAP.
terms and conditions of financial instruments should
be disclosed.
Information about interest rate risk exposures Similar disclosures under US GAAP for derivative
should be disclosed for each type of financial asset instruments and retained interests.
and liability.
Maximum credit risk exposures as well as Similar disclosures under US GAAP.
concentrations of credit risk should be disclosed,
including the maximum credit exposure of each
concentration and their shared characteristics.
Fair value of all financial instruments should be Similar disclosures under US GAAP.
disclosed either in the notes or on the face of the
balance sheet.
The methods and significant assumptions applied to Similar disclosures under US GAAP.
estimate fair values are required to be disclosed.
Gains and losses that are recognised directly in equity Similar disclosures under US GAAP.
are disclosed. These include changes in fair value of
available-for-sale assets (when an entity records these
changes in equity rather than in the income statement)
and the effective portion of the change in value of a
hedging instrument in a cash flow hedge.
Amounts recycled from equity to the income Similar disclosures under US GAAP.
statement must be disclosed.
Disclosures of the nature and amount of an Similar disclosures under US GAAP.
impairment loss or reversal of an impairment loss
should be made.
Disclosure of management’s objectives and policies Disclosure of management’s objectives and policies
is required for those instruments held for risk is required for derivatives held or issued.
management purposes.
Hedging relationships should be disclosed by type of Similar disclosures under US GAAP.
hedge. Disclosure includes a description of the
relationship, including the hedging instrument, the risk
being hedged, and in the case of forecasted transactions
when the transactions are expected to occur.
March 2004

In the area of derecognition, the amendments have added to the differences between IFRS and US GAAP.
As noted in Section 4, the amendments to IFRS first require consideration of whether an SPE should be
consolidated into the reporting entity before consideration of derecognition, and then place the previous
requirements in a hierarchy, with the transfer of risks and rewards generally being considered first, and the
assessment of control being considered only when substantially all the risks and rewards related to transferred
assets have been neither transferred nor retained. If control has not been transferred in these circumstances,
IFRS switches to a continuing involvement model which results in partial derecognition. With respect to the
consolidation of SPEs, SIC–12 remains in place. None of the amendments bring IFRS closer to US GAAP.
In addition, US GAAP has been subject to further developments, few of which converge towards IFRS.
Furthermore, the option in the amendments to designate any financial asset or financial liability as fair value
through profit or loss or as available-for-sale, the new exemption for embedded derivatives denominated in a
currency which is ‘commonly used in that economic environment’ and the new restrictions on the use of
internal transactions as hedged items and hedging instruments create new differences with US GAAP.
The new rules for derivatives on own equity are, in certain respects, similar to new rules for those instruments
under US GAAP. However, some significant differences remain.
In other respects the amendments have moved IFRS closer to US GAAP. For example:
■ the widening of the scope of the amended standards to include commodity contracts where the underlying
is readily convertible to cash;
■ the scope exclusion for certain loan commitments;
■ eliminating the previous policy choice to measure available-for-sale financial assets at fair value through
profit or loss;
■ the clarification that a market price in an active market is the best evidence of fair value, and that the
transaction price is the best evidence of fair value when the instrument is not traded in an active market;
■ the prohibition on reversals of impairment losses on available-for-sale equity instruments;
■ the requirement to account for most firm commitment hedges as fair value hedges;
■ the prohibition on basis adjustment for a cash flow hedge of the purchase or issuance of a financial asset
or liability; and
■ the option not to include a basis adjustment for a cash flow hedge of the purchase of a non-financial asset.

March 2004
C. Abbreviations
AFS Available-for-sale
CCIRS Cross currency interest rate swap
FC Foreign currency
FIFO First-in first-out method (for inventory)
FX Foreign exchange (risk)
GAAP Generally accepted accounting principles
HTM Held-to-maturity
IASB International Accounting Standards Board
IFRIC International Financial Reporting Interpretations Committee
IFRS International Financial Reporting Standard
IGC Implementation Guidance Committee
IRS Interest rate swap
LIBOR London inter bank offered rate
MC Measurement currency
SIC Standing Interpretations Committee
SPE Special purpose entity
228 Appendix C Abbreviations
March 2004
D. List of cases
Page
Section 2
Case 2.1 Guarantee contract versus credit derivative 18
Case 2.2 Guarantee contract held by a third party 18
Section 4
Case 4.1 Low interest loan 30
Case 4.2 Purchase of a bond, comparing trade date and settlement date accounting 32
Case 4.3 Sale of a bond, comparing trade date and settlement date accounting 33
Case 4.4 Receivables sold with full recourse 40
Case 4.5 Transfer of a portfolio of loans 42
Case 4.6 Modification of the terms of a loan 45
Section 5
Case 5.1 Origination of a loan 54
Case 5.2 Held-to-maturity classification 57
Case 5.3 Tainting of held-to-maturity assets 58
Case 5.4 Held-to-maturity portfolio acquired in a business combination 61
Section 6
Case 6.1 Determining the fair value of an interest rate swap 71
Case 6.2 Calculation of (amortised) cost 76
Case 6.3 Effective interest rate calculation 76
Case 6.4 Measurement of monetary financial instruments denominated in a foreign currency 80
Case 6.5 Impairment of a loan 85
Appendix D List of cases 229

March 2004
Page
Section 7
Case 7.1 Transfer and subsequent remeasurement of held-to-maturity investments 95
Case 7.2 Remeasurement of an available-for-sale asset 96
Case 7.3 Available-for-sale debt security in a foreign currency including amortisation 98
Case 7.4 Measurement of available-for-sale equity securities 101
Section 8
Case 8.1 Hedge of a non-monetary item 112
Case 8.2 Hedging with a cross currency interest rate swap (CCIRS) 120
Case 8.3 Documentation of an FX cash flow hedge 122
Case 8.4 Documentation of a fair value hedge relationship 123
Case 8.5 Effectiveness testing 128
Section 9
Case 9.1 Fair value hedge of a fixed interest rate liability 141
Case 9.2 Cash flow hedge of a variable rate liability 144
Case 9.3 Cash flow hedge using an interest rate cap 147
Case 9.4 Net position hedging – interest rate risk 154
Case 9.5 Hedging on a group basis – interest rate risk 155
Case 9.6 Cash flow hedge of foreign currency sales transactions 159
Case 9.7 Cash flow hedge of foreign currency purchase transactions 163
Case 9.8 Fair value hedge of foreign currency risk on available-for-sale equities 165
Case 9.9 Net position hedging – foreign currency risk 169
Case 9.10 Hedging on a group basis – foreign currency risk 170
Case 9.11 Hedged item in a net investment hedge 172
Case 9.12 Hedgeable components of a net investment in a foreign entity 172
Case 9.13 Hedge of a net investment in a foreign entity 174
Case 9.14 Fair value hedge of commodity price risk 177
Case 9.15 Cash flow hedge of commodity price risk 179
Case 9.16 Fair value hedge of equity securities 181
230 Appendix D List of cases
March 2004
Page
Section 10
Case 10.1 Income statement impact of a convertible bond 190
Case 10.2 Example disclosure of risk management objectives and policies 199
Case 10.3 Example disclosures of types of hedges 200
Case 10.4 Example disclosure of gains or losses on hedging instruments recognised in equity 201
Appendix D List of cases 231

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IFRS REPORTING

AUDIT ■ TAX ■ ADVISORY

Organisation of the text

A glossary of frequently used terms is included as Appendix A to the publication. In addition,

Commentary on the December 2003 amendments to the standards is provided separately in

Keep in contact and stay up-to-date

1. Introduction to the financial instruments standards 4

2. Scope and definitions 9

4. Recognition and derecognition 29

7. Subsequent measurement – examples 94

8. Hedge accounting 104

9. Hedge accounting for each type of financial risk 137

10. Presentation and disclosure 184

11. Transition and implementation of IAS 39 206

B. IFRS and US GAAP financial instruments comparison 221

D. List of cases 229

1. Introduction to the financial instruments standards

1.1 The need for financial instruments standards

1.2 Development of the standards

4 1.2 Development of the standards

1.3 Highlights of the standards

Figure 1.1 Overview of the financial instruments standards

1.3.1 Recognition and derecognition

1.3 Highlights of the standards 5

1.3.3 Derivatives and hedge accounting

6 1.3 Highlights of the standards

1.3.4 Disclosure and presentation

December 2003 amendments

1.3 Highlights of the standards 7

IASB Board meeting February 2004

8 1.3 Highlights of the standards

2. Scope and definitions

Key topics covered in this Section:

Reference 2.1 Scope of the standards

Table 2.1 Effect of financial instruments on a corporate / financial institution

2.1 Scope of the standards 9

Table 2.2 Items excluded from the financial instruments standards

Interests in subsidiaries ✗ ✗ IAS 27

“✗ ” Indicates a specific exclusion from the standard.

10 2.1 Scope of the standards

December 2003 amendments

2.1 Scope of the standards 11

December 2003 amendments

2.1.2 Commodities contracts and normal purchases and sales

12 2.1 Scope of the standards

December 2003 amendments

2.2 Definitions relating to financial instruments

2.2.1 Financial assets and financial liabilities

2.2 Definitions relating to financial instruments 13

December 2003 amendments

2.2.2 Equity instruments

December 2003 amendments

39.9 A derivative is a financial instrument:

14 2.2 Definitions relating to financial instruments

December 2003 amendments

2.2.3.1 Change in value based on an underlying

2.2.3.2 Little or no initial net investment

2.2 Definitions relating to financial instruments 15

16 2.2 Definitions relating to financial instruments

2.2.3.3 Settlement at a future date

2.2.3.4 Summary of key concepts concerning derivatives

2.2.4 Financial guarantee contracts and credit derivatives