International Accounting Standard (IAS) 39 «Financial Instruments: Recognition and Measurement»

DO7       Mr Cope dissents from paragraph 64 and agrees with Mr Leisenring’s analysis and conclusions on loan impairment as set out above in paragraph DO4. He finds it counter-intuitive that a loan that has been determined not to be impaired following careful analysis should be subsequently accounted for as if it were impaired when included in a portfolio.

DO8      Mr Cope also dissents from paragraph 98, and, in particular, the Board’s decision to allow a free choice over whether basis adjustment is used when accounting for hedges of forecast transactions that result in the recognition of non-financial assets or non-financial liabilities. In his view, of the three courses of action open to the Board— retaining IAS 39’s requirement to use basis adjustment, prohibiting basis adjustment as proposed in the June 2002 Exposure Draft, or providing a choice—the Board has selected the worst course. Mr Cope believes that the best approach would have been to prohibit basis adjustment, as proposed in the Exposure Draft, because, in his opinion, basis adjustments result in the recognition of assets and liabilities at inappropriate amounts.

DO9      Mr Cope believes that increasing the number of choices in international standards is bad policy. The Board’s decision potentially creates major differences between entities choosing one option and those choosing the other. This lack of comparability will adversely affect users’ ability to make sound economic decisions.

DO10     In addition, Mr Cope notes that entities that are US registrants may choose not to adopt basis adjustment in order to avoid a large reconciling difference to US GAAP. Mr Cope believes that increasing differences between IFRS-compliant entities that are US registrants and those that are not is undesirable.

DO11     Mr McGregor dissents from paragraph 98 and agrees with Mr Cope’s and Mr Leisenring’s analyses and conclusions as set out above in paragraphs DO5 and DO8-DO10.

DO12    Mr McGregor also dissents from this Standard because he disagrees with the conclusions about impairment of certain assets.

DO13    Mr McGregor disagrees with paragraphs 67 and 69, which deal with the impairment of equity investments classified as available for sale. These paragraphs require impairment losses on such assets to be recognised in profit or loss when there is objective evidence that the asset is impaired. Previously recognised impairment losses are not to be reversed through profit and loss when the assets’ fair value increases. Mr McGregor notes that the Board’s reasoning for prohibiting reversals through profit or loss of previously impaired available-for-sale equity investments, set out in paragraph BC130 of the Basis for Conclusions, is that it ‘..could not find an acceptable way to distinguish reversals of impairment losses from other increases in fair value’. He agrees with this reasoning but believes that it applies equally to the recognition of impairment losses in the first place. Mr McGregor believes that the significant subjectivity involved in assessing whether a reduction in fair value represents an impairment (and thus should be recognised in profit or loss) or another decrease in value (and should be recognised directly in equity) will at best lead to a lack of comparability within an entity over time and between entities, and at worst provide an opportunity for entities to manage reported profit or loss.

DO14     Mr McGregor believes that all changes in the fair value of assets classified as available for sale should be recognised in profit or loss. However, such a major change to the Standard would need to be subject to the Board’s full due process. At this time, to overcome the concerns expressed in paragraph DO13, he believes that for equity investments classified as available for sale, the Standard should require all changes in fair value below cost to be recognised in profit or loss as impairments and reversals of impairments and all changes in value above cost to be recognised in equity. This approach treats all changes in value the same way, no matter what their cause. The problem of how to distinguish an impairment loss from another decline in value (and of deciding whether there is an impairment in the first place) is eliminated because there is no longer any subjectivity involved. In addition, the approach is consistent with IAS 16 Property, Plant and Equipment and IAS 38 Intangible Assets.

DO15    Mr McGregor disagrees with paragraph 106 of the Standard and with the consequential amendments to paragraph 27 of IFRS 1 First-time Adoption of International Financial Reporting Standards. Paragraph 106 requires entities to apply the derecognition provisions prospectively to financial assets. Paragraph 27 of IFRS 1 requires first-time adopters to apply the derecognition provisions of IAS 39 (as revised in 2003) prospectively to non-derivative financial assets and financial liabilities. Mr McGregor believes that existing IAS 39 appliers should apply the derecognition provisions retrospectively to financial assets, and that first-time adopters should apply the derecognition provisions of IAS 39 retrospectively to all financial assets and financial liabilities. He is concerned that financial assets may have been derecognised under the original IAS 39 by entities that were subject to it, which might not have been derecognised under the revised IAS 39. He is also concerned that non-derivative financial assets and financial liabilities may have been derecognised by first-time adopters under previous GAAP that would not have been derecognised under the revised IAS 39. These amounts may be significant in many cases. Not requiring recognition of such amounts will result in the loss of relevant information and will impair the ability of users of financial statements to make sound economic decisions.

Dissent of John T Smith from the issue in March 2004 of amendments to IAS 39 on fair value hedge accounting for a portfolio hedge of interest rate risk

DO1      Mr Smith dissents from these Amendments to IAS 39 Financial Instruments: Recognition and Measurement—Fair Value Hedge Accounting for a Portfolio Hedge of Interest Rate Risk. He agrees with the objective of finding a macro hedging solution that would reduce systems demands without undermining the fundamental accounting principles related to derivative instruments and hedging activities. However, Mr Smith believes that some respondents’ support for these Amendments and their willingness to accept IAS 39 is based more on the extent to which the Amendments reduce recognition of ineffectiveness, volatility of profit or loss, and volatility of equity than on whether the Amendments reduce systems demands without undermining the fundamental accounting principles.

DO2      Mr Smith believes some decisions made during the Board’s deliberations result in an approach to hedge accounting for a portfolio hedge that does not capture what was originally intended, namely a result that is substantially equivalent to designating an individual asset or liability as the hedged item. He understands some respondents will not accept IAS 39 unless the Board provides still another alternative that will further reduce reported volatility. Mr Smith believes that the Amendments already go beyond their intended objective. In particular, he believes that features of these Amendments can be applied to smooth out ineffectiveness and achieve results substantially equivalent to the other methods of measuring ineffectiveness that the Board considered when developing the Exposure Draft. The Board rejected those methods because they did not require the immediate recognition of all ineffectiveness. He also believes those features could be used to manage earnings.

Dissent of Mary E Barth, Robert P Garnett and Geoffrey Whittington from the issue in June 2005 of amendments to IAS 39 on the fair value option

DO1       Professor Barth, Mr Garnett and Professor Whittington dissent from the amendment to IAS 39 Financial Instruments: Recognition and Measurement—The Fair Value Option. Their dissenting opinions are set out below.

DO2       These Board members note that the Board considered the concerns expressed by the prudential supervisors on the fair value option as set out in the December 2003 version of IAS 39 when it finalised IAS 39. At that time the Board concluded that these concerns were outweighed by the benefits, in terms of simplifying the practical application of IAS 39 and providing relevant information to users of financial statements, that result from allowing the fair value option to be used for any financial asset or financial liability. In the view of these Board members, no substantive new arguments have been raised that would cause them to revisit this conclusion. Furthermore, the majority of constituents have clearly expressed a preference for the fair value option as set out in the December 2003 version of IAS 39 over the fair value option as contained in the amendment.

DO3      Those Board members note that the amendment introduces a series of complex rules, including those governing transition which would be entirely unnecessary in the absence of the amendment. There will be consequential costs to preparers of financial statements, in order to obtain, in many circumstances, substantially the same result as the much simpler and more easily understood fair value option that was included in the December 2003 version of IAS 39. They believe that the complex rules will also inevitably lead to differing interpretations of the eligibility criteria for the fair value option contained in the amendment.

DO4       These Board members also note that, for paragraph 9(b)(i), application of the amendment may not mitigate, on an ongoing basis, the anomaly of volatility in profit or loss that results from the different measurement attributes in IAS 39 any more than would the option in the December 2003 version of IAS 39. This is because the fair value designation is required to be continued even if one of the offsetting instruments is derecognised. Furthermore, for paragraphs 9(b)(i), 9(b)(ii) and 11A, the fair value designation continues to apply in subsequent periods, irrespective of whether the initial conditions that permitted the use of the option still hold. Therefore, these Board members question the purpose of and need for requiring the criteria to be met at initial designation.

IAS 39 IE

IAS 39 Financial Instruments: Recognition and Measurement

Illustrative Examples

This example accompanies, but is not part of, IAS 39.

Facts___

IE1          On 1 January 20X1, Entity A identifies a portfolio comprising assets and liabilities whose interest rate risk it wishes to hedge. The liabilities include demandable deposit liabilities that the depositor may withdraw at any time without notice. For risk management purposes, the entity views all of the items in the portfolio as fixed rate items.

IE2          For risk management purposes, Entity A analyses the assets and liabilities in the portfolio into repricing time periods based on expected repricing dates. The entity uses monthly time periods and schedules items for the next five years (ie it has 60 separate monthly time periods)*. The assets in the portfolio are prepayable assets that Entity A allocates into time periods based on the expected prepayment dates, by allocating a percentage of all of the assets, rather than individual items, into each time period. The portfolio also includes demandable liabilities that the entity expects, on a portfolio basis, to repay between one month and five years and, for risk management purposes, are scheduled into time periods on this basis. On the basis of this analysis, Entity A decides what amount it wishes to hedge in each time period.

____________________________

* In this Example principal cash flows have been scheduled into time periods but the related interest cash flows have been included when calculating the change in the fair value of the hedged item. Other methods of scheduling assets and liabilities are also possible. Also, in this Example, monthly repricing time periods have been used. An entity may choose narrower or wider time periods.

IE3          This example deals only with the repricing time period expiring in three months’ time, ie the time period maturing on 31 March 20X1 (a similar procedure would be applied for each of the other 59 time periods). Entity A has scheduled assets of CU100 million and liabilities of CU80 million into this time period. All of the liabilities are repayable on demand.

IE4          Entity A decides, for risk management purposes, to hedge the net position of CU20 million and accordingly enters into an interest rate swap^† on 1 January 20X1 to pay a fixed rate and receive LIBOR, with a notional principal amount of CU20 million and a fixed life of three months.

____________________________

^† The Example uses a swap as the hedging instrument. An entity may use forward rate agreements or other derivatives as hedging instruments.

IE5         This Example makes the following simplifying assumptions:

(a)      the coupon on the fixed leg of the swap is equal to the fixed coupon on the asset;

(b)      the coupon on the fixed leg of the swap becomes payable on the same dates as the interest payments on the asset; and

 (c)     the interest on the variable leg of the swap is the overnight LIBOR rate. As a result, the entire fair value change of the swap arises from the fixed leg only, because the variable leg is not exposed to changes in fair value due to changes in interest rates.

In cases when these simplifying assumptions do not hold, greater ineffectiveness will arise. (The ineffectiveness arising from (a) could be eliminated by designating as the hedged item a portion of the cash flows on the asset that are equivalent to the fixed leg of the swap.)

IE6          It is also assumed that Entity A tests effectiveness on a monthly basis.

IE7         The fair value of an equivalent non-prepayable asset of CU20 million, ignoring changes in value that are not attributable to interest rate movements, at various times during the period of the hedge is as follows:

IE8        The fair value of the swap at various times during the period of the hedge is as follows:

Accounting treatment__

IE9         On 1 January 20X1, Entity A designates as the hedged item an amount of CU20 million of assets in the three-month time period. It designates as the hedged risk the change in the value of the hedged item (ie the CU20 million of assets) that is attributable to changes in LIBOR. It also complies with the other designation requirements set out in paragraphs 88(d) and AG119 of the Standard.

IE10      Entity A designates as the hedging instrument the interest rate swap described in paragraph IE4.

End of month 1 (31 January 20X1)

IE11       On 31 January 20X1 (at the end of month 1) when Entity A tests effectiveness, LIBOR has decreased. Based on historical prepayment experience, Entity A estimates that, as a consequence, prepayments will occur faster than previously estimated. As a result it re-estimates the amount of assets scheduled into this time period (excluding new assets originated during the month) as CU96 million.

IE12        The fair value of the designated interest rate swap with a notional principal of CU20 million is (CU47,408)^* (the swap is a liability).

_______________________

*      see paragraph IE8.

IE13       Entity A computes the change in the fair value of the hedged item, taking into account the change in estimated prepayments, as follows.

(a)     First, it calculates the percentage of the initial estimate of the assets in the time period that was hedged. This is 20 per cent (CU20 million ÷ CU100 million).

(b)     Second, it applies this percentage (20 per cent) to its revised estimate of the amount in that time period (CU96 million) to calculate the amount that is the hedged item based on its revised estimate. This is CU19.2 million.

(c)     Third, it calculates the change in the fair value of this revised estimate of the hedged item (CU19.2 million) that is attributable to changes in LIBOR. This is CU45,511 (CU47,408^† × (CU19.2 million ÷ CU20 million)).

_______________________

^†     ie CU20,047,408 - CU20,000,000. See paragraph IE7.

IE14        Entity A makes the following accounting entries relating to this time period:

To recognise the interest received on the hedged amount (CU19.2 million).

To recognise the interest received and paid on the swap designated as the hedging instrument.

To recognise the change in the fair value of the swap.

To recognise the change in the fair value of the hedged amount.

(a)   This Example does not show how amounts of interest income and interest expense are calculated.

IE15       The net result on profit or loss (excluding interest income and interest expense) is to recognise a loss of (CU1,897). This represents ineffectiveness in the hedging relationship that arises from the change in estimated prepayment dates.

Beginning of month 2

IE16      On 1 February 20X1 Entity A sells a proportion of the assets in the various time periods. Entity A calculates that it has sold 8¹/3 per cent of the entire portfolio of assets. Because the assets were allocated into time periods by allocating a percentage of the assets (rather than individual assets) into each time period, Entity A determines that it cannot ascertain into which specific time periods the sold assets were scheduled. Hence it uses a systematic and rational basis of allocation. Based on the fact that it sold a representative selection of the assets in the portfolio, Entity A allocates the sale proportionately over all time periods.

IE17      On this basis, Ent ity A c omputes tha t it has so ld 8¹/₃ per cent of the assets allocated to the three-month time period, ie CU8 million (8¹/₃ per cent of CU96 million). The proceeds received are CU8,018,400, equal to the fair value of the assets.^* On derecognition of the assets, Entity A also removes from the separate balance sheet line item an amount that represents the change in the fair value of the hedged assets that it has now sold. This is 8¹/₃ per cent of the total line item balance of CU45,511, ie CU3,793.

____________________________

* The amount realised on sale of the asset is the fair value of a prepayable asset, which is less than the fair value of the equivalent non-prepayable asset shown in paragraph IE7.

IE18       Entity A makes the following accounting entries to recognise the sale of the asset and the removal of part of the balance in the separate balance sheet line item:

To recognise the sale of the asset at fair value and to recognise a gain on sale.

Because the change in the amount of the assets is not attributable to a change in the hedged interest rate no ineffectiveness arises.

IE19       Entity A now has CU88 million of assets and CU80 million of liabilities in this time period. Hence the net amount Entity A wants to hedge is now CU8 million and, accordingly, it designates CU8 million as the hedged amount.

IE20      Entity A decides to adjust the hedging instrument by designating only a proportion of the original swap as the hedging instrument. Accordingly, it designates as the hedging instrument CU8 million or 40 per cent of the notional amount of the original swap with a remaining life of two months and a fair value of CU18,963.^† It also complies with the other designation requirements in paragraphs 88(a) and AG119 of the Standard. The CU12 million of the notional amount of the swap that is no longer designated as the hedging instrument is either classified as held for trading with changes in fair value recognised in profit or loss, or is designated as the hedging instrument in a different hedge.^§

______________________

^†     CU47,408 × 40 per cent

^§      The entity could instead enter into an offsetting swap with a notional principal of CU12 million to adjust its position and designate as the hedging instrument all CU20 million of the existing swap and all CU12 million of the new offsetting swap.

IE21      As at 1 February 20X1 and after accounting for the sale of assets, the separate balance sheet line item is CU41,718 (CU45,511 - CU3,793), which represents the cumulative change in fair value of CU17.6^* million of assets. However, as at 1 February 20X1, Entity A is hedging only CU8 million of assets that have a cumulative change in fair value of CU18,963.^† The remaining separate balance sheet line item of CU22,755^§ relates to an amount of assets that Entity A still holds but is no longer hedging. Accordingly Entity A amortises this amount over the remaining life of the time period, ie it amortises CU22,755 over two months.

________________________

*     CU19.2 million - (81/3% × CU19.2 million)

†     CU41,718 × (CU8 million ÷ CU17.6 million)

§     CU41,718 - CU18,963

IE22       Entity A determines that it is not practicable to use a method of amortisation based on a recalculated effective yield and hence uses a straight-line method.

End of month 2 (28 February 20X1)

IE23      On 28 February 20X1 when Entity A next tests effectiveness, LIBOR is unchanged. Entity A does not revise its prepayment expectations. The fair value of the designated interest rate swap with a notional principal of CU8 million is (CU9,518)^ø (the swap is a liability). Also, Entity A calculates the fair value of the CU8 million of the hedged assets as at 28 February 20X1 as CU8,009,518.^‡

________________________

ø     CU23,795 [see paragraph IE8] × (CU8 million ÷ CU20 million)

‡     CU20,023,795 [see paragraph IE7] × (CU8 million ÷ CU20 million)

IE24       Entity A makes the following accounting entries relating to the hedge in this time period:

To recognise the interest received on the hedged amount (CU8 million).

To recognise the interest received and paid on the portion of the swap designated as the hedging instrument (CU8 million).

To recognise the change in the fair value of the portion of the swap designated as the hedging instrument (CU8 million) (CU9,518 - CU18,963).

To recognise the change in the fair value of the hedged amount (CU8,009,518 -CU8,018,963).

IE25       The net effect on profit or loss (excluding interest income and interest expense) is nil reflecting that the hedge is fully effective.

IE26       Entity A makes the following accounting entry to amortise the line item balance for this time period:

To recognise the amortisation charge for the period.

(a)   CU22,755 ÷ 2

End of month 3

IE27       During the third month there is no further change in the amount of assets or liabilities in the three-month time period. On 31 March 20X1 the assets and the swap mature and all balances are recognised in profit or loss.

IE28       Entity A makes the following accounting entries relating to this time period:

To recognise the interest and cash received on maturity of the hedged amount (CU8 million).

To recognise the interest received and paid on the portion of the swap designated as the hedging instrument (CU8 million).

To recognise the expiry of the portion of the swap designated as the hedging instrument (CU8 million).

To remove the remaining line item balance on expiry of the time period.

IE29      The net effect on profit or loss (excluding interest income and interest expense) is nil reflecting that the hedge is fully effective.

IE30       Entity A makes the following accounting entry to amortise the line item balance for this time period:

To recognise the amortisation charge for the period.

(a)   CU22,755 ÷ 2

Summary_

IE31       The tables below summarise:

(a)      changes in the separate balance sheet line item;

(b)      the fair value of the derivative;

(c)       the profit or loss effect of the hedge for the entire three-month period of the hedge; and

(d)      interest income and interest expense relating to the amount designated as hedged.

IAS 39 IG

Contents

GUIDANCE ON IMPLEMENTING

IAS 39 FINANCIAL INSTRUMENTS: RECOGNITION AND MEASUREMENT

SECTION A SCOPE

A.1       Practice of settling net: forward contract to purchase a commodity

A.2       Option to put a non-financial asset

SECTION B DEFINITIONS

B.1       Definition of a financial instrument: gold bullion

B.2       Definition of a derivative: examples of derivatives and underlyings

B.3       Definition of a derivative: settlement at a future date, interest rate swap with net or gross settlement

B.4       Definition of a derivative: prepaid interest rate swap (fixed rate payment obligation prepaid at inception or subsequently)

B.5       Definition of a derivative: prepaid pay-variable, receive-fixed interest rate swap

B.6       Definition of a derivative: offsetting loans

B.7       Definition of a derivative: option not expected to be exercised

B.8       Definition of a derivative: foreign currency contract based on sales volume

B.9       Definition of a derivative: prepaid forward

B.10     Definition of a derivative: initial net investment

B.11     Definition of held for trading: portfolio with a recent actual pattern of short-term profit taking

B.12     Definition of held for trading: balancing a portfolio

B.13     Definition of held-to-maturity financial assets: index-linked principal

B.14     Definition of held-to-maturity financial assets: index-linked interest

B.15     Definition of held-to-maturity financial assets: sale following rating downgrade

B.16     Definition of held-to-maturity financial assets: permitted sales

B.17     Definition of held-to-maturity investments: sales in response to entity-specific capital requirements

B.18     Definition of held-to-maturity financial assets: pledged collateral, repurchase agreements (repos) and securities lending agreements

B.19     Definition of held-to-maturity financial assets: ‘tainting’

B.20     Definition of held-to-maturity investments: sub-categorisation for the purpose of applying the ‘tainting’ rule

B.21     Definition of held-to-maturity investments: application of the ‘tainting’ rule on consolidation

B.22     Definition of loans and receivables: equity instrument

B.23     Definition of loans and receivables: banks’ deposits in other banks

B.24     Definition of amortised cost: perpetual debt instruments with fixed or market-based variable rate

B.25     Definition of amortised cost: perpetual debt instruments with decreasing interest rate

B.26     Example of calculating amortised cost: financial asset

B.27     Example of calculating amortised cost: debt instruments with stepped interest payments

B.28     Regular way contracts: no established market

B.29     Regular way contracts: forward contract

B.30     Regular way contracts: which customary settlement provisions apply?

B.31     Regular way contracts: share purchase by call option

B.32     Recognition and derecognition of financial liabilities using trade date or settlement date accounting

SECTION C EMBEDDED DERIVATIVES

C.1       Embedded derivatives: separation of host debt instrument

C.2       Embedded derivatives: separation of embedded option