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

C.3       Embedded derivatives: accounting for a convertible bond

C.4       Embedded derivatives: equity kicker

C.5       Embedded derivatives: debt or equity host contract

C.6       Embedded derivatives: synthetic instruments

C.7       Embedded derivatives: purchases and sales contracts in foreign currency instruments

C.8       Embedded foreign currency derivatives: unrelated foreign currency provision

C.9       Embedded foreign currency derivatives: currency of international commerce

C.10     Embedded derivatives: holder permitted, but not required, to settle without recovering substantially all of its recognised investment

C.11     Embedded derivatives: reliable determination of fair value

SECTION D RECOGNITION AND DERECOGNITION

D.1       Initial recognition

D.1.1    Recognition: cash collateral

D.2       Regular way purchase or sale of a financial asset

D.2.1    Trade date vs settlement date: amounts to be recorded for a purchase

D.2.2    Trade date vs settlement date: amounts to be recorded for a sale

D.2.3    Settlement date accounting: exchange of non-cash financial assets

SECTION E MEASUREMENT

E.1       Initial measurement of financial assets and financial liabilities

E.1.1    Initial measurement: transaction costs

E.2       Fair value measurement considerations

E.2.1    Fair value measurement considerations for investment funds

E.2.2    Fair value measurement: large holding

E.3       Gains and losses

E.3.1    Available-for-sale financial assets: exchange of shares

E.3.2    IAS 39 and IAS 21 Available-for-sale financial assets: separation of currency component

E.3.3    IAS 39 and IAS 21 Exchange differences arising on translation of foreign entities: equity or income?

E.3.4     IAS 39 and IAS 21 Interaction between IAS 39 and IAS 21

E.4       Impairment and uncollectibility of financial assets

E.4.1     Objective evidence of impairment

E.4.2     Impairment: future losses

E.4.3     Assessment of impairment: principal and interest

E.4.4     Assessment of impairment: fair value hedge

E.4.5     Impairment: provision matrix

E.4.6     Impairment: excess losses

E.4.7     Recognition of impairment on a portfolio basis

E.4.8    Impairment: recognition of collateral

E.4.9     Impairment of non-monetary available-for-sale financial asset

E.4.10  Impairment: whether the available-for-sale reserve in equity can be negative

SECTION F HEDGING

F.1       Hedging instruments

F.1.1     Hedging the fair value exposure of a bond denominated in a foreign currency

F.1.2     Hedging with a non-derivative financial asset or liability

F.1.3     Hedge accounting: use of written options in combined hedging instruments

F.1.4     Internal hedges

F.1.5     Offsetting internal derivative contracts used to manage interest rate risk

F.1.6     Offsetting internal derivative contracts used to manage foreign currency risk

F.1.7     Internal derivatives: examples of applying Question F.1.6

F.1.8     Combination of written and purchased options

F.1.9     Delta-neutral hedging strategy

F.1.10   Hedging instrument: out of the money put option

F.1.11   Hedging instrument: proportion of the cash flows of a cash instrument

F.1.12   Hedges of more than one type of risk

F.1.13   Hedging instrument: dual foreign currency forward exchange contract

F.1.14   Concurrent offsetting swaps and use of one as a hedging instrument

F.2       Hedged items

F.2.1     Whether a derivative can be designated as a hedged item

F.2.2     Cash flow hedge: anticipated issue of fixed rate debt

F.2.3     Hedge accounting: core deposit intangibles

F.2.4     Hedge accounting: hedging of future foreign currency revenue streams

F.2.5     Cash flow hedges: ‘all in one’ hedge

F.2.6     Hedge relationships: entity-wide risk

F.2.7     Cash flow hedge: forecast transaction related to an entity’s equity

F.2.8     Hedge accounting: risk of a transaction not occurring

F.2.9     Held-to-maturity investments: hedging variable interest rate payments

F.2.10   Hedged items: purchase of held-to-maturity investment

F.2.11   Cash flow hedges: reinvestment of funds obtained from held-to-maturity investments

F.2.12   Hedge accounting: prepayable financial asset

F.2.13   Fair value hedge: risk that could affect profit or loss

F.2.14   Intragroup and intra-entity hedging transactions

F.2.15   Internal contracts: single offsetting external derivative

F.2.16   Internal contracts: external derivative contracts that are settled net

F.2.17   Partial term hedging

F.2.18   Hedging instrument: cross-currency interest rate swap

F.2.19   Hedged items: hedge of foreign currency risk of publicly traded shares

F.2.20   Hedge accounting: stock index

F.2.21   Hedge accounting: netting of assets and liabilities

F.3       Hedge accounting

F.3.1     Cash flow hedge: fixed interest rate cash flows

F.3.2     Cash flow hedge: reinvestment of fixed interest rate cash flows

F.3.3     Foreign currency hedge

F.3.4     Foreign currency cash flow hedge

F.3.5     Fair value hedge: variable rate debt instrument

F.3.6     Fair value hedge: inventory

F.3.7     Hedge accounting: forecast transaction

F.3.8     Retrospective designation of hedges

F.3.9     Hedge accounting: designation at the inception of the hedge

F.3.10   Hedge accounting: identification of hedged forecast transaction

F.3.11   Cash flow hedge: documentation of timing of forecast transaction

F.4       Hedge effectiveness

F.4.1     Hedging on an after-tax basis

F.4.2     Hedge effectiveness: assessment on cumulative basis

F.4.3     Hedge effectiveness: counterparty credit risk

F.4.4     Hedge effectiveness: effectiveness tests

F.4.5     Hedge effectiveness: less than 100 per cent offset

F.4.7     Assuming perfect hedge effectiveness

F.5       Cash flow hedges

F.5.1    Hedge accounting: non-derivative monetary asset or non-derivative monetary liability used as a hedging instrument

F.5.2    Cash flow hedges: performance of hedging instrument (1)

F.5.3    Cash flow hedges: performance of hedging instrument (2)

F.5.4    Cash flow hedges: forecast transaction occurs before the specified period

F.5.5    Cash flow hedges: measuring effectiveness for a hedge of a forecast transaction in a debt instrument

F.5.6    Cash flow hedges: firm commitment to purchase inventory in a foreign currency

F.6       Hedges: other issues

F.6.1    Hedge accounting: management of interest rate risk in financial institutions

F.6.2    Hedge accounting considerations when interest rate risk is managed on a net basis

F.6.3    Illustrative example of applying the approach in Question F.6.2

F.6.4    Hedge accounting: premium or discount on forward exchange contract

F.6.5    IAS 39 and IAS 21 Fair value hedge of asset measured at cost

SECTION G OTHER

G.1       Disclosure of changes in fair value

G.2       IAS 39 and IAS 7 Hedge accounting: cash flow statements

Guidance on Implementing

IAS 39 Financial Instruments: Recognition and Measurement

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

Section A Scope__

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

Entity XYZ enters into a fixed price forward contract to purchase one million kilograms of copper in accordance with its expected usage requirements. The contract permits XYZ to take physical delivery of the copper at the end of twelve months or to pay or receive a net settlement in cash, based on the change in fair value of copper. Is the contract accounted for as a derivative?

While such a contract meets the definition of a derivative, it is not necessarily accounted for as a derivative. The contract is a derivative instrument because there is no initial net investment, the contract is based on the price of copper, and it is to be settled at a future date. However, if XYZ intends to settle the contract by taking delivery and has no history for similar contracts of settling net in cash or of taking delivery of the copper and selling it within a short period after delivery for the purpose of generating a profit from short-term fluctuations in price or dealer’s margin, the contract is not accounted for as a derivative under IAS 39. Instead, it is accounted for as an executory contract.

A.2 Option to put a non-financial asset

Entity XYZ owns an office building. XYZ enters into a put option with an investor that permits XYZ to put the building to the investor for CU150 million. The current value of the building is CU175* million. The option expires in five years. The option, if exercised, may be settled through physical delivery or net cash, at XYZ’s option. How do both XYZ and the investor account for the option?

_______________________

*      In this Guidance, monetary amounts are denominated in ‘currency units’ (CU).

XYZ’s accounting depends on XYZ’s intention and past practice for settlement. Although the contract meets the definition of a derivative, XYZ does not account for it as a derivative if XYZ intends to settle the contract by delivering the building if XYZ exercises its option and there is no past practice of settling net (IAS 39.5 and IAS 39.AG10).

The investor, however, cannot conclude that the option was entered into to meet the investor’s expected purchase, sale or usage requirements because the investor does not have the ability to require delivery (IAS 39.7). In addition, the option may be settled net in cash. Therefore, the investor has to account for the contract as a derivative. Regardless of past practices, the investor’s intention does not affect whether settlement is by delivery or in cash. The investor has written an option, and a written option in which the holder has a choice of physical settlement or net cash settlement can never satisfy the normal delivery requirement for the exemption from IAS 39 because the option writer does not have the ability to require delivery.

However, if the contract were a forward contract rather than an option, and if the contract required physical delivery and the reporting entity had no past practice of settling net in cash or of taking delivery of the building and selling it within a short period after delivery for the purpose of generating a profit from short-term fluctuations in price or dealer’s margin, the contract would not be accounted for as a derivative.

Section B Definitions__

B.1 Definition of a financial instrument: gold bullion

Is gold bullion a financial instrument (like cash) or is it a commodity?

It is a commodity. Although bullion is highly liquid, there is no contractual right to receive cash or another financial asset inherent in bullion.

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

What are examples of common derivative contracts and the identified underlying?

IAS 39 defines a derivative as follows:

A derivative is a financial instrument or other contract within the scope of this Standard with all three of the following characteristics:

(a)           its value changes in response to the change in a specified interest rate, financial instrument price, commodity price, foreign exchange rate, index of prices or rates, credit rating or credit index, or other variable, provided in the case of a non-financial variable that the variable is not specific to a party to the contract (sometimes called the ‘underlying’);

(b)          it requires no initial net investment or an initial net investment that is smaller than would be required for other types of contracts that would be expected to have a similar response to changes in market factors; and

(c)          it is settled at a future date.

The above list provides examples of contracts that normally qualify as derivatives under IAS 39. The list is not exhaustive. Any contract that has an underlying may be a derivative. Moreover, even if an instrument meets the definition of a derivative contract, special provisions of IAS 39 may apply, for example, if it is a weather derivative (see IAS 39.AG1), a contract to buy or sell a non-financial item such as commodity (see IAS 39.5 and IAS 39.AG10) or a contract settled in an entity’s own shares (see IAS 32.21-IAS 32.24). Therefore, an entity must evaluate the contract to determine whether the other characteristics of a derivative are present and whether special provisions apply.

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

For the purpose of determining whether an interest rate swap is a derivative financial instrument under IAS 39, does it make a difference whether the parties pay the interest payments to each other (gross settlement) or settle on a net basis?

No. The definition of a derivative does not depend on gross or net settlement.

To illustrate: Entity ABC enters into an interest rate swap with a counterparty (XYZ) that requires ABC to pay a fixed rate of 8 per cent and receive a variable amount based on three-month LIBOR, reset on a quarterly basis. The fixed and variable amounts are determined based on a CU100 million notional amount. ABC and XYZ do not exchange the notional amount. ABC pays or receives a net cash amount each quarter based on the difference between 8 per cent and three-month LIBOR. Alternatively, settlement may be on a gross basis.

The contract meets the definition of a derivative regardless of whether there is net or gross settlement because its value changes in response to changes in an underlying variable (LIBOR), there is no initial net investment, and settlements occur at future dates.

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

If a party prepays its obligation under a pay-fixed, receive-variable interest rate swap at inception, is the swap a derivative financial instrument?

Yes.

To illustrate: Entity S enters into a CU100 million notional amount five-year pay-fixed, receive-variable interest rate swap with Counterparty C. The interest rate of the variable part of the swap is reset on a quarterly basis to three-month LIBOR. The interest rate of the fixed part of the swap is 10 per cent per year. Entity S prepays its fixed obligation under the swap of CU50 million (CU100 million × 10 per cent × 5 years) at inception, discounted using market interest rates, while retaining the right to receive interest payments on the CU100 million reset quarterly based on three-month LIBOR over the life of the swap.

The initial net investment in the interest rate swap is significantly less than the notional amount on which the variable payments under the variable leg will be calculated. The contract requires an initial net investment that is smaller than would be required for other types of contracts that would be expected to have a similar response to changes in market factors, such as a variable rate bond. Therefore, the contract fulfils the ‘no initial net investment or an initial net investment that is smaller than would be required for other types of contracts that would be expected to have a similar response to changes in market factors’ provision of IAS 39. Even though Entity S has no future performance obligation, the ultimate settlement of the contract is at a future date and the value of the contract changes in response to changes in the LIBOR index. Accordingly, the contract is regarded as a derivative contract.

Would the answer change if the fixed rate payment obligation is prepaid subsequent to initial recognition?

If the fixed leg is prepaid during the term, that would be regarded as a termination of the old swap and an origination of a new instrument that is evaluated under IAS 39.

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

If a party prepays its obligation under a pay-variable, receive-fixed interest rate swap at inception of the contract or subsequently, is the swap a derivative financial instrument?

No. A prepaid pay-variable, receive-fixed interest rate swap is not a derivative if it is prepaid at inception and it is no longer a derivative if it is prepaid after inception because it provides a return on the prepaid (invested) amount comparable to the return on a debt instrument with fixed cash flows. The prepaid amount fails the ‘no initial net investment or an initial net investment that is smaller than would be required for other types of contracts that would be expected to have a similar response to changes in market factors’ criterion of a derivative.

To illustrate: Entity S enters into a CU100 million notional amount five-year pay-variable, receive-fixed interest rate swap with Counterparty C. The variable leg of the swap is reset on a quarterly basis to three-month LIBOR. The fixed interest payments under the swap are calculated as 10 per cent times the swap’s notional amount, ie CU10 million per year. Entity S prepays its obligation under the variable leg of the swap at inception at current market rates, while retaining the right to receive fixed interest payments of 10 per cent on CU100 million per year.

The cash inflows under the contract are equivalent to those of a financial instrument with a fixed annuity stream since Entity S knows it will receive CU10 million per year over the life of the swap. Therefore, all else being equal, the initial investment in the contract should equal that of other financial instruments that consist of fixed annuities. Thus, the initial net investment in the pay-variable, receive-fixed interest rate swap is equal to the investment required in a non-derivative contract that has a similar response to changes in market conditions. For this reason, the instrument fails the ‘no initial net investment or an initial net investment that is smaller than would be required for other types of contracts that would be expected to have a similar response to changes in market factors’ criterion of IAS 39. Therefore, the contract is not accounted for as a derivative under IAS 39. By discharging the obligation to pay variable interest rate payments, Entity S in effect provides a loan to Counterparty C.

B.6 Definition of a derivative: offsetting loans

Entity A makes a five-year fixed rate loan to Entity B, while B at the same time makes a five-year variable rate loan for the same amount to A. There are no transfers of principal at inception of the two loans, since A and B have a netting agreement. Is this a derivative under IAS 39?

Yes. This meets the definition of a derivative (that is to say, there is an underlying variable, no initial net investment or an initial net investment that is smaller than would be required for other types of contracts that would be expected to have a similar response to changes in market factors, and future settlement). The contractual effect of the loans is the equivalent of an interest rate swap arrangement with no initial net investment. Non-derivative transactions are aggregated and treated as a derivative when the transactions result, in substance, in a derivative. Indicators of this would include:

•      they are entered into at the same time and in contemplation of one another

•      they have the same counterparty

•      they relate to the same risk

•      there is no apparent economic need or substantive business purpose for structuring the transactions separately that could not also have been accomplished in a single transaction.

The same answer would apply if Entity A and Entity B did not have a netting agreement, because the definition of a derivative instrument in IAS 39.9 does not require net settlement.

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

The definition of a derivative in IAS 39.9 requires that the instrument ‘is settled at a future date’. Is this criterion met even if an option is expected not to be exercised, for example, because it is out of the money?

Yes. An option is settled upon exercise or at its maturity. Expiry at maturity is a form of settlement even though there is no additional exchange of consideration.

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

Entity XYZ, whose functional currency is the US dollar, sells products in France denominated in euro. XYZ enters into a contract with an investment bank to convert euro to US dollars at a fixed exchange rate. The contract requires XYZ to remit euro based on its sales volume in France in exchange for US dollars at a fixed exchange rate of 6.00. Is that contract a derivative?

Yes. The contract has two underlying variables (the foreign exchange rate and the volume of sales), no initial net investment or an initial net investment that is smaller than would be required for other types of contracts that would be expected to have a similar response to changes in market factors, and a payment provision. IAS 39 does not exclude from its scope derivatives that are based on sales volume.

B.9 Definition of a derivative: prepaid forward

An entity enters into a forward contract to purchase shares of stock in one year at the forward price. It prepays at inception based on the current price of the shares. Is the forward contract a derivative?

No. The forward contract fails the ‘no initial net investment or an initial net investment that is smaller than would be required for other types of contracts that would be expected to have a similar response to changes in market factors’ test for a derivative.

To illustrate: Entity XYZ enters into a forward contract to purchase one million T ordinary shares in one year. The current market price of T is CU50 per share; the one-year forward price of T is CU55 per share. XYZ is required to prepay the forward contract at inception with a CU50 million payment. The initial investment in the forward contract of CU50 million is less than the notional amount applied to the underlying, one million shares at the forward price of CU55 per share, ie CU55 million. However, the initial net investment approximates the investment that would be required for other types of contracts that would be expected to have a similar response to changes in market factors because T’s shares could be purchased at inception for the same price of CU50. Accordingly, the prepaid forward contract does not meet the initial net investment criterion of a derivative instrument.

B.10 Definition of a derivative: initial net investment

Many derivative instruments, such as futures contracts and exchange traded written options, require margin accounts. Is the margin account part of the initial net investment?

No. The margin account is not part of the initial net investment in a derivative instrument. Margin accounts are a form of collateral for the counterparty or clearing house and may take the form of cash, securities or other specified assets, typically liquid assets. Margin accounts are separate assets that are accounted for separately.

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

The definition of a financial asset or financial liability held for trading states that ‘a financial asset or financial liability is classified as held for trading if it is … 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’. What is a ‘portfolio’ for the purposes of applying this definition?

Although the term ‘portfolio’ is not explicitly defined in IAS 39, the context in which it is used suggests that a portfolio is a group of financial assets or financial liabilities that are managed as part of that group (IAS 39.9). If there is evidence of a recent actual pattern of short-term profit taking on financial instruments included in such a portfolio, those financial instruments qualify as held for trading even though an individual financial instrument may in fact be held for a longer period of time.

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

Entity A has an investment portfolio of debt and equity instruments. The documented portfolio management guidelines specify that the equity exposure of the portfolio should be limited to between 30 and 50 per cent of total portfolio value. The investment manager of the portfolio is authorised to balance the portfolio within the designated guidelines by buying and selling equity and debt instruments. Is Entity A permitted to classify the instruments as available for sale?

It depends on Entity A’s intentions and past practice. If the portfolio manager is authorised to buy and sell instruments to balance the risks in a portfolio, but there is no intention to trade and there is no past practice of trading for short-term profit, the instruments can be classified as available for sale. If the portfolio manager actively buys and sells instruments to generate short-term profits, the financial instruments in the portfolio are classified as held for trading.

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

Entity A purchases a five-year equity-index-linked note with an original issue price of CU10 at a market price of CU12 at the time of purchase. The note requires no interest payments before maturity. At maturity, the note requires payment of the original issue price of CU10 plus a supplemental redemption amount that depends on whether a specified share price index exceeds a predetermined level at the maturity date. If the share index does not exceed or is equal to the predetermined level, no supplemental redemption amount is paid. If the share index exceeds the predetermined level, the supplemental redemption amount equals the product of 1.15 and the difference between the level of the share index at maturity and the level of the share index when the note was issued divided by the level of the share index at the time of issue. Entity A has the positive intention and ability to hold the note to maturity. Can Entity A classify the note as a held-to-maturity investment?

Yes. The note can be classified as a held-to-maturity investment because it has a fixed payment of CU10 and fixed maturity and Entity A has the positive intention and ability to hold it to maturity (IAS 39.9). However, the equity index feature is a call option not closely related to the debt host, which must be separated as an embedded derivative under IAS 39.11. The purchase price of CU12 is allocated between the host debt instrument and the embedded derivative. For example, if the fair value of the embedded option at acquisition is CU4, the host debt instrument is measured at CU8 on initial recognition. In this case, the discount of CU2 that is implicit in the host bond (principal of CU10 minus the original carrying amount of CU8) is amortised to profit or loss over the term to maturity of the note using the effective interest method.

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

Can a bond with a fixed payment at maturity and a fixed maturity date be classified as a held-to-maturity investment if the bond’s interest payments are indexed to the price of a commodity or equity, and the entity has the positive intention and ability to hold the bond to maturity?

Yes. However, the commodity-indexed or equity-indexed interest payments result in an embedded derivative that is separated and accounted for as a derivative at fair value (IAS 39.11). IAS 39.12 is not applicable since it should be straightforward to separate the host debt investment (the fixed payment at maturity) from the embedded derivative (the index-linked interest payments).

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

Would a sale of a held-to-maturity investment following a downgrade of the issuer’s credit rating by a rating agency raise a question about the entity’s intention to hold other investments to maturity?

Not necessarily. A downgrade is likely to indicate a decline in the issuer’s creditworthiness. IAS 39 specifies that a sale due to a significant deterioration in the issuer’s creditworthiness could satisfy the condition in IAS 39 and therefore not raise a question about the entity’s intention to hold other investments to maturity. However, the deterioration in creditworthiness must be significant judged by reference to the credit rating at initial recognition. Also, the rating downgrade must not have been reasonably anticipated when the entity classified the investment as held to maturity in order to meet the condition in IAS 39. A credit downgrade of a notch within a class or from one rating class to the immediately lower rating class could often be regarded as reasonably anticipated. If the rating downgrade in combination with other information provides evidence of impairment, the deterioration in creditworthiness often would be regarded as significant.

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

Would sales of held-to-maturity financial assets due to a change in management compromise the classification of other financial assets as held to maturity?

Yes. A change in management is not identified under IAS 39.AG22 as an instance where sales or transfers from held-to-maturity do not compromise the classification as held to maturity. Sales in response to such a change in management would, therefore, call into question the entity’s intention to hold investments to maturity.

To illustrate: Entity X has a portfolio of financial assets that is classified as held to maturity. In the current period, at the direction of the board of directors, the senior management team has been replaced. The new management wishes to sell a portion of the held-to-maturity financial assets in order to carry out an expansion strategy designated and approved by the board. Although the previous management team had been in place since the entity’s inception and Entity X had never before undergone a major restructuring, the sale nevertheless calls into question Entity X’s intention to hold remaining held-to-maturity financial assets to maturity.

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

In some countries, regulators of banks or other industries may set entity-specific capital requirements that are based on an assessment of the risk in that particular entity. IAS 39.AG22(e) indicates that an entity that sells held-to-maturity investments in response to an unanticipated significant increase by the regulator in the industry’s capital requirements may do so under IAS 39 without necessarily raising a question about its intention to hold other investments to maturity. Would sales of held-to-maturity investments that are due to a significant increase in entity-specific capital requirements imposed by regulators (ie capital requirements applicable to a particular entity, but not to the industry) raise such doubt?

Yes, such sales ‘taint’ the entity’s intention to hold other financial assets as held to maturity unless it can be demonstrated that the sales fulfil the condition in IAS 39.9 in that they result from an increase in capital requirements, which is an isolated event that is beyond the entity’s control, is non-recurring and could not have been reasonably anticipated by the entity.

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