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This article was first published in the November/December 2006 edition of Accounting and Business magazine.
This article looks at some of the more complex areas of IAS 39 including de-recognition, impairment, derivatives, and hedge accounting. The accounting entries for the above elements of the standard are relatively straight forward. The difficulty comes in determining how the standard should be applied.
De-recognition and impairment
De-recognition of a financial asset occurs where:
- the contractual rights to the cash flows of the financial asset have expired, or
- the financial asset has been transferred (e.g., sold) and the transfer qualifies for de-recognition based on the extent of the transfer of the risks and rewards of ownership of the financial asset.
The contractual rights to cash flows may expire if a customer has paid off an obligation to the company or an option held by the company has expired. De-recognition occurs because the rights associated with the financial asset do not now exist.
When a company sells or transfers a financial asset to another party, the company must evaluate the extent to which it has transferred the risks and rewards of ownership. The risks and rewards of ownership are transferred where the seller does not retain any rights or obligations associated with the sold asset or where the seller retains a right to repurchase the financial asset in the future at the current fair value of the asset.
For example a company retains substantially all risks and rewards of ownership where the asset will be returned to the company for a fixed price at a future date. Here the sale would not qualify for de-recognition.
If a company sells an investment in shares, but retains the right to repurchase the shares at any time at a price equal to their current fair value then it should derecognise the asset.
If a company sells an investment in shares and enters into an agreement whereby the buyer will return any increases in value to the company and the company will pay the buyer interest plus compensation for any decrease in the value of the investment, then the company should not derecognise the investment as it has retained substantially all the risks and rewards.
The de-recognition criteria for financial liabilities are different from those for financial assets. There is no requirement to assess the extent to which the company has retained risks and rewards in order to derecognise a financial liability. The de-recognition requirements focus on whether the financial liability has been extinguished.
IAS 39 requires an assessment at each balance sheet date as to whether there is any objective evidence that a financial asset is impaired and whether any impairment has any impact on the estimated future cash flows of the financial asset. The company recognises any impairment loss in profit or loss. Losses expected from future events are not recognised.
Objective evidence of impairment includes observable data about the loss events such as financial difficulty, breach of contract and bankruptcy. For investments in equity instruments that are classified as available for sale, a significant and prolonged decline in fair value below its cost is objective evidence of impairment.
The only category of financial asset that is not subject to testing for impairment is financial assets at fair value through profit or loss, since any decline in value for such assets is recognised immediately. Financial liabilities are not subject to impairment testing.
For loans and receivables and held-to-maturity investments, impaired assets are measured at the present value of the estimated future cash flows discounted using the original effective interest rate of the financial asset.
A company makes a five-year loan of £15,000 at an effective and original interest rate of 7% received at the end of each year. The loan will be repaid at a value of £15,000. One year before maturity, there is evidence of impairment due to the financial difficulties of the borrower and it is estimated the company will only receive £7,500 in the future. The loan is measured at the present value of the estimated future cash flows discounted using the original effective interest rate i.e.£7,500 discounted for one year at 7% (£7,009). The impairment loss recognised would be £ (15,000 – 7,009) i.e. £7,991. IAS 39 requires accrual of interest on impaired loans and receivables using the effective interest rate. Thus interest of £491 would be accrued. (£7,009 x 7%).If the amount of £7,500 is eventually received then the entry would be:
Dr Cash £7,500
Cr Interest income £491
Loans and receivables £7,009
For available-for-sale financial assets, impaired assets continue to be measured at fair value. Any unrealised holding losses that had previously been recognised as a separate component of equity are removed from equity and recognised as an impairment loss in profit or loss.
Reversals of impairment losses
Impairment losses for loans and receivables, held-to-maturity investments, and investments in debt instruments classified as available-for-sale are reversed through profit or loss if the impairment losses decrease and the decrease can be related to an event occurring after the impairment was recognised. Impairment losses for investments in equity instruments are never reversed in profit or loss until the investments are sold.
The difference in treatment of reversals is due to the fact that it is more difficult to distinguish reversals of impairment losses from other increases in fair value for investments in equity instruments.
Derivatives are contracts such as options, forwards, futures, and swaps. They are often entered into at no or very little cost and therefore prior to IAS 39 were not often recognised in financial statements. IAS 39 requires derivatives to be measured at fair value with changes in fair value recognised either in profit or loss or in reserves depending on whether the company uses hedging. Where the derivative is used to offset risk and certain hedging conditions are met, changes in fair value can be recognised separately in reserves.
A derivative is a financial instrument which has the following characteristics:
- 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, credit index or other variable
- it requires no initial net investment or the investment is small
- it is settled at a future date
A company enters into a contract (call option) on 1 September 2006 that gives it the right to purchase 50,000 shares issued by another company on 1 February 2007 at a price of £30 per share. The company pays £1 per share option. The company's year end is 31 December 2006 when the value of the share option is £2.50.
The following entry is made on 1 September 2006:
Dr Call option £50,000
Cr Cash £50,000
The increase in the fair value of the options is recorded on 31 December 2006 :
Dr Call option £75,000
Cr Income statement £75,000
The company purchases the shares on 1 February 2007 for £30 per share when the fair value of the share is £32.50.There has been no increase in the value of the options. The following entries will occur:
Dr Investment in shares £1,625,000
Cr Cash £1,500,000
Cr Call option £125,000
(Exercise and de-recognition of call options and receipt of shares)
IAS 39 requires financial assets to be initially recognised at fair value.
Hedging is a risk management technique designed to offset changes in fair value or cash flows. When certain conditions are met, companies are permitted to apply hedge accounting which differs from the normal accounting methods in IAS 39. These requirements are optional. The main impact of hedge accounting is that gains and losses on the hedging instrument and the hedged item are recognised in the same period.
There will be a hedging instrument (a derivative or a non-derivative financial asset or non-derivative financial liability) and a hedged item (an asset, liability, firm commitment, net investment in a foreign operation etc). The hedged item exposes the company to risks of changes in fair value or future cash flows.
There are three types of hedging in IAS 39:
- Fair value hedges
- Cash flow hedges
- Hedges of a net investment in a foreign operation.
Changes in fair value of the hedged item, when using fair value hedges, are recognised in the current period to offset the recognition of changes in the fair value of the hedging instrument. In the case of cash flow hedges and hedges of a net investment in a foreign entity, changes in fair value of the hedging instrument are deferred in reserves to the extent the hedge is effective and released [amortised?] to profit or loss in the time periods in which the hedged item impacts profit or loss.
IAS 39 limits the use of hedge accounting to situations where certain conditions are met. These conditions are as follows:
1.Formal designation and documentation of the hedging relationship and the company's risk management objective and strategy for undertaking the hedge. Hedge accounting is only permitted from the date such designation and documentation is in place.
2.The hedging relationship is effective:
a.The hedge is expected to be highly effective in achieving offsetting changes in fair value or cash flows attributable to the hedged risk
b.The effectiveness of the hedge can be reliably measured.
c.The hedge is assessed on an ongoing basis and determined to have been highly effective throughout the financial reporting periods for which the hedge was designated
3.For cash flow hedges of forecast transactions, the hedged transaction must be highly probable and must present an exposure to variations in cash flows that could ultimately affect profit or loss.
Example - fair value hedge
A company purchases a £2 million bond that has a fixed interest rate of 6 % per year . The instrument is classed as an available-for-sale financial asset. The fair value of the instrument is £2 million
The company enters into an interest rate swap (fair value zero) to offset the risk of a decline in fair value. If the derivative hedging instrument is effective, any decline in the fair value of the bond should offset by opposite increases in the fair value of the derivative instrument. The company designates and documents the swap as a hedging instrument.
Market interest rates increase to 7% and the fair value of the bond decreases to £1,920,000. Because the instrument is classified as ‘available for sale', the decrease in fair value would normally be recorded directly in reserves. However, since the instrument is a hedged item in a fair value hedge, this change in fair value of the instrument is recognised in profit or loss, as follows:
Dr Income statement £80,000
Cr Bond £80,000
The fair value of the swap has increased by £80,000. Since the swap is a derivative, it is measured at fair value with changes in fair value recognised in profit or loss. The changes in fair value of the hedged item and the hedging instrument exactly offset, the hedge is 100% effective and, the net effect on profit or loss is zero.
Example - cash flow hedge
A company expects to purchase a piece of machinery for €10 million in a years time ( 31 July 2007 ). In order to offset the risk of increases in the euro rate, the company enters into a forward contract to purchase €10 million in 1 year for a fixed amount (£6,500,000). The forward contract is designated as a cash flow hedge and has an initial fair value of zero.
At the year end, ( 31 October 2006 ) the euro has appreciated and the value of €10 million is £6,660,000. The machine will still cost €10 million so the company concludes that the hedge is 100% effective. Thus the entire change in the fair value of the hedging instrument is recognised directly in reserves.
Dr Forward contract £160,000
Cr Reserves £160,000
The effect of the cash flow hedge is to lock in the price of €10 million for the machine. The gain in equity at the time of the purchase of the machine will either be released from equity as the machine is depreciated or be deducted from the initial carrying amount of the machine.
A hedge of net investment in a foreign operation is accounted similarly to a cash flow hedge and generally, a hedge is viewed as being highly effective if actual results are within a range of 80% and 125%.