IAS39 - Part 2

This is the second of a two-part article. The first article was published in the May 2005 issue of student accountant. This article looks at some of the more complex areas of IAS 39, including impairment, derivatives, embedded derivatives, and hedge accounting. It must be read in conjunction with the first article if the points covered are to be fully understood.

Impairment 
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 the impairment has any impact on the estimated future cash flows of the financial asset. The company recognises any impairment loss in profit or loss, and only losses that have been incurred can be reported. Therefore, losses expected from future events are not recognised. The impairment requirements apply to the following financial assets:

•  loans and receivables
• held-to-maturity investments
• available-for-sale financial assets
• investments in unquoted equity instruments whose fair value cannot be reliably measured.

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 in profit and loss. Financial liabilities are not subject to impairment testing.
For loans, receivables, and held-to-maturity investments, impaired assets are measured at the present value of estimated future cash flows, discounted using the original effective interest rate of the financial asset.

Example
At the beginning of 20X5, a company makes a five-year loan of £5,000 that has an effective and original interest rate of 7%, received at the end of each year, and a principal amount of £5,000 at maturity. At the beginning of 20X9, there is evidence of impairment due to the financial difficulties of the borrower, and it is estimated that remaining future cash flows will be £2,500 instead of £5,350 (principal plus interest). The impaired asset is measured at the present value of the estimated future cash flow, discounted using the original effective interest rate, ie £2,500 discounted for one year at 7% (£2,336). Accordingly, the impairment loss recognised at the beginning of 20X9 is £2,664 (£5,000 - £2,336).

IAS 39 requires accrual of interest on impaired loans and receivables at the original effective interest rate. In this case, therefore, an accrual of interest at 7% would be made on the carrying amount of £2,336, ie £164 in 20X9. 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.

For investments in unquoted equity instruments that cannot be reliably measured at fair value, impaired assets are measured at the present value of the estimated future cash flow, discounted using the current market rate of return for a similar financial asset. Any difference between the previous carrying amount and the new measurement of the impaired asset is 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 due to an event occurring after the impairment was recognised. Impairment losses for investments in equity instruments are not reversed in profit or loss until the investments are sold. The difference in treatment of reversals is due to the fact that it is harder to distinguish reversals of impairment losses from other increases in fair value for investments in equity instruments.

Derivatives
Derivatives are contracts such as options, forwards, futures, and swaps. They are often entered into at no cost and therefore prior to IAS 39 were not often recognised in financial statements. The gains and losses on derivatives however can be significant.

IAS 39 requires derivatives to be measured at fair value and changes in fair value should be recognised either in profit or loss or in equity, depending on whether the company uses the derivative to hedge an item. Normally, changes in fair value of a derivative are recognised in profit or loss but where hedging is effective, changes in fair value can be recognised in reserves depending on the nature of the hedge.

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.

Example
A company enters into a call option contract on 1 July 20X6. The contract gives it the right to purchase 5,000 shares issued by another company on 1 December 20X6, at a price of £15 per share. The company’s year-end is 31 October 20X6. The cost of each option is £1. On 1 July 20X6 the following entry is made:

On 31 October 20X6, the value of each option is £1.50. Therefore the increase in the fair value is recorded:

On 1 December 20X6, the fair value of each option is £2. The share price on this date is £16. Since the share price is higher than the exercise price, the company exercises the option (5,000 shares at £15 per share). The shares are recognised at £75,000 and the option asset is de-recognised:

The balance on the call option account will be written off to profit and loss (£5,000).

Embedded derivatives
Derivatives are included in other types of contracts. For example, a company may issue a loan with interest linked to the price of a commodity. Such a loan is a contract that combines a host debt instrument and an embedded derivative on the price of the commodity. This feature is referred to as an embedded derivative, and the contract in which it is embedded is referred to as a host contract.

Companies are required to identify any embedded derivatives and account for them separately from their host contracts, only if the following conditions are met:

• The embedded feature meets the definition of a derivative. 
• The combined contract is not measured at fair value with changes in fair value recognised in profit or loss. If the combined contract is already accounted for at fair value (as for a derivative) there is no need to separate it.
• The economic characteristics and risks of the embedded feature are not closely related to those of the host contract.

When these conditions are met, the embedded derivative is separated from the host contract and accounted for like any other derivative. The host instrument is accounted for under the relevant IFRS separately from the derivative.

Example
A company invests in a convertible debt instrument at a cost of £25,000. The fixed interest rate is 7% and it can be converted into ordinary shares in 10 years’ time, at the company’s option, or, the capital can be repaid at £25,000. The investment is classed as available-for-sale.

The equity conversion option (the embedded derivative) is separated from the host debt instrument because:

• there is an embedded derivative
• it is not measured at fair value with changes in fair value recognised in profit or loss
• equity and debt are not closely related characteristics.

The fair value of the equity conversion option is £3,250:

The derivative asset is accounted for at fair value with changes in fair value recognised in profit or loss. The debt instrument is accounted for as an available-for-sale asset at fair value with changes in fair value recognised directly in reserves. The difference between the initial carrying amount and the amount of the available-for-sale financial asset of £3,250 is amortised to profit or loss using the effective interest rate method. If it is not possible to reliably measure the embedded derivative element, then the instrument is treated as a financial asset or financial liability that is held for trading.

Hedge accounting
Hedge accounting is a risk management technique designed to offset changes in fair value or cash flow. When certain conditions are met, companies are permitted to apply hedge accounting, which differs from the normal accounting techniques 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. The types of hedging set out in IAS 39 are:

• Fair value hedges
• Changes in fair value of the hedged item are recognised in the current period to offset the recognition of changes in the fair value of the hedging instrument. 
• Cash flow hedges
• Changes in fair value of the hedging instrument are deferred in reserves to the extent the hedge is effective, and released to profit or loss in the time periods in which the hedged item impacts on profit or loss.

IAS 39 limits the use of hedge accounting to situations where the following conditions are met:  

There is formal designation and documentation of the hedging relationship, the company’s risk management objective, and the strategy for undertaking the hedge. Hedge accounting is only permitted from the date such designation and documentation is in place.

The hedging relationship is effective, defined as follows:

• The hedge is expected to be highly effective in offsetting changes in fair value or cash flows attributable to the hedged risk.
• The effectiveness of the hedge can be reliably measured.
• 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. 
  
  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 debt instrument that has a principal amount of £1 million at 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 £1 million.

The company is exposed to a risk of the decline in the fair value of the instrument if the market interest rate increases because of the fixed interest rate.

The company enters into an interest rate swap. It exchanges the fixed interest rate payments it receives on the bond for floating interest rate payments, in order 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 be offset by opposite increases in the fair value of the derivative instrument. The company designates and documents the swap as a hedging instrument. On entering into the swap, the swap has a fair value of zero.
Assuming market interest rates have increased to 7%, the fair value of the bond will have decreased to £960,000. The instrument is classified as available-for-sale, therefore 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:

At the same time, the company determines that the fair value of the swap has increased by £40,000. 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 each other: the hedge is 100% effective and the net effect on profit or loss is zero.

Example - cash flow hedge
A company trades in £ sterling. It expects to purchase a piece of plant for 1 million euros in one year from 1 May 20X6. In order to offset the risk of increases in the euro rate, the company enters into a forward contract to purchase 1 million euros in 1 year for a fixed amount (£650,000). The forward contract is designated as a cash flow hedge. At inception, the forward contract has a fair value of zero.

At the year-end of 31 October 20X6, the euro has appreciated and the value of 1 million euros is £660,000. The machine will still cost 1 million euros 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.

The forward contract is settled with no further change in the exchange rate:

The company purchases the machine for 1 million euros and makes the following journal entry:

The deferred gain or loss of £10,000 should either remain in reserves and be released from equity as the machine depreciates, or be deducted from the initial carrying amount of the machine. A hedge of net investment in a foreign operation is accounted for similarly to a cash flow hedge.
 
Hedge effectiveness
Generally, a hedge is viewed as being highly effective if actual results are within a range of 80% and 125%.  

Example
If actual results are such that the gain on a hedging instrument is £190 and the loss on the hedged item is £200, the effectiveness of the hedged item is determined by dividing 200/190, ie 105.2% or 190/200, ie 85%. This is called the degree of offset. Therefore the hedge is effective.

If any of the following circumstances arise a company should discontinue hedge accounting prospectively:

• the hedging instrument expires or is sold, terminated, or exercised 
• the hedge no longer meets the hedge accounting conditions
• the company revokes the hedge designation
• a hedged forecasted transaction is no longer expected to occur.

For discontinued fair value hedges, any previous hedge accounting adjustments made to the carrying amount of hedged items are amortised over the remaining maturity of those assets and liabilities. For discontinued cash flow hedges, hedging gains and losses that have been deferred in equity generally remain in equity until the hedged item affects profit or loss, except in certain circumstances with forecast transactions.

Conclusion
This two-part article sets out the key elements of accounting for financial instruments. It is important that students read around the subject and try and grasp the main principles of the subject. It is not an easy area and changes to IAS 39 are envisaged in the future.

Graham Holt is examiner for Paper 3.6