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Financial Instruments under

IFRS in the UK


Overview of Session
1. Introduction and scope

2. Classification and measurement

3. Embedded derivatives

4. Hedge Accounting

5. Debt vs Equity

6. Derecognition

7. First time adoption in the UK

8. Summary

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Introduction

Introduction Recognition, Embedded Hedge


Classification derivatives Accounting
& scope
&
Measurement

Debt vs Equity Derecognition First time Summary


adoption in
the UK

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Why IAS 32 & 39?

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?
Scope - the good news

Excludes:
Insurance contracts (IFRS 4)
Loan commitments - except those at FVTPL
Own use commodity contracts - net settlement
Employee benefits (IAS 19)
Share based payments (IFRS 2)
Leases almost (IAS 17)
Own equity instruments
Financial guarantee contracts & weather derivatives (if
specific IFRS 4)

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Scope

Includes:
Financial guarantee contracts & weather
derivatives (if not specific)
Derivatives (standalone & embedded)
Debt and equity investments
Loans and receivables
Own issued debt

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Recognition, classification and
measurement
Introduction Recognition, Embedded Hedge
Classification derivatives Accounting
& scope &
Measurement

Debt vs Equity Derecognition First time Summary


adoption in
the UK

PricewaterhouseCoopers
Overview

Recognition

Classification

Measurement

Fair value

Impairment

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Initial recognition

A financial instrument is any contract that gives rise


to a financial asset of one entity and a financial liability
or equity instrument of another entity.

Financial assets and financial liabilities are, generally


recognised on the balance sheet only when the entity
becomes a party to the contractual provisions of the
instrument.

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Initial recognition

Unconditional receivables
Yes
Firm commitment to buy goods (ie No

recognised
when an entity place an order)

Should it
Forward contract to buy US$ in 60 Yes

be
?
days

An option contract to sell a building


for $1m on 31/12/2005 (not net settled) No
Planned future transactions No
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Classification Financial Assets (Four
categories)

1. Financial assets at fair value through profit or loss

2. Loans and receivables

3. Held to maturity

4. Available for sale

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Classification Financial Assets (Four
categories)

At fair value through profit or loss

Held for Designated at


trading inception

No restrictions on designation;
Intention of short term profit; Irrevocable cannot be moved

Derivatives unless if hedges

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Classification Financial Assets (Four
categories)

Loans and receivables

Non-derivative financial assets.


Fixed or determinable payments.
Not quoted.
No intention of trading.

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Classification Financial Assets (Four
categories)

Held to maturity

Non-derivative financial assets.


Fixed or determinable payments & fixed maturity.
No intention of trading & intention and ability to hold
to maturity.

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Held to maturity - tainting

HTM portfolio is tainted if management sold or reclassified as AFS, before


maturity, during the current or two preceding years more than an
insignificant amount of HTM assets (Vs total HTM category)

There are three exceptions to the rule:

The sale is close to maturity;


Collected substantially all of original principal through schedule
payments;
Isolated event beyond entitys control may not invoke tainting.

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Classification Financial Assets (Four
categories)

Available for sale

All equity securities not classified in FVTPL category.


All financial assets not in another category.
Any financial assets other than those held for trading
may be designated to this category at inception

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Classification Financial Liabilities(Two
categories)

1. At fair value through profit or loss

Held for Designated at


trading inception

Intention of short term profit; No restrictions on designation;


Derivatives unless if hedges Irrevocable cannot be moved


2. Other financial liabilities
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Why is classification important?

Because it drives measurement


Subsequent measurement

Assets/Liabilities at fair value At FV through


through profit or loss profit or loss

Loans and receivables


At amortised cost

Held to maturity
At FV through
equity
Available for sale

Other liabilities
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So how shall we value derivatives?

At fair value
Fair Value Hierarchy

Active market
Published quotations Best evidence

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Fair Value Hierarchy

Active market
Published quotations Best evidence

No active market
Valuation Alternative
Techniques

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Fair Value Hierarchy

Active market
Published quotations Best evidence

No active market
Valuation Alternative
Techniques
No active market -
Equity investments Very rare
only
Cost less impairment
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Impairment

Step 1 Objective evidence of impairment

Step 2 Calculate recoverable amount/fair value

Step 3 Record impairment in profit & loss

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Impairment loans Objective evidence

Significant financial High probability


difficulty of the issuer of bankruptcy Granting of a
concession to the
borrower

Breach of contract,
Disappearance such as default or
of an delinquency in
active market interest or principal
Adverse change in
because of financial payment status or factor
difficulties (eg unemployment)

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And what about equities?
Impairment equities Objective
evidence

Adverse effect in the


technological, market,
economic or legal environment Significant or prolonged
decline in the FV of an
investment below its cost

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Embedded derivatives

Introduction Recognition, Embedded Hedge


Classification derivatives Accounting
& scope &
Measurement

Debt vs Equity Derecognition First time Summary


adoption in
the UK

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Overview embedded derivatives

What are they?

Where are they?

Do you need to separate?

How do you value them?

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Definition of derivative

Value changes in response to an underlying

Requires little or no net investment

Settled at a future date

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Example embedded derivatives

Financial instruments
convertible bonds,
exchangeable bonds
Non-financial instrument contracts
Leases
Insurance contracts
Sale and purchase contracts

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Decision tree

Split and separately account


Is the contract No Would it be a Yes Is it closely No
carried at fair derivative if it related
value through was to the host
earnings? freestanding? contract?

Yes No Yes

Do not split out the embedded derivative

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Closely related or not?

Closely related Not closely related


Interest rate swap embedded in a Equity conversion or put option in
debt instrument debt instrument
Inflation indexed lease contracts Fixed rate debt extension option
Cap and floor in a sale and Debt security with interest or
purchase contract principal linked to a stock or
commodity index
Prepayment option in a mortgage
that does result in the exercise Credit derivatives embedded in a
amount approximately equal to host debt instrument
amortised cost

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FX embedded derivatives

Closely related Not closely related


Normal purchases and sales Sales or purchases not in
functional currency of either party
Dual currency bonds
Not in currency in which products
Foreign currency denominated
are routinely denominated in
debt
international commerce (eg crude
Currency that is commonly used oil in USD)
in purchase and sale contracts in
Guarantees not denominated in
the economic environment in
currency of guaranteed loan
which the transaction takes place

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Valuation
Initial recognition
Zero fair value non-optional derivatives
Value using contractual criteria optional derivatives
Subsequently
Based on underlying cash flows
All fair value changes to profit and loss
If all else fails, value hybrid instrument as a whole

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Hedge accounting

Introduction Recognition, Embedded Hedge


Classification derivatives Accounting
& scope &
Measurement

Debt vs Equity Derecognition First time Summary


adoption in
the UK

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Overview of the session

Review of key concepts

When can the right to hedge accounting be earned?

Hedging instruments and hedged items

Different types of hedges and how to account for them

Discontinued hedge accounting

Summary

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Criteria for hedge accounting

Reliable
measurement of
effectiveness

FORMAL
formal hedge DESIGNATION
documentation The hedge is
+ risk expected to be
management and is highly
policy effective

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Effectiveness testing

THE HEDGE IS EXPECTED TO BE


AND HAS BEEN HIGHLY EFFECTIVE

AT INCEPTION AT EACH
REPORTING DATE

PROSPECTIVE
TEST (highly effective) X X
AND

RETROSPECTIVE X
TEST ([80-125%])

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What you can hedge

Highly probable
forecast
transaction
Single item

FIRM
COMMITMENT

Group of similar items


ASSET (sharing the same risk)
LIABILITY

Proportions of an item
Net investment in
foreign operations

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What you can hedge

GROUP OF SIMILAR ITEMS

OK +10% +10% +9% +11% +10%

OK +10% +11% -4% -10% +43%

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What you cant hedge

FUTURE PROFIT
NET POSITION STREAMS
(e.g. group of
forecast sales and
purchases in
foreign currency)
Portions of risks of
non-financial
assets and
liabilities SHARES OWN
(except for FX risk)

DERIVATIVE
INSTRUMENTS HTM ASSETS (for
interest rate and
prepayment risks)

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What can you hedge with

Yes But not

Derivatives (including Written options


x
embedded derivatives)
Non-derivatives for FX Non-derivatives for
risk other risks x
Proportions of Portions of
derivatives derivatives x

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Different types of hedges

Fixed rate assets/liabilities


Assets/liabilities Variable rate
in foreign currencies assets/liabilities
Firm commitments Highly probable
forecast
transactions

Fair Value Cash Flow

Foreign Exchange
Net investments
in foreign operations

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Fair value hedge

A hedge of the exposure to changes in the fair


value of a recognised asset or liability or a firm
commitment or an identified portion of such an
asset or liability or firm commitment that is
attributable to a particular risk and that could
affect profit or loss

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Accounting for a fair value hedge

CHANGES IN FAIR VALUE OF PROFIT OR


THE HEDGING DERIVATIVE LOSS

CHANGES IN FAIR VALUE OF


THE HEDGED INSTRUMENT PROFIT OR
ATTRIBUTABLE TO THE LOSS
HEDGED RISK
INEFFECTIVENESS
(if any)

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Fair value hedge

Fair value
hedge
Period Period
1 2
Total
Hedged Item 30 0
30
Derivative (30)
0 0 0
(30)
P&L (30) 30 0
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Fair value hedge example
On 30/6/03 XYZ Company issued 10 million fixed 7.5% rate debt due in 3
years with semi-annual interest payments.
XYZ Company enters into an interest rate swap with the bank to pay
LIBOR and receive fixed 7.5% annually for 3 years
LIBOR is set at 6% on 5 July 2003 for the first 12 months
The fair value of the swap is 200,000 before cash settlement at 31/12/03

Floating Interest
Principal Amount

Fixed XYZ
Rate Debt Company Bank

Fixed interest
Fixed interest
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Fair value hedge example
The journal entries would look as follows at 31/12/03:
Transaction Balance Sheet Income Statement Equity

Dr Cr Dr Cr Dr Cr
Interest
Pay interest
Cash 375 expense
on the debt
375
Fair value Derivative Interest
swap asset 200 expense 200
Cash settle Derivative
Cash 75
swap asset 75

Adjust
FV Interest
carrying
adjustment expense
amount of
on debt 125 125
debt

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Cash flow hedge

A hedge of the exposure to variability in cash flows


that is attributable to a particular risk associated
with a recognised asset or liability or a forecast
transaction and that could affect profit or loss.

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Accounting for a cash flow hedge

CHANGES IN FAIR Effective portion EQUITY


VALUE OF THE
HEDGING
INSTRUMENT
ATTRIBUTABLE TO PROFIT OR
Ineffective portion
THE HEDGED RISK LOSS

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Cash flow hedge

Cash flow hedge

Period Period
1 2
Total
Hedged Item 30
30 (30) (30)
Derivative (30)
0 0 0
(30)
P&L
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Cash flow hedge example

On 30/9/03 a UK company (functional currency : )


expects to buy equipment for US$ 1m. The delivery date
should be 31/3/04 and the payment date of 30/6/04.

The company enters into a forward exchange contract to


purchase US$ 1m at a fixed exchange rate, in order to
hedge the foreign exchange risk. The forward contract is
designated as a cash flow hedge of the exchange risk of
the forecast transaction.

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Cash flow hedge example continued
Applicable exchange rates are as follows:
Date Spot Forward
30/9/03 1.22 1.23
31/12/03 1.23 1.24
31/3/04 1.25 1.25
30/6/04 1.26 N/A
FV of FX contract on 31/12/03 and 31/3/04 as determined
from market quotes is 9,500 and 19,700 respectively. At
30/6/04 the FV is 30,000 the net amount that is due to be
settled at that date.

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Cash flow hedge example 31/12/03

Transaction Balance Sheet Income Equity


Statement
Dr Cr Dr Cr Dr Cr
Recognise gain in Forward Hedging
FV of forward asset reserve
since30/9/03 9,500
9,500

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Cash flow hedge example 31/03/04

Transaction Balance Sheet Income Equity


Statement
Dr Cr Dr Cr Dr Cr
Recognise receipt Equipment Payables
of equipment at Asset 1,250,000
spot 1,250,000
Recognise gain on Forward Hedging
fv of forward since asset reserve
31/12 10,200 10,200
Gains deferred in Equipment Hedging
equity are included Asset reserve
in the assets 19,700 19,700

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Cash flow hedge example 30/06/04

Transaction Balance Income Equity


Sheet Statement
Dr Cr Dr Cr Dr Cr
Payment for Payable Cash FX loss
equipment at 1,250,000 1,260,000 10,000
spot rate and
exchange loss
on the payable
since 31/3

Gain on forward Forward FX gain


contract for the asset 10,300
period 10,300
Net settlement Cash Forward
under forward 30,000 Asset
contract 30,000

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Discontinuance

CRITERIA FOR
HEDGE
ACCOUNTING ARE
NO LONGER MET
(documentation,
THE HEDGINGeffectiveness testing)
INSTRUMENT
EXPIRES, IS SOLD, REVOCATION OF
TERMINATED OR THE DESIGNATION
EXERCISED (managements
decision)

PROSPECTIVE DISCONTINUANCE OF HEDGE


ACCOUNTING

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Discontinuance

IF THE HEDGED ITEM IS A FINANCIAL


INSTRUMENT MEASURED AT AMORTISED
FAIR VALUE HEDGE COST, AMORTISATION OF ANY
ADJUSTMENT OF ITS CARRYING AMOUNT

GAINS AND LOSSES ACCUMULATED IN


EQUITY REMAIN IN EQUITY UNTIL THE
HEDGED ITEM WILL IMPACT PROFIT OR
CASH FLOW LOSS EXCEPT IF THE FORECAST
HEDGE TRANSACTION NO LONGER EXPECTED TO
OCCUR

GAINS AND LOSSES ACCUMULATED IN


NET INVET. HEDGE EQUITY REMAIN IN EQUITY UNTIL THE
DISPOSAL OF THE FOREIGN OPERATION

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Debt vs equity

Introduction Recognition, Embedded Hedge


Classification derivatives Accounting
& scope &
Measurement

Debt vs Equity Derecognition First time Summary


adoption in
the UK

PricewaterhouseCoopers
Overview Debt vs Equity

Review of key definitions

Identifying substance

Derivatives on own shares

Compound instruments

Accounting

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Debt vs Equity Definitions

Assets - Liabilities = Equity

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Features of liabilities

Obligation to pay cash


Mandatory redemption
Puttable instruments @ NAV
Only a conditional right to avoid
Indirect obligation
Settled in a variable number of shares
Contingent settlement provisions

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Features of Equity

Discretion over cash payments (i.e. no obligation)


Fixed amount of cash for a fixed amount of shares
Not dependent on:
- Ability to make distributions
- Intention to make distributions
- Negative impact on ordinary shares
- Amount of issuers reserves
- Expectation of profits for the period

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Compound instruments

Liability: Fair value using


rate for non-
+ convertible debt
Convertible Debt
Equity: Balancing figure

Total consideration

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Accounting treatment

Income statement treatment follows balance sheet


classification

Interest, dividends, gains and losses relating to financial


liabilities should be reported in the income statement as
expenses or income.

Distributions relating to an equity instrument should be


debited directly to equity.

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Derecognition

Introduction Recognition, Embedded Hedge


Classification derivatives Accounting
& scope &
Measurement

Debt vs Equity Derecognition First time Summary


adoption in
the UK

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When should financial assets be de-
recognised?

Portfolio of trade debtors for 1000 with expected impairment of 200 i.e.
carrying value of 800
Entity will collect the receivables & pass cash collected only immediately
to bank
Bank gives the entity 750 non-refundable
Neither the entity nor the bank can sell/transfer the debtors without the
others consent

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Consolidation

Part or entire asset

YES
Rights to cash flows expired? Derecognition

NO

Rights to cash flows


transferred?
Derecognition NO
NO
Pass through arrangement? No derecognition
Flow-chart YES
YES
Substantially all risks and rewards Derecognition
transferred?
NO
YES
Substantially all risks and No derecognition
rewards retained?
NO
NO
Control retained? Derecognition

YES
PricewaterhouseCoopers Continuing involvement
Consolidation

Part or entire asset

YES
Rights to cash flows expired? Derecognition

NO

Rights to cash flows


transferred?
Consolidate all NO
NO
subsidiaries (including Pass through arrangement? No derecognition
any SPEs)
YES
YES
Substantially all risks and rewards Derecognition
transferred?
NO
YES
Substantially all risks and No derecognition
rewards retained?
NO
NO
Control retained? Derecognition

YES
PricewaterhouseCoopers Continuing involvement
Consolidation

Part or entire asset

YES
Rights to cash flows expired? Derecognition

NO

Rights to cash flows


Determine whether the transferred?
flowchart should be NO
NO
applied to a part or all of Pass through arrangement? No derecognition
an asset (or group of
similar assets) YES
YES
Substantially all risks and rewards Derecognition
transferred?
NO
YES
Substantially all risks and No derecognition
rewards retained?
NO
NO
Control retained? Derecognition

YES
PricewaterhouseCoopers Continuing involvement
Consolidation

Part or entire asset

YES
Rights to cash flows expired? Derecognition

NO

Rights to cash flows


transferred?
Have the rights NO
to the cash NO
Pass through arrangement? No derecognition
flows from the
YES
asset expired? YES
Substantially all risks and rewards Derecognition
transferred?
NO
YES
Substantially all risks and No derecognition
rewards retained?
NO
NO
Control retained? Derecognition

YES
PricewaterhouseCoopers Continuing involvement
Consolidation

Part or entire asset

YES
Rights to cash flows expired? Derecognition

NO

Rights to cash flows


transferred?
NO
Has the entity NO
transferred its Pass through arrangement? No derecognition
rights to receive the YES
cash flows from the YES
Substantially all risks and rewards
asset? transferred?
Derecognition

NO
YES
Substantially all risks and No derecognition
rewards retained?
NO
NO
Control retained? Derecognition

YES
PricewaterhouseCoopers Continuing involvement
Consolidation

Part or entire asset

YES
Has the entity assumed Rights to cash flows expired? Derecognition

an obligation to pay the NO


cash flows from the
Rights to cash flows
asset? transferred?
NO
NO
Pass through arrangement? No derecognition

YES
YES
Substantially all risks and rewards Derecognition
transferred?
NO
YES
Substantially all risks and No derecognition
rewards retained?
NO
NO
Control retained? Derecognition

YES
PricewaterhouseCoopers Continuing involvement
Consolidation

Part or entire asset

YES
Rights to cash flows expired? Derecognition

Has the entity NO

transferred Rights to cash flows


substantially all risks transferred?
NO
and rewards? NO
Pass through arrangement? No derecognition

YES
YES
Substantially all risks and rewards Derecognition
transferred?
NO
YES
Substantially all risks and No derecognition
rewards retained?
NO
NO
Control retained? Derecognition

YES
PricewaterhouseCoopers Continuing involvement
Consolidation

Part or entire asset

YES
Rights to cash flows expired? Derecognition
Has the entity
NO
retained substantially
all risks and rewards? Rights to cash flows
transferred?
NO
NO
Pass through arrangement? No derecognition

YES
YES
Substantially all risks and rewards Derecognition
transferred?
NO
YES
Substantially all risks and No derecognition
rewards retained?
NO
NO
Control retained? Derecognition

YES
PricewaterhouseCoopers Continuing involvement
Consolidation

Part or entire asset

YES
Rights to cash flows expired? Derecognition

NO
Has the entity
Rights to cash flows
retained control of transferred?
the asset? NO
NO
Pass through arrangement? No derecognition

YES
YES
Substantially all risks and rewards Derecognition
transferred?
NO
YES
Substantially all risks and No derecognition
rewards retained?
NO
NO
Control retained? Derecognition

YES
PricewaterhouseCoopers Continuing involvement
Control

Entity has transferred control if:


Transferee has the practical ability to sell the asset in
its entirety (e.g. asset is traded in an active market)
Transferee is able to exercise ability unilaterally
No further restrictions imposed on sale (e.g.
conditions about a loan asset is serviced)

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Consolidation

Part or entire asset

YES
Rights to cash flows expired? Derecognition

NO

Rights to cash flows


Continuing transferred?
NO
involvement NO
Pass through arrangement? No derecognition

YES
YES
Substantially all risks and rewards Derecognition
transferred?
NO
YES
Substantially all risks and No derecognition
rewards retained?
NO
NO
Control retained? Derecognition

YES
PricewaterhouseCoopers Continuing involvement
Derecognition of non-financial assets
and liabilities

IAS 17 Leases

IFRIC D3 - Determining whether an arrangement


contains a lease

IAS 18 - Revenue

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First time adoption in the UK

Introduction Recognition, Embedded Hedge


Classification derivatives Accounting
& scope &
Measurement

Debt vs Equity Derecognition First time Summary


adoption in the
UK

PricewaterhouseCoopers
The EU IAS 39 carve-out

Removal of fair value


option for financial
liabilities

Relaxation of certain
hedging requirements

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Financial instruments exemption (IAS
32, 39)
Entities applying IFRS in 2005 can choose not to restate
comparatives in accordance with IAS 32 and IAS 39.
Disapply both standards.
Apply UK GAAP to comparative period.
Disclosures required about adoption of IAS 32 and IAS 39:
Basis of preparation of comparatives.
Nature of main adjustments to make information comply with
IAS 32 and IAS 39.
Amount of adjustment at end of comparative period to each
line item and to EPS.

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Financial instruments fair value
exemption (IAS 39)
IAS 39 allows a financial asset or financial liability to
be designated on initial recognition at fair value
through profit or loss.
Designation must be made on initial recognition, and
cannot be changed.
Exemption allows designation to be made at the date
IAS 39 is adopted.

BUT : EU Carve Out !

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IFRS 1: hedging

No retrospective designation of hedges.


Fair value all derivatives and eliminate deferred gains/losses.
If hedge under UK GAAP is of a type that qualifies under IAS
39:
Make adjustments as if hedge accounting had taken
place under IAS 39 before date of adoption of IAS 39.
If hedge accounting criteria are not apply discontinuance rules
If hedge accounting criteria are met, hedge account under IAS
39 from date of adoption of IAS 39.

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IFRS 1: hedging - example

Forward contract taken out when a sale is budgeted to


hedge the foreign currency exposure on the cash flow from the
debtor.
Adoption of IAS 39 happens before the sale occurs.
Under UK GAAP nothing has been recorded.
IFRS
Cash flow hedge.
Fair value forward contract.
Hedging reserve

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Hedging on transition: areas to watch
out for
On-balance sheet

Assets and liabilities recorded at a forward or contracted rate


Debtors and creditors, inventory

Accrual accounting for interest rate swaps

Off-balance sheet

Cross-currency swaps

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UK versions of IAS 32 and 39

FRS 25 : Financial instruments - disclosure and


presentation
Will apply to all companies except FRSSE from 1
Jan 05, but if not applying FRS 26, certain disclosures
are not required
FRS 26 : Financial instruments - measurement
Will apply to listed entities from 1 Jan 05 and those
that will apply the Fair Value accounting rules - per the
Directive - from 1 Jan 06

PricewaterhouseCoopers
Summary

Introduction Recognition, Embedded Hedge


Classification derivatives Accounting
& scope &
Measurement

Summary
Debt vs Equity Derecognition First time
adoption in
the UK

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Proposed amendments to IAS 32 and
IAS 39

Limiting the use of the fair value option


Financial guarantee contracts and credit insurance
Cash flow hedge accounting of forecast intra group transactions
Transition and initial recognition of financial assets and liabilities
ED 7 - Financial instrument disclosures
IFRIC D8 Members shares in co-operative entities

Similar ASB proposals for the UK

PricewaterhouseCoopers
Top 10 Financial Instrument Reminders

1. Classification drives 6. Not every embedded


measurement derivative is accounted for
separately
2. All derivatives at fair value
7. Hedging is a privilege not a
3. Quoted prices best right
evidence of fair value 8. Ineffectiveness goes to the
4. Impairment only if objective income statement
evidence 9. Contingent settlement is
debt
5. Embedded derivatives are
everywhere 10. Dont panic!

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