Ifrs Uk Gaap

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
PricewaterhouseCoopers
Introduction
Introduction Recognition, Embedded Hedge

Classification derivatives Accounting
& scope
&
Measurement
Debt vs Equity Derecognition First time Summary

adoption in
the UK
Why IAS 32 & 39?
?
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)
Scope
Includes:
Financial guarantee contracts & weather
derivatives (if not specific)
Derivatives (standalone & embedded)
Debt and equity investments
Loans and receivables
Own issued debt
Recognition, classification and
measurement
& scope &
Measurement

adoption in
the UK
Overview
Recognition
Classification
Measurement
Fair value
Impairment
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.
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
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
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
categories)

Non-derivative financial assets.

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

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.

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.
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
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
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

At amortised cost
Held to maturity
At FV through
equity
Available for sale
Other liabilities
So how shall we value derivatives?
At fair value
Fair Value Hierarchy
Active market
Published quotations Best evidence
Active market
No active market
Valuation Alternative
Techniques
Active market
No active market
Valuation Alternative
Techniques
No active market -
Equity investments Very rare
only
Cost less impairment
Impairment
Step 1 Objective evidence of impairment
Step 2 Calculate recoverable amount/fair value
Step 3 Record impairment in profit & loss
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)
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
Embedded derivatives

& scope &
Measurement

adoption in
the UK
Overview embedded derivatives
What are they?
Where are they?
Do you need to separate?
How do you value them?
Definition of derivative
Value changes in response to an underlying
Requires little or no net investment
Settled at a future date
Example embedded derivatives
Financial instruments
convertible bonds,
exchangeable bonds
Non-financial instrument contracts
Leases
Insurance contracts
Sale and purchase contracts
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
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
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
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
Hedge accounting

& scope &
Measurement

adoption in
the UK
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
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
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%])
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
What you can hedge
GROUP OF SIMILAR ITEMS
OK +10% +10% +9% +11% +10%
OK +10% +11% -4% -10% +43%
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)
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
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
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
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)
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
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
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
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.
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
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
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.
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.
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
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
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
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
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
Debt vs equity

& scope &
Measurement

adoption in
the UK
Overview Debt vs Equity
Review of key definitions
Identifying substance
Derivatives on own shares
Compound instruments
Accounting
Debt vs Equity Definitions
Assets - Liabilities = Equity
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
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
Compound instruments
Liability: Fair value using

rate for non-
+ convertible debt
Convertible Debt
Equity: Balancing figure
Total consideration
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.
Derecognition

& scope &
Measurement

adoption in
the UK
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
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
YES
NO

transferred?
Consolidate all NO
NO
subsidiaries (including Pass through arrangement? No derecognition
any SPEs)
YES
YES
transferred?
NO
YES
rewards retained?
NO
NO
YES
Consolidation
YES
NO

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
transferred?
NO
YES
rewards retained?
NO
NO
YES
Consolidation
YES
NO

transferred?
Have the rights NO
to the cash NO
flows from the
YES
asset expired? YES
transferred?
NO
YES
rewards retained?
NO
NO
YES
Consolidation
YES
NO

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
rewards retained?
NO
NO
YES
Consolidation
YES
Has the entity assumed Rights to cash flows expired? Derecognition
an obligation to pay the NO

cash flows from the
asset? transferred?
NO
NO
YES
YES
transferred?
NO
YES
rewards retained?
NO
NO
YES
Consolidation
YES
Has the entity NO
transferred Rights to cash flows

substantially all risks transferred?
NO
and rewards? NO
YES
YES
transferred?
NO
YES
rewards retained?
NO
NO
YES
Consolidation
YES
Has the entity
NO
retained substantially
all risks and rewards? Rights to cash flows
transferred?
NO
NO
YES
YES
transferred?
NO
YES
rewards retained?
NO
NO
YES
Consolidation
YES
NO
Has the entity
retained control of transferred?
the asset? NO
NO
YES
YES
transferred?
NO
YES
rewards retained?
NO
NO
YES
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)
Consolidation
YES
NO

Continuing transferred?
NO
involvement NO
YES
YES
transferred?
NO
YES
rewards retained?
NO
NO
YES
Derecognition of non-financial assets
and liabilities
IAS 17 Leases
IFRIC D3 - Determining whether an arrangement

contains a lease
IAS 18 - Revenue
First time adoption in the UK

& scope &
Measurement

adoption in the
UK
The EU IAS 39 carve-out
Removal of fair value

option for financial
liabilities
Relaxation of certain
hedging requirements
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.
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 !
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.
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
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
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
Summary

& scope &
Measurement
Summary
Debt vs Equity Derecognition First time
adoption in
the UK
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
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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Financial Instruments under

2. Classification and measurement

7. First time adoption in the UK

Introduction Recognition, Embedded Hedge

Debt vs Equity Derecognition First time Summary

Debt vs Equity Derecognition First time Summary

A financial instrument is any contract that gives rise

Financial assets and financial liabilities are, generally

An option contract to sell a building

1. Financial assets at fair value through profit or loss

2. Loans and receivables

4. Available for sale

At fair value through profit or loss

Held for Designated at

Loans and receivables

Non-derivative financial assets.

Non-derivative financial assets.

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

There are three exceptions to the rule:

The sale is close to maturity;

Available for sale

All equity securities not classified in FVTPL category.

1. At fair value through profit or loss

Held for Designated at

Intention of short term profit; No restrictions on designation;

Because it drives measurement

Assets/Liabilities at fair value At FV through

Loans and receivables

Step 1 Objective evidence of impairment

Step 2 Calculate recoverable amount/fair value

Step 3 Record impairment in profit & loss

Significant financial High probability

Adverse effect in the

Introduction Recognition, Embedded Hedge

Debt vs Equity Derecognition First time Summary

What are they?

Where are they?

Do you need to separate?

How do you value them?

Value changes in response to an underlying

Requires little or no net investment

Settled at a future date

Split and separately account

Do not split out the embedded derivative

Closely related Not closely related

Closely related Not closely related

Introduction Recognition, Embedded Hedge

Debt vs Equity Derecognition First time Summary

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

THE HEDGE IS EXPECTED TO BE

Group of similar items

GROUP OF SIMILAR ITEMS

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

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

Yes But not

Derivatives (including Written options

Fixed rate assets/liabilities

Fair Value Cash Flow

A hedge of the exposure to changes in the fair

CHANGES IN FAIR VALUE OF PROFIT OR