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International Standards Alert

Issued: 12 January 2004 Title: Issued by: Publication of amended IAS 32 and IAS 39 IAS Advisory Services Status: Information Auditing Impact: The revised version of IAS 32 and IAS 39 apply for financial periods beginning on or after 1 January 2005. Accounting IS Alert: 2004/02

On December 17, 2003 revised IAS 32 and IAS 39 were published electronically on the IASBs website and these are expected to be published in hard copy by the end of January 2004. This alert provides brief overview of key changes in revised IAS 32 and IAS 39 and is to be read together with the revised standards themselves, which can be found on our internal website: http://www.iasadvisory.kworld.kpmg.com/Home/default.asp. Further details of the requirements in amended IAS 32 and IAS 39 will be summarised by IAS Advisory Services in a separate alert and in an updated Financial Instruments Accounting publication in due course. The IASB has made many improvements to IAS 32 and IAS 39 in the limited time available. Additionally, the limited amendment to IAS 39 on macro hedging (Fair Value Hedge Accounting for a Portfolio Hedge of an Interest Rate Risk) is still outstanding. The comment period ended on November 14, 2003 and the final amendment is expected in the first quarter of 2004. Highlights of amendments Amended IAS 32 on Disclosure and Presentation of Financial Instruments Definitions The definitions of a financial asset and a financial liability have been expanded to include some contracts that will or may be settled in the entitys own equity instruments and there is new guidance on when derivative contracts on an entitys own equity are liabilities. The Standard requires a derivative with settlement options to be classified as a financial asset or a financial liability unless all the settlement alternatives would result in equity classification. Presentation The Standard has clarified that a financial instrument that gives the holder the right to put it back to the issuer for cash or another financial asset (a puttable instrument) is a financial liability. This is so even when the amount of cash or other financial assets is determined on the basis of an index or other item that has the potential to increase or decrease, or when the legal form of the puttable instrument gives the holder a right to a residual interest in the assets of an issuer. The existence of an option for the holder to put the instrument back to the issuer for cash or another financial asset means that the puttable instrument meets the definition of a financial liability. For example, open-ended mutual funds, unit trusts, partnerships and some co-operative entities may provide their unitholders or members with a right to redeem their interests in the issuer at any time for cash equal to their proportionate share of the asset value of the issuer. However, classification as a financial liability does not preclude the use of descriptors such as net asset value attributable to unitholders and change in net asset value
This Alert is issued by the IAS Desk for the use of staff of the firm and may not be distributed outside the firm. For more information about this Alert please contact Terry Harding at phone +44 20 7694 8640, fax +44 20 7694 8429 or email terry.harding@kpmg.co.uk

kpmg IS Alert 2004/02 Consultation on amended IAS 32 and IAS 39 Page 2 attributable to unitholders on the face of the financial statements of an entity that has no equity capital or the use of additional disclosure to show that total members interests comprise items such as reserves that meet the definition of equity and puttable instruments that do not. The Standard has added that if an entity reacquires its own equity instruments, those instruments (treasury shares) shall be deducted from equity. No gain or loss shall be recognised in profit or loss on the purchase, sale, issue or cancellation of an entitys own equity instruments. Such treasury shares may be acquired and held by the entity or by other members of the consolidated group. Consideration paid or received shall be recognised directly in equity. Amended IAS 32 requires all terms and conditions agreed between members of the group and the holders of the instrument to be considered when determining if the group as a whole has an obligation that would give rise to a financial liability. To the extent there is such an obligation, the instrument or its component that is subject to the obligation, is a financial liability in consolidated financial statements. Disclosure The Standard has new disclosure requirements relating to fair value estimates derived through valuation techniques, by requiring disclosure of: i. the methods and significant assumptions applied in determining fair values of financial assets and financial liabilities separately for significant classes of financial assets and financial liabilities. whether fair values of financial assets and financial liabilities are determined directly, in full or in part, by reference to published price quotations in an active market or are estimated using a valuation technique. whether its financial statements include financial instruments measured at fair values that are determined in full or in part using a valuation technique based on assumptions that are not supported by observable market prices or rates. If changing any such assumption to a reasonably possible alternative would result in a significantly different fair value, the entity shall state this fact and disclose the effect on the fair value of a range of reasonably possible alternative assumptions. For this purpose, significance shall be judged with respect to profit or loss and total assets or total liabilities. the total amount of the change in fair value estimated using a valuation technique that was recognised in profit or loss during the period.

ii.

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Amended IAS 32 requires disclosure of the amount of the change in fair value that is not attributable to changes in a benchmark interest rate for financial liabilities designated as at fair value through profit or loss. This disclosure gives an indication of how much of the change in fair value is caused by changes in the credit risk of the liability.

This Alert is issued by the IAS Desk for the use of staff of the firm and may not be distributed outside the firm.

kpmg IS Alert 2004/02 Consultation on amended IAS 32 and IAS 39 Page 3 Amended IAS 39 on Recognition and Measurement of Financial Instruments Scope The Standard excludes from its scope loan commitments that cannot be settled net and are not classified at fair value through profit or loss. However, it requires that a commitment to extend a loan at a below-market interest rate is initially recognised at fair value, and subsequently measured at the higher of: i. the amount determined under IAS 37; and ii. the amount initially recognised, less where appropriate, cumulative amortisation recognised in accordance with IAS 18. Similarly, there is a requirement for financial guarantees to be initially recognised at fair value and subsequently measured at the higher of the above listed two amounts. This is subject to further changes during discussions on ED 5, Insurance Contracts. Definitions Amended IAS 39 has revised the definition of loans and receivables category, by expanding to include purchased loans and receivables (that are not quoted in an active market), as well as originated ones. This amendment recognises the fact that originated and purchased loans are often managed together. At the same time the definition is amended so that an instrument that is quoted in an active market is not a loan or receivable. New guidance is given on the calculation of effective interest rates and the definition of the effective interest rate is amended by requiring (for all instruments) the use of estimated cash flows (for example prepayment estimates) while calculating effective yield. An exception is made for those rare cases when it is not possible to estimate cash flows reliably, in which cases the Standard requires the use of contractual cash flows over the contractual life of the instrument. It further stipulates that when accounting for a change in estimates, entities need to adjust the carrying amount of the instrument in the period of change with a corresponding gain or loss recognised in profit or loss. Recognition and Derecognition The derecognition rules have been substantially rewritten to clarify their application and the Standard uses the concepts of control and of risks and rewards of ownership to determine whether, and to what extent, a financial asset is derecognised. The continuing involvement approach applies only if an entity retains some, but not substantially all, the risks and rewards of ownership and also retains control. Additional guidance is provided on how to evaluate the concepts of risks and rewards and of control for derecognition purposes. Amended IAS 39 clarifies when a part of larger financial asset should be considered for derecognition. It requires a part of a larger financial asset to be considered for derecognition if, and only if, the part is one of: i. only specifically identified cash flows from a financial asset; ii. only a fully proportionate (pro rata) share of the cash flows from a financial asset; or
This Alert is issued by the IAS Desk for the use of staff of the firm and may not be distributed outside the firm.

kpmg IS Alert 2004/02 Consultation on amended IAS 32 and IAS 39 Page 4 iii. only a fully proportionate (pro rata) share of specifically identified cash flows from a financial asset. In all other cases, the Standard requires the financial asset to be considered for derecognition in its entirety. Amended IAS 39 gives an option to designate at inception any financial instrument as fair value through profit or loss, which gives entities an opportunity to simplify the application of IAS 39 by reducing the need for hedge accounting, eliminating the need to separate embedded derivatives, and eliminating the problems that arise when matched positions of assets and liabilities are not measured consistently. Additionally, it is clarified that the fair value of liabilities with a demand feature, for example, demand deposits, is not less than the amount payable on demand discounted from the first date that the amount could be required to be paid. Amended IAS 39 permits entities, on transition, to designate a previously recognised financial asset or financial liability as a financial asset or a financial liability at fair value through profit or loss or available for sale. Additionally, a disclosure requirement has been added to IAS 32 to provide information about the fair value of the financial assets or financial liabilities designated into each category and the classification and carrying amount in the previous financial statements. The Standard requires prospective application of derecognition provisions, namely that entities do not recognise those assets that were derecognised under the original Standard before 1 January 2004, but permits retrospective application from a date of the entitys choosing. Measurement The Standard contains an expanded guidance on the measurement of fair value. It requires quoted prices in active markets to be used for determining fair value in preference to other valuation techniques. There is also additional guidance that if a rate (rather than a price) is quoted, these quoted rates are used as inputs into valuation techniques to determine the fair value. It further clarifies that if an entity operates in more than one active market, the entity uses the price at which a transaction would occur at the balance sheet date in the same instrument (i.e. without modification or repackaging) in the most advantageous active market to which the entity has immediate access. Amended IAS 39 simplifies the fair value measurement hierarchy in an inactive market so that recent market transactions do not take precedence over a valuation technique. It states that when there is not a price in an active market, a valuation technique is to be used, including the use of recent arms length market transactions. The Standard also clarifies that the best estimate of fair value at initial recognition of a financial instrument that is not quoted in an active market is the transaction price, unless the fair value of the instrument is evidenced by other observable market transactions or is based on a valuation technique whose variables include only data from observable markets. The Standard states that impairment follows an incurred loss model rather than an expected loss model and additional guidance is provided on measuring impairment. Additionally, it is required for available-for-sale debt instruments that an impairment loss is to be reversed through profit or loss when fair value increases and the increase can be objectively related to an event occurring after the loss was recognised. Impairment losses
This Alert is issued by the IAS Desk for the use of staff of the firm and may not be distributed outside the firm.

kpmg IS Alert 2004/02 Consultation on amended IAS 32 and IAS 39 Page 5 recognised on available-for-sale equity instruments cannot be reversed through profit or loss, i.e. any subsequent increase in fair value is recognised in equity. Hedging Amended IAS 39 requires that when a hedged forecast transaction actually occurs and results in the recognition of a financial asset or a financial liability, the gain or loss deferred in equity does not adjust the initial carrying amount of the asset or liability (i.e. basis adjustment is prohibited), but remains in equity and is recognised in profit or loss consistently with the recognition of gains and losses on the asset or liability. However, entities have the option to use the basis adjustment method for hedges of forecast transactions that will result in the recognition of a non-financial asset or non-financial liability. Under this method, deferred gains and losses on the hedging instrument are treated as an adjustment to the cost of the acquired asset or liability. The Standard requires hedges of firm commitments to be accounted for as fair value hedges, rather than cash flow hedges. At the same time, it clarifies that a hedge of the foreign currency risk of a firm commitment may be accounted for as either a fair value hedge or a cash flow hedge. Transitional provisions for first time adopters The implementation process for entities adopting IFRS for the first time in 2005 will be complex due to detailed transitional arrangements, the most significant of which are: Comparative information in the first year of adoption need not comply with IAS 32 and IAS 39 but may, in these respects, continue to be prepared in accordance with the entitys previous GAAP. Adjustments are made to the opening balance sheet (including retained earnings and other reserves) at the beginning of the first IFRS reporting period, in order to measure all recognised financial assets and financial liabilities in accordance with IAS 39. Entities can designate financial instruments as fair value through profit or loss or availablefor-sale on the date they first comply with IAS 32 and IAS 39. Existing hedges are eligible for hedge accounting in the restated opening balances if they qualified for hedge accounting under previous GAAP. Hedges are eligible for hedge accounting subsequently if they are properly designated and documented as such no later than the beginning of the first IFRS reporting period, and otherwise qualify for hedge accounting under IAS 39. Non-derivative financial assets and financial liabilities that were derecognised prior to 1 January 2004, remain derecognised, which gives a safe harbour for transactions that have led to derecognition in the past. However, special purpose entities are required to be consolidated if they are controlled under the criteria in SIC-12. We intend to issue more detailed additional guidance on first-time adoption in due course.

This Alert is issued by the IAS Desk for the use of staff of the firm and may not be distributed outside the firm.