Accounting for Financial Instruments IAS 32 and IAS 39*

Financial Instruments and Categorisation IAS 32.11, 39.9

Financial Instrument: Any contract that gives rise to a financial asset of one entity and a financial liability or equity instrument of another entity. Issues regarding Categorisation: Financial instruments have to be categorised upon initial recognition. Upon initial recognition it has to be considered whether an instrument contains an embedded derivative which has to be separated. Derivatives which are designated and effective hedging instruments are not categorised into one of the four categories. They are subject to the relevant hedge accounting rules.

(as of 31/01/2006)

Financial Assets Categorisation upon initial Recognition IAS 39.9-11A

1 Purpose of selling in near term, portfolio with pattern of short-term profit-taking or non-hedge no derivative or 2 Designation to AFV, if - elimination of an accounting mismatch - group of financial instruments managed on a fair value basis - hybrid contract with embedded derivative(s)
yes yes

Financial Liabilities IAS 32.15, 39.9-11A Categorisation upon initial Recognition

1 Purpose of repurchasing in near term, portfolio with pattern of short term profittaking or non-hedge derivative or 2 Designation to LFV, if - elimination of an accounting mismatch - group of financial instruments managed on a fair value basis - hybird contract with embedded derivative(s)
yes no no yes

IAS 39.11-13 Embedded Derivatives

Embedded Derivative: Component of a hybrid (combined) instrument that also includes a non-derivative host contract with the effect that some of the cash flows of the combined instrument vary in a way similar to a stand-alone derivative. An embedded derivative shall be separated from the host contract and accounted for as a derivative under IAS 39 if, and only if: the economic characteristics and risks of the embedded derivative are not closely related to that of the host contract; a separate instrument with the same terms as the embedded derivative would meet the definition of a derivative; and the hybrid (combined) instrument is not measured at fair value with changes in fair value recognised in profit or loss, i.e. not AFV or LFV. Measurement: The initial carrying amount of the host contract is the residual amount after separating the embedded derivative at inception. The fair value of a non option derivative is zero at inception.

Fair Value Option IAS 39.9, 39.11A

An entity may designate a financial instrument as AFV or LFV only when doing so results in more relevant information, because either it eliminates or significantly reduces a measurement or recognition inconsistency (sometimes referred to as an accounting mismatch); or a group of financial assets, financial liabilities or both is managed and its performance is evaluated on a fair value basis; or in more reliable information regarding a contract that contains one or more embedded derivatives, that have to be separated.

Expectation of losses (not due to credit deterioration) No fixed or determinable payments (equity instruments) or Designated as AFS

no

Quoted in an active market

yes

Fixed maturity and Positive intention and ability to hold to maturity

yes

Compound instrument
yes

Liability component Equity component

Contractual obligation to deliver cash or another financial asset or to exchange financial instruments under unfavourable conditions
no

IAS 39.2, 39.9, 39.47(c) Financial Guarantee Contracts

Financial Guarantee Contracts: Financial guarantee contracts require the issuer to make specified payments to reimburse the holder for a loss it incurs because a specified debtor fails to make payment when due in accordance with the original or modified terms of a debt instrument. Financial guarantee contracts are inluded in the scope of IAS 39, except when the issuer meets the conditions and selects to apply IFRS 4. The issuer initially measures financial guarantee contracts at fair value and subsequently at the higher of the amount determined in accordance with IAS 37 and the amount initially recognised less, when appropriate, cumulative amortisation recognised in accordance with IAS 18.

no no

Possible Categories for Financial Assets

AFV
Swap, option, future, forward, credit derivative Separated embedded derivative Originated or acquired loan Registered bond (illiquid market) Quoted bond Convertible bond (host contract) Perpetual Treasury bond/share Stock Interest in mutual fund Interest in limited liability company (10%, no fair value)

financial assets at fair value (AFV)

AFS LAR HTM 1 trading 2 designated at fair value

available-for-sale (AFS)

loans and receivables (LAR)

held-to-maturity (HTM)

financial liabilities at fair value (LFV)

1 trading 2 designated at fair value

liabilities measured at amortised cost (LAC)

embedded derivative which has to be separated
yes no

equity

embedded derivative which has to be separated

yes no yes no yes no

( ) ( )

Possible Categories for Financial Liabilities

LFV
Swap, option, warrant, future, forward, credit derivatives, separated embedded derivatives Due to banks, due to customers Certificates of deposit Subordinated bonds, profit-sharing rights, silent participation Treasury stock ( ) ( ) [equity]

separated embedded derivative host contract

separated embedded derivative host contract

LAC

[deduction from liability/equity] [if not consolidated according to SIC-12] -

AFV

AFS

LAR

HTM

LFV

LAC

Amortised Cost IAS 39.9 and Regular Way Contracts IAS 39.38
Amortised Cost: Amount at which the financial asset or financial liability is measured at initial recognition minus principal repayments, plus or minus the cumulative amortisation using the effective interest method of any difference between that initial amount and the maturity amount, and minus any reduction (directly or through the use of an allowance account) for impairment or uncollectibility. Transaction Cost: Incremental cost that is directly attributable to the acquisition of a financial asset or issue of a financial liability. Effective Interest Rate: Rate that exactly discounts estimated future cash payments or receipts through the expected life of the financial instrument or, when appropriate, a shorter period to the net carrying amount of the financial asset or financial liability. When calculating the effective interest rate, an entity shall estimate cash flows considering all contractual terms of the financial instrument but shall not consider future credit losses. The calculation includes all fees and points paid or received between parties to the contract that are an integral part of the effective interest rate (see IAS 18), transaction costs, and all other premiums or discounts. Regular Way Contracts: Regular way purchases or sales shall be (de-)recognised using trade date or settlement date accounting consistently for each category.

Reclassification IAS 39.50-54

AFV AFS LAR HTM
Exemption that allows reclassification, e.g. change in statutory requirements or Tainting, i.e. reclassification of all HTM assets if no exemption is applicable Reclassifications of financial liabilities are not permitted. Fixed maturity and Positive intention and ability to hold to maturity

IAS 39.50 Reclassification IAS 32.11, 32.16, IFRIC 2 Equity

Residual interest in the assets of an entity after deducting all of its liabilities.
The instrument is an equity instrument if, and only if, both conditions (a) and (b) below are met. (a) The instrument includes no contractual obligation (i) to deliver cash or another financial asset to another entity; or (ii) to exchange financial assets or financial liabilities with another entity under conditions that are potentially unfavourable to the issuer. (b) If the instrument will or may be settled in the issuers own equity instruments, it is (i) a non-derivative that includes no contractual obligation for the issuer to deliver a variable number of its own equity instruments; or (ii) a derivative that will be settled only by the issuer exchanging a fixed amount of cash or another financial asset for a fixed number of its own equity instruments.

EU Endorsement of IAS 32, IAS 39, IFRS 7

IAS 32: The EU-Commission has endorsed IAS 32 Financial Instruments: Disclosure and Presentation completely by Regulation No. 2237/2004 as of 29/12/2004. IAS 39: The EU-Commission has endorsed IAS 39 Financial Instruments: Recognition and Measurement in a carve out-version by Regulation No. 2086/2004 as of 19/11/2004. Therefore, EU-companies can apply IAS 39 in full or with the following amendments regarding hedge accounting: Overhedging removal of a component permitted to avoid ineffectiveness (such as a liability with a negative spread). Hedging of core deposits on the basis of expected redemption and thus beyond the shortest period in which the holder can demand payment. Testing effectiveness of portfolio-hedges using the layer approach instead of the percentage method to avoid ineffectiveness. The EU-Commission has further endorsed the following IAS 39 Amendments 2005: Initial Recognition by Regulation No. 1751/2005 as of 25/10/2005, Fair Value Option by Regulation No. 1864/2005 as of 15/11/2005, Cash Flow Hedge Accounting by Regulation No. 2106/2005 as of 21/12/2005 and Financial Guarantee Contracts by Regulation No. 108/2006 as of 11/01/2006. IFRS 7: The EU-Commission has endorsed IFRS 7 Financial Instruments: Disclosures by Regulation No. 108/2006 as of 11/01/2006. IFRIC 2: The EU-Commission has endorsed IFRIC 2 Members Shares in Co-operative Entities and Similar Instruments by Regulation No. 1073/2005 as of 7/7/2005.

AFS

HTM

Impairment IAS 39.58-70

Impairment: Objective evidence as a result of one or more events that occurred after the initial recognition of the asset (a loss event) and that loss event (or events) has an impact on the estimated future cash flows of the financial asset or group of financial assets that can be reliably estimated, such as: significant financial difficulty of the issuer or obligor; a breach of contract, such as a default or delinquency in interest or principal payments; the lender, for economic or legal reasons relating to the borrowers financial difficulty, granting to the borrower a concession; it becoming probable that the borrower will enter bankruptcy or other financial reorganisation; observable data indicating that there is a measurable decrease in the estimated future cash flows from a group of financial assets since the initial recognition of those assets, although the decrease cannot yet be identified with the individual financial assets in the group; or a significant or prolonged decline in the fair value of an investment in an equity instrument below its cost.

Measurement IAS 39.43, 39.45-46

AFV
fair value

IAS 39.43, 39.47, 32.31 Measurement

HTM
Category Initial measurement amortised cost recognised in profit or loss not recognised recognised in profit or loss recognised in profit or loss Subsequent measurement Amortisation (eff. interest) Fair valuechanges Impairment losses Reversal of impairment Category Initial measurement Subsequent measurement Amortisation (eff. interest) Fair valuechanges Own credit risk (part of fair valuechanges)

IAS 39.9, IAS 39.48-49, 39.AG69-82 Fair Value

Fair Value: Amount for which an asset could be exchanged, or a liability settled, between knowledgeable, willing parties in an arms length transaction.

AFS

LAR
fair value plus transaction cost

LFV
fair value

LAC
fair value plus transaction cost amortised cost recognised in profit or loss not recognised

Compound Instruments - Equity

When the initial carrying amount of a compound financial instrument is allocated to its equity and liability components, the equity component is assigned the residual amount after deducting from the fair value of the instrument as a whole the amount separately determined for the liability component. No gain or loss arises from initially recognising the components of the instrument separately. On conversion of a convertible instrument at maturity, the entity derecognises the liability component and recognises it as equity. The original equity component remains as equity (although it may be transferred from one line item within equity to another).

Fair Value Measurement Consideration Financial instrument is quoted in an active market, if quoted prices are readily and regularly available from an exchange, dealer, broker, industry group, pricing service or regulatory agency and represent actual and regularly occurring market transactions.
no yes

fair value in profit or loss (implicit) recognised in profit or loss in profit or loss (implicit) in profit or loss (implicit)

fair value recognised in profit or loss recognised in equity

(revaluation reserve)

amortised cost recognised in profit or loss not recognised recognised in profit or loss recognised in profit or loss

fair value in profit or loss (implicit) recognised in profit or loss yes, specific to that financial liability

Use of market prices: bid price for an asset held; asking price for a liability held; mid-market prices for an offsetting risk position.

LAR and HTM (amortised cost)

significant loans/financial assets not significant loans/financial assets
choice yes

AFS (fair value)

Impairment = difference between acquisition cost (net of principal repayment and amortisation) and fair value

Investments in equity instruments that do not have a quoted market price in an active market and derivatives hereon and the range of reasonable fair value estimates is significant and probabilities of various estimates cannot be reasonably assessed.
no

yes

An entity is precluded from measuring the instrument at fair value. Rather the unquoted equity instrument is measured at cost.

impairment trigger event

no

no

impairment trigger event

yes

Individual assessment (specific allowance) present value of expected future cash flows (using effective interest) recognise unwinding for each single loan as interest income

Assessment for impairment on portfolio basis considering the loss identification period (LIP) (portfolio allowance for non-impaired loans) E x PD x LGD x LIP (E: exposure at balance sheet date; LGD: loss given default; PD: probability of default < 1) recognise contractual interest (no unwinding) impairment trigger event

Collective loan assessment (portfolio allowance for insignificant loans)) present value of future cash flows in portfolio or E x PD x LGD; PD=1 recognise unwinding on portolio basis

Exemption AFS (at cost)

Only unquoted equity instruments: Impairment = difference between carrying amount and present value of estimated future cash flows discounted at the current market rate for a similar financial asset

Financial liabilities with demand features (eg demand deposits).

no

yes

Fair value is not less than the amount payable on demand, discounted from the first date that the amount could be required to be paid. The valuation technique incorporates all factors that market participants would consider, i.e. time value of money, credit risk, foreign currency exchange rates etc. is consistent with accepted economic methodologies for pricing financial instruments and is calibrated and tested for its validity (back-testing). No recognition of day one profits or losses.

recognised in profit or loss

equity: recognised in equity debt: recognised in profit or loss

not recognised

specific provisionning for significant assets

transfer to different portfolio, continue assessment on portfolio basis

Use of valuation techniques: use of recent arms length market transactions; reference to the current fair value of another instrument that is substantially the same; discounted cash flow analysis [short-term receivables and payables with no stated interest rate may be measured at the original invoice amount if the effect of discounting is immaterial]; option pricing models.

Hedge Accounting IAS 39.71-88

Hedging Instruments: One or more derivatives, including derivatives with offsetting risks. Non-derivative financial instruments for a hedge of a foreign currency risk. A hedging relationship is designated for a hedging instrument in its entirety. Exceptions: designating only the change in intrinsic value of an option (excluding time value). Separating the interest element of a forward. Designating a proportion of the hedging instrument, e.g. 50 per cent of the notional amount, is permitted; but not designating for only a portion of time during which a hedging instrument remains outstanding. Only instruments that involve a party external to the reporting entity. Hedged Items: Recognised assets or liabilities; unrecognised firm commitments; highly probable forecast transactions; net investments in a foreign entity. Groups of similar assets or liabilites (not an overall net position), for which the change in fair value attributable to the hedged risk of each individual item in the group shall be expected to be approximately proportional to the overall change in fair value attributable to the hedged risk of the group of items. HTM investments cannot be hedged with respect to interest-rate risk or prepayment risk. Criteria for Hedge Accounting: At the inception of the hedge there is formal designation and documentation of the hedging relationship and the entitys risk management objective and strategy for undertaking the hedge. That documentation shall include identification of the hedging instrument, the hedged item or transaction, the nature of the risk being hedged and how the entity will assess the hedging instruments effectiveness. The hedge is expected to be highly effective in achieving offsetting changes in fair value or cash flows attributable to the hedged risk. For cash flow hedges, a forecast transaction that is the subject of the hedge must be highly probable and must present an exposure to variations in cash flows that could ultimately affect profit or loss. The effectiveness of the hedge can be reliably measured. The hedge is assessed on an ongoing basis and determined actually to have been highly effective throughout the financial reporting periods for which the hedge was designated. [Actual results have to be within a range of -80 to -125 per cent.]

Hedge Accounting Fair Value Hedge IAS 39.89-94

hedging instrument derivative
fair value determination of hedged fair value (with respect to hedged risk) recognised in profit or loss (full) fair value recognised in profit or loss ( hedged fair value) cumulative change in fair value hedged fair value (adjustment to the carrying amount) Change in (hedged) fair value Balance sheet amount Effective part ( fv) firm commitment

IAS 39.95-102 Cash Flow Hedge Hedge Accounting

hedge of a net investment in a foreign entity1) hedged item cash flow hedge AFS LAR HTM LAC
according to the category forecast transaction -

IAS 39.91-92, 39.101 Hedge Accounting

Discontinuing a Hedge Relationship: An entity shall discontinue prospectively hedge accounting if the hedging instrument expires or is sold, terminated or exercised; the hedge no longer meets the criteria for hedge accounting; a forecasted transaction is no longer expected to occur; or the entity revokes the designation. If the hedge effectiveness criteria is not met, hedge accounting discontinues from the last date on which compliance was demonstrated. Any adjustment arising from the discontinuing of a hedge relationship to the carrying amount of a hedged financial instrument for which the effective interest method is used shall be amortised to profit or loss (based on a recalculated effective interest rate at the date amortisation begins).

hedged item - fair value hedge AFS LAR HTM LAC

Measurement Measurement

hedging instrument derivative

fair value recognised in equity
(cash flow hedge reserve )

measurement according to the category

according to IAS 21

IAS 39.81A, 39.89A, 39.92 Portfolio-Hedging

In a fair value hedge of the interest rate exposure of a portfolio of financial assets or financial liabilities (and only in such a hedge), the portion hedged may be designated in terms of an amount of a currency rather than as individual assets (or liabilities); but not a net amount. Financial liabilities with a demand feature cannot qualify for fair value hedge accounting for any time period beyond the shortest period in which the holder can demand payment. In a portfolio containing prepayable assets, the entity may hedge the change in fair value that is attributable to a change in the hedged interest rate on the basis of expected, rather than contractual, repricing dates. When the portion hedged is based on expected repricing dates, the effect that changes in the hedged interest rate have on those expected repricing dates shall be included when determining the change in the fair value of the hedged item. Consequently, if a portfolio that contains prepayable items is hedged with a non-prepayable derivative, ineffectiveness arises if the dates on which items in the hedged portfolio are expected to prepay are revised, or actual prepayment dates differ from those expected. For a fair value hedge of the interest rate exposure of a portion of a portfolio of financial assets or financial liabilities, the gain or loss attributable to the hedged item may be presented in a single separate line item within assets or liabilities, respectively. If the portfolio hedge is discontinued, the separate line item can be amortised using straight-line method (instead of effective interest rate method).

Ineffective part ( fv) Balance sheet amount according to IAS 21 according to the category no recognition of the forecast transaction2)

recognised in profit or loss fair value

(full) fair value

1) Accounted for similarly to cash flow hedges. 2) If the forecasted transaction results in the recognition of a non-financial asset/liability, the associated gains and losses that were recognised directly in equity may be included in the initial cost or other carrying amount of the asset or liability (basis adjustment).

Disclosures IFRS 7
Disclosure requirements include: carrying amounts of each of the categories, as defined in IAS 39, either on the face of the balance sheet or in the notes; for a loan designated as AFV: - maximum exposure to credit risk; - amount mitigated by related credit derivatives or similar instruments; - change in fair value of the loan attributable to changes in the credit risk; - change in fair value of related credit derivatives or similar instruments; for a financial liability designated as LFV: - change in fair value attributable to changes in the credit risk of that liability; - difference between carrying amount and maturity amount; reclassification: amount reclassified into and out of each category and the reason for that reclassification; derecognition: disclosures of transfers that do not (completely) qualify for derecognition; collateral: carrying amount of financial assets pledged as collateral for (contingent) liabilities; and fair value of the collateral held; allowance account for credit losses: reconciliation of changes in the allowance account during the period for each class of financial assets; compound financial instruments with multiple embedded derivatives: existence of those features; defaults and breaches for loans payable: details of any defaults; carrying amount; whether the default was remedied, or terms were renegotiated; net gains or net losses on financial assets or financial liabilities in each of the categories, as defined in IAS 39; total interest income and total interest expense (calculated using the effective interest method) for LAR, HTM, AFS and LAC; fee income and expense arising from financial assets or financial liabilities other than AFV and LFV; and trust and other fiduciary activities; interest income on impaired financial assets accrued in accordance with IAS 39.AG93; amount of any impairment loss for each class of financial asset; accounting policies (criteria for designating AFV/LFV; for regular way contracts whether trade date or settlement date accounting is applied; impairment policy; determination of net gains or net losses on each category etc.); hedge accounting: description of each type of hedge; gains and losses recognised in profit or loss (ineffectiveness); fair value and carrying amounts of each class of assets and liabilities; methods and valuation techniques; reference to published price quotations; exposures to risk and how they arise; objectives, policies and processes for managing the risk and the methods used to measure the risk; summary quantitative data about exposure to that risk at the reporting date; concentrations of risk; credit risk: - maximum exposure to credit risk without taking account of any collateral held or other credit enhancements; - credit quality of financial assets that are neither past due nor impaired; - analysis of financial assets that are either past due or impaired; - collateral and other credit enhancements obtained; liquidity risk: maturity analysis for financial liabilities that shows the remaining contractual maturities; and a description of how the entity manages the liquidity risk inherent; market risk: sensitivity analysis for each type of market risk to which the entity is exposed (such as value-at-risk) including explanation of methods.

Derecognition IAS 39.15-37

Consolidation of all subsidiaries (including special purpose entities) Determination whether derecognition principles below are applied to a part or all of an asset (or group of similar assets) Transfer of the rights to receive the cash flows from the asset or Assuming obligation to pay the cash flows from an asset that meets the following conditions:
No obligation to pay amounts to the eventual recipients unless the entity collects equivalent amounts from the original asset. The transferror is prohibited from selling or pledging the original asset other than as security to the eventual recipients for the obligation to pay them cash flows. Obligation to remit any cash flows the transferor collects on behalf of the eventual recipients without material delay.
yes yes yes

IAS 39.39-42 Derecognition

Consolidation of all subsidiaries (including special purpose entities)

IAS 32.4-10, IAS 39.2-7, IFRS 7.3-5 Scope

IAS 32, IAS 39 and IFRS 7 shall be applied by all entities to all types of financial instruments except: interests in subsidiaries, associates and joint ventures that are accounted for under IAS 27, IAS 28 or IAS 31 (except derivatives thereon); rights and obligations under leases to which IAS 17 applies (provisions on derecognition, impairment, embedded derivatives apply) [Only IAS 39]; employers rights and obligations under employee benefit plans, to which IAS 19 applies; financial instruments issued by the entity that meet the definition of an equity instrument in IAS 32 (including options and warrants) [Only IAS 39]; rights and obligations under an insurance contract as defined in IFRS 4 (except derivatives thereon); contracts for contingent consideration in a business combination (applies only to the acquirer; IFRS 3); contracts between an acquirer and a vendor in a business combination to buy or sell an acquiree at a future date [Only IAS 39]; loan commitments that cannot be settled net in cash or another financial instrument. Loan commitments at a rate below-market interest are initially recognised at fair value, and subsequently measured at the higher of the amount recognised under IAS 37, and the amount initially recognised less, where appropriate, cumulative amortisation recognised in accordance with IAS 18 (Derecognition provisions apply) [Only IAS 39]; financial instruments, contracts and obligations under share-based payment transactions to which IFRS 2; rights to payments to reimburse the entity for expenditure it is required to make to settle a liability that it recognises as a provision under IAS 37. [Some exceptions only relate to IAS 39; thus disclosure requirements in IAS 32/IFRS 7 may apply for instruments outside the scope of IAS 39.]

Expiration of the rights to the cash flows from the asset

no

Extinguishment of the liability, i.e. the obligation is discharged or cancelled or expires

no

Repurchase of own debt (regardless of purpose)

no

Exchange between an existing borrower and lender of debt instruments with substantially different terms

Transfer of substantially all risks and rewards

no

no

yes

Retaining substantially all risks and rewards

yes no yes

Terms are substantially different if: the discounted present value of the cash flows under the new terms, including any fees paid net of any fees received and discounted using the original effective interest rate, is at least 10 per cent different from the original financial liability
yes no

IAS 32.96-97, 39.103-108, IFRS 7.43-44 Effective Date and Transition

IAS 32, IAS 39 (revised 2004) and Amendment 2005 Initial Recognition have to be applied for annual periods beginning on or after 1/1/2005. IAS 32 and IAS 39 shall be applied retrospectively except for IAS 39: an entity is permitted to designate a previously recognised financial asset or financial liability as a AFV or LFV or AFS despite requirements. an entity shall apply the derecognition requirements prospectively, i.e. for transactions on or after 1/1/2004. an entity can not adjust the carrying amount of non-financial assets and non-financial liabilities to exclude gains and losses related to cash flow hedges that were included in the carrying amount before the beginning of the financial year in which this Standard is first applied. an entity may apply IAS 39.AG76A regarding day one profits or losses prospectively to transactions entered into after 25/10/2002 or 1/1/2004. IAS 39 Amendments 2005 Cash Flow Hedge Accounting, Fair Value Option and Financial Guarantee Contracts have to be applied for annual periods beginning on or after 1/1/2006. IFRS 7 has to be applied for annual periods beginning on or after 1/1/2007.

Retaining control of the asset

no yes

Derecognition of the asset

*connectedthinking

Continued recognition of the asset to the extent of the entitys continuing involvement

Continued recognition of the asset

Derecognition of the liability; if exchange, recognition a new liability

No derecognition

Your contacts at PwC:

StB Dr. Katja Barz WP Burkhard Eckes WP StB Peter Flick WP CPA Dr. Caroline Sittmann-Haury WP StB Wolfgang Weigel

katja.barz@de.pwc.com burkhard.eckes@de.pwc.com peter.flick@de.pwc.com caroline.sittmann-haury@de.pwc.com wolfgang.weigel@de.pwc.com