SUMMARY OF IAS 39

Deloitte guidance on IFRSs for Financial Instruments

Deloitte & Touche LLP (United Kingdom) has developed iGAAP 2008 Financial Instruments: IAS 32, IAS 39 and IFRS 7 Explained (Fourth Edition), which has been published by LexisNexis. This publication is the authoritative guide for financial instruments accounting under IFRSs. The 2008 edition expands last year's edition with further interpretations, examples, discussions from the IASB and the IFRIC, and updates on comparisons of IFRSs with US GAAP for financial instruments. It also includes extracts from 2007 annual reports illustrating IFRS 7 Financial Instruments Disclosures. iGAAP 2008 Financial Instruments: IAS 32, IAS 39 and IFRS 7 Explained (Fourth Edition) (851 pages, June 2008) can be purchased through www.lexisnexis.co.uk/deloitte.

Scope

Scope exclusions

IAS 39 applies to all types of financial instruments except for the following, which are scoped out of IAS 39: [IAS 39.2]

interests in subsidiaries, associates, and joint ventures accounted for under IAS 27, IAS 28, or IAS 31; however IASs 32 and 39 apply in cases where under IAS 27, IAS 28, or IAS 31 such interests are to be accounted for under IAS 39 - for example, derivatives on an interest in a subsidiary, associate, or joint venture;

employers' rights and obligations under employee benefit plans to which IAS 19 applies;

contracts for contingent consideration in a business combination; rights and obligations under insurance contracts, except IAS 39 does apply to

financial instruments that take the form of an insurance (or reinsurance) contract but that principally involve the transfer of financial risks and derivatives embedded in insurance contracts;

financial instruments that meet the definition of own equity under IAS 32.

Leases

IAS 39 applies to lease receivables and payables only in limited respects: [IAS 39.2(b)]

IAS 39 applies to lease receivables with respect to the derecognition and impairment provisions.

IAS 39 applies to lease payables with respect to the derecognition provisions. IAS 39 applies to derivatives embedded in leases.

Financial guarantees

See August 2005 Amendments to IAS 39 below.

Loan commitments

Loan commitments are outside the scope of IAS 39 if they cannot be settled net in cash or another financial instrument, they are not designated as financial liabilities at fair value through profit or loss, and the entity does not have a past practice of selling the loans that resulted from the commitment shortly after origination. An issuer of a commitment to provide a loan at a below-market interest rate is required initially to recognise the commitment at its fair value; subsequently, the issuer will remeasure it at the higher of (a) the amount recognised under IAS 37 and (b) the amount initially recognised less, where appropriate, cumulative amortisation recognised in accordance with IAS 18. An issuer of loan commitments must apply IAS 37 to other loan commitments that are not within the

scope of IAS 39 (that is, those made at market or above). Loan commitments are subject to the derecognition provisions of IAS 39. [IAS 39.4]

Contracts to buy or sell financial items

Contracts to buy or sell financial items are always within the scope of IAS 39.

Contracts to buy or sell non-financial items

Contracts to buy or sell non-financial items are within the scope of IAS 39 if they can be settled net in cash or another financial asset and are not entered into and held for the purpose of the receipt or delivery of a non-financial item in accordance with the entity's expected purchase, sale, or usage requirements. Contracts to buy or sell non-financial items are inside the scope if net settlement occurs. The following situations constitute net settlement: [IAS 39.5-6]

the terms of the contract permit either counterparty to settle net; there is a past practice of net settling similar contracts; there is a past practice, for similar contracts, of taking delivery of the underlying

and selling it within a short period after delivery to generate a profit from short-term fluctuations in price, or from a dealer's margin; or

the non-financial item is readily convertible to cash.

Weather derivatives

Although contracts requiring payment based on climatic, geological, or other physical variable were generally excluded from the original version of IAS 39, they were added to the scope of the revised IAS 39 in December 2003. [IAS 39.AG1]

Definitions [IAS 39.9]

Financial instrument: A contract that gives rise to a financial asset of one entity and a financial liability or equity instrument of another entity.

Financial asset: Any asset that is:

cash; an equity instrument of another entity; a contractual right:

o to receive cash or another financial asset from another entity; or o to exchange financial assets or financial liabilities with another entity

under conditions that are potentially favourable to the entity; or a contract that will or may be settled in the entity's own equity instruments and

is: o a non-derivative for which the entity is or may be obliged to receive a

variable number of the entity's own equity instruments; or o a derivative that will or may be settled other than by the exchange of a

fixed amount of cash or another financial asset for a fixed number of the entity's own equity instruments. For this purpose the entity's own equity instruments do not include instruments that are themselves contracts for the future receipt or delivery of the entity's own equity instruments.

Financial liability: Any liability that is:

a contractual obligation: o to deliver cash or another financial asset to another entity; or o to exchange financial assets or financial liabilities with another entity

under conditions that are potentially unfavourable to the entity; or

a contract that will or may be settled in the entity's own equity instruments

The same definitions are used in IAS 32.

Common Examples of Financial Instruments Within the Scope of IAS 39

Cash Demand and time deposits Commercial paper Accounts, notes, and loans receivable and payable Debt and equity securities. These are financial instruments from the

perspectives of both the holder and the issuer. This category includes investments in subsidiaries, associates, and joint ventures

Asset backed securities such as collateralised mortgage obligations, repurchase agreements, and securitised packages of receivables

Derivatives, including options, rights, warrants, futures contracts, forward contracts, and swaps.

A derivative is a financial instrument:

Whose value changes in response to the change in an underlying variable such as an interest rate, commodity or security price, or index;

That requires no initial investment, or one that is smaller than would be required for a contract with similar response to changes in market factors; and

That is settled at a future date.

Examples of Derivatives

Forwards: Contracts to purchase or sell a specific quantity of a financial instrument, a commodity, or a foreign currency at a specified price determined at the outset, with delivery or settlement at a specified future date. Settlement is at maturity by actual delivery of the item specified in the contract, or by a net cash settlement.

Interest Rate Swaps and Forward Rate Agreements: Contracts to exchange cash flows as of a specified date or a series of specified dates based on a notional amount and fixed and floating rates.

Futures: Contracts similar to forwards but with the following differences: Futures are generic exchange-traded, whereas forwards are individually tailored. Futures are generally settled through an offsetting (reversing) trade, whereas forwards are generally settled by delivery of the underlying item or cash settlement.

Options: Contracts that give the purchaser the right, but not the obligation, to buy (call option) or sell (put option) a specified quantity of a particular financial instrument, commodity, or foreign currency, at a specified price (strike price), during or at a specified period of time. These can be individually written or exchange-traded. The purchaser of the option pays the seller (writer) of the option a fee (premium) to compensate the seller for the risk of payments under the option.

Caps and Floors: These are contracts sometimes referred to as interest rate options. An interest rate cap will compensate the purchaser of the cap if interest rates rise above a predetermined rate (strike rate) while an interest rate floor will compensate the purchaser if rates fall below a predetermined rate.

Embedded Derivatives

Some contracts that themselves are not financial instruments may nonetheless have financial instruments embedded in them. For example, a contract to purchase a commodity at a fixed price for delivery at a future date has embedded in it a derivative that is indexed to the price of the commodity.

An embedded derivative is a feature within a contract, such that the cash flows associated with that feature behave in a similar fashion to a stand-alone derivative. In the same way that derivatives must be accounted for at fair value on the balance sheet with changes recognised in the income statement, so must some embedded derivatives. IAS 39 requires that an embedded derivative be separated from its host contract and accounted for as a derivative when: [IAS 39.11]

the economic risks and characteristics of the embedded derivative are not closely related to those of the host contract;

a separate instrument with the same terms as the embedded derivative would meet the definition of a derivative; and

the entire instrument is not measured at fair value with changes in fair value recognised in the income statement.

If an embedded derivative is separated, the host contract is accounted for under the appropriate standard (for instance, under IAS 39 if the host is a financial instrument). Appendix A to IAS 39 provides examples of embedded derivatives that are closely related to their hosts, and of those that are not.

Examples of embedded derivatives that are not closely related to their hosts (and therefore must be separately accounted for) include:

the equity conversion option in debt convertible to ordinary shares (from the perspective of the holder only);

commodity indexed interest or principal payments in host debt contracts; cap and floor options in host debt contracts that are in-the-money when the

instrument was issued; leveraged inflation adjustments to lease payments; currency derivatives in purchase or sale contracts for non-financial items where

the foreign currency is not that of either counterparty to the contract, is not the currency in which the related good or service is routinely denominated in commercial transactions around the world, and is not the currency that is commonly used in such contracts in the economic environment in which the transaction takes place.

If IAS 39 requires that an embedded derivative be separated from its host contract, but the entity is unable to measure the embedded derivative separately, the entire combined contract must be treated as a financial asset or financial liability that is held for trading (and, therefore, remeasured to fair value at each reporting date, with value changes in profit or loss). [IAS 39.12]

Classification as Liability or Equity

Since IAS 39 does not address accounting for equity instruments issued by the reporting enterprise but it does deal with accounting for financial liabilities, classification of an instrument as liability or as equity is critical. IAS 32 Financial Instruments: Presentation addresses the classification question.

Classification of Financial Assets

IAS 39 requires financial assets to be classified in one of the following categories: [IAS 39.45]

Financial assets at fair value through profit or loss. Available-for-sale financial assets. Loans and receivables. Held-to-maturity investments.

Those categories are used to determine how a particular financial asset is recognised and measured in the financial statements.

Financial assets at fair value through profit or loss. This category has two subcategories:

Designated. The first includes any financial asset that is designated on initial recognition as one to be measured at fair value with fair value changes in profit or loss. Held for trading. The second category includes financial assets that are held for trading. All derivatives (except those designated hedging instruments) and financial assets acquired or held for the purpose of selling in the short term or for which there is a recent pattern of short-term profit taking are held for trading.

Available-for-sale financial assets (AFS) are any non-derivative financial assets designated on initial recognition as available for sale. AFS assets are measured at fair value in the balance sheet. Fair value changes on AFS assets are recognised directly in equity, through the statement of changes in equity, except for interest on AFS assets (which is recognised in income on an effective yield basis), impairment losses, and (for interest-bearing AFS debt instruments) foreign exchange gains or losses. The cumulative gain or loss that was recognised in equity is recognised in profit or loss when an available-for-sale financial asset is derecognised.

Loans and receivables are non-derivative financial assets with fixed or determinable payments, originated or acquired, that are not quoted in an active market, not held for trading, and not designated on initial recognition as assets at fair value through profit or loss or as available-for-sale. Loans and receivables for which the holder may not recover substantially all of its initial investment, other than because of credit deterioration, should be classified as available-for-sale. Loans and receivables are measured at amortised cost. [IAS 39.46(a)]

Held-to-maturity investments are non-derivative financial assets with fixed or determinable payments that an entity intends and is able to hold to maturity and that do not meet the definition of loans and receivables and are not designated on initial recognition as assets at fair value through profit or loss or as available for sale. Held-to-maturity investments are measured at amortised cost. If an entity sells a held-to-maturity investment other than in insignificant amounts or as a consequence of a non-recurring, isolated event beyond its control that could not be reasonably anticipated, all of its other held-to-maturity investments must be reclassified as available-for-sale for the current and next two financial reporting years. [IAS 39.46(b)]

Classification of Financial Liabilities

IAS 39 recognises two classes of financial liabilities: [IAS 39.47]

Financial liabilities at fair value through profit or loss. Other financial liabilities measured at amortised cost using the effective interest

method.

The category of financial liability at fair value through profit or loss has two subcategories:

Designated. A financial liability that is designated by the entity as a liability at fair value through profit or loss upon initial recognition.

Held for trading. A financial liability classified as held for trading, such as an obligation for securities borrowed in a short sale, which have to be returned in the future.

Initial Recognition

IAS 39 requires recognition of a financial asset or a financial liability when, and only when, the entity becomes a party to the contractual provisions of the instrument, subject to the following provisions in respect of regular way purchases. [IAS 39.14]

Regular way purchases or sales of a financial asset. A regular way purchase or sale of financial assets is recognised and derecognised using either trade date or settlement date accounting. The method used is to be applied consistently for all purchases and sales of financial assets that belong to the same category of financial asset as defined in IAS 39 (note that for this purpose assets held for trading form a different category from assets designated at fair value through profit or loss). The choice of method is an accounting policy. [IAS 39.38]

IAS 39 requires that all financial assets and all financial liabilities be recognised on the balance sheet. That includes all derivatives. Historically, in many parts of the world, derivatives have not been recognised on company balance sheets. The argument has been that at the time the derivative contract was entered into, there was no amount of cash or other assets paid. Zero cost justified non-recognition, notwithstanding that as time passes and the value of the underlying variable (rate, price, or index) changes, the derivative has a positive (asset) or negative (liability) value.

Initial Measurement

Initially, financial assets and liabilities should be measured at fair value (including transaction costs, for assets and liabilities not measured at fair value through profit or loss).

Measurement Subsequent to Initial Recognition

Subsequently, financial assets and liabilities (including derivatives) should be measured at fair value, with the following exceptions: [IAS 39.46]

Loans and receivables, held-to-maturity investments, and non-derivative financial liabilities should be measured at amortised cost using the effective interest method.

Investments in equity instruments with no reliable fair value measurement (and derivatives indexed to such equity instruments) should be measured at cost.

Financial assets and liabilities that are designated as a hedged item or hedging instrument are subject to measurement under the hedge accounting requirements of the IAS 39.

Financial liabilities that arise when a transfer of a financial asset does not qualify for derecognition, or that are accounted for using the continuing-involvement method, are subject to particular measurement requirements.

Fair value is the amount for which an asset could be exchanged, or a liability settled, between knowledgeable, willing parties in an arm's length transaction. IAS 39 provides a hierarchy to be used in determining the fair value for a financial instrument: [IAS 39 Appendix A, paragraphs AG69-82]

Quoted market prices in an active market are the best evidence of fair value and should be used, where they exist, to measure the financial instrument.

If a market for a financial instrument is not active, an entity establishes fair value by using a valuation technique that makes maximum use of market inputs and includes recent arm's length market transactions, reference to the current fair value of another instrument that is substantially the same, discounted cash flow analysis, and option pricing models. An acceptable valuation technique incorporates all factors that market participants would consider in setting a price and is consistent with accepted economic methodologies for pricing financial instruments.

If there is no active market for an equity instrument and the range of reasonable fair values is significant and these estimates cannot be made reliably, then an entity must measure the equity instrument at cost less impairment.

Amortised cost is calculated using the effective interest method. The effective interest rate is the rate that exactly discounts estimated future cash payments or receipts through the expected life of the financial instrument to the net carrying amount of the financial asset or liability. Financial assets that are not carried at fair value though profit and loss are subject to an impairment test. If expected life cannot be determined reliably, then the contractual life is used.

IAS 39 Fair Value Option

IAS 39 permits entities to designate, at the time of acquisition or issuance, any financial asset or financial liability to be measured at fair value, with value changes recognised in profit or loss. This option is available even if the financial asset or financial liability would ordinarily, by its nature, be measured at amortised cost – but only if fair value can be reliably measured. Once an instrument is put in the fair-value-through-profit-and-loss category, it cannot be reclassified out.

IAS 39 Available for Sale Option for Loans and Receivables

IAS 39 permits entities to designate, at the time of acquisition, any loan or receivable as available for sale, in which case it is measured at fair value with changes in fair value recognised in equity.

Impairment

A financial asset or group of assets is impaired, and impairment losses are recognised, only if there is objective evidence as a result of one or more events that occurred after the initial recognition of the asset. An entity is required to assess at each balance sheet date whether there is any objective evidence of impairment. If any such evidence exists, the entity is required to do a detailed impairment calculation to determine whether an impairment loss should be recognised. [IAS 39.58]

The amount of the loss is measured as the difference between the asset's carrying amount and the present value of estimated cash flows discounted at the financial asset's original effective interest rate. [IAS 39.63]

Assets that are individually assessed and for which no impairment exists are grouped with financial assets with similar credit risk statistics and collectively assessed for impairment. [IAS 39.64]

If, in a subsequent period, the amount of the impairment loss relating to a financial asset carried at amortised cost or a debt instrument carried as available-for-sale decreases due to an event occurring after the impairment was originally recognised, the previously recognised impairment loss is reversed through profit and loss. Impairments relating to investments in available-for-sale equity instruments are not reversed. [IAS 39.65]

Derecognition of a Financial Asset

The basic premise for the derecognition model in IAS 39 is to determine whether the asset under consideration for derecognition is: [IAS 39.16]

an asset in its entirety; or specifically identified cash flows from an asset; or a fully proportionate share of the cash flows from an asset; or a fully proportionate share of specifically identified cash flows from a financial

asset.

Once the asset under consideration for derecognition has been determined, an

assessment is made as to whether the asset has been transferred, and if so, whether the transfer of that asset is subsequently eligible for derecognition.

An asset is transferred if either the entity has transferred the contractual rights to receive the cash flows, or the entity has retained the contractual rights to receive the cash flows from the asset, but has assumed a contractual obligation to pass those cash flows on under an arrangement that meets the following three conditions: [IAS 39.17-19]

the entity has no obligation to pay amounts to the eventual recipient unless it collects equivalent amounts on the original asset,

the entity is prohibited from selling or pledging the original asset (other than as security to the eventual recipient), and

the entity has an obligation to remit those cash flows without material delay.

Once an entity has determined that the asset has been transferred, it then determines whether or not it has transferred substantially all of the risks and rewards of ownership of the asset. If substantially all the risks and rewards have been transferred, the asset is derecognised. If substantially all the risks and rewards have been retained, derecognition of the asset is precluded. [IAS 39.20]

If the entity has neither retained nor transferred substantially all of the risks and rewards of the asset, then the entity must assess whether it has relinquished control of the asset or not. If the entity does not control the asset then derecognition is appropriate; however if the entity has retained control of the asset, then the entity continues to recognise the asset to the extent to which it has a continuing involvement in the asset. [IAS 39.30]

These various derecognition steps are summarised below in a decision tree.

Derecognition of a Financial Liability

A financial liability should be removed from the balance sheet when, and only when, it is extinguished, that is, when the obligation specified in the contract is either discharged, cancelled, or expired. Where there has been an exchange between an existing borrower and lender of debt instruments with substantially different terms, or there has been a substantial modification of the terms of an existing financial liability, this transaction is accounted for as an extinguishment of the original financial liability and the recognition of a new financial liability. A gain or loss from extinguishment of the original financial liability is recognised in the income statement. [IAS 39.39]

Hedge Accounting

IAS 39 permits hedge accounting under certain circumstances provided that the hedging relationship is: [IAS 39.88]

formally designated and documented, including the entity's risk management objective and strategy for undertaking the hedge, identification of the hedging instrument, the hedged item, the nature of the risk being hedged, and how the entity will assess the hedging instrument's effectiveness; and

expected to be highly effective in achieving offsetting changes in fair value or cash flows attributable to the hedged risk as designated and documented, and effectiveness can be reliably measured.

Hedging Instruments

All derivative contracts with an external counterparty may be designated as hedging instruments except for some written options. [IAS 39.72-73]

An external non-derivative financial asset or liability may not be designated as a hedging instrument except as a hedge of foreign currency risk. [IAS 39.72]

A proportion of the derivative may be designated as the hedging instrument. Generally, specific cash flows inherent in a derivative cannot be designated in a hedge relationship while other cash flows are excluded. However, the intrinsic value and the time value of an option contract may be separated, with only the intrinsic value being designated. Similarly, the interest element and the spot price of a forward can also be separated, with the spot price being the designated risk. [IAS 39.75]

Hedged Items

A hedged item can be: [IAS 39.78]

a single recognised asset or liability, firm commitment, highly probable transaction, or a net investment in a foreign operation;

a group of assets, liabilities, firm commitments, highly probable forecast transactions, or net investments in foreign operations with similar risk characteristics;

a held-to-maturity investment for foreign currency or credit risk (but not for interest risk or prepayment risk);

a portion of the cash flows or fair value of a financial asset or financial liability; or a non-financial item for foreign currency risk only or the risk of changes in fair

value of the entire item. in a portfolio hedge of interest rate risk (Macro Hedge) only, a portion of the

portfolio of financial assets or financial liabilities that share the risk being hedged.

Effectiveness

IAS 39 requires hedge effectiveness to be assessed both prospectively and retrospectively. To qualify for hedge accounting at the inception of a hedge and, at a minimum, at each reporting date, the changes in the fair value or cash flows of the hedged item attributable to the hedged risk must be expected to be highly effective in offsetting the changes in the fair value or cash flows of the hedging instrument on a prospective basis, and on a retrospective basis where actual results are within a range of 80% to 125%.

All hedge ineffectiveness is recognised immediately in the income statement (including ineffectiveness within the 80% to 125% window).

Categories of Hedges

A fair value hedge is a hedge of the exposure to changes in fair value of a recognised asset or liability or a previously unrecognised firm commitment to buy or sell an asset at a fixed price or an identified portion of such an asset, liability or firm commitment, that is attributable to a particular risk and could affect profit or loss. The gain or loss from the change in fair value of the hedging instrument is recognised immediately in profit or loss. At the same time the carrying amount of the hedged item is adjusted for the corresponding gain or loss with respect to the hedged risk, which is also recognised immediately in net profit or loss.

A cash flow hedge is a hedge of the exposure to variability in cash flows that (i) is attributable to a particular risk associated with a recognised asset or liability (such as all or some future interest payments on variable rate debt) or a highly probable forecast transaction and (ii) could affect profit or loss. [IAS 39.86]

The portion of the gain or loss on the hedging instrument that is determined to be an effective hedge is recognised directly in equity and recycled to the income statement when the hedged cash transaction affects profit or loss. [IAS 39.95]

If a hedge of a forecast transaction subsequently results in the recognition of a financial asset or a financial liability, any gain or loss on the hedging instrument that was previously recognised directly in equity is 'recycled' into profit or loss in the same period(s) in which the financial asset or liability affects profit or loss. [IAS 39.97]

If a hedge of a forecast transaction subsequently results in the recognition of a non-financial asset or non-financial liability, then the entity has an accounting policy option that must be applied to all such hedges of forecast transactions: [IAS 39.98]

Same accounting as for recognition of a financial asset or financial liability – any gain or loss on the hedging instrument that was previously recognised directly in equity is 'recycled' into profit or loss in the same period(s) in which the non-financial asset or liability affects profit or loss.

'Basis adjustment' of the acquired non-financial asset or liability – the gain or loss on the hedging instrument that was previously recognised directly in equity is removed from equity and is included in the initial cost or other carrying amount of the acquired non-financial asset or liability.

A hedge of a net investment in a foreign operation as defined in IAS 21 is accounted for similarly to a cash flow hedge. [IAS 39.86]

A hedge of the foreign currency risk of a firm commitment may be accounted for as a fair value hedge or as a cash flow hedge.

Fair Value Hedge Accounting for a Portfolio Hedge of Interest Rate Risk (Macro Hedging)

IAS 39 allows fair value hedge accounting to be used for a portfolio hedge of interest rate risk (macro hedging) as follows:

1. The entity identifies a portfolio of items whose interest rate risk it wishes to hedge. The portfolio may include both assets and liabilities.

2. The entity analyses the portfolio into time periods based on expected, rather than contractual, repricing dates.

3. The entity designates the hedged item as a percentage of the amount of assets (or liabilities) in each time period from step 2. All of the assets from which the hedged amount is drawn must be items (a) whose fair value changes in response to the risk being hedged and (b) that could have qualified for fair value hedge accounting under IAS 39 had they been hedged individually. The time periods must be sufficiently narrow to ensure that all assets (or liabilities) in a time period are homogeneous with respect to the hedged risk – that is, the fair

value of each item moves proportionately to, and in the same direction as, changes in the hedged interest rate risk.

4. The entity designates what interest rate risk it is hedging. This risk could be a portion of the interest rate risk in each of the items in the portfolio, such as a benchmark interest rate like LIBOR.

5. The entity designates a hedging instrument for each time period. The hedging instrument may be a portfolio of derivatives (for instance, interest rate swaps) containing offsetting risk positions.

6. The entity measures the change in the fair value of the hedged item (from step 3) that is attributable to the hedged risk (from step 4). The result is recognised in profit or loss and may be presented in one of two ways in the balance sheet:

o a. As an adjustment of the carrying amount of the hedged item o b. As a separate line item in the balance sheet. The balance sheet line

item depends on whether the hedged item is an asset (in which case the change in fair value is reported in a separate line item within assets) or is a liability (in which case the value change is reported in a separate line item within liabilities). This separate balance sheet line item is presented on the face of the balance sheet adjacent to the related asset(s) or liability(ies).

7. The entity measures the change in the fair value of the hedging instrument and recognises this as a gain or loss in profit or loss. It recognises the fair value of the hedging instrument as an asset or liability in the balance sheet.

8. Ineffectiveness is the difference in profit or loss between the amounts determined in step 6 and step 7.

A change (up or down) in the amounts that are expected to be repaid or mature in a time period will result in ineffectiveness. That ineffectiveness is the difference between (a) the initial hedge ratio applied to the initially estimated amount in a time period and (b) that same ratio applied to the revised estimate of the amount.

Demand deposits and similar items with a demand feature (such as a bank's 'core deposits') cannot be designated as the hedged item in a fair value hedge for any period beyond the shortest period in which the counterparty can demand repayment. Thus deposits payable immediately on demand are not eligible for hedge accounting.

Discontinuation of Hedge Accounting

Hedge accounting must be discontinued prospectively if: [IAS 39.91 and 39.101]

the hedging instrument expires or is sold, terminated, or exercised; the hedge no longer meets the hedge accounting criteria - for example it is no

longer effective; for cash flow hedges the forecast transaction is no longer expected to occur; or the entity revokes the hedge designation.

For the purpose of measuring the carrying amount of the hedged item when fair value hedge accounting ceases, a revised effective interest rate is calculated. [IAS 39.BC35A]

If hedge accounting ceases for a cash flow hedge relationship because the forecast transaction is no longer expected to occur, gains and losses deferred in equity must be taken to the income statement immediately. If the transaction is still expected to occur and the hedge relationship ceases, the amounts accumulated in equity will be retained in equity until the hedged item affects profit or loss. [IAS 39.101(c)]

If a hedged financial instrument that is measured at amortised cost has been adjusted for the gain or loss attributable to the hedged risk in a fair value hedge, this adjustment is amortised to profit or loss based on a recalculated effective interest rate on this date such that the adjustment is fully amortised by the maturity of the instrument. Amortisation may begin as soon as an adjustment exists and must begin no later than when the hedged item ceases to be adjusted for changes in its fair value attributable to the risks being

hedged.

Transition and Effective Date [IAS 39.103-108]

Comparative Financial Statements

In 2005 financial statements only, an entity may elect for the prior-year comparative information to still be prepared under their existing GAAP. If this election is taken the entity must:

disclose this fact together with the basis used to prepare this information; and disclose the nature of the main adjustments that would make the information

comply with IAS 32 and IAS 39. The entity need not quantify those adjustments. However, the entity must treat any adjustment between the balance sheet at the comparative period's reporting date and the balance sheet at the start of the first IFRS reporting period as arising from a change in accounting policy.

Effective Date

IAS 39 must be applied for annual periods beginning on or after 1 January 2005. Earlier application is permitted only if the entity also early applies IAS 32. If the entity early adopts the two standards that fact should be disclosed.

Transition

On initial adoption, subject to the guidance below, IAS 39 should be applied retrospectively, with the opening balance of retained earnings for the earliest period presented and all other comparative amounts adjusted as if the standard had always been in use, except where restating the information would be impracticable, in which case the entity must disclose that fact and indicate the extent to which the information was restated.

Derecognition

With respect to derecognition the entity may either apply the IAS 39 requirements prospectively for financial years beginning on or after 1 January 2004, or apply the IAS 39 requirements retrospectively from a date of the entity's choosing, provided that the information needed to apply IAS 39 to assets and liabilities derecognised as a result of past transactions was obtained at the time of initially accounting for those transactions.

Designation upon Transition

On initial adoption of the standard an entity may designate a previously recognised financial asset or financial liability as a financial asset or financial liability at fair value through profit or loss or as available for sale.

Hedging

If, before the date of transition to IFRSs, an entity had designated a transaction as a hedge, but the hedge does not meet the conditions for hedge accounting in IAS 39, the entity must apply the rules on discontinuation of hedge accounting. Transactions entered into before the date of transition to IFRSs may not be retrospectively designated as hedges.

The designation and documentation of a hedge relationship must be completed on or before the date of transition to IFRSs if the hedge relationship is to qualify for hedge accounting from that date.

Fair Value Hedges

With respect to fair value hedges, if under previous GAAP the hedged item was not adjusted, the entity should adjust the carrying amount of the hedged item on transition with the adjustment amounting to the lower of:

a. that portion of the cumulative change in the fair value of the hedged item that reflects the designated hedged risk and that was not recognised under previous GAAP; and

b. that portion of the cumulative change in the fair value of the hedging instrument that reflects the designated hedged risk.

Cash Flow Hedges

Under its previous GAAP, an entity may have deferred gains and losses on a cash flow hedge of a forecast transaction. If, at the date of transition to IFRSs, the hedged forecast transaction is not highly probable, but is expected to occur, the entire deferred gain or loss is recognised in equity. Any net cumulative gain or loss that is reclassified to equity on initial application of IAS 39 remains in equity until (a) the forecast transaction subsequently results in the recognition of a non-financial asset or non-financial liability, (b) the forecast transaction affects profit or loss, or (c) circumstances subsequently change and the forecast transaction is no longer expected to occur, in which case any related net cumulative gain or loss that had been recognised directly in equity is recognised in profit or loss. If the hedging instrument is still held, but the hedge does not qualify as a cash flow hedge under IAS 39, hedge accounting is no longer appropriate starting from the date of transition to IFRSs.

An entity may 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 IAS 39 is first applied.

Disclosure

When IAS 32 and IAS 39 were revised in 2003, all of the disclosures about financial instruments that had been in old IAS 39 were moved to IAS 32, so IAS 32 Financial Instruments: Disclosure and Presentation now includes all financial instruments disclosure requirements. In 2005, the IASB issued IFRS 7 Financial Instruments: Disclosures to replace the disclosure portions of IAS 32 effective 1 January 2007, with earlier application encouraged. IFRS 7 also supersedes IAS 30 Disclosurs in the Financial Statements of Banks and Similar Financial Institutions.

April 2005 Amendment to IAS 39 on Cash Flow Hedges of Forecast Intragroup Transactions

On 14 April 2005, the IASB issued an amendment to IAS 39 to permit the foreign currency risk of a highly probable intragroup forecast transaction to qualify as the hedged item in a cash flow hedge in consolidated financial statements – provided that the transaction is denominated in a currency other than the functional currency of the entity entering into that transaction and the foreign currency risk will affect consolidated financial statements. The amendment also specifies that if the hedge of a forecast intragroup transaction qualifies for hedge accounting, any gain or loss that is recognised directly in equity in accordance with the hedge accounting rules in IAS 39 must be reclassified into profit or loss in the same period or periods during which the foreign currency risk of the hedged transaction affects consolidated profit or loss.

The amendment is effective 1 January 2006, although earlier application is encouraged.

This amendment removes a difference with US GAAP that was created when IAS 39 was amended in December 2003, because that amendment did not permit hedge accounting

for forecast intragroup transactions.

June 2005 Amendment to IAS 39 – Fair Value Option

On 15 June 2005 the IASB issued its final amendment to IAS 39 Financial Instruments: Recognition and Measurement to restrict the use of the option to designate any financial asset or any financial liability to be measured at fair value through profit and loss (the 'fair value option'). The IASB developed this amendment after commentators, particularly prudential supervisors of banks, securities companies, and insurers, raised concerns that the fair value option contained in the 2003 revisions of IAS 39 might be used inappropriately. The new revisions limit the use of the option to those financial instruments that meet certain conditions. Those conditions are that: [IAS 39.9]

a. the fair value option designation eliminates or significantly reduces an accounting mismatch, or

b. a group of financial assets, financial liabilities, or both is managed and its performance is evaluated on a fair value basis, in accordance with a documented risk management or investment strategy, and information about the group is provided internally on that basis to the entity's key management personnel.

The fair value option amendment also provides that if a contract contains an embedded derivative, an entity may generally elect to apply the fair value option to the entire hybrid (combined) contract, thereby eliminating the need to separate out the embedded derivative. Conditions (a) and (b) are not relevant to this election. [IAS 39.11A]

The amendment is effective 1 January 2006, with earlier application encouraged. Click for Press Release (PDF 55k).

August 2005 Amendment to IAS 39 and IFRS 4 – Financial Guarantee Contracts

On 18 August 2005, the IASB amended the scope of IAS 39 to include financial guarantee contracts issued. However, if an issuer of financial guarantee contracts has previously asserted explicitly that it regards such contracts as insurance contracts and has used accounting applicable to insurance contracts, the issuer may elect to apply either IAS 39 or IFRS 4 Insurance Contracts to such financial guarantee contracts. The issuer may make that election contract by contract, but the election for each contract is irrevocable.

A financial guarantee contract is a contract that requires 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.

Under IAS 39 as amended, financial guarantee contracts are recognised:

initially at fair value. If the financial guarantee contract was issued in a stand-alone arm's length transaction to an unrelated party, its fair value at inception is likely to equal the consideration received, unless there is evidence to the contrary.

subsequently at the higher of (i) the amount determined in accordance with IAS 37 Provisions, Contingent Liabilities and Contingent Assets and (ii) the amount initially recognised less, when appropriate, cumulative amortisation recognised in accordance with IAS 18 Revenue. (If specified criteria are met, the issuer may use the fair value option in IAS 39, see IASB press release of 16 June 2005. Furthermore, different requirements continue to apply in the specialised context of a 'failed' derecognition transaction.)

Some credit-related guarantees do not, as a precondition for payment, require that the holder is exposed to, and has incurred a loss on, the failure of the debtor to make

payments on the guaranteed asset when due. An example of such a guarantee is a credit derivative that requires payments in response to changes in a specified credit rating or credit index. These are derivatives and are not affected by the amendments. They must be measured at fair value under IAS 39.

The amendments address the treatment of financial guarantee contracts by the issuer. They do not address their treatment by the holder. Accounting by the holder is excluded from the scope of IAS 39 and IFRS 4 (unless the contract is a reinsurance contract). Therefore, paragraphs 10–12 of IAS 8 Accounting Policies, Changes in Accounting Estimates and Errors apply. Those paragraphs specify criteria to use in developing an accounting policy if no IFRS applies specifically to an item.

The amendments to IAS 39 and IFRS 4 are effective for annual periods beginning on or after 1 January 2006, with earlier application encouraged.

July 2008 Amendment to IAS 39 for eligible hedged items

On 30 July 2008, the IASB published amendments to IAS 39 to clarify two hedge accounting issues:

Inflation in a financial hedged item A one-sided risk in a hedged item

The amendments are based on the September 2007 exposure draft Exposures

Qualifying for Hedge Accounting, but focus more narrowly only on the two foregoing areas. The amendment does not address either (a) what can be designated as a hedged portion under IAS 39 or (b) the European carve-out option used by a few European companies. These issues will be addressed separately.

Inflation in a financial hedged itemInflation may only be hedged if changes in inflation are a contractually specified portion of cash flows of a recognised financial instrument. Therefore, where an entity acquires or issues inflation-linked debt, it has a cash flow exposure to changes in future inflation to which cash-flow hedge accounting may be applied. However, the amendment clarifies that an entity may not designate an inflation component of issued or acquired fixed-rate debt in a fair value hedge because such a component is not separately identifiable and reliably measurable. The amendments also clarify that a risk-free or benchmark interest rate portion of the fair value of a fixed-rate financial instrument will normally be separately identifiable and reliably measurable and, therefore, may be hedged.

A one-sided risk in a hedged itemIAS 39 permits an entity to designate purchased options as a hedging instrument in a hedge of a financial or non-financial item. The entity may designate an option as a hedge of changes in the cash flows or fair value of a hedged item above or below a specified price or other variable (that is, a one-sided risk). The amendments make clear that the intrinsic value, not the time value, of an option reflects a one-sided risk and, therefore, an option designated in its entirety cannot be perfectly effective. The time value of a purchased option is not a component of the forecast transaction that impacts profit or loss. Therefore, if an entity designates an option in its entirety as a hedge of a one-sided risk arising from a forecast transaction, hedge ineffectiveness will arise. Alternatively, an entity may choose to exclude time value as permitted by IAS 39 to improve hedge effectiveness.

The amendments to IAS 39 are effective for annual periods beginning on or after 1 July 2009, with earlier application permitted, and must be applied retrospectively. Therefore, if an entity has a hedge accounting relationship that is no longer considered qualifying under the amended IAS 39, the entity must restate its comparative prior period(s). Click for Press Release (PDF 52k).

October 2008: IASB amends IAS 39 to permit some reclassifications

On 13 October 2008, the IASB issued amendments to IAS 39 Financial Instruments: Recognition and Measurement and IFRS 7 Financial Instruments: Disclosures. The amendments are a response to calls from constituents, particularly within the European Union, to create a 'level playing field' with US GAAP regarding the ability to reclassify financial assets. The amendments would permit reclassification of some financial instruments out of the fair-value-through-profit-or-loss category (FVTPL) and out of the available-for-sale category. The amendments introduce into IFRSs the same possibility of reclassifications that is already permitted under US GAAP in limited circumstances. In the event of reclassification, additional disclosures are required under IFRS 7. The amendments are effective 1 July 2008.

The amendments do not permit reclassification into FVTPL.

Click for IASB Press Release (PDF 168k).

The IFRS Global Office of Deloitte has published a special edition IAS Plus Newsletter: Amendments to IAS 39 & IFRS 7 – Reclassification of Financial Assets (PDF 97k) explaining the changes.

December 2008: Proposed amendment to IAS 39 on reassessment of embedded derivatives on reclassification

On 22 December 2008, the IASB issued an exposure draft proposing to clarify the requirements of IAS 39 Financial Instruments: Recognition and Measurement and IFRIC 9 Reassessment of Embedded Derivatives. The proposals, if finalised, would make clear that reclassifications of financial assets under the October 2008 amendments to IAS 39 trigger a (re)assessment for embedded derivatives. Comments are requested by 21 January 2009. If finalised, the amendments would be effective for years ending on or after 15 December 2008.

Click for Press Release (PDF 44k).

Deloitte's IFRS Global Office has published an IAS Plus Update Newsletter (PDF 115k) explaining the proposals.

Discussion at the February 2009 IASB Meeting

The staff presented the Board with its comment letter analysis and recommendations on the IASB's exposure draft Embedded Derivatives (Proposed amendments to IFRIC 9 and IAS 39). The exposure draft proposed the following:

an entity must assess whether an embedded derivative is required to be separated from a host contract when the entity reclassifies a hybrid (combined) financial asset out of the FVTPL category.

this assessment is to be made on the basis of the circumstances that existed when the entity first became a party to the contract.

if the fair value of an embedded derivative that would have to be separated cannot be reliably measured, the entire hybrid financial instrument must remain in the FVTPL category.

The Board agreed without discussion to proceed with the proposed amendments subject to drafting changes as a clear majority of constituents agreed with the proposals.

The staff then informed the Board that some constituents were concerned over the effective date of 15 December 2008, particularly because of the implications of backdating the effective date. It was noted that this causes difficulties in jurisdictions where IFRSs become part of the law, which in some instances prohibits backdating. One

Board member noted it was a good time to go back to normal and propose an effective date of at least 3 months after publication of the final amendments. Other Board members were generally sympathetic to this view. Some believed a different accounting treatment than the one proposed in the exposure draft was an accounting error, admitting that then there would be no reason for an amendment.

In the end, the Board decided that the amendments were to be applied retrospectively for accounting periods ending on or after 30 June 2009.

On this occasion, the staff provided a brief update on the issue of accounting for certain credit-linked instruments, commonly referred to as synthetic collateralised debt obligations (CDO), that do not have the actual assets the credit risk is referenced to in their asset pool.

The issue is whether the credit derivative embedded in the notes issued by such structures have to be bifurcated. Under IFRSs, common practice is to separate the embedded credit derivative in the notes issued by such a structure. Under US GAAP practice has evolved that would not bifurcate. Constituents noted that this would create an unlevel playing field. In December 2008 the Board decided there is no need to change IAS 39 as there is no diversity in practice under IFRS. The FASB has proposed guidance that would clarify the FASB's intentions when bifurcation was required.

Staff noted that the proposed guidance DIG C22 would be different from practice under IFRS in certain scenarios. However it also noted that this might in practice be a small difference (mainly due to the subsequent accounting for some of the beneficial interests issued by a synthetic CDO under US GAAP) and warned the Board not to make further piecemeal amendments to IAS 39 at this stage. If US GAAP wanted to fully align to IFRS this would require fundamental changes to the US guidance.

Some Board members were concerned over this update noting that certain constituents will pick this up. It was suggested to make clear in the IASB Update and on the IASB website about the current status, the practical implications, and the remaining differences on this issue.

March 2009: IAS 39 amended for embedded derivatives on reclassification

On 12 March 2009, the IASB published amendments to IFRIC 9 and IAS 39 to clarify the accounting treatment of embedded derivatives for entities that make use of the Reclassification Amendment issued by the IASB in October 2008. The reclassification amendment allows entities to reclassify particular financial instruments out of the 'fair value through profit or loss' category in specific circumstances. These amendments to IFRIC 9 and IAS 39 clarify that on reclassification of a financial asset out of the 'fair value through profit or loss' category, all embedded derivatives have to be assessed and, if necessary, separately accounted for in financial statements. The amendments apply retrospectively and are required to be applied for annual periods ending on or after 30 June 2009. Click for the IASB Press Release (PDF 22k).