Summary not at fair value through profit or
Summary of IAS 39: IAS 39: Financial Instruments: Recognition and Measure was first adopted by European Union for annual periods beginning on or after January 1st 2005. The goal was to provide principles for recognising and measuring financial assets, financial liabilities (including derivative financial instruments) and some specific contracts to buy and sell non-financial items.
Initial Recognition: Financial asset or financial liability is only recognised on balance sheet when and only when, an entity becomes a party to contractual provisions of the instruments.Initial Measurement: At initial recognition, the financial asset or liability is measured at fair value. Directly attributable transaction cost are added to fair value for financial asset or financial liability not at fair value through profit or loss. Subsequent measurement of financial assets: IAS 39 classifies financial assets into following categories to determine their subsequent measurement criteria.
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(a) Initially recognized financial assets at fair value through profit or loss are subsequently measured at fair value without deducting any transaction cost. b) Loans and receivables and held for maturity investments are measured at amortized cost using effective interest rate method (c) Available for sale assets are measured at cost if fair value cannot be reliably measured. Subsequent measurement of financial liabilities: All financial liabilities are measured at cost using effective interest method. Exceptions to this rule are financial liability at fair value through profit or loss, financial liability arising from transfer of financial asset that does not qualify for derecognition, financial guarantee contracts, and loans at below market rate.Derecognition: A financial liability is derecognized when the contract obligation is discharged or cancelled or expires.
Derecognition of financial asset applies only when the contractual right to the cash flow from the asset expires or when the entity transfers all the risks and rewards of ownership of the asset. In addition, IAS 39 contains extensive hedge accounting regulations especially for derivatives. Derivatives are classified as trading transactions and are valued at fair value. When derivatives are used to hedge risks, IAS 39 allows cash flow hedge and fair value hedge accounting.
IAS 39 requires the documentation of hedge at the time hedge is established and calls for evidence of effective hedge. IAS 39 also requires derivatives that are embedded in no-derivative contracts to be accounted for separately at fair value through profit or loss. The replacement of IAS 39 with IFRS 9: IAS 39 standard is by far one of the most complex standards issued. At their meeting in April 2009, the G20 nations called for standard setters to reduce the complexity of accounting standards for financial instruments and to address the issues arising from the financial crisis of 2008.Consequently, a major initiative was undertaken by IASB to replace IAS 39 with IFRS 9.
All of the requirements of IAS 39 are planned to be replaced by the end of 2011. The new IFRS 9 standard is effective for annual periods beginning on or after January 1st 2013 with earlier adoption permitted. The IASB’s project plan for the replacement of IAS 39 with IFRS 9 consists of three main phases: (a) Phase 1: Classification and measurement (b) Phase 2: Impairment methodology c) Phase 3: Hedge Accounting Phase 1: Classification and measurement: Phase 1 only deals with classification and measurement of financial assets and liabilities.
This phase was completed in October 2010. While most of the standards are followed from IAS 39 to IFRS 9, followings are the notable differences. (1) Classification of financial assets falls into two groups: Measured at fair value and measured at amortised cost. Available for sale and held to maturity category from IAS 39 are removed.
2) An asset is classified as measured at amortised cost if the objective of the business to hold the asset to collect contractual cash flow on specified dates where cash flows are solely payments of interest and principal on outstanding principal and where interest represent payments for the time value of money and credit risk. (3) An asset is classified at measured at fair value if it is not eligible for measurement under amortised cost method or if the asset is designated at fair value under the fair value option. (4) In the case of embedded derivative, unlike IAS 39, there is no more bifurcation.The entire hybrid instrument is either accounted at amortised cost or at fair value.
(5) IAS 39 reclassification rules were very complex. IFRS allows reclassification when the business model changes and always done prospectively. (6) At initial recognition financial assets are measured at fair value and subsequent measurement is at fair value or amortized cost based on the classification. (7) For assets accounted for at fair value, gains or losses are recognized in profit or loss unless the equity instrument exemption applies.For assets accounted for at amortised cost, the gain or losses are recognized in line with the old IAS 39. (8) For equity investment, the profit or loss may be recognized in other comprehensive income with no recycling to profit or loss. (9) IAS 39 allowed to not use fair value for equity investment for which fair value cannot be determined reliably.
IFRS 9 does not allow this; it requires these instruments to be measured at fair value. In October 2010, the requirement for classifying and measuring financial liabilities were added to IFRS 9. It is mostly unchanged from IAS 39 except the requirement related to the fair value ption for financial liabilities were changed to address the issue of own credit risk. The change was a result of exposure draft ED/2010/4 for addressing the volatility in the income statement caused by changes in the credit risk of a financial liability (own risk). The IASB undertook outreach on the issue of own credit including discussions with preparers, audit firms, regulators and investors. Extensive input was obtained and the consensus was that P&L volatility caused by own credit does not provide useful information (except for derivatives and liabilities held for trading).
Investors did not want a new measurement method; but admitted that the information on the effects of own credit can still be useful. In response, IASB proposed a two-step approach in the ED to address the P&L volatility arising from own credit which was finalised in IFRS 9 as follows: • the fair value change of liabilities under the FVO would be recognised in P&L; • the portion of the fair value change due to own credit would be reversed out of P&L and recognised in other comprehensive income.This two-step approach does not apply to financial liabilities that are required to be measured at fair value such as derivatives and liabilities held for trading. Phase 2: Amortised cost and Impairment of financial assets This is the second phase of IFRS 9 project to replace IAS 39 Financial Instruments: Recognition and Measurement. The objective of this phase is to improve the decision-usefulness of financial statements for users by improving the amortised cost measurement, in particular the transparency of provisions for losses on loans and for the credit quality of financial assets.
An exposure draft was published in late 2009 for public input on amortized cost measurement and impairment of financial instruments. Exposure draft proposes to replace Incurred Loss Model of IAS 39 with Expected Loss Approach that enables earlier recognition of credit risk. Under this model, an entity estimates the expected credit losses over the life of the asset on initial measurement of the asset. Incurred Loss Approach delays the recognition of impairment until there is an objective evidence that impairment has occurred.Expected Loss Approach will allow entities to start providing for impairment earlier than current model. However, PriceWaterhouseCoopers was quick to address the significance operational challenge of the application of proposed model, even though they fundamentally agree with the recommendations.
The proposed impairment model of ELA generates changes in Effective Interest rate (EIR) to include Expected loss rate in EIR calculation. Mingling of credit risk and credit rate would be difficult and costly to implement and generate significant operational challenges when it comes to practical implementation.In addition, they argue that the requirement of using probability-weighted approach to determine Expected Cash Flow does not work well for individual asset or small portfolio.
Deliberations on the comments are completed recently, and IASB is planning to incorporate the exposure draft recommendations into IFRS 9 by the end of the third quarter of 2011. Phase 3: Hedge Accounting The objective of hedge accounting is to represent the effect of an entity’s risk management activities in the financial statements. When IAS 39 was implemented for hedge accounting, hedging activities were relatively new and limited.Hedging has become common business practice now and hedge accounting model in IAS 39 is due for a major change for some very apparent reasons.
Many believe that IAS 39 does not allow entities to adequately reflect their risk management practices. In addition, IAS 39 distinction between cash flow and fair value hedge is confusing to some. IASB is proposing some changes to address these concerns regarding hedge accounting thorough an exposure draft ED/2010/13. The proposed model will align hedge accounting more closely with risk management. The model allows entity to use internal nformation for the purpose of risk management thus aligning risk management objectives with accounting objectives.
In addition, the proposed model requires comprehensive disclosure focusing on the risk that entities are managing, how they are managing these risks and the outcomes of these activities including their effect on the financial statement. The model proposes that remeasurement of hedged item in fair value hedge accounting is presented separately and that the information about fair value hedges is reflected in the other comprehensive income.This model will eliminate the restriction of non financial items from hedging as currently applied in IAS 39.
IAS 39 also does not allow net positions to be hedged, but the proposed model will extend the hedge accounting to net positions. The bright line test of 80-125% for hedge effectiveness testing will be eliminated in IFRS 9. The assessment of hedge effectiveness will be prospective and driven by the risk management strategy – with a requirement that no systematic under- or over hedge-hedging is expected.
Rebalancing of the hedge ratio will be required when necessary to maintain the risk management objective. In regards to rebalancing requirement, Ernst and Young raised an important concern in regards to the wording of the requirement. “We have concerns with the wording in the ED which seems to indicate that a hedge relationship must always produce an ‘unbiased’ result and that rebalancing of the hedge relationship is required in order to minimise ineffectiveness.
Our main concerns are that the wording implies an unnecessary degree of precision, such that rebalancing will be required even for very small changes in hedge effectiveness. Furthermore, the ED’s wording implies that, since rebalancing is required as part of hedge effectiveness testing, an entity may fail to qualify for hedge accounting prospectively if it does not rebalance the hedge relationship, even for small amounts of ‘bias’. ” Redeliberations are ongoing at this point in time for the exposure draft and IASB plans to incorporate the proposed changes into IFRS 9 in the second half of 2011.Bibliography: http://www. ey.
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