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International Accounting Standards Committee Issues Under IAS 39 AAA August 2000 International Accounting Standards Committee Issues Under IAS 39 AAA August 2000

Presentation by Paul Pacter Hong Kong paupacter@deloitte. com. hk Presentation by Paul Pacter Hong Kong [email protected] com. hk

IAS 39: SCOPE • All enterprises • All financial instruments except: -- Investments in IAS 39: SCOPE • All enterprises • All financial instruments except: -- Investments in subs, associates, joint ventures -- Leases, pensions, insurance -- Enterprise’s own equity -- Commodity contracts - intent to take delivery

IAS 39: RECOGNITION • All financial assets and liabilities must be on the balance IAS 39: RECOGNITION • All financial assets and liabilities must be on the balance sheet • Including all derivatives

TRADE DATE OR SETTLEMENT DATE? Purchases: Normal purchases either at trade or settlement date, TRADE DATE OR SETTLEMENT DATE? Purchases: Normal purchases either at trade or settlement date, with recognition of certain value changes if settlement date accounting is used. Sales: Settlement date.

INITIAL MEASUREMENT: FINANCIAL ASSETS AND LIABILITIES • Initially all financial instruments measured at cost INITIAL MEASUREMENT: FINANCIAL ASSETS AND LIABILITIES • Initially all financial instruments measured at cost (which is fair value at acquisition) • Transaction cost included in initial measurement.

SUBSEQUENT MEASUREMENT: FINANCIAL ASSETS All financial assets are remeasured to fair value (includes those SUBSEQUENT MEASUREMENT: FINANCIAL ASSETS All financial assets are remeasured to fair value (includes those held for trading or available for sale) except the following, which are measured at amortised cost. . .

SUBSEQUENT MEASUREMENT AT COST • Originated loans and receivables • Fixed maturity investments: must SUBSEQUENT MEASUREMENT AT COST • Originated loans and receivables • Fixed maturity investments: must intend and be able to hold to maturity • Some unquoted equities and derivatives indexed to them (if FV is not measurable reliably)

STRICT TESTS FOR HELD TO MATURITY • Single sale taints all for two years STRICT TESTS FOR HELD TO MATURITY • Single sale taints all for two years -- unless sale is due to isolated event beyond company’s control and not reasonably anticipated • Variable rate debt can be HTM Note: Intent and ability tests do not apply to originated loans

SUBSEQUENT MEASUREMENT: FINANCIAL LIABILITIES • Most financial liabilities at original recorded amount less principal SUBSEQUENT MEASUREMENT: FINANCIAL LIABILITIES • Most financial liabilities at original recorded amount less principal repayments and amortisation • Derivatives and liabilities held for trading (short sales) remeasured to fair value

REPORTING FV CHANGE: Single enterprise-wide option: • Entire FV change in P&L OR • REPORTING FV CHANGE: Single enterprise-wide option: • Entire FV change in P&L OR • In P&L only FV changes relating to trading assets and liabilities. FV changes for nontrading assets in equity until sold, then in P&L. Derivatives always trading (unless hedging)

IMPAIRMENT OF FINANCIAL ASSETS CARRIED AT COST • Recognise impairment losses Individually for large IMPAIRMENT OF FINANCIAL ASSETS CARRIED AT COST • Recognise impairment losses Individually for large assets • Portfolio allowed for groups • Strict indicators of impairment • Write-down to P&L • Reversal to P&L up to cost • Interest after impairment

MEASURING IMPAIRMENT Impairment is the excess of carrying amount over estimated recoverable amount (present MEASURING IMPAIRMENT Impairment is the excess of carrying amount over estimated recoverable amount (present value of cash flows discounted at the loan's original effective interest rate).

DERECOGNITION Assets: Control surrendered -transferee can sell or pledge the asset. Transferor can only DERECOGNITION Assets: Control surrendered -transferee can sell or pledge the asset. Transferor can only reacquire at fair value. Liabilities: Debtor must be legally released. No insubstance defeasance. Partial transfer: Split based on relative FV.

COLLATERAL If a debtor gives collateral to the creditor, and the creditor can sell COLLATERAL If a debtor gives collateral to the creditor, and the creditor can sell or repledge: • Debtor recognises the collateral given as a receivable • Creditor recognises the collateral received as an asset and the obligation to repay the collateral as a liability.

FINANCIAL GUARANTEES • Not normally recognised under IAS 39 (eg letter of credit) • FINANCIAL GUARANTEES • Not normally recognised under IAS 39 (eg letter of credit) • Recognised in some derecognitions • If recognised, measure at fair value until expiration

HEDGE ACCOUNTING Designating a financial instrument as an offset to the change in FV HEDGE ACCOUNTING Designating a financial instrument as an offset to the change in FV or cash flows of an asset, liability, commitment, or forecasted transaction. Offsetting effects recognised in P&L in the same period.

HEDGE ACCOUNTING Permitted by IAS 39 in certain circumstances. The hedging relationship must be: HEDGE ACCOUNTING Permitted by IAS 39 in certain circumstances. The hedging relationship must be: • Clearly designated • Measurable • Actually effective

FAIR VALUE HEDGE • Hedge value change in a recognised asset or liability • FAIR VALUE HEDGE • Hedge value change in a recognised asset or liability • Gain or loss on hedging instrument and on hedged item are both recognised in P&L • Carrying amount of hedged item is adjusted even if otherwise carried at cost

CASH FLOW HEDGE • Hedge cash flow risk from an asset or liability, firm CASH FLOW HEDGE • Hedge cash flow risk from an asset or liability, firm commitment, or forecasted transaction • Gain or loss on hedging instrument in equity until the hedged transaction hits P&L, then “recycled” to P&L

DISCONTINUE HEDGE ACCOUNTING WHEN • Hedging instrument expires (unless replaced or rolled over) • DISCONTINUE HEDGE ACCOUNTING WHEN • Hedging instrument expires (unless replaced or rolled over) • Hedge is no longer effective • The forecasted transaction (if any) is no longer expected to occur

BASIS ADJUSTMENT • When the forecasted transaction occurs, should the amount reported in equity BASIS ADJUSTMENT • When the forecasted transaction occurs, should the amount reported in equity become part of the cost of the asset or liability? • IAS 39: Yes.

DISCLOSURE - 1 • Most IAS 32 disclosures continue • How FV was determined DISCLOSURE - 1 • Most IAS 32 disclosures continue • How FV was determined • FV changes in P&L or equity? • Current period amounts in P&L or equity • Cumulative amounts in equity

DISCLOSURE - 2 • Describe risk management policies • Detailed Info if FV cannot DISCLOSURE - 2 • Describe risk management policies • Detailed Info if FV cannot be reliably measured • Detailed info about hedges • Reclassifications of financial • instruments (e. g. HTM to AFS) • Impairment and reversals

EFFECTIVE DATE • 1 January 2001 • Companies are gearing up now • Postponement EFFECTIVE DATE • 1 January 2001 • Companies are gearing up now • Postponement probability: nil

TRANSITION • Recognise all financial assets and liabilities, including those that had not previously TRANSITION • Recognise all financial assets and liabilities, including those that had not previously been recognised • If a previously designated hedge does not meet IAS 39 conditions, no more hedge accounting

MAINTENANCE OF IAS 39 • Minor amendments to IAS 39: proposed in June • MAINTENANCE OF IAS 39 • Minor amendments to IAS 39: proposed in June • Implementation Guidance Q&A: Special Implementation Guidance Committee is hard at work. Over 100 Q&A exposed.

E 66 JUNE 2000 Minor Amendments to IAS 39 • Symmetry of trade or E 66 JUNE 2000 Minor Amendments to IAS 39 • Symmetry of trade or settlement date for both purchases and sales. • Lender will no longer recognise collateral received from a borrower. Disclose. • Assess impairment individually for large assets.

IMPLEMENTATION GUIDANCE • Being developed by IASC staff • Reviewed by Implementation Guidance Committee IMPLEMENTATION GUIDANCE • Being developed by IASC staff • Reviewed by Implementation Guidance Committee (IGC) • Exposed for public comment • Reviewed and approved by IGC

IMPLEMENTATION GUIDANCE Proposed Guidance: • Batch 1, 8 May 2000: 75 Q&A • Batch IMPLEMENTATION GUIDANCE Proposed Guidance: • Batch 1, 8 May 2000: 75 Q&A • Batch 2, 12 May 2000: 33 Q&A • Batch 3 dealing with bank issues under development • Goal: finish by October • Status: Best practice guidance

SAMPLE GUIDANCE ISSUES • Are credit rating guarantee contracts excluded? No. • Are credit SAMPLE GUIDANCE ISSUES • Are credit rating guarantee contracts excluded? No. • Are credit default derivatives excluded? Yes. • Is gold bullion a financial asset? No. • Are offsetting loans, one fixed one variable, a derivative? Yes.

SAMPLE GUIDANCE ISSUES • Company sells a put on its own shares, and has SAMPLE GUIDANCE ISSUES • Company sells a put on its own shares, and has right to settle in shares. Liability or equity? Eq. • What if holder of put has right to require cash settlement? Liab. • Are royalties based on volume of revenue a derivative? No. • Contract to convert currency at fixed rate -- derivative? Yes.

SAMPLE GUIDANCE ISSUES • Is fixed price forward contract to purchase a commodity a SAMPLE GUIDANCE ISSUES • Is fixed price forward contract to purchase a commodity a derivative? Depends on intent. • Is 5 -year put option to sell building for fixed price a derivative? Depends on history. • Are bank loan commitments derivatives? Yes, but not treated if ‘regular way’ draw-down.

SAMPLE GUIDANCE ISSUES • If embedded is separated from host, show separately on balance SAMPLE GUIDANCE ISSUES • If embedded is separated from host, show separately on balance sheet? Yes. • Can investment in convertible bond be HTM? No. • Transferor has right of first refusal. Derecognise? Yes. • HTM not tainted by sale ‘close to maturity’. What is close? Under 3 months.

SAMPLE GUIDANCE ISSUES • HTM not tainted by sale after collecting ‘substantially all’ principal. SAMPLE GUIDANCE ISSUES • HTM not tainted by sale after collecting ‘substantially all’ principal. Substantially = 90%. • Does reclass from HTM to trading taint all HTM? Yes. • Is amortisation of premium or discount interest (P&L) or part of FV change (equity)? Interest.

SAMPLE GUIDANCE ISSUES • Can impairment of individual loan or HTM asset be ‘ignored’ SAMPLE GUIDANCE ISSUES • Can impairment of individual loan or HTM asset be ‘ignored’ by a portfolio approach? No. • Can partial term hedging get hedge accounting? Yes. • Do bank ‘internal hedges’ get hedge accounting? Only if risk ultimately laid off with 3 rd party.

SAMPLE GUIDANCE ISSUES • Can hedge effectiveness be assessed on after-tax basis? Yes. • SAMPLE GUIDANCE ISSUES • Can hedge effectiveness be assessed on after-tax basis? Yes. • If hedge is considered highly (but not 100%) effective, does ineffective portion go to equity? No, P&L. • Is purchase of bond when issued an originated loan? Yes.

SAMPLE GUIDANCE ISSUES • Is commitment to issue debt at fixed rate accounted for SAMPLE GUIDANCE ISSUES • Is commitment to issue debt at fixed rate accounted for as a derivative? No. • Derecognise receivables “sold” with guarantee for all credit losses? Yes. • Amortise discount or premium on variable rate investment to next repricing date or maturity? Depends on intent to hold.

JOINT WORKING GROUP ON FINANCIAL INSTRUMENTS • IASC and 10 standard setters • Exploring JOINT WORKING GROUP ON FINANCIAL INSTRUMENTS • IASC and 10 standard setters • Exploring full fair value model • Developing proposal by end of 2000 • Each standard-setter will invite comments on JWG discussion paper

KEY TENTATIVE JWG CONCLUSIONS • Applies to all enterprises • Scope similar to IAS KEY TENTATIVE JWG CONCLUSIONS • Applies to all enterprises • Scope similar to IAS 39, but: -- Includes financial guarantee contracts -- Includes weather derivatives -- Applies to acquired servicing assets and liabilities -- Applies to any obligation that either party can settle in cash

KEY TENTATIVE JWG CONCLUSIONS • Recognition of financial instruments: similar to IAS 39 • KEY TENTATIVE JWG CONCLUSIONS • Recognition of financial instruments: similar to IAS 39 • Embedded derivative provisions are similar to IAS 39 except will be fewer separations because more hybrids are measured at fair value

KEY TENTATIVE JWG CONCLUSIONS Derecognition: when enterprise is no longer a party to the KEY TENTATIVE JWG CONCLUSIONS Derecognition: when enterprise is no longer a party to the contractual rights or obligations (“transferor has no continuing interest”)

KEY TENTATIVE JWG CONCLUSIONS • Would derecognise in most repo and securities lending transactions. KEY TENTATIVE JWG CONCLUSIONS • Would derecognise in most repo and securities lending transactions. • Note: Transferee must have substance in its own right or transferred asset is isolated in bankruptcy.

KEY TENTATIVE JWG CONCLUSIONS • Measure all financial instruments at fair value when recognised KEY TENTATIVE JWG CONCLUSIONS • Measure all financial instruments at fair value when recognised initially. • Remeasure to fair value at each reporting date.

KEY TENTATIVE JWG CONCLUSIONS Fair value is exit price based on market transactions Best: KEY TENTATIVE JWG CONCLUSIONS Fair value is exit price based on market transactions Best: observed market price If exchange traded, closing price minus commissions If dealer traded, bid prices for assets, asked prices for liabilities

KEY TENTATIVE JWG CONCLUSIONS Best: market price for identical instrument. • If not available, KEY TENTATIVE JWG CONCLUSIONS Best: market price for identical instrument. • If not available, use price for similar instrument. • If more than one market, use most advantageous price.

KEY TENTATIVE JWG CONCLUSIONS • If no market price for identical or similar, use KEY TENTATIVE JWG CONCLUSIONS • If no market price for identical or similar, use a DPV cash flow model based on general market info (interest rates, FX rates, commodity prices) riskadjusted as necessary. • If not able to make reliable FV estimate currently, use most recent FV estimate.

KEY TENTATIVE JWG CONCLUSIONS • Ignore non-contractual aspects of financial instruments (such as future KEY TENTATIVE JWG CONCLUSIONS • Ignore non-contractual aspects of financial instruments (such as future deposits by depositors or additional purchases by credit card holders). • But do consider behavioural expectations (eg prepayments).

KEY TENTATIVE JWG CONCLUSIONS If financial instrument is denominated in foreign currency: • For KEY TENTATIVE JWG CONCLUSIONS If financial instrument is denominated in foreign currency: • For forward contract use forward rate • For all others use spot rate

KEY TENTATIVE JWG CONCLUSIONS • Do not adjust market price for size of holding. KEY TENTATIVE JWG CONCLUSIONS • Do not adjust market price for size of holding. • Procedures for determining fair value must be documented. • Fair values are generally determinable, at reasonable cost, and are practicably implementable.

KEY TENTATIVE JWG CONCLUSIONS Reported value of liabilities should reflect changes in an enterprise’s KEY TENTATIVE JWG CONCLUSIONS Reported value of liabilities should reflect changes in an enterprise’s own creditworthiness.

KEY TENTATIVE JWG CONCLUSIONS • All gains and losses arising from changes in fair KEY TENTATIVE JWG CONCLUSIONS • All gains and losses arising from changes in fair value of financial instruments reported in net income when they arise. • Interest revenue and interest expense should be calculated on a fair value basis using current YTM, not contractual.

KEY TENTATIVE JWG CONCLUSIONS • Separately report FV changes relating to impaired loan assets. KEY TENTATIVE JWG CONCLUSIONS • Separately report FV changes relating to impaired loan assets. • All forms of hedge accounting prohibited, including hedges of commitments or forecasted transactions. Certain ‘hedging’ note disclosures allowed.

CONCLUSION • The participating JWG countries are committed to invite comments • None has CONCLUSION • The participating JWG countries are committed to invite comments • None has said they accept or reject the JWG conclusions • IASC consideration will await the new restructured IASC Board