EXPOSURE DRAFT
54

November 22, 2002



PROPOSED STATEMENT OF FINANCIAL ACCOUNTING STANDARDS


FINANCIAL INSTRUMENTS: DISCLOSURE AND PRESENTATION


Issued for Comment by the

ACCOUNTING STANDARDS COUNCIL

Comments should be received not later than June 30, 2003 and should be addressed to:

Carlos R. Alindada
Chairman
Accounting Standards Council
PICPA House, 700 Shaw Boulevard
Mandaluyong City

Exposure Draft (ED) 54
Proposed Statement of Financial Accounting Standards


Financial Instruments: Disclosure and Presentation


The Accounting Standards Council (ASC) approved the adoption of International Accounting Standard (IAS) 32 (revised 1998), Financial Instruments: Disclosure and Presentation, issued by the International Accounting Standards Committee (IASC), as generally accepted accounting principles in the Philippines. The effective date (paragraph 96) of IAS 32 (revised 1998), however, is modified in the Philippines as set forth below.


Effective Date in the Philippines

IAS 32 (revised 1998) becomes effective in the Philippines for financial statements covering periods beginning on or after January 1, 2005. Earlier application is encouraged.

Comparison of IAS 32 and SFAS 18


Equivalent presentation and disclosure guidance relating to financial instruments is contained in various standards such as SFAS 10, Summary of Generally Accepted Accounting Principles on Investments, and SFAS 18, Summary of Generally Accepted Accounting Principles on Stockholder’s Equity. Following is a comparison of the more significant provisions of IAS 32 (revised 1998) and the equivalent provisions of SFAS 10 and SFAS 18.

Reference should be made to IAS 32 (revised 1998) for complete and detailed guidance on the standard.

	IAS 32	SFAS 10 and 18
Scope	Covers the presentation and disclosure of all types of financial instruments, both recognized and unrecognized. Exception are specified.	No equivalent comprehensive standard. Equivalent guidance is included in SFAS 10 and 18.
Definitions	A financial instrument is any contract that gives to both a financial asset of one enterprise and a financial liability or equity instrument of another enterprise. A financial liability is any liability that is a contractual obligation: (a) to deliver cash or another financial asset, or (b) to exchange financial instruments with another enterprise under conditions that are potentially unfavorable. A equity instrument, on the other hand, is defined as any contract that evidences a residual interest in the assets of the enterprise after deducting all its liabilities.	No equivalent definitions.
Presentation:		Under SFAS 18, capital stock is classified under stockholders’ equity.
Liability and Equity	The issuer of a financial instrument should classify the instrument, or its component parts, as a liability or equity in accordance with the substance of the contractual arrangement (not its legal form) on initial recognition and the definitions of a financial liability or an equity instrument (see definitions)	Under SFAS 18, capital stock is classified under stockholders’ equity.
Mandatory Redeemable Preferred Stock	When a preferred share provides for mandatory redemption by the  issuer for a fixed or determinable amount at a fixed or determinable future date or gives the holder the right to require the issuer to redeem the share at or after a particular date for a fixed or determinable amount, the instrument meets the definition of a financial liability and is classified as such.	Under SFAS 18, redeemable shares (including mandatory redeemable shares and those redeemable at the holder’s option) are classified under stockholders’ equity.
Classification of compound instruments by the issuer	The issuer of a financial instrument that contains both a liability and an equity element (e.g., a convertible debt) should classify the instrument’s liability and equity components separately.	No equivalent provision.
Interest, Dividends, Losses and Gains	Interest, dividends, losses and gains relating to a financial instrument, or a component part, classified as a financial liability – reported in the income statement as an expense Distributions to holders of a financial instrument classified as an equity instrument – debited by the issuer directly to equity	Under SFAS 18, cash and other non-stock dividends distributed to common and preferred stocks are recognized as dividends and as a direct reduction of retained earnings.
Offsetting of a Financial Asset and a Financial Liability	A financial asset and a financial liability should be offset and the net amount reported in the balance sheet when an enterprise: (a)has a legally enforceable right to set off the recognized amounts, and (b)intends either to settle on a net basis, or to realize the asset and liability simultaneously	Receivable and payable balances with the same persons should not be offset against each other if no right of offset exists or if separate settlement of those balances is expected. If there is a right of offset but this is not actually exercised by the parties and offset is made for financial statement presentation purposes only, disclosure of such in necessary (under superseded SFAS 5, Summary of Generally Accepted Accounting Principles on Liabilities).

International Accounting Standard (IAS) 32
(revised 1998)


Financial Instruments: Disclosure and Presentation

The following IAS 32 (revised 19998) is from the IASC bound volume of International Accounting Standards 2001. It includes amendments arising from the issuance of IAS 39, Financial Instruments, Recognition and Measurement. Text deleted due to the issuance of IAS 39 is shaded and struck through.

IAS 32 (revised 1998)

Contents

International Accounting Standards IAS 32 (revised 1998)

Financial Instruments: Disclosure and Presentation

OBJECTIVE	Paragraphs
SCOPE	1-4
DEFINITIONS	5-17
PRESENTATION	18-41
Liabilities And Equity	18-41
Classification of Compound Instruments by the Issuer	23-29
Interest, Dividends, Losses and Gains	30-32
Offsetting of a Finanical Asset and a Financial Liability	33-41
DISCLOSURE	42-94
Disclosure of Risk Management Policies	43A
Terms, Conditions and Accounting Policies	47-55
Interest Rate Risk	56-65
Credit Risk	66-76
Fair Value	77-87
Financial Assets Carried at an Amount in Excess of Fair Value	88-90
Hedges of Anticipated Future Transactions	91-93
Other Disclosures	94
TRANSITIONAL PROVISION	95
EFFECTIVE DATE	96
APPENDIX
Examples of the Application of the Standard	A1-A27
Definitions	A3-A17
Liabilities and Equity	A18-A24
Offsetting of a Financial Asset and a Financial Liability	A25
Disclosure	A26-A27

International Accounting Standard IAS 32
(revised 1998)


Financial Instruments: Disclosure and Presentation

The standards, which have been set in bold italic type, should be read in the context of the background material and implementation guidance in this Standard, and in the context of the Preface to International Accounting Standards.  International Accounting Standards are not intended to apply to immaterial items (see paragraph 12 of the Preface).


Objective

The dynamic nature of international financial markets has resulted in the widespread use of a variety of financial instruments ranging from traditional primary instruments, such as bonds, to various forms of derivative instruments, such as interest rate swaps.  The objective of this Standard is to enhance financial statement users' understanding of the significance of on-balance-sheet and off-balance-sheet financial instruments to an enterprise's financial position, performance and cash flows.

The Standard prescribes certain requirements for presentation of on-balance-sheet financial instruments and identifies the information that should be disclosed about both on-balance-sheet (recognised) and off-balance-sheet (unrecognised) financial instruments.  The presentation standards deal with the classification of financial instruments between liabilities and equity, the classification of related interest, dividends, losses and gains, and the circumstances in which financial assets and financial liabilities should be offset.  The disclosure standards deal with information about factors that affect the amount, timing and certainty of an enterprise's future cash flows relating to financial instruments and the accounting policies applied to the instruments.  In addition, the Standard encourages disclosure of information about the nature and extent of an enterprise's use of financial instruments, the business purposes that they serve, the risks associated with them and management's policies for controlling those risks.


Scope

1. This Standard should be applied in presenting and disclosing information about all types of financial instruments, both recognised and unrecognised, other than:

(a)  interests in subsidiaries, as defined in IAS 27, Consolidated Financial Statements and
      Accounting for Investments in Subsidiaries;
(b)  interests in associates, as defined in IAS 28, Accounting for Investments in Associates;
(c)  interests in joint ventures, as defined in IAS 31, Financial Reporting of Interests in Joint
      Ventures;
(d)  employers' and plans' obligations for post-employment benefits of all types, including
      retirement benefits as described in IAS 19, Employee Benefits, and IAS 26, Accounting
      and Reporting by Retirement Benefit Plans;
(e)  employers' obligations under employee stock option and stock purchase plans as        
      described in IAS 19, Employee Benefits; and
(f)   obligations arising under insurance contracts.

2. Although this Standard does not apply to an enterprise's interests in subsidiaries, it does apply to all financial instruments included in the consolidated financial statements of a parent, regardless of whether those instruments are held or issued by the parent or by a subsidiary.  Similarly, the Standard applies to financial instruments held or issued by a joint venture and included in the financial statements of a venturer either directly or through proportionate consolidation.

3. For purposes of this Standard, an insurance contract is a contract that exposes the insurer to identified risks of loss from events or circumstances occurring or discovered within a specified period, including death (in the case of an annuity, the survival of the annuitant), sickness, disability, property damage, injury to others and business interruption.  However, the provisions of this Standard apply when a financial instrument takes the form of an insurance contract but principally involves the transfer of financial risks (see paragraph 43), for example, some types of financial reinsurance and guaranteed investment contracts issued by insurance and other enterprises.  Enterprises that have obligations under insurance contracts are encouraged to consider the appropriateness of applying the provisions of this Standard in presenting and disclosing information about such obligations.

4. Other International Accounting Standards specific to certain types of financial instruments contain additional presentation and disclosure requirements.  For example, IAS 17, Leases, and IAS 26, Accounting and Reporting by Retirement Benefit Plans, incorporate specific disclosure requirements relating to finance leases and retirement benefit plan investments, respectively.  In addition, some requirements of other International Accounting Standards, particularly IAS 30, Disclosures in the Financial Statements of Banks and Similar Financial Institutions, and IAS 39, Financial Instruments: Recognition and Measurement, apply to financial instruments.


Definitions

5. The following terms are used in this Standard with the meanings specified:

A financial instrument is any contract that gives rise to both a financial asset of one enterprise and a financial liability or equity instrument of another enterprise.

Commodity-based contracts that give either party the right to settle in cash or some other financial instrument should be accounted for as if they were financial instruments, with the exception of commodity contracts that (a) were entered into and continue to meet the enterprise's expected purchase, sale, or usage requirements, (b) were designated for that purpose at their inception, and (c) are expected to be settled by delivery.

A financial asset is any asset that is:

(a) cash;
(b) a contractual right to receive cash or another financial asset from another enterprise;
(c) a contractual right to exchange financial instruments with another enterprise under conditions that are potentially favourable; or
(d) an equity instrument of another enterprise.

A financial liability is any liability that is a contractual obligation:

(a) to deliver cash or another financial asset to another enterprise; or
(b) to exchange financial instruments with another enterprise under conditions that are potentially unfavourable.

An enterprise may have a contractual obligation that it can settle either by payment of financial assets or by payment in the form of its own equity securities. In such a case, if the number of equity securities required to settle the obligation varies with changes in their fair value so that the total fair value of the equity securities paid always equals the amount of the contractual obligation, the holder of the obligation is not exposed to gain or loss from fluctuations in the price of its equity securities. Such an obligation should be accounted for as a financial liability of the enterprise.

An equity instrument is any contract that evidences a residual interest in the assets of an enterprise after deducting all of its liabilities.

Monetary financial assets and financial liabilities (also referred to as monetary financial instruments) are financial assets and financial liabilities to be received or paid in fixed or determinable amounts of money.

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.

Market value is the amount obtainable from the sale, or payable on the acquisition, of a financial instrument in an active market.

6. In this Standard, the terms "contract" and "contractual" refer to an agreement between two or more parties that has clear economic consequences that the parties have little, if any, discretion to avoid, usually because the agreement is enforceable at law.  Contracts, and thus financial instruments, may take a variety of forms and need not be in writing.

7. For purposes of the definitions in paragraph 5, the term "enterprise" includes individuals, partnerships, incorporated bodies and government agencies.

8. Parts of the definitions of a financial asset and a financial liability include the terms financial asset and financial instrument, but the definitions are not circular.  When there is a contractual right or obligation to exchange financial instruments, the instruments to be exchanged give rise to financial assets, financial liabilities, or equity instruments.  A chain of contractual rights or obligations may be established but it ultimately leads to the receipt or payment of cash or to the acquisition or issuance of an equity instrument.

9. Financial instruments include both primary instruments, such as receivables, payables and equity securities, and derivative instruments, such as financial options, futures and forwards, interest rate swaps and currency swaps.  Derivative financial instruments, whether recognised or unrecognised, meet the definition of a financial instrument and, accordingly, are subject to this Standard.

10. Derivative financial instruments create rights and obligations that have the effect of transferring between the parties to the instrument one or more of the financial risks inherent in an underlying primary financial instrument.  Derivative instruments do not result in a transfer of the underlying primary financial instrument on inception of the contract and such a transfer does not necessarily take place on maturity of the contract.

11. Physical assets such as inventories, property, plant and equipment, leased assets and intangible assets such as patents and trademarks are not financial assets.  Control of such physical and intangible assets creates an opportunity to generate an inflow of cash or other assets but it does not give rise to a present right to receive cash or other financial assets.

12. Assets, such as prepaid expenses, for which the future economic benefit is the receipt of goods or services rather than the right to receive cash or another financial asset are not financial assets.  Similarly, items such as deferred revenue and most warranty obligations are not financial liabilities because the probable outflow of economic benefits associated with them is the delivery of goods and services rather than cash or another financial asset.

13. Liabilities or assets that are not contractual in nature, such as income taxes that are created as a result of statutory requirements imposed by governments, are not financial liabilities or financial assets.  Accounting for income taxes is dealt with in IAS 12, Income Taxes.

14. Contractual rights and obligations that do not involve the transfer of a financial asset do not fall within the scope of the definition of a financial instrument.  For example, some contractual rights (obligations), such as those that arise under a commodity futures contract, can be settled only by the receipt (delivery) of non-financial assets.  Similarly, contractual rights (obligations) such as those that arise under an operating lease for use of a physical asset can be settled only by the receipt (delivery) of services.  In both cases, the contractual right of one party to receive a non-financial asset or service and the corresponding obligation of the other party do not establish a present right or obligation of either party to receive, deliver or exchange a financial asset.

15. The ability to exercise a contractual right or the requirement to satisfy a contractual obligation may be absolute, or it may be contingent on the occurrence of a future event.  For example, a financial guarantee is a contractual right of the lender to receive cash from the guarantor, and a corresponding contractual obligation of the guarantor to pay the lender, if the borrower defaults.  The contractual right and obligation exist because of a past transaction or event (assumption of the guarantee), even though the lender's ability to exercise its right and the requirement for the guarantor to perform under its obligation are both contingent on a future act of default by the borrower.  A contingent right and obligation meet the definition of a financial asset and a financial liability, even though many such assets and liabilities do not qualify for recognition in financial statements.

16. An obligation of an enterprise to issue or deliver its own equity instruments, such as a share option or warrant, is itself an equity instrument, not a financial liability, since the enterprise is not obliged to deliver cash or another financial asset.  Similarly, the cost incurred by an enterprise to purchase a right to re-acquire its own equity instruments from another party is a deduction from its equity, not a financial asset. 1

17. The minority interest that may arise on an enterprise's balance sheet from consolidating a subsidiary is not a financial liability or an equity instrument of the enterprise.  In consolidated financial statements, an enterprise presents the interests of other parties in the equity and income of its subsidiaries in accordance with IAS 27, Consolidated Financial Statements and Accounting for Investments in Subsidiaries.  Accordingly, a financial instrument classified as an equity instrument by a subsidiary is eliminated on consolidation when held by the parent, or presented by the parent in the consolidated balance sheet as a minority interest separate from the equity of its own shareholders.  A financial instrument classified as a financial liability by a subsidiary remains a liability in the parent's consolidated balance sheet unless eliminated on consolidation as an intragroup balance.  The accounting treatment by the parent on consolidation does not affect the basis of presentation by the subsidiary in its financial statements.


Presentation

Liabilities and Equity

18. The issuer of a financial instrument should classify the instrument, or its component parts, as a liability or as equity in accordance with the substance of the contractual arrangement on initial recognition and the definitions of a financial liability and an equity instrument. 2

19. The substance of a financial instrument, rather than its legal form, governs its classification on the issuer's balance sheet.  While substance and legal form are commonly consistent, this is not always the case.  For example, some financial instruments take the legal form of equity but are liabilities in substance and others may combine features associated with equity instruments and features associated with financial liabilities.  The classification of an instrument is made on the basis of an assessment of its substance when it is first recognised.  That classification continues at each subsequent reporting date until the financial instrument is removed from the enterprise's balance sheet.

20. The critical feature in differentiating a financial liability from an equity instrument is the existence of a contractual obligation on one party to the financial instrument (the issuer) either to deliver cash or another financial asset to the other party (the holder) or to exchange another financial instrument with the holder under conditions that are potentially unfavourable to the issuer.  When such a contractual obligation exists, that instrument meets the definition of a financial liability regardless of the manner in which the contractual obligation will be settled.  A restriction on the ability of the issuer to satisfy an obligation, such as lack of access to foreign currency or the need to obtain approval for payment from a regulatory authority, does not negate the issuer's obligation or the holder's right under the instrument.

21. When a financial instrument does not give rise to a contractual obligation on the part of the issuer to deliver cash or another financial asset or to exchange another financial instrument under conditions that are potentially unfavourable, it is an equity instrument.  Although the holder of an equity instrument may be entitled to receive a pro rata share of any dividends or other distributions out of equity, the issuer does not have a contractual obligation to make such distributions.

22. When a preferred share provides for mandatory redemption by the issuer for a fixed or determinable amount at a fixed or determinable future date or gives the holder the right to require the issuer to redeem the share at or after a particular date for a fixed or determinable amount, the instrument meets the definition of a financial liability and is classified as such.  A preferred share that does not establish such a contractual obligation explicitly may establish it indirectly through its terms and conditions.  For example, a preferred share that does not provide for mandatory redemption or redemption at the option of the holder may have a contractually provided accelerating dividend such that, within the foreseeable future, the dividend yield is scheduled to be so high that the issuer will be economically compelled to redeem the instrument.  In these circumstances, classification as a financial liability is appropriate because the issuer has little, if any, discretion to avoid redeeming the instrument.  Similarly, if a financial instrument labelled as a share gives the holder an option to require redemption upon the occurrence of a future event that is highly likely to occur, classification as a financial liability on initial recognition reflects the substance of the instrument.

Classification of Compound Instruments by the Issuer

23. The issuer of a financial instrument that contains both a liability and an equity element should classify the instrument's component parts separately in accordance with paragraph 18.

24. This Standard requires the separate presentation on an issuer's balance sheet of liability and equity elements created by a single financial instrument.  It is more a matter of form than substance that both liabilities and equity interests are created by a single financial instrument rather than two or more separate instruments.  An issuer's financial position is more faithfully represented by separate presentation of liability and equity components contained in a single instrument according to their nature.

25. For purposes of balance sheet presentation, an issuer recognises separately the component parts of a financial instrument that creates a primary financial liability of the issuer and grants an option to the holder of the instrument to convert it into an equity instrument of the issuer.  A bond or similar instrument convertible by the holder into common shares of the issuer is an example of such an instrument.  From the perspective of the issuer, such an instrument comprises two components: a financial liability (a contractual arrangement to deliver cash or other financial assets) and an equity instrument (a call option granting the holder the right, for a specified period of time, to convert into common shares of the issuer).  The economic effect of issuing such an instrument is substantially the same as issuing simultaneously a debt instrument with an early settlement provision and warrants to purchase common shares, or issuing a debt instrument with detachable share purchase warrants.  Accordingly, in all cases, the issuer presents the liability and equity elements separately on its balance sheet.

26. Classification of the liability and equity components of a convertible instrument is not revised as a result of a change in the likelihood that a conversion option will be exercised, even when exercise of the option may appear to have become economically advantageous to some holders.  Holders may not always act in the manner that might be expected because, for example, the tax consequences resulting from conversion may differ among holders.  Furthermore, the likelihood of conversion will change from time to time.  The issuer's obligation to make future payments remains outstanding until it is extinguished through conversion, the maturity of the instrument or some other transaction.

27. A financial instrument may contain components that are neither financial liabilities nor equity instruments of the issuer.  For example, an instrument may give the holder the right to receive a non-financial asset such as a commodity in settlement and an option to exchange that right for shares of the issuer.  The issuer recognises and presents the equity instrument (the exchange option) separately from the liability components of the compound instrument, whether the liabilities are financial or non-financial.

28. This Standard does not deal with measurement of financial assets, financial liabilities and equity instruments and does not therefore prescribe any particular method for assigning a carrying amount to liability and equity elements contained in a single instrument.  Approaches that might be followed include:
  (a) assigning to the less easily measurable component (often an equity instrument), the residual amount after deducting from the instrument as a whole the amount separately determined for the component that is more easily measurable; and
  (b) measuring the liability and equity components separately and, to the extent necessary, adjusting these amounts on a pro rata basis so that the sum of the components equals the amount of the instrument as a whole.

The sum of the carrying amounts assigned to the liability and equity components on initial recognition is always equal to the carrying amount that would be ascribed to the instrument as a whole.  No gain or loss arises from recognising and presenting the components of the instrument separately.

29. Under the first approach described in paragraph 28, the issuer of a bond convertible into common shares first determines the carrying amount of the financial liability by discounting the stream of future payments of interest and principal at the prevailing market rate for a similar liability that does not have an associated equity component.  The carrying amount of the equity instrument represented by the option to convert the instrument into common shares may then be determined by deducting the carrying amount of the financial liability from the amount of the compound instrument as a whole.  Under the second approach, the issuer determines the value of the option directly either by reference to the fair value of a similar option, if one exists, or by using an option pricing model.  The value determined for each component is then adjusted on a pro-rata basis to the extent necessary to ensure that the sum of the carrying amounts assigned to the components equals the amount of the consideration received for the convertible bond.

Interest, Dividends, Losses and Gains

30. Interest, dividends, losses and gains relating to a financial instrument, or a component part, classified as a financial liability should be reported in the income statement as expense or income.  Distributions to holders of a financial instrument classified as an equity instrument should be debited by the issuer directly to equity.

31. The classification of a financial instrument in the balance sheet determines whether interest, dividends, losses and gains relating to that instrument are classified as expenses or income and reported in the income statement.  Thus, dividend payments on shares classified as liabilities are classified as expenses in the same way as interest on a bond and reported in the income statement.  Similarly, gains and losses associated with redemptions or refinancings of instruments classified as liabilities are reported in the income statement, while redemptions or refinancings of instruments classified as equity of the issuer are reported as movements in equity. 3

32. Dividends classified as an expense may be presented in the income statement either with interest on other liabilities or as a separate item.  Disclosure of interest and dividends is subject to the requirements of IAS 1, Presentation of Financial Statements, IAS 30, Disclosures in the Financial Statements of Banks and Similar Financial Institutions and IAS 39, Financial Instruments: Recognition and Measurement.  In some circumstances, because of significant differences between interest and dividends with respect to matters such as tax deductibility, it is desirable to disclose them separately within the income statement.  Disclosures of the amounts of tax effects are made in accordance with IAS 12, Income Taxes.

Offsetting of a Financial Asset and a Financial Liability

33. A financial asset and a financial liability should be offset and the net amount reported in the balance sheet when an enterprise:

  (a) has a legally enforceable right to set off the recognised amounts; and
  (b) intends either to settle on a net basis, or to realise the asset and settle the liability simultaneously.

34. This standard requires the presentation of financial assets and financial liabilities on a net basis when this reflects an enterprise's expected future cash flows from settling two or more separate financial instruments.  When an enterprise has the right to receive or pay a single net amount and intends to do so, it has, in effect, only a single financial asset or financial liability.  In other circumstances, financial assets and financial liabilities are presented separately from each other consistent with their characteristics as resources or obligations of the enterprise.

35. Offsetting a recognised financial asset and a recognised financial liability and presenting the net amount differs from ceasing to recognise a financial asset or a financial liability.  While offsetting does not give rise to recognition of a gain or a loss, ceasing to recognise a financial instrument not only results in the removal of the previously recognised item from the balance sheet but may also result in recognition of a gain or a loss.

36. A right of set-off is a debtor's legal right, by contract or otherwise, to settle or otherwise eliminate all or a portion of an amount due to a creditor by applying against that amount an amount due from the creditor.  In unusual circumstances, a debtor may have a legal right to apply an amount due from a third party against the amount due to a creditor provided that there is an agreement among the three parties that clearly establishes the debtor's right of set-off.  Since the right of set-off is a legal right, the conditions supporting the right may vary from one legal jurisdiction to another and care must be taken to establish which laws apply to the relationships between the parties.

37. The existence of an enforceable right to set off a financial asset and a financial liability affects the rights and obligations associated with a financial asset and a financial liability and may affect significantly an enterprise's exposure to credit and liquidity risk.  However, the existence of the right, by itself, is not a sufficient basis for offsetting.  In the absence of an intention to exercise the right or to settle simultaneously, the amount and timing of an enterprise's future cash flows are not affected.  When an enterprise does intend to exercise the right or to settle simultaneously, presentation of the asset and liability on a net basis reflects more appropriately the amounts and timing of the expected future cash flows, as well as the risks to which those cash flows are exposed. An intention by one or both parties to settle on a net basis without the legal right to do so is not sufficient to justify offsetting since the rights and obligations associated with the individual financial asset and financial liability remain unaltered.

38. An enterprise's intentions with respect to settlement of particular assets and liabilities may be influenced by its normal business practices, the requirements of the financial markets and other circumstances that may limit the ability to settle net or to settle simultaneously.  When an enterprise has a right of set-off but does not intend to settle net or to realise the asset and settle the liability simultaneously, the effect of the right on the enterprise's credit risk exposure is disclosed in accordance with the standard in paragraph 66.

39. Simultaneous settlement of two financial instruments may occur through, for example, the operation of a clearing house in an organised financial market or a face-to-face exchange.  In these circumstances the cash flows are, in effect, equivalent to a single net amount and there is no exposure to credit or liquidity risk.  In other circumstances, an enterprise may settle two instruments by receiving and paying separate amounts, becoming exposed to credit risk for the full amount of the asset or liquidity risk for the full amount of the liability.  Such risk exposures may be significant even though relatively brief.  Accordingly, realisation of a financial asset and settlement of a financial liability are considered simultaneous only when the transactions occur at the same moment.

40. The conditions set out in paragraph 33 are generally not satisfied and offsetting is usually inappropriate when:

  (a) several different financial instruments are used to emulate the features of a single financial instrument (i.e. a "synthetic instrument");
  (b) financial assets and financial liabilities arise from financial instruments having the same primary risk exposure (for example, assets and liabilities within a portfolio of forward contracts or other derivative instruments) but involve different counterparties;
  (c) financial or other assets are pledged as collateral for non-recourse financial liabilities;
  (d) financial assets are set aside in trust by a debtor for the purpose of discharging an obligation without those assets having been accepted by the creditor in settlement of the obligation (for example, a sinking fund arrangement); or
  (e) obligations incurred as a result of events giving rise to losses are expected to be recovered from a third party by virtue of a claim made under an insurance policy.

41. An enterprise that undertakes a number of financial instrument transactions with a single counterparty may enter into a "master netting arrangement" with that counterparty.  Such an agreement provides for a single net settlement of all financial instruments covered by the agreement in the event of default on, or termination of, any one contract.  These arrangements are commonly used by financial institutions to provide protection against loss in the event of bankruptcy or other events that result in a counterparty being unable to meet its obligations.  A master netting arrangement commonly creates a right of set-off that becomes enforceable and affects the realisation or settlement of individual financial assets and financial liabilities only following a specified event of default or in other circumstances not expected to arise in the normal course of business.  A master netting arrangement does not provide a basis for offsetting unless both of the criteria in paragraph 33 are satisfied.  When financial assets and financial liabilities subject to a master netting arrangement are not offset, the effect of the arrangement on an enterprise's exposure to credit risk is disclosed in accordance with paragraph 66.

Disclosure

42. The purpose of the disclosures required by this Standard is to provide  information that will enhance understanding of the significance of on-balance-sheet and off-balance-sheet financial instruments to an enterprise's financial position, performance and cash flows and assist in assessing the amounts, timing and certainty of future cash flows associated with those instruments.  In addition to providing specific information about particular financial instrument balances and transactions, enterprises are encouraged to provide a discussion of the extent to which financial instruments are used, the associated risks and the business purposes served.  A discussion of management's policies for controlling the risks associated with financial instruments, including policies on matters such as hedging of risk exposures, avoidance of undue concentrations of risk and requirements for collateral to mitigate credit risks, provides a valuable additional perspective that is independent of the specific instruments outstanding at a particular time.  Some enterprises provide such information in a commentary that accompanies their financial statements rather than as part of the financial statements.

43. Transactions in financial instruments may result in an enterprise's assuming or transferring to another party one or more of the financial risks described below.  The required disclosures provide information that assists users of financial statements in assessing the extent of risk related to both recognised and unrecognised financial instruments.

(a) Price risk - There are three types of price risk: currency risk, interest rate risk and market risk.

(i) Currency risk is the risk that the value of a financial instrument will fluctuate due to changes in foreign
     exchange rates.
(ii)  Interest rate risk is the risk that the value of a financial instrument will fluctuate due to changes in  market interest rates.
(iii) Market risk is the risk that the value of a financial instrument will fluctuate as a result of changes in  market prices whether those changes are caused by factors specific to the individual security or its  issuer or factors affecting all securities traded in the market.

The term "price risk" embodies not only the potential for loss but also the potential for gain.

(b) Credit risk - Credit risk is the risk that one party to a financial instrument will fail to discharge an obligation and cause the other party to incur a financial loss.
(c) Liquidity risk - Liquidity risk, also referred to as funding risk, is the risk that an enterprise will encounter difficulty in raising funds to meet commitments associated with financial instruments.  Liquidity risk may result from an inability to sell a financial asset quickly at close to its fair value.
(d) Cash flow risk - Cash flow risk is the risk that future cash flows associated with a monetary financial instrument will fluctuate in amount.  In the case of a floating rate debt instrument, for example, such fluctuations result in a change in the effective interest rate of the financial instrument, usually without a corresponding change in its fair value.



Disclosure of Risk Management Policies

43A. An enterprise should describe its financial risk management objectives and policies, including its policy for hedging each major type of forecasted transaction for which hedge accounting is used.

44. The standards do not prescribe either the format of the information required to be disclosed or its location within the financial statements.  With regard to recognised financial instruments, to the extent that the required information is presented on the face of the balance sheet, it is not necessary for it to be repeated in the notes to the financial statements.  With regard to unrecognised financial instruments, however, information in notes or supplementary schedules is the primary means of disclosure.  Disclosures may include a combination of narrative descriptions and specific quantified data, as appropriate to the nature of the instruments and their relative significance to the enterprise.

45. Determination of the level of detail to be disclosed about particular financial instruments is a matter for the exercise of judgement taking into account the relative significance of those instruments.  It is necessary to strike a balance between overburdening financial statements with excessive detail that may not assist users of financial statements and obscuring significant information as a result of too much aggregation.  For example, when an enterprise is party to large numbers of financial instruments with similar characteristics and no one contract is individually significant, summarised information by reference to particular classes of instruments is appropriate.  On the other hand, specific information about an individual instrument may be important when that instrument represents, for example, a significant element in an enterprise's capital structure.

46. Management of an enterprise groups financial instruments into classes that are appropriate to the nature of the information to be disclosed, taking into account matters such as the characteristics of the instruments, whether they are recognised or unrecognised and, if they are recognised, the measurement basis that has been applied.  In general, classes are determined on a basis that distinguishes items carried on a cost basis from items carried at fair value.  When amounts disclosed in notes or supplementary schedules relate to recognised assets and liabilities, sufficient information is provided to permit a reconciliation to relevant line items on the balance sheet.  When an enterprise is a party to financial instruments not dealt with by this Standard, such as obligations under retirement benefit plans or insurance contracts, these instruments constitute a class or classes of financial assets or financial liabilities disclosed separately from those dealt with by this Standard.

Terms, Conditions and Accounting Policies

47. For each class of financial asset, financial liability and equity instrument, both recognised and unrecognised, an enterprise should disclose:

(a)  information about the extent and nature of the financial instruments, including significant terms and conditions that may affect the amount, timing and certainty of future cash flows; and
(b)  the accounting policies and methods adopted, including the criteria for recognition and the basis of measurement applied.

48. The contractual terms and conditions of a financial instrument are an important factor affecting the amount, timing and certainty of future cash receipts and payments by the parties to the instrument.  When recognised and unrecognised instruments are important, either individually or as a class, in relation to the current financial position of an enterprise or its future operating results, their terms and conditions are disclosed.  If no single instrument is individually significant to the future cash flows of a particular enterprise, the essential characteristics of the instruments are described by reference to appropriate groupings of like instruments.

49. When financial instruments held or issued by an enterprise, either individually or as a class, create a potentially significant exposure to the risks described in paragraph 43, terms and conditions that may warrant disclosure include:

(a)  the principal, stated, face or other similar amount which, for some derivative instruments, such as interest rate swaps, may be the amount (referred to as the notional amount) on which future payments are based;
(b)  the date of maturity, expiry or execution;
(c)  early settlement options held by either party to the instrument, including the period in which, or date at which, the options may be exercised and the exercise price or range of prices;
(d)  options held by either party to the instrument to convert the instrument into, or exchange it for, another financial instrument or some other asset or liability, including the period in which, or date at which, the options may be exercised and the conversion or exchange ratio(s);
(e)  the amount and timing of scheduled future cash receipts or payments of the principal amount of the instrument, including installment repayments and any sinking fund or similar requirements;
(f)  stated rate or amount of interest, dividend or other periodic return on principal and the timing of payments;
(g)  collateral held, in the case of a financial asset, or pledged, in the case of a financial liability;
(h)  in the case of an instrument for which cash flows are denominated in a currency other than the enterprise's reporting currency, the currency in which receipts or payments are required;
(i)  in the case of an instrument that provides for an exchange, information described in items (a) to (h) for the instrument to be acquired in the exchange; and
(j)  any condition of the instrument or an associated covenant that, if contravened, would significantly alter any of the other terms (for example, a maximum debt-to-equity ratio in a bond covenant that, if contravened, would make the full principal amount of the bond due and payable immediately).

50. When the balance sheet presentation of a financial instrument differs from the instrument's legal form, it is desirable for an enterprise to explain in the notes to the financial statements the nature of the instrument.

51. The usefulness of information about the extent and nature of financial instruments is enhanced when it highlights any relationships between individual instruments that may affect the amount, timing or certainty of the future cash flows of an enterprise.  For example, it is important to disclose hedging relationships such as might exist when an enterprise holds an investment in shares for which it has purchased a put option.  Similarly, it is important to disclose relationships between the components of "synthetic instruments" such as fixed rate debt created by borrowing at a floating rate and entering into a floating to fixed interest rate swap.  In each case, an enterprise presents the individual financial assets and financial liabilities in its balance sheet according to their nature, either separately or in the class of financial asset or financial liability to which they belong.  The extent to which a risk exposure is altered by the relationships among the assets and liabilities may be apparent to financial statement users from information of the type described in paragraph 49 but in some circumstances further disclosure is necessary.

52. In accordance with IAS 1, Presentation of Financial Statements, an enterprise provides clear and concise disclosure of all significant accounting policies, including both the general principles adopted and the method of applying those principles to significant transactions and circumstances arising in the enterprise's business.  In the case of financial instruments, such disclosure includes:

(a) the criteria applied in determining when to recognise a financial asset or financial liability on the balance sheet and when to cease to recognise it;
(b) the basis of measurement applied to financial assets and financial liabilities both on initial recognition and subsequently; and
(c) the basis on which income and expense arising from financial assets and financial liabilities is recognised and measured.

53. Types of transactions for which it may be necessary to disclose the relevant accounting policies include:

(a) transfers of financial assets when there is a continuing interest in, or involvement with, the assets by the transferor, such as securitisations of financial assets, repurchase agreements and reverse repurchase agreements;
(b) transfers of financial assets to a trust for the purpose of satisfying liabilities when they mature without the obligation of the transferor being discharged at the time of the transfer, such as an in-substance defeasance trust;
(c) acquisition or issuance of separate financial instruments as part of a series of transactions designed to synthesise the effect of acquiring or issuing a single instrument;
(d) acquisition or issuance of financial instruments as hedges of risk exposures; and
(e) acquisition or issuance of monetary financial instruments bearing a stated interest rate that differs from the prevailing market rate at the date of issue.

54. To provide adequate information for users of financial statements to understand the basis on which financial assets and financial liabilities have been measured, disclosures of accounting policies indicate not only whether cost, fair value or some other basis of measurement has been applied to a specific class of asset or liability but also the method of applying that basis.  For example, for financial instruments carried on the cost basis, an enterprise may be required to disclose how it accounts for:

(a) costs of acquisition or issuance;
(b) premiums and discounts on monetary financial assets and financial liabilities;
(c) changes in the estimated amount of determinable future cash flows associated with a monetary financial instrument such as a bond indexed to a commodity price;
(d) changes in circumstances that result in significant uncertainty about the timely collection of all contractual amounts due from monetary financial assets;
(e) declines in the fair value of financial assets below their carrying amount; and
(f) restructured financial liabilities.

For financial assets and financial liabilities carried at fair value, an enterprise indicates whether carrying amounts are determined from quoted market prices, independent appraisals, discounted cash flow analysis or another appropriate method, and discloses any significant assumptions made in applying those methods.

55. An enterprise discloses the basis for reporting in the income statement realised and unrealised gains and losses, interest and other items of income and expense associated with financial assets and financial liabilities.  This disclosure includes information about the basis on which income and expense arising from financial instruments held for hedging purposes are recognised.  When an enterprise presents income and expense items on a net basis even though the corresponding financial assets and financial liabilities on the balance sheet have not been offset, the reason for that presentation is disclosed if the effect is significant.

Interest Rate Risk

56. For each class of financial asset and financial liability, both recognised and unrecognised, an enterprise should disclose information about its exposure to interest rate risk, including:

(a) contractual repricing or maturity dates, whichever dates are earlier; and
(b) effective interest rates, when applicable.

57. An enterprise provides information concerning its exposure to the effects of future changes in the prevailing level of interest rates.  Changes in market interest rates have a direct effect on the contractually determined cash flows associated with some financial assets and financial liabilities (cash flow risk) and on the fair value of others (price risk).

58. Information about maturity dates, or repricing dates when they are earlier, indicates the length of time for which interest rates are fixed and information about effective interest rates indicates the levels at which they are fixed.  Disclosure of this information provides financial statement users with a basis for evaluating the interest rate price risk to which an enterprise is exposed and thus the potential for gain or loss.  For instruments that reprice to a market rate of interest before maturity, disclosure of the period until the next repricing is more important than disclosure of the period to maturity.

59. To supplement the information about contractual repricing and maturity dates, an enterprise may elect to disclose information about expected repricing or maturity dates when those dates differ significantly from the contractual dates.  Such information may be particularly relevant when, for example, an enterprise is able to predict, with reasonable reliability, the amount of fixed rate mortgage loans that will be repaid prior to maturity and it uses this data as the basis for managing its interest rate risk exposure.  The additional information includes disclosure of the fact that it is based on management's expectations of future events and explains the assumptions made about repricing or maturity dates and how those assumptions differ from the contractual dates.

60. An enterprise indicates which of its financial assets and financial liabilities are:

(a) exposed to interest rate price risk, such as monetary financial assets and financial liabilities with a fixed interest rate;
(b) exposed to interest rate cash flow risk, such as monetary financial assets and financial liabilities with a floating interest rate that is reset as market rates change; and
(c) not exposed to interest rate risk, such as some investments in equity securities.

61. The effective interest rate (effective yield) of a monetary financial instrument is the rate that, when used in a present value calculation, results in the carrying amount of the instrument.  The present value calculation applies the interest rate to the stream of future cash receipts or payments from the reporting date to the next repricing (maturity) date and to the expected carrying amount (principal amount) at that date.  The rate is a historical rate for a fixed rate instrument carried at amortised cost and a current market rate for a floating rate instrument or an instrument carried at fair value.  The effective interest rate is sometimes termed the level yield to maturity or to the next repricing date, and is the internal rate of return of the instrument for that period.

62. The requirement in paragraph 56(b) applies to bonds, notes and similar monetary financial instruments involving future payments that create a return to the holder and a cost to the issuer reflecting the time value of money.  The requirement does not apply to financial instruments such as non-monetary and derivative instruments that do not bear a determinable effective interest rate.  For example, while instruments such as interest rate derivatives, including swaps, forward rate agreements and options, are exposed to price or cash flow risk from changes in market interest rates, disclosure of an effective interest rate is not relevant.  However, when providing effective interest rate information, an enterprise discloses the effect on its interest rate risk exposure of hedging or "conversion" transactions such as interest rate swaps.

63. An enterprise may retain an exposure to the interest rate risks associated with financial assets removed from its balance sheet as a result of a transaction such as a securitisation.  Similarly, it may become exposed to interest rate risks as a result of a transaction in which no financial asset or financial liability is recognised on its balance sheet, such as a commitment to lend funds at a fixed interest rate.  In such circumstances, the enterprise discloses information that will permit financial statement users to understand the nature and extent of its exposure.  In the case of a securitisation or similar transfer of financial assets, this information normally includes the nature of the assets transferred, their stated principal, interest rate and term to maturity, and the terms of the transaction giving rise to the retained exposure to interest rate risk.  In the case of a commitment to lend funds, the disclosure normally includes the stated principal, interest rate and term to maturity of the amount to be lent and the significant terms of the transaction giving rise to the exposure to risk.

64. The nature of an enterprise's business and the extent of its activity in financial instruments will determine whether information about interest rate risk is presented in narrative form, in tables, or by using a combination of the two.  When an enterprise has a significant number of financial instruments exposed to interest rate price or cash flow risks, it may adopt one or more of the following approaches to presenting information.

(a) The carrying amounts of financial instruments exposed to interest rate price risk may be presented in tabular form, grouped by those that are contracted to mature or be repriced:

(i)   within one year of the balance sheet date;
(ii)  more than one year and less than five years from the balance sheet date; and
(iii) five years or more from the balance sheet date.

(b) When the performance of an enterprise is significantly affected by the level of its exposure to interest rate price risk or changes in that exposure, more detailed information is desirable.  An enterprise such as a bank may disclose, for example, separate groupings of the carrying amounts of financial instruments contracted to mature or be repriced:

(i)   within one month of the balance sheet date;
(ii)  more than one and less than three months from the balance sheet date; and
(iii) more than three and less than twelve months from the balance sheet date.

(c) Similarly, an enterprise may indicate its exposure to interest rate cash flow risk through a table indicating the aggregate carrying amount of groups of floating rate financial assets and financial liabilities maturing within various future time periods.
(d) Interest rate information may be disclosed for individual financial instruments or weighted average rates or a range of rates may be presented for each class of financial instrument.  An enterprise groups instruments denominated in different currencies or having substantially different credit risks into separate classes when these factors result in instruments having substantially different effective interest rates.

65. In some circumstances, an enterprise may be able to provide useful information about its exposure to interest rate risks by indicating the effect of a hypothetical change in the prevailing level of market interest rates on the fair value of its financial instruments and future earnings and cash flows.  Such interest rate sensitivity information may be based on an assumed 1% change in market interest rates occurring at the balance sheet date.  The effects of a change in interest rates includes changes in interest income and expense relating to floating rate financial instruments and gains or losses resulting from changes in the fair value of fixed rate instruments.  The reported interest rate sensitivity may be restricted to the direct effects of an interest rate change on interest-bearing financial instruments on hand at the balance sheet date since the indirect effects of a rate change on financial markets and individual enterprises cannot normally be predicted reliably.  When disclosing interest rate sensitivity information, an enterprise indicates the basis on which it has prepared the information, including any significant assumptions.

Credit Risk

66. For each class of financial asset, both recognised and unrecognised, an enterprise should disclose information about its exposure to credit risk, including:

(a) the amount that best represents its maximum credit risk exposure at the balance sheet date, without taking account of the fair value of any collateral, in the event other parties fail to perform their obligations under financial instruments; and
(b) significant concentrations of credit risk.

67. An enterprise provides information relating to credit risk to permit users of its financial statements to assess the extent to which failures by counterparties to discharge their obligations could reduce the amount of future cash inflows from financial assets on hand at the balance sheet date.  Such failures give rise to a financial loss recognised in an enterprise's income statement.  Paragraph 66 does not require an enterprise to disclose an assessment of the probability of losses arising in the future.

68. The purposes of disclosing amounts exposed to credit risk without regard to potential recoveries from realisation of collateral ("an enterprise's maximum credit risk exposure") are:

(a) to provide users of financial statements with a consistent measure of the amount exposed to credit risk for both recognised and unrecognised financial assets; and
(b) to take into account the possibility that the maximum exposure to loss may differ from the carrying amount of a recognised financial asset or the fair value of an unrecognised financial asset that is otherwise disclosed in the financial statements.

69. In the case of recognised financial assets exposed to credit risk, the carrying amount of the assets in the balance sheet, net of any applicable provisions for loss, usually represents the amount exposed to credit risk.  For example, in the case of an interest rate swap carried at fair value, the maximum exposure to loss at the balance sheet date is normally the carrying amount since it represents the cost, at current market rates, of replacing the swap in the event of default.  In these circumstances, no additional disclosure beyond that provided on the balance sheet is necessary.  On the other hand, as illustrated by the examples in paragraphs 70 and 71, an enterprise's maximum potential loss from some recognised financial assets may differ significantly from their carrying amount and from other disclosed amounts such as their fair value or principal amount.  In such circumstances, additional disclosure is necessary to meet the requirements of paragraph 66(a).

70. A financial asset subject to a legally enforceable right of set-off against a financial liability is not presented on the balance sheet net of the liability unless settlement is intended to take place on a net basis or simultaneously.  Nevertheless, an enterprise discloses the existence of the legal right of set-off when providing information in accordance with paragraph 66.  For example, when an enterprise is due to receive the proceeds from realisation of a financial asset before settlement of a financial liability of equal or greater amount against which the enterprise has a legal right of set-off, the enterprise has the ability to exercise that right of set-off to avoid incurring a loss in the event of a default by the counterparty.  However, if the enterprise responds, or is likely to respond, to the default by extending the term of the financial asset, an exposure to credit risk would exist if the revised terms are such that collection of the proceeds is expected to be deferred beyond the date on which the liability is required to be settled.  To inform financial statement users of the extent to which exposure to credit risk at a particular point in time has been reduced, the enterprise discloses the existence and effect of the right of set-off when the financial asset is expected to be collected in accordance with its terms.  When the financial liability against which a right of set-off exists is due to be settled before the financial asset, the enterprise is exposed to credit risk on the full carrying amount of the asset if the counterparty defaults after the liability has been settled.

71. An enterprise may have entered into one or more master netting arrangements that serve to mitigate its exposure to credit loss but do not meet the criteria for offsetting.  When a master netting arrangement significantly reduces the credit risk associated with financial assets not offset against financial liabilities with the same counterparty, an enterprise provides additional information concerning the effect of the arrangement.  Such disclosure indicates that:

(a) the credit risk associated with financial assets subject to a master netting arrangement is eliminated only to the extent that financial liabilities due to the same counterparty will be settled after the assets are realised; and
(b) the extent to which an enterprise's overall exposure to credit risk is reduced through a master netting arrangement may change substantially within a short period following the balance sheet date because the exposure is affected by each transaction subject to the arrangement.

It is also desirable for an enterprise to disclose the terms of its master netting arrangements that determine the extent of the reduction in its credit risk.

72. When there is no credit risk associated with an unrecognised financial asset or the maximum exposure is equal to the principal, stated, face or other similar contractual amount of the instrument disclosed in accordance with paragraph 47 or the fair value disclosed in accordance with paragraph 77, no additional disclosure is required to comply with paragraph 66 (a).  However, with some unrecognised financial assets, the maximum loss that would be recognised upon default by the other party to the underlying instrument may differ substantially from the amounts disclosed in accordance with paragraphs 47 and 77.  For example, an enterprise may have a right to mitigate the loss it would otherwise bear by setting off an unrecognised financial asset against an unrecognised financial liability.  In such circumstances, paragraph 66(a) requires disclosure in addition to that provided in accordance with paragraphs 47 and 77.

73. Guaranteeing an obligation of another party exposes the guarantor to credit risk that would be taken into account in making the disclosures required by paragraph 66.  This situation may arise as a result of, for example, a securitisation transaction in which an enterprise remains exposed to credit risk associated with financial assets that have been removed from its balance sheet.  If the enterprise is obligated under recourse provisions of the transaction to indemnify the purchaser of the assets for credit losses, it discloses the nature of the assets removed from its balance sheet, the amount and timing of the future cash flows contractually due from the assets, the terms of the recourse obligation and the maximum loss that could arise under that obligation.  (See also IAS 37, Provisions, Contingent Liabilities and Contingent Assets).

74. Concentrations of credit risk are disclosed when they are not apparent from other disclosures about the nature and financial position of the business and they result in a significant exposure to loss in the event of default by other parties.  Identification of significant concentrations is a matter for the exercise of judgement by management taking into account the circumstances of the enterprise and its debtors. IAS 14, Segment Reporting, provides useful guidance in identifying industry and geographic segments within which credit risk concentrations may arise.

75. Concentrations of credit risk may arise from exposures to a single debtor or to groups of debtors having a similar characteristic such that their ability to meet their obligations is expected to be affected similarly by changes in economic or other conditions.  Characteristics that may give rise to a concentration of risk include the nature of the activities undertaken by debtors, such as the industry in which they operate, the geographic area in which activities are undertaken and the level of creditworthiness of groups of borrowers.  For example, a manufacturer of equipment for the oil and gas industry will normally have trade accounts receivable from sale of its products for which the risk of non-payment is affected by economic changes in the oil and gas industry.  A bank that normally lends on an international scale may have a significant amount of loans outstanding to less developed nations and the bank's ability to recover those loans may be adversely affected by local economic conditions.

76. Disclosure of concentrations of credit risk includes a description of the shared characteristic that identifies each concentration and the amount of the maximum credit risk exposure associated with all recognised and unrecognised financial assets sharing that characteristic.

Fair Value

77. For each class of financial asset and financial liability, both recognised and unrecognised, an enterprise should disclose information about fair value.  When it is not practicable within constraints of timeliness or cost to determine the fair value of a financial asset or financial liability with sufficient reliability, that fact should be disclosed together with information about the principal characteristics of the underlying financial instrument that are pertinent to its fair value.

78. Fair value information is widely used for business purposes in determining an enterprise's overall financial position and in making decisions about individual financial instruments.  It is also relevant to many decisions made by users of financial statements since, in many circumstances, it reflects the judgement of the financial markets as to the present value of expected future cash flows relating to an instrument.  Fair value information permits comparisons of financial instruments having substantially the same economic characteristics, regardless of their purpose and when and by whom they were issued or acquired.  Fair values provide a neutral basis for assessing management's stewardship by indicating the effects of its decisions to buy, sell or hold financial assets and to incur, maintain or discharge financial liabilities.  When an enterprise does not carry a financial asset or financial liability in its balance sheet at fair value, it provides fair value information through supplementary disclosures.

79. The fair value of a financial asset or financial liability may be determined by one of several generally accepted methods.  Disclosure of fair value information includes disclosure of the method adopted and any significant assumptions made in its application.

80. Underlying the definition of fair value is a presumption that an enterprise is a going concern without any intention or need to liquidate, curtail materially the scale of its operations or undertake a transaction on adverse terms.  Fair value is not, therefore, the amount that an enterprise would receive or pay in a forced transaction, involuntary liquidation or distress sale.  However, an enterprise takes its current circumstances into account in determining the fair values of its financial assets and financial liabilities.  For example, the fair value of a financial asset that an enterprise has decided to sell for cash in the immediate future is determined by the amount that it expects to receive from such a sale.  The amount of cash to be realised from an immediate sale will be affected by factors such as the current liquidity and depth of the market for the asset.

81. When a financial instrument is traded in an active and liquid market, its quoted market price, provides the best evidence of fair value.  The appropriate quoted market price for an asset held or liability to be issued is usually the current bid price and, for an asset to be acquired or liability held, the current offer or asking price.  When current bid and offer prices are unavailable, the price of the most recent transaction may provide evidence of the current fair value provided that there has not been a significant change in economic circumstances between the transaction date and the reporting date.  When an enterprise has matching asset and liability positions, it may appropriately use mid-market prices as a basis for establishing fair values.

82. When there is infrequent activity in a market, the market is not well established (for example, some "over the counter" markets) or small volumes are traded relative to the number of trading units of a financial instrument to be valued, quoted market prices may not be indicative of the fair value of the instrument.  In these circumstances, as well as when a quoted market price is not available, estimation techniques may be used to determine fair value with sufficient reliability to satisfy the requirements of this Standard.  Techniques that are well established in financial markets include reference to the current market value of another instrument that is substantially the same, discounted cash flow analysis and option pricing models.  In applying discounted cash flow analysis, an enterprise uses a discount rate equal to the prevailing market rate of interest for financial instruments having substantially the same terms and characteristics, including the creditworthiness of the debtor, the remaining term over which the contractual interest rate is fixed, the remaining term to repayment of the principal and the currency in which payments are to be made.

83. The fair value to an enterprise of a financial asset or financial liability, whether determined from market value or otherwise, is determined without deduction for the costs that would be incurred to exchange or settle the underlying financial instrument.  The costs may be relatively insignificant for instruments traded in organised, liquid markets but may be substantial for other instruments.  Transaction costs may include taxes and duties, fees and commissions paid to agents, advisers, brokers or dealers and levies by regulatory agencies or securities exchanges.

84. When an instrument is not traded in an organised financial market, it may not be appropriate for an enterprise to determine and disclose a single amount that represents an estimate of fair value.  Instead, it may be more useful to disclose a range of amounts within which the fair value of a financial instrument is reasonably believed to lie.

85. When disclosure of fair value information is omitted because it is not practicable to determine fair value with sufficient reliability, information is provided to assist users of the financial statements in making their own judgements about the extent of possible differences between the carrying amount of financial assets and financial liabilities and their fair value.  In addition to an explanation of the reason for the omission and the principal characteristics of the financial instruments that are pertinent to their value, information is provided about the market for the instruments.  In some cases, the terms and conditions of the instruments disclosed in accordance with paragraph 47 may provide sufficient information about the characteristics of the instrument.  When it has a reasonable basis for doing so, management may indicate its opinion as to the relationship between fair value and the carrying amount of financial assets and financial liabilities for which it is unable to determine fair value.

86. The historical cost carrying amount of receivables and payables subject to normal trade credit terms usually approximates fair value.  Similarly, the fair value of a deposit liability without a specified maturity is the amount payable on demand at the reporting date.

87. Fair value information relating to classes of financial assets or financial liabilities that are carried on the balance sheet at other than fair value is provided in a way that permits comparison between the carrying amount and the fair value.  Accordingly, the fair values of recognised financial assets and financial liabilities are grouped into classes and offset only to the extent that their related carrying amounts are offset.  Fair values of unrecognised financial assets and financial liabilities are presented in a class or classes separate from recognised items and are offset only to the extent that they meet the offsetting criteria for recognised financial assets and financial liabilities.

Financial Assets Carried at an Amount in Excess of Fair Value

88. When an enterprise carries one or more financial assets at an amount in excess of their fair value, the enterprise should disclose:

(a) the carrying amount and the fair value of either the individual assets or appropriate groupings of those individual assets; and
(b) the reasons for not reducing the carrying amount, including the nature of the evidence that provides the basis for management's belief that the carrying amount will be recovered.

89. Management exercises judgement in determining the amount it expects to recover from a financial asset and whether to write down the carrying amount of the asset when it is in excess of fair value.  The information required by paragraph 88 provides users of financial statements with a basis for understanding management's exercise of judgement and assessing the possibility that circumstances may change and lead to a reduction in the asset's carrying amount in the future.  When appropriate, the information required by paragraph 88(a) is grouped in a manner that reflects management's reasons for not reducing the carrying amount.

90. An enterprise's accounting policies with respect to recognition of declines in value of financial assets, disclosed in accordance with paragraph 47, assist in explaining why a particular financial asset is carried at an amount in excess of fair value.  In addition, the enterprise provides the reasons and evidence specific to the asset that provide management with the basis for concluding that the asset's carrying amount will be recovered.  For example, the fair value of a fixed rate loan intended to be held to maturity may have declined below its carrying amount as a result of an increase in interest rates.  In such circumstances, the lender may not have reduced the carrying amount because there is no evidence to suggest that the borrower is likely to default.
91.
92.
93.

91.-93. [Deleted]

Other Disclosures

94. Additional disclosures are encouraged when they are likely to enhance financial statement users' understanding of financial instruments.  It may be desirable to disclose such information as:

(a) the total amount of the change in the fair value of financial assets and financial liabilities that has been recognised as income or expense for the period; and
(b) the average aggregate carrying amount during the year of recognised financial assets and financial liabilities, the average aggregate principal, stated, notional or other similar amount during the year of unrecognised financial assets and financial liabilities and the average aggregate fair value during the year of all financial assets and financial liabilities, particularly when the amounts on hand at the balance sheet date are unrepresentative of amounts on hand during the year.

Transitional Provision

95. When comparative information for prior periods is not available when this International Accounting Standard is first adopted, such information need not be presented.

Effective Date

96. This International Accounting Standard becomes operative for financial statements covering periods beginning on or after 1 January, 1996.


Appendix

Examples of the Application of the Standard

The appendix is illustrative only and does not form part of the standards.  The purpose of the appendix is to illustrate the application of the standards to assist in clarifying their meaning.

A1.    This Appendix explains and illustrates the application of certain aspects of the Standard to various common financial instruments.  The detailed examples are illustrative only and do not necessarily represent the only basis for applying the Standard in the specific circumstances discussed.  Changing one or two of the facts assumed in the examples can lead to substantially different conclusions concerning the appropriate presentation or disclosure of a particular financial instrument.  This Appendix does not discuss the application of all requirements of the Standard in the examples provided.  In all cases, the provisions of the Standard prevail.

A2.    The Standard does not deal with the recognition or measurement of financial instruments.  Certain recognition and measurement practices may be assumed for purposes of illustration but they are not required.

Definitions

Common Types of Financial Instruments, Financial Assets and Financial Liabilities

A3.    Currency (cash) is a financial asset because it represents the medium of exchange and is therefore the basis on which all transactions are measured and reported in financial statements.  A deposit of cash with a bank or similar financial institution is a financial asset because it represents the contractual right of the depositor to obtain cash from the institution or to draw a cheque or similar instrument against the balance in favour of a creditor in payment of a financial liability.

A4.    Common examples of financial assets representing a contractual right to receive cash in the future and corresponding financial liabilities representing a contractual obligation to deliver cash in the future are:

(a) trade accounts receivable and payable;
(b) notes receivable and payable;
(c) loans receivable and payable; and
(d) bonds receivable and payable.

In each case, one party's contractual right to receive (or obligation to pay) cash is matched by the other party's corresponding obligation to pay (or right to receive).

A5.    Another type of financial instrument is one for which the economic benefit to be received or given up is a financial asset other than cash.  For example, a note payable in government bonds gives the holder the contractual right to receive and the issuer the contractual obligation to deliver government bonds, not cash.  The bonds are financial assets because they represent obligations of the issuing government to pay cash.  The note is, therefore, a financial asset of the note holder and a financial liability of the note issuer.

A6.    Under IAS 17, Leases, a finance lease is accounted for as a sale with delayed payment terms.  The lease contract is considered to be primarily an entitlement of the lessor to receive, and an obligation of the lessee to pay, a stream of payments that are substantially the same as blended payments of principal and interest under a loan agreement.  The lessor accounts for its investment in the amount receivable under the lease contract rather than the leased asset itself.  An operating lease, on the other hand, is considered to be primarily an uncompleted contract committing the lessor to provide the use of an asset in future periods in exchange for consideration similar to a fee for a service.  The lessor continues to account for the leased asset itself rather than any amount receivable in the future under the contract.  Accordingly, a finance lease is considered to be a financial instrument and an operating lease is considered not to be a financial instrument (except as regards individual payments currently due and payable).

Equity Instruments

A7.    Examples of equity instruments include common shares, certain types of preferred shares, and warrants or options to subscribe for or purchase common shares in the issuing enterprise.  An enterprise's obligation to issue its own equity instruments in exchange for financial assets of another party is not potentially unfavourable since it results in an increase in equity and cannot result in a loss to the enterprise.  The possibility that existing holders of an equity interest in the enterprise may find the fair value of their interest reduced as a result of the obligation does not make the obligation unfavourable to the enterprise itself.

A8.    An option or other similar instrument acquired by an enterprise that gives it the right to reacquire its own equity instruments is not a financial asset of the enterprise.  The enterprise will not receive cash or any other financial asset through exercise of the option.  Exercise of the option is not potentially favourable to the enterprise since it results in a reduction in equity and an outflow of assets.  Any change in equity recorded by the enterprise from reacquiring and cancelling its own equity instruments represents a transfer between those holders of equity instruments who have given up their equity interest and those who continue to hold an equity interest, rather than a gain or loss by the enterprise.

Derivative Financial Instruments

A9.    On inception, derivative financial instruments give one party a contractual right to exchange financial assets with another party under conditions that are potentially favourable, or a contractual obligation to exchange financial assets with another party under conditions that are potentially unfavourable.  Some instruments embody both a right and an obligation to make an exchange.  Since the terms of the exchange are determined on inception of the derivative instrument, as prices in financial markets change, those terms may become either favourable or unfavourable.

A10.    A put or call option to exchange financial instruments gives the holder a right to obtain potential future economic benefits associated with changes in the fair value of the financial instrument underlying the contract.  Conversely, the writer of an option assumes an obligation to forego potential future economic benefits or bear potential losses of economic benefits associated with changes in the fair value of the underlying financial instrument.  The contractual right of the holder and obligation of the writer meet the definition of a financial asset and a financial liability respectively.  The financial instrument underlying an option contract may be any financial asset, including shares and interest-bearing instruments.  An option may require the writer to issue a debt instrument, rather than transfer a financial asset, but the instrument underlying the option would still constitute a financial asset of the holder if the option were exercised.  The option-holder's right to exchange the assets under potentially favourable conditions and the writer's obligation to exchange the assets under potentially unfavourable conditions are distinct from the underlying assets to be exchanged upon exercise of the option.  The nature of the holder's right and the writer's obligation is not affected by the likelihood that the option will be exercised.  An option to buy or sell an asset other than a financial asset (such as a commodity) does not give rise to a financial asset or financial liability because it does not fit the requirements of the definitions for the receipt or delivery of financial assets or exchange of financial instruments.

A11.    Another example of a derivative financial instrument is a forward contract to be settled in six months' time in which one party (the purchaser) promises to deliver 1,000,000 cash in exchange for 1,000,000 face amount of fixed rate government bonds, and the other party (the seller) promises to deliver 1,000,000 face amount of fixed rate government bonds in exchange for 1,000,000 cash.  During the six months, both parties have a contractual right and a contractual obligation to exchange financial instruments.  If the market price of the government bonds rises above 1,000,000, the conditions will be favourable to the purchaser and unfavourable to the seller; if the market price falls below 1,000,000, the effect will be the opposite.  The purchaser has both a contractual right (a financial asset) similar to the right under a call option held and a contractual obligation (a financial liability) similar to the obligation under a put option written; the seller has a contractual right (a financial asset) similar to the right under a put option held and a contractual obligation (a financial liability) similar to the obligation under a call option written.  As with options, these contractual rights and obligations constitute financial assets and financial liabilities separate and distinct from the underlying financial instruments (the bonds and cash to be exchanged).  The significant difference between a forward contract and an option contract is that both parties to a forward contract have an obligation to perform at the agreed time, whereas performance under an option contract occurs only if and when the holder of the option chooses to exercise it.

A12.    Many other types of derivative instruments embody a right or obligation to make a future exchange, including interest rate and currency swaps, interest rate caps, collars and floors, loan commitments, note issuance facilities and letters of credit.  An interest rate swap contract may be viewed as a variation of a forward contract in which the parties agree to make a series of future exchanges of cash amounts, one amount calculated with reference to a floating interest rate and the other with reference to a fixed interest rate.  Futures contracts are another variation of forward contracts, differing primarily in that the contracts are standardised and traded on an exchange.

Commodity Contracts and Commodity-linked Financial Instruments

A13.    As indicated by paragraph 14 of the Standard, contracts that provide for settlement by receipt or delivery of a physical asset only (for example, an option, futures or forward contract on silver) are not financial instruments.  Many commodity contracts are of this type.  Some are standardised in form and traded on organised markets in much the same fashion as some derivative financial instruments.  For example, a commodity futures contract may be readily bought and sold for cash because it is listed for trading on an exchange and may change hands many times.  However, the parties buying and selling the contract are, in effect, trading the underlying commodity.  The ability to buy or sell a commodity contract for cash, the ease with which it may be bought or sold and the possibility of negotiating a cash settlement of the obligation to receive or deliver the commodity do not alter the fundamental character of the contract in a way that creates a financial instrument.

A14.    A contract that involves receipt or delivery of physical assets does not give rise to a financial asset of one party and a financial liability of the other party unless any corresponding payment is deferred past the date on which the physical assets are transferred.  Such is the case with the purchase or sale of goods on trade credit.

A15.    Some contracts are commodity-linked but do not involve settlement through physical receipt or delivery of a commodity.  They specify settlement through cash payments that are determined according to a formula in the contract, rather than through payment of fixed amounts.  For example, the principal amount of a bond may be calculated by applying the market price of oil prevailing at the maturity of the bond to a fixed quantity of oil.  The principal is indexed by reference to a commodity price but is settled only in cash.  Such a contract constitutes a financial instrument.

A16.    The definition of a financial instrument encompasses also a contract that gives rise to a non-financial asset or liability in addition to a financial asset or liability.  Such financial instruments often give one party an option to exchange a financial asset for a non-financial asset.  For example, an oil-linked bond may give the holder the right to receive a stream of fixed periodic interest payments and a fixed amount of cash on maturity, with the option to exchange the principal amount for a fixed quantity of oil.  The desirability of exercising this option will vary from time to time based on the fair value of oil relative to the exchange ratio of cash for oil (the exchange price) inherent in the bond.  The intentions of the bondholder concerning the exercise of the option do not affect the substance of the component assets.  The financial asset of the holder and the financial liability of the issuer make the bond a financial instrument, regardless of the other types of assets and liabilities also created.

A17.    Although the Standard was not developed to apply to commodity or other contracts that do not satisfy the definition of a financial instrument, enterprises may consider whether it is appropriate to apply the relevant portions of the disclosure standards to such contracts.


Liabilities and Equity

A18.    It is relatively easy for issuers to classify certain types of financial instruments as liabilities or equity.  Examples of equity instruments include common (ordinary) shares and options that, if exercised, would require the writer of the option to issue common shares.  Common shares do not oblige the issuer to transfer assets to shareholders, except when the issuer formally acts to make a distribution and becomes legally obligated to the shareholders to do so.  This may be the case following declaration of a dividend or when the enterprise is being wound up and any assets remaining after the satisfaction of liabilities become distributable to shareholders.

"Perpetual" debt instruments

A19.    "Perpetual" debt instruments, such as "perpetual" bonds, debentures and capital notes, normally provide the holder with the contractual right to receive payments on account of interest at fixed dates extending into the indefinite future, either with no right to receive a return of principal or a right to a return of principal under terms that make it very unlikely or very far in the future.  For example, an enterprise may issue a financial instrument requiring it to make annual payments in perpetuity equal to a stated interest rate of 8% applied to a stated par or principal amount of 1,000.  Assuming 8% to be the market rate of interest for the instrument when issued, the issuer assumes a contractual obligation to make a stream of future interest payments having a fair value (present value) of 1,000.  The holder and issuer of the instrument have a financial asset and financial liability, respectively, of 1,000 and corresponding interest income and expense of 80 each year in perpetuity.

Preferred Shares

A20.    Preferred (or preference) shares may be issued with various rights.  In classifying a preferred share as a liability or equity, an enterprise assesses the particular rights attaching to the share to determine whether it exhibits the fundamental characteristic of a financial liability.  For example, a preferred share that provides for redemption on a specific date or at the option of the holder meets the definition of a financial liability if the issuer has an obligation to transfer financial assets to the holder of the share.  The inability of an issuer to satisfy an obligation to redeem a preferred share when contractually required to do so, whether due to a lack of funds or a statutory restriction, does not negate the obligation.  An option of the issuer to redeem the shares does not satisfy the definition of a financial liability because the issuer does not have a present obligation to transfer financial assets to the shareholders.  Redemption of the shares is solely at the discretion of the issuer.  An obligation may arise, however, when the issuer of the shares exercises its option, usually by formally notifying the shareholders of an intention to redeem the shares.

A21.    When preferred shares are non-redeemable, the appropriate classification is determined by the other rights that may attach to them.  When distributions to holders of the preferred shares whether, cumulative or non-cumulative, are at the discretion of the issuer, the shares are equity instruments.

Compound Financial Instruments

A22.    Paragraph 23 of the Standard applies only to a limited group of compound instruments for the purpose of having the issuers present liability and equity components separately on their balance sheets.  Paragraph 23 does not deal with compound instruments from the perspective of holders.

A23.    A common form of compound financial instrument is a debt security with an embedded conversion option, such as a bond convertible into common shares of the issuer.  Paragraph 23 of the Standard requires the issuer of such a financial instrument to present the liability component and the equity component separately on the balance sheet from their initial recognition.

(a)    The issuer's obligation to make scheduled payments of interest and principal constitutes a financial liability which exists as long as the instrument is not converted.  On inception, the fair value of the liability component is the present value of the contractually determined stream of future cash flows discounted at the rate of interest applied by the market at that time to instruments of comparable credit status and providing substantially the same cash flows, on the same terms, but without the conversion option.

(b)    The equity instrument is an embedded option to convert the liability into equity of the issuer.  The fair value of the option comprises its time value and its intrinsic value, if any.  The intrinsic value of an option or other derivative financial instrument is the excess, if any, of the fair value of the underlying financial instrument over the contractual price at which the underlying instrument is to be acquired, issued, sold or exchanged.  The time value of a derivative instrument is its fair value less its intrinsic value.  The time value is associated with the length of the remaining term to maturity or expiry of the derivative instrument.  It reflects the income foregone by the holder of the derivative instrument from not holding the underlying instrument, the cost avoided by the holder of the derivative instrument from not having to finance the underlying instrument and the value placed on the probability that the intrinsic value of the derivative instrument will increase prior to its maturity or expiry due to future volatility in the fair value of the underlying instrument.  It is uncommon for the embedded option in a convertible bond or similar instrument to have any intrinsic value on issuance.

A24.    Paragraph 28 of the Standard describes how the components of a compound financial instrument may be valued on initial recognition.  The following example illustrates in greater detail how such valuations may be made.

An enterprise issues 2,000 convertible bonds at the start of Year 1.  The bonds have a three year term, and are issued at par with a face value of 1,000 per bond, giving total proceeds of 2,000,000.  Interest is payable annually in arrears at a nominal annual interest rate of 6%.  Each bond is convertible at any time up to maturity into 250 common shares.

When the bonds are issued, the prevailing market interest rate for similar debt without conversion options is 9%.  At the issue date, the market price of one common share is 3.  The dividends expected over the three year term of the bonds amount to 0.14 per share at the end of each year.  The risk-free annual interest rate for a three year term is 5%.

Residual valuation of equity component

Under this approach, the liability component is valued first, and the difference between the proceeds of the bond issue and the fair value of the liability is assigned to the equity component.  The present value of the liability component is calculated using a discount rate of 9%, the market interest rate for similar bonds having no conversion rights, as shown.

Present value of the principal                - 2,000,000
    payable at the end of three years        1,544,367
Present value of the interest                    - 120,000 payable
        annually in arrears for three years      303,755
Total liability component                        1,848,122
Equity component (by deduction)              151,878
Proceeds of the bond issue                   2,000,000

Option pricing model valuation of equity component

Option pricing models may be used to determine the fair value of conversion options directly rather than by deduction as illustrated above.  Option pricing models are often used by financial institutions for pricing day-to-day transactions.  There are a number of models available, of which the Black-Scholes model is one of the most well-known, and each has a number of variants.  The following example illustrates the application of a version of the Black-Scholes model that utilises tables available in finance textbooks and other sources.  The steps in applying this version of the model are set out below.

This model first requires the calculation of two amounts that are used in the option valuation tables:
(i)    Standard deviation of proportionate changes in the fair value of the asset underlying the option multiplied by the square root of the time to expiry of the option.

This amount relates to the potential for favourable (and unfavourable) changes in the price of the asset underlying the option, in this case the common shares of the enterprise issuing the convertible bonds.  The volatility of the returns on the underlying asset are estimated by the standard deviation of the returns.  The higher the standard deviation, the greater the fair value of the option.  In this example, the standard deviation of the annual returns on the shares is assumed to be 30%.  The time to expiry of the conversion rights is three years.  The standard deviation of proportionate changes in fair value of the shares multiplied by the square root of the time to expiry of the option is thus determined as:

0.3 x √3 = 0.5196

(ii)    Ratio of the fair value of the asset underlying the option to the present value of the option exercise price.

This amount relates the present value of the asset underlying the option to the cost that the option holder must pay to obtain that asset, and is associated with the intrinsic value of the option.  The higher this amount, the greater the fair value of a call option.  In this example, the market value of each share on issuance of the bonds is 3.  The present value of the expected dividends over the term of the option is deducted from the market price, since the payment of dividends reduces the fair value of the shares and thus the fair value of the option.  The present value of a dividend of 0.14 per share at the end of each year, discounted at the risk-free rate of 5%, is 0.3813. The present value of the asset underlying the option is therefore:

3 - 0.3813 = 2.6187 per share

The present value of the exercise price is 4 per share discounted at the risk-free rate of 5% over three years, assuming that the bonds are converted at maturity, or 3.4554.  The ratio is thus determined as:

2.6187 ÷ 3.4554 = 0.7579

The bond conversion option is a form of call option.  The call option valuation table indicates that, for the two amounts calculated above (i.e. 0.5196 and 0.7579), the fair value of the option is approximately 11.05% of the fair value of the underlying asset.

The valuation of the conversion options can therefore be calculated as:

0.1105 x 2.6187 per share x 250 shares
per bond x 2,000 bonds = 144,683

The fair value of the debt component of the compound instrument calculated above by the present value method plus the fair value of the option calculated by the Black-Scholes option pricing model does not equal the 2,000,000 proceeds from issuance of the convertible bonds (i.e. 1,848,122 + 144,683 = 1,992,805).  The small difference can be prorated over the fair values of the two components to produce a fair value for the liability of 1,854,794 and a fair value for the option of 145,206.





Offsetting of a Financial Asset and a Financial Liability

A25.    The Standard does not provide special treatment for so-called "synthetic instruments", which are groupings of separate financial instruments acquired and held to emulate the characteristics of another instrument.  For example, a floating rate long term debt combined with an interest rate swap that involves receiving floating payments and making fixed payments synthesises a fixed rate long term debt.  Each of the separate components of a "synthetic instrument" represents a contractual right or obligation with its own terms and conditions and each may be transferred or settled separately.  Each component is exposed to risks that may differ from the risks to which other components are exposed.  Accordingly, when one component of a "synthetic instrument" is an asset and another is a liability, they are not offset and presented on an enterprise's balance sheet on a net basis unless they meet the criteria for offsetting in paragraph 33 of the Standard.  Such is often not the case.  Disclosures are provided about the significant terms and conditions of each financial instrument constituting a component of a "synthetic instrument" without regard to the existence of the "synthetic instrument", although an enterprise may indicate in addition the nature of the relationship between the components (see paragraph 51 of the Standard).

Disclosure

A26.    Paragraph 53 of the Standard lists examples of broad categories of matters that, when significant, an enterprise addresses in its disclosure of accounting policies.  In each case, an enterprise has a choice from among two or more different accounting treatments.  The following discussion elaborates on the examples in paragraph 53 and provides further examples of circumstances in which an enterprise discloses its accounting policies.

(a)    An enterprise may acquire or issue a financial instrument under which the obligations of each party are partially or completely unperformed (sometimes referred to as an unexecuted or executory contract).  Such a financial instrument may involve a future exchange and performance may be conditional on a future event.  For example, neither the right nor the obligation to make an exchange under a forward contract results in any transaction in the underlying financial instrument until the maturity of the contract but the right and obligation constitute a financial asset and a financial liability, respectively.  Similarly, a financial guarantee does not require the guarantor to assume any obligation to the holder of the guaranteed debt until an event of default has occurred.  The guarantee is, however, a financial liability of the guarantor because it is a contractual obligation to exchange one financial instrument (usually cash) for another (a receivable from the defaulted debtor) under conditions that are potentially unfavourable.

(b)    An enterprise may undertake a transaction that, in form, constitutes a direct acquisition or disposition of a financial instrument but does not involve the transfer of the economic interest in it.  Such is the case with some types of repurchase and reverse repurchase agreements.  Conversely, an enterprise may acquire or transfer to another party an economic interest in a financial instrument through a transaction that, in form, does not involve an acquisition or disposition of legal title.  For example, in a non-recourse borrowing, an enterprise may pledge accounts receivable as collateral and agree to use receipts from the pledged accounts solely to service the loan.

(c)    An enterprise may undertake a partial or incomplete transfer of a financial asset.  For example, in a securitisation, an enterprise acquires or transfers to another party some, but not all, of the future economic benefits associated with a financial instrument.

(d)    An enterprise may be required, or intend, to link two or more individual financial instruments to provide specific assets to satisfy specific obligations.  Such arrangements include, for example, "in substance" defeasance trusts in which financial assets are set aside for the purpose of discharging an obligation without those assets having been accepted by the creditor in settlement of the obligation, non-recourse secured financing and sinking fund arrangements.
(e)    An enterprise may use various risk management techniques to minimise exposures to financial risks.  Such techniques include, for example, hedging, interest rate conversion from floating rate to fixed rate or fixed rate to floating rate, risk diversification, risk pooling, guarantees and various types of insurance (including sureties and "hold harmless" agreements).  These techniques generally reduce the exposure to loss from only one of several different financial risks associated with a financial instrument and involve the assumption of additional but only partially offsetting risk exposures.

(f)    An enterprise may link two or more separate financial instruments together notionally in a "synthetic" instrument or for some purposes other than those described in items (d) and (e) above.

(g)    An enterprise may acquire or issue a financial instrument in a transaction in which the amount of the consideration exchanged for the instrument is uncertain.  Such transactions may involve non-cash consideration or an exchange of several items.

(h)    An enterprise may acquire or issue a bond, promissory note or other monetary instrument with a stated amount or rate of interest that differs from the prevailing market interest rate applicable to the instrument.  Such financial instruments include zero coupon bonds and loans made on apparently favourable terms but involving non-cash consideration, for example, low interest rate loans to employees.

A27.    Paragraph 54 of the Standard lists several issues that an enterprise addresses in its disclosure of accounting policies when the issues are significant to the application of the cost basis of measurement.  In the case of uncertainty about the collectibility of amounts realisable from a monetary financial asset or a decline in the fair value of a financial asset below its carrying amount due to other causes, an enterprise indicates its policies for determining:

(a) when to reduce the carrying amount of the asset;
(b) the amount to which it reduces the carrying amount;
(c) how to recognise any income from the asset; and
(d) whether the reduction in carrying amount may be reversed in the future if circumstances change.