EXPOSURE DRAFT
55
January 9, 2003


PROPOSED STATEMENT OF FINANCIAL ACCOUNTING STANDARDS

FINANCIAL INSTRUMENTS: RECOGNITION AND MEASUREMENT

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) 55
Proposed Statement of Financial Accounting Standards

Financial Instruments: Recognition and Measurement

The Accounting Standards Council (ASC) approved the adoption of International Accounting Standards (IAS) 39 (revised 2000), Financial Instrument: Recognition and Measurement, issued by the International Accounting Standards Committee (IASC), as generally accepted accounting principles in the Philippines. The effective date (paragraph 171) of IAS 39 (revised 2000), however, is modified in the Philippines as set forth below.


Effective Date in the Philippines

IAS 39 (revised 2000) becomes effective in the Philippines for financial statements covering periods beginning on or after January 1, 2005. Earlier application is encouraged.

SFAS 39/IAS 39 supersedes the following SFASs:

SFAS 10, Summary of Generally Accepted Accounting Principles on Investments.
SFAS 19A, Accounting for Investments in Debt and Marketable Equity Securities of Banks (as amendment of ASC SFAS No. 19, Summary of Generally Accounting Principles for the Banking Industry)

Comparison of IAS 39 and SFAS 10


Following is a comparison of the more significant provisions of IAS 39 (revised 2000) and SFAS 10, Summary of Generally Accepted Accounting Principles on Investments, and SFAS 19A, Accounting for Investments in Debt and Marketable Equity Securities of Banks (an amendment of ASC SFAS No. 19, Summary of Generally Accounting Principles for the Banking Industry).

Reference should be made to IAS 39 (revised 2000) for complete and detailed guidance on the standard.

	IAS 39	SFAS 10 and 19A
Scope	Applies to all enterprises and to all financial instruments (i.e., a financial asset, a financial liability or equity instrument) including derivatives. Exception are specified. Scope of derivative instruments includes derivatives embedded in other contracts.	SFAS 10 applies to enterprises other than banks and covers the following: (a)Marketable securities (current and noncurrent) (b)Other investments including investments in bonds and other debt securities, funds for retirements, stock redemption and other special purposes, investments in real estate and income-producing properties, advances to affiliates, interests in life insurance contracts, interests in partnership and joint ventures, and interest in trust and estates). SFAS 19A applies to banks and covers investments in debt and marketable equity securities of banks.
Definitions	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. 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 favorable; or (d) 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 unfavorable. An equity instrument is any contract that evidences a residual interest in the assets of an enterprise after deducting all of its liabilities. A derivative is a financial instrument: (a) whose value changes in response to the change in a specified interest rate, security price, commodity price, foreign exchange rate, index of prices or rates, a credit rating or credit index, or similar variable (sometimes called the ‘underlying’); (b) that requires no initial net investment or little initial net investments relative to other types of contracts that have a similar response to changes in market conditions; and (c) that is settled at a future date.	No equivalent definitions
Recognition
Initial Recognition	Recognize on the balance sheet all financial assets and financial liabilities, including derivatives, when, and only when, the enterprise becomes a party to the contractual provisions of the instruments.	Investment – No equivalent provision Liabilities – Recognize in the period in which money, goods, or services are received or when a legally enforceable claim against the company is established (under superseded SFAS 5, Summary of GAAP on Liabilities)
Derecognition	IAS 39 established conditions for determining when control over a financial asset or liability has been transferred to another party. A financial asset (or a portion of a financial asset) is derecognized when, and only when, the enterprise loses control of the contractual rights that comprise the financial asset (or a portion of the financial asset). An enterprise loses such control if it realizes the rights to benefits specified in the contract, the rights expire, or the enterprise surrenders those rights. A financial liability (or a part of a financial liability) is removed from the balance sheet when, and only when, it is extinguished – that is, when the obligation specified in the contract is discharged, cancelled, or expires (i.e., when payment is made to the creditor or the borrower is legally released, either judicially or by the creditor, from primary responsibility for the liability. IAS 39 provides more guidance on derecognition of a financial asset or liability.	No equivalent provisions
Measurement:
Initial Measurement	Recognize initially at cost, which is the fair value of the consideration given (in the case of an asset) or received (in the case of a liability) for it. Transaction costs are included in the initial measurement of all financial assets and liabilities.	Record initially current and noncurrent investments acquired at cost, which is measured by the purchase price of the security or the fair value of the asset given up in exchange. Other direct incremental costs may be capitalized provided the total cost does not exceed the fair value of the investment acquired.
Subsequent Measurement	All financial assets are remeasured to fair value, except for the following, which should be carried at amortized cost subject to a test for impairment: (a)Loans and receivables originated by the enterprise and not held for trading. (b)Other fixed maturity investments with fixed or determinable payments (e.g., debt securities and mandatorily redeemable preferred shares) that the enterprise intends and is able to hold to maturity. IAS 39 provides more guidance on accounting for held-to-maturity investments. (c)Financial assets whose fair value cannot be reliably measured (generally limited to some equity securities with no quoted market price and forwards and options on unquoted equity securities). After acquisition, most financial liabilities are measured at original recorded amount less principal repayments and amortization. Only derivatives and liabilities held for trading (such as securities borrowed by a short seller) are remeasured to fair value.	Under SFAS 10: (a)Current and noncurrent marketable equity securities are carried at the lower of aggregate cost or market value. (b)Investments in bonds and other debt securities are carried at cost adjusted for amortized discount and premium, less any provision for permanent impairment in value. (c)Other investments in stock (other than noncurrent marketable equity securities) which do not qualify for equity method are carried at cost less any permanent decline in value of an individual security. Under SFAS 19A for banks: (a)Trading securities, available for sale securities and underwriting accounts are carried at fair market values. (b)Investments in bonds and other debt securities held to maturity are carried at amortized cost. Receivables are carried at face amount less allowance for doubtful accounts (under superseded SFAS 3, Summary of GAAP on Receivables) Liabilities are carried at amounts established in exchanges, usually the amounts to be paid (under superseded SFAS 5)
Gains and Losses on Remeasurement	For financial assets and liabilities that are remeasured to fair value, an enterprise will have a single, enterprise-wide option either to: (a)recognize the entire adjustment in net profit or loss for the period; or (b)recognized in net profit or loss for the period only those changes in fair value relating to financial assets and liabilities held for trading, with the non-trading value changes reported in equity until the financial asset is sold, at which time the realized gain or loss is reported in net profit or loss. For this purpose, derivatives are always deemed held for trading unless they are designated as hedging instruments.	Under SFAS 10 (a)Current marketable equity securities – Realized and unrealized gains are included in current income. (b)Noncurrent marketable equity securities – Realized gains and losses are recognized in income.
Gains and Losses on Financial Assets and Liabilities that are not Remeasured	For financial assets and liabilities carried at amortized cost, a gain or loss is recognized in net income when the financial asset or liability is derecognized or impaired and through the amortization process.	For investments in bonds and other debt securities carried at cost, a gain or loss is recognized in net income when the asset is amortized or a provision for decline in value is recognized.
Impairment and Uncollectibility of Financial Assets	Impairment loss is recognized for a financial asset whose recoverable amount is less than carrying amount. Guidance is provided for calculating impairment.	Provision for decline in value of an investment of for uncollectible receivables is recognized.

nternational Accounting Standard (IAS) 39
(revised 2000)


Financial Instruments: Recognition and Measurement

The following IAS 39 (revised 2000) is from the IASC bound volume of International Accounting Standards 2001. It includes amendments and improvements to IAS 39 made by the IASC in 2000. The new text is shaded and text deleted is shaded and struck through.

Introduction

1.This Standard ('IAS 39') establishes principles for recognising, measuring, and disclosing information about financial assets and financial liabilities.  It is IASC’s first comprehensive Standard on the subject, though some issues within the scope of this Standard have been addressed in other Standards.  IAS 25, Accounting for Investments, covered recognition and measurement of debt and equity investment, as well as investment in land and buildings and other tangible and intangible assets held as investment. This Standard supersedes IAS 25 except with respect to land and buildings and other tangible and intangible assets held as investments.  IASC is currently developing a Standard on such investment properties.  IAS 38, Intangible Assets, superseded IAS 25 with respect to investments in intangible assets.  This Standard also supplements the disclosure provisions of IAS 32, Financial Instruments: Disclosure and Presentation. The various amendments to existing International Accounting Standards are set out at the end of this Standard. IAS 39 is effective for financial statements for financial years beginning on or after 1 January 2001.  Earlier application is permitted only as of the beginning of a financial year that ends after 15 March 1999, the date of issuance of this Standard.

Background

2.In 1988, IASC began a project, jointly with the Canadian Institute of Chartered Accountants, to develop a comprehensive Standard on the recognition, measurement, and disclosure of financial instruments.  IASC issued an exposure draft (E40) for comment in September 1991.  Based on extensive input received, the proposals were reconsidered and a re-exposure draft (E48) was issued for comment in January 1994.

3.In view of the critical responses to E48, evolving practices in the use of financial instruments, and developing thinking by certain national accounting standard setters, IASC decided to divide the project into phases, starting with disclosure and financial statement presentation.

4.The first phase was completed in March 1995 when the IASC Board approved IAS 32, Financial Instruments: Disclosure and Presentation.  IAS 32 deals with:

(a)classification by issuers of financial instruments as liabilities or equity, and the classification of related interest, dividends, and gains and losses. This includes the separation of certain compound instruments into their liability and equity components;
(b)offsetting of financial assets and financial liabilities; and
(c)disclosure of information about financial instruments.

5.The second phase of the project is to consider further the issues of recognition, discontinuing recognition ('derecognition'), measurement, and hedge accounting.  This Standard addresses those matters.

6.In July 1995, IASC reached agreement with the International Organization of Securities Commissions (IOSCO) on the content of a work programme to complete a core set of International Accounting Standards that could be endorsed by IOSCO for cross-border capital raising and listing purposes in all global markets.  Those core standards include standards on recognition and measurement of financial instruments, off-balance sheet items, hedging, and investments.  The disclosure standards of IAS 32, by themselves, do not fulfill IASC's commitment to IOSCO with respect to the minimum core standards.

7.In March 1997, IASC, jointly with the Canadian Institute of Chartered Accountants, published a comprehensive Discussion Paper, Accounting for Financial Assets and Financial Liabilities, and invited comments on the proposals therein.  IASC held a series of special consultative meetings about those proposals with various national and international interest groups and in numerous countries.  Those meetings and analysis of comment letters on the Discussion Paper confirm that IASC faces controversies and complexities in seeking a way forward.  While some acceptance exists of the view put forward in the Discussion Paper - that measurement of all financial assets and liabilities at fair value is necessary to obtain consistency and relevance to users - application of that concept to some industries and to some kinds of financial assets and liabilities continues to present difficulty.  Widespread unease is also evident about the prospect of including unrealised gains, particularly on long-term debt, in income as proposed in the Discussion Paper.  Those difficulties will not be easily or quickly resolved.  Further, while several national standard setters have undertaken projects to develop national standards on various aspects of recognition and measurement of financial instruments, no country has in place or proposed standards that are similar to the proposals in the Discussion Paper.

8.Completion of a single comprehensive International Accounting Standard on financial instruments based on the Discussion Paper for inclusion, before the end of 1998, in the core standards to be considered by IOSCO was not a realistic possibility.  Nonetheless, the ability to use International Accounting Standards for investment and credit decisions and securities offerings and listings is urgent for both investors and business enterprises.  Moreover, while financial instruments are widely held and used throughout the world, only a very few countries now have any national recognition and measurement standards at all for financial instruments.

9.At its meeting in November 1997, therefore, the IASC Board decided that:

(a)IASC should join with national standard setters to develop an integrated and harmonised international accounting standard on financial instruments.  That standard would build on the IASC Discussion Paper, existing and emerging national standards, and the best thinking and research on the subject world wide; and

(b)at the same time, recognising the urgency of the matter, IASC should work to complete an interim international Standard on recognition and measurement of financial instruments in 1998.  That solution, along with IAS 32 on disclosure and presentation of financial instruments and several other existing International Accounting Standards that address matters relating to financial instruments, will serve until the integrated comprehensive standard is completed.

10.A Joint Working Group comprising representatives of IASC and a number of national standard setters has begun work on the first of the foregoing two steps.  This Standard is intended to accomplish the second step.  IASC recognises that the proposals in its March 1997 Discussion Paper represent far-reaching changes from traditional accounting practices for financial instruments and that a number of difficult technical issues (which were discussed in the Discussion Paper) need to be resolved before standards fully reflecting those proposals could be put in place.  IASC also believes that a programme of development work, field testing, preparation of guidance material, and education will be necessary to enable those principles to be effectively implemented.  The IASC Board is committed to work with national standard setters throughout the world to achieve those goals within a reasonable time.  In the interim, until those goals are achieved, this Standard will significantly improve the reporting of financial instruments.

Exposure Draft E62

11.This Standard is based on Exposure Draft E62, which IASC issued for public comment on 17 June 1998.  The formal comment deadline was 30 September 1998, but the Board announced that it would make every effort to consider comments received by 25 October, which it did.  Constituents' views about the proposals in E62 were also solicited by a series of more than 20 seminars conducted around the world by the project manager and through published summaries of E62 in professional journals.  To ensure the longest possible period for IASC constituents to review and develop their comments on E62, a copy of E62 was posted on IASC's web site for downloading.

12.Issues arising as a result of the comment process were considered by an IASC Steering Committee, which made recommendations to the Board, and then by the Board itself at meetings in November and December 1998.

Greater Use of Fair Values for Financial Instruments

13.This Standard significantly increases the use of fair values in accounting for financial instruments, consistent with the direction the Board has given to the Joint Working Group to continue to study further the use of full fair value accounting for all financial assets and liabilities.  This Standard changes current practice by requiring the use of fair values for:
(a)nearly all derivative assets and derivative liabilities;
(b)all debt securities, equity securities, and other financial assets held for trading;
(c)all debt securities, equity securities, and other financial assets that are not held for trading but nonetheless are available for sale;
(d)certain derivatives that are embedded in non-derivative instruments;
(e)non-derivative financial instruments containing embedded derivative instruments that cannot be reliably separated from the non-derivative instrument;
(f)non-derivative assets and liabilities that have fair value exposures being hedged by derivative instruments;
(g)fixed maturity investments that the enterprise does not designate as 'held to maturity'; and
(h)purchased loans and receivables that the enterprise does not designate as 'held to maturity'.

14.The three classes of financial assets that remain carried at cost under this Standard are loans and receivables originated by the enterprise, other fixed-maturity investments that the enterprise intends and is able to hold to maturity, and unquoted equity instruments whose fair value cannot be reliably measured (including derivatives that are linked to and must be settled by delivery of such unquoted equity instruments).  The Board decided not to require fair value measurement for the loans, receivables, and other fixed maturity investments at this time for a number of reasons.  One is the significance of the change from current practice that would be required in many jurisdictions.  Another reason is the portfolio linkage of loans, receivables, and other fixed maturity investments, in many industries, to liabilities that, under this Standard, will be measured at their amortised original amount.  Also, some question the relevance of fair values for fixed maturity investments intended to be held until maturity.  The Joint Working Group is studying those matters.

15.Whether and how fair value can be reliably estimated for the unquoted equity instruments is also under study by the Joint Working Group.  Most liabilities are not measured at fair value under this Standard - though all derivative liabilities (unless indexed to an unquoted equity instrument whose fair value cannot be reliably measured) and those held for trading are measured at fair value.  Fair valuation of liabilities is the subject of several studies currently being undertaken by the Joint Working Group.

Summary of this Standard

16.Under this Standard, all financial assets and financial liabilities should be recognised on the balance sheet, including all derivatives.  They should initially be measured at cost, which is the fair value of the consideration given or received to acquire the financial asset or liability (plus certain hedging gains and losses).

17.Subsequent to initial recognition, all financial assets should be remeasured to fair value, except for the following, which should be carried at amortised cost subject to a test for impairment:

(a)loans and receivables originated by the enterprise and not held for trading;
(b)other fixed maturity investments, such as debt securities and mandatorily redeemable preferred shares, that the enterprise intends and is able to hold to maturity; and
(c)financial assets whose fair value cannot be reliably measured (limited to some equity instruments with no quoted market price and some derivatives that are linked to and must be settled by delivery of such unquoted equity instruments).

18.After acquisition most financial liabilities should be measured at original recorded amount less principal repayments and amortisation.  Only derivatives and liabilities held for trading should be remeasured to fair value.

19.For those financial assets and liabilities that are remeasured to fair value, an enterprise will have a single, enterprise-wide option to either:

(a)recognise the entire adjustment in net profit or loss for the period; or
(b)recognise in net profit or loss for the period only those changes in fair value relating to financial assets and liabilities held for trading, with the value changes for non-trading instruments reported in equity until the financial asset is sold, at which time the realised gain or loss is reported in net profit or loss.  For this purpose, derivatives are always deemed held for trading unless they are part of a hedging relationship that qualifies for hedge accounting.

20.This Standard establishes conditions for determining when control over a financial asset or liability has been transferred to another party.  For financial assets a transfer normally would be recognised if (a) the transferee has the right to sell or pledge the asset and (b) the transferor does not have the right to reacquire the transferred assets unless either the asset is readily obtainable in the market or the reacquisition price is fair value at the time of reacquisition.  With respect to derecognition of liabilities, the debtor must be legally released from primary responsibility for the liability (or part thereof) either judicially or by the creditor.  If part of a financial asset or liability is sold or extinguished, the carrying amount is split based on relative fair values.  If fair values are not determinable, a cost recovery approach to profit recognition is taken.

21.Hedging, for accounting purposes, means designating a derivative or (in limited circumstances) a non-derivative financial instrument as an offset, in whole or in part, to the change in fair value or cash flows of a hedged item.  A hedged item can be an asset, liability, firm commitment, or forecasted future transaction that is exposed to risk of change in value or changes in future cash flows.  Hedge accounting recognises the offsetting effects on net profit or loss symmetrically.

22.Hedge accounting is permitted under this Standard in certain circumstances, provided that the hedging relationship is clearly defined, measurable, and actually effective.

23.This Standard applies to insurance enterprises except for rights and obligations under insurance contracts.  This Standard applies to derivatives that are embedded in insurance contracts.  A separate IASB project is under way on accounting for insurance contracts.



IAS 32 (revised 2000)

Contents

International Accounting Standards IAS 39
(revised 2000)

Financial Instruments: Recognition and Measurement

OBJECTIVE	Paragraphs
SCOPE	1-7
DEFINITIONS	8-26
From IAS 32	8 - 9
Additional Definitions	10
Definition of a Derivative	10
Definitions of Four Categories of Financial Assets	10
Definitions Relating to Recognition and Measurement	10
Definitions Relating to Hedge Accounting	10
Other Definitions	10
Elaboration on the Definitions	11-21
Equity Instrument	11-12
Derivatives	13-16
Transaction Costs	17
Liability Held for Trading	18
Loans and Receivables Originated by the Enterprise	19-20
Available-for-Sale Financial Assets	21
Embedded Derivatives	22-26
RECOGNITION	27-65
Initial Recognition	27-29
Trade Date vs. Settlement Date	30-34
Derecognition	35-65
Derecognition of a Financial Asset	35-43
Accounting for Collateral	44-46
Derecognition of Part of a Financial Asset	47-50
Asset Derecognition Coupled with a New Financial Asset or Liability	51-56
Derecognition of a Financial Liability	57-64
Derecognition of Part of a Financial Liability or Coupled with a New Financial Asset or Liability	65
MEASUREMENT	66-165
Initial Measurement of Financial Assets and Financial Liabilities	66-67
Subsequent Measurement of Financial Assets	68-92
Held-to-Maturity Investments	79-92
Subsequent Measurement of Financial Liabilities	93-94
Fair Value Measurement Considerations	95-102
Gains and Losses on Remeasurement to Fair Value	103-107
Gains and Losses on Financial Assets and Liabilities Not Remeasured to Fair Value	108
Impairment and Uncollectivity of Financial Assets	109-119
Financial Assets Carried at Amortised Cost	111-115
Interest Income After Impairment Recognition	116
Financial Assets Remeasured to Fair Value	117-119
Fair Value Accounting in Certain Financial Services Industries	120
Hedging	121-165
Hedging Instruments	122-126
Hedged Items	127-135
Hedge Accounting	136-145
Assessing Hedge Effectiveness	146-152
Fair Value Hedges	153-157
Cash Flow Hedges	158-163
Hedges of a Net Investment in a Foreign Entity	164
If a Hedge Does Not Qualify for Special Hedge Accounting	165
DISCLOSURE	166-170
EFFECTIVE DATE AND TRANSITION	171-172

 
International Accounting Standard IAS 39 (revised 2000)

Financial Instruments: Recognition and Measurement

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 objective of this Standard is to establish principles for recognising, measuring, and disclosing information about financial instruments in the financial statements of business enterprises. 

Scope

1.This Standard should be applied by all enterprises to all financial instruments except:

(a)those interests in subsidiaries, associates, and joint ventures that are accounted for under IAS 27, Consolidated Financial Statements and Accounting for Investments in Subsidiaries; IAS 28, Accounting for Investments in Associates; and IAS 31, Financial Reporting of Interests in Joint Ventures.  However, an enterprise applies this Standard in its consolidated financial statements to account for an interest in a subsidiary, associate, or joint venture that (a) is acquired and held exclusively with a view to its subsequent disposal in the near future; or (b) operates under severe long-term restrictions that significantly impair its ability to transfer funds to the enterprise.  In these cases, the disclosure requirements in IAS 27, IAS 28, and IAS 31 apply in addition to those in this Standard;
(b)rights and obligations under leases, to which IAS 17, Leases, applies; however, (i) lease receivables recognised on a lessor's balance sheet are subject to the derecognition provisions of this Standard (paragraphs 35-65 and 170(d)) and (ii) this Standard does apply to derivatives that are embedded in leases (see paragraphs 22-26);
(c)employers' assets and liabilities under employee benefit plans, to which IAS 19, Employee Benefits, applies;
(d)rights and obligations under insurance contracts as defined in paragraph 3 of IAS 32, Financial Instruments: Disclosure and Presentation, but this Standard does apply to derivatives that are embedded in insurance contracts (see paragraphs 22-26);
(e)equity instruments issued by the reporting enterprise including options, warrants, and other financial instruments that are classified as shareholders' equity of the reporting enterprise (however, the holder of such instruments is required to apply this Standard to those instruments);
(f)financial guarantee contracts, including letters of credit, that provide for payments to be made if the debtor fails to make payment when due (IAS 37, Provisions, Contingent Liabilities and Contingent Assets, provides guidance for recognising and measuring financial guarantees, warranty obligations, and other similar instruments).  In contrast, financial guarantee contracts are subject to this Standard if they provide for payments to be made in response to changes in a specified interest rate, security price, commodity price, credit rating, foreign exchange rate, index of prices or rates, or other variable (sometimes called the 'underlying').  Also, this Standard does require recognition of financial guarantees incurred or retained as a result of the derecognition standards set out in paragraphs 35-65;
(g)contracts for contingent consideration in a business combination (see paragraphs 65-76 of IAS 22 (Revised 1998), Business Combinations);
(h)contracts that require a payment based on climatic, geological, or other physical variables (see paragraph 2), but this Standard does apply to other types of derivatives that are embedded in such contracts (see paragraphs 22-26).

2.Contracts that require a payment based on climatic, geological, or other physical variables are commonly used as insurance policies.  (Those based on climatic variables are sometimes referred to as weather derivatives.)  In such cases, the payment made is based on an amount of loss to the enterprise.  Rights and obligations under insurance contracts are excluded from the scope of this Standard by paragraph 1(d).  The Board recognises that the payout under some of these contracts is unrelated to the amount of an enterprise's loss.  While the Board considered leaving such derivatives within the scope of the Standard, it concluded that further study is needed to develop operational definitions that distinguish between 'insurance-type' and 'derivative type' contracts.

3.This Standard does not change the requirements relating to:

(a)accounting by a parent for investments in subsidiaries in the parent's separate financial statements as set out in paragraphs 29-31 of IAS 27;
(b)accounting by an investor for investments in associates in the investor's separate financial statements as set out in paragraphs 12-15 of IAS 28;
(c)accounting by a joint venturer for investments in joint ventures in the venturer's or investor's separate financial statements as set out in paragraphs 35 and 42 of IAS 31; or
(d)employee benefit plans that comply with IAS 26, Accounting and Reporting by Retirement Benefit Plans.

4.Sometimes, an enterprise makes what it views as a 'strategic investment' in equity securities issued by another enterprise, with the intent of establishing or maintaining a long-term operating relationship with the enterprise in which the investment is made.  The investor enterprise uses IAS 28, Accounting for Investments in Associates, to determine whether the equity method of accounting is appropriate for such an investment because the investor has significant influence over the associate.  Similarly, the investor enterprise uses IAS 31, Financial Reporting of Interests in Joint Ventures, to determine whether proportionate consolidation or the equity method is appropriate for such an investment.  If neither the equity method nor proportionate consolidation is appropriate, the enterprise will apply this Standard to that strategic investment.

5.This Standard applies to the financial assets and liabilities of insurance companies other than rights and obligations arising under insurance contracts, which are excluded by paragraph 1(d).  A separate IASC project on accounting for insurance contracts is currently under way, and it will address rights and obligations arising under insurance contracts.  See paragraphs 22-26 for guidance on financial instruments that are embedded in insurance contracts.

6.This Standard should be applied to commodity-based contracts that give either party the right to settle in cash or some other financial instrument, 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.

7.If an enterprise follows a pattern of entering into offsetting contracts that effectively accomplish settlement on a net basis, those contracts are not entered into to meet the enterprise's expected purchase, sale, or usage requirements.

Definitions

From IAS 32

8.The following terms are used in this Standard with the meanings specified in IAS 32:

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.

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 equity instrument is any contract that evidences a residual interest in the assets of an enterprise after deducting all of its liabilities (see paragraph 11).

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.

9. For purposes of the foregoing definitions, IAS 32 states that the term 'enterprise' includes individuals, partnerships, incorporated bodies, and government agencies.

Additional Definitions

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

Definition of a Derivative

A derivative is a financial instrument:

(a)whose value changes in response to the change in a specified interest rate, security price, commodity price, foreign exchange rate, index of prices or rates, a credit rating or credit index, or similar variable (sometimes called the 'underlying');
(b)that requires no initial net investment or little initial net investment relative to other types of contracts that have a similar response to changes in market conditions; and
(c)that is settled at a future date.

Definitions of Four Categories of Financial Assets

A financial asset or liability held for trading is one that was acquired or incurred principally for the purpose of generating a profit from short-term fluctuations in price or dealer's margin.  A financial asset should be classified as held for trading if, regardless of why it was acquired, it is part of a portfolio for which there is evidence of a recent actual pattern of short-term profit-taking (see paragraph 21).  Derivative financial assets and derivative financial liabilities are always deemed held for trading unless they are designated and effective hedging instruments.  (See paragraph 18 for an example of a liability held for trading.)

Held-to-maturity investments are financial assets with fixed or determinable payments and fixed maturity that an enterprise has the positive intent and ability to hold to maturity (see paragraphs 80-92) other than loans and receivables originated by the enterprise.

Loans and receivables originated by the enterprise are financial assets that are created by the enterprise by providing money, goods, or services directly to a debtor, other than those that are originated with the intent to be sold immediately or in the short term, which should be classified as held for trading.  Loans and receivables originated by the enterprise are not included in held-to-maturity investments but, rather, are classified separately under this Standard (see paragraphs 19-20).

Available-for-sale financial assets are those financial assets that are not (a) loans and receivables originated by the enterprise, (b) held-to-maturity investments, or (c) financial assets held for trading (see paragraph 21).


Definitions Relating to Recognition and Measurement

Amortised cost of a financial asset or financial liability is the amount at which the financial asset or liability was measured at initial recognition minus principal repayments, plus or minus the cumulative amortisation of any difference between that initial amount and the maturity amount, and minus any write-down (directly or through the use of an allowance account) for impairment or uncollectability.

The effective interest method is a method of calculating amortisation using the effective interest rate of a financial asset or financial liability.  The effective interest rate is the rate that exactly discounts the expected stream of future cash payments through maturity or the next market-based repricing date to the current net carrying amount of the financial asset or financial liability.  That computation should include all fees and points paid or received between parties to the contract.  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 financial asset or financial liability for that period.  (See IAS 18, Revenue, paragraph 31, and IAS 32, paragraph 61.)

Transaction costs are incremental costs that are directly attributable to the acquisition or disposal of a financial asset or liability (see paragraph 17).

A firm commitment is a binding agreement for the exchange of a specified quantity of resources at a specified price on a specified future date or dates.

Control of an asset is the power to obtain the future economic benefits that flow from the asset.

Derecognise means remove a financial asset or liability, or a portion of a financial asset or liability, from an enterprise's balance sheet.

Definitions Relating to Hedge Accounting

Hedging, for accounting purposes, means designating one or more hedging instruments so that their change in fair value is an offset, in whole or in part, to the change in fair value or cash flows of a hedged item.

A hedged item is an asset, liability, firm commitment, or forecasted future transaction that (a) exposes the enterprise to risk of changes in fair value or changes in future cash flows and that (b) for hedge accounting purposes, is designated as being hedged (paragraphs 127-135 elaborate on the definition of hedged items).

A hedging instrument, for hedge accounting purposes, is a designated derivative or (in limited circumstances) another financial asset or liability whose fair value or cash flows are expected to offset changes in the fair value or cash flows of a designated hedged item (paragraphs 122-126 elaborate on the definition of a hedging instrument).  Under this Standard, a non-derivative financial asset or liability may be designated as a hedging instrument for hedge accounting purposes only if it hedges the risk of changes in foreign currency exchange rates.

Hedge effectiveness is the degree to which offsetting changes in fair value or cash flows attributable to a hedged risk are achieved by the hedging instrument (see paragraphs 146-152).

Other Definitions

Securitisation is the process by which financial assets are transformed into securities.

A repurchase agreement is an agreement to transfer a financial asset to another party in exchange for cash or other consideration and a concurrent obligation to reacquire the financial asset at a future date for an amount equal to the cash or other consideration exchanged plus interest.

Elaboration on the Definitions

Equity Instrument

11.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 the equity securities.  Such an obligation should be accounted for as a financial liability of the enterprise and, therefore, is not excluded from the scope of this Standard by paragraph 1(e).

12.An enterprise may have a forward, option, or other derivative instrument whose value changes in response to something other than the market price of the enterprise's own equity securities but that the enterprise can choose to settle or is required to settle in its own equity securities.  In such case, the enterprise accounts for the instrument as a derivative instrument, not as an equity instrument, because the value of such an instrument is unrelated to the changes in the equity of the enterprise.

Derivatives

13.Typical examples of derivatives are futures and forward, swap, and option contracts.  A derivative usually has a notional amount, which is an amount of currency, a number of shares, a number of units of weight or volume, or other units specified in the contract.  However, a derivative instrument does not require the holder or writer to invest or receive the notional amount at the inception of the contract.  Alternatively, a derivative could require a fixed payment as a result of some future event that is unrelated to a notional amount.  For example, a contract may require a fixed payment of 1,000 if six-month LIBOR increases by 100 basis points.  In this example, a notional amount is not specified.

14.Commitments to buy or sell non-financial assets and liabilities that are intended to be settled by the reporting enterprise by making or taking delivery in the normal course of business, and for which there is no practice of settling net (either with the counterparty or by entering into offsetting contracts), are not accounted for as derivatives but rather as executory contracts.  Settling net means making a cash payment based on the change in fair value. 

15.One of the defining conditions of a derivative is that it requires little initial net investment relative to other contracts that have a similar response to market conditions.  An option contract meets that definition because the premium is significantly less than the investment that would be required to obtain the underlying financial instrument to which the option is linked.

16.If an enterprise contracts to buy a financial asset on terms that require delivery of the asset within the time frame established generally by regulation or convention in the market place concerned (sometimes called a 'regular way' contract), the fixed price commitment between trade date and settlement date is a forward contract that meets the definition of a derivative.  This Standard provides for special accounting for such regular way contracts (see paragraphs 30-34).

Transaction Costs

17.Transaction costs include fees and commissions paid to agents, advisers, brokers, and dealers; levies by regulatory agencies and securities exchanges; and transfer taxes and duties.  Transaction costs do not include debt premium or discount, financing costs, or allocations of internal administrative or holding costs.




Liability Held for Trading

18. Liabilities held for trading include (a) derivative liabilities that are not hedging instruments and (b) the obligation to deliver securities borrowed by a short seller (an enterprise that sells securities that it does not yet own).  The fact that a liability is used to fund trading activities does not make that liability one held for trading.

Loans and Receivables Originated by the Enterprise

19.A loan acquired by an enterprise as a participation in a loan from another lender is considered to be originated by the enterprise provided it is funded by the enterprise on the date that the loan is originated by the other lender.  However, the acquisition of an interest in a pool of loans or receivables, for example in connection with a securitisation, is a purchase, not an origination, because the enterprise did not provide money, goods, or services directly to the underlying debtors nor acquire its interest through a participation with another lender on the date the underlying loans or receivables were originated.  Also, a transaction that is, in substance, a purchase of a loan that was previously originated - for example, a loan to an unconsolidated special purpose entity that is made to provide funding for its purchases of loans originated by others - is not a loan originated by the enterprise.  A loan acquired by an enterprise  in a business combination is considered to be originated by the acquiring enterprise provided that it was similarly classified by the acquired enterprise.  The loan is measured at acquisition under IAS 22, Business Combinations.  A loan acquired through a syndication is an originated loan because each lender shares in the origination of the loan and provides money directly to the debtor.

20.Loans or receivables that are purchased by an enterprise, rather than originated, are classified as held to maturity, available for sale, or held for trading, as appropriate.

Available-for-Sale Financial Assets

21.A financial asset is classified as available for sale if it does not properly belong in one of the three other categories of financial assets - held for trading, held to maturity, and loans and receivables originated by the enterprise.  A financial asset is classified as held for trading, rather than available for sale, if it is part of a portfolio of similar assets for which there is a pattern of trading for the purpose of generating a profit from short-term fluctuations in price or dealer's margin.

Embedded Derivatives

22.Sometimes, a derivative may be a component of a hybrid (combined) financial instrument that includes both the derivative and a host contract - with the effect that some of the cash flows of the combined instrument vary in a similar way to a stand-alone derivative.  Such derivatives are sometimes known as 'embedded derivatives'.  An embedded derivative causes some or all of the cash flows that otherwise would be required by the contract to be modified based on a specified interest rate, security price, commodity price, foreign exchange rate, index of prices or rates, or other variable.

23.An embedded derivative should be separated from the host contract and accounted for as a derivative under this Standard if all of the following conditions are met:

(a)the economic characteristics and risks of the embedded derivative are not closely related to the economic characteristics and risks of the host contract;
(b)a separate instrument with the same terms as the embedded derivative would meet the definition of a derivative; and
(c)the hybrid (combined) instrument is not measured at fair value with changes in fair value reported in net profit or loss.

If an embedded derivative is separated, the host contract itself should be accounted for (a) under this Standard if it is, itself, a financial instrument and (b) in accordance with other appropriate International Accounting Standards if it is not a financial instrument.

24.The economic characteristics and risks of an embedded derivative are not considered to be closely related to the host contract (paragraph 23(a)) in the following examples.  In these circumstances, assuming the conditions in paragraphs 23(b) and 23(c) are also met, an enterprise accounts for the embedded derivative separately from the host contract under this Standard:

(a)a put option on an equity instrument held by an enterprise is not closely related to the host equity instrument;
(b)a call option embedded in an equity instrument held by an enterprise is not closely related to the host equity instrument from the perspective of the holder (from the issuer's perspective, the call option is an equity instrument of the issuer if the issuer is required to or has the right to require settlement in shares, in which case it is excluded from the scope of this Standard);
(c)an option or automatic provision to extend the term (maturity date) of debt is not closely related to the host debt contract held by an enterprise unless there is a concurrent adjustment to the market rate of interest at the time of the extension;
(d)equity-indexed interest or principal payments - by which the amount of interest or principal is indexed to the value of equity shares - are not closely related to the host debt instrument or insurance contract because the risks inherent in the host and the embedded derivative are dissimilar;
(e)commodity-indexed interest or principal payments - by which the amount of interest or principal is indexed to the price of a commodity - are not closely related to the host debt instrument or insurance contract because the risks inherent in the host and the embedded derivative are dissimilar;
(f)an equity conversion feature embedded in a debt instrument is not closely related to the host debt instrument;
(g)a call or put option on debt that is issued at a significant discount or premium is not closely related to the debt except for debt (such as a zero coupon bond) that is callable or puttable at its accreted amount; and
(h)arrangements known as credit derivatives that are embedded in a host debt instrument and that allow one party (the 'beneficiary') to transfer the credit risk of an asset, which it may or may not actually own, to another party (the 'guarantor') are not closely related to the host debt instrument.  Such credit derivatives allow the guarantor to assume the credit risk associated with a reference asset without directly purchasing it.

25.On the other hand, the economic characteristics and risks of an embedded derivative are considered to be closely related to the economic characteristics and risks of the host contract in the following examples.  In these circumstances, an enterprise does not account for the embedded derivative separately from the host contract under this Standard:

(a)the embedded derivative is linked to an interest rate or interest rate index that can change the amount of interest that would otherwise be paid or received on the host debt contract (that is, this Standard does not permit floating rate debt to be treated as fixed rate debt with an embedded derivative);
(b)an embedded floor or cap on interest rates is considered to be closely related to the interest rate on a debt instrument if the cap is at or above the market rate of interest or if the floor is at or below the market rate of interest when the instrument is issued, and the cap or floor is not leveraged in relation to the host instrument;
(c)the embedded derivative is a stream of principal or interest payments that are denominated in a foreign currency.  Such a derivative is not separated from the host contract because IAS 21, The Effects of Changes in Foreign Exchange Rates, requires that foreign currency translation gains and losses on the entire host monetary item be recognised in net profit or loss;
(d)the host contract is not a financial instrument and it requires payments denominated in (i) the currency of the primary economic environment in which any substantial party to that contract operates or (ii) the currency in which the price of the related good or service that is acquired or delivered is routinely denominated in international commerce (for example, the U.S. dollar for crude oil transactions).  That is, such contract is not regarded as a host contract with an embedded foreign currency derivative;
(e)the embedded derivative is a prepayment option with an exercise price that would not result in a significant gain or loss;
(f)the embedded derivative is a prepayment option that is embedded in an interest-only or principal-only strip that (i) initially resulted from separating the right to receive contractual cash flows of a financial instrument that, in and of itself, did not contain an embedded derivative and that (ii) does not contain any terms not present in the original host debt contract;
(g)with regard to a host contract that is a lease, the embedded derivative is (i) an inflation-related index such as an index of lease payments to a consumer price index (provided that the lease is not leveraged and the index relates to inflation in the enterprise's own economic environment), (ii) contingent rentals based on related sales, and (iii) contingent rentals based on variable interest rates; or
(h)the embedded derivative is an interest rate or interest rate index that does not alter the net interest payments that otherwise would be paid on the host contract in such a way that the holder would not recover substantially all of its recorded investment or (in the case of a derivative that is a liability) the issuer would pay a rate more than twice the market rate at inception.

26.If an enterprise is required by this Standard to separate an embedded derivative from its host contract but is unable to separately measure the embedded derivative either at acquisition or at a subsequent financial reporting date, it should treat the entire combined contract as a financial instrument held for trading.


Recognition

Initial Recognition

27.An enterprise should recognise a financial asset or financial liability on its balance sheet when, and only when, it becomes a party to the contractual provisions of the instrument.  (See paragraph 30 with respect to 'regular way' purchases of financial assets.)

28.As a consequence of the principle in the preceding paragraph, an enterprise recognises all of its contractual rights or obligations under derivatives in its balance sheet as assets or liabilities.

29.The following are some examples of applying the principle in paragraph 27:

(a)unconditional receivables and payables are recognised as assets or liabilities when the enterprise becomes a party to the contract and, as a consequence, has a legal right to receive, or a legal obligation to pay, cash;
(b)assets to be acquired and liabilities to be incurred as a result of a firm commitment to purchase or sell goods or services are not recognised under present accounting practice until at least one of the parties has performed under the agreement such that it either is entitled to receive an asset or is obligated to disburse an asset.  For example, an enterprise that receives a firm order does not recognise an asset (and the enterprise that places the order does not recognise a liability) at the time of the commitment but, rather, delays recognition until the ordered goods or services have been shipped, delivered, or rendered;
(c)in contrast to (b) above, however, a forward contract - a commitment to purchase or sell a specified financial instrument or commodity subject to this Standard on a future date at a specified price - is recognised as an asset or a liability on the commitment date, rather than waiting until the closing date on which the exchange actually takes place.  When an enterprise becomes a party to a forward contract, the fair values of the right and obligation are often equal, so that the net fair value of the forward is zero, and only any net fair value of the right and obligation is recognised as an asset or liability.  However, each party is exposed to the price risk that is the subject of the contract from that date.  Such a forward contract satisfies the recognition principle of paragraph 27, from the perspectives of both the buyer and the seller, at the time the enterprises become parties to the contract, even though it may have a zero net value at that date.  The fair value of the contract may become a net asset or liability in the future depending on, among other things, the time value of money and the value of the underlying instrument or commodity that is the subject of the forward;
(d)financial options are recognised as assets or liabilities when the holder or writer becomes a party to the contract; and
(e)planned future transactions, no matter how likely, are not assets and liabilities of an enterprise since the enterprise, as of the financial reporting date, has not become a party to a contract requiring future receipt or delivery of assets arising out of the future transactions.

Trade Date vs. Settlement Date

30.A 'regular way' purchase or sale of financial assets should be recognised using either trade date accounting or settlement date accounting as described in paragraphs 32 and 33.  The method used should be applied consistently for all purchases and sales of financial assets that belong to the same category of financial assets defined in paragraph 10.

31.A contract for the purchase or sale of financial assets that requires delivery of the assets within the time frame generally established by regulation or convention in the market place concerned (sometimes called a 'regular way' contract) is a financial instrument as described in this Standard.  The fixed price commitment between trade date and settlement date meets the definition of a derivative - it is a forward contract.  However, because of the short duration of the commitment, such a contract is not recognised as a derivative financial instrument under this Standard.

32.The trade date is the date that an enterprise commits to purchase or sell an asset. Trade date accounting refers to (a) the recognition of an asset to be received and the liability to pay for it on the trade date and (b) the derecognition of an asset that is sold and the recognition of a receivable from the buyer for payment on the trade date.  Generally, interest does not start to accrue on the asset and corresponding liability until the settlement date when title passes.

33.The settlement date is the date that an asset is delivered to or by an enterprise.  Settlement date accounting refers to (a) the recognition of an asset on the day it is transferred to an enterprise and (b) the derecognition of an asset on the day that it is transferred by the enterprise.  When settlement date accounting is applied, under paragraph 106 an enterprise will account for any change in the fair value of the asset to be received during the period between the trade date and the settlement date in the same way as it will account for the acquired asset under this Standard.  That is, the value change is not recognised for assets carried at cost or amortised cost; it is recognised in net profit or loss for assets classified as trading; and it is recognised in net profit or loss or in equity (as appropriate under paragraph 103) for assets classified as available for sale.

34.The following example illustrates the application of paragraphs 30-33 and later parts of this Standard that specify measurement and recognition of changes in fair values for various types of financial assets.  On 29 December 20x1, an enterprise commits to purchase a financial asset for 1,000 (including transaction costs), which is its fair value on commitment (trade) date.  On 31 December 20x1 (financial year end) and on 4 January 20x2 (settlement date) the fair value of the asset is 1,002 and 1,003, respectively.  The amounts to be recorded for the asset will depend on how it is classified and whether trade date or settlement date accounting is used, as shown in the two tables below:

Settlement Date Accounting
Balances	Held-to- Maturity Investments - Carried at Amortised Cost	Available-for- Sale Assets - Remeasured to Fair Value with Changes in Equity	Assets Held for Trading and Available-for- Sale Assets - Remeasured to Fair Value with Changes in Profit or Loss
29 December 20x1 Financial asset Liability	-- --	-- --	-- --
31 December 20x1 Receivable Financial asset   Liability   Equity (fair   value adjustment) Retained earnings (through net profit or loss)	-- -- -- -- --	2 -- -- (2) --	2 -- -- -- (2)
4 January 20x2 Receivable Financial asset Liability Equity (fair value adjustment) Retained earnings (through net profit or loss)	-- 1,000 -- -- --	-- 1,003 -- -- --	-- 1,003 -- -- (3)

Trade Date Accounting
Balances	Held-to- Maturity Investments - Carried at Amortised Cost	Available-for- Sale Assets - Remeasured to Fair Value with Changes in Equity	Assets Held for Trading and Available-for- Sale Assets - Remeasured to Fair Value with Changes in Profit or Loss
29 December 20x1 Financial asset Liability	1,000 (1000)	1,000 (1000)	1,000 (1000)
31 December 20x1 Receivable Financial asset Liability Equity (fair   value adjustment) Retained earnings (through net profit or loss)	-- 1,000 (1,000) -- --	-- 1,002 (1,000) (2) --	-- 1,002 (1,000) -- (2)
4 January 20x2 Receivable Financial asset Liability Equity (fair   value adjustment) Retained earnings (through net profit or loss)	-- 1,000 -- -- --	-- 1,003 -- (3) --	-- 1,003 -- -- --

More on Exposure Draft 55