IAS 32 and IAS 39 Revised - Part 1: Practical Implications
IAS 32 and IAS 39, two of the most high profile of the regulations introduced in the new International Financial Reporting Standards, were revised in December 2003 and March 2004. The second revision incorporated new requirements on fair value hedge accounting for a portfolio hedge of interest rate risk. Other exposure drafts amending IAS 39 are expected, in particular an exposure draft (ED) on the ‘fair value option’ and an ED on financial guarantees and credit insurance.
Entities are required to apply the amended standards retrospectively unless it is impractical to restate the information. There are certain exceptions to retrospective application specified in IAS 32 and 39. Transition adjustments should be classified in the opening balance of retained earnings for the earliest period presented.
Example
An existing IFRS preparer with a 31 December year-end provides one-year comparatives in its financial statements. The company decides not to early adopt IAS 32 and IAS 39. See the timeline below.
The revisions to IAS 39 in December 2003 have a significant impact on energy, utility and commodity contracts. New guidance has been provided relating to the application of the own-use exemption (‘normal purchase and sales’) and the accounting treatment for contracts with volume flexibility.
The revisions clarify the various ways in which a contract to buy or sell a non-financial item can be settled net in cash. The new guidance identifies certain activities that do not qualify for the own-use exemption and must be accounted for under the mark-to-market method of accounting. The new guidance is applied to contracts that are ‘similar’. Companies that utilise a uniform contract for trading and procurement activities will need to identify a method to distinguish the contracts in order to achieve the own-use exemption. Companies must review the scope, scale and structures of their activities to ensure the appropriate method of accounting (mark-to-market versus own-use) is utilised for contracts now caught by the standard.
The revised standard prohibits the application of the own-use exemption to a written option to buy or sell a commodity that can be settled net or that is readily convertible to cash. A commodity contract that includes volume flexibility related to the quantity of the commodity delivered under the contract needs to be considered in the light of this guidance. An assessment will need to be completed to determine whether the contract volume flexibility has the characteristics of a requirements (forward) contract versus a written option (i.e. contains a premium paid at the inception or through the life of the contract). The results of this determination will have a significant impact on the volatility of a company’s financial statements.
IAS 39 requires entities to classify all financial assets (and financial liabilities), except derivatives, into one of four (two) categories when they are first recognised in the balance sheet. Derivatives are designated as hedging instruments. Certain categories of financial assets and financial liabilities have been modified by IAS 39, as shown in the table below.
| Categorisation of financial assets and financial liabilities | |
|---|---|
| Current IAS 39 | IAS 39 revised |
| Financial assets and liabilities held for trading | Financial assets and liabilities at fair value through profit of loss:
|
| Loans and receivables originated by the entity | Loans and receivables |
| Financial assets held to maturity | Financial assets held to maturity |
| Financial assets available for sale | Financial assets available for sale |
| Other financial liabilities | Other financial liabilities |
Financial assets and liabilities at fair value through profit or loss
IAS 39 allows the classification of any financial asset or financial liability as at fair value through profit or loss, even if it is not held for trading. This permits a natural offset of gains and losses on assets with gains and losses on liabilities.
Example
An entity holds an investment in a listed entity with no intent to sell it in the short term. It enters into a derivative instrument to hedge the price risk arising from its investment. This investment is classified as available for sale (AFS) under current IAS 39. To reduce the volatility of its income statement, the company must apply fair value hedge accounting if its accounting policies require the recognition in equity of changes in fair value of AFS investments. The investment can be designated as at fair through profit or loss under IAS 39. Any financial asset or financial liability may be designated as AFS investments.
Such classifications can be made when IAS 39 is first applied. Existing IFRS preparers are allowed to revisit the current classification of all financial assets or liabilities and reclassify some of them as fair value through profit or loss or as available for sale.
The category ‘loans and receivables originated by the entity’ has been removed and replaced with ‘loans and receivables’. This includes non-derivative financial assets with fixed or determinable payments that are not quoted in an active market and that are not classified as at fair value through profit or loss. Existing IFRS preparers should reclassify financial assets that do not meet the definition of loans and receivables in ‘loans and receivables originated by the entity’. For example, debt securities, such as bonds acquired at original issuance date in an active market, can be classified as loans and receivables originated by the entity; they cannot be classified as loans and receivables, as they are quoted in an active market.
Foreign exchange derivatives embedded in contracts to sell or buy non-financial assets are now deemed closely related to the host contract if the hybrid contract is denominated in a currency that is commonly used in contracts to sell or buy non-financial assets in the economic environment in which the transaction takes place. This criterion does not exist in current IAS 39.
Embedded derivatives that have been accounted for separately under current IAS 39 could be reclassified to retained earnings if they are considered to be closely related to their host contracts under IAS 39 revised.
Example
A UK company (functional currency: UK pounds) has entered into a contract to purchase a fixed quantity of electronic spare parts for a fixed price with a Chinese supplier (functional currency: Chinese yuan). Payments will be denominated in US dollars. Under current IAS 39, the contract contains a foreign exchange derivative and must be accounted for separately if (1) the payments are denominated in a currency that is not the functional currency of one of the substantial party to the contract, and (2) the electronic spare parts are not traded around the world in US dollars. Under IAS 39 revised, such a derivative is closely related to the host contract, as the US dollar is likely to be a currency commonly used in contracts to sell or to buy non-financial assets in China. It does not have to be bifurcated.