Derivatives on own shares and compound financial instruments
The accounting for derivatives on own shares and compound financial instruments has changed.
Derivatives on own shares
The classification of derivatives on own shares under IAS 32 now depends on the type of derivative and method of settlement. A derivative on own shares may be accounted for as a derivative instrument, a non-derivative financial liability or an equity instrument.
The table below summarises the accounting treatment for each instrument.
Compound instruments
The table below also applies to entities that have compound instruments that contain derivatives on own shares. Each component of a compound instrument must be separately classified and presented in the balance sheet.
| Derivative contract | No settlement option | Settlement options | |
|---|---|---|---|
| Gross physical settlement1 | Settlement either net in cash or net in shares | ||
| Forward contract to buy | Financial liability | Derivative | Financial liability (if one of the settlement alternatives is gross physical settlement). Otherwise, derivative |
| Forward contract to sell | Equity | Derivative | Derivative |
| Purchased call | Equity | Derivative | Derivative |
| Written call | Equity | Derivative | Derivative |
| Purchased put | Equity | Derivative | Derivative |
| Written put | Financial liability | Derivative | Financial liability (if one of the settlement alternatives is gross physical settlement). Otherwise, derivative |
Existing IFRS preparers should review their accounting for derivatives on own shares and compound instruments. The accounting treatment may have changed.
For example, an entity that has issued a bond convertible in its own shares may include a conversion feature (in substance, a derivative on own shares) giving one party a choice of settlement. In this case, the conversion feature will be accounted for as a derivative.
Accounting for changes in fair value of AFS investments
AFS investments must be carried at fair value. Changes in fair value of these investments can be classified either in equity or in profit or loss under current
IAS 39. The revised standard requires the classification of such gains and losses in equity. Existing IFRS preparers that had chosen to classify changes in fair value of AFS investments in profit or loss should reclassify such gains and losses in a separate component of equity and adjust the opening balance of retained earning accordingly. Alternatively, these investments could be reclassified as financial assets at fair value through profit or loss to keep the same accounting policies as under current IAS 39.
Example
An entity acquires equity instruments in 2004 that have been classified as available for sale. The acquisition price is €100,000 (including transaction costs). The entity’s accounting policies require the classification of changes in fair value of AFS investments in profit or loss. The fair value of these equity instruments at the balance sheet date (31 December 2004) is €130,000.
| AFS invest | 130 | Capital | 100 |
| Retained earnings | 30 | ||
| Cash | 0 |
| AFS invest | 130 | Capital | 100 |
| Retained earnings | 0 | ||
| Cash | 0 | Fair value reserve | 30 |
| Debit | Credit | |
| Retained earnings | 30 | |
| Fair value reserve (in equity) | 30 |
Objective evidence of impairment of equity instruments
A significant or prolonged decline in the fair value of an equity instrument is now evidence of impairment. The standard does not give quantitative guidance on ‘significant or prolonged’. Existing IFRS preparers should perform impairment tests on AFS equity instruments. Impairment losses that have to be recognised at the transition date should be adjusted through opening retained earnings. However, any subsequent losses will go to the income statement.
Example
An entity holds shares of a listed company that have been classified as AFS investments (at fair value through equity). These shares were acquired in 2001 for €5m (including transaction costs). At 1 January 2002, 2003 and 2004, the fair values of these shares are €4m, €3.5m and €2m respectively. No impairment loss has been recognised, as the decrease in fair value of these investments has been attributable to a general decrease in market prices. There is objective evidence of impairment under IAS 39R, as there has been a significant or prolonged decline in the fair value of those shares. An impairment loss should be recognised.
| AFS invest | 2 | Capital | 5 |
| Retained earnings | – | ||
| Cash | 0 | Fair value reserve | (3) |
| AFS invest | 2 | Capital | 5 |
| Retained earnings | (3) | ||
| Cash | 0 |
| Debit | Credit | |
| Retained earnings | 3 | |
| Fair value reserve | 3 |
Derecognition of financial assets
Derecognition is now initially assessed based on the transfer of substantially all risks and rewards of the financial asset. Control is applied as a secondary test.
The new derecognition requirements are applied prospectively from 1 January 2004. Management may choose to apply the new rules from an earlier date if the information needed to make the assessment existed at that time. Existing IFRS preparers should revisit all derecognition transactions that occurred after 1 January 2004 (or an earlier date, if they have chosen to do so).
Entities may have entered into an agreement in which financial assets are transferred on a regular basis (revolving arrangements). Entities are required to assess actual transfers under the revolving agreement that occurred on or after 1 January 2004 to determine whether they qualify for derecognition under the revised standard.
Example
An entity entered into an agreement in 2003 with a bank in which the entity is required to sell receivables on a monthly basis. The entity loses control of the transferred receivables under the agreement but retains substantially all the risks and rewards. Under current IAS 39, receivables have been derecognised in 2003, 2004 and 2005, as the entity has lost control. Under IAS 39R, the receivables cannot be derecognised, as the entity has retained substantially all the risks and rewards. On 1 January 2004, the entity is required to recognise the receivables derecognised in 2004 and in 2005, but not those derecognised in 2003.
Hedge accounting
Cash flow hedge – basis adjustment
The revised standard prohibits the adjustment of the carrying amount of financial assets or liabilities that result from hedged forecast transactions to be adjusted when they are recognised in the balance sheet. This treatment is permitted if the asset or the liability is a non-financial asset or liability.
Existing IFRS preparers are not required to adjust the carrying amount of non-financial assets and liabilities to exclude gains and losses related to cash flow hedges that were included in the carrying amount before the beginning of the financial period in which IAS 39R is first applied.
Effectiveness testing
Hedge accounting can be applied only if the hedge relationship is expected to be, and is, highly effective in offsetting changes in fair value or cash flows. To be consistent with US GAAP, IAS 39R permits the same range of 80-125% effectiveness to be applied for both prospective and retrospective effectiveness-testing.
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1 Assuming the settlement is made by exchanging a fixed amount of cash for a fixed number of the entity’s own shares.