Financial Instruments under IFRS in the UK PwC

PricewaterhouseCoopers Overview of Session 1. Introduction and scope 2. Classification and measurement 3. Embedded derivatives 4. Hedge Accounting 5. Debt vs Equity 6. Derecognition 7. First time adoption in the UK 8. Summary

PricewaterhouseCoopers Introduction & scope Recognition, Classification & Measurement Embedded derivatives Hedge Accounting Debt vs Equity DerecognitionFirst time adoption in the UK Summary

PricewaterhouseCoopers Why IAS 32 & 39? ?

PricewaterhouseCoopers Scope - the good news Excludes:  Insurance contracts (IFRS 4)  Loan commitments - except those at FVTPL  Own use commodity contracts - net settlement  Employee benefits (IAS 19)  Share based payments (IFRS 2)  Leases – almost (IAS 17)  Own equity instruments  Financial guarantee contracts & weather derivatives (if specific  IFRS 4)

PricewaterhouseCoopers Scope Includes:  Financial guarantee contracts & weather derivatives (if not specific)  Derivatives (standalone & embedded)  Debt and equity investments  Loans and receivables  Own issued debt

PricewaterhouseCoopers Recognition, classification and measurement Introduction & scope Recognition, Classification & Measurement Embedded derivatives Hedge Accounting Debt vs Equity DerecognitionFirst time adoption in the UK Summary

PricewaterhouseCoopers Overview Recognition Classification Measurement Fair value Impairment

PricewaterhouseCoopers Initial recognition A financial instrument is any contract that gives rise to a financial asset of one entity and a financial liability or equity instrument of another entity. Financial assets and financial liabilities are, generally recognised on the balance sheet only when the entity becomes a party to the contractual provisions of the instrument.

PricewaterhouseCoopers Initial recognition Should it be recognised ? Unconditional receivables Forward contract to buy US$ in 60 days An option contract to sell a building for $1m on 31/12/2005 (not net settled) Firm commitment to buy goods (ie when an entity place an order) Planned future transactions Yes No Yes No

PricewaterhouseCoopers Classification – Financial Assets (Four categories) 1. Financial assets at fair value through profit or loss 2. Loans and receivables 3. Held to maturity 4. Available for sale

PricewaterhouseCoopers Classification – Financial Assets (Four categories) At fair value through profit or loss Held for trading Designated at inception Intention of short term profit; Derivatives – unless if hedges No restrictions on designation; Irrevocable – cannot be moved

PricewaterhouseCoopers Classification – Financial Assets (Four categories) Loans and receivables Non-derivative financial assets. Fixed or determinable payments. Not quoted. No intention of trading.

PricewaterhouseCoopers Classification – Financial Assets (Four categories) Held to maturity Non-derivative financial assets. Fixed or determinable payments & fixed maturity. No intention of trading & intention and ability to hold to maturity.

PricewaterhouseCoopers Held to maturity - tainting HTM portfolio is tainted if management sold or reclassified as AFS, before maturity, during the current or two preceding years more than an insignificant amount of HTM assets (Vs total HTM category) There are three exceptions to the rule: The sale is close to maturity; Collected substantially all of original principal through schedule payments; Isolated event beyond entity’s control may not invoke tainting.

PricewaterhouseCoopers Classification – Financial Assets (Four categories) Available for sale All equity securities not classified in FVTPL category. All financial assets not in another category.  Any financial assets other than those held for trading may be designated to this category at inception

PricewaterhouseCoopers Classification – Financial Liabilities(Two categories) 1. At fair value through profit or loss Held for trading Designated at inception Intention of short term profit; Derivatives – unless if hedges No restrictions on designation; Irrevocable – cannot be moved 2. Other financial liabilities

Why is classification important? Because it drives measurement…

PricewaterhouseCoopers Subsequent measurement Assets/Liabilities at fair value through profit or loss Held to maturity Available for sale Loans and receivables Other liabilities At FV through profit or loss At amortised cost At FV through equity

So … how shall we value derivatives? At fair value…

PricewaterhouseCoopers Fair Value Hierarchy Active market – Published quotations Best evidence

PricewaterhouseCoopers Fair Value Hierarchy Active market – Published quotations No active market – Valuation Techniques Best evidence Alternative

PricewaterhouseCoopers Fair Value Hierarchy Active market – Published quotations No active market – Valuation Techniques No active market - Equity investments only  Cost less impairment Best evidence Alternative Very rare

PricewaterhouseCoopers Impairment  Step 1 – Objective evidence of impairment  Step 2 – Calculate recoverable amount/fair value  Step 3 – Record impairment in profit & loss

PricewaterhouseCoopers Impairment – loans Objective evidence Significant financial difficulty of the issuer High probability of bankruptcy Granting of a concession to the borrower Adverse change in payment status or factor (eg unemployment) Breach of contract, such as default or delinquency in interest or principal Disappearance of an active market because of financial difficulties And what about equities?

PricewaterhouseCoopers Impairment – equities Objective evidence Adverse effect in the technological, market, economic or legal environment Significant or prolonged decline in the FV of an investment below its cost

PricewaterhouseCoopers Embedded derivatives Introduction & scope Recognition, Classification & Measurement Embedded derivatives Hedge Accounting Debt vs Equity DerecognitionFirst time adoption in the UK Summary

PricewaterhouseCoopers Overview embedded derivatives What are they? Where are they? Do you need to separate? How do you value them?

PricewaterhouseCoopers Definition of derivative Value changes in response to an underlying Requires little or no net investment Settled at a future date

PricewaterhouseCoopers Example embedded derivatives Financial instruments convertible bonds, exchangeable bonds Non-financial instrument contracts Leases Insurance contracts Sale and purchase contracts

PricewaterhouseCoopers Decision tree Is the contract carried at fair value through earnings? Would it be a derivative if it was freestanding? Is it closely related to the host contract? No Yes No Yes Do not split out the embedded derivative Split and separately account No

PricewaterhouseCoopers Closely related or not? Closely related Interest rate swap embedded in a debt instrument Inflation indexed lease contracts Cap and floor in a sale and purchase contract Prepayment option in a mortgage that does result in the exercise amount approximately equal to amortised cost Not closely related Equity conversion or put option in debt instrument Fixed rate debt extension option Debt security with interest or principal linked to a stock or commodity index Credit derivatives embedded in a host debt instrument

PricewaterhouseCoopers FX embedded derivatives Not closely related Sales or purchases not in functional currency of either party Not in currency in which products are routinely denominated in international commerce (eg crude oil in USD) Guarantees not denominated in currency of guaranteed loan Closely related Normal purchases and sales Dual currency bonds Foreign currency denominated debt Currency that is commonly used in purchase and sale contracts in the economic environment in which the transaction takes place

PricewaterhouseCoopers Valuation Initial recognition Zero fair value – non-optional derivatives Value using contractual criteria – optional derivatives Subsequently Based on underlying cash flows All fair value changes to profit and loss If all else fails, value hybrid instrument as a whole

PricewaterhouseCoopers Hedge accounting Introduction & scope Recognition, Classification & Measurement Embedded derivatives Hedge Accounting Debt vs Equity DerecognitionFirst time adoption in the UK Summary

PricewaterhouseCoopers Overview of the session Review of key concepts When can the right to hedge accounting be earned? Hedging instruments and hedged items Different types of hedges and how to account for them Discontinued hedge accounting Summary

PricewaterhouseCoopers Criteria for hedge accounting FORMAL DESIGNATION Reliable measurement of effectiveness The hedge is expected to be and is highly effective formal hedge documentation + risk management policy

PricewaterhouseCoopers Effectiveness testing THE HEDGE IS EXPECTED TO BE AND HAS BEEN HIGHLY EFFECTIVE PROSPECTIVE TEST ( highly effective ) RETROSPECTIVE TEST ([80-125%]) AND AT EACH REPORTING DATE AT INCEPTION X X X

PricewaterhouseCoopers What you can hedge Highly probable forecast transaction FIRM COMMITMENT ASSET LIABILITY Net investment in foreign operations Single item Group of similar items (sharing the same risk) Proportions of an item

PricewaterhouseCoopers What you can hedge GROUP OF SIMILAR ITEMS +11% -4%-10%+43% +10% +9%+11%+10% OK

PricewaterhouseCoopers What you can’t hedge DERIVATIVE INSTRUMENTS HTM ASSETS (for interest rate and prepayment risks) SHARES OWN FUTURE PROFIT STREAMS NET POSITION (e.g. group of forecast sales and purchases in foreign currency) Portions of risks of non-financial assets and liabilities (except for FX risk)

PricewaterhouseCoopers What can you hedge with YesBut not… Derivatives (including embedded derivatives) Written options Non-derivatives for FX risk Non-derivatives for other risks Proportions of derivatives Portions of derivatives x x x

PricewaterhouseCoopers Different types of hedges Fair Value Foreign Exchange Cash Flow Fixed rate assets/liabilities Assets/liabilities in foreign currencies Firm commitments Variable rate assets/liabilities Highly probable forecast transactions Net investments in foreign operations

PricewaterhouseCoopers Fair value hedge A hedge of the exposure to changes in the fair value of a recognised asset or liability or a firm commitment or an identified portion of such an asset or liability or firm commitment that is attributable to a particular risk and that could affect profit or loss

PricewaterhouseCoopers Accounting for a fair value hedge PROFIT OR LOSS CHANGES IN FAIR VALUE OF THE HEDGING DERIVATIVE CHANGES IN FAIR VALUE OF THE HEDGED INSTRUMENT ATTRIBUTABLE TO THE HEDGED RISK PROFIT OR LOSS INEFFECTIVENESS (if any)

PricewaterhouseCoopers Hedged Item30 Derivative(30)(30) P&L(30)300 Period Period 12 Total Fair value hedge

PricewaterhouseCoopers On 30/6/03 XYZ Company issued £10 million fixed 7.5% rate debt due in 3 years with semi-annual interest payments. XYZ Company enters into an interest rate swap with the bank to pay LIBOR and receive fixed 7.5% annually for 3 years LIBOR is set at 6% on 5 July 2003 for the first 12 months The fair value of the swap is £200,000 before cash settlement at 31/12/03 Fair value hedge example XYZ Company Bank Floating Interest Fixed interest Principal Amount Fixed Rate Debt

PricewaterhouseCoopers Fair value hedge example The journal entries would look as follows at 31/12/03: Interest expense 125 FV adjustment on debt 125 Adjust carrying amount of debt Derivative asset 75 Cash 75 Cash settle swap Interest expense 375 Cash 375 Pay interest on the debt Interest expense 200 Derivative asset 200 Fair value swap CrDrCrDrCrDr EquityIncome StatementBalance SheetTransaction

PricewaterhouseCoopers Cash flow hedge A hedge of the exposure to variability in cash flows that is attributable to a particular risk associated with a recognised asset or liability or a forecast transaction and that could affect profit or loss.

PricewaterhouseCoopers Accounting for a cash flow hedge Effective portion Ineffective portion EQUITY PROFIT OR LOSS CHANGES IN FAIR VALUE OF THE HEDGING INSTRUMENT ATTRIBUTABLE TO THE HEDGED RISK

PricewaterhouseCoopers Hedged Item3030 Derivative(30) (30) P&L Period Period 12 Total Cash flow hedge (30) (30) Cash flow hedge

PricewaterhouseCoopers Cash flow hedge example On 30/9/03 a UK company (functional currency : £) expects to buy equipment for US$ 1m. The delivery date should be 31/3/04 and the payment date of 30/6/04. The company enters into a forward exchange contract to purchase US$ 1m at a fixed exchange rate, in order to hedge the foreign exchange risk. The forward contract is designated as a cash flow hedge of the exchange risk of the forecast transaction.

PricewaterhouseCoopers Cash flow hedge example continued Applicable exchange rates are as follows: DateSpotForward 30/9/ /12/ /3/ /6/041.26N/A FV of FX contract on 31/12/03 and 31/3/04 as determined from market quotes is 9,500 and 19,700 respectively. At 30/6/04 the FV is 30,000 the net amount that is due to be settled at that date.

PricewaterhouseCoopers Cash flow hedge example 31/12/03 TransactionBalance SheetIncome Statement Equity DrCrDrCrDrCr Recognise gain in FV of forward since30/9/03 Forward asset 9,500 Hedging reserve 9,500

PricewaterhouseCoopers Cash flow hedge example 31/03/04 TransactionBalance SheetIncome Statement Equity DrCrDrCrDrCr Recognise receipt of equipment at spot Recognise gain on fv of forward since 31/12 Gains deferred in equity are included in the assets Equipment Asset 1,250,000 Payables 1,250,000 Forward asset 10,200 Hedging reserve 10,200 Equipment Asset 19,700 Hedging reserve 19,700

PricewaterhouseCoopers Cash flow hedge example 30/06/04 TransactionBalance Sheet Income Statement Equity DrCrDrCrDrCr Payment for equipment at spot rate and exchange loss on the payable since 31/3 Gain on forward contract for the period Net settlement under forward contract Payable 1,250,000 FX loss 10,000 Cash 1,260,000 Forward asset 10,300 FX gain 10,300 Cash 30,000 Forward Asset 30,000

PricewaterhouseCoopers Discontinuance THE HEDGING INSTRUMENT EXPIRES, IS SOLD, TERMINATED OR EXERCISED REVOCATION OF THE DESIGNATION (management’s decision) PROSPECTIVE DISCONTINUANCE OF HEDGE ACCOUNTING CRITERIA FOR HEDGE ACCOUNTING ARE NO LONGER MET (documentation, effectiveness testing…)

PricewaterhouseCoopers Discontinuance FAIR VALUE HEDGE CASH FLOW HEDGE GAINS AND LOSSES ACCUMULATED IN EQUITY REMAIN IN EQUITY UNTIL THE DISPOSAL OF THE FOREIGN OPERATION GAINS AND LOSSES ACCUMULATED IN EQUITY REMAIN IN EQUITY UNTIL THE HEDGED ITEM WILL IMPACT PROFIT OR LOSS EXCEPT IF THE FORECAST TRANSACTION NO LONGER EXPECTED TO OCCUR IF THE HEDGED ITEM IS A FINANCIAL INSTRUMENT MEASURED AT AMORTISED COST, AMORTISATION OF ANY ADJUSTMENT OF ITS CARRYING AMOUNT NET INVET. HEDGE

PricewaterhouseCoopers Debt vs equity Introduction & scope Recognition, Classification & Measurement Embedded derivatives Hedge Accounting Debt vs Equity DerecognitionFirst time adoption in the UK Summary

PricewaterhouseCoopers Overview Debt vs Equity Review of key definitions Identifying substance Derivatives on own shares Compound instruments Accounting

PricewaterhouseCoopers Debt vs Equity Definitions Assets =- LiabilitiesEquity

PricewaterhouseCoopers Features of liabilities Obligation to pay cash Mandatory redemption Puttable NAV Only a conditional right to avoid Indirect obligation Settled in a variable number of shares Contingent settlement provisions

PricewaterhouseCoopers Features of Equity Discretion over cash payments (i.e. no obligation) Fixed amount of cash for a fixed amount of shares Not dependent on: -Ability to make distributions -Intention to make distributions -Negative impact on ordinary shares -Amount of issuer’s reserves -Expectation of profits for the period

PricewaterhouseCoopers Compound instruments Convertible Debt Liability:Fair value using rate for non- convertible debt Equity:Balancing figure Total consideration +

PricewaterhouseCoopers Accounting treatment Income statement treatment follows balance sheet classification Interest, dividends, gains and losses relating to financial liabilities should be reported in the income statement as expenses or income. Distributions relating to an equity instrument should be debited directly to equity.

PricewaterhouseCoopers Derecognition Introduction & scope Recognition, Classification & Measurement Embedded derivatives Hedge Accounting Debt vs Equity Derecognition First time adoption in the UK Summary

PricewaterhouseCoopers When should financial assets be de- recognised? Portfolio of trade debtors for £1000 with expected impairment of £200 i.e. carrying value of £800 Entity will collect the receivables & pass cash collected only immediately to bank Bank gives the entity £750 non-refundable Neither the entity nor the bank can sell/transfer the debtors without the other’s consent

PricewaterhouseCoopers Derecognition Flow-chart Consolidation Part or entire asset Derecognition Rights to cash flows expired? Rights to cash flows transferred? Pass through arrangement? Substantially all risks and rewards transferred? Substantially all risks and rewards retained? Control retained? Continuing involvement No derecognition Derecognition No derecognition Derecognition YES NO

PricewaterhouseCoopers Consolidation Part or entire asset Derecognition Rights to cash flows expired? Rights to cash flows transferred? Pass through arrangement? Substantially all risks and rewards transferred? Substantially all risks and rewards retained? Control retained? Continuing involvement No derecognition Derecognition No derecognition Derecognition YES NO Consolidate all subsidiaries (including any SPEs)

PricewaterhouseCoopers Consolidation Part or entire asset Derecognition Rights to cash flows expired? Rights to cash flows transferred? Pass through arrangement? Substantially all risks and rewards transferred? Substantially all risks and rewards retained? Control retained? Continuing involvement No derecognition Derecognition No derecognition Derecognition YES NO Determine whether the flowchart should be applied to a part or all of an asset (or group of similar assets)

PricewaterhouseCoopers Consolidation Part or entire asset Derecognition Rights to cash flows expired? Rights to cash flows transferred? Pass through arrangement? Substantially all risks and rewards transferred? Substantially all risks and rewards retained? Control retained? Continuing involvement No derecognition Derecognition No derecognition Derecognition YES NO Have the rights to the cash flows from the asset expired?

PricewaterhouseCoopers Consolidation Part or entire asset Derecognition Rights to cash flows expired? Rights to cash flows transferred? Pass through arrangement? Substantially all risks and rewards transferred? Substantially all risks and rewards retained? Control retained? Continuing involvement No derecognition Derecognition No derecognition Derecognition YES NO Has the entity transferred its rights to receive the cash flows from the asset?

PricewaterhouseCoopers Consolidation Part or entire asset Derecognition Rights to cash flows expired? Rights to cash flows transferred? Pass through arrangement? Substantially all risks and rewards transferred? Substantially all risks and rewards retained? Control retained? Continuing involvement No derecognition Derecognition No derecognition Derecognition YES NO Has the entity assumed an obligation to pay the cash flows from the asset?

PricewaterhouseCoopers Consolidation Part or entire asset Derecognition Rights to cash flows expired? Rights to cash flows transferred? Pass through arrangement? Substantially all risks and rewards transferred? Substantially all risks and rewards retained? Control retained? Continuing involvement No derecognition Derecognition No derecognition Derecognition YES NO Has the entity transferred substantially all risks and rewards?

PricewaterhouseCoopers Consolidation Part or entire asset Derecognition Rights to cash flows expired? Rights to cash flows transferred? Pass through arrangement? Substantially all risks and rewards transferred? Substantially all risks and rewards retained? Control retained? Continuing involvement No derecognition Derecognition No derecognition Derecognition YES NO Has the entity retained substantially all risks and rewards?

PricewaterhouseCoopers Consolidation Part or entire asset Derecognition Rights to cash flows expired? Rights to cash flows transferred? Pass through arrangement? Substantially all risks and rewards transferred? Substantially all risks and rewards retained? Control retained? Continuing involvement No derecognition Derecognition No derecognition Derecognition YES NO Has the entity retained control of the asset?

PricewaterhouseCoopers Control Entity has transferred control if: Transferee has the practical ability to sell the asset in its entirety (e.g. asset is traded in an active market) Transferee is able to exercise ability unilaterally No further restrictions imposed on sale (e.g. conditions about a loan asset is serviced)

PricewaterhouseCoopers Consolidation Part or entire asset Derecognition Rights to cash flows expired? Rights to cash flows transferred? Pass through arrangement? Substantially all risks and rewards transferred? Substantially all risks and rewards retained? Control retained? Continuing involvement No derecognition Derecognition No derecognition Derecognition YES NO Continuing involvement

PricewaterhouseCoopers Derecognition of non-financial assets and liabilities IAS 17 – Leases IFRIC D3 - Determining whether an arrangement contains a lease IAS 18 - Revenue

PricewaterhouseCoopers First time adoption in the UK Introduction & scope Recognition, Classification & Measurement Embedded derivatives Hedge Accounting Debt vs Equity Derecognition First time adoption in the UK Summary

PricewaterhouseCoopers The EU IAS 39 carve-out Removal of fair value option for financial liabilities Relaxation of certain hedging requirements

PricewaterhouseCoopers Financial instruments exemption (IAS 32, 39) Entities applying IFRS in 2005 can choose not to restate comparatives in accordance with IAS 32 and IAS 39. Disapply both standards. Apply UK GAAP to comparative period. Disclosures required about adoption of IAS 32 and IAS 39: Basis of preparation of comparatives. Nature of main adjustments to make information comply with IAS 32 and IAS 39. Amount of adjustment at end of comparative period to each line item and to EPS.

PricewaterhouseCoopers Financial instruments fair value exemption (IAS 39) IAS 39 allows a financial asset or financial liability to be designated on initial recognition at fair value through profit or loss. Designation must be made on initial recognition, and cannot be changed. Exemption allows designation to be made at the date IAS 39 is adopted. BUT : EU Carve Out !

PricewaterhouseCoopers IFRS 1: hedging No retrospective designation of hedges. Fair value all derivatives and eliminate deferred gains/losses. If hedge under UK GAAP is of a type that qualifies under IAS 39: Make adjustments as if hedge accounting had taken place under IAS 39 before date of adoption of IAS 39. If hedge accounting criteria are not apply discontinuance rules If hedge accounting criteria are met, hedge account under IAS 39 from date of adoption of IAS 39.

PricewaterhouseCoopers IFRS 1: hedging - example Forward contract taken out when a sale is budgeted to hedge the foreign currency exposure on the cash flow from the debtor. Adoption of IAS 39 happens before the sale occurs. Under UK GAAP nothing has been recorded. IFRS Cash flow hedge. Fair value forward contract. Hedging reserve

PricewaterhouseCoopers Hedging on transition: areas to watch out for On-balance sheet Assets and liabilities recorded at a forward or contracted rate Debtors and creditors, inventory Accrual accounting for interest rate swaps Off-balance sheet Cross-currency swaps

PricewaterhouseCoopers UK versions of IAS 32 and 39 FRS 25 : Financial instruments - disclosure and presentation Will apply to all companies except FRSSE from 1 Jan 05, but if not applying FRS 26, certain disclosures are not required FRS 26 : Financial instruments - measurement Will apply to listed entities from 1 Jan 05 and those that will apply the Fair Value accounting rules - per the Directive - from 1 Jan 06

PricewaterhouseCoopers Summary Introduction & scope Recognition, Classification & Measurement Embedded derivatives Hedge Accounting Debt vs Equity Derecognition First time adoption in the UK Summary

PricewaterhouseCoopers Proposed amendments to IAS 32 and IAS 39 Limiting the use of the fair value option Financial guarantee contracts and credit insurance Cash flow hedge accounting of forecast intra group transactions Transition and initial recognition of financial assets and liabilities ED 7 - Financial instrument disclosures IFRIC D8 – Members’ shares in co-operative entities Similar ASB proposals for the UK

PricewaterhouseCoopers Top 10 Financial Instrument Reminders 1. Classification drives measurement 2. All derivatives at fair value 3. Quoted prices best evidence of fair value 4. Impairment only if objective evidence 5. Embedded derivatives are everywhere 6. Not every embedded derivative is accounted for separately 7. Hedging is a privilege not a right 8. Ineffectiveness goes to the income statement 9. Contingent settlement is debt 10. Don’t panic!

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