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ASSURANCE & ADVISORY
IAS 39Financial Instruments : Recognition and Measurement
John Kidd
Partner
Financial Services Group
2
ASSURANCE & ADVISORY
Foreign Currency Transaction - Example
• 2 Jan 2004, Tinman Ltd expects to sell of 100 tonnes of Tin
• Receipt from sale = USD 550,000• Tinman hedges the foreign currency risk• Estimated Settlement Date = 10 April 2004 • Tinman enters into a forward foreign exchange contract
– sell USD 550,000– value date 10 April 2004– forward rate .60– spot rate at transaction date .61
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ASSURANCE & ADVISORY
Foreign Currency Transaction – Hedge Steps
1. Determine your functional currency2. Determine the type of hedge 3. Document, Document, Document
• Policy document supported by• Individual hedge documentation
4. Value the derivative5. Quantify the degree of ineffectiveness6. Prepare the journal entries
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ASSURANCE & ADVISORY
Impact on Hedging• Situation – Sales in USD, Cost in AUD
• Functional Currency – USD or AUD?
• Impact on hedging – Functional currency will determine source of foreign currency risk. Hence impacts your risk management approach
E.g. If FC = AUD - then hedge FX exposure on USD SalesIf FC = USD – then hedge FX exposure on AUD
Costs
• Functional Currency decision is subjective and the consequences of the decision must be considered re hedging impact
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ASSURANCE & ADVISORY
Factors re Functional Currency
Factors to consider re the Currency
– That mainly influences sales prices– Of the country whose competitive forces and
regulations – mainly determine the sales prices– That mainly influences labour, material and other
costs
When indicators are mixed and the functional currency is not obvious, management uses judgement to determine the functional currency that most faithfully represents the economic effects of the underlying transactions, events and conditions.
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ASSURANCE & ADVISORY
Foreign Currency Transaction – Hedge Steps
1. Determine your functional currency2. Determine the type of hedge 3. Document, Document, Document
• Policy document supported by• Individual hedge documentation
4. Value the derivative5. Quantify the degree of ineffectiveness6. Prepare the journal entries
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ASSURANCE & ADVISORY
Overview - Hedge Relationship– hedging instrument– hedged item
AND
– formal documentation of the hedging relationship– hedge is highly effective– any forecasted transactions (underlying) must be highly probable (Cash Flow
Hedges)– effectiveness can be reliably measured– effectiveness assessed on an on-going basis and shown to be effective
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ASSURANCE & ADVISORY
• Derivative• Must be designated in its entirety (IAS 39.74)
• Including embedded derivatives • "Proportion" is allowed (IAS 39.75)• not permitted for certain written options (IAS 39.77 & AG92)• time value can be excluded (IAS 39.74)• cannot split the derivative on a time basis (IAS 39.75)• combinations are permitted (IAS 39.77)• must be external to the group in consolidate accounts (IAS 39.73)
• Other financial instruments (IAS 39.72)• Foreign currency risk only• Entity’s own securities are not financial assets/liabilities
Overview – Hedging Instrument
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ASSURANCE & ADVISORY
• Recognised Asset • Recognised Liability• Unrecognised Firm Commitment• Highly Probable Forecast Transaction• Net Investment in a Foreign Operation
Overview - Hedged Item (1 of 2)
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ASSURANCE & ADVISORY
2/1/2004
Expected Sale
Enter into
sell USD
buy AUD
forward fx contract
Recognition Date
10/4/2004
Record Sale
Spot Rate plus gain/loss on fx contact
Record Receivable
Spot Rate
Settle the USD forward
Settle the USD receivable
Foreign Currency Transaction – Example, Sequence
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ASSURANCE & ADVISORY
Overview – Exposures
Net Net investmentinvestmentin a foreignin a foreign
entityentity
Net Net investmentinvestmentin a foreignin a foreign
entityentity
Cash flowCash flowCash flowCash flowFair Fair ValueValueFair Fair
ValueValue
Exposure ?Exposure ?
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ASSURANCE & ADVISORY
• Firm Commitment– Fixed volume– Fixed price– Fixed maturity date
Can be Fair Value or Cash Flow
• Highly probable forecast transaction
Always Cash Flow
Type of Hedge
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ASSURANCE & ADVISORY
Foreign Currency Transaction – Hedge Steps
1. Determine your functional currency2. Determine the type of hedge 3. Document, Document, Document
• Policy document supported by• Individual hedge documentation
4. Value the derivative5. Quantify the degree of ineffectiveness6. Prepare the journal entries
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ASSURANCE & ADVISORY
Example of Documentation
• Policy Document Summarises key aspects of IAS 39 for
your business / hedge arrangements
• Individual Hedge Documentation Documents hedge relationship for each
derivative
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ASSURANCE & ADVISORY
Hedge Documentation Checklist
• Identification of:• the hedging instrument • and the hedged item
• The nature of the risk being hedged• Type of Hedge• Time value included or excluded• The risk management strategy• The risk management objective• How effectiveness will be assessed• Effectiveness assessment
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ASSURANCE & ADVISORY
Nature of the Risk to be Hedged
• Commodity– FX Risk or– Overall Risk
• Financial Asset or Liability– Overall Risk– Credit Risk– Benchmark Interest Rate Risk– FX Risk
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ASSURANCE & ADVISORY
Strategy / Objective
Strategy• Board policy has set a strategy of hedging 100% of
firm commitments to minimise foreign currency risk
Objective• The objective of the hedge is to offset cash flows of
the hedged item from foreign exchange risk, such that when the hedge item and the hedge are combined the AUD cash flow associated with the purchase is fixed.
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ASSURANCE & ADVISORY
Assessing Effectiveness
• IAS 39 AG 105. • A hedge is highly effective if:
– Prospective– at inception and throughout the life of the hedge, the entity can expect changes in the fair value or cash
flows of the hedged item that are attributable to the hedged risk to be almost fully offset by the changes in the fair value or cash flows of the hedging instrument
– Retrospective– and actual results are within a range of 80%-125%
– For example, if actual results are such that the loss on the hedging instrument is CU 120 and the gain on the cash instrument is CU 100, offset can be measured by 120/100 which is 120%, or by 100/120 which is 83%. In this example, the entity would conclude that the hedge is highly effective.
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ASSURANCE & ADVISORY
Assessing Effectiveness: How?
• Regression analysis
• Ratio dollar offset (period-to-period or cumulative)
• Volatility Reduction Method
• Matched terms
• Treatment of time value
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ASSURANCE & ADVISORY
Ratio Dollar Offset
• Ratio of 80% to 125% considered highly effective
• Ratio = Change in FV of derivative Change in FV of hedged item
• Period-to-Period– Compare prices over distinct intervals (Q1 v. Q2)
• Cumulative– Compare prices at two different points in time (beginning of
hedge v. today)• Issues
– Small dollar changes– Point-in-time measurement– Non-statistical
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ASSURANCE & ADVISORY
Month ended
Derivative Gain (Loss) in Period
Hedge Item Gain (Loss) in Period
Period Change Ratio
Cumulative Change Ratio
Aug 2000 100 (95) 105% 105%
Sept 2000 30 (25) 120% 108%
Oct 2000 (10) 10 100% 109%
Nov 2000 (7) 10 70% 113%
Dec 2000 20 (5) 400% 127%
Example – Ratio Dollar Offset
• Entity has firm commitment to purchase copper in January 2006
• Use derivative to hedge against price risk
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ASSURANCE & ADVISORY
Matched Terms Method• If critical terms of the hedging instrument and of the entire
hedged asset or liability or hedged forecasted transaction are the same, conclude no ineffectiveness– Same quantity– Same underlying (including grade, if a commodity)– Same time– Same location– Fair value of the hedging instrument at inception = zero
• Need to consider credit risk and liquidity• Subsequent assessments of effectiveness:
– Verify and document whether the critical terms of the hedge and the underlying risk have changed during the period in review
– Consider risk of default of counterparty
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ASSURANCE & ADVISORY
Highly Probable – FX Exposure
• Considerations– consistency with planned or budgeted production – capacity– frequency of past transactions
• Hedged Item– Project ID expected to occur in a month
• If project schedule rolls than potentially hedge rolls– Not unlimited– Depends on documented hedge strategy– No project / roll limits breached, P&L recognition
• Forecasts– incentive not to change expected dates for future accounting
periods– changes to expected dates within current account period will have
same profit and loss impact
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ASSURANCE & ADVISORY
Settle the USD forward
Settle the USD receivable
Forecast Foreign Currency Transaction – Example
1/2/2004
Forecast Sale
Recognition Date
10/4/2004
Recognise Sale
Recognise Accounts Receivable
Hedged risk is FX cash flow exposure on Hedged risk is FX cash flow exposure on receivable to be settled in 10 April.receivable to be settled in 10 April.
What is the accounting?What is the accounting?
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ASSURANCE & ADVISORY
Foreign Currency Transaction – Hedge Steps
1. Determine your functional currency2. Determine the type of hedge 3. Document, Document, Document
• Policy document supported by• Individual hedge documentation
4. Value the derivative5. Quantify the degree of ineffectiveness6. Prepare the journal entries
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ASSURANCE & ADVISORY
Forecasted Foreign Currency Transaction – Example, Information • Spot rates
– Recognition date – sale (or purchase) – At each receivable (or payable) remeasurement date
• Forward rates– At inception– At each remeasurement date
• Risk-free Interest Rates– Discount cash flows on forward / forecasted transaction*
• * For purposes of this illustration, using notional resulting from change in forward rates, but typically must discount using applicable risk free interest rates
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ASSURANCE & ADVISORY
Forecasted Foreign Currency Transaction – Example, fair Value
Deal 0.5500 Dealt Rate
Buy AUD 1,000,000 Sell USD 550,000
Data
Spot Rate 0.6000Forward Points -10Convert -0.0010Forward Outright 0.5990
Days to Maturity 33Discount Rate 5.0%
Fair Value
AUD Equivalent 918,197 of USD at Forward RateNotional Gain/Loss 81,803 GainFair Value 81,435 Discounted 81,.803 / ( 1+ ( 5 % x 33 / 365 ) )
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ASSURANCE & ADVISORY
Foreign Currency Transaction – Hedge Steps
1. Determine your functional currency2. Determine the type of hedge 3. Document, Document, Document
• Policy document supported by• Individual hedge documentation
4. Value the derivative5. Quantify the degree of ineffectiveness6. Prepare the journal entries
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ASSURANCE & ADVISORY
Where does ineffectiveness come from?
• If all terms are matched the relationship between the hedging instrument and hedged item should be 100% effective
• Ineffectiveness arise when terms are not matched• Examples
– Different reference rate – Different currency – Different grade commodity– Different delivery location
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ASSURANCE & ADVISORY
Effectiveness Assessment and Measurement of Ineffectiveness
• Expectation (assessment) of high effectiveness differs from the measurement of ineffectiveness
• 2 Step Process
– Assessment of effectiveness:• Can hedge accounting be applied?• Prospective and Retrospective
– Measurement of ineffectiveness:• Net profit impact• Based on actual results• Ineffectiveness is not used to determine whether hedge accounting
should be applied• But it may indicate that high effectiveness can no longer be expected
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ASSURANCE & ADVISORY
Measuring Ineffectiveness: Cash Flow
• Need to calculate ineffectiveness separately• Amounts recognised in equity are limited to the
lesser of:– Fair value change of the derivative OR– Expected future cash flows of the hedged transaction
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ASSURANCE & ADVISORY
Measuring Ineffectiveness: Cash Flow
• Limits in Equity:– Derivative fair value changes by more than the change in cash
flows of the hedged item• Derivative increases by $100; expected future cash flows decrease by
$90• $10 would be recorded in earnings as ineffectiveness while $90 would
go to equity as the effective portion of the hedge
– Derivative fair value changes by less than the change in cash flows of the hedged item
• Derivative increases by $90; expected future cash flows decrease by $100
• $0 would be recorded in earnings as ineffectiveness and entire $90 would go to equity as the effective portion of the hedge
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ASSURANCE & ADVISORY
Foreign Currency Transaction – Hedge Steps
1. Determine your functional currency2. Determine the type of hedge 3. Document, Document, Document
• Policy document supported by• Individual hedge documentation
4. Value the derivative5. Quantify the degree of ineffectiveness6. Prepare the journal entries
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ASSURANCE & ADVISORY
Overview - Fair Value Hedge Accounting
Hedging instrument
Changes in fair value go to Net Profit
Hedged item
Fair value the hedged item due to the hedged risk and recognise changes in fair value in Net Profit
Net Profit (net impact = ineffectiveness)Net Profit (net impact = ineffectiveness)
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ASSURANCE & ADVISORY
Overview - Cash Flow Hedge – Accounting (Method 1)
Changes in Fair Value of Hedging Instrument
Net ProfitSeparate
component of Equity (reserve)
Effective portion
Ineffective portion
Recognised with hedged
itemIAS 39.95
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ASSURANCE & ADVISORY
Overview - Cash Flow Hedge – Accounting ( Method 2 – Amendment )
Changes in Fair Value of Hedging Instrument
Net ProfitSeparate
component of Equity (reserve)
Effective portion
Ineffective portion
Basis Adjustment to Hedged Item IAS 39.98(b)
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ASSURANCE & ADVISORY
Forecasted Foreign Currency Transaction – Example, High Level
1/2/2004
Forecast Sale
Recognition Date
10/4/2004
Revalue fx contract to fair value through equity
Record Sale.
Revalue Accounts Receivable at spot through Net Profit
Revalue fx contract to fair value through net profit
Transfer equity to sales (net profit)
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ASSURANCE & ADVISORY
Implementation - Plan
1. Form implementation team
2. Review risk management policies
3. Compile inventory of derivatives & related exposures
4. Categorise inventory & exposures
5. Assess processes/technology and implement changes
6. Develop and test hedge effectiveness / valuation models
7. Determine tax impact / transition adjustments
8. Evaluation of disclosures
9. Develop ongoing monitoring process
10. Inform stakeholders
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ASSURANCE & ADVISORY
• Timeline for companies with June year-end:
Timetable
2005
31stDecember
31stDecember
2004
1stJanuary
Present first reportManage Investor Relations
20052004Scope the impactIdentify business issuesPlan the implementation
Design and implement systemsTrain staff
Implement business decisionsParallel run and test system
INTRODUCTIONOF IFRS
STANDARDS
Full YearComparatives Due
2004 System and documentation requirementsimplemented
2006
31stDecember
2006First Full Year
IFRS CompliantFinancial
StatementsDue
Opening balance sheet
under IFRS
For Nylex, the first presentation of fully compliant financial statements will be for the year ended 30 June 2006
First consolidation and comparatives
ASSURANCE & ADVISORY
Other Issues and further Questions