27 OCT 2022

Insights into
IFRS 18th
Edition
2021/22
Sweet & Maxwell

This PDF Contains

7I. Financial instruments: IAS 39, p.2571

7I.2 Derivatives and embedded derivatives, p.2605

7I.3 Equity and financial liabilities, p.2639

7I.4 Classification of financial assets and financial liabilities, p.2715

7I.5 Recognition and derecognition, p.2741

7I.6 Measurement and gains and losses, p.2803

7I.7 Hedge accounting, p.2863

7I.8 Presentation and disclosures, p.2993

27 OCT 2022 PAGE 2571

Insights into IFRS 18th Edition 2021/22

7I. Financial instruments: IAS 39

7I. FINANCIAL INSTRUMENTS: IAS 39

7I.1 Scope and definitions

7I.1.10 Overview of financial instruments standards 2574

7I.1.20 Scope 2574
7I.1.25 Definitions 2575
7I.1.30 Specific exemptions from financial instruments
standards 2577
7I.1.40 Insurance contracts 2578
7I.1.50 Financial guarantee contracts 2578
7I.1.60 Definition 2578
7I.1.70 Accounting by the issuer 2584
7I.1.80 Accounting by the holder 2586
7I.1.90 Share-based payments 2591
7I.1.100 Lease rights and obligations 2592
7I.1.110 Investments in subsidiaries, associates
and joint ventures 2592
7I.1.115 Derivatives 2593
7I.1.120 Forward contracts between acquirer
and selling shareholder in business
combination 2593
7I.1.130 Venture capital, mutual funds and
similar entities 2594
7I.1.140 Reimbursements 2595
7I.1.150 Purchases and sales of non-financial
items 2595
7I.1.160 Settlement net in cash 2596
7I.1.170 Readily convertible into cash 2600
7I.1.180 Written options 2600
7I.1.190 Embedded derivatives 2601
7I.1.200 Loan commitments 2601
7I.1.210 Rights and obligations in the scope of
IFRS 15 2602
7I. FINANCIAL INSTRUMENTS: IAS 39

7I.1 Scope and definitions

REQUIREMENTS FOR INSURERS THAT APPLY IFRS 4

In July 2014, the International Accounting Standards Board issued IFRS 9 Financial
Instruments, which is effective for annual periods beginning on or after 1 January
2018. However, an insurer may defer the application of IFRS 9 if it meets certain
criteria (see 8.1.180).

This chapter reflects the requirement of IAS 39 Financial Instruments: Recognition

and Measurement and the related standards, excluding any amendments introduced
by IFRS 9. These requirements are relevant to insurers that apply the temporary
exemption from IFRS 9 or the overlay approach to designated financial assets (see
8.1.160) and prepare financial statements for periods beginning on 1 January 2021.
For further discussion, see Introduction to Sections 7 and 7I.

The requirements related to this topic are mainly derived from the following.

STANDARD TITLE

IFRS 7 Financial Instruments: Disclosures

IFRS 15 Revenue from Contracts with Customers

IAS 32 Financial Instruments: Presentation

IAS 39 Financial Instruments: Recognition and Measurement

FORTHCOMING REQUIREMENTS AND FUTURE DEVELOPMENTS

For this topic, there are no forthcoming requirements or future developments.

7I.1.10 OVERVIEW OF FINANCIAL INSTRUMENTS

STANDARDS

IAS 32 IAS 39 IFRS 7

Financial Instruments: Financial Instruments: Financial
Presentation Recognition and Measurement Instruments:
Disclosures

Liabilities Offsetting a Derivatives Classification Recognition Measurement Hedge Disclosures

and equity financial and of financial and and gains accounting (see 7I.8)
(see 7I.3) asset and a embedded assets and derecognition and losses (see 7I.7)
financial derivatives financial (see 7I.5) (see 7I.6)
liability (see 7I.2) liabilities
(see 7I.8) (see 7I.4)
7I.1.20 SCOPE

7I.1.20.10 The reporting of financial instruments is primarily addressed by three

specific standards: IAS 32, IAS 39 and IFRS 7. In addition, the measurement of fair
value of financial instruments and disclosures about fair value are addressed by IFRS
13 (see chapter 2.4).

7I.1.20.20 IAS 32 provides a definition of the term ‘financial instrument’. It also

defines the related concepts of financial assets, financial liabilities and equity
instruments. IAS 32 provides guidance on whether a financial instrument is
considered a financial asset, a financial liability or an equity instrument or whether it
is a compound instrument that includes both liability and equity components. This
guidance is focused largely on determining whether a financial instrument that an
entity has issued is classified as a financial liability or as equity (see chapter 7I.3). IAS
32 does not generally address recognition or measurement issues, but does contain
accounting principles for derivatives on own equity instruments and for initial
measurement, modification and conversion of compound instruments (see chapter
7I.3). IAS 32 also addresses the presentation of interest and dividends (see chapter
7I.3) and the offsetting of financial assets and financial liabilities (see chapter 7I.8).
[IAS 32.4–10]

7I.1.20.30 IAS 39 provides recognition and measurement requirements for

financial assets and financial liabilities. This includes both primary financial
instruments (e.g. cash, receivables, debt and shares in another entity) and derivative
financial instruments (e.g. options, forwards, futures, interest rate swaps and
currency swaps). [IAS 39.2–7]

7I.1.20.40 IFRS 7 requires entities to provide disclosures that enable users of

their financial statements to evaluate the significance of financial instruments for the
entity’s financial position and performance, and the nature and extent of risks arising
from financial instruments to which the entity is exposed and how the entity manages
those risks. [IFRS 7.3–5]

7I.1.20.50 The scopes of the above three standards are not identical and are
subject to different exclusions that are described in more detail in this chapter.
Consequently, a scope exclusion in one standard cannot be assumed to apply equally
in the context of the other standards. In broad outline, IAS 32 generally applies to all
financial instruments, including equity issued, whereas IAS 39 applies only to
financial assets and financial liabilities. IFRS 7 also generally applies to all financial
instruments, although most of its disclosure requirements relate to financial assets
and financial liabilities. However, certain financial assets and financial liabilities that
are excluded from the scope of IAS 39 are included in the scope of IFRS 7. In
addition, IAS 32 and IAS 39 require certain contracts to buy or sell non-financial
items to be accounted for as if they were financial instruments (see 7I.1.150).
Derivatives embedded in non-financial contracts may also be accounted for in
accordance with the financial instruments standards (see 7I.1.190).

7I.1.25 DEFINITIONS
7I.1.25.10 A ‘financial instrument’ is any contract that gives rise to both a
financial asset of one entity and a financial liability or equity instrument of another
entity. [IAS 32.11]

7I.1.25.20 Deferred revenue and prepaid expenses are not financial instruments
because they are settled by the delivery or receipt of goods or services. [IAS 32.AG11]

7I.1.25.30 A ‘financial asset’ is any asset that is:

• cash;
• a contractual right:
– to receive cash or another financial asset; or
– to exchange financial assets or financial liabilities under potentially favourable
conditions;
• an equity instrument of another entity; or
• a contract that will or may be settled in the entity’s own equity instruments and is:
– a non-derivative for which the entity is or may be obliged to receive a variable
number of the entity’s own equity instruments; or
– a derivative that will or may be settled other than by the exchange of a fixed
amount of cash or another financial asset for a fixed number of the entity’s own
equity instruments. For this purpose, the entity’s own equity instruments do not
include: puttable financial instruments or instruments that impose on the entity
an obligation to deliver to another party only on liquidation a pro rata share of
the net assets of the entity that do not meet the definition of equity instruments
even if they are classified as equity instruments (see 7I.3.180); or instruments
that are contracts for the future receipt or delivery of the entity’s own equity
instruments. [IAS 32.11]

7I.1.25.40 Gold bullion is a commodity and not a financial asset; therefore, it is

not in the scope of IAS 32 or IAS 39. Physical holdings of other commodities are also
outside the scope of the financial instruments standards. However, contracts to buy
or sell commodities or non-financial assets in the future are accounted for as
derivatives if certain criteria are met (see 7I.1.150). [IAS 39.IG.B.1]

7I.1.25.43 An entity may hold cryptocurrencies – e.g. Bitcoin – which have the
following characteristics.
• A digital or virtual currency that is recorded on a distributed ledger.
• The cryptocurrency is not issued by a jurisdictional authority or other party.
• The holding of the cryptocurrency does not give rise to a contract between the
holder and another party.

7I.1.25.45 There are no standards under IFRS Standards that specifically include
cryptocurrencies in their scope and it may be unclear how to account for these
holdings. The IFRS Interpretations Committee discussed the application of the
Standards to holdings of cryptocurrencies with the above characteristics (see
7I.1.25.43) and noted that they do not meet the definition of a financial asset. Instead,
holdings of such cryptocurrencies meet the definition of an intangible asset (see
3.3.30.60–70) or inventory. This is because such a cryptocurrency is not cash or an
equity instrument of another entity, does not give rise to a contractual right for the
holder and is not a contract that will or may be settled in the entity’s own equity
instruments. The Committee noted that the description of cash in IAS 32 implies that
cash is expected to be used as a medium of exchange for goods and services and as
the monetary unit in pricing goods or services to such an extent that it would be the
basis on which all transactions are measured and recognised in financial statements.
[IAS 32.AG3, IU 06-19]

7I.1.25.50 A ‘financial liability’ is defined as:

• a contractual obligation:
– to deliver cash or another financial asset to another entity; or
– to exchange financial instruments under potentially unfavourable conditions; or
• a contract that will or may be settled in the entity’s own equity instruments and is:
– a non-derivative for which the entity is or may be obliged to deliver a variable
number of its own equity instruments; or
– a derivative that will or may be settled other than by the exchange of a fixed
amount of cash or another financial asset for a fixed number of the entity’s own
equity instruments. For this purpose, rights, options or warrants to acquire a
fixed number of the entity’s own equity instruments for a fixed amount of any
currency are equity instruments if the entity offers rights, options or warrants
pro rata to all of its existing owners of the same class of its own non-derivative
equity instruments. Also, for this purpose, the entity’s own equity instruments
are limited as described in 7I.1.25.30. [IAS 32.11]

7I.1.25.60 An ‘equity instrument’ is any contract that evidences a residual

interest in the assets of an entity after deducting all of its liabilities (see chapter 7I.3).
[IAS 32.11]

7I.1.25.70 The following two categories of financial instruments issued by an

entity are exempt from liability classification even if they contain an obligation for the
entity to deliver cash or another financial asset:
• puttable financial instruments that meet certain conditions; and
• an instrument, or a component of an instrument, that contains an obligation for
the issuing entity to deliver to the holder a pro rata share of the net assets of the
issuing entity only on its liquidation. [IAS 32.16–16D]

7I.1.25.80 These instruments are classified as equity instruments provided that

both the financial instrument and the issuing entity meet certain conditions (see
7I.3.180).

7I.1.25.90 IAS 32 provides a framework on the accounting for transactions in an

entity’s own equity instruments, including derivatives whose underlying is an entity’s
own equity instruments. IAS 32 also addresses the accounting treatment of treasury
shares. For further discussion of these issues, see chapter 7I.3. [IAS 32.21–24, 33, AG27,
AG36]

7I.1.25.100 The terms ‘contract’ and ‘contractual’ used in the definitions in

7I.1.25.30 and 50 refer to an agreement between two or more parties that has clear
economic consequences and that the parties have little, if any, discretion to avoid,
usually because the agreement is enforceable by law. Contracts defining financial
instruments may take a variety of forms and do not need to be in writing. An example
of an item not meeting the definition of a financial instrument is a tax liability,
because it is not based on a contract between two or more parties; instead, it arises
as a result of tax law. [IAS 32.13, AG12]

7I.1.30 SPECIFIC EXEMPTIONS FROM FINANCIAL

INSTRUMENTS STANDARDS

IAS 32 IAS 39 IFRS 7 APPLICABLE

STANDARD

Interests in IFRS 10
subsidiaries (1) IAS 27

Interests in associates IAS 28

and joint ventures(1) IAS 27

Employers’ rights and IAS 19

obligations under
employee benefit plans

Financial instruments, IFRS 2

contracts and obligations
under share-based
payment transactions

Rights and obligations IFRS 4(2)

under insurance
contracts (except
embedded derivatives and
certain financial
guarantees)

Financial instruments (3) - IFRS 4

with a discretionary
participation feature
(except embedded
derivatives)

Rights and obligations - (4) - IFRS 16

under leases

Equity instruments issued - - IAS 32

by the entity, including
warrants and options that
meet the definition of an
equity instrument (for the
issuer)

Financial instruments - IAS 32

issued by the entity that
are classified as equity
instruments in
accordance with
paragraphs 16A and 16B
or paragraphs 16C and
16D of IAS 32 (for the
issuer)

Forward contracts - - IFRS 3

between an acquirer and a
selling shareholder for
the sale/acquisition of an
acquiree that will result
in a business combination
at a future date of
acquisition

Loan commitments that - - IAS 37

cannot be settled net in
cash or another financial
instrument that are not
designated as at FVTPL
and are not commitments
to provide loans at below-
market interest

Rights to reimbursement - - IAS 37

payments in relation to
provisions

Financial instruments - - IFRS 15

that are rights and
obligations in the scope of
IFRS 15, except for those
that IFRS 15 specifies are
accounted for in
accordance with IAS 39 –
e.g. receivables (see
4.2.470.60 and
7I.6.400.05)
 ‘ ’ indicates a specific exclusion from the standard.

Notes
1. However, in some cases IFRS 10, IAS 27 or IAS 28 requires or permits an entity to
account for an interest in a subsidiary, associate or joint venture in accordance with
some or all of the requirements of IAS 39 (see chapters 3.5 and 5.6), in which case
the requirements of IAS 32, IAS 39 and IFRS 7 apply. An entity applies IAS 32 to
derivatives linked to interests in subsidiaries, associates or joint ventures. An entity
also applies IAS 39 and IFRS 7 to such derivatives, unless the derivative meets the
definition of an equity instrument in IAS 32 (see 7I.1.110 and 130).
2. IAS 39 applies to an insurance contract that is an issued financial guarantee not
accounted for under IFRS 4. IAS 39 applies to a financial guarantee that arises when
a transfer of a financial asset does not qualify for derecognition or when continuing
involvement applies. Financial guarantee contracts held are not in the scope of IAS
39. For a discussion of the accounting for financial guarantee contracts from the
perspective of the holder, see 7I.1.80. [IAS 39.47(b)]
3. The issuer of such instruments is exempt from applying the financial liability/equity
classification principles to the discretionary participation feature (see 8.1.110).
4. However, the following are subject to the specified requirements of IAS 39: (1)
finance lease receivables (i.e. net investments in finance leases) and operating lease
receivables recognised by a lessor – derecognition and impairment requirements; (2)
lease liabilities recognised by a lessee – derecognition requirements; and (3)
derivatives embedded in leases – embedded derivative requirements (see 7I.1.100).

7I.1.40 Insurance contracts

7I.1.40.10 There is a dividing line in the Standards between financial risk and
insurance risk that is especially relevant for counterparty risk because it determines
the nature of the contract as either an insurance contract to which IFRS 4 may apply
or a financial instrument in respect of which IAS 32 and IAS 39 apply.

7I.1.40.20 An ‘insurance contract’ is a contract under which the insurer accepts

significant insurance risk from the policyholder by agreeing to compensate the
policyholder if a specified uncertain future event adversely affects the policyholder
(see 8.1.20). [IFRS 4.A]

7I.1.40.30 Although IAS 32 and IAS 39 do not address the accounting for
insurance contracts, they do not scope out insurance entities. Insurance entities
apply IAS 32 and IAS 39 to all financial instruments other than those that meet the
definition of an insurance contract or a contract with a discretionary participation
feature. Therefore, financial instruments that meet the definition of an insurance
contract and that are in the scope of IFRS 4 are not subject to IAS 39. However, IAS
39 applies to a derivative that is embedded in a contract in the scope of IFRS 4,
unless the derivative itself is also in the scope of IFRS 4 (see 8.1.30). [IAS 39.2(e)]

7I.1.50 Financial guarantee contracts

7I.1.50.10 Financial guarantee contracts issued by an entity fall in the scope of
IAS 39 from the issuer’s perspective except as discussed in 7I.1.70.10. In our view, a
financial guarantee contract held by an entity that is not an integral element of
another financial instrument is not in the scope of IAS 39 (see 7I.1.80.50). [IAS 39.2(e)]

7I.1.60 Definition

7I.1.60.10 A ‘financial guarantee contract’ is a contract that requires the issuer

to make specified payments to reimburse the holder for a loss that it incurs because a
specified debtor fails to make payment when it is due in accordance with the original
or modified terms of a debt instrument. [IAS 39.9]

7I.1.60.13 To be classified as a financial guarantee contract, a contract needs to

comply with all of the following conditions.
• The reference obligation is a debt instrument (see 7I.1.62).
• The holder is compensated only for a loss that it incurs (see 7I.1.64).
• The contract does not compensate the holder for more than the actual loss that it
incurs (see 7I.1.66). [IAS 39.9]

7I.1.60.15 Financial guarantee contracts can have various legal forms, including
certain letters of credit, credit default contracts and insurance contracts. However,
the legal form of such contracts does not affect their accounting treatment. [IAS
39.AG4]

EXAMPLE 1 – FINANCIAL GUARANTEE CONTRACT – LETTER OF CREDIT

7I.1.60.16 Bank B issues a letter of credit in the amount of up to

10,000 on behalf of its Customer C, identifying a foreign Supplier S as
the beneficiary. Under the letter of credit, B promises to reimburse S
for actual losses that S incurs if C fails to make the payments when due
for its future specified purchases of 10,000 from S. The terms of the
arrangement also require any subsequent recovery of reimbursed
amounts from C to be returned to B.

7I.1.60.18 The arrangement meets the definition of a financial

guarantee contract. This is because under the terms of the letter of
credit B is required to reimburse S for a loss incurred if C – i.e. the
specified debtor – fails to make a payment when it is due in accordance
with the original debt instrument – i.e. the trade receivable.

7I.1.60.20 Credit-related contracts that require payment in circumstances other

than those mentioned in 7I.1.60.10 – e.g. if there is no failure by a specified debtor to
make payment when it is due or if the holder would not incur a loss – are generally
credit derivatives that are measured at fair value under IAS 39. For the definition of
derivatives, see 7I.2.20. [IFRS 4.IG2.1.12, IAS 39.9, AG4(b)]
7I.1.62 Reference obligation is a debt instrument
7I.1.62.10 The first condition in the definition of a financial guarantee contract is
that the contract should compensate the holder only for losses that it incurs on debt
instruments – i.e. the ‘reference obligation’ in a financial guarantee contract should
be a debt instrument. However, in our view this does not preclude a contract that
contains a revolving portfolio as the reference obligation from being classified as a
financial guarantee contract under IAS 39. [IAS 39.9]

7I.1.62.20 IAS 39 requires that a financial guarantee contract compensate the

holder for losses that it incurs because of failure by ‘specified debtors’ to make
payment when it is due. Consequently, in our view such a revolving portfolio structure
does not violate the requirements of a financial guarantee contract if the following
criteria are met.
• The portfolio of debt instruments is specified – i.e. the contract includes a list of
debtors included in the reference portfolio at all times.
• All replacements to the portfolio are documented and contain restrictions, so that
the replacement mechanism does not indirectly compensate the holder for any
form of fair value loss on the reference portfolio. [IAS 39.9]

7I.1.62.30 The standard does not state what is meant by the term ‘debt
instrument’ in the context of the definition of a financial guarantee contract. In our
view, alternative approaches to the application of the definition are possible.

7I.1.62.40 Based on a narrow reading, an entity may consider that the phrase is
restricted to certain non-derivative debt instruments that do not include separable
embedded derivatives – e.g. instruments that meet the definition of loans and
receivables or would meet that definition if they were not quoted in an active market.
Under this approach, the inclusion of a derivative instrument in the reference
portfolio in 7I.1.62.20 would violate the requirement that a financial guarantee
contract compensate the holder only for losses that it incurs on debt instruments.

7I.1.62.50 Alternatively, we believe that an entity may adopt a policy of applying

the term to encompass derivatives and hybrid instruments that do or may give rise to
an obligation of the debtor to make specified payments when they are due and that
compensate the holder of the financial guarantee contract for the debtor’s failure to
make timely payment of those specified amounts.

7I.1.62.60 However, whatever the entity’s policy, the definition of a financial

guarantee contract is still met only if the contract compensates the holder solely for
losses arising from the debtor’s failure to make payment when it is due and not for
losses arising from market risk.

EXAMPLE 2A – FINANCIAL GUARANTEE CONTRACT – HYBRID INSTRUMENTS

 7I.1.62.70 Investor Z buys structured notes that provide a return
based on the movement in an equity index. Z also obtains a guarantee
from a bank that, if the issuer of the notes fails to make payment of the
full amount due on maturity of the notes, then the bank will pay the
shortfall to Z. Such a contract may qualify as a financial guarantee
contract depending on Z’s accounting policy (see 7I.1.62.50).

7I.1.62.80 However, if the bank guaranteed to Z that it would pay

any losses that Z incurred under the terms of the note because of a
decrease in the equity index, then the contract would be a derivative
and not a financial guarantee contract.

EXAMPLE 2B – FINANCIAL GUARANTEE CONTRACT – DERIVATIVES

7I.1.62.90 Bank E enters into an interest rate swap contract with a

customer. Under the contract, in the event of default the contract will
be terminated immediately and the replacement cost at that time will
become due and payable. E obtains a guarantee from Bank D. Under
the terms of the guarantee, if the customer fails to pay in full the
amount that on default becomes due and payable, then D will pay the
shortfall to E. Such a contract may qualify as a financial guarantee
contract, depending on E’s accounting policy (see 7I.1.62.50).

7I.1.62.100 However, if D guaranteed to E that it would

compensate E for a fair value loss on the interest rate swap, then the
contract would be a derivative and not a financial guarantee contract.

7I.1.64 Holder compensated only for a loss that it incurs

7I.1.64.10 The second condition that has to be met for a contract to be classified
as a financial guarantee contract under IAS 39 is that it should compensate the
holder only for a loss that it incurs on the debt instrument. In our view, such a loss
cannot be an opportunity loss or a fair value loss on a debt instrument but should be
an actual loss that the entity incurs as a result of failure by a specified debtor to make
payment when it is due. Consequently, contracts compensating the holder for losses
arising from the restructuring of an entity do not lead automatically to a loss for the
holder of the debt instrument other than a fair value loss, and it is possible that the
holder will recover from the restructuring event. Therefore, we do not believe that a
contract that compensates the holder for such losses meets the definition of a
financial guarantee contract. [IAS 39.9]

7I.1.64.20 However, IAS 39 is silent on when the cash flows should occur for
compensation of a loss that an entity incurs. In our view, a contract may still meet the
definition of a financial guarantee contract if the issuer makes payment to the holder
for a past due amount provided that the contract requires any subsequent recovery of
that amount from the specified debtor to be reimbursed to the issuer of the financial
guarantee (see 7I.1.66).

7I.1.64.30 The definition of a financial guarantee contract does not require the
holder of the guarantee also to hold the underlying debt instrument(s) as an asset, as
long as the contract compensates the holder only for its losses arising from the
debtor’s failure to make payment when it is due on those debt instruments.

EXAMPLE 2C – FINANCIAL GUARANTEE CONTRACT – CREDIT-LINKED NOTES

7I.1.64.40 Limited-purpose Vehicle L issues to investors 1,000

credit-linked notes with a stated 1,000 principal and 10% interest rate.
Cash collected on an underlying pool of specified debt instruments
held by L is used to fund distributions to investors. L has no other
assets or operations and is prohibited from selling the debt
instruments. Contractually, L is required to pay investors only to the
extent that cash is collected from the underlying assets. Bank B issues
a guarantee to investors that they will receive the full 1,000 of
principal and 10% interest from L. This is effected by B making
payment of any shortfalls to an investor within 90 days, subject to the
investor being required to reimburse any subsequent recoveries of
such shortfalls to B.

Bank B

Guarantee
principal
+10% interest
Credit­linked
Pool of debt Limited­purpose notes
Investors
instruments Vehicle L

7I.1.64.50 In this example, L’s only exposure to risk that could lead
to its failure to pay the stated return on the notes is the credit risk of
the underlying pool of debt instruments. The investor would also suffer
a loss if L were to fail to make payments when they were due in
accordance with the terms of the notes even when L has obtained
sufficient cash from its assets.

7I.1.64.60 In our view, the guarantee agreement is a financial

guarantee contract because the bank compensates the investor only
for the loss that the investor would incur from a failure by specified
debtors (either by the specified debtors in the underlying pool of debt
instruments in L or by L itself) to make payment when it is due.
 7I.1.64.65 However, if the investor could fail to obtain the full 10%
contractual return because of other risks – e.g. interest rate risk as a
result of the portfolio containing floating rate loans – and the bank
provided a guarantee covering shortfalls arising from those other
risks, then the guarantee would not meet the definition of a financial
guarantee contract.

EXAMPLE 2D – GUARANTEE CONTRACT – TRADED SEPARATELY FROM THE DEBT INSTRUMENT

7I.1.64.67 Bank B issues a guarantee on a specified bond. If the

issuer of the bond fails to make a payment when it is due, then the
holder of the guarantee has the right to deliver the bond to B in return
for an amount equal to the outstanding principal of the bond plus any
accrued (but unpaid) interest. The bond and the guarantee are traded
separately.

7I.1.64.69 In this example, the guarantee contract can be

transferred independently of the related bond and it does not, as a
precondition of payment, require the holder of the guarantee to be
exposed to, and have incurred a loss on, the failure of the debtor to
make payments on the guaranteed asset when they are due. We believe
that such a contract does not meet the definition of a financial
guarantee contract in the scope of IAS 39. [IAS 39 AG4(b)]

7I.1.64.70 Generally, a contract does not qualify as a financial guarantee contract

if it provides for payments by the issuer in respect of amounts that are not past due.
However, in many debt agreements non-payment of an amount that is due
contractually would be an event of default that would trigger the entire remaining
amount (principal and accrued interest) on the debt instrument to fall due.

7I.1.64.80 For example, a contract between a guarantor and the holder of a loan
with a maturity of five years allows for physical settlement – i.e. the guarantor is
required to buy the entire outstanding debt amount at par plus accrued interest in
the event of any non-payment by the debtor (e.g. a missed interest payment) that
persists for 30 days beyond its due date. Under the terms of the loan, such a non-
payment is an event of default. In our view, the contract would meet the definition of a
financial guarantee contract if the non-payment condition that requires settlement of
the guarantee also causes the entire outstanding debt amount to become
immediately repayable. The issue of whether immediate repayment of the full amount
of the debt instrument actually is requested by the creditor following the default does
not affect the analysis.

7I.1.64.90 Guarantee contracts that require payments to be made in response to

changes in another specified variable – e.g. an interest rate, credit rating or credit
index – are accounted for as derivatives in the scope of IAS 39 provided that, in the
case of a non-financial variable, the variable is not specific to a party to the contract
(see 7I.2.30.60). [IAS 39.AG4]

7I.1.66 Holder not compensated for more than actual loss that
it incurs

7I.1.66.10 The third condition that needs to be satisfied is that the contract
should not compensate the holder for an amount greater than the loss that it incurs
on the debt instrument. Consequently, contracts that give rise to a leveraged payout
that is greater than 100% of the loss do not meet the definition of a financial
guarantee contract. For example, a contract such as a CDS that pays out to the
protection buyer even if the holder does not have any exposure to the specified debt
instrument does not meet the definition and is accounted for as a derivative. [IFRS
4.IG2.1.12, IAS 39.9]

7I.1.68 Examples

EXAMPLE 3A – FINANCIAL GUARANTEE CONTRACT – MEETING THE CONDITIONS

7I.1.68.10 Bank M makes a loan to Company D. Company B issues

a guarantee to M that if D fails to make a payment within 30 days after
it falls due, then B will make the payment on behalf of D. The
agreement states that if M subsequently recovers the payment from D,
then M is required to immediately reimburse B for the amount received
from D – i.e. M cannot retain an amount in excess of the loss that it
ultimately incurs on the loan.

Company B

Guarantee

Loan
Bank M Company D

7I.1.68.15 In this example, the contract meets the definition of a

financial guarantee contract and is accounted for as such in B’s
financial statements. This is because the three conditions for
classification as a financial guarantee contract have been met.
• The reference obligation is a debt instrument.
•
 • The holder of the financial guarantee contract is compensated only
for a loss that it incurs as a result of the debtor’s failure to make a
payment when it is due. In the example, M actually may or may not
have incurred a loss when payment was not made within 30 days of
the due date (because the debtor may make an appropriate payment
later). However, as described in 7I.1.64.10–20, if

payment is made by the issuer before a loss is actually incurred by the

holder, then the instrument can still qualify as a financial guarantee
contract if the contract includes a provision that any subsequent
recoveries of the overdue amount be repaid to the guarantor. This is
because the inclusion of this provision ensures that the holder of the
financial guarantee can be compensated only for its actual losses
incurred.
• The financial guarantee contract does not compensate the holder
for more than its actual losses incurred. In the example, this is
achieved by the inclusion of the provision that any subsequent
repayments of the overdue amount be repaid to the guarantor.

EXAMPLE 3B – FINANCIAL GUARANTEE CONTRACT – FAILING THE CONDITIONS

7I.1.68.20 Modifying Example 3A, assume the same arrangement

except that Company B will make payments to Bank M based on
changes in the credit rating of Company D.

7I.1.68.25 In this example, the contract does not meet the

definition of a financial guarantee contract, because B is required to
make payments to M even if there is no failure by D to make payment
when due and M does not incur a loss. Therefore, both B and M
account for the contract as a derivative in their financial statements.

7I.1.70 Accounting by the issuer

7I.1.70.10 Although financial guarantee contracts issued meet the definition of
an insurance contract if the risk transferred is significant, they are generally outside
the scope of IFRS 4 and are accounted for under IAS 39. However, if an entity issuing
financial guarantee contracts has previously asserted explicitly that it regards them
as insurance contracts and has accounted for them as such, then the issuer may make
an election on a contract-by-contract basis to apply either IAS 39 or IFRS 4 to each
contract. The election for each contract is irrevocable. [IFRS 4.4(d), B18(g), IAS 39.2(e),
AG4(a), BC23A]

7I.1.70.20 If the issuer applies IAS 39 to a financial guarantee contract, then it

measures the contract:
initially at fair value. If the financial guarantee contract was issued in a stand-
• alone arm’s length transaction to an unrelated party, then its fair value at
inception is likely to equal the premium received unless there is evidence to the
contrary; and
• subsequently at the higher of:
– the amount determined in accordance with IAS 37 (see chapter 3.12); and
– the amount recognised initially less, when appropriate, the cumulative amount
of income recognised in accordance with the principles of IFRS 15 (see chapter
4.2). [IAS 39.47(c), AG4(a)]

7I.1.70.30 In the case of a guarantee provided by a parent over the liability of a

subsidiary, even if no consideration is or will be received by the parent, the parent is
required to recognise a liability in its separate financial statements for the fair value
of the guarantee. In our view, if no payments from the subsidiary to the parent are
agreed for such a guarantee, then the parent has provided the guarantee in its
capacity as a shareholder and accounts for the issuance of the guarantee as a capital
contribution to the subsidiary.

7I.1.70.40 An exception to the general measurement principles is provided for

financial guarantee contracts that arise when a transfer of financial assets does not
qualify for derecognition or results in continuing involvement. Such contracts are
measured in accordance with specific provisions in IAS 39 (see 7I.5.290). [IAS 39.29–31,
47(b)]

7I.1.70.50 As stated in 7I.1.70.10, if the issuer has previously explicitly asserted

that it regards such contracts as insurance contracts and has used the accounting
applicable to insurance contracts, then the issuer may apply either IAS 39 or IFRS 4
to such contracts on a contract-by-contract basis (see 8.1.10.30). [IAS 39.2(e)]

7I.1.70.60 For an entity whose business includes issuing financial guarantee

contracts, it will generally be clear from contract documentation, previously
published financial statements and the entity’s communications with customers,
regulators and others and other published information, whether it regards, and has
previously accounted for, such contracts as insurance contracts. [IAS 39.AG4A]

7I.1.70.70 In other cases it may be less clear. For example, an entity might
provide financial guarantees from time to time that are incidental to its main
business, perhaps to support borrowings of its subsidiaries or major customers. In
such cases, in our view it is not necessary that insurance contract terminology be
used in documenting the financial guarantee contracts and judgement is required in
determining whether previous assertions in financial statements or elsewhere are
sufficiently explicit to continue to apply insurance accounting.

7I.1.70.80 When the issuer of a financial guarantee contract makes a payment to

the holder, the issuer assesses whether, as a result, it should derecognise the
guarantee. A financial guarantee contract is derecognised when it meets the
derecognition criteria for financial instruments (see chapter 7I.5). In addition, at the
same time the issuer recognises the financial asset that was the subject of the
financial guarantee if the recognition criteria under IAS 39 are met.
EXAMPLE 4 – FINANCIAL GUARANTEE ISSUED – DISCHARGING OBLIGATION

7I.1.70.90 Bank M issues a financial guarantee to Bank P in respect

of a loan that P makes to Company C and receives the full amount of
premium for the guarantee at the time of its issue. The contract meets
the definition of a financial guarantee contract and M accounts for it
under IAS 39. Subsequently, C defaults on the loan. M pays P an
amount equal to the principal of the loan plus any accrued and unpaid
interest. In return, P transfers to M the legal ownership of the loan. M
does not have any further obligations in respect of the financial
guarantee contract and P does not have any further rights to the cash
flows from the loan.

7I.1.70.100 Because M reimbursed P for the loss that it incurred

and has no further obligations in respect of the guarantee, M has
discharged its obligation under the financial guarantee contract.
Accordingly, M concludes that the derecognition criteria for the
guarantee have been met and derecognises the financial guarantee
contract (see 7I.5.370.10).

7I.1.70.110 As part of the arrangement, P transferred to M the legal

ownership of the loan subject to the financial guarantee contract. P
also transferred to M substantially all of the risks and rewards of the
loan. Accordingly, P concludes that it should derecognise the loan and
M concludes that it should recognise the loan at its fair value (see
7I.5.60 and 7I.6.20).

7I.1.70.120 Modifying the fact pattern, following the

reimbursement P continues to be the legal owner of the loan, but is
required by the terms of the financial guarantee contract to
immediately remit to M any amounts subsequently recovered from C. P
is also prohibited by the terms of the contract from selling or pledging
the underlying loan.

7I.1.70.130 M concludes that derecognition of the financial

guarantee contract is appropriate, applying the same reasoning as in
7I.1.70.100.

7I.1.70.140 As part of the arrangement, P has retained the

contractual right to receive the cash flows of the loan but has assumed
a contractual obligation to pay the cash flows to M in an arrangement
that meets the pass-through requirements (see 7I.5.160). Also, P has
transferred to M substantially all of the risks and rewards of the loan.
Accordingly, P concludes that it should derecognise the loan and M
concludes that it should recognise the loan at its fair value (see 7I.5.60
 and 7I.6.20).

7I.1.80 Accounting by the holder

7I.1.80.10 In our view, the criteria for identifying a contract as a financial

guarantee contract are the same for both the holder and the issuer.

7I.1.80.20 An entity may buy a debt instrument whose terms include, or that is
accompanied by, a guarantee of payments on the debt instrument, which is issued by
a party other than the issuer of the debt instrument and which has the features of a
financial guarantee contract. In our view, in determining its accounting for such a
guarantee, the holder should determine whether the guarantee is an integral element
of the debt instrument that is accounted for as a component of that instrument or is a
contract that is accounted for separately. If the holder determines that the guarantee
is an integral element of the debt instrument, then in our view the guarantee should
not be accounted for separately. Instead, the holder should consider the effect of the
protection when measuring the fair value of the debt instrument, when estimating
the expected cash receipts from the debt instrument and when assessing impairment
of the debt instrument.

EXAMPLE 5A – FINANCIAL GUARANTEE – INTEGRAL ELEMENT OF DEBT INSTRUMENT

7I.1.80.30 Company B bought a bond issued by Company D that is

quoted in an active market. The terms of the bond include an
inseparable financial guarantee from D’s parent.

7I.1.80.35 In this example, B concludes that the financial guarantee

is an integral part of the bond because the bond was acquired with the
benefit of the financial guarantee contract that is included in the terms
of the bond and reflected in the quoted price of the bond.

EXAMPLE 5B – FINANCIAL GUARANTEE – NOT INTEGRAL ELEMENT OF DEBT INSTRUMENT

7I.1.80.40 Continuing Example 5A, Company B bought a bond

issued by Company E that is quoted in an active market. Nine months
later, B bought a financial guarantee contract on the bond from an
unrelated third party bank.

7I.1.80.45 In this example, B concludes that the financial guarantee

bought from the bank is not an integral part of the bond because the
financial guarantee was acquired from an unrelated third party (the
bank) after B’s initial recognition of the bond and the financial
guarantee is neither included in the terms of the bond nor reflected in
the quoted price of the bond.
7I.1.80.50 In our view, a financial guarantee contract held by an entity that is not
an integral part of another financial instrument is not in the scope of IAS 39. In our
view, the holder should account for such a financial guarantee contract as a
prepayment measured at an amount equal to the guarantee premium and a
compensation right accounted for by analogy to the guidance for reimbursements in
IAS 37 (see 7I.1.83–87). However, in our view an entity may also choose an
accounting policy, to be applied consistently, to measure a non-integral financial
guarantee contract that it holds at FVTPL if the contract:
• is held for trading, by analogy to the requirements for financial assets held for
trading under IAS 39; or
• guarantees a debt instrument that is measured at FVTPL, to reduce any
accounting mismatch that would otherwise arise.

7I.1.80.55 If a government provides a guarantee over a loan, then the holder also
evaluates whether the provision of the guarantee represents a government grant. If
so, then the holder considers the guidance in 4.3.35 in determining how to account
for it.

7I.1.80.60 In our view, the holder may apply by analogy the derecognition
criteria for financial assets to any prepayment asset relating to a financial guarantee
that is accounted for by analogy to IAS 37.

7I.1.83 Compensation rights

Is the financial guarantee contract an integral

element of the related debt instrument?

Yes No

Compensation right is Compensation right is

accounted for as part of the accounted for separately
debt instrument (see 7I.1.80.20)

Is the financial guarantee contract

measured at FVTPL? (See 7I.1.80.50)
No Yes

Has the loss event occurred? Consider the compensation

right in measuring the fair
No Yes value of the guarantee

Apply guidance for Recognise compensation

reimbursements in IAS 37 receivable when there is an
by analogy until the loss unconditional contractual
event occurs (see 7I.1.85) right to receive it (see 7I.1.87)

7I.1.83.10 If the holder accounts for a non-integral financial guarantee contract

by analogy to the guidance for reimbursements in IAS 37 (see 7I.1.80.50), then in our
view the accounting for any compensation right under the contract would depend on
whether the loss event that creates a right for the holder to assert a claim has
occurred at the reporting date.

7I.1.85 Compensation rights: Loss event has not occurred

7I.1.85.10 In our view, a recognised impairment loss for which there is not yet a
contractual right to assert a claim is similar in nature to a provision as defined in IAS
37. A provision is a liability that is a present obligation arising from a past event, of
uncertain timing or amount; an impairment loss recognised before the event that
allows an entity to assert a claim is an insured loss related to a past event, but there
may be uncertainty about the timing or amount of the ultimate actual loss that will be
incurred. In the case of a financial guarantee contract, there is usually a timing
difference between the recognition of the impairment loss and the related loss event –
e.g. when the impairment is estimated on a collective basis for a portfolio of
contracts, whereas the loss event that creates a right for the entity to assert a claim is
specifically identified in the financial guarantee contract as being the delinquency or
bankruptcy of a specific debtor.

7I.1.85.20 If the loss event that creates a right for the entity to assert a claim at
the reporting date has not occurred, but an impairment loss has been recognised
under IAS 39, then we believe that the compensation right should be accounted for by
analogy to the guidance for reimbursements in IAS 37 because that is the guidance in
the Standards dealing with the most similar issue (see 2.8.10). [IAS 8.11, 37.53]

7I.1.85.30 We believe that no net gain should be accrued when there is no

current right to assert a claim under the financial guarantee contract. During the
period between the initial recognition of the compensation right and the occurrence
of the loss event that creates a right for the entity to assert a claim, the amount of the
compensation right recognised should be limited to the difference between the
impaired carrying amount of the asset and the amount that the carrying amount of
the asset would have been had the impairment not been recognised. [IAS 37.53]

7I.1.85.40 In our view, if the impairment loss recognised includes items not
covered by the financial guarantee contract, then the asset recognised for the
compensation should be limited to the impairment loss covered by the financial
guarantee contract. For example, an impairment loss recognised on an available-for-
sale financial asset (see 7I.6.470) may include not only a credit loss covered by a
financial guarantee contract, but also other fair value changes that have occurred.
We believe that only the credit portion of the impairment loss covered by the financial
guarantee contract should be considered when recognising and measuring the asset
for the compensation right.

EXAMPLE 5C – FINANCIAL GUARANTEE – COMPENSATION RIGHT WHEN INSURED LOSS EVENT HAS
NOT YET OCCURRED
7I.1.85.50 On 1 January 2019, Bank N bought a five-year zero-
coupon bond issued by Company B. The bond matures on 31 December
2023 and on this date B is due to pay N 100. The bond is classified as a
loan and receivable in N’s financial statements.

7I.1.85.60 On 1 January 2020, in line with its new risk management

policy, N entered into a financial guarantee contract with Insurer C, a
third party. The terms of the financial guarantee contract are as
follows.
• C will pay N up to 100 if B has not paid the full 100 to N by 31
January 2024.
• If B pays N less than the 100 owed, then C will pay N the difference
between 100 and the amount received from B.
• If, after any payment from C to N, B subsequently repays any
amount to N, then N is required to pay this amount to C – i.e. C will
not compensate N for an amount greater than the loss incurred.

7I.1.85.70 N determines that the financial guarantee contract is not

integral to the bond and accounts for it by analogy to the guidance for
reimbursements in IAS 37 (see 7I.1.80.50).

7I.1.85.80 In December 2021, B’s credit rating declines, reflecting

recently disclosed operating losses and liquidity shortfalls. N
concludes that there is objective evidence of impairment in respect of
the bond. The following facts at 31 December 2021 are also relevant to
this example.
• The amortised cost of the bond before impairment is 83.
• The original effective interest rate on the bond is 10%.
• The appropriate discount rate for C is 5%.
• N estimates that B will repay only 70 out of the 100 on maturity.
7I.1.85.90 N performs the following calculations at 31 December
2021.

AMOUNT

Amortised cost of the bond before impairment 83

Present value of estimated future cash flow from the

bond 58(1)

Impairment loss (25)(2)

Present value of the compensation right (27)(3)

 Present value of the compensation right limited to the
amount of impairment 25

Notes
1. Calculated as the expected amount to be repaid by B discounted at the
original effective interest rate on the bond of 10% – i.e. 70 / (1 + 10%)2.
2. Calculated as 83 - 58.
3. Calculated as the expected shortfall in the amount receivable from B
discounted at C’s discount rate of 5% – i.e. (100 - 70) / (1 + 5%)2. For
simplicity, the compensation from C is discounted for two years rather
than two years and one month.

7I.1.85.100 N records the following entries(1) in the year ending 31

December 2021.

DEBIT CREDIT

Impairment loss (profit or loss) 25

Allowance for credit losses (statement of

financial position) 25

To recognise impairment loss on bond (see

7I.6.470.20)

Compensation right (statement of financial

position) 25

Compensation right (profit or loss(2)) 25

To recognise compensation right

Notes
1. This example does not illustrate N’s accounting for the premiums paid to
C. For a discussion of the accounting for premiums, see 7I.1.80.50.
2. In the statement of profit or loss and OCI, the amount related to the
compensation right may be presented in the same line item as the
impairment loss that triggers the compensation.

7I.1.85.110 Continuing with the example, N performs the following

calculations for the year ending 31 December 2022.
 AMOUNT

Amortised cost of the bond on 31 December 2022 64(1)

Interest income on the bond for 2022 6(2)

Amortised cost of the bond on 31 December 2022 if it had

not been impaired 91(3)

Present value of the compensation right on 31 December

2022 (limited) 27(4)

Remeasurement of the compensation right 2(5)

Notes
1. Calculated as the expected amount to be repaid by B, which remains
unchanged in 2022, discounted at the original effective interest rate on
the bond of 10% – i.e. 70 / (1 + 10%).
2. Calculated as 58 × 10%.
3. Calculated as the amortised cost of the bond before impairment on 31
December 2021 plus accretion of the interest for 2022 at the original
effective interest rate on the bond of 10% – i.e. 83 + 8.
4. Calculated as the amortised cost of the bond on 31 December 2022 if it
had not been impaired less its actual amortised cost on 31 December
2022 – i.e. 91 - 64. In the absence of the imposed limit, the compensation
right would have been 29 (27 × 1.05) or (30 / 1.05).
5. Calculated as 27 - 25.

7I.1.85.120 N records the following entries in the year ending 31

December 2022.

DEBIT CREDIT

Allowance for credit losses (statement of

financial position) 6

Interest income (profit or loss) 6

To accrete interest on bond for 2022

 DEBIT CREDIT

Compensation right (statement of financial

position) 2

Compensation right (profit or loss) 2

To remeasure compensation right

7I.1.87 Compensation rights: Loss event has occurred

7I.1.87.10 If the loss event that creates a right for the entity to assert a claim has
occurred, then in our view the entity should recognise a receivable for the
compensation when it has an unconditional contractual right to receive the
compensation. The compensation receivable should be measured based on the
amount and timing of the expected cash flows discounted at a rate that reflects the
credit risk of the issuer of the financial guarantee contract. We believe that an entity
would have an unconditional contractual right to receive compensation if:
• the entity has a contract under which it can make a claim for compensation; and
• the loss event that creates a right for the entity to assert a claim at the reporting
date has occurred and the claim is not disputed by the issuer.

7I.1.87.20 Any difference between the carrying amount of the previously

recognised compensation right and the compensation receivable is recognised in
profit or loss.

7I.1.88 Credit risk of the guarantor

7I.1.88.10 In accounting for a financial guarantee contract, the holder considers
the risk that the issuer will fail to perform on its obligation to pay a valid claim under
the guarantee.
• If the guarantee is treated as integral to the guaranteed debt instrument, then the
holder factors this in when measuring the fair value of the debt instrument, when
estimating the expected cash receipts from the debt instrument and when
assessing impairment of the debt instrument (see 7I.1.80.20).
• If the guarantee is not treated as integral to the guaranteed debt instrument, then
the holder factors this into assessing the recoverability of any prepayment asset
for future coverage (e.g. if a premium is paid) and the measurement of any
recognised compensation right (see 7I.1.80.50). Additionally, the holder considers
whether uncertainty arising from non-performance risk of the issuer means that it
is not virtually certain that compensation under the guarantee will be received if a
credit loss is actually suffered and therefore that no compensation right asset can
be recognised (see 7I.1.85.20).

7I.1.90 Share-based payments

7I.1.90.10 A separate standard provides guidance on the accounting for share-
based payments. Accordingly, the initial classification and measurement, and
subsequent measurement, of financial instruments arising from share-based payment
transactions in the scope of IFRS 2 are subject to the requirements of that standard
(see 4.5.2030). Without this scope exclusion, financial instruments arising from these
transactions would generally fall in the scope of IAS 32 and IAS 39. [IAS 32.4(f), 39.2(i)]

7I.1.100 Lease rights and obligations

7I.1.100.10 Rights and obligations under leases are recognised and measured
under IFRS 16 (see chapter 5.1) and consequently are not subject to the general
recognition and measurement requirements of IAS 39. However, finance lease
receivables (i.e. net investments in finance lease) and operating lease receivables
recognised by a lessor are subject to the derecognition and impairment requirements
of IAS 39. Also, lease liabilities recognised by a lessee are subject to the
derecognition requirements of IAS 39. [IAS 39.2(b)]

7I.1.100.20 Derivatives embedded in leases are subject to IAS 39’s embedded

derivative requirements (see 7I.2.130.30). [IAS 39.2(b)]

7I.1.100.30 A lease receivable recognised by the lessor and a lease liability

recognised by the lessee are financial instruments. IFRS 7 applies to all financial
instruments, and rights and obligations under leases are not specifically excluded
from its scope. Consequently, recognised financial assets and financial liabilities
arising from leases are subject to the financial instrument disclosure requirements
(see chapter 7I.8). [IAS 32.AG9]

7I.1.110 Investments in subsidiaries, associates and joint

ventures

7I.1.110.10 Investments in subsidiaries, associates and joint ventures that are

consolidated or equity accounted in the consolidated financial statements (see
chapters 2.5, 3.5 and 3.6) are excluded from the scope of IAS 32 and IAS 39. In some
cases, other standards require or permit an entity to account for its investments in
subsidiaries, associates or joint ventures applying some or all of the requirements of
IAS 39 (see 7I.1.110.30–60). [IAS 32.4(a), 39.2(a)]

7I.1.110.20 An investor may hold more than a single instrument issued by its
equity-accounted investee. In some cases – e.g. preference shares – the investor may
need to apply judgement to determine whether the additional instrument forms part
of the ‘investment in the associate or joint venture’ that is equity-accounted and
therefore scoped out of IAS 39. For further discussion of this assessment, see 3.5.205.

7I.1.110.30 An entity may hold long-term interests in an associate or joint venture

that are not equity-accounted and, in substance, form part of the net investment in
the associate or joint venture. The entity applies IAS 39 to these instruments before
applying the loss absorption requirements and impairment requirements of IAS 28.
For further guidance, see 3.5.425. [IAS 28.14A, BC16L]
7I.1.110.40 Specific requirements apply to investments in subsidiaries held by
investment entities (see chapter 5.6).
• In its consolidated financial statements, an investment entity consolidates a
subsidiary that is not itself an investment entity and whose main purpose and
activities are providing services that relate to the investment entity’s investment
activities.
• In its consolidated and separate financial statements, an investment entity
measures other subsidiaries at FVTPL in accordance with IAS 39. [IAS 39.2(a), 10.31–
32, 27.11A]

7I.1.110.50 An entity is permitted to account for an interest in a subsidiary,

associate or joint venture in accordance with some or all of the requirements of IAS
39 in the following cases.
• In its consolidated financial statements, venture capital or similar organisations
may elect to measure investments in associates and joint ventures at FVTPL in
accordance with IAS 39 (see 3.5.100 and 7I.1.130). This election is available on an
investment-by-investment basis. If an entity elects this option, then it accounts for
these investments in the same way in its separate financial statements.
• In its separate financial statements, an investor may elect to account for
investments in subsidiaries, associates and joint ventures in accordance with IAS
39 (see 3.5.660). [IAS 39.2(a), 27.10, 28.18]

7I.1.110.60 A parent may hold more than a single instrument issued by its
subsidiary. If this is the case, then in preparing its separate financial statements the
parent may need to apply judgement to determine whether each instrument forms
part of the ‘investment in the subsidiary’ that is accounted for under IAS 27 and
therefore scoped out of IAS 39, unless the parent elects to apply IAS 39. For further
discussion of this assessment, see 3.5.670.

7I.1.115 Derivatives
7I.1.115.10 IAS 39 applies to derivatives on an interest in a subsidiary, associate
or joint venture unless the derivative meets the definition of an equity instrument of
the entity in IAS 32 (see 7I.1.30 and 7I.3.20.40). Such derivatives qualify for
exemption from the scope of IAS 39 when they may be settled only by the entity
exchanging a fixed amount of cash or another financial asset for a fixed number of its
own equity instruments (see 7I.3.100.10). [IAS 32.4(a), 39.2(a)]

7I.1.115.20 IAS 39 does not apply to derivatives containing potential voting rights
that in substance currently give access to the economic benefits associated with
ownership interests in a subsidiary, associate or joint venture that are accounted for
in accordance with 7I.1.110.10. In this case, the derivatives are taken into account in
determining the reporting entity’s interest in the investee (see 2.5.140, 470, 690 and
3.5.330). In our view, IAS 39 also does not apply to derivatives to acquire NCI in a
subsidiary that are accounted for under the anticipated-acquisition method (see
2.5.700). [IFRS 10.B90–B91, IAS 28.12–14, 39.2(a)]

7I.1.115.30 Even if a derivative over shares in a subsidiary is not accounted for as

a derivative under IAS 39 (see 7I.1.115.10–20), an entity is required to recognise a
financial liability in its consolidated financial statements for an obligation to acquire
equity instruments of the consolidated group (see 7I.3.150) – e.g. a written put option
or forward purchase contract over equity shares of a consolidated subsidiary.

7I.1.120 Forward contracts between acquirer and selling

shareholder in business combination

7I.1.120.10 IAS 39 excludes from its scope forward contracts between an acquirer
and a selling shareholder to buy or sell an acquiree that will result in a business
combination at a future date of acquisition. The term of such a forward contract
should not exceed a reasonable period normally necessary to obtain any required
approvals and to complete the transaction. The scope exclusion applies from the
perspectives of both the acquirer and a selling shareholder. [IAS 39.2(g)]

7I.1.120.20 To qualify for the scope exclusion, completion of the business

combination should not be dependent on further actions of either party. Accordingly,
the scope exclusion does not apply to option contracts, whether or not they are
currently exercisable, that on exercise would result in a business combination; for a
discussion of business combinations effected through derivatives, see 2.6.320. Option
contracts allow one party to the contract discretion over whether a business
combination occurs and therefore are not covered by the scope exemption. Similarly,
in our view the scope exclusion does not apply to a combination of put and call
options, often described as a ‘synthetic forward’. [IAS 39.BC24B–BC24C]

7I.1.120.30 The completion of a business combination may be conditional on

approval by the shareholders of either party or by a regulator or other governmental
body. The purpose of the exclusion is to prevent particular contracts from being
accounted for as derivatives while necessary regulatory and legal processes,
including any required approvals, are completed. Therefore, in our view application
of the scope exclusion is not usually precluded by the business combination being
dependent on obtaining shareholder or regulatory approvals within a reasonable
timeframe. We believe that this principle would extend to a contractual requirement
for shareholder approval that has been included in the contract in the interests of
good corporate governance, even though such an approval would not otherwise be
required by law. [IAS 39.2(g), BC24A–BC24C]

7I.1.120.40 However, in some cases judgement may be required to determine

whether contractual arrangements relating to approval have been designed so as to
provide management of either party with an option over whether completion will
happen or to allow deferral of completion beyond a reasonably necessary period such
that application of the scope exclusion would not be appropriate. For example, this
might be the case if completion of an agreement is permissible under law only if the
seller obtains a specific regulatory approval but the agreement does not require the
seller to make any effort to seek that approval but allows the seller instead to cancel
the contract without penalty rather than applying for the approval.

7I.1.120.50 The scope exemption does not apply by analogy to contracts to

acquire investments in associates and similar transactions, such as investments in
joint ventures (see 3.5.260). [IAS 39.BC24D]

7I.1.120.60 A purchaser may agree to acquire a business of another entity by

purchasing non-financial assets and related relationships from the entity, rather than
through acquisition of shares in the entity from its shareholders. A contract to
purchase non-financial assets of an entity is not a financial instrument and is outside
the scope IFRS 9 unless it can be settled net in cash or another financial instrument
and the own-use exemption is not applied (see 7I.1.150). Accordingly, the exemptions
from the scope of IAS 39 discussed in 7I.1.120.10-50 are not generally relevant to
such contracts.

7I.1.130 Venture capital, mutual funds and similar entities

7I.1.130.10 Venture capitalists, mutual funds, unit trusts and similar entities that
do not qualify as investment entities under IFRS 10 (see chapter 5.6) may choose to
account for investments in associates and joint ventures at fair value under IAS 39,
with all changes in fair value recognised in profit or loss, rather than applying the
equity method. However, there is no exemption for these entities from the
requirement to consolidate all entities that they control (see 3.5.100.10). [IAS 28.18,
39.AG3, IFRS 10.31–32]

7I.1.130.20 In our view, an entity that has substantive and separately managed
venture capital operations may use the exemption from applying the equity method,
even if the entity also has other operations. However, this exemption may be applied
only to the investments held as part of the venture capital portion of the entity’s
operations.

7I.1.130.30 For a discussion of whether an investor qualifies as a venture capital

organisation and the accounting implications, including the availability of the
exemption on a change in circumstances after initial recognition, see 3.5.100.

7I.1.140 Reimbursements

7I.1.140.10 Rights to reimbursement for expenditure that an entity is required to

make to settle a liability recognised as a provision are outside the scope of IAS 39.
They are recognised and measured in accordance with IAS 37 (see 3.12.190). [IAS
39.2(j)]

7I.1.150 Purchases and sales of non-financial items

7I.1.150.10 A contract to buy or sell a non-financial item may be required to be

accounted for as a derivative, even though the non-financial item itself falls outside
the scope of the financial instruments standards. Non-financial items include
commodities such as gold, oil, wheat and soya beans, as well as motor vehicles,
aircraft and real estate. If contracts to buy or sell non-financial items can be settled
net in cash or another financial instrument, including if the non-financial item is
readily convertible into cash, then they are included in the scope of the financial
instruments standards. [IAS 32.8, 39.5]
7I.1.150.20 There is an exception to this scope inclusion for contracts that are
entered into and continue to be held for the receipt or delivery of a non-financial item
in accordance with the entity’s expected purchase, sale or usage requirements (the
‘normal sales and purchases’ or ‘own-use’ exemption). [IAS 32.8, 39.5]

7I.1.150.30 The accounting for a contract to buy non-financial items – e.g.

commodities, property, plant and equipment, intangible assets and investment
properties – differs depending on whether the purchase contract is regarded as a
derivative. If the purchase contract is considered to be a derivative, then the
purchase contract and the initial recognition of the non-financial item on settlement
of the derivative are treated as separate transactions. The derivative is measured at
FVTPL under IAS 39 (see 7I.6.140) and the consideration paid for the non-financial
item is the cash paid plus the fair value of the derivative on settlement. If the
purchase contract is not regarded as a derivative, then it is treated as an executory
contract (see 1.2.130). Under this approach there is only one transaction, being the
purchase of a non-financial item under the contract, and the consideration paid for
that non-financial item is the agreed price under the purchase contract.

EXAMPLE 6 – CONTRACT TO BUY NON-FINANCIAL ITEMS

7I.1.150.40 Company J enters into a contract to buy 100 tonnes of

cocoa beans at 1,000 per tonne for delivery in 12 months. On the
settlement date, the market price for cocoa beans is 1,500 per tonne. If
the contract cannot be settled net in cash, or if the own-use exemption
applies, then the contract is considered to be an executory contract
outside the scope of IAS 39.

7I.1.150.50 Under the Standards, only one transaction is recognised,

being the purchase of inventory under IAS 2 (see chapter 3.8), and the
consideration paid is 100,000.

7I.1.150.60 However, if the contract can be settled net in cash and

the own-use exemption does not apply, then two transactions are
recognised. The purchase contract is accounted for as a derivative
under IAS 39. The purchase of inventory is a separate transaction and
the consideration paid under IAS 2 is cash of 100,000 plus the fair
value of the derivative on settlement of 50,000, bringing the total cost
of inventory to 150,000.

7I.1.150.70 For a discussion of the hedging of non-financial items,

see 7I.7.440.

7I.1.160 Settlement net in cash

7I.1.160.10 A commitment to buy or sell a non-financial item is considered settled

net in cash if:
• the terms of the contract permit either party to settle net in cash or another
financial instrument or by exchanging financial instruments – e.g. a written option
that permits cash settlement;
• the entity has a past practice of settling similar contracts net in cash or other
financial instruments or by exchanging financial instruments;
• the entity has a past practice of taking delivery of the underlying and selling it
within a short period after delivery for trading purposes; or
• the non-financial item that is subject to the contract is readily convertible into
cash. [IAS 32.9, 39.6]

7I.1.160.20 A contract that can be settled net in cash or one with the underlying
item readily convertible into cash may qualify as a contract entered into and held in
accordance with the entity’s expected purchase, sale or usage requirements as long
as the entity has no past practice of settling similar contracts net or trading the
underlying. [IAS 32.8–9, 39.5]

7I.1.160.30 However, a contract cannot be considered entered into in accordance

with the entity’s expected purchase, sale or usage requirements if the entity has a
past practice of settling similar contracts net in cash or other financial instruments or
by exchanging financial instruments, or taking delivery of the underlying and selling
it within a short period after delivery for trading purposes. Such contracts are in the
scope of IAS 39. [IAS 32.9, 39.6]

7I.1.160.40 In our view, ‘past practice’ should be interpreted narrowly. Infrequent

historical incidences of net settlement in response to events that could not have been
foreseen at inception of a contract would not taint an entity’s ability to apply the own-
use exemption to other contracts. An example is an unplanned and unforeseeable
breakdown (outage) in a power plant. However, any regular or foreseeable events
leading to net settlements or closing out of contracts would taint the ability to apply
the own-use exemption to similar contracts.

7I.1.160.50 In our view, the concept of ‘similar contracts’ includes all contracts to
buy or sell a non-financial item that can be settled net in cash, held for a similar
purpose.

EXAMPLE 7A – CONTRACT HELD FOR SIMILAR PURPOSES

7I.1.160.60 Power-generating Company P has sales contracts for

electricity, each of which is held for one of the following purposes:
1. held for trading – i.e. P has entered or intends to enter into
offsetting purchase contracts;
2. may result in delivery of the underlying power (commodity) but is
available to be closed out from time to time as required – i.e. net
cash settlement with the counterparty before or on the delivery
date;
3. intended to be settled by delivery of the underlying power but may
be closed out only in the case of force majeure or other similar
 unforeseen events; or
4. will always be settled by delivery of the underlying power.

7I.1.160.64 Only contracts of types (3) and (4) qualify as own-use.

However, in our view P should designate contract types (3) and (4) into
an own-use category at inception in order to qualify for the exemption.
Transfers out of these categories – e.g. closing out a contract other
than because of an unforeseen one-off event – would taint P’s ability to
use the own-use exemption in the future.

7I.1.160.67 Furthermore, P should be able to distinguish between

contracts that qualify for the own-use exemption and other contracts.
The designation need not refer specifically to the accounting treatment
under the Standards, but it should be sufficient to ensure that the
different purposes of each type of contract are clearly distinguished.
For example, if an entity has two distinct business models for
managing contracts to buy and sell commodities, each with different
risk management policies, it may be sufficient if the entity clearly
indicates at inception of each contract to which business model the
contract relates.

EXAMPLE 7B – PHYSICAL AND DERIVATIVE CONTRACTS MANAGED TOGETHER

7I.1.160.70 Company C is a chocolate manufacturer. C enters into a

combination of physical contracts for the purchase of cocoa beans and
cash-settled futures contracts. The physical contracts and the
derivatives are managed together to hedge fixed-price sales contracts
from an economic point of view.

7I.1.160.75 In our view, the physical contracts and the derivatives

would be regarded as similar in purpose and therefore the physical
contracts would not qualify for the own-use exemption.

7I.1.160.80 A contract for differences is a contract wherein two parties agree to

pay or receive in cash the difference between the spot price and the fixed price on an
underlying item, without actual delivery or receipt of that underlying item.

7I.1.160.90 Sometimes the market structure in some countries or industries may

preclude a supplier and customer from entering into a direct transaction for the
purchase/sale of a non-financial item. In such situations, the supplier may enter into a
contract with a market intermediary to sell the non-financial item at the spot price
and the customer may enter separately into a contract with a market intermediary
(possibly the same intermediary as that for the supplier) to buy the non-financial item
at the spot price. Depending on the structure of the market, the market intermediary
may act as a principal in its separate contracts with the customer and the supplier or,
alternatively, it may act as an agent on behalf of the customer and the supplier. To fix
the price for the non-financial item, the supplier and the customer may enter
separately into a direct contract for differences between themselves and agree to
pay/receive the difference between the spot price and a fixed price for that non-
financial item.

7I.1.160.100 If the market intermediary is acting as a principal in its separate

contracts with the customer and the supplier, although the customer and supplier
may be permitted to apply the own-use exemption to their respective contracts with
the market intermediary to buy or sell the non-financial item, then in our view the
own-use exemption cannot be applied to the separate contract for differences
between the customer and the supplier, because the contract for differences is not a
contract to buy or sell a non-financial item that will be settled by the delivery or
receipt of that non-financial item. [IU 08-05]

EXAMPLE 8A – CONTRACT FOR DIFFERENCES

7I.1.160.110 Market regulations in the electricity market

established by law may preclude an electricity generator and a
customer (retailer) from contracting directly for the delivery and
purchase of electricity – i.e. the generator has to deliver electricity to,
and a customer can buy electricity only from, a central ‘grid’, whereby
the grid acts as a principal in its separate contracts with the customer
and the generator.

7I.1.160.115 The generator and the customer manage their exposure

to the risk of fluctuations in electricity spot prices by entering into a
bilateral contractual arrangement (a contract for differences) that is
settled outside the spot market, whereby the two parties – i.e. the
generator and the customer – agree to exchange in cash the difference
between the contractually agreed fixed price and the variable spot
price that the customer pays in the market. The notional volume in
such a contract for differences is generally determined either by the
physical energy flow under the customer’s contract with the grid to
buy electricity or the generator’s contract with the grid to deliver
electricity.

7I.1.160.120 In our view, the transactions comprising the customer’s

contract with the grid to buy electricity and the customer’s contract for
differences with the generator, or the generator’s contract with the
grid to deliver electricity and the generator’s contract for differences
with the customer, do not form a single arrangement because:
• these transactions have two distinct, separate purposes; and
• each contract is with different parties.
7I.1.160.130 The structure is not considered to be a single
accounting unit, and therefore the contract for differences and the
 customer’s contract to buy electricity

(or the generator’s contract to deliver electricity) are analysed

separately under IAS 39. Because the contract for differences is settled
in cash, it is precluded from qualifying for the own-use exemption,
despite the linkage of the notional volume of the contract for
differences to the physical energy flow under the customer’s contract
with the grid to buy electricity (or the generator’s contract with the
grid to deliver electricity). However, the customer’s contract with the
grid to buy electricity or the generator’s contract with the grid to
deliver electricity may qualify for the own-use exemption.

7I.1.160.140 The customer/generator would, however, be able to

designate a contract-for-differences derivative in a hedge of the
variability in cash flows arising from the forecast purchases/sales of
electricity at the spot rate if it satisfies the hedge designation and
effectiveness criteria in IAS 39 (see 7I.7.120).

EXAMPLE 8B – INTERMEDIARY IN A WHOLESALE MARKET

7I.1.160.150 Company B is an intermediary in a wholesale market. B

enters into fixed-price contracts to buy aluminium in the market and
sells it in the same condition to customers, who use it in their
manufacturing processes. The market for aluminium is liquid. All
contracts are intended to be settled physically. The specific purpose of
these contracts is to generate stable profits from the margin between
the purchase and sale prices. Open positions are kept to a minimum.

7I.1.160.160 B aims to buy aluminium as cheaply as possible for its

customers and it does not provide the customers with any additional
services. The contracts are not and do not contain written options.

7I.1.160.170 B concludes that the contracts are entered into and

held for the purpose of generating profit from a dealer’s margin, rather
than for the purposes of the receipt or delivery of a non-financial item
in accordance with its expected purchase, sale or use requirements.
Accordingly, the contracts are in the scope of IAS 39 and are measured
at FVTPL.

7I.1.160.180 Modifying the scenario, the conclusion may be different

if B provided significant services to its customers – e.g. shipping,
distribution or repackaging of the commodity into small retail units.
Significant services are typically provided if the entity buys and sells in
different markets (e.g. buys wholesale and sells retail). If additional
services are provided, then determining whether a contract is entered
 into and held for the purposes of the receipt or delivery of a non-
financial item in accordance with its expected purchase, sale or use
requirements may involve significant judgement.

7I.1.160.190 For a related discussion of the definition of a broker-

dealer, see 3.8.70.25.

7I.1.170 Readily convertible into cash

7I.1.170.10 In our view, the following indicators are useful in determining

whether a non-financial item is readily convertible into cash.
• There is an active market for the non-financial item. This refers to the spot market
rather than the forward market. The relevant ‘spot market’ is the market where
the entity sells its products based on its business model. An entity assesses
whether this specific market is active, according to the guidance provided in IFRS
13 (see 2.4.280). It is important that buyers and sellers are present at any time.
This is indicated, for example, by daily trading frequency (traded contracts) and
daily trading volumes. Other indicators that might be considered are:
– binding prices for the item are readily obtainable;
– transfers of the item involve standardised documentation;
– individual contract sales do not require significant negotiation or unique
structuring;
– the period required until the contract is finally closed is not extensive because
of the need to permit legal consultation and document review; and
– the difference between the transaction price and the entity’s assessment of the
value of the contract is insignificant (because a significant difference may
indicate low liquidity).
• The non-financial item is fungible.
• Transaction costs, including commission, distribution and transport costs, are
insignificant compared with gross sale proceeds. [IFRS 13.A]

7I.1.180 Written options

7I.1.180.10 A written option to buy or sell a non-financial asset that can be settled
net in cash or another financial instrument – including when the non-financial item
subject to the contract is readily convertible into cash – can never qualify for the own-
use exemption because the entity cannot control whether the purchase or sale will
take place. Therefore, such a contract cannot be entered into to meet an entity’s
expected purchase, sale or usage requirements. However, written options for
commodities that cannot be settled net in cash (see 7I.1.160) are not in the scope of
IAS 39. [IAS 32.10, 39.7]

7I.1.180.20 Sometimes forward contracts, which may qualify for the own-use
exemption, are combined with written options in one contract. For example, an
agreement to sell a fixed amount of a product at a fixed price may be combined with a
written option under which a customer may buy additional amounts. In our view, in
such cases the contract may be split so that the forward element may qualify as own-
use even though the written option component will not.

7I.1.180.30 In the energy sector, it is common for a power company to provide

‘whole of meter’ contracts, under which the customer pays a fixed price per unit for
the number of units of power it uses in a particular period. In our view, such contracts
are not generally written options because the customer does not have the right to buy
more or less of the product depending on the market price, nor does the customer
have the ability to settle such contracts net in cash. In the case of electricity, the
product cannot be stored or resold by customers and therefore from the perspective
of the customer the power obtained under such contracts is not readily convertible
into cash.

7I.1.190 Embedded derivatives

7I.1.190.10 A contract to buy or sell a non-financial item may be required to be
treated as a derivative and measured at FVTPL in the period between the trade date
and the settlement date (see 7I.5.20.45). [IAS 39.AG54]

7I.1.190.20 If a contract to buy or sell a non-financial item is not a derivative but

contains an embedded derivative, then an entity determines whether the embedded
derivative should be separated from the host contract and accounted for separately
(see 7I.2.110). If the embedded derivative is accounted for separately, then in our
view the host contract might still qualify for the own-use exemption.

7I.1.190.30 For contracts to buy or sell non-financial items that are not treated as
derivatives, the underlying purchase or sale transaction is accounted for in
accordance with the relevant standard. Such contracts are generally executory
contracts (see 1.2.130) to buy or sell the underlying non-financial item. However, if
such contracts contain a ‘price adjustment’ clause, then an assessment is made about
whether such a clause is an embedded derivative that requires separation under IAS
39 (see 7I.2.110). In our view, whether a contract to buy or sell a non-financial item
has an embedded derivative that requires separation – e.g. in the form of a price
adjustment clause – does not affect the conclusion about whether the host contract
meets the own-use exemption under IAS 39 (see 7I.1.150.20). [IAS 39.5, 10, AG35(b)]

7I.1.190.40 For a discussion of derivatives embedded in contracts in the scope of

IFRS 15, see 7I.1.210.10.

7I.1.200 Loan commitments

7I.1.200.10 A loan commitment may be an arrangement under which:

• both the lender and the borrower are committed to a future loan transaction – i.e.
a forward contract to grant/receive a loan; or
• the lender is obliged contractually to grant a loan, but the borrower is not required
to take the loan – i.e. lender’s written option.

7I.1.200.20 Generally, loan commitments, both issued and held, are excluded from
the scope of IAS 39 but are subject to the derecognition provisions of the standard.
However, a loan commitment falls entirely in the scope of IAS 39 when:
• the entity designates the loan commitment as a financial liability at FVTPL;
• the entity has a past practice of selling the assets resulting from its loan
commitments shortly after their origination, in which case IAS 39 applies to all
loan commitments in the same class and they are treated as derivatives;
• the loan commitment can be settled net in cash or by delivering or issuing another
financial instrument – i.e. such a loan commitment is a derivative; or
• the commitment is to provide a loan at a below-market interest rate. [IAS 39.2(h), 4]

7I.1.200.30 A loan commitment that can be settled net in cash or by delivering or

issuing another financial instrument is a derivative in the scope of IAS 39 (see
7I.1.200.20) – i.e. a loan commitment is excluded from the scope of IAS 39 only if it
cannot be settled net. Paying a loan out in instalments is not regarded as net
settlement of a loan commitment. [IAS 39.4(b), BC18]

EXAMPLE 9 – NET SETTLEMENT OF LOAN COMMITMENT

7I.1.200.40 Bank B and Company L enter into an agreement that in

two years B will lend to L and L will borrow from B 100 for 10 years at a
fixed interest rate.

7I.1.200.50 B cannot terminate the loan commitment. However, the

contract gives L an option to terminate the commitment on payment of
a termination fee. The termination fee is calculated as the difference, if
positive, between:
• the present value of the loan’s contractual cash flows discounted at
the risk-free market interest rate at the date of termination plus the
original credit spread determined at the date the contract was
signed; and
• the present value of the loan’s contractual cash flows discounted at
the fixed interest rate of the loan.

7I.1.200.60 Because the loan commitment can be settled by L

making a net cash payment based on the effect of changes in interest
rates on the value of the loan commitment, B and L conclude that the
loan commitment is a derivative in the scope of IAS 39.

7I.1.200.70 A loan commitment that is a hedged item in a fair value or cash flow
hedge is accounted for as a hedged item under IAS 39. Generally, only loan
commitments that are scoped out of IAS 39 could qualify as a hedged item; loan
commitments in the scope of IAS 39 are generally accounted for as derivatives and
therefore do not qualify as hedged items. [IAS 39.4, IG.F.2.1]

7I.1.200.80 IAS 39 includes specific requirements for the measurement of a loan

commitment to provide a loan at a below-market interest rate when the loan
commitment is not measured at FVTPL. Such a loan commitment is measured initially
at fair value and subsequently at the higher of (1) the amount recognised under IAS
37 (see chapter 3.12); and (2) the amount initially recognised less the cumulative
amount of income recognised in accordance with the principles of IFRS 15 (see
chapter 4.2). Loan commitments that are not in the scope of IAS 39 are accounted for
under IAS 37. However, all loan commitments are subject to the derecognition
provisions of IAS 39. [IAS 39.2(h), 4(c), 47(d)]

7I.1.200.90 In our view, under IAS 37 it is likely that a provision for a loan
commitment would be recognised either if an entity is committed to making a loan
that would be considered to be impaired or otherwise only when the contract
becomes onerous.

7I.1.210 Rights and obligations in the scope of IFRS 15

7I.1.210.10 IAS 39 excludes from its scope rights and obligations that are in the
scope of IFRS 15, except for those that IFRS 15 specifies are accounted for in
accordance with IAS 39 – e.g. trade receivables. At the same time, IFRS 15 excludes
from its scope financial instruments and other contractual rights and obligations that
are in the scope of IAS 39. IFRS 15 also states that a contract may be partially in its
scope and partially in the scope of another standard, such as IAS 39. In such cases,
IFRS 15 states that if the other standard specifies how to separate and/or initially
measure one or more parts of the contract, then an entity first applies the separation
and/or measurement requirements of that other standard. For example, if a contract
contains a financial instrument in the scope of IAS 39, then the entity separates and
measures that financial instrument using the guidance in IAS 39 and excludes from
the transaction price under IFRS 15 the amount initially measured in accordance
with IAS 39. Accordingly, the entity first considers whether the contract contains an
embedded derivative that is in the scope of IAS 39, and whether IAS 39 requires it to
be accounted for separately (see 7I.2.110). [IFRS 15.5(c), 7, 108, C9, IAS 39.2(k)]

7I.1.210.20 The impairment requirements of IAS 39 apply to contract assets in the

scope of IFRS 15 (see 4.2.490 and 7I.6.400.05). [IFRS 15.107, C9, IAS 39.2A]
27 OCT 2022 PAGE 2605

Insights into IFRS 18th Edition 2021/22

7I. Financial instruments: IAS 39
7I.2 Derivatives and embedded derivatives

7I.2 Derivatives and embedded derivatives

7I.2.10 Derivatives 2608

7I.2.20 Definition 2608
7I.2.30 Change in value based on an
‘underlying’ 2608
7I.2.40 No or ‘smaller’ initial net
investment 2610
7I.2.50 Settlement at a future date 2611
7I.2.60 Exemptions from derivative treatment 2611
7I.2.70 Regular-way contracts 2611
7I.2.80 Derivatives on own equity 2612
7I.2.90 Gaming contracts 2612
7I.2.100 Rights and obligations
arising on transfer of
financial asset 2612
7I.2.110 Embedded derivatives 2612
7I.2.120 Definition and outline 2612
7I.2.130 Scope exclusions 2613
7I.2.140 Multiple embedded derivatives 2614
7I.2.150 Hybrid instruments measured at FVTPL 2615
7I.2.160 Inability to measure reliably 2615
7I.2.170 Separation not voluntary 2615
7I.2.180 Existence of a contractual commitment 2616
7I.2.190 When to separate 2616
7I.2.200 Closely related criterion 2616
7I.2.210 Multiple embedded
derivatives 2617
7I.2.220 Reassessment of embedded
derivatives 2617
7I.2.230 Extension features 2619
7I.2.240 Calls, puts or prepayment
options 2619
 7I.2.250 Interest rate features in host
debt contracts and insurance
contracts 2622
7I.2.255 Embedded interest rate caps
and floors 2622
7I.2.260 Foreign currency derivatives embedded
in non-financial or insurance contracts 2624
7I.2.265 Foreign currency derivatives embedded
in host debt instruments 2626
7I.2.270 Inflation-indexed embedded derivatives 2627
7I.2.280 Specific hybrid financial instruments 2627
7I.2.290 Bonds with a constant-
maturity yield 2628
7I.2.300 Cash or share bonds 2628
7I.2.310 Bonds with interest
payments linked to equity
index 2628
7I.2.320 Step-down bonds 2629
7I.2.330 Reverse (inverse) floating
notes 2629
7I.2.340 Callable zero-coupon bonds 2631
7I.2.350 Perpetual reset bonds 2631
7I.2.370 Specific hybrid non-financial contracts 2633
7I.2.380 Accounting for separable embedded
derivatives 2635
7I.2.390 Presentation and disclosures 2637

7I.2 Derivatives and embedded derivatives

REQUIREMENTS FOR INSURERS THAT APPLY IFRS 4

In July 2014, the International Accounting Standards Board issued IFRS 9 Financial
Instruments, which is effective for annual periods beginning on or after 1 January
2018. However, an insurer may defer the application of IFRS 9 if it meets certain
criteria (see 8.1.180).

This chapter reflects the requirement of IAS 39 Financial Instruments: Recognition

and Measurement and the related standards, excluding any amendments introduced
by IFRS 9. These requirements are relevant to insurers that apply the temporary
exemption from IFRS 9 or the overlay approach to designated financial assets (see
8.1.160) and prepare financial statements for periods beginning on 1 January 2021.
For further discussion, see Introduction to Sections 7 and 7I.

The requirements related to this topic are mainly derived from the following.
 STANDARD TITLE

IAS 39 Financial Instruments: Recognition and Measurement

IFRIC 9 Reassessment of Embedded Derivatives

FORTHCOMING REQUIREMENTS AND FUTURE DEVELOPMENTS

For this topic, there are no forthcoming requirements or future developments.

7I.2.10 DERIVATIVES

7I.2.20 Definition

7I.2.20.10 A ‘derivative’ is a financial instrument or other contract in the scope of

IAS 39 that has all of the following features:
• its value changes in response to one or more underlying variables – e.g. an interest
rate (see 7I.2.30);
• it has an initial net investment smaller than would be required for other
instruments that have a similar response to the variable (see 7I.2.40); and
• it will be settled at a future date (see 7I.2.50). [IAS 39.9]
7I.2.20.20 The definition of a derivative does not require specific settlement
features. As such, a contract that allows either net or gross settlement may be a
derivative. [IAS 39.IG.B.3]

7I.2.20.30 The definition of a derivative is relevant in considering the treatment

of both stand-alone contracts and features that are embedded in hybrid contracts
(see 7I.2.110). In our view, a stand-alone derivative should not be split into its
component parts. For example, an interest rate collar should not be separated into an
interest rate cap and an interest rate floor that are accounted for separately.

7I.2.30 Change in value based on an ‘underlying’

7I.2.30.10 A derivative is a financial instrument that provides the holder (or
writer) with the right (or obligation) to receive (or pay) cash or another financial
instrument in amounts determined with reference to price changes in an underlying
price or index, or changes in foreign exchange or interest rates, at a future date. A
derivative may have more than one underlying variable. [IAS 39.IG.B.8]

7I.2.30.20 A derivative usually has a notional amount, which can be an amount of

currency, a number of shares, a number of units of weight or volume or other units
specified in the contract. However, in our view contracts without notional amounts or
with variable notional amounts may also meet the definition of a derivative. The
holder or writer is not required to invest in or receive the notional amount at
inception of the contract. [IAS 39.AG9]
7I.2.30.30 A contract to pay or receive a fixed amount on the occurrence or non-
occurrence of a future event meets the definition of a derivative, provided that this
future event depends on a financial variable or a non-financial variable not specific to
a party to the contract. For example, an entity may enter into a contract under which
it will receive a fixed payment of 100 if a specified index increases by a determined
number of points in the next month. The settlement amount is not based on and does
not need to change proportionately with an underlying. [IAS 39.AG9]

7I.2.30.40 The underlying variable on which the fair value of a derivative

instrument is based may be that of:
• the price of a financial instrument – e.g. a bond or equity security;
• the price of a commodity – e.g. gold, oil or wheat;
• a rate – e.g. an interest rate or a foreign exchange rate;
• an index of prices – e.g. a stock exchange index; or
• some other variable that has a measurable value – e.g. a climatic, geological or
other physical variable. [IAS 39.IG.B.2]

7I.2.30.50 An option, forward or swap that is exercisable at the fair value of the
underlying item always has a fair value of zero. Therefore, it does not meet the
definition of a derivative because its value does not depend on an underlying variable.
[IAS 39.9]

7I.2.30.60 The definition of a derivative excludes instruments with a non-

financial underlying variable that is specific to a party to the contract. However, the
Standards do not provide guidance on how to determine whether a non-financial
variable is specific to a party to the contract. In our view, the analysis comprises two
questions:
1. Is the variable non-financial or financial?
2. Is it specific to a party to the contract?

7I.2.30.70 In our view, this exclusion is primarily intended to exclude insurance

contracts. For example, a residual value guarantee on a motor vehicle, in which the
holder is compensated not only for a decline in the market value of the vehicle but
also for the condition of the vehicle, does not meet the definition of a derivative.

7I.2.30.80 However, in our view items such as EBITDA, profit, sales volume,
revenue or cash flows of one counterparty may be considered to be non-financial
variables that are specific to a party to the contract even though the contract, or the
embedded feature being considered, does not meet the definition of an insurance
contract (see 8.1.20). In addition, we believe that the gross domestic product of a
counterparty that is a government or the non-viability of the issuer of a debt
instrument – e.g. the issuer’s regulatory capital ratio falling below a specified
minimum threshold – may be considered to be a non-financial variable that is specific
to a party to the contract. In our view, an entity should choose an accounting policy, to
be applied consistently, on whether such items are considered to be non-financial
variables that are specific to a party to the contract.

7I.2.30.90 If an instrument has more than one underlying variable – i.e. it is dual-
indexed – with one underlying being a non-financial variable specific to one of the
parties, then judgement is required in determining whether the instrument is a
derivative. The assessment depends, in our view, on the predominant characteristics
of the instrument. We believe that a dual-indexed instrument is normally a derivative
if it behaves in a manner that is highly correlated with the behaviour of the financial
underlying variables (or other variables that are not specific to a party to the
contract).

7I.2.30.100 The implementation guidance accompanying IAS 39 identifies the

following examples of a derivative.
• A contract to exchange an amount of foreign currency determined by the sales
volume of the entity at a fixed exchange rate at a future date.
• An ‘equity kicker’ feature under which the lender of a subordinated loan is entitled
to receive shares of the borrower free of charge, if the shares are listed. [IAS
39.IG.B.8, IG.C.4]

7I.2.30.110 Consistent with the equity kicker example described above, in our
view a contractual feature in a debt instrument that converts the instrument into
equity shares of the issuer on occurrence of a specified ‘non-viability event’ (e.g. the
issuer’s regulatory capital falling below a specified level) is a derivative component
(see Examples 10A and 10B).

7I.2.40 No or ‘smaller’ initial net investment

7I.2.40.10 There is no quantified guidance on how much smaller the initial net
investment should be, compared with the investment required for other contracts
that would be expected to have a similar response to changes in market factors, for
the contract to meet the definition of a derivative. The standard requires the initial
net investment to be less than the investment needed to acquire the underlying non-
derivative financial instrument. However, ‘less than’ does not necessarily mean
‘insignificant’ in relation to the overall investment and needs to be interpreted on a
relative basis. [IAS 39.AG11]

7I.2.40.20 Debt and equity securities are generally not derivatives, although
their fair values respond to changes in the underlying – e.g. interest rates or a share
price – in similar ways to derivatives on these instruments. This is because it is not
possible to identify another instrument that would require a greater initial net
investment and have a similar response to changes in the relevant market factors.

7I.2.40.30 Many derivatives, such as at-market forward contracts, do not have

any initial net investment.

7I.2.40.40 Purchased options normally require the payment of an up-front

premium, but the amount paid is normally small in relation to the amount that would
be paid to acquire the underlying instrument. However, certain call options may have
a very low exercise price so that the amount paid to acquire the option is likely to be
equivalent to the amount that would be paid to acquire the underlying asset outright
at inception of the option. In our view, such options should be treated as a purchase of
the underlying asset and not as derivatives. In other words, if an option is so deep in
the money, at the date of issue or acquisition, that the cost of the option is almost
equal to the value of the underlying asset at that date, then it should be accounted for
as an investment in the underlying asset and not as a derivative. [IAS 39.IG.B.9]

7I.2.40.50 A cross-currency swap meets the definition of a derivative, even

though there is an exchange of currencies at inception of the contract, because there
is zero initial net investment. [IAS 39.AG11]

7I.2.40.60 Any required deposits or minimum balance requirement held in

margin accounts as security for derivatives are not considered part of the initial
investment. For example, the initial margin required in respect of exchange-traded
futures comprises cash collateral rather than being part of the initial investment in
the underlying commodity. [IAS 39.IG.B.10]

7I.2.40.70 Sometimes one leg of a derivative is prepaid. Whether the remaining

part still constitutes a derivative depends on whether all of the criteria in the
definition are still met. [IAS 39.IG.B.4–IG.B.5]

7I.2.40.80 If a party to an interest rate swap prepays its pay-fixed obligation at

inception but will continue to receive the floating-rate leg over the life of the swap,
then the floating-rate leg of the swap is still a derivative instrument. This is because
all of the criteria for a derivative are met: the initial net investment – i.e. the amount
prepaid by the entity – is less than investing in a similar primary financial instrument
that responds equally to changes in the underlying interest rate; the instrument’s fair
value changes in response to changes in interest rates; and the instrument is settled
at a future date. If the party prepays the pay-fixed obligation at a subsequent date,
then this would be regarded as a termination of the old swap and an origination of a
new instrument that is evaluated under IAS 39. [IAS 39.IG.B.4]

7I.2.40.90 In the reverse situation, if a party to an interest rate swap prepays its
pay-variable obligation at inception using current market rates, then the swap is no
longer a derivative because the prepaid amount now provides a return that is the
same as that of a fixed-payment annuity or an amortising fixed rate debt instrument
in the amount of the prepayment. Therefore, the initial net investment equals that of
other financial instruments with fixed annuities. [IAS 39.IG.B.5]

7I.2.50 Settlement at a future date

7I.2.50.10 Derivatives require settlement at a future date. A forward contract is
settled on a specified future date, an option has a future exercise date and interest
rate swaps have multiple dates on which interest is settled. An option is considered
settled on exercise or at its maturity. Therefore, even though the option may not be
expected to be exercised when it is out of the money, it still meets the criterion of
settlement at a future date. Any contract in which there is a delay between the trade
date and settlement date is a derivative if the other criteria are also met. [IAS 39.IG.B.7]

7I.2.50.20 Settlement of a derivative, such as an interest rate swap, may be

either a gross or a net exchange of cash or other financial instruments. [IAS 39.IG.B.3]

7I.2.50.30 A key element for a contract to buy or sell a non-financial item to be

treated as a derivative in the scope of IAS 39 is that the transaction should allow for
net settlement in the form of cash or the right to another financial instrument (see
7I.1.150). [IAS 39.AG10, IG.A.1–IG.A.2]

7I.2.60 Exemptions from derivative treatment

7I.2.70 Regular-way contracts

7I.2.70.10 ‘Regular-way contracts’ are contracts to buy or sell financial assets

that will be settled within the timeframe established by regulation or convention in
the market concerned, not necessarily an organised market. Regular-way contracts
are not treated as derivatives between the trade date and settlement date. [IAS 39.9, 38,
AG53–AG56]

EXAMPLE 1 – REGULAR-WAY CONTRACT

7I.2.70.20 Company X purchases a security in a market in which

three days is the normal settlement period for this type of transaction.
X’s commitment to settle the security in three days is not treated as a
derivative because three days is the normal settlement period for this
type of transaction in the environment in which the transaction takes
place.

7I.2.70.30 However, in a market with three-day settlement, if a

contract entered into by X specifies that settlement will take place only
in three months, then the exception would not apply and X would need
to treat the contract as a derivative between the trade date and the
settlement date.

7I.2.70.40 The Standards do not offer any specific guidance on how to treat a
delay in the settlement of a regular-way contract. In our view, a delay would not
preclude the use of the regular-way exemption if the contract requires delivery within
the timeframe established by the convention in the market and the delay is caused by
a factor that is outside the control of the entity.

7I.2.80 Derivatives on own equity

7I.2.80.10 Derivatives on own equity are excluded from the scope of IAS 39 if
they meet the definition of an equity instrument (see 7I.3.20.40, 50 and 130). [IAS
39.2(d)]

7I.2.90 Gaming contracts

7I.2.90.10 A gaming institution may enter into different types of transactions
with its customers. The following are examples.
• Transactions in which the gaming institution administers a scheme among its
 customers and receives a commission based on the amount wagered – e.g.
parimutuel betting. In these transactions, the gaming institution will receive its
commission regardless of the outcome of the wager.
• Transactions in which the gaming institution takes a position against its
customers. In these transactions, the value of the individual contract is contingent
on the outcome of a specified event and the gaming institution is not, therefore,
normally guaranteed a specific commission or return – e.g. a bookmaker that lays
fixed odds on the outcome of a sporting event.

7I.2.90.20 In our view, the first type of transaction in 7I.2.90.10 does not meet
the definition of a derivative, because the value of such contracts does not fluctuate
based on an underlying variable. We believe that these transactions should be
accounted for under IFRS 15 (see chapter 4.2). Conversely, the second type of
transactions in 7I.2.90.10 will normally meet the definition of a derivative, because
the value of such contracts varies depending on the likelihood of the occurrence of a
specified event. In this case, such transactions will be accounted for under IAS 39. [IU
07-07]

7I.2.100 Rights and obligations arising on transfer of financial

asset
7I.2.100.10 Rights and obligations arising on a transfer of a financial asset that
does not qualify for derecognition are not treated as derivatives under IAS 39, if
recognising the derivative would result in recognising the same rights or obligations
twice (see 7I.5.300.20). [IAS 39.AG49]

7I.2.110 EMBEDDED DERIVATIVES

7I.2.120 Definition and outline

7I.2.120.10 A hybrid (combined) contract is a contract that includes both a non-

derivative host contract and one or more embedded derivatives. [IAS 39.10, AG33A]

7I.2.120.20 IAS 39 requires an embedded derivative to be separated from the

host contract and accounted for as a stand-alone derivative if the following conditions
are met:
• the economic characteristics and risks of the embedded derivative are not closely
related to those of the host contract (see 7I.2.200);
• a separate instrument with the same terms as the embedded derivative would
meet the definition of a derivative (see 7I.2.20); and
• the hybrid instrument is not measured at FVTPL (see 7I.2.150). [IAS 39.11]
7I.2.120.30 The following flowchart illustrates how to apply the requirements for
separating an embedded derivative from a hybrid instrument.
 Yes
Is the hybrid instrument measured at FVTPL?

No
Do not
Would the embedded derivative meet the No bifurcate the
definition of a derivative if freestanding? embedded
derivative
Yes

Is the embedded derivative ‘closely related’ Yes

to the host contract?

No
Bifurcate the embedded derivative

7I.2.120.40 A derivative contract attached to a host contract that is transferable

separately from the host contract, or that is added by a third party, is a stand-alone
derivative and not an embedded derivative. For example, a lease or loan may have an
associated interest rate swap. If the swap can be sold separately, then it is a stand-
alone derivative and not an embedded derivative, even if both the derivative and the
host contract have the same counterparty. [IAS 39.10]

7I.2.120.50 Each component of a ‘synthetic instrument’ is accounted for

separately, unless there is a requirement to account for the separate instruments as a
single combined instrument (see 7I.5.40). A synthetic instrument is a combination of
separate instruments that, viewed together, ‘create’ a different instrument.

EXAMPLE 2 – ACCOUNTING FOR COMPONENTS OF SYNTHETIC INSTRUMENT

7I.2.120.60 Company D holds a five-year floating rate debt

instrument and a five-year pay-floating, receive-fixed interest rate
swap; together these two instruments create, for D, a synthetic five-
year fixed rate investment. The individual components of the synthetic
instrument are not embedded derivatives; instead, they are stand-
alone instruments, which are accounted for separately. [IAS 39.IG.C.6]

7I.2.130 Scope exclusions

7I.2.130.10 In our view, if an item that is otherwise excluded from the scope of
IAS 39 contains an embedded derivative, then the entity should evaluate whether the
particular standard that addresses the accounting for the scoped-out item also
addresses the accounting for the embedded derivative. If that standard addresses the
accounting for the embedded derivative, then we believe that the entire hybrid
instrument should be accounted for in accordance with that particular standard. If
the standard does not address the accounting for the embedded derivative, then we
believe that the principles in IAS 39 should be used to evaluate whether the
embedded derivative should be separated. If the embedded derivative is required to
be separated, then the host contract is accounted for under the relevant standard and
the embedded derivative is accounted for under IAS 39.

7I.2.130.20 In our view, before considering whether an embedded derivative

should be separated from a host contract, an entity should evaluate whether the
economic characteristics of the embedded derivative change the nature of the hybrid
instrument to such an extent that the hybrid instrument in its entirety does not
qualify for the IAS 39 scope exemption. For example, we believe that a commitment
to enter into a loan in the future under which the principal advanced is fixed but the
principal repayable is indexed to the price of a commodity would be regarded at
inception as a freestanding derivative rather than a loan commitment with an
embedded derivative.

7I.2.130.30 Although lease contracts and insurance contracts are generally

excluded from the scope of IAS 39, derivatives embedded in them are subject to the
requirements for separation of embedded derivatives. However, an embedded
purchase option for a leased asset included in a lease contract is not separated
because the option is accounted for as part of the lease (see chapter 5.1). All other
derivatives embedded in lease contracts – e.g. foreign currency derivatives,
leveraged escalation clauses etc – are considered for separation (see also 7I.2.260
and 7I.2.265). If an embedded feature in an insurance contract itself transfers
significant insurance risk, then the feature meets the definition of an insurance
contract and therefore is not required to be separated under the embedded
derivative guidance (see 8.1.30.50–70) [IAS 39.2(b), (e), AG33(f), IFRS 4.7, B11]

7I.2.130.40 If an embedded derivative is separated, then the host contract is

accounted for under IAS 39 if it is itself a financial instrument in the scope of IAS 39,
or otherwise in accordance with other appropriate standards if it is not a financial
instrument (see 7I.2.130.10). [IAS 39.11]

7I.2.140 Multiple embedded derivatives

7I.2.140.10 If a single hybrid contract has more than one embedded derivative
with different underlying risk exposures and those embedded derivatives are readily
separable and are independent of each other, then they are accounted for separately
from each other. For example, a debt instrument may contain options to choose the
interest rate index on which interest is determined and the currency in which the
principal is repaid. These are two distinct embedded derivative features with
different underlying risk exposures, which are accounted for separately from each
other. [IAS 39.AG29]

7I.2.140.20 Multiple embedded derivatives in a single hybrid contract that relate

to the same risk exposure, or that are not readily separable and independent of each
other, are treated as a single compound embedded derivative (see 7I.2.210). [IAS
39.AG29]

EXAMPLE 3 – ACCOUNTING FOR HOST CONTRACT

7I.2.140.30 Company X issues a debt instrument that includes two

embedded derivative features.
• Feature 1:Varies the interest rate on the debt instrument.
• Feature 2:Allows the holder of the debt instrument to put it back to
the issuer.

7I.2.140.40 X treats these two features as a single compound

embedded derivative because they both relate to interest rate risk.

7I.2.150 Hybrid instruments measured at FVTPL

7I.2.150.10 If the hybrid (combined) instrument – i.e. the host contract plus the
embedded derivative – is measured at FVTPL, then separate accounting is not
permitted. [IAS 39.11]

7I.2.150.20 If a contract is a financial instrument and contains one or more

embedded derivatives, then an entity may designate the entire combined contract as
a financial asset or financial liability at FVTPL unless:
• the embedded derivative does not significantly modify the cash flows that would
otherwise arise on the contract; or
• it is clear with little or no analysis when a similar hybrid instrument is first
considered that separation would be prohibited. [IAS 39.11A]

7I.2.150.25 The designation discussed in 7I.2.150.20 is used only when:

• it reduces the complexities associated with separating embedded derivatives; or
• measuring the entire instrument at FVTPL is more reliable than measuring the fair
value of the embedded derivative. [IAS 39.AG33A–AG33B]

EXAMPLE 4A – DESIGNATING ENTIRE COMBINED CONTRACT AT FVTPL (1)

7I.2.150.30 Company B has an investment in convertible bonds. If

B classifies the investment as an available-for-sale asset, then changes
in the fair value of the hybrid instrument would be recognised in OCI,
and B would be required to account for and measure the embedded
derivative (equity conversion option) separately at FVTPL. However, it
may be simpler for B to designate the entire investment as at FVTPL
and thereby avoid the need to separately measure and account for the
embedded conversion option.

EXAMPLE 4B – DESIGNATING ENTIRE COMBINED CONTRACT AT FVTPL (2)

 7I.2.150.40 Company B also has a complex investment product that
comprises a host bond contract and a number of embedded derivatives
based on interest rates, equity prices etc. Again, it may be simpler for
B to determine a fair value for the instrument as a whole than to
account separately for the embedded derivative components.

7I.2.160 Inability to measure reliably

7I.2.160.10 If the fair value of an embedded derivative cannot be measured

reliably, although the characteristics are such that separation is required, then the
entire combined contract – i.e. host contract and embedded derivative – is designated
as at FVTPL. In our experience, this situation will be encountered only in rare
circumstances (see 7I.4.70.40). [IAS 39.12]

7I.2.170 Separation not voluntary

7I.2.170.10 If an embedded derivative is not required to be separated, then IAS 39

does not permit an entity to separate it from the hybrid instrument – i.e. separation is
not optional. [IAS 39.11]

7I.2.180 Existence of a contractual commitment

7I.2.180.10 For an embedded derivative to exist, the contract needs to represent a

contractual commitment. For example, forecast but uncommitted sales in a foreign
currency, no matter how likely, cannot contain an embedded derivative.

7I.2.190 When to separate

7I.2.200 Closely related criterion

7I.2.200.10 Determining whether an embedded derivative is closely related to the

host contract requires consideration of the nature – i.e. the economic characteristics
and risks – of the host contract and the nature of the underlying of the derivative. If
the natures of both the underlying and the host contract are similar, then they are
generally closely related. [IAS 39.11, AG30–AG33]

7I.2.200.20 In our view, a derivative with economic characteristics and risk types
that are broadly similar to those of the host contract is not necessarily closely related
to the host contract. This is, for example, the case in the following situations.
• An equity host contract and an embedded equity index-linked derivative are not
closely related unless they are both exposed to the equity characteristics of the
same entity.
• The derivative embedded in an inflation-indexed lease contract is closely related
to the lease only if the inflation index relates to the same economic environment as
the lease contract. [IAS 39.AG27, AG33(f)]

7I.2.200.25 A leverage feature that is not insignificant usually causes an

embedded derivative feature not to be closely related; an exception is discussed in
7I.2.250. ‘Leverage’ in this context (for contracts other than options) means that the
feature increases the variability of the contractual cash flows of the hybrid
instrument at a greater rate than would be inferred from the host instrument’s
economic relationship with the relevant underlying. [IAS 39.AG30, AG33]

7I.2.200.30 Evaluating whether an embedded derivative is closely related to its

host contract requires identifying the nature of the host contract. The nature of a host
financial instrument – i.e. debt or equity – is not always obvious. A debt host contract
has economic characteristics and risks of a debt instrument, is not an equity
instrument, and meets the definition of a financial instrument, whereas an equity host
contract has no stated or predetermined maturity and gives the holder a residual
interest in the net assets of an entity. [IAS 39.AG27]

EXAMPLE 5 – HOST CONTRACT FOR STATED MATURITY INSTRUMENT LINKED TO SHARE PRICE

7I.2.200.40 A company issues a five-year instrument that has a

principal of 100 and that will be redeemed on a specified date at an
amount equal to the principal plus the change in the fair value of 10
shares in a listed company over the term of the instrument.

7I.2.200.50 Even though the redemption amount is linked to a

listed company’s share price, the instrument has a stated maturity and
the host contract has the nature of a debt instrument. [IAS 39.AG27,
IG.C.5]

7I.2.210 Multiple embedded derivatives

7I.2.210.10 As discussed in 7I.2.140.20, in many cases multiple embedded

derivatives are treated as a single compound embedded derivative. In our view, if
there is specific guidance in IAS 39 on whether one or more components of a
compound embedded derivative are closely related to the host contract, then this
guidance should be applied in assessing whether the compound embedded derivative
should be separated. We believe that if the guidance requires a component of the
compound derivative to be separated, then usually the compound derivative as a
whole should be separated. [IAS 39.AG30–AG33]

EXAMPLE 6 – SEPARATING MULTIPLE EMBEDDED DERIVATIVES

7I.2.210.20 Company Y issues a 10-year debt instrument at 100

(par). The following are key terms of the debt instrument.
• Interest rate: The debt pays interest at a floating rate of three-
month IBOR plus a fixed margin.
• Interest rate floor (embedded derivative 1): The floating interest
rate will not be lower than 5% for any period. The interest rate floor
is not in the money on issuing the debt and is not leveraged.
 • Prepayment option (embedded derivative 2): Y may at any time
voluntarily prepay principal and related accrued interest
outstanding in whole or in part plus a penalty of 20% of the
outstanding amount.

7I.2.210.30 Both embedded derivatives relate to the same risk – i.e.

interest rate risk. They are also not readily separable and independent
of each other, because the incentive to prepay increases as the floor
becomes in the money when interest rates fall, and prepaying
extinguishes the floor.

7I.2.210.40 In this example, a component of the compound

embedded derivative, the prepayment option, is not closely related to
the host contract based on the specific guidance in IAS 39, because the
prepayment amount is not approximately equal to the amortised cost
of the host instrument. Therefore, Y concludes that the compound
instrument as a whole is not closely related to the host contract and
separates it. [IAS 39.AG33(b)]

7I.2.220 Reassessment of embedded derivatives

7I.2.220.10 The assessment of whether an embedded derivative is required to be
separated from the host contract and accounted for as a derivative is made at
inception of the contract – i.e. when the entity first becomes a party to the contract.
Subsequent reassessment is prohibited unless there is a change in the terms of the
contract that significantly modifies the cash flows that would otherwise be required
under the contract, in which case reassessment is required. [IFRIC 9.7]

EXAMPLE 7 – REASSESSMENT OF EMBEDDED DERIVATIVES

7I.2.220.20 Company X has not separated a foreign currency

derivative embedded in a host sales contract because the feature is not
leveraged, it does not contain an option and the payments are
denominated in the functional currency of the customer.

7I.2.220.30 The functional currency of the customer changes three

months after inception of the contract. X does not reassess whether to
separate the derivative embedded in the contract. This is because
there have been no changes to the terms of the contract that
significantly modify the cash flows that would otherwise be required
under the contract.

7I.2.220.40 However, if there are changes to the terms of the

contract that significantly modify the cash flows that would otherwise
be required under the contract, then X would be required to make a
 subsequent reassessment for embedded derivative separation.

7I.2.220.50 In addition, when an entity reclassifies a hybrid financial asset out of

the FVTPL category (see 7I.4.220.20), it is also required to assess whether an
embedded derivative is required to be separated from the host contract. The
assessment is made on the basis of the circumstances that existed at the later of:
• when the entity first became a party to the contract; and
• when there was a change in the terms of the contract that significantly modified
the cash flows that would otherwise have been required under the contract. [IFRIC
9.7, 7A]

7I.2.220.60 If an entity is unable to separately measure the fair value of an

embedded derivative that would have to be separated on reclassification out of the
FVTPL category, then reclassification is prohibited and the entire hybrid financial
asset remains in the FVTPL category (see 7I.2.160.10). [IAS 39.13]

EXAMPLE 8 – ASSESSMENT OF EMBEDDED DERIVATIVES ON RECLASSIFICATION

7I.2.220.70 On 1 January 2021, Company X buys a 10-year debt

instrument for 100 (par), which is redeemable at any time at the
issuer’s option for 100. X classifies the debt instrument as held-for-
trading and it is accounted for at fair value with changes in fair value
recognised in profit or loss.

7I.2.220.80 On 1 October 2021, the conditions for reclassification

from the FVTPL category to ‘loans and receivables’ are met and X
reclassifies the debt instrument to loans and receivables (see
7I.4.220.20). At this date, the fair value of the debt instrument is 70
and this becomes the new amortised cost of the debt instrument (see
7I.4.220.60).

7I.2.220.90 On reclassification, X evaluates the embedded call

option to determine whether it is an embedded derivative that requires
separation from the host debt instrument. Because there have been no
changes in the terms of the host debt instrument between the date of
purchase and the date of reclassification, X performs the embedded
derivatives assessment based on the circumstances that existed on the
date of purchase – i.e. 1 January 2021 (see 7I.2.220.50).

7I.2.220.100 On 1 January 2021, given the amortised cost of the

debt instrument of approximately 100, X would probably have
concluded that the embedded call option was closely related to the
host debt instrument (see 7I.2.240). This is because the exercise price
of the call option would be approximately equal to the amortised cost
of the host debt instrument at each exercise date. Therefore, X does
 not separate the embedded call option on reclassification.

7I.2.220.110 In contrast, if there had been a significant change in

the terms of the contract, then the embedded derivative assessment
would be based on circumstances that existed on the modification
date.

7I.2.230 Extension features

7I.2.230.10 An option or automatic provision to extend the remaining term to
maturity of a debt instrument is not closely related to the host debt instrument unless
there is a concurrent adjustment to the approximate current market rate of interest
at the time of the extension. However, depending on its terms, an entity may consider
an extension feature in a debt host contract to be equivalent to a loan commitment
that would not be in the scope of IAS 39 and consequently would not be accounted for
as a derivative if it were a separate instrument (see 7I.1.200). In our view, when an
entity adopts this approach it should not separate such an extension feature as an
embedded derivative from the host debt contract. [IAS 39.11, AG30(c)]

7I.2.240 Calls, puts or prepayment options

7I.2.240.10 A call, put or prepayment option embedded in a host debt contract or
host insurance contract is closely related to the host contract in either of the
following scenarios.
• The exercise price of the option is approximately equal on each exercise date to
the amortised cost of the host debt instrument or the carrying amount of the host
insurance contract.
• The exercise price of the prepayment option reimburses the lender for an amount
up to the approximate present value of lost interest for the remaining term of the
host contract. ‘Lost interest’ is the product of the principal amount prepaid,
multiplied by the interest rate differential. The ‘interest rate differential’ is the
excess of the effective interest rate of the host contract over the effective interest
rate that the entity would receive at the prepayment date if it reinvested the
principal amount prepaid in a similar contract for the remaining term of the host
contract. This exception is conditional on the exercise price compensating the
lender for loss of interest by reducing the economic loss from reinvestment risk.
[IAS 39.11, AG30(g)]

7I.2.240.15 If a convertible debt instrument (see 7I.3.580) contains a call or put

option, then the assessment of whether the call or put option is closely related to the
host debt contract is made before separating the equity element of the convertible
debt instrument. [IAS 39.AG30(g)]

7I.2.240.20 It is generally presumed that a call, put or prepayment option is

closely related to the host contract if the exercise price is approximately equal to the
amortised cost of the host contract at each exercise date. However, in our view, to
evaluate whether a contingent call, put or prepayment option should be bifurcated,
an entity should also consider the nature of the contingency. Accordingly, we believe
that a contingent call, put or prepayment option with an exercise price approximately
equal to the amortised cost of the host debt contract at each exercise date should not
be bifurcated from the host contract if and only if the underlying contingent event
that triggers exercisability of the option:
• is a non-financial variable that is specific to a party to the contract; or
• has economic characteristics and risks that are closely related to those of the host
debt contract – e.g. based on the interest rate or credit risk of the host debt
contract.

7I.2.240.30 Examples of contingent events that would be a non-financial variable

specific to a party to the contract or closely related might include a change in control
of the issuer, a change in relevant taxation or law that specifically affects the
instrument, the occurrence or non-occurrence of an IPO of the issuer or a change in
the credit rating of the instrument.

EXAMPLE 9A – ISSUER REDEMPTION OPTION WITH SHARE PRICE BEING UNDERLYING RISK
EXPOSURE

7I.2.240.40 Company X issues a five-year bond containing an early-

redemption option. The option allows X to redeem the bond at any time
after the second anniversary of the issue date, subject to a 30-day
notice period, if the volume-weighted-average price of X’s shares, for
at least 20 consecutive trading days, equals or exceeds 125% of X’s
share price at the issue date of the bond.

7I.2.240.50 Because the redemption option’s underlying risk

exposure is X’s share price, rather than the interest rate or credit risk
of the host contract, X concludes that the call option should be
separated from the host contract and measured at FVTPL (see
7I.6.140).

EXAMPLE 9B – ISSUER REDEMPTION OPTION IN CONVERTIBLE BOND

7I.2.240.60 Modifying Example 9A, the instrument is a convertible

bond that the holder has the right to convert into a fixed number of
shares any time after the second anniversary of the issue date.
Company X determines that the conversion feature is an equity
component (see 7I.3.100). If X exercises its option to redeem the bond,
then the holder has the opportunity to convert within the 30-day notice
period.

7I.2.240.70 The economic effect of the call option is to incentivise

the holder to convert, thereby limiting the value of the conversion
feature from the holder’s perspective.
 7I.2.240.80 X makes an assessment of whether the call option is
closely related to the host contract before separating the equity
element (see 7I.2.240.15). X therefore considers the convertible bond
including the equity conversion option in assessing whether the
redemption feature has economic characteristics and risks that are
closely related to those of the host contract.

7I.2.240.90 Because both the host contract (including the

conversion option) and the embedded call option include economic
characteristics related to X’s share price, it is possible that the call
option would not be separated in the financial statements of X. This
would depend on whether it can be demonstrated that the call option’s
exercise price is approximately equal on each exercise date to the
amortised cost of the host contract (including the conversion option).
[IAS 39.AG30(g)]

EXAMPLE 10A – DUAL-INDEXED EMBEDDED FEATURE – DERIVATIVE SEPARATED

7I.2.240.100 Bank X issues a 20-year, fixed rate bond of 1,000 at

par. The bond includes a contractual conversion feature that requires
conversion of the bond into a variable number of equity shares of X if
X’s Common Equity Tier 1 ratio (as determined in accordance with
applicable banking regulations) drops below 7.5% (the contingent
event or the non-viability event). Under the conversion mechanism, the
number of shares to be issued would be determined so as to have a fair
value equal to the bond’s par amount plus accrued interest but subject
to a fixed cap on the number of shares to be issued. X does not classify
the bond as measured at FVTPL.

7I.2.240.110 X determines that the fair value of the conversion

feature is mainly dependent on:
• the probability of the contingent event occurring: This is a non-
financial variable specific to X, which is a party to the contract;
• the fair value of the host bond: The conversion feature would result
in X issuing shares with a fair value equal to par plus accrued
interest (subject to the cap), which may be different from the fair
value of the bond received in exchange; and
• the fair value of X’s equity shares: The cap on the number of shares
to be issued means that if the share price is below a particular price
level on the conversion date, then the number of shares to be issued
would be capped and, consequently, the total fair value of the shares
to be issued may be less than the bond’s par amount plus accrued
interest.
 7I.2.240.120 X has made an accounting policy choice to treat the
contingent event as a non-financial variable that is specific to a party to
the contract (see 7I.2.30.80). However, X determines that the
conversion feature meets the definition of a derivative (see
7I.2.30.110). In this case, because the value of the conversion feature
is dependent on changes in the fair value of X’s equity shares, X
concludes that the economic characteristics and risks of the
conversion feature are not closely related to the host debt instrument.
Therefore, X separates the conversion feature from the bond and
accounts for the conversion feature at FVTPL (see 7I.2.380).

EXAMPLE 10B – DUAL-INDEXED EMBEDDED FEATURE – DERIVATIVE NOT SEPARATED

7I.2.240.130 Modifying Example 10A, assume that the conversion

feature does not include any cap on the number of shares to be issued.
Therefore, changes in the fair value of Bank X’s equity shares no
longer affect the value of the conversion feature. In this case, X
determines that the fair value of the conversion feature is mainly
dependent only on:
• the probability of the contingent event occurring; and
• the fair value of the host bond.
7I.2.240.140 X does not separately account for the conversion
feature as a derivative because the conversion feature is closely
related to the host bond – i.e. the exercise price of the conversion
feature at the time of conversion will be approximately equal at all
times to the amortised cost of the host – and the exercise of the
conversion feature is triggered only by the contingent event, which is a
non-financial variable that is specific to a party to the contract (see
7I.2.240.20).

7I.2.240.150 Under IFRS 4, an insurer is not required to separate a policyholder’s

option to surrender an insurance contract for a fixed amount (or for an amount based
on a fixed amount and an interest rate). [IFRS 4.8]

7I.2.250 Interest rate features in host debt contracts and

insurance contracts

7I.2.250.10 An exception to the requirement that all derivatives with leverage be

separated is provided for embedded interest rate derivatives in which the underlying
is an interest rate or index that can change the amount of interest that would
otherwise be paid or received on an interest-bearing host debt contract or insurance
contract. For a hybrid instrument with such an embedded derivative, leverage does
not automatically result in separation unless:
• the embedded interest rate feature could prevent the holder of the hybrid
 instrument from recovering substantially all of its investment at settlement date;
or
• the embedded interest rate feature could result in the holder receiving a rate of
return on the hybrid instrument that is at least double its initial rate of return on
the host instrument and could result in a rate of return that is at least twice the
market return of an instrument with the same terms as the host instrument
(‘double-double test’). [IAS 39.AG33(a)]

7I.2.250.20 In our view, this analysis should not be based on the likelihood of
these limits being exceeded in practice, but rather on whether the contractual terms
make it possible that the limits will be exceeded.

7I.2.255 Embedded interest rate caps and floors

7I.2.255.10 An embedded floor or cap on the interest rate on a debt contract or
insurance contract is closely related to the host contract, provided that the cap is at
or above the market rate of interest and the floor is at or below the market rate of
interest when the contract is issued and the cap or floor is not leveraged in relation to
the host contract. [IAS 39.AG33(b)]

7I.2.255.20 The IFRS Interpretations Committee has discussed when an interest

rate floor should be separated from a floating rate host contract and accounted for as
a derivative. The Committee stated that:
• an entity should compare the overall interest rate floor (i.e. the benchmark
interest rate referenced in the contract plus contractual spreads and if applicable
any premiums, discounts or other elements that would be relevant to the
calculation of the effective interest rate) for the contract to the market rate of
interest for a similar contract without the interest rate floor (i.e. the host
contract);
• in order to determine the appropriate market rate of interest for the host contract,
an entity is required to consider the specific terms of the host contract and the
relevant spreads (including credit spreads) appropriate for the transaction; and
• the term ‘market rate of interest’ is linked to the concept of fair value as defined in
IFRS 13 and is described as the rate of interest ‘for a similar instrument (similar as
to currency, term, type of interest rate and other factors) with a similar credit
rating’ (see 7I.6.20.30 and 60.20). [IU 01-16, IAS 39.AG64]

7I.2.255.30 The Committee also noted that the requirements in paragraph

AG33(b) of IAS 39 (see 7I.2.255.10–20) should be applied to an interest rate floor in a
negative interest rate environment in the same way as they would be applied in a
positive interest rate environment because paragraph AG33(b) of IAS 39 does not
distinguish between positive and negative interest rates. [IU 01-16]

7I.2.255.40 In determining the unit of account for the purposes of the assessment
in 7I.2.255.10, in our view an entity should choose an accounting policy, to be applied
consistently, to evaluate the cap or floor as one instrument or as a series of separate
caplets or floorlets, one for each payment date.
7I.2.255.50 If the cap or floor is assessed as one instrument, then we believe that
the market rate of interest with which each cap or floor is compared could be the
swap rate plus relevant spreads (including credit spreads). If the swap rate (i.e. the
currently quoted rate for the fixed leg of an interest rate swap against a floating
benchmark rate as determined by its particular market) is used, then it should be for
the same period as the cap or floor. This is because the guidance in IAS 39 in relation
to ‘market rate of interest’ requires consideration of the rate of interest for a similar
instrument with a similar term. Therefore, we believe that it would be inappropriate
to use the spot rate for the first reset period as a proxy for the whole period of the cap
or floor. If an entity determines, based on the assessment, that the embedded cap or
floor is not closely related to the host contract, then in our view the entire cap or floor
should be separated and not only those embedded caplets or floorlets that are in the
money. This is consistent with the unit of account assessment. [IAS 39.AG64]

7I.2.255.60 If the unit of account for the purposes of the assessment is a series of
separate caplets or floorlets, then we believe that the market rate of interest with
which each caplet or floorlet is compared should be the forward rate for the period of
that particular caplet or floorlet plus relevant spreads (including credit spreads). If
an entity determines, based on the assessment, that one or more – but not necessarily
all – of the embedded caplets or floorlets are not closely related to the host contract,
then in our view all caplets or floorlets should be separated and not only those
embedded caplets or floorlets that are in the money. This is consistent with the
guidance on multiple embedded derivatives (see 7I.2.140 and 210).

7I.2.260 Foreign currency derivatives embedded in non-financial

or insurance contracts

7I.2.260.10 A host contract that is an insurance contract or a non-financial

instrument (e.g. operating leases from a lessor’s perspective) may be denominated in
a foreign currency – e.g. the premiums on an insurance contract or the price of non-
financial items in a purchase-or-sale transaction. In these circumstances, the foreign
currency embedded derivative is not accounted for separately from the host contract,
provided that it is not leveraged, does not contain an option feature and the payments
required under the contract are denominated in one of the following currencies:
• the functional currency of one of the substantial parties to the contract;
• the currency in which the price of the related goods or services being delivered
under the contract is routinely denominated in commercial transactions around
the world; or
• the currency that is commonly used in contracts to buy or sell non-financial items
in the economic environment in which the transaction takes place. [IAS 39.AG33(d)]

7I.2.260.20 In our view, if the conditions in 7I.2.260.10 are not met, then a foreign
currency embedded derivative should be separated from the host contract. This is
because those conditions are explicit requirements that should be satisfied in order
for the host contract and the derivative to be considered ‘closely related’.

EXAMPLE 11 – SEPARABLE FOREIGN CURRENCY DERIVATIVE EMBEDDED IN NON-FINANCIAL

CONTRACT
 7I.2.260.25 Company E enters into a contract to provide goods and
services to Company B. E and B have the same functional currency. The
settlement of the host contract is to be made in that currency.
However, certain of the goods and services that E will buy from
unrelated third parties to fulfil its obligations will be denominated in a
foreign currency. Accordingly, E and B agree that the final contract
settlement price will be adjusted based on the movement in the foreign
currency. Because the embedded derivative is a foreign currency
embedded derivative and does not meet the conditions in 7I.2.260.10,
both parties conclude that it should be separated from the host
contract even though it may have some economic relationship to the
cost and value of the goods and services supplied.

7I.2.260.30 IAS 39 does not provide guidance on how to identify ‘substantial

parties to the contract’. In our view, the legal parties to a contract are not necessarily
also the substantial parties to it. When determining who is a substantial party to a
contract, an entity needs to consider all of the facts and circumstances related to the
contract, including whether a legally contracting party possesses the requisite
knowledge, resources and technology to fulfil the contract without relying on related
parties. To make this assessment, an entity needs to look through the legal form of
the contract to evaluate the substance of the underlying relationships. In our view,
only one entity within a consolidated group can be deemed a substantial party with
respect to a particular contract with an entity outside the group.

7I.2.260.35 In our view, an entity that will provide the majority of the resources
required under a contract is the substantial party to that contract. Identifying this
entity is a subjective assessment and should be based on an analysis of both
quantitative and qualitative factors. Certain resources – e.g. employees and material
costs specifically used to fulfil the contract – can be quantified. Qualitative factors
that may not be easily measured include developed technology, knowledge,
experience and infrastructure.

7I.2.260.40 ‘Routinely denominated’, as noted in the second bullet in 7I.2.260.10,

should in our view be interpreted narrowly. Transactions qualifying for this
exemption that may be considered to be routinely denominated in US dollars in
commercial transactions around the world include:
• oil transactions;
• transactions related to large passenger aircraft; and
• transactions in certain precious metals – such as gold and silver – and diamonds.
[IAS 39.IG.C.9]

7I.2.260.50 To qualify, the currency would have to be used in similar transactions

around the world, and not just in one local area. For example, if cross-border
transactions in natural gas are denominated in US dollars in North America and in
euro in Europe, then neither the US dollar nor the euro is the currency in which
natural gas is routinely denominated. [IAS 39.IG.C.9]
7I.2.260.60 In our view, ‘routinely denominated in commercial transactions
around the world’ means that a large majority of transactions in international
commerce around the world are traded in that currency. This implies that with
respect to any particular commodity, transactions cannot be considered routinely
denominated in more than one currency.

7I.2.260.70 In our view, if transactions on a local or regional exchange are

denominated in a local currency but are priced using the international price – e.g. US
dollars per barrel of oil – at the spot exchange rate, then those transactions are, in
effect, denominated in the international currency.

7I.2.260.80 In addition, we believe that the existence of a relatively small

proportion of transactions denominated in a local currency in one or two markets, or
particular jurisdictions, does not preclude a commodity from meeting the definition of
‘routinely denominated in commercial transactions around the world’.

7I.2.260.90 The third exemption noted in 7I.2.260.10 for a currency that is

commonly used in the economic environment in which non-financial items are bought
and sold may apply when a country’s local currency is not stable, causing businesses
in that environment to adopt a more stable and liquid currency for internal and cross-
border trade. In our view, the application of this exemption is not limited to countries
with a local currency that is not stable, and it may be applied in other countries as
long as the ‘commonly used currency’ criterion is met. Accordingly, we believe that
the exemption may also apply when the local currency is stable, but business practice
has developed to commonly use a more liquid foreign currency such as the US dollar
or the euro in either internal or cross-border trade. Before concluding that a
currency, other than the local currency of a country, is commonly used in contracts to
buy or sell non-financial items in that country, careful consideration needs to be given
to business practices in that country.

7I.2.260.95 In our view, the assessment of ‘commonly used currency’ in a

specified environment requires judgement and should be evaluated in the context of
the particular facts and circumstances in the jurisdiction, but not in the context of a
specific industry. That judgement should be supported by an analysis of the specific
economic environment in which the transaction takes place. We believe that the
following parameters can provide evidence about whether a currency is commonly
used in a particular jurisdiction:
• for a cross-border transaction, analysing the level of foreign trade transactions in
that currency;
• for a domestic transaction, analysing the level of domestic commercial
transactions in that currency; or
• as an alternative, for cross-border transactions and/or domestic transactions,
analysing the level of all transactions – i.e. both foreign trade transactions and
domestic commercial transactions – in that currency.

7I.2.260.100 In our view, for the analysis in 7I.2.260.95, an entity should establish
criteria, to be applied consistently, to determine the extent to which transactions with
entities whose functional currency is the currency being evaluated are considered.
The following are possible approaches.
• Exclude all of these transactions from the analysis: Under this approach, to
conclude that the euro is a currency that is commonly used in Country X (a non-
eurozone country), for example, the transactions that require consideration are
those entered into by entities in X with other entities that do not have the euro as
their functional currency; this would exclude the majority of cross-border
transactions with entities in the eurozone.
• Include these transactions in the analysis: Under this approach, to conclude that
the euro is a currency commonly used in Country X, cross-border transactions with
entities in the eurozone would be included in the analysis. However, we believe
that it would be inappropriate to conclude that the exemption should apply based
solely on the level of transactions with entities whose functional currency is the
currency being evaluated. There should also be evidence that the currency is used
in the relevant economic environment for other reasons, such as liquidity or
convenience. For example, to conclude that the euro is a currency commonly used
in X, there should be evidence that the euro is commonly used for other reasons
linked to business practice in X and not only because of transactions with euro
functional currency counterparties.

7I.2.260.110 Furthermore, in our view the analysis of a commonly used currency

should be performed on a country-by-country basis and not with reference to specific
goods and services. For example, it is not appropriate to conclude that a particular
currency is commonly used for cross-border leasing transactions and therefore that
the foreign exchange embedded derivatives in all cross-border leases denominated in
that currency do not require separation.

7I.2.260.120 In our view, if a group entity has a separable foreign currency

derivative, then the derivative is separable both in its separate financial statements
and in the consolidated financial statements even if the transaction is denominated in
the functional currency of the parent, which may be chosen as the presentation
currency of the consolidated financial statements (see 2.7.30–40). The consolidated
entity does not have a functional currency and as such cannot be viewed as having a
definable foreign currency exposure that would remove the need for separation on
consolidation.

7I.2.265 Foreign currency derivatives embedded in host debt

instruments

7I.2.265.10 A host contract that is a debt instrument may contain a stream of

principal or interest payments that are denominated in a foreign currency – e.g. a
dual-currency bond. In these circumstances, the embedded foreign currency
derivative is closely related to the host debt instrument. Such a derivative is not
separated from the host contract because IAS 21 requires foreign currency gains and
losses on monetary items to be recognised in profit or loss. [IAS 39.AG33(c), 21.28]

7I.2.265.20 The evaluation of embedded foreign currency derivatives in a lease

contract differs for lessors and lessees. A lessee will recognise a lease liability for its
obligation to make lease payments, unless it elects the recognition exemptions for
short-term leases and/or leases of low-value assets (see 5.1.140). If the lease
payments are denominated in a foreign currency (without any leveraged or option-
based foreign currency features), then no embedded derivative assessment is
required because the obligation to pay future lease payments is recorded as a
monetary liability in a foreign currency subject to retranslation under IAS 21 (see
5.1.25.10 and 7I.2.265.10), rather than an embedded derivative in a non-financial
contract. Similarly, a lessor considers a finance lease receivable to be a financial
instrument and monetary item subject to retranslation under IAS 21. However, the
lessor does not recognise its right to receive lease payments under an operating
lease. In this case, the host contract (i.e. operating lease) is a non-financial item and
the lessor assesses whether the lease contains separable embedded foreign currency
derivative features if the lease payments are denominated in a foreign currency. [IAS
32.AG9, 39.AG33(d), IFRS 16.22]

7I.2.270 Inflation-indexed embedded derivatives

7I.2.270.10 Inflation-indexed lease payments are considered to be closely related

to the host lease contract provided that there is no leverage feature (e.g. a multiple
that would be applied to the inflation rate such that the lease payments would
increase by x times inflation) and the index relates to inflation in the entity’s
economic environment (e.g. the consumer price index of the country in which the
leased asset is operated). If the index is based on inflation rates in a different
economic environment, then the embedded derivative is not closely related. [IAS
39.AG33(f)]

EXAMPLE 12 – SEPARABLE INFLATION-INDEXED DERIVATIVE EMBEDDED IN LEASE CONTRACT

7I.2.270.15 Company L leases a building in Canada, with rental

payments denominated in Canadian dollars. The rent is changed each
year by multiplying the percentage change in the Canadian consumer
price index by a factor of 1.5. Because the adjustments to the rents are
higher than the actual inflation rate (i.e. there is a multiplier above 1
that has more than an insignificant effect), L concludes that the
embedded derivative is leveraged and should be separated from the
host lease contract.

7I.2.270.20 In our view, inflation-indexed embedded derivatives in loans are

considered to be closely related to the host debt instrument if the inflation index is
one commonly used for this purpose in the economic environment of the currency in
which the debt is denominated and it is not leveraged.

7I.2.280 Specific hybrid financial instruments

7I.2.280.10 Specific hybrid financial instruments that may be encountered in

practice, particularly in the financial services sector, are discussed in 7I.2.290–360.
The names of these instruments may vary from one country to another, but their
accounting treatment is similar.
7I.2.290 Bonds with a constant-maturity yield
7I.2.290.10 Bonds with a constant-maturity yield have a floating interest rate that
resets periodically on the basis of a market rate that has a duration extending beyond
that of the reset period. For example, the interest rate on a 10-year bond resets semi-
annually to the then-current weighted-average yield on identified treasury bonds with
a 10-year maturity. The effect of this feature is that the interest rate is always
equivalent to the market return on an instrument with 10 years’ remaining maturity,
even when the instrument itself has a maturity of less than 10 years.

7I.2.290.20 In our view, such a constant-maturity feature comprises an embedded

derivative – i.e. a constant-maturity swap. The embedded derivative is not closely
related to the host debt instrument because it could potentially double the holder’s
initial rate of return and result in a rate of return that is at least twice what the
market return would be for a contract with the same terms as the host contract,
unless it has a cap at an appropriate level to prevent the doubling effect. In this
example, after seven years the bond would still be yielding a return that is the same
as that for an instrument with a 10-year maturity. It is possible that this would be
twice the market rate on an instrument similar to the host contract without the
constant-maturity feature and with three years left to maturity. However, if the bond
also contained a cap that was not leveraged and was above the market rate of interest
when the bond was issued, and which prevented the amount of interest increasing so
as to double the holder’s initial rate of return, then in our view the combined
constant-maturity-and-cap feature would be considered closely related. In our view,
when assessing whether separation of the embedded derivative is required, the host
debt instrument can be assumed to be either a fixed rate or a variable rate
instrument. [IAS 39.AG33(a)–(b)]

7I.2.300 Cash or share bonds

7I.2.300.10 In a cash or share bond, the principal is determined with reference to
movements in fair value of a single equity instrument or an equity index. If the fair
value of the equity index or share price falls below a certain level, then it is the fair
value of this equity index or share price that will be the basis for repayment – rather
than the nominal value of the bond itself – or the bond will be settled by delivering the
underlying shares. Therefore, the holder of the instrument might not recover
substantially all of its initial investment. The bond will pay a higher coupon to
compensate the holder for this increased level of risk.

7I.2.300.20 The holder of such a bond has in effect written a put option. In the
example in 7I.2.300.10, the underlying of the written option is either the single equity
instrument or the equity index. The option premium is embedded in the interest rate
of the bond, which will therefore exceed the current market rate at the date of issuing
the bond. This derivative embedded in the bond is not closely related to the host
contract and is therefore separated. [IAS 39.AG30(d)]

7I.2.310 Bonds with interest payments linked to equity index

7I.2.310.10 If the interest payment on a bond is linked to movements in an equity
index, then the fixed interest on the debt instrument is swapped against a variable
return based on the movement in the equity index. The interest payments are not
dependent on interest rate risk but on equity risk. Therefore, this swap is not closely
related to the host contract and is separated. [IAS 39.AG30(d), IG.B.13–IG.B.14]

7I.2.310.20 An equity index would typically comprise a number of equity

instruments of different entities and therefore its movements would arise from the
changes in the fair value of numerous underlying equity instruments. To be
considered closely related to the host contract, the embedded derivative would have
to possess equity characteristics related to the issuer of the bond (host contract).
Consequently, even if the host contract (bond) were to meet the definition of an equity
instrument, it is unlikely that the embedded derivative could be considered closely
related and therefore it is separated. [IAS 39.11(a), AG27]

7I.2.320 Step-down bonds

7I.2.320.10 Step-down bonds contain an interest feature such that the fixed
interest rate declines over the life of the bond. For example, the first coupon is fixed
at 10 percent whereas the last coupon is fixed at 5 percent.

7I.2.320.20 The interest step-down feature alone would not be an embedded

derivative that needs to be separated from the host contract. Instead, the step-down
feature is taken into account in determining the amortised cost and the effective
interest rate on the bond. Therefore, at inception part of the interest received is
deferred and released when the interest rate coupon falls below the effective interest
rate of the bond. [IAS 39.IG.B.27]

7I.2.330 Reverse (inverse) floating notes

7I.2.330.10 Reverse (inverse) floating notes are bonds that have a coupon that
varies inversely with changes in specified general interest rate levels or indexes – e.g.
Euribor. For such bonds, coupon payments are typically made according to a pre-set
formula such as the following.

X% - (Y x three-month Euribor on a specified date)

where X = a fixed interest rate and Y = a leverage factor

7I.2.330.20 Such instruments can be viewed as a combination of a fixed rate debt

instrument with a fixed-for-floating interest rate swap that is referenced to an
interest rate index. Therefore, the instrument contains an embedded derivative. The
embedded derivative is not closely related to the host contract and needs to be
separated if it could:
• prevent the investor from recovering substantially all of its initial recorded net
investment in the bond (if the inverse floater contains no floor to prevent erosion
of principal resulting from negative coupons); or
• increase the investor’s rate of return on the bond to an amount that is at least
 twice the initial rate of return on the host contract and could result in a rate of
return that is at least twice what the market rate would be for an instrument
similar to the host contract. [IAS 39.AG33(a)]

7I.2.330.30 If such an instrument is capped at less than twice the market rate at
the date of issue and floored at zero, then the embedded interest rate swap is
considered closely related and is not separated. [IAS 39.AG33(a)]

EXAMPLE 13A – INVERSE RATE FEATURE – NOT CLOSELY RELATED

7I.2.330.40 Company X issues a bond at par, which pays coupons

linked to IBOR. The bond includes a binary interest rate feature,
whereby the bond pays:
• 9% coupon, if IBOR is below 3%; and
• 1% coupon, if IBOR is 3% or above.
7I.2.330.50 X needs to determine whether the binary interest rate
feature is closely related to the host bond. To do so, X needs to identify
the terms of the host contract. In this case, X identifies the host
contract’s terms as:
• excluding the binary interest rate feature; and
• issued at par and paying coupons of IBOR plus a fixed spread of
0.5%. The spread is determined based on market data and results in
an overall market rate of interest on the host contract that reflects
its terms and its credit and liquidity risk. At the time of issuing the
bond, IBOR is 4% and therefore the initial rate of return on the host
contract is 4.5%.

7I.2.330.60 X now needs to compare possible rates of return on

the hybrid bond containing the binary interest rate feature with those
of the host instrument.

STEP DETAIL RESULT

Step 1 Calculate whether the If IBOR remains at or

binary interest rate above 3%, the holder’s
feature could at least rate of return on the
double the holder’s initial hybrid contract would
rate of return on the host remain at 1% which is
contract. less than the initial rate of
return on the host
contract of 4.5%.
However, if IBOR declines
below 3%, the return on
the hybrid bond would
increase to 9% which is
 double the initial rate of
return on the host
contract of 4.5%.

Step 2 For scenarios in which When IBOR is below 3%,

Step 1 is satisfied, a contract with the same
calculate whether the terms as the host contact
binary interest rate would provide a market
feature could result in a return of no more than
rate of return that is at 3.5% (i.e. IBOR of 3% plus
least twice the market a fixed margin of 0.5%).
return for a contract with Therefore, when IBOR is
the same terms as the below 3%, the hybrid
host contract. bond would result in a
rate of return of 9% that
is more than twice what
the market return would
be on a contract with the
same terms as the host
contract.

7I.2.330.70 Based on the analysis, X determines that the binary

interest rate feature is not closely related to the host bond.

EXAMPLE 13B – INVERSE RATE FEATURE – CLOSELY RELATED

7I.2.330.80 Modifying Example 13A, assume that the bond pays

7% coupon (instead of 9%) when IBOR goes below 3% and all other
information remains the same.

7I.2.330.90 If IBOR goes to below 3%, then the bond’s coupon of

7%:
• would be at least double the market return on a contract with the
same terms as the host contract (i.e. IBOR of less than 3% plus a
fixed margin of 0.5%); but
• could never double the initial rate of return on host contract of
4.5%.

7I.2.330.100 Further, because the bond pays a minimum of 1%

(when IBOR goes above 3%), the binary interest rate feature would not
prevent the holder of the bond from recovering substantially all of its
recognised investment in the bond – i.e. the bond’s par issuance
amount. Accordingly, unlike in Example 13A, the binary interest rate
feature in this example is considered closely related to the host bond.
7I.2.340 Callable zero-coupon bonds
7I.2.340.10 Callable zero-coupon bonds typically have long maturities – e.g. 30
years. The issuer has the right to redeem the bond at predetermined dates before the
contractual maturity at the accreted amount. In this case, the embedded derivative
(call option) is closely related to the host contract if the bond is callable at an amount
that is approximately equal to the amortised cost of the host debt instrument at each
predetermined date, and is not separated (see 7I.2.240.10–20). [IAS 39.AG30(g)]

7I.2.340.20 In our view, if the embedded call, put or prepayment option has other
underlying financial risks (or non-financial risks that are not specific to a party to the
contract) that are not closely related to those of the host contract – e.g. equity price
risk – then the economic characteristics and risks of the embedded call, put or
prepayment option are not closely related to the host contract and should be
separated (see 7I.2.240). [IAS 39.11, AG30(g)]

7I.2.350 Perpetual reset bonds

7I.2.350.10 Perpetual reset bonds do not have a stated maturity, although the
issuer may have the right to redeem the bonds at a specified date. If the issuer does
not exercise this right, then the interest rate on the bonds will be reset to a new level
(based on a predetermined formula) on this date.

7I.2.350.20 In our view, it is a matter of judgement, based on all relevant facts and
circumstances, whether the issuer should analyse such a perpetual reset bond as:
• a host perpetual debt instrument with an embedded call option and an embedded
interest rate reset feature; or
• a host debt instrument with a fixed maturity (based on the reset date) and an
embedded term-extension feature. [IAS 39.AG28, IG.C.1]

7I.2.350.30 We believe that factors to consider when making this judgement,

which is done on initial recognition, should include:
• the nature of the interest rate reset feature; and
• whether the probability of the entity calling the bond is determined to
substantially exceed the probability of not exercising the call option, or vice versa.

7I.2.350.40 If the host debt instrument is considered to have a fixed maturity, then
the embedded feature, which is an automatic provision to extend the term of the debt,
is not closely related to the host contract unless there is a concurrent adjustment to
the market rate of interest at the date of the extension. Because the resetting of the
interest rate is based on a predetermined formula, this may or may not reflect current
market rates, and consequently such a feature is not generally considered to be
closely related and is separated as an embedded derivative unless it is considered to
be equivalent to a loan commitment that would not be in the scope of IAS 39 (see
7I.2.230). [IAS 39.2(h), 4, AG30(c)]

7I.2.360 Credit-linked notes and cash collateralised debt

obligations
7I.2.360.10 Credit-linked notes are debt instruments that are bundled with an
embedded credit derivative or a financial guarantee. In exchange for a higher yield
on the note, investors accept exposure to a specified credit risk that is not the credit
risk of the issuer of the note. Coupon payments and/or repayment of the principal are
made only if no default occurs in the specified debt portfolio, which may or may not
be held by the issuer.

7I.2.360.20 One form of credit-linked notes is collateralised debt obligations

(CDOs), which are securitised interests in pools of financial assets. The assets usually
comprise loans or debt instruments. Multiple tranches of securities are normally
issued by the CDO vehicle, offering investors various maturities and credit risk
characteristics. Senior and mezzanine tranches are typically rated, with the ratings
reflecting both the credit quality of underlying collateral and how much protection a
given tranche is afforded by the more junior tranches.

7I.2.360.30 In evaluating whether the holder of an investment in a CDO needs to

separate an embedded derivative, it is important to distinguish between cash and
synthetic CDOs. Cash CDOs expose investors to credit risk through the CDO vehicle
holding the reference assets.

7I.2.360.40 In our view, the holder of an investment in a credit-linked note is

generally required to separate the embedded credit default swap (CDS) because the
credit risk inherent in the embedded derivative is not closely related to the credit risk
of the issuer. However, we believe that the holder of an investment in a cash CDO is
not required to separate an embedded credit derivative if the exposure is structured
such that the embedded credit feature meets the definition of a financial guarantee
and not a derivative. The terms of the cash CDO need to be evaluated to determine
whether the embedded feature meets the definition of a financial guarantee contract
(see 7I.1.50).

7I.2.360.50 A synthetic CDO represents a pool of credit derivatives together with

government bonds. In other words, rather than the debt obligation being
collateralised through an actual pool of mortgages or loans (cash instruments), it is
backed by government bonds together with a pool of credit derivatives including
CDSs and credit default options. In such structures, the issuer of the synthetic CDO is
the protection buyer, and the holders of the synthetic CDO are the protection sellers,
because the credit risk inherent in the credit derivatives is passed to the holder.
These synthetic CDOs have all the characteristics of normal debt obligations – i.e.
fixed or determinable payments and a fixed maturity. However, holders of such
instruments share a credit risk inherent in the pool of credit derivatives that is
different from the credit risk of the issuing entity.

7I.2.360.60 In our view, the credit derivative embedded in such a synthetic CDO
should be accounted for separately by the holder. This embedded derivative should be
valued with reference to the credit risk inherent in the pool of credit derivatives that
back the obligation. In some cases, the underlying credit derivatives may be
packaged into a limited-purpose vehicle, which in turn issues the obligation. The
credit risk of the embedded derivative is still the credit risk of the underlying pool of
credit derivatives, and not the credit risk of the limited-purpose vehicle. The fact that
junior and senior tranches are issued does not change the fact that each tranche
contains a separate embedded derivative, although the value of the embedded
derivatives in senior tranches may be small. [IAS 39.AG30(h)]

7I.2.360.70 Distinguishing between cash and synthetic CDOs can become

complex when, for example, an entity invests in a CDO whose reference portfolio
includes CDOs issued by another entity (generally termed ‘CDO squared’ or ‘CDO2’).
In our view, the holder of a CDO2 should account for it based on the reference
portfolio of the first CDO (a ‘look-through’ approach). In this circumstance, the
accounting treatment reflects the true risks of the investment – i.e. the holder’s risk
exposure in the referenced portfolio is impacted by the underlying risks of the CDOs
contained within the portfolio. [IAS 39.AG30(h)]

7I.2.370 Specific hybrid non-financial contracts

7I.2.370.10 Embedded derivatives are often associated with financial

instruments. However, they may arise in non-financial contracts – e.g. contracts for
the delivery of goods and services. These embedded derivatives are also subjected to
the analysis described in 7I.2.120–270 and accounted for separately, when it is
appropriate. In such cases, the host contract will not be a financial instrument, but
will be accounted for under other appropriate standards. Examples 11 and 14
illustrate circumstances in which embedded derivatives exist in non-financial
contracts. [IAS 39.10–11]

EXAMPLE 14 – PRICE-INDEXATION OF A NON-FINANCIAL ITEM

7I.2.370.20 Company X is a manufacturing company. It enters into a

contract for the purchase of three specialised machines that will be
delivered and installed at the end of 2021, 2022 and 2023 respectively.
The price of each machine is determined with reference to a formula
that uses the market price of such a machine at the end of 2020 as the
base price. This base price is adjusted for twice the change in an
employment cost index, as well as an index that reflects cost increases
associated with the industry.

7I.2.370.30 The indexation incorporates leverage into the pricing

mechanism. Therefore, X considers this embedded derivative for
separate accounting.

7I.2.370.40 However, if X is able to demonstrate that the market

prices of similar machines ordinarily move in tandem with the
indexation – i.e. there is a high degree of correlation between the two –
then separation would not be required.

EXAMPLE 15 – MAINTENANCE COST GUARANTEE

 7I.2.370.50 Company Y is a logistics company. Y buys its entire fleet
of delivery vehicles from one vehicle manufacturer. The vehicle
manufacturer provides a guarantee to Y under which it agrees to
reimburse the logistics company for vehicle maintenance costs in
excess of a specified level.

7I.2.370.60 Whether this arrangement contains an embedded

derivative within the purchase contract depends on the terms of the
guarantee. If the fair value of an instrument changes in response to the
change in a specified non-financial variable that is not specific to a
party to the contract, then such an instrument meets the definition of a
derivative under IAS 39.

7I.2.370.70 In our view, the variation in maintenance charges

comprises a non-financial variable. Furthermore, this non-financial
variable is specific to the fleet held by the logistics company because it
is dependent on the condition of the company’s own vehicles.
Consequently, this feature of the contract does not meet the definition
of a derivative and does not require separate accounting under IAS 39.

7I.2.370.80 When an obligation to deliver goods or services under a non-financial

contract is settled, the parties usually will initially recognise a new financial
instrument in respect of the contractual right to receive or obligation to pay the
purchase price. It may therefore be necessary for the parties to consider whether any
embedded derivative is required to be separated from this new financial instrument.

EXAMPLE 16 – PROVISIONAL PRICING OF COMMODITY CONTRACT

7I.2.370.90 On 31 December 2020, Company R, a commodity

producer, enters into an executory contract with Company B, a
commodity processor, to deliver a specified amount of unrefined
commodity X on 31 January 2021. The final purchase price is payable
on 31 March 2021 and is determined with reference to the quoted spot
market price for commodity X on that date (i.e. the purchase price is
‘provisional’ until that date). The parties have agreed that the
purchase price is not determined until 31 March 2021 because it is
expected that it will take B approximately two months to process the
commodity for sale to its customers. The commodity contract is subject
to the own-use exemption (see 7I.1.150).

7I.2.370.100 On 31 December 2020, R and B each consider

whether the provisional pricing feature should be separated from the
commodity contract and separately accounted for as an embedded
derivative. They each conclude that the provisional pricing feature is
closely related to the economic characteristics and risks of the host
 contact because:
• the final price is indexed to the spot market price of the commodity
that is delivered under the host contract; and
• the timing lag between the delivery date and the price fixing date
relates to the estimated time to process the commodity that is
delivered under the host contract.

7I.2.370.110 On 31 January 2021, R settles its contractual

obligation to deliver the commodity and, as a result, R and B recognise
a new financial asset and a new financial liability respectively in
relation to the purchase price that is payable on 31 March 2021. The
host contract is now a debt financial instrument. R and B each
conclude that the provisional pricing feature needs to be separately
accounted for as a derivative because payments indexed to a
commodity price are not closely related to a host debt instrument
because the risks inherent in the host and the embedded derivative are
dissimilar. [IAS 39.AG30(e)]

7I.2.380 Accounting for separable embedded derivatives

7I.2.380.10 Separable embedded derivatives are required to be measured at fair

value, with all changes in fair value recognised in profit or loss unless they form part
of a qualifying cash flow or net investment hedging relationship. [IAS 39.46, 55]

7I.2.380.20 The initial bifurcation of a separable embedded derivative does not

result in any gain or loss being recognised. [IAS 39.AG28, IG.C.1–IG.C.2]

7I.2.380.30 Because the embedded derivative component is measured at fair

value on initial recognition, the carrying amount of the host contract on initial
recognition is the difference between the carrying amount of the hybrid instrument
and the fair value of the embedded derivative. If the fair values of the hybrid
instrument and host contract are more reliably measurable than that of the derivative
component – e.g. because of the availability of quoted market prices – then it may be
acceptable to use those values to determine the fair value of the derivative on initial
recognition indirectly – i.e. as a residual amount. [IAS 32.31, 39.13, AG28]

7I.2.380.40 When separating an embedded derivative that is a forward contract,

the forward price is set such that the fair value of the embedded forward contract is
zero at inception. The same applies if the embedded derivative is a swap.
Consequently, the forward price needs to be at market on initial recognition. When
separating an embedded derivative that is an option, the separation is based on the
stated terms of the option feature documented in the hybrid instrument. As a result,
the embedded derivative would have a fair value of other than zero on initial
recognition of the hybrid instrument. However, the embedded derivative is valued
based on terms that are clearly present in the hybrid instrument. [IAS 39.AG28, IG.C.1–
IG.C.2]
EXAMPLE 17 – ACCOUNTING FOR SEPARABLE EMBEDDED FORWARD CONTRACT

7I.2.380.50 Company G, whose functional currency is sterling,

enters into a contract on 1 March 2021to buy goods from Company B,
whose functional currency is the euro. The purchase contract
stipulates payment in US dollars and requires G to pay USD 380 on
delivery of the goods in six months’ time. The applicable exchange
rates on 1 March 2021 are:
• spot rate: USD 1 = GBP 0.556; and
• six-month forward rate: USD 1 = GBP 0.526.

7I.2.380.60 The contract between G and B contains a foreign

currency derivative that requires separation under IAS 39 because it
does not fall under any of the exemptions for non-separation of
embedded foreign currency derivatives (see 7I.2.260).

7I.2.380.70 The host contract is a purchase contract denominated

in the functional currency of G – i.e. sterling. The embedded derivative
is a foreign currency forward contract to sell USD 380 for sterling at
0.526 at 1 September 2021 – i.e. GBP 200. Because the forward
exchange rate is the market rate on the date of the transaction, the
embedded forward contract has a fair value of zero on initial
recognition.

7I.2.380.80 The embedded foreign currency forward contract is

accounted for as if it were a freestanding derivative (see 7I.6.140), and
the host instrument as an executory contract (see 1.2.130).

7I.2.380.90 If an executory contract to purchase goods or services with an

embedded separable derivative related to variability in the price payable contains
different delivery and payment dates, then a question arises about the maturity of the
embedded derivative. In our view, an entity should choose an accounting policy, to be
applied consistently, to determine the maturity of the embedded derivative as the
delivery date or the payment date. We believe that, regardless of the accounting
policy chosen, the terms of the embedded derivative and its valuation should reflect
the actual terms of the hybrid instrument and not presume cash flows on the delivery
date if cash flows only occur after the delivery date. When the goods or services are
delivered, a financial instrument should be recognised for the amount payable under
the contract – i.e. the nature of the contract changes from an executory contract to a
financial instrument contract. The separable embedded derivative may be a payment
denominated in a third currency (see Example 17) or an embedded foreign currency
option under which an entity can choose between different settlement currencies at
the payment date based on an exchange rate fixed at inception of the executory
contract. The accounting policy choice may have an impact on whether an embedded
derivative continues to be separated subsequent to recognition of the financial
instrument on the delivery date.

EXAMPLE 18 – EXECUTORY CONTRACT WITH SEPARABLE EMBEDDED DERIVATIVE

7I.2.380.100 Modifying Example 17, delivery of the goods occurs on

1 June 2021, three months after entering into the purchase contract
and settlement in USD occurs on 1 September 2021, six months after
entering into the contract. Company G considers the maturity of the
embedded derivative to be at the delivery date.

7I.2.380.110 At inception, the contract between G and Company B

contains a foreign currency derivative that requires separation under
IAS 39 because it does not fall under any of the exemptions for non-
separation of embedded foreign currency derivatives (see 7I.2.260). G
measures the fair value of the embedded derivative using the six
month forward rate reflecting the substantive terms of the hybrid
contract. Because the forward exchange rate is the market rate on the
date of the transaction, the embedded forward contract has a fair value
of zero on initial recognition.

7I.2.380.120 When B settles its contractual obligation to deliver

the goods, B and G recognise a new financial asset and a new financial
liability, respectively, in relation to the foreign currency purchase price
that is payable in three months. The contract is now a debt financial
instrument.

7I.2.380.130 The separated embedded derivative is derecognised

and included in the carrying amount of the debt instrument. B and G no
longer separate an embedded derivative because they each have a
foreign currency-denominated debt instrument. B and G will each
recognise foreign currency gains and losses on this monetary item in
profit or loss.

7I.2.380.140 Conversely, if G considers the maturity of the

embedded derivative to be at the payment date, then the embedded
derivative that was already separated at inception of the executory
contract remains separated once delivery has taken place. In this case,
G has a debt financial instrument that represents an obligation to pay
the purchase price under the host contract denominated in sterling of
GBP 200. [IAS 39.AG33(c)–(d)]

7I.2.380.150 Embedded derivatives accounted for separately may be designated

as hedging instruments. The normal hedge accounting criteria outlined in 7I.7.120
apply to embedded derivatives used as hedging instruments. [IAS 39.72]
7I.2.390 Presentation and disclosures

7I.2.390.10 IAS 39 does not require separate presentation of separated embedded

derivatives in the statement of financial position. In our view, under certain
circumstances embedded derivatives that are separated from a host financial
instrument should be presented together with the host contract (see 7I.8.200).
However, an entity is required to disclose separately financial instruments carried at
amortised cost and those carried at fair value. Therefore, embedded derivatives that
are separated from financial instruments but not presented separately in the
statement of financial position should be disclosed in the notes. [IAS 39.11, IFRS 7.8,
B2(a)]
27 OCT 2022 PAGE 2639

Insights into IFRS 18th Edition 2021/22

7I. Financial instruments: IAS 39
7I.3 Equity and financial liabilities

7I.3 Equity and financial liabilities

7I.3.10 Classification 2642

7I.3.20 Basic principles 2642
7I.3.30 Contractual obligation to deliver cash or
another financial asset 2644
7I.3.40 Perpetual instruments 2647
7I.3.50 Contractual vs statutory
obligations 2647
7I.3.60 Discretionary payments 2648
7I.3.70 Contingent settlement
provisions 2649
7I.3.80 Instruments that will or may be settled
in own equity 2653
7I.3.90 Non-derivative contracts 2653
7I.3.100 Derivative contracts 2655
7I.3.120 Issuer’s option to settle in
cash 2660
7I.3.130 Obligation to acquire own instruments 2661
7I.3.140 Members’ shares in co-
operative entities and similar
instruments 2662
7I.3.150 Contracts to acquire own
equity instruments 2663
7I.3.180 Puttable instruments and obligations
arising on liquidation classified as
equity by exception 2666
7I.3.190 Puttable instruments 2667
7I.3.200 Instruments that oblige the
entity on liquidation 2668
7I.3.220 Pro rata share of entity’s net
assets on liquidation 2671
7I.3.230 Class of instruments
subordinate to all other
classes 2674
 7I.3.240 Identical features test 2675
7I.3.250 No other contractual
obligation to deliver cash or
another financial asset 2676
7I.3.260 Total expected cash flows
attributable to instrument
over its life 2677
7I.3.270 Existence of other contracts
that preclude equity
classification 2678
7I.3.280 Application of the exceptions
to specific instruments 2678
7I.3.320 Reclassification 2680
7I.3.330 Recognition and measurement 2681
7I.3.340 Financial liabilities 2681
7I.3.350 Equity instruments 2681
7I.3.360 Share splits and bonus issues 2681
7I.3.370 Prepaid capital contributions 2682
7I.3.380 Receivables in respect of
equity contributions 2682
7I.3.390 Non-reciprocal capital contributions 2682
7I.3.400 Extinguishing financial liabilities with
equity instruments 2683
7I.3.410 Reclassification of instruments between liability
and equity 2683
7I.3.420 Reclassification due to amendment of
contractual terms 2684
7I.3.430 Reclassification due to change of
effective terms without amendment of
contractual terms 2684
7I.3.440 Costs of an equity transaction 2686
7I.3.450 Qualifying costs 2688
7I.3.460 Costs of anticipated equity transactions 2689
7I.3.470 Related tax benefits 2689
7I.3.480 Presentation and disclosure of equity 2690
7I.3.490 Costs of an equity transaction 2690
7I.3.500 Income tax 2691
7I.3.510 Non-controlling interests 2692
7I.3.520 Capital disclosures 2692
7I.3.530 Capital maintenance 2692
7I.3.540 Dividends 2692
7I.3.550 Share dividends 2695
 7I.3.560
Distributions of non-cash assets to
owners 2695
7I.3.570 Application to specific instruments 2697
7I.3.580 Compound instruments 2697
7I.3.590 Classification of components 2698
7I.3.620 Recognition and
measurement 2700
7I.3.640 Accounting for early
redemption 2701
7I.3.650 Accounting for conversion 2701
7I.3.660 Amendment to induce early
conversion 2703
7I.3.670 Restructuring a convertible
bond 2704
7I.3.680 Treasury shares 2705
7I.3.690 Classification 2705
7I.3.700 Recognition and
measurement 2705
7I.3.750 Presentation 2707
7I.3.760 Preference shares 2708
7I.3.770 Conversion rights with down-
round feature 2709
7I.3.780 Equity instruments with write-down
features and substitution rights 2710
7I.3.790 Write-down features in
equity instruments 2710
7I.3.800 Substitution rights 2711
7I.3.810 Contingent consideration in business
combination 2711

7I.3 Equity and financial liabilities

REQUIREMENTS FOR INSURERS THAT APPLY IFRS 4

In July 2014, the International Accounting Standards Board issued IFRS 9 Financial
Instruments, which is effective for annual periods beginning on or after 1 January
2018. However, an insurer may defer the application of IFRS 9 if it meets certain
criteria (see 8.1.180).

This chapter reflects the requirement of IAS 39 Financial Instruments: Recognition

and Measurement and the related standards, excluding any amendments introduced
by IFRS 9. These requirements are relevant to insurers that apply the temporary
exemption from IFRS 9 or the overlay approach to designated financial assets (see
8.1.160) and prepare financial statements for periods beginning on 1 January 2021.
For further discussion, see Introduction to Sections 7 and 7I.

The requirements related to this topic are mainly derived from the following.

STANDARD TITLE

IAS 1 Presentation of Financial Statements

IAS 12 Income Taxes

IAS 32 Financial Instruments: Presentation

IAS 39 Financial Instruments: Recognition and Measurement

IFRIC 2 Members’ Shares in Co-operative Entities and Similar

Instruments

IFRIC 17 Distributions of Non-cash Assets to Owners

IFRIC 19 Extinguishing Financial Liabilities with Equity

Instruments

FORTHCOMING REQUIREMENTS AND FUTURE DEVELOPMENTS

For this topic, there are no forthcoming requirements or future developments.

7I.3.10 CLASSIFICATION

7I.3.20 Basic principles

7I.3.20.10 An instrument, or its components, is classified on initial recognition as

a financial liability, a financial asset or an equity instrument in accordance with the
substance of the contractual arrangement and the definitions of a financial liability, a
financial asset and an equity instrument. [IAS 32.15]

7I.3.20.20 An instrument is classified as a financial liability if it is:

• a contractual obligation:
– to deliver cash or other financial assets; or
– to exchange financial assets or financial liabilities with another entity under
potentially unfavourable conditions (for the issuer of the instrument); or
• a contract that will or may be settled in the entity’s own equity instruments and is:
– a non-derivative that comprises an obligation for the entity to deliver a variable
number of its own equity instruments; or
– a derivative that will or may be settled other than by the entity exchanging a
fixed amount of cash or other financial assets for a fixed number of its own
equity instruments. [IAS 32.11]

7I.3.20.30 An obligation to transfer cash may arise from a requirement to repay

the principal or to pay interest or dividends.

7I.3.20.40 In general, an ‘equity instrument’ is any contract that evidences a

residual interest in the assets of an entity after deducting all of its liabilities. It meets
both of the following conditions.
• There is no contractual obligation:
– to deliver cash or another financial asset to another party; or
– to exchange financial assets or financial liabilities with another party under
potentially unfavourable conditions (for the issuer of the instrument).
• If the instrument will or may be settled in the issuer’s own equity instruments,
then it is either:
– a non-derivative that comprises an obligation for the issuer to deliver a fixed
number of its own equity instruments; or
– a derivative that will be settled only by the issuer exchanging a fixed amount of
cash or other financial assets for a fixed number of its own equity instruments.
[IAS 32.11, 16]

7I.3.20.50 If an instrument requires the issuer to deliver cash or settle it in such

a way that it would be a financial liability in the event of the occurrence or non-
occurrence of uncertain future events that are outside the control of the holder or
issuer, then it is generally a financial liability (see 7I.3.70). However, a term that
requires settlement only on liquidation of the issuer does not result in financial
liability classification, unless liquidation is certain to occur or the holder has a right
to liquidate the issuer of the instrument, because this would be inconsistent with the
going concern assumption (see 7I.3.70.170–200). As an exception to these general
principles, the following are classified as equity instruments if certain conditions
indicating that they represent a residual interest in the net assets of the entity
(discussed in more detail in 7I.3.190–200) are met:
• puttable instruments; and
• instruments, or components of instruments, that impose on the entity an
obligation to deliver to another party a pro rata share of the net assets of the entity
only on liquidation. [IAS 32.16A, 16C, 25, BC18, BC55–BC56]

7I.3.20.60 Subject to 7I.3.20.50, any financial instrument that an issuer could be

obliged to settle in cash, or by delivering other financial assets, is a financial liability
regardless of the financial ability of the issuer to settle the contractual obligation or
the probability of settlement. The IFRS Interpretations Committee discussed this
issue and noted that such a contractual obligation could be established explicitly or
indirectly, but it needs to be established through the terms and conditions of the
instrument. [IAS 32.19–20, IU 11-06]

EXAMPLE 1 – CLASSIFICATION AS LIABILITY OR EQUITY – LINKED INSTRUMENTS

 7I.3.20.70 Company K issues a non-redeemable financial instrument
(the ‘base’ instrument) with dividends payable if interest is paid on
another instrument (the ‘linked’ instrument). K is required to pay the
interest on the linked instrument.

7I.3.20.80 In this example, the linkage to the linked instrument, on

which interest is contractually payable, creates a contractual
obligation to pay dividends on the base instrument. Therefore, K
concludes that this obligation should be classified as a liability.

7I.3.20.90 When determining whether to classify a financial instrument as a

financial liability or as equity, an entity assesses the substance of a contractual
arrangement rather than its legal form. In assessing the substance of a contractual
arrangement, the entity needs to consider all of the terms and conditions of the
financial instrument, including relevant local laws, regulations and the entity’s
governing charter in effect at the date of classification (see 7I.3.50.70). Therefore, it
is possible for instruments that qualify as equity for legal or regulatory purposes to be
classified as liabilities for the purposes of financial reporting. [IAS 32.15, 18]

7I.3.20.100 The IFRS Interpretations Committee discussed the classification of a

financial instrument as a liability or as equity and noted that in assessing the
substance of a contractual arrangement, an entity needs to exclude a contractual
term that lacks substance. The Committee also noted that IAS 32 does not require or
permit factors not within the contractual arrangement to be taken into consideration
in classifying a financial instrument as a liability or as equity. For example, economic
compulsion should not be used as the basis for classification. This is because a
contractual obligation could be established explicitly or indirectly, but it has to be
established through the terms and conditions of the instrument (see 7I.3.20.60).
Therefore, by itself, economic compulsion does not result in a financial instrument
being classified as a liability. [IAS 32.20, IU 11-06, 01-14]

7I.3.20.110 Judgement is required to determine whether a contractual right –

e.g. to avoid delivering cash, another financial asset or a variable number of the
entity’s own equity instruments – is substantive and therefore needs to be considered
in determining the classification of an instrument as a financial liability or equity (see
7I.3.30.80 and 90.100–140). [IAS 32.15, 20, IU 01-14]

7I.3.20.120 Instruments commonly affected by these requirements include:

• preference shares;
• classes of shares that have special terms and conditions;
• subordinated instruments; and
• convertible and perpetual instruments.

7I.3.20.130 Equity instruments include shares, options and warrants, and any
other instrument that evidences a residual interest in an entity and meets the
relevant conditions in 7I.3.20.40–110.

7I.3.20.140 The classification of an instrument as either liability or equity

determines whether any interest, dividends, losses and gains related to that
instrument are recognised as income or expense in profit or loss or directly in equity
(see 7I.3.540). [IAS 32.35–36, AG37]

7I.3.20.150 The classification of an instrument, or its component parts, as either

financial liability or equity is made on initial recognition. It is not generally revised as
a result of subsequent changes in circumstances – with the exception of puttable
instruments and instruments that impose on the entity an obligation only on
liquidation (see 7I.3.320). However, a reclassification between financial liability and
equity or vice versa may be required in certain circumstances (see 7I.3.410). [IAS
32.15]

7I.3.20.160 The classification of financial instruments as equity or financial

liabilities in the consolidated financial statements may differ from their classification
in any separate or individual financial statements of entities within a group (see
7I.3.260.20). [IAS 32.AG29]

EXAMPLE 2 – CLASSIFICATION IN CONSOLIDATED AND SEPARATE FINANCIAL STATEMENTS

7I.3.20.170 Company P has two subsidiaries, Companies B and G. G

issues non-redeemable preference shares to a party outside the group.
B writes a put option on the preference shares issued by G. The put
option, if it is exercised, will require B to purchase the preference
shares from the holder for cash.

Company P

Company B Company G

Put option on Preference shares

preference shares

Investor

7I.3.20.180 In its separate financial statements, G classifies the

preference shares as equity because it does not have a contractual
 obligation to redeem the shares or to pay dividends. However, in the
consolidated financial statements, the group as a whole has a
contractual obligation to redeem the preference shares (through the
put option written by B). P therefore classifies the preference shares as
a financial liability in the consolidated financial statements.

7I.3.30 Contractual obligation to deliver cash or another

financial asset

7I.3.30.10 The primary factor determining classification is whether the

instrument establishes a contractual obligation for the issuer to make payments
(principal, interest/dividends or both). A right on the part of the holder does not
necessarily translate to a contractual obligation on the part of the issuer. [IAS 32.17]

7I.3.30.20 The holder of an equity instrument might be entitled to receive a pro

rata share of dividends or other equity distributions; however, the issuer does not
have a contractual obligation to make payments until the distribution is appropriately
authorised and is no longer at the discretion of the entity. The holder has a financial
asset, whereas the issuer has an equity instrument rather than a financial liability.
[IAS 32.17]

7I.3.30.30 IAS 32 further clarifies that an instrument that creates an obligation is

a financial liability if the entity does not have the unconditional right to avoid
delivering cash or another financial asset in settlement of that obligation. A
contractual obligation is not negated merely because of a lack of funds, statutory
restrictions or insufficient profits or reserves. [IAS 32.19, AG25]

EXAMPLE 3A – LIABILITY FOR PREPAID CARD

7I.3.30.32 Company C issues a prepaid card with the following

features in exchange for cash:
• there are no expiry date or back-end fees;
• the balance on the card does not reduce unless it is spent by the
cardholder;
• the balance on the card is non-refundable and cannot be exchanged
for cash;
• the balance on the card is redeemable only for goods or services to
a specified monetary amount at specified third party merchants;
and
• when the cardholder purchases goods or services and redeems the
balance at a merchant, C delivers cash to the merchant. [IU 03-16]

7I.3.30.35 The liability for the prepaid card meets the definition of a
financial liability because C:
• has a contractual obligation to deliver cash to the merchants on
behalf of the cardholder when the cardholder uses the prepaid card
 to purchase goods or services; and
• does not have an unconditional right to avoid delivering cash to
settle this contractual obligation. [IU 03-16]

EXAMPLE 3B – CONTRACTUAL OBLIGATION CONTINGENT ON COVENANTS IMPOSED BY LOCAL LAW

7I.3.30.40 Company B has issued a loan, the terms of which

stipulate that it is repayable only if its repayment does not violate
certain covenants imposed by local law.

7I.3.30.50 In this example, B does not have the unconditional right

to avoid making payments; also, the breach of covenants that prevents
repayment at a specific point in time defers, rather than negates, the
obligation. Consequently, B classifies the loan as a financial liability.

7I.3.30.60 An obligation that will be settled only if a holder exercises its right to
redeem is a financial liability, irrespective of how likely or unlikely it is that the holder
will actually exercise its right. [IAS 32.19]

7I.3.30.70 When the terms of a financial instrument provide for cash settlement
at the option of the holder, entities may obtain a letter of undertaking from the holder
indicating that this option will not be called on. In our view, such an undertaking,
unless it is legally enforceable and irrevocable, is not sufficient to warrant
classification of the instrument as equity rather than as a financial liability. For
example, assume that the holder of such an instrument has signed such a letter of
undertaking but is able to sell the instrument. Furthermore, assume that the
purchaser would not be restricted by the letter of undertaking that was signed by the
seller. In this scenario, the instrument would be classified as a financial liability.

7I.3.30.80 In most cases, the terms and conditions of an instrument establish a

contractual obligation explicitly. However, such an obligation may also arise
implicitly. For example, an instrument may include a non-financial obligation that is
required to be settled if the entity fails to make distributions or redeem the
instrument; this is a financial liability, because the entity can avoid payment only by
settling the non-financial obligation. In another example, an instrument may provide
that on settlement an entity delivers either cash or another financial asset, or its own
shares whose value substantially exceeds the value of the cash or other financial
asset; this is also a financial liability, because the value of the share settlement
alternative is such that the entity will settle in cash. Therefore, the holder has in
substance been guaranteed receipt of an amount that is at least equal to the cash
settlement option. [IAS 32.20, BC9]

EXAMPLE 4 – NON-FINANCIAL OBLIGATION

 7I.3.30.90 Company G issues an instrument that includes a term
under which G is required to deliver a property in settlement if the
instrument is not redeemed after 10 years. The instrument is a
financial liability because G can avoid settling the financial obligation
only by settling the non-financial obligation.

EXAMPLE 5 – SHARE SETTLEMENT OPTION

7I.3.30.100 Company B issues an instrument that is required to be

settled either in cash or in a fixed number of B’s own shares, the value
of which will substantially exceed the amount of cash. The instrument
is a financial liability because, although B does not have an explicit
contractual obligation to settle in cash, the value of the share
settlement option is so high that B will always settle in cash.

7I.3.30.110 Instruments containing features that are classified as financial

liabilities generally include the following:
• instruments that are redeemable at the option of the holder – e.g. redeemable
preference shares;
• non-redeemable preference shares with dividends that are not discretionary (see
7I.3.60);
• instruments that become redeemable on the occurrence of an uncertain future
event that is beyond the control of both the holder and the issuer of the instrument
(see 7I.3.70); and
• subordinated liabilities.
7I.3.30.120 As an exception to the general principles, some instruments that are
redeemable, either at the option of the holder or on liquidation – which is either
certain to occur and outside the control of the entity, or uncertain to occur but at the
option of the instrument holder – are classified as equity instruments of the entity if
certain conditions are met (see 7I.3.190–200). [IAS 32.16A, 16C]

7I.3.40 Perpetual instruments

7I.3.40.10 Perpetual debt instruments normally provide the holder with a

contractual right to receive an indefinite stream of interest payments at a market rate
of interest, with no redemption of principal. Even though the holder will not receive
repayment of the principal, such instruments are a liability of the issuer because
there is a contractual obligation to make a stream of future interest payments to the
holder. Assuming that the terms of the instrument are at the market rate, the face
value or the carrying amount of the instrument reflects the present value of the
holder’s right to receive these interest payments in perpetuity. [IAS 32.AG6]

7I.3.50 Contractual vs statutory obligations

7I.3.50.10 To classify a financial instrument as either equity or financial liability,
an entity needs to distinguish between:
• a contractual obligation to deliver cash or another financial asset, which gives rise
to a financial liability; and
• a statutory obligation, which does not necessarily result in a financial liability. [IAS
32.AG12]

7I.3.50.20 For example, local law might require an entity to pay a minimum
specified amount as dividends in each period for a particular instrument. In our view,
such an obligation does not represent a contractual obligation and consequently the
obligation is not classified as a financial liability under IAS 32. However, when an
entity voluntarily incorporates a minimum specified amount of dividends into the
terms of an instrument – e.g. to achieve a desired tax outcome or to achieve a certain
regulatory status – in our view the payment of such dividends represents a
contractual obligation of the entity and consequently the obligation is classified as a
financial liability. [IAS 32.AG12]

EXAMPLE 6A – CONTRACTUAL OBLIGATIONS TO MAINTAIN TAX STATUS

7I.3.50.30 Company S is a real estate investment trust (REIT).

Under a contractual agreement with its shareholders, S is required to
maintain its REIT tax status. To do so, under local tax law S needs to
pay out a specified percentage of its taxable income as dividends each
year. There is no legal obligation, outside the contractual terms in the
shareholder agreement, for S to comply with those specific provisions
of the local tax law. Instead, the decision to be taxed as a REIT is
voluntary.

7I.3.50.40 In this example, a contractual obligation to pay dividends

is created indirectly (see 7I.3.20.100) – i.e. it is a combination of the
contractual requirement in the shareholder agreement to maintain the
REIT tax status and the requirement in the local tax law to pay
dividends in order to maintain that status. The tax law itself does not
oblige S to make dividend payments because it is a voluntary election
available to those that meet certain criteria. However, when viewed in
combination with the contractual agreement with its shareholders, S
has an obligation to make dividend payments. The clause under which
S needs to comply with the REIT dividend requirements is a
contractual obligation and not a statutory obligation. Therefore, this
obligation is classified as a financial liability.

EXAMPLE 6B – NO CONTRACTUAL OBLIGATIONS TO MAINTAIN TAX STATUS

 7I.3.50.50 In contrast to Example 6A, the contractual terms of the
shareholder agreement for Company T, another REIT, do not require
the entity to maintain REIT tax status. Instead, the agreement provides
the management of T with full discretion over the declaration of
dividends even though a failure to declare and pay dividends may
jeopardise its tax status. In this scenario, the legal requirement to pay
dividends in order to maintain REIT tax status would not impact the
classification of T’s shares.

7I.3.50.60 Some debt instruments issued by banks may be subject to a statutory

provision requiring them to be converted into equity or written down when a
supervisory authority determines that such an action is required. These instruments
are commonly referred to as ‘statutory bail-in instruments’. Bail-in occurs before a
bank becomes insolvent – e.g. when the regulatory capital ratio falls below a
minimum threshold that the supervisory authority has set. Statutory bail-in
requirements do not impact the issuer’s classification as financial liabilities or equity
on initial recognition. However, bail-in features that are contractual terms of the
instruments are considered in classification by the issuer.

7I.3.50.70 Although only contractual obligations give rise to financial liability

classification, in certain circumstances terms and conditions existing outside the
contract can affect the classification of an instrument by giving the issuer an
unconditional right to avoid payment. For example, the contractual right of the holder
of a share issued by an entity to request redemption does not, in itself, require that
financial instrument to be classified as a financial liability. Rather, the issuer is
required to consider all of the terms and conditions of the instrument in determining
its classification as a financial liability or equity. Those terms and conditions include
relevant local laws, regulations and the entity’s governing charter in effect at the
date of classification. If a local law, regulation or the entity’s governing charter gives
the issuer of the instrument an unconditional right to avoid redemption, then the
instrument is classified as equity. [IFRIC 2.5–8]

7I.3.50.80 The overall context of IFRIC 2 is the classification of instruments,

issued by co-operatives and similar entities, that are puttable instruments – defined in
IAS 32 as financial liabilities but with equity classification required if certain criteria
are met. Its focus is the interaction of contractual obligations to redeem an
instrument and terms outside the contract that can affect the exercise of those
contractual obligations. Accordingly, in our view IFRIC 2 should be interpreted such
that restrictions on redemption outside the contract itself may negate the existence
of a contractual obligation and lead to equity classification. However, we believe that
it should not be interpreted to mean that a non-contractual obligation to make
payments on an instrument that does not contain a contractual obligation will lead to
financial liability classification of that instrument. For a discussion of members’
shares in co-operative entities and similar instruments, see 7I.3.140.

7I.3.60 Discretionary payments

7I.3.60.10 A contractual requirement to pay dividends is an obligation to deliver
cash; therefore, it gives rise to a financial liability. This does not change, even if the
agreement to pay is conditional on the entity earning sufficient distributable profits; a
restriction on the ability of an entity to satisfy a contractual obligation does not
negate this obligation (see 7I.3.30). [IAS 32.19(a), 25, AG25]

7I.3.60.20 Dividends or other payments may be discretionary – i.e. there is no

obligation to pay. For example, in many jurisdictions dividends on ordinary shares
vary depending on the level of profitability; the entity can decide whether to pay
dividends, and how much to pay. Although there may be an expectation that dividends
will be paid if a certain level of profitability is achieved, this expectation is not a
contractual obligation. Therefore, the entity is able to avoid the transfer of cash or
another financial asset. [IAS 32.19]

7I.3.60.30 Generally, when preference shares are non-redeemable, the

appropriate classification is determined by the other rights that attach to them – in
particular, distributions to holders. If the dividends are cumulative, then this suggests
that the issuer may delay but cannot avoid the payment of dividends. However, if the
issuer can choose to avoid the payment of dividends under all circumstances until
liquidation of the entity and liquidation is neither certain to occur nor at the option of
the instrument holder (see 7I.3.200), then the dividends are discretionary and do not
give rise to an obligation. For example, if a non-redeemable preference share has a
cumulative dividend, but payment is discretionary until liquidation and there are no
other features that would lead to liability classification, then the instrument is
classified as equity (see 7I.3.760.10). [IAS 32.AG26]

7I.3.60.40 If preference shares are redeemable and dividends are discretionary,

then the issuer considers whether unpaid dividends are added to the redemption
amount of the preference shares. If any unpaid dividends are added to the
redemption amount and the entity does not have the unconditional ability to avoid
redemption before liquidation, then the dividends are not in substance discretionary
and the entire instrument including the discretionary dividend feature is a financial
liability. Furthermore, if an entity is or may be obliged to redeem the instrument at
fair value, then in our view unpaid dividends are implicitly added to the redemption
amount if the payment of dividends decreases the fair value of the instrument being
redeemed. Similarly, if an issuer of a puttable instrument is or may be obliged to
repurchase the instrument at any time at an amount equal to a pro rata share of net
assets, then we believe that unpaid dividends are implicitly added to the redemption
amount if the payment of dividends decreases the amount of the entity’s net assets
and the amount that the entity is obliged to pay increases as a result of non-payment
of dividends. [IAS 32.AG37]

7I.3.60.50 An instrument may specify that the issuer may make discretionary
interest payments that are based on a market benchmark interest rate. Such an
instrument would be classified as equity if it does not contain an obligation to pay
cash or another financial asset. In this case, a question may arise whether an interest
rate derivative should be separated. In our view, the floating rate discretionary
coupons (whether floored or unfloored) should not be separated from the equity host
because the issuer is not obliged to make those payments.

7I.3.70 Contingent settlement provisions

7I.3.70.10 An instrument may contain a contractual obligation to deliver cash or

another financial asset depending on the outcome of an uncertain future event that is
beyond the control of both the issuer and the holder of the instrument. Examples of
such uncertain events are changes in:
• a stock market index;
• interest rate;
• taxation requirements; and
• the issuer’s future revenues or debt-to-equity ratio. [IAS 32.25]
7I.3.70.20 When an instrument contains such contingent settlement provisions,
the issuer does not have the unconditional right to avoid making payments.
Therefore, the instrument is a financial liability, unless one of the following applies:
• the part of the contingent settlement provision that could require settlement in
cash or another financial asset is not genuine; or
• the issuer can be required to settle in cash or another financial asset only in the
event of its own liquidation (as long as liquidation is neither predetermined nor at
the option of the holder – see 7I.3.70.170–175).

7I.3.70.30 If the instrument containing such contingent settlement provisions is

a puttable instrument, then it may qualify for classification as equity if it meets all of
the relevant criteria (see 7I.3.190). [IAS 32.16A–16B]

EXAMPLE 7A – CONTRACTUAL OBLIGATION IF IPO DOES NOT TAKE PLACE

7I.3.70.40 Company Y issues a bond that is convertible

automatically into a fixed number of ordinary shares when an IPO
takes place. The offering is planned for two years’ time, but is subject
to the approval of a regulator. The bond is redeemable in cash only if
the IPO does not take place.

7I.3.70.50 In this example, Y cannot avoid the obligation, because it

cannot ensure that regulatory approval will be received; nor can it
ensure that the IPO will actually occur. In this scenario, the bond is
potentially redeemable in cash and the contingency is beyond the
control of both Y and the holder of the bond. The bond therefore
contains a liability, regardless of the likelihood of cash settlement.

7I.3.70.60 The contingent conversion feature qualifies as an equity

instrument because the bond can convert only into a fixed number of
equity shares (see 7I.3.100 and 810.20). Therefore, the bond is
accounted for as a compound instrument with liability and equity
components (see 7I.3.580). [IAS 32.16(b)(ii), 28]
EXAMPLE 7B – CONTRACTUAL OBLIGATION IF IPO TAKES PLACE

7I.3.70.70 If the bond in Example 7A were redeemable in cash only

if the IPO took place and the issuer had the unconditional ability to
avoid the obligation by being able to decide not to launch the IPO, then
the instrument would be classified as equity.

7I.3.70.80 If an entity issues an instrument that becomes immediately

redeemable in cash on the occurrence of a change in control of that entity, such as
when a majority of the entity’s shareholders choose to sell their shares to an
acquiring party in a takeover, then in our view this feature should be classified as a
financial liability. This is because we believe that such a change-in-control event is an
uncertain future event that is not within the control of the entity; therefore, the entity
does not have an unconditional right to avoid delivering cash. This would generally
apply even if such a takeover required formal approval by a majority of shareholders
at a general meeting, because it is reasonable to assume in this case that
shareholders would be acting in their capacity as individual investors rather than as a
body as part of the entity’s internal corporate governance processes (see
7I.3.70.90–130).

7I.3.70.90 In our view, careful analysis of the specific facts and circumstances
and judgement are required to assess whether the shareholders of an entity are
acting as a body under the entity’s governing charter – i.e. as issuer (part of the
entity), or as individual investors (not as part of the entity).

7I.3.70.100 When shareholders participate in the normal governance process,

and in a routine manner related to the decision involved, they are generally acting as
part of the entity. For example, assume that an entity has perpetual bonds with
interest payments linked to dividends on ordinary shares, which need to be approved
by the shareholders. These are classified as equity if the payment of dividends is at
the discretion of the entity. The following may indicate that the entity’s shareholders
are acting as a body on behalf of the entity when approving or disapproving the
payment of dividends on ordinary shares:
• dividend approvals are a recurring item on the agenda of the annual general
meeting; and
• the dividend approval process is carried out consistently over the years as a
matter of routine.

7I.3.70.110 In such cases, we believe that the approval of dividends is within the
control of the entity, that paragraph 25 of IAS 32 does not apply and that the term
‘issuer’ incorporates both the entity and its shareholders.

7I.3.70.120 However, shareholders are not acting as a body under the entity’s
governing charter when they are acting as individual investors. For example,
shareholders are generally considered to be acting outside the normal governance
process when they are voting to dispose of their individual shareholding.

7I.3.70.130 In such cases, we believe that a change in shareholding is not within

the control of the entity, that paragraph 25 of IAS 32 applies and that the term ‘issuer’
does not incorporate both the entity and its shareholders.

7I.3.70.140 As an exception, a contractual provision requiring settlement in cash

or another financial asset that is considered non-genuine does not result in financial
liability classification for that instrument. In our view, only in extremely rare, highly
abnormal and very unlikely circumstances will a contingent settlement feature be
considered ‘non-genuine’. We believe that a contingent settlement feature should be
considered non-genuine only if:
• it has no economic substance; and
• it could be removed by the parties to the contract without any compensation,
either in the form of payment or by altering the other terms and conditions of the
contract.

7I.3.70.150 In our view, in all other cases such provisions should be considered
genuine and therefore should affect classification. For example, an instrument may
provide for cash settlement in the event of a change in tax law because the terms of
the instrument were structured so that the holder and/or issuer could enjoy a specific
tax benefit. However remote the chances of the tax law changing, such an instrument
should be classified as a financial liability. A contingent settlement event – such as a
tax change or a takeover of the issuer – would always be regarded as genuine unless
it was inserted into the contract only to achieve financial liability classification. [IAS
32.AG28]

7I.3.70.160 In our view, subsequent changes in circumstances that lead to a

genuine contingent settlement feature becoming extremely rare, highly abnormal
and very unlikely to occur – i.e. a change in probability – do not change the initial
assessment that the contingent settlement feature is considered genuine and
therefore do not result in reclassification of the instrument from financial liability to
equity. Likewise, subsequent changes in circumstances that lead to a non-genuine
contingent settlement feature becoming likely to occur do not result in a
reclassification of an instrument from equity to financial liability. However,
appropriate disclosure may be required (see 7I.8.10.10).

7I.3.70.170 A contractual provision that requires settlement of a financial

instrument only in the event of liquidation of the issuer does not usually result in
financial liability classification for that instrument. This is because classifying such an
instrument as a financial liability based only on there being an obligation arising on
liquidation would be inconsistent with the going concern assumption. A contingent
settlement provision that provides for payment in cash or another financial asset only
on liquidation of the issuer is similar to an equity instrument that has priority in
liquidation, and therefore is ignored in classification. [IAS 32.25(b), BC18]

7I.3.70.175 However, the entity’s liquidation date may be predetermined;

alternatively, the holder of such an instrument may have the right to liquidate the
issuer of the instrument. In those cases, the conclusion in 7I.3.70.170 does not
generally apply and financial liability classification may be required (see 7I.3.200).
[IAS 32.16C, 25(b)]
7I.3.70.180 Unless the conditions for classification as equity under the
exceptions to the general principles described in 7I.3.200 are met, in our view the
following liquidation rights should also result in financial liability classification:
• a liquidation right held by the instrument holder that becomes exercisable on the
occurrence of an event that is not within the control of the entity – e.g. a change in
control (see 7I.3.70.80). This is because the entity cannot prevent the holder from
obtaining the liquidation right if the uncertain event occurs. For example, if the
liquidation right becomes exercisable on a change in control – e.g. when the
majority of the issuer’s shareholders choose to sell their shares in a takeover –
then the contingent event is not the liquidation itself but the change in control,
which is not within the discretion of the entity; and
• liquidation rights held by the instrument holders as a class rather than included in
the individual instrument – e.g. the majority of preference shareholders have a
contractual right to force the liquidation of the issuer. This is because the entity
cannot avoid its potential obligation to deliver cash or another financial asset if the
instrument holders make a decision to liquidate the entity.

7I.3.70.190 However, we believe that financial liability classification is not

generally appropriate when ordinary shareholders collectively have the right to force
the liquidation of the entity. This is because the ordinary shareholders’ right to
liquidate the entity at a general meeting would generally be considered part of the
normal or ordinary governance processes of the entity (see 7I.3.70.100). Therefore,
the ordinary shareholders acting through the general meeting would be considered
to be acting as part of the entity.

7I.3.70.200 A derivative contract that would otherwise be settled by delivery of a

fixed number of the entity’s own equity instruments in exchange for a fixed amount of
cash may provide for net cash settlement in the event of the counterparty’s
involuntary liquidation or bankruptcy. In our view, the existence of such a clause does
not preclude the entity from classifying the derivative contract as equity.

7I.3.80 Instruments that will or may be settled in own equity

7I.3.80.10 A contract that will be settled by the entity issuing its own equity
instruments does not create an obligation on the part of the entity to deliver cash or
another financial asset. However, IAS 32 imposes additional requirements that have
to be met in order to classify such instruments as equity. [IAS 32.21]

7I.3.90 Non-derivative contracts

7I.3.90.10 If a non-derivative contract will or may be settled in the issuer’s own

equity instruments and does not include an obligation to pay cash or other financial
assets (or exchange financial assets or financial liabilities under potentially
unfavourable conditions), then it is an equity instrument, provided that there is no
contractual obligation for the issuer to deliver a variable number of its own equity
instruments. It is classified as equity because the holder has a direct equity exposure.
If the contract obligates the issuer to settle in a variable number of own equity
instruments, then it would be classified as a financial liability. [IAS 32.11, 16(b)(i), 21,
AG27(d)]

7I.3.90.20 Also, if a contract may be settled either in the issuer’s own equity
instruments (whether fixed or variable in number) or in cash or other financial assets,
at the option of the holder, then the instrument is a financial liability or contains a
liability component – e.g. a bond convertible into shares at the holder’s option. [IAS
32.11, 16(b)]

7I.3.90.30 The IFRS Interpretations Committee discussed the classification of a

financial instrument as a liability or as equity and noted that if the issuer of a financial
instrument has the contractual right to choose to settle the instrument either in cash
or in a fixed number of its own shares, then the instrument meets the definition of an
equity instrument provided that the instrument does not establish an obligation to
deliver cash indirectly through its terms and conditions (see 7I.3.20). This is because
the issuer does not have a contractual obligation to deliver cash or to deliver a
variable number of its own shares. [IAS 32.16, AG25, IU 09-13]

7I.3.90.40 A contract is a financial liability if an entity has an obligation to deliver

a number of its own equity instruments that varies so that the total fair value of the
equity instruments delivered is equal to the amount of the contractual obligation. The
amount of that contractual obligation could be fixed, or it could vary in response to
changes in another market variable that is unrelated to the market value of the
entity’s equity instruments – e.g. the gold price. In these circumstances, the holder is
not exposed to any gain or loss arising from movements in the fair value of the equity
instruments. Consequently, in such instances the entity is using its equity
instruments as currency. Such contracts are financial liabilities of the entity. [IAS
32.21]

7I.3.90.50 The IFRS Interpretations Committee noted that a single obligation to

deliver a variable number of an entity’s own equity instruments is a non-derivative
obligation that meets the definition of a financial liability and cannot be subdivided
into components for the purpose of evaluating whether the instrument contains a
component that meets the definition of equity. [IAS 32.11, IU 05-14]

EXAMPLE 8 – OBLIGATION TO DELIVER VARIABLE NUMBER OF SHARES SUBJECT TO CAP AND FLOOR

7I.3.90.60 Company M has issued a financial instrument for 8,000.

The instrument has a stated maturity date. At maturity, M must deliver
a variable number of its own equity shares, as follows:
• if the share price is below 80, then M issues 100 shares (cap);
• if the share price is above 100, then M issues 80 shares (floor); and
• if the share price is between 80 and 100, then M issues a variable
number of shares with a market value of 8,000.

7I.3.90.70 The IFRS Interpretations Committee discussed a similar

scenario and noted that the instrument in such an example is a
financial liability because it comprises an obligation to deliver a
 variable number of shares. Although the variability is limited by a cap
and a floor, the overall number of equity instruments that the issuer is
obliged to deliver is not fixed and therefore the entire obligation meets
the definition of a financial liability. It would not be appropriate to
divide the instrument into components – e.g. the minimum number of
shares to deliver under the floor – for the purpose of evaluating
whether the instrument contains a component that meets the
definition of equity. [IU 05-14]

7I.3.90.80 The Committee also noted that such cap and floor
features are embedded derivatives that need to be separated from the
host liability – which in this example represents an obligation to deliver
a variable number of shares with a fixed value of 8,000 – and to be
measured at fair value, with all changes in fair value recognised in
profit or loss, assuming that the instrument has not been designated in
its entirety as at FVTPL (see 7I.2.110 and 7I.4.40). [IU 05-14]

7I.3.90.90 This is because:

• the ‘fixed-for-fixed’ requirement is not met in respect of these
features because the cap and floor are net settled derivatives which
do not result in the exchange of a fixed amount of cash for a single
fixed number of equity shares (see 7I.3.100.10); and
• their values change in response to the price of the issuer’s equity
shares and therefore they are not closely related to the host debt
contract. [IU 05-14]

7I.3.90.100 An instrument may establish a contractual obligation to deliver a

variable number of shares indirectly through its terms and conditions, even if the
issuer has a contractual right to settle the instrument by delivering a fixed number of
shares. This is illustrated in Example 9.

EXAMPLE 9 – CLASSIFICATION AS LIABILITY OR EQUITY – IS A CONTRACTUAL RIGHT SUBSTANTIVE?

7I.3.90.110 Company Z issues a financial instrument that matures

after five years.
• On maturity, the instrument is settled by delivering a variable
number of Z’s own equity instruments with a market value equal to
a fixed cash amount, subject to a cap and a floor, similar to Example
8 – i.e. there are both a minimum and

a maximum number of equity instruments that could be delivered if

the price of a single equity instrument is higher or lower than
certain amounts.
• Z also has a contractual right to settle the instrument at any time
before maturity by delivering the maximum number of equity
 instruments specified in the contract – i.e. the cap amount.

7I.3.90.120 In discussing a similar scenario, the IFRS

Interpretations Committee noted that an entity cannot automatically
assume that the financial instrument meets the definition of an equity
instrument because it has a contractual right to settle early by
delivering a fixed number of its own equity instruments. This is
because this contractual right might not be substantive – because the
issuer may have to deliver significantly more shares to settle early than
it may otherwise be obliged to deliver at maturity – and therefore
would not be considered in determining the classification of the
instrument (see 7I.3.20). [IAS 32.15, 20, IU 01-14]

7I.3.90.130 Judgement is required to determine whether the early

settlement option is substantive and therefore should be taken into
account in classifying the instrument. In particular, Z needs to consider
whether there are actual economic or other business reasons for it to
exercise that option. [IU 01-14]

7I.3.90.140 In making this assessment, Z considers the following

factors:
• whether the instrument would have been priced differently if its
early settlement option had not been included within the
contractual terms;
• the width of the range between the cap and the floor; and
• Z’s share price and its volatility. [IU 01-14]

7I.3.100 Derivative contracts

7I.3.100.10 A derivative contract is an equity instrument if it can be settled only

by the entity receiving or delivering a fixed number of its own equity instruments for
a fixed amount of cash or another financial asset (the so-called ‘fixed-for-fixed’
requirement). For example, an issued share option that gives the holder the right to
buy a fixed number of the entity’s shares for a fixed amount of cash or for a fixed
stated principal amount of a bond is an equity instrument. IAS 32 also goes on to state
that changes in the fair value of an instrument as a result of changes in market
interest rates that do not affect the amount of cash or other financial assets to be
received or paid, or the number of equity instruments to be received or delivered, do
not impact classification as an equity instrument. A contract that is settled by an
entity issuing a variable number of own shares for a fixed amount of cash, or a fixed
number of own shares for a variable amount of cash, is a financial asset or financial
liability of the entity. [IAS 32.11, 16(b)(ii), 22]

7I.3.100.20 IAS 32 does not address an exchange of a fixed number of the entity’s
own equity instruments. In our view, a contract to exchange a fixed number of one
class of non-derivative own equity instruments for a fixed number of a different class
of non-derivative own equity instruments should be classified as an equity
instrument. For example, an issued share option that gives the non-controlling
shareholder of an entity’s subsidiary the right to exchange a fixed number of shares
in that subsidiary for a fixed number of shares in the parent entity is an equity
instrument in the consolidated financial statements of the parent entity. [IAS 32.16]

7I.3.100.30 For convertible bonds where the holder has the ability to convert into
a fixed percentage of the issuer’s outstanding shares, an issue arises over whether
the conversion option meets the fixed-for-fixed requirement.

EXAMPLE 10 – BOND CONVERTIBLE INTO A FIXED PERCENTAGE OF AN ENTITY’S OUTSTANDING

SHARES

7I.3.100.40 Company S issued a convertible bond for a principal

amount of 5 million that matures in 10 years. The holder of the
instrument has the option to convert the bond into ordinary shares of
S. S may issue or redeem additional ordinary shares at any time. The
number of ordinary shares to be received on conversion will represent
a fixed percentage (i.e. 5%) of the issued and outstanding shares of S.

7I.3.100.50 The conversion option does not meet the fixed-for-fixed

requirement because the number of ordinary shares to be received
upon conversion will vary when there are changes in the number of
outstanding shares of S.

7I.3.100.60 An obligation in a foreign currency represents a variable amount of

cash. Consequently, contracts (both freestanding and embedded) are classified as
financial assets or financial liabilities if they will be settled by an entity delivering a
fixed number of its own equity instruments in exchange for a fixed amount of foreign
currency. However, there is an exception for rights, options or warrants to acquire a
fixed number of the entity’s own equity instruments for a fixed amount of any
currency. This exception requires that the entity offers the rights, options or warrants
pro rata to all of its existing owners of the same class of its own non-derivative equity
instruments. Under the exception, these rights, options or warrants are equity
instruments. The exception does not extend to other instruments that grant the
holder the right to purchase the entity’s own equity instruments for a fixed amount
denominated in a foreign currency (such as the conversion feature in bonds). For
further discussion of foreign currency convertible bonds, see 7I.3.600. [IAS 32.11(b)(ii),
16(b)(ii), BC4F, BC4K]

7I.3.100.70 In our view, the requirement that a contract be settled by delivering a

fixed number of its own shares for a fixed amount of cash, in order to be classified as
equity, can also be met if the number of shares to be delivered or the amount of cash
to be received changes over the life of the contract but the change is predetermined
at inception of the contract.

EXAMPLE 11 – BERMUDAN OPTION

 7I.3.100.80 Company B issues an option, which the parties can
exercise at predetermined dates (a Bermudan option). At each date,
the option can be settled by B delivering a fixed number of its own
shares for a fixed amount of cash. However, the number of shares and
the amount of cash depend on the date of exercise of the option; the
exact terms of the exchange at each exercise date were determined
when B entered into the contract – i.e. the number of shares to be
delivered is fixed for each date at inception.

7I.3.100.90 Such a contract is in fact a series of European-style

option contracts that would each be settled by B delivering a fixed
amount of its own shares for a fixed amount of cash. Consequently, B
concludes that the contract, assuming that it meets the other
requirements, should be classified as an equity instrument.

7I.3.100.100 Similarly, in our view adjustment clauses that alter the conversion
ratio only to prevent dilution (anti-dilution) do not violate the fixed-for-fixed
requirement and therefore do not result in the instrument being classified as a
financial liability. ‘Anti-dilution’ refers to the adjustment of the conversion ratio to
compensate holders of the instrument for changes in the number of equity
instruments outstanding that relate to share issuances or redemptions not made at
fair value – e.g. arising from rights issues or bonus issues. Anti-dilution can also
include the adjustment of the conversion ratio to compensate holders of the
instrument for dividend payments to existing shareholders that were not taken into
account when the conversion ratio was initially set. Anti-dilution does not comprise
any other form of compensation to the instrument holder for fair value losses – e.g.
when compensation by adjusting the conversion ratio is given if the share price falls
below a certain level or if new shares are issued at a then-current market price that is
below the conversion price.

7I.3.100.110 Many convertible bonds include takeover clauses that either allow or
require the holder to exercise its conversion option at an enhanced conversion ratio if
control of the issuer changes. A takeover may negatively affect bond holders relative
to shareholders in a number of ways – e.g. if current shareholders are bought out by
an acquirer, and the issuer’s business is transferred to a new entity or the underlying
shares are de-listed. The bond holder might suffer the loss of its conversion option (if
conversion is required) or the loss of an option to convert into publicly traded shares
(if the issuer’s shares are no longer publicly traded). In the absence of compensation
to the bond holder, the shareholders would benefit from the relative loss of value
suffered by the bond holders. In our view, if a takeover clause provides an enhanced
conversion ratio that is designed to compensate bond holders for this loss of
optionality that arises on a takeover and is intended to preserve the relative economic
interests of bond holders and shareholders, then it does not violate the fixed-for-fixed
requirement. We believe that takeover clauses are not limited only to those that
necessarily result in a change of control of the issuer in accordance with IFRS 10 (see
2.5.20).

EXAMPLE 12 – TAKEOVER CLAUSE – CHANGE OF CONTROL

7I.3.100.120 Company X, a listed entity located in Country Z, issues

a convertible bond. The holder of the bond can convert it into a fixed
number of common shares of X (i.e. a fixed conversion ratio), except
that the conversion ratio is adjusted when a change of control occurs.
Under the terms of the convertible bond, ‘control’ is defined as an
acquirer attaining ownership of 30% or more of the voting rights of the
issuer and this definition is consistent with the local takeover law.
When a change of control occurs, the law requires the acquirer to
initiate a mandatory purchase offer to all of the remaining
shareholders. However, there is no requirement in the law to make a
similar offer to the convertible bond holders. If a holder of the
convertible bond wanted to participate in an offer from an acquirer,
then they would need to exercise the conversion option (at the adjusted
conversion ratio) and tender the resulting shares.

7I.3.100.130 If the threshold of control in the local takeover law in

Country Z – i.e. 30% of the voting rights – is set by the local legislator
because it is a level that would probably give an acquirer power over a
listed entity at general meetings, then we believe that it would be
appropriate for X to analyse the clause applying the guidance in
7I.3.100.110.

7I.3.100.140 If a convertible bond holder exercises the conversion

option to participate in the purchase offer, then it will lose the
remaining time value of the conversion option. If it does not so exercise
the conversion option, then it may lose the ability to convert the bond
into publicly traded shares at a subsequent date. Therefore, we believe
that if the adjustment to the conversion ratio is to compensate bond
holders for this relative loss of value compared with shareholders and
is intended to preserve the relative economic interests of bond holders
and shareholders, then X may conclude that such an adjustment to the
conversion ratio does not violate the fixed-for-fixed requirement.

7I.3.100.150 Except as described in 7I.3.100.100–110, in our view the

requirement that a contract be settled by delivering a fixed number of the entity’s
own shares for a fixed amount of cash cannot be met when the right to the number of
shares to be delivered is contingent on both the exercise date of the instrument and
equity prices or any other index.

EXAMPLE 13 – PATH-DEPENDENT OPTION

 7I.3.100.160 Company G issues a convertible bond containing a right
for the holder to convert the bond into shares of the issuer. The number
of shares received at each exercise date is dependent on the average
share prices prevailing three months before the exercise date – i.e. a
path-dependent option.

7I.3.100.170 G concludes that the instrument does not meet the

fixed-for-fixed requirement, because there is not only variability in the
date of exercise but also variability in the actual number of shares that
will be issued at each exercise date. In Example 23, even though there
was variability in the date of exercise, such a contract represents a
series of European-style option contracts that will each be settled by
delivering a fixed amount of own shares for a fixed amount of cash.

7I.3.100.180 Any consideration received or paid for an instrument that is

classified as an equity instrument – e.g. the option premium – is added to or deducted
from equity. [IAS 32.22]

7I.3.110 Settlement options in derivative instruments

7I.3.110.10 A choice of the manner in which derivative financial instruments are

settled – e.g. when the issuer or the holder could opt to settle net or gross – could
determine their classification. IAS 32 states that a derivative financial instrument
with settlement options is a financial asset or financial liability unless all of the
settlement alternatives result in equity classification. Consequently, settlement
options, even those that are at the discretion of the entity, could result in instruments
being classified as financial assets or financial liabilities. [IAS 32.26–27]

EXAMPLE 14 – HOLDER SETTLEMENT OPTION

7I.3.110.20 Company K issues a warrant that gives the holder the

right to acquire a fixed number of the issuer’s own equity instruments
for a fixed amount of cash. If the warrant expires unexercised, then the
issuer will pay to the holder a fixed cancellation fee. K classifies the
warrant as a financial liability because the holder may choose to
receive cash or shares.

7I.3.110.30 The provisions in IAS 32 regarding settlement options apply only to

derivative financial instruments. Therefore, if an instrument does not meet the
definition of a derivative, then its classification as a liability or as equity depends on
whether the entity has a contractual obligation to deliver cash or other financial
assets, or to deliver a variable number of its own equity instruments (see 7I.3.20). [IAS
32.11]

EXAMPLE 15 – ISSUER SETTLEMENT OPTION

 7I.3.110.40 Company H issues preference shares at par that are
redeemable in five years and do not carry the right to receive
dividends. At the end of five years H has the option to redeem the
shares, either in a fixed number of its own shares or in cash at an
amount that is equal to the fair value of the shares.

7I.3.110.50 Under the terms of the instrument, H does not have an

obligation to transfer cash or another financial asset, or to deliver a
variable number of its own shares (see 7I.3.90.30); nor does the entire
instrument meet the definition of a derivative, because it fails the
initial net investment criterion (see 7I.2.40). Therefore, the provisions
regarding settlement options do not apply, and H classifies the
instrument as equity.

7I.3.110.60 For a discussion of whether the issuer’s option to settle

in cash should be separated as an embedded derivative, see 7I.3.120.

7I.3.110.70 Additionally, settlement options could determine the manner in which

certain derivative instruments are accounted for. An entity is required to recognise a
liability for the present value of the redemption amount if the contract contains an
obligation to purchase its own equity instruments for cash or another financial asset.
When the contract allows the counterparty discretion to require gross physical
settlement, a gross liability for the present value of the redemption amount is
recorded. The option is at the counterparty’s discretion and therefore the entity
cannot avoid gross physical settlement – i.e. the obligation to purchase its own equity
instrument for cash or another financial asset (see 7I.3.150). [IAS 32.23, 26–27, IE6, IE31]

7I.3.110.80 However, IAS 32 is not clear on the effect of settlement options in a

derivative instrument allowing the issuer discretion to choose gross or net settlement
of a contract to purchase its own equity instruments for cash or another financial
asset – e.g. a forward to purchase or a written put option. Therefore, in our view an
entity should choose an accounting policy, to be applied consistently, from the
following alternatives.
• Recognise a liability for the present value of the redemption amount: According to
the illustrative examples that accompany the standard, an entity should recognise
a liability for the present value of the redemption amount if one of the settlement
alternatives is to exchange cash for shares (gross physical settlement).
• Apply derivative liability accounting in accordance with IAS 39: Because the entity
can choose net rather than gross settlement, it can avoid the obligation to
purchase its own equity instruments for cash or another financial asset (see
7I.3.150). [IAS 32.23, 26–27, IE6, IE31]

7I.3.120 Issuer’s option to settle in cash

7I.3.120.10 An issuer’s option to redeem a non-derivative equity instrument by
delivering cash does not cause the instrument to be classified as a financial liability
because the issuer does not have a contractual obligation to deliver cash or to deliver
a variable number of its own shares under the instrument (see 7I.3.90.30). [IAS 32.16,
AG25, IU 09-13]

7I.3.120.20 However, if the issuer of such an equity instrument has an option to

redeem it by delivering a variable amount of cash, and therefore the fixed-for-fixed
requirement is not met for this feature (see 7I.3.100.10), then a question arises about
whether the whole instrument should be considered as an equity instrument or
whether the issuer’s option to redeem the instrument is an embedded derivative that
should be separated.

7I.3.120.30 In our view, an entity should choose one of the following accounting
policies, to be applied consistently, to account for such redemption options.
• Account for the whole instrument as an equity instrument without separating the
redemption option: Under this approach, such a redemption option is not
accounted for as an embedded derivative, but is considered part of the equity
instrument. This is because the redemption option is already considered in
determining that the entire instrument is a non-derivative equity instrument. In
addition, discretionary payment features – such as discretionary dividends – are
not usually separated from a non-derivative equity instrument but instead are
considered an integral component of the instrument.
• Separate the redemption option as an embedded derivative asset: This approach is
based on the guidance on compound financial instruments (see 7I.3.590) and the
guidance in IAS 39 on the separation of embedded derivatives (see 7I.2.110),
under which the issuer needs to consider whether particular features of the
instrument should be separated. In this case, because the fixed-for-fixed
requirement is not met, the redemption feature is not an equity instrument and is
accounted for as a separate derivative asset. [IAS 32.15, 16(b)(ii), 28, 39.AG30(b)]

EXAMPLE 16 – REDEMPTION OPTION IN FOREIGN CURRENCY

7I.3.120.40 Company R, with a euro functional currency, issues

preference shares denominated in sterling with the following
contractual terms:
• each share is issued for GBP 100;
• there is no maturity date;
• dividend payments are discretionary; and

• R has the right to redeem the preference shares at any time for a
cash payment of GBP 100 per share, which represents a variable
amount of cash because the cash payment is denominated in a
foreign currency (see 7I.3.100.30).

7I.3.120.50 The preference shares meet the definition of an equity

instrument because R does not have a contractual obligation to deliver
cash or to deliver a variable number of its own shares. For the cash
 redemption option, we believe that R should choose an accounting
policy, to be applied consistently, from the approaches discussed in
7I.3.120.30 to either:
• account for the preference shares in their entirety as equity; or
• separate its option to redeem the shares in cash as an embedded
derivative because the redemption amount is in a foreign currency
and therefore the option does not meet the fixed-for-fixed
requirement (see 7I.3.100.30 and 600). Therefore, R recognises the
amount of the consideration equal to the fair value of the
redemption option on initial recognition as a derivative asset.
Subsequently, R measures the derivative at fair value with changes
therein included in profit or loss.

7I.3.130 Obligation to acquire own instruments

7I.3.130.10 Financial instruments that give the holder the right to ‘put’ them back
to the issuer for cash or other financial assets (‘puttable instruments’) are financial
liabilities of the issuer. This applies also in consolidated financial statements to an
obligation or potential obligation to purchase a subsidiary’s equity instruments held
by non-controlling shareholders. However, a puttable instrument or an instrument
that imposes on the entity an obligation only on liquidation is classified as equity in
the issuing entity’s financial statements – but not in a parent’s consolidated financial
statements – if certain conditions are met (see 7I.3.150 and 190). [IAS 32.16A, 18(b)]

7I.3.130.15 A put option creates a contractual obligation that the issuer does not
have the unconditional ability to avoid. In our view, the fact that the instrument may
not be puttable immediately does not affect its classification as a financial liability,
although that fact may affect its measurement (see 7I.3.150) in addition to its
classification as a current or non-current liability.

7I.3.130.20 This principle applies even when:

• the amount of cash or other financial assets is determined on the basis of an index
or other variable that has the potential to increase or decrease – e.g. a share index;
or
• the legal form of the puttable instrument gives the holder a right to a residual
interest in the assets of the issuer. [IAS 32.18(b)]

7I.3.130.30 The amount payable to the holder of a puttable instrument might vary
in response to an index or another variable whose economic characteristics are not
closely related to those of the host contract. In this case, the instrument may contain
an embedded derivative that requires separation (see 7I.2.110). As a result, either:
• the entire puttable instrument (hybrid) is measured at FVTPL; or
• the embedded derivative is separated and accounted for at FVTPL (see 7I.6.120).
7I.3.130.40 Investors in many mutual funds, unit trusts and similar entities have
the right to redeem their interests in exchange for cash that is equivalent to their
share of the net asset value of the entity. This gives the issuer (the fund) a contractual
obligation and therefore these instruments are classified as financial liabilities,
unless they meet the conditions to be classified as equity (see 7I.3.190–200). These
instruments are financial liabilities independent of considerations such as when the
right is exercisable, how the amount payable on exercise is determined and whether
the instrument has a fixed maturity. However, these considerations may affect
whether the instruments qualify for equity classification under the exceptions in
7I.3.190–200. [IAS 32.18(b)]

7I.3.130.50 The requirement addressed in 7I.3.130.40 means that some entities

do not present any equity. However, IAS 32 does not preclude such instruments from
being included in the statement of financial position within a ‘total members’
interests’ subtotal. [IAS 32.IE32]

7I.3.140 Members’ shares in co-operative entities and similar

instruments
7I.3.140.10 The principles in 7I.3.130.40 apply equally to shares issued to
members of a co-operative entity that give the holder the right to request redemption.
Members’ shares and similar instruments that would be classified as equity if they did
not give the holder the right to request redemption are classified as equity only if:
• the entity has an unconditional right to refuse redemption; or
• redemption is unconditionally prohibited by local law, regulation or the entity’s
governing charter (see 7I.3.50.30). [IFRIC 2.2, 6–8]

7I.3.140.20 A distinction is made between unconditional and conditional

prohibitions on redemption. Only an unconditional prohibition on redemption can
lead to the classification of members’ shares and similar instruments as equity.

7I.3.140.30 An unconditional prohibition prevents an entity from incurring a

liability for redemption of all or some of the members’ shares, regardless of whether
the entity would otherwise be able to satisfy the financial liability. Conversely, a
conditional prohibition prevents payments being made only if certain conditions are
met – e.g. liquidity constraints. A conditional prohibition may only defer payment of a
liability that has already been incurred. For example, members can demand
redemption of shares as soon as the local liquidity or reserve requirements are met.
[IFRIC 2.BC14]

7I.3.140.40 An unconditional prohibition may be partial, in that it allows

redemption but requires a stated minimum amount of members’ shares or paid-in
capital to be maintained at all times. In this case, the proportion of members’ shares
subject to the unconditional prohibition on redemption is classified as equity – even
though each individual instrument may be redeemed. [IFRIC 2.9]

EXAMPLE 17 – PARTIAL UNCONDITIONAL PROHIBITION ON REDEEMING SHARES

 7I.3.140.50 Local law prohibits a co-operative from redeeming
members’ shares if that would cause the amount of paid-in capital from
members’ shares to fall below 75% of its highest ever reported amount.
If the highest amount of paid-in capital from members’ shares ever
reported was 100, then 75 would always be classified as equity – even
though each member could, individually, request redemption of their
share.

7I.3.140.60 An unconditional prohibition may be based on a factor that can change

over a period of time. [IFRIC 2.9]

EXAMPLE 18 – PARTIAL UNCONDITIONAL PROHIBITION ON REDEEMING SHARES THAT CHANGES

OVER TIME

7I.3.140.70 The governing charter of Co-operative C states that 25%

of the highest number of members’ shares ever in issue should be
maintained as equity. C decides to amend its governing charter by
reducing this percentage to 20%. Assuming that all other factors
remain the same, then the number of members’ shares subject to the
unconditional prohibition would reduce.

7I.3.140.80 Consequently, C would increase its financial liability to

redeem members’ shares, while simultaneously decreasing the amount
of members’ shares classified as equity. This, and other such changes
to the amount of members’ shares or paid-in capital subject to an
unconditional prohibition on redemption, are treated as transfers
between financial liabilities and equity. [IFRIC 2.9]

7I.3.140.90 For a discussion of changes in the effective terms of an instrument, see

7I.3.430. [IFRIC 2.9]

7I.3.140.100 In our view, an unconditional prohibition may also result in equity

classification when it prohibits a contingent event from taking place. For a discussion
of contingent events, see 7I.3.70.

EXAMPLE 19 – CONTINGENT EVENT UNCONDITIONALLY PROHIBITED BY LAW

 7I.3.140.110 Company C has issued a put option on specified equity
instruments that is exercisable if there is change in control of C. C is
controlled by the government; for public interest reasons, the law
unconditionally prohibits a change in control.

7I.3.140.120 In this example, C concludes that no liability should be

recognised for the potential obligation to redeem the equity
instruments unless there is a change in the law to remove the
prohibition.

7I.3.140.130 On initial recognition, an entity measures its financial liability at fair

value. In the case of members’ shares with a redemption feature, the entity measures
the fair value of the financial liability for redemption at no less than the discounted
maximum amount payable under the redemption provisions of its governing charter
or applicable law. The discount runs from the first date on which the amount could be
required to be paid. [IFRIC 2.10]

7I.3.150 Contracts to acquire own equity instruments

7I.3.150.10 An instrument that creates an obligation or potential obligation for an

entity to purchase its own equity instruments for cash or another financial asset (see
7I.3.130.10) gives rise to a financial liability. The liability is accounted for at the
present value of the redemption amount with a corresponding debit to equity. In
effect, a reclassification is made from equity to reflect the obligation to repurchase
the equity instruments in the future. If the contract expires without the obligation
being settled – e.g. if a written put option expires unexercised – then the carrying
amount of the liability at that time is reclassified to equity. For further discussion, see
7I.3.430. [IAS 32.23]

7I.3.150.20 This applies equally from a consolidated financial statements

perspective to an (potential) obligation to purchase a subsidiary’s equity instruments
held by non-controlling shareholders because a subsidiary’s equity constitutes the
group’s own equity in its consolidated financial statements. For a discussion of the
subsequent accounting for changes in the carrying amount of liabilities resulting
from forwards and put options over NCI, see 2.5.720. [IAS 32.23, IFRS 10.22, IU 11-06]

7I.3.150.30 However, in our view an obligation or potential obligation – either in

the form of forward or option contracts – to purchase an associate’s or a joint
venture’s equity instruments should be classified as a derivative in the separate,
individual and/or consolidated financial statements of the investor. This is because
associates and joint ventures are not part of the group (see 3.5.280).

7I.3.160 Written put option to be settled in shares of parent

7I.3.160.10 The discussion in this section considers three different scenarios in

which non-controlling shareholders have a right to put the subsidiary’s equity shares
to the parent in exchange for equity shares of the parent.
7I.3.160.20 In Scenario 1, a subsidiary issues equity shares to non-controlling
shareholders and a parent writes put options that give the non-controlling
shareholders a right to put their equity shares in the subsidiary to the parent in
exchange for a fixed number of the parent’s equity shares. In this case, in the parent’s
consolidated financial statements, the option gives non-controlling shareholders a
right to exchange a fixed number of one class of non-derivative own equity
instruments for a fixed number of a different class of non-derivative own equity
instruments. In our view, such a contract should be classified as equity (see
7I.3.100.20).

7I.3.160.30 In Scenario 2, a subsidiary issues equity shares to non-controlling

shareholders and a parent writes put options that give the non-controlling
shareholders the right to put their equity shares in the subsidiary to the parent in
exchange for a variable number of the parent’s equity shares. In this case, IAS 32 is
not clear about how such instruments held by non-controlling shareholders should be
classified in the parent’s consolidated financial statements.

7I.3.160.40 In our view, an entity should choose one of the following accounting
policies, to be applied consistently, to account for such instruments.
• Approach 1: Classify the subsidiary’s shares held by non-controlling shareholders
together with the put options as financial liabilities. Under this approach, in
accordance with paragraph AG29 of IAS 32, taking into account all of the terms
and conditions agreed between members of the group and the holders of the
instrument, the subsidiary’s shares are effectively considered to be non-derivative
contracts – i.e. a contractual obligation for the parent to deliver a variable number
of its own equity shares – and there is no separate accounting for the put options
(see 7I.3.20.20 and 90.10).
• Approach 2: Account for the written put options separately as derivative liabilities.
The basis of this approach is that the put option is a separate instrument and there
is no obligation to deliver cash or another financial asset. Accordingly, the
subsidiary’s shares that are held by non-controlling interest holders are presented
as equity reflecting existing ownership interests in the subsidiary and the put
option is accounted for at FVTPL in accordance with IAS 39 (see 7I.3.100.10).

7I.3.160.50 The put options in Scenario 2 in 7I.3.160.30 may be written either

together with the issuance of the shares to the non-controlling shareholders or
subsequent to the issuance of these shares. When the put option is written
subsequent to the issuance of the shares, under Approach 1 in 7I.3.160.40, a
reclassification would be required such that a financial liability is recognised and
measured at fair value at that date. Under Approach 2 in 7I.3.160.40, the put options
are recognised as derivative liabilities regardless of the timing of their issuance.

7I.3.160.60 Modifying Scenario 2, assume that the parent also has an option to
settle by paying cash rather than delivering its own equity shares when the non-
controlling shareholders exercise the options and deliver their shares in the
subsidiary to the parent. If the parent’s accounting policy is to consider the
combination of the shares and the written put options as financial liabilities
(Approach 1 in 7I.3.160.40), then the existence of the parent’s right to settle in cash
does not affect its accounting treatment because the combination still represents a
financial liability. However, if the parent’s accounting policy is to account for the
written put options separately (Approach 2 in 7I.3.160.40), then in our view the
parent should also choose one of the following accounting policies, to be applied
consistently, in respect of the written put options.
• Recognise a financial liability for the present value of the exercise price: Under
this approach, the written put option is a separate instrument that gives rise to a
financial liability for the present value of the exercise price in accordance with
paragraph 23 of IAS 32. The put option represents an obligation to purchase own
shares in the group for cash. In this case, there is an issue of how to account for
the debit side of the transaction because NCI are initially recognised separately
from the written put option. For further discussion of the accounting for the shares
in the subsidiary held by the non-controlling shareholders, see 2.5.690.
• Account for the written put options as derivative liabilities at FVTPL: Under this
approach, the shares held by the non-controlling shareholders are classified as
equity. The related put options are accounted for as derivative liabilities under IAS
39 – i.e. at fair value with changes therein recognised in profit or loss. [IAS 32.23, 26–
27]

7I.3.160.70 We believe that the accounting policy choice in 7I.3.160.60 arises

because IAS 32 is not clear about the issuer’s accounting for a written put option on
its own equity instruments if it can avoid delivering cash or another financial asset
(see 7I.3.110.80). [IU 11-16]

7I.3.160.80 To summarise the principles set out in 7I.3.160.10–70, the following

table contains the various scenarios and the respective classifications in the parent’s
consolidated financial statements.

SCENARIO CLASSIFICATION

Subsidiary issues equity shares to Classify the subsidiary’s shares held

non-controlling shareholders. by non-controlling shareholders
Parent writes put options that give together with the put options as
the non-controlling shareholders a equity.
right to put their equity shares in
the subsidiary to the parent in
exchange for a fixed number of the
parent’s equity shares.

SCENARIO CLASSIFICATION

Subsidiary issues equity shares to Approach 1: Classify the subsidiary’s

non-controlling shareholders. shares held by non-controlling
Parent writes put options that give shareholders together with the put
the non-controlling shareholders options as financial liabilities.
the right to put their equity shares
Approach 2: Classify the subsidiary’s
 in the subsidiary to the parent in shares held by non-controlling
exchange for a variable number of shareholders as equity. Account for
the parent’s equity shares. the written put options separately as
derivative liabilities.

Subsidiary issues equity shares to Approach 1: Classify the subsidiary’s

non-controlling shareholders. shares held by non-controlling
Parent writes put options that give shareholders together with the put
the non-controlling shareholders options as financial liabilities.
the right to put their equity shares
in the subsidiary to the parent in Approach 2a: Recognise a financial
exchange for a variable number of liability for the present value of the
the parent’s equity shares. Parent exercise price. For further discussion
also has an option to settle by of the accounting for the shares in the
paying cash rather than delivering subsidiary held by the non-controlling
its own equity shares. shareholders, see 2.5.690.

Approach 2b: Classify the subsidiary’s

shares held by non-controlling
shareholders as equity. Account for
the written put options separately as
derivative liabilities.

7I.3.170 Written put option to be settled in shares of another

subsidiary
7I.3.170.10 A put option granted to the non-controlling shareholders might give
them a right to put their equity shares in a subsidiary to the parent in exchange for a
variable number of equity shares of another subsidiary of the same parent. Assuming
that settlement of the option does not lead to deconsolidation of the other subsidiary,
in our view in its consolidated financial statements, the parent should choose an
accounting policy, to be applied consistently, from the alternatives set out in
7I.3.160.40 – i.e. either to classify the subsidiary’s shares together with the put
options as financial liabilities or to account for the written put options as derivative
liabilities.

7I.3.170.20 However, if a put option granted to the non-controlling shareholders

gives them a right to put their equity shares in the subsidiary to the parent in
exchange for a fixed number of equity shares of another subsidiary of the same
parent, then in the parent’s consolidated financial statements the option gives the
non-controlling shareholders a right to exchange a fixed number of one class of non-
derivative own equity instruments for a fixed number of a different class of non-
derivative own equity instruments. In our view, such a contract should be classified as
equity (see 7I.3.100.20).

7I.3.180 Puttable instruments and obligations arising on

liquidation classified as equity by exception
7I.3.180.10 As exceptions to the general principles for liability and equity
classification, a puttable instrument or an instrument (or a component of an
instrument) that imposes on the entity an obligation only on liquidation is classified
as equity if the conditions discussed in 7I.3.190–200 are met.

7I.3.180.20 Puttable instruments, and instruments that impose an obligation on

the entity only on liquidation, are classified as equity in the separate or individual
financial statements of the issuing entity (see 2.5.720.30). However, in the
consolidated financial statements of the group, if the instrument is issued by a
subsidiary and is not held by another member of the group, it is classified as a
financial liability because the exception is not extended to classification as NCI in the
consolidated financial statements. [IAS 32.AG29A, BC68]

7I.3.190 Puttable instruments

7I.3.190.10 A puttable instrument is a financial instrument that:
• gives the holder the right to put the instrument back to the issuer for cash or
another financial asset; or
• is automatically put back to the issuer on the occurrence of an uncertain future
event or the death or retirement of the instrument holder.

7I.3.190.20 Even though a puttable instrument contains an obligation for the entity
to deliver cash or another financial asset, it is classified as equity if all of the
conditions in the following flowchart are met. [IAS 32.16A–16B]
 Instrument entitles holder to pro rata share of entity’s net assets in the event of the No
entity’s liquidation

Yes
Instrument belongs to class of instruments that is subordinate to all other classes of No
instruments issued by entity
Yes
No
All financial instruments in this most subordinate class have identical features

Yes
Apart from obligation for issuer to repurchase or redeem instrument, the instrument does No
not include any other contractual obligation to deliver cash or another financial asset or to
exchange financial assets or financial liabilities under potentially unfavourable conditions

Yes
Total expected cash flows attributable to the instrument over its life are based substantially No
on profit or loss, change in recognised net assets or change in fair value of (un)recognised
net assets of the entity
Yes
Issuer has no other financial instrument or contract that has:
total cash flows based substantially on profit or loss, change in recognised net assets or No
change in fair value of (un)recognised net assets of the entity; and
effect of substantially restricting or fixing residual return to puttable instrument holders
Yes
Classification as equity Classification as financial liability

7I.3.190.30 The issuer of a puttable instrument first evaluates the terms of the
instrument to determine whether it is a financial liability or equity instrument in its
entirety, or is a compound instrument that contains both a liability and an equity
component, in accordance with the general definitions of liabilities and equity in IAS
32. If the puttable instrument is initially determined to be a financial liability, or to
contain a financial liability component, then the whole instrument is tested for equity
classification under the exception in 7I.3.180.10. If the instrument meets all of the
conditions for equity classification under the exception, then the whole instrument is
classified as equity. This is because the puttable instrument represents a residual
interest in the net assets of the issuer. If the whole instrument does not meet the
conditions for equity classification under the exception, then it is classified wholly as
a liability or is split into its liability and equity components in accordance with the
general requirements on financial liability and equity classification in IAS 32. [IAS
32.11, 16A, 28, BC56]

7I.3.200 Instruments that oblige the entity on liquidation

7I.3.200.10 An entity may issue instruments that contain a contractual obligation

for the entity to deliver to the holder a pro rata share of its net assets only on
liquidation (see 7I.3.70.170–200). In this case, the obligation arises if liquidation is
either:
• certain to occur and is outside the control of the entity – e.g. a limited-life entity; or
• uncertain to occur but is at the option of the instrument holder – e.g. some
 partnership interests. [IAS 32.16C]

7I.3.200.20 For such an instrument (or component) to qualify for equity

classification by exception, all of the conditions in the following flowchart need to be
met. [IAS 32.16C–16D]

Instrument entitles holder to pro rata share of entity’s net assets only in the event of No
the entity’s liquidation
Yes
No Liquidation date is predetermined or at the option of instrument holders or the
liquidation right is one of the rights in 7I.3.70.180
Yes
Instrument belongs to class of instruments that is subordinate to all other classes of No
instruments issued by the entity
Yes
All financial instruments in this most subordinate class have an identical obligation to No
deliver a pro rata share of the entity’s net assets on liquidation
Yes
Issuer has no other financial instrument or contract that has:
total cash flows based substantially on profit or loss, change in recognised net assets or No
change in fair value of (un)recognised net assets of the entity; and
the effect of substantially restricting or fixing residual return to instrument holders
Yes
Classification as equity Classification as financial liability

7I.3.200.30 The conditions in 7I.3.200.20 are similar to those for a puttable

instrument (see 7I.3.190.20), except that:
• there is no requirement that the instrument contain no other contractual
obligation to deliver cash or other financial assets;
• there is no requirement to consider the total expected cash flows over the life of
the instrument; and
• there is only one feature that needs to be identical among the instruments in the
most subordinate class: this is the obligation for the issuing entity to deliver to the
holder a pro rata share of its net assets on liquidation.

7I.3.200.40 The reason for this distinction between a puttable instrument and an
instrument that imposes on the entity an obligation only on liquidation is the
difference in the timing of settlement of the obligations. A puttable instrument can be
exercised before liquidation of the entity. Therefore, it is important to identify all
contractual obligations that exist throughout its entire life to ensure that it always
represents the most residual interest. However, for an instrument that imposes on
the entity an obligation only on liquidation of the entity, it is appropriate to focus only
on the obligations that exist at liquidation. [IAS 32.BC67]

7I.3.210 Components of instruments

7I.3.210.10 The exception in 7I.3.200 applies to ‘components of instruments that
impose on the entity an obligation to deliver to another party a pro rata share of the
net assets of the entity only on liquidation’. Therefore, if the instrument contains
other contractual obligations, then those other obligations may need to be accounted
for separately as financial liabilities in accordance with IAS 32.

EXAMPLE 20A – COMPONENTS OF INSTRUMENTS – NON-DISCRETIONARY DIVIDENDS

7I.3.210.20 Company B is a limited-life company. B issues instruments

to its unit holders with the following features. The instruments:
• are not puttable; and
• include only a right to:
– fixed non-discretionary dividends each period; and
– a pro rata share of B’s net assets on its liquidation.
7I.3.210.30 The obligation to pay fixed non-discretionary dividends
represents a contractual obligation that is classified as a financial
liability; the obligation to deliver a pro rata share of B’s net assets on
its liquidation is classified as equity, provided that all other criteria are
met.

EXAMPLE 20B – COMPONENTS OF INSTRUMENTS – DISCRETIONARY DIVIDENDS

7I.3.210.40 Modifying Example 20A, if there is no mandatory

dividend requirement, and dividends are entirely at the discretion of
Company B, then the units are classified wholly as equity provided that
all other criteria are met.

7I.3.210.50 In our view, in applying the last condition set out in 7I.3.200.20 when
evaluating a component of an instrument for equity classification, an entity should
choose an accounting policy, to be applied consistently, on whether the term ‘other
financial instrument’ encompasses other components of that same financial
instrument or only financial instruments other than the one that contains the
component being evaluated.

7I.3.210.60 An instrument may include an obligation to distribute mandatory

dividends based on profits of the entity, and an obligation to distribute a pro rata
share of the net assets on a fixed liquidation date. Assume that the entity applies the
last condition in 7I.3.200.20 to the component of the instrument that comprises the
obligation arising only on liquidation; and that, to do this, its policy is to treat the
mandatory dividend feature like another financial instrument. In this case, equity
classification of the obligation arising only on liquidation would be precluded. This is
because the mandatory dividends are based on profits and therefore the condition in
paragraph 16D of IAS 32 is not met.

7I.3.210.70 However, assume that the entity’s policy is to restrict the analysis
under 7I.3.200.20 to consider only financial instruments other than the one that
contains the obligation arising on liquidation. In this case, the mandatory dividend
feature in itself would not preclude equity classification of the obligation arising on
liquidation. This is because the feature is part of the same instrument, and the
condition for equity treatment in paragraph 16D of IAS 32 could be met. For further
discussion of this condition for equity treatment, see 7I.3.270.

EXAMPLE 20C – MANDATORY DIVIDEND FEATURE BASED ON PROFITS

7I.3.210.80 Company C, which has a limited life, issues non-

redeemable Instrument X that requires payment of a dividend
equalling 90% of its profits. The holders of Instrument X will also
participate in the liquidation of C on a pro rata basis.

7I.3.210.90 The instrument is issued for its fair value of 1,000. The
fair value of the mandatory dividend feature is 800 on issuance; this
component of the instrument is classified as a financial liability.

Scenario 1: Analysis not restricted to instruments other than

Instrument X

7I.3.210.100 C’s policy is to regard the mandatory dividend feature

as another financial instrument for the purpose of applying the
condition in 7I.3.200.20 to the component that provides a pro rata
participation in liquidation.

7I.3.210.110 In this scenario, equity classification of the component

that provides a pro rata participation in liquidation is precluded. This is
because the mandatory dividends are substantially based on profits;
therefore, the condition in paragraph 16D of IAS 32 is not met.

Scenario 2: Analysis restricted to instruments other than

Instrument X

7I.3.210.120 C’s policy is to restrict the analysis under 7I.3.200.20 to

consider only financial instruments other than Instrument X.

7I.3.210.130 In this scenario, the mandatory dividend feature of

Instrument X in itself does not preclude equity classification of the
component that provides a pro rata participation in liquidation. This is
because the feature is part of the same financial instrument, and the
condition for equity treatment in paragraph 16D of IAS 32 could be
met.

7I.3.220 Pro rata share of entity’s net assets on liquidation

7I.3.220.10 A pro rata share of the entity’s net assets on liquidation is determined
by:
• dividing the entity’s net assets on liquidation into units of equal amount; and
• multiplying that amount by the number of units held by the financial instrument
holder. [IAS 32.16A(a), 16C(a)]

7I.3.220.20 In our view, the requirement in 7I.3.220.10 means that each

instrument holder has an entitlement to an identical monetary amount per unit on
liquidation. For example, an instrument that entitles the holder to a fixed dividend on
liquidation, in addition to a share of the entity’s net assets, would not qualify under
this requirement. Similarly, if payments to instrument holders on liquidation are
subject to fees that are not computed on an identical per-unit basis – e.g. a fixed fee
per holder rather than per unit – then the instrument would not satisfy this criterion.
Furthermore, instruments that entitled the holder to a pro rata share of only a
specific portion or component of the net assets of an entity would not satisfy this
criterion.

7I.3.220.30 In certain limited partnerships, partners do not hold shares or other

instruments described as ‘units’ but instead net assets at liquidation are allocated to
partners based on each partner’s respective capital account balance. This is in
contrast to other types of entities that, on liquidation, distribute their net assets to
shareholders on a pro rata basis (see 7I.3.220.10). In our view, the fact that there are
no instruments described as shares or units issued by an entity does not in itself
necessarily mean that the requirement in 7I.3.220.10 cannot be met. Instead, we
believe that an entity should analyse the terms of the partnership to evaluate whether
the capital accounts represent pro rata interests that satisfy the requirement in
7I.3.220.10. For example, the requirement may be met if the amounts allocated to
each partner on liquidation are based on the partner’s respective percentage of the
total capital contributions.

7I.3.220.40 Many investment funds are structured as limited partnerships. In a

limited partnership that has a general partner and limited partners, there are cases
in which a fund’s net assets are allocated to the general partner and limited partners
based on their capital contributions. However, the general partner, who acts as the
fund manager, receives a disproportionate allocation of returns (sometimes referred
to as a ‘carried interest’) when the fund achieves a return above a specified targeted
return (‘excess return’). In this case, an analysis is required to determine whether the
carried interest is a transaction between the partnership and the general partner in
its capacity as an owner of the entity or in a separate capacity as a non-owner of the
fund (i.e. a service provider). This is because only the cash flows and the contractual
terms and conditions of the instrument that relate to the instrument holder as an
owner of the entity are considered when assessing whether the instrument should be
classified as equity under paragraph 16A or 16C of IAS 32. [IAS 32.AG14F]

7I.3.220.50 In our view, a carried interest should be considered an arrangement

between the partnership and the general partner in its capacity as a non-owner (i.e. a
service provider) only if:
• the carried interest represents remuneration for services provided by the general
partner; and
• the cash flows and contractual terms and conditions of the carried interest are
 similar to an equivalent transaction that might occur between a non-instrument
holder and the issuing entity (see 7I.3.240.10). [IAS 32.AG14F–AG14I]

7I.3.220.55 If the carried interest is considered an arrangement between the

partnership and the general partner in its capacity as a service provider, then in our
view the remuneration for the service should be treated as an expense of the
partnership and deducted before allocating any excess return to the partners. The
carried interest therefore would not be considered in applying the pro rata
requirements explained in 7I.3.220.10. However, if the carried interest is integral to
the general partner’s interest in its capacity as an owner, then we believe that the
carried interest should be treated as part of the allocation of net assets between the
partners and considered in applying the pro rata requirements explained in
7I.3.220.10.

EXAMPLE 21A – CARRIED INTEREST IN A LIMITED PARTNERSHIP – PRO-RATA REQUIREMENTS –

GENERAL PARTNER ACTING AS AN OWNER

7I.3.220.60 Fund F is a partnership. General Partner GP and Limited

Partners LPs have made capital contributions to F of 1% and 99%. The
following facts are relevant for this example.
• GP is an investment manager and receives a market-based
management fee based on a fixed percentage of the paid-in capital of
F.
• GP also receives carried interest if F achieves a targeted return of
8%.
• Returns are allocated to GP and LPs based on their respective
percentages of the total capital contributions. However, if F achieves
the targeted return, then 20% of LPs’ return above 8% is reallocated
to GP (carried interest). For example, if capital contributions are
1,000 in total and net assets at liquidation are 1,500, then
allocations to GP and LPs are as follows.
 GP LPs TOTAL

Capital contributions 10 990 1,000

Initial pro rata allocation of net assets

(before consideration of carried
interest) 15 1,485 1,500

Distributions

Base return (8%) 10.8(2) 1,069.2(3) 1,080(1)

Excess returns (>8%) 4.2(5) 415.8(6) 420(4)

Carried interest as reallocation of

returns 83.16(7) (83.16) -

Total 98.16 1,401.84 1,500

6.5% 93.5% 100%

Notes
1. Calculated as a contribution of 1,000 + base return of 80 (1,000 × 8%).
2. GP’s share of base return calculated as 1,080 × 1%.
3. LP’s share of base return calculated as 1,080 × 99%.
4. Calculated as 1,500 - 1,080.
5. GP’s share of excess return calculated as 420 × 1%.
6. LP’s share of excess return calculated as 420 × 99%.
7. Calculated as LP’s excess return of 415.8 × 20%.

7I.3.220.70 In this example, it is determined that the carried interest

is a transaction between F and GP in its capacity as an owner.
Therefore, we believe that the allocation between GP and LPs should
be assessed including the carried interest. The instruments would fail
the requirement in 7I.3.220.10 because the allocation is not made pro
rata to capital contribution.

EXAMPLE 21B – CARRIED INTEREST IN A LIMITED PARTNERSHIP – PRO-RATA REQUIREMENTS –

GENERAL PARTNER ACTING AS A SERVICE PROVIDER

7I.3.220.80 Modifying Example 21A, the carried interest represents

remuneration for services provided by General Partner GP and is in line
with what a market participant, who does not own any units in Fund F,
would receive for the services.
 7I.3.220.90 We believe that if the carried interest is considered to be
remuneration to GP for providing investment management services in
the capacity of a non-owner, then the carried interest should be treated
as a payment from F for services rather than as reallocation of returns
from Limited Partners LPs, and therefore should be excluded from the
net assets when determining whether they are allocated between the
partners on a pro rata basis. The table below illustrates how the carried
interest would be excluded from the pro-rata analysis.

GP LPs TOTAL

Distributions

Base return (8%) 10.8 1,069.2 1,080

Excess return of F 420

Carried interest as remuneration for

services 84(1) (84)

Excess returns (>8%) after carried

interest is paid 3.36(2) 332.64(3) 336

Total 98.16 1,401.84 1,500

6.5% 93.5% 100%

Excluding carried interest 14.16(4) 1,401.84 1,416

Allocation excluding carried interest 1% 99% 100%

Notes
1. Calculated as excess return of F: 420 × 20%.
2. GP’s share of excess return calculated as (420 - 84) × 1%.
3. LP’s share of excess return calculated as (420 - 84) × 99%.
4. Total received by GP excluding carried interest calculated as 98.16 - 84.

7I.3.220.100 In this example, unlike Example 21A, the allocation

would meet the requirement in 7I.3.220.10 because it is pro rata to the
capital contributions – i.e. 1%:99% (see 7I.3.220.30–50).

7I.3.220.110 For a discussion of the recognition and measurement of a carried

interest considered as remuneration for services provided, see 7I.3.300.

7I.3.230 Class of instruments subordinate to all other classes

7I.3.230.10 In determining whether an instrument is in the most subordinate class,

an entity evaluates the instrument’s claim on liquidation as if it were to liquidate on
the date on which it classifies the instrument. [IAS 32.AG14B]

7I.3.230.20 IAS 32 does not preclude the existence of several types or classes of
equity. The IFRS Interpretations Committee discussed the classification of puttable
instruments that are subordinate to all other classes of instruments when an entity
also has perpetual instruments that are classified as equity. The Committee noted
that a financial instrument is first classified as a liability or equity instrument in
accordance with the general requirements of IAS 32. As a second step, the entity
considers the exceptions in paragraphs 16A and 16B, or 16C and 16D of IAS 32 (see
7I.3.190–200), to determine whether a financial instrument should be classified as
equity. It would do so if the financial instrument meets the definition of a financial
liability because either:
• it is puttable to the issuer; or
• it imposes on the issuer an obligation on liquidation because liquidation is either:
– certain to occur and outside the control of the entity; or
– uncertain to occur but is at the option of the instrument holder. [IU 03-09]

EXAMPLE 22 – LEVEL OF SUBORDINATION

7I.3.230.30 Company X issues two types of instruments. Instrument A

is a perpetual instrument with no put rights; Instrument B is a puttable
instrument. Both could qualify as equity, provided that all applicable
criteria in IAS 32 are met. The existence of the puttable feature in
Instrument B does not in itself imply that the instrument is less
subordinate than Instrument A, because the level of an instrument’s
subordination is determined by its priority in liquidation.

7I.3.230.40 If Instrument A and Instrument B are equally

subordinate, then together they form the most subordinate class for
the purposes of the ‘identical features’ test discussed in 7I.3.240.
However, in this case Instrument B would fail equity classification
because of the existence of the put feature, which does not exist in
Instrument A.

7I.3.230.50 If Instrument B is more subordinate than Instrument A –

e.g. if Instrument A is entitled to a fixed claim on liquidation and
Instrument B is entitled to the residual net assets – then Instrument B
may qualify for equity classification, provided that all other conditions
in the exceptions are met.

7I.3.230.60 Many investment funds have a nominal amount of founder shares that
are issued to the fund manager. These shares are typically non-redeemable and have
no entitlements to dividends. In our view, even a small amount of founder shares
would disqualify investors’ shares that are puttable from equity classification if the
founder shares are subordinate to the puttable investors’ shares. This is because the
puttable investors’ shares are not the most subordinate class of instruments.

7I.3.230.70 If an investment fund issues redeemable participating shares and

founder shares that rank pari passu in respect of their respective nominal amounts in
liquidation and the founder shares have no further payment rights, then in our view
the founder shares and participating shares together form the most subordinate
class. However, because the redeemable participating shares have other rights, we
believe that the participating shares would be classified as liabilities, because they do
not have identical features to those of the founder shares (see 7I.3.240).

EXAMPLE 23 – CARRIED INTEREST IN A LIMITED PARTNERSHIP – THE MOST SUBORDINATE TEST

7I.3.230.80 Continuing Examples 21A and 21B, the analysis of

subordination would differ depending on whether the carried interest
is considered to be a transaction with General Partner GP entered into
in its capacity as an owner or a non-owner.

7I.3.230.90 If the carried interest is considered to be an arrangement

in which GP acts in its capacity as an owner of Fund F, then we believe
that the subordination analysis should include the carried interest – i.e.
the assessment should be made for GP’s total interest (consisting of
both its capital contribution and the carried interest) and the Limited
Partners LPs’ interests. Although the carried interest is a claim of GP
that is payable only if F achieves the targeted return, in our view this
does not in itself represent ‘in-substance’ subordination to the other
interests. We believe that the subordination analysis should be based
only on the instruments’ priorities on liquidation. Accordingly, if GP’s
interest (inclusive of the carried interest) and LPs’ interests are equally
subordinate on liquidation, then these two instruments would pass the
most subordinate test.

7I.3.230.100 If the carried interest is considered to be an

arrangement in which GP acts in its capacity as a non-owner, then we
believe that the subordination analysis should exclude the carried
interest – i.e. the assessment should be made for only GP’s capital
contribution and LPs’ interests. Accordingly, if GP’s claim based on its
capital contribution and LPs’ interests are equally subordinate on
liquidation, then these two instruments would pass the most
subordinate test. [IAS 32.AG14F–AG14I]

7I.3.240 Identical features test

7I.3.240.10 In respect of puttable instruments, all financial instruments in the

most subordinate class are required to have identical features to qualify for equity
classification. No instrument holder in the most subordinate class of instruments can
have preferential terms or conditions. In our view, this should be interpreted strictly
to mean identical contractual terms and conditions. This includes non-financial
features, such as governance rights, related to the holders of the instruments in their
roles as owners of the entity. Differences in cash flows and contractual terms and
conditions of an instrument attributable to an instrument holder in its role as non-
owner are therefore not considered to violate the identical features test – provided
that the transaction is on similar terms to an equivalent transaction that might occur
between a non-instrument holder and the issuing entity. [IAS 32.AG14C, AG14F–AG14G,
AG14I]

EXAMPLE 24 – GUARANTEE OF GENERAL PARTNERS IN LIMITED PARTNERSHIP

7I.3.240.20 A general partner in Limited Partnership P provides a

guarantee to P and is remunerated for providing that guarantee. If the
guarantee and the associated cash flows relate to the general partner
in its role as guarantor, and not in its role as owner of P, then P
disregards the guarantee and the associated cash flows when
assessing whether the contractual terms of the limited partnership
instruments held by the general partner and limited partners are
identical.

EXAMPLE 25 – ADDITIONAL INFORMATION RIGHTS

7I.3.240.30 A fund manager that holds units in an investment fund

may have access to certain information rights that are not granted to
other unit holders. If these information rights are granted to the fund
manager in its role as manager of the fund, then they are not
considered to violate the identical features test.

7I.3.240.40 As discussed in 7I.3.290, in our experience units issued by sub-funds

within umbrella investment funds fail equity classification in the financial statements
of the umbrella fund (when the umbrella fund and sub-funds form a single legal
entity). In our view, contractual features that would violate the identical features test
include:
• different rates of management fees;
• a choice on issuance by holders whether to receive income or additional units as
distributions (such that the distributive or accumulative feature differs for each
instrument after they are issued);
• different lock-up periods;
• different reference assets on which the pro rata share of net assets is calculated;
or
• different currencies in which payments are denominated.
7I.3.240.50 However, in our view the following features do not violate the identical
features test, because there are no inherent differences in the features of each
instrument within the most subordinate class:
• administrative charges based on the volume of units redeemed before liquidation,
 as long as all unit holders in the most subordinate class are subject to the same fee
structure;
• different subscription fees payable on initial subscription, as long as all other
features become identical once the subscription fees are paid;
• choice by holders on each distribution date to receive income or additional units as
distributions, as long as the same ability to choose distributions or reinvestment is
afforded to all of the unit holders in the most subordinate class – i.e. the choice is
an identical feature for all of the instruments in this most subordinate class; and
• a term contained in identical instruments that carry equal voting rights that caps
the maximum amount of voting rights that any individual holder may exercise.

7I.3.250 No other contractual obligation to deliver cash or

another financial asset

7I.3.250.10 In respect of puttable instruments, one of the conditions for equity

classification is that the instrument does not include any other contractual obligation
to deliver cash other than the put feature. [IAS 32.16A(d)]

EXAMPLE 26 – ADDITIONAL CONTRACTUAL OBLIGATION TO DELIVER CASH

7I.3.250.20 Unlisted Unit Trust T issues instruments that enable the

holder to put the instrument back to T at any time. T is contractually
required to distribute its net accounting profit on an annual basis.

7I.3.250.30 In this example, T concludes that the requirement to

distribute the net accounting profit annually is an additional obligation
to deliver cash. Therefore, these instruments do not qualify for equity
classification.

7I.3.260 Total expected cash flows attributable to instrument

over its life
7I.3.260.10 In respect of puttable instruments, one of the conditions for equity
classification is that the total expected cash flows attributable to the instrument over
its life are based substantially on the profit or loss, the change in the recognised net
assets, or the change in the fair value of the recognised and unrecognised net assets
of the entity. In this context, profit or loss, and the change in recognised net assets,
are measured in line with relevant IFRS standards. [IAS 32.16A(e), AG14E]

7I.3.260.20 In some cases, an instrument may be puttable at a pro rata share of the
entity’s recognised net assets, as calculated in its separate financial statements. The
Standards do not discuss whether such instruments could qualify for equity
classification if the issuer is a parent entity required to present consolidated financial
statements – i.e. in which it consolidates its investments in subsidiaries. The
Standards include no requirement for puttable instruments issued by a parent to be
classified differently in the parent’s separate financial statements and consolidated
financial statements – provided that no additional arrangements exist between the
holder of an instrument and subsidiaries of the issuer. Therefore, in our view when
the entity is a parent, its profit or loss, change in recognised net assets or change in
the fair value of the recognised and unrecognised net assets may be measured either
on a separate or on a consolidated basis. For example, consider an instrument that is
puttable at a pro rata share of a parent’s recognised net assets as presented in its
separate financial statements under the Standards. This may qualify for classification
as equity in both the separate and consolidated financial statements under the
Standards, provided that all other conditions in the exceptions are also met.

7I.3.260.30 Instruments that are puttable at a pro rata share of recognised net
assets determined in accordance with a different basis of accounting – e.g. local
GAAP – may still satisfy the condition in 7I.3.260.10, depending on the
circumstances. For example, it may be possible to argue that the effect of differences
between local GAAP and IFRS Standards is immaterial when applied to the entity; or
it might be argued that the effect is temporary and expected to converge over the life
of the instrument, such that the total ‘expected’ cash flows are ‘based substantially’
on profit or loss or change in net assets recognised under IFRS Standards. In our
view, the use of the terms ‘expected’ and ‘based substantially’ indicates that
judgement should be exercised in determining whether the requirement is met in the
individual circumstances of each specific situation, including consideration of how
local GAAP and IFRS Standards apply to the reporting entity’s business and the terms
of the instrument.

7I.3.260.40 When the redemption amount of a puttable instrument is based on the

change in fair value of the recognised and unrecognised net assets of the entity,
judgement should still be applied to determine whether the total expected cash flows
test is met but, in our experience, it will often be straightforward to determine.

7I.3.270 Existence of other contracts that preclude equity

classification
7I.3.270.10 An issuer may need to assess whether it has any other financial
instrument or contract that precludes equity classification. In doing so, the entity
does not consider a non-financial contract with the holder of the puttable instrument
or the holder of the instrument that imposes an obligation only on liquidation.
However, if there were such a contract, then the entity would first have to determine
that the non-financial contract has terms and conditions that are similar to those of
an equivalent contract that might occur with a non-instrument holder before
excluding it from its analysis. [IAS 32.16B, 16D, AG14J]

7I.3.280 Application of the exceptions to specific instruments

7I.3.290 Instruments issued by umbrella fund

7I.3.290.10 In certain jurisdictions, a collective investment scheme may be
structured as an umbrella fund that operates one or more sub-funds, whereby
investors purchase instruments that entitle the holder to a share of the net assets of a
particular sub-fund. The umbrella fund and sub-funds together form a legal entity,
although the assets and the obligations of individual funds are fully or partially
segregated.

7I.3.290.20 If the umbrella fund presents financial statements that include the
assets and liabilities of the sub-funds, which together with the umbrella fund form a
single legal entity, then the sub-fund instruments are assessed for equity
classification in those financial statements from the perspective of the umbrella fund
as a whole. Therefore, these instruments cannot qualify for equity classification
under the conditions in 7I.3.190–200. This is because they could not meet the ‘pro
rata share of the entity’s net assets on liquidation’ test (see 7I.3.220) and, if they are
puttable instruments, the identical features test (see 7I.3.240).

7I.3.290.30 In an alternative umbrella fund structure, the sub-funds may be

subsidiaries of the umbrella fund. The umbrella fund may present consolidated
financial statements in line with IFRS 10 that consolidate the sub-funds as
subsidiaries. The exceptions to the general principles described in 7I.3.190–200 are
not extended to the classification of NCI in consolidated financial statements.
Therefore, instruments issued by such sub-funds are classified as liabilities in the
consolidated financial statements even if they:
• qualified for equity classification under the conditions in 7I.3.190–200 in the
separate financial statements of each sub-fund; and
• represent NCI. [IAS 32.AG29A]
7I.3.290.40 If the sub-funds are subsidiaries of the umbrella fund, but the umbrella
fund qualifies as an investment entity, then the investments in the sub-funds are
generally measured at FVTPL (see 5.6.10.10). The umbrella fund does not present
consolidated financial statements and therefore no NCI arises in the umbrella fund’s
financial statements in respect of the investments in the sub-funds that are measured
at FVTPL.

7I.3.290.50 The umbrella fund may present combined financial statements. In this
case, to the extent that they are expressed as being prepared in accordance with the
Standards, in our view puttable sub-fund instruments would not qualify for equity
classification in the combined financial statements for the reasons described in
7I.3.290.20–30.

7I.3.300 Carried interest as remuneration for services provided

7I.3.300.10 As discussed in 7I.3.220.40, in some cases a general partner in a
limited partnership receives a disproportionate excess return (i.e. a carried interest)
if the fund achieves a certain targeted return. If the carried interest is considered to
be an arrangement between the fund and the general partner acting in its capacity as
a non-owner (i.e. a service provider – see 7I.3.220.50), then the carried interest
represents remuneration for services provided by the general partner – e.g.
investment management services. In our view, in these cases the partnership should
consider whether it should recognise a separate financial liability for the obligation to
pay for the services provided by the general partner in accordance with the terms of
the carried interest arrangement and the definition of a financial liability. [IAS 32.11,
AG14F–AG14I]

EXAMPLE 27 – CARRIED INTEREST IN A LIMITED PARTNERSHIP – RECOGNITION AND

MEASUREMENT

7I.3.300.20 Continuing Examples 21A and 21B, the following

additional facts are relevant.
• If on termination of Fund F the overall return to Limited Partners
LPs from F fails to meet the targeted return, then General Partner
GP is required to return to F amounts previously paid out as carried
interest, if there are any – i.e. a claw-back provision.
• GP can be removed by LPs without cause but in that case GP would
continue to have a right to an amount of carried interest calculated
based on the fair values of F’s assets at the removal date.

7I.3.300.30 If the carried interest is considered to be an arrangement

in which GP provides investment management services as a non-owner
(see 7I.3.220.50), then we believe that F should recognise a financial
liability to pay for the services provided to date by GP because F has a
contractual obligation to deliver cash for the carried interest. F
determines that it is appropriate to measure the carried interest based
on the fair value of its assets at each reporting date. This means that
the liability would be measured at zero until such time as GP had
provided services to increase the fair value of F’s assets above the
target and would be entitled to a payment for past services based on
the termination clause.

7I.3.310 Entities with no equity

7I.3.310.10 Illustrative Example 7 in IAS 32 includes a statement of financial
position and a statement of profit or loss and other comprehensive income for an
entity, such as a mutual fund, that does not have equity as defined in IAS 32.

7I.3.310.20 This illustrative example in IAS 32 uses the caption ‘net assets
attributable to unitholders’ in the statement of financial position to describe the
residual amount represented by the difference between the entity’s other assets and
liabilities. It also presents in the statement of profit or loss ‘distributions to
unitholders’ as a finance cost and ‘change in net assets attributable to unitholders’ as
a residual. [IAS 32.18(b), IE32]

7I.3.310.30 A question arises about whether an entity with no equity is required to

present the amount of distribution to unitholders separately as a finance cost in the
statement of profit or loss, similar to Example 7 in IAS 32. In our view, the approach
used for presenting income or expense arising from the financial liability to
unitholders should reflect the nature and the terms of the relevant agreement with
instrument holders, and therefore it is not limited to the one illustrated in Example 7
of IAS 32. We believe that an entity should determine the appropriate approach to
presenting income or expense arising from the financial liability to unitholders based
on its specific facts and circumstances and that the following approaches may be
acceptable.
• Approach 1: Present all income or expense related to the financial liability in a
single line item.
• Approach 2: Present distribution of returns on capital as a finance cost and all the
remaining changes in the value of the financial liability as a single line item.

7I.3.310.40 In determining an appropriate approach to presenting income or

expense arising from the financial liability to unitholders, an entity should consider
the specific guidance and examples in IAS 32 and other relevant guidance on
presentation in IAS 1 (see chapter 7I.8). [IAS 1.82, 32.18(b), 35, 40, IE32]

7I.3.320 Reclassification
7I.3.320.10 A puttable instrument or an instrument that imposes on the entity an
obligation only on liquidation is reclassified as equity from the date on which it has all
of the features and meets the conditions set out in 7I.3.190.20 and 200.20. An
instrument is reclassified from equity to financial liabilities from the date on which it
ceases to have all of the features or meet all of the conditions for equity classification.
[IAS 32.16E]

7I.3.320.20 This indicates a continuous assessment model under which an entity

reassesses its classification of instruments:
• whenever there are changes to the capital structure of the entity – e.g. when new
classes of shares are issued or when existing shares are redeemed; or
• when there is a change in expectations over:
– total expected cash flows; and
– the evaluation of whether they are based substantially on profit or loss or
change in net assets recognised under the Standards.

7I.3.320.30 When a puttable instrument, or an instrument that imposes on the

entity an obligation only on liquidation, is reclassified from equity to financial
liabilities, the liability is measured initially at the instrument’s fair value at the date of
reclassification. Any difference between the carrying amount of the equity instrument
and the fair value of the financial liability at the date of reclassification is recognised
in equity. [IAS 32.16F(a)]

7I.3.320.40 When a puttable instrument, or an instrument that imposes on the

entity an obligation only on liquidation, is reclassified from financial liabilities to
equity, the equity instrument is measured at the carrying amount of the financial
liability at the date of reclassification. [IAS 32.16F(b)]

7I.3.320.50 In either case, there is no pre-tax profit or loss impact arising from the
reclassification. Any potential income tax accounting implications under IAS 12 (see
3.13.520) resulting from the reclassification need to be considered.
7I.3.330 RECOGNITION AND MEASUREMENT

7I.3.340 Financial liabilities

7I.3.340.10 Financial liabilities are generally recognised and measured under IAS
39 (see chapters 7I.5and 7I.6). An exception to initial measurement is an obligation or
potential obligation for an entity to purchase its own equity instruments for cash or
another financial asset (see 7I.3.150.10). The amount of the liability is measured at
the present value of the redemption amount. This is the case whether the exercise
price is variable – e.g. based on a multiple of EBITDA – or fixed. A liability is
recognised even if the contract itself is an equity instrument. Consequently, even if a
contract entered into to purchase an entity’s own equity instruments is classified as
equity – i.e. a fixed amount of cash for a fixed number of equity instruments – an
accounting entry is required to recognise a liability. [IAS 32.23]

7I.3.350 Equity instruments

7I.3.350.10 The Standards do not have any specific measurement rules related to
equity, other than in respect of:
• the cost of equity transactions (see 7I.3.440);
• splitting compound instruments (see 7I.3.620.10); and
• own equity instruments acquired and reissued or cancelled (see 7I.3.700.10).
7I.3.350.20 In part this is because the financial instruments standards do not
generally apply to own equity. [IAS 39.2(d)]

7I.3.350.30 As a general principle, the definitions of income and expenses exclude

transactions with holders of equity instruments. Therefore, no gains or losses are
reported in profit or loss on transactions in equity instruments. All of the effects of
transactions with owners are recognised directly in equity. However, certain
derivatives on own equity, when they do not meet the definition of equity, will be
treated as derivative assets or liabilities and will result in gains and losses recognised
in profit or loss (see 7I.6.120).

7I.3.350.40 The recognition and measurement requirements for equity

instruments that are issued in share-based payment transactions are specified by
IFRS 2 (see chapter 4.5).

7I.3.360 Share splits and bonus issues

7I.3.360.10 In the case of a simple split of shares or a bonus issue, the Standards
do not require any adjustment to total equity or to individual components of equity
presented in the financial statements, although they may affect basic and diluted EPS
(see 5.3.530). However, the laws of the country of incorporation may require a
reallocation of capital within equity.

7I.3.360.20 There is no guidance in the Standards on whether a share dividend

should be treated as a share split or bonus issue. For a discussion of the treatment of
share dividends, see 7I.3.550 and 7I.6.720.
7I.3.370 Prepaid capital contributions
7I.3.370.10 Shareholders may pay for shares before they are issued. An issue then
arises about whether the prepayment should be recognised directly in equity or
shown as a liability.

7I.3.370.20 If there is any possibility that the entity may be required to repay the
amount received – e.g. if the share issue is conditional on uncertain future events –
then in our view the amount received should be shown as a liability. However, if there
is no possibility of the prepayment being refunded, so that the entity’s obligation is to
deliver only a fixed number of shares, then in our view the amount should be credited
to a separate category of equity – e.g. a prepaid share reserve. The notes to the
financial statements should disclose the prepayment and the terms of the shares to be
issued.

7I.3.380 Receivables in respect of equity contributions

7I.3.380.10 An entity may be owed an amount:
• in respect of a contribution for new equity shares that have already been issued; or
• as an equity contribution for which no new shares will be issued (see 7I.3.390).

7I.3.380.20 In this case, an issue arises about when the equity should be
recognised.

7I.3.380.30 In our view, the equity and a corresponding receivable should be

recognised if the receivable meets the definition of a financial asset. This requires the
entity to have a contractual right to receive the amount at the reporting date. A
‘contractual right’ is more than an informal agreement or a non-contractual
commitment.

7I.3.380.40 If the shareholder is not committed contractually to making the

contribution at the reporting date, then no receivable is recorded in respect of the
transaction.

7I.3.380.50 If a receivable is recognised but payment is not expected in the short

term, then the amount is discounted and recorded, in both equity and receivables, at
the present value of the amount to be received; unwinding of the discount on the
receivable is accounted for as interest income (see 7I.6.230).

7I.3.380.60 An entity might decide to increase its share capital through a

shareholders’ resolution to issue new shares. However, in certain jurisdictions this
does not establish a contractual right for the entity to receive cash or another
financial asset; nor does it contractually bind the shareholders. In our view, unless
and until there is a contractual right and the new shares are issued, no receivable or
share capital/share premium should be recognised.

7I.3.390 Non-reciprocal capital contributions

7I.3.390.10 Sometimes an entity receives amounts from shareholders in the form

of capital contributions, being either cash or non-monetary assets, which are non-
reciprocal – i.e. no financial or non-financial obligation exists. This may happen, for
example, when an entity requires additional financing or is in financial difficulty.
Amounts might be received from all shareholders or only certain shareholders. For a
discussion in the context of NCI, see 2.5.520.

7I.3.390.20 The Standards do not contain any specific guidance on transactions

with shareholders. However, in applying the definitions of financial liabilities and
equity, in our view the amount received should be accounted for in accordance with
its substance.
• If there is any possibility of having to repay the amount received, then a liability
should be recognised for the advance.
• If there is no requirement to repay the amount under any circumstances and any
repayment would be entirely at the discretion of the entity that receives the
contribution, then the economic substance will normally be an equity contribution
and not income; this is because the shareholder is generally acting in its capacity
as a shareholder in such cases. In our experience, it is highly unlikely that an
entity would receive a non-reciprocal capital contribution from an unrelated third
party.

7I.3.390.30 If the amount is classified as equity, then the sub-classification within

equity will be determined by the legal framework in which the entity operates. The
legal framework may require or permit classification as additional paid-in capital,
share premium and/or as a separate reserve – e.g. ‘contributed assets’.

7I.3.390.40 The recognition criteria for receivables in respect of equity

transactions (see 7I.3.380) should be applied in determining when a non-reciprocal
capital contribution is recognised.

7I.3.390.50 If a shareholder forgives debt, then it is likely that:

• the shareholder is acting in its capacity as a shareholder; and
• the forgiveness of debt should be treated as a capital transaction (see 7I.5.390.20).

7I.3.400 Extinguishing financial liabilities with equity

instruments

7I.3.400.10 A debtor and a creditor may renegotiate the terms of a financial

liability with the result that the debtor extinguishes the liability fully or partially by
issuing equity instruments to the creditor – i.e. a debt-for-equity swap. IFRIC 19
addresses the accounting by the debtor in a debt-for-equity swap transaction (see
7I.5.410). [IFRIC 19.1]

7I.3.410 RECLASSIFICATION OF INSTRUMENTS BETWEEN

LIABILITY AND EQUITY

7I.3.410.10 The following discussion of reclassification (see 7I.3.410–430) applies

to reclassifications of an instrument or its component parts between financial liability
and equity and vice versa, with the exception of:
• puttable instruments (see 7I.3.320);
• instruments that impose on the entity an obligation to deliver to another party a
pro rata share of the net assets of the entity only on liquidation (see 7I.3.320); and
• compound instruments on conversion at maturity (see 7I.3.650).

7I.3.410.20 As discussed in 7I.3.20.150, the classification of an instrument, or its

component parts, as either a financial liability or equity is made on initial recognition
and is not generally revised as a result of subsequent changes in circumstances.
However, a reclassification between financial liability and equity or vice versa may be
required if:
• an entity amends the contractual terms of an instrument;
• the effective terms of an instrument change without any amendment of the
contractual terms; or
• there is a relevant change in the composition of the reporting entity.
7I.3.420 Reclassification due to amendment of contractual terms

7I.3.420.10 An entity may amend the contractual terms of an instrument such that
the classification of the instrument changes from a financial liability to equity or vice
versa.

EXAMPLE 28 – RECLASSIFICATION FROM EQUITY TO FINANCIAL LIABILITY

7I.3.420.20 Company J has perpetual preference shares, which it has

classified as equity instruments. They were issued for 1,000, and carry
the right to receive a discretionary dividend of 10%.

7I.3.420.30 J later amends the terms of the instrument such that:

• redemption is required in the event of a change in control of the
entity; and
• dividends are payable if interest is paid on another instrument on
which the issuer is required to pay interest.

7I.3.420.40 J no longer has the unconditional ability to avoid

redemption, because a change in control is not within the control of the
entity (see 7I.3.70). Furthermore, a contractual obligation to pay
dividends has been created (see 7I.3.20.70–80). For these reasons, J
reclassifies the instrument from equity to a financial liability.

7I.3.420.50 In its discussions, the IFRS Interpretations Committee noted that a

financial liability is initially recognised at the date of reclassification and it is initially
measured at its fair value minus, in the case of a financial liability not at FVTPL,
transaction costs that are directly attributable to the issue of the financial liability
(see 7I.6.20.10). Additionally, the original equity instrument is derecognised at the
reclassification date and no gain or loss is recognised (see 7I.3.700.10). If, in Example
28, the fair value of the financial liability on initial recognition amounts to 1,200, then
an adjustment of 200 needs to be recognised in equity on derecognition of the equity
instrument. [IAS 32.33, 39.43, IU 11-06]

7I.3.420.60 However, when the classification of an instrument changes from a

financial liability to equity due to an amendment of the contractual terms, in our view
this represents the extinguishment of a financial liability and the issue of equity
instruments. In this case, the resulting gain or loss on the extinguishment of the
liability should be recognised in profit or loss (see 7I.5.370.50 and 380) or, when
appropriate, as an equity contribution (see 7I.3.390.50). This view is in line with
IFRIC 19 (see 7I.3.400 and 7I.5.410–420). For a discussion of the restructuring of
convertible bonds, see 7I.3.670.

7I.3.430 Reclassification due to change of effective terms

without amendment of contractual terms

7I.3.430.10 In our view, the effective terms of an instrument are considered to have
changed if relevant contractual provisions of an instrument become effective or cease
to be effective as a result of:
• the passage of time;
• the action of a party; or
• other contingent events that are anticipated in the contractual terms of the
instrument.

7I.3.430.20 A change in the composition of the reporting entity may arise in

consolidated financial statements from acquisitions or disposals of subsidiaries. In
our view, such a change in group structure may trigger a reassessment of the terms
and conditions agreed between members of the group and the holder of an
instrument and reassessment of whether the group as a whole has an obligation to
pay cash or other financial assets to the instrument holder.

7I.3.430.30 The following are examples of changes in the effective terms of

instruments.

EXAMPLE 29A – RECLASSIFICATION – FIXED EXERCISE PRICE AS RESULT OF PASSAGE OF TIME

7I.3.430.40 Company X issues convertible debt with the conversion

ratio based on the lower of a fixed amount and an amount indexed to
the entity’s share price one year after the date of issuance. At the end
of that year, the conversion ratio would become fixed and therefore
reclassification of the conversion option as equity would be
appropriate. The exercise price of the derivative that is settled in the
entity’s own equity instruments therefore becomes fixed as a result of
the passage of time.

EXAMPLE 29B – RECLASSIFICATION – EXPIRED PUT OPTION

 7I.3.430.50 Company Y issues a put option in an instrument that
allows the holder to put the instrument back to Y for a fixed amount of
cash during only the first three years of the instrument’s life. If the put
option expires unexercised at the end of the three years, then
reclassification as equity would be appropriate.

EXAMPLE 29C – RECLASSIFICATION – REDEMPTION OF LINKED INSTRUMENT

7I.3.430.60 Company Z issues a non-redeemable financial instrument

(the ‘base’ instrument) with dividends payable if interest is paid on
another instrument (the ‘linked’ instrument). Z is required to pay the
interest on the linked instrument. When the linked instrument is
redeemed, without any other changes in terms and conditions, the
effective terms of the base instrument have changed. This is because it
no longer contains a contractual obligation to make payments and
therefore reclassification as equity is appropriate.

EXAMPLE 29D – RECLASSIFICATION – CHANGE IN COMPOSITION OF REPORTING ENTITY

7I.3.430.70 Company Z writes a call option under which it has an

obligation to deliver a fixed amount of equity shares in an unrelated
party, Company X, in exchange for a fixed amount of cash.

7I.3.430.80 Because equity shares in X are financial assets from the

perspective of Z, Z classifies the option as a financial liability on initial
recognition. However, if Z subsequently obtains control over and
consolidates X, then Z would reclassify the option from financial
liability to equity in its consolidated financial statements.

This is because the option would now represent an obligation to deliver

a fixed number of equity instruments in Z’s group in exchange for a
fixed amount of cash.

7I.3.430.90 In our view, there is no difference between the accounting for

reclassifications from equity to liability due to an amendment of the contractual
terms (see 7I.3.420.50) and such reclassifications due to a change in the effective
terms. Therefore, we believe that a financial liability should be initially recognised at
the date of reclassification. We believe that it should be initially measured at its fair
value minus, in the case of a financial liability not at FVTPL, transaction costs that are
directly attributable to the issue of the financial liability (see 7I.6.20.10). Additionally,
the original equity instrument should be derecognised at the reclassification date and
no gain or loss should be recognised (see 7I.3.700.10).

7I.3.430.100 IAS 32 does not contain explicit general guidance on accounting for
reclassifications from financial liability to equity because of a change in effective
terms; and neither IAS 32 nor IAS 39 provides comprehensive guidance on the
measurement of an equity instrument on initial recognition. [IAS 32.16F(b), 96B, AG33]

7I.3.430.110 Therefore, it is not clear whether it is appropriate to recognise a gain

or loss in profit or loss on reclassification from financial liability to equity because of a
change in the effective terms without any amendment of the contractual terms. In our
view, an entity should choose an accounting policy, to be applied consistently, from
the following alternatives.
• By analogy to the conversion for compound instruments at maturity (see 7I.3.650):
The equity instrument is measured at the carrying amount of the liability
(component) and no gain or loss is recognised on reclassification.
• By analogy to IFRIC 19 (see 7I.3.400 and 7I.5.410): The equity instrument is
measured at its fair value and any difference between this fair value and the
carrying amount of the liability is recognised in profit or loss.

7I.3.440 COSTS OF AN EQUITY TRANSACTION

7I.3.440.10 Qualifying costs attributable to an equity transaction – e.g. issuing or

buying back own shares – are debited directly to equity. In our view, this includes
qualifying costs attributable to the distribution of a dividend because equity
transactions include dividends to equity participants. Income tax relating to the
transaction costs of an equity transaction are accounted for in accordance with IAS
12 (see 3.13.590). [IAS 32.35–35A, 37]

7I.3.440.20 Issuing shares in a private placement for cash consideration is an

equity transaction and, therefore, in our view the costs directly related to issuing
equity instruments in a private placement should be recognised directly in equity.

7I.3.440.30 Listing transactions often involve both listing existing shares and
issuing new ones. In our view, the costs directly attributable to issuing new shares
should be recognised directly in equity and any costs attributable to listing existing
shares should be expensed as they are incurred.

7I.3.440.40 In our view, similar to a listing of existing shares, secondary offerings –

i.e. where existing outstanding shares are offered by the entity to new shareholders –
and share splits do not result in new equity instruments being issued, so any costs
associated with these transactions should be expensed as they are incurred. [IAS
32.35–36]

EXAMPLE 30A – LISTING OF SHARES ISSUED BY NEWCO – TRANSACTION IS NOT A BUSINESS

COMBINATION

7I.3.440.50 A Newco (see 5.13.180) is set up as the new parent of an

existing Company C, whose shares are unlisted, to provide the existing
shareholders in C with shares that are listed. Newco will issue shares
to C’s existing shareholders in exchange for their shares in C. Newco’s
 shares are listed and Newco incurs costs for issuing them. No
additional cash is invested by the shareholders.

7I.3.440.60 Because only one business is placed under Newco in this

transaction, the transaction is not a business combination and so
Newco applies book value (carry-over basis) accounting (see 5.13.60
and 190). Under this accounting, Newco’s consolidated financial
statements are considered a continuation of those of C and therefore
no equity transaction is reported. Therefore, we believe that the costs
incurred by Newco in issuing the shares to the existing shareholders of
C should be expensed in Newco’s consolidated financial statements as
they are incurred because those costs are in effect the costs of listing
the existing shares of the continuing entity (via a restructuring), rather
than costs of issuing new shares.

7I.3.440.70 The requirement to record in equity all costs attributable to an equity

transaction also applies to costs incurred on the issue of equity instruments in
relation to a business combination (see 2.6.530). [IFRS 3.53]

7I.3.440.80 In our view, the creation of NCI in a subsidiary in the consolidated

financial statements is in effect the issuance of new equity interests in the
consolidated group. This is the case even if the NCI are created by selling existing
shares of a subsidiary to a third party – e.g. a parent sells a portion of its shares in a
subsidiary to third parties while retaining control. This is because from the group’s
perspective, the shares of the subsidiary held by the parent are eliminated in the
consolidated financial statements, and the creation of NCI leads to an increase in
equity in the consolidated financial statements.

7I.3.440.90 Accordingly, we believe that transaction costs that are attributable to

the creation of NCI should be recognised directly in equity in the consolidated
financial statements because they are costs of an equity transaction in the
consolidated financial statements (see 2.5.650). However, if equity shares of a
subsidiary are listed in connection with the creation of NCI, then we believe that an
entity should determine which costs are directly attributable to the equity issuance –
i.e. creation of the NCI – and should be deducted from equity (see 7I.3.450) in the
consolidated financial statements and which costs relate to the listing and should be
expensed when they are incurred (see 7I.3.440.30 and 450.40).

EXAMPLE 30B – LISTING AND SELLING SHARES ISSUED BY SUBSIDIARY – CONTROL RETAINED

7I.3.440.100 Company P owns 100% of the shares in Subsidiary S. P is

planning to list all existing shares of S and simultaneously sell 20% of
its shares in S to third parties. S will not legally issue any new shares
as part of the listing and selling process and P will not lose control of S.
As a result of the transaction, P will recognise NCI in its consolidated
financial statements.
 7I.3.440.110 P and S incur costs of 10 and 2 respectively that are
directly attributable to the sale of 20% of the shares in S to third
parties. S also incurs costs of 5 related to the listing. In its financial
statements, S should recognise the total costs incurred of 7 in profit or
loss because there is no equity transaction from S’s perspective. In P’s
consolidated financial statements, the costs of 12 that are directly
attributable to the sale of 20% of the shares in S should be recognised
directly in equity. However, the costs of 5 that relate to the listing
should be recognised in profit or loss (see 7I.3.450.40).

7I.3.450 Qualifying costs

7I.3.450.10 Only incremental costs that are attributable directly to equity

transactions such as issuing or buying back own equity instruments or distributing
dividends are recognised in equity. These costs may be internal or external, but need
to be incremental. Other costs are recognised in profit or loss even if they relate to
newly issued shares. For further discussion of incremental internal transaction costs,
see 7I.6.30–40. [IAS 32.37]

7I.3.450.20 In some cases, an entity issues new equity shares and simultaneously
lists them. In our view, the following are examples of costs related to the transaction
that should be recognised in equity, if they are incremental costs:
• fees for legal and tax advice related to the share issue;
• the cost of preparing and printing the prospectus;
• fees incurred in respect of valuing the shares;
• fees incurred in respect of valuing other assets – e.g. property – if the valuation is
required to be disclosed in the prospectus;
• underwriting fees;
• fees and commissions paid to employees acting as selling agents that relate to the
share issue;
• costs incurred in holding press conferences related to the share issue; and
• the cost of handling share applications.
7I.3.450.25 We believe that the guidance in 7I.3.450.20 would apply to
determining whether costs should be deducted from equity in the consolidated
financial statements when there is a sale and simultaneous listing of equity shares in
a subsidiary over which the parent retains control.

7I.3.450.30 In our view, few internal costs will meet the incremental test in
practice because we believe that this will be difficult to demonstrate.

7I.3.450.40 In our view, costs that relate to the listing itself and that are not
directly attributable to the new share issue should be expensed. For example, stock
exchange registration costs do not relate to the issue of shares but rather to the
listing of the issued shares; accordingly, they should be expensed as they are
incurred.

7I.3.450.50 In our view, the costs of advertising a share issue should be recognised
directly in equity if the advertising relates directly to the share issue and is not
general advertising aimed at enhancing the entity’s brand. An example may include
incremental costs related to a road show in which the entity is specifically targeting
potential investors. If only a part of the advertising relates to the share issue, then an
apportionment of the costs may be appropriate.

7I.3.450.60 Qualifying costs that relate to both existing shares and new shares are
allocated on a rational and consistent basis – e.g. based on the number of shares. [IAS
32.38]

EXAMPLE 31 – ALLOCATING TRANSACTION COSTS BETWEEN EXISTING AND NEW SHARES

7I.3.450.70 Company G issues 160 new shares and lists 80 existing

shares in an IPO. The total costs related to both existing and new
shares are 300. G allocates the costs between the listing of the existing
shares and the issue of new shares based on the number of shares as
follows.
• Issuing new shares: 200 (300 x 160/ 240). This amount is recognised
directly in equity.
• Listing existing shares: 100 (300 x 80/ 240). This amount is
recognised in profit or loss.

7I.3.450.80 Only costs that relate to both listing existing shares and issuing new
shares are allocated as explained in 7I.3.450.60. We believe that only costs that are
directly attributable to the listing itself should be recognised in profit or loss as they
are incurred (see 7I.3.440.30). The IFRS Interpretations Committee discussed this
issue and noted that judgement may be required to determine which costs relate
solely to activities other than equity transactions – e.g. listing existing shares – and
which costs relate jointly to equity transactions and other activities. [IU 09-08]

7I.3.460 Costs of anticipated equity transactions

7I.3.460.10 Equity transaction costs may be incurred before the equity instrument
is issued or bought back or before the dividend is distributed. The Standards are
silent on how to treat costs incurred before the equity transaction has been recorded.

7I.3.460.20 In our view, costs that are related directly to a probable future equity
transaction should be recognised as a prepayment (asset) in the statement of
financial position. The costs should be transferred to equity when the equity
transaction is recognised, or recognised in profit or loss if the issue or buy-back is no
longer expected to be completed or the dividend is no longer expected to be
distributed.

7I.3.470 Related tax benefits

7I.3.470.10 The tax effects of any transaction costs that are recognised in equity
are generally also recognised directly in equity. [IAS 32.35A, 12.61A(b)]
7I.3.470.20 If the tax benefits associated with the transaction costs are not
probable, then the deferred tax asset is not recognised. In these cases, the gross
transaction costs are deducted from equity. If in a subsequent period the tax benefits
related to the transaction costs qualify for recognition, then the corresponding credit
will generally be recognised directly in equity. For further discussion, see 3.13.590.

7I.3.480 PRESENTATION AND DISCLOSURE OF EQUITY

7I.3.480.10 There are no specific requirements in the Standards on how to present

the individual components of equity. Therefore, in our view net accumulated losses
may be deducted, on a decision by the shareholders or application of the articles of
association, from another component of equity – e.g. additional paid-in capital – if this
is permitted by applicable laws.

7I.3.480.20 Laws in some countries require reserves to be established for specific

purposes. For example, banks may be required to set aside amounts for general
banking risks or losses on loans. Some entities also establish reserves if national tax
laws grant exemptions from, or reductions in, tax liabilities when transfers to such
reserves are made. The Standards neither require nor prohibit the creation of such
reserves, which are merely allocations and designations of components of equity. If
such reserves are created, then in our view they should be classified as a separate
component of equity and created by an appropriation from another category of equity
– e.g. retained earnings. Transfers to these reserves and their related tax effects
should be recognised directly within equity, and should not be recognised in profit or
loss. Also, these reserves may not be recognised as liabilities in the statement of
financial position. Disclosure of the nature and purpose of each reserve within equity
is required. [IAS 1.79(b)]

7I.3.490 Costs of an equity transaction

7I.3.490.10 The Standards do not specify which component of equity the

transaction costs recognised in equity (see 7I.3.440) should be charged against. In
our view, an entity should choose an accounting policy, to be applied consistently, on
the component of equity against which the transaction costs are recognised.

7I.3.490.20 For a discussion about presenting income tax effects within equity, see
3.13.530.60.

7I.3.490.30 If shares have a par value, then regulatory issues may prevent the
amount from being deducted from share capital. In this case, the transaction costs
may be presented as a deduction from share premium, other paid-in capital or
retained earnings; or they might be shown as a separate reserve. If the transaction
costs are presented as a deduction from share capital, then in our view the entity
should disclose the impact.

EXAMPLE 32 – IMPACT OF TRANSACTION COSTS PRESENTED AS DEDUCTION FROM SHARE CAPITAL

 7I.3.490.40 Company C issues shares at their par value of 100.
Transaction costs are 10. C provides the following disclosure.

Share capital (par value) 100

Transaction costs (10)

Share capital in statement of financial position 90

7I.3.490.50 Example 33 illustrates the combined application effect of the

approaches explained in 7I.3.470 and 490.30.

EXAMPLE 33 – RECOGNITION OF SHARE ISSUANCE, RELATED COSTS AND TAX

7I.3.490.60 In year 1, Company Q issues additional shares for

proceeds of 6,000. The total par value of these shares is 600. The costs
of the transaction are 1,200. Under the local tax law, transaction costs
are deducted only in year 2. Because it is probable that Q will earn
sufficient taxable profit in year 2, Q recognises a deferred tax asset
related to the transaction costs. The tax rate is 30%.

7I.3.490.70 Q records the following entries in its financial statements.

DEBIT CREDIT

Cash 6,000

Share capital 600

Share premium 5,400

To recognise share issuance

Deferred tax asset (1,200 × 30%) 360

Share premium 840

Cash 1,200

To recognise transaction costs and related tax

impact
7I.3.500 Income tax

7I.3.500.10 Income tax relating to distributions to holders of an equity instrument

and to transaction costs of an equity transaction is accounted for in accordance with
IAS 12. Current tax and deferred tax that relate to items that are recognised directly
in equity are generally recognised directly in equity. For a further discussion of
income taxes related to payment of dividends, see 3.13.760.

7I.3.500.15 The amount of current and deferred tax recognised directly in equity is
disclosed separately. There is no requirement to present the tax impact of items
recognised in equity separately in the statement of changes in equity. In our
experience, these tax effects are often disclosed in the notes to the financial
statements (see 2.2.10). [IAS 12.52B, 61A(b), 81(a), 32.35A]

7I.3.500.20 In our experience, the tax effects of equity transactions are generally
presented in the same category of equity as the underlying transaction, as opposed to
creating a separate category of equity for taxes (see 3.13.530.60).

7I.3.510 Non-controlling interests

7I.3.510.10 NCI are presented in the consolidated statement of financial position

within equity, separately from the parent’s shareholders’ equity (see 2.5.530).
Therefore, a statement of changes in equity includes an analysis of the amounts
attributable to NCI. [IAS 1.54(q), 106, IFRS 10.22]

7I.3.520 Capital disclosures

7I.3.520.10 An entity discloses information that enables users of its financial

statements to evaluate the entity’s objectives, policies and processes for managing
capital. It discloses the following.
• Qualitative information, including a description of:
– what it manages as capital;
– when the entity is subject to externally imposed capital requirements:
• the nature of those requirements; and
• how those requirements are incorporated into the management of capital;
and
– how it is meeting its objectives for managing capital.
• Summary quantitative data about what it manages as capital. Some entities regard
some financial liabilities – e.g. some forms of subordinated debt – as part of
capital. Other entities regard capital as excluding some components of equity –
e.g. components arising from cash flow hedges.
• Any changes in qualitative information and quantitative data from the previous
period.
• Whether during the period it complied with any externally imposed capital
requirements to which it is subject.
• When the entity has not complied with such externally imposed capital
requirements, the consequences of such non-compliance. [IAS 1.134–135]
7I.3.530 Capital maintenance

7I.3.530.10 The Standards do not establish requirements about what assets or net
assets should be retained and what may be distributed. This is a legal issue that will
depend on the regulatory environment in which an entity operates.

7I.3.530.20 If there is a legal prohibition on the distribution of certain reserves,

and an entity wishes to indicate these restrictions in the statement of changes in
equity, then in our view the entity should transfer the restricted amounts to a
separate component of equity – e.g. a non-distributable reserve or a capital reserve –
if the applicable law permits. Any such transfer would be made through the
statement of changes in equity (see chapter 2.2 and 7I.3.480.20). In any case, the
restrictions on distribution are disclosed in the notes to the financial statements. [IAS
1.79(b)]

7I.3.540 DIVIDENDS

7I.3.540.10 Dividends and other distributions to holders of equity instruments are

recognised directly in equity (see 7I.3.20.140). [IAS 32.35–36]

7I.3.540.20 A liability for a dividend payable is not recognised until an entity has
an obligation to pay dividends. In the case of discretionary dividends, a liability for a
dividend payable is not recognised until the dividend is both appropriately authorised
and no longer at the entity’s discretion – i.e. when the entity has an obligation to pay.
In our view, it is not appropriate to recognise a liability based only on a constructive
obligation. This is consistent with the basis for conclusions to IAS 10 and the
definition of a financial liability in IAS 32 (see 7I.3.20). Therefore, a constructive
obligation cannot arise in connection with a dividend. [IAS 10.12, BC4]

7I.3.540.30 In the case of discretionary dividends, the legal requirements of the

particular jurisdiction are important in determining the point in time at which a
liability is recognised. For example, suppose that the relevant law stated that a board
decision or announcement required no further approval and was binding on the entity
– e.g. the board has no discretion to withdraw its decision or announcement and no
legal discretion to avoid making payment. In this case, the dividend liability is
recognised on the board decision or announcement. However, suppose that the entity
can choose to avoid payment until it is approved by the shareholders, or can
withdraw its decision or announcement of the dividend (see 7I.3.60). In this case, it
would not be appropriate to recognise a liability at the time of the board decision or
announcement.

7I.3.540.40 In our view, an obligation to pay an interim dividend should be

recognised when the entity has an obligation to make the payment and the amount to
be paid can be determined reliably – i.e. the shareholders do not have an obligation to
pay back the interim dividend.

7I.3.540.50 Sometimes, in addition to the declaration or the approval process

required as a condition for the payment of the dividends, additional conditions may
determine the timing or amount of the dividend to be recognised – e.g. the
fulfilment/waiver of all conditions precedent for completion of a proposed business
combination and the holder of the equity instruments continues to hold the securities
until the record date on which the fulfilment/waiver of those conditions is announced.
In this case, the liability is recognised when the fulfilment/waiver of the conditions is
announced and for the amount that the entity has an obligation to pay.

7I.3.540.60 Dividends on shares that are classified as liabilities are presented in

profit or loss as a finance cost unless the dividends are discretionary. Even if the legal
form of the payment is a dividend, it is not recognised directly in equity. Financing
costs on shares classified as liabilities are determined under the effective interest
method.

7I.3.540.70 There is an issue about whether to present discretionary dividends in

profit or loss or equity if all of the fair value of the consideration received on issuing
instruments with a discretionary dividend feature is allocated to and recognised as a
financial liability. In principle, discretionary dividends may always be considered an
equity feature, because an entity does not have a contractual obligation to deliver
cash or another financial asset. However, when all of the fair value of the
consideration received on issuing instruments is allocated to and recognised as a
financial liability, IAS 32 is not clear about whether:
• discretionary dividends are presented in equity because, in principle,
discretionary dividends are always an equity feature irrespective of whether any
amount is allocated to equity; or
• discretionary dividends are presented in profit or loss because dividend payments
on an instrument wholly recognised as a liability are recognised as an expense.
[IAS 32.36, AG37]

7I.3.540.80 Based on the reasoning in 7I.3.540.70 and subject to the guidance in

7I.3.60.40, in our view an entity should choose an accounting policy, to be applied
consistently, to present the discretionary dividends in profit or loss or equity if none
(or no more than a trivial amount) of the fair value of the consideration received on
issuing instruments with a discretionary dividend feature is allocated to and
recognised as equity.

7I.3.540.90 The following flowchart shows the assessment required to determine

whether discretionary dividends should be presented in profit or loss or equity.
 No
Are dividends discretionary?

Yes
Does the instrument include a contractual obligation to deliver cash or another No
financial asset or variable number of entity’s own shares before liquidation?

Yes

Is the entire instrument classified as equity under Yes

paragraphs 16A–16B of IAS 32? (See 7I.3.190)
No

Is the instrument (or a component of the instrument) classified as equity under Yes
paragraphs 16C–16D of IAS 32? (See 7I.3.200)
No

Is none (or no more than a trivial amount) of the fair value of the consideration No
allocated to and recognised as equity?
Yes

Accounting policy choice

Dividends presented in profit or loss Dividends presented in equity

7I.3.540.100 In our view, a similar assessment to that described in 7I.3.540.70–90

applies to the assessment of the presentation of discretionary dividends on NCI
shares subject to a put option written by the entity. If an entity chooses to apply the
anticipated-acquisition method to account for NCI subject to a put option written by
the entity, then the NCI are accounted for as if the put option had already been
exercised. In this case, the NCI are derecognised and a financial liability is
recognised for the present value of the redemption amount in the consolidated
financial statements (see 2.5.700). Subject to the guidance in 7I.3.60.40, we believe
that an entity should choose an accounting policy from the alternatives described in
7I.3.540.70–80, to be applied consistently to the presentation of discretionary
dividends on NCI shares subject to a put option written by the entity. We believe that
these accounting policy choices are available only if the subsequent changes in NCI
put liabilities are recognised in profit or loss (see 2.5.700.40).

7I.3.540.110 The following flowchart shows the assessment required to determine

whether discretionary dividends on NCI shares subject to a put option written by the
entity should be presented in profit or loss or equity.
 Anticipated acquisition method

Accounting policy choice to

recognise subsequent changes in
carrying amount (see 2.5.700.40)

Equity Profit or loss

Dividends Accounting policy choice

presented in equity (see 7I.3.540.100)

Dividends presented
in profit or loss

7I.3.540.120 We believe that the accounting policy choice described in

7I.3.540.100 is not available if the present-access method is applied to account for
NCI, because the NCI continues to be recognised as equity when the put option is
written. Discretionary dividends are paid on the NCI recognised as equity in the
consolidated financial statements (see 2.5.710.10–20).

7I.3.550 Share dividends

7I.3.550.10 The Standards do not provide any guidance on accounting for share
dividends – i.e. the issue of additional shares to shareholders characterised as a
dividend.

7I.3.550.20 Sometimes shares with a value equal to the cash dividend amount are
offered as an alternative to the cash dividend. When the shares are issued, the
liability is settled and a credit to equity is recognised as the proceeds of the issue. In
our view, this practice is acceptable. Any reallocation of capital within equity needs to
be in accordance with the applicable law.

7I.3.550.30 In our view, a share dividend that is not an alternative to a cash

dividend should be treated in the same way as a share split or a bonus issue – i.e. no
entries are required (see 7I.3.360).

7I.3.560 Distributions of non-cash assets to owners

7I.3.560.10 IFRIC 17 addresses specific forms of distributions. The interpretation

deals with measurement and presentation issues in this respect.

7I.3.560.20 A ‘distribution’ is a non-reciprocal transfer of assets from an entity to

its owners, commonly referred to as a ‘dividend’. There is no restriction placed on the
term ‘distribution’ other than that it is non-reciprocal. Neither the reason for the
transfer of assets nor its legal characterisation is a factor in determining whether it
falls in the scope of the interpretation. Therefore, for example, a distribution that is in
effect a return of capital is in the scope of the interpretation. [IFRIC 17.2–3, BC4–BC5]

7I.3.560.30 IFRIC 17 addresses how an entity making distributions of non-cash

assets to owners acting in their capacity as owners accounts for those distributions in
its financial statements (separate, individual and/or consolidated). IFRIC 17 also
applies to distributions in which each owner may elect to receive either their share of
the non-cash asset or a cash alternative. Perhaps the most significant transactions
included in the scope of the interpretation are demergers or spin-offs, in which an
entity distributes its ownership interests in one or more subsidiaries to existing
shareholders. [IFRIC 17.3]

7I.3.560.40 IFRIC 17 does not apply to:

• common control transactions (see 5.13.80);
• distributions of part of the ownership interests in a subsidiary when control is
retained; and
• distributions in which owners of the same class of equity instruments are not
treated equally. [IFRIC 17.4–7]

7I.3.560.50 IFRIC 17 also does not apply to the financial statements of the
recipient of the distribution; recipients apply the requirements of IAS 39 and IAS 27
to the receipt of dividends (see 7I.6.690). [IAS 39.55A, 27.12, IFRIC 17.8]

7I.3.560.60 A liability for the distribution is recognised when the distribution is

authorised and is no longer at the entity’s discretion. This timing will vary depending
on the legal requirements of individual jurisdictions (see 7I.3.540.20). [IFRIC 17.10]

7I.3.560.70 The liability for the distribution is measured, initially and until the
settlement date, at the fair value of the assets to be distributed. Any changes in the
measurement of the liability are recognised in equity; this is consistent with the
accounting for the liability at the time of initial recognition. For distributions in which
the owners may elect to receive either non-cash assets or a cash alternative, the
entity considers the fair value of each alternative and their associated probabilities
when measuring the liability. [IFRIC 17.11–13]

7I.3.560.80 Unless it is required by other standards – e.g. financial assets classified

as at FVTPL or as available-for sale under IAS 39 – the assets to be distributed are not
remeasured to fair value when the liability is recognised. Instead, assets to be
distributed that are in the measurement scope of IFRS 5 are measured in accordance
with that standard (see 5.4.40). Assets to be distributed that are not in the
measurement scope of IFRS 5 (e.g. deferred tax assets) continue to be measured in
accordance with other standards (e.g. IAS 12).

7I.3.560.90 At the date on which the distribution occurs – i.e. settlement date – the
following takes place.
• The liability is remeasured based on the fair value of the assets to be distributed,
 with any change therein recognised in equity.
• The liability and the assets distributed are derecognised.
• Any difference between the fair value of the assets distributed and their carrying
amount in the financial statements is recognised as a separate line item in profit or
loss; this has a consequential effect on EPS.
• Any amounts recognised in OCI in relation to the assets distributed – e.g. fair value
revaluation reserves – are reclassified to profit or loss or they may be transferred
within equity depending on the derecognition requirements in other standards, on
the same basis as would be required if the non-cash assets had been disposed of.
[IFRIC 17.13–15, BC38]

7I.3.560.100 In our experience, the amount recognised in profit or loss at the

settlement date is not generally a loss. This is because, if the fair value of the assets
had been lower than their carrying amount, an impairment loss would have been
recognised before settlement. [IFRIC 17.BC39]

EXAMPLE 34 – DISTRIBUTION OF NON-CASH ASSETS TO OWNERS

7I.3.560.110 Company P distributes items of property, plant and

equipment as dividends to all of its owners acting in their capacity as
owners. The carrying amount of the property, plant and equipment is
100 and the fair value is 130 at the date on which the distribution is
authorised.

7I.3.560.120 At the date of settlement of the distribution, the carrying

amount of the property, plant and equipment is 95 and the fair value is
125.

7I.3.560.130 P records the following entries in its financial

statements.
 DEBIT CREDIT

Equity 130

Liability for distribution 130

To recognise liability at fair value of assets to

be distributed

Liability for distribution 5

Equity 5

To recognise change in carrying amount of

liability up to settlement date

Liability for distribution 125

Property, plant and equipment 95

Profit or loss 30

To derecognise liability and assets distributed

7I.3.570 APPLICATION TO SPECIFIC INSTRUMENTS

7I.3.580 Compound instruments

7I.3.580.10 An instrument may contain both a financial liability (e.g. an obligation

to make interest and/or scheduled principal payments) and an equity component (e.g.
a conversion feature in a convertible bond). Such an instrument is a compound
instrument. [IAS 32.29, AG31]

7I.3.590 Classification of components

7I.3.590.10 The issuer of non-derivative compound instruments classifies the

liability and equity components of the instrument separately as a financial liability
and equity (‘split accounting’). Components of compound instruments are analysed
and classified in accordance with the basic classification principles in 7I.3.20. A non-
derivative component is classified in accordance with the principles in 7I.3.90; a
derivative component is classified in accordance with the principles in 7I.3.100. [IAS
32.28]

7I.3.590.20 A typical form of a compound instrument is a convertible bond, in

which the holder is entitled to convert the instrument into equity instruments of the
entity. Another form of compound instrument is one in which the equity
characteristics lie in the dividend or interest stream rather than in the convertibility
of the principal amount. For example, consider a non-cumulative mandatorily
redeemable preference share, on which dividends are payable at the discretion of the
issuer. In this case, the present value of the redemption amount represents the
financial liability, with any remaining proceeds being attributed to equity. [IAS 32.AG31]

7I.3.590.30 The same split accounting applies to share purchase warrants

attached to debt instruments, irrespective of whether they are formally detachable
from the debt instruments. The share purchase warrants are split and accounted for
as an equity component by the issuer if the warrants meet the definition of an equity
instrument. In this case, the amount allocable to the debt instrument is determined
first, with any remaining proceeds being attributed to the warrants. [IAS 32.31]

7I.3.590.40 Subject to 7I.3.20.150, the initial classification of a convertible

instrument into its liability and equity components is not revised subsequent to initial
recognition – even if the likelihood of the conversion option being exercised changes
over time. However, a reclassification may be required in certain circumstances (see
7I.3.410 and 670). [IAS 32.30]

7I.3.600 Foreign currency convertible bond

7I.3.600.10 If a convertible bond is denominated in a currency other than the
functional currency of the entity, then an issue arises regarding the classification of
the conversion option.

7I.3.600.20 As discussed in 7I.3.100.60, an obligation denominated in a foreign

currency represents a variable amount of cash. Contracts, both freestanding and
embedded, that will be settled by an entity delivering a fixed number of its own equity
instruments in exchange for a fixed amount of foreign currency are classified as
financial assets or financial liabilities. [IAS 32.BC4K]

EXAMPLE 35 – FOREIGN CURRENCY CONVERTIBLE BOND

7I.3.600.30 Company G with a euro functional currency issues a

convertible bond denominated in US dollars. The bond carries a fixed
rate of interest and is convertible at the end of 10 years, at the holder’s
option, into a fixed number of euro-denominated shares of G. No
settlement alternative is provided to the issuer.

7I.3.600.40 The conversion option is an obligation for G to issue a

fixed number of shares in exchange for a variable amount of cash. The
cash is fixed in US dollar terms but variable in functional currency
terms. Therefore, G classifies the conversion feature in the convertible
bond as a derivative liability.

7I.3.600.50 A related issue arises if a convertible bond denominated in a foreign

currency is issued by a subsidiary that has a functional currency different from that of
its parent, and that bond is convertible into the shares of the parent. The IFRS
Interpretations Committee discussed a similar issue and noted that a group does not
have a functional currency (see 2.7.70.20). In our view, two approaches are possible
in the consolidated financial statements. We believe that an entity should choose an
accounting policy, to be applied consistently, to base the classification in the
consolidated financial statements on the functional currency of either the parent or
the subsidiary. [IU 11-06]

7I.3.600.60 In addition, in our view:

• if the bond is denominated in a currency other than the functional currency of
either the parent or the subsidiary, then the conversion feature is a (derivative)
liability;
• the currency in which the shares are denominated is not relevant to the analysis:
the only requirement is that the number of shares is fixed; and
• the presentation currency or currencies of the group’s consolidated financial
statements (see 2.7.40) has no impact on the analysis.

7I.3.600.70 Another issue arises in cases of inflation indexation. For example, an

entity issues a convertible bond denominated in its functional currency. Both
principal and interest payments of the instrument are indexed to changes in the CPI
inflation of the economic environment of the entity. In our view, such indexation
creates variability in the amount of cash being exchanged for a fixed number of
shares and therefore the conversion feature should be classified as a financial
liability. This principle applies even if the functional currency of the entity is the
currency of a hyperinflationary economy (see chapter 2.10).

7I.3.610 Cash settlement option in convertible bond

7I.3.610.10 Many convertible bonds include a cash settlement option for the issuer
if the holder exercises its right to convert the bonds into ordinary shares. For
example, an entity with a euro functional currency issues euro-denominated fixed
rate bonds with a 20-year maturity; the holder has the option to convert these into a
fixed number of the issuer’s ordinary shares at any time during the life of the bond. If
the holder exercises its conversion option, then the issuer has the right to settle
either:
• by delivering a fixed number of shares; or
• in cash at an amount equal to the market value of the shares to be issued.
7I.3.610.20 Generally, a convertible bond is a compound instrument – i.e. having
characteristics of both equity and a liability. In the example in 7I.3.610.10 the
convertible bond comprises the following features, which are clearly characteristics
associated with a financial liability:
• an obligation to make fixed interest payments; and
• an obligation to deliver cash to the holder on redemption of the bond in the event
of the holder not exercising its conversion option.

7I.3.610.30 In addition, the instrument contains a conversion feature whereby

there may be an exchange of a fixed number of shares for a fixed amount of cash. The
issuer can settle the conversion option either by paying the holder the market value
of the shares in cash, or by exchanging its own shares for cash – i.e. physical delivery.
Consequently, the conversion option can be settled other than by the issuer
exchanging a fixed number of shares for a fixed amount of cash. [IAS 32.26]

7I.3.610.40 Because the conversion option is a derivative, the settlement option

causes it to be classified as a financial liability instead of as an equity instrument.
Therefore, in this case the convertible bond is not a compound instrument under IAS
32. Rather, it is a hybrid instrument comprising a host liability for the interest and
principal amount plus an embedded derivative instrument for the conversion option
(see 7I.3.110). The host liability is measured at amortised cost and the derivative, not
being closely related to the host, is measured at FVTPL; alternatively, the entire
instrument is measured at FVTPL (see 7I.4.70). For a discussion of the accounting for
embedded derivatives, see 7I.2.110.

7I.3.610.50 In our view, in contrast to the accounting for conversion of a compound

instrument (see 7I.3.650.10), an entity should choose an accounting policy, to be
applied consistently to all reclassifications from financial liability to equity because of
a change in the effective terms when the contractual terms of the instrument have
not changed, including for example the conversion of a hybrid instrument that is
classified entirely as a financial liability. For a description of the acceptable
accounting policies, see 7I.3.430.110.

7I.3.620 Recognition and measurement

7I.3.620.10 When allocating the initial carrying amount of a compound instrument
to the underlying financial liability and equity components, an entity first determines
the fair value of the liability component. This includes any embedded derivatives –
whether or not they have to be accounted for separately. The fair value of the liability
component is determined with reference to the fair value of a similar stand-alone
debt instrument (including any embedded non-equity derivatives). The amount
allocated to the equity component is the residual amount after deducting the fair
value of the financial liability component from the fair value of the entire compound
instrument. For a discussion of the recognition of deferred tax liabilities on
compound financial instruments, see 3.13.250. [IAS 32.31–32]

EXAMPLE 36 – ALLOCATING PROCEEDS OF ISSUED BOND TO COMPONENTS

 7I.3.620.20 Company Y issues 2,000 convertible bonds at the start of
year 1. The bonds have a three-year term and are issued at par with a
face value of 1,000 per bond, giving total proceeds of 2,000,000. The
bonds have the following contractual terms:
• interest is payable annually in arrears at a nominal annual interest
rate of 6%; and
• each bond is convertible at any time until maturity into 250 ordinary
shares.

7I.3.620.30 When the bonds are issued, the prevailing market interest
rate for a similar liability without a conversion option is 9%.

7I.3.620.40 The present value of the financial liability component is

calculated using a discount rate of 9% (the market interest rate for
similar bonds having no conversion rights).

Present value of the principal – 2,000,000 payable at

the end of three years 1,544,367

Present value of the interest – 120,000 (2,000,000 ×

6%) payable annually in arrears for three years 303,755

Total liability component 1,848,122

Equity component (balancing figure) 151,878

Proceeds of the bond issue 2,000,000

7I.3.620.50 Coupon accruals and the unwinding of the discount are

accounted for as interest expense. However, when dividends are
declared post-conversion of the bonds, these relate to the equity
component and are presented in equity as a distribution of profits.

7I.3.630 Costs of issuing compound instruments

7I.3.630.10 In the case of compound instruments, transaction costs are allocated

to the individual components in proportion to the allocation of the proceeds. The
costs related to the liability component are dealt with in accordance with the
requirements for transaction costs associated with financial liabilities (see 7I.6.30).
However, the costs related to the equity component are reported as a deduction from
equity. [IAS 32.37–38]

7I.3.640 Accounting for early redemption

7I.3.640.10 On early redemption of a convertible instrument, the redemption
payment is allocated to the liability and equity components. The method used is
consistent with that used initially to allocate the instrument between its debt and
equity components (see 7I.3.620). The fair value of the liability component at the
redemption date is compared with its carrying amount, giving rise to a gain or loss on
redemption that is recognised in profit or loss. The remainder of the redemption
payment is recognised in equity. [IAS 32.AG33]

7I.3.650 Accounting for conversion

7I.3.650.10 On conversion of a convertible instrument that is a compound

instrument at maturity, the entity derecognises the liability component that is
extinguished when the conversion feature is exercised and recognises the same
amount as equity. The original equity component remains as equity, although it may
be transferred within equity (see 7I.3.480). No gain or loss is recognised in profit or
loss. [IAS 32.AG32]

7I.3.650.20 If the conversion feature is an American-style option that can be

exercised before the redemption date, then a question arises about whether to
derecognise the liability component based on its carrying amount (e.g. amortised cost
based on the stated maturity ignoring the conversion option) at the time of early
conversion, or to derecognise the liability component after remeasuring it to the
redemption amount at conversion.

7I.3.650.30 Under the first approach, the carrying amount of the liability on
conversion (e.g. amortised cost based on the stated maturity ignoring the conversion
option) is reclassified to equity and no gain or loss is recognised on conversion (see
7I.3.650.10). Under the second approach, the liability is remeasured to the
redemption amount at conversion, with additional interest expense being recognised
in profit or loss under paragraph AG8 of IAS 39, because it is considered a
prepayment of the liability component (see 7I.6.260.10).

7I.3.650.40 In our view, the first approach is appropriate because this conversion
in effect represents a conversion at maturity, because of the way the American-style
option operates. The financial liability component should be accounted for as a non-
prepayable liability, and an American-style equity option recognised in equity.
Consequently, we believe that there is no prepayment feature in the liability that
leads to the recognition of a gain or loss arising from the revision of cash flow
estimates (see 7I.6.260.10).

7I.3.650.50 However, a gain or loss may arise when convertible instruments

contain embedded derivatives (see 7I.3.610.50). If a convertible bond contains a
prepayment feature that enables the issuer to call the bond and the prepayment
feature has not been separately accounted for as a derivative, then in our view when
the issuer announces its intention to exercise the call option it should recognise a
catch-up adjustment to the amortised cost accounting for the financial liability under
paragraph AG8 of IAS 39 (see 7I.6.260.10).

7I.3.650.60 We believe that the requirements for early redemption (see 7I.3.640)
do not apply because they address situations in which convertible debt is bought back
not under the terms inherent in the instrument (call option) but instead through
agreement between the issuer and holder to buy back at fair value without using any
options embedded in the instrument – e.g. tender offers.

EXAMPLE 37A – CONVERTIBLE BOND WITH AMERICAN-STYLE OPTION

7I.3.650.70 Company B issues a 10-year convertible bond that is

convertible at any time after five years at the option of the holder (an
American-style option). If the bond is not converted, then the par
amount is repayable on maturity after 10 years. The conversion feature
is classified at inception as equity, because it meets the fixed-for-fixed
requirement (see 7I.3.100.10). The host debt instrument is measured
at amortised cost.

7I.3.650.80 A question arises about whether to derecognise the

liability component based on its amortised cost carrying amount at the
time of early conversion, or to derecognise the liability component
after remeasuring it to the par amount at conversion.

7I.3.650.90 We believe that such conversion in effect represents a

conversion at maturity. This is because the bond does not have a fixed
maturity of 10 years, because of the way the American-style option
operates. Consequently, we believe

that there is no prepayment feature in the liability that leads to the

recognition of a gain or loss arising from the revision of cash flow
estimates.

7I.3.650.100 The conversion arises from the exercise of the equity

conversion option, which is an American-style option recognised in
equity and not remeasured through profit or loss under IAS 32.
Therefore, we believe that no gain or loss should be recognised in
profit or loss on conversion of the bond.

EXAMPLE 37B – CONVERTIBLE BOND WITH AMERICAN-STYLE OPTION AND ISSUER PREPAYMENT
OPTION

7I.3.650.110 Modifying Example 37A, the convertible bond contains a

prepayment feature that enables the issuer to call the bond at any time
after five years at par. However, the holder still has the option to
exercise its conversion right during a short period following the
announcement of the issuer to call the bond. The prepayment option is
not accounted for separately if it is closely related to the host liability
contract (see 7I.2.240).
 7I.3.650.120 We believe that when the issuer announces its intention
to exercise the call option it should recognise a catch-up adjustment to
the amortised cost accounting under paragraph AG8 of IAS 39 (see
7I.6.260.10). This is because, in contrast to Example 37A, the issuer’s
call option is separate from the holder’s conversion option. If the
holder does not exercise the conversion option, then the conversion
option is extinguished.

7I.3.650.130 If the holder exercises the conversion option, then the

liability component should be converted to equity. No gain or loss
should be recognised in profit or loss on conversion or redemption
because the carrying amount of the liability component has already
been adjusted to the par amount before conversion or redemption.

7I.3.650.140 In both Examples 37A and 37B, the carrying amount of the liability
component at conversion is reclassified to equity on exercise of the conversion
option. However, in Example 37A the carrying amount of the liability component is
less than the par amount at the conversion date; in Example 37B, the carrying
amount of the liability component is adjusted to par under paragraph AG8 of IAS 39
before conversion, with an impact on profit or loss.

7I.3.660 Amendment to induce early conversion

7I.3.660.10 An entity may amend the terms of a convertible instrument to induce
early conversion – e.g. by offering a more favourable conversion ratio in the event of
conversion before a specified date. When the terms are amended, the issuer
recognises in profit or loss the difference between:
• the fair value of the consideration that the holder receives on conversion of the
instrument under the revised terms; and
• the fair value of the consideration that the holder would have received under the
original terms. [IAS 32.AG35]

7I.3.670 Restructuring a convertible bond

7I.3.670.10 Continuing the example in 7I.3.610.10–40, the issuer might
restructure the convertible bond by removing the cash settlement alternative in the
conversion option. As a result, the issuer would have a contract that requires it to
physically deliver a fixed number of shares in exchange for a fixed amount of the bond
on exercise by the holder. Such a contract meets the definition of an equity
instrument, and so the conversion option is classified as such. However, the
restructuring would not fall in the scope of IFRIC 19, because the entity does not
issue equity instruments to extinguish the derivative component (see 7I.3.400 and
7I.5.410).

7I.3.670.20 However, concluding that the restructured conversion option should

be presented as equity is only the first step in accounting for the restructuring.
7I.3.670.30 An entity also needs to consider whether the restructuring is deemed a
significant modification of the terms of the bond, resulting in it being accounted for as
a debt extinguishment (see 7I.5.380).

7I.3.670.40 IAS 39 provides specific guidance when there is a modification in the

cash flows of a debt instrument (see 7I.5.380). However, when the terms of the
conversion option are revised, there is no such cash flow effect. In such
circumstances, in our view the impact of the modification from the holder’s
perspective should be considered.

7I.3.670.50 Consider a convertible bond with a cash settlement option for the
issuer if the holder exercises its right to convert the bonds into ordinary shares. If the
holder exercises its conversion option, then the issuer has the right to settle either:
• by delivering a fixed number of shares; or
• in cash at an amount equal to the market value of the shares to be issued.
7I.3.670.60 The holder might receive cash directly from the issuer at an amount
equal to the market value of the shares, instead of receiving the shares and
converting them into cash. The amount of cash accruing to the holder with or without
the cash settlement option is almost the same. Consequently, removal of the cash
settlement option does not in our view represent a substantial modification of the
bond. As a result, the restructuring does not lead to the derecognition or
extinguishment of the ‘original’ convertible bond and the recognition of a ‘new’
convertible bond. [IAS 39.AG62]

7I.3.670.70 However, the restructuring does result in the extinguishment of the

derivative component, because it is exchanged for an equity component (see
7I.3.420.60). From the holder’s perspective, this is an exchange of financial assets.
However, because there is no cash transfer in the transaction, the consideration paid
will usually be the fair value of the instrument received – i.e. the new conversion
option without a cash settlement feature. Because the fair value of the ‘old’
conversion option is almost identical at the date of the restructuring to the fair value
of the ‘new’ conversion option (see 7I.3.670.80), no significant gain or loss arises.

7I.3.670.80 From the issuer’s perspective, the ‘old’ conversion option would have
been measured at FVTPL until the restructuring of the convertible bond. At the date
of restructuring, the derivative component is derecognised and a new instrument is
recognised in equity at fair value – assuming that the fair value of both options is the
same.

7I.3.680 Treasury shares

7I.3.690 Classification
7I.3.690.10 Treasury shares are deducted from equity. Gains or losses from
purchase, sale, issue or cancellation are recognised in equity and do not affect profit
or loss. [IAS 32.33]
7I.3.700 Recognition and measurement
7I.3.700.10 Generally, any amounts paid by an entity to acquire its own equity
instruments are debited directly to equity. This applies whether the equity
instruments are cancelled immediately or held for resale – i.e. treasury shares.
Amounts received on the sale of treasury shares are credited directly to equity. No
gains or losses are recognised in profit or loss on any purchase, sale, issue or
cancellation of own equity instruments, or in respect of any changes in the value of
treasury shares. [IAS 32.33]

7I.3.700.20 Own equity instruments held in connection with an equity

compensation plan are presented as treasury shares (see 4.5.2280.10). [IAS 32.4(f), 33–
34]

7I.3.700.30 Assets held in respect of employee benefit plans other than equity
compensation plans may include the employer’s own shares. For a discussion of the
treatment of these shares, see 4.4.620.20.

7I.3.710 Treasury shares held for trading purposes

7I.3.710.10 Some entities hold their own equity instruments for trading purposes;
for example, they may be part of a portfolio of investments held for trading purposes.

7I.3.710.20 There are no exemptions for treasury shares held for trading purposes.
Such instruments are not recognised as assets or measured at fair value with gains
and losses recognised in profit or loss, which is the treatment for other trading
investments (see 7I.6.120). [IAS 32.33, AG36]

7I.3.720 Treasury shares held for hedging purposes

7I.3.720.10 Treasury shares may be held for economic hedging purposes – e.g. to
hedge an exposure to an issued index-linked structured note when the index includes
the entity’s own share price, or to hedge against the cost of a share-based payment
arrangement. Holding treasury shares as an economic hedge is not sufficient to
override the treasury share accounting requirements – even though this may give rise
to a profit or loss mismatch. In this situation, the index derivative feature in the
issued structured notes is measured at fair value with all changes therein recognised
in profit or loss (see 7I.6.120). Any own equity instruments held to hedge the index
are accounted for as treasury shares, and changes in their value are not recognised.

7I.3.720.20 In our view, the hedge accounting principles explained in chapter 7I.7
do not apply to treasury shares. Treasury shares cannot be designated as a hedging
instrument. The only non-derivatives that qualify as hedging instruments are
financial assets or financial liabilities (for foreign exchange risk only) and own equity
is not considered to be a financial asset or financial liability. Also, treasury shares
cannot be designated as the hedged item; the hedged risk should be one that could
affect reported income whereas gains and losses on treasury shares are not
recognised in profit or loss. [IAS 39.72, AG97]
7I.3.730 Treasury shares held by subsidiaries
7I.3.730.10 In consolidated financial statements, treasury share accounting
applies to own equity instruments that are held by a consolidated subsidiary. [IAS
32.33]

EXAMPLE 38A – TREASURY SHARES HELD BY SUBSIDIARIES

7I.3.730.20 Company S is a subsidiary of Parent P. S has a 2%

investment in P and S classifies its investment as available-for-sale in
its separate financial statements. The following facts are also relevant
for this example:
• the investment was acquired at a cost of 72; and
• the current fair value of the investment is 87.
7I.3.730.30 P records the following entry in respect of the treasury
shares on consolidation.

DEBIT CREDIT

Available-for-sale revaluation reserve 15

Treasury shares (equity) 72

Available-for-sale investments 87

To eliminate available-for-sale investment on

consolidation and to recognise treasury shares

EXAMPLE 38B – TREASURY SHARES HELD BY SUBSIDIARIES – SALE

 7I.3.730.40 Continuing Example 38A, in the next period Company S
sells its investment in Parent P for its fair value of 90. S will have
recorded the investment in P at 90 (revalued to the date of sale) and
accumulated 18 in its available-for-sale revaluation reserve.

7I.3.730.45 S recognises a profit of 18 in profit or loss on the sale of

the investment in its separate financial statements, which represents
the recycling of the amount accumulated in the available-for-sale
revaluation reserve. On consolidation, P records the following entry to
eliminate the profit recognised by S.

DEBIT CREDIT

Profit on disposal (profit or loss) 18

Equity 18

To eliminate profit recognised by S on the sale

of the treasury shares

7I.3.730.50 For further discussion of the presentation of any surplus or deficit on

the sale of treasury shares, see 7I.3.750. Any current or deferred tax on the
transactions is also recognised in equity (see 3.13.590).

7I.3.740 Treasury shares held by associates and joint ventures

7I.3.740.10 An associate or joint venture may have an investment in its investor.

The carrying amount of the investee under the equity method will include the
investor’s share of the investee’s investment in the investor’s own shares. [IAS 32.33]

7I.3.740.20 In our view, the investor should not make any adjustment in respect of
treasury shares held by an associate or joint venture. We do not believe that the
investor should reclassify this portion of the carrying amount of the investment in the
associate or joint venture as a deduction from equity. Similarly, if dividends are
declared on these equity instruments, then no adjustment should be made to the
entity’s share of the associate’s or joint venture’s profit during the year. We believe
that the lack of control over an associate or joint venture, and the definition of a
group – i.e. a parent and all of its subsidiaries (see 2.1.100.10) – distinguish these
from cases in which treasury shares are held by a subsidiary. Information about own
equity instruments held by associates or joint ventures should be disclosed in the
notes to the financial statements. [IAS 1.79, 32.33, IFRS 10.A]

7I.3.750 Presentation
7I.3.750.10 The Standards do not mandate a specific method of presenting
treasury shares within equity. However, local laws may prescribe the allocation
method. Therefore, an entity needs to take into account its legal environment when
choosing how to present its own shares within equity. An entity needs to choose a
presentation format, to be applied consistently to all treasury shares. Possible
presentation options are explained below, although other methods may also be used.

PRESENTATION OF OUTCOMES
TREASURY SHARES

7I.3.750.20 Total cost of • The cost of treasury shares

treasury shares purchased is debited to a separate
as a separate category of equity.
category of • When treasury shares are sold or
equity reissued, the amount received for
the instruments is credited to this
category.
• Any surplus or deficit on the sale of
treasury shares is shown as an
adjustment to share premium or
reserves, including retained
earnings, or a combination thereof.

This method is illustrated in KPMG’s

Guides to financial statements series.

7I.3.750.30 Par value of • The par value of treasury shares

treasury shares purchased is debited to a separate
as a separate category of equity.
category of • When treasury shares are sold or
equity reissued, the par value of the
instruments is credited to this
category.
• Any premium or discount to par
value is shown as an adjustment to
share premium or reserves,
including retained earnings, or a
combination thereof.
 PRESENTATION OF OUTCOMES
TREASURY SHARES

7I.3.750.40 Par value of • The par value of treasury shares

treasury shares purchased is debited to share
as a deduction capital.
from share • When treasury shares are sold or
capital reissued, the par value of the
instruments is credited to share
capital.
• Any premium or discount to par
value is shown as an adjustment to
share premium or reserves,
including retained earnings, or a
combination thereof.

7I.3.760 Preference shares

7I.3.760.10 Preference shares that provide for redemption at the option of the
holder give rise to a contractual obligation and are therefore classified as financial
liabilities. If preference shares are not redeemable at the option of the holder, then
the appropriate classification depends on the other terms and conditions associated
with such shares – in particular, the attached dividend rights. If dividends are
discretionary, then this fact supports the classification of the preference shares as
equity instruments. If dividends are not discretionary, then they represent a
contractual obligation, and the instrument is classified as a financial liability of the
issuer (see 7I.3.60.30). [IAS 32.AG25–AG26]

7I.3.760.20 A typical example of a cumulative perpetual preference share is one

with the following characteristics:
• the issuer has an obligation to pay dividends on preference shares only if it pays
dividends on its ordinary shares; and
• the preference dividends are cumulative.
7I.3.760.30 The fact that dividends are payable only if ordinary dividends, which
are discretionary, are paid (‘dividend stopper feature’) does not create an obligation.
However, because of the cumulative feature, the instrument is classified as equity
only if:
• the accumulated dividends can be deferred indefinitely – i.e. until liquidation of
the entity if liquidation is neither predetermined nor at the option of the
instrument holder (see 7I.3.60); and
• there is no other feature of the instrument that would lead to financial liability
classification (see 7I.3.70.170–180). [IAS 32.25]

7I.3.760.40 The terms of certain preference shares provide for the accrual of
interest on cumulative discretionary dividends even before such dividends are
declared. In other words, interest accrues from the point in time at which the
dividend might have been declared, such that if the dividend is declared, then an
amount of interest becomes payable automatically. In our view, the accrual of interest
alone does not cause such dividends to give rise to a contractual obligation to deliver
cash or another financial asset as long as the dividends remain discretionary – i.e. the
entity can avoid the payment of both dividends and interest on unpaid dividends until
liquidation of the entity.

7I.3.760.50 A preference dividend in which payment is contingent on the

availability of future distributable profits differs from a discretionary dividend. With a
discretionary dividend, the issuer is able to avoid the payment of dividends
indefinitely. However, the payment of a contingent dividend cannot be avoided
indefinitely (see 7I.3.70). The fact that the issuer might currently be unable to pay the
dividend has no bearing on its classification. Consequently, contingent dividends are
classified as a liability. [IAS 32.25]

EXAMPLE 39A – PREFERENCE SHARES – SEPARATE FINANCIAL STATEMENTS

7I.3.760.60 Company K issues preference shares with the following

contractual terms:
• the shares are redeemable at the option of the issuer, at a fixed
redemption price of 100 per share plus any accrued unpaid
dividends;
• there is no fixed redemption date – i.e. the holder has no right to
demand repayment at a certain date; and

• the payment of dividends is at the discretion of the issuer. However,

K is required to pay dividends if its parent pays dividends on its
ordinary shares.

7I.3.760.70 Therefore, in this example the payment of dividends is

contingent on the occurrence of an uncertain future event that is
beyond the control of both the issuer and the holder of the instrument.

7I.3.760.80 Consequently, K recognises a financial liability. In

substance, this instrument is a perpetual instrument with variable
contingent dividend payments. Therefore, the amount of the initial
investment represents the expected value of the variable contingent
dividend payments, which are classified as a liability.

EXAMPLE 39B – PREFERENCE SHARES – CONSOLIDATED FINANCIAL STATEMENTS

7I.3.760.90 The classification of the instrument in Example 39A would

be different in the consolidated financial statements of the parent if the
payment of dividends at the consolidated level were at the discretion of
the parent (see 7I.3.20.160).
7I.3.770 Conversion rights with down-round feature
7I.3.770.10 There are features other than those discussed in 7I.3.760 that can
preclude non-redeemable preference shares from being classified as equity even if
dividends are discretionary. Preference shares sometimes contain conversion options
that allow the holder to exchange them for ordinary shares at a predetermined
conversion ratio. The conversion ratio may be subject to adjustments to prevent
dilution (i.e. anti-dilution clauses). As discussed in 7I.3.100.100, anti-dilution clauses
that adjust a conversion ratio do not violate the fixed-for-fixed requirement. However,
other adjustments to a conversion ratio to compensate the instrument holder for fair
value losses generally do violate the fixed-for-fixed requirement (see 7I.3.100.100).

7I.3.770.20 A question arises about whether a feature that requires adjustment to

an otherwise fixed conversion ratio when additional equity instruments are issued at
a price below the initial conversion price – i.e. a ‘down-round feature’ that violates
the fixed-for-fixed requirement – creates an obligation for the issuer to issue a
variable number of own equity instruments. In our view, the classification of the
instrument depends on whether the decision not to issue additional equity
instruments that may trigger the down-round feature is in the entity’s control – i.e.
there is neither any contractual nor statutory obligation that may require the entity to
issue additional equity instruments that might trigger the down-round feature.

7I.3.770.30 In some jurisdictions, specific laws or regulations might require an

entity to issue additional equity instruments in certain circumstances – e.g. when the
entity is in financial difficulty or has liquidity problems. In our view, the decision not
to issue additional equity instruments is not in the entity’s control if laws and
regulations require the entity to take a particular course of action that involves
issuing additional equity instruments in specified circumstances and the entity does
not have discretion to avoid the occurrence of those circumstances. Conversely, if the
law merely states general objectives and allows the entity discretion in how to satisfy
general fiduciary responsibilities, then we believe that the entity has control over a
decision not to issue new equity instruments.

7I.3.770.40 If the entity has control over issuing additional equity instruments and
the preference shares contain no other feature that would be inconsistent with equity
classification, then we believe that the entity should choose an accounting policy, to
be applied consistently, to:
• classify the preference shares entirely as equity because the entity has no
contractual obligation to deliver a variable number of own equity instruments; or
• recognise separately the equity host and an embedded derivative for the
conversion option including the down-round feature measured at FVTPL because
it does not meet the fixed-for-fixed requirement (see 7I.2.110).

7I.3.770.50 If the entity does not have control over issuing additional equity
instruments (see 7I.3.770.30), then we believe that the preference shares should be
accounted for as a compound instrument with a liability component to deliver a
variable number of ordinary shares and an equity component that reflects the
holder’s residual right to share in any discretionary dividends.
7I.3.780 Equity instruments with write-down features and
substitution rights

7I.3.790 Write-down features in equity instruments

7I.3.790.10 The contractual terms of some equity instruments issued by regulated

financial institutions include write-down features that may be exercised when a
specified triggering event occurs – e.g. the common equity Tier 1 ratio falls below a
certain level. If the write-down feature is exercised, then the stated principal amount
of the instrument is reduced to zero and there is no potential for subsequent recovery
of the principal amount or future payments of coupons. A question arises about
whether the write-down feature should be separated from the equity instrument and
accounted for as a derivative measured at FVTPL.

7I.3.790.20 In our view, the write-down feature described in 7I.3.790.10 should not
be separated from the equity host because the write-down feature merely allows or
requires the equity instrument to be extinguished (i.e. called) for zero consideration,
and therefore does not meet the definition of a financial asset or a financial liability. In
addition, a feature that reduces the pay-out to the holder of a non-derivative
instrument in certain circumstances is not inconsistent with the definition of an
equity instrument. [IAS 32.11, 16]

7I.3.800 Substitution rights

7I.3.800.10 In some cases, an otherwise equity-classified instrument issued by a
regulated bank may include a feature that gives the issuer the right either to
substitute the entire instrument or to vary some contractual terms so that it will
continue to qualify for a certain regulatory treatment if certain contingent events
occur. For example, if regulatory requirements change, then the feature enables an
entity to continue to meet the additional Tier 1 capital requirements. There are
certain conditions that have to be met for the new or varied instrument – e.g. it needs
to have the same principal and interest amount as before the substitution or variation
or the contractual terms of the new or varied instrument cannot be less favourable to
the holder than before the substitution or variation.

7I.3.800.20 A question arises about whether such an issuer’s substitution or

variation right should be separated as an embedded derivative measured at FVTPL.
In our view, the issuer’s substitution or variation right should not be separated from
the equity host. It is not determined how the new or varied instrument is different
from existing equity instrument unless and until the contingent events occur. Because
the underlying of the option – i.e. the new or varied instrument – is not sufficiently
defined, we believe that the option does not meet the definition of a derivative (see
7I.2.20–30). [IAS 39.9]

7I.3.810 Contingent consideration in business combination

7I.3.810.10 Contingent consideration may be included in the consideration

transferred in a business combination (see 2.6.280). IFRS 3 requires an obligation to
pay contingent consideration to be classified as a liability or equity on the basis of the
definitions of a financial liability and an equity instrument in paragraph 11 of IAS 32.
That means that the obligation has to be to deliver a fixed number of shares in order
for consideration that is settled in own equity instruments to be classified as equity.
The subsequent accounting for the contingent consideration is dependent on this
classification (see 2.6.1100). [IFRS 3.40]

7I.3.810.20 In our view, the existence of any contingency regarding whether a

fixed number of own shares will be delivered does not necessarily disqualify the
contingent consideration from equity classification. We believe that if one of the
possible outcomes in respect of the contingency is the delivery of neither shares nor
other consideration, then this does not in itself preclude equity classification. This is
because the delivery of no consideration does not constitute a ‘settlement’. For
example, if the arrangement involved issuing either zero or a single fixed amount of
equity shares, then the fixed-for-fixed criterion would be met. This is because the only
way that settlement could take place would be by delivering a single fixed amount of
shares.

7I.3.810.30 Also, in our view the classification analysis should be performed for an
obligation to pay contingent consideration as referred to in IFRS 3 rather than for the
entire contract. An entire-contract approach is not generally feasible, given that a
contingent consideration arrangement is usually just one element of an overall sale-
and-purchase agreement that governs all aspects of the business combination. We
believe that a single business combination may involve more than one obligation to
pay contingent consideration and that each obligation should be analysed separately
for whether it is equity or liability. [IFRS 3.40]

7I.3.810.40 In our view, an entity should choose an accounting policy, to be applied

consistently, to analyse such relationships under one of two approaches.
• Approach 1: Obligations are separate when there is no necessary relationship
between their outcomes or settlement (see 7I.3.810.50).
• Approach 2: Obligations are separate only if there is no underlying causal
relationship or significant correlation between their outcomes or settlement (see
7I.3.810.60).

7I.3.810.50 Under the first approach, one obligation is seen as separate from
another obligation if there is no necessary relationship between the outcome or
settlement of the obligations. For example, non-cumulative obligations to deliver
shares based on different profit targets for different years may be seen as
independent and therefore separate. This is because there is no necessary link
between meeting the target for one year and meeting the target for another year.
However, if there were an overlap between the periods, then the targets would not be
independent.

7I.3.810.60 Under the second approach, an obligation is seen as separate from

another obligation only if there is no underlying causal relationship or significant
correlation between the outcome or settlement of the obligations. Therefore, if this
policy is chosen, non-cumulative requirements to deliver shares based on different
profit targets for different years are seen as a single obligation. This is because the
underlying operational and economic factors that influence performance in one year
will tend to influence performance in another year. For example, an entity’s
performance across a number of years may be influenced by the successful
development of, or failure to develop, a new product line.

EXAMPLE 40 – CONTINGENT CONSIDERATION IN BUSINESS COMBINATION

7I.3.810.70 To illustrate the principles set out in 7I.3.810.40–60, the

following table contains several scenarios and the respective
classification assessments.

SCENARIO CLASSIFICATION

The vendor receives shares in Liability, because there is a

the acquirer to the value of 50 single obligation to deliver a
if the acquiree’s cumulative variable number of shares.
profits over a three-year
period are at least 20.

The vendor receives 50 shares Equity, because there is a single

in the acquirer if the obligation to deliver a fixed
acquiree’s cumulative profits number of shares.
over a three-year period are at
least 20.

The vendor receives 50 shares Liability, because the

in the acquirer if the arrangement involves settling
acquiree’s cumulative profits with either 50 or 100 shares – i.e.
over a three-year period are at a variable rather than a fixed
least 20, and 100 shares if number. The profit targets relate
profits are at least 40. to the same period, and
therefore they are not
independent.

The vendor will receive one Liability – the analysis is similar

share in the acquirer for every to the preceding scenario except
1 of profit in excess of 10. that the number of shares is
more obviously variable.
SCENARIO CLASSIFICATION

Share-settled contingent The classification depends on the

consideration is payable in policy adopted as described in
three tranches: 1,000 shares 7I.3.810.40–60. This may be
if an earnings target is considered three separate
achieved for year 1; 1,000 obligations to deliver a fixed
shares if an earnings target is 1,000 shares each (equity) or a
achieved for year 2; and 1,000 single obligation to deliver
shares if an earnings target is 1,000, 2,000 or 3,000 shares
achieved for year 3. Each (liability).
target relates to annual
earnings of the acquiree and
is non-cumulative.
27 OCT 2022 PAGE 2715

Insights into IFRS 18th Edition 2021/22

7I. Financial instruments: IAS 39
7I.4 Classification of financial assets and financial liabilities

7I.4 Classification of financial assets and financial

liabilities

7I.4.10 Classification 2718

7I.4.20 Financial assets or financial liabilities at
FVTPL, including derivatives 2718
7I.4.30 Financial assets and financial
liabilities held for trading 2718
7I.4.40 Financial assets and financial
liabilities designated as at
FVTPL 2720
7I.4.80 Held-to-maturity investments 2724
7I.4.90 Fixed maturity and
determinable payments 2725
7I.4.100 Intent to hold to maturity 2726
7I.4.110 Ability to hold to maturity 2727
7I.4.120 Tainting of held-to-maturity
portfolio 2727
7I.4.130 Exceptions to tainting 2728
7I.4.180 Loans and receivables 2732
7I.4.190 Available-for-sale financial assets 2733
7I.4.200 Other financial liabilities 2734
7I.4.210 Reclassification of financial assets 2734
7I.4.220 To or from FVTPL category 2734
7I.4.230 From held-to-maturity to available-for-
sale 2737
7I.4.240 From available-for-sale category to
measurement at amortised cost 2737
7I.4.250 From available-for-sale to
loans and receivables 2737
7I.4.260 From available-for-sale to
held-to-maturity 2738
7I.4.270 To or from financial instruments
measured at cost 2738
7I.4.280 From loans and receivables to at FVTPL 2739
 7I.4.290
From loans and receivables to
available-for-sale 2739
7I.4.300 Internal transfers of financial
instruments 2739
7I.4.310 Reclassification of financial liabilities 2739
7I.4.320 Loan commitments 2739

7I.4 Classification of financial assets and financial

liabilities

REQUIREMENTS FOR INSURERS THAT APPLY IFRS 4

In July 2014, the International Accounting Standards Board issued IFRS 9 Financial
Instruments, which is effective for annual periods beginning on or after 1 January
2018. However, an insurer may defer the application of IFRS 9 if it meets certain
criteria (see 8.1.180).

This chapter reflects the requirement of IAS 39 Financial Instruments: Recognition

and Measurement and the related standards, excluding any amendments introduced
by IFRS 9. These requirements are relevant to insurers that apply the temporary
exemption from IFRS 9 or the overlay approach to designated financial assets (see
8.1.160) and prepare financial statements for periods beginning on 1 January 2021.
For further discussion, see Introduction to Sections 7 and 7I.

The requirements related to this topic are mainly derived from the following.

STANDARD TITLE

IAS 39 Financial Instruments: Recognition and Measurement

FORTHCOMING REQUIREMENTS AND FUTURE DEVELOPMENTS

For this topic, there are no forthcoming requirements or future developments.

7I.4.10 CLASSIFICATION

7I.4.10.10 IAS 39 establishes specific categories into which all financial assets
and financial liabilities are classified. The classification of financial instruments
dictates how these financial assets and financial liabilities are measured
subsequently in the financial statements of an entity. There are four categories of
financial assets:
• financial assets at FVTPL;
• held-to-maturity investments;
• loans and receivables; and
• available-for-sale financial assets. [IAS 39.9, 45]
7I.4.10.15 Categories of financial liabilities include:
• financial liabilities at FVTPL; and
• other financial liabilities. [IAS 39.9, 47]
7I.4.10.20 In our view, if an entity acquires financial instruments as part of a
business combination (see 2.6.560), then the entity should classify the acquired
financial instruments at the date of acquisition applying the normal classification
rules, without regard to how the instruments were classified by the acquiree before
the acquisition. If these classifications differ from the classifications made by the
acquiree, then the reclassifications are not treated as transfers between portfolios in
the consolidated financial statements of the acquirer – i.e. they would not raise issues
of ‘tainting’ with respect to items classified as held-to-maturity.

7I.4.10.30 The classification rules for each of the categories are discussed below.

7I.4.20 Financial assets or financial liabilities at FVTPL,

including derivatives

7I.4.20.10 This category includes:

• financial assets or financial liabilities held for trading – i.e. any financial asset or
financial liability acquired or incurred to generate short-term profits or that is part
of a portfolio of financial instruments that are managed together for that purpose;
• all derivatives other than hedging instruments (see 7I.7.310);
• contingent consideration as defined in IFRS 3 classified as a financial liability that
is in the scope of IAS 39; and
• financial assets or financial liabilities that are designated by the entity at the time
of initial recognition as measured at FVTPL (see 7I.4.40). [IFRS 3.58, IAS 39.9]

7I.4.20.20 Investment entities, as defined in IFRS 10, are required to account for
their investments in most subsidiaries at FVTPL in accordance with IAS 39 (see
chapter 5.6). In addition, one of the criteria for qualifying as an investment entity is
that investments in associates and joint ventures are accounted for at FVTPL in
accordance with IAS 39. [IFRS 10.31, A, BC250]

7I.4.30 Financial assets and financial liabilities held for trading

7I.4.30.10 A financial asset or financial liability is classified as held-for-trading if
it is:
• acquired or incurred principally for the purpose of selling or repurchasing it in the
near term;
• on initial recognition, part of a portfolio of identified financial instruments that are
managed together and for which there is evidence of a recent actual pattern of
short-term profit taking; or
• a derivative, except for a derivative that is a designated and effective hedging
instrument. [IAS 39.9]

7I.4.30.20 ‘Trading’ generally refers to the active and frequent buying and
selling of an item. Financial assets and financial liabilities classified as held-for-
trading are generally held with the objective of generating a profit from short-term
fluctuations in price or dealer’s margin. However, in our view these general
characteristics are not a prerequisite for all financial instruments that the standard
requires to be classified as held-for-trading. [IAS 39.AG14]

EXAMPLE 1 – FINANCIAL ASSETS HELD FOR TRADING

7I.4.30.30 Bank B originates a loan with the intention of

syndication but fails to find sufficient commitments from other
participants. B intends to sell all or part of the loan in the near term
rather than hold it for the foreseeable future.

7I.4.30.35 The definition of ‘loans and receivables’ in IAS 39

requires a loan or a portion of a loan that is intended to be sold
immediately or in the near term to be classified as held-for-trading on
initial recognition. In our view – notwithstanding the general
characteristics of trading activity (see 7I.4.30.20) – the loan or the
portion that B intends to sell in the near term should be classified as
held-for-trading in accordance with the specific guidance in the
standard. [IAS 39.9]

7I.4.30.37 If subsequent to initial recognition B changes its

intention with respect to the loan and demonstrates the intention and
ability to hold the loan for the foreseeable future or until maturity, then
B may, at such a subsequent date, reclassify the loan from the FVTPL
category to either loans and receivables or the available-for-sale
category (see 7I.4.220.20–40). [IAS 39.50(c)]

7I.4.30.40 The definition of ‘held for trading’ includes an asset or liability being
part of a portfolio of financial instruments. Although IAS 39 does not define ‘portfolio’
explicitly, in this context it is possible to consider a portfolio to be a collection of
financial assets or financial liabilities that are managed as part of the same group. For
example, the takings and placings of a money market desk may be viewed as
comprising one portfolio that qualifies for classification as held-for-trading. [IAS 39.9,
IG.B.11]

7I.4.30.50 The intention to profit from short-term fluctuations in price or dealer’s

margin need not be stated explicitly by the entity. Other evidence may indicate that a
financial asset is being held for trading purposes. Evidence of trading may be
inferred, based on the turnover and the average holding period of financial assets
included in the portfolio. For example, an entity may buy and sell shares for a specific
portfolio, based on movements in those entities’ share prices. If this is done on a
frequent basis, then the entity has established a pattern of trading for the purpose of
generating profits from short-term fluctuations in price. Additional purchases of
shares into this portfolio would also be designated as held-for-trading. [IAS 39.9,
IG.B.11]
7I.4.30.60 In our view, if an entity makes an investment in a fund that is managed
independently by a third party, then whether the entity should classify its investment
in that fund as trading is not influenced by the fact that the underlying assets within
the fund are traded actively. Therefore, the entity’s investment in that fund would not
meet the definition of an asset held for trading unless the entity actively trades in the
investments it holds in such funds. This situation may be contrasted with one in which
an entity holds a portfolio of investments that are managed by a portfolio manager on
the entity’s behalf. In such cases, the entity determines the investment policies and
procedures and, consequently, if the portfolio manager actively buys and sells
instruments within the portfolio to generate short-term profits, then the instruments
in the portfolio are considered held for trading and are classified as at FVTPL. [IAS
39.9, IG.B.12]

7I.4.30.70 Alternatively, a manager of an investment portfolio might buy and sell

investments to rebalance the portfolio in line with an investment mandate. This
activity would generally not result in the investments being classified as held-for-
trading because the activity may not be aimed at generating profits from short-term
fluctuations in prices. Furthermore, if an entity acquires a non-derivative financial
asset with the intention of holding it for a period irrespective of short-term
fluctuations in price, then such an instrument cannot be classified as held-for-trading.
[IAS 39.IG.B.12]

7I.4.30.80 Financial liabilities held for trading include derivatives with a

negative fair value – except those that are hedging instruments – and obligations to
deliver financial assets borrowed by a short seller. This category further includes
financial liabilities that are incurred with an intention of repurchasing them in the
near term and those that are part of a portfolio of financial liabilities for which there
is evidence of a recent pattern of short-term profit taking. [IAS 39.AG15]

7I.4.30.90 A financial liability cannot be considered as held for trading simply

because it funds trading activities. However, financial liabilities that fund trading
activities can be designated as at FVTPL if the criteria for designation are met (see
7I.4.40). [IAS 39.AG15]

7I.4.30.100 The standard does not define ‘near term’. In our view, an entity
should adopt a definition and apply a consistent approach to the definition used. If
there is the intention of generating a profit from short-term fluctuations in price or
dealer’s margin, then the financial asset is classified appropriately as held-for-
trading, even if the asset is not subsequently sold within a short period of time.

7I.4.30.110 To generate short-term profits, traders may actively trade an asset’s

risks rather than the asset itself. For example, a bank may invest in a 30-day money
market instrument for the purpose of generating profit from short-term fluctuations
in the interest rate. When the favourable movement in the interest rate occurs,
instead of selling the instrument the bank may issue an offsetting liability instrument.
The 30-day money market instrument is classified as held-for-trading despite the fact
that there is no intention to sell the instrument physically. The offsetting liability
instrument is also classified as held-for-trading because it was issued for trading
purposes and will be managed together with the related asset. [IAS 39.AG15]

7I.4.40 Financial assets and financial liabilities designated as

at FVTPL

7I.4.40.10 In addition to financial assets and financial liabilities held for trading,
financial assets and financial liabilities are classified in the FVTPL category when an
entity chooses, on initial recognition, to designate such instruments as at FVTPL
using the fair value option. An entity may use this designation only in either of the
following circumstances.
• When doing so results in more relevant information because either:
– it eliminates or significantly reduces a measurement or recognition
inconsistency that would result from measuring assets or liabilities or
recognising gains or losses on them on different bases (an ‘accounting
mismatch’); or
– a group of financial assets or financial liabilities (or both) is managed and its
performance is evaluated on a fair value basis in accordance with the entity’s
documented risk management or investment strategy and information is
provided to key management personnel on this basis.
• In respect of an entire hybrid contract, when the contract contains one or more
embedded derivatives, unless those embedded derivatives either:
– do not significantly modify the cash flows that would otherwise be required by
the contract; or
– are ones for which it is clear with little or no analysis when first considering a
similar hybrid instrument that separation is prohibited (see 7I.4.70.20). [IAS
39.9, 11A]

7I.4.40.20 Investments in equity securities that do not have a quoted market

price in an active market, and whose fair value cannot be measured reliably, cannot
be designated as at FVTPL. [IAS 39.9]

7I.4.40.30 The designation of an instrument as at FVTPL may be used only on

initial recognition and is not reversible. Therefore, this alternative to hedge
accounting cannot be used if an entity buys or issues an instrument and later wishes
to put a hedge in place.

7I.4.40.40 There is no requirement for consistency in the use of the FVTPL

designation, meaning that an entity can choose which, if any, of its financial assets
and financial liabilities are designated into this category. [IAS 39.AG4C]

7I.4.50 Reducing accounting mismatch

7I.4.50.10 Determining whether the fair value option eliminates or significantly
reduces an accounting mismatch requires judgement. In our view, an accounting
mismatch may arise from other financial instruments or from items that are not
financial instruments. The following examples illustrate circumstances in which an
accounting mismatch may cause the relevant financial assets and financial liabilities
to qualify for designation as at FVTPL.
• An entity has liabilities whose cash flows are linked contractually to the
performance of certain assets that would otherwise have been classified as
available-for-sale – e.g. liabilities with a discretionary participation feature that
pay benefits based on realised investment returns of a specified pool of the
insurer’s assets.
• An entity has liabilities under insurance contracts that are measured using current
information as allowed under IFRS 4, and related financial assets that otherwise
would be classified as available-for-sale or measured at amortised cost.
• An entity has financial assets and financial liabilities that share a particular risk,
such that their fair values change in opposite directions, tending to offset each
other. However:
– only some of the instruments are measured at FVTPL, notably derivatives and
those that are held for trading;
– hedge accounting cannot be applied because:
• the hedge criteria (e.g. the effectiveness requirements) are not met; or
• none of the instruments is a derivative and without hedge accounting there
is a significant inconsistency in the recognition of gains or losses; or
– even though hedge accounting is applicable, hedge documentation or
effectiveness testing, for example, is too onerous.
• An entity has issued financial liabilities whose cash flows are linked to both (1) the
cash flows received from investment property measured at fair value under IAS 40
(see 3.4.140), and (2) the fair value of that property. The entity determines that the
contractual linkage does not constitute an embedded derivative and, without
designation, the financial liabilities would be accounted for at amortised cost. [IAS
39.AG4E]

7I.4.50.20 There may be a delay between acquiring a financial asset or incurring

a financial liability and the related transaction that would create an accounting
mismatch. In the event of a reasonable delay, designation of the respective financial
asset and financial liability as at FVTPL is not precluded provided that the
designation is made on initial recognition and, at the time that the first of the
instruments is so designated, the acquisition or incurrence of the other is expected in
the very near future in accordance with a documented strategy. [IAS 39.AG4F]

7I.4.50.30 One of the main benefits of this category is that it may allow an entity
to avoid the cost and complexity of meeting the criteria for hedge accounting in some
cases. For example, an entity that purchases (or issues) a fixed rate bond and
immediately enters into an interest rate swap to convert the interest to a floating rate
might, instead of claiming hedge accounting, designate the bond as at FVTPL.
Because both the bond and the swap will be measured at FVTPL, the offsetting effects
of changes in market interest rates on the fair value of each instrument will be
recognised in profit or loss without the need for hedge accounting. [IAS 39.BC74A]

7I.4.50.40 However, the fair value changes of an item designated into this
category will be affected by more than one risk such that using this designation may
not achieve the exact results that hedge accounting for a particular risk would.
Continuing the example in 7I.4.50.30, when applying hedge accounting for interest
rate risk, the fixed rate bond would be adjusted for changes in its fair value
attributable to interest rate risk only. However, designating the bond as at FVTPL
means that it will be remeasured to fair value in respect of all risks, including the
entity’s own credit risk (for a bond issued by the entity) or the counterparty’s credit
risk (for a bond purchased by the entity). This may result in a difference between the
fair value gains and losses on the interest rate swap and those on the bond that is
greater than when hedge accounting is applied.

7I.4.50.50 An entity’s portfolios of financial assets and financial liabilities (and

related items – e.g. insurance liabilities) may be dynamic. In such circumstances, it
may be challenging to assess whether individual financial assets or financial
liabilities may be designated as at FVTPL. If an entity has dynamic portfolios that do
or would give rise to accounting mismatches, then in performing the accounting
mismatch assessment for individual financial assets or financial liabilities added to
these dynamic portfolios, in our view, the entity may need to consider:
• these portfolios and how they are managed;
• the actual and expected overall level and nature of the assets and liabilities in
these portfolios; and
• how the relevant risks and related accounting mismatches do or do not offset at
the portfolio level. In particular, we believe that:
- an entity cannot designate as at FVTPL a financial asset or financial liability for
which an accounting mismatch would not arise. For example, it is necessary
that an individual financial liability on initial recognition would – in the absence
of designation at FVTPL – contribute to an accounting mismatch in order for an
entity to be able to designate it at FVTPL under the accounting mismatch
criterion. We believe that an entity cannot designate a financial liability at
FVTPL merely because it is in a dynamic portfolio that gives rise overall to
accounting mismatches; and
- a portfolio approach cannot be used to designate financial assets or financial
liabilities in a way that overshoots or ignores previous designations of existing
items such that the new designation does not actually reduce an existing
accounting mismatch (or one that is expected to arise in the very near future –
see 7I.4.50.20). For example, an entity has dynamic portfolios of financial
assets of 60 and related liabilities of 70. These financial assets and related
liabilities would individually give rise to accounting mismatches proportionate
with their values (if the financial assets were not measured at FVTPL) and all
the financial assets are designated as at FVTPL. If the entity acquires similar
additional new financial assets of 40, which in the absence of designation would
not be measured at FVTPL, then we believe that it could generally designate
only up to 10 of the financial assets because designation of the other 30 of new
financial assets would not reduce an accounting mismatch.

7I.4.60 Assets and liabilities managed on fair value basis

7I.4.60.10 The following examples illustrate circumstances in which an entity
could be considered to be managing and evaluating the performance of a group of
financial assets, financial liabilities or both on a fair value basis, such that those
financial assets and financial liabilities may qualify for designation as at FVTPL.
• The entity is a venture capital organisation, mutual fund, unit trust or similar
 entity that invests in financial assets with the objective of profiting from their total
return in the form of interest or dividends and changes in fair value.
• The entity has financial assets and financial liabilities that share one or more risks,
which are managed and evaluated on a fair value basis according to a documented
asset and liability management policy – e.g. a portfolio of structured products that
contain multiple embedded derivatives and that are managed on a fair value basis
using a mixture of derivatives and non-derivatives.
• The entity is an insurer that holds a portfolio of financial assets and manages that
portfolio to maximise its total return from interest or dividends and changes in fair
value, and evaluates its performance on that basis. [IAS 39.AG4I]

7I.4.70 Assets and liabilities containing embedded derivatives

7I.4.70.10 If a contract contains one or more embedded derivatives, then an

entity may designate the entire combined contract as at FVTPL unless the embedded
derivative does not significantly modify the cash flows or it is clear that separation of
the embedded derivative is prohibited (see 7I.2.120.20). [IAS 39.11A]

7I.4.70.20 An example of an embedded derivative for which it is clear that

separation would be prohibited, and therefore designation of the entire hybrid
contract as at FVTPL is not possible, is a mortgage loan that is prepayable at an
amount approximating its amortised cost (see 7I.2.240.10). Another example would
be an instrument containing a non-leveraged cap that is out of the money at
inception. [IAS 39.AG30, AG33]

7I.4.70.30 An entity can apply the fair value option to contractual arrangements
that contain one or more embedded derivatives only when the host contract meets
the definition of a financial instrument under IAS 39. [IAS 39.11A]

7I.4.70.40 If an entity does not apply the designation in 7I.4.70.10 and the
embedded derivative is required to be separated but its fair value cannot be
measured reliably, then the entire combined contract is designated as at FVTPL. If
the fair value of the embedded derivative cannot be measured reliably directly, then it
is necessary to consider whether it can be measured reliably indirectly by deducting
the fair value of the host contract from the fair value of the entire hybrid instrument.
In our experience, circumstances in which the embedded derivative cannot be
measured reliably (either directly or indirectly) are encountered rarely. However, in
those rare circumstances the entire contract is designated as at FVTPL. [IAS 39.12–13]

7I.4.80 Held-to-maturity investments

7I.4.80.10 Held-to-maturity investments are non-derivative financial assets with

fixed or determinable payments and a fixed maturity that an entity has the positive
intention and ability to hold to maturity, other than those that:
• the entity designates on initial recognition as at FVTPL;
• the entity designates as available-for-sale; and
• meet the definition of loans and receivables. [IAS 39.9]
7I.4.80.20 Types of instruments that may meet the held-to-maturity definition
include:
• a fixed-maturity debt security that bears interest at a fixed or variable rate;
• a fixed-maturity debt security even if there is a high risk of non-payment, provided
that the security’s contractual payments are fixed or determinable and the other
criteria for classification are met;
• a debt instrument that is callable by the issuer, as long as substantially all of the
carrying amount would be recovered if the call were exercised; and
• shares with a fixed maturity that are classified as liabilities by the issuer (see
chapter 7I.3). [IAS 39.9, AG17–AG18]

7I.4.80.30 The following instruments cannot be classified as held-to-maturity:

• equity securities;
• an investment that the investor intends to hold for an undefined period or that
does not have fixed or determinable payments;
• an investment that the investor stands ready to sell in response to changes in
market conditions;
• a perpetual debt instrument that will pay interest in perpetuity;
• an instrument that is redeemable at the option of the issuer at an amount
significantly below amortised cost;
• an instrument that is puttable by the holder, because paying for the put feature is
inconsistent with an intention to hold the instrument to maturity – i.e. it is
questionable whether the holder has the intent to hold the instrument to its
maturity if the holder simultaneously acquires the right to require the issuer to
redeem the instrument before its maturity date;
• an asset for which the entity does not have adequate resources to hold to maturity;
and
• an asset that is subject to legal constraints that mean that the entity may be
unable to hold it to maturity. [IAS 39.9, AG16–AG19, AG23]

7I.4.80.40 The effect of using the held-to-maturity classification is that the

investments will be measured at amortised cost. The category is generally used for
fixed interest debt instruments quoted in an active market that are exposed to
significant fair value risk. Debt instruments that are not quoted in an active market
meet the definition of loans and receivables and would not be classified as held-to-
maturity.

7I.4.80.50 An entity is not permitted to classify any investments as held-to-

maturity if the entity has – during the current annual reporting period or during the
two preceding annual reporting periods – sold or reclassified more than an
insignificant amount in relation to the total amount of held-to-maturity investments
before maturity, other than sales or reclassifications that:
• are so close to maturity or the investment’s call date – e.g. less than three months
before maturity – that changes in the market rate of interest would not have a
significant effect on the fair value;
• occur after the entity has collected substantially all of the investments’ original
principal through scheduled payments or prepayments; or
• are attributable to an isolated event that is beyond the entity’s control, is non-
 recurring and could not have been reasonably anticipated by the entity. [IAS 39.9]

7I.4.80.60 A prerequisite for the classification of an investment as held-to-

maturity is the entity’s intent and ability to actually hold that investment until
maturity. An entity assesses its intent and ability to hold its held-to-maturity
investments not only at initial acquisition, but again at each reporting date. [IAS
39.AG25]

7I.4.80.70 Circumstances may arise in which the entity disposes of a significant

amount of its held-to-maturity investments after the reporting date, but before the
financial statements are authorised for issue. In our view, this calls into question the
entity’s intent and ability at the reporting date to hold those investments to maturity
and may require the classification of these investments to be revised at the reporting
date. If a reclassification is required, then this would result in tainting the entire held-
to-maturity portfolio. Such a case requires further consideration of the other
evidence available at the reporting date to support the entity’s intent and ability.

7I.4.80.80 There is no requirement to use the held-to-maturity classification. An

instrument with fixed and determinable payments may be designated as available-for-
sale even if the entity might hold the instrument until its maturity. In our view, this
applies even if there are legal restrictions that require an instrument to be held until
its maturity.

7I.4.80.90 Hedge accounting is not allowed for hedges of the interest rate risk or
prepayment risk on held-to-maturity investments (see 7I.7.170.80). [IAS 39.79]

7I.4.90 Fixed maturity and determinable payments

7I.4.90.10 Investments classified as held-to-maturity should have a fixed
maturity and fixed or determinable payments, meaning a contractual arrangement
that defines both the amounts and dates of payments to the holder, such as interest
and principal payments on debt. A significant risk of non-payment does not preclude
an investment from being classified as held-to-maturity automatically. [IAS 39.9, AG17]

7I.4.90.20 Because held-to-maturity investments should have a fixed maturity,

mainly debt contracts are classified as held-to-maturity. Nevertheless, even certain
debt instruments have an unlimited or unspecified maturity. For example, perpetual
bonds that provide for interest payments for an indefinite period would not qualify as
held-to-maturity investments. [IAS 39.AG17]

7I.4.90.30 In our view, investments that have an equity nature because payments
are dependent on residual cash flows – e.g. subordinated notes for which the amount
of interest or principal paid to the holder will be determined based on the residual
remaining after interest and principal amounts in respect of other creditors are paid –
should not be classified as held-to-maturity investments.

7I.4.90.40 Similarly, in our view investments in funds for which the amount to be
paid out as distributions or on liquidation is not fixed or determinable because it is
based on the performance of the fund should not generally be classified as held-to-
maturity, even if the fund has a final liquidation date – e.g. 10 years after the fund
closes to additional investments.

7I.4.90.50 However, the host contract in a hybrid financial asset may be

designated as held-to-maturity if it meets the relevant criteria.

EXAMPLE 2 – FINANCIAL ASSETS HELD TO MATURITY

7I.4.90.60 Bank Q has the positive intent and ability to hold a bond
issued by an oil company to maturity. The interest on the bond is
indexed to the price of oil. The fact that the return is dependent on the
price of oil means that the bond includes an embedded derivative that
is not closely related to the host contract (see 7I.2.200). The embedded
derivative and host contract are separated, resulting in an embedded
commodity contract to be measured at FVTPL and a host debt
instrument.

7I.4.90.70 Because Q has the positive intent and ability to hold the
host contract to maturity, it classifies the host contract as held-to-
maturity. [IAS 39.IG.B.13–IG.B.14]

7I.4.100 Intent to hold to maturity

7I.4.100.10 If an entity has the intent to hold an investment only for some period,
but has not actually defined that period to be to maturity, then the positive intent to
hold to maturity does not exist. Likewise, if the issuer has the right to settle the
investment at an amount that is significantly below the carrying amount, and
therefore is expected to exercise that right, then the entity cannot demonstrate a
positive intent to hold the investment until maturity. Also, an embedded option that
may shorten the stated maturity of a debt instrument casts doubt on an entity’s intent
to hold an investment until maturity. Therefore, the purchase of an instrument with a
put feature is inconsistent with the positive intent to hold the asset until maturity,
except for some put options described in 7I.4.150.40. However, if the issuer may call
the instrument at or above its carrying amount, then this does not affect the
investor’s intent to hold the instrument until maturity. The issuer’s call option, if it is
exercised, simply accelerates the instrument’s maturity. [IAS 39.AG16, AG18–AG19]

7I.4.100.20 The demonstration of positive intent to hold an investment to

maturity would not be negated by a highly unusual and unlikely occurrence, such as a
run on a bank, that could not be anticipated by the entity when deciding whether it
has the positive intent (and ability) to hold an investment until maturity. [IAS 39.AG21]

7I.4.100.30 A debt instrument that is convertible at the option of the holder

cannot generally be classified as held-to-maturity. This applies in particular when
there is no specified date for exercising the conversion option. Paying for an early
conversion right is inconsistent with an intention to hold the investment to its
maturity. However, in our view an investment that is convertible at the option of the
holder at the maturity date may be classified as held-to-maturity.

7I.4.100.40 Also, the risk profile of a particular financial investment may raise
similar questions about the entity’s intention. For example, the high risk and volatility
of a mortgage-backed interest-only certificate make active management of such
strips more likely than holding them to maturity. The same reasoning may apply to
debt instruments with high credit risk – e.g. high-yield (junk) bonds and subordinated
bonds. A significant risk of non-payment of interest and principal on a bond is not in
itself a consideration in qualifying for the held-to-maturity category as long as there
is an intent and ability to hold the bond until maturity. However, an entity would taint
its held-to-maturity portfolio if it subsequently sold such a bond as a result of a rating
downgrade that could have been foreseen. [IAS 39.AG17, IG.B.15]

7I.4.110 Ability to hold to maturity

7I.4.110.10 An entity cannot demonstrate an ability to hold an investment to
maturity if:
• financial resources are not available to the entity to finance the investment to
maturity – e.g. if it is expected or likely that an entity will acquire another business
and will need all of its funding for this investment, then the resources may not be
available to continue to hold certain debt instruments; or
• legal or other constraints could frustrate the intention of the entity to hold the
investment to maturity – e.g. there might be an expectation that a regulator will
exercise its right in certain industries, such as the banking and insurance
industries, to force an entity to sell certain investments in the event of a credit risk
change of the entity. [IAS 39.AG23]

7I.4.120 Tainting of held-to-maturity portfolio

7I.4.120.10 If an entity sells or transfers more than an insignificant amount of the
portfolio of held-to-maturity investments, then it may not classify any investment as
held-to-maturity for the remainder of the current annual reporting period plus two
annual reporting periods after the annual reporting period in which the event
occurred. [IAS 39.9]

7I.4.120.20 Although ‘more than an insignificant amount’ is interpreted in

relation to the total amount of held-to-maturity investments, the standard does not
provide more detailed guidance; rather, this is assessed by an entity based on the
facts and circumstances when a potential tainting situation arises. It is also important
to consider the reasons for an entity’s actions when determining if the portfolio has
been tainted. [IAS 39.9]

EXAMPLE 3 – TAINTING OF HELD-TO-MATURITY PORTFOLIO

 7I.4.120.30 Company T sells 1,000 bonds from its held-to-maturity
portfolio during the reporting period because the fair value of the
bonds had appreciated significantly over the carrying amount and
management decided that T should realise the gains through a sale.

7I.4.120.35 In these circumstances, selling investments from the

held-to-maturity portfolio taints the entire portfolio, and all remaining
investments in that category are reclassified. T will be prohibited from
classifying any investments as held-to-maturity for the remainder of
the current annual reporting period plus two full annual reporting
periods.

7I.4.120.40 The tainting rules are intended to bring some discipline to an entity’s
assertion that it intends and is able to hold an investment until maturity. Tainting
requires a reclassification of the total remaining held-to-maturity portfolio in the
financial statements into the available-for-sale category. [IAS 39.IG.B.19–IG.B.21]

7I.4.120.50 The tainting requirements apply group-wide, so that a subsidiary that

sells more than an insignificant amount of investments classified as held-to-maturity
in the consolidated financial statements can preclude the entire group from using the
held-to-maturity category in its consolidated financial statements. If an entity has
various portfolios of held-to-maturity investments – e.g. by industry or by country of
issue – then the sale or transfer of more than an insignificant amount of instruments
from one of the portfolios taints all the other held-to-maturity portfolios of the entity.
[IAS 39.IG.B.20–IG.B.21]

7I.4.120.60 Selling securities classified as held-to-maturity under repurchase

agreements does not constrain the entity’s intent and ability to hold those
investments until maturity, unless the entity does not expect to be able to maintain or
recover access to those investments. For example, if an entity is expected to receive
back other comparable securities, but not the securities lent, then classification as
held-to-maturity is not appropriate. [IAS 39.IG.B.18]

7I.4.130 Exceptions to tainting

7I.4.130.10 There are a limited number of exceptions to the tainting rules. First,
the tainting rules do not apply if only an insignificant amount of held-to-maturity
investments is sold or reclassified. Any sale or reclassification should be a one-off
event. If an entity sells or transfers insignificant portions periodically, then this may
cast doubt on the entity’s intent and ability with regard to its held-to-maturity
portfolio. If the sales are not isolated, then the amount sold or reclassified is assessed
on a cumulative basis in assessing whether the sales are insignificant. [IAS 39.9]

7I.4.130.20 Another exception is when almost the entire principal has been
collected through scheduled payments or through prepayments. The remaining part
would not be affected materially by changes in the interest rate and therefore the sale
would not result in a significant gain or loss. IAS 39 does not define the phrase
‘substantially all’ of the principal investment; however, in our view the main question
is whether the remaining fair value exposure is significant. [IAS 39.9]

7I.4.130.30 Circumstances may arise that the entity could not reasonably have
foreseen or anticipated. If, in such a situation, an entity sells or reclassifies held-to-
maturity investments, then the remaining portfolio is not tainted if the event leading
to the sale or reclassification of investments is isolated and non-recurring. If the
event is not isolated or is potentially recurring, and the entity anticipates further
sales or reclassification of held-to-maturity investments, then this inevitably casts
doubt on its ability to hold the remaining portfolio until maturity. Also, if the event
could reasonably have been anticipated at the date on which the held-to-maturity
classification was made, then the investment would not have been classified as such
initially. If an entity has control over or initiated the isolated or non-recurring event –
e.g. sales made after a change in senior management – then this also calls into
question the entity’s intent to hold the remaining portfolio until maturity. [IAS 39.9,
IG.B.16]

7I.4.130.40 Situations that may not have been anticipated when investments were
included in the held-to-maturity category and would not call into question the entity’s
intent and ability to hold investments to maturity may result, for example, from any of
the following:
• a significant deterioration in the creditworthiness of the issuer of the investment
that could not have been anticipated when the investment was acquired;
• significant changes in tax laws, affecting specific investments in the portfolio;
• major business combinations or disposals with consequences for the interest rate
risk position and credit risk policies of an entity; and
• significant changes in statutory or regulatory requirements. [IAS 39.AG22, IG.B.15,
IG.B.17]

7I.4.140 Deterioration in creditworthiness

7I.4.140.10 Although IAS 39 does not provide a definition of a significant
deterioration in an issuer’s creditworthiness, an example of this would be a
significant downgrade by a credit rating agency. Downgrades as reflected in an
entity’s proprietary internal credit rating system may also support the demonstration
of significant deterioration. An external credit rating may be a lagging indicator of
creditworthiness. [IAS 39.AG22, IG.B.15]

7I.4.140.15 An entity might assess that a significant deterioration in the issuer’s

creditworthiness has occurred based on its own current analysis of the issuer’s
creditworthiness supported by evidence available from market prices – e.g. a
significant increase in bond yields and credit default swap spreads could imply a
higher probability of risk of default and therefore could be an indicator of significant
deterioration in the issuer’s creditworthiness. If the deterioration could reasonably
have been foreseen, then the investment did not qualify to be classified as held-to-
maturity. A credit downgrade of a notch within a class or from one rating class to an
immediately lower rating class could often be considered reasonably anticipated.
Therefore, a sale or reclassification triggered by such a minor downgrading would
result in tainting. [IAS 39.AG22, IG.B.15]

7I.4.140.20 In our view, in order for a sale or reclassification to be considered

attributable to a significant deterioration in creditworthiness, the entity’s change of
intent with respect to the investment – i.e. a decision that it may sell the investment –
and the sale or reclassification should generally follow within a reasonably short
period after it identified the significant deterioration. Determining what is an
appropriate period is a matter of judgement that depends on the particular facts and
circumstances, including the entity’s policies and procedures for making such
decisions. Sales or reclassifications should usually take place before the end of the
reporting period in which the significant credit deterioration occurred to avoid
tainting, given that an entity is required to reassert its intent and ability to hold held-
to-maturity investments to maturity at each reporting date. However, sales or
reclassifications shortly after the reporting date may be acceptable, because of the
time required for an entity to complete its evaluation of the issuer’s creditworthiness
and finalise its response.

7I.4.140.25 If, after completing its evaluation and relevant decision-making

processes, an entity concludes that significant credit deterioration has occurred and
that, notwithstanding that identified deterioration, it re-asserts its intent to hold to
maturity, then we believe that it is unlikely that the entity would be able to
demonstrate that a subsequent sale or reclassification is attributable to that
deterioration. However, if there is a further subsequent significant deterioration in
creditworthiness, then a sale or reclassification shortly following that further
significant deterioration might not trigger tainting.

EXAMPLE 4 – EXCEPTION TO TAINTING

7I.4.140.27 Company H classifies an AAA-rated bond as held-to-

maturity. The bond is downgraded to A and H reasserts its intent to
hold it to maturity. Subsequently, the bond is further downgraded from
A to CCC and considered impaired, then H sells the bond. In this
example, the sale shortly after that further significant deterioration
does not trigger tainting.

7I.4.140.30 An entity might hold a number of held-to-maturity investments issued

by a single issuer that have all suffered a significant deterioration in
creditworthiness. Also, it might hold a number of investments issued by different
issuers that are affected by a similar significant deterioration in creditworthiness. If
the entity decides to sell or reclassify some of these investments because of the
significant deterioration in creditworthiness, then it is not required to reclassify the
other investments that have also suffered a significant deterioration in
creditworthiness if it continues to have the intent and ability to hold those other
investments to maturity. However, it would be necessary to consider whether the
circumstances surrounding the entity’s explicit decision to sell or reclassify some
investments called into question its intent and ability to hold the other investments to
maturity, given they have all suffered a similar significant deterioration in
creditworthiness. For example, if an entity’s policies require management to sell any
investment that is downgraded below a certain rating, then it would be expected that
all investments that are downgraded below this threshold would be reclassified.

7I.4.150 Changes in tax laws

7I.4.150.10 A significant change in tax laws – such as the elimination or the

significant reduction of the tax-exempt status of an investment – might not cast doubt
on the intention or ability of the entity with respect to the held-to-maturity category.
[IAS 39.AG22]

7I.4.150.20 For example, an entity has a captive finance company in a tax haven
and, because of changes in tax laws that affect the whole group, needs to relocate its
treasury activities and in that process liquidate the held-to-maturity portfolio in the
finance company. In our view, the classification as held-to-maturity in other group
entities would not be violated, because the entity could not have foreseen the change
in tax laws.

7I.4.150.30 However, a change in the applicable marginal tax rate for interest
income is not sufficient justification for sales of held-to-maturity investments without
tainting, because this change impacts all debt instruments held by the entity. [IAS
39.AG22(b)]

7I.4.150.40 In our view, if an entity holds a put option that it intends to use only in
the event of a change in laws, then a voluntary exercise of that option by the entity
would nevertheless result in tainting. However, if the exercise of an option is
conditional on a change in laws, or the option comes into existence only as a result of
a change in laws, then a sale through the exercise of such an option would not give
rise to tainting.

7I.4.160 Major business combination or disposition

7I.4.160.10 Although a major business combination or the sale of a significant
segment of the entity is a controllable event, it may have consequences for the
entity’s interest rate risk and credit risk positions. In such situations, sales that are
necessary to maintain the entity’s existing risk positions and that support proper risk
management do not taint the held-to-maturity portfolio. [IAS 39.AG22]

7I.4.160.20 Although sales subsequent to business combinations and segment

disposals might not taint the held-to-maturity portfolio, sales of held-to-maturity
investments before a business combination or disposal, or in response to an
unsolicited tender offer, will cast doubt on the entity’s intent to hold its remaining
investments until maturity. [IAS 39.IG.B.19]

7I.4.160.30 In our view, if investments acquired in a business combination were

classified as held-to-maturity by the acquiree, but the acquirer does not have the
intent or ability to hold these securities until maturity, then in the consolidated
financial statements the instruments should not be classified as held-to-maturity.
However, transferring investments held by the acquirer before the acquisition from
the held-to-maturity portfolio would result in tainting.

7I.4.160.40 In our view, a sale following a group reorganisation (including a

common control transaction) that is not a major business combination or disposition
would result in tainting. We do not believe that a sale of a held-to-maturity asset
between group entities would result in tainting in the consolidated financial
statements, as long as the investment remains classified as held-to-maturity in the
consolidated financial statements.

7I.4.160.50 However, in the separate financial statements of the individual

entities within the group, such intra-group transactions may give rise to tainting.

7I.4.170 Changes in statutory or regulatory requirements

7I.4.170.10 Examples of changes in statutory or regulatory requirements that do
not have tainting implications for the held-to-maturity portfolio are:
• changes either in the applicable laws or in regulations affecting the entity that
modify what constitutes a permissible investment or the maximum level of certain
types of investments, as a result of which the entity has to sell (part of) these
investments; and
• significant increases in the industry’s capital requirements or in the risk
weightings of held-to-maturity investments used for risk-based capital purposes,
as a result of which the size of the held-to-maturity portfolio has to be decreased.
[IAS 39.AG22]

7I.4.170.20 The exceptions are intended to shield entities operating in regulated

industries from potential tainting situations resulting from actions taken by the
industry’s regulator. These are actions applicable to the industry as a whole and not
to a specific entity. However, sales could occur in response to an entity-specific
increase in capital requirements set by the industry’s regulator. In that case, it will be
difficult to demonstrate that the regulator’s action could not reasonably have been
anticipated by the entity, unless the increase in entity-specific capital requirements
represents a significant change in the regulator’s policy for setting entity-specific
capital requirements. [IAS 39.IG.B.17]

7I.4.180 Loans and receivables

7I.4.180.10 Loans and receivables are non-derivative financial assets with fixed or
determinable payments that are not quoted in an active market, other than those:
• that the entity intends to sell immediately or in the near term, which are classified
as held-for-trading, and those that the entity designates on initial recognition as at
FVTPL;
• that the entity designates on initial recognition as available-for-sale; or
• for which the holder may not recover substantially all of its initial investment,
other than because of credit deterioration, which are classified as available-for-
sale. [IAS 39.9]
7I.4.180.20 An interest acquired in a pool of assets that are not loans and
receivables – e.g. an interest in a mutual fund or similar fund – is not a loan or
receivable. Cash collateralised debt obligations (CDOs) (see 7I.2.360) are securitised
interests in a pool of financial assets that expose investors to credit risk on reference
assets through the vehicle holding the reference assets. In our view, the holder of a
cash CDO may be able to classify the financial asset as loans and receivables if the
reference assets in the pool meet the criteria in 7I.4.180.10.

7I.4.180.30 In our view, ‘fixed or determinable payments’ generally means that

the cash flows are either fixed or determined by a formula.

7I.4.180.40 The main requirement for a financial asset to be classified as a loan or

receivable is that it has fixed or determinable payments and is not a derivative.
However, the definition also excludes any instrument that is quoted in an active
market. This means that a listed debt security that is actively traded in a market
cannot be classified within loans and receivables, even if it is acquired at the date of
its original issue by providing funds directly to the issuer. [IAS 39.AG26]

7I.4.180.45 An entity is prohibited from classifying a financial asset as a loan or

receivable if it may not recover substantially all of its initial investment, other than
because of credit deterioration (see 7I.4.180.10). [IAS 39.9]

7I.4.180.46 In our view, a financial asset bearing a negative interest rate or yield
may, depending on the circumstances, be eligible for classification as loans and
receivables. We believe that a negative interest rate or yield would not preclude
eligibility if the instrument contractually requires the borrower to repay amounts that
on a present value basis (considering market rates of interest) would result in the
holder recovering substantially all of its recorded investment, thus satisfying the
condition in 7I.4.180.45. For example, a floating-rate loan that is indexed to a
benchmark interest rate that might become negative could be eligible for
classification as loans and receivables. [IAS 39.BC29]

EXAMPLE 5 – FINANCIAL ASSETS WITH LOSS PARTICIPATION FEATURE

7I.4.180.47 Company S holds a debt instrument issued by Company

P, a widget manufacturer, which carries a right to annual interest at the
rate of 7% subject to the following contractual loss participation
features:
• no interest in years when P’s performance results in an accounting
loss;

• any such loss suffered by P is allocated against the principal amount

of the instrument on a proportionate basis and is recovered in
subsequent periods if and to the extent that P makes an accounting
profit; and
• any losses absorbed by the instrument at the time of redemption are
not recovered.
 7I.4.180.48 S concludes that the loss participation feature is not a
derivative in the scope of IAS 39, because it considers the dependency
on P’s accounting profits to be a non-financial variable specific to P
(see 7I.2.30.60–80).

7I.4.180.49 P may suffer a loss that is not linked to credit

deterioration. Consequently, the loss participation feature may lead to
S not recovering substantially all of its initial investment in the
instrument due to a reason other than credit deterioration. Therefore,
S cannot classify its investment in the debt instrument as loans and
receivables.

7I.4.180.50 Both originated loans and purchased loans are included in this
category. This ensures, as far as possible, a consistent accounting treatment across
all loan portfolios. Also, because many entities manage purchased loans and
originated loans together, this prevents system problems arising from having to
separate purchased loans from originated loans purely for financial reporting
purposes. [IAS 39.BC28]

7I.4.180.60 In addition, an entity has a free choice to classify any loan or

receivable as available-for-sale on initial recognition.

7I.4.180.70 Reclassifications and sales of loans and receivables are possible

without any of the tainting issues applicable to the held-to-maturity category (see
7I.4.120). However, in our view if financial assets classified as loans and receivables
are subsequently sold within a short period after origination or purchase, then this
may cast doubt on whether other assets classified as loans and receivables are not
held for the purpose of selling in the near term.

7I.4.190 Available-for-sale financial assets

7I.4.190.10 Available-for-sale financial assets are non-derivative financial assets

that are designated as available-for-sale or that are not classified as:
• loans and receivables;
• held-to-maturity investments; or
• financial assets at FVTPL. [IAS 39.9]
7I.4.190.20 A financial asset that the entity intends to hold to maturity, or a loan
and receivable, may also be designated as available-for-sale on initial recognition.
This category normally includes all debt securities quoted in an active market other
than those classified as held-to-maturity and all equity securities that are not
classified as at FVTPL. [IAS 39.9]

7I.4.190.30 Any financial asset that does not fall into any of the three categories in
7I.4.190.10 is classified as available-for-sale.

7I.4.200 Other financial liabilities

7I.4.200.10 Other financial liabilities constitute the residual category similar to
the available-for-sale category of financial assets. All financial liabilities other than
trading liabilities, financial liabilities designated as at FVTPL and derivatives that are
hedging instruments fall automatically into this category. Common examples are an
entity’s trade payables, borrowings and customer deposit accounts.

7I.4.210 RECLASSIFICATION OF FINANCIAL ASSETS

7I.4.210.10 An entity may wish or need to reclassify a financial asset from one
category to another subsequent to its initial recognition. However, reclassifications
are permitted/required only if certain criteria are met and may not be allowed at all
without tainting implications. In our view, a financial asset is required to meet the
definition of the category of a financial asset into which it is proposed to be
reclassified at the time of reclassification in order for the reclassification to be
permissible. [IAS 39.9, 50–54]

7I.4.210.20 The following table summarises the possible reclassifications of

financial assets. The criteria for reclassification and the circumstances under which
reclassification is permitted or required are discussed in further detail below. [IAS
39.9, 50–54]
 TO: FVTPL AVAILABLE- HELD-TO- LOANS AND MEASURED
FOR-SALE MATURITY RECEIVABLES AT COST
FROM:

FVTPL (non-
derivatives
N/A P P P R
held for
trading)

FVTPL
(derivatives or N/A R
designated)

Available-for-
N/A P P R
sale

Held-to-
R N/A
maturity

Loans and
P N/A
receivables

Measured at
R R N/A
cost

P – permitted in certain circumstances

R – required in certain circumstances
– not allowed

7I.4.220 To or from FVTPL category

7I.4.220.10 An entity may not reclassify any financial asset into the FVTPL
category after initial recognition. An entity may not reclassify out of the FVTPL
category any derivative financial asset or any financial asset designated as at FVTPL
on initial recognition. When a financial asset is held for trading, it is included in this
category based on the objective for which it was acquired initially, which was for
trading purposes. Reclassifying such an asset out of this category would generally be
inconsistent with this initial objective. [IAS 39.50(a)–(c)]

7I.4.220.20 However, an entity may be permitted to reclassify a non-derivative

financial asset out of the held-for-trading category if it is no longer held for the
purpose of being sold or repurchased in the near term. There are different criteria for
reclassifications of loans and receivables, and of other qualifying assets.
• If the financial asset would have met the definition of loans and receivables (see
7I.4.180) if it had not been required to be classified as held-for-trading on initial
recognition, then it may be reclassified if the entity has the intention and ability to
hold the financial asset for the foreseeable future or until maturity.
• If the financial asset is not of the type described in the previous bullet, then it may
be reclassified only in rare circumstances (see 7I.4.220.25). [IAS 39.50(c), 50B, 50D]

7I.4.220.25 IAS 39 does not provide a definition of ‘rare circumstances’ but rare
circumstances arise from a single event that is unusual and highly unlikely to recur in
the near term. In our view, it is not a necessary feature of rare circumstances that the
market for an asset has ceased to be active or become highly illiquid. [IAS 39.BC104D]

7I.4.220.30 The reclassification criteria do not refer directly to financial assets

that are classified as held-for-trading because they are or were part of a portfolio of
financial instruments that are managed together and for which there is evidence of a
recent pattern of short-term profit taking. In our view, if a financial asset was
classified as held-for-trading because previously it was managed as part of such a
portfolio but it is no longer managed as part of such a portfolio, then it may be eligible
for reclassification out of trading, provided that at the date of reclassification the
entity did not hold the financial asset for the purpose of selling it in the near term.
However, if the financial asset continues to be managed as part of a portfolio for
which there is evidence of a recent pattern of short-term profit taking, then it is
unlikely that the entity would be able to assert credibly that the asset is no longer
held for the purpose of selling it in the short term. If the entity is not able to
demonstrate this intent, then the financial asset would not be eligible to be
reclassified.

7I.4.220.40 To be eligible for reclassification, the financial asset should meet the
definition of loans and receivables, except for it having been classified as held-for-
trading. In our view, a financial asset would meet this criterion if it would have met
the definition of loans and receivables immediately before, and at the time of,
reclassification, except for it previously having been classified as held-for-trading,
and it is not necessary for the financial asset to have met the definition of loans and
receivables on initial recognition. Furthermore, notwithstanding that the financial
asset meets the definition of loans and receivables at the time of reclassification, it is
not precluded from being reclassified to the available-for-sale category.

7I.4.220.50 Financial assets previously classified as at FVTPL, which are

reclassified out of this category, may contain embedded derivatives. Before the
reclassification, the embedded derivative would not have been accounted for
separately as a derivative because the entire instrument was classified as at FVTPL
(see 7I.2.150.10). If a financial asset is classified out of trading and is no longer
accounted for at FVTPL, then on reclassification an entity assesses whether the
financial asset contains an embedded derivative that requires separate accounting
(see 7I.2.220.50). If an entity is unable to separately measure the fair value of an
embedded derivative that would have to be separated on reclassification out of the
FVTPL category, then reclassification is prohibited and the entire hybrid financial
instrument remains in the FVTPL category. [IAS 39.13]

7I.4.220.60 If an entity reclassifies a financial asset out of the FVTPL category,

then the financial asset is reclassified at its fair value on the date of reclassification
and this fair value becomes the new cost or amortised cost, as applicable. Any gain or
loss previously recognised in profit or loss is not reversed. On the same date, a new
original effective interest rate is calculated based on the expected future cash flows
as at the reclassification date. [IAS 39.50C, 50F]

7I.4.220.70 A reclassification from the held-for-trading category takes effect

prospectively from the date it is made and cannot be applied retrospectively. A
reclassification may not be effected before the date on which the entity has met all of
the criteria for reclassification, including as applicable a change in management
intent and:
• the occurrence of a rare circumstance; or
• meeting the definition of loans and receivables. [IAS 39.50(c), 50B, 50D, 103H]
7I.4.220.80 If an entity reclassifies a financial asset out of the held-for-trading
category on the basis that it is no longer held for the purpose of selling it in the near
term, or that the entity has the intention and ability to hold the asset for the
foreseeable future or until maturity, then there is no automatic consequence of
subsequent sales of such assets similar to the tainting rules for sales of held-to-
maturity assets. However, in our view if reclassified financial assets are sold
subsequently, then this may cast doubt on whether the entity has the intention and
ability to hold those or other reclassified financial assets for the foreseeable future or
until maturity or, more generally, whether other assets are not held for the purpose of
selling in the near term.

7I.4.220.90 Entities within the same group may undertake transactions in

instruments classified in the FVTPL category. From the perspective of the
consolidated financial statements, unless the instruments were financial assets held
for trading and the criteria for reclassification out of the held-for-trading category
were met (see 7I.4.220.20), such instruments may not be reclassified out of the
FVTPL category purely as a result of intra-group transactions even if the instruments
are not classified into this category by the acquiring group entity in its own financial
statements.

EXAMPLE 6 – INTRA-GROUP TRANSACTION

7I.4.220.95 Subsidiary X sells a debt instrument that it designated

on initial recognition as at FVTPL to Subsidiary Y. However, Y classifies
that instrument as available-for-sale. The consolidated financial
statements should continue to reflect that debt instrument as at
FVTPL.

7I.4.220.100 In some circumstances, an entity’s trading desk may be responsible

for the acquisition of financial assets for the investment purposes of other divisions
within the entity. In our view, when the trading desk clearly acts on behalf of the
investing division – such that an investment is acquired and passed directly to that
division – the entity is not precluded from classifying the investment into the
available-for-sale or held-to-maturity category on initial recognition. This applies
even if – for operational reasons only – the investment is recognised initially in the
trading book. However, should the trading desk have an existing portfolio of financial
assets which were classified for accounting purposes as held-for-trading, such assets
would retain their classification even if an investing division of the entity
subsequently acquired some of the assets for its investment purposes, unless the
criteria for reclassification out of the held-for-trading category were met (see
7I.4.220.20).

7I.4.220.110 Movements of derivatives out of or into the FVTPL category when

they become designated and effective hedging instruments in cash flow or net
investment hedges or when they no longer qualify as designated and effective
hedging instruments in such hedges are not ‘reclassifications’.

7I.4.230 From held-to-maturity to available-for-sale

7I.4.230.10 An investment is reclassified from held-to-maturity to available-for-

sale if and when the entity no longer has the positive intent or ability to hold the
investment to maturity. All held-to-maturity investments are required to be
reclassified to the available-for-sale category if there is tainting of the held-to-
maturity portfolio (see 7I.4.120). [IAS 39.51–52]

7I.4.230.20 A reclassification of an instrument out of the held-to-maturity

category will generally trigger the tainting rules (see 7I.4.120). [IAS 39.9, 52]

7I.4.230.30 Adjustments on remeasurement from amortised cost to fair value on

the date of the reclassification are generally recognised in OCI. However, if the
reclassified asset is impaired at the date of the reclassification, then any impairment
loss based on the asset’s fair value – i.e. the difference between its carrying amount
(amortised cost) and its fair value – is recognised in profit or loss. [IAS 39.55(b)]

7I.4.240 From available-for-sale category to measurement at

amortised cost

7I.4.250 From available-for-sale to loans and receivables

7I.4.250.10 A financial asset that is classified as available-for-sale that would have
met the definition of loans and receivables (see 7I.4.180) if it had not been designated
as available-for-sale may be reclassified out of the available-for-sale category to loans
and receivables if the entity has the intention and ability to hold the financial asset for
the foreseeable future or until maturity. In our view, such an asset should meet the
definition of loans and receivables at the date of reclassification to qualify for
reclassification into that category, but it is not necessary for the financial asset to
have met the definition on initial recognition. For a discussion of the consequences of
subsequent sales of such assets, see 7I.4.220.80. [IAS 39.50E]

7I.4.250.20 If an entity reclassifies a financial asset from the available-for-sale

category to loans and receivables, then the financial asset is reclassified at its fair
value on the date of reclassification and this fair value becomes its new cost or
amortised cost, as applicable. Any gain or loss previously recognised in OCI is
accounted for in accordance with 7I.4.260.30. On the same date, a new original
effective interest rate is calculated based on the expected future cash flows as at the
reclassification date. [IAS 39.50F, IU 07-10]

7I.4.250.30 A reclassification from the available-for-sale category to loans and

receivables takes effect prospectively from the date it is made and cannot be applied
retrospectively. A reclassification cannot be effected before the date on which the
entity met all of the criteria for reclassification – i.e. management has the intent and
ability to hold the financial asset for the foreseeable future or until maturity and the
financial asset would have met the definition of loans and receivables. [IAS 39.50E,
103H]

7I.4.250.40 If an available-for-sale asset is impaired, then it may still be

reclassified provided it meets the definition of loans and receivables and the entity
has the intention and ability to hold the asset for the foreseeable future or until
maturity.

7I.4.260 From available-for-sale to held-to-maturity

7I.4.260.10 A reclassification from the available-for-sale category to the held-to-
maturity category is permitted if:
• any tainting period that previously caused a reclassification from the held-to-
maturity category to the available-for-sale category has lapsed; or
• there is a change in intent or ability, provided that no tainting took place during
the current annual reporting period or during the two previous annual reporting
periods. [IAS 39.54]

EXAMPLE 7 – CHANGE IN INTENT

7I.4.260.15 Company Y has a loan portfolio and classifies the

instruments as available-for-sale. Y subsequently decides to document
its investment policy to hold the loan portfolio to maturity. Y concludes
that the act of formalising the investment policy is a change in intent.
Therefore, Y is allowed to reclassify the loan portfolio from available-
for-sale to held-to-maturity if it has an ability to hold it to maturity.

7I.4.260.20 The fair value immediately before the reclassification to the held-to-
maturity category becomes the new amortised cost. [IAS 39.54]

7I.4.260.30 Following reclassification of a financial asset with a fixed maturity,

any gain or loss previously recognised in OCI and the difference between the newly
established amortised cost and the maturity amount are both amortised over the
remaining term of the financial asset under the effective interest method (see
7I.6.240). However, any gain or loss previously recognised in OCI is immediately
reclassified from equity to profit or loss if the asset is subsequently impaired. For a
financial asset with no stated maturity, any gain or loss previously recognised in OCI
is reclassified from equity to profit or loss when the financial asset is disposed of or
impaired. [IAS 39.54]
7I.4.270 To or from financial instruments measured at cost

7I.4.270.10 For certain unquoted equity instruments and derivatives linked to

such instruments (see 7I.6.210), a reclassification to measure a financial instrument
at cost that was measured previously at fair value is required but only in the rare case
that a reliable measure of the fair value is no longer available. The reason for any
such reclassifications is disclosed. [IAS 39.46(c), 54]

7I.4.270.20 If a reliable measure becomes available for a financial instrument for

which a reliable measure was previously not available, and the financial instrument is
required to be measured at fair value if a reliable measure is available, then the
financial instrument is remeasured at fair value. The difference between the carrying
amount and fair value at the date of such remeasurement is recognised in profit or
loss if the financial instrument is classified as held-for-trading or is recognised in OCI
if the financial instrument is classified as available-for-sale. [IAS 39.53]

7I.4.280 From loans and receivables to at FVTPL

7I.4.280.10 Financial assets that would otherwise meet the definition of loans and
receivables are classified as at FVTPL on initial recognition if the intent is to sell such
loans immediately or in the short term, or if they are part of a portfolio of loans for
which there is an actual pattern of short-term profit taking (see 7I.4.30). An entity
may further decide to designate specific loans and receivables into the FVTPL
category on initial recognition. A subsequent reclassification from loans and
receivables to the FVTPL category is prohibited. [IAS 39.9, 50]

7I.4.290 From loans and receivables to available-for-sale

7I.4.290.10 The definition of loans and receivables excludes financial assets that
are quoted in an active market. If a market subsequently becomes active, then in our
view that would generally not permit a reclassification from loans and receivables to
the available-for-sale category unless the market is expected to remain active for the
foreseeable future. [IAS 39.9]

7I.4.300 Internal transfers of financial instruments

7I.4.300.10 Although internal transactions are eliminated on consolidation, an

internal transfer might be an indication that there has been a change in the group’s
intent for holding the portfolios concerned.

7I.4.310 RECLASSIFICATION OF FINANCIAL LIABILITIES

7I.4.310.10 IAS 39 prohibits reclassifications of financial liabilities out of or into

the FVTPL category after initial recognition.

7I.4.320 Loan commitments

7I.4.320.10 Loan commitments measured at FVTPL on the basis that they were so
designated on initial recognition or because they are derivatives may not be
reclassified. However, in our view if the loan commitment is drawn down and a
financial asset representing the advance is recognised, then that financial asset
would be eligible for reclassification if it satisfied all eligibility criteria (see 7I.4.210).
27 OCT 2022 PAGE 2741

Insights into IFRS 18th Edition 2021/22

7I. Financial instruments: IAS 39
7I.5 Recognition and derecognition

7I.5 Recognition and derecognition

7I.5.10 Initial recognition 2744

7I.5.20 Trade and settlement date accounting 2744
7I.5.30 Normal purchases and sales 2746
7I.5.40 Linked transactions 2747
7I.5.50 Agency relationships 2747
7I.5.55 Client assets 2748
7I.5.60 Derecognition of financial assets 2750
7I.5.70 Derecognition criteria 2751
7I.5.80 Determining the financial
asset subject to derecognition 2751
7I.5.90 Evaluating whether contractual rights
to cash flows have expired 2755
7I.5.95 Modification of terms 2755
7I.5.100 Evaluating whether there is a
transfer 2756
7I.5.190 Risks and rewards evaluation 2760
7I.5.240 Control evaluation 2767
7I.5.250 Continuing involvement 2769
7I.5.260 Assessment of derecognition
in separate financial
statements 2770
7I.5.270 Accounting for a sale 2770
7I.5.280 Transfers that qualify for
derecognition 2770
7I.5.290 Transfers that do not qualify
for derecognition 2771
7I.5.315 Accounting for extinguishment of part
of a financial asset 2775
7I.5.320 Securitisations 2776
7I.5.330 Evaluating pass-through criteria:
Structured entity not consolidated 2777
7I.5.340 Evaluating pass-through criteria:
Structured entity consolidated 2778
 7I.5.345 Without material delay 2779
7I.5.350 Revolving transactions 2780
7I.5.355 Continuing involvement 2781
7I.5.360 Repurchase agreements and securities lending 2781
7I.5.370 Derecognition of financial liabilities 2782
7I.5.380 Modification of terms 2783
7I.5.381 Loan transfers 2784
7I.5.382 Unit of assessment 2784
7I.5.385 Quantitative assessment 2787
7I.5.387 Qualitative assessment 2790
7I.5.390 Accounting for substantial
modification of terms 2792
7I.5.400 Accounting for non-
substantial modification of
terms 2793
7I.5.410 Extinguishment of liabilities
with equity instruments 2794
7I.5.420 Amendment of contractual
terms of financial liability
resulting in change in
classification to equity 2798
7I.5.425 Trade payables and reverse factoring 2798
7I.5.430 Derecognition of derivatives 2798
7I.5.440 Novation of derivatives to central
counterparty 2798
7I.5.450 Variation margin payments and receipts 2799
7I.5.500 Changes required by interest rate benchmark
reform 2802

7I.5 Recognition and derecognition

REQUIREMENTS FOR INSURERS THAT APPLY IFRS 4

In July 2014, the International Accounting Standards Board issued IFRS 9 Financial
Instruments, which is effective for annual periods beginning on or after 1 January
2018. However, an insurer may defer the application of IFRS 9 if it meets certain
criteria (see 8.1.180).

This chapter reflects the requirement of IAS 39 Financial Instruments: Recognition

and Measurement and the related standards, excluding any amendments introduced
by IFRS 9. These requirements are relevant to insurers that apply the temporary
exemption from IFRS 9 or the overlay approach to designated financial assets (see
8.1.160) and prepare financial statements for periods beginning on 1 January 2021.
For further discussion, see Introduction to Sections 7 and 7I.
The requirements related to this topic are mainly derived from the following.

STANDARD TITLE

IAS 39 Financial Instruments: Recognition and Measurement

IFRIC 19 Extinguishing Financial Liabilities with Equity

Instruments

The currently effective requirements include newly effective requirements arising

from Interest Rate Benchmark Reform Phase 2 – Amendments to IFRS 9, IAS 39,
IFRS 7, IFRS 4 and IFRS 16, which are effective for annual periods beginning on or
after 1 January 2021. The impact of the requirements is discussed in the following
sections:
• modifications of financial assets and financial liabilities: 7I.5.500, 7I.6.335 and
8.1.170.35;
• hedge accounting: 7I.7.877;
• disclosures about the nature and extent of risks arising from interest rate
benchmark reform and progress in completing the transition to alternative
benchmarks: 7I.8.277;
• transition requirements: 7I.7.882; and
• leases: 5.1.370.30.

FORTHCOMING REQUIREMENTS AND FUTURE DEVELOPMENTS

For this topic, there are no forthcoming requirements or future developments.

7I.5.10 INITIAL RECOGNITION

7I.5.10.10 An instrument is recognised in the statement of financial position

when the entity becomes party to a contract that is a financial instrument. [IAS 39.14]

7I.5.10.20 Situations in which an entity has become a party to the contractual

provisions include committing to a purchase of securities or agreeing to enter into a
derivative. In contrast, planned but not committed future transactions, no matter how
likely, are not financial assets or financial liabilities because they do not represent
situations in which the entity becomes a party to a contract requiring the future
receipt or delivery of assets. For example, an entity’s expected but uncommitted issue
of commercial paper does not qualify as a financial liability. [IAS 39.AG35]

7I.5.10.30 Similarly, if an entity makes an offer to enter into a contract to buy or

sell a financial instrument, then the entity has not become party to a contract
requiring the future receipt or delivery of a financial instrument. In our view, the
entity should not account for such an offer until the counterparty accepts the offer
and the entity becomes a party to a contractual arrangement. [IAS 39.AG35]

7I.5.10.40 If a transfer of a financial asset does not qualify for derecognition,

then the transferee does not recognise the transferred asset as its asset in its
statement of financial position, but derecognises the cash or other consideration paid
and recognises a receivable from the transferor. For further discussion on the
accounting by the transferee in those cases, see 7I.5.305. [IAS 39.AG50]

7I.5.20 Trade and settlement date accounting

7I.5.20.10 Applying the general recognition principle in IAS 39 would result in all
transactions that happen in regulated markets being accounted for on trade date,
which is when an entity becomes party to the contract. However, the standard
recognises that many financial institutions and other entities use settlement date
accounting for financial assets and that it would be cumbersome to account for such
transactions as derivatives between the trade and settlement dates. [IAS 39.14, 38, AG53,
AG55–AG56]

7I.5.20.20 Because of the short time between the trade date and the settlement
date in these types of regulated market situations, such ‘regular-way’ contracts are
not recognised as derivative contracts under IAS 39. [IAS 39.AG12]

7I.5.20.30 The purchase or sale of a non-derivative financial asset that will be

delivered within the timeframe generally established by regulation or convention in
the market concerned – e.g. a regular-way transaction (see 7I.2.70) – may be
recognised either on the date on which the entity commits to the transaction (the
trade date) or on the date on which the instrument is actually transferred (the
settlement date). [IAS 39.AG53, AG55–AG56]

7I.5.20.40 An entity needs to choose a method to be applied consistently to all

purchases and all sales of financial assets that are classified in the same category. [IAS
39.AG53]

7I.5.20.45 A contract that requires or permits net settlement of the change in its
value is not a regular-way contract and therefore trade date or settlement date
accounting is not applied to the contract. Instead, such a contract is accounted for as
a derivative in the period between the trade date and the settlement date (see
7I.1.190.10). [IAS 39.AG54]

7I.5.20.50 There are no specific requirements for trade date or settlement date
accounting for financial liabilities and therefore financial liabilities are recognised on
the date on which the entity becomes a party to the contractual provisions of the
instrument – i.e. the trade date. Such contracts are not generally recognised unless
one of the parties has performed under the agreement or the contract is a derivative
contract not exempt from the scope of IAS 39. [IAS 39.IG.B.32]

7I.5.20.55 The IFRS Interpretations Committee discussed whether the regular-

way exemption (see 7I.5.20.20) applies to short sales of a security. The Committee
noted that requiring entities to account for short positions as derivatives might create
considerable practical problems for their accounting systems and controls with little,
if any, improvement to the quality of the financial information presented. Therefore, a
liability arising from a short trading position is not accounted for as a derivative
because it represents a transaction in a financial asset for which either trade date or
settlement date accounting may be applied in line with the entity’s policy choice. [IU
01-07]

7I.5.20.60 If an entity that buys a financial asset applies settlement date

accounting, then it accounts for changes in the fair value of that asset between the
trade and settlement dates in the same way as it accounts for fair value changes that
happen after recognition of the asset. This is in line with the logic that these changes
in fair value between the trade date and settlement date are attributable to the buyer
rather than the seller because the seller’s right to changes in the fair value ceases on
the trade date (see also 7I.5.20.80). [IAS 39.AG56, IG.D.2.2]

7I.5.20.65 Therefore, if the acquired asset is measured at fair value, then the
buyer recognises changes in the asset’s fair value between the trade date and
settlement date, regardless of whether trade date accounting or settlement date
accounting is applied. Under settlement date accounting, although the underlying
asset is not recognised until settlement date, changes in the fair value of the
underlying asset are recognised. Therefore, the fair value adjustment is shown as a
receivable or payable until settlement date, at which date the receivable or payable
adjusts the amount initially recognised for the asset. This results in the asset being
initially measured at its fair value on the settlement date. Fair value changes between
trade date and settlement date are recognised in profit or loss for financial assets
classified as at FVTPL, or in OCI for financial assets classified as available-for-sale.
[IAS 39.AG55–AG56, IG.D.2.2]

7I.5.20.70 If the item bought is measured at cost or amortised cost, then any
change in the fair value of the asset between trade date and settlement date is not
recognised. [IAS 39.AG56, IG.B.32]

7I.5.20.80 The difference between trade date and settlement date accounting for
a sale of financial assets is in the timing of derecognition of the transferred assets and
of recognition of any profit or loss on disposal. As explained in 7I.5.20.60, the seller’s
right to changes in the fair value of an asset ceases on the trade date. Therefore, if
the instrument is carried at fair value, then the seller stops recognising changes in
value from the trade date regardless of whether trade date accounting or settlement
date accounting is applied. [IAS 39.IG.D.2.2]

7I.5.20.90 If trade date accounting is applied, then the asset is derecognised and
the profit or loss on disposal and a receivable for the sales proceeds are recognised
on the trade date. [IAS 39.AG55]

7I.5.20.100 If settlement date accounting is applied, then the asset continues to

be recognised until settlement date, although no changes in its fair value after the
trade date are recognised. On settlement date, the asset is derecognised and a profit
or loss on the disposal is recognised. The proceeds are the contract amount; the
carrying amount of the asset sold does not reflect gains and losses between the trade
and settlement dates. [IAS 39.AG56, IG.D.2.2]

7I.5.20.103 In our view, the requirements on trade date accounting and

settlement date accounting for regular-way sales do not override the derecognition
principles in IAS 39 related to evaluating risks and rewards of ownership and control
(see 7I.5.190 and 7I.5.240). We believe that if the transferor continues to have an
involvement with the transferred financial asset, then it should consider the risks and
rewards of ownership and, where applicable, control in order to determine whether
derecognition is appropriate.

EXAMPLE 1 – REGULAR-WAY SALE AND SIMULTANEOUS REPURCHASE – APPLYING DERECOGNITION

REQUIREMENTS

7I.5.20.105 On 1 June 2021, Company C agrees to sell 100 shares

in Company X to Company B for a fixed price and delivery in three
days’ time. The delivery of the shares is within the timeframe
established in the marketplace and, accordingly, the sale transaction
meets the definition of a regular-way sale. Simultaneously with the
sale, C enters into a contract with B to repurchase 100 identical shares
in X at a fixed price on 30 September 2021. C’s policy is to apply trade
date accounting to regular-way purchases and sales.

7I.5.20.107 We believe that C should not derecognise the shares on

the trade date. This is because on the date on which C committed to
sell the shares to B, C also entered into an agreement to repurchase
100 identical shares from B at a fixed price at a future date and,
accordingly, retained substantially all of the risks and rewards of
ownership of the shares (see 7I.5.190).

7I.5.20.110 Because trade date accounting and settlement date accounting for
regular-way purchases or sales of financial assets are specific practices that an entity
may apply in preparing and presenting its financial statements and because an entity
has a choice between them, a change from settlement date to trade date accounting
(or vice versa) is a voluntary change in accounting policy (see 2.8.70). [IAS 39.38, 8.5]

7I.5.20.120 A loan commitment is a firm commitment to provide credit under

pre-specified terms and conditions. A loan commitment that is excluded from the
scope of IAS 39 is in our view also excluded from the requirements on trade date and
settlement date accounting. For a discussion of the accounting implications of a loan
commitment, see 7I.1.200 and 7I.6.23. [IAS 39.BC15]

7I.5.30 Normal purchases and sales

7I.5.30.10 ‘Normal purchases and sales’ are contracts for purchases and sales of
non-financial instruments that are entered into and continue to be held for the receipt
or delivery of the non-financial item in accordance with the entity’s expected
purchase, sale or usage requirements. Normal purchases and sales – even if they can
be settled net in cash or another financial instrument or by exchanging financial
instruments – are outside the scope of IAS 39. Therefore, IAS 39 does not impact the
timing of recognition of these contracts. For example, under IFRS 15 an entity does
not recognise a liability for a binding purchase order until it obtains control over the
underlying goods (see 3.8.90), unless the contract is onerous (see 3.12.600). [IAS
37.66, 39.AG35(b)]

7I.5.40 Linked transactions

7I.5.40.10 Generally, the terms of each contract determine the appropriate

accounting and two financial instruments, even if they are entered into
simultaneously, are accounted for separately. However, in our view the following
indicators should be considered in determining whether two financial instruments
should be accounted for as a single combined instrument:
• whether they are entered into at the same time and in contemplation of each
other;
• whether they have the same counterparty;
• whether they relate to the same risk; and
• whether there is an economic need or substantive business purpose for
structuring the transactions separately that could not also have been
accomplished in a single transaction. [IAS 39.IG.B.6]

7I.5.40.15 The IFRS Interpretations Committee discussed the aggregation of

separate transactions as a single derivative and noted that the indicators listed in
7I.5.40.10 may help an entity to determine the substance of the transaction, but that
the presence or absence of any single specific indicator alone may not be conclusive.
[IAS 39.IG.B.6, IU 03-14]

7I.5.40.20 In our view, structuring transactions separately may be regarded as a

substantive business purpose when separate transactions are necessary to achieve a
direct tax benefit. However, if such a tax benefit is derived primarily from an
accounting result – e.g. when the purpose of structuring transactions separately is to
achieve an accounting result that produces a tax advantage – then we believe that the
substantive business purpose requirement is not met. Similarly, if an entity structures
transactions separately to achieve an accounting result that produces a regulatory
advantage, then in our view the substantive business purpose requirement is not met.
[IAS 39.IG.B.6]

7I.5.50 Agency relationships

7I.5.50.10 When an entity enters into what might be described as an ‘agency

relationship’, an analysis is required of whether the entity is acting as an agent or as
a principal in any transaction entered into as a result of that relationship.
Determining whether an entity is acting as a principal or as an agent, and whether as
a result it becomes party to the contractual provisions of one or more financial
instruments that it should recognise requires assessment of the substance of the
contractual arrangements and consideration of all relevant facts and circumstances.
This may require the application of judgement.

7I.5.50.15 The IFRS Interpretations Committee discussed the principal versus

agent accounting for centrally cleared client derivative contracts from the
perspective of the clearing member and noted that:
• an entity first assesses whether the transaction(s) results in a contract (or
contracts) that is (or are) in the scope of IAS 39 and if it does then the entity
applies the requirements of IAS 39; and
• if a transaction is not in the scope of IAS 39 and another standard does not
specifically apply, then an entity applies the hierarchy principles (see 2.8.20) to
determine an appropriate accounting policy. [IAS 8.10–12, IU 06-17]

EXAMPLE 2A – BROKER ACTING FOR CLIENT

7I.5.50.20 Company S operates as a securities and derivatives

broker at a stock exchange. S acts on behalf of one party, entering the
customer’s order (buy or sell) into the stock exchange’s system. The
order will be executed on the stock exchange when/if there is a
corresponding counterparty offer available. All offers at the stock
exchange are given by authorised brokers acting at the exchange. It is
possible that the counterparty of the deal executed at the stock
exchange is the same broker party – i.e. S acting on behalf of another
customer.

7I.5.50.30 The settlement term in the market in which S is the

broker is trade date plus three days. After this term, the broker is
obliged to settle the open deal if the buyer or the seller does not fulfil
its part of the trade. On settlement date, the money will be paid by the
broker acting on behalf of the buyer through the central depository
and the broker acting on behalf of the seller will receive the money
through the central depository. The only party known to the stock
exchange is the broker.

7I.5.50.40 In our view, despite the fact that the broker is acting on
behalf of a client, the broker is entering into two separate transactions:
one with the stock exchange and one with the client. Each transaction
results in a financial instrument and therefore S recognises each one
separately in its statement of financial position, unless net
presentation is required (see 7I.8.90).

7I.5.55 Client assets

7I.5.55.10 As with other agency transactions, an entity may hold financial assets
on behalf of its clients in a fiduciary or similar capacity. These arrangements may
have different forms and may include holding cash, investment securities or financial
instruments that are linked to precious metals. Accounting for these arrangements
may require judgement based on a careful consideration of all facts and
circumstances.

7I.5.55.20 As a first step, an entity has to determine whether, as a result of these

arrangements, it has become party to the contractual provisions of the financial
assets and should recognise those financial assets in its statement of financial
position. This involves considering who is the legal owner of the asset, who is the
beneficial owner, and the resulting rights of the entity and its clients. In performing
the analysis, the entity may refer to the definition of an asset and the guidance on the
concept of ‘control’ in the Conceptual Framework (see 1.2.120). [IAS 32.11, 39.14, CF
4.20, 24]

7I.5.55.30 Generally, an arrangement in which a financial institution holds a

client’s assets in its own name and may freely use the client’s assets for its own
benefit indicates that the financial institution controls the assets and has a
corresponding liability to the client. Conversely, when a financial institution is
required to hold the assets on behalf of the client in a segregated account completely
separate from that of the financial institution itself, with all of the rewards associated
with the assets being for the benefit of the client, the definition of an asset may not be
met from the perspective of the financial institution. The analysis would be similar if
the client account were opened with a custodian in the name of the financial
institution with a clear indication that the assets are held under a trust arrangement
for the client. Intermediate situations may be harder to deal with.

7I.5.55.40 The following factors may be relevant in the analysis:

• whether there are limitations on what the entity can do with the assets and who
decides what the assets can be used for – e.g. whether the assets under
management can be used for the entity’s own purposes;
• who is at risk from the failure of assets – e.g. which party is exposed to the credit
risk associated with financial instruments;
• the legal position in relation to the assets in the event of the insolvency of either
the entity or the client; and
• which party is entitled to the benefit of income from the asset or whether and how
this might be shared between the parties.

7I.5.55.50 If the entity determines that it has become party to the contractual
provisions of the financial asset, then it also needs to consider the following.
• The requirements for pass-through arrangements: A pass-through arrangement,
under which an entity agrees to pay the cash flows from a financial asset to a third
party, is considered to be a transfer of that asset if certain conditions are met (see
7I.5.160). Therefore, although an entity might be required to initially recognise a
financial asset, the derecognition requirements of the standard would require the
financial asset to be immediately derecognised if the entity is deemed to have
transferred the financial asset, along with substantially all of the risks and
rewards of that asset, to its client (see 7I.5.60).
• An exception to the general recognition requirements: If a transfer of a financial
asset does not qualify for derecognition from the perspective of the transferor,
then the transferee does not recognise the transferred asset as its asset in its
statement of financial position. Instead, the transferee derecognises the cash or
other consideration paid and recognises a receivable from the transferor (see
7I.5.305). This may be relevant if a client transfers a non-cash financial asset
directly to the entity for the entity to hold on the client’s behalf. In this case, the
client might not derecognise the financial asset because it retains substantially all
 of the risks and rewards of the financial asset while the entity would not usually
pay any consideration to its client in respect of the transfer. If so, the entity would
not recognise any asset in respect of that particular transfer, even if the
arrangement would otherwise qualify for recognition based on the general
principle in 7I.5.55.20.

EXAMPLE 2B – CLIENT ASSETS – ACCOUNT IN THE NAME OF THE BANK

7I.5.55.60 Bank C holds financial assets on behalf of its customer in

a fiduciary capacity. C places the assets with Company D, a third party
custodian, for safekeeping. The custodial account is opened in C’s
name and there is no segregation of the assets at D’s level. There is a
contract signed between C and D, which describes C as the owner of
the assets with no reference to the customer.

7I.5.55.70 Because the custodial arrangement between C and D

states that C is the owner of the custodial account and all of the risks
and rewards of ownership flow from D to C, C concludes that it will
recognise the position as its own asset.

At the same time, C recognises an obligation to return amounts

equivalent to the value of the assets to the customer.

7I.5.55.80 Further to this conclusion, C considers the following.

• Whether it should derecognise the asset against the liability based
on there being a qualifying pass-through arrangement that meets
all of the conditions in 7I.5.160.10. For example, if C has the right to
sell the assets placed in the custodial account at its own discretion,
then this would not be the case because the condition that the
transferor is prohibited from selling or pledging the original
financial asset under the terms of the pass-through arrangement
would not be met.
• In the limited circumstances in which the customer had directly
transferred non-cash financial assets to C for safe-keeping, C would
not recognise those assets if the customer retained substantially all
of the risks and rewards of the assets based on the guidance in
7I.5.305.10.

7I.5.60 DERECOGNITION OF FINANCIAL ASSETS

7I.5.60.10 IAS 39 contains specific provisions for the derecognition of financial

assets. [IAS 39.15–37]
 Consolidate all subsidiaries (see chapter 2.5)

Determine whether the derecognition principles below are applied

to a part or all of an asset (or group of similar assets)

Yes
Have the rights to the cash flows from the asset expired? Derecognise the asset
No
Has the entity transferred its rights to receive the
cash flows from the asset?
No
Has the entity assumed an obligation to pay the cash flows from No Continue to recognise
Yes
the asset that meets the conditions in paragraph 19 of IAS 39? the asset
Yes
Yes
Has the entity transferred substantially all risks and rewards? Derecognise the asset

No
Yes Continue to recognise
Has the entity retained substantially all risks and rewards?
the asset
No
No
Has the entity retained control of the asset? Derecognise the asset

Yes
Continue to recognise the asset to the extent of the entity’s
continuing involvement

7I.5.60.20 In consolidated financial statements, the derecognition criteria are

applied at a consolidated level. This avoids the unnecessary consideration of
transactions between individual entities in a group, the effect of which is eliminated
on consolidation. Therefore, if financial instruments are transferred within a group,
then the consolidated financial statements will not reflect derecognition for intra-
group transfers, even if those transfers qualify for derecognition in the individual
financial statements of the entity that is the transferor. [IAS 39.15]

7I.5.60.30 Accordingly, when derecognition is assessed at the consolidated level,

the issue of whether the transferring entity (the transferor) consolidates the
receiving entity (the transferee) has a significant impact on the accounting.

EXAMPLE 3 – DERECOGNITION ASSESSMENT IN CONSOLIDATED FINANCIAL STATEMENTS

 7I.5.60.40 Company T transfers financial assets to Structured
Entity SE, which it consolidates. In T’s consolidated financial
statements, the transaction considered in applying the derecognition
requirements is that between the group (including SE) and any
external beneficial holders in SE. [IAS 39.15]

7I.5.60.50 However, if SE were not consolidated by T, then the

transaction considered by T would be the transfer between T and SE.
[IAS 39.15]

7I.5.60.60 The assessment is different if the derecognition

provisions are applied to separate financial statements of T (see
2.1.120). In that case, only the transactions between T and SE are
analysed.

7I.5.70 Derecognition criteria

7I.5.80 Determining the financial asset subject to

derecognition

7I.5.80.10 The derecognition criteria apply to all financial assets and are
therefore used when assessing the derecognition of both debt and equity instruments
issued by another entity. A financial asset or a group of similar financial assets can be
broken down into various parts that can be segregated – e.g. the principal and
interest cash flows of a debt instrument – and potentially transferred separately to
other parties. Consequently, in applying the derecognition provisions the first step is
to determine the financial asset(s) that is (are) subject to possible derecognition. This
could be the following cash flows from a financial asset or a group of similar financial
assets:
• specifically identified;
• fully proportionate share; or
• fully proportionate share of specifically identified cash flows. [IAS 39.16]
7I.5.80.20 If an entity transfers its rights to all of the cash flows of a financial
asset or a group of similar financial assets, then the derecognition provisions apply to
the entire financial asset or group. However, if an entity transfers its rights to only
certain cash flows of a financial asset – e.g. the interest cash flows in a debt
instrument – or to only certain cash flows of a group of similar financial assets, then it
is important to determine the financial asset or assets to which the derecognition
provisions apply. [IAS 39.16]

7I.5.80.30 In the case of a transfer (or expiry – see 7I.5.90) of specifically

identified cash flows arising from a financial asset (or a group of similar financial
assets), the derecognition provisions apply only to those specifically identified cash
flows. For example, if an entity issues an interest-only strip whereby it transfers the
interest cash flows arising from a debt instrument and not the principal cash flows,
then the derecognition provisions apply only to the cash flows arising from interest
payments. [IAS 39.16(a)]

7I.5.80.40 In our view, when rights to some but not all of the cash flows of a
financial asset are transferred, judgement may be required to determine whether the
cash flows transferred are considered specifically identified. We believe that this
judgement should include an assessment of whether the rights to the instalments
transferred contain risks and rewards related to the rights to instalments retained.
[IAS 39.BC53]

7I.5.80.50 In our view, in order to determine whether the cash flows transferred
are specifically identified, the entity should examine the original contract and the
transfer agreement to assess whether the cash flows transferred are in substance
separate cash flows that are distinct from other cash flows in the original contract,
including considering how cash receipts are allocated between the interests of the
transferor and transferee.

7I.5.80.60 In our view, in order to be considered specifically identified, the cash

flows should be identified as substantively separate cash flows in the terms of the
contract between the debtor and the creditor; by contrast, a portion of cash flows that
is not specified in the terms of the financial asset and is created in the transfer
agreement – e.g. for the purpose of providing a credit enhancement or subordination
– does not constitute specifically identified cash flows. For example, if a loan
agreement contains a single repayment of obligation of 100, then the right to the first
60 of repayment is not considered specifically identified because the loan agreement
does not specify this amount of 60 as a separate cash flow. [IAS 39.16(b)]

7I.5.80.70 If loans and receivables are repayable in separate instalments, then an

entity may need to choose an accounting policy, to be applied consistently, for
analysing transfers of rights to instalments (see Example 4A).

EXAMPLE 4A – DERECOGNITION ASSESSMENT FOR SPECIFICALLY IDENTIFIED CASH FLOWS

7I.5.80.80 Bank B has a loan of 100 and the contract requires the
borrower to make repayment in five separate annual instalments of 20
and that each cash flow received, irrespective of when it is received,
will be allocated first to settling the earliest outstanding instalment. B
transfers the right to the first three instalments.

7I.5.80.90 In our view, B may choose either of the following

approaches.
• Approach 1: View each annual instalment as a separately identified
cash flow because it is specified in the contract and the risks and
rewards related to one instalment are unaffected by agreeing to
transfer another instalment.
• Approach 2: View the rights to the first three instalments as a
priority share in the total cash flows and therefore conclude that
 these instalments are not specifically identified.

7I.5.80.100 Under Approach 1, even though the transferred cash

flows are considered specifically identified cash flows, B needs to
consider whether the transfer contract creates a dependency between
the cash flows transferred and the cash flows retained that is not
present in the original contract. This dependency may represent a
credit enhancement that results in some (and possibly substantially all)
of the risks and rewards in the transferred rights being retained by the
transferor (see 7I.5.190). [IAS 39.AG52]

7I.5.80.110 Modifying the example, if the original loan agreement

allocated cash receipts against overdue instalments on a pro rata basis
but the transfer agreement required allocation of cash receipts against
the earliest outstanding instalment, then this would represent a form
of credit enhancement that is considered in the risks and rewards
analysis. [IAS 39.AG52]

7I.5.80.120 An entity applies the derecognition provisions only to a fully

proportionate share if it transfers the following (or if the following are subject to
expiry – see 7I.5.90):
• only a fully proportionate share of the cash flows of a financial asset (or of a group
of similar financial assets); or
• only a fully proportionate share of specifically identified cash flows as described in
7I.5.80.120.

7I.5.80.130 The derecognition provisions do not require there to be only one

counterparty to whom such cash flows are transferred or that each counterparty
obtains a proportionate right to the cash flows being transferred. However, in order
to consider only the part(s) transferred for derecognition as a fully proportionate
share, it is important to ensure that the transferring entity also retains only a fully
proportionate share of the cash flows.

EXAMPLE 4B – DERECOGNITION ASSESSMENT FOR FULLY PROPORTIONATE SHARE OF CASH FLOWS

7I.5.80.140 Company U transfers 80% of the interest cash flows on

an existing investment to various counterparties; each counterparty
takes up a different portion of the 80%, with the interests of some
counterparties subordinated to those of others.

7I.5.80.150 In this example, U still subjects the 80% to a

derecognition assessment because it retains a fully proportionate
share (20%) of the interest cash flows for itself. This is irrespective of
the actual distribution of the 80% among the various counterparties.
[IAS 39.16(a)]
7I.5.80.155 A lender may forgive certain cash flows from a financial asset that is
not credit-impaired. If the forgiveness is only of specifically identified cash flows, or a
fully proportionate (pro rata) share of cash flows, or a fully proportionate (pro rata)
share of specifically identified cash flows, and there are no other changes to the
contractual terms of the financial asset, then the lender applies derecognition
requirements to the forgiven cash flows only. This results in derecognition of these
cash flows because the forgiven cash flows have expired. For further discussion, see
7I.5.315 [IAS 39.16(b)]

7I.5.80.160 Except as described in 7I.5.80.30–150, the derecognition assessment

applies to a financial asset (or to a group of similar financial assets) in its entirety. For
example, if an entity transfers the rights to the first or last 80 percent of cash receipts
on a debt instrument, or 80 percent of the cash collections on a group of similar
receivables but provides a guarantee to compensate the buyer for any credit losses
up to 9 percent of the principal amount of the receivables, then the derecognition
assessment is applied to the financial asset, or to the group of similar financial assets
respectively, in its entirety and not only to the part that the entity has transferred.
This is because the entity has not transferred a fully proportionate share of the cash
flows, but rather a portion of the cash flows. [IAS 39.16(b)]

7I.5.80.170 IAS 39 indicates that the derecognition assessment may be applied

either to an individual financial asset or to a portfolio of similar financial assets.
However, the standard does not specify the circumstances in which a portfolio
assessment is appropriate. [IAS 39.16]

7I.5.80.180 In our view, if in a transfer there are contractual terms that have an
effect on the risks and rewards of a group of financial assets, then the group of
financial assets rather than each individual financial asset should be assessed for
derecognition. Generally, the existence of such contractual terms is evidence that the
financial assets are similar and share similar risks and rewards. For example, a
financial guarantee issued by the transferor covering a percentage of credit losses in
a portfolio of financial assets links the risks and rewards associated with the
individual financial assets in that portfolio. Consequently, the financial asset that is
considered is the group rather than individual financial assets. However, the financial
guarantee itself is not considered to be part of the group that is transferred. Such a
situation is often encountered in securitisations for which credit enhancement is
provided by the transferor over a portfolio of financial assets in the form of financial
guarantees, subordinated loans and reserve funds.

7I.5.80.190 In our view, it is not appropriate to consider a group of debt and

equity instruments as a group of similar financial assets.

EXAMPLE 4C – DERECOGNITION ASSESSMENT FOR TRANSFER OF PART OF A PORTFOLIO OF

SIMILAR LOANS

7I.5.80.193 Company B wishes to securitise a portfolio of similar

loans. In the jurisdiction where B operates, there is a legal
requirement for the transferor to retain a random selection of 5% of
 the total nominal value of loans that could otherwise have been
securitised. Accordingly, B randomly selects a number of specific loans
that constitute 5% of the nominal value of the portfolio and enters into
an agreement with Company C, a third party, to securitise the other
specified loans in the portfolio. B transfers to C the legal title to these
latter loans with a nominal value of 95% of the total nominal value of
the portfolio and retains the legal title to and the risk and rewards of
ownership of the randomly selected loans with a nominal value of 5%
of the total nominal value of the portfolio. The loans retained do not
provide credit enhancement for the loans transferred and there is no
other contractual link between the cash flows of the loans transferred
and the loans retained in the securitisation agreement.

7I.5.80.195 B applies the derecognition analysis to the specified

loans transferred. This is because only those loans have been
transferred and there is no contractual link between the cash flows of
the loans transferred and the loans retained in the securitisation
agreement.

7I.5.80.200 All subsequent references to ‘the financial asset’ in this section

(derecognition) refer to a financial asset, a part of a financial asset, a portfolio of
financial assets or a part of a portfolio of financial assets, determined in accordance
with 7I.5.80.

7I.5.90 Evaluating whether contractual rights to cash flows

have expired

7I.5.90.10 When the contractual rights to cash flows from the asset have expired,
that asset is derecognised and no further analysis is required. [IAS 39.17]

7I.5.95 Modification of terms

7I.5.95.10 A financial asset may be modified or replaced as part of a transaction
with the same counterparty. For example, when a borrower is in financial difficulties,
the borrower and its creditors may negotiate a restructuring of some or all of the
borrower’s obligations to allow the borrower sufficient capacity to service the debt or
refinance the contract, either entirely or partially. Such circumstances are often
referred to as ‘forbearance’. Examples of forbearance practices include reducing
interest rates, delaying the payment of principal and amending covenants. If a
financial asset is modified as part of forbearance, then it may be more challenging to
conclude that the original financial asset should be derecognised in its entirety. This
is because in such a case the objective and nature of the modification is usually to
maximise recovery of the original contractual cash flows rather than to originate a
new asset on market terms.

7I.5.95.20 In our view, the holder of the financial asset should perform a
quantitative and qualitative evaluation of whether the cash flows of the original
financial asset and the modified or replacement financial asset are substantially
different. If the cash flows are substantially different, then we believe that the
contractual rights to cash flows from the original financial asset should be deemed to
have expired. In our view, in making this evaluation, an entity may analogise to the
guidance on the derecognition of financial liabilities (see 7I.5.370).

7I.5.95.30 If the terms of a financial asset carried at amortised cost are

renegotiated or otherwise modified because of financial difficulties of the borrower or
issuer, then any impairment is measured using the effective interest rate of the
financial asset before the modification of terms. In other words, even if the asset is
derecognised, an impairment assessment is made and an impairment loss is
recognised if necessary, before derecognising the asset. In our view, this requirement
to assess impairment applies irrespective of whether the modification of the existing
asset leads to its derecognition. For a discussion of how to measure impairment in
such a case, see 7I.6.490.30–50. For a discussion on the interaction between
forbearance activities and impairment, see 7I.6.490. [IAS 39.17, AG84]

7I.5.95.40 In some cases, a new law may be enacted that either imposes an
automatic change in the contractual cash flows of a financial asset (e.g. an automatic
payment holiday) or gives borrowers an option to require such a change. In this case,
the lender has to evaluate whether the contractual terms of a financial asset subject
to the law are effectively changed when the law is enacted. If the lender concludes
that the contractual terms of the financial asset are effectively changed at that time,
then the lender performs an analysis of whether the change represents
extinguishment of part of the financial asset (see 7I.5.80.155 and 7I.5.315) or a
modification of the financial asset.

7I.5.95.50 For discussion of modifications of terms required by IBOR reform, see

7I.5.500.

7I.5.100 Evaluating whether there is a transfer

7I.5.100.10 A financial asset qualifies for derecognition under IAS 39, either if the
contractual rights to the cash flows from that financial asset expire or if an entity
transfers a financial asset in a transfer that meets the criteria for derecognition
specified in the standard. An entity transfers a financial asset if, and only if, it
transfers the contractual rights to receive the cash flows of the financial asset (see
7I.5.110) or it enters into a qualifying pass-through arrangement (see 7I.5.160). [IAS
39.17–18]

7I.5.110 Transfer of contractual rights

7I.5.110.10 In our view, to be considered a transfer of the contractual rights to
receive the cash flows of the financial asset, the transfer of legal title should result in
a transfer of all existing rights associated with the financial asset without any
additional restrictions being imposed as a result of the transfer. A right to demand
payment or to obtain legal title that is conditional on the transferor defaulting under
a servicing agreement does not constitute a transfer of contractual rights. In this
case, whether there is a transfer is evaluated using the pass-through requirements
(see 7I.5.160). [IAS 39.18]

7I.5.110.20 A transferor may continue to administer or provide servicing for

assets that it has previously transferred to another entity. For example, a transferor
may transfer all rights to receivables but then continue to collect the cash flows of
those receivables as a servicer in the capacity of an agent of the transferee. The IFRS
Interpretations Committee discussed a related issue and noted that the
determination of whether the contractual rights to cash flows have been transferred
is not affected by the transferor retaining the role of agent to collect the cash flows of
the receivables in this case. Therefore, retention of the servicing rights by the entity
transferring the financial asset does not in itself cause the transfer to fail the
requirements of paragraph 18(a) of IAS 39. [IU 11-05]

7I.5.110.30 However, depending on the legal environment in which an entity

operates and the contractually agreed terms, there may be circumstances in which it
is not clear whether the contractual rights to receive the cash flows of the financial
asset have been transferred. For example, the beneficial interests in a receivable
could be sold without legal title to the financial asset being transferred; the seller
avoids having to notify the debtor of the sale, thereby retaining its relationship with
the debtor, and the debtor continues to make payments directly to the seller. In the
event of breach, the buyer has the right to ‘perfect’ the sale by acquiring legal title to
the receivables. In such circumstances, whether a transfer has taken place is a
question of fact, viewed together with the legal environment in which the entity
operates, and requires the use of judgement.

7I.5.110.40 In our view, for a transfer of contractual rights to take place, the
transferee should have an unconditional right to demand payment from the original
debtor in the case of default by the original debtor (see 7I.5.110.10). A right that is
conditional on the transferor failing to pass on payments under a servicing contract is
not enough. Consequently, in the example in 7I.5.110.30, the fact that the buyer is
able to perfect a sale only in the event of default means that there is no transfer of
contractual rights. Therefore, the transaction would need to be assessed under the
pass-through requirements (see 7I.5.160).

7I.5.110.50 In addition, because of the transfer requirements discussed in

7I.5.110.10–40, we believe that it is not possible to achieve derecognition of a
financial asset by synthetic means.

EXAMPLE 5 – SYNTHETIC STRUCTURE THROUGH WHICH CONTRACTUAL RIGHTS ARE NOT

TRANSFERRED

7I.5.110.60 Bank B has a portfolio of customer loans, which yield

various fixed rate returns. B enters into a synthetic securitisation
structure, comprising the following underlying transactions.

7I.5.120 Credit default swap

7I.5.120.10 B enters into a CDS with Limited-purpose Vehicle L,
under which it transfers to L the default risk on a referenced portfolio
of loans (originated customer loans) in exchange for a fixed premium.

7I.5.130 Deposit

7I.5.130.10 L provides a cash deposit to B equal to the principal

amount of the reference portfolio of loans, which serves as cash
collateral against L’s obligation under the CDS. B pays interest at IBOR
on the deposit.

7I.5.130.20 The combination of the CDS premium and IBOR interest

on the deposit effectively provides L with a return equal to that earned
by B on the referenced financial assets.

7I.5.140 Notes

7I.5.140.10 L issues credit-linked notes to external parties to fund

its ability to take exposure to credit risk in the referenced financial
assets. These notes pay interest at IBOR plus a fixed margin, which is
the margin earned by L on the written CDS less any amount needed by
L to cover its operating costs. The principal on the notes equals the
notional amount on the CDS and the deposit with B, which in turn is
equal to the principal amount of the referenced financial assets. Any
defaults on the referenced financial assets result in an equivalent
reduction in the principal of the notes and the deposit with B.

Customer External
loans parties

Notes
Deposit IBOR + margin
at IBOR
Limited­purpose
Bank B
Vehicle L
CDS
7I.5.150 Analysis

7I.5.150.10 Assuming that L is consolidated by B (see chapter 2.5),

the transaction subject to the derecognition assessment in the B’s
consolidated financial statements is the one that takes place between L
and the credit-linked note holders.
 7I.5.150.20 Although the cash flows in the structure – related to the
CDS, deposit and notes – are determined based on the portfolio of
referenced financial assets, we believe that the combined effect of
these three instruments is not enough to conclude that the
consolidated entity has transferred the referenced financial assets to
the note holders. This is because the entity has not transferred the
contractual cash flows arising from the referenced assets. [IAS 39.17–18]

7I.5.160 Pass-through arrangements

7I.5.160.10 If an entity retains the contractual right to the cash flows of a financial
asset, but also assumes a contractual obligation to pay the cash flows to the
transferee (sometimes called a ‘pass-through arrangement’), then the transaction is
considered a transfer if and only if:
• the entity has no obligation to pay amounts to the transferee unless the entity
collects equivalent amounts from the original financial asset;
• the entity is prohibited from selling or pledging the original financial asset under
the terms of the pass-through arrangement; and
• the entity is obliged to remit all of the cash flows that it collects without material
delay. [IAS 39.19]

EXAMPLE 6 – QUALIFYING PASS-THROUGH ARRANGEMENT

7I.5.160.20 Company N enters into an agreement with Company B in

respect of a debt security that it owns.
• Physical custody of and legal title to the security are retained by N,
but N agrees to pass any cash flows generated by the security to B
immediately.
• There is no obligation for N to pay any amount to B other than the
cash that it receives on the security – i.e. neither the principal nor
any interest in the case of late payment.
• The agreement prohibits N from selling or pledging the security.

Cash flows
Company N Company B

Legal Cash
ownership flows

Security
 7I.5.160.30 In this example, the transaction qualifies as a transfer
because it meets the pass-through criteria (see 7I.5.160.10). The next
step is for N to evaluate whether it has transferred or retained the
risks and rewards of ownership (see 7I.5.190).

7I.5.160.40 Some transfer agreements include a general right of either party

(transferor or transferee) to set off amounts payable by the transferor under the pass-
through obligation against other amounts from other contracts owed by the
transferee to the transferor. As a result, the transferor might not physically pay to the
transferee any or all of the cash collected from the transferred assets, but instead set
off the amount of cash collected against other amounts due from the transferee and
pay to (or receive from) the transferee only the net amount.

7I.5.160.50 If the ‘other amounts’ and ‘other contracts’ are not a reinvestment of
cash flows collected from the financial assets on behalf of the transferee (see
7I.5.350) and are not otherwise connected with the pass-through arrangement, then
in our view a right to set off should not impact the pass-through analysis. This is
because the transferor settles its obligation to remit the cash flows to the transferee
by setting it off against a right to receive cash from the transferee under another
contract. The manner of settlement does not negate the fact that the transferor has
satisfied its obligation to pass amounts due to the transferee.

7I.5.170 Pass-through arrangements involving structured entities

7I.5.170.10 A typical situation in which a pass-through arrangement may exist is

in a securitisation involving structured entities. For a further discussion of practical
issues, see 7I.5.320. [IAS 39.AG37]

7I.5.180 Pass-through arrangements involving total return swaps on

equity instruments

7I.5.180.10 A holder of an equity instrument issued by another entity may enter

into a total return swap under which the holder remits all of the cash flows – i.e.
dividends – from the equity instrument and receives a stream of fixed or floating rate
cash flows. If the terms of the total return swap or any other arrangements that are
part of the transfer require the equity instrument to be transferred at the expiry of
the total return swap, then in our view such a transfer may meet the pass-through
requirements in IAS 39.

EXAMPLE 7 – TOTAL RETURN SWAP ON EQUITY INVESTMENT

7I.5.180.13 On 1 July 2020, Company S enters into a forward

contract to sell an equity instrument issued by another entity to
Company T, with physical delivery to T on 30 June 2021.

7I.5.180.15 On the same date, S and T enter into a total return swap
that expires on 30 June 2021, under which S remits all of the cash flows
 – i.e. dividends – from that equity instrument without material delay
and receives a stream of floating rate cash flows. Under the terms of
the arrangement, S cannot pledge or sell the equity instrument and has
no obligation to pay any dividends to T unless it receives an equivalent
amount as dividends from the equity instrument.

Forward sale of equity instrument

Cash flows from instrument

Company S Company T
Floating rate cash flows

7I.5.180.17 S concludes that the transaction meets the pass-through

conditions. The next step is for S to evaluate whether it has transferred
or retained the risks and rewards of ownership (see 7I.5.190).

7I.5.180.20 Conversely, if a total return swap or the transfer arrangement does

not require the equity instrument to be transferred at expiry but requires only the
transfer of all dividends during the period of the total return swap, then in our view
the holder of the equity instrument has transferred a dividend strip only until the
expiry of the total return swap. Because the dividend strip constitutes separately
identifiable cash flows, it can be considered separately for derecognition. In our view,
the dividend strip, until the expiry of the total return swap, meets the pass-through
conditions if:
• the entity cannot separately pledge or sell the dividend strip arising from the
equity instrument;
• the entity has no obligation to pay any dividends under the arrangement unless it
receives an equivalent amount from the equity instrument; and
• the agreement provides for remittance of the cash flows without any material
delay.

7I.5.180.30 Consequently, assuming that the entity has transferred substantially

all of the risks and rewards (see 7I.5.190), the dividend strip until expiry of the total
return swap should be derecognised and the remaining part of the equity instrument
should continue to be recognised.

7I.5.190 Risks and rewards evaluation

7I.5.190.10 For all transactions that meet the transfer requirements, the entity
next evaluates whether it has transferred or retained the risks and rewards of
ownership of the financial asset. An entity derecognises a transferred financial asset
if it has transferred substantially all of the risks and rewards of ownership of that
asset. Conversely, it continues to recognise a transferred financial asset if it has
retained substantially all of the risks and rewards of ownership of that asset.
However, if an entity has neither transferred nor retained substantially all of the risks
and rewards of ownership of a transferred asset, then it determines whether it has
retained control of that asset to assess whether derecognition is appropriate (see
7I.5.240). [IAS 39.20]

7I.5.190.20 The risks and rewards analysis is performed by comparing the entity’s
exposure, before and after the transfer, to the variability in the present value of the
future net cash flows from the financial asset. This evaluation can be done either
separately for each type of risk that the financial asset is exposed to or for all of the
risks arising from the financial asset. Therefore, for each type of risk or for all of the
risks transferred and retained, an entity determines its exposure to the variability in
the amounts and timing of the net cash flows of the transferred asset arising from
that type of risk or from all of the risks. Even if individual risk types are considered
separately, the evaluation of whether an entity has transferred or retained
substantially all of the risks and rewards is based on the aggregate exposure arising
from all risk types. [IAS 39.21–22]

7I.5.190.23 In some cases, the transfer of the risks and rewards of ownership of
an asset does not occur at the same time as the transfer of the rights to receive the
cash flows, but instead will happen at a later date.

EXAMPLE 8A – TRANSFER OF RISKS AND REWARDS AT A LATER DATE

7I.5.190.24 Company Z sells shares it owns in Company X to

Company B as follows.
• On 1 June 2021, Z agrees to sell 50 shares for initial cash
consideration of 5,000, which is the fair value of the shares on that
date, for settlement on 4 June 2021.
• The sale is a legal transfer.
• The contractual terms of the sale state that Z will pay any decrease
or receive any increase in the value of the shares between the initial
price of 5,000 and the closing market price on 15 June 2021.
• X’s shares are listed on a stock exchange. No dividend can be
declared or paid by X between 1 June and 15 June 2021.

7I.5.190.25 Z remains exposed to substantially all the risks and

rewards of ownership of X’s shares between 1 June and 15 June 2021
as a result of the price adjustment feature included in the contractual
terms of the sale. Accordingly, Z derecognises the shares on 15 June
2021 when the risks and rewards of ownership of the shares transfer to
B.

7I.5.190.26 An entity may transfer a financial asset under a contractual

arrangement that provides for the risks and rewards of ownership of the asset to
transfer gradually over time. In our view, in these cases the entity should develop an
accounting policy, to be applied consistently, to derecognise the transferred financial
asset based on its judgement about the timing of transfer of the risks and rewards of
ownership. We believe that under such a policy, the latest point in time when the
asset should be derecognised is when the entity’s involvement with the transferred
asset comes to an end (i.e. it expires or is extinguished) and, accordingly, the entity is
no longer exposed to any of the risks and rewards associated with ownership of the
transferred asset.

7I.5.190.27 If an entity determines that it has transferred substantially all of the

risks and rewards of ownership of the transferred asset, then it does not recognise
the asset again in a future period, unless it enters into a new transaction to reacquire
the asset.

7I.5.190.30 In our view, if a financial asset is transferred and does not qualify for
derecognition under the risks and rewards evaluation, and the transferor enters into
subsequent transactions that affect the allocation of risks and rewards between the
transferor and the transferee(s), then the transferor should reperform the risks and
rewards assessment on a cumulative basis.

EXAMPLE 8B – RISKS AND REWARDS EVALUATION ON A CUMULATIVE BASIS

7I.5.190.35 Company M enters into two separate transactions.

• It transfers financial assets to unconsolidated Structured Entity SE.
The consideration for the transfer includes a note that represents
an interest in the transferred assets.
• Subsequently, M sells the note unconditionally to an unrelated third
party (Company X) and retains no further involvement with the
transferred financial assets or SE.

Transfer of financial assets

Structured
Company M
Entity SE
Consideration, including note
Sale of
note

Company X

7I.5.190.40 M evaluates the risks and rewards of its interests in the

financial assets on a cumulative basis as follows.
• At the date of the transaction with SE, M concludes that it has
retained substantially all of the risks and rewards of ownership of
the transferred assets because it obtains the note that represents an
 interest in the transferred assets (see 7I.5.230). Accordingly, M
does not derecognise the transferred financial assets at this time.
• At the date of the transaction with X, M considers the subsequent
sale and concludes that it has transferred substantially all of the
risks and rewards of ownership of the financial assets and
derecognises them.

7I.5.200 Risk types

7I.5.200.10 Different types of risk can be briefly summarised as follows.
• Price risk, which is an inherent risk in equity instruments.
• Risks inherent in debt instruments:
– credit risk, also called ‘risk of default’;
– interest rate risk, comprising fair value interest rate risk and cash flow interest
rate risk;
– prepayment risk – i.e. the risk that the principal is repaid earlier than expected;
and
– late-payment risk – i.e. the risk that payments received from the underlying
financial assets are made later than expected, sometimes called ‘slow-payment
risk’.
• Risks inherent in both equity and debt instruments:
– currency risk; and
– other risks – this category covers any risks that may exist in practice in a
particular fact pattern that is not explicitly covered by the above risk
categories: e.g. dispute and legal risks (see 7I.5.210), and structural and other
liquidity risks (see 7I.5.220).

7I.5.210 Dispute and legal risks

7I.5.210.10 ‘Dispute risk’ (also known as ‘warranty’ or ‘dilution risk’) is the risk of
a dispute over a financial asset – e.g. a receivable – because of a claim from the
customer that the quality of goods delivered or services performed varied from what
was agreed contractually. The risk is that the debtor may not be legally obliged to pay
the stated amount of the receivable. Consequently, the originator may have sold a
financial asset that does not legally exist or that does not exist to the extent of its
stated amount.

7I.5.210.20 Typically, the transferee will not accept liability for any such dispute
risk – i.e. the transferor remains liable for any deductions arising from disputes and
has to reimburse the transferee for losses incurred or the transferee has a right to put
the disputed financial asset(s) back to the transferor. Because there is no (legally
existing) financial asset, there is no risk that could be transferred unless the
transferee accepts this risk without the possibility of recourse; in our experience, the
chance of this is remote.

7I.5.210.30 In our view, dispute risk should not be included in the risks and
rewards analysis, because it relates to the existence of a financial asset rather than to
the risks and rewards inherent in an existing financial asset.

7I.5.210.40 Similar considerations apply to other legal risks – i.e. we believe that
they should not normally be included in the risks and rewards analysis because they
relate to the existence of a financial asset rather than to the risks and rewards
inherent in a financial asset. In addition, the transferee will not usually accept these
risks without a right of recourse.

7I.5.220 Structural and other liquidity risks

7I.5.220.10 Structural liquidity risk arises primarily in securitisations when there
is a mismatch between the cash inflows from financial assets and cash outflows on
financial liabilities. It is important to differentiate structural liquidity risk from late-
payment and default risk. For example, in a securitisation structural liquidity risk
may arise because of variability in the timing of defaults on the assets whereby the
structured entity that has issued securities to investors does not have enough cash to
meet its obligations. This variability can arise without altering the cumulative
expectation of defaults on the portfolio. In our view, this risk is not inherent in the
financial asset transferred, but arises as a result of the structure of the transaction.
Consequently, we believe that this risk should not be included in the risks and
rewards analysis.

7I.5.220.20 In certain structures, a transferor also provides a liquidity facility to

the most senior debt component in the structure. In these circumstances, the
provision of the liquidity facility does not generally impact the analysis of risks and
rewards for derecognition purposes. However, if such a facility does not represent
the most senior debt component in the structure, then it is possible that the
transferor is absorbing credit risk through the provision of the facility. In these
circumstances, the granting of such a liquidity facility will have an impact on the risks
and rewards analysis because it makes the transferor absorb credit risk.
Consequently, the terms of any liquidity facility need careful evaluation to determine
whether it plays a part in the risks-and-rewards analysis.

7I.5.230 Substantially all risks and rewards

7I.5.230.10 No specific quantitative guidance is provided on what constitutes

‘substantially all’ of the risks and rewards of a financial asset. In our view, the
analysis should be based on all of the facts and circumstances, considering all of the
risks (except for dispute and legal risks) associated with the financial asset on a
probability-weighted basis. If substantially all of the total variability in the present
value of the future cash flows associated with the financial asset is retained, then we
believe that the entity would be considered to have retained substantially all of the
risks and rewards. [IAS 39.21]

7I.5.230.20 Assessing whether and to what extent exposure to variability in the

present value of cash flows has been retained requires consideration of all relevant
facts and circumstances.
7I.5.230.30 If the transferee is a limited-purpose vehicle, then the consideration
for the transfer often includes securities issued by, or other interests in, the limited-
purpose vehicle. Usually, the limited-purpose vehicle is established for the purpose of
holding similar transferred assets and paying the cash flows from such assets to the
various interest holders in the limited-purpose vehicle in line with the terms of those
interests and its governing arrangements. Accordingly, these interests represent a
repackaging of some or all of the cash flows of the transferred assets.

7I.5.230.40 The transferor may already have a pre-existing interest in the limited-
purpose vehicle, such as subordinated debt or an equity-like interest, and this pre-
existing interest may also represent an exposure to variability in the cash flows of
newly transferred assets that is relevant to the analysis.

7I.5.230.50 In other cases, the assets may be transferred to a substantive

operating entity that carries on its own business activities and that holds many assets
in addition to the financial assets transferred to it by the transferor. In our view, in
these cases the analysis should focus on comparing the variability of the cash flows of
the transferred assets with the variability of the cash flows of the instruments
received as consideration for the transfer. This assessment should include
consideration of any agreements such as a guarantee or put or call options related to
the transferred assets and need not consider ordinary equity interests that the
transferor already held in the transferee.

EXAMPLE 9 – UNCONDITIONAL SALE OF FINANCIAL ASSETS TO OPERATING SUBSIDIARY

7I.5.230.60 A parent company enters into an unconditional sale of

financial assets to a wholly owned subsidiary that carries on banking
operations. We do not believe that derecognition of the assets in the
separate financial statements of the parent is precluded merely as a
result of its 100% ownership interest in the transferee (see
7I.5.230.50).

7I.5.230.70 If financial assets are transferred to a substantive operating entity in

exchange for new equity interests in the transferee, then the transferor evaluates the
nature of the variability to which those new interests expose it. If the transferee has
substantive other operations, then the variability in discretionary dividends and
changes in fair value arising from the new equity interests would usually be
significantly different from an exposure to the transferred assets. In some cases, this
may require consideration of the transferee’s future plans – e.g. if the transferee is a
start-up company. The smaller the transferred assets are in relation to the total
operations of the substantive operating entity and the smaller the new equity
interests are in relation to the total ownership interests in the substantive operating
entity, the more likely it is that substantially all of the risks and rewards of ownership
may be considered to have been transferred.

EXAMPLE 10 – EXCHANGE OF FINANCIAL ASSETS WITH SIGNIFICANTLY DIFFERENT CASH FLOWS

 7I.5.230.80 Company X holds an equity investment in Company W, an
unquoted company, which has been classified as available-for-sale. W’s
parent company is listed. X has agreed to exchange its shares in W for
shares in W’s parent. W is merged into its parent and X receives new
shares in the merged entity.

Before After

W’s parent
W’s parent
and
Company W
(merged)
Company W

Investment Investment

Company X Company X

7I.5.230.85 X no longer owns the shares in W. Instead, X has

received new shares in the parent as consideration. In our view, the
derecognition criteria are met in this example because, subsequent to
the transfer, the equity instruments received by X have cash flows that
are significantly different from the cash flows of the original equity
instrument – i.e. X has received new financial assets and not the
existing assets only with a repackaging. Consequently, X should
derecognise the original assets (equity investment in W) and recognise
the new financial assets (equity investment in the merged entity) at fair
value.

7I.5.230.90 In our view, the fact that a transferor may have a reimbursement right
from another entity – e.g. an insurance company – and thereby economically hedges
its risk exposure arising from the transferred financial assets, is irrelevant in an
analysis of risks and rewards. Only the risks and rewards between the transferor and
the transferee are included in the analysis. Therefore, the analysis of risks and
rewards does not consider whether and how the transferor has entered into other
contracts with third parties that reimburse the transferor for losses incurred in
connection with the transferred assets.

7I.5.230.100 In our view, it is not generally necessary to use cash flow and/or
similar models in performing a risks and rewards analysis. In most cases, evaluating
the terms and conditions of the transaction should be enough to determine whether,
and to what extent, an entity’s exposure to variability in the amounts and timing of
the net cash flows has changed as a result of the transfer.

7I.5.230.110 However, under certain circumstances a degree of statistical

analysis might be required. For example, in transactions in which the transferor and
the transferee share the exposure to the variability in cash flows arising from credit
risk, it might be difficult to determine whether substantially all of the risks and
rewards have been transferred.

7I.5.230.120 Example 11 illustrates how in such circumstances an analysis of the

transfer of risks and rewards might be performed.

EXAMPLE 11 – RISKS AND REWARDS ASSESSMENT BASED ON STATISTICAL ANALYSIS

7I.5.230.130 Company R transfers short-term receivables of 100 to

Company S for 95. There is no significant risk other than credit risk
inherent in the receivables and the default rates are as follows:

• expected credit losses are 5% of the notional amount; and

• the likely range of losses is between 4.5% and 6.5% of the notional
amount, with a 99.9% confidence interval.

7I.5.230.140 R provides a guarantee to reimburse S for losses

exceeding 6.5%. The risk is that actual credit losses may exceed the
expected credit losses of 5%. The rewards, which remain with S, are
that actual credit losses may be less than the expected credit losses of
5%.

Guarantee of losses >6.5%

Receivables of 100
Company R Company S
Consideration of 95
7I.5.230.145 R concludes that it has transferred substantially all of
the risks and rewards associated with the receivables, because R is not
exposed to the variability in cash flows within the range of reasonably
possible outcomes.
7I.5.230.147 In evaluating risks and rewards it is important that the entity not
only transfers substantial rewards but also that it transfers its exposure to a
significant loss arising from a substantial risk. A risk of loss could be considered
‘significant’, for example, if it is based on historical loss experience for the type of
financial asset transferred. For example, if a transfer of credit risk, which is generally
considered to be a substantial risk of the financial assets transferred, will happen
only in a catastrophe or similar situation because historical losses are covered
through a guarantee by the transferor, then this is considered to be outside the range
of likely loss outcomes. This would not be considered a transfer of a significant
exposure to loss from credit risk.

7I.5.230.150 In some cases, it is possible that a third party instead of the

transferor provides credit enhancement. In our view, if the transferor is the
beneficiary of the credit enhancement contract, but agrees to compensate the
transferee for credit losses, then this is an indication that the transferor has retained
the credit risk. In this case, the credit enhancement contract should be disregarded
in evaluating whether the financial assets qualify for derecognition and it should be
assumed that the transferor continues to bear the credit risk. To transfer the credit
risk inherent in the financial assets, in our view the transferee needs to be the
beneficiary under the credit enhancement contract and not the transferor.

7I.5.230.155 If the transferor assigns the benefit of a financial guarantee contract

to the transferee as beneficiary, and the financial guarantee is not in the scope of IAS
39 from the holder’s perspective, then in our view it is appropriate for the transferor
to apply by analogy the derecognition criteria for financial assets to any prepayment
asset relating to the financial guarantee (see 7I.1.80.10). [IAS 8.10–11]

7I.5.230.160 For financial assets with relatively short maturities, such as most
trade receivables, the only substantial risk is generally credit risk. Accordingly, if an
entity sells short-term receivables and guarantees to compensate the transferee for
credit losses that are likely to occur, then it has retained substantially all of the risks
and rewards of ownership. [IAS 39.AG40(e)]

7I.5.240 Control evaluation

7I.5.240.10 If an entity neither transfers nor retains substantially all of the risks
and rewards of ownership of a financial asset, then it evaluates whether it has
retained control of the financial asset. If the entity has not retained control of the
asset, then it derecognises that asset. Conversely, if the entity has retained control,
then it continues to recognise the asset to the extent of its continuing involvement in
the financial asset (see 7I.5.250). [IAS 39.20(c)]

EXAMPLE 12 – SUBSTANTIALLY ALL RISKS AND REWARDS NEITHER TRANSFERRED NOR RETAINED
 7I.5.240.20 Company V transfers long-term mortgage receivables to
Company W such that it retains the credit risk while transferring the
prepayment/late-payment risk and interest rate risk. Both the credit
and the combined prepayment/late-payment and interest rate risks are
considered to be significant.

7I.5.240.25 In this example, V has neither retained nor transferred

substantially all of the risks and rewards and needs to determine if it
has retained control of the receivables.

7I.5.240.30 An entity is considered to have lost control if the transferee has the
practical ability unilaterally to sell the transferred financial asset in its entirety to an
unrelated third party without needing to impose additional restrictions on the sale. If
there is an active market for the financial asset, then the transferee often has the
practical ability to sell the financial asset, even if the contractual arrangements
between the transferor and the transferee could require the transferee to return the
financial asset to the transferor – e.g. if the financial asset is subject to an option that
allows the transferor to repurchase it but the financial asset is readily obtainable in
the market. [IAS 39.23, AG42]

7I.5.240.40 Conversely, the transferee does not usually have the practical ability
to sell the financial asset if there is no market for the financial asset, even if the
contractual arrangements between the transferor and transferee permit such a sale.
[IAS 39.23, AG43(a)]

7I.5.240.43 In our view, determining whether there is a market for the financial
asset and whether the transferee has the practical ability to sell in that market is a
matter of judgement based on consideration of the facts and circumstances. It is not
necessary in all cases to demonstrate that the market for the financial asset is active
or organised. We believe that a market may be considered to exist if there are willing
buyers for an asset and a sale to a market participant could be effected within a
reasonable timescale and at a reasonable cost. The transferee does not have the
practical ability to sell if a call option or a guarantee prevents the transferee from
selling the financial asset – e.g. if the financial asset is subject to an option that allows
the transferor to repurchase it and a replacement is not readily obtainable. As a
result, the transferor would not be considered to have lost control. [IAS 39.23, AG43–
AG44]

7I.5.240.45 In Example 12, if Company V attaches conditions to the transfer that

prevent Company W from selling the mortgage receivables to a third party – e.g. to
maintain customer relationships – then V has retained control over the transferred
financial assets. [IAS 39.23, AG43–AG44]

EXAMPLE 13A – CONTROL RETAINED THROUGH PURCHASED CALL OPTION (1)

7I.5.240.50 Company P sells a portfolio of corporate loans to

Company B. P simultaneously enters into a call option with B under
 which it has the right to repurchase the financial assets after five
years.

Call option over portfolio

Portfolio of corporate loans

Company P Company B
Consideration for portfolio
7I.5.240.55 Although B has the legal right to sell the financial assets,
it does not have the practical ability to do so because it could be
required to return them to P at the end of five years. If B attempts to
sell the financial assets to another party, then it would have to attach a
similar call option to be able to repurchase the financial assets in the
event of P exercising its option.

7I.5.240.56 It is also unlikely that there is an active market for such

financial assets that would allow B to sell the financial assets without
attaching the aforementioned call option to them.

7I.5.240.57 Consequently, because of the call option held by P, it has

retained control over the financial assets and will have to consider
accounting under continuing involvement. [IAS 39.AG42]

EXAMPLE 13B – CONTROL RETAINED THROUGH PURCHASED CALL OPTION (2)

7I.5.240.60 Company Q transfers trade receivables with an option

that allows Q to reacquire overdue receivables at face value. Although
the option has no stand-alone economic value, Q has retained control
to be able to protect its customer relationships.

7I.5.240.70 In our view, no distinction should be made in the separate financial

statements between a derecognition transaction between a parent entity and one of
its operating subsidiaries and one with an independent third party. Therefore, a
parent entity should not normally include indirect control through the ownership of
an operating subsidiary in the evaluation of control, because this control is not
related to the financial asset.

7I.5.240.80 When the transferee is a limited-purpose vehicle or other structured

entity that is not consolidated (i.e. because it is not a subsidiary or because the
derecognition analysis is carried out for the purposes of the transferor’s separate
financial statements), an evaluation of whether control of the transferred assets has
been passed by the transferor raises certain practical considerations. In our view, the
following questions should be addressed to assess whether control has been
transferred.
• Is there any contractual restriction preventing the structured entity from selling
or pledging the financial assets? It is common practice to have such restrictions in
place, because when a structured entity is set up for a securitisation transaction
the financial assets are also used as collateral. In our view, to meet the criterion
that the entity has not retained control of the transferred assets, the structured
entity cannot be prevented from selling the financial assets by means of any
predetermined autopilot rules or pre-agreements.
• Can the structured entity unilaterally sell the financial assets or is this decision
controlled directly by the transferor?

7I.5.250 Continuing involvement

7I.5.250.10 If an entity retains control of a financial asset for which some but not
substantially all of the risks and rewards have been transferred, then the entity
continues to recognise the financial asset to the extent of its continuing involvement
in the financial asset. [IAS 39.20(c)(ii)]

7I.5.250.15 If an entity’s continuing involvement in a transferred asset takes the

form of a guarantee, then the extent of the entity’s continuing involvement is the
lower of: (1) the carrying amount of the asset; and (2) the maximum amount of the
consideration received that the entity could be required to repay. [IAS 39.30(a)]

EXAMPLE 14 – CONTINUED RECOGNITION BASED ON CONTINUING INVOLVEMENT

7I.5.250.20 Company P transfers short-term receivables of 100 to

Company Q. P provides a credit loss guarantee of 2. ECLs are 4 and
historically have varied between 1 and 5. Q is not permitted to sell or
pledge the receivables and there is no market for them.

Guarantee of losses up to a certain amount

Receivables
Company P Company Q
Consideration
7I.5.250.25 In our view, P has retained some, but not substantially
all, of the risks and rewards of ownership associated with the
receivables. In addition, because Q is not permitted to sell or pledge
the receivables and there is no market for such receivables, P has not
given up control and continues to recognise the receivables to the
 extent of its continuing involvement.

7I.5.250.27 The maximum extent of P’s continuing involvement is 2

(the amount of the guarantee). Therefore, we believe that P should
derecognise 98 and continue to recognise 2, which is the lower of (1)
the carrying amount of the financial asset; and (2) the maximum
amount received in the transfer that P could be required to repay. [IAS
39.30(a), AG48]

7I.5.250.28 A question arises about how to determine the extent of the entity’s
continuing involvement when it guarantees an amount of credit losses on a
transferred asset denominated in a foreign currency. In our view, in determining the
extent of the entity’s continuing involvement in this case, the guarantee amount
should be calculated by applying the spot exchange rate at the reporting date to the
maximum amount of the consideration received that the entity could be required to
repay in the foreign currency – i.e. without considering potential future changes in
the foreign currency exchange rate. This is because the maximum amount of the
consideration received that could be repaid is a fixed monetary amount denominated
in the foreign currency that meets the definition of a monetary item in IAS 21.
Monetary items are translated into their functional currency at the spot exchange
rate at the reporting date (see 2.7.110.10). [IAS 39.30(a), 21.16]

7I.5.250.30 Generally, a measurement based on continuing involvement requires

the net carrying amount of the financial asset and the associated financial liability to
reflect, depending on the measurement basis of the financial asset, either the
amortised cost or the fair value of the rights and obligations retained by the entity.
However, notwithstanding the requirement to arrive at a particular net carrying
amount, the financial asset and associated financial liability might not qualify for
offsetting. [IAS 39.AG48]

7I.5.250.40 To qualify for offsetting, an entity has to demonstrate that it currently

has a legally enforceable right to set off – i.e. a cash flow received on the transferred
financial asset would have to result in the elimination of a proportion of the financial
liability of the transferor to the transferee. This would imply that the risks associated
with the transferred financial asset lie with the transferee, which in turn would imply
that derecognition should have taken place; a conclusion that is contrary to that
reached in the derecognition analysis. Consequently, when a transaction does not
result in derecognition, it is not generally possible to meet the offsetting criteria.
Similarly, an entity is prohibited from offsetting any income arising on the transferred
financial asset against expenses arising on the associated financial liability, which
follows from the more general prohibition on offsetting in IAS 1 (see 7I.8.90). [IAS
32.42, 39.36]

7I.5.260 Assessment of derecognition in separate financial

statements
7I.5.260.10 The derecognition requirements in IAS 39, other than the
requirement to start by consolidating all subsidiaries, apply equally to separate
financial statements (see 7I.5.60). [IAS 39.15]

7I.5.260.20 However, the transfer that needs evaluation in the separate financial
statements may be different from that at the consolidated level. Consequently,
depending on the fact pattern, it is possible to achieve derecognition in separate
financial statements while failing to do so in consolidated financial statements. In our
experience, this situation may arise with transactions involving structured entities
that are consolidated in the consolidated financial statements.

7I.5.270 Accounting for a sale

7I.5.280 Transfers that qualify for derecognition

7I.5.280.10 Sometimes only part of a financial asset qualifies for derecognition –
e.g. if an interest-only strip is retained. In these cases, the carrying amount of the
entire financial asset before the transfer is allocated between the sold and retained
portions based on their relative fair values on the date of the transfer. For this
purpose, a retained servicing asset is treated as part of the original asset that
continues to be recognised. [IAS 39.27]

7I.5.280.20 Sometimes new financial assets or financial liabilities are created in

the transfer – e.g. a credit guarantee. New financial assets, financial liabilities or
servicing liabilities created as a result of a transfer that qualifies for derecognition
are recognised separately and measured at fair value. [IAS 39.24–25]

7I.5.280.30 On derecognition of a financial asset, a gain or loss is recognised

based on the difference between (1) the carrying amount of the financial asset (or
part of the financial asset) derecognised; and (2) the consideration received
(including any new asset obtained less any new liability assumed), and the cumulative
gain or loss previously recognised in OCI in respect of the derecognised financial
asset or the part of the derecognised financial asset. [IAS 39.26–27]

7I.5.280.40 If financial assets are exchanged in a transaction that meets the

criteria for derecognition, then the financial assets received are measured at fair
value and the profit or loss on disposal is calculated based on the fair value of the
financial assets received. [IAS 39.14, 26]

7I.5.280.50 The Standards are silent on how to determine the cost of financial
assets sold when they are part of a homogeneous portfolio. Therefore, the application
of the hierarchy for the selection of accounting policies (see 2.8.20) is applied. In our
view, the guidance on cost formulas for inventories should be applied (see 3.8.280).
Therefore, any reasonable cost allocation method – e.g. average cost or first-in, first-
out – may be used. However, the use of specific identification is not precluded if the
entity is able to identify the specific items sold and their costs. For example, a specific
security may be identified as sold by linking the date, amount and cost of securities
bought with the sale transaction, provided that there is no other evidence suggesting
that the actual security sold was not the one identified under this method.
7I.5.280.60 We believe that an entity should choose a reasonable cost allocation
method, to be applied consistently, to determine the cost of financial assets sold when
the financial assets are part of a homogeneous portfolio. In addition, in our view the
approach used to determine the cost of financial assets sold should be applied
consistently when assessing impairment and accounting for the resulting impairment
losses (see 7I.6.450).

7I.5.290 Transfers that do not qualify for derecognition

7I.5.300 Accounting by transferor

7I.5.300.10 If a transfer does not qualify for derecognition, then the financial
asset, or the retained portion of the financial asset, remains in the statement of
financial position and a corresponding financial liability is recognised for any
consideration received. [IAS 39.29, AG47]

7I.5.300.20 If contractual rights and obligations – e.g. derivatives – related to a

transfer prevent the transferor from derecognising the financial assets, then these
rights and obligations are not accounted for separately. For example, a call option
retained by the transferor may prevent the derecognition of certain financial assets,
but recognising the financial assets as well as the call option would result in the
entity double counting its rights to those financial assets. [IAS 39.AG49]

EXAMPLE 15A – RIGHTS THAT PREVENT DERECOGNITION THAT ARE NOT ACCOUNTED FOR
SEPARATELY

7I.5.300.30 Company X transfers receivables of 100 to Company Y in

exchange for a note amounting to 100 that represents a beneficial
interest in the transferred assets – i.e. payments on the note will be
made only out of cash collected from the receivables.

Receivables
Company X Company Y
Note
(beneficial interest in receivables)
7I.5.300.35 X does not derecognise the receivables because the note
effectively passes substantially all of the risks and rewards of
ownership of the receivables back to X (see 7I.5.230).

7I.5.300.40 In addition, X does not recognise a new asset for the

right to receive cash flows from the note, because doing so would
result in double counting the rights to the transferred receivables.
Except for this retained interest in the transferred receivables, which
are already recognised in X’s statement of financial position, X has
 retained no consideration for the transfer. Because no new asset is
recognised, neither is any corresponding financial liability.

7I.5.300.50 It is important to contrast the situation in 7I.5.300.20 with one in

which the derivative requires separate recognition.

EXAMPLE 15B – RIGHTS AND OBLIGATIONS THAT DO NOT PREVENT DERECOGNITION THAT ARE

ACCOUNTED FOR SEPARATELY

7I.5.300.60 Company F transfers fixed rate financial assets to

Company B. F simultaneously enters into an interest rate swap with B
under which it receives fixed rate interest (equal to the rate on the
transferred financial assets) and pays floating rate interest (equal to
the rate on the notes issued by B to fund the acquisition of the financial
assets); the payments are based on a notional amount equal to the
principal amount of the transferred financial assets, but are not
conditional on B receiving any cash flows from the underlying financial
assets.

Transfer of fixed rate

financial assets
Company F Company B
Interest rate swap:
F receives fixed and pays floating
7I.5.300.70 In this example, the interest rate swap does not prevent
F from derecognising the financial assets, because the payments on
the swap are not conditional on payments being made on the
transferred assets. Therefore, F recognises

the interest rate swap separately and subsequently accounts for it as a

derivative (see 7I.5.300.20). [IAS 39.AG51(p)]

7I.5.305 Accounting by transferee

7I.5.305.10 If a transfer of a financial asset does not qualify for derecognition,
then the transferee does not recognise the transferred asset as its asset in its
statement of financial position. Instead, the transferee derecognises the cash or other
consideration paid and recognises a receivable from the transferor. [IAS 39.AG50]

7I.5.305.20 IAS 39 is silent on the accounting by the transferee for transactions

that do not qualify for derecognition by the transferor when the transferee does not
pay cash or other assets but instead issues a new debt instrument as consideration
for the assets transferred (see Example 15A).

7I.5.305.30 In our view, the transferee should usually recognise both a receivable
from the transferor as a financial asset and the debt instrument as a financial liability
in such cases. This is because the terms of each instrument generally determine the
appropriate accounting and two financial instruments, even if they are entered into
simultaneously, are accounted for separately (see 7I.5.40). Therefore, unless these
instruments should be accounted for as a single combined instrument based on the
criteria in 7I.5.40, we believe that the only case in which the transferee should not
recognise a separate financial asset and a financial liability is when the debt
instrument issued by the transferee serves only to pass the cash flows from the
transferred asset back from the transferee to the transferor and the pass-through
criteria (see 7I.5.160) are met from the transferee’s perspective in respect of the
transferred asset legally owned by the transferee. In addition, the transferee does not
offset the financial asset and the financial liability unless the criteria in IAS 32 are
met (see 7I.8.90). [IAS 1.32, 32.42]

EXAMPLE 16A – TRANSFEREE DOES NOT RECOGNISE SEPARATE ASSET AND LIABILITY

7I.5.305.40 Company F transfers legal title to a portfolio of loans to

Company G, which is not controlled by F, in exchange for participation
certificates issued by G.

Portfolio of loans
Company F Company G
Participation certificates
7I.5.305.45 Under the terms of the participation certificates, G
agrees to pay without material delay all of the cash flows from the
portfolio of loans to F and is prohibited from selling or pledging the
loans. G has no obligation to pay any other amounts to F and is not
permitted to reinvest cash receipts from the loans pending their
payment to F. F enters into the transaction because it considers that
the participation certificates would be more attractive to other
investors or as collateral for borrowings.

7I.5.305.50 F does not derecognise the loans because it has retained

substantially all of the risks and rewards of the loans. In our view, G
should not recognise a financial asset or a financial liability at the time
of the transfer because G has simultaneously obtained the contractual
rights to the cash flows from the portfolio of loans and assumed a
contractual obligation to pay those cash flows to F in a manner that
meets the criteria for derecognition of those loans – i.e. the pass-
through criteria (see 7I.5.160) are met from G’s perspective and G
 does not assume the risks and rewards of ownership of the loans.

EXAMPLE 16B – TRANSFEREE RECOGNISES SEPARATE ASSET AND LIABILITY

7I.5.305.60 Modifying Example 16A, the participation certificate

includes a guarantee that Company G will pay at least 90% of the
contractual cash flows of the transferred loans to Company F in the
event that a lesser amount is actually received from the loans. The
expected credit losses on the loans are 3%.

Portfolio of loans
Company F Company G
Participation certificates

Guarantee to pay > 90%

of contractual cash flows
7I.5.305.70 Because the guarantee is expected to be triggered only
in remote circumstances, F has retained substantially all of the risks
and rewards of the loans and does not derecognise them.

7I.5.305.80 From G’s perspective, the participation certificates no

longer meet the pass-through criteria because G has an obligation to
pay amounts to the holder in excess of the amounts collected from the
loans if collections fall below the 90% level. In addition, the transfer
has a business purpose as explained in Example 16A. Therefore, G
recognises the participation certificates as a financial liability and a
receivable from F.

7I.5.310 Receivables sold with full recourse

7I.5.310.10 Receivables sold with full recourse do not generally qualify for
derecognition. Instead, the transaction is generally accounted for by the transferor as
a collateralised borrowing (see 7I.5.300.10).

EXAMPLE 17 – RECEIVABLES TRANSFERRED WITH FULL RECOURSE

 7I.5.310.20 Company H sells trade receivables due in six months
with a carrying amount of 100 for a cash payment of 95 to Company J,
subject to full recourse. Under the right of recourse, H is obliged to
compensate J for the failure of any

debtor to pay when payment is due. In addition to the recourse, J is

entitled to sell the receivables back to the transferor in the event of
unfavourable changes in interest rates or credit ratings of the
underlying debtors.

Receivables
Company H Company J
Right of recourse
and put option
7I.5.310.30 The transaction is accounted for by H as a collateralised
borrowing because it does not qualify for derecognition. Even
assuming that the contractual rights to all of the cash flows on the
receivables have been transferred as a matter of law, this transaction
still fails the derecognition requirements because H has retained
substantially all of the risks and rewards associated with the financial
assets. H is obliged to compensate J for the failure of the debtors to pay
when payments are due. In addition, H has granted J a put option on
the transferred financial assets that allows J to sell the receivables
back to H in the event of actual credit losses and/or changes in
underlying credit ratings or interest rates. Consequently, H has
retained substantially all of the risks and rewards of ownership of the
receivables.

7I.5.310.40 In this example, H recognises 95 as a financial liability,

which is measured at amortised cost with an interest expense of 5
being recognised over the six-month period until maturity. H continues
to recognise the receivables as financial assets. Cash received on the
receivables by either H or J reduces the receivables and, if it is
received by or paid to J, the financial liability. If uncollected receivables
are returned to H for cash, then the financial liability is reduced.

7I.5.315 Accounting for extinguishment of part of a financial

asset

7I.5.315.10 If an entity forgives part of the cash flows of a financial asset that is
not impaired as described in 7I.5.80.155, then a question arises about how it should
allocate the amortised cost of the financial asset between the part derecognised and
the part retained. IAS 39 does not provide specific guidance on this question. It
appears that an entity should choose an accounting policy, to be applied consistently,
to allocate the amortised cost of the financial asset between the part that continues to
be recognised and the part that is derecognised, using one of the following
approaches:
• Approach 1 – Allocate on the basis of the relative amortised cost amounts of those
parts immediately before forgiveness. These carrying amounts would be
determined by discounting the respective cash flows at the financial asset’s
original effective interest rate consistent with the effective interest method.
Proponents of this approach believe that because there is no change in or
derecognition of the part of the financial asset that has not been forgiven, it should
continue to be measured using the original effective interest rate. The outcome of
this approach reflects the result of applying the measurement guidance for
changes in estimates of cash flows in 7I.6.260.
• Approach 2 – Allocate on the basis of the relative fair values of those parts on the
date of the modification by analogy to the guidance on derecognition for transfers
of parts of financial assets (see 7I.5.280.10). [IAS 39.27, AG8]

7I.5.320 SECURITISATIONS

7I.5.320.10 Entities commonly use securitisations to monetise financial assets,

such as homogeneous consumer loans, credit card receivables, trade receivables or
mortgage loans, by selling newly created securities collateralised by these financial
assets to investors. Such securitisation transactions are often executed using
structured entities that have limited activities. The purpose of the structured entities
is to hold the interests in the securitised financial assets and to pass through cash
flows earned on these financial assets to the investors in the notes issued by the
structured entities. In a typical securitisation, the transferring entity assigns financial
assets to the structured entity in return for cash proceeds. The transfer of financial
assets, issue of notes to investors and payment of proceeds to the transferor usually
take place simultaneously.

7I.5.320.20 If financial assets are securitised using a structured entity, then

determining whether those financial assets should be derecognised may be a complex
issue. In many securitisation transactions involving structured entities, the pass-
through requirements will be difficult to achieve or will not be met. In addition,
because the purpose of a securitisation is often to raise highly rated, low-cost finance,
the transferor typically provides some form of credit enhancement to the structured
entity. For example, the transferor may provide additional collateral to the structured
entity in the form of loans or cash, or may provide a guarantee to the investors in the
notes issued by the structured entity. For further discussion of specific practical
application issues, see 7I.5.330–355.

7I.5.320.30 If a structured entity is used to securitise financial assets, then the

derecognition criteria may need to be analysed from different perspectives (see also
7I.5.60.20–30) depending on the circumstances. The first step in the derecognition
assessment is to assess whether the structured entity should be consolidated under
IFRS 10 (see chapter 2.5 and, in particular, 2.5.20).
7I.5.320.40 If the structured entity is consolidated, then the transferor evaluates
at the group level whether there has been a transfer of financial assets by the group,
including the structured entity, to the investors in the securities issued by the
structured entity. If there has been a transfer of financial assets by the group, then
the transferor evaluates to what extent the group, including the structured entity, has
transferred or retained the risks and rewards of (and, if necessary, whether it has
retained control over) the financial assets.

7I.5.320.50 If, however, the structured entity is not consolidated under IFRS 10,
then the transferor evaluates at the group level whether there has been a transfer of
financial assets by the group, excluding the structured entity, to the structured entity.
If there has been, then the transferor evaluates to what extent the group, excluding
the structured entity, has transferred or retained the risks and rewards of (and, if
necessary, whether it has retained control over) the financial assets.

7I.5.320.60 If the transferor is preparing separate financial statements, then for

this purpose the transferor evaluates whether there has been a transfer of financial
assets by it, as a separate entity, to the structured entity. If there has been, then it
evaluates to what extent it, as a separate entity, has transferred or retained the risks
and rewards of (and, if necessary, whether it has retained control over) the financial
assets. [IAS 39.15]

7I.5.320.70 Securitisations usually involve portfolios of financial assets and

include detailed terms setting out the allocation of cash flows between the various
parties. Therefore, it is often challenging to determine:
• whether the derecognition guidance should be applied to a part of the portfolio of
financial assets or to the portfolio in its entirety (see 7I.5.80);
• whether there has been a transfer of the contractual rights to the cash flows of the
financial assets or there is a qualifying pass-through arrangement (see 7I.5.100,
330–340);
• the extent to which the transferor has transferred or retained the risks and
rewards of any financial assets that have been transferred (see 7I.5.190); and
• whether the transferor has retained control of any financial assets that have been
transferred (see 7I.5.240).

7I.5.330 Evaluating pass-through criteria: Structured entity not

consolidated

7I.5.330.10 If the structured entity is not consolidated – i.e. it is not consolidated

as part of the transferor’s consolidated financial statements in accordance with IFRS
10 or the transferor is preparing separate financial statements – and the transferor
does not transfer the contractual rights to receive the cash flows to the structured
entity, then the terms of a credit enhancement or other arrangement provided in
connection with the transferred financial assets may affect the conclusion about
whether the pass-through criteria are met.

7I.5.330.20 If a credit enhancement can require the transferor to make additional

future payments to the structured entity (or its investors) – e.g. an unfunded financial
guarantee or other non-funded credit enhancement – then in our view the transfer
would fail the pass-through requirements. This is because the transferor could be
obliged to pay amounts to the structured entity even if it does not collect the
equivalent amounts from the original assets. [IAS 39.19(a)]

7I.5.330.30 However, if a credit enhancement provided by the transferor could

never require the transferor to make additional future payments to the structured
entity or investors in the structured entity, then in our view the credit enhancement
would not violate the pass-through requirement that the transferor has no obligation
to pay amounts unless it collects equivalent amounts from the original financial
assets. For example, credit enhancement could be provided by means of a pre-funded
financial guarantee under which cash collateral is paid to the structured entity at or
before the time of transfer, a subordinated loan that is made at or before the time of
transfer, or a reserve fund that is built up from the cash collected from the underlying
loans and that is retained by the structured entity. This is because, following the
transfer, the transferor would not be obliged to pay to the structured entity any
amounts in excess of those that it collects from the original financial assets.

EXAMPLE 18 – GUARANTEE COLLATERALISED BY CASH HELD BY UNCONSOLIDATED STRUCTURED

ENTITY

7I.5.330.40 Company T agrees to pay the cash flows collected from a

portfolio of financial assets to Structured Entity SE, which T does not
consolidate. SE issues, for cash of 100, notes to third party investors
that are collateralised by its right to receive the collected cash flows
from T.

7I.5.330.50 SE pays 95 of the cash and issues a subordinated note

with a nominal value of 5 to T. The remaining 5 cash is held by SE and
will be used to compensate the investors for up to 5 of cash shortfalls
arising from defaults in the portfolio of financial assets.

Cash flows
Structured
Company T Entity SE Investors
Unconsolidated Notes (100)
Cash (95)
plus note (5)
Legal Cash
ownership flows

Portfolio of
financial
assets

7I.5.330.60 In evaluating whether the portfolio of financial assets is

derecognised in T’s consolidated financial statements, the
arrangement does not violate the requirement that the transferor in a
pass-through arrangement may be obliged to pay amounts to the
 eventual recipients only if it collects equivalent amounts from the
original financial assets. That is because:
• T is only obliged to pay amounts that it collects from the portfolio;
and
• SE, not T, has the obligation to pay the initial cash retention to the
note holders if there are defaults, and SE is not consolidated by T.

7I.5.330.70 The impact of higher-than-expected credit losses is that

T receives less from the subordinated note issued by SE when the
arrangement comes to an end rather than T being required to pay
additional amounts to SE to cover those losses. Although this
variability in cash flows that T will receive is relevant to assessing the
extent to which T has retained or transferred the risks and rewards of
the financial assets, it does not violate the pass-through criteria.

7I.5.340 Evaluating pass-through criteria: Structured entity

consolidated

7I.5.340.10 If the structured entity is consolidated, then the contractual

arrangements between the consolidated group and the investors in the notes issued
by the structured entity are analysed to determine whether the requirements for a
qualifying pass-through arrangement are met (see 7I.5.60.20–30). This is because the
structured entity, and therefore the transferor’s consolidated group, will not typically
transfer the contractual rights to the cash flows on the underlying financial assets to
the investors in the notes issued by the structured entity. However, the terms of the
notes may provide for payments to be made to the holders based on cash received on
the underlying financial assets in such a manner that the structured entity’s only role
is acting as an agent on behalf of the note holders. Therefore, it is possible that such a
transaction could meet the pass-through conditions listed in 7I.5.160.10.

7I.5.340.20 For the purpose of evaluating whether there is an obligation to pay

amounts in excess of those collected from the original financial assets, the transferor
analyses obligations to pay amounts from the consolidated group, including the
consolidated structured entity, to other holders of interests in the structured entity;
cash flows between the transferor entity and the structured entity are not generally
relevant for this purpose, because they are internal to the group. If the nature of
credit enhancements is such that additional amounts will be paid to the investors in
the notes issued by a structured entity in the event of default – i.e. the consolidated
group will make additional payments in excess of the amounts collected from the
original financial assets – then in our view the credit enhancements provided by the
transferor will violate the pass-through requirements. This applies even if the
guarantee or credit enhancement is supported by paying cash into the structured
entity at the time of transfer.

EXAMPLE 19 – GUARANTEE COLLATERALISED BY CASH HELD BY CONSOLIDATED STRUCTURED

ENTITY
 7I.5.340.30 Company T transfers the contractual rights to receive
the cash flows from a portfolio of financial assets to Structured Entity
SE, which T consolidates. SE issues, for cash of 100, notes to third
party investors that are collateralised by the financial assets.

7I.5.340.40 SE pays 95 of the cash and issues a subordinated note

with a nominal value of 5 to T. The remaining 5 cash is held by SE and
will be used to compensate the investors for up to 5 of cash shortfalls
arising from defaults in the portfolio of financial assets.

Transfer assets
Structured
Company T Entity SE Investors
Consolidated Notes (100)
Cash (95)
plus note (5)
Legal Cash
ownership flows

Portfolio of
financial
assets

7I.5.340.50 The arrangement violates the requirement that the

entity should be obliged to pay amounts to the eventual recipients only
if it collects equivalent amounts from the original financial assets. This
is because SE is part of the consolidated group and therefore the
consolidated group is obliged to pay up to 5 of cash to the third party
investors in excess of collections from the portfolio of financial assets.

7I.5.340.60 Our views on some other specific application issues for determining
whether a securitisation involving a structured entity qualifies as a pass-through
arrangement are included in 7I.5.345–355.

7I.5.345 Without material delay

7I.5.345.10 To meet the pass-through conditions, an entity is required to remit all

cash flows that it collects on behalf of the eventual recipients without material delay.
In our view, the entity can invest the cash flows for periods of up to three months
without violating this requirement provided that:
• the investments are only in cash and cash equivalents (see 2.3.10); and
• all cash flows, both amounts collected and any income earned on investments in
cash or cash equivalents, are remitted to the bond holders on the next payment
date. [IAS 39.19(c)]

7I.5.345.20 Conversely, we believe that refinancing terms exceeding three

months will not meet this criterion; neither will investments in cash and cash
equivalents on a revolving basis over periods exceeding three months.
7I.5.345.30 In some securitisation structures, the transferring entity holds a
junior interest issued by a consolidated structured entity, which is subordinate to
senior notes issued by the structured entity, with specific terms such that the junior
interest represents a retention by the transferring entity of a fully proportionate
share of all or specifically identified cash flows and a subordination of that retained
interest to provide a credit enhancement to the transferee for credit losses. When the
structured entity collects cash flows from the underlying financial assets, the senior
note holders are paid without material delay. However, cash flows that are in excess
of those required to pay the senior note holders are retained within the structured
entity as part of an ‘excess cash reserve fund’. This fund is used to make up for any
future shortfalls in cash flows due to the senior note holders. Amounts remaining in
the fund after the senior note holders have been fully paid are then paid to the junior
note holder. [IAS 39.AG52, BC61–BC63]

7I.5.345.40 In our view, the existence of such an excess cash reserve fund does
not violate the requirement that all cash flows collected on behalf of the eventual
recipients are remitted without material delay. This is because when the excess cash
is first collected in the excess cash reserve fund, it is collected on behalf of the
transferring entity rather than the senior note holders. This is on the basis that if
future collections from the financial assets are enough to pay the senior note holders
in full, then the excess cash will be paid to the transferring entity. The excess cash
reserve fund will become due to the senior note holders only if and when future
collections are not enough to pay the senior note holders in full. At this point, the
excess cash is considered to have been collected on behalf of the senior note holders
as the eventual recipients, and it is only from this time that the extent of any delay in
remitting the excess cash to the senior note holders should be assessed to determine
whether it is material.

7I.5.350 Revolving transactions

7I.5.350.10 If cash flows collected from the underlying financial assets are
reinvested by the structured entity in new financial assets, other than cash or cash
equivalents, under a revolving structure, then problems may be encountered in
meeting the condition that all cash flows should be remitted to the eventual
recipients without material delay. Further analysis of the terms and conditions
governing this reinvestment is required to determine whether the conditions for a
qualifying pass-through arrangement are met. [IAS 39.19]

7I.5.350.20 In our experience, there are four general scenarios that may be
encountered, each having an effect on the pass-through requirements.

SCENARIOS EFFECTS

The structured entity In our view, the pass-through

automatically reinvests the cash requirements are violated because the
flows to buy additional receivables investments are not in cash or cash
in accordance with predetermined equivalents and therefore
contractual arrangements derecognition is precluded.
 embedded in the structure.

The structured entity remits the In our view, this does not violate the
cash flows to the note holders pass-through requirements and the
without material delay, at which transaction should be considered
time the note holders may decide further for derecognition.
whether to reinvest the cash flows
with the structured entity for the
purpose of acquiring further
financial assets.

The structured entity In our view, the pass-through

automatically reinvests the cash requirements are not violated because
flows to buy additional financial the structured entity is obliged to
assets, unless the note holders remit the cash flows to the note
indicate at that stage that they do holders if it is so notified. The lack of a
not want to reinvest in the physical flow of cash from the
structured entity – i.e. the cash structured entity to the note holder
flows are remitted to the note and back to the structured entity does
holders only if they decide not to not impact the derecognition analysis
reinvest. and the transaction should be
considered further for derecognition.

The structured entity remits the In our view, despite the physical flow
cash flows to the note holders, but of cash, the pass-through
the note holders have an up-front requirements are violated because the
contractual agreement that all note holders are contractually obliged
cash flows will be reinvested to reinvest the cash flows immediately
immediately by the structured in order for the structured entity to
entity. acquire additional financial assets.
Therefore, derecognition is precluded.

7I.5.355 Continuing involvement

7I.5.355.10 If the pass-through requirements are met and it is concluded that

some but not substantially all of the risks and rewards of the financial assets are
transferred to the note holders, then it is likely that the transferor will have retained
control of the transferred financial assets. This is because in a typical structure the
structured entity is consolidated and will maintain legal title to the financial assets
whereas the note holders will have no rights to sell the underlying financial assets.
Also, even if the structured entity is not consolidated, the transferor may retain
control because the structured entity may not itself have the practical ability to sell
the transferred assets. In such circumstances, partial derecognition may be
appropriate under continuing involvement accounting (see 7I.5.250). [IAS 39.AG43]
7I.5.360 REPURCHASE AGREEMENTS AND SECURITIES
LENDING

7I.5.360.10 If a sale of a financial asset is subject to a repurchase agreement at a

fixed price, or at the initial selling price plus interest, or if the asset is lent to a third
party that agrees to return it, then the seller retains substantially all of the risks and
rewards of ownership of the asset. Therefore, the seller does not derecognise the
financial asset. If the transferee obtains the right to sell or pledge the financial asset
that does not qualify for derecognition, then the seller reclassifies the financial asset
in its statement of financial position – e.g. as a loaned financial asset or repurchase
receivable. [IAS 39.AG51(a)]

7I.5.360.20 This treatment also applies when:

• the financial asset subject to the agreement is of a type readily obtainable in the
market, such that the transferee could sell the transferred financial asset and
repurchase an identical financial asset in the market to meet its return obligation
to the seller; or
• the agreement permits the transferee to return financial assets that are the same
or substantially the same as the originally transferred asset or financial assets that
are similar and of equal fair value. [IAS 39.AG51(b)–(c)]

7I.5.360.30 Similarly, the transferee does not recognise the financial asset
received under a repurchase or securities lending arrangement. If the transferee
sells the financial asset, then it recognises a financial liability to return the financial
asset based on its fair value. [IAS 39.AG50]

7I.5.360.40 If there is an event of default by the seller and it is no longer entitled

to reclaim the transferred financial asset, then the seller derecognises the financial
asset and the transferee recognises the financial asset at fair value or, if it has sold
the financial asset already, derecognises the financial liability to return the financial
asset. [IAS 39.37(c)]

7I.5.370 DERECOGNITION OF FINANCIAL LIABILITIES

7I.5.370.10 A financial liability is derecognised when it is extinguished – i.e. it is

discharged or cancelled or expires. This may happen when:
• payment is made to the lender – e.g. when the issuer of a debt instrument redeems
the instrument;
• the borrower is legally released from primary responsibility for the financial
liability – this condition can be satisfied even if the borrower has given a
guarantee, as long as the borrower is released from primary responsibility; or
• there is an exchange between an existing lender and borrower of debt instruments
with substantially different terms or a substantial modification of the terms of an
existing debt instrument (together referred to as ‘modification of terms’ in this
chapter). [IAS 39.39–40, AG57, AG62]

7I.5.370.20 The derecognition conditions are also satisfied and a financial liability
is derecognised when an entity repurchases its own debt instruments previously
issued, irrespective of whether the entity intends to resell those instruments to other
parties in the near term or is itself a market maker in those instruments. This is
consistent with the treatment of own equity instruments acquired by an entity, except
that in the case of an extinguishment of a financial liability a gain or loss may be
recognised in profit or loss. [IAS 39.AG58]

7I.5.370.30 It is not possible for an entity to extinguish a financial liability through

an in-substance defeasance of its debt. An ‘in-substance defeasance’ arises when an
entity transfers financial assets covering its obligations to a third party – typically into
a trust or similar vehicle – that then makes payments to the lender from principal and
interest on the transferred financial assets, without the third party having legally
assumed the responsibility for the financial liability and without the lender being part
of the contractual arrangements related to the third party. The entity is not legally
released from the obligation and therefore derecognition of the financial liability is
inappropriate. [IAS 39.AG58–AG59]

7I.5.370.35 An entity may arrange for a third party to assume primary

responsibility for the obligation for a fee while continuing to make the contractual
payments on behalf of the third party. To be able to derecognise the financial liability,
the entity needs to have obtained legal release from the creditor whereby the creditor
agrees to accept the third party as the new primary obligor. [IAS 39.AG59–AG60]

7I.5.370.40 As for a financial asset, when transferring a financial liability, parts of

the financial liability could be retained and new financial instruments (either financial
assets or financial liabilities) could be created. The accounting is similar to the
accounting for the derecognition of parts of financial assets with the creation of new
instruments. [IAS 39.41, 43]

7I.5.370.50 A gain or loss calculated as the difference between the carrying

amount of a financial liability (or part of a financial liability) extinguished or
transferred and the consideration paid is recognised in profit or loss. The
consideration paid includes any non-cash assets transferred and new liabilities
assumed. [IAS 39.41]

7I.5.380 Modification of terms

7I.5.380.10 Issues often arise over whether it is appropriate to derecognise a

financial liability when its terms are renegotiated, including an exchange between an
existing borrower and a lender of debt instruments, and including a renegotiation in
exchange for an immediate cash payment or receipt. For a discussion of transactions
involving the issue of equity instruments in exchange for the extinguishment of all or
part of a liability, see 7I.5.410.

7I.5.380.20 When a debt instrument is restructured or refinanced and the terms

have been substantially modified, the transaction is accounted for as an
extinguishment of the old debt instrument, with a gain or loss (see 7I.5.390). The new
debt instrument is recognised at fair value (see 7I.6.20). In our view, it is not
appropriate to simply assume that the nominal amount of the new loan is the fair
value. In the absence of an available quoted price in an active market for the new
debt instrument, fair value is established using another valuation technique. In our
view, if the valuation technique does not use only data from observable markets, then
this does not preclude the recognition of a gain or loss because the estimate of fair
value is used as the estimate of the transaction price. [IAS 39.40, AG64, AG76]

7I.5.380.30 In our view, the requirements on modifications and exchanges of debt

instruments do not extend to the usual repayment of a loan at maturity and its
replacement by a new loan on arm’s length terms, even if the new loan is with the
same lender, because the original loan is not modified or exchanged but is settled in
accordance with its original terms. In some cases, a borrower may arrange for a
replacement loan from the same lender shortly before maturity of the existing loan.
In these cases, judgement is required to determine whether the original loan has
been modified/exchanged or whether, in substance, it has been settled and replaced
by a new loan on market terms. We believe that the following factors may be relevant
in this analysis:
• proximity of a replacement to maturity of the original loan;
• the remaining time to maturity of the original loan relative to its original
contractual term; and
• whether the new contractual terms are at arm’s length.
7I.5.380.40 Also, we believe that the requirements on modifications and
exchanges of debt instruments do not apply to changes in the amounts or timing of
payments required under a loan that arise from existing features included in the
original debt agreement – e.g. interest rate step-ups or the acceleration of maturity
contingent on a credit downgrade – because these are not modifications of terms.
However, changes in estimated cash flows attributable to such features may result in
the recognition of a gain or loss (see 7I.6.260).

7I.5.380.50 See section 7I.5.500 for discussion of modifications of terms required

by the IBOR reform.

7I.5.381 Loan transfers

7I.5.381.10 An existing individual lender may transfer its right to the future cash
flows of a loan without any involvement of the borrower. For a discussion of the
accounting from the lender’s perspective, see 7I.5.100. Such a transfer may be
performed under the existing loan agreement without any modifications to the terms
of the loan agreement. In this case, the borrower is not legally released from its
primary responsibility to repay the loan and it continues to recognise the existing
loan. However, in other cases an existing loan agreement may be cancelled and
extinguished, and replaced by a new agreement with substantially different terms
between the borrower and the new lender (see 7I.5.370.10). In this case, the old loan
is derecognised. For a discussion of the replacement of a loan agreement, see
7I.5.383.20. [IAS 39.39–40, AG57, AG62]

7I.5.382 Unit of assessment

7I.5.382.10 In our view, the derecognition assessment should generally be
performed on an instrument-by-instrument basis, and not by grouping together
similar financial liabilities. For example, an entity may have issued 100 individual
bonds that are held by different parties, of which it intends to replace 60 with new
debt instruments and redeem the other 40 bonds. The bonds should be considered
individually for derecognition – i.e. the unit of account is each bond. Therefore, the
assessment should be made for each of the 60 bonds replaced and not for all of the
outstanding bonds in total. In this way, the entity would derecognise 40 of the bonds
that are redeemed, and the remaining 60 bonds may or may not qualify for
derecognition, depending on the extent to which the terms of the original and new
instruments differ.

7I.5.382.20 However, if an entity has issued one bond with a nominal amount of
100 held by a single party and intends to pay an amount of 40 and replace the bond
with a debt instrument with modified terms and a nominal amount of 60, then the
assessment is made for the bond as a whole. In our view, the agreement to make a
payment of 40 is an element of the modification and accordingly that payment should
be taken into account in the quantitative assessment (see 7I.5.385) in calculating the
present value of cash flows under the new arrangement.

7I.5.382.30 In contrast, in some cases an entity may amend or settle a proportion

of a single instrument, which is a fully pro rata share in the cash flows of the
instrument, while there is no amendment to the remaining proportion or to any other
instrument entered into with the creditor. In this case, in our view the unit of account
is the part amended or settled because this is the only part whose terms are modified.

7I.5.382.35 Similarly, a creditor may forgive certain specifically identified cash

flows, or a pro-rata share of specifically identified cash flows, of a financial liability
with no amendment to the remaining cash flows or to any other instrument entered
into with them. It appears that only the forgiven cash flows of the liability should be
derecognised because there are no other amendments to the remaining cash flows or
to any other instrument entered into with the creditor, and therefore the part of the
liability consisting of the forgiven cash flows is the part of the liability that has been
extinguished. [IAS 39.39]

7I.5.382.40 In our view, if an entity has issued multiple instruments held by a

single party and the different instruments are modified together in what is in
substance a single agreement, then the entity should assess the impact of the
modification with reference to the group of instruments that together is the subject of
the single modification agreement. In determining whether the modification of the
different instruments is in substance a single agreement, an entity should consider
the indicators discussed in 7I.5.40.

7I.5.383 Loan syndications and loan participations

7I.5.383.10 In our experience, large borrowing arrangements are often funded by
multiple investors. The process of involving several different investors in providing
loan funding is often referred to as ‘loan syndication’ or ‘loan participation’. In some
cases, the borrowing arrangement represents a single loan between the borrower
and a single lender, often referred to as the ‘lead lender’. In such cases, the other
investors are not direct creditors of the borrower; instead, their participation in the
loan is established by a participation agreement with the lead lender. However, in
other cases a borrowing arrangement that is funded by multiple investors represents
multiple separate loans between the borrower and each of the respective lenders –
i.e. the members of a syndicate. Whether a borrowing arrangement represents a
single loan with the lead lender or multiple separate loans with each individual
investor may be relevant in determining the application of the derecognition
requirements for financial liabilities when there are changes to the borrowing
arrangement or investor group.

7I.5.383.20 For example, an investor that co-funded a borrowing arrangement

may be replaced by another investor. If the overall borrowing arrangement
represents multiple separate loans from each individual investor, then the borrower
evaluates whether the replacement should be accounted for as an extinguishment of
the separate loan from that specific individual lender (see 7I.5.381.10). However, for
a borrower that borrowed under a single loan, replacement of one of the investors
that co-funded the loan is irrelevant to the borrower’s accounting if the lead lender is
not replaced. Also, any other amendments to the agreement between the lead lender
and any of the other investors are irrelevant to the borrower’s accounting as long as
the loan agreement between the borrower and the lead lender is not modified. This is
because the lead lender is the borrower’s creditor and because the other investors’
participation in the loan is set up in an agreement with the lead lender to which the
borrower is not a party. [IAS 39.39–40, AG57, AG62]

7I.5.383.30 The Standards do not provide specific guidance to evaluate whether a

borrowing arrangement funded by multiple investors represents a single loan or
multiple separate loans. Therefore, in our view a borrower should determine whether
the arrangement represents a single loan from a single lender or multiple separate
loans from each individual investor based on an evaluation of the legal terms and
substantive conditions of the arrangement. Factors that may indicate individually or
in combination that an entity has obtained separate loans from each individual lender
include the following:
• the terms of the arrangement differ between various investors;
• the borrower can selectively repay amounts to specific investors because
repayments are not automatically allocated among investors on a pro rata basis;
• the borrower can selectively renegotiate portions of the total arrangement with
individual investors or subsets of investors; and
• individual investors can negotiate their loan directly with the borrower without
the approval of other investors.

7I.5.384 Exchange or modification through an intermediary

7I.5.384.10 Sometimes an intermediary (e.g. a bank) may be involved in
restructuring or refinancing existing debt securities of an entity. For example, the
intermediary arranges for the acquisition of existing debt securities held by third
party investors and their exchange for new debt securities that will be held by new
third party investors. In these situations, it is important to identify the role of an
intermediary – i.e. whether it is acting as a principal (i.e. as the existing lender or
investor in the debt securities) or is acting as an agent of the issuer. [IAS 39.40, AG62]

7I.5.384.20 Whether an intermediary is acting as a principal in these situations

depends on the terms of the arrangements and whether it is exposed to any risks. In
our experience, this assessment includes consideration of whether an intermediary:
• independently initiates an exchange or modification of debt securities;
• commits its own funds for acquiring and placing debt securities and is subject to
the risk of loss of those funds;
• is responsible for placing the modified debt securities of the issuer with new
investors on a firmly committed basis (i.e. the intermediary is required to hold any
debt securities that it is unable to sell to others) or on a best-efforts basis (i.e. the
intermediary agrees to buy only those securities that it is able to sell to others);
• exposes itself to the risk of loss from acquiring, exchanging and selling debt
securities; and
• receives only a pre-established fee or may derive variable gains based on the value
of the securities issued by the issuer.

7I.5.384.30 If the intermediary is acting as a principal, then for the purposes of

the derecognition assessment the transaction between the issuer and the
intermediary is considered a debt exchange between an existing borrower and
lender. In this case, if the debt securities exchanged are not substantially modified,
then they are not derecognised. If there is a substantial modification of the existing
debt securities, then they are derecognised (see 7I.5.370.10). [IAS 39.40, AG62]

7I.5.384.40 If the intermediary is acting as an agent, then the derecognition

assessment for the modified debt is performed assuming that the intermediary does
not exist. If an issuer repurchases existing debt securities from their existing holders
and issues new debt securities to new (i.e. different) holders, then the existing debt
securities are derecognised (see 7I.5.370.10). However, if the issuer agrees with an
existing holder to repurchase existing debt securities in exchange for issuing new
debt securities to that same holder, then the exchange is a debt exchange between an
existing borrower and lender and the same principles as in 7I.5.384.30 apply.

7I.5.385 Quantitative assessment

7I.5.385.10 Terms are considered to have been substantially modified when the
net present value of the cash flows under the new terms, including any fees paid net
of any fees received and discounted using the original effective interest rate – i.e. of
the original debt instrument – differs by at least 10 percent from the present value of
the remaining cash flows under the original terms (the so-called ‘10 percent test’ or
‘quantitative assessment’). [IAS 39.AG62]

EXAMPLE 20A – MODIFICATION – QUANTITATIVE ASSESSMENT

7I.5.385.13 Company Z has a loan from Bank B. The loan bears

interest at 2%, which is also the effective interest rate. The interest is
payable annually and the principal is repayable at maturity on 31
 December 2023. On 31 December 2021, Z and B agree to modify the
terms of the loan as follows.
• The principal amount will increase from 100 to 130; B will provide
additional funds to Z on 31 December 2021.
• The interest rate will increase from 2% to 3%.
• The maturity date will extend for a further three years.
7I.5.385.14 The carrying amount of the loan at the date of the
modification is 100. Z does not incur any fees or costs as a result of the
modification.

7I.5.385.16 As part of the quantitative assessment, Z calculates the

net present value (NPV) of the cash flows under the new terms, using
the effective interest rate of 2% as the discount rate, as follows.

31 DECEMBER CASH PRESENT

FLOW VALUE

2021 (30) (30)

2022 3.9 3.8

2023 3.9 3.7

2024 3.9 3.7

2025 3.9 3.6

2026 133.9 121.3

Total NPV 106.1

7I.5.385.19 Z concludes that the quantitative test results in a 6.1%

increase in NPV of the cash flows, based on the difference between:
• the carrying amount of the loan before the modification of 100; and
• the net present value of the cash flows under the new terms of
106.1.

7I.5.385.20 IAS 39 does not define the term ‘fees’ in the context of performing the
quantitative assessment. In our view, for the purposes of quantitative assessment,
fees paid include amounts paid by the borrower to or on behalf of the lender, and fees
received include amounts paid by the lender to or on behalf of the borrower, whether
or not they are described as a fee, as part of the exchange or modification. Fees do
not include any payments made by the borrower or lender to its own advisers or
agents, or other transaction costs incurred by the borrower or lender.
EXAMPLE 20B – MODIFICATION – FEES INCLUDED IN 10% TEST

7I.5.385.23 Company Z has a loan from Bank B. Z negotiates with B a

modification to the terms of the loan, and Z incurs the following costs.

COST AMOUNT

Modification fees payable to B 30,000

External adviser assisting Z with the terms of the

modification transaction 15,000

Z’s internal treasury staff based on time spent and an

average hourly rate 12,000

External lawyer assisting B in drafting the contract;

lawyer’s fees paid by Z directly to the lawyer 8,000

Total costs 65,000

7I.5.385.27 In this example, we believe that only 38,000, comprising

the modification fees payable to B (30,000) and the amount paid to B’s
lawyer (8,000), should be considered to be ‘fees’ for the 10% test
calculation. This is because only these amounts are paid by Z to or on
behalf of B.

7I.5.385.30 IAS 39 does not contain any further guidance on how to determine the
cash flows for the 10 percent test if the terms of a debt instrument are modified and
the cash flows under the new or original terms of the instruments are not fixed. In our
view, if either the original or the new terms include an early prepayment, call or put
feature or a term extension feature that is not separately accounted for as a
derivative, then the effect of the feature should be included in determining the cash
flows under the quantitative assessment. In our view, any of the following approaches
would be a reasonable application of this principle.
• Calculate probability-weighted cash flows taking into account different scenarios,
including the exercise or non-exercise of the features, and use these cash flows as
the basis for the 10 percent test.
• Calculate the present value for each of the different scenarios – i.e. exercise and
non-exercise. The cash flow scenario that results in the smaller difference between
the present values of the cash flows under the original terms and the cash flows
under the revised terms would be the basis for the 10 percent test.
• Use the outcome of the most likely scenario to determine cash flows.
7I.5.385.40 In our view, an entity should use judgement in determining the
appropriate cash flows to be included in performing the 10 percent test if the original
terms of the debt instrument provide for:
• a higher rate of interest in the event of default;
• the acceleration of maturity in the event of default;
• a higher credit spread in the event of credit deterioration; or
• other contingent payment terms or unusual interest terms.

7I.5.385.50 We believe that similar judgement would apply in determining the

cash flows under the new terms for the 10 percent test. This might be reflected by
using the most likely scenario or probability-weighted outcomes in performing the 10
percent test.

7I.5.385.60 For a floating rate instrument, there is no explicit guidance in IAS 39

on how to determine the cash flows under the new terms or the remaining cash flows
under the original terms of the debt instrument. In our view, any of the following
approaches may be acceptable, as long as it is applied consistently, for determining
the variable benchmark components of the cash flows under the new terms and of the
remaining cash flows under the original terms to ensure a like-for-like comparison for
the 10 percent test.
• Use the relevant benchmark interest rate determined for the current interest
accrual period according to the original terms of the debt instrument.
• Use the relevant benchmark interest rate at the date of modification, except for
any remaining coupons of the original liability for which the interest rate has been
determined, in which case the contractual rate should be used.
• Use the relevant benchmark interest rates for the original remaining term based
on the relevant forward interest rate curve – except for any remaining coupons of
the original liability for which the interest rate has been determined, in which case
the contractual rate should be used – and the relevant benchmark interest rates
for the new term of the instrument based on the relevant forward interest rate
curve.

EXAMPLE 21 – APPROACHES TO DETERMINE FLOATING RATE CASH FLOWS IN 10% TEST

7I.5.385.70 On 30 June 2021, Company S modifies the terms of a

bond that was paying interest based on six-month IBOR that resets on
1 April and 1 October.

7I.5.385.72 The following facts are also relevant for this example:
• on 1 April 2021, six-month IBOR is reset to 3.5%;
• on 30 June 2021, six-month IBOR is 4%; and
• under the modified terms, the bond will bear interest at a fixed rate
of 4.5%.

7I.5.385.75 We believe that, for the 10% test, S may determine the
remaining future interest cash flows under the original terms of the
bond by using:
• the six-month IBOR applicable to the current reset period (3.5%);
• the six-month IBOR on the date of modification (4%); however, S
should use 3.5% for the period to 30 September 2021 because the
 interest rate for this period has already been fixed; or
• interest rates from the six-month IBOR forward curve; however, S
should use 3.5% for the period to 30 September 2021 because the
interest rate for this period has already been fixed.

7I.5.385.80 The original effective interest rate to be applied to discount the cash
flows is the effective interest rate of the original unmodified instrument that is being
used to calculate its amortised cost and interest expense under IAS 39. However, in
our view the original effective interest rate excludes adjustments made to the
effective interest rate of a debt instrument as a result of having applied fair value
hedge accounting because these adjustments do not reflect changes in the amount or
timing of cash flows payable on the hedged debt instrument. [IAS 39.AG62]

7I.5.385.90 For floating rate liabilities, in our view the original effective interest
rate is the current effective interest rate that reflects movements in market rates of
interest (see also 7I.5.385.60), determined according to the unmodified terms of the
contract. Such an effective yield might be a variable benchmark interest rate
plus/minus a margin – e.g. three-month IBOR plus 40 basis points. In other words, the
original effective interest rate should consider adjustments to the benchmark interest
rate, but the original credit risk spread should be held constant and not adjusted to
reflect changes in credit risk spread.

7I.5.385.100 The circumstances under which a modification of the terms of a

financial liability is negotiated – e.g. because of financial difficulties of the borrower –
are not relevant in determining whether the modification is an extinguishment of
debt (see also 7I.5.387.60).

7I.5.387 Qualitative assessment

7I.5.387.10 In our view, if the difference in the present value of the cash flows
under the quantitative assessment is at least 10 percent, then a modification should
be accounted for as an extinguishment in all cases. However, if the difference in the
present values of the cash flows is less than 10 percent – then an entity should
perform a qualitative assessment to determine whether the terms of the two
instruments are substantially different.

7I.5.387.20 In our view, the purpose of a qualitative assessment is to identify

substantial differences in terms that by their nature are not captured by a
quantitative assessment. Accordingly, we believe that modifications whose effect is
included in the quantitative assessment, and that are not considered substantial
based on that assessment, cannot generally be considered substantial on their own
from a qualitative perspective. Such modifications may include changes in principal
amounts, maturities, interest rates, prepayment options and other contingent
payment terms. However, if a financial liability has an effective interest rate of nil,
then a change in the timing of cash flows will have no effect on the quantitative
assessment. In this case, we believe that the change in timing of cash flows should be
incorporated into the qualitative assessment to ensure that its impact is considered.
A combination of cash flow changes captured by the quantitative test, but not on their
own considered substantial, and other changes not captured by the quantitative test
may together be considered a substantial modification. Performing the qualitative
assessment may require a high degree of judgement based on the facts and
circumstances of each individual case.

7I.5.387.30 The terms of a debt instrument may be modified from a fixed rate of
interest to a floating rate or vice versa. In such a case, an entity applies one of the
approaches in 7I.5.385.60 to determine the floating rate cash flows for the purpose of
the quantitative test. It appears that the entity then should choose an accounting
policy, to be applied consistently to:
• consider that this quantitative assessment captures the effect of the change from a
fixed to a floating rate (or vice versa) and, accordingly, the change should not be
considered again from a qualitative perspective; or
• consider that the change from a fixed to a floating rate (or vice versa) introduces
or removes variability in the contractual cash flows whose effect is not fully
reflected in a quantitative assessment based on a single point estimate of floating-
rate cash flows. In this case, the impact of this change in economic risks should be
included as part of the qualitative assessment of whether the terms of the two
instruments are substantially different. This qualitative assessment may require
judgement, including consideration of the maturity of the instrument, the relative
present values of variable interest cash flows and total cash flows and the volatility
of the floating-rate index.

EXAMPLE 22A – CHANGE IN TERMS DOES NOT AFFECT QUANTITATIVE ASSESSMENT

7I.5.387.40 Company T has a loan due to its parent that is payable on

demand. The loan has an effective interest rate of zero. T renegotiates
the terms of the loan so that it becomes payable in two years, rather
than on demand. Other terms remain unchanged.

7I.5.387.50 T carries out a quantitative assessment by calculating

the present value of the current and modified cash flows using the
original effective interest rate of zero. The discount rate of zero results
in the present value of cash flows repayable on demand being the same
as the present value of cash flows repayable in two years’ time. The
extension of maturity is not captured by the quantitative assessment,
because the effective interest rate of the loan is zero.

7I.5.387.55 We believe that in this case T should additionally

consider whether the term extension is a substantial modification as
part of its qualitative assessment because it has had no impact on the
quantitative assessment.

EXAMPLE 22B – PROVISION OF ADDITIONAL COLLATERAL

7I.5.387.60 Company T has a loan from Bank B with a coupon of

 IBOR+1%, which is equal to the effective interest rate. T has
experienced a downturn in performance and there is a significant risk
that it may breach some of the loan covenants. To reduce the risk of
being in default, T negotiates a modification of the terms of the loan
with B. B agrees to waive the covenant that is at significant risk of
being breached on condition that the coupon of the loan is increased to
IBOR+2% and T provides additional collateral. The other terms of the
loan remain unchanged. The market interest rate for a loan with the
same terms, except for the additional collateral, is IBOR+4.5%.

7I.5.387.70 T carries out a quantitative assessment by:

• calculating the present value of the revised cash flows based on the
coupon of IBOR+2% discounted using the original effective interest
rate of IBOR+1%; and
• comparing it to the carrying amount of the loan.
7I.5.387.75 T also carries out a qualitative assessment of the impact
of the additional collateral provided because its effect is not included
in the quantitative assessment. T applies judgement in carrying out the
assessment. One possible approach is to estimate what the difference
would be in the market interest rate

for a borrowing with additional collateral compared with a borrowing

with no additional collateral and use this to provide an additional
quantitative measure. The additional measure could be added to the
result of the actual quantitative assessment to provide a composite
indication of whether these changes should together be considered
substantial.

7I.5.387.80 In our view, the following types of changes in terms are of a formal or
incidental nature rather than related to the substance of the liability and accordingly
we believe that they carry no weight in the assessment of whether the modification of
terms is substantial:
• legal form of the instrument;
• tax treatment; and
• whether the instrument is listed.
7I.5.387.90 In our view, a substantial change in the currency of a debt instrument,
or a deletion or addition of a substantial equity conversion feature to a debt
instrument, is a substantial modification of the terms. A change in currency is
considered substantial unless the exchange rate between the old and new currencies
is pegged or managed within narrow bounds by law or relevant monetary authorities.
For example, a debt instrument might be modified such that the new instrument is in
a different currency – for which the exchange rate is not pegged to the old currency
or is not managed within narrow bounds with that currency – and has a different
maturity from the existing financial liability. We believe that the terms of the new debt
instrument in this case would be substantially different even if the present values of
the cash flows were almost identical using the quantitative test. Other modifications
may require a higher degree of judgement about whether they represent a
substantial change in terms – e.g. a change in the seniority or subordination of a
financial liability.

7I.5.387.100 In our view, an equity conversion option is substantial unless it is not

reasonably possible that it will be exercised over its term – e.g. a call option that is
deeply out of the money and expected to remain so. When an equity conversion option
included in the original liability is modified as part of a restructuring of the debt,
judgement should be applied in assessing whether the modification of the conversion
option is substantial. This might include considering the change in fair value of the
conversion option and its likelihood of exercise. If debt with detachable equity
options is exchanged for convertible debt that includes non-detachable equity
conversion options, then we believe that the exchange should be considered a
modification of an equity conversion feature rather than its addition or deletion.

7I.5.387.110 There are no special requirements for troubled debt restructurings

under the Standards. The guidance on modifications of financial liabilities applies
whether or not the borrower is experiencing financial difficulties. For further
discussion, see 7I.5.385.100.

7I.5.390 Accounting for substantial modification of terms

7I.5.390.10 If a modification of the terms of a debt instrument meets the
derecognition conditions in IAS 39, then any difference between the carrying amount
of the original liability and the consideration paid is recognised in profit or loss. The
consideration paid includes non-financial assets transferred and the assumption of
liabilities, including the new modified financial liability. Any new financial liability
recognised is initially measured at fair value. If a modification of terms is accounted
for as an extinguishment, then any costs or fees incurred are recognised as part of
the gain or loss on extinguishment and do not adjust the carrying amount of the new
liability. Accordingly, in our view no transaction costs should be included in the initial
measurement of the new liability unless it can be demonstrated incontrovertibly that
they relate solely to the new liability instrument and in no way to the modification of
the old liability. This would not usually be possible but might apply to taxes and
registration fees payable on execution of the new liability instrument. [IAS 39.41]

EXAMPLE 23 – COSTS INCURRED ON SUBSTANTIAL MODIFICATION OF TERMS

7I.5.390.15 Continuing Example 20B, if the modification transaction

is accounted for as an extinguishment, then all of the costs incurred by
Company Z as part of the modification transaction with Bank B – i.e.
65,000 – should be recognised in profit or loss.

7I.5.390.20 In our view, the accounting treatment for forgiveness of debt should
be based on an analysis of the nature of the transaction.
• If a shareholder forgives the debt, then it is likely that the shareholder is acting in
the capacity of a shareholder and that the forgiveness of debt should be treated as
a capital transaction. The outstanding financial liability should be reclassified to
equity and no gain or loss should be recognised (see 7I.3.390.50). For a discussion
of other debt-for-equity swaps, see 7I.5.410.
• If there is clear evidence that the shareholder is acting as a lender – i.e. in the
same way as an unrelated lender – then a gain or loss should be recognised in
profit or loss (with accompanying related party disclosures – see chapter 5.5).
• If a government forgives a loan, then the forgiveness should be treated as a
government grant (see chapter 4.3) unless the government is also a shareholder
and is acting in that capacity.

7I.5.390.30 The Standards do not specify where in the statement of profit or loss
and OCI a gain or loss on the extinguishment of debt should be presented. In our
view, it should be included in finance income or finance costs (see 7I.8.80).

7I.5.400 Accounting for non-substantial modification of terms

7I.5.400.10 IAS 39 does not provide guidance on the accounting treatment for the
difference in the present value arising as a result of a modification in terms of a debt
instrument that does not result in derecognition – i.e. because the terms are not
substantially different.

7I.5.400.20 A gain or loss can be recognised only when a debt instrument is

derecognised. Consequently, if there has been a modification in the terms of a debt
instrument that does not meet the derecognition conditions, then the carrying
amount of the liability is adjusted for fees and transaction costs incurred and no gain
or loss is recognised. In our view, any difference in present value arising as a result of
the modification should be recognised as an adjustment to the effective interest rate
and amortised over the remaining life of the modified financial liability. We believe
that the guidance in paragraph AG8 of IAS 39 does not apply to a renegotiation of the
contractual terms of an instrument because that guidance is for changes in estimates
within the existing contractual terms (see 7I.6.260.10). [IAS 39.40–41, AG8, AG62]

EXAMPLE 24 – COSTS INCURRED ON NON-SUBSTANTIAL MODIFICATION OF TERMS

7I.5.400.30 Continuing Example 20B, if the modification transaction

is not accounted for as an extinguishment, then the carrying amount of
Company Z’s loan is adjusted for costs of 53,000, comprising the fees
for the modification payable to Bank B (30,000), the cost of Z’s external
adviser (15,000) and the amount paid to B’s lawyer (8,000). However,
the costs of Z’s internal treasury department are recognised in profit
or loss because they are not directly attributable incremental
transaction costs (see 7I.6.30).

7I.5.410 Extinguishment of liabilities with equity instruments

7I.5.410.10 IFRIC 19 addresses the accounting for a renegotiation of the terms of
a financial liability that results in an entity issuing equity instruments to a creditor to
extinguish all or part of the financial liability. [IFRIC 19.2–3]

7I.5.410.20 IFRIC 19 does not apply if:

• the creditor is acting in its capacity as existing direct or indirect shareholder (see
1.2.190 and 7I.5.390.20);
• the creditor and the entity are controlled by the same party or parties before and
after the transaction and the substance of the transaction includes an equity
distribution from, or contribution to, the entity (see 1.2.80 and 7I.5.390.20); and
• the extinguishment is in accordance with the original terms of the financial
liability (see 7I.3.410). [IFRIC 19.3]

7I.5.410.30 If equity instruments are issued to a creditor to extinguish all or part

of a financial liability in a debt-for-equity swap, then the equity instruments are
consideration paid. The equity instruments are measured at fair value, unless their
fair value cannot be measured reliably, in which case the equity instruments are
measured with reference to the fair value of the financial liability extinguished. In
measuring the fair value of a financial liability extinguished that includes a demand
feature, paragraph 47 of IFRS 13 is not applied – i.e. the requirement that the fair
value of a financial liability with a demand feature is not less than the amount payable
on demand, discounted from the first date on which the amount could be required to
be paid, is not applied. The equity instruments are initially measured when the
financial liability (or part of that liability) is extinguished. A gain or loss on
extinguishment is recognised in accordance with 7I.5.370.50. [IAS 39.41, IFRIC 19.5–7, 9]

7I.5.410.40 If only part of the financial liability is extinguished by the issue of

equity instruments, then an assessment is made of whether some of the consideration
paid relates to a modification of the part of the liability that remains outstanding. If it
does, then the consideration paid is allocated between the part of the liability
extinguished and the part of the liability that remains outstanding. The consideration
allocated to the part that remains outstanding forms part of the assessment of
whether there has been a substantial modification of the terms of that remaining
liability (see 7I.5.380). An entity considers all relevant facts and circumstances in
making this allocation. In our view, judgement is required to determine both:
• the allocation of the consideration between the part of the liability extinguished
and the modified part that remains outstanding; and
• the part of the liability that is extinguished and the part that remains outstanding
and is modified. [IFRIC 19.8, 10]

7I.5.410.50 Judgement is required because the cash flows of the remaining loan
will not usually represent solely a fully proportionate share of the cash flows of the
original loan and, in some cases, a simple allocation method based on the change in
the nominal amount of the debt instrument may lead to unreasonable results,
particularly if the effective interest payable on the remaining nominal amount is
increased (see Example 25B).

EXAMPLE 25A – PARTIAL EXTINGUISHMENT BY EQUITY – ALLOCATION OF CONSIDERATION (1)

7I.5.410.60 Company X has an existing loan from Bank B. On 31
December 2021, X renegotiates the loan and enters into a debt-for-
equity swap with B whereby, in exchange for X issuing equity
instruments to B:
• the nominal amount of the loan is reduced by 50%; and
• the terms of the remaining portion are amended by extending the
maturity date and reducing the interest rate payable.

7I.5.410.70 There are no fees or transaction costs. The following

facts are also relevant for this example.

NEW INSTRUMENTS

OLD LOAN MODIFIED EQUITY

LOAN (50%) INSTRUMENTS

Nominal amount 1,000,000 500,000

Carrying amount 1,000,000

Fair value at 31
December 2020 910,000 350,000 560,000

7I.5.410.80 X analyses the transaction as an extinguishment of a 50%

proportionate share of the old loan, reflecting the reduction in nominal
amount, and a modification of the other 50% proportionate share of the
old loan. Based on this, X allocates the consideration paid by issuing
equity instruments between the extinguishment of part of the old loan
and the modification of the remaining loan based on the changes in fair
value of the loan as a result of the renegotiation, as follows:
• the extinguishment of 50% of the loan at fair value – 455,000
(910,000 x 50%); and
• the modification of the remaining 50% of the loan – 105,000
(455,000 - 350,000 or alternatively 560,000 - 455,000).

7I.5.410.90 Accordingly, X derecognises the 50% proportion of the

loan that is extinguished and recognises a gain on this proportion of
45,000 (1,000,000 x 50% - 455,000). X considers the allocation of
105,000 of consideration to the modification of the remaining 50% of
the loan in determining whether that remaining 50% proportion is
substantially modified.

• If the remaining 50% of the loan is considered substantially

modified, then that remaining 50% is also derecognised – leading to
initial recognition of the new loan at its fair value of 350,000 and a
 further gain of 45,000 (1,000,000 x 50% - 105,000 - 350,000).
• If the remaining 50% of the loan is not considered to be
substantially modified, then its carrying amount is reduced by the
consideration paid of 105,000 to 395,000 and a new effective
interest rate is calculated based on the modified terms. [IAS 39.42,
AG62]

7I.5.410.100 As an alternative approach, X may instead first

determine the allocation of the carrying amount of the old loan
between the part that has been extinguished and the remaining part
that has been modified based on the ratio of the decrease in the fair
value of the loan to the fair value of the remaining part of the loan, as
shown in the following table. [IAS 39.42]

FAIR VALUE FAIR VALUE ALLOCATED

RATIO CARRYING
AMOUNT

Old loan 910,000 - 1,000,000

Modified loan 350,000 38.5% 385,000

Extinguished loan 560,000(1) 61.5% 615,000

Note
1. Calculated as 910,000 - 350,000.

7I.5.410.110 Under this approach, in determining the allocation of

the consideration paid by issuing equity instruments between the
partial extinguishment of the loan and the modification of the
remaining loan as required by IFRIC 19 (see 7I.5.410.40), X concludes
that the entire consideration of 560,000 is allocated to extinguishment
of part of the old loan. This is consistent with the approach used to
determine the part of the old loan that is extinguished.

7I.5.410.120 Accordingly, X derecognises the 61.5% proportion of

the old loan that is extinguished and recognises a gain on this
proportion of 55,000 (1,000,000 x 61.5% - 560,000). In determining
whether the remaining 38.5% of the loan is substantially modified, X
compares 38.5% of the present value of the cash flows of the old loan
with the present value of the cash flows of the amended loan,
discounted in each case using the original effective interest rate of the
old loan (see 7I.5.385.10).
• If the remaining 38.5% of the loan is considered substantially
modified, then that remaining 38.5% is also derecognised – leading
 to initial recognition of the new loan at its fair value of 350,000 and
a further gain of 35,000 (385,000 - 350,000).
• If the remaining 38.5% of the loan is not considered to be
substantially modified, then its carrying amount of 385,000 is not
adjusted and a new effective interest rate is calculated based on the
modified terms. [IAS 39.42, AG62]

EXAMPLE 25B – PARTIAL EXTINGUISHMENT BY EQUITY – ALLOCATION OF CONSIDERATION (2)

7I.5.410.130 Modifying Example 25A such that the terms of the

renegotiation are as follows:
• the nominal amount of the loan is reduced by 10%; and
• the terms of the remaining loan are amended by increasing the
interest rate payable.

7I.5.410.140 The following facts are also relevant for this example.

NEW INSTRUMENTS

OLD LOAN MODIFIED EQUITY

LOAN (90%) INSTRUMENTS

Nominal amount 1,000,000 900,000

Carrying amount 1,000,000

Fair value at 31
December 2020 1,000,000 960,000 40,000

7I.5.410.150 If X were to allocate the carrying amount of the old loan

between the amount that has been extinguished and the amount that
has been modified based only on the reduction in the nominal amount
of the loan, then it would compare:
• 10% of the carrying amount of the loan extinguished – i.e. 100,000
(1,000,000 x 10%); and
• the fair value of the consideration paid – i.e. 40,000.
7I.5.410.160 This would lead to the recognition of a gain of 60,000
on derecognition of 100,000 of the old loan.

7I.5.410.170 However, X considers all relevant facts and

circumstances, including the following:
• the rate of interest payable on the remaining loan has been
increased such that the fair value of the modified loan is 60,000
greater than would be implied by a 10% pro rata extinguishment;
and
•
 • the carrying amount of the old loan is equal to the fair value of the
equity instruments plus the fair value of the modified loan.

7I.5.410.180 Therefore, X concludes that the approach discussed in

7I.5.410.80 would not be appropriate and that the fair value of the
equity shares of 40,000 should be allocated against an extinguishment
of only 40,000 of the original liability.

7I.5.410.190 Accordingly, X derecognises 40,000 of the loan that is

extinguished and recognises the consideration paid of 40,000 in equity.
No gain or loss is recognised from the transaction and a new effective
interest rate is calculated based on the modified terms – assuming that
the modification of the remaining part of the loan was not considered
substantial.

7I.5.420 Amendment of contractual terms of financial liability

resulting in change in classification to equity
7I.5.420.10 If the terms of a financial liability are amended such that the financial
liability subsequent to the amendment of the terms meets the definition of an equity
instrument, then in our view the transaction should be accounted for as an
extinguishment of a financial liability in accordance with 7I.5.410.30. For example, a
company issues preference shares that meet the definition of a financial liability.
Subsequently, the entity and the holders of the preference shares agree to amend the
terms of the preference shares so that they meet the criteria for equity classification
(see 7I.3.20). We believe that such a transaction involves two steps: an
extinguishment of a financial liability and the issue of new equity instruments at fair
value. For further discussion, see 7I.3.420.60.

7I.5.425 Trade payables and reverse factoring

7I.5.425.10 Under a reverse factoring arrangement (see 7I.8.45), a factor agrees

to pay amounts to a supplier in respect of invoices owed by the supplier’s customer
and receives settlement from that customer, usually at a later date.

7I.5.425.20 Typically, when an invoice is made subject to the reverse factoring

arrangement and/or when the factor pays the supplier, the customer does not
discharge its financial liability to the supplier (see 7I.5.370.10). However, the
customer assesses whether it is legally released from the primary responsibility for
the original financial liability under the invoice and this is replaced by a new financial
liability to the factor. This assessment may require the assistance of a legal expert.

7I.5.425.30 If there is no such legal release, then the customer assesses whether
the financial liability has been substantially modified as a result of the reverse
factoring arrangement (see 7I.5.380). This is because a substantial modification of
the terms of an existing financial liability (or a part of it) is also accounted for as an
extinguishment of the original financial liability and the recognition of a new financial
liability.

7I.5.425.40 For a further discussion of reverse factoring, see 2.3.75 and 7I.8.45,
205 and 375.

7I.5.430 DERECOGNITION OF DERIVATIVES

7I.5.430.10 Many derivatives – e.g. forward contracts and interest rate swaps – do
or can involve two-way payments between the parties. These derivatives might
change from being an asset to a liability or vice versa. Such derivatives are
derecognised only when they meet both the derecognition criteria for financial assets
(see 7I.5.60) and the derecognition criteria for financial liabilities (see 7I.5.370). [IAS
39.BC220B]

7I.5.440 Novation of derivatives to central counterparty

7I.5.440.10 An example of a transaction that results in the derecognition of a

derivative is the novation of a derivative to a central counterparty. For example,
assume that Company X and Company Y have entered into an over-the-counter
derivative contract. Novation to a central counterparty involves cancelling the
original derivative contract between X and Y and replacing it with two new derivative
contracts – i.e. a new contract between X and the central counterparty, and a new
contract between Y and the central counterparty.

7I.5.440.20 A novation of a derivative to a central counterparty results in the

derecognition of the derivative because, through the novation, each party to the
original derivative has new contractual rights (or obligations) to cash flows from a
new derivative with the central counterparty, and this new contract replaces the
original contract with the original counterparty. Accordingly, the original derivative
with the counterparty has expired and therefore the derecognition criteria for
financial assets are met (see 7I.5.90). In addition, the novation to the central
counterparty releases the party from the responsibility to make payment to the
original counterparty and therefore the derecognition criteria for financial liabilities
are also met (see 7I.5.370.10). [IAS 39.17(a), AG57(b), BC220C–BC220E]

7I.5.440.30 For a discussion about the effect of a novation of a derivative on hedge

accounting, see 7I.7.685.

7I.5.450 Variation margin payments and receipts

7I.5.450.10 Many derivatives involve variation margin payments and receipts.

Many of these transactions are cleared through clearing houses – e.g. futures
contracts – and involve periodic (normally daily or intra-day) payments or receipts of
variation margin that is required by the clearing house and reflects changes in the
value of the related derivative.

7I.5.450.20 Variation margin may take the form of cash, securities or other
specified assets, typically liquid assets. An entity needs to determine based on the
recognition and derecognition criteria for financial assets and financial liabilities (see
7I.5.60 and 370) whether making variation margin payments and receipts represents:
• a partial settlement of contractual rights to receive or obligations to pay cash
under the relevant derivative contracts, which means that derecognition of the
variation margin payments or receipts and the corresponding carrying amount of
the relevant derivative contracts is required at the time of payment; or
• the establishment or settlement of an accumulated variation margin balance that
is a separate financial asset or financial liability.

7I.5.450.25 If the payment or receipt of variation margin is not a settlement of the

derivative contract, then the accumulated balance is usually a financial asset or
financial liability – e.g. the balance may be required to be repaid in the future or may
be used to settle the derivative contract at its maturity.

7I.5.450.30 Whether the payment or receipt of variation margin represents a

settlement of a derivative contract is assessed with reference to the concepts of
extinguishment – i.e. the obligation specified in the contract is discharged or
cancelled or expires – and of expiry of contractual rights to cash flows (see 7I.5.90
and 370.10). Whether these derecognition criteria are met will depend on the specific
contractual terms considered in conjunction with other relevant documentation and
applicable law. [IAS 39.17(a), 39]

EXAMPLE 26 – PAYMENT OF VARIATION MARGIN REPRESENTS SETTLEMENT ON FUTURE

CONTRACTS – COLLATERALISED-TO-MARKET MODEL

7I.5.450.40 On 25 May 2021, Company B enters into a futures

contract through Clearing House C to buy a specified quantity of
shares in Company X for 100 in three months. The contract states that:

• B will pay (receive) variation margin in cash to (from) C equal to the

decrease (increase) in the market futures price at the end of each
day; and
• the exercise price payable on maturity of the contract will be
reduced (increased) by an amount equal to the amount of variation
margin paid by B to C (received by B from C).

Futures contract to buy shares in Company X

Variation margin settled daily

Company B Clearing
House C
Exercise price adjusted
for variation margin
 7I.5.450.50 The contract does not allow for the variation margin to
be repaid and no interest is payable on variation margin.

7I.5.450.60 On 26 May 2021, the market futures price declines to 98.

At the end of that day, B pays variation margin of 2 to C and the
exercise price is reset to 98.

7I.5.450.70 B concludes that the payment of variation margin

represents a settlement of the futures contract because it extinguishes
a specified part of its obligation to pay the exercise price on maturity.

7I.5.450.80 Immediately before payment of variation margin on 26

May 2021, the futures contract is a derivative liability of 2. The
payment of the variation margin represents a derecognition of the
derivative liability and, following the payment of 2, the fair value of the
futures contract is zero because it has an exercise price equal to the
current market price.

EXAMPLE 27 – PAYMENT OF VARIATION MARGIN REPRESENTS SEPARATE ASSET –

COLLATERALISED-TO-MARKET MODEL

7I.5.450.90 Company X enters into a 10-year interest rate swap

derivative with Clearing House C under a ‘collateralised-to-market’
framework. The derivative requires net payments of coupons on each
anniversary of the transaction through to maturity. X has other interest
rate swaps outstanding with C. The rules of C state that:
• X will pay (receive) variation margin in cash to (from) C at the end of
each day, such that the net accumulated balance of the variation
margin is equal and opposite to the estimated fair value of all
outstanding swap contracts between X and C;
• interest at a market rate is payable on the accumulated balance of
variation margin;
• a party is entitled to set off the net balance of variation margin that
it has paid (or received, as the case may be) against the obligation
to make any payment (or right to receive any payment, respectively)
of coupons on the swap contract on the date on which those
coupons fall due for settlement; and

• on maturity or termination of all swap transactions between X and C

and following settlement of all payments due under such swap
contracts, any remaining balance of the variation margin is
returned to the party that paid it.
 10­year interest rate swap

Variation margin settled daily

Clearing
Company X
House C
Swap payments set off
against variation margin
7I.5.450.100 X concludes that the payment of variation margin does
not represent a settlement of rights or obligations under the
derivative. This is because these amounts will continue to become due
and payable in the future in accordance with the terms of the
derivative and are not reduced or increased by any amount of variation
margin received or paid.

7I.5.450.110 The accumulated variation margin balance represents

a separate financial asset or financial liability because:
• the accumulated balance will either be used in the future to settle
payments on this or other swaps or be returned to the payer; and
• interest is payable on the accumulated balance.

EXAMPLE 28 – PAYMENT OF VARIATION MARGIN REPRESENTS SETTLEMENT – SETTLED-TO-

MARKET MODEL

7I.5.450.120 Company X enters into a 10-year interest rate swap

derivative with Clearing House D under a ‘settled-to-market’
framework. The terms of the contract are:
• X will pay to (receive from) D an amount in cash at the end of each
day equal to the net of:
– coupons due for settlement on the swap that day;
– variation margin equal to the decrease (increase) in the net
present value (NPV) of expected future coupons receivable on
the swap, calculated based on current market rates; and
– price alignment adjustment (PAA).
• PAA is calculated as a current market interest rate on the net
cumulative amount of variation margin paid or received to date.
However, there is no right or obligation to the return of variation
margin and the contract states that payment of variation margin is a
partial settlement of the outstanding derivative position and does
not constitute collateral.
• The PAA is included as an extra cash flow within the derivative
 contract and is similar to the interest that would have been paid or
received on cash collateral had a similar contract been transacted
under a collateralised-to-market contract (as in Example 27 above).

7I.5.450.130 X concludes that the daily net cash payments, including

variation margin, should be accounted for as partial settlements of the
derivative in accordance with the terms of the contract.

7I.5.450.140 If daily variation payments are considered settlements on the

underlying trade for a settled-to-market contract, then the daily variation payments
give rise to a partial derecognition of the derivative asset or liability. This reduces the
recognised asset or liability arising from the derivative’s fair value and does not
result in additional financial assets or financial liabilities being recognised. The
derivative continues to exist (i.e. partial settlement does not result in termination)
but has a current fair value of zero (or close to zero) immediately following the daily
settlement payment.

7I.5.450.150 If payments and receipts of variation margin are not a settlement of

the related derivatives, then the entity needs to consider whether the variation
margin balance and the related derivatives should be offset in the statement of
financial position (see 7I.8.90). Conversely, for derivative transactions in which daily
variation payments represent settlements and not collateral, no offsetting takes place
between cumulative variation payment amounts and the underlying derivative
because they are a single unit of account.

7I.5.500 CHANGES REQUIRED BY INTEREST RATE

BENCHMARK REFORM

7I.5.500.10 A change in the basis for determining the contractual cash flows of a
financial asset or a financial liability may be required by interest rate benchmark
reform (see 7I.7.872.10). If the change is necessary as a direct consequence of
interest rate benchmark reform and the new basis is economically equivalent to the
previous basis then, as a practical expedient, an entity applies the guidance on
floating rate financial instruments to account for the changes(see 7I.6.335). [IFRS
4.20R, IFRS 9.5.4.5, 5.4.7]

7I.5.500.20 If changes are made to a financial asset or financial liability in

addition to changes required by interest rate benchmark reform, an entity would first
apply the practical expedient referred to in 7I.5.500.10 to the changes required by
interest rate benchmark reform and then applies the general requirements in 7I.5.95
or 7I.5.380 to the other changes to determine whether the financial instrument
should be derecognised (see 7I.6.335.40). [IFRS 4.20R, IFRS 9.5.4.9, BC5.302, 308, 318]

© 2021 KPMG IFRG Limited, a UK Company, Limited by Guarantee

27 OCT 2022 PAGE 2803

Insights into IFRS 18th Edition 2021/22

7I. Financial instruments: IAS 39
7I.6 Measurement and gains and losses

7I.6 Measurement and gains and losses

7I.6.10 Introduction 2806

7I.6.20 Measurement on initial recognition 2806
7I.6.22 Trade receivables 2806
7I.6.23 Instruments acquired in a business combination in
the scope of IFRS 3 2807
7I.6.24 Instruments acquired as part of a group of assets 2807
7I.6.25 Settlement of contracts to acquire assets and loan
commitments 2808
7I.6.26 Immediate gain or loss 2809
7I.6.30 Transaction costs 2811
7I.6.40 Internal costs 2813
7I.6.50 Facility or commitment fees paid 2813
7I.6.60 Low-interest and interest-free loans 2813
7I.6.70 Determining fair value 2813
7I.6.80 Short-term receivables and payables 2814
7I.6.90 Accounting for differences between fair
value and consideration given or
received 2814
7I.6.100 Intra-group low-interest and interest-
free loans 2815
7I.6.110 Related party transactions 2815
7I.6.115 Financial liability resulting from a failed sale in a
sale-and-lease- back arrangement 2816
7I.6.120 Subsequent measurement 2816
7I.6.130 General considerations 2816
7I.6.140 Derivatives 2816
7I.6.150 Held-to-maturity investments 2816
7I.6.160 Loans and receivables 2817
7I.6.170 Available-for-sale financial assets 2817
7I.6.180 Liabilities 2818
7I.6.185 Financial liability resulting from a failed
sale in a sale and leaseback transaction 2818
7I.6.190 Fair value 2819
7I.6.200 General 2819
7I.6.210 Equity instruments: Fair value exemption 2819
7I.6.220 Amortised cost 2820
7I.6.230 Effective interest rate calculation 2820
7I.6.240 Effective interest method 2820
7I.6.250 Contractual or estimated cash flows 2822
 7I.6.260 Changes in timing or amount of
estimated cash flows 2823
7I.6.270 Floating rate financial assets and financial
liabilities 2824
7I.6.280 Stepped interest 2826
7I.6.290 Modification of financial liabilities 2827
7I.6.300 Instruments acquired in a business combination in
the scope of IFRS 3 2827
7I.6.310 Hedged item in fair value hedge 2828
7I.6.320 Discounts, premiums and pre-acquisition interest 2828
7I.6.330 Interest income after impairment recognition 2829
7I.6.335 Changes required by interest rate benchmark
reform 2829
7I.6.340 Financial instruments measured in foreign currency 2830
7I.6.350 General considerations 2830
7I.6.360 Monetary items carried at amortised cost 2830
7I.6.370 Available-for-sale monetary items 2831
7I.6.380 Non-monetary items measured at fair value 2833
7I.6.390 Dual-currency loans 2834
7I.6.400 Impairment of financial assets 2834
7I.6.410 Objective evidence of impairment 2835
7I.6.420 Debt instruments 2836
7I.6.430 Equity instruments 2837
7I.6.440 Portfolios of assets 2839
7I.6.470 Impairment loss calculations 2840
7I.6.480 Loans and receivables and held-to-
maturity investments 2840
7I.6.500 Available-for-sale financial assets 2843
7I.6.520 Assets measured at cost because fair
value not reliably measurable 2844
7I.6.530 Hedged assets 2844
7I.6.540 Collateral 2846
7I.6.550 Measuring impairment of financial
assets denominated in foreign currency 2848
7I.6.560 Impairment examples 2849
7I.6.570 Collective impairment assessment 2850
7I.6.580 Determining whether individual or
collective assessment is appropriate 2850
7I.6.590 Impairment of reclassified assets 2852
7I.6.600 Recognition of impairment losses
incurred but not reported 2852
7I.6.610 Emergence period 2853
7I.6.620 Measuring collective impairment 2854
7I.6.630 Bad debts and loan losses 2855
7I.6.640 Reversals of impairment losses 2855
7I.6.650 Loans and receivables and held-to-
maturity investments 2855
7I.6.660 Available-for-sale financial assets 2855
 7I.6.670 Assets carried at cost because fair value
not reliably measurable 2858
7I.6.680 Interim financial statements 2858
7I.6.690 Dividend income 2858
7I.6.700 Recognition of dividend income 2858
7I.6.710 Dividends from subsidiaries, associates and joint
ventures 2859
7I.6.720 Share dividends 2859
7I.6.730 Fee income 2860

7I.6 Measurement and gains and losses

REQUIREMENTS FOR INSURERS THAT APPLY IFRS 4

In July 2014, the International Accounting Standards Board issued IFRS 9 Financial Instruments,
which is effective for annual periods beginning on or after 1 January 2018. However, an insurer may
defer the application of IFRS 9 if it meets certain criteria (see 8.1.180).

This chapter reflects the requirement of IAS 39 Financial Instruments: Recognition and
Measurement and the related standards, excluding any amendments introduced by IFRS 9. These
requirements are relevant to insurers that apply the temporary exemption from IFRS 9 or the overlay
approach to designated financial assets (see 8.1.160) and prepare financial statements for periods
beginning on 1 January 2021. For further discussion, see Introduction to Sections 7 and 7I.

The requirements related to this topic are mainly derived from the following.

STANDARD TITLE

IFRS 13 Fair Value Measurement

IFRS 15 Revenue from Contracts with Customers

IAS 21 The Effects of Changes in Foreign Exchange Rates

IAS 39 Financial Instruments: Recognition and Measurement

The currently effective requirements include newly effective requirements arising from Interest Rate
Benchmark Reform Phase 2 – Amendments to IFRS 9, IAS 39, IFRS 7, IFRS 4 and IFRS 16, which are
effective for annual periods beginning on or after 1 January 2021. The impact of the amendments is
discussed in the following sections:
• modifications of financial assets and financial liabilities: 7I.5.500, 7I.6.335 and 8.1.170.35;
• hedge accounting: 7I.7.877;
• disclosures about the nature and extent of risks arising from interest rate benchmark reform and
progress in completing the transition to alternative benchmarks: 7I.8.277;
• transition requirements: 7I.7.882; and
• leases: 5.1.370.30.

FORTHCOMING REQUIREMENTS AND FUTURE DEVELOPMENTS

For this topic, there are no forthcoming requirements or future developments.

7I.6.10 INTRODUCTION

7I.6.10.10 This chapter provides guidance on the measurement of financial assets and financial
liabilities, including financial instruments denominated in foreign currency, and addresses certain
issues related to revenue arising from financial instruments.

7I.6.20 MEASUREMENT ON INITIAL RECOGNITION

7I.6.20.10 On initial recognition, a financial asset or financial liability is measured at fair value
plus directly attributable transaction costs, unless:
• the instrument is classified as at FVTPL, in which case transaction costs are not included; or
• the instrument is a trade receivable that is initially measured at the transaction price as defined in
IFRS 15 (see 7I.6.22). [IAS 39.43, 44A, IFRS 15.60–65]

7I.6.20.20 Normally, the fair value on initial recognition is the transaction price – i.e. the fair
value of the consideration given or received for the financial instrument. For a discussion of
situations in which the fair value on initial recognition may differ from the transaction price, see
7I.6.26 and 2.4.320. [IAS 39.43A, AG64]

7I.6.20.30 If part of the consideration given or received is for something in addition to the
financial instrument, then the entity separately measures the fair value of the financial instrument in
accordance with IFRS 13 (see chapter 2.4). Any additional element is accounted for separately. For
example, in the case of a long-term loan that carries no interest, the fair value of the loan can be
measured as the present value of all cash receipts discounted using the current market interest rate
for a similar financial instrument. Any additional amount lent is an expense or a reduction of income
unless it qualifies for recognition as an asset (see 7I.6.60–70 and 90). [IAS 39.AG64]

7I.6.22 Trade receivables

7I.6.22.10 Trade receivables that do not have a significant financing component (determined in
accordance with IFRS 15) are measured on initial recognition at their transaction price as defined in
IFRS 15 – i.e. the amount of consideration to which the entity expects to be entitled for transferring
the promised goods or services to the customer (see 4.2.90). [IAS 39.44A, IFRS 15.60–65, A]

7I.6.22.20 For a discussion of factors considered in determining whether a contract contains a

significant financing component, see 4.2.130.30.

7I.6.22.30 Trade receivables with a significant financing component are not exempt from being
measured at fair value on initial recognition, unless 7I.6.22.40 applies. Therefore, differences may
arise between the initial amount of revenue recognised in accordance with IFRS 15 – which is
measured at the transaction price as defined in IFRS 15 – and the fair value of the trade receivable
recognised at the date of initial recognition. Any difference between the measurement of the
receivable in accordance with IAS 39 and the corresponding amount of revenue recognised in
accordance with IFRS 15 is presented as an expense. [IFRS 15.108, C9]

7I.6.22.40 If an entity expects, at contract inception, that the period between the entity
transferring a promised good or service to the customer and the customer paying for that good or
service will be one year or less, then as a practical expedient, the entity can choose not to adjust the
promised amount of consideration for the effects of a significant financing component. If the entity
applies this practical expedient, then the trade receivable is measured on initial recognition at the
transaction price as defined in IFRS 15, in the same way as trade receivables that do not have a
significant financing component. [IAS 39.44A, IFRS 15.63]

7I.6.23 Instruments acquired in a business combination in the scope of

IFRS 3

7I.6.23.10 All financial instruments that are acquired as part of a business combination in the
scope of IFRS 3 are initially measured by the acquirer at their fair value at the date of acquisition
(see 2.4.1000). [IFRS 3.18]
7I.6.24 Instruments acquired as part of a group of assets

7I.6.24.10 Financial instruments may be acquired as part of a group of assets and liabilities that
does not constitute a business. In these cases, IFRS 3 requires the purchaser to allocate the cost of
the group to the individual identifiable assets and liabilities on the basis of their relative fair values
at the date of acquisition (see 2.6.1150). [IFRS 3.2(b)].

7I.6.24.20 The IFRS Interpretations Committee considered how this requirement should be
applied when:
• the sum of the individual fair values of the identifiable assets and liabilities is different from the
transaction price; and
• the group includes assets and liabilities initially measured both at cost and at an amount other
than cost.

7I.6.24.30 The Committee noted that to account for such an acquisition, an entity first reviews
the procedures used to determine fair values to assess whether a difference between the sum of the
individual fair values of the identifiable assets and liabilities and the transaction price truly exists.
The entity needs to consider whether there are factors specific to the transaction and/or to the group
that indicate that the total transaction price may not be representative of the total fair value of the
identifiable assets and liabilities. If this is the case, then the entity chooses an accounting policy, to
be applied consistently, based on one of the following approaches.
• Approach 1: Allocate the cost of the group of assets between the individual assets and liabilities
based on their relative fair values at the date of acquisition, and then apply the initial
measurement requirements in the applicable standards to each identifiable asset acquired and
liability assumed, including the requirements on how to account for any difference between the
transaction price and the amount at which the asset or liability is initially measured under the
relevant standard.
• Approach 2: Measure any identifiable asset or liability initially measured at an amount other than
cost in accordance with the applicable standards, deduct from the cost of the group of assets the
amounts allocated to these assets and liabilities, and then allocate the residual cost of acquisition
to the remaining identifiable assets and liabilities based on their relative fair values at the date of
acquisition. [IU 11-17]

7I.6.24.40 When applying Approach 1 in 7I.6.24.30, an entity considers the requirements in IAS
39 to determine how to account for the difference between the allocated transaction price and the
fair value of each financial asset and financial liability acquired (see 7I.6.20.20-30 and 7I.6.26). [IU
11-17]

7I.6.24.50 When applying Approach 2 in 7I.6.24.30, an entity initially measures each financial
asset and financial liability acquired at fair value (plus any eligible transaction costs for instruments
not subsequently measured at FVTPL (see 7I.6.30)), considering the guidance in 7I.6.20.30. If an
entity acquires only financial instruments, then the acquisition is different from the scenario
addressed by the Committee and Approach 2 in 7I.6.24.30 cannot be applied because there are no
other identifiable assets and liabilities. [IU 11-17]

7I.6.25 Settlement of contracts to acquire assets and loan commitments

7I.6.25.10 A contract to acquire a financial asset generally is itself a financial instrument (see
7I.1.25). The financial asset to be acquired is not generally recognised until the acquisition contract
is settled because this is usually when the acquirer becomes a party to the contract that is the
financial asset. In this case, the acquired financial asset is initially recognised based on its fair value
on the settlement date. If the contract to acquire the financial asset is accounted for as a derivative,
then it is measured at FVTPL. Changes in the fair value of the derivative contract between the date of
entering into the derivative contract and its settlement date are recognised in profit or loss as they
arise. The fair value of this derivative contract immediately before settlement usually equals the
difference between the fair value of the acquired asset at settlement and the purchase price payable
at settlement, meaning that no additional gain or loss arises on settlement.

7I.6.25.20 However, if the contract to acquire the financial asset is a regular-way contract, then
it is not accounted for as a derivative. In this case, either trade date or settlement date accounting
may be applicable to the acquired asset and this would determine when the acquired asset is initially
recognised and, for settlement date accounting, the treatment of changes in the fair value of the
acquired asset between the trade date and the settlement date (see 7I.5.20). [IAS 39.14, 38, AG53–AG56]

7I.6.25.30 As opposed to settlement of a contract to acquire an existing financial asset, a loan

may be originated as a result of a drawdown under a loan commitment. To simplify the accounting
for holders and issuers of loan commitments, many loan commitments are excluded from the scope
of IAS 39 so that an entity does not recognise changes in their fair value that result from changes in
market interest rates or credit spreads, consistent with the amortised cost measurement model for
loans and receivables.

7I.6.25.40 Accordingly, in our view, when a loan that will be measured at amortised cost is drawn
down under an arm’s length loan commitment that is outside the scope of IAS 39 and that is not
onerous, the resulting loan asset or liability may be viewed as a continuation of the loan
commitment. Under this approach, the fair value measurement of the loan on initial recognition is
based on circumstances on the commitment date. Therefore, the fair value of the loan on initial
recognition would usually be considered to be the amount advanced, adjusted for facility or
commitment fees paid or received (see 7I.6.30, 50 and 730), being the transaction price agreed on
the commitment date (see 7I.6.20.20). This means that no day one gain or loss would usually be
recognised on the loan origination date.

EXAMPLE 1 – INITIAL MEASUREMENT OF A LOAN RESULTING FROM A LOAN COMMITMENT

7I.6.25.45 On 1 April 2021, Bank B enters into a commitment to make a loan of

100 to Borrower C on arm’s length terms and at an interest rate of 5% a year
(assume that any fees and costs are insignificant). On 31 May 2021, C draws down
the loan. The fair value of the loan is 100 on 1 April and 98 on 31 May.

7I.6.25.47 Applying the approach in 7I.6.25.40, B initially recognises the loan on

31 May using the fair value on 1 April of 100.

7I.6.25.50 An alternative acceptable approach is to view the loan that is drawn down as a
separate financial instrument for the purposes of initial measurement, with the amount initially
recognised for the loan on the draw-down date being based on an analysis of the circumstances at
that time, including the entity’s determination of the transaction price for the loan – i.e. the fair value
of the consideration given for the loan – and the fair value of the loan at that time. Accordingly, the
carrying amount under this alternative acceptable approach would be:
• based on the transaction price if that is the best evidence of fair value on the draw-down date or if
the entity’s alternative estimate of fair value does not satisfy the observability condition in
paragraph AG76(a) of IAS 39 (see 7I.6.26.50); or
• the entity’s alternative estimate of fair value on the draw-down date if this alternative estimate
satisfies the observability condition in paragraph AG76(a) of IAS 39 (see 7I.6.25.40).

7I.6.25.60 For loans drawn down under loan commitments that are measured at FVTPL, the
analysis is similar to that discussed in 7I.6.25.10 for derivative contracts to acquire a financial asset.
In this case, the loan is initially measured at fair value at the time of drawdown. [IAS 39.BC16]

7I.6.26 Immediate gain or loss

7I.6.26.10 Sometimes an entity acquires a financial instrument in one market and intends to sell
it or to issue an offsetting instrument in a different market. There is an issue about whether the
instrument may be initially measured at its fair value in the selling market and therefore whether a
gain may be recognised on initial recognition (‘day one gain’).

7I.6.26.20 Similarly, an entity may believe that the initial fair value of an instrument exceeds the
consideration paid or received, because of the entity’s repackaging of the instrument or a built-in
‘fee’. There is an issue about whether this fee may be recognised immediately (similar to a day one
gain).

7I.6.26.30 Under IFRS 13, the transaction price – i.e. the fair value of the consideration given or
received for the financial instrument – is normally the best evidence of the fair value of a financial
instrument on initial recognition. However, there may be cases in which it is appropriate for an entity
to conclude that the fair value on initial recognition is different from the transaction price – e.g. when
the principal market is different from the market in which the instrument was acquired. For other
examples of conditions that can result in a difference between the fair value on initial recognition
and the transaction price, see 2.4.320. [IAS 39.AG64, AG76, IFRS 13.57–60]

7I.6.26.35 Fair value is defined as the price that would be received to sell an asset or paid to
transfer a liability in an orderly transaction between market participants at the measurement date
(see 2.4.60.10). A fair value measurement therefore reflects factors that a market participant would
consider in pricing the instrument, including any valuation adjustments (see 2.4.240). If valuation
adjustments relate to a group of financial instruments (portfolio-level adjustments), then an entity
needs to allocate these to individual assets and liabilities on a reasonable and consistent basis using
a methodology that is appropriate in the circumstances (see 2.4.430.70). [IFRS 13.A, 50]

7I.6.26.40 If the entity’s fair value measurement is evidenced by a quoted price in an active
market for an identical asset or liability or is based on another valuation technique that uses only
data from observable markets, then the entity immediately recognises a gain or loss. This gain or loss
is equal to the difference between the fair value on initial recognition and the transaction price.
When determining whether an entity’s fair value measurement is based on a valuation technique that
uses only data from observable markets, the entity needs to consider inputs to any valuation
adjustments, including any allocated portfolio-level adjustments (see 2.4.430.70 and 90). [IAS 39.43A,
AG76]

7I.6.26.50 If the entity determines that the fair value on initial recognition differs from the
transaction price, but this fair value measurement is not evidenced by a valuation technique that
uses only data from observable markets, then the carrying amount of the financial instrument on
initial recognition is adjusted to defer the difference between the fair value measurement and the
transaction price. This deferred difference is subsequently recognised as a gain or loss only to the
extent that it arises from a change in a factor (including time) that market participants would
consider in setting a price. [IAS 39.43A, AG76–AG76A]

7I.6.26.60 However, in our experience some banks recognise losses equal to the difference
between the fair value on initial recognition and the transaction price immediately, even if the
valuation technique is not based wholly on observable market data. Additionally, in our experience
banks may consider the recognition of day one gains if any unobservable inputs used in the valuation
technique that forms the basis for determining the instrument’s fair value on initial recognition are
judged to be insignificant in relation to measuring the day one gain.

7I.6.26.70 The table below illustrates the application of the day one gain or loss guidance on
initial recognition if:
• a difference arises between the transaction price (say, 100) and management’s alternative
estimate of fair value (say, 99); and
• the observability condition is not satisfied (see 7I.6.26.50). [IAS 39.AG76–AG76A]
 APPLICATION OF DAY ONE GAIN AND LOSS GUIDANCE IF OBSERVABILITY CONDITION IS NOT MET

Fair value: Management’s estimate of exit price 99

Initial Fair value 99

measurement plus difference between transaction price and fair value 1 (100 - 99)
(ignoring
transaction costs): = 100

EXAMPLE 2 – INITIAL RECOGNITION AT TRANSACTION PRICE (FAIR VALUE OF CONSIDERATION)

7I.6.26.80 Company D acquires a portfolio of impaired loans for 30 from

Company E. The carrying amount of the loans in E’s books is 29 (a face value of 100
less impairment losses of 71). D has superior cash-collection processes in place and
expects to recover 50 of the principal amount of the loans. Based on a discounted
cash flow analysis, D values the loans at 36.

7I.6.26.90 In our view, it would not be appropriate to conclude that the

transaction price of 30 does not represent the fair value of the loans acquired. The
valuation technique used to arrive at the value of 36 takes into account D’s specific
cash-collection processes. This is not an assumption that a market participant would
use when pricing a loan in the portfolio because D’s superior cash-collection
processes are a characteristic specific to D.

7I.6.26.100 Consequently, D should initially recognise the loans acquired at the

transaction price. D’s estimates of the amounts and timing of cash flows should
instead be used to determine the effective interest rate of the loans, which should be
used in subsequent periods to measure their amortised cost.

7I.6.30 Transaction costs

7I.6.30.10 Transaction costs are included in the initial measurement of financial assets and
financial liabilities, except for those classified as at FVTPL and trade receivables initially measured
at the transaction price (see 7I.6.22). [IAS 39.43, 44A]

7I.6.30.15 Transaction costs include only those costs that are directly attributable to the
acquisition or origination of a financial asset or issue of a financial liability. They are incremental
costs that would not have been incurred if the instrument had not been acquired, originated or
issued – e.g. fees and commission paid to agents (including employees acting as selling agents),
advisers, brokers and dealers, levies by regulatory agencies and securities exchanges, transfer taxes
and duties, credit assessment fees, registration charges and similar costs. In our experience, few
internal costs are likely to meet this requirement (see 7I.6.40). The requirement is applied on an
instrument-by-instrument basis. Transaction costs do not include the internal costs associated with
developing a new investment product. [IAS 39.9, 43, AG13]

7I.6.30.20 For financial assets, transaction costs are added to the amount initially recognised,
whereas for financial liabilities transaction costs are deducted from the amount initially recognised.
Transaction costs on financial instruments at FVTPL are not included in the amount at which the
instrument is initially measured; instead, they are immediately recognised in profit or loss. [IAS
39.IG.E.1.1]

EXAMPLE 3 – TRANSACTION COSTS

 7I.6.30.30 Company F issues debt of 1,000 at par and incurs direct incremental
issue costs of 50. The debt will be redeemed at par. Ignoring interest, there is a
difference of 50 between the carrying amount at inception of 950 and the
redemption amount of 1,000.

7I.6.30.35 This difference represents the transaction costs and is recognised by

F as an expense over the period that the debt is outstanding under the effective
interest method.

7I.6.30.40 In our view, transaction costs that are directly related to the probable issue of a
security that will be classified as a financial liability measured at amortised cost should be
recognised as a prepayment (asset) in the statement of financial position. Such transaction costs
should be deducted from the amount of the financial liability when it is initially recognised, or
recognised in profit or loss when the issue is no longer expected to be completed.

7I.6.30.50 Transaction costs that relate to the issue of a compound instrument are allocated to
the liability and equity components of the instrument in proportion to the allocation of proceeds. [IAS
32.38]

7I.6.30.60 In our view, an entity should choose an accounting policy, to be applied consistently,
to allocate transaction costs that relate to a hybrid (combined) instrument that includes a non-
derivative host contract that is not accounted for at FVTPL and an embedded derivative that is
accounted for at FVTPL. The following are examples of approaches.
• Allocate the transaction costs to the non-derivative host contract and embedded derivative
components of the instrument in proportion to the allocation of the total transaction price (e.g.
proceeds), by analogy to the allocation of transaction costs that relate to a compound instrument
(see 7I.6.30.50). Under this approach, the amount of transaction costs allocated to the embedded
derivative will be charged immediately to profit or loss (see 7I.6.30.20). However, if the embedded
derivative is a non-option feature embedded with a host debt instrument, then an amount of zero
would usually be allocated to the embedded derivative (see 7I.2.380.40).
• Measure the embedded derivative at fair value on initial recognition. The carrying amount of the
non-derivative host contract on initial recognition is the difference between the fair value plus or
minus transaction costs of the hybrid instrument and the fair value of the embedded derivative
(see 7I.2.380.30). Under this approach, all of the transaction costs will always be allocated to and
included in or deducted from the carrying amount of the non-derivative host contract on initial
recognition. [IAS 32.38]

7I.6.30.70 Any transaction costs that do not qualify for inclusion in the initial measurement of an
instrument are expensed as they are incurred. These costs are normally included in the finance costs
line item. [IAS 39.43]

7I.6.30.80 Transaction costs do not include debt premiums or discounts, financing costs or
internal administrative or holding costs. In our view, service fees are not directly attributable to the
acquisition of an asset or liability and should be expensed as they are incurred. Similarly, we believe
that the costs of researching or developing an instrument or assessing alternatives with a number of
parties should be expensed as the costs are incurred. [IAS 39.9, AG13]

7I.6.30.90 Transaction costs are generally included in the initial measurement of instruments on
an individual basis. This means that the transaction costs should be identifiable with the acquisition
or origination of each individual instrument. However, in our view it may be appropriate to
accumulate the incremental costs attributable to the acquisition or origination of individual
instruments within a portfolio and then allocate these costs to items in the portfolio using a method
that produces results that are not materially different from those achieved if the amounts are
identified with individual items. It is necessary to make such an allocation to individual balances in
order for unamortised transaction costs to be associated correctly with items that are repaid early,
are sold or become impaired. This approach would be appropriate only when the portfolio comprises
homogeneous items. [IAS 39.9]

7I.6.40 Internal costs

7I.6.40.10 In our view, the only internal transaction costs allowed to be included in the initial
measurement of a financial instrument are commissions, bonuses and other payments that are made
to employees only on completion of each individual transaction. We believe that internal semi-
variable costs – e.g. the costs of marketing a new product or of employing additional staff to deal with
an increase in the volume of transactions – do not qualify as transaction costs. [IAS 39.AG13]

7I.6.50 Facility or commitment fees paid

7I.6.50.10 An issue that often arises is how to treat facility fees – i.e. initial fees to cover
negotiation and arrangement of a facility and periodic fees to compensate the bank for keeping funds
available.

7I.6.50.20 In our view, if it is probable that a facility will be drawn down, then an initial facility
fee is typically, in substance, an adjustment to the interest cost; therefore, the fee should be deferred
and treated as an adjustment to the instrument’s effective interest rate and recognised as an
expense over the instrument’s estimated life. However, if it is not probable that a facility will be
drawn down, then the fee is considered a service fee and recognised as an expense on a straight-line
basis over the commitment period.

7I.6.50.30 For a discussion of fee income received (i.e. accounting by a lender), see 7I.6.730.

7I.6.60 Low-interest and interest-free loans

7I.6.60.10 In most cases, the fair value of a financial instrument on initial recognition will be
equal to its transaction price. However, sometimes interest-free or low-interest loans are given – e.g.
by a shareholder or government or as a means of attracting or supporting customers for other goods
and services (see 2.4.320). [IAS 39.AG64–AG65]

7I.6.60.20 In our view, in assessing whether the interest charged on a loan is at a below-market
rate, an entity should consider the terms and conditions of the loan, local industry practice and local
market circumstances. Evidence that a loan is at market rates might include the interest rates
currently charged by the entity or by other market participants for loans with similar remaining
maturities, cash flow patterns, currency, credit risk, collateral and interest basis. For example, very
low interest rates on current accounts would be viewed as market rates if they are commonly given
in arm’s length transactions between market participants in the relevant market (see also
7I.6.280.70).

7I.6.70 Determining fair value

7I.6.70.10 The fair value of financial instruments is determined in accordance with IFRS 13,
which is the subject of chapter 2.4. The fair value of below-market loans can be measured, for
example, as the present value of the expected future cash flows, discounted using a market-related
rate. [IAS 39.AG64]

7I.6.70.20 The fair value of a financial liability with a demand feature – e.g. a demand deposit – is
not less than the amount payable on demand, discounted from the first date on which the entity could
be required to repay the amount (see 2.4.420). Accordingly, the fair value of an interest-free loan
liability of which the lender can demand repayment of the face value at any time – i.e. a loan
repayable on demand – is not less than its face value. In our view, similar considerations would also
apply to the lender’s measurement of fair value of an interest-free loan repayable on demand to the
extent that a market participant acting in its best interest that acquires the loan asset would be
assumed to maximise value by achieving immediate repayment. [IFRS 13.47]

7I.6.70.30 If a loan has no fixed maturity date and is available in perpetuity, then in our view in
measuring its fair value, discounting should reflect these terms because a market participant acting
in its best interest would not assume repayment of the loan. In our view, the fair value of loans that
have no specified repayment dates and that are not repayable on demand should reflect a market
participant’s assumptions about the timing of the future cash flows (see 2.4.90).

7I.6.80 Short-term receivables and payables

7I.6.80.10 The fair value of a financial instrument reflects the effect of discounting expected
future cash flows. However, an entity is permitted to initially measure short-term receivables and
payables with no stated interest rate at their invoiced amounts without discounting, if the effect of
discounting is immaterial. Therefore, in our view receivables and payables with maturities of up to
six months are generally not required to be discounted. However, in high-interest environments, the
impact of discounting may be significant even for maturities of less than six months.
Notwithstanding the above, trade receivables resulting from contracts with customers in the scope
of IFRS 15 are required or permitted to be measured initially at the transaction price as defined in
IFRS 15 (rather than at fair value) if certain criteria are met (see 7I.6.22). [IFRS 13.BC138A, IAS 39.44A]

7I.6.90 Accounting for differences between fair value and consideration

given or received
7I.6.90.10 Any difference between the amount lent and the fair value of the instrument on initial
recognition is recognised as a gain or a loss unless it qualifies for recognition as an asset or a liability
(see 7I.6.20.30). [IAS 39.AG64]

7I.6.90.20 If a low-interest loan is given in anticipation of a right to receive goods or services at

favourable prices, then the right may be recognised as an asset if it qualifies for recognition as an
intangible asset (see 3.3.30 and 90) or other asset – e.g. prepaid expenses.

7I.6.90.30 If the loan is from a government, then the credit is treated as a government grant (see
4.3.100). [IAS 20.10A]

7I.6.90.40 In our view, if the loan is from a shareholder acting in the capacity of a shareholder,
then the resulting credit should normally be reflected in equity because the substance of the
favourable terms is typically a contribution by a shareholder (see 7I.3.390).

EXAMPLE 4 – INTEREST-FREE LOAN FROM SHAREHOLDERS

7I.6.90.50 The shareholders of Company G provide G with financing in the form

of interest-free loan notes to enable it to acquire investments in subsidiaries. The
loan notes will be redeemed solely out of dividends received from these subsidiaries
and become redeemable only when G has sufficient funds to do so. In this context,
‘sufficient funds’ refers only to dividend receipts from subsidiaries. Therefore, G
could

not be forced to obtain additional external financing or to liquidate its investments

to redeem the shareholder loans. Consequently, the loans could not be considered
payable on demand.

7I.6.90.60 G initially measures the loan notes at their fair value (minus
transaction costs), being the present value of the expected future cash flows,
discounted using a market-related rate. The amount and timing of the expected
 future cash flows are determined on the basis of the expected dividend flow from the
subsidiaries.

7I.6.90.70 Given that the loan notes are interest-free, there will be a difference
between the nominal value of the loan notes – i.e. the cash amount received – and
their fair value on initial recognition. Because the financing is provided by
shareholders, acting in the capacity of shareholders, we believe that the resulting
credit should be reflected in equity as a shareholder contribution in G’s statement of
financial position.

7I.6.100 Intra-group low-interest and interest-free loans

7I.6.100.10 When low-interest or interest-free loans are granted to consolidated subsidiaries, the
effect of discounting is eliminated on consolidation. Therefore, the discounting will be reflected only
in the financial statements of the subsidiary (see 7I.6.90.40) and any separate financial statements of
the parent. In our view, in the separate financial statements of the parent the discount should be
recognised as an additional investment in the subsidiary. [IFRS 10.B86(c)]

7I.6.100.20 Similar principles apply to low-interest or interest-free loans to associates or joint

ventures, except that if the equity method is applied, then the discounting effect on profit or loss may
be eliminated only to the extent of the investor’s interest in the investee (see 3.5.430). This may also
be the case for subsidiaries accounted for by the parent in the parent’s separate financial statements
using the equity method (see 3.7.10).

7I.6.100.30 In the case of loans between entities in a group, in addition to the possibility of these
being granted on an interest-free basis, there may be no stated terms of repayment. This complicates
the measurement of the loan if it is not clear when repayments will take place, what the value of such
repayments will be and what the term of the loan is. In such cases, in our view consideration should
first be given to whether:
• classification as a liability is appropriate;
• there is no agreed means of repayment, either directly in the agreement or via a side agreement;
and
• it is possible to estimate when the loan repayments will take place (see 7I.6.70.30).
7I.6.100.40 In our view, having considered these factors and concluded that no alternative
treatment is available, such a loan may be considered to be payable on demand. This means that it
should be measured at its face value.

7I.6.110 Related party transactions

7I.6.110.10 In our view, the requirement to initially recognise all financial assets and financial
liabilities at fair value applies to all low-interest or interest-free loans, including those to or from
related parties. In addition, related party disclosures will be required if the counterparty is a related
party (see chapter 5.5). [IAS 39.43]

7I.6.115 Financial liability resulting from a failed sale in a sale-and-

leaseback arrangement

7I.6.115.10 If the transfer of an asset in a sale-and-leaseback arrangement does not satisfy the
requirements of IFRS 15 to be accounted for as a sale of the asset (see 5.1.590.20–25), then the
seller-lessee continues to recognise the transferred asset and recognises a financial liability equal to
the transfer proceeds. The financial liability is subsequently accounted for in accordance with IAS 39
(see 7I.6.185). [IFRS 16.103, C20]

7I.6.120 SUBSEQUENT MEASUREMENT

7I.6.130 General considerations

7I.6.130.10 Subsequent to initial measurement:

• derivatives (including separated embedded derivatives) are measured at fair value with changes
therein included in profit or loss;
• other financial assets at FVTPL and available-for-sale financial assets are measured at fair value
with changes therein included in profit or loss or, for available-for-sale financial assets, in OCI;
• loans and receivables and held-to-maturity investments are measured at amortised cost;
• financial liabilities at FVTPL are measured at fair value with changes therein included in profit or
loss; and
• other financial liabilities are generally measured at amortised cost (see 7I.6.180). [IAS 39.46–47]

7I.6.130.20 If an entity continues to recognise a transferred asset to the extent of its continuing
involvement in the asset, then the asset and the associated liability are measured on a basis that
reflects the rights and obligations retained by the entity (see 7I.5.250). [IAS 39.31]

7I.6.130.30 Financial assets and financial liabilities that are designated as hedged items may
require further adjustment in accordance with the hedge accounting requirements (see 7I.7.50).
Furthermore, the effective portion of gains and losses on financial assets and financial liabilities,
including derivatives, designated as hedging instruments in cash flow or net investment hedges is
presented in OCI (see 7I.7.80 and 110). [IAS 39.46–47]

7I.6.140 Derivatives

7I.6.140.10 Derivatives are measured at fair value except for those contracts that are linked to
and must be settled using unquoted equity instruments whose fair value cannot be measured
reliably. Such derivatives are measured at cost. In our view, this exemption cannot be extended to
cover other underlying variables with no available market data (see 7I.6.210). [IAS 39.46(c), 47(a), AG80–
AG81]

7I.6.150 Held-to-maturity investments

7I.6.150.10 Held-to-maturity investments – e.g. quoted bonds with a fixed maturity – are
measured at amortised cost under the effective interest method (see 7I.6.220). [IAS 39.46(b)]

7I.6.160 Loans and receivables

7I.6.160.10 Loans and receivables are measured at amortised cost under the effective interest
method. [IAS 39.46(a)]

7I.6.160.20 Loans and receivables that are perpetual and that have either a fixed or a market-
based variable rate of interest are measured at cost. For example, in the case of perpetual loans with
no repayments of principal and for which fixed or market-based interest payments are due to be paid
in perpetuity, the amortised cost at each point in time will equal the fair value of the proceeds given,
plus transaction costs and accrued interest. Consequently, there is no amortisation of a difference
between the initial amount and a maturity amount. [IAS 39.IG.B.24]

7I.6.160.30 Short-duration receivables with no stated interest rate may be measured at their
original invoice amount unless the effect of imputing interest would be significant – e.g. in high-
inflation countries (see 7I.6.80.10). [IFRS 13.BC138A]

7I.6.170 Available-for-sale financial assets

7I.6.170.10 Available-for-sale financial assets are measured at fair value. However, there is an
exemption for available-for-sale financial assets whose fair value cannot be measured reliably. This
exemption applies only to unquoted equity instruments when there is significant variability in the
range of reasonable fair value estimates and the probabilities of the various estimates within the
range cannot be assessed reasonably. IAS 39 assumes that it is normally possible to estimate the fair
value of a financial asset that has been acquired from a third party. Consequently, in our view the
exemption would apply mainly to start-up entities (see 7I.6.210). [IAS 39.46(c), AG80–AG81]

7I.6.170.15 In rare cases, even though it may be possible to measure the fair value on initial
recognition reliably, it may become more difficult over time to measure the fair value of an available-
for-sale instrument reliably. In our view, in such cases the financial asset should be subsequently
measured at its cost, subject to impairment testing, based on the carrying amount determined at the
last date on which the fair value could be determined reliably. [IAS 39.46, AG80–AG81]

7I.6.170.20 Fair value changes are recognised in OCI. When the relevant asset is derecognised,
on sale or other disposal, or is impaired, the cumulative fair value changes recognised in OCI are
reclassified from equity to profit or loss as a reclassification adjustment. For a partial disposal, a
proportionate share of the fair value gains and losses previously recognised in OCI is reclassified
from equity to profit or loss. Such gains and losses include all fair value changes until the date of
disposal (see 7I.5.280.50). [IAS 39.26–27, 55(b), 67]

7I.6.170.30 In our view, when financial assets classified as available-for-sale are distributed as
dividends in kind to shareholders, the accumulated gains or losses in OCI should be reclassified from
equity to profit or loss on derecognition of the financial assets, even if the transaction with
shareholders is accounted for in equity.

7I.6.170.40 Interest income is recognised under the effective interest method, with the effective
interest rate being calculated on the instrument’s initial recognition. Therefore, even though a debt
instrument is measured at fair value, the holder applies the effective interest method and calculates
the amortised cost of the instrument to determine interest income. Impairment losses and foreign
exchange gains and losses on available-for-sale debt instruments are excluded from the fair value
gains and losses recognised in OCI. Instead, they are recognised in profit or loss as they arise. [IAS
39.55(b)]

7I.6.180 Liabilities

7I.6.180.10 Subsequent to initial recognition, financial liabilities are measured at amortised cost
calculated under the effective interest method except for liabilities:
• measured at FVTPL (see 7I.4.20);
• that arise when a transfer of a financial asset does not qualify for derecognition or is accounted
for using the continuing involvement approach (see 7I.5.250 and 290);
• that are commitments to provide a loan at a below-market interest rate and not measured at
FVTPL (see 7I.1.200.80); and
• that are financial guarantee contracts (see 7I.1.70). [IAS 39.2, 47]

7I.6.185 Financial liability resulting from a failed sale in a sale-and-

leaseback transaction
7I.6.185.10 If a seller-lessee enters into a sale-and-leaseback transaction and obtains a right to
repurchase the underlying asset from the buyer/lessor, then the transaction does not meet the
criteria in IFRS 15 to be accounted for as a sale of the transferred asset (see 5.1.590.20–25). In this
case, the entity recognises a financial liability equal to the amount of the transfer proceeds received
(see 7I.6.115.10). IAS 39 is silent on how to subsequently measure the amortised cost of the financial
liability. Assuming that there is no embedded derivative that is separated, it appears that to calculate
the effective interest rate on initial recognition of the financial liability, the entity should estimate
future cash payments considering the following:
• the expected lease payments over the expected term of the leaseback (excluding any portion
representing compensation to the lessor for costs relating to the asset – e.g. maintenance); and
• expectations relating to the final cash flow to settle the liability. This may be the option exercise
price if it is expected that the asset will be repurchased or the expected fair value of the
 underlying asset at the end of the leaseback period if it is expected that the asset will be
surrendered to the lessor. [IAS 39.9]

7I.6.185.20 It appears that if the entity’s expectations about exercising the purchase option
change during the contractual term, then it should revise the estimated cash flows, adjust the
amortised cost of the financial liability and recognise the adjustment in profit or loss (see
7I.6.260.10). [IAS 39.AG8]

EXAMPLE 5 – DETERMINING CONTRACTUAL CASH FLOWS – FAILED-SALE FINANCIAL LIABILITY IN A SALE-AND-

LEASEBACK ARRANGEMENT

7I.6.185.30 On 1 January 2021, Company K enters into a sale-and-leaseback

transaction for a vessel. The arrangement contains a substantive repurchase option,
and therefore fails sale accounting under IFRS 15 (see 7I.6.185.10). The details of the
transaction are as follows.
• K receives cash proceeds of 1,250 at the start of the arrangement.
• The contractual period is five years.

• Annual lease payments of 220 are payable at the end of each year.
• The annual payments do not include any amounts that represent compensation to
the lessor for costs relating to the asset.
• The agreement gives K an option to repurchase the vessel at the end of the lease
term for a fixed price of 670 and it is K’s intention to exercise the option.

7I.6.185.40 At the start of the arrangement, K recognises a financial liability of

1,250 for the proceeds received. K determines on initial recognition that the
expected future cash flows are as follows:
• annual cash outflows of 220; and
• a cash outflow of 670 at the end of year five.
7I.6.185.50 Based on these estimated cash flows, K calculates the effective
interest rate as 10% and uses this rate to recognise interest expense during the
period of the arrangement as follows.

DATE LEASE INTEREST CARRYING

PAYMENT AMOUNT OF
LIABILITY

1 January 2021 - - 1,250

31 December 2021 220 125 1,155

31 December 2022 220 116 1,051

31 December 2023 220 105 936

31 December 2024 220 93 809

31 December 2025 220 81 670

Total 1,100 520

7I.6.185.60 At the end of the contractual term, K exercises the repurchase option
 as expected and settles the liability by paying the option exercise price of 670.

7I.6.190 FAIR VALUE

7I.6.200 General

7I.6.200.10 Fair value is measured in accordance with IFRS 13, which is the subject of chapter
2.4.

7I.6.210 Equity instruments: Fair value exemption

7I.6.210.10 It is presumed that the fair value of all financial instruments is reliably measurable.
This presumption can be overcome only for an investment in an equity instrument that does not have
a quoted price in an active market and whose fair value cannot be reliably measured, and for
derivatives that are linked to and are settled by the delivery of such instruments. This exemption
applies both to instruments classified as trading and to those classified as available-for-sale. [IAS
39.46]

7I.6.210.15 The fair value of investments in equity instruments that do not have a quoted price in
an active market and of related derivatives is reliably measurable if:
• the variability in the range of reasonable fair value estimates is not significant for that instrument;
or
• the probabilities of various estimates within the range can be reasonably assessed. [IAS 39.AG80–
AG81]

7I.6.210.20 This exemption is very limited. It is unlikely that an investment would be bought if its
fair value could not be estimated. In particular, venture capitalists and other entities that undertake
significant investing activities use some form of valuation technique to evaluate investment
decisions. In our view, in these circumstances – i.e. assuming that another valuation technique
cannot be appropriately applied – the same techniques used to make investment decisions should be
used subsequently to determine the fair value of an investment. The exemption may be used only in
rare cases when it can be demonstrated that the valuation technique generates a wide range of
possible fair values and when the probability of the various outcomes cannot be estimated. For a
discussion of this in the context of investments in investment funds, see 2.4.930.20–30.

7I.6.210.30 When determining the fair value of these instruments, an entity uses a supportable
methodology for identifying the point within a range of reasonable estimates that is most
representative of the fair value rather than simply choosing a fair value from the range (see
2.4.130.50). [IFRS 13.63]

7I.6.210.40 If an embedded derivative that is required to be separated cannot be measured

reliably because it will be settled using an unquoted equity instrument whose fair value cannot be
reliably measured, then the entire combined contract is designated as a financial instrument at
FVTPL. The entity might conclude, however, that the equity component of the combined instrument
may be significant enough to preclude it from obtaining a reliable estimate of fair value for the entire
instrument. In that case, the combined instrument is measured at cost less impairment. [IAS 39.13]

7I.6.220 AMORTISED COST

7I.6.220.10 Amortised cost applies to both financial assets and financial liabilities. The effective
interest method is used for amortising premiums, discounts and transaction costs for both financial
assets and financial liabilities. [IAS 39.9]

7I.6.220.20 When applying the effective interest method, interest is recognised in profit or loss in
the period to which it relates, regardless of when it is to be paid. Therefore, interest is recognised in
the period in which it accrues, even if payment is deferred. [IAS 39.9, AG5–AG8C]

7I.6.230 Effective interest rate calculation

7I.6.240 Effective interest method

7I.6.240.10 The ‘effective interest method’ is a method of calculating the amortised cost of a
financial asset or financial liability and allocating the interest income or expense over the relevant
period. It differs from the straight-line method in that the amortisation under the effective interest
method reflects a constant periodic return on the carrying amount of the asset or liability. [IAS 39.9]

7I.6.240.20 The ‘effective interest rate’ is the rate that exactly discounts the estimated stream of
future cash payments or receipts, without consideration of future credit losses, over the expected life
of the financial instrument or through to the next market-based repricing date, to the net carrying
amount of the financial asset or financial liability on initial recognition. [IAS 39.9, AG5–AG8]

7I.6.240.30 The effective interest rate is calculated on initial recognition of an instrument. For
floating rate financial instruments, periodic re-estimation of cash flows to reflect movements in
market rates of interest alters the effective interest rate. To calculate the effective interest in each
relevant period, the effective interest rate is applied to the amortised cost of the asset or liability at
the previous reporting date. [IAS 39.AG7]

7I.6.240.40 The difference between the calculated effective interest for a given period and the
instrument’s coupon is the amortisation (or accretion) during that period of the difference between
the initial measurement of the instrument and the maturity amount.

EXAMPLE 6 – EFFECTIVE INTEREST CALCULATION

 7I.6.240.50 Company K grants a five-year loan of 50,000 to Company L on 1 January
2021. There is an annual coupon of 10% paid on the last day of each year. L pays an
up-front fee of 1,000 and the net loan proceeds are 49,000. The annual effective
interest rate is calculated by solving for x in the following equation.

7I.6.240.60 Therefore, the effective interest rate is 10.53482% a year. The interest
and amortised cost are as follows.

DATE INTEREST CASH FLOWS AMORTISED

(10.53482%) COST

1 January 2021 - - 49,000

31 December 2021 5,162 5,000 49,162

31 December 2022 5,179 5,000 49,341

31 December 2023 5,198 5,000 49,539

31 December 2024 5,219 5,000 49,758

31 December 2025 5,242 55,000 -

Total 26,000 75,000

7I.6.250 Contractual or estimated cash flows

7I.6.250.10 In determining the effective interest rate, an entity considers all of the contractual
terms of an instrument, including any embedded derivatives – e.g. prepayment, call and similar
options – that are not subject to separation, but without inclusion of future credit losses (see
7I.2.110). In our view, when an instrument gives either the issuer or the holder the option to require
the instrument to be redeemed or cancelled early, and the terms of the instrument are such that it is
not certain whether the option will be exercised, then the probability of the option being exercised
should be assessed in determining the estimated cash flows. [IAS 39.9]

7I.6.250.20 However, for financial liabilities with a demand feature – e.g. a demand deposit – the
fair value is not less than the amount payable on demand, discounted from the first date on which the
amount could be required to be paid (see 2.4.420). Therefore, for example, a non-interest-bearing or
low-interest financial liability for which the holder can demand immediate repayment is not
discounted on initial recognition, even if the issuer does not expect repayment of the liability in the
near future (see 7I.6.70.20). The impact of this requirement is that interest expense would be
recognised at the coupon rate for a low-interest financial liability with an immediate demand feature.
[IFRS 13.47]

7I.6.250.30 The calculation of the effective interest rate includes:

• all fees and points paid or received between parties to the contract that are an integral part of the
effective interest rate (see 7I.6.730);
• transaction costs (see 7I.6.30); and
all other premiums or discounts (see 7I.6.320). [IAS 39.9]
• 7I.6.250.40 Future credit losses are not taken into account because doing so would be a
departure from the incurred-loss model for impairment (see 7I.6.400). In some cases – e.g. when a
financial asset is acquired at a deep discount – credit losses have already occurred and are reflected
in the purchase price (see 7I.8.170.20). Such credit losses are included in the estimated cash flows
when computing the effective interest rate. Any adjustments arising from revisions to estimated cash
flows subsequent to initial recognition are recognised as part of the carrying amount of the financial
asset, with a corresponding amount recognised in profit or loss. [IAS 39.9, AG5–AG8]

7I.6.250.50 The IFRS Interpretations Committee discussed the requirement to include incurred
credit losses that are reflected in the asset’s price on initial recognition in the estimated cash flows
used to determine the effective interest rate and noted that this requirement applies to both
purchased and originated assets. Even though origination of a debt instrument with an incurred loss
is unusual, there may be situations in which such transactions occur. For example, debt instruments
can be originated outside the normal underwriting process as part of a restructuring when the
debtor is in significant financial difficulty. This could include situations in which modifications of debt
instruments result in derecognition of the original financial asset and the recognition of a new
financial asset (see 7I.6.490). These cases are not limited to those in which debt instruments are
effectively forced upon existing lenders, but could also arise in other transactions. [IAS 39.AG5, IU 11-12]

7I.6.250.60 There is a presumption that future cash flows and the expected life can be estimated
reliably for most financial instruments. In the rare case in which it is not possible to estimate the
timing or amount of future cash flows reliably, the entity uses the contractual cash flows over the full
contractual term of the financial instrument. [IAS 39.9]

7I.6.260 Changes in timing or amount of estimated cash flows

7I.6.260.10 If there is a change in the timing or amount of estimated future cash flows (other than
because of impairment), then the carrying amount of the instrument (or group of financial
instruments) is adjusted in the period of change to reflect the actual and/or revised estimated cash
flows, with a corresponding gain or loss being recognised in profit or loss. The revised carrying
amount is recalculated by discounting the revised estimated future cash flows at the instrument’s
original effective interest rate or, when applicable, the revised effective interest rate calculated in
accordance with paragraph 92 of IAS 39 in relation to the amortisation of the fair value hedge
adjustment for fair value hedges. In our view, this approach to changes in estimated cash flows
should apply to changing prepayment expectations and other estimates of cash flows under the
current terms of the financial instrument but not to a renegotiation of the contractual terms of an
instrument (see 7I.5.95, 380, 7I.6.290 and 490). [IAS 39.AG8]

7I.6.260.20 An entity may reclassify certain financial assets out of the FVTPL category and/or the
available-for-sale category in certain circumstances (see 7I.4.210). If a financial asset is so
reclassified and the entity subsequently increases its estimates of future cash receipts as a result of
increased estimates of recoverability of those cash receipts, then the effect of that increase is
recognised as an adjustment to the effective interest rate from the date of the change in estimate
rather than as an adjustment to the carrying amount of the asset at the date of the change in
estimate – i.e. any increase in estimated future cash receipts is not recognised immediately as a gain
in profit or loss. [IAS 39.AG8]

7I.6.260.30 The use of estimated cash flows specifically excludes the effect of expected future
credit losses. Therefore, the amortised cost calculation cannot be used to remove credit spread from
interest income to cover future losses. [IAS 39.9]

7I.6.260.40 The contractual terms of some financial instruments may be linked to the
performance of other assets, as illustrated in Example 7.

EXAMPLE 7 – ESTIMATING CASH FLOWS FOR COLLATERALISED NOTES

 7I.6.260.43 Limited-purpose Vehicle L holds a portfolio of loans and receivables
and has issued to investors notes collateralised by those loans.

Collateralised
Portfolio of loans Limited­purpose notes
Investors
and receivables Vehicle L

7I.6.260.47 The contractual terms of the notes are such that L has an obligation to
pay cash on its notes only to the extent that it receives cash from its loans and
receivables. Also assume that the notes do not contain embedded derivatives
requiring separation (see 7I.2.360) and, at the measurement date, the portfolio of
loans and receivables held by L includes:
• actual defaults by the debtors of 10;
• incurred losses calculated in accordance with IAS 39 of 15; and
• expected losses of 20 (including 15 of incurred losses).

7I.6.260.50 In our view, there are two acceptable approaches for the issuer to
estimate cash flows on the notes.

• Incurred-loss method: This is based on the theory that taking into account losses
incurred on the underlying loan assets is consistent with the requirements that
an entity should estimate cash flows considering all contractual terms of an
instrument but not future credit losses. Therefore, expected cash flows would be
reduced by 15.
• Expected-loss method: This is based on the theory that the requirements
preclude consideration of future credit losses for financial assets only and the
best estimate of the future cash flows payable in respect of the notes includes
current expectation of all future, not just already incurred, losses. Therefore,
expected cash flows would be reduced by 20.

7I.6.260.60 We believe that estimating cash flows for the notes taking into
account only actual defaults by the debtors is not consistent with the requirements
of the standard.

7I.6.270 Floating rate financial assets and financial liabilities

7I.6.270.10 The periodic re-estimation of cash flows to reflect movements in market rates of
interest will change the effective interest rate of a floating rate financial asset or liability. [IAS 39.AG7]

7I.6.270.20 IAS 39 does not contain any further description or definition of ‘floating rate’ or
guidance on how the term ‘market rates of interest’ should be interpreted in this context. Therefore,
judgement may be required in applying these terms to different circumstances – e.g. when the
contractual interest rate is calculated in accordance with a formula or is a discretionary rate. In
many cases, a floating rate instrument may have a contractual interest rate that comprises more
than one component such as a published benchmark rate or other published interest rate index (e.g.
Euribor) and a specified spread (e.g. a predetermined percentage spread above Euribor). In some
circumstances, although changes in the benchmark rate would be considered a change to which the
guidance in 7I.6.270.10 would be applied (leading to a change in the effective interest rate), the
spread might be fixed (i.e. not subject to change) or any changes in the specified spread might not be
considered to reflect movements in market rates of interest and would not lead to a change in the
effective interest rate.

7I.6.270.30 IAS 39 does not specify how to calculate the effective interest rate for floating rate
financial instruments. Therefore, in our view an entity is allowed to follow one of these two
approaches for calculating the effective interest rate, which are illustrated in Example 8.
• Approach 1: Based on the actual benchmark interest rate that was set for the relevant period.
• Approach 2: Taking into account expectations of future interest rates, and changes in these
expectations.

EXAMPLE 8 – CALCULATING THE EFFECTIVE INTEREST RATE FOR FLOATING RATE FINANCIAL INSTRUMENTS

7I.6.270.40 Company M issues at par a financial liability with:

• principal of 100;
• a contractual interest rate of 12-month Euribor plus 2% (payable annually); and
• a maturity of three years.

7I.6.270.50 12-month Euribor on initial recognition of the liability is 2% and is

used to set the first annual coupon. 12-month Euribor is expected to be 3% in year 2
and 4% in year 3.

APPROACH CALCULATION OF INITIAL EFFECTIVE INTEREST RATE

Approach 1 The initial effective interest rate is calculated as 4% per annum –

i.e. 12-month Euribor on initial recognition plus the margin of 2%.

Approach 2 The initial effective interest rate is calculated as approximately 5%

per annum – i.e. the internal rate of return of the following cash
flows:
• expected coupons of 4, 5 and 6; and
• principal repayable at maturity of 100.

7I.6.270.60 We believe that an entity may apply the same approaches when the contractual terms
of a financial instrument provide for the interest rate to be fixed for an initial period and then revert
to a floating market rate of interest. An example is a 25-year mortgage loan that has an initial market
fixed rate of 4 percent for five years and then changes to the published standard variable rate (SVR)
of the lender for the remaining 20 years. If the loan is measured at par on initial recognition, then:
• under Approach 1, the effective interest rate for the first five years would be 4 percent and then it
would change to the actual SVR; and
• under Approach 2, the calculation of the effective interest rate would consider the initial fixed 4
percent, expectations of future levels of the SVR and changes in these expectations.

7I.6.270.70 If the floating rate financial asset or financial liability is initially recognised at an
amount equal to the principal receivable or payable on maturity, then periodic re-estimation of future
interest payments would not normally have a significant effect on the carrying amount of the asset or
liability. [IAS 39.AG7]

7I.6.270.80 Under Approach 1 in Example 8, for a floating rate financial asset or financial liability
that is initially recognised at a discount or premium, the interest income or expense is recognised
based on the current market rate plus or minus amortisation or accretion of the discount or premium
(see 7I.6.320.30). [IAS 39.AG6–AG7]

7I.6.270.90 In our view, this approach could also be applied for a floating rate instrument that
includes embedded derivatives that are not separated – e.g. an instrument on which the interest rate
is subject to market indices such as inflation.

7I.6.270.100 IAS 39 does not prescribe any specific methodology for how transaction costs
should be amortised for a floating rate loan, except as discussed in 7I.6.320. In our view, any
consistent methodology that would establish a reasonable basis for amortisation of the transaction
costs may be used. For example, it would be reasonable to determine an amortisation schedule of the
transaction costs based on the interest rate in effect at inception.

7I.6.280 Stepped interest

7I.6.280.10 Sometimes entities buy or issue debt instruments with a predetermined rate of
interest that increases or decreases progressively (stepped interest) over the term of the debt
instrument. In this case, the entity uses the effective interest method to allocate the interest income
or expense over the term of the debt instrument to achieve a level yield to maturity that is a constant
interest rate on the carrying amount of the instrument in each period. [IAS 39.9, IG.B.27]

EXAMPLE 9A – EFFECTIVE INTEREST CALCULATION – STEPPED INTEREST

7I.6.280.20 On 1 January 2021, Bank N takes a five-year deposit from a customer

with the following rates of interest specified in the agreement.

YEAR RATE

2021 2.0%

2022 2.1%

2023 2.2%

2024 2.4%

2025 3.0%

7I.6.280.30 The effective interest rate for this instrument is 2.33% (rounded).
Therefore, interest is accrued using the 2.33% rate.

EXAMPLE 9B – EFFECTIVE INTEREST CALCULATION – STEPPED INTEREST WITH EARLY WITHDRAWAL OPTION

7I.6.280.40 Assume the same fact pattern as in Example 9A, except that the
customer has an option to withdraw the deposit after four years without penalty.
This option is considered to be closely related to the deposit contract (see 7I.2.190).

7I.6.280.50 If N expects the deposit to be withdrawn after four years without

penalty, then this expectation would be taken into account when calculating the
instrument’s effective interest rate. In this circumstance, the resulting effective
interest rate would be approximately 2.17%. This rate would be used to accrue
interest expense over the deposit’s expected life.

7I.6.280.60 A similar approach is adopted from the perspective of the holder of a financial
instrument – i.e. the holder takes into consideration all contractual terms and the probability of any
prepayment and call and similar options being exercised.

7I.6.280.70 In respect of mortgage loans and credit cards that are issued with a low initial rate of
interest to attract new customers, an issue similar to stepped interest arises. After the initial period,
the interest rate typically returns to a standard market rate so that the lender is able to recover the
discount over the remaining estimated life of the instrument. Normally, any initial discount that is
widely offered to market participants is recognised as part of the effective yield over the estimated
life of the instrument. Alternatively, in our view the fair value of such an initial discount might be
considered as a cost of attracting new business and recognised immediately as an expense. In our
view, any discount that is not offered widely and is therefore in excess of that offered to all market
participants should be recognised immediately as an expense (see 7I.6.60).

7I.6.290 Modification of financial liabilities

7I.6.290.10 If the terms of a financial liability are modified substantially, resulting in an

extinguishment of the old financial liability, then the old liability is derecognised and the
restructured financial instrument is treated as a new financial liability (see 7I.5.390). [IAS 39.39–40]

7I.6.290.20 If a modification of a financial liability results in derecognition of the financial

liability, then the effective interest rate of the new financial liability is calculated based on the
revised terms of the financial liability at the date of the modification. In this case, any costs or fees
incurred are recognised as part of the gain or loss on extinguishment and do not adjust the carrying
amount of the new liability. Accordingly, in our view no transaction costs should be included in the
initial measurement of the new liability unless it can be incontrovertibly demonstrated that they
relate solely to the new liability instrument and in no way to the modification of the old liability. This
would not usually be possible but might apply to taxes and registration fees payable on execution of
the new liability instrument. [IAS 39.41, AG62]

7I.6.290.30 If the exchange or modification is not accounted for as an extinguishment, then any
costs and fees incurred are recognised as an adjustment to the carrying amount of the liability and
amortised over the remaining term of the modified instrument by recomputing the effective interest
rate on the instrument (see 7I.5.400). [IAS 39.AG62]

7I.6.300 Instruments acquired in a business combination in the scope of

IFRS 3

7I.6.300.10 At the date of acquisition, the fair value of the instrument and the total cash flows
expected over the remaining term of the instrument are used by the acquirer to calculate a new
original effective interest rate for the instrument. The new original effective interest rate is used to
determine the interest income or expense in the acquirer’s consolidated financial statements but has
no impact on the accounting in the acquiree’s financial statements. [IAS 39.9]

7I.6.300.20 Because assets of the acquiree are measured in the acquirer’s consolidated accounts
at fair value at the date of acquisition, the acquirer does not recognise a separate valuation
allowance to reflect any credit losses incurred at that date. In our view, for an instrument that has
incurred credit losses at the date of acquisition (see 7I.6.250.40 and 400), the estimated cash flows
should be determined on the basis of the expected receipts as reduced by those incurred credit
losses, rather than on the basis of the cash flows that would arise if the borrower complied with the
contractual terms. Generally, the expected cash flows should exclude any future credit losses. In our
experience, it may be difficult to make a distinction between incurred and future losses if it is
considered that the borrower will not be able to meet the contractual terms in full. However, to the
extent that the distinction can be made, future losses should be excluded from the estimates. [IFRS
3.B41, IAS 39.AG5]

7I.6.300.30 Continuing the example above, if the expected cash flows from that asset are
subsequently revised upwards because of an improvement in the debtor’s credit quality, then in our
view the upward revision is recognised in profit or loss but should not be presented as a recovery of
impairment. This is because no impairment loss had been recognised in the acquirer’s consolidated
financial statements on the asset subsequent to initial recognition and therefore there is no
impairment to reverse. [IAS 39.AG8]

7I.6.310 Hedged item in fair value hedge

7I.6.310.10 An interest-bearing instrument that is the hedged item in a fair value hedge is
remeasured based on changes in fair value in respect of the risk being hedged during the period of
the hedging relationship (see 7I.7.50), even if the item is normally measured at amortised cost. [IAS
39.89(b)]

7I.6.310.20 When hedge accounting is discontinued or earlier, the carrying amount of the
instrument and the total payments to be made over the remaining term of the instrument are used to
calculate a revised effective interest rate for the instrument. The revised effective interest rate is
used to determine interest income or expense in subsequent periods (see 7I.7.680.100). [IAS 39.92]

7I.6.320 Discounts, premiums and pre-acquisition interest

7I.6.320.10 The straight-line amortisation of discounts or premiums is not permitted. Instead,

discounts and premiums – including fees, points paid or received and transaction costs – are
generally recognised over the expected life of the related instrument using the effective interest rate
at the date of initial recognition of the instrument. However, in some cases a shorter period is used if
this is the period to which such discounts and premiums relate – e.g. when the variable is repriced to
market rates before the expected maturity of the instrument. [IAS 39.AG6]

7I.6.320.20 Therefore, for a group of prepayable mortgage loans, any discount, transaction costs
and related fees may be required to be amortised over a period shorter than the contractual
maturity. Historical prepayment patterns would be used to estimate expected lives and subsequent
revisions to prepayment estimates will give rise to gains and losses that are recognised in profit or
loss. [IAS 39.AG6, AG8]

7I.6.320.30 If a discount or premium arises on the acquisition of a floating rate instrument, then
it is important to identify the reason for that discount or premium. For example, if a premium or
discount on a floating rate instrument reflects changes in market rates since the floating rate
instrument was last repriced, then it will be amortised to the next repricing date. Alternatively, if the
premium or discount results from a change in the credit spread over the floating rate specified in the
instrument as a result of a change in credit risk, then it is amortised over the expected life of the
instrument. [IAS 39.AG6]

7I.6.320.40 When an interest-bearing instrument is acquired between interest payment dates,

the buyer normally has an obligation to pay the accrued interest to the seller when it is received or
pays a higher price for the instrument to reimburse the seller for the accrued interest that will be
paid to the buyer. Accordingly, interest that has accrued on an interest-bearing investment before it
is acquired is not recognised as income. If there is an obligation to pay the accrued interest to the
seller, then a receivable and a corresponding payable are recognised in respect of the accrued
interest.

7I.6.320.50 The amortisation of discounts or premiums is included in interest income or expense

and is not required to be disclosed separately.

7I.6.330 Interest income after impairment recognition

7I.6.330.10 If a financial asset or a group of similar financial assets has been written down as a
result of an impairment loss, then interest income is thereafter recognised using the rate of interest
used to discount the future cash flows for the purpose of measuring the impairment loss. For assets
measured at amortised cost, this interest rate would be the original effective interest rate (see
7I.6.480.10). In our view, for an available-for-sale financial asset, an entity may use a new effective
interest rate computed based on the fair value at the date of impairment. [IAS 39.AG93]

7I.6.330.20 It is inappropriate simply to suspend interest recognition on a non-performing

interest-bearing instrument, such as a loan and receivable. Future interest receipts are taken into
account when the entity estimates the future cash flows of the instrument. If no contractual interest
payments will be collected, then the only interest income recognised is the unwinding of the discount
on those cash flows expected to be received. [IAS 39.AG93]

7I.6.330.30 For a detailed discussion of the impairment of financial instruments, see 7I.6.400.

7I.6.335 Changes required by interest rate benchmark reform

7I.6.335.10 A change in the basis for determining the contractual cash flows of a financial
instrument may be required by interest rate benchmark reform (see 7I.7.871.10). If so, then, as a
practical expedient, an insurer applying the temporary exemption from IFRS 9 applies the guidance
on floating rate financial instruments in IAS 39 (see 7I.6.270) to calculate the modification gain or
loss and to account subsequently for the instrument. The practical expedient is applied only if and to
the extent that the change is necessary as a direct consequence of interest rate benchmark reform
and the new basis for determining the contractual cash flows is economically equivalent to the basis
used immediately before the change. [IFRS 4.20R-S, IFRS 9.5.4.7]

7I.6.335.20 The basis for determining the contractual cash flows of a financial instrument can
change in one of the following ways:
• by amending the contractual terms of the financial instrument – e.g. replacing the interest rate
benchmark in the contract with an alternative benchmark;
• by making changes to the method for calculating the interest rate benchmark without amending
the contractual terms of the financial instrument; or
• as a result of the activation of an existing contractual term – e.g. a fallback clause. [IFRS 9.5.4.6]
7I.6.335.30 Judgement may be required to determine whether the new basis for determining the
contractual cash flows is economically equivalent to the basis used immediately before the change.
The following are examples of changes that are economically equivalent to the previous basis:
• the replacement of an existing interest rate benchmark used to determine the contractual cash
flows of a financial instrument with an alternative benchmark rate with the addition of a fixed
spread necessary to compensate for the basis difference between the existing interest rate
benchmark and the alternative benchmark rate;
• changes to the reset period, reset dates or the number of days between coupon payment dates to
implement the reform of an interest rate benchmark rate; and
• the addition of a fallback provision to the contractual terms of a financial instrument to enable any
change described above to be implemented. [IFRS 9.5.4.8, BC5.315]

7I.6.335.40 If changes are made to a financial instrument in addition to changes required by

interest rate benchmark reform, then an insurer applying the temporary exemption first applies the
practical expedient in 7I.6.335.10 to the changes required by interest rate benchmark reform and
then applies other requirements of IAS 39 to the additional changes – i.e. the insurer would assess
whether the other changes require the financial instrument to be derecognised (see 7I.5.95 and
380). If derecognition is not required, then an entity applies the requirements in 7I.6.260.10 to
account for the additional changes. If the additional changes to the instrument require it to be
derecognised, then the insurer applies the general derecognition requirements (see 7I.5.390 and
7I.6.290.10-20 for financial liabilities). [IFRS 4.20R-S, IFRS 9.5.4.9]

7I.6.340 FINANCIAL INSTRUMENTS MEASURED IN FOREIGN CURRENCY

7I.6.350 General considerations

7I.6.350.10 Entities may have exposure to foreign currency risk, either from transactions in
foreign currencies or from investments in foreign operations. The principles for foreign currency
transactions explained in chapter 2.7 apply equally to financial instruments. The application of these
principles to various foreign currency financial instruments is explained below.

7I.6.350.20 ‘Monetary items’ are units of currency held and assets and liabilities to be received or
paid, in a fixed or determinable number of units of currency. This definition is narrower than the
definition of a financial instrument, which means that not all financial instruments are monetary.
Consequently, contractual rights or obligations to receive or pay cash when the amount of money is
neither fixed nor determinable are non-monetary financial instruments. This is the case, for example,
with equity securities and other instruments if the holder has no right to a determinable amount of
money. [IAS 21.8, 16]

7I.6.350.30 Derivative contracts are settled at amounts that are determinable at the settlement
date in accordance with the terms of the contract and the price of the underlying. Derivatives that
are settled in cash are monetary items, even if the underlying is a non-monetary item. [IAS 21.16,
39.AG83]

7I.6.350.40 In our view, the liability component of a convertible bond should be considered to be
a monetary item because it is an obligation to pay a fixed or determinable amount of currency units.

7I.6.360 Monetary items carried at amortised cost

7I.6.360.10 Monetary items denominated in a foreign currency and carried at amortised cost –
i.e. loans and receivables, held-to-maturity investments and other liabilities – are measured as
follows.
• The functional currency carrying amount at the beginning of the reporting period – i.e. the
amount reported in the functional currency of the entity at the previous reporting date – is the
starting point.
• The interest income to be recognised in the period is the amount calculated in the foreign
currency under the effective interest method, multiplied by the average spot exchange rate for
the period. This accrual adjusts the functional currency amortised cost at the beginning of the
reporting period.
• Then the foreign currency amortised cost of the monetary item is calculated as at the reporting
date.
• The functional currency carrying amount at the reporting date is the foreign currency amortised
cost at the reporting date multiplied by the spot exchange rate at the reporting date.
• Then the functional currency carrying amount at the reporting date as calculated above is
compared with the functional currency carrying amount at the beginning of the reporting period
adjusted for the interest accrual and any payments during the period. Any difference between
these two amounts is an exchange gain or loss, which is recognised in profit or loss. [IAS 21.23(a), 28,
39.AG83, IG.E.3.4]

7I.6.370 Available-for-sale monetary items

7I.6.370.10 For the purpose of recognising foreign exchange differences, available-for-sale

monetary items (such as debt securities) are treated as if they were measured at amortised cost in
the foreign currency. Accordingly, the foreign exchange differences arising from changes in
amortised cost are recognised in profit or loss and not in OCI. [IAS 21.23(a), 28, 39.AG83, IG.E.3.2, IG.E.3.4]

7I.6.370.20 The foreign currency differences on these instruments are measured as follows.
• The functional currency amortised cost at the beginning of the reporting period – i.e. the amount
calculated (but not reported) in the functional currency of the entity at the previous reporting
date – is the starting point.
• The interest income to be recognised in the period is the amount calculated in the foreign
currency under the effective interest method, multiplied by the average spot exchange rate for
the period. This accrual adjusts the functional currency amortised cost at the beginning of the
reporting period. For available-for-sale monetary items, interest calculated under the effective
interest method is required to be recognised in profit or loss (see 7I.6.170.40).
• Then the foreign currency amortised cost of the monetary item is calculated as at the reporting
date.
• The functional currency amortised cost at the reporting date is the foreign currency amortised
cost at the reporting date multiplied by the spot exchange rate at the reporting date.
• Then the functional currency amortised cost at the reporting date is compared with the functional
currency amortised cost at the beginning of the reporting period adjusted for the interest accrual
and any payments during the period. Any difference between these two amounts is an exchange
gain or loss, which is recognised in profit or loss. [IAS 39.IG.E.3.2]

7I.6.370.30 The reported carrying amount of such available-for-sale monetary items is calculated
as follows.
• The fair value of the monetary item at the reporting date is calculated in the foreign currency.
• The functional currency carrying amount at the reporting date is determined by multiplying the
fair value in the foreign currency by the spot exchange rate at the reporting date.
• The difference between the functional currency carrying amount at the reporting date – i.e. fair
value – and the functional currency amortised cost at the reporting date is the cumulative gain or
loss to be recognised in OCI at the reporting date. [IAS 39.IG.E.3.2]

EXAMPLE 10 – ACCOUNTING FOR AVAILABLE-FOR-SALE MONETARY ITEM

7I.6.370.40 On 31 December 2020, Company P, which has the euro as its functional
currency, buys a bond denominated in US dollars. The following facts are also relevant
for this example.

31 DEC 2020 31 DEC 2021

Fair value of the bond USD 1,000 USD 1,060

Remaining years to maturity 5 4

Fixed annual coupon on principal of USD 1,250 4.7% or USD 59

Annual effective interest rate 10%

7I.6.370.50 Exchange rates at 31 December 2020 and 31 December 2021 and the
average exchange rate during 2021 were as follows.

USD EUR

Exchange rate at 31 December 2020 1.0 1.5

Average exchange rate during 2021 1.0 1.75

Exchange rate at 31 December 2021 1.0 2.0

7I.6.370.60 P classifies the bond as available-for-sale. P initially recognises the

bond as follows.

DEBIT (EUR) CREDIT (EUR)

Bond 1,500

Cash 1,500

To recognise initial acquisition of bond

7I.6.370.70 P determines:

•
• the amortised cost of the bond at 31 December 2020;
• the interest income for 2021 under the effective interest method;
• the coupon received on 31 December 2021;
• the amortised cost of the bond at 31 December 2021; and
• the exchange difference on the bond for 2021.

USD RATE EUR

Amortised cost of bond at 31

December 2020 1,000 1.5 1,500

Interest income 100(1) 1.75 175

Coupon received (59) 2 (118)

Amortised cost of bond at 31

December 2021 1,041 2 2,082

Exchange difference 525(2)

Notes
1. Calculated as USD 1,000 × 10%.
2. Calculated as EUR 2,082 + EUR 118 - EUR 175 - EUR 1,500.

7I.6.370.80 The exchange difference represents:

• a gain of EUR 500 (1,000 x (2 - 1.5)) arising on the initial amortised cost; and
• a gain of EUR 25 (100 x (2 - 1.75)) arising on the interest income. [IAS 39.IG.E.3.2]
7I.6.370.90 P determines the cumulative gain or loss to be recognised in OCI as
follows.

31 December 2021 USD RATE EUR

Fair value of the bond 1,060 2 2,120

Amortised cost of the bond (1,041) 2 (2,082)

Cumulative fair value changes

in OCI (gain) (19) 2 (38)(1)

Note
1. The balance of the cumulative gain or loss in OCI related to the bond at 31 December
2020 is zero, and therefore the amount of gain or loss to be recognised in OCI in the
statement of profit or loss and OCI for 2021 equals the balance of cumulative gain or
loss to be recognised in OCI at 31 December 2021.

7I.6.370.100 P records the following entry on 31 December 2021.

 DEBIT (EUR) CREDIT (EUR)

Bond 620(1)

Cash 118

Interest income 175

Exchange gain 525

Fair value change in OCI 38

To recognise changes in fair value, interest

income and repayment, and foreign exchange
on bond

Note
1. Calculated as EUR 2,120 - EUR 1,500.

7I.6.380 Non-monetary items measured at fair value

7I.6.380.10 Non-monetary items measured at cost are not translated subsequent to initial
recognition. However, some non-monetary financial instruments, such as investments in equity
securities, are measured at fair value. Such instruments are reported using the exchange rates that
existed when the fair values were determined. Therefore, the fair value is first determined in the
foreign currency, which is translated into the functional currency. Foreign exchange gains and losses
are not separated from the total fair value changes. Therefore, for available-for-sale equity
investments, the entire change in fair value, including any related foreign exchange component, is
recognised in OCI. If the non-monetary item is classified as at FVTPL, then the entire fair value
change is recognised in profit or loss. [IAS 21.23, 30, 39.AG83]

7I.6.390 Dual-currency loans

7I.6.390.10 A dual-currency loan is an instrument with the principal and interest denominated in
different currencies. A dual-currency loan with principal denominated in the functional currency and
interest payments denominated in a foreign currency contains an embedded foreign currency
derivative. However, the embedded derivative is not separated because changes in the spot rate on
the foreign currency denominated element (the accrued interest or the principal) are measured
under IAS 21 at the closing rate, with any resulting foreign exchange gains or losses recognised in
profit or loss. However, IAS 21 does not provide guidance on how to account for a dual-currency
instrument. [IAS 39.AG33(c)]

EXAMPLE 11 – MEASUREMENT OF DUAL-CURRENCY LOANS

7I.6.390.20 Company Q issues a bond with the principal denominated in euro and
the interest denominated in US dollars. The functional currency of Q is sterling. In
our view, to reflect the foreign currency exposure Q should treat the dual-currency
bond as consisting of two components for measurement purposes:
• a zero-coupon bond denominated in euro; and
• an instalment bond with annual payments denominated in US dollars.
7I.6.390.30 On initial recognition, the two components are recognised at fair
value. Subsequently, assuming that the instrument is not classified as at FVTPL, Q
measures each component separately at amortised cost under the effective interest
 method. The interest expense related to each component is calculated separately in
the relevant foreign currency – i.e. in euro for the zero-coupon bond and in US
dollars for the instalment bond – and translated into sterling at the average rate for
the period. The carrying amount of both elements is translated to sterling at each
reporting date using the closing exchange rate, with movements recognised in profit
or loss (see 2.7.140.10).

7I.6.400 IMPAIRMENT OF FINANCIAL ASSETS

7I.6.400.05 The following table sets out instruments that are in and out of the scope of the
impairment requirements of IAS 39. [IFRS 15.107, C9, IAS 39.2, 2A]

IN SCOPE OUT OF SCOPE

• Loans and receivables and held-to- • Financial instruments measured at FVTPL

maturity investments – i.e. assets • Financial guarantee contracts issued (see
measured at amortised cost 7I.1.50)
• Available-for-sale financial assets • Loan commitments issued (see 7I.1.200)
• Assets measured at cost because fair
value is not reliably measurable
• Lease receivables in the scope of IFRS
16
• Contract assets in the scope of IFRS 15

7I.6.400.10 Addressing the impairment of financial assets is a two-step process. First, the entity
assesses whether there is objective evidence that impairment exists for a financial asset or a group of
financial assets. This assessment is done at least at each reporting date. If there is no objective
evidence of impairment, then no impairment loss is recognised at that time for that financial asset or
group of financial assets. However, if there is objective evidence of impairment, then the entity
calculates the amount of any impairment loss and recognises it during that reporting period. [IAS
39.46, 58–59]

7I.6.400.20 The assessment of whether there is objective evidence of an incurred impairment

loss on a financial asset is based on all available information at the reporting date. However, in our
view this does not imply that a full loan review in accordance with the entity’s normal operating
procedures should be carried out at the reporting date as long as the entity has procedures,
processes and systems that provide the relevant information required for such an assessment for the
purposes of financial reporting. [IAS 39.58]

7I.6.400.30 As is discussed in 7I.6.410, there is different guidance on the impairment of

investments in equity instruments from that for investments in debt instruments. The Standards do
not define a debt instrument or an equity instrument from the holder’s perspective. In our view,
determining whether the holder has an investment in a debt instrument or in an equity instrument
requires the use of judgement and consideration of the specific facts and circumstances. A debt
instrument is usually characterised by a fixed or determinable maturity and fixed or determinable
payments, whereas an equity instrument gives the holder a residual interest in the net assets of the
entity.

7I.6.400.35 The nature of the investment may impact the identification of objective evidence of
impairment and recording of reversals of impairment losses. Once it has been determined, the
nature of the holder’s investment is interpreted in a consistent way for the purposes of other
requirements of the standard that distinguish between debt and equity instruments, such as
identification of the host contract for assessing embedded derivatives and the reference asset for
financial guarantee contracts.
7I.6.410 Objective evidence of impairment

7I.6.410.10 A financial asset or a group of financial assets is considered to be impaired only if

objective evidence indicates that one or more events (‘loss events’), happening after its initial
recognition, have an effect on the estimated future cash flows of that asset. It may not be possible to
pinpoint one specific event that caused the impairment because it may have been caused by the
combined effects of a number of events. When a loss event is identified, an impairment loss is
recognised if that loss event has an impact on the cash flows of the financial asset that can be
estimated reliably – i.e. if a loss event is identified, then an entity is required to consider the impact
on the estimated cash flows to determine whether an impairment loss should be recognised. [IAS
39.59]

7I.6.410.20 Indicators that a financial asset or a group of financial assets may be impaired
include:
• significant financial difficulty of the borrower or the issuer;
• breach of contract, such as default or delinquency in interest or principal payments (payment
defaults);
• it becoming probable that the borrower or issuer will enter bankruptcy or other financial
reorganisation;
• renegotiation of the terms of an asset because of financial difficulty of the borrower or issuer,
including granting a concession to the borrower or issuer;
• disappearance of an active market for a financial asset because of financial difficulties; and
• observable data indicating a measurable decrease in the estimated future cash flows from a group
of financial assets since their initial recognition, although the decrease cannot yet be identified
with the individual assets in the group. [IAS 39.59]

7I.6.410.30 For example, for loans to investment property vehicles or property developers,
repayment of principal or interest may be dependent on the income from or value of real estate – e.g.
rental income may be used to pay interest, and the repayment of principal may be dependent on the
sale or refinancing of the property. Adverse changes in property markets and property-specific
factors – e.g. loss or bankruptcy of tenants, development delays or cost overruns – may represent an
impairment trigger for property-based lending.

7I.6.410.40 Loss events arising from significant financial difficulty of the borrower or the issuer
often occur before any actual payment default on the financial asset.

7I.6.410.50 For the purpose of identifying loss events, IAS 39 does not limit the description of
breach of contract or default or delinquency to only 90 or 180 days past due. These terms – i.e.
breach of contract or default or delinquency – may encompass other breaches of contract (e.g.
covenants), including any failure of the debtor to pay when due.

7I.6.410.60 A change in credit rating is not of itself evidence of impairment. However, it may be
evidence of impairment when it is considered with other available information, such as one of the
indicators noted in 7I.6.410.20. In addition, when evaluating evidence of impairment an entity takes
into account:
• information about the debtor’s/issuer’s liquidity and solvency;
• trends for similar financial assets; and
• local economic trends and conditions. [IAS 39.60, IG.E.4.1]
7I.6.410.70 Similarly, in our view a commitment to sell a financial asset measured at amortised
cost at an amount below its amortised cost is not of itself evidence of impairment, but may be
evidence of impairment when it is considered with other available information. We believe that
whether such an asset is impaired and the measurement of impairment should be based on the
general impairment guidance discussed in this section, focusing on the cash flows that the asset will
generate. It would not be appropriate to simply write the asset down to the expected selling price or
to recognise a gain or loss on sale before derecognition of the asset. In addition, an entity should
assess whether a contractual agreement to sell a financial asset at a future date is a regular-way sale
(see 7I.2.70) or whether it should be accounted for as a derivative in the scope of IAS 39 (see
7I.2.10).

7I.6.410.80 Although a loan measured at amortised cost is not in the scope of the measurement
requirements of IFRS 5, it may be in the scope of its presentation requirements if it meets the
criteria for classification as held-for-sale at the reporting date (see 5.4.20.20). [IFRS 5.2, 5]

7I.6.420 Debt instruments

7I.6.420.10 A debt instrument is impaired if there is an indication that a loss event that has
happened since initial recognition has an impact on the estimated future cash flows. A decline in the
fair value of a debt instrument because of changes in market interest rates is not in itself an
indication of impairment. For example, the fair value of a fixed rate debt security would decrease if
market interest rates increased. This is not evidence of impairment if the future contractual cash
flows associated with the debt security are still expected to be received. [IAS 39.59–60]

7I.6.420.20 A debt instrument may be acquired at a deep discount that reflects incurred credit
losses (see also 7I.8.170.20). If the carrying amount of the debt instrument is subsequently adjusted
upwards because of improved recoverability, and then adjusted downwards again because of
reduced recoverability, then there is an issue about whether the downwards adjustment is an
impairment loss (see 7I.6.260).

EXAMPLE 12 – IMPAIRMENT LOSS – DEBT INSTRUMENTS

7I.6.420.30 An impaired debt instrument with a nominal principal of 100 was

initially recognised by Company R at its fair value of 70 on acquisition. Its carrying
amount (amortised cost) was subsequently increased to 80 under the effective
interest method to reflect revised estimated cash flows arising from increased
recoverability. The carrying amount of the debt instrument was subsequently
reduced to 75 because of further revisions to estimated cash flows as a result of
reduced recoverability.

7I.6.420.40 In our view, two approaches to the presentation of this downward

adjustment are possible.
• Recognise an adjustment of 5 to interest or other income (see 7I.6.260) on the
basis that the reduced recoverability was not below that expected on initial
recognition of the debt instrument; therefore, it can be argued that such a
decline does not represent a loss event that has happened since initial
recognition. This analysis is based on the premise that for a loss event to happen
subsequent to initial recognition, it has to reduce the expected cash flows below
those expected on initial recognition.
• Recognise an impairment loss of 5 on the basis that a loss event has happened in
the period since the initial recognition of the debt instrument. [IAS 39.AG8]

7I.6.430 Equity instruments

7I.6.430.10 For equity instruments, impairment cannot be identified based only on analysing
cash flows considering the indicators in 7I.6.410. Additionally, if there has been a significant or
prolonged decline in the fair value of an equity instrument below its cost, then this is considered
objective evidence of impairment. In our view, there is no basis for overriding this evidence in the
light of qualitative factors. [IAS 39.61, IG.E.4.10, IU 07-09]

7I.6.430.20 For an equity instrument denominated in a foreign currency, the assessment of

significant or prolonged decline in fair value is made in the functional currency of the holder of the
instrument because this is consistent with how any impairment loss is determined. [IU 07-09]

7I.6.430.30 In our view, in evaluating whether a decline in fair value is significant in periods after
an impairment loss has been recognised, the extent of the decline should be evaluated in relation to
the cost of the instrument, not its carrying amount at the date on which the last impairment loss was
recognised. Similarly, in our view in evaluating whether the period of a subsequent decline in the fair
value of equity instruments is prolonged, the period of the decline is the entire period for which fair
value has been below cost and not just the period since the last impairment loss was recognised.
Therefore, we believe that once a decline in fair value below cost has been recognised as an
impairment, any subsequent further decline below the carrying amount at the date on which that
impairment loss was recognised is also an impairment, even if the fair value had recovered since the
original decline and regardless of whether the ‘new’ decline is significant or prolonged. [IAS 39.61,
IG.E.4.9, IU 07-09]

7I.6.430.35 However, in our view, for assessing whether a decline in fair value of an available-for-
sale equity instrument that is or was a hedged item in a fair value hedging relationship is significant
or prolonged, its cost should be adjusted for the effects of fair value hedge accounting – i.e. it should
include the fair value gains and losses already recognised in profit or loss as a result of hedge
accounting (see 7I.7.50). This is because we believe that adjustments to the carrying amount that are
recognised in profit or loss (except for impairment losses) change the cost basis. This is consistent
with the treatment of inventories and monetary amounts that have been fair value hedged. We
believe that the adjusted cost should also be used for measuring the impairment loss (see
7I.6.530.50–80). [IAS 39.89(b), IG.F.3.6]

7I.6.430.40 In our view, an entity should establish criteria that it applies consistently to
determine whether a decline in a quoted market price is significant or prolonged. The Standards do
not contain any specific quantitative thresholds for ‘significant’ or ‘prolonged’. In our view, for equity
securities that are quoted in an active market, the general concepts of significance and materiality
should apply. We believe that:
• a decline in excess of 20 percent should generally be regarded as significant; and
• a decline in a quoted market price that persists for nine months should generally be considered to
be prolonged. However, it may be appropriate to consider a shorter period.

7I.6.430.50 In our view, apart from significant or prolonged thresholds, an entity can establish
additional events triggering impairment. These can include, among other things, a combination of
significant and prolonged thresholds based on the particular circumstances and nature of that
entity’s portfolio. For example, a decline in the fair value in excess of 15 percent persisting for six
months could be determined by an entity to be an impairment trigger.

7I.6.430.60 However, in our view the combination of thresholds applied should result in a decline
that is either significant or prolonged, under the guidance set out in 7I.6.430.40, being recognised as
impairment.

7I.6.430.70 In our view, if a decline in fair value is significant or prolonged, then there is objective
evidence of impairment and an impairment loss should be recognised, regardless of how long
management intends to hold the investment. Therefore, if there has been a significant or prolonged
decline in the market price at the reporting date, then an impairment loss should be recognised,
even if the prospects of recovery are good.

7I.6.430.80 A significant or prolonged decline in the fair value of an equity instrument below its
cost that is in line with the overall level of decline in the relevant market does not mean that an entity
can conclude the equity instrument is not impaired. [IU 07-09]

7I.6.430.90 Once it has been concluded that there has been a significant or prolonged decline, an
impairment may not be reversed. A subsequent change in market value normally reflects
circumstances that have arisen subsequently.
7I.6.430.100 In the case of shares in an investment fund, it is likely that a decrease in the fair
value of an investment fund arises from an impairment of at least some of the underlying assets held
by the fund. However, in our view an interest in an investment fund should be evaluated based on the
fair value of the investment fund itself rather than on the underlying investments held by the fund,
because there are some risks that can be evaluated only by considering the investment fund as a
whole.

7I.6.430.110 Even if a decline in fair value is neither significant nor prolonged, it is still necessary
to consider other objective evidence that may indicate impairment. This requires an assessment of
the indicators described in 7I.6.430.50, as well as significant adverse changes in the technological,
market, economic or legal environment in which the issuer operates that indicate that the cost of the
investment may not be recovered. In our experience, additional indicators of impairment of equity
securities may include:
• a decline in the fair value of the equity instrument that seems to be related to issuer conditions
rather than to general market or industry conditions;
• market and industry conditions, to the extent that they influence the recoverable amount of the
financial asset – e.g. if the fair value at the date of acquisition had been extremely high because of
a market level that is unlikely to be recovered in the future, then this may be an impairment
indicator arising from pure market and/or industry conditions;
• a declining relationship of market price per share to net asset value per share at the date of
evaluation compared with the relationship at acquisition;
• a declining price/earnings ratio at the time of evaluation compared with that at the date of
acquisition;
• financial conditions and near-term prospects of the issuer, including any specific adverse events
that may influence the issuer’s operations;
• recent losses of the issuer;
• a qualified independent auditor’s report on the issuer’s most recent financial statements;
• negative changes in the dividend policy of the issuer, such as a decision to suspend or decrease
dividend payments; and
• realisation of a loss on subsequent disposal of the investment. [IAS 39.61]
7I.6.430.120 In our view, this assessment should be performed for all equity securities whose fair
value is below cost, but for which the decline in fair value is not considered significant or prolonged.
In our view, the higher or longer the entity’s thresholds for determining whether a decline is
significant or prolonged, the more comprehensive the qualitative evaluation needs to be. [IAS 39.61]

7I.6.430.130 Generally, we would expect an equity security to become impaired earlier than a
debt security issued by the same counterparty because of the nature of each instrument and the
rights each conveys to its holder.

7I.6.440 Portfolios of assets

7I.6.450 Determining cost

7I.6.450.10 The Standards are silent on how to determine the cost of financial assets when they
are part of a homogeneous portfolio. Therefore, an entity should develop an accounting policy
applying the hierarchy for selecting accounting policies (see 2.8.20). In our view, the guidance on
cost formulas for inventories should be applied (see 3.8.280). Therefore, any reasonable cost
allocation method – i.e. average cost or first-in, first-out – may be used and applied consistently.
However, an entity is not precluded from using specific identification if it is able to identify the costs
of the specific assets.

7I.6.450.20 In our view, the entity should apply the same cost allocation accounting policy both
for assessing and measuring impairment losses and for determining the cost of the financial assets
sold (see 7I.5.280.60).
7I.6.460 Evidence of decrease in estimated cash flows
7I.6.460.10 A decrease in the estimated future cash flows from a group of financial assets usually
indicates impairment of that group of assets. Evidence of a decrease in estimated cash flows from a
group of assets includes:
• an adverse change in the payment status of borrowers in the group – e.g. an increased number of
customers exceeding their credit limit or not making payments on time; or
• a change in national or local economic conditions that is likely to cause higher defaults on
payments. [IAS 39.59(f)]

7I.6.470 Impairment loss calculations

7I.6.470.10 If there is objective evidence that a financial asset is impaired, then the entity
determines the amount of any impairment loss. The measurement of the impairment loss differs for
assets carried at amortised cost or cost, and available-for-sale financial assets. For assets carried at
amortised cost, impairment is measured based on incurred credit losses using the instrument’s
original effective interest rate (see 7I.6.480.10). However, for available-for-sale financial assets an
impairment loss is calculated based on fair value, which reflects market interest rates and market
expectations of expected future, as well as incurred, credit losses. [IAS 39.63, 67–68, IG.E4.2]

7I.6.470.20 For assets carried at amortised cost, an impairment loss may be recognised by
writing down the asset or recording an allowance to be deducted from the carrying amount of the
asset. [IAS 39.63]

7I.6.480 Loans and receivables and held-to-maturity investments

7I.6.480.10 In calculating an impairment loss for a financial asset (or a group of financial assets)
carried at amortised cost, an entity uses the financial asset’s original effective interest rate to
discount the estimated future cash flows. In determining the original effective interest rate, an entity
takes into account the following.
• For a variable rate financial asset, the discount rate used is the current effective interest rate(s)
determined under one of the approaches in 7I.6.270.30. This rate might comprise a variable
benchmark interest rate plus/minus a fixed margin – e.g. three-month Euribor plus 40 basis
points. In other words, the appropriate current effective interest rate considers changes of the
variable benchmark interest rate, but the original credit risk spread is held constant.
• When a financial asset has been reclassified out of the available-for-sale category to loans and
receivables (see 7I.4.250.20) or out of the FVTPL category (see 7I.4.220.60), a new original
effective interest rate is calculated based on the expected future cash flows as at the
reclassification date. This effective interest rate would be adjusted if the entity, subsequent to
reclassification, increases its estimates of future cash receipts as a result of increased
recoverability of those cash receipts (see 7I.6.260.20).
• When the financial asset is the hedged item in a fair value hedge, the original effective interest
rate is adjusted to take account of recognised changes in fair value attributable to the hedged risk
(see 7I.6.530.40).
• If the terms of a loan, receivable or held-to-maturity investment are renegotiated or modified
because of financial difficulties of the borrower or issuer, then impairment is measured using the
original effective interest rate before the modification of the terms. [IAS 39.AG84, IU 07-10]

7I.6.480.20 An impairment loss for financial assets measured at amortised cost is the difference
between the asset’s carrying amount and the present value of the estimated future cash flows
discounted at the asset’s original effective interest rate (see 7I.6.480.10). The estimated future cash
flows include only those credit losses that have been incurred at the time of the impairment loss
calculation – i.e. it is an ‘incurred-loss model’. Losses expected as a result of future events, no matter
how likely, are not taken into account. This is particularly relevant when financial assets are assessed
for impairment collectively. [IAS 39.59, 63]
7I.6.480.30 The asset’s original effective interest rate (see 7I.6.480.10) is used in calculating the
impairment loss because discounting at the current market rate of interest would, in effect, impose
fair value measurement on the financial asset. This would not be appropriate because such assets
are measured at amortised cost. The aim of this requirement is to recognise losses arising from
changes in expected cash flows as a result of loss events happening after initial recognition, not to
reflect changes in the value of the asset because of changes in credit spreads or market interest
rates. However, as a practical expedient, a creditor may measure impairments on the basis of an
instrument’s fair value using an observable market price. [IAS 39.63, AG84]

7I.6.480.40 The process for estimating the amount of an impairment loss may result in a single
amount or in a range of possible amounts. In the latter case, an entity recognises an impairment loss
equal to the best estimate within the range taking into account all relevant information available
before the financial statements are authorised for issue about conditions existing at the reporting
date. [IAS 39.AG86]

7I.6.480.50 Estimates of future cash flows may depend on an entity’s approach to managing
impaired loans – e.g. collection policies, workout strategies, forbearance practices, anticipated debt
restructurings and foreclosure practices. Therefore, changes in the entity’s approach to managing
impaired loans may lead to changes in these estimates and in the amounts of recognised impairment.
If changes in the entity’s approach occur, then an entity discloses such changes along with any
material effect on financial performance. [IFRS 7.7, 33, IAS 8.39]

7I.6.480.60 Although actual or contemplated changes in collection plans and strategies may have
a significant effect on best estimates of impairment, it is unlikely that possible changes in collection
plans and strategies that are not yet contemplated by management would have a significant effect on
current best estimates of impairment, unless management’s current plans and strategies are
unrealistic. However, an entity considers whether the expected continuation of plans and strategies
is an assumption about the future or other source of estimation uncertainty at the reporting date that
should be disclosed in accordance with paragraph 125 of IAS 1 – i.e. one that has a significant risk of
resulting in a material adjustment to the carrying amounts of assets and liabilities within the next
annual reporting period (see 2.8.120.10). [IAS 1.125]

7I.6.490 Actual or expected restructuring of impaired assets

7I.6.490.10 When a debtor is in financial difficulties, the debtor and its creditors may negotiate a
restructuring of some or all of the debtor’s obligations to allow the debtor sufficient capacity to
service the debt or refinance the contract, either entirely or partially. Such circumstances are often
referred to as ‘forbearance’. Examples of forbearance practices include reducing interest rates,
delaying payment of principal and amending covenants. As discussed in 7I.6.410.20, renegotiation of
the terms of a financial asset because of financial difficulty of the debtor is an indicator that the asset
may be impaired. For assessing and measuring impairment, the lender considers the impact of the
modified terms on the estimated future cash flows of the financial asset.

7I.6.490.13 It cannot simply be assumed without appropriate evidence that a forborne exposure
will perform in accordance with the modified terms. This may be unlikely if the borrower is in
financial difficulties and there is no reduction in the present value of the contractual cash flows. [IAS
39.IG.E.4.3]

7I.6.490.15 Also, forborne exposures may display different credit risk characteristics from non-
forborne exposures – e.g. increased propensity to future default – that would indicate that they need
to be segregated for impairment purposes.

7I.6.490.20 As noted in 7I.6.480.10, if the terms of a financial asset measured at amortised cost
are renegotiated or modified because of financial difficulties of the borrower or issuer, then
impairment is measured using the original effective interest rate before the modification. However,
in our view if an existing financial asset is replaced with a new financial asset and the cash flows of
the two instruments are substantially different, then the contractual rights to cash flows from the
original financial asset should be deemed to have expired; in this case, the original financial asset is
derecognised and the new financial asset is recognised and initially measured at fair value (see
7I.5.95). We believe that the same analysis is applicable regardless of whether the legal form of the
transaction is the cancellation of the existing debt instrument in exchange for a new debt instrument
of the debtor or the modification of the terms of the existing debt instrument. Accordingly, if a
renegotiation or modification of terms of an existing financial asset is such that the cash flows of the
modified asset are substantially different from those of the original unmodified asset, then the
original financial asset is derecognised and the modified financial asset is recognised as a new
financial asset and initially measured at fair value. [IAS 39.17, AG84]

7I.6.490.30 In our view, these principles also impact the measurement of impairment of a
financial asset carried at amortised cost if it is expected that a restructuring relating to the debtor’s
financial difficulty will be effected.
• If the expected restructuring will not result in derecognition of the existing asset, then the
estimated cash flows arising from the modified financial asset are included in the measurement of
the existing asset based on their expected timing and amounts discounted at the original effective
interest rate of the existing financial asset.
• If the expected restructuring will result in derecognition of the existing asset, then the expected
fair value of the new asset is treated as the final cash flow from the existing financial asset at the
time of its derecognition. This amount is discounted from the expected date of derecognition to
the reporting date using the original effective interest rate of the existing financial asset. [IAS
39.17, AG84]

EXAMPLE 13 – IMPAIRMENT LOSS – EXPECTED RESTRUCTURING RESULTS IN DERECOGNITION

7I.6.490.40 At 31 December 2021, Company S has a loan asset with an amortised

cost of 1,000 and an effective interest rate of 10% a year. The borrower is in
financial difficulties. S expects that it will participate in a debt restructuring in six
months’ time that will involve a substantial modification to the cash flows receivable
under the loan agreement, including a 50% reduction in the principal amount, a
reduction in the contractual interest rate and a substantial extension of maturity. S
expects that the fair value of the new loan at the time of the restructuring will be
300.

7I.6.490.50 As a result, S measures the existing financial asset at approximately

286 (i.e. 300 / (1 + 10%)6 / 12) at 31 December 2021. If the restructuring proceeds in
the manner expected on 30 June 2022, then any difference between the actual fair
value of the new loan and the previous estimate of 300 would give rise to an
additional impairment loss or a reversal of the impairment loss in 2022.

7I.6.500 Available-for-sale financial assets

7I.6.500.10 For financial assets measured at fair value, impairment is relevant only for those
classified as available-for-sale because changes in fair value are generally recognised in OCI rather
than in profit or loss. For such assets, when there is objective evidence of impairment, the cumulative
loss that had been recognised in OCI is reclassified from equity to profit or loss. Furthermore, once
an investment in equity instruments has been impaired, all subsequent losses are recognised in
profit or loss until the asset is derecognised. [IAS 39.67, IG.E.4.9]

7I.6.500.20 In the case of an equity instrument included in the available-for-sale category, the
cumulative loss referred to in 7I.6.500.10 is the difference between the acquisition cost (see
7I.6.450.10 and 530) and the current fair value of the instrument, less any impairment loss on that
equity instrument previously recognised in profit or loss. In the case of a debt instrument included in
the available-for-sale category, the cumulative loss is the difference between the amortised cost – i.e.
the acquisition cost net of principal repayments and amortisation – and the current fair value of the
instrument, less any impairment loss on that debt instrument previously recognised in profit or loss.
[IAS 39.68]

7I.6.500.30 Any previous net upward revaluation recognised in OCI for the asset is reversed first.
Any additional write-down below the initial amount recognised for the asset is recorded as an
impairment loss in profit or loss. [IAS 39.68]

7I.6.500.40 If the asset was previously revalued through OCI to an amount below the carrying
amount on initial recognition, then the cumulative loss that had been recognised in OCI for that asset
is reclassified from equity and recognised as an impairment loss in profit or loss. The entire amount
of the revaluation below acquisition cost is recognised as an impairment loss even if the estimated
cash flows indicate that some of that decline is reversible. [IAS 39.68]

7I.6.500.50 The implementation guidance to IAS 39 acknowledges that the available-for-sale

revaluation reserve in equity may become negative. This may happen through the remeasurement to
fair value of available-for-sale assets and is not necessarily an indication that the available-for-sale
asset is impaired and that the cumulative net loss that has been recognised in OCI should be
reclassified to profit or loss. IAS 39 contains detailed guidance on indicators of impairment and
assessing a decline in the fair value as evidence of impairment. [IAS 39.59–61, IG.E.4.10]

7I.6.510 Subsequent impairment of available-for-sale debt instruments

7I.6.510.10 IAS 39 does not explicitly address the accounting treatment of a subsequent further
decline in the fair value of an impaired available-for-sale debt instrument when there is no objective
evidence of any further credit-related loss event. In our view, an entity should choose an accounting
policy, to be applied consistently, to recognise such further declines either in OCI or in profit or loss.
For a discussion of the possible inter-relationship with the entity’s accounting policy for reversals of
impairment losses on available-for-sale debt instruments, see 7I.6.660.50. Before applying an
accounting policy to recognise such a further decline in OCI, an entity should first consider all
available evidence to determine whether the further decline in fair value is objective evidence of a
further credit-related loss event, including consideration of the magnitude and duration of the
subsequent loss. If there is objective evidence of a further credit-related loss event, then the further
decline in fair value is recognised in profit or loss.

7I.6.520 Assets measured at cost because fair value not reliably measurable
7I.6.520.10 For financial assets measured at cost because their fair value is not reliably
measurable – i.e. certain unquoted equity instruments and derivatives linked to such instruments
(see 7I.6.210) – the impairment loss is measured as the difference between the carrying amount and
the present value of estimated future cash flows discounted at the current market rate of return for a
similar financial asset. [IAS 39.66]

7I.6.530 Hedged assets

7I.6.530.10 The principles for hedge accounting do not override the accounting treatment under
IAS 36 or IAS 39 if there is impairment of the hedged item. Therefore, if a hedged item is impaired,
then this impairment is recognised even if the risk that causes the impairment is being hedged and
hedge accounting is being applied. However, the hedge accounting principles may require a gain on
a hedging instrument used to hedge the risk that gave rise to the impairment to be recognised
simultaneously in profit or loss and offset (partly) against the recognised impairment. In a fair value
hedge, in our view, the cost basis of the hedged item used for measuring the impairment loss should
be adjusted for the effects of the hedge accounting – i.e. it should include the fair value gains and
losses already recognised in profit or loss as a result of hedge accounting (see 7I.6.530.40–50). [IAS
39.58]
EXAMPLE 14 – IMPAIRMENT LOSS – CASH FLOW HEDGE OF EXPECTED SALE OF ASSETS

7I.6.530.20 Company T holds a portfolio of securities that are classified as

available-for-sale. The cost of the portfolio is 300. T has an option to put the
securities to a third party for a fixed price of 250. T may apply hedge accounting to
this transaction provided that the hedging relationship meets the relevant criteria

(see 7I.7.120). T designates the option as a hedge of the cash flows from an expected
future sale of the securities, with the hedged risk being the elimination of the
variability in cash flows arising from the price of the securities going below 250.

7I.6.530.25 The fair value of the portfolio subsequently decreases by 120 and
there is objective evidence of impairment. The amount of the impairment, which is
recognised in profit or loss, is the difference between the cost of the securities (300)
and the fair value (180), irrespective of whether T has hedged the downside risk on
the cash flows from an expected sale using an option. However, because at this point
the impairment on the hedged item affects profit or loss, the related gain on the put
option would also be recognised in profit or loss. This means that a gain of 70 (250 -
180), ignoring time value, will be recognised in profit or loss and will partly offset
the impairment loss on the securities. [IAS 39.100]

7I.6.530.30 For cash flow hedges of highly probable acquisitions of financial and non-financial
assets, amounts previously recognised in OCI may be reclassified from equity to profit or loss when
the asset affects profit or loss. For non-financial assets, this is possible only if the accounting policy is
not to apply a basis adjustment for such items. If such an asset is impaired, then an appropriate
amount of the gain or loss previously recognised in OCI is reclassified from equity to profit or loss.
[IAS 39.97–98]

7I.6.530.40 In a fair value hedge of a debt instrument, both the original effective interest rate
(see 7I.6.480.10) and the amortised cost of the hedged item are adjusted to take account of
recognised changes in fair value attributable to the hedged risk. The adjusted effective interest rate
is calculated using the adjusted carrying amount of the debt instrument. The impairment loss is the
difference between the carrying amount of the asset after any adjustments as a result of applying
hedge accounting, and the estimated future cash flows of the hedged item discounted at the adjusted
effective interest rate. [IAS 39.IG.E.4.4]

7I.6.530.50 In a fair value hedge of an available-for-sale equity instrument, we believe that for
measuring the impairment loss, the cost of the asset should be adjusted for the effects of the fair
value hedge accounting (see 7I.6.430.35).

EXAMPLE 15 – IMPAIRMENT LOSS – AVAILABLE-FOR-SALE EQUITY INSTRUMENT THAT IS A HEDGED ITEM IN FAIR
VALUE HEDGE

7I.6.530.60 At 1 January 2020, Company U purchased a foreign currency

available-for-sale equity instrument for 100 in U’s functional currency. The foreign
currency risk is hedged in a fair value hedge using a derivative instrument. At 31
December 2020, the fair value of the equity instrument was 200. The entire increase
in the fair value of the equity instrument of 100 was a result of the change in the
exchange rate. There were no changes to the instrument’s quoted market price in
the foreign currency. The fair value of the hedging instrument was a liability of 100.
Therefore, U recognised a gain of 100 for the equity instrument, and an offsetting
loss of 100 for the derivative, both in profit or loss.
 7I.6.530.70 At 31 December 2021, the fair value of the equity instrument is 120.
The entire decrease in the fair value of the equity instrument of 80 is a result of a
decline in the instrument’s quoted market price in the foreign currency by 40%.
There are no changes in the exchange rate during 2021 and there is no change in
the fair value of the hedging instrument at 31 December 2021.

7I.6.530.80 In our view, for assessing and measuring impairment at 31 December

2021, U should compare the acquisition cost adjusted for the effect of the fair value
hedge (i.e. 200) with the current fair value of 120. Therefore, U recognises an
impairment loss of 80 at 31 December 2021, as a result of the significant decline in
the fair value of the investment below its cost.

7I.6.540 Collateral

7I.6.540.10 If the entity holds collateral for a financial asset, and the collateral does not qualify
for recognition as a separate asset under other standards, then the collateral is not recognised as an
asset separate from the impaired financial asset before foreclosure because this would result in
double counting. [IAS 39.AG84, IG.E.4.8]

7I.6.540.20 In our view, the accounting treatment of collateral after foreclosure is dependent on
the legal environment in which the entity operates and the terms on which the collateral is provided.
For example, in the case of a mortgage loan collateralised by a property, two distinct sets of
circumstances could apply.
• The bank (lender) could repossess the property as a result of the borrower’s default with the
intention of recovering the amounts owing on the understanding that: any amounts received in
excess of the mortgage balance will be refunded to the borrower; and any shortfall remains the
obligation of the borrower. The bank may continue to charge interest on the outstanding balance.
The bank remains exposed to interest rate risk on the mortgage and is not exposed directly to
property price risk. We believe that repossession is used only to reinforce the bank’s contractual
right to cash flows from the loan and consequently the bank should continue to recognise the loan
and should not recognise the property.
• The bank could repossess the property, which in terms of the contract comprises the full and final
settlement of the mortgage – i.e. the bank retains any excess proceeds over the outstanding
balance on the mortgage and the borrower is released from its obligation in the event of a
shortfall. Therefore, the bank is directly exposed to property price risk rather than to interest rate
risk on the loan and we believe that the bank should derecognise the loan and recognise the
property.

7I.6.540.30 If a financial asset carried at amortised cost is secured by collateral that is not
accounted for separately from that financial asset, then in calculating the impairment loss for that
financial asset an entity could choose to use either of the following approaches, whether or not
foreclosure is probable.
• Approach 1: Use the fair value of the collateral at the reporting date less costs for obtaining and
selling the collateral.
• Approach 2: Use the cash flows that may result from foreclosure less the costs for obtaining and
selling the collateral. [IAS 39.AG84, IG.E.4.8]

7I.6.540.40 Under Approach 1 in 7I.6.540.30, in determining the cash flows from the collateral an
entity uses the current fair value of the collateral at the reporting date, assuming that this current
fair value will be realised in the future, and then discounts this current fair value back from the
expected future date of realisation to the reporting date using the financial asset’s original effective
interest rate (see 7I.6.480.10). Under Approach 2 in 7I.6.540.30, in determining the cash flows from
the collateral an entity estimates the fair value of the collateral at the expected future date of
realisation of the collateral and then discounts this value back to the reporting date using the
financial asset’s original effective interest rate (see 7I.6.480.10).
7I.6.540.41 Applying either Approach 1 or Approach 2 in measuring impairment is conditional on
the entity having the legal ability to enforce the collateral and obtain the proceeds of its realisation in
the event of the debtor’s default. Also, the entity needs to consider the nature and length of any
enforcement procedures required under applicable laws and regulations in determining the
expected future date of realisation.

7I.6.540.43 In some cases, observable quoted forward prices for collateral may exist, especially
for financial collateral. However, forward prices for financial collateral would generally reflect a
premium or discount to the current market price – i.e. a spot price – with the premium or discount
reflecting benchmark interest rates that would often be below the asset’s original effective interest
rate. Therefore, for the purpose of estimating the cash flows from the collateral – i.e. Approach 2 in
7I.6.540.30 – such prices that do not include a risk premium would not support inflation of estimated
future values based on a projected rate of return for the collateral that includes a risk premium.

7I.6.540.45 In our experience, lenders often realise collateral at a discount to appraised values
and expected discounts on the realisation of collateral are reflected in the measurement of
impairment.

EXAMPLE 16 – IMPAIRMENT LOSS – USE OF CURRENT FAIR VALUE OF COLLATERAL

7I.6.540.50 Bank V issued a mortgage loan of 1,000, which is collateralised by the

financed residential property. At the reporting date, V identified objective evidence
of impairment and estimated that the only cash flows to be received will arise from
the foreclosure of the collateral. The current fair value of the collateral is estimated
at 1,000. It will take V two years to foreclose the collateral and during this period no
other cash flows are expected.

7I.6.540.55 In our view, if V elects to use the current fair value of the collateral in
determining cash flows from the collateral for computing the impairment loss, then
V should discount the current fair value of the collateral (i.e. 1,000) from the
expected future date of realisation back to the reporting date using the loan’s
original effective interest rate (see 7I.6.480.10). The impairment loss recognised
would be the difference between the loan’s carrying amount and the net present
value of the estimated future cash flows.

7I.6.540.60 When measuring an impairment loss incurred on a financial asset denominated in the
entity’s functional currency but collateralised by an asset denominated in a foreign currency, in our
view the estimated foreign currency future cash flows resulting from the foreclosure of the collateral
should be translated into the functional currency of the reporting entity using the appropriate
forward rates and then discounted together with the estimated cash flows in the functional currency,
if there are any, using the instrument’s original effective interest rate (see 7I.6.480.10).

7I.6.540.70 When an entity is calculating the impairment loss for a collateralised financial asset,
in our view a gain should not be recognised, even if the collateral is expected to have a higher value
than the carrying amount of the loan.

7I.6.540.80 On the date of foreclosure, in our view any collateral received should be initially
measured based on the carrying amount of the defaulted loan. Thereafter, it should be accounted for
under the relevant standard and classified as held-for-sale if appropriate (see 5.4.20).

7I.6.550 Measuring impairment of financial assets denominated in foreign

currency

7I.6.550.10 For monetary financial assets denominated in a foreign currency, there is no specific
guidance on how to measure impairment losses. In our view, the present value of estimated future
cash flows or fair value of the asset should be first determined in the foreign currency. This amount
should be translated into the functional currency using the exchange rate at the date on which the
impairment is recognised. The difference between the translated amount and the carrying amount in
the functional currency should be recognised in profit or loss. In certain circumstances, this may
lead to an impairment loss determined in the foreign currency and a foreign exchange gain on
translation of the carrying amount of the financial asset into the functional currency.

7I.6.550.20 Foreign exchange gains and losses on an impaired monetary financial asset
measured at amortised cost continue to be recognised in profit or loss. If, through a subsequent
improvement in circumstances, an entity is able to reverse the impairment loss, in part or entirely,
then in our view the reversal should be recognised at the spot exchange rate at the date on which the
reversal is recognised. [IAS 39.65]

7I.6.550.30 For non-monetary financial assets classified as available-for-sale, the amount of loss
to be removed from equity and included in profit or loss is the cumulative net difference between the
asset’s acquisition cost and current fair value in the functional currency. This will include all foreign
currency changes on the asset that had been recognised in OCI, but not foreign currency changes
that had been recognised in profit or loss as a result of applying fair value hedge accounting (see
7I.6.530.50). [IAS 21.23, 39.68, IG.E.4.9]

7I.6.550.40 In our view, an entity may record any subsequent reversal of impairment of a debt
instrument classified as available-for-sale at the spot rate in effect on the date on which the reversal
is recognised. Any subsequent reversal is limited to the amount of loss, denominated in foreign
currency, previously recognised. In our view, until the previously recognised loss denominated in
foreign currency is fully reversed, the related exchange differences should be recognised in profit or
loss. As a minimum, the accounting treatment applied should be disclosed along with the nature and
the amount of any impairment loss or reversal. [IAS 39.70]

7I.6.550.50 Generally, changes in foreign exchange rates would not trigger impairment for an
investment in a debt instrument. However, there may be situations in which the fair value of an asset
in its currency of denomination is affected by exchange rates. This may happen if there is a sudden
and severe devaluation of a foreign currency. The devaluation of the currency may influence the
credit risk and country risk associated with entities operating in that environment. In our view, an
entity that has foreign currency loans or receivables or that holds debt securities denominated in a
foreign currency that becomes devalued should consider whether the decline should be treated as an
impairment loss rather than as a normal foreign exchange translation loss.

7I.6.560 Impairment examples

EXAMPLE 17A – IMPAIRMENT LOSS CALCULATION – LOANS AND RECEIVABLES

7I.6.560.10 Bank W granted a loan (classified as loans and receivables) on 31

December 2018 to Company X. The interest rate on the loan was 10% and the loan
was issued at 98% of its face value. The maturity date is 31 December 2023. The
effective interest rate at the date of origination was 10.53%.

7I.6.560.20 At 31 December 2021, it becomes clear that X is experiencing severe

financial difficulties and W determines that this represents objective evidence that the
loan is impaired. At that date, the carrying amount of the loan at amortised cost is
4,954.

7I.6.560.30 W expects that it will receive the contractual interest payment of 10%
due at 31 December 2022. However, on maturity of the loan, W expects to recover only
2,500 of the 5,000 principal due and does not expect to receive the interest payment
due at 31 December 2023.
 7I.6.560.40 The impairment loss is measured as the difference between the carrying
amount of the loan and the present value of the estimated future cash flows on the
loan, using as a discount rate the original effective interest rate of 10.53%. Given that
only 2,500 of the principal and the 31 December 2022 interest payment are expected
to be received, the present value at 31 December 2021 using the original effective
interest rate is 2,499. In this example, accrued interest is paid at 31 December 2020
and therefore is not included in the calculation. The discounted remaining cash flows
are calculated as follows.

7I.6.560.50 An impairment loss of 2,455 (4,954 - 2,499) is recognised in profit or

loss at 31 December 2021. W reassesses the impairment loss at each reporting date.

EXAMPLE 17B – IMPAIRMENT LOSS CALCULATION – AVAILABLE-FOR-SALE FINANCIAL ASSETS

7I.6.560.60 If the loan in Example 17A had been classified as available-for-sale, then
the amount of the impairment loss would be measured as the difference between the
acquisition cost of the loan, net of principal repayments and amortisation, and the
current fair value of the loan.

7I.6.560.70 Bank W calculates the fair value of the loan by obtaining the current
market interest rate for loans similar to the loan under consideration and uses this to
discount the estimated future cash flows of the loan. Assume that an effective interest
rate of 12.5% would apply for loans to entities with similar credit risk profiles to
Company X’s and that have terms and structures similar to X’s loan. W uses this rate
to determine the fair value of the loan as follows.

7I.6.560.80 The calculated fair value of 2,420 results in an impairment loss of 2,534
(4,954 - 2,420). This is the amount that is reclassified from equity to profit or loss. It is
adjusted for any amount previously reclassified from equity to profit or loss.

EXAMPLE 17C – IMPAIRMENT LOSS CALCULATION – AVAILABLE-FOR-SALE FINANCIAL ASSETS COLLATERALISED BY

LIQUID SECURITIES
 7I.6.560.90 Assume the same information as in Examples 17A and 17B, except
that the loan (classified as available-for-sale) is collateralised by liquid securities.
Bank W expects that it will be able to recover the amount owed on the loan only by
taking legal possession of the securities.

7I.6.560.100 The fair value of the loan would not exceed the fair value of the
securities less any costs expected to obtain and sell the securities (see 7I.6.540.30).
The cumulative loss to be reclassified from equity to profit or loss is calculated as
the difference between the loan’s acquisition cost, net of principal repayments and
amortisation, and the fair value calculated with reference to the collateral. However,
the collateral itself is not recognised in W’s statement of financial position until the
securities meet the recognition criteria for financial assets.

7I.6.570 Collective impairment assessment

7I.6.580 Determining whether individual or collective assessment is

appropriate

7I.6.580.10 For financial assets that are individually significant, the assessment is performed on
an individual basis. For financial assets that are not individually significant, the assessment can be
performed on an individual or collective (portfolio) basis. If an asset is assessed individually for
impairment and found to be impaired, then it is not included in a collective assessment for
impairment. [IAS 39.64, AG88, IG.E.4.7]

7I.6.580.20 IAS 39 does not provide specific guidance on determining whether a loan is
individually significant. Instead, the standard indicates that the assessment of significance differs
from one entity to another such that identical exposures will be evaluated on different bases,
individually or collectively, depending on their significance to the entity holding them. In our view, an
entity may use its normal loan review policies and procedures in determining what is considered a
significant exposure. [IAS 39.BC114]

7I.6.580.30 A collective evaluation of impairment is performed for:

• assets that have not been assessed individually for impairment; and
• assets that are tested individually but for which no impairment is identified. [IAS 39.64]
7I.6.580.40 In our view, a collective evaluation of impairment for available-for-sale financial
assets is not required.

7I.6.580.50 Impairment losses recognised on a collective basis represent an interim step pending
the identification of impairment losses on individual assets in the group of financial assets that are
collectively assessed for impairment. As soon as information is available that specifically identifies
losses on individually impaired assets in a group, those assets are no longer included in the collective
evaluation for impairment. [IAS 39.AG88]

7I.6.580.60 In the case of assets tested individually but not impaired, an entity might conclude
that no collective provision is required, either because no portfolio of similar items can be identified
(see 7I.6.580.80) or because all possible risks have been considered in the individual impairment
tests.

7I.6.580.70 Loss probabilities and other loss statistics differ at a group level between assets that
have been evaluated individually for impairment and found not to be impaired and assets that have
not been assessed individually for impairment, with the result that a different amount of impairment
loss may be required. [IAS 39.64, AG87]

7I.6.580.75 Therefore, in our view financial assets that have been assessed individually for
impairment and found not to be impaired should generally be treated as one or more separate
portfolios for the purposes of the collective assessment of impairment, based on the principle that
financial assets should be grouped into homogeneous portfolios – i.e. based on similar credit risk
characteristics. For example, if the underlying reason for not recording an impairment loss is
sufficient collateral for some of those financial assets, and a change in the expected cash flow
structure for the other financial assets, then those financial assets are not normally homogeneous
because they do not share the same credit risk characteristics and therefore they should be treated
as two separate portfolios. [IAS 39.64, AG87, IG.E.4.7]

7I.6.580.80 Assets are grouped for collective assessment for impairment only if they share
similar credit risk characteristics. This may be identified based on:
• credit risk grades;
• types of loan;
• geographic location of the borrower;
• type of collateral;
• type of counterparty;
• aging profile; and
• maturity. [IAS 39.AG87]
7I.6.580.85 Loans that have been in arrears and returned to current status may have different
risk characteristics – e.g. higher probability of subsequent default – than loans that have never been
in arrears. This needs to be considered in the determination of collective impairment.

7I.6.580.90 In our view, a portfolio approach to impairment is not appropriate for individual
equity instruments because equity instruments of different issuers do not have similar risk
characteristics and therefore their equity price risk differs.

7I.6.590 Impairment of reclassified assets

7I.6.590.10 An entity may reclassify a financial asset from the available-for-sale category to loans
and receivables (see 7I.4.250). If such a financial asset is subsequently impaired, then the gain or
loss that was previously recognised in OCI is reclassified to profit or loss (see 7I.4.250.20). In our
view, this requires the entity to assess whether each individual reclassified financial asset is impaired
at each reporting date following reclassification. [IU 07-10]

7I.6.590.20 If an individual assessment does not result in the identification of impairment, then
the entity includes that reclassified asset in a collective assessment of impairment if it is appropriate
to do so (see 7I.6.580.60–70). If the entity identifies impairment on a collective basis, then in our
view it is not necessary for the entity to reclassify from equity to profit or loss the full amount of loss
recognised in OCI for the asset before reclassification.

7I.6.600 Recognition of impairment losses incurred but not reported

7I.6.600.10 IAS 39 requires the recognition of impairment for losses that have been ‘incurred but
not reported’. The objective of the collective assessment for impairment is to identify losses that
have been incurred, but not yet identified, on an individual basis. [IAS 39.AG89–AG90]

7I.6.600.20 Of particular relevance to a collective assessment of impairment is the example of

deaths of cardholders in a credit card portfolio, which is identified as the major cause of defaults.
This example assumes that although the death rate may not change from year to year, it is
reasonable to assume that some deaths have occurred and therefore that the portfolio contains
assets that are impaired even if the impaired loans have not been identified individually. It is clear
from IAS 39 that an unchanged death rate represents observable data supporting the estimate that
one or more borrowers have died and that, based on experience, this will result in the loss of one or
more cash flows. Because observable data includes unchanged data, there will normally be
observable data that, through the passage of time, can be used to support estimates based on
historical loss experience. [IAS 39.AG90]

7I.6.600.30 For a portfolio of loans, it may be more appropriate to refer to ‘risk conditions’ being
in place as indicators of impairment, rather than ‘impairment triggers’, because triggers may not be
specifically or individually identified or captured. Risk conditions represent a set of market and
economic events or variables that are associated, based on historical evidence, with the impairment
of financial assets.

7I.6.600.40 In our view, considering risk conditions rather than impairment triggers is consistent
with the requirements in IAS 39 as long as each risk condition is associated with a combination of
observable data that is relevant to losses in that portfolio and that has been observed in practice. In
our view, it is not necessary to establish statistical cause-and-effect relationships between a change
in a risk condition and an estimate of incurred losses. However, we believe that the number of risk
conditions identified should be enough to make it possible to find a set of historical data that closely
approximates the actual data that is observed at the reporting date. Over time, an entity should
develop its database of observed risk conditions to improve and update its ability to match risk
conditions with an estimate of incurred losses. [IAS 39.AG89]

7I.6.600.50 Future cash flows are estimated on the basis of historical loss experience for assets
with similar credit risk characteristics. Not having its own specific historical data is not a sufficient
rationale for an entity not to perform the collective impairment assessment. Relevant and reliable
information available in the market should be obtained to perform the assessment. Entities that have
no or insufficient entity-specific loss experience should use peer group experience for comparable
groups of financial assets. Therefore, the historical data used, whether internal or external, should
be consistent with the characteristics of the group of financial assets being tested. [IAS 39.AG89, AG91]

7I.6.600.60 We believe that the historical data used in the analysis should support the assessment
of losses incurred but not reported and should:
• reflect the relationship between a change in the factor and impairment loss. These may be social
drivers or economic factors; and
• be updated to reflect current economic conditions resulting in impairment losses recognised
being directionally consistent with changes in related observable data from period to period.

7I.6.600.70 In our view, the practical implementation of the requirement to recognise impairment
losses incurred but not reported on loans and receivables can be based on the analysis of historical
loss data, together with the analysis of the underlying factors causing loss, and the emergence
periods.

7I.6.610 Emergence period

7I.6.610.10 One of the possible methodologies for quantifying the collective allowance, or
component thereof, is the ‘emergence period’ approach. This approach recognises that there will be
a period between the occurrence of a specific impairment event and objective evidence of
impairment becoming apparent on an individual basis. In other words, it is the time that it takes an
entity to identify that the loss event actually happened or a time period that lapses between the date
on which the loss event happened and the date on which an entity identified that it had happened.
This period is referred to as the ‘emergence period’.

7I.6.610.20 In our view, an emergence period should be established individually for each entity,
each portfolio and/or possibly for each risk condition or combination thereof. Emergence periods
may vary across entities and portfolios and according to the risk conditions.

7I.6.610.30 As a result, entities can use historical loss experience as an indicator of impairment
provided that it can be linked to the factors (risk conditions) causing impairment loss – e.g. interest
rates, unemployment rates, gross domestic product growth rate etc. Consequently, we believe that
entities should recognise an impairment loss subsequent to the loan origination date if historical loss
experience indicates that X percent of loans have become impaired as a result of the risk conditions
in place and it takes an entity Y months (the emergence period) to identify which individual
exposures became impaired. In our view, the emergence period should generally be relatively short,
but this will depend on the entity’s credit risk management policies and procedures, the nature of
the portfolio being considered – e.g. consumer or commercial loans, credit card balances or
mortgage loans – and the relevant risk conditions. We believe that it is unlikely that an emergence
period will exceed 12 months.

7I.6.610.40 In the retail business, the emergence period might be the time period between the
occurrence of a loss event and the default date (breach of contract), because the actual default of
customers may be the only or most reliable way to identify a loss event.

7I.6.610.50 In our view, entities should justify and support their assessment of the emergence
periods by back-testing them. However, this back-testing does not need to identify an exact time
period elapsing between a loss event happening and a loss event being identified because this would
require individual (specific) identification of loss events, which is impracticable in many
circumstances. Instead, back-testing should test the reasonableness of the estimate made by
management based on the identified loss factors. This should be reassessed when there is evidence
that the loss events or customer behaviour or the entity’s processes have changed. In our view,
emergence periods should remain relatively stable, subject to the changes mentioned above, and any
changes should be justified and disclosed.

7I.6.620 Measuring collective impairment

7I.6.620.10 The estimated future cash flows determined for assets carried at amortised cost
assessed for impairment on a collective basis are discounted at a rate that approximates the original
effective interest rate (see 7I.6.480.10). For portfolios of similar assets, these assets will have a
range of interest rates and therefore judgement is necessary to determine a discounting
methodology appropriate to that portfolio, which may result in using the average effective yield if it
is a homogeneous portfolio. [IAS 39.63, AG92]

7I.6.620.20 The methodology used may include a ‘risk migration’ approach. Entities may use
their historical risk migration data together with observable market data to support their assessment
of losses incurred but not reported. However, a downgrade of an entity’s credit rating is not in itself
evidence of impairment, although it may be evidence of impairment when it is considered with other
available information. Therefore, if a risk migration methodology is used, then in our view it should
distinguish between migration data that evidences incurred losses and data that evidences expected
future losses. [IAS 39.60]

7I.6.620.30 Although impairment losses can be determined using a portfolio methodology for
groups of similar assets, this does not mean that an entity is allowed to take an immediate write-
down on recognising a new financial asset. [IAS 39.59, AG92, IG.E.4.2]

7I.6.630 Bad debts and loan losses

7I.6.630.10 The following practices related to bad debt losses are not acceptable under the
Standards.
• Recognising a provision for losses based on a set percentage of receivable balances having
certain characteristics – e.g. according to the number of days overdue – rather than actual
incurred losses, unless these percentages are validated using historical data.
• Recognising a loss for the gross expected shortfall on non-performing assets and suspending
interest accruals. This is sometimes referred to as putting a loan on ‘non-accrual status’.
• Recognising an impairment loss in excess of incurred losses calculated based on estimated cash
flows, even if local regulations require a specific amount to be set aside (‘general risk provisions’).
In our view, if an entity wishes to identify reserves in addition to the impairment losses calculated
under the Standards, then it may do so by transferring amounts from retained earnings to a
separate category of equity – e.g. a loan loss reserve (see 7I.3.480.20). It is not acceptable to
 recognise any amounts in profit or loss or to reduce the carrying amount of the assets by more
than the estimated actual loss. [IAS 39.63, AG90–AG93, IG.E.4.2, IG.E.4.5–IG.E.4.6]

7I.6.640 Reversals of impairment losses

7I.6.650 Loans and receivables and held-to-maturity investments

7I.6.650.10 If in a subsequent period the amount of any impairment loss of a loan or receivable or
held-to-maturity investment decreases because of an event happening subsequent to the write-down,
then the previously recognised impairment loss is reversed through profit or loss, with a
corresponding increase in the carrying amount of the underlying asset. The reversal is limited to an
amount that does not state the asset at more than what its amortised cost would have been in the
absence of impairment. [IAS 39.65]

7I.6.660 Available-for-sale financial assets

7I.6.660.10 Impairment losses on an available-for-sale equity instrument may not be reversed
through profit or loss. Any increase in the fair value of such an instrument after an impairment loss
has been recognised is treated as a revaluation and is recognised in OCI. [IAS 39.69]

7I.6.660.20 If, in a subsequent period, the fair value of an available-for-sale debt instrument
increases and the increase can be objectively related to an event happening after the impairment
loss was recognised, then the impairment loss is reversed, with the amount of the reversal
recognised in profit or loss. IAS 39 does not further describe the nature of an ‘event’ that gives rise
to reversal of an impairment loss through profit or loss, nor does it discuss situations in which there
continues to be some objective evidence of impairment but in which the amount of the impairment
may be reduced. This raises two questions: what types of events trigger reversal; and how to
measure the amount of any reversal? [IAS 39.70]

7I.6.660.30 In our view, entities should choose an accounting policy, to be applied consistently,
with regard to the nature of an event that would trigger reversal, as follows.
• An entity may limit reversals to reversals of credit events that gave rise to the impairment and
that have a positive impact on the estimated future cash flows of the asset (Option 1).
• An entity may interpret reversal events as also including subsequent improvements in the credit
standing of the issuer that do not affect the estimate of expected future cash flows from the asset,
and then should specify criteria for identifying such events (Option 2).
• Alternatively, an entity may interpret reversal events also to include any event that reverses an
amount that was included in the measurement of the original impairment (see 7I.6.470.10). For
example, to the extent that the original impairment loss included a decline in the fair value of the
asset related to an increase in benchmark interest rates, a subsequent increase in the fair value
related to a subsequent decline in benchmark interest rates would represent a reversal event
(Option 3).

7I.6.660.40 In developing their accounting policies, entities should also consider how to measure
the amount of the impairment loss that is reversed through profit or loss when there is an increase in
fair value and a reversal event has been identified.
• In our view, if there is no longer objective evidence that the asset is impaired at the reporting
date, then, depending on its accounting policy under 7I.6.660.30, the entity should reverse
through profit or loss either (1) the full original impairment loss previously recognised in profit or
loss; or (2) the lesser of the full original impairment loss previously recognised in profit or loss
and the subsequent increase in fair value.
• In our view, if there continues to be objective evidence of impairment at the reporting date but the
amount of the original impairment loss was reduced, then the cumulative loss that continues to be
recognised in profit or loss should not be less than any excess of the original cost over the current
fair value of the asset. When Option 3 as described in 7I.6.660.30 is applied and there is no
improvement in the credit standing of the issuer, the amount of reversal is limited to the portion of
 the original impairment loss that actually has been reversed as a result of a subsequent decrease
in benchmark interest rates (or another relevant factor).
• In our view, for the purpose of measuring the amount of impairment loss to be reversed, the
original impairment loss as well as the subsequent increase in fair value should be reduced for
any increase in the amortised cost of the debt instrument arising from interest accretion
recognised in profit or loss subsequent to recognition of original impairment.

7I.6.660.50 The scenarios in the following example illustrate the application of these principles.

EXAMPLE 18 – IMPAIRMENT LOSS REVERSAL – AVAILABLE-FOR-SALE DEBT INSTRUMENTS

Scenario 1: Reversal when there is no longer any objective evidence of

impairment

7I.6.660.60 Company Y buys an available-for-sale debt instrument for 100. The

fair value of the instrument decreases to 70 and an impairment loss of 30 is
recognised in profit or loss. Subsequently, the fair value of the instrument increases
to 95, the amortised cost is 74 and Y determines that there is no longer any objective
evidence of impairment.

7I.6.660.70 Depending on its chosen accounting policy, Y would either:

• recognise in profit or loss the reversal of 26, comprising the full amount of the
original impairment loss of 30 less the subsequent increase of 4 in the amortised
cost of the instrument, and record the current cumulative loss (the amount by
which fair value is below original cost) of 5 in OCI; or
• recognise in profit or loss only 21 as a reversal of original impairment, being the
subsequent increase in fair value of 25 less the subsequent increase of 4 in the
amortised cost of the instrument.

Scenario 2: Reversal when there is a change in the liquidity/risk premium

but no change in the estimated cash flows

7I.6.660.80 Company Z buys an available-for-sale debt instrument for 100. The

fair value of the instrument decreases to 70 and an impairment loss of 30 is
recognised in profit or loss. Z determines that this loss comprises the effect of a
credit-related decrease in estimated future cash flows of 20 and the effect of an
increase in the liquidity/risk premium of 10. Subsequently, the fair value of the
instrument increases to 75 and the amortised cost to 72; there is no change in the
estimated future cash flows and Z determines that the entire subsequent net
increase in the fair value of 3, net of interest accretion of 2 recognised in profit or
loss, relates to a subsequent reduction in the liquidity/risk premium.

7I.6.660.90 Under Option 1 as described in 7I.6.660.30, Z would recognise the

subsequent net increase in fair value of 3 in OCI because there is no credit-related
increase in expected future cash flows. Under Option 3, Z would recognise the net
increase in fair value of 3 in profit or loss because there was a partial reversal of the
increase in liquidity/risk premium that was included in the measurement of the
original impairment loss. Under Option 2, the answer would depend on Company Z’s
policy for identifying improvements in the credit standing of the issuer.

Scenario 3: Reversal when there is only a change in the risk-free interest rate

7I.6.660.100 Company B buys an available-for-sale debt instrument for 100. The

fair value of the instrument decreases to 70 and an impairment loss of 30 is
 recognised in profit or loss. B determines that this loss comprises the effect of a
credit-related decrease in future cash flows of 20 and the effect of an increase in the
risk-free interest rate of 10. Subsequently, the fair value of the instrument increases
to 85; there is no change in the estimated future cash flows and B determines that
the entire subsequent increase in the fair value of 15 relates to a reduction in the
risk-free interest rate. Assume that there is no interest accretion in the intervening
period.

7I.6.660.110 Under Options 1 and 2 as described in 7I.6.660.30, B would record

the subsequent increase in fair value in OCI because there is no credit-related
increase in future cash flows and no other improvement in the credit standing of the
issuer.

7I.6.660.120 Under Option 3, B would record 10 of the increase in fair value in

profit or loss because there was a reversal of the increase in the risk-free interest
rate that was one of the events that was incorporated in the original impairment
loss. B would not record the entire fair value increase of 15 related to the reduction
in the risk-free rate in profit or loss because the amount of reversal is limited to the
portion of the original impairment loss that actually has been reversed as a result of
the subsequent decrease in the risk-free rate.

7I.6.660.130 In our view, the accounting policy choices adopted for reversals of impairments do
not necessitate the selection of particular accounting policies for subsequent impairments or vice
versa. However, IAS 8 requires management to use its judgement in developing accounting policies
that result in information that is, inter alia, neutral and prudent. Accordingly, entities should
consider whether selection of policies that would lead to both (1) subsequent declines (losses) in the
fair value of an impaired debt instrument arising from changes in interest rates and risk premiums
being recognised in OCI; and (2) subsequent increases (gains) arising from the same cause, without
any improvement in expected cash recoveries, being recognised in profit or loss would be consistent
with these criteria.

7I.6.670 Assets carried at cost because fair value not reliably measurable

7I.6.670.10 For an investment in unquoted equity instruments and a derivative asset that is
linked to and must be settled by delivery of such an instrument, both of which are carried at cost
because their fair value cannot be measured reliably, impairment losses may not be reversed. [IAS
39.66]

7I.6.680 Interim financial statements

7I.6.680.10 Under the Standards, an entity is prohibited from reversing an impairment loss,
recognised in a previous interim period, for an available-for-sale equity instrument or a financial
instrument carried at cost (not amortised cost). [IFRIC 10.8]

7I.6.690 DIVIDEND INCOME

7I.6.700 Recognition of dividend income

7I.6.700.10 IAS 39 defines dividends as distributions of profits to holders of equity investments in

proportion to their holdings of a particular class of capital. Dividend income is recognised in profit or
loss only when:
• the entity’s right to receive payment is established;
• it is probable that the economic benefits associated with the dividend will flow to the entity; and
• the amount of the dividend can be measured reliably (see also 7I.3.540). [IAS 39.9, 55A]
7I.6.700.20 In our view, the shareholder’s right to receive payment of dividends on quoted
investments is normally established on the date on which the security trades ex-dividend. At this
date, the fair value of the security decreases by approximately the dividend amount. Therefore,
recognising a dividend on the ex-dividend date avoids double counting, which would happen if the
dividend were included both as income and in the measurement of the fair value of the investment.
The ‘ex-dividend date’ is the first date on which a sale of the instrument would not settle before the
record date. The ‘record date’ is the date on which shareholders have to be included in the register
of shareholders to receive the dividend. Calculation of the ex-dividend date will depend on local
trading and settlement practices.

7I.6.700.30 In our view, for dividends on unquoted investments, a shareholder’s right to receive
payment is normally established when the shareholders have approved the dividends. However, if
the relevant law provides that a board decision or announcement requires no further approval and is
binding on the declaring entity, then the dividend would be recognised on a board decision or
announcement (see 7I.3.540.20–30). When determining the fair value of such investments, care
should be taken to avoid double counting dividends both as receivables and as part of the fair value
estimate.

EXAMPLE 19 – DIVIDEND INCOME – TIMING OF RECOGNITION

7I.6.700.40 Company C’s directors declare a dividend on 10 March. The dividend

is approved by shareholders on 25 March and will be paid to shareholders of record
– i.e. in the shareholders’ register – on 31 March.

7I.6.700.50 If C’s shares are listed in a market that has three-day settlement, then
the shares would trade ex-dividend from 28 March (assuming that all are business
days). Therefore, we believe that dividend income should be recognised on 28
March. If C’s shares are not listed and the right to receive dividends is established
when the shareholders have approved it, then we believe that the dividends should
be recognised when they are approved – i.e. on 25 March. Thereafter, the dividends
should be excluded when estimating the fair value of the shares.

7I.6.710 Dividends from subsidiaries, associates and joint ventures

7I.6.710.10 An entity recognises a dividend from a subsidiary, an associate or a joint venture in

profit or loss in its separate financial statements when its right to receive the dividend is established.
[IAS 27.12]

7I.6.710.20 A subsidiary, associate or joint venture may make distributions to its shareholders in
excess of its retained profits. A distribution that does not represent a distribution of profits would not
meet the definition of dividends in IAS 39. However, in our view, even if the investment is accounted
for as available-for-sale under IAS 39, an entity may choose an accounting policy, to be applied
consistently, to recognise such distributions as dividend income in profit or loss (see 3.7.10.70) in its
separate financial statements.

7I.6.710.30 The receipt of such a distribution may be an indicator of impairment of the

investment in the subsidiary, associate or joint venture (see 3.10.600.30).

7I.6.720 Share dividends

7I.6.720.10 In some cases, shareholders may receive or choose to receive dividends in the form of
additional shares rather than cash. These may be referred to as ‘scrip’, ‘stock’ or ‘share dividends’.
In our view, the accounting treatment of share dividends depends on whether the investor has a cash
alternative – i.e. a right to demand a cash payment representing the fair value of the shares.

7I.6.720.20 In our view, the substance of share dividends with a cash alternative is the payment
of a cash dividend, with reinvestment of the cash in additional shares. Therefore, we believe that
dividend income should be recognised for the amount of the cash dividend alternative. The
corresponding debit should be treated as an additional investment.

7I.6.720.30 In other cases, an entity may receive bonus shares or other equity instruments on a
pro rata basis with other ordinary shareholders with no cash alternative. Share investments are
generally categorised as available-for-sale financial assets or as at FVTPL and measured at fair value
(see 7I.4.10). If all ordinary shareholders receive bonus shares or other equity instruments in
proportion to their shareholdings, then the fair value of each shareholder’s interest should be
unaffected by the bonus issue. In our view, in such circumstances, dividends should not be
recognised as revenue because it is not probable that there is an economic benefit associated with
the transaction that will flow to the investor. [IAS 39.55A, IU 01-10]

7I.6.720.40 If only certain shareholders are granted additional shares, then the fair value of the
interests of those shareholders will increase. In this case, in our view it is most appropriate to
measure the shares received at their fair value and recognise a corresponding amount of finance
income.

7I.6.730 FEE INCOME

7I.6.730.10 The recognition of revenue for fees depends on the nature of the fees and the basis of
accounting for any associated financial instrument. Fees that are an integral part of the effective
interest rate of a financial instrument and fees on an instrument measured at FVTPL are in the scope
of IAS 39. Other fees are in the scope of the revenue recognition requirements of IFRS 15 (see
4.2.10). [IFRS 15.5, C9, BC28]

7I.6.730.20 In most instances fees earned in relation to the recognition of a financial asset result
in an adjustment of the effective interest rate. Examples of such fees include:
• origination or commitment fees – when it is probable that an entity will enter into a specific
lending agreement;
• compensation from the borrower for transaction costs (see 7I.6.30) incurred by the lender; and
• appraisal fees for evaluating collateral – e.g. for mortgage loans. [IAS 39.AG8B]
7I.6.730.30 However, if the financial instrument is measured at FVTPL, then the fees are
recognised as revenue on initial recognition of the instrument. [IAS 39.AG8A]

7I.6.730.40 Examples of financial service fees that are not an integral part of the effective yield of
an associated financial instrument and are therefore recognised in accordance with IFRS 15 include:
• fees charged for servicing a loan;
• commitment fees to originate loans when it is unlikely that a specific lending arrangement will be
entered into and the loan commitment is not measured at FVTPL;
• loan syndication fees received by an entity that arranges a loan and retains no part of the loan
package for itself (or retains a part at the same effective interest rate for comparable risk as other
participants);
• a commission earned on the allotment of shares to a client;
• placement fees for arranging a loan; and
• investment management fees. [IAS 39.AG8C]
7I.6.730.50 A contract with a customer that results in a recognised financial instrument in an
entity’s financial statements may be partially in the scope of IAS 39 and partially in the scope of IFRS
15. If this is the case, then the entity first applies IAS 39 to separate and measure the part of the
contract that is in the scope of IAS 39 and then applies IFRS 15 to the residual. [IFRS 15.7, C9]

7I.6.730.60 In some cases, it may be difficult to determine whether an amount charged to a

customer at inception of a loan represents a fee for structuring the loan or part of the transaction
price for the financial asset – i.e. whether it is in the scope of IAS 39 or IFRS 15.
7I.6.730.70 For example, a bank may structure a transaction, using its expertise and experience
(‘intellectual capital’) for a particular customer and facilitate the initial steps required – e.g.
consultations with experts, valuations, registration and drafting legal documentation. The customer
is charged a fee up-front for the structuring service.

7I.6.730.80 An entity first applies IAS 39 to the transaction. If the fee is regarded as part of the
transaction price for the loan, then the transaction price, net of the fee, would normally represent
the best evidence of the fair value of the loan on initial recognition and IAS 39 would preclude
recognition of revenue unless the entity determines that:
• the fair value of the loan on initial recognition differs from the transaction price; and
• the fair value is determined applying a valuation technique that uses only data from observable
markets (see 7I.6.26). [IAS 39.AG76]

7I.6.730.90 In our view, an entity should recognise all or part of a structuring fee as revenue
under IFRS 15 only if the fair value of the loan is determined using data from observable markets and
if it can be demonstrated that the amount of revenue recognised is consistent with the effort and
expertise provided for the structuring service – i.e. that it approximates fair value for the service
provided.

EXAMPLE 20 – STRUCTURING FEE

7I.6.730.100 Bank B advances 50,000 as a loan to Customer C. B uses its expertise

and experience in structuring the loan and charges C a structuring fee of 1,000.
Therefore, the net amount advanced to C is 49,000. The fair value of the loan cannot
be determined by applying a valuation technique that uses only data from
observable markets.

7I.6.730.110 First, B applies IAS 39 to separate and measure the part of the
contract that is in the scope of IAS 39. Because the fair value of the loan cannot be
determined by applying a valuation technique that uses only data from observable
markets, we believe that B should recognise the loan at its transaction price of
49,000. This results in no residual amount to which IFRS 15 is applied.

7I.6.730.120 Modifying the fact pattern, the fair value of the loan is 50,000 and it
is determined by applying a valuation technique that uses only data from observable
markets. In this case, we believe that B should recognise the loan at its fair value
and the residual amount of 1,000 should be accounted for under IFRS 15.

7I.6.730.130 IFRS 7 requires the disclosure of fee income or expense arising from financial
instruments that are not at FVTPL, and from trust or other fiduciary activities, other than for
amounts included in the effective interest (see 7I.8.230). [IFRS 7.20(c)]
27 OCT 2022 PAGE 2863

Insights into IFRS 18th Edition 2021/22

7I. Financial instruments: IAS 39
7I.7 Hedge accounting

7I.7 Hedge accounting

7I.7.10 Introduction 2868

7I.7.20 Hedge accounting models 2868
7I.7.30 Fair value hedges 2868
7I.7.40 Definition 2868
7I.7.50 Accounting 2869
7I.7.60 Cash flow hedges 2870
7I.7.70 Definition 2870
7I.7.80 Accounting 2870
7I.7.90 Net investment hedges 2875
7I.7.100 Definition 2875
7I.7.110 Accounting 2875
7I.7.120 Hedge accounting criteria 2876
7I.7.130 Risk reduction 2877
7I.7.140 Flexibility in type of hedge accounting 2877
7I.7.150 Situations in which hedge accounting is not
necessary 2878
7I.7.160 Income taxes 2879
7I.7.170 Qualifying hedged items 2879
7I.7.180 Hedging a portion 2881
7I.7.190 Hedging a proportion 2886
7I.7.200 Hedging a group of items 2886
7I.7.210 Portfolio fair value hedges of interest rate risk 2887
7I.7.220 Net positions 2888
7I.7.230 Highly probable forecast transactions 2889
7I.7.240 Defining period in which forecast
transaction expected to occur 2890
7I.7.250 Expected interest cash flows 2891
7I.7.260 Prepayment risk 2892
7I.7.265 Cash flow hedges of firm commitments to acquire
a business and forecast business combinations 2893
7I.7.270 Items that do not qualify as hedged items 2894
7I.7.280 Derivatives 2894
7I.7.290 Own equity instruments 2894
7I.7.300 Dividends 2894
7I.7.305 Exposures within associate or joint venture 2894
7I.7.310 Qualifying hedging instruments 2895
7I.7.320 Purchased options 2896
7I.7.330 Dynamic hedging strategies 2896
7I.7.340 Written options 2897
 7I.7.350 Non-derivatives 2898
7I.7.360 Proportion of an instrument 2899
7I.7.370 Designation for entire period 2899
7I.7.380 Basis swaps 2900
7I.7.390 Liability bearing constant maturity interest rate 2900
7I.7.400 Hedging zero-coupon bond with plain vanilla
interest rate swap 2901
7I.7.410 Derivatives with knock-in or knock-out features 2902
7I.7.420 Qualifying hedged risks 2903
7I.7.430 Lease payments and receipts 2903
7I.7.440 Non-financial items 2904
7I.7.450 Foreign currency exposures 2908
7I.7.460 General business risks 2910
7I.7.470 Hedges of more than one risk type 2911
7I.7.480 Hedging other market price risks 2912
7I.7.490 Hedging credit risk 2912
7I.7.500 All-in-one cash flow hedges 2912
7I.7.510 Effectiveness testing 2913
7I.7.520 Frequency of effectiveness tests 2914
7I.7.530 Methods for measuring effectiveness 2914
7I.7.540 Prospective effectiveness 2915
7I.7.550 Retrospective or ongoing assessment of
effectiveness 2916
7I.7.560 Regression analysis 2917
7I.7.570 Actual ineffectiveness 2917
7I.7.580 Effect of credit risk on effectiveness testing and
ineffectiveness measurement 2918
7I.7.590 Matching critical terms 2919
7I.7.600 Time value and interest element 2920
7I.7.610 Interest rate risk 2921
7I.7.615 Financial instruments with a benchmark
rate component floored at zero 2922
7I.7.620 Change in fair value method 2925
7I.7.630 Hypothetical derivative method 2925
7I.7.640 Measuring hedge ineffectiveness 2926
7I.7.650 Clean vs dirty prices 2927
7I.7.660 Ineffectiveness in fair value hedge
arising from different fixed rates 2928
7I.7.670 Assessing hedge effectiveness when
hedging with off-market derivative 2928
7I.7.680 Discontinuing hedge accounting 2929
7I.7.685 Clearing derivatives with central counterparties 2933
7I.7.687 Collateralised-to-market and settled-to-
market models 2935
7I.7.690 Effect of delays and other changes in forecast
transaction 2935
 7I.7.700 Firm commitments and forecast
transactions with identified
counterparties 2937
7I.7.710 Forecast transactions with unidentified
counterparties 2937
7I.7.720 Use of layering with ‘first payments
received (paid)’ approach 2938
7I.7.730 Impairment of hedged item 2940
7I.7.733 Modification of hedged item 2941
7I.7.735 When hedge accounting is discontinued 2941
7I.7.737 When hedge accounting is not discontinued 2942
7I.7.740 Net investment hedge 2942
7I.7.750 Net assets of foreign operation 2942
7I.7.760 Expected net profit or loss of net investment in
foreign operation 2946
7I.7.770 Monetary items 2947
7I.7.780 Presentation currency 2947
7I.7.790 Cross-currency interest rate swaps 2948
7I.7.800 Fixed-for-fixed cross-currency interest
rate swap 2948
7I.7.810 Floating-for-floating cross-currency
interest rate swap 2949
7I.7.820
Fixed-for-floating cross-currency
interest rate swap 2949
7I.7.830 Synthetic borrowing 2950
7I.7.840 Hedging on a group basis 2950
7I.7.850 Internal derivatives 2951
7I.7.860
Externalisation and round-tripping 2951
7I.7.870
Intra-group balances or transactions as hedged
item 2953
7I.7.871 Interest rate benchmark reform 2954
7I.7.872 When uncertainty arises from IBOR reform 2954
7I.7.873 Assuming an interest rate benchmark is
not altered as a result of IBOR reform 2955
7I.7.874 Exception from the retrospective
effectiveness test 2955
7I.7.875 Exception from the separately
identifiable criterion 2955
7I.7.876 End of application 2955
7I.7.877 When uncertainty arising from IBOR reform is
resolved 2956
7I.7.878 Amending the hedge designation 2956
7I.7.879 Additional exception from the
retrospective effectiveness test 2958
7I.7.880 Exception for cash flow hedge
accounting 2958
7I.7.881 The 24-month period relief from the
separately identifiable criterion 2959
7I.7.882 Transition 2960
7I.7.885 Worked examples 2961
7I.7.890 Example 40 – Cash flow hedge of variable rate
liability 2961
7I.7.900 Example 41 – Cash flow hedge using interest rate
cap 2964
7I.7.910 Example 42 – Cash flow hedge of foreign currency
sales transactions 2968
7I.7.920 Example 43 – Termination of hedge accounting 2973
7I.7.930 Example 44 – Fair value hedge of foreign currency
risk on available- for-sale equities 2974
7I.7.940 Example 45 – Cash flow hedge of foreign currency
risk of recognised financial liability 2978
7I.7.950 Example 46 – Hedging on group basis – Foreign
currency risk 2981
7I.7.960 Transactions recognised concurrently in
income 2982
7I.7.970 Transactions recognised in different
periods 2982
7I.7.980 Example 47 – Hedge of net investment in foreign
operation 2983
7I.7.990 Example 48 – Hedging other market price risks 2984
7I.7.1000 Example 49 – Impact of a modification of the
hedged item on fair value hedge 2986
7I.7.1010 Future developments 2991

7I.7 Hedge accounting

CURRENTLY EFFECTIVE REQUIREMENTS

In July 2014, the International Accounting Standards Board (the Board) issued IFRS 9 Financial
Instruments, which is effective for annual periods beginning on or after 1 January 2018. However:
• on initial application of IFRS 9, an entity may choose an accounting policy to continue to apply the
hedge accounting requirements in IAS 39 in their entirety instead of those in chapter 6 of IFRS 9
until a new standard resulting from the Board’s ongoing project on accounting for dynamic risk
management becomes effective (see 7.9.80) or apply the hedge accounting requirements in IAS
39 for a fair value hedge of the interest rate exposure of a portfolio of financial assets or financial
liabilities (see 7.9.70); and
• an insurer may defer the application of IFRS 9 if it meets certain criteria (see 8.1.180).
This chapter reflects the requirement of IAS 39 Financial Instruments: Recognition and
Measurement and the related standards, excluding any amendments introduced by IFRS 9. These
requirements are relevant for annual periods beginning on 1 January 2021. For further discussion,
see Introduction to Sections 7 and 7I.

The requirements related to this topic are mainly derived from the following.

STANDARD TITLE

IAS 39 Financial Instruments: Recognition and Measurement

IFRIC 16 Hedges of a Net Investment in a Foreign Operation

The currently effective requirements include newly effective requirements arising from Interest Rate
Benchmark Reform Phase 2 – Amendments to IFRS 9, IAS 39, IFRS 7, IFRS 4 and IFRS 16, which are
effective for annual periods beginning on or after 1 January 2021. The impact of the requirements is
discussed in the following sections:
• modifications of financial assets and financial liabilities: 7I.5.500, 7I.6.335 and 8.1.170.35;
• hedge accounting: 7I.7.877;
• disclosures about the nature and extent of risks arising from interest rate benchmark reform and
progress in completing the transition to alternative benchmarks: 7I.8.277;
• transition requirements: 7I.7.882; and
• leases: 5.1.370.30.

FORTHCOMING REQUIREMENTS
For this topic, there are no forthcoming requirements.

FUTURE DEVELOPMENTS
This topic is subject to future developments resulting from the Board’s project on dynamic risk
management, which may affect aspects of macro hedge accounting. See 7I.7.1010.

7I.7.10 INTRODUCTION

7I.7.10.10 IAS 39 uses a mixed measurement model that requires the measurement of financial
assets and financial liabilities on different bases. For example, certain financial assets and financial
liabilities are measured at amortised cost whereas, in principle, all derivatives are measured at
FVTPL (see 7I.6.120). This results in an accounting mismatch in profit or loss, which results in
volatility in reported results.

7I.7.10.20 Similarly, other standards require or permit assets and liabilities to be measured on
bases other than FVTPL and certain contracts are recognised in financial statements only to the
extent of performance (see 1.2.170). When an entity offsets the risks arising from these recognised
assets and liabilities or unrecognised contracts by entering into hedging instruments, there is a
resulting accounting mismatch in profit or loss.

7I.7.10.30 Consequently, under hedge accounting, an entity could selectively measure assets,
liabilities and firm commitments on a basis different from that stipulated under other requirements
of the Standards, or could defer the recognition in profit or loss of gains or losses on derivatives.
Because hedge accounting results in an entity deviating from the normal measurement or
presentation requirements under the Standards, it is permitted only when strict documentation and
effectiveness testing requirements are met.

7I.7.10.40 There are three hedge accounting models and the type of model applied depends on
whether the hedged exposure is a fair value exposure, a cash flow exposure or a foreign currency
exposure on a net investment in a foreign operation.

7I.7.10.50 Hedge accounting is voluntary and the decision to apply hedge accounting is made on
a transaction-by-transaction basis or for a group of similar transactions. If an economic hedge does
not qualify for hedge accounting, then any derivative used is measured at fair value with all changes
in fair value recognised in profit or loss. These changes will not be offset by gains or losses on the
hedged item when the hedged item is not also measured at FVTPL. In our view, an entity’s risk
management disclosures should contain appropriate explanation of economic hedges that do not
qualify for hedge accounting (see 7I.8.270.40). [IFRS 7.31]

7I.7.10.60 When entering into a derivative transaction to reduce or eliminate a fair value risk
exposure, an entity may find it easier to designate a potential hedged item that is a non-derivative
financial asset or liability as at FVTPL, rather than applying hedge accounting. Such a designation
does not require the entity to perform an assessment of effectiveness; nor does it require rigorous
documentation. However, the entity needs to comply with the conditions for applying the fair value
option, which is irrevocable (see 7I.4.40).

7I.7.20 HEDGE ACCOUNTING MODELS

7I.7.30 Fair value hedges

7I.7.40 Definition
7I.7.40.10 A ‘fair value hedge’ is a hedge of changes in the fair value of a recognised asset or
liability, an unrecognised firm commitment, or an identified portion of such an asset, liability or firm
commitment, that is attributable to a particular risk and could affect profit or loss. [IAS 39.86(a)]

7I.7.40.20 The following are examples of fair value hedges:

• a hedge of interest rate risk associated with a fixed rate interest-bearing asset or liability – e.g.
converting a fixed rate instrument to a floating rate instrument using an interest rate swap;
• a hedge of a firm commitment to purchase an asset or to incur a liability; or
• a hedge of interest rate risk on a portfolio basis (a portfolio fair value hedge (see 7I.7.210)). [IAS
39.78, AG102]

7I.7.40.30 A hedge of the foreign currency risk of a firm commitment may be accounted for as
either a fair value hedge or a cash flow hedge, although in our experience cash flow hedging is
applied more commonly. Fair value hedge accounting can be applied only if there is a firm
commitment. Consequently, if a highly probable forecast transaction exists before an entity enters
into a firm commitment, then the hedge would have to be accounted for as a cash flow hedge until
the entity enters into a firm commitment – from which time it could be accounted for as a fair value
hedge. Generally, it is simpler to implement a single model for hedge accounting purposes, rather
than having to switch models during the life of the hedge. [IAS 39.87]

7I.7.50 Accounting
7I.7.50.10 If the hedging instrument is a derivative, then it is measured at fair value, with
changes in fair value recognised in profit or loss. The hedged item is remeasured for changes in fair
value attributable to the hedged risk during the period of the hedging relationship using the
guidance in IFRS 13 (see chapter 2.4), even if it is normally measured at amortised cost – e.g. a fixed
rate borrowing. Any resulting adjustment to the carrying amount of the hedged item related to the
hedged risk is recognised in profit or loss, even if such a change would normally be recognised in
OCI – e.g. for an available-for-sale financial asset (see 7I.8.220). In our view, the categorisation of the
fair value hedge adjustment as either a monetary or a non-monetary item, under IAS 21, should be
consistent with the categorisation of the hedged item under IAS 21 (see 2.7.120). [IAS 39.89]

7I.7.50.15 In accordance with IFRS 13, a fair value measurement assumes that the transaction
to sell the asset or transfer the liability takes place in the principal market, or in the absence of a
principal market, in the most advantageous market. In some cases, the hedged item in a fair value
hedge can be of a non-financial nature and its location is a characteristic that is relevant in
determining its fair value (see 2.4.70). If the market in which the fair value of the hedged item is
priced is different from the market in which the fair value of the hedging instruments is priced (see
2.4.100), then this difference may cause ineffectiveness in the hedging relationship and affect the
assessment of hedge effectiveness in a fair value hedging relationship. [IFRS 13.16]

7I.7.50.20 On entering into a firm commitment, an entity would not typically recognise the firm
commitment in the statement of financial position. However, for a hedge of a firm commitment, fair
value hedge accounting results in the change in the fair value of the firm commitment attributable to
the hedged risk during the period of the hedging relationship being recognised as an asset or a
liability in the statement of financial position. When the firm commitment is settled, the amount
previously recognised in the statement of financial position in respect of the fair value of the firm
commitment is transferred to adjust the initial measurement of the asset or liability recognised. [IAS
39.93–94]

7I.7.50.30 The adjustment to the carrying amount of the hedged item in a fair value hedge often
results in the item being measured neither at cost nor at fair value. This is because the adjustment:
• is made only for changes attributable to the risk being hedged – not for all risks;
• occurs only during the period in which hedge accounting is applied; and
• is limited to the extent that the item is hedged. [IAS 39.90]

EXAMPLE 1 – HEDGED ITEM MEASURED NEITHER AT COST NOR AT FAIR VALUE

7I.7.50.40 Company Z has a fixed interest liability denominated in its functional

currency and measured at amortised cost. Z enters into a pay-IBOR receive-fixed
interest rate swap to hedge half of the notional amount of the liability in respect of
its benchmark interest exposure. The swap qualifies for hedge accounting. Half of
the liability – i.e. the proportion that is hedged – will be remeasured with respect to
changes in fair value arising from changes in benchmark interest rates from the
beginning of the hedging relationship. The liability will not be remeasured for any
changes in its fair value arising from changes in credit spread, liquidity spread or
other factors.

7I.7.50.50 In a fair value hedge any ineffectiveness is automatically reported in profit or loss
because changes in the measurement of both the hedging instrument and the hedged item are
reported through profit or loss, unlike in a cash flow hedge, in which the ineffectiveness has to be
calculated and recognised separately.

7I.7.60 Cash flow hedges

7I.7.70 Definition

7I.7.70.10 A ‘cash flow hedge’ is a hedge of the exposure to variability in cash flows associated
with a recognised asset or liability or a highly probable forecast transaction that is attributable to a
particular risk and could affect profit or loss. [IAS 39.86(b)]

7I.7.70.20 Examples of cash flow hedges are:

• hedges of floating rate interest-bearing instruments using an interest rate swap, cap, floor or
collar;
• hedges of the foreign currency exposure on foreign currency denominated future lease or payroll
payments, including lease payments for which an entity elects the recognition exemptions for
short-term leases and/or leases of low-value assets; and
• hedges of highly probable forecast purchase or sale transactions. [IAS 39.AG103]

7I.7.80 Accounting

7I.7.80.10 If the hedging instrument is a derivative, then the hedging instrument is measured at
fair value, with the effective portion of changes in its fair value recognised in OCI and presented
within equity, normally in a hedging reserve. The ineffective portion of the gain or loss on the
hedging instrument is recognised immediately in profit or loss. [IAS 39.95]

7I.7.80.20 If the hedging instrument is a non-derivative financial asset or non-derivative

financial liability, which is permitted only for hedges of foreign currency risk, then the effective
portion of the foreign exchange gains and losses on the hedging instrument is recognised in OCI.

7I.7.80.23 More specifically, the separate component of equity associated with the hedged item –
i.e. the cash flow hedge reserve – is adjusted to the lower of the following (in absolute amounts):
• the cumulative gain or loss on the hedging instrument from inception of the hedging relationship.
This is the cumulative change in fair value or, if the hedging instrument is a non-derivative
financial asset or a non-derivative financial liability designated in a hedge of foreign currency risk,
the cumulative remeasurement for foreign currency risk at the spot rate in accordance with IAS
21 (see 2.7.80); and
• the cumulative change in fair value (present value) of the hedged item from inception of the
hedging relationship. [IAS 39.96(a)(i)–(ii)]

7I.7.80.25 The portion of the gain or loss on the hedging instrument that is determined to be an
effective hedge – i.e. the portion that is offset by the change in the cash flow hedge reserve
calculated in accordance with 7I.7.80.23 – is recognised in OCI. [IAS 39.95]

7I.7.80.27 Any gain or loss required to balance the change in the cash flow hedge reserve
(calculated in accordance with 7I.7.80.23) with the cumulative change in fair value of hedging
instrument since the inception of the hedge is ineffectiveness that is recognised in profit or loss. [IAS
39.96(b)]

7I.7.80.30 The change in fair value of the hedging instrument that is recognised in OCI is
reclassified to profit or loss when the hedged item affects profit or loss. Consequently, if the impact of
the hedged risk on profit or loss arising from the hedged item is deferred, then the amount
recognised in the cash flow hedge reserve may remain in equity until the hedged item affects profit
or loss. The standard is not explicit about the manner in which gains or losses should be reclassified
from the cash flow hedge reserve when the forecasted transaction impacts multiple periods or when
there are multiple forecasted transactions that impact multiple periods. Therefore, in our view an
entity should develop a systematic and rational method based on its risk management objective for
determining the amounts to be reclassified in each reporting period if the hedged cash flows affect
profit or loss in multiple reporting periods. [IAS 39.97–100]

EXAMPLE 2A – CASH FLOW HEDGE – RECLASSIFYING GAINS AND LOSSES

7I.7.80.40 On 31 December 2021, Company D issues a floating rate bond that

bears interest based on a benchmark rate payable annually and matures on 31
December 2025. The bond is issued at par of 1,000. In accordance with its risk
management strategy, D enters into a four-year pay-fixed 3% receive-benchmark
interest rate swap on 31 December 2021. On the same date, D designates the swap
as a cash flow hedge of the variability of future interest payments on the bond
attributable to changes in the benchmark rate. The timing of the swap’s cash flows
matches those of the bond. The fair value of the swap at inception is zero.

7I.7.80.50 The effects of credit risk are insignificant to the effectiveness of the
hedging relationship and there are no sources of ineffectiveness during the hedging
period. Therefore, all gains and losses on remeasurement of the swap to fair value
are included in OCI.

7I.7.80.60 Considering its risk management objective and how the effective
interest method is applied to a floating rate liability, D determines that it will
reclassify an amount from OCI to profit or loss during each period reflecting the
time-based

accrual of the net coupon payable or receivable on the swap. Therefore, in each year
it reclassifies amounts equal to the net settlements on the swap.

7I.7.80.70 An entity has some flexibility in the accounting for such reclassifications.
• If the future transaction results in the recognition of a non-financial asset or a non-financial
liability, then an entity may either include the cumulative amount in equity in the initial carrying
amount of that asset or liability (basis adjustment) or retain the amount in equity and reclassify it
to profit or loss in the same period(s) during which the asset or liability affects profit or loss – e.g.
when the asset is sold or as it is depreciated. The same choice applies to a forecast transaction of
a non-financial asset or a non-financial liability that becomes a firm commitment for which fair
value hedge accounting subsequently is applied. An entity chooses an accounting policy, to be
applied consistently to all cash flow hedges of transactions that lead to the recognition of non-
financial assets or liabilities.
• If the future transaction results in the acquisition of a financial instrument, then the cumulative
amount remains in equity and is reclassified to profit or loss in the period(s) during which the
financial instrument’s hedged forecast cash flows affect profit or loss – e.g. as it is amortised or
when it is impaired or sold. For example, an entity has a highly probable forecast purchase of an
available-for-sale listed equity security that it designates as the hedged item in a cash flow hedge.
Following purchase, changes in the fair value of the equity instrument are recognised in OCI until
either an impairment event or a disposal occurs. In our view, the gain or loss on the hedging
instrument should remain in equity until the equity instrument is either impaired or sold. [IAS
39.97–98]

7I.7.80.80 The accounting in 7I.7.80.70 also applies when cash flow hedge accounting is used to
hedge the exposure to the foreign currency risk of firm commitments. For hedges of foreign currency
risk of firm commitments to acquire a business and forecast business combinations, see 7I.7.265.

7I.7.80.85 However, the accounting in 7I.7.80.70 is subject to the requirement that if an entity
expects that all or a portion of a loss recognised in OCI will not be recovered in one or more future
periods, then it reclassifies from equity to profit or loss as a reclassification adjustment the amount
that is not expected to be recovered.

7I.7.80.90 The standard does not provide specific guidance on how to assess the recoverability
of a loss recognised in OCI. In our view, an assessment is needed when there is a cumulative net loss
recognised in the cash flow hedge reserve in respect of a particular hedging relationship. We believe
that any such net losses should be assessed on a hedge-by-hedge basis. We also believe that the
assessment of the recoverability of a net accumulated loss in the cash flow hedge reserve should
consider the relevant requirements in the standards that are applied to the hedged item. For
example, if the hedged item is a forecast transaction to purchase a non-financial item that will be
accounted for as inventory, then the recoverability test should be performed by considering the NRV
of the hedged item (see 3.8.110.10). [IAS 39.97–98]

EXAMPLE 2B – CASH FLOW HEDGE – RECOVERABILITY TEST

7I.7.80.100 Company X is an airline. X hedges a highly probable future purchase

of jet fuel with a forward contract applying cash flow hedge accounting. X is not
committed to buying specified quantities of jet fuel in advance and expects to make

the purchase of jet fuel at the market price at the time of delivery. For simplicity, this
example ignores the time value of money.

7I.7.80.110 The following facts at 31 December 2021 are relevant for this
example.
• The market price of jet fuel has declined significantly because of an economic
recession and the fair value of the forward contract is minus 200.
• X determines that all of the change in the fair value of the hedging instrument is
an effective hedge and recognises it in the cash flow hedge reserve.
• The expected future cost of the jet fuel measured at 31 December, based on the
 available market data, is 800.
• X determines that the expected NRV of the jet fuel is 510.
7I.7.80.120 Because the amount accumulated in the cash flow hedge reserve is a
loss, X evaluates at 31 December 2021 whether it expects to recover that amount in
future periods. X accounts for purchased jet fuel as inventory, which is measured at
the lower of cost and NRV (see 3.8.330) in accordance with IAS 2. Therefore, we
believe that X should consider the expected NRV and the expected cost of the jet
fuel to be acquired in the hedged transaction to assess the recoverability of the loss
deferred in the cash flow hedge reserve.

7I.7.80.130 Because the expected NRV of the jet fuel of 510 is lower than its
expected cost of 800, X reclassifies all of the loss of 200 from the cash flow hedge
reserve immediately to profit or loss as a reclassification adjustment.

7I.7.80.140 In our view, reclassification of a loss that is not expected to be recoverable from the
cash flow hedge reserve to profit or loss should not automatically cause a discontinuation of the
hedging relationship. We believe that this reclassification adjustment is required as part of a
continuing hedging relationship, whereas a discontinuation of hedge accounting should be based on
whether the hedging relationship continues to meet the qualifying criteria (see 7I.7.680), including
whether the hedged transaction remains highly probable.

7I.7.80.150 After an entity reclassifies a loss from the cash flow hedge reserve that is not
expected to be recovered into profit or loss and continues hedge accounting, in our view the entity
should continue to apply the accounting requirements in 7I.7.80.23–27 sequentially in subsequent
periods on a cumulative basis. If the amount accumulated in the cash flow hedge reserve is a loss in
any subsequent period, then the entity should assess the recoverability of the loss at that time and
immediately reclassify any amount that is not expected to be recovered into profit or loss as a
reclassification adjustment.

EXAMPLE 2C – CASH FLOW HEDGE – ACCOUNTING AFTER RECLASSIFICATION OF A NON-RECOVERABLE LOSS

7I.7.80.160 Continuing Example 2B, the following facts at 31 December 2022

are relevant.
• The market price of jet fuel increases by 100 – i.e. the expected cost of the jet fuel
is 900.

• The fair value of the forward contract also increases by 100 – i.e. the fair value of
the forward contract changes from minus 200 to minus 100.
• Company X determines that all fair value changes of the hedging instrument are
an effective hedge.
• X determines that the expected NRV of the jet fuel remains 510.
7I.7.80.170 We believe that at 31 December 2022, X should first calculate the
cash flow hedge reserve in accordance with 7I.7.80.23. Because the cumulative gain
or loss on the hedging instrument from inception of the hedging relationship – i.e.
the fair value of the forward – is minus 100 and the amount is all an effective hedge,
the cash flow hedge reserve is calculated as a loss of 100 before considering any loss
reclassification.

7I.7.80.180 In accordance with 7I.7.80.25, all changes in the fair value of the
forward contract are recognised in OCI because the hedge is fully effective.
 7I.7.80.190 Before considering any loss reclassification, the cash flow hedge
reserve is an accumulated loss of 100 – i.e. a debit balance in accumulated OCI. The
fair value of the forward contract has increased by 100 from 31 December 2021 –
i.e. a debit entry. A credit of 200 to profit or loss is required to balance the change in
the fair value of the forward contract and the cash flow hedge reserve in accordance
with 7I.7.80.27 before considering any loss reclassification.

7I.7.80.200 Finally, X once again needs to assess the recoverability of the cash
flow hedge reserve because the accumulated amount recognised is a loss of 100.
The expected NRV of the jet fuel remains 510 and it continues to be lower than the
expected cost of the jet fuel of 900. As a result, all of the loss of 100 in the cash flow
hedge reserve needs to be immediately reclassified from OCI to profit or loss as a
reclassification adjustment. The net effect of this and the calculations in 7I.7.80.190
is that a gain of 100 is recognised in profit or loss in 2022, representing the
reduction in the cumulative loss on the hedging instrument that is not expected to
be recovered, and a net amount of nil is recognised in OCI.

7I.7.80.210 X records the following entries at 31 December 2021.

DEBIT CREDIT

Forward contract 100

Hedging reserve (OCI) 100

To recognise change in fair value of forward

Hedging reserve (OCI) 200

Hedging ineffectiveness (profit or loss) 200

To adjust balance of cash flow hedge reserve to

a debit of 100

DEBIT CREDIT

Hedging loss (profit or loss) 100

Hedging reserve (OCI) 100

To reclassify the cash flow hedge reserve that is

not expected to be recovered

7I.7.90 Net investment hedges

7I.7.90.10 IAS 39 does not override the principles of IAS 21 (see chapter 2.7), but it does provide
the hedge accounting model for hedging an entity’s foreign exchange exposure arising from net
investments in foreign operations.

7I.7.100 Definition
7I.7.100.10 A ‘net investment hedge’ is a hedge of a net investment in a foreign operation as
defined in IAS 21 (see 2.7.170) for the foreign currency exposure arising when the net assets of that
foreign operation are included in the financial statements. [IAS 39.86(c)]

7I.7.100.20 The hedged risk is the foreign currency exposure arising from a net investment in a
foreign operation when the net assets of that foreign operation are included in the financial
statements (see 7I.7.750.10).

7I.7.100.30 Often the exposure to changes in the value of a net investment arising from
movements in foreign exchange rates is hedged through borrowings denominated in the foreign
operation’s functional currency or, in more limited circumstances, derivative currency contracts.

7I.7.110 Accounting
7I.7.110.10 If the hedging instrument in a net investment hedge is a derivative, then it is
measured at fair value. The effective portion of the change in fair value of the hedging instrument –
computed with reference to the functional currency of the parent entity against whose functional
currency the hedged risk is measured – is recognised in OCI and presented within equity in the
foreign currency translation reserve (see 2.7.260). The ineffective portion of the gain or loss on the
hedging instrument is immediately recognised in profit or loss. [IAS 39.102, IFRIC 16.3, 15]

7I.7.110.20 If the hedging instrument is a non-derivative – e.g. a foreign currency borrowing –

then the effective portion of the foreign exchange gain or loss arising on translation of the hedging
instrument under IAS 21 into the functional currency of the hedging entity is recognised in OCI. The
effective portion is computed with reference to the functional currency of the parent entity against
whose functional currency the hedged risk is measured. [IFRIC 16.15]

7I.7.110.30 On disposal of a net investment in a foreign operation, the cumulative foreign

exchange differences arising on translation of the foreign operation, and the effective portion of the
gain or loss on the hedging instrument presented within equity in the foreign currency translation
reserve (the ‘cumulative amounts’), are treated as follows.
• On disposal of the entire interest in a foreign operation and disposal of part of an ownership
interest that results in the entity losing control over the other entity that includes the foreign
operation (see 2.7.340) or on the cessation of equity accounting, the cumulative amounts
previously recognised in OCI are reclassified to profit or loss and no amount of the reclassification
is allocated to NCI (see 2.5.760.40). As an exception, when a parent loses control of a subsidiary
by contributing it to an associate or joint venture and elects to eliminate the part of the gain or
loss in respect of the continuing interest in the assets and liabilities contributed, then in our view
only a proportionate share of the cumulative amounts previously recognised in OCI should be
reclassified to profit or loss (see 3.5.470).
• When an entity partially disposes of a subsidiary that includes a foreign operation, but retains
control, the entity re-attributes a proportionate share of the cumulative amounts previously
recognised in OCI to NCI (see 2.7.340.140).
• In any other partial disposal of a foreign operation, the entity reclassifies to profit or loss only a
proportionate share of the cumulative amounts previously recognised in OCI (see 2.7.340.150).
[IAS 21.48–49, 39.102, IFRIC 16.6, 16–17]

7I.7.110.40 Therefore, it is necessary for an entity to keep track of the amount recognised in OCI
separately in respect of each foreign operation, to identify the amounts to be reclassified to profit or
loss on disposal or partial disposal.

7I.7.110.50 The method of consolidation – i.e. the step-by-step or the direct method – may affect
the amount that is included in the foreign currency translation reserve for an individual foreign
operation. When the step-by-step method of consolidation is applied, it may lead to the
reclassification to profit or loss of an amount that is different from the amount used to assess hedge
effectiveness. An entity may eliminate this difference by retrospectively determining the amount that
would have resulted from using the direct method of consolidation. The amount so determined would
then be reclassified from equity to profit or loss on disposal or partial disposal, as discussed in
7I.7.110.30. This adjustment is not required by IAS 21. However, an entity needs to choose an
accounting policy, to be applied consistently, for all net investments (see 2.7.340.20). [IFRIC 16.17]

7I.7.120 Hedge accounting criteria

7I.7.120.10 Hedge accounting is permitted only if all of the following conditions are met.
• There is formal designation and written documentation at the inception of the hedge (see
7I.7.120.30).
• The effectiveness of the hedging relationship can be measured reliably. This requires the fair
value of the hedging instrument, and the fair value (or cash flows) of the hedged item with respect
to the risk being hedged, to be reliably measurable.
• The hedge is expected to be highly effective in achieving fair value or cash flow offsets in
accordance with the original documented risk management strategy.
• The hedge is assessed and determined to be highly effective on an ongoing basis throughout the
hedging relationship. A hedge is highly effective if changes in the fair value of the hedging
instrument, and changes in the fair value or expected cash flows of the hedged item attributable
to the hedged risk, offset within the range of 80–125 percent.
• For a cash flow hedge of a forecast transaction, the transaction is highly probable and creates an
exposure to variability in cash flows that could ultimately affect profit or loss. [IAS 39.88]

7I.7.120.20 In our experience, the key challenges in implementing hedge accounting are
identifying a specific asset or liability, or portfolio of similar assets or liabilities, to designate as the
hedged item and demonstrating that the hedge is highly effective (both prospectively and
retrospectively).

7I.7.120.30 At inception of the hedge, an entity establishes formal documentation of the hedging
relationship. The hedge documentation prepared at inception includes a description of the following:
• the entity’s risk management objective and strategy for undertaking the hedge;
• the nature of the risk being hedged;
• clear identification of the hedged item – the asset, liability, firm commitment or cash flows arising
from a forecast transaction – and the hedging instrument; and
• how hedge effectiveness will be assessed both prospectively and retrospectively. The entity
describes the method and procedures in sufficient detail to establish a firm and consistent basis
for measurement in subsequent periods for the particular hedge. [IAS 39.88]

7I.7.120.40 IAS 39 does not mandate a specific format for the documentation and, in our
experience, hedge documentation may vary in terms of layout, methodology and processes used.
Various formats are acceptable as long as the documentation includes the content listed in
7I.7.120.30.

7I.7.130 Risk reduction

7I.7.130.10 Risk exposure is assessed on a transaction basis and entity-wide risk reduction is not
a condition for hedge accounting. For example, an entity may have fixed rate assets and liabilities
that provide a natural economic hedge that leaves the entity with no exposure to interest rate risk.
The entity may decide to enter into a pay-fixed receive-floating swap and to designate this as a hedge
of the fixed rate assets. Although this would increase the entity’s overall exposure to interest rate
risk, hedge accounting may be applied to this transaction provided that the relevant hedge
accounting criteria are met. [IAS 39.IG.F.2.6]

7I.7.140 Flexibility in type of hedge accounting

7I.7.140.10 In some cases, a hedge can be designated either as a cash flow hedge or as a fair
value hedge. The following examples demonstrate this.
• A hedge of the foreign currency risk of a firm commitment may be designated as a fair value
hedge or as a cash flow hedge.
• A forward contract to buy foreign currency may be designated as the hedging instrument in a fair
value hedge of a foreign currency financial liability or alternatively in a cash flow hedge of the
forecast settlement of that liability.
• A receive-fixed pay-floating interest rate swap may be designated as a fair value hedge of a fixed
interest liability or as a cash flow hedge of a variable interest asset. However, the interest rate
swap cannot be designated as a cash flow hedge of a fixed interest liability because it converts
known (fixed) interest cash outflows, for which there is no exposure to variability in cash flows,
into unknown (variable) interest cash outflows. Similarly, the swap cannot be designated as a fair
value hedge of a variable interest asset because a variable interest instrument is not exposed to
changes in fair value arising from changes in market interest rates.
• A purchased put option on a commodity may be designated as the hedging instrument in a fair
value hedge of the commodity inventory or, alternatively, in a cash flow hedge of a forecast sale of
the commodity inventory when such a sale is highly probable to occur. [IAS 39.87, IG.F.3.3, IG.F.3.6]

7I.7.140.20 The designation is done at inception of the hedge. [IAS 39.88]

7I.7.140.30 Although the net profit or loss effect of a hedging relationship will ultimately be the
same regardless of the type of hedge accounting applied, the timing of recognition in the statement
of financial position and in profit or loss, effectiveness testing and the nature of the accounting
adjustments made will differ. Therefore, it is important to choose the model and the method of
effectiveness testing at inception of the hedge and to designate and document the hedge accordingly.

7I.7.140.40 The decision regarding which hedge accounting model to use may also be influenced
by the entity’s information systems. The entity assesses whether its existing information systems are
best set up to manage and track the information required under a fair value hedge model or a cash
flow hedge model. This decision may also depend on the characteristics of the hedged items and
whether hedge accounting criteria can be met.

7I.7.140.50 Under a fair value hedge model, an asset or liability designated as a hedged item is
remeasured for fair value changes attributable to the hedged risk. For exposure to interest-sensitive
rate assets and liabilities, the original effective yield is modified through the amortisation of this
‘hedge adjustment’. Usually, this requires a system that is able to track changes in the hedged risk
and that can calculate associated changes in the fair value of the hedged item. Also, the system
should be able to recompute the effective yield of the hedged item and amortise the changes to profit
or loss over the remaining life of the hedged item. [IAS 39.IG.F.6.2]

7I.7.140.60 Under a cash flow hedge model, the ineffective portion is calculated separately and
recognised in profit or loss. However, the effective portion of the fair value changes of the hedging
instrument is recognised in OCI and is reclassified to profit or loss only when the hedged expected
cash flows affect profit or loss (see 7I.7.80.30), or the amount is a loss and the entity expects that all
or a portion of that loss will not be recovered in one or more future periods. In addition, it is
necessary to demonstrate that forecast transactions are highly probable. This requires a system that
enables an entity to track the timing of the cash flows of the hedged item, as well as the timing of the
reclassification of the hedging gains and losses from equity. Although this may prove a challenge, for
many entities such information can be based on the cash flow information already captured in their
risk management systems. [IAS 39.95–100]

7I.7.140.70 In our experience, for hedges of interest rate risk, it is generally easier to meet the
hedge criteria and to apply hedge accounting if the cash flow hedge model is used. This is because
complex systems are necessary to make partial fair value adjustments to the carrying amount of
interest-bearing hedged items and it is often difficult to demonstrate hedge effectiveness,
particularly if there is a risk of prepayments (see 7I.7.260).

7I.7.150 Situations in which hedge accounting is not necessary

7I.7.150.10 In some cases, there is no accounting mismatch and therefore hedge accounting is
not necessary. Examples of situations in which hedge accounting is not necessary are:
• hedges of recognised foreign currency monetary items with offsetting monetary items – the
remeasurement of both items with respect to changes in foreign exchange rates is required to be
recognised in profit or loss; and
• hedges of changes in the fair value of instruments measured at FVTPL – both the hedged item and
derivative hedging instruments are remeasured to FVTPL. [IAS 39.IG.F.1.1]

7I.7.160 Income taxes

7I.7.160.10 For transactions recognised directly in equity or in OCI, all current and deferred
taxes are also recognised in equity or in OCI (see 3.13.530). In respect of hedge accounting, this
means that current and deferred taxes on gains or losses on hedging instruments recognised in OCI
in a cash flow or net investment hedge are also recognised in OCI until such time as the gain or loss
is reclassified to profit or loss. [IAS 12.61A]

7I.7.170 QUALIFYING HEDGED ITEMS

7I.7.170.10 The hedged item is the item that is exposed to the specific risk(s) that an entity has
chosen to hedge.

7I.7.170.20 The hedged item can be:

• a single recognised asset or liability, unrecognised firm commitment, highly probable forecast
transaction or net investment in a foreign operation;
• a group of recognised assets or liabilities, unrecognised firm commitments, highly probable
forecast transactions or net investments in foreign operations, if they share the same hedged risk;
or
• in a portfolio hedge of interest rate risk, a portion – i.e. an amount of currency – of a portfolio of
financial assets or financial liabilities that share the risk being hedged. [IAS 39.78]

7I.7.170.30 To qualify for hedge accounting, the hedged item should involve a party external to
the entity. Hedge accounting can be applied to transactions between entities in the same group only
in the individual or separate financial statements of those entities and not in the consolidated
financial statements of the group. However, as an exception, the foreign currency risk of an intra-
group monetary item – e.g. a foreign currency denominated payable or receivable between two
subsidiaries – may qualify as a hedged item in the consolidated financial statements if it results in an
exposure to foreign exchange rate gains or losses that are not fully eliminated on consolidation (see
7I.7.870). [IAS 39.80]

7I.7.170.40 The IFRS Interpretations Committee discussed whether a synthetic instrument that
combines non-derivative and derivative instruments could be an eligible hedged item. The
Committee noted that IAS 39 does not allow a ‘synthetic hedged item’ created by combining a
derivative with a non-derivative financial instrument to be designated as the hedged item in a
hedging relationship with another derivative (see 7I.7.280.10). [IU 07-09]

7I.7.170.50 Because hedge accounting is assessed on a transaction-by-transaction basis, in our

view a non-derivative hedging instrument in one hedging relationship can be designated as a hedged
item in a different hedging relationship. [IAS 39.IG.F.2.6]

EXAMPLE 3 – NON-DERIVATIVE INSTRUMENT USED AS BOTH HEDGING INSTRUMENT AND HEDGED ITEM
 7I.7.170.60 Company B’s functional currency is sterling. B has two hedges in
place. The first hedge is a net investment hedge of yen net assets of a foreign
operation whereby the hedging instrument is a yen-denominated floating rate bond
issued by B. The second hedge is a cash flow hedge of the variability in the interest
cash flows on the yen-denominated floating rate bond arising from changes in
benchmark interest rates whereby the hedging instrument is a yen pay-fixed
receive-floating interest rate swap. In this example, the issued bond is the hedging
instrument of foreign currency risk while it is simultaneously designated as the
hedged item in a cash flow hedge of interest rate risk.

7I.7.170.70 To qualify for hedge accounting, the hedged risk should ultimately be capable of
affecting profit or loss. [IAS 39.80, 86]

7I.7.170.80 An exception is that a held-to-maturity investment may never be the hedged item in a
hedge of interest rate or prepayment risk. The designation of an investment as held-to-maturity
requires an intention to hold the investment until maturity without regard to changes in the fair
value or cash flows of the investment because of changes in interest rates. In addition, because
prepayment risk on interest-bearing instruments is primarily a function of interest rates, this risk is
like interest rate risk and therefore cannot also be the hedged risk when the hedged item is a held-to-
maturity investment. This is an important factor to consider before classifying an investment as held-
to-maturity (see 7I.4.80). [IAS 39.79]

7I.7.170.90 Although a held-to-maturity investment may not be hedged for interest rate risk, the
reinvestment of cash flows generated by such an asset may be hedged. Additionally, a held-to-
maturity investment can be hedged with respect to credit risk and/or foreign currency risk. Also, the
forecast purchase of an asset to be classified as held-to-maturity may be hedged for the period until
the asset is recognised in the statement of financial position. [IAS 39.79, IG.F.2.10–IG.F.2.11]

7I.7.170.100 The designation of a hedging instrument for only a portion of the time that it
remains outstanding is specifically prohibited (see 7I.7.370.10). However, an entity may designate a
financial instrument as hedged for only a portion of its period to maturity (see 7I.7.180.20 and 190).
It is possible to designate a hedging relationship after initial recognition of the hedged item, hedging
instrument or both. [IAS 39.IG.F.2.17]

7I.7.170.110 If the hedged item is a non-financial asset or non-financial liability, then the item is
designated as a hedged item for foreign currency risks or in its entirety for all risks. However, in our
view an entity may hedge, in a fair value hedging relationship, a recognised non-financial item for a
specified period. A recognised non-financial item such as inventory does not have a fixed tenure and
therefore can be hedged up to a specific date as long as the item is hedged for all changes in fair
value and the other conditions for hedge accounting are met. [IAS 39.82]

7I.7.170.120 An entity’s own equity instruments under IAS 32 may not be designated as the
hedged item in either a fair value or a cash flow hedge, because changes in fair value or cash flows
arising from such an instrument do not affect profit or loss (see 7I.7.290.10). [IAS 39.86, IG.F.2.7]

7I.7.170.130 A non-monetary item, such as an investment in equity securities quoted on an

exchange (or other recognised marketplace) in which trades are denominated in a foreign currency
and classified as available-for-sale, may also be the hedged item. [IAS 39.IG.F.2.19]

EXAMPLE 4 – NON-MONETARY ITEM USED AS HEDGED ITEM

 7I.7.170.140 Company Q acquires equity securities in Company B on a foreign
stock exchange in which trades are denominated in a foreign currency. Q classifies
its investment as available-for-sale. To hedge against foreign currency risk, Q enters
into a forward currency contract to sell foreign currency. The forward contract may
be designated as a hedging instrument for the fair value changes of the securities
related to foreign currency risk provided that:
• the acquired securities are not traded on a stock exchange on which trades are
denominated in the same currency as Q’s functional currency. This might be the
case if B’s equity securities are dual-listed and one of the listings is on an
exchange where trades are denominated in Q’s functional currency; and
• dividends to Q are not denominated in Q’s functional currency.

7I.7.170.150 If an equity security is traded in multiple currencies and one of those currencies is
the functional currency of the investor, then designation of the foreign exchange risk of the equity
security is not permitted. However, in our view a forecast sale or purchase of a foreign currency-
denominated equity security may qualify for cash flow hedge accounting. In our view, a highly
probable purchase of additional foreign currency denominated shares in a subsidiary – i.e. buying
additional shares in a controlled entity – may qualify as the hedged item as the acquisition of
additional shares will impact profit or loss when the shares are disposed of. Also, a net investment in
a foreign operation in the consolidated financial statements may qualify as the hedged item for
foreign exchange risk. [IAS 39.IG.F.2.19]

7I.7.180 Hedging a portion

7I.7.180.10 In addition to hedging all changes in the fair value or cash flows of a financial
instrument, an entity may designate the following as the hedged item:
• all of the cash flows of the financial instrument for cash flow or fair value changes attributable to
some, but not all, risks; or
• some, but not all, of the cash flows of the financial instrument for cash flow or fair value changes
attributable to all or certain risks – i.e. a portion of the cash flows of the financial instrument may
be designated for changes attributable to all or certain risks. [IAS 39.81, AG99E]

7I.7.180.20 For example, an entity may be permitted to designate the following portions of a
financial item as the hedged item.
• Hedging all cash flows for a specific risk – e.g. hedging only the foreign exchange risk on the
principal and interest cash flows on a foreign currency borrowing.
• Hedging specifically identified cash flows for all risks – e.g. hedging the coupon payments on
financial liabilities for all risks.
• Hedging a portion of specifically identified cash flows for a specific risk – e.g. hedging the interest
rate risk for the first five years of a 10-year fixed rate bond with a five-year pay-fixed receive-
floating interest rate swap. In this situation, the bond is hedged for less than its full term.
However, the hedging instrument is designated for its entire term to maturity.
• Hedging a portion of specifically identified cash flows for a specific risk – e.g. hedging the interest
rate risk on only the risk-free component of coupon payments on financial liabilities – excluding
the credit risk premium.
• Hedging specifically identified cash flows for a specific risk – e.g. hedging the foreign currency
risk on interest cash flows – but not the foreign currency risk on the principal cash flows of a
foreign currency borrowing. [IAS 39.81]

7I.7.180.30 In addition, it is possible to designate a portion of a net investment as the hedged

item (see 7I.7.760.10).

7I.7.180.40 As described in 7I.7.180.20, there are numerous options available when identifying
portions of cash flows as the hedged item in relation to the specific risk(s) being hedged. An entity
may hedge a portion of cash flows due to all risks or specifically identifiable risks inherent in the
hedged item, or it may hedge all or a portion of cash flows due to specific risks inherent in the
hedged item. However, to be eligible for hedge accounting, the designated risks and portions should
be separately identifiable components of the financial instrument and changes in the cash flows or
fair value of the entire financial instrument arising from changes in the designated risks and portions
should be reliably measurable. For example, when designating a fixed rate bond for fair value
changes arising from changes in the risk-free or benchmark interest rate, the risk-free or benchmark
interest rate normally is regarded as being both a separately identifiable component and reliably
measurable. [IAS 39.AG99F]

7I.7.180.50 If a portion of the cash flows of a financial asset or liability is designated, then that
portion should be less than the total cash flows of the asset or liability. However, the entity may
designate all of the cash flows of the entire financial asset or financial liability as the hedged item
and hedge them for only one particular risk. For example, a financial liability bearing interest at
IBOR less 100 basis points could be hedged in its entirety – i.e. principal plus interest at IBOR less
100 basis points – for the change in its cash flows attributable to changes in IBOR, but could not be
hedged for changes in value of the IBOR component of the total cash flows. [IAS 39.AG99C]

7I.7.180.60 The entity may choose a hedge ratio other than one-to-one to improve the
effectiveness of the hedge. This generally involves identifying whether there is a statistical
relationship between the hedging instrument and the hedged item and, if there is such a
relationship, then using the correlation between the items as the hedge ratio.

7I.7.180.70 In our view, it is possible for an entity to designate a portion of the variable interest
payments or receipts on a financial asset or liability as the hedged item if, in addition to the
conditions outlined in 7I.7.120.10 and 180.40, the following conditions are met.
• The actual interest payments or receipts on the hedged item are expected, based on historical
evidence, to exceed the hedged cash flows during the entire hedging relationship.
• There is a reasonable economic relationship between the component of cash flows designated as
the hedged item and the variable rate on which the contractual cash flows are based.

EXAMPLE 5 – DESIGNATION OF PORTION OF VARIABLE INTEREST PAYMENTS OR RECEIPTS AS HEDGED ITEM

7I.7.180.80 Company X will issue two variable rate notes (liabilities) with a
notional of 1,000 each, which reset on the basis of the following rates:
• 90-day IBOR; and
• 90-day IBOR plus 100 basis points.
7I.7.180.90 X simultaneously enters into two swaps with the same notional as the
notes, receiving IBOR and paying fixed, to hedge its exposure to variability in
interest rates.

7I.7.180.100 In this case, the margin above IBOR is fixed and consequently any
change in the cash flows of the swaps will perfectly offset the change in cash flows of
the liabilities. Therefore, in our view it is not necessary to designate a portion of
cash flows as the hedged item when the margin above the benchmark rate is fixed.

7I.7.180.110 However, in certain instances the margin above the benchmark rate may not be
fixed. For example, consider a bank that raises 90-day deposits at three-month Euribor plus 50 basis
points. On maturity it is highly probable that customers will roll over the deposits and the interest
rate on the deposits will be reset to market, which may not be based on three-month Euribor plus 50
basis points. In accordance with its hedging strategy, the bank enters into a swap paying fixed and
receiving three-month Euribor flat.

7I.7.180.120 We believe that in this specific scenario it is not possible to designate a Euribor
portion of the variable cash flows as the hedged item because there is not a reasonable economic
relationship between the rate on which the contractual cash flows are based and the benchmark rate
identified as the hedged item. Therefore, the Euribor portion is not separately identifiable. The entire
cash flow variability should be taken into consideration in designating the hedging relationship.

7I.7.180.130 In our view, it is possible to reduce ineffectiveness in certain circumstances by

designating a portion of the cash flows as the hedged item, as long as the conditions in 7I.7.120.10
and 180.40 are met.

EXAMPLE 6A – DESIGNATION OF PORTION OF CASH FLOWS AS HEDGED ITEM – DIFFERENT CREDIT SPREADS

7I.7.180.133 Company R issues a five-year bond on 1 January 2021 that bears

interest at a fixed rate of 5% – i.e. the benchmark rate on issue plus 100 basis points
for credit spread. On 1 January 2021 R acquires a five-year interest rate swap,
receiving fixed at 4.5% – i.e. the benchmark rate on acquisition plus 50 basis points
for credit spread – and paying variable.

Receive 5% interest 5­year fixed

Company R interest rate
(4% benchmark rate bond issued by R
+ 1% credit spread)
Receive 4.5%
Pay­variable (4% benchmark +
interest 0.5% credit spread)

Interest rate
swap
(5­year)

7I.7.180.135 We believe that in this example it is possible to designate the hedged

item as the principal cash flow plus a portion of the interest coupons – i.e. 4.5% of
the 5% contractual interest cash flows – so as to reduce hedge ineffectiveness
compared with when the entire 5% interest cash flows are designated as a hedged
item. We believe that the hedged item is a separately identifiable and reliably
measurable portion of the bond’s cash flows – i.e. the principal cash flow plus the
4.5% portion of the 5% coupon cash flows. Therefore, the portion of the bond’s cash
flows can be designated as a valid hedged item.

EXAMPLE 6B – DESIGNATION OF PORTION OF CASH FLOWS AS HEDGED ITEM – SUBSEQUENT CHANGE IN

BENCHMARK RATES

7I.7.180.137 Company S issued a five-year bond on 1 January 2019 that bears

interest at a fixed rate of 5%. On 1 January 2021, S acquires a three-year interest
rate swap, receiving fixed at 3% and paying variable. Apart from the interest rates,
the other terms of the hedged item and hedging instrument match. The mismatch
between the interest rate on the bond and the interest rate on the fixed leg of the
swap arises from a decrease in benchmark rates over the two-year period.

7I.7.180.140 We believe that in this example it is possible to designate the hedged

 item as the principal cash flow plus a portion of the interest coupons – i.e. 3% of the
5% contractual interest cash flows – so as to minimise hedge ineffectiveness. We
believe that the hedged item is a separately identifiable and reliably measurable
portion of the bond’s cash flows – i.e. the principal cash flow plus the 3% portion of
the 5% coupon cash flows. Therefore, the portion of the bond’s cash flows can be
designated as a valid hedged item.

7I.7.180.150 Inflation cannot be designated as a risk or a portion of a financial instrument

because it is not separately identifiable or reliably measurable, unless:
• it is a contractually specified portion of the cash flows of a recognised inflation-linked bond
(assuming there is no embedded derivative required to be separately accounted); and
• the other cash flows of the instrument are not affected by the inflation portion. [IAS 39.AG99F]

EXAMPLE 7 – DESIGNATION OF INFLATION AS HEDGED ITEM

7I.7.180.160 In a bond that contractually specifies the interest payments as

comprising a fixed rate plus inflation, inflation could be designated as the hedged
risk or portion. However, in an ordinary variable rate bond that does not
contractually specify an inflation indexation, an entity cannot impute an inflation
indexation and then designate it as the hedged risk or portion.

7I.7.180.170 An entity may designate all changes in the cash flows or fair value of a hedged item
in a hedging relationship. An entity may also designate only changes in the cash flows or fair value of
a hedged item above or below a specified price or other variable – i.e. a one-sided risk. The intrinsic
value of a purchased option hedging instrument (assuming that it has the same principal terms as
the designated risk), but not its time value, reflects a one-sided risk in a hedged item. [IAS 39.AG99BA]

EXAMPLE 8 – EXCLUDING TIME VALUE OF PURCHASED OPTION

7I.7.180.180 Company B forecasts a future purchase of a commodity and it

purchases a commodity call option to hedge against future increases in commodity
prices above the strike price specified in the purchased option. B designates the
variability of future cash flow outcomes arising from the forecast commodity
purchase as a result of a price increase above the strike price. In such a situation,
only cash flow losses that result from an increase in the price above the specified
level are designated. The hedged risk does not include the time value of a purchased
option because the time value is not a component of the forecast transaction that
affects profit or loss.

7I.7.180.190 In our view, an entity may designate the changes in the cash flows of a financial
asset or financial liability that relate to only a portion of its term – i.e. a ‘partial term’ cash flow
hedge. [IAS 39.IG.F.2.17]

EXAMPLE 9 – PARTIAL TERM CASH FLOW HEDGE

7I.7.180.200 Company R has a highly probable forecast issue of fixed rate debt
expected to occur on 31 December 2021. R desires to hedge the variability in the
proceeds received from the debt issue arising from changes in the benchmark
interest rate that occur from 1 October 2021 up to 31 October 2021. On 1 October
2021, R designates a cash flow hedge using a forward starting interest rate swap
with a swap component that starts on 31 October 2021 as the hedging instrument to
hedge that risk. When the swap component starts on 31 October 2021, R will de-
 designate the derivative.

7I.7.180.210 To assess effectiveness, R measures the change in the theoretical

proceeds cash flow up to 31 October 2021 and discounts that change assuming the
cash settlement of that amount occurs on 31 December 2021 (when the forecast
issuance is actually expected to occur). Therefore, ineffectiveness will result from
the time value of money from 31 October 2021 to 31 December 2021.

7I.7.190 Hedging a proportion

7I.7.190.10 The term ‘portion’ (see 7I.7.180.10) should be distinguished from the term
‘proportion’, the latter being used to indicate a certain percentage only.

7I.7.190.20 It is possible to designate a proportion of the cash flows, fair value or net investment
as a hedged item – e.g. 85 percent of the exposure. However, once a partial designation is made,
hedge effectiveness is measured on the basis of the hedged exposure. Considering effectiveness on
the basis of changes in the fair value or cash flows associated with the full underlying, or a
proportion different from that designated as the hedged item – to maximise effectiveness – is not
permitted. [IAS 39.81, AG107A]

7I.7.190.30 If a proportion of the cash flows or fair value of a financial asset or financial liability is
designated as the hedged item, then that designated proportion needs to be less than the total cash
flows of the asset or liability. [IAS 39.AG99C]

7I.7.200 Hedging a group of items

7I.7.200.10 The hedged item can be a portfolio of similar assets, liabilities, highly probable
forecast transactions or net investments in foreign operations. Only ‘similar’ items may be grouped
together in a portfolio. Items are considered to be similar if:
• they share the hedged risk; and
• the change in fair value attributable to the hedged risk for each individual item is expected to be
approximately proportional to the overall change in the fair value of the portfolio attributable to
the hedged risk. [IAS 39.83, BC176]

7I.7.200.20 However, it is not necessary that each item in the portfolio share all of the same risks
and be correlated with respect to all risks, as long as the hedged risk is a common risk characteristic.
For example, in our view a portfolio of interest-bearing receivables may be hedged for benchmark
interest rate exposure because, although each receivable in the portfolio has a different credit risk
exposure, the receivables all carry a similar exposure to benchmark interest rates. [IAS 39.83, IG.F.6.2]

7I.7.200.30 An entity can group more than one net investment in foreign operations together as
the hedged item, provided that such investments are denominated in the same currency.

7I.7.200.40 An example of a portfolio that would not qualify as a hedged item is a portfolio of
different securities that replicates a particular share index. An entity may hold such a portfolio and
economically hedge it with a put option on the share index. However, in this scenario the fair value
changes of individual items in the portfolio would not be approximately proportional to the fair value
change of the entire group. Therefore, the portfolio does not qualify for hedge accounting. However,
as an alternative to hedge accounting, the financial instruments comprising the portfolio could be
designated as at FVTPL (see 7I.4.40). [IAS 39.IG.F.2.20]

7I.7.200.50 Generally, when items are grouped together and designated as a portfolio in a
hedging relationship, the portfolio in its entirety comprises the hedged item – i.e. all of the financial
assets or financial liabilities included in the portfolio are included in the hedging relationship in their
entirety for the risk being hedged. However, in the case of a portfolio hedge of interest rate risk, the
hedged item may comprise a portion of the portfolio of financial assets or financial liabilities that
share the risk being hedged (see 7I.7.210). [IAS 39.78, 81A]

7I.7.200.60 The following are examples of items that may be designated as a portfolio for hedge
accounting.
• A portfolio of short-term non-callable corporate bonds may be hedged as one portfolio with
respect to a shared risk-free interest rate. To achieve the required correlation, the bonds would
need to have the same or very similar maturity or repricing date and exposure to the same
underlying interest rate.
• A group of expected future sales may be hedged as one portfolio with respect to foreign currency
risk. Usually, such a designation requires the individual sales to be denominated in the same
currency and be expected to take place in the same time period (see 7I.7.710.50).

7I.7.200.70 To identify a group of transactions, an entity is required to identify the hedged

transactions with sufficient specificity so that it is possible to determine which transactions are the
hedged transactions when they occur. This can be done either by specifying the number of units
expected to be purchased/sold – e.g. the first 500 units out of expected purchases/sales of 800 units –
or by specifying the monetary value of the purchases or sales – e.g. the first 25 of foreign currency
sales in March 2021 (see 7I.7.720). It is not permitted to designate the first 50 percent of sales as the
hedged item because this designation would not lead to an identifiable amount being hedged – i.e.
the first 50 percent of sales would depend on the total amount of sales in the period – which is not
known until after the fact.

7I.7.210 Portfolio fair value hedges of interest rate risk

7I.7.210.10 Entities, banks in particular, often manage interest rate risk on a portfolio basis – e.g.
for a portfolio of mortgage loans or vehicle financing arrangements. Such hedging practices,
whereby an entity hedges its net exposures, do not generally qualify for hedge accounting. However,
an entity is permitted to designate the interest rate exposure of a portfolio of financial assets or
financial liabilities as the hedged item in a portfolio fair value hedge. The hedged item is designated
in terms of an amount of currency rather than as individual assets or liabilities. Although the
portfolio may – for risk management purposes – include only assets, only liabilities or both assets and
liabilities, the amount designated is an amount of assets or an amount of liabilities. Designation of a
net amount – comprising both assets and liabilities – is not permitted. The entity may hedge a portion
of the interest rate risk associated with the designated amount. [IAS 39.78, 81A, AG114(c), AG116, AG118]

7I.7.210.20 The portfolio fair value hedge model accommodates prepayment risk more readily
than the normal fair value hedge model for individual assets or liabilities. However, the model can be
applied only for hedges of interest rate risk and cannot be used for other risk types – e.g. foreign
currency risk. Under the portfolio fair value hedge model, prepayable items are scheduled into
repricing time periods based on expected, rather than contractual, repricing dates. This captures the
effect of prepayments and consequently there is no need to assess separately the impact of
prepayment risk on the fair value of the portfolio. [IAS 39.81A, AG114(b)]

7I.7.210.30 Because under this hedging model the hedged item is designated as an amount of
currency, all the assets or liabilities from which the hedged item is derived should be items whose
fair value changes in response to changes in the interest rate being hedged and items that could
have qualified for fair value hedge accounting if they had been designated as hedged items
individually. In particular, because the fair value of a financial liability with a demand feature (such
as demand deposits and some types of time deposits) is not less than the amount payable on demand,
discounted from the first date on which the amount could be required to be paid (see 2.4.420), such
an item cannot qualify for hedge accounting for any time period beyond the shortest period in which
the holder can demand payment. For example, because the fair value of a liability that is repayable
immediately on demand is usually equal to the amount payable on demand, there is no fair value
exposure to hedge because the fair value of such a deposit is unaffected by interest rates and does
not change when interest rates change. [IFRS 13.47, AG118(b), BC187(d)]

7I.7.210.40 The standard provides specific guidance on the measurement of effectiveness for
such a hedging relationship, as well as the presentation of the fair value adjustment and its
subsequent amortisation to profit or loss. However, because a single method for assessing hedge
effectiveness is not specified (see 7I.7.530), in our view such specific guidance does not preclude the
use of regression analysis for testing the effectiveness (see 7I.7.560) of such macro fair value
hedges. [IAS 39.AG126–AG127]

7I.7.210.50 In the event that the hedged prepayable items are subject to a prepayment penalty
that represents the difference between the fair value of the hedged item and its carrying amount, in
our view it is acceptable to schedule the hedged items based on contractual repricing dates. The
penalty has the effect of eliminating all fair value exposures arising from prepayment risk.

7I.7.210.60 For a fair value hedge of the interest rate exposure arising from a portion of a
portfolio of financial assets or financial liabilities, the gain or loss attributable to the hedged item
may be presented as a single separate line item within assets or liabilities depending on whether the
hedged item is an asset or a liability for that particular repricing time period. If amortising this gain
or loss using a recalculated effective interest rate is impracticable, then it is amortised using a
straight-line method (see 7I.7.680.100). [IAS 39.89A]

7I.7.220 Net positions

7I.7.220.10 Many entities use net position hedging strategies under which a centralised treasury
function accumulates risk originated in the operational subsidiaries or divisions. The treasury
function hedges the net exposure in accordance with the group’s risk policies by entering into a
hedging transaction with a party external to the group.

7I.7.220.20 Net position hedging does not by itself qualify for hedge accounting treatment
because of the inability to:
• associate hedging gains and losses with a specific item being hedged when measuring
effectiveness; and
• determine the period in which such gains and losses should be recognised in profit or loss. [IAS
39.84]

7I.7.220.30 However, an entity is not necessarily precluded from hedge accounting by hedging
net positions. That is, an entity may choose to manage and (economically) hedge risk on a net basis,
but for hedge accounting purposes designate a specific item within the net position as the hedged
item. For example, if an entity has 100 assets and 90 liabilities with risks and terms of a similar
nature, it can designate 10 of the assets as the hedged item. [IAS 39.AG101]

7I.7.230 Highly probable forecast transactions

7I.7.230.10 Forecast transactions should be highly probable and should present an exposure to
variations in cash flows that could ultimately affect profit or loss. [IAS 39.88(c)]

7I.7.230.20 In our view, for a forecast transaction to be considered highly probable, there should
be at least a 90 percent probability of the transaction occurring. In assessing whether a transaction
is highly probable, consideration should be given to uncertainty over both the timing and magnitude
of the forecast transaction and the facts and circumstances, including:
• the quality of the budgeting processes;
• the extent and frequency of similar transactions in the past;
• whether previous similar expected cash flows actually occurred;
• the availability of adequate resources to finish the transaction;
• the impact on operations if the transaction does not occur;
• the possibility of different transactions being used to achieve the same purpose;
• how far into the future the transaction is expected to occur; and
• the quantity of anticipated transactions. [IAS 39.88(c), IG.F.2.4, IG.F.3.7, IU 03-19]
7I.7.230.30 Normally it is possible to meet the highly probable criterion if significant similar
transactions are expected and hedge accounting is limited to a percentage of these forecast
transactions. For example, the hedged item may be designated as the first 80 of anticipated sales of
approximately 100 expected in March 2021, because it is highly probable that 80 percent of the
anticipated sales will be made. However, if the hedged item is designated as 100 of anticipated sales
of 100 in March 2021, then it is unlikely that the highly probable criterion will be met. [IAS 39.IG.F.3.7]

7I.7.230.40 In our view, the highly probable criterion might not be met when an entity purchases
an option as a hedge of a particular foreign currency because it has made a bid for a large contract in
that foreign currency. For example, if it is not highly probable that the entity will win the bid for the
contract, then the foreign currency cash flows would not be highly probable because they are
dependent on the probability of the entity winning the bid for the contract.

7I.7.230.50 In our view, it is more likely that a large number of homogenous forecast transactions
will meet the highly probable criterion than a single forecast transaction. When determining whether
a single forecast transaction meets this criterion, an entity considers the facts and circumstances
that influence the probability of occurrence of the transaction. Indicators that may suggest that a
forecast transaction is not highly probable may be an illiquid market in which the forecast
transaction takes place, a low number of transactions, no past experience of the entity with such
transactions or historical experience that such transactions do not occur often.

EXAMPLE 10 – HIGHLY PROBABLE HOMOGENEOUS FORECAST TRANSACTIONS

7I.7.230.60 Bank B enters into fixed rate mortgage loan commitments with
potential customers. Such commitments give the customer 90 days to lock in a
mortgage at a discounted variable rate. To reduce the interest rate risk inherent in
the anticipated mortgage transactions, B enters into forward-starting interest rate
swaps based on the expected acceptances.

7I.7.230.65 When evaluating the probability of acceptance by only a single

customer, a high probability would be difficult to demonstrate. However, when
evaluating the probability of a group of commitments, it is possible that B can
estimate with high probability the amount of mortgages that eventually will be
closed. Therefore, B could use cash flow hedge accounting for the hedge of interest
rate risk on the amount of mortgages that are highly probable of being closed.

7I.7.230.70 Similarly, when designating assets or liabilities with prepayment risk in a cash flow
hedge, assessing the probability of interest cash flows arising from the entire portfolio rather than
for a single instrument could result in identifying a bottom layer of interest cash flows that then
could be considered as highly probable.

7I.7.230.80 An entity should be careful in its designation of forecast transactions as hedged

items, because a history of such forecast transactions not occurring when expected could jeopardise
its ability to continue to designate these types of hedges in the future. [IAS 39.IG.F.3.7]

7I.7.240 Defining period in which forecast transaction expected to occur

7I.7.240.10 The standard does not specify a timeframe in which the forecast transaction should
occur, although it should be expected to occur within a ‘reasonable, specific and generally narrow
range of time’. The forecast transaction should be identified and documented with sufficient
specificity so that when the transaction occurs it is clear whether the transaction is the hedged
transaction. An entity is not required to predict and document the exact date on which a forecast
transaction is expected to occur, but the documentation should identify a time period in which the
forecast transaction is expected to occur within a reasonably specific and narrow range, as a basis
for assessing hedge effectiveness. [IAS 39.IG.F.3.11]
7I.7.240.20 In determining appropriate time periods for hedge accounting purposes an entity
may look to the following.
• Forecasts and budgets: An entity would not generally identify longer time periods for hedge
accounting purposes than those used for forecasting and budgeting.
• The nature of the business or industry: The forecasting and budgeting periods used by an entity
are influenced by its ability to reliably forecast the timing of its transactions. Generally, the
forecast periods for manufacturers of ships or aircraft would be longer than those of retail stores.
Usually, retailers sell smaller items in large quantities and can forecast more easily the timing of
sales over shorter periods of time.

7I.7.240.30 Although the factors in 7I.7.240.20 provide an indication of what may be the
appropriate time period in which the transaction is expected to occur, the actual time period is
always determined on a case-by-case basis and will involve some degree of judgement. Generally, the
sooner that the anticipated transaction is expected to occur, the easier it will be to demonstrate that
the highly probable criterion is met. [IAS 39.IG.F.3.7]

7I.7.240.40 In our view, some delay in the occurrence of a highly probable forecast transaction is
acceptable as long as the transaction is considered to be the same forecast transaction – i.e. the
transaction that subsequently happens is clearly identifiable as the original forecast transaction.
Therefore, the subsequent transaction should have the same specifications as the originally forecast
transaction. It would not be appropriate, for example, for a retailer to designate as the hedged item
the first 50 of foreign currency sales in January and when this does not happen to argue that it is
highly probable that there will be 50 of additional foreign currency sales in February to replace the
lost sales in January. In such a case, there would be a forecast error regarding the 50 sales in January
– i.e. these sales would be considered ‘no longer expected to occur’ – which means that hedge
accounting would be terminated (see 7I.7.680). However, if a shipbuilder has a highly probable
forecast sale of a specified ship to a particular customer but the expected delivery date moves from
January to February, then it may be possible to continue hedge accounting because of the specific
nature of the hedged forecast cash flow (see 7I.7.690).

7I.7.240.50 If the hedged item is a series of forecast transactions, then the hedged item is
identified and documented with sufficient specificity in terms of timing and magnitude so that when
the transaction occurs it is clear that it is the hedged transaction. For this reason, the documentation
should specify that the hedged item is an identifiable portion of a series of transactions that will
occur in a specified period. It is not acceptable to designate solely a percentage of transactions in a
period, or the last in a series of transactions, as the hedged item because these cannot be identified
specifically when they occur. For example, the hedged item may be designated as the first 20,000 of
anticipated foreign currency sales in March 2021, but not as 20,000 of anticipated foreign currency
sales in March 2021. As another example, the hedged item is not permitted to be designated as 20
percent of anticipated foreign currency sales over the 2021 financial year. [IAS 39.IG.F.3.10, IU 03-19]

7I.7.250 Expected interest cash flows

7I.7.250.10 To meet the hedge accounting criteria, a forecast debt issue should be highly
probable. This could be the case once the entity enters into an agreement to issue the debt, but may
be evidenced at an earlier stage when management decides on a debt issue as part of its funding
strategy.

7I.7.250.20 An entity may apply cash flow hedge accounting to an anticipated debt issue because
changes in interest rates between the date of deciding on the debt issue and the actual issue date
will influence the rate at which the debt will be issued or the discount or premium that will apply to
the proceeds. For example, if the long-term interest rate were to increase, then the debt would be
issued at a higher rate or for lower proceeds than anticipated originally.

7I.7.250.30 Normally a gain or loss on an appropriate hedging instrument will offset the
higher/lower interest rate or the decrease/increase in proceeds. Using the cash flow hedge model,
the effective portion of the gains or losses resulting from the hedging instrument until the debt is
issued will be recognised in OCI. On issuance of the debt, such gains and losses will remain in equity
and be reclassified to profit or loss in the same periods in which the hedged forecast cash flows affect
profit or loss – i.e. when the interest expense is recognised. This will require the entity to track the
amount of gains or losses recognised in OCI to ensure that the correct amounts are reclassified to
profit or loss at the correct times.

EXAMPLE 11A – HEDGE OF FORECAST INTEREST PAYMENTS

7I.7.250.40 Company K is in the process of issuing a bond. K wishes to hedge the

risk of changes in interest rates between the time it decides to issue the bond and
the date of issue. This could be done using an interest future or other derivative
instruments. To the extent that the hedge is effective, the gain or loss on the
derivative will be recognised in OCI. This gain or loss will remain in equity and will
be reclassified to profit or loss as interest payments on the bond affect profit or loss
and will effectively adjust the interest expense recognised on the bond.

EXAMPLE 11B – HEDGE OF FORECAST INTEREST PAYMENTS – MULTIPLE TRANCHES

7I.7.250.50 Company M plans to issue two tranches of floating rate notes, each
with a maturity of three years. M intends to issue the second tranche on maturity of
the first. In this situation, M may enter into a six-year swap to hedge the variability
in expected interest cash flows on both note issues. For hedge accounting purposes,
the hedge could be designated as a hedge of the expected interest payments in
different periods, including interest payments arising from the forecast refinancing
of the debt. To qualify for hedge accounting, at inception of the hedge the criteria
for hedge accounting need to be met, including the criteria that:
• the hedge will be highly effective; and
• the second issue after three years is highly probable.

7I.7.250.60 In our view, in order for a forecast issue of debt to qualify for hedge accounting, all of
its critical terms should be highly probable. For example, an entity with a euro functional currency
may have a highly probable bond issue, but the currency of issue may not have been determined. If
the entity issues the bond in US dollars, then it will enter into a currency swap to convert the cash
flows to euro. However, regardless of the currency in which the bond is issued, the entity wishes to
hedge its euro interest rate exposure using an interest rate swap. In our view, because the currency
denomination of the forecast bond is not highly probable, the forecast bond issue cannot qualify for
hedge accounting. Similarly, it will not be possible to achieve hedge accounting for forecast issues of
commercial paper unless the currency and maturity (including rollovers) of the future issues can be
determined reliably.

7I.7.260 Prepayment risk

7I.7.260.10 Prepayment risk may also affect whether a forecast transaction designated in a cash
flow hedge is considered highly probable to occur. However, when the hedged item is designated as
the first cash flows of a portfolio occurring in a given period, the effect of a prepayment is less likely
to cause the hedged forecast transactions not to be highly probable as long as there are sufficient
cash flows in the period. This could be demonstrated by the entity preparing a cash flow maturity
schedule that shows sufficient levels of expected cash flows in each period to support a highly
probable assertion. For example, a bank may be able to determine accurately what levels of
prepayments are expected for a particular class of its originated loans. The bank might hedge only a
portion of the contractual cash flows from that portfolio of loans because it expects a number of
borrowers to repay their loans early.
7I.7.265 Cash flow hedges of firm commitments to acquire a business and
forecast business combinations

7I.7.265.10 A firm commitment to acquire a business in a business combination can be a hedged

item only for foreign exchange risk because other risks cannot be specifically identified and
measured. In our view, an entity may also hedge the foreign exchange risk of a highly probable
forecast business combination. In our view, in the consolidated financial statements, a cash flow
hedge of the foreign exchange risk of a firm commitment to acquire a business or a forecast business
combination relates to the foreign currency equivalent of the consideration paid. [IAS 39.AG98]

7I.7.265.20 In a cash flow hedge designation, the effective portion of the gain or loss arising from
the hedging instrument is recognised in OCI. However, an issue arises about when and how this
amount accumulated in equity is reclassified to profit or loss. The answer depends on whether the
hedge represents a hedge of a non-financial item or a financial item.

7I.7.265.30 In our view, a hedge of a firm commitment to acquire a business or a forecast

business combination that will be effected through the acquisition of the assets and liabilities – that
comprise the business rather than the acquisition of an equity interest in the entity – should be
accounted for as a hedge of a non-financial item because the legal form of the transaction does not
involve the acquisition of a financial asset.

7I.7.265.40 In our view, because a hedge of a firm commitment to acquire a business or forecast
business combination relates to the foreign currency equivalent of the consideration paid, the
acquisition of an equity interest in the entity may be viewed as either a hedge of the purchase of
shares of an entity or a hedge of the purchase of a business. A hedge of the purchase of shares
represents a hedge of a financial item, whereas a hedge of the purchase of a business represents a
hedge of a non-financial item. Therefore, we believe that an entity should choose an accounting
policy, to be applied consistently, on whether such hedges are considered hedges of a financial item
or non-financial item.

7I.7.265.50 For hedges of a financial item, the accounting for the reclassification from equity to
profit or loss is complicated by the fact that the shares acquired are not recognised in the
consolidated financial statements and therefore will never directly impact profit or loss. However, for
hedges of financial and non-financial items, the effective portion of the gain or loss arising from the
hedging instrument relates to the foreign currency equivalent of the consideration paid. Therefore,
reclassification of the effective portion of the gain or loss arising from the hedging instrument from
equity to profit or loss occurs when the residual (i.e. goodwill) arising from the business combination
affects profit or loss.

7I.7.265.60 In our view, if the hedge is a hedge of a financial item, then the entity should retain
the gain or loss from the hedging instrument recognised in OCI as a separate component of equity
until the goodwill from the hedged business combination in part or in full affects profit or loss – e.g.
through transactions such as impairment of goodwill or sale of the business acquired. When the
goodwill from the hedged business combination affects profit or loss, all or a portion of the gain or
loss recognised in OCI should be reclassified to profit or loss.

7I.7.265.70 In our view, if the hedge is a hedge of a non-financial item, then the entity should
choose an accounting policy, to be applied consistently, to apply a basis adjustment (see 7I.7.80.70)
in respect of a transaction that results in the acquisition of a non-financial item. Therefore, the entity
may either apply the principles outlined in 7I.7.265.60 similar to the accounting for a financial item
or recognise the gain or loss from the hedging instrument recognised in OCI as an adjustment to
goodwill when the business combination occurs.

7I.7.270 ITEMS THAT DO NOT QUALIFY AS HEDGED ITEMS

7I.7.270.10 There are a number of items that for different reasons do not qualify for hedge
accounting. In these cases, the normal recognition and measurement principles of the Standards are
applied.

7I.7.280 Derivatives

7I.7.280.10 Derivatives are generally precluded from being the hedged item. Therefore,
derivatives can generally serve only as hedging instruments. An exception to this is a purchased
option that is embedded in another financial instrument and that is closely related to the host
contract (see 7I.2.200) such that it is not separately accounted for as a derivative. In this case, it is
possible to designate the embedded derivative as the hedged item in a fair value hedge, with a
written option as the hedging instrument. [IAS 39.AG94, IG.F.2.1]

7I.7.290 Own equity instruments

7I.7.290.10 An entity’s own equity instruments cannot be the hedged item because there is no
risk exposure that affects profit or loss because transactions in own shares are recognised directly in
equity. Likewise, forecast transactions in an entity’s own equity cannot be a hedged item and neither
can distributions to holders of the entity’s equity instruments. However, a dividend that has been
declared but not yet paid and is recognised as a financial liability may qualify as a hedged item – e.g.
for foreign currency risk if it is denominated in a foreign currency. [IAS 39.86, IG.F.2.7]

7I.7.300 Dividends

7I.7.300.10 Entities might also wish to hedge anticipated dividends from foreign operations.
However, expected dividends do not give rise to an exposure that will be recognised in profit or loss
in the consolidated financial statements. Therefore, these cannot be hedged in a cash flow hedge or a
net investment hedge in the consolidated financial statements. It is only once dividends are declared
and become a receivable that hedge accounting may be applied in the consolidated financial
statements. For example, dividends declared and receivable from a foreign subsidiary may be
hedged for foreign currency risk because changes in foreign exchange rates would affect
consolidated profit or loss.

7I.7.305 Exposures within associate or joint venture

7I.7.305.10 In our view, an investor in an associate or a joint venture cannot hedge an exposure
that exists within the associate or joint venture. That is because the potential hedged item is not a
forecast transaction or recognised asset or liability of the investor. The investor’s equity ownership
represents shared ownership of the associate or joint venture’s net assets and liabilities, and the
investor cannot look through to the associate or joint venture’s individual assets or liabilities and
designate one of them as the hedged item.

EXAMPLE 12 – EQUITY-ACCOUNTED INVESTEES

7I.7.305.20 Company R is an investor in Joint Venture J. J issues IBOR-based

variable rate debt. R cannot designate a cash flow hedge of J’s variable rate debt
because the potential hedged item is not a forecast transaction or a recognised
asset or liability of R. R does not have any direct exposure to J’s variable rate debt.
Similarly, the impact of the debt interest payments is indirect on R’s profit or loss
because the impact is netted with the other results of J through R’s application of
the equity method. [IAS 39.86]

7I.7.310 QUALIFYING HEDGING INSTRUMENTS

7I.7.310.10 All derivatives, including separable embedded derivatives, can qualify as hedging
instruments, with the following limitations.
• Written options may be designated as hedging instruments only for hedges of purchased options
(see 7I.7.340).
• A derivative may not be designated as a hedging instrument for only a portion of its remaining
period to maturity.
• Derivatives are generally designated as hedging instruments in their entirety. Except as noted in
7I.7.310.20, it is not permitted to designate only certain components of a derivative as a hedging
instrument. For example, the foreign currency component of a cross-currency swap may not be
designated as the hedging instrument without the interest rate component of the swap also being
designated in the same or another qualifying hedging relationship. However, a proportion of the
entire hedging instrument may be designated as the hedging instrument (see 7I.7.360). [IAS 39.72,
74–75, AG94]

7I.7.310.20 There are two exceptions from the requirement not to split the components of
derivative hedging instruments:
• separating the intrinsic value and time value of an option; and
• separating the interest element and the spot price element in a forward. [IAS 39.74]
7I.7.310.30 The following uses of hedging instruments are permitted:
• designating a derivative as a hedging instrument subsequent to its initial recognition;
• designating two or more derivatives in combination as the hedging instrument, as long as none of
the derivatives is a written option (see 7I.7.340.40);
• designating two or more non-derivatives, or a combination of derivatives and non-derivatives (see
7I.7.830.40), as a hedge of foreign currency risk;
• replacing or rolling over a hedging instrument at its maturity, if the replacement or rollover is
planned and documented at inception of the hedging relationship;
• designating a derivative with an external party that offsets an internal derivative as a hedging
instrument (see 7I.7.850);
• applying hedge accounting in the consolidated financial statements to a derivative entered into by
a group entity different from the one that has the risk exposure (see 7I.7.840); and
• applying hedge accounting to a derivative even though that derivative is fully offset by another
derivative with equal but opposite terms, as long as the second instrument was not entered into in
contemplation of the first or there is a substantive business purpose for entering into both
instruments in separate transactions (see 7I.7.860.40). [IAS 39.74–77, IG.F.1.12–IG.F.1.14, IG.F.3.9]

7I.7.310.40 Non-derivatives may be designated as hedging instruments for hedges of foreign

currency risk only. [IAS 39.72]

7I.7.320 Purchased options

7I.7.320.10 Purchased options may be used as hedging instruments provided that the hedge
accounting criteria are met. Options, in contrast to forward and futures contracts, contain both an
intrinsic value and a time value. [IAS 39.AG94]

7I.7.320.20 The cash flows of forecast transactions do not generally include a time value
component but options do – e.g. a forecast transaction in a foreign currency that is hedged with an
option. If the option is designated in its entirety (including time value), then effectiveness testing is
based on comparing the full fair value change of the option and the present value of the change in
cash flows of the forecast transaction (see 7I.7.600). The change in fair value of the option and the
change in the present value of the cash flows of the forecast transaction will not be the same because
the change in the time value element of the option is not offset by an equal and opposite change in
the cash flows of the forecast transaction. [IAS 39.AG99BA]

7I.7.320.30 The time value of an option may be excluded from the hedging relationship. In this
case, the option is more likely to be an effective hedge if the hedging relationship excludes time
value and effectiveness is measured based on changes in intrinsic value alone. Designating only the
changes in the intrinsic value of an option as a hedging instrument in the hedge of a one-sided risk in
a hedged item may achieve perfect hedge effectiveness if the principal terms of the hedged item (i.e.
amount, maturity etc) and the hedging instrument are the same. However, this results in changes in
the time value of the option being recognised directly in profit or loss regardless of the hedging
model used (see 7I.7.600.20). [IAS 39.74, AG99BA]

7I.7.320.40 In our view, either the spot or the forward price/rate can be used in determining the
intrinsic value of an option. However, the approach should be specified as part of the hedge
documentation and applied consistently during the term of the hedge. Furthermore, if the forward
rate is used for determining the fair value of an American-style option, then the rate should be
determined using the option’s maturity date.

7I.7.330 Dynamic hedging strategies

7I.7.330.10 An entity may apply ‘delta-neutral’ hedging strategies and other dynamic strategies
under which the quantity of the hedging instrument is constantly adjusted to maintain a desired
hedge ratio. This may include a dynamic hedging strategy that assesses both the intrinsic value and
the time value of an option contract. To qualify for hedge accounting, the entity documents how it
will monitor and update the hedge and measure hedge effectiveness, properly track all terminations
and redesignations of the hedging instruments and demonstrate that all other hedge accounting
criteria are met (see 7I.7.120), including the requirement that the hedging instruments are
designated for the whole time period that they remain outstanding. An entity is also required to be
able to demonstrate an expectation that the hedge will be highly effective for a specified short period
of time during which the hedge is not expected to be adjusted. Accordingly, an entity documents that
under such dynamic strategies both prospective and retrospective effectiveness are assessed over
these short periods as if each of these short periods were a separate hedging relationship. In our
view, when the quantity of the hedging instrument is adjusted, such as a change in the proportion of
the derivative instrument designated as the hedging instrument or the addition of or deletion from a
group of hedging derivatives (other than documented rollovers and replacements (see
7I.7.680.90–95)), then the existing hedging relationship should generally be discontinued
prospectively. [IAS 39.74–75, 91(a), 101(a), IG.F.1.9]

7I.7.330.20 In our view, an entity is not precluded from designating a dynamic hedging strategy
under which, to maintain a desired hedge ratio, the quantity of the designated hedged item rather
than the quantity of the hedging instruments is adjusted. For example, an entity has designated a
forecast foreign currency transaction as the hedged item in a cash flow hedging relationship. The
hedged risk is the variability in the cash flows arising from movements in the spot foreign exchange
rate and the hedging instrument is a foreign currency option. The entity designates a dynamic
hedging relationship under which the designated amount of the hedged item is adjusted each week
based on weekly changes in the delta of the foreign currency option. Each time the hedged item is
adjusted, the existing hedging relationship is generally terminated and a new hedging relationship is
designated. Under this approach, effectiveness is assessed separately for each weekly period and
ineffectiveness is recognised to the extent that the change in the fair value of the option over this
period is greater than the change in present value of the hedged cash flows. The present value of the
hedged cash flows is based on their expected settlement dates.

7I.7.340 Written options

7I.7.340.10 The potential loss on an option that an entity writes could be significantly greater
than the potential gain in the fair value of the related hedged item. In other words, a written option is
not effective in reducing the profit or loss exposure of a hedged item and therefore does not qualify
as a hedging instrument unless it is designated as an offset of a closely related purchased option that
is embedded in, and not separated from, a host contract. If the embedded purchased option is
separated, then hedge accounting would be unnecessary because both the separated purchased
option and the written option would be measured at FVTPL. [IAS 39.AG94]

7I.7.340.20 In our view, a combined hedging instrument that is created in a single transaction
with the same counterparty and that is made up of a number of components that are not separately
transferable may be designated as a hedging instrument, even if one of the components is a written
option – e.g. a zero-cost collar created in a single transaction with the same counterparty – as long as
the combination of derivative components does not result in a net written option. [IAS 39.77, IG.F.1.3]

7I.7.340.30 Consequently, an interest rate collar or other single derivative instrument that
includes a written option component and a purchased option component can be designated as a
hedging instrument as long as the instrument is a net purchased option or zero-cost collar, as
opposed to a net written option. The following are considered in determining whether a combination
of derivatives constitutes a net written option.
• No net premium is received either at inception or over the life of the combination. If a premium is
received, then it would be evidence that the instrument is a net written option because it serves to
compensate the writer of the option for the risk incurred.
• The option components have similar critical terms and conditions and, with the exception of strike
prices, the same underlying variable or variables, currency, denomination and maturity.
• The notional amount of the written option component is not greater than the notional amount of
the purchased option component. [IAS 39.IG.F.1.3]

7I.7.340.40 An entity is not permitted to designate as the hedging instrument a combination of

derivatives, concluded in separate transactions, that includes a written option or a net written option
even if the result of such a grouping is economically equivalent to entering into a net purchased
option or a zero-cost collar. For example, a zero-cost collar that is created synthetically by entering
into a cap in one transaction and a floor in a separate transaction would not qualify as a hedging
instrument. [IAS 39.77]

7I.7.350 Non-derivatives

7I.7.350.10 Only for foreign currency hedges, the hedging instrument may be:
• a loan or receivable;
• a held-to-maturity investment;
• an available-for-sale monetary asset; or
• a financial liability or a cash balance. [IAS 39.72, AG95]

7I.7.350.15 However, a foreign currency firm commitment or forecast transaction does not
qualify as a hedging instrument because it is neither a derivative nor a non-derivative financial asset
or liability. [IAS 39.IG.F.1.2]

EXAMPLE 13 – NON-DERIVATIVES CAN ONLY HEDGE FOREIGN CURRENCY RISK

7I.7.350.20 Company J has the yen as its functional currency and has a fixed
interest rate US dollar borrowing. The borrowing may be designated as a hedge of
the foreign exchange exposure on a net investment in a US dollar foreign operation
or a US dollar sales commitment. However, the US dollar borrowing may not be
designated as a hedge of the interest and foreign currency exposure on a fixed rate
US dollar debt security or the entire fair value exposure on a US dollar sales
commitment. This is because non-derivatives qualify as hedges of foreign currency
risk only. [IAS 39.IG.F.1.1–IG.F.1.2]

7I.7.350.30 In a foreign currency hedge, the currency of the hedging instrument and the
currency of the hedged item should be the same or it should be possible to demonstrate a high
degree of correlation between the two currencies. Therefore, extending Example 13, the US dollar
borrowing may not be designated as a hedge of a euro sales commitment unless a very strong
correlation between the US dollar and the euro can be demonstrated.

7I.7.350.40 A combination of derivatives and non-derivatives, or proportions thereof, may be

used as the hedging instrument in a hedge of foreign currency risk (see 7I.7.830.40). [IAS 39.77]

7I.7.350.50 In our view, a lessor’s right to receive future operating lease payments cannot be
designated as a hedging instrument for a hedge of foreign currency risk. This is because the right to
receive payments under an operating lease is not a recognised financial asset that could qualify as a
hedging instrument for a hedge of foreign currency risk except for any individual rental payments
currently due and payable by the lessee. We believe a lessor’s recognised finance lease receivable
can qualify as a hedging instrument of foreign currency risk even though finance lease receivables
otherwise are outside the scope of IAS 39 (or IFRS 9, if applicable), provided that all hedge
accounting requirements are met (see 7I.7.120). [IAS 32.AG9]

7I.7.350.60 Similarly, in our view a lessee’s recognised lease payable can qualify as a hedging
instrument of foreign currency risk even though it is not generally in the scope of IAS 39 (or IFRS 9),
provided that all hedge accounting requirements are met as set out in 7I.7.120. A recognised lease
payable denominated in a foreign currency is a monetary item that is remeasured under IAS 21,
similar to a foreign currency financial liability under IAS 39 (or IFRS 9, if applicable). [IAS 32.AG9]

7I.7.350.70 In our view, a financial liability arising from an entity’s obligation to repurchase its
own equity instruments does not qualify as a hedging instrument. The ability to use non-derivative
items as hedging instruments is restricted to cash instruments. In this case, even though the
repurchase obligation is measured at amortised cost as if it were a non-derivative financial liability,
the instrument is in fact a derivative instrument and not a cash instrument. [IAS 39.72, BC144–BC145]

7I.7.360 Proportion of an instrument

7I.7.360.10 A proportion of a financial instrument may be designated as the hedging instrument.

For example, 50 percent of the notional amount of a forward contract may be designated as the
hedging instrument in a cash flow hedge of a highly probable forecast sale. Gains or losses on the
proportion of the derivative financial instrument not designated as the hedging instrument are
recognised immediately in profit or loss. [IAS 39.75]

7I.7.370 Designation for entire period

7I.7.370.10 Derivatives and non-derivatives are designated as hedging instruments for the entire
period for which they are outstanding because the entire fair value of the hedging instrument is
considered when assessing the effectiveness of the hedge. For example, a pay-fixed receive-floating
interest rate swap with a maturity of 10 years cannot be designated as a hedging instrument of a
floating rate bond for just the first eight years by using the eight-year yield curve to measure the
changes in the fair value of the swap when assessing hedge effectiveness. Such a method would
allow an entity to exclude part of the hedging instrument’s fair value, which is not allowed. Hedge
designation would, however, be permitted in this case if the derivative were designated as the
hedging instrument in its entirety – i.e. the changes in the fair value of the swap are computed using
all of its cash flows based on the 10-year yield curve when assessing hedge effectiveness. However,
such a strategy would lead to ineffectiveness and may also result in hedge accounting being
precluded if the hedging relationship is not expected to be highly effective. [IAS 39.74–75]

7I.7.370.20 It is possible to designate a derivative or non-derivative as the hedging instrument

subsequent to initial recognition provided that the fair value for the entire remaining period for
which the derivative or non-derivative remains outstanding is included when assessing hedge
effectiveness. For example, if a derivative is designated as a hedging instrument at inception – but
hedge accounting ceases because the hedge criteria are no longer met or the designation is revoked
at a later date – then it is possible to designate the derivative as the hedging instrument in another
hedging relationship at a later stage as long as the designation and assessment of hedge
effectiveness include the fair value for the entire period for which the derivative remains
outstanding.

7I.7.370.30 A derivative may be designated as the hedging instrument in a hedge of a forecast

transaction that has a maturity shorter than the remaining maturity of the hedging derivative.
Because the derivative is required to be designated for its entire remaining term to maturity, in such
a hedge there will be some ineffectiveness because of the differences in maturity dates of the hedged
item and hedging derivative. Also, the ineffectiveness may sometimes be significant so as to preclude
application of hedge accounting altogether if the hedge is assessed as not being highly effective.

7I.7.380 Basis swaps

7I.7.380.10 An entity may swap one floating rate exposure into another using basis swaps. Basis
swaps are interest rate swaps that exchange one base rate for another. For example, an entity that
issues a bond paying 12-month Euribor enters into a basis swap whereby it receives 12-month
Euribor and pays three-month Euribor, with the notional and maturity of the swap matching those of
the bond. The question arises about whether such a basis swap can be designated as a hedge of the
floating rate bond.

7I.7.380.20 Although swapping one base rate for another with a different repricing period may
eliminate some of the cash flow variation or some of the fair value variation, there is no model that
explicitly allows for hedge accounting when one floating rate is swapped into another. Because the
bond in 7I.7.380.10 has a floating rate of interest, it may be eligible for cash flow hedge accounting.
However, because the interest rate swap exchanges one floating cash flow stream into another, some
variability in cash flows remains.

7I.7.380.30 Therefore, in our view a basis swap does not generally qualify as a hedging
instrument in a cash flow hedge except in the very specific circumstances discussed in 7I.7.380.40.

7I.7.380.40 If an entity has both an asset and a liability on which it receives interest at a rate
indexed to the base rate on the pay leg (e.g. TIBOR) of the basis swap, and pays interest at a rate
equal to the base rate on the receive leg (e.g. Euribor) of the basis swap, then in our view hedge
accounting would be appropriate assuming that the other hedge criteria are satisfied. Both the
existing asset and the liability are designated as hedged items in the same hedging relationship and
both positions are considered in effectiveness testing. If the hedge fails to be highly effective in
offsetting the exposure to variability in cash flows in response to changes in the designated interest
rates on either or both of the designated asset or liability, then hedge accounting is terminated for
the entire relationship. In this case, the combined variability in cash flows arising from movements in
base rates arising from both the asset and the liability is eliminated by the basis swap. Consequently,
we believe that it is possible to designate the basis swap in a cash flow hedging relationship in this
limited circumstance. [IAS 39.IG.F.2.18]

7I.7.390 Liability bearing constant maturity interest rate

7I.7.390.10 An entity may issue instruments that have a floating rate of interest that resets
periodically according to the fixed-maturity market rate based on an instrument that has a duration
extending beyond that of the reset period (a ‘constant maturity’ interest rate) – e.g. a 10-year bond
on which the interest rate resets semi-annually to the current weighted-average yield on treasury
bonds with a 10-year maturity. The effect of this feature is that the interest rate always is equal to the
market return on an instrument with 10 years left to maturity, even as the instrument paying the
coupon itself nears maturity. To hedge its exposure to the constant maturity interest rate, an entity
may enter into an interest rate swap that pays IBOR or a similar rate and receives the constant
maturity rate.

7I.7.390.20 A question arises over whether such an interest rate swap can be designated as the
hedging instrument in a hedge of the liability – i.e. the issued floating rate instrument. First, it is
necessary to consider whether the constant maturity feature in the liability comprises a separable
embedded derivative. Only after this analysis can the appropriateness of hedge accounting for the
proposed transaction be considered.

7I.7.390.30 In our view, the constant maturity feature comprises an embedded derivative (a
‘constant maturity’ swap). This embedded derivative is not closely related to the host debt
instrument because it could potentially double the holder’s initial rate of return and could result in a
rate of return that is at least twice what the market return would be for a contract with the same
terms as the host contract, unless it has a cap at an appropriate level to prevent the doubling effect
(see 7I.2.250).

7I.7.390.40 In the absence of an appropriate cap, the entity separately accounts for a fixed rate
host debt instrument and a constant maturity swap. Because the constant maturity swap is a non-
option embedded derivative, its terms would have to be determined so as to result in a fair value of
zero at inception (see 7I.2.380.40). Both the embedded derivative and the interest rate swap will be
measured at fair value, with gains and losses recognised in profit or loss. Hedge accounting would
not be permitted in these circumstances because the interest rate swap would have to be designated
as the hedging instrument in a hedge of the separately accounted-for embedded derivative, which is
not permitted. [IAS 39.IG.F.2.1]

7I.7.390.50 However, if the terms of the liability include an appropriate cap, then the embedded
derivative is not accounted for separately and an issue arises over whether such a loan can be
hedged with an interest rate basis swap that pays IBOR and receives the same constant maturity
rate. Although the bond issued is a variable rate bond, the variable rate it pays is a constant maturity
rate. Consequently, the bond has a fair value exposure arising from the difference between the
discounting rate used to value the bond (the repricing basis) and the 10-year constant maturity rate
(the interest-rate basis). For a ‘plain vanilla’ floating rate bond, there is no such difference and
consequently no fair value exposure arising from interest rate changes. Similarly, the basis swap in
this example, being a basis swap that has a repricing basis different from its interest rate basis, also
has a fair value exposure for its entire life.

7I.7.390.60 Consequently, in our view the constant maturity bond with an appropriate interest
rate cap in 7I.7.390.50 can be designated as the hedged item in a fair value hedge of interest rate
risk with the hedging instrument being a constant maturity basis swap that also has a matching
interest rate cap, assuming that the other hedge accounting criteria are met. In such a hedging
relationship, the hedge is of the fair value exposure for the life of the hedged item and hedging
instrument, rather than of an exposure that exists only between repricing dates. Conversely, in our
view it is not possible to designate a plain vanilla floating rate bond in a fair value hedging
relationship using a plain vanilla basis swap as the hedging instrument, because neither the bond
nor the swap has a fair value exposure over its entire life. This designation is possible only when a
fair value exposure exists for the entire life of the hedged item and the instrument.

7I.7.400 Hedging zero-coupon bond with plain vanilla interest rate swap

7I.7.400.10 Zero-coupon debt instruments in the form of bonds, bills of exchange and commercial
paper are exposed to, among other risks, fair value interest rate risk. Entities may seek to hedge this
risk using plain vanilla interest rate swaps. In our view, to achieve hedge accounting in these
circumstances, an entity would need to adopt a dynamic hedging strategy.

EXAMPLE 14 – HEDGING ZERO-COUPON BOND WITH PLAIN VANILLA INTEREST RATE SWAP

7I.7.400.20 Company V acquires a one-year zero-coupon bond at 95 with a face

value (redemption amount) of 100. At the same date, V enters into a one-year
interest rate swap. The swap reprices on a quarterly basis and the interest rate on
the fixed leg of the swap is equal to the bond’s yield. Swap settlements are made
quarterly. V wishes to designate the interest rate swap as the hedging instrument in
a fair value hedge of interest rate risk arising from the bond.

7I.7.400.30 Such a designation is unlikely to be effective because there are

significant differences between the instruments and the way in which their fair
values respond to changes in market interest rates. In particular, there are only two
 cash flows on the bond (an acquisition outflow of 95 and a redemption inflow of
100), whereas there are four cash flows on the interest rate swap because interest
coupons are exchanged on a quarterly basis. Therefore, the hedge is unlikely to
meet the prospective effectiveness requirements; at any time after the first period,
the fair value change of a single cash flow of 100 at the bond’s redemption date will
not correspond to the fair value change of the three remaining interest cash flows on
the swap.

7I.7.400.40 To achieve hedge accounting in these circumstances, an entity would

need to adopt a dynamic hedging strategy. At each payment date of the swap, it
would need to adjust the hedging instrument – e.g. by designating an additional
swap into the hedging relationship. Using this strategy, the entity would need to
prove that the hedge remains effective for the period until the hedging instrument is
next adjusted. This hedging strategy would have to be documented clearly at
inception of the hedging relationship. [IAS 39.AG107]

7I.7.410 Derivatives with knock-in or knock-out features

7I.7.410.10 Except for some written options, the use of derivatives as hedging instruments is not
prohibited if the other requirements for hedge accounting are met (see 7I.7.120). Therefore, if an
entity intends to designate a derivative with a knock-in or knock-out feature as a hedging instrument,
then in our view the entity should assess whether the knock-in or knock-out feature indicates that the
instrument is a net written option for which hedge accounting is precluded (see 7I.7.340). In our
view, knock-in or knock-out features should be considered a net written option if a net premium is
received by the entity in the form of a favourable rate or other term in exchange for these features.
[IAS 39.72]

EXAMPLE 15 – DERIVATIVES WITH KNOCK-IN OR KNOCK-OUT FEATURES

7I.7.410.20 Company N enters into an arm’s length pay-6% receive-IBOR interest

rate swap under which the rights and obligations of both N and the counterparty are
extinguished if a contingent event occurs. If N had entered into an otherwise
identical interest rate swap without the knock-out feature, then the swap would
have been priced at pay-8% receive-IBOR. Unless the hedged item contains an
offsetting and closely related embedded net purchased option, N is not permitted

to designate the swap as a hedging instrument because the favourable difference

between the fixed payment legs represents a net premium that N receives over the
life of the instrument in return for writing the option (see 7I.7.340).

7I.7.410.30 Even if a derivative with a knock-in or a knock-out feature is not considered a net
written option and therefore not precluded from being designated as a hedging instrument, the
entity will have to consider whether it meets all of the hedge eligibility criteria, including the hedge
effectiveness requirements. Even when the hedge effectiveness requirements are met, significant
ineffectiveness can arise if the hedged item does not contain a similar offsetting knock-in or knock-
out feature.

7I.7.410.40 The probability of whether the knock-in or knock-out trigger conditions are met for
the hedging instrument does not affect the highly probable assessment for cash flow hedges if the
hedged item does not contain a similar offsetting knock-in or knock-out feature. This is because the
highly probable requirement applies only to the hedged item. [IAS 39.88, IG.F.5.5]
7I.7.420 QUALIFYING HEDGED RISKS

7I.7.420.10 The hedged risk is the specific financial risk of the qualifying hedged item (see
7I.7.170) that the entity is exposed to and has chosen to hedge.

7I.7.420.20 The hedged risk should be one that could affect profit or loss. For example, a hedge of
the purchase price of treasury shares could not qualify for hedge accounting because all treasury
share transactions are recognised in equity (see 7I.3.700). [IAS 39.86, AG110]

7I.7.420.30 A financial asset or liability can be hedged against exposure to any one or more of its
individual risk types that is identifiable and measurable, including market prices, interest rates or a
component of interest rates, foreign currency rates and credit risk. Conversely, a non-financial item
may be hedged with respect to either all of its risks or foreign currency risk only (see 7I.7.440). [IAS
39.81–82, IG.F.3.5]

7I.7.430 Lease payments and receipts

7I.7.430.10 Whether or not a lease payment or receipt can be designated as a hedged item differs
for lessors and lessees. Unless a lessee elects the recognition exemptions for short-term leases
and/or leases of low value assets (see 5.1.140), it recognises a right-of-use asset representing its
right to use the underlying asset and a lease liability for the present value of its obligation to make
future lease payments. The lease liability is similar to blended payments of principal and interest
under a loan. Accordingly, in our view, the lease liability recognised by a lessee for future lease
payments is a financial item even though the liability is not generally in the scope of IAS 39 (or IFRS
9, if applicable) (see 7I.1.100). Therefore, a lessee may designate the future cash flows in a lease
arrangement as the hedged item in their entirety or for a specific risk component (see 7I.7.180.40) –
e.g. for variability in cash flows arising from foreign currency exposure, a benchmark interest rate or
the inflation rate, when rentals are indexed to such a rate. [IAS 32.AG9]

7I.7.430.20 For lessors, a finance lease receivable is a financial instrument and a monetary item
subject to retranslation under IAS 21 if cash receipts are denominated in a foreign currency.
Therefore, it may designate the future cash flows receivable in a finance lease arrangement as the
hedged item in their entirety or for a specific risk component (see 7I.7.180.40). Lessors that lease a
recognised asset to a lessee under an operating lease do not recognise a lease receivable for the
entire amount of future contractual rental payments since the leased asset is not derecognised.
Accordingly, in our view an operating lease should not be regarded as a financial item by the lessor,
except that individual payments currently due and receivable with respect to the elapsed period of
the lease term for which performance has occurred are financial instruments.

EXAMPLE 16 – HEDGE OF FUTURE CASH FLOWS IN LEASE

 7I.7.430.30 A lessor may wish to designate the future cash flows in an operating
lease arrangement as the hedged item in a hedge of the variability in cash flows
arising from movements in a benchmark interest rate or the inflation rate, when
rentals are indexed to such a rate.

7I.7.430.40 Although the variability in the cash flows because of the interest or
inflation rate may be separately identifiable and reliably measurable, the lessor is
not permitted to designate the interest rate or inflation rate as the hedged risk, nor
designate a portion of the cash flows corresponding thereto since the operating
lease is a non-financial item (see 7I.7.420.30).

7I.7.430.50 Alternatively, the lessor may be able to designate the entire variability
in cash flows arising from the lease arrangement if it can demonstrate high
effectiveness. If lease rentals are denominated in a foreign currency, then the lessor
may be able to designate the variability in those cash flows arising from foreign
currency risk as the hedged risk.

7I.7.440 Non-financial items

7I.7.440.10 A non-financial item is hedged with respect to either all of its risks or foreign
currency risk only. This is because foreign currency risk is the only risk associated with a non-
financial item that is considered to be separately measurable. Consequently, even if an entity is able
to isolate and measure the appropriate portion of the cash flows or fair value changes attributable to
a specific risk component, it is not allowed to designate these cash flows or fair value changes as the
hedged item. This is an outright prohibition in IAS 39. [IAS 39.82, AG100]

EXAMPLE 17 – HEDGING NON-FINANCIAL ITEMS FOR RISKS OTHER THAN FOREIGN CURRENCY RISK

7I.7.440.20 Company C is a producer of chocolate bars. C wishes to hedge the fair

value of its inventory in respect of changes in the sugar price by taking out a sugar
forward in the commodity market. It would not be permissible in this situation to
designate as the hedged risk the price risk only related to the price of sugar because

the hedged item is a non-financial item and the risk of changes in sugar prices is a
risk component other than foreign currency risk.

7I.7.440.25 As an alternative, C may designate the sugar forward as a hedge of all

fair value changes of the entire chocolate bar inventory. However, it is not generally
possible to predict or reliably measure the effect that a change in the price of an
ingredient or component will have on the price of an entire non-financial asset or
liability. Consequently, it is unlikely that a direct and consistent relationship exists
between changes in the sugar price and changes in the fair value of C’s chocolate
bar inventory. Because chocolate bars consist of ingredients other than sugar
(cocoa, milk etc), the hedge is unlikely to be highly effective and in that case hedge
accounting would not be possible unless the other ingredients are also hedged.

7I.7.440.27 However, it may be possible to achieve hedge accounting if all of the

main ingredients are hedged and the ineffectiveness arising from changes in fair
value of the unhedged ingredients is not significant.

7I.7.440.30 However, in our view it is acceptable to hedge a non-financial item with respect to all
of its risks other than foreign currency risk.
EXAMPLE 18 – HEDGING NON-FINANCIAL ITEMS FOR ALL RISKS OTHER THAN FOREIGN CURRENCY RISK

7I.7.440.35 Company G has the euro as its functional currency. G wishes to hedge
its forecast purchases of jet oil. The forecast purchase exposes G to two risks, both
of which are reliably measurable: price risk of jet oil denominated in US dollars, and
foreign exchange risk of US dollars against the euro. G would be able to designate
the foreign currency component of jet oil purchases as the hedged item. Moreover,
we believe that because the price risk of the jet oil denominated in US dollars
represents the risk of the underlying purchases in their entirety, except for
retranslation to euro, it is also acceptable to designate this as the hedged risk.

7I.7.440.40 Certain commodity exchange-traded derivatives are based on a standard quality or

grade. Examples of commodities that are traded in a standardised form are wheat, corn, coffee beans
and metals. Entities often enter into derivatives for a standard commodity before determining the
actual quality of product that they require for production. When a commodity exchange-traded
derivative is used to hedge a non-financial item, an entity is still limited to designating the hedged
risk as either all of its risks or foreign currency risk only.

EXAMPLE 19 – HEDGING FUTURE SALES USING COMMODITY FUTURES

7I.7.440.50 Company C is a producer of commodities. C uses traded commodity

futures to hedge committed future sales of commodities. The contract price for the
physical sale of the commodities is split into two components, which are specified

in the contract terms: the standard commodity price based on the index underlying
the futures contract; and a discount or premium for the specific quality, delivery
location, timing and payment terms for the specific delivery. This clearly enables the
separation of the appropriate portion of the cash flows of the physical contract
attributable to changes in the price of the standard commodity. However, given the
outright prohibition in IAS 39, C would not be allowed to designate as the hedged
item only the portion of cash flows under the sales contract that are linked to the
standard commodity price or designate all the cash flows in the contract but for the
risk of the changes in standard commodity price only.

7I.7.440.60 Instead, the actual selling price is designated as the hedged item.
However, because of the difference between the hedging instrument (futures
contract based on the standard commodity) and the hedged item (actual fair
value/price of the product to be sold), hedge ineffectiveness may arise. Additionally,
it may be difficult to demonstrate on a prospective basis that the hedging
relationship is expected to be highly effective in achieving offsetting changes in fair
value or cash flows attributable to the hedged risk throughout the hedging period.

7I.7.440.70 The problem of ineffectiveness can be addressed partly by

designating the hedging instrument and hedged item in a relationship using a hedge
ratio of other than one. Although the futures contract based on a standard
commodity and the actual purchase or sale differ in some respects, it may be
possible to identify a correlation between the price of the standardised commodity
and the actual commodity. This may be done using statistical models such as
regression analysis. The slope of the resulting regression line can be used to
establish a hedge ratio that maximises hedge effectiveness.

7I.7.440.75 For example, C might hedge its future purchase of Brazilian coffee
 with a commodity future whose underlying is the price of Colombian coffee.
Assuming that there is a valid statistical relationship between the two prices, and a
regression analysis identifies a slope of 1.02 for the regression line, a derivative
with a notional amount of 1.02 tonnes of Colombian coffee could be designated as a
hedge of the purchase of one tonne of Brazilian coffee. Although some
ineffectiveness will inevitably result, using a hedge ratio of other than one may help
to keep this within an acceptable range such that hedge accounting can be
continued. [IAS 39.AG100]

7I.7.440.80 A similar issue arises when an entity hedges an ingredient of a non-financial item.

EXAMPLE 20 – HEDGING INGREDIENT OF NON-FINANCIAL ITEM

7I.7.440.82 Company N hedges the purchase of jet fuel. N may want to hedge its
entire jet fuel price exposure or a component of this price exposure. The price of jet
fuel is derived from the prices of the various components that make up jet fuel. Each
of the components is traded independently, with market prices available

for each component. Although the quantity of each of the components in a metric
tonne of jet fuel always is fixed, the relative value of each of the components differs
because the prices of these components change more or less independently.

7I.7.440.84 Various strategies are possible when hedging a transaction such as jet
fuel purchases. However, not all would qualify for hedge accounting.
• Hedge the components of jet fuel price: N may choose to hedge its price exposure
to only certain components of jet fuel (e.g. brent or gas oil) and to retain its price
exposure to the other components. This may be because of:
– the relatively more liquid nature of these components;
– the fact that these components represent the most significant components of
jet fuel prices; or
– the independent nature of the pricing of the various components.
7I.7.440.86 For example, brent and gas oil swaps could be economic hedges of the
corresponding brent or gas oil components of jet fuel purchases. This may result in
perfect effectiveness for these components because the critical terms of the
derivative and the component match, their prices move in tandem and the notional
amount of the derivative equals the quantity of the component in the jet fuel that
will be purchased. However, as noted in 7I.7.440.10, hedge accounting for
components of risk for non-financial items such as jet fuel is prohibited.

7I.7.440.88 Therefore, in order for this hedging strategy to qualify for hedge
accounting, the entire price risk of the jet fuel purchase is designated as the hedged
item and a high degree of correlation should be demonstrated between the price of
the hedged ingredient and the jet fuel price. Alternatively, if there is some degree of
correlation, then N may use a hedge ratio of other than one to maximise hedge
effectiveness. However, if the prices of the individual components move more or less
independently, then it may not be possible to demonstrate any correlation. This
would also make it difficult to demonstrate on a prospective basis that the hedging
relationship is expected to be highly effective throughout the hedging period even
within the prescribed range of 80–125% (see 7I.7.510).
• Hedge the entire price of jet fuel: To meet the requirements regarding the
hedging of commodity price risk, N may use a jet fuel derivative to hedge the
 entire price risk exposure arising from the purchase of jet fuel. This hedging
strategy would qualify for hedge accounting, assuming that all other criteria
have been met.

7I.7.440.90 Commodity price exposure on inventory qualifies as a hedged risk even if the
inventory is measured at cost; the profit or loss impact arises when the inventory is sold. However, as
noted in 7I.7.440.86, the hedged item is the entire change in the fair value of the inventory and not
just a component of the fair value changes. For example, it is not possible to hedge only the rubber
component in an inventory of tyres. [IAS 39.IG.F.3.6]

7I.7.450 Foreign currency exposures

7I.7.450.10 In our view, hedge accounting is not permitted for hedges that convert one foreign
currency exposure into another foreign currency exposure, unless the entity has a corresponding
position in the second foreign currency or that second foreign currency is closely correlated to the
entity’s functional currency.

EXAMPLE 21 – CONVERTING ONE CURRENCY EXPOSURE TO ANOTHER CURRENCY EXPOSURE

7I.7.450.20 Company S has the rand as its functional currency. S has issued a yen-
denominated bond and has a US dollar receivable; both instruments have the
equivalent notional amount and the same maturity. To hedge both the US dollar and
the yen exposures, S enters into a forward contract to convert yen to US dollars.
This relationship between the bond and the receivable (the hedged items) and the
yen-to-US dollar forward (the hedging instrument) would qualify for hedge
accounting.

Expected Expected
outflows Company S inflows
Bond issued in yen (rand in US dollars US dollar
in yen functional receivable
currency)

Expected Expected
inflows outflows
in yen in US dollars

Forward
contract

7I.7.450.30 In our view, the hedge documentation should identify both foreign
currency positions in designating the hedged risk, and in measuring effectiveness
both positions should be considered. If the hedge fails to be highly effective in
offsetting the exposure to changes in the designated foreign currency exposures on
either or both of the designated US dollar receivable or the yen-denominated bond,
then hedge accounting is terminated for the entire relationship. However, if S had
issued only the bond and did not have a US dollar receivable, then the forward
contract would not qualify for hedge accounting because it merely changes one
currency exposure for another. [IAS 39.IG.F.2.18]

7I.7.450.40 Non-financial items themselves – e.g. property, plant and equipment and intangible
assets – generally have no separately measurable foreign currency risk. One situation in which the
foreign currency risk on non-financial items will affect profit or loss is if the owner has a forecast sale
that will be denominated in a foreign currency. In our view, the risk that the sales proceeds in the
entity’s functional currency would change because of changes in foreign exchange rates qualifies to
be hedged in a cash flow hedge if the forecast sale is highly probable. [IAS 39.IG.F.3.6, IG.F.5.6, IG.F.6.5]

7I.7.450.50 In addition, in our view when the transaction date – i.e. delivery date of the non-
financial asset – precedes the cash settlement date of the related receivable or payable in a highly
probable forecast sale or purchase, the variability in cash flows arising from movements in the
foreign exchange rates may be hedged until the transaction date or the cash settlement date. For
example, an entity forecasts a highly probable future sale denominated in a foreign currency to occur
on 30 September 2021, in respect of which the cash settlement is expected to occur on 31 October
2021. In our view, the entity may hedge the forecast sale in respect of the risk of changes in foreign
exchange rates either to 30 September 2021 or to 31 October 2021. In the former case, a cash inflow
from the sale and a simultaneous cash outflow for the financing of the sale would be deemed to occur
on 30 September 2021. Financing the sale is a different transaction from the forecast sale
transaction, and therefore the timing of the settlement of the financing does not result in
ineffectiveness for the hedging relationship.

7I.7.450.60 In our view, an entity may designate its exposure to changes in either the spot or the
forward rate as the hedged risk. If exposure to changes in the forward rate is designated as the
hedged risk, then the interest component included in the forward rate is part of the hedged foreign
currency risk. Changes in the fair value or cash flows of the hedged item are measured based on
changes in the applicable forward rate.

7I.7.450.70 If, in a cash flow hedge of a recognised foreign currency financial asset or liability, an
entity designates the variability in cash flows arising from movements in the forward exchange rates
as the hedged risk, then the effective portion of the changes in the fair value of the hedging
instrument (e.g. the forward contract) is recognised in OCI. The amount recognised in OCI also
includes the effective portion of the change in fair value of the forward points included in the forward
contract. At each reporting date during the term of the hedge, the entity reclassifies from equity an
amount equal to the remeasurement of the hedged item under IAS 21 based on the spot exchange
rates. In addition, in our view, to ensure that the forward points recognised in OCI are reclassified
fully to profit or loss over the life of the hedge, the entity should reclassify from equity an amount
equal to the cumulative change in the forward points recognised in OCI amortised over the life of the
hedging relationship using the interest rate implicit in the forward contract.

7I.7.450.80 If, in a cash flow hedge of a highly probable forecast sale or purchase of a non-
financial item, an entity uses a forward contract to hedge the forward exchange rate through to the
transaction’s cash settlement date, then in our view cash flow hedge accounting may be applied as
described below.
• The effective portion of the gain or loss on the hedging instrument computed with reference to the
hedged forward rate is recognised in OCI during the period before the occurrence of the forecast
purchase or sale.
• The functional currency interest rate implicit in the hedging relationship as a result of entering
into the forward contract (i.e. forward points) is used to determine the amount of cost or income
to be ascribed to each period of the hedging relationship. The period of the hedging relationship
in this case includes the period from the date of the hedge designation to the date of cash
settlement of the forecast transaction.
• For a highly probable forecast sale, the amount of cost or income ascribed to the forecast period
until the date the sale occurs is reclassified from equity to profit or loss on that date. For a highly
probable forecast purchase, the amount of cost or income ascribed to the forecast period until the
date of purchase is either reclassified from equity as a basis adjustment to the initial cost or other
carrying amount of the purchased non-financial item on the date of purchase, or reclassified from
equity to profit or loss in the same period or periods during which the item acquired affects profit
or loss.
• On occurrence of the forecast sale – i.e. the transaction date – the difference between the spot
foreign exchange rates at the inception of the hedge and on the transaction date is reclassified
from equity to profit or loss. In a hedge of a forecast purchase, a similar amount may be
reclassified from equity as a basis adjustment to the initial cost or other carrying amount of the
purchased non-financial item on the date of purchase. Alternatively, the entity may choose not to
adjust the cost or the carrying amount of the purchased non-financial item and instead reclassify
the deferred gain or loss from equity to profit or loss in the same period or periods during which
the item acquired affects profit or loss.
• At each reporting date during the life of the recognised foreign currency receivable or payable,
the entity reclassifies from equity to profit or loss an amount equal to the remeasurement of the
receivable or payable under IAS 21 based on the spot exchange rates.
• The cost or income ascribed to each period during the life of the recognised foreign currency
receivable or payable is reclassified from equity to profit or loss at each reporting date.

7I.7.450.90 As an alternative to the cash flow hedge accounting described in 7I.7.450.80, an

entity may apply cash flow hedge accounting as follows.
• The effective portion of the gain or loss on the hedging instrument computed with reference to the
hedged forward exchange rate is recognised in OCI during the period before the occurrence of
the forecast purchase or sale.
• For a highly probable forecast sale, this cumulative amount recognised in OCI for the effective
portion of the gain or loss on the hedging instrument is reclassified from equity to profit or loss on
the date the sale occurs. For a highly probable forecast purchase, this cumulative amount is either
reclassified from equity as a basis adjustment to the initial cost or other carrying amount of the
purchased non-financial item on the date of purchase or reclassified from equity to profit or loss in
the same period or periods during which the item acquired affects profit or loss.
• At each reporting date during the life of the recognised foreign currency receivable or payable,
the effective portion of the gain or loss on the hedging instrument – computed with respect to the
forward exchange rate and recognised in OCI – is reclassified to profit or loss. [IAS 39.IG.F.5.6]

7I.7.450.100 A firm commitment to acquire a business in a business combination can qualify as

the hedged item only in a hedge of foreign currency risk. In our view, the same applies to a forecast
business combination, assuming that the transaction is highly probable and meets the other hedge
accounting criteria (see 7I.7.265). In addition, for the purposes of the investor’s separate financial
statements, in our view a hedge of the cash flow variability associated with a forecast purchase or
sale of an investment in a subsidiary (e.g. an investment in equity shares) can qualify as a hedged
item. This is because the investment is or will be recognised as a separate asset (carried at cost or
available-for-sale) in those separate financial statements and its disposal or impairment could affect
profit or loss in those separate financial statements. [IAS 39.88(c), AG98]

7I.7.460 General business risks

7I.7.460.10 To qualify for hedge accounting, the hedged risk should be specific and identifiable. A
hedge against general business risks, such as physical damage of an asset, an increase in the price
payable in a business combination or the risk that a transaction will not occur, does not qualify for
hedge accounting. [IAS 39.AG98, AG110, IG.F.2.8]

7I.7.470 Hedges of more than one risk type

7I.7.470.10 A hedging instrument, or a proportion thereof, is designated in its entirety, because

there is normally a single fair value measure for a hedging instrument and the factors (risk
components) that cause changes in fair value are co-dependent. Using an entire instrument or a
proportion of an instrument is acceptable for hedge accounting, but using only a portion – e.g. a
single risk component – is not generally allowed. For example, a cross-currency interest rate swap is
designated with respect to all changes in its fair value, including those arising from foreign currency
risk and interest rate risk. [IAS 39.74–75]
7I.7.470.20 However, it is possible to designate a single derivative – e.g. a cross-currency swap –
as a hedge of more than one risk type if the following conditions are met:
• the risks being hedged can be identified clearly;
• the effectiveness of the hedge can be demonstrated; and
• it is possible to ensure that there is specific designation of the hedging instrument and the
different risk positions. [IAS 39.76]

7I.7.470.30 Consequently, part of a derivative hedging instrument may be designated for a

particular risk of a hedged item provided that the other parts of the hedging instrument are
designated as hedging other risks of other hedged items (or the same hedged item) and all other
hedge accounting criteria are met. However, practical difficulties in separating fair values between
inter-related risks could present difficulties in meeting the conditions under which such a
designation is permissible. [IU 10-04]

EXAMPLE 22 – HEDGE OF MORE THAN ONE RISK TYPE

7I.7.470.40 Company W with the euro as its functional currency issues a floating
rate sterling-denominated bond. W also has a fixed rate US dollar financial asset
with the same maturity and payment dates as the bond. To offset the currency and
interest rate risk on the financial asset and financial liability, W enters into a pay-US
dollar fixed receive-sterling floating interest rate swap.

7I.7.470.50 The swap may be designated as a hedging instrument of the US dollar

financial asset against the fair value exposure arising from changes in US interest
rates and the foreign currency risk between US dollar and sterling. Alternatively, it
could be designated as a cash flow hedge of the cash flow exposure arising from the
variable cash outflows of the sterling bond and the foreign currency risk arising
from movements in the US dollar/sterling exchange rate.

7I.7.470.60 Both of these designations would be permissible even though the

hedge does not convert the foreign currency exposure into W’s functional currency
of the euro. In our view, this type of hedge is appropriate only as long as W has
foreign currency exposures to both US dollar and sterling and is not creating a new
foreign currency position but rather is decreasing its risk exposure compared with
its functional currency (see 7I.7.450). Both foreign currency exposures should be
referred to in the hedge documentation, and the hedge is a single hedging
relationship (see 7I.7.120.30). It should be clear in the documentation that the
relationship

between the swap and the US dollar financial asset qualifies for hedge accounting
only because of the existence of both a US dollar financial asset and a sterling
financial liability – i.e. both are hedged items in a single hedging relationship. [IAS
39.IG.F.2.18]

7I.7.480 Hedging other market price risks

7I.7.480.10 Entities that hold equity securities as investments are exposed to market price risk.
Hedge accounting for the price risk of such securities is relevant only for securities classified as
available-for-sale because fair value changes are recognised as a component of equity. For financial
assets and financial liabilities measured at FVTPL, gains and losses are recognised directly in profit
or loss, making hedge accounting unnecessary. The issues related to hedge accounting for equity
price risk are similar to those for commodity price risk (see 7I.7.440).
7I.7.490 Hedging credit risk

7I.7.490.10 IAS 39 indicates that a financial item may be hedged with respect to credit risk. In
order for a hedging relationship to be eligible for hedge accounting, the designated risk should be
separately identifiable and changes in the cash flows or fair value of the entire hedged item arising
from changes in the designated risk should be reliably measurable such that effectiveness can be
measured. This provides a practical barrier to hedging credit risk to the extent that it may not be
possible to measure changes in the fair value of a hedged debt instrument arising from changes in
credit risk separately from those arising from changes in liquidity risk. [IAS 39.81]

7I.7.490.20 A CDS is a derivative financial instrument that provides protection against the risk of
default by an obligor with respect to a reference debt instrument of the obligor. Under a typical CDS,
if a specified credit event occurs, then the seller of protection would either purchase the reference
debt instrument from the buyer of protection for a fixed amount, usually par or par plus accrued
interest, or pay the difference between that fixed amount and the fair value of the reference debt
instrument at that time. The buyer of protection would pay fixed periodic premiums to the seller until
the end of the term of the CDS or a credit event occurs. A holder of a debt instrument may purchase a
CDS referenced to that debt instrument, or a similar debt instrument of the same obligor, to provide
protection against the risk of a fair value loss arising on the occurrence of a credit event as specified
in the CDS contract. In our view, an entity may designate this risk as the hedged risk in a hedging
relationship provided that the entity can reliably measure changes in the fair value of the debt
instrument attributable to this risk and can demonstrate high effectiveness. This approach may be
acceptable in the following circumstances, assuming that the relevant testing demonstrated high
effectiveness:
• the hedging CDS is referenced to the hedged asset and there is an active market (see 2.4.280.10)
for such CDSs, in which case there is likely to be high effectiveness; or
• the hedging CDS is referenced to a similar but not identical obligation issued by the same issuer
as the hedged asset and there is an active market for both: CDSs of the same type as the hedging
CDS and CDSs referenced to the hedged asset.

7I.7.500 All-in-one cash flow hedges

7I.7.500.10 An entity may enter into a contract to purchase or sell a non-financial item or a
financial asset and the contract may be required to be accounted for as a derivative. For example, a
fixed price contract to purchase a commodity would not be eligible for the own-use scope exemption
when the entity has a past practice of taking delivery of the underlying and selling it within a short
period after delivery for trading purposes (see 7I.1.160.10). In such a scenario, if the derivative will
be settled gross, then the entity may designate this derivative as the hedging instrument in a cash
flow hedge of the variability of the consideration to be paid or received in the future transaction that
will occur on gross settlement of the derivative contract itself – i.e. a hedge of the forecast
transaction that is implicit in the derivative itself – assuming that the other cash flow hedging criteria
are met. [IAS 39.IG.F.2.5]

7I.7.500.20 This hedging strategy is referred to as an ‘all-in-one cash flow hedge’ and applies to
all fixed price contracts that are accounted for as derivatives. By designating an all-in-one cash flow
hedge, the entity avoids recognising in profit or loss the changes in the fair value of the
purchase/sale contract that would otherwise be recognised in profit or loss because the contract is
accounted for as a derivative.

7I.7.500.30 An all-in-one hedge may also be designated in a forecast purchase or sale involving a
financial asset. For example, a financial institution manages the price risk associated with forecast
sales of loans that it originates by entering into forward loan sale agreements to sell mortgage loans
at a fixed price. This forward contract to sell loans meets the definition of a derivative and is required
to be accounted for at FVTPL. However, the forward loan sale agreement may be designated as a
cash flow hedge of the forecast sale of loans – i.e. as an all-in-one hedge of price risk – provided that
the contract will be settled gross.
7I.7.500.40 However, an all-in-one hedge cannot be designated if the hedged risk – i.e. the
change in fair value of the underlying item that is implicit in the settlement of the derivative – does
not impact future profit or loss. This will generally be the case when the underlying item is or will be
measured at FVTPL. For example, an entity would not be able to designate an all-in-one cash flow
hedge of a purchase of an item that will be measured at FVTPL using a fixed-price forward contract
because the item will be measured at fair value on settlement and changes in the fair value of the
item before settlement will not affect profit or loss after settlement. Conversely, an all-in-one hedge
can be designated in a forecast purchase of a financial asset that will be classified as available for
sale, even if the financial asset will be measured at fair value on settlement. This is because changes
in the fair value of the financial asset before settlement will affect profit or loss after settlement
through the effective interest method or when it is impaired or sold (see 7I.7.80.70).

7I.7.510 EFFECTIVENESS TESTING

7I.7.510.10 To qualify for hedge accounting, a hedge should be ‘expected to be’ (prospectively)
and ‘actually have been’ (retrospectively) highly effective. In other words, a hedge is regarded at
inception and at subsequent assessment dates as highly effective only if the following conditions are
met:
• the hedge is expected to be highly effective in achieving offsetting changes in fair value or cash
flows attributable to the hedged risk during the period for which the hedge is designated or for
the period until the amount of the hedging instrument next is adjusted (see 7I.7.530.10)
(prospective effectiveness); and
• the actual results of the hedge are within the range of 80–125 percent (retrospective
effectiveness). [IAS 39.88(b), 88(e), AG105]

7I.7.510.20 If either one of these tests fails, then hedge accounting may not be applied at all.
Even when a hedging relationship is expected to be highly effective and meets the retrospective
effectiveness criterion – i.e. actual effectiveness is in the range of 80–125 percent – ineffectiveness
still may arise from the relationship. Such ineffectiveness is recognised immediately in profit or loss
even if it is within the 80–125 percent range. [IAS 39.95(b), 102(b)]

7I.7.520 Frequency of effectiveness tests

7I.7.520.10 At a minimum, effectiveness is measured at each reporting date, including interim

reporting dates. [IAS 39.AG106]

7I.7.520.20 If a hedge no longer is effective, then hedge accounting is discontinued prospectively

from the last date on which the hedge was proven to be effective (see 7I.7.680). Therefore, the more
frequently that effectiveness is tested, the sooner the entity will identify the opportunity to rebalance
its hedges to minimise the impact of ineffectiveness. This provides an incentive to perform hedge
effectiveness testing frequently for hedges that may fail the effectiveness tests. [IAS 39.AG113]

7I.7.530 Methods for measuring effectiveness

7I.7.530.10 The methods that are used in measuring effectiveness are not prescribed. The
method an entity adopts depends on its risk management strategy and hedge accounting systems
and practices. For example, if the entity’s risk management strategy is to adjust the amount of the
hedging instrument periodically to reflect changes in the hedged position, then the entity needs to
demonstrate that the hedge is expected to be highly effective only for the period until the amount of
the hedging instrument next is adjusted. [IAS 39.88(a), AG107]

7I.7.530.20 The method that will be used in measuring hedge effectiveness is specified in the
hedge documentation. [IAS 39.88(a)]

7I.7.530.30 An entity is not required to use a single method for prospective and retrospective
assessments of effectiveness, and the method applied may be different for different types of hedges.
In our experience, the periodic measurement of hedge effectiveness usually involves a method that
compares the actual change in fair value of the hedged asset or liability or in cash flows with respect
to the hedged risk with the change in the fair value of the hedging instrument (an offset method).
When assessing both prospective and retrospective effectiveness and when measuring actual
effectiveness, the creditworthiness of the counterparty to the hedging instrument and of the entity
itself and the likelihood of default are considered (see 7I.7.580 and 2.4.460.30). For example, the
value of a swap could be affected by changes in the credit rating of the swap counterparty or in the
entity’s credit rating. [IAS 39.AG107, IG.F.4.3, IG.F.5.2, IFRS 13.42–44]

7I.7.530.40 Also, the method that will be used to measure effectiveness is determined on a hedge-
by-hedge basis. There is no requirement to adopt a consistent method for all hedging relationships.
However, in our view an entity should adopt a method for assessing hedge effectiveness that is
applied consistently for similar types of hedges unless different methods are explicitly justified. For
example, an entity should use the same methods for assessing effectiveness prospectively, as well as
the same methods for measuring actual hedge effectiveness, for forecast sales to the same export
market undertaken on a regular basis. [IAS 39.88(a)]

7I.7.530.50 An entity may decide to designate less than 100 percent of the exposure on an item –
e.g. the changes in fair value attributable to interest rate risk on 85 percent of the notional amount of
a fixed rate debt instrument. In such circumstances, the hedged item comprises the actual
percentage being hedged – 85 percent in this case – and ineffectiveness is measured and
effectiveness is assessed based on the change in the fair value of that exposure. [IAS 39.AG107A]

7I.7.530.60 Effectiveness calculations may be done on a pre-tax or post-tax basis. Whichever

method is used, the basis of calculating the change in fair value or cash flows of the hedged item and
the change in fair value of the hedging instrument should be consistent. [IAS 39.IG.F.4.1]

7I.7.540 Prospective effectiveness

7I.7.540.10 Prospective effectiveness may be demonstrated in several ways – e.g. by:

• demonstrating a high statistical correlation between the fair value or cash flows of the hedged
item and those of the hedging instrument using, for example, a statistical model such as
regression analysis to analyse this correlation for a given period;
• comparing past changes in the fair value or cash flows of the hedged item that are attributable to
the hedged risk with past changes in the fair value or cash flows of the hedging instrument (offset
method); or
• demonstrating that a ‘critical terms match’ (see 7I.7.590) exists at inception and in subsequent
periods. [IAS 39.AG105, IG.F.4.4]

7I.7.540.20 There is no specific guidance on what is meant by ‘highly effective in achieving

offsetting changes’ in the context of prospective effectiveness. In our view, this should be interpreted
as a statistical relationship within a range of 80–125 percent, in line with the requirement for
retrospective effectiveness testing.

7I.7.540.30 A prospective effectiveness test that is based on an 80–125 percent range provides
some latitude for hedging non-financial assets and non-financial liabilities. For example, transactions
for the sale or purchase of commodities that practically can be hedged only using exchange-traded
commodity contracts that refer to standardised quantities and grades of the particular quantity (see
7I.7.440.40). The primary concern is that such hedging relationships will not qualify for hedge
accounting as a result of ineffectiveness that arises because of the terms of the hedging instrument
being different from those of the hedged item. However, if the fair values or cash flows of the hedging
instrument and hedged item respectively are expected to generate an 80–125 percent offset, then
there is a chance that such a hedging relationship will qualify for hedge accounting.

7I.7.540.40 Also, such a prospective effectiveness test would accommodate interest rate hedges
using swaps when, for example, ineffectiveness arises because of differences between the fixed rate
in the swap and that on the hedged item, or in the timing of cash flows on the hedged item and those
on the swap. Although ineffectiveness will be recognised in profit or loss, the hedging relationship
will not necessarily fail to qualify for hedge accounting on the basis of there not being an almost
perfect offset of fair values or cash flows at inception.

7I.7.540.50 An effectiveness assessment approach that considers only the cash flows generated
by a derivative hedging instrument as they are paid or received is prohibited. The expectations of
cash flows in subsequent periods and any resulting ineffectiveness are taken into account in
assessing effectiveness. [IAS 39.IG.F.5.5]

7I.7.540.60 It is common for entities to hedge their exposure to interest rate variability by
entering into a pay-fixed receive-variable interest rate swap. If such a hedge is designated in a cash
flow hedging relationship, then it would be inappropriate for the entity to measure retrospective
effectiveness by comparing the actual cash flows on the swap with the actual cash flows on the
hedged item. Such an effectiveness test would ignore the impact of past interest rate movements on
the future cash flows of both the hedged item and the hedging instrument – i.e. it would ignore the
impact of the movements in past rates on forward rates. Although the actual cash flows on the
hedged item and hedging instrument may offset perfectly, the future cash flows may not. Such a
situation may arise when the cash flows on the hedged item and hedging instrument are based on
different yield curves or when the maturities of the hedged item and hedging instrument are
different. [IAS 39.IG.F.5.5]

7I.7.540.70 When the critical terms of the hedged item and the hedging instruments are not
exactly the same, prospective hedge effectiveness is assessed and documented other than by a
‘critical terms match’ (see 7I.7.590). When a statistical model is used, the hedge documentation
should specify how the results of the analysis are to be interpreted. [IAS 39.AG108, IG.F.4.4]

7I.7.550 Retrospective or ongoing assessment of effectiveness

7I.7.550.10 Effectiveness is measured on an ongoing basis and the hedging relationship should
be shown actually to have been highly effective throughout the reporting period. [IAS 39.88(e)]

7I.7.550.20 The gain or loss on the hedged item is measured independently from that on the
hedging instrument – i.e. it cannot be assumed that the change in fair value or cash flows of the
hedged item in respect of the hedged risk equals the fair value change of the hedging instrument.
The reason for this is that any ineffectiveness of the hedging instrument is recognised in profit or
loss. [IAS 39.89, 95(b)]

7I.7.550.30 Retrospective effectiveness may be measured on a cumulative or period-by-period

basis. Normally it is advantageous to measure effectiveness on a cumulative basis. For example, if
the hedging instrument is an interest rate swap that resets at different times to the interest rate on
the underlying, then the hedge is more likely to meet the effectiveness tests if effectiveness is
measured on a cumulative basis. [IAS 39.IG.F.4.2]

7I.7.550.40 No particular method for retrospective effectiveness testing is required under IAS
39. An entity may use the offset method for hedge effectiveness testing. The offset method expresses
the degree of offset between changes in the fair value of the hedging instrument and changes in the
fair value or cash flows of the hedged item, as a percentage. [IAS 39.AG105, IG.F.5.5]

7I.7.550.50 In our view, when statistical methods such as regression analysis are used to
demonstrate the effectiveness of a hedging relationship, it is permitted to use data originated before
the date on which the hedging relationship was designated to demonstrate retrospective
effectiveness.

EXAMPLE 23 – USE OF REGRESSION TO ASSESS HEDGE EFFECTIVENESS

 7I.7.550.60 Company T is assessing retrospective hedge effectiveness during the
first reporting period after inception of a fair value hedge – e.g. one quarter after
inception – and the changes in the fair value of the hedging instrument did not offset
the changes in the fair value of the hedged item attributable to the hedged risk as
anticipated.

7I.7.550.70 If T had chosen initially to use an offset approach, which is based only
on the hedge period, then it would conclude that the retrospective hedge
effectiveness test is failed.

7I.7.550.80 However, if T had chosen initially to use a statistical analysis based on

a trailing 12-month average – which includes three months of the hedge period and
nine months before the hedge period – then it may be able to conclude that the
retrospective effectiveness test is met. This is because the results of the earlier nine
months may negate the unfavourable hedge results of the last three months.
Moreover, by using data originated before the inception of the hedge, T may use the
same regression test for assessing both prospective and retrospective effectiveness.
[IU 11-06]

7I.7.550.90 In our view, the use of a statistical method such as regression analysis requires the
quality of the output from the statistical method to be evaluated on an ongoing basis to ensure that
the results are statistically valid. If a statistical method does not provide valid results, then it cannot
be used to demonstrate hedge effectiveness. For example, an entity concludes that a hedge is
effective using regression analysis because it meets the 80–125 percent requirement (see
7I.7.510.10). However, had the offset method been applied then the hedge would have consistently
failed the 80–125 percent requirement. In our view, the fact that the hedging relationship, on a
consistent basis, would not have been highly effective had the offset method been applied indicates
that the data used for the regression analysis may not be statistically valid.

7I.7.550.100 For a further discussion of a cash flow hedge of interest rate risk using interest rate
swaps, see 7I.7.610.

7I.7.560 Regression analysis

7I.7.560.10 Linear regression techniques are used for determining whether and by how much a
change in one variable will result in a change in another variable. Consequently, through the use of
regression analysis, it is possible to demonstrate the effectiveness of a hedging relationship by
determining how much of the change in the fair value or cash flows of the dependent variable is
caused by a change in the fair value or cash flows of the independent variable. In our view, the
hedging instrument or the hedged item may be assigned as the dependent variable and likewise
either can be assigned as the independent variable.

7I.7.560.20 In reviewing the regression model, in our view as a minimum the following
parameters should be assessed.
• R squared (co-efficient of determination), which measures the proportion of the variability in the
dependent variable that can be explained by the variation in the independent variable.
• Slope of the regression line, which indicates the change in the dependent variable for every
change in the independent variable. The slope should be within a 0.8–1.25 range, which indicates
that the hedging relationship is within the 80–125 percent effectiveness requirement.
• Confidence interval of the slope being within the 80–125 percentage range; in our view, a
minimum 95 percent confidence level should be used when assessing the effectiveness of the
hedging relationship.
7I.7.570 Actual ineffectiveness

7I.7.570.10 In a cash flow hedge, regardless of the methods that are used to assess prospective
and retrospective effectiveness, the actual ineffectiveness recognised in profit or loss is calculated
under the offset method on a cumulative basis to ensure that all ineffectiveness is recognised in
profit or loss immediately. [IAS 39.IG.F.5.5]

7I.7.570.20 In a cash flow hedge, if the cumulative gain or loss on the hedging instrument is more
than the cumulative change in the fair value of the expected future cash flows on the hedged item
attributable to the hedged risk, then the difference is recognised in profit or loss as ineffectiveness.
However, if the reverse is true, then the full cumulative gain or loss on the hedging instrument is
recognised in OCI. Consequently, in a cash flow hedge ineffectiveness is recognised in profit or loss
only when the cumulative change in fair value of the hedging instrument is greater than the
cumulative change in fair value of the expected future cash flows on the hedged item attributable to
the hedged risk. [IAS 39.95–96]

7I.7.570.30 In other words, ineffectiveness arising from over-hedging is recognised in profit or

loss, but ineffectiveness arising from under-hedging is not recognised because the hedged item is not
recognised.

7I.7.570.40 In a fair value hedge, ineffectiveness is recognised automatically in profit or loss as a

result of separately remeasuring the hedging instrument and the hedged item. No separate
calculation is required of the amount of ineffectiveness to be recognised in profit or loss.

7I.7.580 Effect of credit risk on effectiveness testing and ineffectiveness

measurement

7I.7.580.10 Entities consider the effect of both changes in counterparty credit risk and own
credit risk on the assessment of hedge effectiveness and the measurement of hedge ineffectiveness
(see 2.4.460.30). [IAS 39.AG109, IG.F.4.3, IFRS 13.42–44]

7I.7.580.20 For all hedges, an entity considers the risk that the counterparty to the hedging
instrument will default by failing to make any contractual payments to the entity. For cash flow
hedges, if it becomes probable that a counterparty will default by failing to make any contractual
payments to the entity, then the entity will be unable to conclude that the hedging relationship will
be highly effective. [IAS 39.IG.F.4.3]

7I.7.580.30 For all hedges, changes in both counterparty credit risk and own credit risk impact
the measurement of changes in the fair value of a derivative hedging instrument. These changes will
likely have no offsetting effect on the measurement of the changes in the value of the hedged item
attributable to the hedged risk. Such differences in measurement resulting from changes in
counterparty and own credit risk will impact assessments of effectiveness and may lead to a
conclusion that the hedging relationship has not been and/or is not expected to be highly effective
(see 7I.7.680). Even when it is concluded that a hedge has been highly effective, such differences will
result in ineffectiveness being recognised in profit or loss for fair value hedges. Such differences
would also require the recognition of ineffectiveness in profit or loss for cash flow hedges if the
cumulative gain or loss on the hedging instrument is greater than the cumulative change in fair or
present value of the expected future cash flows on the hedged item. Similarly, for net investment
hedges in which the hedging instrument is a derivative, ineffectiveness is recognised in profit or loss
if the cumulative gain or loss on the hedging instrument exceeds the cumulative foreign exchange
differences arising on the designated net investment. [IAS 39.AG107, IG.F.5.2]

7I.7.580.40 An entity may have a group of derivative assets and liabilities with a particular
counterparty and meet the criteria for applying the portfolio measurement exception related to that
counterparty’s credit risk (see 2.4.430). In that case, the effect of the entity’s net exposure to the
credit risk of that counterparty or the counterparty’s net exposure to the credit risk of the entity may
result in a portfolio-level credit risk adjustment. However, for assessing hedge effectiveness and
recognising ineffectiveness, an entity needs to determine the individual credit risk adjustments to
arrive at the fair values of the individual hedging derivatives or the appropriate credit adjustment for
a group of derivatives that have been designated together as the hedging instrument in a single
hedging relationship. In our view, the entity should adopt a reasonable and consistently applied
methodology for allocating all risk adjustments, including credit risk adjustments, determined at a
portfolio level to individual derivative instruments for the purpose of measuring the fair values of
individual hedging instruments that are used in assessing effectiveness and measuring hedge
ineffectiveness.

7I.7.590 Matching critical terms

7I.7.590.10 If the critical terms of the hedging instrument and the hedged item exactly match,
then this may demonstrate prospective effectiveness – a qualitative approach for assessing
prospective effectiveness. However, an entity is still required to assess hedge effectiveness
retrospectively based on the actual results of the hedge (see 7I.7.510.10 and 550.10). [IAS 39.AG108,
IG.F.4.7]

7I.7.590.20 In our view, an entity can apply a qualitative approach for assessing prospective
effectiveness only when:
• all critical terms exactly match, which as a minimum includes notional, maturity, repricing dates
and underlying – e.g. the index on which the asset or liability’s variable rate is based; and
• the hedging instrument has a fair value that is zero or approximates zero at inception and any
difference between the transaction price of zero and the fair value at inception of the hedge is
attributable solely to differing prices within the bid-ask spread between the actual entry
transaction and a hypothetical exit transaction.

7I.7.590.30 If the fair value of the hedging instrument is other than zero at inception, then the
difference between the transaction price of zero and the fair value may be attributable to the bid-ask
spread and/or to other factors – e.g. the terms of the derivative do not reflect current market pricing
when the hedge is designated. If the initial non-zero fair value of the hedging instrument is
attributable to other factors, then the initial non-zero fair value reflects a source of potential future
ineffectiveness (see 7I.7.670). This is not consistent with the assumption of high prospective
effectiveness underlying the critical terms match approach.

7I.7.590.40 Applying a qualitative approach does not mean applying the ‘shortcut method’ as
allowed under US GAAP, whereby an entity compares the critical terms of the hedging instrument
and the hedged item at inception and is not required to perform any reassessment in subsequent
periods. This is not permitted under the Standards. A qualitative approach requires all critical terms
to be reviewed and compared at inception and in subsequent periods. If it is concluded that there is
no change in any critical term, then such a test would be sufficient to satisfy the prospective
effectiveness testing requirements. However, the effect of credit risk is considered (see 7I.7.580).
Also, retrospective effectiveness can never be assumed and is always measured numerically.

7I.7.590.50 Examples of situations in which the critical terms exactly match are:
• a hedge of a foreign currency sales commitment with a futures contract to sell the same amount of
the same foreign currency on the same date, if the fair value of the future at inception of the
hedge is zero;
• a hedge of benchmark interest rate risk associated with a recognised asset or liability using a
swap with a zero fair value at inception of the hedge and the same notional amount as the asset or
liability and with the same key terms;
• a hedge of a forecast commodity sale with a forward contract to purchase the same quantity of the
same commodity on the same date, if the fair value of the forward at inception of the hedge is
zero, and either the change in the discount or premium on the forward contract is excluded from
the assessment of effectiveness and recognised directly in profit or loss, or the change in expected
cash flows on the forecast transaction is based on the forward price of the commodity; and
• a hedge of a specific bond held with a forward contract to sell an equivalent bond with the same
 notional amount, currency and maturity, if the forward contract has at the designation date a fair
value of zero. [IAS 39.AG108, IG.F.4.7]

7I.7.600 Time value and interest element

7I.7.600.10 If it is appropriately documented at inception of the hedging relationship, then the

time value of an option may be excluded from the effectiveness tests and effectiveness may be tested
based solely on the intrinsic value of the option. Similarly, the interest element of a forward contract
may be excluded and effectiveness may be measured based solely on the spot component of the
forward contract. This choice is available on a hedge-by-hedge basis, and there is no requirement to
have a consistently applied policy. However, an entity is not permitted to exclude the credit risk (or
any other risk) associated with a derivative from the measurement of hedge effectiveness. [IAS 39.74]

7I.7.600.20 Changes in the fair value of components of the hedging instrument that are excluded
from effectiveness measurement – i.e. the time value or interest component – are recognised
immediately in profit or loss. [IAS 39.96(c)]

7I.7.600.30 If the hedging instrument is an option, then measuring effectiveness based only on
the intrinsic value of the option may improve the effectiveness of the hedging relationship. This is
because the hedged transaction is unlikely to have an equivalent time value effect; therefore, if the
time value component of the option is included, then it will give rise to ineffectiveness. When
intrinsic value designation is used and the option remains out of the money during the period for
which effectiveness is being assessed – on a period-by-period basis or cumulative basis depending on
the method used by the entity (see 7I.7.550.30) – then quantitative retrospective effectiveness
assessment is not necessary. However, prospective assessment is still required.

7I.7.600.40 If the time value or the interest element is included in the measurement of hedge
effectiveness, then the full fair value of the option or forward contract, respectively, is used in the
effectiveness calculation.

7I.7.600.50 Whichever method is used to deal with the time value or interest elements of hedged
items and hedging instruments, the basis of calculating the change in fair value or cash flows of the
hedged item and the change in fair value of the hedging instrument is consistent. For example, if the
interest element is excluded from the measurement of changes in the fair value of the hedging
instrument, then the change in the cash flows or fair value of the hedged item attributable to the
hedged risk is measured based on spot rates. However, if the interest element is included in the
effectiveness measurement, then the change in fair value or cash flows of the hedged item
attributable to the hedged risk is based on forward rates. [IAS 39.IG.F.5.5]

7I.7.600.60 It is possible to apply a dynamic hedging strategy, including both the intrinsic and
time values of an option, although there is little guidance about how this should be performed. A
delta-neutral hedging strategy, whereby the hedging instrument is adjusted constantly to maintain a
desired hedge ratio, may qualify for hedge accounting if the other hedge accounting criteria are met
(see 7I.7.330).

7I.7.610 Interest rate risk

7I.7.610.10 To maximise effectiveness, when hedging interest rate risk, the hedged risk is
normally designated as the benchmark interest rate only and the credit risk spread on the hedged
item is excluded from the hedged risk. This is because credit risk normally will not affect the fair
value or cash flows of the hedged item and the hedging instrument in the same way.

7I.7.610.20 Similarly, if the interest exposure on an interest-bearing instrument is hedged for

only a portion of the instrument’s remaining period to maturity, then it is easier to meet the
effectiveness rules if the hedged risk is documented as being based on the same yield curve as the
derivative. For example, an entity hedges the interest rate risk on a 10-year bond for the first five
years using a five-year interest rate swap. Effectiveness could be maximised by designating the swap
as a hedge of the fair value of the interest payments on the bond for the first five years, and of the
change in the value of the principal amount of the bond arising from changes in the yield curve
related to the five years of the swap. If the hedged risk is simply designated as the change in fair
value of the bond, then the hedge is likely to be ineffective because the value of the bond will be
affected by changes in the 10-year yield curve whereas the value of the derivative will be affected by
changes in the five-year yield curve. [IAS 39.IG.F.2.17]

7I.7.610.30 It is quite common for financial instruments having an exposure to interest rate risk
also to be exposed to prepayment risk. For a prepayable asset or liability, changes in interest rates
will have an effect on the fair value of the asset or liability by changing the expectations about the
timing of future cash flows. This has an impact on effectiveness assessment and measurement.

7I.7.610.40 Prepayment risk affects the timing as well as the amount of cash flows. Consequently,
this may impact the effectiveness of fair value hedges as well as the highly probable requirement for
forecast cash flows. A prepayable hedged item will generally experience smaller fair value changes
when interest rates fall than a non-prepayable hedged item, while fair value changes as interest
rates rise will be closer to those of a non-prepayable item. When hedging a portfolio of such
instruments, effectiveness is likely to be more difficult to demonstrate for a fair value hedge than for
a cash flow hedge. In a static fair value hedge, it may be difficult to group a portfolio of fixed rate
assets subject to prepayment risk, because it may be difficult to prove that the changes in fair value
of the individual assets are approximately proportional to the overall change in fair value of the
portfolio, unless each item contains identical prepayment options. As a result, fixed rate assets
subject to prepayment risk may have to be hedged on a one-to-one basis. In this case, ineffectiveness
will arise unless the hedging instrument also contains a prepayment option.

7I.7.610.50 Therefore, the risk of prepayment or changes to the timing of future cash flows is
considered when an entity designates its hedging relationships. In our view, prepayment is not a risk
that is capable of separate designation; rather, it is a component of interest rate risk and is
designated as such. This is because it is difficult to measure and isolate the change in fair value
arising from a change in prepayments separately from the overall change arising from a change in
interest rates.

7I.7.610.60 In a portfolio fair value hedge of interest rate risk the assessment of hedge
effectiveness can be performed using a maturity schedule. Such a schedule usually determines the
net position for each maturity period by aggregating assets and liabilities maturing or repricing in
that maturity period. However, the net exposure should be associated with a specific asset, liability
or cash inflow or outflow to apply hedge accounting, such that the correlation of the changes of the
hedging instrument and the designated hedged item can be assessed.

7I.7.615 Financial instruments with a benchmark rate component floored at

zero
7I.7.615.10 A debt instrument on which the interest rate is linked to a benchmark rate but with
the benchmark component floored at zero may be a hedged item in a cash flow hedge of the
variability of interest payments or receipts due to changes in the benchmark rate. If the benchmark
rate becomes negative, then a question arises about whether the designated hedged risk continues
to exist because interest cash flows on the debt instrument are not variable during the period in
which the benchmark rate is negative. In our view, in these situations the designated hedged risk
continues to exist and remains eligible for hedge accounting because the benchmark rate may turn
positive in future periods and therefore there is still exposure to variability in future interest cash
flows. [IAS 39.86(b)]

7I.7.615.20 Another question that arises if an entity hedges benchmark-based interest cash flows
floored at zero is whether the hedged benchmark-based cash flows can be regarded as highly
probable if the benchmark rate becomes negative. Again, in our view the analysis is not changed
merely by the benchmark rate becoming negative. This is because the hedged forecast transactions
are the receipts or payments of interest and these transactions are still forecast to occur, although
the benchmark-based component may be zero.

7I.7.615.30 However, if there is an embedded floor in the hedged item but no equal and opposite
floor on the benchmark-based cash flows in the hedging instrument, then the embedded floor in the
hedged item means that the negative benchmark rate will cause the hedge not to be fully effective.
Therefore, hedge ineffectiveness may arise because changes in the benchmark rate will not have an
equal and opposite effect on the hedging instrument and the hedged item.

7I.7.615.40 Also, the entity has to determine whether – considering this mismatch between the
variability of the cash flows of the hedging instrument and the hedged item – the hedge is expected
to be highly effective on a prospective basis. [IAS 39.88(c)]

EXAMPLE 24 – CASH FLOW HEDGES OF FLOATING INTEREST RATES – NEGATIVE INTEREST RATE ENVIRONMENT

7I.7.615.50 Company R has a loan receivable in which the interest rate is linked to
IBOR. The loan is not prepayable and credit risk is not significant.

7I.7.615.60 R’s strategy is to hedge the variability in IBOR cash flows receivable
from the loan by applying cash flow hedging using an interest rate swap. The
derivative has the same notional and maturity as the hedged item and is designated
in the hedging relationship from inception. R considers alternative hedging
relationships depending on whether there is a floor on the IBOR rate in the swap
and/or in the loan in a negative interest rate environment.

Scenario 1: Hedged item and hedging instrument do not contain floors

7I.7.615.70 R can designate a vanilla interest rate swap as a hedging instrument

in a cash flow hedge of the variability in IBOR cash flows receivable from the loan.
As a consequence, hedge effectiveness is expected to be achieved because all
critical terms are matched.

Scenario 2: Only the hedged item has a floor

7I.7.615.80 In this scenario, the IBOR cash flows on the loan are floored at zero
and the proposed hedging instrument is a vanilla interest rate swap that pays IBOR
and receives a fixed rate. As noted in 7I.7.615.10, a loan in which the interest rate is
linked to IBOR but floored at zero may be a hedged item in a cash flow hedge of the
variability of interest payments or receipts due to changes in IBOR. First R must
make a prospective test in order to assess the effectiveness of the hedging
relationship at inception. However, assuming that the hedging relationship is
expected to be highly effective at inception (see 7I.7.510), hedge ineffectiveness
may arise in future periods because changes in IBOR will not have an equal and
opposite effect on the hedging instrument and the hedged item (see
7I.7.615.10–40).

Scenario 3: Only the hedging instrument has a floor

7I.7.615.90 In this scenario, R considers an interest rate swap that pays IBOR
floored at zero and receives a fixed rate. With this instrument, R would pay the
greater of IBOR and zero. This swap is in effect a net written option and so does not
qualify as a hedging instrument. As noted in 7I.7.340, an instrument or combination
of instruments that in effect is a net written option qualifies as a hedging instrument
only if it is designated as an offset to a purchased option. [IAS 39.AG94]
 Scenario 4: Both the hedged item and the hedging instrument have a floor

7I.7.615.100 R designates, as the hedging instrument, an interest rate swap that

pays IBOR floored at zero and receives a fixed rate. The hedged item is the
variability in IBOR cash flows receivable from a loan that also contains a floor on the
IBOR component at zero.

7I.7.615.110 Similar to Scenario 3, the hedging instrument is in effect a net

written option and the fair value is zero at the date of designation. However, the
IBOR cash flows on the loan are also floored at zero and this is considered a
purchased option. A written option may be designated as a hedging instrument if it
is designated as

an offset to a purchased option (see 7I.7.340). As a consequence, considering that

all other critical terms are matched, the presence of floors in both the hedged item
and the hedging instrument results in high effectiveness.

7I.7.615.120 An additional question arises when considering the designation of a hedged item
with embedded optionality in a cash flow hedge. That is, should the time value of the embedded
option be included within the change in value of the hedged item for effectiveness purposes? IAS 39
permits the exclusion of the time value of an option contract from the hedging relationship. This
results in the immediate recognition of the change in the time value of the hedging option through
earnings and can be helpful in cases where equivalent time value does not exist in the hedged item.
However, the standard does not address a situation in which the hedged item and the hedging
instrument both contain time value. [IAS 39.74(a)]

7I.7.615.130 In our view, if the hedged item contains embedded optionality matched by
optionality within the hedging instrument, then the inclusion of time value from both the hedged
item and the hedging instrument within the hedging relationship would provide high effectiveness.

EXAMPLE 25 – INCLUSION OF TIME VALUE WITHIN HEDGED ITEM IN CASH FLOW HEDGING RELATIONSHIP

7I.7.615.140 Company X has a variability in IBOR cash flows receivable from a

loan. The loan also contains a floor on the IBOR component at zero. X wants to
hedge the variability in IBOR cash flows considering the following hedging
relationship.
• Hedged item: variability in IBOR cash flows (i.e. the hedged item will receive the
greater of IBOR and zero).
• Hedging instrument: interest rate swap that pays IBOR and receives a fixed rate.
IBOR cash flows under the swap are floored at zero (i.e. the interest rate swap
pays the greater of IBOR and zero).
• The maturity of the hedged item and the hedging instrument are the same (i.e.
two years).
• The hedged item and the hedging instrument are of the same notional amount.
The loan is not prepayable and the credit risk is not significant.
• The hedging instrument (including the interest rate swap and the embedded
floor) has nil fair value at inception and the change in the fair value goes through
OCI after inception.

7I.7.615.150 In this case, if IBOR is above 0%, then X will receive IBOR interest
from the loan and will pay IBOR interest on the floating leg of the swap. Conversely,
if IBOR is below 0%, then X will receive 0% from the loan and will pay 0% on the
floating leg of the swap. In both scenarios, the time between inception and maturity
 is two years and this period of time will be reflected in the calculation for
measurement of hedge ineffectiveness.

7I.7.615.160 For the calculation of the variability in the hedged item, the
embedded premium (including the intrinsic value and the time value) is considered
within the hedged item cash flows and so forms part of the calculation at inception.
Accordingly, the inclusion of time value from both the hedged item and the hedging
instrument within the hedging relationship results in high effectiveness.

7I.7.615.170 In our view, the following are some of the methods that could be used for measuring
hedge ineffectiveness in a cash flow hedge of interest rate risk using an interest rate swap.

7I.7.620 Change in fair value method

7I.7.620.10 Ineffectiveness is measured by considering movements in the present value of the
cumulative expected/contractual future interest cash flows that are designated as the hedged item
and the cumulative change in the fair value of the designated hedging instrument – e.g. a pay-fixed
receive-floating interest rate swap. Although this approach is permitted and simple to apply, it will
lead to ineffectiveness. This is because the overall change in the fair value of the hedging instrument
will be influenced by the change in value of the pay-fixed leg of the interest rate swap as this pay-
fixed leg does not reprice to the current fixed market rate at each testing date. As a result,
ineffectiveness arises because there is no such change in the present value of the hedged item
because it does not include a fixed leg.

7I.7.630 Hypothetical derivative method

7I.7.630.10 Ineffectiveness is measured by comparing the change in the fair value of the actual
derivative designated as the hedging instrument and the change in the fair value of a hypothetical
derivative representing the hedged item. The hypothetical derivative is defined so that it matches
the critical terms of the hedged item – e.g. notional, repricing dates, index on which the asset or
liability’s variable rate is based, mirror image caps and floors etc. The hypothetical derivative should
have a zero fair value at inception of the hedge. The hypothetical derivative would be expected to
offset perfectly the hedged cash flows, and the change in fair value of the hypothetical derivative is
regarded as a proxy for the present value of the cumulative change in the expected future cash flows
on the hedged item.

7I.7.630.20 The hypothetical derivative method is likely to be more difficult to apply in our
experience because a separate hypothetical derivative needs to be identified for each hedging
relationship. However, this method does result in lower ineffectiveness in most instances compared
with the change in fair value method. Typically, only one hypothetical derivative is identified for each
hedged item based on the terms of the hedged item. Without such a restriction entities could design
a perfect hypothetical derivative to match exactly the terms of the hedging instrument, thereby
reporting no ineffectiveness.

7I.7.630.30 In our view, the valuation methodology for determining the change in fair value of the
hypothetical derivative should utilise market valuation conventions – e.g. the discount rate – to
measure a derivative. If there is a change in market valuation conventions, then it is appropriate for
an entity to adjust the inputs when determining the change in fair value of the hypothetical
derivative. For example, an entity has previously used six-month IBOR as the discount rate when
determining the change in fair value of a pay-fixed receive-floating interest rate swap. Because of
changes in market valuation conventions, the entity now determines that three-month IBOR is the
appropriate discount rate for determining the change in fair value. We believe that it is appropriate
for the entity to adjust the discount rate from six-month IBOR to three-month IBOR when
determining the change in fair value of both the actual instrument and the hypothetical derivative.
Such an adjustment would not be considered a de-designation/redesignation event.

7I.7.630.40 In our view, a related issue arises when an entity’s hedge documentation is silent on
whether the hypothetical derivative instrument is collateralised and the resulting impact on
determining the change in its fair value. For example, an entity had previously designated a
collateralised interest rate swap as the hedging instrument in a cash flow hedge of a variable rate
debt instrument. The hedge documentation is silent because it relates to whether the hypothetical
derivative instrument is collateralised. The entity has determined that because of changes in market
valuation conventions, it is appropriate to use an overnight index swap rate (OIS) discount rate to
determine the change in fair value of similar collateralised interest rate swaps. Although the entity
had previously used six-month IBOR as the discount rate to determine the fair value of the
hypothetical derivative, we believe that it is appropriate for the entity to adjust the discount rate
from six-month IBOR to OIS without de-designating and redesignating the hedging relationship.
Such an adjustment is allowed only as a one-time refinement of the methodology for assessing hedge
effectiveness. [IAS 39.88]

7I.7.630.50 In our view, the hypothetical derivative method is not available in a fair value hedging
relationship, and therefore ineffectiveness may arise when there is a change in market valuation
conventions that affect the discount rate that would be used to determine the fair value of a hedging
instrument. For example, an entity has designated a collateralised pay-fixed receive-floating interest
rate swap in a fair value hedge for changes in six-month IBOR of a fixed rate bond. A shift in market
valuation convention from using six-month IBOR to an OIS discount rate in determining the change
in fair value of the interest rate swap would not allow the entity to start using an OIS discount rate
when determining the change in fair value of the bond for changes in six-month IBOR.

7I.7.640 Measuring hedge ineffectiveness

7I.7.640.10 In most circumstances, the effectiveness of both the variable and the fixed legs of the
swap needs to be considered when using one of the methods described in 7I.7.620–630. Considering
only the change in fair value of the floating leg of the swap would in our view be appropriate for
effectiveness testing purposes when using the hypothetical derivative only when the fixed rate on the
swap is equal to the fixed rate that would have been obtained on the hedged item at its designation
date – i.e. when the fixed leg of the hedging swap equals the fixed leg on a hypothetical derivative
that, had such hypothetical derivative been created on the hedge designation date, would perfectly
offset the hedged cash flows. In other words, if the fixed leg of the swap is the market rate at
inception of the hedging relationship such that the swap has a fair value of zero or close to zero, and
there are no differences in the principal terms (notional, repricing dates, basis) and credit risk (or
credit risk is not designated in the hedging relationship), then such a method for testing
effectiveness may be appropriate. In such circumstances, the changes in fair value arising on the
fixed leg of the hedging instrument and on the fixed leg of the perfectly effective hypothetical
derivative offset each other perfectly and consequently do not contribute to any ineffectiveness in
the relationship.

7I.7.640.20 If the hedge is designated subsequent to entering into the hedging swap, then it is
unlikely that the fixed leg of the hedging swap will be equal to the fixed rate on the perfectly effective
hypothetical derivative. Therefore, a method that compares only the changes in the fair values of the
floating legs of the hedging swap and the hedged item is not appropriate to use in this case.

7I.7.640.30 In our view, IFRS Standards do not permit what has been termed as ‘terminal value’
hedging under US GAAP. Additionally, it is not appropriate to identify and designate as the hedged
item a portion containing a risk exposure similar to that of a written option – e.g. designating a
written option as the hypothetical derivative in highly probable forecast cash flows. For example, if
an entity purchases an option to hedge the downside foreign currency risk in a highly probable
foreign currency revenue stream, then it is not appropriate to designate as the hedged item a portion
of the forecast cash flows such that it represents an exposure to losses in a way that this portion is a
written option, including time value, that then perfectly offsets the purchased option.
7I.7.640.40 It is not possible, in the absence of actual optionality in the hedged item, to designate
the hedged risk in a manner such that it has a time value component. Therefore, in most cases hedge
effectiveness can be achieved only by excluding the time value from the hedging relationship (see
7I.7.600).

7I.7.640.50 Forecast transactions create a cash flow exposure to interest rate changes because
interest payments will be based on the actual market rate when the transaction occurs. In these
circumstances, hedge effectiveness is based on the highly probable expected interest payments
calculated using the forward interest rate based on the applicable yield curve. For forecast
transactions such as anticipated debt issues, it is not possible to determine what the actual market
interest rate will be for the debt issue. In these situations, retrospective hedge effectiveness may be
measured based on changes in the interest rates that have occurred between the designation of the
hedge and the date on which effectiveness testing is performed. The forward interest rates that
should be used are those that correspond with the term of the expected transaction at inception and
at the date of the effectiveness testing. The implementation guidance to IAS 39 provides an example
of how hedge effectiveness may be measured for a forecast transaction in a debt instrument. [IAS
39.IG.F.5.5]

7I.7.650 Clean vs dirty prices

7I.7.650.10 In hedging interest rate risk arising from fixed rate financial assets or financial
liabilities using interest rate swaps, a highly effective hedging relationship can usually be achieved
by ensuring that the principal terms of the hedged item and hedging instrument match. However,
when the interest rate on the swap reprices at a date other than the reporting date (at which date
effectiveness is assessed), ineffectiveness may arise from the variable leg of the swap because of
interest rate movements between these two dates. For example, an interest rate swap reprices every
three months and the last repricing date is 30 November, which is before the reporting date. On 30
November, the interest on the variable leg of the swap is fixed for the next three months.
Consequently, changes in market interest rates between this date and the reporting date of 31
December will cause the fair value of the floating leg of the swap to change, giving rise to
ineffectiveness – this is reflected in the ‘dirty’ price of the swap. During initial periods and periods
near the end of a hedging relationship, this ineffectiveness may be substantial enough, in relative
terms, to preclude hedge accounting.

7I.7.650.20 In our view, an entity could indicate that in assessing hedge effectiveness it will
disregard the accrued interest on the hedging instrument and the hedged item – this is referred to as
the ‘clean’ price of the swap. In this case, it may be possible to prove that the relationship was
effective on a retrospective basis – i.e. within the 80–125 percent range – and therefore to continue
hedge accounting, assuming that the other conditions continue to be met. Disregarding accrued
interest implies that the entity will, for the purpose of assessing hedge effectiveness only, determine
the fair value of the swap as the clean price. By considering clean prices, while the entire
ineffectiveness from the floating leg of the swap would not be eliminated, the resulting
ineffectiveness would then be limited to fair value changes on the unaccrued portion of the interest
coupon to the next swap settlement date.

7I.7.650.30 In our view, such a methodology should improve both the retrospective and the
prospective effectiveness of the hedging relationship. However, this does not mean that there will be
no ineffectiveness. The entity is still required to calculate the extent to which the hedge was
ineffective and this amount should be recognised in profit or loss. So although the continuation of
hedge accounting should be possible, the actual ineffectiveness should be recognised in profit or loss
under the offset method (see 7I.7.570).

7I.7.660 Ineffectiveness in fair value hedge arising from different fixed rates
7I.7.660.10 Entities may designate fixed rate financial assets or financial liabilities as hedged
items in a fair value hedge, with the hedged risk being changes in fair value arising from changes in
interest rates. The hedged cash flows in this case would include all coupons and principal payments
arising from the instruments. In such a hedging relationship, issues may arise in respect of
effectiveness because of mismatches between the fixed rate on the hedged item and the fixed
interest rate on the hedging instrument. Such a mismatch could arise in the following circumstances.
• The hedged financial asset or financial liability bears interest at a fixed rate calculated as the
benchmark rate on issue plus a certain number of basis points for credit spread, whereas the fixed
leg of the hedging instrument is based on the benchmark interest rate at inception plus a different
number of basis points for credit spread.
• The interest rate on the hedged financial asset or financial liability is based on the benchmark
interest rate at the date of issue, whereas the fixed leg of the hedging instrument is based on the
benchmark interest rate at a later date. This difference is arising from movements in the
benchmark rate between these two dates.

7I.7.660.20 For both cases in 7I.7.660.10, in our view it may be possible to designate a portion of
the cash flows of the fixed rate financial asset or financial liability as the hedged item to achieve high
effectiveness. For further discussion, see 7I.7.180.130–140.

7I.7.670 Assessing hedge effectiveness when hedging with off-market

derivative
7I.7.670.10 In certain scenarios, an entity may enter into a hedging relationship in which the
designated hedging instrument is a non-option derivative with the initial non-zero fair value that is
attributable to factors other than the bid-ask spread – e.g. when an entity has to de-designate a
hedging relationship and then redesignates the derivative in another hedging relationship (see
7I.7.590.30).

7I.7.670.20 In our view, the ineffectiveness that is caused by the hedging instrument having a
non-zero fair value at the designation date of the hedging relationship may be reduced by excluding
the following two elements when computing, for hedge effectiveness testing purposes only, the
change in the hedging instrument’s fair value, as well as the related effects on the hedged item:
• the interest accretion due to passage of time alone; and
• the realisation/settlement of the off-market element. This can be analogised to the receipts of
principal on a debt security that are not fair value gains or losses, but are a return of capital.

7I.7.670.30 In our view, it is appropriate to exclude the interest accretion because it is not
attributable to changes in any risk factor between two successive effectiveness assessment dates,
and it arises only because of the passage of time, similar to accrued interest (see 7I.7.650). Also, it is
appropriate to exclude the realisation/settlement of the off-market element because it is a
return/payment of the amount invested in the derivative at the designation date of the hedging
relationship.

EXAMPLE 26 – EXCLUSION OF INTEREST ACCRETION AND REALISATION/SETTLEMENT OF OFF-MARKET ELEMENT

FROM EFFECTIVENESS ASSESSMENT

7I.7.670.40 On 1 October 2020, Company X entered into a three-year interest rate

swap at current market terms – i.e. zero fair value at inception – with a notional
amount of 10,000. Under the terms of the swap, X receives 6% and pays IBOR. On 1
October 2021, X designates the swap as the hedging instrument in a fair value
hedge of a financial liability with the same notional, maturity and contractual
interest payments of 6%. On the hedge designation date, the interest rate swap has
a fair value of 400 (an asset), because the swap curve has moved since 1 October
2020, and the fixed leg of the swap if priced on 1 October 2021 would be 4%.

7I.7.670.50 For hedge effectiveness testing purposes, we believe that X could

exclude the following from the fair value change of the interest rate swap.

•
 • The interest accretion due to passage of time of the interest rate swap from the
fair value of 400, which represents the discounted excess 2% cash flows to be
received over the remaining life of the swap, to the undiscounted amount of the
excess 2% cash flows as the swap moves closer to maturity – e.g. 408.
• The realisation of the off-market element of the interest rate swap, which would
be a portion of each net interest payment – e.g. approximately 204 each year
until maturity.

7I.7.670.60 Although the interest accretion and realisation/settlement of the off-

market element may be excluded for hedge effectiveness testing purposes, they
impact the change in the fair value of the derivative. However, the related changes
in fair value are immediately recognised in profit or loss similar to the time value of
an option or the interest element of a forward contract (see 7I.7.600).

7I.7.680 DISCONTINUING HEDGE ACCOUNTING

7I.7.680.10 Hedge accounting is discontinued prospectively if:

• the hedged transaction no longer is highly probable;
• the hedging instrument expires or is sold, terminated or exercised;
• the hedged item is sold, settled or otherwise disposed of;
• the hedge no longer is highly effective; or
• the entity revokes the designation.

7I.7.680.15 If an entity does not meet all hedge effectiveness criteria, then hedge accounting is
terminated as at the date on which the hedge was last proved effective, which may be the previous
interim or annual reporting date, or from the date on which the hedged item or hedging instrument
is derecognised. For this reason, testing hedge effectiveness more frequently is a way of reducing
the impact of the unexpected termination of a hedging relationship. If the entity can identify the
event or change in circumstances that caused the hedge to fail the effectiveness criteria, and can
prove that the hedge was effective before the date on which this occurred, then the entity can cease
hedge accounting from the date of such event or change in circumstances. If there is a retrospective
hedge effectiveness test failure, then even if prospective effectiveness can be demonstrated for the
existing hedging relationship, hedge accounting based on the previous designation is discontinued,
although it may be possible to designate prospectively a new hedging relationship. Also, because the
retrospective effectiveness criterion is not met, hedge accounting cannot be applied for the period
just ended. In contrast, if a hedging relationship is demonstrated to be highly effective for the period
just ended, but the prospective effectiveness criterion is not met, then hedge accounting is
discontinued prospectively from the date of such assessment. Also, in this case it is necessary to
report any ineffectiveness in profit or loss on the date on which hedge accounting is discontinued.
[IAS 39.91, 101, AG113, IG.F.6.2(i)]

7I.7.680.20 Hedge accounting would also be discontinued if the recognised asset, liability, firm
commitment or forecast transaction is no longer eligible for designation as a hedged item. This
would occur, for example, when an entity acquires, or otherwise begins to consolidate, the
counterparty to a hedged forecast transaction or firm commitment, resulting in that transaction no
longer involving a party external to the reporting entity. Another example is when an entity sells, or
otherwise is required to deconsolidate, a subsidiary (see 2.5.760), resulting in a hedged item of that
subsidiary becoming derecognised. Also, when there is a change in the functional currency of an
entity, foreign currency exposures denominated in the new functional currency will no longer qualify
for hedge accounting for foreign currency risk.

7I.7.680.30 When an entity voluntarily terminates a hedging relationship in between two regular
effectiveness assessment dates, then in our view the hedging relationship should be assessed for
effectiveness on the date of voluntary termination to determine whether it was retrospectively
effective. If the hedge is determined to be retrospectively effective, then hedge accounting should be
applied up to the date of voluntary termination, including recognising any ineffectiveness up to that
date in profit or loss. If, however, the retrospective test is failed, then hedge accounting cannot be
applied after the last date on which the effectiveness criteria were met.

7I.7.680.40 A hedging relationship is discontinued when the hedging instrument is sold or

terminated. In our experience, certain events of default, such as a filing for bankruptcy by the
counterparty, would – under the standard International Swaps and Derivatives Association (ISDA)
terms for some derivatives – either result automatically in termination of the derivative or permit the
entity to terminate the derivative in exchange for a net cash settlement and to replace it with another
instrument having similar terms with another counterparty. Whether this is the case is likely to
depend on the legal and contractual arrangements in each country. In our view, unless it is a
replacement of a hedging instrument as part of the entity’s existing documented hedging strategy,
the termination of a hedging derivative and its replacement by another derivative with another
counterparty would result in the termination of the existing hedging relationship and, if it is
appropriately designated, the establishment of a new one.

7I.7.680.50 Beginning a new replacement hedging relationship using a derivative that has a fair
value other than zero may result in hedge ineffectiveness in the future (see 7I.7.670). This is because
the initial fair value of the derivative is itself subject to change with changes in market interest rates.
Unless an offsetting fair value effect is also present in the hedged item, ineffectiveness may result.

7I.7.680.60 If the hedged item is partially repaid (determination depends on how the hedged item
has been defined in the hedge designation) before its expected repayment date, then this will cause
the entity to be over-hedged because the notional amount of the hedging instrument may be more
than the remaining outstanding amount of the hedged item. In this case, the entity would be required
to terminate the existing hedging relationship unless the existing hedging relationship continues to
be highly effective with the reduced hedged item – i.e. if the originally designated hedging
instrument continues to be highly effective in offsetting the changes in fair value or cash flows of the
now-reduced hedged item. If, as a result of the partial repayment of the hedged item, the over-hedge
is such that the 80–125 percent effectiveness test is no longer met, then the original hedging
relationship is discontinued in its entirety. The entity may redesignate the remaining hedged item in
a new hedging relationship, which may include a proportion of the original hedging instrument, if all
the criteria for hedge accounting are met. The adverse effect of a partial repayment of the hedged
item on continuity of the entire hedging relationship may be mitigated by use of a layering hedge
strategy as discussed in 7I.7.720.

7I.7.680.70 If a hedging instrument ceases to be part of a hedging relationship, then it may be

redesignated in a new hedging relationship, as long as the redesignation is for the entire remaining
term of the instrument. For example, a forward contract of 100 that was initially designated as the
hedging instrument to hedge forecast transactions of 100 would no longer be expected to be highly
effective if revisions to forecasts subsequent to the hedge designation date indicate that only 70 of
the forecast transactions are now highly probable. In this situation, the original hedge designation
would be discontinued because it would no longer meet the highly effective criteria. A new hedging
relationship under which a proportion (e.g. 70 percent) of the original forward is designated to
hedge the highly probable forecast transactions of 70 is permissible. The new hedging relationship
may not be fully effective because the forward contract would normally have a fair value other than
zero at the date of redesignation (see 7I.7.670). Changes in fair value of the remaining proportion of
the forward (i.e. 30 percent), if not designated in another hedging relationship, would be recognised
in profit or loss. [IAS 39.75]

7I.7.680.72 An entity may seek to alter an existing hedging relationship by introducing a new
hedging instrument, changing the hedged risk or changing the ratio between the quantity of hedging
instruments and hedged items. Subject to 7I.7.680.80, in our view the introduction of a new hedging
instrument, changing the hedged risk and adjustment of the hedge ratio represent fundamental
changes to the hedge designation that require the entire existing hedging relationship to be de-
designated and, if appropriate, permit a new hedging relationship to be redesignated.
7I.7.680.74 An entity may designate a single derivative in a hedge of more than one risk type (see
7I.7.470). We believe that the principle contained in 7I.7.680.72 would also apply in its entirety to a
hedge of more than one risk type if there is such a change with respect to one of the hedged risks –
i.e. the existing hedging relationship relating to all risk types would be de-designated in its entirety.
This is because the existing hedging relationship is a single hedging relationship even though it
relates to more than one hedged risk. [IAS 39.76]

EXAMPLE 27 – REDESIGNATION IN A NEW CASH FLOW HEDGE

7I.7.680.76 Company C, whose functional currency is sterling, issues a 20-year

fixed rate debt liability denominated in US dollars in year 0. C’s risk management
strategy is to hedge currency risk and interest rate risk. C plans to convert the first
10 years of interest and foreign currency exposure to a fixed interest rate
denominated in sterling. For the last 10 years of the debt instrument, C plans to
convert the exposure to a floating interest rate in sterling. This strategy will be
achieved by the following.
• Year 0: Enter into a 20-year cross-currency interest rate swap to receive a fixed
interest rate and principal in US dollars and pay a variable interest rate and
principal in sterling (Swap 1).
• Year 0: Enter into a 10-year interest rate swap to receive a variable rate in
sterling and pay a fixed rate in sterling (Swap 2).
• Year 10: On maturity of Swap 2, plan to enter into a new 10-year interest rate
swap to receive a variable rate in sterling and pay a fixed rate in sterling (Swap
3). The variable interest receipts in sterling on Swap 3 will offset the variable
interest payments in sterling on Swap 1 until the maturity date of this
transaction.

7I.7.680.77 At inception of the hedging relationship in year 0, C anticipates that it

will enter into Swap 3 in year 10 and reflects this in its hedge documentation. Swaps
1 and 2 are combined and designated as the hedging instrument in a cash flow
hedge of currency risk for years 0 to 10 and a fair value hedge of currency and
interest rate risk for years 11 to 20. C expects that, in year 10, the remainder of
Swap 1 and Swap 3 will be jointly designated as a cash flow hedge of currency risk
for years 11 to 20.

7I.7.680.78 On initial designation in year 0, the cash flows in years 11 to 20 are

hedged for both currency and interest rate risk. When Swap 3 is designated in year
10, then the risk being hedged in years 11 to 20 will be only currency risk. Under
IAS 39 the replacement or rollover of a hedging instrument into another hedging
instrument is not an expiration or termination if such replacement or rollover is part
of the entity’s documented hedging strategy. However, the introduction of a new
hedging instrument with a different risk profile to the existing hedging instrument
represents a fundamental change to the hedge designation (see 7I.7.680.72).
Therefore, C needs to de-designate the entire hedging relationship and, if it wishes
to continue hedge accounting, designate a new cash flow hedge that includes the
remainder of Swap 1 and Swap 3. If so, the terms of any hypothetical derivative
used to demonstrate the effectiveness of the new hedging relationship would be
established on the date of designation. [IAS 39.101(a)]

7I.7.680.80 A replacement or rollover of a hedging instrument is not deemed to be a termination

if the new instrument has the same characteristics as the instrument being replaced, it continues to
meet the hedge criteria and the rollover strategy was documented properly at inception of the initial
hedge. In our view, using a rollover hedge strategy, the entity may continue to perform hedge
effectiveness testing on a cumulative basis from the beginning of the period in which the first
hedging instrument was rolled over. The amortisation of any fair value adjustment made to the
hedged item under a fair value hedge may continue to be deferred until the rollover hedge strategy is
discontinued. [IAS 39.91]

EXAMPLE 28 – ROLLOVER HEDGE STRATEGY

7I.7.680.90 Company X forecasts a highly probable purchase of a commodity in

one year. As part of its risk management strategy, X wants to fix the cash flow
variability that would arise from changes in market prices of the commodity from
now until the date of purchase. However, the market to which X has access does not
offer commodity future contracts for a duration longer than three months.
Therefore, X decides to hedge its exposure to changes in commodity prices by
entering into four successive commodity futures.

7I.7.680.95 If X documents this hedging strategy, including the expected rollovers

of the hedging futures, at inception of the hedge, then the expiry of one future
contract and its replacement with a successive future contract with the same
characteristics would not be deemed to be a termination of the hedge.

7I.7.680.100 When an effective hedging relationship no longer exists, the accounting for the
hedging instrument and the hedged item revert to accounting under the usual principles of IAS 39
and other applicable standards. All derivatives in the scope of IAS 39 are accounted for at fair value,
with changes in fair value recognised in profit or loss. When fair value hedge accounting is
discontinued prospectively, any hedging adjustment made previously to a hedged financial
instrument for which the effective interest method is used is amortised to profit or loss by adjusting
the effective interest rate of the hedged item from the date on which amortisation begins.
Amortisation may begin as soon as an adjustment exists – i.e. while the hedging relationship still
exists – but cannot begin later than the date on which the hedged item ceases to be adjusted for
changes in fair value attributable to the hedged risk. If, in the case of a portfolio hedge of interest
rate risk, amortising using a recalculated effective interest rate is impracticable, then the
adjustment is amortised using a straight-line method. The adjustment is amortised fully by the
maturity of the financial instrument or, in the case of a portfolio hedge of interest rate risk, by the
expiry of the relevant repricing time period. In the event that the hedged item is derecognised, the
adjustment is recognised immediately in profit or loss when the item is derecognised. [IAS 39.92]

7I.7.680.110 For a hedge of a net investment in a foreign operation, the cumulative amount
previously recognised in OCI remains in the foreign currency translation reserve until there is a
disposal or partial disposal of the investment (see 7I.7.110.30–40). A partial disposal of a net
investment in a foreign operation may require the existing hedge to be terminated if the hedging
instrument is no longer highly effective in offsetting the foreign currency risk on the reduced net
investment. [IAS 39.102]

7I.7.685 Clearing derivatives with central counterparties

7I.7.685.10 There is relief from discontinuing an existing hedging relationship if a novation that
was not contemplated in the original hedging documentation meets the following criteria:
• the novation is made as a consequence of laws or regulations, or the introduction of laws or
regulations;
• the novation results in one or more clearing counterparties becoming the new counterparty to
each of the parties to the novated derivative; and
• any changes to the terms of the novated derivative are limited to those necessary to effect such a
replacement of the counterparty but only if those changes are consistent with the terms that
would be expected if the novated derivative were originally cleared with the clearing
counterparty; these changes include:
–
 – changes in the contractual collateral requirements of the novated derivative;
– rights to set off receivables and payables balances with the clearing counterparty; and
– charges levied by the clearing counterparty. [IAS 39.91(a), 101(a)]
7I.7.685.20 The following flowchart summarises how to apply the criteria.

Is the novation made as a consequence No

of laws or regulations or the
introduction of laws or regulations?

Yes

Does a clearing counterparty become No Discontinue

a new counterparty to each of the hedge
original parties? accounting

Yes

Are the changes to the terms of the No

derivative limited to those necessary
to replace the counterparty?

Yes

Continue hedge accounting

7I.7.685.30 A ‘clearing counterparty’ is a central counterparty (sometimes referred to as a

‘clearing organisation’ or a ‘clearing agency’), or an entity or entities – e.g. a clearing member of a
clearing organisation or a client of a clearing member of a clearing organisation – that are acting as
counterparty to effect clearing by a central counterparty. [IAS 39.91(a), 101(a)]

7I.7.685.40 If the parties to the hedging instrument replace their original counterparties with
different counterparties, then the relief is available only if each of those parties effects clearing with
the same central counterparty. [IAS 39.91(a), 101(a)]

7I.7.685.50 For hedging relationships that continue after the hedging instrument is novated to a
clearing counterparty, IAS 39 is still applied as usual to account for the derivative and the hedging
relationship. For example, any changes in the credit quality of the counterparty, or in the contractual
collateral requirements, are reflected in the fair value of the novated derivative and in the
measurement of hedge ineffectiveness. [IAS 39.AG113A]

7I.7.685.60 In some jurisdictions, a novation of a derivative to a clearing counterparty may not be

required by laws and regulations, but an entity may voluntarily novate a derivative as a consequence
of laws and regulations. In such cases, to continue hedge accounting the voluntary novation should
be associated with laws or regulations that are relevant to the central clearing of derivatives. The
mere possibility of laws or regulations being introduced is not a sufficient basis for the continuation
of hedge accounting. [IAS 39.BC220Q]

7I.7.685.70 There may be other situations in which a derivative is novated but the criteria to
continue hedge accounting are not met – e.g. an entity agrees to a counterparty novating an over-
the-counter derivative to a third party as a consequence of laws or regulations, and no clearing
counterparty is introduced.
7I.7.685.80 To mitigate the risk that novation would cause hedge accounting to be discontinued,
an entity may state in its hedge documentation that its intention is for the hedging relationship to
continue if the hedging derivative is subsequently novated in circumstances other than those
contemplated in the criteria in 7I.7.685.10.

7I.7.687 Collateralised-to-market and settled-to-market models

7I.7.687.10 Changes to the contractual terms of the clearing arrangements used for the
execution of derivative contracts may impact the hedging relationship if an affected derivative is
designated as a hedging instrument. This may be the case if the legal characterisation of variation
margin payments is changed from collateral to partial settlement – i.e. a change from collateralised-
to-market to settled-to-market – without any other changes to the contractual terms. In our view,
such a change on its own would not represent a termination of the derivative contract or a change in
its critical terms and would not require clearing members or end users to discontinue the existing
hedge accounting relationship for those reasons. However, different entities may have different
approaches to assessing effectiveness, as set out in their hedge accounting documentation. For an
affected hedge, an entity would need to consider how the contractual changes (including the
introduction of price alignment adjustment) impact the application of its documented approach and
whether it remains fit for purpose (see 7I.5.450).

7I.7.690 Effect of delays and other changes in forecast transaction

7I.7.690.10 The notion of a highly probable forecast transaction implies a higher degree of
probability than one that is merely expected to occur. If a forecast transaction is no longer highly
probable but is still expected to occur, then this means that the criteria for hedge accounting are no
longer met and, prospectively, the entity ceases applying hedge accounting. However, the net
cumulative gain or loss that was recognised in OCI during the effective period of the hedge remains
in equity until the expected transaction actually occurs. The same treatment applies in any other
case when hedge accounting is terminated because the hedging criteria are no longer met. [IAS
39.101(b)]

EXAMPLE 29 – DISCONTINUATION – RECLASSIFYING GAINS AND LOSSES – HEDGED FUTURE CASH FLOWS

EXPECTED TO OCCUR

7I.7.690.20 On 31 December 2021, Company D issues a floating rate bond that

bears interest based on a benchmark rate payable annually and matures on 31
December 2025. The bond is issued at par of 1,000. In accordance with its risk

management strategy, D enters into a four-year pay-fixed 3% receive-benchmark

interest rate swap on 31 December 2021. On the same date, D designates the swap
as a cash flow hedge of the variability of future interest payments on the bond
attributable to changes in the benchmark rate. The timing of the swap’s cash flows
matches those of the bond. The fair value of the swap at inception is zero.

7I.7.690.30 The effects of credit risk are insignificant to the effectiveness of the
hedging relationship and there are no sources of ineffectiveness during the hedging
period. Therefore, during 2022 and 2023 all gains and losses on remeasurement of
the swap to fair value are included in OCI.

7I.7.690.40 On 31 December 2023, D changes its risk management strategy and it

no longer wishes to hedge its exposure to variable interest payments. Therefore, on
that date D terminates the interest rate swap by receiving its current fair value of 28
from the counterparty and discontinues hedge accounting. Interest payments on the
bond are still expected to occur through to maturity on 31 December 2025.
 7I.7.690.50 At 31 December 2023, the market one-year benchmark rate is 4% and
the one-year benchmark forward rate for fixing on 31 December 2023 and settling
on 31 December 2024 is 5%.

7I.7.690.60 We believe that D may apply the following approaches to reclassify

the accumulated balance of 28 recognised in OCI at 31 December 2023 to profit or
loss during 2024 and 2025 (see 7I.7.80.30).
• Approach 1: Using the information on the yield curve, D analyses the fair value of
the swap of 28 as representing the present value of expected net receipts of 10
on 31 December 2024 and 18 on 31 December 2025 – i.e. the expected present
values of the cash flows that would have occurred under the swap if it had not
been terminated. Based on this analysis, D reclassifies 10 during 2024 and 18
during 2025.
• Approach 2: D amortises the total balance of 28 on a straight-line basis over the
two-year period – i.e. 14 in each year.

7I.7.690.70 If a hedged forecast transaction is no longer expected to occur within the original
time period or a relatively short period thereafter, then hedge accounting is terminated. The related
cumulative gain or loss on the hedging instrument that was recognised in OCI is immediately
reclassified to profit or loss. An entity cannot continue to defer the cumulative gain or loss in equity
on the basis that the original hedged transaction has been replaced by a new forecast transaction
that has features similar to those of the original hedged transaction. In our view, if the extension of
the time period is relatively short, then the hedge still may qualify for hedge accounting if the
effectiveness criteria continue to be met (see 7I.7.510). [IAS 39.101]

7I.7.690.80 In determining the appropriate accounting treatment for delayed transactions, it is

important to distinguish between hedged cash flows related to:
• a firm commitment;
• a highly probable forecast transaction with an identified counterparty; and
• forecast transactions with unidentified counterparties.

7I.7.700 Firm commitments and forecast transactions with identified

counterparties

7I.7.700.10 When the timing of delivery or payments or other terms under a firm commitment are
changed, an entity evaluates whether the original firm commitment still exists or whether a new firm
commitment has been created. The latter situation would result in the original hedging relationship
being terminated and hedge accounting being discontinued prospectively (see 7I.7.680). [IAS 39.91,
101]

7I.7.700.20 If a firm commitment is delayed but will still occur, then it is important to determine
the cause and extent of the delay. In our view, when delays occur in the cash flows associated with a
firm commitment, hedge accounting may be continued under the following circumstances:
• the firm commitment can still be uniquely identified; and
• a binding agreement still exists and the cash flows are still expected to occur within a relatively
short period of time after the original delivery/payment date.

7I.7.700.30 The contract supporting a firm commitment should specify a date or range of dates
within which the cash flows are expected to occur. If a date, such as a delivery or completion date, is
not specified, then the transaction is unlikely to meet the definition of a firm commitment; rather, it
can be hedged only as a forecast transaction with an identified counterparty.

7I.7.700.40 For a highly probable forecast transaction with an identified counterparty, there may
be a little more flexibility in what could be regarded as a relatively short period of time if a delivery
date has not yet been established. [IAS 39.IG.F.3.11]
7I.7.700.50 The key issue, when taking into account all facts and circumstances surrounding the
delay, is whether the entity can demonstrate that the delayed transaction is the same transaction as
the one that originally was hedged.

7I.7.700.60 When the timing of a firm commitment or a highly probable forecast transaction is
delayed, some degree of ineffectiveness is likely to occur, if the timing of the hedged item and the
timing of the hedging instrument no longer are the same. When the hedging instrument originally
had a duration longer than the original expected timeframe for the firm commitment or forecast
transaction, then the effectiveness could, in fact, improve as a result of the delay in the hedged
transaction. In other cases, the hedged cash flow may arise earlier than originally expected. Because
the hedging instrument will expire later than the hedged cash flows, some ineffectiveness is likely to
occur in this situation as well. However, the hedging instrument may not be redesignated for a
shorter period. [IAS 39.IG.F.5.4]

7I.7.710 Forecast transactions with unidentified counterparties

7I.7.710.10 An example of a forecast transaction with an unidentified counterparty is the sale of
mobile handsets. Typically, the hedged cash flow would be the first ‘x’ amount of sales revenue to be
received on the sale of handsets in a particular month or quarter (see 7I.7.720). Exactly which
retailer or end user will purchase the handsets is not specified in the hedge documentation.

7I.7.710.20 Cash flows from forecast transactions with unidentified counterparties are
designated with reference to the time period in which the transactions are expected to occur. [IAS
39.IG.F.3.7]

7I.7.710.30 When forecast cash flows in a particular period do not occur, it is possible that such a
shortfall will be offset by increased cash flows in a later period. For example, an entity initially
forecasts sales of summer clothing of 100 in each of the first two quarters of the coming year.
Subsequently, the entity revises its forecast to sales of 75 in the first quarter and 125 in the second
quarter. The total amount of sales in the two quarters remains unchanged at 200.

7I.7.710.40 For hedge accounting to be continued, the original forecast transaction should still
exist and be highly probable. If the hedged item is a forecast transaction (e.g. forecast sales) with
unidentified counterparties within a certain time period, then it is unlikely that an entity will be able
to demonstrate that sales in later periods replace a shortfall in an earlier period. Consequently,
hedge accounting is discontinued. In addition, a history of designating hedges of forecast
transactions and then determining that they are no longer expected to occur may call into question
the entity’s ability to predict forecast transactions accurately, as well as the appropriateness of using
hedge accounting in the future for similar transactions. [IAS 39.88, 101]

7I.7.710.50 In our view, the transactions should be grouped into relatively narrow bands of time
within which the forecast transactions are expected to occur. In determining the length of such a
period, the industry and environment in which the entity operates should be considered. In our view,
for forecast transactions with unidentified counterparties, this narrow range of time should be
interpreted more strictly (i.e. a shorter time period used) than for forecast transactions with
identified counterparties.

7I.7.720 Use of layering with ‘first payments received (paid)’ approach

7I.7.720.10 In hedging groups of forecast transactions in a cash flow hedge using a first
payments received (paid) approach (see 7I.7.200.70), an entity may choose to enter into multiple
derivative contracts and layer these contracts such that each derivative will be designated in a
separate hedging relationship.

EXAMPLE 30 – USE OF LAYERING APPROACH

 7I.7.720.15 On 1 January 2021, Company J, whose functional currency is sterling,
forecasts EUR 1,000 sales to occur during the month of June 2021. On the same
date, it enters into four separate forward contracts, each to sell EUR 250, that
expire in June 2021. Instead of combining the four forward contracts and
designating them as the hedging instrument in a single hedge (see 7I.7.310.30), J
may designate four separate cash flow hedging relationships in which the first
forward contract hedges the cash flows from the first EUR 250 of forecast sales, the
second forward hedges the next EUR 250 of sales that have not been identified as
hedged forecast sales in a previously designated hedging relationship etc.

7I.7.720.20 Using this layering approach meets the requirements to identify, for
each of the individual hedging relationships, the hedged forecast transactions with
sufficient specificity for J to determine which transactions are the hedged
transactions

when they occur. The layering approach provides J with the flexibility to add
additional hedging relationships (i.e. add layers) and to remove existing
relationships (i.e. delete layers) without affecting the other hedging relationships
via termination and redesignation because no change is required to the
identification of the hedged forecast transactions associated with those other
relationships.

7I.7.720.25 This approach is possible because the designation of each relationship

will always identify the hedged forecast transactions as the first payments received
after (1) those cash flows that already have been identified as hedged forecast
transactions in a previously designated hedging relationship that continues to be
active and (2) those cash flows that were previously identified in a hedging
relationship that has been terminated (i.e. is inactive) but still are at least expected
to occur such that some portion of the gain or loss on the terminated hedging
relationship remains in OCI.

7I.7.720.30 If subsequent to designation J revises its sales forecasts and

determines that only EUR 725 of future sales remain highly probable to occur, then
under the layered hedge designation:
• the first two hedging relationships in respect of the first EUR 500 of forecast
sales will continue unaffected;
• the third hedging relationship will be likely to continue, albeit with higher
ineffectiveness, if the third EUR 250 forward contract remains highly effective in
offsetting the foreign currency risk on future cash flows of EUR 225; and
• the fourth hedging relationship will be terminated.
7I.7.720.40 In contrast, if J had designated all four forward contracts as the
combined hedging instrument in a single hedging relationship, then hedge
accounting would be required to be terminated for all forecast sales because the
combined hedging instrument to sell EUR 1,000 would not be effective in offsetting
the foreign currency risk arising from only EUR 725 of highly probable sales.

7I.7.720.50 Adding a derivative to the existing layers will put that relationship at the end of the
priority chain, such that it will be designated as hedging the first forecast transactions occurring
after (1) and (2), as discussed in 7I.7.720.25, without impacting the designation of those earlier
relationships. Furthermore, if a derivative matures such that a relationship early in the priority chain
terminates, then the identification of the forecast transactions for the relationships later in the
priority chain is not impacted because they will continue to hedge the first payments received after
(1) those that already are hedged in active hedging relationships and (2) those that were previously
identified in a hedging relationship that has been terminated (i.e. is inactive) for which amounts
remain in equity.

7I.7.720.55 If no amounts remain in equity related to the derivative that matured, the forecast
transactions that are identified with the active relationships and those inactive relationships that
continue to have amounts in equity are the forecast transactions occurring earlier in the priority
chain than before. This is because those relationships will have moved up in priority because of the
disappearance of the earlier layer as a result of the derivative’s maturity and the reclassification of
its related amounts from equity to profit or loss. When a relationship moves up in the priority chain,
then the perfectly effective hypothetical derivative – assuming that the entity employs the
hypothetical derivative method discussed in 7I.7.630 – associated with that relationship will be
adjusted to reflect the most recent best estimate of the forecast transactions that are identified with
that relationship. The terms of the adjusted perfectly effective hypothetical derivative would be so
determined that if constructed at hedge inception it would have a fair value of zero.

7I.7.720.60 We believe that the layering approach is a simple and effective methodology for
identifying the hedged forecast transactions for many hedging programmes. However, entities
cannot lose sight of the fact that each hedging relationship stands on its own; that is, entities cannot
apply a hedge documentation approach that ignores the priority chain designation of forecast
transactions. Therefore, complexities arise and the level of documentation may be higher in certain
hedging programmes, particularly those in which an entity is actively managing groups of existing
hedging relationships – e.g. terminating or de-designating derivatives before maturity – and is
experiencing shortfalls of forecast transactions.

7I.7.730 Impairment of hedged item

7I.7.730.10 An entity discontinues fair value hedge accounting when the hedge no longer meets
the criteria for hedge accounting (see 7I.7.120). [IAS 39.91]

7I.7.730.20 In our view, in many circumstances when a hedged asset has been impaired, the
current hedge accounting relationship should be discontinued. This is because when there is a
change in estimated cash flows of the hedged asset, the hedge is no longer expected to be highly
effective in achieving offsetting changes in fair value or cash flows attributable to the hedged risk
that is consistent with the originally documented risk management strategy for the particular
hedging relationship. For example, in the case of a hedge of benchmark interest rate risk, there
cannot be interest rate sensitivity on cash flows that are not expected to be recovered.

7I.7.730.30 An entity discontinues hedge accounting from the last date on which compliance with
the hedge effectiveness criteria was demonstrated. However, if the entity can identify the event or
change in circumstances that caused the hedging relationship to fail the effectiveness criteria, and
demonstrates that the hedge was effective before the event or change in circumstances occurred,
then the entity discontinues hedge accounting from the date of the event or change in
circumstances. [IAS 39.AG113]

7I.7.730.40 There may be circumstances in which an entity may determine that continuation of
the current hedging relationship is still appropriate – e.g. the impairment is for a small amount, and
the entity can conclude that effectiveness based on the original hedging relationship will remain
within 80–125 percent. Judgement should be applied based on the specific facts and circumstances
of a particular situation.

7I.7.730.50 If the existing hedging relationship is discontinued, then it may be possible to

designate a new hedging relationship based on the revised estimated recoverable cash flows.
Whether this is possible is a matter of judgement that depends on the entity’s ability to reliably
estimate the recoverable cash flows and separately identify the effect of changes in the benchmark
interest rate on the item’s fair value, as well as the availability of a hedging instrument that would be
effective in relation to the revised recoverable cash flow profile.
7I.7.733 MODIFICATION OF HEDGED ITEM

7I.7.733.05 The guidance in 7I.7.733.10–737.20 assumes that an entity applies IFRS 9

requirements other than hedge accounting requirements.

7I.7.733.10 If a hedged item is a financial instrument, then the contractual cash flows may be
affected by a modification that may impact the hedging relationship. For example, a payment holiday
on a loan designated as a hedged item in a hedge of benchmark interest rate risk may adjust the
timing and amount of the principal or interest cash flows. This may affect the carrying amount of a
hedged item through the application of modification or derecognition accounting (see 7.7.340 and
365) and may impact hedge accounting itself. The effects will depend on the nature of the hedge, the
nature of the modification and how the modification is accounted for.

7I.7.733.20 When there is a modification to the hedged item, an entity needs to consider whether
a discontinuation of the hedging relationship is required. The modification of the hedged item may
indicate that the hedged item is credit-impaired or has undergone a significant increase in credit
risk. We believe that in many circumstances a hedging relationship should be discontinued when a
hedged asset has been impaired (see 7I.7.730.20). In addition, the hedging relationship may need to
be discontinued because it no longer meets hedge accounting criteria (see 7I.7.120) – e.g. the highly
probable criterion or hedge effectiveness requirement.

7I.7.735 When hedge accounting is discontinued

7I.7.735.10 If a fair value hedge of interest rate risk is discontinued because of a modification to a
hedged financial instrument measured at amortised cost or FVOCI and an entity is required to
calculate a modification gain or loss on the hedged item (see 7.7.345 and 370), then it calculates the
modification gain or loss as the difference between:
• the present value of the modified contractual cash flows, discounted at the revised effective
interest rate that reflects the accumulated hedge adjustments. The effective interest rate is
revised as a result of fair value hedge adjustments at the date on which an entity begins to
amortise them (see 7.7.280.40); and
• the old gross carrying amount immediately before modification, including the accumulated hedge
adjustments made before discontinuation. As discussed in 7.7.265.20, it appears that the
unamortised adjustment for the hedging gain or loss amends the gross carrying amount of the
financial instrument. [IAS 39.92, IFRS 9.5.4.3, B5.4.6]

7I.7.735.20 For further discussion of the accounting when an entity discontinues hedge
accounting, see 7I.7.680.

7I.7.735.30 If the hedged item in a fair value hedge of interest rate risk is derecognised as a
result of the modification (see 7.7.360 and 375), then the hedge adjustment is immediately
recognised in profit or loss as part of the gain or loss on derecognition (see Example 49). [IFRS
9.B5.5.25]

7I.7.737 When hedge accounting is not discontinued

7I.7.737.10 If a modification to a hedged item in a fair value hedge of interest rate risk that is a
financial instrument measured at amortised cost or FVOCI is not substantial and does not lead to
discontinuation of the hedging relationship, then an entity needs to consider whether amortisation of
the hedge adjustment has commenced in order to calculate the modification gain or loss (see
7.7.345.10, 370.10 and 390.20).
• Amortisation has not commenced: If amortisation has not commenced, then the new gross
carrying amount of the hedged financial instrument is calculated as the present value of the
modified contractual cash flows discounted at the hedged item’s original effective interest rate
unadjusted for hedge accounting effects because the original effective interest rate is not revised
until the amortisation has commenced. The modification gain or loss will be the difference
between this new gross carrying amount and the old gross carrying amount of the hedged item,
 excluding any hedge adjustments. This is because the original effective interest rate is used to
calculate the new gross carrying amount and the effect of hedge adjustments therefore does not
need to be incorporated for the modification gain and loss. However, an entity also needs to
recalculate the cumulative hedge adjustments based on the modified cash flows because the
modification has impacted the hedged portion (see Example 49).
• Amortisation has commenced: If amortisation has commenced, then the new gross carrying
amount of the hedged financial instrument is calculated as the present value of the modified
contractual cash flows discounted at the revised effective interest rate – i.e. adjusted for hedge
accounting effects. The modification gain or loss will be the difference between this new gross
carrying amount and the old gross carrying amount of the hedged financial asset including any
hedge adjustments (see Example 49). [IFRS 9.5.4.3, B5.4.6]

7I.7.737.20 Even if a cash flow hedge of interest rate risk is not discontinued because of a
modification to a hedged item, an entity needs to consider the impact of the modification on the
accounting for the hedging relationship. For example, if the hypothetical derivative method was used
to measure the change in value of the hedged item for the purpose of determining the amounts to be
included in the cash flow hedge reserve and for measuring hedge ineffectiveness, then the terms of
the hypothetical derivative would need to be updated to reflect the modified cash flows of the hedged
item resulting from the modification.

7I.7.740 NET INVESTMENT HEDGE

7I.7.750 Net assets of foreign operation

7I.7.750.10 The hedged item in a net investment hedge is the foreign currency exposure on the
carrying amount of the net assets of the foreign operation, but only if they are included in the
financial statements. The types of foreign operations included in financial statements vary depending
on the type of the financial statements. The following table provides a summary of foreign operations
included in consolidated, individual and separate financial statements. [IFRIC 16.2, 7]

TYPE OF FINANCIAL STATEMENTS TYPES OF FOREIGN OPERATIONS

Consolidated financial statements • Consolidated subsidiaries

• Investments in associates and joint
ventures accounted for using the equity
method
• Branches and joint operations
Individual financial statements (see • Investments in associates and joint
2.1.110) ventures accounted for using the equity
method
• Branches and joint operations
Separate financial statements (see • Investments in subsidiaries, associates
2.1.120) and joint ventures accounted for using the
equity method
• Branches and joint operations

7I.7.750.13 In our view, an investment in an entity that does not meet the definition of a foreign
operation of the reporting entity cannot be designated as a hedged item in a net investment hedge.
For example, an entity cannot designate an investment in an associate of an associate that is not also
an associate of the reporting entity (because the reporting entity is not able to exercise significant
influence over that investee) as a hedged item in the consolidated financial statements of the
reporting entity because that investee does not meet the definition of a foreign operation from the
perspective of the reporting entity.

EXAMPLE 31A – NET INVESTMENT HEDGES – CHAIN OF OWNERSHIP

7I.7.750.15 Parent P, whose functional currency is sterling, owns 30% of the

shares in Associate A1, whose functional currency is also sterling. A1 owns 20% of
the shares in Associate A2, whose functional currency is the euro. P does not have
any other relationship with A2 beyond its indirect investment through A1, and A2 is
not considered an associate of P.

7I.7.750.17 The impact of sterling/euro exchange rate changes on the indirect

investment in A2 is included in the OCI in P’s consolidated financial statements
related to P’s equity-accounted investment in A1. However, because A2 does not
meet the definition of a foreign operation from the perspective of P’s consolidated
financial statements, we believe that P cannot designate the indirect investment in
A2 as a hedged item in a net investment hedge.

7I.7.750.20 In a hedge of a net investment in a foreign operation, a derivative instrument, a non-

derivative instrument or a combination of both (see 7I.7.830.40) may be used as the hedging
instrument. The hedging instrument can be held by any entity within the group. [IFRIC 16.14]

7I.7.750.30 The ‘hedged risk’ is the foreign currency exposure arising from the functional
currency of the foreign operation and the functional currency of any parent – i.e. immediate,
intermediate or ultimate parent of the foreign operation. The foreign exchange differences arising
between the functional currency of the foreign operation and the presentation currency of any
parent cannot be designated as the hedged risk (see 7I.7.780). The foreign currency risk arising from
the net investment in the consolidated financial statements can be hedged only once. [IFRIC 16.10, 12–
13, AG2, BC14]

7I.7.750.40 When the hedging instrument is a forward contract, the entity may hedge the spot
foreign exchange rate or the forward rate. If exposure to changes in the forward rate is designated
as the hedged risk, then the interest component included in the forward rate is part of the hedged
foreign currency risk. Therefore, total changes in the fair value of the hedging derivative contract,
including the interest element – i.e. the spot-forward premium or forward points – are recognised in
OCI and accumulated in a separate component of equity. However, when the entity hedges the spot
foreign exchange rate, then the change in the interest element of the hedging derivative contract is
recognised immediately in profit or loss and only the changes in the fair value of the hedging
derivative that are attributable to changes in spot foreign exchange differences are recognised in
OCI. When the hedging instrument is a non-derivative financial instrument, IFRIC 16 suggests
designating the spot foreign exchange risk as the hedged risk. The method of translating the foreign
currency financial statements of the foreign operation as described in IAS 21 (see 2.7.230) does not
change, whichever hedging strategy is used.

EXAMPLE 31B – NET INVESTMENT HEDGES – ELIGIBLE HEDGED RISK

7I.7.750.50 Parent P, whose functional currency is sterling, has the following net
investments in each of its subsidiaries.
• Subsidiary S1’s functional currency is the euro. P directly owns S1 and has a EUR
500 net investment in the subsidiary.
• Subsidiary S2’s functional currency is the US dollar. P directly owns S2 and has a
USD 300 net investment in the subsidiary.
• Subsidiary S3’s functional currency is the Australian dollar. S2 directly owns S3
and has an AUD 100 net investment in the subsidiary. Therefore, assuming an
Australian dollar/US dollar exchange rate of 1.25, P’s total USD 300 net
 investment in S2 includes USD 80 in respect of S2’s AUD 100 net investment in
S3. In other words, S2’s net assets other than its investment in S3 are USD 220.
[IFRIC 16.AG2, AG9]

Parent P
GBP

Subsidiary S1 Subsidiary S2
EUR 500 USD 300

Subsidiary S3
AUD 100

7I.7.750.60 In this situation, the following are examples of alternative net

investment hedge designations that may be possible in the consolidated financial
statements of P.
• P can hedge its net investment in each of subsidiaries S1, S2 and S3 for the
foreign exchange risk between their respective functional currencies and
sterling. The maximum amounts that can be designated as effective hedges in P’s
consolidated financial statements are:
– EUR 500 net investment in S1 for sterling/euro risk;
– USD 220 net investment in S2 for sterling/US dollar risk; and
– AUD 100 net investment in S3 for sterling/Australian dollar risk.
• P can hedge its net investment in only S1 and S2 for the foreign exchange risk
between their respective functional currencies and sterling. In this case, up to
the full USD 300 investment in S2 could be designated. Note, however, that P
could not designate both the full USD 300 of its net investment in S2 with respect
to the sterling/US dollar risk and its AUD 100 net investment in S3 with respect
to the sterling/Australian dollar risk because this would involve hedging the net
investment in S3 with respect to the sterling twice.
• P can hedge, in its consolidated financial statements, its AUD 100 net investment
in S3 for the US dollar/Australian dollar risk between the functional currencies of
S2 and S3, and also designate a hedge of the entire USD 300 of its net investment
in S2 with respect to sterling/US dollar risk, because the designation of the US
dollar/Australian dollar risk between S2 and S3 does not include any sterling/US
dollar risk.

7I.7.750.70 The hedged risk cannot be designated as the fair value of the
underlying shares, or the foreign currency exposure on the fair value of the shares,
because the consolidation process recognises the subsidiary’s profit or loss, rather
than changes in the investment’s fair value. The same is true of a net investment in
an associate or joint venture, because equity accounting recognises the investor’s
share of the associate’s profit or loss (see 3.5.180). [IAS 39.AG99]

7I.7.750.80 Groups with foreign operations may wish to hedge the foreign currency exposure
arising from the expected profits from the foreign operations by using derivatives or other financial
instruments. In our view, a forecast transaction in the foreign operation’s own functional currency
does not create an exposure to variability in cash flows that could affect profit or loss at the
consolidated level. Therefore, at the consolidated level, hedge accounting cannot be applied. From a
foreign operation’s own perspective, cash flows generated from its operations are in its own
functional currency and therefore do not give rise to a foreign currency risk exposure; such cash
flows therefore cannot be hedged. However, a foreign operation may hedge its foreign currency
exposure in respect of transactions denominated in currencies other than its functional currency.

7I.7.750.90 Hedging an amount of net assets equal to or less than the carrying amount of the net
assets of a foreign operation is permitted. Effectiveness would be measured based on the amount of
the net assets hedged. However, if the notional amount of the hedging instrument exceeds the
carrying amount of the underlying net assets – e.g. because of losses incurred by the foreign
operation that reduce its net assets – then changes in fair value on the excess portion of the hedging
instrument are recognised in profit or loss immediately. [IAS 39.102]

7I.7.750.100 In testing hedge effectiveness, the change in value of the hedging instrument is
determined with reference to the functional currency of the parent against which the hedged risk is
measured. Depending on where the hedging instrument is held, in the absence of hedge accounting
the total change in value of the hedging instrument may be recognised in profit or loss, OCI or both.
However, the assessment of hedge effectiveness is not affected by whether the change in value of the
hedging instrument is recognised in profit or loss or OCI. The assessment of hedge effectiveness is
also not affected by the method of consolidation – i.e. the direct or step-by-step method – or whether
the hedging instrument is a derivative or non-derivative instrument. [IFRIC 16.15]

EXAMPLE 32 – DESIGNATION OF A FINANCIAL INSTRUMENT AS A HEDGED ITEM IN A FAIR VALUE HEDGE AND AS A

HEDGING INSTRUMENT IN A NET INVESTMENT HEDGE

7I.7.750.110 Company X, whose functional currency is South Korean won, issues

a fixed interest rate bond denominated in US dollars (Bond A) to acquire a foreign
subsidiary (Company Y). The notional amount of Bond A and the investment in Y are
each USD 1,000.

7I.7.750.115 X has the following hedging relationship.

• Hedged item: Bond A (fixed interest rate risk).
• Hedging instrument: interest rate swap that pays IBOR and receives a fixed
interest rate.
• The notional amount of the interest rate swap is USD 1,000.
• The swap is a qualifying hedging instrument for a fair value hedge and Bond A is
the hedged item.

7I.7.750.120 It is possible for X also to designate the foreign currency risk

component of Bond A as the hedging instrument in a hedge of the net investment in
Y provided that the fair value hedge adjustment is expected to be immaterial
compared with the hedged net investment amount. If this is the case, then the ratio
between Bond A and the net investment in Y may result in ineffectiveness, but not in
hedge failure.

7I.7.760 Expected net profit or loss of net investment in foreign operation

7I.7.760.10 The hedged item may be an amount of net assets equal to or less than the carrying
amount of the net assets of the foreign operation at the beginning of any given period. [IAS 39.81, IFRIC
16.2, 11, AG3–AG6]

7I.7.760.20 Consequently, the expected profits from the foreign operation in that period cannot
be designated as the hedged item in a net investment hedge. Translation risk arises once the net
profit is recognised as an increase in net assets of the foreign operation. The additional net assets
can be designated as a hedged item in a net investment hedge as they arise, although in our
experience most groups will revisit their net investment hedges only quarterly or semi-annually. [IAS
39.81, IFRIC 16.2, 11]

7I.7.760.30 Expected net profits from a foreign operation expose a group to potential volatility in
consolidated profit or loss because transactions in the foreign operation are translated into the
group’s presentation currency at spot rates at the transaction dates, or at appropriate average rates
(see 2.7.240). However, because expected net profits in future reporting periods do not constitute
recognised assets, liabilities or forecast transactions that will ultimately affect profit or loss at the
consolidated level, they cannot be designated in a hedging relationship under either a fair value or a
cash flow hedge model. [IAS 21.39–40]

7I.7.760.40 Expected net losses in a foreign operation will reduce the net investment balance,
which could result in an over-hedged position. Therefore, if a group expects its foreign operation to
make losses, then it may decide to hedge less than the full carrying amount of the net assets.
Otherwise it will not be able to satisfy the hedge accounting criterion that the hedging relationship is
expected to be highly effective on an ongoing basis. In our view, an entity should take into account
expected losses in a foreign operation when assessing hedge effectiveness if they are highly
probable.

7I.7.770 Monetary items

7I.7.770.10 An investor’s net investment may also include monetary items that are receivable
from or payable to the foreign operation, settlement of which is neither planned nor likely to occur in
the foreseeable future. Loans provided by a subsidiary to a fellow subsidiary may form part of the
group’s net investment in a foreign operation, even when the loan is in neither the parent’s nor the
borrowing subsidiary’s functional currency. Consequently, the net investment may include an intra-
group loan in any currency when settlement is neither planned nor likely to occur in the foreseeable
future.

EXAMPLE 33 – NET INVESTMENT HEDGE WITH INTRA-GROUP LOAN

7I.7.770.20 In 2017, Company T, whose functional currency is the euro, bought

Company B for GBP 100. The carrying amount of B’s net assets was GBP 60, and T
recognised fair value adjustments to specific assets and liabilities of GBP 30 and
goodwill of GBP 10. During 2017, T extended a loan to B of GBP 20.

7I.7.770.30 In 2021, the carrying amount (excluding fair value adjustments from
the acquisition) of B’s assets and liabilities is GBP 70. The remaining fair value
adjustments are GBP 25 and goodwill remains at GBP 10. The loan has not been
repaid nor is it intended to be repaid. The carrying amount of the net investment
that T may designate as the hedged item is equal to the amount of T’s net
investment in B, including goodwill. This amount would be GBP 125 (70 + 25 + 10 +
20).

7I.7.780 Presentation currency

7I.7.780.10 The group’s presentation currency is not relevant to net investment hedging.
Translation of the financial statements of an entity into the group presentation currency under IAS
21 is an accounting exercise that does not create an exposure to foreign exchange risk; therefore,
hedge accounting for such translation risk is not permitted. An economic exchange risk arises only
from an exposure between two or more functional currencies, not from translation into a
presentation currency. [IFRIC 16.BC13–BC14]

EXAMPLE 34 – PRESENTATION CURRENCY DIFFERS FROM FUNCTIONAL CURRENCY

 7I.7.780.20 When a group’s presentation currency differs from the parent’s
functional currency, then the appropriate hedged risk to be designated in a net
investment hedge is still the exposure to changes in the exchange rate between the
foreign operation’s functional currency and the parent’s functional currency.
Therefore, net investment hedging may be applied only to hedge the exchange rate
risk that exists between the functional currency of a parent entity and the functional
currency of the foreign operation.

7I.7.790 Cross-currency interest rate swaps

7I.7.790.10 Net investments in foreign operations are commonly hedged with forward contracts
or non-derivative financial items such as foreign currency loans. Some entities may want to use, as
hedging instruments, cross-currency interest rate swaps (CCIRSs) or a synthetic borrowing that is a
combination of a borrowing and an interest rate swap and/or a CCIRS (see 7I.7.830). In our view,
although they are more complex, these hedging strategies may qualify for hedge accounting if
particular care is taken in identifying and designating the hedging instrument and the hedged item.

7I.7.800 Fixed-for-fixed cross-currency interest rate swap

7I.7.800.10 Economically, a foreign currency forward contract and a fixed-for-fixed CCIRS are
similar; the primary difference between the two is that the interest component of the fixed-for-fixed
CCIRS is explicitly identified through an exchange of coupons instead of being implicit as in the case
of the forward points component in a foreign currency forward contract. Therefore, the coupon
exchanges in a fixed-for-fixed CCIRS are equivalent to the forward points in a foreign currency
forward contract. In our view, a fixed-for-fixed CCIRS can be designated as the hedging instrument in
a hedge of the net investment in a foreign operation. The amount of the hedged item would be the
notional amount of the CCIRS, excluding its coupon exchanges. As is the case of a hedge using a
forward contract, we believe that there are two possible approaches that can be applied in
designating the hedged risk: an approach based on changes in the forward exchange rate and an
approach based on changes in the spot exchange rate.

7I.7.800.20 Under the first approach, the entity designates the hedge based on changes in
forward rates. In our view, the hypothetical derivative method may be used to assess effectiveness.
The perfectly effective hypothetical derivative would have the same relevant critical terms – e.g.
notional, underlying etc – as the hedged item and the same maturity as the hedging instrument. In
many cases, the perfectly effective hypothetical derivative could be constructed as a CCIRS with
identical terms as the actual CCIRS, if the actual CCIRS’ critical terms are the same as those of the
hedged item. In this case, the hedging relationship might achieve near perfect hedge effectiveness.

7I.7.800.30 Under the first approach, the effective portion of the fair value gains and losses,
including any interest accruals, on the hedging instrument would be recognised in OCI and
presented in the foreign currency translation reserve. The actual payment or receipt of interest on
the hedging instrument represents partial settlement of the hedging instrument’s carrying amount
and does not lead to any reclassification from OCI to profit or loss.

7I.7.800.40 Under the second approach, the entity designates the hedge based on changes in
spot rates. Changes in the fair value of the notional amount of the CCIRS that arise from changes in
spot exchange rates would be effective in offsetting changes in the designated amount of the hedged
net investment. Such changes would be recognised in OCI and presented in the foreign currency
translation reserve. The remaining fair value changes in the CCIRS, which are equivalent to the
forward points in a forward contract, would be excluded from the hedging relationship and
measured at FVTPL.

7I.7.810 Floating-for-floating cross-currency interest rate swap

7I.7.810.10 In our view, a floating-for-floating CCIRS with initial and final exchanges of notional
amounts potentially could be designated as a hedging instrument in a net investment hedge.
Provided that the hedge is expected to be highly effective throughout the hedging relationship and
the other hedge criteria are met, this hedging strategy should qualify for hedge accounting.

7I.7.810.20 When using floating-for-floating CCIRS, a net investment hedge can be designated as
a hedged item for the forward exchange rate risk. However, in our view the perfectly effective
hypothetical cannot be constructed as a CCIRS with terms identical to the actual floating-for-floating
CCIRS, because floating interest rate cash flows do not exist in the hedged item. Instead, the
perfectly effective hypothetical derivative may be constructed as either a fixed-for-fixed CCIRS or a
forward contract. In either case, the floating interest payments will give rise to some ineffectiveness
because of movements in interest rate curves between repricing dates.

7I.7.810.30 In our experience, if the notional amount of a floating-for-floating CCIRS does not
exceed the amount of a net investment, then designating the notional amount of the CCIRS as a
hedging instrument in a hedge based on changes in spot rates is more likely to result in lower
ineffectiveness. This is because the floating interest rate cash flows and principal amounts of the
CCIRS would be discounted at market in the respective currencies, resulting in amounts that
approximate the notional amount of the hedged item, and are converted at the spot rate – thereby
following the changes in the value of the hedge item, which is also converted using the spot rate.

7I.7.820 Fixed-for-floating cross-currency interest rate swap

7I.7.820.10 A fixed-for-floating CCIRS is exposed to both interest rate risk and foreign currency
risk. In our view, a fixed-for-floating CCIRS cannot generally be designated as a hedging instrument
in a net investment hedge because the interest rate risk inherent in the instrument gives rises to
ineffectiveness that precludes hedge accounting.

7I.7.820.20 However, it may be possible to designate such an instrument in its entirety in more
than one hedging relationship simultaneously and achieve hedge accounting. For example, a pay-
fixed US dollar receive-floating euro CCIRS can be viewed as comprising a pay-fixed US dollar
receive-fixed euro CCIRS and a pay-fixed euro receive-floating euro interest rate swap. The pay-fixed
US dollar receive-fixed euro CCIRS can be designated as a hedging instrument of a US dollar net
investment, while the pay-fixed euro receive-floating euro interest rate swap can be designated as
either a fair value hedge of a fixed rate asset or a cash flow hedge of a floating rate liability.

7I.7.820.30 When such an approach is adopted, the hedge documentation should clearly identify
the various hedged items for which the CCIRS is designated as the hedging instrument. Only in
measuring effectiveness is the CCIRS separated into a fixed-for-fixed CCIRS and a fixed-for-floating
interest rate swap. In the event that any of the hedges becomes ineffective, in our view hedge
accounting would be terminated for all of the hedging relationships in which the CCIRS is the
designated hedging instrument.

7I.7.830 Synthetic borrowing

7I.7.830.10 A synthetic borrowing is created through the combination of a borrowing in one
currency with a CCIRS that effectively changes the interest and principal payments of the original
borrowing into a different currency. For example, Company T has a euro functional currency. T has a
net investment in a sterling functional currency subsidiary and a bond in issue that is denominated in
US dollars. T wishes to enter into a pay-floating sterling receive-fixed US dollar CCIRS and to
designate the bond and the CCIRS together as the hedging instrument in a hedge of a net
investment.

7I.7.830.20 The combination of a borrowing and a CCIRS may seem to be similar to a plain vanilla
borrowing, but there are significant differences between the synthetic position and the plain vanilla
position.
7I.7.830.30 For a plain vanilla borrowing, only the foreign currency translation gains or losses on
the amortised cost arising from foreign currency spot risk are recognised in accordance with IAS 21.
The effective portion of these translation gains or losses will offset the corresponding IAS 21
translation gains or losses on the net investment and both are recognised in OCI. However, for a
synthetic borrowing the bond and the CCIRS are not measured on a consistent basis. The carrying
amount of the US dollar bond is translated into euro under IAS 21, but is not remeasured to fair value
for changes in interest rates, whereas the CCIRS is measured at fair value with respect to both
currency and interest rate risk.

7I.7.830.40 A combination of derivatives and non-derivatives can be used as the hedging

instrument only in respect of foreign currency risk. Because the synthetic borrowing – i.e. the plain
vanilla bond combined with the CCIRS – has an exposure to both interest rate and foreign currency
risk, in our view such a combined designation would not generally be appropriate because the
interest rate exposure on the hedging instrument would likely cause the hedge not to be highly
effective. One solution that would reduce volatility in profit or loss would be to measure both the
bond and the CCIRS at fair value. However, in our view there is no possibility under the Standards to
measure the bond at fair value and then to include these fair value changes in a net investment
hedging relationship. [IAS 39.77]

7I.7.840 HEDGING ON A GROUP BASIS

7I.7.840.10 For a foreign currency hedge transacted on a group basis, it is important that the
foreign currency exposure of the hedging instrument and the hedged transaction is the same.

EXAMPLE 35 – FOREIGN CURRENCY HEDGE TRANSACTED ON GROUP BASIS

7I.7.840.20 Company E has the euro as its functional currency and Company F, a
subsidiary of E, has the Swiss franc as its functional currency. F has a foreign
currency exposure arising from a highly probable forecast transaction denominated
in US dollars. If E hedges this exposure through its central treasury by entering

into a Swiss franc-to-US dollar forward contract, then the transaction may qualify
for hedge accounting in E’s consolidated financial statements. However, if E enters
into a euro-to-US dollar forward contract, then the contract does not qualify as a
hedging instrument because the currency of the forward contract does not match
the underlying exposure that the entity wishes to hedge unless it can be
demonstrated that the euro and the Swiss franc are highly correlated.

7I.7.850 Internal derivatives

7I.7.850.10 One of the key issues that arise in applying hedge accounting at the group level is the
need to eliminate internal derivatives for the purposes of consolidation.

7I.7.850.20 An entity may use internal derivatives to transfer risk from individual operations
within the group to a centralised treasury. Derivatives between entities within the same reporting
group can also be used to control and monitor risks through the central treasury function to benefit
from pricing advantages and to offset equal and opposite exposures arising from different parts of
the group. However, all such internal derivatives eliminate on consolidation and therefore are not
eligible for hedge accounting in the consolidated financial statements. Therefore, only derivatives
involving external third parties can be designated as hedging instruments in consolidated financial
statements. [IAS 39.73, IG.F.1.4]

7I.7.850.30 However, it is possible for the centralised treasury to enter into one or more
derivatives with external counterparties to offset the internal derivatives. Such external derivatives
may qualify as hedging instruments in the consolidated financial statements provided that they are
legally separate contracts and serve a valid business purpose – e.g. laying off risk exposures on a
gross basis. In our view, a relationship should exist between the internal transactions and one or
multiple related external transactions, and this relationship should be documented at inception of
the hedging relationship. [IAS 39.73, IG.F.1.4]

7I.7.860 Externalisation and round-tripping

7I.7.860.10 In consolidated financial statements, hedge accounting may be applied to an external

hedge even if the group entity that is subject to the risk being hedged is not a direct party to the
hedging instrument. [IAS 39.IG.F.1.4, IG.F.2.14]

EXAMPLE 36 – EXTERNALISATION AND ROUND-TRIPPING

7I.7.860.20 Subsidiary B has a financial asset (with a counterparty outside the

group) on which it receives a fixed rate of interest. For the purposes of hedging its
individual exposure to the fixed interest rate, B enters into a pay-fixed receive-
floating interest rate swap with the group’s central treasury. The swap is an internal
derivative, which does not qualify as a hedging instrument in the consolidated
financial statements. To achieve hedge accounting at the group level, the central
treasury enters into a matching pay-fixed receive-floating interest rate swap with an
external counterparty and documents this link. The fixed interest financial asset and
the external derivative then can be designated in a hedging relationship that
qualifies for hedge accounting in the consolidated financial statements. [IAS
39.IG.F.1.4]

7I.7.860.30 By entering into an external derivative the group ‘externalises’ the transaction in
order to achieve hedge accounting in the consolidated financial statements. However, there may be
circumstances in which the entity concurrently would enter into two offsetting external derivatives.
The first of these derivatives would be designated as the hedging instrument in the consolidated
financial statements, whereas the offsetting swap would be included in the entity’s trading book.
Normally the reason for the offsetting transaction is to ‘create’ an external hedging instrument for
hedge accounting purposes without changing the risk position of the central treasury. At the same
time as entering into an external derivative that would qualify as a hedging instrument as described
in Example 36, the central treasury would enter into an exactly offsetting swap with the same
counterparty. This is known as ‘round-tripping’.

7I.7.860.40 It is clear that when offsetting derivatives are entered into concurrently, an entity is
prohibited from viewing the derivatives separately and therefore designating one of them in a
hedging relationship, unless the derivatives were not entered into in contemplation of one another or
there is a substantive business purpose for structuring the transactions separately. Therefore, to
qualify for hedge accounting when following the round-tripping approach, it is necessary for an
entity to demonstrate compliance with one of these two conditions. [IAS 39.IG.F.1.14]

7I.7.860.50 In our view, a substantive business purpose generally exists in the following
circumstances:
• when group risk management is undertaken by a central treasury function, which gives separate
consideration to whether and how much of an offsetting position is required. Because the
cheapest form of risk mitigation is usually entering into offsetting transactions with the same
derivative counterparty, it is plausible that a facility may exist to enter into an offsetting
transaction. However, such an offset should not automatically be put in place by an entity, but
should be based on an evaluation of whether such an offsetting position is required; and
• when an entity’s internal derivatives are novated to a central clearing party and then subjected to
trade compression with otherwise unrelated derivatives originally entered into with third parties
and also novated to the central clearing party. If the inter-company derivatives had not been
 novated to a central clearing party, then the inter-company derivatives would have been
eliminated on consolidation and would not have externalised any risk. Similarly, there would have
been no externalisation of market risk if the derivatives were novated to the central clearing party
but left otherwise unchanged (e.g. there would be only equal and opposite trades between the
group and the central clearing party). However, in some cases novation followed by trade
compression may externalise risk that otherwise would have been eliminated on consolidation.

EXAMPLE 37 – HEDGES TRANSACTED ON GROUP BASIS

7I.7.860.55 Consider the following two situations.

• Company H performs a day-end review of its risk exposures, documents this
review and enters into offsetting derivatives as part of its risk balancing
procedures.
• Company B immediately enters into an offsetting derivative for each transaction
and undertakes no further formal risk management procedures.

7I.7.860.60 H is likely to be able to prove that it has a substantive business

purpose for entering into offsetting derivatives. B, however, has a practice of
automatically entering into offsetting derivatives, without giving further
consideration to its actual risk exposures. Accordingly, B would have difficulty in
meeting the ‘substantive business purpose’ condition.

7I.7.860.70 In addition, in our view entering into a derivative with a non-substantive

counterparty does not validate an internal hedge. For example, a limited-purpose vehicle established
to act as a dedicated counterparty to validate internal hedges might not be regarded as a substantive
third party counterparty even if consolidation of the limited-purpose vehicle is not required. [IAS
39.IG.F.1.4, IG.F.2.16]

7I.7.860.80 An entity may designate a hedging relationship at the consolidated level that differs
from the hedging relationship designated as at the level of an individual entity within the group,
provided that the hedge criteria are met.

7I.7.870 Intra-group balances or transactions as hedged item

7I.7.870.10 Intra-group balances and transactions eliminate on consolidation and therefore are
not permitted to be designated as hedged items at the group level. However, foreign currency
exposures on intra-group monetary items give rise to foreign exchange gains and losses that do not
eliminate in the consolidated financial statements (see 2.7.130). Intra-group monetary items lead to
an exposure that affects group profit or loss in the following instances:
• items have been transacted between group entities with different functional currencies; and
• the items are denominated in a currency other than the functional currency of the entity entering
into the transaction. [IAS 39.80]

EXAMPLE 38 – INTRA-GROUP BALANCES OR TRANSACTIONS AS HEDGED ITEM

7I.7.870.20 An intra-group payable/receivable between a parent with a euro

functional currency and its foreign subsidiary denominated in US dollars (the
subsidiary’s functional currency) creates such a foreign currency exposure at the
group level. Consequently, the foreign currency risk on recognised intra-group
monetary items qualifies for hedge accounting in the consolidated financial
statements.

7I.7.870.30 In our view, it is not possible to extend this rationale to the designation of intra-group
monetary items as hedging instruments in a hedge of foreign currency risk. This is because IAS 39
explicitly requires that only instruments involving external parties be designated as hedging
instruments. Therefore, intra-group monetary items cannot be designated as hedging instruments in
the consolidated financial statements. [IAS 39.73]

7I.7.870.40 The foreign currency risk of a highly probable forecast intra-group transaction may
qualify as the hedged item in the consolidated financial statements provided that the transaction is
denominated in a currency other than the currency of the entity entering into the transaction, and
the foreign currency risk will affect consolidated profit or loss. Examples of forecast intra-group
transactions that will affect consolidated profit or loss include:
• forecast purchases or sales of inventory between group members, provided that there is an
onward sale to a party outside the group; and
• a forecast sale of equipment by one group entity to another because the depreciation charge
recognised on the equipment will differ if the transaction is denominated in a currency other than
the buying entity’s functional currency. [IAS 39.AG99A]

7I.7.870.50 However, royalties, head office charges and similar items would not affect profit or
loss in the consolidated financial statements because these transactions are eliminated completely.
Therefore, such items do not usually qualify as hedged items unless there is a related external
transaction. [IAS 39.AG99A]

7I.7.870.60 In our view, the exception in 7I.7.870.10 extends to the foreign currency risk of an
intra-company monetary item (see 2.7.120.35) – e.g. a foreign currency-denominated payable or
receivable between two branches with different functional currencies. Such an item may qualify as a
hedged item in individual or separate financial statements if the exchange differences are not fully
eliminated in those financial statements. We believe that a single legal entity may have a foreign
operation with a different functional currency in some circumstances (see 2.7.200). A branch that
qualifies as a foreign operation is included in individual or separate financial statements in a similar
way to how a subsidiary is consolidated in group financial statements. Consequently, if an intra-
company monetary item is not considered to be a net investment in the branch (see 2.7.150), then
exchange differences may arise when translating that intra-company monetary item and these
amounts would be recognised in profit or loss in the individual or separate financial statements.

7I.7.871 INTEREST RATE BENCHMARK REFORM

7I.7.871.10 If a hedging relationship is directly affected by interest rate benchmark reform (IBOR
reform), then it is subject to certain exceptions from applying the general hedge accounting
requirements (see 7I.7.872). In addition, when uncertainty arising from IBOR reform is resolved with
respect to a specific element of the relationship, additional exceptions apply (see 7I.7.877). For the
purpose of applying the exceptions, ‘IBOR reform’ refers to the market-wide reform of an interest
rate benchmark, including the replacement of an interest rate benchmark with an alternative
benchmark rate such as that resulting from the recommendations set out in the Financial Stability
Board’s July 2014 report Reforming Major Interest Rate Benchmarks. [IAS 39.102A–102B, 102P–102U]

7I.7.872 When uncertainty arises from IBOR reform

7I.7.872.10 A hedging relationship is directly affected by IBOR reform if it is subject to the

following uncertainty arising from the reform:
• an interest rate benchmark subject to the reform is designated as the hedged risk, regardless of
whether the rate is contractually specified; and/or
• the timing or amounts of interest rate benchmark-based cash flows of the hedged item or of the
hedging instrument are uncertain. [IAS 39.102A]

7I.7.872.20 However, when applying the exceptions to a hedging relationship that is directly
affected by IBOR reform, an entity continues to measure and recognise any hedge ineffectiveness in
its financial statements. [IAS 39.BC253–BC254]
7I.7.872.30 An entity is required to disclose the uncertainty arising from IBOR reform when it
applies the exceptions to a hedging relationship that is directly affected by IBOR reform (see
7I.8.275).

7I.7.873 Assuming an interest rate benchmark is not altered as a result of

IBOR reform

7I.7.873.10 An entity assumes that the interest rate benchmark on which the cash flows of the
hedged item or the hedging instrument are based is not altered as a result of IBOR reform when
applying the following hedge requirements. These exceptions are limited to hedging relationships
that are directly affected by IBOR reform:
• determining whether a forecast transaction is highly probable (see 7I.7.230);
• determining whether the hedged future cash flows are still expected to occur for a discontinued
cash flow hedging relationship (see 7I.7.690); and
• assessing whether the hedge is expected to be highly effective prospectively (see 7I.7.510). [IAS
39.102D–102F]

7I.7.874 Exception from the retrospective effectiveness test

7I.7.874.10 When an entity assesses the actual results – i.e. performs a retrospective
effectiveness test (see 7I.7.550) – of a hedging relationship that is directly affected by IBOR reform,
it does not discontinue the hedging relationship only because the actual results are not within the
range of 80–125 percent. In other words, if all other hedge criteria, including the prospective
effectiveness assessment (reflecting the application of 7I.7.874.10), are met except the retrospective
effectiveness result, then an entity is not required to discontinue hedge accounting. [IAS 39.102G]

7I.7.875 Exception from the separately identifiable criterion

7I.7.875.10 For a hedge of a non-contractually specified benchmark component of interest rate

risk, an entity applies the separately identifiable criterion only at the inception of the hedging
relationship. This exception does not apply to a risk component that is explicitly specified in the
contract because, in that case, it is clear whether the risk component is separately identifiable. [IAS
39.102H, BC258]

7I.7.875.20 In addition, if an entity frequently resets a hedging relationship in accordance with

its hedge documentation – i.e. using a dynamic process in which both the hedged items and the
hedging instruments used to manage that exposure do not remain the same for long – then it applies
the separately identifiable criterion only when it initially designates a hedged item in that hedging
relationship. If a hedged item has been assessed on its initial designation, then it is not subsequently
reassessed at the time of any subsequent redesignation in the same hedging relationship. [IAS 39.102I]

7I.7.875.30 However, if the changes in the cash flows or the fair value of the hedged risk
component are no longer reliably measurable, then a hedging relationship needs to be discontinued
because the risk component is no longer an eligible hedged item (see 7I.7.180). [IAS 39.BC261]

7I.7.876 End of application

7I.7.876.10 The exceptions for a hedging relationship that is directly affected by IBOR reform
prospectively cease to apply at the earlier of:
• when the uncertainty regarding the timing and the amount of interest rate benchmark-based cash
flows or uncertainty with respect to the hedged risk is no longer present; or
• when the hedging relationship is discontinued. [IAS 39.102J, 102L–102M]
7I.7.876.20 However, the exception for determining whether the hedged future cash flows are
still expected to occur for a discontinued cash flow hedging relationship prospectively ceases to
apply at the earlier of:
• when the uncertainty regarding the timing and the amount of interest rate benchmark-based
future cash flows of the hedged item is no longer present; or
• when the entire amount accumulated in the cash flow hedge reserve has been reclassified to
profit or loss. [IAS 39.102K]

7I.7.876.30 If a hedging relationship to which the exceptions have been applied contains multiple
hedged items or hedging instruments, then an entity assesses whether the uncertainty regarding the
timing and the amount of interest rate benchmark cash flows is no longer present and ceases to
apply the exceptions on an item-by-item basis. [IAS 39.102N]

7I.7.876.40 The exception from the separately identifiable criterion prospectively ceases to apply
at the earlier of:
• when changes required by IBOR reform are made to the non-contractually specified risk
component; or
• when the hedging relationship is discontinued. [IAS 39.102O]
7I.7.877 When uncertainty arising from IBOR reform is resolved

7I.7.878 Amending the hedge designation

7I.7.878.10 As and when the exceptions for a hedging relationship that is directly affected by
IBOR reform cease to apply because an uncertainty arising from IBOR reform is no longer present
(see 7I.7.876), an entity amends the formal designation of the hedging relationship to reflect the
changes required by IBOR reform. A change is ‘required by IBOR reform’ if the change is necessary
as a direct consequence of IBOR reform and made on an economically equivalent basis (see
7I.6.335). For this purpose, the hedge designation can only be amended to make one or more of the
following changes:
• designating an alternative benchmark rate (contractually or non-contractually specified) as a
hedged risk;
• amending the description of the hedged item, including the description of the designated portion,
so that it refers to an alternative benchmark rate;
• amending the description of the hedging instrument; or
• amending the description of how the entity will assess hedge effectiveness. [IAS 39.102P]
7I.7.878.20 If a change required by IBOR reform is made using an approach other than changing
the basis for determining the contractual cash flows of the hedging instrument (see 7I.6.335.20),
then the description of the hedging instrument cannot be amended without a discontinuation of
hedge accounting unless the following criteria are met:
• the original hedging instrument is not derecognised; and
• the chosen approach is economically equivalent to changing the basis for determining the
contractual cash flows of the original hedging instrument (see 7I.6.335.30). [IAS 39.102Q]

EXAMPLE 39 – CHANGE REQUIRED BY IBOR REFORM – OTHER THAN CHANGING THE BASIS FOR DETERMINING

CONTRACTUAL CASH FLOWS

7I.7.878.30 As part of IBOR reform, Company X is considering the following

approaches to amend a derivative that is designated as a hedging instrument.

Approach 1
• Enter into a new derivative that is equal and offsetting to the original derivative
• Enter into another new derivative as follows.
– It is based on an alternative benchmark rate.
– It has the same terms as the original derivative so the fair value of the new
derivative on initial recognition is equivalent to the fair value of the original
 derivative on that date.
• The counterparty to both new derivatives is the same as the original derivative.
Approach 2
• Terminate the original derivative with a cash settlement.
• Enter into a new alternative benchmark-based derivative with substantially
different terms and a fair value of zero on initial recognition.
• The counterparty to the new derivative is the same as the original derivative.
7I.7.878.40 Approach 1 in 7I.7.878.30 does not result in derecognition of the
original derivative because the terms of the new alternative benchmark rate
derivative are not substantially different from those of the original derivative – i.e.
the original derivative and the new alternative benchmark-based derivative are
economically equivalent. As a result, this approach is regarded as consistent with
the changes required by IBOR reform and the formal designation can be amended
without the discontinuation of hedge accounting. [IAS 39.BC312(a)]

7I.7.878.50 In contrast, under Approach 2 in 7I.7.878.30 the original derivative is

derecognised because the terms of the new alternative benchmark rate derivative
are substantially different from those of the original derivative – i.e. the original
derivative and the new alternative benchmark-based derivative are not
economically equivalent. Therefore, this approach is not regarded as consistent
with the changes required by IBOR reform and the formal designation cannot be
amended without a discontinuing hedge accounting. This approach would result in a
discontinuation of hedge accounting because the hedging instrument is
derecognised [IAS 39.BC312(b)]

7I.7.878.60 Changes required by IBOR reform can occur at different times for a hedged item and
a hedging instrument. Accordingly, an entity may be required to amend the formal designation of its
hedging relationships at different times or may be required to amend the formal designation of a
hedging relationship more than once. When a change required by IBOR reform is made, the entity
changes the formal hedge designation. [IAS 39.102R]

7I.7.878.70 If an entity is required to amend the formal designation of a hedging relationship to

reflect changes required by IBOR reform in accordance with 7I.7.878.10, then it needs to do so by
the end of the reporting period during which a change required by IBOR reform is made to the
hedged risk, hedged item or hedging instrument. These amendments to the hedge designation do not
result in the discontinuation of the hedge accounting relationship. [IAS 39.102S]

7I.7.878.80 If changes are made in addition to those required by IBOR reform to the hedged risk,
hedged item or hedging instrument, then an entity first assesses whether those additional changes
result in the discontinuation of hedge accounting in accordance with the general hedge accounting
requirements. If the additional changes do not result in the discontinuation of hedge accounting,
then the entity amends the formal designation of the hedging relationship in accordance with
7I.7.878.10 and continues hedge accounting. [IAS 39.102T]

7I.7.878.90 When the designation of a hedging relationship is amended to reflect changes

required by IBOR reform, any changes in the fair value of the hedged item or the hedging instrument
are recognised in accordance with the general hedge accounting requirements. In other words, in a
fair value hedge a gain or loss arising from the remeasurement of the hedged item attributable to the
hedged risk or from remeasuring the hedging instrument is reflected in profit or loss when
measuring and recognising hedge ineffectiveness. In a cash flow hedge, if the cumulative gain or loss
on the hedging instrument is more than the cumulative change in the fair value of the expected
future cash flows on the hedged item attributable to the hedged risk, then the difference is
recognised in profit or loss as hedge ineffectiveness (see 7I.7.570). [IAS 39.102R, 102Z, BC316]
7I.7.878.100 When an entity amends the formal designation of a hedging relationship (see
7I.7.878.10) in which the hedged item is a group of items, the hedged items are allocated to
subgroups within the same hedging relationship based on the benchmark rate being hedged. The
eligibility of the group as a hedged item (see 7I.7.200) is assessed separately for each subgroup. If
any subgroup is determined not to be an eligible hedged item, then the entity discontinues hedge
accounting for the relationship in its entirety. [IAS 39.102Y–102Z]

7I.7.879 Additional exception from the retrospective effectiveness test

7I.7.879.10 When an entity performs the retrospective effectiveness test on a cumulative basis
(see 7I.7.550), it is permitted to reset the cumulative fair value changes of the hedged item and the
hedging instrument to zero when it ceases to apply the exception described in 7I.7.874.10 (see
7I.7.876.30). The reset of these amounts is only for the purposes of retrospective effectiveness
testing and the entity is required to measure and recognise any hedge ineffectiveness by comparing
the actual gains or losses of the hedged item with those of the hedging instruments. The reset may
be applied separately for each hedging relationship – i.e. on an individual hedging relationship basis.
[IAS 39.102V]

7I.7.880 Exception for cash flow hedge accounting

7I.7.880.10 For cash flow hedging relationships, the amount accumulated in the cash flow hedge
reserve at the date an entity amends the description of the hedged item in a cash flow hedge is
deemed to be based on the alternative benchmark rate on which the hedged future cash flows are
determined. [IAS 39.102W]

7I.7.880.20 The same exception as in 7I.7.880.10 is also applied to discontinued cash flow
hedging relationships. When determining whether the hedged future cash flows are expected to
occur for the purpose of reclassifying the cash flow hedge reserve (see 7I.7.240 and 7I.7.690), the
previous hedged future cash flows are deemed to be based on the alternative benchmark rate on
which the future contractual cash flows will be based when the interest rate benchmark is changed
as required by IBOR reform. [IAS 39.102X]

7I.7.881 The 24-month-period relief from the separately identifiable

criterion
7I.7.881.10 An alternative benchmark rate designated as a non-contractually specified risk
portion that is not separately identifiable at the time of designation is deemed to have met the
separately identifiable criterion if the entity reasonably expects that the alternative benchmark rate
will be separately identifiable within a period of 24 months from the designation date. However, if
subsequently the entity reasonably expects that the alternative benchmark rate will not be
separately identifiable within 24 months from the date it was designated as a non-contractually
specified risk portion for the first time, then the entity discontinues hedge accounting prospectively
from the date of that reassessment. [IAS 39.102Z1–102Z2]

7I.7.881.20 The 24-month period applies to each alternative benchmark rate separately, and
therefore the period begins from the date on which an entity designates that alternative benchmark
rate as a non-contractually specified risk portion for the first time – i.e. the 24-month period applies
on a rate-by-rate basis. [IAS 39.102Z1]

7I.7.881.30 It appears that if the term (i.e. period or duration) of non-contractually specified
alternative benchmark rate portions differs between different hedging relationships, then the
assessment of whether each alternative benchmark rate portion is reasonably expected to become
separately identifiable within a period of 24 months from the first designation date should be done
separately for each term of that alternative benchmark rate. This is because those risk portions are
different and hedge accounting criteria are assessed for each hedging relationship. For example, an
assessment of a three-year alternative benchmark rate portion would be different from an
assessment of a 30-year alternative benchmark rate portion. Even if the three-year rate portion is
reasonably expected to become separately identifiable within a period of 24 months, the 30-year rate
portion might not be reasonably expected to become separately identifiable within the same period.

7I.7.881.40 In addition, the Standards do not specify at what level the phrase ‘alternative
benchmark rate’ should be applied for the purpose of identifying the start of the 24-month period of
relief on a rate-by-rate basis in accordance with 7I.7.881.20 – i.e. whether a rate should be
considered separately if the term of the alternative benchmark rate portion is different. Because the
Standards do not provide specific guidance on this point, it appears that an entity may determine
that the 24-month period commences either:
• simultaneously for all non-contractually specified alternative benchmark rate portions that are
referenced to the same alternative benchmark rate index, irrespective of the duration of the
portion; or
• simultaneously for all non-contractually specified alternative benchmark rate portions that are
referenced to the same alternative benchmark rate index and have the same duration – i.e. the 24-
month period commences at different times for non-contractually specified alternative benchmark
rate portions that reference the same alternative benchmark rate but have different durations.

7I.7.881.50 Furthermore, we believe that when a non-contractually specified risk portion that
relates to a particular term of an alternative benchmark rate is no longer reasonably expected to be
separately identifiable within the 24-month period, an entity does not need to discontinue hedge
accounting for a hedge of a risk portion that has a different term of the alternative benchmark rate
and is still reasonably expected to be separately identifiable within the 24-month period. For
example, if a 30-year alternative benchmark rate portion is no longer reasonably expected to be
separately identifiable within the 24-month period but a three-year alternative benchmark rate
portion is still reasonably expected to be separately identifiable within the 24-month period, then the
entity does not need to discontinue hedge accounting for a hedge of the three-year alternative
benchmark rate portion even if hedge accounting for a hedge of the 30-year alternative benchmark
rate portion needs to be discontinued. As noted in 7I.7.881.30, the assessment of whether an
alternative benchmark rate portion is reasonably expected to be separately identifiable is different
for different terms of the alternative benchmark rate and hedge accounting criteria are generally
assessed for each hedging relationship.

7I.7.881.60 However, we also believe that if an alternative benchmark rate portion is no longer
forecast to be separately identifiable within the 24-month period of relief, then the 24-month period
continues to elapse. An entity may not pause the 24-month period or restart with a new 24-month
period if it subsequently forecasts that the rate will once again become a separately identifiable risk
portion because reapplying the relief with a further 24 months or other extension would be
inconsistent with the temporary nature of the relief.

7I.7.882 Transition

7I.7.882.10 The IBOR Phase 2 amendments are generally applied retrospectively. However, an
entity is not required to restate comparatives for prior periods to reflect the application of the
amendments. An entity may restate comparatives for prior periods if it is possible without the use of
hindsight. In addition, an entity reinstates a discontinued hedging relationship only if the following
conditions are met:
• the hedging relationship was discontinued solely due to changes required by IBOR reform;
• the entity would not have been required to discontinue that hedging relationship if the IBOR
Phase 2 amendments had been applied at that time; and
• at the date of initial application of the amendments – i.e. at the beginning of the reporting period
in which an entity first applies the amendments – that discontinued relationship still met the risk
management objective on the basis of which it originally qualified for hedge accounting and
continued to meet all other qualifying criteria. [IAS 39.108H-108I, 108K]

7I.7.882.20 If an entity does not restate comparatives for prior periods, then it recognises the
effect on the carrying amounts of assets and liabilities as at the beginning of the annual reporting
period that includes initial application in the opening retained earnings (or other component of
equity) of that period. [IAS 39.108K]

7I.7.882.30 If a discontinued hedging relationship is required to be reinstated (see 7I.7.882.10)

and relates to a non-contractually specified risk portion that is not separately identifiable, then the
24-month period of potential relief (see 7I.7.881) begins from the date of initial application of the
amendments. [IAS 39.108J]

7I.7.882.40 When an entity first applies the newly effective requirements of the IBOR Phase 2
amendments, it can choose not to present the quantitative information required by paragraph 28(f)
of IAS 8 – i.e. the entity is not required to disclose, for the current period and each prior period
presented, the amount of adjustment for:
• each financial statement line item affected; and
• if applicable, basic and diluted earnings per share. [IFRS 7.44HH]

7I.7.885 WORKED EXAMPLES

7I.7.885.10 The following examples demonstrate a number of the issues that have been discussed
in this chapter.

7I.7.890 Example 40 – Cash flow hedge of variable rate liability

7I.7.890.10 On 1 January 2021, Company P issues non-callable five-year floating

rate bonds of 100 million denominated in its functional currency. The floating
interest of six-month IBOR plus 50 basis points (0.5%) is payable semi-annually. The
bonds are issued at par.

7I.7.890.20 As part of P’s risk management policy, it determines that it does not
wish to expose itself to cash flow fluctuations from changes in market interest rates.
After the issue of the bonds, P immediately enters into a five-year interest rate swap
with a notional of 100 million. Under the terms of the swap, P pays 6% fixed and
receives floating cash flows based on six-month IBOR (set at 5.7% for the period
from 1 January to 30 June 2021). The timing of the swap’s cash flows matches those
of the bond. The fair value of the swap at inception is zero.

7I.7.890.30 The swap is designated and documented as the hedging instrument in

a cash flow hedge of the variability of future interest payments on the bond
attributable to movements in the benchmark interest rate – i.e. six-month IBOR only
– excluding the credit spread on the bond of 50 basis points. The hedging
relationship is expected to be highly effective.

7I.7.890.40 P indicates in its hedge documentation that it will use the hypothetical
derivative method for assessing the effectiveness of the hedging relationship. P
identifies a hypothetical swap in the bond under which it receives 6% fixed – i.e. the
fixed market rate of interest at the time of issuing the bond – and pays six-month
IBOR. Although the interest rate on the bond is IBOR plus 50 basis points, P has
designated as the hedged risk only the benchmark interest component of the total
interest rate risk exposure of the bond. Therefore, the hypothetical swap has a
floating leg equal to IBOR, rather than IBOR plus 50 basis points.
 5­year 5­year
100 million bond interest rate swap

Pay Receive
IBOR IBOR
Hedge

Pay 50 basis Pay

spread fixed rate

7I.7.890.50 Considering the combined effect of the bond and the swap, the
interest that effectively is payable is fixed at 6.5% (6% fixed on the swap plus the
additional actual 0.5% on the bond). P records the following entries.

DEBIT CREDIT

1 January 2021

Cash 100,000,000

Bonds payable 100,000,000

To recognise proceeds from bond issue

7I.7.890.60 No entry is necessary for the swap because its fair value is zero at
inception.

7I.7.890.70 At 30 June 2021, six-month IBOR increases to 6.7%. The fair value of
the swap is determined to be 3,803,843 after the settlement of interest due on 30
June 2021. The fair value of the hypothetical swap is also 3,803,843 at this date.
Therefore, the hedge is considered to be 100% effective. The full change in the fair
value of the swap is recognised in OCI.

DEBIT CREDIT

30 June 2021

Interest expense 3,100,000

Cash 3,100,000

To recognise payment of 6.2% floating interest

(IBOR of 5.7% plus premium of 0.5%)

Interest expense 150,000

Cash 150,000

To recognise net settlement of swap from 1

January to 30 June 2021 (pay 6% fixed
3,000,000; receive 5.7% floating 2,850,000)
 DEBIT CREDIT

Swap (asset) 3,803,843

Hedging reserve (OCI) 3,803,843

To recognise change in fair value of swap after

settlement of interest

7I.7.890.80 At 31 December 2021, interest rates have not changed. However, the
credit risk associated with the counterparty to the swap has worsened and is now
higher than the general market rate. The increased credit risk of the counterparty
results in a specific credit spread of 0.4%. Consequently, the rate used to determine
the fair value of the swap will be 0.4% higher than that used to value the
hypothetical swap, because the hypothetical swap is not affected by counterparty
credit risk.

7I.7.890.90 The fair value of the swap is 3,414,177 at 31 December 2021. The fair
value of the hypothetical swap is 3,436,978 at the same date. Based on the offsetting
of the change in the fair value of the swap and the change in the fair value of the
hypothetical swap (99% offset), the hedge is still effective within the acceptable
range of 80–125%. The difference of 22,801 is recognised in OCI because the
hedging reserve is adjusted to the lesser of the cumulative gain or loss on the
hedging instrument and the cumulative change in fair value of the expected future
cash flows on the hedged item attributable to the hedged risk, both from inception
of the hedge (see 7I.7.570.20).

DEBIT CREDIT

31 December 2021

Interest expense 3,600,000

Cash 3,600,000

To recognise payment of 7.2% floating interest

(IBOR of 6.7% plus premium of 0.5%)

Cash 350,000

Interest expense(1) 350,000

To recognise net settlement of swap from 1 July

to 31 December 2021 (pay 6% fixed 3,000,000;
receive 6.7% floating 3,350,000)

Hedging reserve (OCI) 389,666

Swap (asset) 389,666

To recognise change in fair value of swap

 Note
1. P has chosen to present the net interest accrual on the swap as an adjustment to
interest expense because the designated hedged item is an interest-bearing liability.

7I.7.890.100 The statement of financial position at 31 December 2021 will be as

follows.

ASSETS LIABILITIES AND EQUITY

Cash 93,500,000 Retained earnings (6,500,000)

Swap 3,414,177 Hedging reserve 3,414,177

Bonds payable 100,000,000

96,914,177 96,914,177

7I.7.900 Example 41 – Cash flow hedge using interest rate cap

7I.7.900.10 On 1 January 2021, Company R obtains a three-year loan of 10 million.

The interest rate on the loan is variable at IBOR plus 2%. R is concerned that
interest rates may rise during the three years, but wants to retain the ability to
benefit from IBOR rates below 8%. To hedge itself, R purchases for 300,000 an out-
of-the-money interest rate cap from a bank. Under the cap, when IBOR exceeds 8%
for a particular year R receives from the bank an amount calculated as 10 million x
(IBOR - 8%).

7I.7.900.20 The combination of the cap and the loan results in R paying interest at
a variable rate (IBOR plus 2%) not exceeding 10%. On both the variable rate loan
and the interest rate cap, rates are reset on 1 January and interest is settled on 31
December.

7I.7.900.30 R designates and documents the intrinsic value of the purchased

interest rate cap as the hedging instrument in a cash flow hedge of the interest rate
risk attributable to the future interest payments on the loan for changes in IBOR
above 8%. Changes in the time value of the option are excluded from the assessment
of hedge effectiveness and are recognised in profit or loss as they arise.

7I.7.900.40 The critical terms of the cap are identical to those of the loan and R
concludes that, both at inception of the hedge and on an ongoing basis, the hedging
relationship is expected to be highly effective in achieving offsetting cash flows
attributable to changes in IBOR when IBOR is greater than 8%. Because the cap is
being used to purchase one-way protection against any increase in IBOR, R

does not need to assess effectiveness in instances when IBOR is less than 8%. The
cumulative gains or losses on the interest rate cap – adjusted to remove time value
gains and losses – can reasonably be expected to equal the present value of the
cumulative change in expected future cash flows on the debt obligation when IBOR is
greater than 8%. This is reassessed at each reporting date.

7I.7.900.50 During the three-year period IBOR rates and related amounts are as
follows.

DATE RATE RECEIVABLE INTEREST NET INTEREST NET INTEREST

UNDER CAP PAYABLE ON PAYABLE PAYABLE
LOAN

2021 7% - 900,000 900,000 9%

2022 9% (100,000) 1,100,000 1,000,000 10%

2023 10% (200,000) 1,200,000 1,000,000 10%

7I.7.900.60 The fair value, intrinsic value and time value of the interest rate cap
and changes therein at the end of each accounting period, but before the settlement
of interest, are as follows.

DATE FAIR VALUE INTRINSIC TIME VALUE CHANGE IN CHANGE IN

VALUE FAIR VALUE TIME VALUE
GAIN/(LOSS) GAIN/(LOSS)

1 January 2021 300,000 - 300,000 - -

31 December 2021 280,000 - 280,000 (20,000) (20,000)

31 December 2022 350,000 200,000 150,000 70,000 (130,000)

31 December 2023 300,000 300,000 - (50,000) (150,000)

7I.7.900.70 IAS 39 does not specify how to compute the intrinsic value of a cap
option when the option involves a series of payments. In this example, the intrinsic
value of the cap is calculated based on simplified assumptions. Alternatively, and
more precisely, the intrinsic value of the cap (in the case of a long position) can be
calculated for each single period by subtracting the cap rate from the forward IBOR
of the respective period, multiplying the result by the notional amount of the cap
contract and then discounting the result to the date under consideration. The sum of
the discounted values yields the intrinsic value of the cap.

7I.7.900.80 Assuming that all criteria for hedge accounting have been met, R
records the following entries.

DEBIT CREDIT

1 January 2021

Cash 10,000,000

Loan payable 10,000,000

To recognise proceeds from loan

Interest rate cap (asset) 300,000

Cash 300,000

To recognise purchase of interest rate cap

31 December 2021

Interest expense 900,000

Cash 900,000

To recognise interest expense on loan (IBOR +

2%)

Hedge expense (profit or loss) 20,000

Interest rate cap (asset) 20,000

To recognise change in fair value of cap (time

value change)

31 December 2022

Interest expense 1,100,000

Cash 1,100,000

To recognise interest expense on loan (IBOR +

2%)

Hedge expense (profit or loss) 130,000

Interest rate cap (asset) 70,000

Hedging reserve (OCI) 200,000

To recognise change in fair value of cap

(130,000 represents the change in time value,
which is excluded from assessment of hedge
effectiveness; 200,000 represents increase in
interest rate cap’s intrinsic value)

Hedging reserve (OCI) 100,000

Hedge income/interest income (profit or loss) 100,000

To reclassify proportion of increase in intrinsic

value of cap related to realised cash flow to
profit or loss

DEBIT CREDIT

Cash 100,000
 Interest rate cap (asset) 100,000

To recognise cash received on settlement of

interest rate cap

31 December 2023

Interest expense (profit or loss) 1,200,000

Cash 1,200,000

To recognise interest expense on loan (IBOR +

2%)

Hedge expense (profit or loss) 150,000

Interest rate cap (asset) 50,000

Hedging reserve (OCI) 100,000

To recognise change in fair value of cap

(150,000 represents change in time value,
which is excluded from assessment of hedge
effectiveness; 100,000 represents increase in
the interest rate cap’s intrinsic value)

Hedging reserve (OCI) 200,000

Hedge income/interest income (profit or loss) 200,000

To reclassify proportion of increased intrinsic

value of cap related to realised cash flow to
profit or loss

Cash 200,000

Interest rate cap (asset) 200,000

To recognise cash received on final settlement

of interest rate cap

7I.7.900.90 As a result of the hedge, effectively R has capped its interest expense
on the three-year loan at 10%. Specifically, during those periods when the
contractual terms of this loan would result in an interest expense greater than 10%
or 1 million – i.e. in instances when IBOR exceeded 8% – the payments received from
the interest rate cap effectively reduce interest expense to 10% as illustrated below.
However, the recognition in profit or loss of changes in the fair value of the cap
arising from changes in time value results in variability of total interest expense.
 2021 2022 2023

Interest on IBOR plus 2% debt 900,000 1,100,000 1,200,000

Reclassified from OCI (effect of cap) - (100,000) (200,000)

Interest expense adjusted by effect of

hedge 900,000 1,000,000 1,000,000

Change in time value of cap 20,000 130,000 150,000

Total expense 920,000 1,130,000 1,150,000

7I.7.910 Example 42 – Cash flow hedge of foreign currency sales transactions

7I.7.910.10 Company M produces components that are sold to domestic (UK) and
foreign customers (US). Company M’s functional currency is sterling. Export sales to
customers in the US are denominated in the customers’ functional currency (US
dollars). To reduce the foreign currency risk from the export sales, M has the
following hedging policy.
• A transaction is committed when the pricing, quantity and timing are fixed.
• Committed transactions are hedged 100%.
• Anticipated transactions that are highly probable are hedged 50%.
• Only transactions anticipated to occur within six months are hedged.
7I.7.910.20 For export sales, cash payment falls due one month after the invoice
date. M projects sales to its foreign customers during April 2021 of 100,000 units,
amounting to sales revenue of USD 10 million.

7I.7.910.30 At 28 February 2021, all of the USD 10,000,000 of sales in April 2021
are still anticipated but uncommitted. Therefore, only 50% of the total anticipated
sales are hedged. The hedge is transacted by entering into a foreign currency forward
contract (forward 1) to sell USD 5 million and receive sterling at 0.6829 on 15 May
2021 and is documented as a cash flow hedge of the cash receipts pertaining to the
first USD 5 million of forecast sales. The hedge is expected to be highly effective.
Hedge effectiveness will be assessed by comparing the changes in the discounted
cash flows of the incoming amounts of US dollars to the changes in the fair value of
the forward contract. M includes the interest element of the foreign currency forward
contract when measuring hedge effectiveness. This is expected to result in a highly
effective cash flow hedge because the fair value of the sales transactions during the
period of the hedge will be affected by US dollar interest rates as well as by the spot
exchange rates.

7I.7.910.40 A review of the sales order book at 31 March 2021 shows that all of the
anticipated sale contracts for invoicing in April are now signed. In accordance with
the hedging policy, a further foreign currency forward contract (forward 2) is entered
into to sell USD 5 million and receive sterling at 0.7100 on 15 May 2021 in order to
hedge the cash receipts pertaining to the next USD 5 million of forecast sales.

7I.7.910.50 The spot and forward exchange rates and the fair value of the forward
contracts are as follows.

DATE SPOT FORWARD FAIR VALUE FAIR VALUE

RATE RATE OF FORWARD OF FORWARD
USD 1 USD 1 USD
SALE OF SALE OFUSD
= = 5,000,000 5,000,000
GBP GBP (FORWARD 1) (FORWARD 2)
GBP GBP

28 February 2021 0.6860 0.6829 - N/A

31 March 2021 0.7120 0.7100 (134,491) -

30 April 2021 0.7117 0.7108 (139,152) (3,990)

15 May 2021 0.7208 N/A (189,500) (54,000)

7I.7.910.60 The fair value of the foreign currency forward contracts at each
measurement date is computed as the present value of the expected settlement
amount, which is the difference between the contractually set forward rate and the
actual forward rate on the date of measurement multiplied by the notional foreign
currency amount. The discount rate used is 6%.

7I.7.910.70 During April 2021, export sales of USD 10 million are invoiced and
recognised in profit or loss. The deferred gain or loss on the hedging forward
contracts that was recognised in OCI up to the date of sale is reclassified from
equity to profit or loss. The cash flows being hedged are recognised in the statement
of financial position as receivables of USD 10 million. M determines that hedge
accounting no longer is necessary because foreign currency gains and losses on the
amounts receivable are recognised in profit or loss and will mostly be offset by the
revaluation gains and losses on the forwards.

7I.7.910.80 Assuming that all criteria for hedge accounting have been met, M
records the following entries.

DEBIT (GBP) CREDIT (GBP)

28 February 2021

No entries in profit or loss or statement of

financial position required; fair value of forward
contract is zero

31 March 2021

Hedging reserve (OCI) 134,491

Derivatives (liabilities) 134,491

To recognise change in fair value of forward 1

DEBIT (GBP) CREDIT (GBP)

1 to 30 April 2021

Trade receivables 7,115,000

Export sales 7,115,000

To recognise USD 10,000,000 sales transactions

at exchange rates on dates of transactions (on
average assumed to be 0.7115)

30 April 2021

Trade receivables 2,000

Foreign exchange gain on trade receivables

(profit or loss) 2,000

To remeasure trade receivables at closing spot

rate: USD 10,000,000 × (0.7117 - 0.7115)

Hedging reserve (OCI) 4,661

Derivatives (liabilities) 4,661

To recognise change in fair value of forward 1

for period

Hedging reserve (OCI) 3,990

Derivatives (liabilities) 3,990

To recognise change in fair value of forward 2

for period

Export sales (profit or loss) 143,142

Hedging reserve (OCI) 143,142

To reclassify deferred hedge results on

recording sales (GBP 139,152 + GBP 3,990)

1 to 15 May 2021

Cash 3,575,000

Trade receivables 3,575,000

To recognise receipts from receivables from

first USD 5,000,000 of sales at spot rate at date
of payment (on average 0.7150)

Trade receivables 16,500

Foreign exchange gain on trade receivables

(profit or loss) 16,500

To recognise gain on trade receivables: USD

5,000,000 × (0.7150 - 0.7117)

DEBIT (GBP) CREDIT (GBP)

15 May 2021

Cash 29,000

Foreign exchange gain on cash (profit or loss) 29,000

To remeasure bank balance at spot rate: USD

5,000,000 × (0.7208 - 0.7150)

Trade receivables 45,500

Foreign exchange gain on trade receivables

(profit or loss) 45,500

To recognise foreign exchange gain on trade

receivables: USD 5,000,000 × (0.7208 - 0.7117)

Foreign exchange loss on forward (profit or

loss) 50,348

Derivatives (liabilities) 50,348

To recognise change in fair value of forward 1

for period

Foreign exchange loss on forward (profit or

loss) 50,010

Derivatives (liabilities) 50,010

To recognise change in fair value of forward 2

for period

Derivatives (liabilities) 189,500

Cash 189,500

To recognise settlement of forward 1

Derivatives (liabilities) 54,000

Cash 54,000

To recognise settlement of forward 2

15 to 31 May 2021

Cash 3,655,000

Trade receivables 3,655,000

 To recognise payments of receivables at spot
rate at date of payment (on average 0.7310)

Foreign exchange loss on cash (profit or loss) 51,000

Cash 51,000

To recognise foreign exchange loss on forwards

settled before all receivables settled (US dollars
bank account was overdrawn for a period): USD
5,000,000 × (0.7310 - 0.7208)

DEBIT (GBP) CREDIT (GBP)

Trade receivables 51,000

Foreign exchange gain on trade receivables

(profit or loss) 51,000

To recognise foreign exchange gain on

settlement of receivables: USD 5,000,000 ×
(0.7310 - 0.7208)

7I.7.910.90 After all transactions have been settled, the statement of financial
position, including the profit or loss impact, is as follows (amounts in sterling).

ASSETS EQUITY

Cash 6,964,500 Export sales (retained

earnings) 6,971,858

Foreign exchange loss

(retained earnings) (7,358)

Total assets 6,964,500 Total equity 6,964,500

7I.7.910.100 The bank balance reflects the settlement of the two forward
contracts (amounts in sterling).

Forward 1: USD 5,000,000 at 0.6829 3,414,500

Forward 2: USD 5,000,000 at 0.7100 3,550,000

Total 6,964,500

7I.7.910.110 The foreign exchange loss in this example has two causes.
• Timing mismatches – receivables and sales are recognised at the spot exchange
rate at the date of the transaction (on average 0.7115) during April 2021,
whereas the release from the hedging reserve is recognised at the end of April
2021 (for practical reasons), when the rate was 0.7117. Furthermore, receivables
 are collected during the month of May 2021 and recognised at the relevant spot
rates, whereas the forward contracts are settled on 15 May 2021.
• Interest element on the forward contracts for the period in which hedge
accounting is not applied (1 to 15 May 2021) – from 30 April 2021 the cash flow
hedge is de-designated, but the forward contracts remain as an economic hedge
of the receivables to be collected during May 2021. The foreign exchange results
on the receivables are recognised in profit or loss, as are changes in the fair value
of the forward contracts. However, a perfect offset is not achieved because of the
interest element included in the changes in fair value of the forward contracts.

7I.7.910.120 As an alternative to the cash flow hedge accounting described in this

example, M could have applied the approach suggested in 7I.7.450.80, with the
following results.
• On occurrence of the forecast sales – i.e. the transaction date – the difference
between the spot foreign exchange rates at the inception of each of the two
hedges and spot foreign exchange rates on the sale dates would have been
reclassified from equity to profit or loss.
• The forward points (interest cost in this case) in each hedging relationship that
are ascribed to the period until sale would have been recognised in profit or loss
on sale. For example, in the hedge of the cash receipts pertaining to the first USD
5 million of forecast sales using the first forward contract, the forward points of
GBP 15,500 (USD 5,000,000 x (0.6860 - 0.6829)) would be allocated to sales in
the ratio of the period from hedge inception to date of sale and period from date
of sale until estimated date of cash collection.
• The net effect of these steps would be that the sales under each of the two
hedging relationships would be recognised in sterling in profit or loss at the
respective spot exchange rates at hedge inception, less an allocation of the
interest cost represented by the forward point ascribed to the sale under each
hedge.
• Subsequent to recognition of the receivables arising from the US dollar sales, the
entire change in the fair value of the hedging forward contracts would be
recognised in OCI and the forward points – other than those allocated to the
period up to sale as discussed above – would be amortised and reclassified from
equity to profit or loss. If there was a reporting date between the dates when the
receivables are recognised and when they are collected, then M would reclassify
from equity to profit or loss an amount equal to the remeasurement of the
receivable or payable under IAS 21 based on the spot exchange rates.

7I.7.920 Example 43 – Termination of hedge accounting

7I.7.920.10 Modifying Example 42, assume that on 31 March 2021 the committed
transactions actually are only USD 3 million and that no more transactions for April
2021 are anticipated. It is now unlikely that the original forward contract to sell
USD 5 million would be highly effective in hedging the cash flows pertaining to the
now expected future sales of USD 3 million. Therefore, the original hedging
relationship is discontinued. However, Company M may designate the remaining
USD 3 million of committed sales as the hedged item in a new hedging relationship.

7I.7.920.20 The unrealised foreign exchange loss deferred in equity related to the
forecast sales of USD 2 million that are no longer expected to occur are immediately
 recognised in profit or loss because the cash flow is no longer expected to occur. The
unrealised foreign exchange loss related to the USD 3 million of sales that still are
expected to occur remains in equity.

7I.7.920.30 M records the following entry.

DEBIT (GBP) CREDIT (GBP)

31 March 2021

Foreign exchange losses (profit or loss) 53,796

Hedging reserve (OCI) 53,796

To reclassify portion of deferred losses that

reflects cash flows no longer expected to occur
(134,491 × 2 / 5)

7I.7.930 Example 44 – Fair value hedge of foreign currency risk on available-

for-sale equities

7I.7.930.10 Company S is a large pension fund set up for the employees of a

brewery. In recent years the pension fund assets have grown and management is
finding it increasingly difficult to achieve sufficient diversification in the domestic
equity market. Also, management believes that it is possible to earn a higher return
on equity shares in certain foreign markets. Consequently, management decides to
invest in a large foreign equity market. However, all of S’s pension obligations are
denominated in Singapore dollars, its functional currency, and as part of the
investment strategy S seeks to hedge all significant exposure to foreign currency
risk beyond certain limits.

7I.7.930.20 On 1 April 2021, S buys a portfolio of equity shares of Company T on

the London Stock Exchange in which transactions are denominated in sterling and
dividends on T’s shares are paid only in sterling. T’s shares are traded only on the
London Stock Exchange and T operates only in the UK. T’s shares are acquired for
GBP 30 million and are classified as available-for-sale financial assets.

7I.7.930.30 Although a steady growth in the value of the shares is expected in the
medium to long term, creating an increased foreign currency exposure, S decides to
hedge only the foreign exchange exposure on a portion of the market value of the
portfolio in foreign currency. This is because of the uncertainty about the short-term
development in the market value and, therefore, the exposure. S enters into a
foreign currency forward contract to sell GBP 25.5 million and receive Singapore
dollars on 15 October 2021. This contract will then be rolled for as long as the
position is outstanding (see 7I.7.680.80).

7I.7.930.40 The forward contract is designated as a fair value hedge of the foreign
currency risk associated with the GBP 25.5 million portion of the fair value of the shares.
The time value of the forward contract is excluded from the assessment of hedge
effectiveness. The hedge is expected to be highly effective and hedge effectiveness will
be assessed by comparing the changes in the fair value of the GBP 25.5 million portion
of shares arising from changes in spot exchange rates with the changes in the value of
the forward contract also arising from changes in spot rates – because the time value is
excluded from the hedging relationship.

7I.7.930.50 The terms of the forward contract are as follows:

• sell GBP 25,500,000;
• buy SGD 64,359,915; and
• maturity of 15 October 2021.
7I.7.930.60 The terms imply a forward rate of 2.5239.

7I.7.930.70 During the period of the hedge, the value of the forward is as follows
(amounts in SGD).

DATE SPOT RATE VALUE OF VALUE SPOT FORWARD

(GBP 1 CONTRACT CHANGE ELEMENT ELEMENT
= SGD) FORWARD GAIN/(LOSS) GAIN/(LOSS) GAIN/(LOSS)

1 April 2021 2.55 - - - -

30 June 2021 2.41 3,031,769 3,031,769 3,570,000 (538,231)

30 September 2021 2.39 3,406,748 374,979 510,000 (135,021)

15 October 2021 2.45 1,884,915 (1,521,833) (1,530,000) 8,167

1,884,915 2,550,000 (665,085)

7I.7.930.80 The value of the foreign equity portfolio changes as follows, as a result of
changes in equity prices and changes in the exchange rate.

DATE VALUE VALUE VALUE

(GBP) (SGD) CHANGE
(SGD)

1 April 2021 30,000,000 76,500,000 -

30 June 2021 35,000,000 84,350,000 7,850,000

30 September 2021 28,000,000 66,920,000 (17,430,000)

15 October 2021 32,000,000 78,400,000 11,480,000

7I.7.930.90 Assuming that all the criteria for hedge accounting have been met, S
records the following entries.

DEBIT (SGD) CREDIT (SGD)

1 April 2021

No entries in profit or loss or statement of

financial position required; fair value of forward
contract is zero
Available-for-sale financial assets 76,500,000

Cash 76,500,000

To recognise purchase of securities; GBP 30

million at 2.55

30 June 2021

Available-for-sale financial assets 7,850,000

Available-for-sale revaluation reserve (OCI) 7,850,000

To recognise change in fair value of securities

Derivatives (assets) 3,031,769

Derivative revaluation gain (profit or loss) 3,031,769

To recognise change in fair value of forward

Hedge revaluation loss (profit or loss) 3,570,000

Available-for-sale revaluation reserve (OCI) 3,570,000

To reclassify fair value change of securities in

respect of hedged risk to profit or loss; GBP
25.5 million × (2.41 - 2.55)

30 September 2021

Available-for-sale revaluation reserve (OCI) 17,430,000

Available-for-sale financial assets 17,430,000

To recognise change in fair value of securities

Derivatives (assets) 374,979

Derivative revaluation gain (profit or loss) 374,979

To recognise change in fair value of forward

Hedge revaluation loss (profit or loss) 510,000

Available-for-sale revaluation reserve (OCI) 510,000

To reclassify fair value change of securities in

respect of hedged risk to profit or loss; GBP
25.5 million × (2.39 - 2.41)

DEBIT (SGD) CREDIT (SGD)

15 October 2021
 Available-for-sale financial assets 11,480,000

Available-for-sale revaluation reserve (OCI) 11,480,000

To recognise change in fair value of securities

Derivative revaluation loss (profit or loss) 1,521,833

Derivatives (assets) 1,521,833

To recognise change in fair value of forward

Available-for-sale revaluation reserve (OCI) 1,530,000

Hedge revaluation gain (profit or loss) 1,530,000

To reclassify fair value change of securities in

respect of hedged risk to profit or loss: GBP
25.5 million × (2.45 - 2.39)

Cash 1,884,915

Derivatives (assets) 1,884,915

To recognise settlement of forward

7I.7.930.100 The hedge stays effective for the full period because changes in the
fair value of the forward contract, arising from changes in spot rates, perfectly
offset changes in the value of GBP 25.5 million of the equity portfolio arising from
the same spot exchange rates.

7I.7.930.110 Variability in the fair value of the shares in foreign currency would
not affect the assessment of hedge effectiveness unless the fair value of the shares
in foreign currency declined below GBP 25.5 million.

7I.7.930.120 In order for fair value hedge accounting to be applied, the portfolio
of shares that was designated as the hedged item at 1 April 2021 should continue to
be the hedged item for the entire period of the hedge. This means that active
management of the portfolio may preclude fair value hedge accounting.

7I.7.930.130 As an alternative approach, management may designate the hedge

as a hedge of the anticipated disposal of the shares, providing that the timing of
such disposal is highly probable, and apply cash flow hedge accounting. Cash flow
hedge accounting requires specifying the size and timing of the cash flow being
hedged. The model that is more appropriate may also depend on the entity’s ability
to collect the relevant information required under each model.

7I.7.940 Example 45 – Cash flow hedge of foreign currency risk of recognised

financial liability

7I.7.940.10 On 1 January 2021, Company G issues a non-callable three-year 5.5%

fixed rate bond of USD 15 million at par. G’s functional currency is sterling.

7I.7.940.20 As part of its risk management policy, G decides to eliminate the

exposure arising from movements in the US dollar/sterling exchange rates on the
principal amount of the bond for three years. G enters into a foreign currency
forward contract to buy USD 15 million and sell GBP 9,835,389 at 31 December
2023.

7I.7.940.30 G designates and documents the forward contract as the hedging

instrument in a cash flow hedge of the variability in cash flows arising from the
repayment of the principal amount of the bond because of movements in forward US
dollar/sterling exchange rates.

7I.7.940.40 G states in its hedge documentation (see 7I.7.120.30) that it will use
the hypothetical derivative method to assess hedge effectiveness. G identifies the
hypothetical derivative as a forward contract under which it sells USD 15 million
and purchases GBP 9,835,389 at 31 December 2023 (the repayment date of the
bond). The hypothetical foreign currency forward contract has a fair value of zero at
1 January 2021.

7I.7.940.50 The spot and the forward exchange rates and the fair value of the
foreign currency forward contract are as follows.

DATE SPOT RATE FORWARD FAIR VALUE

USD 1 RATE OF FORWARD
= USD 1 CONTRACT
GBP = GBP
GBP

1 January 2021 0.6213 0.6557 -

31 December 2021 0.5585 0.5858 (957,205)

31 December 2022 0.5209 0.5280 (1,833,457)

31 December 2023 0.5825 0.5825 (1,097,889)

7I.7.940.60 For the purposes of this example, it is assumed that the average
exchange rates approximate the exchange rates at the ends of the respective years.

7I.7.940.70 The hedge remains effective for the entire period, with changes in the
fair value of the hypothetical forward contract and the hedging instrument being
perfectly offset. Because G has designated the variability in cash flows arising from
movements in the forward rates as the hedged risk, the entire change in the fair
value of the forward contract is recognised in OCI. At each reporting date, G

reclassifies from equity an amount equal to the movement in the spot rate on the
principal amount of the bond. In addition, to ensure that the forward points
recognised in OCI are reclassified fully to profit or loss over the life of the hedge, G
reclassifies from equity an amount equal to the cumulative change in the forward
points recognised in OCI amortised over the life of the hedging relationship using
the interest rate implicit in the forward contract.

7I.7.940.80 Assuming that all criteria for hedge accounting have been met, G
records the following entries.

DEBIT (GBP) CREDIT (GBP)

1 January 2021

No entries in profit or loss or statement of

financial position required; fair value of forward
contract is zero

Cash 9,319,500

Bond (financial liability) 9,319,500

To recognise issue of bond: USD 15 million at

0.6213

31 December 2021

Hedging reserve (OCI) 957,205

Derivative (liability) 957,205

To recognise change in fair value of forward

contract (100% effective)

Bond (financial liability) 942,000

Foreign currency translation (profit or loss) 942,000

To recognise foreign exchange gain on issued

bond

Foreign currency translation (profit or loss) 942,000

Hedging reserve (OCI) 942,000

To reclassify movement in spot rate

Foreign currency translation (profit or loss) 168,884

Hedging reserve (OCI) 168,884

To reclassify forward points using interest rate

implicit in forward contract

Interest expense (profit or loss) 460,763

Cash 460,763

Interest: 5.5% of USD 15 million at 0.5585

DEBIT (GBP) CREDIT (GBP)

31 December 2022

Hedging reserve (OCI) 876,252

Derivative (liability) 876,252

To recognise change in fair value of forward
contract (100% effective)

Bond (financial liability) 564,000

Foreign currency translation (profit or loss) 564,000

To recognise foreign exchange gain on issued

bond

Foreign currency translation (profit or loss) 564,000

Hedging reserve (OCI) 564,000

To reclassify movement in spot rate

Foreign currency translation (profit or loss) 171,945

Hedging reserve (OCI) 171,945

To reclassify forward points using interest rate

implicit in forward contract

Interest expense (profit or loss) 429,743

Cash 429,743

To recognise interest:
5.5% of USD 15 million at 0.5209

31 December 2023

Derivative (liability) 735,568

Hedging reserve (OCI) 735,568

To recognise change in fair value of forward

contract (100% effective)

Foreign currency translation (profit or loss) 924,000

Bond (financial liability) 924,000

To recognise foreign exchange loss on issued

bond

Hedging reserve (OCI) 924,000

Foreign currency translation (profit or loss) 924,000

To reclassify movement in spot rate

Foreign currency translation (profit or loss) 175,060

Hedging reserve (OCI) 175,060

To reclassify forward points using interest rate

implicit in forward contract
 DEBIT (GBP) CREDIT (GBP)

Bond (financial liability) 8,737,500

Cash 8,737,500

To recognise settlement of bond: USD 15 million

at 0.5825

Derivative (liability) 1,097,889

Cash 1,097,889

To recognise settlement of forward contract

Interest expense (profit or loss) 480,563

Cash 480,563

To recognise interest: 5.5% of USD 15 million at

0.5825

7I.7.950 Example 46 – Hedging on group basis – Foreign currency risk

7I.7.950.10 A group consists of a parent entity (including a corporate treasury)

and its subsidiaries, Subsidiary J and Subsidiary B, all of which have a euro
functional currency. J has highly probable cash inflows from future revenues of USD
200 that it expects to receive in 60 days. To hedge this exposure, J enters into a
forward contract with the corporate treasury to pay USD 200 in 60 days.

7I.7.950.20 B has highly probable forecast purchases of US dollar 500 that it

expects to pay in 60 days. B hedges this exposure by entering into a forward
contract with the corporate treasury to receive US dollar 500 in 60 days.

7I.7.950.30 The parent entity itself has no expected exposure to that foreign
currency during this period.
 External counterparty
(bank)

Forward of USD 300

Group corporate
treasury

Subsidiary J Subsidiary B

Forecast sales of Forecast purchases of

USD 200 USD 500

7I.7.950.40 The effect of the internal derivatives with the subsidiaries is to

transfer the foreign currency risk to the corporate treasury. The net foreign
currency exposure from US dollars in the next time period is a USD 300 outflow. The
corporate treasury hedges this exposure by entering into a forward contract with an
external third party.

7I.7.950.50 To apply hedge accounting to this transaction, the group designates

the external forward contract as a hedge of a gross exposure in one of the
subsidiaries rather than the net exposure. The group does this by designating the
first USD 300 of cash outflows from purchases in B as the hedged item and the
external forward contract as the hedging instrument. Whether adjustments are
required on consolidation to the hedge accounting entries made by J and B depends
on whether the forecast transactions of J and B are recognised in profit or loss at the
same time. Two possibilities are considered in 7I.7.960 and 970.

7I.7.960 Transactions recognised concurrently in income

7I.7.960.10 The forecast sales and forecast purchases of J and B respectively are
recognised in profit or loss at the same time and both subsidiaries applied cash flow
hedge accounting for their respective internal derivatives. On consolidation the
internal transactions offset, leaving only the external derivative and its associated
gain or loss to be accounted for. The group can apply hedge accounting to the
relationship between this external derivative and the first USD 300 of outflows
representing B’s purchases without making any adjustments to the hedge
accounting entries made at the subsidiary level. The internal derivatives are used as
an indicator of the external transaction that qualifies for hedge accounting.

7I.7.970 Transactions recognised in different periods

7I.7.970.10 The forecast sales of J are recognised in profit or loss in July, whereas
B’s purchases are recognised in June. Both subsidiaries applied cash flow hedge
accounting for their respective internal derivatives. On consolidation as at 30 June,
the internal transactions will not offset completely because they are recognised in
profit or loss in different periods. Consequently, the group cannot automatically
 apply hedge accounting to the relationship between the external derivative and the
first USD 300 of outflows representing B’s purchases; some adjustments will have to
be made to the subsidiaries’ accounting. In this case, the internal derivatives cannot
be used as an indicator of the external transaction that qualifies for hedge
accounting. An alternative approach would be to:
• enter into external derivatives to hedge aggregate long positions and short
positions in each currency and each time period separately – i.e. by aggregating
and not netting internal derivatives at corporate treasury – and then designating
the external derivatives as hedging instruments at the group level; and
• put in place additional documentation at the group level to link each external
derivative to its associated group of internal derivatives such that the chain of
hedge documentation is complete, via the internal contracts, between each
hedged cash flow within the group and a portion of the related external
derivative.

7I.7.980 Example 47 – Hedge of net investment in foreign operation

7I.7.980.10 Company G, whose functional currency is the euro, has a net

investment in a foreign subsidiary of GBP 50 million. On 1 October 2021, G enters
into a foreign exchange forward contract to sell GBP 50 million and receive euro on
1 April 2022. G will review the net investment balance on a quarterly basis and
adjust the hedge to the value of the net investment. The time value of the forward
contract is excluded from the assessment of hedge effectiveness.

7I.7.980.20 The exchange rate and fair value of the forward contract move as
follows.

DATE SPOT RATE FORWARD FAIR VALUE

GBP 1 RATE OF FORWARD
= GBP 1 CONTRACT
EUR = EUR
EUR

1 October 2021 1.71 1.70 -

31 December 2021 1.64 1.63 3,430,000

31 March 2022 1.60 N/A 5,000,000

7I.7.980.30 Assuming that all criteria for hedge accounting have been met, G
records the following entries.

DEBIT (EUR) CREDIT (EUR)

1 October 2021

No entries in profit or loss or statement of

financial position required; fair value of forward
contract is zero

31 December 2021

Derivatives (asset) 3,430,000

 Foreign exchange losses (profit or loss) 70,000

Foreign currency translation reserve (OCI) 3,500,000

To recognise change in fair value of forward

Foreign currency translation reserve (OCI) 3,500,000

Net investment in subsidiary (asset) 3,500,000

To recognise foreign exchange loss on net

investment in subsidiary (adjustment to net
investment would be derived by translating
subsidiary’s statement of financial position at
spot rate at each reporting date)

DEBIT (EUR) CREDIT (EUR)

31 March 2022

Derivatives (asset) 1,570,000

Foreign exchange losses (profit or loss) 430,000

Foreign currency translation reserve (OCI) 2,000,000

To recognise change in fair value of forward

Foreign currency translation reserve (OCI) 2,000,000

Net investment in subsidiary (asset) 2,000,000

To recognise change in foreign exchange losses

on net investment

Cash 5,000,000

Derivatives (assets) 5,000,000

To recognise settlement of forward

7I.7.980.40 The gain on the hedging transaction will remain in equity until the
subsidiary is disposed of (see 7I.7.110.30–40).

7I.7.990 Example 48 – Hedging other market price risks

7I.7.990.10 Company X owns equity securities in an entity listed on a domestic

stock exchange. The securities are classified as available-for-sale. At 1 January
2021, the fair value of the securities is 120 million; the fair value on initial
recognition was 115 million. The revaluation gain of 5 million is recognised in OCI.

7I.7.990.20 At 30 June 2021, the value of the securities has increased from 120
million to 130 million. The securities are remeasured at fair value with the
cumulative change of 15 million recognised in OCI.

7I.7.990.30 At 30 June 2021, because of volatility in the price risk of the securities
and to comply with internal risk management policies, management decides to
purchase a European put option on the securities with a strike price equal to the
current market price of 130 million and a maturity date of 30 June 2022. The option
premium paid is 12 million.

7I.7.990.40 Management has documented the hedging relationship and assessed

that the purchased put option is an effective hedge in offsetting decreases in the fair
value of the equity securities below 130 million. The time value component will not
be included in determining the effectiveness of the hedge. The fair value of the
securities and the put option during the period are as follows.

DATE VALUE OF TOTAL OPTION INTRINSIC TIME VALUE

SECURITIES VALUE VALUE

1 January 2021 120,000,000 - - -

30 June 2021 130,000,000 12,000,000 - 12,000,000

30 September 2021 136,000,000 7,000,000 - 7,000,000

31 December 2021 126,000,000 9,000,000 4,000,000 5,000,000

7I.7.990.50 The following entries are made to record the remeasurement of the
securities and the payment of the option premium.
 DEBIT CREDIT

30 June 2021

Available-for-sale securities 10,000,000

Available-for-sale revaluation reserve (OCI) 10,000,000

To recognise remeasurement gain on available-

for-sale securities

Hedging derivatives (assets) 12,000,000

Cash 12,000,000

To recognise payment of option premium

30 September 2021

Available-for-sale securities 6,000,000

Available-for-sale revaluation reserve (OCI) 6,000,000

To recognise remeasurement gain on available-

for-sale securities

Hedging costs (profit or loss) 5,000,000

Hedging derivatives (assets) 5,000,000

To recognise remeasurement loss on option

because of change in time value (not part of
hedging relationship)

7I.7.990.60 The option is still expected to be effective as a hedge of decreases in

the fair value of the available-for-sale securities below the strike price of the option.

7I.7.990.70 At 31 December 2021, the value of the hedged securities decreases to

126 million. The value of the put option increases to 9 million; of that amount, 4
million represents intrinsic value and 5 million represents time value. As such, the
following entries are made to recognise the change in the fair value of the available-
for-sale securities and the changes in the fair value of the option.

7I.7.990.80 For illustrative purposes, these entries have been separated into two
parts to demonstrate the accounting for the changes in the value of the securities
that are not being hedged (decrease to 130 million) and the changes in value that
are being hedged (decrease below 130 million). Likewise, changes in the fair value
of the option are separated to demonstrate changes in the time value, which have
been excluded from the hedging relationship, and changes in the option’s intrinsic
value.

DEBIT CREDIT

31 December 2021
 Available-for-sale revaluation reserve (OCI) 6,000,000

Available-for-sale securities 6,000,000

To recognise unhedged decrease in fair value of

securities (from 136 million to 130 million)

Hedge results (profit or loss) 4,000,000

Available-for-sale securities 4,000,000

To recognise hedged decrease in fair value of

securities (from 130 million to 126 million)

Hedging costs (profit or loss) 2,000,000

Hedging derivatives (assets) 2,000,000

To recognise changes in time value of option

(excluded from hedging relationship)

Hedging derivatives (assets) 4,000,000

Hedge results (profit or loss) 4,000,000

To recognise change in intrinsic value of option

(effective part of hedge)

7I.7.990.90 At 31 December 2021, the equity securities are recognised at a fair

value of 126 million compared with an original cost of 115 million. As a result of the
hedging strategy designated by X in 7I.7.990.40 using a European put option with a
strike price of 130 million, a gain of 15 million has been included in the available-for-
sale revaluation reserve, while a loss of 4 million – i.e. the decline in the value from
130 million to 126 million – has been included in profit or loss.

7I.7.1000 Example 49 – Impact of a modification of the hedged item on a fair

value hedge

7I.7.1000.10 At 1 January 2021, Company X buys a financial asset for 10,000 that
has five years of 7% annual coupon and a par amount of 10,000 with a bullet
repayment at 31 December 2025. The original effective interest rate is 7%.
Immediately after the purchase, X designates the asset as the hedged item in a fair
value hedge

of benchmark interest rate (IBOR) risk. The hedged item is four-sevenths of each
coupon cash flow (i.e. 4% out of the original coupon of 7%), being the benchmark
portion of the fixed rate asset at inception, plus the principal repayment of the loan.

7I.7.1000.20 The hedging instrument is an interest rate swap that receives IBOR
and pays 4%. X enters into the swap on 1 January 2021. All of the critical terms of
the swap and the hedged item match and the fair value of the swap is nil at
inception. This example does not include accounting for impairment.

7I.7.1000.30 At 31 December 2021, the fair value of the swap is minus 184 and
the hedge adjustment is 184. The net interest settlement on the swap for 2021 is nil.
X records the following entries.

DEBIT CREDIT

1 January 2021

Financial asset 10,000

Cash 10,000

To recognise financial asset

31 December 2021

Cash 700

Interest income (profit or loss) 700

To recognise interest income on financial asset

Financial asset – hedge adjustment 184

Hedge revaluation gain (profit or loss) 184

To recognise change in fair value of financial

asset as a result of hedged risk

Derivative revaluation loss (profit or loss) 184

Hedging derivatives (liability) 184

To recognise change in fair value of interest rate

swap

7I.7.1000.40 At 1 January 2022, a payment holiday is given on the financial asset

such that all interest in 2022 and half of the interest in 2023 is forgiven. The IBOR
rate is 3.5% (flat) at 1 January 2022.

Scenario 1

7I.7.1000.50 The following facts are relevant for Scenario 1.

• The payment holiday is not a substantial modification.
• The hedging relationship is not determined to be discontinued.
• Amortisation of the hedge adjustment has not started yet.
• X is applying IFRS 9 but has chosen to continue to apply the hedge accounting
requirements of IAS 39.

7I.7.1000.60 Because the amortisation has not started, in calculating the

modification gain or loss (see 7.7.345.10), the new gross carrying amount of the
hedged financial asset is calculated as the present value of the modified contractual
cash flows discounted at the hedged item’s original effective interest rate (i.e.
unadjusted for hedge accounting effects). The modification gain or loss will be the
difference between this new gross carrying amount and the old gross carrying
amount of the hedged item excluding any hedge adjustments. The modification gain
or loss is calculated as follows.

31 DEC 2022 31 DEC 2023 31 DEC 2024 31 DEC 2025

Modified cash
flows - 350 700 10,700

Discounted at
7% - 306 571 8,163

1 January 2022

Sum of the discounted cash flows – the new gross carrying

amount 9,040

The old gross carrying amount excluding any hedge adjustments (10,000)

Modification loss (960)

7I.7.1000.70 In addition, X needs to recalculate the cumulative hedge adjustment

based on the modified cash flows. The new cumulative hedge adjustment is
calculated as follows.

Step 1: The hedged portion of the modified cash flows discounted at the
benchmark interest rate at inception of the hedge

31 DEC 2022 31 DEC 2023 31 DEC 2024 31 DEC 2025

Modified
hedged cash
flows - 200 400 10,400

Discounted at
4% - 185 355 8,890

1 January 2022

Sum of the discounted cash flows 9,430

Step 2: The hedged portion of the modified cash flows discounted at the
current benchmark interest rate
 31 DEC 2022 31 DEC 2023 31 DEC 2024 31 DEC 2025

Modified
hedged cash
flows - 200 400 10,400

Discounted at
3.5% - 187 360 9,063

1 January
2022

Sum of the discounted cash flows 9,610

Step 3: The new hedge adjustment

The new hedge adjustment is the difference between the amounts determined under
Step 1 and Step 2 – i.e. 180, calculated as 9,610 - 9,430.

7I.7.1000.80 At 1 January 2022, X records the following entries.

DEBIT CREDIT

1 January 2022

Modification loss (profit or loss) 960

Financial asset 960

To recognise modification loss on financial asset

as a result of payment holiday

Hedge revaluation loss (profit or loss) 4(1)

Financial asset – hedge adjustment 4(1)

To recognise change in hedge adjustment of

financial asset

Note
1. The change in the hedge adjustment is calculated as 184 - 180.

Scenario 2

7I.7.1000.90 Modifying Scenario 1, amortisation of the hedge adjustment has

started.

7I.7.1000.100 Because the amortisation has started, the new gross carrying
amount of the hedged financial asset is calculated as the present value of the
modified contractual cash flows discounted at the revised effective interest rate (i.e.
adjusted for hedge accounting effects). The modification gain or loss will be the
difference between this new gross carrying amount and the old gross carrying
amount of the hedged item including any hedge adjustments. The revised effective
interest rate and the modification gain or loss are calculated as follows.
Step 1: The revised effective interest rate

7I.7.1000.110 The revised effective interest rate is the rate that exactly discounts
the present value of the remaining cash flows of the financial asset (before
considering the payment holiday) to 10,184 – i.e. the carrying amount of 10,000 plus
the hedge adjustment of 184. The revised effective interest rate is calculated as
6.46%.

Step 2: The modification gain or loss

31 DEC 2022 31 DEC 2023 31 DEC 2024 31 DEC 2025

Modified
hedged cash
flows - 350 700 10,700

Discounted at
6.46% - 309 580 8,330

1 January
2022

Sum of the discounted cash flows – the new gross carrying

amount 9,219

The old gross carrying amount including any hedge adjustments (10,184)

Modification loss (965)

7I.7.1000.120 X does not need to recalculate the cumulative hedge adjustment

because it is incorporated into the calculation of the new gross carrying amount and
modification gain or loss. At 1 January 2022, X records the following entries.

DEBIT CREDIT

1 January 2022

Modification loss (profit or loss) 965

Financial asset 965

To recognise modification loss on financial asset

as a result of payment holiday

Scenario 3

7I.7.1000.130 Modifying Scenario 1, the payment holiday is a substantial

modification and the hedging relationship is determined to be discontinued.

7I.7.1000.140 Because the payment holiday is a substantial modification, X needs

 to derecognise the old financial asset – i.e. hedged item – and recognise the modified
instrument as a new financial asset at fair value. The market interest rate for the
new financial asset is 6.8%. The derecognition gain or loss, ignoring any
impairment, will be the difference between the fair value of the new financial asset
and the old gross carrying amount of the hedged item including any hedge
adjustments. The derecognition gain or loss is calculated as follows.

31 DEC 2022 31 DEC 2023 31 DEC 2024 31 DEC 2025

Modified
hedged cash
flows - 350 700 10,700

Discounted at
6.80% - 307 575 8,224

1 January 2022

Sum of the discounted cash flows – the fair value of new financial
asset 9,106

The old gross carrying amount including any hedge adjustments (10,184)

Derecognition loss (1,078)

7I.7.1000.150 At 1 January 2022, X records the following entries.

DEBIT CREDIT

1 January 2022

Financial asset (new) 9,106

Derecognition loss (profit or loss) 1,078

Financial asset (old) 10,000

Financial asset (old) – hedge adjustment 184

To recognise new financial asset and

derecognise old financial asset as a result of
payment holiday

7I.7.1010 FUTURE DEVELOPMENTS

7I.7.1010.10 Although IAS 39 and IFRS 9 provide models for macro hedge accounting, these
contain restrictions that limit entities’ ability to reflect some common dynamic risk management
(DRM) activities; moreover, some of these models deal specifically with interest rate risk
management rather than other types of risk. Without an accounting model that reflects the broader
use of DRM activities, some have raised concerns that it can be difficult to faithfully represent these
activities in financial statements.

7I.7.1010.20 In response to these issues, in April 2014 the International Accounting Standards
Board (the Board) published Discussion Paper Accounting for Dynamic Risk Management – a
Portfolio Revaluation Approach to Macro Hedging as the first due process document for the project.
Because the project involves fundamental accounting questions and is not simply a modification to
current hedge accounting models, the Board did not proceed straight to issuing an exposure draft.

7I.7.1010.30 Based on the feedback received from respondents on the discussion paper, the
Board tentatively decided to:
• first consider how the information needs of constituents concerning dynamic risk management
activities could be addressed through disclosures before considering those areas that need to be
addressed through recognition and measurement;
• prioritise the consideration of interest rate risk and consider other risks at a later stage in the
project; and
• establish an Expert Advisory Panel at a later stage in the project. [IASBU 05-15]
7I.7.1010.40 In November 2017, the Board tentatively decided to develop a new hedge
accounting model based on cash flow hedge mechanics. The project plan consists of two phases. The
first phase focuses on developing a core model for the most important issues that are central to the
dynamic risk management model. Non-core issues represent an extension of the core model. These
issues will be addressed as a final step in the second phase before finalising the dynamic risk
management project.

7I.7.1010.50 The Board gathered stakeholders’ views over 2020 on the core model and is
considering the challenges identified during outreach before determining the future direction of the
project in the first half of 2022.
27 OCT 2022 PAGE 2993

Insights into IFRS 18th Edition 2021/22

7I. Financial instruments: IAS 39
7I.8 Presentation and disclosures

7I.8 Presentation and disclosures

7I.8.10 Overview 2996

7I.8.20 Scope 2996
7I.8.30 Presentation: General considerations 2996
7I.8.40 Statement of financial position 2996
7I.8.45 Trade payables and reverse factoring 2997
7I.8.50 Classes vs categories of financial
instruments 2998
7I.8.60 Current vs non-current classification of
financial instruments 2999
7I.8.65 Statement of profit or loss and OCI 3000
7I.8.70 Profit or loss 3000
7I.8.80 Finance income and finance costs 3001
7I.8.85 Other comprehensive income 3002
7I.8.90 Offsetting 3002
7I.8.91 Multiple financial instruments 3003
7I.8.92 Unit of account 3005
7I.8.93 Current legally enforceable right to set
off 3006
7I.8.95 Intention to settle on net basis or realise
asset and settle liability simultaneously 3008
7I.8.97 Applying the offsetting requirements 3011
7I.8.100 Significance of financial instruments for financial position and
performance 3013
7I.8.110 Statement of financial position 3013
7I.8.120 Carrying amount 3013
7I.8.130 Financial assets or financial liabilities
designated as at FVTPL 3014
7I.8.140 Reclassification 3014
7I.8.145 Derecognition 3015
7I.8.150 Offsetting disclosures 3015
7I.8.160 Collateral 3018
7I.8.170 Allowance account for credit losses 3018
7I.8.180 Compound financial instruments with
multiple embedded derivatives 3019
7I.8.190 Defaults and breaches 3019
7I.8.200 Embedded derivatives 3019
7I.8.205 Reverse factoring arrangements 3019
7I.8.210 Statement of profit or loss and OCI 3020
 7I.8.220
Items of income, expense, gains or
losses 3020
7I.8.225 Split presentation of gains and losses on
derivatives 3020
7I.8.230 Fee income and expense 3021
7I.8.240 Interest income 3021
7I.8.250 Other disclosures 3022
7I.8.260 Accounting policies 3022
7I.8.270 Hedge accounting 3022
7I.8.277 Interest rate benchmark reform 3023
7I.8.280 Fair value 3024
7I.8.290 Day one gain or loss 3025
7I.8.300 Nature and extent of risks arising from financial instruments 3025
7I.8.310 Qualitative disclosures 3026
7I.8.320 Quantitative disclosures 3026
7I.8.330 Concentrations of risk 3027
7I.8.340 Credit risk 3027
7I.8.370 Liquidity risk 3030
7I.8.380 Market risk 3032
7I.8.390 Other market risk disclosures 3033
7I.8.395 Application by investment entities 3033
7I.8.400 Transfers of financial assets 3035
7I.8.410 Disclosures for transfers of financial assets 3035
7I.8.415 Scope of disclosure requirements on transfers of
financial assets 3036
7I.8.420 Definition of a ‘transfer’ 3037
7I.8.430 Identifying contractual obligation to pay
cash flows of asset 3037
7I.8.440 Continuing involvement 3038
7I.8.450 Interactions between derecognition requirements
in IAS 39 and disclosure requirements in IFRS 7 3039
7I.8.460 Transferred financial asset 3040

7I.8 Presentation and disclosures

REQUIREMENTS FOR INSURERS THAT APPLY IFRS 4

In July 2014, the International Accounting Standards Board issued IFRS 9 Financial Instruments,
which is effective for annual periods beginning on or after 1 January 2018. However, an insurer may
defer the application of IFRS 9 if it meets certain criteria (see 8.1.180).

This chapter reflects the requirement of IAS 39 Financial Instruments: Recognition and
Measurement and the related standards, excluding any amendments introduced by IFRS 9. These
requirements are relevant to insurers that apply the temporary exemption from IFRS 9 or the overlay
approach to designated financial assets (see 8.1.160) and prepare financial statements for periods
beginning on 1 January 2021. For further discussion, see Introduction to Sections 7 and 7I.

The requirements related to this topic are mainly derived from the following.
 STANDARD TITLE

IFRS 7 Financial Instruments: Disclosures

IFRS 13 Fair Value Measurement

IAS 1 Presentation of Financial Statements

IAS 32 Financial Instruments: Presentation

The currently effective requirements include newly effective requirements arising from Interest Rate
Benchmark Reform Phase 2 – Amendments to IFRS 9, IAS 39, IFRS 7, IFRS 4 and IFRS 16, which are
effective for annual periods beginning on or after 1 January 2021. The impact of the amendments is
discussed in the following sections:
• modifications of financial assets and financial liabilities: 7I.5.500, 7I.6.335 and 8.1.170.35;
• hedge accounting: 7I.7.877;
• disclosures about the nature and extent of risks arising from interest rate benchmark reform and
progress in completing the transition to alternative benchmarks: 7I.8.277;
• transition requirements: 7I.7.882; and
• leases: 5.1.370.30.

FORTHCOMING REQUIREMENTS AND FUTURE DEVELOPMENTS

For this topic, there are no forthcoming requirements or future developments.

7I.8.10 OVERVIEW

7I.8.10.10 IFRS 7 sets out the disclosure requirements for all financial instruments. The
objective of the disclosures is to enhance financial statement users’ understanding of:
• the significance of financial instruments to an entity’s overall financial position and performance;
• the risk exposures resulting from such financial instruments; and
• how the entity manages those risks. [IFRS 7.1]

7I.8.20 SCOPE

7I.8.20.10 IFRS 7 applies to all entities and to all types of recognised and unrecognised financial
instruments – e.g. loan commitments. The standard also applies to contracts to buy or sell a non-
financial item that are in the scope of IAS 39 (see 7I.1.150). For financial instruments that are
excluded from IFRS 7, see 7I.1.30. [IFRS 7.3–5]

7I.8.20.20 As can be seen from the table in 7I.1.30, interests in subsidiaries, associates and joint
ventures accounted for in accordance with IFRS 10, IAS 27 or IAS 28 are excluded from the
disclosure requirements in IFRS 7. However, when such interests are accounted for in accordance
with IAS 39 (see 7I.1.110), they are subject to the disclosure requirements of IFRS 7, and those in
IAS 27 and IFRS 12. [IFRS 7.3(a)]

7I.8.20.30 Also, as can be seen from the table in 7I.1.30, insurance contracts as defined in IFRS
4 are excluded from the scope of IFRS 7 (see 7I.1.40). However, certain derivatives embedded in
those contracts, and financial guarantee contracts to which IAS 39 is applied (see 7I.1.50), are
subject to the disclosure requirements of IFRS 7. [IFRS 7.3(d)]

7I.8.30 PRESENTATION: GENERAL CONSIDERATIONS

7I.8.40 Statement of financial position

7I.8.40.10 As a minimum, financial assets are presented in the statement of financial position,
with separate presentation of cash and cash equivalents, trade and other receivables, and
investments accounted for under the equity method (see chapter 3.5). Financial liabilities are
presented in the statement of financial position, with separate presentation of trade and other
payables. Additional line items may be presented. [IAS 1.54, 55]

7I.8.40.20 Using different measurement bases for different classes of assets suggests that their
nature or function differs; therefore, instruments that are measured at cost or amortised cost, and
those that are measured at fair value, are generally presented as separate line items. However, in
our view in certain cases instruments with different measurement bases may be included in the same
line item – e.g. a host financial instrument that is carried at amortised cost and a separable
embedded derivative (see 7I.2.110), or an instrument carried at amortised cost that is the hedged
item in a fair value hedge and other similar instruments that are not hedged. In these cases, the
notes to the financial statements should disclose the carrying amount of each category of financial
instruments that are combined in a single line item in the statement of financial position. [IFRS 7.8, IAS
1.59]

7I.8.45 Trade payables and reverse factoring

7I.8.45.10 Amounts owed to a supplier of goods or services are generally presented as trade
payables – i.e. liabilities to pay for goods or services that have been received and have been invoiced
or formally agreed with the supplier. [IAS 1.54(k), 37.11(a)]

7I.8.45.20 In a traditional factoring arrangement, a supplier of goods or services obtains cash

from a bank or other financial institution (i.e. the factor) against receivables due from its customers.
The arrangement might take different legal forms – e.g. the receivables might be sold outright to the
factor or pledged as security for a loan from the factor and the factor may or may not have recourse
to the supplier in the event that the customer does not settle. A traditional factoring arrangement is
initiated by the supplier and the factor, rather than the customer. In some cases, the customer might
be unaware of the arrangement. In our experience, in such an arrangement, the customer generally
continues to classify the amounts payable as trade payables, even if it is aware of the factoring
arrangement.

7I.8.45.30 In contrast, reverse factoring is initiated by the customer and the factor. The terms of
reverse factoring arrangements vary but are usually three-party agreements involving the customer,
the factor and the supplier. Under a reverse factoring arrangement, the factor agrees to pay amounts
to the supplier in respect of invoices owed by the customer, receiving settlement from that customer
usually at a later date.

7I.8.45.40 A reverse factoring arrangement may provide liquidity to the customer if it allows
deferral of payment to the factor beyond the original maturity of the supplier’s invoice or if the
arrangement enables the customer to negotiate extended payment terms with its supplier.
Depending on the terms of the arrangement, and similar to traditional factoring, the reverse
factoring arrangement may also provide to the supplier:
• liquidity by enabling it to receive cash before the invoice due date; and
• access to funding at a lower interest rate based on the customer’s credit rating.
7I.8.45.50 Similarly, the reverse factoring arrangement may allow the customer to take
advantage of an early payment discount offered by the supplier. The reverse factoring arrangement
may also allow the supplier and the customer to make administrative savings through more
streamlined collection and payment procedures.

7I.8.45.60 In some cases, a reverse factoring arrangement may result in the derecognition of the
original trade payable and the recognition of a new financial liability (see 7I.5.370); in other cases,
there will be no derecognition of the original trade payable to which the reverse factoring
arrangement applies (see 7I.5.425).
7I.8.45.70 In our view, regardless of whether the original trade payable is derecognised, an
entity should consider the appropriate presentation of amounts related to reverse factoring
arrangements in the statement of financial position (see 3.1.10.30), including whether the headings
and line items should be adapted to suit the particular circumstances – for example:
• reclassifying amounts to a different line – e.g. within ‘other financial liabilities’; or
• presenting an additional line item – e.g. supplier factoring facility – on the face of the statement of
financial position. [IAS 1.29–30, 55]

7I.8.45.75 The IFRS Interpretations Committee discussed the presentation of liabilities that are
part of reverse factoring arrangements in the statement of financial position. The Committee noted
that applying IAS 1 an entity presents liabilities that are part of a reverse factoring arrangement as
follows:
• as part of ‘trade and other payables’ only when those liabilities have a similar nature and function
to trade payables – e.g. when those liabilities are part of the working capital used in the entity’s
normal operating cycle; and
• separately when the size, nature or function of those liabilities makes separate presentation
relevant to an understanding of the entity’s financial position. In assessing whether it is required
to present such liabilities separately (including whether to disaggregate trade and other
payables), an entity considers the amounts, nature and timing of those liabilities. [IAS 1.55, 58, 70,
37.11(a), IU 12-20]

7I.8.45.80 An entity needs to apply judgement in determining whether the reverse factoring
arrangement indicates that it is appropriate to present the amounts due separately on the face of the
statement of financial position or to disaggregate those amounts in the notes. We believe that the
following are examples of features that may indicate that the nature or function of the amounts due
is sufficiently different from a trade payable and therefore separate presentation may be
appropriate:
• the principal business purpose of the reverse factoring arrangement is to provide funding to the
customer, rather than to provide funding to the supplier or to facilitate efficient payment
processing;
• the factor is a bank or similar financial institution; and
• the arrangement:
– significantly extends payment terms beyond the normal terms agreed with other suppliers;
– adds a requirement for the customer to pay interest or to pay interest at a higher rate;
– requires additional collateral or a guarantee; or
– changes the terms defining default and cancellation.
7I.8.45.90 None of the features in 7I.8.45.80 is necessarily a determinative indicator on its own.
We believe that an entity should weigh those features to determine whether separate presentation,
on the face of the statement of financial position or in the notes, is appropriate. [IU 12-20]

7I.8.45.100 For a further discussion of reverse factoring, see 2.3.75, 7I.5.425, 7I.8.205 and 375.

7I.8.50 Classes vs categories of financial instruments

7I.8.50.10 Some of the IFRS 7 disclosure requirements mandate disclosure by category of
financial instruments, whereas others are by class of financial instruments. ‘Categories of financial
instruments’ are:
• financial assets or financial liabilities at FVTPL;
• held-to-maturity investments;
• loans and receivables;
• available-for-sale financial assets; and
• other liabilities (see 7I.4.10.10–15). [IFRS 7.8, IAS 39.9]
7I.8.50.20 There is no specific guidance on what comprises a class except that financial
instruments are grouped into classes that:
• are appropriate to the nature of the disclosure; and
• take into account the characteristics of those financial instruments. [IFRS 7.6, B1]
7I.8.50.30 Examples of classes of financial instruments include cash and cash equivalents,
unsecured bank facilities and convertible notes (liability). In determining classes, the entity, as a
minimum:
• distinguishes instruments measured at amortised cost from those measured at fair value; and
• treats financial instruments outside the scope of IFRS 7 as a separate class or classes. [IFRS 7.6, B2]
7I.8.50.40 In deciding how much detail to include and how to aggregate the information, an
entity has to strike a balance between too much and too little detail. It also needs to ensure that the
information is sufficient to allow a reconciliation to the line items presented in the statement of
financial position. [IFRS 7.6, B3]

7I.8.50.50 In our view, derivative assets and liabilities should be presented in separate line items
in the statement of financial position if they are significant. If derivative instruments are not
significant, then they may be included in other financial assets and other financial liabilities,
respectively. Additional details should be disclosed in the notes to the financial statements.

7I.8.60 Current vs non-current classification of financial instruments

7I.8.60.10 If an entity makes a distinction between current and non-current assets and liabilities
in the statement of financial position (classified statement of financial position – see 3.1.10.10), then
instruments within the financial instrument classes are classified as current or non-current in
accordance with their expected recovery (financial assets) or contractual settlement date (financial
liabilities). [IAS 1.60]

7I.8.60.20 In particular, an asset is classified as current when it:

• is expected to be realised in or is held for sale in the entity’s normal operating cycle;
• is held primarily for trading purposes;
• is expected to be realised within 12 months of the reporting date; or
• is cash or a cash equivalent that is not restricted from being exchanged or used to settle a liability
for at least 12 months after the reporting date (see 2.3.10). [IAS 1.66, 68]

7I.8.60.30 A liability is classified as current when it:

• is expected to be settled in the entity’s normal operating cycle;
• is held primarily for trading purposes;
• is due to be settled within 12 months of the reporting date; or
• is not subject to an unconditional right of the entity at the reporting date to defer settlement of
the liability for at least 12 months after the reporting date. [IAS 1.69]

7I.8.60.35 However, a liability is not classified as current only because the counterparty has an
option to require settlement within 12 months in equity instruments issued by the entity. [IAS 1.69]

7I.8.60.40 Derivatives not held primarily for trading purposes are classified as current or non-
current based on their outstanding maturities. For example, derivatives with maturities exceeding
12 months that the entity intends to hold for more than 12 months from the reporting date are
classified as non-current assets or liabilities. [IAS 1.BC38J]

7I.8.60.50 In addition to derivatives (see 3.1.30.45 and 7I.8.60.40), the FVTPL category also
includes:
• assets and liabilities held primarily for the purpose of being traded – e.g. certain financial assets
classified as held-for-trading – which are classified as current; and
• assets and liabilities of longer duration – e.g. those that were designated on initial recognition into
this category.

7I.8.60.60 In our view, such assets and liabilities of longer duration should be presented as non-
current to the extent that they are not expected to be realised, or are not due to be settled, within 12
months of the reporting date or within the entity’s normal operating cycle. In our view, this also
applies to available-for-sale financial assets. [IAS 1.68]

7I.8.65 Statement of profit or loss and OCI

7I.8.70 Profit or loss

7I.8.70.10 Other than as set out below, there is currently no specific guidance on presenting
gains and losses on financial instruments in profit or loss (see also 4.1.130). In our view, gains and
losses on financial instruments should be reported in the most appropriate line item according to
their nature. [IAS 1.86, 39.56]

7I.8.70.20 For example, an entity may present foreign currency gains and losses on financial
assets and financial liabilities that arise from operating activities – e.g. payables arising on the
purchase of goods – as part of income and expenses before finance costs, and foreign currency gains
and losses related to financing activities as part of finance income and finance costs (see 2.7.160.20
and 7I.8.80). [IAS 21.28, 39.55–56, AG83]

7I.8.70.30 There is also no specific guidance on the presentation of gains and losses on
derivatives (see 7I.8.225.10). However, if an entity elects to disclose the results of operating
activities (or a similar line item), then it presents foreign exchange gains and losses and gains and
losses on derivatives that it normally regards as being of an operating nature as part of operating
activities. See also 2.7.160.20, 4.1.120.10–30, 7I.8.70.50–60 and 80.20. [IAS 1.BC56, 21.52]

7I.8.70.40 For financial assets and financial liabilities at FVTPL, there is no need to distinguish
between the fair value changes and interest and dividend income or expense (see 7I.8.220.20). The
net fair value changes – i.e. gains and losses – on each financial asset or financial liability are usually
classified as finance income or finance costs (see 7I.8.80). However, fair value changes (net gains or
net losses) on these instruments are presented separately, if they are material. [IAS 1.35, 97]

7I.8.70.50 For non-derivatives measured at FVTPL, an entity may present either:

• foreign exchange gains and losses and/or interest income and expense separately from other fair
value changes; or
• the entire fair value change on a net basis as a single amount.

7I.8.70.60 Whichever method is adopted, if an entity elects to disclose the results of operating
activities (or a similar line item) in profit or loss, then it presents any amounts that it normally
regards as being of an operating nature as part of operating activities. In addition, if interest on non-
derivative instruments measured at FVTPL is presented separately, then it is measured using the
effective interest method or a similar basis, excluding transaction costs, and presented as interest
income or expense. Because transaction costs directly attributable to the acquisition of a financial
instrument classified as at FVTPL are not included in its initial measurement, but are instead
expensed as they are incurred, they are not included in calculating an effective interest rate for the
instrument (see 7I.6.30.10 and 70). See also 4.1.120.10–30, 7I.8.70.30 and 80.20. [IFRS 7.BC34, IAS
1.BC56, 39.43A]

7I.8.70.70 If hedge accounting is not applied to a derivative instrument that is entered into as an
economic hedge, then in our view derivative gains and losses may be shown in profit or loss as either
operating or financing items, depending on the nature of the item being economically hedged.

7I.8.80 Finance income and finance costs

7I.8.80.10 A separate line item is required in profit or loss for finance costs. There is no
requirement to present a separate ‘finance income’ line item in profit or loss unless such
presentation is relevant to an understanding of the entity’s financial performance. Significant
categories of revenue, including interest and dividends, are disclosed in the financial statements.
[IAS 1.82(b), 85, 97]

7I.8.80.20 There is no guidance in the Standards on what should be included in finance income
and finance costs. Non-financial sector entities usually include the following items in finance income
and finance costs:
• interest income and expense (see 7I.6.230);
• dividend income;
• foreign exchange gains and losses arising from investing and financing activities – e.g. exchange
gains and losses on financial investments or exchange gains and losses on foreign currency
borrowings (see 2.7.160.20);
• gains and losses on derivatives related to investing and financing activities – e.g. gains and losses
on interest rate swaps, or gains and losses on foreign currency forward contracts that hedge
foreign currency borrowings (see 7I.7.50);
• gains and losses on the derecognition of financial investments (see 4.1.130);
• gains and losses on trading activities involving financial instruments;
• gains and losses on financial instruments designated as at FVTPL;
• impairment losses and reversals of impairment losses on financial investments;
• the unwinding of discounts on non-financial assets and non-financial liabilities; and
• gains and losses on the derecognition of financial liabilities (see 7I.5.370.50 and 410.30).
7I.8.80.25 The IFRS Interpretations Committee discussed the accounting implications of the
economic phenomenon of negative effective interest rates on the presentation of income and
expenses in profit or loss. The Committee noted that interest resulting from a negative effective
interest rate on a financial asset reflects a gross outflow (instead of a gross inflow) of economic
benefits; consequently, it did not meet the definition of interest revenue under the Standards at that
time and should not be presented as such. Instead, it noted that negative interest arising from
financial assets should be presented in an appropriate expense classification, accompanied by
additional information as required by IAS 1. IAS 39 does not define revenue or income. However,
income continues to be defined in the Conceptual Framework and IFRS 15, and negative interest
arising from financial assets does not meet those definitions because it represents a decrease
(instead of an increase) in assets that results in a decrease in equity. [IU 01-15, IFRS 15.A, IAS 1.85, 112(c),
CF 4.68–69]

7I.8.80.27 Based on a rationale similar to that in 7I.8.80.25, it appears that an entity should
present interest resulting from a negative effective interest rate on financial liabilities as interest
income because it leads to a gross inflow of economic benefits.

7I.8.80.30 Interest income and expense includes interest that is recognised in respect of an
asset or liability that is measured at a discounted amount – for example:
• the interest expense that arises on a provision that is initially measured at a discounted amount
(see 3.12.120);
• the interest on a contract asset or a contract liability recognised for a contract with a customer
that contains a significant financing component (see 4.2.130); or
• the interest that is imputed on the cost of inventories when payment for the inventories is
deferred beyond normal credit terms (see 3.8.150).

7I.8.80.40 Dividend income is presented as a separate line item in profit or loss when such
presentation is relevant to an understanding of the entity’s financial performance. [IAS 1.85]

7I.8.80.50 In our view, finance income and finance costs should not be presented on a net basis
(e.g. as ‘net finance costs’) in profit or loss without presenting an analysis of finance income and
finance costs. However, this does not preclude presentation of finance income immediately followed
by finance costs and a subtotal – e.g. ‘net finance costs’ – in profit or loss. [IAS 1.32, 82, 85–85B]

7I.8.80.60 In our view, expenses related to shares that are classified as a liability – e.g. dividends
on redeemable preference shares – may be included with interest on other liabilities or presented
separately within finance costs.
7I.8.80.70 The profit or loss of banks and similar financial institutions comprises mainly finance
income and finance costs. The presentation and disclosure for financial institutions is illustrated in
KPMG’s Guides to financial statements series.

7I.8.80.80 For further discussion of specific presentation issues arising from the application of
IFRS 7, see 7I.8.210.

7I.8.85 Other comprehensive income

7I.8.85.10 Each component of OCI classified by nature is presented as a separate line item in the
statement of profit or loss and OCI. This includes:
• the net change in fair value on available-for-sale financial assets;
• the effective portion of the net gain or loss on hedges of net investments in foreign operations;
and
• the effective portion of changes in fair value in respect of hedging instruments in cash flow
hedges. [IAS 1.82A(a)]

7I.8.85.20 Separate components of OCI are created in accordance with the requirements of IAS
39, which also determine how and when amounts previously recognised in these components are
reclassified to profit or loss. Reclassification adjustments are included with the related component of
OCI in the period during which the adjustment is reclassified to profit or loss. They may be presented
in the statement of profit or loss and OCI or in the notes to the financial statements. At any point in
time, the cumulative amounts previously recognised in these separate components of OCI represent
a cumulative gain or loss that will be reclassified to profit or loss at some future date. In our view, it
would not be appropriate for an entity to reduce or increase components of OCI for any reasons
other than those allowed under IAS 39 – except for related tax effects under IAS 12 (see 3.13.570).
[IAS 1.91–94]

7I.8.90 Offsetting

7I.8.90.10 Financial assets and financial liabilities are offset and a net amount is presented in
the statement of financial position only if both of the following conditions are met:
• the entity currently has a legally enforceable right to set off the recognised amounts – i.e. a legal
right to settle or eliminate all or a portion of an amount due to a creditor by applying against that
amount an amount due from the creditor; and
• the entity has the intention to:
– settle on a net basis; or
– realise the asset and settle the liability simultaneously. [IAS 32.42, 45]
7I.8.90.20 For a discussion of how to present the related income or expense when a financial
asset and financial liability are offset, see 4.1.200.20.

7I.8.91 Multiple financial instruments

7I.8.91.10 The offsetting criteria relate only to determining whether two or more separate
financial instruments should be offset and presented net in the statement of financial position. They
are not relevant in determining how a single financial instrument should be measured and
presented. For example, an interest rate swap comprises an obligation to pay and receive interest
cash flows over time – i.e. payments and receipts might be made on a gross basis at different points
in time or, even if each individual periodic cash flow is determined as a single net payment or receipt
for that period, it might be expected that net amounts will be received in some periods and net
amounts paid in other periods. However, the swap is a single derivative financial instrument that is
measured at its fair value, which reflects the net value of the expected cash inflows and outflows
even though those cash inflows and outflows will not be settled on a net basis.

EXAMPLE 1A – CASH POOLING ARRANGEMENT – MULTIPLE GROUP ENTITIES

 7I.8.91.20 For cash management purposes, Company B and its subsidiaries
enter into a cash pooling arrangement, whereby debit and credit balances in the
same currency with Bank C are pooled to optimise the interest earned and paid on
the aggregated balance.

7I.8.91.30 Before considering the offsetting requirements in IAS 32, B needs to

assess whether the arrangement between the B group and C involves either:
• a single financial instrument; or
• multiple financial instruments.
7I.8.91.40 If this cash pooling arrangement results in a single omnibus account
that B holds with C, and the aggregate balance represents a single amount payable
or receivable between B and C, then any accumulated ‘memorandum balances’ on
constituent ‘sub-accounts’ that record transactions initiated by subsidiaries of B do
not represent amounts payable or receivable between those subsidiaries and C, but
rather reflect intra-group amounts payable or receivable between those subsidiaries
and B. In this case, B presents the aggregated balance on the single omnibus
account as a financial asset or financial liability in its consolidated statement of
financial position. Therefore, the offsetting requirements are irrelevant.

7I.8.91.50 Alternatively, assume that B and each of its subsidiaries have

accounts with C in their own names and the balance on each of these accounts
represents an amount payable or receivable between that individual member of the
B group and C. In that case, for the purposes of B’s consolidated financial
statements, each account is a separate financial asset or financial liability and B
should consider the offsetting criteria to determine whether they should be
presented separately or offset.

7I.8.91.60 Judgement may be required in determining whether an arrangement involves a single

or multiple financial instruments. Generally, rights and obligations arising under different contracts
give rise to separate financial instruments. Furthermore, a single legal contract may give rise to
more than one financial instrument, such as separate derivatives, loans and deposits or trade
receivables and payables. However, in some cases, it may be necessary to aggregate different
financial instruments and account for them as a single combined financial instrument (see
7I.5.40.10). To determine whether multiple balances or transactions arising from a single legal
contract between two entities represent a single or multiple financial instruments, an entity may
consider whether:
• each transaction results in separate performance rights and obligations that may be transferred
or settled separately;
• transactions are intended to be performed concurrently or consecutively with other transactions;
• transactions relate to the same risks or may be exposed to different risks;
• the pricing of individual transactions is independent; and
• transactions are negotiated as separate trades and/or have different commercial objectives.
EXAMPLE 1B – DERIVATIVE MASTER AGREEMENT

7I.8.91.70 Company X enters into a derivative master agreement with Bank B.

The agreement states that:
• the parties may agree in the future to enter into a variety of swap, forward,
option or other derivative transactions and to terminate such transactions;
• the terms of each transaction or termination, including pricing, will be subject to
negotiation based on market conditions at the time;
• any such transactions will form part of the master agreement, which constitutes
 the only contract at law between the parties;
• collateral is paid or received in accordance with the detailed terms of a credit
support annex;
• either party may demand net settlement of amounts due and payable on the same
day in the same currency; and
• in the event of either party’s default, the other party may demand that all
outstanding transactions are terminated at their market values and that a single
net settlement of all such amounts is made.

7I.8.91.80 Based on the factors in 7I.8.91.70, X concludes that each derivative

transaction entered into under the master agreement represents a separate
financial asset or financial liability.

EXAMPLE 1C – CASH POOLING ARRANGEMENT – MULTIPLE-CURRENCY FACILITY

7I.8.91.90 Company T enters into a cash pooling agreement with Bank X. Under
the terms of the agreement, all of which are contained in a single document, T has
several current accounts in different currencies with the following conditions.
• All accounts are held by T at X in Country Y.
• T is generally free to make drawings from and deposits into each account, and
the individual accounts can be in a positive or negative position subject to an

overall credit limit on T’s net drawn balances. T could not withdraw the positive
balance on one of the accounts, unless the net balance on all accounts following
withdrawal would still be within the overall credit limit.
• The credit limit is stated in a single reference currency. It is applied and
monitored by X using current market rates of exchange.
• If foreign exchange rates change and the credit limit is breached, then X may
require T to bring the aggregated balances back within the credit limit.
• Interest is calculated on each account on a gross basis at a predetermined fixed
or variable rate for the respective currency.
• The agreement has a stated maturity date that applies to all accounts and to the
credit limit. At the maturity date, unless T and X agree to extend the agreement,
all accounts are closed and the remaining balances are settled on a net basis in
the reference currency.
• In the event of default of either party, the non-defaulting party may demand that
balances on all accounts are translated into the reference currency and settled
net. The same would apply in the event of either party’s bankruptcy.
• There is no regular transfer of balances into a sweep account and there is no
intention to settle any amounts net or simultaneously, except for any balances
that remain at maturity.
• T receives quarterly statements showing the individual gross balances for each
account and a subtotal of all of those in debit/credit positions in the single
reference currency.

7I.8.91.100 The fact that the various accounts arise from a single contractual
agreement does not mean that there is a single financial instrument. Similarly,
stating a common maturity date does not necessarily mean that there is a single
financial instrument. Although there is an overall credit limit and requirements for
set off in certain circumstances, each current account is denominated in a different
currency and gives rise to performance rights and obligations in that currency.
Performance rights and obligations in relation to one currency account are different
 from those of other accounts and balances on different accounts may be individually
settled. Accordingly, T and X conclude that in this example each current account is a
separate financial instrument.

7I.8.92 Unit of account

7I.8.92.10 IAS 32 does not specify whether the unit of account when considering the offsetting
requirements in IAS 32 should be:
• entire financial assets and financial liabilities: In this case, the entity considers whether all – and
not just some – of the cash flows from one instrument satisfy the offsetting criteria with respect to
another instrument. If they all do, then the instrument is offset in its entirety; otherwise, no
offsetting is applied (Approach 1); or
• individual identifiable cash flows from financial assets and financial liabilities: In this case, an
entity considers whether each individual cash flow of a financial instrument satisfies the offsetting
criteria with respect to the cash flows of another instrument. If it does, then the portion of the
individual instrument that represents those cash flows is offset (Approach 2). [IAS 32.BC105–BC106]

7I.8.92.20 In our experience, the approach that is adopted by an entity depends on industry
practice, the entity’s operational capabilities and the complexity and volume of transactions subject
to set off. For example, energy producers and traders generally apply the offsetting criteria to
identifiable cash flows, whereas financial institutions generally apply the offsetting criteria to entire
financial assets and financial liabilities. An approach of applying to individual cash flows may lead to
more offsetting but may be more burdensome to apply. Offsetting is mandatory when the offsetting
criteria are satisfied, and therefore an entity may find it impracticable to apply an approach based on
individual cash flows. In our view, an entity should choose an accounting policy, to be applied
consistently to similar assets and liabilities, to apply either Approach 1 or 2 in 7I.8.92.10. [IAS
32.BC111]

7I.8.93 Current legally enforceable right to set off

7I.8.93.10 An entity currently has a legally enforceable right to set off if the right is:
• not contingent on a future event; and
• enforceable both in the normal course of business and in the event of default, insolvency or
bankruptcy of the entity and all of the counterparties. [IAS 32.AG38B]

EXAMPLE 2A – OFFSETTING – LEGAL ENFORCEABILITY FOR ALL COUNTERPARTIES

7I.8.93.20 Company B enters into an agreement with Company C that gives B a

right to set off.

7I.8.93.30 To determine whether its right is legally enforceable in the normal

course of business and in the event of default, insolvency or bankruptcy of the entity
and all of the counterparties, B evaluates whether it can enforce its right in the
normal course of business as well as in the case of its own default, insolvency or
bankruptcy, and in the case of C’s default, insolvency or bankruptcy.

7I.8.93.40 In doing so, B considers whether C has any rights that do or might
prevent B from enforcing its right to set off. For example, if, in the event of C’s
bankruptcy, C could insist on separate settlement of any amounts due to and from B,
then B’s right to set off would not be enforceable in those circumstances and it
would not satisfy the offsetting criteria. [IAS 32.42(a), AG38B, AG38D, BC80]

7I.8.93.50 Rights to set off may arise on the termination of a contract. In many cases, the
termination of a contract may be contingent on an event that is outside the entity’s control – e.g. the
counterparty’s default or bankruptcy. In such cases, the right to set off is clearly conditional and
could not qualify for offsetting. However, in some cases the termination of a contract may be a free
choice of the entity and is therefore within the entity’s control – e.g. the exercise of an early
repayment option in a loan. IAS 32 does not discuss whether events that are within the entity’s
control should be considered contingent on the occurrence of a future event. Therefore, it is not
clear whether such rights could be considered currently legally enforceable. However, even if a right
to set off arising on termination of a contract could be considered not to be contingent on a future
event, such a right on its own would not qualify for offsetting, unless termination would arise in the
normal course of business and the entity intends to settle net. [IAS 32.AG38B, BC82]

7I.8.93.60 To qualify for offsetting, a right to set off needs to be exercisable when the amounts
are due and payable. In addition, the passage of time and uncertainties in the amounts to be settled
are not considered contingencies. [IAS 32.BC82–BC84]

EXAMPLE 2B – OFFSETTING – AMOUNT OR TIMING OF PAYMENT UNCERTAIN

7I.8.93.70 Company B has a loan receivable of 100 from Company C that is due
and payable on 30 June 2022. B has also written a net-cash-settled put option to C.

7I.8.93.80 The following facts are also relevant for this example.
• Under the option, B is obliged to pay C the amount (if any) by which the market
price of commodity X exceeds 10 on the exercise date.
• If the market price of commodity X is below 10 on the exercise date, then no
payment is required.
• The option matures on 30 June 2022.
• The fair value of the option liability on 31 December 2020 is 30.
• The two transactions – i.e. the loan and the put option – are subject to a right to
set off that requires net settlement of amounts due and payable on the same date
in all circumstances.
• There are no collateral or margin arrangements.

Loan
100
Company B Company C
Put option
30
7I.8.93.90 Whether B is required to present the loan receivable from C and the
derivative liability owed to C net in the statement of financial position will depend on
whether the option is a European option (exercisable only on 30 June 2022) or an
American option (exercisable at any time up to 30 June 2022).

Scenario 1 – European option

7I.8.93.100 If the option written by B is a European option – i.e. exercisable only

on 30 June 2022 – then both the loan and the written option fall due for settlement
on 30 June 2022 and the right to set off ensures that settlement will be on a net
basis.

7I.8.93.110 It is uncertain whether any amount will actually be due in respect of

the option; however, if an amount does arise, then it will certainly be set off. The
 passage of time and uncertainties in the amounts to be paid do not preclude B from
currently having a legally enforceable right to set off. The fact that payments subject
to the right will arise only at a future date is not itself a contingency or condition
that precludes offsetting.

7I.8.93.120 Therefore, in this scenario B presents the loan receivable from C

and the derivative liability owed to C net in the statement of financial position.

Scenario 2 – American option

7I.8.93.130 If the option written by B is an American option – i.e. exercisable at

any time up to and including 30 June 2022 – then C could choose to exercise its
option before 30 June 2022. If C does exercise early, then B does not have the right
to set off, and the two transactions will be settled separately.

7I.8.93.140 Therefore, in this scenario B presents the loan receivable from C

and the derivative liability due to C separately in the statement of financial position.
[IAS 32.BC83–BC84]

7I.8.93.150 The following do not meet the offsetting criteria in IAS 32:
• rights to set off that can be enforced only in the normal course of business; or
• rights to set off that cannot be enforced in the event of the entity’s own default, insolvency or
bankruptcy. [IAS 32.BC81, BC92]

7I.8.93.160 An entity would typically consider the following in determining whether it has a
legally enforceable right to set off:
• the counterparties to the contract;
• the terms of the contract; and
• laws in the relevant jurisdictions, including the respective bankruptcy regimes and laws. This
would typically include the entity’s own jurisdiction, the jurisdiction of other counterparties to the
contract and the specific laws governing the contract.

EXAMPLE 2C – CASH POOLING ARRANGEMENT – CURRENT LEGALLY ENFORCEABLE RIGHT TO SET OFF

7I.8.93.170 Continuing Example 1, assume that the cash pooling arrangement

with Bank C involves separate bank accounts and borrowings in each of the group
entities’ names – i.e. there are multiple financial instruments between the B group
and C. Determining whether the reporting entity has a currently enforceable right
to set off requires consideration of the terms of the contract(s). For example, the
terms of the contract may permit each individual entity within the B group that has
more than one account with C to set off debit and credit balances on those accounts
that the individual entity has with C, but may not permit the B group or its members
to require set off between accounts held by different members of the B group with C.
C would have to perform a similar analysis for the purposes of its financial
statements. However, C would not be able to demonstrate that it has a current
legally enforceable right to set off if members of the B group are free to withdraw
funds from accounts that are in credit and C cannot require those funds instead to
be set off against accounts that are overdrawn.

7I.8.95 Intention to settle on net basis or realise asset and settle liability
simultaneously
7I.8.95.10 To meet the intention criterion (see 7I.8.90.10), an entity must intend either to:
• settle the financial asset and the financial liability on a net basis; or
• realise the financial asset and settle the financial liability simultaneously (see 7I.8.95.20). [IAS
32.42(b), AG38E]

7I.8.95.20 When assessing whether there is an intention to settle net, an entity considers normal
business practices, the requirements of the financial markets and other circumstances that may limit
its ability to settle net. [IAS 32.47]

EXAMPLE 3 – CASH POOLING ARRANGEMENT – INTENTION TO SETTLE NET

7I.8.95.30 Continuing Examples 1 and 2C, assume that the B group determines
that:
• there are multiple financial instruments involved in the arrangement; and
• there is a current legally enforceable right to set off debit and credit balances
held by group members with Bank C.

7I.8.95.40 To determine whether it has the intention to settle net, B considers

the nature of the set off arrangement.

7I.8.95.50 There are two main types of cash management schemes involving
multiple financial instruments:
• zero balancing/cash sweep: Balances on the separate accounts falling under the
arrangement are set off and physically transferred to a single account on a
regular basis; and
• notional pooling: Balances on the separate accounts falling under the
arrangement are not physically transferred and the bank calculates the synthetic
(net) balance on a number of designated accounts with interest being earned and
paid on the net amount.

7I.8.95.60 If the balances on the accounts are physically transferred into a

single account, then B needs to assess the frequency of set off to determine whether
the intention criterion is met. If the cash balances are physically moved into a single
netting account on a daily basis, then this would mean that at the end of each day
(including the reporting date) the amounts in the bank accounts involved in the cash
management arrangement will be physically settled and aggregated in one bank
account. Other than the single balance in the main account, all other bank balances
will be zero, making the IAS 32 balance sheet offsetting considerations irrelevant
(i.e. the position at the end of each day will approximate that described under
Approach 1 in 7I.8.92.10 because there will be only one account between the B
group and C with a non-zero balance).

7I.8.95.70 However, if the sweep does not take place on a daily basis, then B
assesses whether the frequency of sweeping supports the intention to settle net
requirement in paragraph 42(b) of IAS 32. This requires an evaluation of whether
balances outstanding at the reporting date will be settled through netting at the
next sweep date (or by net settlement before then – e.g. if B intends its group
members

to make transfers from accounts that are in credit to those that are overdrawn) or
whether they will be settled through normal day-to-day business before the next
sweep.

7I.8.95.80 In the case in 7I.8.95.70, if C has a current legally enforceable right

 to set off, then it will have to make a similar analysis. However, it will usually be
difficult for C to demonstrate that it intends to settle net in the normal course of
business because entities in the B group may choose to withdraw funds from
accounts that are in credit or may pay down overdrawn balances using funds
obtained from other sources.

7I.8.95.90 If the balances on the accounts are not physically transferred into a
single account or otherwise intended to be settled on a net basis, then an entity
would fail the intention to settle net requirement, because the arrangement does
not result in the balances being settled net. Consequently, net balance sheet
presentation would not be allowed.

7I.8.95.100 The IFRS Interpretations Committee discussed a scenario that is similar to that in
7I.8.95.70 and noted that a group needs to assess whether, at the reporting date, there is an
intention to settle its subsidiaries’ bank account balances on a net basis or whether the intention is
for its subsidiaries to use those individual bank account balances for other purposes before the next
net settlement date.

7I.8.95.110 The Committee observed that in the scenario that it considered, the group expects
cash movements to take place on individual bank accounts before the next net settlement date
because the group expects its subsidiaries to use those bank accounts in their normal course of
business. Consequently, the Committee noted that, to the extent to which the group did not expect to
settle its subsidiaries’ period-end account balances on a net basis, it would not be appropriate for the
group to assert that it had the intention to settle the entire period-end balances on a net basis at the
reporting date. This is because presenting these balances net would not appropriately reflect the
amounts and timings of the expected future cash flows, taking into account the group’s and its
subsidiaries’ normal business practices.

7I.8.95.120 However, the Committee also observed that in other cash pooling arrangements a
group’s expectations regarding how subsidiaries will use their bank accounts before the next net
settlement date may be different. Consequently, it was noted that, in those circumstances, the group
would be required to apply judgement in determining whether there was an intention to settle on a
net basis at the reporting date. [IU 03-16]

7I.8.95.130 If an entity will settle amounts in a manner such that the outcome is, in effect,
equivalent to net settlement, then it meets the intention criterion in IAS 32. A gross settlement
system is equivalent to net settlement if, and only if, it has features that:
• eliminate or result in insignificant credit and liquidity risk; and
• will process receivables and payables in a single settlement process or cycle. [IAS 32.AG38F]
7I.8.95.140 IAS 32 identifies an example of a gross settlement system that would be equivalent
to net settlement. It has all of the following features.
a. Financial assets and financial liabilities are submitted for processing at the same point in time.
b. The parties are committed to fulfilling the settlement obligation once the financial assets and
financial liabilities are submitted for processing.
c. Once they have been submitted, there is no potential for the cash flows arising from the financial
assets and financial liabilities to change (unless processing fails – see (d)).
d. Assets and liabilities that are collateralised with securities are settled on a system in which the
processing of the receivable or payable fails if the transfer of the related securities fails (and vice
versa).
e. Failed transactions are re-entered for processing until they are settled.
f. The same settlement institution carries out the settlement.
g. There is an intra-day credit facility that:
– will provide sufficient overdraft amounts to each party at the settlement date; and
– is virtually certain to be honoured if it is called on. [IAS 32.AG38F]
7I.8.97 Applying the offsetting requirements
7I.8.97.10 The offsetting requirements may apply to instruments such as receivables and
payables with the same counterparty if a legal right to set off is agreed to between the parties.
Generally, it would not be appropriate to offset assets and liabilities that the entity has with different
counterparties. To qualify for offsetting, there would have to be an agreement in place between all
parties, which would be unusual. Also, it may be difficult in practice to demonstrate the intention to
settle net or simultaneously with all parties to the arrangement. Consequently, it is unlikely that
either of the conditions for offsetting will be met. [IAS 32.45]

7I.8.97.20 Individual instruments that, when viewed together, would form a synthetic
instrument do not usually qualify for offsetting. For example, in the case of a fixed rate liability and a
fixed-to-floating interest rate swap that together form a synthetic floating rate liability, there is
generally no legal right to set off the swap’s cash flows and the interest payments on the liability.
Also, the settlement of the liability and the realisation of the swap may not occur simultaneously. [IAS
32.49(a)]

7I.8.97.30 When a transfer of financial assets does not qualify for derecognition (see 7I.5.290),
the associated liability and the corresponding assets are not offset. [IAS 32.42]

7I.8.97.40 In addition, offsetting is usually not appropriate when:

• financial assets are set aside in a trust by a debtor for the purpose of discharging an obligation
without those assets having been accepted by the creditor in settlement of the obligation; or
• an entity incurs an obligation as a result of certain loss events, which it expects to recover
through a claim made under an insurance contract. [IAS 32.49(d)–(e)]

7I.8.97.50 An entity may be required to provide (receive) cash or non-cash collateral in

connection with certain types of transactions. The offsetting requirements do not give special
consideration to items referred to as ‘collateral’. Accordingly, collateral that is represented by a
recognised financial instrument is presented net against the related financial asset or financial
liability if, and only if, it meets the offsetting criteria in IAS 32. If an entity can be required to return
or receive back collateral, then it does not currently have a legally enforceable right to set off in all of
the following circumstances:
• in the normal course of business;
• in the event of default; and
• on the insolvency or bankruptcy of one of the counterparties. [IAS 32.49(c), BC103]
7I.8.97.60 Generally, the offsetting criteria in IAS 32 (see 7I.8.90.10) are not satisfied, and
therefore offsetting is not appropriate, when an entity pledges financial or other assets as collateral
for recourse or non-recourse financial liabilities. In addition, in arrangements involving collateral,
the offsetting criteria are not satisfied and presenting the respective financial asset and financial
liability net is not permissible when the legal right to set off is enforceable only in the case of default.
[IAS 32.42(a), 49(c), AG38B]

7I.8.97.70 Derivative assets and liabilities are presented on a gross basis as separate line items
in the statement of financial position when they do not meet the offsetting criteria even if they have
the same primary risk exposure. This is because they are usually entered into with different
counterparties, and therefore there is no right to set off the recognised amounts. Even if they are
entered into with (or novated to) the same counterparty – e.g. a central counterparty clearing house
(see 7I.7.685) – derivative assets and liabilities may have different settlement dates or cash flow
structures. Therefore, it may be difficult to identify matching cash flows that could be offset at a
specific date, even if this was allowed by the contractual relationships. In addition, a legal right to set
off may often be conditional on a specified future event, in which case there is no current legally
enforceable right to set off. [IAS 32.49(b), BC82]

EXAMPLE 4A – OFFSETTING – LEGAL ENFORCEABILITY AND NET SETTLEMENT IN SPECIFIC CIRCUMSTANCES ONLY
 7I.8.97.80 Bank B enters into a master netting arrangement with Counterparty
C because they undertake a number of financial instruments transactions together.
The agreement provides for a single net settlement of all financial instruments
covered by the agreement in the event of default on any one contract.

7I.8.97.85 The master netting arrangement creates a right to set off that

becomes enforceable and affects the realisation or settlement of individual financial
assets and financial liabilities only following a specified event of default. Therefore,
it does not provide a basis for offsetting. A master netting arrangement does not
provide a basis for offsetting unless both of the offsetting criteria are met – i.e. the
entity has a current legally enforceable right and an intention to settle net or
simultaneously. [IAS 32.50]

EXAMPLE 4B – OFFSETTING – LEGAL ENFORCEABILITY AND NET SETTLEMENT IN ALL CIRCUMSTANCES – PASSAGE
OF TIME OR UNCERTAINTIES IN AMOUNTS DO NOT PRECLUDE OFFSETTING

7I.8.97.90 Bank K is a member of a clearing house. Transactions entered into

with other members of the clearing house are novated such that the clearing house
is the legal counterparty to K for all such transactions. The contractual terms are as
follows:

• cash margins are payable or receivable between K and the clearing house based
on the fair value of outstanding transactions;
• the payment (receipt) of a cash margin does not itself extinguish or settle any
obligation (right) to make (receive) future cash flows under the outstanding
transactions; rather, it creates a distinct receivable (payable) that may be set off
against those obligations (rights) when they mature (see 7I.5.450);
• only one net cash payment or receipt, which covers final settlement of maturing
transactions, periodic payments on existing transactions and net payment or
receipt of cash margin, occurs each day between K and the clearing house; and
• in the event of default, insolvency or bankruptcy of any of the parties in the
arrangement, the outstanding amounts will be set off.

7I.8.97.100 In our view, the cash flows arising from each daily settlement are, in
effect, net settlements. Accordingly, offsetting is appropriate in these
circumstances. This is because, despite uncertainties about the amounts and timing,
payments that will arise in the future will be set off. The passage of time or
uncertainties in amounts to be paid will not preclude K from currently having a
legally enforceable right to set off. Therefore, because K has the current legally
enforceable right to set off and the intention to settle net or simultaneously, it
satisfies the offsetting criteria in IAS 32. [IAS 32.42, 48]

7I.8.100 SIGNIFICANCE OF FINANCIAL INSTRUMENTS FOR FINANCIAL

POSITION AND PERFORMANCE

7I.8.100.10 An entity provides sufficient disclosures to enable users of the financial statements to
evaluate the significance of financial instruments to the entity’s financial position and performance.
To help satisfy this principle, IFRS 7 lists specific disclosure requirements (see 7I.8.110–290). [IFRS
7.7]

7I.8.110 Statement of financial position

7I.8.120 Carrying amount
7I.8.120.10 The carrying amounts of the following categories of financial assets and financial
liabilities are disclosed, either in the statement of financial position or in the notes:
• financial assets measured at FVTPL;
• held-to-maturity investments;
• loans and receivables;
• available-for-sale financial assets;
• financial liabilities at FVTPL; and
• financial liabilities measured at amortised cost. [IFRS 7.8]
7I.8.120.20 The carrying amounts of instruments that are designated as at FVTPL are disclosed
separately from the carrying amounts of instruments held for trading purposes. [IFRS 7.8]

7I.8.130 Financial assets or financial liabilities designated as at FVTPL

7I.8.130.10 As noted in 7I.4.40, entities may designate financial assets and financial liabilities
into the financial assets or financial liabilities at FVTPL category.

7I.8.130.20 An entity may have designated a loan or receivable as at FVTPL. In this case, it
discloses:
• the maximum exposure to credit risk of that loan or receivable at the reporting date;
• the amount by which this risk is mitigated by credit derivatives or similar instruments;
• the amount of change in the fair value of the loan or receivable that is attributable to changes in
credit risk, both for the period and cumulatively; and
• the amount of change in the fair value of any related credit derivative or similar instrument, both
for the period and cumulatively since the loan or receivable was designated. [IFRS 7.9]

7I.8.130.30 If the entity has designated a financial liability as at FVTPL, then it discloses:
• the amount of change in the fair value of the financial liability that is attributable to changes in
credit risk, both for the period and cumulatively; and
• the difference between the carrying amount of the financial liability and the amount that the
entity will be contractually required to pay at maturity. [IFRS 7.10]

7I.8.130.40 In our view, the amount that the entity is ‘contractually required to pay at maturity’
should be the undiscounted amount payable at maturity. Furthermore, when the amount payable at
maturity is not fixed – e.g. in the case of a liability containing an embedded derivative that modifies
the principal amount payable at maturity – the amount disclosed should be based on conditions
existing at the reporting date.

7I.8.130.50 In the case of both a loan or receivable and a financial liability, the change in the
instrument’s fair value attributable to changes in credit risk is determined either: (1) as the amount
of the change in its fair value not attributable to changes in market conditions; or (2) using an
alternative method that represents more faithfully the amount of the change in fair value
attributable to credit risk. In this regard, an entity discloses:
• the methods used to determine the change in fair value attributable to changes in credit risk; and
• if the entity does not believe that the information provided in order to comply with the standard
faithfully represents the change in the instrument’s fair value attributable to credit risk, then the
reasons for reaching this conclusion and the factors that the entity considers relevant. [IFRS 7.9(c),
10(a), 11]

7I.8.140 Reclassification
7I.8.140.10 If an entity reclassifies a financial asset into or out of either the cost or amortised cost
category or the fair value category, with the exception of those reclassifications permitted by
paragraph 50B (rare circumstances) or 50D or 50E (assets that would have met the definition of
loans and receivables and are intended to be held for the foreseeable future or to maturity) of IAS 39
(see 7I.4.220.20 and 250.10), then the amount reclassified and the reason for the reclassification are
disclosed. This would be relevant for held-to-maturity investments being reclassified from the
available-for-sale category because the two-year tainting period has expired (see 7I.4.120 and 260);
it would also apply in exceptional circumstances in which a fair value measure for a financial asset no
longer is available. [IFRS 7.12]

7I.8.140.20 If an entity reclassifies a financial asset out of FVTPL or available-for-sale as

permitted by paragraph 50B, 50D or 50E of IAS 39 (see 7I.4.220.20 and 250.10), then it discloses:
• the amount reclassified into and out of each category;
• for each reporting period until derecognition of the reclassified financial assets, the carrying
amounts and fair values of all financial assets that have been reclassified in the current and
previous reporting periods;
• if the financial asset was reclassified because of rare circumstances, then the facts and
circumstances indicating that the situation was rare;
• for the reporting period in which the financial asset was reclassified, the fair value gain or loss on
the financial asset recognised in profit or loss or OCI in both the current and previous reporting
period;
• for each reporting period following the reclassification, including the reporting period in which
the financial asset was reclassified, until derecognition of the financial asset:
– the fair value gain or loss that would have been recognised in profit or loss or OCI if the
financial asset had not been reclassified; and
– the gain, loss, income and expense recognised in profit or loss; and
• the effective interest rate and the estimated amounts of cash flows that the entity expects to
recover, as at the date of reclassification of the financial asset. [IFRS 7.12A]

7I.8.145 Derecognition
7I.8.145.10 If the terms of a financial liability are modified substantially, resulting in an
extinguishment of the old financial liability, then the old liability is derecognised and the
restructured financial instrument is treated as a new financial liability (see 7I.5.380). In our view, any
gains or losses arising as a result of the derecognition of the old financial liability (including any
unamortised discount or premium) should be presented as a separate line item within the disclosure
of finance income or expense, respectively.

7I.8.150 Offsetting disclosures

7I.8.150.10 An entity discloses information to enable users of its financial statements to evaluate
the effect or potential effect of netting arrangements on its financial position. The disclosures are
required for financial assets and financial liabilities that are:
• offset in the statement of financial position in accordance with IAS 32 (see 7I.8.90.10); and
• subject to an enforceable master netting arrangement or similar agreement that covers similar
financial instruments and transactions, irrespective of whether the financial assets and financial
liabilities meet the offsetting criteria in IAS 32 (see 7I.8.97.80–85). [IFRS 7.13A–13B, B40]

7I.8.150.20 To apply the disclosure requirements, an entity follows these steps:

• identify which instruments are in the scope;
• determine how to (dis)aggregate the quantitative disclosures;
• calculate the amounts to be disclosed;
• describe the types and nature of rights to set off that do not meet the offsetting criteria in IAS 32;
and
• determine whether additional disclosures are required.

7I.8.150.30 Neither IAS 32 nor IFRS 7 defines ‘master netting arrangements or similar
agreements’. Therefore, an entity may need to use judgement in identifying them. IAS 32 notes the
following as characteristics of master netting arrangements:
• they provide for net settlement of financial instruments covered by the agreement in the event of
default on, or termination of, any contact;
• they provide protection against losses when a counterparty is unable to meet its obligations; and
• they commonly create a right to set off that may be enforced only following a specified event of
default, or in other circumstances that are not expected to arise in the normal course of business.
[IAS 32.50]

7I.8.150.40 Financial assets and financial liabilities subject to similar agreements that cover
similar financial instruments and transactions are in the scope of the disclosure requirements of
IFRS 7. ‘Similar agreements’ and ‘similar financial instruments and transactions’ are explained in
IFRS 7 as follows. [IFRS 7.13A, B40–B41]

TERM INCLUDES

Similar agreements • Derivative clearing agreements

• Global master repurchase agreements
• Global master securities lending
agreements
• Any related rights to financial collateral

Similar financial instruments and • Derivatives

transactions • (Reverse) Sale-and-repurchase
agreements
• Securities borrowing and lending
agreements

7I.8.150.50 Financial instruments that are outside the scope of the disclosure requirements –
unless they are offset in the statement of financial position in accordance with IAS 32 – include:
• loans and customer deposits at the same institution; and
• instruments subject only to a collateral agreement. [IFRS 7.B41]
7I.8.150.60 An entity discloses the following quantitative information separately for recognised
financial assets and recognised financial liabilities in a tabular format unless another format is more
appropriate:
a. the gross amounts;
b. the amounts offset in accordance with the offsetting criteria in IAS 32;
c. the net amounts presented in the statement of financial position – i.e. the difference between (a)
and (b). These amounts are reconciled to the line item amounts presented in the statement of
financial position;
d. the amounts subject to enforceable master netting arrangements or similar agreements that do
not meet the offsetting criteria in IAS 32, including:
– amounts related to recognised financial assets and financial liabilities that do not meet the
offsetting criteria in IAS 32; and
– amounts related to financial collateral; and
e. the net amounts after deducting the amounts in (d) from those in (c). [IFRS 7.13C, B46]

7I.8.150.65 The disclosure requirements in 7I.8.150.60 may be grouped by type of financial

instrument or transaction. Alternatively, an entity may present disclosures (a)–(c) in 7I.8.150.60 by
type of financial instrument, and disclosures (c)–(e) by counterparty. [IFRS 7.B51–B52]

7I.8.150.70 To satisfy the minimum disclosure requirements described in 7I.8.150.60, an entity

calculates the amounts as follows. [IFRS 7.13A, 13C, B43–B49]

ITEM (SEE 7I.8.150.60) WHAT IT INCLUDES

 a. Gross amounts The carrying amounts of recognised financial assets and
financial liabilities that are in the scope of the disclosure
requirements (see 7I.8.150.10). However, the gross amounts
disclosed exclude any amounts recognised as a result of a right
to financial collateral that does not meet the offsetting criteria in
IAS 32. Such collateral is included under (d) below.

b. Amounts offset The amounts included in (a) that have been offset in the
statement of financial position in accordance with IAS 32.

c. Net amounts The difference between (a) and (b) above.

presented in the
statement of
financial position

d. Amounts subject to • For recognised assets and liabilities that do not meet the
enforceable master offsetting criteria in IAS 32, the amount disclosed is the
netting or similar carrying amount to which the right to set off applies.
agreements that are • For financial collateral received or pledged that is not offset
not included in (b) in the statement of financial position in accordance with IAS
32, the amount disclosed is the fair value of the collateral
actually pledged or received.

However, in each case the entity limits the amounts disclosed to

eliminate the effect of over-collateralisation. This adjustment is
calculated at the level of the financial asset or the financial
liability (or group of financial assets/liabilities) to which the right
to collateral relates.

e. Net amounts The difference between items (c) and (d) above.

7I.8.150.80 An entity discloses recognised financial assets and financial liabilities based on their
carrying amounts. Different measurement requirements may apply to the various financial assets or
financial liabilities within an individual line item in the statement of financial position. Therefore,
offsetting may result in a presentation that includes measurement differences. For example, within a
line item, a financial asset that is measured at fair value may be offset against a liability that is
measured at amortised cost. An entity is required to describe any such measurement differences.
[IFRS 7.B42]

7I.8.150.90 An entity is required to reconcile the disclosed net amounts included in the statement
of financial position, (c) in 7I.8.150.60, to the individual line item amounts presented in the
statement of financial position. The scope of the disclosures does not extend to all financial assets
and financial liabilities; it is possible that only some of the instruments within a particular line item
might be captured, while others are not. Therefore, the net amounts disclosed under item (c) in
7I.8.150.60 may represent subsets of amounts presented in individual line items. [IFRS 7.B46]

7I.8.150.100 An entity describes the nature and the types of rights to set off that do not meet the
criteria for offsetting in IAS 32. For example, it describes:
• conditional rights;
• the reasons why rights to set off that are not contingent do not meet the offsetting criteria in IAS
32; and
• the terms of the related rights to financial collateral. [IFRS 7.13E, B50]
7I.8.150.110 The disclosure requirements described in 7I.8.150.60 are minimum requirements.
An entity supplements them with additional qualitative disclosures if necessary for financial
statement users to evaluate the actual or potential effect of netting arrangements on its financial
position. When disclosing quantitative information by counterparty, an entity considers qualitative
disclosure about the types of counterparties. [IFRS 7.B52–B53]

7I.8.160 Collateral

7I.8.160.10 An entity that has pledged financial assets as collateral for liabilities and contingent
liabilities discloses:
• the carrying amount of these assets pledged as collateral; and
• the terms and conditions related to the pledge. [IFRS 7.14]
7I.8.160.20 When an entity has accepted collateral that it is entitled to sell or repledge in the
absence of default by the owner, it discloses:
• the fair value of the collateral held (financial and non-financial assets);
• the fair value of such collateral sold or repledged, and whether the entity has an obligation to
return it; and
• any terms and conditions associated with its use of this collateral. [IFRS 7.15]

7I.8.170 Allowance account for credit losses

7I.8.170.10 If an entity recognises an impairment of financial assets resulting from credit losses
in a separate account, then it discloses a reconciliation of changes in that account during the period
for each class of financial asset. In the rare circumstances that an entity does not use such an
account, then there is no requirement to produce equivalent information. [IFRS 7.16, BC27]

7I.8.170.20 In our view, it is not appropriate to set up an impairment allowance account on the
initial recognition of a financial asset. Financial instruments are measured on initial recognition at
fair value, plus transaction costs if appropriate. The impairment of a financial asset is recognised
only if there is objective evidence of impairment as a result of events that occur after the initial
recognition of an asset (see 7I.6.410.10 and 420). In addition, IFRS 3 provides specific guidance
related to business combinations. Under this guidance, the acquirer in a business combination does
not recognise a separate valuation allowance as at the date of acquisition for assets acquired in a
business combination that are measured at their acquisition date fair values; this is because the
uncertainty about future cash flows is included in the fair value measurement (see 2.6.610.10). [IFRS
3.B41, IAS 39.43]

7I.8.180 Compound financial instruments with multiple embedded

derivatives
7I.8.180.10 An entity may issue a compound financial instrument that contains multiple
embedded derivative features whose values are interdependent. In this case, it discloses the
existence of these features. For example, a callable convertible debt instrument has more than one
embedded derivative feature; the value of the call option depends on both interest rates and equity
prices. The interdependency between interest rates and equity prices is disclosed. [IFRS 7.17, BC28–
BC31]

7I.8.190 Defaults and breaches

7I.8.190.10 If the entity has defaulted during the period on the principal, interest, sinking fund or
redemption provisions of a loan payable – i.e. a financial liability, other than a short-term trade
payable on normal credit terms – recognised in the statement of financial position, then it discloses:
• details of the default or breach;
• the amount recognised at the reporting date in respect of the loan payable on which the default or
breach occurred; and
• with respect to the above amounts, whether the default or breach was remedied or the terms of
 the loan payable renegotiated before the financial statements were authorised for issue. [IFRS 7.18,
A]

7I.8.190.20 An entity also discloses the items listed in 7I.8.190.10 if during the period there were
other breaches of loan agreement terms, and those breaches were not remedied or the terms were
not renegotiated before the reporting date such that the lender could demand accelerated
repayment. [IFRS 7.19]

7I.8.200 Embedded derivatives

7I.8.200.10 There is no specific guidance on the presentation of embedded derivatives and the
related host contracts (see 7I.2.390.10). [IAS 39.11]

7I.8.200.20 In our view, when an embedded derivative is not required to be accounted for
separately (see 7I.2.110), it should be presented in the same line item as the host contract.

7I.8.200.30 When an embedded derivative is accounted for separately, an issue arises about
whether it should be:
• included in the same line item as the host contract, on the basis that the two instruments are
subject to the same contract; or
• presented separately, together with other derivative instruments.
7I.8.200.40 The Standards do not address whether an embedded derivative should be presented
separately in the statement of financial position. Therefore, the general presentation rules in IAS 1
and IAS 32 apply (see chapter 3.1). In our view, if the host contract is a financial instrument and the
offsetting criteria are met for the host and the embedded derivative, then a separable embedded
derivative and the host contract should be presented on a net basis (see 7I.8.90). [IAS 39.11]

7I.8.205 Reverse factoring arrangements

7I.8.205.10 In addition to appropriate presentation and disaggregation of relevant balances, an
entity that is the customer in a reverse factoring arrangement (see 7I.8.45) is required to disclose
information about those arrangements that is relevant to an understanding of its financial position
and performance. This disclosure might include an explanation of the nature of the arrangements
and how they are reflected in the financial statements. Relevant disclosure requirements under the
Standards include:
• disclosure of significant accounting policies; and
• disclosure of significant judgements that management has made in the process of applying the
accounting policies and that have the most significant effect on the amounts recognised in the
financial statements. [IAS 1.112, 117–122, IU 12-20]

7I.8.205.20 For a further discussion of reverse factoring, see 2.3.75, 7I.5.425, 7I.8.45 and 375.

7I.8.210 Statement of profit or loss and OCI

7I.8.220 Items of income, expense, gains or losses

7I.8.220.10 Net gains or losses on the following are disclosed either in the statement of profit or
loss and OCI or in the notes to the financial statements:
• financial assets or financial liabilities measured at FVTPL, separately for:
– those that are designated as such on initial recognition; and
– those classified as held-for-trading;
• available-for-sale financial assets, showing separately:
– the amount of gain or loss recognised in OCI during the period; and
– the amount reclassified from equity to profit or loss for the period;
• held-to-maturity investments;
• loans and receivables; and
• financial liabilities measured at amortised cost. [IFRS 7.20(a)]
7I.8.220.20 An entity discloses within its accounting policies whether it has separated interest
income and expense from the net gains and losses on items measured at FVTPL (see 7I.8.70.40).
[IFRS 7.B5(e)]

7I.8.220.30 Total interest income and total interest expense for financial assets or financial
liabilities that are not at FVTPL (calculated under the effective interest method) are disclosed either
in the statement of profit or loss and OCI or in the notes. Total interest expense disclosed forms part
of finance costs, which are required by paragraph 82(b) of IAS 1 to be presented separately in the
statement of profit or loss and OCI (see 7I.8.80). [IFRS 7.20(b), IG13]

7I.8.220.40 If interest income or expense includes both amounts from instruments at FVTPL and
amounts from instruments not at FVTPL, then an entity is required to disclose total interest income
and total interest expense for financial assets and financial liabilities that are not at FVTPL. [IFRS
7.20(b)]

7I.8.225 Split presentation of gains and losses on derivatives

7I.8.225.10 There are no specific requirements in the Standards addressing the presentation of
gains and losses on derivatives. However, in our view it would be inappropriate to separate and
present gains and losses on derivatives using a method different from one of those described in
7I.8.225.20–50.

7I.8.225.20 If an entity designates derivatives as hedging instruments for accounting purposes,

or applies the fair value option to an economically hedged non-derivative as an alternative to hedge
accounting (see 7I.4.40), then in our view gains or losses on both the non-derivative, being the item
that is economically hedged or subject to hedge accounting, and the derivative may be split for
presentation purposes in order to reflect best the impact on profit or loss of the economics of the
relationship. For example, if a bank applies the fair value option to a portfolio of fixed rate loans that
are hedged economically using a portfolio of interest rate swaps, then we believe that it is
appropriate to separate accrued interest, measured on an effective interest basis, from other fair
value changes on both the loans and the swaps and to present the accrued amounts in interest
income.

7I.8.225.30 Gains and losses on derivatives designated in a hedging relationship as hedging

instruments have three possible elements:
1. the effective portion;
2. the ineffective portion; and
3. the portion excluded from the assessment of effectiveness.

7I.8.225.40 There are several options to consider when presenting such gains and losses. The
following options relate to a fair value hedge.
• Present the entire change in fair value of the derivative hedging instrument in the same line
item(s) as gains and losses from the hedged item.
• Present the effective and ineffective portions of the derivative hedging instrument in the same
line item(s) as gains and losses from the hedged item. Present the portion excluded from the
assessment of hedge effectiveness in the same line item(s) as gains or losses on non-hedging
derivative instruments.
• Present only the effective portion of the derivative hedging instrument in the same line item(s) as
gains and losses from the hedged item. Present the ineffective portion and the excluded portion in
the same line item(s) as gains or losses on non-hedging derivative instruments.

7I.8.225.50 Of the options noted in 7I.8.225.40, we prefer the third method. This is because only
the effective portion of the hedging derivative matches the opposite gains or losses on the hedged
item.
7I.8.225.60 The same options exist for a cash flow hedge. However, the timing of recognition in
profit or loss of the effective portion of the hedging instrument would be different.

7I.8.225.70 In our view, the options for the presentation in the statement of profit or loss and OCI
also apply to the presentation in the statement of cash flows (see 2.3.60).

7I.8.230 Fee income and expense

7I.8.230.10 An entity discloses fee income and expense arising from financial assets and financial
liabilities that are not measured at FVTPL, and from trust or other fiduciary activities. The amounts
disclosed exclude amounts included in calculating the effective interest rate. [IFRS 7.20(c)]

7I.8.240 Interest income

7I.8.240.10 An entity discloses interest income on impaired financial assets. In our view, when
impairment testing is carried out on a portfolio basis (see 7I.6.460) and the portfolio is found to be
impaired, the interest income disclosure should be consistent with the portfolio approach used for
impairment testing. [IFRS 7.20(d)]

7I.8.240.20 For each class of financial asset, the amount of any impairment loss is disclosed. In
addition, IFRS 15 requires an entity to disclose, separately from other impairment losses,
impairment losses recognised on trade receivables or contract assets arising from the entity’s
contracts with customers. [IFRS 7.20(e), 15.113(b), C9]

7I.8.250 Other disclosures

7I.8.260 Accounting policies

7I.8.260.10 The summary of accounting policies includes disclosure of the measurement basis (or
bases) used in preparing the financial statements. An entity also discloses any other accounting
policies that are relevant to understanding the financial statements. As an example, the disclosure
may include:
• the nature of financial assets and financial liabilities designated as at FVTPL;
• the criteria for designating financial assets and financial liabilities as at FVTPL;
• how the entity satisfied the criteria for designating financial assets and financial liabilities as at
FVTPL (see 7I.4.40 and 7I.2.160);
• the criteria for designating financial assets as available-for-sale;
• whether regular-way transactions are accounted for using trade or settlement date accounting
(see 7I.2.70);
• when an impairment allowance account for credit losses is used, the criteria for determining
when this account is used in place of directly reducing the carrying amount of the impaired asset;
• when an impairment allowance account for credit losses is used, the criteria for writing off
amounts charged to the allowance account against the carrying amount of the impaired financial
asset;
• for each category of financial instruments, how the net gains and losses are determined – e.g. for
items measured at FVTPL whether the entity includes interest or dividend income;
• the criteria for determining that there is objective evidence that an impairment loss has occurred;
and
• when terms of the financial assets that otherwise would be past due or impaired have been
renegotiated, the accounting policies for financial assets that are subject to the renegotiated
terms. [IFRS 7.21, B5, IAS 1.117]

7I.8.270 Hedge accounting

7I.8.270.10 An entity is required to make specific disclosures about its outstanding hedge
accounting relationships. The following disclosures are made separately for fair value hedges, cash
flow hedges and hedges of net investments in foreign operations:
• a description of each type of hedge;
• a description of the financial instruments designated as hedging instruments for the hedge and
their fair values at the reporting date;
• the nature of the risks being hedged;
• gains or losses on the hedging instrument and the hedged item attributable to the hedged risk in a
fair value hedge;
• ineffectiveness recognised in profit or loss arising from cash flow hedges; and
• ineffectiveness recognised in profit or loss arising from hedges of net investments in foreign
operations. [IFRS 7.22, 24]

7I.8.270.20 In addition, for a cash flow hedge the entity discloses:

• the periods in which the transactions are expected to occur, and when they are expected to affect
profit or loss;
• a description of any forecast transactions that were hedged, but are no longer expected to occur;
• the amount recognised in OCI during the period;
• the amount reclassified from equity to profit or loss during the period, showing the amount
included in each line item in the statement of profit or loss and OCI; and
• the amount removed from equity and added to the initial measurement of a non-financial asset or
non-financial liability during the period. [IFRS 7.23]

7I.8.270.30 For a discussion on presenting gains and losses on derivatives designated in a

hedging relationship, see 7I.8.225.

7I.8.270.40 In our view, when hedge accounting is not applied, either because an entity chooses
not to apply hedge accounting or because the criteria for hedge accounting are not met, information
should be provided to explain the relationship between the derivatives and the transactions for
which there are economic hedges. We believe that this should be done to enable users of the financial
statements to understand the extent to which risk is mitigated through the use of the derivatives.

7I.8.275 Uncertainty arising from interest rate benchmark reform

7I.8.275.10 When an entity applies the temporary exceptions from applying specific hedge
accounting requirements to hedge accounting relationships directly affected by interest rate
benchmark reform (see 7I.7.880), it discloses the following:
• the significant interest rate benchmarks to which the entity’s hedging relationships are exposed;
• the nominal amounts of the hedging instruments in those hedging relationships;
• the extent of the risk exposure managed by the entity that is directly affected by the benchmark
reform;
• how the entity is managing the transition to alternative benchmark interest rates; and
• a description of significant assumptions or judgements made in applying the temporary
exceptions – e.g. assumptions or judgements about when the uncertainty arising from benchmark
reform is no longer present with respect to the timing and the amount of cash flows. [IFRS 7.24H]

7I.8.277 Interest rate benchmark reform

7I.8.277.10 An entity discloses the effect of interest rate benchmark reform on its financial
instruments and risk management strategy. Specifically, an entity discloses the following:
• the nature and extent of risks arising from financial instruments that are subject to interest rate
benchmark reform to which the entity is exposed and how these risks are managed;
• the progress to complete the transition to alternative benchmark rates at the reporting date and
how this transition is managed;
• a description of changes to the entity’s risk management strategy as a result of the above; and
• a disaggregation by interest rate benchmark of those financial instruments that have yet to
transition to an alternative benchmark rate, showing separately non-derivative financial assets,
non-derivative financial liabilities and derivatives. [IFRS 7.24I–24J]
7I.8.277.20 When an entity first applies the newly effective requirements of the IBOR Phase 2
amendments, it can choose not to present the quantitative information required by paragraph 28(f)
of IAS 8 (see 7I.7.882.40). [IFRS 7.44HH]

7I.8.280 Fair value

7I.8.280.10 For each class of financial assets and financial liabilities, an entity discloses the fair
value in a manner that allows users of financial statements to compare it with its carrying amount.
However, this disclosure is not required:
• if the carrying amount is a reasonable approximation of fair value;
• for an investment in equity instruments that do not have a quoted market price in an active
market – and for derivatives linked to such equity instruments – that are measured at cost
because fair value cannot be determined reliably;
• for a contract containing a discretionary participation feature when the fair value of the feature
cannot be measured reliably; and
• lease liabilities. [IFRS 7.25, 29]
7I.8.280.20 The carrying amounts of short-term receivables and payables are likely to
approximate their fair values in a low-interest rate environment in which the effect of discounting is
not material. In such cases, it is not necessary to disclose these instruments’ fair values. However,
the fair values of long-term liabilities and receivables carried at amortised cost are disclosed
because the effect of discounting is expected to be material. [IFRS 7.29(a), 13.BC138A]

7I.8.280.30 As described in 7I.6.210.20, IAS 39 presumes that a reliable fair value can be
determined for almost all financial instruments. The only exceptions to this are:
• certain unquoted equity instruments or derivatives linked to and to be settled by delivery of such
equity instruments; and
• contracts containing discretionary participation features for which a reliable fair value cannot be
obtained. [IAS 39.46, AG81]

7I.8.280.40 If any of the instruments described in 7I.8.280.30 are not stated at fair value, then
the entity discloses:
• the fact that the fair value of these instruments cannot be measured reliably;
• a description of the financial instruments;
• the carrying amount;
• an explanation of why fair value cannot be measured reliably;
• information about the market for the instruments;
• information about whether and how the entity intends to dispose of the instruments; and
• if an instrument is derecognised:
– the fact that the fair value could not be measured reliably;
– the carrying amount at the time of derecognition; and
– the amount of the gain or loss recognised. [IFRS 7.29(c), 30]
7I.8.280.50 An entity, such as a mutual fund or a co-operative, whose share capital is classified as
financial liabilities may present its share capital as net assets attributable to shareholders in its
statement of financial position. If the carrying amounts of the issued shares classified as financial
liabilities are not a reasonable approximation of their fair values, then in our view the entity should
disclose the fair values of the shares even if this presentation option is elected (see 7I.3.50.50 and
2.4.980.20–30). [IFRS 7.25, 29, IAS 32.IE32]

7I.8.280.60 The fair value disclosures are based on financial asset and financial liability classes.
They are offset only to the extent that their carrying amounts are offset in the statement of financial
position (see 7I.8.90). [IFRS 7.26]

7I.8.280.70 IFRS 13 provides guidance on fair value measurement and the related disclosure
requirements, which are the subject of chapter 2.4 (see 2.4.490).
7I.8.290 Day one gain or loss
7I.8.290.10 In some cases, the fair value of a financial asset or a financial liability on initial
recognition may differ from the transaction price. If an entity does not recognise a gain or loss on
initial recognition because fair value is neither evidenced by a quoted price in an active market for
an identical asset or liability nor based on a valuation technique that uses only data from observable
markets, then it discloses the following for each class of financial asset and financial liability:
• the accounting policy for subsequently recognising the difference in profit or loss;
• the aggregate difference yet to be recognised in profit or loss at the beginning and end of the
period, and a reconciliation of changes in this difference during the period; and
• the reason why the transaction price is not the best evidence of the fair value, including a
description of the evidence that supports the fair value (see 7I.6.25.50). [IFRS 7.28]

7I.8.300 NATURE AND EXTENT OF RISKS ARISING FROM FINANCIAL

INSTRUMENTS

7I.8.300.10 The general disclosure principle in IFRS 7 requires an entity to make qualitative and
quantitative disclosures that enable users of its financial statements to evaluate the nature and the
extent of risks arising from financial instruments to which the entity is exposed at the reporting date,
and how the entity has managed them. The extent of disclosure depends on the extent of the entity’s
exposure to risks arising from financial instruments. The types of risks covered by the disclosures
include, but are not limited to, credit risk, liquidity risk and market risk. [IFRS 7.31–32]

7I.8.300.20 The disclosures are included either in the financial statements or in another
statement, such as a management commentary or risk report. The location of the disclosures may be
limited by local laws. If the disclosures are made outside the financial statements, then the financial
statements are cross-referenced to this information (see 5.8.10.90). The disclosures are made
available to users on the same terms and timing as the financial statements. [IFRS 7.B6]

7I.8.300.30 IFRS 7 addresses risks arising from financial instruments and contracts to buy or sell
a non-financial item that are in the scope of IAS 39. Consequently, the following are excluded from
the scope of IFRS 7, even though they may give rise to financial risk for the entity:
• exposures from commodity contracts that meet the own-use exemption (see 7I.1.150.20);
• purchase and sale contracts for non-financial items that are to be settled in a foreign currency
unless they are scoped into IAS 39 (see 7I.1.150 and 7I.2.260); and
• future expected transactions that do not arise from existing financial instruments. [IFRS 7.5, 31]
7I.8.300.40 An entity may manage its financial risk based on its total exposure – i.e. including risk
arising from those items not included in the scope of IFRS 7 – and these exposures may be included
in reports to key management personnel. In this case, in our view IFRS 7 does not prohibit an entity
from providing additional disclosures about its total financial risk exposure rather than just the risk
arising from financial instruments. However, we believe that all such additional disclosures should
be clearly separated from those required by IFRS 7.

7I.8.310 Qualitative disclosures

7I.8.310.10 An entity discloses the following, for each type of risk arising from financial
instruments:
• the exposure to the risk and how it arises;
• the entity’s objectives, policies and processes for managing the risk; and
• the methods used to measure the risk. [IFRS 7.33(a)–(b)]
7I.8.310.20 If there are any changes to the factors described in 7I.8.310.10 from the previous
period, then an entity discloses the reason for the changes. The changes may result from changes in
exposures themselves, or the way in which the entity manages them. [IFRS 7.33(c)]
7I.8.320 Quantitative disclosures

7I.8.320.10 An entity discloses summary quantitative data about its exposure to each risk arising
from its financial instruments at the reporting date. The disclosure is based on information that is
provided internally to key management personnel of the entity – e.g. the board of directors or the
CEO. If an entity uses several methods to manage risk, then it bases the disclosure on the method
that provides the most relevant and reliable information. The quantitative disclosures described in
7I.8.330–390 are required, if they are not already provided as part of the summary quantitative data
based on information that is provided internally to key management personnel. [IFRS 7.34]

7I.8.320.20 The quantitative data disclosed at the reporting date may not be representative of the
risk exposure over the course of the reporting period. In this case, the entity provides additional
disclosure that is representative. [IFRS 7.35]

EXAMPLE 5 – ADDITIONAL REPRESENTATIVE DISCLOSURE

7I.8.320.30 Company X’s cash flows are highly seasonal. X’s net debt (i.e.
financing liabilities less cash) outstanding at the reporting date is less than half of
the average amount outstanding during the year and less than one-third of the
highest amount outstanding during the year.

7I.8.320.40 X concludes that the quantitative data that it presents about liquidity
risk at the reporting date is not representative of the risk exposure over the course
of the reporting period. Therefore, X provides additional quantitative and qualitative
information about its liquidity position throughout the year, such as:
• the amounts and components of net debt outstanding at the end of each month;
and
• the average and peak levels during the year.

7I.8.330 Concentrations of risk

7I.8.330.10 An entity discloses concentrations of risk. [IFRS 7.34(c)]

7I.8.330.20 Concentrations of risk arise from financial instruments that:

• have similar characteristics; and
• are affected in a similar manner when there are changes in economic or other conditions. [IFRS
7.B8]

7I.8.330.30 Identifying concentrations of risk is a matter of judgement and therefore an entity

discloses:
• a description of how management determines concentrations;
• a description of the shared characteristics that identify each concentration – e.g. counterparty,
geographic area, currency or market; and
• the amount of the risk exposure associated with financial instruments sharing that characteristic.
[IFRS 7.B8]

7I.8.340 Credit risk

7I.8.340.10 ‘Credit risk’ is the risk that one party to a financial instrument will cause a financial
loss for the other party by failing to discharge an obligation. In our view, the credit risk disclosures
are not required for investments in equity instruments, because these do not impose an obligation on
the issuer to make any payments to the holder and, consequently, the holder is not exposed to the
risk of the issuer failing to discharge an obligation. [IFRS 7.A]

7I.8.340.20 An entity discloses, by class of financial instrument, the amount that best represents
the entity’s maximum exposure to credit risk, unless this exposure is best represented by the
carrying amount. The amount does not take into account any collateral held or other credit
enhancements, unless the IAS 32 offsetting criteria are met. For example, the amount for a financial
asset would typically be the gross carrying amount less any required offset (in accordance with IAS
32) and any impairment losses recognised. This disclosure is not required for financial instruments
whose carrying amount best represents the maximum exposure to credit risk. [IFRS 7.36(a), B9, B10(c)]

7I.8.340.30 An entity discloses information about the credit quality of financial assets (by class)
that are neither past due nor impaired. [IFRS 7.36(c)]

7I.8.350 Collateral and other credit enhancements held

7I.8.350.10 The entity discloses a description of any collateral held as security and other credit
enhancements and their financial effect in respect of the amount that best represents the maximum
exposure to credit risk. [IFRS 7.36(b)]

7I.8.350.20 IFRS 7 does not specify how an entity should apply the term ‘financial effect’ in
practice. Providing quantitative disclosure of the financial effect of collateral may be appropriate in
some cases. However, in other cases it may be impractical to obtain quantitative information; or, if it
is available, the information may not be determined to be relevant, meaningful or reliable.

7I.8.350.30 If quantitative disclosure is deemed appropriate, some possible quantitative

approaches may include a quantification of:
• the current value of collateral – e.g. fair value or net realisable value of collateral or other credit
enhancements – for each class of assets adjusted for the effect of over-collateralisation; or
• the effect that collateral or other credit enhancements have on the entity’s impairment losses –
i.e. an estimate of the difference between the entity’s actual impairment losses and what they
might have been without the collateral or other credit enhancements.

7I.8.350.40 As part of its determination of whether quantitative disclosure of the current value of
collateral is appropriate, an entity may, for example, consider whether:
• the collateral is specifically identifiable and therefore measurable – e.g. a fixed charge over
specified assets vs a floating charge that has not yet attached to any specific assets; and
• the entity is able to access the collateral at its full value and is not restricted by a higher-ranking
or pari passu charge of another creditor.

EXAMPLE 6A – APPROPRIATENESS OF QUANTITATIVE DISCLOSURE OF FINANCIAL EFFECT OF COLLATERAL (1)

7I.8.350.50 Bank X holds a portfolio of loans secured on residential properties.

The security is in the form of the first charge over each property. Historically, in the
event of default X has enforced this type of collateral and was able to dispose of it in
an established market. X updates the value of the collateral regularly and monitors
internally for risk management purposes the loan to value ratios. Therefore, X
determines that disclosure of the current value of the collateral is appropriate and
provides relevant information on the extent to which the collateral mitigates the
credit risk on its portfolio of loans.

EXAMPLE 6B – APPROPRIATENESS OF QUANTITATIVE DISCLOSURE OF FINANCIAL EFFECT OF COLLATERAL (2)

 7I.8.350.60 Company Y holds a portfolio of second-lien residential mortgage
loans. In this case, disclosing the fair value of the collateral held may be
inappropriate if historically, in the case of default, its right to collateral has been
worthless. Therefore, it may be more appropriate for Y to disclose the fact that its
right to collateral may be worthless in default and that the fair value of the collateral
may be irrelevant in those circumstances.

7I.8.350.70 If quantitative disclosure of the financial effect of certain types of collateral or other
credit enhancements is not considered appropriate, then an entity would still be required to disclose
sufficient qualitative information for a financial statement user to understand:
• how the entity considers and incorporates collateral or other credit enhancements into its credit
risk management; and
• how such incorporation of collateral or other credit enhancements in its credit risk management
relates to its quantitative disclosures of its maximum exposure to credit risk, possibly including its
effect in relation to disclosures of credit quality. [IFRS 7.32A, 33(b), 36(b)]

7I.8.350.80 An entity may obtain financial or non-financial assets under collateral and credit
enhancement arrangements. If those assets meet the recognition criteria in the Standards, then it
discloses the nature and the carrying amount of the assets held. In addition, when such assets are
not readily convertible into cash, the entity discloses its policies for using the assets in its operations
or disposing of them. These requirements apply only to assets held at the reporting date. [IFRS 7.38]

7I.8.360 Financial assets either past due or impaired

7I.8.360.10 For each class of financial asset, an entity discloses an ageing analysis of financial
assets that are past due but not impaired as at the reporting date. [IFRS 7.37(a)]

7I.8.360.20 An entity discloses an analysis of:

• financial assets that are individually determined to be impaired as at the reporting date; and
• the factors considered by the entity in determining that the financial asset was impaired. [IFRS
7.37(b)]

7I.8.365 Forbearance

7I.8.365.10 The Standards do not contain specific disclosure requirements relating to

forbearance activities (see 7I.5.95.10). However, an entity is required to disclose significant
measurement bases related to impairment, including the criteria that it uses for identifying objective
evidence of impairment and its accounting policy for financial assets that are subject to renegotiated
terms if the financial asset would have been otherwise past due or impaired. Furthermore, an entity
discloses the assumptions made about the future and other sources of estimation uncertainty that
have a significant risk of a material adjustment to the carrying amounts of assets and liabilities. For
example, loans subject to forbearance may be subject to management processes separate from other
credit exposures, may have different risk characteristics and may be subject to different inputs and
assumptions in impairment loss calculations. [IAS 1.125, IFRS 7.21, B5(g)]

7I.8.365.15 To meet the disclosure objectives in IFRS 7 (see 7I.8.10.10), an entity determines the
level of detail and aggregation of information (see 7I.8.50.40) for disclosures in respect of forborne
loans based on the level of forbearance activities, potential exposure to losses related to these
activities and their impact on the entity’s performance. [IFRS 7.6, B3]

7I.8.365.20 Qualitative disclosures in respect of the nature and extent of forbearance practices
may include narrative information about:
• types of forbearance activities and programmes, and of the exposures subject to them;
• objectives, policies and processes for managing risk and the methods used to measure risk; and
• changes from the previous period. [IFRS 7.33]
7I.8.365.30 Quantitative disclosures in respect of forbearance practices may include:
• carrying amounts of assets subject to forbearance – analysed, for example, by type of forbearance
measure or business or geographic area, as appropriate;
• forbearance activities during the period, including a reconciliation of opening and closing
balances;
• related impairment allowances;
• newly recognised assets (see 7I.5.95.20);
• interest income; and
• analysis of credit quality. [IFRS 7.16, 20, 34(a), 36(c)]

7I.8.370 Liquidity risk

7I.8.370.10 ‘Liquidity risk’ is the risk that an entity will encounter difficulty in meeting the
obligations associated with its financial liabilities that are settled by delivering cash or another
financial asset. [IFRS 7.A]

7I.8.370.20 An entity discloses a maturity analysis for:

• non-derivative financial liabilities, including issued financial guarantee contracts that shows their
remaining contractual maturities; and
• derivative financial liabilities, including the remaining contractual maturities for those derivative
financial liabilities for which contractual maturities are essential for an understanding of the
timing of the cash flows – e.g. loan commitments and interest rate swaps designated in a cash flow
hedging relationship. [IFRS 7.39(a)–(b), B11B]

7I.8.370.30 In our view, the maturity analysis should include all derivative financial liabilities, but
contractual maturities only are required for those essential for an understanding of the timing of the
cash flows.

7I.8.370.40 In determining what is essential for an understanding of the cash flows, we believe
that an entity should apply judgement over what is appropriate based on management’s liquidity risk
management strategy and the facts and circumstances. For example, most non-trading derivatives
that are held for risk management purposes might be expected to be held to maturity. Also, most
hedging strategies will not involve closing out a derivative before maturity. However, some ‘trading’
derivatives – e.g. interest rate swaps that a bank executes with corporate counterparties – might be
expected to be held until maturity, and some hedging strategies may involve closing out a derivative
before maturity.

7I.8.370.50 An entity explains how it manages the liquidity risk inherent in the maturity analyses
described in 7I.8.370.20. This includes a maturity analysis for financial assets it holds as part of
managing liquidity risk – e.g. financial assets that are expected to generate cash inflows to meet cash
outflows on financial liabilities – if this information is necessary to enable financial statement users
to evaluate the nature and extent of liquidity risk. In addition, disclosure of financial assets pledged
as collateral – e.g. cash collateral and securities under repurchase transactions – may be considered
necessary in this context if this information is provided internally to key management personnel.
[IFRS 7.34(a), 39(c), B11E–B11F]

7I.8.370.60 In disclosing the maturity analyses described in 7I.8.370.20, an entity does not
separate an embedded derivative from a hybrid (combined) financial instrument. For such an
instrument, the entity applies the disclosure requirements for non-derivative financial liabilities – i.e.
it discloses the remaining contractual maturities. [IFRS 7.B11A]

7I.8.370.70 IFRS 7 does not define contractual maturities. Therefore, it leaves open to
interpretation the amounts that need to be included in the maturity analysis for certain types of
financial liabilities, such as derivatives and perpetual instruments. In our view, both the interest and
principal cash flows should be included in the analysis because this best represents the liquidity risk
being faced by the entity. The principal amount of a perpetual instrument represents the present
value of the payments of the interest stream. As a minimum, for such an instrument, the principal
amount should be disclosed and sufficient appropriate narrative disclosures should be provided, to
present a meaningful picture of the entity’s liquidity exposures.

7I.8.370.80 IFRS 7 does not mandate the number of time bands to be used in the analysis. Rather,
it requires the entity to use its judgement to determine an appropriate number of time bands. [IFRS
7.B11]

7I.8.370.90 When the creditor can choose when an amount is paid, the liability is included in the
time band that represents the earliest date on which the entity could be required to pay. This
disclosure shows the worst-case scenario from the perspective of the entity. For example:
• a demand deposit would be included in the earliest time band; and
• a financial liability that contains a put option allowing the holder of the instrument to demand
redemption before maturity would be included in the time band for the earliest date on which the
entity could be required to pay. [IFRS 7.B11C(a), BC57]

7I.8.370.100 The amounts disclosed are the contractual undiscounted cash flows. In our view, the
amounts disclosed should generally be gross unless the liabilities will be settled net. These amounts
will differ from the amounts included in the statement of financial position, because those amounts
are based on discounted cash flows. [IFRS 7.B11D]

7I.8.370.110 When the amount payable is not fixed, the amount to be disclosed is determined
with reference to conditions existing at the reporting date. For example, for a floating rate bond with
interest payments indexed to three-month Euribor, in our view the amount to be disclosed should be
based on forward rates rather than spot rates prevailing at the reporting date because the spot
interest rates do not represent the level of the index based on which the cash flows will be payable.
The forward interest rates better describe the level of the index in accordance with the conditions
existing at the reporting date. [IFRS 7.B11D]

7I.8.370.120 When an issued guarantee meets the definition of a financial guarantee contract
under IAS 39 (see 7I.1.50), the maximum amount of the guarantee is disclosed in the earliest period
in which the guarantee could be called. [IFRS 7.B11C(c)]

7I.8.370.130 In disclosing summary quantitative data about exposure to liquidity risk on the basis
of information provided internally to key management, an entity explains how this data is
determined. If the outflows included in the data could occur either significantly earlier or at
significantly different amounts, then the entity discloses that fact and provides further quantitative
information to enable users to evaluate the extent of this risk, unless this information is included in
the contractual maturity analysis required by IFRS 7 (see 7I.8.370.20). The amounts disclosed need
to be explained so that it is clear whether they are compiled on a contractual or another basis. [IFRS
7.34(a), B10A]

7I.8.370.140 An entity may have liabilities that are subject to accelerated repayment before their
stated maturities in certain circumstances. For example, a term loan may become repayable on
demand if the entity fails to comply with covenants on its financial condition or performance, or if its
credit rating is downgraded. Depending on the circumstances, information about such terms and
their effect may be necessary to allow users to evaluate the nature and extent of liquidity risk.
Additional disclosure may be appropriate – e.g. on concentrations of liquidity risk arising from such
terms or how the entity manages the associated liquidity risk. [IFRS 7.31, 34(c), B10A, B11F(f)]

7I.8.375 Reverse factoring arrangements

7I.8.375.10 Reverse factoring arrangements (see 7I.8.45) may impact the customer’s exposure to
– and be part of its management of – liquidity risk from financial instruments. An entity that is the
customer in a reverse factoring arrangement is required to disclose information that enables users of
financial statements to evaluate the nature and extent of these risks. The disclosure requirements
that may be particularly relevant to such arrangements include:
• qualitative disclosures about the entity’s exposure to liquidity risk:
– the exposure to risk and how it arises;
– the entity’s objectives, policies and processes for managing the risk and the method used to
measure the risk; and
– any changes in the above from the previous period; and
• quantitative information relating to liquidity risk, including concentrations of it. [IFRS 7.31, 33–34, IU
12-20]

7I.8.375.20 For a further discussion of reverse factoring, see 2.3.75, 7I.5.425, 7I.8.45 and 205.

7I.8.380 Market risk

7I.8.380.10 ‘Market risk’ is the risk that the fair value or future cash flows of a financial
instrument will fluctuate because of changes in market prices. Market risk comprises three types of
risk: currency risk, interest rate risk and other price risk – e.g. equity price risk, commodity price
risk and residual value risk. [IFRS 7.A, IG32]

7I.8.380.20 An entity presents a sensitivity analysis for each type of market risk that it is exposed
to as at the reporting date, including the methods and assumptions used in preparing the analysis. If
the methods and assumptions change from one period to another, then the entity discloses such
changes together with the reasons for them. [IFRS 7.40]

7I.8.380.30 An entity may hold an investment in an equity instrument quoted in a foreign

currency. In our view, the entity is not required to split the currency risk from other price risk for an
equity instrument. However, for a debt instrument, as a minimum, the split between currency risk
and interest rate risk is presented. [IFRS 7.B23]

7I.8.380.40 The sensitivity analysis reflects the impact, on profit or loss and equity, of changes in
the relevant risk variables that are reasonably possible at the reporting date. The ‘reasonably
possible’ change does not include remote or worst case scenarios or stress tests. The sensitivity
calculation assumes that the reasonably possible change had occurred at the reporting date and had
been applied to the risk exposures at that date. For example, if an entity has a floating rate liability at
the reporting date, then it would disclose the effect on profit or loss (e.g. interest expense) for the
current year if interest rates had varied by reasonably possible amounts. [IFRS 7.40(a), B18–B19]

7I.8.380.50 The sensitivity analysis described in 7I.8.380.20 is not required if the entity already
prepares an analysis that reflects interdependencies between risk variables – e.g. a value at risk
(VAR) approach – and uses it to manage its financial risk. If the entity uses this analysis to fulfil its
disclosure requirements, then it explains the method used in preparing the analysis. This includes
the main parameters and assumptions underlying the data. Furthermore, the entity explains the
objective of the method used and any limitations that may result in the method not fully capturing
the risk exposure arising from the underlying assets and liabilities. If the entity applies VAR to only a
part of its financial instruments portfolio, then it provides a separate sensitivity analysis described in
7I.8.380.20 for those financial instruments not included in the VAR analysis. [IFRS 7.41, B20]

7I.8.380.60 In our view, the sensitivity analysis should include financial assets and financial
liabilities measured at amortised cost as well as those financial instruments measured at fair value.

7I.8.380.70 An entity provides a sensitivity analysis for the whole of its business – e.g. in the case
of a bank, this will include both its trading and its non-trading books. The entity may also provide
different types of analysis for different classes of financial instruments. [IFRS 7.B21]

7I.8.380.80 In our view, ‘translation risk’, arising from translating the financial statements of a
foreign operation into the presentation currency of the group, does not meet the definition of
currency risk as defined in IFRS 7. Consequently, in our view translation risk should not be included
in the sensitivity analysis on a consolidated basis. In our view, in consolidated financial statements
the sensitivity analysis should address each currency to which an entity in the group has significant
exposure based on each entity’s functional currency.

7I.8.380.90 When the functional currency of an entity is different from that of its foreign
operation, the resulting economic exposure can usually be hedged (see 7I.7.740). Therefore, in our
view an entity may include net investments in foreign operations in the sensitivity analysis in
consolidated financial statements if, and only if, that net investment has been hedged, and only to the
extent that it has been hedged.

7I.8.390 Other market risk disclosures

7I.8.390.10 If an entity believes that the sensitivity analysis is not representative of a risk
inherent in a financial instrument, then it discloses this fact and the reason why it believes that the
sensitivity analysis is unrepresentative. This may be the case, for example, when the year-end risk
exposure is not representative of the risk exposure during the year. [IFRS 7.42]

7I.8.390.20 Financial instruments that are classified as equity of the entity do not impact profit or
loss or equity, because they are not remeasured. Therefore, no sensitivity analysis is required. [IFRS
7.B28]

7I.8.395 Application by investment entities

7I.8.395.10 Investment entities are required to measure certain subsidiaries at FVTPL, rather
than consolidating them (see chapter 5.6). This includes circumstances in which an investment entity
is required to measure at fair value its investments in a subsidiary that is itself an investment entity
(see 5.6.200). [IFRS 10.31]

7I.8.395.15 In determining what to disclose, the investment entity parent considers the
disclosure objectives of IFRS 7, IFRS 12 (see 5.10.80) and IFRS 13 (see 2.4.533). In addition to the
disclosure requirements of these standards, an investment entity parent also considers whether to
provide disclosures about particular transactions, events or conditions that have an impact on the
financial statements. [IAS 1.31]

7I.8.395.20 An investment in a subsidiary that is measured at fair value is in the scope of IFRS 7
and may represent a significant concentration of risk. Furthermore, the parent may be directly or
indirectly exposed to risks arising from the subsidiary’s financial instruments; also, key management
of the parent and the subsidiary may be the same persons and use the same information for
managing the risks of both entities. [IFRS 7.3(a)]

7I.8.395.30 Depending on the facts and circumstances, the risk disclosures of the investment
entity parent may include information about risks arising from financial instruments held by an
investment entity subsidiary and be based on corresponding disclosures of the investment entity
subsidiary – for example:
• analysis of credit quality;
• concentration of risk;
• summarised interest rate gap analysis; and
• foreign currency risk.
EXAMPLE 7 – RISK DISCLOSURES OF THE FEEDER FUND

7I.8.395.40 Feeder Fund F, an open-ended investment fund, invests substantially

all of its assets in Master Fund M, another open-ended investment fund and which
has the same investment objectives as F. As at 31 December 2021, F owns 100% of
M (2020: 100%).

7I.8.395.50 M is primarily involved in investing in a highly diversified portfolio of

equity securities issued by companies listed on major stock exchanges, unlisted
 companies, unlisted investment funds, investment-grade debt securities and
derivatives, with the objective of providing investors in F with above-average
returns over the medium to long term.

7I.8.395.60 F is managed together with M as an integrated structure. Managing

the funds together also helps to ensure that cash flows from the underlying assets of
M match the redemption obligations of M – and ultimately of F. The pricing of the
shares in M held by F is based on M’s net asset value.

7I.8.395.70 F’s management decides that the objectives of IFRS 7 are met by
providing disclosures on:
• the amount and terms of its investment in – and the nature of its relationship with
– M;
• credit risk, interest rate risk, currency risk and other price risk of the underlying
investments held by M; and
• the liquidity risk of both M and F.

7I.8.400 TRANSFERS OF FINANCIAL ASSETS

7I.8.400.10 For the users of financial statements to understand the link between transferred
financial assets that are not derecognised in their entirety and the associated liabilities and the
nature of, and risks associated with, the entity’s continuing involvement in derecognised financial
assets, an entity discloses information on:
• transferred financial assets that are not derecognised in their entirety; and
• transferred financial assets that are derecognised in their entirety, in which the entity retains
continuing involvement. [IFRS 7.42A–42B]

7I.8.410 Disclosures for transfers of financial assets

7I.8.410.10 The following disclosures are required for each class of transferred assets that are
not derecognised in their entirety:
• the nature of the transferred assets;
• the nature of the risks and rewards associated with those assets to which the entity is exposed;
and
• the nature of the relationship between the transferred assets and the associated liabilities and the
restrictions on the entity’s use of those assets. [IFRS 7.42D(a)–(c)]

7I.8.410.20 Additional disclosures are required for each class of transferred assets that are not
derecognised in their entirety in the following circumstances:
• when the counterparty to the associated liabilities has recourse only to the transferred assets:
– the fair value of the transferred assets;
– the fair value of the associated liabilities; and
– the net position – i.e. the difference between the fair value of the transferred assets and the
associated liabilities;
• when the entity continues to recognise all of the transferred assets, the carrying amounts of the
transferred assets and associated liabilities; and
• when the entity continues to recognise the assets to the extent of its continuing involvement:
– the total carrying amount of the original assets before the transfer;
– the carrying amount of the assets that the entity continues to recognise; and
– the carrying amount of associated liabilities. [IFRS 7.42D(d)–(f)]
7I.8.410.30 The following disclosures are required for each type of continuing involvement in
transferred assets that are derecognised in their entirety:
• the carrying amounts and fair values of the assets and liabilities representing the entity’s
 continuing involvement;
• the location of the carrying amounts of those assets and liabilities in the statement of financial
position;
• the entity’s maximum exposure to loss from its continuing involvement, including how that
maximum exposure to loss has been determined;
• a maturity analysis of the undiscounted cash flows that may be payable to the transferee in
respect of those assets;
• the gain or loss on transfer and income and expense, both in the reporting period and
cumulatively, arising from the entity’s continuing involvement; and
• qualitative disclosures to explain and support the quantitative disclosures. [IFRS 7.42E, 42G(a)–(b)]

7I.8.410.40 In addition, if the total amount of proceeds from transfer activity is not evenly
distributed throughout the reporting period, then the following disclosures are required for each
type of continuing involvement in transferred assets that are derecognised in their entirety:
• the part within the reporting period to which the greatest transfer activity is attributable;
• the amount – e.g. related gains or losses – recognised from transfer activity in that part of the
reporting period; and
• the total amount of proceeds from transfer activity in that part of the reporting period. [IFRS
7.42G(c)]

7I.8.415 Scope of disclosure requirements on transfers of financial assets

7I.8.415.10 Entities often transfer financial assets to structured entities (see 7I.5.320). If
financial assets have been transferred to an unconsolidated structured entity, then disclosures
required by IFRS 12 may be appropriate in addition to disclosures of transfers of financial assets
required by IFRS 7. For further discussion of disclosures about structured entities, see
5.10.230–270.

7I.8.415.20 To assess what information on which financial assets needs to be disclosed, an entity
determines:
• which financial assets have been transferred;
• whether it has derecognised a transferred financial asset in its entirety; and
• whether it has continuing involvement in a transferred financial asset that it derecognised in its
entirety. [IFRS 7.42A, 42C, IAS 39.17–20]

7I.8.415.30 This is illustrated in the following flowchart.

 Has the entity transferred the financial asset?
(See 7I.8.420)

Yes

Is the financial asset derecognised in its entirety?

No Yes
No
All or a part of the transferred financial Does the entity have
asset continues to be recognised continuing involvement
and so is in the scope of disclosures in the transferred
on transferred financial assets that financial asset?
are not derecognised in their entirety (See 7I.8.440)

Yes No

Financial asset is in the scope of

disclosures on transferred financial
Financial asset is not in the scope of
assets that are derecognised in their
disclosures on transferred financial assets
entirety in which the entity has
continuing involvement

7I.8.415.40 The definition of ‘transfer’ and the concept of ‘continuing involvement’ for the
purposes of these disclosures are different from those in IAS 39 for the purpose of determining
whether a financial asset is derecognised (see 7I.5.60). [IFRS 7.42A, 42C, BC65S, IAS 39.17–20]

7I.8.420 Definition of a ‘transfer’

7I.8.420.10 For the purposes of the disclosures, an entity transfers all or a part of a financial
asset if it:
• transfers the contractual rights to receive the cash flows of that asset; or
• retains the contractual rights to receive cash flows and assumes a contractual obligation to pay
these cash flows to one or more recipients. Such an arrangement is a transfer for the purposes of
the disclosure requirements even if it does not comply with the pass-through requirements of IAS
39 and would not therefore be considered a transfer under IAS 39 (see 7I.5.160). [IFRS 7.42A]

7I.8.430 Identifying contractual obligation to pay cash flows of asset

7I.8.430.10 A transfer is subject to the disclosure requirements in IFRS 7 for transfers of
financial assets if the entity retains the contractual rights to receive the cash flows of a financial
asset but assumes a contractual obligation to pay the cash flows to one or more recipients in an
arrangement. The purpose of these disclosure requirements is to provide users of financial
statements with a better understanding of the relationship between the transferred financial assets
and the associated liabilities. Therefore, in our view there should be a direct (explicit or implicit) link
between the cash receipts on specified financial assets that the entity owns and the obligation to
remit the cash receipts to another party, in order for the arrangement to be considered a transfer
subject to these disclosure requirements. [IFRS 7.BC65E]

7I.8.430.20 In arrangements that do not involve structured entities (see 5.10.190), the legal
documentation may directly identify the assets and cash receipts that are being referenced and
explicitly set out the requirements for directly passing through cash flows when an amount is
received on the specified financial asset. This may make the analysis of such transactions relatively
straightforward.

7I.8.430.30 In some cases, an arrangement may require the entity to make payments based on
the performance of an underlying financial asset, whereby there is no link between the cash receipts
on specified financial assets that the entity owns and the obligation to pay cash. We do not believe
that such an arrangement is subject to the disclosure requirements on transfers of financial assets.
Examples of arrangements that we believe are not subject to the disclosure requirements in IFRS 7
include:
• credit-linked notes in which payments are referenced to the default of specified assets that an
entity is not required to own; and
• equity-linked notes and total return swaps in which payments are referenced to the fair value of –
but not receipts from – underlying financial assets.

7I.8.430.40 In our view, all of the terms of an arrangement should be considered in determining
whether it is subject to the disclosure requirements on transfers of financial assets. Arrangements
involving consolidated structured entities may be more complex. Notes issued by these entities
might not themselves directly reference specific cash receipts or financial assets. However, the
governing terms of the overall arrangement may indicate that the structured entity owns specified
financial assets and that, as a result of a ‘waterfall’ or a similar arrangement, notes issued to third
parties represent an obligation to pass on cash receipts from those assets to the note holders.

7I.8.430.50 To qualify as a pass-through arrangement under IAS 39 (see 7I.5.160), cash receipts
need to be remitted to the eventual recipients without material delay and may only be reinvested in
cash and cash equivalents before being paid on. In our view, these strict criteria do not apply in
determining whether an arrangement is a transfer subject to the disclosure requirements in IFRS 7.
Accordingly, an arrangement that does not meet the strict criteria in IAS 39 may be subject to the
disclosure requirements on transfers of financial assets.

7I.8.430.60 Judgement may be involved in distinguishing between:

• an obligation to pass on cash flows from specified financial assets that is subject to the transfer of
financial assets disclosure requirements; and
• interests in or linked to investment funds issued by the reporting entity that are not subject to
these disclosure requirements.

7I.8.430.70 In typical mutual or unit-linked fund structures, investors hold instruments that are
redeemable based on the value of assets in the fund. In these cases, cash flows are collected from
existing assets. Assets may also be sold to generate cash proceeds. An entity is not required to pay
these amounts to investors but instead cash received by the fund is reinvested in different assets.
Cash payments are made to investors in accordance with the entity’s dividend policies and when
investors redeem their investment in the fund. In our view, in these circumstances, the nature of the
arrangement results in a financial liability that is indexed to the value of a moving pool of assets that
the entity manages, rather than in an obligation to pass on the cash flows of specified financial assets
when they are received. Consequently, we believe that the arrangement is not subject to the
disclosure requirements on transfers of financial assets.

7I.8.430.80 Similarly, in our view, in certain arrangements – e.g. complex arrangements involving
consolidated structured entities, other entities in the consolidated group and external holders of
instruments issued by the structured entity – judgement may be required to determine whether the
arrangement results in:
• an obligation to pass on cash flows from specified financial assets held within the structured
entity that is subject to the transfer of financial assets disclosure requirements; or
• a general obligation for which assets held within the structured entity act only as a form of
collateral. In this case, the collateral is subject to the collateral disclosure requirements (see
7I.8.160); but we believe that the disclosure requirements in respect of transfers of financial
assets do not apply to the arrangement.

7I.8.430.90 In our view, factors that may affect this judgement include the following:
• the purpose and design of the structured entity;
• the extent of recourse to the transferor’s wider group;
• the nature and extent of differences between the cash flow profile of beneficial interests issued by
 the structured entity and the cash flow profile of financial assets held in the structured entity; and
• rights to substitute financial assets held within the structured entity.

7I.8.440 Continuing involvement

7I.8.440.10 For the purposes of the disclosures, an entity has continuing involvement in a
transferred financial asset if, as part of the transfer, it retains any of the contractual rights or
obligations relating to the transferred financial assets or obtains any new contractual rights or
obligations relating to those assets. Continuing involvement may result from contractual provisions
in the transfer agreement or in a separate agreement entered into with the transferee or another
party in connection with the transfer. Normal representations and warranties, contracts to reacquire
the transferred financial asset at fair value, and a qualifying pass-through arrangement under IAS 39
do not constitute continuing involvement. [IAS 39.19, IFRS 7.42C, B31]

7I.8.440.20 An entity does not have continuing involvement for disclosure purposes in a
transferred financial asset if it has neither an interest in the future performance of the transferred
financial asset nor a responsibility under any circumstances to make payments in respect of the
transferred financial asset in the future, other than paying on cash flows of the transferred asset that
an entity collects and is required to transfer to the transferee. [IFRS 7.B30]

7I.8.440.30 In many cases, entities (especially financial institutions) retain the right or obligation
to service, for a fee, transferred financial assets that qualify for derecognition in their entirety. These
servicing arrangements represent continuing involvement for the purposes of the disclosures on
transfers of financial assets if the conditions in 7I.8.440.10–20 are met. A servicer has continuing
involvement in a transferred asset (for the purposes of the disclosure requirements) if it has an
interest in the future performance of the transferred assets – e.g. if the servicing fee is dependent on
the amount or timing of the cash flows from the transferred assets, or a fixed servicing fee would not
be paid in full if the transferred assets do not perform. [IFRS 7.42C, B30–B30A]

7I.8.450 Interactions between derecognition requirements in IAS 39 and

disclosure requirements in IFRS 7

7I.8.450.10 Some of the interactions between the application of the IAS 39 derecognition
requirements and the IFRS 7 disclosure requirements are illustrated in the table below.
• The first column relates to the financial asset that is being considered for derecognition – it could
be either the entire financial asset or an eligible part.
• The second column relates to whether the financial asset is derecognised under IAS 39.
• The third and fourth columns indicate whether IFRS 7’s disclosure requirements for either:
– transferred financial assets that are not derecognised in their entirety; or
– transferred financial assets that are derecognised in their entirety apply in the circumstances
described. [IFRS 7.42A, 42C, IAS 39.17–20]
FACT PATTERN DERECOGNITION IN LINE IN SCOPE OF IFRS 7 DISCLOSURE
WITH IAS 39? REQUIREMENTS FOR TRANSFERRED
FINANCIAL ASSETS THAT ARE

NOT DERECOGNISED IN
DERECOGNISED IN THEIR ENTIRETY?
THEIR ENTIRETY?

Entity retains the No; the entity Yes No

contractual rights to receive continues to
the cash flows of the recognise the
financial asset, but assumes financial asset in its
a contractual obligation to entirety.
pay these cash flows to a
third party in a way that
does not comply with the
pass-through requirements
of IAS 39.

FACT PATTERN DERECOGNITION IN LINE IN SCOPE OF IFRS 7 DISCLOSURE

WITH IAS 39? REQUIREMENTS FOR TRANSFERRED
FINANCIAL ASSETS THAT ARE

NOT DERECOGNISED IN
DERECOGNISED IN THEIR ENTIRETY?
THEIR ENTIRETY?

Entity transfers the No; the entity Yes No

financial asset in a way that continues to
meets the definition of recognise the
transfer in IAS 39 but financial asset in its
retains substantially all the entirety.
risks and rewards of the
transferred financial asset.

Entity transfers the Yes; the financial No Yes; it retains

financial asset in a way that asset is derecognised continuing
meets the definition of in its entirety. involvement in
transfer in IAS 39 but the transferred
neither transfers nor retains financial asset
substantially all the risks because the
and rewards of the entity neither
transferred financial asset transfers nor
and does not retain control retains
of the asset. substantially all
the risks and
rewards of the
transferred
financial asset.

Entity transfers the The financial asset Yes No

financial asset in a way that continues to be
 meets the definition of recognised to the
transfer in IAS 39 but extent of the entity’s
neither transfers nor retains continuing
substantially all the risks involvement in the
and rewards of the asset.
transferred financial asset
and retains control of the
asset.

Entity transfers the Yes; the financial No Yes; it retains

financial asset in a way that asset is derecognised continuing
meets the definition of in its entirety. involvement
transfer in IAS 39 and because it
transfers substantially all retains an
the risks and rewards of the insignificant
transferred financial asset portion of the
but retains an insignificant risks and
portion of the risks and rewards.
rewards.

7I.8.460 Transferred financial asset

7I.8.460.10 When applying the disclosure requirements, the term ‘transferred financial asset’
refers to all or a part of a financial asset. Therefore, when an entity transfers a part of a financial
asset, its evaluation of whether and which disclosures are required depends on:
• whether that part is derecognised in its entirety; and
• whether the entity retains continuing involvement in that part. [IFRS 7.42A, 42D–42E, B32]

EXAMPLE 8A – APPLICATION OF DISCLOSURES TO PROPORTION OF FINANCIAL ASSET (1)

7I.8.460.20 An entity transfers the contractual rights to only a fully proportionate

share of 40% of the cash flows of a financial asset – i.e. the derecognition guidance
in IAS 39 is applied to that part of the financial asset. This fully proportionate 40%
share is not derecognised in its entirety because the transfer does not meet the IAS
39 requirements for full derecognition of that part. In this case, the fully
proportionate 40% share is subject to the disclosure requirements for transferred
financial assets that are not derecognised in their entirety.

EXAMPLE 8B – APPLICATION OF DISCLOSURES TO PROPORTION OF FINANCIAL ASSET (2)

7I.8.460.30 Conversely, if this fully proportionate 40% share of a financial asset

met the derecognition criteria in IAS 39 and the entity retained continuing
involvement in that derecognised part, then the fully proportionate 40% share
would be subject to the disclosure requirements for transferred financial assets that
are derecognised in their entirety but for which the entity retains continuing
involvement.

7I.8.460.35 In both Examples 8A and 8B, the fully proportionate 60% share that
has not been transferred is not in the scope of the disclosure requirements because
it has not been transferred. [IFRS 7.42A, 42E]

7I.8.460.40 A more complex question relates to transfers of some, but not all, of the cash flows of
a financial asset, when these transferred cash flows are not a part that meets the criteria for
separate derecognition analysis in paragraph 16(a) of IAS 39 (see 7I.5.80.30–150). Although
paragraph 16 of IAS 39 requires the derecognition guidance in IAS 39 to be applied to a part only if
that part meets specified criteria, it does not define a ‘part’ of a financial asset for the purposes of the
IFRS 7 transfer disclosures. Therefore, in our view an obligation to pay some of the cash flows from a
financial asset should be considered a transfer for the purposes of these disclosures even if the cash
flows passed on do not meet the criteria in paragraph 16(a) of IAS 39.

7I.8.460.50 If the part of a financial asset that is transferred does not meet the criteria in
paragraph 16(a) of IAS 39, then in our view an entity can satisfy the disclosure requirements in
respect of the carrying amounts of transferred assets (see 7I.8.410.20) by disclosing the carrying
amount of the entire asset or by applying a reasonable allocation methodology, together with such
additional explanation as may be appropriate in the circumstances.

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