ISDA
International Swaps and Derivatives Association, Inc.
ISDA Workshop – The practical
implications of the new
accounting rules
24 January 2005
0
ISDA
“Standard’s rules may obscure the true picture”
(FT,Jan)
“Companies “face hedging errors” (FT, Dec)
“IFRS für alle? - Viele Mittelständler zögern noch”
(Handesblat, Jan)
“Rule changes put Vodafone in the black” (Evening
Standard, Jan 05)
“IAS, L’adeguamento colpisce ali oneri” (Sole 24 Ore
Jan)
“Les nouvelles normes comptables, frien potential aux
introductions en Borse” (Les Echos, Jan)
1
ISDA
IFRS and their significance
• What are IFRS and where do they come from?
• Importance in the short term
(i) EU adoption
(ii) Rest of the world
(iii) Local GAAP convergence
• Long term significance
(i) FASB/IASB Convergence project
(ii) SEC/US Senate
(iii) Impact on local GAAP (influence on FASB)
2
ISDA
IFRS – Key standards for financial
instruments accounting
IAS 39: - Recognition and measurement of financial assets and
liabilities;
- Treatment of certain other non-financial items eg,
commodity contracts;
- Derecognition of financial assets and liabilities
IAS 32: - Presentation of financial instruments from the perspective
of the issuer;
- Provides detailed rules covering netting;
- Requires disclosures to enable a user to understand
significance of financial instruments to an entity’s financial
position
SIC 12: - Consolidation of Special Purpose Entities
IFRS 4: - Insurance contracts
IAS 37: - Provisions, contingent liabilities and contingent assets
3
ED-7:
- Financial Instruments: Disclosures
ISDA
The measurement categories
Category
Loans and
receivables
Held to maturity
(HTM)

Held at Fair Value
Through Profit &
Loss
(FVTPL)

to profit and loss
Available for sale
(AFS)

Non-trading
liabilities
•
4
Fair value

to equity – unless
impaired

Cost / amortised cost

At effective yield

At effective yield
Only if FV cannot be
reliably measured (very
limited – use only for
unquoted equity
instruments and
derivatives thereon)
(as above)

IAS 39 includes an option to designate ANY financial instrument at fair value
at inception
ISDA
Hedge accounting
• Since all derivatives need to be recorded at fair
value, but items they “hedge” may not
• Extremely complex
• Based on US GAAP but not the same
5
ISDA
Fair Value Measurement
• Defined as:
“The amount for which an asset could be
exchanged, or a liability settled, between
knowledgeable, willing parties in an arms length
transaction”
• It is not the amount that an entity would receive or
pay in a forced transaction or distressed sale
• Active v non-active markets
• Includes assessment of credit
6
ISDA
Consolidation and Derecognition
• Significant differences from the previous IAS 39
and US GAAP
• Risks and rewards are given more weight than
control
7
ISDA
Presentation
• IAS 32 rules are different from US GAAP
• Debt v equity
• Derivatives on own equity
• Offset rules
8
ISDA
IFRS: Analysis and Impact
9
ISDA
The measurement categories
Category
Loans and
receivables
Held to maturity
(HTM)
Held at fair value
through profit & loss
(FVTPL)
Available for sale
(AFS)
Non-trading
liabilities
10
Fair value



to profit and loss
(includes all derivatives
except effective
hedges)

to equity – unless
impaired

Cost / amortised cost

At effective yield

At effective yield
Only if FV cannot be
reliably measured (very
limited – use only for
unquoted equity
instruments and
derivatives thereon)
(as above)

ISDA
The measurement categories
• Increased volatility of earnings and equity
• As with US GAAP, banned from using HTM if sell or
reclassify, but with two year limit
• IAS 39 includes an option to designate ANY
financial instrument to be held at fair value through
profit or loss at inception
• But resistance from banking regulators. European Union
has forbidden such designation for liabilities
• IASB has issued ED and now new proposals to restrict the
option, to try to placate regulators and the EU
• Rules on embedded derivatives similar to US
GAAP, with no “grandfathering”
11
ISDA
Hedge accounting – similar to US
GAAP
• Originally based on FAS 133
• Similar need to designate, demonstrate
effectiveness and document
• Similar restrictions on what can be treated as a
hedge and what can be hedged
• Similar concepts of fair value hedge and cash flow
hedge
• Leading to p/l volatility where hedge fails to qualify
for hedge accounting or ineffectiveness, and equity
volatility for cash flow hedges
12
ISDA
Hedge accounting – differences
from US GAAP
• No “short cut” method. Need instead to demonstrate
effective and record ineffectiveness
• But allowed to hedge a “component”, eg LIBOR risk on debt
without necessarily any ineffectiveness
• Items can be hedged for part of their term under IAS 39
• Wider use of non-derivative assets and liabilities as FX
hedges
• Macro hedging models – both cash flow and fair value – but
not possible to include demand deposits in fair value macro
hedge. Opposition led to EU “carve out” of constraints on
fair value macro hedging. Discussions continue
• Intragroup FX hedges – still under debate
13
ISDA
Fair Value Measurement
• Active markets –where “quoted prices are readily
and regularly available” and “represent actual and
regularly occurring market transactions”
• Must use quoted price
• Allows for valuation on a portfolio basis
• Other reserves necessary to adjust to fair value are
acceptable (with the exception of block discounts)
• Markets with quoted rates are considered active,
even though rates are an input to a model
14
ISDA
Fair Value Measurement (cont)
• Non-active market – models that are commonly
used by the market are considered appropriate for
valuing financial instruments
• “Day one profit” can be recognised only if all inputs
to a model are observable in the market – similar to
US EITF 02/03, but choice of transition date
– Fully retroactive
– 25 October 2002
– 1 January 2004
• IASB has so far not given significant guidance on
when day one profit can subsequently be
recognised
15
ISDA
Consolidation and Derecognition
Consolidation Principles (SIC 12)
• An enterprise should consolidate enterprises it controls
• Control of SPEs is determined by considering
–
Who benefits
–
Who has the control to obtain the majority of the benefits
–
Who has the majority of the risks and rewards
• This is not the same as FIN 46
• There is no concept of a “Q”
Derecognition Principles (IAS 39)
•
Applied to transferor’s consolidated group, including SPEs if
consolidated
•
Mixed model, based on both risks and rewards and control.
16
ISDA
Consolidation and Derecognition
Consolidate subsidiaries (including SPEs)
Yes
No
Has entity transferred its right to receive cash flows?
No
Has entity assumed obligation
to pass through cash flows?
No
Don’’ttderecognise
derecognise
Don
Yes
Has entity transferred substantially all risks/rewards?
Yes
Derecognise
Derecognise
Yes
Don’’ttderecognise
derecognise
Don
No
Has entity retained substantially all risks/rewards?
No
Has entity retained control of the assets?
No
Derecognise
Derecognise
Yes
Continue
to recognisethe
theassets
assets to
Continue
to recognise
to
extent of continuing involvement
17
IAS 39 AG36
ISDA
Consolidation and Derecognition
• There are no “grandfathering” rules for SIC 12
• Many securitisations, including most securitisations
of short term assets will not achieve “off balance
sheet” presentation
• Otherwise, derecognition rules do not need to be
applied to transactions pre 1 January 2004
18
ISDA
Presentation – Debt v Equity
• Many instruments that are equity in legal form are
treated as liabilities under IAS 32– eg most
preference shares, and many fund units
• Some instruments have both a liability and equity
component – eg convertible bonds. The fair value
of the liability is initially recorded in the liability
section of the balance sheet and the “plug” in
equity
• Complex rules for derivatives on own shares
19
ISDA
Presentation –Netting
• Financial assets and liabilities may only be offset in the
balance sheet when there is both:
-
a legal, enforceable right of set-off; and
an intention to exercise the right or settle
simultaneously
• An ISDA master agreement will not meet these criteria
if the set-off rights are contingent upon default or other
circumstances expected to arise outside of the normal
course of business
• This treatment is not consistent with US GAAP, where
master netting agreements such as an ISDA are
explicitly allowed for netting purposes, even if the
netting would only be done upon a contingent event
20
ISDA